Managerial economics

Managerial Economics

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Karnataka State Open University

(KSOU) was established on 1st June 1996 with the assent of H.E. Governor of Karnataka

as a full fledged University in the academic year 1996 vide Government notification

No/EDI/UOV/dated 12th February 1996 (Karnataka State Open University Act – 1992).

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Unit 1- Meaning And Importance Of Managerial Economics

Introduction

Economics is a growing subject. Many new branches have been developed by various economists from

time to time to meet the requirements of the Time. One such new addition is Managerial Economics. It

is interesting to study the reasons for the emergence of this new branch of economics. In the last few

decades all over the world business has expanded and diversified at a fast rate. Variety of goods and

services unheard of so far have been developed. Wide-ranging changes have taken place both in the

scope and the modes of business operation. Government interference in business has become very

common in all nations. Side by side, the business world has become increasingly complex, challenging

and competitive in recent years. Business uncertainties and fluctuations have become the order of the

day. The traditional micro economic theories have failed to offer solutions to the problems faced by

business units today. In order to help the business executives to solve their business and managerial

problems, a new branch of economics now popularly known as managerial economics has been

developed by modern economists.

Learning Objective 1:

Learn the meaning and special features of managerial econamic

Meaning

Managerial economics is a science that deals with the application of various economic theories,

principles, concepts and techniques to business management in order to solve business and

management problems. It deals with the practical application of economic theory and methodology to

decision-making problems faced by private, public and non-profit making organizations.

The same idea has been expressed by Spencer and Seigelman in the following words. “Managerial

Economics is the integration of economic theory with business practice for the purpose of facilitating

decision making and forward planning by the management”.According to Mc Nair and Meriam,

“Managerial economics is the use of economic modes of thought to analyze business situation”.

Brighman and Pappas define managerial economics as,” the application of economic theory and

methodology to business administration practice”.Joel dean is of the opinion that use of economic

analysis in formulating business and management policies is known as managerial economics.


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Managerial economics is a highly specialized and new branch of economics developed in recent years. It

highlights on practical application of principles and concepts of economics in to business decision

making process in order to find out optimal solutions to managerial problems. It fills up the gap between

abstract economic theory and managerial practice. It lies mid-way between economic theory and

business practice and serves as a connecting link between the two.

Features of managerial Economics

1. It is a new discipline and of recent origin

2. It is a highly specialized and separate branch by itself.

3. It is basically a branch of microeconomics and as such it studies the problems of only one

firm in detail.

1. It is mainly a normative science and as such it is a goal oriented and prescriptive science.

2. It is more realistic, pragmatic and highlights on practical application of various economic

theories to solve business and management problems.

1. It is a science of decision-making. It concentrates on decision-making process, decision-

models and decision variables and their relationships.

1. It is both conceptual and metrical and it helps the decision-maker by providing measurement

of various economic variables and their interrelationships.

2. It uses various macro economic concepts like national income, inflation, deflation, trade

cycles etc to understand and adjust its policies to the environment in which the firm operates.

3. It also gives importance to the study of non-economic variables having implications of economic

performance of the firm. For example, impact of technology, environmental forces, socio-

political and cultural factors etc.

4. It uses the services of many other sister sciences like mathematics, statistics, engineering,

accounting, operation research and psychology etc to find solutions to business and

management problems.

It should be clearly remembered that Managerial Economics does not provide ready-made solutions to

all kinds of problems faced by a firm. It provides only the logic and methodology to find out answers and

not the answers themselves. It all depends on the manager’s ability, experience, expertise and


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intelligence to use different tools of economic analysis to find out the correct answers to business

problems.

Learning objective – 2

SCOPE OF MANAGERIAL ECONOMICS

The term “scope” indicates the area of study, boundaries, subject matter and width of a subject.

Business economics is comparatively a new and upcoming subject. Consequently, there is no

unanimity among different economists with respect to the exact scope of business economics.

However, the following topics are covered in this subject.

1. OBJECTIVES OF A FIRM

Profit maximization has been considered as the main objective of a business unit in olden days.

But in the context of present day business environment, many new objectives have come to the

fore. Today, there are multiple objectives and they are multi dimensional in nature. Some of

them are competitive while others are supplementary in nature. A few others are inter-connected

and a few others are opposing in nature. There are economic, social, organizational, human, and

national goals. There are managerial and behavioral theories. All the objectives are determined

by various factors and forces like corporate environment, socio-economic conditions, and nature

of power in the organization and external constraints under which a firm operates. In the midst of

several objectives, the traditional profit maximization objective even today has a very high place.

All other policies and programmes of a firm revolve round this objective. However, a firm aims

at profit- optimization rather than profit maximization today.

2. DEMAND ANALYSIS AND FORECASTING

A firm is basically a producing unit. It produces different kinds of goods and services. It has to

meet the requirements of consumers in the market. The basic problems of what to produce,

where to produce, for whom to produce, how to produce, how much to produce and how to

distribute them in the market are to be answered by a firm. Hence, it has to study in detail the

various determinants of demand, nature, composition and characteristics of demand, elasticity of

demand, demand distinctions, demand forecasting and so on. The production plan prepared by a

firm should take all these points into account.

3. PRODUCTION AND COST ANALYSIS


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Production implies transformation of inputs into outputs. It may be either in physical or

monetary terms. The physical production deals with how output is to be produced by a firm by

employing different factor inputs in proper proportions. Maximization of output is one of the

basic goals of a firm. Production analysis deals with production function, laws of returns, returns

to scale, economies of scale, etc. Production cost is concerned with estimation of costs to

produce a given quantity of output. Cost controls, cost reduction, cost cutting and cost

minimization receive top most priority in production and cost analysis. Maximization of output

with minimum cost is the basic slogan of any firm. Cost analysis deals with the study of various

cost concepts, their classification, cost-output relationship in the short run and long run.

4. PRICING DECISIONS, POLICIES AND PRACTICES

Pricing decision is related to fixing the prices of goods and services.This depends on the pricing

policy and practices adopted by a firm. Price setting is one of the most important policies of a

firm. The amount of revenue, the level of income and above all the volume of profits earned by a

firm directly depend on its pricing decisions. Hence, we have to study price-output determination

under different market conditions, objectives and considerations of pricing policies, pricing

methods, practices, policies etc. we also study price forecasting, marketing channel, distribution

channel, sales promotion policies etc.

5. PROFIT MANAGEMENT

A firm is basically a commercial or business unit. Consequently, the success or failure of it is

measured in terms of the amount of profit it is able to earn in a competitive market. The

management gives top most priority to this aspect. Under profit management, one has to study

various theories of profit, emergence of profit, functions of profit, and its measurement, profit

policies, techniques, profit planning, profit forecasting and Break Even Point etc.

6. CAPITAL MANAGEMENT

It is another crucial area of business.Success of any business depends on adequate capital

investment and its proper management. Basically one has to study the cost of employing capital

and the rate of return expected from each and every project. It is cost-benefit analysis. Under

capital management, one has to study capital requirement, methods of capital mobilization,

capital budgeting, optimal allocation of capital, selection of highly profitable projects, cost of

capital, return on capital, planning and control of capital expenditure etc.

7. LINEAR PROGRAMMING AND THE THEORY OF GAMES


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The term linear means that the relationships handled are the same as those represented by

straight lines and programming implies systematic planning or decision-making. It implies

maximization or minimization of a linear function of variables subject to a constraint of linear

inequalities. It offers actual numerical solution to the problems of making optimum choices. It

involves either maximization of profits or minimization of costs.

The theory of games basically attempts to explain what is the rational course of action for an

individual firm or an entrepreneur who is confronted with the a situation where in the outcome

depends not only on his own actions, but also on the actions of others who are also confronted

with the same problem of selecting a rational course of action. In short, under the conditions of

conflicts and uncertainty, a firm or an individual faces problem similar to that of the player of

any game. Both these techniques are extensively used in business economics to solve various

business and managerial problems.

8. MARKET STRUCTURE AND CONDITIONS

The knowledge of market structure and conditions existing in various kinds of markets are of

great importance in any business. The number of sellers and buyers, the nature, extent and degree

of competition etc determines the nature of policies to be adopted by a firm in the market.

9. STRATEGIC PLANNING

It provides a framework on which long term decisions can be made which have an impact on the

behavior of the firm. The firm sets certain long-term goals and objectives and selects the strategy

to achieve the same. It is now a new addition to the scope of business economics with the

emergence of MNCs. The perspective of strategic planning is global. In fact, the integration of

business economics and strategic planning has given rise to a new area of study called corporate

economics.

10. OTHER AREAS

1. Macroeconomic management of the country relating to economic system, national

income, trade cycles Savings and investments and its impact on the working of a firm.

1. Budgetary operations of the government and its implications on the firm

2. Knowledge and information about various government policies like monetary, fiscal,

physical, industrial, labor, foreign trade, foreign capital and technology, MNCs etc and

their impact on the working of a firm.


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1. Impact of liberalization, globalization, privatization and marketization on the

operations of firm.

3. Impact of international changes, role of international financial and trade institutions in

formulating domestic polices of a firm.

1. Problems of environmental degradation and pollution and its impact on the

policies of a firm.

2. Improvements in the field of science and technology and its impact on a firm etc

3. Socio-political, cultural and other external forces and their influence of business

operations.

Thus it is clear that the scope of managerial economics is expanding with the growth of

modern business and business environment.

Importance of the study of Managerial Economics

Managerial Economics does not give importance to the study of theoretical economic concepts. Its main

concern is to apply theories to find solutions to day –to-day practical problems faced by a firm. The

following points indicate the significance of the study of this subject in its right perspective.

1. It gives guidance for identification of key variables in decision-making process.

2. It helps the business executives to understand the various intricacies of business and managerial

problems and to take right decision at the right time.

3. It provides the necessary conceptual, technical skills, toolbox of analysis and techniques of

thinking and other such most modern tools and instruments like elasticity of demand and

supply, cost and revenue, income and expenditure, profit and volume of production etc to solve

various business problems.

4. It is both a science and an art. In the context of globalization, privatization, liberalization and

marketization and a highly competitive dynamic economy, it helps in identifying various

business and managerial problems, their causes and consequence, and suggests various policies

and programs to overcome them.

5. It helps the business executives to become much more responsive, realistic and competent to

face the ever changing challenges in the modern business world.

6. It helps in the optimum use of scarce resources of a firm to maximize its profits.

7. It also helps in achieving other objectives a firm like attaining industry leadership, market share

expansion and social responsibilities etc.

8. It helps a firm in forecasting the most important economic variables like demand, supply, cost,

revenue, price, sales and profit etc and formulate sound business polices

9. It also helps in understanding the various external factors and forces which affect the decision-

making of a firm.

Thus, it has become a highly useful and practical discipline in recent years to analyze and find

solutions to various kinds of problems in a systematic and rational manner.



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Knowledge of decision making and forward planning

Managerial Economist is a specialist and an expert in analyzing and finding answers to business and

managerial problems. He has in-depth knowledge of the subject. He is an authority and has total

command over his subject.

A Managerial Economist has to perform several functions in an organization. Among them, decision-

making and forward planning are described as the two major functions and all other functions are

derived from these two basic functions. A detailed description of the two functions is given below for a

understanding.

1. Decision-making

The word ‘decision’ suggests a deliberate choice made out of several possible alternative courses of

action after carefully considering them. The act of choice signifying solution to an economic problem is

economic decision making. It involves choices among a set of alternative courses of action.

Decision-making is essentially a process of selecting the best out of many alternative opportunities or

courses of action that are open to a management.

Decision-making is a management function. Decision-making is a routine affair in any business unit.

Hence, it is a part of business activity. It is a basic function of a managerial economist. In the day-to-day

business, he has to take innumerable decisions. Sometimes the manager takes the decision himself,

sometimes in collaboration and consultations with others. Some decisions are taken on the spot and

some others are taken after careful thinking. Some decisions are major and complex while others are

minor and simple. Some decisions are taken in the absence of any information. Some decisions are

taken in the background of certainty, known factors and information. Some other decisions are taken in

the midst of uncertainties.

The choice made by the business executives are difficult, crucial and have far-reaching consequences.

The basic aim of taking a decision is to select the best course of action which maximizes the economic

benefits and minimizes the use of scarce resources of a firm. Hence, each decision involves cost-benefit

analysis. Any slight error or delay in decision making may cause considerable economic and financial

damage to a firm. It is for this reason, management experts are of the opinion that right decision –

making at the right time is the secret of a successful manager.

2. Forward planning

The term ‘planning’ implies a consciously directed activity with certain predetermined goals and

means to carry them out. It is a deliberate activity. It is a programmed action. Basically planning is

concerned with tackling future situations in a systematic manner.


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Forward planning implies planning in advance for the future. It is associated with deciding the future

course of action of a firm. It is prepared on the basis of past and current experience of a firm. It is

prepared in the background of uncertain and unpredictable environment and guess work. Future events

and happenings cannot be predicted accurately. The success or failure of the future plan depends on a

number of factors and forces which are unknown in nature. Much of economic activity is forward

looking. Every time we build a new factory, add to the stocks of inputs, trucks, computers or

improvements in R&D, our intension is to enhance the future productivity of the firm. Growing firms

devote a significant share of their current output to net capital formation to bolster future economic

output. A business executive must be sufficiently intelligent enough to think in advance, prepare a

sound plan and take all possible precautionary measures to meet all types of challenges of the future

business. Hence, forward planning has acquired greater significance in business circles.

Summary

Managerial economics is a new and a highly specialized branch of economics. It brings together

economic theory and business practice. It assists in applying various economic theories and principles to

find solutions to business and management problems.

It is applied economics and makes an attempt to explain how various economic concepts are

usefully employed in business management. It is a practical subject. It opens up the mind of a

managerial economist to the complex and highly challenging business world. The features of

managerial economics throw light on the nature of the emerging subject and the scope gives

information about the wide coverage of the subject. The concepts of decision- making and

forward planning are the two basic functions of a managerial economist. In a way the entire

subject matter of managerial economics is to be understood in the background of these two

functions

Self Assessment Questions 1

1. Managerial Economics is the integration of________ with ____ for solving business and

management problems.

2. Managerial Economics fills up the gap between _______ and _______.

3. Managerial Economics is mainly a ______ science.

4. Basic objective a firm to day is ________.

5. Managerial Economic is basically a branch of __ economics.

6. Two major function of a Managerial Economic are ______ and ______.


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Terminal Questions

1. Define Managerial Economic and explain its main characteristics.

2. Discuss the scope of Managerial Economics

3. Explain the importance of Managerial Economics

4. Discuss the functions of a Managerial Economist

Answer to SAQs and TQs

Answer for Self Assessment Questions 1

1. Economic theory, Business Practice

2. Economic theory Practice.

3. Prescriptive

4. Profit optimization

5. Micro

6. Decision- making Forward Planning

Answer to Terminal Questions)

1. Refer to unit 1.2




Unit- 2 Demand Analysis

Introduction

Demand and Supply are the two main concepts in Economics. Experts are of the opinion that

entire subject of economics can be summarized in terms of these two basic concepts. Hence the

knowledge about demand and supply are of great importance to a student of Economics.


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Learning Objective- 1

Understand the concept of demand and its features.

The term demand is different from desire, want, will or wish. In the language of economics,

demand has different meaning. Any want or desire will not constitute demand

Demand = Desire to buy

+ Ability to pay

+ Willingness to pay

The term demand refers to total or given quantity of a commodity or a service that are

purchased by the consumer in the market at a particular price and at a particular time

The following are some of the important qualifications of demand-

• It is backed up by adequate purchasing power.

• It is always at a price.

• It should always be expressed in terms of specific quantity

• It is created in the market.

• It is related to a person, place and time.

Consumers create demand. Demand basically depends on utility of a product. There is a direct

relation between the two i.e., higher the utility, higher would be demand and lower the utility,

lower would be the demand.

Learning objective -2

Knowledge of demand schedule , law of demand , exceptions to the law of demand and shifts in

demand

The demand schedule explains the functional relation ship between price and quantity variations, It is a

list of various amounts of a commodity that a consumer is willing to buy (and so seller to sell) at

different prices at one instant of time. It is necessary to note that the demand schedule is prepared

with reference to the price of the given commodity alone. We ignore the influence of all other

determinants of demand on the purchase made by a consumer. The following individual

demand schedule shows that people buy more when price is low and buy less when price is high.


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Market Demand Schedule

When the demand schedules of all buyers are taken together, we get the aggregate or market demand

schedule. In other words, the total quantity of a commodity demanded at different prices in a market

by the whole body consumers at a particular period of time is called market demand schedule. It

refers to the aggregate behavior of the entire market rather than mere totaling of individual demand

schedules. Market demand schedule is more continuous and smooth when compared to an individual

demand schedule.

The study of the market demand schedule is of great importance to a business manager on account of

the following reasons:

1. It helps to make an intelligent forecast of the quantity to be sold at different prices.

2. It helps the business executives to know the various quantities that are likely to be demanded at

different prices.

3. It helps to study the effect of taxes on the total demand for goods in the market.

4. It helps to forecast the percentage of profits due to variation in prices and to arrange production

well in advance.


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5 It helps the monopolist to manipulate prices to stimulate demand for a product.

6. It helps the managers to estimate its production plan in accordance with the market demand.

Demand Curve

A demand curve is a locus of points showing various alternative price – quantity combinations. In short,

the graphical presentation of the demand schedule is called as a demand curve.

It represents the functional relationship between quantity demanded and prices of a given commodity.

The demand curve has a negative slope or it slope downwards to the right. The negative slope of the

demand curve clearly indicates that quantity demanded goes on increasing as price falls and vice versa.

The Law Of Demand

It explains the relationship between price and quantity demanded of a commodity. It says that demand

varies inversely with the price. The law can be explained in the following manner: “Other things being

equal, a fall in price leads to expansion in demand and a rise in price leads to contraction in demand”.

The law can be expressed in mathematical terms as “Demand is a decreasing function of price”.

Symbolically, thus D = F (p) where, D represent Demand, P stands for Price and F denotes the Functional

relationships. The law explains the cause and effect relationship between the independent variable

[price] and the dependent variable [demand]. There is no rule that a consumer has to buy more

whenever price of the commodity falls and vice-versa. The law explains only the general tendency of

consumers while buying a product. Thus, the law does not have universal validity.

A consumer would buy more when price falls due to the following reasons:


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1. A product becomes cheaper.[Price effect]

2. Purchasing power of a consumer would go up.[Income effect]

3. Consumers can save some amount of money.

4. Cheaper products are substituted for costly products [substitution effect].

Important Features of Law of Demand

1. There is an inverse relationship between price and demand.

2. Price is an independent variable and demand is a dependent variable

3. It is only a qualitative statement and as such it does not indicate quantitative changes in price and

demand.

4. Generally, the demand curve slopes downwards from left to right.

The operation of the law is conditioned by the phrase “Other things being equal”. It indicates that given

certain conditions certain results would follow. The inverse relationship between price and demand

would be valid only when tastes and preferences, customs and habits of consumers, prices of related

goods, and income of consumers would remains constant.

Exceptions To The Law Of Demand

Generally speaking, customers would buy more when price falls in accordance with the law of demand.

Exceptions to law of demand states that with a fall in price, demand also falls and with a rise in price

demand also rises. This can be represented by rising demand curve. In other words, the demand curve

slopes upwards from left to right. It is known as an exceptional demand curve or unusual demand curve.

It is clear from the diagram that as price rises from Rs. 4.00 to Rs. 5.00, quantity demanded also

expands from 10 units to 20 units.


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Following are the exception to the law of demand

1. Giffen’s Paradox

A paradox is a foolish or absurd statement, but it will be true. Sir Robert Giffen, an Irish Economists,

with the help of his own example (inferior goods) disproved the law of demand. The Giffen’s paradox

holds that “Demand is strengthened with a rise in price or weakened with a fall in price”. He gave the

example of poor people of Ireland who were using potatoes and meat as daily food articles. When price

of potatoes declined, customers instead of buying greater quantities of potatoes started buying more of

meat (superior goods). Thus, the demand for potatoes declined in spite of fall in its price.

2. Veblen’s effect

Thorstein Veblen, a noted American Economist contends that there are certain commodities which are

purchased by rich people not for their direct satisfaction, but for their ’snob – appeal’ or

‘ostentation’.Veblen’s effect states that demand for status symbol goods would go up with a arise in

price and vice-versa. In case of such status symbol commodities it is not the price which is important

but the prestige conferred by that commodity on a person makes him to go for it. More commonly cited

examples of such goods are diamonds and precious stones, world famous paintings, commodities used

by world figures, personalities etc. Therefore, commodities having ’snob – appeal’ are to be considered

as exceptions to the law of demand.

3. Fear of shortage

When serious shortages are anticipated by the people, (e.g., during the war period) they purchase more

goods at present even though the current price is higher.

4. Fear of future rise in price

If people expect future hike in prices, they buy more even though they feel that current prices are

higher. Otherwise, they have to pay a still high price for the same product.

5. Speculation


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Speculation implies purchase or sale of an asset with the hope that its price may rise of fall and make

speculative profit. Normally speculation is witnessed in the stock exchange market. People buy more

shares only when their prices show a rising trend. This is because they get more profit, if they sell their

shares when the prices actually rise. Thus, speculation becomes an exception to the law of demand.

6 Conspicuous necessaries

Conspicuous necessaries are those items which are purchased by consumers even though their prices

are rising on account of their special uses in our modern style of life.

In case of articles like wrist watches, scooters, motorcycles, tape recorders, mobile phones etc

customers buy more in spite of their high prices.

7. Emergencies

During emergency periods like war, famine, floods cyclone, accidents etc., people buy certain articles

even though the prices are quite high.

8. Ignorance

Sometimes people may not be aware of the prices prevailing in the market. Hence, they buy more at

higher prices because of sheer ignorance.

9. Necessaries

Necessaries are those items which are purchased by consumers what ever may be the price.

Consumers would buy more necessaries in spite of their higher prices.

Changes Or Shifts In Demand

It is to be clearly understood that if demand changes only because of changes in the price of the given

commodity in that case there would be only either expansion or contraction in demand. Both of them

can be explained with the help of only one demand curve. If demand changes not because of price

changes but because of other factors or forces, then in that case there would be either increase or

decrease in demand. If demand increases, there would be forward shift in the demand curve to the

right and if demand decreases, then there would be backward shift in the demand cure.


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Understand the various determinates demand and demand function

Demand for a commodity or service is determined by a number of factors. All such factors are called as

‘demand determinants’.

1. Price of the given commodity, prices of other substitutes and/or complements, future expected

trend in prices etc.

2. General Price level existing in the country- inflation or deflation.

3. Level of income and living standards of the people.

4. Size, rate of growth and composition of population.

5. Tastes, preferences, customs, habits, fashion and styles

6. Publicity, propaganda and advertisements.

7. Quality of the product.

8. Profit margin kept by the sellers.

9. Weather and climatic conditions.

10. Conditions of trade- boom or prosperity in the economy.

11. Terms & conditions of trade.

12. Governments’ policy- taxation, liberal or restrictive measures.

13. Level of savings & pattern of consumer expenditure.

14. Total supply of money circulation and liquidity preference of the people.

15. Improvements in educational standards etc.

Thus, several factors are responsible for bringing changes in the demand for a product in the market. A

business executive should have the knowledge and information about all these factors and forces in

order to finalize his own production marketing and other business strategies.

Demand function


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The law of demand and demand schedule explains only the price – quantity relations. It is necessary to

note that many factors and forces affect the demand. It these factors are related to demand, the

demand schedule is transformed into a demand function.

The demand function for a product explains the quantities of a product demanded due to different

factors other than price in the market at a particular point of time

Demand function is a comprehensive formulation which specifies the factors that influence the demand

for a product other than price. Mathematically, a demand function can be represented in the following

manner.

The knowledge of demand function is more important for a firm than the law of demand. Demand

function explains the various factors and forces other than price that would affect the demand for a

commodity in the market. In accordance with changes in different factors or forces, a firm can take

suitable measures to prepare its production, distribution and marketing programs scientifically.


1. In a typical demand schedule quantity demanded varies ___________ with price.

2. In case of Giffen’s goods, price and demand go in the ______ directions.

3. If demand changes as a result of price changes, than it is a case of _____ and ____ in

demand.

4. Law of demand is a _________ statement.

5. Demand function is much more _______- than law of demand.

6. In case of Veblen goods, a fall in price leads to a _______ in demand.


Learn the concept of elasticity of demand, its different kinds and their practical application

in business decision


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Earlier we have discussed the law of demand and its determinants. It tells us only the direction of

change in price and quantity demanded. But it does not specify how much more is purchased

when price falls or how much less is bought when price rises. In order to understand the

quantitative changes or rate of changes in price and demand, we have to study the concept of

elasticity of demand.

Meaning And Definition

The term elasticity is borrowed from physics. It shows the reaction of one variable with

respect to a change in other variables on which it is dependent. Elasticity is an index of

reaction.

In economics the term elasticity refers to a ratio of the relative changes in two quantities. It

measures the responsiveness of one variable to the changes in another variable.

Elasticity of demand is generally defined as the responsiveness or sensitiveness of demand

to a given change in the price of a commodity. It refers to the capacity of demand either to

stretch or shrink to a given change in price. Elasticity of demand indicates a ratio of relative

changes in two quantities.ie, price and demand. According to prof. Boulding. “Elasticity of

demand measures the responsiveness of demand to changes in price”.1 In the words of

Marshall,” The elasticity (or responsiveness) of demand in a market is great or small according

to as the amount demanded much or little for a given fall in price, and diminishes much or little

for a given rise in price” 2

Kinds of elasticity of demand

Broadly speaking there are five kinds of elasticities of demand. We shall discuss each one of

them in some detail.

Price Elasticity Of Demand

Price elasticity of demand is one of the important concepts of elasticity which is used to describe

the effect of change in price on quantity demanded. In the words of

Prof. .Stonier and Hague, price elasticity of demand is a technical term used by economists to

explain the degree of responsiveness of the demand for a product to a change in its price. Price

elasticity of demand is a ratio of two pure numbers, the numerator is the percentage change in


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quantity demanded and the denominator is the percentage change in price of the commodity. It is

measured by using the following formula.

It implies that at the present level with every change in price, there will be a change in demand

four times inversely. Generally the co-efficient of price elasticity of demand always holds a

negative sign because there is an inverse relation between the price and quantity demanded.

Original demand = 20 units original price = 6 – 00

New demand = 60 units New price = 4 – 00

In the above example, price elasticity is – 6.

The rate of change in demand may not always be proportionate to the change in price. A small

change in price may lead to very great change in demand or a big change in price may not lead to

a great change in demand. Based on numerical values of the co-efficient of elasticity, we can

have the following five degrees of price elasticity of demand.

Different Degree of Price Elasticity of Demand

1. Perfectly Elastic Demand: In this case, a very small change in price leads to an infinite

change in demand. The demand cure is a horizontal line and parallel to OX axis. The

numerical co-efficient of perfectly elastic demand is infinity (ED=00)


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1. Perfectly Inelastic Demand: In this case, what ever may be the change in price, quantity

demanded will remain perfectly constant. The demand curve is a vertical straight line and

parallel to OY axis. Quantity demanded would be 10 units, irrespective of price changes

from Rs. 10.00 to Rs. 2.00. Hence, the numerical co-efficient of perfectly inelastic

demand is zero. ED = 0

1. Relative Elastic Demand: In this case, a slight change in price leads to more than

proportionate change in demand. One can notice here that a change in demand is more

than that of change in price. Hence, the elasticity is greater than one. For e.g., price falls

by 3 % and demand rises by 9 %. Hence, the numerical co-efficient of demand is greater

than one.


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1. Relatively Inelastic Demand In this case, a large change in price, say 8 % fall price,

leads to less than proportionate change in demand, say 4 % rise in demand. One can

notice here that change in demand is less than that of change in price. This can be

represented by a steeper demand curve. Hence, elasticity is less than one.

In all economic discussion, relatively elastic demand is generally called as ‘elastic demand’ or

‘more elastic’ demand while relatively inelastic demand is popularly known as ‘inelastic

demand’ or ‘less elastic demand’.

1. Unitary elastic demand: In this case, proportionate change in price leads to equal

proportionate change in demand. For e.g., 5 % fall in price leads to exactly 5 % increase

in demand. Hence, elasticity is equal to unity. It is possible to come across unitary elastic

demand but it is a rare phenomenon.


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Out of five different degrees, the first two are theoretical and the last one is a rare possibility.

Hence, in all our general discussion, we make reference only to two terms-relatively elastic

demand and relatively inelastic demand.

Determinants Of Price Elasticity Of Demand

The elasticity of demand depends on several factors of which the following are some of the

important ones.

1. Nature of the Commodity

Commodities coming under the category of necessaries and essentials tend to be inelastic

because people buy them whatever may be the price. For example, rice, wheat, sugar, milk,

vegetables etc. on the other hand, for comforts and luxuries, demand tends to be elastic e.g., TV

sets, refrigerators etc.

2. Existence of Substitutes

Substitute goods are those that are considered to be economically interchangeable by buyers. If a commodity has no substitutes in the market, demand tends to be inelastic because

people have to pay higher price for such articles. For example. salt, onions, garlic, ginger etc. In

case of commodities having different substitutes, demand tends to be elastic. For example,

blades, tooth pastes, soaps etc.

3. Number of uses for the commodity

Single-use goods are those items which can be used for only one purpose and multiple-use

goods can be used for a variety of purposes. If a commodity has only one use (singe use

product) then in that case, demand tends to be inelastic because people have to pay more prices if

they have to use that product for only one use. For example, all kinds of. eatables, seeds,

fertilizers, pesticides etc. On the contrary, commodities having several uses, [multiple –use-

products] demand tends to be elastic. For example, coal, electricity, steel etc.

4. Durability and reparability of a commodity

Durable goods are those which can be used for a long period of time. Demand tends to be

elastic in case of durable and repairable goods because people do not buy them frequently. For

example, table, chair, vessels etc. On the other hand, for perishable and non- repairable goods,

demand tends to be inelastic e.g., milk, vegetables, electronic watches etc.

5. Possibility of postponing the use of a commodity


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In case there is no possibility to postpone the use of a commodity to future, the demand tends to

be inelastic because people have to buy them irrespective of their prices. For example,

medicines. If there is possibility to postpone the use of a commodity, demand tends to be elastic

e.g., buying a TV set, motor cycle, washing machine or a car etc.

6. Level of Income of the people

Generally speaking, demand will be relatively inelastic in case of rich people because any

change in market price will not alter and affect their purchase plans. On the contrary, demand

tends to be elastic in case of poor.

7. Range of Prices

There are certain goods or products like imported cars, computers, refrigerators, TV etc, which

are costly in nature. Similarly, a few other goods like nails; needles etc. are low priced goods. In

all these case, a small fall or rise in prices will have insignificant effect on their demand. Hence,

demand for them is inelastic in nature. However, commodities having normal prices are elastic in

nature.

8. Proportion of the expenditure on a commodity

When the amount of money spent on buying a product is either too small or too big, in that case

demand tends to be inelastic. For example, salt, newspaper or a site or house. On the other hand,

the amount of money spent is moderate; demand in that case tends to be elastic. For example,

vegetables and fruits, cloths, provision items etc.

9 Habits

When people are habituated for the use of a commodity, they do not care for price changes over

a certain range. For example, in case of smoking, drinking, use of tobacco etc. In that case,

demand tends to be inelastic. If people are not habituated for the use of any products, then

demand generally tends to be elastic.

10. Period of time

Price elasticity of demand varies with the length of the time period. Generally speaking, in the

short period, demand is inelastic because consumption habits of the people, customs and

traditions etc. do not change. On the contrary, demand tends to be elastic in the long period

where there is possibility of all kinds o f changes.


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11. Level of Knowledge

Demand in case of enlightened customer would be elastic and in case of ignorant customers, it

would be inelastic.

12. Existence of complementary goods

Goods or services whose demands are interrelated so that an increase in the price of one of the products results in a fall in the demand for the other. Goods which are jointly demanded

are inelastic in nature. For example, pen and ink, vehicles and petrol, shoes and cocks etc have

inelastic demand for this reason. If a product does not have complements, in that case demand

tends to be elastic. For example, biscuits, chocolates, ice0creams etc. In this case the use of a

product is not linked to any other products.

1. Purchase frequency of a product

If the frequency of purchase is very high, the demand tends to be inelastic. For e.g., coffee, tea,

milk, match box etc. on the other hand, if people buy a product occasionally, in that case demand

tends to be elastic for example, durable goods like radio, tape recorders, refrigerators etc.

Thus, the demand for a product is elastic or inelastic will depend on a number of factors.

Measurement of price elasticity of demand

There are different methods to measure the price elasticity of demand and among them the

following two methods are most important ones.

1. Total expenditure method.

2. Point method.

3. Arc method.

1. Total Expenditure Method

Under this method, the price elasticity is measured by comparing the total expenditure of

the consumers (or total revenue i.e., total sales values from the point of view of the seller) before and after variations in price. We measure price elasticity by examining the change in

total expenditure as a result of change in the price and quantity demanded for a commodity.

Total expenditure = Price per unit x Total quantity purchased

Price in (Rs.) Qty Demanded Total expenditure Nature of PED


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I Case 5.00 2000 10000

> 1 4.00 3000 12000

2.00 7000 14000

II Case 5.00 2000 10000

= 1 4.00 2500 10000

2.00 5000 10000

III Case 5.00 2000 10000

< 1 4.00 2200 8000

2.00 4200 8400

Note:

1. When new outlay is greater than the original outlay, then ED > 1.

2. When new outlay is equal to the original outlay then ED = 1.

3. When new outlay is less than the original outlay then ED < 1.

Graphical Representation

From the diagram it is clear that

1. From A to B price elasticity is greater than one.

2. From B to C price elasticity is equal than one.

3. From C to D price elasticity is lesser than one.


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Note :

• It is to be noted that when total expenditure increases with the fall in price and decreases

with a rise in price, then the PED is greater that one.

• When the total expenditure remains the same either due to a rise or fall in price, the PED

is equal to one.

• When total expenditure, decrease with a fall in price and increase with a rise in price,

PED is said to be less than one.

2. Point Method:

Prof. Marshall advocated this method. The point method measures price elasticity of demand. at

different points on a demand curve. Hence, in this case attempt is made to measure small changes in

both price and demand. It can be explained either with the help of mathematical calculation or with the

help of a diagram or graphic

representation.

Mathematical Illustrations

Points price is Rs Demand in units

A 10 – 00 40

B 09 – 00 46

In order to measure price elasticity at two points, A and B, the following formula is to be adopted.

In order to find out percentage change in demand, the formula is –


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In order to find out percentage change in price, the following formula is employed-

It is clear that on any straight line demand curve, price elasticity will be different at different points since

the demand curve represents the demand schedule and the demand schedule has different elasticity’s

at various alternatives prices.

Graphical representation

The simplest way of explaining the point method is to consider a linear or straight- line demand

curve. Let the straight – line demand curve be extended to meet the two axis X and Y when a


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point is plotted on the demand curve, it divides the curve into two segments. The point elasticity

is measured by the ration of lower segment of the demand curve below, the given point to the

upper segment of the curve above the point. Hence.

In short, e = L / U where e stands for Point elasticity, L for lower segment and U for upper

segment.

In the diagram AB is the straight line demand curve and P is is a given point. PB is the lower

segment and PA is the upper segment.

In the diagram, AB is the straight-line demand curve and P is a give point PB is the lower

segment and PA is the upper segment.

E = L / U = PB / PA

If after the actual measurement of the two parts of the demand curve, we find that

PB = 3 CMs and PA = 2 CMs then elasticity at Point P is 3 / 2 = 1.5

If the demand curve is non–linear then we have to draw a tangent at the given point extending it

to intersect both axes. Point elasticity is measure by the ratio of the lower part of the tangent

below that given point to the upper part of the tangent above the point. Then, elasticity at point P

can be measured as PB / PA.


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In case of point method, the demand function is continuous and hence, only marginal changes

can be measured. In short, Ep is measured only when changes in price and quantity demanded

are small.

3. Arc Method

This method is suggested to measure large changes in both price and demand. When elasticity is

measured over an interval of a demand curve, the elasticity is called as an interval or Arc elasticity. It is the average elasticity over a segment or range of the demand curve. Hence, it

is also called as average elasticity of demand.

The following formula is used to measure Arc elasticity.

Illustration

P1 = original price 10 – 00. Q1 = original quantity = 200 units

P2 = New price 05 – 00 Q2 = New quantity = 300units By substituting the values in

to the equation, we can find out Arc elasticity of demand.


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In the diagram, in order to measure arc elasticity between two points M & N on the demand

curve, one has to take the average of prices OP1 and OP2 and also the average quantities of Q1

& Q2.

Practical application of price elasticity of demand

1. Production planning

It helps a producer to decide about the volume of production. If the demand for his products is

inelastic, specific quantities can be produced while he has to produce different quantities, if the

demand is elastic.

2. Helps in fixing the prices of different goods

It helps a producer to fix the price of his product. If the demand for his product is inelastic, he

can fix a higher price and if the demand is elastic, he has to charge a lower price. Thus, price-

increase policy is to be followed if the demand is inelastic in the market and price-decrease

policy is to be followed if the demand is elastic.

Similarly, it helps a monopolist to practice price discrimination on the basis of elasticity of

demand.

2. Helps in fixing the rewards for factor inputs

Factor rewards refers to the price paid for their services in the production process. It helps

the producer to determine the rewards for factors of production. If the demand for any factor unit

is inelastic, the producer has to pay higher reward for it and vice-versa.

3. Helps in determining the foreign exchange rates

Exchange rate refers to the rate at which currency of one country is converted in to the

currency of another country. It helps in the determination of the rate of exchange between the

currencies of two different nations. For e.g. if the demand for US dollar to an Indian rupee is

inelastic, in that case, an Indian has to pay more Indian currency to get one unit of US dollar and

vice-versa.

4. Helps in determining the terms of trade

It is the basis for deciding the ‘terms of trade’ between two nations. The terms of trade implies

the rate at which the domestic goods are exchanged to foreign goods. For e.g. if the demand

for Japan’s products in India is inelastic, in that case, we have to pay more in terms of our

commodities to get one unit of a commodity from Japan and vice-versa.

5. Helps in fixing the rate of taxes


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Taxes refer to the compulsory payment made by a citizen to the government periodically

without expecting any direct return benfit from it. It helps the finance minister to formulate

sound taxation policy of the country. He can impose more taxes on those goods for which the

demand is inelastic and fewer taxes if the demand is elastic in the market.

6. Helps in Declaration of Public Utilities

Public utilities are those institutions which provide certain essential goods to the general

public at economical prices. The Government may declare a particular industry as ‘public

utility’ or nationalize it, if the demand for its products is inelastic.

7. Poverty in the Midst of Plenty:

The concept explains the paradox of poverty in the midst of plenty. A bumper crop of

rice or wheat instead of bringing prosperity to farmers may actually bring poverty to them

because the demand for rice and wheat is inelastic.

Thus, the concept of price elasticity of demand has great practical application in economic

theory.

INCOME ELASTICITY OF DEMAND

Income elasticity of demand may be defined as the ratio or proportionate change in the

quantity demanded of a commodity to a given proportionate change in the income. In short,

it indicates the extent to which demand changes with a variation in consumers income. The

following formula helps to measure Ey.

Original demand = 400 units Original Income = 4000-00


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New demand = 700 units New Income = 6000-00

Generally speaking, Ey is positive. This is because there is a direct relationship between income

and demand, i.e. higher the income; higher would be the demand and vice-versa. On the basis of

the numerical value of the co-efficient, Ey is classified as greater than one, less than one, equal to

one, equal to zero, and negative. The concept of Ey helps us in classifying commodities into

different categories.

1. When Ey is positive, the commodity is normal [used in day-to-day life]

2. When Ey is negative, the commodity is inferior. .For example Jowar, beedi etc.

3. When Ey is positive and greater than one, the commodity is luxury.

4. When Ey is positive, but less than one, the commodity is essential.

5. When Ey is zero, the commodity is neutral e.g. salt, match box etc.

Practical application of income elasticity of demand

1. Helps in determining the rate of growth of the firm.

If the growth rate of the economy and income growth of the people is reasonably forecasted, in

that case it is possible to predict expected increase in the sales of a firm and vice-versa.

2. Helps in the demand forecasting of a firm.

It can be used in estimating future demand provided the rate of increase in income and Ey for the

products are known. Thus, it helps in demand forecasting activities of a firm.

3. Helps in production planning and marketing

The knowledge of Ey is essential for production planning, formulating marketing strategy,

deciding advertising expenditure and nature of distribution channel etc in the long run.

4. Helps in ensuring stability in production

Proper estimation of different degrees of income elasticity of demand for different types of

products helps in avoiding over-production or under production of a firm. One should also know

whether rise or fall in come is permanent or temporary.

5. Helps in estimating construction of houses.

The rate of growth in incomes of the people also helps in housing programs in a


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country. Thus, it helps a lot in managerial decisions of a firm.

Cross Elasticity Of Demand

It may be defined as the proportionate change in the quantity demanded of a particular commodity in response to a change in the price of another related commodity. In the words

of Prof. Watson cross elasticity of demand is the percentage change in quantity associated with a

percentage change in the price of related goods. Generally speaking, it arises in case of

substitutes and complements. The formula for calculating cross elasticity of demand is as

follows.

Ec = Percentage change in quantity demanded commodity X

Percentage change in the price of Y

Price of Tea rises from Rs. 4-00 to 6 -00 per cup

Demand for coffee rises from 50 cups to 80 cups.

Cross elasticity of coffee in this case is 1.6.

It is to be noted that-

1. Cross elasticity of demand is positive in case of good substitutes e.g. coffee and tea.

2. High cross elasticity of demand exists for those commodities which are close substitutes. In

other

words, if commodities are perfect substitutes For example Bata or Corona Shoes, close up or

pepsodent tooth paste, Beans and ladies finger, Pepsi and coca cola etc.

3. The cross elasticity is zero when commodities are independent of each other. For example,

stainless steel, aluminum vessels etc.

4. Cross elasticity between two goods is negative when they are complementaries. In these cases,

rise in the price of one will lead to fall in the quantity demanded of another commodity For


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example, car and petrol, pen and ink.etc.

Practical application of cross elasticity of demand

1. Helps at the firm level

Knowledge of cross elasticity of demand is essential to study the impact of change in the price of

a commodity which possesses either substitutes or complementaries. If accurate measures of

cross elasticities are available, a firm can forecast the demand for its product and can adopt

necessary safe guard against fluctuating prices of substitutes and complements. The pricing and

marketing strategy of a firm would depend on the extent of cross elasticities between different

alternative goods.

2. Helps at the industry level

Knowledge of cross elasticity would help the industry to know whether an industry has any

substitutes or complementaries in the market. This helps in formulating various alternative

business strategies to promote different items in the market.

Advertising Or Promotional Elasticity Of Demand.

Most of the firms, in the present marketing conditions spend considerable amounts of money on

advertisement and other such sales promotional activities with the object of promoting its sales.

Advertising elasticity refers to the responsiveness demand or sales to change in advertising or other promotional expenses. The formula to calculate the advertising elasticity is as follows.

Original sales = 10,000 units original advertisement expenditure = 800-00

New sales = 50,000 units new advertisement expenditure = 2000-00

In the above example, advertising elasticity of demand is 1.67. it implies that for every one

time increase in advertising expenditure, the sales would go up 1.67 times Thus, Ea is more than

one.


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Practical application of advertising elasticity of demand

The study of advertising elasticity of demand is of paramount importance to a firm in recent

years because of fierce competition.

1. Helps in determining the level of prices

The level of prices fixed by one firm for its product would depend on the amount of

advertisement expenditure incurred by it in the market.

2. Helps in formulating appropriate sales promotional strategy

The volume of advertisement expenditure also throws light on the sales promotional strategies

adopted by a firm to push off its total sales in the market. Thus, it helps a firm to stimulate its

total sales in the market.

3. Helps in manipulating the sales

It is useful in determining the optimum level of sales in the market. This is because the sales

made by one firm would also depend on the total amount of money spent on sales promotion of

other firms in the market.

Substitution Elasticity Of Demand.

It measures the effects of the substitution of one commodity for another. It may be defined as

the proportionate change in the demand ratios of two substitute goods X and y to the proportionate change in the price ratio of two goods X and Y The following formulas is used

to measure substitution elasticity of demand.

Where Dx / Dy is ratio of quantity demanded of two goods X & Y.


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Delta DX / Dy is the change in the quantity ratio of two goods X & Y.

PX / Py is the price ratio of two goods X & Y.

Delta PX / PY is change in price ratio of two goods X & Y

Illustration.

The coefficient of substitution elasticity is equal to one when the percentage change in demand

ratio’s of two goods x and y are exactly equal to the percentage change in price ratios of two

goods x and y. It is greater than one when the changes in the demand ratios of x and y is more

than proportionate to change in their price ratios.

Practical Application Of Substitution Elasticity Of Demand

The concept of substitution elasticity is of great importance to a firm in the context of availability

of various kinds of substitutes for one factor inputs to another. For example, let us assume one

computer can do the job of 10 laborers and if the cost of computer becomes cheaper than

employing workers, in that case, a firm would certainly go for substituting workers for

computers. .An employer would always compare the cost of different alternative inputs and

employ those inputs which are much cheaper than others to cut down his cost of operations.

Thus, the concept of elasticity of demand has great theoretical as well as practical application in

economic theory.

Self Assessment Question 2

• Law of demand explain the ______________change in demand and elasticity of demand

explain ______ change in demand.

• According to Marshall, _________ is the degree of responsiveness of demand to the

change in price of that commodity.

• The relatively elastic demand curve is ______

• When the quantity demanded increases with the increase in income, we say that income

elasticity of demand will be____. When quantity demanded decreases with increase in

income, we say that the income elasticity of demand is ____.

• _______ helps the manager to decide the advertisement expense.

• Point method helps to measure _________ quantity of change in demand and arc

methods helps to measure ____ changes in demand.


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Summary

Demand is created by consumers. Consumers can create demand only when they have adequate

purchasing power and willingness to buy different goods and services. There is a direct

relationship between utility and demand. Law of demand tells us that there is an inverse

relationship between price and demand in general. Sometimes customers buy more in spite of

rise in the prices of some commodities. Thus, the law of demand has certain exceptions. Demand

for a product not only depends on price but also on a number of other factors. In order to know

the quantitative changes in both price and demand, one has to study elasticity of demand. Price

elasticity of demand indicates the percentage changes in demand as a consequence of changes in

prices. The response from demand to price changes is different. Hence, we have elastic and

inelastic demand. One can exactly measure the extent of price elasticity of demand with the help

of different methods like point and Arc methods. Income elasticity measures the quantum of

changes in demand and changes in income of the customers. Cross elasticity tells us the extent of

change in the price of one commodity and corresponding changes in the demand for another

related commodity. Substitution elasticity measures the amount of changes in demand ratio of

two substitute goods to changes in price ratio of two substitute goods in the market. The concept

of elasticity of demand has great theoretical and practical application in all aspects of business

life.

Terminal Questions

1. State and explain the law of demand.

2. Discuss the various exceptions to law of demand.

3. Explain the concepts of shifts in demand

4. Explain the various determinants of demand

5. What is elasticity of demand ? explain the different degree of price elasticity with suitable

diagrams

6. Discuss the determinants of price elasticity of demand.

7. Discuss any one method of measuring price elasticity of demand.

8. Explain the cross, income, advertising and substitution elasticity of demand.

9. Discuss the practical importance of various trends of elasticity of demand.

Answer for Self Assessment Questions


1. Inversely

2. Same / upward

3. Expansion , contraction

4. Qualitative

5. Comprehensive / wider


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6. Fall.


1. Direction percentage

2. Price Elasticity of Demand

3. Flatter

4. Positive ; negative.

5. Advertisement Elasticity of Demand.

6. Small, large

Answers to Terminal Questions (View in SLM)

1. Refer to units 2.2




5. Refer to units 2.2.1 and 2.2.2

6. Refer to units 2.2.3


8. Refer to units 2.2.5, 2.2.6, 2.2.7 to 2.2.8

9. Refer to units 2.2.4, 2.2.5, 2.2.6, 2.2.7 and 2.2.8

Unit -3- Demand Forecasting

Introduction

An important aspect of demand analysis from the management point of view is concerned with

forecasting demand for products, either existing or new. Demand forecasting refers to an

estimate of most likely future demand for product under given conditions. Such forecasts are of

immense use in making decisions with regard to production, sales, investment, expansion,

employment of manpower etc., both in the short run as well as in the long run. Forecasts are

made at micro level and macro level. There are different methods of forecasts like survey

methods and statistical methods generally for the existing products and for new products

depending upon the nature, number of methods like evolutionary approach substitute approach,

growth curve approach etc.


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Learning Objective 1

Know the meaning features and uses of demand forecasting

Meaning And Features

Demand forecasting seeks to investigate and measure the forces that determine sales for existing

and new products. Generally companies plan their business – production or sales in anticipation

of future demand. Hence forecasting future demand becomes important. In fact it is the very soul

of good business because every business decision is based on some assumptions about the future

whether right or wrong, implicit or explicit. The art of successful business lies in avoiding or

minimizing the risks involved as far as possible and face the uncertainties in a most befitting

manner .Thus Demand Forecasting refers to an estimation of most likely future demand for

a product under given conditions.

Important features of demand forecasting

• It is basically a guess work – but it is an educated and well thought out guesswork.

• It is in terms of specific quantities

• It is undertaken in an uncertain atmosphere.

• A forecast is made for a specific period of time which would be sufficient to take a

decision and put it into action.

• It is based on historical information and the past data.

• It tells us only the approximate demand for a product in the future.

• It is based on certain assumptions.

• It cannot be 100% precise as it deals with future expected demand

Demand forecasting is needed to know whether the demand is subject to cyclical fluctuations or not, so

that the production and inventory policies, etc, can be suitably formulated

Demand forecasting is generally associated with forecasting sales and manipulating demand. A firm can

make use of the sales forecasts made by the industry as a powerful tool for formulating sales policy and

sales strategy. They can become action guides to select the course of action which will maximize the

firm’s earnings. When external economic factors like the size of market, competitors attitudes,

movement in prices, consumer tastes, possibilities of new threats from substitute products etc,

influence sales forecasting, internal factors like money spent on advertising, pricing policy, product

improvements, sales efforts etc., help in manipulating demand. To use demand forecasting in an active

rather than a passive way, management must recognize the degree to which sales are a result not only

of external economic environment but also of the action of the company itself.


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Managerial uses of demand forecasting:

In the short run:

Demand forecasts for short periods are made on the assumption that the company has a given

production capacity and the period is too short to change the existing production capacity.

Generally it would be one year period.

• Production planning: It helps in determining the level of output at various periods and

avoiding under or over production.

• Helps to formulate right purchase policy: It helps in better material management, of

buying inputs and control its inventory level which cuts down cost of operation.

• Helps to frame realistic pricing policy: A rational pricing policy can be formulated to

suit short run and seasonal variations in demand.

• Sales forecasting: It helps the company to set realistic sales targets for each individual

salesman and for the company as a whole.

• Helps in estimating short run financial requirements: It helps the company to plan the

finances required for achieving the production and sales targets. The company will be

able to raise the required finance well in advance at reasonable rates of interest.

• Reduce the dependence on chances: The firm would be able to plan its production

properly and face the challenges of competition efficiently.

• Helps to evolve a suitable labour policy: A proper sales and production policies help to

determine the exact number of labourers to be employed in the short run.

In the long run:

Long run forecasting of probable demand for a product of a company is generally for a

period of 3 to 5 or 10 years.

1. Business planning:

It helps to plan expansion of the existing unit or a new production unit. Capital budgeting of a

firm

is based on long run demand forecasting.

1. Financial planning:

It helps to plan long run financial requirements and investment programs by floating shares and

debentures in the open market.

1. Manpower planning :


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It helps in preparing long term planning for imparting training to the existing staff and recruit

skilled and efficient labour force for its long run growth.

1. Business control :

Effective control over total costs and revenues of a company helps to determine the value and

volume of business. This in its turn helps to estimate the total profits of the firm. Thus it is

possible to regulate business effectively to meet the challenges of the market.

1. Determination of the growth rate of the firm :

A steady and well conceived demand forecasting determine the speed at which the company

can grow.

1. Establishment of stability in the working of the firm :

Fluctuations in production cause ups and downs in business which retards smooth

functioning of the firm. Demand forecasting reduces production uncertainties and help in

stabilizing the activities of the firm.

1. Indicates interdependence of different industries :

Demand forecasts of particular products become the basis for demand forecasts of other

related industries, e.g., demand forecast for cotton textile industry supply information to the

most likely demand for textile machinery, colour, dye-stuff industry etc.,

1. More useful in case of developed nations:

It is of great use in industrially advanced countries where demand conditions fluctuate

much more than supply conditions.

The above analysis clearly indicates the significance of demand forecasting in the modern

business set up.


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Learning objective 2

Have the knowledge of levels of demand forecasting & criteria of demand forecasting

Levels Of Demand Forecasting

Demand forecasting may be undertaken at three different levels, viz., micro level or firm level,

industry level and macro level.

Micro level or firm level

This refers to the demand forecasting by the firm for its product. The management of a firm is

really interested in such forecasting. Generally speaking, demand forecasting refers to the

forecasting of demand of a firm.

Industry level

Demand forecasting for the product of an industry as a whole is generally undertaken by the

trade associations and the results are made available to the members. A member firm by using

such data and information may determine its market share.

Macro-level

Estimating industry demand for the economy as a whole will be based on macro-economic

variables like national income, national expenditure, consumption function, index of industrial

production, aggregate demand, aggregate supply etc, Generally, it is undertaken by national

institutes, govt. agencies etc. Such forecasts are helpful to the Government in determining the

volume of exports and imports, control of prices etc.

The managerial economist has to take into consideration the estimates of aggregate demand and

also industry demand while making the demand forecast for the product of a particular firm.

Criteria For Good Demand Forecasting

Apart from being technically efficient and economically ideal a good method of demand

forecasting should satisfy a few broad economic criteria. They are as follows:


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• Accuracy: Accuracy is the most important criterion of a demand forecast, even though

cent percent accuracy about the future demand cannot be assured. It is generally

measured in terms of the past forecasts on the present sales and by the number of times it

is correct.

• Plausibility: The techniques used and the assumptions made should be intelligible to the

management. It is essential for a correct interpretation of the results.

• Simplicity: It should be simple, reasonable and consistent with the existing knowledge.

A simple method is always more comprehensive than the complicated one

• Durability: Durability of demand forecast depends on the relationships of the variables

considered and the stability underlying such relationships, as for instance, the relation

between price and demand, between advertisement and sales, between the level of

income and the volume of sales, and so on.

• Flexibility: There should be scope for adjustments to meet the changing conditions. This

imparts durability to the technique.

• Availability of data: Immediate availability of required data is of vital importance to

business. It should be made available on an up-to-date basis. There should be scope for

making changes in the demand relationships as they occur.

• Economy: It should involve lesser costs as far as possible. Its costs must be compared

against the benefits of forecasts

• Quickness: It should be capable of yielding quick and useful results. This helps the

management to take quick and effective decisions.

Thus, an ideal forecasting method should be accurate, plausible, durable, flexible, make the data

available readily, economical and quick in yielding results.

Learning objective 3

Analyze different methods demand forecasting for both old and new products

Methods or Techniques of Forecasting

Demand forecasting is a highly complicated process as it deals with the estimation of future

demand. It requires the assistance and opinion of experts in the field of sales management. While

estimating future demand, one should not give too much of importance to either statistical

information, past data or experience, intelligence and judgment of the experts. Demand


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forecasting, to become more realistic should consider the two aspects in a balanced manner.

Application of commonsense is needed to follow a pragmatic approach in demand forecasting.

Broadly speaking, there are two methods of demand forecasting. They are: 1.Survey methods

and 2 Statistical methods.

Survey Methods

Survey methods help us in obtaining information about the future purchase plans of potential

buyers through collecting the opinions of experts or by interviewing the consumers. These

methods are extensively used in short run and estimating the demand for new products. There are

different approaches under survey methods. They are

A. Consumers’ interview method:

Under this method, efforts are made to collect the relevant information directly from the

consumers with regard to their future purchase plans. In order to gather information from

consumers, a number of alternative techniques are developed from time to time. Among them,

the following are some of the important ones.


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• Survey of buyer’s intentions or preferences: It is one of the oldest methods of demand

forecasting. It is also called as “Opinion surveys”.

Under this method, consumer-buyers are requested to indicate their preferences and

willingness about particular products. They are asked to reveal their ‘future purchase plans with respect to specific items. They are expected to give answers to questions like what

items they intend to buy, in what quantity, why, where, when, what quality they expect, how

much money they are planning to spend etc. Generally, the field survey is conducted by the

marketing research department of the company or hiring the services of outside research

organizations consisting of learned and highly qualified professionals.

The heart of the survey is questionnaire. It is a comprehensive one covering almost all questions

either directly or indirectly in a most intelligent manner. It is prepared by an expert body who are

specialists in the field or marketing.

The questionnaire is distributed among the consumer buyers either through mail or in person by

the company. Consumers are requested to furnish all relevant and correct information.

The next step is to collect the questionnaire from the consumers for the purpose of evaluation.

The materials collected will be classified, edited analyzed. If any bias prejudices, exaggerations,

artificial or excess demand creation etc., are found at the time of answering they would be

eliminated.

The information so collected will now be consolidated and reviewed by the top executives with

lot of experience. It will be examined thoroughly. Inferences are drawn and conclusions are

arrived at. Finally a report is prepared and submitted to management for taking final decisions.

The success of the survey method depends on many factors. 1) The nature of the questions asked,

2) The ability of the surveyed 3) The representative of the samples 4) Nature of the product 5)

characteristics of the market 6) consumer buyers behavior, their intentions, attitudes, thoughts,

motives, honesty etc. 7) Techniques of analysis conclusions drawn etc.

The management should not entirely depend on the results of survey reports to project future

demand. Consumer buyers may not express their honest and real views and as such they may

give only the broad trends in the market. In order to arrive at right conclusions, field surveys

should be regularly checked and supervised.

This method is simple and useful to the producers who produce goods in bulk. Here the burden

of forecasting is put on customers.

However this method is not much useful in estimating the future demand of the households as

they run in large numbers and also do not freely express their future demand requirements. It is

expensive and also difficult. Preparation of a questionnaire is not an easy task. At best it can be

used for short term forecasting.


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B. Direct Interview Method

Experience has shown that many customers do not respond to questionnaire addressed to them

even if it is simple due to varied reasons. Hence, an alternative method is developed. Under this

method, customers are directly contacted and interviewed. Direct and simple questions are asked to them. They are requested to answer specifically about their budget, expenditure plans,

particular items to be selected, the quality and quantity of products, relative price preferences etc.

for a particular period of time. There are two different methods of direct personal interviews.

They are as follows:

i. Complete enumeration method

Under this method, all potential customers are interviewed in a particular city or a region.

The answers elicited are consolidated and carefully studied to obtain the most probable demand

for a product. The management can safely project the future demand for its products. This

method is free from all types of prejudices. The result mainly depends on the nature of questions

asked and answers received from the customers.

However, this method cannot be used successfully by all sellers in all cases. This method can

be employed to only those products whose customers are concentrated in a small region or

locality. In case consumers are widely dispersed, this method may not be physically adopted or

prove costly both in terms of time and money. Hence, this method is highly cumbersome in

nature.

ii. Sample survey method or the consumer panel method

Experience of the experts’ show that it is impossible to approach all customers; as such careful

sampling of representative customers is essential. Hence, another variant of complete

enumeration method has been developed, which is popularly known as sample survey method.

Under this method, different cross sections of customers that make up the bulk of the

market are carefully chosen. Only such consumers selected from the relevant market through some sampling method are interviewed or surveyed. In other words, a group of

consumers are chosen and queried about their preferences in concrete situations. The selection of

a few customers is known as sampling. The selected consumers form a panel. This method uses

either random sampling or the stratified sampling technique. The method of survey may be direct

interview or mailed questionnaire to the selected consumers. On the basis of the views expressed

by these selected consumers, most likely demand may be estimated. The advantage of a panel

lies in the fact that the same panel is continued and new expensive panel does not have to be

formulated every time a new product is investigated.

As compared to the complete enumeration method, the sample survey method is less tedious, less

expensive, much simpler and less time consuming. This method is generally used to estimate

short run demand by government departments and business firms.

Success of this method depends upon the sincere co-operation of the selected customers. Hence,

selection of suitable consumers for the specific purpose is of great importance.


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Even with careful selection of customers and the truthful information about their buying

intention, the results of the survey can only be of limited use. A sudden change in price,

inconsistency in buying intentions of consumers, number of sensible questions asked and

dropouts from the panel for various reasons put a serious limitation on the practical usefulness of

the panel method.

C. Collective opinion method or opinion survey method

This is a variant of the survey method. This method is also known as “Sales – force polling” or “Opinion

poll method”. Under this method, sales representatives, professional experts and the market

consultants and others are asked to express their considered opinions about the volume of sales

expected in the future. The logic and reasoning behind the method is that these salesmen and other

people connected with the sales department are directly involved in the marketing and selling of the

products in different regions. Salesmen, being very close to the customers, will be in a position to know

and feel the customer’s reactions towards the product. They can study the pulse of the people and

identify the specific views of the customers. These people are quite capable of estimating the likely

demand for the products with the help of their intimate and friendly contact with the customers and

their personal judgments based on the past experience. Thus, they provide approximate, if not accurate

estimates. Then, the views of all salesmen are aggregated to get the overall probable demand for a

product.

Further, these opinions or estimates collected from the various experts are considered, consolidated

and reviewed by the top executives to eliminate the bias or optimism and pessimism of different

salesmen. These revised estimates are further examined in the light of factors like proposed change in

selling prices, product designs and advertisement programs, expected changes in the degree of

competition, income distribution, population etc. The final sales forecast would emerge after these

factors have been taken into account. This method heavily depends on the collective wisdom of

salesmen, departmental heads and the top executives.

It is simple, less expensive and useful for short run forecasting particularly in case of new

products.

The main drawback is that it is subjective and depends on the intelligence and awareness of the

salesmen. It cannot be relied upon for long term business planning.

D. Delphi Method or Experts Opinion Method

This method was originally developed at Rand Corporation in the late 1940’s by Olaf Helmer,

Dalkey and Gordon. This method was used to predict future technological changes. It has proved

more useful and popular in forecasting non– economic rather than economical variables.

It is a variant of opinion poll and survey method of demand forecasting. Under this method,

outside experts are appointed. They are supplied with all kinds of information and

statistical data. The management requests the experts to express their considered opinions and views about the expected future sales of the company. Their views are generally regarded

as most objective ones. Their views generally avoid or reduce the “Halo – Effects” and “Ego –

Involvement” of the views of the others. Since experts’ opinions are more valuable, a firm will


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give lot of importance to them and prepare their future plan on the basis of the forecasts made by

the experts.

E. End Use or Input – Output Method

Under this method, the sale of the product under consideration is projected on the basis of

demand surveys of the industries using the given product as an intermediate product. The

demand for the final product is the end – use demand of the intermediate product used in the

production of the final product. An intermediate product may have many end – users, For e.g.,

steel can be used for making various types of agricultural and industrial machinery, for

construction, for transportation etc. It may have the demand both in the domestic market as well

as international market. Thus, end – use demand estimation of an intermediate product may

involve many final goods industries using this product, at home and abroad. Once we know the

demand for final consumption goods including their exports we can estimate the demand for the

product which is used as intermediate good in the production of these final goods with the help

of input – output coefficients. The input – output table containing input – output coefficients for

particular periods are made available in every country either by the Government or by research

organizations.

This method is used to forecast the demand for intermediate products only. It is quite useful for

industries which are largely producers’ goods, like aluminum, steel etc. The main limitation of

the method is that as the number of end – users of a product increase, it becomes more

inconvenient to use this method.

Statistical Method

It is the second most popular method of demand forecasting. It is the best available technique and most

commonly used method in recent years. Under this method, statistical, mathematical models,

equations etc are extensively used in order to estimate future demand of a particular product. They

are used for estimating long term demand. They are highly complex and complicated in nature. Some of

them require considerable mathematical back – ground and competence.

They use historical data in estimating future demand. The analysis of the past demand serves as

the basis for present trends and both of them become the basis for calculating the future demand

of a commodity in question after taking into account of likely changes in the future.

There are several statistical methods and their application should be done by some one who is

reasonably well versed in the methods of statistical analysis and in the interpretation of the

results of such analysis.

A. Trend Projection Method

An old firm operating in the market for a long period will have the accumulated previous data on either

production or sales pertaining to different years. If we arrange them in chronological order, we get what


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is called as ‘time series’. It is an ordered sequence of events over a period of time pertaining to certain

variables. It shows a series of values of a dependent variable say, sales as it changes from one point of

time to another. In short, a time series is a set of observations taken at specified time, generally at equal

intervals. It depicts the historical pattern under normal conditions. This method is not based on any

particular theory as to what causes the variables to change but merely assumes that whatever forces

contributed to change in the recent past will continue to have the same effect. On the basis of time

series, it is possible to project the future sales of a company.

Further, the statistics and information with regard to the sales call for further analysis. When we

represent the time series in the form of a graph, we get a curve, the sales curve. It shows the trend in

sales at different periods of time. Also, it indicates fluctuations and turning points in demand. If the

turning points are few and their intervals are also widely spread, they yield acceptable results. Here the

time series show a persistent tendency to move in the same direction. Frequency in turning points

indicates uncertain demand conditions and in this case, the trend projection breaks down.

The major task of a firm while estimating the future demand lies in the prediction of turning points in

the business rather than in the projection of trends. When turning points occur more frequently, the

firm has to make radical changes in its basic policy with respect to future demand. It is for this reason

that the experts give importance to identification of turning points while projecting the future demand

for a product.

The heart of this method lies in the use of time series. Changes in time series arise on account of the

following reasons:-

1. Secular or long run movements: Secular movements indicate the general conditions and

direction in which graph of a time series move in relatively a long period of time.

2. Seasonal movements: Time series also undergo changes during seasonal sales of a company.

During festival season, sales clearance season etc., we come across most unexpected changes.

3. Cyclical Movements: It implies change in time series or fluctuations in the demand for a product

during different phases of a business cycle like depression, revival, boom etc.

4. Random movement. When changes take place at random, we call them irregular or random

movements. These movements imply sporadic changes in time series occurring due to

unforeseen events such as floods, strikes, elections, earth quakes, droughts and other such

natural calamities. Such changes take place only in the short run. Still they have their own

impact on the sales of a company.

An important question in this connection is how to ascertain the trend in time series? A statistician, in

order to find out the pattern of change in time series may make use of the following methods.

1. The Least Squares method.

2. The Free hand method.

3. The moving average method.

4. The method of semi – averages.


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The method of Least Squares is more scientific, popular and thus more commonly used when compared

to the other methods. It uses the straight line equation Y= a + bx to fit the trend to the data.

Illustration.

Under this method, the past data of the company are taken into account to assess the nature of present

demand. On the basis of this information, future demand is projected. For e.g., A businessman will

collect the data pertaining to his sales over the last 5 years. The statistics regarding the past sales of the

company is given below.

The table indicates that the sales fluctuate over a period of 5 years. However, there is an up trend in the

business. The same can be represented in a diagram.

Diagrammatic representation.

a)Deriving sales Curve.

Year Sales (Rs.)

1990 30

1991 40

1992 35

1993 50

1994 45

We can find out the trend values for each of the 5 years and also for the subsequent years making use

of a statistical equation, the method of Least Squares. In a time series, x denotes time and y denotes

variable. With the passage of time, we need to find out the value of the variable.


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To calculate the trend values i.e., Yc, the regression equation used is –

Yc = a+ bx.

As the values of ‘a’ and ‘b’ are unknown, we can solve the following two normal equations

simultaneously.

Where,


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Regression equation = Yc = a + bx

For 1990 Y = 40+(4x-2)

Y = 40-8 = 32

For 1991 Y = 40+(4x-1)

Y = 40-4 = 36

For 1992 Y = 40+(40×0)

Y = 40+0 = 40

For 1993 Y = 40+(4X1)

Y = 40+4 = 44

For 1994 Y = 40+(4X2)

Y = 40+8 = 48

For the next two years, the estimated sales would be:

For 1995 Y = 40+(4X3)

Y = 40+12 = 52


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For 1996 Y = 40+(4X4)

Y = 40+16 = 56

Finding trend values when Even Years are given.

Note : –

1. When even years are given, the base year would be in between the two middle years. In

this example, in between the two middle years is 1991.5 ( one year = 1 where as 6 months

= .5)

2. For the purpose of simple calculation, we assume the value for each 6 months i.e. o.5 = 1

To find out the value of a = 200/4 = 50

To find out the value of b = 40/20 = 2

a=50, b=2.

Calculation for each year. Finding trend values.


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1991.5 = Base Year For 1990 Y = 50 +2X –3

Y = 50 – 6 = 44

90 = -3

90.5 = -2 For 1991 Y = 50+2X -1

91 = -1 Y = 50 – 2 = 48

91.5 = 0

92 = +1 For 1992 Y = 50+2X1

92.5 = +2 Y = 50+2 = 52

93 = +3

For 1993 Y = 50+2 X 3

Y = 50+ 6 = 56

Deriving trend line


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Trend projection method requires simple working knowledge of statistics, quite

inexpensive and yields fairly reliable estimates of future course of demand…

While estimating future demand we assume that the past rate of change in the dependent variable

will continue to remain the same in future also. Hence, the method yields result only for that

period where we assume there are no changes. It does not explain the vital upturns and

downturns in sales, thus not very useful in formulating business policies.

B. Economic Indicators

Economic indicators as a method of demand forecasting are developed recently. Under this

method, a few economic indicators become the basis for forecasting the sales of a company. An

economic indicator indicates change in the magnitude of an economic variable. It gives the

signal about the direction of change in an economic variable. This helps in decision making

process of a company. We can mention a few economic indicators in this context.

1. Construction contracts sanctioned for demand towards building materials like cement.

2. Personal income towards demand for consumer goods.


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3. Agriculture income towards the demand for agricultural in puts, instruments, fertilizers,

manure,

etc,

4. Automobile registration towards demand for car spare parts, petrol etc.,

5. Personal Income, Consumer Price Index, Money supply etc., towards demand For

consumption

goods.

The above mentioned and other types of economic indicators are published by specialist

organizations like the Central Statistical Organization etc. The analyst should establish

relationship between the sale of the product and the economic indicators to project the correct

sales and to measure as to what extent these indicators affect the sales. The job of establishing

relationship is a highly difficult task. This is particularly so in case of new products where there

are no past records.

Under this method, demand forecasting involves the following steps:

a. The forecaster has to ensure whether a relationship exists between the demand for a

product and certain specified economic indicators.

b. The forecaster has to establish the relationship through the method of least square and derive

the

regression equation. Assuming the relationship to be linear, the equation

will be y = a + bx.

c. Once the regression equation is obtained by forecasting the value of x, economic

indicator can be applied to forecast the values of Y. i.e. demand.

d. Past relationship between different factors may not be repeated. Therefore, the value

judgment is required to forecast the value of future demand. In addition to it, many other new

factors may also have to be taken into consideration.


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When economic indicators are used to forecast the demand, a firm should know whether the

forecasting is undertaken for a short period or long period. It should collect adequate and

appropriate data and select the ideal method of demand forecasting. The next stage is to

determine the most likely relationship between the dependent variables and finally interpret the

results of the forecasting.

However it is difficult to find out an appropriate economic indicator. This method is not useful in

forecasting demand for new products.

Demand Forecasting For A New Product

Demand forecasting for new products is quite different from that for established products. Here

the firms will not have any past experience or past data for this purpose. An intensive study of

the economic and competitive characteristics of the product should be made to make efficient

forecasts.

Professor Joel Dean, however, has suggested a few guidelines to make forecasting of demand

for new products.

a. Evolutionary approach

The demand for the new product may be considered as an outgrowth of an existing product. For

e.g., Demand for new Tata Indica, which is a modified version of Old Indica can most effectively

be projected based on the sales of the old Indica, the demand for new Pulsor can be forecasted

based on the sales of the old Pulsor. Thus when a new product is evolved from the old product,

the demand conditions of the old product can be taken as a basis for forecasting the demand for

the new product.

b. Substitute approach

If the new product developed serves as substitute for the existing product, the demand for the

new product may be worked out on the basis of a ‘market share’. The growths of demand for all

the products have to be worked out on the basis of intelligent forecasts for independent variables

that influence the demand for the substitutes. After that, a portion of the market can be sliced out

for the new product. For e.g., A moped as a substitute for a scooter, a cell phone as a substitute

for a land line. In some cases price plays an important role in shaping future demand for the

product.

c. Opinion Poll approach

Under this approach the potential buyers are directly contacted, or through the use of samples of

the new product and their responses are found out. These are finally blown up to forecast the

demand for the new product.


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d. Sales experience approach

Offer the new product for sale in a sample market; say supermarkets or big bazaars in big cities,

which are also big marketing centers. The product may be offered for sale through one super

market and the estimate of sales obtained may be ‘blown up’ to arrive at estimated demand for

the product.

e. Growth Curve approach

According to this, the rate of growth and the ultimate level of demand for the new product are

estimated on the basis of the pattern of growth of established products. For e.g., An Automobile

Co., while introducing a new version of a car will study the level of demand for the existing car.

f. Vicarious approach

A firm will survey consumers’ reactions to a new product indirectly through getting in touch

with some specialized and informed dealers who have good knowledge about the market, about

the different varieties of the product already available in the market, the consumers’ preferences

etc. This helps in making a more efficient estimation of future demand.

These methods are not mutually exclusive. The management can use a combination of several of

them supplement and cross check each other.

Summary

An important aspect of demand analysis from the management point of view is concerned with

forecasting demand either for existing or new products. Demand forecasting refers to the

estimation of future demand under given conditions. Such forecasts have immense managerial

uses in the short run like production planning, formulating right purchase policy, pricing policy,

sales forecasting, estimating short run financial requirements, reducing the dependence on

chances, evolving suitable labor policy, control on stocks etc. In the long run they help in

efficient business planning, financial planning, regulating business efficiently, determination of

growth rate of firm, stabilizing the activities of the firm and help in the growth of industries

dependent on each other providing required information particularly in the developed nations.

Demand forecasts are done at micro level, industry level and macro level. A good demand

forecasting method must be accurate, plausible, economical, durable, flexible, simple quick

yielding and permit changes in the demand relationships on an up-to-date basis.

Broadly speaking there are two methods of demand forecasting – 1. Survey Methods, 2

Statistical Methods. Under the survey methods there are a number of variants like consumers’

interview method, collective opinion method, experts’ opinion method and end-use method.

Under the consumers’ interview method demand forecasting is done either by conducting a


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survey of buyers’ intentions through questionnaire or by interviewing directly all the consumers

residing in a region or by forming a panel of consumers. Under the collective opinion method

forecasts are made on the basis of the information gathered from the sales men and market

experts regarding the future demand for the product. Under the Expert opinion method assistance

of outside experts are taken to forecast future demand. The end use method is adopted to forecast

the demand for the intermediate products making use of the input-output coefficients for

particular periods.

Statistical methods like trend projection and economic indicators are generally used to make long

run demand forecasts. Under the trend projection method, based on the past data, adopting a

regression analysis demand forecasts are made. Sometimes changes in the magnitude of the

economic variables too serve as a basis for demand forecasting. A rise in the personal income

indicates a rise in the demand for consumption goods.

In case of new products as the firm will not have any past experience or past sales data, it will

have to follow a few guidelines while making demand forecasts. Depending upon the nature of

the development of the product different approaches like evolutionary approach, substitute,

growth-curve, opinion poll, sales-experience, vicarious etc., are adopted.

Thus a number of methods are being adopted to estimate the future demand for the products,

which is of very great importance in the efficient management of the business.

Unit 4-Market Equilibrium

SUPPLY ANALYSIS

Introduction

The supply analysis is related to the behavior of producers or manufactures. Supply is made by

producers. Each firm has to make a careful calculation about its total supply in the market.

Supply analysis deals with mainly the different factors which bring about changes in the supply

of a product in the market. Supply of a product basically depends on cost of production and the

management decision. Hence it covers such problems like whereto sell, when to sell, for whom

to sell, and how much to sell and at what price to sell etc.

Demand and supply are the two important concepts in economies, the knowledge of which is

very essential to a manufacturing firm for taking numerous decisions almost everyday. These

two concepts link the market behavior of consumers, producers and sellers and with that of price.

The behavior of supply is just the opposite of demand. Both demand and supply are influenced

by the price.



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Know the law of supply and its exceptions

Meaning Of Supply And Law Of Supply

Supply is one of the two forces that determine the price of a commodity in the market. The study

of supply, therefore, is important as the study of demand. Supply means the amount offered for

sale at a given price. According to Thomas, “The supply of goods is the quantity offered for sale

in a given market at a given time at various prices. “According to Prof. Macconnel – “supply

may be defined as a schedule which shows the various amounts of a product which a producer is

willing to and able to produce and make available for sale in the market at each specific price in

a set of possible prices during some given period.” ” To quote Meyers – “We may define supply

as a schedule of the amount of a good that would be offered for sale at all possible prices at any

one instant of time, or during any one period of time, for example, a day, a week and so on, in

which the conditions of supply remain the same.” Thus supply of a product refers to the

various amounts which are offered for sale at a particular price during a given period of

time.

Supply is different from production and stock.Often we assume that the volume of supply is

equal to the volume of production. This, however, is not necessary. Supply can be equal, more or

less, than the current production depending upon the nature of the commodity, price and the

requirements of the producers.

Supply is also different from stock. Stock is the total volume of a commodity which can be

brought into the market for sale at a short notice and supply means the quantity which is actually brought in the market. For perishable commodities, like fish and fruits, supply and

stock are the same because they cannot be stored. The commodities which are not perishable can

be held back, if prices are not favorable and released in large quantities when prices are

favorable. In short, stock is potential supply.

Supply Schedule

Supply schedule is a tabular representation of different quantities of a commodity supplied

at varying prices. It represents the functional relationship between quantity supplied and price.

It is strictly prepared with reference to the price of a given commodity.

The following imaginary supply schedule shows that as price rises, supply extends and as price

falls, supply contracts. Supply schedule is never absolute. It varies with different prices and at

different times. 0.75 paisa is the minimum price to be charged per unit because it equals cost of

production. No producer would like to charge cost price to customers. Hence, supply is zero at

this price. It is called as reserve price.

Price in Rs. Quantity supplied in Units

5-00 500


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4-00 400

3-00 300

2-00 200

1-00 100

0-75 00

Market supply Schedule

The total quantity of commodity supplied at different prices in a market by the

whole body of sellers is called as market supply schedule. It refers to the aggregate behavior

of the market rather than mere totaling of all individual supply schedules.

Price in Rs. Quantity Supplied in Units

Total (A+B+C) A B C

5.00 500 600 700 1800

4.00 400 500 600 1500

3.00 300 400 500 1200

2.00 200 300 400 900

1.00 100 200 300 600

The market supply schedule helps a firm to formulate its sales policy by manipulating the prices.

It helps the management to know how much sales can be increased by raising the price without

losing the demand for the product.


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Supply Curve

The supply curve is a geometrical representation of the supply schedule. The upward sloping curve

clearly indicates that as price rises, quantity supplied expands and vice-versa.

The Law of Supply

The law of supply is just the opposite of the law of demand. Normally, a seller supplies more

units of a commodity at a higher price and vice-versa. Given the cost of production, profits are

likely to be high at higher prices. Higher the price, the greater is the inducement to the producers

to produce and sell more and appropriate more profits. Hence more quantity is supplied at higher

prices and less is supplied to lower prices. This relation ship between the price and the quantity

supplied is popularly known as the law of supply. It states that “Other things remaining

constant, the quantity supplied varies directly with the price i.e. when the price falls,

supply will contract and when price rises, supply will extend“. According to S.E.Thomas, “a

rise in price tends to increase supply and a fall in price tends to reduce it.” There is a functional

relationship between supply and price. Mathematically S= F (P). The law of supply is based on a

number of assumptions.

The other things which should remain constant for the law to operate are:

1. Number of firms, the scale of production and the speed of production.

2. Availability of other inputs.

3. Techniques of production.

4. Cost of production.

5. Market prices of other related goods.

6. Climate and weather conditions.

Special features of law of supply

1. There is a direct relationship between price and supply i.e., higher the prices higher will

be the supply and vice-versa.

2. Price is an independent variable and supply is a dependent variable.

3. The applicability of the law is conditioned by the phrase “Other things being equal”.

Thus the law is not universal in nature.

4. The supply curve normally rises from left to right.

5. It is only qualitative statement.

Exceptions To The Law Of Supply

Generally supply expands with the rise in price and contract with the fall in price. But under certain

exceptional circumstances, in spite of rise in price supply may not expand or at a lower rate more

quantity may be sold. This will happen under exceptional situations. In this case, the supply curve slopes

backward.


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In the diagram when price is Rs. 5.00, 10 units are sold and when price is Rs. 6.00, 30 units are

sold. But, when price rises to Rs. 8.00 quantity supplied falls from 30 units to 20 units.

The following are some of the exceptions to the law of supply.

1. If the seller is badly in need of money, he will sell more even at lower prices.

2. If the seller wants to get rid of his products, then also he will sell more at reduced rates.

3. When further heavy fall in price is anticipated the seller may become panicky and sell

more at a current lower price.

4. In case of auction, the auctioneer is not interested in maximizing profits by selling more

units at a higher price. Here, the price is determined by the bidder while selling an item in

an auction, the auctioner may have some other motives to sell the product. Thus, an

auction sale is an exception to the law of supply.


Understand charges in supply and the factors affecting such changes

Changes Or Shifts In Supply

When supply of a product changes only due to a change in the price of that product alone, it is called as either expansion or contraction in supply. Expansion in supply means, more

quantity is supplied at a higher price and contraction in supply means, less quantity is supplied at

a lower price.


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This tendency can be represented through a single supply curve. In this case, the seller will be

moving either in the upward or downward direction along with the same supply curve. It is

clear from the following diagram.

In the diagram, we can notice that when price is Rs. 2.00, 20 units are sold and when the price rises to

Rs. 4.00, 40 units are sold (extension). On the other hand, when price falls from Rs. 4.00 to Rs. 2.00

quantity supplied also falls from 40 to 20 units.

Supply of a product may change due to changes in other factors. If supply changes not because

of changes in price, but because of changes in other determinants, then, it will be a case of either

increase or decrease in supply.

Increase in Supply

It implies more supply at the same price or same quantity of supply at a lower price. In this

case, we have to draw a new supply curve. In the diagram, Original price = Rs 6.00

Original supply = 10 units Original supply Curve = SS


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Now the seller sells 20 units at the same price of Rs. 6=00.Hence, we get a new point P’. or same

quantity of 10 units are sold at a lower price of Rs. 4=00. Hence, we get another new point P”. If

we join these two new points P’&P” we get a new supply curve S’S’. There is forward shift in

the position of supply curve. Forward shift indicates increase in supply.

Decrease in supply

It implies that less quantity is supplied at the same price or same quantity is supplied at a

higher price. In this case also, we have to draw a new supply curve.

In the diagram,

Original price = Rs.4=00

Original supply = 20 units

Original supply Curve = SS

When less quantity of 10 units are supplied at the same price of Rs.4.00, we get a new point P. Similarly,

when same quantity of 20 units is supplied at a higher price of Rs.6 -00, we get a new point P”. If we join

these new points P’ & P” then we get a new supply curve S’S', which is located to the left of the original

supply curve. There is backward shift in the position of supply curve. Backward shift in the curve

indicates decrease in supply.

Managerial uses of the Law of supply

* Helps a producer to take decisions with respect to:-

1. What product he has to produce and sell.

i. What quantity he has to sell.

ii. At what price he has to sell.


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iii. When he has to produce.

iv. Where he has to sell.

v. For whom he has to sell etc.

1. Helps him to maintain a balance between stock & supply.

2. Helps him in preparing the sales budget policy.

3. Helps in estimating the present and future expected revenue and profit levels.

4. Helps to analyze the effects of taxes on total sales in the market.

5. Helps to analyze the impact of various govt. policies on the supply of a product.

6. Helps in identifying the factors which affect supply of a product.

Determinants Of Supply

Apart from price, many factors bring about changes in supply. Among them the important factors

are:

1. Natural factors Favorable natural factors like good climatic conditions, timely,

adequate, well distributed rainfall results in higher production and expansion in supply.

On the other hand, adverse factors like bad weather conditions, earthquakes, droughts,

untimely, ill-distributed, inadequate rainfall, pests etc., may cause decline in production

and contraction in supply.

2. Change in techniques of production An improvement in techniques of production and

use of modern highly sophisticated machines and equipments will go a long way in

raising the output and expansion in supply. On the contrary, primitive techniques are

responsible for lower output and hence lower supply.

3. Cost of production Given the market price of a product, if the cost of production rises

due to higher wages, interest and price of inputs, supply decreases. If the cost of

production falls, on account of lower wages, interest and price of inputs, supply rises.

4. Prices of related goods If prices of related goods fall, the seller of a given commodity

offer more units in the market even though, the price of his product has not gone up.

Opposite will be the case when the price of related goods rises.

5. Government policy When the government follows a positive policy, it encourages

production in the private sector. Consequently, supply expands. For example granting of

subsidies, development rebates, tax concession, etc,. On the other hand, output and

supply cripples when the government adopts a negative policy. For example withdrawal

of all concessions and incentives, imposition of high taxes, introduction of controls and

quota system etc.

6. Monopoly power Supply tends to be low, when the market is controlled by monopolists,

or a few sellers as in the case of oligopoly. Generally supply would be more under

competitive conditions.

7. Number of sellers or firms Supply would be more when there are a large number of

sellers. Similarly production and supply tends to be more when production is organized


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on large scale basis. If rate or speed of production is high supply expands. Opposite will

be the case when number of sellers is less, small scale production and low rate of

production.

8. Complementary goods In case of joint demand, the production & sale of one product

may lead to production and sale of other product also.

9. Discovery of new source of inputs Discovery of new sources of inputs helps the

producers to supply more at the same price & vice-versa.

10. Improvements in transport and communication This will facilitate free and quick

movements

of goods and services from production centers to marketing centers.

11. Future rise in prices When sellers anticipate a further rise in price, in that case current

supply

tends to fall. Opposite will be the case when, the seller expect a fall in price.

Thus, many factors influence the supply of a product in the market. A firm should have a

thorough knowledge of all these factors because it helps in preparing its production plan and

sales strategy.

Supply Function.

The law of supply and supply schedule explains only the direct relationship between price and

supply. Mathematically S = f (P). Both analyses the impact of change in price on quantity

supplied. Supply of a product, apart from price changes also depends upon many factors. When

we analyze the influence of these factors on supply, supply schedule will be converted into a

supply function.

Supply function is a comprehensive one as it analyses the causes for changes in supply in a

detailed manner. Mathematically a supply function can be represented in the following manner.

Sx = f (Pf, T, Cp,Gp,N………etc)

Where

Sx = supply of a given product x

Pf = price of factor input

T = Technology

Cp = cost of production

Gp = Government policy


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N = Number of firms etc

Supply function is also described as shifts in supply.


Understand elasticity and factors determining elasticity of supply

Elasticity Of Supply

It is a parallel concept to elasticity of demand. It refers to the sensitiveness or responsiveness

of supply to a given change in price. In short, it measures the degree of adjustability of supply

to a given change in price of a product.

. The formula to calculate elasticity of supply is as follows:

It implies that at the present level with every change in price one time, there will be a change in

supply four times directly.

Types of elasticity of supply

Just like elasticity of demand, elasticity of supply is also equal to infinity, zero, greater than

one, lower than one and equal to one.

1. Perfectly elastic supply

Supply is said to be perfectly elastic when a slight change in price leads to immeasurable

changes in supply. Hence supply curve would be a horizontal or parallel line to OX axis.


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2. Perfectly inelastic supply

When supply of a commodity remains constant and does not change whatever may be

the

change in price, it is said to be absolutely or perfectly inelastic supply. Here the supply

curve tends to be a vertical straight line. ES = 00 (zero) .

3. Relatively Elastic supply

If change in the supply is more than proportionate to the change in price, elasticity of

supply

is greater than one. In that case, the supply curve is flatter and is more inclined to x axis.


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4. Relatively Inelastic supply

If the change in supply is less than proportionate to a given change in price, then,

elasticity of

supply is said to be less than one. Here the supply is a steeply rising one.

5. Unitary elastic supply

If proportionate change in supply is exactly equal and proportionate to the change in

price,

then elasticity of supply is equal to one.


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Factors Determining Elasticity Of Supply (DETERMINANTS)

1. Time period

Time has a greater influence on elasticity of supply than on demand. Generally supply tends to

be inelastic in the short run because time available to organize and adjust supply to demand is

insufficient. Supply would be more elastic in the long run.

1. Availability and mobility of factors of production

When factors of production are available in plenty and freely mobile from one occupation to

another, supply tends to be elastic and vice – versa.

1. Technological improvements

Modern methods of production expands output and hence supply tends to be elastic. Old

methods reduce output and supply tends to be inelastic.

1. Cost of production

If cost of production rise rapidly as output expands, then there will not be much incentive to

increase output as the extra benefit will be choked off by increase in cost. Hence supply tends to

be inelastic and vice-versa.

1. Kinds and nature of markets

If the seller is selling his product in different markets, supply tends to be elastic in any one of the

market because, a fall in the price in one market will induce him to sell in another market. Again,

if he is producing several types of goods and can switch over easily from one to another, then

each of his products will be elastic in supply.

1. Political conditions

Political conditions may disrupt production of a product. In that case, supply tends to become

inelastic.


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1. Number of sellers

Supply tends to become more elastic if there are more sellers freely selling their products and

vice-versa.

1. Prices of related goods

A firm can charge a higher price for its products, if prices of other products are higher and

vice-versa.

1. Goals of the firm

If the seller is happy with small output, supply tends to be inelastic and vice-versa.

Thus, several factors influence the elasticity of supply.

Practical Importance

1. The concept of elasticity of supply is of great importance to the finance minister while

formulating the taxation policy of the country. If the supply is inelastic, the imposition of

tax may not bring about any change in the supply. If supply is elastic, reasonable taxes

are to be levied.

2. The price of a commodity depends upon the degree of elasticity of demand and supply.

3. It is used in the theory of incidence of taxation. The money burden of taxation is shared

by the tax payers and the sellers in the ratio of elasticity of supply and demand.

Thus, it has both theoretical as well as practical application in our study.


Understand the concept of equilibrium and the equilibrium between demand and supply

Market Equilibrium And Changes In Market Equilibrium

Meaning of equilibrium

The word equilibrium is derived from the Latin word “aequilibrium” which means equal balance.

It means a state of even balance in which opposing forces or tendencies neutralize each

other. It is a position of rest characterized by absence of change. It is a state where there is

complete agreement of the economic plans of the various market participants so that no


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one has a tendency to revise or alter his decision. In the words of professor Mehta:

“Equilibrium denotes in economics absence of change in movement.”

Market Equilibrium

There are two approaches to market equilibrium viz., partial equilibrium approach and the

general equilibrium approach. The partial equilibrium approach to pricing explains price

determination of a single commodity keeping the prices of other commodities constant. On the

other hand, the general equilibrium approach explains the mutual and simultaneous

determination of the prices of all goods and factors. Thus it explains a multi market equilibrium

position.

Before Marshall, there was a dispute among economists on whether the force of demand or the

force of supply is more important in determining price. Marshall gave equal importance to both

the demand and supply in the determination of value or price. He compared supply and demand

to a pair of scissors – ” We might as reasonably dispute whether it is the upper or the under blade

of a pair of scissors that cuts a piece of paper, as whether value is governed by utility or cost of

production…” Thus neither the upper blade nor the lower blade taken separately can cut the

paper; both have their importance in the process of cutting. Likewise neither supply alone, nor

demand alone can determine the price of a commodity, both are equally important in the

determination of price. But the relative importance of the two may vary depending upon the time

under consideration. Thus, the demand of all consumers and the supply of all firms together

determine the price of a commodity in the market.

Equilibrium between demand and supply price:

Equilibrium between demand and supply price is obtained by the interaction of these two forces.

Price is an independent variable. Demand and supply are dependent variables. They depend on

price. Demand varies inversely with price, a rise in price causes a fall in demand and a fall in

price causes a rise in demand. Thus the demand curve will have a downward slope indicating the

expansion of demand with a fall in price and contraction of demand with a rise in price. On the

other hand supply varies directly with the changes in price, a rise in price causes a rise in supply

and a fall in price causes a fall in supply. Thus the supply curve will have an upward slope. At a

point where these two curves intersect with each other the equilibrium price is established.

At this price quantity demanded equals the quantity supplied. This we can explain with the

help of a table and a diagram


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In the table at Rs. 20 the quantity demanded is equal to the quantity supplied. Since this price is

agreeable to both the buyers and the sellers, there will be no tendency for it to change; this is

called the equilibrium price. Suppose the price falls to Rs.5 the buyers will demand 30 units

while the sellers will supply only 5 units. Excess of demand over supply pushes the price

upwards until it reaches the equilibrium position where supply is equal to demand. On the other

hand if the price rises to Rs. 30 the buyers will demand only 5 units while the sellers are ready to

supply 25 units. Sellers compete with each other to sell more units of the commodity. Excess of

supply over demand pushes the price downwards until it reaches the equilibrium. This process

will continue till the equilibrium price of Rs. 20 is reached. Thus the interactions of supply and

demand forces acting upon each other restore the equilibrium position in the market.

In the diagram DD is the demand curve, SS is the supply curve. Demand and supply are in

equilibrium at point E where the two curves intersect each other. OQ is the equilibrium output.

OP is the equilibrium price. Suppose the price is higher than the equilibrium price i.e. OP2. At

this price quantity demanded is P2 D2, while the quantity supplied is P2 S2. Thus D2 S2 is the

excess supply which the sellers want to push off in the market, competition among sellers will

bring down the price to the equilibrium level where the supply is just equal to the demand. At

price OP1, the buyers will demand P1D1 quantity while the sellers are prepared to sell P1S1.

Demand exceeds supply. Excess demand for goods pushes up the price; this process will go on

until the equilibrium is reached where supply becomes equal to demand.


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Changes In Market Equilibrium

The changes in equilibrium price will occur when there will be shift either in demand curve

or in supply curve or both.

Effects of shit in demand

Demand changes when there is a change in the determinants of demand like the income, tastes,

prices of substitutes and complements, size of the population etc. If demand raises due to a

change in any one of these conditions the demand curve shifts upward to the right. If, on the

other hand, demand falls, the demand curve shifts downward to the left. Such rise and fall in

demand are referred to as increase and decrease in demand.

A change in the market equilibrium caused by the shifts in demand can be explained with the

help of a diagram

Quantity demanded and supplied is shown on OX axis, Price is shown on OY axis. SS is the

supply curve which remains unchanged. DD is the demand curve. Demand and supply curves

intersect each other at point E. Thus OP is the equilibrium price and OQ is the equilibrium

quantity demanded and supplied. Now, suppose the demand increases. The demand curve shifts

forward to D1D1. The new demand curve intersects the supply curve at point E1, where the

quantity demanded increases to OQ1 and price to OP1. In the same way, if the demand curve

shifts backwards and assumes the position D2D2, the new equilibrium will be at E2 and the

quantity demanded will be OQ2, price will be OP2. Thus the market equilibrium price and

quantity demanded will change when there is an increase or decrease in demand.


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Effects Of Shifts In Supply

To study of the effects of changes in supply on market equilibrium we assume the demand to

remain constant. An increase in supply is represented by a shift of the supply curve to the right

and a decrease in supply is represented by a shift to the left. The general rule is, if supply

increases, price falls and if supply decreases price rises.We can show the effects of shifts in

supply with the help of a diagram

In the diagram supply and demand curves intersect each other at point E, establishing

equilibrium price at OP and equilibrium quantity supplied and demanded at OQ. Suppose, supply

increases and the supply curve shifts from SS to S1S1. The new supply curve intersects the

demand curve at E1 reducing the equilibrium price to P1 and raising the quantity demanded to

OQ1. On the other hand if the supply decreases and the supply curve shifts backward to S2S2,

the equilibrium price is pushed upwards to OP2 and the quantity demanded is reduced to OQ2.

Thus changes in supply, demand remaining constant will cause changes in the market

equilibrium.

Effects Of Changes In Both Demand And Supply

Changes can occur in both demand and supply conditions. The effects of such changes on

the market equilibrium depend on the rate of change in the two variables. If the rate of change in

demand is matched with the rate of change in supply there will be no change in the market

equilibrium, the new equilibrium shows expanded market with increased quantity of both supply

and demand at the same price.

This is made clear from the diagram below:


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If the increase in demand is greater than the increase in supply, the new market equilibrium is at

a higher level showing a rise in both the equilibrium price and the equilibrium quantity

demanded and supplied. On the other hand if the increase in supply is greater than the increase in

demand, the new market equilibrium is at lower level, showing a lower equilibrium price and a

higher quantity of good supplied and demanded.

Similar will be the effects when the decrease in demand is greater than the decrease in supply on

the market equilibrium.


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Summary

The management should have a clear understanding of the supply and demand conditions in the

market to have an effective control on business. Supply refers to the quantity of a commodity

offered for sale at a particular price during a given period of time. Supply is different from

production and stock.

Supply schedule is a tabular representation of different quantities of a commodity supplied at

varying prices and the supply curve drawn on the basis of supply schedule which shows the

direct relationship that exists between price and supply. Thus the supply curve will have a

positive slope. The law of supply states that ‘other things being constant’, a rise in price causes

extension of supply and a fall in price causes contraction of supply .There are a few exceptions to

this law.

There will be a shift or a change in supply when the determinants of supply like the natural

factors, techniques of production, cost of production, government policy, monopoly power,

prices of related goods, number of sellers etc., change.

In order to regulate production and supply efficiently management should have proper

knowledge of the concept of elasticity of supply. Elasticity of supply refers to the responsiveness

of supply to a change in price. It is influenced by a number of factors like the period of time

under consideration, availability and mobility of factors of production, technological

improvements, cost of production, number of sellers, prices of related goods etc.

Modern economics is sometimes called equilibrium analysis. Market is in equilibrium when

there is a balance between supply and demand forces. The price and output determined by the

interaction of supply and demand forces are called the equilibrium price and the equilibrium

output. There will be a change in the equilibrium price and output when there is a change in

demand or change in supply or change in both demand and supply. Understanding of the position

of market equilibrium is of very great importance in the decision making process of the firm.


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Unit 5 Production Analysis

Introduction

A business firm is an economic unit. It is also called as a production unit. Production is one of

the most important activities of a firm in the circle of economic activity. The main objective of

production is to satisfy the demand for different kinds

of goods and services of the community.

Learning Objective – 1

1. Understand the concept of production and production function , kinds of production

function and their uses

Meaning Of Production And Production Function

The concept of production can be represented in the following manner.

The term “Production” means transformation of physical “Inputs” into physical

“Outputs”.

The term “Inputs” refers to all those things or items which are required by the firm to produce a

particular product. Four factors of production are land, labor, capital and organization. In

addition to four factors of production, inputs also include other items like raw materials of all

kinds, power, fuel, water, technology, time and services like transport and communications,

warehousing, marketing, banking, shipping and Insurance etc. It also includes the ability, talents,

capacities, knowledge, experience, wisdom of human beings. Thus, the term inputs have a wider


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meaning in economics. What we get at the end of productive process is called as “Outputs”. In

short, “Outputs” refer to finished products.

Production always results in either creation of new utilities or addition of values. It is an activity

that increases consumer satiability of goods and services. Production is undertaken by producers

and basically it depends on cost of production. Production analysis is always made in physical

terms and it shows the relationship between physical inputs and physical outputs.

It is to be noted that higher levels of production is an index of progress and growth of an

organization and that of a society. It leads to higher income, employment and economic

prosperity. Production of different types of goods and services in different nations indicates the

nature of economic inter dependence between different nations.

PRODUCTION FUNCTION

The entire theory of production centre round the concept of production function. “A production

Function” expresses the technological or engineering relationship between physical quantity of

inputs employed and physical quantity of outputs obtained by a firm. It specifies a flow of output

resulting from a flow of inputs during a specified period of time. It may be in the form of a table,

a graph or an equation specifying maximum output rate from a given amount of inputs used.

Since it relates inputs to outputs, it is also called as “Input-output relation.” The production is

purely physical in nature and is determined by the quantum of technology, availability of

equipments, labor, and raw materials, and so on employed by a firm.

A production function can be represented in the form of a mathematical model or equation as Q = f (L,

N, K….etc) where Q stands for quantity of output per unit of time and L N K etc are the various factor

inputs like land, capital labor etc which are used in the production of output. The rate of output Q is

thus, a function of the factor inputs L N K etc, employed by the firm per unit of time.

Factor inputs are of two types.

1. Fixed Inputs. Fixed inputs are those factors the quantity of which remains constant irrespective of the level of output produced by a firm. For example, land, buildings,

machines, tools, equipments, superior types of labor, top management etc.

2. Variable inputs. Variable inputs are those factors the quantity of which varies with variations in the levels of output produced by a firm For example, raw materials, power, fuel,

water, transport and communication etc.

The distinction between the two will hold good only in the short run. In the long run, all factor

inputs will become variable in nature.

Short run is a period of time in which only the variable factors can be varied while fixed factors like plants, machineries, top management etc would remain constant. Time available


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at the disposal of a producer to make changes in the quantum of factor inputs is very much

limited in the short run. Long run is a period of time where in the producer will have

adequate time to make any sort of changes in the factor combinations.

It is necessary to note that production function is assumed to be a continuous function, i.e. it is

assumed that a change in any of the variable factors produces corresponding changes in the out

put.

Generally speaking, there are two types of production functions. They are as follows.

1. Short Run Production Function

In this case, the producer will keep all fixed factors as constant and change only a few variable

factor inputs. In the short run, we come across two kinds of production functions-

1. Quantities of all inputs both fixed and variable will be kept constant and only one variable

input will be varied. For example, Law of Variable Proportions.

2. Quantities of all factor inputs are kept constant and only two variable factor inputs are varied.

For example, Iso-Quants and Iso- Cost curves.

2. Long Run Production Function

In this case, the producer will vary the quantities of all factor inputs, both fixed as well as

variable in the same proportion. For Example, The laws of returns to scale.

Each firm has its own production function which is determined by the state of technology,

managerial ability, organizational skills etc of a firm. If there are any improvements in them, the

old production function is disturbed and a new one takes its place. It may be in the following

manner:-

1. The quantity of inputs may be reduced while the quantity of output may remain same.

2. The quantity of output may increase while the quantity of inputs may remain same.

3. The quantity of output may increase and quantity of inputs may decrease.

Uses Of Production Function

Though production function may appear as highly abstract and unrealistic, in reality, it is both logical

and useful. It is of immense utility to the managers and executives in the decision making process at the

firm level.

There are several possible combinations of inputs and decision makers have to choose the most

appropriate among them. The following are some of the important uses of production function.


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1. It can be used to calculate or work out the least cost input combination for a given output or

the

maximum output-input combination for a given cost.

2. It is useful in working out an optimum, and economic combination of inputs for getting a

certain

level of output. The utility of employing a unit of variable factor input in the production process

can

be better judged with the help of production function. Additional employment of a variable

factor

input is desirable only when the marginal revenue productivity of that variable factor input is

greater than or equal to cost of employing it in an organization.

3. Production function also helps in making long run decisions. If returns to scale are increasing, it is

wise to employ more factor units and increase production. If returns to scale are diminishing, it is

unwise to employ more factor inputs & increase production. Managers will be indifferent whether

to increase or decrease production, if production is subject to constant returns to scale.

Thus, production function helps both in the short run and long run decision – making process.


Learn short-run and long –run production functions

THE LAW OF VARIABLE PROPORTIONS

This law is one of the most fundamental laws of production. It gives us one of the key insights to

the working out of the most ideal combination of factor inputs. All factor inputs are not available

in plenty. Hence, in order to expand the output, scarce factors must be kept constant and variable

factors are to increased in greater quantities. Additional units of a variable factor on the fixed

factors will certainly mean a variation in output. The law of variable proportions or the law of

non-proportional output will explain how variation in one factor input give place for variations in

outputs. The law can be stated as the following. As the quantity of different units of only one

factor input is increased to a given quantity of fixed factors, beyond a particular point, the

marginal, average and total output eventually decline

The law of variable proportions is the new name for the famous “Law of Diminishing Returns”

of classical economists. This law is stated by various economists in the following manner –


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According to Prof. Benham, “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 diminish”1. The same idea has been expressed by Prof.Marshall in the following words. An

increase in the quantity of a variable factor added to fixed factors, at the end results in a less than

proportionate increase in the amount of product, given technical conditions.

ASSUMPTIONS OF THE LAW

1. Only one variable factor unit is to be varied while all other factors should be kept constant.

• Different units of a variable factor are homogeneous.

• Techniques of production remain constant.

• The law will hold good only for a short and a given period.

• There are possibilities for varying the proportion of factor inputs.

ILLUSTRATION

A hypothetical production schedule is worked out to explain the operation of the law.

Fixed factors = 1 Acre of land + Rs 5000-00 capital. Variable factor = labor.

Total Product or Output : (TP) It is the output derived from all factors units, both fixed & variable

employed by the producer. It is also a sum of marginal output.


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Average Product or Output: (AP). It can be obtained by dividing total output by the number of variable

factors employed.

Marginal Product or Output: (MP) It is the output derived from the employment of an additional unit of

variable factor unit

Trends in output

From the table, one can observe the following tendencies in the TP, AP, & MP.

1. Total output goes on increasing as long as MP is positive. It is the highest when MP is zero

and TP declines when MP becomes negative.

2. MP increases in the beginning, reaches the highest point and diminishes at the end.

3. AP will also have the same tendencies as the MP. In the beginning MP will be higher than AP

but at the end AP will be higher than MP.

Diagrammatic Representation


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In the above diagram along with OX axis, we measure the amount of variable factors employed and

along OY – axis, we measure TP, AP & MP. From the diagram it is clear that there are III stages.

Stage Number I. The Law Of Increasing Returns

The total output increases at an increasing rate (More than proportionately) up to the point P

because corresponding to this point P the MP is rising and reaches its highest point. After the

point P, MP decline and as such TP increases gradually.

The first stage comes to an end at the point where MP curve cuts the AP curve when the AP is

maximum at N.

The I stage is called as the law of increasing returns on account of the following reasons.

1. The proportion of fixed factors is greater than the quantity of variable factors. When the

producer


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increases the quantity of variable factor, intensive and effective utilization of fixed factors

become

possible leading to higher output.

2. When the producer increases the quantity of variable factor, output increases due to the

complete

utilization. of the “Indivisible Factors”

3. As more units of the variable factor is employed, the efficiency of variable factors will go up

because it creates more opportunity for the introduction of division of labor and specialization

resulting in higher output.

Stage Number II The Law Of Diminishing Returns

In this case as the quantity of variable inputs is increased to a given quantity of fixed factors, output

increases less than proportionately. In this stage, the T.P increases at a diminishing rate since both AP &

MP are declining but they are positive. The II stage comes to an end at the point where TP is the highest

at the point E and MP is zero at the point B. It is known as the stage of “Diminishing Returns” because

both the AP & MP of the variable factor continuously fall during this stage. It is only in this stage, the

firm is maximizing its total output.

Diminishing returns arise due to the following reasons:

1. The proportion of variable factors are greater than the quantity of fixed factors. Hence,

both AP & MP decline.

2. Total output diminishes because there is a limit to the full utilization of indivisible factors

and introduction of specialization. Hence, output declines.

3. Diseconomies of scale will operate beyond the stage of optimum production.

4. Imperfect substitutability of factor inputs is another cause. Up to certain point

substitution is beneficial. Once optimum point is reached, the fixed factors cannot be

compensated by the variable factor. Diminishing returns are bound to appear as long as

one or more factors are fixed and cannot be substituted by the others.

The III Stage The Stage Of Negative Returns.

In this case, as the quantity of variable input is increased to a given quantity of fixed factors, output

becomes negative. During this stage, TP starts diminishing, AP continues to diminish and MP becomes

negative. The negative returns are the result of excessive quantity of variable factors to a constant

quantity of fixed factors. Hence, output declines. The proverb “Too many cooks spoil the broth” and ”


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Too much is too bad” aptly applies to this stage. Generally, the III stage is a theoretical possibility

because no producer would like to come to this stage.

The producer being rational will not select either the stage I (because there is opportunity for him to

increase output by employing more units of variable factor) or the III stage (because the MP is negative).

The stage I & III is described as NON-Economic Region or Uneconomic Region. Hence, the producer will

select the II stage (which is described as the most economic region) where he can maximize the output.

The II stage represents the range of rational production decision.

It is clear that in the above example, the most ideal or optimum combination of factor units

= 1 Acre of land+ Rs. 5000 – 00 capital and 9 laborers.

All the 3 stages together constitute the law of variable proportions. Since the second stage is the most

important, in practice we normally refer this law as the law of Diminishing Returns.

PRACTICAL application of the law

1. It helps a producer to work out the most ideal combination of factor inputs or the least

cost combination of factor inputs.

2. It is useful to a businessman in the short run production planning at the micro-level.

3. The law gives guidance that by making continuous improvements in science and

technology, the producer can postpone the occurrence of diminishing returns.

Production Function With Two Variable Inputs

ISO-QUANTS AND ISO- COSTS

The prime concern of a firm is to workout the cheapest factor combinations to produce a given

quantity of output. There are a large number of alternative combinations of factor inputs which

can produce a given quantity of output for a given amount of investment. Hence, a producer has

to select the most economical combination out of them. Iso-product curve is a technique

developed in recent years to show the equilibrium of a producer with two variable factor inputs.

It is a parallel concept to the indifference curve in the theory of consumption.

MEANING AND DEFINITIONS

The term “Iso –Quant” has been derived from ‘Iso’ meaning equal and ‘Quant’ meaning quantity. Hence,

Iso – Quant is also called as Equal Product Curve or Product Indifference Curve or Constant Product

Curve. An Iso – product curve represents all the possible combinations of two factor inputs which are

capable of producing the same level of output. It may be defined as – ” a curve which shows the

different combinations of the two inputs producing the same level of output .”

Each Iso – Quant curve represents only one particular level of output. If there are different Iso–Quant

curves, they represent different levels of output. Any point on an Iso–Quant curve represents same level

of output. Since each point indicates equal level of output, the producer becomes indifferent with

respect to any one of the combinations.


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EQUAL PRODUCT COMBINATION

Combinations Factor X (Labor) Factor Y Capital Total Output in units

A 12 1 100

B 8 2 100

C 5 3 100

D 3 4 100

E 2 5 100

In the above schedule, all the five factor combinations will produce the equal level of output, i.e.100

units. Hence, the producer is indifferent with respect to any one of the combinations mentioned above.

Graphic Representation

In the diagram, if we join points ABCDE (which represents different combinations of factor x and y) we

get an Iso-quant curve IQ. This curve represents 100 units of output that may be produced by employing

any one of the combinations of two factor inputs mentioned above. It is to be noted that an Iso-Product

Curve shows the exact physical units of output that can be produced by alternative combinations of two

factor inputs. Hence, absolute measurement of output is possible.

Iso – Quant Map


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A catalogue of different combinations of inputs with different levels of output can be indicated in a

graph which is called as equal product map or Iso-quant map. In other words, a number of Iso Quants

representing different amount of out put are known as Iso-quant map.

Marginal Rate of Technical Substitution (MRTS)

It may be defined as the rate at which a factor of production can be substituted for another at the

margin without affecting any change in the quantity of output. For example, MRTS of X for Y is the

number of units of factor Y that can be replaced by one unit of factor X quantity of output remaining the

same.

Combinations

Factor

X

Factor Y MRTS of x for y

A 12 1 Nil

B 8 2 4:1

C 5 3 3:1

D 3 4 .2:1

E 2 5 1:1


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In the above example, we can notice that in the second combination the producer is substituting 4

units of X for 1 unit of Y. Hence, in this case MRTS of Y for X is 4:1

Generally speaking, the MRTS will be diminishing. In the above table, we can observe that as the

quantity of factor Y is increased relative to the quantity of X, the number of units of X that will be

required to be replaced by one unit of factor Y will diminish, quantity of output remaining the same. This

is known as the law of Diminishing Marginal Rate of Technical Substitution (DMRTS).

Properties of Iso- Quants.

1. An Iso-Quant curve slope downwards from left to right.

2. Generally an Iso-Quant curve is convex to the origin.

3. No two Iso-product curves intersect each other.

4. An Iso-product curve lying to the right represents higher output and vice-versa.

5. Always one Iso-Quant curve need not be parallel to other.

6. It will not touch either X or Y – axis.

ISO-COST LINE OR CURVE

It is a parallel concept to the budget or price line of the consumer. It indicates the different

combinations of the two inputs which the firm can purchase at given prices with a given outlay. It shows

two things (a) prices of two inputs (b) total outlay of the firm. Each Iso-cost line will show various

combinations of two factors which can be purchased with a given amount of money at the given price of

each input. We can draw the Iso-cost line on the basis of an imaginary example.

Let us suppose that a producer wants to spend Rs. 3,000 to purchase factor X and Y. If the price of X per

unit Rs. 100 -.00 he can purchase 30 units of X. Similarly if the price of factor Y is Rs. 50.- 00 then he can

purchase 60 units of Y.

When 30 units of factor X are represented on OY – axis and 60 units of factor Y are represented on OX-

axis, we get two points A & B. If we join these two points A and B, then we get the Iso-Cost line AB. This

line represents the different combinations of factor X and Y that can be purchased with Rs. 3,000.00


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The Iso-Cost line will shift to the right if the producer increase his outlay from Rs. 3,000.- 00 to Rs. 4,000-

00. On the contrary, if his outlay decreases to Rs. 2,000 -00, there will be a backward shift in the position

of Iso-cost line.

The slope of the Iso-cost line represents the ratio of the price of a unit of factor X to the price of a unit of

factor Y. In case, the price of any one of them changes there would be a corresponding change in the

slope and position of Iso-cost line.

PRODUCERS EQUILIBRIUM (Optimum factor combination or least cost combination)

The optimal combination of factor inputs may help in either minimizing cost for a given level of

output or maximizing output with a given amount of investment expenditure. In order to

explain producer’s equilibrium, we have to integrate Iso-quant curve with that of Iso-cost line.

Iso-product curve represent different alternative possible combinations of two factor inputs with

the help of which a given level of output can be produced. On the other hand, Iso-cost line shows

the total outlay of the producer and the prices of factors of production.


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The intention of the producer is to maximize his profits. Profits can be maximized when he is producing

maximum output with minimum production cost. Hence, the producer selects the least cost

combination of the factor inputs. Maximum output with minimum cost is possible only when he reaches

the position of equilibrium. The position of equilibrium is indicated at the point where Iso-Quant curve is

tangential to Iso-Cost line. The following diagram explains how the producer reaches the position of

equilibrium.

It is quite clear from the diagram that the producer will reach the position of equilibrium at the point E

where the Iso-quant curve IQ and Iso-cost line AB is tangent to each other. With a given total out lay of

Rs. 5,000 the producer will be producing the highest output, i.e. 500 units by employing 25 units of

factors X and 50 units of factor Y. (assuming Rs. 2,500 each is spent on X and Y)

The price of one unit of factor X is Rs.100-00 and that of Y is Rs. 50-00.. Rs.100 x 25 units of 2500 – 00

and Rs. 50 x 50 units of Y = 2500 – 00. He will not reach the position of equilibrium either at the point E1

and E2 because they are on a higher Iso-cost line. Similarly, he cannot move to the left side of E, because

they are on a lower Iso-Cost line and he will not be able to produce 500 units of output by any

combinations which lie to the left of E.

Thus, the point at which the Iso-Quant is tangent to the Iso-Cost line represents the minimum cost or

optimum factor combination for producing a given level of output. At this point, MRTS between the two

points is equal to the ratio between the prices of the inputs.

Long Run Production Function [Change In All Factor Inputs In The Same Proportion]

LAWS OF RETURNS TO SCALE

The concept of returns to scale is a long run phenomenon. In this case, we study the change in

output when all factor inputs are changed or made available in required quantity. An increase in

scale means that all factor inputs are increased in the same proportion. In returns to scale, all the

necessary factor inputs are increased or decreased to the same extent so that what ever the scale

of production, the proportion among the factors remains the same.


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Three Phases of Returns to Scale

Generally speaking, we study the behavior pattern of output when all factor inputs are increased

in the same proportion under returns to scale. Many economists have questioned the validity of

returns to scale on the ground that all factor inputs cannot be increased in the same proportion

and the proportion between the factor inputs cannot be kept uniform. But in some cases, it is

possible that all factor inputs can be changed in the same proportion and the output is steadied

when the input is doubled or tripled or increased five-fold or ten-fold. An ordinary person may

think that when the quantity of inputs is increased 10 times, output will also go up by10 times.

But it may or may not happen as expected.

It may be noted that when the quantity of inputs are increased in the same proportion, the scale

of output or returns to scale may be either more than equal, equal or less than equal. Thus, when

the scale of output is increased, we may get increasing returns, constant returns or diminishing

returns.

When the quantity of all factor inputs are increased in a given proportion and output increases

more than proportionately, then the returns to scale are said to be increasing; when the output

increases in the same proportion, then the returns to scale are said to be constant; when the

output increases less than proportionately, then the returns to scale are said to be diminishing.

Sl No. Scale

Total Product

in Units

Marginal Product in units

1 1 Acre of land + 3 labor 5 5





6 6 Acre of land + 13labor 54 11



It is clear from the table that the quantity of land and labor (Scale) is increasing in the same

proportion, i.e. by 1 acre of land and 2 units of labor through out in our example. The output

increases more than proportionately when the producer is employing 4 acres of land and 9 units

of labor. Output increases in the same proportion when the quantity of land is 5 acres and 11units

of labor and 6 acres of land and 13 units of labor. In the later stages, when he employs 7 & 8

acres of land and 15 & 17 units of labor, output increases less than proportionately. Thus, one

can clearly understand the operation of the three phases of the laws of returns to scale with the

help of the table.


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Diagrammatic representation

In the diagram, it is clear that the marginal returns curve slope upwards from A to B, indicating

increasing returns to scale. The curve is horizontal from B to C indicating constant returns to

scale and from C to D, the curve slope downwards from left to right indicating the operation of

diminishing returns to scale.

INCREASING RETURNS TO SCALE:

Increasing returns to scale is said to operate when the producer is increasing the

quantity of all factors [scale] in a given proportion, output increases more than proportionately. For example, when the quantity of all inputs are increased by 10%, and output

increases by 15%, then we say that increasing returns to scale is operating. In order to explain the

operation of this law, an equal product map has been drawn with the assumption that only two

factors X and Y are required. In the diagram, Factor X is represented along .OX- axis and factor

Y is represented along OY axis. The scale line OP is a straight line passing through the origin on

the Iso Quant map indicating the increase in scale as we move upward. The scale line OP

represent different quantities of inputs where the proportion between factor X and factor Y is


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remains constant. When the scale is increased from A to B, the return increases from 100 units of

output to 200 units. The scale line OP passing through origin is called as the “Expansion path”.

Any line passing through the origin will indicate the path of expansion or increase in scale with

definite proportion between the two factors. It is very clear that the increase in the quantities

of factor X and Y [scale] is small as we go up the scale and the output is larger. The distance

between each Iso Quant curve is progressively diminishing. It implies that in order to get an

increase in output by another 100 units, a producer is employing lesser quantities of inputs and

his production cost is declining. Thus, the law of increasing returns to scale is operating

Causes for Increasing Returns to Scale

Increasing returns to scale operate in a firm on account of several reasons. Some of the most

important ones are as follows

1. Wider scope for the use of latest tools, equipments, machineries, techniques etc to

increase production and reduce cost per unit.

2. Large-scale production leads to full and complete utilization of indivisible factor inputs

leading to further reduction in production cost.

3. As the size of the plant increases, more output can be obtained at lower cost.

4. As output increases, it is possible to introduce the principle of division of labor and

specialization, effective supervision and scientific management of the firm etc would help

in reducing cost of operations.

5. As output increases, it becomes possible to enjoy several other kinds of economies of

scale like overhead, financial, marketing and risk-bearing economies etc, which is

responsible for cost reduction.

It is important to note that economies of scale outweigh diseconomies of scale in case of

increasing returns to scale.


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CONSTANT RETURNS TO SCALE

Constant returns to scale is operating when all factor inputs [scale] are increased in a given proportion, output also increases in the same proportion. When the quantity of all inputs is

increased by 10%, and output also increases exactly by 10%, then we say that constant returns to

scale are operating.In the diagram, it is clear that the successive Iso Quant curves are equi distant

from each other. Along the scale line OP. It indicates that as the producer increases the quantity

of both factor X and Y in a given proportion, output also increases in the same proportion.

Economists also describe Constant returns to scale as the Linear homogeneous Production

function. It shows that with constant returns to scale, there will be one input proportion which

does not change, what ever may be the level of output.

Causes for Constant Returns to Scale

In case of constant returns to scale, the various internal and external economies of scale are

neutralized by internal and external diseconomies. Thus, when both internal and external

economies and diseconomies are exactly balanced with each other, constant returns to scale will

operate.

DIMINISHING RETURNS TO SCALE

Diminishing returns to scale is operating when output increases less than proportionately

when compared the quantity of inputs used in the production process. For example, when


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the quantity of all inputs are increased by 10%, and output increases by 5%, then we say that

diminishing returns to scale is operating.

In the diagram, it is clear that the distance Between each successive Iso Quant curve

Is progressively increasing along the scale line OP it indicates that as the producer is

increasing the quantity of both factor X and Y, in a given proportion, output increases

less than proportionately. Thus, the law of Diminishing returns to scale is operating.

Causes for Diminishing Returns to Scale

Diminishing Returns to Scale operate due to the following reasons-

1. Emergence of difficulties in co-ordination and control.

2. Difficulty in effective and better supervision.

3. Delays in management decisions.

4. Inefficient and mis-management due to over growth and expansion of the firm.

5. Productivity and efficiency declines unavoidably after a point.

Thus, in this case, diseconomies outweigh economies of scale. The result is the operation of

diminishing returns to scale.

The concept of Returns to Scale helps a producer to workout the most desirable


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Combination of factor inputs so as to maximize his output and minimize his production cost. It

also helps him, to increase his production, maintain the same level or decrease it depending on

the demand for the product.


Knowledge of economies of scale and diseconomies of sale and economies and diseconomies

of scope

Economies Of Scale

The study of economies of scale is associated with large scale production. To-day there is a

general tendency to organize production on a large scale basis. Mass production of standardized

goods has become the order of the day. Large scale production is beneficial and economical in

nature. “The advantages or benefits that accrue to a firm as a result of increase in its scale

of production are called ‘Economies of scale’. They have close relationship with the size of the

firm. They influence the average cost over different ranges of output. They are gain to a firm.

They help in reducing production cost and establishing an optimum size of a firm. Thus, they

help a lot and go a long way in the development and growth of a firm. According to Prof.

Marshall these economies are of two types, viz Internal Economies and External Economics

Now we shall study both of them in detail.

I Internal Economies or Real Economies

Internal Economies are those economies which arise because of the actions of an individual firm to

economize its cost. They arise due to increased division of labor or specialization and complete

utilization of indivisible factor inputs. Prof. Cairncross points out that internal economies are open to a

single factory or a single firm independently of the actions of other firms. They arise on account of an

increase in the scale of output of a firm and cannot be achieved unless output increases. The following

are some of the important aspects of internal economies.

1. They arise “with in” or “inside” a firm.

2. They arise due to improvements in internal factors.

3. They arise due to specific efforts of one firm.

4. They are particular to a firm and enjoyed by only one firm.

5. They arise due to increase in the scale of production.

6. They are dependent on the size of the firm.


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7. They can be effectively controlled by the management of a firm.

8. They are called as “Business Secrets “of a firm.

Kinds of Internal Economies.

1. Technical Economies

These economies arise on account of technological improvements and its practical

application in the

field of business. Economies of techniques or technical economies are further subdivided into

five

heads.

a. Economies of superior techniques: These economies are the result of the application of the

most modern techniques of production. When the size of the firm grows, it becomes possible to

employ bigger and better types of machinery. The latest and improved techniques give place for

specialized production. It is bound to be cost reducing in nature. For example, cultivating the

land with modern tractors instead of using age old wooden ploughs and bullock carts, use of

computers instead of human labor etc.

b. Economies of increased dimension: It is found that a firm enjoys the reduction in cost when

it increases its dimension. A large firm avoids wastage of time and economizes its expenditure.

Thus, an increase in dimension of a firm will reduce the cost of production. For example,

operation of a double decker instead of two separate buses.

c. Economies of linked process: It is quite possible that a firm may not have various processes

of production with in its own premises. Also it is possible that different firms through mutual

agreement may decide to work together and derive the benefits of linked processes, for example,

in diary farming, printing press, nursing homes etc.

d. Economies arising out of research and by – products: A firm can invest adequate funds for

research and the benefits of research and its costs can be shared by all other firms. Similarly, a

large firm can make use of its wastes and by-products in the most economical manner by

producing other products. For example, cane pulp, molasses, and bagasse of sugar factory can be

used for the production of paper, varnish distilleries etc.

e. Inventory Economies. Inventory management is a part of better materials management. A big

firm can save a lot of money by adopting latest inventory management techniques. For example,

Just- In-Time or zero level inventory techniques. The rationale of the Just-in-Time technique is

that instead of having huge stocks worth of lakhs and crores of rupees, it can ask the seller of the


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inputs to supply them just before the commencement of work in the production department each

day.

2. Managerial Economies.

They arise because of better, efficient, and scientific management of a firm. Such economies

arise in two different ways.

a. Delegation of details The general manager of a firm cannot look after the working of all

processes of production. In order to keep an eye on each production process he has to delegate

some of his powers or functions to trained or specialized personnel and thus relieve himself for

co-ordination, planning and executing the plans. This will enable him to bring about

improvements in production process and in bringing down the cost of production.

b. Functional Specialization. It is possible to secure economies of large scale production by

dividing the work of management into several separate departments. Each department is placed

under an expert and the rest of the work is left into the hands of specialists. This will ensure

better and more efficient productive management with scientific business administration. This

would lead to higher efficiency and reduction in the cost of production.

3. Marketing or Commercial economies:

These economies will arise on account of buying and selling goods on large scale basis at favorable terms. A large firm can buy raw materials and other inputs in bulk at concessional

rates. As the bargaining capacity of a big firm is much greater than that of small firms, it can get

quantity discounts and rebates. In this way economies may be secured in the purchase of

different inputs.

A firm can reduce its selling costs also. A large firm can have its own sales agency and

channel. The firm can have a separate selling organization, marketing department manned by

experts who are well versed in the art of pushing the products in the market. It can follow an

aggressive sales promotion policy to influence the decisions of the consumers

4. Financial Economies

They arise because of the advantages secured by a firm in mobilizing huge financial resources. A large firm on account of its reputation, name and fame can mobilize huge funds

from money market, capital market, and other private financial institutions at concessional

interest rates. It can borrow from banks at relatively cheaper rates. It is also possible to have

large overdrafts from banks. A large firm can float debentures and issue shares and get

subscribed by the general public. Another advantage will be that the raw material suppliers,

machine suppliers etc., are willing to supply material and components at comparatively low

rates, because they are likely to get bulk orders. Thus, a big firm has an edge over small firms in

securing sufficient funds more easily and cheaply.

5 Labor Economies.


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These economies will arise as a result of employing skilled, trained, qualified and highly experienced

persons by offering higher wages and salaries. As a firm expands, it can employ a large number of

highly talented persons and get the benefits of specialization and division of labor. It can also impart

training to existing labor force in order to raise skills, efficiency and productivity of workers. New

schemes may be chalked out to speed up the work, conserve the scarce resources, economize the

expenditure and save labor time. It can provide better working conditions promotional opportunities,

rest rooms, sports rooms etc, and create facilities like subsidized canteen, crèches for infants,

recreations. All these measures will definitely raise the average productivity of a worker and reduce the

cost per unit output.

6. Transport and Storage Economies

They arise on account of the provision of better, highly organized and cheap transport and storage facilities and their complete utilization. A large company can have its own fleet of

vehicles or means of transport which are more economical than hired ones. Similarly, a firm can

also have its own storage facilities which reduce cost of operations.

7. Over Head Economies

These economies will arise on account of large scale operations. The expenses on

establishment, administration, book-keeping, etc, are more or less the same whether production

is carried on small or large scale. Hence, cost per unit will be low if production is organized on

large scale.

8. Economies of Vertical integration

A firm can also reap this benefit when it succeeds in integrating a number of stages of

production. It secures the advantages that the flow of goods through various stages in

production processes is more readily controlled. Because of vertical integration, most of the costs

become controllable costs which help an enterprise to reduce cost of production.

9. Risk-bearing or survival economies

These economies will arise as a result of avoiding or minimizing several kinds of risks and

uncertainties in a business. A manufacturing unit has to face a number of risks in the business.

Unless these risks are effectively tackled, the survival of the firm may become, difficult. Hence

many steps are taken by a firm to eliminate or to avoid or to minimize various kinds of risks.

Generally speaking, the risk-bearing capacity of a big firm will be much greater than that of a

small firm. Risk is avoided when few firms amalgamate or join together or when competition

between different firms is either eliminated or reduced to the minimum or expanding the size of

the firm. A large firm secures risk-spreading advantages in either of the four ways or through all

of them.

• Diversification of output Instead of producing only one particular variety, a firm has to

produce multiple products If there is loss in one item it can be made good in other items.


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• Diversification of market: Instead of selling the goods in only one market, a firm has to

sell its products in different markets. If consumers in one market desert a product, it can

cover the losses in other markets.

• Diversification of source of supply: Instead of buying raw materials and other inputs

from only one source, it is better to purchase them from different sources. If one person

fails to supply, a firm can buy from several sources.

• Diversification of the process of manufacture: Instead adopting only one process of

production to manufacture a commodity, it is better to use different processes or methods

to produce the same commodity so as to avoid the loss arising out of the failure of any

one process.

II. External Economies or Pecuniary Economies

External economies are those economies which accrue to the firms as a result of the

expansion in the output of whole industry and they are not dependent on the output level of

individual firms. These economies or gains will arise on account of the over all growth of an

industry or a region or a particular area. They arise due to benefit of localization and specialized

progress in the industry or region. Prof. Stonier & Hague points out that external economies are

those economies in production which depend on increase in the output of the whole industry

rather than increase in the output of the individual firm The following are some of the important

aspect of external economies.

1. They arise ‘outside’ the firm.

2. They arise due to improvement in external factors.

3. They arise due to collective efforts of an industry.

4. They are general, common & enjoyed by all firms.

5. They arise due to overall development, expansion & growth of an industry or a

region.

6. They are dependent on the size of industry.

7. They are beyond the control of management of a firm.

8. They are called as “open secrets “of a firm.

Kinds of External Economies


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1. Economies of concentration or Agglomeration

They arise because in a particular area a very large number of firms which produce the same commodity are established. In other words, this is an advantage which arises from what

is called ‘Localization of Industry’. The following benefits of localization of industry is enjoyed

by all the firms-provision of better and cheap labor at low or reasonable rates, trained educated

and skilled labor, transport and communication, water, power, raw materials financial assistance

through private and public institutions at low interest rates, marketing facilities, benefits of

common repairs, maintenance and service shops, services of specialists or outside experts, better

use of by- products and other such benefits. Thus, it helps in reducing the cost of operation of a

firm.

1. Economies of Information

These economies will arise as a result of getting quick, latest and up to date information

from various sources. Another form of benefit that arises due to localization of industry is

economies of information. Since a large number of firms are located in a region, it becomes

possible for them to exchange their views frequently, to have discussions with others, to organize

lectures, symposiums, seminars, workshops, training camps, demonstrations on topics of mutual

interest. Revolution in the field of information technology, expansion in inter net facilities,

mobile phones, e-mails, video conferences, etc has helped in the free flow of latest information

from all parts of the globe in a very short span of time. Similarly, publication of journals,

magazines, information papers etc have helped a lot in the dissemination of quick information.

Statistical, technical and other market information becomes more readily available to all firms.

This will help in developing contacts between different firms. When inter-firm relationship

strengthens, it helps a lot to economize the expenditure of a single firm.

1. Economies of Disintegration

These economies will arise as a result of dividing one big unit in to different small units for the sake of convenience of management and administration. When an industry grows beyond

a limit, in that case, it becomes necessary to split it in to small units. New subsidiary units may

grow up to serve the needs of the main industry. For example, in cotton textiles industry, some

firms may specialize in manufacturing threads, a few others in printing, and some others in

dyeing and coloring etc. This will certainly enhance the efficiency in the working of a firm and

cut down unit costs considerably.

4. Economies of Government Action

These economies will arise as a result of active support and assistance given by the

government to stimulate production in the private sector units. In recent years the

government, in order to encourage the development of private industries have come up with

several kinds of assistance. It is granting tax-concessions, tax-holidays, tax-exemptions,

subsidies, development rebates financial assistance at low interest rates, etc.


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It is quite clear from the above detailed description that both internal and external economies

arise on account of large scale production and they are benefits to a firm and cost reducing in

nature.

1. Economies of Physical Factors

These economies will arise due to the availability of favorable physical factors and environment. As the size of an industry expands, positive physical environment may to reduce

the costs of all firms working in the industry. For example, Climate, weather conditions, fertility

of the soil, physical environment in a particular place may help all firms to enjoy certain physical

benefits.

1. Economies of Welfare

These economies will arise on account of various welfare programs under taken by an

industry to help its own staff. A big industry is in a better position to provide welfare facilities

to the workers. It may get land at concessional rates and procure special facilities from the local

governments for setting up housing colonies for the workers. It may also establish health care

units, training centers, computer centers and educational institutions of all types. It may grant

concessions to its workers. All these measures would help in raising the overall efficiency and

productivity of workers.

Diseconomies Of Scale

When a firm expands beyond the optimum limit, economies of scale will be converted in to

diseconomies of scale. Over growth becomes a burden. Hence, one should not cross the limit. On

account of diseconomies of scale, more output is obtained at higher cost of production. The

following are some of the main diseconomies of scale

1. Financial diseconomies. . As there is over growth, the required amount of fiancée may

not be available to a firm. Consequently, higher interest rates are to be paid for additional

funds.

2. Managerial diseconomies Excess growth leads to loss of effective supervision, control

management, coordination of factors of production leading to all kinds of wastages,

indiscipline and rise in production and operating costs.

3. Marketing diseconomies. Unplanned excess production may lead to mismatch between

demand and supply of goods leading to fall in prices. Stocks may pile up, sales may

decline leading to fall in revenue and profits.

4. Technical diseconomies When output is carried beyond the plant capacity, per unit cost

will certainly go up. There is a limit for division of labor and specialization. Beyond a

point, they become negative. Hence, operation costs would go up.

5. Diseconomies of risk and uncertainty bearing. If output expends beyond a limit,

investment increases. The level of inventory goes up. Sales do not go up correspondingly.

Business risks appear in all fields of activities. Supply of factor inputs become inelastic

leading to high prices.


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6. Labor diseconomies. An unwieldy firm may become impersonal. Contact between labor

and management may disappear. Workers may demand higher wages and salaries, bonus

and other such benefits etc. Industrial disputes may arise. Labor unions may not

cooperate with the management. All of them may contribute for higher operation costs.

II External diseconomies. When several business units are concentrated in only place or

locality, it may lead to congestion,, environmental pollution, scarcity of factor inputs like, raw

materials, water, power, fuel, transport and communications etc leading to higher production and

operational costs.

Thus, it is very clear that a firm can enjoy benefits of large scale production only up to a limit.

Beyond the optimum limit, it is bound to experience diseconomies of scale. Hence, there should

be proper check on the growth and expansion of a firm.

Internalisation Of External Economies

It implies that a firm will convert certain external benefits created by the government or the

entire society to its own favor with out making any additional investments. A firm may start a

new unit in between two big railway stations or near the air port or near the national high ways

or a port so that it can enjoy all the infrastructure benefits. Similarly, a new computer firm can

commence its operations where there is 24 hours supply of electricity. Hence, they are also

called as privatization of public benefits. Such type of efforts is to be encouraged by the

government.

Externalisation Of Internal Diseconomies

In this case, a particular firm on account of its regular operations will pass on certain costs on the

entire society. A firm instead of taking certain precautionary measures by spending some amount

of money will escape and pass on this burden to the government or the society. For example, a

firm may throw chemical or industrial wastes, dirt and filth either to open air or rivers leading to

environmental pollution. In that case, the government is forced to spend more money to clean

river water or prevent environmental pollution. This is a clear case of externalized internal

diseconomies. It is to be avoided at all costs.

Economies Of Scope

It is a common factor to observe that when a single-product firm expands its volume of output, it

would enjoy certain economies of scale. As a result, production cost per unit declines and more

output is obtained at lower cost of production. Sometimes they would enjoy certain other

external benefits due to the overall improvements in the entire area or city in which operates.


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Apart from these two types of benefits, we also come across another type of benefits in recent

years. They are popularly known as economies of scope.

Economies of scope may be defined as those benefits which arise to a firm when it produces

more than one product jointly rather than producing two items separately by two different business units. In this case, the benefits of the joint output of a single firm are greater than the

benefits if two products are produced separately by two different firms. Such benefits may arise

on account of joint use of production facilities, joint marketing efforts, or use of the same

administrative office and staff in an organization. Sometimes, production of one product

automatically results in the production of another by-product leading to a reduction in average

cost of production.

Economies of scope results in saving production costs. It can be measured with the help of the

following equation.

Where SC = Saving Cost, C Q1 = cost of producing output Q1, C Q2 = cost of producing

outputQ2 and C [Q1, Q2] = joint cost of producing both outputs.

ILLUSTRATION

A firm produces product A & B separately. Cost of producing 100 units of A is Rs. 8000 – 00

and cost of producing 100 units of B is Rs. 5,000-00. If the firm produces both products A & B

jointly, in that case, its total cost would be Rs. 10,000 – 00.

Now one can find out saving cost by substituting the values to the above mentioned formula.

In this case, the joint cost [10,000-00] is less than a sum of individual costs [13,000-00]. Thus, a

firm can save 3% cost if it produces both products A & B jointly. Hence, the SC is more than

zero.

Diseconomies Of Scope


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Diseconomies of scope may be defined as those disadvantages which occur when cost of

producing two products jointly are costlier than producing them individually. In this case, it

would be profitable to produce two goods separately than jointly. For example, with the help of

same machinery, it is not possible to produce two goods together. It involves buying two

different machineries. Hence, production costs would certainly go up in this case.

Difference between Economies of Scale and Economies of Scope


1. Production creates _____ or ___ of value.

2. Production function explain ___ or ____ relationship between inputs and outputs.

3. In the short period only ___________ factor inputs are changed.

4. When marginal product is zero toal product will be _________.

5. An ISO _ quant curve shows combination of the inputs which helps to produce same

level of output where as an ISO-cost curve shows __ combination of two inputs that can

be purchased with a given that can be purchased with a given investment to prices two

factor inputs.

6. When all inputs are increased by 8% and output increases by 13% then its is a case of

laws of ____.

7. Internal economic depends on the growth of a ___ and external economics depends on

the growth of the ____.

8. Economic of scope refers to the benefits which arise to a firm when it produces more than

_______ rather than producing more than ________.two items separately by two firms.


Understand the meaning , importance and the determinants of various cost concepts

Meaning of cost of production.


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Cost is analyzed from the producer’s point of view. Cost estimates are made in terms of money.

Cost calculations are indispensable for management decisions.

In the production process, a producer employs different factor inputs. These factor inputs are to

be compensated by the producer for the services in the production of a commodity. The

compensation is the cost. The value of inputs required in the production of a commodity

determines its cost of output. Cost of production refers to the total money expenses (Both

explicit and implicit) incurred by the producer in the process of transforming inputs into

outputs. In short, it refers total money expenses incurred to produce a particular quantity of

output by the producer. The knowledge of various concepts of costs, cost-output relationship etc.

occupies a prominent place in cost analysis.

Managerial Uses Of Cost Analysis

A detailed study of cost analysis is very useful for managerial decisions. It helps the management

–

1. To find the most profitable rate of operation of the firm.

2. To determine the optimum quantity of output to be produced and supplied.

3. To determine in advance the cost of business operations.

4. To locate weak points in production management to minimize costs.

5. To fix the price of the product.

6. To decide what sales channel to use.

7. To have a clear understanding of alternative plans and the right costs involved in

them.

8. To have clarity about the various cost concepts.

9. To decide and determine the very existence of a firm in the production field.

10. To regulate the number of firms engaged in production.

11. To decide about the method of cost estimation or calculations.

12. To find out decision making costs by re-classifications of elements, reprising of input factors

etc, so as to fit the relevant costs into management planning, choice etc.

Different Kinds Of Cost Concepts.


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1. Money Cost and Real Cost

When cost is expressed in terms of money, it is called as money cost It relates to money outlays by a firm on various factor inputs to produce a commodity. In a monetary economy,

all kinds of cost estimations and calculations are made in terms of money only. .Hence, the

knowledge of money cost is of great importance in economics. Exact measurement of money

cost is possible.

When cost is expressed in terms of physical or mental efforts put in by a person in the making of a product, it is called as real cost. It refers to the physical, mental or psychological

efforts, the exertions, sacrifices, the pains, the discomforts, displeasures and inconveniences

which various members of the society have to undergo to produce a commodity. It is a subjective

And relative concept and hence exact measurement is not possible.

2. Implicit or Imputed Costs and Explicit Costs

Explicit costs are those costs which are in the nature of contractual payments and are paid

by an entrepreneur to the factors of production [excluding himself] in the form of rent, wages, interest and profits, utility expenses, and payments for raw materials etc. They can

be estimated and calculated exactly and recorded in the books of accounts.

Implicit or imputed costs are implied costs. They do not take the form of cash outlays and as

such do not appear in the books of accounts. They are the earnings of owner-employed

resources. For example, the factor inputs owned by the entrepreneur himself like capital can be

utilized by himself or can be supplied to others for a contractual sum if he himself does not

utilize them in the business. It is to be remembered that the total cost is a sum of both implicit

and explicit costs.

3. Actual costs and Opportunity Costs

Actual costs are also called as outlay costs, absolute costs and acquisition costs. They are those

costs that involve financial expenditures at some time and hence are recorded in the books of

accounts. They are the actual expenses incurred for producing or acquiring a commodity or

service by a firm. For example, wages paid to workers, expenses on raw materials, power, fuel

and other types of inputs. They can be exactly calculated and accounted without any difficulty.

Opportunity cost of a good or service is measured in terms of revenue which could have been earned by employing that good or service in some other alternative uses. In other

words, opportunity cost of anything is the cost of displaced alternatives or costs of sacrificed

alternatives. It implies that opportunity cost of anything is the alternative that has been

foregone. Hence, they are also called as alternative costs. Opportunity cost represents only

sacrificed alternatives. Hence, they can never be exactly measured and recorded in the books of

accounts.

The knowledge of opportunity cost is of great importance to management decision. They help in taking

a decision among alternatives. While taking a decision among several alternatives, a manager selects the


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best one which is more profitable or beneficial by sacrificing other alternatives. For example, a firm may

decide to buy a computer which can do the work of 10 laborers. If the cost of buying a computer is much

lower than that of the total wages to be paid to the workers over a period of time, it will be a wise

decision. On the other hand, if the total wage bill is much lower than that of the cost of computer, it is

better to employ workers instead of buying a computer. Thus, a firm has to take a number of decisions

almost daily.

4. Direct costs and indirect costs

Direct costs are those costs which can be specifically attributed to a particular product, a department,

or a process of production. For example, expenses on raw materials, fuel, wages to workers, salary to a

divisional manager etc are direct costs. On the other hand, indirect costs are those costs, which are not

traceable to any one unit of operation. They cannot be attributed to a product, a department or a

process. For example, expenses incurred on electricity bill, water bill, telephone bill, administrative

expeneses etc.

5. Past and future costs.

Past costs are those costs which are spent in the previous periods. On the other hand, future costs are

those which are to be spent. in the future. Past helps in taking decisions for future.

6. Marginal and Incremental costs

Marginal cost refers to the cost incurred on the production of another or one more unit .It implies

additional cost incurred to produce an additional unit of output It has nothing to do with fixed cost and

is always associated with variable cost.

Incremental cost on the other hand refers to the costs involved in the production of a batch or group of

output. They are the added costs due to a change in the level or nature of business activity. For

example, cost involved in the setting up of a new sales depot in another city or cost involved in the

production of another 100 extra units.

1. Fixed costs and variable costs.

Fixed costs are those costs which do not vary with either expansion or contraction in output. They

remain constant irrespective of the level of output. They are positive even if there is no production.

They are also called as supplementary or over head costs.

On the other hand, variable costs are those costs which directly and proportionately increase or

decrease with the level of output produced. They are also called as prime costs or direct costs.


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8. Accounting costs and economic costs.

Accounting costs are those costs which are already incurred on the production of a particular

commodity. It includes only the acquisition costs. They are the actual costs involved in the making of a

commodity. On the other hand, economic costs are those costs that are to be incurred by an

entrepreneur on various alternative programs. It involves the application of opportunity costs in

decision making.

Determinants Of Costs

Cost behavior is the result of many factors and forces. But it is very difficult to determine in general the

factors influencing the cost as they widely differ from firm to firm and even industry to industry.

However, economists have given some factors considering them as general determinants of costs. They

have enough importance in modern business set up and decision making process. The following factors

deserve our attention in this connection.

1. Technology

Modern technology leads to optimum utilization of resources, avoid all kinds of wastages, saving

of time, reduction in production costs and resulting in higher output. On the other hand, primitive

technology would lead to higher production costs.

2. Rate of output: (the degree of utilization of the plant and machinery)

Complete and effective utilization of all kinds of plants and equipments would reduce production

costs and under utilization of existing plants and equipments would lead to higher production

costs.

3. Size of Plant

and scale of production

Generally speaking big companies with huge plants and machineries organize production on

large scale basis and enjoy the economies of scale which reduce the cost per unit.

4. Prices of input factors

. Higher market prices of various factor inputs result in higher cost of production and vice-versa.

5. Efficiency of factors of production and the management

Higher productivity and efficiency of factors of production would lead to lower production costs and

vice-versa.


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6. Stability of output

Stability in production would lead to optimum utilization of the existing capacity of plants and

equipments. It also brings savings of various kinds of hidden costs of interruption and learning leading to

higher output and reduction in production costs.

7. Law of returns

Increasing returns would reduce cost of production and diminishing returns increase cost.

8. Time period

In the short run, cost will be relatively high and in the long run, it will be low as it is possible to make all

kinds of adjustments and readjustments in production process.

Thus, many factors influence cost of production of a firm.


Learn short – run and long – run cost functions

Cost and output are correlated. Cost output relations play an important role in almost all business

decisions. It throws light on cost minimization or profit maximization and optimization of output. The

relation between the cost and output is technically described as the “COST FUNCTION”. The

significance of cost-output relationship is so great that in economic analysis the cost function usually

refers to the relationship between cost and rate of output alone and we assume that all other

independent variables are kept constant. Mathematically speaking TC = f (Q) where TC = Total cost and

Q stands for output produced.

However, cost function depends on three important variables.

1 Production function

If a firm is able to produce higher output with a little quantity of inputs, in that case, the cost function

becomes cheaper and vice-versa.

2. The market prices of inputs

If market prices of different factor inputs are high in that case, cost function becomes higher and vice-

versa.

3. Period of time

Cost function becomes cheaper in the long run and it would be relatively costlier in the short run.


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Types of cost function.

Generally speaking there are two types of cost functions.

1. Short run cost function.

2. Long run cost function.

Cost-Output Relation Ship And Cost Curves In The Short-Run.

It is interesting to note that the relationship between the cost and output is different at two different

periods of time i.e. short-run and long run. Generally speaking, cost of production will be relatively

higher in the short-run when compared to the long run. This is because a producer will get enough time

to make all kinds of adjustments in the productive process in the long run than in the short run. When

cost and output relationship is represented with the help of diagrams, we get short run and long run

cost curves of the firm. Now we shall make a detailed study of cost out put relations both in the short-

run as well as in the long run.

MEANING OF SHORT RUN

Short-run is a period of time in which only the variable factors can be varied while fixed factors like

plant, machinery etc remains constant. Hence, the plant capacity is fixed in the short run. The total

number of firms in an industry will remain the same. Time is insufficient either for the entry of new firms

or exit of the old firms. If a firm wants to produce greater quantities of output, it can do so only by

employing more units of variable factors or by having additional shifts, or by having over time work for

the existing labor force or by intensive utilization of existing stock of capital assets etc. Hence, short run

is defined as a period where adjustments to changed conditions are only partial.

The short run cost function relates to the short run production function. It implies two sets of input

components – (a) fixed inputs and (b) variable inputs. Fixed inputs are unalterable. They remain

unchanged over a period of time. On the other hand, variable factors are changed to vary the output in

the short run. Thus, in the short period some inputs are fixed in amount and a firm can expand or

contract its output only by changing the amounts of other variable inputs. The cost-output relationship

in the short run refers to a particular set of conditions where the scale of operation is limited by the

fixed plant and equipment. Hence, the costs of the firm in the short run are divided into fixed cost and

variable costs. We shall study these two concepts of costs in some detail

1. Fixed costs

These costs are incurred on fixed factors like land, buildings, equipments, plants, superior type of

labor, top management etc.

Fixed costs in the short run remain constant because the firm does not change the size of plant and

the amount of fixed factors employed. Fixed costs do not vary with either expansion or contraction in

output. These costs are to be incurred by a firm even output is zero. Even if the firm close down its

operation for some time temporarily in the short run, but remains in business, these costs have to be


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borne by it. Hence, these costs are independent of output and are referred to as unavoidable

contractual cost.

Prof. Marshall called fixed costs as supplementary costs. They include such items as contractual rent

payment, interest on capital borrowed, insurance premiums, depreciation and maintenance allowances,

administrative expenses like manager’s salary or salary of the permanent staff, property and business

taxes, license fees, etc. They are called as over-head costs because these costs are to be incurred

whether there is production or not. These costs are to be distributed on each unit of output produced

by a firm. Hence, they are called as indirect costs.

2. Variable costs

The cost corresponding to variable factors are discussed as variable costs. These costs are incurred on

raw materials, ordinary labor, transport, power, fuel, water etc, which directly vary in the short run.

Variable costs directly and proportionately increase or decrease with the level of output. If a firm shuts

down for some time in the short run; then it will not use the variable factors of production and will not

therefore incur any variable costs. Variable costs are incurred only when some amount of output is

produced. Total variable costs increase with increase in the level of production and vice-versa. Prof.

Marshall called variable costs as prime costs or direct costs because the volume of output produced by a

firm depends directly upon them.

It is clear from the above description that production costs consist of both fixed as well as variable costs.

The difference between the two is meaningful and relevant only in the short run. In the long run all costs

become variable because all factors of production become adjustable and variable in the long run.

However, the distinction between fixed and variable costs is very significant in the short run because it

influences the average cost behavior of the firm. In the short run, even if a firm wants to close down its

operation but wants to remain in business, it will have to incur fixed costs but it must cover at least its

variable costs.

Cost-output relationship and nature and behavior of cost curves in the short run

In order to study the relationship between the level of output and corresponding cost of production,

we have to prepare the cost schedule of the firm. A cost-schedule is a statement of a variation in costs

resulting from variations in the levels of output. It shows the response of cost to changes in output. A

hypothetical cost schedule of a firm has been represented in the following table.

Output in Units TFC TVC TC AFC AVC AC MC

0 360 – 360 – – – –

1 360 180 540 360 180 540 180

2 360 240 600 180 120 300 60

3 360 270 630 120 90 210 30


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4 360 315 675 90 78.75 168.75 45

5 360 420 780 72 84 156 105

6 360 630 990 60 105 165 210

On the basis of the above cost schedule, we can analyse the relationship between changes in the

level of output and cost of production. If we represent the relationship between the two in a

geometrical manner, we get different types of cost curves in the short run. In the short run,

generally we study the following kinds of cost concepts and cost curves.

1. Total fixed cost (TFC)

TFC refers to total money expenses incurred on fixed inputs like plant, machinery, tools & equipments

in the short run. Total fixed cost corresponds to the fixed inputs in the short run production function.

TFC remains the same at all levels of output in the short run. It is the same when output is nil. It

indicates that whatever may be the quantity of output, whether 1 to 6 units, TFC remain constant. The

TFC curve is horizontal and parallel to OX-axis, showing that it is constant regardless of out put per unit

of time. TFC starts from a point on Y-axis indicating that the total fixed cost will be incurred even if the

output is zero. In our example, Rs 300-00 is TFC. It is obtained by summing up the product or quantities

of the fixed factors multiplied by their respective unit price.

2. Total variable cost (TVC)

TVC refers to total money expenses incurred on the variable factors inputs like raw materials,

power, fuel, water, transport and communication etc, in the short run. Total variable cost corresponds

to variable inputs in the short run production function. It is obtained by summing up the production of

quantities of variable inputs multiplied by their prices. The formula to calculate TVC is as follows. TVC =

TC-TFC. TVC = f (Q) i.e. TVC is an increasing function of out put. In other words TVC varies with output. It

is nil, if there is no production. Thus, it is a direct cost of output. TVC rises sharply in the beginning,

gradually in the middle and sharply at the end in accordance with the law of variable proportion. The

law of variable proportion explains that in the beginning to obtain a given quantity of output, relative

variation in factors needed are in less proportion, but after a point when the diminishing returns

operate, variable factors are to be employed in a larger proportion to increase the same level of output.


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TVC curve slope upwards from left to right. TVC curve rises as output is expanded. When out

put is Zero, TVC also will be zero. Hence, the TVC curve starts from the origin.

3. Total cost (TC)

The total cost refers to the aggregate money expenditure incurred by a firm to produce a given quantity of output. The total cost is measured in relation to the production function by

multiplying the factor prices with their quantities. TC = f (Q) which means that the T.C. varies

with the output. Theoretically speaking TC includes all kinds of money costs, both explicit and

implicit cost. Normal profit is included in the total cost as it is an implicit cost. It includes fixed

as well as variable costs. Hence, TC = TFC +TVC.

TC varies in the same proportion as TVC. In other words, a variation in TC is the result of

variation in TVC since TFC is always constant in the short run.

The total cost curve is rising upwards from left to right. In our example the TC curve starts form

Rs. 300-00 because even if there is no output, TFC is a positive amount. TC and TVC have same

shape because an increase in output increases them both by the same amount since TFC is

constant. TC curve is derived by adding up vertically the TVC and TFC curves. The vertical


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distance between TVC curve and TC curve is equal to TFC and is constant throughout because

TFC is constant.

4. Average fixed cost (AFC)

Average fixed cost is the fixed cost per unit of output. When TFC is divided by total units

of out put AFC is obtained, Thus, AFC = TFC/Q

AFC and output have inverse relationship. It is higher at smaller level and lower at the higher

levels of output in a given plant. The reason is simple to understand. Since AFC = TFC/Q, it is a

pure mathematical result that the numerator remaining unchanged, the increasing denominator

causes diminishing product. Hence, TFC spreads over each unit of out put with the increase in

output. Consequently, AFC diminishes continuously. This relationship between output and fixed

cost is universal for all types of business concerns.

The AFC curve has a negative slope. The curve slopes downwards throughout the length. The

AFC curve goes very nearer to X axis, but never touches axis. Graphically it will fall steeply in

the beginning, gently in middle and tend to become parallel to OX-axis. Mathematically

speaking as output increases, AFC diminishes. But AFC will never become zero because the

TFC is a positive amount. AFC will never fall below a minimum amount because in the short

run, plant capacity is fixed and output cannot be enlarged to an unlimited extent.

5. Average variable cost: (AVC)

The average variable cost is variable cost per unit of output. AVC can be computed by dividing the TVC by total units of output. Thus AVC = TVC/Q. The AVC will come down in

the beginning and then rise as more units of output are produced with a given plant. This is

because as we add more units of variable factors in a fixed plant, the efficiency of the inputs first

increases and then it decreases.

The AVC curve is a U-shaped cost curve. It has three phases. Page 198 ( B.A)


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a. Decreasing phase

In the first phase from A to B, AVC declines, As output expands, AVC declines because when

we add more quantity of variable factors to a given quantity of fixed factors, output increases

more efficiently and more than proportionately due to the operation of increasing returns.

b. Constant phase

In the II phase, i.e. at B, AVC reaches its minimum point. When the proportion of both fixed and

variable factors are the most ideal, the output will be the optimum. Once the firm operates at its

normal full capacity, output reaches its zenith and as such AVC will become the minimum.

c. Increasing phase

In the III phase, from B to C, AVC rises when once the normal capacity is crossed, the AVC

rises sharply. This is because additional units of variables factors will not result in more than

proportionate output. Hence, greater output may be obtained but at much greater AVC. The old

proverb “Too many cooks spoil the broth” aptly applies to this III stage. It is clear that as long as

increasing returns operate, AVC falls and when diminishing returns set in, AVC tends to

increase.

6. Average total cost (ATC) or Average cost (AC)

Ac refers to cost per unit of output. AC is also known as the unit cost since it is the cost per unit of output produced. AC is the sum of AFC and AVC. Average total cost or average cost is

obtained by dividing the total cost by total output produced. AC = TC/Q Also AC is the sum of

AFC and AVC.

In the short run AC curve also tends to be U-shaped. The combined influence of AFC and AVC

curves will shape the nature of AC curve.


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As we observe, average fixed cost begin to fall with an increase in output while average variable

costs come down and rise. As long as the falling effect of AFC is much more than the rising

effect of AVC, the AC tends to fall. At this stage, increasing returns and economies of scale

operate and complete utilization of resources force the AC to fall.

When the firm produces the optimum output, AC becomes minimum. This is called as least –

cost output level. Again, at the point where the rise in AVC exactly counter balances the fall in

AFC, the balancing effect causes AC to remain constant.

In the third stage when the rise in average variable cost is more than drop in AFC, then the AC

shows a rise, When output is expanded beyond the optimum level of output, diminishing returns

set in and diseconomies of scale starts operating. At this stage, the indivisible factors are used in

wrong proportions. Thus, AC starts rising in the third stage.

The short run AC curve is also called as “Plant curve”. It indicates the optimum utilization of a

given plant or optimum plant capacity.

7. Marginal Cost (MC)

Marginal cost may be defined as the net addition to the total cost as one more unit of

output is produced. In other words, it implies additional cost incurred to produce an additional unit. For example, if it costs Rs. 100 to produce 50 units of a commodity and Rs. 105

to produce 51 units, then MC would be Rs. 5. It is obtained by calculating the change in total

costs as a result of a change in the total output. Also MC is the rate at which total cost changes

with output. Hence,

It is necessary to note that MC is independent of TFC and it is directly related to TVC as we

calculate the cost of producing only one unit. In the short run, the MC curve also tends to be U-

shaped.


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The shape of the MC curve is determined by the laws of returns. If MC is falling, production will

be under the conditions of increasing returns and if MC is rising, production will be subject of

diminishing returns.

The table indicates the relationship between AC & MC

Output in Units TC in Rs. AC in Rs.

Difference in Rs.

MC

1 150 150 –

2 190 95 40

3 220 73.3 30

4 236 59 16

5 270 54 34

6 324 54 54

7 415 59.3 91

8 580 72.2 165

Relation between AC and MC


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From the diagram it is clear that:

1. Both MC and AC fall at a certain range of output and rise afterwards.

2. When AC falls, MC also falls but at certain range of output MC tends to rise even though

AC continues to fall. However, MC would be less than AC. This is because MC is

attributed to a single unit where as in case of AC, the decreasing AC is distributed over

all the units of output produced.

3. So long as AC is falling, MC is less than AC. Hence, MC curve lies below AC curve. It

indicates that fall in MC is more than the fall in AC. MC reaches its minimum point

before AC reaches its minimum.

4. When AC is rising, after the point of intersection, MC will be greater than AC. This is

because in case of MC, the increasing MC is attributed to a single unit, where as in case

of AC, the increasing AC is distributed over all the output produced.

5. So long as the AC is rising, MC is greater and AC. Hence, AC curve lies to the left side

of the MC curve. It indicates that rise in MC is more than the rise in AC.

6. MC curve cuts the AC curve at the minimum point of the AC curve. This is because,

when MC decreases, it pulls AC down and when MC increases, it pushes AC up. When

AC is at its minimum, it is neither being pulled down or being pushed up by the MC.

Thus, When AC is minimum, MC = AC. The point of intersection indicates the least cost

combination point or the optimum position of the firm. At output Q the firm is working at

its “Optimum Capacity” with lowest AC. Beyond Q, there is scope for “Maximum

Capacity” with rising cost.

Cost Output Relationship In The Long Run


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Long run is defined as a period of time where adjustments to changed conditions are

complete. It is actually a period during which the quantities of all factors, variable as well as

fixed factors can be adjusted. Hence, there are no fixed costs in the long run. In the short run, a

firm has to carry on its production within the existing plant capacity, but in the long run it is not

tied up to a particular plant capacity. If demand for the product increases, it can expand output by

enlarging its plant capacity. It can construct new buildings or hire them, install new machines,

employ administrative and other permanent staff. It can make use of the existing as well as new

staff in the most efficient way and there is lot of scope for making indivisible factors to become

divisible factors. On the other hand, if demand for the product declines, a firm can cut down its

production permanently. The size of the plant can also be reduced and other expenditure can be

minimized. Hence, production cost comes down to a greater extent in the long run.

As all costs are variable in the long run, the total of these costs is total cost of production.

Hence, the distinction between fixed and variables costs in the total cost of production will

disappear in the long run. In the long run only the average total cost is important and

considered in taking long term output decisions.

Long run average cost is the long run total cost divided by the level of output. In brief, it is the

per unit cost of production of different levels of output by changing the size of the plant or scale

of production.

The long run cost – output relationship is explained by drawing a long run cost curve through

short – run curves as the long period is made up of many short – periods as the day is made up of

24 hours and a week is made out of 7 days. This curve explains how costs will change when the

scale of production is varied.

The long run -cost curves are influenced by the laws of return to scale as against the short run

cost curves which are subject to the working of law of variable proportions.

In the short run the firm is tied with a given plant and as such the scale of operation remains

constant. There will be only one AC curve to represent one fixed scale of output in the short run.


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In the long run as it is possible to alter the scale of production, one can have as many AC curves

as there are changes in the scale of operations.

In order to derive LAC curve, one has to draw a number of SAC curves, each curve representing

a particular scale of output. The LAC curve will be tangential to the entire family of SAC cures.

It means that it will touch each SAC curve at its minimum point.

Production cost difference in the short run and long run

In the diagram, the LAC curve is drawn on the basis of three possible plant sizes. Consequently, we

have three different SAC curves – SAC1, SAC2 and SAC3. They represent three different scales of output.

For output OM3 the AC will be L2M2 in the short run as well as the long run.

When output is to be expanded to OM3, it can be obtained at a higher average cost of

production. K3, M3 is the short run AC because, scale of production would remain constant in

the short run. But the same output of OM3 can be produced at a lower AC of L3M3 in the long

run since the scale of production can be modified according to the requirements. The distance

between K3L3 represent difference between the cost of production in the short run and long run.

Similarly, when output is contracted to OM1 in the short run, K1M1 will become the short run

AC and L1M1 will be the long run AC. Hence, K1L1 indicates the differences between short run

and long run cost of production. If we join points L1, L2 and L3 we get LAC curve.

Important features of long run AC curves


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1. Tangent curve

Different SAC curves represent different operational capacities of different plants in the short

run. LAC curve is locus of all these points of tangency. The SAC curve can never cut a LAC

curve though they are tangential to each other. This implies that for any given level of output, no

SAC curve can ever be below the LAC curve. Hence, SAC cannot be lower than the LAC in the

ling run. Thus, LAC curve is tangential to various SAC curves.

2. Envelope curve

It is known as Envelope curve because it envelopes a group of SAC curves appropriate to

different levels of output.

3. Flatter U-shaped or dish-shaped curve.

The LAC curve is also U shaped or dish shaped cost curve. But It is less pronounced and much

flatter in nature. LAC gradually falls and rises due to economies and diseconomies of scale.

4. Planning curve.

The LAC cure is described as the Planning Curve of the firm because it represents the least cost

of producing each possible level of output. This helps in producing optimum level of output at

the minimum LAC. This is possible when the entrepreneur is selecting the optimum scale plant.

Optimum scale plant is that size where the minimum point of SAC is tangent to the minimum

point of LAC.

5. Minimum point of LAC curve should be always lower than the minimum point of SAC

curve.

This is because LAC can never be higher than SAC or SAC can never be lower than LAC. The

LAC curve will touch the optimum plant SAC curve at its minimum point.

A rational entrepreneur would select the optimum scale plant. Optimum scale plant is that size at

which SAC is tangent to LAC, such that both the curves have the minimum point of tangency. In

the diagram, OM2 is regarded as the optimum scale of output, as it has the least per unit cost. At

OM2 output LAC = SAC.

LAC curve will be tangent to SAC curves lying to the left of the optimum scale or right side of

the optimum scale. But at these points of tangency, neither LAC is minimum nor will SAC be

minimum. SAC curves are either rising or falling indicating a higher cost

Managerial Use of LAC

The study of LAC is of greater importance in managerial decision making process.


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1. It helps the management in the determination of the best size of the plant to be

constructed or when a new one is introduced in getting the minimum cost output for a

given plant. But it is interested in producing a given output at the minimum cost.

2. The LAC curve helps a firm to decide the size of the plant to be adopted for producing

the given output. For outputs less than cost lowering combination at the optimum scale

i.e., when the firm is working subject to increasing returns to scale, it is more economical

to under use a slightly large plant operating at less than its minimum cost – output than to

over use smaller unit. Conversely, at output beyond the optimum level, that is when the

firm experience decreasing return to scale, it is more economical to over use a slightly

smaller plant than to under use a slightly larger one. Thus, it explains why it is more

economical to over use a slightly small plant rather than to under use a large plant.

3. LAC is used to show how a firm determines the optimum size of the plant. An optimum

size of plant is one that helps in best utilization of resources in the most economical

manner.

Long Run

Marginal cost

A long-run marginal cost curve can be derived from the long-run average cost curve. Just as the

SMC is related to the SAC, similarly the LMC is related to the LAC and, therefore, we can

derive the LMC directly from the LAC. In the diagram we have taken three plant sizes (for the

sake of simplicity) and the corresponding three SAC and SMC curves. The LAC curve is drawn

by enveloping the family of SAC curves. The points of tangency between the SAC and the LAC

curves indicate different outputs for different plant sizes.

If the firm wants to produce ON output in the long run, it will have to choose the plant size

corresponding to SAC1. The LAC curve is tangent to SAC1 at point A. For ON output, the


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average cost is NA and the corresponding marginal cost is NB If LAC curve is tangent to SAC1

curve at point A, the corresponding LMC curve will have to be equal to SMC1 curve at point B.

The LMC will pass through point B. In other words, where LAC is equal to SAC curve (for a

given output) the LMC will have to be equal to a given SMC.

If output OQ is to be produced in the long run, it will be done at point c which is the point of

tangency between SAC2 and the LAC. At point C, the short –run average cost (SAC2) and the

short-run marginal cost (SMC2) are equal and, therefore, the LAC for output OQ is QC and the

corresponding LMC is also QC. The LMC curve will, therefore pass through point C.

Finally, for output OR,at point D the LAC is tangent to SAC3. For OR output at point E LMC is

passing through SMC3. By connecting points B ,C and E, we can draw the long-run marginal

cost curve.

COST OF PRODUCTION: FORMULAS


1. Opportunity cost of anything is the alternative that has been _____-

2. Marginal cost deals with changes in cost of ______ unit where as incremental cost deals

with changes in cost of ________.

3. AC minus AVC would give us _________

4. Total cost include ___________ profits.

5. Marginal cost is associated with _________ costs.

6. In the long run all cost are ______________.

Summary

In this unit-5 we have discussed about the meaning of production, production function and its

managerial uses. Production in economics implies transformation of inputs into outputs for our

final consumption. Production function explains the quantitative relationship between the


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amounts of inputs used to.. get a particular physical quantity of outputs. The ratios between the

two quantities are of great importance to a producer to take his decisions in the production

process. There are two kinds of production functions – short run and long run. In case of short

run production function we come across a change in either one or two variable factor inputs

while all other inputs are kept constant. The law of variable proportion explain how there will be

variations in the quantity of output when there is change in only one variable factor inputs while

all other inputs are kept constant. On the other hand Iso-Quants and Iso-cost curves explain how

there will be changes in output when only two variable inputs are changed while all other inputs

are kept constant. Under long run production function, the laws of returns to scale explain

changes in output when all inputs, both variable as well as fixed changes in the same proportion.

Economies of scale give information about the various benefits that a firm will get when it goes

for large scale production. Economies of scope on the other hand tells us how there will be

certain specific advantages when one firm produces more than two products jointly than two or

three firms produce them separately. Diseconomies of scale and diseconomies of scope tells us

that there are certain limitations to expansion in output Cost analysis on the other hand, indicates

the various amounts of costs incurred to produce a particular quantity of output in monetary

terms. The various kinds of cost concepts help a manager to take right decisions. Cost function

explains the relationship between the amounts of costs to be incurred to produce a particular

quantity of output. Short run cost function gives information about the nature and behavior of

various cost curves. Long run cost function tells us how it is possible to obtain more output at

lower costs in the long run. Thus, the knowledge of both production function and cost functions

help a business executive to work out the best possible factor combinations to maximize output

with minimum costs.

Terminal Questions

1. Define production function and distinguish between shortrun and long run production

function.

2. Discuss the user of production function.

3. Explain the law of variable proportions

4. Explain how a product would reach equilibrium position with the heap of ISO Quants and

ISO cost curve.

5. Discuss any one laws of returns to scale with example.

6. Explain either various internal or external economics of scale.

7. Explain the concept of economic of scope with suitable illustration.

8. Give a suit description of

a. Implicit and explicit cost

b. Actual and opportunity cost

9. Discuss the various determinants of costs.

10. Explain cost output relationship with reference to


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a. Total fixed cost to output

b. Total variable cost to output

c. Total cost to output

11. Explain features of LAC curve with a diagram.

Answer to Self Assessment Questions


1. New utilities, addition.

2. Technological, engineering.

3. Variable.

4. Highest

5. Various alternative, particular

6. Demanding returns

7. Firms industry

8. One product jointly


1. foregone

2. one , a group of units

3. AFC

4. normal

5. Variable

6. Variable

Answer to Terminal Questions(View in SLM)








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8. Refer to unit 5.2.2




Unit 6 Objectives Of Firms

Introduction

A business firm is an economic unit. It is a producing unit. It converts inputs in to outputs. It is a legal

entity on the basis of ownership and contractual relationship organized for production and sale of goods

and services. All business units are set up and managed by people and are called by various names like

shops, firms, enterprise, production and business concerns etc. They can take several forms like sole

trader, partnership concern, Joint Stock Company, cooperatives or even public utilities. They produce

and supply different goods and services for the direct satisfaction of consumers for producing other final

goods and services.

Each firm lays down its own objectives. They are fundamental to the very existence of a firm. They are

the end-point towards rational activity. They indicate the very existence of a firm and guide the actions

of a firm. They indicate how a firm has to organize its activities and perform its functions. A modem

business unit has multiple objectives and they are multi-dimensional in their nature. Some of them are

competitive while others are supplementary in nature. A few other objectives are mutually

interconnected and a few others are opposing in nature. These objectives are determined by various

factors and forces like corporate environment, socio-economic conditions, and the nature of power in

the organization and extraneous conditions, and constraints under which a firm operates. Each business

unit defines its own objectives which may have to satisfy the needs of those groups whose cooperation

makes the continued existence of the business possible-the share holders, management, employees,

suppliers and consumers etc. Thus, we come across multiple and diversified objectives.

Learning Objective-1:

Understand various profit – maximizing and non-profit maximizing objectives

Economists over a period of time have developed various theories and models to explain different kinds

of goals of modern firms. Broadly speaking they can be dived in to three groups. They are as follows-

1. The profit maximization model.

2. Managerial theories or models


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3. Behavioral theories or models.

Let us study some of the important theories under each category.

Profit Maximization Model

Profit-making is one of the most traditional, basic and major objectives of a firm. Profit-motive is the

driving-force behind all business activities of a company. It is the primary measure of success or failure

of a firm in the market. Profit earning capacity indicates the position, performance and status of a firm

in the market. It is an acid test of economic ability and performance of an individual firm. There is no

place for a firm unless it earns a reasonable amount of profit in the business. It is necessary to stay in

business and maintain in tact the wealth producing agents. It is a widely accepted goal and there is

nothing bad or immoral about it. Earlier profit maximization was the sole objective of a firm. This

assumption has a long history in economic literature and the conventional price theory was based on

this very assumption about profit making. In spite of several changes and development of several

alternative objectives, profit maximization has remained as one of the single most important objectives

of the firm even today. Both small and large firms consistently make an attempt to maximize their profit

by adopting novel techniques in business. Specific efforts have been made to maximize output and

minimize production and other operating costs. Cot reduction, cost cutting and cost minimization has

become the slogan of a modern firm.

It helps to predict the price-output behavior of a firm under changing market conditions like tax rates,

wages and salaries, bonus, the degree of availability of resources, technology, fashions, tastes and

preferences of consumers etc. It is a very simple and unambiguous model. It is the single most ideal

model that can explain the normal behavior of a firm. It is often argued that no other alternative

hypothesis can explain and predict the behavior of business firms better than profit-maximization

hypothesis. This model gives a proper insight in to the working behavior of a firm. There are well

developed mathematical models to explain this hypothesis in a systematic and scientific manner.

Main propositions of the profit-maximization model.

The model is based on the assumption that each firm seeks to maximize its profit given certain technical

and market constraints. The following are the main propositions of the model.

1. A firm is a producing unit and as such it converts various inputs into outputs of higher value

under a given technique of production.

2. The basic objective of each firm is to earn maximum profit.

3. A firm operates under a given market condition.

4. A firm will select that alternative course of action which helps to maximize consistent profits

5. A firm makes an attempt to change its prices, input and output quantity to maximize its profit.

The model

Profit-maximization implies earning highest possible amount of profits during a given period of time.

A firm has to generate largest amount of profits by building optimum productive capacity both in the

short run and long run depending upon various internal and external factors and forces. There should be


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proper balance between short run and long run objectives. In the short run a firm is able to make only

slight or minor adjustments in the production process as well as in business conditions. The plant

capacity in the short run is fixed and as such, it can increase its production and sales by intensive

utilization of existing plants and machineries, having over time work for the existing staff etc. Thus, in

the short run, a firm has its own technical and managerial constraints. But in the long run, as there is

plenty of time at the disposal of a firm, it can expand and add to the existing capacities, build up new

plants, employ additional workers etc to meet the rising demand in the market. Thus, in the long run, a

firm will have adequate time and ample opportunity to make all kinds of adjustments and readjustments

in production process and in its marketing strategies.

It is to be noted with great care that a firm has to maximize its profits after taking in to consideration of

various factors in to account. They are as follows-

1. Pricing and business strategies of rival firms and its impact on the working of the given firm.

2. Aggressive sales promotion policies adopted by rival firms in the market.

3. Without inducing the workers to demand higher wages and salaries leading to rise in operation

costs.

4. Without resorting to monopolistic and exploitative practices inviting government controls and

takeovers.

5. Maintaining the quality of the product and services to the customers.

6. Taking various kinds of risks and uncertainties in the changing business environment.

7. Adopting a stable business policy.

8. Avoiding any sort of clash between short run and long run profits in the business policy and

maintaining proper balance between them.

9. Maintaining its reputation, name, fame and image in the market.

10. Profit maximization is necessary in both perfect and imperfect markets. In a perfect market, a

firm is a price-taker and under imperfect market it becomes a price-searcher.

Assumptions of the model

The profit maximization model is based on tree important assumptions. They are as follows

1. Profit maximization is the main goal of the firm.

2. Rational behavior on the part of the firm to achieve its goal of profit maximization.

3. The firm is managed by owner-entrepreneur.

Determination of profit –maximizing price and output

Profit maximization of a firm can be explained in two different ways.-

a. Total Revenue and Total Cost approach.

b. Marginal Revenue and Marginal Cost approach.


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Profits of a firm are estimated by making comparison between total revenue and total costs. Profit is the

difference between TR and TC. In other words, excess of revenue over costs is the profits. Profit = TR –

TC. If TR is equal to TC in that case, there will be break even point. If TR is less than TC, in that case, a

firm will be incurring losses. In this case, we take in to account of total cost and total revenue of the firm

while measuring profits.

It is clear from the following diagram how profit arises when TR is greater than that of TC

2. MR and MC approach

In this case, we take in to account of revenue earned from one unit and cost incurred to produce only

one unit of output. A firm will be maximizing its profits when MR= MC and MC curve cuts MR curve from

below. If MC curve cuts MR curve from above either under perfect market or under imperfect market,

no doubt MR equals MC but total output will not be maximized and hence total profits also will not be

maximized. Hence, two conditions are necessary for profit maximization-

1. MR = MC. 2. MC curve cut MR curve from below. It is clear form the following diagram.


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Justification for profit maximization

1. Basic objective of traditional economic theory. The traditional economic theory assumes that a

firm is owned and managed by the entrepreneur himself and as such he always aims at

maximum return on his capital invested in the business. Hence profit-maximization becomes the

natural principle of a firm.

2. A firm is not a charitable institution. A firm is a business unit. It is organized on commercial

principles. A firm is not a charitable institution. Hence, it has to earn reasonable amount of

profits.

3. To predict most realistic price-output behavior. This model helps to predict usual and general

behavior of business firms in the real world as it provides a practical guidance. It also helps in

predicting the reasonable behavior of a firm with more accuracy. Thus, it is a very simple, plain,

realistic, pragmatic and most useful hypothesis in forecasting price output behavior of a firm.

4. Necessary for survival It is to be noted that the very existence and survival of a firm depends on

its capacity to earn maximum profits. It is a time-honored hypothesis and there is common


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agreement among businessmen to make highest possible profits both in the short run and long

run.

5. To achieve other objectives. In recent years several other objectives have become much more

popular and all these objectives have become highly relevant in the context of modern business

set up. But it is to be remembered that they can be achieved only when a firm is making

maximum profits.

Criticisms

1. Ambiguous term. The term profit maximization is ambiguous in nature. There is no clear cut

explanation whether a firm has to maximize its net profit, total profit or the rate of profit in a business

unit. Again maximum amount of profit cannot be precisely defined in quantitative terms.

2. Always it may not be possible. Profit maximization, no doubt is the basic objective of a firm. But in

the context of highly competitive business environment, always it may not be possible for a firm to

achieve this objective. Other objectives like sales maximization, market share expansion, market

leadership building its own image, name, fame and reputation, spending more time with members of

the family, enjoying leisure, developing better and cordial relationship with employees and customers

etc. also has assumed greater significance in recent years.

3. Separation of ownership and management. In many cases, to-day we come across the business units

are organized on partnership or joint stock company or cooperative basis. In case of many large

organizations, ownership and management is clearly separated and they are run and managed by

salaried managers who have their own self interests and as such always profit maximization may not

become possible.

4. Difficulty in getting relevant information and data. In spite of revolution in the field of information

technology, always it may not be possible to get adequate and relevant information to take right

decisions in a highly fluctuating business scenario. Hence, profits may not be maximized.

5. Conflict in inter-departmental goals. A firm has several departments and sections headed by experts

in their own fields. Each one of them will have its own independent goals and many a times there is

possibility of clashes between the interests of different departments and as such always profits may not

be maximized.

6. Changes in business environment. In the context of highly competitive and changing business

environment and changes in consumers’ tastes and requirements, a firm may not be able to cope up

with the expectations and adjust its policies and as such profits may not be maximized.

7. Growth of oligopolistic firms. In the context of globalization, growth of oligopoly firms has become so

common through mergers, amalgamations and takeovers. Leading firms dominate the market and the

small firms have to follow the policies of the leading firms. Hence, in many cases, there are limited

chances for making maximum profits.


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8. Significance of other managerial gains. Salaried managers have limited freedom in decision making

process. Some of them are unable to forecast the right type of changes and meet the market challenges.

They are more worried about their salaries, promotions, perquisites, security of jobs, and other types of

benefits. They may lack strong motivations to make higher profits as profits would go to the

organization. They may be contented with only satisfactory level of profits rather than maximum profits.

9. Emphasis on non-profit goals. Many organizations give more stress on non-profit goals. From the

point of view of today’s business environment, productivity, efficiency, better management, customer

satisfaction, durability of products, higher quality of products and services etc have gained importance

to cope with business competition. Hence, emphasis has been shifted from profit maximization to other

practical aspects.

10. Aversion to reduction in power. In case of several small business units, the owners do not want to

share their powers with many new partners and hence, they try to keep maximum powers in their

hands. In such cases, keeping more power becomes more important than profit maximization.

11. Official restrictions over profits of public utilities. Public utilities or public corporations are legally

prohibited to make huge profits in many developing countries like India.

Thus, it is clear that a firm cannot maximize its profits always. There are many constraints in the

background of multiple objectives. Each one of the objectives has its own merits and demerits and a

firm has to strike a balance between all kinds of objectives. However, today it is the view of many

experts that in spite of several alternative objectives, a firm has to make adequate profits. For

undertaking any kind of welfare or other activities to promote the welfare of either consumers or

workers, a firm should have sufficient revenue. Other wise all other objectives would remain only on

paper and can never be implemented. Non-profit goals serve as supplementary or complementary ones

to the primary objective of profit maximization Thus, the traditional objective of profit maximization has

relevance even today of course with some modifications.


1. In _____________ model, the important assumption is that the entrepreneur aims at

maximising his profits.

2. _________ is the point where the firm has stopped incurring losses but yet to start

gaining profit.

3. The full form of TR is ___________

Economist Theory Of Firm

According to Economist theory of firm, a firm is a producing unit. It transforms or converts all kinds of

inputs in to outputs. The basic function a firm is to produce those goods and services which are

demanded by consumers in the market. It produces various kinds of goods and services and supplies

them in the market for the satisfaction of different groups of people either directly or indirectly. A firm


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is a business unit and it is organized on commercial principles. In the process of production and sale of

different goods and services, it aims at making profits.

According to this theory, a traditional firm is a group with a particular organizational and

management structure having command over its own property rights. It is a legal entity on the basis of

ownership and contractual relationship organized for production and sale of goods and services. In

olden days a firm was called by various names like shops, firms, enterprise, production and business

concerns etc. But today, it is organized on various forms like a sole trader, partnership concern, Joint

Stock Company, cooperative society etc.

A firm is formed, run and managed by an owner, employer or an entrepreneur who has the following

characteristics.

1. He has the legal permission to run an enterprise.

2. He can enter in to contract with any group of people who supply productive resources.

3. He can take his own decisions to maximize his economic gains.

4. He is entitled to enjoy the residual income after making payments to all productive resources in

the form of rent, wages and salaries and interest.

5. He can transfer his rights and obligations to other individuals on the basis of contracts.

6. He can direct and dictate the suppliers of productive resources in the manner he likes of course

on the basis of legal contracts.

7. He can change the nature of management according to his convenience.

8. He has all the rights to make changes in his organization which he feels the best. He can consult

others or he can take his own final decisions.

Thus, a firm is managed by a private person who centralizes all his decisions on the basis of legal

contracts and makes enough profits. He has his own personal interests to run the business unit. Such a

type of business unit has emerged as a dominant form of business organization over a period of time. It

has its won advantages as the firm is managed by an individual.

A firm managed by an individual has several advantages over other forms of organization.

1. He can take immediate and quick decisions to maximize his economic gains.

2. Direct control over the firm will ensure higher productivity, efficiency, better supervision, better

performance etc. Better control and management helps him to have time-bound programs

3. He can reward factor inputs on the basis of their performance and get best services from them.

4. He adopts a flexible business policy to suit the changing conditions without any of loss of time.

Thus, this form of business organization has emerged as the classical entrepreneurial firm and has

become most popular over a period of time. The above mentioned features of the classical firm have

been described as the theory of firm by various economists.

The traditional or classical firm basically engages itself in various kinds of economic activities which help

in maximizing its profits. It concentrates on wealth-creation and through it surplus creation. Surplus

value is nothing but the difference between the value of the final product and the value of various

inputs employed in the production process. Surplus generation is possible when the firm produces

maximum output with minimum costs. Hence, a firm works out the most ideal factor combinations to


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avoid all kinds of wastages, cut down costs and maximize its output. When the firm produces maximum

output with minimum costs then it will reach the equilibrium position. This is possible when total

revenue is equal to total cost or marginal revenue is equal to marginal cost. At the equilibrium point, it is

said that a firm will be maximizing its profits. The nature of working of a firm depends on several factors

like number of firms in the market, size of the firm, volume of production, entry and exit if firms, degree

of competition, existence of alternative substitutes, prices of goods etc.

Thus, the traditional or classical firm aims at profit maximization and over the years this objective has

been replaced by profit optimization.


1. According to Economist Theory Of Firm, a firm is a ____unit, which converts input into

output and while doing so, tries to create surplus value.

2. The firm aiming for profit maximization reaches its equilibrium only when it produces

_________.

3. Business decisions are made to cope with _____

Cyert And March’s Behavior Theory

Another alternative non-profit maximizing theory has been developed by Cyert and March. The theory

makes an attempt to explain the behavior of inter group conflicts and their multiple objectives in an

organization. Basically, this theory explains the usual and normal behavior of different groups of people

who work in an organization having mutually opposite goals. Prof, Simon has developed the initial

behavioral model and Prof. Cyert and March have further elaborated the theory in their book

“Behavioral Theory of the Firm” published in 1963.

Cyert and March explain how complicated decisions are taken in big industrial houses under various

kinds of risks and uncertainties in an imperfect market in the background of limited data and

information. The organizational structure, goals of different departments, behavioral pattern and

internal working of a big and multi – product firm differs from that of small organizations. The various

kinds of internal conflicts and problems faced by these organizations would certainly affect the decision-

making process of these organizations. They also explain how there are certain common problems faced

by similar organizations in an industry and their effects on the internal working of each individual

organization and their decision making process.

Cyert and March consider that a modern firm is a multi-product, multi-goal and multi-decision making

coalition business unit. Like a coalition government, it is managed by a number of groups. The group

consists of share holders, managers, workers, customers, suppliers, distributors, financiers, legal experts

and so on. Each group is independent by itself and has its own set of objectives and they try to maximize

their individual benefits. For example, shareholders expect faster growth of the company and higher

dividends, workers expect maximum wages and minimum work, better working conditions, welfare

measures, managers want higher salary, greater power, autonomy in day to day working, dominance,

control etc, suppliers quick and immediate payments etc. contributions made by each one of the group


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is equally important in carrying the activities of a firm. In their view out of several groups, the most

important ones are the shareholders, workers and managers in an organization.

Cyert and March points out the goals of a business organization would depend upon the multiple

objectives of each group and their collective demands. The nature of demand depends on the relative

strength and importance of each group in an organization, aspiration and expectation level of each

group, past success in their demands, relative success of other groups both with in and out side the

organization etc. It is quite clear that goals of each one of the group is multiple, conflicting and opposite

in their nature. Each one of the group out of their past experience and success, availability of limited

resources at the disposal of a firm, would arrange their demand on the basis of priorities. Most urgent

demands are highlighted and low-priority demands are postponed to latter periods. The management

may honor a few demands of a few groups and postpone the demands of other groups in view of

financial constraints. This may create heart-burns and conflict between different groups in the same

organization.

It is to be remembered that the demands of each group would depend on their aspiration levels,

expectations, actual performance of the organization, bargaining power of the each group, past success

in their demands, etc. As all of them change over a period of time, the demands of each group would

also under go changes. If actual performance and achievements of the organization is much better than

expected aspirations and target level, in that case, there will be upward revision in their demands and

vice-versa. Thus, there is a strong linkage between the expected and actual demand of each group in the

organization, past success and future environment. Each group makes an attempt to achieve its demand

in its own way. Through the process of hard bargaining, a winning coalition is formed and the broad

objectives are setout by the management. There may be conflict in different objectives of different

groups and the management has to overcome them intelligently.

Cyert and March suggest the following methods to overcome the conflicts of different groups and

smooth working of the organization. They are as follows. Demands of each group may be separated

from that of the other and separate attempts are made to fulfill them so that their impact on the whole

organization may be avoided. For example, they would grant higher monetary rewards for various factor

inputs like higher wages, salaries and bonus to workers, grant of other perquisites to keep them happy.

They may also grant side payments to different departments to carryon their work smoothly, For

example, more funds may be released to R&D, buying computers & other equipments etc. share holders

may be granted higher dividends, managers are given more powers, more autonomy, higher salaries,

lavish and luxurious air-conditioned offices, vehicles, and various kinds of facilities to keep them happy.

They are called as slack payments. Certainly, it will have stabilizing effects on the working of an

organization as it will build up the morale of the top management. These additional benefits may be

flexible to suit to the profit and loss conditions of a firm.

Demands of each group may be met over a period of time as and when they arise without jeopardizing

the general interest of the organization. The management may follow the policy of sequential attention.

On the basis of the priority and importance of each demand, the management may fulfill most urgent

demand first and then postpone the remaining less-urgent ones.

The management may also tackle the problem by decentralizing the decision making process. It can give

more autonomy to each department to work out its program, avoid mutual conflicts, ensure harmony

and balance in different goals, and optimize its working.


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Cyert and March are of the opinion that out of several objectives a firm has five important goals. They

are –

1. Production goal. Production is to be organized on the basis of demand in the market. Neither

there should be over production nor under production but just that much to meet the required

demand in the market, avoid excess capacity, over utilization of capital assets, lay-off of workers

etc.

2. Inventory goal. Inventory refers to stock of various inputs. In order to ensure continuity in

production and supply, certain minimum level of inventory has to be maintained by a firm.

Neither there should be surplus stock or shortage of different inputs. Proper balance between

demand and supply is to be maintained.

3. Sales goal. There should be adequate sales in any organization to earn reasonable amounts of

profits. In order to create demand sales promotion policies may be adopted from time to time.

4. Market-share goal. Each firm has to make consistent effort to increase its market share to

compete successfully with other firms and make sufficient profits

5. Profit goal. This is one of the basic objectives of any firm. The very survival and success of the

firm would depend upon the volume of profits earned by it.

The above mentioned objectives also would under go changes over a period of time in the background

of modern business environment. Hence, decision making would become complex and complicated.

It is quite clear that each business organization has its own set of goals. These goals would depend on

the ever changing demands of different groups who have their own conflicting objectives. There is need

for harmonious and balanced blending of different objectives of an organization and multiple objectives

of different groups working in the organization. The final objectives emerge after continuous bargaining

between different groups of the coalition. The management has to accommodate as many as possible

demands of different groups with out jeopardizing its own basic goal of making profits The model

developed by Cyert and March is also similar to that of the model developed by prof. Simon. The model

highlights on satisfactory levels of performance and achievements of its multiple objectives as

maximization of different goals may not be possible in the context of complex business world. Hence,

making satisfactory levels of profits rather than maximum profits has become the order of the day.

On the basis of its performance, the goals are set. If the target goals are not achieved, in that case it

makes an attempt to search the reasons for its failure and on the basis of experience it revises its goal.

Suitable changes are made in its objectives, targets, and strategies to achieve them in a given time

frame. If the modified objectives are achieved drastic changes in them become inevitable. The top

management takes the decisions in the background of limited time, resources, knowledge, information

and data. It is too difficult for them to examine the merits and demerits of all available alternatives and

choose the best one among them. They take rational decisions to achieve satisfactory levels of goals.

Hence, Cyert and March points out that satisfactory behavior is most rational in nature

Demerits.

1. The theory fails to analyze the behavior of the firm but it simply predicts the future expected

behavior of different groups.

2. It does not explain equilibrium of the industry as a whole.


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3. It fails to analyze the impact of the potential entry of new firms in to the industry and the

behavior of the well established firms in the market.

4. It highlights only on short run goals rather than long run objectives of an organization. Thus,

there are certain limitations to this theory.


1. ______ is related to demand of sales management and sales decision.

1. ________ is related to price and resource allocation decisions.

2. ____ works as a shock absorber.

3. ____ and ___ types of resolving conflicts are qualitative.

4. Cyert and March points out that the coalition group has multiple, _____ and ________ goals

Marris Growth Maximization Model

Profit-maximization is a traditional objective of a firm. Sales maximization objective is explained by Prof.

Boumal. On similar lines, Prof. Marris has developed another alternative growth maximization model in

recent years. It is a common factor to observe that each firm aims at maximizing its growth rate as this

goal would answer many of the objectives of a firm. A growth rate is a better yardstick to measure the

success of a firm. Growth depends on the volume of investment. Investment depends on capital

availability. Capital may come from either internal or external source. External source of capital is costly

where as internal generation of funds is economical. Generation of internal capital depends on profit

making capacity of a firm. Hence, profit maximization would automatically lead to growth maximization.

It is for this reason, Marris points out that a firm has to maximize its balanced growth rate over a period

of time.

Marris assumes that the ownership and control of the firm is in the hands of two groups of people, ie,

owners and managers. He further points out that both of them have two distinctive goals. Managers

have a utility function in which the amount of salary, status, position, power, prestige and security of job

etc are the most important variables where as in case of owners are more concerned about the size of

output, volume of profits, market share and sales maximization etc.

Utility function of the managers and that the owners are expressed in the following manner-

Uo = f [size of output, market share, volume of profit, capital, public esteem etc]

Um = f [salaries, power, status, prestige, job security etc].

In view of Marris the realization of these two functions would depend on the size of the firm. Larger the

firm, greater would be the realization of these functions and vice-versa. Size of the firm according to

Marris depends on the amount of corporate capital which includes total volume of assets, inventory

levels, cash reserves etc. He further points out that the managers always aim at maximizing the rate of


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growth of the firm rather than growth in absolute size of the firm. Generally managers like to stay in a

growing firm. Higher growth rate of the firm satisfy the promotional opportunities of managers and also

the share holders as they get more dividends.

Marris identifies two constraints in the rate of growth of a firm.-

1. There is a limit up to which output of a firm can be increased more economically, limit to

manage the firm efficiently, limit to employ highly qualified and experienced managers, limit to

research and development and innovation etc.

2. The ambition of job security puts a limit to the growth rate of the firm itself deliberately. If

growth reaches the maximum, then there would be no opportunity to expand further and as

such the managers may loose their jobs. Rapid growth and financial soundness should go

together. Managers hesitate to take unwanted risks and uncertainties in the organization at the

cost of their jobs They would like to avoid risky investment projects, concentrate on generating

more internal funds and invest more finance on only those products and services which brings

more profits Hence, managers would like to seek their job security through adoption of a

cautious and prudent financial policy.

He further points out that a high risk-loving management would like to maintain a relatively low amount

of cash on hand and invest more on business, borrow more external funds and invest more in business

expansion and keep a low profit levels. On the other hand, a highly risk-averting management may have

exactly opposite policy. Ultimately, it is the job security which puts a constraint on business decisions by

the managers.

The Marris growth maximization model. highlights on achieving a balanced growth rate of a firm.

Maximum growth rate [g] is equal to two important variables-

1. The rate of demand for the products [gd]

2. 2. Growth rate of capital[gc]

Hence, Max g = gd = gc.

The growth rate of the firm depends on two factors- a] the rate of diversification [d]and b] the average

profit margin.

The diversification rate depends on the number of new products introduced per unit of time and the

rate of success of new products in the market. The success of new products is determined by its changes

in fashion styles, consumption habits, the range of products offered etc. More over diminishing marginal

returns would operate in any business and as such there is a limit to diversification. Similarly, market

price of the given product, availability of alternative substitute products and their relative prices,

publicity, propaganda and advertisements, R&D expenses and utility and comparative value of the

product etc would decide the profit ratio. Higher expenditure on sales promotion and R&D would

certainly reduce profits level as there are limits to them.

The rate of capital growth is determined by either issue of new shares to obtain additional funds and

external funds and generation of more internal surplus. Generally a firm would select the last one to

avoid higher degrees of risks in the business.


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The Marris model states that in order to maximize balanced growth rate or reach equilibrium position,

there should be equality between the growth rate in demand for the products and growth rate in supply

of capital. This implies the satisfaction of three conditions.

1. The management has to maintain a low liquidity ratio, ie, liquid asset / total assets. But this ratio

should not create any financial embarrassment to meet the required payments to all the

concerned parties.

2. The management has to maintain a high ratio between a debt / asset so that it will have enough

money to invest in order to stimulate growth.

3. The management has to keep a high level of retained profits for further expansion and

development but it should not displease the share holder by giving low dividends.

In this case, the mangers would maximize their utility function and the owners would maximize their

utility functions. The managers are able to get their job security with a high rate of growth of the firm

and share holder would become happy as they get higher amount of dividends.

Demerits

1. It is doubtful whether both managers and owners would maximize their utility functions

simultaneously always

2. The assumption of constant price and production costs are not correct.

3. It is difficult to achieve both growth maximization and profit maximization together.


1. According to ____ modern firms are managed by both the manager and the shareholders

(owners).

2. In_______, the objective of the firm is balanced growth.

1. In Marris Growth Maximization Model, the manager tries to maximize his satisfaction

and his satisfaction lies in the ______.

2. In ______ relationship, growth determines profit.

Boumal’s Static And Dynamic Models.

Sales maximization model is an alternative model for profit maximization. This model is developed by

Prof. W.J.Boumal, an American economist. This alternative goal has assumed greater significance in the

context of the growth of Oligopolistic firms. The model highlights that the primary objective of a firm is

to maximize its sales rather than profit maximization. It states that the goal of the firm is

maximization of sales revenue subject to a minimum profit constraint. The minimum profit constraint

is determined by the expectations of the share holders. This is because no company can displease the


EDUPROZ Page 146

share holders. It is to be noted here that maximization of sales does not mean maximization of physical

sales but maximization of total sales revenue. Hence, the managers are more interested in maximizing

sales rather than profit. The basic philosophy is that when sales are maximized automatically profits of

the company would also go up. Hence, attention is diverted to increase the sales of the company in

recent years in the context of highly competitive markets.

In defense of this model, the following arguments are given.

1. Increase in sales and expansion in its market share is a sign of healthy growth of a normal

company.

2. It increases the competitive ability of the firm and enhances its influence in the market.

3. The amount of slack earnings and salaries of the top managers are directly linked to it.

4. It helps in enhancing the prestige and reputation of top management, distribute more dividends

to share holders and increase the wages of workers and keep them happy.

5. The financial and other lending institutions always keep a watch on the sales revenues of a firm

as it is an indication of financial health of a firm.

6. It helps the managers to pursue a policy of steady performance with satisfactory levels of profits

rather than spectacular profit maximization over a period of time. Managers are reluctant to

take up those kinds of projects which yield high level of profits having high degree of risks and

uncertainties. The risk-averting and avoiding managers prefer to select those projects which

ensure steady and satisfactory levels of profits.

Prof, Boumal has developed two models. The first is static model and the second one is the

dynamic model.

The Static Model

This model is based on the following assumptions.

1. The model is applicable to a particular time period and the model does not operate at different

periods of time.

2. The firm aims at maximizing its sales revenue subject to a minimum profit constraint.

3. The demand curve of the firm slope downwards from left to right.

4. .The average cost curve of the firm is U-shaped one.

With the help of the following diagram, we can explain sales maximization model subject to a

minimum profit constraint.


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At OX1 level of output profit is maximum, TR is much in excess of TC. If the firm chooses to produce OX3

output profit will fall to X3K though the TR is still in excess of TC. Profit constraint is les at OX2 level of

output as the firm earns X2 N profit depending upon the market condition a firm can determine the

level of output with minimum profit constraint.

Sales maximization [dynamic model]

In the real world many changes takes place which affects business decisions of a firm. In order to include

such changes, Boumal has developed another dynamic model. This model explains how changes in

advertisement expenditure, a major determinant of demand, would affect the sales revenue of a firm

under severe competitions. Assumptions

1. Higher advertisement expenditure would certainly increase sales revenue of a firm.

2. Market price remains constant.

3. Demand and cost curves of the firm are conventional in nature.

Generally under competitive conditions, a firm in order to increase its volume of sales and sales revenue

would go for aggressive advertisements. This leads to a shift in the. demand curve to the right. Forward


EDUPROZ Page 148

shift in demand curve implies increased advertisement expenditure resulting in higher sales and sales

revenue. A price cut may increase sales in general. But increase in sales mainly depends on whether the

demand for a product is elastic or inelastic. A price reduction policy may increase its sales only when the

demand is elastic and if the demand is inelastic; such a policy would have adverse effects on sales.

Hence, to promote sales, advertisements become an effective instrument today. It is the experience of

most of the firms that with an increase in advertisement expenditure, sales of the company would also

go up. A sales maximizer would generally incur higher amounts of advertisement expenditure than a

profit maximizer. However, it is to be remembered that amount allotted for sales promotion should

bring more than proportionate increase in sales and total profits of a firm. Otherwise, it will have a

negative effect on business decisions

Thus, by introducing, a non-price variable in to his model, Boumal makes a successful attempt to analyze

the behavior of a competitive firm under oligopoly market conditions. Under oligopoly conditions as

there are only a few big firms competing with each other either producing similar or differentiated

products, would resort to heavy advertisements as an effective means to increase their sales and sales

revenue. This appears to be more practical in the present day situations.


1. Sales maximization model is an alternative for ____ model.

2. Boumal thinks managers are more interested in maximising ___ rather than profit.

3. In oligopoly market structure, the firms compete more in terms of advertisement, product

variations etc. rather than ____.

Williamson’s Managerial Discretionary Theory

Prof. O.Williamson has developed a highly useful and most practical managerial utility model to explain

goals of a business firm in recent years. In many organizations we come across that when once a firm

achieves a certain amount of growth, the top mangers concentrate their attention on maximizing their

self-interest and allow the growth rate to continue. Thus, profit maximization and managers’ utility

maximization go together.

Assumptions of the model

1. Existence of imperfect markets.

2. Ownership and management is separated

3. A minimum level of profit is to be achieved by a firm to pay dividends to share holders.

The model

Williamson is of the opinion that managers as a powerful group in any organization have their own set

of utility functions. They have certain expectations and demands. Generally they aim at maximizing their

managerial utility functions rather than maximizing total profits of the company. They feel that a firm is

making profit on account of the efforts of top management and as such they are entitled to certain

special privileges and eligible to enjoy special benefits. The various kinds of managerial satisfaction


EDUPROZ Page 149

includes the degree of freedom and autonomy given to them, their status, prestige, power enjoyed by

them, dominance, professional excellence, security of their jobs, salary and other perquisites etc. Out of

these variables, only salary is measurable and all other variables are non-measurable. In order to

measure other variables, Williamson introduces the concept of “expense preference”. This concept

helps to measure the level of satisfaction which managers would derive from certain types of

expenditures. The managers’ utility function is expressed as U = f [S, M, Id] Where

S = Additional expenditure of staff.

M = Managerial Emoluments

Id = Discretionary investment.

The staff expenditure [S] includes the wages and salaries paid to additional staff employed who have to

work under the top management. Now managers will have a larger team than before and allot the work

to new staff as a firm expands. The mangers now enjoy more powers to control their subordinates.

Higher wages or salaries are paid in accordance with their productive ability and professional excellence

which certainly would motivate the workers to work more.

Managerial emoluments [ M] include expenses on entertainment, luxurious air-conditioned office,

Costly company cars and other allowances, given to managers. It has been pointed out that these

expenses are justified by managers as it would enhance their status, prestige, power, better working

environment and image of the company in the eyes of public etc. This would motivate the managers to

do their work in a congenial atmosphere and free manner.

Discretionary power of investment expenditure {Id] includes those investment expenses which confer

certain personal benefits and satisfaction to managers. For example, expenditure on latest equipments,

furniture, decoration materials etc. These expenses are expected to elevate the status and esteem of

managers. They satisfy their ego and sense of pride.

Thus, all these expenditures are made by a firm to keep the managers happy and motivate them to work

more. The above mentioned expenditures are measurable in terms of money and they can be used as

proxy variables to replace the non-operational concepts like power, status, prestige, professional

excellence etc appearing in the managerial utility function.

It is to be noted that all the expenses are included in total cost of operations of a firm. The profits of the

company are measured by taking tin to account of total expenses and total revenue earned by a firm.

The difference between the TR and TC would measure the volume of profits. A minimum amount of

profits are required to distribute reasonable dividends to share holders. Otherwise, they demand for a

change in management. This would create job insecurity to the managers. Hence they can maximize

their utility functions only when they ensure reasonable profits to a company.

There is no direct relationship between managers’ utility function and better performance always. The

empirical evidence is not enough for the verification of the theory. Always a firm cannot spend more

money on only improvements in the working conditions of mangers. It has to look in to the interests of

all groups in an organization.


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1. The expenditure, which is incurred by the Manager’s indulgence in a company car is

termed by Williamson as _____

2. In the equation , S stands for ____ and D stands for ____.

Summary

Units 6 enlighten us about the various alternative objectives of a firm. The traditional objective is that of

profit maximization. But in recent years, economists have developed various alternative objectives to

suit to modern business environment. The theory of firm highlights on wealth-maximization or creation

of maximum assets through which it can generate economic surpluses. The profit maximization theory

stresses on earning maximum amount of profits by a firm. Cyert and March theory concentrates on the

behavior of various coalition partners in an organization and explain how opposite goals of different

groups would affect the decision making of a firm. Marris model analyses the rate of growth of a firm via

maximizing managers’ powers and status. Boumal analyses the impact of advertisement expenditures

incurred by a firm on sales promotion and its impact on total sales revenue of a firm. Williamson studies

the impact of managerial utility functions on the performance of a firm. Thus, a firm has several

alternative goals and the selection of particular goals depends on the management of a firm. It is to be

remembered that all other objectives of a firm can be realized only when a firm is making reasonable

amount of profits. Any organization has to earn adequate profits to please the shareholders. In order to

make more profits, a firm has to create more wealth, assets, and surpluses, satisfy the expectations of

top managers, workers, and achieve a high growth rate of the firm. All objectives are inter connected

and supplement one another. Realization of one objective would depend on other objectives. Hence,

there should be a proper balance between different objectives.

Terminal Questions

1. Discuss profit maximising model.

2. Explain economist theory of firms.

3. Analyse Syert to March’s behavious theory

4. Examine the Marris growth maximising model.

5. Critically examine Boumal’s static and dynamic models.

6. Give an account of William son’s managerial discretionary theory.




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1. Profit Maximisation Model

2. Break Even point

3. Total Revenue


1.

Transformation

2. Profit maximizing output

3. Changes


1. Market share goal

2. Profit goal

3. Slack payment

4. Sequential hearing to demand and Decentralizing the decision making

5. Conflicting and opposite


1. Robin Marris

2. Marris Growth Maximization Model

3. Growth rate of the firm

4. Differentiated diversification


1. Profit maximization

2. Sales

3. Price


1. Management slack

2. Staff expenditure and discretionary profit


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1. Refer to Unit 6.2






Unit 7 Revenue Analysis And Pricing Policies

Introduction

The awareness of both revenue and cost concepts are important to a managerial economist.

Revenue and revenue curves like the cost and cost curves explain the position and the

functioning of a firm in the market. While costs indicate the expenses of a firm revenue indicates

the receipts of a firm. Revenue means the sale receipts of the output produced by the firm. It

depends on the market price. Elasticity of demand has an important bearing on the receipts of a

firm. The amount of money, which the firm receives by the sale of its output in the market,

is known as its revenue. The major objective of a firm is to make maximum profit. Cost and

revenue concepts help in the maximization of its profit under various kinds of markets like

perfect, imperfect etc. The management of a firm should formulate an appropriate pricing policy

keeping the long run prospects in view, to attract maxim profit.


Understand different kinds of revenue and their behaviour under different market

conditions

Meaning And Different Types Of Revenues

Revenue is the income received by the firm. There are three concepts of revenue – Total

revenue, Average revenue and Marginal revenue

1. Total revenue (TR):


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Total revenue refers to the total amount of money that the firm receives from the sale of

its products, i.e. .gross revenue. In other words, it is the total sales receipts earned from the sale

of its total output produced over a given period of time. In brief, it refers to the total sales

proceeds. It will vary with the firm’s output and sales. We may show total revenue as a function

of the total quantity sold at a given price as below.

TR = f(q). It implies that higher the sales, larger would be the TR and vice-versa. TR is

calculated by multiplying the quantity sold by its price. Thus, TR = PXQ. For e.g. a firm sells

5000 units of a commodity at the rate of Rs. 5 per unit, then TR would be

TR = P x Q = 5 x 5000 = 25,000.00.

2.Average revenue (AR)

Average revenue is the revenue per unit of the commodity sold. It can be obtained

by dividing the TR by the number of units sold. Then, AR = TR/Q AR = 150/15= 10.

When different units of a commodity are sold at the same price, in the market, average revenue

equals price at which the commodity is sold for e.g. 2 units are sold at the rate of Rs.10 per unit,

then total revenue would be Rs. 20 (2×10). Thus AR = TR/Q 20/2 = 10. Thus average revenue

means price. Since the demand curve shows the relationship between price and the quantity

demanded, it also represents the average revenue or price at which the various amounts of a

commodity are sold, because the price offered by the buyer is the revenue from seller’s point of

view. Therefore, average revenue curve of the firm is the same as demand curve of the

consumer.

Therefore, in economics we use AR and price as synonymous except in the context of price

discrimination by the seller. Mathematically P = AR.


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3. Marginal Revenue (MR)

Marginal revenue is the net increase in total revenue realized from selling one more unit of a

product. It is the additional revenue earned by selling an additional unit of output by the

seller.

MR differs from the price of the product because it takes into account the effect of changes in

price. For example if a firm can sell 10 units at Rs.20 each or 11 units at Rs.19 each, then the

marginal revenue from the eleventh unit is (10 × 20) – (11 × 19) = Rs.9.

If the price of a product falls when more of it is offered for sale then that would involve a loss on

the previous units which were sold at a higher price before and is now sold at the reduced price

along with the additional one. This loss in the previous units must be deducted from the revenue

earned by the additional unit.

Suppose a firm is selling 4 units of the output at the price of Rs.14 per unit. Now if it wants to

sell 5 units instead of 4 units and thereby the price of the product falls to Rs.12 per unit, then the

marginal revenue will not be equal to Rs.12 at which the 5th unit is sold. 4 units, which were sold

at the price of Rs.14 before, will all have to be sold at the reduced price of Rs.12 and that will

mean the loss of 2 rupees on each of the previous 4 units. The total loss on the previous units will

be equal to Rs.8. Therefore, this loss of 8 rupees should be deducted from the price of Rs.12 of

the 5th

unit while calculating the marginal revenue. The marginal revenue in this case, therefore,

will be Rs.12 – Rs.8 =Rs.4 and not Rs.12 which is the average revenue.

Marginal revenue can also be directly calculated by finding out the difference between the total

revenue before and after selling the additional unit of the product.

Total revenue when 4 units are sold at the price of Rs.14=4X14=Rs.56

Total revenue when 5 units are sold at the price of Rs.12=5X12=Rs.60

Therefore, Marginal revenue or the net revenue earned by the 5th

unit = 60-56=Rs.4.

Thus, Marginal revenue of the nth unit = difference in total revenue in increasing the sale from n-

1 to n units or

Marginal revenue = price of nth unit minus loss in revenue on previous units resulting from price

reduction.

The concept is important in micro economics because a firm’s optimal output (most profitable) is

where its marginal revenue equals its marginal cost i.e. as long as the extra revenue from selling

one more unit is greater than the extra cost of making it, it is profitable to do so.

It is usual for marginal revenue to fall as output goes up both at the level of a firm and that of a

market, because lower prices are needed to achieve higher sales or demand respectively.


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MR = = where ∆ TR represents change in TR

And indicates change in total quantity sold.

Also MR = TRn – TRn-1

Marginal revenue is equal to the change in total revenue over the change in quantity

Marginal Revenue = (Change in total revenue) divided by (Change in sales)

Units Price TR AR MR

1 20 20 20 -

2 18 36 18 16

3 16 48 16 12

4 14 56 14 8

5 12 60 12 4

According to the table, people will not buy more than 4 units at a price of Rs.14.00. To sell more,

price must drop. Suppose that to sell 5 units, the price must drop to Rs.12. What will the

marginal revenue of the 5th unit be?

There is a temptation to answer this question by replying, Rs.12. A little arithmetic shows that

this answer is incorrect. Total revenue when 4 are sold is Rs.56. When 5 units are sold, total

revenue is (5) x (Rs.12) = Rs.60. The marginal revenue of the 5th unit is only Rs.4.

To see why the marginal revenue is less than price, one must understand the importance of the

downward-sloping demand curve. To sell another unit, seller must lower price on all units. He

received an extra Rs.4 for the 5th unit, but lost Rs.8 on 4 units he was previously selling. So the

net increase in revenue was Rs.12 minus Rs.8 or Rs.4.

There is another way to see why marginal revenue will be less than price when a demand curve

slopes downward. Price is average revenue. If the firm sells 4 units for

Rs.14, the average revenue for each unit is Rs.14.00. But as seller sells more, the


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average revenue (or price) drops, and this can only happen if the marginal revenue is below

price, pulling the average down.

If one knows marginal revenue, one can tell what happens to total revenue if sales change. If

selling another unit increases total revenue, the marginal revenue must be greater than zero. If

marginal revenue is less than zero, then selling another unit takes away from total revenue. If

marginal revenue is zero, than selling another does not change total revenue. This relationship

exists because marginal revenue measures the slope of the total revenue curve.

Relationship between Total revenue, Average revenue and Marginal Revenue concepts

In order to understand the relationship between TR, AR and MR, we can prepare a hypothetical

revenue schedule.

Number of Units sold TR (Rs.) AR (Rs.) MR (Rs.)

1 10 10 –

2 18 9 8

3 24 8 6

4 28 7 4

5 30 6 2

6 30 5 0

7 28 4 -2

From the table, it is clear that:

1. MR falls as more units are sold.

2. TR increases as more units are sold but at a diminishing rate.

3. TR is the highest when MR is zero

4. TR falls when MR become negative

5. AR and MR both falls, but fall in MR is greater than AR i.e., MR falls more steeply than

AR.


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Relationship between AR and MR and the nature of AR and MR curves under difference market

conditions

1. Under Perfect Market

Under perfect competition, an individual firm by its own action cannot influence the market price. The

market price is determined by the interaction between demand and supply forces. A firm can sell any

amount of goods at the existing market prices. Hence, the TR of the firm would increase

proportionately with the output offered for sale. When the total revenue increases in direct proportion

to the sale of output, the AR would remain constant. Since the market price of it is constant without any

variation due to changes in the units sold by the individual firm, the extra output would fetch

proportionate increase in the revenue. Hence, MR & AR will be equal to each other and remain

constant. This will be equal to price.

Number of Units sold Price per Unit Rs. 8.00

AR TR MR

1 8 8 8

2 8 16 8

3 8 24 8

4 8 32 8

5 8 40 8

6 8 48 8

Under perfect market condition, the AR curve will be a horizontal straight line and parallel to OX axis.

This is because a firm has to sell its product at the constant existing market price. The MR cure also

coincides with the AR curve. This is because additional units are sold at the same constant price in the

market.


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2. Under Imperfect Market

Under all forms of imperfect markets, the relation between TR, AR, and MR is different. This can be

understood with the help of the following imaginary revenue schedule.

Number of Units sold TR AR or price in Rs. MR

1 10 10 10

2 18 9 8

3 24 8 6

4 28 7 4

5 30 6 2

6 30 5 0

7 28 4 -2

From the above table it is clear that:

In order to increase the sales, a firm is reducing its price, hence AR falls.

1. As a result of fall in price, TR increase but at a diminishing rate.

2. TR will be higher when MR is zero

3. TR falls when MR becomes negative

4. AR and MR both declines. But fall in MR will be greater than the fall in AR.

5. The relationship between AR and MR curves is determined by the elasticity of demand on the

average revenue curve.


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Under imperfect market, the AR curve of an individual firm slope downwards from left to right. This is

because; a firm can sell larger quantities only when it reduces the price. Hence, AR curve has a negative

slope.

The MR curve is similar to that of the AR curve. But MR is less than AR. AR and MR curves are different.

Generally MR curve lies below the AR curve.

The AR curve of the firm or the seller and the demand curve of the buyer is the same

Since, the demand curve represents graphically the quantities demanded by the buyers at various prices

it shows the AR at which the various amounts of the goods that are sold by the seller. This is because the

price paid by the buyer is the revenue for the seller (One man’s expenditure is another man’s income).

Hence, the AR curve of the firm is the same thing as that of the demand curve of the consumers.

Suppose, a consumer buys 10 units of a product when the price per unit is Rs.5 per unit. Hence, the total

expenditure is 10 x 5 = Rs.50/-. The seller is selling 10 units at the rate of Rs.5 per unit. Hence, his total

income is 10 x 5 = Rs.50/-. Thus, it is clear that AR curve and demand curve is really one and the same.


Understand the relationship between revenue concepts and price elasticity of demand


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Relationship Between Revenue Concepts And Price Elasticity Of Demand

Elasticity of Demand, Average Revenue and Marginal Revenue

There is a very useful relationship between elasticity of demand, average revenue and marginal

revenue at any level of output. Elasticity of demand at any point on a consumer’s demand curve

is the same thing as the elasticity on the given point on the firm’s average revenue curve. With

the help of the point elasticity of demand, we can study the relationship between average

revenue, marginal revenue and elasticity of demand at any level of output.

In the diagram AR and MR respectively are the average revenue and the marginal revenue

curves. Elasticity of demand at point R on the average revenue curve = RT/Rt Now in the

triangles PtR and MRT

tPR = RMT (right angles)

tRP = RTM (corresponding angles)

PtR= MRT (being the third angle)

Therefore, triangles PtR and MRT are equiangular.

Hence RT / Rt = RM / tP


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In the triangles PtK and KRQ

PK = RK

PKt = RKQ (vertically opposite)

tPK = KRQ (right angles )

Therefore, triangles PtK and RQK are congruent (i.e., equal in all respects).

Hence Pt = RQ

Elasticity at R = RT / Rt = RM / tP = RM / RQ

Hence elasticity at R = RM / RM – QM

It is also clear from the diagram that RM is average revenue and QM is the marginal revenue at

the output OM which corresponds to the point R on the average revenue curve. Therefore

elasticity at R = Average Revenue / Average Revenue – Marginal Revenue

If A stands for Average Revenue, M stands for Marginal Revenue and e stands for point

elasticity on the average revenue curve Then e = A / A – M .

Thus, elasticity of demand is equal to AR over AR minus MR.

By using the above elasticity formula, we can derive the formula for AR and MR separately.

eA – eM = A bringing A’s together, we have

eA – A = eM

A ( e – 1 ) = eM

A = eM / e – 1

A =M (e / e – 1)


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Therefore Average Revenue or price = M (e / e – 1)

Thus the price (i.e., AR) per unit is equal to marginal revenue x elasticity over elasticity minus

one. The marginal revenue formula can be written straight away as

M = A ((e – 1) / e)

The general rule therefore is: at any output,

Average Revenue = Marginal Revenue x (e / e – 1) and

Marginal Revenue = Average Revenue x (e – 1 / e)

Where, e stands for point elasticity of demand on the average revenue curve.

With the help of these formulae, we can find marginal revenue at any point from average

revenue at the same point, provided we know the point elasticity of demand on the average

revenue curve. Suppose that the price of a product is Rs.8 and the elasticity is 4 at that price.

Marginal revenue will be:

M = A (( e – 1) / e)

= 8 (( 4 – 1 / 4)

= 8 x 3 /4

= 24 / 4

= 6. Marginal Revenue is Rs. 6.

Suppose that the price of a product is Rs.4 and the elasticity coefficient is 1 then the

corresponding MR will be:

M = A (( e-1) / e)

= 4 (( 4 – 1) / 4)

= 4 x 3 / 4

= 12 / 4

= 3 Marginal revenue is Rs.3


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Suppose that the price of commodity is Rs.10 and the elasticity coefficient at that price is 1 MR

will be:

M = A(( e-1) / e)

=10 ((1-1) /1)

=10 x 0/1

= 0

Whenever elasticity of demand is unity, marginal revenue will be zero, whatever be the price(or

AR). It follows from this that if a demand curve shows unitary elasticity throughout its length the

corresponding marginal revenue will be zero throughout, that is, the x axis itself will be the

marginal revenue curve.

Thus, the higher the elasticity coefficient, the closer is the MR to AR / price. When elasticity

coefficient is one for any given price, the corresponding marginal revenue will be zero, marginal

revenue is always positive when the elasticity coefficient is greater than one and marginal

revenue is always negative when the elasticity coefficient is less than one.

Kinked Demand curve and the corresponding Marginal Revenue curve


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We measure quantity on the x axis and price on the Y axis. The demand curve AD has a kink at

point B, thus exhibiting two different characteristics. From A to B it is elastic but from B to D it

is inelastic. Because the demand is elastic from A to B a very small fall in price causes a very big

rise in demand, but to realize the same increase in demand a very big fall in price is required as

the demand curve assumes inelastic shape after point B. The corresponding marginal revenue

curve initially falls smoothly, though at a greater rate. However as the table shows and the

diagram clearly illustrates, there is a sudden fall from Rs.600 to Rs.50 then to -50. In the diagram

there is a gap in MR between output 300 and 350. Generally an Oligopolist who faces a kinked

demand curve will make a good gain when he reduces the price a little before the kink (point B),

but if he lowers the price below B; the rival firms will lower their prices too; accordingly the

price cutting firm will not be able to increase its sales correspondingly or may not be able to

increase its sales at all. As a result, the demand curve of price cutting firm below B is more

inelastic. The corresponding MR curve is not smooth but has a gap or discontinuity between G

and L.

In certain cases, the kinked demand curve may show a high elasticity in the lower portion of the

demand curve beyond the kink and low elasticity in higher portion of the demand curve before

the kink Marginal revenue to such a demand curve will show a gap but


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Instead of at a lower level, it will start at a higher level.

Relationship between AR, MR, TR and Elasticity of Demand

In the diagram AR is the average revenue curve, MR is the marginal revenue curve and OD is

the total revenue curve. At the middle point C of average revenue curve elasticity is equal to one.

On its lower half it is less than one and on the upper half it is greater than one. MR

corresponding to the middle point C of the AR curve is zero. This is shown by the fact that MR

curve cuts the x axis at Q which corresponds to the point C on the AR curve. If the quantity is

greater than OQ it will correspond to that portion of the AR curve where e<1 marginal revenue is

negative because MR goes below the x axis. Likewise for a quantity less than OQ, e>1 and the

marginal revenue is positive. This means that if quantity greater than OQ is sold, the total

revenue will be diminishing and for a quantity less than OQ the total revenue TR will be

increasing. Thus the total revenue TR will be maximum at the point H where elasticity is equal to

one and marginal revenue is zero.

Significance of Revenue curves

The relationship between price elasticity of demand and total revenue is important because every

firm has to decide whether to increase or decrease the price depending on the price elasticity of

demand of the product. If the price elasticity of demand for his product is relatively elastic it will

be advantageous to reduce price as it increases his total revenue. On the other hand, if the price

elasticity of demand for his product is relatively inelastic he should raise the price as it increases

his total revenue.


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Average revenue, which is the price per unit, considered along with average cost will show to the

firm whether it is profitable to produce and sell. If average revenue is greater than average cost,

the firm is getting excess profit; if it is less than average cost, the firm is running at a loss.

Firm’s profit is maximum at a point where Marginal revenue is equal to Marginal cost. Any

increase in output beyond that point will mean loss on additional units produced; restriction of

output before that point will mean lower profit. Thus the concept of average revenue is relevant

to find out whether the firm is running on profit or loss; the concept of marginal revenue together

with marginal cost will show profit maximizing output for the firm.


Have full knowledge of pricing policies of a firm

Pricing Policies

A detailed study of the market structure gives us information about the way in which prices are

determined under different market conditions. However, in reality, a firm adopts different

policies and methods to fix the price of its products. Pricing policy refers to the policy of

setting the price of the product or products and services by the management after taking

into account of various internal and external factors, forces and its own business objectives. Pricing Policy basically depends on price theory that is the corner stone of economic theory.

Pricing is considered as one of the basic and central problems of economic theory in a modern

economy. Fixing prices are the most important aspect of managerial decision making because

market price charged by the company affects the present and future production plans, pattern of

distribution, nature of marketing etc. Above all, the sales revenue and profit ratio of the producer

directly depend upon the prices. Hence, a firm has to charge the most appropriate price to the

customers. Charging an ideal price, which is neither too high nor too low, would depend on a

number of factors and forces. There are no standard formulas or equations in economics to fix

the best possible price for a product. The dynamic nature of the economy forces a firm to raise

and reduce the prices continuously. Hence, prices fluctuate over a period of time.

Generally speaking, in economic theory, we take into account of only two parties, i.e., buyers

and sellers while fixing the prices. However, in practice many parties are associated with pricing

of a product. They are rival competitors, potential rivals, middlemen, wholesalers, retailers,

commission agents and above all the Govt. Hence, we should give due consideration to the

influence exerted by these parties in the process of price determination.

Broadly speaking, the various factors and forces that affect the price are divided into two

categories. They are as follows:


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I External Factors (Outside factors)

1. Demand, supply and their determinants.

2. Elasticity of demand and supply.

3. Degree of competition in the market.

4. Size of the market.

5. Good will, name, fame and reputation of a firm in the market.

6. Trends in the market.

7. Purchasing power of the buyers.

8. Bargaining power of customers

9. Buyers behavior in respect of particular product

10. Availability of substitutes and complements.

11. Government’s policy relating to various kinds of incentives, disincentives, controls,

restrictions

and regulations, licensing, taxation, export & import, foreign aid, foreign capital, foreign

technology, MNCs etc.

12. Competitors pricing policy.

13. Social consideration.

14. Bargaining power of customers.

1. Internal Factors (Inside Factors)

15. Objectives of the firm.

16. Production Costs.

17. Quality of the product and its characteristics.

18. Scale of production.

19. Efficient management of resources.

20. Policy towards percentage of profits and dividend distribution.

21. Advertising and sales promotion policies.

22. Wage policy and sales turn over policy etc.

23. The stages of the product on the product life cycle.

24. Use pattern of the product.

25. Extent of the distinctiveness of the product and extent of product differentiation practiced

by the

firm.

26. Composition of the product and life of the firm.

Thus, multiple factors and forces affect the pricing policy of a firm


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Objectives Of The Price Policy

A firm has multiple objectives today. In spite of several objectives, the ultimate aim of

every business concern is to maximize its profits. This is possible when the returns

exceed costs. In this context, setting an ideal price for a product assumes greater

importance. Pricing objectives has to be established by top management to ensure not

only that the company’s profitability is adequate but also that pricing is complementary

to the total strategy of the organization. While formulating the pricing policy, a firm has

to consider various economic, social, political and other factors. The following objectives

are to be considered while fixing the prices of the product.

1. Profit maximization in the short term

The primary objective of the firm is to maximize its profits. Pricing policy as an

instrument to achieve this objective should be formulated in such a way as to

maximize the sales revenue and profit. Maximum profit refers to the highest

possible of profit. In the short run, a firm not only should be able to recover its

total costs, but also should get excess revenue over costs. This will build the

morale of the firm and instill the spirit of confidence in its operations. It may

follow skimming price policy, i.e., charging a very high price when the product is

launched to cater to the needs of only a few sections of people. It may exploit

wide opportunities in the beginning. But it may prove fatal in the long run. It may

lose its customers and business in the market. Alternatively, it may adopt

penetration pricing policy i.e., charging a relatively lower price in the latter stages

in the long run so as to attract more customers and capture the market.

2. Profit optimization in the long run

The traditional profit maximization hypothesis may not prove beneficial in the

long run. With the sole motive of profit making a firm may resort to several kinds

of unethical practices like charging exorbitant prices, follow Monopoly Trade

Practices (MTP), Restrictive Trade Practices (RTP) and Unfair Trade Practices

(UTP) etc. This may lead to opposition from the people. In order to over come

these evils, a firm instead of profit maximization, aims at profit optimization.

Optimum profit refers to the most ideal or desirable level of profit. Hence,

earning the most reasonable or optimum profit has become a part and parcel of a

sound pricing policy of a firm in recent years.

3. Price Stabilization

Price stabilization over a period of time is another objective. The prices as far as

possible should not fluctuate too often. Price instability creates uncertain

atmosphere in business circles. Sales plan becomes difficult under such

circumstances. Hence, price stability is one of the pre requisite conditions for


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steady and persistent growth of a firm. A stable price policy only can win the

confidence of customers and may add to the good will of the concern. It builds up

the reputation and image of the firm.

4. Facing competitive situation

One of the objectives of the pricing policy is to face the competitive situations in

the market. In many cases, this policy has been merely influenced by the market

share psychology. Wherever companies are aware of specific competitive

products, they try to match the prices of their products with those of their rivals to

expand the volume of their business. Most of the firms are not merely interested

in meeting competition but are keen to prevent it. Hence, a firm is always busy

with its counter business strategy.

5. Maintenance of market share

Market share refers to the share of a firm’s sales of a particular product in

the total sales of all firms in the market. The economic strength and success of

a firm is measured in terms of its market share. In a competitive world, each firm

makes a successful attempt to expand its market share. If it is impossible, it has to

maintain its existing market share. Any decline in market share is a symptom of

the poor performance of a firm. Hence, the pricing policy has to assist a firm to

maintain its market share at any cost.

6. Capturing the Market

Another objective in recent years is to capture the market, dominate the market,

command and control the market in the long run. In order to achieve this goal,

sometimes the firm fixes a lower price for its product and at other times even it

may sell at a loss in the short term. It may prove beneficial in the long run. Such a

pricing is generally followed in price sensitive markets.

7. Entry into new markets.

Apart from growth, market share expansion, diversification in its activities a firm

makes a special attempt to enter into new markets. Entry into new markets speaks

about the successful story of the firm. Consequently, it has to bear the pioneering

and subsequent risks and uncertainties. The price set by a firm has to be so

attractive that the buyers in other markets have to switch on to the products of the

candidate firm.

8. Deeper penetration of the market

The pricing policy has to be designed in such a manner that a firm can make

inroads into the market with minimum difficulties. Deeper penetration is the first

step in the direction of capturing and dominating the market in the latter stages.


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9. Achieving a target return

A predetermined target return on capital investment and sales turnover is another

long run pricing objective of a firm. The targets are set according to the position

of individual firm. Hence, prices of the products are so calculated as to earn the

target return on cost of production, sales and capital investment. Different target

returns may be fixed for different products or brands or markets but such returns

should be related to a single overall rate of return target.

10. Target profit on the entire product line irrespective of profit level of

individual products.

The price set by a firm should increase the sale of all the products rather than

yield a profit on one product only. A rational pricing policy should always keep in

view the entire product line and maximum total sales revenue from the sale of all

products. A product line may be defined as a group of products which have

similar physical features and perform generally similar functions. In a

product line, a few products are regarded as less profit earning products and

others are considered as more profit earning. Hence, a proper balance in pricing is

required.

11. Long run welfare of the firm

A firm has multiple objectives. They are laid down on the basis of past experience

and future expectations. Simultaneous achievement of all objectives are necessary

for the over all growth of a firm. Objective of the pricing policy has to be

designed in such a way as to fulfill the long run interests of the firm keeping

internal conditions and external environment in mind.

12. Ability to pay

Pricing decisions are sometimes taken on the basis of the ability to pay of the

customers, i.e., higher price can be charged to those who can afford to pay. Such a

policy is generally followed by those people who supply different types of

services to their customers.

13. Ethical Pricing

Basically, pricing policy should be based on certain ethical principles. Business

without ethics is a sin. While setting the prices, some moral standards are to be

followed. Although profit is one of the most important objectives, a firm cannot

earn it in a moral vacuum. Instead of squeezing customer, a firm has to charge

moderate prices for its products. The pricing policy has to secure reasonable

amount of profits to a firm to preserve the interests of the community and promote

its welfare.


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Besides these goals, there are various other objectives such as promotion of new

items, steady working of plants, maintenance of comfortable liquidity position,

making quick money, maintaining regular income to the company, continued

survival, rapid growth of the firm etc which firms may set while taking pricing

decisions.


Have knowledge of different pricing methods to set the right price

Pricing Methods

The traditional theory of value and pricing policies etc., provide a theoretical base to the

management to take decision on setting the right price. The actual pricing of products

depend upon various factors and considerations. Hence there are several methods of

pricing.

1. Full – Cost pricing or Cost Plus Pricing Method

Full cost pricing is one of the simplest and common methods of pricing adopted by

different firms. Hall and Hitch of the Oxford University in their empirical study of actual

business behavior found that business firms do not determine price and output by

comparing MR and MC. On the other hand, under Oligopoly and monopolistic conditions

they base their market price on full cost conditions. According to this principle,

businessmen charge price that cover their average cost in which are included normal or

conventional profits. Cost refers to full allocated costs. According to Joel Dean, it has

three components -

I. Actual cost which refers to the actual or total expenses incurred in production. For

e.g., wage bills, raw material cost, overhead charges etc.

ii. Expected cost refers to the forecast for the pricing period on the basis of expected

prices, output rate and productivity.

iii. Standard cost refers to cost incurred at the normal level of output.

In brief, a firm computes the selling price of its product by adding certain percentage to the average total cost of the product. The percentage added to costs is

called as margin or mark-ups. Hence, this method is also called as Margin – pricing and

Mark – up pricing. Cost +pricing = Cost + Fair profit


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Fair profit means a fixed percentage of profit markups. It is arbitrarily determined. The

margin of profits included in the price of a product differs from industry to industry and

commodity to commodity on account of differences in competitive strength, cost of

production, total turnover, accounting practices etc. Past traditions, directives from trade

associations, guidelines from the government may also decide the percentage of profits.

This method envisages covering the total costs incurred in producing and selling a

commodity In this case businessmen do not seek supernormal profit. Hence, a price based

on full average cost is the ‘right cost’, the one which ought to be charged based on the

idea of fairness under Oligopoly and Monopolistic competition.

Illustration

Evaluation of the full cost pricing

Generally, the firms will not have information about demand conditions, nature and

degree of competition, technology used etc., further modern business conditions are

extremely uncertain. Besides a firm may be producing or selling innumerable varieties of

goods and to calculate prices on the basis of profit maximization may be almost

impossible. The cost plus method is convenient since the firms have only to add some

standard mark-up to their cost. Over a period of time, through trial and error, they can

find out the proper mark – up. The supreme merit of this method lies in its mechanical

simplicity and its apparent fairness.

It is safer, cheaper and imparts competitive stability particularly when there is tough

competition in the market. It is useful particularly in product tailoring and public utility

pricing. It is justified on moral grounds because price based on costs is a just price.

According to Professor Joel Dean, it is the best method of pricing in case of new products

because if the firm is able to realize its normal profits, then only it can take a decision to

produce and market a product otherwise not.

This method attaches too much of significance to allotted costs and mark-ups


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It tends to diminish the interest of the producer in cost control

However, many firms adopt this method of pricing due to its inherent benefits.

2. Rate of Return Pricing

Rate of return pricing is a modified form of full cost pricing. Under this method, a

producer decides a predetermined target rate of return on capital invested. Full –

cost pricing considers the mark-ups or profit arbitrarily. Instead of setting the percentage

arbitrarily a firm will determine the average mark- up on costs necessary to produce a

desired rate of return on the company’s investments. Thus, under this method, price is

determined along a planned rate of return on investment. In this case, a company

estimates future sales, future costs and arrive at a mark – up that will achieve a target

return on a company’s investment.

Professor Davies and Hughes in their book, “Managerial Economics” have used the

following formula to calculate the desired rate of return when a mark up is applied on

cost.

Let us suppose that the capital employed by a firm is Rs.16 lacks and the total cost is

Rs.12 lacks with a planned rate of return of 30 percent. By making use of the above

formula, we can find out the percentage mark-up of the firm in the following way.

Illustration:


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The mark-up is thus carefully planned and calculated, as different from the arbitrary

percentage used in the cost plus pricing.

The management will regard this price as the base price applicable over a period of time.

However, when cost of production changes as a result of changes in the prices of raw

materials or due to changes in the levels of wages, the management can change the price

suitably. Besides, the base price can be modified suitably according to changes in

demand and competitive conditions in the market.

Evaluation of rate of return pricing

As it is a refined version of cost-plus pricing it is superior to cost plus pricing in two

ways:

i. The analysis is based on standard cost which is computed on the basis of normal

output; and

ii .The profit mark-up is based on a planned rate of return on investment and not on

any arbitrary figure.

As it is a refined form of cost plus pricing method all the merits and demerits of cost plus

pricing method apply to rate of return pricing too.

3. Going Rate Pricing.


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Going rate pricing is the opposite of full cost pricing. In this method, emphasis is given

on market conditions rather than on costs. Generally, we come across this method of

pricing under oligopoly market especially under price leadership. Under this method, a

firm, fix its price according to the price fixed by the leader. A firm has monopoly

power over the product it produces and can charge its own price and face all the

consequences of monopoly. However, a firm chooses the price which is going in the

market and charge a particular price that the other followers are charging.

This type of pricing is not the same as accepting a price set in a perfectly competitive

market. A firm has some power to fix the price but instead of doing so, it adjusts its own

price to the general price structure in the industry. Hence this method of pricing is known

as acceptance pricing. Normally under this method, the industry tries to determine the

lowest prices that the sellers or followers can afford to accept considering various

alternatives.

The price follower, however compare the price of the leader and his cost, revenue

conditions and long run profitability. As small firms recognize the big firm as their

leader, they try to imitate their leader in pricing decisions. Since a price leader is a firm

with a successful profit history, significant market share and long experience in market

matters, the imitating firms follow the leader in the hope of earning larger profits under

the shelter of the leader’s price umbrella.

Imitation is the easy way of decision making. The follower uses another firm’s market

analysis without worrying himself about demand and cost estimate. Many executives

desire to devote minimum time for pricing decision and hence they follow this method.

This policy is not confined to only small business firms. Even large firms follow a price

set by a price leader or by the market. Some firms adjust their costs to a predetermined

price by keeping their costs within the percentage limits of their selling prices in order to

achieve the targeted profit. This policy suits to those products which have reached a

mature stage and where both customers and rivals have come to accept a stable price. The

going rate pricing is generally adopted –i. when costs are difficult to measure; ii. And the

firm wants to avoid tension of price rivalry in the market; or iii. When there is price

leadership of a dominant firm in the market.

This method of pricing is easy to adopt, economical and rational. It helps in avoiding cut-

throat competition among firms.

Imitation Pricing It is a variant of going rate pricing. The firms which join the industry

late just imitate the price fixed by the leader. This is the same as going rate pricing.

4. Administered prices


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The term administered prices was introduced by Keynes for the prices charged by a

monopolist and therefore determined by considerations other than marginal cost. A

monopolist being a price maker consciously administers the price of his product.

Indian economists like L.K. Jha and Malcolm Adiseshaiah have, however, a slightly

different conception about administered prices. According to the Indian economists, an

administered price for a commodity is the one which is decided and arbitrarily fixed by the government. It is not allowed to be determined by the free play of market forces

of demand and supply. In short, administered prices are the prices which are fixed

and enforced by the government in the overall interest of the economy.

Administered prices are fixed by the government for a few carefully selected goods like

steel, coal, aluminum, fertilizers, petroleum, cooking gas etc., these products are the raw

materials for other industries and as such there is great need for establishing and

stabilizing the total output and their prices. The public distribution system is also subject

to administered prices.

Administered prices are normally set on the basis of cost plus a stipulated margin of

profit. They represent a pool price where the individual producing units are being granted

retention prices. These retention prices may either be uniform or different for different

units. As cost of production changes, administered prices also would be modified. This is

the right method of pricing and based on logical considerations

Characteristics:

• They are fixed by the government.

• They are statutory in form.

• They are regulatory in nature.

• They are meant as corrective measures.

• They are the outcome of the pricing policy of the government.

Objectives:

• To protect the interests of weaker sections against high prices.

• To curb or encourage the consumption of certain commodities.

• To contain inflation and ensure price stability.

• To counter stagflation and the consequent recession.

• To mobilize revenue for the government

• To ensure efficient allocation of resources among different users.

• To improve living standards of the masses and promote their economic welfare.

• To ensure equitable distribution of certain goods which are scarce in supply.

• To achieve macro economic goals like welfare, equity and stability.

Need for Administered Prices:


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• To correct imperfections in price mechanism in a free enterprise economy.

• To prevent price escalation of essential commodities when their supply falls short of

demand.

• To protect the interests of consumers against profit greedy monopolists.

• To provide certain necessaries of life at least in minimum quantities at fair prices to

poorer sections of the society

Generally speaking there exists a gap between administered prices and rise in cost of production.

Due to the dynamic nature of the economy, cost of production rises quickly. On the contrary on

account of slow and sluggish actions of the government, the administered prices do not rise in

commensurate with rise in cost of production. Many a times change in price may be introduced

much later than cost escalation. Consequently, the contention of the manufacturers under this

method of pricing is the increases granted to them are very often inadequate to cover the rise in

costs. Again, an important problem centers around fixed costs which are not adequately

compensated, since such price increases are considered only once in three to four years, when the

basic price is reviewed.

As the administered prices are often inadequate to meet cost escalation, certain basic industries

like fertilizers, cement, steel, etc., have not been able to generate sufficient financial resources

for modernization and expansion of their plants. In this connection, it is necessary to note that

there should be adequate incentives for new investments in industries which are subject to

administered prices to avoid and or accentuate shortage. As industry cannot be expected to

continue production unless costs are reasonably covered, there is need to evolve certain criteria

for revising administered prices.

It is quite clear from the above discussion, that administered prices have certain defects. In order

to make administered prices more realistic, they should reflect, the cost realities from time to

time and quickly respond to these changes in the most pragmatic manner. The government

administration should be active and prompt at the decision making level. This will bring a

reputation to administered prices and they may be accepted without much criticism.

5. Marginal Cost Pricing

It is based on a pure economic concept of equilibrium of a firm, where marginal cost is equal to

marginal revenue. Under this method price is determined on the basis of marginal cost

which refers to the cost of producing additional units. Price based on marginal cost will be

much more aggressive than the one based on total cost. A firm with large unused capacity will

have to explore the possibility of producing and selling more. If the price is sufficient to cover

the marginal cost, particularly in times of recession the firm should be able to produce and sell

the commodity and can think of recovering the total cost in the long run.

This method though sounds excellent theoretically has the serious limitation of ascertaining the

marginal cost.


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6. Customary Pricing

Prices of certain goods are more or less fixed in the minds of consumers; these are known as

“Charm prices”. e.g., prices of soft drinks and other beverages. In this case a moderate change in

cost of production will not have any influence on price.

Though this method has the advantage of stability, it is not cost reflective.

7. Pricing of a New Product

Basically the pricing policy of a new product is the same as that for an established product. The

price must cover the full costs in the long run and direct costs or prime costs in the short run. In

case of new products the degree of uncertainty would be more as the firm is generally ignorant

about the cost and the market conditions. There are two alternative price strategies which a firm

introducing a new product can adopt, viz., skimming price policy and penetration pricing policy.

a. Skimming Price Policy

The system of charging high prices for new products is known as price skimming for the object is to “skim the cream” from the market. A firm would charge a high price initially

when it gets a feeling that initially the product will have relatively inelastic demand, when the

product life is expected to be short and when there is heavy investment of capital e.g., electronic

calculators,

b. Penetration price policy

Instead of setting a high price, the firm may set a low price for a new product by adding a low mark-up to the full cost. This is done to penetrate the market as quickly as possible. This

method is generally adopted when there are already well known brands of the product in the

market, to maximize sales even in the short period and to prevent entry of rival products.

Summary

Knowledge of cost and revenue concepts is of very great importance in

understanding the various methods of price-output determination and pricing policies under both

perfect and imperfect markets. Total revenue refers to the total receipts from the sale of the

goods, Average revenue refers to the revenue per unit of the commodity sold and marginal

revenue is the additional revenue earned by selling an additional unit of output. The relationship

between revenue and price elasticity of demand has practical significance in real business life.

These two concepts help the management in taking a right decision with regard to the size of the

out put and the determination of price.


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Different pricing policies and methods give an insight into the actual functioning of a firm.

Dynamic conditions of the market necessitate frequent changes in the pricing policies and

methods followed by a firm. While formulating its pricing policy a firm has to keep in its view

some of the external factors like elasticity of demand, size of the market, government policy,

etc., and internal factors like production costs, the stages of the product on the product life cycle

etc., There are a few considerations to be kept in mind like the objectives of a firm, competitive

situation in the market, cost of production, elasticity of demand, economic environment,

government policy etc. The main objectives of the pricing policy are profit maximization, price

stabilization, facing competitive situation, capturing the market etc. Market price of a product

depends upon a number of factors like production cost, demand, consumer psychology, profit

policy of the management, government policy etc.

There are different methods of pricing for both established products as well as new products. Full

cost pricing or cost plus pricing, is one of the simplest and common method of pricing adopted

by different firms. Here the price is determined by adding a certain mark-up to the average total

cost. Rate of return pricing is a modified form of full cost pricing where the mark-up is decided

on the basis of capital employed. Going rate pricing is the opposite of full cost pricing generally

followed under oligopoly market. Here the firm just follows the price prevailing in the market

without bothering about other things. Imitative pricing is similar to going rate pricing. Marginal

cost pricing, where price is determined on the basis of marginal cost is more theoretical than

being practical. Administered prices are the prices statutorily determined by the government for

certain important goods like steel, cement etc. There are two schemes of pricing for a new

product viz., skimming price and penetration price. Based on the market conditions and the cost

conditions these two methods are adopted.

Unit 8 Market Analysis

Introduction

Efficiency of management lies in its capacity to analyze the market. Study of demand and

supply, its determinants, elasticity of demand and supply, market equilibrium, basic concepts of

production function, revenue analysis, pricing policies and pricing methods help in analyzing the

market in a more pragmatic manner. Knowledge of market structure and different kinds of

markets is of utmost importance to a business manager in taking right decision and planning

business activities efficiently.


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Understand the structure of market and analyze perfect competition

Meaning Of Market And Market Structure

Market in economics does not refer to a place or places but to a commodity and also to buyers and sellers of that commodity who are in competition with one another e.g., the

cotton market may not be confined to a particular place, but may cover the entire country and, in

fact, even the entire world. Buyers and sellers of cotton may be spread all over the world.

Market situation varies in their structure. Market structure refers to economically significant

features of a market, which affect the behavior, and working of firms in the industry. It tells us

how a market is built up and what its basic features are. According to Pappas and Hirschey,

“Market structure refers to the number and size distribution of buyers and sellers in the market

for a good or service“. It indicates a set of market characteristics that determine the nature

of market in which a firm operates. Different market structures affect the behavior of sellers

and buyers in different manners. The chief characteristics are as follows –

1. The number and size distribution of sellers

A market may consist of a large, very large or a few sellers. There may be a few big firms with

huge investments or a large number of small firms with limited investments. Thus, the operating

size of the firm may be large or small in a market. The number and size of sellers influence the

working of a market

2. The number and size distribution of buyers

In a market, there may be large number of buyers. Similarly, a market may consist of many small

buyers or only a few buyers. The total number of buyers exercises their influence on the nature

of transactions in the market

3. Product differentiation

Products sold in the market may be homogeneous, or have substitutes, close substitutes or remote

substitutes. A firm may deliberately differentiate its product with that of the products of other

firms by adopting several techniques.

4. Condition of entry and exit

In case of a few market situations, new firms may enter the industry or old firms may leave the

industry at their own free will and wish. In case of other markets, there will be deliberate entry

barriers.

Thus, the characteristics of market structure give us information about the nature of working of

different markets.


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Thus in common parlance, market refers to a place where sellers and buyers meet for the purpose

of exchanges of goods, but in the language of economics it has a wider meaning. It refers to a

wide range of area where the buyers and sellers come into close contact with one another

for the settlement of their transactions.

According to Prof.Cournot, the term market is “not any particular market place in which things

are brought or sold, but the whole of any region in which buyers and sellers are in such free

intercourse with one another that the price of the same goods tend to equality easily and

quickly”. In the words of Prof. Benham, Market is “any area over which buyers and sellers are in

such close touch with one another, either directly or through dealers that the prices obtainable in

one part of the market affects the prices paid in other parts”. For the existence of a market, there

is no need for face-to-face contact between the buyers and sellers to conclude their transactions.

In recent years, means of transport and communication have developed so fast that buyers and

sellers can easily come into close contact with each other for the settlement of their transactions

without establishing face-to-face relationship.

The term market hence implies:

i. Existence of a commodity to be traded.

ii. Existence of sellers and buyers.

iii. Establishment of contact between the sellers and

buyers.

iv. Willingness and ability to buy and sell a commodity and

v. Existence of a price at which the given commodity is to be bought and sold.

Among the different market situations, perfect competition and monopoly form the two

extremes. In between these two market situations we come across a number of market situations

which may be collectively termed as imperfect markets. In these imperfect markets, we notice

the elements of competition as well as monopoly. They are bi-lateral monopoly, monopsony (one

buyer), duopoly (two sellers) duopsony (two buyers), oligopoly (few sellers), oligopsony (few

buyers) and monopolistic competition (many sellers). This can be better understood by the

following chart.


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Kinds Of Markets

The market situations vary in their structure. Different market structures affect the behavior of

buyers and sellers and firms. Further, prices and trade volumes are influenced by different types

of markets and price – output determination under different market conditions.

Perfect Competition

Perfect competition is a comprehensive term which includes pure competition also. Before we

discuss the details of perfect competition, it is necessary to have a clear idea regarding the nature

and characteristics of pure competition.

Pure Competition is a part of perfect competition. Competition in the market is said to be pure

when the following conditions are satisfied:

1. Prevalence of a large number of buyers and sellers.

2. The commodity supplied by each firm is homogeneous.

3. Free entry and exit of firms.

4. Absence of any kind of monopoly element.


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Under these conditions no individual producer is in a position to influence the market price of the

product. According to Prof. E.H. Chamberline - “Under Pure Competition, the individual

sellers market being completely merged with the general one, he can sell as much as he please at the going price”. Further, he remarks “Pure competition means unalloyed by

monopoly elements. It is a much simpler and less exclusive concept than perfect competition”.

Prof. Joel Dean, after going through the features of pure competition observes that “Pure

competition does exist in reality but it is a rare phenomenon”. Hence, it is pointed out that it is

possible to come across pure competition in our life. For e.g., in the markets for rice, wheat,

cotton, jowar, and other such food grains, fruits, vegetables, eggs etc, where there are a large

number of sellers and buyers and we find that practically goods are identical. If we look at the

present market, we notice that even in these cases, there is possibility of forming cartels by

sellers to influence the market price. Now, we shall turn our attention to perfect competition.

Meaning and Definition of Perfect Competition

A perfectly competitive market is one in which the number of buyers and sellers are very

large, all engaged in buying and selling a homogeneous product without any artificial restriction and possessing perfect knowledge of market at a time. According to Bilas, “the

perfect competition is characterized by the presence of many firms: They all sell identically the

same product. The seller is the price – taker”. According to Prof. F. Knight perfect competition

entails “Rational conduct on the part of buyers and sellers, full knowledge, absence of friction,

perfect mobility and perfect divisibility of factors of production and completely static

conditions”.

Features of the Perfect Competition

1. Existence of very large number of buyers and sellers

A perfectly competitive market will have large number of sellers and buyer. Output of a seller

(firm) will be so small that it is a negligible fraction of the output of the industry. Hence, changes

in supply made by a particular firm will not affect the total output and price. Similarly, no one

particular buyer can influence the price of the commodity because the quantity purchased by him

is a very small fraction of total quantity.

2. Homogenous products

Different firms constituting the industry produce homogenous goods. They are identical in

character. Hence, no firm can raise its price above the general level.


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3. Free entry and exit of firms

There is absolute freedom to firms to get in or get out of the industry. If the industry is making

profits, new firms are attracted into the industry. Conversely, firms will quit the industry if there

are losses. This results in the realization of normal profits by all the firms in the long run.

4. Existence of single price

Each unit bought and sold, in the market commands the same price since products are

homogeneous.

5. Perfect knowledge of the market

All sellers and buyers will have perfect knowledge of the market. Sellers cannot influence buyers

and buyers cannot influence sellers.

6. Perfect mobility of factors of Production

Factors of production are free to move into any use or occupation in order to earn higher

rewards. Similarly, they are also free to come out of the occupation or industry if they feel that

they are under remunerated.

7. Full and unrestricted competition

Perfectly competitive market is free from all sorts of monopoly, oligopoly conditions. Since

there are very large number of buyers and sellers, it is difficult for them to join together and form

cartels or some other forms of organizations. Hence, each firm acts independently.

8. Absence of transport cost

All firms will have equal access to the market. Market price charged by the sellers should not

vary because of differences in the cost of transportation.

9. Absence of artificial Government controls

The Government should not interfere in matters pertaining to supply and price. It should not

place any barriers in the way of smooth exchange. Price of a commodity must be determined

only by the interaction of supply and demand forces.

10. The market price is flexible over a period of time

Market price changes only because of changes in either demand or supply force or both. Thus,

price is not affected by the sellers, buyers, firm, industry or the Government.

11. Normal Profit


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As the market price is equal to cost of production, the firm can earn only normal profits under

perfect competition. Normal profits are those which are just sufficient to induce the firms to stay

in business. It is the minimum reasonable level of profit which the entrepreneur must get in the

long run. It is a part of total cost of production because it is the price paid for the services of the

entrepreneur, i.e., profit is an item of expenditure to a firm.

Special Features of Perfect Competition

i. It is an extreme form of market situation rarely to be found in the real world.

ii. It is a mere concept, a myth, an illusion and purely theoretical in nature.

iii. It is a hypothetical model.

iv. It is an ideal market situation.

Reasons for the Study of Perfect Competition

1. It is used as a yardstick against which all other models can be compared and evaluated.

2. It is quite accurate and useful in explaining and predicting the behaviour of market and

the firm under certain circumstances.

3. It is a good simplified model for beginners to start with. Its study is useful to prepare a

ground for future study of imperfect markets.

4. It is a useful model to compare the actual with the ideal, what is and what ought to be.

5. It helps us to understand optimum allocation of resources in an ideal market.

Price – Output Determination under Perfect Competition (General Model)

It is very interesting to study the price – output model under perfect competition. Under a

perfectly competitive market, in case of the industry, market price of the product is determined

by the interaction of supply and demand. The market price is not fixed by either the buyer or the

seller, firm, industry or the government. It is only the market forces, i.e., demand and supply

determines the equilibrium price of the product. We come across this peculiar feature under

perfect competition alone.


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Alfred Marshall compared supply and demand to the two blades of a scissors. Just as both the

blades work together to cut a piece of cloth, both supply and demand interact with each other to

determine the market price at which exchange takes place. In the process of price determination,

supply is not more important than demand or demand is not more important than supply. Both

forces play an equally important role.

We can explain how price is determined in the market by the interaction of demand and supply

with the help of the following schedule.

Price in Rs. Demand in Units Supply in Units State of Market Pressure on price

10 1000 9000 Surplus S > D Downward

8 3000 7000 Surplus S > D Downward

6 5000 5000 Equilibrium S =D Neutral

4 7000 3000 Shortage D > S Upward

2 9000 1000 Shortage D > S Upward

From the table above, it is clear that equilibrium price is determined at Rs.6.00 where quantity

demanded is exactly equal to quantity supplied i.e., 5000 units.

In case of industry, interaction of supply and demand will determine the equilibrium market

price. In the diagram, P indicates OR as equilibrium price and OQ as equilibrium output. The

price at which demand and supply are equal is known as equilibrium price. The quantity

bought and sold at the equilibrium price is known as equilibrium output.


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In the figure equilibrium price is determined at the point P where both demand and supply are

equal. The upper limit to the price of a product/service is determined by the demand. This price

should not exceed ‘what the market can bear’. In short, the price of the product / service should

not exceed the value of its benefit to the buyers (price should not be more than the utility of

product / service).

The lower limit to the price is determined by production cost. In the long run, the price should

not fall below production costs of making and distributing the product / service.With reference to

the industry, the point P can be regarded as the position of stable equilibrium. Even if there are

changes in price, there will be automatic adjustments in supply and demand, restoring the

original equilibrium position. When the price rises from OR to OR1 supply exceeds demand,

there will be excess supply over demand excess supply of goods push down the price from OR1

to OR, the original price.

Similarly, when price falls from OR to OR2, demand exceeds supply, excess demand over

supply in its turn push up the prices from OR2 to OR – the original price. Thus, equality between

demand and supply determine the market price.

Under perfect competition, a firm will not have any independence to fix the price of its own

product. The industry is the price – maker or giver and a firm is a price – taker or price

acceptor and quantity adjuster. As a part of the industry, it has to simply charge the price which

is determined by the industry. If it charges a higher price it will loose its sales and if it charges

lesser price, it will incur losses.

In case of the firm, the price line which is equal to AR and MR, will be horizontal and parallel to

OX – axis. This is because same price has to be charged by the firm for all the units supplied,

irrespective of changes in demand. Hence,

Difference between Firm and Industry

Basically there is difference between a firm and an industry. A firm is a single manufacturing unit

producing and selling either a commodity or service. It is a part of the industry. It is called as a business

enterprise. Business is an economic activity and a business unit is an economic unit. It is an individual

producing unit. It converts inputs into outputs. These production units are organized and run by the

people either as individuals or as members of households or as a group of people. It is basically an

income-generating unit. It buys inputs like raw materials, labor, capital, power, fuel etc and produce

goods and services for sale to consumers. It organizes and combines all kinds of resources and plan for

the use of these resources in the best possible manner.

Profit making is the basic objective of a firm. The traditional and conventional objective of a firm was

profit maximization and now profit optimization has become the main objective.


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A business firm is a legal entity on the basis of ownership and contractual relationship organized for

production and sale of goods and services.

Many firms producing similar or homogeneous goods or services collectively make an industry. The

term industry refers to a set or group of firms engaged in the production of a particular product or a

service. For example, Tata textile mills, Binny mills, Digjam, Bhilwara, Vimal, Raymond’s etc are firms

producing textile cloth. All of them put together constitute the textile industry in India. Thus, an industry

is engaged in the production of homogeneous goods that are substitutes for each other, use common

raw materials, have similar processes, etc. All firms engaged in providing the same kind of services or

doing a common trade or business constitutes an industry. For example, banks, hotels etc. An industry

is a particular line of productive activity in which many firms are engaged each adopting its own

production and pricing policies to its best advantage.

Equilibrium of the Industry and Firm under Perfect Competition

1. Equilibrium of the Industry in the short run

The term ‘Equilibrium’ in physical science implies a state of balance or rest. In economics, it

refers to a position or situation from which there is no incentive to change. At the equilibrium

point, an economic unit is maximizing its benefits or advantages. Hence, always there will be

a tendency on the part of each economic unit to move towards the equilibrium condition.

Reaching the position of equilibrium is a basic objective of all firms.

In the short period, time available is too short and hence all types of adjustments in the

production process are impossible. As plant capacity is fixed, output can be increased only by

intensive utilization of existing plants and machineries or by having more shifts. Fixed factors

remain the same and only variable factors can be changed to expand output. Total number of

firms remains the same in the short period. Hence, total supply of the product can be adjusted to

demand only to a limited extent.

In the short run, price is determined in the industry through the interaction of the forces of

demand and supply. This price is given to the firm. Hence, the firm is a price taker and not price

maker. On the basis of this price, a firm adjusts its output depending on the cost conditions.

An industry under perfect competition in the short run, reaches the position of equilibrium when

the following conditions are fulfilled:

1. There is no scope for either expansion or contraction of the output in the entire industry.

This is possible when all firms in the industry are producing an equilibrium level of output at

which MR = MC. In brief, the total output remains constant in the short run at the

equilibrium point. Thus a firm in the short run has only temporary equilibrium.


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2. There is no scope for the new firms to enter the industry or existing firms to leave the

industry.

3. Short run demand should be equal to short run supply. The price so determined is called

as ’subnormal price’. Normal price is determined only in the long run. Hence, short run

price is not a stable price.

Equilibrium of the competitive firm in the short run

A competitive firm will reach equilibrium position at the point where short run MR equals MC.

At this point equilibrium output and price is determined.

The firm in the short run will have only temporary equilibrium. The short run equilibrium price

is not a stable price. It is also called as sub – normal price.

The competitive firm, in the short run, will not be in a position to cover its fixed costs. But it

must recover short run variable costs for its survival and to continue in the industry. A firm will

not produce any output unless the price is at least equal to the minimum AVC. If short run price

is just equal to AVC, it will not cover fixed costs and hence, there will be losses. But it will

continue in the industry with the hope that it will

recover the fixed costs in the future.


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If price is above the AVC and below the AC, it is called as “Loss minimization” zone. If the

price is lower than AVC, the firm is compelled to stop production altogether.

While analyzing short term equilibrium output and price, apart from making reference to SMC

and AVC, we have to look into AC also. If AC = price, there will be normal profits. If AC is

greater than price, there will be losses and if AC is lower than price, then there will be super

normal profits.

In the short run, a competitive firm can be in equilibrium at various points E1, E2 and E3

depending upon cost conditions and market price. At these various unstable equilibrium points,

though MR = MC, the firm will be earning either super normal profits or incurring losses or

earning normal profits.

In the case of the firm:

1. At OP4 price the firm will neither cover AFC nor AVC and hence it has to wind up its

operations. It is regarded as shut-down point.

2. At OP1 price, OQ1 is the equilibrium output. E1 indicates the price or AR = AVC only.

It does not cover fixed costs. The firm is ready to suffer this loss and continue in business

with the hope that price may go up in the future.


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3. At OP2 price, OQ2 is the equilibrium output. E2 indicates the price = AR = AC. At this

point MR is also equal to MC. At this level of output total average revenue = total average

cost hence, the firm is earning only normal profits. It is also known as Break – even point

of the firm, a zone of no loss or no profit. The distance between two equilibrium points E2

and E1 indicates loss- minimization zone.

4. At OP3 price, OQ3 is the output produced by the firm. At E3, MR = MC. But AR is

greater than AC. For OQ3 output, the total cost is OQ3AB. The total revenue is OQ3E3P3.

Hence, P3E3AB is the total super normal profits.

Thus in the short run, a firm can either incur losses or earn super normal profits. The main reason

for this is that the producer does not have adequate time to make all kinds of adjustments to

avoid losses in the short run.

In case of the industry, E indicates the position of equilibrium where short run demand is equal

to short run supply. OR indicates short run price and OQ indicates short run demand and supply.

Equilibrium of the Industry in the long run

In the long run, there is adequate time to make all kinds of changes, adjustments and

readjustments in the productive process. All factor inputs become variable in the long run. Total

number of firms can be varied and plant capacity also can be changed depending upon the nature

of requirements. Economies of scale, technological improvements, better management and

organization may reduce production costs substantially in the long run. Hence, production can be

either increased or decreased according to the needs of the individual firms and the industry as a

whole. In short, supply of the product can be fully adjusted to its demand in the long period.

An industry, in the long run will be reaching the position of equilibrium under the following

conditions:

1. At the point of equilibrium, the long run demand and supply of the products of the

industry must be equal to each other. This will determine long run normal price.

2. There will be no scope for the industry to either expand or contract output. Hence, the

total production remains stable in the long run.

3. All the firms in the industry should be in the position of equilibrium. All firms in the

industry must be producing an equilibrium level of output at which long run MC is equated

to long run MR. (MC = MR).

4. There should be no scope for entry of new firms into the industry or exit of old firms out

of the industry. In brief, the total number of firms in the industry should remain constant.


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5. All firms should be earning only normal profits. This happens when all firms equate AR

(Price) with AC. This will help the industry in attaining a stable equilibrium in the long run.

Equilibrium of the firm in the long run

A competitive firm reaches the equilibrium position when it maximizes its profits. This is

possible when:

1. The firm would produce that level of output at which MR = MC and MC curve cuts MR

curve from below. The firm adjusts its output and the scale of its plant so as to equate MC

with market price.

2. The firm in the long run must cover its full costs and should earn only normal profits.

This is possible when long run normal price is equal to long run average cost of production.

Hence,

3. When AR is greater than AC, there will be place for super normal profits. This leads to

entry of new firms – increase in total number of firms – expansion in output – increase in

supply – fall in price – fall in the ratio of profits. This process will continue till supernormal

profits are reduced to zero. On the other hand, when AC is greater than AR the industry will

be incurring losses. This leads to exit of old firms, number of firms decrease, contraction in

output, rise in price, and rise in the ratio of profits. Thus, losses are avoided by automatic

adjustments. Such adjustments will continue till the firm reaches the position of equilibrium

when AC becomes equal to AR. Thus losses and profits are incompatible with the position of

equilibrium. Hence,

4. The firm is operating at its minimum AC making optimum use of available

resources.


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In the case of the industry, E is the position of equilibrium at which LRS = LRD, indicating OR

as the equilibrium price and OQ as the equilibrium quantity demanded and supplied.

In case of the firm P indicates the position of equilibrium. At P, LMR = LMC and LMC curve

cuts LMR curve from below. At the same point P the minimum point of LAC is tangent to LAR

curve. Hence,.

A competitive firm in the long run must operate at the minimum point of the LAC curve. It

cannot afford to operate at any other point on the LAC curve. Other wise, it cannot produce the

optimum output or it will incur losses.

Time will play an important role in determining the price of a product in the market. As the time

under consideration is short, demand will have a more decisive role than supply in the

determination of price. Longer the time under consideration, supply becomes more important

than demand in the determination of price.

The price determined in the long run is called as normal price and it remains stable.


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Market price:

It refers to that price which is determined by the forces of demand and supply in the very short

period where demand plays a major role than supply. Supply plays a passive role. Market price is

unstable.

Normal price:

It is determined by demand and supply forces in the long period. It includes normal profits also.

It is stable in nature.


Analyze monopoly market and price discrimination

Monopoly

Meaning and definition:

The word monopoly is made up of two syllables – ‘MONO’ means single and “POLY” means to

sell. Thus, monopoly means existence of a single seller in the market. Monopoly is that market

form in which a single producer controls the whole supply of a single commodity which has no close substitutes. Monopoly may be defined as a condition of production in which a person

or a number of persons acting in combination have the power to fix the price of the commodity

or the output of the commodity. It is a situation where there exists a single control over the

market producing a commodity having no substitutes and no possibilities for any one to enter the

industry to compete.

According to Prof. Watson – “A monopolist is the only producer of a product that has no close

substitutes”.

Features of monopoly

1. Anti-Thesis of competition

Absence of competition in the market creates a situation of monopoly and hence the seller

faces no threat of competition.


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2. Existence of a single seller

There will be only one seller in the market who exercises single control over the market.

3. Absence of substitutes

There are no close substitutes for his product with a strong cross elasticity of demand.

Hence, buyers have no alternatives.

4. Control over supply

He will have complete control over output and supply of the commodity.

5. Price Maker

The monopolist is the price – maker and in taking decisions on price fixation, he is

independent. He can set the price to the best of his advantage. Hence, he can either charge a

high price for all customers or adopt price discrimination policy.

6. Entry barriers

Entry of other firms is barred somehow. Hence, monopolist will not have direct

competitors or direct rivals in the market.

7. Firm and industry is same

There will be no difference between firm and an industry.

8. Nature of firm

The monopoly firm may be a proprietary concern, partnership concern, Joint Stock

Company or a public utility which pursues an independent price-output policy.

9. Existence of super normal profits

There will be place for supernormal profits under monopoly, because market price is greater than

cost of production.

There are different kinds of monopolies – Private and public, pure monopoly, simple monopoly

and discriminatory monopoly. It is to be clearly understood that with the exception of public

utilities or institutions of a similar nature, whose price is set by regulatory bodies, monopolies

rarely exist. Just like perfect competition, pure monopoly does not exist. Hence, we make a

detailed study of simple monopoly and discriminatory monopoly in the foregoing analysis.


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Price – Output Determination Under Monopoly

Assumptions

a. The monopoly firm aims at maximizing its total profit.

b. It is completely free from Govt. controls.

c. It charges a single & uniform high price to all customers.

It is necessary to note that the price output analysis and equilibrium of the firm and industry is

one and the same under monopoly.

As output and supply are under the effective control of the monopolist, the market forces of

demand and supply do not work freely in the determination of equilibrium price and output in

case of the monopoly market. While fixing the price and output, the monopoly firm generally

considers the following important aspects.

1. The monopolist can either fix the price of his product or its supply. He cannot fix the

price and control the supply simultaneously. He may fix the price of his product and allow

supply to be determined by the demand conditions or he may fix the output and leave the

price to be determined by the demand conditions.

2. It would be more beneficial to the monopolist to fix the price of the product rather than

fixing the supply because it would be difficult to estimate the accurate demand and elasticity

of demand for the products.

3. While determining the price, the monopolist has to consider the conditions of demand,

cost of the product, possibility of the emergence of substitutes, potential competition, import

possibilities, government control policies etc.

4. If the demand for his product is inelastic, he can charge a relatively higher price and if

the demand is elastic, he has to charge a relatively lower price.

5. He can sell larger quantities at lower price or smaller quantities at a higher price.

6. He should charge the most reasonable price which is neither too high nor too low.

7. The most ideal price is that under which the total profit of the monopolist is the highest.

Price-Output Determination in the Short Period.

Short period is a time period in which there are two types of factors of production. One is the

fixed factors and the other is the variable factors. In the short period, production can be changed


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only by changing the variable factors of production. Fixed factors of production cannot be

changed. In other words, in the short period, supply can be changed only to some extent. In this

period volume of production can be changed but capacity of the plant cannot be changed. He can

increase the supply only with the help of existing machines and plants. New factories and plant-

equipment cannot be installed.

The aim of a monopolist is to earn maximum profits or suffer minimum losses if the

circumstances compel. Monopolist, being single seller of his product, can fix his price equal to,

above or less than the short period average cost of the product. Thus, he can earn normal profits,

supernormal profits or incur losses even in the short period. This depends upon the nature and

extent of the demand for his product. In order to earn maximum profits or suffer minimum

losses, a monopolist compares his marginal revenue (MR) with marginal cost (MC). If marginal

revenue exceeds marginal cost of a product, the monopolist can increase his profit by increasing

his production. On the contrary, if MC exceeds MR at a particular level of output, the monopolist

can minimize his losses by reducing his production. So the monopolist is said to be in

equilibrium where marginal revenue is equal to marginal cost.

In the short period, a monopoly firm can earn supernormal profits, normal profits or incur losses.

In case of losses, price must be covering at least the average variable costs. Otherwise the firm

will stop production. The maximum loss can be equal to fixed costs. The three cases of

monopoly equilibrium can be shown through the figures drawn below.


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In figure (a) AR > AC. Hence, super normal profits.

In figure (b) AR = AC. Hence, normal profits.

In figure (c) AR < AC. Hence, losses.

The figures explain how a monopoly firm can earn supernormal profits, normal profits or incur

losses in the short period.

Price-output determination in the long run.

In the long run, there is adequate time to make all kinds of adjustments in both fixed as well as

variable factor inputs. Supply can be adjusted to demand conditions. The total amount of long

run profits will depend on the cost conditions under which the monopolist has to operate and the

demand curve he has to face in the long run.


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Under monopoly, the AR or demand curve slope downwards from left to right. This is because

the monopolist can increase his sales and maximize his profits only when he reduces the price.

MR is less than AR and hence, the MR curve lies below the AR curve. This is in accordance

with the usual relationship between AR & MR.

The cost curve of the monopoly firm is influenced by the laws of returns. The price he has to

charge for his product mainly depends on the nature of his cost curves.

The monopoly firm, in the long run, will continue its operations till it reaches the equilibrium

point where long run MR equals long run MC. The price charged at this level of output is known

as equilibrium price.

In the diagram, the monopoly firm reaches the position of equilibrium at E. At this point, MR =

MC and MC curve cuts MR curve from below. The monopolist will stop his output before AC

reaches its minimum point. He does not bother to reach the minimum point on AC.

He restricts his output in order to maximize his profit, OQ is the output. The price charged by the

firm is QR (PQ) which is equal to AR. This price is higher than average cost QM per unit. The

excess profit per unit of output is PM and the total profits of the firm is PM X RN = NRPM .

Under monopoly, no doubt MR = MC but M R is less than AR. Hence, monopoly price = AR

only. Price is greater than AC, MC and MR.


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Generally speaking, monopoly price is slightly higher than that of competitive price because

market price is over and above MC, MR and AC. The single seller has complete control over the

supply as he can successfully prevent the entry of other new firms into the market. Thus, the

monopoly power is reflected on its price. Monopoly price is generally higher than competitive

price and thus detrimental to the interests of the society.

Monopoly price need not be high always on account of the following reasons:

1. Due to the operation of both internal as well as external economies of scale, he may

reduce the cost of production and hence, price too.

2. The monopolist need not spend more money on sales promotion programmes. He can

save quite a lot of money and charge a lower price for his product.

3. He has the fear that consumers may boycott his product if he charges a very high price.

4. There is the fear of discovery of new substitutes by other competitors in the market.

Hence, he charges low prices.

5. He is afraid of the Govt. intervention in controlling monopoly power and hence, he may

charge a lower price.

6. He may spend lot of money on R&D and reduce cost of operation. Cost reduction may

facilitate price reduction.

Thus, in order to maintain the good will of the consumers and to secure good business, instead of

charging high price, he may charge a relatively lower price.

Price Discrimination

Generally, speaking the monopolist will not charge uniform price for all the customers in the

market. He will follow different methods under different circumstances. The policy of price

discrimination refers to the practice of a seller to charge different prices for different

customers for the same commodity, produced under a single control without corresponding

differences in cost. When a monopoly firm adopts this policy, it will become a discriminatory

monopoly. According to Prof. Benham, “Monopolist may be able however, to divide his sales

among a number of different markets and to charge a different price in each market.”

According to Mrs. Joan Robbinson “The act of selling the same article produced under a single

control at different prices to different customers is known as price discrimination.”


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Kinds of price discrimination:

Prof. A.C. Pigou speaks of three kinds of price discrimination.

1. Discrimination of the first degree:

Under price discrimination of the first degree the producer exploits the consumers to the

maximum possible extent by asking him to pay the maximum he is prepared to pay rather than

go with out the commodity. In this case, the monopolist will not allow any consumer’s

surplus to the consumer. This type of price discrimination is called perfect discrimination.

2. Discrimination of the second degree:

In case of discrimination of the second degree, the monopolist charges different prices for

different units of the same commodity, but not at maximum possible rate but at a lower rate. The

monopolist will leave a certain amount of consumer’s surplus with the consumers. This is

done to keep the consumers satisfied and prevent the entry of potential rivals. This method is

adopted by railway companies.

3. Discrimination of the third degree:

In case of discrimination of the third degree, the markets are divided into many sub markets or

sub groups. The price charged in each case roughly depends on the ability to pay of different sub

groups in the market. This is the most common type of discrimination followed by a monopolist.

PRICE DISCRIMINATION MAY TAKE THE FOLLOWING FORMS: (BASIS OF

PRICE DISCRIMINATION)

1. Personal differences:

This is nothing but charging different prices for the same commodity because of personal

differences arising out of ignorance and irrationality of consumers, preferences, prejudices and

needs.

2. Place:

Markets may be divided on the basis of entry barriers, for e.g. price of goods will be high in the

place where taxes are imposed. Price will be low in the place where there are no taxes or low

taxes.

3. Different uses of the same commodity:

When a particular commodity or service is meant for different purposes, different rates may be

charged depending upon the nature of consumption. For e.g. different rates may be charged for


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the consumption of electricity for lighting, heating and productive purposes in industry and

agriculture.

4. Time:

Special concessions or rebates may be given during festival seasons or on important occasions.

5. Distance:

Railway companies and other transporters, for e.g., charge lower rates per KM if the distance is

long and higher rates if the distance is short.

6. Special orders:

When the goods are made to order it is easy to charge different prices to different customers. In

this case, particular consumer will not know the price charged by the firm for other consumers.

7. Nature of the product:

Prices charged also depends on nature of products e.g., railway department charge higher prices

for carrying coal and luxuries and less prices for cotton, necessaries of life etc.

8. Quantity of purchase:

When customers buy large quantities, discount will be allowed by the sellers. When small

quantities are purchased, discount may not be offered.

9. Geographical area:

Business enterprises may charge different prices at the national and international markets. For

example, dumping – charging lower price in the competitive foreign market and higher price in

protected home market.

10. Discrimination on the basis of income and wealth:

For e.g., A doctor may charge higher fees for rich patients and lower fees for poor patients.

11. Special classification of consumers:

For E.g., Transport authorities such as Railway and Roadways show concessions to students and

daily travelers. Different charges for I class and II class traveling, ordinary coach and air

conditioned coaches, special rooms and ordinary rooms in hotels etc.

12. Age:


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Cinema houses in rural areas and transport authorities charge different rates for adults and

children.

13. Preference or brands:

Certain goods will be sold under different brand names or trade marks in order to attract

customers. Different brands will be sold at different prices even though there is not much

difference in terms of costs.

14. Social and or professional status of the buyer:

A seller may charge a higher price for those customers who occupy higher positions and have

higher social status and less price to common man on the street.

15. Convenience of the buyer:

If a customer is in a hurry, higher price would be charged. Otherwise normal price would be

charged.

16. Discrimination on the basis of sex:

In selling certain goods, producers may discriminate between male and female buyers by

charging low prices to females.

17. If price differences are minor, customers do not bother about such discrimination.

18. Peak season and off peak season services

Hotel and transport authorities charge different rates during peak season and off-peak

seasons.

Pre-Requisite Conditions for Price Discrimination (when price descrimination is possible)

1. Existence of imperfect market:

Under perfect competition there is no scope for price discrimination because all the buyers and

sellers will have perfect knowledge of market. Under monopoly, there will be place for price

discrimination as there are buyers with incomplete knowledge and information about the market.

2. Existence of different degrees of elasticity of demand in different markets:

A Monopolist will succeed in charging higher price in inelastic market and lower price in the

elastic market.


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3. Existence of different markets for the same commodity:

This will facilitate price discrimination because buyers in one market will not be knowing the

prices charged for the same commodity in other markets.

4. No contact among buyers:

If there is possibility of contact and communication among buyers, they will come to know that

discriminatory practices are followed by buyers.

5. No possibility of resale:

Monopoly product purchased by consumers in the low priced market should not be resold in the

high priced market. Prevention of re exchange of goods is a must for price discrimination.

6. Legal sanction:

In some cases, price discrimination is legally allowed. For E.g., The electricity department will

charge different rates per unit of electricity for different purposes. Similarly charges on trunk

calls; book post, registered posts, insured parcel, and courier parcel are different.

7. Buyers illusion:

When consumers have an irrational attitude that high priced goods are of high quality, a

monopolist can resort to price-discrimination.

8. Ignorance and lethargy:

Due to laziness and lethargy consumers may not compare the price of the same product in

different shops. Ignorance of consumers with regard to price variations would enable the

monopolist to charge different prices.

9. Preferences and Prejudices of buyers:

The monopolist may charge different prices for different varieties or brands of the same product

to different buyers. For e.g. low price for popular edition of the book and high price for deluxe

edition.

10. Non-Transferability features:

In case of direct personal services like private tuitions, hair-cuts, beauty and medical treatments,

a seller can conveniently charge different prices.

11. Purpose of service:


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The electricity department charges different rates per unit of electricity for different purposes

like lighting, AEH, agriculture, industrial operations etc. railways charge different rates for

carrying perishable goods, durable goods, necessaries and luxuries etc.

12. Geographical distance and tariff barriers:

When markets are separated by large distances and tariff barriers, the monopolist has to charge

different prices due to high transport cost and high rate of taxes etc.

Price Output determination under Discriminatory Monopoly

Prices to be charged by the monopolist under price discrimination depend upon elasticity of

demand for the products in different markets. The total output to be produced and supplied

depends on marginal revenue and marginal cost. The principle of equilibrium under price

discrimination is that marginal revenues in different markets are equal to marginal cost of the

total output.

MR1 = MR2 = MC of the total output.

The monopolist, for the sake of his convenience, divides the market into two sub-markets, sub-

market A and sub-market B, on the basis of price elasticity of demand. His total sales are

distributed in these two markets. In the sub-market A, the demand for the product is inelastic and

hence he charges a relatively higher price of P1 & M1. The output sold in this market is OM1.

E1 is the equilibrium position where MR = MC. P1 & E1 indicates the price over and above MR

& MC.


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In the sub-market B, the demand for the product is elastic. He is charging a relatively lower price

of P2 and M2. The output, sold in this market is OM2. E2 is the equilibrium position where MR

= MC. The distance between P2 & E2 indicates the excess of price over MR and MC.

The third diagram represents the total market for the product of the monopolist. AMR is the

aggregate MR in both the markets and AAR is the aggregate AR in both the markets. MC is the

marginal cost curve. At E MR = MC, the equilibrium position of the monopoly firm. The total

output sold in the two sub-markets is represented by OM.

The above description clearly shows that the monopolist has discriminated the two markets and

charged different prices in these two markets.

When price discrimination is profitable and justified:

1. It is profitable for a monopolist when he is charging a relatively higher price for those

products having in elastic demand and lower price for those having elastic demand. In this

case, his total profits would be certainly high when compared to a simple monopolist who

charges a single price.

2. It is profitable to the general public only when price discrimination is allowed in public

utility services and public sector where total receipts are lower than total costs. For e.g.

railways, P & T, telephones, news paper, houses, electricity department, water supply

department etc. Otherwise common man and economically weaker section will not get

certain products and services at cheaper rates. In such cases, from the point of view of their

survival, growth and social welfare, price discrimination has to be justified.

3. It is profitable when community’s welfare requires price discrimination. For e.g. a

doctor, a lawyer, a chartered accountant will charge a relatively higher fees for rich

customers and lower fees for common man and poor people; this policy has re distributive

effect. Inequalities in income and wealth distribution can be reduced through price

discrimination. On the other hand rich people can also get better service by paying higher

fees or price.

4. It is profitable when the monopolist is organizing his production on large scale basis,

increase total output, reduce production cost and charge lower price in one market and higher

price in another market.

5. It is profitable when the monopolist is sharing a part of his total profits with his workers

in the form of higher wages, salaries, bonus etc.

6. It is profitable to entire society when price discrimination leads to fuller utilization of

national resources, higher output, income and employment and promote the welfare of the

general public.


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7. Normal dumping is profitable to a society because surplus production is cleared off in

foreign markets at lower prices and thus promotes export of the country.

8. It is not profitable in cases where it leads to exploitation of the poor, common man,

elimination of small entrepreneurs from the field of business, over investments in business,

under utilization of resources and all other kinds of wastages etc.

Dumping policy

It refers to selling of goods at lower prices in the competitive International market and at higher prices in the protected domestic market. Normal dumping policy is justified because a

commodity is sold in both national and international markets. Hence, output will be naturally

high. Large scale production enables the firm to reduce average cost.

If goods are produced only for the local markets scale of production will be low, and A.C. will

be high. Naturally prices of goods will be high. Thus monopoly firm following dumping policy

will be able to sell more units at lower pr ices and maximize profits.

Dumping policy is adopted for the following reasons

i. To get rid of excess production.

ii. To crush rivals in the foreign markets.

iii. To reap the advantages of increasing returns in the industry.

iv. To take the advantage of differences in elasticity of demand in different markets.

v. To explore new markets.


Understand and appreciate the function of monopolistic competition

Monopolistic Competition


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Perfect competition and monopoly are the two extreme forms of market situations, rarely to be

found in the real world. Generally, markets are imperfect. A number of attempts have been made

by different economists like Piero Shraffa, Hotelling, Zeuthen and others in the early 1920’s,

Mrs Joan Robinson and Prof Chamberlin in 1930’s to explain the behavior of imperfect

competition.

Prof. Chamberlin is the main architect of the theory of Monopolistic Competition. This market

exhibits the characteristics of both competition and monopoly. Since modern markets are

combined and integrated with monopoly power and competitive forces they are called as

Monopolistic Competition. It is a market structure in which a large number of small sellers

sell differentiated products which are close, but not perfect substitutes for one another. Under this market, the products produced and sold are different, but they are close substitutes for

one another. This leads to competition among different sellers. Thus, in this market situation

every producer is a sort of monopolist and between such “mini-monopolists” there exists

competition. It is one of most popular and realistic market situation to be found in the present

day world. A number of examples may be given for this kind of market. Tooth paste, blades,

motor cycles and bicycles, cigarettes, cosmetics, biscuits, soaps and detergents, shoes, ice –

creams etc.

Characteristics of Monopolistic Competition

1. Existence of a large Number of firms:

Under Monopolistic competition, the number of firms producing a product will be large. The size

of each firm is small. No individual firm can influence the market price. Hence, each firm will

act independently without worrying about the policies followed by other firms. Each firm

follows an independent price-output policy.

2. Market is characterized by imperfections

Imperfections may arise due to advertisements, differences in transport cost, irrational

preferences of consumers, ignorance about the availability of different brands of products and

prices of products etc., sellers may also have inadequate knowledge about market and prices

existing at different segments of markets.

3. Free entry and exit of firms

Each firm produces a very close substitute for the existing brands of a product. Thus,

differentiation provides ample opportunity for a firm to enter with the group or industry. On the

contrary, if the firm faces the problem of product obsolescence, it may be forced to go out of the

industry.

4. Element of monopoly and competition


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Every firm enjoys some sort of monopoly power over the product it produces. But it is neither

absolute nor complete because each product faces competition from rival sellers selling different

brands of the product.

5. Similar products but not identical

Under monopolistic competition, the firm produces commodities which are similar to one

another but not identical or homogenous. For E.g. toothpastes, blades, cigarettes, shoes etc,

6. Non-price competition

In this market, there will be competition among “Mini-monopolists” for their products and not

for the price of the product. Thus, there is “product competition” rather than “price competition”.

7. Definite preference of the consumers

Consumers will have definite preference for particular variety or brands loyalty owing to the

special features of a product produced by a particular firm.

8. Product differentiation

The most outstanding feature of monopolistic competition is product differentiation. Firms adopt

different techniques to differentiate their products from one another. It may take mainly two

forms:

a. Real product difference:

It will arise –

i. When they are produced out of materials of higher quality, durability and strength.

ii. When they are extraordinary on the basis of workmanship, higher cost of material, color,

design, size, shape, style, fragrance etc.

iii. When personal care is taken to produce it.

b. Imaginary product difference:

Producers adopt different methods to differentiate their products from that of other close

substitutes in the following manner.

i. Proper location of sales depots in busy and prestigious commercial centers.


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ii. Selling goods under different trade marks, patenting rights, different brands and packing

them in attractive wrappers or containers.

iii. Providing convenient Working hours to customers.

iv. Home delivery of goods with no extra cost.

v. Courteous treatment to customers, quick and prompt delivery of goods in time and

developing cordial, personal and friendly relations with them.

vi. Offering gifts, discounts, lucky dip schemes, special prices, guarantee of repairs and

other free services, guarantee of products, fair dealings, sales on credit or credit cards & debit

cards etc.

vii. Agreement to take back goods if they are unsatisfactory.

viii. Air conditioned stores etc.

9. Selling Costs

All those expenses which are incurred on sales promotion of a product are called as selling

costs. In the words of Prof. Chamberlin – “selling Costs are those which are incurred by the

producers (sellers) to alter the position or shape of the demand curve for a product”. In short,

selling costs represents all those selling activities which are directed to persuade buyers to

change their preferences so as to maximized the demand for a given commodity. Selling costs

include expenses on sales depots, decoration of the shop, commission given to intermediaries,

window displays, demonstrations, exhibitions, door to door canvassing, distribution of free

samples, printing & distributing pamphlets, cinema slides, radio, T.V., newspaper advertisements

(informative and manipulative advertisements) etc.

10. The concept of Industry & Product Groups

Prof. Chamberlin introduced the concept of group in place of industry. Industry in economics

refers to a number of firms producing similar products. Under monopolistic competition no

doubt, different firms produce similar products but they are not identical. Hence, Prof.

Chamberlin has made an attempt to redefine the industry. According to him, the monopolistically

competitive industry is a ‘group’of firms producing a “closely related” commodity referred to as

“product group” thus group refers to a collection of firms that produce closely related but not

identical products.


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11. More elastic demand curve

Product differentiation makes the demand curve of the firm much more elastic. It implies that a

slight reduction in the price of one product assuming the price of all other products remaining

constant leads to a large increase in the demand for the given product.

PRICE – OUTPUT DETERMINATION

Short run equilibrium

Short period is a period of time where time is inadequate to make all sorts of changes and

adjustments in the productive process. The demand & cost conditions may vary substantially

forcing the firm either to charge a higher or lower price leading to supernormal profits or losses.

However, each firm fixes such price and produce output which maximizes its profit. The

equilibrium price and output is determined at the point where Short run Marginal cost equals

Marginal revenue. Thus, the first condition for Short run equilibrium is MC = MR in both

diagrams.

The first diagram shows supernormal profits. In this case, price (AR) is greater than AC (cost Per

Unit). MQ is the cost per unit and total cost for OQ output is = MQ X OQ = ONMQ. PQ is the

price or revenue per unit and the total revenue for OQ output is = PQ X OQ = ORPQ.

Supernormal profit = TR (ORPQ) – TC (ONMQ). Hence, NRPM is the total profit.

The second diagram shows losses. In this case, AC is greater than AR. PQ is the cost per unit and

the total cost is PQ x OQ = ORPQ. MQ is the revenue per unit & the total revenue for OQ output

is MQ X OQ = ONMQ.


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Total losses = TC (ORPQ) – TR (ONMQ) = NRPM. Thus, in the Short run, there will be place

for supernormal profits or losses.

Price output determination in the long run

Long run is a period of time where a firm will get adequate time to make any changes in the

productive process or business. A firm can initiate several measures to minimize its production

costs and enjoy all the benefits of large scale production.The cost conditions, as a result differ

slightly in the long run. While fixing the price, a firm in the long run should consider its AC &

AR.

Generally speaking in the long run a firm can earn only normal profits. If AR is greater than AC,

there will be super normal profits. This leads to entry of new firms – increase in the total number

of firms – total production – fall in prices – decline in profit ratio. On the other hand, if AC is

greater than AR, there will be losses. This leads to exit of old firms – decrease in the number of

firms – total production – rise in prices – increase in profit ratio. Thus, the entry and exit of firms

continue till AR becomes equal to AC. Thus, in the long run, two conditions are required for the

equilibrium of the firm –

1) MR=MC and

2) AR=AC. However, it should be noted that price is greater than MR & MC.

In the diagram E is the equilibrium position where MR = MC and MC curve cuts MR curve from

below. At P, AR = AC = price.

It is necessary to understand that a firm under monopolistic competition in the long run also can

earn supernormal normal profits. Prof. Stonier & Hague suggest that a firm can go for innovation

to introduce new changes in the context of a modern competitive business. This appears to be

more realistic because today almost all firms make heavy profits. Hence, it is regarded as one of

the most practical forms of market situations in the present day world.

Existence of oligopoly ,duopoly, bilateral monopoly , monopsony , duopsony , oligopsony


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Oligopoly

The term oligopoly is derived from two Greek words “Oligoi” means a few and ‘Poly’ means to

sell. Under oligopoly, we come across a few producers specializing in the production of

identical goods or differentiated goods competing with one another. The products traded by

the oligopolists may be differentiated or homogeneous. In the case of former, we can give the

e.g., of automobile industry where different model of cars, ambassador, fiat etc., are

manufactured. Other examples are cigarettes, refrigerators, T.V. sets etc., pure or homogeneous

oligopoly includes such industries as cooking and commercial gas cement, food, vegetable oils,

cable wires, dry batteries, petroleum etc., In the modern industrial set up there is a strong

tendency towards oligopoly market situation. To avoid the wastes of competition in case of

competitive industries and to face the emergence of new substitutes in case of monopoly

industries, oligopoly market is developed. e.g., an electric refrigerator, automatic washing

machines, radios etc.

Characteristics of Oligopoly

1. Interdependence:

Each and every firm has to be conscious of the reactions of its rivals. Since the number of firms

is very few, any change in price, output, product etc., by one firm will have direct effect on the

policy of other firms. Therefore, economic calculations must be made always with reference to

the reactions of the rival firms, as they have a high degree of cross elasticity’s of demand for

their products.

2. Indeterminateness of the demand curve:

Under oligopoly, there will be the element of uncertainty. Firms will not be knowing the

particular factors which could affect demand. Naturally rise or fall in the demand for the product

cannot be speculated. Changes that would be taking place may be contrary to the expected

changes in the product curve.. Thus, the demand curve for the product will be indeterminate or

indefinite. Prof. Sweezy explains it as a kinky demand curve.

3. Conflicting attitude of firms:

Under oligopoly, on the one hand, firms may realize the disadvantages of competition and rivalry

and desire to unite together to maximize their profits. On the other hand firms guided by

individualistic considerations may continuously come in clash and conflict with one another.

This creates uncertainty in the market.

4. Element of monopoly and competition:


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Under oligopoly, a firm has some monopoly power over the product it produces but not on the

entire market. But monopoly power enjoyed by the firm will be limited by the extent of

competition.

5. Price rigidity:

Generally, prices tend to be sticky or rigid under oligopoly. This is because of the fact that if one

firm changes its price, other firms may also resort to the same technique.

6. Aggressive or defensive marketing methods:

Firms resort to aggressive and sometimes defensive marketing methods in order to either

increase their share of the market or to prevent a decline of their share in the market. If one

adopts extensive advertisement and sales promotion policy it provokes others to do the same.

Prof. Boumal rightly remarks in this connection- “Under oligopoly, advertising can become a life

and death matter where a firm which fails to keep up with the advertising budget of its

competitors may find its customers drifting off to rival firms”.

7. Constant struggle:

Competition is of unique type in an oligopolistic market. Hence, competition consists of constant

struggle of rivals against rivals.

8. Lack of uniformity:

Lack of uniformity in the rise of different oligopolies is another remarkable feature.

9. Small number of large firms:

The numbers of firms in the market are small. But the size of each firm is big. The market share

of each firm is sufficiently large to dominate the market.

10.Existence of kinked demand curve :

A kinked demand curve is said to occur when there is a sudden change in the

slope of the demand curve. It explains price rigidity under oligopoly.

Price – Output Determination under Oligopoly

It is necessary to note that there is no one system of pricing under oligopoly market. Pricing

policy followed by a firm depends on the nature of oligopoly and rivals reactions. However, we

can think of three popular types of pricing under oligopoly. They are as follows:


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Independent Pricing: (Non-collusive oligopoly)

When goods produced by different oligopolists are more or less similar or homogeneous in

nature, there will be a tendency for the firms to fix a common pricing. A firm generally accepts

the “Going price” and adjusts itself to this price. So long as the firm earns adequate profits at this

price, it may not endeavor to change this price, as any effort to do so may create uncertainty.

Hence, a firm follows what is called is “Acceptance pricing” in the market.

When goods produced by different firms are different in nature (differentiated oligopoly), each

firm will be following an independent pricing policy as in the case of monopoly. In this case,

each firm is aware of the fact that what it does would be closely watched by other oligopolists in

the industry. However, due to product differentiation, each firm has some monopoly power. It is

referred, to as monopoly behavior of the Oligopolist. On the contrary, it may lead to Price-wars

between different firms and each firm may fix price at the competitive level. A firm tends to

charge prices even below their variable costs. They occur as a result of one firm cutting the

prices and others following the same. It is due to cut-throat competition in oligopoly. The actual

price fixed by a firm may fall in between the upper limit laid down by the monopoly price and

the lower limit fixed by the competitive price. It may be similar to that of the pricing under

monopolistic competition. However, independent pricing in reality leads to antagonism, friction,

rivalry, infighting, price-wars etc., which may bring undesirable changes in the market. The

Oligopolist may realize the harmful effects of competition and may decide to avoid all kinds of

wastes. It encourages a tendency to come together. This leads to pricing under collusion. In other

words independent pricing can be followed only for a short period and it cannot last for a long

period of time.

Pricing Under Collusion

Collusion is just opposite of competition. The term collusion means to “play together” in

economics. It means that the firms co-operate with each other in taking joint actions to keep their

bargaining position stronger against the consumer. Firms give place for collusion when they join

their hands in order to put an end to antagonism, uncertainty and its evils.

When the government action is responsible for brining the firms together, there will be place for

EXPLICIT COLLUSION. On the other hand, when restrictions are introduced, firms may form

themselves into secret societies resulting in IMPLICIT COLLUSION.

Collusion may be based on either oral or written agreements. Collusion based on oral agreement

leads to the creation of what is called as “Gentleman’s Agreement “. It does not consist of any

records. On the other hand, collusion based on written agreement creates what is known as

CARTELS.

There are different types of cartel agreements. On the one extreme, the firms surrender all their

rights to a central authority which sets prices, determine output, marketing quotas for each firm,

distributes profits etc. This is called as centralized cartels. A centralized or perfect cartel is an


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arrangement where the firms in an industry reach an agreement which maximizes joint profits.

Hence, the cartel can act as a monopolist. Since the firms in the cartel are assumed to produce

homogeneous goods, the market demand for the product is the cartel’s demand. It is also

assumed that the cartel management knows the demand at each possible price and also the

marginal costs of all its firms, it can therefore, find out the MR and MC for the industry. The

desire of the firms to have large joint profits gives impulse to form cartels. But such a desire is

short lived and therefore, the formal arrangement or cartels cannot be a long term phenomenon.

Under the second type of cartel agreement, market – sharing cartel, the firms in the industry

produce homogeneous products and agree upon the share each firm is going to have. Each firm

sells at the same price but sells with in a given region. Such a system can function only if the

firms having identical costs.

Market sharing model has a very restrictive assumption of identical costs for all firms. Since in

practice the firms have unequal costs and every firm wants to have some degree of independent

action, the market-sharing cartels are not long-lived.

Price Leadership

Perfect collusion is not possible in practice. Mutual suspicision and distrust among member-

firms and their unwillingness to surrender all their sovereignty makes the collusion imperfect.

There are a number of imperfect collusions and one of the most important form is PRICE

LEADERSHIP. According to Prof. Bain, – “If changes are usually or always price changes by

other sellers, price competition may be said to involve price leadership”.

In this case, a particular strong firm which is enjoying the benefits of large scale production will

dominate the small firms. The price fixed by the dominating firm will be followed by all other

small firms. Hence, the dominating firm becomes the PRICE LEADER. All other firms

following the price policy of the dominating firm in the industry are called as PRICE

FOLLOWERS. The price leader is generally a leader in all markets. However, the same firm

may become a follower in one market and price leader in other markets. The leadership may

emerge spontaneously due to technical reasons or out of tacit or explicit agreement between

different firms to assign leadership role to one of them. There may be either Dominant-firm

leadership or collusive-firm leadership.

Generally the leadership arises in a market on account of the following reasons:

i. The leading firm will be enjoying the benefits of lower cost of production and possess

huge financial resources at its disposal.

ii. It may have substantial share in the market.


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iii. It will have reputation for sound pricing policy.

iv. It may take the initiative in dominating and controlling other firms in the industry as a

normal method of functioning.

v. It may follow aggressive price policy & there by it can acquire control over other firms.

vi. If a dominant firm is unable to perform its role as a leader either due to inherent

deficiencies or government restrictions, in that case it will assign the leadership role to other

firms. It is called as Barometric price leadership.

The price leader has to make the following calculations before fixing the price of given product:

i. Reaction from rival firms for his product.

ii. Elasticity of substitution between his and other’s product.

iii. The price leader should follow an appropriate price policy where by he can retain the

leadership in the market. He should be able to get the support and loyalty of his followers or

price-takers. The guess work of the leading firm while fixing the price should reflect the real

condition in the market. He should be able to prevent other small firms from reducing the

price to attract the customers in the market.

iv. He should remember that the power of the leader rests on the differences in costs. This

type of price-leadership is called as partial monopoly.

Features of Price Leadership

i. The price leader should be able to bear the risks of price-wars in order to establish and

maintain leadership. When once leadership is established, there should be persistent efforts to

continue the lead.

ii. The price-leader normally take the lead in increasing prices and in case of price

reductions, the leader becomes only a follower.

iii. Instead of thinking only about the short-term gains, the leader normally thinks about the

long-term gains.

iv. The price leader has an important part in forecasting the demand, cost condition to play

his role effectively to win the confidence of his followers.


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v. Normally the leader changes the price when he feels that change in cost and demand

conditions are permanent.

vi. The leader follows a definite and consistent pricing policy in a most intelligent manner

so as to capture the market, win over the small firms etc.

vii. An important aspect of price leadership is that it very often serves as a means to price

discipline and price stabilizations.

Advantages of Price Leadership: (for both leader and FOLLOWERS)

i. It helps the small firms to formulate their price policy on the basis of leader’s price

because they do not normally possess complete information regarding varies types of costs.

ii. It is a simple and economical method of pricing because it does not involve any

expenditure on market survey etc.

iii. It ensures stability in the market by avoiding price-wars as much as possible.

iv. It will put an end to the operation of wide fluctuations in the market (Operation of trade

cycles).

v. It reduces the number of reactions from different small firms and thus ensures certainty

in the market.

vi. It ensures the spirit of live and let live.

Thus, price leadership has become an important method of pricing under oligopoly market

conditions at present. It exists for a short period only. It is one of the most convenient methods of

pricing for oligopoly firms which intend to stay and grow in the market.

Price – Rigidity and Kinked Demand Curve under Oligopoly

Kinked demand curve was first used by Prof. M. Sweezy to explain price rigidity under

oligopoly. It represents the behavior of an oligopoly firm which has no incentive either to

increase or decrease its price. Each firm by its experience has learnt what will be the reactions of

rivals to actions on her part and may voluntarily avoid any activity that will lead to the situation

of price-war. Each firm is content with present price-output and profits and it does not want to

make any change. Hence, they do not change their price-quantity combinations in response to

small shifts in their cost curves.


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When there are significant differences in quality, service and reputation in an industry, the price-

leader himself operate in the upper quality stratum with a rich mixture of service and charges

some price premium for his superiority.

After a situation of price leadership is established, it is probably maintained fully as much by the

followers as by the leader. The price-leader should meet a temporary drop in price by informal

concessions from the official price because frequent changes in announced prices disrupt

follower’s adjustments and undermine the leader’s prestige. He changes price only when he feels

that changes in demand conditions and cost is permanent.

The price-leader has an important part in forecasting the demand and cost conditions to play his

role effectively, accurately and in conformity with confidence of followers.

The term ‘Kink’ refers to a short backward twist to cause obstructions. A Kinked demand curve

is said to occur when there is a sudden change in the slope of the demand curve. This gives rise

to a kink, that is, a sharp corner in the demand curve. It arises when it is assumed that the rivals

will lower their prices when the Oligopolist lowers his own price but the rivals will not raise

their prices when the Oligopolist raises his price.

Kinked demand curve analysis does not explain how price and output are determined under

oligopoly rather it seeks to explain why once a price-quantity combination has been established a

firm will avoid changing it, why the price becomes sticky. Hence, it provides an explanation to

price rigidity under oligopoly conditions.

In the diagram, E represents the firm’s original price-quantity combination.

When the Oligopolist changes his price, the reaction of his rivals will be as follows:

a. Reaction to Price Reduction


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If the Oligopolist reduces his price while followers keep their price as constant, rival firms

experience reduction in their demand and sales and a drift of customers to the Oligopolist, they

will also reduce their price to match the price reduction of the Oligopolist. Even though, the

Oligopolist reduces his price, there will not be any appreciable increase in demand for his

product and also the sales. ED is the new demand curve which is inelastic. Even though, price

falls, demand and sales will not go up considerably. Thus, his policy of price cut will not yield

good results.

b. Reaction to Price Increase

When the Oligopolist increases his price, the followers do not increase their prices. Now rival

firms get more customers because their prices are much lower than the oligopolist’s price.

Hence, with out increasing their prices, the followers will earn more income. Now the

oligopolists due to increase in his price, looses his demand and sales. The demand curve will be

elastic segment DE.

An Oligopolist faced with a knifed demand curve will be extremely unwilling to change his

price, for a fall in his price will cause no large increase in his sales and price increase will cause

a substantial fall in his sales. Thus, neither a price increase nor price reduction will be an

attractive proposition for the Oligopolist.

Duopoly

Features

Many economists are of the opinion that Duopoly is only a form of simple oligopoly. In other

words, duopoly is only a limited oligopoly. Duopoly models and explanations can also be taken

as oligopoly models. Duopoly is a market with two sellers exercising control over the supply

of commodities. It is a two-firm industry. In the words of Cohen and Cyret – “When there are

exactly two sellers in the market, there is a special case of oligopoly called Duopoly”. Each seller

knows what ever he does will affect his rival’s policies. Each seller attempts to make a correct

guess of his rivals motives and actions. The action by one will have a reaction from the other.

The two firms may either resort to competition or come together. On the one extreme, the two

rivals may go in for cut-throat competition with a view of eliminating the other from the market

and setting himself as a monopolist. Such a type of competition may be ruinous for both. On the

other extreme, the rivals may realize that competition between them will ruin both and hence,

they may fix the same price and restrict competition to advertisement only.

Bilateral Monopoly


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Bilateral monopoly is a special type of market situation in which a single seller faces a single

buyer, i.e., a monopsonist is facing a monopolist. Suppose that in a town, there is only one steel

factory offering employment for labor in the area and suppose a trade union controls the entire

labor supply, the trade union which controls the supply of lab our is the monopoly and the steel

factory which is the sole buyer of labor is the monopsony.

In principle the monopolist wishes to operate on a scale where the marginal cost is equal to

marginal revenue, which will bring him the maximum monopoly profit. On the other hand, the

monopsonist wishes to purchase an amount at which marginal cost is equal to marginal utility.

This indicates one optimum price for the buyer and another for the seller.There is, thus,

indeterminateness in price fixation in bilateral monopoly. The two parties must enter into

negotiations and the final price and quantity will depend upon the relative bargaining strength of

the two parties. If the monopsonist is more powerful, the price will tend to be low; but if the

monopolist is more powerful, the actual price will tend to be high.

Monopsony

Monopsony refers to a market with a single buyer who buys the entire amount produced. A

monopsony may be created when all the consumers of commodity are organized together.

Suppose there is only one cotton mill in a region. It becomes a monopsonist buyer of raw cotton,

while the suppliers of cotton to the mill will be the large number of cotton growers.Just as the

monopolist aims at maximizing his profit, in the same manner the monopsonist aims at

maximizing his consumer’s surplus, and the consumer’s surplus is maximum when the marginal

cost is equal to marginal utility. A monopsonist too can adopt price discrimination paying

different prices to different sellers according to the elasticity of supply.

Duopsony

Duopsony is an economic condition similar to a duopoly, in which there are only two large

buyers for a specific product or service. Members of a duopsony have great influence over sellers

and can effectively lower market prices for their advantage.

For example, let’s imagine a town in which only two restaurants operate. There are only two

employment options for waiters and chefs. Because the restaurants have less competition for

finding employees, they can offer lower wages. The chefs and waiters have no choice but to

accept the low pay, unless they choose not to work. This shows that firms that are part of a

duopsony have the power not only to lower the cost of supplies, but also to lower the price of

labor.


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Oligopsony

Similar to an oligopoly, this is a market in which there are a few large buyers for a product or

service. This allows the buyers to have a great deal of control over the sellers and can effectively

push down the prices.


Make an analysis of the industry

Industry Analysis

A detailed study of the market analysis enables us to understand how the business organization is

influenced by the market structure, conduct of the buyers and sellers and the overall performance

of the market.

Structure

Under perfect competition there are a large number of buyers and sellers, commodity dealt with

is homogeneous and there is free entry and exit of firms into and out of the industry. Since the

buyers and the sellers possess perfect knowledge of the market conditions same price prevails for

the same commodity at the same time throughout the market. Such a situation promotes welfare

of both the buyers and the sellers. It establishes ideal conditions of a market. It serves as a

yardstick to measure the functioning of other markets.

Under monopoly a single seller controls the entire market. He has the power to control supply

and price. Generally a high price is charged by restricting the output. Product differentiation and

selling costs dominate a monopolistic market. Intense competition prevails among the firms to

promote the sale of their products. Oligopoly describes the situation where there are a few firms

producing either homogeneous or differentiated products. Tough competition prevails among

firms. Thus different market structure explains different conditions under which a firm has to

operate.

Conduct


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Conduct of a firm depends upon the market structure in which it is operating. A firm under

imperfect competition conducts more efficiently than under perfect competition. Under perfect

competition an individual firm has no control on price; it will have to just adjust its output to the

existing price in the market. Thus the firm need not struggle much. Under imperfect competition

because of product differentiation and imperfect knowledge about the market firms generally

adopt aggressive sales promotion measures to survive and grow. Heavy investment is also made

on research and development. Thus there is incentive for growth and development. Welfare of

the community is the highest.

Performance

Firms under perfect competition will have to perform efficiently to stay in the market In the long

run price=MR=AR=MC=AC As a rule they cannot make abnormal profit. Under imperfect

competition price is equal only to AR and AC in the long run, MC and MR are less than AR and

AC. Thus there is scope for supernormal profit. Firms naturally under imperfect competition

perform better than the firms under perfect competition. Such an analysis of structure – conduct

–performance of an industry is explained as structure-conduct-performance paradigm. Structure

affects the conduct, conduct determines the performance. They are mutually interlinked.

Summary

The organization and functioning of a firm is determined by the type of market in which it is

operating. A market structure is characterized by the number of buyers and sellers, nature of the

commodity dealt with, the scope for entry and exit of firms and the determination of price.

Perfect competition exhibits an ideal market situation, where there are a large number of buyers

and sellers, the commodity dealt with is homogeneous and there is free entry and exit of firms

into and out of the industry, a uniform price prevails in the market. In the long run Price is equal

to MR=AR=MC=AC. The firms can make only normal profit in the long run.

Monopoly is a market situation where a single seller has total control over the price and output.

There is scope for price discrimination. He can charge different prices to different customers at

different places for different uses at different periods of time for the commodity produced under

same cost conditions.

Oligopoly is a market condition where a few big sellers producing either homogeneous or

differentiated goods control the market. Popular methods of pricing under oligopoly are collusive

pricing or price leadership.

Bilateral monopoly is a situation where a monopolist faces a Monopsonist. Monopsony is a case

of single buyer, Duopsony explains a situation of two buyers and Oligopsony, a situation of a

few big buyers controlling the market, Industry analysis explains how the entire market is closely


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knit and how the structure of the market, conduct of the buyers and sellers performance of the

industry as a whole are inter related.

UNIT 9 OPERATIONAL SIGNIFICANCE OF CONSUMERS’

SURPLUS

Introduction

The concept of Consumers’ Surplus was first invented by a French Engineer Economist Dupuit in the year

1844. Further, it was refined and popularized by Prof. Marshall in 1980. Hence, it is called as Marshallian

concept. Prof. Boulding described it as “Buyer’s Surplus”. It is one of the most common experiences in

our day to-day life that many a times we come across surplus satisfaction in the process of consumption.

Similarly, a producer sometimes earns surplus revenue than what he expects in the sale of a product.

This surplus income enjoyed by the producer is described as producers’ surplus in economics.

Learning Objective- 1:

Learn the concept of consumers’ surplus and its practical application in business decision

Meaning Of Consumers’ Surplus

In a monetary economy, we measure the utility of a commodity with the help of price. The price we pay

for a commodity basically depends on its worthiness and utility. If a product possesses higher utility,

then it would command a higher price and vice-versa. The law of Equi – marginal utility states that the

price paid for a commodity should be equal to its marginal utility. This is one of the basic conditions for

consumer’s equilibrium. At the point of equilibrium, neither there will be higher utility nor lower utility,

but M .U = Price.

In the real life, a consumer may not act according to the Law of equi-marginal utility always. The balance

between the price and utility may not be maintained always. Sometimes he may get lower utility from a

commodity when compared to the price he is paying for it[ [M.U< Price]. In some other cases, he may

get higher utility [M.U >price].

When the satisfaction obtained by the consumer is much more than the price he is paying for the

commodity, he will be enjoying a surplus. The excess or surplus satisfaction enjoyed by a consumer

over and above the price he is paying for the product rather than go without it is technically described


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as consumers’ surplus in economics. It is essentially found in the purchase of useful and very cheap

articles like salt, postcard, newspaper, matchbox and many other such durable and non-durable articles

etc. In all these cases, we receive more than we pay for them.

Consumer’s Surplus may be defined as the excess of what a consumer is willing to pay over what he

actually does pay. According to Prof. Marshall, “The excess of price which a person would be willing to

pay rather than go without the thing over which what he actually does pay is the economic measure of

this surplus satisfaction. It may be called consumer surplus. In the words of Prof. Bilas, “The difference

between what the consumer does pay for the commodity and what he would be willing to pay rather

than do without it is called consignment surplus”.

The concept may be explained with the help of a formula-

Consumers’ surplus = what we are prepared to pay – [minus] what we actually pay.

It is the difference between ex-ante and ex-post satisfaction. Also it is the difference between the

potential price and actual price. Hence, it is the difference between the value of the total utility that

may be derived from the consumption of a product and the total amount of money spent on that

product.

It is essential to note that there is an inverse relationship between price and consumers’ surplus. If price

rises, consumers’ surplus falls and vice versa.

It is a product of opportunities and environment. For example, in developed countries consumers’

surplus is high because with a little amount of money the consumer can buy larger quantities of goods

and services. On the contrary, in developing countries, consumers’ surplus is low because with more

amount of money, the consumer can purchase little amount of goods and services.

The concept of consumers’ surplus is derived from the Law of Diminishing Marginal Utility (L.D.M.U.). It

is clear from the following table

Units of commodities

purchased M.U. of a commodity

in units Price per unit in

paisa Consumer’s surplus in units

1 50 30 20

2 45 30 15

3 40 30 10

4 35 30 10

5 30 30 Nil

Total units purchased =

5 Total utility form 5

units = 200 Total price paid for

5 units = 150 Consumers surplus = 50 units

200 – 150 = 50.

Consumer Surplus = Total Utility – (Price x Quantity)


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Symbolically C.S. = TU – (P x Q)

= 200 – (30 x 5)

= 200 – 150

= 50.

C.S. = What we are prepared to pay – What we actually pay.

C.S. = 200 – 150 = 50

(In our example we measure that 1 unit of utility is equal to 1 paisa).

In the diagram,

OD = Price willing to pay

OQ = Quantity willing to buy

OD X OQ = ODPQ = Total expenditure willing to incur

OR = Actual Market price

OQ = Actual quantity purchased

OR x OQ = OPPQ = Actual expenditure incurred by the consumer.

Therefore, C.S. = Price willing to pay – price actually paid = ODPQ – ORPQ = RDP.

It is to be remembered that the concept is based on a number of unrealistic assumptions. It poses a

number of difficulties in its measurement. Hence, always it is not possible to measure the exact volume


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of consumers’ surplus. In spite of several practical problems, economists have made successful attempts

to measure it as precisely as possible.

Operational Significance Of Consumers’ Surplus

1. Conjectural Advantages

The concept enables us to compare the advantages of environment and opportunities or conjectural

benefits. The conjectural benefits derived by people enable us to compare the standards of living in

different parts of the world. If consumers’ surplus is more in any country, then living standards of the

people are high and vice – versa. For example, the living standards of the people of USA or Japan is

certainly more when compared to India because in those countries the national output, national income

and per capita income of the people are high Thus, it helps to measure the volume of economic welfare

of the people who live in different parts of the world.

2. Use in cost-benefit analysis

To day the concept is extensively used in estimating the cost-benefits of various investment projects

both in the private and public sectors. Costs and benefits do not merely mean money costs and

monetary benefits but also real costs and real benefits in terms of satisfaction and the amount of

resource utilization. The quantum of consumers’ surplus derived from social projects like railways,

roads, bridges, dams, flyovers, parks, libraries, water and electricity supply etc by consumers are

definitely higher when compared to the amount of money spent on them. For example, a consumer

would pay a very little amount of money to travel in a public transport vehicle than what he has to pay if

he were to travel in an autorikshaw or taxi. The cost savings from these projects are directly derived

from consumers’ surplus.

3. Use in public Finance

a. It is the basis to impose taxes on people. If consumer’s surplus is high in case of any product or

service, then the finance minister can impose higher taxes on them and vice – versa. This is because

people are ready to pay more price for such products rather than go with out them.

b. It is the basis to declare whether taxation policy of a government is good or bad. If the gain to the

government on account of tax collection is greater than the losses to the consumers on account of tax

payment, it is a good taxation policy and vice – versa. In this case, the total tax amount collected by the

government is greater than that of the total amount of sacrifice made by the people on account of tax

payments.

c. It is the basis to grant subsidy by the government to private entrepreneurs. If the amount of gain to

the people on account of subsidy is greater than the financial loss to the government owing to the grant

of subsidy, we can justify such subsidy and vice – versa. For example, if government grants subsidy to

sugar, market price of sugar declines and consequently, more consumers would buy more quantity of

sugar and enjoy greater amount of satisfaction.


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4. Pricing of public utilities.

The concept helps in determining prices of public utilities. In case of construction of railway lines, air

ports, roads, bridges, generation and supply of electricity, water supply etc, people enjoy enormous

amount of surplus satisfaction. While fixing the prices of these services, or commodities, the

government does not look into its production and supply cost. As they are public utilities, the

government follows the policy of price discrimination.

5. Helps to resolve the paradox of value

Generally speaking market value of product depends on its demand and supply. In case of certain

essential commodities like water etc supply will be more and as such its market price will be low. In

these cases, marginal utility will be low whatever may be the value of total utility. In case there is

scarcity of a product in the market, its price would go up. In this case, marginal utility will be high

whatever may be value of total utility. Commodities which have more value in use give more satisfaction

than others which have more value in exchange. For example, in case of salt, match box, news paper etc

total utility is more but marginal utility is less and as such we pay much less money for them. Value-in-

use in case of such goods is much higher than their value-in-exchange. Commodities which have more

value- in- exchange give less satisfaction than others which have more value in use. For example, in case

of diamond, value – in –exchange is more than value-in-use because in these cases, marginal utility is

higher than total utility. Thus, the concept helps to distinguish between value-in-use and value-in –

exchange.

6. Use monopoly Pricing

It helps the monopolist to practice price discrimination. If consumers’ surplus is high, in case of any

commodity or service, then the monopolist can charge higher prices and vice – versa.

7. Use in international Trade

It is the basis to import certain items from other countries. If consumers’ surplus is more in case of

imported goods than domestically manufactured goods, in that case it is better to import. Similarly, if

consumers’ surplus is low with in the country and high in other nations, in that case, it is better to export

them to other nations.

8. Use in welfare Economics

It is used as a tool in welfare economics. The doctrine emphasis the advantages derived due to a fall in

the prices of the commodities. Fall in price leads to rise in the real income of the consumer and this will

definitely raise the level of welfare of the people, the level of economic well being of the people is

higher in those countries. According to Dr. Little, the government should adopt those economic policies

which promote consumers’ surplus. Such policies will certainly help to increase the economic welfare of

the people to the maximum extent.

9. Use in introduction of new products


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If consumers’ surplus is greater in the case of introduction of a new product than the disappearance of

the old product, we can justify the introduction of a new product into the market. This helps the

consumers to maximize their satisfaction.

Thus the concept of consumers’ surplus has great practical application in all most all fields of economic

activities.

Learning objective- 2

Understand the concept of producers’ surplus

Producers’ Surplus

It is parallel concept to consumers’ surplus. Producers’ surplus is owners’ surplus. It may be defined as

the excess or surplus income received by a seller over above the price at which he is willing to sell a

product. It is the different between the actual price at which he is selling and the price at which he is

willing to sell Hence, it arises when the actual price received exceeds the minimum price that the seller

is ready to accept.

Producers’ surplus = what the seller is actually receiving – what the seller is ready to receive. It is the

difference between ex-post and ex-ante income received.

Illustration In Rs.

Units of

commodities sold Price at which actually

sold Price at which ready to

sell

Producers’

surplus in Rs.

1 25 5 20

2 20 5 15

3 15 5 10

4 10 5 05

5 05 5 Nil

Total units sold = 5 Total price received

from 5 units =75-00 Total price expected

from 5 units = 25-00 Producers’ surplus = 75-00

-25-00 = 50-00.

Producers’ = Total receipts – (Price x Quantity)

Symbolically P.S. = TR – (P x Q)

= 75-00 – (5 x 5)


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= 75-00 – 25-00

= 50-00

P.S. = What seller receives – What seller expects.

P.S. = 75-00 – 25-00 = 50-00

(In our example we assume cost price is Rs.5-00and minimum market price is Rs.5-00]

In the diagram,

OM = Actual Price received.

OQ = Actual sales

OM X OQ = OMNQ = Total price received.

OS = Price at which willing to sell

OQ = Supply willing to make

OS x OQ = OSNQ = Price expected to get.

Therefore, P.S. = Price received – price willing to receive = OMNQ – OSNQ = SNM.

Producers’ surplus may appear as profit. In general it is true. It may also take some other forms. For

example, market price of wheat may increase from Rs. 30- 00 to 40-00. Consequently, more land may be

brought under wheat cultivation. Now farmers, who are cultivating and selling wheat, are enjoying

producers’ surplus of Rs. 10-00.on account of increase in wheat price in the market.

Similarly, rise in wheat price may increase the demand for land for wheat cultivation. This leads to

increase in the land price. Hence, landlords as resource owners would earn more rents on land. Thus,


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producers’ surplus takes the form of increased rents on land. Recent increase in the price of cricketers is

another example.


Emergence and application of consumers’ surplus and producers’ surplus

A simple example may be given to show the emergence of both these surpluses

Vivek is a seller and is ready to sell his CD at Rs. 20-00

Vivek now sells the CD at Rs. 30-00.

Producers’ surplus = price received – price ready to charge.30-00 – 20-00 = 10-00

Vinay is ready to pay Rs. 40-00 for the same CD

Vinay now buy the CD at Rs. 30-00

Consumers’ surplus = Price ready to pay – price actually paid.= 40-00 – 30-00 = 10-00.

The concepts of both consumers’ surplus and producers’ surplus can be explained with the help of

demand and supply curves simultaneously.

In the above diagram, price is represented on Y Axis and quantity demanded and supplied on X Axis.

Demand and supply are equal at E. OR is the equilibrium price and OQ is the equilibrium quantity

demanded and supplied. In the diagram. The consumer is ready to pay OD price and he actually pays OR

price. Hence, consumers’ surplus is RDE ie, area A. Generally consumers’ surplus is the area under

demand curve and above the market price line. Hence, the area A is the consumers’ surplus in the

diagram.

The seller is ready to accept the minimum price of OS and sells it at OR price. Hence, producers’ surplus

is SRE, ie, the area B. Producers’ surplus is the area above the supply curve and below the market price

line Hence, the area B is producers’ surplus. Thus, with the help of one diagram we can explain the

emergence of both surpluses.


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Application Of Two Concepts

In any market, if sellers collude with each other, they can raise the price and transfer some of the

consumers’ surplus in to producers’ surplus. In the same way consumers can organize themselves in to

strong groups under certain situations and decrease the price and take away some part of producers’

surplus.

Now sellers can organize against consumers and restrict output and increase the market price. Generally

this can happen when the firms enjoy some amount of monopoly power in the market. If price rises,

quantity demanded falls in accordance with law of demand. Consequently output is restricted. The

volume of consumers’ surplus shrinks. This leads to transfer of consumer’s surplus to producers’ surplus.

As a result of rise in price, producer’s surplus increases. It is to be noted that after rise in price, if the

volume of producers’ surplus is greater than consumers’ surplus, then producers gain.

In a similar manner, buyers can organize together against sellers and capture producers’ surplus. This is

possible where there are a few buyers and many sellers in the market, where buyers can restrict their

purchases and decrease price.

Summary

Consumers’ surplus is the difference between what a consumer is prepared to pay minus what a

consumer actually pays. The volume of consumers’ surplus varies with variations in price. When price

rises, consumers’ surplus falls and vice-versa. In several cases, we come across a situation where in a

consumer would enjoy surplus satisfaction than what he expects. Economists have made successful

attempts to measure the volume of consumers’ surplus in spite of several practical problems. The total

amount of consumers’ surplus is the area below the demand curve and above the price line. The

concept helps in making various types of cost-benefit analysis of public investments which determines

the amount of public welfare. The concept is usefully employed in all most all branches of economic

activities.

Producers’ surplus is a parallel concept to consumers’ surplus. It is the difference between the price

received and the price he is willing to charge. The total amount of producers’ surplus is the area above

the supply curve and below the price line. The volume of producers’ surplus directly varies with

variations in price. Higher the price, higher would be the volume of producers’ surplus and vice-versa.

Depending on market situations, producers try to convert consumers’ surplus in to producers’ surplus

and consumers would try to convert producers’ surplus in to consumers’ surplus.


1. The concept of consumer surplus is based on demand theory by ____.

2. If the price increases there will be ____ in consumer surplus.


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3. _____is used to judge the desirability of public investment of any public projects or

investment

4. The excess burden or net loss in welfare is called ______.

5. The direct or indirect payment by government to producers or consumers to defray part of

the cost of economic activity is called ____.

6. ____ exists when the actual price exceeds the minimum price that the seller is ready to

accept.

Terminal Questions

1. Explain the concept of Consumers surplus with suitable illustration.

2. Discuss practical importance of Consumers surplus.

3. Examine concept of Producers surplus with examples.

4. Explain the emergence of Consumers surplus with their practical application.



1. Marshall

2. Decrease

3. Cost Benefit Analysis

4. Dead weight loss.

5. Subsidies

6. Producer’s surplus


1. Refer unit 9.9.2

2. Refer unit 9.9.3

3. Refer unit 9.9.4

4. Refer unit 9.9.4

Unit-10-Macro Economics And Business Decisions

Learning Objective – 1


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Understand macro economics and various macro economics concepts

Introduction to Macro Economics

Macroeconomics is that branch of economics, which deals with the study of aggregative or

average behavior of the entire economy. In it we study the collective functioning of the whole

economy. It deals with the great aggregates of the economic system rather than with individual

parts of it. It is the study of the entire forest rather than the study of individual trees. Hence, it is

called as “Aggregative Economics.” It splits up the economy into big lumps for the purpose of

the convenience of the study. Hence, it is called as “Lumping Method”. It gives a detailed

description about the performance and achievements of different sectors of the economy like

agriculture, industry, export and import etc In it we study how the entire economy reaches the

position of equilibrium. Hence, it is called as “General Equilibrium Analysis”. It is called as

“Income theory” as it explains how equilibrium level of national income is determined in an

economy. The scope of macro economics covers the following topics.

1. The theory of Income and employment with consumption function, saving and investment

function and trade cycles.

2. The general theory of price level, which includes inflation and deflation.

3. The theory of economic growth, development and planning.

4. The theory of macroeconomic distribution, which includes the study of relative shares of

rent, wages, interest and profits in the national income of a country.

In general we study aggregate demand, aggregate supply, aggregate saving and investment, aggregate

income and expenditure, unemployment and poverty problems etc in macro economics.

Managerial economics is a part of micro economics. It is to be noted that a business unit carry on its

business operations in the midst of the society and not in isolation. It has to meet the requirements of

the members of the society. Hence, the knowledge about macro economic environment is very

essential. Macro economic concepts, principles, and policies greatly influence the decision making

process of a firm. Changes in the level of incomes of the people, their purchasing power, consumption

habits, general price level, business fluctuations, government economic policies like monetary, fiscal,

financial, physical, industrial, labor, import and export, foreign capital and investment etc would

certainly affect the decision-making and forward planning of the firm. Therefore, macro economic

background provides a solid basis for the working of a micro unit.

Learning Objectives:

After studying this unit, you should be able to understand the following

1. Know what macro economics is.

2. Analyze basic macro economic concepts.

3. Define important economic ratios.


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4. Analyze the importance of macro economic environment on decision making of a business unit.

5. Explain the relationship between macro economics and business management.

Basic Macro Economic Concepts

1. Variables

A variable is a symbol or quantity which during a specified time period under consideration, may

assume different values or a set of admissible values. It is something that can take on different values.

It is a changing quantity. There are two types of variables. They are

a. Endogenous variables. In this case, values of a variable are to be determined with in the system.

b. Exogenous variables. In this case, values of a variable are influenced by outside or external

factors or forces.

There are micro economic variable as well as macro economic variables. Microeconomic variables deal

with the study of individual units. Some of the microeconomic variables are demand, supply, price, cost

etc which deals with only individual units.

On the other hand macroeconomic variables deal with aggregates like gross national product, national

income, consumption function, saving function, investment function, general price level, total money

supply and general level of employment or unemployment in the country etc. These variables are

further divided in to two parts.-

a. Stock variable

A stock variable is a quantity measured at a specific point of time. It may be referred to as a certain

amount or quantity at

a specific point of time. For example, we can say that total money supply in India as on 27-2-2008 is Rs

80,000 crores. Stock variable has time reference. In this case, both time and quantity is specified in clear

terms and there is no ambiguity.

b. Flow variable

A flow variable is a quantity which can be measured in terms of specific period of time and not at a

point of time. For example, GNP during the period 2004-05 is worth of Rs. 90,000 crores. It is clear that

goods and services worth of Rs 90,000 crores is produced in India during the period covering 2004-05.

Thus, flow variable has a time dimension.

2. Ratio variables

Economic variables are measured in terms of ratio variables. A ratio variable expresses quantitative

relationship between two different variables at a certain time. For example, average propensity to

save expresses the ratio of total savings to total income. Similarly, average propensity to consume

expresses the relationship between total consumption to total income. Hence,


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These tow examples come under flow ratio. Liquidity ratio shows relationship between liquid assets and

total assets where as Leverage ratio shows value of debts and total assets. Hence,

These two examples come under stock ratio.

1. Functional variables

Functional variables explain the functional relationship between different variables under consideration.

They are further divided in to two kinds. They are-

1. Dependent variable

A variable is dependent if its value varies as a result of variations in the value of some other

independent variables. In short value of one variable depends on the value of another variable or

variables.

b. Independent variable

In this case, the value of one variable will influence the value of another variable. If a change in one

variable cause changes in another variable, it is called as independent variable. An independent

variable cause changes in another variable.

For example, consumption function explains the relationship between changes in the level of

consumption as a result of changes in the level of income of consumers. It indicates how consumption

varies as income changes. It is expressed as C = f [Y] where C refers to consumption and Y implies

Income of consumers. In this case, consumption is dependent variable and income is dependent

variable.

It is to be noted that functional relationship may be related to either two or more variables. In case of

micro analysis, we explain that D = f [P] where demand depends on price of the commodity concerned

only. Similarly, we can explain that economic development, ED = f [C, L, T …..]. This implies that

economic development depends on several factors like capital, labor, technology etc

5. Functions


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Functions suggest that the value of something depends on the value of one or more other things.

There are uncountable numbers of functional relationships in the real world. D = F [P] or S = f [P] at the

micro level and C = f [ Y] or S = f [Y] at the macro level.

6. Constant

A constant is a magnitude or value the quantity of which does not change.

7. Parameter

A parameter is a quantity which when varies affects the value of another variable.

8. Capital and investment

In the ordinary language, the term capital refers to cash or money held by a person. It is measured at a

point of time. But in economics, it has a wider meaning. It is defined as all man-made aids that are used

for further production of wealth. It includes all kinds of producers’ goods, inventory of materials,

machine tools, equipments, instruments, factories, dams, transport and communications etc which are

used for further production of goods and services.

The term investment in the ordinary language refers to financial investment. It means purchase of

stocks shares, bonds debentures etc where there is only transfer of titles or rights from one person to

another. The term investment in economics refers to creation of new capital assets or additions to the

existing stock of productive assets. Creation of income-earning assets is called as investment in

economics. Investment is the change in the capital stock over a period of time. Hence the term capital

and investment are used as synonymous words.

9. Ex-post and Ex-Ante

These are the two Latin phrases. It implies before hand and afterwards. Ex-Ante means anything

planned, anticipated, expected or intended. For example, Ex-Ante saving is an amount that the people

intend to save out of their income. Ex-Post refers to actual or realized value. For example, Ex-Post

saving is the exact amount that the people actually save in a particular time period. These two terms

have greater significance in macro economic forecasts. One has to compare the expected rate of

economic growth in a particular year and the actual achieved growth rate in that year. If the actual

growth rate is more or equal to the expected rate, the government assumes that the various economic

policies are in the right direction. On the other hand, if the actual growth rate is less than expected one,

in that case, the government has to modify its economic policies.

10. Equilibrium and disequilibrium

These are the two terms which are frequently used in economic discussions. It is a position where in

two opposing forces tend to balance with each other so that there will be no further changes. Hence,

it is described as a position of rest in general. But in economics, it has a different meaning. A state of

rest implies that the various quantities used in the economic system remain constant and with the help


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of these constant quantities, the economy continues to churn over. There is movement or activity. But

his movement is regular, smooth, certain and constant. The equilibrium position is free from violent

fluctuations, frequent variations and sudden changes. At the point of equilibrium, an economic unit is

maximizing its benefits or gains. Hence, it is described as the coziest position of an economic unit.

Always there will be a tendency to move towards this equilibrium position.

Disequilibrium on the other hand is a position where in the forces operating in the system is not in

balance. There is imbalance in different forces which are working in the system. Hence, there are

disturbances and disorders in the system.

Generally speaking in microeconomics we make reference to partial equilibrium analysis and in macro

economics general equilibrium analysis. We can explain these two concepts with the help of two simple

examples. When demand for a particular commodity is equal to its supply in the market, equilibrium

price is established at the micro level. Any imbalance between either demand or supply would create

disequilibrium. At macro level, an economy is said to be in equilibrium when aggregate demand for

goods and services is equal to aggregate supply and total investment is equal to total savings. If

aggregate demand is either greater than aggregate supply or aggregate supply is greater than aggregate

demand, it would disturb the equilibrium in the economic system.

11. Economic models

An economic model shows the relationship among different economic variables in a precise manner.

Its purpose is to explain causal relations among different variables in the real world avoiding all kinds of

complexities in order to get a clear picture how an economy operates. It is a method of analysis which

presents an over-simplification of the real world. It is just a precise formal statement of one or more

economic relationships. It is a quantitative hypothesis based on certain assumptions framed to achieve

a set of objectives. An economic model is presented in the form of a statement, logical statement of

economic theory, geometrical form or in mathematical or statistical equations. Any economic model

cannot give a perfect answer to any economic problem. It can give only a rough solution because we

have to make certain assumptions which are not to be found in real world. Hence, it helps in arriving at a

probable conclusion. An economic model is essentially based on some institutional frame work- a free

enterprise economy, a socialist economy or a mixed economy etc.

A simple demand and supply model is prepared to explain the determination of market price in a

microeconomic model. A macro economic model explains relationships between different macro

economic variables and their impact on the working of the economy. Harrod-Domar model of economic

growth is one such example for macro economic model.


1. Inventory, Capital stock are Macro ___variables.

2. National Income and output are Macro ___variables.

3. Investment is the ____ in the capital stock over a period of time.

4. _______ means planned and desired whereas ____ means actual or realised value.


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5. A variable is __________ if its value varies as a result of variatious in the value if some

other independent variable.


Learn various macro economies ratios

Macro Economic Ratios

In this section, let us try to understand some of the important macro economic ratios. There are several

macro economic ratios and an attempt is made to explain twelve such macro economic ratios. The

knowledge of these macro economic ratios is indispensable for taking micro economic decisions by a

business firm.

Consumption Income Ratio

Y= C + S. Out of a given income, people can either spend or save or they can only consume without

saving even a small part of income. Hence, C = Y – S.

The consumption income ratio explains the relationship between two variables, ie, the amount of

income and amount of consumption. In other words, it tells us about the percentage of consumption

out of a given level of income. It can be expressed as C = f [Y] where C = consumption, Y = income and f

= function. Consumption is an increasing function of income. Higher the income, higher would be the

consumption and vice-versa. There is a direct relationship between the two. For example, Out of Rs.

100-00 a person can consume Rs. 80-00 and save Rs 20-00. In this case, the consumption income ratio is

1:08. This ratio helps a businessman to forecast his sales in the market.

2. Saving income ratio

Excess of income over expenditure is saving. The saving function can be easily derived by subtracting or

spending from income. Hence, S = Y – C where S= saving, Y = income and f = function. It is a function of

income. S = f [Y]. It implies that there is a direct relationship between the two. Higher the income higher

would be the savings and vice-versa. The saving-income ratio indicates the amount of savings made

out of a given level of income. In the above example, saving income ratio is 1:02. The consumption

income ratio and saving income ratio would enable a businessman to plan his production schedule and

helps in his sales forecasts.

3. Capital output ratio

There is a close relationship between capital investment and income-growth in any economy.

Capital is regarded as the life-blood of all economic activities and as such it constitutes a major

determinant of economic growth rate in an economy. The volume of investment generally

determines the rate of growth in the real income of the people in an economy.


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The concept of capital output ratio explains the relationship between the value of capital

investment and the value of output. It is a ratio of increase in output or real income to an increase in capital. According to Prof. Rosen, the COR may be defined as “the relationship of

investment in a given economy or industry for a given time period to the output of that economy

or industry for a similar time period”. It refers to the amount of capital required to produce a unit

of output. When we say that COR is 4:1, it implies that a capital investment of Rs. 4-00 is

required to produce one unit of output. It is to be noted that COR would differ from one sector to

another and even from one industry to another. Generally, it would be higher in case of capital

goods industries and industries using capital intensive techniques of production and lower in case

of consumer goods industries and industries using labor intensive techniques of production. COR

depends on several factors However, a decrease in COR is an indication of economic efficiency

and progress of an economy

4. Capital labor ratio

This ratio indicates the proportion of two factor inputs. It tells us the ratio between the numbers of

laborers required to a given amount of capital invested in any business. The knowledge of this ratio is

very much needed to work out the least cost combination by substituting one factor input to another.

This ratio can be expressed as

5. Output-labor ratio

The term productivity in general is defined as a ratio of what comes out of a business to what goes in to

the business, ie, it is the ratio of ‘outcome’ to the ‘efforts’ of the business. Hence, productivity would

mean the value of output divided by the value of inputs employed. There are different kinds of

productivity ratios.

Output labor ratio expresses the relationship between the quantity of output produced and the

number of laborers employed for a specific time period. It indicates productivity of labor. It can be

obtained from dividing total output by the number of labourerers employed. Hence,

This ratio widely varies from industry to industry. Labor productivity depends on a number of factors like

capital endowment of labor, quality of labor, organization of work, hours of work, incentives to work,

methods of payments, industrial climate, quality of management and quality of raw materials used etc.

Increase in labor productivity implies increase of the ratio of output to labor. The knowledge of this ratio

would help the management of an organization to the right types of labor in right quantity.


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6. Input- Output Ratio

It explains the relationship between two variables, ie, inputs and outputs. Input-output ratio

indicates the quantity of inputs employed and the quantity of outputs obtained. It is also

called as production function in economics. Production is purely physical in nature and as such

the ratio between inputs and outputs is determined by technology, availability of equipments,

labor, materials etc. It can be expressed in the form of a mathematical equation.-

Q = f [ L,N,K --------etc] where Q = quantity of output per unit of time LNK etc are different

factor inputs like land, capital, labor etc which are used in the production process. Thus, the rate

of output is a function of the factor inputs LNK etc, employed by the firm per unit of time. The

knowledge of production function would help a producer to work out the most ideal factor

combinations so as to maximize output and minimize cost.

7. Value added output ratio.

Value added output is the difference between the value of output produced and the value of

inputs employed. In other words, it is a ratio of increase in the quantity of inputs employed

and the corresponding increase in output obtained. It is very much necessary to find out the

difference between the value of inputs used and output obtained. This will help in taking decision

whether to increase the employment of additional units of factor inputs in the production process.

8. Cash Reserve Ratio.

A commercial bank mobilizes deposits from the general public. The entire amount of deposits is

not kept in the form of cash. Out of his experience, a banker knows that all depositors will not

withdraw their entire deposits on the same day at the same time. Hence, he keeps only a fraction

of total deposits in the form of liquid cash to honor the cheques drawn on demand deposit by the

customers. The remaining excess deposits are used for lending and investment purposes by the

bank. Thus, each commercial bank with a view to make profits follows a customary cash reserve

ratio for the sake of liquidity and safety. The percentage of total deposits which the bank is

required to hold in the form of cash reserves for meeting the depositors’ demand for cash is

called cash reserve ratio. Thus, CRR indicates the ratio between the liquid cash with that of

total deposits of the bank. For example, if CRR is 20%, in that case for every Rs.100-00 deposits

collected, the bank has to keep 20-00 as cash reserves requirement.

9. Cash income ratio

A bank is a commercial institution based on business principles. Its main objective is to make

profits. This depends on its portfolio management. A bank has to keep adequate amount of cash

in order to meet the requirements of its customers. How much deposits it will keep in the form of


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liquid cash and how much money it will lend and invest on various assets will depend on its

CRR. This ratio helps the banker to know his income earning capacity during a financial year.

The cash – income ratio tells us the amount of cash held by a bank in liquid form and the

percentage of income earned during an accounting year through its investments. This ratio

gives us information about the income –earning capacity of an institution during an accounting

year.

10. Labor’s share of income

Production is the result of combined and cooperative efforts put in by all the factors of

production in the production process. All factors of production which are involved in this process

of production are entitled to enjoy their respective rewards in the form of rent, wages, interest

and profits. If we add all factor incomes, then we get national income at factor cost. Hence, NI at

factor cost = a sum of total rent + total wages + total interest + total profits. For example, if

national income is Rs. 1000-00, in that case, the share of rent is Rs. 200-00, the share of wages is

Rs. 300-00, the share of capital is Rs. 150-00 and the share of profit is Rs. 350-00. The labor’s

share of income indicates the percentage of income earned by labourerers in the form of wages out of total national income is called as labor’s share of income. In the above example,

the share of laborers’ income is Rs. 300-00. This ratio gives information about the contribution

made by workers in the generation of total national income of the country. Also it indicates level

of wages and their living standards

11. Capital’s share of income.

Capital is a very powerful and important input in the production process. Capital is described as

the life-blood of all economic activities. Without adequate capital no economic activity can be

undertaken today. Capital as a factor of production is earning interest as its income in the total

national income generation. The capital’s share of income indicates the percentage of income

earned by capital in the form of interest out of total national income is called as capital’s

share of income. In the above example, the share of capital in total income is Rs. 150-00. This

ratio gives information about the contribution made by capital in the generation of total national

income of the country. Also it indicates the level of interest rate and the ability of capitalists to

earn their income.

12. Land’s share of income

Land is one of the primary factors of production. It is a free gift of nature. It is an immovable

factor input. The landlord supply this factor input and earns his income in the form of rent.

Land’s share of income indicates the percentage of income earned by the landlord in the form of rent out of total national income is called as land’s share of income. In the above

example, the share of land’s income is Rs. 200-00.This ratio gives information about the

contribution made by landlord in the generation of total national income of the country. Also it

indicates the level of rent and the ability of landlords to earn their income.



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Knowledge of index number and its significance

Index Number

The days of barter are gone. We are living in a monetary economy where every thing is

measured in terms of money. It is to be noted that money by its substance is quite value less or

worthless. Its value to its possessor arises out of its acceptability as a means of payment. Its

value to its possessors lies in its capacity to purchase other goods and services which are useful

in themselves. Thus, the value of money, the purchasing power of money is derivative.

In a monetary economy, the exchange value of everything is measured by its price expressed in

terms of money. The purchasing power of money depends on the level of prices of goods and

services to be purchased. The lower the price level, the greater would be the value of money and

the higher the level of prices, the lower would be the value of money. There is an inverse

relationship between the two. The value of money is thus inversely related with the general price

level. It is to be noted that prices of all goods and services do not change in a uniform manner.

Price of some goods may rise while price of some other goods may fall. In order to bring an

element of uniformity to price change, the concept of general price level is used. Index number

explains this concept.

The value of everything is measured in terms of money because money acts as a measuring rod

or measure of value. But the value of money cannot be measured in terms of money itself.

Hence, economists have developed index numbers to measure the changes in the value of money

over a period of time.

When a number of commodities and their prices at two different periods are arranged in a

tabular form it is called as an index number. Index number is a statistical device by which

changes in prices of the same articles at different periods are calculated and computed. It is

to be remembered that index number helps us to measure only how much value of money has

changed between two different periods of time and not the value money itself.

There are different kinds of index numbers. Some of them are wholesale price index, consumer

or retail price index, cost of living index, wage index numbers and industrial index numbers etc.

Out of them the most important ones are WPI and CPI.

a. Consumer’s price index

In this case, we include the prices of a basket of consumption goods and services. Generally

speaking, goods and services which are commonly consumed are included in this basket. The

goods and services consumed by consumers widely differ from group to group and place to

place. It also varies as tastes and preferences of consumers change. In order to measure the

changes in prices of consumer goods and services, we take in to account of prices existing at the

base year and the prices in the current year. The formula to calculate CPI is as follows-


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The consumption basket data comes from family budget surveys conducted from time to time

and price data are taken from retail outlets. The base year is changed every few years in order to

take in to account of changes in consumption habits, prices etc in the market. Such updating is

required so that the usefulness is not lost.

In a simple model index number, we have assumed a total weight age of 20 units and each commodity is

given a certain weight according to its influence or importance. To get the index, the actual price in the

base year is reduced to 100, which is multiplied by the approximate weight. For example, the price of

rice in the base year is Rs.50=00 per quintal. The weight assigned to rice is 8 so the index for 1960 will be

equivalent to 100 x 8= 800. Similarly the index numbers for other items is calculated. The simple

arithmetic average is used to calculate the index. In 1976, the price of rice is Rs.125=00 i.e. two and half

times the 1960 price, if the 1960 price is 100, then the 1976 price is equal to Rs.250=00. This is

multiplied by the weight to get the index for 1976.

Between 1960 and 1976, the price level has risen by 2.2 times. To state the same thing in a different

manner, what Rs.100 could buy in 1960, Rs 220 can buy in 1976. In 1976 the purchasing power of money

or the value of money has fallen to 45.5% or (100/200 X100) as compared to 1960.

Thus, the fluctuations in prices or the degrees of inflation are measured with the help of index number

of prices.

A MODEL OF WEIGHTED PRICE INDEX NUMBER

Base Year 1960 current Year 1976

Articles Weights Price Index Price % Change Index

Rice 8 50.00 per quintal 100 X 8 =800 125.00 per quintal 2.5 250 x 8 2000

Wheat 5 30.00 per quintal 100 X 5 =500 75.00 per quintal 2.5 250 X 5 1250

Sugar 3 100.00 per quintal 100 X 3 =300 150.00 per quintal 1.5 150 X 3 450

Cloth 2 2.50 per meter 100 X 2 =200 3.75 per meter 1.5 150 X 2 300

Vanaspathi 1 3.00 per Kg 100 X 1 =100 6.00 per Kg 2.0 200 X 1 200

Cigarettes 1 0.40 per packet 100 X 1 =100 0.08 per packet 2.0 200 x 1 200

Total 20

2000/100

= 20 20

4400/

220


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In 1960 – G P L

– 100

In 1976 – G P L

– 220

2.2 times

increased

100/220 X 100 =

45.5 %

Value of money has fallen by 45.5%

between 1960-1976

1. Whole sale price index [WPI]

These index numbers are constructed on the basis of the whole sale prices of certain important

commodities. The items included in WPI are totally different from those included in CPI. The

items included are fertilizers, industrial raw materials, minerals, semi finished goods,

machineries etc. It is an index of prices paid by producers for their inputs. Whole sale prices are

published by various government agencies at regular intervals and are collected for the purpose

of calculating variations in their prices for different periods. The method of calculating WPI is

same as that of the CPI.

Practical Importance Of Index Numbers

1. They help us to measure the level of changes in prices and the value of money over a

period of time.

2. They help us to measure the degree of inflation and deflation enable the government to

come out with suitable price stabilization policies.

3. They help us to know the extent of changes in cost of living of different sections of

people and thus help the government to adjust the wages and salaries of workers and

avoid strikes and lockouts.

4. They help us to know the purchasing power of two currencies and thus help in the

determination of exchange rates of the currencies of two countries.

5. They also help us to know the economic progress achieved in different sectors of the economy

through economic planning.


Knowledge of national income deflators and its application

National Income Deflators

National income of a country can be either calculated in terms of Nominal GNP or Real GNP.

If we calculate GNP at current market prices, it is called as Nominal GNP and if we

measure GNP at constant prices, ie, prices prevailing at the base year, it is described as

Real GNP. In economics we give importance to Real GNP rather than Nominal GNP. This is


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because, GNP at current prices depicts a misleading picture of economic performance when

prices are continuously rising or falling. For example, if prices are rising and the gross national

output is remaining the same, in that case, the nominal GNP represents an inflated estimate of the

national income and creates false sense of economic growth in the country. In order to avoid this

kind of misleading estimates of national income, the economists use a simple adjustment factor

called GNP Deflator or National Income Deflator to eliminate the effect of rising prices on the

GNP and to work out Real GNP at the price level of the base year.

The GNP deflator acts as an adjustment factor which is used to convert nominal GNP into Real GNP. The GNP Deflator is the ratio of price index number[PIN] of a chosen year to the

price index number of the base year[ PIN of the base year = 100]. Hence,

We can calculate the Real GNP by dividing nominal GNP by the GNP Deflator. This can be

expresses in the following formula.

Where PIN cy is the price index number of the chosen year.

Application of GNP Deflator

In order to estimate the Real GNP for the year 2005 and 2006, we can make use of GNP

Deflator.

Nominal GNP for the year 2005-06 = Rs. 15, 00,000

WPI for the same year = 120

Base year PIN = 100.

Given the data, GNP Deflator for the year 2005-06


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1.2 is the GNP Deflator for the 2005-06. We can now calculate real GNP for 2005-06 as follows

Real GNP for 2005-06 = Rs 15, 00,000 = Rs 12,50,000

1.2

Deflator can also be calculated for GDP, NDP or NNP etc.


1. ________ the statistical device, which indicates relative changes of a variable over a

period of time.

2. A flow variable is a quantity which can be measured in terms of specific period of time

and not at a __________.

3. ________ is an index of prices paid by producers for their inputs.

4. ________ tells us the percentage of consumption out of a given level of income.

5. When a number of commodities and their prices at two different periods are arranged in a

tabular form, it is called as ______________.

Summary

Unit 10 helps us to understand various macro economic concepts. The knowledge of these

fundamental concepts is very essential to take several practical decisions by a business unit. A

business unit may be a micro unit but macro economic environment is of great importance in the

present day competitive world. Macro economic concepts provide the working knowledge to

business managers. Apart from them, 12 macro economic ratios help them to understand the

relationship between different macro economic variables and their application in day to day

business. Index numbers help us to measure the degree of price changes or inflation and deflation

and points out the different price stabilization policies to be taken by the government in advance.

National income deflator helps us to know the actual value of either GDP or GNP during a given

period of time. All these concepts help in business planning and business forecasting and take

appropriate decisions well in advance.

Terminal Questions

1. Given a brief note on stock and ratio variables.


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2. Explain the concepts of function, constant, export and ex-anti and equilibrium and

disequilibrium.

3. Discuss any four macro economic ratios.

4. Explain either consumer’s weighted price index or whole sale price index with suitable

illustration.

5. Examine the concepts national income deflator with its application.



1. Stock

2. Flow

3. Change

4. Ex-ante; Ex-post

5. Dependent


1. Index number

2. Point of time.

3. Wholesale price Index

4. Consumption income ratio

5. Index number


1. Refer to unit 10.2 .



4. Refer to unit 10.3.2 a & b


Unit 11 Consumption Function And Investment Function

Introduction


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An increase in income leads to an increase in the level of consumption. But the increase in consumption

is not proportionate to the increase in the level of income. Consumption function explains the functional

relationship that exists between income and the level of consumption. Psychological law of

consumption, the average propensity to consume and the marginal propensity to consume help us to

understand the community behaviour.

Investment function explains the relationship between aggregate income and aggregate investment.

Various types of investment like gross investment and net investment, public investment and private

investment, autonomous investment and induced investment, marginal efficiency of capital and the rate

of interest as the determinants of investment give us an insight into the nature of investment activity.

Multiplier is the ratio of change in income to a change in investment. Accelerator explains the increase

in the level of investment as a consequence upon the increase in the level of income and consumption.


Understand consumption function, psychological law of consumption, average and marginal

propensity to consume

Meaning of Consumption Function

The consumption function indicates the relationship between consumption and income. Consumption is

an increasing function of income. Lord Keynes in his theory of Income and Employment has given a very

significant place to this concept. According to him, the level of national output, income and employment

directly depends on effective demand in an economy. Higher the level of effective demand, higher

would be the level of income and employment and vice-versa. Effective demand consists of

consumption expenditure and investment expenditure. Consumption expenditure depends on the size

of income and the consumers’ propensity to consume and investment expenditure depends on the

marginal efficiency of capital and the rate of interest. Keynes suggested a high propensity to consume to

tackle the problem of unemployment in an economy and one of the remedial measures suggested to

overcome unemployment is to increase the propensity to consume. According to Prof. Hanson, “This

concept is Keynes’s greatest contribution to the economist’s kit of tools in our generation”. It is also

called propensity to consume. It does not mean a mere desire to consume, but the actual consumption

that takes place out of varying levels of income. To understand the concept clearly it is necessary to

distinguish between consumption and consumption function. The term consumption refers to a

particular amount of consumption out of a given amount of income. On the other hand, Consumption

function refers to different amounts of consumption at different levels of income. It explains a

functional relationship between changes in the level of consumption as a result of changes in the levels

of income. It indicates how consumption varies as income changes. It is expressed as C = f [Y] If

consumption is represented by C and Income by Y then, the propensity to consume is C= f (Y). It implies

that consumption is an increasing function of income. There is a direct relationship between the two.

Higher the income, higher would be the consumption and vice-versa.

Income (y) in Rs crores Consumption ( c )

10 10


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15 14

20 18

25 22

30 26

The table shows consumption as an increasing function of income, both the variables, Y and C, move in

the same direction. Further consumption is shown to change by Rs.4 crores for each change of Rs.5

crores in income. It is assumed that in the short run the propensity to consume will remain stable.

Increase in consumption is less than proportionate to the increase in income.

When we represent this on a diagram we get a curve rising upwards but less steeply, this shows that

the increase in consumption is smaller than the increase in income.

In the diagram, the Y axis measures consumption and the X axis real income. The CC curve

represents the consumption function.

Psychological Law Of Consumption

In the words of Keynes “Men are disposed, as a rule and on the average, to increase their consumption

as their income increases, but not by as much as the increase in their incomes”. In the short period, as

the level of income of the people remains the same, the level of consumption also remains the same.

Generally it is observed that when income increases, consumption also increases but by a less

proportion than the increase in income. Suppose the total income of the community is Rs 10 crore and

the consumption expenditure is also Rs 10 crore. In that case, there is no saving and investment. Further

the income increases to Rs.15 crore. Then, consumption also increases, but not to the extent of Rs15

crore. It may increase to Rs14 crore and Rs 1 crore constitutes the savings. This savings create a gap

between Income and Consumption. This gap is in conformity with Keynes Psychological law of

consumption, which states that, when aggregate income increases, consumption expenditure shall

also increase but by a somewhat smaller amount”. This law tells us that people fail to spend on


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consumption the full amount of increment in income. As income increases, the wants of the people get

satisfied and as such when income increases they save more than what they spend. This law may be

considered as a rough indication of the actual macro-behavior of consumers in the short-run. This is the

fundamental principle upon which the Keynesian consumption function is based.

It is based upon his observations and conclusion derived from the study of consumption function.

This law is also called the fundamental law of consumption. It consists of three inter related

propositions: –

1. When the aggregate income increases, expenditure on consumption will also increase but

by a smaller amount.

2. The increased income is distributed over both spending and saving.

3. As income increases, both consumption spending and saving will go up.

These three prepositions form Keynes psychological law of consumption.

As consumption expenditure progressively diminishes when income increases, a gap between

income and expenditure arises. This tendency is so deep rooted in people’s habits, customs, and

the psychological set up that it is difficult to change in the short run. Hence, it is impossible to

raise the propensity to consume of the people so as to increase the national output, income and

employment. Increasing the volume of investment in an economy can only fill up the gap

between income and Consumption.

The Average Propensity to consume and The Marginal Propensity to Consume .

1. The Average Propensity to consume

The relationship between income and consumption is measured by the average and marginal propensity

to consume. The APC explains the relationship between total consumption and total income. At a

certain period of time, it indicates the ratio of aggregate consumption expenditure to aggregate income.

Thus, it is the ratio of consumption to income and is expressed as C/Y.

Suppose the income of the community is Rs.10, 000 crore and consumption expenditure is Rs. 8,000

crore, then the APC is 8000/10,000 = 80% or 0.8. Thus, we can derive APC by dividing consumption

expenditure by the total income.

2. Marginal Propensity to consume


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MPC may be defined as the incremental change in consumption as a result of a given increment in

income. It refers to the ratio of the change in aggregate consumption to the change in the level of

aggregate income. It may be derived by dividing an increment in consumption by an increment in

income. Symbolically

Suppose total income increases from Rs.10,000 crore to Rs. 20,000 crore and total

consumption increases from Rs8000 crore to Rs 15,000 crore, then,

Technical characteristics of MPC

1 The value of MPC is always positive but less than one.

This means that when income increases, the whole income is not spent on consumption.

Similarly, when income declines, consumption expenditure does not decline in the same

proportion. Consumption expenditure never becomes zero.

2. MPC is greater than zero.

It is always positive.

This means that an increase in income will lead to an increase in consumption. MPC cannot

be negative.

3. MPC goes down as income increases.

4. MPC may rise, fall or remain constant, depending on many factors, both subjective and objective.

5. MPC of the poor is greater than that of the rich.

6. In the short-run MPC is stable.

The concept of MPC

throws light on the possible division of additional income between consumption and saving.

It also tells us how the extra income will be divided in the Keynesian system. Saving, in the

ultimate analysis is equal to investment. In our example, MPC is 70% and as such the MPS must

be30%. The reason is that the income of a community is divided between saving and spending.

The sum of MPC and MPS equals 1.


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Relationship Between MPC And APC

The Table showing the Relationship between APC & MPC

Rs. In crores.

Income Consumption APC MPC

100 100 100 % —

200 180 90 % 80 %

300 240 80 % 60 %

400 280 70 % 40 %

500 300 60 % 20 %

1. Generally speaking, when income increases, APC as well as MPC declines but the

decline in

MPC is greater than APC.

1. As income goes down, MPC falls and APC also falls but at a slower rate.

2. If MPC is rising, the APC will also be rising although at a slower rate.

3. When MPC is constant, APC may also remain constant.

4. APC, in some cases, may be equal to MPC. It is quite possible, if 50% of increased

income is consumed and the remaining 50% is saved.

5. MPC is generally high in poor countries when compared to rich countries. In rich

countries the basic requirements are satisfied and therefore, the MPC would be less and

MPS would be high. But in poor countries majority of the people have to satisfy their

basic needs and hence as income increases the MPC also increases while MPS is

generally low.

Factors determining consumption function

Broadly speaking, there are two factors, which influence consumption function in the long

run. They are 1. Subjective Factors. 2. Objective factors.

1. Subjective factors: Subjective factors basically underlie

and determine the form of the consumption; the subjective factors are internal or endogenous

in nature. They mainly depend upon the personal decisions taken by the people. Keynes

has listed eight main motives, which compel people to refrain from current spending. They

are the motives of precaution, foresight, calculation, improvement, independence,

enterprise, pride and avarice.


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In addition to these factors, he has also added a list of motives, which leads to

consumption. “We could also draw up a corresponding list of motives to consumption such

as enjoyment, shortsightedness, generosity, miscalculation, ostentation and

extravagance” Keynes.

II. Objective factors

Objective factors are those, which depends on merits and facts. In this case personal

factors will not come into picture. The following are some of the important objective factors,

which influence consumption.

1. Distribution of national income, 2. Fiscal Policy, 3. Money income, 4. Real income,5. Price

and wage level, 6.Changes in tastes and fashion,7. Changes in expectations, 8. Windfall

(Sudden) gains and losses, 9. The level of consumer Indebtedness,10.Attitude towards

thrift11.Liquid assets,12. Social and life insurances,13. Rate of interest,14. Business policies of

corporations, 15emonstration effect,16. Changes in expectations, and 17 Installment buying, etc.

The objective factors generally remain unchanged in the short period. Thus, propensity to

consume in the short period is generally stable. It is because of this, Keynes places his reliance

on investment for the purpose of increasing employment during depression.

Importance Of Consumption Function

It has got great theoretical as well as practical importance. All most all countries of the world

aim at removing unemployment raise their national income and enjoy prosperity. For this

purpose, a policy of planned economic development is essential. In the formulation of this policy

consumption function plays a very important role.

1. It invalidates Say’s law of markets.

Say’ law of markets which is the fundamental basis of classical theory of income and

employment, states that” Supply creates its own demand”. As a result, there is no possibility of

over production and unemployment. Consumption function tells us that the entire increase in

additional income is not spent on consumption goods. Hence, according to Keynes, supply

instead of creating its own demand very often exceeds it and creates a glut of goods leading

directly to over production and mass unemployment.

2. It highlights the importance of investment in employment theory.

According to Keynes, in order to increase the volume of employment, both consumption and

investment must be stepped up. But consumption function in the short run remains more or less

constant and as such it may be taken as given. Hence, investment plays a crucial role in

determining the level of employment.


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3. It helps to explain the turning points of the business cycle.

During the boom period, though income increases, consumption expenditure fails to match the

increased incomes. Hence, saving increases-demand declines-and ultimately the slump develops.

Similarly, during the period of slump, income contracts, people fail to reduce their expenditure

on consumption to the full extent of the decrease in incomes. This tendency ultimately leads to

boom.

4. It helps to explain the declining tendency of MEC

In rich advanced nations, the MPC is less than one. Hence, MEC shows a declining trend. This is

because as income increases, expenditure- falls-saving rises-demand-declines-production moves

in the downward direction- profits fall leading to a decline in MEC. Hence, investment declines

and economic growth declines.

5. It helps to explain the concept of secular stagnation

Generally speaking, the MPC is low and MPS is high in most of the industrialized nations. The

gap between income and consumption continues to raise necessitating increase in investment. As

propensity to consume is stable, propensity to save also tends to be stable. On the other hand, it

becomes less and less with the lapse of time. The economy may sooner or latter reach a stage

where it finds itself unable to utilize fully and effectively its savings for the task of promoting

full employment. Keynes calls such a situation as”Secular Stagnation”.

6. It helps to find out the value of Multiplier

The value of multiplier is derived from consumption function.

Since the MPC is less than unity, the increase in national income is not in proportion to

investment. The magnifying effect of multiplier declines due to fall in consumption expenditure

in an economy.

7. It helps to explain the concept of under employment equilibrium.

As MPC is less than one, the consumers fail to spend on consumption the full increased income.

Effective demand becomes inadequate to bring about full employment equilibrium. Thus, the

economy remains at under employment equilibrium.

1. It upholds the state intervention.


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Since over production and unemployment are possible owing to the deficiency of consumption,

the economy cannot be a self-adjusting system by itself. Hence, state intervention is a must.

Thus, consumption function helps us to analyze the process of income generation, expansion in

employment opportunities, need for the state intervention and a very high level of investment to

maintain the national income and employment.


Have thorough knowledge of investment function, various types of investment and the

determinants of investment

11.2. Investment Function

Investment is the second important component of effective demand. In Keynesian economics, the term

investment has a different meaning. In the ordinary language, it refers to financial investment. It

means purchase of stocks, shares, debentures, bonds etc. In this case, there is only transfer of rights or

titles from one person to another. It is an investment by one and disinvestment by another and as such

the value transaction mutually cancels out each other. They do not add anything to the total stock of

capital of the nation.

Investment, according to Keynes, refers to real investment. It implies creation of new capital assets or

additions to the existing stock of productive assets. It refers to that part of the aggregate income,

which is used for the creation of new structures, new capital equipments, machines etc that help in

the production of final goods and services in an economy. Creation of income – earning assets is called

investment. Thus, investment must generate income in the economy. In the words of Joan Robinson,

“By investment, is meant an addition to capital, such investment occurs when a new house is built or a

new factory is built. Investment means making an addition to the stock of goods in existence”. These

activities necessitate the employment of more labor and thus result in an increase in national income

and employment. Investment is not a stock but a flow, a variable because it highlights on the additions

to the existing stock of capital. The productive ability of an economy is measured in terms of its stock of

capital and its capacity to add to the existing stock of capital. Hence, it is a crucial factor in the economic

development of any nation.

Types Of Investment

Keynes speaks of 5 types of investment.

1. Private Investment.

It is made by private entrepreneurs on the purchase of different capital assets like machinery, plants,

construction of houses and factories, offices, shops, etc. It is influenced by MEC and interest rate. It is


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profit – elastic. Profit motive is the basis for private investment. Private entrepreneurs would take up

only those projects, which yield quick results and generally have small gestation period.

2. Public investment.

It is undertaken by the public authorities like Central, State and Local authorities. It is made on

building up of infrastructure of the economy, public utilities and on social goods. For example

expenditure on basic industries, defense industries, construction of multi purpose river valley projects,

etc. In this case the basic criterion and motto is social net gain, social welfare and not profit motive.

The principle of maximum social advantage would govern public expenditure. It is influenced by social

and political considerations also.

3. Foreign Investment.

It consists of excess of exports over the imports of a country. It depends upon many factors

such as propensity to export of a given country, foreigner’s capacity to import, prices of exports

and imports, state trading and other factors.

1. Induced investment

It is another name for private investment. Investment, which varies with the changes in the

level of national income, is called induced investment. When national income increases, the

aggregate demand and level of consumption of the community also increases. In order to meet

this increased demand, investment has to be stepped up in capital goods sector which finally

leads to increase in the production of consumption goods Therefore, we can say that induced

investment is income –elastic i.e., it increases as income increases and vice-versa.

Thus, it is sensitive to changes in income and is governed by profit – motive. The shape of the

induced investment curve has been shown as rising upwards to the right. This means that as

income increases, investment also increases and vice-versa.


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5. Autonomous Investment

It is another name for public investment. The investment, which is independent of the level of

income, is called as autonomous investment. Such investments do not vary with the level of

income. Therefore it is called income-inelastic. It does not depend on changes in the level of

income, consumption, rate of interest or expected profit.

Autonomous investment depends upon population growth, technological progress, discovery of

new resources etc for example expenditure on public buildings, transport and communications,

defense, public utilities, water supply, generation of electricity etc are considered as autonomous

investment. It is guided by social welfare rather than profit motive.

The investment curve is perfectly elastic. And as such it indicates that though income changes,

investment more or less remains constant.

There are a few other concepts of investment. They are as follows

1. Gross Investment:

Gross investment refers to the total real investment or an addition to capital stock of the country.

2. Replacement Investment: A part of gross investment that is used for replacing the old capital

equipments is called replacement investment.

3. Net investment: The net investment is equal to the gross investment minus replacement

investment. Hence, Net Investment = Gross investment – capital consumption or replacement

investment.


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4.

Ex-ante investment: The investment that is intended or expected or planned is known as ex-ante

investment.

5. Ex-post investment: The actual or realized investment is known as ex-post investment.

Determinants Of Investment

Investment decisions taken by the entrepreneurs depend upon a number of factors like interest

rate, level of uncertainty,

political environment, rate of growth of population, level of existing stock of capital, the

necessity of new products, investor’s level of income, level of inventions and innovations, level

of Consumer’s demand, availability of capital and liquid assets of the investors, government

policy etc.

It is necessary to note that investment is more volatile and unpredictable. It is highly unstable

in the short run because the factors determining it are highly complex and uncertain in their

nature. The above-mentioned factors no doubt generally affect the volume of investment.

However, the most important inducement to invest is the consideration of the profit. The

profitability of investment depends mainly on two factors – 1. Marginal Efficiency of capital

(MEC) and 2. Interest Rate (IR). It relates to the cost-benefit analysis. The businessman while

investing capital has to calculate the cost of borrowing and the expected rate of profits from it.

Marginal Effeciency Of Capital And Business Expectations

Marginal Efficiency of Capital

It refers to productivity of capital. It may be defined as the highest rate of return over cost accruing

from an additional unit of capital asset. Also it refers to the yield expected from a new unit of capital.

The MEC in its turn depends on two important factors.

1. Prospective yield from the capital asset and

2. The supply price of the capital asset.

The MEC is the ratio of these two factors.

The prospective yield of a capital asset means the total net returns expected from the asset over its lifetime. After deducting the variable costs like cost of raw materials, wages, etc from

the marginal revenue productivity of capital, an investor can estimate the prospective income


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(expected annual returns and not the actual returns) from the capital asset. Along with it he also

has to consider the supply price or replacement cost of the capital asset.

Supply price of a capital asset is the cost of producing a brand new asset of that kind, not

the supply price of an existing asset. It is the actual amount of money spent by an investor

while purchasing new machinery or erecting a new factory.

The MEC of a particular type of asset means what an investor expects to earn from an additional unit of

it compared with what it costs him. To be more specific, MEC is the rate of discount, which will make the

present value of the capital assets equal to their future value (prospective yield) in their lifetime. Supply

price = discounted prospective yield.

The MEC can be calculated with the help of the following formula.

In the above formula Cr represents Supply price or replacement cost of the new capital asset. Q1,

Q2, Q3 indicate the prospective yields in the various years 1 2 3 … and n. represents the rate of

discount which will make the present value of the series of the annual returns just equal to the

supply price of capital asset. Thus, r

denotes the rate of discount or MEC.

We can illustrate the meaning of MEC as a rate of discount by means of a simple arithmetical

example. Suppose, the supply price of a capital asset is Rs.3000/- and the asset will become

useless after two years. Further suppose that capital asset is expected to yield Rs.1100/- at the

end of one year and Rs.2420/- at the end of 2 years. Now, it is obvious that the rate of discount of

10% will equate the future yields of the asset with its current supply price. At 10% discount rate

the present value of Rs1100/- discounted for one year plus Rs.2420/- discounted for 2 years

amounts to an aggregate sum of Rs.3000/- which is as pointed out above the supply price of the

capital asset. The above-mentioned formula can be used to explain the same point.

In this case, the discounted prospective yield is equal to the current supply price of the capital

asset. If the expected rate of yield is greater than the supply price, then only it becomes profitable

to invest and otherwise not. The volume of induced investment depends on MEC and IR. It is

necessary to note that –


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When MEC >>>> IR, the effect on investment is favorable.

When MEC <<<< IR, the effect on investment is adverse.

When MEC = IR, the effect on investment is neutral.

Generally speaking, the MEC of a capital falls as investment increase. We can give the following

reasons for this.

1. The prospective yields of the asset will fall as more and more units of it are produced.

This happens because as more assets are produced, they will compete with each other to

meet the demand for the product and consequently, their general earnings will decline.

2. The operation of the law of diminishing marginal returns.

3. Higher investments create higher demand for capital assets leading to an increase in supply

price of capital assets. Consequently, the total production cost rises. Thus, MEC declines with an

increase in investment either as a result of decreasing prospective yield or increasing supply

price of capital asset.

4. Higher investment results in higher production, reduction in per unit cost, lower price for

the products and lower earnings from the sales.

Thus, the MEC falls as investment increases because costs go up and earnings fall. The fall in

MEC will be different at different levels of investment. The MEC curve slope downwards from

left to right. This tendency can be explained with the help of the following example.

The IR in % p.a Volume of investment in Crores MEC of capital in % p.a

13% 5000 13%

11% 7000 11%

9% 9000 9%

7% 11000 7%

5% 13000 5%

3% 15000 3%

On the OX axis, we represent different amounts of investment and on OY axis, we represent MEC and IR.

The ME curve indicates the MEC. It can be seen that as investment increases, the ME curve slope

downward. It is clear that if the current IR 9 %, then the entrepreneurs will invest Rs 9000/- because at

this point the MEC is also 9%. MEC = IR. If the IR falls to 7%, then the entrepreneurs will invest Rs

11000/-. This is because the MEC is also 7% at this point.


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The MEC represents an investor’s return and the IR is his cost. Obviously, the return on capital

must be equal to its cost. Thus, the MEC and IR are closely related to each other and they move

together. We can conclude that given a MEC curve, the investment will depend on the existing

IR in the market.

DETERMINANTS OF MEC

Several factors that affect MEC are given below.

1. Short run factors: Expectation of increased demand, higher MEC leads to larger

investment and vice-versa.

2. Cost and Price: If the production costs are expected to decline and market prices to go up

in future, MEC will be high leading to a rise in investment and vice-versa.

3. Higher Propensity to consume leading to a rise in MEC

encourages higher investment.

4. Changes in income:

An increase in income will simulate investment and MEC while a decline in the level of

incomes will discourage investment.

5. Current state of expectations:


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If the current rates of returns are high, the MEC is bound to be high for new projects of

investment and vice-versa. This is because the future expectations to a very great extent

depend on the current rate of earnings.

6. State of business confidence:

During the period of optimism (boom) the MEC will be generally high and during period of

pessimism (depression), it will be generally less.

II Long run factors.

1. Rate of growth of population:

In a capitalist economy, a high rate of population growth leads to an increase in MEC

because it leads to an increase in the demand for both consumption and investment goods. On

the contrary, a decline in the population growth depresses MEC.

2. Development of new areas:

Development activities in the new fields like transport and communications, generation of

electricity, construction of irrigation projects, ports etc would lead to a rise in MEC.

3. Technological progress:

Technological progress would lead to the development and use of highly sophisticated and latest

machines, equipments and instruments. This will add to the productive capacity of the economy

leading to an increase in MEC.

4. Productive capacity of existing capital equipments:

Under utilised existing capital assets may be fully utilized if the demand for goods increases in

the economy. In that case the MEC of the same asset will definitely rise.

5. The rate of current investment:

If the current rate of investment is already high, there would be little scope for further investment

and as such the MEC declines.

Thus, several factors both in the short run and in the long run affect the MEC of a capital asset.

Thus, several measures are to be taken to stimulate private investment in an economy.


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In the Keynesian theory, investment is a very important and strategic variable. In order to increase the

volume of national output, income and to tackle the problem of unemployment, the remedial measure

suggested by Lord Keynes is to raise the level of investment in an economy. In this connection Prof.

Dillard remarks –”A fundamental principle is that as the income of the community increases,

consumption also increase but by less than the increase in income. Hence, in order to have sufficient

demand to sustain an increase in employment, there must be increase in real investment equal to the

gap between income and consumption out of income. In other words, employment cannot increase

unless investment increases”.

Role of Business Expectations in Determining MEC

Business expectations play a vital role in determining MEC and therefore investment. Level of income

and employment in an economy are determined by two factors, viz., Propensity to consume and

inducement to invest. Of these two propensity to consume is more or less stable, fluctuations in income

and employment, therefore, depend mainly on the inducement to invest. The inducement to invest in

turn depends on the rate of interest and the marginal efficiency of capital. Since the rate of interest is

relatively stable or sticky, fluctuations in investment depend primarily upon the changes in the MEC.

There are two determinants of the MEC, the cost of the capital asset and the rate of return from the

asset.

Uncertainty in the prospective yield or business expectations causes instability in MEC. As business

expectations change, the volume of investment changes and this causes changes in business activity and

employment.

Expectations regarding the prospective yield of capital assets are of two types:Short – term expectations

(b) Long – term expectations.

Short – term expectations are based on the existing stock of capital and the intensity of consumers

demand for the goods which are known and remain more or less stable.

On the other hand, long – term expectations relate to future changes in the size of the stock of capital

assets and about changes in the level of aggregate demand which are uncertain. Thus the long term

expectations are highly unstable, but are more important in explaining fluctuations in investment and

employment.

The long term expectations are influenced by the following factors:

• The state of confidence – How certain and confident are businessmen with regard to the future

change. • Stock exchange valuation – The value attached to it by the dealers in stock exchange. • Irrevocable decisions – Decisions made by bold and dynamic entrepreneurs. • Elements of instability – Frequent changes in the assessment of the prospects of various

investments have introduced lot of changes in the investment activity. • Link with investments – Stock exchange dealings influence new investments by establishing

links between the new investments and the present investments. • Behaviour of investors – Since there is mass valuation of assets on the stock exchange, there

are alternating waves of pessimism and optimism.


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Apart from these political events like war, elections etc. also influence the prospective yield of the

capital assets.

Thus investment decisions are made in an uncertain atmosphere, based on business expectations with

regard to the marginal efficiency of capital.


Appreciate the working of the multiplier

Multiplier

Meaning and working of Multiplier

Prof. Kahn developed the concept of “Multiplier” with reference to employment. Lord Keynes, on the

lines of employment multiplier, developed an “Investment Multiplier”. It is derived from the concept of

marginal propensity to consume and refers to the effects of changes in investment outlays on aggregate

income through consumption expenditure. It has acquired greater significance in recent years to explain

the process of income generation in an economy when the volume of investment changes.

There are various types of Multiplier such as Income multiplier, investment multiplier,

employment multiplier and foreign trade multiplier etc.

Keynes’ investment multiplier is based on “The fundamental psychological law of

Consumption”. It states that as income increases, consumption also increases but less than

proportionately. Consequently, the consumption demand in the short run remains constant and it

cannot be increased. The alternative to increase the output is to increase the volume of

investment. Even though consumption function is a major determinant of aggregate demand, it is

not the prime initiator of changes in income and output. The changes in the volume of

investment will bring about changes in the level of income and output. How changes in income

are affected can be understood with the help of investment multiplier.

Multiplier may be defined as a ratio of change in income to a change in investment. It

expresses the relationship between an initial increment in investment and the final increment in

income. It shows by how many times the effect of an initial change in investment is

multiplied by causing changes in consumption and finally in the aggregate income. Change

in investment

generally gives rise to change in income by a multiple amount. Whenever an additional

investment is made in the economy, it increases the aggregate income not only by an amount

equal to the additional investment but by somewhat greater than that. The logic is simple. The

original investment increases income not only in the industry where investment is made but also

in certain other industries whose products are demanded by men employed in investment goods


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industries. For example, if an increase in investment of Rs.5 Lakhs causes an increase in income

of Rs.25 Lakhs, then the multiplier would be 5. If the increase in income is Rs.30 Lakhs, then the

multiplier would be 6. Algebraically, this relationship can be expressed as-

Where delta stands for change or increase, K for multiplier and Y for income and I for Investment

respectively.

The size of the multiplier is directly derived from the size of MPC. Higher the MPC, higher would be the

size of multiplier and vice-versa. The multiplier is equal to the reciprocal of 1 minus MPC. The formula to

calculate the size of the multiplier is as follows.

1 – MPC. can be easily found out. If MPC is 2 / 3, then multiplier would be as follows.

We know that MPC + MPS =1. If we deduct MPC from 1 we get MPS. Hence, the above

equation can be expressed in the following manner.

If the MPC is 9 / 10, deducting 9 / 10 from 1, we get 1 / 10. This is the MPS. The reciprocal

of 1 / 10 is 10, which is the value of multiplier. In short, the multiplier is the reciprocal of the

MPS, which is always equal to 1 minus the MPC.

From the above explanation, it is clear that –

1. Higher the value of MPC, higher would be the value of K and vice – versa.

2. When MPS = 0 and MPC =1, then there will be a 100 percent increase in income every

time or the multiplier effect will be continuous.


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3. When MPS =1 and MPC = 0, then what is earned will be saved and the value of multiplier

will be equal to 0.

WORKING OF THE multiplier AND THE PROCESS OF INCOME GENERATION:

The process of income generation through the working of the multiplier can be expressed in the

following manner.

ASSUMPTIONS:

1. MPC = ½ or K = 2.

2. An investment of Rs 10 crores will generate an income of Rs 20 crores.

Period or Rounds Investment in Crore (Rs) Change in Income in Crore (Rs)

1 10 10

2 10 05

3 10 2.50

4 10 1.25

5 10 0.62

6 10 0.31

Total 20

The multiplier process is based on the principle that one man’s expenditure is another man’s

income. If MPC of one individual is high, the income of another man is also high. From the

above table it is clear that as we move from one round to another, the initial investment gives rise

to a dwindling series of successive increments in income because MPC is generally less than

one.

Assumptions:

1. MPC = 2 / 3 or MPS = 1 / 3 or K = 3.

2. Original investment is Rs 30 crores.


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3. Additional investment is Rs 10 crores.

As the multiplier is 3, the additional investment of Rs.10 crores leads to an increase in the

income of the community to Rs.30 crores. This can be understood with the help of the following

diagram.

In the diagram above, QR represents original investment of Rs 30 Crores. SS is the saving curve,

which intersects the investment curve at the point M, which indicates the original income of the

community at Rs 130 Crores. Q1R1 is the new investment line, which indicates an additional

investment of Rs 10 Crores. The new investment Curve Q1R1 intersects the same saving curve at

M1. At this new equilibrium point, the income of the community is Rs 160 Crores. It is clear that

as a result of an additional investment of Rs 10 crores, income has gone up by 3 times (From Rs

130 crores to Rs 160 crores).

ASSUMPTIONS AND LIMITAIONS OF THE MULTIPLER:

1. Availability of consumer goods:

Multiplier works satisfactorily if the volume of goods and services on which the

additional income may be spent are available in plenty. Otherwise, people are unable to

spend their income on them. Consequently, MPC falls leading to a decline in the value of

K.

2. Maintenance of Investment:

In order to realize the full value of K, it is necessary that the various increments in investment be

repeated at regular intervals. In case, it is not done, it will not be possible to raise the income to

the multiplier level.

3. Net Increase in Investment:


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In order to get the full value of K, there should be a net increase in investment. Increase

in investment in one sector of the economy should not be neutralized by decrease in

investment in another sector of economy. Otherwise, the working of the multiplier is

obstructed.

4. No change in size of MPC:

In the process of income generation, there should not be any change in the value of MPC.

If there is any change in the size of MPC, then the value of K also changes.

5. No investment from induced consumption.

In the multiplier theory we analyze only the impact of investment on consumption. But

the reverse, viz., accelerator is totally ignored. If the accelerator is allowed to operate and

effects of induced consumption on investment are also taken into account, then the value

of the multiplier would be far greater and would also be achieved at an earlier stage in the

process of income generation.

6. No time gap between successive expenditure on consumption.

If there is a gap between receipt of income and expenditure even in the short run, the full

value of the K cannot be realized because as MPC falls, the size of the K also declines.

7. Existence of a closed economy.

If there is trade between different countries, the value of K may be restricted by the

amount of excess of imports over exports. A part of the total money will go out of the

country if there are imports and to that extent the value of the K declines.

8. Existence of less than full employment condition.

If the economy is working at full employment level, in that case there is no scope for

increase in output, income and employment even though investment increases.

9. It is based on number of assumptions.

These assumptions may not be found in practice. Consequently, the ‘actual’ multiplier

may be greatly restricted and will be different from the ‘ideal’ multiplier.

10. No direct relation between investment and income:

According to Prof. Hazilitt, there is no precise, pre-determinable or mechanical

relationship between social income, consumption, investment and extent of employment.

11. Keynes multiplier is a static concept:


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It shows the process of income propagation from one point of equilibrium to another and

that too under static conditions. It gives little insight into the actual process by which the

economy achieves a new equilibrium.

PRE REQUSITE CONDITIONS FOR THE WORKING OF THE MULTIPLIER

1. Existence of involuntary unemployment.

National output, income and expenditure can be increased by additional investment only when

there is involuntary unemployment condition in an economy. Otherwise, there will be no scope

for expansion in employment even if investment increases.

2. Existence of an Industrial Economy.

Multiplier can freely operate in an industrial economy rather than in an agricultural economy

because the demand for industrial goods is relatively stable than that of agricultural goods and

as such the MPC and the value of K will be high.

3. Existence of excess capacity in consumer goods industries.

A high level of investment will succeed in utilizing the unutilized and under utilized excess

capacity to the extent possible. This leads to the creation of more employment.

4. Existence of elastic supply of other factor inputs in the market.

A higher investment would result in higher output, income and employment only when the

other supplemental factor inputs are available in abundance.

LEAKAGES IN THE MULTIPLIER

Income not spent on consumption is called ‘leakage’ in the cumulative income stream. This

leakage obstructs the increase in output and income. These leakages will arise on account of the

following reasons.

5. Savings:

Higher the level of savings, the lower would be the value of K and vice-versa.

6. Accumulation of idle cash balances:

If people keep more idle cash balances with them, then the MPC declines and the value of K

declines.

7. Debt cancellations:


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If people use a part of their income to repay their old debts, then the current MPC declines and

the value of K also declines.

8. Purchase of old shares and stocks:

A part of the income may be spent on buying old stocks, shares and other securities in the

market. This would lead to a decline in current MPC and a decline in the value of K also.

9. Imports:

Payments on imports would reduce domestic consumption leading to a decline in the value of K.

10. Price inflation:

Inflation would reduce the purchasing power of the people and consequently the MPC and the

value of the K also.

11. Taxes:

Higher taxes would reduce the incomes of the people, MPC and also the value of K.

12. Corporate savings:

Undistributed profits of joint stock companies would reduce the incomes of the shareholders,

their MPC and thus the value of the K.

If all these leakages are properly plugged in the income stream, the effect of multiplier in the

process of income generation would be higher, taking the economy towards full employment

level.

PRATICAL IMPORTANCE OF THE MULTIPLIER

13. It is a major tool of macro economic theory focusing attention on investment as the significant

element in increasing the level of employment.

14. It summarizes the working of the entire Keynesian model.

15. It describes how income is generated in an economic system like stone causing ripples in a lake.

16. It is a valuable guide to public investment policy.

17. It is helpful for framing a suitable full employment policy.

18. It has great practical significance in formulating anti-cyclical policy to smoothen business

fluctuations in an economy. Thus, it is necessary for the study of trade cycle, its trends and

control.


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19. According to Prof. Samuelson, the multiplier theory explains why an easy money policy is

ineffective and deficit spending is effective during the period of depression.

20. For increasing the income and employment, investment should be started in a sector where the

multiplier may be greater.

21. It is used for explaining expansion in different fields of economic activities. For example credit

multiplier, budget multiplier etc.

22. It upholds the Government intervention, active participation and macro economic management

relating to income, output and employment etc.

23. It helps to understand how equality between saving and investment is brought about. An

increase in investment leads to increase in income. Consequently, saving also increases and

becomes equal to investment.

24. It emphasizes the significance of deficit financing. Increase in public expenditure by creating

deficit budget help in creating income and employment multiple times the initial increase in

expenditure.

Thus, the concept of multiplier has not only brought about a revolution in economic theory but

also in framing various economic policies. Keynes regards it as a path-breaking contribution to

economic theory.


Understand the magnification of derived demand

Accelerator

The principle of “accelerator or acceleration” is another important tool of economic analysis. It is older

than multiplier. The accelerator dates back to 1914 or even before. It is associated with the name of

Prof. J.M. Clark, an American economist who was mainly responsible for popularizing it in 1917

Multiplier and accelerator are the two parallel concepts. The multiplier concept is inadequate to explain

the process of income generation in a complete manner. It shows the effect of investment only on

consumption expenditure and how the increase in investment will bring about increase in national

income through multiplier effect. In short, multiplier explains the effects of investment on consumption

and how the volume of consumption depends on the volume of investment. The multiplier fails to

analyze the effect of increase in consumption on investment. In order to know how consumption affects

the volume of investment, we have to study the concept of accelerator

Accelerator shows the effect of changes in consumption on induced investment and tells us how the

volume of investment depends on the level of consumption. The combined action of both multiplier

and accelerator will clearly explain how the aggregate national income increases as a result of increase

in the volume of investment in an economy. When incomes of the people increase, purchasing power

and the demand for consumption goods increase. In order to produce more consumption goods, more

capital goods are required. This leads to an increase in the demand for investment in capital goods


EDUPROZ Page 273

industries. Thus, a rise in income leads to a rise induced investment in capital goods industries. For e.g.,

an expenditure of Rs.4 crores on consumption goods industries, leads to an investment of Rs.12 crores

in capital goods industries, then, we can say that the accelerator is 3. Production of consumer goods

requires a particular amount of capital goods. Therefore, the accelerator is generally more than one. In

order to produce consumption goods sometimes, more capital is not necessary and some times, even it

is not required at all because the existing stock of capital goods become sufficient. Hence, accelerator

may be less than one or zero. Accelerator is called as “Magnification of derived demand” because

investment depends on employment.

In order to understand the effect of accelerator, it is necessary to know the acceleration co-efficient.

The ratio between the net change in consumption expenditure and the induced investment is called

‘Acceleration Co-efficient”. Symbolically,

where,

a stands for acceleration co-efficient

net change in investment expenditure

net change in consumption expenditure.

The working of the accelerator can be explained with the following imaginary example. Let us suppose

that in order to produce 1000 units of consumer goods, 100 machines are required. The capital output

ratio in this case is 1:10. Further suppose that the working life of a machine is 10 years and after 10

years the machine has to be replaced. It implies that every year 10 machines have to be replaced in

order to maintain the constant flow of 1000 units of consumer goods. Hence, the acceleration

coefficient in this case is 1. Hence, the annual demand for machines will be 10. This is called

“Replacement Demand”.

Now let us suppose that the demand for consumer goods goes up by 10%. Consequently, more

machines are required now to meet the increased demand for consumer goods. Now we require 10% or

10 new machines. (10% of 100 machines are 10. Hence, the total demand for machines will now be 20. It

means a 100% increase in the demand for machines (10 for replacement and another 10 for meeting the

increased demand). The investment in capital goods industry has doubled, because in our example the

value of the accelerator is 10.

Acceleration effects on Investment

Peri

od

Consumpti

on

Goods

Capital

Goods

Requir

Investme

nt

needed

Induced

Investm

ent

Total

Investm

ent

%

change

in


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ed for

replacem

ent

Total

Investm

ent

0 1000 100 10 Nil 10 -

1 1000 110 10 10 20 100

From the table it is clear that a 10% increase in demand for consumption goods has resulted in a 100%

increase in total investment outlay, as accelerator is one.

The working of the accelerator can be explained with the help of the following diagram.

In the diagram, SS and II represent saving and investment curves. E indicates the original

equilibrium position where S and I meet each other. OQ is the original equilibrium income.

Now investment increases from I2 to I4. Consequently, the National Income increases from OQ to

OQ2. The jump in income is Q to Q2. If the increase in investment from I2 to I4 had been purely

public investment, then the entire increase in income Q to Q2 would have been due to only the

multiplier effect. But Q to Q1 increase in national income is due to the multiplier effect because

increase in investment from I2 to I3 is public investment.


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Increase in National Income from Q1 to Q2 is due to the acceleration effect because increase in

investment from I3 to I4 is due to induced investment. The total multiplier and accelerator effect on

income is measured by QQ2 (QQ1 due to multiplier effect and Q1 Q2 due to acceleration effect).

Limitations of accelerator

1. There should be no excess capacity in capital goods industries. If there is excess capacity in that

case, additional production of consumer goods does not require additional capital goods.

2. If there is excessive number of machines, in that case there is no need for further investment in

capital goods industries.

3. If the demand for consumption goods is purely temporary in nature in that case producers will

not make any additional investment in capital goods industries. On the other hand, they make use of

existing machines more intensively.

4. In many cases, investments made in capital goods industries do not await changes or increase in

consumption, e.g., investment in public sector industries.

5. If adequate financial resources are not forthcoming to capital goods industries, in that case in

spite of increase in consumption, production of capital goods cannot be increased.

6. It is always wrong on our part to expect constant ratio between production of consumer goods

and capital goods.

In all these cases, the value of the accelerator may not be fully realized.

Practical Importance

1. It explains the process of income generation more clearly as it takes into account of the effect of

consumption on investment.

2. It explains why fluctuations in income and employment occur rather violently.

3. It tells us why capital goods industries fluctuate much more than consumption goods industries.

1. It helps in understanding of the different phases of business cycles very clearly.

But accelerator left to it, cannot completely explain the entire cause for trade

cycles.

Summary

Macro economic concepts of Consumption function, Investment function, Multiplier,

Accelerator etc. explain vividly the functioning of an economy. Consumption function refers to

the schedule of propensity to consume at various levels of income. The psychological law of

consumption states that consumption tends to rise with income, but less proportionately. Average


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propensity to consume is the ratio of consumption to income and is expressed as C/Y. Marginal

propensity to consume is the ratio of the change in consumption to the change in the level of

income. And is expressed as delta C/deltaY. Consumption function is determined by a number of

subjective and objective factors. The concept explains the obstacles in the attainment of full

employment equilibrium. It explains the turning points of the business cycles, declining tendency

of MEC, secular stagnation, underemployment equilibrium and upholds the importance of state

intervention and increased investment in the generation of employment and income. The value of

the multiplier is derived from consumption function.

Investment refers to real investment denoting an addition to real capital assets as well as to the

wealth of the society. There are various kinds of investment like Private investment, Public

investment, Foreign, Induced, Autonomous, Gross. Net,etc. Investment is determined by a

number of factors like the rate of interest, Marginal efficiency of Capital, Level of uncertainty,

political environment, rate of growth of population, level of existing stock of capital, inventions,

consumers’ demand etc. Investment is highly unstable in the short run. Inducement to invest

mainly depends on the rate of interest and the marginal efficiency of capital.

The MEC depends on (a) the prospective yields i.e., expected profitability of the capital assets,

and (b) the replacement cost of these assets. Business expectations play a very important role in

determining MEC and therefore investment.

Multiplier is the ratio of change in income to a given change in investment. There are a number

of limitations to the working of the multiplier and it presupposes the existence of involuntary

unemployment, industrial economy, excess capacity in consumer goods industry etc. A number

of Leakages like savings, imports, taxes etc. obstruct the increase in output and income. It

describes how income is generated in an economic system like stone causing ripples in a lake. It

is a valuable guide to public investment policy.

Accelerator explains the effect of increase in consumption on the demand for capital goods and

the related investment. Acceleration depends on the capital output ratio and the durability of the

capital assets. It explains the process of income generation more clearly as it takes into account

the effect of consumption on investment.

Unit 12 Stabilisation Policies

Introduction

Macro economics deals with such aggregates which influence and mould economic growth. The

study of aggregate demand, Aggregate supply, aggregate saving, aggregate investment,

aggregate output, aggregate income, aggregate employment, money supply, inflation, deflation

etc. give an insight into the functioning of an economy. It also includes policies such as monetary

policy, fiscal policy, exchange rate policy, physical control etc. to achieve growth with stability

and to maintain stable conditions in the economy. Economic development is not a smooth


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upward march and there will be many jerks and jolts in the process, necessitating various kinds

of corrective measures.

Learning Objectives:

After studying this unit, you should be able to understand the following

• To understand and appreciate the macro economic goals such as attainment of full

employment, increasing the level of national income, level of output, promoting stable

conditions in the economy etc.

• Effectiveness of monetary policy as an instrument of establishing economic stability,

controlling inflation and deflation in the economy.

• Effectiveness of fiscal policy in controlling consumption, regulating production,

encouraging saving and investment and in the redistribution of income to establish stable

conditions in the economy.

• Physical policy or direct controls regulating consumption, production, foreign trade and

establishing stable conditions in the economy.


Understand the importance of maintaining stable conditions in the economy

Concept Of Economic Stability

Promoting economic stability is partly a matter of avoiding economic and financial crisis. A

dynamic market economy necessarily involves some degree of instability, as well as gradual

structural change. The challenge for the policy makers is to minimize this instability without

reducing the ability of the economic system to raise living standards through the increasing

productivity, efficiency and employment that it generates. Economic stability is also fostered by

robust economic and financial institutions and regulatory frameworks.

Economic stability implies avoiding fluctuations in the level of economic activities a 100%

stability is neither possible nor desirable. It implies only relative stability in the over all level of

economic activities.

A stabilization policy is a set of measures introduced to stabilize a financial system or economy.

It can refer to correcting the normal behaviour of the business cycle. In this case the term

generally refers to demand management by monetary and fiscal policy to reduce normal

fluctuations in output, sometimes referred to as “keeping the economy on an even keel.” The

policy changes in these circumstances are usually countercyclical, compensating for the

predicted changes in employment and output to increase short run and medium run welfare.


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It can also refer to measures taken to resolve a specific economic crisis for instance an exchange

rate crisis or stock market crash, in order to prevent the economy developing recession or

inflation.

The initiative is taken by the government or Central Bank or both. Depending on the goal to be

achieved it involves some combination of restrictive fiscal measures and monetary tightening.

Such stabilization policies can be painful, in the short run, for the economy because of lower

output and higher unemployment. They are designed to be a platform for successful long run

growth and reform.

Different Instruments Of Economic Stability

1. Monetary Policy. 2. Fiscal Policy & 3. Physical policy or Direct Controls.

The Central Bank and the Government have developed these instruments to correct the

discrepancies that occur in the process of economic growth.


Understand of the monitory policy, its objectives and techniques of controlling inflation

and deflation

Monetary Policy

Monetary policy is a part over all economic policy of a country. It is employed by the

government as an effective tool to promote economic stability and achieve certain predetermined

objectives.

Meaning and definition:

Monetary Policy deals with the total money supply and its management in an economy. It is

essentially a programme of action undertaken by the monetary authorities generally the central

bank to control and regulate the supply of money with the public and the flow of credit with a

view to achieving economic stability and certain predetermined macro economic goals.

Monetary policy can be explained in two different ways. In a narrow sense, it is concerned

with administering and controlling a country’s money supply including currency notes and

coins, credit money, level of interest rates and managing the exchange rates. In a broader

sense, monetary policy deals with all those monetary and non-monetary measures and

decisions that affect the total money supply and its circulation in an economy. It also

includes several non-monetary measures like wages and price control, income policy,


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budgetary operations taken by the government which indirectly influence the monetary

situations in an economy.

Different writers have defined monetary policy in different ways. Some of the important ones are

as follows.

1. According to RP Kent, “Monetary policy is the management of the expansion and contraction

of the volume of money in circulation for the explicit purpose of attaining a specific objective

such as full employment”.

2. In the words of D.C.Rowan, “The monetary policy is defined as discretionary act undertaken

by the authorities designed to influence the supply of money, cost of money or interest rate and

the availability of money”.

Monetary policy basically deals with total supply of legal tender money, i.e., currency notes and

coins, total amount of credit money, level of interest rates, exchange rate policy and general

liquidity position of the country.

Credit policy which is different from the monetary policy affects allocation of bank credit

according to the objective of monetary policy.

The government in consultation with the central bank formulates monetary policy and it is

generally carried out and implemented by the central bank. It is evolved over a period of time on

the basis of the experience of a nation. It is structured and operated with in the institutional

framework and money market of the country. Its objectives, scope and nature of working etc is

collectively conditioned by the economic environment and philosophy of time. Monetary policy

along with fiscal policy and debt management lumped together form the financial policy of the

country.

Monetary policy is passive when the central bank decides to abstain deliberately from applying

monetary measures. It is active when the central bank makes use of certain instruments to

achieve the desired objectives. It may be positive or negative. It is positive when it promotes

economic activities and it is negative when it restricts or curbs economic activities. Similarly, it

is liberal when there is expansion in credit money and it is restrictive when it leads to

contraction in money supply. Again, a cheap money policy may be followed by cutting down

the interest rates or a dear money policy by raising the rate of interest.

The Scope and effectiveness of monetary policy depends on the monetization of the economy

and the development of the money market.

Parameters of monetary policy:

Broadly speaking there are three parameters of monetary policy of a country. It is through these

parameters, the monetary policy has to operate. They are

1. Total money supply available in a country.


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2. Cost of borrowings or the level of interest rates.

3. The nature of credit control measures.

All the three put together determine the nature of working of monetary policy.

Objectives Of Monetary Policy

Objectives of monetary policy must be regarded as a part of overall economic objectives of the

government. It should be designed and directed to achieve different macro economic goals. The

objectives may be manifold in relation to the general economic policy of a nation. The various

objectives may be inter related, inter dependent and mutually complementary to each other. They

may also be mutually inconsistent and clash with each other. Hence, very often the monetary

authorities are concerned with a careful choice between alternative ends. The priorities of the

objectives depend on the nature of economic problems, its magnitude and economic policy of a

nation. The various objectives also change over a time period.

Economists have conflicting and divergent views with regard to the objectives of monetary

policy in a developed and developing economy. There are certain general objectives for which

there is common consent and certain other objectives are laid down to suit to the special

conditions of a developing economy. The main objective in a developed economy is to ensure

economic stability and help in maintaining equilibrium in different sectors of the economy where

as in a developing economy it has to give a big push to a slowly developing economy and

accelerate the rate of economic growth.

General objectives of monetary policy.

1. Neutral money policy:

Prof. Wicksteed, Hayak, Robertson and others have advocated this policy. This objective was in

vogue during the days of gold standard. According to this policy, money is only a technical

devise having no other role to play. It should be a passive factor having only one function,

namely to facilitate exchange. It should not inject any disturbances. It should be neutral in its

effects on prices, income, output, and employment. They considered that changes in total

money supply are the root cause for all kinds of economic fluctuations and as such if money

supply is stabilized and money becomes neutral, the price level will vary inversely with the

productive power of the economy. If productivity increases, cost per unit of output declines and

prices fall and vice-versa. According to this policy, money supply is not rigidly fixed. It will

change whenever there are changes in productivity, population, improvements in technology etc

to neutralize fundamental changes in the economy. Under these conditions, increase or decrease

in money supply is allowed to result in either fall or raise in general price level. In a dynamic

economy, this policy cannot be continued and it is highly impracticable in the present day

economy.

2. Price stability:


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With the suspension of the gold standard, maintenance of domestic price level has become an

important aim of monetary policy all over the world. The bitter experience of 1920’s and 1930’s

has made all most all economies to go for price stability. Both inflation and deflation are

dangerous and detrimental to smooth economic growth. They distort and disturb the working of

the economic system and create chaos. Both of them are bad as they bring unnecessary loss to

some groups where as undue advantage to some others. They have potential power to create

economic inequality, political upheavals and social unrest in any economy. In view of this, price

stability is considered as one of the main objectives of monetary policy in recent years. It is to be

remembered that price stability does not mean that prices of all commodities are kept constant or

fixed over a period of time. It refers to the absence of sharp variations or fluctuations in the

average price level in the country. A hundred percent price stability is neither possible nor

desirable in any economy. It simply implies relative price stability. A policy of price stability

checks cyclical fluctuations and smoothen production and distribution, keeps the value of

money stable, prevent artificial scarcity or prosperity, makes economic calculations

possible, introduces an element of certainty, eliminate socio-economic disturbances, ensure

equitable distribution of income and wealth, secure social justice and promote economic

welfare. On account of all these benefits, monetary authorities have to take concrete steps to

check price oscillations. Price stability is considered as one of the prerequisite condition for

economic development and it contributes positively to the attainment of a steady rate of growth

in an economy. This is because price stability will build up public morale and instill confidence

in the minds of people, boost up business activity, expand various kinds of economic activities

and ensure distributive justice in the country. Prof Basu rightly observes, “A monetary policy

which can maintain a reasonable degree of price stability and keep employment reasonably full,

sets the stage of economic development”.

3. Exchange rate stability:

Maintenance of stable or fixed exchange rate was one of the major objects of monetary policy for

a long time under the gold standard. The stability of national output and internal price level was

considered secondary and subservient to the former. It was through free and automatic imports

and exports of gold that the country was able to remove the disequilibrium in the balance of

payments and ensure stability of exchange rates with other countries. The government followed

the policy of expanding currency and credit with the inflow of gold and contracting currency and

credit with the outflow of gold. In view of suspension of gold standard and IMF mechanism, this

object has lost its significance. However, in order to have smooth and unhindered

international trade and free flow of foreign capital in to a country, it becomes imperative

for a county to maintain exchange rate stability. Changes in domestic prices would affect

exchange rates and as such there is great need for stabilizing both internal price level and

exchange rates. Frequent changes in exchange rates would adversely affect imports, exports,

inflow of foreign capital etc. Hence, it should be controlled properly.

4. Control of trade cycles:

Operation of trade cycles has become very common in modern economies. A very high degree of

fluctuations in over all economic activities is detrimental to the smooth growth of any economy.

Economic instability in the form of inflation, deflation or stagflation etc would serve as great


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obstacles to the normal functioning of an economy. Basically, changes in total supply of money

are the root cause for business cycles and its dampening effects on the entire economy. Hence, it

has become one of the major objectives of monetary authorities to control the operation of

trade cycles and ensure economic stability by regulating total money supply effectively. During the period of inflation, a policy of contraction in money supply and during the period of

deflation, a policy of expansion in money supply has to be adopted. This would create the

necessary economic stability for rapid economic development.

5. Full employment:

In recent years it has become another major goal of monetary policy all over the world especially

with the publication of general theory by Lord Keynes. Many well-known economists like

Crowther, Halm. Gardner Ackley, William, Beveridge and Lord Keynes have strongly advocated

this objective in the context of present day situations in most of the countries. Advanced

countries normally work at near full employment conditions. Their major problem is to maintain

this high level of employment situation through various economic polices. This object has

become much more important and crucial in developing countries as there is unemployment and

under employment of most of the resources. Deliberate efforts are to be made by the

monetary authorities to ensure adequate supply of financial resources to exploit and utilize

resources in the best possible manner so as to raise the level of aggregate effective demand

in the economy. It should also help to maintain balance between aggregate savings and

aggregate investments. This would ensure optimum utilization of all kinds of resources, higher

national output, income and higher living standards to the common man.

6. Equilibrium in the balance of payments:

This objective has assumed greater importance in the context of expanding international trade

and globalization. To day most of the countries of the world are experiencing adverse balance of

payments on account of various reasons. It is a situation where in the import payments are in

excess of export earnings. Most of the countries which have embarked on the road to economic

development cannot do away with imports on a large scale. Imports of several items have

become indispensable and without these imports their development process will be halted.

Hence, monetary authorities have to take appropriate monetary measures like deflation,

exchange depreciation, devaluation, exchange control, current account and capital account

convertibility, regulate credit facilities and interest rate structures and exchange rates etc.

In order to achieve a higher rate of economic growth, balance of payments equilibrium is very

much required and as such monetary authorities have to take suitable action in this direction.

7. Rapid economic growth:

This is comparatively a recent objective of monetary policy. Achieving a higher rate of per capita

output and income over a long period of time has become one of the supreme goals of monetary

policy in recent years. A higher rate of economic growth would ensure full employment

condition, higher output, income and better living standards to the people. Consequently,

monetary authorities have to take the necessary steps to raise the productive capacity of the

economy, increase the level of effective demand for various kinds of goods and services and


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ensure balance between demand for and supply of goods and services in the economy. Also they

should take measures to increase the rate of savings, capital formation, step up the volume of

investment, direct credit money into desired directions, regulate interest rate structure, minimize

economic and business fluctuations by balancing demand for money and supply of money,

ensure price and overall economic stability, better and full utilization of resources, remove

imperfections in money and capital markets, maintain exchange rate stability, allow the inflow of

foreign capital into the country, maintain the growth of money supply in consistent with the rate

of growth of output minimize adversity in balance of payments condition, etc. Depending upon

the conditions of the economy money supply has to be changed from time to time. A flexible

policy of monetary expansion or contraction has to be adopted to meet a particular situation.

Thus, a growth-friendly monetary policy has to be pursued by monetary authorities in order to

stimulate economic growth.

It is to be noted that the above-mentioned objectives are inter related, inter dependent and inter

connected with each other. Each one of the objectives would affect the other and in its turn is

influenced by the others. Many objectives would come in clash with others under certain

circumstances. A proper balance between different objectives becomes imperative. Monetary

authorities have to determine the priorities depending upon the economic environment in a

country. Thus, there is great need for compromise between different objectives

Objectives of monetary policy in developing countries:

As the development problems of developing countries are different from that of developed

countries, the objectives of monetary policy also changes. The following objectives may be

considered in the context of developing countries.

1. Development role:

It has to promote economic development by creating, mobilizing and providing adequate credit

to different sectors of the economy. Supply of sufficient financial resources, its proper direction,

canalization and utilization, control of inflation and deflation etc would create proper

background for laying a solid foundation for rapid economic development.

2. Effective central banking:

In order to achieve various objectives of monetary policy and to meet the ever-growing

development requirements of the economy, the central bank of the country has to operate

effectively. It has to control the volume of credit money and its distribution through the use of

various quantitative and qualitative credit instruments. Central bank of the country should act as

an effective leader to control the activities of all other financial institutions in the country. It

should command the respect of other institutions.

3. Inducement to savings:


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It has to encourage the saving habits of the common man by providing all kinds of monetary

incentives. It has to take the necessary steps to expand the banking facilities in the country and

mobilize savings made by them. Special steps are to be taken to mobilize rural small savings.

4. Investment of savings:

It should help in converting savings into productive investments. For this purpose, it has to create

an institutional base and investment climate in the country. People should have variety of

opportunities to invest their hard earned money and earn adequate retunes on them.

5. Developing banking habits:

Monetary authorities have to take effective and imaginary steps to popularize the use of various

credit instruments by the common man. Banking transactions should become the part of their

day-to-day life.

6. Magnetization of the economy:

The monetary authorities have to take different measures to convert non-monetized sector or

barter sector into monetized sector and make people use credit money extensively in their day-to-

day life. Increase in total money supply should be in accordance with the degree of monetization

of the economy.

7. Monetary equilibrium:

It is the responsibility of the monetary authorities to maintain a proper balance between demand

for money and supply of money and ensure adequate liquidity position in the economy so that

neither there will be excess supply of money nor shortage in the circulation of money.

8. Maintaining equilibrium in the balance of payments:

It is the job of the monetary authorities to employ suitable monetary measures to set right

disequilibrium in the balance of payments of a country.

10. Creation and expansion of financial institutions:

Monetary authorities of the country have to take effective steps to improve the existing currency

and credit system. They should help in developing banking industry, credit institutions,

cooperative societies, development banks and other types of financial institutions, to mobilize

more savings and direct them to productive activities.

11. Integration of organized and unorganized money markets:

The money markets are under developed, undeveloped, highly unorganized and they are not

functioning on any well laid down principles. In fact, there is no proper integration between

organized and unorganized money markets. This has come in the way of well-developed money


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markets in these countries. Hence, money markets are to be brought under the purview of the

central bank of the country.

12. Integrated interest rate structure:

The monetary authorities have to minimize the existence of different interest rates in different

segments of the money market and ensure an integrated interest rate structure.

13. Debt management:

Monetary authorities have to decide the total volume of internal as well as external borrowings,

timing of the issue of bonds, stabilizing their prices, the interest rates to be paid for them, nature

of debt servicing, time and methods of debt redemption, the number of installments, time of

repayment etc. The primary aim of the debt management policy is to create conditions in which

public borrowing is increased from year to year on a big scale without giving any jolt to the

system and this must be at cheap rates to keep the burden of the debt as low as possible. Thus,

debt management of the country is to be successfully organized by the monetary authorities.

14. Long term loan for industrial development:

The monetary policy should be framed in such a way as to promote rapid industrial development

in a country by providing adequate finance for them.

15. Reforming rural credit system:

The existing rural credit system is defective and as such it has to be reformed to assist the rural

masses.

16. To create a broad and continuous market for government securities:

It is the responsibility of the monetary authorities of the country to develop a well-organized

securities market so that funds are easily available for the needy people.

Thus, the objectives of monetary policy are manifold in nature in developing countries and a

proper balance between them is required very much to achieve desired goals of the government.

Monetary policy and economic development:

Monetary policy has to play a major and constructive role in developing countries in order to

accelerate and promote economic development. The rate of economic growth of a country

depends on the volume of investment. Higher the investment higher would the growth rate and

vice-versa. In order to raise the level of investment, the monetary authorizes have to take a

number of steps like giving incentives to savings, increase the rate of capital formation, mobilize

more funds, both in urban and rural areas, set up various financial institutions, channalise them in

to productive areas, offer reasonable interest rates, etc. It has to follow a flexible and elastic

monetary policy to suit particular conditions. The various objectives have already highlighted the


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significance of each one of them and how they contribute for economic development of a

country. All kinds of monetary instruments are to be used in the right proportion so as to fulfill

the desired goals. An appropriate monetary policy will certainly help in achieving full

employment condition and ensure rapid economic growth. Hence, a growth promoting monetary

policy has to be formulated in the context of a developing economy.

Instruments Of Monetary Policy

Broadly speaking there are two instruments through which monetary policy operates.They are

also called techniques of credit control.

I. Quantitative techniques of credit control:

They include bank rate policy, open market operations and variable reserve ratio.

II. Qualitative techniques of credit controls:

They include change in margin requirements, rationing of credit, regulation of consumers credit,

moral suasion, issue of directives, direct action and publicity etc.

1. Quantitative techniques of credit control:

The operation of the quantitative techniques or general methods will have a general impact on

the entire economy regulating the supply of credit made available to different activities.

The Bank Rate is the rate at which the central bank of a country is willing to discount first class

bills. If the Bank Rate is raised, the market rates and other lending rates of the money market

also go up. Conversely, the lending rates go down when the central bank lowers its bank rate.

These changes affect the supply and demand for money. Borrowing is discouraged when the

rates go up and encouraged when they go down.

The flow of foreign short term capital also is affected. There is an inflow of foreign funds when

the rates are raised and an outflow when they are reduced.

Internal price level tends to fall with the contraction of credit. And it tends to rise with its

expansion.

Business activity, both industrial and commercial, is stimulated when the rates of interest are

low, and discouraged when they are high.

Adverse balance of payments in foreign trade can be corrected through lowering of costs and

prices.


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Thus bank rate through its influence on supply of and demand for money helps in the

establishment of stability in the economy.

Open Market Operations refer to the purchase or sale of government securities, short-term as

well as long-term, by the central bank. When the central bank sells securities cash balances with

the commercial banks decline, they are compelled to reduce their lending. Thus credit contracts.

On the other hand purchases of securities enable commercial banks to expand credit.

This method is sometimes adopted to make the bank rate effective.

Varying Reserve Ratio – Variations of reserve requirements affect the liquidity position of the

banks and hence their ability to lend. By raising the reserve requirements inflationary trend can

be kept under control. The lowering of the reserve ratio makes more cash available with the

banks. The Reserve Bank of India has been empowered to vary the Cash reserve ratio from the

minimum requirement of 3 % to 15 % of the aggregate liabilities. Cash Reserves maintained by

commercial banks is called statutory reserve and the reserve over and above the statutory

reserves is called excess reserve.

Qualitative Techniques of Credit Control

Changes in the margin requirements, direct action, moral suasion, rationing of credit, issue of

directives, and regulation of consumer credit are some of the qualitative techniques which are in

practice generally.

While lending money against securities banks keep a certain margin. Central Bank can issue

directives to commercial banks to maintain higher margins when it wants to curtail credit and

lower the margin requirements to expand credit.

Direct action implies a coercive measure like, central bank refusing to provide the benefit of

rediscounting of bills for such banks whose credit policy is not in accordance with the wishes of

the central bank.

The central bank on the other may follow a mild policy of moral suasion where it requests and

persuades a member bank to refrain from lending for speculative or non essential activities.

The Credit is rationed by limiting the amount available to each applicant. Central bank may also

restrict its discounts to bills maturing after short periods.

Central bank, in the form of directives to commercial banks can see that the available funds are

utilized in a proper manner.

Regulation of consumer credit can have a direct impact on the demand for various consumer

durables.


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Thus Crowther concludes that the policy 0f the central bank using its free discretion within limits

that are normally very broad can control the volume of money and credit, in its own field the

central bank is clearly a dictator.

Monetary Policy To Control Inflation

The best remedy for fighting inflation is to reduce the aggregate spending. Monetary policy can

help in reducing the pressure on demand. During inflation, the central bank can raise the cost of

borrowing and reduce the credit creation capacity of the commercial banks. This makes banks to

become more cautious in their lending policies. The rise in the bank rate, raising the interest

rates not only makes borrowing costly but also will have an adverse psychological effect on

business confidence. A rise in the rate of interest may also encourage saving and discourage

spending. The central bank can reduce the credit creation capacity of the commercial banks

through the open market sale of securities and raising the cash reserve ratio to be maintained

with the central bank. Some of the selective credit control measures can also be adopted, like

varying margin requirements, moral suasion, direct action etc. to regulate credit.

Monetary policy has its own limitations in controlling inflation.

An increase in the bank rate may be ineffective if commercial banks do not follow the rise in the

bank rate by raising their own interest rates. Even if there is a rise in the interest rate it may not

be able to curb spending significantly. For the open market operations to be effective there

should be a well developed and closely knit money market. If the commercial banks are in the

habit of maintaining excess reserves with the central bank rising of the statutory reserve ratio

will not have any impact on their lending.

A major difficulty arises because of the dichotomy in the money market. In our country the

Reserve Bank can control only the organized sector which constitutes only a very small portion

of the money market. Indigenous bankers and money lenders who do bulk of lending lie outside

the control of the Reserve Bank.

Thus effectiveness of monetary policy in controlling inflation particularly in a developing

economy is very much limited.

Monetary Policy To Check Deflation

Deflation is the opposite of inflation. It is essentially a matter of falling prices. Deflation arises

when the total expenditure of the community is not equal to the value of the output at the existing

prices. Consequently the value of money goes up and prices fall. Deflation has an adverse effect

on the level of production, business activity and employment. It also adversely affects

distribution of wealth and income. In this sense, deflation is worse than inflation. Both inflation

and deflation are socially bad, but inflation may be considered to be the lesser of the two evils.

Monetary measures like Bank Rate, Open Market Operations, Variable Reserve Ratio and

selective techniques of credit control may be used to expand credit, stimulate bank advances for

various schemes. When the business community is in the grip of pessimism, substantial


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reduction in interest rates do not induce them to venture into new investments and expand

production. The horse may be taken to water, but it may refuse to drink. The monetary authority

can only encourage business enterprises. The lower interest rate may only improve the state of

liquidity in the economy.

Hence, Modern economists do not give much importance to monetary policy as a tool to keep

economic activity in proper trim.


Learn about Fiscal Policy and its Instruments

Fiscal policy – instruments, objectives, its role in economic development and control of

inflation and deflation

Fiscal Policy

Fiscal policy is an important part of the over all economic policy of a nation. It is being

increasingly used in modern times to achieve economic stability and growth throughout the

world. Lord Keynes for the first time emphasized the significance of fiscal policy as an

instrument of economic control. It exerts deep impact on the level of economic activity of a

nation.

Meaning

The term “fisc” in English language means “treasury”, and as such, policy related to treasury or

government exchequer is known as fiscal policy. Fiscal policy is a package of economic

measures of the government regarding its public expenditure, public revenue, public debt or

public borrowings. It concerns itself with the aggregate effects of government expenditure and

taxation on income, production and employment. In short it refers to the budgetary policy of the

government.

Definitions

1. In the words of Ursula Hicks, ” Fiscal policy is concerned with the manner in which all the

different elements of public finance, while still primarily concerned with carrying out their own

duties [as the first duty of a tax is to raise revenue] may collectively be geared to forward the

aims of economic policy”.

2. Gardner Ackley points out, “Fiscal policy involves alterations in government expenditures for

goods and services or the level of tax rates. Unlike monetary policy, these measures involve

direct government interference in to the market for goods and services [in case of public

expenditure] and direct impact on private demand [in case of taxes].


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Instruments Of Fiscal Policy

1 Public Revenue: It refers to the income or receipts of public authorities. It is classified into

two parts – Tax-revenue and non-tax revenue. Taxes are the main source of revenue to a

government. There are two types of taxes. They are direct taxes like personal and corporate

income tax, property tax and expenditure tax etc and indirect taxes like customs duties, excise

duties, sales tax now called VAT etc. Administrative revenues are the bi-products of administrate

functions of the government. They include Fees, license fees, price of public goods and services,

fines, escheats, special assessment etc.

2. Public expenditure policy: It refers to the expenditure incurred by the public authorities like

central, state and local governments. It is of two kinds, development or plan expenditure and

non-development or non-plan expenditure. Plan expenditure include income-generating projects

like development of basic industries, generation of electricity, development of transport and

communications, construction of dams etc Non-plan expenditure include defense expenditure,

subsidies, interest payments and debt servicing changes etc.

3. Public debt or public borrowing policy: All loans taken by the government constitutes

public debt. It refers to the borrowings made by the government to meet the ever-rising

expenditure. It is of two types, internal borrowings and external borrowings.

4. Deficit financing: It is an extraordinary technique of financing the deficits in the budgets. It

implies printing of fresh and new currency notes by the government by running down the cash

balances with the central bank. The amount of new money printed by the government depends on

the absorption capacity of the economy.

5. Built in stabilizers or automatic stabilizers: [BIS] The automatic or built in stabilizers

imply, automatic changes in tax collections and transfer payments or public expenditure

programmes so that it may reduce destabilizing effect on aggregate effective demand. When

income expands, automatic increase in taxes or reduction in transfer payments or government

expenditures will tend to moderate the rise in income. On the contrary, when the income

declines, tax falls automatically and transfers and government expenditure will rise and thus built

in stabilisers cushions the fall in income.

Fiscal tools: Subsidies, development rebates, tax relief’s, tax concessions, tax exemptions, and

tax holidays, freight concessions, relief expenditures, debt relief’s, transfer payments, public

works programmes etc. are some of the main tools of the fiscal policy.

Keynes insisted that public finance should be adjusted to the changing conditions of the

economy, to fight inflationary pressures and deflationary tendencies. The role of fiscal policy can

be compared to the driving of a car. While driving up a gradient (i.e., stepping up production and

productivity), what is needed is an increase in power (promotion of higher savings and

investment through fiscal measures).On the other hand, when it moves against the national

interest, it is necessary to control the supply of power (to combat inflationary and foreign

exchange crisis through higher taxation) and also to apply brakes judiciously to ensure that the


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vehicle does not slip out of control but keeps on moving all the same. The national exchequer

should see that the brakes are not pressed so much as to bring the vehicle to a stop.

In short, it is the function of public finance to make economy grow; maintain it in good health

and to protect it from internal and external dangers.

Objectives Of Fiscal Policy

1 To help in optimum allocation of scarce resources and its maximum utilization:

Idle are to be mobilized and allocated to different sectors of the economy in accordance with

national priorities. Hence, suitable fiscal policy is to be formulated in this direction.

2. To accelerate the rate of capital formation.

Fiscal policy should help in mobilizing the small savings both in rural and urban areas so as to

raise the level of capital formation in the country.

3. To encourage investment:

Fiscal policy should direct investment in the desired channels both in the public and in the

private sectors by providing suitable incentives.

4. To ensure price stability:

Appropriate fiscal policy has to be formulated in order to control the demon of inflation,

deflation and stagflation and ensure a reasonable degree of price stability in the country.

5. To control the operation of business cycles:

An appropriate fiscal policy has to be formulated so as to counteract the adverse and dampening

effects of trade cycles, to minimize business fluctuations and achieve a reasonable degree of

economic stability in the economy.

6. To ensure full employment condition:

Fiscal policy should help in exploiting all kinds of resources available in the country in the best

possible manner and ensure full employment condition in the economy.

7. To accelerate the rate of economic growth.

The main objective of the fiscal policy is to stimulate and accelerate the rate of economic growth

in the country. All instruments of fiscal policy have to be employed in order to give a big push to

the process of development in the country.


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8 To ensure equitable distribution of income and wealth:

In the course of economic development, it is quite possible that monopoly houses would grow

and income and wealth gets concentrated in the hands of only a few powerful and influential

persons. Hence, suitable fiscal policy has to be adopted to reduce income disparities and ensure

distributive justice to the common man.

9. To reduce and minimize regional and sectoral imbalances:

In most of the countries there is wide spread disparities in the levels of development in different

regions of the country. Suitable fiscal policy has to be designed to avoid, minimize and reduce

regional and sectoral imbalances and ensures balanced growth in the country.

10. To mobilize real and financial resources for public sector in larger quantity

Public sector has assumed greater significance in planned economic development of a country in

recent years. Hence, an appropriate fiscal policy is to be designed to mobilize all kinds of real

and financial resources for the successful working of the public sector.

Objectives in developing countries

The development problems of developing countries are totally different from that of developed

countries and as such the objectives of fiscal policy also changes in such economies. These

objectives are listed below.

1. Help to break the vicious circle of poverty:

Most of the developing countries are caught in the grip of vicious circle of poverty for the past

several decades and centuries. They are struggling very hard to come out of this vicious circle

and create the background for normal economic growth. It is possible only through increasing

the rate of investments in all sectors simultaneously. Hence, suitable fiscal policy has to be

formulated to mobilize financial resources required for heavy doses of investments.

2. Help to formulate a rational consumption policy:

In order to reduce MPC and increase MPS, it becomes inevitable to pursue a rational

consumption policy, which helps in curbing conspicuous consumption, and release the resources

for saving purposes.

3. Help to raise the rate of savings:

Fiscal policy should help in mobilizing both voluntary and forced savings. Various kinds of

incentives may be offered to encourage savings.

4. Help to increase the volume of investment:


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Economic development directly depends on the amount of money invested in different sectors of

the economy. Fiscal policy should help in converting the savings made by the people into

investments and create the required economic environment to promote investment activity in the

country.

5. Help to diversify the flow of resources:

The existing scarce resources are to be diverted from unproductive and speculative areas and

directed towards the most productive uses and socially desirable channels so as to maximize net

social gains to the common man.

6. Help to raise living standards:

One of the main growth parameters is that the common man in the country should be in a

position to enjoy the basic necessaries of life in adequate quantity. Hence, the government has to

take concrete measures to ensure the supply of social goods on a large-scale. In order to achieve

this objective; suitable fiscal policy has to be formulated. For example, through public

distribution system, minimum quantities of certain items are to be supplied at subsidized rates.

7. Help to achieve full employment and stimulate growth rates:

The supreme goal of developing countries is to achieve higher rates of economic growth.

Suitable fiscal policy has to be formulated to exploit all kinds of resources so that the economy

can reach the stage of full employment condition. Full employment condition results in optimum

national output, higher aggregate demand, and income.

8. Help to reduce economic inequalities:

Through a rational fiscal policy, the government has to take adequate measures to control the

growth of monopoly houses, minimize economic inequalities and ensure distributive justice to

all.

9. Help to control inflation and deflation:

Rapid economic growth requires price stability. It is the duty of the government to adopt all

kinds of measures through suitable fiscal instruments to control inflation, deflation and

stagflation so as to achieve a reasonable degree of price stability. It should also help in

mobilizing excess purchasing power in the hands of people through suitable taxation policy.

10 Help to create more job opportunities:

In most of the developing nations, there is an army of unemployed people. The services of these

people are to be utilized by creating more productive jobs on a large-scale to absorb them. The

government through appropriate fiscal policy has to mobilize huge funds and invest them in

different sectors of the economy. Higher investment results in higher economic growth rate and

creation of more employment opportunities.


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It is quite clear that the objectives of fiscal policy are different for developed and developing

countries. It is to be noted that the various objectives listed above are mutually interrelated and

inter connected to each other. Some of the objectives are common to both developed and

developing countries. In some cases, one objective may come in clash with the other. For

example, growth objective may come in clash with controlling inflation. Again, with rapid

development, there may be growth of monopolies and concentration of income and wealth and

this will come in clash with the objective of minimizing economic inequalities in the country.

Hence, the government has to maintain harmony and balance between different objectives and

determine the priorities from time to time to meet the changing requirement of the economy


Know the Role of Fiscal Policy in the Economic Development

Role of fiscal policy in the economic development:

In order to achieve the above listed objectives, fiscal policy has to play a positive and

constructive role both in developed and developing nations. The specific role to be played by

fiscal policy can be discussed as follows.

1. To act as optimum allocator of resources.

As most of the resources are scarce in their supply, careful planning is needed in its allocation so

as to achieve the set targets. Rational allocation would ensure fulfillment of various objectives.

2. To act as a saver.

a. It should follow a rational consumption policy which reduces the MPC and raises the MPS.

b. Taxation policy has to be modified to raise the rates of old taxes, introduce new and additional

taxes, and extend the tax-net.

c. Profit earning capacity of public sector units are to be raise substantially to mop-up financial

resources.

d. The government should borrow more money both with in the country and outside the country.

e. Higher rates of interests are to be offered for government bonds and securities.

f. Introduction and popularization of small savings schemes

g. Introduction of various kinds of Insurance schemes.


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h. Enlarging banking facilities to the nook and corner of the country and adopting a rational

credit

policy.

i. Development and promotion of private financial institutions.

j. Mobilization of hoarded wealth in the country through imaginative schemes.

k. Going for moderate doses of deficit financing

l. Effective exercise of various kinds of physical control measures so as to release more resources

for development purposes etc.

3. To act as an investor.

Mere mobilization of financial resources is not an end in itself. It should result in the creation of

real resources which are more important in accelerating the growth process. Rapid economic

growth depends on the volume of investment. Hence, fiscal policy has to ensure higher volume

of investment in both public and private sectors. In the public sector the government has to

increase its investment so as to build up the required infrastructure in the country on the principle

of social marginal productivity. This would automatically stimulate investments in private

sectors. In its qualitative aspect, it should aim at changing the composition and flow of

investments in the country. It should discourage the flow of investments in to unproductive, non-

essential and speculative activities in the private sector and help in diverting these scarce

resources in to highly productive areas

4. To act as price stabilizer

Price stability is of paramount importance in an economy. Extreme levels of both inflation and

defilation would disrupt and disturb the normal and regular working of an economic system. This

would come in the way of stable and persistent growth. Hence, all measures are to be taken to

check these two dangerous situations so as to create the necessary congenial atmosphere to

prepare the background for rapid economic growth.

5. To act as an economic stabilizer.

Price stability would create the necessary background for over all economic stability. Upswings

and downswings in the level of economic activities are to be avoided. If an economy is subject to

frequent fluctuations in the form of trade cycles, certainly, it would undermine and disturb the

growth process. Instability would come in the way of persistent and consistent growth in a

country. Hence, all out measures are to taken to ensure economic stability.

6. To act as an employment generator.


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Fiscal policy should help in mobilizing more financial resources, convert them in to investment

and create more employment opportunities to absorb the huge unemployed man power.

7. To act as balancer.

There must be proper balance between aggregate savings and aggregate investments, demand

and supply, income, output and expenditure, economic over head capital and social overhead

capital etc. Any sort of imbalance would result in either surpluses or scarcity in different sectors

of the economy leading to fast growth in some sectors followed by lagging of some other sectors;

thus, disturbing the process of smooth economic growth.

8. To act as growth promoter.

The basic objective of any economic policy is to ensure higher economic growth rates. This is

possible when there is higher national savings, investment, production, employment and income.

Hence, fiscal policy is to be designed in such a manner so as to promote higher growth in an

economy.

9. To act as an income redistributor.

Fiscal policy has to minimize economic inequalities and ensure distributive justice in an

economy. This is possible when a rational taxation and public expenditure policy is adopted.

More money is to be collected from richer sections of the society through various imaginative

taxation policies and a larger amount of money is to be spent in favor of poorer sections of the

society. Thus, inequality is to be reduced to the minimum.

10. To act as stimulator of living standards of people.

The final objective is to raise the level of living standards of the people. This is possible when

there is higher output, income and employment leading to higher purchasing power in the hands

of common man. Hence, fiscal policy should help in creating more wealth in an economy. If

there is economic prosperity, then it is possible to have a satisfactory, contented and peaceful

life.

Thus, fiscal policy has to play a major role in promoting economic growth in a country.


Know the Role of Fiscal Policy to Control Inflation and Depression

Fiscal Policy To Control Inflation

Inflation is caused either by an increase in demand or increase in costs. A rise in prices generally


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gives rise to demand for rise in wages and if these demands are met, the rise in wages causes

costs and prices to rise further, thus worsening the inflationary situation. Taxation as an anti-

inflationary measure should be used carefully choosing different types of taxes. Direct taxes like

income tax, expenditure tax, and excess profit tax etc., take away from the public in a very

progressive manner a part of the purchasing power. These will have discouraging effect on

consumption. Indirect taxes carefully chosen on a few commodities may suppress the demand for

such commodities and thereby reduce the inflationary pressure to some extent.

All inessential and unproductive expenses of the government should be cut down. But as most of

the public expenditure is for the planned economic development and for the well being of the

people the scope for reducing public expenditure to dampen the inflationary pressure is very

much limited.

Public borrowing particularly from the non banking lenders will have disinflationary effect by

reducing their cash reserves and thereby keeping down the demand for goods and services.

If the government succeeds in raising revenue and reducing public expenditure, it will create a

budget surplus. If the government uses this surplus to buy off the government securities held by

the general public or the banking system there would be an expansion in the cash reserves with

the public and the credit creation capacity of the commercial banks offsetting the favourable anti-

inflationary effect of higher taxation. It should be used to redeem the debt held by the central

bank of the country. This would have the effect of reducing the supply of money in the

community and, in turn, reducing the pressure on the price level. In practice, however, the scope

for surplus budgeting is extremely limited.

Appraisal of anti-inflationary fiscal policy:

Fiscal measures are not wholly successful in preventing inflation in times of war or in periods of

rapid economic development. Large government expenditure is inevitable in such conditions and

a certain amount of deficit financing may have to be allowed. In case of developing countries

because of heavy investments in long term projects incomes are generated much ahead of the

availability of goods and services. The reduction of demand through control of public

expenditure has thus limited scope.

Increase in tax rates may discourage production and public borrowing also has its own

limitations. Total effect of all these measures may just help in reducing the inflationary pressure

but not in complete elimination of it.

Fiscal Policy To Control Depression

Lord Keynes maintains that a business depression and unemployment are due to deficiency of

aggregate demand and strongly advocates the use of fiscal policy to make up this deficiency.

There should be a reduction in personal income tax and corporate tax which will promote saving

and investment and excise and sales taxes which will promote consumption.


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During depression tax reduction alone is not adequate to push up consumption and investment to

appropriate levels, the government can make up this shortage through increase in public

expenditure. Government by investing in public works programmes, social and economic

overheads can encourage businessmen and industrialists to take up new investment activity.

Since public works programmes cannot be continued for a long period and beyond certain limits

some social security schemes, unemployment insurance, pension, subsidies of various types can

also be provided to raise the level of consumption.

Public borrowing, debt servicing and debt repayment also serve as important measures to fight

depression and cyclical unemployment.

Fiscal policy as an instrument to fight depression and create full employment conditions is much

more effective than monetary policy, since it affects the level of effective demand directly, while

monetary policy attempts to do it only indirectly.


Know about Physical policy in the regulation of consumptions, investment and foreign

trade

Physical Policy or Direct Controls

Government interference with the forces of demand and supply in the market and state regulation

of prices of commodities are common features in these days. Thus when monetary and fiscal

measures are inadequate to control prices government resorts to direct control. During the war,

when inflationary forces are strong price control involve, imposing ceilings in respect of certain

prices and prices are to be stopped from rising too high. In a planned economy, the objective of

price control is to bring about allocation of resources in accordance with the objects of plan.

Price control normally involves some control of supply or demand or both. These are done by

control of distribution of commodities through rationing. Rationing is, therefore, an essential part

of price control policy. In the U.S. price control takes the form of price support programme in

which prices are prevented from falling below certain levels considered fair. Under certain

circumstances government may resort to dual pricing, which is yet another form of price control

by the government.

Instruments Of Physical Policy

Direct controls are imposed by government to ensure proper allocation of scarce resources like

food, raw materials, consumer goods, capital goods etc. Government can strictly forbid or restrict

certain kinds of investments or economic activity. During the period of inflation government can

directly exercise control over prices and wages. During World War II, price-wage controls were

employed along with consumer rationing to curb excess demand. Monetary and fiscal controls

will have a general impact on the economy while physical controls can be employed to affect

specific scarcity areas.


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Generally Direct Controls are of three forms:

• Control over consumption and distribution through price control and rationing.

• Control over investment and production through licensing and fixing of quotas etc.

• Control over foreign trade through import control, import quotas, export control, etc.

During the war period there will be a terrific increase in the demand for certain commodities

causing a steep rise in prices of such commodities, further, this is intensified by the war

financing, allowing surplus purchasing power in the economy. Price control attempts to check

the inflationary rise in prices, enable all citizens to get a minimum of certain basic necessaries of

life and serves as an effective instrument of resource mobilization.

Government may fix ceiling prices for various commodities. If government is forced to revise

such prices from time to time, it may lead to hoarding and black-marketing. It requires

government to exercise some control over supply and demand. The state may have to

compulsorily acquire some stocks of controlled commodities and distribute them through “fair

price shops”, known as public Distribution System.

Since there is a close link between commodity market and factor market, under emergency

conditions, government may resort to control of profit, interest, rent and wages.

When prices are falling in time of depression, there is pressure for government to fix minimum

prices. In case of some farm products, when there is a bumper harvest, farmers demand for

minimum support prices to avoid excessive loss. Subsidies are granted to some farm as well as

industrial products to enable them to meet their costs.

Under certain special circumstances ‘Dual Pricing’ is adopted, there are two prices for the same

commodity at the same time – one is a controlled price fixed by the government for the benefit of

lower income groups and the other is a free market price determined by the conditions of demand

and supply, which enables the producers to make up their loss in the controlled market.

Apart from these there are “Administered Prices “, fixed by the government on a few carefully

selected goods like steel, aluminium, fertilizers, cement etc. which serve as raw materials for

other industries and fluctuations in their prices is dangerous for the growth of such industries.

Control over investment and production is equally essential. Factors of production are allocated

to industrial concerns in accordance with their requirements. Priorities are laid down in

accordance with the importance of commodities produced by different industries.

Stringent measures are taken against hoarding and black-marketing. To overcome the short term

scarcity generally essential goods are imported to meet the excess demand. Reduction of excise

duties, granting of tax concessions, credit facilities, supply of raw materials are some of the

measures adopted to encourage production, in the long run.

Globalization and liberalization policies have made control over foreign trade a more sensitive

issue. Intervention of the government in the foreign exchange market neutralizing the forces of


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demand and supply now has lost its significance. Import duties, i.e., levying tariffs on imports to

discourage such imports, Import Quotas, i.e., fixing of maximum quantity of a commodity to be

imported during a given period have become more popular as direct control measures. Besides

exports may be promoted, through reduction of export duties, use of export bounties and

subsidies and so on, if certain goods are found essential for domestic consumption, then export

of such goods can be prohibited.

Advantages of direct controls

• They can be introduced quickly and easily; hence the effects of these can be rapid.

• Direct controls can be more discriminatory than monetary and fiscal controls.

• There can be variation in the intensity of the operation of controls from time to time in

different sectors.

Disadvantages

• Direct controls suppress individual initiative and enterprise.

• They tend to inhibit innovations, such as new techniques of production, new products etc.

• Direct controls may induce speculation which may have destabilizing effect. It thus

encourages the creation of artificial scarcity through large scale hoardings.

• Direct controls need a cumbersome, honest and efficient administrative organization if

they are to work effectively.

• Gross disturbances may appear when the controls are removed.

In brief, direct controls are to be used only in extraordinary circumstances like emergencies and

not in a peacetime economy.

All measures suggested above must be carefully coordinated and implemented to achieve

economic stabilization. It may not be possible to eliminate all fluctuations in employment, output

and prices but can be controlled reasonably if measures are effectively adopted.

Summary

Stable economic conditions are a pre requisite for a systematic and smooth economic growth.

Since fluctuations are inherent in a dynamic set up, deliberate policy measures become necessary

to establish stable conditions in the economy. Stabilization policies include monetary policy,

fiscal policy and physical policy.

Monetary policy is the policy of the central bank, it consists if using such instruments as bank

rate, open market operations, variable reserve ratio and selective credit controls like margin


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requirements, moral suasion, direct action, rationing of consumer credit, etc. to regulate the

supply of money in accordance with the requirements of the economy. The principal objectives

of monetary policy are price stability, exchange stability, elimination of cyclical fluctuations,

achievement of full employment and in case of underdeveloped countries, accelerating economic

growth, controlling inflation deflation etc. Monetary policy to be effective in imparting economic

stability there should be a well organized and well developed money market.

Fiscal policy or the budgetary policy of the government refers to the policy of the government

regarding taxation, public expenditure, and management of public debt. There is a general belief

that government can influence economic and business activity through fiscal measures. The

major objectives of fiscal policy are to achieve optimum allocation of economic resources, bring

about equal distribution of income and wealth, maintain price stability, Promote and achieve full

employment, promote saving and investment, control inflation, control depression etc. Various

instruments of fiscal policy like taxation and public expenditure have their own limitations in

stabilizing the economic growth.

Physical policy refers to direct control on different activities by the government to achieve the

desired goal. It is more specific, simple and direct compared to the monetary and fiscal policies.

Government, controls consumption and distribution of essential goods like food and raw material

through price control and rationing. Direct controls are used generally to tide over a situation of

shortage or surplus, to avoid large fluctuations in the prices of essential commodities.

Investments in certain fields and foreign trade is regulated through licensing, fixing of quotas,

import controls, export controls, export promotion, etc.

Unit 13 Business Cycles

Introduction

The world has registered remarkable progress especially during the last 150 years. But the course

of world’s economic growth has seldom run smooth. There have been many upswings and

downswings in the process causing enormous impact on the economic development. Such

upswings and downswings are termed as Business Cycles or Trade Cycles. They are

characterized by recurring periods of depression followed by recovery, full employment, boom

and recession. The economists have put forward a number of theories giving explanations to

such cyclical fluctuations. Suggestions have been made to redress their adverse effects on

economic development. Businessmen will have to make right decisions during different phases

of trade cycles to counteract their impact on business.


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Study business cycles, features, characteristics, causes and phases of business cycles

Meaning And Features

Cyclical fluctuations have become a regular feature of a capitalist system. A capitalist economy

is guided by competition and profit motive. There is freedom of private enterprise, private

ownership of property and free play of market forces of supply and demand. Businessmen in

their anxiety to earn more and amass wealth, produce much in excess of the absorption capacity

of the economy causing imbalances in the supply and demand conditions. Thus, the smooth

functioning of the economy is disturbed and subject to many ups and downs. Such ups and

downs have been termed as business cycles.

The world has registered remarkable progress especially after the Industrial Revolution. But the

course of world economic growth has not been a steady upward movement. The economic

history of several economies is essentially the history of upswings and downswings. Rarely one

can witness steady and stable growth. On the other hand, economic evolution is characterized by

–

1. A period of upswing followed by a period of downswing.

2. A period of prosperity alternating with poverty and adversity.

3. A period of boom followed by a period of slump.

4. A period of expansion followed by a period of contraction.

5. A period of recession followed by a period of revival.

6. A period of optimism followed by a period of pessimism.

7. A period of inflation followed by a period of deflation.

8. A period of favorable condition by an adverse condition.

9. A Period of rise followed by a period of fall in the level of economic activity etc.

Thus, cyclical oscillations are a part of the structure of a modern dynamic economy. They are

periodical changes in the level of business activities differing in intensity and changing in their

coverage. These fluctuations occur in a more or less regular time sequence. They arise in some

sectors and spread over to entire economy. Some of these fluctuations are abrupt, isolated,

discontinuous and catastrophic. Some are regular, continuous, persistent and mild, lasting for

long periods of time in the same direction. Some are rhythmic and recurrent in nature. Thus, a

trade cycle is a highly complex phenomenon. It is associated with sweeping, violent and sudden

fluctuations in economic activity. The duration of a business cycle has not been of the same

length. It has varied from a minimum of two years to a maximum of 10 – 12 years.

The term business cycle refers to a wave like fluctuation in the over all level of economic

activity particularly in national output, income, employment and prices that occur in a

more or less regular time sequence. It is nothing but rhythmic fluctuations in the aggregate level of economic activity of a nation. Different writers have defined business cycles in


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different ways. According to Prof. Haberler, “The business cycle in the general sense may be

defined as an alternation of periods of prosperity and depression of good and bad trade”. In the

words of Prof.

Gordon, “Business cycles consists of recurring alternations of expansion and contraction in

aggregate economic activity, the alternating movements in each direction being self- reinforcing

and pervading virtually all parts of the economy”. According to Keynes “A trade cycle is

composed of periods of good trade characterized by rising prices and low unemployment

percentages, alternating with periods of bad trade characterized by falling prices and high

unemployment percentages.” Thus, one can notice a common feature in all these definitions, i.e.,

variations in the aggregate level of economic activities in different magnitudes.

Characteristics of Business Cycle

1. It is a wave-like movement and it is not a random fluctuation.

2. It is synchronic in nature. It is all embracing, it covers the entire economy. The entire

business of the economy acts like a living organism. Hence, any change in one part of the

economy affects the entire economy.

3. It occurs periodically and hence recurrent in nature. It is repetitive in the sense that it has

some recognized pattern.

4. It is to be noted that different trade cycles are similar but not identical in their nature.

Prof. Pigou points out that all recorded trade cycles are the members of the same family

but among them there are no twins.

5. The effects of different trade cycles are different on different activities.

6. It is self – generating. The process is cumulative and self-reinforcing. The self-

generating forces terminate one phase and start another phase. No phase is permanent.

7. It is international in character.

8. The prosperity phase takes double the time taken by the depression phase.

9. The downward movement is more sudden and violent than the change from downward to

upward.

10. Profits fluctuate more than the other incomes.

11. Employment and output in durable goods and capital goods industries fluctuate more than

in the consumption goods industries.

12. It is characterized by the presence of a crisis according to Lord Keynes. No two phases

are quite symmetrical. Each phase distinctly represent a crisis of different nature.

CAUSES OF BUSINESS CYCLES

The following are some of the important causes, which deserve our attention.

1. William Stanley Jevons points out that climatic conditions- good or bad create boom

and depression

2. Pigou is of the opinion that variations in business confidence, over optimism and over

pessimism and other psychological factors cause fluctuations in business.

3. Schumpeter highlights that cyclical fluctuations are caused by innovations carried out

in industrial and commercial organizations.


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4. According to JA Hobson business cycles are due to either under consumption or over

consumption. 5. In the opinion of Hawtrey non-monetary factors such as wars, earthquakes, strikes,

crop failures etc., may only cause partial or temporary fluctuations. But substantial

changes in total money supply in an economy are one of the major causes for cyclical

oscillations or alternate phase of prosperity and depression of good and bad trade

conditions.

6. According to Prof.Hayek business cycles are caused by the excess of investment over

voluntary savings. 7. According to Lord Keynes business cycles are caused by variations in the rate of

investment, which are caused by fluctuations in Marginal Efficiency of Capital and

Interest rate.

8. JR Hicks is of the opinion that autonomous Investment and Induced Investment cause

cyclical fluctuations in economic activity via. Multiplier and accelerator respectively.

9. Mitchell recognizes the fact that different parts of an economy are inter-related and

inter-connected and as such any maladjustment started in one-part spreads out to the

entire economy.

10. Kaldor stresses that changes in the stock of capital brings about changes in the level of

savings and investment which in its turn causes variations in the level of output, income

and employment in an economy.

11. Samuelson is of the opinion that either multiplier or accelerator can explain the process of

cyclical fluctuations in any economy. On the other hand, these two forces working

together [super multiplier] can satisfactorily explain the whole income generation and

income fluctuations.

12. Friedman and Schwartz observe that a change in the total stock of money supply will

have its rapid transmission effect on the level of income and prices in an economy.

Thus, it is very clear that several factors and forces are collectively responsible for the

emergence of trade cycles in an economy.

Phases of Trade Cycle.

Basically, a business cycle has only two parts- expansion and contraction or prosperity and

depression. Burns and Mitchell observe that peaks and troughs are the two main mark-off points

of a business cycle. The expansion phase starts from revival and includes prosperity and boom.

Contraction phase includes recession, depression and trough. In between these two main parts,

we come across a few other interrelated transitional phases. In its broader perspective, a business

cycle has five phases. They are as follows.


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1. Depression, contraction or downswing

It is the first phase of a trade cycle. It is a protracted period in which business activity is far

below the normal level and is extremely low. According to Prof. Haberler depression is a

“state of affairs in which the real income consumed or volume of production per head and the

rate of employment are falling and are sub-normal in the sense that there are idle resources and

unused capacity, especially unused labor”.

This period is characterized by:

a. A sharp reduction in the volume of output, trade and other transactions.

b. An increase in the level of unemployment.

c. A sharp reduction in the aggregate income of the community especially wages and profits. In

a few cases, profits turns out to be negative.

d. A drop in prices of most of the products and fall in interest rates.

e. A steep decline in consumption expenditure and fall in the level of aggregative effective

demand.

f. A decline in marginal efficiency of capital and hence the volume of investment.

g. Absence of incentives for production as the market has become dull.

h. A low demand for Loanable funds, surplus cash balances with banks leading to a contraction

in the creation of bank credit.


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i. A high rate of business failures.

j. An increasing difficulty in returning old debts by the debtors. This forces them to sell their

inventories in the market where prices are already falling. This deepens depression further.

k. A decline in the level of investment in stocks as it becomes less attractive and less profitable.

This reduces the deposits with the banks and other financial institutions leading to a contraction

in bank credit.

l. A lot of excess capacity exists in capital and consumer goods industries which work much

below their capacity due to lack of demand.

During depression, all construction activities come to a more or less halting stage. Capital

goods industries suffer more than consumer goods industries. Since costs are ’sticky’ and do not

fall as rapidly as prices, the producers suffer heavy losses. Prices of agricultural goods fall

rapidly than industrial goods. During this period purchasing power of money is very high but the

general purchasing power of the community is very low. Thus, the aggregate level of economic

activity reaches its rock bottom position. It is the stage of trough. The economy enters the phase

of depression, as the process of depression is complete. It is also called, the period of slump.

During this period, there is disorder, demoralization, dislocation and disturbances in the

normal working of the economic system. Consequently, one can notice all-round pessimism,

frustration and despair. The entire atmosphere is gloomy and hopes are less. It is a period of

great suffering and hardship to the people. Thus, it is the worst and most fearful phase of the

business cycle. USA experienced depression two times, between 1873- 1879 and 1929 – 1933.

2. Recovery or revival I

Depression cannot last long, forever. After a period of depression, recovery starts.

It is a period where in, economic activities receive stimulus and recover from the shocks. This is

the lower turning point from depression to revival towards upswing. Depression carries with

itself the seeds of its own recovery. After sometime, the rays of hope appear on the business

horizon. Pessimism is slowly replaced by optimism. Recovery helps to restore the confidence of

the business people and create a favorable climate for business ventures.

The recovery may be initiated by the following factors:

a. Increase in government expenditure so as to increase purchasing power in the hands of

consumers.

b. Changes in production techniques and business strategies.

c. Diversification in investments or Investment in new regions.


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d. Explorations and exploitation of new sources of energy etc.

e. New innovations- developing new products or services, new marketing strategy etc.

As a result of these factors, business people take more risks and invest more. Low wages

and low interest rates, low production costs, recovery in marginal efficiency of capital etc induce

the business people to take up new ventures. In the early phase of the revival, there is

considerable excess capacity in the economy so, the output increases without a proportionate

increase in total costs. Repairs, renewals and replacement of plants take place. Increase in

government expenditure stimulates the demand for consumption goods, which in its turn pushes

up the demand for capital goods. Construction activity receives an impetus. As a result, the level

of output, income, employment, wages, prices, profits, start rising. Rise in dividends induce the

producers to float fresh investment proposals in the stock market. Recovery in stock market

begins. Share prices go up. Optimistic expectations generate a favorable climate for new

investment. Attracted by the profits, banks lend more money leading to a high level of

investment. The upward trends in business give a sort of fillip to economic activity. Through

multiplier and acceleration effects, the economy moves upward rapidly. It is to be noted that

revival may be slow or fast, weak or strong; the wave of recovery once initiated begins to feed

upon itself. Generally, the process of recovery once started takes the economy to the peak of

prosperity.

3. Prosperity or Full-employment

The recovery once started gathers momentum. The cumulative process of recovery

continues till the economy reaches full employment. Full employment may be defined as a

situation where in all available resources are fully employed at the current wage rate. Hence,

achieving full employment has become the most important objective of all most all

economies. Now, there is all round stability in output, wages, prices, income, etc. According

to Prof. Haberler “Prosperity is a state of affair in which the real income consumed,

produced and the level of employment are high or rising and there are no idle resources or unemployed workers or very few of either.” During the period of prosperity an

economy experiences-

a. A high level of output, income, employment and trade.

b. A high level of purchasing power, consumption expenditure and effective demand.

c. A high level of Marginal Efficiency of Capital and volume of investment.

d. A period of mild inflation sets in leading to a feeling of optimism among businessmen and

industrialists.

e. An increase in the level of inventories of both inputs and outputs.

f. A rise in Interest Rate.


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g. A large expansion in bank credit and financial institutions lend more money to business

men.

h. Firms operate almost at full capacity along with its production possibility frontier.

i. Share markets give handsome gains to investors as dividends and share prices go up.

Consequently, idle funds find their way to productive investments.

j. A state of exuberance and enthusiasm exists in business community.

k. Industrial and commercial activity, both speculative and non-speculative show remarkable

expansion.

l. There is all round expansion, development, growth and prosperity in the economy. Every

one seems to be happy during this period.

The USA experienced the longest period of prosperity between 1923 &29.

4. Boom or Over full Employment or Inflation

The prosperity phase does not stop at full employment. It gives way to the emergence of a boom.

It is a phase where in there will be an artificial and temporary prosperity in an economy.

Business optimism stimulates further investment leading to rapid expansion in all spheres of

business activities during the stage of full employment, unutilized capacity gradually disappears.

Idle resources are fully employed. Hence, rise in investment can only mean increased pressure

for the available men and materials. Factor inputs become scarce commanding higher

remuneration. This leads to a rise in wages and prices. Production costs go up. Consequently,

higher output is obtained only at a higher cost of production. Once full employment is reached, a

further increase in the demand for factor inputs will lead to an increase in prices rather than an

increase in output and income. Demand for Loanable funds increases leading to a rise in interest

rates. Now there will be hectic economic activity. Soon a situation develops in which the number

of jobs exceed the number of workers available in the market. Such a situation is known as

overfull employment or hyper-employment. During this phase:

a. Prices, wages, interest, incomes, profits etc move in the upward direction.

b. MEC raises leading to business expansion.

c. Business people borrow more and invest. This adds fuel to the fire. The tempo of boom

reaches new heights.

d. There is higher output, income and employment. Living standards of the people also

increases.

e. There is higher purchasing power and the level of effective demand will reach new

heights.


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f. There is an atmosphere of “over optimism” all round, which results in over investment.

Cost of living increases at a rate relatively higher than the increase in household incomes.

g. It is a symptom of the end of prosperity phase and the beginning of recession.

The boom carries with it the gems of its own destruction. The prosperity phase comes to an end

when the forces favoring expansion becomes progressively weak. Bottlenecks begin to appear.

Scarcity of factor inputs and rise in their prices disturb the cost calculations of the entrepreneurs.

Now the entrepreneurs realize that they have over stepped the mark and become over cautious

and their over-optimism paves the way for their pessimism. Thus, prosperity digs its own grave.

Generally the failure of a company or a bank bursts the boom and ushers in a recession. USA

experienced prosperity between 1923 and 1929.

5. Recession – A turn from prosperity to Depression

The period of recession begins when the phase of prosperity ends. It is a period of time

where in the aggregate level of economic activity starts declining. There is contraction or

slowing down of business activities. After reaching the peak point, demand for goods decline.

Over investment and production creates imbalance between supply and demand. Inventories of

finished goods pile up. Future investment plans are given up. Orders placed for new equipments

and raw materials and other inputs are cancelled. Replacement of worn out capital is postponed.

The cancellation of orders for the inputs by the producers of consumer goods creates a chain

reaction in the input market. Incomes of the factor inputs decline this creates demand recession.

In order to get rid of their high inventories, and to clear off their bank obligations, producers

reduce market prices. In anticipation of further fall in prices, consumers postpone their

purchases. Production schedules by firms are curtailed and workers are laid-off. Banks curtail

credit. Share prices decline and there will be slackness in stock and financial market.

Consequently, there will be a decline in investment, employment, income and consumption.

Liquidity preference suddenly develops. Multiplier and accelerator work in the reverse direction.

Unemployment sets in the capital goods industries and with the passage of time, it spreads to

other industries also. The process of recession is complete. The wave of pessimism gets

transmitted to other sectors of the economy. The whole economic system thereby runs in to a

crisis.

Failure of some business creates panic among businessmen and their confidence is shaken.

Business pessimism during this period is characterized by a feeling of hesitation, nervousness,

doubt and fear. Prof. M. W. Lee remarks, “A recession, once started, tends to build upon itself

much as forest fire. Once under way, it tends to create its own drafts and find internal impetus to

its destructive ability”. Once the recession starts, it becomes almost difficult to stop the rot. It

goes on gathering momentum and finally converts itself in to a full- fledged depression, which is

the period of utmost suffering for businessmen. Thus, now we have a full description about a

business cycle. The USA experienced one of the severe recessions during 1957-58.

Lord Overstone describes the course of business cycle in the following words – “A state

of quiescence (inert or silent) – next improvement – growing confidence – prosperity –

excitement – overtrading – convulsion – pressure – distress – ending – again in quiescence”


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A detailed study of the various phases of a business cycle is of paramount importance to

the management. It helps the management to formulate various anti-cyclical measures to be

taken up to check the adverse effects of a trade cycle and create the necessary conditions for

ensuring stability in business.


Have the knowledge of various theories of business cycles and the measures to control

business cycles

Theories of Business Cycles.

Economists have put forward a number of theories to explain the causes of Business Cycles. We

will discuss some important theories.

Schumpeter’s Innovations Theory of Business Cycles

According to Schumpeter, innovations are the source of business fluctuations. An innovation is

defined as the development of a new product, or the introduction of a new method of

production, a new process of production, development of a new market, development of a

new source of raw material, a change in the organization of business, and so on. In other

words an innovation is anything which is introduced by a firm to change the position of supply

and/or demand curves. Any innovation, thus, results in the establishment of a new equilibrium in

the system.

Let us assume that there is full employment in the economy. Suppose that an innovation in the

form of a new product has been introduced. The new plant and equipment required to produce

the new product has to be drawn from the old industries paying higher rewards. This compels old

industries too to raise the factor rewards. For this banks provide additional loans. There will be a

rise in the cost of production in both the old and the new industries. Factor services earning

higher remuneration will push up the demand for both old and new goods. Such of the industries

whose cost of production is less and the prices of products go high enough to fetch abnormal

profits expand their production.

When the new product introduced becomes commercially successful and promoters earn

abnormal profit, many similar products and imitations crop up in the market. With the result

employment, output and incomes raise leading to expansion in the market. A period of

cumulative prosperity sets in motion.

The new product loses its novelty with the introduction of many competing varieties of product

being introduced in the market. Abnormal profits are competed away. Some of the firms may

incur losses and quit the market. Workers are laid off. Demand for goods fall, employment falls,


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incomes fall pushing down the prices and profits further. Banks pressurize for the repayment of

loans, with the result money in circulation falls setting in a deflationary situation.

Thus Schumpeter attributes business expansion and contraction to the innovations of various

kinds.

The assumption of full employment and the financing of innovations by means of bank loans are

subject to criticism. Again Innovations cannot be considered as the only cause of business

fluctuations.

Over – Investment theory of Von Hayek

According to Professor Hayek business cycles are caused by overinvestment and consequent

overproduction. According to him, there is a “natural” or equilibrium rate of interest at which the

demand for loanable funds is equal to the supply of the same through voluntary savings. There is

yet another rate of interest called the market rate of interest based on demand for and supply of

loanable funds in the market. According to him when both’ natural’ and ‘market rate of interest’

are the same, there will be stability in business conditions. Any disparity between the two will

lead to business fluctuations.

The market rate of interest may fall below the natural rate when there is an increase in the supply

of money and bank credit. This encourages investment activity causing an increase in the

demand for capital goods. This leads to a rise in the prices of capital goods inducing the

entrepreneurs to divert the resources from the production of consumption goods to the

production of capital goods – resulting in the reduction of the supply of consumption goods. As

the people engaged in capital goods industry earn larger incomes the demand for consumption

goods will increase causing a rise in their prices. There will now be a competition between the

capital goods industries and consumption goods industries for the use of scarce resources,

leading to a rise in their prices. This will result in a fall in the profit margins of the capital goods

industries. At the same time banks decide to reduce the rate of credit expansion by raising the

market rate of interest above the natural rate. Thus, on the one hand profit margins are low, and,

on the other, credit has become costly. The business expansion and boom brought about by low

market rate of interest and heavy investment activity crashes when banking system puts a stop on

additional lending to entrepreneurs.

Thus excess supply of money and bank credit leading to a fall in the market rate below the

equilibrium rate is responsible for business fluctuations. Hayek’s solution to control the cyclical

fluctuations is simple; Keep the supply of money and bank credit stable to maintain stable

economic activity.

The basic weakness of the theory is its emphasis on the rate of interest and complete neglect of

such real factors as technological changes and innovations influencing the volume of investment.

Further his suggestion to maintain a constant supply of money to avoid fluctuations in business is

based on the discarded quantity theory of money. The theory also fails to offer a convincing

explanation as to why fluctuations in investment take place almost regularly. It does not provide

explanation to all the characteristics of a trade cycle and its duration.


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Hawtrey’s Pure Monetary Theory of Trade Cycles

Professor

Hawtrey regards trade cycle as a purely monetary phenomenon. Changes in the flow of money

are mainly responsible for creating business fluctuations in an economy. According to him the

main factor affecting the flow of money supply is the credit creation by the banking system.

When the central bank reduces the Bank Rate, the commercial banks in the country reduce their

lending rates. A reduction in the lending rates induce traders and businessmen to borrow more

from banks and hold larger stocks and place more orders with the manufacturers. Producers to

meet the increased demand purchase more materials and employ more men. Incomes increase

and prices show an upward trend. There is boom in the economy. But soon when banks find that

they have created too much credit and their cash reserves are too small in relation to their

deposits, they restrict credit and call back loans. The central bank raises the Bank Rate to tighten

the supply of money. This compels the commercial banks to raise their lending rates and contract

their credit. This comes as a big shock to the businessmen. They are then forced to sell their

stocks and cancel new orders for products. There will be a fall in the level of investment

resulting in a fall in the level of employment and incomes. This will lead to a steep fall in the

aggregate demand causing a fall in the prices. The prosperity phase comes to an end when credit

expansion ends. Depression sets in.

Thus, the monetary phenomena of hoarding and dishoarding , credit expansion and credit

contraction have a lot to do with business cycles, since they represent a succession of inflationary

and deflationary processes.

Hawtrey has not explained how the initial expansion or contraction of credit starts and why bank

policy gets unstable. There is also no explanation why booms and depression occur with such

regularity. No doubt banking system plays an important role in financing trade activities. But it is

not always correct to say that banks cause business cycles. They may aggravate matters.

Moreover, borrowing and investment will not depend upon the rate of interest. Expansion and

contraction of bank credit alone cannot explain prosperity and depression.

Modern Theory: Interaction of Multiplier and Acceleration Principle

According to Samuelson the interaction between multiplier and accelerator gives rise to cyclical

fluctuations in economic activity. He constructed a multiplier – accelerator model assuming one

period lag and different values for the MPC and the accelerator. The changes in the level of

income caused by the operation of the super multiplier have been explained in five different

types of fluctuations. – 1. Cycle less path based only on the multiplier effect, 2. A damped

cyclical path fluctuating around the static multiplier level and gradually subsiding to that level. 3.

Cycles of constant amplitude repeating themselves around the multiplier level 4. Explosive

cycles 5. Cycle less explosive approaching an upward path. Out of the five types explained only

the second and the fourth have been experienced in a milder form over the first half century.

Generally, cycles in the post-war period have been relatively damped compared to those in the

interwar period.


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One-period lag means that an increase in income in one period induces an increase in the

consumption in the succeeding period. An autonomous increase in the level of investment gives

rise to an increase in the income according to the value of the multiplier. This increase in the

income will induce further increase in investment through acceleration effect. The Increase in

consumption, income and investment caused by an increase in initial investment through the

interaction between the multiplier and accelerator is linked round a ‘loop’. The table makes the

concept clear

Autonomous Induced Induced Total deviation of income

Base period investment

consumption investment from base period

0

1 10 0 0 10

2 10 5 10 25

3 10 12.5 15 37.5

4 10 18.75 12.50 41.25

5 10 20.68 3.86 34.54

In the table we have assumed that the Marginal propensity to consume is ½, the accelerator is

2.and that there is one period lag. We have further assumed that an autonomous investment of

Rs.10 crores is added in each period which is continuously maintained in the succeeding periods.

It will be noticed from the table that, when autonomous increase in investment of Rs.10 crores is

added in period 1, it gives rise to an increase in income of only Rs.10 crores. It does not induce

increase in consumption in period 1, as we have assumed a lag of one period.. Now with MPC of

½, the increase in income of Rs.10 crores in period 1 induces an increase in consumption of Rs.5

crores in period 2. With the value of accelerator as 2, there will be induced investment of Rs.10

crores in period 2. Now the total increase in income in period 2 over the base period will be

equal to the autonomous investment of Rs.10 crores which is maintained in the second period

plus the induced consumption of Rs.5 crores plus the induced investment of Rs 10 crores(total

increase in income in period 2 = 25). Now, in the third period, the consumption would be equal

to Rs. 12.5 crores. The increase in consumption in period 3 over period 2 is Rs.7.5 crores, this

increase in consumption of Rs.7.5 crores will induce investment of the value of Rs.15 crores in

period 3. Thus the total increase in income in period 3 over the base period is equal to Rs.37.5

crores. In the same manner, the changes in income for the succeeding periods will be determined.

A glance at the table will show that there are great fluctuations in total income. Under the


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combined effect of the multiplier and accelerator, the income increases up to a certain period, but

beyond that period, it begins to decrease. First to fourth is the stage of expansion or upswing.

The fifth one is a turning point and from fifth onward is the phase of contraction or downswing.

Thus, an initial increase in investment through the multiplier and acceleration effects causes

fluctuations in income, employment and output causing upswings and downswings in economic

activity.

The principle of multiplier – acceleration interaction serves as a useful tool not only for

explaining business cycles but also as a guide to stabilization policy. As pointed out by professor

Kurihara, “it is in conjunction with the multiplier analysis based on the concept of the marginal

propensity to consume(being less than one) that the acceleration principle serves as a useful tool

of business cycle analysis and a helpful guide to business cycle policies”. The multiplier and the

accelerator combined together produce cyclical fluctuations. The greater the value of the

multiplier, the greater is the chance of a cycle less path. The greater the value of the accelerator,

the greater is the chance of an explosive cycle. We may conclude with professor Estey, “Thus the

combination of the multiplier and the accelerator seems capable of producing cyclical

fluctuations. The multiplier alone produces no cycles from any given impulse but only a gradual

increase to a constant level of income determined by the propensity to consume. But if the

principle of acceleration is introduced, the result is a series of oscillation about what might be

called the multiplier level. The accelerator first carries total income above its level, but as the

rate of increase of income diminishes, the accelerator introduces a downturn which carries total

income below the multiplier level, then up again, and so on.”

Despite its usefulness, it suffers from a few limitations. Samuelson does not say anything about

the length of the period in the different cycles. He assumes the marginal propensity to consume

and the accelerator to remain constant; he also has ignored the growth aspect. This has led Hicks

to formulate his theory of the trade cycles in a growing economy.

Hicks classified investment into autonomous and induced. Autonomous investment an

exogenous factor, through the multiplier and Induced investment an endogenous factor through

the accelerator cause cyclical fluctuations in business activity. An autonomous investment of

some amount will expand output and income to the degree indicated by the multiplier. This

expansion of income and output will result in induced investment via accelerator which gives

rise to further expansion of income and further induced investment and so on. In this process

output raises faster than the equilibrium rate, investment also increases beyond its normal rate.

The expansion of income and output will continue till it reaches the upper limit or the ceiling

determined by full employment. An expanding income and output hit the ceiling and as such the

expansionist force is bound to be checked. The rate of expansion is slowed down to the natural

rate which it had been exceeding till now. The rate of induced investment is also reduced

because the spurt of autonomous investment was short lived. But now the multiplier accelerator

mechanism sets in the reverse order, causing a fall in income and investment. The output may

plunge downward below the equilibrium level and touch the floor level.

Professor Hicks has, built a model of the trade cycle assuming values that would make for

‘explosive cycles’ kept in check by ‘ceilings’ and ‘floors’. He assumes full employment as the


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ceiling which grows at the same rate as autonomous investment and checks expansion of income

further. When the economy reaches this point national income ceases to increase at a rapid rate,

the induced investment via accelerator falls off to the level consistent with the modest rate of

growth. But the economy cannot crawl along its full employment ceiling for a long time. The

sharp decline in induced investment, when national income and hence consumption, ceases to

increase rapidly, initiates a contraction in the level of income and business activity. The fall in

national income and output resulting from the sharp fall in induced investment will go on until

the floor has been reached. The economy may crawl along for some time, in doing so; there is a

growth in the level of national income. This rate of growth as before induces investment and

both the multiplier and accelerator come into operation and the economy will move towards full

employment ceiling. According to Hicks, this is how the interaction between multiplier and

accelerator causes economic fluctuations. Such fluctuations are caused mainly by the operation

of the monetary factors like expansion and contraction of credit by the banking system.

Hicks explanation of the ceiling or the upper limit of the cycle fails to explain adequately the

onset of depression. The floor and the lower turning point is not convincingThe model can be

used to explain especially in a capitalist economy with a substantial amount of durable

equipment, how a period of contraction inevitably follows expansion.

Measures To Control Business Cycles

Control of business cycles has become an important objective of all most all economies at

present. Broadly speaking, the remedial measures can be classified under three heads, viz.,

monetary, fiscal and miscellaneous measures.

1. Monetary measures:

According to Hawtrey, Hicks and many others expansion and contraction of supply of money is

the major cause for the operation of business cycles.

Monetary policy and the expansionary phase: when the economy is moving fast in the upward

direction, the monetary measures should aim at (i) restricting the issue of legal tender money (ii)

putting restrictions to the expansion of bank credit by adopting both quantitative and qualitative

techniques of credit control. As expansionary phase is mainly supported by bank credit, adoption

of a dear money policy can put an effective check on further expansion. A rise in the Bank Rate,

by raising the lending rates of the commercial banks, making credit costly will have a

discouraging effect on more borrowings. A check can be imposed on the liquidity position of the

commercial banks by raising the Cash Reserve Ratio and Statutory Liquidity Ratio. Open market

sale of securities can also be conducted to make bank rate more effective. Selective techniques,

like raising of margin requirements, rationing of credit, moral suasion, direct action, publicity

etc., can also be used efficiently to tighten the credit situation in the economy.

Apart from these direct measures indirect measures like wage control, price control etc., can also

be adopted to put a check on the inflationary trend in the economy. Such monetary measures are

found fairly successful in controlling unwieldy expansion of the economy. Many countries like

U.K., U.S.A., France, Germany and India have used monetary measures to control inflation.


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Monetary Policy and the Phase of Depression:

During the period of depression, to enlarge employment opportunities and raise the level of

income all out measures are to be adopted to increase the level of investment. To encourage

investment activity the central bank has to follow a cheap money policy. The bank rate and the

lending rates of the commercial banks should be reduced; money should be made available freely

by reducing the CRR and SLR. Through open market sale of securities, Cash reserves with the

banks should be increased to enable them to lend money easily for various investment activities.

Various qualitative techniques of credit control like reducing the margin requirements, moral

suasion etc., may be adopted to encourage businessmen to borrow and invest.

Cheap money policy, to induce businessmen to borrow and invest is not very effective as

investment is more guided by the marginal efficiency of capital than the rate of interest. Because

of low level of income and low prices and the low profit margins entrepreneurs do not come

forward to borrow and invest in spite of the low rates of interest. One can take a horse to the

water but cannot force to have it; a plethora of money cannot induce the public horse to have it.

Thus monetary policy as a remedy to solve depression has its own limitations.

2. Fiscal policy:

During the period of inflation or uptrend in the economy, when the private enterprise is over

enthusiastic and there is over expansion and over production government can use taxation and

licensing policy as very effective instruments to check such unwieldy growth. Price control

measures can be adopted. Government should adopt surplus budget, reduce public expenditure

and resort to public borrowing. The cumulative result of these measures would reduce the supply

of money in circulation, purchasing power and demand.

On the contrary,

during the period of depression government should adopt deficit budget, Increase the volume of

public expenditure, redeem public debt and resort to external borrowings, indulge in a moderate

dose of deficit financing, reduce tax rates, grant subsidies, development rebates, tax-concessions,

tax-relief’s and freight concessions etc. As a result of these measures, supply of money in

circulation will increase. This in its turn would raise the purchasing power, demand for goods

and services, production and employment etc. J.M. Keynes recommended a number of public

works programmes to be launched by the government to cure depression. The New Deal policy

of President Roosevelt in the U.S.A. and Blum experiment in France were based on this very

belief.

3. Physical controls:

During the period of inflation, a price control policy has to be adopted where as during

depression a price-support policy has to be followed. During the period of contraction

unemployment insurance schemes, Proper management of savings, investments, production,

distribution, expansion of income and employment etc., are needed depending upon the nature of

economic fluctuations.


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4. Miscellaneous Measures:

(i) Introduction of automatic stabilizers:

An automatic stabilizer (or built in stabilizer) is an economic shock absorber that helps to

smoothen the cyclical business fluctuations of its own accord, without requiring deliberate action

on the part of the government e.g., progressive taxation policy, unemployment Insurance scheme

adopted in The U.S.A.

(ii) Price support policy followed in the U.S.A. during the post war period to fight the prospects

of depression.

(iii) The policy of stabilization of the prices of agricultural products in India through

procurement and building up of buffer stocks aim at economic stability.

(iv) Foreign aid is also used for influencing the aggregate demand and supply of goods in a

country.

(v) Granting of aid might help in recovering from slump.

In addition to these, some of the measures can be adopted at international level to mitigate the

adverse effects of business cycles and promote stability in the world economic growth like

control of private investment, control and distribution of essential goods, regulation of

international investments in developing nations, creation of international buffer stocks etc.

Thus, several measures are to be taken to smoothen the cyclical movements and to ensure

economic stability in an economy.


Know about the Business decisions to be taken during different phases of business cycles

Business Cycles And Business Decisions

Business cycles affect the smooth growth of an economy. Expansionary phase has, however, a

favorable impact on income, output and employment. But recession and depression imply

slackness in growth, contraction of economic activity, increasing unemployment, falling incomes

and so on.

Business cycles have their effects on individual business firms, as well. During expansionary

phase, there is a business boom. The firm gains due to rising demand, rising prices and


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increasing profits. Prosperity makes the business firms prosperous. But in a capitalist economy

prosperity digs its own grave.

During this period, a firm may have to face some adverse effects. Rising prices and optimism in

the market may encourage many new firms to enter the market and the existing firms to expand

their output. Competition becomes intense. Increased demand for factors may cause a rise in

their prices. Marketing and distribution costs may go up. Demand for investment funds increase.

All these may result in raising the cost of production causing a rise in the product price.

During this period a business unit should be extraordinarily cautious. Business decisions are to

be made carefully after estimating the market situation properly. Expansion in production and

sale of goods should be so organized that they take full advantage of the situation without

involving themselves into any kind of risk. A prudent businessman should adopt all possible

precautionary measures to avoid and minimize business problems as much as possible. He

should have knowledge of the economic characteristics of the trade cycles and usual sequence of

events during such periods, the phase of the trade cycle through which business is then passing,

relation between cyclical changes and general business and cyclical changes and the business of

the given enterprise, in particular, cyclical movements in production and sales and in the prices

of commodities purchased and sold. A business firm should have a comprehensive view of the

entire market – internal and external factors affecting business in order to adopt an efficient

business programme and prevent the adverse effects of cyclical changes on business. He should

mainly see that the costs are kept under control, avoid over investment, overproduction and over

expansion, excessive inventories of raw materials and finished goods. Employ a flexible credit

standard, avoid excessive borrowing. Check temporary diversification programme, avoid

purchase commitments, maintain satisfactory labour conditions and create sizable reserve fund.

Various such measures may help a firm in avoiding the harmful effects of business expansion.

During the phase of contraction, recession and depression the basic objective is to fight against

pessimism and to give a big boost to all kinds of business activities. There must be a strong

psychological shift during this period. A few measures are to be adopted to mitigate the harmful

effects of contraction. (1)Quick liquidation of inventories.(2) Reduction of cost of production.

(3) Improvement in quality (4) adoption of new selling methods.(5) Development of new

methods of organization etc.(6)Management of the labour force carefully.

Apart from these measures a businessman may also take up a few important steps in the best

interest of the firm. By adopting a very cautious policy of planning during the period of

contraction when all costs are low a firm can take up the expansion and extension programmes.

The firm will have to restructure its advertising policy to suit the circumstances. Cyclical price

adjustment poses the most challenging job for the firm. It will have to choose a right pricing

policy keeping in view various factors like changing costs, prices of substitutes, market share,

changes in general price level etc.

Thus during different phases of trade cycles a firm has to make careful decisions with regard to

finance,


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Capital budgeting, investment, production, distribution, marketing, purchasing, pricing etc. A

firm should gear up itself to face the challenges of cyclical changes in a most befitting manner.

Summary

Cyclical fluctuations have become a regular feature of a capitalist system. A business cycle

refers to a wave like fluctuations in aggregate economic activity particularly in the level of

employment, output and income. There are five phases of a trade cycle – Depression, recovery,

full employment ,boom and recession.

Depression is characterized by falling prices, falling profits, large scale unemployment and a

pessimistic atmosphere spread all over. This phase comes to an end with the recovery

programmes introduced like public works, reduction in the rate of interest etc. The recovery

helps to restore the confidence of the business people and create a favorable climate for business

ventures. Growth becomes automatic, prosperity sets in. Economic development starts in full

swing and there will be fuller utilization of resources, high level of employment, output and

incomes. This stage is characterized by rising prices, interest rate, and expansion of bank credit,

confidence and optimism in the environment. This gives rise to a state of overfull employment or

boom, over enthusiasm and a hectic business activity taking the economy beyond limits. The

boom carries with it the germs of its own destruction, the bubble of prosperity bursts and

recession sets in, a turn from prosperity to depression. This phase is characterized by hesitation,

doubt and fear, which results in stock market crash.

There are a number of theories of trade cycles giving different explanations for the occurrence of

business cycles. According to Schumpeter innovations in the field of production are responsible

for the cyclical fluctuations. Von Hayek attributes business cycles to the over investment

financed by bank credit. In the opinion of Hawtrey Business cycles are purely a monetary

phenomenon caused by the expansion and contraction in the supply of money and credit.

Professor Samuelson and Professor Hicks explain cyclical fluctuations in terms of the interaction

of multiplier – accelerator. Thus in conclusion we can say, in a dynamic economy cyclical

fluctuations are caused by any one of these factors or some of these factors or all these factors

put together.

It is essential for a business manager to be aware of the causes for cyclical fluctuations, the

nature of fluctuations, and their impact on the general business and on his business in particular

in order to take appropriate decisions at the appropriate time. Expansionary phase provides

ample opportunities to expand and make good profit, at the same time he should be careful while

formulating business policies as prosperity is only a temporary phenomenon. Again when there

is contraction he should adopt suitable measures in the field of advertisement, pricing, inventory

and the employment of labour etc. to safeguard his business against the harmful effects of

depression. Thus he should gear up to face the challenges in a befitting manner.


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Unit 14 Inflation And Deflation

Introduction

Inflation refers to a period of steady rise in price level. It is generally considered as a monetary

phenomenon caused by excess supply of money. There are different kinds of inflation – ‘demand

pull inflation and cost push inflation, etc.. Inflation is caused by a number of factors like,

increase in the supply of money, increase in the incomes, increase in exports, consumption etc.,

on the demand side and shortage in the supply of factors of production, operation of the law of

diminishing returns, war, hoarding etc., on the supply side. The effects of inflation are different

on different sections of the society. A mild inflation is beneficial to economic growth, producers

and business men are benefited by it. But when it assumes larger proportions it becomes

dangerous to the growth of the economy and is painful to consumers and laborers. A number of

anti-inflationary measures like monetary, fiscal and administrative are adopted to control

inflation.

The concept of inflationary gap was first developed by J.M.Keynes, which means ‘an excess of

anticipated expenditure over available output at a base price’.

Phillips curve explains the relationship between inflation and unemployment.

Stagflation is a new concept developed to explain the situation of stagnant conditions in

economic activity when there is inflation in the economy.

Deflation is just the opposite of inflation. It is essentially a period of falling prices and rise in the

value of money. Deflation is more dangerous than inflation.


Understand inflation and its kinds

Meaning and Kinds of Inflation

Inflation has become a global phenomenon in recent years. “Inflation is a sin; every government

denounces it and every government practices it”. Prof. ML.Stigum. Development economics is

very much associated with inflation. An in-depth study of inflation is of paramount importance

to a student of managerial economics.

The term inflation is used in many senses and hence it is very difficult to give generally

accepted, universally agreeable and precise definition to the term inflation. Popularly inflation is

associated with high prices, which causes a decline in the value of money.

Inflation is commonly understood as a situation of substantial and rapid general increase in

the level of prices and consequent deterioration in the value of money over a period of time.


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It refers to the average rise in the general level of prices and fall in the value of money.

Prof.Crowther defines inflation as “a state in which the value of money is falling i.e. Prices are

rising”. Prof. Samuelson puts it thus, “inflation occurs when the general level of prices and the

cost is rising”. According to Prof. Parkin and Bade, “Inflation is an upward movement in the

average level of prices. Its opposite is deflation, a downward movement in the average level of

prices”. Thus, the common feature of inflation is rise in prices and the degree of inflation may be

measured by price indices.

Inflation is statistically measured in terms of percentage increase in the price index, as a rate percent per unit of time- usually a year or a month. The trend of price indices reveals the

course of inflation in the economy. Usually, the Wholesale price Index [WPI] numbers are used

to measure inflation. Alternatively, the Consumer price Index [CPI] or the cost of living

Index can be adopted in measuring the rate of inflation. In order to measure the percentage rate

of inflation, Prof, Rowan suggests the following formula

Change in price [t] = P [t] – P [t-1]. Here, P = price level and [t], [t-1] are the periods of calendar

time to which the observations are made.

Most of the economists considered inflation as purely a monetary phenomenon. According to this

approach, it is increase in the quantity of money, which causes an inflationary rise in the price level. An

expansion in money supply unaccompanied by an expansion in the supply of goods and services

inevitably results in price rise. Prof Kemmerer thinks, “Inflation will exist when the amount of money in

the country is much in excess of the physical volume of goods and services”. Prof Coulbourn explains it

as ” Too much of money chasing too few goods”. To Hawtrey “Inflation is the issue of too much of

money”. Prof Einzig is of the opinion that money supply and rising price level are both cause and effect

by themselves. In his own words, “Inflation is that state of disequilibrium in which an expansion of

purchasing power tends to cause or is the effect of an increase of the price level”. Therefore, Prof.

Milton Friedman remarks – “Inflation is always and everywhere a monetary phenomenon”. The classical

economists advocated quantity theory of money and as such they analyzed the causes of inflation in

terms of money. This approach failed to explain the causes of hyperinflation, which appeared in

Germany after First World War and this theory is not applicable to an economy suffering from

depression and unemployment.

The Cambridge economists like Lord Keynes and A.C Pigou viewed inflation as a phenomenon

of full employment. According to Keynes “an inflationary rise in price cannot take place before

the point of full employment”. An expansion of money supply in a situation of under

employment equilibrium, leads to increased production of goods and services and expansion in

employment by using unemployed resources. Any rise in price level before the point of full


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employment is called “Semi – inflation” or “Bottleneck inflation”. This will continue till all

unemployed men and other resources are employed. Beyond this stage, any increase in money

supply will lead to only rise in prices, but not to rise in production and employment. Hence

according to Keynes, the rise in price level after the point of full employment is the true

inflation.

According to another approach the sole cause of inflation is the existence of a persistent excess

demand in the economy. Inflation is the excess demand over the supply of everything after the

limits of the supply have been reached.

TYPES OF INFLATION

Depending upon the rate of rise in prices and the prevailing situation inflation has been classified

under different heads:

1. Creeping inflation: When the rise in prices is very slow like that of a snail or creeper, (less

than 3 %) it is called creeping inflation.

2. Walking inflation: When the price rise is moderate (is in the range of 3 to 7 %) and the

annual inflation rate is of a single digit, it is called walking inflation. It is a warning signal for the

government to control it before it turns into running inflation.

3. Running inflation: When the prices rise rapidly, at a rate of speed of 10 to 20 percent per

annum, it is called running inflation. Such inflation affects the poor and middle classes

adversely. Its control requires strong monetary and fiscal measures; otherwise it leads to hyper

inflation.

4. Hyper Inflation: Hyper inflation is also called by various names like jumping, runaway, or

galloping inflation. During this period prices rise very fast, at double or triple digit rates from

more than 20 to 100 percent per annum or more and becomes absolutely uncontrollable. Such a

situation brings a total collapse of the monetary system because of the continuous fall in the

purchasing power of money.

5. Demand pull Inflation

It may be defined as a situation where the total monetary demand persistently exceeds total supply

of goods and services at current prices, so that prices are pulled upwards by the continuous upward

shift of the aggregate demand function. It arises as a result of an excessive aggregate effective demand

over aggregate supply of goods and services in a slowly growing economy. Supply of goods and services

will not match with rising demand. The productive ability of the economy is so poor that it is difficult to

increase the supply at a quicker rate to match the increase in demand for goods and services.

When exports increase the money income of the people rises. With excess money income,

purchasing power, demand, prices move in the upward direction.


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It is essential to note that demand-pull inflation is the result of increase in money supply. This

leads to fall in the interest rate- rise in investment- increase in production- increase in the

incomes of factors of production- increase in the demand for goods and services and finally, in

the level of prices. Thus, excess supply of money results in escalation of prices.

Again, when there is a diversion of productive resources from the production of consumer goods

to either capital or defense goods or non-essential goods, prices start rising in view of scarcity of

consumer goods and excess income in the hands of people. It is clear from the following diagram

In the diagram, the point F indicates the equilibrium position where aggregate demand is equal to

aggregate supply of goods and services. OP is the price level and OY indicates the supply of

goods and services. As demand increases, supply being constant, the price level rises from OP to

OP1 and OP2.

6. Cost- Push Inflation

It refers to a situation where in prices rise on account of increasing cost of production.

Thus, in this case, rise in price is initiated by growing factor costs. Hence, such a price rise is

termed as “cost –push’ inflation as prices are being pushed up by the rising factor costs. A

number of factors contribute for the increase in cost of production.

1. Demand for higher wages by the labour class.

2. Fixing up of higher profit margins by the manufacturers.

3. Introduction of new taxes and raising the level of old taxes.

4. Increase in the prices of different inputs in the market.

5. Rise in administrative prices by the government etc.,

These factors in turn cause prices to rise in the market. Out of many causes, rise in wages

is the most important one. It is estimated and believed that wages constitute nearly 70%

of the total cost of production. A rise in wages leads to a rise in the total cost of

production and a consequent rise in the price level. Thus cost-push inflation occurs due to

wage push or profit-push.


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We can explain the cost-push inflation with the help of the following diagram.

In the diagram, the point F indicates the original equilibrium position where demand and

supply are equal to each other. OP is the original price level and OY is the supply. A is

the new equilibrium point when the supply curve shifts upwards on account of cost –push

factors. OP1 will be the new price level, which is higher than the original one. OY1will

be the new supply and so on.


Causes of inflation and its effects on different sections of the society

Causes of Inflation

Demand side

Increase in aggregative effective demand is responsible for inflation. In this case,

aggregate demand exceeds aggregate supply of goods and services. Demand rises much

faster than the supply. We can enumerate the following reasons for increase in effective

demand.

1. Increase in money supply

Supply of money in circulation increases on account of the following reasons – deficit

financing by the government, expansion in public expenditure, expansion in bank credit

and repayment of past debt by the government to the people, increase in legal tender

money and public borrowing.

2. Increase in disposable income


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Aggregate effective demand rises when disposable income of the people increases.

Disposable income rises on account of the following reasons – reduction in the rates of

taxes, increase in national income while tax level remains constant and decline in the

level of savings.

3. Increase in private consumption expenditure and investment expenditure

An increase in private expenditure both on consumption and on investment leads to

emergence of excess demand in an economy. When business is prosperous, business

expectations are optimistic and prices are rising, more investment is made by private

entrepreneurs causing an increase in factor prices. When the incomes of the factors rise,

there is more expenditure on consumer goods.

4. Increase in Exports

An increase in the foreign demand for a country’s exports reduces the stock of goods

available for home consumption. This creates shortages in the country leading to rise in

price level.

5. Existence of Black Money

The existence of black money in a country due to corruption, tax evasion, black-

marketing etc, increases the aggregate demand. People spend such unaccounted money

extravagantly thereby creating un-necessary demand for goods and services causing

inflation.

6. Increase in Foreign Exchange Reserves: It may increase on account of the inflow of foreign

money in to the country. Foreign Direct Investment may increase and non-resident deposits may

also increase due to the policy of the government.

7. Increase in population growth creates increase in demand for every thing in a

country.

8. High rates of indirect taxes would lead to rise in prices.

9. Reduction in the rates of direct taxes would leave more cash in the hands of people

inducing them to buy more goods and services leading to an increase in prices.

10. Reduction in the level of savings creates more demand for goods and services.

II. Supply side

Generally, the supply of goods and services do not keep pace with the ever-increasing

demand for goods and services. Thus, supply does not match with the demand. Supply


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falls short of demand. Increase in supply of goods and services may be limited because of

the following reasons.

1. Shortage in the supply of factors of production

When there is shortage in the supply of factors of production like raw materials, labor,

capital equipments etc. there will be a rise in their prices. Thus, when supply falls short of

demand, a situation of excess demand emerges creating inflationary pressures in an

economy.

2. Operation of law of diminishing returns

When the law of diminishing returns operate, increase in production is possible only at a

higher cost which de motivates the producers to invest in large amounts. Thus production

will not increase proportionately to meet the increase in demand. Hence, supply falls

short of demand.

3. Hoardings by Traders and speculators

During the period of shortage and rise in prices, hoarding of essential commodities by

traders and speculators with the object of earning extra profits in future creates artificial

scarcity of commodities. This creates a situation of excess demand paving the way for

further inflation.

4. Hoarding by Consumers

Consumers may also hoard essential goods to avoid payment of higher prices in future.

This leads to increase in current demand, which in turn stimulate prices.

5. Role of Trade unions

Trade union activities leading to industrial unrest in the form of strikes and lockouts also

reduce production. This will lead to creation of excess demand that eventually brings a

rise in the price level.

6. Role of natural Calamities

Natural calamities such as earthquake, floods and drought conditions also affect

adversely the supplies of agricultural products and create shortage of food grains and raw

materials, which in turn creates inflationary conditions.

7. War. During the period of war, shortage of essential goods create rise in prices.

8. International factors also would cause either shortage of goods and services or rise in

the prices of factor inputs leading to inflation. E.g., High prices of imports.


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9. Increase in prices of inputs with in the country.

III. Role of Expectations

Expectations also play a significant role in accentuating inflation. The following points

are worth mentioning:

1. If people expect further rise in price, the current aggregate demand increases which in

its turn causes a raise in the prices.

2. Expectations about higher wages and salaries affect very much the prices of related

goods.

3. Expectations of wage increase often induce some business houses to increase prices

even before upward wage revisions are actually made.

Thus, many factors are responsible for escalation of prices.


Know about the Effects Of Inflation

Positive side of effects of inflation:

6. Leads to rise in investment: Rise in prices leads to a rise in profits, incomes, savings,

and finally the volume of investment by the businessmen.

7. Creates better opportunities: Rise in prices, which is much higher than the production

costs, creates better and more opportunities in new fields of business activities.

8. Encourage entrepreneurship: As profits rise, it encourages entrepreneurs to enter in to

business field in an increasing manner

9. Inflation tax: Government in order to cover the deficit in the budget may resort to

inflation- tax.

10. Full utilization of resources: It helps in fuller utilization of all kinds of economic

resources in an economy as the efforts of entrepreneurs are suitably rewarded in the form

of higher profits.

11. Leads to increase in the demand for money: As price rises, people require more money

to buy the same quantity of goods and services. Hence, it leads to expansion in money

supply in the country, which leads to higher growth rate in the economy.

12. It is a necessary cost of development: It becomes inevitable during the process of

economic development. In fact, inflation promotes economic development and economic

development results in inflation. Thus, both of them go together.


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Effects on production:

1. A low inflation rate stimulates economic growth: A small amount of inflation is

often viewed as having a positive effect on the economy. For example, a mild inflation

has a stimulating or tonic effect on the economy. Rise in price leads to increase in profit

ratio – investment – output – employment and incomes in an economy.

2.

Disturbs the working of price- mechanism: The most harmful effect of inflation is that

it disrupts the smooth working of the price mechanism and economic system and as a

consequence, economic adjustments become very difficult.

3. Adverse effects on investment and production: Rise in price leads to fall in the value

of money – reduction in purchasing power – reduction in savings – reduction in

investment and production.

4. Adverse effects on savings and capital formation: Capital formation suffers as a

consequence of depreciation in the value of money and it may be driven out of the

country. Similarly, it discourages the inflow of foreign capital into the country.

5. Creates business uncertainty: Production will be adversely affected on account of

business uncertainty. A sort of tension prevails during the period of inflation, which

discourages the entrepreneurs from taking risks involved in production.

6. Reduces production: On account of fall in the rate of capital formation and

uncertainty in business, total volume of production declines.

7. Leads to change in the pattern of production: It affects the pattern of production.

Resources will be diverted from the production of essential goods to luxury goods to reap

higher profit margins.

8. Leads to hoardings and black marketing: During inflation, the traders hoard

essential goods with a view to get higher profits. The buyers also hoard essential goods

for the fear of paying higher prices in future. Thus it also leads to the growth of black

marketing.

9. Develops a sellers market: During inflation the sellers market develop. As prices are

rising people want to sell away their goods rather than buy them. Quality of goods and

services also will be affected by inflation.

10. Encourages speculative activities: Speculative activities gain momentum during

inflation.

11. Distortion in resource allocation: It leads to diversion of resources from productive

uses to unproductive uses with the sole objective of earning more profits by the


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entrepreneurs. With rise in prices, the costs of development projects also will go up

leading to more diversion of resources to complete the same project by the government.

B) Effects on distribution

1. Leads to unequal distribution of income and wealth: Prolonged and persistent

inflation leads to inequitable distribution of wealth and income in the society. Inflation

robs the poor to enrich the rich. Rich entrepreneurs earn more profits at the cost of

customers. This leads to unequal distribution of income and wealth as rich becomes

richer and poor becomes much poorer.

2. Inflation creates hardships for fixed income earners: Rentiers, bond holders with

fixed rates of interest, holders of government securities, persons who live on past savings,

pensioners etc, are adversely affected as their monetary income remains the same while

the value of money falls.

3. Debtors gain and creditors lose: During inflation generally debtors gain as they

return the borrowed money when its face value is less and creditors lose because they get

back their money with depreciation in its value.

4. Adverse effects on wage-earners and salaried class: The wage earners, salaried class

and middle class people are worst affected as their living standards deteriorate due to

escalation of prices while their money incomes remain the same.

5. Entrepreneurs and business community gain: Businessmen welcome inflation as they stand

to gain by rising prices. Their inventory value rises. Price of finished products rise much faster

than the production costs. Hence their profit margins also would go up substantially.

6. Effects on investors: If investors invest their capital on equity shares and debentures,

they stand to gain because their prices are rising. On the other hand, if they invest on

bonds and securities, they lose because their incomes from them remain the same.

7. Effects on farmers: Virtually farmers are the gainers because prices of agricultural

goods rise on the one hand & cost of cultivation lags behind prices received.

Inflation favors one group at the expense of other groups. It is generally regressive in

nature, as many people cannot protect their own self-interest.

C) Social and political effects of inflation

1. Social effects: Inflation is a powerful engine of wealth distributor in favor of the rich. It

widens the gap between the rich and the poor and thus hampers social justice. It creates a sense

of heart burning in poorer sections of the society. It leads to social conflicts between the rich

and poor.


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2.Moral and ethical effects: In order to earn higher profits, business people resort to

black marketing, adulteration, smuggling, hoarding, quality deterioration and other such

anti-social tactics. Hence, inflation gives a serious blow to business morality and ethics.

The general morality declines, corruption increases. This leads to over all

discontentments among people.

3. Political effects: Deterioration in social and ethical standards and discontentment

among the people reflects in political uncertainty. People loose faith in the administrative

ability of the Govt., which gives place for an explosive political situation in the country.

Hyper inflation in Germany during 1920’s is a glaring example for the rise of Hitler as a

director. It has been rightly said that, “Hitler is the foster-child of inflation”.

4. Impact of demonstration effect: It encourages consumerism and a country may have

to suffer on account of demonstration effects.

D) External effects of Inflation

1. Reduces the volume of exports: It reduces the volume of exports of a nation, as domestic

prices are much higher than international prices.

2. Create exchange rate difficulties: Fall in the value of home currency may reduce

external value of a currency and thus create problems in the determination of rate

exchange between the currencies of different countries.

3. Discourage the inflow of foreign capital: It discourages the inflow of foreign capital

into a country. Thus inflation has far-reaching consequences on an economy.

4. Decline in international competitiveness: If a country experiences a high rate of

inflation compared to other nations, in that case, the international competitiveness of the

given country will decline.

Thus, inflation has far-reaching consequences on an economy.


Know about the Measures that can be adopted to control inflation.

Anti-Inflationary Measures Or Measures To Control Inflation

The anti-inflationary measures are broadly classified into 3 categories.

I. MONETARY MEASURES


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Inflation is basically a monetary phenomenon. Excess money supply over the quantity of

goods and services is mainly responsible for rise in prices.

Hence, monetary authorities

aim at reducing and absorbing excess supply of money in an economy. The following are

some of the anti-inflationary monetary measures: -

1. The volume of legal tender money may be reduced either by withdrawing a part of the

notes already issued or by avoiding large-scale issue of notes.

2. Restrictions on bank credits.

3. Freezing and blocking particular type of assets.

4. Increasing bank rate and other interest rates.

5. Sale of Govt., securities in the open market by central bank.

6. Raising the legal reserve requirements like CRR and SLR

7. Prescribing a higher margin that bank and other lenders must maintain for the loans

granted by them against stocks and shares.

8. Regulation of consumer’s credit.

9. Rationing of credit etc.

Thus, the government to control inflation may exercise various quantitative and

qualitative techniques of credit controls.

II. FISCAL MEASURES

The following are some of the important anti-inflationary fiscal measures: -

1. Reduction in the volume of public expenditure.

2. Rise in the levels of taxes, introduction of new taxes and bringing more people under

the coverage of taxes.

3. More internal borrowings by public authorities.

4. Postponing the repayment of debt to people.

5. Control on the volume of deficit financing.

6. Preparation of a surplus budget.


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7. Introduction of compulsory deposit schemes.

8. Incentive to savings.

9. Diverting the public expenditure towards the projects where the time gap between

investment and production is least, (small gestation period).

10. Tariffs should be reduced to increase imports and thus allow a part of the increased

domestic money income to ‘leak-out’.

11. Inducing wage earners to buy voluntarily Govt., bonds and securities etc.

Thus, Fiscal measures succeed to a greater extent to contain inflation in its own way.

III. OTHER MEASURES- direct or administrative measures

Direct controls refer to the regulatory or administrative measures taken by the

government directly with an objective of controlling rise in prices. Modern governments

directly intervene in the working of the economy in several ways. Hence, the

governments take several concrete measures to check the rise in prices. The following are

some of these direct measures taken by modern governments.

1. Expansion in the volume of domestic output so as to meet the ever- increasing rise in the

demand for them.

2. Direct control of prices and introduction of rationing.

3. Control of speculative and gambling activities.

4. Wage – profit freeze by adopting appropriate wage- profit policy.

5. Adopting an appropriate income policy.

6. Overvaluation of currency. Over valuation of domestic currency in terms of foreign

currencies in order to increase imports to add to the stocks with in the country and

decrease in exports so that more goods will become available for domestic consumption.

7. Indexing: It refers to monetary corrections by periodic adjustments in money incomes

of the people and in the value of financial assets, saving deposits, etc held by the public

in accordance with the changes in price level. For if price rises by 15%, the money

incomes and the value of the financial assets should be increased by 15% under the

system of indexing.

8. Control of population. It is considered as one of the most important methods because if

population is controlled, it is possible to keep a check on demand for goods and services.


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9. Exhortations – it implies authoritative persuasions, publicity campaigns etc., National

saving campaign, requests to trade union for voluntary resistance to demand for rise in

wagescompanies to restrict dividend distributions to workers and management to increase

productivity and output etc.

The above said measures are to be employed in a judicious manner in order to combat the

demon of inflation in a country.


Understand the concept of Inflationary gap, Stagflation and Phillips curve.

The Inflationary Gap

J.M.Keynes invented the term ‘inflationary gap’ to describe a situation when there is

“excess of anticipated expenditure over the available output at base prices.” It is a gap

between /money incomes of the community and the available supply of output of goods

and services. According to Lipsey “The inflationary gap is the amount by which

aggregate expenditure would exceed aggregate output at the full employment level of income.” The larger the aggregate expenditure, the larger is the gap and more rapid

the inflation. During a war period, the volume of money expenditure by the government

increases, resulting in increased income with the community leading to increased

consumption expenditure and investment. Given a constant average propensity to save,

rising money incomes at full employment level lead to an excess of demand over supply

and result in the development of inflationary gap.

Now the net disposable income with the community is 12,000, but the available output

for civilian consumption is only 9,000. There is excess of demand over available supply


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to the extent of Rs.3000 crores. This is referred to as the inflationary gap. Though Keynes

associated an inflationary gap with war, such a gap can arise even during the period of

economic development.

We can show the inflationary gap diagrammatically using the Keynesian concepts of

aggregate supply and aggregate demand:

YF is the full employment level of income 45 degree line represents aggregate supply

(AS) and C+I+G line (AD).The community’s aggregate demand curve intersects the

aggregate supply curve at E , at OY1 level of income, which is greater than the full

employment level of income YF. The amount by which aggregate demand (YF A)

exceeds the aggregate supply(YF B) at the full employment level of income is the

inflationary gap(AB).

Measures to wipe out inflationary gap

13. Increase in savings to reduce aggregate demand.

14. Raise the out put to match the disposable income.

15. Raise the taxes to mop up the excess purchasing power.

The first two measures have a limited scope, monetary policy also cannot be very

effective so the government will have to rely more on fiscal measures like taxation to

wipe out the inflationary gap.

Stagflation

The present day inflation is the best explanation for stagflation in the whole world. It is

inflation accompanied by stagnation on the development front in an economy. Instead of

leading to full employment, inflation has resulted in un-employment in most of the


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countries of the world. It is a global phenomenon today. Both developed and developing

countries are not free from its clutches.

Stagflation is a portmanteau term in macro economics used to describe a period

with a high rate of inflation combined with unemployment and economic recession. Inflationary gap occurs when aggregate demand exceeds the available supply and

deflationary gap occurs when aggregate demand is less than the aggregate supply. These

are two opposite situations. For instance, when inflation goes unchecked for some time,

and prices reach very high level, aggregate demand contracts and a slump follows.

Private investment is discouraged. Inflationary and deflationary pressures exist

simultaneously. The existence of an economic recession at the height of inflation is called

’stagflation’.

The effects of rising inflation and unemployment are especially hard to counteract for the

government and the central bank. If monetary and fiscal measures are adopted to redress

one problem, the other gets aggravated. Say, if a cheap money policy and public works

programme are adopted to remedy unemployment inflation gets aggravated. On the other

hand, if a dear money policy and stringent fiscal measures are followed unemployment

will get aggravated. It is the most difficult type of inflation that the world is facing today.

Keynesian remedial measures have not succeeded in containing inflation but actually

have aggravated un-employment. Thus, the world stands today between the devil

(inflation) and deep sea (unemployment).

Phillips Curve

A.W.Phillips the British economist was the first to identify the inverse relationship

between the rate of unemployment and the rate of increase in money wages. Phillips in

his empirical study found that when unemployment was high, the rate of increase in

money wage rates was low; and when unemployment was low, the rate of increase in

money wage rates was high.

Phillips calls it as the trade-off between unemployment and money wages. This is

illustrated in the figure below.


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In the figure the horizontal axis represents the rate of unemployment and the vertical axis

represents the rate of money wages. In the figure PC represents the Phillips curve; PC is

sloping downwards and is convex to the origin of the two axes and cuts the horizontal

axis. The convexity of PC shows that money wages fall with increase in the rate of

unemployment or conversely money wages rise with decrease in the rate of

unemployment.

This inverse relationship between money wage rates and unemployment is based on the

nature of business activity. During the period of rising business activity wage rate is high

and the rate of unemployment is low and during periods of declining business activity

wage rate is low and the rate of unemployment is high.

Paul Samuelson and Robert Solow extended the Phillips curve analysis to the relationship

between the rate of change in prices and the rate of unemployment and concluded that

there is a trade-off between the level of unemployment in a country and the rate of

inflation.

We can use the same figure to illustrate this concept, instead of money wages we show

rise in the price level on the OY axis. It will be clear from the above figure, that the

higher the rate of inflation, the lower is the rate of unemployment in the country; and

lower the rate of inflation, the higher the rate of unemployment in the country i.e., one

can be achieved at the cost of the other. Phillips curve analysis can be a guide to the

government in striking a balance between the measures to be adopted to solve the

problem of unemployment and inflation.


Understand the concepts of deflation its effects an the measures to control deflation

Deflation


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Meaning

Deflation is just opposite to inflation. It is essentially a period of falling prices, fall in

incomes and rise in the value of money. According to Prof. Crowther “Deflation is that

state of the economy where the value of money is rising or the prices are falling. But

every fall in price level is not deflation. In the words of Prof. Pigou “Deflation is that

state of falling prices which occurs at the time when output of goods and services

increases more rapidly than the value of money income in the economy”. Prof. Paul

Einzig gives a better and convincing definition. In his view – “deflation is a state of

disequilibrium in which a contraction of purchasing power tends to cause, or is the effect

of a decline of price level”. Thus, fall in price level is both the result as well as the cause

of fall in money supply.

Effects of Deflation

Deflation like inflation will have both dampening and encouraging effects on different

sections of the society.

On Production

Deflation has an adverse effect on the level of production, business and employment. Fall

in demand and fall in prices force many firms to quit the industry or operate partially.

Wages are reduced or workers are retrenched. It creates a hopeless situation in the field of

production.

On Distribution

Deflation affects adversely distribution of income too. In the first place, producers,

merchants and speculators lose badly during this period because prices of the goods fall

at a much greater rate and faster than their costs. Being unable to manage with the

situation many are compelled to quit the industry.

Failure of business and inability to repay the loans incurred with the banks worsens the

position of the merchants and the producers.

Debtors lose while the creditors gain. Fixed income groups enjoy a better standard of

living as the money income is fixed, there will be a rise in their real incomes.

The salaried persons and wage earners will benefit by deflation.

However, the beneficial effects of deflation are far less compared to its adverse effects.

During this period because of unemployment, falling incomes, falling output, a kind of

pessimistic atmosphere is established in the entire economy.

Methods to Control Deflation


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Anti-deflationary measures are opposite of those which are used to control inflation.

Monetary policy Central bank will have to follow a cheap money policy – reducing the

Bank Rate, organizing open market purchase of securities, reducing the margin

requirements etc to encourage borrowing. But because of falling prices and low marginal

efficiency of capital, cheap money policy of the central bank may not be very effective in

controlling deflation.

Fiscal Policy: Fiscal measures like deficit financing, reduction in tax rates, tax

concessions, public works programmers, may prove to be more efficient in improving the

situation than the monetary measures.

Other measures Price support programmes, rationing of essential commodities, import

of essential goods, grant of subsidies, development of infrastructure, marketing facilities

etc., to some extent may ease the situation.

Both inflation and deflation are dangerous. Of the two deflation is more dangerous as it

cripples the system and establishes a hopeless situation everywhere.

Summary

Inflation refers to a period of general rise in price level. There are different types of

Inflation, like demand pull inflation, cost push inflation etc. Inflation is caused by a

number of factors like rise in the supply of money, increase in exports, black money, rise

in the coast of production, hoarding, war etc. It affects different sections of the population

differently. Producers, merchants, debtors gain while the consumers, laborers, fixed

income groups suffer. A number of measures like monetary, fiscal and physical controls

are adopted to control inflation

Inflationary gap is a Keynesian concept; it arises when the expenditure is in excess of the

goods available in the economy.

Phillips curve explains the inverse relationship that exists between the rate of

unemployment and the rate of increase in money wages. Paul Samuelson and Robert

Solow using Phillips curve explain how at a higher of inflation rate of unemployment is

low and at lower rate of inflation the unemployment rate is high. It serves as a good guide

to the government and the monetary authorities to adopt appropriate policies to tackle the

problem of unemployment and inflation.

Deflation is a state of falling prices, incomes, output and employment. As deflation has

the danger of creating conditions of depression it must be cured adopting various

monetary and fiscal measures.

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.

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Unit 15 Natural Environment And Business

Introduction

Rapid industrialization has become one of the main objectives in recent years. Industrial

development and economic development are used as synonymous words today. Industrialization

has brought several benefits to the man kind and accelerated the process of economic

development. At the same time, it has posed several challenges to the entire world. Sustainable

economic development has become the major goal in many countries of the world. It demands

higher rates of economic growth with environmental preservation. Environmental degradation in

the process of rapid growth has become the main concern in recent times. Global warming and

damage to the ozone layer are the talk of the day. There is great need for taking extra care to

maintain ecological balance in the entire world. A healthy globe can emerge only with a healthy

environment. Business has close relationships with natural environment and business units have

greater responsibilities in this direction. Maintenance of reasonable ecological balance has

become one of the pre-requisite conditions for any business to flourish. This unit deals with

various facets of environmental degradation and its harmful effects on business and the entire

society.

Learning Objective-1

Learn the concepts of externalities and environment degradation

Externalities

It is a common factor to observe that almost all economic activities are interrelated and inter

connected to each other either directly or indirectly. On account of one particular economic

activity, it may have positive or negative effects on others. Such effects are so common in our

day to day life. The concept of externalities gives us the idea about such types of effects in either

private or public activities. Externalities or spillover effects or neighborhood effects are common

in almost all kinds of economic activities.

Externalities are an effect of one economic agent’s action on another in such a way that one

agent’s decisions make another better or worse-off by changing their utility or cost. Externalities

occur when one person’s actions affect another person’s well-being and the relevant costs and

benefits are not reflected in market prices either at the micro level or macro level. In short,

externalities occur when business firms or people impose costs or benefits outside the market


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place. The term externalities refer to a benefit or cost associated with an economic

transaction, which is not taken into account by those directly involved in making it.

External costs and benefits together are called externalities.

Externalities are of two types. They may be either positive or beneficial and negative or harmful.

Positive externalities confer external benefits while negative externalities involve external costs.

These externalities arise in case of both consumption and production. Let us take some simple

illustration to explain both of them.

1. Positive externality in consumption

When the government makes arrangement for various kinds of vaccinations, in that case they not

only help the person vaccinated but also the entire neighborhood where the person lives in by

preventing the spread of different kinds of contagious diseases.

2. Negative externality in consumption

When a young man rides a noisy motor cycle, he will get greater amount of enjoyment if he

create more noise. But this will disturb the peace and tranquility in the near by areas and create

displeasure among the people

3. Positive externality in production

Beekeepers try to put their beehives on farms because the nectar from the plants increases the

production of honey. The farmers also receive advantages from the beehives because the bees aid

pollination of the plants.

4. Negative externality in production

When an industrial unit dumps its industrial wastages in to the near by river, in that case people

cannot use the water for drinking purposes.

Now let us discuss these two kinds of externalities in some detail.

1. Positive or beneficial externalities

A positive externality arises when due to the action of one person or firm others get the benefits. For example, at the micro level, if a person or an organization constructs a free

hospital, a temple by spending private money, all people living in that area certainly will get

some general or external benefits. The external benefits are the benefits the individual or firm

gives to others without receiving any monetary compensation in returns. Similarly, at the macro

level we can give several such examples. The government provides many public goods for the

benefits and convenience of the general public in all countries. The external benefits derived

from expenditures on national defense, maintenance of law and order, control on terrorism, etc.


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In all these cases, all members of the society will get the same amount of security irrespective of

the group to which one belongs. In some other cases, the government may charge a nominal

amount for certain items. But the amount of benefits derived from such goods and services are

far greater than the money paid for them by common man. Development of all the means of

transport and communication systems, construction of dams, generation and supply of electricity,

supply of essential goods through public distribution system etc are a few examples. As an

economy grows, provision of such types of external benefits to the members of the society

becomes a common feature. In this case, all will enjoy certain benefits due to the actions of

either micro units or macro units.

2. Negative or harmful externalities

A negative externality arises when one person’s or firm’s actions harm others in the society. When polluting air, water or soil, factory owners may not consider the costs that

pollution imposes on others or the government. Creation of such external costs are said to be the

negative externalities. The external cost is the uncompensated cost an individual or the firm

imposes on the others or the government. We can give a few examples to illustrate this point.

When a firm dumps toxic or chemical wastes in to a stream, it may kill fish and plants and

reduce the stream’s value for recreation. Again when industrial wastes are thrown in to the river,

water cannot be used for consumption purposes. Refineries may pollute the air, paint industry

may create bad odour, atomic and nuclear wastes may create respiratory track infections and

other kinds of diseases to all the people living in the area i.e. around the factories. This is a

negative externality created by a firm because it does not compensate people for the damages it

has created. The government is very much concerned about these types of negative externalities

because it imposes extra financial burden on it. Thus, negative externalities will increase the

social cost as the cost on the clean up and health will increase. External cost due to traffic jams,

an individual deciding to go for a drive in the peak hours and increasing the travel time of the

other drivers are all examples of negative externalities. They are defined as third party effects

arising from production and consumption of different goods and services for which no

appropriate compensation is paid.

The study of externalities by various economists has assumed greater significance in recent years

as there is a direct link between the management of the economy and environment. Externalities

create a sort of divergence between private and social costs. For example, costs of pollution is

not included in the production costs of an organization which is creating pollution, but it is

included in the social cost as the community has to bear the cost in one way or the other. Thus, to

day modern governments are spending lots of money to prevent the adverse effects of negative

externalities in all most all nations. Hence, there is lot of concern about these types of

externalities.

In the study of externalities, one has to look in to two important concepts. They are marginal

social benefits and marginal social costs.

Marginal social benefits are those additional benefits which are enjoyed by the entire

society on account of an additional economic activity and marginal social cost refers to the

cost incurred by the people or the government due to an additional economic activity.


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Marginal Social Benefit [MSB] = Marginal Private Benefit + Marginal External Benefit.

Hence, MSB = MPB + MEB.

Marginal Social Cost [MSC] = Marginal Private Cost + Marginal External Cost.

Hence, MSC = MPC + MEC.

It is clear that When MSB = MSC, there is over all economic efficiency in resource allocation to

produce different goods. If MSB > MSC, in that case, it gives green signal to produce a

commodity in larger quantities because the benefits exceed costs. On the other hand, if MSC >

MSB, in that case, it gives danger signal so that one has to decrease its production as costs

exceed benefits. Thus, the fundamental criterion is to see that both MSB and MSC are to be

balanced to each other to maximize benefits.

Environmental Degradation

In recent years, there has been very fast and quick economic growth in many countries of the

world. There is a visible change in the pattern of economic growth. In the name of quick

economic development in a very short period of time, there is fast depletion of all kinds of

resources and many types of resources may be exhausted in the near future. There has been

excessive and over-utilization of many resources. Shortsightedness in the developmental policies

has shifted the emphasis from future to the present welfare of the people. This has been

responsible for environmental disorder, dislocation and degradation. There is widespread air,

water, soil and noise pollution on account of rapid industrialization and growth in all modes of

transportation. There is environmental decay and degeneration all round the world. The

destruction in eco-system has dangerous and demoralizing effects on the economy. Degradation

and destruction of resource-base is unpardonable. They have adverse effects on health, efficiency

and quality of life of the people. Hence, there is cry for environmental protection in recent years.

Unless concrete measures are taken in right time, the man kind may have to pay a heavy price in

the near future. In this background, to day economists are talking about the concept of

sustainable economic development

Sustainable economic development seeks to meet the needs and aspirations of the present

without compromising the ability of future generations to meet their own needs. It is felt

that sustainable development can be achieved only when the environment is protected,

conserved, saved and improved consciously by the people in a country. The process of

development will become sustainable only when the stock of various types of resources are

maintained and further improved. The various sources of resources, their quantities represent a

common heritage for all the generations. Hence, all out efforts are to be made to augment these

resources in several ways and means. There should be proper balance between the present and

future use of resources. There should be proper balance between short-run and long run interests.

Hence, it has been suggested that there should be some form of environmental accounting system

in the development policy measures.


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While estimating the national income of a country, under the new system of accounting, one has

to take in to account of the total physical volume of resources and their monetary value. The total

depreciation charges include the wear and tear of capital assets, depletion of natural resources,,

various kinds of losses arising out of environmental decay and degradation etc. This will give us

a new measure of environmentally adjusted national output.

Environmental damages may be in the following categories. They are as follows.

1. Water pollution

It is one of the most important types of pollution that is taking a heavy toll in recent years. The

main water pollutants are disease-causing agents which include bacteria, viruses, protozoa and

parasitic worms that enter water from domestic sewage and untreated human and animal wastes,

oxygen-depleting wastes, inorganic plant nutrients, fertilizers, pesticides, water-soluble inorganic

chemicals which includes acids, salts, and compounds of toxic metals such as mercury and lead,

organic chemicals like oil, gasoline, plastic cleaning solvents, detergents and many other

varieties of items. As industrial wastes are dumped in to the rivers and lakes, water is

contaminated and it cannot be used for drinking purposes. It creates health hazards. The capacity

of the water to preserve the aquatic life is becoming more and more difficult. Even underground

water is polluted today on account of various reasons and is creating innumerable problems.

Billions of people are affected by water contamination in the world.

2. Air pollution

The air may become polluted by natural causes such as volcanoes, which release ash, dust,

sulphur, and other gases or by forest fires that are occasionally naturally caused by lightening.

But there are five primary pollutants that together contribute to about 90% of the global air

pollution. These are- carbon monoxide, sulfur oxides, nitrogen oxides, hydrocarbons and

particular. Human sufferings increase due to the air pollution. Respiratory disorders and cancers

are due to inhalation of polluted air. The vehicles increase the sulfur dioxide concentration in the

air creating breathing problems for children and affect their neurological developments.

3. Soil pollution

It arises as a result of excessive use of fertilizers, soil erosion, Salinization and water logging,

dumping of garbage and other kinds of unused wastes.

4. Deforestation

Forests protect environment in several ways. They provide a livelihood and cultural integrity for

forest dwellers and a habitat for a wealth of plants and animals. They protect and enrich soils,

provide natural regulation of the hydrologic cycle, affect local and regional climate through

evaporation, influence watershed flows of surface and ground water, and help to stabilize the

global climate. Hence, they play a more useful role in preserving the ecological and

environmental balance and in maintaining the biodiversity and eco systems. However, in recent


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years, there is terrific deforestation due to reckless industrialization and growth in urban areas

which is responsible for several problems.

5. Loss of biodiversity

Biological diversity, a composite of genetic information, species and eco systems, all provide

material wealth in the form of food, medicine and inputs to industrial processes. It supplies the

raw material that may assist human communities to adapt to future and unforeseen

environmental stresses. Further more, many people value sharing the earth with numerous other

forms of life and want to bequeath this heritage to future generations. Loss of biodiversity

jeopardizes all this benefits.

6. Solid and hazardous wastes

Excessive quantities of solid wastes generation, inadequate collection and unmanaged disposal

etc present serious problems for human health and productivity. Open dumping and uncontrolled

land filling causes several types of diseases and contributes for the spread of diseases. Solid and

hazardous wastes pollute ground water resources.

Thus, several factors have contributed for environmental degradation.


Understand the relationship between business and natural environment

Business And Natural Environment

Business and environment are very closely related to each other. The nature, magnitude,

composition and direction of business basically depends upon the type of natural environment

exists in a country. Business and environment has symbiotic relationship with each other. They

are inseparable in nature. Natural environment includes land form, location aspects,

topographical conditions, mountains, rivers, oceans, coast lines, forests, soil, weather and climatic conditions, natural endowments, flora and fauna etc. Natural environment is also

called as physical environment. Ecological factors which include both renewable and non-

renewable resources would affect the type of economic and business activities in a country.

Geographical factors would decide the type of goods and services that may be produced most

economically in a county. Natural hazards like floods, droughts, earth quakes, storms, heat and

cold waves and volcanic eruptions would decide the nature of business. Thus, all business

activities are guided and influenced by natural environment either directly or indirectly. Nature is

a great storehouse of all kinds of materials which are to be used by a business unit in the most

economical and profitable manner.

Apart from it, the natural environment also provides certain physical and biological conditions

with in which man lives, works and carry on his business. How best business units exploit and

use these resources to maximize their profits and maximize social benefits is the question before

any economy. Business units have to come out with such business plans which results in proper,


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better and full utilization of all kinds of resources in the most optimum manner leading to higher

output, income and employment in the country with minimum costs. It is to be remembered that

business activities should not create environmental pollution and degradation at any cost. This

calls for greater social responsibilities on them. They have to realize that only good environment

can bring good business. Social costs are to be considered while making private profits and

private profits should not come in the way of social benefits and welfare. Hence, proper

balancing is required between the two. If social costs exceed private profits, in that case,

government interference will become inevitable and it will be justified in the overall interest of

the entire society.


Knowledge of inter relationship between externalities, environmental degradation and

market failure

Externalities, Environmental Degradation And Market Failure

All the above three are interrelated to each other. While taking any decision, one has to weigh

the impact of each one of them on another. In a competitive market oriented economy, every

thing is left to the free and automatic market mechanism. The allocation of resources in to

various productive channels is made by the invisible hand of price mechanism so as to meet the

society’s maximum needs in an optimum way. Prices of all goods and services are collectively

called as the price mechanism. Price mechanism indicates the price movements caused by

changes in supply and demand for goods and services in the market. It is the connecting link

between different groups like consumers, producers, distributors etc operating in the market. It is

self-regulating and self-correcting in nature. Order and efficiency emerge spontaneously from a

seemingly uncontrolled society. All major decisions are made with the assistance of price

mechanism.

Vilifredo Pareto, an Italian economist has laid down an objective test of social welfare on the

basis of best allocation of resources in a free and perfectly competitive economy. According to

him, maximum social welfare is possible only when the resources are allocated in the most ideal

manner. Social welfare is said to be optimum when nobody can be made better off without

making somebody worse-off. In short, it is impossible to make any one better off without making

some one worse off because already there is optimum allocation of resources. Thus, there is no

scope for any sort of reallocation or reorganization of resources in the system. But it is to be

remembered that in many cases, the market mechanism fails to achieve an efficient allocation of

resources on account of several constraints. This is often called as market failure in economics.

Market failures

Market failures arise on account of the following reasons.

1. The assumption of perfect competition in the market is wrong.


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The present day markets are characterized by different degrees of imperfections. Hence, it is

difficult to expect the best allocation of resources to maximize economic gains always.

2. The assumption that there is no difference between private and social valuations is

wrong

Private costs of an economic activity always do not equal the social costs. They are totally

different in many cases. For example, when a business unit pollutes either air or water by

discharging its wastes, it can save some amount of money or private costs. This action of a

business unit would certainly impose additional burden on the entire society. The market does

not consider such kinds of social costs [creation of negative externalities].

3. Failure to supply public goods

Markets fail to supply several types of public goods to the general public in the overall interest of

the society. A public good is also called as social good or collective good used by all people

irrespective of the class to which one belongs. For example, in case of construction of a railway

line or provision of postal service, the cost of supply of the service is several times more than

that of the benefits enjoyed by the people in general. Markets do not take these costs in to

consideration.

4. Failure to supply merit goods

These are certain goods which are to be consumed by the people irrespective their level of

income. We can give a few examples for such goods. The subsidized food, clothing, shelter, free

distribution of sites to economically weaker sections, mid-day meal schemes etc. Markets cannot

realize the value and significance of such goods.

5. Failure to supply a few other goods

Economic efficiency calls for control on the growth of monopoly houses and their impact, better

and equal distribution of income and wealth in the society, correcting regional imbalances etc.

Markets cannot take in to account of these aspects.

The working of the market economy is based on Darwin’s principle of survival of the fittest and

the fittest species survive and totally ignore the economic welfare of weak and unlucky people.

Free market economy creates several types of negative externalities, environmental degradation

and many other problems in an economy. Hence, when markets fail, the government has to

interfere and look after the general well being of the especially economically weaker sections

and other downtrodden groups through various developmental and welfare programmes.

Now let us analyze the impact of negative externality in consumption and the measures to be

taken by the government in some detail.


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1. NEGATIVE EXTERNALITY IN CONSUMPTION

Consumers create negative externalities by purchasing and consuming certain commodities and

services. A few examples are given below for our understanding. Creating noise pollution by

using the car stereos, peculiar horns, smoking in public places and drinking alcohol, indulging in

various types of crimes, ill-treating animals, litter on public places and on streets, pollution from

cars and bikes, use of narcotic drugs etc.

In our example, we assume that there are no externalities in production and as such marginal

social cost and marginal private cost are equal and the competitive supply curve reflects the

common marginal cost. The demand curve reflects the marginal private benefit MPB. As MSB is

less than the MPB, the MSB curve is below the MPB curve.

In the diagram, OQ = Optimum output where MSB = MSC and OP is the original price. OQ! =

Production and consumption without tax and OP1 = price without tax.

In order to restrict production and consumption of output from OQ1 to OQ quantity, market price

has to be increased to OP2. Hence, a tax equal to P2-P has to be levied. Now the price the

consumer pays is P2 which equals the marginal private cost of production P plus the cost of

externality in consumption P2 – P. Again, the revenue generated from the tax could be used to

compensate those who are hurt by the external cost arising from the consumption of this product.

The area of the shaded triangle measures the net benefit of the tax to the society.

2. POSITIVE EXTERNALITY IN CONSUMPTION.

Some times in order to encourage consumption, the government may have to grant subsidy to

consumers. Otherwise, the total consumption in the society will be relatively lower. Hence, the


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government grants subsidy to consumers. We can explain the positive externality in consumption

with the help of a diagram.

The supply curve represents MSC which equals MPC also. The demand curve DD is the MPB

curve. As there are external benefits, MSB > MPB. Consequently, the MSB curve lies above the

demand curve.

In the diagram, OQ = social optimal quantity of consumption where MSB = MSC. Without any

sort of government intervention, the quantity produced is OQ1 and the corresponding price is P1.

It is clear that there is underproduction when compared to the socially optimal level of OQ

quantity. If OQ amount is produced, the market price will be P but the marginal cost of

production will be P2. Thus, the consumers need to be given a subsidy equal to P2 – P. The

producers will get P2 price but the consumers would pay only price P. At least part of the cost of

the subsidy P2 – P X OQ could possibly be collected from those reaping the external benefits

arising from the consumption of this commodity.

The net benefit to society from the subsidy is measured by the area of the shaded triangle in the

diagram. It represents the excess of social benefits over social costs for the output range Q1 to

OQ.

3. NEGATIVE EXTERNALITY IN PRODUCTION

Producers while producing certain types of goods like chemicals, fertilizers, pharmaceuticals etc

create negative externalities. These externalities are responsible for environmental degradation.

Unless the government takes certain concrete measures, the negative effects are minimized or

controlled. Hence, there is great need for state intervention in these cases. Negative externality in

production is explained with the help of the following diagram


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In this case, we are assuming that there are no externalities in consumption. The demand curve

DD shows the marginal private and social benefits and MPB = MSB. The supply curve

represents the marginal private costs only. The MSC curve lies above the competitive supply

curve.

In the diagram, OQ = original output where MSB = MSC .and OP = original price. The

competitive market, if left alone, will produce OQ1 quantity with a new price of OP1. Thus,

there is a tendency of over production without government regulation.

At the optimal quantity of OQ output, the price is OP but marginal private cost would be P2.

Now the government can levy a tax per unit of P – P2 on the firm and increase marginal private

cost by P – P2.and reduce output from OQ1 to OQ. Consumers would pay the price P which

includes marginal social cost of production.

The revenue from tax could be used to pay for the external damages from the production of this

quantity of output. The tax revenue could be more or less than the external damage. The revenue

would equal P – P2 X OQ quantity of output where as the total external cost would equal the

area between MSC and MPC up to OQ.

The net tax gain to the society is shown by the shaded area in the diagram. This is the excess of

costs over benefits for the units which are eliminated by the tax.

4. POSITIVE EXTERNALITY IN PRODUCTION.

All externalities are not negative. Some economic activities benefit the others and as such these

activities are to be encouraged by the government by giving various kinds of monetary and fiscal

incentives like subsidies or tax-concessions. We can give a few examples for such type of


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activities. Subsidy for fertilizers, electricity, water and interest rates on agricultural loans etc.

Positive externality can be explained with the help of the following diagram.

In this example, we assume that there are external benefits to the people. Hence, the MSC curve

is below the MPC curve. It implies that MSC < MPC. The demand curve represents the marginal

social private benefit. In the diagram, OQ = optimal level of output and the corresponding

original price is P. This original price is determined at the point where the demand curve

intersects the MSC curve.

The competitive market if left alone will produce only OQ1 quantity of output where the demand

curve intersects the MPC curve. Now it is clear that the output produced by the firm is too little

from the point of the entire society.

If the firm produces the output OQ it will charge only OP price. At this level of output their

private marginal cost is OP2. It tells us that output can be increased by providing the producers a

subsidy equal to P2 – P. The consumer pays marginal costs of production P2 minus the external

benefit P2 – P. or a price P. in case of negative externality in production; we had a tax equal to

the marginal external cost. In this case, we have a subsidy equal to the external benefit. The

government pays the subsidy to producers by collecting money from the people who enjoy

external benefits. It is to be remembered that the expenditure on subsidy may not be equal to the

total external benefit.

The net benefit to society from the subsidy is given by the shaded area in the diagram. This is the

excess of social benefit over social cost for the extra units produced as the result of the grant of

subsidy by the government.

All externalities are not negative. Some of them benefit the others and for which no

compensation is given. The important source of benefit is the creation of knowledge in modem

days. Creation and improvements in knowledge by one institution would certainly benefit a large

number of people and organizations in a society. Similarly, innovation by one firm leads to

imitating it and improving it by the rival firm. This leads to overall improvements and spread of


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knowledge in the community. This is known as technology spillover. Positive externality

involves the creation of knowledge and new technologies are difficult to identify and measure

the benefits where as negative externalities can be easily identified and measured.

Internalising Externalities

Internalizing externality occurs when an individual business unit takes external cost or benefits

in to account. In case there are external benefits, they can be internalized or external costs may

be borne by the business unit itself. However, a firm has to make cost-benefit analysis in its

business operations both at the micro level and macro level. Externalities will not always result

in inefficiency as a firm compares the benefits also. Some sort of government intervention is

necessary to overcome the market failures associated with pollution and other externalities. The

government may take several measures to solve the problems arising out of negative

externalities. The following measures deserve our attention in this direction.

1. Government taxes and subsidies

a. If MSC > MPC of an activity, the government has to tax on producers.

b. If MSC < MPC of an activity, the government has to subsidize producers.

c. If MSB < MPB of an activity, the government has to tax on consumers.

d. If MSB > MPB of an activity, the government has to subsidize consumers.

Again, if the government wants to control pollution, in that case, it will collect pollution cost in

the form of imposing taxes on business units. But it is to be noted that the entire pollution cost

cannot be compensated by the firm. Industrial growth inevitably leads to the creation of negative

externalities and the society has to bear a part of the cost unavoidably. Hence, total elimination

of industrial pollution is not possible and industrial units cannot pay in the form of taxes to

compensate the adverse effects of pollution. The tax amount is to be compared with loss to

consumers and reduction in the quantity of output by the firms.

2. Direct government regulations

In case of all kinds of pollution and other health and security externalities, the government may

introduce direct regulatory controls [social regulations] over the externality by setting certain

rules and regulations regarding pollution, which every industry should follow. Under the

command and control regulations, the government would simply order the firm to comply,

giving detailed instructions on what pollution-control technology to use and where to apply etc.

For example, installation of pollution control equipment in factories and disposing the chemical

and industrial wastes in a specific way is directly regulated by the government.

3. Introduction of emission standards


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An emission standard is a legal limit on how much pollution a firm can emit. If the firm exceeds

the limit, it can face monetary and even criminal penalties. The standard prescribed by the

government ensures that the firm produces efficiently. The firm meets the standard by installing

pollution abatement or reducing equipment. The cost incurred by the firm to install the new

equipment is included in its final market price and thus it internalizes the externalities.

4. Prescribing emission fees

An emission fee is a charge levied on each unit of a firm’s emissions. Such emission fees would

require that firms pay a tax on their pollution equal to the amount of external damage it causes. If

a firm is imposing external marginal costs of Rs. 200-00 per ton on the surroundings, in that

case, the appropriate emissions charge would be Rs. 200-00 per ton. This is another way of

internalizing the externality by making the firm to include the social costs of its activities in total

cost of production.

5. Introduction of transferable emissions permits

Under this system, each firm must have a permit to generate emissions. Each permit specifies

exactly how much the firm is allowed to emit. Any firm that generates emissions that are not

allowed by permit is subject to substantial monetary sanctions. Permits are allocated among

firms, with the number of permits chosen to achieve the desired maximum level of emissions.

The permits are marketable-they can be bought and sold.

6. Introduction of Liability rules

Instead of direct government regulations, a government may come out with the introduction of

liability rules or laws. Under this approach, the legal system makes the generators of externalities

legally liable for any damages caused to other persons. In effect, by imposing an appropriate

liability system, the externality is internalized.

7. Defining property rights

Defining individual property rights to some extent solve the problem of externalities. Property

rights are the legal rules that describe what people or firms may do with their property. When

people have property rights to land for example, they may build on it or sell it or protect it from

interference by others. A factory constructed near a lake starts throwing wastes and toxic

chemicals in the river. This leads to water pollution as people have an attitude that lake is

nobody’s property and convenient to dump the wastes and garbage. Cleaning of such a polluted

lake either by a private institution or the government involves a free-rider problem if no one

owns the lake. The benefits of a clean lake are enjoyed by many people and no one can be

charged for these benefits. However, if the same lake is owned by a person or institution, they

can charge higher prices to fishermen, boaters, recreation users and others who benefit from the

lake

8. Negotiation and the Coase theorem


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Prof. Ronald H. Coase has suggested an alternative approach to tackle the problem of

externalities. Economic efficiency can be achieved without government intervention when the

externality affects relatively few parties and when property rights are clearly specified. The

Coase theorem states that when the parties affected by externalities can negotiate costlessly with

one another, an efficient outcome results no matter how the law assigns responsibility for

damages. In other words, when parties bargain without cost and to their mutual advantage the

resulting outcome will be efficient, regardless of how the property rights are specified. For

example, if a steel factory’s effluent reduces the fisherman’s profit. Now they have two

alternatives to solve the problem. The factory can install a filter system to reduce its effluent or

the fisherman can pay for the installation of a water treatment plant. The efficient solution should

maximize the joint profit of the factory and the fishermen also. This can happen when the factory

installs a filter and the fishermen do not build a treatment plant. The optimum solution can be

found out by mutual negotiations and bargaining between the two parties in an amicable manner

so as to benefit both the parties.

Thus, there are several techniques to internalize the externalities.


Understand global environmental threats

The Global Environmental Threats.

Rapid industrialization, urbanization and economic growth have created innumerable global

environmental problems in recent years. They have posed severe threats to the very survival of

the mankind. Some of the important threats are as follows- change in climate, global warming,

acid rain, ozone layer depletion, nuclear accidents and holocaust etc. Let us study them in some

detail.

1. Climate change

Climate is the average weather conditions of a place for a fairly long period of time covering a

number of years. Climate change is a shift in the average weather that a given region

experiences. This is measured by changes in all the features one can associate with weather, such

as temperature, wind patterns, precipitation and storms etc. Global climate change implies

changes that occur in global climatic conditions. Climate change is a normal process. The rate

and magnitude of change in global climate is dramatic in recent years. It is brought about by a

number of factors such as the latitude of a place, altitude of the place, and distance from the sea,

ocean currents, position of mountains, direction of prevailing winds, nature of soil etc.

The world is adversely affected by extreme climatic changes. It can bring about changes in

frequency and intensity of the droughts and floods. It would affect public health adversely. It

may reduce the availability of clean drinking water, contaminate water, damage sewage systems,

spread infectious diseases, increase in pests and plant animal diseases, reduce food production,

create starvation and malnutrition etc. Food and water shortages may lead to conflicts leading to

displacement of a large number of people. Changes in climate may also affect the distribution of


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vector species like mosquitoes which in turn will increase the spread of diseases like malaria and

filariasis and spread to new areas. Thus, climatic change may have serious impacts on human

health. It may also increase various current health problems and also bring new and unexpected

ones.

2. Global warming or green house effect.

Global warming means an increase in the average temperature of the atmosphere, oceans, and

landmasses of Earth. The average temperature has been increasing in many regions in recent

decades. The average temperature of Earth is about 15 oC. Over the last century, this average has

risen by about 0.6 Celsius degrees. Scientists are of the opinion that it may increase to 1.4 to 5.8

Celsius degrees by the year 2100. This warming will be greatest over land areas and at high

latitudes. The projected rate of warming is greater than that has occurred in the last 10,000 years.

This temperature rise is expected to melt polar ice caps and glaciers as well as warm the oceans,

all of which will expand ocean volume and raise sea level by an estimated 9 to 100 em flooding

some coastal regions and even entire islands. Some regions in warmer climates will receive more

rainfall than before, but soils will dry out faster between storms. This may damage crops, disrupt

food supply. Plant and animal species will shift their ranges toward the poles or to higher

elevations seeking cooler temperatures, and species that cannot do so may extinct.

The main causes for global warming are as follows- burning of fossil fuels such as coal, oil, gas

which releases into the atmosphere carbon dioxide and other substances known as greenhouse

gases. As the atmosphere becomes richer in these gases, it becomes a better insulator, retaining

more of the heat provided to the planet by the sun.

The word Green House Effect was first coined by J. Fourier in the year 1827. Greenhouse is

constructed for plants mainly in the cold countries where total insolation at least during winter

season is not sufficient enough to support plant growth. The glasses of greenhouses are such that

they allow the visible sunlight to enter but prevent the long wave infra red rays to go out. The

greenhouse effect on earth means progressive warming-up of the earth’s surface due to the

blanketting effect of man-made carbon dioxide in the atmosphere. In short, the trapping of

heat from the sun by certain pollutant gases like carbon dioxide, chlorofluoro carbons,

nitrous oxide, methane etc in the atmosphere, leading to rise in the earth’s mean

temperature, is known as greenhouse effect. Carbon-dioxide is a natural constituent of the

atmosphere but its concentration is increasing in that air at an alarming rate. It is released by

combustion of fossil fuels. About half of the CO2 emitted stays in the atmosphere and the other

half of it is removed by the oceans and the plants. The increased amount of CO2 in atmosphere is

found to increase the temperature of earth. Under normal conditions, the temperature on the

surface of the earth is maintained by the energy balance of the sun rays that strike the planet

earth and the heat that is radiated back into the space. But when there is an increase in carbon

dioxide concentration or in other greenhouse gasses, the carbon dioxide or other greenhouse

gasses prevents the heat from being radiated out. That is thick carbon dioxide layer or the layer

of other greenhouse gases functions as the glass panel of a green house allowing the sunlight to

filter through, but preventing the heat from being radiated into outer space. As a result, most heat

is absorbed by carbon dioxide layer and water vapor in the atmosphere, which adds to the heat

that is already present. The net result is the warming or heating up of the earth’s atmosphere,


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which is termed as the greenhouse effect. It is clear that the energy received from the sun by

earth should be balanced by the outgoing energy and incoming energy. To maintain global

energy balance, both the atmosphere and the surface will warm until the outgoing energy equals

the incoming energy. When there is an increase in greenhouse gases, it causes warming up of the

earth. The greenhouse effect is also known as global warming.

Adverse effects of global warming

1. It causes climatic changes. Extreme weather conditions like floods and droughts are

likely to occur more frequently.

2. It results in melting of ice and glaciers leading to rise in sea levels and flooding of coastal

areas.

3. Small islands may even disappear due to submergence.

4. It leads to a change in crop pattern.

5. It creates adverse effects on eco systems biodiversity.

6. It results in changes in hydrological cycle and storms will be more frequent and intense.

7. Weather pattern becomes more unpredictable and crops are affected by different varieties

of insects and plant diseases.

8. Animals find it difficult to adjust to the changed environment leading to migration.

9. More people become sick due to global warming

10. Tropical diseases such as malaria, dengue fever, yellow fever etc will spread to other

parts of the world etc.

3. Acid rain

The term acid rain was first coined by Robert Angus in 1872. When fossil fuels such as coal, oil

and natural gas are burned, chemicals like sulfur dioxide and nitrogen oxides are produced.

These chemicals react with water and other chemicals in the air to form sulfuric acid, nitric acid,

and other harmful pollutants like sulfates and nitrates. These acid pollutants spread upwards into

the atmosphere, and are carried by air currents, to finally return to the ground in the form of acid

rain, fog or snow. The corrosive nature of acid rain causes many forms of environmental

damage. Acid pollutants also occur as dry particles and gases, which when washed from the

ground by rain, add to the acids in the rain to form an even more corrosive solution. This is

called as acid deposition.

Adverse effects of acid rain

1. Have ill-effects on vegetation.

2. Have ill-effects on soils and crop productivity.

3. Have effects on monuments statues and buildings.

4. Have adverse effects due to acidification of lakes and streams and acquatic life


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5. Have ill-effects on man. Human health may be affected by increased respiratory and skin

problems etc.

4. Ozone layer depletion

Ozone is formed by the action of sunlight on oxygen. It forms a layer 20 to 50 Kms above the

surface of the earth. This action takes place naturally in the atmosphere, but is very slow. Ozone

is a highly poisonous gas with a strong odor. It is a form of oxygen that has three atoms in each

molecule. It is considered a pollutant at ground level and constitutes a health hazard by causing

respiratory ailments like asthma and bronchitis. It also causes harm to vegetation and leads to a

deterioration of certain materials like plastic and rubber. Ozone in the upper atmosphere

however, is vital to all forms of life as it protects the earth from the sun’s harmful UV radiation.

Ozone layer is a thin band in the ozonosphere which blocks out sun’s ultra violet rays [ie, screens

out sun's harmful ultra radiation] and protects life on earth from the harmful ultraviolet radiation

from the sun.

In the ozonosphere, small amounts of ozone are constantly being formed by the action of

sunlight or oxygen. At the same time, ozone is being broken down by natural processes. Hence,

normally, the total amount of ozone usually stays constant, because its formation and destruction

occur at about the same rate. But unfortunately, human activities have recently changed the

natural balance. Some manufactured substances, such as chlorofluoro carbons, hydrochlorofluoro

and hydrochloric carbons, which are used in refrigerators, air conditioners, solvents, hospital

sterilizations etc, enter ozonosphere and destroy ozone much faster than it is formed. The result

is ozone depletion.

Adverse effects of ozone depletion

1. More ultra violet radiations are harmful to the life system on the earth and natural

vegetation.

2. Create adverse effects of productivity and crop yield

3. Create adverse effects on animal life and cause damage to wild life and marine life.

4. Create adverse effects on human health. It is responsible for sunburn, skin cancer,

blindness etc.

5. Nuclear accidents and holocaust.

Nuclear accidents refer to accidents resulting from nuclear devices and radio-active

materials. It also includes accidents resulting from the release of radio active

contamination. One can recollect a few nuclear accidents in some parts of the world.

The Three Mile Island disaster occurred at a nuclear thermal power station at Three Mile Island

in Pennsylvania in USA. Here, a private corporation constructed nuclear thermal power station

and an accident took place at the nuclear power station on 28th march, 1979. in the accident, half


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of the nuclear power reactor was completely burnt, releasing radioactivity. Due to this accident,

about 10,000 people fled away and several persons suffered form radioactivity.

The Chernobyl disaster is the most serious one. This accident occurred ion 26th

April, 1986 at the

Chernobyl reactor near Kiev, the capital of Ukraine. This accident occurred 3whenan explosion

and fire took place at the nuclear reactor. The core fires allowed a continuous release of activity

which was slowly reduced. Again a second release of activity occurred on 5th

may 1986. Nearly

31 people were killed, 200 people were diagnosed as suffering from acute radiation effect. About

1 35,000 people and a large number of animals were evacuated from a 30Km radius surrounding

the plant

Nuclear holocaust refers to whole sale destruction caused by fully burnt nuclear weapons

or bombs.

The best examples of nuclear holocausts are the dropping of atom bombs by American army on

Hiroshima and Nagasaki cities in Japan during the II world war. On 6th

august 1845, the nuclear

bomb was dropped on the city of Hiroshima and on 9th

August 1945, another bomb was dropped

over the industrial city of Nagasaki. It was estimated that as many as 1,40,000 people died in

Hiroshima and about 74,000 people died in Nagasaki on account of the dropping of the bombs.

The incidence is in the green memory of the entire world.

Another serious threat is emerging in many countries on account of using mobile phones while

driving the vehicles. It has created problems not only for the person who drive the vehicle but

also for other people who drive their vehicles on the roads and pedestrians.

Yet another major threat is from international terrorism which has taken a heavy toll in the entire

world.


1. External cost and benefits together are called ____

2. ____are defined as third party effects arising from production and / or consumption of

goods and services for which no appropriate compensation is paid.

3. Marginal social benefit = Marginal private benefit + ___________.

4. When there are negative externalities in ____, the marginal social cost will be more than

the private marginal cost.


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5. The process of development will become sustainable only when the stock of various

types of resources are maintained and __________.

6. __________ on earth means progressive warming-up of the earth’s surface due to the

blanketing effect of man-made carbon dioxide with atmosphere.

7. the term acid rain was first coined by ___________ in 1872.

8. _________________ refer to accidents resulting from nuclear device and radio-active

materials.

Summary

External costs and benefits are known as externalities. External costs indicate negative

externalities and external benefits indicate positive externalities. Environmental pollution is an

example for negative externality. A technology spillover is an external benefit that results when

knowledge spreads among individuals and the firms. A number of factors have contributed for

environmental degradation in the form of water, air, soil and noise pollution, and deforestation

etc. Markets do not take into account of externalities and as such there are market failures.

Markets are purely guided by private profit considerations and it does not look in to the welfare

of the common man in the society. In view of market failures, government intervention becomes

inevitable in any civilized society to confer certain benefits to all members of the society in the

most economical manner. Government intervention may take in the form of imposing taxes,

granting of subsidies, define property rights, introduce direct government regulations, emission

standards, transferable permits, emission fees, liability rules and through negotiations solve the

problems arising out of externalities. In recent years we find growing international threats in

several forms which are proving to be more dangerous for the peaceful living of the mankind.

Some of the important threats are change in climatic conditions, global warming, acid rain,

ozone layer depletion, nuclear accidents and holocausts. It is time for the governments and

private organizations to think seriously about this burning problem at the global level and take

concrete action at the micro and macro levels. Management students should be aware of these

global problems in its right perspective as it helps them to take right decisions as prospective

managers.

Terminal Questions

1. what are externalities ? explain positive and negative externalities.

2. Discuss the various forms of environmental degradation.

3. Analyse the inter dependence of business and natural environment.

4. Identity the reasons for market failures.

5. Explain the positive and negative externalities in consumption.

6. Analyse positive and negative externality in production.

7. Give an account of the measures to be taken to internalising externalities.

8. Discuss the various aspects of global environmental threat.

Answer to Self Assessment Questions 1


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1. Externalities

2. Negative externalities

3. Marginal external benefit.

4. Production.

5. Further improved.

6. Green house effect

7. Robert Angus

8. Nuclear accidents


1. Refer to units15.2




5. Refer to units 15.5.1 and 15.2.2

6. Refer to units 15.5.3 & 15.5.4



Economy & Finance

Managerial economics