Managerial Economics

MANAGERIAL
ECONOMICS
(FOR PRIVATE CIRCULATION ONLY)

2019
PROGRAMME COORDINATOR
Dr. Padmpriya Irabatti
COURSE DESIGN AND REVIEW COMMITTEE

Prof. Pradeep Datar Prof. Dr. Shrish Limaye
Prof. Umesh Kulkarni Prof. Prashant Ubarhande
Prof. Dr. Sudeep Limaye Mr. Dalip Mehra
Mr. Arun Vartak
COURSE WRITER
Prof. Pradeep Datar
EDITOR
Ms. Neha Mule
Published by Symbiosis Centre for Distance Learning (SCDL), Pune

2001 (Revision 03, 2018)
Copyright © 2019 Symbiosis Open Education Society

All rights reserved. No part of this book may be reproduced, transmitted or utilised in any form or by any
means, electronic or mechanical, including photocopying, recording or by any information storage or retrieval
system without written permission from the publisher.
Acknowledgement
Every attempt has been made to trace the copyright holders of materials reproduced in this book. Should any
infringement have occurred, SCDL apologises for the same and will be pleased to make necessary corrections
in future editions of this book.
PREFACE
This SLM on Managerial Economics is written with an aim to present a simple text to the students
who have limited exposure to Economics and are pursuing a programme in management studies.The
SLM is also designed to provide standard reading materials especially for the students of M.B.A.,
M.M.M., C.A., Diploma and Degree Courses in Business Management. This book will satisfy the
needs of the students who are pursuing a Distance Learning Programme in management studies. The
SLM, I hope, would also help refresh the practicing managers.
The SLM mainly lays emphasis on the applied part of the principles of Economics. The text relies
on standard works on the subject. I am deeply indebted to my teachers as well as colleagues, for
inspiring me to write this book. To cap it all, my special thanks to the Director and the respected staff
of Symbiosis Centre for Distance Learning (SCDL) for their kind cooperation.
Prof. Pradeep Datar
iii
ABOUT THE AUTHOR
Prof. Pradeep Datar is a Lecturer in the Department of Economics at S.P. College, Pune, since 1980.
He has written a few books on Economics both in English and Marathi. He has also been associated
as a visiting faculty at various management institutes in and around Pune. As a member of the visiting
faculty, he has been teaching a variety of subjects related to Economics, such as Managerial Economics
at Masters in Marketing Management Course., D. B. M.; Degree in Hotel Management and Catering
Technology; Economics of Labour at M.P.M., Indian Economic Environment at M.M.M. level etc.
All these courses are affiliated to Pune University. Furthermore, he has also worked as a visiting
faculty at SIMS, Pune; teaching Managerial Economics to PGDBM students and delivered lectures
on Monetary Economics to the students pursuing a course in M. A. (Economics).
The author has judiciously used his wide academic experience, knowledge and observation about
the current economic affairs at Global and Indian level, to present updated information which can
immensely benefit the students pursuing a programme in Management Studies.
iv
CONTENTS
Unit No. TITLE Page No.

1 Introduction to Managerial Economics 1 - 20
1.1 Introduction
1.2 Definitions of Managerial Economics
1.3 Nature of Managerial Economics
1.4 Scope of Managerial Economics
1.5 Significance of Managerial Economics
1.6 Economic Problems
1.7 Meaning of Economic Problem
1.8 Basic Economic Problems
Summary
Key Words
Self-Assessment Questions
Answers to Check your Progress
Suggested Reading
2 Profit 21 - 42
2.1 Meaning of Profit
2.2 Types of Profit
2.3 Theories of Profit
2.4 Measurement of Profit
2.5 Profit Policy
2.6 Reasonable Profit Target
Summary
Key Words
Suggested Reading
3 Demand 43 - 66
3.1 Concept of Demand
3.2 Determinants of Demand
3.3 Demand Schedule
3.4 Demand Curve
3.5 The Law of Demand
3.6 Assumptions underlying the Law of Demand
3.7 Exceptions to the Law of Demand or Exceptional Demand Curve
3.8 Changes in Quantity Demanded and Changes in Demand
Summary
Key Words
Suggested Reading
v
4 Elasticity of Demand 67 - 98
4.1 Introduction
4.2 Price Elasticity of Demand
4.3 Types of Price Elasticity
4.4 Measurement of Elasticity
4.5 Factors Influencing Price Elasticity of Demand
4.6 Practical Significance of the Concept of Elasticity of Demand
4.7 Income Elasticity of Demand : Measurement, Types
and Uses of the Concept
4.8 Cross Elasticity of Demand : Concept, Measurement and its Uses
Summary
Key Words
Suggested Reading
5 Demand Forecasting 99 - 118
5.1 Meaning and Importance
5.2 Necessity of Forecasting Demand
5.3 Factors Influencing Demand Forecasts
5.4 Techniques or Methods of Forecasting Demand
5.5 Criteria for a Good Demand Forecast
Summary
Key Words
Suggested Reading
6 Supply Analysis 119 - 140
6.1 Meaning of Supply
6.2 Determinants of Supply
6.3 The Law of Supply
6.4 Assumptions underlying the Law
6.5 Exceptions to the Law of Supply (Backward – Sloping Supply Curve)
6.6 Expansion & Contraction in Supply
6.7 Increase & Decrease in Supply
6.8 Causes of Change in Supply
6.9 Elasticity of Supply
6.10 Measurement of Elasticity of Supply
6.11 Factors Determining Elasticity of Supply
Summary
Key Words
Suggested Reading
vi
7 Production and Costs - I 141 – 164
7.1 Introduction
7.2 Production Function
7.3 Practical importance of Production Function
7.4 Linear Homogeneous Production Function
7.5 Time-Periods
7.6 The Law of Diminishing Returns or The Law of Variable Proportion
7.7 Returns to Scale or Laws of Returns to Scale
7.8 Economies and Diseconomies of Scale
Summary
Key Words
Suggested Reading
8 Production and Costs - II 165 – 186

8.1 Cost Concepts (Meaning and Importance)
8.2 Accounting Costs
8.3 Economic Costs
8.4 Opportunity Costs
8.5 Explicit and Implicit Costs
8.6 Other Production Costs
8.7 Firms’ Cost Curves
8.8 Determinants of Costs
8.9 Break-Even Point
Summary
Key Words
Suggested Reading
9 Pricing and Output Determination under Perfect Competition 187 – 212
9.1 Introduction
9.2 Concept of Market
9.3 Classification of Market based on the nature of Competition
9.4 Pure Competition
9.5 Perfect Competition
9.6 Demand Curve under Perfect Competition
9.7 Working of Price Mechanism under Perfect Competition
9.8 Equilibrium of Firm and Industry under Perfect Competition
Summary
Key Words
Suggested Reading
vii
10 Imperfect Competition 213 – 248
10.1 Introduction
10.2 Monopoly
10.3 Distinction between Perfect Competition and Monopoly
10.4 Determination of Price and Output (Equilibrium Under Monopoly)
10.5 Price Discrimination under Monopoly
10.6 Conditions of Equilibrium under Price-Discrimination
10.7 Equilibrium under Discriminating Monopoly
10.8 Dumping
10.9 Degrees of Price Discrimination
10.10 Monopolistic Competition
10.11 Determination of Price and Output under Monopolistic Competition
10.12 Comparison of Long-Run Equilibrium under Perfect
Competition and Monopolistic Competition
10.13 Monopsony
10.14 Oligopoly and Duopoly
10.15 Miscellaneous Issues in Monopolistic Competition
Summary
Key Words
Suggested Reading
11 Pricing Methods or Pricing Practices 249 – 278
11.1 Introduction
11.2 Full Cost or Cost Plus Pricing
11.3 Going Rate Pricing
11.4 Marginal Cost Pricing
11.5 Some Other Approaches
11.6 Some Guidelines for Fixation
11.7 Pricing in Public Sector Undertakings (PSUs)
11.8 Pricing in Co-operative Societies
Summary
Key Words
Suggested Reading
viii
12 Cost Benefit Analysis 279 – 306
12.1 Introduction
12.2 Public Goods vs. Private Goods
12.3 Externalities
12.4 Marginal Cost
12.5 Average Cost
12.6 Impure Public Goods
12.7 Steps in Cost Benefit Analysis
12.8 Justification for the use of Cost-Benefit Analysis
12.9 Cost-Benefit Analysis: Private and Social
12.10 Policies to Reconcile Private and Public Costs and Benefits
12.11 Cost Benefit Analysis and Overall Resource Allocation
12.12 Overall Resource Allocation
12.13 Foundations of Market System of Economy
Summary
Key Words
Suggested Reading
13 Macro Economic Analysis 307 - 344
13.1 Introduction
13.2 Importance of Macro-Economic Studies
13.3 Keynesian Macro-Economic Theory
13.4 Determination of Equilibrium Level of Output/ Employment
13.5 Keynesian Remedy to Unemployment : Government Intervention
13.6 Business Fluctuations
13.7 Inflation
13.8 Macro Policies
Summary
Key Words
Suggested Reading
ix
14 Government and Private Businesses 345 – 380
14.1 Introduction
14.2 Need for Government Intervention
14.3 Cause for Rise in Prices in India
14.4 Price Controls in India
14.5 Protection of Consumer Interests
14.6 The New Industrial Policy 1991
14.7 MRTP ACT
14.8 De-Reservation - Further Liberalisation
14.9 Economic Liberalisation
14.10 The Process of Disinvestment: Need and Methods
Summary
Key Words
Suggested Reading
References 381
x
Introduction to Managerial Economics
UNIT
1
Structure:
1.1 Introduction
1.2 Definitions of Managerial Economics
1.3 Nature of Managerial Economics
1.4 Scope of Managerial Economics
1.5 Significance of Managerial Economics
1.6 Economic Problems
1.7 Meaning of Economic Problem
1.8 Basic Economic Problems
Summary
Key Words
Suggested Reading
Introduction to Managerial Economics 1

Notes
Objectives
----------------------
After going through this unit, you will be able to:
----------------------
• Define and explain the concept of managerial economics.
----------------------
• Explain the nature and scope of managerial economics.
---------------------- • Identify economic problems.
---------------------- • Analyse basic economic problems faced by different economies.
----------------------
1.1 INTRODUCTION
----------------------
Managerial Economics generally refers to the integration of economic
----------------------
theory with business practice while economics provides the tools which
---------------------- explain various concepts such as Demand, Supply, Price, and Competition
etc. Managerial Economics applies these tools to the management of business.
---------------------- In this sense, Managerial Economics is also understood to refer to business
economics or applied economics.
----------------------
Managerial Economics lies on the border line of management and
---------------------- economics. It is a hybrid of two disciplines and it is primarily an applied branch
of knowledge. Management deals with principles which help in decision making
----------------------
under uncertainty and improve effectiveness of an organisation. Economics on
---------------------- the other hand provides a set of propositions for optimum allocation of scarce
resources to achieve the desired objectives.
----------------------
---------------------- 1.2 DEFINITIONS OF MANAGERIAL ECONOMICS
---------------------- 1. Prof. Spencer Singleman : “Managerial Economics deals with integration

of economic theory with business practice for the purpose of facilitating
---------------------- decision making and forward planning by management.”
---------------------- 2. Prof. Hague : “Managerial Economics is concerned with using logic
of economics, mathematics and statistics to provide effective ways of
---------------------- thinking about business decision problems.”
---------------------- 3. Prof. Joel Dean : “The purpose of Managerial Economics is to show how
economic analysis can be used in formulating business policies.”
----------------------
4. Prof. Mansfield : “Managerial Economics attempts to bridge the gap
---------------------- between the purely analytical problems that intrigue many economic
theories and the problems of policies that the management must face.”
----------------------
5. Mc Nair and Meriam: “Managerial economics consists of the use of
---------------------- economic modes of thought to analyse business situations.”
---------------------- The definitions given above highlight the following points:
●● Economic theory provides the basis for the decision making process.
----------------------
2 Managerial Economics
●● There is some difference between the generalisations based on abstraction Notes
and actual practices.
●● Besides economic theory, mathematics and statistics help in decision- ----------------------
making. ----------------------
●● An attempt is made to arrive at generalizations regarding business policies.
----------------------
●● Since decisions have repercussions on the working of firms in future, and
most firms envisage continuing operations over a period of time, forward ----------------------
planning becomes an important element.
----------------------
The problem of decision making arises whenever a number of alternatives are
available ----------------------
For example: What should be the price of the product? ----------------------
What should be the size of the plant to be installed?
----------------------
How many workers should be employed?
----------------------
What kind of training should be imparted to them?
What is the optimal level of inventories of finished products, ----------------------
raw materials, spare parts, etc.?
----------------------
The significance of a good system of forward planning can be appreciated
from the fact that it helps in selecting the plant to be installed and it is not ----------------------
possible to change its capacity as and when required. Also different production ----------------------
processes require different skills which have to be provided. Similarly, based
on the long-term plans, funds have to be arranged or procured from outside or ----------------------
retained out of the earnings of the firm. For example, when a retired person
intends to start a small-time business of his own, he can fund it either from his ----------------------
own savings or take a bank loan with an easy-repayment scheme or may even ----------------------
take an unsecured loan from his children.
Economics provides the solution to some of these problems to enable ----------------------
the firm to achieve its objective. For example, the demand for a product is ----------------------
influenced by factors such as (i) the distribution of income, (ii) prices of related
products, and (iii) data on demand at some future point of time facilitates the ----------------------
task of forward planning. Similarly, the theoretical explanation of the problem
of input-mix (the ratio in which machines, men and other resources are to be ----------------------
employed) is provided by production function along with the prices of inputs. ----------------------
This indirectly facilitates the choice regarding the technique of production to
be employed and the plant to be installed. For example, in a country like India, ----------------------
where labour is in abundance and therefore cheap, labour-intensive technique
of production becomes the obvious choice in most cases. Of course the quality ----------------------
of labour has to suit the needs of manufacturing. ----------------------
The propositions of economics, however, require to be modified keeping in
mind the constraints of availability of requisite data and the time at the hands ----------------------
of the decision-maker. ----------------------
----------------------

Notes 1.3 NATURE OF MANAGERIAL ECONOMICS
---------------------- ●● It is true that managerial economics aims at providing help in decision-
making by firms. For this purpose, it draws heavily on the propositions
---------------------- of micro economic theory. Micro economics studies the phenomenon
at the individual’s level : behaviour of individual consumers household
----------------------
firms. The concepts of micro economics used frequently in managerial
---------------------- economics are : (i) elasticity of demand, (ii) marginal cost, (iii) marginal
revenue, (iv) market structures and their significance in pricing policies,
---------------------- etc. Some of these concepts, however, provide only the logical base and
have to be modified in practice.
----------------------
●● Macro economics assists firms in forecasting. Macro economic theory
---------------------- studies the economy at the aggregate level and ignores the distinguishing
features of individual observations. For example, macro economics
----------------------
indicates the relationship between (i) the magnitude of investment and
---------------------- the level of national income, (ii) the level of national income and the level
of employment, (iii) the level of consumption and the national income,
---------------------- etc. Therefore, the postulates of macro economics can be used to identify
the level of demand at some future point in time, based on the relationship
----------------------
between the level of national income and the demand for a particular
---------------------- product. For example, there is a relationship between the level of national
income and demand for electric motors. Also, the demand for durable
---------------------- goods such as refrigerators, air-conditioners, motor cars depends upon the
level of national income.
----------------------
●● Study of one firm in the manufacturing of RMG (ready-made garments)
---------------------- comes under the purview of micro economics, but the impact of changing
trends in fashion and style on the textile industry as a whole, its changing
----------------------
line of production in the domestic as well as in the foreign market is the
---------------------- case study of macro economics.
●● Managerial Economics is decidedly applied branch of knowledge.
----------------------
Therefore, the emphasis is laid on those propositions which are likely to
---------------------- be useful to the management.
●● Managerial Economics is prescriptive in nature and character. It
----------------------
recommends that how a thing should be done under alternative conditions.
---------------------- For example, if the price of the synthetic yarn falls by 50%, it may be
desirable to increase its use in producing different types of textiles. Thus,
---------------------- managerial economics is one of the normative sciences and reflects upon
the desirability or otherwise of the propositions. For example, if the
----------------------
analysis suggests that the benefit-cost ratio of a large plant is less than
---------------------- that for a smaller plant and the benefit-cost ratio is used as the criterion for
project appraisal it is recommended that the firm should not install a large
---------------------- plant. Contrast this with the positive sciences which state the propositions
without commenting upon what should be done. For example, if the
----------------------
distribution of income has become more uneven, it is stated without
---------------------- indicating what should be done to correct this phenomenon.
●● Managerial Economics, to the extent that it uses economic thought, is a Notes
science, but it is an applied science. Economic thought uses deductive
logic (if X is true, then Y is true). For example, if the triangles are ----------------------
congruent, their angles are equal. To have confidence in the findings,
the propositions deduced are subjected to empirical verification. For ----------------------
example, empirical studies try to verify whether cost curves faced by a ----------------------
firm are really U-shaped as suggested by the theory. Furthermore, there
is an attempt to generalise the propositions which provide a predictive ----------------------
character. For example, empirical studies may suggest that for every
1% rise in expenditure on advertising, the demand for the product shall ----------------------
increase by 0.5%. ----------------------
From the above, it follows that managerial economics uses a scientific
approach. In practice, some firms may use simple rules based on past experience. ----------------------
However, the quality of discussions made can be improved using a systematic ----------------------
approach. This is pursued in managerial economics.
----------------------
Check your Progress 1
----------------------
State True or False. ----------------------

1. Micro economics studies the phenomenon at the individual level. ----------------------
2. Micro economics does not assist in forecasting. ----------------------
3. Demand for durable goods does not depend upon the level of national
income. ----------------------
4. Managerial economics is an applied branch of knowledge; it is applied ----------------------

science also.
----------------------
----------------------
Activity 1
----------------------
A assume that you are about to open a new boutique. As manager of the
shop, what are the immediate economic questions that come to your mind? ----------------------
----------------------
1.4 SCOPE OF MANAGERIAL ECONOMICS ----------------------
The scope of Managerial Economics is so wide that it embraces almost all the ----------------------
problems and areas of the manager and the firm. It deals with demand analysis and
forecasting, production function, cost analysis, inventory management advertising ----------------------
price system, resource allocation, capital budgeting etc. While an in-depth treatment ----------------------
is given to these aspects in the relevant chapters, a cursory treatment of these aspects
has been attempted here, merely to explain the scope of the subject. ----------------------
1. Demand Analysis and Forecasting ----------------------
It analyses carefully and systematically the various types of demand
----------------------
which enable the manager to arrive at a reasonable estimate of demand for

Notes products of his company. He takes into account such concepts as income
elasticity and cross elasticity. When demand is estimated, the manager
---------------------- does not stop at the stage of assessing the current demand but estimates
future demand as well. This is what is meant by demand forecasting.
---------------------- For example, if the manufacturer of umbrellas experienced a fall in the
---------------------- demand the last season because of incorrect size (the size of his product
being smaller than the one in demand) and also less choice of colours in
---------------------- the product, then this season, he needs to make sure that his inventory can
cater to the changing needs of the consumer.
----------------------
2. Production Function
----------------------
We know that resources are scarce and also have alternative uses. Inputs
---------------------- play a vital role in the economics of production. The factors of production,
otherwise called inputs, may be combined in a particular way to yield the
---------------------- maximum output. Alternatively, when the price of inputs shoot up, a firm
is forced to work out a combination of inputs so as to ensure that this
----------------------
combination becomes a least cost combination. In this way, the production
---------------------- function is pressed into service by managerial economics. If the price of
petrol shoots up considerably, then the firm needs to include diesel cars
---------------------- for the regular-pickup service for its employees. Also in recent times it
is economical and also the need of the hour to hire one IT professional
----------------------
that can develop and run the tailor-made software replacing the work of
---------------------- hoards of accountancy professionals. Softwares like MAGIC and SAP are
developed to cater to the needs particular to a firm.
----------------------
3. Cost Analysis
---------------------- Cost analysis is one of the important areas studied by managerial
---------------------- economics. For instance, determinants of cost, methods of estimating
costs, the relationship between cost and output, the forecast of cost and
---------------------- profit-these are very vital to a firm. Managerial Economics touches these
aspects of cost-analysis, an effective knowledge and application of which
---------------------- is cornerstone for the success of a firm. Only inclusion of all costs in the
---------------------- analysis will lead to the correct understanding of the profit standing of the
firm.
---------------------- 4. Inventory Management
---------------------- An inventory refers to stock of raw materials which a firm keeps. Now
the problem is, how much of the inventory is an ideal stock. If it is high,
---------------------- capital is unproductively tied up, which might, if the stock of inventory
---------------------- is reduced, be used for other productive purposes. On the other hand,
if level of inventory is low, production will be hampered. Therefore,
---------------------- managerial economics will use such methods as ABC analysis, a simple
simulation exercise and some mathematical models with a view to
---------------------- minimize the inventory cost. It also goes deeper into such aspects as the
---------------------- need for inventory control; it classifies inventories and discusses the costs
of carrying them.
----------------------
5. Advertising Notes
It may sound strange when we say that advertising is an area which
----------------------
managerial economics embraces. While the copy, illustration, etc., of an
advertisement are the responsibility of those who get it ready for the press, ----------------------
the problems of cost, the methods of determining the total advertisement
costs and budget, the measuring of the economic effects of advertising – ----------------------
these are the problems of the manager. To produce a commodity is one
----------------------
thing; to market it is another. Yet the message about the product should
reach the consumer before he thinks of buying it. Therefore, advertising ----------------------
forms an integral part of decision-making and forward planning.
Improving the face value of the product can go long way in improving its ----------------------
market value. A product which has a good standing in the export market
----------------------
can improve its face value by adding colour and instructions suiting the
likes of the people of the particular country. ----------------------
6. Price System
----------------------
It has already been pointed out that the pricing system as a concept was
developed by economics and it is widely used in managerial economics. ----------------------
The central functions of an enterprise are not only production but pricing
----------------------
as well. While the cost of production has to be taken into account while
pricing a commodity, a complete knowledge of the price system is quite ----------------------
essential to determine the price. For instance, an understanding of how a
product has to be priced under different kinds of competition, for different ----------------------
markets is essential to the pricing of those commodities. An understanding
----------------------
of the pricing of a product under conditions of Oligopoly is also essential.
Pricing is actually guided by considerations of cost plus pricing and ----------------------
the policies of public enterprises. Further, there is such a thing as price
leadership and non-price competition. It is clear from these facts that the ----------------------
price system touches upon several aspects of managerial economics and
----------------------
aids or guides the manager to take valid and profitable decisions. For
example, pricing of a toothpaste which has heavy competition has a lot of ----------------------
constraints for its increase, but let us say for a product which gives you
a soothing foot and back massage as well as talks to you soothingly after ----------------------
work, the genius manufacturer can quote its price. Similarly, in the film
----------------------
industry there are loads of side actors who have set limits, but a successful
star can surely quote his/ her price. ----------------------
7. Resources Allocation ----------------------
Scarce resources obviously have alternate uses. How best can these
scarce resources be allocated to competing needs? The aim, of course, is ----------------------
to achieve optimisation. For this purpose, some advanced tools, such as ----------------------
linear programming, are used to arrive at the best course of action for a
specified end. Generally speaking, two kinds of problems are of utmost ----------------------
importance and concern to the manager. First, how should he arrive at
an optimum combination of inputs in order to get the maximum output? ----------------------
Secondly, when the prices of inputs increase, what type of substitution ----------------------

Notes should he resort to? Or, alternatively, what type of combination of inputs
should he work out in order to ensure the least-cost combination? Again,
---------------------- speaking of India, which is a developing nation, capital does play a major
role. So use of less capital and more labour will be apt in most cases.
----------------------
8. Capital Budgeting
----------------------
This is another area which calls for a thorough understanding on the
---------------------- part of the manager if he is to arrive at meaningful decisions. Capital is
scarce, and it costs something. Now the problem is how to arrive at the
---------------------- cost of capital; how to ensure that capital becomes rational; how to face
up to budgeting problems; how to arrive at investment decisions under
----------------------
conditions of uncertainty; how to effect a cost-benefit analysis, etc. These
---------------------- areas cannot be ignored by any manager.
It is obvious from the foregoing discussion that managerial economics is
----------------------
applied economics. It makes use of the tools which have been developed
---------------------- not only to economics but by other disciplines as well. The subject matter
of managerial economics covers two important areas, namely, decision-
---------------------- making and forward planning. These two areas are essential to every
stage of planning, production, marketing, etc. Managerial economics,
----------------------
therefore, plays a vital role in the successful business operations of a firm.
---------------------- Some other areas covered by Managerial Economics are:
---------------------- ●● Linear programming, its assumptions and solutions.
---------------------- ●● Decision-making under risk and uncertainty.
●● Profit planning and investment analysis. Sources of information on new
---------------------- projects, methods of project appraisal, social benefit cost analysis etc.
----------------------
----------------------
---------------------- State True or False.

1. Demand forecasting means not only assessing current demand but
---------------------- also estimating future demand.
---------------------- 2. ABC analysis is not useful for minimising inventory cost.
---------------------- 3. The central function of any enterprise is not only production, but
pricing as well.
----------------------
---------------------- Activity 2
----------------------
Assume that you are into manufacturing of a new brand of soap. The product
---------------------- is ready. Write down the next three steps you will need to take to reach it to
the consumer.
----------------------
----------------------
1.5 SIGNIFICANCE OF MANAGERIAL ECONOMICS Notes
While performing his functions, a manager has to take a number of ----------------------
decisions in conformity with the goal of the firm. Many of the decisions are
taken under the condition of uncertainty and therefore involve risk. Uncertainty ----------------------
and risk arise mainly due to uncertain behaviour of the market forces, i.e.
----------------------
the demand and supply, changing business environment, government policy,
external influence on the domestic market and social and political changes in ----------------------
the country. The complexity of the modern business would add complexity to
the business decision - making. However, the degree of uncertainty and risk can ----------------------
be greatly reduced if market conditions could be predicted with a high degree
----------------------
of reliability.
Taking appropriate business decisions requires a clear understanding of ----------------------
the technical and environmental conditions under which decisions are to be ----------------------
taken. Application of economic theories to explain and analyse the technical
conditions and the economic environment in which a business undertaking ----------------------
operates contributes a good deal to the rational decision-making. Economic
theories have therefore gained a wide application to the analysis of practical ----------------------
problems of business. With the growing complexity of business environment, ----------------------
the usefulness of economic theory as a tool of analysis and its contribution to
the process of decision- making has been widely recognised. ----------------------
Prof. Baumol has pointed out three main contributions of economic ----------------------
theory to business economics. First, ‘one of the most important things which
the economic (theories) can contribute to the management science’ is building ----------------------
analytical models which help in recognising the structure of managerial
problems, eliminating the minor details which might obstruct decision-making, ----------------------
and in concentrating on the main issue. Secondly, economic theory contributes ----------------------
to the business analysis ‘a set of analytical methods’ which may not be directly
applied to specific business problems but they do enhance the analytical ----------------------
capabilities of the business analyst. Thirdly, economic theories offer clarity to
the various concepts used in business analysis, which enables the managers to ----------------------
avoid conceptual pitfalls. ----------------------
1.6 ECONOMIC PROBLEMS ----------------------
The source of economic problems: Resources and scarcity ----------------------
The resources of a society consist not only of the free gifts of nature, ----------------------
such as land, forests and minerals, but also of human capacity, both mental and
physical, and of all sorts of man-made aids to further production, such as tools, ----------------------
machinery and buildings. It is sometimes useful to divide those resources into ----------------------
three main groups:
----------------------
1. All those free gifts of nature, such as land, forests, minerals, etc.,
commonly called natural resources and known to economists as LAND; ----------------------
----------------------

Notes 2. All human resources, mental and physical, both inherited and acquired,
which economists call LABOUR; and
----------------------
3. All those man-made aids to further production, such as tools, machinery,
---------------------- plant and equipment, including everything man-made which is not
consumed for its own sake but is used in the process of making other
---------------------- goods and services, which economists call CAPITAL.
---------------------- These resources are called FACTORS OF PRODUCTION because they are
used in the process of production. Often a fourth factor, ENTREPRENEURSHIP
---------------------- (from the French word entrepreneur, meaning the one who undertakes tasks),
is distinguished. The entrepreneur is the one who takes risks by introducing
----------------------
both new products and new ways of making old products. He organises the
---------------------- other factors of production and directs them along new lines. (When it is not
distinguished as a fourth factor, entrepreneurship is included under labour.)
----------------------
The things that are produced by the factors of production are called
---------------------- commodities. Commodities may be divided into goods and services : goods are
tangible, as are food grains, cars or shoes; services are intangible, as they are
---------------------- valued because of the services they confer on their owners. A car, for example,
is valued because of the transportation that it provides – and possibly also for
----------------------
the flow of satisfaction because of the transportation that it provides – and
---------------------- possibly also for the flow of satisfaction the owner gets from displaying it as
a status symbol. The total output of all commodities in one country over some
---------------------- period, usually taken as a year, is called Gross National Product, or often just
National Product.
----------------------
In most societies goods and services are not regarded as desirable in
---------------------- themselves; no great virtue is attached to piling them up endlessly in warehouses,
---------------------- never to be consumed. Usually the end or goal that is desired is that individuals
should have at least some of their wants satisfied. Goods and services are thus
---------------------- regarded as means by which the goal of satisfaction of wants may be reached.
The act of making goods and services is called production, and the act of using
---------------------- these goods and services to satisfy wants is called consumption. Anyone who
---------------------- produces goods or services is called a producer, and anyone who consumes
them to satisfy his or her wants is called a consumer.
---------------------- The wants that can be satisfied by consuming goods and services may be
---------------------- regarded, for all practical purposes in today’s world, as insatiable. In relation to
the known desires of individuals for such commodities as better food, clothing,
---------------------- housing, schooling, holidays, hospital care and entertainments, the existing
supply of resources is woefully inadequate. It can produce only a small fraction
---------------------- of the goods and services that people desire. This gives rise to one of the basic
---------------------- economic problems: the problem of scarcity.
Every nation’s resources are insufficient to produce the quantities of
---------------------- goods and services that would be required to satisfy all of its citizens’ wants.
---------------------- Most of the problems of economics arise out of the use of scarce resources
to satisfy human wants.
----------------------
Notes
----------------------
Fill in the blanks. ----------------------
1. Economic theories have contributed to business economics in
----------------------
building analytical models for studying ______________as
a set of _____________ and offer clarity to concepts used in ----------------------
_______________.
----------------------
2. After land, labour, capital, the fourth factor of production is
_______________. ----------------------
3. The total output of all commodities of one country, say in one year, is ----------------------
called ___________.
----------------------
Activity 3 ----------------------
----------------------
1. List the factors of production with examples.
----------------------
----------------------
1.7 MEANING OF ECONOMIC PROBLEM
----------------------
Now, if we put together the four characteristics – namely, human wants
are unlimited, that human wants vary in their intensity, that means or resources ----------------------
are relatively limited, and they have alternative uses, but if used to satisfy one
want, the same means cannot be used to satisfy any other want – it becomes ----------------------
clear that every man begins to face the problem of economizing his means. ----------------------
The problem of economy is how to use the relatively limited resources with
alternative uses in the face of unlimited wants. Naturally, everyone will try to ----------------------
use his relatively limited resources with alternative uses that he gets maximum
satisfaction out of his resources. In view of limited resources and unlimited ----------------------
wants, he will try to satisfy those wants which are most urgent or intense and ----------------------
then those wants which are slightly less urgent and so on. Thus, sacrificing the
satisfaction of those wants which are lower on the scale of preference for which ----------------------
he may not have resources. This is the problem of economy – how to economise
or make the maximum use of limited resources. For example, a salaried person ----------------------
faces high expenditure during a festive season. He has to weigh the expenditure ----------------------
heads on a scale of priority. Maybe he will purchase clothes first for his children
and wife and last for his own self – if expenses permit. ----------------------
A very rich man - however rich - surely has dearth of time. Every man ----------------------
– rich or poor – has only 24 hours at his disposal for a day. He cannot be
everywhere to make decisions. Of course with emerging technologies a person ----------------------
can be accessible, but his very presence at a particular place, at a particular time
cannot the place of a large T.V. screen. ----------------------
----------------------

Notes In the light of the above situation, Lionel Robbins writes: “Economics
is a science which studies human behaviour as a relationship between ends and
---------------------- scarce means which have alternative uses.”
---------------------- A) Economic Problem at the Family Level
Almost in every community, family is the basic unit of a social
----------------------
organization. Just as, every individual has to face the basic economic
---------------------- problem – namely, unlimited wants and limited means with alternative
uses – exactly in the same way, every family, poor or rich, Indian, European
---------------------- and American, ancient or modern, finds that it has unlimited wants (e.g.
food grains, clothing, shelter, education of children, medicines during
----------------------
sickness, insurance, tax-payment, guests, recreation, religious and social
---------------------- ceremonies, etc.); but the resources at its disposal are relatively limited.
Every family, poor or rich, therefore faces the basic economic problem –
---------------------- how to make the best use of the limited resources so as to secure maximum
satisfaction out of them. The Indian family may be thinking in terms of Rs.
----------------------
5,000/- which may be its monthly income, whereas an average American
---------------------- family earning U.S. $ 5,000 a month may be thinking in terms of that as
a fairly big amount. But as we have observed, each family in relation to
---------------------- its wants, finds that the resources at its disposal are limited, that they have
alternative uses and therefore the problem of economising them must be
----------------------
faced. No family can avoid this basic economic problem.
---------------------- B) Economic Problem at the Universal Level Or Economic Problem – A
Universal Problem
----------------------
The same basic economic problem – unlimited wants and relatively
---------------------- limited resources - arises at all levels of human organisation. Thus
---------------------- whether we are thinking of a Grampanchayat, or of Zilla Parishad, or of a
club or hospital or university or the national government, all have to face
---------------------- the same basic economic problem. Thus, whether it is the Government of
India or the Government of the richest country namely the United States,
---------------------- the problem of economy always exists. The Government of India with an
---------------------- annual revenue of about Rs.1,00,000/- crores has innumerable demands
on its resources such as meeting mounting defense expenditure, expanding
---------------------- expenditure in respect of development that is to be brought about in
various sectors like agriculture, industries, transport, education and so
---------------------- on and so forth, with no limit on its increasing wants. The Government
---------------------- of India therefore continually faces the basic problem of economy of
how to make the best use of its limited resources. In the same way, the
---------------------- Federal Government of the United States, the richest government, faces
the same basic economic problem. Though in absolute terms, its annual
---------------------- revenues are enormous running into billions or trillions of dollars, its
---------------------- needs are also unlimited – expanding and modernizing defense forces,
establishing military bases all over the world giving economic and
---------------------- military assistance to friendly countries, meeting expanding expenditure
on space and military research, exploring oceans and so on and so forth.
---------------------- Therefore, even the richest Government of the United States is always
confronted by the same basic economic problem – unlimited wants and Notes
limited resources with alternative uses. Every nation, poor or rich, small
or great, with small population or with huge population, has to face this ----------------------
basic economic problem; no nation can ever escape it.
----------------------
Thus there is something ‘universal’ about the problems of economy.
The basic problem of economy arises in the case of an aboriginal, a ----------------------
villager, a city – dweller, in the case of the poor as also the rich, in the case
----------------------
of an Indian, a Frenchman and an American, in the case of associations
like clubs, schools, hospitals and government organisations right from ----------------------
the village level to the national level. The problem of economy was there
in ancient times and it is there before everybody at present. The problem ----------------------
of economy – unlimited wants and limited means with alternative uses
----------------------
– has been forever confronting mankind. The economic problem is an
universal problem. Economic problems do not recognise boundaries of ----------------------
caste, creed, colour, religion, culture etc.
----------------------
1.8 BASIC ECONOMIC PROBLEMS ----------------------
Seven more general questions that must be faced in all economies, whether ----------------------
they are capitalist, socialist or communist or mixed are explained below.
----------------------
Q1. What commodities are being produced and in what quantities?
This question arises directly out of the scarcity of resources. It concerns ----------------------
the allocation of scarce resources among alternative uses (a shorter phrase,
----------------------
resource allocation, will often be used). The question ‘What determines the
allocation of resources or resource allocation?’ have occupied economists ----------------------
since the earliest days of the subject. In free – market economies, most
decisions concerning the allocation of resources are made through the ----------------------
price system. The study of how this system works is the major topic in the
----------------------
THEORY OF PRICE.
Q2. By what methods are these commodities produced? ----------------------
This question arises because there is almost always more than one ----------------------
technically possible way in which goods and services can be produced.
Agricultural goods, for example, can be produced by farming a small ----------------------
quantity of land very intensively, using large quantities of fertilizer, labour ----------------------
and machinery, or farming a large quantity of land extensively, using
only small quantities of fertilizer, labour and machinery. Both methods ----------------------
can be used to produce the same quantity of some good; one method is
frugal with land but uses larger quantities of other resources, whereas the ----------------------
other method uses large quantities of land but is frugal in its use of other ----------------------
resources. The same is true of manufactured goods; it is usually possible
to produce the same output by several different techniques, ranging from ----------------------
the ones using a large quantity of labour and only a few simple machines
to the ones using a large quantity of highly automated machines rather ----------------------
than another, and the consequences of these choices about production ----------------------
methods, are topics in the THEORY OF PRODUCTION.

Notes Q3. How is society’s output of goods and services divided among its members?
Why can some individuals and groups consume a large share of the national
----------------------
output while other individuals and groups can consume only a small share?
---------------------- The superficial answer is because the former earn large incomes while the
latter earn small incomes. But this only pushes the question one stage back.
---------------------- Why do some individuals and groups earn large incomes while others earn
only small incomes? Economists wish to know why any particular division
----------------------
occurs in a free – market society and what forces, including government
---------------------- intervention, can cause it to change. It concerns with the problem of inequality
of wealth and income of the people.
----------------------
Such questions have been of great concern to economists since the
---------------------- beginning of the subject. These questions are the subject of the THEORY
OF DISTRIBUTION. When they speak of the division of the national
---------------------- product among any set of groups in the society, economists speak of THE
DISTRIBUTION OF INCOME.
----------------------
Q4. How efficient is the society’s production and distribution?
----------------------
This question quite naturally arises out of question 1, 2 and 3. Having
---------------------- asked what quantities of goods are produced, how they are produced and
to whom they are distributed, it is natural to go on to ask whether the
---------------------- production and distribution decisions are efficient.
---------------------- The concept of efficiency is quite distinct from the concept of justice. The
latter is a normative concept, and a just distribution of the national product
---------------------- would be one that our value judgements told us was a good or a desirable
---------------------- distribution. Efficiency and inefficiency are positive concepts. Production
is said to be inefficient if it would be possible to produce more of at least
---------------------- one commodity without simultaneously producing less of any other – by
merely reallocating resources. The commodities that are produced are
---------------------- said to be inefficiently distributed if it would be possible to redistribute
---------------------- them among the individuals in the society and make at least one person
better off without simultaneously making anyone worse off. Questions
---------------------- about the efficiency of production and allocation belong to the branch of
economic theory called WELFARE ECONOMICS. For instance, in the
---------------------- wake of computerisation, in a bank, let’s say at a point of time, the bank
---------------------- needs to retrench on five employees. Instead of dismissing them without
any notice, (remember they have served your firm for many years!), as
---------------------- the ‘agent’ of the bank, you can give them Voluntary Retirement (pre-
matured retirement) option that goes either with a pension or offering a
---------------------- lumpsum amount at one go. In today’s parlance, in many public sector
---------------------- undertakings, like SAIL, NTPC (National Thermal Power Corporation)
or in private sector like Bajaj Auto, it is termed as a ‘Golden Hand-shake’.
---------------------- Questions 1 to 4 are related to the allocation of resources and the
---------------------- distribution of income and are intimately connected, in a market economy,
to the way in which the price system works. They are sometimes grouped
---------------------- under the general heading of MICRO ECONOMICS.
Q5. Are the country’s resources being fully utilised, or are some of them Notes
lying idle?
----------------------
We have already noted that the existing resources of any county are not
sufficient to satisfy even the most pressing needs of all the individual ----------------------
consumers. Surely if resources are so scarce that there are not enough of
them to produce all of those commodities which are urgently required, there ----------------------
can be no question of leaving idle any of the resources that are available.
----------------------
Yet one of the most disturbing characteristics of free – market economies
is that such waste sometimes occurs. When this happens the resources ----------------------
are said to be involuntarily unemployed (or, more simply, unemployed).
Unemployed workers would like to have jobs, the factories in which they ----------------------
could work are available, the managers and owners would like to be able
----------------------
to operate their factories, raw materials are available in abundance, and
the goods that could be produced by these resources are urgently required ----------------------
by individuals in the community. Yet, for some reason, nothing happens :
the workers stay unemployed, the factories lie idle and the raw materials ----------------------
remain unused. The cost of such periods of unemployment is felt both in
----------------------
terms of the goods and services that could have been produced by the idle
resources, and in terms of the effects on people who are unable to find ----------------------
work for prolonged periods of time.
----------------------
Why do markets experience such periods of involuntary unemployment
which are unwanted by virtually everyone in the society, and can ----------------------
such unemployment be prevented from occurring in the future? These
questions have long concerned economists, and have been studied under ----------------------
the heading TRADE CYCLE THEORY. Their study was given renewed
----------------------
significance by the Great Depression of the 1930s. In the USA and the
United Kingdom, for example, this unemployment was never less than ----------------------
one worker in ten, and it rose to a maximum of approximately one worker
in four. This meant that, during the worst part of the depression, one ----------------------
quarter of these countries’ resources were lying involuntarily idle. A great
----------------------
advance was made in the study of these phenomena with the publication in
1936 of the General Theory of Employment, Interest and Money, by J. M. ----------------------
Keynes. This book, and the whole branch of economic theory that grew
out of it, has greatly widened the scope of economic theory and greatly ----------------------
added to our knowledge of the problems of unemployed resources. This
----------------------
branch of economics is called MACRO ECONOMICS.
Q6. Is the purchasing power of money and savings constant, or is it being ----------------------
eroded because of inflation?
----------------------
The world’s economies have often experienced periods of prolonged and
rapid changes in price levels. Over the long swing of history, price levels ----------------------
have sometimes risen and sometimes fallen. In recent decades, however, the ----------------------
course of prices has almost always been upward. The 1970s, 1980s and 1990s
saw a period of accelerating inflation in Europe, the United States and in most ----------------------
of the world, more particularly in the less developed countries.
----------------------

Notes Inflation reduces the purchasing power of money and savings. Rising prices
especially adversely affects salaried people who have fixed incomes, for
---------------------- example if the price of vegetables rises, housewives are surely to ask for
higher allowance from their salaried husbands but hoteliers will be quite
---------------------- unaffected since they will increase the menu-rates. It is closely related to
---------------------- the amount of money in the economy. Money is the invention of human
beings, not of nature, and the amount in existence can be controlled by
---------------------- them. Economists ask many questions about the causes and consequences
of changes in the quantity of money and the effects of such changes on the
---------------------- price level. They also ask about other causes of inflation.
---------------------- Q7. Is the economy’s capacity to produce goods and services growing
from year to year or is it remaining static?
----------------------
Why the capacity to produce grows rapidly in some economies, slowly in
---------------------- others, and not at all in yet others is a critical problem which has exercised
the minds of some of the best economists since the time of Adam Smith.
----------------------
Although a certain amount is now known in this field, a great deal remains
---------------------- to be discovered. Problems of this type are topics in the THEORY OF
ECONOMIC GROWTH. Is the economic growth maximum? Can the
---------------------- economic growth be higher then the present level of growth? These are
few questions which are answered by economists in the best possible way.
----------------------
---------------------- Check your Progress 4

----------------------
Fill in the blanks.
---------------------- 1. The problem of economy is how to use ______________ with
---------------------- alternative uses in the face of ___________ wants.
2. No family can avoid ________________ problems.
----------------------
3. Economic problem is a _____________ problem.
----------------------
Match the following.
---------------------- Theory used Economic problem
---------------------- i. Theory of price a. By what methods commodities are
produced?
---------------------- ii. Theory of production b. Is the economy’s capacity to produce
goods and services growing from year to
---------------------- year or is it remaining static?
---------------------- iii. Theory of distribution c. What commodities are being produced
and in what quantities?
---------------------- iv. Theory of welfare d. Are the country’s resources being fully
economics utilised or are some of them lying idle?
---------------------- v. Trade cycle theory e. How is society’s output of goods and
services divided among its members?
----------------------
vi. Theory of economic growth f. How efficient is the society’s production
---------------------- /distribution?
Notes
Activity 4
----------------------
1. An economic problem is such that it is faced by a simple hutman as ----------------------
well as a movie star. Can you reason out this ironic universality?
----------------------
2. Can you think of an instance following the norm of Welfare
Economics? ----------------------
3. Your friend has a large house of 10 big rooms. One servant is
----------------------
sufficient to do the work of one room. He has employed 15 servants.
Do you think this is a viable case of employment? Give reasons for ----------------------
your answer.
----------------------
Summary ----------------------
●● Managerial economics is such a stream of study that engulfs economic ----------------------

theory as well as principles of management. It is thus an applied branch ----------------------
of knowledge, very useful to today’s emerging and competitive world of
management. It touches upon all the problems of a manager and a firm, ----------------------
right from the inceptional stages of production to the high-end approach
of widening the base of market reach. Decision–making under conditions ----------------------
of uncertainty and risk and forward planning are its prime areas. ----------------------
●● This branch of economics looks at the economic problem from micro to
macro. Its analysis starts from the grass-root level to the universality of the ----------------------
problem and helps in decision making in the face of an economic problem ----------------------
and universally to all types of economies. The approach is scientific,
statistical, analytical and deductive. This is a boon to all managers in the ----------------------
world.
----------------------
Keywords ----------------------
●● Consumption : Act of using the above to satisfy wants. ----------------------
●● Demand forecasting : Assessing the current demand and future demand. ----------------------
●● Gross National Product : Total output of all commodities of one country
over some period. ----------------------
●● Inputs : Factors of production. ----------------------
●● Micro economics : Study of behaviour of individual consumers, firms,
----------------------
etc.
●● Macro economics : Study of aggregates; views the economy at large. ----------------------
●● Managerial economics : Hybrid of management and economics. ----------------------
●● Production function : Combination of inputs to yield the maximum
output. ----------------------
●● Production : Act of making goods and services. ----------------------

Notes ●● Resource optimization : Allocating scarce resources having alternative
uses in the best possible way.
----------------------
---------------------- Self-Assessment Questions
---------------------- 1. Managerial Economics is a conglomeration of two streams – management

and economics. Comment.
----------------------
2. Managerial Economics has been defined by various economists. Write
---------------------- down the definitions.
---------------------- 3. What is the nature and subject matter of Managerial Economics?

4. What is an economic problem? Or what is the root cause of any economic
---------------------- problem
---------------------- 5. Highlight the major economic problems faced by any economy in this
world.
----------------------
6. Explain the term resource optimisation.
----------------------
7. What is the significance of Managerial Economics?
----------------------
----------------------
----------------------
State True or False.
----------------------
1. True
---------------------- 2. False
---------------------- 3. False
---------------------- 4. True
----------------------
----------------------
1. True
---------------------- 2. False
---------------------- 3. True
Fill in the blanks.
----------------------
1. Economic theories have contributed to business economics in building
---------------------- analytical models for studying structural problems as a set of analytical
methods and offer clarity to concepts used in business analysis.
----------------------
2. After land, labour, capital, the fourth factor of production is
---------------------- entrepreneurship.
----------------------
2. The total output of all commodities of one country, say in one year, is Notes
called Gross National Product (GNP).
----------------------
1. The problem of economy is how to use relatively limited resources with ----------------------
alternative uses in the face of unlimited wants.
----------------------
2. No family can avoid basic economic problems.
3. Economic problem is a universal problem. ----------------------
Match the following. ----------------------

i. – c. ----------------------
ii. – a.
----------------------
iii. – e.
----------------------
iv. – f.
v. – d. ----------------------
vi. – b. ----------------------
----------------------
Suggested Reading
----------------------
1. Arun Kumar, Rachana Sharma, Managerial Economics, Atlantic
Publishers & Dist., 1998 ----------------------
2. Damodaran, Suma. 2010. Managerial Economics. New Delhi: Oxford ----------------------

University Press.
----------------------
3. Eastham, J.K. 1950. An Introduction to Economic Analysis.
London:Universities Press. ----------------------
4. Heady, Earl O. 1952. Economics of Agricultural Production and Resource ----------------------
Use. New York: Prentice-Hall, Inc.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Notes
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Profit
UNIT
2
Structure:
2.1 Meaning of Profit

2.2 Types of Profit
2.3 Theories of Profit
2.4 Measurement of Profit
2.5 Profit Policy
2.6 Reasonable Profit Target
Summary
Key Words
Suggested Reading
Profit 21
Notes
Objectives
----------------------
----------------------
• Determine profit
----------------------
• Underline the different types of profit
---------------------- • Discuss the theories of profit
---------------------- • Evaluate profit by using different accounting methods
---------------------- • Justify the criteria for “reasonable profit”
----------------------
2.1 MEANING OF PROFIT
----------------------
Profit means different things to different people. The word ‘Profit’ has
---------------------- different meanings to businessmen, accountants, tax collectors, workers and
---------------------- economists and it is often used in a loose sense that buries its real significance.
In general sense, ‘profit’ is regarded as income accruing to the equity holders,
---------------------- in the same sense as wages accrue to the labour, rent accrues to the owners of
rentable assets; and interest accrues to the money lenders. To a layman, profit
---------------------- means all incomes that flow to the investors. To an accountant, ‘profit’ means
---------------------- the excess of revenue over all paid-out costs including both manufacturing and
overhead expenses. It is more or less the same as ‘net profit’. For all practical
---------------------- purposes, businessmen also use this definition of profit. For taxation purposes,
profit or business income means profit in accountancy sense plus non-allowable
---------------------- expenses. Economist’s concept of profit is of ‘Pure Profit’, also called ‘economic
---------------------- profit’ or ‘just profit’. Pure profit is a return over and above the opportunity
cost, i.e. the income which a businessman might expect from the second best
---------------------- alternative use of his resources. These two concepts of profit are discussed
below in details.
----------------------
Accounting Profit vs. Economic Profit
----------------------
The two important concepts of profit that figure in business decisions are
---------------------- ‘economic profit’ and ‘accounting profit’. It will be useful to explain the difference
between the two concepts of profit. In accounting sense, profit is surplus of
---------------------- revenue over and above all paid-out costs, including both manufacturing and
overhead expenses. Accounting profit may be calculated as-
----------------------
Accounting profit = TR - (W + R + I + M)
----------------------
where TR = Total Revenue, W = Wages, R = Rent, I = Interest and M = cost of
---------------------- materials .
---------------------- Obviously, while calculating accounting profit, only explicit or book

costs, i.e. the cost recorded in the books of accounts, are considered.
---------------------- The concept of ‘economic profit’ differs from that of ‘accounting profit.’
---------------------- Economic profit takes into account also the implicit or imputed costs. The
implicit cost is opportunity cost. Opportunity cost is defined as the payment Notes
that would be ‘necessary to draw forth the factors of productions from their
most remunerative alternative employment’. In simple terms, opportunity cost ----------------------
is the income foregone, which a businessman could expect from the second best
alternative use of his resources. For example, if an entrepreneur uses his capital ----------------------
in his own business, he foregoes interest which he might earn by purchasing ----------------------
debentures of other companies or by depositing his money with joint stock
companies for a period. Furthermore, if an entrepreneur uses his labour in his ----------------------
own business, he foregoes his income (salary) which he might earn by working
as a manager in another firm. Similarly, by using productive assets (land and ----------------------
building) in his own business, he sacrifices his market rent. These foregone ----------------------
incomes - interest, salary, and rent are called opportunity costs or transfer costs.
Accounting profit does not take into account the opportunity cost. ----------------------
To understand the concept of ‘Opportunity Cost’, an example has been given ----------------------
below with a diagram:
----------------------
O
----------------------
----------------------
Work ----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Home
----------------------
Every individual divides his time between home and work. Assuming
other things remaining constant, the downward sloping curve O-O’ depicts the ----------------------
‘Time’ curve which an individual has on hand and which he can devote to the
two factors. It shows an inverse relation between the two, in the sense, the ----------------------
less time he devotes at work, the more time he can be at home and vice versa. ----------------------
Devoting more time to any one of them in turn measures less time to the other.
Thus we can say that the spending long hours in one’s office is the ‘Opportunity ----------------------
cost’ of spending quality time with family and friends. No wonder why working
family people are in a constant dilemma, wondering which option to cater first!! ----------------------
It should also be noted that the economic or pure profit makes provision ----------------------
also for (a) insurable risks, (b) depreciation, and (c) necessary minimum
payment of shareholders to prevent them from withdrawing their capital. Pure ----------------------
profit may thus be defined as ‘residual left after all contractual costs have been ----------------------
Profit 23
Notes met, including the transfer costs of management, insurable risks, depreciation
and payments to shareholders, sufficient to maintain investment at its current
---------------------- level.’’ Thus,
---------------------- Pure profit = Total revenue - (explicit costs + implicit costs)
Pure profit so defined may not be necessarily positive for a single firm in
----------------------
a single year - it may be even negative, since it may not be possible to decide
---------------------- beforehand the best way of using the resources. Besides, in economics, pure
profit is considered to be a short term phenomenon - it does not exist in the long
---------------------- run under perfectly competitive conditions.
---------------------- An entrepreneur brings together various factors of production such as land,
labour and capital. He ensures co-ordination between the factors and supervises
---------------------- the productive activity. He looks after purchase of raw materials, production,
marketing, recovery of receivable and personnel. The most important function
----------------------
performed by an entrepreneur is, however to undertake risk and uncertainty
---------------------- in business. The reward which is paid to an entrepreneur for discharging this
function is called Profit. In this chapter, we propose to study the emergence of
---------------------- profit.
----------------------
2.2 TYPES OF PROFIT
----------------------
(A) Gross Profit and Pure (Net) Profit
----------------------
When cost of production is deducted from the total sales proceeds, the
---------------------- residual portion is called Gross Profit.
---------------------- Gross Profit = Total Receipts - Total Expenditure

An entrepreneur is required to make following payments out of the Gross
---------------------- Profit.
---------------------- (a) Remuneration for the factors of production contributed by the
entrepreneur himself
----------------------
He must pay rent for the use of land. If the land is owned by him, he
---------------------- must pay notional reward for the use of land, because, he is otherwise
required to pay rent if he hires land from some other person. Also
----------------------
let’s say an owner of a grocery shop himself goes every morning to
---------------------- the market in his own vehicle to get the groceries. In this case, his
own service charge and the transportation fee should be deducted
---------------------- from the gross profit.
---------------------- (b) Depreciation and Maintenance Charges
---------------------- Some portion should be deducted from gross profit by way of

depreciation on machinery and other assets.
---------------------- For example uses several cars which he has grouped under two heads:
---------------------- office use and personal(family) use. Depreciation is a percentage
of the MRP (maximum retail price) that is to be deducted every
---------------------- financial year from the gross profit, caused due to the wear and
tear of the durable good. For accounting purposes, he classifies the Notes
depreciation for the office car under ‘Business Bills’ and that for the
personal (use) car under ‘Personal Expenditure’. These deductions ----------------------
from the gross profit, help him in giving the correct figure of his Net
profit. ----------------------
Also, let’s say the owner of a workplace doesn’t hire plumbers ----------------------
or electricians, but does the work himself. As part of regular
----------------------
maintenance, had he employed them for the same, he would
definitely be paying them for the services incurred. Thus, in this ----------------------
case, he should be paid for, even if he is being paid from his own
pocket to arrive at the right figure of Net Profit. ----------------------
(c) Extra-Personal Profits ----------------------
This includes
----------------------
i) Monopoly Profit : If a producer is a monopolist, he may be
earning monopoly profits. These are profits not because of the ----------------------
business skills or ability of the entrepreneur, but because he is ----------------------
a monopolist in his field. Monopoly profits must be deducted
from gross profits to arrive at net (pure) profits. For example, ----------------------
a shop of basic necessaries in a very remote place (where
there are none) can enjoy monopoly profits, as people living ----------------------
in and around that place are bound to visit that shop, inspite ----------------------
of high prices.
ii) Chance Profit : An entrepreneur may earn high profits just ----------------------
‘by chance’, say because of an outbreak of war. This is not a ----------------------
part of net profits. In case of a war, imports will fall or stop.
Domestic production cannot increase immediately. Increasing ----------------------
demand thus not met will lead to price hike.
----------------------
(d) Net Profits
----------------------
When all the above payments are made out of gross profit, the
residual portion is called Pure (Net) Profit. The reward which an ----------------------
entrepreneur gets (i) for undertaking risk and uncertainty, (ii) for
co-ordinating and organising production and (iii) for innovating is ----------------------
called Pure Profit.
----------------------
2.3 THEORIES OF PROFITS ----------------------
Various theories have been developed to explain the emergence of Profit. ----------------------
It is worthwhile to explain some of the theories of profit.
----------------------
(1) Risk Taking Theory
----------------------
The Risk-Taking Theory was developed by the American economist
Hawley. According to him, profit arises because a considerable amount of ----------------------
risk is involved in business. Profit is, therefore, the reward for risk-taking.
Hawley’s theory has been criticized on several grounds. In the first place, ----------------------
Profit 25
Notes Hawley has not classified the types of risks. Secondly, as Cawer has
pointed out, profit is not the reward for risk-taking. It is the reward for risk-
---------------------- avoiding. An entrepreneur is required to minimize his risk, if he cannot
eliminate it totally. A successful entrepreneur is he who earns good profits
---------------------- by eliminating the risk. On the other hand, a mediocre businessmen is not
---------------------- able to reduce the risk in business; and therefore, is subjected to losses.
For example, an entrepreneur comes up with a novel idea of opening a
---------------------- shop selling all the products pertaining to religious ceremonies in a very
developing area of a city. There are two elements of risk here – whether
---------------------- this idea will click and if yes, then how many customers will really turn
---------------------- up on a daily basis to give him a regular source of income.
(2) Uncertainty-Bearing Theory of Profit
----------------------
Uncertainty-Bearing Theory of profit was developed by the American
---------------------- economist, Prof. F.H. Knight. He has classified the risks under the two
heads.
----------------------
(a) Certain risks such as risk of fire, risk of theft, risk of accident etc.
---------------------- are less important because they can be passed on to an insurance
company. An entrepreneur can take an insurance policy by paying
----------------------
the premium. Since such risks are covered by insurance, they are
---------------------- called “Insurable Risks.”
---------------------- (b) There are other risks which cannot be passed on to an insurance
company or to the paid managers. Every business involves great
---------------------- amount of uncertainty and the losses arising there from cannot
be estimated with precision. The prices of raw materials may
---------------------- suddenly increase, the supply of raw materials may be restricted
---------------------- and introduction of new substitutes in the market may reduce
the demand for the product.When demand declines, large stocks
---------------------- may remain unsold in the go-down. A producer may have to face
keen competition if the market is characterised by monopolistic
---------------------- competition. All these factors are uncertain and losses arising there
---------------------- from cannot be insured with any insurance company. These risks
and losses must be borne by the entrepreneur himself. According to
---------------------- Prof. Knight, profit is, therefore, the reward for uncertainty-bearing.
---------------------- Uncertainty theory of profit has gained wide popularity since its
publication. After the Industrial Revolution, production is carried out on
---------------------- a large scale and in anticipation of demand. Producers take into account
the tastes and fashions of the people and produce the goods accordingly.
---------------------- Sudden change in the tastes and fashions may affect the demand for
---------------------- products. If a particular fashion is receded in the background, goods may
not be sold at all. The losses arising out of such uncertainty cannot be
---------------------- estimated with precision. According to Prof. Knight, profit is, therefore,
a reward of uncertainty. For example, fashion trends are changing by the
---------------------- day. With the evolving revolution in fashion and exposure to television
---------------------- and cinema, what was ‘trendy’ yesterday may become ‘obsolete’ today.
Salwar-khameez have now taken the place of pants and kurtis. A fashion Notes
designer having a studio of his own has to constantly fight with these
factors to survive in this fiercely competitive market. If his designs are ----------------------
unaccepted in this world of high-end consumerism, then he better be
ready to incur huge losses!! ----------------------
(3) Innovation Theory of Profit ----------------------

Innovation Theory was developed by Joseph Schumpeter. According ----------------------
to him, profit is the reward paid to an entrepreneur for his innovative
endeavours. ----------------------
Schumpeter has made distinction between invention and innovation. A ----------------------
scientist may make an invention, but this invention is exploited on a commercial
basis by an entrepreneur. The basis on which the invention is exploited depends ----------------------
upon the innovative nature of the entrepreneur. If he is successful in exploiting
----------------------
the invention, it is an innovation. According to Schumpeter, profit is the reward
for innovation. ----------------------
As they say, ‘necessity is the mother of invention’. People would queue ----------------------
up in banks, waiting for their turn to withdraw money. The need of the
hour was to enable bank-customers to withdraw at their will and need and ----------------------
thus save up a lot of time on part of the customers as well as the cashier.
The invention was to facilitate this necessity. Thus, the banking sector ----------------------
introduced ATMs (Any-Time-Money) at different locations, which further ----------------------
helps the customers to withdraw at their nearest available location. This
in turn helps the growth of banking business in the country. The idea was ----------------------
invented, the practical application of which is nothing but ‘innovation’.
It has got popularized, mainly because of the easy applicability and ----------------------
accessibility. Banks right from nationalized as well as co-operative banks ----------------------
have introduced this innovative technique in their area of functioning.
Schumpeter’s theory has been criticised on several grounds. Profit is the ----------------------
reward for discharging many duties; but Schumpeter has overlooked the ----------------------
other duties. Another point of criticism is that Schumpeter has neglected
the fact that profit is also the reward for risk and uncertainty bearing. ----------------------
The most serious criticism of this theory is that a particular producer
who exhibits an innovative character may earn super-normal profits in ----------------------
the short-run. But the super normal profits will attract new firms to the ----------------------
industry. If new firms enter the industry, the super-normal profits would
be shared between the existing as well as the new firms. In the long run, ----------------------
super normal profits would, therefore, disappear. It is said that profits are
caused by innovation and disappear by imitation. Schumpeter’s theory is, ----------------------
therefore, to be taken to a limited extent. ----------------------
(4) Dynamic Theory of Profit
----------------------
The Dynamic Theory of Profit was developed by the renowned economist,
J.B. Clark. Prof. Clark points out that the whole world is dynamic. Changes ----------------------
after changes are taking place every day; and the economic consequences
----------------------
Profit 27
Notes of these changes are of a far reaching character. Prof. Clark has pointed
out the following types of changes.
----------------------
a) Changes in the quantity and quality of human needs
---------------------- b) Changes in the techniques of production
---------------------- c) Changes in the supply of capital
---------------------- d) Changes in organisation of business

e) Changes in population
----------------------
These changes can occur at any time. Techniques of production may
---------------------- change and improved machinery may be introduced. This may reduce
the cost and increase the profit and output. But to purchase the improved
---------------------- machinery, a larger amount of fixed capital is required. This may necessitate
---------------------- the admission of a new partner or conversion of the partnership firm into
a joint stock company to raise capital on a large scale.
----------------------
All these changes can occur suddenly, and an entrepreneur has to face
---------------------- them properly. A producer who overcomes these hurdles is successful in
earning higher profits. He must adjust himself to the changing times. A
---------------------- producer who cannot address himself to the dynamic world lags behind.
In order to survive and grow every producer must change the methods
----------------------
to suit the changing needs. According to Prof. Clark, profit is the reward
---------------------- paid for dynamism.
In this regard, it can be pointed out that with the emergence of privatisatin
----------------------
of banks, computerization in the working order and added facilities like
---------------------- ATM became the need of the hour, which were known some years back in
our country. Also one can say that today apart from the services offered,
---------------------- the décor of the place does have an impact e.g. Air conditioners are widely
used even in small-time shops.
----------------------
Today is the era of ‘Multiplexes’, be it cinema halls or shopping complexes.
---------------------- Consumers are largely getting used to the idea of ‘One-stop-shop’. This
---------------------- is technological advancement which is fast acting on the Indian psyche in
the larger perspective.
---------------------- Profits in a Static Society
---------------------- According to Prof. Clark, profit cannot arise in a static society. In a static
society there are no changes. Population is stable and the demand is stationary.
---------------------- Since the demand is limited, output is also limited. The general price level and
---------------------- factor prices being stable; the cost of production is constant. The selling price
and the margin of profit are also constant. A producer has to produce a limited
---------------------- quantity of goods and it is sold immediately, the moment it is produced.
Since demand is constant, a producer does not run the risk of uncertainty.
---------------------- In a static society, there are no inventions and producers are not required to
---------------------- make innovations. Producers in a static society have not to face any changes
in the tastes, fashions and output. They produce a given quantity and sell it
---------------------- in a routine manner. A producer in a static society works like a paid manager.
He performs only the routine duties and gets normal profit. The normal profit Notes
which he gets may be called ‘Wages for Management’. According to Prof.
Clark, a producer in a static society gets only normal profits, because pure ----------------------
profit does not arise.
----------------------
Conclusion
----------------------
Prof. Clark’s Dynamic Theory of Profit has been criticised on several
grounds. He has classified the changes under five categories but has ----------------------
overlooked many other important changes. In this dynamic world, the
Government policy may suddenly change. A change in the Monetary ----------------------
Policy of the Central Bank may bring about an expansion or contraction
----------------------
in the supply of money. This may lead to an expansion or contraction in
the supply of capital. Ultimately it may affect the fortunes of business. ----------------------
Prof. Clark has overlooked such important factors.
----------------------
Changes in the money supply for example can have far-reaching on the
economy as a whole, affecting all sections of society. Increase in the same ----------------------
will affect the general price level, thus money incomes. Therefore, even if
the profits do show an increase, it will be a fictitious one, because of the ----------------------
fall in the real incomes.
----------------------
Check your Progress 1 ----------------------
----------------------
Fill in the blanks.
----------------------
1. To an accountant, profit means _____________ over all paid out
____________. ----------------------
2. Pure profit or economic profit means return over and above the
----------------------
____________.
3. Pure profit is calculated as Profit = ____________− (______+_____) ----------------------
4. Innovation Theory of Profit was developed by _____________. ----------------------
5. As per Clark’s Dynamic Theory, profit is the ____________ for ----------------------
__________.
----------------------
----------------------
Activity 1
----------------------
1. “A” is a qualified IT professional, working full time and “B” having ----------------------
done her MBA is a full- time housewife. Reason the “opportunity cost
“in each of the case, if any. ----------------------
2. A farmer and his family growing rice every season on a highly fertile ----------------------
land is accounted for “opportunity cost as implicit cost”. Can you
explain why? ----------------------
----------------------
Profit 29
Notes 2.4 MEASUREMENT OF PROFIT
---------------------- Our discussion of profit so far, has made it clear how difficult it is to have a
simple definition of profit that is acceptable to all. The measurement of profit is
---------------------- also equally difficult. For one thing, the economic concept of profit-and loss and
the legal concept of profit-and-loss are not the same. This is especially difficult
----------------------
when it comes to the measurement of net profit. For calculating net profit, it is
---------------------- necessary to deduct all costs from the total revenue. But the inclusiveness of
costs itself involves many difficulties. All these problems, therefore, deserve a
---------------------- more careful and detailed analysis.
---------------------- (A) Economic Profit and Accounting Profit
---------------------- Let us take an example to understand the difference between the economic
concept of profit and the accounting concept of profit. Suppose an
---------------------- individual starts at his residence the business of repairing scooters. At the
end of the year, he gets a total revenue of Rs.1,50,000/-. Out of this, let us
---------------------- say, he spents Rs.50,000/- on the wages of his helper, tools and spare parts,
---------------------- etc. What remains is a sum of Rs.l,00,000/-. Apparently, one would be
tempted to conclude that this is his profit. But it is not so. The place that is
---------------------- available to him might have saved him a sum of, say Rs.30,000/-. In other
words, the place of work might have an opportunity cost. His own transfer
---------------------- earnings may be say Rs.60,000/-. Had he borrowed the money capital, the
---------------------- interest would have been say Rs.l0,000/-. Besides, a provision will have
to be made for the wear and tear of the tools and instruments, i.e. a certain
---------------------- amount will have to be deducted for depreciation.Thus, calculated, the
total costs would be (i) Helper’s wages, spares etc. Rs.50,000 + (ii) Rent
---------------------- Rs.30,000 + (iii) Entrepreneur’s management wages : Rs.60,000 + (iv)
---------------------- Interest : Rs.l0,000 + (v) Depreciation Rs.5,000. This takes the total cost
equal to Rs.l,55,000 against the total revenue of Rs.l,50,000 showing a
---------------------- net loss of Rs.5,000.
---------------------- The loss in the above example does not become apparent because the
entrepreneur uses some of the factors owned by himself and therefore, the
---------------------- remunerations to these are not actually paid. It should be obvious from
the above example that these difficulties may not arise in respect of large
----------------------
industrial units. In such units, ownership is with the shareholders while
---------------------- the management is entrusted to the salaried managers. Thus, most of the
costs enter the account books and the accounting and economic concepts
---------------------- of costs in such cases come closer.
---------------------- According to the financial accounting principle, the assets of a concern
have claims from two sides : from the owners and from the lenders.
---------------------- Therefore, in any business unit,
---------------------- Assets = Liabilities + Proprietorship
---------------------- Therefore, Assets - Liabilities = Proprietorship or the net worth

The balance sheet of any concern shows, during a given period, the total
---------------------- liabilities and the net worth after these are deducted. Similarly, the profit
and loss account or the income statement shows the changes in the balance Notes
sheet of the unit from the beginning of the year and those at the end of
the year is the net income or profit. The funds statement is based on this ----------------------
profit and loss statement. This statement indicates the financial standing
of the business concern. The funds statement shows the amount of cash ----------------------
available and how it has been invested. ----------------------
While preparing all these statements, the accountant has to include items,
----------------------
the truth about which can be tested. But in doing so, many difficulties
arise. For example, while preparing the balance-sheet, the cost of the ----------------------
asset that is taken is the one at which the asset was purchased. The current
value of the asset is not considered. Similarly, the changes in the value of ----------------------
money are ignored. It is also incorrect as is done in financial accounts, to
----------------------
calculate net profits by deducting from the total revenue of year the total
costs incurred during that year. ----------------------
The economic concept of net profit will have to be altogether different.
----------------------
In the valuation of any asset, the economist is guided by the concept
of opportunity cost. For example, the accounting method will take into ----------------------
account the original price of a machine; but in the economic concept,
the replacement cost of the machine would be used. For valuation of the ----------------------
machine, further alternatives would be to take the price of a similar machine,
----------------------
if the same is not available; or to consider the total expected return of the
machine and from that calculate the present worth of the machine. We are ----------------------
familiar with the various cost concepts. Thus, the differences in the profit
concepts arise out of the differences in cost concepts. The modern method ----------------------
used for valuation is based on the cash flow technique.
----------------------
It will also be necessary to remember that the sum total of all the
individual machines added together will not be the correct value of the ----------------------
total establishment. This is because the goodwill enjoyed by the concern
----------------------
will also have to be included in its total worth. This is how the economic
and the accounting approaches differ and make measurement of profit ----------------------
more complicated.
----------------------
(B) Factors Leading to Differences in the Economic and the Traditional
Concepts of Valuation ----------------------
The above discussion makes it clear how valuation of asset is important ----------------------
in the measurement of profits. Let us now consider those factors which
underline the differences in the economic and the accounting approaches ----------------------
to the problem. These factors are : (a) Depreciation (b) Inventory Valuation
and (c) the unaccounted value changes in the assets and the liabilities. ----------------------
a) Depreciation ----------------------
Depreciation is the loss in value caused by the continuous use of an ----------------------
asset. Every durable asset has a certain life at the end of which it has
got to be replaced. For such a replacement, a provision in the form ----------------------
of depreciation is required to be made.
----------------------
Profit 31
Notes There are various methods of calculating this depreciation. Following are
the important ones among them.
----------------------
(i) Straight Line Method
---------------------- This is the simplest method of all. What is done is the life of an asset
is first estimated and then the share of one year in the total value of the
----------------------
asset is deducted. What remains is taken as the value of the asset for
---------------------- the next year. In this way, at the end of the life-time of the asset, the
firm will have collected an amount equal to the value of the asset. If,
---------------------- for example, the price of a machine is P, the scrap-value at the end of
its life-time is S and the life of the machine is Y years, then the amount
----------------------
of depreciation (D) will be given by the formula :
---------------------- P–S
D=
---------------------- Y
---------------------- If P = Rs.25,000/-; S = Rs.5,000/- and Y = 20 years, the annual

25,000 – 5,000
amount of depreciation will be = 2,000 . This
---------------------- 20
means that the annual allotment towards, depreciation will have to
----------------------
be Rs.2,000 only.
----------------------
(ii) Diminishing Balance Method
----------------------
In this method, the amount of depreciation is large in the initial
---------------------- years. Suppose the annual amount of depreciation is taken as 10
per cent of the value of the machine. Then, in the first year the
---------------------- depreciation will be 10 per cent of the value of the machine; but
during the second year, it will be 10 per cent of the total value minus
----------------------
the depreciation fund created during the first year. By this method,
---------------------- the value of the machine will never become zero and the amount of
depreciation will go on diminishing.
----------------------
Study the table 2.1 given below: Depreciation = 10%
----------------------
Year Value for Current Year Value for the following year
---------------------- 1 100 90
100 – (10%*100)
----------------------
2 90 81
---------------------- 3 81 72.9
4 72.9 65.61
----------------------
5 65.61 59.05
----------------------
And so on …..
---------------------- (iii) Annuity Method
---------------------- In this method, equal annual amounts are first calculated for the
length of the life of an asset. However, along with the annual
---------------------- allotment, the interest that can be earned is also calculated.
(iv) Service Unit Method Notes
Instead of considering the life of an asset in years, the actual working
----------------------
hours can be taken. This is the basis of service unit method. If a
machine can work for l,000 hours, then the value of the machine ----------------------
divided by l,000 will be the hourly rate of depreciation. The total
number of hours for which the machine was actually used during a ----------------------
given period can thus give us the amount of depreciation during that
----------------------
period. The original value of machine minus depreciation will give
its value for the remaining period. ----------------------
Whatever method used for the valuation of assets, in the accounting
----------------------
sense, some problems remain unsolved. Thus, for instance, every
asset has a limited life and at the end of it, the asset needs to be replaced. ----------------------
At the time of replacement, new and more efficient machines may
be available. If such new machines are to be purchased, how much ----------------------
money will be required and at what rate depreciation will have to be
----------------------
provided cannot be decided before hand, by any of these methods.
This makes measurement of profit difficult. ----------------------
b) Inventory Valuation
----------------------
Another difficulty that is encountered is in respect of inventory
valuation. This difficulty would not arise if the prices of all products ----------------------
and the level of all production were constant. But this never happens. ----------------------
The raw materials are purchased at different prices. The costs of
production also change from time to time. This makes the valuation ----------------------
of stocks of finished products very difficult. Let us first consider the
two most widely used methods of inventory valuation. ----------------------
i) First-In-First Out Method (FIFO) : In this method, it is ----------------------
assumed that goods which entered the firm’s stock first were
used first. Then, in this assumption, the cost of producing the ----------------------
given output is estimated. ----------------------
ii) Last-In-First Out Method (LIFO) : In this method, the cost of
production is calculated on the assumption that the material ----------------------
which was last to enter the inventory of the company was ----------------------
used first.
----------------------
It is obvious that a change in the use from either of the two
methods mentioned above to the other one must lead to a change ----------------------
in estimate of profit. There would be a great divergence between
the profits estimated by these two methods especially when the ----------------------
above mentioned changes in prices etc. are very rapid. The profit
----------------------
would appear to be abnormally high if it is calculated on the basis of
FIFO in times of inflation and abnormally low in times of deflation. ----------------------
The methods, however, are in use due to their convenience from
accounting point of view. ----------------------
----------------------
Profit 33
Notes It is thus, clear that by either method, it is difficult to state precisely
the value of the inventory. This is mainly because of the changes in
---------------------- the value of money. Taking a stable value of money, i.e. valuation
at constant prices would also not serve the purpose. Thus, due to
---------------------- these difficulties in the valuation of inventories, the measurement
---------------------- of profit is rendered difficult.
c) The Unaccounted Value Changes in the Assets and the Liabilities
----------------------
Besides the above two factors which create difficulties of valuation,
---------------------- there is a third category of changes in the value of assets and
liabilities that poses a challenge to valuation. The research that is
----------------------
undertaken to improve the quality of the product, the expenses on
---------------------- improving the efficiency of management etc. increase the value
of the establishment. These costs create assets, which cannot be
---------------------- precisely valued. They do increase profits but cannot be expressed
in terms of money, and therefore, measurement of changes in the
----------------------
value of assets becomes difficult.
---------------------- Thus, it is clear, how difficult the precise measurement of profits
is. By simply using historical cost the profits are likely to be either
----------------------
inflated or deflated. It is, therefore, necessary to calculate costs
---------------------- and profits at constant price to take utmost care in calculating
depreciation, to take cognizance of modern methods like cost
---------------------- flow techniques, management accounting and so on, and to use
opportunity costs wherever necessary. Even then, a correct amount
----------------------
of profit may not be found out. But we shall be close to the correct
---------------------- estimate. The calculation of profit will also vary according to the
purpose for which the calculation is required.
----------------------

---------------------- Fill in the blanks with the options given: public relation, networked,
---------------------- complex, human
1. Business involves relationship with a number of people and the more
----------------------
_______________ one is, better is one’s business.
---------------------- 2. The owner or the entrepreneur who conceives and implements
business is ________________.
----------------------
3. business requires very wide ________________________.
----------------------
4. bigger the business, more of managing is required and it becomes
---------------------- more ________________.
----------------------
----------------------
----------------------
Notes
Activity 2
----------------------
The information available is as under: ----------------------
●● Price of a car is Rs 3,50,000. Its life is estimated to be 10 years and
----------------------
the value of the car by the end of its life is given to be Rs 1,50,000.
Calculate the depreciation amount to be allowed each year. Which ----------------------
method/methods will be used to calculate this?
----------------------
●● For the rest of the methods of depreciation to be used what more
information is required? ----------------------
----------------------
2.5 PROFIT POLICY
----------------------
By and large, we say that an entrepreneur aims at maximum profits. But
‘how much’ profit should be taken as the maximum ? This is a difficult question ----------------------
to answer. A scientific thought to this question must provide a guidance on
----------------------
the following two lines : (a) What profit should an entrepreneur expect in any
enterprise, and (b) How far is profit influenced by factors, which are external to ----------------------
the firm.
----------------------
It must be understood at the outset that the freedom of an entrepreneur to
decide his rate of profit depends on the nature of the market and other constraints ----------------------
including legal provisions, business conventions, consumer resistance and so
on. ----------------------
Profit is usually expressed as gross profit, or as net profit or as a per cent ----------------------
return to capital invested. In modern business, the common practice is to express
profit as a per cent net return to capital. ----------------------
(a) Profit Expectations : The profit that an entrepreneur should expect can ----------------------
be subjected to a number of criteria. The following four criteria are widely
accepted : ----------------------
i) The rate of profit should be sufficient to attract share capital ----------------------

if felt necessary. When new shares are to be issued for expansion,
----------------------
the old shareholders should not have a feeling of having suffered a
capital loss. New shares must therefore be sold at a price that gives ----------------------
the old shareholders a satisfaction that they are in possession of
sound shares. Their rate of profit should be enough to command a ----------------------
good price for the new issue of shares.
----------------------
For instance, Reliance Petrochemicals – is a blue-chip (very sound)
company; they issue shares to meet their expansion plans. When ----------------------
shares get over-subscribed i.e. many people apply for it than the
----------------------
expected number, for example, if Reliance wants Rs. 200 crores,
it collects Rs. 500 crores, it in turn reflects the capacity of the ----------------------
company to do even better and achieve a higher rate of profit in
future. But that the people are investing shares in this company in ----------------------
Profit 35
Notes the first place, in fact reflects the strong belief that the people have
in its functioning. They are aware about the high rate of profit that
---------------------- the company is churning out for years.
---------------------- ii) The rate of profit should be comparable to that in similar
companies. Many times, there are many independent units under
---------------------- the same management. In all these sister-concerns, the rates of
profitability should be comparable.
----------------------
For instance, Maruti Suzuki is one company, having several
---------------------- independent units like production unit, sales unit, customer
care, servicing unit, etc. The manufacture of the car is under the
----------------------
production unit, bringing the product to the market comes under
---------------------- the sales department, the after-sales service (like 3 free servicing
within a stipulated time period) is the forte of the servicing centres
---------------------- and taking care of any complaints by customers is the responsibility
of the customer care unit.
----------------------
iii) The present profit rate should be comparable to the profit rates
---------------------- in the past.
---------------------- iv) The profits should be large enough to allow for a plough-back
for business expansion. It is, however, necessary to see that
---------------------- reinvestment of profits does not cause a dwindling in the reasonable
---------------------- rate of profit.
It is true that expansion of a firm can be effected from re-investing
---------------------- profits, but not at the cost of lowering down the current rate of profit.
---------------------- For example, if a tailoring house lavishly spends on new machines
without having enough new orders on hand, then it would not mean
---------------------- the right economic move.
---------------------- (b) External Factors : Besides the criteria mentioned above, there are certain
external factors that influence the profitability of a firm in modern times.
---------------------- These factors are :
---------------------- i) Full Employment : Under conditions of full employment,
maintenance of cordial labour relations is of utmost importance.
---------------------- Excessive profits, under such circumstances, become an invitation
to labour unrest. Care should be taken to keep profits within
----------------------
reasonable limits.
---------------------- Today labour unions are very strong, affecting company policies to
a large extent. For example, labour unions in PSUs (Public Sector
----------------------
Undertakings) like Steel Authority of India Limited, National
---------------------- Thermal Power Corporation are very strong. They protect the
interests of labour community of the industry. They negotiate with
---------------------- the government regarding their labour demands like increase in the
wage-rate, increasing remuneration, increasing the retirement age,
----------------------
better pension facilities, etc.
----------------------
ii) Potential Rivals : In any business, the possibility of emergence of Notes
rival firms must be taken into consideration. Abnormal profits attract
rivals and wipe out profits. To keep away the rivals, it becomes ----------------------
necessary to control profits. Whether this will be possible depends
upon many factors, but an effort should be made to abide by this ----------------------
rule. ----------------------
One statement can be mentioned here that will highlight the meaning
----------------------
aptly– “Anything that is overdone loses its charm”. If a coffee shop
is running a good business in a particular locality and people around ----------------------
are aware of it, it may invite more entrepreneurs in the same line of
business. The end resultant: nobody really does very well !! ----------------------
iii) Consumers’ Confidence : It is also necessary to maintain the ----------------------
confidence of the consumers in the reasonableness of the firm’s
prices. Those entrepreneurs who are tempted to exploit the ----------------------
situation of reaping huge profits usually lose the sympathies of their
----------------------
customers. It pays in the long-run to overcome such temptations
and continue to enjoy the confidence of the customers. ----------------------
iv) Political Climate : In modern times, entrepreneurs are also required
----------------------
to take note of the political climate in the country. This is especially
true where a firm supplies products to government departments, or ----------------------
public enterprises. Charges of profiteering and exploitation may
invite public inquiries and this will cause a great deal to the firm. It ----------------------
is, therefore, advisable to keep profit rates low and create an image
----------------------
of a firm with fair dealings.
Thus, profit policy involves many important considerations and all ----------------------
the factors noted above go into the formulation of a sound profit ----------------------
policy.
The last two points hold good, especially in a market-driven democracy ----------------------
like India. Consumer is king and has the right to vote the politicians in ----------------------
and out their position of power. Consumer is sovereign. People’s power is
supreme. No firm or politician can put up an act of ignorance against this. ----------------------
A suspicion leading to public outcry can sweep any firm off its feet, no
matter how strong the backing of any political power. Take for instance, ----------------------
‘Cadbury’ sales started dipping in the market after it was exposed on ----------------------
the media that the packaging was defined flaws and there were germs
inside the product. They strengthened their packaging by introducing new ----------------------
techniques (like putting in additional cover inside the main cover) and
roped in superstar Amitabh Bachchan to endorse the product with a new ----------------------
improved look. ----------------------
2.6 REASONABLE PROFIT TARGET ----------------------
We have already studied that modern firms and corporations may not aim ----------------------
at profit maximization. Instead they set ‘a standard’, ‘a target’ or ‘a reasonable ----------------------
Profit 37
Notes profit’ which they strive to achieve. We have also studied the reasons for aiming
at ‘Reasonable Profits’ in the previous chapter.
----------------------
Let us now look into the policy questions related to setting standards or criteria
---------------------- for reasonable profits. The important policy questions are :
a) What are the criteria for determining the profit standard?
----------------------
b) How should ‘reasonable profits’ be determined?
----------------------
Let us now briefly examine the policy implications of these questions.
---------------------- a) Standards of Reasonable Profits
---------------------- When firms voluntarily exercise restraint on profit maximization and
choose to make only a ‘reasonable profit’, the questions that arise are:
---------------------- (i) what form of profit standard should be used, and (ii) how should
---------------------- reasonable profits be determined ?
Forms of Profit Standard
----------------------
The profit standards may be determined in terms of (a) aggregate money
---------------------- terms, (b) percentage of sales, and (c) percentage return on investment.
These standards may be determined with respect to the whole product
----------------------
line or for each product separately. Of all the forms of profit standards,
---------------------- the total net profits of the enterprise usually receive the greatest attention.
But when purpose is to discourage the potential competitors, then a target
---------------------- rate of return on investment is the appropriate profit standard, provided
competitors’ cost curves are similar.
----------------------
b) Setting the Profit Standard
----------------------
The following are the important criteria that are taken into account while
---------------------- setting the standards for a ‘reasonable profit’.
---------------------- Capital attracting standard

An important criterion of profit standard is that it must be high enough to
----------------------
attract external capital. For example, if stocks are being sold in market at
---------------------- five times their current earnings, it is necessary that the firm earns a profit
of 20 percent on the book investment.
----------------------
There are however certain problems that are associated with this criterion:
---------------------- (i) capital structure of the firms (i.e. the proportions of bonds, equity and
preference shares) affects the cost of capital and thereby the rate of profit,
---------------------- (ii) whether profit standard has to be based on current or long run average
cost of capital as it varies widely from company to company and may at
----------------------
times prove treacherous i.e. unpredictable.
---------------------- ‘Plough back’ standard
---------------------- In case a company intends to rely on its own sources for financing its
growth, then the most relevant standard is the aggregate profit that provides
---------------------- for an adequate “plough-back” for financing a desired growth of company
---------------------- without resorting to the capital market. This standard of profit is used
when maintaining liquidity and avoiding debt are main considerations in Notes
profit policy.
----------------------
Plough back standard is however socially less acceptable than capital-
attracting standard. The reason, that, it is more desirable that all earnings ----------------------
are distributed to stockholders and they should decide the further
investment pattern. This is based on a belief that market forces allocate ----------------------
funds more efficiently and the individual is the best judge of this resource
----------------------
use. On the other hand, retained earnings which are under the exclusive
control of the management are likely to be wasted on low-earning projects ----------------------
within the company. But one cannot say for certain as to which of the two
allocating agencies is actually superior. It depends on ‘the relative abilities ----------------------
of management and outside investors to estimate earnings prospects.’
----------------------
Normal earnings standard
----------------------
Another important criterion for setting standard of reasonable profit is
the ‘normal’ earnings of firms of an industry over a normal period. Company’s ----------------------
own normal eanrings over a period of time often serve as a valid criterion of
reasonable profit, provided it succeeded in (i) attracting external capital, (ii) ----------------------
discouraging growth of competition, (iii) keeping stockholders satisfied. When
----------------------
an average of ‘normal earnings of a group of firms is used, then only comparable
firms and normal periods are chosen.’ ----------------------
However, none of these standards of profit is perfect. A standard is ----------------------
therefore chosen after giving due consideration to the prevailing market
conditions and public attitudes. In fact, different standards are used for different ----------------------
purposes because no single criterion satisfies all the conditions and all the people
concerned. ----------------------
----------------------
----------------------
1. The criterion on which profit calculation is based is that the rate of
----------------------
profit should be ___________to attract share capital.
2. The profit standards are determined in terms of percentage of ----------------------
________.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Profit 39
Notes
Activity 3
----------------------
---------------------- Hari Sons Ltd, a joint stock company, is issuing new shares at the
beginning of the financial year. The brothers expect to do better than the
---------------------- previous year. They experienced a slack last financial year. Somewhere
they went wrong in their estimations. The actual profit was much below
----------------------
their expectation. They don’t want to repeat the same mistakes. Therefore,
---------------------- they have appointed a new panel of experts this year; you are amongst
one of them.
----------------------
The company is into manufacturing of only wooden furniture items.
---------------------- There are a lot of competitors in the market who provide a wide range of
furniture items. In the last financial year, mistakes were committed in the
---------------------- calculation of profit because of three factors. Considering the situation
given above, can you think of and suggest ways of avoiding the mistakes
----------------------
this year?
----------------------
---------------------- Summary
---------------------- ●● This unit has given the realistic view of the term ‘profit’. Beginning with
the correct meaning of the term, it has highlighted in full the different
---------------------- views attached in defining it.
---------------------- ●● Gross profit is different from Net profit, the Economic profit is different
from Accounting profit. The difference basically lies in its valuation at
---------------------- different stages and thus gives birth to different factors leading to the
differences in the concepts. These are seen in factors like Depreciation,
----------------------
Inventory Evaluation and unaccounted value changes in the assets and
---------------------- liabilities.
●● The Dynamic theory has surely a touch of dynamism and thus more
----------------------
apt to today’s world as it takes under its fold various dynamic changes
---------------------- like those production techniques, supply of capital, population, business
organisations, etc.
----------------------
●● The profit policy should answer the ever high-flying question to any
---------------------- entrepreneur : ‘how much profit should I expect?’. There are a number
of criteria given in this unit for the rate of profit as expected by the
---------------------- entrepreneur, that will help solve the question to a large extent i.e. it should
be sufficient enough to attract new share-capital and for further expansion
----------------------
plans and should be comparable to that of similar other companies and
---------------------- also its own in the past. Attached to the criteria are also external factors
like labour relations, market conditions, and political environment.
----------------------
●● Lastly, the unit points out that modern day corporations do not aim at profit
---------------------- maximization, but in fact set a ‘reasonable profit standard’ and strive to
achieve and then maintain it. Capital attracting standard, ‘Plough back’
---------------------- standard, Normal earnings standard, though can help the entrepreneur
in striking the balance, realistically speaking not a single one criterion Notes
fulfills all the required conditions that an organisation encounters.
----------------------
Keywords ----------------------
●● Accounting Profit : Surplus of revenue over and above all paid-out costs ----------------------
●● Assets of a Firm : Its net worth plus its liabilities
----------------------
●● Capital Structure of Firms : Proportions of bonds, equity, preference
shares ----------------------
●● Depreciation : Loss of value due to the continuous use of an asset ----------------------
●● Gross Profit : Gross profit is total receipts minus total expenditure
----------------------
●● Innovation : Invention is exploited on a commercial basis
●● Insurable Risks : Risks which can be covered by insurance (by paying the ----------------------
premium)
----------------------
●● Pure or Net Profit : Pure or net profit is total revenue minus the
government–aggregate of implicit and explicit costs ----------------------
----------------------
----------------------
1. Give a brief review about the theories of profit.
----------------------
2. Critically evaluate F.H. Knight’s Uncertainly Bearing Theory of Profit.
3. Distinguish between gross and net profit. ----------------------
4. How would you distinguish between Accounting Profit and Economic ----------------------
Profit?
----------------------
5. “Profit is a reward of the entrepreneur for innovation.” Discuss.
----------------------
6. State and explain Dynamic Theory of Profit.
7. Explain how profit can be measured in practice. ----------------------
8. Write notes on: ----------------------

a. Profit Policy ----------------------
b. Standards of reasonable profit
----------------------
c. Reasons for limiting profits.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Profit 41
Notes Answers to Check your Progress
---------------------- Fill in the blanks.

1. To an accountant, profit means excess of revenue over all paid out costs.
----------------------
2. Pure profit or economic profit means return over and above the opportunity
---------------------- cost.
---------------------- 3. Pure profit is calculated as Profit = Total revenue − (Explicit cost +
Implicit cost)
----------------------
4. Innovation Theory of Profit was developed by Joseph Shumpeter.
---------------------- 5. As per Clark’s Dynamic Theory, profit is the reward payment for
---------------------- dynamism.
----------------------
Fill in the blanks.
----------------------
1. As per the financial accounting principle, the assets of a concern have
---------------------- claims from owners and lenders.
2. Net worth = Assets – Liabilities.
----------------------
3. The various important methods of calculating depreciation are straight
---------------------- line, diminishing balance, annuity and service unit method.
---------------------- 4. The term FIFO means First In First out.

Fill in the blanks.
----------------------
1. The criterion on which profit calculation is based is that the rate of profit
---------------------- should be sufficient to attract share capital.
---------------------- 2. The profit standards are determined in terms of percentage of sales.
----------------------
Suggested Reading
----------------------
1. http://www.old.li.suu.edu/library/circulation/Tufte/econ6200dt
---------------------- ManagerialEconomicsFa12Ch1.pdf
---------------------- 2. Samuelson, Paul, and William Nordhaus. Economics. 2005. New Delhi:
Tata McGraw-Hill Education.
----------------------
----------------------
----------------------
----------------------
----------------------
Demand
UNIT
3
Structure:
3.1 Concept of Demand

3.2 Determinants of Demand
3.3 Demand Schedule
3.4 Demand Curve
3.5 The Law of Demand
3.6 Assumptions underlying the Law of Demand
3.7 Exceptions to the Law of Demand or Exceptional Demand Curve
3.8 Changes in Quantity Demanded and Changes in Demand
Summary
Key Words
Suggested Reading
Demand 43
Notes
Objectives
----------------------
----------------------
• Define demand and its related concepts
----------------------
• List the factors affecting demand
---------------------- • Assess market demand
---------------------- • Derive individual and market demand curves
---------------------- • State the law of demand

• Analyse its assumptions and exceptions
----------------------
---------------------- 3.1 CONCEPT OF DEMAND

---------------------- In Economics, ‘Demand’ does not mean simple desire. Thus, a poor
man’s desire to have a motor-car or middle class person’s desire to have an
----------------------
air-conditioned bunglow in a city or suburb will not have any influence on the
---------------------- production of cars and bunglows.
Nor does ‘Demand’ mean ‘need’. For example, a beggar’s need for more
----------------------
bread, clothing and shelter will have absolutely no influence on the production
---------------------- of those three goods, however urgently they may be needed by a beggar.
In Economics ‘Demand’ means ‘desire backed by adequate purchasing
---------------------- power’ or enough money to purchase desired goods.
---------------------- In fact, in Economics, ‘demand’ means specific quantity of a commodity
actually purchased or bought.
----------------------
Further, since quantity purchased will depend upon price of the commodity
---------------------- in question, it follows that ‘demand means at a specific price’. Unless the price
per unit of the commodity is stated, the concept of demand will not be clear.
----------------------
‘Demand’ in Economics also means ‘demand per unit of time’, say, per
---------------------- day, per month, per year and so on.
---------------------- Thus, it can be said that in Pune, demand (i.e. quantity actually purchased)
for milk per month is 1,50,000 litres when the price of milk is Rs. 15 per litre.
---------------------- Or at an individual level, a person demands (i.e. actually purchases) one
litre of milk per day (or 30 litres of milk per month), when the price of milk is
----------------------
Rs. 15 per litre.
---------------------- Other examples explaining the concept of demand may be as follows :
---------------------- In India, demand (i.e. actual quantity that is purchased) for wheat per year
is 40 lakh tones, when the price of wheat is Rs. 15 per Kg.
----------------------
Though not generally mentioned in any book, along with price and unit of
---------------------- time, it would be logical to mention specific market in which buying and selling
transactions are taking place, say demand in a village, in Pune, in Mumbai, in
---------------------- India and so on.
Thus, now the full statement of the concept of demand would be as Notes
follows:
----------------------
At a price of Rs. 15 per litre in village A, 100 litres of milk are demanded
(i.e. actually bought) per day. ----------------------
In Pune, at the price of Rs. 15 per litre, 1,50,000 litres of milk are demanded
----------------------
(actually purchased) per day.
In Mumbai, at the price of Rs. 15 per litre, 4,50,000 litres demanded ----------------------
(actually purchased) per day.
----------------------
In Maharashtra, at an average price of Rs. 15 per litre, 50 lakh litres of
milk are demanded (actually purchased) per day. ----------------------
The above examples should make the concept of demand clear. Omission ----------------------
of price per unit of a commodity, or unit of time or of specific market would
leave the concept of demand vague. ----------------------
----------------------
3.2 DETERMINANTS OF DEMAND
----------------------
Demand for a commodity depends on a number of factors.
----------------------
a) Factors Influencing Individual Demand
An individual’s demand for a commodity is generally determined by ----------------------
factors such as : ----------------------
i) Price of the product : Price is always a basic consideration in
----------------------
determining the demand for a commodity. Normally, a larger
quantity is demanded at a lower price than at a higher price. If the ----------------------
price of the product falls, the consumer might buy the product if he
had initially denied its consumption solely on the basis of its high ----------------------
price. For example, if the price of cashew nuts fall, then housewives
----------------------
will increase its consumption; give the kids in the tiffin box, keep it
for snacks or even include it in the recipe of their favourite dishes. ----------------------
ii) Income : Income is an equally important determinant of demand.
----------------------
Obviously, with the increase in income one can buy more goods.
Thus, a rich consumer usually demands more goods than a poor ----------------------
consumer. For instance, a sudden increase in Mr. John’s salary
because of ‘increments’ (as they are termed for the employee salary ----------------------
raise) or ‘promotion’ in one’s designation means higher disposable
----------------------
income (income on hand). As a mark of celebration, Mr. John takes
his family for shopping and also throws a party for his friends. ----------------------
Thus, he has increased his demand for a number of things at the
same time. He may even increase the monthly allowance that he ----------------------
gives his wife and children that further hikes the demand coming
----------------------
from a single family.
iii) Tastes and Habits : Demand for many goods depend on the person’s ----------------------
tastes, habits and preferences. Demand for several products like ice- ----------------------
Demand 45
Notes cream, chocolates, behl-puri, etc. depend on an individual’s tastes.
Demand for tea, betel, tobacco, etc. is a matter of habit.
----------------------
If a person is habituated to having tea at a particular point of time in
---------------------- a day, then he is bound to have it, be it any place, be it at any price.
Also with the fear of ‘bird-flu’, many people stopped the
----------------------
consumption of eggs, as recommended; but there were some, who
---------------------- were so accustomed to having eggs for breakfast -barring a few
days in the very beginning- then went in search of the so-called
---------------------- ‘good-testified’ eggs to fulfill their consumption.
---------------------- People with different tastes and habits have different preferences for
different goods. A strict vegetarian will have no demand for meat
---------------------- at any price, whereas a non-vegetarian who has liking for chicken
or fish may demand it even at a high price. Similar is the case with
----------------------
demand for cigarettes by non-smokers and smokers.
---------------------- iv) Relative Prices of Other Goods - Substitutes and Complementary
---------------------- Products: How much the consumer would like to buy of a given
commodity, however, also depends on the relative prices of other
---------------------- related goods such as substitutes or complementary goods to a
commodity.
----------------------
When a desire/want can be satisfied by alternative similar goods,
---------------------- they are called substitutes. For example, peas and beans, groundnut
oil and til oil, tea and coffee, jowar and bajra etc., are substitutes of
---------------------- each other.
---------------------- In case of monopolistic competition, the same product can have
various brands like BRU coffee, SUNRISE coffee. Increase on
---------------------- the price of one will effect an increase in the demand to the other.
---------------------- Ofcourse one cannot forget the loyalty a consumer can have towards
one particular product – a strong personal inclination that may make
---------------------- the consumer buy the same product inspite of rise in price.
---------------------- The demand for a commodity depends on the relative prices of its
substitutes. If the substitutes are relatively costly, then there will be
---------------------- more demand for the commodity in question at a given price than in
case its substitutes are relatively cheaper. For example, if the price
----------------------
of petrol rises steeply, a consumer who is about to buy a new car
---------------------- will think of buying a diesel-driven car instead. Of course there are
many factors to making this decision which one cannot deny! OR
---------------------- let’s say if the price of refined oil increases, a consumer will start
using ghee or ‘dalda’ or vice versa or there are various varieties
----------------------
of rice available in the market e.g. basmati, kohinoor, ambe-mohar
---------------------- etc. a smart consumer will keep track of the price changes in each
of them and buy the right one at the right time.
----------------------
Similarly, the demand for a commodity is also affected by its
---------------------- complementary products. When in order to satisfy a given want,
two or more goods are needed in combination, these goods are Notes
referred to as complementary goods. For example, car and petrol,
pen and ink, tea and sugar, shoes and socks, sarees and blouses, gun ----------------------
and bullets etc. are complementary to each other.
----------------------
Complementary goods are always in joint demand. One commodity
cannot be consumed without the other. Thus, if a given commodity ----------------------
is a complementary product, its demand will be relatively high
----------------------
when its related commodity’s price is lower than otherwise. Or,
when the price of one commodity decreases, the demand for its ----------------------
complementary product will tend to increase and vice versa. For
example, a fall in the price of cars will lead to an increase in the ----------------------
demand for petrol. Similarly, a steep rise in the price of petrol will
----------------------
cause a decrease in demand for petrol driven motor cars and its
accessories. Also let’s say, if the price of batteries goes up, parents ----------------------
will start buying toys (for their children) that are not battery operated
i.e. the demand for battery-operated toys will decline. ----------------------
v) Consumer’s Expectations : A consumer’s expectations about the ----------------------
future changes in the price of a given commodity also may affect its
demand. When he expects its prices to fall in future, he will tend to ----------------------
buy less at the present prevailing price. Similarly, if he expects its
----------------------
price to rise in future, he will tend to buy more at present. What an
individual expects, thinks and reacts is not anybody’s direct control. ----------------------
For example, a farmer friend tells a consumer that there is going to
be a shortage of onions and potatoes in the market because of large ----------------------
scale exports. Shortage means high prices which lead the consumer
----------------------
to immediately go to the market and buy 10 kgs. of each.
vi) Advertisement Effect : In modern times, the preferences of a ----------------------
consumer can be altered by advertisement and sales propaganda,
----------------------
albeit to a certain extent only. Thus, demand for many products like
tooth-paste, toilet-soap, washing powder, processed foods, etc., is ----------------------
partially caused by the advertisement effect in a modern man’s life.
----------------------
For instance, advertisements play a strong effect on the minds of
children. They see their favourite stars acting as brand ambassadors ----------------------
for the product. Thus, they in turn ‘desire’ (not demand, since it
may not be fulfilled by all parents) for products they are not meant ----------------------
to consume, for example, colas. But ads can even have a positive ----------------------
effect on them. For instance, they may take to consuming more milk
or nutritious biscuits or even understand the importance of exercise. ----------------------
A lady seeing an advertisement repeatedly on television about a ----------------------
particular ab-machine that helps reduce the flab in 20 days is
highly influenced by the same and thus buys the machine with the ----------------------
aspiration of looking like the model in the ad.
----------------------
----------------------
Demand 47
Notes b) Factors Influencing Market Demand
The market demand for a commodity originates and is affected by the
----------------------
form of change in the general demand pattern of the community of the
---------------------- people at large. The following factors affect the common demand pattern
for a commodity in the market.
----------------------
i) Price of the Product : At a low market price, market demand for
---------------------- the product tends to be high and vice versa. For example, street
hawkers in a bustling city area sell anything from watches to shoes
---------------------- to clothes to household and kitchen items and other accessories
at very low prices. Thus, they invite a very high demand for their
----------------------
products.
---------------------- ii) Distribution of Income and Wealth in the Community: If there
is equal distribution of income and wealth, the market demand for
----------------------
many products of common consumption tends to be greater than in
---------------------- the case of unequal distribution.
---------------------- In a capitalist economy, where there is unequal distribution of

income, the aggregate demand will be a mixture of luxury items
---------------------- like Air conditioners, VCD or DVD players, high-tech sound
systems, lavish furniture items, gems and jewellery demanded
---------------------- by the rich-elite class on one hand, and basic necessities like low
---------------------- quality foodgrains, rice, dal etc. on the other.
iii) Community’s Common Habits and Scale of Preferences : The
---------------------- market demand for a product is greatly affected by the scale of
---------------------- preferences by the buyers in general. For example, when a large
section of population shifts its preference from vegetarian foods
---------------------- to non-vegetarian foods, the demand for the former will tend to
decrease and that for the latter will increase. In today’s era of fitness
---------------------- and health awareness, a lot of people are getting calorie-conscious
---------------------- only to reduce the demand for traditional sweets and thus increase
the demand for low-fat and high protein diet items.
---------------------- iv) General Standards of Living and Spending Habits of the People:
---------------------- When people in general adopt a high standard of living and are
ready to spend more, demand for many comforts and luxury items
---------------------- will tend to be higher than otherwise.
---------------------- With increasing incomes, people fit in Air-Conditioners in their
homes too, (its quite commonplace to have them in the offices today),
---------------------- buy a flat-screen T.V. or generally re-furnish their houses with better
quality interiors. Instead of having a common family car, there can
----------------------
be a car for each family member; spend more on entertainment
---------------------- and socialising; go for frequent holidays, also to better and farther
destinations (trip to Europe, World-tour etc.); lavish food habits;
---------------------- enroll their children in better schools or universities, etc.
----------------------
v) Number of Buyers in the Market and Growth of Population: Notes
The size of market demand for a product obviously depends on
the number of buyers in the market. A large number of buyers will ----------------------
constitute a large demand and vice versa.
----------------------
Thus, growth of population is an important factor. A high growth of
population over a period of time tends to imply a rising demand for ----------------------
essential goods and services in general.
----------------------
vi) Age Structure and Sex ratio of the Population : Age structure
of population determines market demand for many products in ----------------------
a relative sense. If the population pyramid of a country is broad-
----------------------
based with a larger proportion of juvenile population (see below),
then the market demand for milk, toys, school bags etc. goods and ----------------------
services required by children will be much higher than the market
demand for goods needed by the elderly people. Similarly, sex ratio ----------------------
has its impact on demand for many goods. An adverse sex ratio, i.e.
----------------------
females exceeding males in number (or, males exceeding females
as in Mumbai), would mean a greater demand for goods required by ----------------------
the female population than by the male population (or the reverse).
----------------------
----------------------
----------------------
Retired,
senior citizens ----------------------
----------------------
Working ----------------------
population
----------------------
----------------------
----------------------
Adolescents
----------------------
----------------------
Infants and children ----------------------
----------------------
The above structure shows that the age-ratio of population of ----------------------

a country, wherein infant population is the highest and old-age
----------------------
population is the lowest.
But, with advancement in medical science, there’s increase in the ----------------------
life expectancy and so is the demand consumed by old people on ----------------------
Demand 49
Notes a routine-basis. For instance, demand for dentures and denture
lotions, walking sticks or hearing aids or spectacles have increased.
---------------------- But if a country has a “baby-boom” one particular year, then there
will be spurt in the demand for toys, diapers, teethers, baby powder
---------------------- and creams and soaps, bath tubs, cradles, baby-walkers, etc.
---------------------- vii) Future Expectations : If buyers in general expect that prices of a
commodity will rise in future, etc. present market demand would be
----------------------
more as most of them would like to hoard the commodity. The reverse
---------------------- happens if a fall in the future price is expected. For example, if the world
political scenario is very adverse, outbreak of war is expected and so
---------------------- the increase in the prices of basic necessaries. In this case, people will
increase the demand for the same extensively. As a security, they will
----------------------
hoard these items prior to the expected rise in prices.
---------------------- viii) Level of Taxation and Tax Structure : A progressively high tax
rate would generally mean a low demand for goods in general and
----------------------
vice-versa. But a highly taxed commodity will have a relatively
---------------------- lower demand than an untaxed commodity - if that happens to be a
remote substitute. For instance, a higher sales tax on a commodity
---------------------- increases its price and thus lessens its demand. On the other hand,
tax-free cinema tickets reduce the ticket-rate and thus increase the
----------------------
audience to the film.
---------------------- ix) Inventions and Innovations: Introduction of new goods or
substitutes as a result of inventions and innovations in a dynamic
----------------------
modern economy tends to adversely affect the demand for the
---------------------- existing products, which as a result of innovations, definitely
become obsolete. For example, the advent of latest digital media
---------------------- like Compact Disks (CDs) has made audio and video cassettes
obsolete. Also, the advent of digital cameras has thinned down the
----------------------
market for photo-studios and photo prints.
---------------------- x) Fashions : Market demand for many products is affected by
---------------------- changing fashions. For example, demand for commodities like
jeans, shirts, salwar-kameej etc. are based on current fashions.
---------------------- Square-rimmed glasses became quite a fashion when one favourite
sports-star adorned it.
----------------------
xi) Climate or Weather Conditions : Demand for certain products are
---------------------- determined by climatic or weather conditions. For example, in summer,
there is a greater demand for cold drinks, fans, coolers, air conditioners
---------------------- etc. Similarly, demand for umbrellas and raincoats are seasonal. People
---------------------- living in cold places demand for products (food items, clothes, types of
housing) different from the ones living in warmer places.
---------------------- xii) Customs : Demand for certain goods are determined by social customs,
---------------------- festivals, etc. For example, during Diwali holidays, there is a greater
demand for sweets, crackers, vehicles and white goods; and during
---------------------- Christmas, cakes, sweets and confectioneries are in more demand.
xiii) Advertisement and Sales Propaganda : Market demand for many Notes
products in the present day are influenced by the sellers’ efforts through
advertisements and sales propaganda. Demand is manipulated through ----------------------
selling efforts. Of course, there is always a limit.
----------------------
For example, one sees discount schemes like ‘Buy one get one free’ and
ends up buying the product with the temptation of getting the other one ----------------------
completely free. Also at a food store, you buy one pizza and get 50% off
----------------------
on the second one. These are ‘sales gimmicks’ by which the seller lures
the buyer into buying his product. Firms with big budgets can get the big ----------------------
stars to endorse their products and thus try to convince the people about
their product authenticity and usability. ----------------------
When these factors change, the general demand pattern will be affected, ----------------------
causing a change in the market demand as a whole.
----------------------
3.3 DEMAND SCHEDULE
----------------------
A tabular statement of price-quantity relationship is known as the demand
schedule. It narrates how much amount of a commodity is demanded by an ----------------------
individual or a group of individuals in the market at alternative prices, per unit ----------------------
of time. There are, thus, two types of demand schedules : (i) the individual
demand schedule, and (ii) the market demand schedule. ----------------------
Individual Demand Schedule ----------------------
A tabular list showing the quantities of a commodity that will be purchased
----------------------
by an individual at various prices in a given period of time (say per day, per
week, per month or per annum) is referred to as an individual demand schedule. ----------------------
Table 3.1
----------------------
Price of X in Rs. (per kg.) Quantity Demanded of X per week (in kg.)
30 2 ----------------------
25 4 ----------------------
20 6
15 10 ----------------------
10 16 ----------------------
This illustrates a hypothetical (purely imaginary) demand schedule of an
----------------------
individual consumer Mr. A for commodity X.
Characteristics of Demand Schedule ----------------------
1) The demand schedule does not indicate any change in demand by the ----------------------
individual concerned, but merely expresses his present behaviour in
purchasing the commodity at alternative prices. ----------------------
2) It shows only the variation in demand at varying prices. ----------------------
3) It seeks to illustrate the principle that more of a commodity is demanded ----------------------
at a lower price than at a higher one. In fact, most of the demand schedules
show an inverse relationship between price and quantity demanded. ----------------------
Demand 51
Notes Market Demand Schedule
It is a tabular statement narrating the quantities of a commodity demanded
----------------------
in aggregate by all the buyers in the market at different prices in a given period
---------------------- of time. A market demand schedule, thus, represents the total market demand at
various prices.
----------------------
Theoretically, the demand schedules of all individual consumers of
---------------------- a commodity can be compiled and combined to form a composite demand
schedule, representing the total demand for the commodity at various alternative
---------------------- prices. The derivation of market demand from individual demand schedules
is illustrated in the table given below. Here it is assumed that the market is
----------------------
composed only of three buyers.
---------------------- Table 3.2
---------------------- Price in Rupees Units of Commodity X Quantity Demanded in
(per unit) Demanded per day by the market for X
---------------------- Individuals
---------------------- A+ B+ C+ =
4 1 3 3 7
----------------------
3 2 4 5 11
---------------------- 2 3 5 7 15
1 5 9 10 24
----------------------
Apparently, the market demand schedule is constructed by the horizontal
---------------------- additions of quantities at various prices shown by the individual demand
schedules. It follows that like an individual demand schedule, the market
----------------------
demand schedule also depicts an inverse relationship between the price and
---------------------- quantity demanded.

----------------------
Fill in the blanks.
----------------------
1. Demand means _________ backed by adequate _______________.
----------------------
2. The two types of demand schedules are _______________ and
---------------------- _______________.
----------------------
1. Demand schedule shows only the variation in demand at varying
---------------------- prices.
---------------------- 2. Like an individual demand schedule, the market demand schedule
does not depict an inverse relationship between price and quantity
---------------------- demanded.
----------------------
----------------------
Notes
Activity 1
----------------------
1. Which of the following statements depicting demand are correct?
----------------------
Give reasons for your answer.
i. 50 buffaloes give 150 litres of milk each day, which is consumed ----------------------
by the entire village in one day. ----------------------
ii. In a bustling part of a city, 100 packets of idlis are sold within an
hour. ----------------------
iii. A fruit vendor sells 50 fruits of nine different varieties in a day. ----------------------
iv. A toyshop selling different types of toys, each priced at Rs 20 at ----------------------
a hill station makes a business of Rs 3500 each day.
----------------------
2. Following are some instances. For each, write how the demand will
be affected for that product, some other goods or service or in general ----------------------
and why.
----------------------
i. A firm announces a double bonus for all its employees during
this Diwali. ----------------------
ii. Right next to a busy snack centre , a new one comes up. ----------------------
iii. Value added tax is announced on all saleable commodities (
goods and services). ----------------------
iv. A vegetable hawker announces that all customers after 9.30 p.m. ----------------------
to his shop will enjoy a 25% off on any good day.
----------------------
v. An epidemic in a country kills thousands of people, mostly
affecting the older generation. ----------------------
vi. Prices of washing machines go down drastically. ----------------------
----------------------
3.4 DEMAND CURVE
----------------------
A demand curve is a graphical presentation of a demand schedule. When
----------------------
price-quantity information of a demand schedule is plotted on a graph, a demand
curve is drawn. Demand curve thus depicts the picture of the data contained in ----------------------
the demand schedule.
----------------------
Conventionally, a demand curve is drawn by representing the price
variable on the Y-axis and the demand variable on the X-axis. ----------------------
Fig. given below illustrates the demand curve based on the data contained ----------------------
in Table 3.2.
In this figure, the quantity demanded is measured on the horizontal ----------------------
axis (X-axis) and the price per kg. is measured on the vertical axis (Y-axis). ----------------------
Corresponding to the price-quantity relations given in the demand schedule,
various points like a, b, c, d and e are obtained on the graph. These points are ----------------------
Demand 53
Notes joined and the smooth curve DD is drawn, which is called the demand curve.
The demand curve has a negative slope. It slopes downwards from left to
----------------------
right, representing an inverse relationship between price and demand.
---------------------- Y D
---------------------- a
30
---------------------- b
Price (Per Kg.)

25
---------------------- c
20
---------------------- d
15
e
---------------------- D
10
----------------------
5
---------------------- X
O 2 4 6 8 10 12 14 16
---------------------- Quantity Demanded
---------------------- Fig 3.1 : Individual Demand Curve
---------------------- The Fig 3.1 given above, represents an individual demand curve. Likewise,
by plotting the market demand schedule graphically, the market demand curve
---------------------- may be drawn.
---------------------- Derivation of Market Demand Curve
---------------------- Market demand curve is derived by the horizontal summation of individual

demand curves for a given commodity. Fig 3.2 given illustrates this :
---------------------- A’s Demand B’s Demand C’s Demand Market Demand
----------------------
Y Y Y Y
Price (Per Unit)
---------------------- 4 4 4 4
---------------------- 3 3 3 3
---------------------- 2 2 2 2
----------------------
1 1 1 1
X X X X
---------------------- O 2 4 6 8 10 O 2 4 6 8 10 O 2 4 6 8 10
O
6 10 16 24 26
---------------------- Fig 3.2 : Derivation of Market Demand Curve

It may be observed that the slope of the market demand curve is an average of
----------------------
the slopes of individual demand curves. Essentially, the market demand curve
---------------------- too has a downward slope indicating an inverse price-quantity relationship, i.e.
quantity demanded rises when the price falls, and vice-versa.
----------------------
----------------------
3.5 THE LAW OF DEMAND Notes
The general tendency of consumers’ behaviour in demanding a commodity ----------------------
in relation to the changes in its price is described by the law of demand. The
law of demand expresses the nature of functional relationship between two ----------------------
variables of the demand relation, viz., the price and the quantity demanded. It
----------------------
simply states that demand varies inversely with change in price.
Statement of the Law ----------------------
The law may be stated thus : “Other things being equal, the higher ----------------------
the price of a commodity, the smaller is the quantity demanded and lower the
price, larger is the quantity demanded.” In other words, the demand for a ----------------------
commodity expands (i.e., the demand rises) as the price falls and contracts ----------------------
(i.e. the demand falls) as the price rises. Or briefly stated, the law of demand
emphasises that, other things remaining unchanged, demand varies inversely ----------------------
with price.
----------------------
The conventional law of demand, however, relates to the much simplified
demand function: ----------------------
D = f(P) ----------------------
where, D represents demand, P the price and f connotes a functional
----------------------
relationship. It, however, assumes that other determinants of demand are
constant and only price is the variable and influencing factor. The relation ----------------------
between price and quantity of demand is usually an inverse or negative relation,
indicating a larger quantity demanded at a lower price and a smaller quantity ----------------------
demanded at a higher price.
----------------------
Explanation of the Law of Demand
----------------------
The law of demand is usually referred to the market demand. The law of
demand can be illustrated with the help of a market demand schedule, i.e. as the ----------------------
price of a commodity decreases, the corresponding quantity demanded for that
commodity increases and vice-versa. ----------------------
Table 3.3 ----------------------

Price of Commodity X (in Rs.) per unit Quantity Demanded per week ----------------------
5 10
----------------------
4 20
3 30 ----------------------
2 40
----------------------
1 50
This table represents a hypothetical demand schedule for commodity X. ----------------------
We can read of from this table that with a fall in price at each stage, quantity ----------------------
demanded tends to rise. There is an inverse relationship between price and
quantity demanded. Usually, economists draw a demand curve to give a ----------------------
pictorial presentation of the law of demand. When the data of table are plotted
graphically, a demand curve is drawn as shown in Figure given below. (Here, ----------------------
Demand 55
Notes incidentally, the demand curve being a straight line is a linear demand curve.
Y
---------------------- D
5
----------------------
Price (Per Unit)

4
---------------------- 3
---------------------- 2
1 D
----------------------
0 X
---------------------- 10 20 30 40 50
Quantity Demanded of X
----------------------
Fig 3.3 : Demand Curve
----------------------
In this Fig 3.3, DD is a downward sloping demand curve indicating an
---------------------- inverse relationship between price and quantity demanded.
---------------------- From the given market demand-curve, one can easily locate the market
demand for a product at a given price. Further, the demand curve geometrically
---------------------- represents the mathematical demand function : Dx = f (Px)
----------------------
----------------------

1. Demand curve is drawn by representing price variable on “x” axis
---------------------- and demand variable on “y” axis.
---------------------- 2. Consumers’ behaviour in demanding a commodity in relation to the
change in price is described by law of demand.
----------------------
3. There is parallel relationship between price and quantity demanded.
----------------------
----------------------
Activity 2
----------------------
1. Write a hypothetical example depicting the inverse relation between
----------------------
price and quantity demanded of your favorite fruit and derive the
---------------------- demand curve.
2. In the stock market, there are “BULLS’ and “BEARS”. Given a
----------------------
situation that both of them are acting and reacting, then who do you
---------------------- think will the market demand curve?
----------------------
3.6 ASSUMPTIONS UNDERLYING THE LAW OF DEMAND
----------------------
The above stated law of demand is conditional. It will hold good only if
---------------------- certain conditions are given and constant.
Thus, it is always stated with “other things being equal”. It relates to the Notes
change in price variable only, assuming other determinants of demand to be
constant. The law of demand is, thus, based on the following ceteris paribus ----------------------
assumptions.
----------------------
1) No Change in Consumer’s Income : Throughout the operation of the law,
the consumer’s income should remain the same. If the level of a buyer’s ----------------------
income changes, he may buy more even at a higher price, invalidating the
----------------------
law of demand. Let’s say an individual gets windfall profit or a lottery
prize, then he is bound to increase his demand for a number of items. ----------------------
2) No Change in Consumer’s Preferences: The consumer’s tastes, habits
----------------------
and preferences should remain constant.
3) No Change in Fashion: If the commodity in question goes out of fashion, ----------------------
a buyer may not buy more of it even at a substantial price reduction.
----------------------
4) No Change in the Prices of Related Goods : Prices of other goods like
substitutes and complementary goods remain unchanged. If the prices of ----------------------
other related goods change, the consumer’s preferences would change ----------------------
which may invalidate the law of demand.
5) No Expectations of Future Price Changes or Shortages : The law ----------------------
requires that the given price change for the commodity is a normal ----------------------
one and has no speculative consideration. That is to say, the buyers do
not expect any shortages in the supply of the commodity in the market ----------------------
and consequent future changes in the prices. The given price change is
assumed to be final at a time. ----------------------
6) No Change in size, age composition and sex ratio of the Population: ----------------------
For the operation of the law in respect of total market demand, it is essential
that the number of buyers and their preferences should remain constant. ----------------------
This necessitates that the size of population as well as the age-structure ----------------------
and sex-ratio of the population should remain the same throughout the
operation of the law. Otherwise, if population changes, there will be ----------------------
additional buyers in the market, so that the total market demand may not
contract with a rise in price. ----------------------
7) No Change in the range of Goods available to the Consumers : This ----------------------

implies that there is no innovation and arrival of new varieties of products
----------------------
in the market which may distort consumer’s preferences.
8) No Change in the distribution of income and wealth of the Community: ----------------------
There is no redistribution of income either, so that the levels of income of
----------------------
the consumers remain the same.
9) No Change in Government Policy : The level of taxation and fiscal ----------------------
policy of the government remain the same throughout the operation of the ----------------------
law. Otherwise, changes in income tax, for instance, may cause changes
in consumers’ income or changes in commodity taxes (sales tax or excise ----------------------
duties) may lead to distortions in consumer’s preferences.
----------------------
Demand 57
Notes 10) No Change in Weather conditions: It is assumed that climatic and
weather conditions are unchanged in affecting the demand for certain
---------------------- goods like woollen clothes, umbrellas etc.
---------------------- In short, the law of demand presumes that except for the price of the
product, all other determinants of its demand are unchanged.
----------------------
It means we are living in a static society, where there are no changes
---------------------- in anything except the price. There’s no technological progress, no medical
advancement, no innovative ideas, no industrial revolution etc. people are just
---------------------- widely consuming the line of products that are available to them at a particular
price, they have just the product price to react to. Thus, all these assumptions do
----------------------
not have strong foothold in today’s fast changing world.
---------------------- Apparently, the validity of the law of demand or the inference about
inverse relationship between price and quantity demanded depends on the
----------------------
existence of these conditions or assumptions.
----------------------
3.7 EXCEPTIONS TO THE LAW OF DEMAND OR
----------------------
EXCEPTIONAL DEMAND CURVE
----------------------
It is almost a universal phenomenon of the law of demand that when
---------------------- the price falls, the demand expands and it contracts when the price rises. But
sometimes, it may be observed, though, of course, very rarely, that with a fall
---------------------- in price, demand also falls and with a rise in a price, demand also rises. This is
a paradoxical situation or a situation which is apparently contrary to the law of
----------------------
demand. Cases in which this tendency is observed are referred to as exceptions
---------------------- to the general law of demand. The demand curve for such cases will be typically
unusual. It will be an upward sloping demand curve as shown in Fig 3.4 given
---------------------- below. It is described as an exceptional demand curve.
Y
----------------------
----------------------
D
----------------------
----------------------
----------------------
Price (Per Unit)
P2
----------------------
----------------------
P1
----------------------
----------------------
---------------------- O Q1 Q2 X
---------------------- Fig 3.4 : Exceptional Demand Curve
In this Fig 3.4, DD is the demand curve which slopes upward from left Notes
to right. It appears thus that when OP1 is the price, QQ1, is the demand and
when the price rises to OP2' demand also expands to QQ2. Thus, the upward ----------------------
sloping demand curve expresses a direct functional relationship between price
and demand. ----------------------
Such upward sloping demand curves are unusual and quite contradictory ----------------------
to the law of demand as they represent the phenomenon that ‘more will be
----------------------
demanded at a higher price and vice versa”. The upward sloping demand
curve, thus, refers to the exceptions to the law of demand. There are a few such ----------------------
exceptional cases, which may be categorised as follows :
----------------------
1) Giffen Goods: In the case of certain inferior goods called Giffen goods, as
introduced by Robert Giffen when the price falls, quite often less quantity ----------------------
will be purchased than before because of the negative income effect and
people’s increasing preference for a superior commodity with the rise in ----------------------
their real income. Probably, a few appropriate examples of inferior goods
----------------------
may be listed, such as foodstuffs like cheap potatoes, cheap bread, pucca
rice, vegetable ghee, etc., as against superior commodities like good ----------------------
potatoes, cakes, basmati rice, pure ghee.
----------------------
2) Articles of Snob Appeal : Sometimes, certain commodities are demanded
just because they happen to be expensive or prestige goods, and have a ----------------------
‘snob appeal’. These are generally ostentatious articles, and purchased
only by rich people for using them as ‘status symbol’. Thus, when prices ----------------------
of such articles like say diamonds rise, their demand also rises; similarly,
----------------------
Rolls Royce cars, Johney Walker Scotch Whiskey are another outstanding
illustration. ----------------------
3) Speculation : When people speculate in changes in the price of a ----------------------
commodity in the future, they may not act according to the law of demand
at present. Say, when people are convinced that the price of a particular ----------------------
commodity will rise still further, they will not contract their demand with
the given price rise; on the contrary, they may purchase more for the ----------------------
purpose of hoarding. In the stock exchange market, some people tend ----------------------
to buy more shares when the prices are rising, in the hope that the rising
trend would continue, so they can make a good fortune in future. ----------------------
4) Consumer’s Psychological bias or illusion: When the consumer is wrongly ----------------------
biased against the quality of a commodity with the price change, he may
contract his demand with a fall in price. Some sophisticated consumers ----------------------
do not buy when there is a stock clearance sale at reduced prices, thinking
that the goods may be of bad quality. ----------------------
----------------------
----------------------
----------------------
----------------------
Demand 59
Notes 3.8 CHANGES IN QUANTITY DEMANDED AND
CHANGES IN DEMAND
----------------------
In economic analysis, the terms ‘changes in quantity demanded’ and
---------------------- ‘changes in demand’ have different meanings.
---------------------- The term ‘changes in quantity demanded’ or variation in demand relates
to the law of demand. It refers to the changes in quantities purchased by the
----------------------
consumer on account of changes in price only. Thus, we may say that the
---------------------- quantity demanded of a commodity increases when it’s price decreases, or the
quantity demanded decreases when it’s price increases. But, it is incorrect to
---------------------- say that demand decreases when price increases or demand increases when
price decreases. For “increase” and “decrease” in demand refers to “changes in
----------------------
demand” caused by the changes in various other determinants of demand, price
---------------------- remaining unchanged.
Changes in quantity demanded in relation to the price are measured by
----------------------
the movement along the demand curve, while changes in demand are reflected
---------------------- through shifts in the demand curve. The terms changes in quantity demanded
essentially means variation in demand referring to “ expansion” or “extension”
---------------------- or “contraction” of demand which are quite distinct from the terms “increase”
or “decrease” in demand.
----------------------
A) Expansion or Extension and Contraction of Demand (Changes in Q. D.)
----------------------
A variation in demand implies “expansion” or “contraction” of demand.
---------------------- When with the fall in the price with the commodity is brought, there is
expansion of demand. Similarly, when a lesser quantity is demanded with
---------------------- a rise in price, there is contraction of demand. In short, demand expands
---------------------- when the price falls and it contracts when the price rises. Thus, the terms
“expansion” and “contraction” are used in stating the law of demand.
---------------------- The terms “expansion” and “contraction” of demand, should, however,
---------------------- be distinguished from increase or decrease in demand. The former is used
for indicating increase in demand, while the later is used for indicating
---------------------- changes in demand, and variation in demand is the connotation of the
law of demand. It expresses a functional relationship between quantity
---------------------- demanded and price. A change in demand due to change in price is called
---------------------- expansion or contraction. Expansion and contraction refer to the same
demand curve. A change in demand due to causes other than price is
---------------------- called increase or decrease in demand.
---------------------- In graphical exposition, expansion or contraction of demand is shown
by the movement along the same demand curve. A downward movement
---------------------- from one point to the another on the same demand curve implies expansion
of demand, for instance, movement from a to b in the following figure. It
----------------------
suggests that when the price decreases from OP to OP1, demand expands
---------------------- from OQ to OQ1. While an upward movement from one point to another
on the same demand curve implies contraction of demand, e.g. movement
---------------------- from a to c in the diagram.
Y Notes
----------------------
D
----------------------
Co
ntr
----------------------
act
ion
P2 c ----------------------
Price (Per Unit)
Ex ----------------------
pan
a sio
P n ----------------------
P1 b ----------------------
D
----------------------
Q2 Q Q1 X ----------------------
Quantity Demanded of X ----------------------
Fig 3.5 : Expansion and Contraction of Demand
----------------------
The Fig 3.5, shows that when price rises from OP to OP2 demand contracts
from OQ to OQ2. ----------------------
In short, a change in quantity demanded in response to the change in price ----------------------

is explained by the terms expansion or contraction of demand. Further,
expansion or contraction implies a movement on the same demand curve ----------------------
which means the demand schedule remains the same. ----------------------
B) Increase and Decrease in Demand (Changes in Demand)
----------------------
These two terms are used to express changes in demand. Changes in
demand are a result of the change in the conditions or factors determining ----------------------
demand, other than the price. A change in demand, thus implies an increase
----------------------
or decrease in demand. When more of a commodity is bought than before
at any given price, there is increase in demand. Similarly, when with price ----------------------
remaining unchanged less of a commodity is bought than before, there is
decrease in demand. ----------------------
In other words, an “increase” in demand signifies either that more will be ----------------------
demanded at given price or the same will be demanded at a higher price.
Thus, an increase in demand means that more is now demanded than ----------------------
before, at each and every price. likewise, “a decrease in demand” signifies
----------------------
either that less will be demanded at given price or the same quantity will
be demanded at a lower price. ----------------------
Thus increase and decrease in demand are shown by shifting the demand
----------------------
curves.
The terms “increase” or “decrease” in demand are graphically expressed ----------------------
by the movements from one demand curve to the another. In other words, ----------------------
Demand 61
Notes the change in demand is denoted by the shifting of the demand curve. In
the case of an increase in demand, the demand curve is shifted to the right.
---------------------- In the following figure (A), thus, the movement of demand curve from
DD to D1D1 shows an increase in demand. In this case, the movement
---------------------- from point a to b indicates that the price remains the same at OP, but more
---------------------- quantity OQ1 is now demanded, instead of OQ. Thus increase in demand
is QQ1. Similarly, as in Fig B, a decrease in demand is depicted by the
---------------------- shifting of the demand curve towards it’s left.
Y Y
---------------------- D
D1
---------------------- D D2
----------------------
Price (Per Unit)
Price (Per Unit)

Increase
b Decrease
---------------------- P a D1 c a
D
----------------------
D D2
----------------------
X
---------------------- O Q Q1 X O Q2 Q
---------------------- Fig 3.6 : Increase and Decrease in Demand

---------------------- In the above Fig.3.6, thus, the movement of demand curve from DD to
D2D2 show a decrease in demand. In this case, movement from point a to
---------------------- c, indicates that the price remains same at the OP, but less quantity OQ2
is now demanded than before. Here decrease in demand is QQ2.
----------------------
Reasons for Change (Increase or Decrease in Demand)
----------------------
A change in demand occurs when the basic factors affecting demand other
---------------------- than price changes. Thus, an increase or decrease in demand is brought
about by many kinds of changes. Some of the important changes are:
----------------------
1) Change in income
---------------------- 2) Change in the pattern of income distribution.
---------------------- 3) Change in tastes, habits and preferences.
---------------------- 4) Change in fashions and customs.
5) Change in the supply of the substitutes and in their prices.
----------------------
6) Change in the supply or demand supply of the complementary
---------------------- goods and change in their prices
---------------------- 7) Change in population
---------------------- 8) Advertisement and Publicity persuasion
----------------------
----------------------
Notes
----------------------
1. Law of demand is based on the assumption that there is “No change
----------------------
in consumer‘s income.”
2. Law of demand is based on the assumption that “there can be changes ----------------------
in the prices of related goods”.
----------------------
3. Law of demand is based on the assumption that “there can be changes
in weather conditions”. ----------------------
4. One of the few exceptions to the Law of demand is that with the fall ----------------------
in price, demand also falls.
----------------------
5. Demand for Giffen goods increase with fall in prices.
----------------------
Activity 3 ----------------------
----------------------
1. Can you think of an example validating the “Giffen Goods”
paradox? ----------------------
2. A farmer gets a bumper crop this season and makes a lot of money. ----------------------
He goes to the market and buys a lot of things for his family. This
is “expansion of demand”. Is this statement true or false? Give ----------------------
reasons for your answer.
----------------------
3. Making door-to-door calls for the product has brought in lot of
orders for the product. Now how will the demand behave and how ----------------------
will you term it? Show it graphically and explain.
----------------------
----------------------
Summary
----------------------
●● Demand is such a common term that is so widely used by common people
at common place that the term itself has become a ‘cliché’. That it is an ----------------------
economic term in the real sense has almost been forgotten. Thus, ‘demand’ ----------------------
has been aptly brought to light in this unit.
●● The terms ‘increase’, ‘decrease’, expansion, and ‘contraction’ of demand, ----------------------
each has a special significance. This unit teaches how to use each of these ----------------------
terms in a special context.
●● Here, we are introduced to graphical representations, which at times ----------------------
speak better than words. ----------------------
●● Individual demand has been differentiated from market demand whereas
many a times one may identify with the other. In studying the determinants ----------------------
affecting each of them, this unit has introduced concepts of different types ----------------------
Demand 63
Notes of goods with varying demand behaviour. In this respect, ‘Giffen Goods’
paradox is very interesting. In fact, the demand to different types of goods
---------------------- comes from basic individual reactions to market situations. The ‘Law of
Demand’ with its assumptions and exceptions is nothing but individual
---------------------- behaviour, highlighting how he would act and react to the given changes
---------------------- in the market.
●● Thus, this is a general individual behaviour, which one experiences in
---------------------- every walk of life.
----------------------
Keywords
----------------------
●● Complimentary Goods : When two or more goods are consumed in
---------------------- combination to satisfy a given want.
---------------------- ●● Demand : Desire backed by adequate purchasing power.
---------------------- ●● Demand Schedule : Tabular statement of price-quantity relationship.
●● Demand Curve : Graphical representation of the demand schedule.
----------------------
●● Expansion of Demand : More goods are demanded with a fall in price.
---------------------- ●● Future Expectations : Predictions about the future regarding market
changes in price, the level of aggregate demand and so the supply, etc.
----------------------
●● Giffen Goods : Inferior goods contradicting the law of demand.
----------------------
●● Law of Demand : Consumerial behaviour towards demanding a
---------------------- commodity in relation to its price changes.
●● Scale of Preference : Range of goods and services that consumers would
---------------------- want to consume, given a level of income.
---------------------- ●● Standard of Living : Range of goods and services that consumer can
afford, given his level of income.
----------------------
●● Shift in the Demand Curve : Demand ‘increases’ or ‘decreases’ because
---------------------- of factors other than price.
---------------------- ●● Substitute Goods : Alternative similar goods that can satisfy a want.

---------------------- 1. What is demand in economics? Explain the determinants of demand.
---------------------- 2. State and explain the law of demand.
---------------------- 3. The law of demand can be in fact criticised on the basis of its assumptions.
Highlight each point with an example.
----------------------
4. Explain graphically each of the following:
---------------------- a. Giffen Goods paradox
---------------------- b. Expansion and contraction of demand
---------------------- c. Increase and decrease in demand
Answers to Check your Progress Notes

1. Demand means desire backed by adequate purchasing power. ----------------------
3. The two types of demand schedules are individual demand schedule and
----------------------
market demand schedule.
1. True. ----------------------
2. False ----------------------
----------------------
----------------------
1 False
2. True ----------------------
3. False ----------------------
----------------------
1. True
----------------------
2. False
3. False ----------------------
4. True ----------------------
5. False ----------------------
----------------------
Suggested Reading
----------------------
1. Varshney, R.L., and K.L. Maheswari. 2011. Managerial Economics. New
Delhi: Sultan Chand & Sons. ----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Demand 65
Notes
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Elasticity of Demand
UNIT
4
Structure:
4.1 Introduction
4.2 Price Elasticity of Demand
4.3 Types of Price Elasticity
4.4 Measurement of Elasticity
4.5 Factors Influencing Price Elasticity of Demand
4.6 Practical Significance of the Concept of Elasticity of Demand
4.7 Income Elasticity of Demand : Measurement, Types and Uses of the
Concept
4.8 Cross Elasticity of Demand : Concept, Measurement and its Uses
Summary
Key Words
Suggested Reading
Elasticity of Demand 67
Notes
Objectives
----------------------
----------------------
• Define elasticity of demand
----------------------
• Differentiate, compute and evaluate the types of demand elasticity
---------------------- • Explain the factors affecting demand elasticity
---------------------- • Label a commodity depending on its demand elasticity price,
income, cross-elasticity
----------------------
----------------------
4.1 INTRODUCTION
----------------------
Demand for goods varies with price. But the extent of variation is not
---------------------- uniform in all cases. In some cases the variation is extremely wide; in some
others it may just be nominal. That means, sometimes demand is greatly
---------------------- responsive to changes in price; at other times, it may not be so responsive. The
extent of variation in demand is technically expressed as elasticity of demand.
----------------------
According to Marshall, the elasticity (or responsiveness) of demand in a market
---------------------- is great or small, depending on whether the amount demanded increases much
or little for a given fall in price; and diminishes much or little for a given rise in
---------------------- price.
---------------------- The term "elasticity of demand", when used without qualifications is
commonly referred to as price elasticity of demand. This is a loose interpretation
---------------------- of the term. In a strict logical sense, however, the concept of elasticity of demand
---------------------- should measure the responsiveness of demand for a commodity to changes in
its determinants.
---------------------- There are, thus, as many kinds of elasticities of demand as its determinants.
---------------------- Economists usually consider three important kinds of elasticity of demand : (1)
Price elasticity of demand, (2) Income-elasticity of demand and (3) Cross-price
---------------------- elasticity of demand or just cross elasticity.
---------------------- "Price elasticity" refers to the degree of responsiveness of demand for a
commodity to a given change in its price.
----------------------
"Income elasticity" refers to the degree of responsiveness of demand for
---------------------- a commodity to a given change in the income of the consumer.
"Cross elasticity" refers to the responsiveness of demand for a
----------------------
commodity to a given change in the price of a related commodity - substitute or
---------------------- complementary product.
---------------------- In the present unit, we shall study them one by one.
----------------------
----------------------
4.2 PRICE ELASTICITY OF DEMAND Notes
The extent of the change of demand for a commodity to a given change ----------------------
in price, other demand determinants remaining constant, is termed as the price
----------------------
elasticity of demand. The coefficient of price elasticity of demand may, thus, be
defined as the ratio of the relative change in demand to the relative change in ----------------------
price.
----------------------
Since, the relative change of variables can be measured either in terms of
percentage change or as proportional change, the price elasticity coefficient can ----------------------
be measured :
----------------------
The percentage change in Quantity demanded
e =
The percentage change in price ----------------------
Price elasticity of dema nd can also be measured alternatively as ----------------------
Net change in Quantity demanded Net change in price
e= : ----------------------
Original Quantity demanded Original price
Representing it in symbols, thus, the price elasticity formula can be stated ----------------------
as :
----------------------
 Q  P
e= ÷ ----------------------
Q P
 Q P ----------------------
= X
Q P ----------------------
 Q P ----------------------
\ e= X
 P Q
----------------------
Q = the original demand (Say Q1)
----------------------
P = the original price (Say P1)
 Q = the change in demand. It is measured as the difference ----------------------
between new demand (say Q2) and the old demand (Q1) ----------------------
Thus,  Q = Q2 – Q1 ----------------------
 P = the change in Price. It is measured as the difference
----------------------
between new Price P2' and the old price (P1)
----------------------
Thus,  P = P2 – P1
The above formula, in fact, relates to point-price elasticity of demand, that is, ----------------------
the coefficient signifies very small or marginal changes only. ----------------------
----------------------
----------------------
----------------------
Notes To illustrate the use of the formula, let us consider the following information
from the demand schedule :
----------------------
Price of Tea (Rs.) Quantity Demanded (Kg.)
---------------------- 20 (P1) 10 (Q1)
22 (P2) 9 (Q2)
----------------------
Thus,
----------------------
 P = 22 - 20 = 2, and P = P1 = 20
----------------------  Q = 09 - 10 = 1, and Q = Q1 = 10
---------------------- (Here, minus signs are ignored)
Therefore e =  Q P
---------------------- X
 P Q
---------------------- 1 20
X
---------------------- = 2 10
\ e = 1
----------------------
This means, the elasticity of demand is equal to one or unity.
---------------------- Using the above formula, the numerical coefficient of price elasticity
---------------------- can be measured from any such given data. Apparently, depending upon the
magnitude and proportional change involved in the data on demand and prices,
---------------------- one may obtain various numerical values of coefficients of price elasticity,
ranging from zero to infinity.
----------------------

----------------------
Fill in the blanks.
---------------------- 1. The extent of variation in demand is technically expressed as
---------------------- ________________.
2. The types of elasticity of demand are ___________, ______________
---------------------- and __________________.
---------------------- 3. Price elasticity of demand is measured as
---------------------- e = % change in the _____________/ percentage change in ________.
----------------------
----------------------
Activity 1
---------------------- Calculate the elasticity of demand from the following table:
---------------------- Price per unit of commodity A (Rs) Quantity demanded (Units)

50 100
----------------------
65 80
---------------------- Can you think of a commodity to suit the above example?
4.3 TYPES OF PRICE ELASTICITY Notes
Demand may be elastic or inelastic, depending on the degree of ----------------------

responsiveness of the demand for a commodity to a given change in its price. ----------------------
By elastic demand, we mean that demand responds greatly or relatively
more to a price change. It however, does not imply that the consumers are fully ----------------------
responsive to a price change. What it means is simply this that a relatively larger ----------------------
change in demand is caused by a smaller change in price. Similarly, inelastic
demand does not mean that demand is totally insensitive. It only means that the ----------------------
relative change in demand is less than that of price. It means demand responds
to a lesser extent only. ----------------------
Measuring numerical coefficient of price elasticity in different cases, ----------------------

we will find that its value ranges from zero to infinity. When the elasticity
coefficient is greater than one, demand is said to be elastic; and it is inelastic ----------------------
when the numerical coefficient is less than one; and when it is exactly one (or ----------------------
unity), the demand is unitary elastic.
----------------------
Treating this concept in a more elaborate manner, we may mention the
following five types of price elasticity of demand : ----------------------
1) Perfectly elastic demand when e = α
----------------------
2) Perfectly inelastic demand when e = O
----------------------
3) Relatively elastic demand when e >1
4) Relatively inelastic demand when e <1 ----------------------
5) Unitary elastic demand when e = 1 ----------------------

1) Perfectly Elastic Demand (e = α) ----------------------
An infinite demand at the given price is a case of perfectly elastic demand.
----------------------
When demand is perfectly elastic, with a slight or infinitely small rise in
the price of the commodity, the consumer stops buying it. The numerical ----------------------
coefficient of perfectly elastic demand is infinity (e = α).
----------------------
In fact, the degree of elasticity determines the shape and slope of the
demand curve. Thus, elasticity of demand can be ascertained from the ----------------------
slope of the demand curve. The slope of demand curve reflects the
elasticity of demand. Flatter the demand curve, higher the elasticity. ----------------------
In the case of a perfectly elastic demand, the demand curve will be a ----------------------
horizontal straight line. Thus, the demand curve in Figure A given below
implies, that at the ruling price of OP, the demand is infinite, while a ----------------------
slight rise in price would mean a zero demand. This figure indicates that ----------------------
at price OP, a person would buy as much of the given commodity, as can
be obtained, i.e. an infinite quantity, and that at a slightly higher price ----------------------
he would buy nothing. Perfectly, elastic demand is a case of theoretical
extremity. It is hardly encountered in practice. ----------------------
----------------------
Notes Fig. (A)
Y
---------------------- e=α
----------------------
D
Price (Per Unit)

---------------------- P D
----------------------
----------------------
---------------------- X
O
---------------------- Quantity Demanded
---------------------- Fig 4.1 : Types of Price Elasticity of Demand
---------------------- In economic theory, however, the demand for the product of a firm in
a perfectly, competitive market is assumed to be perfectly elastic.
---------------------- Theoretically, perfectly elastic demand or the horizontal demand curve (as
shown in Figure above), from the firm's point of view implies that it can
---------------------- sell as much as it produces at the ruling market price, since at the given
---------------------- price (say OP in Figure shown above), buyers tend to have an infinite
demand for its product in the market. But it also implies that a slight
---------------------- increase in price will bring the demand down to zero. This holds true in a
perfectly competitive market where there is perfect product homogeneity.
---------------------- All the products in the market are exactly the same. Any firm increasing
---------------------- the price by even an iota will have absolutely no demand for his product.
Let's say, the product is black umbrellas. So the buyer will never buy the
---------------------- same product from a particular firm at a higher price when the very same
product is available in the market at a lower price.
----------------------
2) Perfectly Inelastic Demand (e = 0)
---------------------- Y
e=0
---------------------- D
P1
Price (Per Unit)
----------------------
---------------------- P2
---------------------- P3
----------------------
D
X
---------------------- O Q
Quantity Demanded
----------------------
When the demand for a commodity shows no response at all to a change
---------------------- in price, that is to say, whatever the change in price the demand remains
the same, then it is called a perfectly inelastic demand. Perfectly, inelastic
----------------------
demand has zero elasticity (e = 0). In this case, the demand curve would Notes
be a straight vertical line as in Figure B shown above. This figure indicates
that whether the price moves from OP1 to OP2 or OP3, the quantity ----------------------
demanded remains the same OQ only. Perfect inelasticity is again a
theoretical consideration rather than a practical phenomenon. However, ----------------------
a commodity of absolute necessity like salt seems to have perfectly ----------------------
inelastic demand for most consumers. This can be seen in the example
given below: ----------------------
Price of SALT per kg. Quantity Demanded (kg.) ----------------------
25 1000
----------------------
35 1000
Elasticity of demand for salt = 0 (change in quantity demanded = 0) ----------------------
3) Relatively Elastic Demand ( e > l ) ----------------------
Fig. (c)
Y ----------------------
----------------------
D e>1 ----------------------
Price (Per Unit)
P1 ----------------------
P2 D
----------------------
----------------------
O X
Q1 Q2 ----------------------
Quantity Demanded
----------------------
Fig 4.3
When the proportion of change in the quantity demanded is greater than ----------------------
that of price, the demand is said to be relatively elastic. The numerical ----------------------
value of relatively elastic demand lies between one and infinity. Thus, what
Marshall called as elasticity of demand being greater than unity referred ----------------------
to 'relatively elastic' demand or 'more elastic' demand. A relatively elastic
demand will be represented by a gradually sloping, i.e. rather a flatter ----------------------
demand curve as shown in Figure 4.3 above. In this Figure 4.3 above ----------------------
when the price falls by P1 P2, the demand expands by Q1 Q2 which is
relatively large in proportion to the change in price. ----------------------
 Q  P ----------------------
e = ÷ = > 1
Q P ----------------------
Therefore, elasticity is greater than one; it is a more realistic concept, as many
commodities can have more elastic demand. ----------------------
For instance, price of a soda bottle increases from Rs. 15 - Rs. 20. There would ----------------------
be many consumers who may stop the consumption of the same (instead
of having Fresh Lime Soda, they will now have Fresh Lime Water). But ----------------------
Notes there would be still some who may continue to consume the same. Here
we can say that the former lot tends to be much larger than the latter.
---------------------- Therefore overall the demand is relatively elastic.
---------------------- This is highlighted in the numerical example given below :
---------------------- Price of 1 bottle of Soda Quantity Demanded (kg.)

15- verify 100
---------------------- 20 50
---------------------- The price hasn't doubled, but the demand has reduced to half.
---------------------- 4) Relatively Inelastic Demand (e < l)
Fig.
----------------------
D e<1
----------------------
P1
Price (Per Unit)

----------------------
----------------------
P2
----------------------
---------------------- D
O Q1 Q2 X
----------------------
---------------------- Fig 4.4
---------------------- When the proportion of change in the quantity demanded is less than
that of price, the demand is considered to be relatively inelastic. The
---------------------- numerical value of relatively inelastic demand lies between zero and one.
Hence, the concept “relatively inelastic” or ‘less elastic’ demand is the
---------------------- same as what Marshall presented as elasticity being less than unity. A
---------------------- relatively inelastic demand will be represented by a rapidly sloping, i.e.,
rather a steeper, demand curve as shown in Figure (D) above. In Figure
---------------------- (D) when the price falls by P1 P2, the demand expands just by Q1 Q2 which
is relatively small in proportion to the change in price.
----------------------
Q P
---------------------- e = ÷ = <1
Q P
---------------------- Therefore, elasticity is less than one. This is also a very realistic concept.
---------------------- For instance, a commodity like milk that is used on a daily basis by
consumers, enjoys a highly inelastic demand. Consumption of milk is by
---------------------- consumers of all ages as matter of habit or liking or health compulsion.
See the example given below :
----------------------
Price of milk (per litre) Quantity Demanded (litres)
----------------------
12 200
---------------------- 14.50 190
Using the formula given above, price elasticity of milk = 0.24. Thus it is Notes
less than 1. The price per litre of milk has increased to more than double,
but there is a marginal decline in its quantity demanded. ----------------------
For instance, when price of a routine-used commodity like potatoes or ----------------------
onions reduces to let us say half of the original price (it does happens
many a times in case of agricultural products, when's there's a bumper ----------------------
crop and the whole of it comes to the market for sale at the same time
----------------------
because of lack of storage), consumers will buy much more than required.
There will be a tendency to hoard them, a general psychology that the ----------------------
present price fall will lead to price rise in future.
----------------------
Price of potatoes per Kg. Quantity Demanded (Kg.)
12 100 ----------------------
6 300 ----------------------
The price of potatoes has reduced by half, but its demand has increased
to more than double. This is an example of rel. elastic demand, but its ----------------------
demand will be rel. inelastic in case of a price rise of the same product. ----------------------
5) Unitary Elastic Demand (e = 1)
----------------------
Fig. (E)
Y
e=1 ----------------------
D ----------------------
Price (Per Unit)
----------------------
P1
----------------------
P2 D
----------------------
----------------------
O X
Q1 Q1 ----------------------
Quantity Demanded
----------------------
Fig 4.5
When the proportion of change in demand is exactly the same as the ----------------------
change in price, the demand is said to be unitary elastic. The numerical
----------------------
value of unitary elastic demand is exactly 1. In the case of unitary elastic
demand, the demand curve would be a rectangular hyperbola asymptotic ----------------------
to the two axis, as shown in Figure 4.5 above. In Figure 4.5, when the
price falls by P1 P2, the demand expands by Q1 Q2 which is in the same ----------------------
proportion to change in price.
----------------------
Q P
e = ÷ =1 ----------------------
Q P
Hence, elasticity is equal to unity. This is a theoretical norm, which helps ----------------------
to distinguish between elastic and inelastic demand in general. ----------------------
Notes Price Quantity Demanded
10 5
----------------------
20 10
---------------------- The price has doubled and the quantity demanded has become half of the
---------------------- original. Let's say, the above product is a brand of coffee. When its price
doubles, half of the consumers originally demanding the same product
---------------------- will now take to consuming to another brand, but there are still some who
remain loyal to their original brand of coffee.
----------------------
The different kinds of price elasticity of demand discussed above have
---------------------- been summarised in Table 4.1.
---------------------- Table 4.1 : Price Elasticity of Demand
(Definition e = Percentage change in the quantity demand ÷ Percentage change
----------------------
in price)
----------------------
Numerical Terminology Description
---------------------- Value
e=α Perfectly (or infinitely Consumers have infinite demand
---------------------- elastic) at a particular price and none at
all at even slightly higher than this
----------------------
given price.
---------------------- e=O Perfectly (or completely) Demand remains unchanged
inelastic whatever may be the change in
---------------------- price.
---------------------- e>1 Relatively elastic Quantity demanded changes by a
larger percentage than does price.
---------------------- e<1 Relatively inelastic Quantity demanded changes by a
---------------------- smaller percentage than does price.
e=1 Unitary elastic Quantity demanded changes by
---------------------- exactly the same percentage as
does price.
----------------------
---------------------- 4.4 MEASUREMENT OF ELASTICITY

---------------------- There are five different methods of measuring price elasticity of demand-
(1) Percentage Method (2) Point Elasticity Method (3) Total Outlay Method (4)
---------------------- Point Geometric Method and (5) Arc Elasticity Method.
---------------------- (1) Percentage Method : The following formula is used
---------------------- % Change in Quantity Demanded
e=
% Change in Price
----------------------
New Quantity Demanded – Old Quantity Demanded
---------------------- % Change in Q.D. = X 100
Average Quantity Demanded
----------------------
New Price – Old Price Notes
% Change in Price = X 100
Average Price
----------------------
Look at the numerical example given below :
Price per unit (Rs.) Quantity Demanded (units) ----------------------
10 100 ----------------------
5 150
----------------------
150 – 100
% Change in Q.D. = into 100 = 50 / 5 = 10
125 ----------------------
% Change in Price = 5 – 10 into 100 = 66.667 (ignoring negative sign)
7.5
----------------------
e = 10 / 66.667 = 0.145
thus e <1, it is rel. inelastic demand. ----------------------
(2) Point Elasticity Method ----------------------
The calculation of the coefficient of price elasticity has been already ----------------------
discussed in the previous sub-unit using the ratio :
 Q P ----------------------
e = ÷
Q P ----------------------
 Q P
\ e= X
Q  P ----------------------
 Q P
\ e= X ----------------------
 P Q
(3) Total Outlay Expenditure or Revenue Method ----------------------
Dr. Alfred Marshall suggested that the easiest way of ascertaining whether
or not demand is elastic is to examine the change in the total outlay of the ----------------------
consumer or the total revenue of the seller. ----------------------
Total outlay (or Total Revenue) = Price per unit x Quantity demanded
----------------------
Dr. Marshall laid down the following propositions
----------------------
(1) When with a change in price, the total outlay remains unchanged, demand
is unitary elastic (e = 1). ----------------------
The total outlay remains constant in the case of unitary elastic demand, ----------------------
because the demand changes in the same proportion as the price. This is
illustrated in Table 4.2 given below : ----------------------
Table 4.2 : Total Outlay Method ----------------------
Price (per Quantity Total Outlay Elasticity of ----------------------
unit) (Rs.) demanded (or revenue) Demand
(Units) (Rs.) ----------------------
Original 5 16 80 – ----------------------
Change 1 8 10 80 } e=1
----------------------
Change 2 1 80 80 } (unitary)
----------------------
Notes (2) When with a rise in price, the total outlay falls, or with a fall in price, the
total outlay rises, elasticity of demand is greater than unity. This happens
---------------------- because the proportion of change in demand is relatively greater than
that of price. In short, when the price and total outlay move in opposite
---------------------- directions, demand is relatively elastic (see Table 4.3 below).
---------------------- Table 4.3 : Total Outlay Method
---------------------- Price (per Quantity Total Outlay Elasticity of
----------------------
(Units) (Rs.)
---------------------- Original 5 20 100 –
---------------------- Change 1 8 10 80 } e>1
Change 2 4 4 160 } (Elastic)
----------------------

---------------------- (3) When with a rise in price, the total outlay also rises, and with a fall in
---------------------- price, the total outlay falls, elasticity of demand is less than unity. This
happens because the proportion of change in demand is relatively less
---------------------- than the proportion of change in price. Briefly, thus, when the price and
total outlay move in the same direction, demand is relatively inelastic (see
---------------------- Table 4.4).
---------------------- Table 4.4 : Total Outlay Method
---------------------- Price (per Quantity Total Outlay Elasticity of
---------------------- (Units) (Rs.)
---------------------- Original 5 13 65 –
Change 1 8 10 80 } e<1
----------------------
Change 2 2 14 28 } (Inelastic)
----------------------
We may now summarise the total outlay method as follows :
----------------------
Price (per unit) Total Outlay Types of Elasticity
---------------------- 1. Increases Constant e=1
---------------------- Decreases Constant (Unitary)
2. Increases Decreases } e<1
---------------------- Decreases (Relatively elastic)
Increases
---------------------- 3. Increases Increases } (Inelastic)
---------------------- Decreases Decreases (Relatively inelastic)
Thus, from the behaviour of the total outlay or the total revenue, we can
----------------------
infer the nature of price elasticity of demand. Likewise, from a given price
---------------------- elasticity, we can conclude about the nature of change in the consumer's
total outlay or the seller's total revenue. In the case of unitary elastic
---------------------- demand, with any change in price, the total revenue remains unaltered.
But when there is elastic demand, the total revenue would change in the Notes
opposite direction of the price change. In the case of inelastic demand, the
total revenue would change in the same direction as the price changes. ----------------------
The total outlay method of measuring elasticity is, however, less exact. It ----------------------
can indicate only the type of elasticity, but not its exact numerical value.
To get the exact numerical value, we have to resort to the ratio method or ----------------------
the point method. However, the economic significance of the total outlay
----------------------
or the total revenue method is that it tells more directly what happens to
the total outlay or revenue as a practical guide for determining a price ----------------------
policy and its effect on demand and revenue.
----------------------
(4) Point Geometric Method
Dr. Alfred Marshall also suggested another method called the geometrical ----------------------
method of measuring price elasticity at a point on the demand curve.
----------------------
The simplest way of explaining the point method is to consider a linear
(straight-line) demand curve. Let the straight-line demand curve be ----------------------
extended to meet the two axes, as shown in Figure 4.6. When a point ----------------------
is taken on the straight-line demand curve (like point P in Fig below),
it divides the straight-line demand curve into two segments (parts). The ----------------------
point elasticity is, thus, measured by the ratio of the lower segment of the
curve below the given point to the upper segment (the upper part) of the ----------------------
curve above the point. ----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
For brevity, we may again put that
----------------------
Lower segment of the demand curve below the given point
Point elasticity = ----------------------
Upper segment of the demand curve above the point
L ----------------------
or, to remember through symbols, we may put it as e =
U ----------------------
where, e, stands for point elasticity, L stands for lower segment and U for ----------------------
the upper segment.
----------------------
----------------------
----------------------
Notes (5) Arc Elasticity Method : This method is used to measure elasticity of
demand on an arc of the demand curve. The formula is
----------------------
(Q0 – Q1) (P0 – P1)
---------------------- (Q0 + Q1) (P0 + P1)
---------------------- e=–x 2 ÷ 2
---------------------- (Q0 – Q1) (P0 + P1)

\e=–x x
---------------------- (Q0 + Q1) (P0 – P1)
---------------------- Here,
---------------------- Q0 = Original demand

Q1 = New demand
---------------------- P0 = Original price
---------------------- P1 = New price
There can be different answers to elasticity of demand ranging from zero
----------------------
to infinity.
---------------------- Using the same numerical as above, let us now calculate the elasticity
---------------------- using this method :
---------------------- Price per unit (Rs.) Quantity Demanded (units)

10 100
----------------------
5 150
----------------------
100 – 150 into 10 + 5
---------------------- e=
100 + 150 10 – 5
----------------------
50 into 15
---------------------- e= = 3 /5
250 5
---------------------- e = 0.6
---------------------- Thus elasticity < 1, thus relatively inelastic demand. We get the same
answer as above.
----------------------
----------------------
---------------------- Match the following.

---------------------- i. Perfectly elastic demand a. When e= 1
ii. Perfectly inelastic demand b. When e <1
---------------------- iii. Relatively elastic demand c. When e=α
iv. Relatively inelastic demand d. When e=0
----------------------
v. Unitary elastic demand e. When e=>1
----------------------
State True or False. Notes
1. The degree of elasticity does not determine the shape and slope of the ----------------------
demand curve.
----------------------
2. Flatter the demand curve, higher the elasticity.
3. When the proportion of change in the quantity demanded is greater ----------------------
than that of price, the demand is said to be relatively elastic. ----------------------
----------------------
Activity 2
----------------------
1. Given below is a numerical example. Calculate the price ----------------------
elasticity of demand. Determine the product elasticity. Show
diagrammatically as well. Can you think of a product that suits ----------------------
this example? Also explain why?
----------------------
Price Quantity Demanded
----------------------
10 20
----------------------
8 25
2. Write numerical examples of your own for commodity A having ----------------------
a highly elastic demand and for commodity B having highly ----------------------
inelastic demand.
3. Fill in the following table. ----------------------
Price in Rs Quantity Total outlay Elasticity of ----------------------

demanded (units) demand
----------------------
10 20
15 18 ----------------------
18 15
20 10 ----------------------
8 25
5 35 ----------------------
2 40 ----------------------
Given above is the statistics of a company on price and quantity
demanded. Compute the elasticity of demand and state what it ----------------------
shows in each case. ----------------------
4. First write down the formula for calculating the elasticity of
demand using the percentage Method and Point Elasticity method. ----------------------
Solve the following numerical examples; determine the product ----------------------
elasticity and the type of product. Give reasons for the same.
----------------------
Price (Rs) Quantity demanded ( Units)
8 20 ----------------------
15 12 ----------------------
Notes 4.5 FACTORS INFLUENCING PRICE ELASTICITY OF
DEMAND
----------------------
Whether the demand for a commodity is elastic or inelastic will depend
---------------------- on a variety of factors. The major factors affecting elasticity of demand are :
---------------------- 1. Nature of Commodity
---------------------- Certain goods by their very nature tend to have an elastic or inelastic
demand. By nature, goods may be classified into luxury, comfort or
---------------------- necessary goods. In general, demand for luxuries and comforts is relatively
elastic and that of necessaries relatively inelastic. Thus, for example, the
---------------------- demand for foodgrains, cloth, vegetables, sugar, salt etc. is generally
---------------------- inelastic.
Food is the basic necessity for all, whether rich or poor, thus the demand
---------------------- for the same is generally inelastic, but there are different varieties or
---------------------- types of food and the elasticity of a food item varies with the type of
food, since the food type decides the kind of demand it is going to attract.
---------------------- Lavish food items may have elastic demand like frozen food items, types
of cheese, butter, pastries, imported food items like chocolate cookies,
---------------------- pasta, etc. even the kind of clothing one wears – poor will wear whatever
available at the price they can afford, but the elite will wear according to
----------------------
their fancies.
---------------------- Thus, the demand for a commodity depends on the nature of the commodity
and the class of people that consumes.
----------------------
2. Availability of a Substitute
----------------------
Where there exists a close substitute in the relevant price range, its
---------------------- demand will tend to be elastic. But in respect of a commodity having no
substitute, the demand will be somewhat inelastic. Thus, for example,
---------------------- demand for salt, potatoes, onions, etc., is highly inelastic as there are no
close or effective substitutes for these commodities, while commodities
---------------------- like tea, coffee or beverages such as Thums Up, Mangola, Gold Spot,
---------------------- Fanta, Limca etc. have a wide range of substitutes and therefore they have
a more elastic demand in general.
---------------------- Even in the case of white goods like T.V., fridge, washing machines, mixers
---------------------- and grinders, cars, vehicles, there are different companies manufacturing
the same product. Thus one has to be careful, has to take proper stock of
---------------------- the market and affect price increase. Of course firms today are very aware
and will add value to their products to convince the buyer that with price
---------------------- increase, their product is 'better-off' than most others.
---------------------- Today we see competition, not just in case o goods but also in case of
services. Demand for services also tends to be relatively elastic, because
---------------------- of the availability of substitutes for the same. For instance hotels,
hospitals, parlours, hair cutting salons, tailoring houses. Consumers are
----------------------
on a constant lookout for good but affordable services. Thus, they tend to
---------------------- rule out the 'bad ones' very fast and go for something else.
3. Number of Uses Notes
Single-use goods will have generally less elastic demand as compared to
----------------------
multi-use goods, e.g., for commodities like coal or electricity having a
composite demand, elasticity is relatively high. With a fall in price, these ----------------------
commodities may be demanded greatly for various uses. It is, however,
also possible that the demand for a commodity which has a variety of uses ----------------------
may be elastic in some of the uses, and may be inelastic in some other
----------------------
uses e.g. coal used by railways and by consumers as fuel. But the former's
demand is inelastic as compared to the latter's. One more example : ----------------------
for instance, if price of cocoa powder increases, a consumer A having
regularly milk may now switch to another flavour, but a bakeman using it ----------------------
regularly in cakes will tend to have a fairly inelastic demand for the same.
----------------------
4. Consumer's Income
----------------------
Generally, larger the income of a consumer, his demand for overall
commodities tends to be relatively inelastic. For example, the demand ----------------------
pattern of a millionaire is rarely affected even by significant price changes.
Similarly, the redistribution of income in favour of low-income people ----------------------
may tend to make demand for some goods relatively inelastic. Take for
----------------------
example, commodity like milk, a commodity of daily consumption for
most population. If its price increase from say Rs. 10 - Rs. 12.50, its ----------------------
demand will remain least affected by most of the population, but for the
poorest of the poor, maybe relatively elastic, who find very difficult to ----------------------
make ends meet. Thus, we can say that if the distribution of income in
----------------------
an economy is favourable (even), then price hike of such goods will least
affect the overall demand elasticity. ----------------------
5. Height of Price and Range of Price Change ----------------------
There are certain white goods like costly luxury items or bulky goods
such as double door refrigerators, Colour T.V. sets, D.V.D. players etc. ----------------------
which are highly priced in general. In their case, a small change in price ----------------------
will have an insignificant effect on their demand. Their demand will,
therefore, be inelastic. However, if the price change is large enough, ----------------------
then their demand will be elastic. Similarly, there are divisible goods
like potatoes and onions, etc. which are relatively low priced and bought ----------------------
in bulk, so a small variation in price will not have much effect on their ----------------------
demand, hence demand tends to be inelastic in their case.
6. Proportion of Expenditure ----------------------
Items that constitute a smaller amount of expenditure in a consumer's ----------------------

family budget tend to have a relatively inelastic demand, e.g., a cinegoer
----------------------
who sees a film once a month is not likely to give it up when the ticket
rates are raised. But one who sees a film once every week perhaps may ----------------------
cut down the number of films seen per week. Similarly, a family which
enjoys eating out twice a week, may reduce their rejoicing if the rates go ----------------------
up. But may not hold true incase of a family which does the same only on
----------------------
Notes somebody's birthday in the house. Cheap or small expenditure items like
matches, sugar, kerosene candles, broomstick tend to have more demand
---------------------- in elasticity than expensive or large expenditure items.
---------------------- 7. Durability of the Commodity
In the case of durable goods, the demand generally tends to be elastic
----------------------
e.g. furniture, motor cycles, T.V. sets etc. In the case of perishable
---------------------- commodities, on the other hand, demand is relatively inelastic, e.g. milk,
vegetables etc.
----------------------
8. Influence of Habit and Customs
---------------------- There are certain articles which have a demand on account of conventions,
---------------------- customs or habit with which these articles are closely associated and in these
cases, elasticity is less, e.g. cigarettes to a smoker or alcohol to an alcoholic
---------------------- have inelastic demand. Consumers are surely habituated to particular things
at particular times. For instance, a small tea shop outside college campus will
---------------------- definitely attract a fixed clientele at all times of the day even if it hikes the
---------------------- rate per tea-cup from Rs. 1.50 to Rs. 3.00. in case of customs, an economy
like India knows best. Even for the poorest of the poor, a marriage without
---------------------- a mangal sutra will not be considered authentic. A daughter is sent to her in-
laws also with many other things in order to secure her life.
----------------------
9. Complementary of Goods
---------------------- Goods which are jointly demanded have less elasticity, e.g. ball-point
---------------------- pen and refills, motor cycle and petrol etc. have inelastic demand for this
reason. In this case, demand for one good affects that of the other, as to
---------------------- satisfy a want, they need to be jointly consumed. Can you think of tea or
coffee without sugar, unless the consumer is diabetic!
----------------------
10. Time
----------------------
In the short period, demand in general will be less elastic, while in the
---------------------- long period, it becomes more elastic. This is because (i) it takes some time
for the news of price change to reach all the buyers; (ii) consumers may
---------------------- expect a further change, so they may not react to an immediate change
in price; (iii) people are reluctant to change their habits all of a sudden,
----------------------
but gradually, in the long run, their habits may change and so the demand
---------------------- pattern; (iv) durable goods take some time to exhaust their utility. In
the long run, lapse of time results in their wearing out, then these are
---------------------- demanded more; (v) demand for certain commodities may be postponed
for some time, but, in the long run, it has to be satisfied. For instance, a
----------------------
person dreams of owning a big car someday. He already owns a small and
---------------------- a medium-sized car. An old friend of his, dealing in cars asks him to be
patient and wait for a few months, as the market awaits the arrival of a
---------------------- BIG LUXURY car at a very affordable price. This sounds tempting to our
man and he thus decides to wait to fulfill his long-cherished dream. Here
----------------------
we cannot say that his demand has died down, but has been postponed for
---------------------- the time-being. The demand will be finally realised in the long run.
11. Recurrence of Demand Notes
If the demand for a commodity is of a recurring nature, its price elasticity
----------------------
is higher than that of a commodity which is purchased only once. For
instance, motorcycles, V.C.D. players, T.V. sets, cars, two-wheelers etc. are ----------------------
purchased only once, these are big purchases and often done on auspicious
days in India like Dasshera, Diwali; also birthdays, anniversaries etc. ----------------------
Once planned, the consumers will rarely cancel their purchase altogether
----------------------
(unless some untoward incident). But the demand for cassettes or Compact
Disks may remain relatively elastic. Such goods have recurrent usability ----------------------
and also wear out fast, thus they are to be purchased again and again.
----------------------
12. Possibility of Postponement
When the demand for a product can be postponed (is postponable), it ----------------------
will tend to be price-elastic. In the case of consumption goods which
----------------------
are urgently and immediately required, their demand will be inelastic.
For example, life saving drugs during sickness, habituated goods etc. In ----------------------
case of a near and a dear one taking ill, family members will hardly think
or pre-evaluate the expenses to be incurred. They will have to pay the ----------------------
hospitalisation charges, doctors' fee, buy life saving drugs (maybe foreign
----------------------
makes that are very expensive). Similarly, a fitness freak will not be able
to postpone his demand for any of the products that he consumes daily for ----------------------
his overall fitness, stopping which he will tend to go out of shape and thus
out of job (maybe) like, soya milk, protein biscuits, protein shakes, dates, ----------------------
wheat or corn flakes, musli etc.
----------------------
4.6 PRACTICAL SIGNIFICANCE OF THE CONCEPT OF ----------------------

ELASTICITY OF DEMAND ----------------------
The concept of elasticity of demand has a wide range of practical ----------------------
application in economics and business.
1. Its importance to the Businessman ----------------------
The elasticity of demand for the product he produces is the prime concern ----------------------
of every producer. It guides him in determining the price policy for his
product. He finds that it will be profitable to raise prices, provided the ----------------------
demand is inelastic. In the case of products having a highly elastic demand, ----------------------
it is better to lower their prices so that, with a little marginal profit, their
sales will be more, hence their total revenues, and thus the total profit will ----------------------
be large. For instance a firm comes up a new brand of product and thus
starts off with an introductory offer. This is to see the market demand ----------------------
behavior for the new product. Analysing the response that the firm gets,
----------------------
it will decide in which areas and how much to increase the price. Once
the product sets in the market, the firm can hike the price where demand ----------------------
is relatively inelastic and not increase much, where demand is relatively
elastic. This situation is like the one of a monopolist where he resorts to ----------------------
price discrimination i.e. charging different price to the same product to
different consumers, depending on their demand for the same. ----------------------
Notes 2. Importance to Government
In determining fiscal policy, the concept of elasticity of demand is very
----------------------
important to the government. The Finance Minister has to consider
---------------------- the elasticity of demand while selecting commodities for taxation. Tax
imposition on commodities for getting a substantial revenue becomes
---------------------- worthwhile only if taxed goods have an inelastic demand. Otherwise, if
their demand is more elastic, then it will contract very much with a rise
----------------------
in price as a result of added taxation (like sales tax or excise duty), hence
---------------------- the total revenue yield would not be much different from the earlier one.
That is, there will not be any significant rise in revenue. That is why,
---------------------- generally taxes are levied on commodities like petrol, cigarettes, alcohol,
steel, white goods like refrigerators, washing machines etc. which have
----------------------
an inelastic demand.
---------------------- The government also keeps hiking the price of petroleum gas (LPG), the
demand of which is inelastic to most consumers. No matter how much the
----------------------
price hike, after the initial public outcry, the consumers finally succumb
---------------------- to the government price hike. Well, can they do anything more!
3. Its Importance to the Trade Unionists
----------------------
The concept of price-elasticity is useful to trade union leaders in wage
---------------------- bargaining. Wage is the price for labour. Higher the wage-rate, naturally
---------------------- better the money income (wages) for the labourers and thus better living
standards for them. The work of the union leader is to facilitate higher
---------------------- wages and fairer standards of living. The union leader, when he finds that
demand for their industry's product is fairly elastic, will ask for a high wage
---------------------- for workers and suggest the producer to cut the price and increase sales
---------------------- which will compensate for his loss in total profit. For example, let's say
demand for a soft drink increases because of a super-sports-star endorsing
---------------------- it. So will the demand for plastic bottles increase. The trade union leader
will thus demand for higher wage-rate because of the labourers involved
---------------------- in the manufacture of plastic bottles.
---------------------- 4. Its importance to Economists
---------------------- The concept is highly useful to the economists in understanding and solving
many problems. For instance, the concept is useful in solving the mystery as
---------------------- to how farmers may remain poor despite a bumper crop. Since agricultural
products, particularly foodgrains, have an inelastic demand, when there
---------------------- is a bumper crop it can be sold only by cutting down prices substantially.
---------------------- This is because of lack ofgood storage facilities, perishability natutre of the
product and thus the farmers have to sell off the goods within a short time, for
---------------------- example, we see large amounts of water melons, oranges, sweet limes being
sold on the streets at low prises, since they want to sell the fruits at whatever
---------------------- prices before they get very stale.Hence, the total income of farmers will be
---------------------- lower inspite of a bigger crop. Thus, for policy-makers, it implies that higher
farm incomes depend, among other things, upon restriction of the supply of
---------------------- foodgrains and other farm products.
5. Its importance in International Trade Notes
If demand for Indian goods in foreign countries is inelastic, India can
----------------------
raise the price of its commodities substantially and still export the same
quantity at a higher price, thus, getting larger amount of money and higher ----------------------
profit from their exports. For example, goods like Indian handicrafts,
certain fruits like mangoes, strawberries, high quality food grains and ----------------------
rice, leather goods, cotton-khadi or silk textiles find a huge export market.
----------------------
Thus, during 1950's when demand for Indian jute manufactures in foreign
countries was highly inelastic, realising this fact Government of India ----------------------
raised the price of jute manufacturers by practically trebling export duty
----------------------
on these goods forcing foreign importers to pay nearly three times the
price as compared to old price and yet selling same quantity as before, ----------------------
thus getting higher amount of profit by exporting the same amount of jute
manufactures as before. ----------------------
Similarly, during 1970's, petroleum oil-exporting countries formed OPEC, ----------------------
a monopolistic organisation of oil-exporting countries and raised the price
of crude oil from 3 dollars per barrel to nearly 30 dollars per barrel and ----------------------
still could export the same quantity as before, thus making enormously
----------------------
larger profits than before. This made the Middle East oil-producing Arab
countries very rich as petroleum has as yet no substitute. For example, ----------------------
India's oil bill rose nearly ten times though importing the same quantity as
before from the Middle East. All this could happen because of the highly ----------------------
inelastic demand for crude oil produced in the Middle East countries
----------------------
which are the main supplier of crude oil to the world.
Thus, in international trading transactions, trading nations make an effort ----------------------
to know the degree of elasticity of demand for their goods in foreign ----------------------
countries with a view to fix prices of export goods at a level that would
give exporting countries maximum profit. ----------------------
----------------------
----------------------
----------------------
1. In general, the demand for luxuries and comforts is relatively elastic
and of necessities relatively inelastic. ----------------------
2. When there exists a close substitute in the relevant price range, its ----------------------
demand will tend to be inelastic.
----------------------
3. In the short period, demand in general will be more elastic, while in
the long period it becomes less elastic. ----------------------
4. While deciding taxation on commodities, the Finance Minister has to ----------------------
consider the elasticity of demand.
----------------------
----------------------
Notes
Activity 3
----------------------
---------------------- 1. Just think of the product mangoes. It a) is perishable commodity,

b) has no substitute, c ) has high demand in the domestic/foreign
---------------------- market.
---------------------- What can you say about its demand elasticity in each of the above
aspects?
----------------------
2. There is a travel agency “Happy Travel”. It has two branches in two
---------------------- different cities − one in a metro, the other in a small city. To increase
its profit when it comes to increasing its charges, what will it do in
---------------------- each of the following aspects and why?
---------------------- a) Ticket rates
---------------------- b) Travel destinations

c) Office environment (décor, use of machines, etc)
----------------------
d) Employees
----------------------
---------------------- 4.7 INCOME ELASTICITY OF DEMAND:

---------------------- MEASUREMENT, TYPES AND USES OF THE CONCEPT
---------------------- As indicated in the beginning, we can now switch over to another

determinant of demand viz. income and consider elasticity of demand by
---------------------- holding all other determinants, including price, constant. Income elasticity of
demand for a product shows the extent to which a consumer's demand for that
---------------------- product changes consequent upon a change in his income. Income elasticity
---------------------- of demand can be defined as the ratio of proportionate change in the quantity
demanded of the commodity to a given proportionate change in income of the
---------------------- consumer.
---------------------- (A) Measurement of Income Elasticity
The formula for measuring income elasticity of demand can be stated
----------------------
thus:
----------------------
Proportionate change in quantity demanded
Formula 1 : Ey =
---------------------- Proportionate change in consumer’s income
---------------------- Example : A 20% rise in income causes a 30% increase in demand for a
product ‘X’, what will be the income elasticity of demand for ‘X’ ?
----------------------
Solution : According to formula mentioned above :
----------------------
30
---------------------- Ey = = 1.5
20
----------------------
Formula 2 Notes
A second formula which is mathematically more rational is suggested as
----------------------
under :
Q2 – Q1 Y2 – Y1 ----------------------
Ey = ÷
Q2 + Q1 Y2 + Y1 ----------------------
In this formula Q1, is the initial consumer expenditure on any commodity ----------------------
‘X’ (which represents the demand for the product ‘X’) and Q2 is the new
----------------------
expenditure on the same commodity after a change in income. Y1 denotes
initial income and Y2 stands for changed or new income. ----------------------
Example : A consumer spends Rs. 60/- per month on sugar when his
----------------------
income is Rs. 1,500/- per month. When his income increases to Rs.1,800/-
per month he spends Rs. 84 on sugar. What will be the income elasticity ----------------------
of demand for sugar in this case?
----------------------
Solution : According to the above formula
----------------------
84 – 60 1800 – 1500
Ey = ÷
84 + 60 1800 + 1500 ----------------------

----------------------
24 300
= ÷
144 3300 ----------------------
----------------------
24 3300
= x ----------------------
144 300
----------------------
1 11
= x ----------------------
6 1
----------------------
11
= = 1.8 ----------------------
6
\ Ey = >1 ----------------------
(Income elasticity of demand in this case is 1.8 \ positive) ----------------------
B) Types of Income Elasticity of Demand ----------------------
According to the value of income elasticity of demand, we can classify
----------------------
income-elasticity into the following types :
1. Negative Income Elasticity : When the demand for a product ----------------------
decreases as income increases and conversely where demand for a
----------------------
product increases as there is fall in income, the income elasticity of
demand is negative. The demand for inferior goods is of this type. ----------------------
Remember the Giffen Goods Paradox!
----------------------
Notes For instance, a man with low income will take his children to lowly
eating-joints, but with a rise in his income, he will now want to take
---------------------- children to better eating places, put them in better schools, so that
they can interact with children of their new risen stature.
----------------------
2. Zero Income Elasticity : When a change in income has no effect
---------------------- upon the quantity demanded of a product, the income elasticity of
demand would be zero. Demand for salt is an example of this type.
----------------------
A millionaire takes salt in his food just as the poorest of the poor
---------------------- does.
3. Unit Income Elasticity : Income elasticity of demand will be equal
----------------------
to unity (i.e.1) when demand for the product increases in the same
---------------------- proportion in which income increases. Unit elasticity of demand is
considered to be a dividing line between necessaries and comforts.
---------------------- In other words, the income elasticity of demand for necessaries will
be less than unity : while the income elasticity of the demand for
----------------------
comforts will be more than unity. Both these cases are noted below.
---------------------- 4. Low Income Elasticity of demand : When the income elasticity of
demand for a product is positive i.e. greater than zero, but less than
----------------------
one, we say that the income elasticity of that demand is relatively
---------------------- less. Such a variety of relatively less income elasticity or income-
elasticity of demand suggests that the commodity concerned must
---------------------- be necessary. This is because as income increases the percentage of
income spent on necessaries goes on diminishing, according to the
----------------------
Engel's Law of family expenditure.
---------------------- Let's say, a person earning Rs. 2,500 per month spends Rs. 250 on
---------------------- the monthly dal and rice for the household is spending 10% of his
income on the same. With an income raise to Rs. 4,500 (after a few
---------------------- months), the expenditure on the above items now holds only 5.5%
of the total income. This shows a fall in the proportion of his income
---------------------- on necessary goods. In fact the expenditure on such necessary items
---------------------- may go still lower than Rs. 250, because this gentleman may take
to consuming bread and eggs sometimes, from which he must have
---------------------- completely stood away.
---------------------- 5. High Income Elasticity : As opposed to the above category, we

get high income elasticity of demand for products which satisfy
---------------------- the consumers' comforts and luxuries. In other words, the income
elasticity of demand for articles of comforts and luxuries is greater
---------------------- than unity.
---------------------- The income elasticity for different products differs widely. Income -
elasticity of demand tends to be very high in respect of luxury articles
---------------------- like gold (see the example given below), jewellery, precious stones,
---------------------- paintings, cars etc. As against this, income elasticity of demand is
very low in respect of commodities like salt, vanaspati, matches,
---------------------- kerosene, washing soap etc. Besides the type of a commodity i.e.
whether it is a necessary or comfort or luxury, the proportion of a Notes
consumer's income spent on the commodity is also a major factor
influencing income elasticity of demand. ----------------------
For example, in India, even today every parent saves for a ----------------------
daughter's wedding. An Indian wedding is quite incomplete without
the purchase of gold; large or small purchase depending on the ----------------------
income of the family. A rich wedding with a total expenditure of
----------------------
whopping 10 lakhs, spending Rs. 2,00,000 will mean 20% of the
total expenditure on gold, but for a family with a total expenditure ----------------------
of Rs. 1 lakh, the expenditure on gold will be in some thousands.
The latter will be highly affected by a gold price rise and will result ----------------------
in falling proportion of gold in the total expense. But it will not be
----------------------
so with the former.
C) Uses of the Concept of Income Elasticity of Demand ----------------------
The concept of income elasticity of demand is useful in many areas of ----------------------
economic policy formulations as well as analyses of various situations.
----------------------
1) Economic Development : In case of economic development, when
national income is increasing, we can find out how much will be ----------------------
the increase in the demand for a given product, by considering the
income elasticity of demand for that product. If an economy is on a ----------------------
road to progress, with the incomes generally rising, if a commodity's ----------------------
demand is income-elastic, then with the economy prospering the
aggregate demand for this product is bound to show an increase. ----------------------
This means that it is boom-time for the firm manufacturing this
commodity. For example, the advent of foreign brands in the Indian ----------------------
market is a sign of economic maturity. It shows that the demand for ----------------------
these goods is highly income-elastic. A firm is in the manufacture of
shoes. With incomes rising, consumers now demand for imported ----------------------
brands as well. With the doors of the economy opening up, the firm
is smart to get into collaborations and thus introduce the brands for ----------------------
the domestic consumers. One has to act with the changing times! ----------------------
2) Economic Fluctuations : Economic fluctuations are the
characteristic features of a capitalistic economy. Phases of prosperity ----------------------
and depression alternate in such an economy. The concept of income ----------------------
elasticity can be a very useful guide in finding out what products
would be demanded during the phase of prosperity. Similarly, ----------------------
during the phase of depression, certain necessaries will continue
to be demanded. As noted above, necessaries are commodities ----------------------
with very low income elasticities. For instance, a new entrepreneur ----------------------
decides to act safe, beginning to manufacture low cost hand-bags
which will find a small, but a definite market, covering his cost of ----------------------
production with a reasonable profit, rather than going in for high-
end material for the same. He fears that that the latter may find no ----------------------
market, in case of depressionary factors in the economy. ----------------------
Notes 3) Economic Planning : The concept of income elasticity of demand
is of great help to the planners who are planning for the economy as a
---------------------- whole. When economic development is being planned, the planners
have to set targets of production in terms of physical quantities for
---------------------- various sectors of the economy. With the help of income elasticity,
---------------------- the planners can estimate the possible increase in demand for the
product as a result of the targeted rate of growth of the economy.
---------------------- This would make the physical targets more realistic and would serve
to maintain physical balances - a difficult task for the planners.
----------------------
4) Demand Forecasting : Firms are required to forecast the demand
---------------------- for their product. With the help of statistical information regarding
trends in growth of income as well as changes of distribution of
----------------------
income, the firm can forecast the demand for its product by using
---------------------- income elasticity of demand for that product as a guide. More about
this in detail is given in the next unit.
----------------------
5) Foreign Trade : In the area of foreign trade, a country needs to take
---------------------- into account the income elasticity of demand for its imports as well
as exports. A country exporting agricultural products and articles of
---------------------- necessity faces an income-elastic demand, compared to a country
which is exporting articles of luxury. This difference influences
----------------------
terms of trade. Income elasticity of demand serves as a guide in the
---------------------- matter of balance of payments disequilibrium also. For example,
India has been an exporter of jute, tea, coffee and spices; but the
---------------------- demand for all these commodities is income-inelastic. The rate of
growth of India's exports therefore has remained relatively low. As
----------------------
against this, India's demand for imports like electronics, machinery,
---------------------- consumer durable etc. is income-elastic. Consequently, the rate of
growth of India's imports has remained high. Thus, we have been
---------------------- facing the problem of an increasing trade deficit in India during the
last few years.
----------------------
The list of areas where income elasticity of demand is useful can be
---------------------- increased further by mentioning public finance, labour policy, industrial
policy etc. where the concept is useful.
----------------------
---------------------- 4.8 CROSS ELASTICITY OF DEMAND: CONCEPT,
----------------------
MEASUREMENT AND ITS USES
---------------------- A) Concept
In practice, commodities are seldom independent of one another. Among
---------------------- the wide range of products that we see at the market, we find that most
---------------------- of these goods are related. On the basis of the relationship, we can group
these products either as substitutes or as complements or as a third group
---------------------- of goods which are neutral. In the context of the relationship between
goods, the concept of cross elasticity of demand can be used. Cross
----------------------
elasticity of demand may be defined as the ratio of proportionate change Notes
of quantity demanded of commodity 'X' to a given proportionate change
in price of the related commodity 'Y'. With the help of formula, similar to ----------------------
the one we noted earlier, we can say :
----------------------
Percentage change in quantity demanded of 'X'
Ec = ----------------------
Percentage change in the price of ‘Y’
----------------------
If we assume the two commodities X and Y are substitutes of each other
and that the price of Y rises but that of X remains constant, the quantity ----------------------
demanded of X will increase because the consumers will substitute X for
Y, since Y has become costlier. Conversely, if the price of Y falls leaving ----------------------
the price of X unchanged, the quantity demanded of x will decrease ----------------------
because the consumers will now substitute Y for X since Y has become
cheaper than before. ----------------------
B) Measurement ----------------------
Cross elasticity can also be measured by another formula as given below
----------------------
QX2 – QX1 PY2 – PY1
Ec = ÷ ----------------------
QX2 + QX1 PY2 + PY1
----------------------
In this formula QX2 is the new demand for X, QX1 is the original demand
for X; PY2 is the new price of Y and PY1 is the original price of Y. ----------------------
If X and Y are perfect substitute for each other, the cross elasticity of demand ----------------------
will be infinity. It means that the slightest rise in the price of Y will cause an
almost infinite rise in the demand for X and the slightest fall in the price of Y ----------------------
will reduce the demand for X to almost zero. If, on the other hand, two goods
are not substitutes at all, the cross elasticity of demand will be zero. A change ----------------------
in the price of one commodity will not affect the quantity demanded of the
----------------------
other commodity. It will thus be clear that the cross elasticity of demand for
substitutes varies between zero and infinity. ----------------------
If the relationship between X and Y is that of complementary, the cross
----------------------
elasticity in such a case will be negative. A rise in the price of Y will mean
not only a decrease in the quantity demanded of Y but also a decrease in ----------------------
the quantity demanded of X because both are demanded together. For
example, ball-point pens and refills are complementary goods. When the ----------------------
price of refills rises, it causes a fall in the demand for refills as well as for
ball-point pens, because both are demanded together. ----------------------
Commodities X and Y will be the perfect substitutes only when they are ----------------------
totally identical. In that case, they will not be two different commodities
at all. Therefore, in practice, infinite cross elasticity of demand cannot ----------------------
be found. In practice, the cross elasticity of demand can thus be positive, ----------------------
zero or negative. The cross elasticity is positive when X and Y are good
substitutes (and almost infinity when X and Y are perfect substitutes). It ----------------------
is zero when X and Y are not related to each other or do not possess any
substitutability : they are independent of each other. It is negative when ----------------------
Notes X and Y are complimentary goods. In the first case, a rise in the price of
Y (price of X remaining constant) will cause an increase in the quantity
---------------------- demanded of X. In the second case, a rise or fall in the price of Y (price
of X remaining unchanged) does not affect the quantity demanded of X
---------------------- at all. In the third case, a rise in the price of Y (the price of X remaining
unchanged) will cause a decrease in the quantity demanded of X.
----------------------
Example : Because the price of Y increases from Rs.10 to Rs.12 per kg.,
---------------------- the sale of a firm's product commodity X rises to 220 kg. from 200 kg.
per week. Find out the cross elasticity and state the relationship between
----------------------
commodities X and Y.
----------------------
QX2 – QX1 PY2 – PY1
Solution : Ec = ÷
---------------------- QX2 + QX1 PY2 + PY1
---------------------- 220 – 200 12 – 10
= ÷
---------------------- 220 + 200 12 + 10
---------------------- 220 – 200 12 + 10
= X
---------------------- 220 + 200 12 – 10
---------------------- 20 22
Solution: Ec = X
---------------------- 420 2
---------------------- 11
\ Ec = = 0.523
---------------------- 21
The cross elasticity of demand is positive and X and Y are substitutes.
----------------------
Considering the same example as above, if the sale of Commodity X
---------------------- falls from 220 kg. to 200 kg. per week with the same rise in price of
Commodity Y, then the Cross elasticity is negative, (-0.523) in which case
----------------------
the 2 goods are complements of each other.
---------------------- C) Uses of Cross Elasticity of Demand
---------------------- Perfect substitutes are seldom found in practice. Perfect complementarity
is equally rare. But, broadly speaking, there is complimentarity or
---------------------- competition i.e. substitutability among several commodities. Under such
circumstances, the entrepreneur can judge the effect of his pricing policy
---------------------- on the quantities demanded of the products of others and vise versa on the
---------------------- basis of the cross elasticity of demand.
For instance, a firm in the manufacture of cosmetic products, now
---------------------- decides to increase its range of products. These products now have heavy
---------------------- competition in the market. With increasing awareness, consumers now
want value for money; they will not just buy anything and everything
---------------------- at given prices. Thus, the firm has to do a good analysis of the cross
elasticities of the different products and brands available in the market
---------------------- and only then start off with the extension programmmes.
Notes
----------------------
1. Income elasticity of demand is defined as the _________ of
----------------------
proportionate change in the quantity demanded of a commodity to a
given proportionate change in the _________ of the consumer. ----------------------
2. The income elasticity of demand is measured as: Ey =
----------------------
_________/__________
3. When change in the income has no effect upon the quantity demanded ----------------------
of a product, the income elasticity of demand would be ________. ----------------------
4. Cross elasticity of demand is calculated as:
----------------------
Ec = _____________/____________
----------------------
Activity 4 ----------------------
----------------------
1. There are three income bracket people, very poor, middle class and
elite class. Following is the list of items. In one particular month, ----------------------
the prices of each of them rise. Can you state how each class will ----------------------
react? Give reasons for your answer.
----------------------
a) Potatoes
b) Diamonds ----------------------
c) Cotton
d) Paper ----------------------
e) Wheat
----------------------
2. Calculate the cross-elasticity of the product in the following cases
and determine whether the products are complements or substitutes ----------------------
of each other.
----------------------
Instances Price of X Quantity demanded of Y
----------------------
01 10 100
20 200 ----------------------
02 15 150
----------------------
10 150
03 8 100 ----------------------
20 0 ----------------------
04 20 100
15 50 ----------------------
----------------------
----------------------
Notes Summary
---------------------- ●● Demand elasticity is anlysed under 3 heads : (1) Price elasticity of demand,
(2) Income-elasticity of demand and (3) Cross-price elasticity of demand
----------------------
or just cross elasticity.
---------------------- ●● Negative income elasticity is at the base of the Giffen goods paradox.
---------------------- ●● Elasticity is a powerful tool at the hands of the decision makers in the
market and thus helps the policy makers in striking the right chord
---------------------- between production and consumption.
----------------------
Keywords
----------------------
●● Cross elasticity : Refers to the responsiveness of demand for a commodity
---------------------- to a given change in the price of a related commodity - substitute or
complementary.
----------------------
●● Income elasticity : It refers to the degree of responsiveness of demand
---------------------- for a commodity to a given change in the income of the consumer
---------------------- ●● Price elasticity : Degree of responsiveness of demand for a commodity
to a given change in its price
---------------------- ●● Perfectly inelastic : When the demand doesn’t’ change at all, irrespective
---------------------- of the demand change in price.
●● Perfectly elastic : When the demand goes down to zero with the slightest
---------------------- price demand change
---------------------- ●● Practical significance : Its usefulness to people belonging to different
streams, who of the concept affect the national output.
----------------------
●● Total outlay or total : It is total quantity demanded (of the product)
---------------------- multiplied by revenue price per unit of the product.
●● Unitary elastic demand : Change in demand is proportional to the
----------------------
change in price
----------------------
----------------------
---------------------- 1. Explain the different concepts of elasticity of demand each with a

numerical as well as a product example.
---------------------- 2. What are the different methods of measuring elasticity? Enumerate with
---------------------- a numerical example and show a diagram highlighting the same.
3. What are the factors affecting price elasticity of demand?
----------------------
4. Mr. Agarwal is a very successful business man today and has to maintain
---------------------- that position. The country's Union Finance Minster shoulders a big
responsibility towards the country's economic progress. The Foreign
----------------------
Minister must increase the country's exports in the coming financial year.
---------------------- Reason how the concept of elasticity can help each of the above.
5. Write short notes on : Notes
a. Types of Income elasticity
----------------------
b. Cross elasticity of demand
----------------------
c. Income elasticity of demand
d. Uses of the concept of cross elasticity ----------------------
e. Uses of the concept of income elasticity ----------------------
----------------------
----------------------
1. The extent of variation in demand is technically expressed as elasticity of ----------------------

demand.
----------------------
2. The types of elasticity of demand are price elasticity, income elasticity
and cross-price elasticity. ----------------------
3. Price elasticity of demand is measured as e = % change in the quantity ----------------------
demanded/ percentage change in price.
----------------------
i. – c. ----------------------
ii. – d. ----------------------
iii. – e.
----------------------
iv. – b.
----------------------
v. – a.
1. False ----------------------
2. True ----------------------
3. True
----------------------
----------------------
1. True ----------------------
2. False ----------------------
3. False ----------------------
4. True
----------------------
----------------------
Notes Check your Progress 4
Fill in the blanks.
----------------------
1. Income elasticity of demand is defined as the ratio of proportionate change
---------------------- in the quantity demanded of a commodity to a given proportionate change
in the income of the consumer.
----------------------
2. The income elasticity of demand is measured as: Ey = Proportionate
---------------------- change in the quantity demanded/Proportionate change in the consumer’s
income
----------------------
3. When change in the income has no effect upon the quantity demanded of
---------------------- a product , the income elasticity of demand would be zero.
---------------------- 4. Cross elasticity of demand is calculated as:
---------------------- Ec = Percentage change in the quantity demanded of “x”/Percentage

change in the price of “y”
----------------------
---------------------- Suggested Reading
---------------------- 1. Lipsey, Richard. 1995. An Introduction to Positive Economics. Oxford
University Press.
----------------------
2. Varshney, R.L., and K.L. Maheswari. 2011. Managerial Economics. New
---------------------- Delhi: Sultan Chand.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Demand Forecasting
UNIT
5
Structure:
5.1 Meaning and Importance

5.2 Necessity of Forecasting Demand
5.3 Factors Influencing Demand Forecasts
5.4 Techniques or Methods of Forecasting Demand
5.5 Criteria for a Good Demand Forecast
Summary
Key Words
Suggested Reading
Demand Forecasting 99
Notes
Objectives
----------------------
----------------------
• Define demand forecasting
----------------------
• List various objectives of demand forecasting
---------------------- • Indicate the factors influencing it
---------------------- • Identify the wide range of demand forecasting methods, separately
for established and new products
----------------------
• Assess the criteria for a good forecast
----------------------
---------------------- 5.1 MEANING AND IMPORTANCE
---------------------- A forecast is a guess or anticipation or a prediction about any event which

is likely to happen in the future. Forecasts are made either through experience
---------------------- or through statistical methods. As individual may forecast his job prospects,
a consumer may forecast an increase in his income and therefore purchases,
----------------------
similarly a firm may forecast the sales of its product.
---------------------- Predictions of future demand for a firm’s product or products are called
demand forecasts.
----------------------
Demand Forecasting is the method of predicting the future demand of a firm’s
---------------------- product.
----------------------
5.2 NECESSITY OF FORECASTING DEMAND
----------------------
As mentioned above, demand forecasts may be based on judgment of the
---------------------- experienced staff of a business concern or on scientific analysis (with the help
of statistics).
----------------------
When a firm is small in size it may not need or afford an organised
---------------------- forecasting system. They can base their forecasts on the judgment or foresight
of their experienced staff. However, as a firm increases in size and produces
----------------------
a number of products and uses modern techniques of production, it becomes
---------------------- necessary for the firm to forecast the demand for its various products, in a more
scientific manner. Such forecasts are more accurate and thus help the firm to
---------------------- produce efficiently, with the help of the available resources. Forecasts have
become a part of business management of most of the firms.
----------------------
Forecasts are necessary for
----------------------
(1) Fulfilment of objective of the Plans
---------------------- Every business unit, industry or the government starts with certain pre-
---------------------- decided objectives. These objectives can be fulfilled with the help of
accurate demand forecasts.
----------------------

For instance, if a firm decides to start a ‘24/7 Cafeteria’ for its employees Notes
in future and it obviously wants to win the best bet, then from now on
it will start working towards the same. The firm can, through its own ----------------------
product marketing, start targeting those firms, from which it can secure
the required contenders for the Cafeteria. ----------------------
(2) Preparation of a Budget ----------------------

Scientific forecasts are useful to the entrepreneur to take business decision. ----------------------
Every business unit has to prepare a budget. A budget includes the cost
and expected revenues. Expected revenues can be estimated only on the ----------------------
basis of demand forecasts.
----------------------
For instance, in a developing part of a city, there are huge complexes
coming up. There are big construction houses vying for the same. This ----------------------
means there is boom-time for the cement industry. Thus, a firm into the
----------------------
manufacture of cement has to bear in mind the increased required supply
for the current year in laying down the budget for the current financial ----------------------
year.
----------------------
(3) Stabilisation of Employment and Production
Demand for a product changes according to seasons or business cycles or ----------------------
tastes etc.; the supply, however, cannot be changed suddenly. If however, ----------------------
it is possible to estimate the demand for a firm’s product, it can be possible
to produce according to the expected demand. This can avoid wastage ----------------------
of scarce resources of the firm. So also the employment policy can be
decided in advance, with the help of these forecasts. ----------------------
In view of the above example, the demand for bricks is also expected to ----------------------
increase. So the brick-manufacturers will employ more labour to meet the
increased demand. Now in the process of manufacture of bricks, when ----------------------
they are semi-set and with a heavy downpour of rains, it is possible that ----------------------
it may damage the quality of the bricks, which can affect its supply in the
market. Even after resetting the bricks, it is possible that the bricks may ----------------------
not get the original strength, which they may have otherwise got without
the downpour. Thus, with forecasting for the product demand, at times it ----------------------
becomes imperative to forecast the weather as well! ----------------------
(4) Expansion of firms
----------------------
When a firm has to decide whether it should expand or not and to what
extent it should expand, it has to consider the expected demand for its ----------------------
product, at a future date. Demand forecasts become useful in such cases.
----------------------
For instance, opening a new branch is on the agenda of a particular
coaching class for Std.X– MATHS. It has decided to do so in one area of ----------------------
the city which has so far been untapped. But before stepping into such an ----------------------
expansion, the firm should bear in mind the influx of students expected
at the new place. One factor can help the decision amongst others i.e. in ----------------------
past years, the firm should analyse that how many students were denied
admission because of lack of space. ----------------------

Notes (5) Other Uses
Demand forecasts are also useful to a firm, for long-term investment
----------------------
decision, Budgeting policies and Warehouse and Inventory Control.
---------------------- Inventory Control depends on the nature of the commodity, the degree of
perishability of the commodity. The decision regarding the manufacture
----------------------
of a good and its storage depends on the life span of the product. If very
---------------------- less, then the firm cannot accrue the benefits of large-scale production at
one time, in which case the decisions regarding the demand, supply of
---------------------- the product and investment will differ from the ones producing durable
goods.
----------------------
---------------------- 5.3 FACTORS INFLUENCING DEMAND FORECASTS

---------------------- A number of factors affect the demand forecasts. Each of these factors has
to be studied together with the other factors while forecasting demand. Thus,
----------------------
these factors outline the scope of demand forecasting.
---------------------- 1) Time-Period
---------------------- Forecasts can be for a short-period, long period or very long (secular)
period.
----------------------
a) Short-period
---------------------- These forecasts are for a period of one year and are based on the
---------------------- judgment of experienced staff of the firm. Within this short period
the sales promotion policies of the firm or the tax-policies of the
---------------------- government do not change. Short period forecasts are important
for deciding the production policy, price policy, credit policy and
---------------------- marketing and distribution of the firm’s product.
---------------------- In case of a completely labour-intensive product like hand-made
carpets, it is easy to cut or stop the production depending on the
---------------------- demand forecasts. Hire less labour or work lesser number of hours
---------------------- per day could be the hour of the day. Also, for small firms it is easier
to take small and short-term loans, which they are to repay in the
---------------------- near future. The demand forecasts will give them the strength to
take the right step.
----------------------
b) Long-period forecasts
----------------------
These are forecasts for a period of 5 to 10 years and are based on
---------------------- scientific analysis and statistical methods. Long period forecasts are
important to decide about whether a new factory is to be established,
---------------------- a new product can be introduced, or capital needs are to be raised.
---------------------- The example given in Activity A is not the analysis based on a
very short period, but at least 8-10 years, where business might
---------------------- have picked up. The trend is changing. People wear not just straight
sweaters, but also woollen jackets (open, closed, with or without
----------------------

caps) just tops that go on jeans (with or without sleeves and so with Notes
or without zips) are the different range of goods one can think of
(anyway, have you ?). Thus, the factors strengthening the decision ----------------------
to expand are amount of funds required and those which can be
made available; the demand that could be attracted, if all goes fine!! ----------------------
c) Very-long period forecasts ----------------------

These are for a period of over 10 years. Secular factors like growth ----------------------
of population, development of the economy, the political situation
in the country, the changes in the international trade, sociological ----------------------
factors, like age of marriage, changes in traditions, have to be
----------------------
considered for forecasting the demand over a very long period.
For instance, marriages today have become elaborate functions, ----------------------
extending not just for the said day, but probably a whole week.
----------------------
Each day is an event in itself. People toady have the willingness to
spend. They want style and want to exhibit exuberance, especially ----------------------
in a age of single-child or at the most two-child couples. Thus, this
has brought out a new age of Event Management firms who take ----------------------
the whole marriage event ranging for whatever number of days,
----------------------
the parents wish to. There are themes set in for each day. This is a
very changing trend that has been set about in a long period in our ----------------------
country, especially that relates to the spending will of the Indian
people. Event Management firms were unheard of till a few years ----------------------
back and now they take up events right from birthday parties to
----------------------
marriage anniversary parties. They are management schools set up,
that impart training to aspiring students in this field. ----------------------
2) Level of Forecasts ----------------------
Forecasts can be made at the level of the firm or the industry or the nation.
----------------------
a) A firm
----------------------
A firm forecasts the sales of its products. It bases its forecasts on the
forecasts of the industries and the nation. ----------------------
b) An Industry
----------------------
Forecasts at this level are prepared by the trade association. These
are based on statistical data and market survey. These forecasts are ----------------------
available to all the firms of the industry. ----------------------
c) The Nation
----------------------
These forecasts are national level forecasts and are based on indices
such as national income and national expenditure. ----------------------
3) General and Specific Forecasts ----------------------
Forecasts can be of a general type, giving a total picture of the demand
----------------------
for all the products of a firm or demand from all the markets of the firm’s
product. These are not very useful to a firm. Specific demand forecasts give ----------------------

Notes specific information. Product-specific demand forecasts give the forecasts
of each of the products produced by the firm. For example, a company
---------------------- like Johnson & Johnson, is into the manufacture of a whole range of baby
products (baby body oil, hair oil, body creams and lotions, baby powder
---------------------- tearless shampoo, soap, etc.). The demand forecast conducted by a team
---------------------- has to consider this whole range, before it gives any decision-making
feedbacks to the firm.
----------------------
Area, specific demand forecasts give the forecasts each of the markets for
---------------------- the firm’s he markets for the firm’s product. For example, a product like
steel vessels may sell well in a part of the city (old area), where people are
---------------------- accustomed for years to have them in their kitchen. It may not find such a
ready market in another part of the same city that is more cosmopolitan,
----------------------
where people do not want to follow old standards; may purchase stylish
---------------------- glassware instead. Thus, the demand forecasts for the product will vary,
depending on the area it is going to be marketed, resting highly on the
---------------------- likes residing in those areas.
---------------------- 4) Established Products and New Products
Established goods, are goods which are already established in the market;
----------------------
information about these goods is available, the present demand, the
---------------------- number of substitutes to the product, the level of competition, the markets
are known.
----------------------
New products are those which are yet to be introduced in the market,
---------------------- information about these products is not known.
---------------------- Thus depending on whether the product is an established or new product,

different methods are used for forecasting demand.
---------------------- 5) Product-Classification
---------------------- For the purpose of Demand Forecasting products can be classified as:
---------------------- a) Capital goods and Consumer goods
---------------------- b) Durable goods and Perishable goods

c) The demand for capital goods (machinery, spare parts) is a derived
---------------------- demand. It is derived from the demand for the product produced by
---------------------- the capital goods. This demand is highly fluctuating.
The demand for consumer goods depends on the incomes of the
---------------------- consumers. An increase in income leads to an increase in the demand
---------------------- for consumer goods, but a fall in the income does not immediately
lead to a decrease in the demand for consumer goods; (e.g. Sugar,
---------------------- Food grains, Soaps etc.)
---------------------- d) The demand for durable goods can be postponed. Thus, if prices
of these goods increase, then the demand falls, because people will
---------------------- postpone their consumption of these goods (e.g. washing machines,
refrigerators, mixers etc.)
----------------------

The demand for perishable goods like vegetables and fruits depends Notes
on the current incomes and current demand.
----------------------
Thus, depending on the type of product, demand forecasts and
methods of forecasting demand will be different. ----------------------
6) Other Factors
----------------------
The level of uncertainty, the nature of competition, the number of
substitutes to a product, the elasticities of demand for the product are ----------------------
important factors which have to be considered while forecasting the
----------------------
demand for a product.
These factors depend on the type of product, on the market for the product ----------------------
and on the time-period. ----------------------
Thus, tastes and preferences and fashion have to be considered while
forecasting demand for readymade garments. Weather forecasts are ----------------------
important for the firms producing raincoats, rainy-shoes and umbrellas. ----------------------
The above can be clearer by studying the chart given below:
----------------------
The factors influencing Demand Forecasting ----------------------
Time Period Types of Forecasts Types of Goods
----------------------
----------------------
----------------------
Short Long Very General Specific Capital Consumer
Period Period Long (Product- goods Goods ----------------------
Period specific (derived (direct
----------------------
& Area- demand) demand)
specific) ----------------------
Durable Perishable ----------------------
Goods Goods
----------------------
1. Prediction of future demand for a firm’s product/products is called ----------------------

_____________.
----------------------
2. Level forecasts can be made for a ____________, an industry and
the ___________. ----------------------
3. The main factors that influence demand forecasting are ________, ----------------------
types of __________, and types of ____________.
----------------------
----------------------

Notes
Activity 1
----------------------
There is an old shop by the name “Citizen’s Weavers” in one remote corner
----------------------
in a lane of a shopping area. Five school friends who are now ageing run it.
---------------------- They are into hand-knit sweaters alone. Just by the word of mouth, they are
getting new clientele this season, which in turn have encouraged opening a
---------------------- new and bigger shop on the main line shopping area. This will bring them in
direct competition with the already established ones; but as friends say, their
----------------------
products are more customer-friendly, economical and trendy. Help these
---------------------- women entrepreneurs. Prepare a list of objectives. How can they increase
their labour power is something to think of and extend help in giving them
---------------------- the line of action.
----------------------
5.4 TECHNIQUES OR METHODS OF FORECASTING
---------------------- DEMAND
----------------------
The methods of forecasting demand depend upon whether the product is
---------------------- an established good or a new good, and on the level of forecasts, i.e. macro or
micro-level.
----------------------
Macro-level forecasts are used in national economic planning. These
---------------------- are forecasts about general business conditions, and these forecasts make use
of information regarding the macro-variables, like government expenditure,
---------------------- savings, the aggregate demand etc.
---------------------- Micro level forecasts are at the level of the firm or industry. Micro level
forecasts make use of macro-level information. We are concerned with these
---------------------- types of forecasts.
---------------------- As mentioned above, the methods of forecasting demand for established
goods and for new goods are different. We shall first study the methods of
---------------------- forecasting the demand for established goods and then for new goods.
---------------------- (A) Methods of Forecasting Demand for Established Goods
---------------------- Information about established goods is available and so forecasts can be
based on this information.
----------------------
There are two basic methods of forecasting the demand for established
---------------------- goods
---------------------- 1) Interview and Survey Approach (short period forecasts)

2) Projection Approach (long period forecasts)
----------------------
(I) Interview and Survey Approach : (for Short Period Forecasts)
----------------------
To anticipate the expected sales of a commodity, it is necessary to
---------------------- collect the information regarding the expected expenditures of the
consumers.
----------------------

The interview and survey approach, tries to collect this information, Notes
in different ways, and forecasts are based on this information.
Depending on how this information is collected, we have different ----------------------
sub-methods of this survey approach.
----------------------
(1) Opinion-Polling Method
----------------------
This method tries to collect information, directly or indirectly, from
the prospective consumers. This is possible through the market ----------------------
research department of the firm or through the wholesalers and
retailers. ----------------------
If consumers cannot be contacted personally or directly, then they ----------------------
are contacted through mail or now-a-days they can be contacted on
‘internet’ and the information regarding their expected expenditure ----------------------
is collected.
----------------------
For instance, newspaper companies like The Times of India, Indian
Express, Loksatta, Sakal, conduct this method in the market, wherein they ----------------------
come in direct contact with the readers via door-to-door campaigns. They ----------------------
try to convince the readers about the strong points of their product and
thus grab orders for the company, for example, a job-seeker is convinced ----------------------
how reading the concerned newspaper can help him fetch the right job,
probably within a month. The policy is to reach out to the readers for ----------------------
enhancing circulation. ----------------------
This method is useful when the product and consumers come into direct
contact or when the number of consumers is small. This method is also ----------------------
useful when the consumer is another firm. ----------------------
Limitations
----------------------
1) Individual consumers are not sure of their purchase plans
----------------------
2) It is difficult and costly to contact all the consumers
3) Useful only in the short period ----------------------
(2) Collective Opinion method ----------------------
Large firms have an organised sales department. The salesmen have ----------------------
technical training about how to collect the information from the
buyers. Many times the production manager sales manager finance ----------------------
managers come together and make use of this information to finalise
the forecasts. ----------------------
These forecasts are based on information which is more certain and ----------------------
thus forecasts based on this information may be more accurate.
----------------------
Limitations
----------------------
1) This method is based on value-judgment and has no scientific basis
2) Useful only in the short period ----------------------
3) It is difficult and costly to contact all the consumers. ----------------------

Notes (3) Sample-Survey Method
The total number of consumers for a firm’s product is called the
----------------------
population. When the number of consumers is very large (size of
---------------------- population is large), it is not possible to contact each and every
consumer. A few consumers are contacted, this forms the sample.
----------------------
Information is collected from the consumers in the sample and
---------------------- forecasts are based on this information. These forecasts are then
generalised for the whole population. This is possible through the
---------------------- advanced statistical methods.
---------------------- For instance, a firm which is already in the manufacture of a range of
products, now wants to add another product in its basket i.e. toothpaste.
---------------------- Now this is a very established product. People have strong loyalty to such
a product that each one of us uses daily. A new toothpaste may not have a
----------------------
very fast acceptance rate. So the firm has to indulge in a good homework
---------------------- of Demand forecasting for the same, in terms of the existing likes, tastes
and preferences of the people; whether gel-based or not, whether a
---------------------- different colour like green or baby pink or flavour such as a new fruit
flavour like water melon or sweet lime or lime would be accepted in the
----------------------
market. These would be the ingredients of the questionnaire.
---------------------- Limitations
---------------------- a) Information collected may not be accurate.
---------------------- b) The sample selected must be a random sample, so that when the
results are generalised for the population, accurate forecasts are
---------------------- made very often, the sample is not a random sample. What is true
for a sample, may not hold true for the whole (population).
----------------------
c) Consumers do not co-operate by giving a correct idea of their
---------------------- expected purchases. Sometimes, the consumers themselves make
unplanned purchases.
----------------------
(4) Panel of Experts
----------------------
Panel of experts consists of either persons from within the firm or
---------------------- from outside. These experts come together and forecast the demand
for the firm’s product. If forecasts are based on judgement of these
---------------------- experts, the forecasts will have no scientific basis, and thus, may be
less accurate.
----------------------
If however, forecasts are made on the basis of statistical information
---------------------- and with the use of scientific methods, the forecasts will be more
---------------------- accurate.
A two-wheeler company - TVS decides to launch a new vehicle
---------------------- in the market, suited to teenagers, for example PEP SCOOTY. The
---------------------- company has to connect with the young generation. To decide the
friendly operation and maintenance of the new bike is one set of
---------------------- experts and to decide about the overall look of the bike that can

buy easy acceptability is another set of experts (which can also lead Notes
into advertising and selecting the right model for the same) and that
regarding the easy-accessibility for loans and easy repayment suited ----------------------
to the pockets of middle-class parents as well is headed by a team
of established bankers. Thus, the final decision making process is ----------------------
guided by the mixed expertise coming from different fields. ----------------------
(5) Composite Management Opinion
----------------------
The opinions of the experienced persons with the firm are collected
and a committee or the general manager of the firm analyses this ----------------------
information and forecasts the demand for the firms product. This
----------------------
method is quick, easy and saves time and cost, but is not based on
scientific analysis and thus may not give very accurate results. ----------------------
For instance, there’s a very established orthopaedic hospital in
----------------------
the city started by a doctor who has now his grandchildren in the
league. For years, his son has headed it, who specialised in the same ----------------------
field. Now one of his dear grandsons has specialised in Dentistry.
Thus, the grandpa-doctor intends to start a new wing to fulfill the ----------------------
ambitions of this particular grandson, much to the wrath of the
----------------------
others in the family.
The chart given below can help you with the classification of the methods ----------------------
Methods for Established Goods Methods for New ----------------------

Goods
----------------------
----------------------
----------------------
Interview & Survey Projection Approach 1. Evolutionary
Method (Short period (Long period analysis) Method ----------------------
analysis) 2. Substitution ----------------------
Method
----------------------
3. Growth Pattern
Method ----------------------
1) Opinion-Polling 1. Correlation
and Regression 4. Opinion Method ----------------------
2) Collective
Opinion Analysis 5. Sample-Survey
Method ----------------------
3) Sample-Survey 2. Time-Series
Analysis 6. Indirect Opinion ----------------------
4) Panel of Experts
Method
5) Composite ----------------------
Management ----------------------
Opinion
----------------------

----------------------

Notes (II) Projection Approach (for long period forecasts)
In this method, the past experience is projected into the future. This can
----------------------
be done with the help of statistical methods.
---------------------- (1) Correlation and Regression Analysis
---------------------- (2) Time Series Analysis
---------------------- In both these methods, past data is collected, a trend is observed then a
functional relationship (correlation) is established between the variables.
---------------------- This is done with the help of Regression. Once a relationship is established,
it is possible to project this into the future.
----------------------
(1) Correlation and Regression Analysis
---------------------- As mentioned above, the past data regarding the factors affecting demand
---------------------- can be collected. It is possible to express this on a graph. This is a scatter
diagram.
----------------------
For example, if we collect the past data about the sales and advertisement
---------------------- expenditure of a firm, it is possible to express this in the form of a scatter
diagram, as shown below :
---------------------- Y
---------------------- A
----------------------
----------------------
Sales
----------------------
A
----------------------
----------------------
O Advertisement Expenditure X
----------------------
---------------------- Now, with the help of Regression techniques, like, the least square method
or the maximum likelihood method (correlation), it is possible to get the
---------------------- best fit, i.e. a best possible functional relationship between the variables.
---------------------- In the above diagram, we get this functional relationship as a straight-line
AA.
----------------------
There are some independent variables (Advertisement expenditure, in
---------------------- our example) and some dependent variables (sales, in our example). The
relationship (cause effect) between these variables is the correlation and
---------------------- the technique of establishing this relationship is regression. If the past
---------------------- correlation is assumed to remain the same in the future, we can use this
relationship to estimate the demand for the future.
----------------------
In simple correlation, we have a relationship between two variables and a
---------------------- relationship between more than two variables is multiple correlation.

For example Simple Correlation Notes
C = f(Y)
----------------------
where C is the consumption (Demand), and Y is the consumers income.
----------------------
Suppose, from past-experience, we have a specific functional relationship
C = a + .8y ----------------------
Then, if we know the changes in Y (income) we can predict or project the ----------------------
changes in consumption, and thus forecast the demand for the product.
----------------------
Limitations
----------------------
a) Assumption made is that the correlation between the two variables
will continue in future also, this might not happen e.g. number ----------------------
of students and the demand for text books, may have a direct
relationship, but when the textbooks change, this relationship no ----------------------
longer holds good in future.
----------------------
b) Correlation does not necessarily mean that there is a cause effect
relationship between the two variables e.g. suppose, in a particular ----------------------
year, the incomes of consumers have increased, and in the same
----------------------
year the demand/sales of cassettes have increased, can we conclude
that there is a direct (positive) correlation between income and ----------------------
demand for cassettes ? Even though it appears that there is a positive
correlation between income and demand for compact disks, it is just ----------------------
chance that in that year both income and demand for compact disks
----------------------
increased. There is no cause-effect relationship and thus forecasts
based on this relationship will not be correct. ----------------------
(2) Time Series Analysis ----------------------
Demand forecasts for a period of more than 2-3 years are based on Time-
Series Analysis. ----------------------
Time-series Analysis is similar to correlation analysis. It is based on the ----------------------

assumption that the relationship between the dependent and independent
variables will continue to hold in the future. ----------------------
(B) Methods of Demand Forecasting for new Products ----------------------

As mentioned above, new goods are goods which are new to the market. ----------------------
The information regarding these new goods is therefore, not available.
However, firms producing these goods find it necessary to estimate the ----------------------
future demand for their product. Thus, indirect methods of forecasting
----------------------
are used to estimate the demand for new products. Joel Dean suggests the
following methods: ----------------------
(1) Evolutionary Method
----------------------
Some new goods evolve from already established goods. The demand
forecasts of such new goods can be based on the information about ----------------------
the already established goods from which it is evolved. Thus, the ----------------------

Notes demand for coloured T.V. could be based on the assumption that, it
has been evolved from black and white T.V., thus the information
---------------------- about black and white T.V. can be used to estimate the demand for
coloured T.V.
----------------------
Similarly, the demand for VCDs, DVDs, LCDs can be estimated on the
---------------------- basis that these products have been evolved from video tapes OR that of
compact discs can be estimated from audio tapes etc.
----------------------
Limitations
----------------------
a) The new products should have been evolved from existing product.
---------------------- b) It ignores the problem of how the new product differs from the
---------------------- established product.
(2) Substitution Method
----------------------
Some new goods are substitutes of already established goods. Since
---------------------- most new goods are substitutes of already established goods, this
method has wide-uses. New L.C.D., T.V. are substitutes of already
---------------------- established Colour and Black and White T.V.
---------------------- The same can be said in case of Mixers and Grinders. Now they
are termed as ‘Food Processors’, which do a lot more functions
----------------------
that the old models such as dough kneading, cutting and chopping
---------------------- vegetables in different shapes and sizes (because of different blades’
operations), esp., chopping potato like ‘French Fries’, suiting to the
---------------------- emerging tastes.
---------------------- Limitations
---------------------- (a) Some new products have many uses and each use has a different
substitutability, forecasting demand of such new goods becomes
---------------------- difficult.
---------------------- (b) When a new substitute is added to the market, the existing firms
react in different ways (changes in price, advertisement etc.)
---------------------- (3) Growth Pattern Method
---------------------- If there is some relationship between the new good and an already
established good. It is possible to estimate the demand for the new
----------------------
good by studying how the established good has grown. Thus, we
---------------------- can study the growth pattern of all the toothpaste or refined oil or
ghee in the market, and make use of this information to forecast the
---------------------- demand for the new toothpaste.
---------------------- Limitations
a) This method is very time-consuming and has limited use.
----------------------
b) This is useful for the forecasts of the new goods at a later stage of
---------------------- growth.
----------------------

(4) Opinion-Polling Method Notes
The expected consumers/buyers are directly contacted and their
----------------------
opinion about the new product is gathered. If the number of
expected consumers is very large, then a sample is selected and the ----------------------
results obtained from the sample are generalised for the population.
This is a very useful method and is used by many firms to estimate ----------------------
the demand for their new product. A new drug, for example, is to be
----------------------
introduced in the market, the firm concerned will contact the doctors
and gather their opinion about the drug, before it is introduced in ----------------------
the market.
----------------------
Limitations
a) Individual consumers are not sure of their purchase plans ----------------------
b) It is difficult and costly to contact all the consumers. ----------------------
c) Useful only in the short period ----------------------
(5) Sample-Survey Method
----------------------
The new product is first introduced in some sample-markets and
the results seen in the sample market are generalised for the total ----------------------
market.
----------------------
For instance, many years back, when ‘Maggi Instant Noodles’ were
introduced in the market for the first time, free small packets were ----------------------
distributed in schools to popularise the idea, where advertising
----------------------
wasn’t half as aggressive as it is today. The concept of instant foods
was alien to the Indian people. But the distribution idea to relate to ----------------------
school-going children worked wonders for the company.
----------------------
Limitations
a) The sample chosen, should be a correct representation of the total. ----------------------
b) Tastes and preferences differ from market to market. ----------------------

6) Indirect Opinion-Polling Method ----------------------
The opinions of the consumers are indirectly collected through
----------------------
dealers who are aware of the needs of the consumers. However, the
success of this method depends on the judgment of these dealers. ----------------------
Limitations
----------------------
a) Based on value judgement, therefore, has no scientific basis, and
forecasts may not be accurate. ----------------------
b) Limited scope ----------------------
----------------------
----------------------
----------------------

Notes 5.5 CRITERIA FOR A GOOD DEMAND FORECAST
---------------------- A forecast is said to be good when the expected demand is close to the
actual demand. A firm has to choose the best method of forecasting, so that the
---------------------- forecasts are good. The following are the criteria which need to be considered
before forecasting the demand for a product.
----------------------
a) Accuracy : Forecasts must be as close to reality as possible. There is no
---------------------- point in spending so much money and time if the forecasts do not give a
real picture of the market demand.
----------------------
b) Durability : Forecasts require a lot of time and money, thus they should
---------------------- be such that they can be used for a long period, they should be durable.
The relationship between the variables should be stable, for the forecasts
---------------------- to be durable.
c) Flexibility : Forecasts should be adjustable. Business means a lot of
----------------------
uncertainty and to accommodate this uncertainty, the forecasts should
---------------------- take into account all the possible factors affecting the forecasts.
d) Acceptability : Advanced statistical techniques are available to the
---------------------- firms for forecasting demand. But because they are very complex, these
---------------------- methods are not acceptable by most firms. Firms prefer simple and easy
method for forecasting the demand for their product.
---------------------- e) Availability : Sufficient and up-to-date data must be available for the
forecast to be good. Also, the forecasts must be available to the firms on
---------------------- time, so that the firms can make the necessary arrangements to produce
---------------------- and supply their product in the markets.
f) Plausibility : Forecasts should be plausible. They should be understood
---------------------- by the executives who are going to make use of it.
---------------------- g) Economy : Economy or the cost-factor is very important in demand
forecasting, because good forecasts require both time and money. While
---------------------- incurring costs on forecasting, a firm should weigh the costs and benefits.
If accurate forecasts are going to give very high returns, then it is worth
---------------------- spending more money on forecasting demand. If however, accuracy of
---------------------- forecasts will mean a lot of money, but will not make much difference to
the return, in such cases, a slight degree of inaccuracy would not matter
---------------------- and it will save money at the same time.
----------------------
----------------------
Fill in the blanks.
----------------------
1. The methods for forecasting demand for established goods are
---------------------- _____________ and ___________.
---------------------- 2. A forecast is said to be good when _________ is close to the
__________ demand.
----------------------
3. Correlation is a method used to understand the relationship between
---------------------- ____________ and ___________ variables.

Notes
Activity 2
----------------------
1. Correlation does not necessarily mean that there is cause-effect
----------------------
relationship between two variables. Give an example (other than the
one given in the unit). ----------------------
2. Match the following. In column C describe the method in one sentence. ----------------------
Column A Column B Column C
----------------------
1. Evolutionary a. A very time-
method consuming method ----------------------
2. Growth pattern b. Not applicable to long
----------------------
method duration time
3. Indirect opinion c. The advertising effect ----------------------
polling method lies outside its foray
4. Opinion polling d. Lacks scientific basis ----------------------
method ----------------------
5. Sample survey e. Assumes that a part
method represents the whole ----------------------
6. Substitution f. Ignores the problem ----------------------
method how the new product
could be different from ----------------------
the already existing
product ----------------------
----------------------
Summary ----------------------
●● There is a difference between actual demand and estimated demand. ----------------------

Demand Forecasting, with its different methods aims at reducing the gap
between the two to the minimum. It is therefore the method of predicting ----------------------
the future demand of a firm’s product. It is anticipating the demand for the ----------------------
firm’s product or a range of products before the actual demand is realised.
It gives a fair idea to the managerial decision-making and this can help ----------------------
them in their plan of actions. There are special teams at firms indulging in
this activity of Demand forecasting. This is done on the basis of a unique ----------------------
mixture - particular to the firm – of experience and statistical methods. ----------------------
There is a panel of experts employed that are either internal or external
to the firm. ----------------------
●● Forecasts thus have become integral to the world of business management. ----------------------
They are guided by different objectives of the firm, right from laying
down the budget to resource employment to optimum production to firm ----------------------
expansion.
----------------------
●● Thus unit gives in length the different factors influencing Demand
Forecasting with a very clear classification on the basis of Time Period, ----------------------

Notes the level at which the forecast is being conducted and the type of product
under consideration.
---------------------- ●● The methods of Demand Forecasting have been grouped under two major
---------------------- heads – Established products and New Products.
●● For the former, the Interview and Survey Approach fall under short period
---------------------- analysis and Projection Approach come for long period analysis, which
---------------------- enfolds the Correlation and Regression and Time-series Analysis. For
the latter, Joel Dean has suggested methods like Evolutionary Method,
---------------------- Growth Pattern Method, Indirect Opinion-Polling Method, Opinion-
Polling Method, Sample-Survey Method and Substitution Method.
----------------------
●● There are seven points given in this unit to validate the criteria for a good
---------------------- forecast.
●● Thus, Demand Forecasting is a very important guiding tool for firm
----------------------
operating in a market either with an established or a new product. The
---------------------- methods used for this analysis answer various questions that could help
the firm to a very large extent.
----------------------
---------------------- Keywords
---------------------- ●● Objectives : Targets set by a firm, on the basis of the economic
position of the firm
----------------------
●● Budget : The cost and estimated revenue icture of a firm that outlines that
---------------------- spending power of the firm for a give period of time
●● Expansion : Firm starching its wings to more avenues of production,
----------------------
either introducing new products or revising the existing ones
---------------------- ●● General Forecasts : The aggregate picture of the demand for all the
firms’ goods and all the markets the firm caters to
----------------------
●● Specific Forecasts : Specific Forecasts gives information about a specific
---------------------- product or a specific market, as the case maybe.
---------------------- ●● Macro Forecasts : Forecasts on the aggregate level; of the economy as
a whole
---------------------- ●● Micro Forecasts : Forecasts pertaining to a particular firm or industry
---------------------- ●● Survey : A method which deals with directly or indirectly approaching
consumers in order to take their opinions on specific issues, which helps
---------------------- the firm to make certain decisions
---------------------- ●● Correlation : A method to understand the relationship between dependent
and independent variables
----------------------
●● Time Series : It believes that the relationship between the dependent and
---------------------- the independent variables continues to hold in future.
----------------------
----------------------

Notes
----------------------
1. What are the different criteria used to bridge the gap between expected
demand and the actual demand? ----------------------
2. What are the factors influencing Demand Forecasting? Explain each with
----------------------
an example.
3. Explain in short the different methods for forecasting demand for ----------------------
established goods. Highlight with an example and one limitation which ----------------------
you think is most important and give a reason for thought.
4. Write a short note on Correlation and Regression Analysis. ----------------------
----------------------
----------------------
----------------------
Fill in the blanks.
1. Prediction of future demand for a firm’s product/products are called ----------------------
demand forecasting ----------------------
2. Level forecasts can be made for a firm, an industry and the nation.
----------------------
3. The main factors that influence demand forecasting are time period, types
of forecasts and types of goods. ----------------------
1. The methods for forecasting demand for established goods are interview
and survey approach and projection approach. ----------------------
2. A forecast is said to be good when expected demand is close to the actual ----------------------
demand.
----------------------
3. Correlation is a method used to understand the relationship between
dependent and independent variables. ----------------------
----------------------
Suggested Reading
----------------------
1. Koutsoyiannis, A. 1991. Modern Micro Economics. London: Macmillan.
----------------------
2. Milgrom, P and J, Roberts. 1992. Economics Organisation and
Management. New Jersey: Prentice Hall Inc. ----------------------
----------------------
----------------------
----------------------
----------------------

Notes
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Supply Analysis
UNIT
6
Structure:
6.1 Meaning of Supply

6.2 Determinants of Supply
6.3 The Law of Supply
6.4 Assumptions underlying the Law
6.5 Exceptions to the Law of Supply (Backward – Sloping Supply Curve)
6.6 Expansion & Contraction in Supply
6.7 Increase & Decrease in Supply
6.8 Causes of Change in Supply
6.9 Elasticity of Supply
6.10 Measurement of Elasticity of Supply
6.11 Factors Determining Elasticity of Supply
Summary
Key Words
Suggested Reading
Supply Analysis 119

Notes
Objectives
----------------------
----------------------
• Define the term supply in the right sense of its meaning
----------------------
• Justify the factors affecting supply
---------------------- • State the law of supply
---------------------- • Analyse its assumptions and exceptions
---------------------- • Construct the supply curve

• Differentiate between “expansion” and “increase” in supply
----------------------
• Measure elasticity of supply
----------------------
• Explain the factors determining the supply
----------------------
---------------------- 6.1 MEANING OF SUPPLY
---------------------- In economics, supply during a given period of time means the quantities
of goods which are offered for sale at particular prices. Thus, the supply of
---------------------- a commodity may be defined as the amount of the commodity which the
sellers (or producers) are able and willing to offer for sale at a particular
----------------------
price, during a certain period of time.
---------------------- Supply is a relative term. It is always referred to in relation to price
and time. A statement of supply without reference to price and time conveys
----------------------
no economic sense. For instance, a statement such as : “the supply of milk is
---------------------- 500 litres” is meaningless in economic analysis. One must say, “the supply at
such and such a price and during a specific period.” Hence, the above statement
---------------------- becomes meaningful if it is said “at the price of Rs.20 per litre, a dairy farm’s
daily supply of milk is 500 litres.” Here, both price and time are referred to with
----------------------
the quantity of milk supplied.
---------------------- Secondly, supply is what the seller is able and willing to offer for sale.
---------------------- The ability of a seller to supply a commodity, however, depends on the stock
available with him. Thus, stocks is the determinate of supply.
---------------------- Similarly, another determining factor is the will of the seller. A seller’s
---------------------- willingness to supply a commodity, however, depend on the difference between
the reservation price, the minimum or cost price the seller must get and the
---------------------- prevailing market price or the price which is offered by the buyer for that
commodity. If the ruling market price is greater than the seller’s reservation
---------------------- price, he (the seller) is willing to sell more. But at a price below the reservation
---------------------- price, the seller refuses to sell.
Let us say, a supplier of a product X has in stock 1000 kgs. of his product.
---------------------- The minimum price that he expects for his product is Rs. 95 per unit and the
---------------------- on-going supply price is Rs. 98.50 thus he will bring some supply to the market

(580 kgs), but is not ready to release all of it, since he is waiting for the better Notes
price in the near future. Thus at this point of time, we can infer from the above
that the supply of product X is 580 kgs. at Rs. 98.50 per unit. ----------------------
In short, supply always means supply at a given price. At different ----------------------
prices, the supply may be different. Normally, higher the price, greater the
supply and vice versa. ----------------------
----------------------
6.2 DETERMINANTS OF SUPPLY
----------------------
There are a number of factors influencing the supply of a commodity. They are
known as the determinants of supply. The important determinants of supply are: ----------------------
1) Price : Price is the single largest factor influencing the supply of a commodity. ----------------------
More commodity is supplied at a higher price and less commodity is supplied
at a lower price. The change in the quantity supplied in response to the change ----------------------
in price is known as the variation in supply. Even expectations about the
----------------------
future price affect the supply. If a dealer expects the price to rise in the future,
he will withhold his stock at present and so there will be less supply now. ----------------------
There are several factors other than the price, influencing the supply. The
changes in these factors lead to changes in the supply of the commodity. ----------------------
The change in the supply may be in the form of the increase or decrease in
----------------------
supply. The other factors are given below.
2) Natural Conditions : The supply of some commodities, such as agricultural ----------------------
products, depends on the natural environment or climatic conditions like
----------------------
rainfall, temperature, etc. A change in these natural conditions will cause
a change in the supply. For instance, a good monsoon will produce a good ----------------------
harvest; so the supply of the agricultural products will increase. On the
other hand, their supply decreases during the drought conditions. ----------------------
Similarly, we can also say that untimely rains spoil the crop, for example ----------------------
rains in winter is not a typical to the Indian weather conditions. Rabi
(winter) crops like grapes are not acclimatised to having rains in their ----------------------
harvest period. If so, then the crop gets heavily damaged, as experienced
----------------------
in India in Dec. 2005. Contrarily, rains are a boon to kharif (summer)
crops like wheat, rice. Thus good agricultural produce is under the mercy ----------------------
of a good and a timely rainfall.
----------------------
3) State of Technology : The improvement in the technique of production
leads to increased productivity and results in an increase in the supply of ----------------------
manufactured goods.
----------------------
For instance, there’s a breakthrough in the production of fertilizers and high-
quality seeds, as a result of which there is a better crop. Thus, the supply of ----------------------
foodgrains in the market increases. Similarly, with the installation of state-
of-art printing machines in the press, the printing of newspapers per hour ----------------------
increases from 15,000 to 25,000 copies. This can result to two situations,
----------------------
both mean increased productivity i.e. printing the daily required copies of i.e.
2,00,000 copies in a lesser time-period and in the same time-period as before, ----------------------
Supply Analysis 121

Notes more copies can be printed. Thus, the total copies coming to the market can
be increased without increasing the actual printing time and so the labour
---------------------- time (machines are doing the work!)
---------------------- 4) Transport Conditions : The difficulties in transport may cause a temporary

decrease in the supply, as goods cannot be brought in time to the market. So,
---------------------- even at the rising prices, the quantity supplied cannot be increased.
---------------------- In India, even today, road transport is one of the most used modes of
transport. Bad road conditions due to heavy rains or low maintenance by
---------------------- the government bodies predominantly pose a big hindrance to the free
flow of transport. Goods manufactured in one corner of the country have
---------------------- to reach out to all parts via road transport. These goods can get damaged
to a large extent because of the bumpy roads and also the delays so caused.
----------------------
Perishable goods cannot be travelling for ever to reach the customers;
---------------------- they might just have to be thrown away. So is the case of durable goods.
Today, the customer is highly intolerant and is not willing to wait too long
---------------------- on the waiting list! It can even lead to customers to local alternative to
avoid the daily trouble of delayed transportation. For example, a designer
---------------------- is tired of delays in the supply of various types of cloth, threads, beads
---------------------- etc. coming from Ahmedabad, now decides to look for the same from
Mumbai, or probably from a local trader even if at a price slightly higher
---------------------- than the former. The time saved can cover the loss made (paying more for
the same material) by taking more orders and giving them on time and
---------------------- avoiding the wrath of his precious customers.
---------------------- 5) Factor Prices and their Availability : When the factors of production
are easily available at low prices, more investment is encouraged due to
---------------------- better returns. Under such circumstances, the supply of the commodity
which these factors help to produce may tend to increase and vice versa.
----------------------
For instance, there’s a construction site next to an elite locality, having a
---------------------- high population of working mothers. There are a lot of young girls living
at the site whose parents are employed. They are here to stay for at least
----------------------
another 2 ½ to 3 years. They can’t afford school and are not allowed to
---------------------- work at the site. The word spreads around for the possible employment at
the elite colony for these young seekers. They are to the daily household
---------------------- chores or even baby-sit the young children while the mothers are away
at work. Seekers are lot many than the houses willing to employ them.
---------------------- Thus, they are willing to work at whatever wages their rich bosses will
---------------------- pay. They don’t want to bargain much for fear of loss of the opportunity.
6) Government’s Policy : The government’s economic policies like
---------------------- industrial policy, fiscal policy, etc., influence the supply. If the industrial
---------------------- licensing policy of the government is liberal, more firms are encouraged to
enter into registrations and high custom duties may decrease the supply of
---------------------- the imported goods but it would encourage the domestic industrial activity,
so that the supply of domestic products may increase. An increase in tax
---------------------- such as excise duties will reduce the supply while granting of subsidy will
increase the supply.
----------------------

7) Cost of Production : If there is a rise in the cost of production of a Notes
commodity, its supply will tend to decrease. So, with the rise in the cost
of production, the supply curve tends to shift leftward. Conversely, a fall ----------------------
in the cost of production tends to increase the supply.
----------------------
This point is in-turn related to points 3, 4, and 5 above. The rise in the cost
of production of a commodity can be due to various reasons. (1) The piece ----------------------
of land has lost its fertility. So to get the same crop, the farmer has to use
----------------------
high dose of fertilizers. (2) The price of fertilizers and manure has itself
increased. The (2a) product price has increased, because of low subsidies ----------------------
(2b). So has transport cost gone up. Roads are bad, diesel consumption
is high that has pushed up the price of reaching them to the farmer’s ----------------------
land. (3) Government too has a hand in creasing the cost, by reducing the
----------------------
subsidy grant, which the farmer hitherto enjoyed.
8) Prices of other Products : The prices of substitutes or related products also ----------------------
influence the supply of a commodity. If the price of wheat rises, the farmers
----------------------
may grow more of wheat and less of rice. So the supply of rice will decrease.
Again, if the prices of fountain pens rise, the prices of ink will also tend to ----------------------
rise. If the price of sugar rises, the price of jaggery (gur) will also tend to rise.
----------------------
6.3 THE LAW OF SUPPLY ----------------------
The law of supply reflects the general tendency of the sellers in offering ----------------------
their stock of a commodity for sale in relation to the varying prices. It describes
seller’s supply behaviour under given conditions. It has been observed that ----------------------
usually sellers are willing to supply more with a rise in prices.
----------------------
Statement of the Law
----------------------
The law of supply may be stated as follows :
Other things remaining unchanged, the supply of a commodity expands with a ----------------------
rise in its price and contracts with a fall in its price. ----------------------
The law, thus, suggests that the supply varies directly with the change in price. So, a
larger amount is supplied at a higher price than at a lower price in the market. ----------------------
Explanation of the Law ----------------------

The law can be explained and illustrated with the help of a supply schedule as ----------------------
well as a supply curve, based on imaginary data, as follows :
----------------------
Price of Ballpen (per unit) Quantity Supplied
Rs. (in ’000 per week) ----------------------
10 10 ----------------------
12 13
14 20 ----------------------
16 25 ----------------------
----------------------
Supply Analysis 123

Notes Supply Curve
Y
----------------------
----------------------
S
---------------------- 16
Price Per Unit

---------------------- 14
12
----------------------
S
10
----------------------
---------------------- X
0 5 10 15 20 25
----------------------
Quantity Supplied (Units)
----------------------
X axis = Units of Ballpen
---------------------- Y axis = Price per Unit
---------------------- When the data of Table are plotted on a graph, a supply curve can be
drawn as shown in the Figure given above.
----------------------
From the supply schedule, it appears that the market supply tends to
---------------------- expand with the rise in price and vice versa. Similarly, the upward sloping curve
also depicts a direct relation between price and quantity supplied.
----------------------

----------------------
---------------------- 1. A statement of supply without reference to price and time conveys no
---------------------- economic sense.
2. The prices of substitutes or related products do not influence the
---------------------- supply of a commodity.
---------------------- 3. If there is a rise in the cost of production of a commodity, its supply
will tend to increase.
----------------------
Fill in the blanks.
----------------------
1. The law of supply states, other things remaining unchanged the
---------------------- supply of a commodity expands with a __________ in its price and
_________with a ________ in its price.
----------------------
2. An increase in taxes such as excise duties will ________ the supply
---------------------- while granting of subsidies will ____________the supply.
----------------------
----------------------

Notes
Activity 1
----------------------
Write a situation for a perfect market supply for apples (produced ----------------------
in Shimla), in terms of its demand and the price expected, weather
conditions for its produce, optimum production, its market spread using ----------------------
the different modes of production, the factors of production, their prices
----------------------
and availability and also the government policy. There is also influx of
oranges and watermelons happening around the same time. Do you think ----------------------
it will directly harm the market for apples? Write down your views and
suggestions. ----------------------
----------------------
6.4 ASSUMPTIONS UNDERLYING THE LAW
----------------------
The law of supply is conditional, since we have stated it under the
----------------------
assumption: “other things remaining unchanged”. It is based on the following
ceterius paribus assumptions : ----------------------
1) Cost of production is unchanged : It is assumed that the price of the ----------------------
product changes, but there is no change in the cost of production. If the
cost of production increases along with the rise in the price of product, ----------------------
the sellers will not find it worthwhile to produce more and supply more.
Therefore, the law of supply is valid only if the cost of production remains ----------------------
constant. It implies that the factor prices, such as wages, interest, rent etc. ----------------------
are also unchanged.
2) No change in technique of production : The technique of production ----------------------
is assumed to be unchanged.This is essential for the cost to remain ----------------------
unchanged. With the improvements in technique, if the cost of production
is reduced, the seller would supply more even at falling prices. ----------------------
There is no change at the printing press (of newspapers, now new machines ----------------------
are installed). Also, at a given tailoring shop, inspite of a spurt of orders in
Diwali, the owner continues with the same set of old working machines. ----------------------
3) Fixed scale of production : During a given period of time, it is assumed ----------------------
that the scale of production is held constant. If there is a changing scale of
production, the level of supply will change, irrespective of the changes in ----------------------
the price of the product.
----------------------
This assumption ignores the fact that some factors could be more
specialised in one field that some other factors. Thus, factors can have ----------------------
varying efficiency in different sectors, thus leading either to increasing or
----------------------
decreasing returns to scale of production.
4) Government policies are unchanged : Government policies like taxation ----------------------
policy, trade policy, etc., are assumed to be constant. For instance, an ----------------------
increase in or totally fresh levy of excise duties would imply an increase
in the cost or in case there is fixation of quotas for the raw materials or ----------------------
Supply Analysis 125

Notes imported components of a product, then such a situation will not permit
the expansion of supply with a rise in prices.
----------------------
The above assumes that there is no change in power; there are no elections
---------------------- or re-elections. There is a peaceful stability in the functioning of the
government bodies across the nation. Thus, when the working authorities
---------------------- are the same, so are the working policies.
---------------------- 5) No change in transport costs : It is assumed that transport facilities and
transport costs are unchanged. Otherwise, a reduction in transport cost
---------------------- implies lowering of cost of production, so that more would be supplied
even at a lower price.
----------------------
This, in turn, assumes that the roads are in perfect condition all the year
---------------------- round and there’s no need to spend any money on their maintenance, etc.
This will be a dream come true for the civic authorities, right ?
----------------------
6) No speculation : The law also assumes that the sellers do not speculate
---------------------- about the future changes in the price of the product. If, however, sellers
---------------------- expect prices to rise further in future, they may not expand supply with
the present price rise.
---------------------- The above assumption of no speculation means that the economy is
---------------------- balanced, that the general public is contented with the scheme of things
prevailing in the country. They are happy and want no change, thus do not
---------------------- indulge in any kind of speculation.
---------------------- 7) The prices of other goods are held constant : The law assumes that there
are no changes in the prices of other products. If the price of some other
---------------------- product rises faster than that of the product in consideration, producers
might transfer their resources to the other product which is more profit -
---------------------- yielding due to rising prices. Under this situation, more of the product in
---------------------- consideration may not be supplied, despite the rising prices.
Moreover, the above assume that we are living in a static world.
----------------------
Realistically speaking, this is generally not possible!
----------------------
6.5 EXCEPTIONS TO THE LAW OF SUPPLY (BACKWARD
----------------------
– SLOPING SUPPLY CURVE)
----------------------
The law of supply states that supply, tends to rise with a rise in price
---------------------- is a universal phenomenon. There are, however, a few exceptions to this law.
Supply of labour and savings are two such exceptions commonly pointed out by
---------------------- the economists. It may be observed, in these cases, that the supply tends to fall
with a rise in prices at a point. This paradoxical situation of supply behaviour is
----------------------
represented by a backward sloping or regressive supply curve over a part of its
---------------------- length as shown in Figure 6.1. It is also known as an exceptional supply curve,
as such a thing happens only in some exceptional cases like labour supply or
---------------------- savings.
----------------------

Y Notes
S1
200 ----------------------
----------------------
180 M ----------------------
----------------------
Wage Rate
160 ----------------------
150 ----------------------
----------------------
----------------------
S
----------------------
O X
50 55 60 65
----------------------
Quantity Supplied of Labour Leisure
in hours ----------------------
Fig 6.1 : Backward Sloping Supply Curve of Labour ----------------------
In figure the curve SMS1 represents a backward - sloping supply curve
----------------------
for labour as a commodity. Here, the wage - rate is regarded as the price of
labour and the labour supply is determined in terms of labour - hours the worker ----------------------
is willing to work at a given wage rate. It is observed that as wages increase, a
worker might work for a lesser number of hours than before. To illustrate the ----------------------
point, say, when the wage rate is Rs. 150 per hour, the worker works for 50
----------------------
hours per week and gets Rs. 7,500; when it is Rs. 160 per hour, he works for 60
hours per week, and gets Rs.8,800; at Rs. 180, he works for 65 hours and gets ----------------------
Rs. 11,700 and at Rs. 200, he works for 60 hours and gets Rs. 12,000.
----------------------
As exception to the law is also seen in the case of persons who want to
have a fixed income from their investment. As interest rates rises, the amount ----------------------
on investment required to reach the same amount of interest yields is obviously
less. For instance, a person wants to earn Rs.100 per year require an investment ----------------------
of Rs. 1,000/- at an interest rate of 20 per cent he will require an investment of
----------------------
Rs.500. Thus, as the rate of interest rises, the volume of investment required
declines. In this case, he will decrease his savings and investment when the ----------------------
rate of interest rises and increase his savings and investment when the rate of
interest falls, which is contrary to the usual law of supply. ----------------------
----------------------
----------------------
----------------------
----------------------
Supply Analysis 127

Notes 6.6 EXPANSION AND CONTRACTION IN SUPPLY
Y
----------------------
---------------------- S
---------------------- b
P2
----------------------
Price per Unit
A
---------------------- P1
----------------------
----------------------
S
----------------------
O Q1 Q2 X
---------------------- Quantity Supplied
---------------------- Fig 6.2 : Extension and Contraction of Supply

The law of supply refers to the change in supply due to a change in price.
----------------------
If, with a rise in price, the quantity supplied rises, it is called expansion of supply.
---------------------- If with a fall in price, the quantity supplied declines, it is called contraction of
supply. The change in the quantity in accordance with the price change is, thus,
---------------------- called either as “expansion” (or extension) or “contraction” of supply and refers
to the same supply curve.
----------------------
In figure, the movement from point a to b on the supply curve shows expansion
---------------------- and b to a shows contraction of supply.
----------------------
6.7 INCREASE AND DECREASE IN SUPPLY
----------------------
These two terms are introduced to explain the change in supply without any
---------------------- change in price. Sometimes, there might be more supply forthcoming in the
Y
---------------------- Y
----------------------
S S2
---------------------- S1
S
Price (Per Unit)
Price (Per Unit)
a b b a
---------------------- P P
---------------------- S2
S
S
---------------------- S1
X K X
---------------------- O Q M O Q
Quantity Supplied Quantity Supplied
(Increase in Supply) (Decrease in Supply)
----------------------
Fig 6.3(a) Fig 6.3(b)
----------------------

market without a change in price, in which case it is called increase in supply. Notes
There might be less supply forthcoming in the market without a change in
price, then it is called decrease in supply. The change in supply due to causes or ----------------------
determinants other than price is called “decrease” or “increase” in supply, and
can be shown on different supply curves. ----------------------
In Fig. 6.3(a), at price OP, the supply is OQ. Later on, at the same price, ----------------------
when the supply increases from OQ to OM, it is called increase in supply. It
----------------------
cannot be shown on the initial supply curve, but the supply curve shifts to the
right as S1S1 curve. Likewise, in ----------------------
Fig. 6.3(b), when at price OP, the supply becomes OK instead of OQ, it
----------------------
means a decrease in supply. This can be shown by leftward shifts which need
not be parallel. ----------------------
6.8 CAUSES OF CHANGE IN SUPPLY ----------------------
----------------------
There are many causes which bring about a change (increase or decrease) in the
conditions of supply. The important ones among them are : ----------------------
1) Cost of Production : Given the price, the supply changes with the change
in the cost of production. If the cost of production increases because of ----------------------
higher wages to workers or higher price of raw materials, there will be a ----------------------
decrease in supply. If the cost of production falls due to any of the above
reasons, the supply will increase. ----------------------
2) Supply also depends on Natural Factors : There might be a decrease ----------------------
in the supply due to floods, paucity of rainfall, pests, earthquakes, etc.
Absence of the above calamities or an exceptionally good as well as a ----------------------
timely monsoon might increase supply.
----------------------
3) Change in Technique of Production : This has an important influence
on supply. An improvement in the technique of production might go a ----------------------
long way in increasing the supply. For instance, introduction of highly
sophisticated machines increases the supply of goods. ----------------------
4) Government Policies : Often government’s policies regarding taxation, ----------------------
issuing of licenses, import-export policies and monetary policy of the
Central Bank of the country etc. may affect the production and then the ----------------------
supply of goods under consideration. ----------------------
5) Development of Transport : Improvement in means of transport
obviously increases the supply of goods as they facilitate the movement ----------------------
of goods from one place to another.
----------------------
The construction of the Pune-Mumbai Expressway has largely added
positive value to the traffic relating to the two cities as well as the ones ----------------------
connecting them, in terms of reducing the travel time, increasing the
----------------------
comfort level, reducing the damage element of the perishable as well as
durable goods. High-end two storied trucks carry four wheelers from one ----------------------
city to another. Even the slightest damage to any one of the cars can cost
phenomenal sums to the company. ----------------------
Supply Analysis 129

Notes 6) Business Combines : The producers also might reduce the supply by
entering into an agreement among themselves through their business
---------------------- combines like trust, cartel or business syndicate, with a view to raising
prices in the market.
----------------------
For example, let’s say all the banks come together to decide on certain
---------------------- norms on short-term (i.e. a loan for a maximum period of one year). They
decide a certain interest rate band –within which the interest-rate offered
----------------------
by banks will float. Each bank has to operate within the set limit i.e. can
---------------------- go neither higher nor lower than the band.

----------------------
----------------------
1. The law of supply is valid only if the cost of production remains
---------------------- constant.
---------------------- 2. The law of supply holds good even when the traders speculate about
the future changes in the prices of a product.
----------------------
3. The law of supply assumes that there are no changes in the prices of
---------------------- other products.
Fill in the blanks.
----------------------
1. The exceptions to the law of supply are ___________ and
---------------------- _____________
---------------------- 2. The change in the supply due to causes or determinants other than
price is called ____________ or ____________ in supply.
----------------------
3. Improvement in the means of transport ________ the supply of goods.
----------------------
4. The producers of goods may reduce the supply by forming business
---------------------- combines with a view to __________ the prices in the market.
----------------------
Activity 2
----------------------
---------------------- Visit the website of the Ministry of Agriculture and analyse the ways
Government stabilises the demand and supply of foodgrain.
----------------------
----------------------
---------------------- 6.9 ELASTICITY OF SUPPLY

---------------------- Supply changes due to change in price. The extent of change in supply in
accordance with the change in price is called elasticity of supply. When, with
---------------------- a little change in price (rise or fall), there is a considerable change in quantity
----------------------

supplied (expansion or contraction) the supply is said to be elastic. When, with Notes
a considerable change in price, there is little change in quantity supplied, the
supply is said to be less elastic. More precisely, with a small fall in price, when ----------------------
there is a big contraction of supply or with a small rise in price, when there is
a big expansion of supply, the supply is said to be elastic. If, with a big fall in ----------------------
price, there is a very little contraction of supply or with a big rise in price, there ----------------------
is a very small expansion of supply, the supply is said to inelastic.
----------------------
a) Elasticity of supply may be defined as the ratio of the percentage change
or the proportionate change in quantity supplied to the percentage or ----------------------
proportionate change in price :
----------------------
Thus,
Percentage change in Quantity Supplied ----------------------
es =
Percentage change in price ----------------------

Elasticity of supply can also be measured alternatively as ----------------------
Net change in Quantity Supplied Net change in Price ----------------------

es = ÷
Original Quantity Supplied Original Price ----------------------
Representing it in symbols, thus elasticity of supply formula can be stated as : ----------------------
 QS P ----------------------
es = ÷
QS P
----------------------
 QS P ----------------------
= x
QS P ----------------------

 QS P ----------------------
Therefore, es = x
P QS ----------------------
QS = The Original Quantity Supplied ----------------------
Q = Net change in Quantity Supplied ----------------------
P = The original Price
----------------------
P = Net change in Price
----------------------
For example, if, as a result of a change in the price of a commodity from
Rs. 40 to Rs. 45 per unit, the total Quantity supplied of the commodity by ----------------------
the sellers is increased from 1,000 units to 1,200 units, then the elasticity
of supply may be calculated as under : ----------------------
200 40 ----------------------
es = x = 1.6
5 1000 ----------------------
----------------------
Supply Analysis 131

Notes There are, thus, various degrees of elasticity of supply. It may be relatively
elastic, relatively inelastic or may have perfect elasticity or inelasticity.
---------------------- Different types of supply elasticity’s have been illustrated in the following
Figure.
---------------------- Y Y
S
----------------------
----------------------
(Per Unit)
e=0
e=α
(Per Unit)
Price
---------------------- P2 P S
Price
----------------------
P1
----------------------
---------------------- X X
O Q O
---------------------- (a) Quantity Supplied (b) Quantity Supplied
---------------------- Fig 6.4 : Elasticity of Supply - Extreme Cases

The panel (a) of Fig. 6.4 represents the supply curve of zero elasticity.
---------------------- Irrespective of the price, the producer would be supplying OQ quantity
---------------------- (es = 0).
Geographical land of any nation can be posed as an example for a
---------------------- perfectly inelastic supply. The geographical area at the disposal of any
---------------------- country cannot be altered, come what may, unless it gets a part from some
country –maybe as result of war. But in that case the land so available
---------------------- with the latter will be less than before. Thus we can say that the total land
available in the world is constant; its supply is perfectly inelastic.
----------------------
The (b) represents the supply curve of infinite elasticity. At OP price, the
---------------------- producer would be supplying any amount of the commodity. (es = a).
Y Y
----------------------
S S1
----------------------
e=1
e<1
---------------------- S2
----------------------
e>1
----------------------
---------------------- S
X X
O O
---------------------- (a) Quantity Supplied (b) Quantity Supplied
----------------------
Fig 6.5 : Elasticity of Supply - Usual Cases
---------------------- In the above figure in panel (a) the curve SS represents the supply curve of
---------------------- unit elasticity. Any variation in price will be accompanied by an equally

proportionate variation in the amount supplied (es = 1). Similarly, in panel Notes
(b), the curve S1, represents a relatively inelastic supply, (es < 1), and S2
represents elastic supply, ----------------------
(es > 1). The curve S1 shows a steeper supply curve, depicting the less ----------------------
responsiveness of supply to a change in price.
----------------------
For example, road transport is on the high. Therefore prices of road trucks
are on the high too. To meet the increasing need of supply, the companies ----------------------
cannot affect this in matter of a short time. Thus, it will be fairly inelastic
in the short period but then will catch up in the long period i.e. be fairly ----------------------
elastic. To build a truck is a very money as well as time-consuming
----------------------
production.
Lets’ say, a professor, is offered by a Management Institute for a series of ----------------------
guest lectures. He is known to be a very good orator and is very popular
----------------------
with the students. The students want and so the Institute. He is being
offered a high price to deliver these lectures. But he is retired and aging ----------------------
and is therefore willing to deliver only eight lectures out of 10 in the
series. Thus the supply of his services can be said to be relatively inelastic. ----------------------
On the contrary, S2 is a flatter curve, depicting the high degree of supply ----------------------
reaction to a given change in price. For example, at a tea-stall, the person-
in-charge, sells ‘vada-pavs’, the price of which increases from Rs. 2.50 ----------------------
– to Rs. 3.50. This instigates him to increase the supply to gain more. The ----------------------
supply of the popular snack is completely in his control and which he can
effect right from the very next day. He just has to buy more ingredients ----------------------
and wake up two hrs. before to prepare more.
----------------------
6.10 MEASUREMENT OF ELASTICITY OF SUPPLY ----------------------
There are two methods of measuring elasticity of supply : (1) the ratio ----------------------
method, and (2) the point method.
----------------------
 QS P
es = x ----------------------
Q P
----------------------
The coefficient of elasticity of supply(ies) may vary between zero to infinity.
----------------------
(A) The Point Method
On a given supply curve, the elasticity of supply at point P is measured by ----------------------
the ratio of the distance along the tangent (drawn to the curve at the point) ----------------------
from the point P on the supply curve to the point where it intersects the
horizontal axis and the distance along the tangent from the point P on the ----------------------
supply curve to the point where it intersects the vertical axis.
----------------------
----------------------
----------------------
Supply Analysis 133

Notes Y Y
---------------------- (I) S1 (II)

F S1
----------------------
Price (Per Unit)
Price (Per Unit)

F
---------------------- P
S P
---------------------- S
----------------------
---------------------- X X
O T B T O B
---------------------- QUANTITY SUPPLIED
---------------------- Measurement of Point Elasticity of Supply
---------------------- To find out the elasticity on the supply curve at point P as in the above
Fig., draw a tangent TF to the supply curve SS at point P intersecting
---------------------- the horizontal axis at T. Draw a perpendicular PB from point P and
---------------------- intersecting at point B on the horizontal axis.
The elasticity of supply at point P is measured as :
----------------------
TB
---------------------- Es =
OB
----------------------
In panel (1) TB < OB, therefore, as es < 1 at point P. In panel (2) TB > OB,
---------------------- therefore, es > 1 point P.
---------------------- 6.11 FACTORS DETERMINING ELASTICITY OF SUPPLY

----------------------
The elasticity of supply of commodities depends on a number of factors,
---------------------- such as :
1) Nature of commodity : In the case of some commodities like antiques,
----------------------
old wines, old stamps, old and original handwritten manuscripts, etc. their
---------------------- supply remains fixed or constant as they cannot be reproduced in their
original form or shape. In the case of such commodities price changes
---------------------- will have no influence on their supply.
---------------------- In the case of houses, high artistic works, paintings and statues, etc. it
may take quite some time for their supply to expand in response to rise in
---------------------- their prices.
---------------------- In respect of commodities like cloth and other factory-made goods of
daily consumption, response of supply in response to change in their
---------------------- prices would be fairly quick.
---------------------- 2) Level of Technology : Higher level of technology in a country generally
helps to bring about a relatively quicker response from the supply side to
----------------------

change in their prices. Thus, if a community depends for its cloth only Notes
on handloom technology, changes in price of cloth would take relatively
longer time for supply to respond, than if that community possesses ----------------------
technology consisting of modern automatic spinning and weaving
machines. ----------------------
3) Time Element : Time element is very important factor in determining ----------------------

elasticity of supply. Generally, shorter the time-span, less responsive will
----------------------
be the supply side; and longer the time-span, generally more responsive
would be the supply side of the commodity to changes in price. ----------------------
Thus, if price of a commodity rises, that may cause no response from
----------------------
supply side in one or two hours or even one or two days(except in the case
of commodities like shares and internationally traded goods like gold, ----------------------
silver and other valuable metals in case of which future trading takes
place on telephone, telex etc.). ----------------------
Rise in price of houses may bring only gradual response from the supply ----------------------
side of houses, as it takes some time to build new houses.
----------------------
4) Scale of Production : Goods produced on a small scale have a relatively
inelastic supply, while goods produced on a large scale have a relatively ----------------------
elastic supply.
----------------------
For instance, a multi-national company like Hindustan Lever into the
manufacture of soaps, because of its large scale production can alter the ----------------------
quantity supplied according to the changes in price in the market. As the
price increases, it can increase the supply without much time lag, because ----------------------
of the enormity of the production involved at its disposal, thus the supply is ----------------------
relatively elastic. But at the same time, a local small-time manufacturer of
the same commodity will not be in such a powerful position as the former ----------------------
and therefore cannot react to the price changes even half as quickly. Thus,
the supply of soaps by the latter remains relatively inelastic and hence he ----------------------
cannot reap the benefits of large scale production. ----------------------
5) Size of the Firm and the number of Products produced : When the big
firms produce a variety of products at a time, they can easily transfer the ----------------------
resources from one product to the other so that the supply may become ----------------------
more elastic.
----------------------
For instance, a firm into the manufacture of large range of stationery
products : different types of pencils and paper – coloured or non-coloured, ----------------------
envelopes, note-pads, autograph books, note books – each product coming
in a range of various shapes and sizes, also some conventional looking, ----------------------
some to suit teenage tastes etc. the common ingredient coming in each
----------------------
of these products is paper made out of wood particles. So wood posing
as a common intermediary product for the manufacture of plain paper, ----------------------
which in itself goes into the manufacture of many other products of the
same firm. Thus, shortage of the intermediary products in one unit of the ----------------------
firm can be brought from some other unit. Thus, excess from one can be
----------------------
Supply Analysis 135

Notes supplied to another to cover up shortage. This way, the firm can be self-
independent and need not look at outside sources.
----------------------
But the underlying assumption is that the factor is equally equipped or
---------------------- specialized to perform in all sectors, that may not always be the case.
6) Natural Factors : Natural factors like climate, monsoon, fertility of
----------------------
the soil, etc., considerably affect the elasticity of supply of agricultural
---------------------- goods. The supply of agricultural goods is relatively inelastic, because
these natural factors are beyond the control of man. The seasonal nature
---------------------- of cultivation is the main contributory factor, making the supply of
agricultural commodities less elastic.
----------------------
7) Mobility of Factors : In those industries where there is a high degree of
---------------------- mobility of factors of production, supply will be more elastic.Immobility
of factors causes inelasticity of supply.
----------------------
It is a known fact that Rajasthani prints embroidered work and designs
---------------------- are a delicacy amongst many. The hand-work that one gets to see in their
---------------------- products is almost unseen in any other. But the Rajasthani folk residing
in small towns are unwilling to leave their home-towns and migrate to
---------------------- metropolitan cities to get employed and display their craftsmanship. They
know they will be under the whims and fancies of big traders and away
---------------------- from their near and dear ones. Their reluctance has resulted in the low
---------------------- elasticity of supply of their ethnic products. Of course, nowadays, the
attitudes are not as rigid as they were in the past, but they form just a
---------------------- minuscule of the entire lot.
----------------------
----------------------
1. The extent of change in supply in accordance with the change in price
----------------------
is called ____________.
---------------------- 2. Elasticity of supply is defined as the ratio of _________ change or
__________ change in the quantity supplied to the ___________
----------------------
or________ change in the price.
---------------------- 3. The elasticity of supply is measured by the ____________ and the
---------------------- _____________.
----------------------
1. In the case of commodities like antiques, old stamps, the price changes
---------------------- will have no influence on the supply.
---------------------- 2. Time element is not an important factor in determining elasticity of
supply.
----------------------
3. Natural factors like climate and monsoon considerably affect the
---------------------- elasticity of supply of agricultural products.
----------------------

Notes
Activity 3
----------------------
1. In reality, the supply hovers between two extremes, perfectly elastic ----------------------
and perfectly inelastic. What can you say about the following cases
and give reasons for your answer. ----------------------
Mangoes, stuff toys, management institutes, fluent English speaking ----------------------
stenographers.
----------------------
2. Complete the following table:
----------------------
Price (Rs) Quantity Elasticity Relative elastic Yes or No
supplied (Kg) ----------------------
10 100
20 280 ----------------------
18 200 ----------------------
15 80
----------------------
8 50
3. You want to manufacture a commodity, supply of which should be ----------------------
elastic, in order to avoid huge losses and also the supply of which is
----------------------
completely under your control. Which factors would you want to be
in your stride and why? ----------------------
----------------------
Summary
----------------------
●● We are introduced to the concept of supply in this unit. It is here that
we know that there is a specific meaning attached to the concept and the ----------------------
way it is expressed. Supply is a very common term that one uses, but ----------------------
when it comes to relating to a subject like Economics, one just cannot use
the normal way, but has to follow certain norms, in the sense bring it in ----------------------
relation to time and the price per unit.
----------------------
●● Undoubtedly the major factor affecting supply is the price of the product
under consideration. Changes in price affect ‘expansion’ or ‘contraction’ ----------------------
of supply.
----------------------
●● There are other factors like, natural conditions, technological development
in terms of capital development and improvement in the factor quality and ----------------------
availability, low factor prices, economic development in terms of better
infrastructural facilities like better roads, easy accessibility to remote ----------------------
area in the country, backed by supply-friendly government policies. The
----------------------
performance of related goods in the market also counts.
●● The Law of Supply, ceteris paribus states the direct relation between price ----------------------
of a commodity and its quantity supplied. The exception to it comes in the
----------------------
form of the Backward Bending or the Regressive Supply curve. Supply of
----------------------
Supply Analysis 137

Notes labour and saving validate this exception, which shows that after a certain
point the supply tends to fall with a rise in price.
---------------------- ●● Further in this unit, we study the Elasticity of Supply, which is defined as
---------------------- the ratio of the percentage change or the proportionate change in quantity
supplied to the percentage or proportionate change in price. There are
---------------------- various degrees : relatively elastic, relatively inelastic or perfectly elastic
(where e = 0) or perfectly inelastic (where e = infinity) supply.
----------------------
●● There are two methods of measuring Elasticity of supply, namely, the
---------------------- Ratio Method and the Point Method.
---------------------- ●● Lastly, the unit give information of the various factors affecting supply
elasticity. Right from the commodity under consideration – the character
---------------------- type and the type of production – the techniques, its scale, the nature
and the price of factors of production involved, the time factor from its
---------------------- production to realisation. Most importantly, for an agrarian economy like
---------------------- India, natural factors play a very decisive role in affecting the supply
of various goods – wherein agricultural goods are either final goods or
---------------------- intermediary goods for a vast large of non-agricultural goods. Therefore,
one cannot ignore the factors affecting the direct as well as the supply
---------------------- which are very important ingredients for the development of the economy
---------------------- as a whole.
---------------------- Keywords
---------------------- ●● Supply : Amount of goods and services that sellers are able and willing
---------------------- to offer to sell at a particular price.
●● State of Technology : Techniques of production that are responsible for
---------------------- increasing the level of supply.
---------------------- ●● Law of Supply : General tendency of sellers in bringing their stock of
goods to market in relation to the varying prices.
----------------------
●● Backward Bending Supply Curve : Exception to the Law of Supply.
---------------------- ●● Expansion and Contraction of Supply : Movement along the same
supply curve, because of Price as the only determining factor for supply.
----------------------
●● Increase and Decrease in Supply : Shift in the supply curve, brought
---------------------- about due to changes in factors other than price.
---------------------- ●● Natural Factors : Occurrence of floods, earthquakes, rainfall, climatic
conditions land fertility.
---------------------- ●● Supply Elasticity : Responsiveness of the quantity supplied to changes
---------------------- in price.
----------------------
----------------------
----------------------

Notes
----------------------
1. Write in full the meaning of the term ‘Supply’ and the factors affecting it.
2. State and explain the Law of Supply. What are the assumptions underlying ----------------------
the Law?
----------------------
3. What is elasticity of Supply? What are the types of elasticity of Supply?
----------------------
4. Write short notes on :
a. Backward Bending Supply Curve ----------------------
b. Contraction in Supply Increase ----------------------
----------------------
----------------------
----------------------
1. True ----------------------
2. False ----------------------
3. False ----------------------
Fill in the blanks.
----------------------
1. The law of supply states other things remaining unchanged the supply of
a commodity expands with a rise in its price and contracts with a fall in ----------------------
its price.
----------------------
2. An increase in taxes such as excise duties will reduce the supply while
granting of subsidies will increase the supply. ----------------------
1. True
----------------------
2. False
----------------------
3. True
1. The exceptions to the law of supply are supply of labour and savings. ----------------------
2. The change in the supply due to causes or determinants other than price is ----------------------
called increase or decrease in supply.
3. Improvement in the means of transport increases the supply of goods. ----------------------
4. The producers of goods may reduce the supply by forming business ----------------------
combines with a view to raising the prices in the market.
----------------------
----------------------
Supply Analysis 139

Fill in the blanks.
----------------------
1. The extent of change in supply in accordance with the change in price is
---------------------- called elasticity of supply.
---------------------- 2. Elasticity of supply is defined as the ratio of percentage change or
the proportionate change in the quantity supplied to the percentage or
---------------------- proportionate change in the price.
---------------------- 3. The elasticity of supply is measured by the ratio method and the point
method.
----------------------
---------------------- 1. True
---------------------- 2. False
---------------------- 3. True
----------------------
Suggested Reading
----------------------
1. Adhikary, M. 2000. Business Economics. New Delhi: Excel Books.
----------------------
2. Chopra, O P. 1985. Managerial Economics. New Delhi: Tata McGraw
---------------------- Hill.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Production and Costs - I
UNIT
7
Structure:
7.1 Introduction
7.2 Production Function
7.3 Practical importance of Production Function
7.4 Linear Homogeneous Production Function
7.5 Time-Periods
7.6 The Law of Diminishing Returns or The Law of Variable Proportion
7.7 Returns to Scale or Laws of Returns to Scale
7.8 Economies and Diseconomies of Scale
Summary
Key Words
Suggested Reading
Production and Costs - I 141

Notes
Objectives
----------------------
----------------------
• Define production function
----------------------
• Analyse its practical importance
---------------------- • Differentiate between total physical, marginal and average products
---------------------- • State the law of variable proportions
---------------------- • Explain the three stages of law

• State and explain the laws of returns to scale
----------------------
• Justify economies and diseconomies of large scale of production
----------------------
---------------------- 7.1 INTRODUCTION

---------------------- Till now we have studied demand analysis i.e. individual demand curve,
---------------------- market demand curve, law of demand and elasticity of demand and demand
forecasting. In our study of demand side the demand was expressed as Da = f
---------------------- (Pa, Pb, I, P3 -------- n).
---------------------- Now we will shift our attention to the study of supply side of the product
pricing i.e. “Theory of Production” and cost. By production or the act of
---------------------- production involves “transformation of inputs into output”.
---------------------- By output we mean supply of product which depends upon cost of
production which again depends upon input price and relationship between
---------------------- input and output which is called production function. Theory of production
means nothing but study of production function.
----------------------
---------------------- 7.2 PRODUCTION FUNCTION

---------------------- Production function is the relation between input and output. The
production function is the name given to the relationship between the rates
----------------------
of input of productive services and the rate of output of a product. Thus,
---------------------- the production function expresses the relationship between the quantity of
output and the quantities of various inputs used for the production. With
---------------------- the technological advances, the flow of output increases from the given input.
The two aspects which are stressed under production function are :
----------------------
1) Maximum quantity of output that can be produced from any chosen
---------------------- quantities of various inputs
---------------------- 2) Minimum quantities of various input that are required to yield a given
quantity of output
----------------------
----------------------

The production function can be studied in three ways : Notes
1) Law of Variable proportion : Where quantities of some factors is kept
----------------------
fixed but the other factors is varied.
2) Laws of Return to Scale : Where quantities of all factors is varied. ----------------------
3) Optimum combinations of inputs. ----------------------
The cost of production is also influenced by input prices. Input price ----------------------
depends upon demand for factors of production which ultimately depends upon
marginal productivity of the factor. The demand for factors is derived from ----------------------
marginal productivity curve which is actually taken in economics as a part
of theory of distribution. That means theory of production is related to factor ----------------------
prices such as wage, rate of interest which is a micro aspect. Macro aspect i.e. ----------------------
aggregate wages, share of profit in national income are related to production
function. ----------------------
Production function can be algebraically expressed as : ----------------------
Q = f (N, L, K, T)
----------------------
Where Q = Quantity of output
----------------------
N, L, K, T = quantities of factors (Inputs)
f = unspecified form of functional relationship between ‘N, L, K, T’ where ----------------------
through mathematical methods we can work out quantitative measure of this ----------------------
relationship.
The inputs or the factors of production can be classified into fixed and ----------------------
variable inputs. The fixed inputs are those which do not change in quantity ----------------------
irrespective of the level of output. As output increases the fixed inputs used
per unit of output declines. In the short run a firm uses fixed inputs such as ----------------------
land, building, plant and machinery. The variable inputs are those inputs whose
quantity changes along with a change in the output. It means, the variable inputs ----------------------
are required more and more to increase production. The practical observation of ----------------------
the production function indicates two normal relationships :
1) When the quantity of a variable input increases while other inputs remain ----------------------
fixed, the output also increases. It means, there is a direct relation between ----------------------
variable input and output.
----------------------
2) Input and output do not increase in the same proportion. There may be a
phase when output increases faster than increase in a particular variable ----------------------
input. This is a phase of increasing returns to the variable input. When
input and output increase in the same proportion, it is a phase of constant ----------------------
returns.
----------------------
----------------------
----------------------
----------------------

Notes 7.3 PRACTICAL IMPORTANCE OF PRODUCTION FUNCTION
---------------------- The concept of production function is practically significant and useful for the
following reasons :
----------------------
1) Production function gives us an idea of the optimum level of the
---------------------- output and the optimum employment of the variable inputs.
---------------------- A firm which wants to maximize the efficiency with given prices of inputs
should try to find out the optimum proportion between fixed and variable
---------------------- input. This can be discovered with the help of production function.
---------------------- 2) Production function tells management the budget constraint for
increase in output.
----------------------
As generally, output cannot be increased without an increase in the input.
---------------------- It follows that the expansion of a firm requires more funds to employ
more inputs. The firm can judge how far it is worthwhile and profitable to
---------------------- increase output.
---------------------- 3) The production function explains the degree of substitution and
complementarity of different factors of production.
----------------------
From this the firm can select its expansion path. It means, if the firm
---------------------- wants to increase output in what proportion it should increase its various
inputs can be judged from the observed behaviour of production function.
----------------------
4) The management should endeavour to produce an upward shift
---------------------- in production function which can definitely improve its financial
performance under the given market conditions.
----------------------
As such upward shift in production function involves technological
---------------------- progress and indicates the possibility to generate surplus the use of
better methods of production, reorganisation of production activity and
---------------------- creating more incentives and motivation to produce more can help a firm
---------------------- to produce such upward shift.
5) The theory of production function can also explain the possibility of
----------------------
disguised unemployment.
---------------------- When we excessively employ only one factor in the production of a certain
commodity, we reach a stage when the marginal product of that factor
----------------------
becomes zero or negative. This stage is called disguised unemployment
---------------------- which is supposedly present in the agricultural sector in countries like
India. Such disguised unemployment indicates that it is possible to divert
---------------------- surplus labour to other sectors where their marginal product (this concept
is explained in the next part) would be greater than zero. Therefore, it
----------------------
gives policy guidance to both management and government about the
---------------------- priority in the development process.
6) As production function is an engineering concept, we can study the
----------------------
behaviour of production function under different conditions.
---------------------- It can explain inter - firm, inter - regional or international differences in

the productivity. It can explain why the reward to the factors and the rate Notes
of industrial growth are not same at all the places in all the countries.
----------------------
Thus, the concept of production function supplemented with other tools
of economic analysis is relevant for rational decision - making in practical ----------------------
business.
----------------------
7.4 LINEAR HOMOGENEOUS PRODUCTION FUNCTION ----------------------
This is a particular production function which assumes constant returns ----------------------
to scale. It states that if all inputs are increased in the same proportion, the
output also increases in the same proportion. It means, the change in scale of ----------------------
production does not have any effect on efficiency of the firm. The returns to
scale are constant. ----------------------
According to Stigler, the production function is “the name given to ----------------------

relationship between rates of input of productive services to the rates of product
----------------------
output and it is economist’s summary of technological knowledge”. We have
also said that in the simplest form, it is the relationship between “Input and ----------------------
output” and further this relationship can be studied with reference to two
laws : ----------------------
A. Law of variable proportion ----------------------
B. Laws of returns to scale
----------------------
In case of former quantities of some factors are fixed while that of others
are varied and in case of later all factors are variable. ----------------------
Before discussing law of variable proportion let us consider the following ----------------------
definitions which will help in understanding the law.
----------------------
1. Total Physical Product : Total quantity of output produced
in physical units by a firm during a ----------------------
period of time.
----------------------
2. Marginal Product : The change in total product caused
as a result of one additional unit ----------------------
of variable factor employed in
----------------------
combination with fixed factors is
called marginal product. ----------------------
 T. P. ----------------------
M. P. =
Variable factor units ----------------------
3. Average Product : It is the total product that a firm
----------------------
produces in a given time period
divided by the quantity of a variable ----------------------
factor that is used to produce it.
----------------------
T. P.
A. P. = ----------------------
Variable factor units

Notes Alternative way of describing relationship between total product,
marginal product and average product is : All these measures “ Total product”,
---------------------- “Marginal Product” and “Average Product” are related in a simple mathematical
way which can be explained with the help of the table given under the law of
---------------------- variable proportion.
----------------------
7.5 TIME-PERIODS
----------------------
It is necessary to make clear distinction between (a) Short run (b)
---------------------- Long run and (c) Very long run. These are the three time spans for decision -
---------------------- making for a firm. At any given time a firm is less than perfectly flexible which
means when firm enters in Industry, it comes with certain size or capacity and
---------------------- commitment. It has commitment to buy, contain minimum material inputs or
have leased land for some years or firm has some fixed obligations at any given
---------------------- time and therefore we say it is less than perfectly flexible.
---------------------- Short Run : It is a period of time during which at least one of the firms’ input
cannot be varied. It is not possible to tell how long, short run will last. For a
---------------------- small house painting firm it may be for two days because two days are enough
---------------------- to buy more equipment and hire more workers / painters. But for steel making
firm short run lasts for four years even as four years is the time it takes to change
---------------------- furnace and built separate plant, building, add more furnaces etc. In other words
steel plant has a commitment to its present plant for four years.
----------------------
Long Run : It is the period of time long enough to make all the changes that
---------------------- a firm wants to make within limits of existing or present production function.
This is the second time span in which business decisions are made. Except level
----------------------
of technology, everything else changes in the long run. When new technology
---------------------- is introduced and production function itself changes then it is a case of a very
long run.
----------------------
Very Long Run : It is the period of time long enough that the whole new
---------------------- technology can be introduced and production function itself is changed.
With the advent of computers the whole scenario of the Indian working system
----------------------
changed at banks, at corporate offices, at educational institutions, at shopping
---------------------- complexes, etc. The intent of the use (of computers) differs from place to place;
the use now is highly existent. High-end softwares are developed that do the
---------------------- work of many hands and thus save a lot of time and money. This has brought
about a general overall efficiency in the functioning of systems at various levels
----------------------
in the country. Some use for billing purpose, some for storing useful information
---------------------- [with the use of passwords for security purpose, bringing about the concept of
inaccessibility of one information to anyone and everyone!].
----------------------
Computer education got incorporated at several colleges and universities’
---------------------- curriculum. This has, in fact, revolutionised the operations and functions at the
educational [student], corporate, and retail level. The Indian thinking and so the
---------------------- world’s outlook towards our country has gone through a tremendous change in
---------------------- the past few years because of computerization.

Internet changed the face of communication. Posts, stamps, waiting in queues Notes
at post offices, waiting anxiously for letters from long distance - all this is now
obsolete. Internet has brought the world closer. With a click, a person at one end ----------------------
of the world can reach out to anybody at any part. This revolution has brought
about not in a span of a short time but in spanning over a couple of years [very ----------------------
long run] ----------------------
----------------------
Fill in the blanks.
----------------------
1. Production function is the relation between _________ and
____________. ----------------------
2. Very long run is the period of time, long enough that the whole new ----------------------
technology can be introduced and the _______________ itself is
changed. ----------------------
1. There is direct relationship between variable input and output
----------------------
2. Theory of production factors cannot explain the possibility of
disguised unemployment. ----------------------
3. The changes in the scale of production does not have any effect on the ----------------------
efficiency of the firm.
----------------------
Activity 1 ----------------------
----------------------
Following are certain instances. You have to point out which change falls
under which time period and also reason out your answer: ----------------------
1. Cell phones ----------------------
2. Becoming a grandparent
----------------------
3. Hotel changeover
----------------------
4. Expansion of a bank’s number of branches
----------------------
5. Fulfilling the dream of moving out from one BHK to a four BHK row
house in a city’s prime locality ----------------------
6. An established firm stepping to a completely different line of
----------------------
production
----------------------
----------------------
----------------------
----------------------

Notes 7.6 THE LAW OF DIMINISHING RETURNS OR THE LAW
----------------------
OF VARIABLE PROPORTION
---------------------- Introduction
Law of variable proportion occupies an important place in economic theory.
----------------------
This law examines the production function with one factor variable, keeping
---------------------- the quantities of other factors fixed. In other words, it refers to the input output
relation when the output is increased by varying the quantity of one input. When
---------------------- the quantity of one factor is varied, keeping the quantity of the other factors
constant, the proportion between the variable factor and the fixed factor is
----------------------
altered; the ratio of employment of the variable factor to that of the fixed factor
---------------------- goes on increasing as the quantity of the variable factor is increased. Since under
this law, we study the effects on output variations in factor proportions, this is
---------------------- known as the law of variable proportions. The law of variable proportions is
the new name for the famous “Law of Diminishing Returns” of classical
----------------------
economics.
---------------------- Statement of the Law
---------------------- 1) As equal increments of one input are added; the inputs of other productive
services being held, constant, beyond a certain point the resulting
---------------------- increments of product will decrease, i.e., the marginal product will
diminish. - G. Stigler
----------------------
2) As the proportion of one factor in a combination of factors is increased,
---------------------- after a point, first the marginal and then the average product of that factor
---------------------- will diminish. - F. Benham
3) An increase in some inputs relative to other fixed inputs will, in a given
---------------------- state of technology, cause output to increase; but after a point the extra
---------------------- output resulting from the same additions of extra inputs will become less
and less. -P. A. Samulson
---------------------- It is obvious from the above definitions of the Law of variable proportions
---------------------- (or the law of diminishing returns) that it refers to the behaviour of output
as the quantity of one factor is increased, keeping the quantity of other
---------------------- factors fixed and further it states that the marginal product and average
product will eventually decline.
----------------------
(A) Assumptions of the Law of Variable Proportion
----------------------
The law of variable proportion (or diminishing returns) as stated above
---------------------- holds good under the following conditions :
1) The state of technology is assumed to be given and unchanged.
----------------------
If there is improvement in technology, then marginal and average
---------------------- product may rise instead of diminishing.
---------------------- 2) There must be some inputs whose quantity is kept fixed. It is only
in this way that, we can alter the factor proportions and know its
---------------------- effects on output.

3) The law is based upon the possibility of varying the proportions in Notes
which the various factors can be combined to produce a product.
The law does not apply to those cases where the factors must be ----------------------
used in fixed proportions to yield a product.
----------------------
4) Homogeneous nature of units of variable factor is assumed.
----------------------
5) It is assumed that units of variable factor are divisible into smaller
homogeneous units. This assumption may not always be true. ----------------------
6) While discussing the Law of Returns money and monetary value
----------------------
of output is not at all taken into consideration. Only physical
relationship between factor inputs and output of products is ----------------------
considered.
----------------------
(B) Explanation of the Law of Diminishing Returns (Variable proportion)
with the help of a table : ----------------------
Fixed Variable Total Average Marginal ----------------------
Factor Factor Product Product Product
(say land (Labour (units) (units) (units) ----------------------
& capital) units)
F 1 5 5 5 Increasing ----------------------
F 2 15 7.5 10 Returns ----------------------
F 3 30 10 15
F 4 50 12.5 20 Constant ----------------------
F 5 70 14.0 20 Returns
----------------------
F 6 90 15 20
F 7 105 15 15 ----------------------
F 8 115 14.3 10 Diminishing
----------------------
F 9 120 13.3 5 Returns
F 10 124 12.4 4 ----------------------
F 11 127 11.5 3
F 12 127 10.5 0 ----------------------
F 13 118 9.07 -9 Negative
----------------------
Returns
Average Marginal Relationship ----------------------
Observations of the table : ----------------------
The above table shows that eventually the total product also starts declining.
----------------------
But first to decline is the marginal product. The relationship between them is as
follows : ----------------------
1) As long as average product is rising, marginal product would be larger
than the average product. ----------------------
2) M. P. is less than A. P., when A. P. is decreasing. ----------------------

3) The A. P. remains constant when M. P. and A. P. are equal. Also, when A. ----------------------
P. is maximum M. P. equals A. P.
4) Total product is maximum when M. P. is zero. ----------------------

Notes 5) M. P. becomes negative when T. P. falls.
6) It will be noticed from the table that when 1 to 4 workers are employed,
----------------------
the marginal product goes on increasing. This is the phase of ‘Increasing
---------------------- Returns’.
7) When workers 4, 5 and 6 are employed we notice that in their case, that
----------------------
M. P. is 20, 20, 20. This is the phase when the ‘Law of Constant Returns’
---------------------- is in operation.
8) From 7 to 11 workers, it is noticed that though T. P. is increasing, the M.
----------------------
P. goes on decreasing. This is the phase of ‘Diminishing Returns’. This
---------------------- phase may also be called the phase of ‘Diminishing Marginal Returns’.
Thus, we observe that the ‘Law of Diminishing Marginal Returns’ (M. P.)
---------------------- is in operation in the third phase.
---------------------- Thus, the Law of Returns states that, if one factor of production (Land
or Capital) is held constant and other factor is varied, for sometime the Law of
---------------------- Increasing Returns, then the Law of Constant Returns and finally the Law of
---------------------- Diminishing Returns come into operation.
Diagrammatic illustration of the law of diminishing returns (variable
---------------------- proportion)
---------------------- Three stages of the Law of Variable Proportions or diminishing returns
---------------------- Fig 6.1 is a diagrammatic presentation of the Laws of Returns roughly
representing the figures in the table given before.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Three stages of the law of diminishing returns (variable proportions)
----------------------
point H is the maximum point of T. P. when M. P. = O.
It will be observed from the figure that the T. P. curve goes on increasing Notes
to a point and after that it starts declining. A. P. and M. P. curves also rise
and then decline. M. P. curve starts declining earlier than the A. P. curve. The ----------------------
behaviour of the output when the varying quantity of one factor is combined
with a fixed quantity of other can be divided into three distinct stages, which are ----------------------
explained below : ----------------------
Stage I : Increasing Returns
----------------------
In this stage T. P. to a point increases at an increasing rate. In the figure
from the origin to the point F, slope of the total product curve T. P. is increasing ----------------------
i.e. up to the point F, i.e. T.P. increases at an increasing rate, which means that
----------------------
M. P. rises. From the point F onwards during the Stage 1, the T. P. curve goes
on rising but its slope is declining which means that from point F onwards the ----------------------
T. P. increases at a diminishing rate i.e. M. P. falls but it is positive. The point
F where the total product stops at an increasing rate and starts increasing at a ----------------------
diminishing rate is called the ‘point of inflexion’. Corresponding vertically to
----------------------
this point of inflexion, M. P. is maximum, after which it slopes downwards.
The stage I ends where the AP curve reaches its highest point S. Stage 1 ----------------------
is known as the stage of ‘increasing returns’ because A. P. of the variable factor
----------------------
increases throughout this stage. It should be noted that the M. P. in this stage
increases but in a later part it starts declining but remains greater than the A. P. ----------------------
so that the A. P. continues to rise.
----------------------
Stage II : Diminishing Returns
In stage II, the T. P. continues to increase at a diminishing rate until it ----------------------
reaches its maximum point H where the second stage ends. In this stage both ----------------------
the M. P. and A. P. of the variable factor is zero (when T. P. is highest as shown
by point H). Stage II is important because the firm will seek to produce in its ----------------------
range. This stage is known as the ‘stage of diminishing returns’ as both the A. P.
and M. P. continuously fall during this stage. ----------------------
Stage III : Negative Returns ----------------------

In stage III, T. P. declines and therefore T. P. curve slopes downwards. As ----------------------
a result M. P. of the variable factor is negative and the M. P. curve goes below
the X axis. This stage is called the stage of negative returns, since the M. P. of ----------------------
the variable factor is negative during this stage.
----------------------
Explanation of the Various Stages
----------------------
1) Increasing returns : In the beginning, the quantity of fixed factor is
abundant relative to the quantity of the variable factor. As more and more ----------------------
units of variable factors are added to constant quantity of fixed factor then
fixed factor gets more intensively and effectively utilised and production ----------------------
increases at a rapid rate. ----------------------
Let us consider the example through the table mentioned in the three
stages of law of variable proportion. Through out the three stages fixed ----------------------
variable i.e. machinery (capital) remains constant. The variable factor i.e. ----------------------

Notes number of workers increase as a firm expands its production. A worker
contributes 5 units per day to the firms’ output. The total product reaches
---------------------- 50 units per day when the 4th worker contributes to the production. Fuller
utilisation of capital is possible due to the addition of a variable factor.
---------------------- One worker cannot take full advantage of the capabilities of capital. When
---------------------- the fourth worker joins it is possible to use the full potential of the capital.
Moreover, increasing returns can also be attributed to the principle of
---------------------- division of labour or of specialisation of work. The question may arise
that if fixed factor is abundant as compared to variable factor, why fixed
---------------------- factor be not taken in accordance to the availability of variable factor. The
---------------------- answer is that fixed factors are fixed i.e. they are indivisible. The number
of machinery cannot be changed in the short run.
----------------------
A tailoring house has four machines and four workers. Each worker
---------------------- gets one machine to himself, he can work effectively, independently and
diligently. He can sort out his own time as he doesn’t have to share the
---------------------- machine with anybody. There is general understanding. Orders can be
fulfilled in time and without chaos. Number of outfits stitched is on the
----------------------
rise.
---------------------- 2) Diminishing returns : The peculiar feature of this stage is that the
marginal product falls through out the stage and finally touches to zero.
----------------------
Corresponding vertically is the point H which is the highest point of the
---------------------- TP curve. Here stage II ends.
In continuation of the above example, let’s say when the fifth and sixth
----------------------
worker came into picture, they came in to good spirit. Others are willing
---------------------- to share their machine during their respective lunch times. Work proceeds
but at a slower rate since one what man would work independently is not
---------------------- the case completely now. There is machine and time sharing and thereby
birth of constraints. The increase in output is existent but not good enough,
----------------------
thus the firm floats in the area of constant returns.
---------------------- In the table given on page 147, the third stage is set in by hiring 7th
---------------------- worker who adds only 15 units per day as compared to 20 units per day
added by the 6th worker. Total product increases but gain form 7th worker
---------------------- is not as great as gain from 6th worker. Explanation to this can be given
as once the point is reached at which variable factor is sufficient to ensure
---------------------- full utillisation of fixed factor, then further increase in variable factor will
---------------------- cause MP as well as AP to fall because fixed factor has now become
inadequate (as against it was abundant earlier) relative to the quantity of
---------------------- variable factors. In stage II, fixed factor is scarce as compared to variable
factor. According to Mrs. Joan Robinson, a famous economist, the factors
---------------------- of production are imperfect substitutes for one another, the stage of
---------------------- diminishing returns occur. Fixed factor is scarce and variable factor then
fixed factor would not have remained scarce. The paucity of fixed could
---------------------- have been made up by such perfect substitutes. If one of the variable
factors added to the fixed factor were a perfect substitute, deficiency of
---------------------- fixed could have been made up but elasticity of substitute between factors

is not infinite, substitution is not possible and diminishing returns occur. Notes
The fixed factor [for tailoring machines] is constant. This firm is in no
----------------------
position at the moment to purchase more. So the firm necessarily has to
operate within the set provisions. With the entry of more workers the firm ----------------------
ceases to function at optimum level. One saying can be aptly put in here:
“too many cooks spoil the broth.” In our case there are too many tailors ----------------------
here who spoil the show. Lack of time management, interference, lack
----------------------
of cordial relationship amongst workers, element of jealously, feeling
of cutthroat competition, one trying to overpower the other [“who takes ----------------------
maximum orders and who fulfills the quickest”] leading to decline in
quality of work, in the quest of running behind quantity of work. ----------------------
3) Negative returns : In this stage, marginal product falls below ‘X’ axis ----------------------
i.e. negative because total product starts falling. In our example this is
set in by hiring 13th worker. The total product falls from 127 units to 118 ----------------------
units. The large number of variable factors impairs the efficiency of the
----------------------
fixed factor. The excessive variable factor as compared to less fixed factor
results in a fall of total output. In such a situation, a reduction in the units ----------------------
of the variable factor will increase the total output.
----------------------
Finally, the situation reaches at its worst, when workers are all getting
clustered under one roof. The work gets clogged.There is complete ----------------------
unhealthy and inefficient environment at this particular workplace. The
only alternative now is to take more machines [increase fixed capital] or ----------------------
decline the workforce.
----------------------
(C) Limitation of the Law of Diminishing Returns
----------------------
There are a number of exceptions to this law. This law does not apply to
all conditions in agriculture. ----------------------
(1) New methods of cultivation ----------------------
As mentioned earlier, this law assumes no change in the technique
----------------------
of production. Scientific rotation of crops, better quality seeds,
modern implements, fertilizers, better irrigation facilities, however ----------------------
are the changes which take place in agriculture. The marginal
product under these conditions, will infact increase. New methods ----------------------
of cultivation, therefore, are an exception to the law.
----------------------
(2) New Soil
----------------------
When new land (soil) is brought under cultivation, the marginal
product will increase for a time; thus the law of diminishing returns ----------------------
does not operate in the beginning.
----------------------
(3) Insufficient Capital
If capital is not sufficient, increased used of capital, will give more ----------------------
than proportionate return, but later the marginal return will decrease. ----------------------
The early stage is an exception to the law of variable proportion.
----------------------

Notes (D) Application of the Law of Diminishing Returns
The law of diminishing returns applies to agriculture, because land is
----------------------
fixed. From society’s point of view, as Ricardo assumed and other factors
---------------------- are variable. However, the law has universal application and operates
in all fields of productive activity where one or more fixed factors are
---------------------- combined with one or more variable factors.
---------------------- Thus, if in industrial enterprise capital is kept fixed and other factors are
increased, the marginal product will initially increase but will ultimately
---------------------- diminish.
---------------------- Thus, the law also operates in industries like mining, fisheries and also in
building industries.
----------------------
---------------------- 7.7 RETURNS TO SCALE OR LAWS OF RETURNS TO SCALE
---------------------- Under the law of diminishing returns (i.e. variable proportion) we have
studied the behaviour of output (T. P., M.P. and A. P.) when factor proportions are
---------------------- changed. That is, we have seen the behaviour of output by keeping the quantity
of one or some factors fixed and changing the quantity of other (e.g.labour).
----------------------
Now, we will undertake the study of changes in output when all factors of
---------------------- production or inputs are increased together. In other words, we shall now study
the behaviour of output in response to changes in scale. An increase in the scale
----------------------
means that all inputs or factors are increased in the same proportion. Increase
---------------------- in the scale thus occurs when all factors or inputs are increased keeping factor
proportions unchanged. The study of changes in output as a result of changes in
---------------------- the scale forms the subject matter of “returns to scale”.
Y
----------------------
----------------------
Constant Returns To Scale
----------------------
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Marginal Product
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----------------------
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----------------------
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----------------------
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----------------------
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---------------------- O
Scale or Proportion
---------------------- Fig 7.2 : The Laws of Returns to Scale
---------------------- 1) Law of Increasing Returns to Scale
---------------------- Meaning : If the increase in all factors leads to more than proportionate
increase in output, returns to scale are said to be increasing. Thus, if all
---------------------- factors are doubled, and output increases by more than double, then the

returns to scale are increasing. If for instance, all inputs are increased by Notes
25%, and output increases by 40% then the increasing returns to scale
will be prevailing. This is because of greater specialisation of labour and ----------------------
machinery. This phenomenon according to Prof. Baumol also occurs
because of dimensional relations. For example, if the diameter of a pipe is ----------------------
doubled, the flow of water through it is more than doubled. Another reason ----------------------
for increasing returns is because of the indivisibility of some factors.
These factors are available in large and lumpy units and can therefore be ----------------------
used with utmost efficiency at only larger output. This reason is given by
Prof. Mrs. Joan Robinson, Kaldor and Lerner. ----------------------
2) Law of Constant Returns to Scale ----------------------

Meaning : If we increase all factors of production (i.e. scale) in a given ----------------------
proportion and the output increases in the same proportion, returns to
scale are said to be constant. Thus, if doubling or trebling of all factors ----------------------
causes a doubling or trebling of output, returns to scale are constant. In
----------------------
mathematics, the case of constant returns to scale is called ‘ linear and
homogeneous production function’ or ‘homogeneous production function ----------------------
of the first degree’.
----------------------
3) Law of Diminishing or Decreasing Returns to Scale
Meaning : If the increase in all factors leads to a less than proportionate ----------------------
increase in output, returns to scale are decreasing. When a firm goes on ----------------------
expanding all its inputs, then eventually diminishing returns to scale will
occur. Diminishing returns to scale eventually occur because of increasing ----------------------
difficulties of management, coordination and control. When the firm has
expanded to a too gigantic size, it is difficult to manage it with the same ----------------------
efficiency as previous. This in other words, means that the firm starts ----------------------
suffering from the diseconomies of scale.
----------------------
7.8 ECONOMIES AND DISECONOMIES OF SCALE
----------------------
Introduction
----------------------
An attempt is made in this sub -unit to outline the economies of large - scale
production with reference to the Laws of Returns. ----------------------
(A) Diseconomies of Small-Scale Production ----------------------
Any firm, which is newly established, operates on a small scale in the
----------------------
initial stages. Production on a small scale is, however, found to be
disadvantageous on the following grounds. ----------------------
(1) A new firm is required to acquire land, construct factory building,
----------------------
install machinery and provide other infrastructural facilities. A lot of
time is wasted in erecting the factory. Meanwhile, the firm has to spend ----------------------
on preliminary expenses. All these expenses are debited to the profit
and loss account for the first operating year. If the total expenditure ----------------------
incurred during the first year is taken into account, the average cost of
production works out to be very high in the initial stages. ----------------------

Notes (2) The workers appointed in the factory take some time to adjust
themselves to the techniques of production. Till this adjustment is
---------------------- made, there is a lot of wastage of raw materials and power. Naturally,
the average cost of production is high.
----------------------
(3) In the initial stages, production is on a small scale because the
---------------------- product is not yet known in the market. The firm is not sure whether
the entire production would be sold. Every new firm, therefore,
---------------------- decides to produce on a small scale till it gets a ‘real feel of the
market’. In the initial stages small - scale production may, therefore,
----------------------
lead to a high average cost and losses.
---------------------- (B) Economies of Scale
---------------------- But with the passage of time, the firm is fairly established in the market. Its
products are constantly in demand. The workers also acquire proficiency
---------------------- in producing high quality goods. As a result, the firm decides to increase
the scale of production. Ultimately, a number of economies of scale
---------------------- accrue to the firm. These economies are classified as internal and external
---------------------- economies. It is worthwhile to explain the economies at length :
Internal economies are those advantages of large - scale production
---------------------- which accrue to a firm on account of its superior techniques and
management. They are broadly classified under the following heads:
----------------------
(1) Technical Economies
----------------------
A firm that produces goods on a large scale can install improved and
---------------------- up - to - date machinery. On account of new machines, a firm is able to
effect a substantial reduction in the cost of production. It is also possible
---------------------- in a big firm to avail the benefits of specialisation and division of labour.
Quality of goods produced by such a firm is, therefore, superior.
----------------------
Let’s say take an example of potato chips. The difference between
---------------------- homemade chips or a local brand and that of a big company like
‘Lays’. The former will utilise primitive methods of production,
---------------------- whereas the latter will employ superior state-of-art technology.
---------------------- The established firm employs division of labour, decentralization of
work and hence different sectors handle different lines of work. There
---------------------- is an efficiency of work, time management, optimum utilisation of
available resources, whereas in case of the local brand it is just the
----------------------
reverse; all work clogged under one head, thereby wastage of time
---------------------- and other resources, a very chaotic atmosphere very likely to exist.
Specialisation can be seen in a big firm, not so in a small one,
----------------------
thereby we can say that one is at his best at whatever he can do. For
---------------------- example, selecting good potatoes from the bad ones can be done
manually (a machine cannot be doing this job), but the thin slicing
---------------------- of the same of course is the department of a machine.
---------------------- Thus, the quality is good, the time is less and so is the cost of
production and thus a lower average cost of production (this term -
---------------------- is explained in the next unit).

(2) Commercial Economies Notes
A firm that produces on a large - scale is required to buy raw
materials on a large - scale. Bulk buying enables a firm to procure ----------------------
the materials at a lower cost. A firm making purchases on a large ----------------------
scale acquires a strong bargaining power in the market. It can secure
favourable credit terms from the suppliers. A big firm can negotiate ----------------------
with transport operators and can secure concessional freight rates
for transportation of raw materials and finished products. A big firm ----------------------
enjoys high reputation and its products are in constant demand in
----------------------
the market.
In case of the established firm, because of large scale production, ----------------------
the inputs required are also to be purchased on a big scale, e.g.
obviously potatoes (in our example). They can be even purchased ----------------------
at a rate lower than the whole sale market price. The price can be ----------------------
negotiated at source. The firm is buying on a regular basis, a buyer
for all seasons, at all times of the year. It is even not a perishable ----------------------
product. They have a name in the market and thus enjoy a command
able position in the market. Therefore, the raw-materials’ suppliers ----------------------
do not want to lose such a customer.
----------------------
(3) Managerial Economies
----------------------
A firm producing on a large scale can afford to hire the services of
expects in various fields such as purchases, production, marketing ----------------------
and finance. These experts utilise their knowledge and experience
towards maximization of profits. ----------------------
Needless to say, that the salaries can he higher than those in the ----------------------
unorganised sector like the local brand. The former invites a
competent flow of management, which can still help the firm to ----------------------
push up its output in a big and efficient way.
----------------------
Today management being such a competent field, to grab the
smartest lot, a firm has to be ready to fulfill their expectations. ----------------------
To get the expertise and to drive the business to higher grounds,
management today demands a high bargaining power in today’s ----------------------
context.
----------------------
(4) Financial Economies
----------------------
A firm which is producing on a large scale can avail of the benefits
of cheaper finance. A firm which has acquired reputation and a high ----------------------
credit - rating can raise new capital quickly, easily and on much
favourable terms. ----------------------
Banks are willing to forward loans who have a strong footing in ----------------------
the market and a good credential as a repayer. To keep up to its
clientele list (yes, who the banks’ customers are matters; it has a ----------------------
reputation to protect!), the banks would be ever willing to hone
their policies and the repayment schemes. Thus, a bog firm enjoys ----------------------
the status showered by the banks as well. ----------------------

Notes (5) Risk and Uncertainty
A firm which produces on a large scale can earn large profits. It
---------------------- can build up huge reserves out of undistributed profits. Capacity of
---------------------- such a firm to sustain losses is, therefore, big. On the other hand,
a smaller firm with slender reserves cannot withstand the losses
---------------------- incurred in the business.
‘Lays’ caters to areas spread across the country. Maybe one city
----------------------
shows a loss (or insignificant profit) from small-time towns in the
---------------------- South, where people are accustomed to eating home-made banana
chips – more popular there, but the metros and hill stations are
---------------------- doing well. The brand is very popular there and the general public
do not really have any bias against it. These places command a
---------------------- good demand than let’s say small conventional towns. The response
---------------------- varies from place to place. The product overall does well. So the
risk in tapping new market is more or less taken care of because the
---------------------- product being already established in other cities.
---------------------- (C) External Economies

The above advantages of large - scale production may accrue to an
---------------------- individual firm because they arise out of the superior technique and
management of the firm. If in a particular region, many such firms are
----------------------
concentrated they may promote some common activities. These activities
---------------------- may bring several benefits for all the firms, in an industry. For example,
in such a region facilities of transport, banking, post - office etc. may be
---------------------- developed and all the firms can take the benefits of these services. What is
more important is that, a number of new firms dealing in ancillary products
---------------------- are developed in this region. These firms may manufacture spare parts on
---------------------- a large scale. The big firms can buy the spare parts at a lower cost. If the
big firms produce the spare parts themselves, the cost would be higher.
---------------------- It would, therefore, be profitable for big firms if they buy the parts from
small firms. Similarly, various firms concentrated in a particular region
---------------------- can start a Research Institute. The benefits of this research can be passed
on to all the firms. All such economies are called external economies.
----------------------
The benefits that a particular firm enjoys is not necessarily because of its
---------------------- in house efforts. But the benefits have arisen due to the expansion of the
industry as a whole. For example, the industrial belt at Pimpri-Chinchwad
----------------------
is a flourishing ground for both small and big scale production units. For
---------------------- example, the Maruti service center is housed there in and also the Auto
Mart that deals in second hand cars. Thus, this area becomes a birth
---------------------- ground for shops dealing in car accessories, tyres, auto-mechanic centers
and service stations.
----------------------
Similarly, even the IT park at Hinjewadi has a credential of housing
---------------------- several developed as well as developing software companies. The BPO
uprising is on a fast track and thus a major source of employment in India
---------------------- today. The hours are tedious but the money is good which hence attracts
a good work force.
----------------------

(D) Diseconomies of Large-Scale Production Notes
Large - scale production may encounter certain diseconomies and
disadvantages. In course of a firm’s expansion, a stage may be reached ----------------------
when the firm becomes too large to manage. It may face several problems ----------------------
just because its size has become very large. Let us note these disadvantages
of large - scale production. ----------------------
Internal and External Diseconomies
----------------------
As a firm expands beyond a certain limit, it becomes unmanageable and
unwieldy. The top executive may find it impossible to look into even the ----------------------
broad functioning of various departments. Delegation of responsibilities
----------------------
and decentralization of very large number of work cannot be stretched too
far. Co-ordination of various activities becomes impossible. A very large ----------------------
number of workers may cause factions and groupism amongst them. This
may disturb the healthy atmosphere and may cause indiscipline, quarrels, ----------------------
and rivalries. A large establishment with thousands of employees makes
work impersonal and the relations between the employers and employees ----------------------
becomes formal. This fact causes strains on industrial relations. With ----------------------
increase in the number of salaried administrative, managerial and sales
staff, personal touch with dealers and customers is lost. As these salaried ----------------------
employees have to stake in the company, efficiency, urge, punctuality,
integrity and inventiveness disappear and their place is taken by ----------------------
disinterestedness, routine dealings and work to rule.
----------------------
The internal diseconomies of large-scale production can be
summarised thus: ----------------------
(1) Management and supervision becomes difficult and waste of time ----------------------
and material results.
There could be a cluster with supervisors. Their responsibilities and ----------------------
work centers have to be carefully defined and segregated, lack of ----------------------
which of these can be every room for confusion and bad “isms” in
the firm. Lack of discipline and communication can bring down the ----------------------
firm’s productivity to a large-scale.
----------------------
(2) For want of a personal touch, strikes, lockouts and such other
eventualities causing stoppage of work or obstructions to work ----------------------
increase.
----------------------
Miscommunication houses a lack of cordial relations. Insecurities
and unhealthy work environment within the firm crop up. This in ----------------------
turn harms the organisational and functional powers that can bring
about a compete stoppage to its working. ----------------------
(3) No direct contact with customers is possible. So, tastes of consumers ----------------------
are ignored. Products are standardized and no specialised services
to consumers are possible. ----------------------
The customer has to buy whatever is available in the market, at ----------------------
best what the firm can offer. Standardisation of product has certain
limitations to meeting customer requirements and so customer ----------------------

Notes satisfaction. A customer may have to club several products to satisfy
his one need. This is the reason, why many people get furniture
---------------------- items tailor-made to the needs of their homes; they hire carpenters
who do a neat job, suiting their requirements. Many a time, ready-
---------------------- made furniture items or certain fittings do not go with the tastes
or are very stereotyped. Thus, one has to get the carpenters, get
----------------------
the material, and decide the colour schemes to achieve aesthetic
---------------------- satisfaction.
(4) Large- scale production may cause overproduction and this may
----------------------
result in losses.
---------------------- Let’s say a machine makes 20 bags of milk every hour. Now for
a particular day the order supposedly is for 110 bags. Then the
---------------------- dilemma is either to fulfill the order (but then it is a direct case of
---------------------- over-production of 10 bags of milk) or let go of 10 bags of milk i.e.
supply only 100 bags of milk to the extent of machine capacity.
---------------------- (5) Large producers have to fight for capturing and maintaining markets.
---------------------- This may result in cut-throat competition.
There is a waging price-war. Each firm wants to popularise its
---------------------- product and is in the quest to do so, has to indulge in a huge amount
of money in advertising. In today’s context, advertising budgets are
----------------------
unimaginably high. The firms take in popular stars to have a high
---------------------- standing in the market. One firm starts a trend and the others have
to follow it to survive, be it initial ‘promos’ (as it is very popularly
---------------------- termed), on various channels, hoardings at major city points, banners
outside colleges (to popularise the brands amongst youngsters),
---------------------- right from leaflets to probably a web-site on the internet, etc. A
---------------------- weak fish cannot survive in a big pond!
(6) Large firms cannot easily adapt to ups and downs in business.
----------------------
(7) Large-scale production may involve imports of raw materials and
---------------------- exports of products.
---------------------- For instance, when a big firm goes into collaborations with a foreign
company, apart from the manufacturing unit, there are many things
---------------------- that the company has to cater to. There are guests (the CEOs of
foreign companies visiting them), they might need (language)
---------------------- interpreters, they have to be very hospitable, arrange for seminars
and the like, and above all show that they are performing their duties
----------------------
responsibly and that they have a good catch of the market. This
---------------------- is not an easy task and needs a lot of careful attention and funds
in various streams. Since they are to import foreign technology,
---------------------- government sanction in view of import licenses and thus need for
foreign exchange is of prime importance. All these factors would
---------------------- be difficult for a small-scale unit. At the same time, a popular firm
---------------------- always has to be more careful with its market gimmicks, since it is
always in the cynosure of public attention.
----------------------

(8) There are additional elements of risk due to possibilities of war, Notes
changed international relations and so on.
Expansion of industry and overcrowding of industrial units in ----------------------
a locality also causes diseconomies which can be called external ----------------------
diseconomies. The competition among firms to secure raw materials
and other resources for itself causes their prices to rise. Moreover, ----------------------
with increase in demand for resources, additional resources which
become available are naturally of a lower quality compared to those ----------------------
already employed. For example, the best workers are selected first
----------------------
and as more and more workers are required, a firm has to appoint
whoever are available rather than who are suited for the work. Thus, ----------------------
not only wage - rates increase, but productivity per worker goes
down. The same applies to machinery spare parts, raw materials, ----------------------
distribution channels and so on.
----------------------
Similar external diseconomies flow from concentration of
industries in certain localities. Overcrowding of cities, traffic ----------------------
congestion, pollution of air and water, strain on civic amenities
like drinking water, public health, sanitation etc. and problems of ----------------------
housing, education, medical care and law and order are some of the
----------------------
consequences. They affect efficiency of labour, availability of quick
transport, timely deliveries of finished products and an overall strain ----------------------
on the whole industrial system.
----------------------
1. The law of variable proportion examines the __________ with one ----------------------
factor variable, keeping the quantities of other factors fixed.
----------------------
2. The law of diminishing returns is now known as the “law of
__________________”. ----------------------
3. According to law of diminishing or decreasing returns to scale, if the ----------------------
increase in all factors leads to a ____________ proportionate increase
in the output, the returns of scale are decreasing. ----------------------
1. In the law of variable proportions, the homogeneous nature of units of
----------------------
variable factors is not necessary to be an assumption.
2. According to law of increasing returns to scale, if the increase in all ----------------------
factors leads to more proportionate increase in output, returns to the ----------------------
scale are said to be increasing.
----------------------
----------------------
----------------------

Notes
Activity 2
----------------------
---------------------- 1. Prepare a hypothetical example representing the law of variable

proportions. Explain the three stages on the basis and the reasoning
---------------------- of your example. You have to include ten labourers.
---------------------- 2. Can you highlight the three stages of “returns to scale” using a
numerical example?
----------------------
---------------------- Summary
---------------------- ●● This unit, at its outset, introduces us to the concept of ‘Production
---------------------- Function’. Its definition and the three different ways of studying it brought
about very significantly. It is given as the relationship between the rates of
---------------------- input of productive services and the rate of output of a product.
---------------------- ●● The Law of Variable Proportion, the Law of Returns to Scale and Optimum
combination of inputs are the different heads of study.
---------------------- ●● The Production Function has been given as the functional relationship
---------------------- between quantity of Output and the quantities of different factors.
---------------------- Keywords
---------------------- ●● Production function : Relation between input and output.
---------------------- ●● Disguised Unemployment : When a factor is employed, but is not
contributing to its fullest available capacity.
----------------------
●● Increasing Returns : Total output increases at an increasing rate with the
---------------------- increase in factor employment.
●● Diminishing Returns : Total output increase at a decreasing or
----------------------
diminishing rate with the increase in factor employment.
---------------------- ●● Internal Economies : Advantages that accrue to a firm because of
superior techniques and management.
----------------------
●● External Economies : Advantages which accrue to a firm because of
---------------------- factors that are external to the firm.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Notes
----------------------
1. Explain the Law of Variable Proportion with the help of three stages.
2. Bring out clearly the meaning of the concept ‘Production Function’, ----------------------
complete with its practicability for a production unit.
----------------------
3. Explain graphically the different Laws of Returns to Scale.
----------------------
4. Differentiate between
a. Short Run and very Long Run ----------------------
b. Marginal Product and Average Product ----------------------

c. Internal and External Economies of large-scale production ----------------------
d. Internal and External Diseconomies of large-scale production ----------------------
5. Differentiate between the Law of Variable Proportion and Returns to Scale.
----------------------
Answers to Check your Progress ----------------------
1. Production function is the relation between input and output.
----------------------
2. Very long run is the period of time, long enough that the whole new
technology can be introduced and the production function itself is ----------------------
changed.
----------------------
----------------------
1. True.
2. False ----------------------
3. True ----------------------
Fill in the blanks.
----------------------
1. The law of variable proportion examines the production function with
one factor variable, keeping the quantities of other factors fixed. ----------------------
2. The law of diminishing returns is now known as the “law of variable ----------------------
proportions”.
----------------------
3. According to law of diminishing or decreasing returns to scale, if the
increase in all factors leads to a less than proportionate increase in the ----------------------
output, the returns of scale are decreasing.
----------------------
----------------------
1. False
2. True ----------------------

Notes
Suggested Reading
----------------------
1. Keat, Paul G, and Philips, K. Y. Young. 1996. Managerial Economics.
---------------------- New Jersey: Prentice Hall.
2. Maheshwari, Yogesh. 2009. Managerial Economics. New Delhi: Sultan
----------------------
Chand & Sons.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Production and Costs - II
UNIT
8
Structure:
8.1 Cost Concepts (Meaning and Importance)

8.2 Accounting Costs
8.3 Economic Costs
8.4 Opportunity Costs
8.5 Explicit and Implicit Costs
8.6 Other Production Costs
8.7 Firms’ Cost Curves
8.8 Determinants of Costs
8.9 Break-Even Point
Summary
Key Words
Suggested Reading
Production and Costs - II 165

Notes
Objectives
----------------------
----------------------
• Define cost of production
----------------------
• Recognise different types of costs of production
---------------------- • Differentiate between economic profit and accounting profit
---------------------- • Compute and represent the cost curves of a firm with the change in
output and factor employment
----------------------
• Judge the performance of a firm on the basis of its cost-output and
---------------------- cost-input relationship
----------------------
---------------------- 8.1 COST CONCEPTS (MEANING AND IMPORTANCE)

---------------------- The cost of production of an individual firm has an important influence
on the market supply of a commodity. The product prices are determined by
---------------------- the interaction of the forces of demand and supply. We have seen that the basic
factor underlying the ability and willingness of firms to supply a product in the
----------------------
market is the cost of production. A firm aims at maximizing its profits; profits
---------------------- depend on the costs of production and the prices of products. Thus, given the
market price of the firm’s product, the amount a firm is willing to supply in the
---------------------- market will depend on the cost of production. It is therefore, necessary to have
a clear idea about the concept of the cost of production.
----------------------
Costs may be nominal costs or real costs. Nominal cost is the money
---------------------- cost of production. It is also called expenses of production. The real cost is the
---------------------- opportunity cost of production (see below). Money costs and real costs do not
coincide with each other.
----------------------
8.2 ACCOUNTING COSTS
----------------------
Accounting costs are the costs of production of a firm. These are money
----------------------
costs or expenses of production. These costs are paid for by the producer and
---------------------- are also known as entrepreneur’s costs. These are the explicit costs, and they
enter the accounts books of the firms. These costs include : (i) wages to labour,
---------------------- (ii) interest on borrowed capital, (iii) rent or royalty paid to owners of land
which is borrowed by the firm, (iv) cost of raw materials, (v) replacement and
----------------------
repairing charges of machinery, (vi) depreciation of capital goods, and (vii)
---------------------- normal profits of the manufacturer (amount sufficient to induce him to continue
production).
----------------------
----------------------
----------------------

Accordingly costs may be classified as : (a) Production costs, including Notes
material costs, wage cost and interest cost (b) Selling costs, including costs of
advertising and (c) Other costs, including insurance charges, taxes etc. ----------------------
These accounting costs are important from the point of view of the ----------------------
producer. He must make sure that the price of the product, must cover these
costs and normal profits, or else, he cannot afford to continue production. ----------------------
How do we measure the cost of inputs? ----------------------
Economists might want to discuss the production behaviour of firm for a number
----------------------
of reasons:
(a) To predict how the firm’s behaviour will respond to a given change in the ----------------------
conditions it faces. ----------------------
(b) To help the firm make the best decisions that it can in achieving its
objectives. ----------------------
(c) To find out how well the firms use scarce resources. ----------------------
The same measure of cost may not be correct for each of these purposes. ----------------------
Economists know exactly how to define costs in order to solve problems
----------------------
like (b) and (c). Only if we assume that, the businessman (accountant) uses the
same concept of costs, the economist’s definition will be useful for problems ----------------------
like (a).
----------------------
The economic costs are based on a common principle that is sometimes
called user cost, but is commonly known as opportunity cost. ----------------------
8.3 ECONOMIC COSTS ----------------------
The economist’s idea of cost is based on the fact that resources are scarce ----------------------
and have alternative uses. Thus, if resources are used for the production of some
----------------------
commodities, then it means that the production of some alternative commodities
are foregone. ----------------------
Thus, by economic costs it means those payments which must be received
----------------------
by resource- owners in order to ensure that they will continue to supply the
resources for production. ----------------------
Explicit costs, implicit costs and normal profits together form the total ----------------------
costs of a firm or Economic Cost = Explicit Costs + Implicit Costs + Normal
Profits. ----------------------
8.4 OPPORTUNITY COSTS ----------------------
----------------------
Since productive resources are limited, the production of one commodity
can only be at the cost of another.The commodity that is sacrificed is the ----------------------
opportunity cost of the commodity produced. Thus, economists define the cost
of production of a particular product as the value of the foregone alternative ----------------------
products, that resource used in its production could have produced.
----------------------

Notes The opportunity cost of a product, is therefore, the opportunity lost of not
being able to produce some other product.
----------------------
Given the resources, a firm can either produce plastic household items
---------------------- or toys (stuff toys excluded). Now the situation is such that if the firm goes
in for one line of production, then it loses the other one. It cannot have both.
---------------------- Producing one type forgoes the opportunity to have the other. The major raw
material can be moulded to produce either of the two, as allowed by the exiting
----------------------
plant capacity, resource availability, labour employment, subordinate resources
---------------------- availability and money resources. Thus, to live within the productivity of the
firm, it has to make the take one and leave the other !!
----------------------
Resources can be used for a number of purposes. The opportunity cost of
---------------------- these resources to a firm is the value in their next best alternative use.
Similarly, the available resources ca be put to use in a restricted way. Like
----------------------
‘plastic’ has alternative uses, but what about the total quantity of it available at
---------------------- the hands of the firm. Let’s say it has 100 tons of it, it can either go into fulfilling
100 orders of household items or 100 orders of children’s’ toys.
----------------------
Example
---------------------- Thus, if Rs. 20 lakhs are invested in project A at a 10 per cent rate of
---------------------- return, and if this amount was not invested in project A, it would have been
invested in project B (next best alternative use of Rs. 20 lakh) at 9 per cent rate
---------------------- of return. Then the opportunity cost of Rs. 20 lakh in project A is 9 per cent,
which is the value of this amount in its next best alternative use.
----------------------
Similarly, if a consumer uses Rs. 20,000 to buy a washing machine,
---------------------- he cannot use this money to buy a microwave oven. By buying a washing
machine, he has forgone the opportunity of buying a microwave oven. Thus,
---------------------- the opportunity cost of buying a washing machine is the opportunity cost of not
---------------------- being able to buy a microwave oven. Therefore, we can say that the opportunity
cost of producing X having considered Px in terms of Y given
----------------------
Px
---------------------- P.y is =
Py
---------------------- (a) Significance of Opportunity Costs
---------------------- The concept of opportunity costs is an important tool to measure the
implicit costs of a firm. The implicit costs distinguish the accounting
---------------------- costs from the economic costs. Thus, the economic profits to a firm can
---------------------- be calculated with the help of implicit costs of a firm, and these costs are
imputed on the basis of the opportunity cost principle. This concept is,
---------------------- therefore, used for, (a) measuring profits, (b) policy decision of the firms,
(c) forming capital budget and (d) alternatives available to the firm.
----------------------
The opportunity cost principle has a wide application in economic theory.
---------------------- It is useful in the determination of values internally and internationally. It
is also used to understand income distribution.
----------------------

(b) Limitations Notes
There are, however, some limitations in its application.
----------------------
(i) Specific : It does not apply to productive services which are specific.
A specific factor has no alternative use. Its opportunity (transfer) ----------------------
cost is, therefore, zero.
----------------------
For instance, a person trained in IT (information technology) and
an owner of a software developing firm will work at his best at his ----------------------
own workplace and only in his trained field. He is not trained to do
anything else. Also, he is a very self-respecting person, so he wil ----------------------
never give up his firm and work for anybody else for anything in ----------------------
the world. He will never be willing to give his services to any other
firm. Thus, he is a very special case and hence the opportunity cost ----------------------
of this particular productive service is zero.
----------------------
(ii) Factors are not homogeneous : Units of productive services are
not homogeneous, this obstructs their transfer. ----------------------
This may not always hold true. Let’s talk about labour again. Different
----------------------
people have different capacities to work. Their line of work may be the
same, all surrounding factors maybe the same, but personal capabilities ----------------------
may be different. Each unit of labour may contribute differently to the
total output of the firm. Labourers are not machines and thus should not ----------------------
be treated so. Also, we can say that the same person may put in different
----------------------
levels of productive service at different places, depending on the work
environment, working conditions, work timings, colleague relations, ----------------------
the distance to work (work travel) and of course the pay packets and the
perks given in addition to the basic salary which motivate the working ----------------------
lot more or vice versa.
----------------------
(iii) Wrong Assumptions : The theory is based on the assumption
of perfect competition which rarely exists (more on Perfect ----------------------
Competition in the next unit).
----------------------
(iv) Individual and Social Costs : A product may cost the firm Rs. 5,000
per unit, but to the society it will cost something in the form of bad ----------------------
- health due to the smoke and soot that this firm let out. This creates
----------------------
problems for measuring opportunity costs.
For instance, industrial belts are not popular with residential ----------------------
houses. Industries in a particular areas house smoke and unhygienic
environment, not fit for people to live in. Most people are not ----------------------
willing to go in for buying houses in such areas (though at times ----------------------
the rates are much lower than those in prime city areas) because
of the uncomfortable living conditions like (air) pollution as well ----------------------
as noise pollution, for example, a production unit of ball-bearings
produces a typical screeching sound that can be a nuisance to the ----------------------
neighbourhood. But when it comes to lowering down the rates of ----------------------
these places to reside, how much lower should one go in view of the
opportunity costs, is something very difficult to calculate. ----------------------

Notes Conclusion : Inspite of these limitations, the theory of opportunity costs,
is the most widely used theory of cost at present.
----------------------
----------------------
---------------------- Match the following.

---------------------- i. Type of cost a. Description.
ii. Nominal cost b. These are expenses of production.
----------------------
iii. Real cost c. It is the money cost of production.
---------------------- iv. Accounting costs d. It is the opportunity cost of production.
---------------------- 1. Empirical costs distinguish ____________costs from the

____________costs.
---------------------- 2. The concept of opportunity cost is used for measuring __________,
---------------------- ____________ of the firm, forming ______________ and alternatives
available to the firm.
----------------------
----------------------
Activity 1
----------------------
---------------------- 1. A producer is into the production of leather purses. He is at a point of

decision-making whether he should continue this line of production
---------------------- or not. He wants to weigh the firm’s performance level before he
---------------------- makes the right economic decision. You are to help him to sort out
his position. How will you go about it, considering the different
---------------------- costs involved?
----------------------
8.5 EXPLICIT AND IMPLICIT COSTS
----------------------
Costs of production have also been classified as explicit and implicit
----------------------
costs.
---------------------- From the point of view of the firm, we can say that economic costs are those
payments a firm must make, or incomes it must earn, to owners of factors of
----------------------
production to attract these resources away form other uses. These payments or
---------------------- incomes may be either explicit or implicit.
(a) Explicit Costs
----------------------
The money payment, which a firm makes to those ‘outsiders’ who
---------------------- supply labour services, raw materials, transport services, electricity
---------------------- etc. are called explicit costs. Thus, explicit costs are out - of - pocket
costs, i.e. payments made for resources purchased or hired by the firm.
---------------------- These are expenditure costs, like, the salaries and wages paid to the

employees, prices of raw materials, fixed or overhead costs, and payments Notes
into depreciation and sinking fund accounts. These are firm’s accounting
expenses. ----------------------
(b) Implicit Costs ----------------------
But in addition, the firm often uses resources which the firm itself owns.
----------------------
The costs of ‘self owned’ resources which are employed by the firm
are non-expenditure or implicit costs, like, the salary of the proprietor, ----------------------
or the interest on the entrepreneur’s own investment, rent on own land
used by the firm. ----------------------
To the firm the implicit cost are the money - payments which the self ----------------------
- owned and employed resources could have earned in their next best
alternative use. ----------------------
Thus, since implicit costs are non- expenditure costs and actual payment ----------------------
is not made, these costs have to be calculated or imputed. Implicit costs
are calculated on the basis of the opportunity cost principle. Implicit costs ----------------------
are ignored while calculating the expenses of production.These costs do ----------------------
not enter the account books of a firm.
(c) Normal Profits as a Cost ----------------------
Explicit costs, implicit cost and normal profits together form the full ----------------------
costs of a firm (economic costs). The entrepreneur must be sure of normal
profits if he is to continue in business. Thus, normal profits are also costs. ----------------------
(d) Economic (or Pure) Profits ----------------------

From the above discussion of accounting and economic costs, it becomes ----------------------
clear that economists and accountants use the term ‘profits’ differently.
By ‘profits’ the accountant means total revenue minus explicit costs. But ----------------------
to the economist ‘profits’ means total revenue minus all costs (i.e. explicit
----------------------
costs, implicit costs and normal profits).
Therefore, when an economist says that a firm is just covering its costs, ----------------------
he means that all explicit and implicit costs are being covered and that the ----------------------
entrepreneur is therefore, receiving a return just large enough to keep him
in his present job. If a firm’s total revenue is more than all the economic ----------------------
costs, then the residue is to the entrepreneur. This residue is economic or
pure profit. It is not a cost, because by definition, it is a return more than ----------------------
the normal profit required to keep the entrepreneur in his present line of ----------------------
production.
----------------------
8.6 OTHER PRODUCTION COSTS
----------------------
As discussed above, the term cost has varied meanings. We shall now
----------------------
discuss some important types of costs of production.
(1) Fixed Costs and Variable Costs (F.C. and V.C) ----------------------
This distinction between fixed and variable costs is relevant in the short ----------------------

Notes period only. In the short period, some factors, like capital, machinery,
land, management, are fixed and some factors, like labour, electricity,
---------------------- raw material, etc are variable. Costs on fixed factors are called fixed
costs and costs on variable factors are called variable costs. The costs,
---------------------- which remain fixed irrespective of the level of output, are called fixed
---------------------- costs. These costs remain fixed till the capacity output is reached. Fixed
costs include costs on capital, land, and salaries of top managers who are
---------------------- permanent employees.
---------------------- For instance, in today’s fast competing managerial environment, targets
are set up for the employees and so are set time-periods, withing which
---------------------- the employees have to show results or then they have to hear the music
from their bosses! If the music sounds good, then they get increments
----------------------
(income-raise) or else they see the Doom of Day!! Till the targets are
---------------------- reached, the salaries of the employees can be counted under Fixed Costs
of the firm.
----------------------
Also the rent on land or the apartment, in which the office is situated,
---------------------- comes under Fixed Costs in short period, since it is only in the long run
that the firm can look for a new place or a new property to up its plant or
---------------------- like.
---------------------- Variable costs are those costs, which vary with the level of output. Variable
costs include costs of raw material, electricity charges, wages etc. Fixed
---------------------- costs do not change with change in production. Variable costs, however,
change with the change in production. F.C. + V.C. = T.C. (Total Cost).
----------------------
Labour (especially the one from the unorganised sector) payment is under
---------------------- Variable Costs. The firm can take as much as it wants and retrench as
---------------------- much as it wants, when there is no written contract, for example, those
like the gardeners of the huge property or the sweepers or the bathroom
---------------------- cleaners or the watchmen- let’s say there are 4 of them at 4 different gates
of the estate and the firm decides, just one fine day to keep 1 watchman
---------------------- as a care-taker for two gate-points, in which case two existing ones have
---------------------- to be sent home. This is considered a simple decision with no heavy
complexities in most cases.
---------------------- In the long period, however all factors are variable and so all costs are
---------------------- variable. The difference between the fixed and variable costs disappears
in the long period.
---------------------- (2) Avoidable and Unavoidable Costs
---------------------- At times a firm faces a problem of retrenchment or contraction. Costs
which can be avoided due to contraction of the firm are called avoidable
----------------------
costs and the costs which cannot be avoided because of contraction are
---------------------- unavoidable costs. e.g. A firm decides to close it’s showroom. By closing
the showroom it can avoid the rent of the showroom, wages to workers in
---------------------- the showroom, electricity charges etc. these are avoidable costs. However,
it has to continue to employ the salesmen who move from place to place;
----------------------

the salaries of these salespeople cannot be avoided because of contraction Notes
of the firm; these become unavoidable costs.
----------------------
(3) Incremental and Sunk Costs
At times the firm undertakes expansion. It might set up a new factory or ----------------------
introduce a new product. Costs which increase because of expansion of
----------------------
a firm are called incremental costs, and costs which have to be borne
whether there is expansion or not are called Sunk costs. ----------------------
For example, if a firm wants to purchase a machine, it has to bear the
----------------------
following costs:
1) Cost of purchase. ----------------------
2) Installation charges. ----------------------
3) Maintenance charges
----------------------
4) Operational charges.
Now, instead of purchasing the machine a firm decided to hire a machine ----------------------
(not expansion), it does not have to bear the cost of purchase and the ----------------------
maintenance or installation charges. These are costs, which increase
only through expansion and are incremental costs. However, by hiring a ----------------------
machine the firm cannot avoid operational charges. These costs have to be
borne by the firm whether there is expansion or not; these are Sunk costs. ----------------------
For instance, a lady by the name Nancy has taken up a place on rent. ----------------------
The rest is Rs. 3,500/- and the name of the place is ‘Pastry Corner’. She
bakes fabulous cakes and pastries and makes a living on this. Now she ----------------------
intends to have extensions in her range of products. She now wants to ----------------------
include - as demanded by her friendly customers – other products like
puddings, deserts, ice creams, new flavours in the same as well in her ----------------------
cakes with more innovative kinds of icings etc. She also wants to do
up her shop with bright new colour schemes on the walls as well on ----------------------
the curtains and the overall set-up. This will mean more funds. These ----------------------
all come under ‘Incremental Costs’, but the rent that she pays remains
constant, irrespective whether she does the renovation or not. Thus this ----------------------
rent payment by Nancy comes under ‘Sunk Costs’.
----------------------
(4) Common and Traceable Costs
----------------------
Today, most firms are multiple product firms, i.e. firms producing more
than one product. Some costs are common to all the products of multiple ----------------------
product firm. These are Common Costs. However, there are some costs
which are Traceable to a particular product of a multiple product firm; ----------------------
these are called Traceable Costs.
----------------------
For example, consider a press, publishing a newspaper and a monthly
magazine, some costs like a cost of printer, salaries of publishers etc are ----------------------
common to both these products; these are common costs. However, the
----------------------
raw material used or a cutter used for the magazine or newspaper can be
specific to a particular product; these are traceable costs. ----------------------

Notes (5) Historical and Replacement Costs
Cost of purchase of a capital asset, when it was initially purchased, say,
----------------------
2011 is the historical cost of the asset. Over a period, the value of every
---------------------- asset depreciates; and a time comes when it becomes necessary to replace
the asset. The cost of the asset when it is to be replaced say in the year
---------------------- 2018, is the replacement cost of the asset.
---------------------- Replacement cost is highest for perishable goods, then comes in line the
non-perishable goods like commodities which you can use over a period
---------------------- of time, for example, vehicles, electronic goods, etc.
---------------------- Historical cost reduces because of two factors: namely (a) the depreciation
of the commodity because of its use over a period and (b) depreciated
---------------------- value because of the depreciation of the commodity claimed for income
tax.
----------------------
The historical value appreciates over a period of time, especially in case
---------------------- of immobile fixed assets like land, building, etc; moreover metals like
---------------------- gold.
(6) Short run and Long run costs
----------------------
All the costs discussed previously are important. However, for our
---------------------- present study we shall concentrate on firms fixed and variable costs. This
distinction between FC and VC depends on the time period. In the short
---------------------- period some costs are fixed and some are variable. We shall now study
---------------------- the short run costs with reference to total marginal and average costs. To
understand the meaning of these costs and relationship between them, we
---------------------- will make use of cost curves as shown on next page.
----------------------
8.7 FIRMS COST CURVES
----------------------
(A) Short run Cost Curves
---------------------- Short run is a period within which some costs change, (because some
---------------------- factors like labour change), whereas some costs do not change (because
some factors like machinery, capital, do not change). Thus, we talk of
---------------------- fixed costs and variable costs in the short run.
---------------------- (1) Total Fixed Costs (TFC):
Some factors like machinery, land, capital remain fixed in the short
----------------------
period, the total cost of all these factors is the total fixed costs.
---------------------- TFC’s do not change in the short period. They are the same for any
level of production (see figure mentioned below). The TFC curve is
---------------------- a horizontal straight line parallel to X axis.
---------------------- (2) Total Variable Costs (TVC) :
---------------------- Some factors like raw material, electricity, spare parts and labour
change as the output changes. The cost on these factors is the total
---------------------- variable costs. The total variable costs increase with increase in

production (see fig shown on next page). We have a rising TVC Notes
curve.
----------------------
(3) Total Costs (TC) :
The sum of total fixed costs and total variable costs is the total cost. ----------------------
This is the total cost of production.
----------------------
TC = TFC + TVC
----------------------
The TFC is constant, but TVC increases as production increases,
so TC also increases as production increases. The TC curve is also ----------------------
a rising curve and the vertical distance between the TVC and TC
curve, for any level of production is the same and is equal to TFC ----------------------
(see the figure shown on next page). ----------------------
Y
----------------------
TC ----------------------
TVC
----------------------
----------------------
----------------------
Cost
----------------------
TFC ----------------------
----------------------
----------------------
X
O
Production ----------------------
(4) Average Fixed Costs (AFC) and Average Variable Cost (AVC): ----------------------
AFC is the per unit fixed cost of production which is calculated as: ----------------------
AFC = TFC / Units of Output
----------------------
Since TFC is constant as production increases; the AFC decreases
as production increases (see fig. shown on the other page). ----------------------
AVC is the per unit variable cost of production which is calculated ----------------------
as
----------------------
AVC = TVC / Units of Output
The AVC curve is a U shaped curve, which means that, initially ----------------------
AVC decreases as output increases and later AVC increases as ----------------------
output increases (see fig. shown below).
----------------------
----------------------

Notes (5) Average Cost of Production (AC):
Average cost is the cost per unit of output produced which is
----------------------
calculated as:
---------------------- AC = TC / Units of output
---------------------- OR
---------------------- AC = AFC + AVC

The AVC curve is also a U shaped curve, which means that initially,
---------------------- AC decreases as output increases and later AC increases as output
---------------------- increases (see the fig. shown on the next page).
Y
---------------------- AVC MC
AFC AC AC
---------------------- AVC
----------------------
----------------------
----------------------
----------------------
MC
----------------------
----------------------
---------------------- AFC
---------------------- O X
---------------------- (6) Marginal Cost

---------------------- The Marginal Cost is the change in total cost caused due to one
additional unit of output produced. MC is therefore, the rate of
---------------------- change of total cost. It is calculated as,
---------------------- MC =  TC /  Output
---------------------- The MC curve is a U shaped curve which implies that the MC

decreases as output increases initially, but ultimately the MC starts
---------------------- decreasing with increase in Output (as shown in the above fig). this
also means that TC (and TVC) initially increases at a decreasing
---------------------- rate and later it increases at an increasing rate. The relationship
---------------------- between TVC and MC is the same as the relationship between TC
and MC because TVC changes at the same rate as TC, since TFC is
---------------------- constant.
----------------------
----------------------

MC = MVC + MFC, but MFC = 0, therefore, MC = MVC Notes
Also, the relationship between AVC and MC is the same as the
----------------------
relationship between AC and MC. Thus, the MC curve cuts both
the AVC and AC curves at their respective lowest points. ----------------------
Units Total Total Total Average Average Average Marginal
----------------------
of Fixed Variable Costs Fixed Variable Costs Costs
output Costs Costs (2) + (3) Costs Costs (5) + (6) ----------------------
(2) ÷ (1) (3) ÷ (1)
1 2 3 4 5 6 7 8 ----------------------
0 15 0 15 –– 0 –– ––
----------------------
1 15 5 20 15 5 20 5
2 15 9 24 7.5 4.5 12 4 ----------------------
3 15 12 27 5 4 9 3
4 15 16 31 3.75 4 7.75 4 ----------------------
5 15 25 40 3 5 8 9
----------------------
(B) Why Short Run Average Cost Curves are U-shaped?
----------------------
The average cost (AC) is made up of average fixed cost (AFC) and average
variable cost (AVC). ----------------------
The total fixed cost is fixed as output increases, so the AFC declines as
----------------------
output increases. In the initial stages the AVC also declines as output
increases. Thus, upto same level of output the AC (AFC + AVC) also ----------------------
declines as output increases. However, even though AFC falls continuously
as output increases, the AVC increases steeply, after reaching a minimum. ----------------------
This rise in AVC more than offsets the fall in AFC and the AC (AFC +
----------------------
AVC) starts rising as output increases.
We can explain the short-run average cost curves with the help of the Law ----------------------
of Variable Proportion.
----------------------
The marginal cost and average cost falls as output increases, in the initial
stage of production because : ----------------------
(i) The fixed factor is used in a better way in the initial stage of ----------------------
production therefore, the AFC falls steeply and thus AC falls steeply.
----------------------
(ii) The average variable cost falls initially till the normal capacity of
the machine is used up, because the variable factors are used only ----------------------
to assist the fixed factors, therefore initially AC falls steeply.
----------------------
But after a certain stage, the AC will register a sharp rise because,
----------------------
(i) The fixed factors are used up, and further production is possible
only with more of variable factors, the TVC curve increases sharply ----------------------
as output increases, therefore, the AVC also increases sharply, and
it cannot be offset by the slow fall in AFC over larger output. Thus ----------------------
fixity of factors causes the AC to rise sharply over larger output.
----------------------
----------------------

Notes (ii) Further, factors of production are not perfect substitutes of each
other; thus if the fixed factor is used up, the variable factor cannot
---------------------- be used instead of the fixed factor. Thus, both the AFC and AVC and
so the AC rises as output increases.
----------------------
An initial fall in AC as output increases, and then a rise in AC as output
---------------------- increases further, gives the AC curve a U-shaped curve. One can conclude
that the short run AC curve is U-shaped and this is explained by the
----------------------
Law of Variable Proportion, which operates only in the short-run.
----------------------
----------------------
---------------------- 1. Money payment which the firm makes to the “outsiders” who supply
labour services, raw material, electricity, etc. are called ____________.
---------------------- 2. The cost of self-owned resources, which are employed by the firm are
---------------------- non-expenditure. These are referred to as __________.
3. The costs, which remain fixed irrespective of the level of output is
----------------------
called ______ cost.
---------------------- 1. Normal profits are also costs.
---------------------- 2. To the economist, “profit” means total revenue minus all costs.
3. Variable costs do not vary with the level of output.
----------------------
----------------------
8.8 DETERMINANTS OF COSTS
----------------------
The determinants of demand have already been discussed in the unit
---------------------- “Demand Analysis and Forecasting.” The idea was to identify the more
important determinants of demand, so that each determinant might be taken
---------------------- care of at the time of a forecast. Now, the more important determinants of cost
---------------------- have to be identified, so that each determinant might be forecast, and we are
able to arrive at a realistic picture of cost behaviour in the future. There are so
---------------------- many factors which determine cost that is virtually impossible to enumerate
them. However, it is possible to identify the more important factors of cost
---------------------- which influence cost pattern or cost behaviour.
---------------------- When the factors which influence or constitute cost are spelt out, it is
possible to build up the cost function. Generally speaking the prices of inputs,
---------------------- the rate of output, the size of the plant, the technology used broadly constitute
---------------------- the cost. In other words, cost is a function of prices, of inputs, the rate of
output, the size of the plant and technology.
----------------------
----------------------

Therefore, the cost function may be written as : Notes
Cost = f (I, O, P,T)
----------------------
Where
----------------------
I - denotes the prices of such inputs as labour, capital and other
materials. ----------------------
O - denotes the rate of output, i.e., how fast or slow the fixed plant is ----------------------
utilized.
P - denotes the size of the plant ----------------------
T - denotes the state of technology ----------------------

These constituents of cost help one to conceive cost behaviour as a single ----------------------
comprehensive cost function which expresses the complex relationship of cost
to its many constituents. Each component of this complex function is a separate ----------------------
function by itself; and the sum of these separate functions pluralistically yields
----------------------
the complex function. For example, consider the first determinant in this
complex function, that is input. Now the cost - input relationship is a separate ----------------------
function. Similarly, the cost output relationship is another separate function;
and so on. Consider now the cost - input relationship. ----------------------
(A) Cost-Input Relationship ----------------------
In the cost-input relationship, it is the prices of various inputs which make ----------------------
up the cost. For example,
Q = A.Lα .K1-α ----------------------
Where, O = the amount of output ----------------------

A = a constant ----------------------
L and K denote labour and capital
----------------------
α and 1 are the production co-efficient or elasticities
-α
----------------------
Now, the cost-input function can also be written as
C = f (La Kb Mc) ----------------------
where C denotes the cost which is a function of L (labour) and a the ----------------------
price of the factor labour. K denotes the quantity of capital, b the price
of capital and Mc denotes materials and the price of materials. These ----------------------
input factors, namely, labour, capital and materials, multiplied by their ----------------------
quantities, determine the cost. The quantities which are bought, however,
depend upon their prices. ----------------------
It has already been indicated that producers generally try to combine ----------------------
the factors of production in such a way as to minimize cost. In other
words, they go on substituting one factor for another till all the costlier ----------------------
factors are replaced by the factors which are cheaper. This is known as
----------------------
the process of substitution. The purpose of this substitution is to enable
the management to arrive at the least - cost combination of factors of ----------------------

Notes inputs; and this process goes on till a stage is reached at which further
substitution is not possible. This process is known as the marginal rate of
---------------------- substitution.
---------------------- For instance, let us consider this example of substitution: hand embroidery
to machine embroidery – machine-knit sweaters to hand knit sweaters.
---------------------- This example of substitution is not as easy as it appears. These cannot be
perfect substitutes to each other. There is lot of difference in the finishing
----------------------
of the product or the intricacy of work. What intricate a hand can do cannot
---------------------- be wholly done by a machine. But at the same time, the product finish got
a machine may not be done from the former. Each has its own limitations
---------------------- and advantages. Thus a smart firm for want of purchase of new machines
cannot always retrench its workers (the embroiders). 10 machines may
----------------------
not be able to do the work of one genius; also one may need 20 labourers
---------------------- to the tedious work which one machine would do within minutes.
In the costing of inputs, a cost function is developed on the same lines
----------------------
on which the production function is developed. The objective of the
---------------------- production function is twofold : to arrive at the least cost combination
and to achieve the maximum output. In the cost function, the least - cost
---------------------- combination of inputs is determined. For example, if labour is costly, the
producer goes in for a capital intensive technique. On the other hand, if
----------------------
capital is costly, the labour intensive technique is adopted. In other words,
---------------------- a relation of substitution between labour and capital is established. But
what happens when capital is constant and the price of labour or the price
---------------------- of materials rises? It is difficult to analyse this situation because labour
is costly, the producer cannot use less of labour and more materials. This
----------------------
would be absurd because labour and materials cannot be substituted for
---------------------- each other. The ingenuity of the managerial economist arises when he
goes beyond this limitation and finds out whether there is some factor
---------------------- influencing labour and materials alike. If labour is costly and the price of
materials is constant, a capital - intensive technique would be used. On
----------------------
the other hand, if materials are costly, research receives an impetus, for it
---------------------- becomes necessary to find substitutes. These facts indicate that the cost -
input function is one of the complex functions of cost analysis.
----------------------
(B) Cost-Output Relationship
---------------------- Cost generally varies with the level of output. When we analyse how and
---------------------- why the cost varies, what we have in mind is to determine how costs vary
over a period of time. This time period is a crucial factor in any analysis of
---------------------- costs, and is generally broken into two parts, namely, short-run, and long-
run factors. It has often been claimed that, in the short-run, certain factors
---------------------- do not change; for example, the size of a plant, the state of technology,
---------------------- etc. In the long-run, however, these factors adapt themselves to changed
conditions. In other words, in the short-run, only certain factors, vary and
---------------------- not all; for example the raw materials vary in price; so do wages because
these factors, namely, raw materials and labour, are subject to the forces
---------------------- of demand and supply. In other words, this is a short-run phenomenon.

And so one arrives at an analysis of short-run cost behaviour and long-run Notes
cost behaviour. Costs, of course, are of several kinds - fixed cost, variable
costs, average costs and marginal costs. However, the total cost is the ----------------------
summation of fixed and variable costs. Fixed and variable costs have
already been dealt with. For the purpose of the cost - output analysis, what ----------------------
is needed is a study of the total cost, the average cost, and the marginal ----------------------
cost, both in the short-run and in the long - run. The relationship between
the total cost the average cost, the marginal cost, the total fixed cost, and ----------------------
the average fixed costs is illustrated in table given previously.
----------------------
8.9 BREAK-EVEN POINT ----------------------
Equilibrium of the Firm : By Total Revenue and Total Cost Curves : ----------------------
We have noted that, a firm will be said to be in equilibrium when it tends to ----------------------
stabilise at a given level of output and is reluctant either to increase or to decrease
its output. Since maximizing money - profits is assumed to be the objective of the ----------------------
firm, the firm will try to attain that level of output which fetches maximum profits.
Once this level is attained, the firm will tend to stabilize this level of output. In other ----------------------
words, equilibrium of the firm will be established where its output maximizes its ----------------------
money profits. Since profit is the difference between total revenue and total cost, to
maximize this difference becomes the objective of a firm. ----------------------
We have already considered the behaviour of costs in relation to variations ----------------------
in the output of a firm. Now we shall consider the behaviour of revenue of a
firm. To simplify our analysis, we shall assume that the firm is producing one ----------------------
product only. Diagram indicates the movements of total cost and total revenue
----------------------
as the level of output which corresponds to the longest vertical distance between
total revenue and total cost, the latter being less than the former. ----------------------
The following figure illustrates the equilibrium of a firm with the help of
----------------------
Total Revenue (TR) and Total Cost (TC) curves. This is known as a ‘break -
even chart’ or Cost Volume profit analysis, in the business world. The TR and ----------------------
TC curves in figure are total revenue and total cost curves respectively. The
TR curve originates from point O since total revenue is zero when production ----------------------
is zero. However, a firm is required to incur fixed costs even when its level of
----------------------
production is zero. Total cost is more than revenue until OA level of output
is reached. At OA level of output, TR = TC which means the firm is making ----------------------
neither profits nor losses. Point D in the figure.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Notes
----------------------
Total Cost & Total Revenue

----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
---------------------- Output (Units)
---------------------- Fig : Equilibrium of a firm with the help of TR &TC method

which is a point of intersection of TR and TC curves, is therefore, known
---------------------- as the break - even point. As output increases beyond the level OA, TR curve
---------------------- rises above the TC curve and the gap between the two goes on increasing. This
widening of the gap between the two curves indicates increasing profits. The
---------------------- vertical distance between TR and TC curves indicates total profits. This vertical
distance is longest at OB level of output, where EF is the total profit and EF is
---------------------- the longest possible vertical line that can be drawn between the two curves TR
---------------------- and TC as drawn here. Hence, OB is the profit maximizing level of output and
at this level of output the firm will be in equilibrium. If production increases
---------------------- further, profits will decline. At point G, TR and TC are again equal. Point G,
therefore, is the second break - even point. OC level of output is again a no-
---------------------- profit no -loss. Output increases beyond OC, the firm will incur losses, which
---------------------- can be seen after point G, where TC curve is vertically above TR curve.
In order to decide the largest vertical distance between TC and TR, we
---------------------- can draw a number of tangents to the TR and TC curves. Of all theses tangents,
---------------------- we have to find a pair of lines which are parallel to each other and at the same
time, the points of tangency are on a straight line drawn perpendicular to X axis.
---------------------- In fig. JK/LM are the parallel lines and E and F are the points of tangency. These
two points (E and F) are on the straight line BFE which is drawn perpendicular
---------------------- to the X axis. This ensure that EF is the longest vertical distance between TR
---------------------- and TC. EF is the total profit at OB level of output.
This method can illustrate the equilibrium of the firm. Besides, it is most
----------------------
widely used in business to find out total profits of a firm. But this method has two
---------------------- limitations : (i) The longest vertical distance between TC and TR curves is difficult
to find out at a glance. We have to draw many tangents to the two curves before we
---------------------- come across a pair of tangents which are parallel to each other. (ii) Secondly, the
price per unit of the commodity cannot be shown in the same diagram. It is true that
----------------------
TR : Units produced would be the price per unit. In fig. BE : OB is the price. But

still we cannot precisely show the price as a particular distance. Hence, the method Notes
is not very significant especially in the context of problems in the theory of value
we are required to discuss with the help of equilibrium of the firm. Instead, the ----------------------
equilibrium as based on marginal analysis, i.e., by the curves of marginal revenue
and marginal cost, proves to be more useful. ----------------------
----------------------
----------------------
1. Cost is the _____________ of prices, inputs, rate of output, size of ----------------------
plant, technology.
2. Producers generally try to combine the factors of production in such ----------------------
a way as to ___________ cost. ----------------------
3. Breakeven point is reached when a firm makes neither __________
nor __________. ----------------------
----------------------
----------------------
Activity 2
----------------------
1. There are two discussions happening at the same time in two ----------------------
different rooms. You have to bring out the focus of each one of these
(whether it is cost-input or cost-output). Needless to say, you are to ----------------------
reason out your verdict.
----------------------
i. One group is talking about trade union’s demand for better
bargaining power, the need for improving working conditions. ----------------------
ii. The other group is talking about the problem with the other ----------------------
workers arising because of the minimum capacity of the
machine being too low and that workers are wasting their ----------------------
time doing the same odd job all the day.
----------------------
Summary ----------------------
----------------------
●● The concept of cost of production is a very important one. It plays a major
role in determining the market supply of a commodity. A firm aims at ----------------------
profit maximization, which in turn depends on product prices and the
costs of production. ----------------------
●● Costs may be nominal costs or real costs. The former is the money cost of ----------------------
production and the latter is the opportunity cost of production.
----------------------
●● This unit introduces us to the various cost concepts that are well illustrated
that give the reader a good idea about the same. ----------------------
●● Accounting costs are money costs or expenses of production that are
----------------------
paid for by the producer or the entrepreneur. These are explicit costs that

Notes get entered into the account books and hence the same. The economic
costs erupt from the basic economic principle that resources are scare
---------------------- and have alternative uses. Explicit costs, implicit costs and normal profit
together form the full costs of a firm, which all come under the purview
---------------------- of economic costs.
---------------------- ●● Opportunity cost is defined as the value of resource in its next best use. It
is the value of the opportunities forgone to produce alternative products.
----------------------
●● Explicit costs are differentiated from implicit costs. The former are direct
---------------------- money payments to the resources that are purchased or hired by the firm
in the process of production. Normal profits are also treated as costs,
---------------------- which is a pre-requisite for a firm to remain in business.
---------------------- ●● The term ‘economic profits’ is largely different from an accountant’s
angle of defining the same term. He would define it as total revenue minus
---------------------- explicit costs. But an economist terms profit as total revenue minus all
---------------------- costs (i.e. explicit costs, implicit costs and normal profits).
●● The MC curve is a u-shaped curve. The TC initially increases at a
---------------------- decreasing rate and later increases at an increasing rate. We are shown
how the MC curve cuts both the AVC and AC curves at their respective
----------------------
lowest points.
---------------------- ●● Also a very clear explanation is given regarding why the Short Run AC
curves are U-shaped.
----------------------
●● Since cost is a function of prices, the rate of output, the size of plant and
---------------------- technology, it is worthwhile to know about the Cost-Input relationship
and the Cost-Output relationship. The former tells us about the prices of
----------------------
inputs that make up the cost and the latter brings in a relation between the
---------------------- level of output and the costs of production.
---------------------- Keywords
----------------------
●● Accounting Costs : Money costs that are paid by the producer.
---------------------- ●● Average Fixed Cost : Total fixed cost divided by total unit of output.
---------------------- ●● Average Variable Costs : Total variable cost divided by total unit of
output.
---------------------- ●● Average Cost : Aggregate of average fixed cost and average variable
---------------------- costs.
●● Cost-Input Relationship : Study of prices of various inputs which make
---------------------- up the cost.
---------------------- ●● Cost-Output Relationship : Study and the analysis of how the costs vary
with the level of output.
----------------------
●● Explicit Costs : Costs which enter the books of accounts.
---------------------- ●● Economic Costs : Aggregate of explicit costs, implicit costs and normal
---------------------- profits.

●● Implicit Costs : Costs of ‘self-owned’ resources. Notes
●● Opportunity Costs : Costs of the forgone alternative products which
would have been otherwise produced using the same level of resources. ----------------------
●● Total Costs : Aggregate of fixed and variable costs. ----------------------
----------------------
----------------------
1. Differentiate between Accounting Costs and Opportunity Costs.
----------------------
2. Elaborate on the full costs to a firm.
3. Show graphically the relationship between Total Fixed Costs, Total ----------------------
Average Costs and Marginal Costs.
----------------------
4. Explain how a firm achieves its ‘break-even point’, illustrate with the
help of Total Revenue and Total Cost Method. ----------------------
5. Why are Short Run Average Cost Curves U-shaped? ----------------------
6. Write short notes on : ----------------------
a. Fixed and Variable Costs
----------------------
b. Economic Profits
----------------------
c. Explicit & Implicit Cost
d. Historical and Replacement Costs ----------------------
e. Cost-Input Relationship ----------------------

f. Cost-Output Relationship ----------------------
Answers to Check your Progress ----------------------

i. – a. ----------------------
ii. – c.
----------------------
iii. – d.
----------------------
iv. – b.
1. Empirical costs distinguish accounting costs from the economic costs. ----------------------
2. The concept of opportunity cost is used for measuring profits, policy ----------------------
decisions of the firm, forming capital budget and alternatives available to
the firm. ----------------------
----------------------
----------------------

Fill in the blanks.
----------------------
1. Money payment, which the firm makes to the “outsiders” who supply
---------------------- labour services, raw material, electricity, etc. are called explicit costs.
---------------------- 2. The cost of self-owned resources, which are employed by the firm are
non-expenditure. These are referred to as implicit costs.
----------------------
3. The cost which remain fixed irrespective of the level of output is called
---------------------- fixed cost.

1. True
----------------------
2. True
----------------------
3. False
---------------------- 1. Cost is the function of prices, inputs, rate of output, size of plant,
technology.
----------------------
2. Producers generally try to combine the factors of production in such a
---------------------- way as to minimise cost
3. Breakeven point is reached when a firm makes neither profit nor loss.
----------------------

---------------------- 1. Varshney, R.L. 2007. Managerial Economics. New Delhi: Sulatn Chand
---------------------- & Sons.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Pricing and Output Determination under Perfect
Competition UNIT
Structure: 9
9.1 Introduction
9.2 Concept of Market
9.3 Classification of Market based on the nature of Competition
9.4 Pure Competition
9.5 Perfect Competition
9.6 Demand Curve under Perfect Competition
9.7 Working of Price Mechanism under Perfect Competition
9.8 Equilibrium of Firm and Industry under Perfect Competition
Summary
Key Words
Suggested Reading
Pricing and Output Determination under Perfect Competition 187

Notes
Objectives
----------------------
----------------------
• Define marker
----------------------
• Indicate the features of pure competition
---------------------- • Differentiate between pure competition and perfect competition
---------------------- • Determine price and output under perfect competition
---------------------- • Assess equilibrium price on the basis of time period classification

• Identify equilibrium of a firm and that of an industry
----------------------
• Demonstrate geographically the conditions of equilibrium for a
---------------------- firm and industry
---------------------- • Assess the profit range of a firm under the said time periods
----------------------
9.1 INTRODUCTION
----------------------
Demand and Supply are powerful forces operating in markets. They act
----------------------
and react upon each other and determine the price of a product. In the previous
---------------------- chapters, we have already studied the nature of Demand and Supply. In this
chapter we propose to study the market where these forces are constantly at
---------------------- work. An attempt is, therefore, made in the following few paragraphs to define
the term ‘market’ and explain the nature of competition.
----------------------
---------------------- 9.2 CONCEPT OF MARKET

---------------------- In the traditional sense, the market is a place where buyers and sellers
meet each other to effect a business transaction. It is a place, a street or a
----------------------
building where a number of shops dealing in a particular commodity are located.
---------------------- Several examples of markets in Pune can be given. For example, Mahatma
Phule market is a retail market in vegetables whereas, Gultekdi Market Yard is a
---------------------- wholesale market in vegetables. In Mumbai, Zaveri Bazar is the market for gold
and silver ornaments. The diamond market in Mumbai is located in two sky-
----------------------
scrapers at Opera House viz.- Pancha - Ratna and Prasad Chambers. Wholesale
---------------------- textile business in Mumbai is concentrated in Swadeshi market, Mulji Jetha
market and Mangaldas market. Similarly, most of the Indian and foreign banks
---------------------- are concentrated near Horniman Circle and Nariman Point in Mumbai. These
areas, therefore, constitute the Mumbai Money Market. Dalal Street in Mumbai
----------------------
is known for the Bombay Stock Exchange. It is the largest capital market in
---------------------- shares, stocks, debentures and government securities. It will be seen from
these examples that the market for a particular commodity is concentrated in a
---------------------- particular building or a street in a city.
----------------------

(A) National Markets Notes
Like a particular street in a city, the entire city may sometimes specialise
----------------------
in the production of a particular commodity. In course of time, the city
acquires the status of a national market. Thus, Ahmedabad has specialised ----------------------
in the manufacture of textiles, Banaras in silk, Kashmir in shawls and
Faridabad in bangle-making industry. Similarly, Coimbatore in South ----------------------
India has developed a big market in spinning. The market for leather
----------------------
goods is concentrated in Kanpur, and Kolkata whereas the hosiery market
is centered in Ludhiana. Recently, Surat has specialized in diamond ----------------------
polishing.
----------------------
In view of International markets, there are certain instances given here.
Electronic goods (musical , domestic, home appliances) market has a ----------------------
different picture in the international scenario. Most Japanese companies
----------------------
have set up their plants in China because of labour policies and also
import policies. As a result of these pricing policies, a product from Japan ----------------------
is treated differently from that coming from China, in spite of the product
being the same. This is especially true from the Indian point of view ----------------------
because of the price constraint and import policies. Goods from Japan
----------------------
are priced double from those (same ones) from China. Even those from
Indonesia and Korea would cost lesser than Japan. ----------------------
Even products principally manufactured in the U.S.A. are available in ----------------------
India against rupee payments. Thus the American companies set up plants
in Indonesia, Korea, China because the production cost is less (they don’t ----------------------
mind bearing the transport cost, that gets covered up!). All these efforts
are lined in order to tap the Asian markets. ----------------------
(B) Modern View ----------------------
The above examples would indicate how various markets are developed at ----------------------
various places in a country. The meaning of the term market, as understood
in the above sense is, however, traditional; and is not acceptable to the ----------------------
economists. In economics, the term market is understood in a different
sense. According to Jevons, an eminent English economist, it is not ----------------------
necessary for the sellers to exhibit their products at a particular place or ----------------------
a building. The goods may be stored in a warehouse, and the buyers and
sellers may be away from each other by thousands of miles still, they ----------------------
may be able to talk to each other over telephone or through the post-
office and finalise the transaction of sale or purchase. The same view has ----------------------
been expressed by Cournot, the renowned French economist. According ----------------------
to him, the buyers and sellers may be away form each other; but they may
be able to establish contacts through communication, so as to finalise the ----------------------
transactions. If they are able to speak with each other, prices in different
parts of a country, would tend to equality easily and quickly. ----------------------
Talking of more recent ways of communication, today we have the ----------------------

concept of ‘Video Conferencing’. There are two ways; Conference of
----------------------

Notes various people spread across the world or the nation as the case be).
One way is - through a camera set up on the computer screen and the
---------------------- voice transfer via a microphone. The medium could either be a computer
screen, a T.V. screen, a Plasma T.V. screen etc. bigger the screen, better
---------------------- the way to communicate to several number of people at the same time.
---------------------- This is actually ‘Satellite Conferencing’. The other way is ‘Satellite
Communication’, happening on channels, for example, the way we see
---------------------- live cricket matches on the ESPN channel. Of course this is a one-way
communication.
----------------------
Thus, according to the modern view,
----------------------
(a) It is not necessary that the market for a commodity should always
---------------------- be located on a particular street or in a building.
(b) The buyers and sellers may be away from each other and yet they
----------------------
may constitute a market over the telephone or through the internet.
---------------------- (c) When buyers and sellers are in close contact with each other, the
prices prevailing in different parts of a country would tend to
----------------------
equality.
---------------------- It is clear that modern economists have considerably widened the scope
of the term ‘market’. If this meaning is accepted, the entire world may
---------------------- be described as a single market. This holds especially true, in case of
---------------------- international market scene (as mentioned above), where buyers and
sellers are not individual ones but the players in the market are the trading
---------------------- countries themselves. Generally, developing countries export primary
goods and labour services (specially India is a standing example of ‘Brain
---------------------- Drain’ – be it medical, softwares, engineering or creative arts. But, of late
the scene is slightly changing and one can see a ray of hope in pulling
----------------------
them back to the home grounds!) whereas the developed ones export
---------------------- secondary and tertiary goods and services (electronic goods – given
above, automobiles, etc.)
----------------------
9.3 CLASSIFICATION OF MARKET BASED ON THE NATURE
---------------------- OF COMPETITION
---------------------- MARKET
----------------------
---------------------- Perfect Competition Imperfect Competition
----------------------
Pure Perfect
----------------------
---------------------- Monopoly Duopoly Oligopoly Monopolistic Monopsony

Competition
----------------------
Competition in the market can be either perfect or imperfect. The Classical
---------------------- economists assumed the existence of the perfect competition, and all their

analysis is based on this assumption. The dream of the Classical economists is, Notes
however, was hardly realised in practice. It has been pointed out that the real
world is full of imperfect competition. In particular, Mrs. Joan Robinson of ----------------------
the Cambridge University and Prof. Edward Chamberlin of Harvard University
have done a pioneering analysis of imperfect competition. Based on their ----------------------
analysis, competition in the market is classified as under : ----------------------
(A) Pure and Perfect Competition : Usually, a distinction is made in
----------------------
economic theory between pure competition and perfect competition.
The concept of perfect competition is much broader in scope than pure ----------------------
competition. It includes all the features of pure competition plus some
more features of the two forms; let us discuss first the features of pure ----------------------
competition.
----------------------
9.4 PURE COMPETITION ----------------------
1. Large Number of Buyers and Sellers (Firms) ----------------------

The number of buyers and sellers operating under pure competition is ----------------------
very large. The position of an individual seller is like a drop in the ocean.
An individual seller cannot, therefore, fix the price nor can he change it ----------------------
by his individual action. Similarly, no single buyer can fix the price or
----------------------
change it by his action. Even if he increases or reduces his demand, it
does not make any effect on the total demand in the market. Price of a ----------------------
product is determined by the interaction of total demand and total supply
in the market. Naturally, it is beyond the capacity of an individual seller or ----------------------
a buyer to determine or influence the price. Every seller and a buyer under
----------------------
pure competition is a Price-Taker and not a Price-Maker.
2. Homogeneous Products ----------------------
The products sold by different sellers under pure competition are homogeneous ----------------------
i.e. exactly alike in quality. Usually, a product which is capable of being
standardised is sold by the sellers. For example, rice produced in different ----------------------
parts of India is classified under different standard grades such as Resham
----------------------
Basmati, Kamod, Kali, Much, Ambemohor etc. Since every buyer is buying
the standard variety, he does not bother to know as to which particular farmer ----------------------
has grown that rice. He is interested in ensuring that all the rice in the bag is
homogeneous, i.e. exactly alike in quality. ----------------------
3. Free Entry and Free Exit of Firms ----------------------
Another important feature of pure competition is that there is free entry ----------------------
and exit of firms. An entrepreneur who has the necessary capital and skill
can start any business of his choice. In every industry, new firms are, ----------------------
therefore, opened from time to time. Similarly, an existing producer is
free to close down his business if he so chooses. As a result, some firms ----------------------
are going out of the industry. Since there are no hindrances to the entry of ----------------------
new firms and the exist of existing firms, the number of total firms under
pure competition always remains very large. ----------------------

Notes 9.5 PERFECT COMPETITION
---------------------- It has been already remarked that the concept of perfect competition is
broader than pure competition. This means that perfect competition does exhibit
---------------------- the above features of pure competition viz. large number of buyers and sellers,
homogeneous products and free entry and exist of firms. In addition to these,
----------------------
perfect competition exhibits the following features.
---------------------- 1. Perfect Knowledge
---------------------- All the buyers and sellers operating under perfect competition have
perfect knowledge of the market conditions. For example, every seller
---------------------- knows the total quantity supplied and sold on a particular day or during a
---------------------- week. Similarly, every buyer knows about the price of the product and the
related information.
----------------------
2. No Discrimination
---------------------- Under perfect competition, no seller should discriminate between buyers.
He cannot say that he would sell his product only to white and handsome
----------------------
people; and not to the black and ugly people. The seller must deliver
---------------------- the goods so long as every buyer visiting his shop, is willing to pay the
required price. Similarly, no buyer would discriminate between sellers.
---------------------- He cannot say that he would buy only from a particular seller and that
he would not buy from others. A buyer has no reason to discriminate
----------------------
between sellers so long as every seller is charging the same price.
---------------------- 3. No Cost of Transportation
---------------------- Under perfect competition, it is assumed that the cost of transportation
does not exist for carrying goods from one place to another.
----------------------
4. Mobility of Factors of Production
---------------------- Various factors of production are assumed to be perfectly mobile from
---------------------- one place to another and from one occupation to another. For example, a
worker migrating from one industry can be diverted to another industry
---------------------- if the return on investment is going to be higher. It is assumed that all the
factors of production are perfectly mobile and that there are no hindrances
---------------------- to their movement. Mobility of factors of production is guided under
---------------------- perfect competition, by self-interest and profit-motive, the principle so
nicely elaborated by Adam Smith in his book, ‘Wealth of Nations’.
----------------------
5. Automatic Price Mechanism
---------------------- The most significant feature of perfect competition is the existence of
an automatic price mechanism. Price of a product is determined by the
----------------------
interaction of the total demand and the total supply in the market. Since
---------------------- there are many sellers and many buyers, no individual seller or buyer
can fix or influence the price. The forces of demand and supply are very
---------------------- powerful and always remain outside the control of an individual seller or
a buyer. Price mechanism is not only automatic but also delicate.
----------------------

But for instance, there are a 100 stalls of fruit and vegetable vendors. As Notes
a buyer, it is not physically possible to go to each and every vendor and
enquire about the prices of all the products available. The vendors are ----------------------
smart and are completely aware of this. Thus, the buyer may get duped
into paying a high price for some products which may be available at ----------------------
some other vendor at a low price. This is the case at many places, like ----------------------
exhibitions which houses several stalls selling same products. Thus, the
unawareness on the part of the buyers leads to super normal profits for the ----------------------
sellers. This point is to bring out how the existence of Perfect Competition
is a myth in reality. In this regard, let’s look at some points given below. ----------------------
Price discrimination is an important tool at the hands of a monopolist and ----------------------

also in other forms imperfect competition (as will be clear in the later
----------------------
units). A monopolist indulges in price discrimination, which means for the
same product he charges different price. With this, he earns supernormal ----------------------
profits. in case of other markets, the product is not always absolutely
the same, but then there are ‘similar’ products; there are some changes ----------------------
here and there, in terms of the colour or the material or the texture, for
----------------------
example, following the above example of the exhibition, there could be
several stalls selling shawls, but each may have some distinct features ----------------------
different from the other.
----------------------
The product may be the same, but in fact it is because of the transportation
cost that many a times, the price of the same product is different at different ----------------------
places. We see the price tag on the product that says “Rs. 20/- within
Maharashtra; Rs. 28/- outside Maharashtra”. This means that the product ----------------------
is manufactured in Maharashtra. In fact perfect product homogeneity is
----------------------
just not the order of the day; every seller wants to bring in some product
ingenuity or differentiation in his product; he wants his product to stand ----------------------
differently from the others. It is the age of consumerism. To attract
consumer attention is one task; to make him buy the product is a bigger ----------------------
task and to make him revert to the same product - when the other options
----------------------
are plentiful - is a mind-blowing task today!
With government policing and policies (licensing policies, etc), entry of ----------------------
new firms is not very simple; it is a procedural process.
----------------------
Also, all factors of production are not perfectly mobile. A worker may not
be willing to leave his hometown and family and migrate to other cities in ----------------------
search of better lucrative jobs. Money cannot lure him to leave his land, ----------------------
where he belongs by birth. Also mobility of huge (indivisible) machinery
also cannot always be feasible. Wear and tear of such al goods, transport ----------------------
cost charges, are the factors, one cannot ignore in reality.
----------------------
----------------------
----------------------
----------------------

Notes
----------------------

1. It is not necessary that the market for a commodity should always be
----------------------
located on a particular street or building.
---------------------- 2. When buyers and sellers are away and communicate over telephone/
Internet, it is not called “market”.
----------------------
3. The number of buyers and sellers operating under pure competition is
---------------------- very large.
---------------------- 1. Competition in the market can be either _________ or ________.

2. The products sold by different sellers under pure competition are
----------------------
________.
----------------------
---------------------- Activity 1
----------------------
In a huge stadium there is a “car mela” − an open ground for the direct
---------------------- buying and selling. Different models of different companies are displayed
on the huge podium. They have come from different cities from across the
---------------------- nation. Hundreds of people have assembled looking out for the right buy for
---------------------- themselves. The luxury cars have been displayed a little away from the main
ground and there is an entry fee of Rs 100 per person (age 4 and above).
----------------------
From the example given above, you have to point out those factors, which
---------------------- suit the conditions of perfect competition and those which do not. Give
reasons for your answer.
----------------------
---------------------- 9.6 DEMAND CURVE UNDER PERFECT COMPETITION

---------------------- Under perfect competition, the number of firms in the industry is very
large. Each firm is very small in size. A single firm action does not affect the
----------------------
market supply. Thus, each firm is a price-taker under perfect competition. The
---------------------- price is determined in the market and every firm has to accept this price.
MARKET Price (AR) FIRM
---------------------- Price DM
SM
(Per Unit)
----------------------
PM OP0 AR
---------------------- Perfectly Elastic Demand
Curve
---------------------- SM DM
QM X X
O O
---------------------- Quantity Demanded/Supplied Output (Units)

In the fig DM DM line is the market demand curve and SM SM is the Notes
market supply curve, EM is the point of market equilibrium where market
demand and a market supply are equal to OQM. This gives the equilibrium ----------------------
price in the market (OPM). This price is accepted by every firm. (OP0) under
perfect competition. Thus the demand curve of the firm is perfectly elastic ----------------------
under perfect competition. ----------------------
9.7 WORKING OF PRICE MECHANISM UNDER ----------------------

PERFECT COMPETITION ----------------------
Perfect Competition is said to exist when the number of buyers and sellers
----------------------
operating in the market is very large. Then buyers and sellers have perfect
knowledge of the conditions prevailing in different parts of the market. All the ----------------------
sellers are selling homogeneous products which are exactly alike in quality.
Moreover, no seller would discriminate between buyers and no buyer would ----------------------
discriminate between sellers. That is to say, a seller has no reason to refuse to
----------------------
sell to a particular buyer who is willing to pay the required price. Similarly,
no buyer would hesitate to buy from a particular seller who is charging the ----------------------
same price. Under perfect competition, no buyer or seller can fix the price of a
product, nor can he influence it by his own action. Price is determined by the ----------------------
interaction of demand and supply. Demand and Supply are powerful forces
----------------------
which constitute the essence of price-mechanism under perfect competition.
The price mechanism determines the price and output of various products. ----------------------
It is, therefore, worthwhile to explain the working of the price mechanism
----------------------
under perfect competition.
(A) General Rule of Price Determination ----------------------
Under Perfect Competition, generally, demand and supply play an ----------------------
equally important role in determining the price. They act and react upon
each other and determine the price at the equilibrium point. This is called ----------------------
Equilibrium Price. Determination of equilibrium price can be explained ----------------------
with the help of the following demand and supply schedule and demand
and supply curves. ----------------------
Demand for & Supply of Textiles ----------------------
Price (Rs. per Quantity Quantity Supplied ----------------------
metre) Demanded (million metres)
(million metres) ----------------------
250 19 28
----------------------
240 20 26
230 22 22 ----------------------
220 25 17 ----------------------
210 30 10
----------------------
The above demand schedule can be shown with the help of the following
diagram. ----------------------

Notes Y Equilibrium Price
D
---------------------- S
Price per unit

----------------------
P E
----------------------
---------------------- S
D
---------------------- O M
X

---------------------- Quantity Demanded/Supplied
---------------------- In the figure quantity demanded and sold is shown on the X- axis and the
price is shown on the Y- axis. DD is the demand curve showing total demand
----------------------
at different prices, and SS is the supply curve representing the quantity
---------------------- supplied at different prices. The demand curve and the supply curve balance
each other at point E. This point is called on Equilibrium point. Under perfect
---------------------- competition, the equilibrium price would, therefore, be Rs.230/- per metre
and at this price quantity OM would be sold in the market.
----------------------
(B) Changes in Equilibrium Price
----------------------
The equilibrium price, determined by the interaction of demand and
---------------------- supply need not remain constant. It can change with every change in
the relative positions of demand supply. For example, if some festival
---------------------- is forthcoming, demand for a product would increase. The supply being
---------------------- constant, price would rise. Similarly, during a slack season, demand may
fall, but supply being constant, price would fall, changes in supply would
---------------------- also influence the equilibrium price. For example, in a particular year, the
cotton crop may be affected on account of natural calamities. Supply of
---------------------- cotton in this case is reduced; but demand being constant, price of cotton
---------------------- textiles would rise. There is a third possibility; demand and supply may
both change simultaneously.In all the three cases, the equilibrium price
---------------------- would change. It is worthwhile to see how changes in demand, changes
in supply and changes in both, affect the equilibrium price.
----------------------
(1) Changes in Demand
---------------------- Changes in Demand
Y
D1
---------------------- D
S
Price Per Unit
----------------------
P1 F
---------------------- P E
---------------------- D1
S D
X
---------------------- O M M1
---------------------- Quantity Demanded/Supplied

In the figure changes in demand are shown by different demand Notes
curves DD and D1D1. The supply is shown by the supply curve SS.
Demand for a product may increase on account of a festival, growth ----------------------
of population or on account of some other factor. In figure original
equilibrium price is shown at point E i.e. OP. But on account of a ----------------------
higher demand curve D1D1 a different picture would emerge. The ----------------------
new demand curve D1D1 intersects the supply curve at point F. The
new price would, therefore, be OP1. Thus, it is clear that supply ----------------------
being constant, every increase in demand would lead to a rise in the
equilibrium price. ----------------------
(2) Changes in Supply ----------------------

Similarly, demand being constant, every change in supply would ----------------------
change the price. This is clear from the following figure.
----------------------
Changes in Supply
----------------------
----------------------
----------------------
Price Per Unit
----------------------
----------------------
----------------------
----------------------
Quantity Demanded/Supplied
----------------------
In the figure, the quantity is shown on the X-axis and the price
is shown on the Y- axis. DD is the demand curve and SS is the ----------------------
original supply curve. These curves balance each other at point
E; i.e. equilibrium point. OP is, therefore, the equilibrium price. ----------------------
Now, S1S1 is the new supply curve which shows a reduction in the ----------------------
supply. The new supply curve S1S1 intersects the demand curve
at a new equilibrium point E1. OP1 would, therefore, be the new ----------------------
price. This means that the total supply has diminished from OM to
OM1; and at the same time, price has risen from OP to OP1. ----------------------
(3) Changes in Demand and Supply ----------------------

The third possibility is that demand and supply both may change ----------------------
simultaneously. On account of these changes, a new equilibrium
price would be established. This would be clear from the following ----------------------
figure.
----------------------
----------------------
----------------------

Notes Changes in Demand and Supply
----------------------
----------------------
Price Per Unit

----------------------
----------------------
----------------------
----------------------
----------------------
In the figure, DD is the original demand curve and SS is the original
---------------------- supply curve. They balance each other at point E. The equilibrium
price is, therefore, OP. Now D1D1 is the new demand curve which
----------------------
shows a higher demand, and S1S1 is the new supply curve. The new
---------------------- equilibrium price would, therefore, be OP1.
---------------------- The equilibrium point is now showing at a higher pirce because the
incease in demand is higher than the increase in supply. Thus in this
---------------------- situation, the demand is till higher than the supply coming to the
market. The demand is not fully met and hence the price rises.
----------------------
This may hold true in the short period, when the supply is relatively
---------------------- inelastic (cannot respond very fast to the changing demand ) and
remains at a level lower than the increased demand.
----------------------
(C) Laws of Demand, Supply and Price
----------------------
From the foregoing discussion the following laws of demand, supply and
---------------------- price can be stated :
(1) Under perfect competition, price of a product is determined by the
----------------------
interaction of total demand and total supply in the market. This is
---------------------- called ‘Equilibrium Price.’
(2) If demand increases, supply being constant, the price would rise. If
----------------------
demand falls, supply being constant, price would fall.
---------------------- (3) If supply is reduced, demand being constant, price would rise and if
---------------------- supply increases, demand being constant, the price would fall.
(4) If a change occurs in demand and supply simultaneously, a new
---------------------- equilibrium price is established.
---------------------- (D) Dr. Alfred Marshall’s Classification of Market on the Basis of Time
---------------------- The above laws of demand, supply and price, however, constitute the
general framework of price determination. As Marshall has elegantly
---------------------- pointed out, time element plays an important role in determination of
price. Marshall has classified the period of time under four heads; but
----------------------

for the sake of simplicity we can reduce this classification of period only Notes
under three heads viz.
----------------------
(1) Market Period (2) Short Run and (3) Long Run
It is worthwhile to see how price is determined in the market, in market ----------------------
period, the Short period and the Long period.
----------------------
(1) Market Period
----------------------
According to Marshall, market period relates to a few hours or a few
days. Perishable goods such as fish, eggs, leafy vegetables etc. are ----------------------
sold in this market. The supply of these goods on any particular day
is fixed. It cannot be increased or decreased within the market period. ----------------------
At the same time, such goods being perishable, their supply cannot ----------------------
be held back from the market. The entire supply is to be disposed
off on the same day; because it cannot be stored or preserved. In ----------------------
such circumstances, price would be determined according to the
total demand in the market. If on a particular day, more customers ----------------------
come to buy, the supply would be less and the supply being constant, ----------------------
price would rise. Thus, in the short run, determination of price in
the market period is shown in the following figure : ----------------------
Price in Market Period ----------------------
----------------------
----------------------
Price Per Unit
----------------------
----------------------
----------------------
----------------------
----------------------
In figure, SS is the supply curve representing perfectly inelastic or ----------------------
a fixed supply in the market period. ----------------------
Since supply cannot be increased or decreased in a very short
----------------------
period, the supply curve is vertical to the X-axis. Demand is shown
by different demand curves, i.e. DD, D1D1 and D2D2. Accordingly, ----------------------
OP would be the price if demand is shown by the curve DD. If on
the next day, only a few customers come, demand would be shown ----------------------
by D1D1 and the price would fall to OP1. If on some other day,
----------------------
demand is higher it would be shown by D2D2 and the price would
rise to OP2. Thus, price in the market period is determined from the ----------------------
demand side, and supply plays a passive role.
----------------------

Notes (2) Short-Run
In the short-run, supply of goods can be adjusted to the demand
----------------------
to some extent, because, some factors remain fixed, whereas other
---------------------- factors can be changed in the short - period, the price in the short
period is thus determined with the help of the active role of both
---------------------- supply as well as demand.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
In the figure, the supply curve is positively sloping, the equilibrium
----------------------
price is OP at which quantity supplied the equal quantity demanded
---------------------- OQ.
(3) Long-Run
----------------------
In the longrun, the supply of goods can be adjusted to the demand,
---------------------- Dr. Marshall has taken an example of durable goods, which are
---------------------- sold in the long run. Durable goods such as wheat, rice, oil, textiles
etc. can be stored for some time. Their supply can be increased or
---------------------- reduced according to the demand. Since the supply is adjustable,
supply curve is horizontal to the X-axis. The sellers of durable
---------------------- goods are unwilling to sell unless they recover a minimum price.
---------------------- This price is based on the cost of production. Producers of durable
goods would not, therefore, sell unless the cost of production is
---------------------- recovered. If the price is less, they would hold back the supply from
the market. On the other hand, if they are getting the minimum
---------------------- expected price which covers the cost of production, they would be
---------------------- prepared to sell more. i.e., they would increase the supply at the
same price.
---------------------- It is because of this theory, that hoarding takes place. Huge amounts
---------------------- of grains, rice, sugar, wheat, jowar or bajra are stored in godowns
by the undisputed people, both in rural as well as urban areas. It
---------------------- is more incidental in rural areas in India, since the villagers are
illiterate and unaware and the checks by the rationing inspectors
---------------------- is on a low key. The sathebaaj dalal (as they are termed) will not
---------------------- release the product to the market till they are happy with the on-
going price. They can be greedy and at times deliberately withhold
---------------------- in order to fetch a higher price. They bring in artificial shortages

in the market, as a result of which the prices of such necessary Notes
goods increase. Once satisfied, the gates are open to the buyers.
The demand for these goods is relatively inelastic and the sathebaaj ----------------------
dalal take full advantage of the existing situation.
----------------------
Determination of price in the long run is shown in the following
diagram : ----------------------
Long Run Normal Price ----------------------
----------------------
----------------------
Price Per Unit
----------------------
----------------------
----------------------
----------------------
----------------------
In figure, the supply curve is horizontal to the X-axis because it is ----------------------
adjustable to demand. Here, price of the product would be OP which
----------------------
covers the cost of production. In this case, an increase or decrease
in demand would not influence the price because it is based on the ----------------------
cost of production. If less people come, a small quantity would be
supplied and if more people come, a larger quantity would be sold ----------------------
at the same price.
----------------------
We can see from the above graph, that there is zero supply below the
price OP. But at anything higher than this price, there is unlimited ----------------------
supply – as much as the market wants. For instance, there is a
showroom selling many types of white goods like T.V.s (different ----------------------
types like right from 12 inch to 72 inch T.V. screens, then we have
----------------------
the regular T.V., flat screen T.V., plasma T.V., LCD, projection T.V.),
refrigerators (like single –door, double-door, frost-free, or non- ----------------------
frost-free) VCD players, DVD players, various audio application
systems right from cassette to IPOD and audio systems like two- ----------------------
in-one, CD systems, home theatres, 5.1 DTS surround, 7.1 DTS
surround. They all have a tag price. Buyers coming in to buy have ----------------------
to pay the said price in order to get the good of their choice. If they ----------------------
don’t they will be shown the door – of course very politely. It is a
take-it-or-leave-it market in the world of today. ----------------------
It will be seen that in the long run, supply plays a dominant role and ----------------------
demand is passive in determining the price.
----------------------
----------------------

Notes Conclusion :
Under perfect competition, the price is determined by the
---------------------- interaction of total demand and total supply in the market. The
---------------------- price which is so determined is called the Equilibrium Price.
The equilibrium price may change on account of changes in the
---------------------- relative positions of demand and supply. The most significant point
---------------------- to be emphasised here is that the time element plays an important
role in determination of price in the short and long run. In the short
---------------------- run demand is active, whereas in the long run supply is active
in determining the price. By introducing the importance of time
---------------------- element, Dr. Marshall has made a significant contribution to the
---------------------- theory of value. By introducing the time element, he has given a
new dimension to the theory. This has made the theoretical concept
---------------------- closer to the reality issues and answered many queries regarding
consumer behavior, market reactions and production patterns. The
---------------------- ‘time element’ has given an added edge to the understanding and
---------------------- thinking pattern of economists.
---------------------- 9.8 EQUILIBRIUM OF FIRM AND INDUSTRY UNDER

---------------------- PERFECT COMPETITION
---------------------- In the previous sub-unit, we have studied how price of a product is

determined by the interaction of demand and supply. We have also seen the
---------------------- important role played by the time element in the theory of value. We have thus
studied the rules of price determination under perfect competition. However, we
---------------------- have not yet studied how a firm or an industry would maximize its profits. An
---------------------- attempt is, therefore, made in this chapter to explain how equilibrium position
of a firm or an industry is reached under perfect competition.
---------------------- (A) Concept of Firm and Industry
---------------------- Before explaining the equilibrium of a firm or an industry, it is necessary
to revise the distinction between a firm and an industry. Any business unit
---------------------- organised under one ownership and management is called a firm. The firm
---------------------- may be organised as a sole proprietorship, partnership or a joint stock
company. The form of organisation can be anything. It is necessary that
---------------------- the business should be owned and managed by one management.
---------------------- An industry is a group of firms dealing in the same line of business. The
ownership and management of each firm may be different; but since all
---------------------- such firms are engaged in the production of the same commodity, they
are collectively called an industry. Thus Swadeshi Mills in Mumbai is
---------------------- a firm dealing in textiles. Similarly, Shriram Mills is another firm and
Kohinoor Mills is still another firm dealing in textiles. But when we take
----------------------
into account all the textile firms in India we describe them collectively
---------------------- as the cotton textile industry of India. Similarly, we can say about the
automobile industry, in which there are companies like HONDA,
---------------------- HYUNDAI, MARUTI, FORD, AUDI, PORSCH, BMW, MITSUBISHI,
TOYOTA etc.
(B) Concept of Equilibrium Notes
The term equilibrium is frequently used in economic theory. Thus, there is
an equilibrium of a consumer, an equilibrium of a firm or an equilibrium ----------------------
of an industry. Since the concept occupies a central position in the theory ----------------------
of value it is necessary to know the meaning of the term equilibrium.
A consumer who spends his income on various goods may derive ----------------------
satisfaction from the consumption of those goods. When consumer ----------------------
maximizes his satisfaction he is said to be in equilibrium. In the case of
a firm, equilibrium is reached when the firm’s profits are maximized. The ----------------------
ultimate aim of every firm is to maximize its profits and that of every
consumer is to maximize his satisfaction. Accordingly, the firm tries to ----------------------
reach the stage of maximum profit by adjusting its output.
----------------------
In the initial stages, when production is on a small scale, the margin of
profit is small. But when the scale of production is increased the average ----------------------
cost goes on diminishing and the margin of profit goes on increasing.
----------------------
After some time, the disadvantages of large-scale production begin to
operate. As a result, the difference between the selling price and the cost ----------------------
goes on diminishing. Even though the margin of profit is reduced, there is
still some addition to the total profits. It is, therefore, worthwhile to carry ----------------------
on production for some more time. Finally, a point is reached when cost
----------------------
of production exceeds the selling price. From this point, losses begin to
occur. Every firm would, therefore, stop to produce. At this point, the total ----------------------
profit is maximum and the firm is said to be in equilibrium. Like a firm,
an industry can also achieve its equilibrium when all the firms in the ----------------------
industry are in equilibrium.
----------------------
(C) Equilibrium of Firm
----------------------
There are two methods to study the equilibrium of a firm. viz.
----------------------
(a) Total Cost and Total Revenue method, and
(b) Marginal Cost and Marginal Revenue method. ----------------------
Before we examine these methods, it is worthwhile to know the ----------------------
assumptions on which our analysis is based :
----------------------
(a) It is presumed that a firm is managed as a sole proprietary concern.
This would enable us to study the behaviour of an individual. ----------------------
(b) Every individual proprietor aims at profit maximization and he ----------------------
exhibits rational economic behaviour.
(c) It is also assumed that the firm is producing only one commodity. ----------------------
It is possible to consider a firm producing more commodities, but ----------------------
in that case, our analysis would become more complicated. For the
sake of simplicity we, therefore, assume that the firm is producing ----------------------
only one commodity.
----------------------
----------------------

Notes (1) Equilibrium of a firm with Marginal Cost and Marginal Revenue
Method
----------------------
The total cost incurred to produce a given quantity is called the Total Cost
---------------------- (TC). Now, the addition made to the total cost on account of production of
one more unit of output is called the Marginal Cost (MC). Similarly, the
---------------------- revenue received from the sale of a given output is called Total Revenue
(TR) and the addition made to the total revenue on account of sale of one
----------------------
more unit is called Marginal Revenue (MR).
---------------------- (i) Marginal Revenue should be equal to Marginal Cost i.e. MR = MC
---------------------- (ii) The marginal cost curve should cut the marginal revenue curve
from below at the equilibrium point.
----------------------
Firm’s equilibrium, arrived at by this method is shown in the following
---------------------- diagram :
---------------------- Equilibrium of a Firm

MR = MC
----------------------
----------------------
----------------------
Cost/Revenue
----------------------
----------------------
----------------------
----------------------
Output
----------------------
In figure, MC is the marginal cost curve and MR is the marginal revenue
---------------------- curve. Similarly, AC is the average cost curve and AR is the average
revenue curve. When OM output is produced, MC and MR curves balance
---------------------- each other at point E. At this point, the firm’s profits are maximum and
---------------------- the firm is in equilibrium. If smaller output is produced than OM the
marginal cost is smaller than marginal revenue, which means that addition
---------------------- to the cost is less than addition to the revenue by producing more output.
This means that there is scope to earn more profits by increasing output.
---------------------- Output will, therefore, be increased from OL to OM. When production is
---------------------- OL, average cost is LH and average revenue is LG. Profit per unit is HG.
Since there is marginal profit, output will be carried on upto OM. After
---------------------- the point OM, marginal cost would exceed the marginal revenue; and
the firm’s profit will begin to fall, because more is added to cost than to
---------------------- revenue by increasing output. For example, if ON output is produced, KN
---------------------- is the average cost and SN is the average revenue. There is a profit per
unit to the extent of SK, which is less than QD (profit per unit at output
---------------------- OM). Therefore, it would not be worthwhile to produce ON output. The

firm should stop production when its output is OM, and its profits are Notes
maximum.
----------------------
(2) Equilibrium of Firm under Perfect Competition
The conditions of equilibrium of a firm are applicable to all the types ----------------------
of markets. i.e. they are applicable to perfect competition, monopoly,
----------------------
monopolistic competition etc. These conditions are i) MR = MC and ii)
MC Curve must cut MR curve from below. An attempt is made below ----------------------
to examine the equilibrium of a firm under perfect competition.
----------------------
Equilibrium under Perfect Competition
----------------------
----------------------
Cost / Revenue
----------------------
----------------------
----------------------
----------------------
Output (units) ----------------------
Under perfect competition, no firm can fix the price or influence it by ----------------------
its own action. Price is determined by the interaction of total demand
and total supply in the market. Under these circumstances the firm has to ----------------------
satisfy both the conditions to achieve its equilibrium, viz. ----------------------
(i) Its marginal revenue should be equal to marginal cost, and
----------------------
(ii) Marginal cost curve should cut the marginal revenue curve from
below. ----------------------
The general rule of firm’s equilibrium under perfect competition is shown ----------------------
in the figure.
----------------------
In the Figure, the straight line PL shows marginal revenue as well as
average revenue. The curve MC shows the marginal cost. When price is ----------------------
OP, marginal cost curve cuts the marginal revenue curve from below, at
point R. Therefore, the firm will be in equilibrium when its output is OM ----------------------
and the price is OP. ----------------------
(3) Short-Run Equilibrium
----------------------
Although we have discussed the general rule of firm’s equilibrium under
perfect competition, it is worthwhile to follow Dr. Marshall’s classification ----------------------
of time - period into short-run and long-run. In particular, we would like
----------------------
to see how a firm achieves its equilibrium in the following circumstances:
(i) When the firm earns supernormal profits. ----------------------
(ii) When the firm earns only normal profits. ----------------------

Notes (iii) When the firm begins to incur losses.
(iv) When the firm is obliged to stop production.
----------------------
(i) Super-Normal Profits
----------------------
In figure, Op1 is the price, P1 L1 is the average revenue curve
---------------------- and marginal revenue curve MC is the marginal cost curve which
intersects the average revenue curve at point Q from below.
---------------------- Therefore, at point Q the firm is in equilibrium and OM’ is the ideal
output. Here average cost is M’G and profit is equal to GQ. This
----------------------
firm is earning supernormal profit equal to P1QGH. Since all the
---------------------- firms in the industry are working more or less under the same cost
conditions, all of them would be in equilibrium. The fact that the
---------------------- existing firms are earning super-normal profits may attract new
producers to the industry. But in the short-run it will not be possible
----------------------
for them to start new firms.
---------------------- Short-Run Equilibrium of a Firm
----------------------
----------------------
Price Cost / Revenue
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
---------------------- Output (units)

---------------------- (ii) Normal Profit
In figure, OP is the price and PL is the average and marginal revenue
----------------------
curve. Here, the firm is in equilibrium at point R and the ideal output
---------------------- is OM. This form is earning only the normal profit. Therefore, there
would be no reason for new producers to enter this industry. Like
---------------------- this firm, the entire industry is in equilibrium at point R. Thus in the
short-run, both the firm and the industry, are in equilibrium.
----------------------
(iii) Losses
----------------------
In figure, if the price falls to OP2 the firm will be in equilibrium at
---------------------- point S; because at this marginal cost curve intersects the marginal
revenue curve from below. But at this point, when output is OM2,
---------------------- the firm is making losses because the average revenue of SM2
is less than the average cost of EM2. Thus the firm is incurring
----------------------

a loss P2SEF. If the firm desires to continue to produce, it must Notes
incur this minimum loss. It is obvious that greater production would
mean a greater loss. Since all the firms under perfect competition ----------------------
are working more or less under the same cost conditions, all the
firms would have to incur losses; if they continue to produce ----------------------
more. Some of the firms, which are incurring losses, may think of ----------------------
closing down the production. But in practice, firms cannot stop their
production and cannot avoid losses. This is because, every firm has ----------------------
to incur some fixed costs on account of bank interest, insurance,
depreciation, rent etc. even if production is stopped. By stopping ----------------------
the production, a firm can only reduce its variable cost on account ----------------------
of raw materials, wages and power. Thus, if a firm decided to close
down production it can save variable costs; but it cannot save fixed ----------------------
costs. Every firm, therefore, decides to continue to produce so long
as it is able to recover its variable costs. In other words, a firm ----------------------
would produce more even if it incurs a loss equal to the fixed costs. ----------------------
Here, every firm takes an optimist view that “half a glass of water is
better than nothing”. ----------------------
(iv) Closing-down Production ----------------------
Closing - down Production
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Output (units)
----------------------
If the price falls further to P4 and is less than the average variable
cost, the firm cannot afford to carry on its production. Here the firm ----------------------
is neither able to stop its fixed cost, nor the average variable cost.
Even in the short-run the firm will have to stop its production. This ----------------------
would be clear form the above figure. ----------------------
In the above figure, price has fallen to P4. This price does not cover
even the average variable cost. The firm will, therefore, have to stop ----------------------
its production at point D, price OP3 and output OM2. ----------------------
(D) Long - Run Equilibrium
----------------------
In the long-run every firm gets sufficient time to adjust its output in
relation to the demand. It also finds time to buy new machinery or to ----------------------

Notes implement new techniques of production. In the fairly long run, the firm
can change the composition of various factors of production.
----------------------
In the short-run a firm reaches its equilibrium when MR = MC. This
---------------------- principle is also applicable to the long-run equilibrium. In the long-run
one more thing is, however, necessary. i.e. the marginal cost, marginal
---------------------- revenue, average cost and average revenue should all be equal. Thus,
under perfect competition in the long-run, a firm is in full equilibrium
----------------------
when
---------------------- MR = LMC = LAC = AR = Price
---------------------- If the price is more than the average cost, the firm may earn supernormal
profits and this would attract new firms to the industry. Entry of new
---------------------- firms would result in a greater production, and a reduction in supernormal
profit. In the long run, all firms would, therefore, earn only the normal
----------------------
profit. Similarly, if the price is less than the average cost, losses would
---------------------- occur and this may drive some of the firms out of the industry. The firm’s
equilibrium under perfect competition in the long run is shown in the
---------------------- following diagram.
---------------------- In the following figure, marginal cost, marginal revenue and price are
all equal at point E. The firm is, therefore, in equilibrium in the long run
---------------------- when its output is OM and price is OP.
---------------------- Long - Run Equilibrium of a Firm
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
---------------------- Output (units)
(E) Equilibrium of Industry
----------------------
When all the firms engaged in an industry are in equilibrium, the industry
---------------------- as a whole is in equilibrium. This means that equilibrium is established by
---------------------- total supply and total demand in the industry.
If demand is more than the supply, production may be increased.
---------------------- Conversely, if the demand is less than the supply, the output may be
---------------------- curtailed. Such changes in the output can not take place when the industry is
in equilibrium. Equilibrium of the industry is determined by total demand
---------------------- and total supply. The price is also fixed by total demand and total supply

of the industry; and not by any single firm. It is, therefore, necessary that, Notes
for the equilibrium of the industry size of production should be stabilised
at a certain point. There should be no tendency for firms to increase or ----------------------
curtail their output. When ideal size of output is achieved, there is no
temptation for new firms to enter the industry and there should be no ----------------------
reason for existing firms to go out of the industry. Thus, when output is ----------------------
stabilised at the optimum point, marginal cost will be equal to marginal
revenue and the firm would earn only normal profit. All the firms would ----------------------
earn normal profits. If they earn super-normal profits or incur losses, it
would lead to an entry or exit of firms; ultimately, equilibrium of the ----------------------
industry would be disturbed. ----------------------
Conclusion
----------------------
It will be seen from the foregoing discussion that a firm maximizes its
profit and achieves an equilibrium position when its marginal cost, is ----------------------
equal to the marginal revenue. When all the firms in an industry are in
----------------------
equilibrium, the industry as a whole is also in equilibrium. In the long-run
equilibrium of an industry, output is stabilised at an optimum or ideal size ----------------------
and there is no entry or exit of firms; because in the long run every firm is
earning only normal profit. ----------------------
----------------------
----------------------
1. Under perfect competition, each firm is considered as a price-taker
and not price-maker. ----------------------
2. Under perfect competition, if supply is reduced, demand being ----------------------

constant, price will fall.
----------------------
3. In the long run, supply plays a dominant role and demand is passive
in determining price. ----------------------
4. When a consumer minimises his satisfaction, he is said to be in ----------------------
equilibrium.
----------------------
Fill in the blanks.
1. Under perfect competition price is determined by interaction of ----------------------
_________ and _________. ----------------------
2. When demand and supply curves balance each other it is called the
----------------------
____________.
3. A group of firms operating in the same line of business is called an ----------------------
___________.
----------------------
4. Under perfect competition when all the firms engaged in an industry
are in equilibrium, the industry is said to be in ____________. ----------------------
----------------------

Notes
Activity 2
----------------------
---------------------- A firm is in a formidably commanding position. It is earning supernormal

profits. The consumers are happy with the product, quality thereby
---------------------- deriving product satisfaction. The firm is also satisfied with the way the
market is treating it. Now what do you think is the biggest threat to this
----------------------
firm? Why?
----------------------
---------------------- Summary
---------------------- ●● The unit begins with the concept of a ‘market’, depicting local, national
and international markets. The modern view as given by economist,
----------------------
Jevons tells that there are no restrictions for a commodity on the products’
---------------------- location (its placement in the market) and also that of the buyers and
sellers in the market.
---------------------- ●● Pure Competition is differentiated from Perfect Competition. The former
---------------------- is featured on the basis of a large number of buyers and sellers, product
homogeneity, and free entry and exit of firms. A Perfect Competition
---------------------- features - in addition to the above - perfect knowledge of market conditions
by all those operating in the said market, bringing in no discrimination
---------------------- amongst buyers on the basis of caste, creed or colour. It further assumes
---------------------- no transportation cost, perfect mobility of factors of production and
automatic price mechanism.
---------------------- ●● In this unit, we study the various concepts and situations arising under
---------------------- conditions of Perfect Competition.
●● The demand curve is a perfectly elastic curve, which represents the
---------------------- Average Revenue curve as well; this reflects that every firm is a price-
---------------------- taker; a single firm hence is no position to affect the market supply.
●● The equilibrium price is determined by the market forces of demand and
---------------------- supply.
---------------------- ●● Under Perfect Competition, for a firm to be in equilibrium, the conditions
are : (1) MR = MC and (2) MC curve must cut the MR curve from below.
---------------------- The output and the price at which this happens are the equilibrium output
and the equilibrium price respectively.
----------------------
●● The very interesting part of the unit comes with the four clauses that
---------------------- are given on the basis of the time-period classification. The graphical
explanation of the 4 circumstances from the firm earning super normal
----------------------
profits to finally closing down its production is worth a good study.
---------------------- ●● This unit thus highlights features of a perfectly competitive market – the
behavioural patterns, the price and output determination and the process
----------------------
of attaining equilibrium of the firm and the industry as a whole.
----------------------

Keywords Notes
----------------------
●● Entry of Firms : Firms can start business and thus can become a part of
the already existing transacting ground, add to the total supply coming to ----------------------
the market and enjoy consumer demand.
●● Exit of Firms : When firms discontinue to remain in business, when they ----------------------
continue to incur losses. ----------------------
●● Equilibrium : State at which consumer achieves maximum satisfaction
and firm achieves maximum profit. ----------------------
●● Marginal Revenue : Addition made to the total revenue as a result of the ----------------------
sale of one more unit of output.
----------------------
●● Market : Transacting ground for buyers and sellers.
●● Total Revenue : Total receipts from the sale of a given ouput. ----------------------
----------------------
----------------------
1. Elaborate on the features of Perfect Competition.
----------------------
2. How is the price of the product determined under conditions of perfect
competition in the short run and in the long run? ----------------------
3. For an industry to be in equilibrium, the pre-requisite or the effect of it is ----------------------
that all the firms in the industry are earning only normal profits. Why is it
so? ----------------------
4. What are the conditions of equilibrium for a firm under Perfect ----------------------
Competition?
----------------------
5. Write in full about a firm’s business journey from earning super normal
profits to finally shutting down its office, in view of Dr. Alfred Marshall’s ----------------------
classification of time-period.
----------------------
6. Write short notes on:
a. Market – local, national and international ----------------------
b. Demand curve under Perfect Competition ----------------------

c. Changes in Demand and Supply (its effect on price) ----------------------
d. Market Period
----------------------
e. Firm shuts down its production
----------------------
----------------------
----------------------
----------------------
----------------------


1. True
----------------------
2. False
----------------------
3. True
---------------------- 1. Competition in the market can be either perfect or imperfect.
---------------------- 2. The products sold by different sellers under pure competition are
homogeneous.
---------------------- Check your progress 2
---------------------- 1. True
2. False
----------------------
3. True
----------------------
4. False
----------------------
Fill in the blanks.
---------------------- 1. Under perfect competition price is determined by interaction of total
demand and total supply.
----------------------
2. When demand and supply curves balance each other it is called the
---------------------- equilibrium point.
---------------------- 3. A group of firms operating in the same line of business is called an
industry.
----------------------
4. Under perfect competition when all the firms engaged in an industry are
---------------------- in equilibrium, the industry is said to be in equilibrium.
----------------------
Suggested Reading
----------------------
1. Baumol W. J. 1996. Economics Theory and Operations Analysis. Prentice
---------------------- Hall Inc.
----------------------
----------------------
----------------------
----------------------
----------------------

Imperfect Competition
UNIT
10
Structure:
10.1 Introduction
10.2 Monopoly
10.3 Distinction between Perfect Competition and Monopoly
10.4 Determination of Price and Output (Equilibrium Under Monopoly)
10.5 Price Discrimination under Monopoly
10.6 Conditions of Equilibrium under Price-Discrimination
10.7 Equilibrium under Discriminating Monopoly
10.8 Dumping
10.9 Degrees of Price Discrimination
10.10 Monopolistic Competition
10.11 Determination of Price and Output under Monopolistic Competition
10.12 Comparison of Long-Run Equilibrium under Perfect Competition and
Monopolistic Competition
10.13 Monopsony
10.14 Oligopoly and Duopoly
10.15 Miscellaneous Issues in Monopolistic Competition
Summary
Key Words
Suggested Reading
Imperfect Competition 213

Notes
Objectives
----------------------
----------------------
• Differentiate between perfect competition and imperfect
---------------------- competition
---------------------- • Classify monopoly, monopolistic competition, monopsony,
oligopoly, duopoly
----------------------
• Construct kinky demand curve
----------------------
---------------------- 10.1 INTRODUCTION

---------------------- In the real world, perfect competition is seldom realised. What we
experience is the imperfect competition in its several forms. In the 20th century,
----------------------
markets all over the world have become imperfect on account of several factors.
---------------------- Buyers and sellers do not possess perfect knowledge and the products sold are
no more homogeneous. They are often differentiated as to their size, design and
---------------------- colour. The number of buyers and sellers is also small. Depending on the number
of sellers operating in the market, imperfect competition is further classified
----------------------
under the following heads : 1) Monopoly 2) Monopolistic Competition 3)
---------------------- Monopsony 4) Oligopoly 5) Duopoly
---------------------- 10.2 MONOPOLY

----------------------
The other extreme type of market, is the one where there is absence of any
---------------------- competition. This is a situation, where there is only one producer, it is called
Monopoly.
----------------------
(A) Pure and Perfect Monopoly
---------------------- For pure monopoly to exist, the following conditions must be satisfied :
---------------------- (i) One firm producing in the market,
---------------------- (ii) The commodity produced should have no substitute.
(B) Impure Monopoly
----------------------
Impure or simple monopoly exists in the market of a commodity, where
---------------------- there is only one producer of the commodity; and the commodity has no
close substitute.
----------------------
Since there is only one producer, the distinction between the firm and the
---------------------- industry does not exist under monopoly.
---------------------- (C) The following features are seen under simple or limited monopoly
---------------------- (i) Single Producer : For monopoly to exist only one producer should
be in the market. The producer may be an individual, a partnership
---------------------- firm, the Government or a joint-stock company.

(ii) No Close Substitutes : To avoid any possibility of competition in Notes
the market, there should be no close substitutes for the product of
the monopolist. This means that the cross-elasticity of demand for ----------------------
the monopolists product is low.
----------------------
(iii) Barriers to entry of firms : The basis of monopoly is the barriers or
restrictions of new firms into the market; these can either be natural ----------------------
barriers or artificial barriers.
----------------------
(iv) Demand Curve under Monopoly : The above features explain the
demand curve or the average revenue (AR) curve under monopoly. ----------------------
The demand curve for a firm (which means the industry under
----------------------
monopoly) is downward sloping. It is the monopolist who is the
price-maker in the market. ----------------------
Y
----------------------
----------------------
----------------------
AR/Price
----------------------
----------------------
AR/Demand Curve ----------------------
----------------------
O X
Units of output ----------------------
(D) The Demand Curve Under Monopoly ----------------------
Under monopoly, there is only one seller who controls the entire supply in the
market. Since there is only one producer or one seller he can fix the price of ----------------------
his product. In order to maximize his profit, he may raise the price frequently. ----------------------
He may exploit the consumers by charging an exorbitant price. Since there
are no other sellers, the buyers have no alternative than to buy from the ----------------------
monopolist. Indeed, all buyers are put at the mercy of the monopolist.
----------------------
Many times, monopolies are created under law. Urban transport, supply
of cooking gas and electricity and such other public utilities are usually ----------------------
managed as monopolies. Such monopolies are called Natural Monopolies.
----------------------
On the other hand, if a producer acquires monopoly on the basis of Patent
Laws, it is a case of an Artificial Monopoly. ----------------------
Indian Railways is a classic example of monopoly, which is created by the
----------------------
government in the interest of the general public. Creation of atomic energy
is also in the hands of the government. At the international level, Bill Gates' ----------------------
Microsoft is an example of very close to monopoly, in the field of IT.
----------------------
----------------------

Notes 10.3 DISTINCTION BETWEEN PERFECT COMPETITION
AND MONOPOLY
----------------------
Monopoly differs from perfect competition in the following important
---------------------- respects.
---------------------- (a) Under perfect competition, there are many buyers and many sellers. No
individual seller or buyer is able to fix or change the market price. The
----------------------
price under perfect competition is fixed by the interaction of total demand
---------------------- and total supply in the market. It is beyond the scope of an individual
seller (firm) to influence the price by his own action. On the other hand,
---------------------- under monopoly there is only one seller who is free to fix the price, or
change it, whenever he likes.
----------------------
The distinction between Perfect Competition and Monopoly can be shown
---------------------- with the help of the positions of A.R. and Marginal Revenue Curves as
shown below.
----------------------
Diagram (i) Diagram (ii)
----------------------
A Firm under Perfect Competition Monoploy
---------------------- Y Y
----------------------
Price Price
---------------------- AR & P AR = MR AR &
MR MR
---------------------- AR
MR
----------------------
O Units of output X O Units of output X
----------------------
Under perfect competition the demand curve (AR) of a firm is perfectly
---------------------- elastic and the price is fixed at OP.
---------------------- Where as in diagram (ii) the demand curve AR is sloping downwards to
the right and the price (AR) on the Y - axis can be at any point as decided
---------------------- by the monopolist.
---------------------- (b) Under perfect competition there are many firms in an industry; and all
of them are selling homogeneous products; but under monopoly the
---------------------- distinction between firm and industry recedes in the background. Since
---------------------- there is only one seller, firm and industry is the same under monopoly.
(c) Under perfect competition there is a free entry and a free exit of firms.
----------------------
There are no hindrances to the new producers who desire to enter the
---------------------- industry. But under monopoly entry of new firms is prohibited. For
example, in India no new firm can be started to deal in railways; because
---------------------- the monopoly of railways has been entrusted to the Indian Railways.
---------------------- (d) Under perfect competition, every seller is charging the same price in
the long run and is making normal profits. If a particular firm charges a
---------------------- slightly higher price the customers would turn to other sellers. But under

monopoly, there is only one seller, and he can raise the price any time; Notes
and the customers have no other alternative than to buy from the same
monopolist. Under perfect competition a firm attains its equilibrium when ----------------------
marginal cost is equal to marginal revenue, average revenue and price.
But under monopoly, average cost is much lower than the price. ----------------------
(e) Since under monopoly, average cost is much lower than the price, the ----------------------
monopolist can earn supernormal profits in the long run. Under perfect
----------------------
competition, however, a firm can earn only the Normal profits in the long
run. If it earns supernormal profits, there will be entry of new firms and ----------------------
this profit would be shared by all the firms. Ultimately, the firm would
earn only the normal profit. Under monopoly, the entry of new firms being ----------------------
prohibited, the monopolist can earn supernormal profits in the long run.
----------------------
(f) Since there are many firms operating under perfect competition, total
output in the society is larger and the price charged is also reasonable. ----------------------
But under monopoly, total output is smaller and the price charged is
----------------------
unreasonable.
----------------------
10.4 DETERMINATION OF PRICE AND OUTPUT
(EQUILIBRIUM UNDER MONOPOLY) ----------------------
(A) Marginal Cost and Marginal Revenue ----------------------

Under monopoly, the firm is a price-marker, a firm can therefore fix the ----------------------
price of its product, given the output. The demand curve (AR curve) is
therefore, downward sloping under monopoly, and so the MR curve is ----------------------
below the AR curve.
----------------------
The conditions of equilibrium are the same as under perfect competition, i.e.
----------------------
MR = MC and MC curve cuts MR curve from below.
Y ----------------------
----------------------
AR
----------------------
MR
----------------------
AR ----------------------
MR ----------------------
O Output (units) X ----------------------
Short - run ----------------------
A monopolist can make either normal profits or supernormal profits in
----------------------
the short-run. A monopolist making sub-normal profits will remain in
production in the short-run so long as its AVC is covered. ----------------------
----------------------

Notes Thus, in the short-run under monopoly, there are three possibilities as
shown below.
----------------------
Normal Profits
----------------------
----------------------

----------------------
----------------------
----------------------
----------------------
----------------------
---------------------- In the figure, E1 is the point of equilibrium, OQ1 is the equilibrium output
and OP1 is the equilibrium price.
----------------------
AC = A1Q1 AR = A1Q1
----------------------
AC = AR, the firm makes normal profits.
---------------------- Super-Normal Profits
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Output (units)
----------------------
In the above figure, E2 is the point of equilibrium, OQ2 is the equilibrium
---------------------- output, OP2 is the equilibrium price.
---------------------- AC = A2Q2
---------------------- AR = R2Q2
AR > AC, the firm makes Super- Normal profits equal to the area given
----------------------
by P2R2A2C2
---------------------- Sub-Normal Profits Covering AVC
----------------------

Notes
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
In the figure, E3 is the point of equilibrium, OQ3 is the equilibrium output, ----------------------
OP3 is the equilibrium price.
----------------------
AC = A3Q3
----------------------
AR = R3Q3, AVC = R3Q3
----------------------
AR < AC, the firm makes sub-normal profits equal to C3A3R3P3. Even
though the firm makes losses, it continues to produce in the short-run ----------------------
because AVC is covered.
----------------------
(B) Long - run equilibrium under Monopoly
A firm under monopoly may make normal profits in the long-run; ----------------------
however, it tries to make super-normal (abnormal) profits in the long-
----------------------
run. The LRAC is flatter than the short-run average cost curve, but the
conditions of equilibrium are the same as in the short-run. ----------------------
E0 is the point of equilibrium, OQ0 the equilibrium output, OP0 equilibrium ----------------------
price.
AR = R0Q0. AC = C0Q0, AR > AC so the firm makes super - normal profits ----------------------
equal to P0R0C0P. ----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Notes Fig. showing Long Run Equilibrium under Monopoly
----------------------
----------------------
----------------------

----------------------
----------------------
----------------------
----------------------
----------------------
---------------------- Output (units)

----------------------
Fill in the blanks.
----------------------
1. The important features seen under simple or limited monopoly
---------------------- are__________, no close ____________, _________ to entry of
firms and a downward slopping __________.
----------------------
2. If a producer acquires monopoly based on patent laws it is called
---------------------- ____________.
---------------------- 3. Under perfect competition, there is ____________ and ________ of
firms.
----------------------
---------------------- 1. Under monopoly, there is only one seller.
---------------------- 2. Under perfect competition, any individual seller is able to influence
the price by his own action.
----------------------
3. A monopolist can make normal profit but he cannot make supernormal
---------------------- profits in the short run.
----------------------
---------------------- Activity 1
---------------------- Can you think of two examples of monopoly (or close to monopoly) at the
local level and at the national and international level?
----------------------
----------------------
----------------------

10.5 PRICE DISCRIMINATION UNDER MONOPOLY Notes
Introduction ----------------------
By following trial and error method, a monopolist fixes the price of his product ----------------------
so as to maximize his profit. There is a second alternative open to the monopolist.
He can discriminate between buyers and charge different prices to different ----------------------
customers. This is called Price Discrimination or Discriminating Monopoly.
An attempt should therefore, be made to explain how price discrimination is ----------------------
practiced by the monopolist. ----------------------
(A) What is Price Discrimination?
----------------------
Instead of charging a uniform price to all the consumers a monopolist may
divide the market into different classes of people. One market segment ----------------------
may consist of poor, whereas another market segment may be inhabited
----------------------
by the rich. The monopolist may charge a lower price to the poor and
middle class people whereas he may charge a higher price to the rich ----------------------
customers. Charging different prices to different customers for the same
product is called Price Discrimination. ----------------------
Examples of price discrimination are many. A surgeon may charge Rs. ----------------------
5000/- for operating a middle class patient, whereas he may charge Rs.
10000/- for the similar operation of a rich patient. The skill used in both ----------------------
the operations is the same; but the fees charged to different patients are
----------------------
different. Similarly, different prices are charged by a cinema house for
different classes of viewers. All the viewers see the same movie; but they ----------------------
have to pay a higher price for occupying a seat in the first class or balcony.
Railway companies also charge different fares to first class, second class ----------------------
and air-conditioned class passengers. As a matter of fact, the passengers
----------------------
in different compartments reach the destination at the same time. But
they have to pay different fares for traveling by II class, I class or AC ----------------------
class. Similarly, an electric company can charge lower rates for domestic
consumption and higher rates for commercial consumption and marginal ----------------------
rate to farmers.
----------------------
Although there is some difference in the comforts provided to different
classes of customers, this difference is negligible. Difference in the prices ----------------------
charged is, however, substantial. Thus, a monopolist can charge different
----------------------
prices to different segments of markets so as to maximize his profit.
(B) When is Price Discrimination Possible? ----------------------
Charging different prices to different customers is rendered possible in ----------------------

the following circumstances :
----------------------
(a) Legal Sanction
----------------------
Public utilities such as railway or electric supply companies,
cooking gas supply companies are allowed under Law to charge ----------------------
different prices to different classes of consumers.
----------------------

Notes (b) Nature of Commodity
Price discrimination is possible where personal service sold to the
----------------------
customers cannot be resold. Thus a surgeon may charge a lower
---------------------- fee for operation of a poor patient than a rich patient for similar
operation. Similarly, an advocate may charge very high fees to a
---------------------- rich client, whereas he may charge a lower fee to a poor client for a
similar court litigation.
----------------------
(c) Geographical Barriers
----------------------
If two markets are separated from each other on account of
---------------------- geographical barriers it may enable a monopolist to charge different
prices in two different markets. In international trade, markets are
---------------------- separated by raising the protection wall and different custom duties
are charged on the imports from different countries.
----------------------
(d) Ignorance of Buyers
----------------------
Price discrimination is possible if the consumers in one market do
---------------------- not know that a lower price is charged in another market. Ignorance
of consumers thus enables the monopolist to charge different prices.
---------------------- Sometimes, the consumers may exhibit an irrational feeling that
---------------------- they are paying a higher price for better quality of goods. It is likely
that the customers may know that a lower price is being charged
---------------------- in another market; but the difference in price being negligible they
may not go to the other market. This may enable the monopolist to
---------------------- charge different prices in different markets.
---------------------- (C) Conditions of Price Discrimination
---------------------- The foregoing discussion should explain the situations when price
discrimination is possible. For price discrimination to be successful the
---------------------- following conditions should be fulfilled :
---------------------- (a) The different markets in which the product is sold should be
separated. i.e. there should be no contact between buyers in the
---------------------- two markets. If buyers in one market know that the price charged
in another market is lower, they would buy the product in another
----------------------
market and sell it in their own market. This will lead to equality of
---------------------- price in both the markets and price discrimination would no more
be possible. No possibility of resale of the product.
----------------------
(b) The elasticity of demand in different markets should be different.
---------------------- Price discrimination may not be possible if elasticity of demand is
the same in both the markets.
----------------------
(c) Market must be imperfect.
---------------------- (D) When is it Profitable?
---------------------- Having known the conditions of price discrimination, it is worthwhile to
know when it is profitable to the monopolist. In other words, it is necessary
----------------------

to study the position of equilibrium when the monopolist maximizes his Notes
profit. The principles which apply to the equilibrium of a firm are also
applicable in this case. An additional assumption to be made here is that ----------------------
the monopolist is selling his product in two different markets. This would
make our analysis complicated but it does not affect the basic principle of ----------------------
equilibrium, viz. a firm is in equilibrium when its marginal cost is equal to ----------------------
marginal revenue. One more assumption is that the elasticity of demand
in two different markets is different. ----------------------
----------------------
10.6 CONDITIONS OF EQUILIBRIUM UNDER
PRICE-DISCRIMINATION ----------------------
(A) MR = MC (B) MRA = MRB where A and B are two markets. ----------------------
On the basis of these assumptions, let us understand when price ----------------------
discrimination would be profitable.
----------------------
Let us presume that the monopolist sells his product in market A and
market B. Demand in market A is inelastic or rigid and demand in market B is ----------------------
very elastic i.e. responsive to the changes in price. Under such circumstances
the monopolist would raise the price in market A. His sales in this market would ----------------------
not be affected because demand is inelastic. On the other hand, the demand in
market B being elastic, a slight reduction in the price would increase the sales. ----------------------
The monopolist would, therefore, raise the price in market A and would reduce ----------------------
it in market B. The volume of sales in market A would remain more or less the
same, but sales in market B will increase, on account of reduction in the price ----------------------
would increase the sales. The monopolist would, therefore, raise the price in
market A and would reduce it in market B. The volume of sales in market A ----------------------
would remain more or less the same, but sales in market B will increase, on
----------------------
account of reduction in the price. Naturally, the monopolist would have to divert
the supply from market A to market B. If sales in market A are slightly reduced ----------------------
on the account of higher price, this loss would be compensated by an increase in
sales in market B. A pertinent question that arises here is that how long supply ----------------------
would be transferred form market A to market B ? The answer to this question
is that the supply would be diverted so long as the marginal revenue earned in ----------------------
market B is higher than the marginal revenue earned in market A. The transfer ----------------------
of supply from market A to market B would be stopped when marginal revenue
in both the markets is equal. At this point, total profit earned by the monopolist ----------------------
is maximum and he is in equilibrium.
----------------------
To give an instance of price discrimination under monopoly, again we
can say about Indian railways. The system charges two different fares from ----------------------
the passenger travelling in First Class AC chair car and First Class and Second
Class. ----------------------
MSEB charge two different prices for one unit of electricity sold from ----------------------
households and industrial undertakings. The domestic rate varies with the level
of consumption; the rate increases as the level of consumption level of the ----------------------
household increase. For example, it is Rs. 1.50 per unit (all inclusive i.e. metre ----------------------

Notes rent, taxes, surcharge, etc.) for those below the consumption of 100 units per
month and the maximum rate is Rs. 4 per unit consumption. The commercial
---------------------- rate is around Rs. 6 per unit of consumption.
----------------------
10.7 EQUILIBRIUM UNDER DISCRIMINATING MONOPOLY
----------------------
---------------------- Price /Cost/Revenue
Price /Cost/Revenue
Price /Cost/Revenue
----------------------
---------------------- AR1
----------------------
Output Output Output
---------------------- Consider two markets, market A with relatively inelastic demand and
---------------------- market B with relatively elastic demand.
In figure 3, E is the point of equilibrium where MR = MC, OQ is the total
---------------------- output of the firm. This is to be sold in the two markets at different prices.
---------------------- In Market B, E2 is the point at which MC = MR which is related to MR2.
OQ2 is the output sold in market B and at price OP2.
----------------------
In Market A, E1 is the point at which MC = MR which is related to MR1.
---------------------- OQ1 is the output sold in market A sold and at price OP1.
---------------------- Thus, OQ = OQ1 + OQ2
---------------------- The price in market A is higher than the price in market B; and the sales
in market A are lower than the sales in market B.
---------------------- The total revenue to the firm, however, increases because of price-
---------------------- discrimination.
---------------------- 10.8 DUMPING

---------------------- Where a monopolist is charging a higher price in the home market and
---------------------- a lower price in the international market, it is called Dumping. In Dumping,
the losses incurred in the international market are compensated in the home
---------------------- market. The weapon of dumping is successfully handled by the monopolist.
In India, dumping is encouraged with a view to promoting the exports. The
---------------------- Indian exporters are selling their products abroad at lower prices. The losses
---------------------- they incur in foreign markets are converted in the home market where higher
price is charged. If the monopolist is unable to recover his losses he is given
---------------------- a subsidy or an Export Bounty, by the Government of India. The incentive of
export bounties has contributed to higher exports and higher earnings of foreign
---------------------- exchange.
---------------------- A recent example could be cited of the Chinese economy, which was
'dumping' its products in the Indian market at throw away prices, namely, Chinese
---------------------- toys and batteries and cycles, etc. Some years ago, when China was not actively

involved, or even their products were underrated, electronic items, electronic Notes
components, musical instruments were dumped into India from countries like
Taiwan, and Korea, Indonesia, Mexico. Even now, to a large extent electronic ----------------------
goods like T.V., all types of musical instruments, home theatres (semi-domestic
consumption), are available in the Indian markets that come from these said ----------------------
countries. If one goes abroad and buys the product therefrom and finally brings ----------------------
to his home ground by paying the customs, it is going to cost him a lot more
than (in most cases) what the same kind would be available here at a lesser rate. ----------------------
----------------------
----------------------
Fill in the blanks.
----------------------
1. Price discrimination is possible under legal sanction, nature of
_________, ___________ barrier and ignorance of _________. ----------------------
2. Where a monopolist can discriminate buyers and charge different ----------------------

prices to the customers, it is called _______________ or
_________________. ----------------------

1. A monopolist cannot do any price discrimination. ----------------------
2. In India, dumping is encouraged where exporters sell their products
----------------------
abroad at lower prices.
----------------------
Activity 2 ----------------------
----------------------
Under which conditions can you resort to price discrimination if you are
a seller of your labour service? How will you succeed in your endeavour? ----------------------
----------------------
10.9 DEGREES OF PRICE DISCRIMINATION ----------------------
The degrees of price discrimination have been elegantly shown by Prof. ----------------------
A. C. Pigou. According to him, there are three degrees of price discrimination.
----------------------
(a) Under the first degree, the monopolist charges the highest price. This does
not leave any consumer's surplus to the buyers. An example of this degree ----------------------
is provided by a surgeon or a barrister who charges the maximum fees.
----------------------
(b) Under the second degree of price discrimination, the monopolist does
not charge different prices to individual customers. Instead, he classifies ----------------------
the customers into certain groups according to the level of their incomes.
Thus, he may classify the customers into the rich, middle class and poor ----------------------
customers. He charges different prices to different groups of people.
----------------------
The example of this type is provided by a railway company that charges
different fares to II class, I class and Air-conditioned class passengers. ----------------------

Notes Under this degree, the lowest price which the poorest customer from
every group can bear is charged. Therefore, it leaves some surplus to
---------------------- other consumers who are relatively better off than others in that group.
---------------------- (c) Under the third degree, different prices are charged in different markets.
The example is provided by dumping where a lower price is charged in
---------------------- the international market and a higher price is charged in the home market.
---------------------- Conclusion
Thus a monopolist can practice price discrimination by charging different prices
----------------------
to different customers. It is also practised under dumping where different prices
---------------------- are charged in international and the home market. Such price discrimination,
---------------------- (a) adds to the power of the monopolist,

(b) adds to the profit of the monopolist, and
----------------------
(c) adds to the total output than the output under pure monopoly.
----------------------
----------------------
10.10 MONOPOLISTIC COMPETITION
---------------------- (i) Fairly Large Number of Firms

The number of sellers operating under this type of competition is larger
---------------------- than under oligopoly but less than under perfect competition. There
---------------------- may be (20-25) sellers engaged in the same line of business. They are
producing commodities which are close substitutes for each other. Every
---------------------- seller has to compete with others to increase his sales. Since every seller
is selling a standardised product for a long time, he acquires monopoly of
---------------------- that product. When such monopolistic producers are competing amongst
themselves, it is called monopolistic competition. The competition being
----------------------
very keen, the sellers have to find out different methods to maintain
---------------------- their sales and profit. Professor Chamberlin has elegantly shown the
methods used by such monopolistic producers. Most of these methods
---------------------- are hazardous and each seller tries to be rich at the cost of others. This
competition is, therefore, called cut-throat competition and the methods
---------------------- followed are called 'Beggar thy Neighbour tactics'. It is worthwhile to
---------------------- outline the salient features and the methods of monopolistic competition.
(ii) Product Differentiation
----------------------
Under monopolistic competition, every seller tries to distinguish his
---------------------- product from the products manufactured by others. He claims that his
Research and Development Department has developed a new product
---------------------- after considerable research. As a matter of fact, the product so introduced
in the market is not new. The same old product is sold under a different
----------------------
trade name, style, design and colour. Thus, by changing the outward
---------------------- appearance of the product, the general public is made to believe that it
is a new product. Basically, it does not differ in quality and the process
---------------------- of manufacture. But the people are fooled by stating that it is a product
different than the old one. This is called Product Differentiation. For
----------------------

example, Hindustan Lever Ltd. sells bathing soaps under different trade Notes
marks such as Lux and Rexona. Basic contents and ingredients in both
the soaps are the same. Lux may be used by one popular actress, whereas ----------------------
Rexona may be used by another popular actress. Differences thus exist only
in outward appearance, not in their contents. Such a method of product ----------------------
differentiation helps the producers under monopolistic competition to
----------------------
increase their total sales.
(iii) Selling Costs ----------------------
Every producer operating under monopolistic competition spends huge ----------------------
amounts on publicity. He spends on all the media of advertising such as
press, radio, television, hoarding, sites, neon signs etc. Every effort is ----------------------
made to keep the product before the eyes of the consumers, throughout
----------------------
the year. Whether he likes it or not, he has to incur a huge amounts on
publicity. This is because when others are spending, he cannot afford to ----------------------
lag behind in the race. Every producer therefore attempts to spend more
than his rivals. ----------------------
(iv) Price differences within a Price range ----------------------
Due to factor-immobility, or transport costs or ignorance of market, a
----------------------
single uniform price cannot be established in the market characterised by
monopolistic competition. On the contrary, similar products which are ----------------------
differentiated by brand names and advertisements are sold at different
prices. Every producer enjoys the freedom to price his own product; this ----------------------
freedom is within certain limits. Every producer has his own price-policy.
Under perfect competition, this freedom is not available to an individual ----------------------
firm. ----------------------
(v) Elastic Demand
----------------------
The Average Revenue Curve of a firm under monopolistic competition is
not parallel to the X-axis as it is under condition of perfect competition. ----------------------
As the products of all firms are not identical, buyers can have preferences.
So it is not possible for a firm to sell an infinite amount of the product ----------------------
at the ruling price as it is assumed to happen under perfect competition.
----------------------
Therefore, under monopolistic competition, the Average Revenue Curve
of a firm is not parallel to the X-axis as it is under perfect competition. ----------------------
Under monopoly, the Average Revenue Curve of the firm is steep because
there are no close substitutes for the product. Under monopolistic ----------------------
competition, on the other hand, a firm's product does have close
substitutes, and therefore, the Average Revenue Curve cannot be steep. ----------------------
Thus, the AR Curve faced by a firm under monopolistic competition is ----------------------
shallow indicating a highly elastic demand. Therefore, if a firm reduces
the price of its product while prices of rival products are unchanged, there ----------------------
would be a sizeable increase in the sales of the firm.
----------------------
(vi) Price War
----------------------
Another method followed to extinguish the rivals from the market, is a
reduction in the selling price. In order to attract new customers, a particular ----------------------

Notes producer may reduce the price of his product. Naturally, other producers
are required to reduce their prices in order to retain their customers. Price
---------------------- reduction is sometimes carried to such an extent that it takes the form of
a price war.
----------------------
An example of price war is provide by the Indian shipping industry.
---------------------- The Scindia Steam Navigation Company Limited was started by Seth
Walchand Hirachand on the 19th June 1919. He purchased a second-hand
---------------------- ship called S. S. Loyally and started the voyage. In course of time, the
---------------------- company made good progress, acquired more fleet and began to compete
with the British Shipping Companies. In these days, shipping industry
---------------------- was controlled by the British and the British ship-owners did not like
that an Indian company should come up to share the profits. In order to
---------------------- extinguish the Scindia Steam, the British ship owners reduced the freight
charges. The Scindia too was required to reduce its freight. The reduction
----------------------
in freight rate went to such an extent that the British ship owners began
---------------------- to advertise in the newspapers that they were prepared to carry the cargo
from Bombay to Rangoon free of charge. They thought that the Scindia
---------------------- would not be able to withstand the shocks of the price war; but the Scindia
could manage in such critical times and could come up as the nation's
---------------------- largest shipping company in the private sector.
---------------------- (vii) Gift Articles
---------------------- Price war is, however, harmful to all the sellers because it reduces the
profits of all. Producers working under cut-throat competition have,
---------------------- therefore, found out a novel method of increasing the sales. Instead of
reducing the price, they hand over small gift articles to the buyers who
---------------------- buy the product. The gift scheme is operative only for a limited period and
---------------------- it is advertised in the newspapers on a large scale. This enables a producer
to achieve a substantial increase in sales within a short-time. For example,
---------------------- there are many tooth-paste manufacturing companies such as Colgate,
Palmolive, Promise, Close-up, Babul, Cibaca etc. In order to increase the
---------------------- sales, a particular company may hand over a tooth-brush free, to a buyer
who buys the tooth-paste. Companies like Nescafe or Cadbury organise
----------------------
cross-word competitions. An essential condition for submitting an entry
---------------------- form in the crossword contest is that a certain number of used wrappers
are to be attached to the entry form. Since many customers participate in
---------------------- the contest it results in an automatic increase in sales within a short time.
---------------------- (viii) Unfair Methods
Under cut-throat competition, a number of unfair methods are used to
---------------------- extinguish the rivals from the market. Some of these methods may be
---------------------- described in brief.
(a) A producer who maintains a skilled and qualified staff, is able
---------------------- to produce high quality products. On the basis of quality, he can
---------------------- capture the whole market within a short time. Other producers who
cannot compete with him may, therefore, snatch away key persons
---------------------- from his factory, by paying them higher salaries. Thus, when the

Chief Production Engineer is snatched away, the quality of goods is Notes
deteriorates and the firm loses its control on the market. The other
producer, who has snatched away the engineer, may gain control on ----------------------
the market.
----------------------
(b) A firm which has prospered becomes a target of attack by the rival
producers. They may get hold of the Union Leader in the prosperous ----------------------
company; and may ask him to arrange a strike. This would affect
the production schedule of the prosperous company and at the same ----------------------
time, help the rivals to gain control over the market.
----------------------
(c) The rivals may try to lower the reputation of the prosperous producer.
They pass on false information to the government departments. ----------------------
They may make several allegations that the prosperous producer
----------------------
is evading excise duty, sales tax and income tax. Government
departments may institute raids on the prosperous producer. This ----------------------
may lower his reputation and he might be extinguished from the
market. Thus, the methods followed under cut-throat competition ----------------------
are hazardous, harmful and immoral.
----------------------
Thus, the market form with the characteristics noted above,
contains elements of both monopoly as well as competition and ----------------------
therefore it is called monopolistic competition. Products like tooth
paste, tooth brush, soaps, detergents, cigarettes, different brands of ----------------------
alcohol, different brands of body talcum powder, cosmetics etc. are ----------------------
produced under monopolistic competition.
----------------------
10.11 DETERMINATION OF PRICE AND OUTPUT
----------------------
UNDER MONOPOLISTIC COMPETITION
----------------------
The foregoing account would indicate how monopolistic competition is
characterised by product differentiation, selling costs. It is worthwhile to see ----------------------
how price of a product is determined under monopolistic competition.
----------------------
Every producer operating under monopolistic competition is selling his
product under a particular brand or trade name. Before, fixing the price he has ----------------------
to take into account the prices of substitutes. The prices charged by rivals enable
----------------------
him to fix his price.A producer who has introduced a new product in the market,
would necessarily fix the price which is lower than the price charged by his ----------------------
rivals. The price, fixed in this manner, may not, however, remain constant. The
producer may be required to reduce his price, if the competitors have reduced ----------------------
their respective prices. Although an individual producer, under monopolistic
----------------------
competition, is free to fix his price, he cannot fix it without taking into account
the prices charged by rivals. The price policy under monopolistic competition ----------------------
is thus dependent on the prices charged by other rival firms. It is, therefore,
worthwhile to see how price is fixed and the equilibrium position is reached ----------------------
under monopolistic competition in the short-run. To determine the equilibrium
----------------------
price and output under monopolistic competition we assume the demand and
cost curves as given. ----------------------

Notes (A) Short-run Equilibrium under Monopolistic Competition
Under monopolistic competition, equilibrium of a firm is arrived at in the
----------------------
same manner as under other forms of competition. A firm's profit is maximum
---------------------- and the firm is in equilibrium when its marginal cost is equal to marginal
revenue. This would be clear form the following diagram :
----------------------
Short-Run Equilibrium
---------------------- Under Monopolistic Competition : Profit
----------------------
----------------------
---------------------- Cost/Price/Revenue
----------------------
----------------------
----------------------
----------------------
----------------------
---------------------- Output
---------------------- In the figure, MR is the marginal revenue curve and AR is the average
revenue curve. Similarly, AC is the average cost curve and MC is the marginal
---------------------- cost curve. Here, the price is OP and the total profit is TSPP'. The profit is
shown by the shaded area. This profit is supernormal. An existing firm can also
---------------------- incur losses in the short- run. If the position of demand and cost is unfavorable,
---------------------- the firm may incur losses as shown below :
Losses under Monopolistic Competition
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
---------------------- In figure, AC is the average cost curve and it is higher than the average

revenue curve AR. Here the firm would incur a loss of STPP. Thus, in the short- Notes
run a firm working under monopolistic competition can earn supernormal profit
as well as incur a loss or may earn normal profits. ----------------------
(B) Long-run Equilibrium under Monopolistic Competition ----------------------
The supernormal profit earned by a firm may not last long; because new
----------------------
firms may be attracted to the industry, and the excess profits would be shared
between existing and new firms. The supernormal profits earned in the short- ----------------------
run would, therefore, disappear in the long-run. Another characteristic of long
term equilibrium is that a number of substitutes are available in the market. The ----------------------
marginal revenue curve is, therefore, elastic. The following figure would show
----------------------
how the firm would earn normal profits under long-run equilibrium.
Long Run Equilibrium under Monopolistic Competition ----------------------
Y ----------------------
MC ----------------------
AC
----------------------
T
P ----------------------
E AR ----------------------
----------------------
----------------------
MR
----------------------
X
O M
----------------------
In the figure, AR is the average revenue curve and MR is the marginal ----------------------
revenue curve. Similarly, MC is the marginal cost curve and AC is the average
cost curve. The average cost curve touches the average revenue curve at point T. ----------------------
At point E, MC = MR, OM is the ideal output and OP is the price. At this price
----------------------
and output the firm's profit is maximum and it is in equilibrium.
(C) Group Equilibrium under Monopolistic Competition ----------------------
We have seen how equilibrium of a firm is reached under monopolistic ----------------------
competition. We have now to see how and when the equilibrium of all the firms
is reached. Under monopolistic competition, the number of sellers is large and ----------------------
each seller is selling his product under a particular brand name. These products
----------------------
are not homogeneous, but are differentiated from each other. It is therefore,
difficult to analyse the conditions of group equilibrium where different firms ----------------------
are selling different products. For the sake of simplicity of analysis, we would
therefore, make the following assumptions : ----------------------
(a) Competing firms are selling more or less the same product. ----------------------
(b) The share of every firm in the total sales is equal. ----------------------

Notes (c) All firms are working with same efficiency.
(D) The number of sellers is large and there is free entry and exit of firms
----------------------
Under these assumptions, let us see how group equilibrium is reached.
---------------------- If these firms are earning supernormal profits in the short-run new firms may
be attracted to the industry. The new firms would charge a lower price so as to
----------------------
secure some customers. This will compel the old existing firms to reduce their
---------------------- prices. Naturally, the supernormal profits earned in the short-run will disappear
in the long-run. All the firms would then earn only the normal profit as shown in
---------------------- the figure. Thus, when all the firms are earning normal profit, the long-run group
equilibrium would be reached. This position is similar to the one prevailing
----------------------
under perfect competition. The only difference is that under perfect competition,
---------------------- output is very large, whereas under monopolistic competition output is much
less. Another point of distinction is that under perfect competition an inefficient
---------------------- firm is thrown out of the industry whereas under monopolistic competition even
an inefficient firm can survive.
----------------------
---------------------- 10.12 COMPARISON OF LONG-RUN EQUILIBRIUM
UNDER PERFECT COMPETITION AND
----------------------
MONOPOLISTIC COMPETITION
----------------------
Both under perfect competition and under monopolistic competition the
---------------------- firm makes normal profits in the long-run. However, the price-output situation
is different in the two cases.
----------------------
This is seen clearly in figure.
----------------------
Y
----------------------
LRMC
---------------------- LRAC
Cost/Price/Revenue
---------------------- E1
Pm
Ep
Pp ARp = MRp
----------------------
---------------------- Em
ARm
---------------------- MRm
X
---------------------- O Qm Qp
Output
----------------------
----------------------
----------------------
----------------------
----------------------

The description of the figure showing the comparison between Long Notes
run equilibrium under perfect competition and monopolistic competition is as
below. ----------------------
Perfect Competition Monopolistic Competition ----------------------
1. ARp = MRp (i.e. average revenue 1. ARm (i.e. average revenue is
equals marginal revenue) falling) MRm (marginal revenue ----------------------
is below the average revenue.) ----------------------
2. Ep equilibrium where LRMC = 2. Em equilibrium where LRMC =
MRp MRm ----------------------
3. OQp equilibrium output. (also 3. OQm equilibrium output (less ----------------------

optimum output because LRAC than optimum output OQp)
is minimum at this output). ----------------------
4. OQp > OQm Output under perfect 4. OQm < OQp Output under ----------------------
competition is more than output monopolistic competition is less
----------------------
under monopolistic competition. than under perfect competition.
5. Full capacity used up because 5. Waste of capacity is equal to Qm ----------------------
equilibrium output is optimum Qp because equilibrium output
----------------------
output. is less than optimum output.
“Wastes of competition.” ----------------------
6. Firm is in full - equilibrium ARp 6. Firm is not in full equilibrium i.e.
----------------------
= MRp = LRMC = LRAC it produces at the falling portion
of the LRAC ----------------------
7. OPp equilibrium price is less than 7. OPm equilibrium price is more
----------------------
price OPm under monopolistic than OPp price under perfect
competition. competition. ----------------------
8. Firm makes normal profits. 8. Firm makes normal profits.
----------------------
(ARp = AC - Ep Qp) at OQp output. (ARm = AC = E1Qm) at OQm
output. ----------------------
We can the conclude, that, the long - run price is lower and output is higher
under perfect competition as compared to under monopolistic competition. ----------------------
----------------------
10.13 MONOPSONY
----------------------
Another type of imperfect competition is called Monopsony. Under
Monopsony, there are many sellers but only one buyer. The buyer is influential ----------------------
and determines the price of the product. He may exploit the sellers by offering ----------------------
a very low price. An example of monopsony in India is provided by the Cotton
Corporation of India who purchases all cotton grown by the farmers. Since ----------------------
there is only one buyer the CCI can influence the prices of cotton. Monopsony
is the opposite form of Monopoly. If there is one seller (monopoly) and one ----------------------
buyer (monopsony) then it is a case of Bilateral monopoly. ----------------------
One example can be given that of the Indian Army, who is the single
----------------------

Notes buyer of Shaktiman Trucks.

----------------------
Fill in the blanks.
----------------------
1. A.C. Pigou mentioned about ____________ degrees of price
---------------------- discrimination.
---------------------- 2. The competition among sellers who are operating in monopolistic

market is called ____________.
---------------------- 3. When the same product is sold under a different brand name, style,
---------------------- design, colour it is called __________.
----------------------
1. Under monopolistic competition, if a firm reduces the price of its
---------------------- products while prices of rival products are unchanged, there would
be a sizeable increase in the sales.
----------------------
2. The price policy under monopolistic competition is independent of
---------------------- the prices charged by rivals.
----------------------
---------------------- Activity 3
----------------------
Is dumping a threat to fair and free trade? Cite the adverse effects of
---------------------- dumping on the Indian economy.
----------------------
----------------------
10.14 OLIGOPOLY AND DUOPOLY
---------------------- Introduction : Oligopoly is a type of imperfect market. It has few firms

capable of influencing the total supply in the market. When there are more than
---------------------- two firms and not many, selling homogenous or differentiated products then
oligopoly market is said to exist.
----------------------
Duopoly market comprises of two firms. Both the firms are interdependent on
---------------------- each other regarding prices and output. If one decides to reduce the price the
other will follow the same. A detail explanation of Duoploy is avoided, instead
---------------------- we will study oligopoly market.
---------------------- (A) Features of Oligopoly
---------------------- (i) Few Sellers / Producers (Firms) : The small number of firm
dominates the market of the commodity firms. There are three or
---------------------- four major producerss or firms sharing about 80% of the market for
the product and the rest of the market is shared by a small number
----------------------
of firms. Each firm has a large share of market supply, therefore, all
---------------------- firms action results in a reaction of other firms in the market. This

means that firm under Oligopoly are mutually dependent on each Notes
other. In Duopoly, the number of firms is two. These firms are also
dependent on each other. ----------------------
(ii) Product may be homogeneous or there may be product ----------------------
differentiation: Duopolistic or Oligopolistic firms producing raw
materials or intermediate products, generally produce homogeneous ----------------------
products, as for example, the production of coal, copper or any other
----------------------
metal; whereas, firms producing automobiles, computers are firms
which differentiate amongst their products. ----------------------
(iii) Restrictions to Entry : Under oligopoly there are restrictions to
----------------------
the entry of new firms. The restriction arises due to the market
size, technical, financial and also because of the pricing policy ----------------------
adopted by the existing firms. Sometimes there are some built-in-
restrictions like the size of the market is small and may be able to ----------------------
support the sales of two or three firms only or the pricing of the
----------------------
product may be fixed in such a way that new entrant may not find
it viable because of cost. The existing firms get cost advantage for ----------------------
their early establishment.
----------------------
However there are no legal barriers therfore entry is not impossible
under oligopoly but it is difficult. ----------------------
(iv) Advertisement : If product differentiation exists, it becomes ----------------------
necessary to advertise the firms product. This is done to convince the
buyers about the superiority of the product over the products of rival ----------------------
firms. However, if the products are homogeneous advertisement
may take the form of informative advertisement. ----------------------
(v) Price - Control : Firms under oligopoly / duopoly are mutually ----------------------
dependent. Thus, all firms actions results in the reaction by other
firms. ----------------------
If one firm reduces the price of its product, other firms will follow. The ----------------------
first firm will again reduce its price, the other firms will again follow. This
process can continue till the price falls even below the cost of production. ----------------------
This situation is called a price - war. Thus, there is a tendency that one of ----------------------
the firms not reducing its price to start with. Similarly, if a firm increases
the price of its product, other firms will not follow. The first firm will ----------------------
therefore, lose its customers. To start with, therefore, the first firm will not
increase its price. ----------------------
The above explanation leads us to the conclusion, that prices tend to be ----------------------
sticky or rigid under oligopoly / duopoly.
----------------------
Companies like Procter and Gamble and Hindustan Lever both are into
the manufacture of soaps, detergents, shampoo, etc. Companies like Hero ----------------------
Honda, Bajaj Auto, Escorts Yamaha, TVS, Kinetic, Hindustan Lever,
----------------------
are into the manufacture of two-wheelers. The mobile industry has two
segments - one the service provider and the other providing hand-sets. In ----------------------

Notes the former, we have TATA Indicom, IDEA, Airtel, Hutch, Essar, etc. In
the latter, we have Nokia, Motorola, Sony, Samsung, etc.
----------------------
(B) Demand Curve under Oligopoly / Duopoly
---------------------- Demand Curve under Oligopoly
Y
----------------------
D1
----------------------
----------------------
----------------------
P K
----------------------
----------------------
Price (AR)
----------------------
---------------------- D1
O X
----------------------
---------------------- Since firms under Oligopoly - Duopoly are mutually dependent, there is a
situation of action and reaction by firms. This explains that prices tend to
---------------------- be rigid at OP under Oligopoly / Duopoly.
---------------------- If any firm tries to increase the price of its product above OP, other firms
will not react. This results in a large fall in the quantity demanded of the
---------------------- firm which increases the price of its product. The demand curve (D1K) is
thus relatively elastic.
----------------------
If however, a firm reduces the price of its product, other firms will also
---------------------- reduce their prices and there would be a price war. The quantity demanded
of the firms' product would increase less than proportionately, the demand
----------------------
curve (KD2) is therefore, relatively inelastic.
---------------------- Thus, the demand curve under Oligopoly, is a kinky demand curve. Price
---------------------- tends to be rigid at the kink, K.
(C) Equilibrium under Oligopoly
----------------------
Oligopoly, as we have already noted, is a market structure in which a small
---------------------- number of large firms producing either homogeneous or differentiated
products dominate an industry. A characteristic feature of oligopoly is
----------------------
that any change in the output or price of one firm almost always provokes
---------------------- retaliation from other producers. This reaction can take many forms. All
the firms may come together to form a cartel or they may openly or tacitly
---------------------- accept the price leadership of the largest firm or firms, may enter into non-
price competition or a situation of price rigidities may prevail. Producers
----------------------
of differentiated products in oligopoly are actually free to set their own
---------------------- prices. But experience shows that they try to maintain status quo. This is

so because a price-cut initiated by any one firm can trigger off a chain of Notes
reactions. A price-cut once introduced is not reversible. A price - war may
start. Ultimately all stand to lose. Under such circumstances non-price ----------------------
competition on the basis of quality design, service, sales - promotion etc.
is preferred to a price competition. Oligopoly prices therefore are found ----------------------
to be rigid. ----------------------
Various models have been suggested to demonstrate the equilibrium and
----------------------
price - and - output determination under oligopoly. Prof. Paul Sweezy's
model is perhaps the most popular one and hence we shall consider that ----------------------
one model only. This model provides an explanation of price - rigidity,
i.e. why price is not changed. The individual oligopolist sees the situation ----------------------
somewhat like this. If he raises the price his rivals would not follow suit
----------------------
and would do the same thing quickly. As a result, at a price higher than
the customary one, demand is seen to be highly elastic; while at a price ----------------------
lower than the ruling one, the demand is seen to be highly inelastic. See
figure given here. In this diagram, DD1 is the demand curve which is more ----------------------
elastic in the portion DP1 and less elastic in the portion P1D1.
----------------------
Y
----------------------
----------------------
D ----------------------
----------------------
P1
P M C1
----------------------
MC
A R ,M R ,M C
----------------------
----------------------
----------------------
D1 ----------------------
R
X ----------------------
O
Q
----------------------
O utput
MR ----------------------
Figure showing Oligopoly Equilibrium: Kinked demand curve model ----------------------

The equilibrium condition is the profit maximizing condition i.e. MR = ----------------------
MC. Note that the DD1 curve is the AR curve. The marginal revenue
curve (MR) is discontinuous between points H and R. It is this gap HR ----------------------
that explains price-rigidity. According to the usual condition MC = MR, ----------------------
we can find out the profit maximizing output. Marginal cost curves like
MC, MC1 cut the discontinuous portion HR of the MR curve so as to give ----------------------

Notes the same equilibrium output OQ. The price therefore remains unchanged
at OP though costs rise or fall.
----------------------
If the second option of a cartel is chosen by the oligopolists, and if it
---------------------- is a perfect cartel, the price would be determined by the joint MC and
MR curves of all firms taken together. All the firms would then adjust
---------------------- their individual supplies to the cartel price as given. Some firms may earn
profits and other may earn only normal profits. Due to such differences
----------------------
in profitability, cartels do not last long. At times, therefore, profits are
---------------------- pooled together and are then distributed. But this arrangement also cannot
satisfy all.
----------------------
Price Leadership is another possibility when there is one big or established
---------------------- firm, it sets the price and others accept that price for adjusting their
supplies. If the product is homogeneous, one price may get fixed. If
---------------------- products are differentiated, a range of prices may move together. Thus,
for example, cigarettes, bathing soaps, washing soaps, electric fans; etc.
----------------------
are produced in oligopolistic conditions, in India, and a particular grade
---------------------- of the product is priced between a certain price - range. A change in the
price is usually effected by the price - leader and others follow suit.
----------------------
To conclude, therefore, we can say that oligopoly is more common but
---------------------- since it can take various forms, a single model cannot explain its price and
output equilibrium. Non-price competition makes things more complex.
---------------------- Rivals use advertising quality changes and competition. A determinate
economic explanation as a guide to policy is therefore not possible though
----------------------
broadly one can describe how output and pricing policies are determined
---------------------- by the oligopolists.
---------------------- (D) Case Study : Case Name: The Magazine "Cover Gifts" War
Magazines frequently include free gifts on their covers to entice readers.
---------------------- Examples have ranged from Bach CDs to scented candles to DVDs.
---------------------- The gifts started as an attempt to increase readership, but some business
insiders now feel that they have become a serious problem for the industry.
---------------------- According to Simon Kippin, publishing director of Good Housekeeping:
"My colleagues say they wish they had never started doing it because it
---------------------- costs them a fortune." Adds Ian Rockett, business director at MindShare,
---------------------- a media planning and buying agency: "It's often a defensive measure for
publishers. ... Publishers are afraid they will lose the market share if they
---------------------- don't offer gifts to readers." Noleen Wyatt-Jones, group manager of the
press department at Zenith Media, argues that "cover mounting is a very
---------------------- dangerous thing because once you start you cannot get out of it."
---------------------- Analysts say that the situation varies considerably across segments of the
industry. In women's magazines, publishers typically bear a large share of
---------------------- the cost of cover gifts. The magazines often use gifts to enhance the brand
---------------------- image of the magazine. For example, Elle recently offered its readers an
Elle metal key chain. With music, computer, and video-game magazines,
---------------------- however, the cost of gifts is typically covered by the supplier, who pays

for the privilege of having its product reach a targeted audience. "We Notes
give them the space; they give us the product," says Andy Harris, sales
executive at PC Plus magazine. There is also a variation across geographic ----------------------
segments. Cover gifts are very common in the UK, less so in the US.
----------------------
10.15 MISCELLANEOUS ISSUES IN MONOPOLISTIC ----------------------
COMPETITION
----------------------
Having discussed the determination of price and output under monopolistic
----------------------
competition we are now required to study some miscellaneous issues. These
issues are as follows : ----------------------
(A) Selling Costs
----------------------
(B) Non - Price Competition
----------------------
(C) Wastes of Monopolistic Competition
(A) Selling Costs ----------------------
(i) Meaning ----------------------

Selling Cost is the cost of increasing the sales of the firm. It is the ----------------------
cost which the firm bears in order to try to increase the demand for
its product. Selling Costs can be looked at the cost borne by the ----------------------
firm to convince the consumer to demand one commodity instead of
----------------------
another. In effect it means that the cost borne by the firm to 'create'
demand for its product is the selling cost. ----------------------
Many times the consumers do not know what they need. It is the
----------------------
producers who have to make the consumers aware of their needs.
This is done through selling costs (Advertising). ----------------------
Sales promotion includes not only taking 'orders' for their goods ----------------------
but also creating demand for their goods. Under conditions of
perfect - competition, it is assumed that the consumers have perfect ----------------------
knowledge about the market and thus the concept of selling costs is
not relevant under perfect competition. Selling costs is a feature of ----------------------
an imperfect market condition. ----------------------
Selling costs include not only cost on advertisement (which forms a
large part of selling costs), but also salaries of sales - managers and ----------------------
sales- representatives, cost on exhibitions, show - room expenditure, ----------------------
cost on attractive wrappings, gifts, etc., thus any expenditure which
the firm makes, in order to promote its sales, is selling cost. ----------------------
----------------------
----------------------
----------------------
----------------------

Notes (ii) Selling - cost curve is U-shaped
Y
---------------------- ASC
----------------------
Selling Cost
----------------------
----------------------
----------------------
----------------------
O S1 X
---------------------- Quantity Sold
---------------------- As the sales of the firm increase, the average selling cost (ASC) first
decreases (upto OS1 sales), and then the ASC increases (after OS1
---------------------- sales), thus the ASC curve is a U-shaped curve.
---------------------- Total Selling Cost
ASC =
---------------------- Quantity Sold
---------------------- ASC decreases upto OS1 sales because of

(i) Economies of specialisation : As output and sales increase, a large
---------------------- amount is used for promoting sales and the firm can employ experts
---------------------- to increase its sales or it can advertise through mass media. These
methods of promoting sales are expensive but the sales increase to
---------------------- an extent that the average selling cost (ASC) decreases.
---------------------- (ii) Economies of repetition : As a firms advertising, initially it does
not influence the minds of the consumers. But repeated advertising,
---------------------- slowly has an impact on the minds of the consumers and the sales
increases and ASC decreases.
----------------------
ASC increases beyond OS1 sales because of
---------------------- (i) Difficulties in trying to influence the buyers' preferences : Once
the weak consumers are influenced, it is difficult to influence the
----------------------
more 'hardened' consumers (who are already using another brand of
---------------------- the product), and so the expenditure on sales increases but sales do
not increase much. The ASC therefore, increases.
----------------------
(ii) Counter - advertisement by competitors : Once a producer reaches
---------------------- a high level of sales, his competitors are affected and they try to defend
themselves by advertising their product. The producer now has to
---------------------- spend more money to increase the sales. The ASC increases.
---------------------- (iii) Factors influencing selling costs
(1) Type of Product : With product differentiation, the sale -
----------------------
expenditure increases.
---------------------- (2) Introduction of new goods : Firms producing commodities,

like clothes, cosmetics, where the fashion and styles change, Notes
have to bear large selling costs.
(3) Technology changes : Firms producing commodities, like ----------------------
machines, also have to resort to advertisement, but this is of ----------------------
the informative type.
(4) Other factors : The number of competitors, the psychology ----------------------
of the consumers, the elasticity of demand and promotional ----------------------
elasticity of a product also affect the selling costs of a firm.
(iv) Selling Cost and the Demand (Average Revenue) Curve of the firm ----------------------
There are two effects of the selling costs on the demand curve of a firm. ----------------------
(1) The demand curve shifts to the right : Selling costs result
----------------------
in higher quantity being demanded at every price. So, the
original demand curve DD shifts to the right to D1D1. ----------------------
(2) The demand curve becomes relatively inelastic (Steeper) :
----------------------
Selling Costs result in consumer preferences being stronger. If
a consumer likes a particular brand of a product, a charge in the ----------------------
price of the product will not affect the quantity demanded of
the product, by the consumer. The demand becomes relatively ----------------------
inelastic (Steeper). In the figure the original demand curve DD is
----------------------
less steeper (less inelastic) than the new demand curve D1D1.
Y ----------------------
D1
----------------------
Steeper Demand Curve
----------------------
Price per unit
D ----------------------
Effect of Selling Costs on ----------------------

D1 the Demand Curve of a firm
D ----------------------
O X
Quantity Demanded ----------------------
The average cost curve of the firm, AC, moves upwards to AC1 ----------------------
because of selling costs as shown in the following figure :
----------------------
Y
AC1
----------------------
AC ----------------------
Average Cost
----------------------
----------------------
----------------------
O X
Production ----------------------

Notes (v) Effect of Selling costs on the Price of the Product: The selling costs
are initially borne by the producers, but ultimately they are passed -
---------------------- on to the consumers in the form of a higher price of the product. This
is possible because through selling costs, the demand for the firm's
---------------------- product becomes relatively inelastic, because consumer preferences
---------------------- become stronger.
(B) Non-Price Competition
----------------------
We have seen earlier that under monopolist competition the sellers reduce
---------------------- their prices in order to attract new customers. The reduction in price may
go to such an extent that it may become a price war. Since this type of
----------------------
competition is based on price reduction, it is called 'price competition'.
---------------------- Price competition is, however harmful to all the sellers. Instead of
competing by price - reduction they, therefore, use some other methods.
----------------------
When they compete on grounds other than the price, it is called 'Non-
---------------------- Price Competition'. Non-Price Competition is usually practiced through
advertising or gift articles.
----------------------
It is true that spending large amounts on advertising or gift articles
---------------------- amounts to extra expenditure. But this expenditure is preferable to the
loss incurred on account of price-reduction. There is a vital difference
---------------------- between the two types of losses. In the first place, reduction in price is
---------------------- against the business ethics. On the other hand, nobody raises any objection
if a producer spends too much amount on advertising. If the producers
---------------------- find that the expenditure on advertising does not promote sales, they can
curtail it. But when price is reduced it cannot be increased immediately.
---------------------- If expenditure on advertising is fruitful its benefit is permanent. Similarly,
---------------------- the losses incurred on the account of price reduction are permanent.Most
of the producers operating under cut-throat competition, therefore, prefer
---------------------- to spend more on advertising, rather than effecting a reduction in price.
---------------------- This does not mean that advertising is done through newspapers, radio or
television. Since any expenditure on sales promotion is included in the
---------------------- selling costs, the producers under monopolistic competition spend on the
following schemes of sales promotion.
----------------------
(i) Gift Articles : To promote sales, a producer may hand over a gift
---------------------- article to the buyers who purchases the product at the usual price.
A customer who receives the article is permanently attracted to the
---------------------- product. For example, various breads are manufactured and sold by
---------------------- companies like Hindustan, Bharat Bakery, Modern Bakery, Kwality,
Blue Diamond, etc. A few years ago a new bread was introduced by
---------------------- Bakeman Company. The Bakeman bread at once captured the market
because from the very beginning the company was giving stickers
---------------------- along with the bread. Initially the stickers contained pictures of
---------------------- various models of cars. Thereafter, they contained the photographs
of the actors and actresses in the popular T.V. series viz. Mahabharat.
---------------------- The children, therefore, developed a hobby of collecting these

stickers. Since every Bakeman bread was accompanied by a free Notes
sticker, the sales of this bread have surpassed the sales of all other
breads in the Indian market. Similarly, toothpaste manufacturers in ----------------------
India give a free toothbrush along with the toothpaste to the buyers.
----------------------
(ii) Crossword Contests : Some producers organise crossword contests
or painting contests for children. An essential condition is that the ----------------------
entry form to be submitted in the contest, is to be accompanied by a
----------------------
certain number of used wrappers of some companies like Nescafe or
Cadbury. The companies which organise such contests also award ----------------------
prizes to the winners. For example, the winner of the first prize can
visit Singapore or Hongkong at the cost of the company. Thus, by ----------------------
giving free gift articles or by organising crossword contests, the
----------------------
producers are able to achieve a tremendous increase in their sales.
Since in this type of competition, the price of the product remains ----------------------
unaltered, it is called Non-Price Competition.
----------------------
(C) Wastes of Monopolistic Competition
----------------------
Monopolistic competition results in the waste of resources in the following
manner : ----------------------
(i) Selling Costs : Products under monopolistic competition are ----------------------
spending huge amounts on advertising and publicity. Much of this
expenditure is wasteful from the social point of view. It is argued ----------------------
that instead of spending so much amount on publicity; producers
can reduce the price. This would be beneficial to the consumers and ----------------------
the society at large. ----------------------
(ii) Excess Capacity : Under imperfect competition, the installed
capacity of every firm is large, but it is not fully utilised. Total ----------------------
output is, therefore, less than the output which is socially desirable. ----------------------
Since production capacity is not fully utilised, the resources lie idle.
Therefore, the production under monopolistic competition is below ----------------------
the full capacity level.
----------------------
A diagram given below will make this point clear. Output is measured on
OX - axis and price (AR), MR, AC and MC are measured on OY - axis. ----------------------
Y
MC ----------------------
AC
----------------------
P ----------------------
Price
----------------------
(AR)
MR AC, E ----------------------
MC MR
AR ----------------------
X
----------------------
O Xe X
Units of Output
Notes The equilibrium output is OXe determined by the condition MC =
MR and MC curve cuts the MR curve from below.
---------------------- The equilibrium is achieved on the falling portion of the Average
cost curve and not at the minimum point of AC curve.
----------------------
The firm can efficiently produce OX level of output at minimum
---------------------- point of AC curve, but to realise a higher profit the firm produces
OXe level of output at a higher price.
----------------------
The difference of XeX level of output is the excess capacity or
---------------------- wastage of the resources under monopolistic competition.
(iii) Unemployment : Idle capacity under monopolistic competition
----------------------
leads to unemployment. In particular, unemployment of workers
---------------------- leads to poverty and misery in the society. If idle capacity is fully
used, the problem of unemployment can be solved to some extent.
---------------------- (iv) Cross Transport : Under monopolistic competition expenditure is
---------------------- incurred on cross transportation. Goods produced in Ahmedabad
are sold in Chennai and goods produced in Chennai are sold in
---------------------- Ahmedabad. If these goods are sold locally, wasteful expenditure
on cross transport could be avoided.
----------------------
(v) Lack of Specialisation : Under monopolistic competition there
---------------------- is little scope for specialisation or standardization. Product
differentiation practiced under this competition leads to wasteful
---------------------- expenditure. It is argued that instead of producing too many similar
products, only a few standardized products may be produced. This
----------------------
would ensure better allocation of resources and would promote
---------------------- economic welfare of the society.
(vi) Inefficiency : Under perfect competition, an inefficient firm is
----------------------
thrown out of the industry. But under monopolistic competition
---------------------- inefficient firms continue to survive.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Notes
----------------------
1. Duopoly market comprises ________ firms.
----------------------
2. The main features of oligopoly are _______ sellers/producers
(firms), _____________or there may be product _____________, ----------------------
____________ to entry, _____________ and price control.
1. Under oligopoly, small number of firms influences the total supply in ----------------------
the market.
2. Under oligopoly, there is no restriction to the entry of new firms. ----------------------
3. In case of firms operating under oligopoly/duopoly, if one firm reduces ----------------------
the price of its product other firms will follow.
----------------------
4. Firms operating under monopolistic competition spend huge amounts
on advertisement and publicity. ----------------------
----------------------
Activity 4 ----------------------
1. If yours’ were a monopolistic competitive firm, which steps would ----------------------

you take in order to increase the profit margin of your firm?
----------------------
2. Bring out the role of advertisement in today’s context by citing
certain gimmicks implemented by ad-gurus. ----------------------
----------------------
Summary
----------------------
●● Perfect competition is not a realistic concept. What is actually seen in
----------------------
the real world, our day-to-day experience is the existence of Imperfect
Competition. ----------------------
●● The most important and powerful tool in the hands of a monopolist is
----------------------
Price Discrimination.
●● In equilibrium under price discrimination, the monopolist deals with ----------------------
different buyers, having different elasticity of demand (which in turn
----------------------
decides the degree of price discrimination) and the aggregate of all, gives
him the level of market demand. ----------------------
●● Monopolistic competition is characterised by a large number of firms,
----------------------
thus fairly elastic demand.
●● Under oligopoly, the product may be homogenous or differentiated, thus ----------------------
the apparent effect of advertisement levies on the market.
----------------------
----------------------

Notes Keywords
----------------------
●● Dumping : Monopolist charges high domestic price and low international
---------------------- price for the same product.
●● Industry : Various firms operating with same efficiency under
---------------------- monopolistic competition selling more or less same product.
---------------------- ●● Monopoly : Existence of a single seller.
---------------------- ●● Monopsony : Existence of a single buyer.
●● Non-price War : Firms resort to activities to increase sales, keeping the
---------------------- price of the product untouched.
---------------------- ●● Oligopoly : Market of few sellers.
●● Price Discrimination : Monopolist charges different prices to the same
----------------------
product.
---------------------- ●● Price war : Firms resort to price cutting in order to attract more demand
for their product.
----------------------

---------------------- 1. Explain how price is determined under monopoly.
---------------------- 2. What is price discrimination? Explain the degrees of price discrimination.
---------------------- 3. When is price discrimination possible and profitable?
4. Bring out the difference between perfect competition and monopolistic
----------------------
competition.
---------------------- 5. How is the price determined under monopolistic competition in both the
short and long run?
----------------------
6. Bring out the difference between Price war and Non-price war.
----------------------
7. Write short notes on :
---------------------- a. Product Differentiation
---------------------- b. Selling Costs
---------------------- c. Group Equilibrium
d. Monopsony
----------------------
e. Features of Monopoly
----------------------
f. Features of Oligopoly
---------------------- g. Equilibrium under Oligopoly
---------------------- h. Equilibrium under Discriminating Monopoly
----------------------
----------------------

1. The important features seen under simple or limited monopoly are single
producer, no close substitute, barriers to entry of firms and a downward ----------------------
slopping demand curve. ----------------------
2. If a producer acquires monopoly based on patent laws, it is called artificial
----------------------
monopoly.
3. Under perfect competition, there is free entry and free exit of firms. ----------------------
1. True ----------------------
2. False
----------------------
3. False
----------------------
1. Price discrimination is possible under legal sanction, nature of commodity, ----------------------
geographical barrier and ignorance of buyers.
----------------------
2. Where a monopolist can discriminate buyers and charge different prices
to the customers, it is called price discrimination or discriminating ----------------------
monopoly.
----------------------
----------------------
1. False
2. True ----------------------
1. A.C. Pigou mentioned about three degrees of price discrimination.
----------------------
2. The competition among sellers who are operating in monopolistic market
is called cutthroat competition. ----------------------
3. When the same product is sold under a different brand name, style, design, ----------------------
colour it is called product differentiation.
----------------------
1. True. ----------------------
2. False ----------------------
----------------------
----------------------

Fill in the blanks.
----------------------
1. Duopoly market comprises two firms.
----------------------
2. The main features of oligopoly are few sellers/producers (firms),
---------------------- homogeneous product or there may be product differentiation, restriction
to entry, advertisement and price control.
----------------------
---------------------- 1. True
---------------------- 2. False
---------------------- 3. True
4. True
----------------------

---------------------- 1. Atmanand. 2009. Managerial Economics. New Delhi: Excel Books.
---------------------- 2. Hague, D.C. Managerial Economics. Longman.
---------------------- 3. Haynes, William Warren, Vasant Mote, and Samuel Paul. 1970.
Managerial Economics—Analysis and Cases. Mumbai: Vakils, Feffer &
---------------------- Simons Private Ltd.
---------------------- 4. P. McNair, Malcolm, and Richard S. Meriam. 1941. Problems in Business
Economics. New York: McGraw-Hill Book.
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Pricing Methods or Pricing Practices
UNIT
11
Structure:
11.1 Introduction
11.2 Full Cost or Cost Plus Pricing
11.3 Going Rate Pricing
11.4 Marginal Cost Pricing
11.5 Some Other Approaches
11.6 Some Guidelines for Fixation
11.7 Pricing in Public Sector Undertakings (PSUs)
11.8 Pricing in Co-operative Societies
Summary
Key Words
Suggested Reading
Pricing Methods or Pricing Practices 249

Notes
Objectives
----------------------
----------------------
• Measure selling price of a firm
----------------------
• Assess and evaluate full cost
---------------------- • Justify and differentiate between cost plus pricing and cost minus
pricing
----------------------
• Construct policies for multiple products
----------------------
• Recognise the factors considered for pricing
---------------------- • Classify and state the guidelines on the basis of the nature of the
---------------------- product
• Analyse the rationale of public sector pricing
----------------------
• Judge the performance and success of the policies of PSUs
----------------------
• Explain the pricing in cooperative societies
----------------------
----------------------
11.1 INTRODUCTION
----------------------
As already discussed, firms pursue a variety of objectives with different
---------------------- weightages assigned to different objectives. The pricing policy of a firm must
therefore conform to the composite objective accepted by a firm. This can be
---------------------- ensured by following certain guidelines or 'pricing objectives'. Several such
---------------------- pricing objectives have been suggested; and are actually being pursued by
firms. One such pricing objective is stability. Firms tend to keep prices stable
---------------------- and short-run fluctuations in costs, demand etc. are not allowed to influence the
price. Maintaining one's share of the market is another such objective. This is
---------------------- a norm which can be monitored and hence is accepted as an important one. A
---------------------- decline in the market share can be taken as an indication of falling popularity
of the product. Target Return on Capital is another objective adopted by firms.
---------------------- A certain target rate of return on capital provides a guarantee of a floor limit.
Pricing policy also, at times, aims at meeting or preventing competition as a goal.
---------------------- This approach underlines a long-run view of the pricing policy. Finally, when
---------------------- private firms help the government in carrying out socio-economic programmes
like the supply of medicines or school books or nutritious food etc., they follow
---------------------- the principle of Ethical Pricing, i.e. reasonableness of pricing that will create a
good image of the firm.
----------------------
The aforesaid principles act as pointers to a proper pricing policy. The
---------------------- method of pricing to be chosen is a major decision. Basically there are two
methods of deciding the selling price: 1) Full Cost Pricing and 2) Marginal Cost
---------------------- Pricing. In the first one, cost is the decisive factor; while in the second, various
---------------------- other considerations are involved.

11.2 FULL COST OR COST PLUS PRICING Notes
According to this method, the price is set to cover the costs of material, ----------------------
labour, overheads and a certain percentage of profit. Costs to be included in the ----------------------
price are normally actual costs, expected costs or standard costs. Actual costs
are costs actually incurred in the production period. Expected costs are based on ----------------------
the forecasts of production and prices. Standard costs are based on the forecasts
made on the basis of the assumption that the efficiency, sales, prices, etc., will ----------------------
be normal. ----------------------
For the profit mark-up to be included in costs, various practices are
followed. Sometimes profit is expressed as a percentage of costs. ----------------------
By simple arithmetic, a formula is usually evolved. For example, let us ----------------------

say, a producer produces 10 units of product X. He then estimates overhead
costs, labour costs and material cost. Supposing allocable to X and divides it ----------------------
by 10. This gives per unit overhead, labour, material cost. Supposing they are ----------------------
Rs.10, Rs.10 and 5, and profit mark-up is 12% of costs, the price of product X
per unit will be Rs.10 + 10 + 5 + 3 = Rs.28. ----------------------
Price = Average fixed cost + Average variable cost + Certain percentage ----------------------
of profit margin
----------------------
Though relating profit to costs is easy, it is not scientific. Profit should be
related to investment. ----------------------
Whatever the method of deciding costs and profit mark-up, the cost
----------------------
plus the profit gives what is known as cost plus or full cost price. This is also
known as basic price because as and when any of the cost component changes, ----------------------
necessary adjustments in price are made accordingly. If, for instance, labour
costs increase, the per unit increase in labour costs can be added to the basic ----------------------
price to give the selling price of the product.
----------------------
(A) Inadequacies of Cost Pricing
----------------------
(1) This method ignores demand. The price the consumer is willing to
pay is important for purposes of calculating profits. The price the ----------------------
consumer is willing to pay has no relation with costs. Thus a price
based on cost is one-sided. ----------------------
(2) This method is easy to operate; but it ignores the nature of competition ----------------------
in the market. Whatever price is fixed is bound to invite reactions
from rival firms. The method ignores the rival firms' reactions. It ----------------------
also ignores the future possibilities of competition as a result of ----------------------
price policy.
----------------------
(3) The cost-plus method assumes that costs can be allocated to
individual products. This assumption, as is clear from the example ----------------------
we have taken, is unrealistic. Many costs are common and cannot
be traced to individual products. ----------------------
(4) It considers full costs. This is not always logical. For planned ----------------------

Notes expansion, incremental costs rather than full costs should be taken
as a basis. Also to base future prices on present or past costs is
---------------------- equally illogical.
---------------------- (5) Cost plus pricing suffers from the fallacy of circular reasoning. Sales
depend upon price, production depends upon sales, costs depend
---------------------- upon production (because costs change as level of production
change) and price is said to depend upon cost-which completes the
----------------------
circle!
---------------------- (B) Justification of Cost-plus Pricing
---------------------- In spite of the above mentioned inadequacies, the method is widely used
for several reasons which are:
----------------------
(1) In practice, businessmen may not strictly adhere to the cost plus
---------------------- formula. Many times this formula gives a comparative picture
of prices of different products. But in personal interviews many
---------------------- businessmen say that they follow this method because this method
---------------------- sounds just, in the sense that cost plus a reasonable profit is taken as
price, there is no profiteering and no exploitation of the consumer.
---------------------- (2) Profit maximization is not the only, or even the principal objective
---------------------- of all firms. The firms want to ensure that they are earning profits
which they feel are 'fair'. This can be done by adding the profit
---------------------- mark-up to the cost; by following the full-cost method.
---------------------- (3) It is possible that the faith that in the long run only normal profit can
be earned might be at the roots of popularity of this method. In the
---------------------- long run, this method for ensuring fair return to capital appears to
be logical.
----------------------
(4) In practice, firms are uncertain about the shape of their demand
---------------------- curve and about the return to capital. Thus cost plus pricing becomes
the best method of pricing.
----------------------
(5) For pricing new products, this method is suitable. If the new product
---------------------- fetches a price that covers full cost, the product can remain in the
market. Otherwise, the firm can conclude that it cannot afford to
----------------------
produce that product.
---------------------- (6) When there is competition in the product market, and costs are more
---------------------- or less the same for all the firms, cost plus pricing can introduce a
particular level of prices and avoid a price-war.
---------------------- (7) If an average level of production is taken into account for calculating
---------------------- prices, this method is secure in the sense that excessive profits
during prosperity compensate for the losses during depression.
---------------------- (C) Role of Cost-plus Pricing
---------------------- (1) For Product Tailoring: Many times there already exists a great
deal of competition in the field in which a firm wishes to enter.
----------------------

As such, a common level of prices has already been established Notes
in the market. Under such circumstances, the producers can first
determine the price and work back by calculating the retailers' ----------------------
marginal distribution costs, own profit and what remains is the cost
of production. A product that is first in such a cost by its design, etc., ----------------------
is then selected for production. This is known as product-tailoring. ----------------------
(2) For Refusal Pricing: When products are supplied according to
----------------------
specifications given by the customer; the minimum price can be
decided by the full cost method. For example, while supplying ----------------------
school uniforms, the minimum price below which the offer cannot
be accepted, can be fixed on the basis of this method. ----------------------
(3) For Monopsony Pricing: When there are only one or very few ----------------------
buyers for a product, it is desirable to charge full cost price only.
This is so because the bulk buyers are mostly business concerns ----------------------
who may otherwise decide to produce the commodity themselves.
----------------------
For example, let us suppose, the university wants to get some books
printed. The printing press should charge at 'full cost' rates otherwise ----------------------
the University may decide to print the books in its own press if the
rates quoted are high. ----------------------
(4) For Public Utility Pricing: When the Government (or a private ----------------------
company) supplies public utilities like electricity, water, telephone,
etc., to the people, the cost of service is considered as the proper ----------------------
basis. Even when an element of profit is included in price, the
----------------------
method is cost plus pricing.
(D) Pricing of Multiple Products ----------------------
The economic theory assumes that a firm produces only one homogeneous ----------------------
commodity. This is done to simplify the analysis. But, in practice, a
firm produces many commodities and, in Managerial Economics, it is ----------------------
necessary to take cognizance of this fact and examine the problem of ----------------------
pricing multiple products. For example, YAMAHA produces products
like Enticer, Crux, Rx100, Rx 135, YBX etc. or FIAT has products like ----------------------
Padmini, Uno, Palio, Siena & Petra.
----------------------
(1) Opportunities to produce Multiple Products: A firm gets an
opportunity to produce multiple products due to the following ----------------------
reasons.
----------------------
(i) Excess Capacity: The reason for adding a new product to the product-
line is usually to increase profits or to increase the competitive ----------------------
strength. To attain this goal, a firm may use its excess capacity (i.e.
----------------------
unused capacity to produce) if it is there.
A simple example will make this point clear. Suppose, a printing ----------------------
press printing a daily newspaper, installs additional machinery with
----------------------
a capacity to print one lakh copies (assuming that a machine with
lower capacity is not available). Further if the additional demand ----------------------

Notes for newspaper is only 50,000 copies then the excess capacity
(remaining 50,000 copies of printing capacity) can be utilized to
---------------------- print new weekly, fortnightly newspapers and magazines.
---------------------- In the above example, excess capacity in technical factor is
considered. Similar, excess capacity, may occur in the fields of
---------------------- management, distribution etc. The existence of such an excess
capacity provides an opportunity to add new products to the line.
----------------------
(ii) Seasonal Variations: Some times the demand is specific to certain
---------------------- seasons, i.e., the commodity is in demand in particular seasons. For
instance, the demand for umbrellas. In other seasons, the machinery
----------------------
and other factors may remain unemployed. This provides an
---------------------- opportunity to produce some other commodities during the off-
season.
----------------------
(iii) Cyclical Changes: When demand fluctuates as a result of business
---------------------- cycles, i.e., when demand increases and decreases alternatively, the
firm suffers. These ups and downs in business are more accentuated
---------------------- in respect of durable consumers' goods and luxuries. The producers
of such products, therefore, may add some new products which are
----------------------
not affected (or less affected) by these ups and downs in demand.
---------------------- (iv) Secular Shifts: When there are secular changes in conditions of
---------------------- demand and supply like changes in the tastes of the consumers,
income of the consumers, availability of raw material, etc., it
---------------------- may be necessary to drop old products and add new products to
the line. For example, in the face of competition of mill cloth, the
---------------------- handloom industry had to introduce a variety of designs to increase
---------------------- its competitive strength.
(v) Vertical Integration: Vertical integration of different production
---------------------- processes also offers an opportunity for increasing the number
---------------------- of products. For example, printing of books and publication are
two processes which can be integrated if the publisher purchases
---------------------- a printing press. Now, after printing all the books which he is
publishing, if the press remains idle for some period of the year,
---------------------- this excess capacity may be utilized by accepting outside jobs like
---------------------- printing of visiting cards, receipt books, hand-bills etc.
(vi) Research: Research creates new methods of production, new
---------------------- techniques, etc. Old techniques then become outmoded. New
---------------------- products are therefore discovered which can be produced with the
help of the tile machinery at hand.
----------------------
(E) Policy of Adding Products
---------------------- In a dynamic business world, monopoly power does not last long and
competition forces firms to introduce new products. Hence, the policy
----------------------
of adding new products becomes important, in practice. In selecting new
---------------------- product; the following problems arise.

(1) Standards of Profitability: The products to be selected are to be Notes
considered in order of profitability - the most profitable getting
first priority. Here, the question is what concept of profit should be ----------------------
adopted? Should the firm use 'incremental profit' as a test? That is,
should the addition product is made to bear its share of common ----------------------
costs? If the new product is to be adopted temporarily, the former ----------------------
concept of profit will be appropriate; but if the new product is to be
added permanently, the latter concept will be suitable. ----------------------
Contribution of each unit to total profits, percentage return to ----------------------
investment and total money profits and profits per unit are a better
measure of profitability. ----------------------
It is not possible to forecast the profit contribution of a product ----------------------
throughout its life. But such forecasts are usually made for a period
of 3 to 5 years and on that basis, order of preferences is prepared for ----------------------
addition to the product-line.
----------------------
(2) Product Strategy: Profit is just one consideration in the policy of
adding new products. But there are other objectives as well and a ----------------------
strategy of choosing new products has to be evolved, which keeps
----------------------
in view all these objectives. This 'strategy' has to be evolved with an
eye on the policies of rival firms. ----------------------
Complementarity is an important part of this strategy. If products ----------------------
in a product-line are complementary to one another, they create
demand for one another. For example, if an electric supply company ----------------------
starts the production of electrical appliances like fans, irons etc.,
the demand for these appliances also increases the demand for ----------------------
electricity. ----------------------
Sometimes it is desirable to establish the reputation that the firm
supplies all alternatives. For example, for a company producing ----------------------
paints and varnishes, it is desirable that it produces all types and ----------------------
shades of paints. This establishes the company's reputation and the
customers rely on the company for all their requirements ----------------------
Besides the above considerations, common raw material, common ----------------------
processes of production, common distribution channels, etc.,
are additional considerations which are important in the product ----------------------
strategy.
----------------------
(3) Criteria for New Products: What has been referred to above as
additional consideration can be considered in details as criteria ----------------------
for choosing new products. They are: (a) Interrelation of demand
----------------------
characteristics: New products and existing products may have a
demand relationship of either complementarity or of an alternative ----------------------
character. A firm may decide to produce alternatives to retain its
goodwill and it may also win over new customers if it successfully ----------------------
establishes a reputation as a firm producing up-to date alternatives.
----------------------

Notes Similarly, in case of complementary goods 'we supply the whole
range' is a good motto for the firm. If a firm is already producing
---------------------- household appliances like choppers, mixers, toasters, etc., it is
desirable to add heaters, geysers, cookers, etc., and make the
---------------------- range as complete as possible. (b) Distinctive know-how: When
---------------------- a company has some distinctive know-how, it is desirable to add
products that can be based on the same know-how. For example, a
---------------------- firm producing electronic appliances can only add more electronic
appliances. (c) Common production facilities: We have already
---------------------- seen that new products utilizing existing production facilities and
---------------------- excess capacity are desirable. (d) Common distribution channels:
It is also desirable to select a new product that can be brought to
---------------------- the market through the existing distribution channels. For example,
a company producing medicines can add a few cosmetics, but not
---------------------- readymade garments. (e) Common raw materials: It is obviously
---------------------- economical to add a product that uses the same raw materials being
used for existing products or that which uses the by products of
---------------------- existing products. A textile mill can start the production of towels
and bed-sheets or raw cotton blankets. (f) Benefit to present product
---------------------- link: So far we have considered the benefits of existing products to
---------------------- new products. Here we have to consider the benefit of new products
to the established ones. This criterion suggests the benefits accruing
---------------------- to the old products (i) of demand inter-relationship, (ii) of research
for new products, and (iii) of market surveys for new products.
----------------------
(F) Policy of Dropping Products
----------------------
The policy of dropping old products is as important as that of adding new
---------------------- products.
(1) How does the problem arise? Sometimes the choice of the product
----------------------
proves wrong, sometimes some other company is merged with a
---------------------- company when the products of that company which are unprofitable
also come into the product line. Sometimes due to product
---------------------- improvements effected by rival companies, the existing products
become out dated. In all these circumstances, the need arises for
----------------------
dropping old products.
---------------------- (2) What are the choices? When the profits or sales of a product are
---------------------- found unsatisfactory, the company may try to improve distribution
or reduce costs of production or improve the quality of the product.
---------------------- Bulk sales or buying from others and selling under the firm's label
can also be tried. When all these efforts are rendered useless, the
---------------------- only alternative is dropping the products, i.e., to stop its production.
---------------------- (G) Cost of Multiple Product
---------------------- In a firm producing many products, the problem of determining costs
of individual articles is of great practical importance. The accounting
---------------------- allocation of production cost is useful only for a few-business decisions.

They are mainly useful for computing enterprise profits. But these Notes
product-costs supplied by conventional cost accounting are, according to
Joel Dean, defective in several respects: (i) Over - heads that do not vary ----------------------
with a decision are nevertheless allocated to individual products; (ii) the
method of allocation is scientific but arbitrary; (iii) No distinction is made ----------------------
between joint and alternative products, and (iv) there is no recognition of ----------------------
the significance of controllability of the product mix in estimating costs.
The analysis of the economic characteristics of the managerial problems ----------------------
and of the production process can help rectify these defects.
----------------------
(1) Jointness of Products : The problem of allocation arises when costs
are common. This may happen with respect to joint products or ----------------------
alternative products.
----------------------
As we have already seen, joint products are produced together (meat
and raw hides and skins). In the case of joint products there are two ----------------------
possibilities: one that the proportions of joint products are variable,
----------------------
i.e. one of the two can be increased by keeping the other constant.
If this is the case, the cost of each can be found out by keeping one ----------------------
product constant and observing how much is the increase in costs
by increasing the production of the other product. ----------------------
In the second possibility, where the proportions are fixed, like meat ----------------------
and skins, it is not possible to find out individual product costs.
----------------------
When products are alternative, as in a case of dressed chicken and
eggs, the opportunity cost of dressed chicken is the earnings forgone ----------------------
from selling eggs.
----------------------
When products are in joint supply, the product-mix is difficult to
control when the proportions are fixed. In other cases, product-mix ----------------------
can be controlled. The problem then is easy, as the output of one
product can be increased by keeping the other constant. ----------------------
(2) Allocation of Variable Overheads : The only problem that now ----------------------
remains is allocating short run common overhead costs which are
variable. This can be done in various ways: ----------------------
(i) Share in common costs can be estimated by proportions in ----------------------

traceable costs, for example, if direct labour cost is traceable
----------------------
and is 10% of the common costs then it can also be treated as
allocable. ----------------------
(ii) The sum method may be applied by taking together all
----------------------
traceable costs, e.g., adding direct labour and direct material
to find proportion in total costs. ----------------------
(iii) The most closely associated traceable cost can be selected as ----------------------
the basis of the allocation of common cost, e.g., the cost of
electricity (common cost) can be estimated individually by ----------------------
taking into account the machine hours worked for the product.
----------------------

Notes Any of these or a different method can be accepted. Thus the
jointness of production is not a difficult problem.
----------------------
To sum up, in case of multiple products, the problem will arise
---------------------- when costs are not traceable. In such cases, more logical methods of
allocation than those followed in accounting practices are desirable.
---------------------- Such methods can be found for joint products with variable
proportions and alternative products. In case of joint products with
----------------------
fixed proportions, however, the allocation has to be arbitrary, as no
---------------------- logical method of allocation can be thought of.
---------------------- 11.3 GOING RATE PRICING

---------------------- While full-cost pricing takes into account the cost of production, without
---------------------- reference to demand, the going rate pricing emphasize the market conditions.
The firm does have control over its own price and output. However, the firm
---------------------- adjusts its own pricing finding and allocation of costs is very difficult. In many
cases, where costs are difficult of measurement, this method is adopted. In
---------------------- cases, where a price leader exists and he charges a price in keeping with what
---------------------- the followers are charging, some firm may follow this policy.
Where demand is elastic and where price competition is likely to set in motion
----------------------
a price-war, a firm may begin its calculations from price rather than from costs.
---------------------- Thus, for instance, a firm may accept a certain price as a going rate price and
then adjust its costs by providing for a certain margin of profits. This method of
---------------------- pricing is simple to grasp and can be of help where the products have reached a
mature stage. In such a situation, customers as well as rival firms prefer a stable
----------------------
price. This method seeks to maintain price-stability and allows changes in costs
---------------------- where necessary. Hence cost control is a problem in this method. In a way, this
method is exactly the opposite of the above one; the one we saw earlier was a
---------------------- method of cost plus pricing. While the one we are discussing here is a method
of price minus costing.
----------------------
---------------------- 11.4 MARGINAL COST PRICING

---------------------- One of the soundest pricing practices is the full-cost pricing which we
have discussed in great detail. Going-rate pricing is, as we saw, approaching
---------------------- the problem from the opposite end. Going-rate pricing, however, is not a policy
---------------------- that could be followed on a permanent and a long-term basis. This is obviously
because of the fact that a firm cannot accept the responsibility of controlling
---------------------- costs, all the time. Many elements of costs are such as are hardly within a
firm's control. Transport costs, fuel costs, taxes are just a few examples worth
---------------------- mentioning.
---------------------- The second approach to pricing which calls for our attention now is
marginal pricing. Marginal analysis occupies an important position in the
----------------------
classical economic theory. A firm's equilibrium can be explained by comparing
---------------------- marginal revenue and marginal cost at each level of output. Where marginal

revenue just covers marginal cost, a firm can stabilize its production or output. Notes
What price should be charged? One that is given by the average revenue curve
(or the demand curve) at the equilibrium level of output is the answer. The ----------------------
marginal cost pricing appears to suggest that the price charged should be equal to
the marginal cost. This policy must entail losses and this fact can be ascertained ----------------------
by a look at the diagrams explaining the equilibrium of a firm. What marginal ----------------------
cost pricing suggests is that it sets the lower limits. A firm can set a price that
ensures the targeted or possible level of profitability. ----------------------
The method of pricing we are discussing is 'marginal' cost pricing while ----------------------
the sub-title we have given is 'incremental' cost pricing. Are they the same?
Strictly speaking, they are not the same. The incremental principle is commonly ----------------------
used in business decisions. When a firm takes any decision, it involves a course
----------------------
of action. This course of action must have some impact upon the total cost and
the total revenue. According to the incremental principle, the decision can be ----------------------
considered sound if incremental revenue i.e. an increase in revenue exceeds
incremental cost or increase in costs. It is possible that both these quantities ----------------------
would be negative. In other words, a course of action may involve a fall in
----------------------
cost as well as a fall in revenue. However, the action can be justified if a fall
in revenue is less than the fall in costs. As against this, marginal cost refers to ----------------------
the change in total revenue following a unit change in total revenue following
a unit change in output. Marginal revenue, in the same way, is a change in total ----------------------
revenue following a unit change in output. In spite of this technical difference,
----------------------
business discussion usually ignores the difference and the two terms are used
interchangeably. In the context of pricing, marginal cost would be the proper ----------------------
method.
----------------------
In this method of pricing, fixed costs are ignored, because the marginal
cost represents an addition to the total cost. When fixed costs are high, full-cost ----------------------
pricing is likely to make the price uncompetitive. Marginal cost pricing avoids
this possibility. Orders are not turned down because the price offered does ----------------------
not cover average cost. Whatever excess of price over average variable cost
----------------------
is available, can be used for meeting profit requirements and the contribution
towards fixed costs. Marginal cost pricing helps the firm to become more ----------------------
aggressive at the market. The firm can take a full-life perspective and can plan
to cover full costs over a long period. Where full-cost pricing is difficult for ----------------------
reasons noted earlier, marginal cost pricing is found to be very convenient,
----------------------
though not necessarily satisfactory.
This method has been criticized on the following counts: ----------------------
(1) In practice, this method faces many difficulties. Many businesses do not ----------------------
possess the knowledge of finding out the marginal cost and the marginal
revenue. ----------------------
(2) Pricing has to take into account the future costs and prices. Due to ----------------------
uncertainties involved on both sides, there always arises a discrepancy
between planned profits and actual profits. ----------------------
(3) It is pointed out that a strict adherence to marginal cost pricing leads ----------------------

Notes to frequent price changes. Such changes are not liked by the buyers.
Moreover, they create problems in planning, distribution and credit sales
---------------------- and purchases.
---------------------- (4) A price-cut is usually irreversible and in the absence of a necessary
upward revision of prices, the firm stands to lose.
----------------------
(5) For a firm producing different products, the cost of operating this method
---------------------- is very high. This is because the operation involves the creation of a
machinery that calculates and monitors the demand's elasticity, sales
---------------------- forecasts etc.
---------------------- (6) Adherence to marginal cost pricing puts the firm to losses because
overhead costs are not covered by this price.
----------------------
The criticism is not fully warranted. The points that this method will put
---------------------- the firm to losses is based on the assumption that MC > AC. We have seen that
this holds good only when costs are diminishing. When the costs are rising, MC
---------------------- >AC. Again, the full-cost principle may suggest that one should not produce so
---------------------- long as all the costs are fully covered. This is obviously wrong, because fixed
costs are incurred even with zero production level. Wisdom, therefore, lies in
---------------------- producing when the incremental costs are covered. This, however, would be a
short-term policy. Marginal cost pricing therefore should be viewed as measure
---------------------- of suggesting the floor-price of a product and as a guide for modifying profit-
---------------------- maximizing price when market conditions so demand.

----------------------
Fill in the blanks.
----------------------
1. Two important methods of pricing are ___________ and
---------------------- _____________.
2. A price that fluctuates with the fluctuation in the market is called
----------------------
___________.
---------------------- 3. When a producer is not willing to offer the product below the
---------------------- minimum price as decided by the full cost pricing, the method is
called _____________.
---------------------- 4. The method that says the price be charged equal to the marginal cost
---------------------- of production the pricing is called _____________.
----------------------
1. Expected costs are based on the forecast made assuming that the
---------------------- efficiency, sales, prices will be normal.
---------------------- 2. Price based on cost is one sided.
---------------------- 3. The method of fixing the price in view of the current demand situation
in the domestic/international market is known as import parity price.
----------------------

Notes
Activity 1
----------------------
1. Suppose a firm supplying school uniforms finds that its per unit ----------------------
overhead labour and material cost put together is Rs 100 and the
expected profit per unit is 25% of this cost, find the per unit price of ----------------------
the product using cost-plus pricing method.
----------------------
2. Visit the Procter & Gamble website (www.pg.com/en) and identify
the range of their products. Classify according to their nature − hair ----------------------
care, health care, etc.
----------------------
11.5 SOME OTHER APPROACHES ----------------------
----------------------
Full-cost and marginal-cost are the two basic methods we have noted
so far. In practice, we come across a very wide variety of practices in pricing. ----------------------
Let us consider the major approaches to pricing which lie at the basis of the
actual pricing practices. These approaches are not alternatives but can act as ----------------------
complementary or supplementary to one another.
----------------------
1) Intuitive Pricing :
----------------------
This psychological and subjective approach to pricing is surprisingly very
common. Intuitive pricing, as the term itself suggests, is a response or a ----------------------
reaction to feel the market. The approach can be variously applied. Price
for launching a new product can be taken as a starting point. At the other ----------------------
end, price based on full cost is taken as a basis. This price-estimate can ----------------------
then be modified according to the market conditions and the nature of
competition. Thus, though the approach is intuitive, the price cannot be ----------------------
entirely left to the intuition of the entrepreneur.
----------------------
The success of pricing policy can be judged by whether the price
that the firm needs and that which the buyers want is the same, or at ----------------------
least, the two come very close. This is hardly possible and requires a
great deal of knowledge on the parts of both sellers and buyers. Some ----------------------
types of managements can correctly guess future trends in demand and ----------------------
competition. Their intuitive prices prove to be successful.
2) Experimental Pricing : ----------------------
In search of an optimum price, the firm takes some cognizance of the ----------------------
demand for the product, and proceeds, to fix a price by the trial-and-error
----------------------
method. This is experimental pricing. Usually a sample of test markets
is selected, and price is varied to see the reactions. These reactions are ----------------------
observed and then a price that maximizes the profits is fixed. This method
is widely used in respect of new products. This method has the potential ----------------------
of providing a scientific base for pricing policy. However, in oligopolistic
----------------------
structure, where buyers cannot be separated, this method has got to be
applied with caution. ----------------------

Notes 3) Imitative Pricing :
As the name itself suggests, the firm fixes its price equal to, or in some
----------------------
proportion of, the price of another firm. We have already noted the
---------------------- possible price-leadership situation in the context of oligopoly. A firm that
initiates a change in prices is the price-leader. Others, known as price-
---------------------- followers, make adequate changes in price. The price-leader usually has
a large share in the market or an established reputation or a sound profit
----------------------
history. Others, therefore, hope to gain by the leader's experience without
---------------------- risking their own market share.
Imitative pricing perhaps is the easiest method to follow and finds popularity
----------------------
in many fields. Especially in retail trade or in other manufacturing areas
---------------------- where monopolistic competition exists, prices are imitated so as not to
disturb the inter-firm competitive structure. The firm can then conveniently
---------------------- concentrate on non-price competition. The disadvantage of this method is
that it sacrifices flexibility and leaves no room for adjustments as per local
----------------------
conditions.
----------------------
11.6 SOME GUIDELINES FOR FIXATION
----------------------
The foregoing discussion concerned some of the approaches to pricing.
----------------------
We shall now try to provide practical guidelines evolved by people through
---------------------- their business experience. These guidelines are important in bridging the gap
between theoretical prescriptions and practical applications.
----------------------
(A) Single Product Pricing
---------------------- (1) Pioneering Price
---------------------- Every product has a life-cycle: a product is new, it clicks and gets
established; but after some time the stagnation and decline phases
---------------------- follow. Once this fact is accepted, two possible approaches emerge
---------------------- for a pioneering price. They are:
(a) Skimming Price: The entry of a new product into the market
---------------------- is usually preceded by a great deal of research and promotional
---------------------- expenditure. For a new product, the demand initially is not
likely to be price-elastic. A firm can decide to skim the cream
---------------------- of the market by charging a high price. Subsequently, the
price can be reduced to reach the lower income customers.
----------------------
(b) Penetration Price: Alternatively a firm can begin by charging
---------------------- a very low price to penetrate the market. In the short-run
the firm may make losses; but in the long-run a profit can
---------------------- be earned. This is because, after capturing a large part of the
---------------------- market, the firm can gradually raise the price. Where large-
scale production is likely to reduce costs considerably, this
---------------------- policy is helpful.
----------------------

(2) Price in Maturity Notes
After the take-off, a product reaches maturity stage. During this
----------------------
stage, the competition is keener, substitutes are available and
the preference for the product becomes weaker. There aspects of ----------------------
maturity therefore become relevant for reckoning:
----------------------
(i) technical maturity reflected in increasing standardization with
set prototypes and less product variation; ----------------------
(ii) market saturation with a weakened preference and a higher
----------------------
ratio replacement sales to new sales; and
(iii) stability of production methods, market shares and price- ----------------------
structures. During this stage, therefore, price should be set ----------------------
carefully by taking into account estimated elasticity of
demand, competitive degeneration as well as the possibilities ----------------------
of non-price competition.
----------------------
(3) Cyclical Price
In course of its life, a product experiences fluctuations in demand. ----------------------
Firms may decide to respond to these fluctuations by reducing ----------------------
off-season prices and raising prices when conditions are brisk.
Alternatively, a firm may decide to maintain its quality-and-price ----------------------
reputation by keeping the price unchanged throughout recession
and prosperity. ----------------------
(4) Backward Cost Pricing ----------------------

When competition is keen and the quality as well as the price is of ----------------------
consequence to the buyers, a selling-price is determined first, and
by working backward, the product design can be arrived at. A wide ----------------------
variety of products including electrical appliances and automobiles
----------------------
are subjected to this type of pricing; as the market is flooded with
competitive products. ----------------------
(5) Refusal Pricing
----------------------
Many products are such as to serve the specific needs of the users.
Surgical equipment is an example of this type. High price and ----------------------
profiteering cannot be followed in such cases. Therefore, cost plus ----------------------
limits as floor price are ascertained. No price-reduction is possible.
So, at less than this, the seller just refuses to supply the product. ----------------------
(6) Psychological Consideration ----------------------
Many times, producers resort to tactics which actually exploit the
----------------------
consumers psychologically. Double-pricing is one such tactic. On
the price-tag two prices are printed and the higher one is crossed. The ----------------------
consumer gets the feeling that price is lowered by the company and
therefore sales get boosted. Prestige pricing is another tactic. A high ----------------------
price is maintained where buyers attach prestige considerations to
----------------------

Notes the product. Customary prices are charged in respect of commodities
having kinked demand curves.
----------------------
These are a few guidelines for a single product, i.e. where the firm
---------------------- is producing a single product. However, when a firm is producing
many products-and such firms are many-a problem of product line
---------------------- pricing arises.
---------------------- (B) Product Line Pricing
A modern firm produces a wide range of products. Under such
----------------------
circumstances, the problem of pricing these multiple products in a product
---------------------- line is of vital importance.
---------------------- (1) Alternative Policies of Price Relationship

In pricing products in a line, various alternatives are possible.
---------------------- Important among them are:
---------------------- (i) Price that are proportional to full cost: According to this
policy, common costs are allocated to individual products.
---------------------- Traceable costs are then added to them and then by adding a
---------------------- profit mark-up the selling price is fixed. This is the cost plus
price which we have discussed earlier.
----------------------
(ii) The prices are proportional to incremental costs: Without
---------------------- considering common costs, only incremental costs may be
taken into account and prices may be fixed in proportion of
---------------------- three products - A, B and C costs are increasing by Rs.4,000/-
, Rs.3,000/- and Rs.1000/- respectively, the expected revenue
----------------------
from the three products will be distributed over these in the
---------------------- proportion 4:3:1. By dividing the expected revenue from each
by the units of that product, we get the price. This removes
---------------------- the defect of arbitrariness in the first method. But this does
not recognize the extent of composition in the market or the
----------------------
elasticity of demand.
---------------------- (iii) Prices with profit margins proportional to conversion
costs: Conversion cost is the cost of converting raw material
----------------------
into final product. This may not be the same for all the products
---------------------- in the line. For example, the milk collected by a dairy can be
pasteurised and bottled or can be powdered and filled into tins.
---------------------- The conversion costs of these two are obviously different. If
these costs are 4:6 then the profit also may be divided in the
----------------------
proportion of 4:6. With this profit added to the costs, the price
---------------------- can be fixed.
---------------------- (iv) Prices that produce contribution margins depend upon

the elasticity of demand of different market segments:
---------------------- The market is divided into segments according to elasticity.
Elastic demand has to escape with a low profit margin while
---------------------- inelastic demand can be burdened with a high profit margin.

Firms can take advantage of the ignorance of customers or a Notes
desire for distinction or just the laziness of customers. These
provide opportunities for changing different prices. The more ----------------------
complicated the process and design of the product, the more
are the opportunities for such discrimination. For example, ----------------------
the price differences in the case of A and B grade sugar ----------------------
cannot be much. But with different cases and dials, two wrist-
watches with the same machines can be sold at a difference ----------------------
of a hundred rupees. In this method, the maximum advantage
is taken of the differences in elasticity. ----------------------
(v) Prices that are systematically related to the stage of the ----------------------
market and the competitive development of individual
----------------------
members of the product line: Every product has to pass
through three stages: It is introduced, reaches the height ----------------------
of popularity then lags behind. It is possible that different
products in a line are in different stages. An old product should ----------------------
have a low price. A product that is on the top of popularity can
----------------------
bear a high price. A new product has to be low-priced. That is
why Mr. E. S. Freeman compares a product line with a family. ----------------------
Young children have a share in costs. The old members of
the family earn just enough for their upkeep or live by the ----------------------
pension they get for the work done when they were in this
----------------------
price. But the total cost of the family is covered by the total
family earnings. This analogy explains the price policy under ----------------------
consideration most effectively.
----------------------
What each product should earn is dependent upon the nature
of the competition in the market and the elasticity of demand for ----------------------
each product.
----------------------
(2) Factors to be considered in pricing
Of the alternative pricing policies suggested above, whichever is ----------------------
chosen, the following factors need to be considered: ----------------------
(i) Demand Relationship in the Product Line: Products in the
same line have many types of demand relationships. They ----------------------
may be complementary products, like torches and cells ----------------------
produced by the same company. They may be alternative
products like the different models of a radio set produced by ----------------------
the same company. A new product can be introduced in the
market by taking advantages of these demand relationships. ----------------------
This is how new models of radio-sets are introduced, or ----------------------
this is why a company producing toothpaste introduces it's
tooth brush (complementary) and tooth powder (alternative) ----------------------
as well. Differences in the elasticity of demand provide an
opportunity for increasing profits by taking advantage of the ----------------------
ignorance of customers or of their craze for distinction. ----------------------

Notes (ii) Competitive Differences: All markets where products from
one product line are sold do not have the same degree of
---------------------- competition. The number of competing firms, the firm's share
in the total market supply and differences in the nature of
---------------------- competing products indicates the extent of competition. The
---------------------- competition also depends upon the costs of entry, the costs
of acquiring new patents, capital and technical difficulties in
---------------------- starting a new firm etc.. The less the possibility of emergence
of competition, the more obvious are the opportunities of
---------------------- increasing the profitability by charging high prices.
---------------------- (iii) Cost Estimates: Each set of process will produce a particular
product-mix (i.e. proportions of sales of various products in
----------------------
the line) and a corresponding total revenue and total cost.
---------------------- This is so because as price changes, demand changes and so
does the total revenue. Similarly, because the supply changes,
---------------------- the cost will also change. That set of price is the best which
fetches the maximum profit. The cost estimate to be used here
----------------------
will be dependent on the objectives of the firm. For example,
---------------------- if the profits are subject to legal restriction, the full cost
should be included. If using excess capacity is the objective,
---------------------- incremental costs are relevant and a nominal profit will be
considered satisfactory.
----------------------
(3) Some Problems of Product-Line Pricing
----------------------
(i) Pricing Products that Differ in Size: Is it desirable to charge
---------------------- different prices for different sizes of a product? Price can be
the same if costs and satisfaction accruing to the consumer
---------------------- are the same. In the case of footwear for adults, the cost of
production does not differ much with the size. Still, different
----------------------
prices can be charged for different size of footwear. But if
---------------------- it is decided to vary prices according to sizes, it is desirable
to have a systematic pattern. If a shirt of 75 cm is charged
---------------------- at Rs.40 and that of 80 cm is charged at Rs.45, than that of
85 cm should be charged Rs.50. This has an appearance of
----------------------
equity.
---------------------- While pricing alternative sizes, it is advantageous to reduce
---------------------- the price as the size increases. For example, the price of a
20ml. bottle of hair oil should be less than the price of two
---------------------- bottles of 100 ml. taken together. This saves packing costs
and encourages demand.
----------------------
(ii) Pricing Products that Differ in Quality: When there are
---------------------- products of different quality in a product line, their prices will
be determined in accordance with the objectives of the firm.
---------------------- Sometimes the objective is to bring prestige to the entire line.
---------------------- Then some high priced products are kept deliberately higher.

This increases the sale of low and medium priced products. If Notes
a company prices its quality neckties at Rs.50 each it can sell
cheap ties in large numbers. It is these cheap ties that really ----------------------
fetch profit.
----------------------
If price competition is the objective the firm produces low
quality products and charges minimum prices. This enables ----------------------
the firm to project its image as 'a firm charging reasonable
----------------------
prices'.
(iii) Charm Prices: There has been a belief in the business world ----------------------
that prices ending in odd figures give a feeling that they are
----------------------
reasonable and they appear to be less than what they actually
are. This increases sales. This is why prices like Rs.9.95, ----------------------
Rs.24.95 are charged instead of Rs.10 or Rs.25.
----------------------
(iv) Pricing Special Designs: When a product is custom made
or prepared on special order and specifications, what price ----------------------
should be charged? As already seen, if the customer himself
is a producer, full cost price is desirable. Alternatively, what ----------------------
businessmen call as 'parity price' or what economists call
----------------------
'opportunity cost' should be charged.
(v) Charging Different Prices at Different Times: When the ----------------------
demand is seasonal at least fixed costs are required to be borne ----------------------
in the off-season. To cover such costs concessional prices can
be charged in the off-season. For instance, fans in winter and ----------------------
blankets in summer can be sold at concessional prices. It is
possible to win new customers by keeping the prices low at ----------------------
a time when the demand is less. For example, when matinee ----------------------
shows are screened at lower charges, it is possible to attract
spectators who are not habitués. The same group may later be ----------------------
habituates and may start visiting regular shows.
----------------------
(vi) Pricing Repair Parts: Many firms producing spare parts
earn more than firms producing the whole machine. Because ----------------------
of the irregularity of demand and the risk of obsolescence, the
price of spare parts is required to be kept high. It is desirable ----------------------
to distinguish between parts that can be produced easily ----------------------
which must be sold at a competitive price and parts requiring
specialized techniques that can be sold at a high price. ----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Notes
----------------------

1. The major approaches to pricing which form the basis of the actual
----------------------
pricing practices are _________ pricing, ___________ pricing and
---------------------- _________ pricing.
2. In case of a commodity, on the pricing tag, two prices are printed and
----------------------
the higher one is crossed. It is called ___________ pricing.
---------------------- 1. When a firm begins by charging a very low price to make inroads in
the market, it is referred to as skimming prices.
----------------------
2. The lesser the possibility of emergence of competition the more
---------------------- obvious are the opportunities of increasing the profitability by
charging higher price.
----------------------
3. If price competition is the objective, the firm produces high quality
---------------------- products and charges minimum price.
----------------------
---------------------- Activity 2
---------------------- Quote some example of skimming price.

----------------------
----------------------
11.7 PRICING IN PUBLIC SECTOR UNDERTAKINGS (PSUs)
---------------------- This has many faces to it, which we will see step by step as given below.
The price policy of public enterprises has a special significance. Also the policies
---------------------- have to bear the responsibility towards the economy in achieving the goals and
the targets set, keeping in view the nature of the economy and the problems
---------------------- faced by it. In fixing the policies, the PSUs have to weigh the demand as well as
---------------------- the supply side the economic structure. It has to follow certain guidelines that
are to be under the purview of growth with economic welfare. Let us each of
---------------------- these facets one by one.
---------------------- (A) The Significance
i) The price fixed by a public enterprise should be such as to enable it
----------------------
to raise adequate resources for re-investment;
---------------------- ii) The price policy of a public enterprise should be such as to enable
it to operate at the lowest cost possible and at maximum efficiency;
----------------------
iii) The price policy should be such as to enable consumers at all levels
---------------------- to buy and make use of the goods and services produced by the
public enterprise;
----------------------

iv) It will have to calculate costs and benefits to the various sections of Notes
the community and
----------------------
v) The price policy in a public enterprise shall have to consider the
requirements of foreign trade, competition from private enterprises, ----------------------
inter-enterprises relationship, etc.
----------------------
All these factors make the price policy of public enterprises really
significant as well as difficult. ----------------------
(B) Responsibility for Pricing
----------------------
In a private company, the management has the responsibility of fixing
prices for the goods the company produces, though, of course, the broad ----------------------
principles of the price policy are laid down by the Board of Directors ----------------------
representing the general body of shareholders. In public enterprises the
pricing function is "diffused over the minister, the department and the ----------------------
managers". The government has the ultimate responsibility to decide about
the way a public undertaking will conduct its affairs. This is particularly ----------------------
so when the quantum of profits which the undertaking has to earn is to ----------------------
be decided. Even when the government, through the minister concerned,
decides about the general price- profit policy in a PSU, the actual details ----------------------
of the price structure will have to be worked out by the managers of the
undertaking. In general, therefore, the government decides the price policy ----------------------
while the managers of particular enterprises decide the price structure ----------------------
within the general framework of the government's price policy.
(C) Features of Pricing in Public Enterprises ----------------------
In order to appreciate the pricing policy in public enterprises in ----------------------

India, it is necessary to understand the distinctive features of pricing of
public enterprises. These features may relate to the demand side or on the ----------------------
supply side. ----------------------
1) On the demand side, the main problem is one of maintaining
----------------------
conditions of full competition between the public and private sector
units. A public enterprise may attract demand because of its special ----------------------
strength. Government enterprises working under competitive
conditions are: Ashoka Hotel and Janpath Hotel and the shipping ----------------------
Corporation Ltd. The pricing problem becomes more significant
----------------------
and highly complicated when a public enterprise operates under
conditions of monopoly. A private monopoly will generally aim ----------------------
at profit maximizing price but a public enterprise may or may not
follow such a policy. Essentially, the price policy of the public ----------------------
enterprise will depend upon the profit target fixed by the government.
----------------------
Generally, the public enterprise enjoying a high degree of monopoly
power may opt for a high price structure. On the other hand, such ----------------------
government undertaking may opt for a low price structure, if among
other things, the management is under a bias for full utilization of ----------------------
resources or maximum production of the commodity or service.
----------------------

Notes The railways, the Indian Airlines Corporation (till recently) and
the electricity boards are monopolies. Hindustan Steel Ltd. and the
---------------------- Fertiliser Corporation of India are operating in a seller's market. In
these cases, the possibility of inter-unit competition does not exist
---------------------- or is only nominal. In such cases, it is the lowest possible costs
---------------------- which determine the prices in the long run, unless the Government
creates, openly or covertly, unequal conditions of competition in
---------------------- favour of public enterprises.
---------------------- 2) On the cost and supply side, public enterprises are generally set
up with large capacities even from the beginning and naturally,
---------------------- larger production up to the full capacity will be accompanied by
declining costs. At the same time, public enterprises may get hold
----------------------
of some or all factors at lower prices. For instance, government
---------------------- enterprises may have the advantages of bulk contracts of purchases
and concessions available to government. Moreover a government
---------------------- enterprise can get hold of cheap capital either through government
subscription or under government guarantee. This is indeed a great
----------------------
advantage for capital intensive projects.
---------------------- 3) Public enterprises may incur some social costs which private
enterprise may not bear at all or may shift to other agencies. For
----------------------
example, a public enterprise may engage a large labour force, spend
---------------------- more heavily on employees-housing, or provide generous medical
facilities and consumer amenities which a private enterprise may
---------------------- not be willing to do.
---------------------- 4) Public enterprises are subject to the investigations by parliamentary
committees, criticism by members of parliament, audit by the
---------------------- Comptroller and Auditor- General and public criticism in press.
As a result, they are very careful in their expenditure. This leads
----------------------
to delay in taking important decisions and higher costs naturally
---------------------- follow.
---------------------- 5) Moreover, public enterprises may have to incur higher costs because
they are subject to certain external pressures. For instance, a public
---------------------- enterprise may be forced to go slow in its construction work. Or the
Government may decide to over-capitalise the enterprise from the
---------------------- start and hence may force the enterprise to have heavy overhead
---------------------- capital in the early periods. Or complementary resources may not
have been developed and may subject an enterprise to unfavorable
---------------------- cost conditions.
---------------------- Thus there are many distinctive features of pricing in government

enterprises which are not generally met with in private enterprises.
---------------------- (D) Price Policies of Public Enterprises in India
---------------------- Government undertakings in India have not developed any precise
and uniform policy of pricing. Each undertaking has been following a
----------------------

price policy conditioned by certain internal and external circumstances. Notes
Some of the following features of price policy are practiced in India.
----------------------
(1) Profit as the basis of price policy - public enterprises in India generally
follow a policy of profitability. Profits of a public enterprise indicate ----------------------
its efficiency (apart from its monopoly character) as well as serve
important sources of self-financing. The Indian Railways and the ----------------------
Reserve Bank of India are two important Government undertakings
----------------------
which contribute considerable amounts to the general exchequer.
Sindri Fertilizers, Hindustan Antibiotics, Hindustan Machine ----------------------
Tools, etc. were some of the public enterprises whose profits were
ploughed back for expansion. ----------------------
(2) No profit basis - Some Government enterprises have been required ----------------------
by law or by the Memorandum and Articles of Association to follow
a "no- profit no-loss" price policy. The Hindustan Antibiotics and ----------------------
the Hindustan Insecticides have been following this rule. These
----------------------
corporations have been marketing their products on the "no profits
no loss basis." ----------------------
(3) Import-parity price - Those public enterprises whose products are
----------------------
in direct competition with imported goods have adhered to a policy
of import - parity prices. The Hindustan Shipyards Ltd. accepted ----------------------
the principle of selling the ships in the Vishakhapatanam shipyard
at a price approximately equal to the cost of building a similar ship ----------------------
in the United Kingdom.
----------------------
(E) Guidelines on Pricing Policy
----------------------
The Government of India has issued three guidelines on Pricing
Policies for the public sector enterprises, viz., ----------------------
1) Public enterprises should be economically viable units and an all out ----------------------
effort should be made to increase their efficiency and to establish
their profitability at the earliest; ----------------------
2) Public enterprises which produce goods and services in competition ----------------------
with the domestic producers, the normal market forces of demand
and supply will operate and their productivity will be governed by ----------------------
the prices prevailing in the market; and
----------------------
3) Public enterprises which operate under monopolistic and semi-
monopolistic conditions, the pricing of their products should be on ----------------------
the basis of the landed cost of comparable imported goods which
----------------------
would be the normal ceiling.
According to the Bureau of Public Enterprises (1986-87), "it has ----------------------
been accepted in principle that the prices of products produced and the ----------------------
services rendered by public enterprises should be so determined that
at a satisfactory level of capacity utilization, these enterprises not only ----------------------
cover their costs of production, but also generate a reasonable amount
of surplus." "Profit making in public enterprises is considered quite ----------------------

Notes consistent in public purpose. There may be situations where profitability
in the strict sense of the term may be somewhat of secondary importance.
---------------------- For instance, the prices of infrastructural services and basic industrial
and agricultural inputs, such as transport, coal, steel, petroleum products
---------------------- and fertilizers, have to be regulated /administered in line with economic
---------------------- costs to prevent a spiralling effect on prices. In general, the prices of
such products and services should be rationalized in a manner as to cover
---------------------- total costs and bring about a fair margin of return by means of general
improvements in efficiency and greater utilization of capacity."
----------------------
With this policy, the Government took a number of decisions in
---------------------- raising the prices of steel, coal, petroleum products, fertilizers, aluminium,
molasses and alcohol. Similarly, the price of indigenous crude oil was
----------------------
revised. These price escalations were motivated by the desire to earn more
---------------------- revenue for the Government. The critics, however, believe that instead of
absorbing the rise in costs by improving efficiency and productivity, the
---------------------- govt. has been adopting the rather easy method of raising administered
prices. The Government intends to generate more profit by the use of its
----------------------
monopoly power. The critics further state that this is in direct conflict with
---------------------- the guidelines on pricing policy laid down by the Government.
---------------------- 11.8 PRICING IN CO-OPERATIVE SOCIETIES

---------------------- In India, the co-operative sector has expanded considerably in the last 50-
---------------------- 70 years. However, co-operative management in India has mostly come under
criticism for its lack of professionalism, absence of marketing skills, lack of
---------------------- productive efficiency and cost-heavy structures. Of late, there have been signs
of the emergence of a professionally managed co-operative sector. In the areas
---------------------- of food processing, milk production, transport, production of sugar etc., several
---------------------- cooperative institutions have made their mark. The pricing of products/services
in these co-operative organizations now needs our attention.
----------------------
Production in the co-operative sector, in a way, stands between that in
---------------------- the public sector and the same in the private sector. Like the public sector,
the co-operative sector also has to fulfill certain social objectives and a purely
---------------------- commercial approach is, therefore, ruled out. At the same time, some co-
operative organizations are operating under competition with private sector
----------------------
organizations and are expected to remain economically viable. As such, the
---------------------- pricing policy of co-operative societies conforms to the norms of public sector
pricing where the situation so demands. Alternatively, in some cases, they have
---------------------- to face market competition and have to set competitive prices or leave the prices
to the market forces.
----------------------
1) Cost-based Pricing: In many cases, pricing aims at covering the total cost.
---------------------- This is applicable to societies where goods/services are of an essential
nature and the benefits of the services are required to be distributed among
----------------------
the users in the form of cheap or fair priced availability of goods/services.
----------------------

The distribution of food grains, lift irrigation services, etc. are examples Notes
of this type. In some cases the cost-plus pricing method is followed. In
this case, the price is fixed to the equal average maintenance of a certain ----------------------
quality of products/services. In the first case, the price is said to equal
the average cost; while in the latter case, some profit is ensured for the ----------------------
organization. In cases where all the beneficiaries are only the members of ----------------------
the co-operative society, full-cost pricing (or price equating average cost)
is followed. In cases where the number of users is much larger than the ----------------------
number of members, cost-plus pricing is followed. The credit and micro-
credit societies belong to the former category. ----------------------
2) Subsidized Pricing: Many co-operative societies are following certain ----------------------

social objectives. Weavers' societies, handicrafts societies or farm-service
----------------------
societies are examples of this type. Such societies have objectives like
providing employment, preserving traditional skills, supplying cheap ----------------------
inputs or supplying consumer products at fair prices. Such societies are
therefore based on 'average cost minus subsidy per unit' basis. Sometimes ----------------------
the subsidy is available in a lump sum and sometimes it is paid in the form
----------------------
of rebate per unit of the product sold, as in case of handloom fabrics.
3) Demand-based Pricing: In many producers' co-operatives, the pricing ----------------------
is required to follow the dictates of demand. In keeping with the law of
----------------------
demand, the price is an important independent variable and lower the
price the greater is going to be the demand. The society would therefore ----------------------
be free to charge a high price and get a limited demand or charge a low
price and get a higher demand. Sometimes, if the society enjoys a certain ----------------------
amount of monopoly, it can resort to price discrimination. Discrimination
----------------------
can be as between the rest of the society or as between different uses
or as between different places. As a case of discriminating prices, one ----------------------
can cite the example of the dual pricing of sugar which was followed in
India. In this case, the government imposed a certain percentage of levy ----------------------
on sugar factories most of which are in the co-operative sector. This levy
----------------------
on sugar quantity was imposed and purchased by the government at a low
price and was distributed through fair - price shops. The remaining sugar ----------------------
produced by the factories were given the freedom to price sugar in such a
way as to compensate for the loss they incurred in selling the levy sugar to ----------------------
the government and also to charge a cost plus price and supply the sugar
----------------------
to the market as free sale sugar. Other pricing practices like penetrating
price and price skimming are also at a loss in the beginning for penetrating ----------------------
the market and then raise the price when the favourable conditions at the
market so as to earn maximum possible profit. It is necessary to remember ----------------------
that such commercial and competitive practices can be followed by a very
----------------------
small number of co-operatives which are competitive enough both in
terms of quality as well as cost of production. For example, co-operatives ----------------------
like Anand Milk Union Ltd. (Amul) can afford to follow such practices.
----------------------
----------------------

Notes 4) Competitive Pricing: When a society is embarking upon a new venture,
it has to price its products on the basis of the going rate and many times,
---------------------- such a rate has got to be comparable to imported products. When there
exists a competition among the local producers, the price has got to be
---------------------- comparable to the range of prices of similar products produced by other
---------------------- firms, For example, societies producing milk and milk products, or those
producing mango pulps or orange syrups and squashes have to set prices
---------------------- which are comparable to other firms' prices of their existing products.
Sometimes, sealed bids sell the bagasse in the factories by following this
---------------------- method.
---------------------- The pricing methods discussed above are subject to regulations and
rules framed by the government, in this regard. Co-operatives are in the
----------------------
jurisdiction of the state government in India and, in many cases, the prices
---------------------- charged by co-operatives need the approval of the state government. This
is especially true in respect of prices of commodities like milk, sugar,
---------------------- cotton and cotton-yarn, etc. This is because the commodities concerned
have either the potential of generating cost-push inflation or they are
----------------------
essential consumption goods which can exclude poor consumers when
---------------------- the goods are priced high.

----------------------
Fill in the blanks.
----------------------
1. Cooperative societies have to fulfill social objectives and pure
---------------------- ______________ approach is ruled out.
---------------------- 2. When a firm undertakes various production processes under its own
facility and increases the number of products the process is known as
---------------------- ___________.
1. The price policy of a public enterprise should be such as to enable it
----------------------
to operate at the lowest cost possible at maximum efficiency.
---------------------- 2. The pricing methods followed by the cooperatives keeping in view
the social objective is called standard pricing.
----------------------
----------------------
Activity 3
----------------------
---------------------- Do you think that Government has social considerations while setting
the prices of the products and services sold by it? Study the services, viz,
---------------------- railways, postal services, electricity.
----------------------
----------------------

Summary Notes
●● Firms pursue a number of objectives. Keeping these objectives in mind, ----------------------

forms set the prices of their products. The prices in a way attain these
----------------------
objectives set by these firms. Hence, they are also called as the pricing
objectives. These could be: (1) stability in prices; (2) maintenance of ----------------------
market share; (3) targeted return on capital (4) ethical pricing etc.
----------------------
●● There are two broad methods of deciding the selling price.
1) Full Cost Pricing and ----------------------
2) Marginal Cost Pricing ----------------------
●● The role of cost plus pricing can be identified in case of setting the refusal
----------------------
price. It is the minimum price which can be decided after considering the
overall costs incurred. ----------------------
●● The determination of product strategy is also an important consideration
----------------------
in determining the new product.
●● The firms also have to decide whether to drop some of its old products. ----------------------
Before doing so, the firms may consider the revival of that product and if
----------------------
all its efforts to do so fail, then it may finally stop its production.
●● As an alternate method to pricing, we also have the going rate pricing. It ----------------------
is an improvement over full cost pricing and takes into consideration the
----------------------
market conditions. In cases where the costs cannot be determined, this
method is adopted. ----------------------
●● The most commonly accepted method of pricing is the marginal cost pricing.
----------------------
Keywords ----------------------
●● Cyclical Price : A price that fluctuates with the fluctuations in the market- ----------------------
demand positions.
----------------------
●● Conversion Cost : Cost of converting the raw material into the final
product ----------------------
●● Competitive Pricing : The method of fixing the price in view of the ----------------------
current demand situation in the domestic as well as the foreign market.
●● Incremental Revenue : The increase in revenue that exceeds incremental ----------------------
costs or increase in costs. ----------------------
●● Import Parity Price : Directly competitive goods of public enterprises
are brought into the line of the pricing standards of the foreign goods. ----------------------
●● Marginal Costs Pricing : Method that says that the price be charged ----------------------
equal to the marginal cost of the product.
----------------------
●● Product Tailoring : The process of working backwards, in the sense of
first determining te price of the product, distributors’ margin, firm’s profit ----------------------
margin and then the product which fits into this scheme of things is finally
selected by the firm for production. ----------------------

Notes ●● Refusal Pricing : Not willing to offer the product below the minimum
price as decided by the full cost pricing.
---------------------- ●● Standard Costs : Costs that are based on the forecasts on the basis of the
---------------------- assumption of normal efficiency, sales, prices, etc.
●● Subsidized Pricing : Pricing methods followed by the co-operatives
---------------------- keeping in view the social objectives of the firm.
---------------------- ●● Vertical Integration : When a firm undertakes various production
processes under its own forte, thus increasing the number of products that
---------------------- it can produce during a given period of time.
----------------------
----------------------
1. What are the features of the pricing of products as produced by the PSUs?
----------------------
2. Which pricing policies are used by the P. S. Enterprises in India?
----------------------
3. Which guidelines can be suggested for price fixation?
---------------------- 4. Elaborate on the multiple-product production capability of a firm.
---------------------- 5. Differentiate between Intuitive pricing and Imitative pricing.
---------------------- 6. Write short notes on :

a. Marginal Cost Pricing
----------------------
b. Customary prices
----------------------
c. Cost plus pricing
---------------------- d. Pricing in co-operative societies
---------------------- e. Going-rate pricing
----------------------
----------------------
---------------------- 1. Two important methods of pricing are full cost pricing and marginal cost
pricing.
----------------------
2. A price that fluctuates with the fluctuation in the market is called cyclical
---------------------- price.
---------------------- 3. When a producer is not willing to offer the product below the minimum
price as decided by the full cost pricing, the method is called refusal
---------------------- pricing.
---------------------- 4. The method that says the price be charged equal to the marginal cost of
production, the pricing is called marginal cost pricing.
----------------------
----------------------

State True or False. Notes
1. False
----------------------
2. True
----------------------
3. False
1. The major approaches to pricing which form the basis of the actual pricing ----------------------
practices are intuitive pricing, experimental pricing and imitative pricing.
----------------------
2. In case of a commodity, on the pricing tag, two prices are printed and the
higher one is crossed. It is called double pricing. ----------------------
----------------------
1. False
----------------------
2. True
3. False ----------------------

1. Cooperative societies have to fulfill social objectives and pure commercial
----------------------
approach is ruled out.
2. When a firm undertakes various production processes under its own ----------------------
facility and increases the number of products the process is known as ----------------------
vertical integration.
1. True ----------------------
2. False ----------------------
----------------------
Suggested Reading
----------------------
1. Atmanand. 2009. Managerial Economics. New Delhi: Excel Books.
2. Hague, D.C. Managerial Economics. Longman. ----------------------
3. Haynes, William Warren, Vasant Mote, and Samuel Paul. 1970. ----------------------
Managerial Economics—Analysis and Cases. Mumbai: Vakils, Feffer &
----------------------
Simons Private Ltd.
4. P. McNair, Malcolm, and Richard S. Meriam. 1941. Problems in Business ----------------------
Economics. New York: McGraw-Hill Book.
----------------------
5. Datt, Ruddar, and K. P. M. 2008. Sunderam. Indian Economy. New Delhi:
Sultan Chand & Sons. ----------------------
----------------------

Notes
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
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----------------------
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----------------------

Cost Benefit Analysis
UNIT
12
Structure:
12.1 Introduction
12.2 Public Goods vs. Private Goods
12.3 Externalities
12.4 Marginal Cost
12.5 Average Cost
12.6 Impure Public Goods
12.7 Steps in Cost Benefit Analysis
12.8 Justification for the use of Cost-Benefit Analysis
12.9 Cost-Benefit Analysis: Private and Social
12.10 Policies to Reconcile Private and Public Costs and Benefits
12.11 Cost Benefit Analysis & Overall Resource Allocation
12.12 Overall Resource Allocation
12.13 Foundations of Market System of Economy
Summary
Key Words
Suggested Reading
Cost Benefit Analysis 279

Notes
Objectives
----------------------
----------------------
• Understand the difference between public and private goods
----------------------
• Identify externalities of pure public goods
---------------------- • Show and judge the steps in cost-benefit analysis
---------------------- • Evaluate the costs and the benefits in terms of private and social
goods
----------------------
• Show the divergence between marginal, private and social costs
---------------------- • Discuss the cost-benefit analysis in terms of overall resource
---------------------- allocation
---------------------- 12.1 INTRODUCTION

----------------------
The cost-benefit analysis, in a very narrow sense, would just be limited
---------------------- to finding out the cost-benefit ratio which happens to be a measure inter alia,
to analyse various investment opportunities and to find out the worth of each
---------------------- of them. However, in its broader sense, cost benefit analysis refers to the
evaluation of any project. Investment whether government or private should
----------------------
find out its worth and benefits in comparison to other available opportunities of
---------------------- investment. In this sense, the cost-benefit analysis refers to finding out the worth
of investment and enable ranking of optional investments by using any one of
---------------------- the methods (or more than one methods in combination). It should be obvious
that anybody contemplating investment must try to judge its cost benefits. But
----------------------
whatever has been said here, regarding the 'broader' sense has a reference to a
---------------------- micro level decision, whether by a private or by a public sector undertaking.
However, in the broadest sense, the cost-benefits can be adopted on a macro
---------------------- level either at the level of the economy as a whole, as a part of a five year plan,
or for the public sector activity where such a partial or overall analysis is more
----------------------
important a guide for the government as well as for the business world.
----------------------
12.2 PUBLIC GOODS VS. PRIVATE GOODS
----------------------
The Product Divisibility
----------------------
There are certain goods the availability of which to users can be decided in a
---------------------- discriminatory manner. Goods may be priced in the market and only those who pay
its stipulated price may be allowed the use of it. To put it differently, such goods may
----------------------
be priced and the principle of exclusion may be applied to its use. Those who do not
---------------------- agree to pay its market price, or those who cannot pay for it, are excluded from its
use. In this way, the good becomes divisible so far as its use is concerned. Thus, the
---------------------- ability to price a good, its divisibility of a good and the exclusion principle, all go
together. The indivisibility characteristic is also stated to mean that each individual
----------------------
has an access to the entire amount of public good. His use of it does not reduce its

availability to others. Tuning in of a radio or TV programme by one does not deprive Notes
anyone else from enjoying the same programme. On the other hand, it may be that
in the case of certain goods, some members of the society cannot be prevented from ----------------------
its consumption, provided some other members have the access to its use. A typical
example would be the defence service. Once the country is protected against foreign ----------------------
aggression, every citizen is more or less equally protected and benefited. A section ----------------------
of the society cannot be excluded from enjoying the benefit of this protection. The
defence service, in other words, is indivisible. It cannot be priced in the market in ----------------------
order to deprive some members of the society from its use or its benefits. In some
cases a consumer cannot surrender the use of a service even if he wants to. An ----------------------
individual cannot ask to be left undefended by the defence arrangement of the state, ----------------------
or refuse the benefit of a reduction in air pollution or that of street lighting etc.
----------------------
People voluntarily decide to pay for the supply of good which can be
priced and to which the exclusion principle applies because those who do not pay ----------------------
can be excluded from its use. If, for example, an individual does not voluntarily
agree to pay the market price for the milk, the market would refuse to supply ----------------------
him the required quantity. But we have seen that this exclusion principle cannot
----------------------
be applied to the indivisible goods. And this creates a problem of raising the
necessary finances in their case. For example, in the case of the defence service, ----------------------
every individual would argue that even if he does not pay for it, the supply of
the service would still be there. So he would rather avoid the payment and let ----------------------
others contribute for providing the defence service. Under the influence of this
----------------------
argument, very few would pay voluntarily, hoping that through the contributions
and efforts of others the service will be there. This is referred to as the problems ----------------------
of free riders - which mean that everybody would like to have the benefit of
the good without sharing the cost of its supply and so the necessary finances ----------------------
cannot be raised on a voluntary basis. As a result the provision of such a good
----------------------
or service has to be made through compulsory contributions by the members of
the society - such as through taxation. ----------------------
In the case of a good which cannot be priced, the buyers would decide,
----------------------
through their demand, preferences, whether or not they are to be supplied at
all; and in case they are to be supplied, then they will also decide about the ----------------------
quantity of its supply. But in the case of indivisible goods, such decisions
cannot be taken through the market mechanism. Society has to decide the way ----------------------
in which these decisions will be taken and financed and these decisions need
----------------------
not be unanimous. As seen above, since very few individuals beneficiaries
will be ready to pay for it voluntarily, there is to be some form of compulsion ----------------------
in providing the necessary finance. The decisions regarding these goods are,
therefore, left to the government agencies. ----------------------
The indivisible goods, whose benefits cannot be priced, and therefore, ----------------------
to which the principle of exclusion does not apply, are called pure public
goods. Pure private goods are completely divisible and to them the principle of ----------------------
exclusion applies in full measure. In the market, any one who disagrees to pay
----------------------
(or cannot pay) the requisite price will be excluded from their consumption.
It must be noted that the indivisibility of a product does not necessarily ----------------------

Notes imply that every citizen of the society has actually an equal share in its benefits.
People living near the political boundaries of a country may, for obvious reasons, be
---------------------- relatively less protected. People living near public parks are actually more benefited
even when the parks are accessible to all the members of the society. Thus, the main
---------------------- criterion of indivisibility is that the good in question should be equally available to
---------------------- all the members of the society (or a section there of) irrespective of the ability or
willingness of the individual members to pay for it. The financing of the concerned
---------------------- activity has to be through public expenditure and not through market pricing. This
conclusion implies that the pure public goods must be in the hands of public sector
---------------------- only. It, however, does not prove as to which sector (Public or Private) should
---------------------- provide the pure private goods. In order to get an answer to this question we have to
consider the following additional factors:
----------------------
i. The level of the efficiency at which the public and private sectors may be
---------------------- expected to operate and productive resources at disposal of the two sectors;
ii. The political and social considerations such as the philosophy that the
---------------------- economy should not be dominated by private monopolies.
---------------------- iii. Additional characteristics of pure public and pure private goods.
---------------------- 12.3 EXTERNALITIES

----------------------
Another important characteristic of pure public goods is the existence of
---------------------- externalities. The term externalities refers to the economic effects which flow from
the production or use of the good to other parties or economic units. Such economic
---------------------- effects may also be called spill-over effects, neighbourhood effects or third party
effects. Such an externality may be an economic gain or an economic loss to other
----------------------
economic units and would be referred to as pecuniary externality. (This is in contrast
---------------------- with a technological externality in which the consumption/ production levels of an
economic unit affects those of others in the economy.) This affects the prices in the
---------------------- economy which in turn transmit their effects on to production and consumption
decisions of other economic units. This causes a divergence between the "internal"
----------------------
(or private) and "social" marginal costs (or benefits) of the goods in question. Thus,
---------------------- for example, a powerhouse using coal would cause a lot of ash-throwing in the
neighbourhood through its chimneys. Similarly, the railways using a lot of coal in
---------------------- firing the steam locomotives put the residential and other areas near the railway
loco-shades to a lot of sufferings on account of smoke nuisance. This is a cost to
----------------------
society but not to the individual undertakings like the power house or the railways.
---------------------- Similarly, driving the smoke-emitting buses and trucks in the cities add to the social
cost of these transport facilities. An example of the externalities in the form of an
---------------------- economic gain would be the benefits of social overhead like a road to areas and the
industries served by it.
----------------------
These externalities are of two types :
---------------------- i. market-external effects, and
---------------------- ii. non-market-external effects
When the external effects cannot be priced in the market with reference
----------------------
to the demand and supply behaviour, they are termed 'non-market-external

effects'. It means that through the market mechanism, individual economy Notes
units cannot be protected from the economic loss (or cannot be excluded from
the economic gain) resulting from the public good in question. Thus, in our ----------------------
above example, it is highly difficult to apportion the economic gains of the new
road amongst its beneficiaries. Even if it was possible to identify some of the ----------------------
beneficiaries such as those who actually use the road, other beneficiaries would ----------------------
be left out. Therefore, the pricing of economic benefits of a road would not be
strictly satisfying the rule of exclusion. ----------------------
It would follow that such public goods which have non-market external ----------------------
effects should be preferably in the hands of the public authorities (provided
they can run these undertakings efficiently) since they can decide about the ----------------------
creation and location of industries producing public goods irrespective of their
----------------------
commercial profitability of the same. Thus, it follows that those amongst pure
public goods which have non-market external effects would qualify for inclusion ----------------------
in the public sector. Those pure public goods which have market external effects
may be left in the hands in private sector from this point of view. (However, ----------------------
remember that even then the characteristics of the indivisibility of pure public
----------------------
goods still tells us that they should be in the hands of the public sector only).
By contrast, a pure private good is supposed not to have any externalities. ----------------------
In its case, there will be no difference between private and social marginal costs
----------------------
of supply. The market pricing would, therefore, be representing the social cost
of supplying the goods and so even if it is left in the hands of private sector, ----------------------
its supply would be at the socially optimum level. Ordinarily, therefore, the
provision of pure private goods should be entrusted to the private sector. But ----------------------
on account of various reasons this may not be adhered to in every case. The
----------------------
government might decide to step in where 'merit wants' are concerned. Other
relevant considerations could be the cost conditions (discussed below), resource ----------------------
availability, social and political philosophy, and so on.
----------------------
12.4 MARGINAL COST ----------------------
A likely characteristic of a pure public good is that its marginal cost ----------------------
would be zero or close to zero. It means that an additional member of society
can be benefited by its use without appreciably adding to its total cost. To put ----------------------
it differently, the use of a pure public good by one more member of the society
----------------------
does not reduce its availability to the others. A good example of it is the tuning
in of your radio set. Still another example is that of a bridge over which an ----------------------
additional vehicle may pass without any additional cost to the society. It must,
however, be remembered that this principle mostly applies only to a limited ----------------------
extent, in reality. One cannot say that we can keep on adding to the number of
----------------------
vehicles that may use the same bridge; we cannot have the same defence budget
if our population keeps on increasing, and so on. Also it may be added that a ----------------------
large number of members of society may not be able to enjoy the benefits of the
public good without adding to the cost of its supply. Similarly, the provision of ----------------------
the public goods may be increased or decreased for budgetary reasons or due to
----------------------
extraneous factors. Pure public goods which possess this characteristic have a

Notes strong case for inclusion in the public sector since public goods are indivisible
also. In the case of private goods, on the other hand, the argument is basically in
---------------------- the favour of large-scale production - for which either the society should agree
to monopolistic type of private enterprise or should go in for public sector.
----------------------
---------------------- 12.5 AVERAGE COST

---------------------- Another likely characteristic of pure public goods is that it would be subject to the
law of decreasing costs. Being lumpy, it would be subject to the economies of scale.
---------------------- If the public good is provided in small units, then the average cost is likely to be
---------------------- much more. For example, the average cost of operating a sewerage system would
be much less if it serves a wide area than when it serves only a portion of the city.
---------------------- When it comes to the choice between public and private sectors for the provision of
goods possessing this characteristic, considerations similar to the ones mentioned
---------------------- above in the case of 'Marginal cost' characteristic apply.
----------------------
12.6 IMPURE PUBLIC GOODS
----------------------
It would be noticed that it is highly difficult to come across which fully
---------------------- satisfy all the characteristics of the pure public goods. Similarly, it is highly
---------------------- difficult to come across pure private goods. In general most goods possess
elements of both 'publicness' and 'privateness'. The difference between goods
---------------------- is mostly of degree and not of kind. Such goods which are neither pure public
goods nor pure private goods are called impure public goods (also called
---------------------- quasi-public goods or quasi-private goods). If the elements of 'publicness' are
---------------------- predominant in the mixture of characteristics of a good, then it may be termed
a public good; and in the opposite case, a private good.
----------------------
----------------------

---------------------- 1. Cost-benefit analysis refers to the ___________ of any project.
2. The indivisible goods whose benefits cannot be priced and to which the
---------------------- principle of exclusion does not apply are called ____________ goods.
---------------------- 3. Goods which are neither pure public goods nor pure private goods are
called ____________.
----------------------
---------------------- 1. The indivisibility of a product necessarily implies that every citizen
of the society has actually an equal share in its benefit.
----------------------
2. When external effects cannot be priced in the market with reference
---------------------- to the demand and supply behaviour, they are termed as non-market
external effects.
----------------------
3. One of the characteristics of a pure good is that its marginal cost
---------------------- would be zero or close to zero.

Notes
Activity 1
----------------------
Visit homepage.univie.ac.at/ ----------------------
What are externalities? Can you say that the municipal transport buses in
----------------------
various cities are creating negative externalities in society?
----------------------
12.7 STEPS IN COST BENEFITS ANALYSIS ----------------------
The cost-benefits analysis is a technique used for analyzing investment ----------------------

and for rating the alternative investment opportunities as well as for ranking
----------------------
such opportunities on the basis of the rate of return to investment. Investment
analysis is very important but very difficult due to the elements of uncertainty, ----------------------
changing value of money etc., as discussed above. Besides there are capital
constraints and social costs and benefits involved. Steps involved in the cost- ----------------------
benefit analysis are, in fact, the steps involved in capital budgeting and then in
----------------------
analysing various projects from the point of view of an individual investor. The
cost -benefit analysis as a method for investment analysis can proceed along the ----------------------
following steps:
----------------------
1) Identification of a Project: The first thing an investor has to do is to search
various investment opportunities for the purpose of finally selecting one ----------------------
of them. In doing so, he has to keep in mind the size of the investments
he has contemplated and his own expertise and interest. For this purpose, ----------------------
the investor can get the necessary information from the development
----------------------
organizations who are engaged in developing project profiles. He can
also borrow ideas from the established and reputed investors within and ----------------------
outside the country. It is possible that he has some new project ideas.
Whatever the case, one has to choose a few project alternatives for further ----------------------
scrutiny by carefully including the good or sound projects promising a
----------------------
high rate of return.
2) Formulation of the Project: Once a list of projects chosen for scrutiny ----------------------
is ready, with a blue print and all details of requirements in terms of ----------------------
land, building, plant and machinery, raw materials, fuel, power, labour
and technocrats etc. with prices of each, one can proceed further. The ----------------------
next thing he has to take into account is the capacity likely to be created
and possible utilization of the capacity over time and the prices at which ----------------------
the products could be sold over the time -span considered ads the life of ----------------------
the project. After the alternatives are formulated, each of them has to be
examined in terms of its feasibility. Feasibility of implementation includes ----------------------
technical feasibility, i.e., the availability of land, plant and machinery,
raw materials, and technical know-how; financial feasibility, i.e., ----------------------
availability of finance in time and at reasonable rates and for desired time ----------------------
periods; economic feasibility ,i.e., prospects of employment generation,
development of backward areas/social groups etc.; and management ----------------------

Notes feasibility,i.e., availability of management personnel for implementing
and running the project smoothly and professionally. It should be obvious
---------------------- that some of the projects identified and selected for scrutiny could be
dropped at this stage because they are not feasible on anyone or more of
---------------------- the feasibilities listed here.
---------------------- 3) Appraisal and Selection of the Project: Appraisal of feasible projects
refers to their assessment in terms of economic viability. This can be done
----------------------
with the help of projected cash outflows and inflows from each project and
---------------------- then comparing them on merit. For this purpose, various measures used
for evaluating the investment worth, including cost-benefit analysis, can
---------------------- be adopted. Through this step of screening, those of the selected projects
which are viable as well as within the investment limit contemplated by
----------------------
the investor are selected.
---------------------- 4) Comparison of Cash-Flow: Projects which pass the third test of feasibility
are then put to test by comparing the cash-flows by using the cost-benefit
----------------------
ratio (or any of the other measures discussed above). If and where critical
---------------------- values are involved, each measure will produce several outcomes. This
would enable the investor to compare the rates of return along with the
---------------------- risks involved. This sort of comparison is of crucial importance because
one determinate mathematical solution is not available and one has to
----------------------
be guided by one's subjective evaluation of the risk involved as well as
---------------------- one's attitude towards the acceptance of risk. One may select a project
promising high returns with a high uncertainty or a low profitability with
---------------------- a low risk level.
---------------------- 5) Selection and Implementation: Keeping in view the funds available for
investment one or more of the projects can be selected for implementation.
---------------------- The selected projects will then be implemented in accordance with the
blue prints already prepared. While implementing the project after it being
----------------------
commissioned, it is necessary to monitor the project on a regular basis.
---------------------- This includes ensuring the projected time period involved is observed in
practice, after ascertaining the quality and quantity are as per the norms
---------------------- assumed and the marketing of the product, industrial relations, repayment
of loans and payments of dividend follow the norms anticipated while
----------------------
formulating the project.
---------------------- 6) Mid-term Project Evaluation: A post-compilation audit of the project
---------------------- is the last step. But in respect of long term projects, amid-term appraisal
is always desirable. This can be done by re-calculating the measure of
---------------------- investment worth with a view to find out the actual worth and compare it
with the anticipated worth at the stage of anticipated worth estimated at
---------------------- the formulation stage. This would enable the investor to find out whether
---------------------- the expected results have been realized or not and then find out the causes
responsible for divergence between the expected and the realized results.
---------------------- Such an appraisal provides opportunity for rectifying any mistakes and
improving upon the performance.
----------------------

12.8 JUSTIFICATION FOR THE USE OF COST-BENEFIT Notes
ANALYSIS
----------------------
We have discussed above various techniques of measuring the worth of
investment. However, the reader must have realized that all these measures ----------------------
use the rate of return as the criterion for deciding the acceptance or rejection
----------------------
of an investment project as well as for ranking of the projects. It is only the
cost-benefits analysis which provides as with the insight into the private as ----------------------
well as the social costs and benefits involved. It can also incorporate other
considerations besides the monetary returns, for assessing the worth of an ----------------------
investment. In justification of the cost-benefits analysis, therefore, we can
enumerate the following arguments: ----------------------
1) Social Costs and Benefits: As discussed in a subsequent section, the ----------------------

government has to intervene, regulate and even control; the business
activities even in a market-driven economy, as and when necessary. ----------------------
We have also noted the distinction between private and social costs and ----------------------
benefits. At the macro level it is necessary to minimize the divergence
between public and private costs and benefits. By going through the ----------------------
exercise of finding out such divergence it becomes the duty of the
government to formulate adequate policies aimed at minimizing such ----------------------
cases of divergence. However, it is in the interest of private firms to look
----------------------
for social benefits and costs involved in their private project and take
necessary measures to reconcile the conflicting interests. This is possible ----------------------
by resorting to a modified version to reconcile the conflicting interests.
2) Intangible Factors: Many times certain intangible factors enter into the ----------------------
consideration of project appraisal and such factors are not unimportant. ----------------------
The prestige of the business firm, the reputation or the image of the firm
in the market, the morale of the employees, the long stranding traditions ----------------------
of the company or the ideas and the values inherited by a company over
the long period of its existence are some such examples. Under such ----------------------
circumstances, the pecuniary (i.e. monetary) considerations may not be
----------------------
proper guides for acceptance or rejection of a project. It is true that these
ultra-financial criteria are difficult to quantify. But this cannot be an excuse ----------------------
for discarding them. There are ways like shadow/pricing which can be
adopted for computing costs or benefits of such intangible factors. This ----------------------
is possible only with the broad-based or a comprehensive cost-benefit
analysis. ----------------------
3) Overall Profitability: A strict adherence to the rate of return criterion ----------------------

would lead to the choice of a smaller investment proposal with a higher
rate of return. In such a case, a proposal with a smaller rate of return but ----------------------
a larger size of investment would get rejected. Such a decision would ----------------------
lead some of the funds unutilized. In fact the overall profitability, i.e.,
the rate of return related to all the investible funds available with the ----------------------
company rather than funds actually invested would be a better guide to
investment policy. Such a criterion can be evolved with the help of cost- ----------------------
benefit analysis.
----------------------

Notes 4) Certain Uncertainty vs. Uncertain Certainty: Uncertainty is an
important element in the case of any business in the modern dynamic
---------------------- competitive world. But the investor would always endeavour to minimize
uncertainty. In this exercise, he will come across a certain lucrative return
---------------------- whose occurrence may be rendered uncertain due to the rapidity in the
changes of technology and /or changes in market conditions. As against
----------------------
this, some projects would involve uncertainty which can be incorporated
---------------------- in the measure adopted, as disused earlier. This (the latter) then becomes a
case of a certain uncertainty. The investor therefore is faced with a choice
---------------------- between a certain uncertainty and uncertain certainty. When guided by
the cost-benefits analysis rather than by a leap in the dark (i.e. purely
---------------------- subjective valuations), the investor would prefer an uncertainty which is
---------------------- certain i.e., estimable.
5) Social Scale of Preferences: A private firm which is guided by its own
---------------------- private cost and benefit is likely to ignore the social scale of preferences
---------------------- involving social investments and social urgencies. Such neglect would
accentuate the gap between the organized sector and the unorganized
---------------------- sector in a dualistic developing economy. It is necessary to remember
that the development of the economy presupposes the development of
---------------------- the entire society and if no heed is paid to the needs of the deprived
unorganized sector, it can act as a limping partner and thwart the pace
----------------------
of development. It is for this reason rather than for any other form of
---------------------- social obligation that the business sector has to be careful about the social
fall-outs of their activities. The cost benefit analysis is a measuring rod
---------------------- that can be used for recognizing and incorporating the social scale of
preferences into the appraisal of an investment proposal.
----------------------
6) National Industrial Policy: Every country has its own set of economic
---------------------- policies including the industrial policy. In India we have the industrial
policy announced by the government of India and modification or changes
---------------------- in it are done from time to time. Besides the industrial policy, there are
---------------------- other policies like the import-export policy, the MRTPA & policies under
the act, the monetary policy, fiscal policy etc. which have a bearing on
---------------------- an industry's performance. While preparing the cost-benefit analysis,
cognizance has got to be taken of the implications of these policies upon
---------------------- the costs as well as the benefits accruing to the firm. Further, in view of
the fact that there is a divergence between the private and social costs and
----------------------
benefits, the policies formulated by the government contain correctives
---------------------- for narrowing down the gaps between the private and the social costs/
benefits. In fact, such policies are viewed as instruments of performing
---------------------- these tasks, inter alia. This fact about the State policy as it affects the
performance of industries justifies the cost benefits analysis.
----------------------
7) Future Disposable value: The cost- benefit analysis is the right measure
---------------------- for deciding the worth of an investment project and such an exercise
is needed to be undertaken with a certain periodicity like a year or two
---------------------- years. This enables the firm to find out the current worth of the project
---------------------- and also enables it to project the future worth over a period of time. Such

a regularity in analysing costs and benefits not only helps to review the Notes
performance but also provides the basis for acquisitions and mergers etc.
which have become a familiar event in the present context of liberalization. ----------------------
With the intense global competition and highly dynamic changes taking
place in the business world, no firm can rule out the possibility of handing ----------------------
over or taking over or purchasing a share in the investment of some other
----------------------
firm. Under such circumstances, a scrupulously carried out cost benefit
analysis on a continuing basis has become an important prerequisite. ----------------------
8) Unforeseen Circumstances: In spite of all efforts at a systematic
----------------------
planning of future steps and the incorporation of uncertainty in the
investment analysis, contingencies and eventualities may occur which ----------------------
were unforeseen at the time of the launching of the project. Natural
calamities, wars, mass riots etc., are such examples. Such calamities not ----------------------
only demand urgent steps and expenses to make good the losses but also
a quick quantification of such losses. For this purpose, a cost-benefit ----------------------
analysis can be of great help. ----------------------
12.9 COST-BENEFIT ANALYSIS: PRIVATE AND SOCIAL ----------------------
We have noted earlier that the economic and accounting concepts of costs ----------------------
are different. We also saw that the economic concept of the opportunity cost
is more relevant than the accounting concept of the total cost or the individual ----------------------
resource cost. This is why, when we come to the distinction f\between private ----------------------
and social cost-benefit analysis, the latter is recognized as economic cost-benefit
analysis to be contra-distinguished from financial cost-benefits analysis which ----------------------
is analogous to private cost- benefit analysis.
----------------------
It was well-known Cambridge economist, Prof. A.C. Pigou, who discussed
at length the divergence between (what he called) Marginal Private Net Product ----------------------
and Marginal Social Net Product (MPNP and MSNP), way back in 1920 in
his book economics of welfare'. this path-breaking work not only placed the ----------------------
'Welfare Economics' branch of economics on the right pedestal it deserved, but
----------------------
also triggered off pioneering line of thinking in the area of private vs. social
accounting of resource allocation emerging through the market mechanism. ----------------------
Modern economists treat the social costs and benefits as externalities of private
investment and production decisions. Prof. Samuelson, for instance, uses the ----------------------
terms Marginal Social Damage (MSP) and Marginal Private Damage MPD to
denote social and private costs of externalities like pollution and goes further to ----------------------
clarify the divergence between the two and the costs of abatement of damage ----------------------
involved for the private enterprise and the society as a whole and advocates
public intervention for reconciling the two abatement costs. ----------------------
Managerial economics as a social science is more concerned with the ----------------------
application of economic principles to management practices and relates this
divergence to the cost-benefit analysis. The firm's cost-benefit analysis would ----------------------
remain incomplete, and even irrelevant in the modern business environment,
if the social aspect of its operation is neglected. It is therefore, necessary to ----------------------
understand the distinction between private and social cost-benefit analysis.
----------------------

Notes 1) Private vs. Social Goals: In a market economy, a firm in the private sector
basically aims at the maximization of money profits. Social goals, on the
---------------------- other hand, are different. At the level of the society as whole, the macro-
economic objectives of economic stabilization, employment generation,
---------------------- reduction in the distribution of income, promotion of regional balance
in the course of economic development, economic development itself
----------------------
alleviation of poverty etc., are important. The 'divergence' noted above
---------------------- starts from the divergence, between objectives only. A firm is guided
by it's own private motives and endeavours to make its own investment
---------------------- economically viable. But whatever the firm does may entail externalities
which may intervene in the contravention of socially desirable goals.
---------------------- It is also possible that the pursuit of social objectives may go against
---------------------- a personal or a private firm's interest. It is necessary to remember that
the modern business management understands that, for its own long-term
---------------------- interest, a firm has to take cognizance of social obligations as well. But
individuals tend to limit their frame of reference to the present. Hence
---------------------- arises the distinction between private and social valuations of costs and
benefits.
----------------------
2) Partial Contradiction between Interests: The classical method
---------------------- advocated of near-complete economic freedom, believed that if every
individual member of the society was allowed to freely to maximise
----------------------
his interest, maximum social benefit would be automatically achieved.
---------------------- It was Karl Marx who emphatically refuted this belief. What he meant
was, in terms of the well-known dictum,' one man's food is another
---------------------- man's poison'. This is of course partially true. What we have referred
to as 'externalities' arise and lead to a conflict of interests which needs
---------------------- to be resolved. Industrialization and concentration of industrial activity
---------------------- at one locality leads to several social costs in terms of air and water
pollution, emergence of slums, traffic congestions, accidents, a strain on
---------------------- civic amenities and several health hazards. All these are social costs not
included in any of the firm's account-books. On the other hand, when a
---------------------- private project involves the construction of a swimming pool, a play field,
a garden etc. which are open to the public, social benefit exceeds private
----------------------
benefit. Plantation programmes undertaken for making one's own factory
---------------------- environment - generates friendly social benefits for which no social cost
has been incurred.
----------------------
The above examples clearly show that a private project may involve,
---------------------- along with private costs and benefits, certain social costs and benefits.
Sometimes social costs exceed private costs; while at other times private
---------------------- benefits would be less than social benefits. Therefore, we can say that
there is a partial contradiction as between private and social interests.
---------------------- Private firms tend to be unmindful of both costs and benefits for the
---------------------- society arising out of their pursuits of self-interest. One cannot forget the
Bhopal gas tragedy which entailed social suffering for years on end; nor
---------------------- can we ignore the damage being done by the factories at and around Agra
to the Taj Mahal. We must pay enough attention to the social costs and
---------------------- benefits involved, though they are difficult to measure.

3) Valuation of Costs and Benefits: The fundamental difference between Notes
private and social costs and benefits arises due to the problem of finding out
the values involved. So far as the private costs and benefits are concerned, ----------------------
they can be found out by taking into account the prices received in case
of benefits and the prices paid in case of the costs incurred. However, ----------------------
when it comes to comparison with social costs and benefits, the problem
----------------------
of valuation arises due to the difficulties in quantifying the costs and
benefits. What is the cost of suffering by the people due to pollution? ----------------------
How to value the damage to the priceless heritage of Taj caused by all the
industrial units in its vicinity? ----------------------
For overcoming this difficulty, one method suggested by the experts for ----------------------
valuing social costs and benefits was to value these costs and benefits at
the world prices; while a U.N. agency advised the use of shadow prices ----------------------
(i.e. resource costs) for the same purpose. In respect of the former, the
problem of valuation of items which are not traded remains unresolved. ----------------------
Therefore, the World Bank in 1975 suggested a synthesis of the two ----------------------
approaches. According to the World Bank's approach, the tradable items
would be valued at the corresponding world prices; and the non- tradable ----------------------
ones at the shadow prices. In adopting both these methods, foreign
exchange earnings as well as the expenses or uses of foreign exchange are ----------------------
valued at the shadow exchange rate (and not at the official or market rate).
----------------------
Similarly, the labour cost, too, is computed at the shadow rate. Systematic
methods for calculating shadow prices have been evolved in most of the ----------------------
developing countries. In India, the planning commission has evolved such
methods and announces the shadow exchange rates and shadow wage ----------------------
rates from time to time.
----------------------
4) Methods of Valuation: In the valuation of costs and benefits, for finding
out the present value, one has to use a discount rate. In the private cost- ----------------------
benefit analysis, the weighted average cost of capital for the project can
be used for discounting. In respect of the social costs and benefits, our ----------------------
concern is to know the cost to the society. The government, on behalf ----------------------
of the society, undertakes social investments. Therefore, one cannot
turn to the rates at which the government could have got the funds from ----------------------
international financial institutions; the funds here would be the equivalent
of those employed in a private project under review. This rate could be ----------------------
treated as the rate of discount for finding out the present cost of the private
----------------------
project to the society.
In case of the private cost-benefit analysis, in this way, private costs and benefits ----------------------
valued at their respective market prices are taken into account. This can be done
----------------------
by using various investment appraisal techniques, on the basis of the weighted
average cost of capital as the discount rate. By this procedure, one can take the ----------------------
investment decision. In the social cost-benefit accounting, these two are valued
at the world or shadow prices and then various measures of finding out the worth ----------------------
of investment can be adopted. Again, in finding out social benefits and costs, due
attention is paid to the social objectives like employment generation, reduction ----------------------
of regional disparities etc. For example, if a project is located in a backward ----------------------

Notes region or provides employment to unskilled workers in large numbers, then the
social benefits of such a project is compounded to incorporate these benefits. If
---------------------- a project, on the other hand, is producing goods which are luxuries or are likely
to create health hazards, the social benefits would be discounted to incorporate
---------------------- the undesirable effects on society
---------------------- It is necessary to remember that the points of difference between the private and
the social cost-benefits analysis relate to (a) the estimates of costs and benefits,
---------------------- and (b) the discount or hurdle rates used. However, the techniques or methods
of assessing the investment worth remain the same. In other words, in both
----------------------
these analysis, one can use the Pay Back period method or the Internal Rate of
---------------------- Return Method or the Net Present Value Method etc., for the purpose of judging
the acceptability or otherwise of any project and /or ranking of alternative
---------------------- investment opportunities on the basis of their worth.
---------------------- For a better understanding of the divergence between private and social costs,
let us take the example of pollution, as is done by Prof. Samuelson. He then
---------------------- proceeds to illustrate his point with the help of a diagram.
---------------------- The figure to follow on the next page shows the divergence and suggests the
correction of such a divergence.
---------------------- Pollution Standard
Imposed
---------------------- Y Marginal Cost S Marginal Social
C Damage (MSD)
of Abatement
---------------------- (MCA)
Damage per tonne (Rs.)
---------------------- Z
Marginal Cost and
----------------------
---------------------- P E
Marginal Private
---------------------- Damage (MPD)
T
---------------------- B
---------------------- X
O
Q2 Q1 R
---------------------- Pollution Quantity (per tonne)
---------------------- Figure Showing Divergence between Marginal, Private and Social Costs
and it's Correction
----------------------
In the above diagram, Marginal Social Damage (MSD) and the Marginal
---------------------- Private Damage (MDP) lines indicate the incremental damage done to the
society by the pollution produced by a factory. MPD (dotted line) shows the
----------------------
damage done; while the MSD line, which is higher, shows the total social
---------------------- damage including sufferings of the people living around or passing by and
inhaling polluted air. The MCA line shows the marginal cost of abatements, i.e.
---------------------- how much the firm will have to pay to reduce pollution per tonne of pollution
for every increment of out put. Without any intervention by the pollution control
----------------------

authority, the firm will strike equilibrium at pint P where marginal private cost Notes
and marginal private benefit would be balanced. It should be noted that at this
equilibrium level of output of pollution, marginal private damage is Q1T but ----------------------
marginal social damage is Q1S which is at least three times the private damage.
If a pollution standard is imposed by the government, the equilibrium point ----------------------
will be at E, the MPD and MSD are equal. If this standard limit is crossed, the ----------------------
factory will have to pay a penalty plus a pollution tax on a continuing basis. As
a result, the MPD line moves upward and ultimately the factor's own MPD plus ----------------------
tax/penalty would make MPD = MSD, so that the gap between the two would
be bridged and the equilibrium level will correspond to the standard level of ----------------------
OQ2 which might be judged as the safe limit of pollution. ----------------------
----------------------
Fill in the blanks.
----------------------
1. Economic effect that flow from the production or the use of a goods
to other economic unit is referred to as ___________. ----------------------
2. For valuing social cost and benefit as per the World Bank approach, ----------------------
the tradable items would be valued at __________ prices and non-
tradable at __________prices. ----------------------
1. A private firm, which is guided by its own private cost benefit is likely
----------------------
to ignore the social scale of preferences involving social investments
and social urgencies. ----------------------
2. In a market economy a firm in the private sector basically aims at
----------------------
maximisation of money profits.
----------------------
Activity 2 ----------------------
----------------------
Visit www.slideshare.net and www.statemaster.com
----------------------
Identify any four private costs associated with a firm producing paper.
Which social costs does this firm levy on the society? ----------------------
----------------------
12.10 POLICIES TO RECONCILE PRIVATE AND PUBLIC
COSTS AND BENEFITS ----------------------
----------------------
As we saw earlier, the private costs and benefits are 'internal' to a firm
and as external diseconomies or economies of the activities going on in the firm ----------------------
itself, they are counted by the firm. The social costs and benefits, however, are
the external economies and diseconomies resulting from the firm's activities. ----------------------
They are therefore, known as 'externalities'.
----------------------

Notes As some examples of the negative externalities i.e. social costs, Prof.
Samuelson mentions the air and water pollution, risks from unsafe factories
---------------------- or nuclear power plants, danger from drunken drivers or gargantuan trucks
etc. these he calls negative economies. As positive externalities, he cities the
---------------------- examples of radical inventions, the radio or TV signals that we get free of
---------------------- charge or the benefits of widespread public health measures that have eradicated
epidemics such as small-pox, polio, typhoid, plague etc.
----------------------
All these externalities are suggestive of a market failure or inefficiency on
---------------------- the part of free markets. “……… the general remedy for externalities”, observes
Prof. Samuelson, “is that the externality must be somehow internalized”. In
---------------------- terms of the diagram of divergence between private and social costs/benefits,
we saw that when pollution standards are imposed, the MPD corresponds to the
----------------------
MSD because of the incentive to improve (or a disincentive to degenerate).
---------------------- (A) Private Action providing Correctives
---------------------- In most of the developing countries, an action on that part of the
government would be necessary in such cases. However, in advanced
---------------------- countries, where the legal and judiciary systems are transparent, private
approaches may also succeed.
----------------------
1) Negotiation: One such remedy is negotiation. If a factory is polluting
---------------------- the water or air of a locality, the local residents can use the company
---------------------- and place a claim for compensation. The time involved and the
affected people and pay compensation to motivate the company to
---------------------- negotiate with the affected people and pay compensation to them.
This corrective, however, has three limitations: i) the negotiated
---------------------- compensation would be less than warranted by the damage; ii) the
---------------------- loss of damage must be identifiable; and iii) the number of firms as
well as that of the affected people must be limited.
---------------------- 2) Liability Rules: where the law clearly lays down rules regarding
---------------------- liability of the persons causing damage, the affected people
can always take recourse to judicial intervention and demand
---------------------- compensation. The court may order a compensation which would
fully (or partly) bridge the gap between MPD and MSD.
----------------------
(B) Government Action
----------------------
A more effective solution to the problem of internalizing these externalities
---------------------- is an intervention by the government in the form of some action against
the generation of social costs. Such action may be in terms of a direct
---------------------- control or financial penalties.
---------------------- It is observed that in most of the countries, governments rely on
direct controls in the matter of combating health and safety-related
---------------------- externalization, including pollution. In cases of firms or persons who
cause damage, the government orders to keep the damage under specified
----------------------
limits which are judged to be safe. Such safe limits are publicized and
---------------------- those who exceed these limits are penalized. The Pollution Under Control

(PUC) certificate has to be kept ready for examination. In the diagram Notes
we have already seen how such a standard-setting works. The pertinent
question however is, does this solution work in practice? This brings us to ----------------------
the practical problems and limitation standards involved in the imposition
of these and subsequent penalties. ----------------------
These limitations are: ----------------------

1) For choosing a minimum standard, the government has to perform ----------------------
a cost-benefit analysis for which it must have full data regarding
damage and abatement costs. Such a situation is almost impossible ----------------------
to obtain.
----------------------
2) Strictly speaking, the standard will have to be zero, in which case
the factory will have to be closed down unless it invents and adopts ----------------------
a new pollution-free technology.
----------------------
3) The enforcement of control is not effective enough. In fact, unless
the penalty imposed exceeds the cost of removing the shortcomings, ----------------------
the private firms/persons will never reach the required standards. ----------------------
They may opt to pay the firm and continue doing the damage
because this is a cheaper option. ----------------------
4) The enforcing officials themselves must be above suspicion, or else ----------------------
they could be bribed to ignore the default,
5) Finally, the law fails to distinguish between large firms and small ----------------------
firms, more hazardous and less harmful pollutants, and so on. Such ----------------------
a road roller application of standards cannot work. Moreover, under
such a system of rules, the big defaulters escape and the small ones ----------------------
bear the penalty.
----------------------
(C) Externality Taxes
----------------------
Another way suggested by economists is the imposition of an emission
tax or an externality tax in general. The rate of taxation will have to be ----------------------
high enough to induce the firm to adhere to the standards rather then pay
the tax. ----------------------
This measure also suffers from certain limitation : ----------------------
1) Though economists have advocated these taxes, in practice, very ----------------------
few governments have given them a trial, maybe because they think
it difficult to impose and collect them. For one thing, the legislative ----------------------
bodies should have the political will to follow this course of action.
----------------------
2) Secondly, the tax measure should be economical, i.e., the cost of
collection should be reasonable, and should be certain, not to fetch ----------------------
revenue to the treasury but to hit the target of bringing around
these guilty of showering externalities on the society. But these ----------------------
considerations are unattractive to the politicians on whose initiative ----------------------
rests the tax-measure legislation.
----------------------

Notes 3) Finally, there is a basic conflict of objectives which strengthens the
inaction referred to in the preceding limitation. The success of this
---------------------- tax measure lies in damage-control but this means the tax would
not yield any revenue; and if it does, it would confirm its failure to
---------------------- control the damage caused by the externality concerned.
----------------------
12.11 COST BENEFIT ANALYSIS AND OVERALL
---------------------- RESOURCE ALLOCATION
---------------------- We saw that in a market economy where consumers and producers enjoy
the maximum economic freedom, the role of the government as a producer
----------------------
gets limited. However, the government is not supposed to simply watch what
---------------------- is happening in the economy as a whole. In fact, in a modern economy, the
complexities of economic relations have increased so much that the government
---------------------- has to remain on its toes so that no undesirable set of actions is undertaken by
any of the economic players. Therefore, after carefully outlining the objectives
----------------------
of such a policy, the government has to plan macro-economic policy. The need
---------------------- for such a policy can be stated as follows:
i) Correctives for shocks and disturbances: Inspite of the fact that the
----------------------
market mechanism functions automatically, the free enterprise system
---------------------- does not automatically adjust itself to various shocks and disturbances
which are bound to appear in an open economy. For adjusting the economy
---------------------- to such shocks and aberrations, a well thought-out policy has got to be
formulated.
----------------------
ii) Speeding up the pace of the economy: Every government has a set of
---------------------- well-defined and declared objectives that the economy would be expected
to attain but by itself the economy may take a long time to attain these
----------------------
objectives. A macro-economic policy and governmental intervention is
---------------------- needed to give a stimulus to force declared objectives. Such an action/
policy instrument becomes necessary when the economy is either going
---------------------- to slow or it is going in the wrong direction.
---------------------- iii) Weeding out economic evils: Unemployment, inflation, business
fluctuations etc. are the economic evils which need to be eradicated by
---------------------- adopting the right types of macro-economic policy instruments. These
---------------------- instruments would serve to stimulate the right types of forces and to
discourage or pre-suppose the undesirable trends in the economy. In a
---------------------- dynamic global modern economy, such situations are likely to occur from
time to time and they need to be corrected in time.
----------------------
iv) Structural changes in the economy: The very dynamism of the economy
---------------------- makes it necessary to adopt structural changes in the economy. However,
there are several obstacles and frictions in switching over to the new
---------------------- order. But the system demands that these changes must be brought about
---------------------- promptly and properly. The State is, therefore, called upon to intervene
and take necessary legislative and regulatory measures for assisting the
---------------------- smooth change-over.

v) Fine tuning of the economy: The functioning of the economy, at any Notes
given time, could be going through deviations from the normal and
competent course. Under such circumstances, many of the economic ----------------------
operations might need fine-tuning. This task can be performed by macro-
economic policy instruments. ----------------------
(A) Cost-Benefit Considerations at the Macro Level ----------------------

The cost-benefit analysis is expected to provide an approach to the ----------------------
implementation of macro-economic policy which happens to be the responsibility
of the government. This approach has been found to be useful in handling the ----------------------
problems related to welfare objectives. However, welfare consideration follows
the net wealth consideration. This is because the cost-benefit analysis is basically ----------------------
devised to maximize the net wealth i.e. to maximize the difference between ----------------------
benefits and costs. Our objective would be to understand the functioning of the
cost-benefit analysis as such and then to find out qualifications which can be ----------------------
added to this analysis for applying it in the formulation of a macro economic
policy aiming at maximizing social benefit. ----------------------
With a view to understand the working of the cost-benefit principles, let ----------------------
us start by assuming that economic welfare as part of total community welfare
can be maximized by maximizing net wealth. A little elaboration, at this ----------------------
juncture, is perhaps necessary. Welfare is the resultant of a state contentment
and fulfillment which itself is the result of the feeling of satisfaction. Since ----------------------
satisfaction is a state of mind, there is no way of quantifying it. Moreover, ----------------------
satisfaction can result from many non-economic activities. Therefore total
welfare of an individual or of the society comprises of various human activities ----------------------
which lead to welfare. Here, we are concerned with economic welfare which is
assumed to be maximized by satisfying as many of human wants as possible. ----------------------
For satisfying wants we need the production and/or acquisition of economic
----------------------
goods and services. There are, however, various qualification to the assumption
that the maximization of net wealth maximizes social benefit. In the first place, ----------------------
the satisfaction of wants as a pre-condition for well-being can be applied and
accepted in respect of necessaries of life and of efficiency. But when it comes ----------------------
to comforts and luxurious, the same cannot be said. Secondly many economic
activities generate wealth but do not lead to welfare. Production and trading ----------------------
of several commodities can be cited as an example of this type. Productions ----------------------
of cigarettes, liquor or drug-trafficking are examples of this type. Thirdly,
on the macro-level, a summation of maximum individual welfare does not ----------------------
automatically lead to the maximum social welfare of each and every individual.
This is because one man's food, as the saying goes, is another man's poison. ----------------------
Finally, dividing welfare parameters involves value judgments which may vary
----------------------
from society to society and from one set of objectives to another.
For achieving the maximization of net wealth, full utilization of all the ----------------------
resources is necessary. This is because the addition to total level of wealth which
----------------------
we called net wealth is nothing but the net value of producers' and consumer's
goods and services produced by the economy during a given period -usually ----------------------
one year. Maximum output that can be produced during a year is subject to
the constraint of production possibility which demarcates the boundary or the ----------------------

Notes frontier which cannot be crossed, given the amount of available resources. See
the following figure as an illustration.
---------------------- Y
----------------------
---------------------- A E
---------------------- C
Commodity Y
---------------------- M
D
----------------------
----------------------
----------------------
----------------------
N B X
---------------------- Commodity X
---------------------- Figure showing Production Possibility Curve
---------------------- In this diagram, the curve AB is the frontier which is known as the
production possibility curve or the production possibility frontier. With the
---------------------- resources being given and limited, the limit AB can be reached only by using
the resources fully. In this diagram, we assume that the economy has an option
----------------------
of producing either commodity X (shown along the X-axis) or commodity
---------------------- Y (shown along the Y-axis); or a combination of both X and Y. By using all
the resources, the economy can produce OB amount of commodity X or OA
---------------------- amount of commodity Y. Alternatively, the economy can produce a combination
of X and Y as given by all the points on the curve AB or inside the curve AB.
----------------------
For example, point D indicates the possible combination as OM amount of
---------------------- commodity Y plus ON amount of Commodity X. In the same way, any other
point on the AB curve, like the point E, would show the maximum possible
---------------------- amount of output with varying resources. As against this, point C in the diagram
indicates under utilization of resources. As against this, point C in the diagram
----------------------
indicates under utilization of resources, since the production has been stabilized
---------------------- at point C when it is possible to move forward to any other point like D and
E. It should therefore be clear what we mean by full utilization of resources. It
---------------------- should also be clear that the terms maximization of output or maximization of
net wealth imply reaching any point on the production possibility frontier AB.
----------------------
For maximization of output, we have to fully utilize all the resources
---------------------- available to us which means discarding any position like the one shown by
point C and trying to reach the boundary by aiming at any combination of X and
----------------------
Y of our choice. By doing this, the output can be maximized and employment
---------------------- (which means harnessing the productive resources for producing a given level
of output) can also be maximized. If we want to produce more than what the
---------------------- production possibility curve demands, we shall have to reach a point which

would lie on another and outer production possibility curve which would lie Notes
beyond AB and away from the point of origin O. This would be possible only
by raising the productive capacity of the economy, either by finding out or ----------------------
mobilizing additional resources or by increasing the productive efficiency of
the existing resources. Such a shift in the production possibility curve indicates ----------------------
economic growth. For achieving economic growth we shall have to maximize ----------------------
the output in the existing conditions of resource-availability. The cost-benefit
analysis, under the assumption noted above, can serve as a guide for macro- ----------------------
economic policy.
----------------------
(B) Advantages of Cost-Benefit Analysis
----------------------
The policy objective of maximizing the difference between cost and
benefit has various advantages which can be noted briefly as follows: ----------------------
i) It aims at maximization of social welfare through maximization of net
----------------------
wealth, on the assumption that any move that increases net wealth can
increase social benefit and, in turn, can increase social welfare. ----------------------
ii) In following this principle, the problem of infinite target value does not ----------------------
arise. This is because, by assuming a definite correlation between wealth
and economic welfare, the principle can suggest measures to maximise ----------------------
the difference between the total benefit and the total cost.
----------------------
iii) By using this analysis we can show the measures necessary for attaining
maximum net wealth and optimal policy aiming at this goal. ----------------------
iv) Even when a target is partially attained, the costs and benefits can be ----------------------
calculated and whatever change has taken place in the net wealth can be
ascertained at that point of time. ----------------------
v) The measurement of a trade off between different targets is always a ----------------------
difficult problem. In this case, the problem does not arise because the
money value of costs and benefits associated with the achievement ----------------------
of alternative targets can be explicitly pointed out. This enables us to
----------------------
measure objectively the trade-off.
vi) In this approach, the cost of a policy measure can be explicitly identified ----------------------
and can be incorporated in the total cost of the project.
----------------------
vii) By adopting a suitable discounting method, the costs and benefits
as arising in different periods of time in future can be estimated. The ----------------------
problem of assigning costs and benefits to various targets does not arise ----------------------
in this analysis.
(C) Limitations of Cost-Benefit Analysis ----------------------
The cost-benefit analysis as discussed above obviously suffers form certain ----------------------
limitations.
----------------------
i) Critics have pointed out that this analysis is applicable in a partial
equilibrium framework. However economists like A. C. Harberger have ----------------------
shown that it can be applied to the general equilibrium analysis as well.
----------------------

Notes ii) The exactness and usefulness of this analysis is limited by the fact that
it is based on the assumption that maximization of net wealth can ensure
---------------------- maximization of social welfare. We have already seen that this is not so.
---------------------- iii) The cost benefit analysis is applied on another assumption that the existing
pattern of distribution of income, distribution is given and has to be kept
---------------------- as it is. In fact, a change in income distribution does lead to a change in
net wealth and further in social welfare.
----------------------
iv) Another limitation of the analysis is that it ignores the effect of diminishing
---------------------- marginal utility of additional wealth or income with every incremental
dose of income or wealth being added to the existing total.
----------------------
v) By assuming the positive correlation between wealth and welfare, the
---------------------- analysis assumes away all difficulties involved in the calculation of
present and future cost as well as private and social cost.
----------------------
vi) Whatever applies to costs also applies to benefits i.e., calculation of
---------------------- present and future benefits as well as private and social benefits involves
similar difficulties.
----------------------
12.12 OVERALL RESOURCE ALLOCATION
----------------------
The Market System or Market Economy (or Market Mechanism or Price
---------------------- Mechanism) comes into existence when custom gives place to competition and
---------------------- practically everyone begins to produce goods and services for the market with
a view to make maximum profit out of the production for the market. Market
---------------------- System or Market Economy may be said to come into existence when freely
fluctuating prices in the market begin to influence allocation of the community's
---------------------- resources and distribution of income and wealth produced in the community.
---------------------- During modern times we get what is called as 'Market System' or 'Market
Economy'. Increasing division of labour or specialization has been taking
---------------------- place in both developing and developed countries. This means everyone is at
present producing goods and services (including labour of various types) for
----------------------
the market. Everyone at present carries thousands of exchanges which alone
---------------------- enable him to live comfortably. Market has become the pivotal point in modern
capitalist and mixed economies. All prices have become closely interrelated
---------------------- and influence all other prices. It is when market becomes the pivotal or central
fulcrum of the economy and influences allocation of resources and distribution
---------------------- of income and wealth, we say that there has emerged the 'Market System' or
---------------------- 'Market Economy'.
Market mechanism or freely fluctuating price mechanism is another
---------------------- system of solving the basic economic problem before the community:
---------------------- In this system, all are supposed to enjoy personal freedom as consumers
and producers and are free to use their resources as they please without any
---------------------- legal or other restrictions or barriers.
---------------------- Consumers, who are free to spend their income as they please, express
their preferences through prices. Thus if consumers begin to prefer TV sets than
----------------------

radio sets, prices of TV sets will go on rising more relatively to prices of radio Notes
sets. Under market mechanism, since producers are free to use their resources
as they like, and as they are motivated to make maximum profit, they will divert ----------------------
their resources from production of radio sets to the production of TV sets. Thus
more TV sets and relatively less radio sets will be produced for the market. ----------------------
People express their preferences through prices. Changes in free fluctuating
----------------------
prices acts as a signal to producers. They switch their resources, on the basis of
price changes, to the production of goods according to the changing preferences ----------------------
of consumers. This gives consumers what they prefer more. Naturally this
results in maximization of welfare of the community everyone getting what he ----------------------
wants. This also means that market mechanism brings about most efficient use
of the community's resources. ----------------------
Shift of resources from production of radio sets to production of TV sets ----------------------

will go on until more TV sets in the market are produce and relatively less radio
sets there will bring down the prices of TV sets and raise the prices of radio ----------------------
sets as there are fewer radio sets available, to a level where profits in both TV ----------------------
manufacturing and radio manufacturing industries become equal.
Market (or price) mechanism is explained above with a simple model of ----------------------
only two commodities. Market or price mechanism operates along the same ----------------------
principle even when there are many commodities and services. Thus market or
price mechanism is supposed to help solve the basic economic problem - how ----------------------
to make the most efficient use of community's resources and how to derive the
maximum satisfaction from the community's resources. ----------------------
(A) Assumptions of Market (or Price) Mechanism ----------------------
There are certain assumptions on which operation of the market (or price) ----------------------
mechanism is based. The important assumptions are as follows:
i. Each consumer knows what is in his best interest and acts rationally ----------------------
to secure maximum satisfaction. ----------------------
ii. There is perfect competition in the market - competition among
consumers and among producers, each consumer and producer ----------------------
knowing fully well about what is taking place in the market and
----------------------
how prices are moving.
iii. Different factors of production have perfect mobility and they can ----------------------
move easily and quickly from one industry to any other in search of
----------------------
higher profits.
(B) Criticism of Market or Price mechanism ----------------------
But in the actual live market, price mechanism does not operate as ----------------------
smoothly and efficiently as described in the above model. This is because the
above assumptions are not always and fully valid and are not found in real ----------------------
world. Thus consumers do not always know what is in their best interest and
----------------------
do not always act rationally. The competition among consumers and producers
assumed in the above model is often absent. There is also no full knowledge ----------------------
among consumers and producers about market conditions and happenings.
Absence of competition often gives rise to monopoly which can prevent entry of ----------------------

Notes outside units in its line of production and manipulate prices by creating artificial
scarcities. There is never perfect mobility of factors of production, especially
---------------------- in the case of labour. Some factors of production are specific and can produce
only certain goods and not other goods though the prices of the latter may rise.
---------------------- Different factors of production even if there is competition will find it difficult
---------------------- to move from industry to industry in search of higher profits as depicted in the
above model.
----------------------
----------------------
12.13 FOUNDATIONS OF MARKET SYSTEM OF ECONOMY
---------------------- The market system of economy (also known as Laissez Faire Capitalism or
simply Capitalism) is built on the following foundations:
---------------------- i. Individual, the best judge of self-interest :
---------------------- In the market system or capitalist economy, it is assumed that every
individual is the best judge of his personal interest. Every individual
----------------------
knows what is in his interest and no one does that better than himself.
---------------------- Every individual should therefore be left free to carry on his economic
activities as a consumer and as a producer and so on without being dictated
---------------------- by any one else including the government.
---------------------- ii. Consumer's Sovereignty :
The above assumption implies that in a market system of economy, a
----------------------
consumer with his complete freedom to spend his income as he likes is
---------------------- sovereign as a consumer, dictating to producer what goods he prefers and
these therefore should be produced. This means the market system of
---------------------- economy is characterized by the consumer's sovereignty.
---------------------- iii. Freely Fluctuating Price Mechanism :
---------------------- The sovereign consumers express their demands and preferences through
freely operating prices or through price mechanism. Freely operating
---------------------- price mechanism thus acts as a signaling system indicating to various
producers,consumers' preferences - that they prefer TV sets to radio and
---------------------- radio sets to gramophone and so on - and influencing and bringing about
---------------------- allocation of limited resources of the community in accordance with
consumers' preferences.
---------------------- iv. Private Enterprise :
---------------------- In the market system in economy, most of the goods and services are
produced by individual producers or groups of individual producers. That
----------------------
is why the market system is also known as private enterprise economy.
---------------------- The government has no role to play as a producer of goods and services
except to a very limited extent where private enterprise may not be
---------------------- interested.
---------------------- v. Private Profit Motive :
---------------------- In the market system of economy most of the goods and services are

produced by individual producers who enjoy perfect freedom as Notes
producers without being dictated in this regard by anyone else including
the government. The chief or major foundation of the market system or ----------------------
private enterprise economic system is that among all motives to human
activities, the private profit motive (i.e. self-interest) is the most powerful ----------------------
motive which will bring out the best efforts by every individual. And ----------------------
therefore under this system all production is carried on by individual
producers with a view to maximize their personal profit. ----------------------
vi. Institution of Private Property : ----------------------
Another major foundation of the market system of economy is the
----------------------
institution of private property (i.e. exclusive right to own and enjoy one's
property in land, buildings, factories, precious metals like gold and silver, ----------------------
share and other financial assets and such other tangible and intangible
goods). ----------------------
vii. Existence of Competition : ----------------------
Open and free competition among consumers and producers may be ----------------------
said to be the very soul of the market system of economy. In this system
consumers compete among themselves for goods and services in the ----------------------
market by offering competitive prices to get them, and producers compete
among themselves for getting factors of production to produce goods and ----------------------
services to be sold to consumers at competitive prices. ----------------------
viii. Harmony between Individual Interests and Interests of the community :
----------------------
Since in the market systems (or private enterprise economy or capitalism)
each individual is free to strive to maximize his personal satisfaction ----------------------
of which he is the best judge, it follows that when all individuals attain
maximum satisfaction of their own, community made up of those ----------------------
individuals would automatically attend the maximum satisfaction or ----------------------
welfare. There is thus no clash between interest of an individual and that
of community. ----------------------
ix. Non-interference by the State (or Laissez Faire) : ----------------------
If under the market system every individual acting for his personal
----------------------
interest or personal profit can automatically ensure maximum welfare,
not only of himself but also that of the community, and if there is no clash ----------------------
between interest of an individual and welfare of the community, and no
clash of interest between welfare of consumers and that of producers, ----------------------
if freely functioning price-mechanism with its competitive system can
----------------------
automatically ensure maximum welfare of the consumers and most in the
State or government trying to interfere in the economic activities of the ----------------------
people telling to do this and not to do that and so on. People should be free
to carry on their economic activities as consumers and as producers. ----------------------
The above are the foundations (that means the assumptions) on which the ----------------------
'Market System' (also known as Market Economy or Capitalism) stands
or functions. ----------------------

Notes
----------------------

1. Laissez faire capitalism is a _________ of economy
----------------------
2. Under market system of economy, all production is carried on by
---------------------- individual producers with a view to ______________ their personal
______________.
----------------------
----------------------
1. Market system of economy is characterised by consumers’ sovereignty.
----------------------
----------------------
Activity 3
----------------------
Do you think that the current market scene completely suits the conditions
----------------------
of a market economy? Which do you think falls outside and or inside the
---------------------- purview of a market economy? Why?
----------------------
Summary
----------------------
---------------------- ●● If the costs and the benefits are equal, the firm seemingly attains break-
even and the acceptability of the project widens as the benefits outperform
---------------------- the costs.
---------------------- ●● Goods are classified as public goods and private goods.

●● In the production process, there are externalities created, which could be
---------------------- positive or negative. Externalities refer to the effects which flow from the
production or use of the good. These effects flow to other economic units.
----------------------
●● Cost-benefit Analysis comes in for a rescue where finding the worth of
---------------------- the project is not possible. There are many other counts on which the cost
benefit analysis is justified.
----------------------
●● This unit gives us the concept of Market Economy. It is also called as
---------------------- the 'Laissez faire economy'. This means that there is no government
intervention. Market mechanism believes in competition and is based on
----------------------
certain assumptions such as consumer knows his interests and tries to
---------------------- maximize satisfaction, there is perfect competition in the market and price
mechanism plays a big role in determining equilibrium in the market.
----------------------
----------------------
----------------------
----------------------

Keywords Notes
----------------------
●● Cost Benefit Analysis : Technique used for analyzing investment, for
rating alternative investment opportunities on the basis of the rate of ----------------------
return to investment.
●● Externalities : Economic effects that flow from the production or the use ----------------------
of the good to other economic units. ----------------------
●● Externality Tax : Rate of taxation should be high enough to motivate the
firm to follow the set standards rather than pay tax. ----------------------
●● Impure Public Goods : Goods, the production of which is reflected in ----------------------
private costs being higher than the social benefits.
----------------------
●● Laissez Faire : Complete non-interference of the government and
complete faith in the working of the free private market system to operate ----------------------
automatically so as to ensure maximum welfare.
----------------------
●● Non-market Effects : The external effects (externalities) that cannot be
priced in the market with reference to the market demand and supply. ----------------------
●● Pure Public Goods : Goods that do not have any externalities, wherein
----------------------
private costs equal the social costs.
●● PPC (Production Possibility Curve) : Depicts the indirect relationship ----------------------
between he total output of two commodities that a economy can produce
----------------------
given full employment level of all the available resources.
●● Right to Private Property : The exclusive right to own and enjoy one’s ----------------------
property to land, precious metals, other financial assets, and such other
----------------------
tangible and intangible goods.
●● Social Marginal Costs : Indirect costs borne by the society because of ----------------------
the or Benefits process of production will not get entered in the books of
----------------------
accounts.
----------------------
----------------------
1. Explain the distinction between public and private goods.
----------------------
2. Give an idea about government investment in the context of the Indian
economy. ----------------------
3. Explain with illustrations, how resource allocation and income distribution ----------------------
takes place in a free enterprise economy.
----------------------
4. What are the foundations of Market Economy?
----------------------
5. Compare and Contrast Private and Social Cost-Benefit.
----------------------
----------------------
----------------------


1. Cost-benefit analysis refers to the evaluation of any project.
----------------------
2. The indivisible goods whose benefits cannot be priced and to which the
---------------------- principle of exclusion does not apply are called pure public goods.
---------------------- 3. Goods which are neither pure public goods nor pure private goods are
called impure goods.
----------------------
---------------------- 1. False
---------------------- 2. True
---------------------- 3. True
----------------------
Fill in the blanks.
----------------------
1. Economic effect that flow from the production or the use of goods to other
---------------------- economic unit is referred to as externalities.
---------------------- 2. For valuing social cost and benefit as per the World Bank approach,
the tradable items would be valued at world prices and non-tradable at
---------------------- shadow prices.

1. True
----------------------
2. True
----------------------
---------------------- 1. Laissez faire capitalism is a market system of economy.
---------------------- 2. Under market system of economy, all production is carried on by

individual producers with a view to maximise their personal profit.
----------------------
---------------------- 1. True
----------------------
Suggested Reading
----------------------
1. Agarwal, A.N. 1977. Indian Economy. New Delhi: Vikas Publishing
---------------------- House.
---------------------- 2. Atmanand. 2009. Managerial Economics. New Delhi: Excel Books.
---------------------- 3. Englewood Cliffs, N.J., Managerial Economics, Prentice-Hall, Inc.

4. Joan Robinson, The Economics of Imperfect Competition, Macmillan.
Macro Economic Analysis
UNIT
13
Structure:
13.1 Introduction
13.2 Importance of Macro-Economic Studies
13.3 Keynesian Macro-Economic Theory
13.4 Determination of Equilibrium Level of Output/ Employment
13.5 Keynesian Remedy to Unemployment : Government Intervention
13.6 Business Fluctuations
13.7 Inflation
13.8 Macro Policies
Summary
Key Words
Suggested Reading
Macro Economic Analysis 307

Notes
Objectives
----------------------
----------------------
• Differentiate between micro and macroeconomics
----------------------
• Underline the importance of macroeconomic study
---------------------- • Reproduce and generalise on the Keynesian macroeconomic theory
---------------------- • Define the effective demand, aggregate demand function and
aggregate supply function
----------------------
---------------------- 13.1 INTRODUCTION

---------------------- Macro-economics is the study of the aggregate behaviour of the economy
---------------------- as a whole. It is concerned with the macro-economic problems such as the
growth of output and employment, national income, the rates of inflation, the
---------------------- balance of payments, exchange rates, trade cycles, etc.
---------------------- According to Prof. Ackley, “Macro economics deals with economic

affairs ‘in the large’; it concerns the overall dimensions of economic life.”
----------------------
In short, macro-economics deals with the major economic issues,
---------------------- problems and policies of the present times.
National income, money, total investment, savings, unemployment,
----------------------
inflation, balance of payments, exchange rates, etc. are the crucial economic
---------------------- aggregates.
In macro-economic analysis, the behaviour of economic agents such as
----------------------
firms, house-holds and government is seen in total, disregarding details at the
---------------------- particular level - i.e., micro level.
---------------------- An individual consumer, the particular market for a given commodity,

operation of a firm, etc. are the subject matter of Micro economics. Macro-
---------------------- economics deals with the market for all goods as a whole. It is considered as the
product or commodity market in general. Similarly, labour market is taken as a
---------------------- whole for the entire labour force in the economy. Likewise, financial market is
---------------------- taken as a whole which covers money market, capital market and all banking
and non-banking institutions taken together.
---------------------- Prior to Keynesian revolution in economic thinking in the 1930s, the
---------------------- classical economists had concentrated more on micro-economic approach
and macro behaviour was also described as mere summation of individual
---------------------- observations. Prof. J. M. Keynes in 1936 published The General Theory of
Employment, Interest and Money which revolutionized the whole of economic
---------------------- thinking. He suggested that macro economic behaviour should be studied
---------------------- separately. Behaviour in total is quite different then what we may try to infer
by summation of individual behaviour. He said that, for instance, saving is a
---------------------- private virtue but it is a public vice in a matured economy that causes deficiency

of demand leading to depression. Notes
Keynes prescribed macro-economics as a policy-oriented science to deal with
----------------------
the problems like unemployment, inflation etc.
Economics of Keynes serves as the foundation centre for modern economics. ----------------------
It follows that the scope of macro-economics is confined with the behaviour of ----------------------
the economy in total. It does not examine individual behaviour. It relates to the
economy-wide total or aggregates and problems of general nature. Its policies ----------------------
are general.
----------------------
The subject matter of macro-economics includes the theory of income and
employment, theory of money and banking, theory of trade cycles and economic ----------------------
growth. ----------------------
13.2 IMPORTANCE OF MACRO - ECONOMIC STUDIES ----------------------
Macro-economic studies have unique theoretical and practice significance. ----------------------

1) Macro-economics provides an exploration to the Functioning of ----------------------
an Economy in general: Using macro-economic tools and technique
of economic analysis one can understand the working of the economic ----------------------
system in a better way. ----------------------
2) Empirical Evidences: Macro-studies are based on empirical evidences
of the theoretical issues. Macro - economics is more realistic. ----------------------
3) Policy-orientation: Macro-economics is a policy - oriented science. ----------------------

It suggests a best of policy measures, such as fiscal policy, monetary
policy, income policy, etc. to deal with complex economic problem like ----------------------
unemployment, poverty, inequality, inflation, etc. faced by the country in ----------------------
modern times.
----------------------
4) National Income: Macro-economics teaches the computation, use and
application of national income data. With the help of national income ----------------------
statistics and accounting one can understand and evaluate the growth
performance of an economy over a period of time. ----------------------
5) Income and Employment Theory and Monetary Theory: Economics ----------------------
of employment and income and monetary economics are the major fields
of macro - economics which have utmost practical relevance. Planning ----------------------
and policy making is not possible without the base of the understanding
----------------------
of these two fields.
6) Dynamic Science: Macro - economics is a dynamic science. It studies ----------------------
and suggests solutions to the issues and problems from the dynamic ----------------------
view point. It allows for change. One can have a better idea of a dynamic
perspective in the real economic world in the light of macro - economic ----------------------
tools and mode of its general equilibrium analysis.
----------------------
----------------------

Notes 13.3 KEYNESIAN MACRO-ECONOMIC THEORY
---------------------- Background of The Theory
---------------------- The Keynesian Theory of Employment and output determination was

presented in the famous work of Lord J.M. Keynes’ “The General Theory of
---------------------- Employment, Interest and Money” in 1936.
---------------------- The Keynesian theory is basically a criticism against the classical analysis
and classical belief in the automatic adjustments in a capitalist economy leading
---------------------- to full employment. The General Theory, as the theory is popularly known,
was published immediately in the post Great Depression period of 1929-33.
---------------------- The Great Depression had clearly proved that a pure capitalist system by itself
---------------------- could not sustain itself and was self-defeating. The Keynesian Theory is an
outcome of the depression and was basically a critique of the classical analysis.
---------------------- It provided an alternative approach to the problem of employment and output
determination in an economy, and was more realistic because it did not accept
---------------------- the classical belief in full employment. Keynes believed that full employment
---------------------- is not the general case but a rare occurrence and that deliberate government
intervention is required to achieve full employment in an economy.
----------------------
He was however, not advocating a socialist pattern of society, but
---------------------- recommended government intervention in a capitalist economy to solve
the problems of this type of an economy, especially unemployment. Based on
---------------------- Keynes’ analysis governments have intervened in the economies to avert the
repetition of the depression.
----------------------
The theory addresses itself to three major issues:
----------------------
A) The determination of the equilibrium level of output/ employment and income.
---------------------- B) The causes of unemployment.
---------------------- C) The solutions to the problems of unemployment.
---------------------- In order to understand Keynes theory. It is necessary to start with the
assumptions of the theory.
----------------------
(A) Basic Assumptions of The Theory
---------------------- 1. Keynes theory is a short-run equilibrium analysis within the
framework of a capitalist economy.
----------------------
2. The technology and stock of capital are assumed to be constant in
---------------------- the short-run and therefore the level of output is determined by the
level of employment.
----------------------
3. There is perfect competition in the labour and product markets.
----------------------
4. Keynes assumed increasing costs in the industries which implies
---------------------- that to produce more output, the marginal cost of production would
go on increasing.
----------------------
5. The analysis pertains to a closed economy i.e. the foreign sector
---------------------- was kept out of the basic analysis.

6. The government is introduced only as solution to stabilize the Notes
economy in Keynes theory.
----------------------
(B) The Theory
Before proceeding to details of the theory, it is necessary to list out some ----------------------
major propositions of the theory.
----------------------
1. The level of output and employment in an economy get determined
simultaneously. ----------------------
2. Output and employment get determined by the level of effective ----------------------
demand (ED)
----------------------
3. This level of effective demand itself is determined or dependent
upon two factors: ----------------------
(i) The Aggregate Supply Function (ASF) ----------------------
(ii) The Aggregate Demand Function (ADF)
----------------------
4. The equilibrium level of effective demand is determined at point
where ----------------------
ASF = ADF ----------------------
\ ED = ASF = ADF ----------------------
5. The level of ED therefore becomes the crucial factor in Keynes
theory which determines the level of employment and output. E.D. ----------------------
is Effective Demand. ----------------------
6. If the level of ‘ED’ is high the level of employment also will be
----------------------
high and if the level of ED is not high enough, it would generate
shortages in Aggregate Demand and the possibilities of ----------------------
unemployment.
----------------------
7. Keynes found that in a purely Capitalist system the level of ED
was not high enough to support full employment and therefore ----------------------
advocated government intervention to solve the problem of
unemployment. ----------------------
(c) The Concept of Effective Demand ----------------------
Effective demand in very simple terms refers to the aggregate demand ----------------------
in an economy. It is the most important element in Keynes theory. The
level of effective demand in the economy would determine the level of ----------------------
employment. The level of effective demand is made up of two components
i.e. Consumption demand and Investment demand – any short-fall in ----------------------
either of these two would cause unemployment. If the economy has to sustain ----------------------
itself, both these types of demands constituting the ‘Aggregate demand’
should increase to maintain employment at the full employment level. ----------------------
The concept of effective demand is therefore nothing but ----------------------
the aggregate expenditure in the economy which is made up of the
Consumption Expenditure (i.e. Consumption Demand) and Investment ----------------------

Notes Expenditure (Investment Demand). Keynes showed that as income goes
on increasing in the economy consumption demand increases but at a
---------------------- slower rate and hence, a consumption gap is created. This consumption
gap can be overcome only if the investment demand is able to increase at
---------------------- an adequately high rate. However, according to Keynes, investment left
---------------------- to the private individuals fails to generate the required demand to sustain
full employment equilibrium. Hence, according to Keynes, government
---------------------- intervention becomes essential to ensure full employment. Keynes theory
is thus a theory of ‘Deficient Aggregate Demand’.
----------------------
Since the level of ED is dependent on ASF and ADF, one can
---------------------- proceed to explain these concepts in detail.
---------------------- (i) The Aggregate supply function (ASF)
ASF can be defined as “A schedule which shows the minimum
----------------------
expected receipts for different levels of output and employment”. The
---------------------- ASF can be considered as the supply price of the various levels of output
or it represents the ‘Total Cost’ aspect of production.
----------------------
To draw the ASF it is necessary to start with the Aggregate Supply
---------------------- Schedule.
---------------------- Aggregate supply schedule

This schedule shows the relationship between different levels of output/
---------------------- employment and the minimum expected receipts.
---------------------- Aggregate Supply Schedule
---------------------- Levels of Output & Employment Minimum Expected Sales Receipts
(Units) (Rs.)
----------------------
10 200
---------------------- 20 400
30 600
----------------------
40 800
---------------------- 50 1000
50 1200
----------------------
Observations:
----------------------
As can be seen, initially as the output increases, the total cost or minimum
---------------------- expected receipts also increase till the level of full employment is reached
at level 50 in the table given above.
----------------------
Once this level is reached output/employment will remain constant but
---------------------- costs would go on increasing.
---------------------- On the basis of the above schedule one can draw the ASF as given below:
----------------------
----------------------

Notes
1800
----------------------
1600
Minimum Expected Receipts (Rs.)
A.S.F. ----------------------
1400
----------------------
1200
----------------------
1000
----------------------
800
----------------------
600
----------------------
400
----------------------
200
----------------------
0 0 10 20 30 40 50 60 70 80 90 Q/
Qf E ----------------------
Level of Output and Employment
----------------------
Observations:
(a) As can be seen, initially as the levels of Output/ Employment ----------------------
increases the minimum expected receipts (or Total Cost) also go on
----------------------
increasing till the level of full employment is reached at OQF (i.e.
at level 50 ) ----------------------
(b) Beyond the level of full employment Q/E remains constant at Qf ----------------------
where-as total cost goes on increasing.
(c) Therefore the ASF takes the above shape. ----------------------
As seen in the graph and as discussed above, we have seen that at a ----------------------
particular point, full employment is reached, but after which costs are still
increasing. According to your understanding, why do you think that costs ----------------------
are rising? Do you think that an economy at full employment is always an ----------------------
ideally happy economy? Highlight in terms of a labourer’s actual working
capacity (answer : it may happen that a worker is employed, but is not ----------------------
working to his /her fullest or optimum capacity, and so is getting returns
that he/she would actually deserve). ----------------------
(ii) The aggregate demand function (ADF) ----------------------

ADF can be defined as “The maximum expected sales proceeds from ----------------------
different levels of output”; it is the maximum that consumers are willing
to pay for the different levels of output or it represents the total revenue ----------------------
(expected) from the sale of various levels of output.
----------------------
A point to be noted is that how much individuals can pay would depend
upon the level of income. The level of income in an economy is itself ----------------------
dependent on the level of output and employment. Hence the ADF is ----------------------

Notes positive function of the level of output and employment, as level of
output increases the aggregate demand price also tends to increase.
----------------------
The Aggregate Demand Schedule: The aggregate demand schedule
---------------------- states the relation between various levels of employment and the maximum
sales proceed from the sale of those levels of output, as shown below:
----------------------
Aggregate Demand schedule
---------------------- Levels of employment / output Maximum expected sales proceeds
---------------------- (Units) (Rs.)
10 350
---------------------- 20 500
---------------------- 30 650
40 800
---------------------- 50 950
---------------------- 50 1100
---------------------- Observations:
As output and employment goes on increasing, the expected sales proceeds
---------------------- or the demand price increases. After the level of full employment reached,
---------------------- the demand price goes on increasing but output and employment remains
constant at level 50 in the example.
---------------------- On the basis of the ‘Aggregate Demand Schedule’ one can draw the
---------------------- Aggregate Demand Function (ADF) as given below.
----------------------
Maximum
---------------------- Expected
Sales
---------------------- Proceeds
(Rs.)
---------------------- ADF
---------------------- a
----------------------
---------------------- O Levels of Output and Employment Q/E
---------------------- Observations:
a) The ADF is a positive function of the level of employment and
----------------------
output.
---------------------- b) The ADF begins from above the origin at point “a” indicating that
even at zero level of income, there is some positive consumption,
----------------------
(i.e. to meet the basic minimum needs.) for which Keynes uses the
---------------------- word Autonomous Consumption.
----------------------

13.4 DETERMINATION OF EQUILIBRIUM LEVEL OF Notes
OUTPUT/ EMPLOYMENT
----------------------
(A) Effective Demand
----------------------
The Equilibrium level of output and employment in Keynes Theory is
determined at the level of “Effective Demand” i.e. at point where ----------------------
ASF = ADF
----------------------
As stated earlier this is also a point where Supply Price = Demand
Price. The ASF or Supply Price represents the Costs of Production (C) ----------------------
(including competitive profit). The ADF represents the Revenue (R) from
sale of output. Thus in familiar terms, equilibrium will be established at a ----------------------
point where Costs = Revenue. ----------------------
As long as Revenue is greater than Costs, the employment/ output will go
on increasing. At the point where Revenue = Costs, the equilibrium level ----------------------
of output and employment is determined; beyond this when Costs exceed
----------------------
revenue, employment and output will have a tendency to decrease, since no
rational producer will produce a level of output where cost exceeds revenue. ----------------------
To sum up
----------------------
1. When ASF = ADF Equilibrium level
or C = R Output/ employment ----------------------
2. When ASF > ADF Output and Employment ----------------------
or C > R has a tendency to decrease.
3. When ASF < ADF Output and Employment has a ----------------------
or C < R tendency to increase. ----------------------
In sum, therefore, the point where ASF (i.e. costs of production) is equal
----------------------
to ADF (i.e. the revenue from sale of output), is the point of ‘Effective
demand’ which determines the equilibrium level of employment and ----------------------
output in Keynes theory. And this equilibrium in Keynes analysis can
occur before the level of Full Employment. ----------------------
A comparison of ASF/ ADF ----------------------
Levels of Minimum Maximum Comparison Behaviour of
employment/ expected sales proceeds of levels of employment/ ----------------------
output receipts (ADF) Rs. ASF & ADF output
(ASF) Rs. ----------------------
10 200 350 ASF<ADF Employment ----------------------
will increase
20 400 500 ASF<ADF ‘Effective ----------------------
demand’
30 600 650 ASF<ADF ‘Equilibrium ----------------------
level of ----------------------
40 800 800 ASF=ADF employment/
output ----------------------
50 1000 950 ASF>ADF Employment
50 1200 1100 ASF>ADF will decrease ----------------------

Notes Observations:
As can be seen in the table given above, equilibrium level of employment
----------------------
is determined at the level of 40, where ASF=ADF which is the level of
---------------------- Effective Demand. This is below the full employment level i.e. at 50,
indicating that in the Keynesian analysis equilibrium occurs at Under
---------------------- Full Employment level. According to Keynes it is ‘Deficient demand’
or shortages in Aggregate demand which leads to unemployment in an
----------------------
economy. The above analysis is illustrated with the help of a diagram
---------------------- given below:
This is shown with the help of a diagram.
----------------------
Y
---------------------- ASF
----------------------
Expected Level of
---------------------- Minimum
Effective Demand
Sales
---------------------- Receipts
and ef
---------------------- Maximum
(ASF = ADF) DF
Proceeds A ADF
F>
---------------------- (Rs.) e AS
Pe
---------------------- a
SF
A
F>
---------------------- AD
---------------------- O Qe < Qf X
Levels of Output and Employment
----------------------
(B) Determination of Equilibrium at less than Full Employment
----------------------
Observations:
---------------------- 1. In the diagram to begin with, the level of equilibrium employment /
output is determined at the point Qe which corresponds to point ‘e’
----------------------
where ADF=ASF, which is the level of Effective Demand.
---------------------- 2. This equilibrium occurs at employment level Qe which is below the
---------------------- full employment level indicated by Qf in the diagram; according
to Keynes it is short-falls in the aggregate demand which is the
---------------------- main cause of unemployment in a capitalist economy.
---------------------- 3. Before point ‘e’ is reached ADF>ASF, employment / output will go

on increasing, beyond point e, ASF>ADF and hence employment
---------------------- will begin to decrease, Thus, point e becomes the point of
effective demand determining the equilibrium level of output and
---------------------- employment.
---------------------- 4. The equilibrium level of prices is determined at point Pe
corresponding to point e in the diagram.
----------------------

5. According to Keynes, an increase in the level of effective demand Notes
can increase the level of employment and output to the full
employment i.e. Qf. ----------------------
6. Changes in the ASF or ADF could bring about the desired change ----------------------
in the level of Effective Demand. In the Keynesian analysis, it is the
‘Aggregate Demand Function’, which becomes important to bring ----------------------
about changes in the level of employment.
----------------------
(C) The Importance of Aggregate Demand Function
----------------------
The ‘Effective’ element in determination of the Level of Effective Demand
is the Aggregate Demand Function. ----------------------
In the Keynesian analysis ASF is considered to be relatively stable ----------------------
function in the short-run and hence it is the ADF which becomes crucial
in determining the level of employment. ----------------------
The Aggregate Supply Function is considered to be relatively stable ----------------------
function and received little importance in the further analysis because of
the following factors – ----------------------
a) The Keynesian analysis is a short-run analysis. ----------------------
b) In the short-run the stock of capital and technology are considered
----------------------
to be stable.
The General theory is therefore a theory of ‘Aggregate Demand’. ----------------------
It is changes in Aggregate Demand which becomes the effective ----------------------
element in determining the level of Effective Demand and hence
employment and output in an economy. ----------------------
The aggregate demand as already stated is the aggregate expenditures ----------------------
in the economy which in effect is made up of Consumption Demand
(i.e. expenditure) and Investment Demand (i.e. expenditure), this can be ----------------------
denoted as: ----------------------
AD = C+I
----------------------
Where AD is the aggregate demand, C is consumption expenditure/
demand and I the investment/ expenditure. ----------------------
The level of Effective Demand will increase if C increases or I increases ----------------------
however, according to Keynes, in a private capitalist economy left
to itself the consumption and investment expenditures are not high ----------------------
enough to generate full employment. What Keynes advocated was to
----------------------
introduce Government Expenditures to overcome the shortages
in aggregate demand to achieve the level of full employment in an ----------------------
economy. Government intervention could take the form of government
Expenditures, Taxes, Subsidies; deficit financing all Fiscal Policy ----------------------
Measures, Government Expenditures would increase the level of
----------------------
Effective Demand to attain full employment equilibrium. By introducing
government expenditure the aggregate demand would become: ----------------------

Notes AD = C + I + G
Where the new term ‘G’ is government expenditure.
----------------------
In this manner a capitalist economy would solve the problem of
---------------------- unemployment in times of depression in the economy. The effect of
introducing government intervention on the employment level can be
----------------------
seen in the following analysis.
----------------------
----------------------

---------------------- 1. Micro economics deals with ________ issues problems and policies of
the present times.
---------------------- 2. The subject matter of macroeconomics includes the theory of_______
and ______________.
----------------------
3. The Keynesian Theory is an outcome of the depression and was basically
---------------------- a critic of the ________________.
1. Macroeconomics is not concerned with national income
----------------------
2. Keynes believed that full employment is the general case and Government
---------------------- in turn is not required to achieve full employment in an economy.
3. As per the Keynesian Theory, output and employment get determined by
---------------------- the level of effective demand.
---------------------- 4. Keynes advocated to introduce Government expenditure to overcome
the shortages in aggregate demand.
----------------------
----------------------
Activity 1
----------------------
A poor man of low means strives hard to make ends meet. He lives in a
----------------------
very shoddy locality; owes a lot of money to creditors and cannot send his
---------------------- children to school. He is basically living below the poverty line. He wants
to come out of his pathetic condition, by taking up for better jobs (he is
---------------------- willing to put in more number of hours as well). He wants his income to
grow and improve his living condition on the whole.
----------------------
How can you transform this example to suit that of micro-economic
---------------------- study?
----------------------
13.5 KEYNESIAN REMEDY TO UNEMPLOYMENT:
---------------------- GOVERNMENT INTERVENTION
---------------------- When the Government intervenes in the economy and undertakes
expenditures, it generates demand in the economy, thereby increasing the level
---------------------- of aggregate demand to be able to attain full employment in the economy. This

can be shown in the diagram below: Notes
Y
----------------------
ASF
----------------------
Expected
Minimum ----------------------
Sales
Proceeds ----------------------
e2 AD1 = C+I+G
(ADF) and
Minimum ----------------------
Expected AD1 = C+I+G AD = C+I
Receipts ----------------------
e
(ASF)
----------------------
----------------------
X ----------------------
O Qe < Qf Q
Levels of Output and Employment ----------------------
(A) Effect of government expenditures on equilibrium level of employment ----------------------
Explanation:
----------------------
1) Keynes had advocated Government expenditures to sustain full
employment in a capitalist economy. As can be seen in figure, in ----------------------
the absence of the government, the level of Aggregate Demand is
shown by AD = C+I, equilibrium is established at point e where ----------------------
AD= ASF, and level of employment is determined at point Qe ----------------------
which is less than full employment level Qf.
2) By introducing government expenditure, ‘G’, the level of aggregate ----------------------
demand now shifts up to AD1 = C+I+G. Equilibrium is now ----------------------
established at point e2 where AD=ASF and level of employment is
now determined at Qf level which is the full employment level. ----------------------
3) The short- fall in the aggregate demand i. e. effective demand is ----------------------
made good by government expenditures as a result it is possible to
attain full employment. ----------------------
4) Keynes strongly advocated Government intervention through ----------------------
fiscal policy measures to solve the problem of unemployment and
stabilise the economy. ----------------------
(B) Consumption Function ----------------------
The consumption appears to be a significant factor, determining the ----------------------
level of effective demand in an economy. Consumption function, or the
propensity to consume, denotes the consumption demand in the aggregate ----------------------
demand of the community, which depends on the size of income and the
share that is spent on consumption goods. The propensity to consume ----------------------
is schedule showing the various amounts of consumption corresponding ----------------------

Notes to different levels of income. Thus, by consumption function, we mean
a schedule of functional relationship, indicating how consumption
---------------------- reacts to income variations. Keynes, on the basis of a fundamental
psychological law, observed that as income increases, consumption
---------------------- also increases, but less proportionately. Secondly, he also stated that
---------------------- the propensity to consume is relatively stable in the short run and,
therefore, the amount of the community’s consumption varies in a
---------------------- regular manner with aggregate income. Since consumption increases
less than income, there is always a widening gap between income and
---------------------- consumption as income expands. Keynes, thus, argued that in order to
---------------------- sustain the level of income and employment in the economy, investment
demand should be increased because consumption demand is relatively a
---------------------- stable component of the aggregate “effective demand”. Thus, the crucial
factor in employment - income theory is the investment function.
----------------------
(C) Investment Function
----------------------
Investment Function or the inducement to invest is the second but
---------------------- crucial factor of effective demand. Effective demand for investment or
the investment demand function is more complex and more unstable than
---------------------- the consumption function. According to Keynes, by investment it means
only real investment, denoting an addition to real capital assets as well as
----------------------
the accumulated wealth of the society.
---------------------- The volume of investment in a private enterprise economy depends
on the inducement to invest on the part of the business community. Thus,
----------------------
according to the Keynesian theory, inducement to invest is determined by
---------------------- the business community’s estimates of the profitability of investment in
relation to the rate of interest on money for investment. The estimates or
---------------------- the expectations of profitability of new investment by the entrepreneurs
are technically termed as the Marginal Efficiency of Capital.
----------------------
Thus, there are two factors determining investment functions,
---------------------- namely, (i) the marginal efficiency of capital and (ii) the rate of
---------------------- interest. Accordingly, when the marginal efficiency of capital is greater
than the rate of interest, the greater is the inducement to invest. Thus,
---------------------- in general, entrepreneurs keep a fair margin between the two variables.
In this sense, the marginal efficiency of capital and the rate of interest
---------------------- combines to influence the rate of investment in an economy.
---------------------- Keynes defined marginal efficiency of capital is the highest
rate of return over cost expected from producing an additional (or
---------------------- marginal) unit of a special asset. The marginal efficiency of capital is,
---------------------- thus, estimated by taking two factors into account: (i) the prospective
yield of a particular capital asset, and (ii) the supply price or the
---------------------- replacement cost of that asset. The marginal efficiency of capital is
estimated to be greater if the difference between the prospective yield and
---------------------- the supply price of a capital asset is larger. The supply price of a capital
---------------------- asset can be easily calculated and it is more or less a definite quantity,

while the prospective yield is a very indefinite factor as it relates to the Notes
future, which is highly uncertain. Nevertheless, entrepreneurs do make
their own estimates on the marginal efficiency of new capital assets by ----------------------
taking these two factors into account. Keynes, however, mentioned that
the marginal efficiency of capital is a highly fluctuating phenomenon in ----------------------
the short run and has a tendency to decline in the long run. ----------------------
Once the marginal efficiency of capital is estimated, it is to be
----------------------
compared with the rate of interest. Thus, the rate of interest is the
second important determinant of the investment function. The rate ----------------------
of interest, according to Keynes, depends upon two factors: (i) the
liquidity preferences function, and (ii) the quantity of money (or the ----------------------
money supply). The first factor pertains to the demand aspect, and the
----------------------
second, to the supply aspect, of the price of borrowing money, i.e. the rate
of interest. Thus, the liquidity preference function determines the demand ----------------------
for money. It denotes the desire of the people to hold money or cash
balance as the most liquid assets. ----------------------
According to Keynes there are three different motives for ----------------------
holding cash for liquidity preference: (i) the transactions motive,
(ii) the precautionary motive, and (iii) the speculative motive. Thus, ----------------------
the total demand for money is the aggregate demand for each under
----------------------
the three motives. Keynes, thus, formulates his own theory of interest
called “liquidity preference theory of interest”. He stated that liquidity ----------------------
preference is an important factor affecting the rate of interest. To him,
the other factor, namely, the money supply, is not very significant in the ----------------------
short run, because it does not change all of a sudden and it is relatively
----------------------
a stable phenomenon. It is the liquidity preference function which is a
highly fluctuating phenomenon, especially due to the speculative motive. ----------------------
Thus, assuming money supply to be constant, the rate of interest can be
directly related to the liquidity preference function. Hence, the higher the ----------------------
liquidity preference, higher will be the rate of interest and the lower the
----------------------
liquidity preference, the lower will be the rate of interest.
Keynes, however, regarded the rate of interest as a relatively stable ----------------------
factor in the short run, which did not change violently. Thus, it follows
----------------------
that the investment function is largely influenced by the behaviour of the
marginal efficiency of capital which is a fluctuating variable in the short ----------------------
run. Thus, the marginal efficiency of capital with a given rate of interest is
the most significant factor determining the inducement to invest. In fact, ----------------------
as Keynes believed, fluctuations in the marginal efficiency of capital are
----------------------
the fundamental cause of trade cycles and income fluctuations in a capital
economy. ----------------------
It is to be noted here that we have so far considered the consumption ----------------------
and investment expenditure of the community relating to private
individuals and enterprises only, because the original Keynesian Theory ----------------------
of Employment has considered consumption and investment expenditure
only, and does not take government expenditures into account. But, ----------------------

Notes modern economists give due recognition to government expenditure as
an important factor of effective demand. In today’s world, government
---------------------- expenditure is increasing day by day, and it cannot be ignored in estimating
the effective demand in a community.
----------------------
Thus, to be more realistic, we may formulate effective demand thus:
----------------------
Effective demand = C + I + G,
---------------------- where
---------------------- C = Consumption outlay for the households,
---------------------- I = Investment outlay in the private sector, and

G = Government’s spending for consumption as well as
---------------------- investment.
---------------------- It should be noted, however, that government expenditure is
autonomous, as it depends on the policies of the existing government
----------------------
which are largely influenced by political and social rather than economic
---------------------- factors.
---------------------- 13.6 BUSINESS FLUCTUATIONS

---------------------- Business fluctuations, booms and slumps, in the economic activities
---------------------- essentially from the economic environment of a country. They influence business
decisions tremendously and set the trend of the future business. The period of
---------------------- prosperity opens up new and larger opportunities for investment, employment
and production, and thereby promotes business. On the contrary, the period of
---------------------- depression reduces the business opportunities. A profit maximizing entrepreneur
---------------------- must therefore analyse the economic environment of the period relevant for his
important business decisions, particularly those pertaining to forward planning.
----------------------
This part of the chapter is in fact devoted to a brief discussion of the main
---------------------- phases of business cycles and their causes.
(A) Definition of a Business or Trade Cycle
----------------------
The term “trade cycle” in economics refers to the wave-like fluctuations
---------------------- in the aggregate economic activity, particularly in employment, output
---------------------- and income. In other words, trade cycles are ups and downs in economic
activity. A trade cycle is defined in various ways by different economists.
---------------------- For instance, Mitchell defined trade cycle as “a fluctuation in
aggregate economic activity”. According to 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.”
The following features of a trade cycle are worth noting:
----------------------
(1) A trade cycle is a wave-like movement.
----------------------
(2) Cyclical fluctuations are recurrent in nature.
---------------------- (3) Expansion and contraction in a trade cycle are cumulative in effect.

(4) Trade cycles are all-pervading in their impact. Notes
(5) A trade cycle is characterized by the presence of crisis, i.e., the peak
----------------------
and the trough are not symmetrical, that is to say, the downward
movement is more sudden and violent than the change from ----------------------
downward to upward.
----------------------
(6) Though cycles differ in timing and amplitude, they have a common
pattern of phases which are sequential in nature. ----------------------
Keynes, points out that “A trade cycle is composed of periods of
----------------------
good trade characterized by rising prices and low unemployment,
altering with periods of bad trade characterised by falling prices and ----------------------
high unemployment.” Keynes, thus, stresses two indices namely, prices
and unemployment, for measuring the upswing and downswing of the ----------------------
business cycles.
----------------------
(B) Phases of Business Cycles
----------------------
The ups and downs in the economy are reflected by the fluctuations
in aggregate economic magnitudes, such as, production, investment, ----------------------
employment, prices, wages, bank credits, etc. The upward and downward
movements in these magnitudes show different phases of a business ----------------------
cycle. Basically there are only two phases in a cycle, viz., prosperity and ----------------------
depression. But considering the intermediate stages between prosperity
and depression, the various phases of trade cycle may be enumerated as ----------------------
follows:
----------------------
1. Expansion
----------------------
2. Peak
3. Recession ----------------------
4. Trough ----------------------
5. Recovery and expansion ----------------------
The five phases of a business cycle have been presented in the figure.
The steady growth line shows the growth of the economy when there ----------------------
are no economic fluctuations. The various phases of business cycles are ----------------------
shown by the line of cycle which moves up and down the steady growth
line. The line of cycle moving above the steady growth line marks the ----------------------
beginning of the period of ‘expansion’ or ‘prosperity’ in the economy. The
phase of expansion is characterized by increase in output, employment, ----------------------
investment, aggregate demand, sales, profits, bank credits, wholesale and ----------------------
retail prices, per capita output and a rise in standard of living. The growth
rate eventually slows down and reaches the peak. The phase of peak is ----------------------
generally characterized by slacking in the expansion rate, the highest
level of prosperity, and downward slide in the economic activities from ----------------------
the peak. ----------------------
----------------------

Notes
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
Business Fluctuations. A figure showing phases of Business Cycle
----------------------
The phase of recession begins when the downward slide in the growth
---------------------- rate becomes rapid and steady. Output, employment, prices, etc. register a rapid
decline, though the realized growth rate may still remain above the steady growth
----------------------
line. So long as growth rate exceeds or equals the expected steady growth rate,
---------------------- the economy enjoys the period of prosperity - high and low. When the growth
rate goes below the steady growth rate, it makes the beginning of depression in
---------------------- the economy.
---------------------- In a stagnated economy, depression begins when growth rate is less than
zero, i.e. the total output, employment, prices, bank advances, etc., decline
---------------------- during the subsequent periods. The span of depression spreads over the period
---------------------- growth rate stays below the secular growth rate or zero growth rate in a stagnated
economy. Trough is the phase during which the down - trend in the economy
---------------------- slows down and eventually stops, and the economic activities once again
register an upward movement. Trough is the period of most severe strain on
---------------------- the economy. When the economy registers a continuous and rapid upward trend
---------------------- in output, employment, etc., it enters the phase of recovery though the growth
rate may still remain below the steady growth rate. And, when it exceeds this
---------------------- rate, the economy once again enters the phase of expansion and prosperity. If
economic fluctuations are not controlled by the government, the business cycles
---------------------- continue to recur as stated above.
---------------------- Let us now describe in some detail the important features of the various
phases of business cycle, and also the causes of the turning points.
----------------------
1. Prosperity: Expansion and Peak
----------------------
The prosperity phase is characterized by rise in the national output,
---------------------- rise in consumer and capital expenditure rise in the level of employment.
Inventories of both, the input and the output increase. Debtors find it more
---------------------- and more convenient to pay off their debts. Bank advances grow rapidly

even though bank rate increases. There is general expansion of credit. Notes
Idle funds find their way to productive investment since stock prices
increase due to increase in profitability and dividend. Purchasing power ----------------------
continues to flow in and out of all kinds of economic activities. So long as
the conditions permit, the expansion continues, following the multiplier ----------------------
process. ----------------------
In the later stages of prosperity, however, inputs start falling short
----------------------
of their demand. Additional workers are hard to find. Hence additional
workers can be obtained by bidding a wage rate higher than the prevailing ----------------------
rates. Labour market becomes seller’s market. A similar situation appears
also in other input markets. Consequently, input prices increase rapidly ----------------------
leading to increase in cost of production. As a result, prices increase and
----------------------
overtake the increase in output and employment. Cost of living increases
at a rate relatively higher than the increase in household income. Hence ----------------------
consumers, particularly the wage earners and fixed income class, review
their consumption. Consumer’s resistance gets momentum. Actual demand ----------------------
stagnates or even decreases. The first and most pronounced impact falls on
----------------------
the demand for new houses, flats and apartments. Following this, demand
for cement, iron and steel, construction-labour tends to halt. This trend ----------------------
subsequently appears in other durable goods industries like automobiles,
refrigerators, furniture, etc. This marks reaching the Peak. ----------------------
2. Turning-Point and Recession ----------------------
Once the economy reaches the peak, the increase in demand is
----------------------
halted. It even starts decreasing in some sectors, for the reason stated
above. Producers, on the other hand, unaware of this fact, continue to ----------------------
maintain their existing levels of production and investment. As a result,
a discrepancy between output supply and demand arises. The growth of ----------------------
discrepancy, between supply and demand is so slow that it goes unnoticed
----------------------
for some time. But producers suddenly realize that their inventories are
piling up. This situation might appear in a few industries at the first instance, ----------------------
but later it spreads to other industries also. Initially, it might be taken as
a problem arisen out of minor mal-adjustment. But, the persistence of the ----------------------
problem makes the producers believe that they have indulged in ‘over-
----------------------
investment’. Consequently, future investment plans are given up; orders
placed for new equipments, raw materials and other inputs are cancelled. ----------------------
Replacement of worn-out capital is postponed. Demand for labour ceases
to increase; rather, temporary and casual workers are removed in a bid ----------------------
to bring demand and supply in balance. The cancellation of orders for
----------------------
the inputs by the producers of consumer goods creates a chain -reaction
in the input market. Producers of capital goods and raw materials cancel ----------------------
their orders for their input. This is the turning point and the beginning of
recession. ----------------------
Since demand for inputs has decreased, input prices, e.g., wages, ----------------------
interest etc., show a gradual decline leading to a simultaneous decrease
in the incomes of wage and interest earners. This ultimately causes ----------------------

Notes demand recession. On the other hand, producers lower down the price
in order to get rid of their inventories and also to meet their obligations.
---------------------- Consumers in their turn expect a further decrease in price, and hence,
postpone their purchases. As a result, the discrepancy between demand
---------------------- and supply continues to grow. When this process gathers speed, it takes
---------------------- the form of irreversible recession. Investments start declining. The decline
in investment leads to decline in income and consumption. The process
---------------------- of reverse (negative) multiplier gets underway. (The process is exactly
reverse of expansion). When investments are curtailed, production and
---------------------- employment decline resulting in further decline in demand for both
---------------------- consumer and capital goods. Borrowings for investment decreases; bank
credit shrinks; share prices decrease; unemployment increases along with
---------------------- a fall in wage rates. At this stage, the process of recession is complete and
the economy enters the phase of depression.
----------------------
3. Depression and Trough
----------------------
During the phase of depression, economic activities slide down their
---------------------- normal level. The growth rate becomes negative. The level of national
income and expenditure declines rapidly. Prices of consumer and capital
---------------------- goods decline steadily. Workers lose their jobs. Debtors find it difficult
to pay off their debts. Demand for bank credit reaches its low ebb and
----------------------
banks experience mounting of their cash balances. Investment in stock
---------------------- becomes less profitable and least attractive. At the depth of depression, all
economic activities touch the bottom and the phase of trough is reached.
---------------------- Even the expenditure on maintenance is deferred in view of excess
production capacity. Weaker firms are eliminated from the industries. At
----------------------
this point, the process of depression is complete.
---------------------- How is the process reversed? The factors (variables) reverse the
downswing varying from cycle to cycle, just like the factors responsible
----------------------
for the business cycle vary form cycle to cycle. Generally, the process
---------------------- begins in the labour market, Because of widespread unemployment;
workers offer to work at wages less than the prevailing rates. The
---------------------- producers anticipating better future try to maintain their capital stock and
offer jobs to some workers here and there. They do so because they feel
----------------------
encouraged by the halt in decrease in price in the trough phase. Consumers
---------------------- on their part, expecting no further decline in price, begin to spend on their
postponed consumption and hence demand picks up, though gradually.
---------------------- Bankers having accumulated excess liquidity (idle cash reserve) try to
salvage their financial position by the private investors. Consequently,
----------------------
security prices move up and interest rates move downward. On the other
---------------------- hand, stock prices begin to rise for the simple reason that fall in stock
prices comes to an end and an optimism is underway in the stock market.
----------------------
Besides, there is a self-correcting process within the price
---------------------- mechanism. When prices fall during recession the prices of raw materials
and that of other inputs fall faster than the prices of finished products.
---------------------- Therefore, some profitability always remains there, which tends to increase

after the trough. Hence the optimism generated in the stock market gets Notes
strengthened in the commodity market. Producers start replacing the worn-
out capital and making-up the depleted capital stock, though cautiously ----------------------
and slowly. Consequently, investment picks up and employment gradually
increases. Following this recovery in production and income, demand ----------------------
for both consumer and capital goods, start increasing. Since banks have ----------------------
accumulated excess cash reserves, bank credit becomes easily available
and at a lower rate. Speculative increase in prices gives an indication of ----------------------
the continued rise in level. For all these reasons, the economic activities
get accelerated. Due to the increase in income and consumption, the ----------------------
process of multiplier gives further impetus to the economic activities, and ----------------------
the phase of recovery gets underway. The phase of depression comes to
an end over time, depending on the speed of recovery. ----------------------
4. The Recovery or Revival ----------------------
As the recovery gathers momentum, some firms plan additional
----------------------
investment, some undertake renovation programmes, some undertake
both. These activities generate construction activities in both, consumer ----------------------
and capital good sectors. Individuals who had postponed their plans to
construct houses undertake it now, lest cost of construction mounts up. ----------------------
As a result, more and more employment is generated in the construction
----------------------
sector. As employment increases, despite the wage rates moving upward,
the total wage income increases at a rate higher than the employment ----------------------
rate. Wage income rises and so does the consumption expenditure.
Businessmen realize a quick turn over and an increase in profitability. ----------------------
Hence, they speed up the production machinery.
----------------------
Over a period, as the factors of production become fully employed,
wages and other input prices move upward rapidly. Investors therefore, ----------------------
become discriminatory between alternative investments. Like prices,
----------------------
wages and other factors like a prices increase, a number of related
developments begin to take place. Businessmen start increasing their ----------------------
inventories, consumers start buying more and more of durable goods
and variety items. With this process catching up, the economy enters the ----------------------
phase of expansion and prosperity. The cycle is thus complete.
----------------------
----------------------
Fill in the blanks.
1. Keynes advocated Government intervention through ____________ ----------------------
measures to solve the problem of ___________and stabilise the
----------------------
economy.
2. The features determining the investment function are ______________ ----------------------
efficiency of capital and the rate of ________.
----------------------
3. As per Keynesian theory, the motives for holding cash are _________
motive, ___________ motive and ____________ motive. ----------------------

Notes
Activity 2
----------------------
---------------------- If you were to depict the consumption function of yourself, from the time
you were a student at school till now and hence further when you start
---------------------- earning at a growing rate, how do you think your consumption will react
to the change in your income?
----------------------
----------------------
13.7 INFLATION
----------------------
(A) Meaning
---------------------- In the words of Prof. Samuelson, “Inflation occurs when the general
---------------------- level of prices and costs is rising - rising prices for bread, gasoline,
cars; rising wages, land prices, rentals on capital goods”. Thus, inflation
---------------------- marks rising commodity prices as well as factor prices. Factor prices,
when they rise, cause an increase in costs. According to Milton Friedman,
---------------------- inflation is a “process of a steady and sustained rise in the prices”. Many
more definitions of inflation can be given. Instead of going into all these
----------------------
definitions, let us outline the characteristics of inflation as they emerge
---------------------- from the above-mentioned (and other similar) definitions of inflation:
(i) Inflation is a phenomenon of rising prices. However, every price-
----------------------
rise is not inflationary, though every period of inflation indicates a
---------------------- price-rise. In other words, a temporary price-rise in some sectors
may occur due to some causes but they may not necessarily be
---------------------- indicative of inflation.
---------------------- (ii) Inflation is a sustained and appreciable rise in prices. Once started,
inflation goes on feeding itself and it is not self-limiting. It is a
---------------------- continuous process.
---------------------- (iii) Inflation is a general and a dynamic phenomenon. It is not limited
to one or two sectors or geographical localities of a country. Rather,
---------------------- it takes within its stride the entire country and all the sectors of the
economy. It is dynamic in the sense that its severity, nature etc. go
---------------------- on changing (and causing changes) over a period of time. Inflation
---------------------- occurs over a period of time.
(iv) True inflation or pure inflation starts only after reaching the full
---------------------- employment level.
---------------------- (v) It cannot be anticipated, in the sense that one cannot be sure
regarding the timing and intensity of inflation.
----------------------
(vi) Inflation is characterized by an excess of demand or an increase in
---------------------- costs or usually both.
---------------------- (B) The Causes of Inflation

The causes of inflation can be studied from two sides, i.e. from the demand
---------------------- side and from the supply side.

(1) The Factors from Demand Side Notes
(i) Increase in Public Expenditure: There may be an increase in the
----------------------
expenditure of the government because of wars or for developing
the economy. This increase in government expenditure means an ----------------------
increase in the total demand, which leads to rise in prices. This
demand is in addition to the normal demand, which leads to a price ----------------------
rise.
----------------------
For instance, the state government has taken up the huge
activity of building flyovers in 5 main cities of the State. Also doing ----------------------
up the main roads in main city areas falls under their agenda. Hence
----------------------
their demand for all the relevant raw materials like tar, cements,
stone, and gravel increases. Also, the demand for labour, like skilled ----------------------
engineers, supervisors, and also unskilled labour, increases, so such
projects help to increase the rate of employment. Similarly there is ----------------------
a high demand for capital goods like high-tech machinery, high-
----------------------
illuminating system, so that they can have day-night shifts as well,
alloy wound up steel girdles, sight reading machines to check the ----------------------
balance of the roads etc. Particularly for such constructions, certain
balancing machines to check the balance of the ups and downs of ----------------------
the flyovers and the turns in them are required. These are Swedish
----------------------
made machines. Thus, the demand for imported goods increases as
well. On the service side, there is obviously the need for assistance ----------------------
of the city police personnel, that would help in traffic control and
route-planning. These are the different expenditure heads that are ----------------------
particular to this event.
----------------------
Here’s one more example to highlight the other side of public
expenditure. One of the worst depressions of the world can be ----------------------
quoted as the one faced by Germany at the time of World War II.
----------------------
It would be no exaggeration to say that people carried money in
bullock carts to buy a loaf of bread. Hitler, the then-dictator of the ----------------------
country, went on increasing the defence expenditure. In fact he was
so engrossed by this that he paid heed only to the defence side and ----------------------
so hardly any necessary goods were available. It was a complete
----------------------
lop-sided expenditure picture of the country.
(ii)
Increase in Private Expenditure: When optimism prevails in the ----------------------
business world, businessmen are eager to spend more money on ----------------------
capital goods. This increases the demand for capital goods, and in
turn, brings about an increase in the demand for consumer’s goods. ----------------------
This is because there is an increase in the income of the people who
work in capital goods’ industries. Therefore, they are in a position ----------------------
to spend more, and thus, there is an increase in the demand for the ----------------------
both types of goods.
The mood is good and people generally have an optimistic ----------------------
view of the future. The business acumen is to invest now and reap ----------------------

Notes the advantages in the future. Let’s say that the up-coming trend of
malls in cities is fast spreading to smaller cities as well. Looking at
---------------------- the fast growing popularity and the convenience, it is fast investing
ground for many in smaller cities too. So is the case of cinema–
---------------------- multiplexes. The trend is moving and the business world wants to
---------------------- explore and incorporate it in other places. Thus leads to a chain
of reactions. Construction houses go in demand which further
---------------------- place orders to those supplying the needful materials like those
mentioned in the above example. Hence the demand increases for
---------------------- capital goods like the huge machinery to set up big complexes,
---------------------- which in turn will increase the demand to a vast range of consumer
goods once the complexes are actually set up. It’s a one-stop shop.
---------------------- Your business is doing well; you want to purchase stylish office-
wear. You go to buy garments, but looking around, you see some
---------------------- crockery as well and you are tempted to buy it, even when it is
---------------------- not there in your shopping list. A thought could cross your mind
about the forthcoming dinner parties at your place the following
---------------------- weekend. Mothers going to buy kids’ and baby wear might see
a range of utility items which would make their household work
---------------------- easy and comfortable, so there’s a possibility that this is bought,
---------------------- especially when their pocket allows them to do so!! All this adds to
the aggregate demand which ultimately results in the rise in prices.
----------------------
(iii)
Increase in Foreign Demand: When there is an increase in foreign
---------------------- demand for the goods manufactured in a country, exports increase
and the prices of commodities in the country increase, as their
---------------------- supply cannot be increased instantaneously.
---------------------- Increase is the price of the prime alphonso mangoes is primarily
because of its large demand in the foreign market. This is also the
---------------------- case about leather and leather products.
---------------------- (iv)
Reduction in Taxation: If there is a reduction in the taxes levied
by the government, people are left with more money, which can
---------------------- be spent. This increases their expenditure, as well as the prices of
commodities.
----------------------
If the government decreases the income tax slab, the disposable
---------------------- income with the working class or the business class increases, and
---------------------- so does their purchasing power, which enables them to increase
their demand for various goods and services. All these add to the
---------------------- inflationary elements in the economy.
---------------------- (v) Repayment of Internal Debts: When the government repays old
loans, more purchasing power is placed at the disposal of the people.
---------------------- A part of the amount obtained in this manner may be re-invested in
various assets, but the rest of it, may be spent on consumer goods
---------------------- and services. It is responsible for the increase in prices to the extent
---------------------- that this repayment of loans leads to an increase in the total demand.

(vi)
Changes in Expectation: In the context of the price-rise, the Notes
expectations of the people play a very important role. When people
expect a rise in prices, businessmen increase their investment and ----------------------
this leads to an increase in the demand for capital goods. If the
----------------------
consumers think that there will be an increase in the prices in the
future, they will start purchasing commodities which they will ----------------------
require in the future. This increases the demand for consumer’s
goods. The increase in the demand for both consumers’ and ----------------------
producers’ goods leads to the rise in prices. ----------------------
For instance, land prices are expected to increase two-fold within
a short time. Thus people will tend to go for the purchase of new ----------------------
flats or houses or a piece of land. Some may see it as an solely ----------------------
investment purpose, which the can sell in future and take home easy
money. Some may actually prepone their decision to buy a house ----------------------
for their children who are to get married in the near future. They
----------------------
would not have thought of this investment at this point of time, if
not for the rising expectations in the market. ----------------------
(2) Factors form Supply Side ----------------------
(i) Scarcity of the Factors of Production: If one or more factors of
----------------------
production are in short supply, there is a reduction in production or
hurdles may be created in the expansion of production. This reduces ----------------------
the total supply and causes a rise in price.
----------------------
About two decades ago, there was a tremendous scarcity of cement,
so it’s price sky-rocketed, and thus also the price of housing and the ----------------------
rate per square foot. Another reason one can give for the increased
demand for housing is because of the existence of nuclear families ----------------------
today. In case of the joint family system, the need for new houses ----------------------
and flats is low, since the whole family is living together under one
roof. The housing development is largely happening on the outskirts ----------------------
of the city, thus extending the city limits. One cannot increase the
----------------------
supply of land, thus giving way to huge buildings erupting all over
the place, with in-built parking spaces so as to save the land space. ----------------------
(ii)
Bottlenecks: At times, all the factors are or may be available. But
----------------------
bottlenecks are created and this makes it difficult to make these
factors available at the right time and place, for actual production. ----------------------
For example, iron ore and coal are available at mines, but the
transport facilities required to transport these raw materials to the ----------------------
production site are not available. Transportation then becomes ----------------------
a bottle-neck. Therefore, in this case, production will suffer.
Similarly, the paucity of credit facilities, labour unrest and strikes, ----------------------
the unreliability of transport and several other difficulties may arise
----------------------
and make production impossible or difficult. This may cause an
increase in prices. ----------------------

Notes (iii) Natural Calamities: There are several natural calamities which may
reduce production. Excess of rains, drought, earthquakes, cyclones,
---------------------- may substantially reduce the total annual production. Agricultural
production suffers and all other agro-based industries such as the
---------------------- sugar industry, the textile industry (cotton and jute) the oil industry,
---------------------- etc., also suffer. This results in the reduction of production and this
leads to a rise in the prices.
----------------------
The floods in Gujarat, or the floods in Bombay or the earthquake at
---------------------- Gujarat are standing examples of natural calamites, that takes the
economy by storm and throws it solve innumerable problems, like
---------------------- supply of necessary goods (that falls; vegetable or fruit vendors may
not come at your doorstep of the same city), problem of providing
----------------------
basic necessaries to thousands of homeless people, business fall-
---------------------- outs, thus eventually leading to rise in prices and a total cluster of
mismanagement of issues.
----------------------
(iv)
Hoarding by Merchants: When traders and merchants know that
---------------------- there is a short supply of any commodity, they will purchase and
stock large quantities of these commodities. These commodities
---------------------- then go underground and are not available in the open market. Thus,
there is a shortage of other commodities too and this leads to a rise
----------------------
in prices.
---------------------- (v) Rise in Costs: Rise in costs due to an increase in factor prices is
another cause from the supply side. Rent, interest and wages can
----------------------
rise due to a number of reasons. The Central Bank may raise interest
---------------------- rates or unions may cause a wage - rise. This may lead to inflation.
---------------------- The best example that can be given is about four years ago, when the
RBI dropped down the interest rate on fixed deposits which includes the
---------------------- private as well as the public sector (nationalised banks and co-operative
banks) with the intention to allow them to have the substantial flow of
---------------------- credits to be issued to the common industrialists at a lesser interest rate so
---------------------- that the cost of production reduced at the base level. This proved to be a
very successful measure to fight recession.
---------------------- (C) Consequences of Inflation
---------------------- Effects or consequences of Inflation can be studied under (i) Effects on
Production, (ii) Effects on Distribution, (iii) Other Effects, and (iv) Non -
---------------------- economic Effects.
---------------------- 1. Effects on Production
---------------------- The effects of inflation on production are very important. As long as there
is no full employment and inflation is proceeding at a slow rate, inflation
---------------------- may be helpful. As some of the factors of production are unemployed,
there is no change in the costs of production. But prices continue to
----------------------
rise, which results in larger profits, and tempts entrepreneurs to increase
---------------------- investment. This increases total production and employment. This process

continues undisturbed till the full employment level is reached. But once Notes
the full employment level is reached or crossed, prices start rising rapidly
and there is true inflation. ----------------------
This rapid inflation is very dangerous to the smooth working of any ----------------------
economy. Hyperinflation is perhaps the worst from the point of view of
production. Inflation affects production in the following manner: ----------------------
(i) Through Investment: During a period of rising prices, because ----------------------
of several reasons, investment in the field of production goes on
decreasing. The value of money falls, the propensity to save is ----------------------
reduced, and this results in the reduction of savings, which in turn
----------------------
reduces the rate of capital accumulation. The value of foreign capital
is reduced, and there is flight of capital from the country, which ----------------------
results in reduction in investment and in turn, reduces production.
----------------------
(ii)
Switchover of Business: During a period of rising prices,
speculation and stockpiling appears to be more profitable. To ----------------------
undertake production, one has to begin with obtaining a license, and
go to the other end and maintain good relations with labour. This is ----------------------
very troublesome. Instead, if one indulges in purchase and sales of
----------------------
products, property and other types of assets, one can perhaps earn
equal or even more profits, and avoid all the headaches mentioned ----------------------
above. These opportunities of making easy money tempt capitalists
to invest their capital in these activities rather than to undertake ----------------------
production. Thus, there is no growth in production. But if prices rise
----------------------
very fast, production may even decrease.
(iii)
Uncertainty: During a period of rising prices, there is an atmosphere ----------------------
of uncertainty in every field. This makes entrepreneurs more and ----------------------
more reluctant to accept any risks in production. This results in
decrease in production. ----------------------
(iv)
Change in the Composition of Production: Rising prices also ----------------------
influence the composition of production. During the period of
rising prices, those who get large profits and easy money become ----------------------
rich. Similarly, the owners of factors of production who are in short
supply (like owners of land, plots, houses etc ), get huge profits ----------------------
because of rising prices. On the contrary, the working class, the ----------------------
middle class and others who belong to fixed income group, are put
to great hardships. They are not even in a position to satisfy their ----------------------
basic needs because they do not have the required purchasing power.
As the income of the rich increases, the demand for luxuries go on ----------------------
increasing. As supply always follows demand, the production of ----------------------
luxury articles increases and that of necessities decreases. It is most
undesirable to spend the resources of a country in producing luxury ----------------------
articles before producing adequate necessities. So, this change in
the composition of production is said to be undesirable. ----------------------
----------------------

Notes (v) Poor Quality of Output: During a period of rising prices, there is
a scarcity of goods and services on a very large scale. This results
---------------------- in the deterioration of the quality of production, because anything
and everything that is produced, is sold. Thus, inferior commodities
---------------------- flood the market.
---------------------- (vi)
Public Unrest: When the pangs of a price-rise are felt by the
labourers, they become frustrated, and there are demonstrations,
----------------------
strikes, and several other types of agitations in order to secure
---------------------- higher wages. Because of this, production decreases further, which
leads to further shortages and thus to another price-rise.
----------------------
(vii) Distortion of prices: The expansion of currency creates several
---------------------- hurdles in the pricing system, and makes it weak. It’s essential to
have a properly functioning price mechanism in order to have a
---------------------- smoothly functioning production system. This distortion of the
price mechanism is another adverse effect on production.
----------------------
2) Effects on Distribution
----------------------
The effects of inflation on various groups of people on society can be
---------------------- summarized as follows:
---------------------- (i) The creditor and debtor: During periods of inflation, creditors are
put to losses because there is a difference in the value of the unit
---------------------- of currency when it was loaned out and when it was returned. As
prices rise, the value of money goes on decreasing with lapse of
---------------------- time. The case of borrowers is exactly the opposite. A borrower is
---------------------- benefited as the value of money when he borrowed it is more than
when he repays it.
---------------------- (ii)
The wage and salary earners: Those who get fixed income in terms
---------------------- of money are put to losses during inflation. If workers are well
organized, they can secure dearness allowances or a rise in wages
---------------------- or salaries. But even then, in the race between the rise in prices and
the rise in wages, the rise in prices is more rapid, thereby putting
---------------------- wage earners to a great loss. The fortune of unorganized labour is
---------------------- extremely pitiable. Thus, as a result of inflation, the fixed income
earners suffer great hardships. Those, whose income is permanently
---------------------- fixed, are put to heavier losses. Pensioners mainly belong to this
class.
----------------------
(iii)
The entrepreneurs as a class: The traders, merchants and
---------------------- manufacturers are the people who benefit more during inflation.
Inflation is the great opportunity for them to make huge profits. The
----------------------
prices of stocks of finished products hoarded by these businessmen
---------------------- go on increasing continuously, and they get huge profits on these
goods by selling them in the black market. Moreover, expenses
---------------------- to be incurred on wages, raw materials and machinery, lag behind
the prices. This leads to a continuous rise in profits. If the rate of
----------------------

growth of inflation is very high, there is a tendency of stockpiling Notes
by the traders. In this way, the share in the national income of the
entrepreneurial class as a whole goes on increasing. ----------------------
(iv)
Investors as a class: Normally, investors are found to invest their ----------------------
money in the following two ways: 1) In such assets which give fixed
and guaranteed returns per year. For example, bonds, debentures, ----------------------
long term deposits in banks, etc. 2) In share or equity capital which
----------------------
do not give guaranteed returns. The investors belonging to the first
category are put to a loss, but those in the second category may ----------------------
stand to gain profits. Because of rising prices, companies make
huge profits, declare large dividends, and thus, their real income ----------------------
increases. In most cases, the rich invest in equity shares as their
----------------------
capacity to take risk is more. The middle class people, whose
savings are limited, invest in assets which earn guaranteed returns. ----------------------
So here again, the rich have an advantage.
----------------------
(v) The farmers: During periods of inflation, the income of farmers
as a class increases. The supply of agricultural goods is normally ----------------------
inelastic. So it is not possible to increase production immediately.
In the mean time, prices rise further. Moreover, whenever there is ----------------------
a price-hike, the prices of agricultural goods increase sharply and
----------------------
quickly. This is a common experience in developing countries. But
even in this field, the small farmers are benefited least because they ----------------------
do not have large quantities of agricultural goods as marketable
surplus. But, the large farmers get the maximum possible advantage. ----------------------
3) Other Consequences ----------------------
(i) Financial institutions: When inflation is limited, banks, insurance ----------------------
companies and other financial institutions get advantages because
their activities are boosted. But as soon as prices begin to rise at a ----------------------
faster rate, the savings of the people are reduced, and most of the
financial institutions fall in trouble. ----------------------
(ii)
Foreign trade: Foreign goods become cheaper and imports ----------------------
increase, and simultaneously, exports dwindle as the prices of
domestic goods rise. This creates several problems in the balance of ----------------------
payments. If restrictions are imposed, to check imports, smuggling ----------------------
activities increase.
(iii)
Price structure: During inflation, the prices of all goods rise. But ----------------------
the prices of those goods whose supply is inelastic, rise more. This ----------------------
disturbs the entire price structure as well as the distribution system
in the economy. For example, if the price of the steel furniture is ----------------------
very high, the available steel will be used for the manufacture of
steel furniture, even though the manufacture of railway wagons and ----------------------
rails may be more necessary. ----------------------
----------------------

Notes (iv)
Reduction in development expenditure: Inflation has very bad
effect on Economic planning and public expenditure. People who
---------------------- are already suffering from rising prices, cannot be overburdened
by increasing the taxation. But the expenditure of the Government
---------------------- increases with rising prices. During periods of economic planning,
---------------------- large investments have to be made in the public sector. The saving
capacity of the people is reduced, and the invested amounts become
---------------------- less and less valuable which makes it difficult to raise loans.
Additional deficit financing is likely to increase inflation further.
---------------------- Thus, it becomes imperative for the government to reduce its
---------------------- expenditure on development plans. Several expansion programs
have to be dropped. Inflation mostly affects the schemes to
---------------------- improve educational, medical aid, research and other social welfare
programs.
----------------------
(v) Effect on Currency: If inflation rises very rapidly, people loose
---------------------- faith in the currency and the currency cannot function as a currency
at all. This endangers the very existence of the economy.
----------------------
4) Non-Economic Effects
----------------------
There are several political and social effects. These are very serious
---------------------- and may continue to be in existence for a very long period of time. The
gap between the rich and the poor widens. Those who toil continue to
---------------------- become poorer, and those who hold important positions, go on amassing
wealth. This puts an end to harmony and understanding in society.
----------------------
Morality and business ethics are violated and people do not hesitate to do
---------------------- anything unscrupulous to become rich quickly. Thefts, dacoity, gambling
and other social evils become rampant. Demonstrations, arson and looting
---------------------- become very common and it is found difficult to maintain law and order.
Political stability in the country is endangered. The desire to amass wealth
----------------------
and become rich as early as possible gives rise to bribery, corruption,
---------------------- favouritism etc. Once the seeds of corruption are sown, corruption spreads
very easily and becomes all-pervasive. This gives rise to several social,
---------------------- economic and political evils.
----------------------
----------------------

1. Inflation occurs when general level of _________and __________ is
---------------------- rising.
1. Inflation or pure inflation starts only after reaching full employment
---------------------- level.
---------------------- 2. As prices rise value of money goes on decreasing with lapse of time.
3. During inflation the income of farmers as a class decreases.
----------------------

Notes
Activity 3
----------------------
If you were to start a business of your own, in which stage of the cycle will ----------------------
you start thinking of a new concept and conceptualise the idea? In which
stage will you actually implement the concept, as in starting-off with the ----------------------
business? Will it all be in one stage or in different stages? Explain how
----------------------
and why.
----------------------
13.8 MACRO POLICIES ----------------------
Business cycles i.e., fluctuations in the economic activities, cause not only ----------------------
harm to business but also misery to human beings by creating unemployment
and poverty. Economists and the government have, of late, felt concerned ----------------------
with the business cycles and suggested various ways and means to control the ----------------------
economic fluctuations.
The experience of the Great Depression and Keynesian revolution in mid ----------------------
- 1930s assigned a big role to the government in economic growth, employment ----------------------
and preventing business fluctuations. Therefore, the government interventions
with the economy all over the world increased in a big way. The free enterprise ----------------------
economies not only entered the production of commodities and services but also
adopted a number of fiscal and monetary measures to control and regulate the ----------------------
economy and prevent violent economic fluctuations. The governments in many ----------------------
developing countries like India assumed the role of a key player in economic
growth, employment and stabilization. ----------------------
The problems similar to those faced in the different phases of the trade ----------------------
cycle are being faced by the world in modern times. The major stabilisation
problem in the developing countries is the problem of controlling prices and ----------------------
preventing growth rate from sliding further down. For developed countries
----------------------
maintaining the growth rate to, fight against recession world over are the major
stabilisation problems. ----------------------
We have discussed below the major macro economic stabilisation policies
----------------------
which are relevant to the current problems of the world.
(A) Full Employment ----------------------
Full employment is the commonly accepted goal of macro economic ----------------------
policy in a developed country. The classical economists assumed that
full employment is automatically attained by a free and competitive ----------------------
market economy in the long run. Keynes, however, pointed out that full ----------------------
employment in practice is a rare phenomenon. Actually an economy
attains equilibrium at under employment level. Accepting Keynesian ----------------------
argument, countries have set full employment as an important goal in
their macro - economic policies. ----------------------
In the technical language of macro - economic analysis, full ----------------------

Notes employment is viewed as an equilibrium situation in which the sum of the
demands in all labour markets tends to be equal to the sum of the supplies,
---------------------- though, of course, in many of these markets, there is the likelihood of an excess
of demand over supply, or of supply over demand, Keynes also provides an
---------------------- alternative definition of full employment in that it is “a situation in which
---------------------- aggregate employment is inelastic in response to an increase in the effective
demand for its output.” He, therefore, suggested that an economic policy aiming
---------------------- at achieving full employment, should be designed to uplift the effective demand
appropriately.
----------------------
(B) Economic Stabilisation
----------------------
Stabilisation broadly means preventing the extremes of ups and
---------------------- downs or booms and depression in the economy without preventing
factors of economic growth to operate. It also implies preventing over
---------------------- and under - employment. Stabilisation does not mean rigidities, it should
permit a reasonable degree of flexibility for ‘self - adjusting forces of the
----------------------
economy.’
---------------------- The major objective of stabilisation policies are :
---------------------- (i) preventing excessive economic fluctuations;
---------------------- (ii) efficient utilisation of labour and other productive resources as far
as possible;
---------------------- (iii) encouraging free competitive enterprise with minimum interference
---------------------- with the functioning of the market economy.
The two most important and widely used economic policies to achieve
----------------------
economic stability are (i) fiscal policy; and (ii) monetary policy.
---------------------- (1) Fiscal Policy
---------------------- The ‘fiscal policy’ refers to the variations in taxation and
public expenditure programmes by the government to achieve pre-
---------------------- determined objectives. Taxation is a measure of transferring funds from
---------------------- the private purses to the public coffers; it amounts to the withdrawal of
funds from private use. Public expenditure, on the other hand, increases
---------------------- the flow of funds into the private economy. Thus, taxation reduces
private disposable income and thereby the private expenditure, and
---------------------- public expenditure increases private incomes and thereby the private
---------------------- expenditure. Since tax-revenue and public expenditure form the two sides
of the government budget, the taxation and public expenditure policies
---------------------- are also jointly called as ‘budgetary policy.’
---------------------- Fiscal or budgetary policy is regarded as a powerful instrument of

economic stabilization. The importance of fiscal policy as an instrument
---------------------- of economic stabilization rests on the fact that government activities in
modern economies are greatly enlarged, and government tax-revenue
---------------------- and expenditure account for a considerable proportion of GNP, ranging
---------------------- from 10 - 25 per cent. Therefore, the government may affect the private

economic activities to the same extent through variations in taxation Notes
and public expenditure. Besides, fiscal policy is considered to be more
effective than monetary policy because the former directly affects the ----------------------
private decisions while the latter does so indirectly. If fiscal policy of the
government is so formulated that if used during the period of expansion, ----------------------
it is known as ‘counter-cyclical fiscal policy’. ----------------------
(2) Monetary Policy
----------------------
Monetary policy refers to the programme of the Central Bank’s variations,
in the total supply of money and cost of money to achieve certain ----------------------
predetermined objectives. One of the primary objectives of monetary
----------------------
policy is to achieve economic stability. The traditional instruments through
which Central Bank carries out the monetary policies are: Quantitative ----------------------
Credit Control Measures such as open market operations, changes in
the Bank Rate (or discount rate), and changes in the statutory reserve ----------------------
ratios. Briefly speaking, open market operation by the Central Bank is
----------------------
the sale and purchase of government bonds, treasure bills, securities,
etc., to and from the public. Bank rate is the rate at which the Central ----------------------
Bank discounts the commercial banks’ bills of exchange or first class bill.
The statutory reserve ratio is the proportion of commercial banks’ time ----------------------
and demand deposits which they are required to deposit with the Central
----------------------
Bank or keep the cash in vaults. All these instruments when operated
by the Central Bank reduce (or enhance) directly and indirectly the ----------------------
credit creation capacity of the commercial banks and thereby reduce (or
increase) the flow of funds from the banks to the public. ----------------------
In addition these instruments, Central Banks also use various ----------------------
selective credit control measures and moral persuasion. The selective
credit controls are intended to control the credit flows to particular sectors ----------------------
without affecting the total credit, and also to change the composition of
----------------------
credit from undesirable to desirable pattern. Moral suasion is a persuasive
method to convince the commercial banks to behave in accordance with ----------------------
the demand of the time and in the interest of the nation.
----------------------
The fiscal and monetary policies may be alternatively used to
control the business cycles in the economy, though the monetary policy ----------------------
is considered to be more effective to control inflation than to control
depression. It is however, always desirable to adopt a proper mix of fiscal ----------------------
and monetary policies to check the business cycles. ----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Notes
----------------------

1. The governments in developing countries have assumed the role
---------------------- of a key player in ____________ growth, ____________and
---------------------- ___________.
2. The two important economic policies used to achieve economic
---------------------- stability are ____________ and ___________.
---------------------- 3. One of the primary objectives of monetary policy is to achieve
___________.
---------------------- 1. Taxation is a measure of transferring funds from the private purses to
the public coffers.
---------------------- 2. Central bank of the country also uses various selective credit control
---------------------- measures to control/direct credit flow.
----------------------
Activity 4
----------------------
---------------------- There is huge influx of unskilled labour pouring in to the city of Mumbai
every day. Let us assume that one day large subsidies are announced on
---------------------- agricultural production which tempts most of this labour to go back to
---------------------- their home towns .The new influx almost comes to a standstill. Discuss
the economic effects on the city of Mumbai and the nearby rural areas.
----------------------
---------------------- Summary
---------------------- ●● Macro-economics is the study of the aggregate behaviour of the economy
as a whole.
----------------------
●● Keynes attacked the classical doctrine that automatic adjustments in a
---------------------- capitalist economy leads to full employment.
---------------------- ●● Keynes believed that full employment is not the general case but a rare
occurrence and that deliberate government intervention is required to
---------------------- achieve full employment in an economy.
---------------------- ●● As long as Revenue is greater than Costs, the employment/ output will go
on increasing.
----------------------
----------------------
----------------------
----------------------

Keywords Notes
●● Aggregate Supply Schedule or Aggregate Supply Function : The ----------------------

minimum price of revenue proceeds that the entrepreneurs must get from ----------------------
the sale of output at different levels of employment.
●● Aggregate Demand Function : Schedule of maximum sales proceeds ----------------------
that the entrepreneurs expects from the sale of the different quantities of ----------------------
output realised at different levels of employment.
●● Consumption Function : The relation between consumption and ----------------------
income that depicts that as income increase, consumption increases less
----------------------
proportionately.
●● Effective Demand : Aggregate of consumption expenditure for ----------------------
households, investment expenditure of private firms and government
expenditure on consumption and investment goods. ----------------------
●● Fiscal Policy : Stabilization objective of the government brought about ----------------------
by variations in taxation and public expenditure.
----------------------
●● Investment Function : The relation between investment and the two
factors of marginal efficiency of capital and the rate of interest. ----------------------
●● Inflation : Sustained and appreciable rise in prices.
----------------------
●● Liquidity Preference : Preference for holding cash, depending on the
three motives as given by Keynes. ----------------------
●● Line of Cycle : The various phases of a business cycle.
----------------------
●● Peak : The highest level of prosperity and then onwards follows a slack
in expansion, the beginning of recession. ----------------------
●● Trade Cycle : The cyclical fluctuations in business showing alternate ----------------------
swings of depression and prosperity.
●● Trough : The lowest low of economic activities; then onwards the ----------------------
slowdown eventually stops and begins the upward trend, the beginning ----------------------
of recovery.
----------------------
Self-Assessment Questions ----------------------
1. Define Macro-Economics. ----------------------
2. Explain the nature and scope of Macro-economics.
----------------------
3. Explain J. M. Keynes’ analysis of income determination in the context of
the principle of Effective Demand. ----------------------
4. Write short notes on : ----------------------
a. Factors determining Effective Demand ----------------------
b. Consumption Function
----------------------
c. Investment Function
----------------------

Notes d. Fiscal Policy
e. Monetary Policy
----------------------
5. Explain with an illustration the various phases of a business cycle.
----------------------
6. Define Inflation and explain it’s causes.
---------------------- 7. What are the consequences of Inflation?
---------------------- 8. Explain Macro-Economic Polices with special emphasis on
---------------------- a. Full Employment and
b. Economic Stabilisation.
----------------------
---------------------- Answers to Check your Progress

---------------------- 1. Micro economics deals with major economic issues, problems and
policies of the present times.
----------------------
2. The subject matter of macroeconomics includes the theory of income and
---------------------- employment.
---------------------- 3. The Keynesian Theory is an outcome of the depression and was basically
a critic of the classical analysis.
---------------------- 1. False
---------------------- 2. False
---------------------- 3. True
4. True
----------------------
----------------------
Fill in the blanks.
----------------------
1. Keynes advocated Government intervention through fiscal measures to
---------------------- solve the problem of unemployment and stabilize the economy.
---------------------- 2. The factors determining the investment function are ________ efficiency
of capital and the rate of interest.
----------------------
3. As per Keynesian theory, the motives for holding cash are transaction
---------------------- motive, precautionary motive and speculative motive.
----------------------
----------------------
----------------------

Check your Progress 3 Notes
Fill in the blanks.
----------------------
1. Inflation occurs when general level of prices and cost is rising.
----------------------
1. True ----------------------
2. True ----------------------
3. False ----------------------
----------------------
Fill in the blanks.
----------------------
1. The governments in developing countries have assumed the role of a key
player in economic growth, employment and stabilisation. ----------------------
2. The two important economic policies used to achieve economic stability ----------------------
are fiscal policy and monetary policy.
3. One of the primary objectives of monetary policy is to achieve economic ----------------------
stability. ----------------------
----------------------
1. True
----------------------
2. True
----------------------
Suggested Reading ----------------------
1. Atmanand. 2009. Managerial Economics. New Delhi: Excel Books. ----------------------
2. Curwen, Peter J. 1974. Managerial Economics. London: Macmillan.
----------------------
3. Eastham, J.K. 1950. An Introduction to Economic Analysis.
London:Universities Press. ----------------------
4. Heady, Earl O. 1952. Economics of Agricultural Production and Resource ----------------------
Use. New York: Prentice-Hall, Inc.
----------------------
5. Nemmers, E.E. 1962. Managerial Economics: Test and Cases. New York:
John Wiley ----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Notes
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

Government and Private Businesses
UNIT
14
Structure:
14.1 Introduction
14.2 Need for Government Intervention
14.3 Cause for Rise in Prices in India
14.4 Price Controls in India
14.5 Protection of Consumer Interests
14.6 The New Industrial Policy 1991
14.7 MRTP ACT
14.8 De-Reservation - Further Liberalisation
14.9 Economic Liberalisation
14.10 The Process of Disinvestment: Need and Methods
Summary
Key Words
Suggested Reading
Government and Private Businesses 345

Notes
Objectives
----------------------
----------------------
• Analyse and justify government intervention in private business
----------------------
• Differentiate between demand pull and cost-pull factors
---------------------- • Assess the performance of fiscal and monetary measures
---------------------- • Discuss government role in controlling inflation in the economy
---------------------- • Defend de-reservation and economic liberation

• Evaluate the process and importance of disinvestment in India
----------------------
---------------------- 14.1 INTRODUCTION

---------------------- In our discussion about business decisions regarding production, pricing,
---------------------- investment etc, in the previous units, we assumed the existence of a ‘free
enterprise system’ in which there is the least interference by the State with the
---------------------- choices, preferences and decisions of the individuals regarding their economic
pursuits.
----------------------
The real life situation is, however, quite different even in the free enterprise
---------------------- economies, let alone the State-controlled economies. The government holds
a tremendous authority not only to influence the private business decisions
---------------------- but also to control and regulate, whether directly and indirectly, the private
---------------------- business activities. By using its powers, the government can enact the laws
against production, sale and consumption of certain goods; can prevent the
---------------------- entry of private entrepreneurs to certain industries through its Industrial Policy,
can limit the growth of private firms beyond a certain limit (for example, the
---------------------- MRTP Act.) and can nationalize the industries whenever it thinks necessary and
---------------------- desirable.
GST (Goods and Services Tax) is transferable to the consumers; it is a
---------------------- compulsory payment on every purchase. GST that is charged floats in the range
---------------------- between 0% to 28 % (rules differ depending on the nature of the commodity –
necessary & perishable goods.
----------------------
Another form of government intervention with private business is the
---------------------- formulation and implementation of various kinds of economic policies such
as a fiscal policy, a monetary or credit policy, an industrial licensing policy,
---------------------- commercial policy, exchange control policy, etc. Besides, the government affects
private businesses too, in its capacity of a competitor in the input market. Public
----------------------
sector industries being owned and managed by the government get a preferential
---------------------- treatment in the allocation of a scarce input. All these activities and policies of
the State are the various forms of intervention with the free enterprise system,
---------------------- which affect the private business activities. The interference raises several
questions: is government intervention with free enterprise inevitable? If yes,
----------------------
what should be the limit of government intervention or the limit of government

economic activities? How can the public and private sector in a mixed economy Notes
work in cooperation and coordination with each other? How and to what extent
do the government’s economic policies affect the private businesses ? We shall ----------------------
answer some of these questions in this part of the book.
----------------------
14.2 NEED FOR GOVERNMENT INTERVENTION ----------------------
The need for government intervention with the functioning of the free ----------------------
market mechanism has arisen out of the failure of the free market economy
expected to ensure (i) that all those who are willing to work at prevailing wage ----------------------
rate get employment; (ii) that all those who are employed get their living in ----------------------
accordance with their contribution to the total output, (i.e., their productivity);
(iii) that factors of production are optimally allocated between the various ----------------------
industries; and (iv) production and distribution pattern of national product is
such that all get sufficient income to meet their basic needs - food, clothing, ----------------------
shelter, education, medical care, etc. The world has however experienced that ----------------------
the free enterprise system has failed to organize the economy which would
satisfy the above requirements. The failure of the free market economy is ----------------------
attributed to its following shortcomings.
----------------------
Shortcomings of Market System/Limitations or Defects of Market System
----------------------
Following are the important limitations of the market mechanism (i.e. of
market economy or capitalism): ----------------------
(i) Inequalities of Income and Wealth
----------------------
One of the serious limitations of market mechanism is that it
results in an extremely unequal distribution of income and wealth. In a ----------------------
free competitive economic system, those with productive resources or
----------------------
intellectual abilities find it easy to obtain a rising income and wealth,
whereas those who have no productive resources or mental abilities do ----------------------
not get much of a share in the annual national income and wealth. And
the number of such people in any society is generally so great that they ----------------------
constitute the majority. Thus, market mechanism results in the unequal
----------------------
distribution of income and wealth and its concentration in the hands of
a few people in society. The rich go on becoming richer, while the poor ----------------------
who constitute the majority continue to remain poor. These economic
inequalities give rise to social and political unrest, disturbing the social ----------------------
and political peace in the country.
----------------------
(ii) Emergence of Monopolies
----------------------
It is observed from the economic histories of the United States and
West European countries, that competition, which is at the heart of the ----------------------
market mechanism, itself gives rise to monopolies. If for example there
----------------------
are a number of producers of a commodity, the efficient ones who are
always few because of uneven distribution of organizational abilities ----------------------
among people, will begin to absorb the inefficient ones. The final result
is that only one (absolute monopoly), two (duopoly) or a few (oligopoly) ----------------------

Notes units in the industry remain. These units naturally begin to enjoy
monopolistic power exploiting both, consumers and workers. Also, these
---------------------- monopolies establish political lobbies and through corruption and other
favors to legislators get suitable legislation passed, thus protecting their
----------------------
own interests and sacrificing the interests of vast body of consumers.
---------------------- An example for real monopoly product or service can be MSEB)
---------------------- Maharashtra State Electricity Board). There’s no competition for it. This
is thus a monopoly. No private sector is allowed to enter this service,
---------------------- expect that in Mumbai, where TATA, BEST (Bombay Electrical Supply&
Transport), etc. are entering this service sector to supply electricity.
----------------------
Competitive Monopoly is where the monopoly emerges for a
---------------------- particular sector of buyers due to their steady consumption and habits
---------------------- (‘Brand Monopoly’), for example, Lifebuoy soap, Dove Soap or Pears
Soap; similarly Philips Lights and Tubes, Cadbury, etc. Customers are
---------------------- so accustomed to consuming their brand of products that they are almost
adamantly reluctant to consume other products. This is consumer loyalty,
----------------------
which at times can be used as a tool, by the companies to exploit the
---------------------- group of customers by increasing the prices of their products. These can
be posed as the disadvantages arising out of this particular situation. To
---------------------- go for ‘Competitive Monopoly’ is the basic target of every company in
---------------------- today’s competitive world. The tactic lies in the way to fill old wine in
a new bottle. It is necessary for the survival and it is the survival of the
---------------------- fittest which is the ‘mantra’ today.
---------------------- (iii) Failure to Provide Full Employment
---------------------- It was assumed that under competitive conditions, market

mechanism or price mechanism would automatically bring about and
---------------------- establish equilibrium at the level of full employment. J. M. Keynes
however showed that due to several rigidities (especially wage rigidities
----------------------
due to emergence of trade unions in the labour market), it so happens that
---------------------- the economy may get established at the level of less than full employment.
Thus market mechanism does not ensure full employment of labour force.
---------------------- Thus the labour force which could have produced much needed wealth
---------------------- lies unemployed and is wasted.
(iv) Instability
----------------------
Market economy or private enterprise economy is a planless
---------------------- economy. In such an economy where millions of consumers and millions
of producers are taking their own independent decisions, it is rarely that
---------------------- some sort of balance would be achieved between the demand for thousands
of commodities and their supply. This imbalance gives rise to frictional
----------------------
disturbances and cyclical booms and depressions. It is inconceivable
---------------------- that the modern complex economy involving millions of commodities
and millions of consumers and producers would always work smoothly.
---------------------- Market economy is bound to be characterized by great instability.

Basically, instability arises because of a large variety of goods Notes
available and thus there is a difficulty in arriving at the right decision,
especially in case of garments, shoes, cars etc. In spite of the available ----------------------
purchasing power with the buyers, the sales’ level goes down because of
lack of decision making on par of the consumers. They are confused and ----------------------
do not understand what to buy from the enormous range of goods and
----------------------
services. This is the start of recession. This is largely because of giving
multiple licenses (by the government) to produce or import similar type ----------------------
of commodities.
----------------------
(v) Wastages of Market Economy
As we have seen, market system or market economy suffers from ----------------------
time to time from economic depressions. During the period of depression,
----------------------
various factors of production lie unutilized. These factors could have been
used to produce much needed wealth for the poorer sections of the society. ----------------------
Secondly, we have seen that competition often gives rise to
----------------------
monopolies. Often these monopolies purposely keep certain factors of
production idle, creating artificial scarcities of their products with a view ----------------------
to raise prices to the maximum, if such a step gives maximum profit. Thus,
under monopoly there is tremendous wastages of productive resources. ----------------------
In those lines of production where competition exists, there appear ----------------------
what may be called wastages of competition. Thousands of units in the
same industry take independent decisions regarding production. Often ----------------------
there is over-production in some industries and there is under-production
in certain other industries. ----------------------
The monopolist has tremendous capacity to hold his product from ----------------------
the market. He can afford to do so. So the cycle fro production to sales
goes dim and till the products are idle, the resources which are being used ----------------------
to produce those products go waste. For example, warehouse rent, bank ----------------------
interest on capital, possibly perishable because of the non-use of those
products (they remain idle in stock). If two out of ten goods go waste, the ----------------------
monopolist has the power to cover up the loss made by increasing the price
on the remaining eight. He is not at loss, but the fact remains that two goods ----------------------
did go waste!
----------------------
Also, in a competitive regime, there are wastages of advertisement.
Hundreds of producers of a similar commodity spend vast amounts on ----------------------
advertisement. Since rivals are advertising, it is possible that the final
----------------------
effect of advertisement by rival parties is neutralized. This would mean that
great amounts of labour and other resources employed for advertisement ----------------------
are wasted. While some advertisements are truly informative, most are
misleading and therefore, the claim that under the free enterprise system ----------------------
or market system competition leads to the most efficient use of the
----------------------
community’s various productive resources is not valid. On the contrary,
capitalism abounds in wastages due to unemployment, over and under- ----------------------
production and a vast expenditure on advertisements necessitated by cut-
throat competition among rival firms. ----------------------

Notes Overproduction may put the producer in a tense situation to
recover high funds. So at times, he may be eager to sell his product at a
---------------------- lower price. This confuses the entire economy. If a commodity is suddenly
available in the market at a low price, it may leave the buyers as well as
---------------------- sellers of its substitutes astonished about the reasons behind it.
---------------------- Overproduction may take place due to the part of the producer to
produce more (since average cost is always less for large quantities of
----------------------
goods produced). If a person A is taking orders from a person B, B is
---------------------- willing to give 1,000 units for Rs. 1,000, or 2000 units for Rs. 1,500 or
further 3000 units for Rs. 1,800. Thus A gets tempted to consider the last
---------------------- deal, which gives him an edge in the market to reduce the price at the right
time. In this case, underproduction producers’ lot cannot afford to follow
----------------------
suit in lowering the price.
---------------------- In case of underproduction, there is a danger of increasing the
overhead cost to the ratio of selling cost. For instance, one production
----------------------
unit is capable of producing 100 goods per day but to act on safer lines he
---------------------- produces only 50 goods; he is not of the market demand for his product.
The overhead cost which could have been distributed over 100 goods,
---------------------- now gets distributed over only 50 goods. Hence the cost is more. The
same is in the case of selling cost. Selling cost has to go with the trend.
----------------------
For instance, a person inserts a quarter page ad in the newspaper for his
---------------------- product, when the substitute product enjoys a full-page ad in the same
daily; this automatically reduces the rapport of the former product in
---------------------- the market. Products having high exhibition value are viewed on a high
platter than those products exhibiting less. This is the fact of the day;
----------------------
whether one likes it or not!!
---------------------- If underproduction is not met by rising demand, then there is a
tendency to go for its substitutes. For instance AVEO car, a product of
----------------------
Chevrolet, has a waiting period of 3 months (Dec. 2006). Thus consumers
---------------------- are not always willing to wait that long and hence would go for say, Honda
City. But in the case of MSEB, in spite of regular power cuts, people are
---------------------- bearing with it, as they have no other choice but to abide by it.
---------------------- (vi) Indifference to and Sacrifice of Social Welfare
---------------------- In a market economy or free enterprise economy, production of

goods and services is all guided by the aim of securing the maximum
---------------------- private profit. Goods are produced for which there is greater demand. That
is how in capitalism luxury and semi-luxury goods, which richer sections
---------------------- of the community can afford to buy because they have the necessary
---------------------- purchasing power, get preference over production of mass consumption
goods needed by poorer sections of the community. Their production is
---------------------- neglected in preference to production of luxury and semi-luxury goods
for richer sections of society. This means that very little attention is paid
---------------------- to the welfare of the society.
----------------------

(vii) Poverty in the Midst of Plenty Notes
In a market economy, inspired by private profit motives, a tremendous
----------------------
technological progress has taken place. This has tremendously increased
the productive powers of the economy and production of various goods ----------------------
and services. But due to the institution of private property and the law
of inheritance and succession (which are the basic features of the free ----------------------
enterprise system of economy), the rich become richer and continue to
----------------------
exploit the vast poor masses. The vast masses of people living on bare
minimum wages prevailing under competitive conditions cannot get a ----------------------
continually rising share in the increasing productivity and production of
wealth in the commodity. ----------------------
In a free enterprise economy, there is thus observed the existence of ----------------------
contradictory position of poverty in the midst of plenty.
----------------------
Any progress needs labour – skilled and unskilled. The imbalance
is less in case of skilled labour than in the case of unskilled labour. Most ----------------------
of the latter is concentrated in the rural areas, where outlets (to spend)
are less. The living standard is minimum and the requirements are much ----------------------
lesser than those in the urban industrialized areas. In the rural areas, with
----------------------
less purchasing power, they are able to lead very satisfied and comfortable
lives. But when they come to the urban areas, they are driven by the high ----------------------
living standards. The same purchasing power cannot give them the comfort
levels, when they join the industrial world. For example, the Brain Drain ----------------------
in India is mainly happening because the educated class gets attracted to
----------------------
the high living styles and money power which they can get abroad and
which with the same qualification, they cannot of dream of getting the ----------------------
same over here. So for developed nations like the U.S.A., developing
countries like India are a less industrialized sector. Thus imbalance is a ----------------------
relative concept.
----------------------
If we are to stand against them in the international market, we have
to cope up with the technological progress that is happening world-wide, ----------------------
for example the use of cell phones is fast becoming a necessity and almost
----------------------
on the verge of taking over the land-line phone system.
(viii) Undesirable Psychological and Social Effects ----------------------
Capitalism with it’s emphasis on motives of private profit and money ----------------------
making, has great adverse social, cultural and psychological effects. In
capitalism, money becomes the yardstick of measuring success in every ----------------------
field - art, music, literature and so on. Art, music and literature all come to
----------------------
be judged by their financial success and not on the basis of their inherent
quality or merit. ----------------------
People can widely accept established names, their work and their
----------------------
creativity. Somehow, it is largely felt that they are the ones setting the
flow and others are to follow. Established names can become trend- ----------------------
setters, in a way. Success is displayed on the materialistic resources.
----------------------

Notes Those who are in the cynosure of attention all the time do have to exhibit
themselves compulsorily, in order to keep up their name in success or else
---------------------- it keeps others wondering about their standards and so their position. For
instance, a highly qualified musician who goes around on a two-wheeler
---------------------- is not perhaps looked up to, but on the other hand a simple percussionist,
---------------------- who has joined the Music Film Industry, could afford to have at least a
second-hand car. Judging by musical value, the former stands at a much
---------------------- higher level than the other, but actually it is largely seen as the reverse,
unfortunately!
----------------------
Emphasis on private profit motive and on money-making arouses
---------------------- in capitalist regime instincts of acquisitiveness, unscrupulousness,
combativeness and immorality suppressing good human instincts like
---------------------- kindness, love, cooperation and consideration for the welfare of others.
---------------------- (ix) Exploitation of Backward Countries and World Rivalry
---------------------- The developed capitalist countries, with a view to make higher and
higher profits, have been exploiting backward countries in Africa and Asia
---------------------- through great multi national corporations and through the sale of arms
and ammunition to both the opposing parties or countries (Arabs versus
---------------------- the Jews, India versus Pakistan, etc.) just because the defence industries
owned by rich capitalists in Western countries should make rising profits.
----------------------
Developed capitalist countries are putting restrictions on exports
---------------------- from developing or backward countries thus hampering their rapid
economic development.
----------------------
Giant multi national corporations try to subvert national governments
----------------------
opposed to their interests by sabotage and various other methods.
---------------------- All this has led to international rivalry, disturbances and violence
---------------------- which go against economic development of poor and backward countries
in Asia, Africa and Latin America.
----------------------
Concluding Remarks
---------------------- It would thus be seen that while free enterprise economy or market
---------------------- system has some solid achievements to its credit, it also suffers from very
serious limitations or evils, affecting both its own working and that of
---------------------- other countries.
----------------------
14.3 CAUSES FOR RISE IN PRICES IN INDIA
----------------------
A strong inflationary pressure has been built into the Indian economy for
---------------------- a long time - precisely from the start of the Second World War - partly through
---------------------- ever-mounting demand on the one side and inadequately rising supply on the
other. The expanding demand is due to the rapid growth of our population, rising
---------------------- money income, expansion in money supply and liquidity in the country, rising
volume of black money and continuous rise in demand for goods and services
----------------------

due to periodic wars, rapid economic development, etc. Supply of goods and Notes
services too has been rising but the rise in supply has not been proportionate
and matching the rise in demand; this is due to monsoon, use of backward ----------------------
technology, bottlenecks in transport and power and shortages of various inputs.
----------------------
At any given time, therefore, there is demand and supply imbalance.
----------------------
Let us emphasize some of the causes behind the inflationary rise in
prices in India in recent years. ----------------------
(A) DEMAND PULL FACTORS
----------------------
(i) Mounting Government Expenditure: Government expenditure
has been steadily increasing over the years. In a predominantly ----------------------
agricultural economy like India, big programmes of economic ----------------------
development involving huge investments have been undertaken.
Mounting government expenditure implies a growing demand for ----------------------
goods and services and thus, is an important factor for the rise in
price. Beside, continuous increase in government expenditure has ----------------------
the effect of putting in large money income in the hands of the ----------------------
general public and causing the fire of inflation.
(ii) Deficit Financing and Increase in Money Supply: The Government ----------------------
of India is responsible for adopting deficit financing as a method of ----------------------
financing economic development.
----------------------
Mounting Government expenditure financed through deficits pushes
up the money supply in the country and consequently pushes up the ----------------------
public demand for goods and services.
----------------------
The Government of India has been responsible for the inflationary
situation in the country through its policy of deficit financing and ----------------------
state governments contributed their share through their persistent
financial indiscipline, reckless expenditures and unauthorized over- ----------------------
drafts.
----------------------
(iii) Role of Black Money: There is considerable slush money with
politicians and Government servants, especially those dealing with ----------------------
licensing, registration, collection of taxes, etc. A large part of the ----------------------
unaccounted money is used in buying and selling of real estate
in urban areas, extensive hoarding and black marketing in many ----------------------
essential and inflation - sensitive goods, such as sugar, edible oils,
etc. It is difficult to estimate the amount of black money or the ----------------------
precise influence of this money in pushing up prices but there is no ----------------------
denying the fact that one of the important factors responsible for
inflationary pressures in recent years is the existence and the active ----------------------
role of black money.
----------------------
(iv) Uncontrolled Growth of Population: It is the continually rising
population in India which is responsible for the persistent gap ----------------------
between demand and supply, in almost all consumer goods and
services, thus exerting continuous pressure on prices. ----------------------

Notes (B) COST-PUSH FACTORS
If supply of goods and services can be increased to correspond
----------------------
with every increase in demand, price level will tend to be stable. Prices,
---------------------- however, rose whenever the production of food grains and other consumer
goods declined or was stagnant.
----------------------
(i) Fluctuation in output and supply: In this connection, we may
---------------------- refer to violent fluctuations in food grains output.
Such huge fluctuations in the output of food grains in certain
----------------------
years was a major factor in the rise of food grains prices as well
---------------------- as general prices. Likewise, we may also refer to the fact that the
supply of manufactured goods, did not increase adequately in certain
---------------------- periods. Power breakdowns, strikes and lock-outs and shortage of
---------------------- transport facilities are major factors for lower rate of production
of manufactured goods. With ever rising demand for manufactured
---------------------- products, the producers are in a position to push up the prices of
their products.
----------------------
Apart from fluctuations in production, market arrivals have
---------------------- also tended to be erratic. In fact, the upward pressure on agricultural
prices is also due to large hoarding by farmers, and hoarding and
----------------------
speculation of food grains by traders and blackmarketeers. At one
---------------------- time, hoarding was done only by middlemen but now farmers have
also joined the traders in this vicious game. With increased credit
---------------------- facilities from the co-operative societies and commercial banks,
even small farmers have now more holding capacity. They hold on
----------------------
to their stock in anticipation of higher prices.
---------------------- (ii) Taxation, as a factor in rising costs: Cost-push factors consist
---------------------- mainly of rise in wages, profit-margins and rise in other costs. In
this connection the government and the public sector were also
---------------------- responsible, to a large extent, for pushing up the price level in
the country. With every budget, the government imposed fresh
---------------------- commodity taxes and gave an opportunity to the trading classes to
---------------------- raise the prices, often more than the levy of the taxes.
(iii) Administered price: The public sector enterprises too were
----------------------
continuously raising the prices of their products and services
---------------------- which generally constitute raw materials for other industries. A
good example is the Railways which have been regularly raising
---------------------- fares and freight rates in the last few years. Likewise, there has
been regular upward revision of several administered prices such
----------------------
as those of petrol, diesel, steel, cement, coal, etc., pushing up the
---------------------- price level further. Every rise in administered prices adds fuel to the
inflationary potential in the country.
----------------------
(iv) Hike in oil prices and global inflation: Serious inflationary
---------------------- pressures were also created because of the sharp hike in the price of
crude oil.
(C) OTHER FACTORS Notes
The failure of the Government policy on the price front at various
----------------------
times was a serious factor in the inflationary rise in prices. We can cite
specific cases. In 1973, the Government nationalized the wholesale trade ----------------------
in wheat along with a threat to introduce a similar measure for rice. This
measure completely upset the normal trade and the price of open market ----------------------
wheat shot up. At the same time, the government did not fail to procure
----------------------
an adequate amount of food grains for the public distribution system, nor
was it able to import the necessary quantity from foreign countries. ----------------------
The Government of India has generally followed a highly vacillating
----------------------
and anti-peasant policy in fixing procurement prices. This is equally true
in fixing and controlling prices of such essential goods as sugar, vanaspati, ----------------------
soap, cloth, etc. Nor are the controls properly enforced thus giving great
scope for rampant black-marketing to exist, for the benefit of the traders. ----------------------
Causes for inflationary pressure in the 90’s and after 2000 ----------------------
All the causes we have discussed above are basic causes for the ----------------------
existence of general inflationary pressure in the Indian economy and they
have been present and active over the last many years. The immediate ----------------------
cause for the pressure on prices since, 1990, as mentioned earlier, was
the Gulf War and the consequent shortages and increase in the prices ----------------------
of administered items such as coal, petroleum products, fertilizers, ----------------------
electricity, etc. According to the Government, the buildup of inflationary
pressure during the Nineties was mainly attributable to: ----------------------
(a) Higher fiscal deficit: Large and persistent fiscal deficits over the ----------------------
years resulting in excessive growth in money supply and liquid
resources with the community: there was automatic monetization ----------------------
of fiscal deficit;
----------------------
(b) Sharp reserve money (RM) during the three years (1993-96) due
to large inward remittances and heavy accumulation of net foreign ----------------------
exchange assets with RBI; this was the basis of the rise in money
supply and liquid resources with the general public at that time; ----------------------
(c) Supply-demand imbalances: Sensitive commodities like pulses, ----------------------

edible oils, and even onions and potatoes due to shortfalls in
----------------------
domestic production; and
(d) A sharp increase in procurement prices of cereals and consequent ----------------------
rise in the issue price;
----------------------
(e) The 9/11 attack on W.T.C. (U.S.A.); U.S. and allied forces invading
Afghanisthan, Iraq and take-over of the Iraq by U.S. and allied ----------------------
forces global recession etc.
----------------------
----------------------
----------------------

Notes 14.4 PRICE CONTROLS IN INDIA
---------------------- A wide range of measures are being adopted to ensure stable conditions as
well as to prevent speculators form taking an undue advantage of the conditions
---------------------- of scarcity. Since the price situation is the outcome of shortages in basic goods
and services and a rapid growth in money supply and bank credit, various types
----------------------
of measures relating to money supply, pricing and distribution of commodities
---------------------- are pressed into service.
(A) Demand Management
----------------------
(i) Fiscal measures - The Government of India has generally insisted
---------------------- on controlling its own expenditure and keeping in check both its
revenue deficit and fiscal deficit - this has been a major instrument
----------------------
of inflation - control.
---------------------- (ii) Monetary measures: The monetary policy of RBI consists of
extensive use of general and selective credit control measures. The
---------------------- main thrust has been to restrict bank-credit against inflation sensitive
---------------------- goods and to influence the cost and availability of commercial bank
credit. The RBI relies heavily on selective credit controls on bank
---------------------- loans against food grains, cotton, oil-seeds and oils, sugar and
textiles so as to discourage speculative hoarding.
----------------------
During the Eighties and Nineties, monetary policy has been directed
---------------------- essentially to prevent any excessive increase in liquidity and at the
same time to ensure that the genuine credit requirements of the
----------------------
industrial sector and the priority sectors are adequately met. The Cash
---------------------- Reserve Ratio (CRR) was raised from 6 to the statutory maximum
of 15 per cent gradually. These steps resulted in a large measure, ‘in
---------------------- mopping up excess liquidity in the economy, moderating monetary
---------------------- and credit expansion and consequently helped in bringing down the
rate of inflation.
----------------------
(B) Supply Management
---------------------- Supply management is related to the volume of supply and its
---------------------- distribution system. On the commodity front the Government has generally
focused its attention in securing greater control over the prices of rice, wheat,
---------------------- sugar, oils and other commodities of mass consumption. Through increase
in domestic supplies, large releases from official stocks and widening and
----------------------
streamlining of the network of public distribution, the Government attempts
---------------------- to prevent an undue increase in the prices of essential commodities. Let us
touch some of the important aspects of this policy.
----------------------
(a) Fixation of Maximum Prices : For eliminating the incentive
---------------------- for hoarding and the speculative activity in food grains, the State
Governments have been asked to fix the wholesale and retail
---------------------- prices of food grains. Further, the Government also fixes minimum
---------------------- procurement prices for major crops on the recommendation of the

Agricultural Prices Commission (APC). Prices of other important Notes
goods like cloth, sugar, vanaspati, etc., are also controlled.
----------------------
(b) The System of Dual Prices : The Government has adopted a
system of dual prices in the case of goods like sugar, cement, paper, ----------------------
etc. Under this system, the weaker sections of the community are
supplied with these goods through fair price shops, at controlled ----------------------
prices and the rest and allowed to purchase their requirements at
----------------------
higher prices from the open market.
(c) Increase in Supplies of Food grains : The Government attempts to ----------------------
increase supplies of food grains and other essential goods in times
----------------------
of internal shortage through larger imports.
(d) Problem of Oilseeds and Edible Oils : In recent years, a steep ----------------------
rise in the prices of edible oils along with those of pulses, tea and
----------------------
sugar have been responsible for rise in the general price level. The
Government has prepared medium and long-term plans to step up ----------------------
the production of oilseeds in the country. The Government has
announced higher support prices for groundnut, soya bean and ----------------------
sunflower seed - the last two crops offer the maximum scope for
----------------------
augmenting the supply of edible oil in the country. In the short
period, the Government has been relying on imports of edible oils, ----------------------
at reduced or concessional import duties.
----------------------
In this connection, we should refer to the steps taken by the
Government to increase the production of all other agricultural ----------------------
products.
----------------------
(e) Public Distributions System (PDS) and Consumer Protection :
An important aspect of the Government’s policy was strengthening ----------------------
of the PDS. The Government has set up a network of fair price
shops numbering nearly 4,00,000 which cover a population of over ----------------------
5-million and which distribute wheat, rice, sugar, imported edible ----------------------
oils (palm oil), kerosene, soft coke and controlled cloth. The public
distribution system serves two purposes. Firstly it helps to hold ----------------------
down prices. Secondly, it provides essential commodities to low
income groups at relatively low prices. But whenever the PDS is ----------------------
hard pressed due to inadequate supply, prices of essential goods ----------------------
tend to rise. PDS has been strengthened and extended to rural areas.
(f) Control over Private Trade in Food grains : To check prices and ----------------------
to eliminate hoarding and speculative activity in food grains trade, ----------------------
wholesale dealers in food grains were licensed in many States.
Limits were also fixed beyond which traders and producers could ----------------------
not hold stock without declaration. The Food Corporation of India
has helped a lot to buy in surplus areas and sell in deficit areas and ----------------------
thus moderate the differences in prices. ----------------------
----------------------

Notes (g) Other relevant measures by Government of India to control
Inflation.
---------------------- i) Adoption of OGL (Open General License) import policy for
---------------------- importing sugar, pulses etc.
ii) Adjustment in trade and tariff policies in the Central
----------------------
Government Budgets to ensure their domestic prices of
---------------------- Industrial products remain competitive.
iii) Great reduction in excise duties on a numbers of items is
----------------------
expected to accelerate the speed of industrial revival and raise
---------------------- industrial growth.
---------------------- (C) Direct Government Role

(1) Administered Prices
----------------------
The Government of India follows an administered price policy
---------------------- in respect of commodities which are either vital industrial raw
materials, produced wholly or largely in the public sector such
---------------------- as steel, fertilizer, coal and petroleum products. The Government
---------------------- also fixes the rates and charges of public utilities like railways and
state electricity boards. The products and services produced by the
---------------------- public sector in India constitute important raw materials for other
industries and are subject to serious output and price fluctuations.
---------------------- Administered prices are normally set on the basis of cost plus
---------------------- a stipulated margin of profit. There are two basic objectives of
administered prices:
----------------------
(i) to fix and maintain the prices of essential raw materials
---------------------- so as to avoid cost and price escalation; this has a special
significance during a period of shortages and rising prices;
---------------------- and
---------------------- (ii) to ensure economic prices to uneconomic units so that the
latter too can earn profits.
----------------------
Whenever there is a change in cost, the administered price is also
---------------------- changed. As the Government is generally slow and sluggish
in its actions, the change in administered prices may not
---------------------- be proportionate to change in cost and, besides, the change
in price may come much later than change in cost. In fact,
---------------------- this has been a major criticism against administered prices
---------------------- in India. As the administered prices are often inadequate
to meet cost escalation, basic industries like fertilizers and
---------------------- cement were unable to generate sufficient financial resources
for modernization and expansion. The present policy of the
---------------------- Government is to adjust administered prices to enable public
---------------------- sector units to earn sufficient profits and over a period of time
give up the system of administered prices.
----------------------

(2) The System of Dual Prices Notes
It is a commonly accepted principle in India that the basic needs
----------------------
of the weaker sections of the community should be met and for
this the Government should subsidies the prices of certain basic ----------------------
goods. This does not mean that the benefit of subsidy and low price
should go even to those who do not require it. At the same time the ----------------------
burden of subsidy should not fall on the producers of these basic
----------------------
goods but should be spread on the community as a whole. Such
a policy is (a) in the interest of the vulnerable sections, and (b) it ----------------------
does not discourage the producers from expanding production and
investment in the particular sector. ----------------------
Originally started with the price of steel, dual pricing was extended ----------------------
to many other essential goods such as major food grains, sugar,
edible oils, and cheaper varieties of cotton cloth. Dual pricing is ----------------------
a form of short cut price control and it enabled the Government to
----------------------
acquire essential goods at lower controlled prices for its own use,
even though it was meant to benefit the weaker sections. ----------------------
(3) Support/Procurement Prices
----------------------
A proper price policy will have to include measures directed
towards cereals, pulses and oil-seeds viz. their production, purchase, ----------------------
movement, sale and distribution. The level at which agricultural ----------------------
prices should be stabilized is important from the point of view
of production and consumption. In fixing food grain prices, three ----------------------
aspects may be kept in mind:
----------------------
(a) The Government should fix and guarantee such procurement
prices for various food grains as this will provide suitable ----------------------
incentives to the producers. This is particularly important as
the volume of production has increased considerably under ----------------------
the influence of the “green revolution”. ----------------------
(b) The retail prices should be fixed in such a way that the interests
of the consumers are safeguarded and at the same time there ----------------------
is no scope for hoarding and speculation. Food zones are ----------------------
abolished and inter-state movement of the food grains is the
monopoly of the Food Corporation of India. ----------------------
(c) Holding the price line covers not only to cereals, but to all ----------------------
basic consumption goods as for instance pulses, sugar, oil and
vanaspati, cloth, kerosene, etc. ----------------------
The Government of India announces support prices on the ----------------------
recommendations of the Agricultural Prices Commission, redesignated
as Commission for Agricultural Costs and Prices. The Commission is ----------------------
guided in recent years by the three-fold objectives of
----------------------
(a) raising productivity through assured remunerative prices to
farmers; ----------------------

Notes (b) procuring sufficient quantities of rice and wheat for running
the public distribution system; and
----------------------
(c) promoting a desirable inter-crop balance.
---------------------- While making recommendations to the Government regarding
the revision of minimum procurement and support prices, the
----------------------
Commission takes into account, among other things, the changes
---------------------- in production costs, the inter-crop balance and the terms of trade
between agriculture and other sectors of the economy.
----------------------
The basic framework for determining support prices for
---------------------- major cereals has been relatively fair. The interests of both farmers
and general consumers have been well protected. But there are a
---------------------- number of distortions: One is the announcement of higher minimum
prices by state Government to satisfy local interests. Another is
----------------------
that support prices for coarse grains, pulses and oilseeds are of
---------------------- a notional nature and are not backed by an organized system of
official procurement. In these case also, support prices should be
---------------------- rationally determined (as in the case of wheat and rice) and should
be made effective through public purchases and public distribution.
----------------------
(4) Public Distribution System
----------------------
Rationale of PDS: The distribution of essential commodities
---------------------- through fair price shops at government-controlled prices has come
to be known as public distribution system.
----------------------
There are various reasons for the setting up of the public
---------------------- distribution system in India.
---------------------- 1) In order to maintain stable price conditions, an efficient
management of the supplies of essential consumer goods
---------------------- is necessary. Moreover, as most of these commodities are
agriculture-based, their prices are subject to large seasonal
----------------------
variation. Public distribution system will, therefore, have to
---------------------- play a major role in ensuring supplies of essential consumer
goods of mass consumption to people at reasonable prices,
---------------------- particularly to the weaker sections of the community.
---------------------- State trading and buffer stock operation on the one side
and public distribution on the other are essential in the case of
---------------------- agricultural products.
---------------------- 2) A large proportion of agricultural products - both food
grains and raw materials - come to the market soon after
---------------------- the harvest when prices are depressed. It is necessary to
---------------------- devise a scheme to buy such commodities at prices which
ensure a certain minimum profit to the farmers. The Food
---------------------- Corporation of India (FCI) and other institutions have been
set up to buy agricultural goods at prices that would ensure
---------------------- minimum profit for the farmers; they also help in stabilizing

agricultural process. At the same time, these goods would be Notes
supplied through public channels to consumers especially
the weaker sections of the community - this would mean ----------------------
that in critical times, they would receive supplies of essential
commodities at reasonable prices. ----------------------
3) The PDS has become a stable and permanent feature of ----------------------

India’s strategy to control prices, reduce fluctuations in prices
----------------------
and achieve an equitable distribution of essential consumer
goods among the people. ----------------------
Goods to be included in the public distribution
----------------------
system: Since distribution is a highly complex matter, only
the most essential goods of mass consumption should be ----------------------
brought under the public distribution system, for example,
cereals, sugar, edible oils and vanaspati, kerosene, soft coke, ----------------------
controlled cloth, tea, toilet soap and washing soap, match
----------------------
boxes, exercise books for children, etc.
Supplies to the public distribution system : Both ----------------------
Central and State Governments have made arrangements to
----------------------
procure essential commodities and supply them through the
public distribution outlets. In the case of food grains, FCI ----------------------
undertakes the necessary operations. In regard to sugar, FCI
undertakes these operations. The State Trading Corporation ----------------------
(STC) has been entrusted with the responsibility of importing
----------------------
and distributing edible oils. Kerosene is being handled by the
public sector corporations like Indian Oil Corporation (IOC), ----------------------
Hindustan Petroleum, Bharat Petroleum, etc. The production
of controlled cloth has now been generally entrusted to the ----------------------
National Textile Corporation (NTC) and distributed through
----------------------
the National Consumers Co-operative Federation (NCCF).
----------------------
----------------------

1. Post Second World War, inflation has been built into the Indian economy ----------------------
due to ever-increasing ___________ and inadequately rising __________.
3. RBI uses its monetary policy to achieve judicious balance between ----------------------
___________and control of ____________.
----------------------
1. Competitive monopoly is where the monopoly emerges for a particular ----------------------
sector of buyers.
----------------------
2. Government of India is responsible for the inflationary situation in the
country through its policies of deficit financing. ----------------------
3. Administered prices are based on cost price only.
----------------------

Notes 14.5 PROTECTION OF CONSUMER INTERESTS
---------------------- The consumer who is often considered as the king who has been enslaved
by the aggressive and dominant market manipulations by the large-sized
---------------------- corporations. The tug-of-war between monopoly producers and scattered
consumers obviously works to the advantage of the producers. This is why Prof.
----------------------
J.K.Galbraith favoured the organization of the advantage of the producers. This
---------------------- he termed as countervailing power. A consumer’s interest has several facets
and its protection amounts to empowering the consumer. Such an empowerment
---------------------- can be achieved by the consumers themselves by organizing together and further
by creating consumer’s co-operatives. Such an option is difficult to achieve,
----------------------
especially where the consumers are spread over a vast area and where they lack
---------------------- in awareness, education and organizational ethics. It is under these conditions
that the government is called upon to step in, in order to protect the consumer’s
---------------------- interest.
---------------------- One way of protecting the interest of the consumers is the formation of their
co-operatives. But due to various limitations it is lengthy and tedious process.
---------------------- Therefore, the government, at best, can announce a set of concessions and
---------------------- facilities for their development. The direct way with which we are concerned here
is an effective intervention in the price system and in the supply of commodities
---------------------- by undertaking legal measures. The Consumer Protection Act, 1986, in India
is such an effort. The act provides for the settings up of quasi-judicial bodies
---------------------- at the district, state and central levels for the redressal of consumer protection
---------------------- act which provides for reliefs and compensation to the consumers wherever
deemed appropriate.
---------------------- A consumer’s interests or rights as enunciated by the Consumer
---------------------- Protection Act, 1986, are as follows:
i) Protection from Hazardous Commodities: A consumer is within his
----------------------
rights to demand protection against the marketing of goods and services
---------------------- which are hazardous to life and property.
ii) Right to Information: A consumer has a right to the information
----------------------
regarding the quality, quantity, potency, purity, standard and the price of
---------------------- goods and services as the case may be, so that he can protect himself
against unfair trade practices like being misguided and cheated.
----------------------
iii) Right to a Competitive Price: Wherever possible, the consumer must be
---------------------- assured of an access to a variety of goods and services at a competitive
price. This right, on the one hand accepts the freedom of retailers from the
---------------------- exploitative conditions imposed by the producers and on the other hand,
contains the monopoly powers of the producers.
----------------------
iv) Right to be Heard: The establishment of appropriate forums at various
---------------------- levels aims at hearing the grievances of the consumers.
---------------------- v) Right to Information regarding Protection: By passing an act the
interests of the consumers cannot be protected unless the consumers have
---------------------- full knowledge of the protection given to them. It is therefore necessary

to educate the consumers about the protection guaranteed to them. It is Notes
therefore, necessary to educate the consumers in this regard.
----------------------
Consumers protection involves protection from unfair trade
practices for the purpose of promoting sales and making money at the ----------------------
cost of the consumers health and well-being. Such practices include; a)
False representation of the quality, quantity, grade, composition, style, etc. of ----------------------
the product; b) False claims regarding the quality, grade or effectiveness of
----------------------
a service; c) False representation regarding re-built, removed, reconditioned
or old goods as new goods; d) False claims regarding sponsorship, approval, ----------------------
performance uses or benefits which the goods really do not possess; e) false
representation regarding affiliation or authorized dealership; f) misleading ----------------------
representation concerning the need for or the usefulness of goods/services; and
----------------------
g) giving as untested or unrealistic guarantee regarding the quality/performance
of the goods /services. ----------------------
Protection of a consumer’s freedom to buy the goods and services of his
----------------------
choice is necessary, and goods which are found defective must be treated as
an infringement of his freedom of choice. Therefore, action is required to be ----------------------
taken against the producers/ sellers of substandard goods and services. For
this purpose action based upon certain standards should be laid down, like ----------------------
AGMARK or ISI seal, can be taken by the government. Similarly, protection
----------------------
against deficiency in the product or service implying a fault, imperfection,
shortcoming or inadequacy in the quality, nature or performance has got to be ----------------------
accorded.
----------------------
It is necessary to remember that in respect of the protection of consumer’s
interests, the Consumer Protection Act is not only an act, in fact, the Indian ----------------------
Contract Act, the Sale of Goods Act, the Negotiable Instrument Act, the
Banking Regulation Act, the Companies Act etc., also contain provisions ----------------------
regarding protection accorded to the consumers in cases relevant under the
----------------------
Act concerned. Because the Consumer Protection Act is specially intended
and framed for this purpose, we have discussed some of the provisions/ ----------------------
considerations of this Act.
----------------------
Under the various Acts, in accordance with the provisions in this regard,
the consumer has to be provided with an access to the machinery evolved for ----------------------
or already existing to the redressal of his grievances. As an aggrieved party, the
consumer can take recourse to filing suits in the relevant court of law. ----------------------
For instance, it was claimed that the level of certain ingredients in Coke ----------------------
are injurious to health; so there was a lot of protest in this regard. The company,
in turn, brought in popular faces - whom the people can relate to – to defend its ----------------------
product. ----------------------
Obviously, this whole issue of consumer protection is shrouded with
complexities and demands on the government to undertake the responsibility ----------------------
of safeguarding the interests of the consumers not only as consumers but also ----------------------
as ordinary citizens of the land. This is a part of the normal functions of the
government and it is in conformity with the government’s responsibility in the ----------------------

Notes dispensation of natural justice. As such, it involves various steps by way of
creating machinery, monitoring the performance and penalizing the defaulters.
---------------------- This in turn, created the need for maintaining inspection/ supervision personnel,
procedures for enforcing the laws and actions for penalizing the defaulters and
---------------------- compensating the sufferers. Needless to say that this is a major and pervasive
---------------------- intervention in the system of marketing and pricing. In this context, it is essential
to implement the suggestions and recommendations given by a committee
---------------------- headed by Anna Hazare, a great Social Reformer. He is a social activist who
fights against corruption in the government. He takes up causes like high suicide
---------------------- rate of farmers in Maharshtra, by courageously taking up hunger strikes in order
---------------------- bring the government machinery to task.
---------------------- 14.6 THE NEW INDUSTRIAL POLICY 1991

---------------------- The Congress Government led by Mr. Narasimha Rao announced the new
---------------------- industrial policy in July 1991. The main aim of the new industrial policy was:
(a) to unshackle the Indian industrial economy form the cobwebs of
---------------------- unnecessary bureaucratic control,
---------------------- (b) to introduce liberalisation with a view to integrate the Indian economy
with the world economy,
----------------------
(c) to remove restrictions on direct foreign investment as also to free the
---------------------- domestic entrepreneur form the restriction of MRTP Act, and,
---------------------- (d) The policy aimed to shed the load of the public enterprises which have
shown a very low rate of return or are incurring losses over the years.
----------------------
All these reforms of industrial policy led the government to take a series
---------------------- of initiatives in respect of policies in the following areas: (a) Industrial
licensing; (b) Foreign investment; (c) Foreign technology policy; (d)
---------------------- Public sector policy; and (e) MRTP Act.
---------------------- (I) Industrial Licensing Policy
---------------------- In the sphere of industrial licensing, the role of the government was
to be changed from that of only exercising control to one of providing
---------------------- help and guidance by making essential procedures fully transparent and
by eliminating delays.
----------------------
(A) Industrial Licensing to be abolished for all projects except
---------------------- for a short list of industries related to security and strategic
---------------------- concerns, social reasons, hazardous chemicals and overriding
environmental reason and items of elitist consumption. Industries
---------------------- reserved for the small scale sector will continue to be so reserved.
---------------------- List of Industries in respect of which Industrial Licensing will

be Compulsory
----------------------
1. Coal and Lignite. 2. Petroleum (other than crude) and its
---------------------- distillation products. 3. Distillation and brewing of alcoholic

drinks. 4. Sugar. 5. Animal fats and oils. 6. Cigars and cigarettes Notes
of tobacco and manufactured tobacco substitutes. 7. Asbestos and
asbestos based products. 8. Plywood, decorative veneers, and other ----------------------
wood based products such as particle board, medium density fiber
board, block board. 9. Raw hides and skins, leather, chamois leather ----------------------
and patent leather. 10. Tanned or dressed fur skins. 11. Motor cars. ----------------------
12. Paper and Newsprint except bagasse-based units. 13. Electronic
aerospace and defense equipment; all types. 14. Industrial ----------------------
explosives, including detonating fuse, safety fuse, gun powder,
nitrocellulose and matches. 15. Hazardous chemicals. 16. Drugs ----------------------
and Pharmaceuticals (according to Drug Policy). 17. Entertainment ----------------------
Electronics (VCRs, Colour TVs, C.D. Players, Tape Recorders).
18. White goods (Domestic Refrigerators, Domestic Dish Washing ----------------------
Machines, Programmable Domestic Washing Machines, Microwave
ovens, Air Conditioners). ----------------------
The compulsory licensing provisions would not apply in ----------------------

respect of the small-scale units taking up the manufacture of any of
----------------------
the above items reserved for exclusive manufacture in small sector.
(B) Areas where security and strategic concerns predominate, will ----------------------
continue to be reserved for the public sector.
----------------------
List of Industries to be reserved for the Public Sector
----------------------
1. Arms and ammunition and allied items of defense equipments,
Defense aircraft and warships. 2. Atomic Energy. 3. Coal and lignite. ----------------------
4. Mineral oils. 5. Mining of iron ore, manganese ore, chrome ore,
gypsum, sulphur, gold and diamond. 6. Mining of copper, lead, ----------------------
zinc, tin, molybdenum and wolfram. 7. Minerals specified in the ----------------------
Schedule to the Atomic Energy (Control of production and use)
Order, 1953. 8. Railway transport. ----------------------
(C) In projects where imported capital goods are required, automatic ----------------------
clearance will be given in cases where foreign exchange availability
is ensured through foreign equity; or if the CIF value of imported ----------------------
capital goods required is less than 25% of total value (net of taxes)
of plant and equipment, up to a maximum value of Rs. 2 crore. ----------------------
In other cases, imports of capital goods will require clearance form ----------------------
the Secretariat of Industrial Approvals (SIA) in the Department
of Industrial Development according to availability of foreign ----------------------
exchange resources.
----------------------
(D) In locations other than cities of more than 1 million population,
there will be no requirement of obtaining industrial approvals from ----------------------
the Central Government except for industries subject to compulsory
----------------------
licensing. In respect of cities with population greater than 1 million,
industries other than those of a non-polluting nature such as ----------------------
electronics, computer software and printing will be located outside
25 kms of the periphery, except in prior designated industrial areas. ----------------------

Notes (II) Foreign Investment
In order to invite foreign investment in high priority industries,
---------------------- requiring large investment and advanced technology, it has been decided
---------------------- to provide approval for direct foreign investment upto 51 per cent foreign
equity in such industries.
---------------------- (III) Foreign Technology
---------------------- With a view to injecting the desired level of technological dynamism
in Indian industry, government would provide automatic approval for
---------------------- technology agreements related to high priority industries within specified
---------------------- parameters. No permission will be necessary for hiring of foreign
technicians, foreign testing of indigenously developed technologies.
---------------------- Initially there was collaboration and that too was too difficult to
---------------------- happen. For example, the relationship of India & Suzuki gave birth to
Maruti and today you get the foreign branded stuffs as it is by putting
---------------------- up their plants in our country and the product itself gets manufactured
completed on our grounds using Indian labour, for example, all foreign
---------------------- cars that rae available in India are manufactured in India, to name a few,
AVEO, Honda City, TOYOTA etc. most of the TV companies are foreign
----------------------
brands- hardly one may find indigenous TVs.
---------------------- (IV) Public Sector Policy
---------------------- Public enterprises have shown a very low rate of return of the
capital invested. This has inhibited their ability to regenerate themselves
---------------------- in terms of new investments as well as in technology development. The
result is that many of the public enterprises have become a burden rather
----------------------
than being an asset to the Government.
---------------------- The 1991 Industrial Policy has adopted a new approach to public
---------------------- enterprises. The priority areas for growth of public enterprises in the
future will be the following :
----------------------
(a) Essential infrastructure goods and services.
---------------------- (b) Exploration and exploitation of oil and mineral resources.
---------------------- (c) Technology development and building of manufacturing capabilities
in areas which are crucial in the long term development of the
---------------------- economy and the long term development of the economy and where
---------------------- private sector investment is inadequate.
(d) Manufacture of products where strategic considerations predominate
----------------------
such as defence equipment.
---------------------- Government will strengthen those public enterprises which fall in
---------------------- the reserved areas or are generating goods or reasonable profits. Such
enterprises will be provided a much greater degree of management
---------------------- autonomy through the system of memoranda of understanding.
Competition will also be induced in these areas by inviting private sector
----------------------

participation. In the case of selected enterprises, part of Government Notes
holdings in the equity share capital of these enterprises will be disinvested
in order to provide further market discipline to the performance of public ----------------------
enterprises.
----------------------
There are a large number of chronically sick public enterprises
incurring heavy losses, operating in a competitive market and serving ----------------------
little or no public purpose. The following measures are being adopted. ----------------------
(i) BIFR - Public enterprises which are chronically sick and which are
----------------------
unlikely to be turned around would, be referred to the Board for
Industrial and Financial Reconstruction (BIFR) for formulation of ----------------------
revival / rehabilitation schemes. A social security mechanism is to
be created to protect the interests of workers likely to be affected by ----------------------
such rehabilitation packages. ----------------------
(ii) Disinvestment - In order to raise resources and encourage wider
----------------------
public participation, a part of the government’s shareholding in the
public sector would be offered to mutual funds, financial institutions, ----------------------
the general public and workers.
----------------------
(iii) Boards of public sector companies would be made more professional
and will be given greater powers. ----------------------
(iv) There would be greater trust on performance improvement ----------------------
and managements would be granted greater autonomy through
Memorandum of Understanding (MOU) and would be held ----------------------
accountable. ----------------------
14.7 MRTP ACT ----------------------
With the growing complexity of industrial structure and the need for ----------------------
achieving economies of scale for ensuring higher productivity and competitive
----------------------
advantage in the international market, the interference of the Government
through the MRTP Act has to be restricted. Towards this end: ----------------------
(i) The pre-entry scrutiny of investment decisions by so-called MRTP ----------------------
companies will no longer be required. Instead, the emphasis will be
on controlling and regulating monopolistic, restrictive and unfair trade ----------------------
practices rather than making it necessary for the monopoly houses to obtain
prior approval of Central Government for expansion, establishment of ----------------------
new undertakings, merger, amalgamation and takeover and appointment ----------------------
of certain directors.
(ii) The thrust of policy will be more on controlling unfair or restrictive ----------------------
business practices. ----------------------
----------------------
----------------------

Notes
----------------------

1. The formation of cooperatives is one of the ways of _________the
----------------------
________of the consumers.
---------------------- 2. The reforms of industrial policy led the government to undertake initiatives
such as industrial licensing, ____________, foreign ___________,
----------------------
public sector policy and _____________.
---------------------- 1. Pre-entry scrutiny of investment decisions by MRTP companies are
required.
----------------------
2. The thrust of industrial policy is more on controlling unfair or restrictive
---------------------- business practices.
----------------------
14.8 DE-RESERVATION - FURTHER LIBERALISATION
----------------------
---------------------- (A) The Government decided in April 1993 to remove three more items
from the list of 18 industries reserved for compulsory licensing. These
---------------------- three items were: motor cars, white goods (which include refrigerators,
washing machines, air conditioners, etc.) and raw hides and skins and
----------------------
patent leather. The basic purpose of dereservation of these items was to
---------------------- increase the flow of investment in these industries. With the growth of a
large middle class, ranging between 100 to 120 millions, the demand for
---------------------- the white goods like washing machine, refrigerators, air conditioners is
---------------------- growing and these items are no longer viewed as luxury goods. Similarly
the demand for motor cars by the upper middle class and the affluent
---------------------- sections is also growing, more especially when the government is
providing loans to business executives and other senior officials to buy
----------------------
cars. To provide a boost to the motor car and white goods industries, the
---------------------- government has decided to de-reserve these items so that their production
improves as response to the market, instead of remaining shackled by the
---------------------- bureaucratic process of licensing.
---------------------- Regarding raw hides and skins and patent leather, the Government
wants to push up their exports. Leather and good quality shoes have a
---------------------- tremendous export potential and the small scale units are ill equipped to
---------------------- provide quality goods for the international markets.
In pursuance of the liberalization policy towards foreign investment,
----------------------
the Government decided in December 1996 to include 16 categories of
---------------------- industries in respect of which automatic approval would be accorded
to foreign equity participation up to 51 per cent. This additional list
---------------------- of industries eligible for automatic approval up to 51 per cent foreign

equity cover a wide range of industrial activities in the capital goods and Notes
metallurgical industries, mining (up to 50 per cent), and those having
significant export potential. ----------------------
(B) The government, however, also added another list of nine industries for ----------------------
which automatic approval upto 74 per cent would be allowed. The nine
industries are mining, services related to oil and gas fields, basic metals ----------------------
and alloy industries, not-conventional energy sources, manufacture
----------------------
of navigational, meteorological, geophysical and related instruments
and apparatus, electric generation and transmission, construction and ----------------------
maintenance of roads, ropeways, ports, harbours, construction and
maintenance of power plants. Besides, land transport, water transport and ----------------------
storage and warehousing services have also been included.
----------------------
The basic thrust of these changes is that there will be no case-by-case
approval for various proposals lying before the government. The main aim ----------------------
of the major policy initiative is to facilitate foreign direct investment in ----------------------
infrastructure sector, core and priority sectors, export oriented industries,
linkage with agro and farm sectors. ----------------------
----------------------
14.9 ECONOMIC LIBERALISATION
----------------------
The first phase of economic reforms is believed to have begun in 1985
when Rajiv Gandhi enunciated the uppermost goals of the new economic policy ----------------------
as improvement in productivity, absorption of modern technology and full
utilization of capacity. The strategy visualized for the purpose gave increasingly ----------------------
greater scope for the private sector This shift in favour of the private sector
----------------------
encompassed a wide range of measures demanding a reformulation of several
policies like the industrial licensing policy, export import policy, policy towards ----------------------
foreign capital, policy regarding rationalization and technology upgradation
----------------------
etc., which are covered by the umbrella of economic reforms.
The real all-pervading beginning of economic reforms were however ----------------------
witnessed since the installation of the P.V. Narsimha Rao’s Congress Government ----------------------
in Mid-1991 The reigns of the reforms were in the hands of Dr. Manmohan
Singh the then Finance Minister, who enumerated the objectives of the new ----------------------
Economic Policy as under:
----------------------
a) To increase the efficiency and international competitiveness of industrial
production. ----------------------
b) To utilize foreign investment and technology to a much greater degree ----------------------

than in the past,
----------------------
c) To improve the performance and rationalize the scope of the public sector,
and ----------------------
d) To reform and modernize the financial sector so that it can more efficiently ----------------------
serve the needs of the economy.
----------------------

Notes For achieving these long-term objectives, the government undertook
to instill internal and external confidence in the economy by adopting
---------------------- stabilization measures, the major ones beings as follows:
---------------------- i) Fiscal Policy Reforms aimed at reducing the overall public sector
deficit from 12.5% to 4% of GDP by mid-nineties. This involved
---------------------- raising the income level through both tax and non-tax revenues and
---------------------- controlling public expenditure. This required a greater tax-effort, a
more realistic administered price structure, a reduction in subsidies
---------------------- and a better fiscal discipline.
---------------------- ii) Financial Sector Reforms based on stricter monetary policy first and
then a reversal to a liberal policy, embraced a wide range of industrial
----------------------
areas including the Reserve Bank, Scheduled Banks, Co-operative
---------------------- Banks, Foreign Banks, Mutual Funds Insurance Companies, Housing
Finance Companies, and Stock exchanges. Measures as recommended
---------------------- by both the Narasimham Committees (1991 and 1998) and accepted
---------------------- by the Government included a restructuring of controls by the RBI
and the SEBI, norms of capital adequacy, insistence of credit rating
---------------------- and scaling down of interest rates and more autonomy to the financial
---------------------- institutions. All these aimed at strengthening the financial sector and
making it more competitive.
----------------------
iii) Social Sector Policy was guided by the needs of human development.
---------------------- It aimed at revitalized efforts at poverty alleviation, spread of
education through formal and nonformal streams, employment
---------------------- guarantee initiatives, supply of safe drinking water, revamping of
housing programmes, immunization and other health measures
----------------------
and special attention to the welfare of woman, children and the
---------------------- privileged sections of the society.
---------------------- iv) Industrial Policy was thoroughly reformed so as to provide

unhindered and uninhibited access to new initiatives by the domestic
---------------------- as well as foreign private sector. This was sought to be achieved
by following a phased programme of de-regulation. Expecting the
---------------------- industries of strategic importance in the areas of defence, defence
---------------------- production and internal energy and such other industries related to
protection of environment and internal security, industrial licensing
---------------------- was abolished. The Monopolies and Restrictive Trade Practices
Act was amended and modified so that the big industrial houses do
---------------------- not need prior permission of the Government either for expansion
---------------------- or for establishing a new undertaking. Areas of industrial activity
reserved for the public sector were opened to the private sector,
---------------------- thereby narrowing down the scope of the public sector.
---------------------- v) The policy regarding Foreign Capital was recast so as to attract
foreign capital, increase foreign exchange earnings, avail of
---------------------- marketing techniques. For this purpose, several reforms and changes

were made in the policy. Direct Foreign Investment, up to 51%, Notes
was permitted in export oriented industrial units, trading companies
too could have 51% foreigners held equity if they were primarily ----------------------
engaged in export trade. For foreign collaborations, automatic
----------------------
permission was granted subject to a ceiling on royalty payment of
5% of domestic trade and 8% of export trade or a lumpsum of Rs. 1 ----------------------
crore.
----------------------
vi) Trade Policy was modified, in phases, so as to remove most of
the protection granted to Indian industries and to make them ----------------------
internationally competitive import and export duties were readjusted
in keeping with the WTO agreement with effect from April 2001, ----------------------
all quantitative restrictions on imports were removed and a price- ----------------------
based system of duties, wherever necessary, was substituted.
vii) Public Sector Policy underwent an overhaul. The new involved ----------------------
a more realistic review of earlier policy, greater autonomy to ----------------------
units which needed to continue in the public sector, a progressive
reduction in the budgetary support to public sector, a discipline to ----------------------
make public sector undertaking (PSUs) more competitive and cost-
effective and making all PSUs self-reliant (no losses to be incurred). ----------------------
With these ends in view, the measures taken included (a) reduction ----------------------
in the number of industries reserved for the public sector from 17to 8,
----------------------
(b) rehabilitation of sick units through BIFR (Board for Industrial and
Financial Reconstruction), (c) a close monitoring to ensure profitability, ----------------------
and (d) a policy of disinvestment. Besides, several steps for protecting
the interests of the employees were taken which included VRS packages, ----------------------
retaining programmes etc. ----------------------
A preview of the deals of liberalisation is not very encouraging
----------------------
from certain angles. It has opened up new avenues for enterprise and has
attained some success in terms of global linkages of the Indian economy. ----------------------
However, the rates of industrial growth have fallen, agriculture remains
neglected, regional as well as personal income disparities have widened ----------------------
and poverty, unemployment and development have attained higher
----------------------
magnitude, as if to mock reforms!
----------------------
14.10 THE PROCESS OF DISINVESTMENT: NEED AND
----------------------
METHODS
----------------------
With economic liberalisation, the private sector was given more freedom
and greater scope in the interest of improving the overall performance of the ----------------------
economy as a whole. Greater scope for the private sector may mean incremental
disinvestment which connotes the expansion of PSUs can be left to some private ----------------------
company. It may also mean denationalisation of the public sector units taking ----------------------
private sector as a partner. In other words, disinvestment is a part of the process
of privatisation. ----------------------

Notes (A) Need for Disinvestment
Over a period of four decade beginning with 1950s, the scope of public
----------------------
sector was continuously expanding, due to various reasons like lack of
---------------------- public sector’s funds, no interest on the part of private sector in undertaking
long-term investment projects and so on. With the onset of the New
---------------------- Economic Policy oriented towards providing an upper hand to the private
sector, a reversal of the erstwhile policy of public-sector-dominance was
----------------------
set in motion. As a part of this, the process of disinvestment which meant
---------------------- selling of the shares of a PSU to private corporates and individuals started.
By selling stocks the public sector could encash part of its investment and
---------------------- hence, the term disinvestment.
---------------------- The need for disinvestment can arise due to any one or more of the
following reasons:
----------------------
i) Phased Privatisation: Larger scope for the private enterprise means
---------------------- shrinking of the public sector. This is done through disinvestment.
ii) Professionalism: In a highly dynamic modern world, efficiency and
----------------------
competitive strength requires the association of professional and
---------------------- management experts with the PSUs (public sector undertakings).
But the cream of such expertise is always attracted by the private
---------------------- sector by offering them lucrative, flexible and potentially progressive
working conditions. If this expertise is to be available to the public
----------------------
sector, the public sector must offer a share in ownership to the
---------------------- private sector. The public sector in India has continuously been
under criticism for its lack of professional approach, mainly due
---------------------- to the fact that most of these units are headed by administrative
experts rather than management experts.
----------------------
iii) Reducing Deficits: As noted earlier, the Government of India was
---------------------- keen on reducing the overall deficit of the public sector to 4% of
GDP. For this purpose it needed funds which would help bridge the
---------------------- gap. Disinvestment provided an opportunity of selling stocks and
---------------------- raising funds.
iv) Re-allocation of Resources: Conceptually, the process of
---------------------- disinvestment amounts to reallocation of resources between the
---------------------- private and the public sectors. This step, in the new business
environment, was expected to improve the productive efficiency of
---------------------- the PSUs, thereby paving the way for improving the performance of
the economy as a whole.
----------------------
v) Capital Support to Plans : Non-Plan expenditure has been
---------------------- continuously increasing due to a number of reasons like higher rates
of D.A. for the employees, a rise in the salary bill due to the Fifth Pay
---------------------- Commission’s recommendations, rising prices of goods purchased
plan projects which needed capital support were therefore, starved
---------------------- of investible funds. Disinvestment accruals are a part of the capital
---------------------- receipts and can be diverted to the capital needs of the plan projects.

vi) Substitute for Taxation : If we take into account the ground-level Notes
need in the midst of present difficulties faced by the Government
of India, the disinvestment programme apparently is viewed by the ----------------------
government as a substitute of greater tax-effort and curtailment of
subsidies both of which are being opposed by parties in the coalition. ----------------------
‘Selling family silver’ for getting a series of square meals over a
----------------------
number of days appears to be a softer option for tiding over the
financial crisis temporarily. ----------------------
(B) Methods of Disinvestment
----------------------
Disinvestment, in itself, is a method of privatization. The methods
followed are as under: ----------------------
1) Partial Transfer of Ownership: Disinvestment mostly is through ----------------------
this method of ownership transfer under which the ownership is
transferred fully or partly. In the present method we are concerned ----------------------
with partial ownership transfer. Ownership can be transferred by
----------------------
selling a part of the shares to individuals, co-operative societies or
corporate organizations. Such a transfer results in the creation of ----------------------
joint sector where the public sector and the private sector jointly
hold the stocks, jointly exercise their voting rights and jointly ----------------------
participate in the exercise of control.
----------------------
In India, the proposals of creating a joint ownership are
contemplated on the following three lines: ----------------------
i) Transfer of 25% of shares to the private sector (i.e. to banks, to ----------------------
mutual funds) corporations or individuals including workers
who are given a share up to 5% of the total equity. This type of ----------------------
transfer ensures government control with private partnership
that enables the unit to avail the guidance and advice of the ----------------------
private sector. ----------------------
ii) Government may retain 51% of the equity with itself and
transfer 49% to similar private sector partners/s. It provides ----------------------
for a sizeable ownership transfer. At the same time the ----------------------
majority voting rights remain with the government.
iii) In this case, majority of the ownership i.e. 74% is transferred ----------------------
to the effective private partner, while the government retains ----------------------
26% with itself. As saving clause, with the provision of veto
power the government can influence the major decisions. ----------------------
So far as the first variant is concerned, it is not likely to be very ----------------------
effective in achieving the objective of greater operational efficiency
and higher level of competitiveness. The second variant transfers ----------------------
almost half ownership and as such, is likely to bring about certain
noticeable changes in terms of revamping of managerial practices, ----------------------
cost-effectiveness and the units capacity to generate profits, for the
----------------------
simple reason that the stakes are higher for the private sector. In
case of the third variant, the private sector will be the real owner in ----------------------

Notes matters of policy decisions and operational control. Government’s
veto power is reserved only for ensuring that the firm’s operation is
---------------------- consistent with the macroeconomic objectives. Micro-decisions are
left fully in the hands of the private sector.
----------------------
2) Total Denationalization: The second method involves a complete
---------------------- sellout of a PSU to a private corporate organization- it may be
domestic or foreign or a collaboration concern. Such a step can be
---------------------- taken under a number of possible situations. Firstly, it is possible that
the unit which earlier existed in the private sector was nationalized,
----------------------
with a specific objective. Once the objective is fulfilled, the
---------------------- same unit can be denationalized. Secondly, it is possible (though
conceptually only!) that the unit was sick and was taken over by
---------------------- the state. After its complete recovery and rehabilitation, the same
can be handed back to the private sector. Finally, a PSU is incurring
---------------------- losses due to mismanagement in the public sector. If a private body
---------------------- corporate comes forward with confidence to set things right, it can
buy the entire unit with all assets and liabilities.
---------------------- 3) Liquidation: By going through the procedure laid down by the
---------------------- constitution/MOU of the PSU, the government may announce its
decision of going into liquidation in case of the unit concerned. A
---------------------- private buyer may buy it and use the assets so purchased for the
same type of production or for some other variety of production
----------------------
4) Management buy-out: As a special case of de-nationalization, a PSU
---------------------- can be sold to the employees of the project. All the assets could be sold
to the employees’ organization which could be formed as a worker’s
---------------------- cooperative, or they can form a joint company’s act. Provision of bank
finance for enabling the workers to buy the assets can be made. The
----------------------
employees would continue getting wages as before plus a divided from
---------------------- the companies pool of distributed profits.
5) Disinvestment without privatisation: One more method of
----------------------
disinvestment which is mainly designed to overcome the capital
---------------------- paucity is to sell part of the equity to other public sector organization
mainly from the financial system. The buyers of stocks, in such
---------------------- cases, can be the Life Insurance Corporation of India, the General
---------------------- Insurance Corporation of India, the Industrial Development Bank
of India, and the Unit Trust of India and so on.
---------------------- (C) Methods of Implementation
---------------------- Once the decision is taken, the option of disinvestment to be chosen as
a method of disinvestment, i.e. actual implementation of the decision
---------------------- to part with ownership either partially or wholly, either in favour of the
---------------------- employees or in favour of other public sector institutions etc. There are
various methods of implementation for achieving this end.
----------------------
1) Sale of Stocks and Allotment: Like any other company, a PSU can
---------------------- announce a new issue or the existing shares with a premium can

be offered for sale and a policy of allotment can be declared. The Notes
prospective buyers will be allotted with the subscribed number of shares.
In keeping with the goals to be predetermined, the PSU concerned can ----------------------
decide upon a premium over and above the face value and can also
----------------------
decide the mode of allotment. It would include the proportion to be
allotted to individuals, the same to be sold to institutions and so on. ----------------------
2) Negotiating joint Ownership: When a part of equity is to be sold ----------------------
to a prospective buyer, such a buyer has got to be identified and
then the terms and conditions of partial transfer of ownership are ----------------------
to be negotiated. When an agreement is reached and is duly signed,
----------------------
the process of disinvestment is carried out in accordance with the
agreement, i.e. whether the entire sum is to be paid in a lump sum ----------------------
or whether it is to be paid partly or wholly in a foreign currency
or whether payment to be made is through installments, etc. This ----------------------
method can be adopted where specialized products are involved are ----------------------
a few reputed accountability, the whole deal must be transparent
and a fairly reasonable price must be negotiated. ----------------------
3) Open Auction: Another method is the auction method. Under this ----------------------
method, the government may announce its intention to sell a given
amount of shares to a particular class of buyers (e.g. individuals, ----------------------
resident or non-resident, institutional: domestic or/ and foreign etc.) ----------------------
and may invite bids or offers. The highest bid may be accepted.
However, this can be qualified with other conditions like technical ----------------------
know-how, managerial track-record, market reputation and so on.
----------------------
It is possible that a prospective buyer offers a second best price but
has a very good track-record and a reputation in the market. Such ----------------------
an offer may be accepted.
----------------------
4) Informal Approach: Informally, the government department
concerned or the PSU itself may probe into the world-wide ----------------------
corporate sector for finding a prospective partner. Such a buyer may
----------------------
then be contacted and the terms and conditions may be finalized.
These terms and conditions would include the payment in foreign ----------------------
or domestic currency, its mode; powers etc. and such a deal would
be subject to the approval of the public authorities concerned like ----------------------
the disinvestment committee and the parliament. ----------------------
5) Pre-planned Transfer: In cases of types (4) and (5) discussed
----------------------
above, a systematic plan can be prepared and worked out. When the
company is to be handed over to the employees, all details like price ----------------------
per share amount of down payments, the mode of allotment, loan-
arrangements phased transfer of management, policy regarding ----------------------
managerial/supervisory staff, the form of oraganisation to be ----------------------
adopted etc. are to be well planned and then the whole plan has got
to be implemented. ----------------------

Notes Where the ownership is to be partially transferred to other public
sector institutions, the quota given to each such institution is fixed
---------------------- in consultation with these institutional buyers as well as the central
bank of the country.
----------------------
6) Systematic Denationalisation: Such a step involves a phased
---------------------- programme. Generally, stocks are dispensed within lots and then
---------------------- the promoters or the business house concerned would elect/select
a board of directors and take over the responsibility. A phased out
---------------------- programme is preferred because a sudden transfer may send shock
waves in the stock market as well as among the working classes
----------------------
and the employees. Repercussions on demand are also expected
---------------------- through a change in the expectations of the consumers.
---------------------- 7) Liquidation: In case of liquidation, the procedure is analogous to

any private company going into liquidation. Asset values are low,
---------------------- share-prices are to be valued through assessors and share holder
being the government, it receives payment in installments and on
----------------------
the basis of the price decided by the assessor/expert committee
---------------------- appointed for this task.
---------------------- Summary
----------------------
●● The government holds tremendous authority not only to influence the
---------------------- private business decisions but also to control and regulate, directly and
indirectly the private business activities (MRTP ACT). The government
----------------------
can also intervene through various economic policies like fiscal, monetary,
---------------------- etc.
●● The need for government intervention arises because of failure of free
----------------------
market economy, which cannot ensure the proper distribution of basic
---------------------- needs, income and wealth.
●● There are various factors for rising prices that can be classifies as demand-
---------------------- pull and cost push factors.
---------------------- ●● The cost-push factors can be given as raising of administered prices,
taxation policies, and fluctuations in production and so its distribution in
---------------------- the market.
---------------------- ●● Under monetary measures, the government controls money supply,
bank rate, bank credit and uses tools like the cash reserve ratio. Under
---------------------- fiscal measures, government controls its own expenditure in the wake
---------------------- of revenue deficit and fiscal deficit; it sought to control the disposable
income and dividend incomes.
----------------------
----------------------
----------------------

Keywords Notes
----------------------
●● Administered Price : Government intervenes to check the price rise of
mainly public goods, thus government ‘administers’ or keeps the price ----------------------
under control; normally set on the basis of cost plus stipulated margin of
profit. ----------------------
●● Consumer Protection : Protection of the consumer from certain hazardous ----------------------

goods and services and conferring certain rights to the consumer, the
----------------------
violation of which the consumer can seek legal help, as sanctioned by the
consumer protection act, 1986. ----------------------
●● Deficit Financing : Tool in the hands of the government that increases ----------------------
the supply of money in the economy, mainly leading to rise in prices.
----------------------
●● Dual Pricing : System adopted by the government of charging lower
prices to poor sections and higher prices to the richer class of society. ----------------------
●● Denationalisation : Complete sell-out of a PSU to a private organisation ----------------------
– domestic, foreign or a collaboration.
●● Disinvestment : Government’s shareholding in the public sector is offered ----------------------
for private participation, in the form of mutual funds, financial institutions, ----------------------
general public, etc. To raise financial resources for the government.
----------------------
●● De-reservation : The private and even the foreign sector are now allowed to
invest in those industries which were initially completely under government ----------------------
monopoly.
----------------------
●● Economic Liberalisation : Economic reforms which opened the door
of our economy to foreign companies, in terms of FDI (foreign direct ----------------------
investment) or free flow of foreign goods, services and technology to
----------------------
Indian shores.
●● Fiscal Deficit : Gap between mounting public expenditure and government ----------------------
revenue like taxation.
----------------------
●● Foreign Investment : Foreign companies are invited and/or allowed to
invest in the share capital of the domestic companies. ----------------------
●● Inequalities of Income : Concentration of wealth in a few rich hands of ----------------------
society
----------------------
●● and Wealth due to its unequal distribution.
●● Industrial Licensing : In the light of industrialization, the government ----------------------
takes the reigns of supreme power in exercising control by way of ----------------------
proving guidance, by bringing in complete procedural transparency and
eliminating delays. ----------------------
●● International : Uplifting the standards (productivity) of domestic ----------------------
●● Competitiveness products in order to suit those traded in the international
markets. ----------------------

Notes ●● Management Buy-out : A PSU being sold to the employees of the project.
●● Procurement Price Policy : Policy which is to effect fair and proper
----------------------
production, purchase, movement, sale and distribution of mainly food
---------------------- grains.
●● Public Distribution System : That which is to effect a fair distribution
----------------------
of essential commodities (keeping in mind specially the weaker class of
---------------------- the economy) at controlled prices through fair price shops at government.
●● Privatisation : Complete take-over of the public enterprise (government-
----------------------
owned) by the private sector.
----------------------
---------------------- 1. What is the need for government’s intervention in a free enterprise market
economy?
---------------------- 2. Explain the causes of price rises in India. What are its consequences?
---------------------- 3. Briefly outline the various measures taken by the government to control
the problem of rapidly rising prices in India.
----------------------
4. Explain the policy of economic liberalisation as followed in India.
----------------------
5. Write notes on :
---------------------- a. Support prices
---------------------- b. Administered prices
c. Public Distribution System (PDS)
----------------------
d. Price controls
----------------------
e. Consumer Protection Act
---------------------- f. Methods of implementing the policy of disinvestment
---------------------- g. Disinvestment of Public Sector Undertakings in India
---------------------- h. Limitations of market system
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------
----------------------

----------------------
Fill in the blanks.
----------------------
1. Post Second World War, inflation has been built in to the Indian economy
due to ever-increasing demand and inadequately rising supply. ----------------------
2. RBI uses its monetary policy to achieve judicious balance between growth
----------------------
and control of price level.
1. True ----------------------
2. True ----------------------
3. False
----------------------
1. The formation of cooperatives is one of the ways of protecting the interest ----------------------
of the consumers.
----------------------
2. The reforms of industrial policy led the government to undertake initiatives
such as industrial licensing, foreign investment, foreign technology ----------------------
policy, public sector policy and MRTP Act.
----------------------
----------------------
1. False
2. True ----------------------
Fill in the blanks.
----------------------
1. Disinvestment is a part of the process of privatisation.
----------------------
2. Various rounds of disinvestment were carried out in pursuance of
Industrial Policy of the year 1999. ----------------------
1. True
----------------------
2. False
3. False ----------------------
----------------------
Suggested Reading
----------------------
1. Ahuja, H. L. 2005. Advanced Economic Theory (Microeconomic ----------------------
Analysis). New Delhi: Sultan Chand & Sons.
2. Gopalkrishna, D . 2003. A Study in Managerial Economics. Mumbai: ----------------------
Himalaya Publishing House. ----------------------

Notes
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References Notes
1. Economics - Samuelson ----------------------
----------------------
2. Introduction to Positive Economics - Richard Lipsey
----------------------
3. A Study of Managerial Economics - D. Gopalkrishna
----------------------
4. Managerial Economics - Maheshwari and Varshney
----------------------
5. Advanced Economic Theory (Micro Analysis) - H. L. Ahuja ----------------------
6. Indian Economy - Ruddar Datt & K.P. M. Sundaram ----------------------
----------------------
7. Indian Economy - A. N. Aggarwal
----------------------
8. Industrial Economics (an Introductory Text Book) - R. R. Barthwal
----------------------
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References 381
Notes
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Glossary Notes
1. Producer : Anyone who helps to produce goods or services. ----------------------
2. Consume : Anyone who consumes to satisfy his or her wants. ----------------------
3. Economic problem : Problem arising due to unlimited wants and limited ----------------------
resources having alternative uses to satisfy them.
----------------------
4. Inventory : Stock of raw materials that is kept by a firm.
----------------------
5. Efficiency : Doing any activity without leaving anybody else worse off.
----------------------
6. Unemployment : Resources which are wanting to be employed, but are
remaining idle. ----------------------
7. Full employment : The resources that are ready to be employed are fully ----------------------
employed or fully utilized, contributing to the national output.
----------------------
8. Purchasing power : The amount of goods and services that money can buy.
----------------------
9. Production capacity : Given the resources, the total output that the country
can produce within a specific time period. ----------------------
10. Land : Natural resources. ----------------------

11. Labour : Human resources. ----------------------
12. Capital : Man-made tools of production. ----------------------
13. Entrepreneur : He is the thought behind the process of production; organizes ----------------------
all the factors and leads them to produce new products or revise old products;
undertakes risk. ----------------------
14. Determinants : Factors which are capable of bringing about changes in the ----------------------
particular variable.
----------------------
15. Wages : Reward to labour for the services rendered in the process of
production. ----------------------
16. Rent : Reward to land for the services rendered in the process of production. ----------------------
17. Interest : Reward to capital for the services rendered in the process of ----------------------
production
----------------------
18. Dynamic economy : Reverse to static economy; changes occurring in
techniques of production, supply of capital, business organizations, level ----------------------
of population, human needs, etc.
----------------------
19. Demand : Desire backed by adequate purchasing power.
----------------------
20. Depreciation : Loss of value due to the continuous use of an asset.
----------------------
21. Capital structure of firms : Proportions of bonds, equity, preference shares.
----------------------
Glossary 383
Notes 22. Speculation : Predictions about the future about certain changes to occur in
a particular direction, which eventually do happen, in most cases, because
---------------------- of the power of aggregate behaviour.
---------------------- 23. Direct relation : When the dependent variable changes in the same direction
with the change in the independent variable.
----------------------
24. Indirect relation : When the dependent variable changes in the reverse
---------------------- direction with the change in the independent variable.
---------------------- 25. Demand (price) elasticity : Degree of responsiveness of demand for a
commodity as a result of change in its price.
----------------------
26. Economic development : Increasing per capita income of a country over
---------------------- a period of time.
---------------------- 27. Economic planning : Organization of various economic activities of various
sectors of the economy that contribute to the national output, estimations
---------------------- about future growth factors, striving to in a planned way, to achieve the
---------------------- targeted rate of growth for the economy.
28. Foreign trade : The export and the import status of a country in relation to
----------------------
other nations.
----------------------
29. Established goods : Goods that are already released in the market for sale
---------------------- and consumers are aware of their presence in the market.
---------------------- 30. New products : Goods whish are yet to be introduced in the market.
31. Optimum proportion of inputs : The best possible combination of inputs
----------------------
employed in the process of production so as to get the maximum output
---------------------- with highest level of efficiency.
---------------------- 32. Total physical product : total quantity of output produced in physical terms,
by a firm during a period of time
----------------------
33. Marginal product : Change in total product caused as a result og one
---------------------- additional unit of available factor employed in combination with fixed
factors.
----------------------
34. Average product : Total physical product divided by the quantity of a
---------------------- variable factor.
---------------------- 35. Diseconomies : Disadvantages that accrue to a firm arising out of factors
that are internal or external to the firm because of the firm’s large scale
---------------------- production.
---------------------- 36. Selling costs : Advertising costs incurred by the firm in order to increase
sales of the product.
----------------------
37. Variable factor : The supply of which can be varied depending on the level
---------------------- of output and employment and costs.
---------------------- 38. Fixed factor : The supply of which remains constant.

39. Product / factor homogeneity : The products or the factors under Notes
consideration are identical in satisfying the consumer need or rendering the
service or contributing to production s the case may be. ----------------------
40. Break-even point : No profit no loss position of a firm. ----------------------
41. Market period : Very short period relating to few hours or few days. ----------------------
42. Equilibrium price : Price at which demand equals supply. ----------------------
43. Product differentiation : Similar product are differentiated on certain ----------------------
grounds like outward appearances or the tastes or the colour etc.
----------------------
44. Excess capacity : Firms are operating under less than full utilization resource
capacity. ----------------------
45. Actual costs : Costs that are actually incurred in the production period. ----------------------
46. Expected costs : Costs that are based on the forecasts of production and ----------------------
prices. ----------------------
47. Strategy : Decisions made and thus implemented to achieve set targets, in ----------------------
view of the set time limit also.
----------------------
48. PSUs : Public sector undertakings : firms or production houses that are
government-owned. ----------------------
49. Public goods : Goods that are produced and owned by the public sector ----------------------
(government-owned). ----------------------
50. Private goods : Goods that are produced and owned by the private sector.
----------------------
51. Bottlenecks : Generally infrastructural difficulties that come in the way
----------------------
of smooth production, distribution and expansion processes of goods and
services; mostly faced by the developing economies. ----------------------
52. Hoarding : Not making the goods available for release in the market; ----------------------
generally a malpractice followed to artificially hike the prices.
----------------------
53. Stabilization : Preventing the extreme ups and downs (booms and
----------------------
depression) in economic activities of a country, giving way to economic
growth. ----------------------
54. Free market economy : Allowing the free flow or the interplay of the market ----------------------
forces of demand and supply to operate and affect the price changes and so
on, without government interference. ----------------------
55. Instability : Frictional disturbances in the economy in the form of cyclical ----------------------
booms and depressions as a result of various independent decisions ----------------------
happening with a large number of consumption and production units at the
same time, generally features in a modern complex private economy. ----------------------
Glossary 385
Notes 56. Social welfare : Norm of increasing the satisfaction of one unit without
decreasing that of any other in society.
----------------------
57. Capitalist society : That which is mainly guided by profit motive and
---------------------- recognizes money as a yardstick of success.
---------------------- 58. Rivalry : Competing units put up against each other, either directly or
indirectly, in order to get as much hold over market as possible.
----------------------
59. Productivity : The capacity of a factor resource to contribute to production
---------------------- per unit of that factor within a specific time period.
---------------------- 60. Consumer sovereignty : Consumer enjoys complete freedom to spend his
income on whatever goods or services he prefers, he demands solely by his
---------------------- own preference.
---------------------- 61. Private enterprise : Total production o goods and services is completely
---------------------- in the hands of the private sector and government has no role to play.
62. Appraisal : Assessment (of a project) for its economic viability.
----------------------
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Notes
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References 387
Notes
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Glossary 389
Notes
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Glossary 391
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MANAGERIAL

(FOR PRIVATE CIRCULATION ONLY)

COURSE DESIGN AND REVIEW COMMITTEE

Published by Symbiosis Centre for Distance Learning (SCDL), Pune

Copyright © 2019 Symbiosis Open Education Society

Prof. Pradeep Datar

Unit No. TITLE Page No.

8 Production and Costs - II 165 – 186

Introduction to Managerial Economics 1

---------------------- 1.2 DEFINITIONS OF MANAGERIAL ECONOMICS

---------------------- 1. Prof. Spencer Singleman : “Managerial Economics deals with integration

Introduction to Managerial Economics 3

State True or False. ----------------------

4. Managerial economics is an applied branch of knowledge; it is applied ----------------------

Introduction to Managerial Economics 5

Introduction to Managerial Economics 7

---------------------- State True or False.

1.6 ECONOMIC PROBLEMS ----------------------

The source of economic problems: Resources and scarcity ----------------------

Introduction to Managerial Economics 9

Introduction to Managerial Economics 11

Introduction to Managerial Economics 13

Introduction to Managerial Economics 15

---------------------- Check your Progress 4

●● Managerial economics is such a stream of study that engulfs economic ----------------------

●● Production : Act of making goods and services. ----------------------

Introduction to Managerial Economics 17

---------------------- Self-Assessment Questions

---------------------- 1. Managerial Economics is a conglomeration of two streams – management

---------------------- 3. What is the nature and subject matter of Managerial Economics?

Match the following. ----------------------

2. Damodaran, Suma. 2010. Managerial Economics. New Delhi: Oxford ----------------------

Introduction to Managerial Economics 19

2.1 Meaning of Profit

---------------------- • Justify the criteria for “reasonable profit”

---------------------- Obviously, while calculating accounting profit, only explicit or book

---------------------- Gross Profit = Total Receipts - Total Expenditure

---------------------- Some portion should be deducted from gross profit by way of

(3) Innovation Theory of Profit ----------------------

---------------------- d) Changes in organisation of business

Check your Progress 1 ----------------------

---------------------- Therefore, Assets - Liabilities = Proprietorship or the net worth

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

---------------------- Check your Progress 2

i) The rate of profit should be sufficient to attract share capital ----------------------

2.6 REASONABLE PROFIT TARGET ----------------------

---------------------- Capital attracting standard

8. Write notes on: ----------------------

---------------------- Fill in the blanks.

---------------------- Check your Progress 3

3.1 Concept of Demand

---------------------- • State the law of demand

---------------------- 3.1 CONCEPT OF DEMAND

---------------------- In a capitalist economy, where there is unequal distribution of

Infants and children ----------------------

The above structure shows that the age-ratio of population of ----------------------

---------------------- Check your Progress 1

Price (Per Kg.)

---------------------- Market demand curve is derived by the horizontal summation of individual

---------------------- Fig 3.2 : Derivation of Market Demand Curve