managerial economic

MANAGERIAL

ECONOMICS

BY

Prof. Pradeep DatarM.A. (Economics)

Published by

Symbiosis Center for Distance Learning,Pune.

© Symbiosis Center for Distance Learning (SCDL)No part of this book may be reproduced or copied or transmitted

in any form without prior permission of the publisher.

April 2004

PREFACE

Dear Reader,

This book on Managerial Economics is written to present a simple text to the

students who have limited exposure to Economics and are pursuing a

programme in management studies.The book 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 book, I hope, would also help refresh

the practicing managers.

The book mainly lays emphasis on the applied part of the principles of

Economics. The text of the book relies on standard works on the subject. I am

deeply indebted to my teachers as well as colleagues, for inspiring me to write

this book. To cap it all, my special thanks to the Director and the respected

staff of Symbiosis Center for Distance Learning (SCDL) for their kind

cooperation.

Prof. Pradeep Datar

Pune.

April, 2004

ABOUT THE AUTHOR

The author of this book 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 Master 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.

Mrs. Swati Chaudhari

Director - S. C. D. L.

CONTENTS

Chapter TITLE Page

No. No.

1 Introduction to Managerial Economics 1

2 Types of business Organizations 17

3 Profit 65

4 Demand Analysis 83

5 Production and Costs 141

6 Pricing and output determination in different markets 185

7 Cost- Benefit Analysis 257

8 Macro Economic Analysis 285

9 Government and Private Business 319

Reference Book 351

Introduction to Managerial Economics 1

Chapter 1

INTRODUCTION TOMANAGERIAL ECONOMICS

Preview

Introduction, Definition of Managerial Economics, Nature and Scope of Managerial Economics,Significance of Managerial Economics, Economic Problem.

INTRODUCTION

Managerial Economics generally refers to the integration of economic theory with businesspractice. While economics provides the tools which explain various concepts such as Demand,Supply, Price, Competition etc. Managerial Economics applies these tools to the managementof business. In this sense, Managerial Economics is also understood to refer to businesseconomics or applied economics.

“Managerial Economics lies on the border line of management & economics. It is a hybrid oftwo disciplines and it is primarily an applied branch of knowledge. Management deals withprinciples which help in decision making under uncertainly and improve effectiveness oforganization. Economics on the other hand provides a set of propositions for optimum allocationof scarce resources to achieve the desired objectives.

1. Definitions of Managerial Economics

1. Prof. Spencer Sigelman : Managerial Economics deals with integration of economictheory with business practice for the purpose of facilitating decision making and forwardplanning by management.

2. Prof. Hague : Managerial Economics is concerned with using logic of economics,mathematics & statistics to provide effective ways of thinking about business decisionproblems.

3. Prof. Joel Dean : “The purpose of Managerial Economics is to show how economicanalysis can be used in formulating business polices.”

Managerial Economics2

4. Prof. Mansfield : “Managerial Economics attempts to bridge the gap between the purelyanalytical problems that intrigue many economic theories and the problems of policiesthat the management must face.”

5. Mc Nair and Meriam : Managerial economics consists of the use of economic modesof thought to analyse business situations.

The definitions given above highlight the following points :

i) Economic theory provides the basis for the decision making process.

ii) There is some difference between the generalizations based on abstraction and actualpractices.

iii) Besides economic theory, mathematics & statistics help in decision-making.

iv) An attempt is made to arrive at generalizations regarding business policies.

v) Since decisions have repercussions on the working of firms in future, and most firmsenvisage to continue operations over a period of time, forward planning becomes animportant 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 mater

spare parts, etc.?

The significance of a good system of forward planning can be appreciated from the fact that ithelps in selecting the plant to be installed and it is not possible to change its capacity as andwhen required. Also different production process require different skills which have to be provided.Similarly, based on the long-term plans, funds have to be arranged : either procured fromoutside or retained out of the earnings of the firm.

Economics provides the solution to some of these problems to enable the firm to achieve itsobjective. For example, the demand for a product is influenced by factors such as (i) thedistribution of income, (ii) prices of related products, and (iii) data on demand at some futurepoint of time facilitates the task of forward planning. Similarly, the theoretical explanation ofthe problem of input-mix (the ratio in which machines, men and other resources are to beemployed) is provided by production function along with the prices of inputs. This indirectlyfacilitates the choice regarding the technique of production to be employed and the plant to beinstalled.


The propositions of economics, however, require to be modified keeping in mind the constraintsof availability of requisite data and the time at the decision-maker.

2. Nature of Managerial Economics :

1. 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. Notethat micro economics studies the phenomenon at the individual’s level : behavior ofindividual consumers, firms. The concepts of micro economics used frequently inmanagerial economics are : (i) elasticity of demand, (ii) marginal cost, (iii) marginalrevenue, (iv) market structures and their significance in pricing policies, etc. Some ofthese concepts, however, provide only the logical base and have to be modified in practice.

2. Micro economics assists firms in forecasting. Note that macro economic theory studiesthe economy at the aggregative level and ignores the distinguishing features of individualobservations. For example, macro economics indicates the relationship between (i) themagnitude of investment and the level of national income, (ii) the level of national incomeand 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 demandat some future point in time, based on the relationship between the level of nationalincome and the demand for a particular product. For example, there is a relationshipbetween the level of national income and demand for electric motors. Also, the demandfor durable goods such as refrigerators, air-conditioners, motor cars depends upon thelevel of national income.

3. Managerial Economics is decidedly applied branch of knowledge. There fore, the emphasisis laid on those propositions which are likely to be useful to the management.

4. Managerial Economics is prescriptive in nature and character. It recommends that athing should be done under alternative conditions. For example, If the price of the syntheticyarn falls by 50%, it may be desirable to increase its use in producing different types oftextiles. Thus, managerial economics is one of the normative sciences and reflects uponthe desirability or otherwise of the propositions. For example if the analysis suggeststhat the benefit-cost ratio of a large plant is less than that for a smaller plant and thebenefit-cost ratio is used as the criterion for project appraisal it is recommended that thefirm should not install a large plant. Contrast this with the positive sciences which statethe propositions without commenting upon what should be done. For example, if thedistribution of income has become more uneven, it is stated without indicating whatshould be done to correct this phenomenon.

5. Managerial Economics, to the extent that it uses economic thought, is a science, but itis 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 confidencein the findings, the propositions deduced are subjected to empirical verification. Forexample, 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 generalize thepropositions which provide a predictive character. For example, empirical studies maysuggest that for every 1% rise in expenditure on advertising, the demand for the productshall increase by 0.5%.

From the above it follows that managerial economics uses a scientific approach. Inpractice, some firms may use simple rules based on past experience. However, thequality of discussions made can be improved using a systematic approach. This isattempted in managerial economics.

3. Scope of Managerial Economics :

The scope of Managerial Economics is so wide that it embraces almost all the problems &areas of the manager and the firm. It deals with demand analysis and forecasting, productionfunction, cost analysis, inventory management advertising price system, resource allocation,capital budgeting etc. While an in-depth treatment is given to these aspects in the relevantchapters, a cursory treatment of these aspects has been attempted here, merely to explainthe scope of the subject.

1. Demand analysis and forecasting :

It analyses carefully and systematically the various types of demand which enable themanager to arrive at a reasonable estimate of demand for products of his company. Hetakes into account such concepts as income elasticity and cross elasticity. When demandis estimated, the manager does not stop at the stage of assessing the current demandbut estimates future demand as well. This is what is meant by demand forecasting.

2. Production Function :

We know that resources are scarce and also have alternative uses. Inputs play a vitalrole 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, whenthe price of inputs shoot up, a firm is forced to work out a combination of inputs so as toensure that this combination becomes least cost combination. In this way, the productionfunction is pressed into service by managerial economics.

3. Cost Analysis :

Cost analysis is yet another area studied by managerial economics. For instance,determinants of cost, methods of estimating costs, the relationship between cost &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 whichis cornerstone for the success of a firm.

4. Inventory Management :

An inventory refers to stock of raw materials which a firm keeps. Now the problem is howmuch of the inventory is ideal stock. If it is high, capital is unproductively tied up, whichmight, if the stock of inventory is reduced, be used for other productive purposes. On theother hand, if level of inventory is low, production will be hampered. Therefore, managerialeconomics will use such methods as ABC analysis, a simple simulation exercise andsome mathematical models with a view to minimize the inventory cost. It also goesdeeper into such aspects as the need for inventory control; it classifies inventories anddiscusses the costs of carrying them.

5. Advertising :

It may sound strange when we say that advertising is an area which managerialeconomics embraces. While the copy, illustration, etc., of an advertisement are theresponsibility of those who get it ready for the press, the problems of cost, the methodsof determining the total advertisement costs and budget, the measuring of the economiceffects of advertising – these are the problems of the manager. To produce a commodityis one thing; to market it is another. Yet the massage about the product should reach theconsumer before he thinks of buying it. Therefore, advertising forms an integral part ofdecision-making and forward planning.

6. Price System :

It has already been pointed out that the pricing system as a concept was developed byeconomics and it is widely used in managerial economics. The central functions of anenterprise are not only production but pricing as well. While the cost of production has tobe taken into account while pricing a commodity, a complete knowledge of the pricesystem is quite essential to determination of price. For instance, an understanding ofhow a product has to be priced under different kinds of competition, for different marketsis essential to the pricing of those commodities. An understanding of the pricing of aproduct under conditions of Oligopoly is also essential. Pricing is actually guided byconsiderations of cost plus pricing and the policies of public enterprises. Further, thereis such a thing as price leadership and non-price competition. It is clear from these factsthat the price system touches upon several aspects of managerial economics and aidsor guides the manager to take valid and profitable decisions.

7. Resources Allocation :

Scarce resources obviously have alternate uses. How best can these scarce resourcesbe allocated to competing needs? The aim, of course, is to achieve optimization. For


this purpose, some advanced tools, such as linear programming, are used to arrive atthe best course of action for a specified end. Generally speaking, two kinds of problemsare of the utmost importance and concern to the manager. First, how should he arrive atan optimum combination of inputs in order to get the maximum output? Secondly, whenthe prices of inputs increase, what type of sub-situation should he resort to? Or,alternatively, what type of combination of inputs should he work out in order to ensure theleast-cost combination?

8. Capital Budgeting :

This is another area which calls for a thorough understanding on the part of the managerif he is to arrive at meaningful decisions. Capital is scarce, and it costs something. Nowthe problem is how to arrive at the cost of capital; how to ensure that capital becomesrational; how to face up to budgeting problems; how to arrive at investment decisionsunder conditions of uncertainty; how to effect a cost-benefit analysis, etc. These areascannot be ignored by any manager.

It is obvious form the foregoing discussion that managerial economics is appliedeconomics. It makes use of the tools which have been developed not only be economicsbut by other disciplines as well. The subject matter of managerial economics coverstwo important areas, namely, decision-making and forward planning. These twoareas are essential to every stage of planning, production, marketing, etc. Managerialeconomics, therefore, plays a vital role in the successful business operations of a firm.

Some other areas covered by Managerial Economics are :

1. Linear programming, its assumptions and solutions.

2. Decision making under risk and uncertainty.

3. Profit planning and investment analysis. Sources of information on new projects, methodsof project appraisal, social benefit cost analysis etc.

4. Significance of Managerial Economics./ How Does Economics Contribute toManagement?:

While performing his functions, a manager has to take a number of decisions in conformitywith the goal of the firm. Many of the decisions are taken under the condition of uncertaintyand therefore involve risk. Uncertainty and risk arise mainly due to uncertain behaviour of themarket forces, i.e. the demand and supply, changing business environment,government policy, external influence on the domestic market and social and political changesin the country. The complexity of the modern business would add complexity to the businessdecision - making. However, the degree of uncertainty and risk can be greatly reduced ifmarket conditions could be predicted with a high degree of reliability.


Taking appropriate business decisions requires a clear understanding of the technical andenvironmental conditions under which decisions are to be taken. Application of economictheories to explain and analyse the technical conditions and the economic environment inwhich 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 problemsof business. With the growing complexity of business environment, the usefulness of economictheory as a tool of analysis and its contribution to the process of decision- making has beenwidely recognized.

Prof. Baumol has pointed out three main contributions of economic theory to businesseconomics. First, ‘one of the most important things which the economic (theories) can contributeto the management science’ is building analytical models which help in recognizing thestructure of managerial problems, eliminating the minor details which might obstruct decision-making, and in concentrating on the main issue. Secondly, economic theory contributes tothe business analysis ‘a set of analytical methods’ which may not be directly applied tospecific business problems but they do enhance the analytical capabilities of the businessanalyst. Thirdly, economic theories offer clarity to the various concepts used in businessanalysis, which enables the managers to avoid conceptual pitfalls.

5. Economic Problem :

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 andminerals, but also of human capacity, both mental and physical, and of all sorts of man-madeaids to further production, such as tools, machinery and buildings. It is sometimes useful todivide those resources into three main groups :

1. All those free gifts of nature, such as land, forests, minerals, etc., commonly callednatural resources and known to economists as LAND;

2. All human resources, mental and physical, both inherited and acquired, which economistscall LABOUR; and

3. All those man-made aids to further production, such as tools, machinery, plant andequipment, including everything man-made which is not consumed for its own sake butis used in the process of making other goods and services, which economists callCAPITAL.

These resources are called FACTORS OF PRPDUCTION because they are used in the processof production. Often a fourth factor, ENTEPRENEURSHIP (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. Heorganizes the other factors of production and directs them along new lines. (When it is notdistinguished as a fourth factor, entrepreneurship is included under labour.)

The things that are produced by the factors of production are called commodities. Commoditiesmay be divided into goods and services : goods are tangible, as are food grains, cars orshoes; services are intangible, as they are valued because of the services they confer on theirowners. A car, for example, is valued because of the transportation that it provides – andpossibly also for the flow of satisfaction because of the transportation that it provides – andpossibly 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 greatvirtue is attached to piling them up endlessly in warehouses, never to be consumed. Usuallythe end or goal that is desired is that individuals should have at least some of their wantssatisfied. Goods and services are thus regarded as means by which the goal of the satisfactionof wants may be reached. The act of making goods and services is called production, andthe act of using these goods and services to satisfy wants is called consumption. Anyonewho helps to produce goods or services is called a producer, and anyone who consumesthem 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 allpractical purposes in today’s world, as insatiable. In relation to the known desires of individualsfor such commodities as better food, clothing, housing, schooling, holidays, hospital care andentertainments, the existing supply of resources is woefully inadequate. It can produce only asmall fraction of the goods and services that people desire. This gives rise to one of the basiceconomic problems : the problem of scarcity.

Every nation’s resources are insufficient to produce the quantities of goods andservices 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 humanwants.

6. Meaning of Economic Problem :

Now, if we put together the four characteristics – namely, human wants are unlimited, thathuman wants vary in their intensity, that means or resources are relatively limited, and theyhave alternative uses, but if used to satisfy one want, the same means cannot be used tosatisfy any other want – it becomes clear that every man begins to face the problem ofeconomizing 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 so try to use hisrelatively limited resources with alternative uses that he gets maximum satisfaction out of hisresources. In view of limited resources and unlimited wants, he will try to satisfy those wantswhich are most urgent or intense and then those wants slightly less urgent and so on thussacrificing the satisfaction of those wants which are lower on the scale of preference for whichhe may not have resources. This is the problem of economy – how to economics or make themaximum use of limited resources.

In the light of the above situation, Lionel Robbins writes : “Economics is a science whichstudies human behavior as a relationship between ends and scarce means whichhave alternative uses.”

Economic Problem at the Family Level

Almost in every community, family is the basic unit of social organization. Just as, everyindividual has to face the basic economic problem – namely unlimited wants and limitedmeans 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 disposalare 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 outof them. The Indian family may be thinking in terms of Rs.5,000/- which may be its monthlyincome, whereas an average American family earning U.S. $ 5,000 a month may be thinkingin terms of that as a fairly big amount. But as we have observed, each family in relation to itswants, finds that the resources at its disposal are limited, that they have alternative uses andtherefore the problem of economizing them must be faced. No family can avoid this basiceconomic problem.

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 organization. Thus whether we are thinking of aGrampanchayat, or of Zilla Parishad, or of a club or hospital or university or the nationalgovernment, all have to face the same basic economic problem. Thus whether it is theGovernment of India or the Government of the richest country namely the United States, theproblem of economy is always there. The Government of India with an annual revenue of aboutRs.1,00,000/- corers has innumerable demands on its resources such as meeting mountingdefense expenditure, expanding expenditure in respect of development that is to be broughtabout in various sectors like agriculture, industries, transport, education and so on and soforth, 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 thesome way, the Federal Government of the United States, the richest government, faces thesame basic economic problem. Though in absolute terms, its annual revenues are enormousrunning into billions or trillions of dollars, its needs are also unlimited – expanding andmodernizing defense forces, establishing military bases all over the world giving economicand military assistance to friendly countries, meeting expanding expenditure on space andmilitary research, exploring oceans and so on and so forth. And therefore even the richestGovernment of the United States is always confronted by the same basic economic problem– unlimited wants and limited resources with alternative uses. Every nation, poor or rich, smallor great, with small population or with huge population, has to face this basic economicproblem; no nation can ever escape it.

Thus there is something ‘universal’ about the problem of economy. The basic problemof economy arises in the case of an aboriginal, a villager, a city – dweller, in the caseof 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 organizationsright from the village level to the national level. The problem of economy was therein ancient times and it is there before everybody at present. The problem of economy– unlimited wants and limited means with alternative uses – has been foreverconfronting mankind. The economic problem is a universal problem. Economicproblem does not recognize boundaries of caste, creed, colour , religion, culture

Basic Economic Problems

Seven more general questions that must be faced in all economies, whether they be capitalist,socialist or communist, & mixed are explained below.

7. Seven Questions faced by all economies :

1) What commodities are being produced and in what quantities? This questionarises directly out of the scarcity of resources. It concerns the allocation of scarceresources among alternative uses (a shorter phrase, resource allocation, will often beused). The question ‘What determines the allocation of resources or resource allocation?’have occupied economists since the earliest days of the subject. In free – marketeconomies, most decisions concerning the allocation of resources are made throughthe price system. The study of how this system works is the major topic in the THEORYOF PRICE.

2) By what methods are these commodities produced? This question arises becausethere is almost always more than one technically possible way in which goods andservices 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 andmachinery, or farming a large quantity of land extensively, using only small quantities offertilizer, labour and machinery. Both methods can be used to produce the same quantityof 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 otherresources. The same is true of manufactured goods; it is usually possible to produce thesame output by several different techniques, ranging from ones using a large quantity oflabour and only a few simple machines to ones using a large quantity of highly automatedmachines rather than another, and the consequences of these choices about productionmethods, are topics in the THEORY OF PROCDUCTION.

3) How is society’s output of goods and services divided among its members? Whycan some individuals and groups consume a large share of the national output whileother individuals and groups can consume only a small share? The superficial answer isbecause the former earn large incomes while the latter earn small incomes. But this onlypushes the question one stage back. Why do some individuals and groups earn largeincomes while others earn only small incomes? Economists wish to know why anyparticular division occurs in a free – market society and what forces, including governmentintervention, can cause it to change.

Such questions have been of great concern to economists since the beginning of thesubject. These questions are the subject of the THEORY OF DISTRIBUTION. Whenthey speak of the division of the national product among any set of groups in the society,economists speak of THE DISTRIBUTION OF INCOME.

4) How efficient is the society’s production and distribution? This questions quitenaturally arises out of question 1, 2 and 3. Having asked what quantities of goods areproduced, how they are produced and to whom they are distributed, it is natural to go onto ask whether the production and distribution decisions are efficient.

The concept of efficiency is quite distinct form the concept of justice. The latter is anormative concept, and a just distribution of the national product would be one that ourvalue judgments told us was a good or a desirable distribution. Efficiency and inefficiencyare positive concepts. Production is said to be inefficient if it would be possible to producemore of at least one commodity without simultaneously producing less of any other – bymerely reallocating resources. The commodities that are produced are said to beinefficiently distributed if it would be possible to redistribute them among the individualsin the society and make at least one person better off without simultaneously makinganyone worse off. Questions about the efficient of production and allocation belong tothe branch of economic theory called WELFARE ECONOMICS.


Questions 1 to 4 are related to the allocation of resources and the distribution of incomeand are intimately connected, in a market economy, to the way in which the price systemworks. They are sometimes grouped under the general heading of MICRO ECONOMICS.

5) Are the country’s resources being fully utilized, or are some of them lying idle?We have already noted that the existing resources of any county are not sufficient tosatisfy even the most pressing needs of all the individual consumers. Surely if resourcesare so scarce that there are not enough of them to produce all of those commoditieswhich are urgently required, there can be no question of leaving idle any of the resourcesthat are available. Yet one of the most disturbing characteristics of free – market economiesis that such waste sometimes occurs. When this happens the resources are said to beinvoluntarily unemployed (or, more simply, unemployed). Unemployed workers wouldlike to have jobs, the factories in which they could work are available, the managers andowners would like to be able to operate their factories, raw materials are available inabundance, and the goods that could be produced by these resources are urgentlyrequired by individuals in the community. Yet, for some reason, nothing happens : theworkers 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 servicesthat could have been produced by the idle resources, and in terms of the effects onpeople who are unable to find work for prolonged periods of time.

Why do market society’s experiences such periods of involuntary unemployment whichare unwanted by virtually everyone in the society, and can such unemployment beprevented from occurring in the future? These questions have long concerned economists,and have been studied under the heading TRADE CYCLE THEORY. Their study wasgiven renewed significance by the Great Depression of the 1930s. In the USA and theUnited 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, duringthe worst part of the depression, one quarter of these countries’ resources were lyinginvoluntarily idle. A great advance was made in the study of these phenomena with thepublication 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, hasgreatly widened the scope of economic theory and greatly added to our knowledge of theproblems of unemployed resources. This branch of economics is called MACROECONOMICS.

6) Is the purchasing power of money and savings constant, or is it being erodedbecause of inflation? The world’s economies have often experienced periods ofprolonged and rapid changes in price levels. Over the long swing of history, price levelshave sometimes risen and sometimes fallen. In recent decades, however, the course ofprices 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, moreparticularly in the less developed countries.

Inflation reduces the purchasing power of money and savings. It is closely related to theamount 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 questionsabout the causes and consequences of changes in the quantity of money and the effectsof such changes on the price level. They also ask about other causes of inflation.

7) Is the economy’s capacity to produce goods and services growing from year toyear or is it remaining static? Why the capacity to produce grows rapidly in someeconomies, slowly in others, and not at all in yet others is a critical problem which hasexercised 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 THEORTY OF ECONOMIC GROWTH.


Exercise :

1. Define Managerial Economics.

2. Explain the Nature and Scope of Managerial Economics.

3. What is the Significance of Marginal Economics?

4. What is an economics problem?

5. “There is something Universal about and economic problem” Discuss.


NOTES

Types of Business Organisations 17

Chapter 2

TYPES OF BUSINESS ORGANISATIONS

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Introduction, A firm, plant, Industry, Types of Business organizations - Proprietary Firms,Partnership Firms, Joint Stock Companies, Public Sector Undertakings, Co-operative Societies,Non-profit organizations, Business Organization in new millennium, Organization Goals -Profit Maximization, sales Maximization, Satisfying Theory, other goals or objectives of firms.

INTRODUCTION

Organisation of production requires bringing together various factors of production andcoordinating the efforts of all the participants in the process of production. The level at whichthis is done is the level of a firm.

Production with the profit motive is modern concept, in the sense that it has become dominantonly after the Industrial Revolution. Before the Industrial Revolution, most of the economies ofthe world were agricultural economies. The profit motive was always a secondary motive in anagricultural economy. But in modern times the profit motive became the only dominant motiveof production. A firm is a unit of production where production is done with the sole aim of profitmaximization.

1. Definition of a firm as a producing unit.

For the sake of understanding this concept of the firm, let us study some definitions of the firmgiven by eminent economists.

1. Hansn : The firm may be defined as an independently administered business unit.

2. "A firm is a centre of control where the decisions about what to produce and how toproduce are taken."

3. "A firm is a business unit which hires productive resources for the purpose of producinggoods and services."


4. Harvey Leibenstein : A firm is " an independent organization whose destiny is determinedby the magnitude of the aggregate pay off and in which the aggregate pay off dependsdirectly on its performance and especially on the production and sale of services orgoods."

5. In the words of Prof. Lipsey, "The firm is defined as the unit that uses factors of productionto produce commodities that it then sells either to other firms, to households or to thecentral authorities (meaning government, public agencies etc.) The firm is thus the unitthat makes the decisions regarding the employment of factors of production and theoutput of commodities." How much to consume is decided by the households. In keepingwith preferences of the consumers, the firms decide how much to produce, how toproduce etc. Through advertisements, a firm may try to increase its sales, but thedecisions to buy belong to the buyers. The decisions regarding choice of techniques andquantify of a commodity are taken by the firm. The firm is assumed to take consistentdecisions in relation to the choice open to it. The internal problems regarding the processof decision - making i.e. who reaches decision, how are they reached etc. are ignored.We take firm as a single unit - smallest possible unit. It is taken as our atom of behavioron the demand side.

Again, just as the household is assumed to seek satisfaction maximization, the firm isassumed to seek maximization of its profits.

The firm may be a proprietorship firm or a partnership firm or a Multi-National Corporation.That it is a unit of decision - making is our criterion. Therefore, for an economist, TataEngineering and Locomotive Company Ltd. is a firm. Again, what form of businessorganization and management experts? An economist assumes that the firm is internallyproperly organized and is capable of taking decisions.

From the above definitions, it will be seen that there is a substantial difference in all thesedefinitions and still in their own way they describe the firm correctly. This is so because theseeconomists have given prominence to the questions which were more important for them or fortheir country or when they were writing, and so if we study the various features of firm asrevealed by these definitions, the concept will be more clear. The following features of afirm emerge from these definitions:

1) It is a centre where decisions about what, where, how and how much to produce aretaken.

2) It is a centre where the means of production are hired or purchased and used for production.

3) It is a centre, where the success of production is reviewed in its entire context anddecisions are taken.


4) It is a centre, where the means of production are collected, the production is done, andthe sale and distribution of production is also affected.

5) It is a centre, where all the decisions about production are taken. These include decisionsregarding the distribution of the product, advertising, sale and those regarding facingcompetition also.

From the above features of a firm, it will be clear that a firm has to perform several functionssimultaneously - i.e. to produce a commodity, to sell and distribute the commodity, to advertisethe commodity and to perform all those things which will be required to survive competition. Tocap it all, the firm is expected to make as much profits as possible. Theoretically speaking, afirm is expected to organize all the factors of production in the most profitable manner. If onestudies the structure and function of modern firm the above definitions will appear to be toosimple, because in modern times the firm is expected to perform so many other functions.

Formerly, the entrepreneur was taken to be an independent factor of production. Even todaythe entrepreneur is no doubt a very important factor of production but he has become so highlyindispensable that it is very difficult to separate him from the production unit of the firm becauseultimately the will to produce is provided by the entrepreneur. The mere presence of all thefactors of production and a market does not guarantee production. The will be to produce isvery important and it cannot be separated from the entrepreneur. Thus, the entrepreneur becomesinseparable from the firm.

2. The firm and the industry

For understanding the difference between a firm and an industry, it would be advisable tounderstand the nature of a competitive industry. A competitive industry has three basiccharacteristics:

(a) Large number of firms, (b) Homogeneous product; and (c) Freedom of entry and exit.

In a competitive industry, there is a large number of firms so that the action of a single firm hasno effect on the price and output of the whole industry. Every firm therefore enjoys the freedomto increase or decrease its output substantially by taking the price of the product as given.Secondly, every firm in a purely competitive industry, it must be making a product which isaccepted by customers as being identical with that made by all the other producers in theindustry. This is known as the condition of homogeneity. This ensures that all firms have tocharge the same price. The buyers, of course, are to decide that the product is the same. Thebuyers should not find any real or imaginary differences between the products sold by any twopairs of firms, Finally, there should be no barriers to the entry of new firms (or exit of old firm)to (or from) the industry.


We considered competitive industry because we wanted to contrast such an industry with amonopoly. Under monopoly, there is only one firm producing a product. Entry into the industryis not free; because if entry of an additional firm is allowed, it no longer remains a monopoly.Thus, under monopoly, the firm is the industry or the distinction between the firm and theindustry disappears under conditions of monopoly.

Between these two extremes, we get a wide range of marked structures where there are morethan one firms product. Strictly speaking, all firms producing the same i.e. homogeneousproduct make an industry and whatever all such firms supply becomes the supply of theindustry. In practice, however, we speak of the cotton textile industry, though all cotton textileunits do not produce identical textile products. Though the sugar produced by sugar factoriesmight have different grades of quality, we speak of one sugar industry. Similarly, we speak ofthe automobile industry, steel industry, cement industry and so on.

It should, therefore, be clear that all firms, producing a given product, together make anindustry.

3. The firm and the plant

A plant is a technical unit of a given capacity of output. For example, we speak of sugar plantWhat is it? It is nothing but an assembly of several machines, linked together (not necessarilyphysically but by processes also) capable of producing a given quantity of sugar per day.

There is, for example, a weighing system which weighs the sugarcane, the conveyor systemwhat takes the cane for crushing, the crushing machinery, and the machinery for removingimpurities and so on, until finally sugar is filled in gunny bags. This whole plant taken togetheris capable of producing a given quantity of one product sugar. A plant thus produces any oneproduct, obviously in cooperation with other factors of production. A sugar plant will producesugar in co-operation with workers, managers, technicians etc. and after the necessary amountsof raw material; other chemicals and fuel are supplied to it.

The firm, on the other hand, is an economic unit. The decisions are taken by the firm. Whatquality of sugar is to be produced, how much of it is to be produced, to which market it shouldbe sold and from which farmers the sugarcane should be purchased etc. are decisions to betaken by the firm.

It is not necessary that a firm has only one plant. Thus, for example, a sugar factory (i.e. a firmengaged in the production of sugar) may have a sugar plant, an alcohol plant (i.e. a distillery),a cattle - feed plant (producing cattle feed out of bagasse) - all under one management. Whenwe say one management, we are implying one firm though there are various plants, it is alsopossible that a plant supplies goods to more than one firms. The difference, basically, is thatbetween a technical unit and an economic unit.


One last word about a firm. We speak of the producer or the entrepreneur. Whenever wespeak of a producer or an entrepreneur we imply a firm that takes decisions. Internally thedecisions might be taken by a group of directors, managers or a sole proprietor - our unit onthe supply side is the firm.

4. Types of Business Organisations

Introduction:

A business organization is concerned with how production and sale of a commodity areorganized.

In this chapter, we study various forms of business organization.

� Types of Business Organization :

The main types of business organization are as follows:

i) One -man Business or Individual or Sole Proprietorship or Proprietary Firms.

ii) Partnership

iii) Joint Stock Company

iv) Joint Hindu Family Firms

v) Co-operative Organizations

vi) State Enterprise/Public Enterprises

vii) Joint Sector Organizations

viii) Non-Profit Organizations and

ix) Business Organizations of the New Millennium

A. Private Sector :

In a capitalist economy, the first four types of business organizations are set up in the privatesector. The private sector is owned by private individuals, families or groups of individuals. It ischaracterized by private ownership in the means of production, economic freedoms and profitmotive.

In addition to the first three types of business organization, there are also Joint Hindu FamilyFirms in the private sector in India and Business Organizations of the New Millennium.

B. Public Sector :

The public sector includes public or state enterprises like railways, post sand telegraphs, etc.The public sector is owned and controlled by the State. In India we have also a number ofpublic enterprises like Hindustan Machine Tools, Life Insurance Corporation, Bharat HeavyElectrical Ltd. etc. They are constituted as companies, public corporations and departmentalundertakings.


C. Co - operative Sector :

There are many co-operative organizations in the private sector. But they are non-capitalist innature, e.g., Co-operative credit societies, consumers' co-operative societies, producers' co-operative societies, service societies, etc.

D. Joint Sector :

Joint sector organizations or enterprises are jointly owned by the public and private sectors.But day-today management is left to the private sector.

The following chart indicates various forms of business organization:

Types of Business Organization

Private Sector Public Sector Joint Sector

(7) State Enterprises (8) PublicPrivate

Organizations

Capitalist Non - CapitalistForm Form

1) Proprietary Firms 6) Co-operativeor Proprietorship Organizations

2) Partnership3) Joint-Stock Company4) Joint-Hindu Family Firms5) Business Organizations of the New Millennium

Let us now study the types of business organizations as given in the above chart.

1. SOLE PROPRIETORSHIP OR PROPRIETARY FIRMS :

(A) Definition : Individual or sole proprietorship which is also called sole trader shipor single entrepreneurship or proprietary firms is the most common, the simplestand the oldest form of business organization.

In such a unit, a single man called proprietor organizes a business. It is owned, managed,controlled and directed by him.


He fixes the amount of capital to be invested, (his own or borrowed), uses his own labourand that of his family members, hires factors, whenever necessary, organizes productionas efficiently as possible and markets the product at the highest possible prices. Heassumes full responsibility for all business risks. He alone enjoys all profits, if he issuccessful and suffers all losses, if his business fails.

(B) Characteristics: The definition of sole proprietorship Proprietary Firm gives itscharacteristics or features which are as follows:

(i) Ownership by a Single Person: A single person initiates a business whoseownership lies in his hands. He enjoys full powers to fix the lay-out of his businessfirm.

(ii) Organization and Control: A single person organizes and manages his businessaccording to his experience and efficiency. He has full powers to conduct hisbusiness in any manner he likes. He need not consult any one. He is also notrequired to take approval or agreement from others.

(iii) Capital: The owner uses his own capital. He may also borrow capital to invest it inhis business and thereby expand it.

(iv) No Sharing of Profits and Losses: All the profits of business earned by the ownerare enjoyed by him alone. These profits of business are not shared with otherpersons. On the other hand, if there are losses, he has to bear them alone entirely.

(v) Unlimited Liability: His liability is unlimited for all his debts. If he fails to clear hisbusiness debts, all his private property can be attached by his creditors.

(vi) Easy to Form: It can be easily set up. It is not subject to any special legislation.So no legal formalities are involved in starting such a concern by any person who isof major age, i.e. 18 years and above.

(vii) Legal Status: A sole trading concern cannot be legally separated from its owner orproprietor. The owner and organization are the same. The life of such a concerndepends upon the life of its proprietor.

This type of organization is found in agriculture, retail trade, hotel, printing press, tailoring etc.

(C) Merits and Demerits of Sole Proprietorship or Proprietary Firm :

MERITS OF PROPRIETORSHIP OR PROPRIETARY FIRM :

(i) Easily Started: Such a concern can be easily started without any legal formalities.There is also little government interference. Also it is simple to manage and control and


requires a small amount of capital for generally it adopts labour - intensive techniques.He can also get finance on personal credit.

(ii) Prompt Action: The proprietor can take quick decisions and prompt action regardinghis business, its location, method of production etc. He need not consult others aboutthese problems.

(iii) Personal Interest: He would always take personal interest in the business with a viewto finding out causes of loss and waste of resources. He would then take measures toremove them. Thus he would maximize his profits.

(iv) Requirements of Consumers: He has direct contact with his customers, so he canpersonally attend to all their requirements. He can produce goods according to theirdesires, tastes and needs. His attempts to meet their needs will help him to increase hissales and profits. Thus it is suitable for small business.

(v) Cordial Relations: He has direct and continuous contact with his employees. So hecan establish cordial relations with them. This is because he will be in a continuoustouch with them. He can also supervise them directly. Hence any scope for conflictbetween workers and himself can be avoided.

(vi) Efficiency, Hard Work and Direct Gain: He will always attempt to work hard, efficientlyand continuously. This helps to enjoy maximum profits and avoid any loss for his liabilityis unlimited.

(vii) Business Secrecy : He can carry on his business in secrecy. He is not required to givepublicity to the activities of his concern nor disclose his profits to the public. He can alsomake use of any new idea for his business.

(viii) Winding Up: Just as a sole trader can easily start a business, so also he may easilywind up his business at any time.

(ix) Economy in Expenses : Its overhead expense are low. Hence it is economical. Thenumber of employees employed by him is low. Hence the working expenses can beminimized.

(x) Flexibility and Elasticity : Any change in business can be easily introduced withoutconsulting any body. So it is flexible and elastic. It can easily and quickly adapt tochanges in the market conditions.

(xi) Transferability : It is easily transferable to heirs.

(xii) Self - Employment : It promotes self-employment, self-reliance, development of one'spersonality, self-confidence etc.


(xiii) Lower Tax Burden : It is also subject to lower tax burden than other forms of businessorganizations.

(xiv) Concentration of Wealth : It helps prevent concentration of wealth and income in thehands of a few persons.

DEMERITS OF PROPRIETORSHIP OR PROPRIETARY FIRM :

(i) Limited Capital : The amount of capital which an individual can command is limited. Hehas to depend mainly on his own savings. So it would be difficult for him to expand hisbusiness activities much. It may also be difficult for him to raise additional capital byborrowing from banks. Hence the size of his business is small.

(ii) Unlimited Liability and Risks : It may be very risky for him to invest in a particularbusiness. This is because if he adopts a wrong policy, he may lose everything and alsobecome insolvent. This is because his liability is unlimited. This implies that if his debtsexceed his business assets and if he suffers a loss, he will have to use his privateproperty to clear his debts. So the unlimited liability restricts his business activities.

(iii) Lack of Skill for Efficient Management : It may not also be possible for him to attendpersonally to all the activities of his concern such as correspondence, maintainingaccounts, advertisements, supervision, arrangement of finance etc. He cannot undertakeall activities alone efficiently. Further his business activities may be spread in differentplaces and he may not possess all the qualities and skill required for an efficientmanagement, supervision and control.

(iv) Limited Ability of Management : The limited managerial ability may make it difficultfor a sole proprietor to face competition in his business which is subjected to manychanges.

(v) No Economies of Scale : A sole trader cannot secure many of the economies of large- scale production such as purchase of raw materials at low prices, advantages ofspecialization etc., and minimize its cost of production or running business.

(vi) Weakness in Bargaining and Competition : On account of the limitations of capital,ability and skill, the proprietor is likely to remain weak in respect of bargaining andcompetition.

(vii) Wrong Decisions : All the decisions about his business are taken by the sole proprietor.Some of his decisions may prove to be wrong. This may involve him in losses and ruin.

(viii) Closure on Death : Such a concern may be closed on the death of the proprietor. Thisis because he may not have heirs to run it or they may not like to continue in hisbusiness. Hence the business may not be continued.


2. PARTNERSHIP :

(A) Definition and Meaning : The Indian Partnership Act, 1932, defines the partnership as"the relation between two or more persons who have agreed to share profits of a businesscarried on by all or any one of them acting for all."

The English Partnership Act, 1890, defines partnership as "the relation which subsistsbetween persons carrying on a business in common with a view to profit."

So a partnership refers to an organization owned and managed by two or more persons.They pool their capital and undertake all risks associated with their business. Thus thereis joint ownership, management, control and risk - taking.

The persons who own the partnership concern are called "partners" Collectively, all partnersconstitute a "firm".

(B) Characteristics or Features of a Partnership Firm :

(i) Contract : It is formed voluntarily by an agreement between two or more personscarrying on a particular business for common benefit. It may also be formed tocarry on certain trade, profession or lawful occupation.

(ii) Age Limit : Only persons who have attained the major status can become partners.In other words, minors cannot become partners.

(iii) A Partnership Deed : A partnership is formally based upon a partnership deed oragreement. It indicates the names of partners, the shares of individual partners inthe capital, their rights and duties, proportion for sharing profits and losses by eachof them etc.

(iv) Registration : The registration of a partnership firm is voluntary. It may or may notbe registered. However, if the partners so desire, it can be registered at any time.

(v) Joint - Ownership : The partners are joint owners of the property of the firm. Itsproperty must be used only for the business purpose for which the partnership wasformed. It cannot be used by any partner for his personal purposes.

(vi) Joint - Management : All the partners enjoy equal rights of management. Soevery partner can participate in management. But for the sake of convenience, asingle partner may be given right to manage the firm.

(vii) No Remuneration : No remuneration is paid to any partner for services renderedby him to the firm. Each partner is supposed to work in the best possible mannerfor promoting the interest of the firm.


(viii) Statutory Limit or Number of Partners : It consists of minimum two persons andmaximum 20 persons in the case of general business and maximum 10 persons inthe case of banking.

(ix) Business Activity : Any business selected by the partners can be undertaken. Allof them or any of them can carry on business activity for all.

(x) Sharing of Profit and Losses : There is a sharing of profits and losses. Profitscan be distributed according to the partnership agreement or the capital ratio. Profitmay be shared equally by partners, if nothing is mentioned in the partnership deed.A manager who is an employee of the firm may also be given a part of the profits.

(xi) Mutual Confidence and Faith : A partnership is based upon mutual confidenceand trust of partners in each other or one another. Every partner must be honestregarding the partnership dealings and should provide all the facts and informationregarding their business to all partners.

(xii) Combination of Capital, Abilities and Skill : In a partnership firm, some offer capital,some management and organizational abilities and others, technical skills etc.

(xiii) Working and Dormant Partners : Some of the partners who provide only capital,and enjoy limited liability as in England are called Sleeping or Dormant or SpecialPartners while others who run and manage the concern are called Active or Workingor General Partners. But, in India all partners have unlimited liability.

(xiv) Unlimited Liability : The liability of all partners is unlimited. Hence all partnersare, jointly and severally, held responsible for the losses or debts of the firm to thefull extent of their personal assets. Creditors are entitled to attach assets of anyone partner or those of others so as to recover their dues.

(xv) Non-Transferability of Interest : A partner cannot transfer his powers or rights toany third party to do any work of the firm on his behalf. If he cannot do it himself, hehas to retire from the partnership firm. However, a partner may admit another personas a new partner if other partners give their consent.

(xvi) Principle of Agency : Every partner carries on business activities on behalf of thefirm. So he binds the firm and other partners for every commitment that he makesin conducting business. Likewise he is bound by the business activities of theother partners.

Thus every partner becomes a principal at one time and an agent of the firm atanother time. Hence a partnership firm can be run by one or more partners actingon behalf of all partners.


(xvii)Dissolution : A partnership firm may not last long. It may be dissolved by anypartner after giving a written notice to other partners and a new partnership may beformed by the remaining partners. It may also be dissolved due to the death of apartner or due to an adjudication of a partner as an insolvent.

Such partnership firms are found among builders, solicitors, chartered accountants,small factories etc.

(C) MERITS AND DEMERITS OF PARTNERSHIP :

MERITS OF PARTNERSHIP :

(i) Easy to Form : A partnership firm can be easily formed. Its formation does not involvelegal formalities.

(ii) More or Additional Capital : Under the partnership, more funds can be raised by allpartners to start a business on a large scale. Because of the reputation of the partnersand their contacts, it will not be difficult for a partnership concern to borrow from bankson easy terms.

(iii) Greater Efficiency due to Division of Labour : There is a greater efficiency in theworking of partnership concerns because different partners can be assigned those tasksfor which they are best suited as per their qualifications, experience, abilities, talentsand aptitude. Thus, there would be specialization in the task of every partner.

(iv) Expansion of Business : A partnership firm can expand its business by admitting morepartners and raising more capital from them and thereby attempt to earn more profits.

(v) Flexibility : It is also quite flexible and capable of adapting itself to changed circumstancesof business by means of quick decisions and prompt action by the partners, i.e. it canquickly adapt itself to change in demand for its product, by increasing and decreasing itsbusiness operations and by changing its business policy.

Thus the organizational structure of a partnership firm is flexible. The decision taking bya partnership firm does not involve any legal procedure. Its operations are not also subjectto any restriction by a government.

(vi) Co-operation : It may elicit full co-operation from workers by keeping a close touch withthem, by understanding and solving their difficulties.

(vii) Advantages of Large-scale Production : It can secure all the advantages of large -scale production such as advantages of division of labour, bulk purchases of raw materialsat lower price, best use of machinery etc.

(viii) Business Secrecy : All the activities of partnership concerns need not be given anypublicity. Hence they can carry on their activities under secrecy so far as the outsidersare concerned. It is not compulsory for a partnership concern to publish its profit andloss account and its balance sheet. Outsiders are not given its business secrets.


(ix) Business Risks and Rewards : Business risks are equally shared by all the partners.In case business fails, they would suffer losses. But if it succeeds, they will enjoyprofits. Hence, they will try to manage it efficiently and make their business profitable byputting the assets of the firm to the best uses so as to avoid waste.

(x) Close Watch : Every partner has a right to take part in the partnership business. Sincethere is unlimited liability, every partner will keep a close watch on the activities of otherpartners so that losses are avoided and profits are maximized. Thus the interest of everypartner is protected.

(xi) Unlimited Liability : Since there is unlimited liability, the business status of a partnershipfirm is raised. Hence it will be easy for it to get loans from financers.

(xii) Management and Organizational Abilities : In a partnership firm, there is a combinationof capital, abilities and skill. Some partners offer capital. Some partners are experts inmanagement and organization. Some of them possess technical skill. As a result of thepooling of the expert services of all partners, it is possible to run a partnership firmefficiently.

(xiii) Dissolution : In case a partner is not happy with the working of his partnership firm, hecan legally dissolve it. He can do so by giving a written notice to the other partnersindicating his decision to resign from it.

(xiv) Mutual Consent : All the business decisions are taken with mutual consent of allpartners. They hold mutual consultations and discussions on important matters. Thusevery partner benefits form the advice of other partners. As a result, their wisdom ispooled for the benefit of the firm.

DEMERITS OF PARTNERSHIP

(i) Unlimited Liability and No Risk Business : On account of the principle of unlimitedliability, any bad or irresponsible partner may ruin all the partners. This is because hisactivities will be binding on all other partners. Every partner runs a considerable risk forany one of them is, jointly or severally, held responsible for the debts or losses of thefirm. Further due to unlimited liability, the partners may not undertake any risk in businessor take any hasty step to expand business. Hence the spirit of enterprise is checked.

(ii) Limited on Size of Business : It is also difficult to increase the size of business onaccount of limited amount of capital which the partners can raise or provide from theirown sources. A partnership firm cannot also admit more than 20 members for raisingadditional resources. This limitation on the number of partners restricts the growth of apartnership form.


(iii) Short - Lived : A partnership can be dissolved by any partner by giving a written noticeto other partners. So this type of business is short-lived. Also default, bankruptcy orinsanity of any one of the partners leads to dissolution of the firm unless a provision ismade in the partnership deed to the contrary.

(iv) Non - Transferability : A share in a partnership firm cannot be transferred by anypartner without the consent of all the partners. He cannot also transfer his powers orrights to any third party to do any work of the firm on his behalf.

(v) Differences of Opinion : The partners may not agree upon certain matters of businesspolicy. There might by differences of opinion, clashes of interest, mistrust, disputes etc.Such differences among partners may result in dissolution of partnership firms.

(vi) No Trust : The activities of a partnership firm are kept secret from outsiders. It is notrequired to publish its accounts. It is also not subject to legal restrictions. Hence peoplemay not fully trust a partnership concern.

(vii) No Government Control : There is no government control or supervision on the activitiesof a partnership concern. Hence there is lack of public confidence in such concerns.

(viii) Leakage of Important Information : Some of the partners may leak important informationto outsiders. This may happen when there are differences of opinion among the partners.Hence it may be difficult to maintain business secrecy in a partnership firm.

(ix) Joint Liability and Dishonest Activities of Some Partners : The activities of a partnerare binding on the partnership firm. Some partners may not behave properly. Some ofthem may be dishonest. Hence they may misuse their rights and bring the firm intodifficulties and ruin its business. As a result, the honest and efficient partners will have tosuffer losses.

3. JOINT - STOCK COMPANY :

Introduction : In a modern economy, the predominant form of business organization is theJoint - Stock Company which is called Corporation in the U. S. A. Such form of businessorganization is necessary to undertake any business or industry on a large scale. This isbecause it overcomes the drawbacks of sole proprietorship and partnership.

(A) Definition : In the words of Mr. Kuchhal, a joint -stock company is "an incorporatedassociation which is an artificial legal person, having independent legal entity, with aperpetual succession, a carrying a limited liability."

As per the Indian Companies Act of 1956, a joint - stock company is a companywhich has a permanent paid-up or nominal share capital or a fixed amount of capitaldivided into shares held and transferable as stock by shareholders who are its members.


Thus a joint-stock company is a voluntary incorporated association of shareholders orstockholders who contribute to the common stock, (i.e., capital) of which they are theowners. But all of them do not directly manage it. It is managed by some directorselected by shareholders. Their liability is limited to the value of shares held by them.They share in profits and losses.

(B) How Is It Formed ? : Minimum seven persons have to come together to start a joint -stock company. Those who take initiative to start it are called promoters. The promotersof a company have to get it incorporated by filing with the Registrar of Companies variousdocuments such as Memorandum of Association, Articles of Association, Prospectus,List of Persons who have agreed to act as directors etc.

The Memorandum of Association : This gives information about the company, namely,its place of location, its objects, the amount of capital to be raised etc.

The Articles of Association : This gives us information about the rules and regulationsand bye-laws of the company.

The Registrar of Joint - Stock Companies is given these documents.

After going through these documents, the Registrar issues a Certificate of Incorporation.After this, the company comes into existence.

Hence the registration of a joint - stock company is compulsory.

(C) Features of a Joint - Stock Company :

(i) Voluntary Organization : A joint - stock company is a voluntary organization orassociation of shareholders.

(ii) Legal Person : It is a legal or an artificial person as a result of law. It has nophysical existence. But it functions as a separate and independent legal person. Itis distinct from its shareholders and its directors.

(iii) Perpetual Succession : It has a perpetual or continuous succession under thelaw because it continues to exist even if some shareholders or directors die orbecome insolvent or leave the company by transferring their shares.

(iv) Common Seal : It has a common seal to be affixed on its contracts and legaldocuments.

(v) Open Membership : Its membership is open to any person in any part of a country.

(vi) Limited Liability : Liability of shareholders is limited to the nominal value of sharesheld by them.


(vii) Free Transferability of Shares : The shareholders are free to transfer or sell theirshares to any person.

(viii) Management by Elected Board of Directors : It is owned by its shareholders.But it is managed by a Board of Directors elected by shareholders.

(ix) Fragmented Rights of Ownership : the shareholders enjoy a fragmented right ofownership due to shares purchased by them.

(x) Dividends : The profits of a joint - stock company are annually distributed asdividends among its shareholders.

(D) How is Capital Raised By a Joint Stock Company?:

(a) Methods of Raising Capital : A company raises its capital in two ways, namely,

(i) Through the sale of shares or stocks and

(ii) Through the sale of bonds or debentures.

Sale of shares of stocks

(b) Types of Share Capital : A company divides its share capital as :

(i) Registered or Authorized Capital,

(ii) Issued Capital and

(iii) Paid - up Capital.

(i) Authorized Capital : Authorized Capital refers to the maximum amount whichcan be raised by a company by selling shares. This may be, say, Rs. 20 crores.

(ii) Issued Capital : Issued Capital refers to that part of the authorized capital which isissued to the public for subscription by dividing into shares. This may be, say, Rs.16 crores.

(iii) Subscribed Capital : Subscribed Capital refers to that part of the issued capitalwhich is actually subscribed by the public. This may be say, Rs. 14 crores.

(iv) Paid - up Capital : Paid - up Capital refers to that part of the subscribed capitalwhich the public directly pay-up to the company, as a part payment of the value oftheir shares. This may be, say, Rs. 10 crores. The remaining amount of thesubscribed capital is paid after further calls from the company.

(c) Types of Shares : The capital of a company can be divided into three types of shares :

(i) Equity or Ordinary Shares,

(ii) Preference Shares and

(iii) Deferred Shares.


(i) Equity or Ordinary Shares : Such shares form the main basis of the finance of acompany. The holders of such shares get dividend only after the preferenceshareholders are paid out of its profits. Hence they bear maximum risk. This isbecause they do not get any dividend if the company does not make any profit. Attimes when profits are high, they get much more than the rate of dividend paid topreference shareholders.

The ordinary shareholders have the right to vote to elect the Board of Directors ofthe Company. They have also the right to vote on policy decisions of the company.Hence they control the affairs of their company.

(ii) Preference Shares : These shareholders enjoy a preferential or prior right overequity shareholders to the profit of a company. They are entitled to a fixed rate ofdividend after paying interest on debentures and before any dividend is paid toequity shareholders.

However, preference shares are classified as :

(a) Simple or Non-Cumulative Preference Shares,

(b) Cumulative Preferences Shares,

(c) Participating Preference Shares and

(d) Redeemable Preference Shares.

(a) Simple or Non-Cumulative Preference Shares : People holding such sharesare entitled to a fixed rate of dividend only in the year in which profits aremade. They get the dividend before it is paid to other types of shareholders.

(b) Cumulative Preference Shares : Such shareholders are entitled to a fixedrate of dividend even when there are no profits in any year. These claims willstand as arrears to be paid first out of subsequent year's profit before it is paidto other types of shareholders.

(c) Participating Preference Shares : The holders of such shares are paid afixed rate of dividend before it is paid to other classes of shareholders. Theyare also entitled to participate in the balance of profits,in a certain proportionalong with equity shareholders, after reasonable claims of these equityshareholders are met.

(d) Redeemable Preference Shares : Capital raised by issuing such sharesmust be paid back after a certain period of time either out of profits or byraising fresh capital by issuing new shares or by selling some of the assets ofthe company.


The preference shareholders do not enjoy normal voting rights. However they havea prior claim on the assets of the company in the event of its liquidation.

(iii) Deferred Shares : They are called the Promoters' or Management's of Founders'shares. The holders of such shares are paid dividend last out of the profits left aftermeeting the claims of ordinary and preference shareholders and the reserve funds.Normally they are issued to promoters of a company but they may also be issuedto public. If dividend paid to other classes of shareholders is restricted, the deferredshareholders will enjoy a bigger share of profits. But if there are no profits, they donot get anything.

The deferred shareholders enjoy special or preferred voting rights. But the IndianCompanies Act. Of 1956, has eliminated the system of issuing deferred shares bypublic limited companies.

However a private limited company can issue deferred shares also.

Sale of Bonds or Debentures –

Debentures : A company may also raise additional finance by borrowing from thepublic for a specific period of time, say, 15 to 25 years, at a particular rate ofinterest. This is done by issuing debentures or bonds.

A debenture is an undertaking by a company to repay the borrowed moneyon or before the specified date at a particular interest rate, irrespective ofprofit or loss made by the company.

The capital raised by selling debentures is like taking loans form the public.

Hence, a debenture-holder is a creditor of a company with no voting right. As such,he cannot directly interfere with the activities of its management.

A Debenture may be classified as (i) secured and (ii) simple.

(i) A secured debenture is secured against the assets or property of a company.

(ii) A simple debenture is not secured against its assets or property.

A company is also free to issue convertible debentures which can be converted intoequity shares after a period of time, say, 5 to 10 years, at a ratio fixed in advance.

(E) Types of Joint - Stock Companies :

On Ownership Basis, all types of the registered companies in the private sectorcan be classified as :

(a) Public Limited Companies and

(b) Private Limited Companies.


In the public sector, we have government companies in which 51% of the paid-up share capitalis held by the government.

(F) Distinction Between Private Limited Companies and Public Limited Companies(Limited By Shares) :

(1) A private limited company can be formed with two to fifty members maximumexcluding employee shareholders of the company. But a public limited companycan have any number of the members of the public but it should have a minimum 7members.

(2) Public limited companies are required to issue prospectus before allotting shares.But it is not necessary in the case of private limited companies.

(3) Public limited companies must submit statutory reports to the Registrar ofCompanies. But private limited companies are not required to do so.

(4) A public limited company has to send its duly audited accounts to its shareholders.But a private limited company is not required to publish its accounts for the informationof the public. However a private limited company must send three certified copies ofits balance sheet to the Registrar of Companies.

(5) The shares of a private limited company cannot be freely transferred on stockexchanges. But the shares of public limited companies can be freely transferred onstock exchanges.

(6) The share of a private limited company openly invites public to subscribe to itsshares or debentures. But a private limited company cannot appeal to the public todo so.

(7) A private limited company can start its business after it is registered. But a publiclimited company can do so only after it gets a certificate for commencement ofbusiness.

(8) A private limited company should have minimum two directors. But a public limitedcompany must have at least three directors.

(9) A private limited company may increase its number of directors without thegovernment's approval. But a public limited company can do so only after gettingthe government's approval.

(10) In the case of a public limited company only an individual can be appointed as itsmanager. But a private limited company can appoint a firm a as its manager.


(11) A private limited company can issue different classes of shares with disproportionatevoting rights. But there are restrictions in this respect on a public limited company.

A partnership may be converted into a private limited company to enjoy theadvantages of limited liability.

(G) Management of Joint - Stock Companies : There is separation between ownershipand management in a joint-stock company. Its ownership is in the hands of shareholders.But they do not manage it directly. They elect a Board of Directors which manages thecompany.

The policies of the company are laid down by the directors. These policies are executedby salaried managers and executives.

(H) Merits and Demerits of Joint-Stock Companies :

MERITS OF JOINT - STOCK COMPANIES :

(i) Limited Liability : The principle of limited liability is applicable to a joint-stock company.Hence we write word "Ltd." after the name of a company. Since the liability of shareholdersis limited, risk faced by them are reduced. Hence even if a company suffers losses, theyneed not pay more than the face value of shares purchased by them. So the creditors ofthe company cannot make personnel attachments on their private property. Hence peopleare induced to invest their money in such companies.

(ii) Large Amount of Capital : Large - scale production is facilitated under the companyform of business organization. This is because it is easy for a company to raise a largeamount of capital, by accepting fixed deposits from the public. Thus the savings of thepeople can be productively used.

(iii) Transfer of Shares : The shares of a company are transferable whenever one likes.Hence it would encourage small savers to invest in the shares of companies. If they donot like to keep their funds in a particular company, they would be free to sell theirshares on stock exchange and invest in some other companies.

Thus the money of a share holder is not blocked. At the same time, this does not affectthe company in any way. This is because the sales of shares of a company by some arecounterbalanced by the purchase of these shares on a stock exchange by others.

(iv) Shares of Different Varieties : The shares of a company are of different types, namely,equity shares, simple preference shares, cumulative preference shares etc. The equityshares may be purchased by people who want take greater risks. On the other hand,those who do not want to take any risk may invest in cumulative preference shares.Thus, by providing a wide choice to shareholders, it is possible for a company to raise alarge amount of capital.


(v) Risky Enterprises : A joint-stock company can start a risky enterprise. This is becausethe risks associated with a business are greatly reduced due to the limited liability ofshareholders and a small value of the shares of each shareholder. Further an individualmay purchase shares of different companies so as to minimize the loss still further. Soeven if there is a loss in the case of one company, the individual shareholders may not beaffected much.

(vi) Less Danger of Misappropriation of funds : There is a less danger of misappropriationof funds. This is because the audited accounts of the companies must be published.

(vii) Combination of Capital and Business Abilities : Many individuals possessing a largeamount of capital and not having capacities to start and run a business can invest incompanies. Other persons, having no capital but possessing capacities to manage abusiness, can secure jobs as managers and executives in companies.

(viii) Efficient Management : In a joint-stock company, the ownership and management areseparated. The shareholders are owners but they do not manage it. It is managed byexperts in different fields, who work under the direction of the Board of Directors.

(ix) Economies of Scale : A joint - stock company can enjoy the economics of scale suchas advantages of specialization and division of labour etc. by making full use of managerialskills and abilities and other factors of production.

(x) Continuity and Stability : Since it has a perpetual succession, a company continuesto carry on its business even if some of the original shareholders leave the company ordie or become insolvent. So it is permanent and stable in nature. So the businessactivities can be undertaken with a long-term objective.

(xi) Legal control : Since companies are subject to rules and regulations of the CompaniesAct, they are supposed to work in the interest of their shareholders.

(xii) Democratic Management : There is democratic management in a joint-stock company.This is because the directors are elected by shareholders from time to time. The electedboard of directors manage the company successfully because of their wide experience,abilities and efficiencies.

(xiii) Research : Because of its continuous existence and a large amount of resources at itsdisposal, a company can conduct research and experiments, and apply the fruits ofresearch to industrial uses. This will enable it to improve the quality of its product,reduce its cost of production and thereby enjoy good profits in due course.

DEMERITS OF JOINT - STOCK COMPANIES :

(i) Lack of Personal Interest and Inefficient Management : The actual management ofa joint - stock company is in the hands of salaried executives. They have no personalinterest in the functioning of their company. Hence they may not always manage the


affairs of their company efficiently. Some of them might even leak out secrets of theircompany to rival companies.

(ii) Indifference of Shareholders and Oligarchy : On account of their : limited liability,many of the shareholders are indifferent. They may not take an active part in the affairsof their company. They are also scattered. They are interested only in dividend. So a fewbig shareholders manage to get directorships and take all decisions.

So, in actual life, there is oligarchy rather than democracy in the management of acompany. Further these few directors manage to remain in power by some means or theother and enjoy vast powers of management and decision making. So shareholders areowners only in name.

(iii) Promotion of self - interests and misuse of power by directors : A few big directors,who control the affairs of the company, try to promote their own interests in various waysat the cost of other shareholders.

Further when the directors are dishonest, they may commit some frauds and cheat andexploit the shareholders. They may also purchase inputs from their friends and relativesat high prices and resort to other corrupt practices. They may also claim excessive fees.

(iv) To Risky Ventures : the directors may be inclined to start very risky enterprises whichmay fail. Hence they will involve the shareholders in losses.

(v) Extravagance : The directors may not behave in a responsible manner. They mayspend in an extravagant way.

(vi) Favouritism : The selection of the staff to work in various departments may not be madeby directors or managers on the basis of merit, but on the basis of favouratism, influence,personal relations etc. They may employ their friends and relatives in high posts payinghigh salaries. Hence the general working of a company is likely to suffer.

(vii) Unethical Practices : Directors possess inside information of the working of theircompany. Hence they may dispose of their shares at high prices by creating an impressionthat their company is going to make good profits when, in fact, the things are otherwise.So those who buy such shares will suffer losses. In the opposite case, when a companyis likely to make good profits, they may try to create an impression that it would sufferlosses. This impression will induce other shareholders to sell their shares. They buythem through their agents. Hence they can get all the profits for themselves.

The transferability and marketability of shares is also responsible for unhealthy speculativeactivities on stock exchanges on the part of some directors. As a result, the interests ofshareholders are ignored with the result that a large number of them may be ruined.


(viii) Conflict : There is no close personal contact between employees and management.Hence there is likely to be a conflict between employees and the management. Attimes, this may result in strikes and lockouts. So the company's output would suffercausing thereby a loss to the shareholders.

(ix) Political Corruption : A number of joint-stock companies may pay a large amount ofmoney as donations to political parties. They are given for the personal benefit of directorsand / or for the benefit of the company at the cost of the public.

(x) Concentration of Economic Power and Wealth and Inefficient Management :Most of the important companies in a country are dominated by a few wealthy individuals.As they are elected as directors, there would be a concentration of wealth and economicpower in their hands. They manage to get themselves re-elected by some means or theother. However such people may lack adequate experience and skill. Hence they maynot be in a position to manage the affairs of the company efficiently.

(xi) Delay in Taking Decisions : The Board of Directors of a joint-stock company cannottake quick decisions and prompt action to meet the changes in demand for its product.This is because there is a lot of discussion and consultation before taking any decision.This causes unnecessary delay. Hence when quick decision and prompt action arerequired, a company form of organization is not suitable as a partnership concern oreven a private proprietorship concern.

CONCLUSION : The joint-stock system has much contributed to economic progress.This is because it is responsible for tremendous industrial progress, production and trade.

4. JOINT - HINDU FAMILY FIRMS OR ORGANISATIONS :

Such organization undertaking business activities exist in India. They are also calledHindu Undivided Family Business (HUF). In a Hindu Joint Family firm, all members of afamily come under 'karta', a common head, who is the eldest member in the family.

The Hindu Law determines their rights and liabilities.

Such organizations were important in the past. But now their importance has declined.This is because they are not suitable for many economic activities in modern times.

Joint Hindu Family have some of the features of a partnership firm. However, the ownershipof a joint family firm is not due to A contract but due to inheritance. Hence the malemembers of joint family firms are called co-parceness and not partners.

5. CO-OPERATIVE SOCIETIES OR CO-OPERATIVE FORM OF BUSINESSORGANISATIONS :

Introduction : The co-operative movement started in England and Germany in the middleof the 19th century. But, in India, it began only in 1904 after the Co-operative Societies


Act, 1904, was passed. This Act was passed mainly to provide credit to farmers andprevent them from borrowing from money-lenders. Since 1904, the co-operative movementhas made considerable progress in India.

(A) Definition of Co-operation : In a wide sense, "co-operation means working together fora common purpose". Hence, in the co-operation, the main principle adopted is" all foreach and each for all".

As per the International Labour Organization (ILO). Co-operation is a voluntaryassociation of individuals with limited income on the basis of equal rights andresponsibilities for achieving certain economic interests common to all of them.

This is done by forming a democratically controlled organization and making an equitablecontribution to its capital and accepting a fair share of risks and benefits of the organization.

(B) Principles of Co-operative Organizations :

(i) A co-operative organization is a voluntary association.

(ii) It is established to promote common economic interests of all its members andthereby promote their general welfare.

(iii) Its management is democratic in nature. There is one vote for one member.

(iv) All members enjoy equal rights and status.

(v) Its business is very often confined to the members only.

(vi) Profit motive is not supreme. It stresses mutual help, honest means and moralvalues. It believes in the principle of "all for each and each for all".

(C) Features of Co-operative Organizations :

(i) Voluntary Association : A co-operative society is a voluntary association ofindividuals having limited means, formed to promote and protect their commoneconomic interests.

(ii) Democratic Management : The members of the managing committee are electedby the members of a society on the basis of "one head" one vote", whatever be theirindividual share holding.

(iii) Equality : A co-operative society functions on the basis of equal rights, equalstatus and responsibilities of members.


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

(v) Thrift and Self-help : It promotes thrift, self-help and mutual assistance.

(vi) Sharing of Risks and Profits : The members have to bear a fair share of risks andenjoy a fair share of profits from their co-operative society.

(vii) Service Motive : Although a society enjoys profits, its main objective is service forpromoting common economic interests of the members as well as for promotingself-reliance, brotherhood, honesty and social relations among them.

(viii) Evils of Capitalism : It eliminates some of the evils of capitalism, e.g., exploitation ofconsumers, workers, concentration of wealth and economic power in a few hands, etc.

(ix) Legal Status : A co-operative society enjoys a legal status, for it is registeredunder the Co-operative Societies Act.

(x) Government Control : Such societies are controlled and regulated by thegovernment.

(D) Types of Co-operative Societies :

There are various types of co-operative societies such as Consumers' Co-operativeSocieties, Producers' Co-operative Societies, Co-operative Credit Societies, Co-operative Service Societies, Co-operative Farming Societies, Co-operativeMarketing Societies, Co-operative Housing Societies, etc.

(E) Merits and Demerits of Co-operative Societies :

Merits of Co-operative Societies.

(a) Voluntary Association : They are formed voluntarily. Individuals are free to join orleave the societies.

(b) No Evils of Capitalism : Such societies can eliminate some of the evils of capitalismand communism for they lie in between the two extreme economic systems. Theycheck the malpractices of monopolists and capitalists.

(c) Purchases and Sale of Goods : There is no speculative buying of goods. There isalso no problem of sales promotion by means of advertisement.

(d) No Malpractices and Reasonable Prices : They can also remove malpracticesin business like black-marketing, adulteration of goods, etc. The consumers alsoget various goods at low prices.

(e) Legal Status : A co-operative society has an independent legal status.


(f) Common Benefits : People with small means can easily form such societies topromote their common interests. They do not involve many legal formalities.

(g) Team Spirit : They are democratically managed, i.e. they are managed by electedrepresentatives. The members have right to vote. Such societies help develop teamspirit among their members.

(h) Social Values : They promote social values such as mutual sacrifice, mutual helpetc. and bring about an economic equality. They stress equal distribution of wealth.

(i) Service Motive : They provide various types of services to their members. They alsoobtain voluntary services from their members. Hence their cost of operation is low.

(j) Liability : In such a society, the liability of members in limited to the extent towhich they hold the shares therein.

(k) Concessions and Encouragement : The government provides various facilities topromote their growth by means of assistance, concessions etc. For e.g. the lowincome groups can form housing societies to solve their housing problem in citiesand towns.

(l) Debt, Insolvency etc. : They are not affected by debts, insolvency or insanity oftheir members. Hence they are relatively stable.

(m) Undistributed Profits : Their undistributed profits add to their capital which can beused to expand their activities.

Demerits of Co-operative Societies.

(a) Malpractices : Some of the members of a society may be unscrupulous. They mayresort to malpractices to exploit weak members and to promote their personal interest.This would result in conflicts, rivalry, quarrels and failure of the society to function properly.

(b) Limited Finance : As compared to a joint-stock company, the power of a co-operativesociety to raise finance is limited. So it is financially weak.

(c) Inefficient Management : Members of the management of such societies may be selectedon personal considerations. They may not be honest and competant. They may not alsopossess skill and efficiency to run them efficiently. Hence their efficient management isdifficult. They cannot also secure the services of experts and specialists nor can they gettrained personnel. This is because they cannot afford to pay high salaries.

(d) Rivalry : There may be rivalry among the members of the society to secure control overthe management of societies.

(e) Lack of zeal : Their member may not possess zeal, enthusiasm and urge to membersand may not extend whole-hearted co-operation. They try to get only the services renderedby a co-operative society and enjoy their benefits.


(f) Lack of Co-operative Spirit : Lack of co-operative spirit and Lack of knowledge of theprinciples of co-operation on the part of members may obstruct the growth of co-operativeorganizations.

(g) Business Secrecy : In such societies, business secrecy may not be maintained becausetheir affairs are carried on democratically.

(h) Government Control : They are subject to too much government control and regulations.Hence they might not be in a position to work efficiently.

(i) Limits of Expansion : Such organizations cannot extend their activities much due tolimited finance and limited management skill.

(j) Limited Buyers : The sales of a co-operative society are generally restricted to a limitednumber of buyers.

(k) Political Parties : The political parties may use such societies to promote their interests.

However, in spite of their limitations, they have an important role to play in improvingthe conditions of the poor people. Hence they should be made more effective.

6. PUBLIC ENTERPRISES / PUBLIC SECTOR UNDERTAKINGS (P.S.U’s) :

(A) Definition : The public enterprises refer to enterprises which are owned, managed andcontrolled by the government – either Central or State or Local self governments. Theyare called "state enterprises" or "public undertakings". They include Indian Railways,river projects, basic and key industries, various public utility undertakings providing roadtransport, water, electricity, gas etc.

(B) The Main Features of Public Enterprises :

(1) State Control : They are owned, managed and controlled by the departmentsconcerned of the government or by the government bodies.

(2) Management : Some of them may be managed by professionals.

(3) Accountability : They are accountable to the public because they are accountableto the government which represents the people.

(4) Separate Funds : They are assigned separate funds to undertake their activities.

(5) Legal Status : Each public enterprises is a separate legal entity, for it is establishedby law. Some of the public enterprises enjoy autonomous status operating as perthe state policy and general directives from the government. So they are influencedmore by the state policy than the enterprises in the private sector.

(6) Profit : Some of them may work for promoting welfare of the people rather thanmaking profits. Some of them are run on commercial principle so as to makeprofits. But profit-making is not their main motive for, at the same time, they have topromote social ends.


(C) Forms of Public Enterprises :

There are three forms of organization adopted for the management of public enterprises.

1) Departmental Management

2) Company Management or management by boards and

3) Public Corporations.

1) Departmental Management : There are some undertakings which are run by thegovernment departments e.g. posts and telegraphs, railways, defence industries,information and broadcasting, atomic energy etc.

Normally enterprises which are strategically important and which provide steadyincome to the government are departmentally-managed.

The main features of the Departmentally - managed Undertakings are :

1. They are managed by various departments of the government.

2. The civil servants are assigned the job of running them.

3. The ministries concerned exercise control over them.

4. They are financed by the government by means of annual appropriations fromthe treasury.

5. They are accountable to the public through the government.

Their defects are : Such departmentally-run enterprises are subject to a numberof criticisms such as lack of initiative, rigidity in operations, ignorance of consumers'requirements, red-tapism, delay in taking decisions, wrong decision, politically-motivated decisions, etc. Hence their working efficiency suffers.

It these defects are eliminated, they can be run efficiently. This can be achieved, toa large extent, if an autonomy is given to such enterprises in their day-to-dayworking.

2) Joint Stock Company Form of Management : Certain enterprises, which maybe entirely owned by the government, are operated as private limited companies.

The main features of the Government Companies are :

1. They are owned by the government.

2. They are commercial in nature. They are dynamic and quick in decision - making.

3. They are registered as private limited companies.

4. Their financial operations are subject to a close scrutiny by the government.


5. Their attempt to eliminate some of the defects of the departmentally runenterprises.

Some of the important government companies in India are : The Bharat HeavyElectricals Ltd., (BHL), the Hindustan Steel Limited (HSL), the Hindustan AntibioticsLimited (HAL), the Bharat Aluminum Company Limited (BACL), the Steel Authorityof India Limited (SAIL), etc.

3) Public Corporations : Public corporations refer to autonomous organizationscreated by statutes or special acts of the legislature to run the nationalized to runthe nationalized enterprises or newly set up public undertakings.

Their main feature are :

1. They are created by special acts of the parliament. So they are legal entitiesowned by the government.

2. They enjoy internal and financial autonomy, i.e. they are financially independentautonomous institutions. So they are free from the parliamentary control inrespect of their day-to-day management t and financial operations. They takeall decisions independently.

3. Their powers and functions are clearly laid down by respective acts of theparliament.

4. They are run like commercial concerns.

5. They attempt to blend the public ownership and private initiative and flexibilityfor they are free from bureaucracy in administration and management.

6. They are supposed to eliminate the defects of the departmentally - runenterprises as well as those of company type undertaking of the state.

7. They are managed by Boards of Directors appointed by the government whoneed not be form the cadre of civil servants.

Some of the corporation set up in India are the Life Insurance Corporations (LIC),the State Road Development Corporation (SRDCs), the State Trading Corporation(STC), The Damodar Valley Corporation (DVC), the Reserve Bank of India (RBI), theOil and Natural Gas Commission (ONGC), the Air India, the Indian Airlines Corporation,the Industrial Finance Corporation of India (IFCI), Food Corporation of India etc.

(D) Advantages (i.e. Merits) and Disadvantages (i.e. Demerits) of Public Enterprises :

Merits of Public Enterprises

1) Use of Profit : Some of the public enterprises like post and telegraphs are not runfor earning profit while other enterprises like Hindustan Machine Tools (HMT) as in


India are run for making profits. But the profits earned by them are utilized forimproving services rendered or for further expansion of their activities.

Thus profits earned by state enterprises can be used to promote general welfare.

2) Nature of Investment : There are certain fields in which the private sector will notinvest either because it is too risky or because the yield on such investment is toolow and spread over a very long period. The government has, therefore, to undertakesuch investment in the interest of society, e.g. construction and management ofriver linking projects.

3) Sufficient Capital : It is also quite likely that the private sector may not be in aposition to raise enough capital for a project or an industry. But the government canraise any amount of capital from various sources for investment in any project or anindustry. Hence such projects or industries are started in the public sector.

4) Public Welfare : In certain fields, the state enterprises may work more efficientlythan private enterprises. This is particularly the case with public utility services likeelectricity, water, railway service etc. If they are left to the private sector, theconsumers may be exploited. Hence they are organized by the government on themonopoly basis to secure economies of scale.

5) Economies of Large-scale Production : On account of large-scale production,they can enjoy the economies of large-scale production.

6) Consumer Interests and Quality of Goods : As compared with the private sectorenterprises, the quality of goods or services provided by the public enterprises islikely to be better. They will also be made available at reasonable prices. Hence theinterests of consumers would be safeguarded.

7) Labour Relations : The scope for conflicts between workers and the publicenterprises would be minimum. This is because the workers are likely to be morecontented due to security and justice in service.

8) Industrial Development : When a country has a few entrepreneurs and the skilledlabour is limited. The government may set up a number of industries by invitingforeign skilled labour to help it to accelerate the pace of industrial development. Itmay also attract very efficient personnel and best managerial talent by offering highsalaries and better service conditions.

9) No Wastes : All wastes of economic resources in the form of existence of excesscapacity in the private sector industries, competitive advertisement etc. can beeliminated if they are nationalized and run by the government.

10) Check on Concentration of Economic Power and Private Monopoly : Thepublic enterprises can help to check the concentration of economic power in thehands of a few individuals and the growth of private monopolies.


11) Balanced Development : They can contribute to a balanced regional developmentby locating public enterprises in less developed areas and thereby reduce the regionalincome inequalities.

12) Ultimate Control by People : The working of the public enterprises is subject tothe criticism of the people and the Members of Parliament. Hence, if there isanything wrong in the working of the public enterprises, it would be set right. So thepublic enterprises are ultimately controlled by the people themselves.

Demerits of Public Enterprises :

1) Inefficient management : The government officials may take a long time in takingdecisions as well as action. Hence the government enterprises may be run withexcessive social cost of operation. This may be so because all of them may notpossess much business experience.

2) No Incentive for Hard Work : The public enterprises may not create incentives forhard work for their workers. The managers may not take any risk. This is becausetheir acts are questioned.

3) Bureaucracy and Red-tapism : Bureaucracy, red-tapism and corruption mayobstruct the growth of public enterprises. The bureaucrats may not take quickaction because they have followed the established procedures. Hence they maycause losses to the public enterprises. This would involve a burden to the taxpayers.

4) Lack of Incentives : Because of lack of incentives, personal initiative may belacking and the responsibilities may be avoided. This is because the governmentofficials may work in a routine way. In other words, they may not work enthusiasticallyand efficiently.

5) Extravagance : The officials in charge of managing these enterprises may plan ina big way and spend extravagantly. This would cause much loss to the publicsector year after year.

6) Friction : There may also be an internal friction between various officials in a publicenterprise. Hence its efficiency would suffer.

7) Political Considerations : Political considerations may determine appointments,transfers and promotions. Hence right man may not be placed in the right place.Such a policy is detrimental to the efficient working of the public enterprises. Furtherbribery and corruption may predominate. Also an enterprise may be located in aparticular area out of the political rather than economic considerations.

8) Rigidity : There may be rigidity in the working of the public sector enterprises dueto strict rules and regulations.


9) Transfers : There might be frequent transfers of the government officials. This woulddisturb the smooth working of the government enterprises.

10) Helplessness of Consumers : Individual consumers will be helpless when goodsand services are provided by big public enterprises. They may not much care forthe public. They may not get proper treatment from the officers in the publicenterprises.

11) Personal Liberty : Extension of the public sector may result in centralization ofpowers and a loss of personal liberty. Also it may reduce resources available forinvestment in the private sector. Hence the working to the private sector industrieswould suffer.

12) Government Interference : Due to too much interference form the government,the executives in charge of the public enterprises may not take their own decisionsto run them properly.

13) Workers' Interests : The workers' interests may not always be protected resultingin labour unrest. However the authorities may, sometimes, yield to the pressure ofworkers' demand due to the political considerations.

14) Prices : The public enterprises may go on increasing prices of their goods andservices periodically. This would result in a decline in the welfare of the people.

Some of these disadvantages can be largely eliminated if autonomy is ensured in theirinternal working and proper incentives are provided for their successful working. Thiswould reduce economic inequalities and promote public welfare.

7. JOINT - SECTOR ENTERPRISES :

In India, the concept of joint-sector was accepted by the Government of India through itsIndustrial Licensing Policy of 1970. The Government reiterated it in its Industrial Policydecision of February, 1973.

In simple terms, the joint-sector is a form of partnership between the private sector andsector and the government.

In this, the government and public financial institution provide a part of the capital and theother part of the capital comes from the private sector and investing public.

However the day-to-day management of the joint-sector enterprises is left in the hands ofthe private sector which possesses the technical and managerial expertise. However onthe Board of Directors of a joint-sector, the government is adequately represented toregulate its functioning. The Board of Directors would lay down the policies for the join-sector enterprises. The government has to guide their management and operations.


Thus the joint-sector enterprises are controlled by the government and the private sectorjointly.

The joint-sector can be used to promote socio-economic objectives of the governmentsuch as regional dispersal of industries, etc.

Thus a joint-sector involves a social control over industries without resorting to theirnationalization, i.e. it lies between private enterprise and outright nationalization.

In India, some of the important joint-sector enterprises are Indian Telephone IndustriesLimited (ITI), Hindustan Machine Tools (HMT), etc.

The state government in India have also entered into joint ventures with the multi-nationalcorporations.

8. NON - PROFIT ORGANISATIONS :

Non - Profit organisation can be classified into public sector organisations and privatesector organisations. Some organisations created by the Government in the publicsector are directed towards meeting the basic needs of the people. Many privatesector organisations are created by socially oriented people with a view to meetcertain needs of the society which are not yet fulfilled. In both these cases profit -making is not a goal.

It is possible to classify non- profit organisation into public utilities and social serviceorganisations. Water supply, postal services, general hospitals, etc., are examples ofpublic utilities. On the other hand, organisation of voluntary social workers, also knownas NGOs (non-governmental organisations) working in the fields like rehabilitation ofdisabled persons, pensioners' homes, adult education, non-formal education, schoolsfor the blind or the deaf, HIV/AIDS awareness etc., are examples of this type. Thefollowing chart illustrates this classification :

Non-Profit Organisation

Public Sector Private Sector

Public Utilities Social Service Organisations


Organisation : Public sector non - profit organization can take various forms likedepartmental establishments, autonomous boards / corporations etc. Their organizationalpatterns, merits and demerits are as discussed earlier under public sector undertakings.Some characteristics, however are worth noting.

(i) Most of these organizations enjoy a certain degree of autonomy to make room forflexibility and quick decision;

(ii) Such organizations have a provision for advisory boards or committees which canprovide broad guidelines for the functioning of the organization as well as for thepurpose of a general monitoring;

(iii) Normally local or regional branches / boards have the freedom to adjust their activitiesto the local needs of the society;

(iv) The beneficiaries or the users can send their suggestions / complaints for improvingthe performance of these organizations;

(v) Annual accounts are audited and placed before the house concerned like themunicipal corporation, legislative assembly or the parliament.

Private sector organizations usually prepare their own constitution and get the organizationregistered under the Public Trust Acts as well as / or Societies Act. The membersconstituting such charitable social service organization constitute what is known as theGeneral Body which meets once a year to review the report and to accept the accounts.The day - to - day functioning is taken care of by the Executive Committee or theManagement Council or some such committee under any other name like the businesscouncil, supervisory board etc.

Whatever the type of non-profit organization, a common characteristics is that it servessome very important need of the people which either cannot be met through the marketmechanism or, if left to market mechanism, users are likely to be exploited or go unserved.The pricing policy of such organizations depends upon whether the organization is aidedor funded by some other philanthropic organization. At times the services are renderedfree of charge and the costs are entirely borne by the funding agencies or the government,as the case may be. Sometimes the prices are subsidized for keeping them low andwithin the reach of the low income beneficiaries. Sometimes prices / fees are discriminatorybeing linked to the annual income of the users. In some cases, the prices just cover thecosts.

In modern times, and especially in more developed countries, voluntary agencies arebeing entrusted with task which earlier were performed by the government. Thisarrangement of voluntarism has various advantages. Such voluntary organizations -


(i) can provide quality service for they are run by committed social workers,

(ii) can ensure peoples, participation due to their service motive,

(ii) can be flexible in procedure and approach and this suits the people,

(iv) are close to the people and therefore, can remain in touch with the users and canmonitor the way in which needs of the people are met,

(v) can take a feed back and re-adjust their methods / procedures to instill more efficiencyor better quality in service.

9. BUSINESS ORGANISATIONS OF THE NEW MILLENNIUM :

By the turn of the century, mainly due to the technological developments, the firms allover the world started experiencing phenomenal changes and challenges. The followingcan be listed as the major ones :

(i) With a systematic removal of barriers to trade, under the WTO system, the marketswidened suddenly and extended to global dimensions.

(ii) Relaxation of exchange controls and freedom of convertibility of currencies expandedinvestment opportunities and subsequent flows of capital.

(iii) Mass production of personalized products replaced mass production of the yesteryears.

(iv) Aggressive sales promotion and attractive marketing campaigns became an inevitablepart of the firm's business strategy.

(v) Widening of markets and reduction in average costs shifted the point of optimumproduction so high that the firms kept growing and reaping advantages of large-scale production.

(vi) The incidence of industrial sickness and closures reached unforeseen dimensions.

(vii) The process of acquisitions and mergers was accelerated out of the survival instinctof the firms.

(viii) Advertising, mainly through the powerful electronic media, reached unprecedentedproportions and started designing the tastes of the consumers.

(ix) The competition that emerged was in pleasing the consumers by apparently satisfyinghis need which, in reality, were actually tailored by the gigantic firms with theirclever manipulation.


10. DISTINCTION BETWEEN PRIVATE SECTOR AND PUBLIC SECTOR :

(i) On the Basis of Economic System : The private sector is fully owned and managedby private individuals and private firms. There is private ownership in the means ofproduction. But the public sector is fully owned and managed by the State. There ispublic ownership in the means of production.

(ii) On the Basis of Economic System : The private sector is based upon capitalism.But the public sector is based upon socialism.

(iii) On the Basis of Motive : The private sector is profit-motivated. But the publicsector is to promote social welfare by rendering various types of services to public.

(iv) On the Basis of Principle of Pricing : In the case of the private sector, the pricesof goods and services are determined by the market forces of supply and demand.The prices are fixed in such a way that the profits are maximized. For maximizingprofits, the marginal cost is equated to marginal revenue.

In the case of the public sector, the prices are administratively fixed. They are notdetermined by market forces. The objective of social welfare is given emphasiswhile fixing the prices in the public sector.

(v) On the Basis of Controls : The private sector is controlled by individuals, partnershipfirms and joint-stock companies. But the public sector is controlled by the State.

(vi) On the Basis of Nature of Investment : The private sector is interested mainly inthe investments in those industries which provide reasonable profits in a shortperiod, e.g., light consumer goods industries, durable consumer goods industries,etc., producing TV sets, medicines, cloth, transistors, etc. But the public sectorinvests in those industries or projects in which the private sector will not investeither because it is too risky or because the yield on such investment is very lowand spread over a very long period, e.g., defense industries, river projects, iron andsteel industry, fertilizer industry, railways, posts and telegraphs, oil exploration etc.

11. SPECIFIC ORGANISATIONAL GOALS / MOTIVATION / OBJECTIVES OF FIRMS :

Introduction :

The decision-making of firms is guided by the goals and objectives which they seek toachieve. Over time different assertions have been made regarding their objectives. Thisis particularly so since corporations have emerged as an important form of organization.Even in developing economies, corporations contribute a significant percentage ofmanufacturing activities. The objectives of the firm as put forth by Williamson, Marris,Simon, Cyert and March start from this basic fact, i.e. the emergence of corporations asan important form of organisation. Since the interests of managers may be different fromthose of owners, different hypothesis have been presented by these authors regardingthe objectives of the firm. Those modify the decision-making process.


A) MAXIMIZATION OF PROFIT / TRADITIONAL APPROACH :

Profit maximization has been the most important assumption on which economists havebuilt price and production, theories. This hypothesis has however been stronglyquestioned. This issue will be dealt with later. Let us first look into the importance of theprofit maximization hypothesis and theoretical conditions of profit maximization.

The conventional economic theory assumes profit maximization as the only objective ofbusiness firms. Profit maximization as the objective of business firms has a long historyin economic literature. It forms the basis of conventional price theory. Profit maximizationis regarded as the most reasonable and analytically most 'productive' business objective.The strength of this assumption lies in the fact that this assumption 'has never beenunambiguously disproved'.

Besides, profit maximizations assumption has a great predictive power. It helps inpredicting the behavior of business firms in the real world and also the behavior of priceand output under different market conditions. No alternative hypothesis explains andpredicts the behaviour of firms better than the profit maximization assumption.

Maximum Profit Conditions :

There are two conditions that must be fulfilled for the profit to be maximum : (i) necessaryconditions and (ii) secondary conditions.

The necessary condition requires that marginal revenue (MR) must be equal to marginalcost (MC). Marginal revenue is obtained from the production and sale of one additionalunit of output. Marginal cost is the cost arising due to the production of one additionalunit of output.

The secondary condition requires that the necessary condition must be satisfied underthe condition of decreasing MR and rising MC. i.e. MC curve must cut the MR curve frombelow. The fulfillment of the two conditions makes the sufficient condition.

Controversy over Profit Maximization :

Although profit maximization has been the most widely known objective of businessfirms, some economists have raised doubts on the validity of this objective. The importantobjections to this objective are the following.

First, profit maximization assumption is too simple to explain the business phenomenonin the real world. In fact, businessmen are themselves not aware of this objective attributedto them.

Second, it is claimed that there are alternative and equally simple objectives of businessfirms that explain better the real world business phenomenon, e.g. sales maximization,a target rate of return, a target market share, preventing price competition and so on.


Third, it is argued that firms do not have the necessary knowledge and a priori data toequalise MR and MC. Hence firms cannot attempt to maximize their profits in the mannersuggested by the conventional theory.

In Defense of Profit Maximization Assumption :

The conventional economic theory defends the profit maximization assumption on thefollowing grounds.

First, only those firms survive in the long run in a competitive market which are able tomake a reasonable profit. Once they are able to make profit, they would always try tomake it as large as possible. All other objectives are subjugated to this primary objective.

Second, profit maximization assumption has been found extremely accurate in predictingcertain aspects of a firm's behaviour. Friedmen argues that the validity of profitmaximization hypothesis cannot be judged by a priori logic or by asking the businessexecutive. The ultimate test is its ability to predict the business behaviour and trends.

Third, profit maximization assumption is a time-honored objective of a business firmand evidence against this objective is not conclusive or unambiguous.

Fourth, though not perfect, profit is the most efficient and reliable measure of efficiencyof a firm. If is also the source of internal finance. In developed economies, internal sourcecontributes more than three fourths of the total finance.

B) REASONABLE PROFIT TARGET :

We have noted that profit maximization is theoretically the most sound and time-honouredobjective of business firms. But profit maximization in a technical sense, i.e. making MC= MR, is beset with serious computational and data problems. Most goods and servicesare produced in large quantities - bulks and batches. Only few goods like ships, planes,turbines, big plant and machinery, etc., are countable in units. Business books of accountsdo not reveal unit cost and revenue. For Example HMT or TITAN would not be able to findcost of one additional wrist watch produced and the addition to its total revenue.

In practice, therefore, modern firms and corporations do not aim at profit maximization.Instead they have "a standard", "a target" or "a reasonable profit" which they strive to achieve.

Why do modern corporations aim at a "reasonable profit" rather than attempting tomaximize profits?

Reasons for Aiming at "Reasonable Profits"

For a variety of reasons, modern large corporations aim at making a reasonable profitrather than at maximizing the profit. Joel Dean has listed the following reasons.


1. Preventing entry of competitors : Profits maximization under imperfect marketconditions generally leads to a high 'pure profit' which is bound to attract competitors,particularly in case of a weak monopoly. The firms therefore adopt a pricing and aprofit policy that assures them a reasonable profit and, at the same time, keepspotential competitors away.

2. Projecting a favourable public image : It often becomes necessary for largecorporations to project and maintain a very good public image, for if public opinionturns against it and government officials start raising their eyebrows on profit figures,corporations may find it difficult to sail smoothly. So most firms set prices lowerthan that conforming to the maximum profit but high enough to ensure a "reasonableprofit".

3. Restraining trade union demands : High profits make trade unions feel that theyare deprived of their due share and therefore they raise demands for wage hike.Wage-hike may lead to wage - price spiral and frustrate the firms' objective ofmaximizing profit. Therefore, profit restrain is sometimes used as a weapon againsttrade union activities.

4. Maintaining customer goodwill : Customers' goodwill plays a significant role inmaintaining and promoting demand for the product of a firm. Customers, goodwilldepends largely on the quality of the product and its, 'fair price'. What consumersview as fair price may not be commensurate with profit maximization. Firms aimingat better profit prospects in the long run, sacrifice short-run profit maximization infavour of a "reasonable profit'.

5. Other factors : Some other factors that put restraint on profit maximization include(a) managerial utility function being preferable to profits maximation for executive,(b) congenial relation between executive levels within the firm, (c) maintaining internalcontrol over management by restricting firm's size and profit, and (d) forestalling theanti-trust suits.

C) SALES REVENUE MAXIMIZATION :

Baumol has suggested maximization of sales revenue as an alternative objective to profit-maximization. The reason behind this objective is the separation of ownership andmanagement interests. This dichotomy gives managers opportunity to set their goals otherthan profit maximization which most owner-businessmen pursue. Given the opportunity,managers choose to maximize their own utility function. According to Baumol, the mostplausible factor in managers' utility functions is maximization of the sales revenue.

The factors which explain the pursuance of this goal by the managers are thefollowing. First, salary and other earnings of managers are more closely related tosales revenue than to profits. Secondly, banks and financial corporations look at sales


revenue while financing the corporation. Thirdly, trend in sales revenue is the readilyavailable indicator of performance of the firm. It helps also in handling the personnelproblem. Fourthly, increasing sales revenue enhances the prestige of managers whileprofits go to the owners. Fifthly, managers find profit maximization a difficult objective tofulfill consistently over time and at the same level. Profits may fluctuate with changingconditions. Finally, growing sales strengthen competitive spirit of the firm in the marketand vice versa.

D) MAXIMIZATION OF FIRM'S GROWTH RATE :

Prof. Morris has suggested another alternative objective i.e., maximization of balancedgrowth rate of the firm, which means maximization of 'demand for firm's product' or 'growthof capital supply'. According to Morris, by maximizing these variables, managers maximizeboth their own utility function and that of the owners. The managers can do so becausemost of the variables (e.g., salaries, status, job security, power, etc.) appearing in theirown utility function and those appearing in the utility function of owners (e.g. profit, capital,market share, etc.) are positively and strongly correlated with a single variable, i.e. size ofthe firm. Maximization of these variables depends on the maximization of the growth rateof the firms. The managers therefore seek to maximize the steady growth rate.

Morris's theory, though more rigorous and sophisticated than Baumol's sales revenuemaximization, has its own weaknesses. It fails to deal satisfactorily with oligopolisticinterdependence. Another serious shortcoming of his model is that it ignores pricedetermination which is the main concern of profit maximization hypothesis. Morris'smodel too does not seriously challenge the profit maximization hypothesis.

E) SATISFYING BEHAVIOUR :

Some economists like Cyert R. M. and J. G. March argue that the real business world isfull of uncertainty, accurate and adequate data are not readily available; where data areavailable managers have little time and ability to process data; and managers workunder a number of constraints. Under such conditions it is not possible for the firms toact in terms of rationality postulated under profit maximization hypothesis. Nor do thefirms seek to maximize sales, growth or anything else. Instead they seek to achieve a'satisfactory profit', a 'satisfactory growth', and so on. This behaviour of firms is termedas 'Satisfaction Behaviour'. The underlying assumption of 'Satisfaction Behaviour' of firmsis that a firm is coalition of different groups connected with the various activities of thefirm e.g., shareholders, managers, workers, input supplier, customers, bankers, taxauthorities and so on. All of these groups have some kind of expectations - often conflicting- from the firm, and the firm seeks to satisfy all of them in one way or another.

The behavioural theory has however been criticized on the following grounds. First, thoughthe behavioural theory deals realistically with the firm's activity, it cannot explain the


firm's behaviour under dynamic conditions in the long run. Secondly, it cannot be used topredict exactly the future course of firm's activities. Thirdly, this theory does not deal withequilibrium of the industry. Fourthly, like other alternative hypothesis, this theory, toofails to deal with interdependence and interaction of the firms.

F) LONG-RUN SURVIVAL AND MARKET SHARE GOALS :

Another alternative objective of a firm - as an alternative to profit maximization - wassuggested by Rothschild. According to him, the primary goal of the firm is long - runsurvival. Some others have suggested that attainment and retention of a constant marketshare is the objective of the firms. The managers therefore seek to secure their marketshare and long-run survival, the firms may seek to maximize their profit in the long-run,though it is not certain.

G) ENTRY - PREVENTION AND RISK AVOIDANCE :

Yet another alternative objective of the firms suggested by some writers is to prevententry of new firms into the industry. The motive behind entry-prevention may be (a) profitmaximization in the long run, (b) securing a constant market share, and (c) avoidance ofrisk caused by the unpredictable behaviour of the new entrants. The evidence on whetherfirms maximize profits in the long run is not conclusive. Some argue that wheremanagement is divorced from the ownership, the possibility of profit maximization isreduced. Some argue that only profit-maximizing firms can survive in the long run. Theycan achieve all other subsidiary goals easily if they maximize their profits.

No doubt, prevention of entry may be the major objective in the pricing policy of the firm,particularly in case of limit pricing. But then, the motive behind entry-prevention is tosecure a constant share in the market. Securing constant market share is compatiblewith profit maximization.

H) THE HOMEOSTATIC THEORY

Prof.Kenneth Boulding was critical of the traditional theory on the ground that it ignoredthe information that could be available to the firm and assumed the availability of informationwhich could never be available. The theory therefore, was of no use as a guide to practicalpolicy. For this reason he advocates the homoeostatic theory.

According to the homeostatic approach, there is some state of the system which it isdesigned to maintain. If any disequilibrium in this state occurs, counteracting forcesstart operating and the desired state is re-established. the organism has a usual tendencyto maintain its stability by keeping its mood and configuration stable. Only when somestress is applied, the organism causes a deviation from normal state. Such a deviationbrings about changes in mood and configuration and the effects of the stress are nullified.


In explaining the approach, Boulding says," There is some desired quantity of all thevarious items in the balance sheet, and that any disturbance of this structure immediatelysets in motion forces which will restore the status quo. Thus, if a customer purchases aproduct, this diminishes the firms' stocks of finished product, and increases its stock ofmoney. In order to restore the status quo, the firm must spend the increased moneystock to produce more finished products'. A firm adjusts its entire behavior to maintaininga given state or position. Its existing asset-structure, for instance, is what it would seekto preserve. Any change in this structure would be responded by countervailing action. Afall in liquidity, to take another example, would prompt the firm to restore its originalliquidity position.

The homeostatic theory is useful as a first approximation regarding the motivation of afirm. But when we extend this theory to complex areas of decision-making, it breaksdown. Main objections raised against the theory can be summed up as following: i) It isstatic theory and does not allow any change in the original state, ii) it has nothing to sayregarding normal and ideal structure of a balance-sheet which the firm tries maintain. iii)a study of the decision taken by firms does not be what Boulding says. Even in theshort-run certain fluctuations arise which actually show a lack of an adequate homeostaticmechanism.

I) THE LIFE-CYCLE APPROACH

Like all organism, the firm, too is an organism, according to the life-cycle theory. Thefirm therefore, has its own law of growth and survival. It exhibits a cycle of birth, growth,decay and death. A firm is born when there is an opportunity and a scope for its existence.An existing firm may face unfavorable circumstances in terms of rising costs of inputs orfalling demand. When such a firm incurs losses, it may continue to operate for a while;but will ultimately close down. This is because the resources available to the firm can beutilized productivity in some other field. In the early stages the firm has the advantage ofa new market or a new product and can forge its way ahead with strong competitivecourage and capability. With growth, it consolidates its position and gets structured withinternal efficiency and managerial acumen. At a later stage rival firms may cause anerosion of its market mainly due to their superior techniques or marketing advantages.The firm's objective then becomes increasing competitive strength. But as the industryapproaches maturity, demand is saturated, costs of further market penetration get highand the firm aims at long-term growth and flexibility, though these objectives becomedifficult to attain. The firm may survive for some time or may face decay, at such a time.

This is an evolutionary approach and it does apply to all organisms living in a dynamicworld. However, in the short -run, evolutionary characters do not become apparent. Again,the theory leaves out several other considerations which are relevant.


12. OTHER GOALS OR OBJECTIVES OF FIRMS :

Normally, it is the entrepreneur who decides about the size of the firm which he wants tomanage or start. This he will decide after finalizing the aims and objectives of the firm. Sowe have to consider the other possible objectives of a firm in addition to the goals wehave already discussed in a free enterprise economy.

The following are the other objectives of a firm in a free enterprise economy:

1. Personal Ambitions: Many times a firm desires to increase its own individualimportance in the business world. Many times this craving is found among firmsowned by one single individual or family. This is done in more than one way. Somemay have a desire to earn a name as a great donor others may desire to eliminatelabour dissatisfaction, while some others may be out to provide comforts for theirworkers and so on. This being a personal choice any whim of the entrepreneur orowner may be the aim of the firm.

2. Political Dominance: In a democracy, political parties and elections are inevitable.Many industrialists or businessmen have a desire to back a particular politicalparty and to acquire political importance.

3. Facing Competition: Every businessman or producer has to face competition. Byreducing the cost of production to the minimum, a producer may survive or facecompetition. But if every producer does this, his cost reaches the rock-bottom andfurther reduction in cost is not possible. Under these circumstances, a producermay even prefer to incur losses and continue to reduce the price even though hecannot reduce the cost. This is done on the presumption that sooner or later, someof the competitors may be out of the business and then those who survive may beable to make profit and make up their losses. Under these conditions, the aim ofproduction is not to make profit but to drive away competitors.

4. Establishment of Monopoly : Establishment of monopoly of a particular productmay even be the aim of production. For establishing monopoly, more than one trickare employed by the producers - advertising on a very large scale, dumping, sellingthe product at two different prices in two markets, offering rewards, etc. It is verydifficult to establish and maintain monopoly over the production of any commodity.Thus, in such an effort, maximization of profits becomes a secondary objective ofproduction and establishing monopoly becomes the primary objective.

5. Maximization of Long-run profits: Modern production has become very complicated.Production necessarily being on a large scale includes several things, such asadvertising, printing price lists and labels, supplying these lists to retailers, etc. Thisinvolves a lot of expenditure in terms of money and time. Under these circumstances,it becomes more desirable to keep long term maximum profit as the goal of production.This enables the producer to neglect short term marginal losses.


6. Reasonableness of Price of Production Policy: In modern times, while planningproduction and the price strategy, it is necessary to take into account the probableeffects of the strategy. If the price appears to be too high, the government mayinterfere and fix the price. In rare cases even the consumers' boycott cannot beruled out. Avoiding any of these may even be the objective of production.

We have discussed several objectives of production, other than profit maximization.In practice, we find that all these objectives do exist. But finally profit - maximizationremains the only most important motive of production because without obtainingmaximum profit no firm can remain in business for ever. The index of the success ofproduction is the rate of profit. Even the success of a joint stock company is gaugedby the rate of dividend. So theoretically speaking, profit maximization must betaken to be the only goal of production. Even while determining the ideal size of theunit of production, we have taken profit maximization as the only motive of production.


Exercise:

1. What is 'plant', 'firm' and 'industry'?

2. Explain 'Proprietary firm' as a form of business Organization. State its merits and demerits.

3. Explain partnership form of business organization. State its merits and demerits.

4. Explain the features / characteristics of a cooperative organization. Point out its meritsand demerits.

5. Write short notes on

a) Profit maximization

b) Prof. Baumol's sales maximization goal,

c) Reasonable Rate of profit as an organization goal

d) Satisfying behavior theory as an organization goal

e) The Homeostatic Theory

f) The Life Cycle Approach


NOTES

Profit 65

Chapter 3

PROFIT

Preview

Meaning of Profit, Accounting Profit vs. Economic Profit, A brief review about the theories ofprofit, Measurement of profit, Profit Policies and Reasons for limiting profit, standard of limitedprofits.

1. MEANING OF PROFIT :

Profit means different things to different people. "The word 'Profit' has different meanings tobusinessmen, accountants, tax collectors, workers and economists and it is often used in aloose sense that buries its real significance. In general sense, 'profit' is regarded as incomeaccruing to the equity holders, in the same sense as wages accrue to the labour, rent accruesto 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 excessof revenue over all paid-out costs including both manufacturing and overhead expenses. It ismore or less the same as 'net profit'. For all practical purposes, businessmen also use thisdefinition of profit. For taxation purposes, profit or business income means profit in accountancysense plus non-allowable expenses. Economist's concept of profit is of 'Pure Profit', alsocalled 'economic profit' or 'just profit'. Pure profit is a return over and above the opportunitycost, i.e. the income which a businessman might expect from the second best alternative useof his resources. These two concepts of profit are discussed below in detail.

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. Inaccounting sense, profit is surplus of revenue over and above all paid-out costs, includingboth manufacturing and overhead expenses. Accounting profit may be calculated as-

Accounting profit = TR - (W + R + I + M)

where 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 recordedin the books of accounts, are considered.


The concept of 'economic profit' differs from that of 'accounting profit.' Economic profit takesinto account also the implicit or imputed costs. The implicit cost is opportunity cost.Opportunity cost is defined as the payment that would be 'necessary to drawforth thefactors of productions from their most remunerative alternative employment'. In simpleterms, opportunity cost is the income foregone, which a businessman could expectfrom the second best alternative use of his resources. For example, if an entrepreneuruses his capital in his own business, he foregoes interest which he might earn by purchasingdebentures of other companies or by depositing his money with joint stock companies for aperiod. Furthermore, if an entrepreneur uses his labour in his own business, he foregoes hisincome (salary) which he might earn by working as a manager in another firm. Similarly, byusing 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 transfercosts. Accounting profit does not take into account the opportunity cost.

It should also be noted that the economic or pure profit makes provision also for (a) insurablerisks, (b) depreciation, and (c) necessary minimum payment of shareholders to prevent themfrom withdrawing their capital. Pure profit may thus be defined as 'residual left after allcontractual costs have been met, including the transfer costs of management,insurable risks, depreciation and payments to shareholders, sufficient to maintaininvestment 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 maybe even negative, since it may not be possible to decide beforehand the best way of using theresources. 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 looksafter purchase of raw materials, production, marketing, recovery of receivable and personnel.The most important function performed by an entrepreneur is, however to undertake risk anduncertainty in business. The reward which is paid to an entrepreneur for discharging thisfunction is called Profit. In this chapter, we propose to study the emergence of profit.

(A) Gross Profit and Pure (Net) Profit

When cost of production is deducted from the total sales proceeds, the residual portionis called Gross Profit.

Gross Profit = Total Receipts - Total Expenditure

An entrepreneur is required to make following payments out of the Gross Profit :

Profit 67

(a) Remuneration for the factors of production contributed by the entrepreneurhimself-

He must pay rent for the use of land. If the land is owned by him, he must pay notionalreward for the use of land, because, he is otherwise required to pay rent if he hires landfrom some other person.

(b) Depreciation and Maintenance Charges

Some portion should be deducted from gross profit by way of depreciation on machineryand other assets.

(c) Extra - Personal Profits

This includes -

i) Monopoly Profits : If a producer is a monopolist, he may be earning monopolyprofits. These are profits not because of the business skill or ability of the entrepreneur,but because he is a monopolist in his field. Monopoly profits must be deductedfrom gross profits to arrive at net (pure) profits.

ii) Chance Profit : An entrepreneur may earn high profits just 'by chance', say becauseof an outbreak of war. This is not a part of net profits.

(d) Net Profits :

When all the above payments are made out of gross profit, the residual portion is calledPure (Net) Profit. The reward which an entrepreneur gets (i) for undertaking risk anduncertainty, (ii) for co-ordinating and organizing production and (iii) for innovating is calledPure Profit.

2. THEORIES OF PROFITS :

Various theories have been developed to explain the emergence of Profit. It is worthwhile toexplain some of the theories of profit.

(1) Risk Taking Theory -

The Risk-Taking Theory was developed by the American economist Hawley. Accordingto him, profit arises because considerable amount of risk is involved in business. Profitis, therefore, the reward for risk-taking. Hawley's theory has been criticized on severalgrounds. In the first place, Hawley has not classified the types of risks. Secondly, asCawer 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 ittotally. 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.

(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 importantbecause they can be passed on to an insurance company. An entrepreneur cantake an insurance policy by paying the premium. Since such risks are covered byinsurance, they are called "Insurable Risks."

(b) There are other risks which cannot be passed on to an insurance company or tothe paid managers. Every business involves great amount of uncertainty and thelosses arising there from cannot be estimated with precision. The prices of rawmaterials may suddenly increase, the supply of raw materials may be restrictedand introduction of new substitutes in the market may reduce the demand for theproduct. 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 bymonopolistic competition. All these factors are uncertain and losses arising therefrom cannot be insured with any insurance company. These risks and losses mustbe 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 theIndustrial Revolution, production is carried out on a large scale and in anticipation ofdemand. Producers take into account the tastes and fashions of the people and producethe goods accordingly. Sudden change in the tastes and fashions may affect the demandfor products. If a particular fashion is receded in the background, goods may not be soldat all. The losses arising out of such uncertainty cannot be estimated with precision.According to Prof. Knight, profit is, therefore, a reward of uncertainty.

Uncertainty theory has been criticized on the ground that profit is the reward paid to anentrepreneur for discharging several duties. Prof. Knight has overlooked other duties andhas glorified the uncertainty; the theory has no sound foundations either in logic or inpractice. A number of illiterate producers who have not studied the theory, are able toanticipate precisely the profits or losses that would arise in future.

(3) Innovation Theory of Profit.

Innovation Theory was developed by Joseph Schumpeter. According to him, profit is thereward paid to an entrepreneur for his innovative endeavours.

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Schumpeter has made distinction between invention and innovation. A scientist maymake an invention, but this invention is exploited on a commercial basis by anentrepreneur. The basis on which the invention is exploited depends upon the innovativenature of the entrepreneur. If he is successful in exploiting the invention it is innovation.According to Schumpeter, profit is the reward for innovation.

Schumpeter's theory has been criticized on several grounds. Profit is the reward fordischarging so many duties; but Schumpeter has overlooked the other duties. Anotherpoint of criticism is that Schumpeter has neglected the fact that profit is also the rewardfor risk and uncertainty bearing. The most serious criticism of this theory is that a particularproducer 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 enterthe industry, the super-normal profits would be shared between the existing as well asthe new firms. In the long run, super normal profits would, therefore, disappear. It is saidthat 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 takingplace every day; and the economic consequences of these changes are of a far reachingcharacter. 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 organization of business

e) Changes in population

These changes can occur at any time. Techniques of production may change and improvedmachinery may be introduced. This may reduce the cost and increase the profit andoutput. But to purchase the improved machinery, a larger amount of fixed capital isrequired. This may necessitate the admission of a new partner or conversion of thepartnership 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. Aproducer who overcomes these hurdles is successful in earning higher profits. He mustadjust himself to the changing times. A producer who cannot address himself to thedynamic world lags behind. In order to survive and grow every producer must change themethods to suit the changing needs. According to Prof. Clark, profit is the reward paidfor dynamism.


Profits in a Static Society

According to Prof. Clark, profit cannot arise in a static society. In a static society there are nochanges. 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 ofproduction is constant. The selling price and the margin of profit are also constant. A producerhas 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 static society,there are no inventions and producers are not required to make innovations. Producers in astatic society have not to face any changes in the tastes, fashions and output. They producea given quantity and sell it in a routine manner. A producer in a static society works like a paidmanager. He performs only the routine duties and gets normal profit. The normal profit whichhe gets may be called 'Wages for Management'. According to Prof. Clark, a producer in astatic society gets only normal profits, because pure profit does not arise.

Conclusion

Prof. Clark's Dynamic Theory of Profit has been criticized on several grounds. He has classifiedthe changes under five categories but has overlooked many other important changes. In thisdynamic world, the Government policy may suddenly change. A change in the MonetaryPolicy of the Central Bank may bring about an expansion or contraction in the supply ofmoney. This may lead to an expansion or contraction in the supply of capital. Ultimately itmay affect the fortunes of business. Prof. Clark has overlooked such important factors.

3. MEASUREMENT OF PROFIT :

Our discussion of profit so far, has made it clear how difficult it is to have a simple definition ofprofit that is acceptable to all. The measurement of profit is also equally difficult. For onething, the economic concept of profit-and loss and the legal concept of profit-and-loss are notthe same. This is especially difficult when it comes to the measurement of net profit. Forcalculating net profit, it is necessary to deduct all costs from the total revenue. But theinclusiveness of costs itself involves many difficulties. All these problems, therefore, deservea more careful and detailed analysis.

(A) Economic Profit and Accounting Profit :

Let us take an example to understand the difference between the economic concept ofprofit and the accounting concept of profit. Suppose an individual starts at his residencethe business of repairing scooters. At the end of the year, he gets a total revenue ofRs.1,50,000/-. Out of this, let us say, he spent Rs.50,000/- on the wages of his helper,tools and spare parts, etc. What remains is a sum of Rs.l,00,000/-. Apparently, onewould be tempted to conclude that this is his profit. But it is not so. The place that isavailable to him might have saved him a sum of, say Rs.30,000/-. In other words, theplace of work might have an opportunity cost. His own transfer earnings may be say

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Rs.60,000/-. Had he borrowed the money capital, the interest would have been sayRs.l0,000/-. Besides, a provision will have to be made for the wear and tear of the toolsand 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) RentRs.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,55,000against the total revenue of Rs.l,50,000 showing a let net loss of Rs.5,000.

The loss in the above example does not become apparent because the entrepreneuruses some of the factors owned by himself and therefore, the remunerations to these arenot actually paid. It should be obvious from the above example that these difficulties maynot arise in respect of large industrial units. In such units, ownership is with theshareholders while the management is entrusted to the salaried managers. Thus, mostof the costs enter the account books and the accounting and economic concepts ofcosts in such cases come closer.

According to the financial accounting principle, the assets of a concern have claims fromtwo 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 andthe net worth after these are deducted. Similarly, the profit and loss account or theincome statement shows the changes in the balance sheet of the unit from the beginningof the year and those at the end of the year is the net income or profit. The fundsstatement is based on this profit and loss statement. This statement indicates the financialstanding of the business concern. The funds statement shows the amount of cash availableand how it has been invested.

While preparing all these statements, the accountant has to include items, the truthabout which can be tested. But in doing so, many difficulties arise. For example, whilepreparing the balance-sheet, the cost of the asset that is taken is the one at which theasset was purchased. The current value of the asset is not considered. Similarly thechanges in the value of money are ignored. It is also incorrect as is done in financialaccounts, to calculate net profits by deducting from the total revenue of year the totalcosts incurred during that year.

The economic concept of net profit will have to be altogether different. In the valuation ofany asset, the economist is guided by the concept of opportunity cost. For example, theaccounting method will take into account the original price of a machine; but in theeconomic 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 thesame is not available; or to consider the total expected return of the machine and fromthat calculate the present worth of the machine. We are familiar with the various costconcepts. Thus, the differences in the profit concepts arise out of the differences in costconcepts. 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 machinesadded together will not be the correct value of the total establishment. This is becausethe goodwill enjoyed by the concern will also have to be included in its total worth. Thisis how the economic and the accounting approaches differ and make measurement ofprofit more complicated.

(B) Factors Leading to Differences in the Economic and the Traditional Concepts ofValuation -

The above discussion makes it clear how valuation of asset is important in themeasurement of profits. Let us now consider those factors which underline the differencesin the economic and the accounting approaches to the problem. These factors are :(a) Depreciation, (b) Inventory Valuation and (c) the unaccounted value changes in theassets and the liabilities.

a) Depreciation : Depreciation is the loss in value caused by the continuous use ofan asset. Every durable asset has a certain life at the end of which it has got to bereplaced. For such a replacement, a provision in the form of depreciation is requiredto be made.

There are various methods of calculating this depreciation. Following are the importantones among them.

i) Staright Line Method -

This is the simplest method of all. What is done is the life of an asset is firstestimated and then the share of one year in the total value of the asset isdeducted. 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 collectedan amount equal to the value of the asset. If, for example, the price of amachine is P, the scrap-value at the end of its life-time is S and the life of themachine is Y years, then the amount of depreciation (D) will be given by theformula :

D = P – S

Y

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If P = Rs.25,000/-; S = Rs.5,000/- and Y = 20 years, the annual amount ofdepreciation will be 25,000 – 5,000 = 2000. This means that the

20

annual allotment towards, depreciation will have to be Rs.2000 only.

(ii) Diminishing Balance Method -

In this method, the amount of depreciation is large in the initial years. Supposethe annual amount of depreciation is taken as 10 per cent of the value of themachine. Then, in the first year the depreciation will be 10 per cent of thevalue of the machine; but during the second year, it will be l0 per cent of thetotal value minus the depreciation fund created during the first year. By thismethod, the value of the machine will never become zero and the amount ofdepreciation will go on diminishing.

(iii) Annuity Method -

In this method, equal annual amounts are first calculated for the length of thelife of an asset. However, along with the annual allotment, the interest that canbe earned is also calculated.

(iv) Service Unit Method -

Instead of considering the life of an asset in years, the actual working hourscan be taken. This is the basis of service unit method. If a machine can workfor l,000 hours, then the value of the machine divided by l,000 will be thehourly rate of depreciation. The total number of hours for which the machinewas actually used during a given period can thus give us the amount ofdepreciation during that period. The original value of machine minus depreciationwill 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 limitedlife and at the end of it, the asset needs to be replaced. At the time ofreplacement, new and more efficient machines may be available. If such newmachines are to be purchased, how much money will be required and at whatrate depreciation will have to be provided cannot be decided before hand, byany of these methods. This makes measurement of profit difficult.

(b) Inventory Valuation -

Another difficulty that is encountered is in respect of inventory valuation. This difficultywould not arise if the prices of all products and the level of all production wereconstant. But this never happens. The raw materials are purchased at differentprices. The costs of production also change from time to time. This makes the


valuation of of stocks of finished products very difficult. Let us first consider the twomost widely used methods of inventory valuation.

i) First-In-First Out Method (FIFO) : In this method, it is assumed that goodswhich 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 iscalculated on the assumption that the material which was last to enter theinventory of the company was used first.

It is obvious that a change in the use from either of the two methods mentionedabove to the other one must lead to a change in estimate of profit. There would bea great divergence between the profits estimated by these two methods especiallywhen the above mentioned changes in prices etc. are very rapid. The profit wouldappear to be abnormally high if it is calculated on the basis of FIFO in times ofinflation and abnormally low in times of deflation. The methods, however, are in usedue to their convenience from accounting point of view.

It is thus, clear that by either method, it is difficult to state precisely the value of theinventory. This is mainly because of the changes in the value of money. Taking astable value of money, i.e. valuation at constant prices would also not serve thepurpose. Thus, due to these difficulties in the valuation of inventories, themeasurement 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 categoryof changes in the value of assets and liabilities that poses a challenge to valuation. Theresearch that is undertaken to improve the quality of the product, the expenses onimproving the efficiency of management etc. increase the value of the establishment.These costs create assets, which cannot be precisely valued. They do increase profitsbut cannot be expressed in terms of money, and therefore, measurement of changes inthe value of assets becomes difficult.

Thus, it is clear, how difficult the precise measurement of profits is. By simply usinghistorical cost the profits are likely to be either inflated or deflated. It is, therefore, necessaryto calculate costs and profits at constant price to take utmost care in calculatingdepreciation, 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 thecorrect estimate. The calculation of profit will also vary according to the purpose forwhich the calculation is required.

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4. PROFIT POLICY :

By and large, we say that an entrepreneur aims at maximum profits. But 'how much' profitshould be taken as the maximum ? This is a difficult question to answer. A scientific thoughtto this question must provide a guidance on the following two lines : (a) What profit should anentrepreneur expect in any enterprise, and (b) How far is profit influenced by factors, which areexternal to the firm.

It must be understood at the outset that the freedom of an entrepreneur to decide his rate ofprofit 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 capitalinvested. In modern business, the common practice is to express profit as a per cent netreturn to capital.

(a) Profit Expectations : The profit that an entrepreneur should expect can be subjected toa 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 nothave a feeling of having suffered a capital loss. New shares must therefore be soldat a price that gives the old shareholders a satisfaction that they are in possessionof sound shares. Their rate of profit should be enough to command a good price forthe new issue of shares.

ii) The rate of profit should be comparable to that in similar companies. Manytimes, there are many independent units under the same management. In all thesesiter-concerns, the rates of profitability should be comparable.

iii) The 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 businessexpansion. It is, however, necessary to see that reinvestment of profits does notcause a dwindling in the reasonable rate of profit.

(b) External Factors : Besides the criteria mentioned above, there are certain externalfactors that influence the profitability of a firm in modern times. These factors are :

i) Full Employment : Under conditions of full employment, maintenance of cordiallabour relations is of utmost importance. Excessive profits, under suchcircumstances, become an invitation to labour unrest. Care should be taken tokeep profits within reasonable limits.


ii) Potential Rivals : In any business, the possibility of emergence of rival firms must betaken into consideration. Abnormal profits attract rivals and wipe out profits. To keepaway the rivals, it becomes necessary to control profits. Whether this will be possibledepends upon many factors, but an effort should be made to abide by this rule.

iii) Consumers' Confidence : It is also necessary to maintain the confidence of theconsumers in the reasonableness of the firm's prices. Those entrepreneurs whoare tempted to exploit the situation of reaping huge profits usually lose thesympathies of their customers. It pays in the long-run to overcome such temptationsand continue to enjoy the confidence of the customers.

iv) Political Climate : In modern times, entrepreneurs are also required to take note ofthe political climate in the country. This is especially true where a firm suppliesproducts to government departments, or public enterprises. Charges of profiteeringand exploitation may invite public inquiries and this will cause a great deal to thefirm. It is, therefore, advisable to keep profit rates low and create an image of a firmwith fair dealings.

Thus, profit policy involves many important considerations and all the factors notedabove go into the formulation of a sound profit policy.

5. REASONABLE PROFIT TARGET :

We have already studied that modern firms and corporations may not aim at profit maximization.Instead they set 'a standard', 'a target' or 'a reasonable profit' which they strive to achieve. Wehave 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 reasonableprofits. 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 beused, and (ii) how should reasonable profits be determined ?

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Forms of Profit Standard

The profit standards may be determined in terms of (a) aggregate money terms, (b) percentageof sales, or (c) percentage return on investment. These standards may be determined withrespect to the whole product line or for each product separately. Of all the forms of profitstandards, the total net profits of the enterprise usually receive the greatest attention. Butwhen purpose is to discourage the potential competitors, then a target rate of return on investmentis 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 standardsfor a 'reasonable profit'.

Capital attracting standard

An important criterion of profit standard is that it must be high enough to attract externalcapital. For example, if stocks are being sold in market at five times their current earnings, itis 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 structureof the firms (i.e. the proportions of bonds, equity and preference shares) affects the cost ofcapital and thereby the rate of profit, (ii) whether profit standard has to be based on current orlong run average cost of capital as it varies widely from company to company and may attimes 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 mostrelevant standard is the aggregate profit that provides for an adequate "plough-back" for financinga desired growth of company without resorting to the capital market. This standard of profit isused when maintaining liquidity and avoiding debt are main considerations in 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 theyshould decide the further investment pattern. This is based on a belief that market forcesallocate funds more efficiently and the individual is the best judge of this resource use. On theother hand, retained earnings which are under the exclusive control of the management arelikely to be wasted on low-earning projects within the company. But one cannot say for certainas to which of the two allocating agencies is actually superior. It depends on 'the relativeabilities 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 offirms of an industry over a normal period. Company's own normal eanrings over a period oftime often serve as a valid criterion of reasonable profit, provided it succeeded in (i) attractingexternal capital, (ii) discouraging growth of competition, (iii) keeping stockholders satisfied.When average of 'normal earnings of a group of firms is used, then only comparable firms andnormal periods are chosen.

However, none of these standards of profit is perfect. A standard is therefore chosen aftergiving due consideration to the prevailing market conditions and public attitudes. In fact, differentstandards are used for different purposes because no single criterion satisfies all the conditionsand all the people concerned.

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Exercise :

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 limitingprofits.


NOTES

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NOTES


NOTES

Demand Analysis 83

Chapter 4

DEMAND ANALYSIS

Preview

Introduction:

Concept of demand, Individual Demand and Market Demand, Determinants of Demand, Lawof demand, Elasticity of demand, Measurement and its uses. Demand Forecasting-methods/techniques of demand forecasting. Introduction to Index Numbers.

1) CONCEPT OF DEMAND

In Economics, ’Demand’ does not mean simple desire. Thus, a poor man’s desire to have amotor-car or middle class person’s desire to have an air-conditioned bunglow in a city orsuburb 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 andshelter will have absolutely no influence on the production of those three goods, howeverurgently they may be needed by a beggar.

In Economics ‘Demand’ means ‘desire backed by adequate purchasing power’ or enoughmoney to purchase desired goods.

In fact, in Economics, ‘demand’ means specific quantity of a commodity actually purchasedor bought.

Further, since quantity purchased will depend upon price of the commodity in question, itfollows that ‘demand means at a specific price’. Unless the price per unit of the commodity isstated, the concept of demand will not be clear.

‘Demand’ in Economics also means ‘demand per unit of time’, say per day, per month, peryear and so on.

Thus, it can be said that in Pune, demand (i.e. quantity actually purchased) for milk permonths is 1,50,000 liters 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 belogical 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 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 ofa commodity, or unit of time or of specific market would leave the concept of demand vague.

Determinants Of Demand :

Demand for a commodity depends on a number of factors.

a) Factors Influencing Individual Demand

An individual's demand for a commodity is generally determined by factors such as :

i) PRICE OF THE PRODUCT : Price is always a basic consideration in determining thedemand for a commodity. Normally, a larger quantity is demanded at a lower price thanat a higher price.

ii) INCOME : Income is an equally important determinant of demand. Obviously, with theincrease in income one can buy more goods. Thus, a rich consumer usually demandsmore goods than a poor consumer.

iii) TASTES AND HABITS : Demand for many goods depend on the person's tastes, habitsand preferences. Demand for several products like ice-cream, chocolates, behl-puri, etc.depend on an individual's tastes. Demand for tea, betel, tobacco, etc. is a matter of habit.

People with different tastes and habits have different preferences for different goods. Astrict vegetarian will have no demand for meat at any price, whereas a non-vegetarianwho has liking for chicken or fish may demand it even at a high price. Similar is the casewith demand for cigarettes by non-smokers and smokers.

Demand Analysis 85

iv) RELATIVE PRICES OF OTHER GOODS : SUBSTITUTES AND COMPLEMENTARYPRODUCTS : 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 orcomplementary goods to a commodity.

When a want can be satisfied by alternative similar goods, they are called substitutes.For example, peas and beans, groundnut oil and til oil, tea and coffee, jowar and bajraetc., are substitutes of each other.

The demand for a commodity depends on the relative prices of its substitutes. If thesubstitutes are relatively costly, then there will be more demand for the commodity inquestion at a given price than in case its substitutes are relatively cheaper.

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 referred to as complementary goods. For example, car and petrol, penand ink, tea and sugar, shoes and socks, sarees and blouses, gun and bullets etc. arecomplementary to each other. Complementary goods are always in joint demand. Thus,if a given commodity is a complementary product, its demand will be relatively high whenits related commodity's price is lower than otherwise. Or, when the price of one commoditydecreases, the demand for its complementary product will tend to increase and viceversa. For example, a fall in the price of cars will lead to an increase in the demand forpetrol. Similarly a steep rise in the price of petrol will cause a decrease in demand forpetrol driven motor cars and its accessories.

v) CONSUMER'S EXPECTATIONS : A consumer's expectations about the future changesin the price of a given commodity also may affect its demand. When he expects itsprices to fall in future, he will tend to buy less at the present prevailing price. Similarly, ifhe expects its price to rise in future, he will tend to buy more at present.

vi) ADVERTISEMENT EFFECT : In modern times, the preferences of a consumer can bealtered by advertisement and sales propaganda, albeit to a certain extent only. Thus,demand for many products like tooth-paste, toilet-soap, washing powder, processedfoods, etc., is partially caused by the advertisement effect in a modern man's life.

b) Factors Influencing Market Demand :

The market demand for a commodity originates and is affected by the form of change in thegeneral demand pattern of the community of the people at large. The following factors affectthe common demand pattern for a commodity in the market.

1) PRICE OF THE PRODUCT : At a low market price, market demand for the producttends to be high and vice versa.


2) DISTRIBUTION OF INCOME AND WEALTH IN THE COMMUNITY : If there is equaldistribution of income and wealth, the market demand for many products of commonconsumption tends to be greater than in the case of unequal distribution.

3) COMMUNITY'S COMMON HABITS AND SCALE OF PREFERENCES : The marketdemand for a product is greatly affected by the scale of preferences by the buyers ingeneral. For example, when a large section of population shifts its preference fromvegetarian foods to non-vegetarian foods, the demand for the former will tend to decreaseand that for the latter will increase.

4) 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.

5) NUMBER OF BUYERS IN THE MARKET AND THE GROWTH OF POPULATION : Thesize of market demand for a product obviously depends on the number of buyers in themarket. 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 aperiod of time tends to imply a rising demand for essential goods and services in general.

6) AGE STRUCTURE AND SEX RATIO OF THE POPULATION : Age structure of populationdetermines market demand for many products in a relative sense. If the population pyramidof a country is broad-based with a larger proportion of juvenile population, then the marketdemand for milk, toys, school bags etc. - goods and services required by children - willbe 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. femalesexceeding males in number (or, males exceeding females as in Mumbai), would mean agreater demand for goods required by the female population than by the male population(or the reverse).

7) FUTURE EXPECTATIONS : If buyers in general expect that prices of a commodity willrise in future, etc. present market demand would be more as most of them would like tohoard the commodity. The reverse happens if a fall in the future price is expected.

8) LEVEL OF TAXATION AND TAX STRUCTURE : A progressively high tax rate wouldgenerally mean a low demand for goods in general and vice-versa. But a highly taxedcommodity will have a relatively lower demand than an untaxed commodity - if thathappens to be a remote substitute.

9) INVENTIONS AND INNOVATIONS : Introduction of new goods or substitutes as a resultof inventions and innovations in a dynamic modern economy tends to adversely affectthe demand for the existing products, which as a result of innovations, definitely becomeobsolete. For example, the advent of latest digital media like Compact Disks (C.Ds) hasmade audio & video cassettes obsolete.

Demand Analysis 87

10) FASHIONS : Market demand for many products is affected by changing fashions. Forexample, demand for commodities like jeans, shirts, salwar-kameej etc. are based oncurrent fashions.

11) CLIMATE OR WEATHER CONDITIONS : Demand for certain products are determined byclimatic or weather conditions. For example, in summer, there is a greater demand for colddrinks, fans, coolers, air conditioners etc. Similarly, demand for umbrellas and raincoatsare seasonal.

12) 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 arein more demand.

13) ADVERTISEMENT AND SALES PROPAGANDA : Market demand for many products inthe present day are influenced by the sellers' efforts through advertisements and salespropaganda. Demand is manipulated through selling efforts. Of course, there is always alimit.

When these factors change, the general demand pattern will be affected, causing achange in the market demand as a whole.

2. DEMAND SCHEDULE :

A tabular statement of price-quantity relationship is known as the demand schedule. It narrateshow much amount of a commodity is demanded by an individual or a group of individuals in themarket 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 atvarious prices in a given period of time (say per day, per week, per month or per annum) isreferred to as an individual demand schedule.

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 consumerMr 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 alternativeprices.

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 pricethan at a higher one. In fact, most of the demand schedules show an inverse relationshipbetween price and quantity demanded.

MARKET DEMAND SCHEDULE

It is a tabular statement narrating the quantities of a commodity demanded in aggregateby all the buyers in the market at different prices in a given period of time. A marketdemand schedule, thus, represents the total market demand at various prices.

Theoretically, the demand schedules of all individual consumers of a commodity can becompiled and combined to form a composite demand schedule, representing the totaldemand for the commodity at various alternative prices. The derivation of market demandfrom individual demand schedules is illustrated in the table given below. Here it is assumedthat the market is composed only of three buyers.

Price in Rupees Units of Commodity X Demanded Quantity(per unit) per day by Individuals Demanded in the

market for X

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 quantitiesat various prices shown by the individual demand schedules. It follows that like an individualdemand schedule, the market demand schedule also depicts an inverse relationship betweenthe price and quantity demanded.

Demand Analysis 89

4. THE DEMAND CURVE :

A demand curve is a graphical presentation of a demand schedule. When price-quantityinformation of a demand schedule is plotted on a graph, a demand curve is drawn. Demandcurve 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 andthe demand variable on the X-axis.

Fig. given below illustrates the demand curve based on the data contained in Table.

In this figure, the quantity demanded is measured on the horizontal axis (X-axis) and the priceper kg. is measured on the vertical axis (Y-axis). Corresponding to the price-quantity relationsgiven in the demand schedule, various points like a, b, c, d and e are obtained on the graph.These points are joined and the smooth curve DD is drawn, which is called the demand curve.

The demand curve has a negative slope. It slopes downwards from left to right, representingan inverse relationship between price and demand.

Individual Demand Curve

The figure, given above, represents an individual demand curve. Likewise, by plotting themarket 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 fora given commodity. Figure given on the next next illustrates this:

Quantity Demanded

Pri

ce (

Per

Kg

.)

Y

XO

De

D

dc

b

a

2 4 6 10 168 12 14

5

10

15

20

25

30


Derivation of Market Demand Curve

It may be observed that the slope of the market demand curve is an average of the slopes ofindividual demand curves. Essentially, the market demand curve too has a downward slopeindicating an inverse price-quantity relationship, i.e. quantity demand rises when the pricefalls, and vice-versa.

5. THE LAW OF DEMAND :

The general tendency of consumers' behaviour in demanding a commodity in relation to thechanges in its price is described by the law of demand. The law of demand expresses the natureof functional relationship between two variables of the demand relation, viz., the price and thequantity 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 acommodity, the smaller is the quantity demanded and lower the price, larger is thequantity demanded." In other words, the demand for a commodity expands (i.e., the demandrises) as the price falls and contracts (i.e. the demand falls) as the price rises. Or brieflystated, the law of demand emphasises that, other things remaining unchanged, demandvaries 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 andinfluencing factor. The relation between price and quantity of demand is usually an inverse ornegative relation, indicating a larger quantity demanded at a lower price and a smaller quantitydemanded at a higher price.

Quantity Demanded of X

Pri

ce (

Per

Un

it)

Y

XO

Y

XO XO XO

Y YA’s Demand B’s Demand C’s Demand Market Demand

D(A) D(B) D(C) D(Market)+ + =

Demand Analysis 91

EXPLANATION OF THE LAW OF DEMAND

The law of demand is usually referred to the market demand. The law of demand can beillustrated with the help of a market demand schedule, thus : i.e. as the price of a commoditydecreases, the corresponding quantity demanded for that commodity increases and vice-versa.

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 fromthis table that with a fall in price at each stage, quantity demanded tends to rise. There is aninverse relationship between price and quantity demanded. Usually, economists draw a demandcurve to give a pictorial presentation of the law of demand. When the data of table are plottedgraphically, a demand curve is drawn as shown in Figure given below. (Here, incidentally, thedemand curve being a straight line is a linear demand curve.

Demand Curve

In this figure, DD is a downward sloping demand curve indicating an inverse relationshipbetween price and quantity demanded.

From the given market demand-curve one can easily locate the market demand for a productat a given price. Further, the demand curve geometrically represents the mathematical demandfunction : Dx = f (Px)

OX

D

D

Y


Pri

ce (

Per

Un

it)

5

4

3

2

1

10 20 30 40 50


ASSUMPTIONS UNDERLYING THE LAW OF DEMAND

The above stated law of demand is conditional. It will hold good only if certain conditions aregiven and constant.

Thus, it is always stated with "other things being equal". It relates to the change in pricevariable 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, theconsumer's income should remain the same. If the level of a buyer's income changes, hemay buy more even at a higher price, invalidating the law of demand.

2) NO CHANGE IN CONSUMER'S PREFERENCES : The consumer's tastes, habits andpreferences should remain constant.

3) NO CHANGE IN FASHION : If the commodity in question goes out of fashion, a buyermay not buy more of it even at a substantial price reduction.

4) NO CHANGE IN THE PRICES OF RELATED GOODS : Prices of other goods likesubstitutes and complementary goods remain unchanged. If the prices of other relatedgoods change, the consumer's preferences would change which may invalidate the lawof demand.

5) NO EXPECTATIONS OF FUTURE PRICE CHANGES OR SHORTAGES : The law requiresthat the given price change for the commodity is a normal one and has no speculativeconsideration. That is to say, the buyers do not expect any shortages in the supply ofthe commodity in the market and consequent future changes in the prices. The givenprice 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 thenumber of buyers and their preferences should remain constant. This necessitates thatthe size of population as well as the age-structure and sex-ratio of the population shouldremain 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 notcontract with a rise in price.

7) NO CHANGE IN THE RANGE OF GOODS AVAILABLE TO THE CONSUMERS : Thisimplies that there is no innovation and arrival of new varieties of products in the marketwhich may distort consumer's preferences.

8) NO CHANGE IN THE DISTRIBUTION OF INCOME AND WEALTH OF THECOMMUNITY : There is no redistribution of income either, so that the levels of income ofthe consumers remain the same.

Demand Analysis 93

9) NO CHANGE IN GOVERNMENT POLICY : The level of taxation and fiscal policy of thegovernment remain the same throughout the operation of the law. Otherwise, changes inincome tax, for instance, may cause changes in consumers' income or changescommodity taxes (sales tax or excise duties) may lead to distortions in consumer'spreferences.

10) NO CHANGE IN WEATHER CONDITIONS : It is assumed that climatic and weatherconditions 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 otherdeterminants of its demand are unchanged.

Apparently, the validity of the law of demand or the inference about inverse relationship betweenprice and quantity demanded depends on the existence of these conditions or assumptions.

EXCEPTIONS TO THE LAW OF DEMAND OR EXCEPTIONAL DEMAND CURVE :

It is almost a universal phenomenon of the law of demand that when the price falls, thedemand 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 aprice, demand also rises. This is a paradoxical situation or a situation which is apparentlycontrary to the law of demand. Cases in which this tendency is observed are referred to asexceptions to the general law of demand. The demand curve for such cases will be typicallyunusual. It will be an upward sloping demand curve as shown in Figure given below. It isdescribed as an exceptional demand curve.

Exceptional Demand Curve

Pri

ce (

Per

Un

it)


In this fugre, DD is the demand curve which slopes upward from left to right. It appears thusthat when OP1 is the price, QQ1, is the demand and when the price rises to OP2' demandalso expands to QQ2. Thus, the upward sloping demand curve expresses a direct functionalrelationship between price and demand.

Such upward sloping demand curves are unusual and quite contradictory to the law of demandas they represent the phenomenon that 'more will be demanded at a higher price and viceversa". 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 introducedby Robert Giffen when the price falls, quite often less quantity will be purchased thanbefore because of the negative income effect and people's increasing preference for asuperior commodity with the rise in their real income. Probably, a few appropriate examplesof 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,cake, basmati rice, pure ghee.

2) ARTICLES OF SNOB APPEAL : Sometimes, certain commodities are demanded justbecause 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 usingthem as 'status symbol'. Thus, when prices of such articles like say diamonds rise, theirdemand also rises; similarly, Rolls Royce cars, Johney Walker Scotch Whiskey areanother outstanding illustration.

3) SPECULATION : When people speculate in changes in the price of a commodity in thefuture, they may not act according to the law of demand at present. Say, when peopleare convinced that the price of a particular commodity will rise still further, they will notcontract their demand with the given price rise; on the contrary, they may purchase morefor the purpose of hoarding. In the stock exchange market, some people tend to buymore 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 wronglybiased against the quality of a commodity with the price change, he may contract hisdemand with a fall in price. Some sophisticated consumers do not buy when there is astock clearance sale at reduced prices, thinking that the goods may be of bad quality.

6. CHANGES IN QUANTITY DEMANDED AND CHANGES IN DEMAND:

In economic analysis, the terms 'changes in quantity demanded' and 'changes in demand'have different meanings.

Demand Analysis 95

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 inprice only. Thus, we may say that the quantity demanded of a commodity increases when it'sprice decreases, or the quantity demanded decreases when it's price increases. But, it isincorrect to say that demand decreases when price increases or demand increases whenprice 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 alongthe 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 fallin 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" & "contraction" are used in stating the law of demand.

The terms "expansion" and "contraction" of demand, should, however, be distinguishedfrom increase or decrease in demand. The former is used for indicating increase indemand, while the later is used for indicating changes in demand, and Variation in demandis the connotation of the law of demand. It expresses a functional relationship betweenquantity demanded and price. a change in demand due to change in price is calledexpansion or contraction. Expansion and contraction refer to the same demand curve. Achange in demand due to causes other than price is called increase or decrease indemand.

In graphical exposition, expansion or contraction of demand is shown by the movementalong the same demand curve. A downward movement from one point to the another onthe same demand curve implies expansion of demand, for instance, movement from a tob in the following figure. It suggests that when the price decreases from OP to OP1,demand expands from OQ to OQ1. While an upward moment from one point to anotheron the same demand curve implies contraction of demand, eg: movement from a to c inthe diagram.


Expansion and Contraction of demand

The fig. shows that when price rises from OP to OP2 demand contracts from OQ to OQ2.

In short, a change in quantity demanded in response to the change in price is explainedby the terms expansion or contraction of demand. Further, expansion or contractionimplies a movement on the same demand curve which means the demand scheduleremains the same.

B) INCREASE AND DECREASE IN DEMAND (Changes in Demand):

These two terms are used to express changes in demand. Changes in demand areresult of the change in the conditions or factors determining demand, other than theprice. A change in demand, thus implies an increase or decrease in demand. Whenmore of a commodity is bought than before at any given price, there is increase indemand. Similarly, when with price remaining unchanged less of a commodity is boughtthan before, there is decrease in demand.

In other words, an "increase" in demand signifies either that more will be demanded atgiven price or the same will be demanded at a higher price. Thus, an increase in demandmeans that more is now demanded than before, at each and every price. likewise, "adecrease in demand signifies either that less will be demanded at given price or thesame 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 themovements from one demand curve to the another. In other words, the change in demandis denoted by the shifting of the demand curve. In the case of an increase in demand, thedemand curve is shifted to the right. In the following figure (A), thus, the movement ofdemand curve from DD to D1D1 shows an increase in demand. In this case, the movement


Pri

ce (

Per

Un

it)

Contraction

Expansiona

b

c

D

Demand Analysis 97

Increase & Decrease in demand

In the above fig, thus, the movement of demand curve from DD to D2D2 show a decreasein demand. In this case, movement from point a to c, indicates that the price remainssame at the OP, but less quantity OQ2 is now demanded than before. Here decrease indemand is QQ2.

REASONS FOR CHANGE (Increase or Decrease in Demand)

A change in demand occurs when the basic conditions of the demand change. Thus anincrease or decrease in demand is brought about by many kinds of changes. Some ofthe 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 changein their prices.

7) Change in population.

8) Advertisement and Publicity persuasion.

from point a to b indicates that the price remains the same at OP, but more quantity OQ1is now demanded, instead of OQ. Thus increase in demand is QQ1. Similarly, as in FigB, a decrease in demand is depicted by the shifting of the demand curve towards it's left.

Pri

ce (

Per

Un

it)

Pri

ce (

Per

Un

it)

Y

O X O X

Y

D1D

D

D1

DD2

D2

D

c a

Q2 QQ Q1

a bIncrease

PDecrease

P

(A) (B)


7. ELASTICITY OF DEMAND :

INTRODUCTION

Demand for goods varies with price. But the extent of variation is not uniform in all cases. Insome cases the variation is extremely wide; in some others it may just be nominal. Thatmeans, sometimes demand is greatly responsive to changes in price; at other times, it maynot be so responsive. The extent of variation in demand is technically expressed as elasticityof demand. According to Marshall, the elasticity (or responsiveness) of demand in a market isgreat or small, depending on whether the amount demanded increases much or little for agiven fall in price; and diminishes much or little for a given rise in price.

A) ELASTICITY OF DEMAND : PRICE ELASTICITY OF DEMAND

The term "elasticity of demand", when used without qualifications is commonly referredto as price elasticity of demand. This is a loose interpretation of the term. In a strictlogical sense, however, the concept of elasticity of demand should measure theresponsiveness of demand for a commodity to changes in its determinants.

There are, thus, as many kinds of elasticities of demand as its determinants. Economistsusually consider three important kinds of elasticity of demand : (1) Price elasticity ofdemand, (2) Income-elasticity of demand and (3) Cross-price elasticity of demand or justcross elasticity.

"Price elasticity" refers to the degree of responsiveness of demand for acommodity to a given change in its price.

"Income elasticity" refers to the degree of responsiveness of demand for acommodity to a given change in the income of the consumer.

"Cross elasticity" refers to the responsiveness of demand for a commodity to a givenchange in the price of a related commodity - substitute or complementary product.

In the present chapter, we shall study them one by one.

B) PRICE ELASTICITY OF DEMAND

The extent of the change of demand for a commodity to a given change in price,other demand determinants remaining constant, is termed as the price elasticityof demand. The coefficient of price elasticity of demand may, thus, be defined as theratio 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 percentagechange or as proportional change, the price elasticity coefficient can be measured :

The percentage change in quantity demandede = ––––––––––––––––––––––––––––––––––––––

The percentage change in price

Demand Analysis 99

Price elasticity of demand can also be measured alternatively as

Net change in Quantity demanded Net change in pricee = –––––––––––––––––––––––––––––– : ––––––––––––––––

Original Quantity demanded Original price

Representing it in symbols, thus, the price elasticity formula can be stated as :

� Q � Pe = Q

:P

� Q P = Q

X�P

� Q P∴ e =

��PX

QQ = the original demand (Say Q1)

P = the original price (Say P1)

� Q = the change in demand. It is measured as the differencebetween new demand (say Q2) and the old demand (Q1)

Thus, � Q = Q2 - Q1

� P = the change in Price. It is measured as the differencebetween 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 coefficientsignifies very small or marginal changes only.

To illustrate the use of the formula, let us consider the following information from thedemand schedule :

Price of Tea (Rs.) Quantity Demanded (Kg.)

20 (P1) 10(Q1)

22 (P2) 9(Q

2)


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��P

XQ

1 20 = 2

X10

∴ 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 measuredfrom any such given data. Apparently, depending upon the magnitude and proportionalchange involved in the data on demand and prices, one may obtain various numericalvalues of coefficients of price elasticity, ranging from zero to infinity.

TYPES OF PRICE ELASTICITY : DEGREE OF ELASTICITY OF DEMAND

Demand may be elastic or inelastic, depending on the degree of responsiveness of thedemand for a commodity to a given change in its price.

By elastic demand, we mean that demand responds greatly or relatively more to a pricechange. It however, does not imply that the consumers are fully responsive to a pricechange. What it means is simply this that a relatively larger change in demand is causedby a smaller change in price. Similarly, inelastic demand does not mean that demand istotally insensitive. It only means that the relative change in demand is less than that ofprice. It means demand responds to a lesser extent only.

Measuring numerical coefficient of price elasticity in different cases, we will find that itsvalue 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 lessthan 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 fivetypes of price elasticity of demand :

1) Perfectly elastic demand when e = ∝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

Demand Analysis 101

1) Perfectly Elastic Demand (e = α)α)α)α)α)An infinite demand at the given price is a case of perfectly elastic demand. When demandis perfectly elastic, with a slight or infinitely small rise in the price of the commodity, theconsumer stops buying it. The numerical coefficient of perfectly elastic demand is infinity(e = α).

In fact, the degree of elasticity determines the sahpe and slope of the demand curve.Thus, elasticity of demand can be ascertained from the slope of the demand curve. Theslope of demand curve reflects the elasticity of demand. In the case of a perfectly elasticdemand, the demand curve will be a horizontal straight line. Thus, the demand curve inFigure A given below implies, that at the ruling price of OP, the demand is infinite, whilea slight rise in price would mean a zero demand. This figure indicates that at price OP, aperson would buy as much of the given commodity, as can be obtained, i.e. an infinitequantity, and that at a slightly higher price he would buy nothing. Perfectly, elasticdemand is a case of theoretical extremity. It is hardly encountered in practice.

Types of Price Elasticity of Demand

In economic theory, however, the demand for the product of a firm in a perfectly, competitivemarket is assumed to be perfectly elastic. Theoretically, perfectly elastic demand or thehorizontal demand curve (as shown in Figure above), from the firm's point of view impliesthat 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 inthe market.

Pri

ce (

Per

Un

it)

Y

OX

DD

e=ααααα

(A)

P

Quantity Demanded


2) Perfectly Inelastic Demand (e = 0)

Pri

ce (

Per

Un

it)

Y

O X

Quantity Demanded

D

D

Q

P3

P2

P1

(B)

e= 0

When the demand for a commodity shows no response at all to a change in price, thatis to say, whatever the change in price the demand remains the same, then it is called aperfectly inelastic demand. Perfectly, inelastic demand has, thus, zero elasticity (e = 0).In this case, the demand curve would be a straight vertical line as in Figure B shownabove. This figure indicates that whether the price moves from Op1 to OP2 or Op3, thequantity demanded remains the same OQ only. Perfect inelasticity is again a theoreticalconsideration rather than a practical phenomenon. However, a commodity of absolutenecessity like salt seems to have perfectly inelastic demand for most consumers.

3) Relatively Elastic Demand ( e > l )

Pri

ce (

Per

Un

it)

Y

O X

Quantity Demanded

D

D

Q1 Q2

P1

P2

(C)

e>1

When the proportion of change in the quantity demanded is greater than that of price, thedemand is said to be relatively elastic. The numerical value of relatively elastic demand

Demand Analysis 103

Pri

ce (

Per

Un

it)

Y

O X

Quantity Demanded

D

D

Q1 Q2

P1

P2

(D)

e<1

lies between one and infinity. Thus, what Marshall called as elasticity of demand beinggreater than unity referred to 'relatively elastic' demand or 'more elastic' demand. Arelatively elastic demand will be represented by a gradually sloping, i.e. rather a flatterdemand curve as shown in Figure(C) above. In this Figure(C) above when the price fallsby P

1 P

2, the demand expands by Q

1 Q

2 which is relatively large in proportion to the

change in price.

� Q ��Pe = ÷ = > 1

Q PTherefore, elasticity is greater than one, it is a more realistic concept, as many commoditiescan have more elastic demand.

4) Relatively Inelastic Demand ( e < l )

When the proportion of change in the quantity demanded is less than that of price, thedemand is considered to be relatively inelastic. The numerical value of relatively inelasticdemand lies between zero and one. Hence, the concept "relatively inelastic" or 'lesselastic" demand is the same as what Marshall presented as elasticity being less thanunity. A relatively inelastic demand will be represented by a rapidly sloping, i.e., rather asteeper, demand curve as shown in Figure (D) above. In Figure (D) when the price falls byP

1 P

2, the demand expands just by Q

1 Q

2 which is relatively small in proportion to the

change in price.

� Q ��Pe = ÷ = < 1

Q PTherefore, elasticity is less than one. This is also a very realistic concept.


5) Unitary Elastic Demand (e = 1)

Pri

ce (

Per

Un

it)

Y

O X

Quantity Demanded

D

D

Q1 Q2

P1

P2

(E)

e=11111

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 demandis exactly 1. In the case of unitary elastic demand, the demand curve would be a rectangularhyperbola asymptotic to the two axis, as shown in Figure (E ) above. In Figure (E), whenthe price falls by P1 P2,, the demand expands by Q1 Q2 which is in the same proportionto change in price.

� Q ��Pe = ÷ = 1

Q P

Hence, elasticity is equal to unity. This is a theoretical norm, which helps to distinguishbetween elastic and inelastic demand in general.

The different kinds of price elasticity of demand discussed above have been summarisedin Table A on the next page.

Demand Analysis 105

Table APRICE ELASTICITY OF DEMAND

(Definition e = Percentage change in the quantity demand : Percentage change in price)

Numerical Terminology DescriptionValue

e = α Perfectly (or infinitely Consumers have infinite demand at a particularelastic) price and none at all at even slightly higher

than this given price.

e = O Perfectly (or Demand remains unchanged whatever maycompletely) inelastic be the change in price.

e > 1 Relatively elastic Quantity demanded changes by a largerpercentage than does price.

e < 1 Relatively inelastic Quantity demanded changes by a smallerpercentage than does price.

e = 1 Unitary elastic Quantity demanded changes by exactly thesame percentage as does price.

C) MEASUREMENT OF ELASTICITY

There are five different methods of measuring price elasticity of demand- (1) PercentageMethod (2) Point elasticity Method (3) Total outlay Method (4) Point Geometric Methodand (5) Arc elasticity Method.

(1) Percentage Method : The following formula is used

e =% Change in Quantity Demanded

% Change in Price

% Change in Q.D. = New Quantity Demanded – Old Quantity Demanded

X 100Average Quantity Demanded

% Change in Price = New Price – Old Price

X 100Average Price

(2) Point Elasticity MethodThe calculation of the coefficient of price elasticity has been already discussed in theprevious sub unit using the ratio :

� Q �Pe = –––– ÷ ––––

Q P

� Q P∴ e = –––– ÷ ––––

Q ��P


� Q P∴ e = –––– ÷ ––––

� P Q

(3) Total Outlay Expenditure or Revenue Method

Dr. Alfred Marshall suggested that the easiest way of ascertaining whether or not demand is elasticis 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 unitaryelastic (e = 1).

The total outlay remains constant in the case of unitary elastic demand, because the demandchanges in the same proportion as the price. This is illustrated in Table B given below :

Table B

TOTAL OUTLAY METHOD

Quantity Total Outlay Elasticity ofPrice (per unit) demanded (or revenue) Demand

(Rs.) (Units) (Rs.)

Original 5 16 80 –

Change 1 8 10 80 } e = 1

Change 2 1 80 80 } (unitary)

(2) When with a rise in price, the total outlay falls, or with a fall in price, the total outlayrises, elasticity of demand is greater than unity. This happens because the proportion ofchange in demand is relatively greater than that of price. In short, when the price andtotal outlay move in opposite directions, demand is relatively elastic (see Table C below).

Table C

TOTAL OUTLAY METHOD


(Rs.) (Units) (Rs.)


Change 8 10 80 } e < 1

Change 4 4 160 } (Elastic)

Demand Analysis 107

(3) When with a rise in price, the total outlay also rises, and with a fall in price, the totaloutlay falls, elasticity of demand is less than unity. This happens because the proportionof 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 relativelyinelastic (see Table D below).

Table D

TOTAL OUTLAY METHOD


(Rs.) (Units) (Rs.)


Change 8 10 80 } e < 1

Change 2 14 28 } (Inelastic)

We may now summaries the total outlay method as follows :

Price (per unit) Total Outlay Types of Elasticity

1. Increases Constant e = 1Decreases Constant (Unitary)

2. Increases Decreases e> 1Decreases Increases (Relatively elastic)

3. Increases Increases e<1Decreases Decreases (Relatively inelastic

Thus, from the behaviour of the total outlay or the total revenue, we can infer the natureof price elasticity of demand. Likewise, from a given price elasticity, we can concludeabout the nature of change in the consumer's total outlay or the seller's total revenue. Inthe case of unitary elastic demand, with any change in price, the total revenue remainsunaltered. But when there is elastic demand, the total revenue would change in theopposite direction of the price change. In the case of inelastic demand, the total revenuewould change in the same direction as the price changes.

The total outlay method of measuring elasticity is, however, less exact. It can indicateonly the type of elasticity, but not its exact numerical value. To get the exact numericalvalue, we have to resort to the ratio method or the point method. However, the economicsignificance 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 pricepolicy and its effect on demand and revenue.

(4) Point Geometric Method

Dr. Alfred Marshall also suggested another method called the geometrical method ofmeasuring 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, asshown in Figure shown below. 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 thecurve below the given point to the upper segment (the upper part) of the curve above thepoint.

For brevity, we may again put that -

Lower segment of the demand curve below the given pointPoint elasticity =

Upper segment of the demand curve above the pointL

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 uppersegment.

Pri

ce (

Per

Un

it)

Pri

ce (

Per

Un

it)

Point Method Point Method

Demand Analysis 109

In the Figure on the previous page, AB is a straight-line demand curve, P is a givenpoint. Thus, PB is the lower-segment, PA is the upper segment.

e = L = PBU PA

If after actual measurement of the two parts of the demand curve, we find that PB = 4 cm.and PA = 2 cm., the elasticity at point

3P = 2 = 1.5.

If, however, the demand curve is non-linear, then draw a tangent at the given point,extending it to intercept both the axes (See figure)

Point elasticity at point P in Figure is measured as PBPA

(5) Arc Elasticity Method : This method is used to measure elasticity of demand on an arcof the demand curve. The formula is

(Q0 – Q1) (P0 – P1)

(Q0 + Q1) (P0 + P1)e = – x ÷

2 2

∴ e =(Q0 – Q1) (P0 + P1)

– x(Q0 + Q1)

X(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.

8. 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 food grains, cloth, vegetables, sugar, salt etc. isgenerally inelastic.

2. Availability of a Substitute

Where there exists a close substitute in the relevant price range, its demand will tend tobe elastic. But in respect of a commodity having no substitute, the demand will besomewhat inelastic. Thus, for example, demand for salt, potatoes, onions, etc., is highlyinelastic as there are no close or effective substitutes for these commodities, whilecommodities 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 moreelastic demand in general.

3. Number of Uses

Single-use goods will have generally less elastic demand as compared to multi-usegoods, e.g., for commodities like coal or electricity having a composite demand, elasticityis relatively high. With a fall in price, these commodities may be demanded greatly forvarious uses. It is, however, also possible that the demand for a commodity which has avariety of uses may be elastic in some of the uses, and may be inelastic in some otheruses, e.g., coal used by railways and by consumers as fuel. But the former's demand isinelastic as compared to the latter's.

4. Consumer's Income

Generally, the larger the income of a consumer, his demand for overall commoditiestends to be relatively inelastic. For example, the demand pattern of a millionaire is rarelyaffected even by significant price changes. Similarly, the redistribution of income in favourof low-income people may tend to make demand for some goods relatively inelastic.

5. Height of Price and Range of Price Change

There are certain white goods like costly luxury items or bulky goods such as doubledoor 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 andonions, etc. which are relatively low priced and bought in bulk, so a small variation inprice will not have much effect on their demand, hence demand tends to be inelastic intheir case.

6. Proportion of Expenditure

Items that constitute a smaller amount of expenditure in a consumer's family budgettend to have a relatively inelastic demand, e.g., a cinegoer who sees a film every fortnightis not likely to give it up when the ticket rates are raised. But one who sees a film every

Demand Analysis 111

alternate day perhaps may cut down the number of films seen per week. So is the casewith matches, sugar, kerosene candles, broomstick, haircut etc. Thus, cheap or smallexpenditure items tend to have more demand inelasticity than expensive or largeexpenditure items.

7. Durability of the Commodity

In the case of durable goods, the demand generally tends to be inelastic in the short run,e.g., furniture, motor cycles, T.V. sets etc. In the case of perishable commodities, on theother hand, demand is relatively elastic, e.g. milk, vegetables etc.

8. Influence of Habit and Customs

There are certain articles which have a demand on account of conventions, customs orhabit with which these articles are closely associated and in these cases, elasticity isless, e.g. Mangal Sutra to a Hindu bride or cigarettes to a smoker or alcohol to analcoholic have inelastic of demand.

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.

10. Time

In the short period, demand in general will be less elastic, while in the long period, itbecomes more elastic. This is because (i) it takes some time for the news of price changeto reach all the buyers; (ii) consumers may expect a further change, so they may not reactto an immediate change in price; (iii) people are reluctant to change their habits all of asudden, but gradually, in the long run, their habits may change and so too the demandpattern; (iv) durable goods take some time to exhaust their utility. In the long run, lapse oftime results in their wearing out, then these are demanded more; (v) demand for certaincommodities may be postponed for some time, but, in the long run, it has to be satisfied.

11. Recurrence of Demand

If the demand for a commodity is of a recurring nature, its price elasticity is higher thanthat of a commodity which is purchased only once. For instance, motorcycles, V.C.D.players, T.V. sets etc. are purchased only once, hence their price elasticity will be less.But the demand for cassettes or Compact Disks may remain relatively elastic.

12. Possibility of Postponement

When the demand for a product is postponable, it will tend to be price-elastic. In thecase of consumption goods which are urgently and immediately required, their demandwill be inelastic. For example life saving drugs during sickness, habituated goods etc.


9. PRACTICAL SIGNIFICANCE OF THE CONCEPT OF ELASTICITY OF DEMAND :

The concept of elasticity of demand has a wide range of practical application in economicsand business.

1. Its importance to the Businessman

The elasticity of demand for the product he produces is the prime concern of everyproducer. It guides him in determining the price policy for his product. He finds that it willbe profitable to raise prices, provided the demand is inelastic. And in the case of productshaving a highly elastic demand, it is better to lower their prices so that, with a littlemarginal profit, their sales will be more, hence their total revenues, and thus the totalprofit will be large.

2. Importance to Government

In determining fiscal policy, the concept of elasticity of demand is very important to thegovernment. The Finance Minister has to consider the elasticity of demand while selectingcommodities for taxation. Tax imposition on commodities for getting a substantial revenuebecomes worthwhile only if taxed goods have an inelastic demand. Otherwise, if theirdemand is more elastic, then it will contract very much with a rise in price as a result ofadded taxation (like sales tax or excise duty), hence the total revenue yield would not bemuch different from the earlier one. That is, there will not be any significant rise inrevenue. That is why, generally taxes are levied on commodities like petrol, cigarettes,alcohol, steel, white goods like refrigerators, washing machines etc. which have aninelastic demand.

3. Its Importance to the Trade Unionists

The concept of price-elasticity is useful to trade union leaders in wage bargaining. Theunion leader, when he finds that demand for their industry's product is fairly elastic, willask for a high wage for workers and suggest the producer to cut the price and increasesales which will compensate for his loss in total profit.

4. Its importance to Economists

The concept is highly useful to the economists in understanding and solving manyproblems. For instance, the concept is useful in solving the mystery as to how farmersmay remain poor despite a bumper crop. Since agricultural products, particularlyfoodgrains, have an inelastic demand, when there is a bumper crop it can be sold only bycutting down prices substantially. Hence, the total income of farmers will be lower inspiteof 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

If demand for Indian goods in foreign countries is inelastic, India can raise the price of itscommodities substantially and still export the same quantity at a higher price, thus,getting larger amount of money and higher profit from their exports.

Demand Analysis 113

Thus, during 1950’s when demand for Indian jute manufactures in foreign countries washighly inelastic, realizing this fact Government of India raised the price of jute manufacturesby practically trebling export duty on these goods forcing foreign importers to pay nearlythree 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 manufacturesas before.

Similarly, during 1970’s, petroleum oil-exporting countries formed OPEC, a monopolisticorganization of oil-exporting countries and raised the price of crude oil from 3 dollars perbarrel 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 fromthe Middle East. All this could happen because of the highly inelastic demand for crudeoil produced in the Middle East countries which are the main supplier of crude oil to theworld.

Thus, in international trading transactions, trading nations make an effort to know thedegree of elasticity of demand for their goods in foreign countries with a view to fix pricesof export goods at a level that would give exporting countries maximum profit.

10. INCOME ELASTICITY OF DEMAND :

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'sdemand for that product changes consequent upon a change in his income. Income elasticityof demand can be defined as the ratio of proportionate change in the quantitydemanded of the commodity to a given proportionate change in income of theconsumer.

(A) MEASUREMENT OF INCOME ELASTICITY

The formula for measuring income elasticity of demand can be stated thus :

Proportionate change in quantity demandedFormula 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 :

30Ey = –– = 1.5

20

Formula 2

A second formula which is mathematically more rational is suggested as under :

Q2 - Q1 Y2 - Y1Ey = ––––––– ÷ ––––––

Q2 + Q1 Y2 + Y1

In this formula Q1, is the initial consumer expenditure on any commodity 'X" (whichrepresents the demand for the product 'X") and Q2 is the new expenditure on the samecommodity after a change in income. Y1 denotes initial income and Y2 stands for changedor new income.

Example : A consumer spends Rs.60/- per month on sugar when his income is Rs.l,500/- per month. When his income increases to Rs.1800/- per month he spends Rs.84 onsugar. What will be the income elasticity of demand for sugar in this case?

Solution : According to the above formula

84 - 60 1800 - 1500Ey = ––––––– ÷ ––––––––––

84 + 60 1800 + 1500

24 300= ––––––– ÷ –––––––

144 3300

24 3300= ––––– x ––––––

144 300

1 11= –––––– x ––––––

6 1

=11

––––– = 1.86

∴ Ey = >1

(Income elasticity of demand in this case is 1.8 ∴ positive)

Demand Analysis 115

B) Types of Income Elasticity of Demand

According to the value of income elasticity of demand, we can classify income-elasticityinto the following types :

1. Negative Income Elasticity : When the demand for a product decreases as incomeincreases and conversely where demand for a product increases as there is fall inincome, the income elasticity of demand is negative. The demand for inferior goodsis of this type.

2. Zero Income Elasticity : When a change in income has no effect upon the quantitydemanded of a product, the income elasticity of demand would be zero. Demandfor salt is an example of this type.

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 incomeincreases. Unit elasticity of demand is considered to be a dividing line betweennecessaries and comforts. In other words the income elasticity of demand fornecessaries will be less than unity : while the income elasticity of the demand forcomforts 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 productis positive i.e. greater than zero, but less than one, we say that the income elasticity ofthat 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. Thisis because as income increases the percentage of income spent on necessaries goeson diminishing, according to the Engel's Law of family expenditure.

5) High Income Elasticity

As opposed to the above category, we get high income elasticity of demand forproducts which satisfy the consumers' comforts and luxuries. In other words, theincome elasticity of demand for articles of comforts and luxuries is greater than unity.

The income elasticity for different products differs widely. Income - elasticity ofdemand tends to be very high in respect of luxury articles like gold, jewellery,precious stones, paintings, cars etc. As against this, income elasticity of demandis 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 necessaryor comfort or luxury, the proportion of a consumer's income spent on the commodityis also a major factor influencing income elasticity of demand.

C) Uses of the Concept of Income Elasticity of Demand

The concept of income elasticity of demand is useful in many areas of economic policyformulations as well as analyses of various situations.


1) Economic Development : In case of economic development, when notional incomeis increasing, we can find out how much will be the increase in the demand for agiven product, by considering the income elasticity of demand for that product.

2) Economic Fluctuations : Economic fluctuations are the characteristic features ofa capitalistic economy. Phases of prosperity and depression alternate in such aneconomy. The concept of income elasticity can be a very useful guide in finding outwhat products would be demanded during the phase of prosperity. Similarly, duringthe phase of depression, certain necessaries will continue to be demanded. Asnoted above, necessaries are commodities with very low income elasticities.

3) Economic Planning : The concept of income elasticity of demand is of great helpto the planners who are planning for the economy as a whole. When economicdevelopment is being planned, the planners have to set targets of production interms of physical quantities for various sectors of the economy. With the help ofincome elasticity, the planners can estimate the possible increase in demand forthe product as a result of the targeted rate of growth of the economy. This wouldmake the physical targets more realistic and would serve to maintain physicalbalances - 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 wellas changes of distribution of income, the firm can forecast the demand for itsproduct by using income elasticity of demand for that product as a guide.

5) Foreign Trade : In the area of foreign trade, a country needs to take into accountthe income elasticity of demand for its imports as well as exports. A country exportingagricultural products and articles of necessity faces an income-elastic demand,compared to a country which is exporting articles of luxury. This difference influencesterms of trade. Income elasticity of demand serves as a guide in the matter ofbalance of payments disequilibrium also. For example, India has been an exporterof 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, consumerdurable etc. is income-elastic. Consequently, the rate of growth of India's importshas remained high. Thus we have been facing the problem of an increasing tradedeficit in India during the last few years.

The list of areas where income elasticity of demand is useful can be increasedfurther by mentioning public finance, labour policy, industrial policy etc. where theconcept is useful.

11. CROSS ELASTICITY OF DEMAND :

In practice, commodities are seldom independent of one another. Among the wide range of

Demand Analysis 117

products that we see at the market, we find that most of these goods are related. On the basisof the relationship, we can group these products either as substitutes or as complements oras 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 bedefined as the ratio of proportionate change of quantity demanded of commodity 'X'to a given proportionate change in price of the related commodity 'Y'. With the help offormula, 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 ofY rises but that of X remains constant, the quantity demanded of X will increase because theconsumers will substitute X for Y, since Y has become costlier. Conversely, if the price of Yfalls leaving the price of X unchanged, the quantity demanded of x will decrease because theconsumers will now substitute Y for X since Y has become cheaper than before.

Cross elasticity can also be measured by another formula as given below

OX2 – OX1 PY2 – PY1Ec =

OX2 + OX1:

PY2 + PY1

In this formula QX2 is the new demand for X, QX1 is the original demand for X; PY2 is the newprice 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 demandfor X and the slightest fall in the price of Y will reduce the demand for X to almost zero. If, onthe other hand, two goods are not substitutes at all, the cross elasticity of demand will bezero. A change in the price of one commodity will not affect the quantity demanded of theother commodity. It will thus be clear that the cross elasticity of demand for substitutes variesbetween zero and infinity.

If the relationship between X and Y is that of complementary, the cross elasticity in such acase will be negative. A rise in the price of Y will mean not only a decrease in the quantitydemanded of Y but also a decrease in the quantity demanded of X because both are demandedtogether. For example, ball-point pens and refills are complementary goods. When the priceof refills rises, it causes a fall in the demand for refills as well as for ball-point pens, becauseboth are demanded together.


Commodities X and Y will be the perfect substitutes only when they are totally identical. Inthat case, they will not be two different commodities at all. Therefore, in practice, infinite crosselasticity of demand cannot be found. In practice, the cross elasticity of demand can thus bepositive, zero or negative. The cross elasticity is positive when X and Y are good substitutes(and almost infinity when X and Y are almost substitutes). It is zero when X and Y are notrelated to each other or do not possess any substitutability : they are independent of eachother. It is negative when X and Y are complimentary goods. In the first case, a rise in the priceof Y (price of X remaining constant) will cause an increase in the quantity demanded of X. Inthe second case, a rise or fall in the price of Y (price of X remaining unchanged) does notaffect the quantity demanded of X at all. In the third case, a rise in the price of Y (the price ofX 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’sproduct commodity X rises to 220 kg. from 200 kg. per week. Find out the cross elasticity andstate the relationship between commodities X and Y.

Solution : Ec = OX2 – OX1 PY2 – PY1

OX2 + OX1

:PY2 + PY1

220 – 200 12 – 10= –––––––– : ––––––––

220 + 200 12 + 10

220 – 200 12 +10= –––––––– X ––––––––

220 + 200 12 – 10

20 22Solution : Ec =–––––––– X –––

420 2

∴ Ec =11

21

The cross elasticity of demand is positive and X and Y are substitutes.

12. USES OF CROSS ELASTICITY OF DEMAND :

Perfect substitutes are seldom found in practice. Perfect complementarity is equally rare.But, broadly speaking, there is complimentarity or competition i.e. substitutability amongseveral commodities. Under such circumstances, the entrepreneur can judge the effect of hispricing policy on the quantities demanded of the products of others and vise versa on thebasis of the cross elasticity of demand.

Demand Analysis 119

13. DEMAND FORECASTING :

(A) Meaning and Importance

A forecast is a guess or anticipation or a prediction about any event which is likely tohappen in the future. Forecasts are made either through experience or through statisticalmethods. As individual may forecast his job prospects, a consumer may forecast anincrease in his income and therefore purchases, similarly a firm may forecast the salesof its product.

Predictions of future demand for a firm's product or products are called demandforecasts.

Demand Forecasting is the method of predicting the future demand of a firm'sproduct.

(B) Necessity of Forecasting Demand

As mentioned above, demand forecasts may be based on judgment of the experiencedstaff of a business concern or on scientific analysis (with the help of statistics).

When a firm is small in size it may not need or afford an organized forecasting 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 usesmodern techniques of production, it becomes necessary for the firm to forecast thedemand for its various products, in a more scientific manner. Such forecasts are moreaccurate and thus help the firm to produce efficiently, with the help of the availableresources. Forecasts have become a part of business management of most of the firms.

Forecasts are necessary for :

(1) Fulfillment of objective of the Plans

Every business unit, industry or the government starts with certain pre-decidedobjectives. These objectives can be fulfilled with the help of accurate demandforecasts.

(2) Preparation of a Budget

Scientific forecasts are useful to the entrepreneur to take business decision. Everybusiness unit has to prepare a budget. A budget includes the cost and expectedrevenues. Expected revenues can be estimated only on the basis of demand forecasts.

(3) Stabilization of Employment and Production

Demand for a product changes according to seasons or business cycles or tastesetc., the supply, however, cannot be changed suddenly if however, it is possible toestimate 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 theseforecasts.

(4) Expansion of firms

When a firm has to decide whether it should expand or not and to what extent itshould expand, it has to consider the expected demand for its product, at a futuredate. Demand forecasts become useful in such cases.

(5) Other Uses

Demand forecasts are also useful to a firm, for long-term investment decision.Budgeting policies and Warehouse and Inventory Control.

(C) Factors Influencing Demand Forecasts

A number of factors affect the demand forecasts. Each of these factors has to be studiedtogether with the other factors while forecasting demand. Thus, these factors outline thescope 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 ofexperienced staff of the firm. Within this short period the sales promotion policiesof the firm or the tax-policies of the government do not change. Short period forecastsare important for deciding the production policy, price policy, credit policy andmarketing and distribution of the firm's product.

b) Long-period forecasts

These are forecasts for a period of 5 to 10 years and are based on scientific analysisand statistical methods. Long period forecasts are important to decide about whethera new factory is to be established, a new product can be introduced, or capitalneeds are to be raised.

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 inthe international trade, sociological factors, like age of marriage, changes in traditions,have to be considered for forecasting the demand over a very long period.

2) Level of Forecasts

Forecasts can be made at the level of the firm or the industry or the nation.

Demand Analysis 121

a) A firm

A firm forecasts the sales of its products. It bases its forecasts on the forecasts ofthe industries and the nation.

b) An Industry

Forecasts at this level are prepared by the trade association. These are based onstatistical data and market survey. These forecasts are available to all the firms ofthe industry.

c) The Nation

These forecasts are national level forecasts and are based on indices such asnational 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 theproducts of a firm or demand from all the markets of the firm's product. These are notvery useful to a firm. Specific demand forecasts give specific information. Product-specificdemand forecasts give the forecasts of each of the products produced by the firm. Area,specific demand forecasts give the forecasts each of the markets for the firm's he marketsfor the firm's product.

4) Established Products and New Products

Established goods, are goods which are already established in the market; informationabout these goods is available, the present demand, the number of substitutes to theproduct, the level of competition, the markets are known.

New products are those which are yet to be introduced in the market, information aboutthese products is not known.

Thus depending on whether the product is an established or new product, different methodsare 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

a) The demand for capital goods (machinery, spare parts) is a derived demand. It isderived from the demand for the product produced by the capital goods. This demandis highly fluctuating.


The demand for consumer goods depends on the incomes of the consumers. Anincrease in income leads to an increase in the demand for consumer goods, but afall in the income does not immediately lead to a decrease in the demand forconsumer goods; (e.g. Sugar, Food grains, Soaps etc.)

b) The demand for durable goods can be postponed. Thus if prices of these goodsincrease, then the demand falls, because people will postpone their consumptionof these goods (e.g. washing machines, refrigerators, mixers etc.)

The demand for perishable goods like vegetables and fruits depends on the currentincomes and current demand.

Thus, depending on the type of product, demand forecasts and methods of forecastingdemand 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 consideredwhile forecasting the demand for a product.

These factors depend on the type of product, on the market for the product and on thetime-period.

Thus, tastes and preferences and fashion have to be considered while forecasting demandfor readymade garments. Weather forecasts are important for the firms producing raincoats,rainy-shoes and umbrellas.

D) Techniques or Methods of Forecasting Demand

The methods of forecasting demand depend upon, whether the product is an establishedgood 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 aboutgeneral business conditions, and these forecasts make use of information regarding themacro-variables, like government expenditure, savings, the aggregate demand etc.

Micro level forecasts are at the level of the firm or industry. These forecasts make use ofmacro-level information. We are concerned with these types of forecasts.

As mentioned above, the methods of forecasting demand for established goods and fornew goods are different. We shall first study the methods of forecasting the demand forestablished goods and then for new goods.

Demand Analysis 123

(a) Methods of Forecasting Demand for Established Goods

Information about established goods is available and so forecasts can be basedon 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 theinformation regarding the expected expenditures of the consumers.

The interview and survey approach, tries to collect this information, in differentways, and forecasts are based on this information. Depending on how this informationis 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 prospectiveconsumers. This is possible through the market research department of the firm orthrough the wholesalers and retailers.

If consumers cannot be contacted personally or directly, then they are contactedthrough mail or now-a-days they can be contacted on 'internet' and the informationregarding their expected expenditure is collected.

This method is useful when the product and consumers come into direct contact orwhen the number of consumers is small. This method is also useful when theconsumer 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 technicaltraining about how to collect the information from the buyers. Many times theproduction manager, sales manager, finance managers come together and makeuse of this information to finalise the forecasts.

These forecasts are based on information which is more certain and thus forecastsbased on this information may be more accurate.


Limitations

1) This method based on value-judgement and has no scientific basis

2) Useful only in the short period

3) It is difficult and costly to contact all the consumers.

(3) Sample-Survey Method

The total number of consumers for a firm's product is called the population. Whenthe number of consumers is very large (size of population is large), it is not possibleto contact each and every consumer. A few consumers are contacted, this formsthe sample.

Information is collected from the consumers in the sample and forecasts are basedon this information. These forecasts are then generalized for the whole population.This is possible through the advanced statistical methods.

Limitations

a) Information collected may not be accurate.

b) The sample selected must be a random sample, so that when the results aregeneralized for the population, accurate forecasts are made very often, thesample is not a random sample.

c) Consumers do not co-operate by giving a correct idea of their expectedpurchases. Sometimes, the consumers themselves make unplannedpurchases.

(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. Ifforecasts are based on judgement of these experts, the forecasts will have noscientific basis, and thus, may be less accurate.

If however, forecasts are made on the basis of statistical information and with theuse of scientific methods, the forecasts will be more accurate.

(5) Composite Management Opinion

The opinions of the experienced persons with the firm are collected and a committeeor the general manager of the firm analyses this information and forecasts thedemand 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.

Demand Analysis 125

(II) Projection Approach (for long period forecasts)

In this method, the past experience is projected into the future. This can be donewith 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 functionalrelationship (correlation) is established between the variables. This is done with thehelp of Regression. Once a relationship is established, it is possible to project thisinto the future.

1) Correlation and Regression Analysis

As mentioned above, the past data regarding the factors affecting demand can becollected. 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 advertisementexpenditure of a firm, it is possible to express this in the form of a scatter diagram,as shown below :

O X

Y

Sa

les

Advertisement Expenditure

A

A

Now, with the help of Regression Techniques, like, the least square method or themaximum likelihood method (correlation), it is possible to get the best fit, i.e. abest 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 (causeeffect) between these variables is the correlation and the technique of establishing


this relationship is regression. If the past correlation is assumed to remain thesame in the future, we can use this relationship to estimate the demand for thefuture.

In simple correlation, we have a relationship between two variables and a relationshipbetween more than two variables is multiple correlation.

For example Simple Correlation

C = f(Y)

where C is the consumption (Demand), and Y is the consumers income.

Suppose, from past-experience, we have a specific functional relationship

C = a + .8y

Then, if we know the changes in Y (income) we can predict or project the changesin consumption, and thus forecast the demand for the product.

Limitations

a) Assumption made is that the correlation between the two variables will continuein future also, this might not happen. E.g. Number of students and the demandfor text books, may have a direct relationship, but when the text-books change,this relationship no longer holds good in future.

b) Correlation does not necessarily mean that there is a cause effect relationshipbetween the two variables Eg. suppose, in a particular year, the incomes ofconsumers have increased, and in the same year the demand/sales ofcassettes have increased, can we conclude that there is a direct (positive)correlation between income and demand for cassettes ? Even though it appearsthat there is a positive correlation between income and demand for compactdisks, it is just chance that in that year both income and demand for compactdisks increased. There is no cause-effect relationship and thus forecasts basedon 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-SeriesAnalysis.

Time-series Analysis is similar to correlation analysis. It is based on the assumptionthat the relationship between the dependent and independent variables will continueto hold in the future.

Demand Analysis 127

(b) METHODS OF DEMAND FORCASTING NEW PRODUCTS

As mentioned above, new goods are goods which are new to the market. The informationregarding these new goods is therefore, not available. However, firms producing thesegoods find it necessary to estimate the future demand for their product. Thus, indirectmethods of forecasting are used to estimate the demand for new products. Joel Deansuggests the following methods.

1) Evolutionary Method

Some new goods evolve from already established goods. The demand forecasts of suchnew goods can be based on the information about the already established goods fromwhich it is evolved. Thus, the demand for coloured T.V.'s could be based on the assumptionthat, it has been evolved from black and white T.V.'s, thus the information about blackand white T.V.'s can be used to estimate the demand for coloured T.V.

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 goodsare substitutes of already established goods, this method has wide-uses. New L.C.D.,T.Vs are substitutes of already established Colour & Black & White T.Vs.

Limitations

(a) 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 differentways (changes in price, advertisement etc.)

3) Growth Pattern Method

If there is some relationship between the new good and an already established good. Itis possible to estimate the demand for the new good by studying how the establishedgood has grown. Thus, we can study the growth pattern of all the toothpaste in themarket, 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

The expected consumers/buyers are directly contacted and their opinion about the newproduct is gathered. If the number of expected consumers is very large, then a sample isselected and the results obtained from the sample are generalised for the population.This is very useful method and is used by many firms to estimate the demand for theirnew product. A new drug, for example, is to be introduced in the market, the firm concernedwill contact the doctors and gather their opinion about the drug, before it is introduced inthe 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 thesample market are generalised for the total market.

Limitations

a) The sample chosen, should be a correct representation of the toal.

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 ofthe needs of the consumers. However, the success of this method depends on thejudgement of these dealers.

Limitations

a) Based on value judgement, therefore, has no scientific basis, and forecasts maynot be accurate.

b) Limited scope.

C) 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. Thefollowing are the criteria which need to be considered before forecasting the demand fora product.

Demand Analysis 129

a) Accuracy : Forecasts must be as close to reality as possible. There is no point inspending so much money and time if the forecasts do not give a real picture of themarket demand.

b) Durability : Forecasts require a lot of time and money, thus they should be suchthat they can be used for a long period, they should be durable. The relationshipbetween the variables should be stable, for the forecasts to be durable.

c) Flexibility : Forecasts should be adjustable. Business means a lot of uncertaintyand to accommodate this uncertainty, the forecasts should take into account allthe possible factors affecting the forecasts.

d) Acceptability : Advanced statisical techniques are available to the firms forforecasting demand. But because they are very complex, these methods are notacceptable by most firms. Firms prefer simple and easy method for forecasting thedemand for their product.

e) Availability : Sufficient and upto-date data must be available for the forecast to begood. Also, the forecasts must be available to the firms on time, so that the firmscan make the necessary arrangements to produce and supply their product in themarkets.

f) Plausibility : Forecasts should be plausible. They should be understood by theexecutives 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 onforecasting, a firm should weigh the costs and benefits. If accurate forecasts aregoing to give very high returns, then it is worth spending more money on forecastingdemand. If however, accuracy of forecasts will mean a lot of money, but will notmake much difference to the return, in such cases, a slight degree of inaccuracywould not matter and it will save money at the same time.

14. INTRODUCTION TO INDEX NUMBERS :

1) MEANING OF INDEX NUMBERS

Index number is defined by the classical economist Edgeworth as : "a numberby its variations to indicate the increase or decrease of a magnitude notsusceptible to accurate measurements."

In fact, the index number is a statistical device for measuring differences in the magnitudeof a group of related variables over two different situations. The two 'different situations'may refer to two different periods or two different places. The group of variables may bephenomena like the price of commodities, the quantity of goods produced, marketed orconsumed etc. An index number compares one group of related variables with another


group in a relative sense. The comparison may be between periods of time, or betweenplaces. Thus, we may have index numbers comparing the prices of a specified group ofcommodities at different times or in different countries or localities, the level of productionin different years and so on.

Index numbers measure changes in accordance with a reference base or comparisonbase expressed as 100. Thus, index numbers are always expressed in the form ofpercentages, compared with the base year index which is always assumed to be 100.Because an index number is a measurement of relative and not absolute changes in thevariable over a period, it is a coefficient or relative measure of movement of a statisticalvariation from a standard giving a general trend. Thus, index numbers are applied to themeasurement of the general movement of prices, cost of living, wages, production,consumption, employment etc. Since changes in such variates are not easily capable ofdirect quantitative measurement, they are relatively measured in terms of percentage bythe technique of index numbers.

As R.G.D. Allen states, the range of index number is very great and they canindicate changes in variables such as wage rates, shipping freights, securityprices, commodity prices, volume of output, sales and profits. Therefore, indexnumbers are generally used by businessmen, economists and social workers tomeasure changes in prices, wages, sales, production, stocks, exports, importsand cost of living etc.

Index numbers are described as "economic barometers". They are indispensable toeconomists, businessmen, planners, policy-makers and statesmen alike.

2) CLASSIFICATION OF INDEX NUMBERS

From the point of view of "what they measure", index numbers may broadly be classifiedas : "Price Indices, Quantity indices and Special purpose indices.

1. Price Indices

A price index number is a sort of average of the individual price relative to a set ofcommodities, and it measures the price changes of all such commodities collectively.Thus, price indices measure and permit compariason of the prices of certain goods.

Price indices may either be of : (1) Wholesale prices or (2) retail prices. Thus, priceindices may further be classified as :

(1) Wholesale price index numbers, and

(2) a) Retail price index numbers

b) Consumer price index numbers or cost of living index numbers

Wholesale price index numbers measure the changes in the general price level of acountry. It is interesting to note that such indices published in India are known as EconomicAdvisers Index Numbers of Wholesale Prices.

Demand Analysis 131

Retail Price Index Numbers are compiled to measure the changes in retail prices ofvarious commodities such as consumption goods, stocks and shares, bonds andgovernment securities, treasury bills etc. which have bearing on various economic aspects.Moreover the common man is "largely affected by the retail prices than the whole-saleprice level in the country. In India such indices are available in the form of :

(1) Index Number of Security Prices

(2) Labour Bureau Index Number of Retial Prices (Urban Centre); and

(3) Labour Bureau Index Number of Retail Prices (Rural Cedntre)

Consumer's price index numbers are the specialised forms of retail price indices inwhich only prices of those commodities are considered which enter into the consumptionof different classes of people. Consumers' price index numbers are compiled to measurethe changes in the cost of maintaining a consumption pattern (i.e., standard of living) ofa class of people over a period of time. Therefore, these indices are popularly known ascost of living index numbers. There are three prominent types of cost indicesavailable in India.

(1) Cost of living index numbers of the employees of the Central Government.

(2) The middle-class cost of living index numbers, and

(3) The working class cost of living index numbers

However, the first two are ad hoc enquiries and the data are compiled after making familybudget enquiries. The working class cost of living index numbers are published by theLabour Bureau, Ministry of Labour, Government of India.

Cost of living index numbers are of great practical use to trade, commerce and industry.Wage policies are laid down and wage disputes may be settled on the basis of theseindices.

2. Quantity Indices

A quantity index number expresses the relative average of the volume of production indifferent sectors of an industry. Thus, quantity index numbers measure and permitcomparison of the volume of goods produced or distributed or consumed. The index ofproduction is the leading type of quantity index number. There are indices of industrialproduction, agricultural production and so on and so forth. Production indices are highlyuseful as indicators of the level of output in the economy. The growth rate and the directionin which an economy is moving is shown by how much is being produced and whetherthe present production level has gone up or gone down as compared to the previouslevels.


3. Special Purpose Indices

A large variety of index numbers used for specific purposes may be included under thisheading. To study the various special kinds of problems such index numbers are compiled.For instance, there are import-export indices, stock-exchange share price indices, labour-productivity indices, etc.

3) PRINCIPLES AND PRACTICAL STEPS INVOLVED IN THE CONSTRUCTION OF APRICE INDEX NUMBER

THE BASIC PRINCIPLES INVOLVED IN CONSTRUCTION OF A PRICE INDEXNUMBER ARE :

1) The object of the index number be determined.

2) A base year is selected and the price of a group of commodities in that year arenoted.

3) Prices of the selected group of commodities for the given years that are to becompared are noted.

4) The index number for the base year prices is always denoted as 100.

5) Changes in the prices of the given years (current years, in statistical terms) areshown as a percentage variation from the base.

Thus, the construction of a price index number involves the following steps :

a) The choice of the base year;

b) The choice of commodities whose prices are to be taken into account'

c) The collection of data, i.e. price quotations, for the selected group of items in thebase year and the current year;

d) assigning proper weights to different items. If so desired, to remove ambiguity orbias; and

e) Averaging the data so as to express the prices of the given years as percentage ofthe prices of the base year.

4) PROBLEMS OF CONSTRUCTION OF INDEX NUMBERS

The construction of an index number involves the consideration of the following majorproblems :

(1) Purpose of Index Number -

It is absolutely necessary that the purpose of the index number should be clearly andunambiguously defined, since most of the later problems will depend upon the purpose.

Demand Analysis 133

Before collecting data and making calculations, it is important that one knows what onewants to measure and how to make use of the given measure. Once the purpose isclear, the rest of the procedure is easy to apprehend.

One must be sure of which type of index number is to be computed - whether it iswholesale price index number, consumer's price index number, the quantity index numberand then proceed accordingly.

Similarly, it is also necessary to determine the scope of the index number - such as, theregional coverage or the place, the frequency of compilation, etc. Indeed, the scope willbe determined on the basis of the object.

(2) SELECTION OF BASE PERIOD

Base period is a point of reference for comparison to measure the relative changes in thelevel of a phenomenon (e.g. price level in the case of a price index number) for the currentperiod. Usually, against the base year's norm (100), the relative changes for all the otheryears are compared. Suppose the price levels of two time periods, that of 1994 with thatof 1990, the former is called current period and the latter base period. The base period,therefore, is the basis of comparison.

Selection of the base year needs to be done with utmost care. The base yearshould be a normal economic year. It should neither be a year of economic crisis nor ofunprecedented boom. There should not be any erratic forces in operation like politicalupheavals, war, floods, famines etc. If by change an abnormal or inappropriate base yearis chosen, the indices related to such a base year present distorted figures andconclusions. For instance, a base period at the peak of a boom or inflation makes theindex numbers appear unusually low at most other periods. Conversely, a base at thetrough of economic depression makes all the indices appear unusually high.

(3) SELECTION OF ITEMS

Selection of items is another problem. Out of unwieldy list of commodities, the requiredrepresentative items are to be selected according to the purpose and type of the indexnumber. In selecting items the following points are to be considered.

a) items should be representative of the tastes, habits and traditions of the people.;

b) they should be cognizable;

c) they should be such as are not likely to vary in quality over two different periods andplaces;

d) the economic and social important of the various items of consumption should alsobe considered; and


e) the items must be fairly large in number, because reliability greatly depends on theadequacy of the number.

The right selection of items presents the real difficulties. As a general working rule, areasonable number of commodities should be selected, consistent with economy intime, money and labour, simplicity and accuracy of measurement.

(4) PRICE QUOTATIONS

Collection of price quotations for the commodities selected is a somewhat more difficultproblem. The price of a commodity varies from market to market and even at one market,from shop to shop. It is not possible, therefore, to obtain price quotations from all themarkets where a commodity is bought and sold. A selection of representative markets isto be made.

There may be a number of such agencies. viz. business firms, chambers of commerce,news correspondents, trade associations, government agents etc. Select an agencywhich is most reliable. To check the accuracy of price quotations supplied by an agency,obtain such quotations from more than one reporting agency.

Another problem associated with the price quotation is the frequency of price quotation.That is, how often the price quotations should be obtained, on weekly or monthly basis.Usually, in the case of weekly index numbers, one quotation per week for each commodityis considered sufficient. For instance, the Economic Advisers Index Number of WholesalePrices in India is a weekly index number and is based on price quotations obtained everyFriday. But if a monthly base is considered, a more frequent quotation may be desirable.

(5) PROBLEM OF WEIGHTING

The items included in the index numbers are not of equal importance. So the differentitems included in the index number must be weighted according to their importance. Thepurpose of weighting is to make the index truly representative of the population it is tomeasure.

The system of weighting may be either arbitrary or rational. Arbitrary or chance weightingmeans that the statistician is free to assign weights to different items, which he thinks fitor reasonable. Rational or logical weighting means some criteria have to be fixed forassigning weights. However, it is impossible to give a comprehensive definition to theterm "rational weights". Weights which are perfectly rational for one investigation may beequally unsuitable for another. In fact, a decision regarding rational weights depends onthe purpose of the index number and the nature of the data related to it.

Demand Analysis 135

(6) SELECTION OF AN AVERAGE

Since an index number is a technique of averaging all the changes in a group of valuesover a period of time, the problem is to select an average which summarises the changesin the component items adequately. Usually, the arithmetic mean is employed forconstructing the index numbers. For arithmetic mean is simple to calculate.

(7) SELECTION OF FORMULA

A large number of formulae has been devised for constructing index numbers. They aresimple aggregate indices, weighted aggregate indices and Laspeyre's formula, Paasche'sformula. etc. for computing weighted averages of price relatives. The device of a particularformula will depend upon the information available and the accuracy desired.

(8) THE PROBLEM OF DYNAMIC CHANGES

In a dynamic economy, there is a continuous change in the nature of consumption andcommodities which adds to the difficulties of comparison and the construction of indexnumbers over a period of time.

(a) Many new commodities may come into existence and the old may disappear.

(b) The quality and quantity of commodities may change from time to time, e.g. thequality of a l09- model motor car is quite different from that of a 1990 model.

(c) Income, education, fashion and other factors may change the consumption patternof the people and indices compiled for a period of time may become incomparable.

(d) In the modern world, due to changes in fashions, tastes, outlook of the people andtechnological advancement, more and more new goods appear in the market whileold goods often disappear, over a period of time. Thus, a comparison of either pricelevel or quantity levels from two separate and distant points of time becomes difficult.Therefore, most index number series are to be revised periodically, every decade orso. A new and more modern samples of comparable items have to be included.

(9) DIFFICULTY IN USAGE

An economic statistic an has to be very careful in using the index numbers for economicanalysis. The following points must be borne in mind in this regard.

a) An index number deals with averages - the average tastes and habits, earning andspending of an average number of people. Since it deals with averages, it cannot dealwith one individual's money and changes in its purchasing power since an individual maynot be affected by a rise or fall in the price level to the extent indicated by the indexnumber.


b) An index number constructed for one purpose may not be useful for another. A wholesaleprice index cannot be compared with a cost of living retail price index. Similarly, the costof living index number of textile workers cannot be used to measure changes in the valueof money of the middle-class group.

c) Index numbers do not provide a reliable basis for comparison of international prices, sothat differences in changes in the value of money between two countries may be measured.As items included in the index number of different countries differ in pattern and quality,comparison is not possible. The base years will also not be the same. Moreover, thereare various methods of averaging the use of different types of averages by different countriesin the computation of index numbers gives different results, thereby making comparisoneven more difficult.

As a result of all these difficulties, the index number is seriously limited in its utility, i.e. incomparing the purchasing power of money over time and space. In the face of thesedifficulties and inaccuracies in its construction, the index number can simply be regardedas a mere approximation indicating the rising or falling trends.

6. LIMITATIONS OF INDEX NUMBERS

The following are the limitations of index numbers :

(1) Approximation –

They are only approximate indicators of the relative changes, due to the fact that onecannot conceive of absolute accuracy in their construction. There can be errors not onlyin the collection of data but also in the selection of the base, selection of representativeitems and selection of appropriate weights. Any such error means inaccuracy in theconstruction of index numbers.

(2) Sample-based –

An index number is generally based on samples. Thus, the problem of computing anindex number is the problem of describing a universe from the sample. If proper andadequate samples are not selected, then the computed indices may not be trulyrepresentative. Therefore, Ilersic said that, "the index numbers are often unrepresentativeas they are usually based on imperfect data."

(3) Disregard qualitative change –

The index numbers of prices or production may not take into account variations in quality,which may be significant. Naturally, a superior commodity will cost more at any giventime than an inferior commodity, and a rise in the price index may be due to an improvementin quality and not to a rise in prices but very often there is no information on this point.

Demand Analysis 137

(4) Arbitrariness –

Weights are assigned arbitrarily.

(5) Differences –

An index number can be calculated in so many different ways and different methods givedifferent answers. Unless a proper method is used in a given situation, the results maybe misleading and inaccurate.

(6) Limited Scope –

An index number is useful for the purpose for which it is designed. Hence its use islimited to a particular phenomenon only. Thus, indices constructed for one purposeshould not be used for other purposes where they may not be fully appropriate and givenerroneous conclusions. They are not intentionally comparable.


Exercise :

1. What is demand in Economics ? Explain the determinants of market demand.

2. State and explain the law of demand.

3. What is price elasticity of demand ? What are its types?

4. Explain the methods of measurement of price elasticity of demand.

5. Write short notes on. (a) Total outlay Method of measuring elasticity of demand (b) DemandForecasting. (c) Determinants of demand (d) Criteria for good demand forecasting(e) Significance or Practical uses of price elasticity of demand. (f) Increase and decreasein demand. (g) Techniques of demand forecasting for new products. (h) Expansion andIncrease in demand (i) Exceptional demand curve (j) Cross elasticity of demand(k) Income elasticity of demand (l) Index Numbers.

Demand Analysis 139

NOTES


NOTES

Production and Costs 141

Chapter 5

PRODUCTION AND COSTS

Preview

Meaning of Production function, Law of Variable proportion and Laws of Returns to Scale,Economies Diseconomies of scale, Law of Supply and Elasticity of Supply, Cost Concepts -Accounting (actual) Costs, Economic Cost, Opportunity costs, Individual and Social Cost, Explicitand Implicit Cost, Fixed Cost and Variable Cost, Avoidable and Unavoidable Costs, Incrementaland Sunk Costs, Common and Traceable Costs, Historical (past) and Replacement (present)Costs, Short Run Cost, Short Run Cost Curves and their use on decision making, Determinantsof Cost, Break Even Point (i.e. The Traditional Concept of Equilibrium of a firm).

INTRODUCTION

Uptill now we have studied demand analysis i.e. individual demand curve, market demandcurve, law of demand and elasticity of demand and demand forecasting. In our study of demandside 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 ofProduction" and cost. By production or the act of production involves "transformation of inputsinto output".

By output we mean supply of product which depends upon cost of production which againdepends upon input price & relationship between input and output which is called productionfunction. Theory of production means nothing but study of production function.

1. PRODUCTION FUNCTION :

Production function is the relation between Input and output. The production function is thename given to the relationship between the rates of input of productive services andthe rate of output of a product. Thus the production function expresses the relationshipbetween the quantity of output and the quantities of various inputs used for theproduction. With the technological advances, the flow of output increases form the giveninput. The two aspects which are stressed under production function are :


1) Maximum quantity of output that can be produced from any chosen quantities of variousinputs

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 :

1) Law of Variable proportion : Where quantities of some factors is kept fixed butthe 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 forfactors of production which ultimately depends upon marginal productivity of the factor. Thedemand for factors is derived from marginal productivity curve which is actually taken ineconomics as a part of theory of distribution. That means theory of production is related tofactor prices such as wage, rate of interest which is a micro aspect. Macro aspect i.e. aggregatewages, 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 mathematicalmethods we can work out quantitative measure of this relationship.

The inputs or the factors of production can be classified into fixed and variable inputs. Thefixed inputs are those which do not change in quantity irrespective of the level of output. Asoutput increases the fixed inputs used per unit of output declines. In the short run a firm usesfixed inputs such as land, building, plant & machinery. The variable inputs are those inputswhose quantity changes along with a change in the output. It means, the variable inputs arerequired more & more to increase production. The practical observation of the productionfunction indicates 2 normal relationships :

1) When the quantity of a variable input increases while other inputs remain fixed, the outputalso 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 whenoutput increases faster than increase in a particular variable input. This is a phase ofincreasing returns to the variable input. When input and output increase in the sameproportion, it is a phase of constant returns.


2. PRACTICAL IMPORTANCE OF PRODUCTION FUNCTION :

The concept of production function is practically significant and useful for the followingreasons :

1) Production function gives us idea of the optimum level of the output and theoptimum employment of the variable inputs. A firm which wants to maximize theefficiency with given prices of inputs should try to find out the optimum proportion betweenfixed and variable input. This can be discovered with the help of production function.

2) Production function tells management the budget constraint for increase inoutput. As generally output cannot be increased without an increase in the input. Itfollows that the expansion of a firm requires more funds to employ more inputs. The firmcan judge how far it is worthwhile and profitable to increase output.

3) The production function explains the degree of substitution and complementarityof different factors of production. From this the firm can select its expansion path. Itmeans, if the firm wants to increase output in what proportion it should increase itsvarious inputs can be judged from the observed behaviour of production function.

4) The management should endeavour to produce an upward shift in productionfunction which can definitely improve its financial performance under the givenmarket conditions. Because, such upward shift in production function involvestechnological progress and indicates the possibility to generate surplus. The use ofbetter methods of production, reorganization of production activity and creating moreincentives 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 disguisedunemployment. When we excessively employ only one factor in the production of acertain commodity, we reach a stage when the marginal product of that factor becomeszero or negative. This stage is called disguised unemployment which is supposedlypresent in the agricultural sector in countries like India. Such disguised unemploymentindicates that it is possible to divert surplus labour to other sectors where their marginalproduct would be greater than zero. Therefore, it gives policy guidance to both managementand government about the priority in the development process.

6) As production function is an engineering concept, we can study the behaviourof production function under different conditions. It can explain inter - firm, inter -regional or international differences in the productivity. It can explain why the reward tothe factors and the rate of industrial growth are not same at all the places in all thecountries.

Thus the concept of production function supplemented with other tools of economicanalysis is relevant for rational decision - making in practical business.


Linear Homogeneous Production Function

This is a particular production function which assumes constant returns to scale. It statesthat if all inputs are increased in the same proportion, the output also increases in the sameproportion. It means, the change in scale of production does not have any effect on efficiencyof the firm. The returns to scale are constant.

According to Stigler, the production function is "the name given to relationship between ratesof input of productive services to the rates of product output and it is economist’s summary oftechnological knowledge". We have also said that in the simplest form, it is therelationship between "Input and output" and further this relationship can be studiedwith 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 caseof later all factors are variable.

Before discussing law of variable proportion let us consider the following definitions which willhelp in understanding the law.

1. Total Physical Product : Total quantity of output produced in physical units by a firmduring a period of time.

2. Marginal Product : The change in total product caused as a result of oneadditional unit of variable factor employed in combinationwith 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 timeperiod divided by the quantity of a variable factor that is usedto produce it.

T. P.A. P. = –––––––––––––––––

Variable factor Units

Alternative way of describing relationship between total product, marginal product and averageproduct 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 table givenunder the law of variable proportion.


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 giventime a firm is less than perfectly flexible which means when firm enters in Industry, it comeswith certain size or capacity and commitment. It has commitment to buy contain minimummaterial inputs or have leased land for some years or firm has some fixed obligations at anygiven time and therefore we say it is a less than perfectly flexible.

Short Run : It is period of time during which at least one of the firms input can not be varied.It is not possible to tell how long short run will last. For a small house painting firm it may befor 2 days because two days are enough to buy more equipment and hire more workers /painters. But for steel making firm short run lasts for 4 years even as 4 years is the time ittakes to change furnace and built separate plant, building, add more furnaces etc. In otherwords steel plant has a commitment to its present plant for 4 years.

Long Run : It is the period of time long enough to make all the changes that a firm wants tomake within limits of existing or present production function. This is the second time span inwhich business decisions are made. Except level of technology, everything else changes inthe long run. When new technology is introduced and production function itself changes thenit 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 beintroduced and production function itself is changed.

3. The Law Of Diminishing Returns or The Law of Variable Proportion. Or TheLaws of Returns :

Introduction :

Law of variable proportion occupies an important place in economic theory. This law examinesthe production function with one factor variable, keeping the quantities of other factors fixed. Inother words, it refers to the input output relation when the output is increased by varying thequantity of one input. When the quantity of one factor is varied, keeping the quantity of theother 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 asthe quantity of the variable factor is increased. Since under this law, we study the effects onoutput variations in factor proportions, this is known as the law of variable proportions. Thelaw of variable proportions is the new name for the famous "Law of DiminishingReturns" of classical economics.

Statement of the Law :

1) As equal increments of one input are added; the inputs of other productiveservices being held, constant, beyond a certain point the resulting increments ofproduct 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 apoint, 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 oftechnology, cause output to increase; but after a point the extra output resultingfrom the same additions of extra inputs will become less and less". (P. A.Samulson)

It is obvious form the above definitions of the Law of variable proportions (or the law of diminishingreturns) 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 andaverage product will eventually decline.

Assumptions of the Law of Variable Proportion :

The law of variable proportion (or diminishing returns) as stated above holds good under thefollowing conditions :

1) The state of technology is assumed to be given and unchanged. It there is improvementin 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, wecan alter the factor proportions and know its effects on output.

3) The law is based upon the possibility of varying the proportions in which the variousfactors can be combined to produce a product. The law does not apply to those caseswhere 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 in to 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 alltaken into consideration. Only physical relationship between factor inputs and output ofproducts is considered.

Explanation of the Law of Diminishing Returns (Variable proportion) with the help ofa table :


Fixed Variable Total Average MarginalFactor Factor Product Product Product

(say land (Labour units) (units) (units) (units)& Capital

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 NegativeReturns

Average Marginal Relationship :

Observations of the table :

The above table shows that eventually the total product also starts declining. But first todecline 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 averageproduct.

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 maximumM. P. equals A. P.

4) Total product is maximum when M. P. is zero.

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 marginalproduct 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.

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8) Form 7 to 11 workers, it is noticed that though T. P. is increasing, the M. P. goes ondecreasing. This is the phase of 'Diminishing Returns'. This phase may also be calledthe phase of 'Diminishing Marginal Returns'. Thus, we observe that the 'Law of DiminishingMarginal 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 heldconstant and other factor is varied, for sometime the Law of Increasing Returns, then the Lawof 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

The following figure is a diagrammatic presentation of the Laws of Returns roughly representingthe figures in the table given before.

Three stages of the law of diminishing returns (variable proportions) point H is the maximumpoint of T. P. when M. P. = O.

Y

H

T.P. CurveT.P.,A.P.,M.P.

M

F

X

S

Units of Variable factor(labour) employed

M.P. Curve

A.P. Curve

Stage I Stage II Stage III


It will be observed from the figure that the T. P. curve goes on increasing to a point and afterthat it starts declining. A. P. and M. P. curves also rise and then decline. M. P. curve startsdeclining earlier than the A. P. curve. The behaviour of the output when the varying quantity ofone 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 thepoint 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 onwardsduring the Stage 1, the T. P. curve goes on rising but its slope is declining which means thatfrom 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 adiminishing 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 thestage of 'increasing returns' because A. P. of the variable factor increases throughout thisstage. It should be noted that the M. P. in this stage increases but in a later part it startsdeclining 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 maximumpoint H where the second stage ends. In this stage both the M. P. and A. P. of the variablefactor is zero (when T. P. is highest as shown by point H). Stage II is important because thefirm 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 thevariable factor in negative and the M. P. curve goes below the X axis. This stage is called thestage 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 tothe quantity of the variable factor. As more and more units of variable factors are addedto constant quantity of fixed factor then fixed factor gets more intensively & effectivelyutilized and production increases at a rapid rate.

Let us consider the example through the table mentioned in the three stages of law ofvariable proportion. Through out the three stages fixed variable i.e. machinery (capital)


remains constant. The variable factor i.e. no. of workers increase as a firm expands itsproduction. A worker contributes 5 units per day to the firms output. The total productreaches 50 units per day when the 4th worker contributes to the production. Fullerutilization of capital is possible due to the addition of a variable factor. One worker cannottake full advantage of the capabilities of capital. When the fourth worker joins it is possibleto use the full potential of the capital. Moreover increasing returns can also be attributedto the principle of division of labour of specialization of work. The question may arise thatif fixed factor is abundant as compared to variable factor, why fixed factor be not taken inaccordance to the availability of variable factor. The answer is that fixed factors are fixedi.e. they are indivisible. The number of machinery cannot be changed in the short run.

2) Diminishing returns : The peculiar feature of this stage is that the marginal product fallsthrough out the stage and finally touches to zero. Corresponding vertically is the point Hwhich is the highest point of the TP curve. Here stage II ends.

In the table given on page 147, the third stage is set in by hiring 7th worker who addsonly 15 units per day as compared to 20 units per day added by the 6th worker. Totalproduct 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 issufficient to ensure full utillisation of fixed factor, then further increase in variable factorwill cause MP as well as AP to fall because fixed factor has now become inadequate (asagainst it was abundant earlier) relative to the quantity of variable factors. In stage twofixed factor is scarce as compared to variable factor. According to Mrs. Joan Robinson,a famous economist, the factors of production are imperfect substitutes for on another,the stage of diminishing returns occur. Fixed factor is scarce and variable factor thenfixed factor would not have remained scarce. The paucity of fixed could have been madeup by such perfect substitutes. If one of the variable factor added to the fixed factor wereperfect substitute deficiency of fixed could have been made up but elasticity of substitutebetween factors is not infinite, substitution is not possible and diminishing returns occur.

3) Negative returns : In this stage, marginal product falls below 'X' axis i.e. negative becausetotal product starts falling. In our example this is set in by hiring 13th worker. The totalproduct falls from 127 units to 118 units. The large number of variable factors impairs theefficiency of the fixed factor. The excessive variable factor as compared to less fixedfactor results in a fall of total output. In such a situation, a reduction in the units of thevariable factor will increase the total output.

Limitation of the Law of Diminishing Returns :

There are a number of exceptions to this law. This law does not apply to all conditions inagriculture.


(i) New methods of cultivation :

As mentioned earlier, this law assumes no change in the technique of production. Scientificrotation of crops, better quality seeds, modern implements, fertilizers, better irrigationfacilities, however are the changes which take place in agriculture. The marginal productunder these conditions, will in fact increase. New methods of cultivation, therefore, arean exception to the law.

(ii) New Soil :

When new land (soil) is brought under cultivation, the marginal product will increase fora time; thus the law of diminishing returns does not operate in the beginning.

(iii) Insufficient Capital :

If capital is not sufficient, increased used of capital, will give more than proportionatereturn, but later the marginal return will decrease. The early stage is an exception to thelaw of variable proportion.

Application of the Law of Diminishing Returns :

The law of diminishing returns applies to agriculture, because land if fixed. From society'spoint of view as Recardo assumed and other factors are variable. However, the law has universalapplication and operates in all fields of productive activity where one or more fixed factors arecombined with one or more variable factors.

Thus, if an industrial enterprise capital is kept fixed and other factors are increased, themarginal product will initially increase but will ultimately diminish.

Thus, the law also operates in industries like mining, fisheries and also in building industries.

4. Returns to Scale or Laws of Returns to Scale :

Under the law of diminishing returns (i.e. variable proportion) we have studied the behaviour ofoutput (T. P., M.P. and A. P.) when factor proportions are changed. That is, we have seen thebehaviour of output by keeping the quantity of one or some factors fixed and changing thequantity of other (e.g. Labour)

Now, we will undertake the study of changes in output when all factors of productionor inputs are increased together. In other words, we shall now study the behaviour ofoutput in response to changes in scale. An increase in the scale means that all inputsor factors are increased in the same proportion. Increase in the scale thus occurswhen all factors or inputs are increased keeping factor proportions unchanged. Thestudy of changes in output as a result of changes in the scale forms the subject matterof "returns to scale".


1) Law of Increasing Returns to Scale :

Meaning : If the increase in all factors leads to more than proportionate increasein 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 25%, and output increases by 40% then theincreasing returns to scale will be prevailing. This is because of greater specialization oflabour and machinery. This phenomenon according to Prof. Baumol also occurs becauseof dimensional relations. For example, if the diameter of a pipe is doubled, the flow ofwater through it is more than doubled. Another reason for increasing returns is becauseof the indivisibility of some factors. These factors are available in large and lumpy unitsand can therefore be used with utmost efficiency at only larger output. This reason isgiven 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 proportionand the output increases in the same proportion, returns to scale are said to beconstant. Thus, if doubling or trebling of all factors causes a doubling or trebling ofoutput, returns to scale are constant. In mathematics, the case of constant returns toscale is called ' linear and homogeneous production function' or 'homogeneous, productionfunction 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 increasein output, returns to scale are decreasing. When a firm goes on expanding all itsinputs, then eventually diminishing returns to scale will occur. Diminishing returns to

The Laws of Returns to Scale :Y

XO Scale or Proportion

Mar

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rod

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Mar

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rod

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Incr

easi

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ecreasing Returns To Scale

Constant Returns To Scale


scale eventually occur because of increasing difficulties of management, coordinationand control. When the firm has expanded to a too gigantic size, it is difficult to manageit with the same efficiency as previous. This in other words, means that the firm startssuffering from the diseconomies of scale.

5. ECONOMIES AND DISECONOMIES OF SCALE :

Introduction :

An attempt is made in this sub -unit to outline the economies of large - scale production withreference 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 followinggrounds.

(a) A new firm is required to acquire land, construct factory building, install machineryand provide other infrastructural facilities. A lot of time is wasted in erecting thefactory. Meanwhile, the firm has to spend on preliminary expenses. All theseexpenses are debited to the profit and loss account for the first operating year. If thetotal expenditure incurred during the first year is taken into account, the averagecost of production works out to be very high in the initial stages.

(b) The workers appointed in the factory take some time to adjust themselves to thetechniques of production. Till this adjustment is made, there is lot of wastage of rawmaterials and power. Naturally, the average cost of production is high.

(c) In the initial stages, production is on a small scale because the product is not yetknown in the market. The firm is not sure whether the entire production would besold. 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 areconstantly in demand. The workers also acquire proficiency in producing high qualitygoods. As a result, the firm decides to increase the scale of production. Ultimately, anumber of economies of scale accrue to the firm. These economies are classified asinternal and external economies. It is worthwhile to explain the economies at length :

Internal economies are those advantages of large - scale production which accrueto a firm on account of its superior techniques and management. They are broadlyclassified under the following heads:


(a) Technical Economies :

A firm that produces goods on a large scale can install improved and up - to - datemachinery. On account of new machines, a firm is able to effect a substantialreduction in the cost of production. It is also possible in a big firm to avail thebenefits of specialization and division of labour. Quality of goods produced by sucha firm is, therefore, superior.

(b) Commercial Economies :

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 firmmaking purchases on a large scale acquires a strong bargaining power in the market.It can secure favorable credit terms from the suppliers. A big firm can negotiate withtransport operators and can secure concessional freight rates for transportation ofraw materials and finished products. A big firm enjoys high reputation and its productsare in constant demand in the market.

(c) Managerial Economies :

A firm producing on a large scale can afford to hire the services of expects invarious fields such as purchases, production, marketing and finance. These expertsutilize their knowledge and experience towards maximization of profits.

(d) Financial Economies :

A firm which is producing on a large scale can avail the benefits of cheaper finance.A firm which has acquired reputation and a high credit - rating can raise new capitalquickly, easily and on much favourable terms.

(e) Risk and Uncertainty :

A firm which produces on a large scale can earn large profits. It can build up hugereserves 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 cannotwithstand the losses incurred in the business.

c) External Economies :

The above advantages of large - scale production may accrue to an individual firm becausethey arise out of the superior technique and management of the firm. If in a particularregion, 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 andall the firms can take the benefits of these services. What is more important is that, anumber of new firms dealing in ancillary products are developed in this region. Thesefirms 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 wouldbe higher. It would, therefore, be profitable for big firms if they buy the parts from smallfirms. Similarly, various firms concentrated in a particular region can start a ResearchInstitute. The benefits of this research can be passed on to all the firms. All such economiesare called external economies.

d) Diseconomies of Large - Scale Production :

Large - scale production may encounter certain diseconomies and disadvantages. Incourse of a firm's expansion, a stage may be reached when the firm becomes too largeto 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 variousdepartments. Delegation of responsibilities and decentralization of very large number of workcan not be stretched too far. Co-ordination of various activities becomes impossible. A verylarge number of workers may cause factions and groupism amongst them. This may disturbthe healthy atmosphere and may cause indiscipline, quarrels, and rivalries. A largeestablishment with thousands of employees makes work impersonal and the relations betweenthe employers and employees becomes formal. This fact causes strains on industrial relations.With increase in the number of salaried administrative, managerial and sales staff, personaltouch with dealers and customers is lost. Because these salaried employees have to stake inthe company, efficiency, urge, punctuality, integrity and inventiveness disappear and theirplace is taken by disinterestedness, routine dealings and work to rule.

The internal diseconomies of large - scale production can be summarized thus :

(i) Management and supervision becomes difficult and waste of time and material results.

(ii) For want of a personal touch, strikes, lockouts and such other eventualities causingstoppage of work or obstructions to work increase.

(iii) No direct contact with customers is possible. So, tastes of consumers are ignored.Products are standardized and no specialized services to consumers are possible.

(iv) Large - scale production may cause overproduction and this may result in losses.

(v) Large producers have to fight for capturing and maintaining markets. This may result incut-throat competition.

(vi) Large firms cannot easily adapt to ups and downs in business.

(vii) Large - scale production may involve imports of raw materials and exports of products.


(viii) There are additional elements of risk due to possibilities of war, changed internationalrelations and so on.

Expansion of industry and overcrowding of industrial units in a locality also causesdiseconomies which can be called external diseconomies. The competition amongfirms 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 naturallyof a lower quality compared to those already employed. For example, the best workers areselected first and as more and more workers are required, a firm has to appoint whosever areavailable rather than who are suited for the work. Thus, not only wage - rates increase, butproductivity 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 certainlocalities. Overcrowding of cities, traffic congestion, pollution of air and water, strain on civicamenities 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 oflabour, availability of quick transport, timely deliveries of finished products and an overall strainon the whole industrial system.

6. SUPPLY ANALYSIS :

a) Meaning of Supply :

In economics, supply during a given period of time means the quantities of goods whichare offered for sale at particular prices. Thus, the supply of a commodity may be definedas the amount of the commodity which the sellers (or producers) are able andwilling 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. Astatement of supply without reference to price and time conveys no economic sense.For instance, a statement such as : "the supply of milk is 500 liters" is meaningless ineconomic analysis. One must say, "the supply at such and such a price and during aspecific period." Hence, the above statement becomes meaningful if it is said "at theprice of Rs.20. per liter, a dairy - farm's daily supply of milk is 500 liters." Here, both priceand 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 abilityof 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 willingnessto 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 thanthe seller's reservation price, he (the seller) is willing to sell more. But at a price belowthe reservation price, the seller refuses to sell.

In short, supply always means supply at a given price. At different prices, thesupply may be different. Normally, the higher the price, the greater the supplyand vice versa.

b) Determinants of Supply :

There are a number of factors influencing the supply of a commodity. They are known asthe 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 alower price. The change in the quantity supplied in response to the change in priceis known as the variation in supply. Even expectations about the future price affectthe supply. If a dealer expects the price to rise in the future, he will withhold hisstock at present and so there will be less supply now. There are several factorsother than the price, influencing the supply. The changes in these factors lead tochanges in the supply of the commodity. The change in the supply may be in theform of the increase or decrease in supply. These other factors are given below.

2) Natural Conditions : The supply of some commodities, such as agriculturalproducts, depends on the natural environment or climatic conditions like rainfall,temperature, etc. A change in these natural conditions will cause a change in thesupply. For instance, a good monsoon will produce a good harvest; so the supply ofthe agricultural products will increase. On the other hand, their supply decreasesduring the drought conditions.

3) State of Technology : The improvement in the technique of production leads toincreased productivity and results in an increase in the supply of manufactured goods.

4) Transport Conditions : The difficulties in transport may cause a temporary decreasein the supply, as goods cannot be brought in time to the market. So, even at therising prices, the quantity supplied cannot be increased.

5) Factor Prices and their Availability : When the factors of production are easilyavailable at low prices, more investment is encouraged due to better returns. Undersuch circumstances the supply of the commodity which these factors help to producemay tend to increase and vice versa.

6) Government's Policy : The government's economic policies like industrial policy,fiscal policy, etc., influence the supply. If the industrial licensing policy of thegovernment is liberal, more firms are encouraged to enter into registrations and


high custom duties may decrease the supply of the imported goods but it wouldencourage the domestic industrial activity, so that the supply of domestic productsmay increase. An increase in tax such as excise duties will reduce the supplywhile granting of subsidy will increase the supply.

7) Cost of Production : If there is a rise in the cost of production of a commodity, itssupply will tend to decrease. So, with the rise in the cost of production, the supplycurve tends to shift leftward. Conversely, a fall in the cost of production tends toincrease the supply.

8) Prices of other Products : The prices of substitutes or related products alsoinfluence the supply of a commodity. If the price of wheat rises, the farmers maygrow more of wheat and less of rice. So the supply of rice will decrease. Again, ifthe prices of fountain pens rise, the prices of ink will also tend to rise. If the price ofsugar rises, the price of jaggery (gur) will also tend to rise.

7. THE LAW OF SUPPLY :

The law of supply reflects the general tendency of the sellers in offering their stock of acommodity for sale in relation to the varying prices. It describes seller's supply behaviourunder given conditions. It has been observed that usually sellers are willing to supply morewith 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 risein 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 largeramount 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 asupply curve, based on imaginary data, as follows :

Price of Ballpen (per unit) Quantity SuppliedRs. (in '000 per week)

10 1012 1314 2016 25


X axis = Units of Ball Pen

Y axis = Price per Unit

When the data of Table are plotted on a graph, a supply curve can be drawn as shown asshown in Figure.

From the supply schedule, it appears that the market supply tends to expand with the rise inprice and vice versa. Similarly, the upward sloping curve also depicts a direct relation betweenprice and quantity supplied.

Assumptions Underlying the Law of Supply :

The law of supply is conditional, since we have stated it under the assumption : "other thingsremaining 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 alongwith the rise in the price of product, the sellers will not find it worthwhile to produce moreand supply more. Therefore, the law of supply is valid only if the cost of productionremains constant. It implies that the factor prices, such as wages, interest, rent etc., arealso unchanged.

2) No change in technique of production : The technique of production is assumed to beunchanged. This is essential for the cost to remain unchanged. With the improvementsin technique, if the cost of production is reduced, the seller would supply more even atfalling prices.

3) Fixed scale of production : During a given period of time, it is assumed that the scaleof production is held constant. If there is a changing scale of production, the level ofsupply will change, irrespective of the changes in the price of the product.

Supply Curve

Pri

ce

Per

Un

it

Quantity Supplied (Units)

XO

Y

S

S10

12

14

16

5 10 15 20 25


4) Government policies are unchanged : Government policies like taxation policy, tradepolicy, etc., are assumed to be constant. For instance, an increase in or totally freshlevy of excise duties would imply an increase in the cost or in case there is fixation ofquotas for the raw materials or imported components of a product, then such a situationwill not permit the expansion of supply with a rise in prices.

5) No change in transport costs : It is assumed that transport facilities and transportcosts are unchanged. Otherwise, a reduction in transport cost implies lowering of cost ofproduction, so that more would be supplied even at a lower price.

6) No speculation : The law also assumes that the sellers do not speculate about thefuture changes in the price of the product. If, however, sellers expect prices to rise furtherin future, they may not expand supply with the present price rise.

7) The prices of other goods are held constant : The law assumes that there are nochanges in the prices of other products. If the price of some other product rises fasterthan that of the product in consideration, producers might transfer their resources to theother 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.

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 suchexceptions 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 supplybehaviour is represented by a backward sloping or regressive supply curve over a part of itslength as shown in the following Figure. It is also known as an exceptional supply curve, assuch a thing happens only in some exceptional cases like labour supply or savings.

Backward Sloping Supply Curve of Labour

Wag

e R

ate

XO

Y

Quantity Supplied ofLabour in hours

Leisure

S1

S

200

180

160

150

50 55 60 65

M


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 interms of labour - hours the worker is willing to work at a given wage rate. It is observed that aswages increase, a worker might work for a lesser number of hours than before. To illustrate thepoint, say, when the wage rate is Rs. 150 per hour, the worker works for 50 hours per weekand gets Rs. 7,500; when it is Rs. 160 per hour, he works for 60 hours per week, and getsRs.8,800; at Rs. 180, he works for 65 hours and gets Rs. 11,700 and at Rs. 200, he works for60 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 incomefrom their investment. As interest rates rises, the amount on investment required to reach thesame amount of interest yields is obviously less. For instance, a person wants to earn Rs.100per year require an investment of Rs. 1,000 and at 20 per cent, he will require an investmentof Rs.500. Thus, as the rate of interest rises, the volume of investment required declines. Inthis case, he will decrease his savings and investment when the rate of interest rises andincrease his savings and investment when the rate of interest falls, which is contrary to theusual law of supply.

8. EXPANSION AND CONTRACTION IN SUPPLY :

The law of supply refers to the change in supply due to a change in price. If, with a rise inprice, the quantity supplied rises, it is called expansion of supply. If with a fall in price, thequantity supplied declines, it is called contraction of supply. The change in the quantity inaccordance 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 ashows contraction of supply.


Fig. A Fig. B

price, in which case it is called increase in supply. There might be less supply forthcoming inthe market without a change in price, then it is called decrease in supply. The change insupply due to causes or determinants other than price is called "decrease" or "increase" insupply, and can be shown on different supply curves.

In figure A, at price OP, the supply is QQ. Later on, at the same price, when the supplyincreases from OQ to OM, it is called increase in supply. It cannot be shown on the initialsupply curve, but the supply curve shifts to the right as S1S1 curve. Likewise, in figure B,when at price OP, the supply becomes OK instead of OQ, it means a decrease in supply. Thiscan be shown by leftward shifts which need not be parallel.

The Causes of Change in Supply :

There are many causes which bring about a change (increase or decrease) in the conditionsof supply. The important ones among them are :

1) Cost of Production : Given the price, the supply changes with the change in the cost ofproduction. If the cost of production increases because of higher wages to workers orhigher price of raw materials, there will be a decrease in supply. If the cost of productionfalls 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 supplydue to floods, paucity of rainfall, pests, earthquakes, etc. Absence of the above calamitiesor an exceptionally good as well as a timely monsoon might increase supply.

9. 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 market without a change in

S

S1

S1

SS 2

S

SS 2

a b

Quantity Supplied(Increase In Supply)

Quantity Supplied(Decrease In Supply)

Pric

e (P

er U

nit)

Pric

e (P

er U

nit)

Y

O X

Y

O X

b a

Q M K Q

P P


3) Change in Technique of Production : This has an important influence on supply. Animprovement in the technique of production might go a long way in increasing the supply.For instance, introduction of highly sophisticated machines increases the supply ofgoods.

4) Policy of Government also Influences Supply : Taxes on production, sales, importduties and import restrictions may reduce supply. It may also be deliberately reduced bygovernment policies.

5) Development of Transport : Improvement in means of transport obviously increasesthe supply of goods as they facilitate the movement of goods from one place to another.

6) Business Combines : The producers also might reduce the supply by entering into anagreement among themselves through their business combines like trust, cartel orbusiness syndicate, with a view to raising prices in the market.

10. ELASTICITY OF SUPPLY :

Supply changes due to change in price. The extent of change in supply in accordance withthe change in price is called elasticity of supply. When, with a little change in price (rise orfall), there is a considerable change in quantity supplied (expansion or contraction) the supplyis said to be elastic. When, with a considerable change in price, there is little change inquantity supplied, the supply is said to be less elastic. More precisely, with a small fall inprice, when there is a big contraction of supply or with a small rise in price, when there is a bigexpansion of supply, the supply is said to be elastic. If, with a big fall in price, there is verylittle 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 theproportionate change in quantity supplied to the percentage or proportionatechange 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 Pricees = ---------------------------------------------------------------- ÷ ---------------------------------------------------

Original Quantity Supplied Original Price


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

� QS �Pes = -------------- ÷ ----------------

QS P

�QS P= -------------- x ----------------

QS �P

�QS PTherefore, 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. 45per unit, the total Quantity supplied of the commodity by the sellers is increased from1,000 units to 1,200 units, then the elasticity of supply may be calculated as under :

200 40es = -------------- x -------------- = 1.6

5 1000


Elasticity of Supply - Extreme Cases

The panel (a) of Figure represents the supply curve of zero elasticity. Irrespective of theprice, the producer would be supplying OQ quantity (es = 0).

The (b) represents the supply curve of infinite elasticity. At OP price, the producer wouldbe supplying any amount of the commodity. (es = α).

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 supplyelasticity's have been illustrated in the following Figure.

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 theamount supplied (es = 1). Similarly, in panel (b), the curve S1, represents a relativelyinelastic supply, (es < 1), and S2 represents elastic supply, (es > 1).

(Per Unit)(Per Unit)

(Per Unit) (Per Unit)


b) Measurement of Elasticity of Supply :

There are two methods of measuring elasticity of supply : (1) the ratio method, and(2) the point method.

∆ Q Pes = –––––– x ––––––

Q ∆ P

The coefficient of elasticity of supply(ies) may vary between zero to infinity.

The Point Method :

On a given supply curve, the elasticity of supply at point P is measured by the ratio of thedistance along the tangent (drawn to the curve at the point) from the point P on thesupply curve to the point where it intersects the horizontal axis and the distance alongthe tangent from the point P on the supply curve to the point where it intersects thevertical axis.

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 TFto the supply curve SS at point P intersecting the horizontal axis at T. Draw a perpendicularPB form point P and intersecting at point B on the horizontal axis.

The elasticity of supply at point P is measured as :

TBEs = ––––––

OB

In panel (1) TB < OB, therefore, as es < 1 at point P. In panel (2) TB > OB, therefore,es > 1 point P.

Pri

ce (

Per

Un

it)F

F

Pri

ce (

Per

Un

it)


c) Factors Determining Elasticity of Supply :

The elasticity of supply of commodities depends on a number of factors, such as :

1) Nature of commodity : In the case of some commodities like antiques, old wines, oldstamps, old and original handwritten manuscripts, etc. their supply remains fixed orconstant as they cannot be reproduced in their original form or shape. In the case ofsuch commodities price changes will have no influence on their supply.

In the case of houses, high artistic works, paintings and statutes, etc. it may take quitesome 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 bringabout a relatively quicker response from the supply side to change in their prices. Thus,if a community depends for its cloth only on handloom technology, changes in price ofcloth would take relatively longer time for supply to respond, than if that communitypossesses 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 thetime-span, generally more responsive would be the supply side of the commodity tochanges in price.

Thus, if price of a commodity rises, that may cause no response from supply side in oneor two hours or even one or two days(except in the case of commodities like shares andinternationally traded goods like gold, silver and other valuable metals in case of whichfuture 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 inelasticsupply, while gods produced on a large scale have a relatively elastic supply.

5) Size of the Firm and the Number of products produced : When the big firms producea variety of products at a time, they can easily transfer the resources from one productto the other so that the supply may become more elastic.

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 agriculturalgoods 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 supplyof agricultural commodities less elastic.

7) Mobility of Factors : In those industries where there is a high degree of mobility offactors of production, supply will be more elastic. Immobility of factors causes inelasticityof supply.

11. COST CONCEPTS :

Meaning and Importance :

The cost of production of an individual firm has an important influence on the market supply ofa commodity. The product prices are determined by the interaction of the forces of demandand supply. We have seen that the basic factor underlying the ability and willingness of firmsto supply a product in the market is the cost of production. A firm aims at maximizing itsprofits; profits depend on the costs of production and the prices of products. Thus, given themarket price of the firm's; product, the amount a firm is willing to supply in the market willdepend on the cost of production. It is therefore, necessary to have a clear idea about theconcept of the cost of production.

Costs may be nominal costs or real costs. Nominal cost is the money cost of production. It isalso called expenses of production. The real cost is the opportunity cost of production (seebelow). Money costs and real costs do not coincide with each other.

Types of Costs :

1) Accounting Costs :

Accounting costs are the costs of production of the firm. These are money costs orexpenses of production. These costs are paid for by the producer and are also known asentrepreneur's costs. These are the explicit costs, and they enter the accounts books ofthe 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 rawmaterials, (v) replacement and repairing charges of machinery, (vi) depreciation of capitalgoods, and (vii) normal profits of the manufacturer (amount sufficient to induce him tocontinue production).

Accordingly costs may be classified as : (a) Production costs, including 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 mustmake sure that the price of the product, must cover these costs and normal profits, orelse, 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 ofreasons :

(a) To predict how the firm's behaviour will respond to a given change in the conditionsit faces.

(b) To help the firm make the best decisions 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 usercost, but is commonly known as opportunity cost.

2) Economic costs :

The economist's idea of cost is based on the fact that resources are scarce and havealternative 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 is meant those payment 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 full costs of a firm(economic costs).

3) Opportunity Costs (Alternative or Transfer costs)

Since productive resources are limited, the production of one commodity can only be atthe cost of another. The commodity that is sacrificed is the opportunity cost of thecommodity produced. Thus, economists define the cost of production of a particularproduct as the value of the foregone alternative products, that resource used in itsproduction could have produced.

The opportunity cost of a product, is therefore, the opportunity lost of not being able toproduce some other product.

Resources can be used for a number of purposes. The opportunity cost of these resourcesto a firm is the value in their next best alternative use.


Example

Thus, if Rs. 20 lakhs are invested in project A at a 10 per cent rate of return, and if thisamount was not invested in project A, it would have been invested in project B (next bestalternative use of Rs. 20 lakh) at 9 per cent rate of return. Then the opportunity cost ofRs. 20 lakh in project A is 9 per cent, which is the value of this amount in its next bestalternative use.

Similarly, if a consumer uses Rs. 20,000 to buy a washing machine, he cannot use thismoney to buy a microwave oven. By buying a washing machine, he has forgone theopportunity of buying a microwave oven. Thus, the opportunity cost of buying a washingmachine is the opportunity cost of not being able to buy a microwave oven. Therefore wecan say that the opportunity cost of producing X having considered Px in terms of Y givenPy is = Px

P y

(a) Significance of Opportunity Costs :

The concept of opportunity costs is an important tool to measure the implicit costsof a firm. The implicit costs distinguish the accounting costs from the economiccosts. Thus, the economic profits to a firm can be calculated with the help ofimplicit costs of a firm, and these costs are imputed on the basis of the opportunitycost principle. This concept is, therefore, used for, (a) measuring profits, (b) policydecision of the firms, (c) forming capital budget and (d) alternatives available to thefirm.

The opportunity cost principle has a wide application in economic theory. It isuseful in the determination of values internally and internationally. It is also used tounderstand income distribution.

(b) Limitations :

There are, however, some limitations in its application.

(i) Specific : It does not apply to productive services which are specific. A specificfactor has no alternative use. Its opportunity (transfer) cost is, therefore, zero.

(ii) Factors are not homogeneous : Units of productive services are not homogeneous,this obstructs their transfer.

(iii) Wrong - Assumption : The theory is based on the assumption of perfect competitionwhich rarely exists.

(iv) Individual and Social Costs : A product may cost the firm Rs. 5,000 per unit, butto 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 opportunitycosts.

Conclusion : Inspite of these limitations, the theory of opportunity costs, is the mostwidely used theory of cost at present.

4) 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 paymentsa firm must make, or incomes it must earn, to owners of factors of production to attractthese resources away form other uses. These payments or incomes may be eitherexplicit or implicit.

(a) Explicit Costs :

The money payment, which a firm makes to those 'outsiders' who supplylabour services, raw materials, transport services, electricity etc. are calledexplicit costs. Thus, explicit costs are out - of - pocket costs, i.e. payments madefor resources purchased or hired by the firm. These are expenditure costs, like, thesalaries and wages paid to the employees, prices of raw materials, fixed or overheadcosts, and payments into depreciation and sinking fund accounts. These are firm'saccounting expenses.

(b) Implicit Costs :

But in addition, the firm often uses resources which the firm itself owns. The costsof 'self owned' resources which are employed by the firm are non-expenditure or implicit costs, like, the salary of the proprietor, or the interest onthe 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 andemployed 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 basisof the opportunity cost principle. Implicit costs are ignored while calculating the expensesof production. These costs do not enter the account books of a firm.

(c) Normal Profits as a cost :

Explicit costs, implicit cost and normal profits together form the full costs o a firm(economic costs). The entrepreneur must be sure of normal profits if he is to continuein business. Thus, normal profits are also costs.


(d) Economic (or Pure), Profits :

From the above discussion of accounting and economic costs, it becomes clearthat economists and accountants use the term 'profits' differently. By 'profits' theaccountant means total revenue minus explicit costs. But to the economist 'profits'means total revenue minus all costs (i.e. explicit costs, implicit costs and normalprofits).

Therefore, when an economist says that a firm is just covering its costs, he meansthat all explicit and implicit costs are being covered and that the entrepreneur istherefore, receiving a return just large enough to keep him in his present job. If afirm's total revenue is more than all the economic costs, then the residue is to theentrepreneur. This residue is economic or pure profit. It is not a cost, because bydefinition, it is a return more than the normal profits required to keep the entrepreneurin his present line of production.

Other Production Costs :

As discussed above, the term cost has varied meanings. We shall now discuss someimportant types of costs of production.

i) Fixed Costs and Variable costs ( F.C. and V.C ) :

This distinction between fixed and variable costs is relevant in the short period only.In the short period, some factors, like capital, machinery, land, management, arefixed and some factors, like labour, electricity, raw material, etc are variable. Costson fixed factors are called fixed costs and costs on variable factors are calledvariable costs. The costs which remain fixed irrespective of the level of output arecalled 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 arepermanent employees. Variable costs are those costs which vary with the level ofoutput. Variable costs include costs of raw material, electricity charges, wagesetc. 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).

In the long period, however all factors are variable and so all costs are variable. Thedifference between the fixed and variable costs disappears in the long period.

ii) Avoidable and Unavoidable costs :

At times a firm faces a problem of retrenchment or contraction. Costs which canbe avoided due to contraction of the firm are called avoidable costs andthe costs which cannot be avoided because of contraction are unavoidablecosts. 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, electricitycharges etc. these are avoidable costs. However, it has to continue to employ thesalesman who move from place to place; the salaries of these salesman cannot beavoided because of contraction of the firm; these become unavoidable costs.

iii) Incremental and Sunk Costs :

At times the firm undertakes expansion. It might set up a new factory or introducea new product. Costs which increase because of expansion of a firm arecalled incremental costs, and costs which have to be borne whether thereis 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 costshave to borne by the firm whether there is expansion or not; these are Sunk costs.

iv) Common and Traceable costs :

Today, most firms are multiple product firms, i.e. firms producing more than oneproduct. Some costs are common to all the products of multiple productfirm. These are common costs. However, there are some costs which aretraceable to a particular product of a multiple product firm; these are calledtraceable 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 boththese products; these are common costs. However, the raw material used or acutter used for the magazine or newspaper can be specific to a particular product;these are traceable costs.

v) Historical and replacement costs:

Cost of purchase of a capital asset, when it was initially purchased, say,1994 is the historical cost of the asset. Over a period, the value of every assetdepreciates; 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 2004, is thereplacement cost of the asset.

vi) Short run and Long run costs:

All the costs discussed previously are important. However, for our present study weshall concentrate on firms fixed and variable costs. This distinction between FCand VC depends on the time period. In the short period some costs are fixed andsome are variable. We shall now study the short run costs with reference tototal marginal and average costs. To understand the meaning of these costsand relationship between them, we will make use of cost curves as shown on nextpage.

Firms Cost curves :

(A) Short run Cost Curves:

Short run is a period within which some costs change, (because some factors likelabour change), whereas some costs do not change (because some factors likemachinery, capital, do not change). Thus, we talk of fixed costs and variable costsin the short run.

a) Total Fixed Costs (TFC):

Some factors like machinery, land, capital remain fixed in the short period, the totalcost of all these factors is the total fixed costs. TFC's do not change in the shortperiod. 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.

b) Total Variable Costs: (TVC) :

Some factors like raw material, electricity, spare parts and labour change as theoutput changes. The cost on these factors is the total variable costs. The totalvariable costs increase with increase in production(see fig shown on next page).We have a rising TVC curve.

c) Total Costs (TC) :

The sum of total fixed costs and total variable costs is the total cost. This is thetotal cost of production.

TC = TFC + TVC

The TFC is constant, but TVC increases as production increases, so TC alsoincreases as production increases. The TC curve is also a rising curve and thevertical distance between the TVC and TC curve, for any level of production is thesame and is equal to TFC(see the figure shown on next page).


d) 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 productionincreases (see fig shown below).

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 asoutput increases and later AVC increases as output increases (see fig shown below).

e) 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 asoutput increases and later AC increases as output increases (see the fig shown nextpage).


f) Marginal Cost:

The marginal Cost is the change in total cost caused due to one additional unit ofoutput 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 outputincreases 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 ata decreasing rate and later it increases at an increasing rate. The relationshipbetween TVC and MC is the same as the relationship between TC and MC becauseTVC changes at the same rate as TC, since TFC is constant.

MC = MVC + MFC, but MFC = 0, therefore, MC = MVC

Also, the relationship between AVC and MC is the same as the relationship betweenAC and MC. Thus, the MC curve cuts both the AVC and AC curves at their respectivelowest points.

Units Total Total Total Average Average Average Marginalof 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

Units of outputs

Co

st


(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 ofoutput the AC (AFC + AVC) also declines as output increases. However, even thoughAFC falls continuously as output increases, the AVC increases steeply, after reaching aminimum. 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 VariableProportion.

The marginal cost and average cost falls as output increase, in the initial stage of productionbecause :

(i) The fixed factor is used in a better and better way in the initial stage of productiontherefore, the AFC falls steeply and thus AC falls steeply.

(ii) The average variable cost falls initially till the normal capacity of the machine isused up, because the variable factors are used only to assist the fixed factors, theAC 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 ofvariable factors, the TVC cost increases sharply as output increases, therefore, theAVC also increases sharply, and it cannot be offset by the slow fall in AFC overlarger output. Thus fixity of factors causes the AC to rise sharply over larger output.

(ii) Further, factors of production are not perfect substitutes of each other; thus if thefixed 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 increasesfurther, gives the AC curve a U - shaped curve. One can conclude that the short runAC curve is U - shaped and this is explained by the Law of Variable Proportion,which operates only in the short - run.

12. DETERMINANTS OF COSTS :

The determinants of demand have already been discussed in the Chapter "Demand Analysisand 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 importantdeterminants of cost have to be identified, so that each determinant might be forecast, and weare able to arrive at a realistic picture of cost behaviour in the future. There are so many factorswhich determine cost that is virtually impossible to enumerate them. However, it is possible toidentify 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 thecost 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 ofprices, of inputs, the rate of output, the size of the plant and technology.

Therefore, the cost function may be written as :

Cost = f (I, O, P,T)

Where

I - denotes the prices of such inputs as labour and capital material.

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 comprehensivecost 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 ofthese separate functions pluralistically yields the complex function. For example, considerthe first determinant in this complex function, that is input. Now the cost - input relationship isa seperate function. Similarly, the cost output relationship is another separate function; andso on. Consider now the cost - input relationship.

Cost - Input Relationship :

In the cost - input relationship, it is the prices of various inputs which make up the cost. Forexample,

O = ALα K1-

α

Where, O = the amount of output

A = a constant

L and K denote labour and capital

α and 1-α are the production co – efficient or elasticities


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 theprice of materials. These input factors, namely, labour, capital and materials, multiplied bytheir quantities, determine the cost. The quantities which are bought, however, depend upontheir prices.

It has already been indicated that producers generally try to combine the factors of productionin such a way as to minimize cost. In other words, they go on substituting one factor foranother till all the costlier factors are replaced by the factors which are cheaper. This is knownas the process of substitution. The purpose of this substitution is to enable the managementto arrive at the least - cost combination of factors or inputs; and this process goes on till astage is reached at which further substitution is not possible. This process is known as themarginal rate of substitution.

In the costing of inputs, a cost function is developed on the same lines on which the productionfunction is developed. The objective of the production function is twofold : to arrive at the leastcost combination and to achieve the maximum output. In the cost function, the least - costcombination of inputs is determined. For example, if labour is costly, the producer goes in fora capital intensive technique. On the other hand, if capital is costly, the labour intensivetechnique is adopted. In other words, a relation of substitution between labour and capital isestablished. But what happens when capital is constant and the price of labour or the price ofmaterials rises ? it is difficult to analyse this situation because labour is costly, the producercannot use less of labour and more materials. This would be absurd because labour andmaterials cannot be substituted for each other. The ingenuity of the managerial economistarises when he goes beyond this limitation and find out whether there is some factor influencinglabour and materials alike. If labour is costly and the price of materials is constant, a capitalintensive technique would be used. On the other hand, if materials are costly, researchreceives an impetus, for it becomes necessary to find substitutes. These facts indicate thatthe cost - input function is one of the complex functions of cost analysis.

Cost - Output Relationship :

Cost generally vary 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 isa 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 factorsdo 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 dowages because these factors, namely, raw materials and labour, are subject to the forces ofdemand 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 cost behaviour.Costs, of course, are of several kinds - fixed cost, variable costs, average costs and marginalcosts. However, the total cost is the summation of fixed and variable costs. Fixed and variablecosts have already been dealt with. For the purpose of the cost - output analysis, what isneeded 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, themarginal cost, the total fixed cost, and the average fixed costs is illustrated in table givenpreviously.

13. BREAK EVEN POINT :

The Traditional Concept of Equilibrium of a Firm

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 stabilize at a givenlevel of output and is reluctant either to increase or to decrease its output. Since maximizingmoney - profits is assumed to be the objective of the firm, the firm will try to attain that level ofoutput which fetches maximum profits. Once this level is attained, the firm will tend to stabilizethis level of output. In other words, equilibrium of the firm will be established where its outputmaximizes its money profits. Since profit is the difference between total revenue and totalcost, 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 afirm. Now we shall consider the behaviour of revenue of a firm. To simplify our analysis, weshall assume that the firm is producing one product only. Table indicates the movements oftotal cost and total revenue as the level of output which corresponds to the longest verticaldistance 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) andTotal 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 curvesrespectively. The TR curve originates form point O since total revenue is zero when productionis zero. However, a firm is required to incur fixed costs even when its level of production iszero. 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,


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 - evenpoint. As output increases beyond the level OA, TR curve rises above the TC curve and thegap between the two goes on increasing. This widening of the gap between the two curvesindicates increasing profits. The vertical distance between TR and TC curves indicates totalprofits. This vertical distance is longest at OB level of output, where EF is the total profit andEF is the longest possible vertical line that can be drawn between the two curves TR and TCas drawn here. Hence, OB is the profit maximizing level of output and at this level of output thefirm will be in equilibrium. If production increases further, profits will decline. At point G, TRand TC are again equal. Point G, therefore, is the second break - even point. OC level of outputis again a no- profit no -loss level of output. If output is increases beyond OC the firm will incurlosses which will increase as output is increased beyond OC.

In order to decide the largest vertical distance between TC and TR, we can draw a number oftangents to the TR and TC curves. Of all theses tangents, we have to find a pair of lines whichare parallel to each other and at the same time, the points of tangency are on a straight linedrawn perpendicular to X axis. In fig. JK/LM are the parallel lines and E and F are the points oftangency. These two points (E and F) are on the straight line BFE which is drawn perpendicularto the X axis. To ensure that EF is the longest vertical distance between TR and TC. EF is thetotal profit at OB level of output.

This method can illustrate the equilibrium of the firm. Besides, it is most widely used in businessto find out total profits of a firm. But this method has two limitations : (i) The longest verticaldistance between TC and TR curves is difficult to find out at a glance. We have to draw manytangents to the two curves before we come across a pair of tangents which are parallel to eachother. (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. Butstill we cannot precisely show the price as a particular distance. Hence, the method is not verysignificant especially in the context of problems in the theory of value we are required to discusswith 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.

Output (Units)

Tota

l C

ost

& T

ota

l R

even

ue

Y

O X

TR

TC

E G

J

L

M

CBA

H

D

K

F


Exercise :

1. Explain The Law of Variable proportion with the help of three stages.

2. State and explain Law of Supply? What are its exceptions?

3. What is elasticity of Supply? What are the types of elasticity of Supply?

4. Write short notes on : (a) Methods of measurement of elasticity of supply(b) Diseconomies of large scale production (c) Opportunity Cost and Actual Costs(d) Explicit & Implicit Cost (e) Past and Present Cost (f) Fixed and Variable Costs(g) Avoidable and Unavoidable Costs (h) Incremental & Sunk Cost (i) Increase anddecrease in quantity supplied and increase and decrease in supply. (j) Determinants ofcost of production (k) Short run cost curves.

5. Explain with illustration the Laws of Returns to Scale.


NOTES

Pricing and Output Determination in Different Markets 185

Chapter 6

PRICING AND OUTPUT DETERMINATIONIN DIFFERENT MARKETS

Preview

Introduction, Meaning of Market, Traditional view, Modern View, Classification of Marketsbased on the Notion of Competition, Pure and Perfect Competition, Determination of Priceand output under perfect Competition, Price in Short run and long rung, Equilibrium of Firmand Industry Under Perfect Competition, Imperfect Competition, - Monopoly, Distinction betweenperfect competition and Monopoly, Determination of Price and Output (Equilibrium UnderMonopoly); Monopolistic Competition (Features), Determination of Price and Output underMonopolistic Competition, Oligopoly and Duopoly (Features), Pricing Methods / PricingPractices, Introduction to Cost Pricing.

INTRODUCTION

Demand and Supply are the powerful forces operating in any market. They act and react uponeach other and determine the price of a product. In the previous chapters, we have alreadystudied the nature of Demand and Supply. In this chapter we propose to study the marketwhere these forces are constantly at work. An attempt is, therefore, made in the following fewparagraphs to define the term 'market' and explain the nature of competition.

1) What is 'Market'?

In the traditional sense, market is a place where buyers and sellers meet each other to effecta business transaction. It is a place, a street or a building where a number of shops dealing ina particular commodity are located. Several examples of market in Pune can be given forexmple Mahatma Phule Market is a retail market in vegetables whereas, Gultekdi MarketYard is a wholesale market in vegetables. In Mumbai, Zaveri Bazar is the market for gold andsilver ornaments. The diamond market in Mumbai is located in two sky-scrapers at OperaHouse viz.- Pancha - Ratna and Prasad Chambers. Wholesale textile business in Mumbai isconcentrated in Swadeshi Market, Mulji Jetha Market and Mangaldas Market. Similarly, mostof the Indian and foreign banks are concentrated near Horniman Circle and Nariman Point inMumbai. These areas, therefore, constitute the Mumbai Money Market. Dalal Street in Mumbaiis 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 fora particular commodity is concentrated in a particular building or a street in a city.

2) National Markets

Like a particular street in a city, the entire city may sometimes specialize in the production ofa particular commodity. In course of time, the city acquires the status of a national market.Thus, Ahmedabad has specialized in the manufacture of textiles, Banaras in silk, Kashmir inshawls and Faridabad in bangle-making industry. Similarly, Coimbatore in South India hasdeveloped a big market in spinning. The market for leather goods is concentrated in Kanpur,and Kolkata whereas hosiery market is centered in Ludhiana. Recently, Surat has specializedin diamond polishing.

3) Modern View

Above examples would indicate how various markets are developed at various places in acountry. 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 adifferent sense. According to Jevons, an eminent English economist, it is not necessary forthe sellers to exhibit their products at a particular place or a building. The goods may bestored in a warehouse, and the buyers and sellers may be away form each other by thousandsof miles still, they may be able to talk to each other over telephone or through the post-officeand finalize the transaction of sale or purchase. The same view has been expressed byCournot, the renowned French economist. According to him, the buyers and sellers may beaway form each other; but they may be able to establish contacts through communication, soas to finalize the transactions. If they are able to speak with each other, prices in differentparts of a country, would tend to equality easily and quickly.

Thus, according to the modern view,

(a) It is not necessary that market for a commodity should always be located on a particularstreet or in a building.

(b) The buyers and sellers may be away form each other and yet they may constitute amarket over telephone or through internet.

(c) When buyers and sellers are in close contact with each other, prices prevailing in differentparts 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.


4. Classification of Market based on the Nature of Competition :

MARKET

Perfect Competition Imperfect Competition

Pure Perfect

Monopoly Duopoly Oligopoly Monopolistic MonopsonyCompetition

Competition in the market can be either perfect or imperfect. The Classical economists assumedthe existence of perfect competition, and all their analysis is based on this assumption. Thedream of the Classical economists is, however, hardly realized in practice. It has been pointed outthat the real world is full of imperfect competition. In particular, Mrs. Joan Robinson of the CambridgeUniversity and Prof. Edward Chamberlin of Harward University have done a pioneering analysis ofimperfect 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 theorybetween pure competition and perfect competition. The concept of perfect competition ismuch broader in scope than pure competition. It includes all the features of pure competitionplus some more features of the two forms; let us discuss first the features of pure competition.

a) Large Number of Buyers & 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 sellercannot, 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 orreduces 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 supplyin the market. Naturally, it is beyond the capacity of an individual seller or a buyerto determine or influence the price. Every seller and a buyer under pure competitionis a Price-Taker and not a Price-Maker.

b) 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 standardizedis sold by the sellers. For example, rice produced in different parts of India isclassified under different standard grades such as Resham Basamati, Kamod,


Kali, Much, Ambemohor etc. Since every buyer is buying the standard variety, hedoes not bother to know as to which particular farmer has grown that rice. He isinterested in ensuring that all the rice in the bag is homogeneous, i.e. exactly alikein quality.

c) Free Entry & Free Exit of Firms

Another important feature of pure competition is that there is free entry and exit offirms. An entrepreneur who has the necessary capital and skill can start anybusiness of his choice. In every industry, new firms are, therefore, opened fromtime to time. Similarly, an existing producer is free to close down his business if heso chooses. As a result, some firms are going out of the industry. Since there areno hindrances to the entry of new firms and exist of existing firms, the number oftotal firms under pure competition always remains very large.

(C) Perfect Competition : It has been already remarked that the concept of perfectcompetition is broader than pure competition. This means that perfect competition doesexhibit 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, perfectcompetition exhibits the following features.

a) Perfect Knowledge

All the buyers and sellers operating under perfect competition have perfect knowledgeof the market conditions. For example, every seller knows the total quantity suppliedand sold on a particular day or during a week. Similarly, every buyer knows what ishappening in the other corner of the market.

b) No Discrimination

Under perfect competition, no seller should discriminate between buyers. He cannotsay that he would sell his product only to white and handsome people; and not tothe black and ugly people. The seller must deliver the goods so long as everybuyer, visiting his shop, is willing to pay the required price. Similarly, no buyerwould discriminate between sellers. He cannot say that he would buy only from aparticular seller and that he would not buy from others. A buyer has no reason todiscriminate between sellers so long as every seller is charging the same price.

c) No Cost of Transportation

Under perfect competition, it is assumed that the cost of transportation does notexist for carrying goods from one place to another.

d) Mobility of Factors of Production

Various factors of production are assumed to be perfectly mobile from one place toanother and from one occupation to another. For example, a worker would migrate


from industry can be diverted to another industry if the return on investment is goingto be higher. It is assumed that all the factors of production are perfectly mobile andthat there are no hindrances to their movement. Mobility of factors of production isguided under perfect competition, by self-interest and profit-motive, the principle sonicely elaborated by Adam Smith in his Book, 'Wealth of Nations'.

e) Automatic Price Mechanism

The most significant feature of perfect competition is the existence of an automaticprice mechanism. Price of a product is determined by the interaction of total demandand total supply in the market. Since there are many sellers and many buyers, noindividual seller or a buyer can fix or influence the price. The forces of demand andsupply are very powerful and always remain outside the control of an individualseller or a buyer. Price mechanism is not only automatic but is delicate.

(D) Demand Curve under Perfect Competition : Under perfect competition, the number offirms in the industry is very large. Each firm is very small in size. A single firm action doesnot 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.

In the fig DM DM is the market demand curve and SM SM is the market supply curve,EM is the point of market equilibrium where market demand and a market supply areequal to OQM. This gives the equilibrium price in the market (OPM). This price is acceptedby every firm. (OP0) under perfect competition. Thus the demand curve of the firm isperfectly elastic under perfect competition.

(A) Determination of Price And Output Under Perfect Competition :

INTRODUCTION

Perfect Competition is said to exist when the number of buyers and sellers operating in themarket is very large. Then buyers and sellers have perfect knowledge of the conditions prevailingin different parts of the market. All the sellers are selling homogeneous products which areexactly alike in quality. Moreover, no seller would discriminate between buyers and no buyer

MARKET FIRMDM SM

SM DM

EM OP0

QM

PM

Price(Per Unit)

Output (Units)

AR

Quantity Demanded/SuppliedX X

Perfectly ElasticDemand Curve

Price (AR)

O O


would discriminate between sellers. That is to say, a seller has no reason to refuse to sell toa particular buyer who is willing to pay the required price. Similarly, no buyer would hesitate tobuy form a particular seller who is charging the same price. Under perfect competition, nobuyer or seller can fix the price of a product, nor can he influence it by his own action. Priceis determined by the interaction of demand and supply. Demand and Supply are powerfulforces which constitute the essence of price-mechanism under perfect competition. The pricemechanism determines the price and output of various products.

It is, therefore, worthwhile to explain the working of the price mechanism under perfectcompetition.

General Rule Of Price Determination :

Under Perfect Competition, generally, demand and supply play an equally important role indetermining the price. They act and react upon each other and determine the price at the equilibriumpoint. This is called Equilibrium Price. Determination of equilibrium price can be explained with thehelp of the following demand and supply schedule and demand and supply curves.

Demand for & Supply of Textiles

Price Quantity Demanded Quantity Supplied(Rs. Per metre) (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.

Equilibrium Price

Quantity Demanded/Supplied

Pri

ce p

er u

nit

Y

X

P

SD

E

SD

MO


In the figure quantity demanded and sold is shown on the X- axis and the price is shown on theY- axis. DD is the demand curve showing total demand at different prices, and SS is thesupply curve representing the quantity supplied at different prices. The demand curve and thesupply curve balance each other at point E. This point is called on Equilibrium point. Underperfect competition, the equilibrium price would, therefore, be Rs.230/- per metre and at thisprice quantity OM would be sold in the market.

Changes in Equilibrium Price :

The equilibrium price, determined by the interaction of demand and supply need not remainconstant. It can change with every change in the relative positions of demand supply. Forexample, if some festival is forthcoming, demand for a product would increase. The supplybeing constant, price would rise. Similarly, during a slack season, demand may fall, butsupply being constant, price would fall, Changes in supply would also influence the equilibriumprice. For example, in a particular year, the cotton crop may be affected on account of naturalcalamities. Supply of cotton in this case is reduced; but demand being constant, price ofcotton textiles would rise. There is a third possibility; demand and supply may both changesimultaneously. In all the three cases, the equilibrium price would change. It is worthwhile tosee how changes in demand, changes in supply and changes in both, affect the equilibriumprice.

(A) Changes in Demand

Changes in Demand

In figure changes in demand are shown by different demand curves DD and D1D1. Thesupply is shown by the supply curve SS. Demand for a product may increase on accountof a festival, growth of population or on account of some other factor. In figure originalequilibrium price is shown at point E i.e. OP. But on account of a higher demand curve


Pri

ce P

er U

nit

X

YD1

D1

F

M1

E

M

D S

D

O

S

P1

P


D1D1 a different picture would emerge. The new demand curve D11 intersects the supplycurve at point F. The new price would, therefore, be OP1. Thus it is clear that supply beingconstant, every increase in demand would lead to a rise in the equilibrium price.

D ↑ E.

(B) Changes in Supply

Similarly, demand being constant, every change in supply would change the price. Thisis clear form the following figure.

Changes in Supply

In figure, the quantity is shown on the X-axis and the price is shown on the Y- axis. DDis the demand curve and SS is the original supply curve. These curves balance eachother 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 curveS1S1 intersects the demand curve at a new equilibrium point E1. OP1 would, therefore, bethe new price. This means that the total supply has diminished from OM to OM1; and atthe same time, price has risen from OP to OP1.

(C) Changes in Demand and Supply

The third possibility is that demand and supply both may change simultaneously. Onaccount of these changes, a new equilibrium price would be established. This would beclear form the following figure.

Pri

ce P

er U

nit


X

Y

O

S1

S

S1

S

D

D

MM1

PP1

EE 1


Changes in Demand and Supply

In figure, DD is the original demand curve and SS is the original supply curve. Theybalance each other at point E. The equilibrium price is, therefore, OP. Now D1D1 is thenew demand curve which shows a higher demand, and S1S1 is the new supply curve.The new equilibrium price would, therefore, be OP1.

Laws of Demand, Supply & Price :

From the foregoing discussion the following laws of demand, supply and price can bestated :

(d) Under perfect competition, price of a product is determined by the interaction of totaldemand and total supply in the market. This is called 'Equilibrium Price.'

(e) If demand increases, supply being constant, the price would rise. If demand falls, supplybeing constant, price would fall.

(f) If supply is reduced, demand being constant, price would rise and if supply increases,demand being constant, the price would fall.

(g) If a change occurs in demand and supply simultaneously, a new equilibrium price isestablished.

Price in the Short Run and Long Run :

The above laws of demand, supply and price, however, constitute the general framework of pricedetermination. As Marshall has elegantly pointed out, time element plays an important role indetermination of price. Marshall has classified the period of time under four heads; but for thesake of simplicity we can reduce this classification of period only under three heads viz.

Pri

ce P

er U

nit


X

Y

O

SS1

S1

S

D1

D1

D

D

M M1

PP1

EE 1


In figure, SS is the supply curve representing perfectly inelastic or a fixed supply in themarket period.

Since supply cannot be increased or decreased in a very short period, the supply curveis vertical to the X-axis. Demand is shown by different demand curves, i.e. DD, D1D1 andD2D2. Accordingly, OP would be the price if demand is shown by the curve DD. If on thenext day, only a few customers come, demand would be shown by D1D1 and the pricewould fall to OP1. If on some other day, demand is higher it would be shown by D2D2 andthe price would rise to OP2. Thus, price in the market period is determined from thedemand side, and supply plays a passive role.

(i) Market Period (ii) Short Run, and (iii) Long Run.

It is worthwhile to see how price is determined in the market, in market period, Short periodand the Long run or period.

(i) Market Period :

According to Marshall, market period relates to few hours or few days. Perishablegoods such as fish, eggs, leafy vegetables etc. are sold in this market. The supply ofthese goods on any particular day is fixed. It cannot be increased or decreased withinthe market period. At the same time, such goods being perishable, their supply cannotbe 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 bedetermined according to the total demand in the market. If on a particular day, morecustomers come to buy, the supply would be less and the supply being constant, pricewould rise. Thus, in the short run, determination of price in the market period is shown inthe following figure :

Price in Market Period

Pri

ce P

er U

nit


X

Y

O

P2

P

P1

D 2

D 2

DD1

DD1

S

S


In figure, the supply curve is positively sloping, the equilibrium price is OP at whichquantity supplied equantity demanded equals OQ.

(iii) Long - Run :

In the Long - run, supply of goods can be adjusted to the demand, Dr. Marshall has takenan example of durable goods, which are sold in the long run. Durable goods such aswheat, rice, oil, textiles etc. can be stored for some time. Their supply can be increasedor reduced according to the demand. Since the supply is adjustable, supply curve ishorizontal to the X-axis. The sellers of durable goods are unwilling to sell unless theyrecover a minimum price. This price is based on the cost of production. Producers ofdurable goods would not, therefore, sell unless the cost of production is recovered. If theprice is less, they would hold back the supply from the market. On the other hand, if theyare getting the minimum expected price which covers the cost of production, they wouldbe prepared to sell more. i.e., they would increase the supply at the same price.Determination of price in the long run is shown in the following diagram :

(ii) 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 bothsupply as well as demand.

Pri

ce P

er U

nit


Y

DS

DS

QX

O

P


Long Run Normal Price

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 onthe cost of production. If less people come, a small quantity would be supplied and ifmore people come, a larger quantity would be sold at the same price.

It will be seen that in the long run, supply plays a dominant role and demand is passivein determining the price.

Conclusion :

Under perfect competition, price is determined by the interaction of total demandand total supply in the market. The price which is so determined is called theEquilibrium Price.

The equilibrium price may change on account of changes in the relative positions ofdemand and supply. The most significant point to be emphasized here is that the timeelement plays an important role in determination of price in the short and long run. In theshort run demand is active, whereas in the long run supply is active in determining theprice. By introducing the importance of time element, Dr. Marshall has made a significantcontribution to the theory of value.

(B) Equilibrium of Firm And Industry Under Perfect Competition

INTRODUCTION

In the previous sub-unit, we have studied how price of a product is determined by the interactionof demand and supply. We have also seen the important role played by the time element inthe theory of value. We have thus studied the rules of price determination under perfect

Pri

ce P

er U

nit


Y

O

P S

X

DD1

D11

D1D11

D


competition. However, we have not yet studied how a firm or an industry would maximize itsprofits. An attempt is, therefore, made in this chapter to explain how equilibrium position of afirm or an industry is reached under perfect competition.

Firm And Industry :

Before explaining the equilibrium of a firm or an industry it is necessary to revise the distinctionbetween a firm and an industry. Any business unit organized under one ownership andmanagement is called a firm. The firm may be organized as a sole proprietorship, partnershipor a joint stock company. The form of organization can be anything. It is necessary that thebusiness should be owned and managed by one management.

An industry is a group of firms dealing in the same line of business. The ownership andmanagement of each firm may be different; but since all such firms are engaged in the productionof the same commodity, they are collectively called an industry. Thus Swadeshi Mills inMumabi is a firm dealing in textiles. Similarly, Shriram Mills is another firm and Kohinoor Millsis still another firm dealing in textiles. But when we take into account all the textile firms inIndia we describe them collectively as the cotton textile industry of India.

Concept of Equilibrium :

The term equilibrium is frequently used in economic theory. Thus, there is an equilibrium of aconsumer, an equilibrium of a firm or an equilibrium of an industry. Since the concept occupiesa central position in the theory of value it is necessary to know the meaning of the termequilibrium.

A consumer who spends his income on various goods may derive satisfaction from theconsumption of those goods. When consumer maximizes his satisfaction he is said to be inequilibrium. 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. Accordingly, the firm tries to reach thestage of maximum profit by adjusting its output.

In the initial stages, when production is on a small scale, the margin of profit is small. Butwhen the scale of production is increased the average cost goes on diminishing and themargin of profit goes on increasing. After some time, the disadvantages of large-scale productionbegin to operate. As a result, the difference between the selling price and the cost goes ondiminishing. Even though the margin of profit is reduced, there is still some addition to thetotal profits. It is, therefore, worthwhile to carry on production for some more time. Finally, apoint is reached when cost of production exceeds the selling price. From this point, lossesbegin to occur. Every firm would, therefore, stop to produce. At this point, the total profit ismaximum and the firm is said to be in equilibrium. Like a firm, an industry can also achieve itsequilibrium when all the firms in the industry are in equilibrium.


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 ouranalysis is based :

(i) It is presumed that a firm is managed as a sole proprietary concern. This would enableus to study the behaviour of an individual.

(ii) Every individual proprietor aims at profit maximization and he exhibits rational economicbehavior.

(iii) It is also assumed that the firm is producing only one commodity. It is possible toconsider a firm producing more commodities, but in that case, our analysis would becomemore complicated. For the sake of simplicity we, therefore, assume that the firm isproducing only one commodity.

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, theaddition made to the total cost on account of production of one more unit of output iscalled the Marginal Cost (MC). Similarly, the revenue received from the sale of a givenoutput is called Total Revenue (TR) and the addition made to the total revenue on accountof 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 theequilibrium point.

Firm's equilibrium, arrived at by this method is shown in the following diagram :

Equilibrium of a FirmMR = MC

Co

st/R

even

ue

Output

X

Y

O

MC

AC

AR

MR

E

M NL

D

Q

K

S

H

G

T

R


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 isproduced, MC and MR curves balance each other at point E. At this point the firm'sprofits are maximum and the firm is in equilibrium. If smaller output is produced than OMthe marginal cost is smaller than marginal revenue, which means that addition to thecost is less than addition to the revenue by producing more output. This means thatthere is scope to earn more profits be increasing output. Output will, therefore, be increasedfrom 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'sprofit will begin to fall, because more is added to cost than to revenue by increasingoutput. For example, if ON output is produced, KN is the average cost and SN is theaverage 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 maximum.

Equilibrium of Firm under Perfect Competition :

The conditions equilibrium of a firm are applicable to all the types of markets. i.e.they are applicable to perfect competition, monopoly, monopolistic competition etc. Theseconditions are i) MR = MC and ii) MC Curve must cut MR curve from below. Anattempt is made below to examine the equilibrium of a firm under perfect competition.

Equilibrium under Perfect Competition

Under perfect competition, no firm can fix the price or influence it by its own action. Priceis determined by the interaction of total demand and total supply in the market. Underthese circumstances the firm has to satisfy both the conditions to achieve its equilibrium,viz.,

Output (units)

Co

st /

Rev

enu

e

X


(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 figure, the curve PL shows marginal revenue as well as average revenue. The curve MCshows the marginal cost. When price is OP, marginal cost curve cuts the marginalrevenue curve from below, at point R. Therefore, the firm will be in equilibrium when itsoutput is OM and the price is OP.

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 andlong-run. In particular, we would like to see how a firm achieves its equilibrium in thefollowing circumstances :

(i) When the firm earns supernormal profits.

(ii) When the firm earns only normal profits.

(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 - MC is the marginal costcurve which intersects the average revenue curve at point Q from below. Therefore, atpoint Q the firm is in equilibrium and OM' is the ideal output. Here average cost is M'Gand profit is equal to GQ. This firm is earning supernormal profit equal to P1QGH. Sinceall the firms in the industry are working more or less under the same cost conditions, allof them would be in equilibrium. The fact that the existing firms are earning super-normalprofits may attract new producers to the industry. But in the short-run it will not bepossible for them to start new firms.


(ii) Normal Profit :

In figure, OP is the price and PL is the average and marginal revenue curve. Here, thefirm is in equilibrium at point R and the ideal output is OM. This form is earning only thenormal 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, boththe 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 thismarginal 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 isless than the average cost of EM2. Thus the firm is incurring a loss P2SEF. If the firmdesires to continue to produce, it must incur this minimum loss. It is obvious that greaterproduction would mean a grater loss. Since all the firms under perfect competition areworking more or less under the same cost conditions, all the firms would have to incurlosses; 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 productionand cannot avoid losses. This is because, every firm has to incur some fixed costs onaccount 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 rawmaterials, wages and power. Thus, if a firm decided to close down production it can savevariable costs; but it cannot save fixed costs. Every firm, therefore, decides to continueto produce so long as it is able to recover its variable costs. In other, words, a firm wouldproduce more even if it incurs a loss equal to the fixed costs. Here, every firm takes anoptimist view that "half a glass of water is better than nothing".

Short-Run Equilibrium of a Firm

Output (units)

Pri

ce C

ost

/ R

even

ue

Q

E

M2 M1O M X

L2 (AR) = MR

L (AR) = MR

L1 (AR) = MR

ACMCY

P1

FH

P

P2

S

R G


If the price falls further and is less than the average variable cost, the firm cannot affordto carry on its production. Because, 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 averagevariable cost. The firm will, therefore, have to stop its production at point D, price OP3and output OM2.

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 implement new techniques of production. Inthe 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 alsoapplicable 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 beequal. Thus, under perfect competition in the long-run a firm is in full equilibrium when

MR = MC = AC = AR = Price

If the price is more than the average cost, the firm may earn supernormal profits and thiswould attract new firms to the industry. Entry of new firms would result in a greaterproduction, and a reduction in supernormal profit. In the long run, all firms would, therefore,

(iv) Closing - down Production :

Closing - down Production

Output (units)

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/ R

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Equilibrium of Industry

When all the firms engaged in an industry are in equilibrium, the industry as a whole isin equilibrium. This means that equilibrium is established by total supply and total demandin the industry.

If demand is more than the supply, production may be increased, Conversely, if demandis less than the supply, output may be curtailed. Such changes in the output can nottake place when the industry is in equilibrium. Equilibrium of the industry is determinedby total demand and total supply. The price is also fixed by total demand and totalsupply of the industry; and not by any single firm. It is, therefore, necessary that, forequilibrium of the industry size of production should be stabilized at a certain point.There should be no tendency for firms to increase or curtail their output. When ideal sizeof output is achieved, there is no temptation for new firms to enter the industry and thereshould be no reason for existing firms to go out of the industry. Thus, when output isstabilized at the optimum point, marginal cost will be equal to marginal revenue and thefirm would earn only normal profit. All the firms would earn normal profits. If they earnsuper-normal profits or incur losses, it would lead to an entry or exit of firms; ultimately,equilibrium of the industry would be disturbed.

earn only the normal profit. Similarly, if the price is less than the average cost, losseswould occur and this may drive some of the firms out of the industry. The firm's equilibriumunder 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)

Pri

ce C

ost

/ R

even

ue

Y

P

MX

AR = MR = Price


Conclusion

It will be seen form the foregoing discussion that a firm maximizes its profit and achieves anequilibrium position when its marginal cost, is equal to marginal revenue. When all the firms inan industry are in equilibrium, the industry as a whole is also in equilibrium. In the long-runequilibrium of an industry, output is stabilized at an optimum or ideal size and there is no entryor exit of firms; because in the long run every firm is earning only the normal profit.

(B) Imperfect Competition :

In the real world, perfect competition is seldom realized. What we experience is the imperfectcompetition in its several forms. In the 20th century, markets all over the world have becomeimperfect on account of several factors. Buyers and sellers do not possess perfect knowledgeand the products sold are no more homogeneous. They are often differentiated as to theirsize, design and colour. The number of buyers and sellers is also small. Depending on thenumber of sellers operating in the market, imperfect competition is further classified under thefollowing heads : 1) Monopoly 2) Monopolistic Competition 3) Monopsony 4) Oligopoly5) Duopoly

1) 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 isonly 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 industrydoes 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 themarket. The producer may be an individual, a partnership firm, the Governmentor a Joint-stock Company.

(ii) No Close Substituties : To avoid any possibility of competition in the market,there should be no close substitutes for the product of the monopolist. Thismeans that the cross-elasticity of demand for the monopolists product is low.


The Demand Curve Under Monopoly

Under monopoly, there is only one seller who controls the entire supply in the market.Since there is the only producer and a seller he can fix the price of his product. In orderto maximize his profit, he may raise the price frequently. He may exploit the consumersby charging an exorbitant price. Since there are no sellers, the buyers have no alternativethan 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 gasand electricity and such other public utilities are usually managed as monopolies. Suchmonopolies are called Natural Monopolies. On the other hand, if a producer acquiresmonopoly on the basis of Patent Laws, it is a case of an Artificial Monopoly.

(d) 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 individualseller or buyer is able to fix or change the market price. The price under perfectcompetition is fixed by the interaction of total demand and total supply in the market.It is beyond the scope of an individual seller to influence the price by his ownaction. On the other hand, under monopoly there is only one seller who is free to fixthe price, or change it, whenever he likes.

(iii) Barriers to entry of firms : The basis of monopoly is the barriers or restrictionsof new firms into the market; these can either be natural barriers or artificialbarriers.

(iv) Demand Curve under Monopoly : the above features explain the demandcurve or the average revenue (AR) curve under monopoly. The demand curvefor a firm (which means the industry under monopoly) is downward sloping. Itis the monopolist who is the price-maker in the market.

AR

/Pri

ce

Y

XOUnits of output

AR/Demand Curve


(b) Under perfect competition there are many firms in an industry; and all of them areselling homogeneous products; but under monopoly the distinction between firmand industry receeds in the background. Since there is only one seller, firm andindustry is the same under monopoly.

(c) Under perfect competition there is free entry and free exit of firms. There are nohindrances to the new producers who desire to enter the industry. But undermonopoly entry of new firms is prohibited. For example, in India no new firm can bestarted to deal in railways; because the monopoly of railways has been entrustedto the Indian Railways.

(d) Under perfect competition every seller is charging the same price in the long runand is making normal profits. If a particular firm charges a slightly higher price thecustomers would turn to other sellers. But under monopoly, there is only one seller,and he can raise the price any time; and the customers have no other alternativethan to buy from the same monopolist. Under perfect competition a firm attains itsequilibrium when marginal cost is equal to average cost, marginal revenue, averagerevenue 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 canearn supernormal profits in the long run. Under perfect competition, however, a firm canearn only the Normal profits in the long run. If it earns supernormal profits, there will beentry of new firms and this profit would be shared by all the firms. Ultimately, the firmwould earn only the normal profit. Under monopoly, the entry of new firms being prohibited,the monopolist can earn supernormal profit in the long run.

(f) Since there many firms operating under perfect competition, total output in thesociety is larger and the price charged is also reasonable. But under monopoly,total output is smaller and the price charged is unreasonable.

(e) Determination of Price and output (Equilibrium Under Monopoly) :

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 undermonopoly, and so the MR curve is below the AR curve

The conditions of equilibrium are the same as under perfect competition, i.e.


Short - run

A monopolist can make either normal profits or supernormal profits in the short-run. Amonopolist making sub-normal profits will remain in production in the short-run so longas its AVC is covered.

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 theequilibrium price.

AC = A1Q1 AR = A1Q1

MR = MC and MC curve cuts MR curve from below.

Output (units)X

Y

O

AR

MR

Output (units)

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/ R

even

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O

P1

Y Normal Profits

MC

A1

AC

AR

MR

Q1

E1

X

MRAR


In the above figure, E2 is the point of equilibrium, OQ2 is the equilibrium output, OP2 isthe 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

AC = AR, the firm makes normal Profits.

Super-Normal Profits

Output (units)

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/ R

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Pri

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/ R

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A2


In the figure, E3 is the point of equilibrium, OQ3 is the equilibrium output, OP3 is theequilibrium price.

AC = A3Q3

AR = R3Q3, AVC = R3Q3

AR < AC, the firm makes sub-normal profits equal to C3A3R3P3. Even though the firmmakes losses, it continues to produce in the short-run because AVC are covered.

Long - run equilibrium under Monopoly

A firm under monopoly may make normal profits in the long-run; however, it tries to makesuper-normal (abnormal) profits in the long-run. The LRAC is flatter than the short-runaverage 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.

A Fig showing Long Run Equilibrium under Monopoly

(f) Price Discrimination Under Monopoly :

INTRODUCTION

By following Trial and Error method, a monopolist fixes the price of his product so as tomaximize his profit. There is a second alternative open to the monopolist. He can discriminatebetween buyers and charge different prices to different customers. This is called PriceDiscrimination or Discriminating Monopoly. An attempt should, therefore, be made to explainhow price discrimination is practiced by the monopolist.

Pri

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/ R

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Output (units)

RoPo

P

Qo

LRMC

LRAC

O

Y

MR

AR

MC

Eo

Co


(1) What is Price Discrimination?

Instead of charging a uniform price to all the consumers a monopolist may divide themarket into different classes of people. One market segment may consist of poor, whereasanother market segment may be inhabited by the rich. The monopolist may charge alower price to the poor and middle class people whereas he may charge a higher price tothe rich customers. Charging different prices to different customers for the same productis called Price Discrimination.

Examples of price discrimination are many. A surgeon may charge Rs. 5000/- for operatinga middle class patient, whereas he may charge Rs. 10000/- for the similar operation of arich patient. The skill used in both the operations is the same; but the fees charged todifferent patients are different. Similarly, different prices are charged by a cinema housefor different classes of viewers. All the viewers see the same movie; but they have to paya higher price for occupying a seat in the first class or balcony. Railway companies alsocharge 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 atthe same time. But they have to pay different fares for traveling by II class, I class or ACclass. Similarly, an electricity company can charge lower rates for domestic consumptionand higher rates for commercial consumption.

Although there is some difference in the comforts provided to different classes ofcustomers, this difference is negligible. Difference in the prices charged is, however,substantial. Thus, a monopolist can charge different prices to different segments ofmarkets so as to maximize his profit.

(2) When is Price Discrimination Possible?

Charging different prices to different customers is rendered possible in the followingcircumstances :

(a) Legal Sanction :

Public utilities such as railway or electric supply companies, cooking gas supplycompanies are allowed under Law to charge different prices to different classes ofconsumers.

(b) Nature of Commodity :

Price discrimination is possible where personal service sold to the customers cannotbe resold. Thus a surgeon may charge a lower fee for operation of a poor patientthan a rich patient for similar operation. Similarly, an advocate may charge veryhigh fees to a rich client, whereas he may charge a lower fee to a poor client for asimilar court litigation.

(c) Geographical Barriers :

If two markets are separated from each other on account of geographical barriers itmay enable a monopolist to charge different prices in two different markets. In


international trade, markets are separated by raising the protection wall and differentcustom 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 alower price is charged in another market. Ignorance of consumers thus enables themonopolist to charge different prices. Sometimes, the consumers may exhibit anirrational feeling that they are paying a higher price for better quality of goods. It islikely that the customers may know that a lower price for bertter quality of goods. Itis likely that the customers may know that a lower price is being charged in anothermarket; but the difference in price being negligible they may not go to the othermarket. This may enable the monopolist to charge different prices in different markets.

(3) 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 two markets in which the product is sold should be kept separate. i.e. Thereshould be no contact between buyers in the two markets. If buyers in one marketknow that the price charged in another market is lower, they would buy the productin another market and sell it in their own market. This will lead to equality of price inboth the markets and price discrimination would no more be possible. No possibilityof resale of the product.

(b) The elasticity of demand in different markets should be different. Price discriminationmay not be possible if elasticity of demand is the same in both the markets.

(c) Market must be imperfect.

(4) When is it Profitable?

Having known the conditions of price discrimination, it is worthwhile to know when it isprofitable to the monopolist. In other words, it is necessary to study the position ofequilibrium when the monopolist maximizes his profit. The principles which apply to theequilibrium of a firm are also applicable in this case. An additional assumption to bemade here is that the monopolist is selling his product in two different markets. Thiswould make our analysis complicated but it does not affect the basic principle ofequilibrium, viz. a firm is in equilibrium when its marginal cost is equal to marginalrevenue. One more assumption is that the elasticity of demand in two different marketsis different.

(5) 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 wouldbe profitable.

Let us presume that the monopolist sells his product in market A and market B. Demandin market A is inelastic or rigid and demand in market B is very elastic i.e. responsive tothe changes in price. Under such circumstances the monopolist would raise the price inmarket 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 pricewould increase the sales. The monopolist would, therefore, raise the price in market Aand would reduce it in market B. The volume of sales in market A would remain more orless the same, but sales in market B will increase, on account of reduction in the pricewould increase the sales. The monopolist would, therefore, raise the price in market A andwould reduce it in market B. The volume of sales in market A would remain more or lessthe same, but sales in market B will increase, on account of reduction in the price. Naturally,the monopolist would have to divert the supply form market A to market B. If sales inmarket A are slightly reduced on account of higher price, this loss would be compensatedby an increase in sales in market B. A pertinent question that arises here is that how longsupply would be transferred form market A to market B ? the answer to this question isthat the supply would be diverted so long as the marginal revenue earned in market B ishigher than the marginal revenue earned in market A. The transfer of supply from market Ato market B would be stopped when marginal revenue in both the markets is equal. At thispoint, total profit earned by the monopolist is maximum and he is in equilibrium.

(6) Equilibrium under Discriminating Monopoly

Consider two markets, market A with relatively inelastic demand and market B withrelatively 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 outputsold in market B and at price OP2.

Y

O X

P1

E1

Q1

AR1

MR1

Pri

ce /C

ost

/Rev

enu

e

Pri

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ost

/Rev

enu

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P2

AR2

MR2

E2

Q2

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/Rev

enu

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Q

MR

MC

EC

Y

OX

Y

O X

Market A Market B Total A+B (figure 3)Output Output Output


In Market A, E1 is the point at which MC = MR which is related to MR1. OQ1 is the outputsold 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 arelower than the sales in market B.

The total revenue to the firm, however, increases because of price-discrimination.

(7) Dumping

Where monopolist is charging a higher price in the home market and a lower price in theinternational market, it is called Dumping. In Dumping, the losses incurred in theinternational market are compensated in the home market. The weapon of dumping issuccessfully handled by the monopolist. In India, dumping is encouraged with a view topromoting the exports. The Indian exporters are selling their products abroad at lowerprices. The losses they incur in foreign markets are converted in the home market wherehigher price is charged. If the monopolist is unable to recover his losses he is given asubsidy or an Export Bounty, by the Government of India. The incentive of export bountieshas contributed to higher exports and earnings of foreign exchange.

(8) 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 notleave any consumer's surplus to the buyers. An example of this degree is providedby a surgeon or a barrister who charges the maximum fees.

(b) Under the second degree of price discrimination the monopolist does not chargedifferent prices to individual customers. Instead, he classifies the customers intocertain groups according to the level of their incomes. Thus, he may classify thecustomers into the rich, middle class and poor customers. He charges differentprices to different groups of people. The example of this type is provided by arailway company that charges different fares to II class, I class and Air-conditionedclass passengers. Under this degree, the lowest price which the poorest customerfrom every group can bear is charged. Therefore, it leaves some surplus to otherconsumers who are relatively better off than others in that group.

(c) Under the third degree, different prices are charged in different markets. The exampleis provided by dumping where a lower price is charged in the international marketand a higher price is charged in the home market.


(9) Conclusion

Thus a monopolist can practice price discrimination by charging different prices to differentcustomers. It is also practiced under dumping where different prices are charged ininternational 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.

2) Monopolistic Competition - Features

(i) Fairly Large Number of Firms

The number of sellers operating under this type of competition is larger than underoligopoly but less than under perfect competition. There may be 20-25 sellers engagedin the same line of business. They are producing commodities which are closesubstitutes for each other. Every seller has to compete with others to increase hissales. Since every seller is selling a standardized product for a long time, he acquiresmonopoly of that product. When such monopolistic producers are competingamongst themselves, it is called monopolistic competition. The competition beingvery keen, the sellers have to find out different methods to maintain their sales andprofit. Professor Chamberlin has elegantly shown the methods used by suchmonopolistic producers. Most of these methods are hazardous and each sellertries to be rich at the cost of others. This competition is, therefore, called cut-throatcompetition and the methods followed are called 'Beggar thy Neighbour tactics'. Itis worthwhile to outline the salient features and the methods of monopolisticcompetition.

(ii) Product Differentiation

Under monopolistic competition, every seller tries to distinguish his product fromthe products manufactured by others. He claims that his Research and DevelopmentDepartment has developed a new product after considerable research. As a matterof fact, the product so introduced in the market is not new. The same old product issold under a different trade name, style, design and colour. Thus, by changing theoutward appearance of the product, the general public is made to believe that it isa 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 bathingsoaps under different trade marks such as Lux and Rexona. Basic contents andingredients in both the soaps are the same. They different. Lux may be used byone popular actress, whereas Rexona may be used by another popular actress


from the films. Differences thus exist only in outward appearance, not in their contents.Such a method of product differentiation helps the producers under monopolisticcompetition to increase their total sales.

(iii) Selling Costs

Every producer operating under monopolistic competition spends huge amountson publicity. He follows all the media of advertising such as press, radio, television,hoarding, sites, neon signs etc. Every effort is made to keep the product before theeyes of the consumers, throughout the year. Whether he likes it or not, he has tospend huge amounts on publicity. This is because when others are spending, hecannot afford to lag behind in the race. Every producer therefore attempts to spendmore than his rivals.

(iv) Multiplicity of Prices

Due to factor-immobilities, or transport costs or ignorance of market, a single uniformprice cannot be established in the market characterised by monopolistic competition.On the contrary, similar products which are differentiated by brand names andadvertisements are sold at different prices. Every producer enjoys the freedom toprice his own product; this freedom is within certain limits. Every producer has hisown price-policy. Under perfect competition, this freedom is not available to anindividual firm.

(v) Elastic Demand

The Average Revenue Curve of a firm under monopolistic competition is not parallelto the X-axis as it is under condition of perfect competition. Because, the productsof all firms are not identical, buyers can have preferences. So it is not possible fora firm to sell an infinite amount of the product at the ruling price as it is assumed tohappen under perfect competition. Therefore, under monopolistic competition, theAverage Revenue Curve of a firm is not parallel to the X-axis as it is under perfectcompetition. Under monopoly, the Average Revenue Curve of the firm is steep becausethere are no close substitutes for the product. Under monopolistic competition, onthe other hand, a firm’s product does have close subsitutes, and therefore, theAverage Revenue Curve cannot be steep. Thus, the AR Curve faced by a firm undermonopolistic 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 a sizable increase in the sales of the firm.


(vi) Price War

Another method followed to extinguish the rivals from the market, is a reduction inthe selling price. In order to attract new customers, a particular producer mayreduce the price of his product. Naturally, other producers are required to reducetheir prices in order to retain their customers. Price reduction is sometimes carriedto 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 ScindiaSteam Navigation Company Limited was started by Seth Walchand Hirachand onthe 19th June 1919. He purchased a second-hand ship called S. S. Loyally andstarted the voyage. In course of time, the company made good progress, acquiredmore fleet and began to compete with the British Shipping Companies. In thesedays, shipping industry was controlled by the British and the British ship-ownersdid not like that an Indian company should come up to share the profits. In order toextinguish the Scindia Steam, the British shipowners reduced the freight charges.The Scindia too was required to reduce its freight. The reduction in freight rate wentto such an extent that the British shipowners began to advertise in the newspapersthat 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 theprice war; but the Scindia could manage in such critical times and could come upas 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 novelmethod of increasing the sales. Instead of reducing the price, they hand over smallgift articles to the buyers who buy the product. The gift scheme is operative only fora limited period and it is advertised in the newspapers on a large scale. This enablesa 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 particularcompany may hand over a tooth-brush free, to a buyer who buys the tooth-paste.Companies like Nescafe or Cadbury organize cross-word competitions. An essentialcondition for submitting an entry form in the crossword contest is that a certainnumber of used wrappers are to be attached to the entry form. Since many customersparticipate in the contest it results in an automatic increase in sales within a shorttime.


(viii) Unfair Methods

Under cut-throat competition, a number of unfair methods are used to extinguishthe 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 highquality products. On the basis of quality he can capture the whole marketwithin a short time. Other producers who cannot compete with him may,therefore, snatch away key persons from his factory, by paying them highersalaries. Thus, when the Chief Production engineer is snatched away thequality of goods is deteriorated and the firm loses its control on the market.The other producer, who has snatched away the engineer, may gain controlon 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 mayask him to arrange a strike. This would affect the production schedule of theprosperous company and at the same time, help the rivals to gain control overthe market.

(c) The rivals may try to lower the reputation of the prosperous producer. Theypass on false information to the government departments. They may makeseveral allegations that the prosperous producer is evading excise duty, salestax and income tax. Government departments may institute raids on theprosperous producer. This may lower his reputation and he might beextinguished form the market. Thus, the methods followed under cut-throatcompetition are hazardous, harmful and immoral.

Thus, the market form with characteristics noted above, contains elements ofboth monopoly as well as competition and therefore it is called monopolisticcompetition. Products like tooth paste, tooth brush, soaps, detergents,cigarettes, different brands of alcohol, different brands of body talcum powder,cosmetic etc. are produced under the conditions of monopolistic competition.

(1) Determination of Price and Output under Monopolistic Competition :

The foregoing account would indicate how monopolistic competition is characterizedby product differentiation, selling costs, price war and unfair methods. It is worthwhileto see how price of a product is determined under monopolistic competition.

Every producer operating under monopolistic competition is selling his productunder 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 hisprice. A producer who has introduced a new product in the market, would necessarilyfix the price which is lower than the price charged by his rivals. The price, fixed inthis manner, may not, however, remain constant. The producer may be required toreduce his price, if the competitors have reduced their respective prices. Althoughan individual producer, under monopolistic competition, is free to fix his price, hecannot fix it without taking into account the prices charged by rivals. The pricepolicy under monopolistic competition is thus dependent on the prices charged byother rival firms. It is, therefore, worthwhile to see how price is fixed and the equilibriumposition is reached under monopolistic competition in the short-run.

Short-run Equilibrium under Monopolistic Competition

Under monopolistic competition, equilibrium of a firm is arrived at in the same manner asunder other forms of competition. A firm's profit is maximum and the firm is in equilibriumwhen its marginal cost is equal to marginal revenue. This would be clear form the followingdiagram :

Short - Run EquilibriumUnder Monopolistic Competition : Profit

In figure, MR is the marginal revenue curve and AR is the average revenue curve. Similarly,AC is the average cost curve and MC is the marginal cost curve. Here, the price is OPand the total profit is TSPP'. The profit is shown by the shaded area. This profit issupernormal. An existing firm can also incur losses in the short- run. If the position ofdemand and cost is unfavorable, the firm may incur losses as shown below :


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-run a firm working undermonopolistic competition can earn supernormal profit as well as incur a loss or may earnnormal profits.

Long-run Equilibrium under Monopolistic Competition

The supernormal profit earned by a firm may not last long; because new firms may beattracted to the industry, and the excess profits would be shared between existing andnew firms. The supernormal profits earned in the short-run would, therefore, disappear inthe long-run. Another characteristic of long term equilibrium is that a number of substitutesare available in the market. The marginal revenue curve is, therefore, elastic. The followingfigure would show how the firm would earn normal profits under long-run equilibrium.

Long Run Equilibrium under Monopolistic Competition

Y

P

OX

M

MR

AR

AC

MC

E

T

Output

Co

st/P

rice

/Rev

enu

e

Losses under Monopolistic CompetitionY

P

P1

O

MRX

AR

ACMC

T

S

E

Output


In figure, AR is the average revenue curve and MR is the marginal revenue curve. Similarly,MC is marginal cost curve and AC is the average cost curve. The average cost curvetouches the average revenue curve at point T. At point E, MC = MR, OM is the idealoutput and OP is the price. At this price and output the firm's profit is maximum and it isin equilibrium.

(2) 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. Undermonopolistic competition the number of sellers is large and each seller is sellinghis product under a particular Trade name. These products are not homogeneous,but are differentiated from each other. It is therefore, difficult to analyse the conditionsof group equilibrium where different firms are selling different products. For the sakeof 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.

(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 thesefirms are earning supernormal profits in the short-run new firms may be attracted tothe industry. The new firms would charge a lower price so as to secure somecustomers. 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 thefirms would then earn only the normal profit as shown in figure. Thus, when all thefirms are earning normal profit, the long-run group equilibrium would be reached.This position is similar to the one prevailing under perfect competition. The onlydifference is that under perfect competition, output is very large, whereas undermonopolistic competition output is much less. Another point of distinction is thatunder perfect competition an inefficient firm is thrown out of the industry whereasunder monopolistic competition even an inefficient firm can survive.

(3) Comparison of Long-run Equilibrium under Perfect Competition and MonopolisticCompetition

Both under perfect competition and under monopolistic competition the firm makes normalprofits in the long-run. However, the price-output situation is different in the two cases.This is seen clearly in figure.


The description of the figure showing the comparison between Long run equilibrium underperfect 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 falling)equals marginal revenue) MRm (marginal revenue is below the

average revenue.)

2. Ep equilibrium where LRMC = MRp 2. Em equilibrium where LRMC = MRm

3. OQp equilibrium output. (also optimum 3. OQm equilibrium output (less thanoutput because LRMC is minimum at optimum output OQp)this output).

4. OQp > OQm Output under perfect 4. OQm < OQp Output under monopolisticcompetition is more than output under competition is less than under perfectmonopolistic competition. competition.

5. Full capacity used up because 5. Waste of capacity is equal to Qm Qp

equilibrium output is optimum output. because equilibrium output is less thanoptimum output. "Wastes ofcompetition."

6. Firm is in full - equilibrium 6. Firm not in full equilibrium.ARp = MRp = LRMC - LRAC

7. OPp equilibrium price is less than price 7. OPm equilibrium price is more than OPp

OPm under monopolistic competition. price under perfect competition.

8. Firm makes normal profits. 8. Firm makes normal profits.(ARp = AC - Ep Qp) at OQp output. (ARm = AC = E1Qm) at OQm output.

Output

RMC

Y

Pm

O

ARm

ARp = MRp

Em

MRm

Qm

E1Ep

Pp

Qp

RACC

ost

/Pri

ce/R

even

ue

X


We can the conclude, that, the long - run price is lower and output is higher under perfectcompetition as compared to under monopolistic competition.

3) Monopsony

Another type of imperfect competition is called Monopsony. Under Monopsony, thereare many sellers but only one buyer. The buyer is influential and determines the price ofthe product. He may exploit the sellers by offering a very low price. An example ofmonopsony in India is provided by the Cotton Corporation of India who purchases allcotton grown by the farmers. Since there is only one buyer the CCI can influence theprices of cotton. Monopsony is the opposite form of Monopoly.

4) Oligopoly and Duopoly :

Oligopoly is a type of imperfect market. A few firms exist in the industry. An extremecase of Oligopoly is Duopoly since Duopoly is an extension of an oligopoly market, it isnot necessary to discuss its features separately, where only two firms exist in the market.

The following are the features of Oligopoly :

(i) Small number of Producers : The small number of firm dominates the market ofthe commodity. Each firm has a large share of market supply, therefore, all firmsaction results in a reaction of other firms in the market. This means that firm underOligopoly are mutually dependent on each other. In Duopoly, the number of firms istwo. These firms are also dependent on each other.

(ii) Product may be homogenous 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 arefirms which differentiate amongst their products.

(iii) Restrictions to Entry : Under Duopoly and Oligopoly, there are restrictions to theentry of new firm into the industry. These restrictions are generally financial ortechnological in nature. However, entry is not impossible under Oligopoly / Duopolybut it is difficult.

(iv) Advertisement : If product differentiation exists, it becomes necessary to advertisethe firms product. This is done to convince the buyers about the superiority of theproduct over the products of rival firms. However, if the products are homogeneousadvertisement may take the form of informative advertisement.

(v) Price - Control : Firms under oligopoly / duopoly are mutually dependent. Thus allfirms actions results in the reaction by other firms.


If one firm reduces the price of its product, other firms will follow. The first firm willagain reduce its price, the other firms will again follow. This process can continuetill 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 startwith. 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 firmwill not increase its price.

The above explanation leads us to the conclusion, that prices tend to be sticky orrigid under oligopoly / duopoly.

(vi) Demand Curve under Oligopoly / Duopoly :

Demand Curve under Oligopoly

Since firms under Oligopoly - Duopoly are mutually dependent, there is a situation ofaction and reaction by firms. This explains that prices tend to be rigid at OP underOligopoly / 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 priceof 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 pricesand there would be a price war. The quantity demanded of the firms' product wouldincrease less than proportionately, the demanded curve (KD2) is therefore, relativelyinelastic.

Thus, the demand curve under Oligopoly, is a kinky demand curve. Price tends to berigid at the kink, K.

Y

O XQuantity Demanded

Pri

ce (

AR

) P K

D1

D2


More about Equilibrium under Oligopoly :

Oligopoly, as we have already noted, is a market structure in which a small number oflarge 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 firmalmost always provokes retaliation from other producers. This reaction can take manyforms. All the firms may come together to form a cartel or they may openly or tacitlyaccept the price leadership of the largest firm or firms may enter into non-price competitionor a situation of price rigidities may prevail. Producers of differentiated products in oligopolyare actually free to set their own prices. But experience shows that they try to maintainstatus quo. This is so because a price-cut initiated by any one firm can trigger off a chainof 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 thebasis 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 mostpopular one and hence we shall consider that one model only. This model provides anexplanation of price - rigidity, i.e. why price is not changed. The individual oligopolistsees the situation somewhat like this. If he raises the price his rivals would not followsuit and would do the same thing quickly. As a result, at a price higher than the customaryone, demand is seen to be highly elastic; while at a price lower than the ruling one, thedemand is seen to be highly inelastic. See figure given here. In this diagram, DD1 is thedemand curve which is more elastic in the portion DP1 and less elastic in the portionP

1D

1.

Figure showing Oligopoly Equilibrium: Kinked demand curve model

D

P1

D1

QR

Y

MC1

MCP

O X

MRMR

AR

,MR

,MC

Output

H


The equilibrium condition is the profit maximizing condition i.e. MR = MC. Note that theDD1 curve is the AR curve. The marginal revenue curve (MR) is discontinuous betweenpoints H and R. It is this gap HR that explains price-rigidity. According to the usual conditionMC = 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 the same equilibriumoutput 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. Somefirms may earn profits and other may earn only normal profits. Due to such differences inprofitability, cartels do not last long. At times, therefore, profits are pooled together andare then distributed. But this arrangement also cannot satisfy all.

Price Leadership is another possibility when there is one big or established firm, it setsthe price and others accept that price for adjusting their supplies. If the product ishomogeneous, one price may get fixed. If products are differentiated, a range a pricesmay move together. Thus, for example, cigarettes, bathing soaps, washing soaps, electricfans; etc. are produced in oligopolistic conditions, in India, and a particular grade of theproduct is priced between a certain price - range. A change in the price is usuallyeffected by the price - leader and others follow suit.

To conclude, therefore, we can say that oligopoly is more common but since it can takevarious forms, a single model cannot explain its price and output equilibrium. Non-pricecompetition makes things more complex. Rivals use advertising quality changes,competition. A determinate economic explanation as a guide to policy is therefore notpossible though broadly one can describe how output and pricing policies are determinedby the oligopolists.

Miscellaneous Issues in Monopolistic Competition :

Having discussed the determination of price and output under monopolistic competitionwe 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 thefirm 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 onecommodity 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 haveto make the consumers aware of their needs. This is done through selling costs.

Sales promotion includes not only taking 'orders' for their goods but also creatingdemand for their goods. Under conditions of perfect - competition, it is assumedthat the consumers have perfect knowledge about the market and thus the conceptof selling costs is not relevant under perfect competition. Selling costs is a featureof an imperfect market condition.

Selling costs include not only cost on advertisement (which forms a large part ofselling 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, isselling cost.

(ii) Selling - cost curve is U - shaped :

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 ASCcurve is a U-shaped curve.

Total Selling CostASC = –––––––––––––––

Quantity Sold

ASC decreases upto OS1 sales because of -

(i) Economies of specialization : As output and sales increase, a large amount isused for promoting sales and the firm can employ experts to increase its sales or

Sel

ling

Co

st

Y

O XS1

Quantity Sold


it can advertise through mass media. These methods of promoting sales areexpensive but the sales increase to an extent that the average selling cost (ASC)decreases.

(ii) Economies of repetition : As a firm advertising, initially it does not influence theminds of the consumers. But repeated advertising, slowly has an impact on theminds of the consumers and the sales increase. And ASC decreases.

ASC increases beyond OS1 sales because of -

(i) Difficulties in trying to influence the buyers' preferences : Once the weakconsumers are influenced, it is difficult to influence the more 'hardened' consumers(who are already using another brand of the product), and so the expenditure onsales increases but sales do not increase much. The ASC therefore, increases.

(ii) Counter - advertisement by competitors : Once a producer reaches a high levelof sales, his competitors are affected and they try to defend themselves by advertisingtheir 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 charge, have to bear large selling costs.

(3) Technology changes : Firms producing commodities, like machines, alsohave 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 theselling 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 quantitybeing demanded at every price. So, the original demand curve DD shifts to theright to D1D1.

(2) The demand curve becomes relatively inelastic (Steeper) : Selling Costsresult 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 thequantity demanded of the product, by the consumer. The demand becomesrelatively inelastic (Steeper). In the figure the original demand curve DD is lesssteeper (less inelastic) than the new demand curve D1D1.

The average cost curve of the firm, AC, moves upwards to AC1 because ofselling costs as shown in the following figure :

(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 possiblebecause through selling costs, the demand for the firm's product becomes relativelyinelastic, because consumer preferences become stronger.

(b) Non - Price Competition :

We have seen earlier that under monopolist competition the sellers reduce theirprices in order to attract new customers. The reduction in price may go to such anextent that it may become a price war. Since this type of competition is based onprice reduction, it is called ' price competition'.

Pri

ce p

er u

nit

Quantity Demanded

Y

XEffect of Selling Costs onthe Demand Curve of a firm

Ave

rag

e C

ost

Y

O XProduction


Price competition is, however harmful to all the sellers. Instead of competing byprice - reduction they, therefore, use some other methods. When they compete ongrounds other than the price, it is called 'Non-Price Competition'. Non-PriceCompetitions is usually practiced through advertising or gift articles.

It is true that spending large amounts on advertising or gift articles amounts tolosses. But this loss is preferable to the loss incurred on account of price-reduction.There is a vital difference between the two types of losses. In the first place, reductionin price is against the business ethics. On the other hand, nobody raises anyobjection if a producer spends too much amount on advertising. If the producersfind 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 onadvertising is fruitful its benefit is permanent. Similarly, the losses incurred on accountof price reduction are permanent. Most of the producers operating under cut-throatcompetition, therefore, prefer to spend more on advertising, rather than effecting areduction 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, theproducers under monopolistic competition spend on the following schemes of salespromotion.

(i) Gift Articles : To promote sales, a producer may hand over a gift article to thebuyers who purchases the product at the usual price. A customer who receivesthe article is permanently attracted to the product. For example, various breadsare manufactured and sold by companies like Hindustan, Bharat Bakery, ModernBakery, Kwality, Blue Diamond, etc. A few years ago a new bread was introducedby Bakeman Company. The Bakeman bread at once captured the marketbecause from the very beginning the company was giving stickers along withthe bread. Initially the stickers contained pictures of various models of cars.Thereafter, they contained the photographs of the actors and actresses in thepopular T.V. series viz. Mahabharat. The children, therefore, developed a hobbyof collecting these stickers. Since every Bakeman bread was accompanied bya free sticker, the sales of this bread have surpassed the sales of all otherbreads in the Indian market. Similarly, toothpaste manufacturers in India give afree toothbrush along with the toothpaste to the buyers.

(ii) Crossword Contests : Some producers organize crossword contests or paintingcontests for children. An essential condition is that the entry form to besubmitted in the contest, is to be accompanied by a certain number of usedwrappers companies like Nescafe or Cadbury organize such contests. The


companies which organize such contests also award prizes to the winners.For example, the winner of the first prize can visit Singapore or Honkong atthe cost of the Company. Thus, by giving free gift articles or by organizingcrossword contests, the producers are able to achieve a tremendous increasein 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 hugeamounts on advertising and publicity. Much of this expenditure is wastefulfrom the social point of view. It is argued that instead of spending so muchamount on publicity; producers can reduce the price. This would be beneficialto the consumers and the society at large.

(ii) Excess Capacity : Under imperfect competition, the installed capacity of everyfirm is large, but it is not fully utilized. Total output is, therefore, less than theoutput which is socially desirable. Since production capacity is not properlycapacity under perfect competition is fully utilized leading to full employmentof factors of production.

(iii) Unemployment : Idle capacity under monopolistic competition leads tounemployment. In particular, unemployment of workers leads to poverty andmisery in the society. If idle capacity is fully used, the problem of unemploymentcan be solved to some extent.

(iv) Cross Transport : Under monopolistic competition expenditure is incurred oncross transportation. Goods produced in Ahmedabad are sold in Chennai andgoods produced in Chenni are sold in Ahmedabad. If these goods are soldlocally, wasteful expenditure on cross transport could be avoided.

(v) Lack of Specialization : Under monopolistic competition there is little scopefor specialization or standardization. Product differentiation practiced underthis competition leads to wasteful expenditure. It is argued that instead ofproducing too many similar products, only a few standardized products maybe produced. This would ensure better allocation of resources and wouldpromote economic welfare of the society.

(vi) Inefficiency : Under perfect competition, an inefficient firm is thrown out of theindustry. But under monopolistic competition inefficient firms continue to survive.


Thus under imperfect competition, inefficiency is worshipped and efficiency isdispensed with.

PRICING METHODS OR PRICING PRACTICES

INTRODUCTION

As already discussed, firms pursue a variety of objectives with different weightages to differentobjectives. The pricing policy of a firm must therefore conform to the composite objectiveaccepted 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 byfirms. One such pricing objective is stability. Firms tend to keep-prices stable and short-runfluctuations in costs, demand etc. are not allowed to influence the price. Maintaining one'sshare of the market is another such objective. This is a norm which can be monitored andhence is accepted as an important one. A decline in the market share can be taken as anindication of falling popularity of the product. Target Return on Capital is another objectiveadopted 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 approachunderlines a long-run view of the pricing policy. Finally, when private firms help the governmentin carrying out socio-economic programmes like supply of medicines or school books ornutrition's food etc., they follow the principle of Ethical Pricing, i.e. reasonableness of pricingthat would create a good image of the firm.

The aforesaid principles act as pointers to a proper pricing policy. The method of pricing to bechosen is a major decision. Basically there are two methods of deciding the sellingprice : 1) Full Cost Pricing and 2) Marginal Cost Pricing. In the first one, cost is thedecisive factor; while in the second one, various other consideration are involved.

1) FULL COST OR COST PLUS PRICING

According to this method, the price is set to cover costs; material, labour, overheads anda certain percentage of profit. Costs to be included in the price are normally actualcosts, expected costs or standard costs. Actual costs are costs actually incurred in theproduction period. Expected costs are based on forecasts of production and prices.Standard costs are based on the forecasts made on the basis of the assumption that theefficiency, sales, prices, etc., will be normal.

For the profit make-up to be included in costs, various practices are followed. Sometimesprofit is expressed as a percentage of costs.

By simple arithmetic, a formula is usually evolved. For example, let us say, a producerproduces 10 units of product X. He then estimates overhead costs, labour costs andmaterial 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.1- + 10 + 5 + 3 = Rs.28.

Though relating profit to costs is easy, it is not scientific. Profit should be related toinvestment.

Whatever the method of deciding costs and profit make-up, the cost plus the profit giveswhat is known as cost plus or full cost price. This is also known as basic price becauseas and when any of the cost component charges, necessary adjustments in price aremade accordingly. If, for instance, labour cost increase, the per unit increase in labourcosts can be added to the basic price to give the selling price of the product.

Inadequacies of Cost Pricing

(1) This method ignores demand. The price the consumer is willing to pay is importantfor purposes of calculating profits. The price the consumer is willing to pay has norelation with costs. Thus, a price based on cost is one-side.

(2) This method is easy to operate; but is ignores the nature of competition in themarket. Whatever price is fixed is bound to invite reactions form rival firms. But thisthe method ignores. It also ignores the future possibilities of competition as a resultof the price policy.

(3) The cost-plus method assumes that costs can be allocated to individual products.This assumption, as is clear form the example, we have taken, is unrealistic. Manycosts are common and cannot be traced to individual products.

(4) It considers full costs. This is not always logical. For planned expansion, incrementalcosts rather than full costs should be taken as a basis. Also to base future priceson present or past costs is equally illogical.

(5) Cost plus pricing suffers from the fallacy of circular reasoning. Sales depend uponprice, production depends upon sales, costs depend upon production (becausecosts change as level of production change) and price is said to depend upon cost-which completes the circle !

Justification of cost plus pricing

In spite of the above mentioned inadequacies, the method is widely used for severalreasons which are :

(1) In practice, businessmen may not strictly adhere to the cost plays formula. Manytimes this formula gives a comparative picture of prices of different products. But inpersonal 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 asprice, 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. Thefirms want to ensure that they are earning profits which they feel are 'fair'. This canbe done by adding the profit mark-up to the cost; by following full-cost method.

(3) It is possible that the faith that in the long run only normal profit can be earnedmight be at the roots of popularity of this method. In the long run, this methodensuring fair return to capital appears to be logical.

(4) In practice, firms are uncertain about the shape of their demand curve and aboutthe return to capital appears to be logical.

(5) For pricing new products, this method is suitable. If the new product fetches a pricethat covers full cost, the product can remain in the market. Otherwise, the firm canconclude that it cannot afford to produce that product.

(6) When there is competition in the product market, and costs are more or less thesame for all the firms, cost plus pricing can introduce a particular level of prices andavoids a price-war.

(7) If an average level of production is taken into account for calculating price, thismethod is secure in the sense that excessive profits during prosperity compensatefor the losses during depression.

Role of Cost-plus Pricing

(1) For product Tailoring : Many times there already exists a great deal of competitionin the field where a firm wishes to enter. As such a common level of prices hasalready been established in the market. Under such circumstances, the producerscan first determine the price and work back by calculating the retailers marginaldistribution costs, own profit and what remains is the cost of production. A productthat first in such a cost by its design, etc., is then selected for production. This isknown as product-tailoring.

(2) For Refusal Pricing : When products are supplied according to specificationsgiven by the customer; minimum price can be decided by full cost method. Forexample, while supplying school uniforms, minimum price below which the offercannot be accepted, can be fixed on the basis of this method.

(3) For Monopsony Pricing : When there is only one or very few buyers for a product,it is desirable to charge full cost price only. This is so because the bulk buyers aremostly business concerns who may otherwise decide to produce the commodity


themselves. For example, let us suppose, the university wants to get some booksprinted. The printing press should charge at 'full cost' rates otherwise the Universitymay decide to print the books in its own press if rates quoted are high.

(4) For Public Utility Pricing : When the Government (or a private company) suppliespublic utilities like electricity, water, telephone, etc., to the people, cost of service,is considered as the proper basis. Even when an element of profit this included inprice, the method is cost plus pricing.

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 commoditiesand, in Managerial Economics, it is necessary to take cognizance of this fact and examinethe problem of pricing multiple products.

Opportunities to produce Multiple Products : A firm gets an opportunity to producemultiple products due to the following reasons.

(1) Excess Capacity : The reason for adding a new product to the product-time isusually to increase profits or to increase competitive strength. To attain this goal, afirm may use its excess capacity (i.e. unused capacity to produce) if it is there.

A simple example will make this point clear. Suppose, a press printing a dailynewspaper installs new machinery which can print 1 lakh copies. This means halfthe capacity of the machine is unused. To utilize this excess capacity, the pressmay think of starting a new weekly, fortnightly etc.

In the above example, excess capacity in technical factor is considered. Similar,excess capacity, may occur in the fields of management, distribution etc. Theexistence of such an excess capacity provides an opportunity to add new productsto the line.

(2) Seasonal Variations : Some times the demand is specific to certain seasons, i.e.,the commodity is in demand in a particular seasons. For instance, the demand forumbrellas. In other seasons, the machinery and other factors may remainunemployed. This provides an opportunity to produce some other commoditiesduring off season.

(3) Cyclical Changes : When demand fluctuates as a result of business cycles, i.e.,when demand increases and decreases alternatively, the firm suffers. These upsand downs in business are more accentuated in respect of durable consumers'goods and luxuries. The producers of such products, therefore, may add some newproducts which are not affected (or less affected) by these ups and downs in demand.


(4) Secular Shifts : When there are secular changes in conditions of demand andsupply 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 addnew products to the line. For example, in the face of competition of mill cloth, thehandloom industry had to introduce a variety of designs to increase its competitivestrength.

(5) Vertical Integration : Vertical integration of different production processes alsooffers an opportunity for increasing the number of products. For example, printing ofbooks and publication are two processes which can be integration if the publisherpurchases a printing press. Now, after printing all the books he is publishing, if thepress remains idle for some period of the year, this excess capacity may be utilizedby accepting outside jobs like printing of visiting cards, receipt books, hand-billsetc.

(6) Research : Research creates new methods of production, new techniques, etc.Old techniques then become outmoded. New products are therefore, discoveredwhich can be produced with the help of tile machinery, at hand.

Policy of Adding Products

In a dynamic business world, monopoly power does not last long and competition forcesfirms to introduce new products. Hence, the policy of adding new products becomesimportant, in practice. In selecting new product; the following problems arise.

(1) Standards of Profitability : The products to be selected are to be considered inorder of profitability - the most profitable getting priority. Here, the question is whatconcept of profit should be adopted? Should the firm use 'incremental profit' as atest? That is, should the addition product is made to bear its share of commoncosts? If the new product is to be adopted temporarily, the former concept of profitwill be appropriate; but id the new product is to be added permanently, the latterconcept will be suitable.

Once the concept of profit is finalized, the problem of measurement of profit arises.Contribution of each unit to total profits, percentage return to investment and totalmoney profits are the each unit to profit is a better measure of profitability. If, no theother hand, new products are being added on a large scale, percent return to additionalinvestment is a desirable 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. Butthere are other objectives as well and a strategy of choosing new products has tobe evolved, which keeps in view all these objectives. This 'strategy' has to be evolvedwith an eye on the policies of rival firms.

Complementarity is an important part of this strategy. If products in a product-lineare complementary to one another, they create demand for one another. For example,if an electric supply company starts the production of electrical appliances likefans, irons etc., the demand for these appliances increases the demand for electricity.

Some times, it is desirable to establish the reputation that the firm supplies allalternatives. For example, for a company producing paints and varnishes, it isdesirable that it produces all types and shades of paints. This establishes thecompany's reputation and the customers rely on the company for all theirrequirements

Besides the above considerations, common raw material, common processes ofproduction, common distribution channels, etc., are additional considerations whichare important in the product strategy.

(3) Criteria for New Products : What has been referred to above as additionalconsideration can be considered in details as criteria for choosing new products.They are : (a) Interrelation of demand characteristics : New products and existingproducts may have a demand relationship of either complementarity or of alternativecharacter. A firm may decide to produce alternatives to retain its goodwill and itmay also win over new customers if it successfully establishes a reputation as afirm producing up-to date alternatives. Similarly, in case of complementary goods'we supply the whole range' is a good motto for the firm. If a firm is already producinghousehold appliances like choppers, mixers, toasters, etc., it is desirable to addheaters, geysers, cookers, etc., and make the range a s complete as possible. (b)Distinctive know-how : When a company has some distinctive know-how, it isdesirable to add products that can be based on the same know-how. For example,a firm producing electronic appliances can add more electronic appliances only. (c)Common production facilities : We have already seen that new products utilizingexisting production facilities and excess capacity are desirable. (d) Commondistribution channels : It is also desirable to select a new product that can bebrought to the market through the existing distribution channels. For example, acompany producing medicines can add a few cosmetics, but not readymadegarments. (e) Common raw materials : It is obviously economical to add a productthat uses the same raw materials being used for existing products or that whichuses the by products of existing products. A textile mill can start the production oftowels and bed-sheets or raw cotton blankets. (f0 Benefit to present product lint :


So far we have considered the benefits of existing products to new products. Herewe have to consider the benefit of new products the established ones. This criterionsuggests 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.

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 wrongSometimes some other company is merged with a company when the products ofthat company which are unprofitable also come into the product line. Sometimesdue to product improvements effected by rival companies, the existing productsbecome out dated. In all these circumstances, the need arises for dropping oldproducts.

(2) What are the choices? : When the profit s or sales of a product are foundunsatisfactory, the company may try to improve distribution or reduce costs ofproduction or improve the quality of the product. Bulk sales or buying from othersand selling under the firm's label can also be tried. When all these efforts arerendered useless the only alternative is dropping the products, i.e., to stop itsproduction.

Cost of Multiple Product

In a firm producing many products, the problem of determining costs of individual articlesis of great practical importance. The accounting allocation of production cost is usefulonly for a few-business decisions. They are mainly useful for computing enterprise profits.But these product-costs supplied by conventional cost accounting are, according to JoelDean defective in several respects : (i) Over - heads that do not vary with a decision arenevertheless allocated to individual products; (ii) the method of allocation is scientific,but arbitrary; (iii) No distinction is made between joint and alternative products, and (iv0there is no recognition of the significance of controllability of the product mix in estimatingcosts. The analysis of the economic characteristics of the managerial problems and ofthe production process can help rectify these defects.

Jointness of Products : The problem of allocation arises when costs are common. Thismay happen with respect to joint products or alternative products.

As we have already seen, joint products are produced together (meat and raw hides andskins). In the case of joint products there are two possibilities : one that the proportionsof joint products are variable, i.e. one of the two can be increased by keeping the otherconstant. 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 productionof the other product.

In the second possibility, where the proportions are fixed, like meat and skins, it is notpossible to find out individual product costs.

When products are alternative, (case of dressed chicken and eggs as we saw earlier),the costs can be estimated by the use of the concept of opportunity costs. For example,the cost of dressed chicken is the earnings foregone of eggs that could be sold.

When products are in joint supply, the product-mix is difficult to control when the proportionsare fixed. In other cases, product-mix can be controlled. The problem then is easy, asthe output of one product can be increased by keeping the other constant.

Allocation of Variable Overheads : The only problem that now remains is allocatingshort run common overhead costs which are variable. This can be done in various ways :

(1) Share in common costs can be estimated by proportions in traceable costs, e.g.,if direct labour cost is traceable and is 10% of the common can also be treatedallocable.

(2) The some method may be applied by taking together all traceable costs, e.g.,adding direct labour and direct material to find proportion in total costs.

(3) The most closely associated traceable cost can be selected as the basis of theallocation of common cost, e.g., the cost of electricity (common cost) can beestimated individually by taking into account the machine hours worked for theproduct.

Any of these or a different method can be accepted. Thus the jointness of production, isnot a difficult problem.

To sum up, in case of multiple products, the problem wit cost allocating arises wherecosts are not traceable. In such cases, more logical methods of allocation than thosefollowed in accounting practices are desirable. Such methods can be found for jointproducts with variable proportions and alternative products. In case of joint products withfixed proportions, however, the allocation has to be arbitrary, as no logical method ofallocation can be thought of.

2) GOING RATE PRICING

While full-cost pricing takes into account the cost of production, without reference to demand,the going rate pricing emphasizen the market conditions. The firm does have control over itsown 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 idadopted. In cases, where a price leader exists and he charges a price in keeping with whatthe 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, afirm may begin its calculations form price rather than from costs. Thus, for instance, a firmmay accept a certain price as a going rate price and then adjust its costs by providing for acertain margin of profits. This method of pricing is simple to grasp and can be of help wherethe products have reached a mature stage. In such a situation, customers as well as rivalfirms prefer a stable price. This method seeds to maintain price-stability and allows changesin costs where necessary. Hence cost control is a problem in this method. In a way, thismethod is exactly opposite the above one; the one we saw earlier was a method of cost-pluspricing. While the one we are discussing here is a method of price-minus costing.

B) Marginal Cost Pricing

One of the most sound pricing practice is the full-cost pricing which we discussed in greatdetail. Going-rate pricing is, as we saw, approaching the problem form the opposite end.Going-rate pricing, however, is not a policy that could by followed on a permanent and a long-term basis. This is obviously because of the fact that a firm cannot accept the responsibilityof controlling costs, all the time. Many elements of costs are such as are hardly within a firm'scontrol. 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. Marginalanalysis occupies an important position in the classical economic theory. A firm's equilibriumcan 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.What price should be charged? One that is given by the average revenue curve (or the demandcurve) at the equilibrium level of output, is the answer. The marginal cost pricing appears tosuggest that price charged should be equal to the marginal cost. This policy must entaillosses and this fact can be ascertained by a look at the diagrams explaining equilibrium of afirm. What marginal cost pricing suggests is that it sets the lower limits a firm can set a pricethat ensures the targeted or possible level of profitability.

The method of pricing we are discussing is 'marginal' cost pricing while the sub-title we havegiven is 'incremental' cost pricing. Are they the same? Strictly speaking, they are not thesame. The incremental principle is commonly used in business decisions. When a firm takesany decision, it involves a course of action. This course of action must have some impactupon total cost and total revenue. According to the incremental principle, the decision can beconsidered sound if incremental revenue i.e. increase in revenue exceeds incremental cost orincrease 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 refersto the change in total revenue following a unit change in total revenue following a unit changein output. Marginal revenue, in the same way, is a charge in total revenue following a unitchange in output. In spite of this technical difference, business discussion usually ignores thedifference and the two terms are used interchangeably. In the context of pricing, marginal costwould be the proper expression to denote the method.

In this method of pricing, fixed costs are ignored, because marginal cost represents additionto total cost, which takes place due to variable costs only. When fixed costs are high, full-costpricing 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. Whateverexcess of price over average variable cost is available can be used for meeting profitrequirements and contribution towards fixed costs. Marginal cost pricing helps the firm tobecome more aggressive at the market. The firm can take a full-life perspective and can planto cover full costs over a long period. Where full-cost pricing is difficult for reasons notedearlier, 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 business do not possess theknowledge of finding out marginal cost and marginal revenue.

(2) Pricing has to take into account, future costs and prices. Due to uncertainties involvedon both sides, there always arises a discrepancy between planned profits and actualprofits.

(3) It is pointed out that a strict adherence to marginal cost pricing leads to frequent pricechanges. Such changes are not liked by the buyers. Moreover, they create problems inplanning, distribution and credit sales and purchases.

(4) A price-cut is usually irreversible and in the absence of a necessary upward revision ofprices, 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 andmonitors demand elasticity's, sales forecasts etc.

(6) Adherence to marginal cost pricing puts the firm to losses because overhead costs arenot covered by this price.

The criticism is not fully warranted. The points that this method will put the firm to losses isbased on the assumption that MC > AC. We have seen that this holds goods only when c0stsare diminishing. When costs are rising, MC > AC. Again, full-cost principle may suggest thatone should not produce so long as all the costs are fully covered. This is obviously wrong.Fixed costs must be incurred even with zero production level. Wisdom, therefore, lies in


producing when 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 aproduct and as a guide for modifying profit-maximizing price when market conditions so demand.

4) SOME OTHER APPROACHES

Full-cost marginal-cost are the two basic methods we noted so far. In practice, we comeacross a very wide, variety of practices in pricing. Let us consider the major approaches, topricing which lie at the basis of actual pricing practices. These approaches are not alternativesbut can act as complementary or supplementary to one another.

(A) Intuitive Pricing :

This psychological and subjective approach to pricing is surprisingly very common. Intuitivepricing, as the term itself suggests, is a response or a reaction to the feel of the market.The approach can be variously applied. Price based on pure lunch can be taken as astarting 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 ofcompetition. Thus, though the approach is intuitive, the price cannot be entirely left tothe intuition of the entrepreneur.

The success of pricing policy can be judged by whether the price that the firm needs andthat which the buyers want is the same, or at least, the two come very close. This ishardly possible and requires a great deal of knowledge on the parts of both sellers andbuyers. Some managements can guess correctly the future treads in demand andcompetition. Their intuitive prices prove to be successful.

(B) Experimental Pricing :

In search of an optimum price, the firm takes some cognizance of the demand for theproduct, and proceeds, to fix a price by a trial- and - error method. This is experimentalpricing. Usually a sample of test markets is selected, and price is varied to see thereactions. These reactions are observed and then a price that maximizes profits is fixed.This method is widely used in respect of new products. This method has the potential ofproviding a scientific base for pricing policy. However, in oligopolistic structure, wherebuyers cannot be separated, this method has got to be applied with caution.

(C) Imitative Pricing

As the name itself suggests, the firm fixes its price equal to, or in some proportion of, theprice of another firm. We have already noted the possible price-leadership situation inthe context of oligopoly. A firm that initiates a change in price in the price-leader. Otherknown as price - followers, make adequate change in price. Price-leader usually has alarge 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 popularly in manyfields. Especially in retail trade or in other manufacturing areas where monopolisticcompetition exists, prices are kept imitative so as not to disturb the inter-firm competitivestructure. The firm can then conveniently concentrate on non-price competition. Thedisadvantage of this method is that it sacrifices flexibility and leaves no room foradjustments as per local conditions.

5) SOME GUIDELINES FOR FIXATION

The foregoing discussion concerned some of the approaches to pricing. We shall now try toprovide practical guidelines evolved by people through their business experience. Theseguidelines are important in bridging the gap between theoretical prescriptions and practicalapplications.

(A) Single Product Pricing

1. Pioneering Price

Every product has a life-cycle : a product is new, it clicks and gets established; butafter some time 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 precededby 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 skimthe cream of the market by charging a high price. Subsequently price can bereduced to reach lower income customers.

(b) Penetration Price : Alternatively a firm can begin by charging a very low priceto penetrate the market. In the short-run the firm may make losses; but in thelong-run profits can be earned. This is because, after capturing a large part ofthe market, the firm can gradually raise the price. Where large-scale productionis likely to reduce costs considerably, this policy is helpful.

2. Price in Maturity

After the take-off a product reaches maturity stage. During this stage, competitionis keener, substitutes are available and preference for the product becomes weaker.There aspects of maturity therefore become relevant for reckoning :

(a) technical maturity reflected in increasing standardization with set prototypesand less product variation;

(b) market saturation with weakened preference and a higher ratio replacementsales to new sales; and


(c) stability of production methods, market shares and price-structures. Duringthis stage, therefore, price should be set carefully by taking into accountestimated elasticity of demand, competitive degeneration as well as thepossibilities of non-price competition.

3. Cyclical Price :

In course of its life, a product experiences fluctuations in demand. Firms maydecide to respond to these fluctuations by reducing off-season prices and raisingprices when conditions are brisk. Alternatively, a firm may decide to maintain itsquality- and - price reputation by keeping the price unchanged throughout recessionand prosperity.

4. Backward Cost Pricing

When competition is keen and quality as well as price are consequential to thebuyers, a selling - price is determined first and by working backward, the productdesign can be arrived at. A wide variety of products including electrical appliancesautomobiles are subjected to this type of pricing; by cause the market is floodedwith competitive products.

5. Refusal Pricing

Many products are such as to serve specific needs of the users. Surgical equipmentis an example of this type. High price and profiteering cannot be followed - in suchcases. Therefore, cost plus limits as floor price are ascertained. No price-reductionis possible. So, at less than this, he seller just refuses to supply the product.

6. Psychological Consideration

Many times producers resort to tactics which actually exploit the consumerspsychologically. Double-pricing is one such tactic. On the price-tag two prices ateprinted with upper one, which is a higher one, crossed. The consumer get a feelingthat price is lowered by the company and therefore sales get boosted. Prestigepricing is another tactic. A high price is maintained where buyers attach prestigeconsiderations to the product. Customary prices are charged in respect ofcommodities having kinked demand curves.

These are a few guidelines for single product, i.e. where the firm is producing asingle product. However, when a firm is producing many products-and such firmsare 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 problemof 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 amongthem are :

(a) Price that are proportional to full cost : According to this policy common costsare allocated to individual products. Traceable costs are then added to themand then by6 adding a profit mark-up the selling price is fixed. This is the costplus price we have discussed earlier.

(b) Prices the are proportional to incremental costs : Without considering commoncosts only incremental costs may be taken into account and prices may befixed in proportion of three products - A, B and C costs are increasing byRs.4,000/-, Rs.3,000/- and Rs.1000/- respectively, the expected revenue formthe three products will be distributed over these in the proportion 4:3:1. Bydividing the expected revenue from each by the units of that product, we getthe price. This removes the defect of arbitrariness in the first method. But thisdoes not recognize the extent of composition in the market or the elasticity ofdemand.

(c) Prices with profit margins proportional to conversion costs : Conversion costis the cost of converting raw material into final product. This may not be thesame for all the products in the line. E.g. the milk collected by a dairy can bepasturised and bottled or can be powdered and filled into tins. The conversioncosts of these two are obviously different. If these costs are 4:6 then the profitalso may be divide in the proportion 4:6. With this profit added to costs theprice can be fixed.

(d) Price that produce contribution margins that depend upon the elasticity ofdemand of different market segments : The market is divided into segmentsaccording to elasticity. Elastic demand has to escape with a low profit marginwhile inelastic demand can be burdened with a high profit margin. Firms cantake advantage of the ignorance of customers or a desire for distinction or justthe laziness of customers. These provide opportunities for changing differentprices. The more complicated the process and design of the product the moreare opportunities for such discrimination. E.g. the price differences in thecase of A and B grade sugar cannot be much. But with different cases anddials, two wrist-watches with the same machines can be sold at a differenceof a hundred rupees. In this method, differences in elasticity are taken maximumadvantage of.

(e) Prices that are systematically related to the stage of the market and thecompetitive development of individual members of the product line : Everyproduct 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 arein different stages. An old product should have a law price. A product that is onthe 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. Youngchildren have a share in costs. The old members of the family earn just enoughfor their upkeep or live by the pension they get for the work done when theywere in this price. But the total cost of the family is covered by the total familyearnings. This analogy explains the price policy under consideration mosteloquently.

What each product should earn is dependent upon the nature of the competitionin 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 followingfactors need to be considered :

(a) Demand Relationship in the Product Line : Products in the same line havemany types of demand relationships. They may be complementary products,e.g. torches and cells produced by the same company. They may be alternativeproducts e.g. different models of a radio set produced by the same company.A new product can be introduced in the market by taking advantages of thesedemand relationships. This is how new models of radio-sets are introduced,or this is why a company producing tooth past introduces it s tooth brush(complementary) and tooth powder (alternative) as well. Differences in theelasticity of demand provide an opportunity for increasing profits by takingadvantage of the ignorance of customers or their craze for distinction.

(b) Competitive Differences : All markets where products form one product lineare sold do not have the same degree of competition. The number of competingfirms the firm's share in the total market supply and differences in the natureof competing products indicate the extent of competition. The competitionalso depends upon the costs of entry, the costs of acquiring new patents.Capital and technical difficulties in starting a new firm etc. the less thepossibility of emergence of competition, the more, obvious are the opportunitiesof increasing profitability by charging high prices.

(c) 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 correspondingtotal revenue and total cost. This is so because as price changes, demandchanges and so does the total revenue. Similarly, because supply changes,costs will also change. That set of price is the best which fetches the maximumprofit. The cost estimate to be used here will be dependent on the objectives


of the firm. If for example, profits are subject to letal restriction, full cost shouldbe included. If using excess capacity is the objective, incremental costs arerelevant and a nominal profit will be considered satisfactory.

3. Some Problems of Product - Line Pricing

(1) Pricing Products that Differ in Size : It is desirable to charge different pricesfor different sizes of a product? Price can be the same if costs and satisfactionaccruing to the consumer are the same. E.g. in the case of footwear for adults,costs do not differ much and it is not the that a man wearing a bigger shoesimply because their feet are of different sizes. But if it is decided to varyprices according to sizes, it is desirable to have a systematic pattern. E.g. ifa 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 ofequity.

While pricing alternative sizes, it is advantageous to reduce the price as thesize increases. E.g. the price of a 20ml. bottle of hair oil should be less thanthe price of two bottles of 100 ml. taken together. This saves packing costsand encourages demand.

(2) Pricing Products that Differ in Quality : When there are products of differentquality in a product line, their prices will be determined in accordance with theobjectives of the firm. Sometimes the objective is to bring prestige to theentire line. Then some high price products are kept deliberately. This increasesthe sale of low and medium priced products. If a company prices its qualityneckties at Rs.50 each it can sell cheap ties in large numbers. It is thesecheap ties that really fetch profit.

If price competition is the objective the firm produces low quality products andcharges minimum prices. This enables the firm to project its image as 'a firmcharging reasonable prices'.

(3) Charm Prices : There has been a belief in the business would that pricesending in odd figures give a feeling that they are reasonable and they appearto be less than what they actually are. This increases sales. This is whyprices like Rs.9.95, Rs.24.95 are charged in place of Rs.10 or Rs.25.

(4) Pricing Special Designs : When a product is custom made or prepared onspecial order and specifications, what price should be charge ? As alreadyseen, if the customer himself is a producer, full cost price is desirable.Alternatively, what businessmen calla 'parity price' or what economist call'opportunity cost' should be charged.


(5) Charging Different Prices at Different Times : When the demand is seasonalat least fixed costs are required to be borne in the off-season. To cover suchcosts concessional prices can be charged in the off-season. For instance,fans in winter and blankets in summer can be sold at concessional prices. Itis possible to win new customers by keeping price low at a time when demandis less. E.g. when matinee shows are screened at lower charges, it is possibleto attract spectators who are not habituals. The same group may later behabituates and may start visiting regular shows.

(6) Pricing Repair Parts : Many firms producing spare parts earn more than firmsproducing the whole machine. Because of the irregularity of demand and therisk of obsolescence, the price of spare parts are required to be kept high. It isdesirable to distinguish between parts that can be produced easily whichmust be sold at a competitive price and parts requiring specialized techniquesthat can be sold at a high price.

(6) Pricing in Public Sector Undertakings (PSU)

The price policy of public enterprises has special significance:

i) The price fixed by a public enterprise should be such as to enable it to raise adequateresources for re-investment;

ii) The price policy of a public enterprise should be such as to enble it to operate at thelowest cost possible and maximise efficiency;

iii) The price policy should be such as to enble consumers at all levels to buy and make useof the goods and services produced by the public enterprise;

iv) It will have to calculate costs and benefits to the various sections of the community and

v) The price policy in a public enterprise shall have to consider the requirements of foreigntrade, competition from private enterprises, inter-enterprises relationship, etc.

All these factors make the price policy of public enterprises really significant as well as difficult

Responsibility for pricing :

In a Private company, management has the responsibility of fixing prices for the goods thecompany produces, though, of course, the broad principles of the price policy are laid downby the Board of Directors representing the general body of shareholders. In public enterprisesthe pricing function is "diffused over the minister, the department and the managers". Thegovernment has the ultimate responsibility to decide about the way a public undertaking willconduct its affairs. This is particularly so when the quantum of profits which the undertakinghas 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 structurewill have to be worked out by the managers of the undertaking. In general, therefore, thegovernment decides the price policy while the managers of particular enterprises decide theprice structure within the general framework of the government's price policy.

Features of pricing in public enterprises

In order to appreciate the pricing policy in public enterprises in India, it is necessary tounderstand the distinctive features of pricing of public enterprises. These features may relateto the demand side or on the supply side.

1) On the demand side, the main problem is one of maintaining conditions of fullcompetition between the public and private sector units. A public enterprise mayattract demand because of its special strength. Government enterprises working undercompetitive conditions are: Ashoka Hotel and Janpath Hotel and the shipping CorporationLtd. The pricing problem becomes more significant and highly complicated when a publicenterprise operates under conditions of monopoly. A private monopoly will generally aimat 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 targetfixed by the government. Generally, the public enterprise enjoying a high degree ofmonopoly power may opt for a high price structure. On other hand, such governmentundertaking may opt for a low price structure, if among other things, the management inunder a bias for full utilization of resources or maximum production of the commodity orservice. The Railways, the Indian Airlines Corporation (till recently) and the ElectricityBoards are monopolies. Hindustan Steel Ltd. and the Fertiliser Corporation of India areoperating in a seller's market. In these cases, the possibility of inter-unit competitiondoes not exist or is only nominal. In such cases, it is the lowest possible costs whichdetermine 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 capacitieseven from the beginning and naturally, larger production up to the full capacity will beaccompanied by declining costs. At the same time, public enterprises may get hold ofsome or all factors at lower prices. For instance, government enterprises may have theadvantages of bulk contracts of purchases and concessions available to government.Moreover a government enterprise can get hold of cheap capital either through governmentsubscription or under government guarantee. This is indeed a great advantage for capitalintensive projects.

3) Public enterprises may incur some social costs which private enterprise may notbear at all or may shift to other agencies. For example a public enterprise mayengage large labour force, spend more heavily on employees- housing, or provide generousmedical facilities and consumer amenities than a private enterprise may 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- Generaland 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 aresubject to certain external pressures. For instance, a public enterprise may be forcedto go slow in its construction work. Or the Government may decide to over-capitalise theenterprise from the start and hence may force the enterprise to have heavy overheadcapital in the early periods. Or complementary resources may not have been developedand may subject an enterprise to unfavorable cost conditions.

Thus there are many distinctive features of pricing in government enterprises which are notgenerally met with in private enterprises.

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 externalcircumstances. Some of the following features of price polity are to be met with in India.

i) Profit as the basis of price policy – public enterprises in India generally follow a policyof profitability. Profits of a public enterprise indicate its efficiency (apart from its monopolycharacter) as well as serve important sources of self-financing. The Indian Railways andthe Reserve Bank of India are two important Government undertakings which contributeconsiderable amounts to the general exchequer. Sindri Fertilizers,Hindustan Antibiotics,Hindustan Machine Tools, etc. were some of the public enterprises whose profits wereploughed back for expansion.

ii) No profit basis – Some Government enterprises have been required by law or by theMemorandum 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 "no profits no loss basis."

iii) Import-parity Price – Those public enterprises whose products are in direct competitionwith imported goods have adhered to a policy of import - parity prices. The HindustanShipyards Ltd. accepted the principle of selling the ships in the Vishakhapatanam shipyardat a price approximately equal to the cost of building a similar ship in the United Kingdom.

Guidelines on Pricing Policy

The Government of India has issued three guidelines on Pricing Policies for the publicsector enterprises, viz.,

a) Public enterprises should be economically viable units and an all out effort should bemade to increase their efficiency and to establish their profitability at the earliest;


b) Public enterprises which produce goods and services in competition with the domesticproducers, the normal market forces of demand and supply will operate and theirproductivity will be governed by the prices prevailing in the market; and

c) 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 comparableimported goods which would be the normal ceiling.

According to the Bureau of Public Enterprises (1986-87). "it has been accepted in principlethat prices of products produced and services rendered by public enterprises should beso determined that at a satisfactory level of capacity utilization these enterprises notonly cover their costs of production, but also generate a reasonable amount of surplus""Profit making in public enterprises is considered quite consistent in public purpose.There may be situations where profitability in the strict sense of the term may be somewhatof secondary importance. For instance, the prices of infrastructural services and basicindustrial and agricultural inputs, such as transport, coal, steel, petroleum products andfertilizers, have to be regulated /administered in line with economic costs to prevent aspiralling effect on prices. In general, the prices of such products and services should berationalized in a manner as to cover total costs and bring about a fair margin of return bymeans of general improvements in efficiency and greater utilization of capacity."

With this policy, the Government took a number of decisions in raising the prices ofsteel, coal, petroleum products, fertilizers, aluminium, molasses, alcohol. Similarly theprice of indigeneous crude oil was revised. These price escalations are motivated by thedesire to earn more revenue for the Government. The critics however believe that insteadof absorbing the rise in costs by improving efficiency and productivity, the govt. has beenadopting the rather easy method of raising administered prices. The Government intendsto generate more profit by the use of its monopoly power. The critics further state thatthis is in direct conflict with the guidelines on pricing policy laid down by the Government.

(7) Pricing in co-operative societies

In India, the co-operative sector has expanded considerably in the last 50-70 years. Howeverco-operative management in India, for most of its part, has come under criticism for the lackof professionalism, absence of marketing skills, lack of productive efficiency and cost-heavystructures. Of late there are signs of the emergence of a professionally managed co-operativesector. In the areas of food processing, milk production, transport, production of sugar etc.several cooperative institutions have made their mark. Pricing of products/services in theseco-operative organizations now needs our attention.

Production in the co-operative sector, in a way, stands between that in the public sector andthe same in the private sector. Like the public sector, the co-operative sector also has to fulfillcertain social objectives and a purely commercial approach is, therefore, ruled out. At the


same time, some co-operative organizations are operating in competition with private sectororganizations and are expected to remain economically viable. As such, the pricing policy ofco-operative societies conforms to the norms of public sector pricing where the situation sodemands. Alternatively, in some cases, they have to face market competition and have to setcompetitive prices or leave the prices to the market forces.

1) Cost-based pricing : In many cases, pricing aims at covering the total cost. This isapplicable to societies where goods/services are of an essential nature and the benefitsof the services are required to be distributed among the users in the form of cheap or fairpriced availability of goods/services.

Distribution of food grains, lift irrigation services are examples of this type. In somecases cost-plus pricing method is followed in this case, the price is fixed to equal averagemaintenance of certain quality of products/services. In the first case the price is said toequal 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 numberof users is much larger than the number of members, cost-plus pricing is followed. Thecredit 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 thistype. Such societies have objectives like providing employment, preserving traditionalskills, supplying cheap inputs or supplying onsumers products ay fair prices. Suchsocieties are therefore based on 'average cost minus subsidy per unit basis.Sometimes the subsidy is available in a lumpsum and sometimes it is paid in thus formof rebate per unit of the product sold, as in case of handloom fabrics.

3) Demand- based Pricing : In many producers 'co-operatives pricing is required tofollow the dicates of demand. In keeping with the law of demand, the price is animportant 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 orcharge a low price and get a higher demand. Sometimes, if the society enjoys a certainamount of monopoly, it can resort to price discrimination. Discrimination can be asbetween and the rest of the society or as between different uses or as between differentplaces. As a case of discriminating prices one can cite the example of dual pricing ofsugar which was followed in India. I this case, the government imposed a certainpercentage of levy on sugar factories most of which are in the co-operative sector. Thislevy sugar quantity was purchased by the government at a low price and was distributedthrough fair - price shops at remaining sugar produced by the factories, they were giventhe freedom to price sugar in such a way as to compensate for the loss they incurred inselling the levy sugar to the government and also to charge a costplus price and supply


the sugar to the market as free sale sugar. Other pricing practices like penetrating priceand price skimming are also at a loss in the beginning for penetrating the market andthen raise the price when the favourable conditions at the market so as to earn maximumpossible profit. It is necessary to remember that such commercial and competitivepractices can be followed by a very small number of co-operatives which are competitiveenough both in terms of quality as well as cost of production. For example, co-operativeslike Anand Milk Union Ltd. (amul) can afford to follow such practices.

4) Competitive Pricing : When a society is embarking upon a new venture, it has toprice its product on the basis of going rate and many times such a rate has got tobe comparable to imported products. When there exists competition among thelocal producers, the price has got to be comparable to the range of prices of similarproducts produced by other firms, For example, societies producing milk and milkproducts, or those producing mango pulps or orange syrups and squashes have to setprices which are comparable to other firms' prices of their existing products. Sometimes,sealed bids are sell the bagasse in their factories by following this method.

The pricing methods discussed above are subject to regulations and rules framed by thegovernment, in this regard. CO-operatives are in the jurisdiction of the state governmentin India and, in many cases, the prices charged by co-operatives need an approval of thestat 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 haveeither the potential of generating cost-push inflation or they are essential consumptiongoods which can exclude poor consumers when the goods are priced high.


Exercise :

1. How is the price of a product determined under conditions of perfect competition in theshort run and in the long run?

2. Explain how price is determined under monopoly? What is price discrimination? Whenis it possible and profitable?

3. How is the price determined under monopolistic competition in both the short and longrun ?

4. Write Short notes on :

(a) Perfect Competition (b) Monopoly (c) Monopsony (d) Selling costs (e) Wasteges ofcompetition. (f) Short run cost curves (g) Imitative pricing (h) Intuitive pricing (i) Customaryprices (j) Features of oligopoly (k) Non-price competition (l) Pricing in public sectorundertakings (m) Cost plus pricing (n) Pricing in cooperative societies (o) Changes inequilibrium price.

5. What guidelines for price fixation can be suggested?


NOTES

Cost Benefit Analysis 257

Chapter 7

COST BENEFIT ANALYSIS

Preview

Introduction, Private versus Public Goods, Government Investment, Overall Resource Allocation-Steps in Cost-Benefit Analysis-Justification for the use of Cost-Benefit Analysis.

INTRODUCTION

The cost-benefit analysis, in a very narrow sense, would just be limited to finding out thebenefit cost ratio which happens to be a measure inter alia, to analyse various investmentopportunities and to find out the worth of each of them. However, in its broader sense, costbenefit analysis refers to the analysis undertaken to judge any project f investment whethergovernment or private and find out its worth and facilities its comparison with other availableopportunities of investment. In this sense, the cost-benefit analysis refers to finding out theworth 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 contemplatinginvestment 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 publicsector undertaking. However, in the broadest sense, the cost-benefits can be adopted on amacro level either at the level of the economy as whole, as a part of a five year plan, or for thepublic sector activity where such a partial or overall analysis is more important a guide for thegovernment as well as for the business world.

1. PUBLIC GOODS VS PRIVATE GOODS :

The Product Divisibility

There are certain goods the availability of which to users can be decided in a discriminatorymanner. A good may be priced in the market and only those may be allowed the use of it whopay its stipulated price. To put it differently, such a good may be priced and the principle ofexclusion may be applied to its use. Those who do not agree to pay its market price, or thosewho cannot pay for it, are excluded from its use. In this way, the good becomes divisible so faras 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 thateach individual has an access to the entire amount of public good. His use of it does notreduce its availability to others. Tuning in of a radio or TV programme by one does not depriveanyone else from enjoying the same programme. On the other hand, it may be that in thecase of a certain good, 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 thedefence service. Once the country is protected against foreign aggression, every citizen ismore or less equally protected and benefited. A section of the society cannot be excludedfrom 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 useor its benefits. In some cases a consumer cannot surrender the use of a service even if hewants to. An individual cannot ask to be left undefended by the defence arrangement of thestate, 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 theexclusion principle applies because those who do not pay can be excluded from its use. If, forexample, an individual does not voluntarily agree to pay the market price for the milk, themarket would refuse to supply him the required quantity. But we have seen that this exclusionprinciple can not be applied to the indivisible goods. And this creates a problem of raising thenecessary finances in their case. For example, in the case of defence service, every individualwould argue that even if he does not pay for it, the supply of the service will still be there. Sohe 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 thecontributions and efforts of others the service will be there. This is referred to as the problemsof free riders - which means that everybody would like to have the benefit of the good withoutsharing the cost of its supply and so the necessary finances cannot be raised on a voluntarybasis. As a result the provision of such a good or service has to be made through compulsorycontributions 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 it is to be supplied at all; and in case it is to be supplied, then theywill also decide about the quantity of its supply. But in the case of an indivisible good, suchdecisions cannot be taken through market mechanism. The society has to decide the way inwhich 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 decisionsregarding these goods are, therefore, left to the government agencies.

The indivisible goods, whose benefits cannot be priced, and therefore, to which the principle ofexclusion 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 onewho disagrees to pay (or cannot pay) the requisite price would be excluded from theirconsumption.

It must be noted that the indivisibility of a good does not necessarily imply that every citizenof the society has actually an equal share in its benefits. People living near the politicalboundaries of a country may, for obvious reasons, be relatively less protected. People livingnear public parks are actually more benefited even when the parks are accessible to all themembers of the society. Thus, the main criterion of indivisibility is that the good in questionshould be equally available to to all the members of the society (or a section there of) irrespectiveof the ability or willingness of the individual members to pay for it. The financing of the concernedactivity has to be through public expenditure and not through market pricing. This conclusionimplies that the pure public goods must be in the hands of public sector only. It, however, doesnot prove as to which sector (Public or Private) should provide the pure private goods. In orderto 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 tooperate and productive resources at disposal of the two sectors;

ii. The political and social considerations such as the philosophy that the economy shouldnot be dominated by private monopolies.

iii. Additional characteristics of pure public and pure private goods.

Externalities

Another important characteristic of pure pubic goods is the existence of externalities. Theterm externalities refers to the economic effects which flow from the production or use of thegood to other parties or economic units. Such economic effects may also be called spill-overeffects, neighbourhood effects or third party effects. Such an externality may be an economicgain or an economic loss to other economic units and would be referred to as pecuniaryexternality. (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 theprices in the economy which in turn transmit their effects on to production and consumptiondecisions 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, apowerhouse using coal would cause a lot of ash-throwing in the neighbourhood through itschimneys. Similarly, the railways using a lot of coal in firing the steam locomotives put theresidential and other areas near the railway loco-shades to a lot of sufferings on account ofsmoke nuisance. This is a cost to society but not to the individual undertakings like the powerhouse or the railways. Similarly, driving the smoke-emitting buses and trucks in the cities addto 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 industriesserved 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 andsupply behaviour, they are termed ‘non-market-external effects’. It means that through themarket mechanism, individual economy units cannot be protected from the economic loss (orcannot 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 roadamongst its beneficiaries. Even if it was possible to identify some of the beneficiaries such asthose who actually use the road, other beneficiaries would be left out. Therefore, the pricing ofeconomic benefits of a road would not be strictly satisfying the rule of exclusion.

It would follow that such public goods as have non-market external effects should be preferablyin 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 goodsirrespective of their commercial profitability of the same. Thus, it follows that those amongstpure public goods which have non-market external effects would qualify for inclusion in thepublic sector. Those pure public goods which have market external effects may be left in thehands in private sector from this point of view. (However, remember that even then thecharacteristics of indivisibility of pure public goods still tells us that they should be in thehands of the public sector only).

By contrast, a pure private good is supposed not to have any externalities. In its case, therewill be no difference between private and social marginal costs of supply. The market pricingwould, therefore, be representing the social cost of supplying the goods and so even if it is leftin 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 onaccount of various reasons this may not be adhered to in every case. The government mightdecide to step in where 'merit wants' are concerned. Other relevant considerations could bethe cost conditions (discussed below), resource availability, social and political philosophy,and so on.

Marginal Cost

A likely characteristic of a pure public good is that its marginal cost would be zero or close tozero. It means that an additional member of society can be benefited by its use withoutappreciably adding to its total cost. To put it differently, the use of a pure public good by onemore member of the society does not reduce its availability to the others. A good example ofit is the tuning in of your radio set. Still another example is that of a bridge over which anadditional vehicle may pass without any additional cost to the society. It must, however, be


remembered that mostly this principle applies in reality, only to a limited extent. One cannotsay that we can keep on adding to the number of vehicles that may use the same bridge; wecannot have the same defence budget if our population keeps on increasing, and so on. Alsoit may be added that a large number of members of the society may not be able to enjoy thebenefits of the public good without adding to the cost of its supply. Similarly, the provision ofthe public goods may be increased or decreased for budgetary reasons or due to extraneousfactors. Pure public goods which possess this characteristic have a strong case for inclusion inthe public sector since public goods are indivisible also. In the case of private goods, on theother hand, the argument is basically in the favour of large-scale production - for which either thesociety should agree to monopolistic type of private enterprise or should go in for public sector.

Decreasing Average cost

Another likely characteristic of pure public goods is that it would be subject to the law ofdecreasing costs. Being lumpy, it would be subject to the economies of scale. If the publicgood is provided in small units, then the average cost is likely to be much more. For example,the average costs of operating a sewerage system would be much less if it serves a wide areathan when it serves only a portion of the city. When it comes to the choice between public andprivate sectors for the provision of goods possessing this characteristic, considerations similarto the ones mentioned above in the case of 'Marginal cost' characteristic apply.

IMPURE PUBLIC GOODS

It would be noticed that it is highly difficult to come across which fully satisfy all thecharacteristics of the pure public goods. Similarly, it is highly difficult to come across pureprivate 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 areneither pure public goods nor pure private goods are called impure public goods (also calledquasi-public goods or quasi-private goods). If the elements of 'publicness' are predominant inthe mixture of characteristics of a good, then it may be termed a public good; and in theopposite case, a private good.

2. STEPS IN COST BENEFITS ANALYSIS :

The cost-benefits analysis is a technique used for analyzing investment and for rating thealternative investment opportunities as well as for ranking such opportunities on the basis ofthe rate of return to investment. Investment analysis is very important but very difficult due tothe elements of uncertainty, changing value of money etc., as discussed above. besides,there are capital constraints and social costs and benefits involved. steps above. Besidesthere 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 analysingvarious projects from the point of view of an individual investor. The cost -benefit analysis asa 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 variousinvestment opportunities for the purpose of finally selecting one of them. In doing so, hehas to keep in mind the size of the investments he has contemplated and his ownexpertise and interest. For this purpose, the investor can get the necessary informationfrom development organizations who are engaged in developing project profiles. He canalso borrow ideas from the established and reputed investors within and outside thecountry. It is possible that he has some new project ideas. Whatever the case, one hasto choose a few project alternatives for further scrutiny by carefully including the good orsound projects promising a high rate of return.

2) Formulation of the Project : Once a list of projects chosen for scrutiny is ready, witha blue print and all details of requirements in terms of land, building, plant and machinery,raw materials fuel, and power, labour and technocrats etc. with prices of each, one canproceed further. The next thing he has to take into account is the capacity likely to becreated and possible utilization of the capacity over time and the prices at which theproducts could be sold over the time -span considered ads the life of the project. Afterthe 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; economicfeasibility ,i.e., prospects of employment generation, development of backward areas/social groups etc.; and management feasibility ,i.e., availability of management personnelfor implementing and running the project smoothly and professionaly. It should be obviousthat some of the projects identified and selected for scrutiny could be dropped at thisstage 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 theirassessment in terms of economic viability. This can be done with the help of projectedcash outflows and inflows from each project and then comparing them out on merit. Forthis purpose various measures used for evaluating the investment worth, including cost-benefit analysis, can be adopted. Through this step of screening, those of the selectedprojects which are viable as well as within the investment limit contemplated by theinvestor are selected.

4) Comparison of Cash-Flow : Projects which pass the third test of feasibility are thenput to best comparing the cash-flows by using the cost-benefit ratio (or any of the othermeasures discussed above). If and where critical values are involved, each measurewould produce several outcomes. This would enable the investor to compare the rates ofreturn along with the risks involved. This sort of comparison is of crucial importancebecause one determinate mathematical solution is not available and one has to beguided by one's subjective evaluation of the risk involved as well as one's attitude towards


acceptance of risk. One may select a project promising high returns with high uncertaintyor low profitability with low risk level.

5) Selection and Implementation: Keeping in view the funds available for investment oneor more of the projects can be selected for implementation. The selected projects willthen be implemented in accordance with the blue prints already prepared. Whileimplementing the project after it being commissioned, it is necessary to monitor theproject on a regular basis. This includes ensuring the projected time period involved isobserved in practice, after ascertaining the quality and quantity are as per norms assumedand the marketing of the product industrial relations, repayment of loans and paymentsof 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 canbe done by re-calculating the measure of investment worth with a view to find out theactual worth and compare it with the anticipated worth at the stage of anticipated worthestimated at the formulation stage. This would enable the investor to find out whether theexpected results have been realized or not and then find out the causes responsible fordivergence between the expected and the realized results. Such an appraisal providesopportunity for rectifying any mistakes and improving upon the performance.

3. JUSTIFICATION FOR THE USE OF COST-BENEFIT 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 fordeciding the acceptance or rejection of an investment project as well as for ranking of theprojects. it is only the cost -benefits analysis which provides as insight into the private as wellas social costs and benefits involved. It can also incorporate other consideration besides themonetory returns, for assessing the worth of an investment. In justification of the cost-benefitsanalysis, therefore, we can enumerate the following arguments:

1) Social Costs and Benefits : As discussed in a subsequent section, the government hasto intervene, regulate and even control; the business activities even in a market-driveneconomy, as and when necessary. We have also noted the distinction between privateand social costs and benefits. At the macro level it is necessary to minimize the divergencebetween public and private costs and benefits. By going through the exercise of findingout such divergence it becomes the duty of the government to formulate adequate policiesaimed at minimizing such cases of divergence. However, it is in the interest of privatefirms to look for social benefits and costs involved in their private project and take necessarymeasures to reconcile the conflicting interests. This is possible by resorting to a modifiedversion to reconcile the conflicting interests. This is possible by resorting to a discussedin detail.


2) Intangible Factors : many times certain intangible factors enter into the considerationof project appraisal and such factors are not unimportant. The prestige of the businessfirm, the reputation or the image of the firm in the market, the moral of the employees,the long stranding tradition of then company or the ideas and the values inherited by acompany over the long period of its existence are some such examples. Under suchcircumstances, the pecuniary (ie monetary)considerations may not be proper guides foracceptance or rejection of a project. It is true that these ultra-financial criteria are difficultto quantify. But this cannot be an excuse for discarding them. There are ways likeshadow/pricing which can be adopted for computing costs or benefits of such intangiblefactors. This is possible only with the broad-based or a comprehensive cost-benefitanalysis.

3) Overall Profitability : A strict adherence to the rate of return criterion would lead to thechoice of a smaller investment proposal with a higher rate of return. In such a case, aproposal 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 ratherthan funds actually invested would be a better guide to investment policy. Such a criterioncan be evolved with the help of cost-benefit analysis.

4) Certain Uncertainty Vs. Uncertain Certainty : uncertainty is an important element incase of any business in the modern dynamic competitive world. But the investor wouldalways endeavour to minimize uncertainty. in this exercise he would come across acertain lucrative return whose occurrence ma be rendered uncertain due to the rapidity inthe changes of technology and /or changes in the market conditions. As against this,some projects would involve uncertainty which can be incorporated in the measureadopted, as disused earlier. This (latter) then becomes a case of certain uncertainty. Theinvestor therefore is faced with a choice between certain uncertainty and uncertain certainty.When guided by the cost-benefits analysis rather than by a leap in the dark(i.e. purelysubjective valuations), the investor would prefer an uncertainty which is certain i.e.,estimable.

5) Social Scale of Preferences : A private firm guided by its own private cost and benefit islikely to ignore the social scale of preferences involving social investments and socialurgencies. Such a neglect would accentuate the gap between the organized sector andthe unorganized sector in a dualistic developing economy. It is necessary to rememberthat the development of the economy presupposes the development of the entire societyand if no heed is paid to the needs of the deprived unorganized sector, it can act aslimping partner and thwart the pace of development. It is for this reason rather than forany other form of social obligation that the business sector has to care for social fall-outsof their activities. The cost benefit analysis is a measuring rod that can be used forrecognizing and incorporating the social scale of preferences into the appraisal of aninvestment proposal.


6) National Industrial Policy : Every country has its own set of economic policies includingthe industrial policy. In India we have the industrial policy announced by the governmentof India and modification changes in the same are announced from time to time. Besidesthe industrial policy, there are other policies like the import-export policy, the MRTPA &policies under the act, the monetory policy, the fiscal policy etc. which have a bearing onan industry's performance. While preparing the cost-benefit analysis, cognizance hasgot to be taken of the implications of these policies upon the costs as well as thebenefits accruing to the firm. Further in view of the fact that there is a divergence betweenprivate and social costs and benefits, the policies formulated by the government containcorrectives 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. Thisfact about the State policy as it effects the performance of industries justifies the costbenefits analysis.

7) Future Disposable value : The cost- benefit analysis is the right measure for decidingthe worth of an investment project and such an exercise is needed to be undertaken witha certain periodicity like a year or two years. This enables the firm to find out the currentworth of the project and also enables it to project the future worth over a period of time.Such a regularity of analyzing costs and benefits not only helps to review the performancebut also provides basis for acquisitions and mergers etc. which have become a familiarevent in the present context of liberalization. With intense global competition and highlydynamic changes taking place in the business world, no firm can rule out the possibilityof handing over or taking over or purchasing a share in investment of some other firm.Under such circumstances, a scrupulously carried out cost benefit analysis on acontinuing basis has become as important prerequisite.

8) Unforeseen Circumstances : in spite of all the efforts at a systematic planning of futuresteps and the incorporation of uncertainty in the investment analysis, contingencies andeventualities 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 onlydemand urgent steps and expenses to make good the losses but also a quick quantificationof such losses. For this purpose cost-benefit analysis can be of great help.

4. COST-BENEFIT ANALYSIS: PRIVATE AND SOCIAL :

We have noted earlier that economics and accounting concepts of costs are different. Wealso saw that the economic concept of opportunity cost is more relevant than the accountingconcept of total cost or individual resource cost. This is why, when we come to the distinctionf\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 hisanalogous to private cost- benefit analysis.


It was well-known Cambridge economist, Prof. A.C. Pigou, who discussed at length thedivergence between (what he called) Marginal Private Net Product and Marginal Social NetProduct (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 rightpedestal it deswerved, but also triggered off pioneering line of thinking in the area of private Vs.social accounting of resource allocation emerging through the market mechanism. Moderneconomists treat the social costs and benefits as externalities of private investment andproduction decisions. Prof. Samuelson, for instance, uses the terms Marginal Social Damage(MSP) and Marginal Private Damage MPD to denote social and private costs of externalitieslike pollution and goes further to clarify the divergence between the two and the costs ofabatement of damage involved for the private enterprise and the society as a whle and advocatespublic intervention for reconciling the two abatement costs.

Managerial economics, as a social science more concerned with the application of economicprinciples to management practices, relates this divergence to the cost-benefit analysis. Thefirm’s cost-benefit analysis would remain incomplete, and even irrelevant in the modern businessenvironment, if the social aspect of its operation is neglected. Its is therefore, necessary tounderstand the distinction between private and social cost-benefit analysis.

i) Private Vs. Social Goals : In a market economy, a firm in the private sector basicallyaims at maximization of money profits. Social goals, on the other hand, are different. Atthe level of the society as whole, the macro-economic objectives of economic stabilization,employment generation, reduction in the distribution of income, promotion of regionalbalance in course of economic development, economic development itself alleviation ofpoverty etc., are important. the 'divergence' noted above starts from the divergence,between objectives only. A firm is guided by its own private motives and endeavours tomake its own investment economically viable. But whatever the firm does may entailexternalities which may ne in the contravention of socially desirable goals. It is alsopossible that the pursuit of social objectives may go against personal or a private firm'sinterest. It is necessary to remember that the modern business management understandsthat, in its own long-term interest, a firm has to take cognizance of social obligations aswell. But individuals tend to limit their frame of reference to the present. Hence, arisesthe distinction between private and social valuations of costs and benefits.

ii) Partial Contradiction between Interests : The classical advocated of near-completeeconomic freedom believed that if every individual member of the society was allowedfreely 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 ofthe well-known dictum,' one man's food is another man' poison'. This is of course partiallytrue. What we have referred to as 'externalities' arise and lead to a conflict of interestswhich 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, emergenceof slums, traffic congestions, accidents, strain on civic amenities and several healthhazards. All these are social costs not included in any of the firm's account -books. Onthe other hand, when a private project involves construction of a swimming pool, a playfield, a garden etc. which are open to public, social exceeds private benefit. Plantationprogrammes undertaken for making one's own factory environment - friendly generatessocial benefits for which no social cost has been incurred.

The above examples clearly show that a private project may involve, alongwith privatecosts and benefits, certain social costs and benefits. Sometimes social costs exceedprivate costs; while at other times a private benefits would be less than social benefits.Therefore, we can say that there is a partial contradiction as between private and socialinterests. Private firms tend to be unmindful of both costs and benefits for the societyarising out of their pursuits of self-interest. One can not forget the Bhopal gas tragedyentailing social suffering for years on end; nor can we ignore the damage being done bythe factories at and around Agra to Taj Mahal. We must pay enough attention to thesocial costs and benefits involved, though they are difficult to measure.

iii) Valuation of costs and Benefits : A fundamental difference between the private and thesocial costs and benefits arises due to the problem of finding out the values involved. Sofar as the private costs and benefits are concerm\ned, they can be found out by takinginto account the prices received in case of benefits and the prices paid in case of costsincurred. However when it comes to comparison with social costs and benefits, theproblem of valuation arised due to the difficulties in quantifying the costs and benefits.What is the cost of sufferingd by the people due to pollution ? how to value the damageto the priceless heritage of Taj caused by all the industrial units in tis vicinity?

For overcoming this difficulty, one method suggested by experts for valuing social costsand benefits was to value these costs and benefits at the world prices; while a U.N.agency advsed to use shadow prices (i.e. resource costs) for the same purpose. Inrespect of the formar, the problem of valuation of items which are not traded remainsunresolved. Therefore, the World Bank, in 1975 suggested a synthesis of the twoapproaches. According to the World Bank 's approach, the tradeable items would bevalued at the corresponding world prices; and the non- tradeable ones at the shadowprices. In adopting both these methods foreign exchange earnings as well as expensesor uses of foreign exchange are valued at the shadow exchange rae(and not at the officialor market rate). Siumilarly, the labour cost, too, is computed at the shadow rate.Systematic methods for calculating shadow prices have been evoled in most of thedeveloping countries. In India, the planning commission has evoled sech methods andannounces the shadow exchange rates and shadow wage rates from time to time.


iv) Methods of valuation : In the valuation of costs and benefits, for finding out the presentvaluve, one has to use a discount rate. In the private cost-benefit analysis, the weightedaverage cost of capital for the project can be used for discounting. In respect of thesocial costs and benefits, our concern is to know the cost to the society. The government,on behalf of the society, undertakes social investmensts. Therefore, one cant trun to therates at which the government could have got the funds from international financialinstitutetions, the funds here would be the equivalent of those employed in a privateproject under review. This rate could be treated as the rate of discount for finding out thepresent cost of the private project to the society.

In case of the private cost-benefit analysis, in this way, private costs and benefits valuedat their respectivew market prices are taken into account. This can be done by usingvarious investment appraisal techniques, on he basis of the weighted average cost ofcapital as the discount rate. By this procedure, one can take the investment decision. Inthe social cost-benefit accounting, these two are vlued at the world or shadow prices andthen various measures of finding out the worth of investment can be adopted. Again, infinding out social benefits and costs, due attention is paid to the social objectives likeemployment generation, reduction of regional disparities etc. For example, if a project islocated in a backward region or provides employment to unskilled workers in largenumbers, then the social benefits of such a project are compounded to incorporatethese benefits. If a project, on the other hand, is producing goods which are luxuries orare likely to create health hazards, the social benefits would be discounted to incorporatethe undesirable effects on society

It is necessary to remember that the points of difference between the private and thesocial cost-benefits analysis relate to (a) the estimates of costs and benefits, and (b) thediscount or hurdle rates used. However, the techniques or methods of assessing theinvestment worth remain the same. in other words, in both these analysis, one can usethe Pay Back period method or the Internal Rate of Return Method or the Net PresentValue Method etc., for the purpose of judging the acceptability or otherwise of any projectand /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 ustake the example of pollution, as is done by Prof. Samuelsonm.He then proceeds toillustrate his point with the help of a diagram.

The figure to follow on the next page shows the divergence and suggests the correctionof such a divergence.


Figure Showing Divergence between Marginal, Private and Social Costs and it'sCorrection

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 producedby a factory. MPD (dotted line) shows the damage including the done; while the MSDline, which is higher, shows the total social damage including sufferings of the peopleliving around or passing by and inhaling polluted air. The MCA line shows the marginalcost of abatements, i.e. how much the firm will have to pay to reduce pollution per tonneof pollution for every increment of out put. Without any intervention by the pollutioncontrol authority, the firm will strike equilibrium at pint P where marginal private cost andmarginal private benefit would be balanced. It should be noted that at this equilibriumlevel of output of pollution, marginal private damage is QT but marginal social damage isQ

1S 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 thisstandard limit is crossed, the factory willhave to pay a penalty plus a pollution tax on acontinuing basis. As a result, the MPD line moves upward and ultimately the factor'sown MPD plus tax/penalty would make MPD= MSD, so that the gap between the twowould be bridged and the equilibrium level will correspond to the standard level of OQ2which might be judged as the safe limit of pollution.

5. Policies to Reconcile Private and Public Costs and Benefits :

AS we saw earlir, the private costs and benefits ae 'internal' to a firm and as externaldiseconomies or economies of the activites going on in the firm itself, they are countedby the firm. The social costs and benefits,however, are the external economies anddiseconomies resulting fro the firm's activities. they are therefore, known as 'externalites'.

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Pollution StandardInposed

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Pollution Quantity (per tonne)


As some exmples of the negative externalities. i.e. social costs, Prof. Samulson mentionsthe air and water pollution, risks from unsafe factories or nuclear power plsnts,dangerfrom drunken drivers or gargantuan trucks etc. these he calls negative economies. Aspositive externalities, he cities the examples of radical inventions, the radio or TV signalsthat we get free of charge or the benefits of widespread public health measures that haveeradicated epidemics such as small-pox, polio,typhoid, plague etc.

All these externalities are suggestive of a market failure or an inefficiency on the part offree markets."……… the general remedy for externalities", observes Prof. SAmulson,' isthat the externality must be somehow internalized". Interms of the diagram of divergencebetween private andsocial costs/benefits, we saw that when pollution standards areimposed, the MPD corresponds to the MSD because of the incentive to improve (or adisincentive to degenenrate).

Private Action providing Correctives: In most of the developing countries, an action onthat part of the government would be necessary in such cases. However, in advancedcountries, where the legal and judiciary systems are transparent, private approachesmay also succeed.

i) Negotiation: One such remedy is negotiation .If a factory is polluting the water orair of a locality, the local residents can use the company and place a claim focompensation. The time involved and the affected people and pay compensation tomotivate the company to negotiate with the afffectd eople and pay compensation tothe people. This corrective ,however, has three limitations: i) the negitiatiedcompensation would be less than warranted by the damage; ii) the loss o damagemust be indentifiable ; and iii) the number of firms as well as that of the affectedpeople must be limited.

ii) Liability Rules: where tha law clearly lays down reules regarding liability of theperson/s causing damage, the affected people can always take resourse to judicialintervention and demand compensation. The court may order a compensation whichwould fully (or partly) bridge the gap between MPD and MSD.

Government Action: A more effective solution to the problem of internalizing theseexternalities is an intervention by the government in the form of some action against thegeneration of social costs. Such action may be in terms of a direct control or financialpenalties.

i) It is observed that in most of the countries, governments rely on direct controls in tmatter of combating health and safety-related externalization including pollution. incases of firms or persons causing damage, the government orders to keep thedamage under specified limits which are judged to be safe. Such safe limits are


publicized and those who exceed these limits are penalized. The pollution undercontrol (PUC) certificate to be kept ready for examination by environment. in thediagram we have already seen how such a standard -setting works. The pertinentquestion however is does this solution work in practice? This brings us to thepractical problems and limitation standards involved in the imposition of these andsubsequent penalties.

These limitations are: i) for choosing a minimum standard, the government has toperform a cost-benefit analysis for which it must have full data regarding damageand abatement costs. Such a situation is almost impossibleto obtain. ii)strictlyspeaking the standard willl have to be zero, in which case the factory will ah veto becloe\sed down unless it invents and adopts a new pollution-free-technology. iii) Theenforcement of control is not effective enough. In fact, unless the penalty imposedexceeds the cost of removing the short-comings, the private firms/persons willnever reach the required standards. They may opt to pay the firm and continuedoing he damage because this is a cheaper option. iv) The enforcing officialsthemselves must be above suspicion, or else they could be bribed to ignore thedefault, v) 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 applicationof standards cannot work. Moreover, under such a system of rules, the big defaultersescape and the small ones penalty.

ii) Externality taxes : Another way suggested by economists is the imposition of anemission tax or an externality tax, in general. The rate of taxation will have to behigh enough to induce the firm to adhere to the standards rather then pay the tax.

This measure also suffers from certain limitation: i) though economists haveadvocated these taxes, in practice, very few governments have given them atrial,may be 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.ii)secondly, the taxmeasure should be economical, I,e, the cost of collection shouldbe reasonable,andshould be cartain, not fetch revenue to the treasury but to hit thetarget of bringing round these guilty of showering externalities on the society. Butthese considerations are unattractive to the politicians on whose initiative rests thetax-measure legislation. iii) finally, there is basic conflict of objectives whichstrenthensthe inaction referred to in the preceding limitation. The success of this tax measurelies in damage -control but this means the tax would notyield any revenue; and if itdoes, it would confirm its failure to control the dmage caused by the externalityconcerned.


6. COST BENEFITS ANALYSIS AND OVERALL RESOURCE ALLOCATION :

We saw that in a market economy where consumers and producers are enjoying maximumeconomic freedom, the role of the government as a producer gets limited. However, thegovernment is not supposed to simly watch what is happening in the economy as a whole.Infact, in a modern economy, the complexities of economic relations have increased so muchthat the government has to remain on its toes so that no undesirable set of actions is undertakenby any of the economic palyers. Therefore, after carefully outlining the objectives of such apolicy, the government has to plan macro-economic policy. The need for such a policy can bestated as follows:

i) Correctives fir shocks and disturbances: Inspite of the fact that the market mechanismfunctions automatically, the free enterprise system does not automatically adjust itselfto the variety of shocks and dusturnaces which are bound to appear in an open economy.for adjusting the economy to such shocks and abrrations, awell thought-out policy hasgot to be formulated.

ii) Speeding up the pace of the Economy: Every government has a set of well- definedand declared objectgives that the economy would be expected to attain but by itself theeconomy may taker a long time to attain these objectives. A macro-economic policy anda governmental intervention is needed to give a stimulus to forces declared objectives.Such an action/policy instrument becomes necessary when the economy is either goingto slow or it is going in the wrong direction.

iii) Weeding out Economic Evils: Unemployment, inflation, business fluctuations etc. arethe 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 typesof forces and to discourage or suppose the undesirable trends in the economy. In adynamic global modern economy, such situations are likely to occur from time to timeand they need to be corrected in time.

iv) Structural Changes in the Economy: The very dynamism of the economy makes itnecessary to adopt structural changes in the economy. However, there are severalobstacles and frictions in switching over to the new order. But the system demands thatthese changes must be brought about promptly and properly. The State is, therefore,called upon to intervene and take necessary legislative and regulatory measures forassisting the smooth change-over.

v) Fine Tuning of the Economy: The functioning of the economy, at any given time, couldbe going through deviations from the normal and competent course. Under suchcircumstances many of the economic operations might need a fine-tuning. This task canbe 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 ofmacro-economic policy which happens to be the responsibility of the government. Thisapproach has been found to be useful in handling the problems related to the welfareobjectives. However, welfare consideration follows the net wealth consideration. This isbecause thecost-benefit analysis is basically devised to maximize the net wealth i.e. tomaximize the difference between benefits and costs. Our objective would be to understandthe functioning of the cost-benefit analysis as such and then to find out qualifiacationswhich can be added to this analysis for applying it in the formulation of a macro economicpolicy aiming at maximizing social benefit.

With a view to understand the working of the cost-benefit principles, let us start byassuming that economic welfare as part of total community welfare can be maximizedby maximizing net wealth. A little elaboration, at this juncture, is perhaps necessary.Welfare is the resultant of a state contenment and fulfillment which itself is the result ofthe feeling of satisfaction. Since satisfaction is a state of mind,there is no way of quantifyingit. Moreever, satisfaction can result from many non-economic activities. Therefore totalwelfare of an individual or of the society comprises of various human activities which leadto welfare. Here, we are concerned with economic welfare whch is assumed to bemaximized by satisfying as many of human wants as possible. For satisfying wants weneed the production and/ or acquisition of economic goods and services. There are,however, various qualification to assumptions that maximization of net wealth maximizessocial benefit. In the first plcace, 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. Butwhen it comes to comforts and luxurious, the same can not be said .Secondly manyeconomic activities generate wealth but do not lead towelfare. Production and trading ofseveral commodities can be cited as an exmple of this type. Production of cigarettes,liquor or drug-trafficking are examples of this type. Thirdly, on the macro-level, a summationof maximum individual welfare does not automatically lead to maximum social welfare.This is because one man's food, as the saying goes, is another man's poison. Finally,dividing welfare parameters involve value judgements which may vary from society tosociety and from one set of objectives to another .

For acheiveing the maximization of net wealth, full utilization of all the resources isnecessary. Ths is because the addition to total level of wealth which we called net wealthis nothing but the net value of producers' and consumer's goods and services producedby the economy during a given period -usually one year. Maximum oyutput that can beproduced during a year issubject to the constraint of production possibility whichdemarcates the boundary or the frontier which cannot be crossed, given the amount ofavailable resources.See the following figure as an illustrsation. In this diagram, the curve


AB is the frontier which is known as the production possibility curve or the productionpossibility frontier. With the resources being given and limited, the limit AB can berached only by using the resources fullu. In this diagram, we assume that the economyhas an option of producing either commodity X(shown along the X-axis) or commodityY(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 thepoints on the curve AB or inside the curve AB. For example, point D indicates thepossible 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 thepoint E, would show themaximum possible amount of output with varying resources. As against this, point C inthe diagram indicates under utilization of resources. As against this, point C in thediagram indicates under utilization of resources, since the production has been stabilizedat point C when it is possible to move forward to any other point like D and E. It shouldtherefore be clear what we mean by full utilization of resources. It should also be clearthat the terms maximization of output or maximization of net wealth imply reaching anypoint on the production possibility frontier AB.

For maximization of output, we have to utilize fully all the resources available to us whichmeans discarding any position like the one shown by point C and trying to reach theboundary by aiming at any combination of X and Y of our choice. By doing this outputcan be maximized and employment (which means harnessing the productive resourcesfor producing a given level of output) can also be maximized. If we want to produce morethan what the production possibility curve demands, we shall have to reach a point which

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Figure showing Production Possibility Curve


would lie on another and outer production possibility curve which would lie beyond ABand away from the point of origin O. This would be possible only by raising the productivecapacity of the economy, either by finding out or mobilizing additional resources or byincreasing the productive efficiency of the existing resources. Such a shift in the productionpossibility curve indicates economic growth. For achieving economic growth we shallhave 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 variousadvantages which can be noted briefly as follows :

i) It aims at maximization of social welfare through maximization of net wealth, on theassumption that any move that increases net wealth can increase social benefitand, in turn, can increase social welfare.

ii) In following this principle, the problem of infinite target value does not arise. This isbecause, by assuming a definite correlation between wealth and economic welfare,the principle can suggest measures to maximise the difference between the totalbenefit and the total cost.

iii) By using this analysis we can show the measures necessary for attaining maximumnet wealth and optimal policy aiming at this goal.

iv) Even when a target is partially attained, the costs and benefits can be calculatedand whatever change has taken place in the net wealth can be ascertained at thatpoint of time.

v) The measurement of a trade - off between different targets is always a difficultproblem. In this case, the problem does not arise because the money value ofcosts and benefits associated with the achievement of alternative targets can beexplicitly 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 canbe incorporated in the total cost of the project.

vii) By adopting a suitable discounting method, the costs and benefits as arising indifferent periods of time in future can be estimated. The problem of assigning costsand 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 equilibriumframework. However economists like A. C. Harberger have shown that it can beapplied to the general equilibrium analysis as well.

ii) The exactness and usefulness of this analysis is limited by the fact that it is basedon the assumption that maximization of net wealth can ensure maximization ofsocial welfare. We have already seen that this is not so.

iii) The cost benefit analysis is applied on another assumption that the existing patternof distribution of income, distribution is given and has to be kept as it is. In fact, achange in income distribution does lead to a change in net wealth and further insocial welfare.

iv) Another limitation of the analysis is that it ignores the effect of diminishing marginalutility of additional wealth or income with every incremental dose of income orwealth being added to the existing total.

v) By assuming the positive correlation between wealth and welfare, the analysisassumes away all difficulties involved in the calculation of present and future costas well as private and social cost.

vi) Whatever applies to costs also applies to benefits i.e., calculation of present andfuture benefits as well as private and social benefits involves similar difficulties.

7. Overall Resource Allocation :

Market System or Market Economy (or Market Mechanism or Price Mechanism) comes intoexistence when custom gives place to competition and practically everyone begins to producegoods and services for the market with a view to make maximum profit out of the productionfor the market. Market System or Market Economy may be said to come into existence whenfreely fluctuating prices in the market begin to influence allocation of the community's resourcesand distribution of income and wealth produced in the community

During modern times we get what is called 'Market System' or 'Market Economy'. Increasingdivision of labour or specialization has been taking place in both developing and developedcountries. This means everyone is at present producing goods and services (including labourof various types) for the market. Everyone at present carries thousands of exchanges whichalone enable him to live comfortably. Market has become the pivotal point in modern capitalistand mixed economies. All prices have become closely interrelated and influence all otherprices. It is when market becomes the pivotal or central folcrum of the economy and influencesallocation of resources and distribution of income and wealth, we say that there has emerged''Market System' or 'Market Economy'.


Market mechanism or freely fluctuating price mechanism is another system of solving thebasic economic problem before the community:

In this system all the persons are supposed to enjoy personal freedom as consumers andproducers and are free to use their resources as they please without any legal or otherrestrictions or barriers.

Consumers, who are free to spend their income as they please, express their preferencesthrough prices. Thus if consumers begine to prefer TV sets than radio sets, prices of TV setswill go on rising more relatively to prices of radio sets. Under market mechanism, sinceproducers are free to use their resources as they like, and as they are motivated to makemaximum profit, they will divert their resources from production of radio sets to the productionof 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 act assignal to producers. They switch their resources, on the basis of price changes, to the productionof goods according to the changing preferences of consumers. This gives consumers whatthey prefer more. Naturally this results in maximization of welfare of the community everyonegetting what he wants. This also means that market mechanism brings about most efficientuse of the community's resources.

Shift of resources from production of radio sets to production of TV sets will go on until moreTV sets in the market and relatively less radio sets there will bring down the prices of TV setsand raise the prices of radio sets as there are fewer radio sets available, to a level whereprofits 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 manycommodities and services. Thus market or price mechanism is supposed to help solve thebasic economic problem - how to make the most efficient use of community's resources andhow to derive the maximum satisfaction from the community's resources.

Assumption of Market (or Price) Mechanism

There are certain assumptions on which operation of the market (or price) mechanism isbased. The important assumptions are as follows:

i. Each consumer knows what is in his best interest and acts rationally to secure maximumsatisfaction.

ii. There is perfect competition in the market - competition among consumers and amongproducers, each consumer and producer knowing fully well what is taking place in themarket and hoe prices are moving.


iii. Different factors of production have perfect mobility and they can move easily and quicklyfrom one industry to any other in search of higher profits.

Criticism of Market or Price mechanism

But in actual life market or price mechanism does not operate as smoothly and efficiently asdescribed in the above model. This is because the above assumptions are not always andfully valid and do not obtain in real world. Thus consumers do not always know what is in theirbest interest and do not always act rationally. The competition among consumers and producersassumed in the above model is often absent. There is also not full knowledge among consumersand producers about market conditions and happenings. Absence of competition often givesrise to monopoly which can prevent entry of outside units in its line of production and manipulateprices 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 onlycertain goods and not other goods though the prices of the latter may rise. Different factors ofproduction even if there is competition will find it difficult to move from industry to industry insearch of higher profits as depicted in the above model.

8. 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 thebest judge of his personal interest. Every individual knows what is in his interest and noone does that well than himself. Every individual should therefore be left free to carry onhis economic activities as a consumer and as a producer and so on without beingdictated 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 hiscomplete freedom to spend his income as he likes is sovereign as a consumer dictatingto producer what goods he prefers and therefore should be produced. This means themarket system of economy is characterized by consumer's sovereignty.

iii. Freely Fluctuating Price Mechanism :

The sovereign consumers express their demands and preferences through freely operatingprices or through price mechanism. Freely operating price mechanism thus acts as asignaling system indicating to various producers ,consumers' preferences - that theyprefer 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 withconsumers' preferences.

iv. Private Enterprise :

In the market system in economy, most of the goods and services are produced byindividual producers or groups of individual producers. That is why the market system isalso known as private enterprise economy. The government has no role to play as aproducer of goods and services except to a very limited extent where private enterprisemay not be interested.

v. Private Profit Motive :

In the market system of economy most of the goods and services are produced by individualproducers who enjoy perfect freedom as producers without being dictated in this regard byanyone else including the government. The chief or major foundation of the market systemor private enterprise economic system is that among all motives to human activities, privateprofit motive (i.e self-interest) is the most powerful motive which will bring out the best effortby every individual. And therefore under this system all production is carried on by individualproducers 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 privateproperty (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 othertangible and intangible goods).

vii. Existence of Competition :

Open and free competition among consumers and producers may be said to be the verysoul of the market system of economy. In this system consumers compete amongthemselves for goods and services in the market by offering competitive prices to getthem, and producers compete among themselves for getting factors of production toproduce 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 individualis free to strive to maximize his personal satisfaction of which he is the best judge, itfollows that when all individuals attain maximum satisfaction of their own, communitymade up of those individuals would automatically attend the maximum satisfaction orwelfare. 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 personalprofit can automatically ensure maximum welfare, not only of himself but also that of thecommunity, and if there is no clash between interest of an individual and welfare of thecommunity, and no clash of interest between welfare of consumers and that of producers,if freely functioning price-mechanism with its competitive system can automatically ensuremaximum welfare of the consumers and most in the State or government trying to interferein the economic activities of the people telling to do this and not to do that and so on.People should 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.


Exercise :

1. Explain fully the distinction between Public goods and Private goods.

2. Give an idea about government investment in the context of Indian economy.

3. Explain with illustration, how resource allocation and income distribution takes place ina free enterprise economy.

4. What are the foundations of Market Economy?

5. Compare and Contrast Private and Social Cost-Benefit.


NOTES

Macro Economic Analysis 285

Chapter 8

MACRO ECONOMIC ANALYSIS

Preview

Macro Economics - The Keynesian Macro Economic Theory - Income determination,Consumption and Investment Function; Business Fluctuations, Inflation - Macro Polices ofFull Employment, Economic Stabilization.

MICRO ECONOMICS

INTRODUCTION

Macro-economics is the study of the aggregate behaviour of the economy as a whole. It isconcerned 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 thelarge'; it concerns the overall dimensions of economic life."

In short, macro-economics deals with the major economic issues, problems and policies ofthe present times.

Macro-economics deals with the major economic issues, problems and policies of the presenttimes.

National income, money, total investment, savings, unemployment, inflation, balance ofpayments, exchange rates, etc. Are the crucial economic aggregates.

In macro-economic analysis the behaviour of economic agents such as firms, house-holdsand government is seen in total, disregarding details at the particular level - i.e., micro level.

An individual consumer, particular market for a given commodity, operation of a firm, etc arethe subject matter of Micro economics. Macro-economics deals with the market for all goodsas 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, financialmarket is taken as a whole which covers money market, capital market and all banking andnon-banking institutions taken together.

Prior to Keynesian revolution in economic thinking in the 1930s, the classical economists hadconcentrated more on micro-economic approach and macro behaviour was also described asmere summation of individual observations. Prof. J. M. Keynes in 1936 published The GeneralTheory of Employment, Interest and Money which revolutionized the whole economicthinking. He suggested that macro economic behaviour should be studied separately. Behaviourin total is quite different then what we may try to infer by summation of individual behaviour. Hesaid that, for instance, saving is a private virtue but it is a public vice in a matured economycause deficiency of demand leading to depression.

Keynes prescribed macro-economics as a policy - oriented science to deal with the problemslike unemployment, inflation etc.

Economics of Keynes serves as the foundation centre for the modern economics.

It follows that the scope of macro-economics is confined with the behaviour of the economy intotal. It does not examine individual behaviour. It relates to the economy-wide total or aggregatesand 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.

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 ingeneral: Using macro - economic tools and technique of economic analysis one canunderstand the working of the economic system in a better way.

2) Empirical Evidences : Macro - studies are based on empirical evidences of the theoreticalissues. Macro - economics is more realistic.

3) Policy - orientation : Macro - economics is a policy - oriented science. It suggests abest of policy measures, such as fiscal policy, monetary policy, income policy, etc. todeal 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 ofnational income data. With the help of national income statistics and accounting onecan understand and evaluate the growth performance of an economy over a period oftime.


5) Income and Employment Theory and Monetary Theory: Economics of employmentand income and monetary economics are the major fields of macro - economics whichhave utmost practical relevance. Planning and policy making is not possible without thebase of the understanding of these two fields.

6) Dynamic Science: Macro - economics is a dynamic science. It studies and suggestssolutions to the issues and problems from the dynamic view point. It allows for changes.One can have a better idea of a dynamic perspective in the real economic would in thelight of macro - economic tools and mode of its general equilibrium analysis.

The Keynesian Macro Economic Theory :

INTRODUCTION:

In his book, The General Theory of Employment, Interest and Money (popularly known as 'TheGeneral Theory'), published in 1936, Prof. J. M. Keynes rejected the classical dogma of full -employment equilibrium by invalidating Say's Law of markets. He, thus, propounded a macro-economic theory of income and employment that highlighted the real nature of the determinantsof income in a modern economy.

In contrast to the classical theory, the Keynesian theory is demand-oriented. It stresseseffective demand as a crucial factor in determining the level of income and employment.

Macro-economic Analysis:

The economic analysis by Keynes is a macro-economic analysis. In macro-economic analysis,the functioning of economic system is viewed as a whole or in an aggregate sense. This is incontrast to the classical micro-economic approach, which dealt with the segregated behaviourof individual economic entities (such as a particular consumer's demand behaviour, a particularfirm's production behaviour, etc. in the system). The basic concepts underlying the Keynesiantheory are interpreted in aggregative terms only. Thus, in his General Theory, we come acrossconcepts like aggregate demand and aggregate supply, 'consumption' implying totalconsumption of the community, 'income' for national income, 'employment' for total employment;'output' meant aggregate national output, 'saving' implied total savings in the economy; andthe term 'investment' connoting aggregate real investment. As such, the economics of Keynesis also referred to as 'Aggregative Economics'.

Short - Period Analysis:

Keynes realistically adopts the short-term variables. He believed in the short-run philosophyof life. To him, 'in the long run, we are all dead'. Thus, Keynes presumed an economic modelas a short-period model in his analysis.

Since it deals primarily with short-term phenomena in economic life, many of the strategicvariables in the Keynesian theory, like consumption function, interest rates etc. are assumedto be constant, as they would change very little in the short period.


Again, on account of his short-period analysis of the problem, Keynes treated national incomeas Gross National Product (GNP), rather than Net National Product (NNP). Because he feltthat in the short period, repairs, replacement etc. have no significant relevance; so depreciationallowances, etc. are to be considered only in the long-run analysis. So, GNP is appropriatelyused for measuring the community's total income during the short run.

Generality of Approach:

Keynes' theory is general. Its approach and analysis are general. It is general in the sensethat it is not time - bound. Keynesian tools of analysis are applicable at any point of time, inany economy.

Again, Keynesian, analysis being macro-economic, it contains generality in approach. It takesa general view of the economic system as a whole.

Keynes argued that the postulates of the classical theory are applicable to a special case offull employment only and not to general cases. He criticized classical economists for theirunrealistic assumption of full employment equilibrium condition in their economic models. Heobserved that there is always less than full employment in the economy; full employment isonly a rare phenomenon. He claimed his theory to be general in the sense that it deals with alllevels of employment and in all cases. It applied equally well to economies with less than fullemployment, under - employment or full employment. Thus, its generality implies its universalapplicability.

The Principle of Effective Demand :

The gist of Keynesian analysis of income determination lies in the principle of effective demand.Keynes pointed out that the level of income and output in an economy is determined by thelevel of employment (i.e. the employment of workers along with the exploitation of other givenresources such as land, capital, etc.) Which, in turn, is determined by the level of effectivedemand.

In a money economy, effective demand is revealed by the total expenditure incurred by thepeople on real goods and services, meant for consumption as well as investment. The flow ofexpenditure, in turn, determines the flow of income, as one man's expenditure becomesanother man's income in the economic system. It thus follows that Total Expenditure = TotalIncome.

As the flow of expenditure varies, the level of income also varies accordingly. That is to say, ifthe total expenditure flow in an economy increases, the flow of income will also increase inthe same proportion. And, if the aggregate expenditure flow decreases, income flow alsodecreases likewise.


In real terms, the expenditure flow in the community consists of consumption expenditure andinvestment expenditure, expressing the total demand for consumption goods and capital goods.Effective demand, thus, represents the total expenditure on the total output produced, at anyequilibrium level of employment. It thus denotes the value of total output of the community,which is described as national income. Obviously, national income equals national expenditure.And, as total output comprises consumption goods and capital or investment goods, so thenational expenditure consists of expenditure on consumption goods plus investment goods.

In short, there are two basic determinants of effective demand in an economy. These areconsumption and investment. The level of effective demand determines the level of employmentwhich, in turn, determines the level of output and income in the economy. It follows, thus, thatthe level of employment is fundamentally determined by consumption and investment.

Since Keynes sought to explain the point of effective demand in a capitalist economy, freefrom government intervention, he considered consumption and investment expenditure of thecommunity relating to private individuals and enterprises only. But, in modern times, a capitalisteconomy is actually a mixed economy due to that, government expenditure is also a significantdeterminant of effective demand in a modern economy.

Modern economists, therefore, define effective demand as:

Effective demand = C + I + G,

Where,

C = Consumption expenditure of the households.

I = Investment expenditure of private firms.

G = Government's expenditure on consumption and investment goods.

It must, however, be noted that government expenditure is autonomous. Thus, it is the outcomeof government's value judgment and policies, based on political and social considerationsrather than economic forces.

Following Keynes, we shall, however, restrict our analysis to the consumption and investment,elements of effective demand relating to the private sector only. If must be borne in mind thatthe investment and employment activities in the private sector are induced and not autonomous,as in the case of public sector.

Again, from the Keynesian dictum that the level of employment and income depends on thelevel of effective demand in an economy, it also follows that the lack of effective demandimplies unemployment and corresponding poverty, or low level of income. As such, to easethe unemployment problem, and to raise the level of income and economic prosperity, thelevel of effective demand has to be raised. Income and employment, thus, increase only whenthe total demand either from consumption side or from the investment side increases.


Analysis of The level of Effective Demand (Factors Determining Effective Demand) :

Since the level of activity in an economy is a matter of demand and supply, using technicalterminology, Keynes stated that effective demand is determined by the interaction of theaggregate supply function and the aggregate demand function. That is to say, the volume ofemployment in an economy is determined by the entrepreneur's considerations of the aggregatedemand price and the aggregate supply price at that particular level of employment. Pricehere means the amount of money received from the sale of output, i.e. sales proceeds.

Aggregate Supply Function (ASF):

The "supply price" for any given quantity of commodity refers to that price at which the selleris willing to or induced to supply that amount in the market. Hence, the supply schedule ofthat commodity shows the varying level of quantities of the commodity the seller offers for saleat alternative prices. Similarly, the aggregate supply schedule for the economy as a wholerefers to the response of all entrepreneurs in supplying the whole of the output of the economy.Keynes measured the whole of output of the economy in terms of the amount of laboouremployed with a given marginal productivity. He, thus, said that the level of output varies withthe level of employment, obviously, each level of employment results in a certain level ofoutput of commodities, i.e. real income along with the money income generated in the processof investment expenditure.

Each level of employment (of labour) necessitates certain quantities of the other factors ofproduction like land, capital, raw materials, etc., to assist the labour employed. All thesefactors of production are to be paid according to the prevailing factor prices, which are knownas cost of production. Thus, each level of employment would involve certain money costs(including profits). Every prudent entrepreneur must at least seek to recover the total cost ofproduction, including normal profit. Thus, the entrepreneur must get some minimum amountof sales revenue to cover the total costs incurred at a given level of employment. Only if thesales proceeds are high enough to cover the total costs of production at a given level ofemployment and output, the entrepreneur will be induced to provide that particular level ofemployment.

This minimum price of revenue proceeds that the entrepreneurs must get from thesale of output, associated with different levels of employment, is defined as, "aggregatesupply price schedule" or "aggregate supply function". Thus, the aggregate supplyfunction refers to a schedule of the various minimum amounts of proceeds or revenueswhich must be expected to be received by the entrepreneur class from the sale ofoutput resulting at various levels of employment.

According to Keynes, using employment as a single measure of total output of the economy,the supply price of employment can be determined in terms of labour cost. We may illustratethe Keynesian aggregate supply function hypothetically as in following Table :


The Aggregate Supply Function

Level of employment Money wages Aggregate Supply Price (ASF)(in lakhs of workers) (per annum in 1,000) (in crores of Rs.)

(N) (W) (N x W)

1 10 100

2 10 200

3 10 300

4 10 400

5 10 500

6 10 600

In the table it is assumed that money wages, on an average to be paid per year, is. Rs.10,000.Thus, the schedule shows for each alternative level of employment how much minimum salesproceeds must be raised by the entrepreneurial class to undertake to level of employment. Itcan be seen that to employ one lakh workers during the year, entrepreneurs should expect toget a minimum of Rs.100 crores from the economy by selling the resulting output. Similarly,for two lakh workers to be employed, the minimum expectation of sales proceeds is Rs.200crores, and so on.

Graphical Presentation : The numerical schedule of aggregate supply price of employmentmay be plotted graphically and the cruve so derived is called ASF curve. Following figureillustrates the ASF curve drawn by the graphical representation of data contained in previoustable.

Min

imu

m R

ec

eip

ts/I

nc

om

e

Employment (N) (In lakhs of workers)

ASF

Q

Y

Rs.crores


In the figure, the X - axis represents the level of employment and the Y - axis measures theexpected minimum sales proceeds. The curve ASF represents the aggregate supply function.It is linear, because we have assumed a constant wage rate. But, if the wage rate is changing(increasing) or costs of employment are rising with an increase in employment, the ASF curvewill be non-linear and upward sloping. Indeed the aggregate supply price is correlative with theemployment level, in any case. However, the aggregate supply function - ASF curve - willbecome perfectly inelastic at a point where the economy is at a full employment level. Thus,at the full employment level, the aggregate supply function will be a vertical straight line.Suppose, in our illustration, the economy reaches full employment when all its 6 lakh workersare employed, then the ASF curve will become vertical at point Z as shown in the figure. Thatmeans, the level of employment cannot exceed Q level (i.e.600 in our example), whatever theexpectations of minimum sales proceeds. It is interesting to note that modern economistsmeasure the aggregate supply function in terms of real income or value of total output bymeasuring GNP rather than the level of employment as Keynes did.

The Shape of ASF Curve :

As has been seen in previous figure, the ASF curve is an upward sloping curve, but it is notvery easy to conclude about its shape. To determine the shape of the curve ASF, the relationshipbetween employment (N) and marginal productivity should be traced. The value of marginalproduct (VMP) is called marginal productivity which is obtained by multiplying the marginalphysical product (MP) of labour with price of output (P). In a technical sense, thus, ASF isobtained by aggregating the expected total revenue functions of all the firms. The actualshape of the ASF curve, however, will be determined by the aggregate production functions ofall firms in the economy and money wages.

Apparently, the linear ASF curve, assumed in previous figure, is a much simplified case. It isbased on the assumption that : (i) the money price of all outputs and inputs is constant, and(ii) when prices are constant, the community's total outlay (national expenditure) which ismeasured at these constant prices and the level of employment and income, change in thesame proportion. This means that if the total money expenditure is doubled, employment andincome will also double and vice versa. In reality, however, such proportionate relationship israrely found. Thus, the actual ASF curve which relates to changes in prices of all outputs andinputs, cannot be linear. The linear ASF curve was assumed by Keynes for the sake ofsimplicity in analysis. Again, the steepness of the ASF curve depends on the technicalproduction conditions. It depends on the productivity of labour, capital and other resourcesemployed by the economy.

Aggregate Demand Function (ADF) :

In the Keynesian terminology, the aggregate demand function refers to the scheduleof maximum sales proceeds which the entrepreneurial community actually doesexpect to be received from the sale of different quantities of output, resulting at


various levels of employment. Thus, the quantum of maximum sales revenue expectedfrom the output produced is described as the demand price of a particular level ofemployment. There is a positive correlation between the level of employment andthe demand price, i.e. expected sales receipts.

Thus, with an increase in the level of employment, the aggregate demand price tends to rise,and vice versa. The aggregate demand price - the maximum sales proceeds expected for agiven level of output - depends upon the total expenditure flow of the economy, which isdetermined by the spending decisions of the community as a whole. In a free capitalist economy,households and firms are the two major economic sectors which spend on consumption andinvestment. Now, what these sectors are expected to spend in the next period is viewed asthe aggregate demand price, the expectation of sales revenue, for the given level of output andemployment by the entrepreneurs.

A much simplified presentation of aggregate demand function may be illustrated through thefollowing hypothetical table.

The Aggregate Demand Function (Schedule)

Level of Employment Expected minimum sales proceeds(N) (expected Total Expenditure ADF)

(in lakhs of workers) (in crores of Rs.)

1 175

2 250

3 325

4 400

5 475

6 550

The aggregate demand schedule links real income or output (which Keynes measured interms of the quantity of employment) and spending decisions, thus, the expenditure flow inthe economy as a whole. Evidently, the aggregate demand schedule shows the aggregatedemand price for each possible level of employment.

The aggregate demand function may be represented graphically as in following figure.

In following figure, the curve ADF represents the aggregate demand schedule. It shows thatthe aggregate demand price is the direct or increasing function of the volume of employment.


The ADF curve drawn in the above figure is linear. It can be non-linear, too. Its shape and slopedepend on the assumptions and nature of data related to the aggregate demand schedule.For the sake of simplicity, we shall, however, consider linear functions only. Thus, it may berecalled that the statement showing the varying levels of aggregate demand prices,i.e. expected sales revenue by the entrepreneur for the output associated with differentlevels of employment, is called the aggregate demand price schedule or the aggregatedemand function.

Equilibrium Level of Employment - The Point of Effective Demand :

The intersection of the aggregate demand function with the aggregate supply function determinesthe level of income and employment. The aggregate supply schedule represents costs involvedat each possible level of employment. The aggregate demand schedule represents theexpectation of maximum receipts of the entrepreneurs at each possible level of employment.It, thus follows that so long as receipts exceed costs, the level of employment will go onincreasing. The process will continue till receipts become equal to cost. Needless to say,when costs exceed receipts, the employment level will tend to decrease. This is what we canobserve by comparing the two functions as represented in the following table.

Max

imu

m E

xpec

ted

Rec

eip

ts(A

nti

cip

ated

To

tal

Exp

end

itu

re)

Volume of Employment (In lakhs)

ADF = f (N)


The Equilibrium Level of Employment

Employment Aggregate Aggregate Comparison Direction of

(in lakhs of Supply Function Demand Function change in

workers) (in crores of Rs.) (in crores of Rs.) employment

(N) (ADF) (ADF) (DN)

1 100 175 ADF > ASF Increase2 200 250 ADF > ASF Increase3 300 325 ADF > ASF Increase4 400 400 AD = AS Equilibrium5 500 475 ADF < ASF Decrease6 600 550 ADF < ASF Decrease

So long as the aggregate demand price (ADF is greater than the aggregate supply price(ASF), the level of employment tends to increase. The economy reaches equilibrium level ofemployment when the aggregate demand function becomes equal to the aggregate supplyfunction. At this point, the amount of sales proceeds which entrepreneurs expect to receive isequal to what they must receive in order to just appropriate their total costs. In the givenschedule above, it is Rs.400 crores which is the entrepreneur's expected minimum as well asmaximum sales proceeds, so that 4 lakh workers' employment is the equilibrium amount.This is the point of effective demand.

In graphical terms, the point of effective demand and equilibrium of the economy can berepresented in the following figure.

Following figure has two panels. Panel (A) depicts linear AD and AS curve. Panel (B showsnon-linear AD and AS curves. We have preferred linear curves for the sake of simplicity ofanalysis, though non-linear curves are more realistic.

ADF

&

ASF

Effective Demand

(A) (B)

X

Y Y

ADF

&

ASF

O N1 N Nf

Z

Ea

b

R

X OVolume of Employment (N) Volume of Employment

N

E

ASF

ADF

ASF

ADF


In the Figure (A), on the previous page the two curves ADF and ASF intersect at point E,which is called the point of effective demand. In fact, the value OR, i.e. the sales proceedswhich entrepreneurs expect to receive at the point of aggregate demand function where it isintersected by the aggregate supply function, is called the effective demand because it is atthis point that the entrepreneurs' expectation of profits will be maximized. Thus, when theaggregate demand prices are equal to the aggregate supply prices, the entrepreneurs wouldearn the highest normal profits as their sales proceeds equal their total costs at this point. itgoes without saying that so long as the aggregate demand function lies above the aggregatesupply function, i.e. ADF > ASF, indicating that costs remain less than the revenue, theentrepreneurs would be induced to provide increasing employment till both of them are equalized.But after the point of intersection of the aggregate demand function and the aggregate supplyfunction, for a further rise in employment, the aggregate supply prices become higher thanaggregate demand price, i.e. ASF > ADF, indicating that total costs exceed total revenueexpected, so that entrepreneurs would incur losses and refuse to employ that particular numberof workers. Diagrammatically, thus, actually only ON number of men will be employed wherethe aggregate demand function (ADF) equals the aggregate supply function (ASF). ON1 numberof workers will provide some possibility of maximising profits by increasing the employmentfurther, since ADF > ASF by ab, whereas, any number of men exceeding ON cannot beemployed, because then ASF would exceed ADF, implying losses to the entrepreneurs. it isonly at point E where ADF = ASF and the normal profit is maximum that the equilibrium levelof employment is ON. Thus, it may be concluded that employment in an economy will increasetill ADF = ASF.

Thus, point E, the point of effective demand, is called the point of equilibrium which determinesthe actual level of employment and output. It should be noted that though E is the point ofequilibrium, it does not imply that the economy is necessarily having full employment at thisequilibrium point. According to Keynes, the equilibrium between the aggregate demandfunction and the aggregate supply function can, and often does, take place at a pointless than full employment. To him, ADF = ASF at full employment level, only if theinvestment spending is appropriately adequate to fill the gap emerging betweenincome and consumption in relation to full employment. But, this is scarcely found inpractice. Usually, the investment outlay is insufficient to fill the gap between incomeand consumption, hence ADF = ASF at less than full employment. This is how Keynesexplains the points of under - employment equilibrium in a real economy.

Of these two determinants of the level of effective demand, Keynes' effective demand, however,assumes the aggregated supply function as given in the short run. Thus, he speaks littleabout the aggregate supply function.

Keynes did not make a detailed study of the ASF, firstly, because he assumed a staticmacro-economic model of the economy, which ruled out the possibility of t5echnological andother changes of a dynamic nature and, secondly, he was concerned with the short periodanalysis during which prevailing conditions are unlikely to change. Especially, changes in


technical conditions and technological advancement can occur only in the long period. He,therefore, assumed a given ASF curve for the economy, simply ignoring it in the further analysisof income - employment determinants. Stonier and Hague observe that another importantreason why Keynes did not pay much attention to the analysis of ASF is that he was mainlyconcerned with solving the problem of unemployment caused by the cyclical phase of theGreat Depression in the mid-thirties. In view of the mounting unemployment, it was unnecessaryfor him, to examine the problem of optimum use of the given resources. His main task was toshow hot to use the given unutilised resources and create more employment and income.Again, he felt that the problem of ASF and especially the optimum use of the given resources,was adequately dealt with by the classical (and neo-classical) economists in developing themarginal productivity theory of distribution. But, it was aggregate demand which was notadequately analysed, and rather neglected, in the past, Keynes, thus, concentrated on theanalysis of aggregate demand function.

Since the aggregate supply function is assumed as given, the essence of Keynes' theory ofemployment and income is found in his analysis of the aggregate demand function. that iswhy his theory is sometimes regarded as a theory of aggregate demand. the aggregate demandschedule is a vital factor in his employment theory, for only if aggregate demand is largeenough will all resources be used, with any given aggregate supply function. The aggregatedemand schedule shows how much money the community is expected to spend on theproducts resulting a t various levels of employment. Thus, the Keynesian economics mayalso be called the economics of spending.

In the equilibrium model, ADF is known by the sum total of expenditure of all the buyers in theeconomy. It represents money expenditure of all buyers on domestically produced goods tothe level of aggregate employment. In fact, ADF is the schedule which indicates the alternativeexpenditure totals in relation to alternative levels of employment in the economy. The volumeof total expenditure, as given by the ADF, where it is intersected by the ASF, is described as"effective demand". Effective demand is the point where the actual total expenditure of thecommunity equals the aggregate required sales receipts and their expectations by theentrepreneurial class as a sales receipts and their expectations by the entrepreneurial classas a whole. That is to say, the level of effective demand represents an equilibrium level ofexpenditure at which entrepreneurial expectations are just being realised, so that the amountof labour hired and investment incurred in the economy are unlikely to vary at this point.Apparently, the aggregate demand function signifies a functional relationship between totalexpenditure and total income of the community. It must be noted that this relationship betweenexpenditure and income traced in the Keynesian model is behavioural.

In short, Kenyes' theory stated that, in the short run, the equilibrium level of employment isdetermined by the actual level of aggregate demand with a given aggregate supply function.The greater the aggregate demand is at the point where it is equal to aggregate supply, thehigher will the employment be; thus, it is the aggregate demand function which becomes"effective" in determining the level of employment. This implies that in order to raise the level


In the above figure, curve ADF1 (representing the aggregate demand function) indicates anemployment level up to ON1 at point E1 of the effective demand. While curve ADF2 is at ahigher level and shows a higher level of employment ON2 at point E2 of effective demand.Thus, the diagram reveals the point that a higher aggregate demand function leads to a higherlevel of employment.

In short, the point of effective demand at which the aggregate demand function intersects theaggregate supply function is the point of macro-economic equilibrium.

Indeed, effective demand equals the total expenditure on consumer goods plus investmentgoods. It can be said that the level of employment which depends on effective demand alsodepends on the volume of consumption expenditure. Thus, consumption and investment arethe main determinants of effective demand, and in turn the level of employment and income.

Introduction to Consumption Function and Investment Function :

According to Keynes, the aggregate demand function - the "effective" element of effectivedemand - depends on two factors : (i) the consumption function (or the propensity to consume),and (ii) the investment function (or the inducement to invest). This consideration is based onthe fact that effective demand is the sum of expenditure on consumption on investment in acommunity. It implies that if consumption is constant and investment is increases, employmentwill increase. Similarly, if investment is constant and consumption increases, employmentwill increase. Increase or decrease in both consumption and investment will cause an increaseor decrease in the levels of employment respectively. Thus, the fundamental idea of the

of employment in any economy, it requires an increase in the effective demand by raising thelevel of aggregate demand. In graphical terms, the higher the aggregate demand functioncurve, with a given aggregate supply function schedule, the higher will be the level ofemployment;following figure illustrates this point.

Re

ce

ipts

/In

co

me

Level of Employment

ASF

ADF2

ADF1

E2

E1

N1N2

R1

R2

Y

OX


Keynesian economics is that an increased level of employment can only be achieved andmaintained by an increased level of expenditure on either consumption or investment or both.

In short, effective demand which determines the level of employment in an economy isdetermined by the size of aggregate demand expenditure or the aggregate demand function,which is composed of consumption and investment functions.

Consumption Function :

The consumption appears to be a significant factor, determining the level of effective demand inan economy. Consumption function, or the propensity to consume, denotes the consumptiondemand in the aggregate demand of the community, which depends on the size of income andthe share that is spent on consumption goods. The propensity to consume is schedule showingthe various amounts of consumption corresponding to different levels of income. Thus, byconsumption function, we mean a schedule of functional relationship, indicating how consumptionreacts 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 states that the propensity to consume is relatively stable in the shortrun and, therefore, the amount of community's consumption varies in a regular mannerwith aggregate income. Since consumption increases less than income, there is always awidening gap between income and consumption as income expands. Keynes, thus, arguedthat in order to sustain the level of income and employment in the economy, investment demandshould be increased because consumption demand is relatively a stable component of theaggregate "effective demand". Thus, the crucial factor in employment - income theory is theinvestment function.

Investment Function :

Investment Function or the inducement to invest is the second but crucial factor of effectivedemand. Effective demand for investment or the investment demand function is more complexand more unstable than the consumption function. According to Keynes, by investment ismeant only real investment, denoting an addition to real capital assets as well as theaccumulated wealth of the society.

The volume of investment in an economy depends on the inducement to invest on the part ofthe business community. But the induce expectations about the profitability of business.Thus, according to the Keynesian theory, inducement to invest is determined by the businesscommunity's estimates of the profitability of investment in relation to the rate of interest onmoney for investment. The estimates or the expectations of profitability of new investment bythe entrepreneurs are technically termed as the Marginal Efficiency of Capital.

Thus, there are two factors determining the investment functions, namely, (i) themarginal efficiency of capital and (ii) the rate of interest. Accordingly, when the marginalefficiency 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 combine to influence the rate ofinvestment in an economy.

Keynes defined marginal efficiency of capital as the highest rate of return over costexpected form producing an additional (or marginal) unit of a special asset. Themarginal 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 thereplacement cost of that asset. The marginal efficiency of capital is estimated to be greaterif 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 definitequantity, while the prospective yield is a very indefinite factor as it relates to future, which ishighly uncertain. Nevertheless, entrepreneurs do make their own estimates on the marginalefficiency 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 theshort 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 ofinterest. Thus, the rate of interest is the second important determinant of the investmentfunction. The rate of interest, according to Keynes, depends upon two factors : (i) theliquidity 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 theprice of borrowing money, i.e. the rate of interest. Thus, the liquidity preference functiondetermines the demand for money. It denotes the desire of the people to hold money or cashbalance as the most liquid assets.

According to Keynes there are three different motives for holding cash for liquiditypreference : (i) the transactions motive, (ii) the precautionary motive, and (iii) the speculativemotive. Thus, the total demand for money is the aggregate demand for each under the threemotives. Keynes, thus, formulates his own theory of interest called "liquidity preference theoryof interest". He stated that liquidity preference is an important factor affecting the rate ofinterest. To him, the other factor, namely, the money supply, is not very significant in the shortrun, because it does not change all of a sudden and it is relatively a stable phenomenon. It isthe liquidity preference function which is a highly fluctuating phenomenon, specially due tothe speculative motive. Thus, assuming money supply to be constant, the rate of interest canbe 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 therate of interest.

Keynes, however, regarded that the rate of interest is relatively a stable factor in the short run,and does not change violently. Thus, it follows that the investment function is largely influencedby 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 significantfactor determining the inducement to invest. In fact, as Keynes believed, fluctuations in themarginal efficiency of capital are the fundamental cause of trade cycles and income fluctuationsin a capital economy.

It is to be noted here that we have so far considered consumption and investment expenditureof the community relating to private individuals and enterprises only, because the originalKeynesian Theory of Employment has considered consumption and investment expenditureonly, and does not take government expenditures into account. But, modern economists givedue recognition to government expenditure as an important factor of effective demand. Intoday’s world, government expenditure is day be day increasing, and it cannot be ignored inestimating 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 onthe policies of the existing government which are largely influenced by political and socialrather than economic factors.

BUSINESS FLUCTUATIONS

INTRODUCTION

Business fluctuations, booms and slumps, in the economic activities form essentially theeconomic environment of a country. They influence business decisions tremendously and setthe trend of future business. The period of prosperity opens up new and larger opportunities forinvestment, employment and production, and thereby promotes business. On the contrary,the period of depression reduces the business opportunities. A profit maximizing entrepreneurmust therefore analyse the economic environment of the period relevant for his importantbusiness decisions, particularly those pertaining to forward planning.

This part of the chapter is in fact devoted to a brief discussion of, main phases of businesscycles and their causes.


Definition of a Business or Trade Cycle

The term "trade cycle" in economics refers to the wave-like fluctuations in the aggregateeconomic activity, particularly in employment, output and income. In other words, trade cyclesare ups and downs in economic activity. A trade cycle is defined in various ways by differenteconomists. For instance, Mitchell defined trade cycle as “a fluctuation in aggregateeconomic activity”. According to Haberler, "The business cycle in the general sensemay be defined as an alternation of periods of prosperity and depression, of goodand bad trade."

The following features of a trade cycle are worth noting :

(a) A trade cycle is wave - like movement.

(b) Cyclical fluctuations are recurrent in nature.

(c) Expansion and contraction in a trade cycle are cumulative in effect.

(d) Trade cycles are all-pervading in their impact.

(e) A trade cycle is characterized by the presence of crisis, i.e., the peak and the trough arenot symmetrical, that is to say, the downward movement is more sudden and violentthan the change from downward to upward.

(f) Though cycles differ in timing and amplitude, they have a common pattern of phaseswhich are sequential in nature.

Keynes, points out that "A trade cycle is composed of periods of good tradecharacterized by rising prices and low unemployment percentages, altering withperiods of bad trade characterized by falling prices and high unemploymentpercentages." Keynes, thus, stresses two indices namely, prices and unemployment, formeasuring the upswing and downswing of the business cycles.

PHASES OF BUSINESS CYCLES

The ups and downs in the economy are reflected by the fluctuations in aggregate economicmagnitudes, such as, production, investment, employment, prices, wages, bank credits, etc.The upward and downward movements in these magnitudes show different phases of a businesscycle. Basically there are only two phases in a cycle, viz., prosperity and depression. Butconsidering the intermediate stages between prosperity and depression, the various phasesof trade cycle may be enumerated as follows :

1. Expansion

2. Peak


Business Fluctuations. A figure showing phases of Business Cycle

The phase of recession begins when the downward slide in the growth rate becomes rapid andsteady. Output, employment, prices, etc. register a rapid decline, though the realized growthrate may still remain above the steady growth line. So long as growth rate exceeds or equalsthe 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 depressionin the economy.

In a stagnated economy, depression begins when growth rate is less than zero, i.e. the totaloutput, employment, prices, bank advances, etc., decline during the subsequent periods. Thespan of depression spreads over the period growth rate stays below the secular growth rate orzero growth rate in a stagnated economy. Trough is the phase during which the down - trendin the economy slows down and eventually stops, and the economic activities once again

3. Recession

4. Trough

5. Recovery and expansion.

The five phases of a business cycle have been presented in the figure. The steady growth lineshows the growth of the economy when there are no economic fluctuations. The variousphases of business cycles are shown by the line of cycle which moves up and down thesteady growth line. The line of cycle moving above the steady growth line marks the beginningof the period of 'expansion' or 'prosperity' in the economy. the phase of expansion is characterizedby 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 rateeventually slows down and reaches the peak. The phase of peak is generally characterizedby slacking in the expansion rate, the highest level of prosperity, and downward slide in theeconomic activities from the peak.


register an upward movement. Trough is the period of most severe strain on the economy.When the economy registers a continuous and repaid upward trend in output, employment,etc., it enters the phase of recovery though the growth rate may still remain below the steadygrowth rate. And, when it exceeds this rate, the economy once again enters the phase ofexpansion and prosperity. If economic fluctuations are not controlled by the government, thebusiness cycles continue to recur as stated above.

Let us now describe in some detail the important features of the various phases of businesscycle, and also the causes of turning points.

Prosperity : Expansion and Peak

The prosperity phase is characterized by rise in the national output, rise in consumer andcapital expenditure rise in the level of employment. Inventories of both input and output increase.Debtors find it more and more convenient to pay off their debts. Bank advances grow rapidlyeven thought bank rate increases. There is general expansion of credit. Idle funds find theirway to productive investment since stock prices increase due to increase in profitability anddividend. Purchasing power continues to flow in and out of all kinds of economic activities. Solong 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. Additionalworkers are hard to find. Hence additional workers can be obtained by bidding a wage ratehigher than the prevailing rates. Labour market becomes seller's market. A similar situationappears also in other input markets. Consequently, input prices increase rapidly leading toincrease in cost of production. As a result, prices increase and overtake the increase inoutput and employment. Cost of living increases at a rate relatively higher than the increase inhousehold income. Hence consumers, particularly the wage earners and fixed income class,review their consumption. Consumer's resistance gets momentum. Actual demand stagnatesor 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-labourtends to halt. This trend subsequently appears in other durable goods industries like automobiles,refrigerators, furniture, etc. This marks reaching the Peak.

Turning - Point and Recession

Once the economy reaches the peak, increase in demand is halted. It even starts decreasingin some sectors, for the reason stated above. Producers, on the other hand, unaware of thisfact continue to maintain their existing levels of production and investment. As a result, adiscrepancy between output supply and demand arises. The growth of discrepancy, betweensupply and demand is so slow that it goes unnoticed for some time. But producers suddenlyrealize that their inventories are piling up. This situation might appear in a few industries at thefirst instance, but later it spreads to other industries also. Initially, it might be taken as aproblem 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 investmentplans are given up; orders placed for new equipments, raw materials and other inputs arecancelled. Replacement of worn-out capital is postponed. Demand for labour ceases toincrease; rather, temporary and casual workers are removed in a bid to bring demand andsupply in balance. The cancellation of orders for the inputs by the producers of consumergoods creates a chain -reaction in the input market. Producers of capital gods and raw materialscancel 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 agradual decline leading to a simultaneous decrease in the incomes of wage and interestearners. This ultimately causes demand recession. On the other hand, producers lower downthe price in order to get rid of their inventories and also to meet their obligations. Consumersin their turn expect a further decrease in price, and hence, postpone their purchases. As aresult, the discrepancy between demand and supply continues to grow. When this processgathers speed, it takes the form of irreversible recession. Investments start declining. Thedecline in investment leads to decline in income and consumption. The process of reverse of(of negative) multiplier gets underway. (The process is exactly reverse of expansion). Wheninvestments are curtailed, production and employment decline resulting in further decline indemand for both consumer and capital goods. Borrowings for investment decreases; bankcredit shrinks; share prices decrease; unemployment gets generated along with a fall in wagerates. At this stage, the process of recession is complete and the economy enters the phaseof depression.

Depression and Trough

During the phase of depression, economic activities slide down their normal level. The growthrate becomes negative. The level of national income and expenditure declines rapidly. Pricesof consumer and capital goods decline steadily. Workers lose their jobs. Debtors find it difficultto pay off their debts. Demand for bank credit reaches its low ebb and banks experiencemounting of their cash balances. Investment in stock becomes less profitable and leastattractive. At the depth of depression, all economic activities touch the bottom and the phaseof trough is reached. Even the expenditure on maintenance is deferred in view of excessproduction capacity. Weaker firms are eliminated from the industries. At this point, the processof depression is complete.

How is the process reversed? The factors reverse the downswing vary form cycle to cycle likefactors responsible for business cycle vary form cycle to cycle. Generally, the process beginsin the labour market, Because of widespread unemployment; workers offer to work at wagesless than the prevailing rates. The producers anticipating better future try to maintain theircapital stock and offer jobs to some workers here and there. They do so also because theyfeel encouraged by the halt in decrease in price in the trough phase. Consumers on their partexpecting no further decline in price begin to spend on their postponed consumption and


hence demand picks up, though gradually. Bankers having accumulated excess liquidity (idlecash 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 pricesbegin to rise for the simple reason that fall in stock prices comes to an end and an optimismis underway in the stock market.

Besides, there is a self - correcting process within the price mechanism. When prices fallduring recession the prices of raw materials and that of other inputs fall faster than the pricesof finished products. Therefore, some profitability always remains there, which tends to increaseafter the trough. Hence the optimism generated in the stock market gets strengthened in thecommodity market. Producers start replacing the worn - out capital and making - up thedepleted capital stock, though cautiously and slowly. Consequently, investment picks up andemployment gradually increases. Following this recovery in production and income, demandfor both consumer and capital goods, start increasing. Since banks have accumulated excesscash reserves, bank credit becomes easily available and at a lower rate. Speculative increasein prices give indication of continued rise in level. For all these reasons, the economic activitiesget accelerated. Due to increase in income and consumption, the process of multiplier givesfurther impetus to the economic activities, and the phase of recovery gets underway. Thephase of depression comes to an end over time, depending on the speed of recovery.

The Recovery

As the recovery gathers momentum, some firms plan additional investment, some undertakerenovation programmes, some undertake both. These activities generate construction activitiesin both consumer and capital good sectors. Individuals who had postponed their plans to constructhouses undertake it now, lest cost of construction mounts up. As a result, more and moreemployment is generated in the construction sector. As employment increases despite wagerates moving upward the total wage income increase at a rate higher than employment rate.Wage income rises, so does the consumption expenditure. Businessmen realize quick turnover and an increase in profitability. Hence, they speed up the production machinery.

Over a period, as the factors of production become more fully employed wages and other inputprices move upward rapidly. Investors therefore, become discriminatory between alternativeinvestments. As prices, wages and other factor - prices increase, a number of relateddevelopments begin to take place. Businessmen start increasing their inventories, consumersstart buying more and more of durable goods and variety items. With this process catchingup, the economy enters the phase of expansion and prosperity. The cycle is thus complete.

INFLATION

The Meaning of Inflation

In the words of Prof. Samuelson, "Inflation occurs when the general level of prices andcosts 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 rise, cause an increase in costs. According to Milton Friedman, inflationis "process of a steady and sustained rise in the prices". Many more definitions ofinflation can be given. Instead of going into all these definitions, let us outline thecharacteristics of inflation as they emerge form the above - mentioned (and other similar)definitions of inflation :

(i) Inflation is a phenomenon of rising prices. However, every price - rise is not inflationary,though every period of inflation indicates price - rise. In other words, temporary price -rise in some sectors may occur due to some causes but they may not necessarily beindicative of inflation.

(ii) Inflation is a sustained and appreciable rise in prices. Once started, inflation goes onfeeding 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 sectorsor geographical localities of a country. Rather, it takes within its stride the entire countryand all the sectors of the economy. It is dynamic in the sense that its severity, natureetc. go on changing (and causing changes) over a period of time. Inflation occurs over aperiod 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 andintensity of inflation.

(vi) Inflation is characterized by an excess of demand or an increase in costs or usuallyboth.

The Causes of Inflation

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

1. The Factors from Demand Side

(i) Increase in Public Expenditure : There may be an increase in the expenditure ofthe government because of wars or for developing the economy. This increase ingovernment expenditure means an increase in the total demand, which leads torise in prices. This demand is in addition to the normal demand, which leads to aprice rise.

(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 forconsumer's goods. This is because there is an increase in the income of the peoplewho work in capital goods' industries. Therefore, they are in a position to spendmore, and thus, there is an increase in the demand for the both types of goods.

(iii) Increase in Foreign Demand : When there is an increase in foreign demand forthe goods manufactured in a country, exports increase and the prices of commoditiesin the country increase, as their supply cannot be increased instantaneously.

(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 theirexpenditure, as well as the prices of commodities.

(v) Repayment of Internal Debts : When the government repays old loans, morepurchasing power is placed at the disposal of the people. A part of the amountobtained in this manner, may be re-invested in various assets, but the rest of it,may be spent on consumer's goods and services. It is responsible for increase inprices to the extent that this repayment of loans leads to an increase in the totaldemand.

(vi) Changes in Expectation : In the context of the price - rise, the expectations of thepeople play a very important role. When people expect a rise in prices, businessmenincrease their investment and this leads to an increase in the demand for capitalgoods. If the consumers think that there will be an increase in prices in the future,they will start purchasing commodities which they will require in the future. Thisincreases the demand for consumer's goods. The increase in the demand for both,consumer's and producers' goods leads to the rise in prices.

2. Factors form Supply Side

(i) Scarcity of the Factors of Production : If one or more factors of production are inshort supply, there is a reduction in production or hurdles may be created in theexpansion of product6ion. This reduces the total supply and causes a rise in price.

(ii) Bottlenecks : At times, all the factors are or may be available. But bottlenecks arecreated and this makes it difficult to make these factors available at the right timeand place, for actual production. For example, iron ore and coal are available atmines, but the transport facilities required to transport these raw materials to theproduction 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 difficultiesmay arise and make production impossible or difficult. This may cause an increasein prices.


(iii) Natural Calamities : There are several natural calamities which may reduceproduction. Excess of rains, drought, earthquakes, cyclones, may substantiallyreduce 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 thisleads to a rise in the prices.

(iv) Hoarding by Merchants : When traders and merchants know that there is a shortsupply of any commodity, they will purchase and stock large quantities of thesecommodities. These commodities then go underground and are not available in theopen market. Thus, there is a shortage of other commodities too and this leads toa rise in prices.

(v) Rise in Costs : Rise in costs due to an increase in factor prices is another causefrom 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. Thismay lead to inflation.

Consequences of Inflation

Effects or Consequences of Inflation can be studied under (i) Effects on Production, (ii) Effectson 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 employmentand inflation is proceeding at a slow rate, inflation may be helpful. As some of the factorsof production are unemployed, there is no change in the costs of production. But pricescontinue to rise, which results in larger profits, and tempts entrepreneurs to increaseinvestment. This increases total production and employment. This process continuesundisturbed till the full employment level is reached. But once the full employment level isreached or crossed, prices start rising rapidly and there is true inflation.

This rapid inflation is very dangerous to the smooth working of any economy. Hyperinflationis perhaps the worst from the point of view of production. Inflation affects production inthe following manner :

1. 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 capitalis reduced, and there is flight of capital from the country, which results in reductionin investment and in turn, reduces production.

2. Switchover of Business : During a period of rising prices, speculation and stockpilingappears 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 productsproperty 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 easymoney, tempt capitalist to invest their capital in these activities rather than undertakeproduction. Thus, there is no growth in production. But if prices rise very fast,production may even decrease.

3. Uncertainty : During a period of rising prices, there is an atmosphere uncertainty inevery field. This makes entrepreneurs more and more reluctant to accept any risksin production. This results in decrease in production.

4. Change in the Composition of Production: Rising prices also influences thecomposition of production. During the period of rising prices, those who get largeprofits and easy money become rich. Similarly, the owners of factors of productionwho are in short supply (eg. Owners of land, plots, houses etc ), get huge profitsbecause of rising prices. On the contrary, the working class, the middle class andothers who belong to fixed income group, are put to great hardships. They are noteven in a position to satisfy their basic needs because they do not have the requiredpurchasing power. As the income of the rich increases, the demand for luxuries goon increasing. As supply always follows demand, the production of luxury articlesincreases and that of necessities decreases. It is most undesirable to spend theresources of a country in producing luxury articles before producing adequatenecessities. So, this change in the composition of production is said to beundesirable.

5. Poor Quality of Output: During a period of rising prices, there is a scarcity ofgoods and services on a very large scale. This results in the deterioration of thequality of production, because anything and everything that is produced, is sold.Thus, inferior commodities flood the market.

6. Public Unrest: When the pangs of price- rise are felt by the labourers, they becomefrustrated, and there are demonstrations, strikes, and several other types of agitationsto secure higher wages. Because of this, production decreases further, which leadsto further shortages and thus, price-rise.

7. Distortion of prices: The expansion of currency creates several hurdles in thepricing system, and makes it weak. It's essential to have a properly functioningprice mechanism in order to have smoothly functioning production system. Thisdistortion 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 asfollows:


a) The creditor and debtor: During periods of inflation, creditors are put to lossesbecause there is difference in the value of the unit of currency when it was loanedout, and when it was returned. As prices rise, the value of money goes on decreasingwith lapse of time. The case of borrowers is exactly the opposite. A borrower isbenefited as the value of money when he borrowed it, is more than when he repaysit.

b) The wage and salary earners: Those who get fixed income in terms of money, areput to losses during inflation. If workers are well organized, they can secure dearnessallowances or a rise in wages or salaries. But even then, in the race between therise in prices and the rise in wages, the rise in prices is more rapid, thereby puttingwage earners to a great loss. The fortune unorganized labour is extremely pitiable.Thus, as a result of inflation, the fixed income earners suffer great hardships. Thosewhose income is permanently fixed, are put to heavier losses. Pensioners mainlybelong to this class.

c) The entrepreneurs as a Class: The traders, merchants and manufacturers are thepeople who benefit more during inflation. Inflation is the great opportunity for themto make huge profits. The prices of stocks of finished products hoarded by thesebusinessmen go on increasing continuously, and they get huge profits on thesegoods by selling them in the black market. Moreover. expenses to be incurred onwages, raw materials and machinery, lag behind prices. This leads to a continuousrise in profits. If the rate of growth of inflation is very high, there is a tendency ofstockpiling by the traders. In this way, the share in the national income of theentrepreneurial class as a whole, goes on increasing.

d) Investors as a class: Normally, investors are found to invest their money in thefollowing two ways: 1) In such assets which give fixed and guaranteed returns peryear. For e.g. : Bonds, Debentures, long term, deposits in banks etc. 2) In shareor equity capital which do not give guaranteed returns. The investors belonging tothe first category are put to a loss, but those in the second category may stand togain profits. Because of rising prices, companies make huge profits declare largedividends, and thus, their real income increases. In most cases, the rich invest inequity shares as their capacity to take risk is more. The middle class people,whose savings are limited, invest in assets earning guaranteed returns. So hereagain, the rich have an advantage.

e) 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 increaseproduction immediately. In the mean time, prices rise further. Moreover, wheneverthere 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, thesmall farmers are benefited least because they do not have large quantities of


agricultural goods as marketable surplus. But, the large farmers get the maximumpossible advantage.

3) Other Consequences :

a) Financial institutions: When inflation is limited, banks, insurance companies andother financial institutions get advantages because their activities are boosted. Butas soon as prices begin to rise at a faster rate, the savings of the people arereduced, and most of the financial institutions fall in trouble.

b) Foreign Trade: Foreign goods become cheaper and imports increase, andsimultaneously, exports dwindle as the prices of domestic goods rise. This createsseveral problems in the balance of payments. If restrictions are imposed, to checkimports, smuggling activities increase.

c) Price structure: During inflation, the prices of all goods rise. But the prices of thosegoods whose supply is inelastic, rise more. This disturbs the entire price structureas well as the distribution system in the economy. For e.g., If the price of the steelfurniture is very high, the available steel will be used for the manufacture of steelfurniture, even though the manufacture of railway wagons and rails may be morenecessary.

d) Reduction in development expenditure: Inflation has very bad effect on Economicplanning and public expenditure. People who are already suffering from rising prices,cannot be overburdened by increasing the taxation. But the expenditure of theGovernment increases with rising prices. During periods of Economic planning,large investments have to be made in the Public sector. The saving capacity of thepeople is reduced, and the invested amounts become less and less valuable whichmakes it difficult to raise loans. Additional deficit financing is likely to increaseinflation further. Thus, it becomes imperative for the government to reduce itsexpenditure on development plans. Several expansion programs have to be dropped.Inflation mostly affects the schemes to improve educational, medical aid, researchand other social welfare programs.

e) Effect on Currency: If inflation rises very rapidly, people loose faith in the currencyand the currency cannot function as a currency at all. This endangers the veryexistence of the economy.

4) Non- Economic Effects :

There are several political and social effects. These are very serious and may continue tobe in existence for a very long period of time. The gap between the rich and the poorwidens. Those who toil and moil continue to become poorer, and those who hold importantpositions, go on amassing wealth. This puts an end to harmony and understanding insociety. Morality and business ethics are violated and people do not hesitate to do


anything unscrupulous to become rich quickly. Thefts, dacoity, gambling and other socialevils become rampant. Demonstrations, arson and looting becomes very common andthere is difficulty in maintaining law and order. Political stability in the country isendangered. The desire to amass wealth and become rich as early as possible givesrise to bribery, corruption, favouritism etc. Once the seeds of corruption are sown corruptionspreads very easily and becomes all- pervasive. This gives rise to several social, economicand political evils.

MACRO POLICIES

INTRODUCTION

Business cycles i.e., fluctuations in the economic activities, cause not only harm to businessbut also misery to human beings by creating unemployment and poverty. Economists and thegovernment have, of late, felt concerned with the business cycles and suggested variousways and means to control the economic fluctuations.

The experience of the Great Depression and Keynesian revolution in mid - 1930s assigned abig role to the government in economic growth, employment and preventing businessfluctuations. Therefore, the government interventions with the economy all over the worldincreased in a big way. The free enterprise economies not only entered the production ofcommodities and services but also adopted a number of fiscal and monetary measures tocontrol and regulate the economy and prevent violent economic fluctuations. The governmentsin 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 facedby the world in modern times. The major stabilisation problem in the developing countries isthe problem of controlling prices and preventing growth rate from sliding further down. Fordeveloped countries maintaining the growth rate to, fight against recession world over are themajor stabilisation problems.

We have discussed below the major macro economic stabilisation policies which are relevantto the current problems of the world.

1) Full Employment

Full employment is the commonly accepted goal of macro economic policy in a developedcountry. The classical economists assumed that full employment is automatically attainedby a free and competitive market economy in the long run. Keynes, however, pointed outthat full employment in practice is a rare phenomenon. Actually an economy attainsequilibrium at under employment level. Accepting Keynesian argument, countries haveset full employment as an important goal in their macro - economic policies.


In the technical language of macro - economic analysis, full employment is viewed as anequilibrium situation in which the sum of the demands in all labour markets tends to beequal to the sum of the supplies, though, of course, in many of these markets, there isthe likelihood of an excess of demand over supply, or of supply over demand, Keynesalso provides an alternative definition of full employment in that it is "a situation in whichaggregate employment is inelastic in response to an increase in the effective demand forits output." He, therefore, suggested that an economic policy aiming at achieving fullemployment, should be designed to uplift the effective demand appropriately.

2) Economic Stabilisation

Stabilisation broadly means preventing the extremes of ups and downs or booms anddepression in the economy without preventing factors of economic growth to operate. Italso 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 stabilization policies are :

(i) preventing excessive economic fluctuations,

(ii) efficient utilization of labour and other productive resources as far as possible;

(iii) encouraging free competitive enterprise with minimum interference with thefunctioning of the market economy.

The two most important and widely used economic policies to achieve economic stabilityare (i) fiscal policy; and (ii) monetary policy.

a) Fiscal Policy :

The 'fiscal policy' refers to the variations in taxation and public expenditureprogrammes by the government to achieve the predetermined objectives. Taxationis a measure of transferring funds from the private purses to the public coffers; it amountsto withdrawal of funds from the private use. Public expenditure, on the other hand,increases the flow of funds into the private economy. Thus, taxation reduces privatedisposable income and thereby the private expenditure, and public expenditure increasesprivate incomes and thereby the private expenditure. Since tax-revenue and publicexpenditure form the two sides of the government budget, the taxation and publicexpenditure 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 thefact that government activities in modern economies are greatly enlarged, and government


tax-revenue and expenditure account for a considerable proportion of GNP, ranging from10 - 25 per cent. Therefore, the government may affect the private economic activities tothe same extent through variations in taxation and public expenditure. Besides, fiscalpolicy is considered to be more effective than monetary policy because the former directlyaffects the private decisions while the latter does so indirectly. If fiscal policy of thegovernment is so formulated that it during the period of expansion, it is known as 'counter- cyclical fiscal policy'.

b) Monetary Policy :

Monetary policy refers to the programme of the Central Bank's variations, in the totalsupply of money and cost of money to achieve certain predetermined objectives. One ofthe primary objectives of monetary policy is to achieve economic stability. The traditionalinstruments through which Central Bank carries out the monetary policies are :Quantitative Credit Control Measures such as open market operations, changes inthe Bank Rate (or discount rate), and changes in the statutory reserve ratios. Brieflyspeaking, open market operation by the Central Bank is the sale and purchase ofgovernment bonds, treasure bills, securities, etc., to and form the public. Bank rate isthe rate at which Central Bank discounts the commercial banks' bills of exchange or firstclass bill. The statutory reserve ratio is the proportion of commercial banks' time anddemand deposits which they are required to deposit with the Central Bank or keep cash- in - vault. All these instruments when operated by the Central Bank reduce (or enhance)directly and indirectly the credit creation capacity of the commercial banks and therebyreduce (or increase) the flow of funds from the banks to the public.

In addition these instruments, Central Banks use also various selective credit controlmeasures and moral suasion. The selective credit controls are intented to control thecredit flows to particular sectors without affecting the total credit, and also to change thecomposition of credit from undesirable to desirable pattern. Moral suasion is a persuasivemethod to convince the commercial banks to behave in accordance with the demand ofthe time and in the interest of the nation.

The fiscal and monetary policies may be alternatively used to control business cycles inthe economy, though monetary policy is considered to be more effective to control inflationthan to control depression. It is however, always desirable to adopt a proper mix of fiscaland monetary policies to check the business cycles.


Exercise :

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 ofEffective Demand.

4. Write Short notes on :

a) Factors determining Effective Demand b) Consumption Function c) Investment Functiond) Fiscal Policy e) Monetary Policy.

5. Explain with an illustration, various phases of Business Cycle.

6. Define Inflation. Explain the Causes of Inflation.

7. What are the consequences of Inflation?

8. Explain Macro Economic Polices with special emphasis on a) Full Employment and b)Economic Stabilization.


NOTES

Government and Private Business 319

Chapter 9

GOVERNMENT AND PRIVATE BUSINESS

Preview

Introduction, Need for government intervention in the market, Price Controls(IndianExperience),Causes of Price rise in India, Price controls in India, Support prices andAdministered Prices, P.D.S., Protection of consumers' interest; Economic Liberalization,Process of Disinvestment - need and methods, Disinvestment of PSU in India, Policy Planningas a guide to overall business development.

INTORDUCTION

In our discussion of business decisions regarding production, pricing, investment etc, in previouschapters, we assumed the existence of a 'free enterprise system' in which there is the leastinterference by the State with the choices, preferences and decisions of the individuals regardingtheir economic pursuits.

The real life situation is however quite different even in the free enterprise economies, let alonethe State-controlled economies. The government holds tremendous authority not only toinfluence the private business decisions but also to control and regulate, directly and indirectly,the private business activities. By using its powers, the government can enact the laws againstproduction, sale and consumption of certain goods; can prevent the entry of private entrepreneursto certain industries through its Industrial Policy, can limit the growth of private firms beyond acertain limit (e.g., MRTP Act.); and can nationalize the industries whenever it thinks necessaryand desirable.

Another form of government intervention with private business is formulation and implementationof various kinds of economic policies such as fiscal policy, monetary or credit policy, industriallicensing policy, commercial policy, exchange control policy, etc. Besides, the governmentaffects private business also in its capacity of a competitor in the input market. Public sectorindustries being owned and managed by the government get a preferential treatment in theallocation of scarce input. All these activities and policies of the State are the various forms ofintervention with the free enterprise system, which affect the private business activities. Theinterference 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 economicactivities? How can the public and private sector in a mixed economy work in cooperation andcoordination with each other? How and to what extent do the government’s economic policiesaffect the private business ? We shall answer some of these questions in this part of the book.

1) NEED FOR GOVT. INTERVENTION:

The need for government intervention with the functioning of free market mechanism hasarisen out of failure of free market economy expected to ensure (i) that all those who arewilling to work at prevailing wage rate get employment; (ii) that all those who are employed gettheir 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 tomeet their basic needs - food, clothing, shelter, education, medical care, etc. The world hashowever experienced that the free enterprise system has failed to orgainse the economywhich would satisfy the above requirements. The failure of the free market economy is attributedto 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 orcapitalism) :

(i) Inequalities of Income and Wealth :

One of the serious limitations of market mechanism is that it results in extremely unequaldistribution of income and wealth. In a free competitive economic system, those withproductive resources or intellectual abilities find it easy to obtain rising income andwealth, whereas those who have no productive resources or mental abilities do not getmuch share in annual national income and wealth. And the number of such people in anysociety is generally so great that they constitute the majority. Thus, market mechanismresults in unequal distribution of income and wealth and their concentration in the handsof a few people in society. The rich go on becoming richer, while the poor who constitutemajority continue to remain poor. These economic inequalities give rise to social andpolitical unrest disturbing social and political peace in the country.

(ii) Emergence of Monopolies:

It is observed from the economic histories of the United States and West Europeancountries that competition which is the heart of market mechanism itself gives rise tomonopolies. If for example there are a number of producers of a commodity, the efficientones who are always few because of uneven distribution of organizational abilities amongpeople, will begin to absorb the inefficient ones. The final result is that only one (absolute


monopoly), two (duopoly) or a few (oligopoly) units in the industry remain. These unitsnaturally begin to enjoy monopolistic power exploiting both consumers and workers.Also, these monopolies establish political lobbies and through corruption and other favorsto legislators get suitable legislation passed thus protecting their own interests andsacrificing the interests of vast body of consumers.

(iii) Failure to Provide Full Employment :

It was assumed that under competitive conditions, market mechanism or price mechanismwould automatically bring about and establish equilibrium at the level of full employment.J. M. Keynes however showed that due to several rigidities (especially wage rigiditiesdue to emergence of trade unions in the labour market), it so happens that the economymay get established at the level of less than full employment. Thus market mechanismdoes not ensure full employment of labour force. Thus the labour force which could haveproduced much needed wealth lies unemployed and is wasted.

(iv) Instability :

Market economy or private enterprise economy is a planless economy. In such aneconomy where millions of consumers and millions of producers are taking their ownindependent decisions, it is rarely that some sort of balance would be achieved betweendemand for thousands of commodities and their supply. This imbalance gives rise tofrictional disturbances and cyclical booms and depressions. It is inconceivable that themodern complex economy involving millions of commodities and millions of consumersand producers would always work smoothly. Market economy is bound to be characterizedby great instability.

(v) Wastages of Market Economy :

As we have seen, market system or market economy suffers from time to time fromeconomic depressions. During period of depression various factors of production lieunutilized. These factors could have been used to produce much needed wealth for thepoorer sections of the society.

Secondly, we have seen that competition often gives rise to monopolies. Often thesemonopolies purposely keep certain factors of production idle creating artificial scarcitiesof their products with a view to raise prices to the maximum, if such a step gives maximumprofit. Thus under monopoly there is tremendous wastages of productive resources.

In those lines of production where competition exists, there appear what may be calledwastages of competition. Thousands of units in the same industry take independentdecisions regarding production. Often there is over-production in some industries andthere is under-production in certain other industries.


Also, in a competitive regime, there are wastages of advertisement. Hundreds of producersof 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. Thiswould mean that great amount of labour and other resources employed for advertisementare wasted. While some advertisements are truly informative most are misleading andtherefore, the claim that under free enterprise system or market system competitionleads to the most efficient use of community's various productive resources is not valid.On the contrary capitalism abounds in wastages due to unemployment, over and under-production and vast expenditure on advertisements necessitated by cut-throat competitionamong rival firms.

(vi) Indifference to and Sacrifice of Social Welfare :

In a market economy or free enterprise economy, production of goods and services is allguided by the aim of securing maximum private profit. Goods are produced for whichthere is greater demand. That is how in capitalism luxury and semi-luxury goods, whichricher sections of the community can afford to buy because they have the necessarypurchasing power, get preference over production of mass consumption goods neededby poorer sections of the community. Their production is neglected in preference toproduction of luxury and semi-luxury goods for richer sections of society. This meansthat very little attention is paid to the welfare of the society.

(vii) Poverty in the midst of Plenty :

In a market economy, inspired by private profit motive, tremendous technological progresshas taken place. This has tremendously increased productive powers of the economyand production of various goods and services. But due to the institution of private propertyand law of inheritance and succession (which are basic features of free enterprise systemof economy), rich become richer who continue to exploit the vast poor masses. The vastmasses of people living on bare minimum wages prevailing under competitive conditionscannot get continually rising share in the increasing productivity and production of wealthin the commodity.

In a free enterprise economy, there is thus observed the existence of contradictory positionof poverty in the midst of plenty.

(viii) Undesirable Psychological and Social Effects :

Capitalism with emphasis on private profit motive and money making has great adversesocial, cultural and psychological effects. In capitalism, money becomes the yardstickof measuring success in every field - art, music, literature and so on. Art, music andliterature all come to be judged by their financial success and not on the basis of theirinherent quality or merit.


Emphasis on private profit motive and on money-making arouses in capitalist regimeinstincts of acquisitiveness, unscrupulousness, combativeness and immoralitysuppressing good human instincts like kindness, love, cooperation and consideration forthe welfare of others.

(ix) Exploitation of Backward Countries and World Rivalry :

The developed capitalist countries, with a view to make higher and higher profits, havebeen exploiting backward countries in Africa and Asia through great multi nationalcorporations and through the sale of arms and ammunition to both the opposing partiesor countries (Arabs versus the Jews, India versus Pakistan, etc.) just because the defenceindustries owned by rich capitalists in Western countries should make rising profits.

Developed capitalist countries are putting restrictions on exports from developing orbackward counties thus hampering their rapid economic development.

Giant multi national corporations try to subvert national governments opposed to theirinterests by sabotage and various other methods.

All this has led to international rivalry, disturbances and violence which go against economicdevelopment 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 somesolid achievements to its credit, it also suffers from very serious limitations or evils,affecting both its own working and that of other countries.

2) PRICE CONTROLS IN INDIA

CAUSES FOR RISE IN PRICES IN INDIA:

A strong inflationary pressure has been built into the Indian economy for a long time - preciselyfrom the start of the Second World War - partly through ever-mounting demand on the oneside and inadequately rising supply on the other. The expanding demand is due to the rapidgrowth of our population, rising money income, expansion in money supply and liquidity in thecountry, rising volume of black money and continuous rise in demand for goods and servicesdue to periodic wars, rapid economic development, etc. Supply of goods and services too hasbeen 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 andshortages 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 inrecent years.


A. DEMAND PULL FACTORS

(i) Mounting Government Expenditure - Government expenditure has been steadilyincreasing over the years. The total expenditure of both Central and StateGovernments including Union Territories had risen from nearly Rs.740 crores in1950-51 to Rs.37000 crores in 1980-81; and nearly Rs.5, 69,400 crores in 1999-2000 an more than Rs. 11,000 crores in 2003 approximately. In a predominantlyagricultural economy like India, big programmes of economic development involvinghuge investments have been undertaken. Mounting government expenditure impliesa growing demand for goods and services and thus, is an important factor for therise in price. Beside, continuous increase in government expenditure has the effectof putting in large money income in the hands of the general public and causing thefire of inflation.

(ii) Deficit Financing and increase in money supply - the Government of India isresponsible for adopting deficit financing as a method of financing economicdevelopment.

Mounting Government expenditure financed through deficits pushes up the moneysupply in the country and consequently pushes up the public demand for goodsand services.

The Government of India has been responsible for the inflationary situation in thecountry through its policy of deficit financing and state governments contributedtheir share through their persistent financial indiscipline, reckless expendituresand unauthorized over-drafts.

(iii) Role of Black Money - It is well-known that there is a large accumulation ofunaccounted money in the hands of income-tax evaders, smugglers, builders andcorrupt politicians and government servants estimated at Rs.6,00,000 crores in1997-98. There is considerable slush money with politicians and Governmentservants, especially those dealing with licensing, registration, collection of taxes,etc. A large part of the unaccounted money is used in buying and selling of realestate in urban areas, extensive hoarding and black marketing in many essentialand inflation - sensitive goods, such as sugar, edible oils, etc. It is difficult to estimatethe amount of black money or the precise influence of this money in pushing upprices but there is no denying the fact that one of the important factors responsiblefor inflationary pressures in recent years is the existence and the active role ofblack money.

(iv) Uncontrolled growth of population - It is the continually rising population in Indiawhich is responsible for the persistent gap between demand and supply, in almostall consumer goods and services, thus exerting continuous pressure on prices.


B. COST - PUSH FACTORS

If supply of goods and services can be increased to correspond with every increase indemand, price level will tend to be stable. Prices, however, rose whenever the productionof food grains and other consumer goods declined or was stagnant.

(i) Fluctuation in output and supply - In this connection, we may refer to violentfluctuations in food grains output.

Such huge fluctuations in the output of food grains in certain years was a majorfactor in the rise of food grains prices as well as general prices. Likewise, we mayalso refer to the fact that the supply of manufactured goods, did not increaseadequately in certain periods. Power breakdowns, strikes and lock-outs and shortageof transport facilities are major factors for lower rate of production of manufacturedgoods. With ever rising demand for manufactured products, the producers are in aposition 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 byfarmers, and hoarding and speculation of food grains by traders and blackmarketeers.At one time, hoarding was done only by middlemen but now farmers have alsojoined the traders in this vicious game. With increased credit facilities from the co-operative societies and commercial banks, even small farmers have now moreholding 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 inwages, profit-margins and rise in other costs. In this connection the governmentand the public sector were also responsible, to a large extent, for pushing up theprice level in the country. With every budget, the government imposed freshcommodity 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 raisingthe prices of their products and services which generally constitute raw materialsfor other industries. A good example is the Railways which have been regularlyraising fares and freight rates in the last few years. Likewise, there has been regularupward revision of several administered prices such as those of petrol, diesel, steel,cement, coal, etc., pushing up the price level further. Every rise in administeredprices adds fuel to the inflationary potential in the country.

(iv) Hike in oil prices and global inflation - Serous inflationary pressures were alsocreated because of the sharp hike in the price of crude oil since September 1973and the consequent upward revision of the prices of oil and oil-based goods. In1980 alone, there was 130 per cent increase in all fuel prices by the OPEC. The


gulf-surcharge which raised the prices of petroleum products to an unprecedentedlevel in one single jump is major cause for rise in price during 1990-91.

C. OTHER FACTORS

The failure of the Government policy on the price front at various times was a seriousfactor in the inflationary rise in prices. We can cite specific cases. In 1973, the Governmentnationalized the wholesale trade in wheat along with a threat to introduce a similarmeasure for rice. This measure completely upset the normal trade and the price of openmarket wheat shot up. At the same time, the government did not fail to procure adequateamount of food grains for the public distribution system, nor was it able to import thenecessary quantity from foreign countries.

The Government of India has generally followed a highly vacillating and anti-peasantpolicy in fixing procurement prices. This is equally true in fixing and controlling prices ofsuch essential goods as sugar, vanaspati, soap, cloth, etc. Nor are the controls properlyenforced thus giving great scope for rampant black-marketing to exist, for the benefit ofthe 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 generalinflationary pressure in the Indian economy and they have been present and active overthe last many years. The immediate cause for the pressure on prices since, 1990, asmentioned earlier, was the Gulf War and the consequent shortages and increase in theprices of administered items such as coal, petroleum products, fertilizers, electricity,etc. According to the Government, the buildup of inflationary pressure during the Ninetieswas mainly attributable to:

(a) Higher fiscal deficit - large and persistent fiscal deficits over the years resulting inexcessive growth in money supply and liquid resources with the community: therewas automatic monetization of fiscal deficit.

(b) Sharp reserve money (RM) during the three years (1993-96) due to large inwardremittances and heavy accumulation of net foreign exchange assets with RBI; thiswas the basis of the rise in money supply and liquid resources with the generalpublic at that time;

(c) Supply-demand imbalances - sensitive commodities like pulses, edible oils, andeven 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.


3) PRICE CONTROLS IN INDIA :

A wide range of measures are being adopted to ensure stable conditions as well as to preventspeculators form taking an undue advantage of the conditions of scarcity. Since the pricesituation is the outcome of shortages in basic goods and services and a rapid growth inmoney supply and bank credit, various types of measures relating to money supply, pricingand distribution of commodities are pressed into service.

Demand Management

(i) Fiscal measures - The Government of India has generally insisted on controlling its ownexpenditure and keeping in check both its revenue deficit and fiscal deficit - this hasbeen a major instrument of inflation - control. In July 1974, for example, the Governmentof India promulgated three ordinances to limit the disposable money incomes in thehands of consumers through freezing wages and salaries on the one side and dividendincomes on the other. Again in January 1984, the Government of India announced apackage of programmes to curtail public expenditure, to postpone fresh recruitments toGovernment job etc.

It was only since 1990-91 that the Government of India has appreciated the importanceof reducing fiscal deficit. The Government of India since 1991-92 restricted its borrowingfrom RBI through the issue of ad hoc treasury bills and thus reduced the issue of newcurrency.

These measures, along with monetary measures helped to contain the volume of monetarymeasures helped to contain the inflationary pressure on price since 1995-96.

(ii) Monetary measures - The monetary policy of RBI consists of extensive use of generaland selective credit control measures. The main thrust has been to restrict bank-creditagainst inflation sensitive goods and to influence the cost and availability of commercialbank credit. The RBI relies heavily on selective credit controls on bank loans againstfood grains, cotton, oil-seeds and oils, sugar and textiles so as to discourage speculativehoarding.

During the Eighties and Nineties, monetary policy has been directed essentially to preventany excessive increase in liquidity and at the same time to ensure that the genuinecredit 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 centgradually. These steps resulted in a large measure, 'in mopping up excess liquidity inthe economy, moderating monetary and credit expansion and consequently helped inbringing down the rate of inflation.


In general, RBI uses its monetary policy to achieve a judicious balance between thegrowth of production and control of the general price level. Generally RBI uses BankRate, CRR., SLR and open market operations to increase bank credit and expansion ofbusiness activity (in times of business recession) or to contract bank credit and checkbusiness and speculative activity (in periods of inflation).

Supply Management

Supply management is related to the volume of supply and its distribution system. On thecommodity front the Government has generally focused its attention in securing greater controlover the prices of rice, wheat, sugar, oils and other commodities of mass consumption. Throughincrease in domestic supplies, large releases from official stocks and widening and streamliningof the network of public distribution, the Government attempts to prevent an undue increase inthe prices of essential commodities. Let us touch some of the important aspects of thispolicy.

(a) Fixation of Maximum Prices - For elimination the incentive for hoarding and speculativeactivity in food grains, the State Governments have been asked to fix the wholesale andretail prices of food grains. Further, the Government also fixes minimum procurementprices for major crops on the recommendation of the Agricultural Prices Commission(APC). Prices of other important 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 thecase of goods like sugar, cement, paper, etc. Under this system, the weaker sections ofthe community are supplied these goods through fair price shops, at controlled pricesand the rest and allowed to purchase their requirements at higher prices from the openmarket.

(c) Increase in Supplies of Food grains - The Government attempts to increase suppliesof food grains and other essential goods in times of internal shortage through largerimports.

(d) Problem of oilseeds and edible oils - In recent years, steep rise in the prices of edibleoils along with those of pulses, tea and sugar have been responsible for rise in thegeneral price level. The Government has prepared medium and long-term plans to stepup the production of oilseeds in the country. The Government has announced highersupport prices for groundnut, soybean and sunflower seed - the last two crops offer themaximum scope for augmenting the supply of edible oil in the country. In the shortperiod, the Government has been relying on imports of edible oils, at reduced orconfessional import duties.

In this connection, we should refer to the steps taken by the Government to increase theproduction of all other agricultural products.


(e) Public Distributions System (PDS) and consumer protection - An important aspectof the Government's policy was strengthening of the PDS. The Government has set up anetwork 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 lowincome groups at relatively low prices. But whenever the PDS is hard pressed due toinadequate supply, prices of essential goods tend to rise. PDS has been strengthenedand extended to rural areas.

(f) Control over Private Trade in Food grains - To check prices and to eliminate hoardingand speculative activity in food grains trade, wholesale dealers in food grains were licensedin many States. Limits were also fixed beyond which traders and producers could nothold stock without declaration. The Food Corporation of India has helped a lot to buy insurplus areas and sell in deficit areas and thus moderate the differences in prices.

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 ensuretheir domestic prices of Industrial products remain competitive.

iii) Great reduction in excise duties on a numbers of items expected to accelerate thespeed of industrial revival and raise industrial growth.

(1) Administered Prices :

The Government of India follows administered price policy in respect of commoditieswhich are either vital industrial raw materials, produced wholly or largely in thepublic sector such as steel, fertilizer, coal and petroleum products. The Governmentalso fixes the rates and charges of public utilities like railways and state electricityboards. The products and services produced by the public sector in India constituteimportant raw materials for other industries and are subject to serious output andprice fluctuations. Administered prices are normally set on the basis of costplus a stipulated margin of profit. There are two basic objectives ofadministered prices. :

(i) to fix and maintain the prices of essential raw materials so to avoidcost and price escalation; this has special significance during a periodof shortages and rising prices; and

(ii) to ensure economic prices to uneconomic units so that the latter toocan earn profits.


Whenever there is a change in cost, the administered price is also changed. As theGovernment is generally slow and sluggish in its actions, the change in administeredprices may not be proportionate to change in cost and, besides, the change inprice may come much later than change in cost. In fact, this has been a majorcriticism against administered prices in India. As the administered prices are ofteninadequate to meet cost escalation, basis industries like fertilizers and cementwere unable to generate sufficient financial resources for modernization andexpansion. The present policy of the Government is to adjust administered pricesto enable public sector units to earn sufficient profits and over a period of time giveup the system of administered prices.

(2) The System of Dual Prices :

It is a commonly accepted principle in India that the basic needs of the weakersections of the community should be met and for this the Government shouldsubsidies the prices of certain basic goods. This does not mean that the benefit ofsubsidy and low price should go even to those who do not require it. At the sametime the burden of subsidy should not fall on the producers of these basic goodsbut should be spread on the community as a whole. Such a policy is (a) in theinterest of the vulnerable sections, and (b) it does not discourage the producersfrom expanding production and investment in the particular sector.

Originally started with the price of steel, dual pricing was extended to many otheressential goods such as major food grains, sugar, edible oils, and cheaper varietiesof cotton cloth. Dual pricing is a form of short cut price control and it enabled theGovernment 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, pulsesand oil-seeds viz. their production, purchase, movement, sale and distribution. Thelevel at which agricultural prices should be stabilized is important from the point ofview of production and consumption. In fixing food grain prices, three aspects maybe kept in mind :

(a) The Government should fix and guarantee such procurement prices for variousfood grain as will provide suitable incentives to the producers. This is particularlyimportant as the volume of production has increased considerably under theinfluence of the "green revolution".

(b) The retail prices should be fixed in such a way that the interests of theconsumers are safeguarded and at the same time there is no scope for hoarding


and speculation. Food zones are abolished and inter-state movement of thefood grains is the monopoly of the Food Corporation of India.

(c) Holding the price line covers not only to cereals, but to all basic consumptiongoods as for instance pulses, sugar, oil and vanaspati, cloth, kerosene, etc.

The Government of India announces support prices on the recommendations of theAgricultural Prices Commission, redesignated as Commission for Agricultural Costsand Prices. The Commission is guided in recent years by the three-fold objectives of

(a) raising productivity through assured remunerative prices to farmers ;

(b) procuring sufficient quantities of rice and wheat for running the public distributionsystem; and

(c) promoting a desirable inter-crop balance.

While making recommendations to the Government regarding revision of minimumprocurement and support prices, the Commission takes into account, among otherthings, the changes in production costs, the inter-crop balance and the terms oftrade between agriculture and other sectors of the economy.

The basic framework for determining support prices for major cereals has beenrelatively fair. The interests of both farmers and general consumers have been wellprotected. But there are a number of distortions: One is the announcement ofhigher minimum prices by state Government to satisfy local interests. Another isthat support prices for coarse grains, pulses and oilseeds are of a notional natureand are not backed by an organized system of official procurement. In these casealso, support prices should be rationally determined (as in the case of wheat andrice) and should be made effective through public purchases and public distribution.

(4) Public Distribution System :

Rationale of PDS : The distribution of essential commodities through fairprice shops at government - controlled prices has come to be known aspublic distribution system.

There are various reasons for the setting up of the public distribution systemin India.

1) In order to maintain stable price conditions, an efficient management of thesupplies of essential consumer goods is necessary. Moreover, as most of thesecommodities are agriculture-based, their prices are subject to large seasonalvariation. Public distribution system will, therefore, have to play a major role inensuring supplies of essential consumer goods of mass consumption to peopleat reasonable prices, particularly to the weaker sections of the community.


State trading and buffer stock operation on the one side and public distributionon the other are essential in the case of agricultural products.

2) A large proportion of agricultural products - both food grains and rawmaterials - come to the market soon after the harvest when prices aredepressed. It is necessary to devise a scheme to buy such commoditiesat prices which ensure a certain minimum profit to the farmers. TheFood Corporation of India (FCI) and other institutions have been set up to buyagricultural goods at prices that would ensure minimum profit for the farmers;they also help in stabilizing agricultural process. At the same time, thesegoods would be supplied through public channels to consumers especiallythe 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 tocontrol prices, reduce fluctuations in prices and achieve an equitable distributionof essential consumer goods among the people.

Goods to be included in the public distribution system. Since distribution is ahighly complex matter, only the most essential goods of mass consumption shouldbe brought under the public distribution system, e.g. cereals, sugar, edible oils andvanaspati, 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 Governmentshave made arrangements to procure essential commodities and supply them throughthe public distribution outlets. In the case of food grains, FCI undertakes thenecessary operations. In regard to sugar, FCI undertakes these operations. TheState Trading Corporation (STC) has been entrusted with the responsibility ofimporting and distributing edible oils. Kerosene is being handled by the publicsector corporations like Indian Oil Corporation (IOC), Hindustan Petroleum, BharatPetroleum, etc. The production of controlled cloth has now been generally entrustedto the National Textile Corporation (NTC) and distributed through the NationalConsumers Co-operative Federation (NCCF).

5) PROTECTION OF CONSUMER INTEREST:

The consumer who is often considered as the king is practically enslaved by the aggressiveand dominant market manipulations by the large-sized corporations. The tug-of-war betweenmonopoly producers and scattered consumers obviously works to the advantage of theproducers. This is why Prof. J.K.Galbraith favoured the organization of the advantage of theproducers. This he termed countervailing power. A consumer's interest has several facets and


its protection amounts to empowering the consumer. Such an empowerment can be achievedby 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 spreadover a vast area and where they lack in awareness, education and organizational ethics. It isunder these conditions that the government is called upon to step in, in order to protect theconsumer'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, atbest, can announce a set of concessions and facilities for their development. The direct waywith which we are concerned here is an effective intervention in the price system and in thesupply 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 thedistrict, state and central levels for the redressal of consumer protection act which provides forreliefs and compensation to the consumers wherever deemed appropriate.

A consumer's interests or rights as enunciated by The Consumer Protection Act 1986are as follows:

i) Protection from Hazardous Commodities: A consumer is within his right to demandprotection against the marketing of goods and services which are hazardous to life andproperty.

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 maybe, so that he can protect himself against unfair trade practices like being misguidedand cheated.

iii) Right to a competitive Price: Wherever possible, the consumer must be assured of anaccess to a variety of goods and services at a competitive price. This right, on the onehand accepts the freedom of retailers from the exploitative conditions imposed by theproducers 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 athearing the grievances of the consumers.

v) Right to Information regarding Protection: By passing an act the interests of theconsumers cannot be protected unless the consumers have full knowledge of the protectiongiven to them. It is therefore, necessary to educate the consumers in this protectiongiven to them. It is therefore, necessary to educate the consumers in this regard.

Consumers protection involves protection from unfair trade practices for the purposeof 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 oreffectiveness of a service; c) False representation regarding re-built, removed, reconditionedor old goods as new goods; d) False claims regarding sponsorship, approval, performanceuses or benefits which the goods really do not possess; e) false representation regardingaffiliation or authorized dealership; f) misleading representation concerning the need for or theusefulness of goods/services; and g) giving as untested or unrealistic guarantee regarding thequality /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 ofchoice. Therefore, action is required to be taken against the producers/ sellers of substandardgoods and services. For this purpose action based upon certain standards should be laiddown, like AGMARK or ISI seal, can be taken by the government. Similarly, protection againstdeficiency in the product or service implying a fault, imperfection, shortcoming or inadequacyin 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, theConsumer Protection Act is not only act concerned. In fact, the Indian ContractAct, theSale of Goods Act, the Negotaible Instrument Act, the Banking Regulation Act, theCompines Act etc.,also contain provisions regarding protection accorded to the consumersin cases relevant under the Act concerned. Because the Consumer Protection Act is speciallyintended and framed for this purpose, we have discussed some of the provisions/ considerationsof this Act.

Under the various Acts, in accordance with the provisions in this regard, the consumer has tobe provided with an access to the machinery evolved for or already existing to the redressal ofhis grievances. As such as aggrived parties, the consumers can take resourse to filing suitsin the relevant course. Obviously, this whole issue of consumer protection is shrouded withcomplexities and demands the government to undertake the responsibility of safeguarding theinterests 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 thegovernment's responsibility in the dispensation of natural justice. As such, it involves varioussteps by way of creating machinery,monitoring the performance and penalizing the defaulters.This in turn, created the need for maintaining inspection/ supervision personnel, proceduresfor enforcing the laws and actions for penalizing the defaulters andcompensating the sufferers.Needless to say that this is a major and pervasive intervention in the system of marketing andpricing. In this context, it is essential to implement fhe suggestions and recommendationsgiven by a committee headed by Anna Hazare, a great Social Reformer.


6) THE NEW INDUSTRIAL POLICY (1991) :

The Congress Government led by Mr. Narasimha Rao announced the new industrial policy inJuly 1991. The main aim of the new industrial policy was:

(a) to unshackle the Indian industrial economy form the cobwebs of unnecessary bureaucraticcontrol,

(b) to introduce liberalization with a view to integrate the Indian economy with the worldeconomy,

(c) to remove restrictions on direct foreign investment as also to free the domesticentrepreneur form the restriction of MRTP Act, and,

(d) The policy aimed to shed the load of the public enterprises which have shown a very lowrate of return or are incurring losses over the years.

All these reforms of industrial policy led the government to take a series of initiatives inrespect of policies in the following areas : (a) Industrial licensing; (b) Foreign investment; (c)Foreign technology policy; (d) Public sector policy; and (e) MRTP Act.

Industrial Licensing Policy

In the sphere of industrial licensing, the role of the government was to be changed from that ofonly exercising control to one of providing help and guidance by making essential proceduresfully transparent and by eliminating delays.

(A) Industrial Licensing to be abolished for all projects except for a short list of industriesrelated to security and strategic concerns, social reasons, hazardous chemicals andoverriding environmental reason and items of elitist consumption. Industries reserved forthe 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. Cigarsand cigarettes of tobacco and manufactured tobacco substitutes. 7. Asbestos andasbestos based products. 8. Plywood, decorative veneers, and other wood based productssuch as particle board, medium density fiber board, block board. 9. Raw hides andskins, leather, chamois leather and patent leather. 10. Tanned or dressed fur skins. 11.Motor cars. 12. Paper and Newsprint except bagasse-based units. 13. Electronicaerospace and defense equipment; all types. 14. Industrial explosives, including detonatingfuse, 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 (DomesticRefrigerators, Domestic Dish Washing Machines, Programmable Domestic WashingMachines, Microwave ovens, Air conditioners).

The compulsory licensing provisions would not apply in respect of the small-scale unitstaking up the manufacture of any of the above items reserved for exclusive manufacturein small sector.

(B) Areas where security and strategic concerns predominate, will continue to be reservedfor 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 andwarships. 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 theAtomic Energy (Control of production and use) Order, 1953. 8. Railway transport.

(C) In projects where imported capital goods are required, automatic clearance will be givenin cases where foreign exchange availability is ensured through foreign equity; or if theCIF 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 ore cases, imports of capital goods will require clearance form the Secretariat ofIndustrial Approvals (SIA) in the Department of Industrial Development according toavailability of foreign exchange resources.

(D) In locations other than cities of more than 1 million population, there will be no requirementof obtaining industrial approvals from the Central Government except for industries subjectto 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 softwareand printing will be located outside 25 kms of the periphery, except in prior designatedindustrial areas.

Foreign Investment

In order to invite foreign investment in high priority industries, requiring large investment andadvanced technology, it has been decided to provide approval for direct foreign investmentupto 51 per cent foreign equity in such industries.

Foreign Technology

With a view to injecting the desired level of technological dynamism in Indian industry, governmentwould 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.

Public Sector Policy

Public enterprises have shown a very low rate of return of the capital invested. This hasinhibited their ability to regenerate themselves in terms of new investments as well as intechnology development. The result is that many of the public enterprises have become aburden rather than being an asset to the Government.

The 1991 Industrial Policy has adopted a new approach to public enterprises. The priorityareas 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 arecrucial in the long term development of the economy and the long term development ofthe economy and where private sector investment is inadequate.

(d) Manufacture of products where strategic considerations predominate such as defenceequipment.

Government will strengthen those public enterprises which fall in the reserved areas or aregenerating goods or reasonable profits. Such enterprises will be provided a much greaterdegree of management autonomy through the system of memoranda of understanding.Competition will also be induced in these areas by inviting private sector participation. In thecase of selected enterprises, part of Government holdings in the equity share capital of theseenterprises will be disinvested in order to provide further market discipline to the performanceof public enterprises.

There are a large number of chronically sick public enterprises incurring heavy losses, operatingin a competitive market and serving little or no public purpose. The following measures arebeing adopted.

(i) BIFR - Public enterprises which are chronically sick and which are unlikely to be turnedaround would, be referred to the Board for Industrial and Financial Reconstruction (BIFR) forformulation of revival / rehabilitation schemes. A social security mechanism is to be createdto 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, apart of the government's shareholding in the public sector would be offered to mutualfunds, financial institutions, the general public and workers.


(iii) Boards of public sector companies would be made more professional and given greaterpowers.

(iv) There would be greater trust on performance imnprovement and managements would begranted greater autonomy through Memorandum of Understanding (MOU) and would beheld accountable.

MRTP ACT.

With the growing complexity of industrial structure and the need for achieving economies ofscale for ensuring higher productivity and competitive advantage in the international market, theinterference 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 nolonger be require. Instead, emphasis will be on controlling and regulating monopolistic,restrictive and unfair trade practices rather than making it necessary for the monopolyhouses to obtain prior approval of Central Government for expansion, establishment ofnew undertakings, merger, amalgamation and takeover and appointment of certaindirectors.

(ii) The thrust of policy will be more on controlling unfair or restrictive business practices.

Further Liberalization by de-reservation :

a) The Government decided in April 1993 remove three more items from the list of 18industries reserved for compulsory licensing. These three items were : motor cars, whitegoods (which include refrigerators, washing machines, air conditioners, etc.) and rawhides and skins and patent leather. The basic purpose fo dereservation of these itemswas to increase the flow of investment in these industries. With the growth of a largemiddle class, ranging between 100 to 120 milions, the demand for the white goods likewashing machine, refrigerators, air conditioners is growing and these items are no longerviewed as luxury goods. Similary the demand for motor cars by the upper middle classand the affluent sections is also growing, more especially when the government is providingloans to businee executives and other senior officials to buy cars. To provide a boost toth motor car and white goods industries, the government has decided to de-reservethese items so that their production improves as response to the market, instead ofremaining shackled by the bureaucratic process of liscenceing.

Regardsing raw hides and skins and patent leather, the Government wants to push uptheir exports. Leather and good quality shoes have a tremendous export postential andthe small scale units are ill equipped to provide quality goods for the international markets.

In pursuance of the liberalization policy towards foreign investment, the Governmentdecided 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 foreignequity cover a wide range of industrial activities in the capital goods and metallurgicalindustries, 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 automaticapproval upto 74 per cent would be allowed. The nine industries are mining servicesrelated to oil and gas fields services, basic metals and alloy industries, not-conventionalenergy sources, manufacture of navigational, meteorological, geophysical and relatedinstruments and apparatus, electric generation and transmission, construction andmaintenance of roads, ropeways, ports, harbors, construction and maintenance of powerplants. Besides, land transport, water transport and storage and warehousing serviceshave also been included.

The basic thrust of these changes is that there will be no case-by-case approval forvarious proposals lying before the government. The main aim of the major policy initiativeis to facilitate foreign direct investment in infrastructure sector, core and priority sectors,export oriented industries, linkage with agro and farm sectors.

7) ECONOMIC LIBERALISATION:

The first phase of economic reforms is believed to have begun in 1985 when Rajiv Gandhienunciated 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 thepurpose gave increasingly greater scope for the private sector This shift in favour of the privatesector encompassed a wide range of measures demanding a reformulation of several policieslike the industrial licensing policy, export import policy, policy towards foreign capital, policyregarding rationalization and technology upgradation etc., which are covered by the umbrellaof economic reforms.

The real all-pervading beginning of economic reforms were however witnessed since theinstallation of the P.V. Narsimha Rao's Congress Government in Mid-1991 The reins of thereforms were in the hands of Dr. Manmohan Singh the then Finance Minister, who enumeratedthe 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 grater 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 theneeds of the economy.


For achieving these long-term objectives, the government undertook to instill internal andexternal confidence in to the economy by adopting stabilization measures, the major onesbeings as follows:

i) Fiscal Policy Reforms aimed at reducing the overall public sector defict from 12.5% to4% of GDP by mid-nineties. This involved raising the income level through both tax andnon-tax revenues and controlling public expenditure. This required a greater tax-effort, amore realistic administered price structure, a reduction in subsidies and a better fiscaldiscipline.

ii) Financial Sector Reforms based on stricter monitory policy first and then a reversal to aliberal policy, embraced a wide range of industrial areas including the Reserve Bank,Sheduled Banks, CO-operative Banks ,Foreign Banks, Mutual Funds InsuranceCompanies, Housing Finance Companies, and Stock exchanges. Measures asrecommended by both the Narasimha Committees(1991 and 1998) and accepted by theGovernment included a restructuring of controls by the RBI and the SEBI, norms ofcapital adequacy, insistence of credit rating and scaling down of interest rates and moreautonomy to the financial institutions. All these aimed at strengthening the financialsector and making it more competitive

iii) Social Sector Policy was guided by the needs of human development. It aimed at revitalizedefforts at poverty alleviation, spread of education through formal and nonformal streams,employment guarantee initiatives, supply of safe drinking water,revamping of housingprogrammes, immunization and other health measures and special attention to the welfareof woman, children and the privileged sections of the society.

iv) Industrial Policy was thoroughly reformed so as to provide unhindered and uninhibitedaccess to new initiatives by the domestic as well as foreign private sector. This wassought to be achieved by following a phased programme of de-regulation. Expecting theindustries of strategic: importance in the areas of defence, defence production and internalenergy and such other industries related to protection of environment and internal security,industrial licensing was abolished. The Monopolies asn Restrictive Trade Practices Actwas amended and modified so that the big industrial houses do not need a prior permissionof the Government either for expansion or for establishing a new undertaking. Areas ofindustrial activity reserved for the public sector were opened to the private sector, therebynarrowing down the scope of the public sector.

v) The policy regarding Foreign Capital was recast so as to attract foreign capital, increaseforeign exchange earnings, avail of marketing techniques. For this purpose, several reformsand changes were made in the policy. Diract Foreign Investment, up to 51%, was permittedin export=oriented industrial units, trading companies too could have 51% foreignersheld 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% ofdomestic trade of 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 toIndian industries and to make then internationally competitive import and export dutieswere readjusted in keeping with the WTO agreement with effect from April 2001, allquantitative restrictions on imports were removed and a system of price-based systemof duties, wherever necessary, was substituted.

vii) Public Sector Policy underwent an overhaul. The new involved a more realistic review ofearlier policy, greater autonomy to units which needed to continue in the public sector, aprogressive reduction in the budgetary support to public sector, a discipline to makepublic sector undertaking (PSUs) more competitive and cost-effective and making allPSUs self-reliant (no losses to be incurred)

With these ends in view, the measures taken included a) reduction in the number ofindustries reserved for the public sector from 17to 8, b) rehabilitation of sick units throughBIFR (Board for Industrial and Financial Reconstruction), c) a close monitoring to ensureprofitability, and d) a policy of disinvestment. Besides, several steps for protecting theinterests of the employees were taken which included VRS packages, retainingprogrammes etc.

A preview of the deals of liberalisation is not very encouraging from certain angles. It hasopened up new avenues for enterprise and has attained some success in terms of globallinkages of the Indian economy. However, the rates of industrial growth have fallen,agriculture remains neglected, regional as well as personal income disparities havewidened and poverty, unemployment and development have attained higher magnitude,as if to mock reforms!

8) THE PROCESS OF DISINVESTMENT: NEED AND METHODS

With economic liberalization, the private sector was given more freedom and greater scope inthe interest of improving the overall performance of the economy as a whole. Greater scope forthe private sector may mean incremental disinvestment which connotes the expansion ofPSUs can be left to some private company. It may also mean denationalization of the publicsector units taking private sector as a partner. In other words, disinvestment is a part of theprocess of privatization.

a) Need for Disinvestment

Over a period of four decades beginnings with the 1950s, the scope of public sector wascontinuously expanding, due to various reasons like lack of public sector's funds, non-


interest on the part of private sector in undertaking long-term investment projects and soon. With the onset of the New Economic Policy oriented towards providing an upperhand to the private sector, a reversal of the erstwhile policy of public-sector-dominancewas set in motion. As a part of this, the process of disinvestment which meant selling ofthe shares of a PSU to private corporates and individuals started. By selling stocks thepublic 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 followingreasons:

i) Phased Privatization: Larger scope for the private enterprise menas a shrinkingof the public to the private sector. This is done through disinvestment.

ii) Professionalism: Ina highly dynamic modern world, efficiency and competitivestrength requires the association of professional and management experts with thePSUs (public sector undertakings). But the cream of such expertise is alwaysattracted by the private sector by offering them lucrative, flexible and potentiallyprogressive working conditions. If this expertise is to be available to the publicsector, the public sector must offer a share in ownership to the private sector. Thepublic sector in India has continuously been under criticism ofr its lack of aprofessional approach, mainly due to the fact that most of these units are headedby administrative experts rather than management experts.

iii) Reducing deficit: As noted earliar, the Government of India was keen on reducingthe overall deficit of the public sector to 4% of GDP. For this purpose it neededfunds which would help bridge the gap. Disinvestment provided an opportunity ofselling stocks and raising funds.

iv) Re-allocation of Resources: Conceptually, the process of disinvestment amountsto reallocation of resources between the private and the public sectors. This step,in the new business environment, was expected to improve the productive efficiencyof the PSUs, thereby paving the way for improving the performance of the economyas a whole.

v) Capital Support to Plans: Non-Plan expenditure has been continuously increasingdue to a number of reasons like higher rates of D.A. for the employees, a rise in thesalary bill due to the Fifth Pay Commission's recommendations, rising prices ofgoods purchased plan projects which needed capital support were therefore, starvedof investible funds. Desinvestment accruals are a part of the capital receipts andcan be diverted to the capital needs of the plan projets.

vi) Substitute for Taxation: If we take into account the ground-level need in the midstof present difficulties faced by the Government of India, the disinvestment programme


apparently is viewed by the government as a substitute of greater tax-effort andcurtailment 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 daysappears to be a softer option for tiding over, the temporarily, the finanacial crisis.

b) Methods of Disinvestment

Disinvestment, in itself, is a method of privatization. The methods followed are as under:

1) Partial Transfer of Ownership: Disinvestment mostly is through this method ofownership transfer under which the ownership is transferred fully or partly. In thepresent method we are concerned with partial ownership transfer. Ownership canbe transferred by selling a part of the shares to individuals, co-operative societies orcorporate organizations. Such a transfer results in the creation of joint sector wherethe public sector and the private sector jointly hold the stocks, jointly exercise theirvoting rights and jointly participate in the exercise of control.

In India, the proposals of creating a joint ownership are contemplated on thefollowing 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 thetotal equity. This type of transfer ensures government control with private partnershipthat enables the unit of avail of the guidance and advice of the private sector.

ii) Government may retain 51% of the equity with itself and transfer 49% to similarprivate sector patners/s. It provides for a sizeable ownership transfer. At the sametime the majority voting rights remain with the government.

iii) In this case, majority of the ownership i.e. 74% is transferred to the effective inachieving while the government retains 26% with itself. As saving clause, usuallythere is provision for veto a power with the government is respect of major decisions.

So far as the first variant is concerned, it is not likely to be very effective in achieving theobjective of greater operational efficiency and higher level of competitiveness. The secondvariant transfers almost half ownership and as such, is likely to bring about certainnoticeable changes in the terms of revamping of managerial practices, cost-effectivenessand the units capacity to generate profits, for the simple reason that the stakes arehigher for the private sector. In case of the third variant, the private sector will be the realowner in matters of policy decisions and operational control. Government's veto power isreserved only for ensuring that the firm's operation is consistent with the macroeconomicobjectives. Micro-decisions are left fully in the hands of the private sector.


2) Total Denationalization: The second method involves a complete sellout of aPSU to a private corporate organization- it may be domestic or foreign or acollaboration concern. Such a step can be taken under a number of possiblesituations. Firstly, it is possible that the unit which earlier existed in the privatesector was nationalized, with a specific objective. Once the objective is fulfilled, thesame unit can be denationalized. Secondly, it is possible (though conceptuallyonly!) that the unit was sick and was taken over by the state. After its completerecovery 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 aprivate body corporate comes forward with confidence to set things right, it can buythe entire unit with all assets and liabilities.

3) Liquidation: By going through the procedure laid down by the constitution/MOU ofthe PSU, the government may announce its decision of going into liquidation incase of the unit concerned. A Private buyer may buy it and use the assets sopurchased 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 besold to the employees of the project. All the assets could be sold to the employeesorganization which could be formed as a worker's cooperative, or they can form ajoint companies act. Provision of bank finance for enabling the workers to buy theassets can be made. The employees would continue getting wages as before plusa divided from the companies pool of distributed profits.

5) Disinvestment without privatization: one more method of disinvestment whichis mainly designed to overcome the capital paucity is to sell part of the equity toother public sector organization mainly from the financial system. The buyers ofstocks, in such cases, can be the Life Insurance Corporation of India, the GeneralInsurance Corporation of India, the Industrial Development Bank of India, and theUnit Trust of India and so on.

c) Methods of Implementation:

Once the decision is taken regarding the option of disinvestment to be choose a method ofdisinvestment, i.e. actual implementation of the decision to part with ownership either partiallyor 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 -not a new issue but existing shares - an issue with a premium and a policy ofallotment intending buyers may apply and will be allotted shares. In keeping withthe goals to be predetermined, the PSU concerned can decide upon a premiumover 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 institutionsand so on.

2) Negotiating joint ownership: when a part of equity is to be made over to aprospective buyer, such a buyer has got to be identified and then the terms andconditions of partial transfer of ownership are to be negotiated. When an agreementis reached and is duly signed, the process of disinvestment is carried out inaccordance with the agreement, i.e. whether the entire sum is to be paid in a lumpsum or whether it is to be paid partly or wholly in a foreign currency or whetherpayment to be made is through installments, etc. This method can be adoptedwhere specialized products are involved are a few reputed accountability, the wholedeal must be transparent and a fairly reasonable price must be negotiated.

3) Open auction: Another method is the auction method. Under this method, thegovernment may announce its intention to sell a given amount of shares to a particularclass of buyers (e.g. individuals, resident or non-resident, institutional: domesticor/ 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 prospectivebuyer offers a second best price but has a very good track- record and a reputationin the market. Such an offer may be accepted.

4) Informal Approach: Informally, the government department concerned or the PSUitself 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 domesticcurrency, its mode; powers etc. and such a deal would be subject to the approval ofthe public authorities concerned like the disinvestment committee and parliament.

5) Pre-planned Transfer: In cases of types (4) and (5) discussed above, a systematicplan can be prepared and worked out. When the company is to be handed over tothe employees, all details like price per share amount of down payments, the modeof allotment ,loan- arrangements phased transfer of management, policy regardingmanagerial/supervisory staff, the form of oraganisation to be adopted etc. are to bewell planned and then the whole plan has got to be implemented.

Where the ownership is to be partially transferred to other public sector institutions,the quota given to each such institution is fixed in consultation with these institutionalbuyers as well as the central bank of the country.

6) Systematic Denationalization: Such a step involves a phasedprogramme.Generally, stocks are dispensed with in lots and then the promoters or


the business house concerned would elect/select a board of directors and takeover the responsibility. A phased out programmers is preferred because a suddentransfer may send shock waves in the stock market as well as among the workingclasses and the employees. Repercussions on demand are also expected througha change in the expectations of the consumers.

7) Liquidation: Incase of liquidation, the procedure is analogous to any privatecompany going into liquidation. Asset values are low, share-prices are to be valuedthrough assessors and share holder being the government, it receives payment ininstallments and on the basis of the price decided by the assessor/expert committeeappointed for this task.

d) Disinvestment of Public sector share holding- Indian experience:

Considering the performance and shortcomings of the Public Sector Undertakings, thegovernment has gone in for a programme of disinvestment of public sector enterprises.The 1991 Industrial Policy Statement envisaged the disinvestment of a part of thegovernment sharholding in selected PSUs to provide financial discipline and improvetheir performance. In the 1991-92 budget, the government announced the intention ofpartial disinvestment in selected PSUs in order to raise resources, encourage widerpublic participation and promote greater accountability. Upto 20% of the governmentequity in 31 selected enterprises was offered to Mutual Funds, Financial / InvestmentInstitutions, workers and general public. It is likely that such a measure may provideresources to the tune of Rs.2,500 crores to the Government to reduce its deficit.

Disinvestment of PSU Shares :

In pursuance of Industrial policy Statement of 1991, the Government has carried outvarious rounds of disinvestment of equity shareholding, realizing a total amount ofRs.20,320 crores form PSUs till March 2000.

The Government of India set up the Disinvestment Commission in August 1996 to adviseit on the extent, strategy, methodology and hiring for investment in each PSU. Till March1998, the Government referred 50 PSUs to the Commission for its advice. So far theCommission has given its recommendations on 41 PSUs - these recommendationsinclude trade sale (6 units), strategic sale (18 units) and offer of shares (5 units). In other12 cases, the Commission has recommended : no disinvestment, disinvestment deferred,and closure and sale of assets (for 4 units)

As against a total budgeted estimate of Rs.38,307 crores during 1991-92 and 2000-01,the Government realized only Rs.20,320 crores i.e. 38.4 per cent of the budgeted amount.Obviously, Government failed to raise the budgeted disinvestment in the capital market.Many reasons may by ascribed for this failure, but the most important is the non-


acceptability of the shares of PSUs in the capital market. The token privatization to theextent of 8 - 10 per cent of the shares of PSUs did not enthuse the Indian / foreigninvestors to buy these shares because they could hardly exercise any control on PSUs.

Year wise Receipts from Disinvestment of PSUs

Rs. Crores

Year Disinvestment Budgeted estimate Receipts Actual

1991-91 2,500 3,038

1992-93 2,500 1,913

1993-94 3,500 Nil

1994-95 4,000 4,843

1995-96 7,000 168

1996-97 5,000 380

1997-98 4,800 910

1998-99 9,006 5,371

1999-2000 10,000 1,829

2000-2001 10,000 1,869

Total 58,306 20,320

Source : RBI, Report on Currency and Finance (1998-99) and Economic Survey (2002-2002.)

The Cabinet Committee on Disinvestment in its meeting held on June 23, 2000 gave aclearance for disinvestment to 11 PSUs including IBP. MMTC, STC and SCI. BESIDESTHE 11 PSUs cleared, 19 other PSUs had been given clearance earlier. All this is beingdone to fulfill the objective of raising Rs.10,000 crores form disinvestment during theyear. The Government hopes to complete the disinvestment process in Indian Airlines,Air India, ITDC, BALCO and IPCL within the financial Year 2000-01.


Exercise:

1) What is the need for government's intervention in a free enterprise market economy?

2) Explain the causes of price rise in India, what are its consequences?

3) Briefly outline various measures taken by the government to control the problem of rapidlygrowing prices in India.

4) Explain the policy of economic liberalization 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


NOTES

351Reference Books

REFERENCE BOOKS FOR FURTHER READING

1) Economics - Samuelson.

2) Introduction to Positive Economics - Richard Lipsey

3) A study of Managerial Economics - D.Gopalkrishna

352 Managerial Economics

NOTES

353Reference Books

NOTES

354 Managerial Economics

NOTES

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