Professional Documents
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SYLLABUS
Unit 1
Unit 2
managerial economics.
Demand Analysis: Meaning, types and determinants of
Unit 3
demand.
Cost Concepts:
Cost
function
and
cost
output
Unit 5
Price
discrimination;
Price
discount
and
differentials.
Profit: Measurement of profit; Profit planning and
forecasting; Profit maximization; Cost volume profit
Unit 6
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LESSON 1
will
provide
the
most
efficient
means
of
attaining
an
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DEFINITION
According to McNair the Merriam, Managerial Economics consists of
the use of economic modes of thought to analyse business situations.
Spencer and Siegelman have defined Managerial Economics as
the integration of economic theory with business practice for the
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between
economics,
business
management
and
managerial economics.
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firm
unrealistic
since
it
fails
to
provide
satisfactory
with
actual
business
practice
and
develop
from
economic
concepts.
In
managerial
Estimating
economic
relationships:
This
involves
the
predicated
in
numerical
terms
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together
with
their
external
forces
that
constitute
the
business
to
taxation,
foreign
trade,
labour
relations,
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firms.
Conversely,
managerial
economics
is
managerial economics
is prescriptive
rather
than
variables
without
judging
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what
is
desirable
or
economics,
however,
is
concerned
with
what
these
economics,
aims
in
therefore,
particular
has
been
situations.
described
as
Managerial
normative
an
intelligent
understanding
of
the
business
DIFFFFERENCE
BETWEEN
MANAGERIAL
ECONOMICS
AND
ECONOMICS
The difference between managerial economics and economics can be
understood with the help of the following points:
Managerial
economics
involves
application
of
economic
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serves
the
specific
problem
solving
process.
Thus,
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First, Economics of the Firm deals with the theory of the firm,
which is a body of economic principles relating to the firm
alone. Managerial economics on the other hand deals with the,
application of the same principles to business.
Profit management.
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Capital management.
These aspects may also be defined as the Subject-Matter of
economics.
It
comprises
of
discovering
the
forces
Demand determinants
Demand distinctions
Demand forecasting.
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Cost-output relationships
Economics of scale
Production functions
Cost control.
Pricing methods
Profit Management
Business firms are generally organised with the purpose of making
profits. In the long run, profits provide the chief measure of success.
In this connection, an important point worth considering is the
element of uncertainty existing about profits. This uncertainty occurs
because of variations in costs and revenues. These are caused by
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Capital Management
Among the various types and classes of business problems, the most
complex and troublesome for the business manager are those relating
to the firms capital investments. Capital management implies
planning and control and capital expenditure. In this procedure,
relatively large sums are involved and the problems are so complex
that their disposal not only requires considerable time and labour but
also
top-level
decisions.
The
main
elements
dealt
with
cost
management are:
Cost of capital
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managerial
economics
and
economics,
statistics,
practice.
Economics
has
two
main
divisions-
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Opportunity cost
Multiplier
Propensity to consume
Speculative motive
Production function
Liquidity preference
Business financing
related to Economics.
economics
also
employs
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statistical
methods
for
disciplines,
viz.,
psychology,
sociology,
statistics
and
engineering.
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making purpose. for instance, the profit and loss statement of a firm
shows how well the firm has done and whether the information it
contains can be used by managerial economist to throw significant
light on the future course of action that is whether the firm should
improve its productivity or close down. Therefore, accounting data
require careful interpretation, reconstruction and adjustments before
they can be used safely and effectively. It is in this context that the
link between management accounting and managerial economics
deserves special mention. The main task of management accounting is
to provide the sort of data, which managers need if they are to apply
the ideas of managerial economics to solve business problems
correctly. The accounting data should be provided in such a form that
they fit easily into the concepts and analysis of managerial economics.
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Competitive
problems:
competitive
problems
deal
with
Inventory
problems:
Inventory
problems
deal
with
the
principal question: What is the optimum level of stocks of rawmaterials, components or finished goods for the firm to hold?
The above discussion explains that the managerial economics is
closely related to certain subjects such as economics, statistics,
mathematics
and
accounting.
trained
managerial
economist
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exist,
e.g.,
finance,
marketing,
personnel,
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The opportunity cost of holding Rs. 500 as cash in hand for one
year is equal to the 10% rate of interest, which would have been
earned had the money been kept as fixed deposit in a bank.
Thus, it is clear that opportunity costs require the ascertaining
of sacrifices. If a decision involves no sacrifice, its opportunity
cost is nil.
For decision-making, opportunity costs are the only relevant
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Emphasising the changes in total cost and total cost and total
revenue resulting from changes in prices, products, procedures,
investments or whatever may be at stake in the decision.
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Rs. 1,500
Rs. 2,000
Rs. 1,800
Rs. 700
Rs. 6,000
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Labour
Material
Overhead
Total Incremental Cost
Rs. 1,500
Rs. 2,000
Rs. 500
Rs. 3,500
While it appeared in the first instance that the order will result
in a loss of Rs. 1,000, it now appears that it will lead to an addition of
Rs. 1,500 (Rs. 5,000- Rs. 3,500) to profit. Incremental reasoning does
not mean that the firm should accept all orders at prices, which cover
merely their incremental costs. The acceptance of the Rs. 5,000 order
depends upon the existence of idle capacity and labour that would go
unutilised in the absence of more profitable opportunities. Earleys
study of excellently managed large firms suggests that progressive
corporations do make formal use of incremental analysis. It is,
however, impossible to generalise on the use of incremental principle,
since the observed behaviour is variable.
IIIustration
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capacity
to
take
up
business
with
higher
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below full cost though it often experienced idle capacity and the
management was fully aware that the incremental cost was far below
full cost. This was because the management realised that the long-run
repercussions of pricing below full cost would make up for any shortrun gain. The management felt that the reduction in rates for some
customers might have an undesirable effect on customer goodwill
particularly among regular customers not benefiting from price
reductions. It wanted to avoid crating such an image of the firm that
it exploited the market when demand was favorable but which was
willing to negotiate prices downward when demand was unfavorable.
4. Discounting Principle
One of the fundamental ideas in economics is that a rupee tomorrow
is worth less than a rupee today. This seems similar to the saying that
a bird in hand is worth two in the bush. A simple example would
make this point clear. Suppose a person is offered a choice to make
between a gift of Rs. 100 today or Rs. 100 next year. Naturally he will
choose the Rs. 100 today.
This is true for two reasons. First, the future is uncertain and
there may be uncertainty in getting Rs. 100 if the present opportunity
is not availed of. Secondly, even if he is sure to receive the gift in
future, todays Rs. 100 can be invested so as to earn interest, say, at 8
percent so that. one year after the Rs. 100 of today will become Rs.
108 whereas if he does not accept Rs. 100 today, he will get Rs. 100
only in the next year. Naturally, he would prefer the first alternative
because he is likely to gain by Rs. 8 in future. Another way of saying
the same thing is that the value of Rs. 100 after one year is not equal
to the value of Rs. 100 of today but less than that. To find out how
much money today is equal to Rs. 100 would earn if one decides to
invest the money. Suppose the rate of interest is 8 percent. Then we
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shall have to discount Rs. 100 at 8 per cent in order to ascertain how
much money today will become Rs. 100 one year after. The formula is:
V=
Rs. 100
1+i
where,
V = present value
i = rate of interest.
Now, applying the formula, we get
V=
=
Rs. 100
1+i
100
1.08
V=
Rs. 100
(1+i)2
Rs. 100
(1.08)2
Rs. 100
1.1664
5. Equi-marginal Principle
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aspects
of
the
equi-marginal
principle
need
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paise so that the 100 units will sell for Rs. 50. But the increased
output consumes raw materials, fuel and other inputs so that
variable costs in activity B (not counting the labour cost) are
higher. Let us say that the incremental costs are Rs. 30 leaving
a net addition of Rs. 20. The value of the marginal product
relevant for our purpose is thus Rs. 20.
Fourthly,
the
equi-marginal
principle
may
break
under
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which enables the manager to optimise or search for the best values
within the limits set by inequality conditions.
and
thereby
eliminating
considerable
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resource
allocation
under
perfect
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And
the
firms
objective
thus
becomes
sales
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CONCLUSION
The various gaps between the economic theory of the firm and the
actual decision-making process at the firm level are many in number.
They do, however, stress that economic theory seriously needs major
fixing up and substantial changes are in progress for creating better
and different models. Thus the classical economic concepts like those
of rational man is undergoing important changes; the notion of
satisfying is pushing aside the aim of maximisation and newer lines
and patterns of thoughts are being developed for finding improved
applications to managerial decision-making. A strong emphasis is laid
on quantitative model building, experimentation and empirical
investigation and newer techniques and concepts, such as linear
programming, game theory, statistical decision-making, etc., are being
applied to revolutionise the approaches to problem solving in business
and economics.
houses
have
understood
the
need
for
managerial
economists. Such business firms like the Tatas, DCM and Hindustan
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External
Internal
The external factors lie outside the control of management
because they are external to the firm and are said to constitute
business environment. The internal factors lie within the scope and
operations of a firm and hence within the control of management, and
they are known as business operations. To illustrate, a business firm
is free to take decisions about what to invest, where to invest, how
much labour to employ and what to pay for it, how to price its
products, and so on. But all these decisions are taken within the
framework of a particular business environment, and the firms degree
of freedom depends on such factors as the governments economic
policy, the actions of its competitors and the like.
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The outlook for the national economy, the most important local,
regional or worldwide economic trends, the nature of phase of
the business cycle that lies immediately ahead.
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the
ever-growing
economic
literature
and
advise
top
economy
like
that
of India,
the managerial
economist
Business Operations
A managerial economist can also be helpful to the management in
making decisions relating to the internal operations of a firm in
respect of such problems as price, rate of operations, investment,
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What will be a reasonable sales and profit budget for the next
year?
How much cash will be available next month and how should
it be invested?
Specific Functions
The managerial economists can play a further role, which can cover
the following specific functions as revealed by a survey pertaining to
Brittain conducted by K.J.W. Alexander and Alexander G. Kemp:
Sales forecasting.
Capital projects.
Production programmes.
Environmental forecasting.
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Economic Intelligence
Besides these functions involving sophisticated analysis, managerial
economist may also provide general intelligence service. Thus the
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briefs;
speeches,
articles
and
papers
for
top
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Conferences, etc
Keeping management informed of various national and
International Developments on economic/industrial matters.
With the adoption of the new economic policy, the macroeconomic environment is changing fast and these changes have
tremendous implications for business. The managerial economists
have to playa much more significant role. They ha'1e to constantly
measure the possibilities of translating the rapidly changing economic
scenario into workable business opportunities. As India marches
towards globalisation, the managerial economists will have to interpret
the global economic events and find out how the firm can avail itself of
the various export opportunities or of establishing plants abroad
either wholly owned or in association with local partners.
Responsibilities of a Managerial Economist
Besides considering the opportunities that lie before a managerial
economist it is necessary to take into account the services that are
expected by the management. For this, it is necessary for a
managerial economist to thoroughly recognise the responsibilities
and obligations. A managerial economist can serve the management
best by recognising that the main objective of the business, is to
make a profit on its invested capital. Academic training and the
critical comments from people outside the business may lead a
managerial economist to adopt an apologetic or defensive attitude
towards profits. There should be a strong personal conviction on part
of the managerial economist that profits are essential and it is
necessary to help enhance the ability of the firm to make profits.
Otherwise it is difficult to succeed in serving management.
Most management decisions necessarily concern the future, which
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economist
recognises
his
responsibility
to
make
fairly
positive
developments.
These
statements
can
be
about
based
impending
upon
the
economic
best
possible
adjustment
in
policies
and
programmes
and
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that
managerial
economist
joins
professional
associations and tak~ active part in them. In fact, one of the best
means of determining the quality of a managerial economist is to
evaluate his ability to obtain information quickly by personal
contacts rather than by lengthy research from either readily
available or obscure reference sources. Within any business,
there' may be a wealth of knowledge and experience but the
managerial economist would be really useful ifit is possible pn
his part to supplement the existing know-how with additional
information and in the quickest possible manner.
Again, if a managerial economist is to be really helpful to the
management in successful decision-making and forward planning, it
is necessary'" to able to earn full status on the business team.
Readiness to take up special assignments, be that in study teams,
committees or special projects is another important requirement. This
is because it is necessary for the managerial economist to win
continuing support for himself and his professional ideas. Clarity of
expression
terminology
and
attempting
while
to
minimise
communJcating
his
the
use
ideas
to
of
technical
management
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the
significance
of
economic
analysis
in
business
decisions.
4. Managerial Economics is perspective rather than descriptive in
character? Examine this statement.
5. Assess the contribution and limitations of economic analysis to
business decision-making.
6. Briefly explain the five principles, which are basic to the entire
gamut of managerial economics.
7. Explain the role of marginal analysis in determining optimal
solution if managerial economics. How does it compare with
break-even analysis?
8.Discuss
some
of
the
important
economic
concepts
and
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LESSON 2
DEMAND ANALYSIS
product
reflects
what
the
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TYPES OF DEMAND
The demand for various kinds of goods is generally classified on the
basis of kinds of consumers, suppliers of goods, nature of goods,
duration of consumption goods, interdependence of demand, period
of demand and nature of use of goods (intermediate or final), The
major classifications of demand are as follows:
Individual and market demand
Demand for firm's prodtictand industry's products
Autonomous and derived demand
Demand for durable and non-durable goods
Short-term and long-term demand
Individual and Market Demand
The quantity of a product, which an individual is willing to buy at a
particular price during a specific time period, given his money
income, his taste, and prices of other commodities (particularly
substitutes and complements), is called 'individual's demand for a
product'. The total quantity, which all comsumers are willing to buy
at a given price per time unit, given their money income, taste, and
prices of other commodities is known as 'market demand for the
good'. In other words, the market demand for a good is the sum of
the individual demands of all the c6-nsumers of a product, over a
time period at given prices.
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the
prices
permissible
under
local
conditions
and
Autonomous
demand
for
product
is
one
that
arises
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look more closely at the distinction between the two kinds of demand,
consider the demand for commodities, which arise directly from the
biological or physical needs of the human beings, such as demand for
food, clothes and shelter. The demand for these goods is autonomous
demand.
Autotnomous
demand
also
arises
as
a'
result
of
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goods. Durable goods are those goods whose total utility is not
exhausted in single or short-run use. Such goods can be used
continuously over a period of time. Durable goods may be consumer
goods as well as producer goods. Durable consumer goods include
clothes, shoes, house furniture, refrigerators, scooters, and cars. The
durable producer goods include mainly the items under fixed assets,
such as building, plant and machinery, office furniture and fixture.
The durable goods, both consumer and producer goods, may be
further classified as semi-durable goods such as, clothes and
furniture and durable goods such as residential and factory buildings
and cars. On the other harid, non-durable goods are those goods,
which can be used only once such as food items and their total utility
is exhausted in a single use. This category of goods can also be
grouped under non-durable consumer and producer goods. All food
items such as drinks, soap, cooking fuel, gas, kerosene, coal and
cosmetics fall in the former category whereas, goods such as raw
materials', fuel and power, finishing materials and packing items come
in the latter category.
The demand for non-durable goods depends largely on their
current prices, consumers' income and fashion whereas the expected
price, income and change in technology influence the demand for the
durable good. The demand for durable goods changes over a relatively
longer period. There is another point of distinction between demands
for durable and non-durable goods. Durable goods create demand for
replacement or substitution of the goods whereas non-durable goods
do not. Also the demand for non-durable goods increases or decreases
with a fixed or constant rate whereas the demand for durable goods
increases or decreases exponentially, i.e., it may depend upon some
factors such as obsolescence of machinery, etg. For example, let us
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10,000
1000
1000
-3id year
12,000
1200
4th year
14,200
1420
2000
1000
12,000
_
14,200
1000
16,620
2420
2200
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over a short period. In this category fall mostly the fashion consumer
goods, goods of seasonal use and inferior substitutes during the
scarcity period of superior goods. For instance, the demand for
fashion wears is short-term demand though the demand for the
generic goods such as trousers, shoes and ties continues to remain a
longterm
demand.
Similarly,
demand
for
umbrella,
raincoats,
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Consumer-credit facility
not
equally
important.
Besides,
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some
of
them
are
not
quantifiable.
For
example,
consumer's
preferences,
utility,
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Complementary Goods
A good is said to be a complement for another when it complements
the use of the other or when the two goods are used together in such a
way
that
their
demand
changes
(increases
or
decreases)
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taste
and preference
play
an important
role
in
5. Advertisel11ent Expenditure
Advertisement costs are incurred with the objective of increasing the
demand for the goods. This is done in the following ways:
By informing the potential consumers about the availability of
the goods.
By showing its superiority to the rival goods.
By influencing consumers' choice against the rival goods, and
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Assumptions
Therelatiqnship between demand and advertisement cost as shown in
Figure 2.4 is based on the following assumptions:
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impact on demand.
Per unit cost of advertisement added to the price does not make
the price prohibitive for consumers, as compared particularly to
the price of substitutes.
6. Consumers Expectations
Consumers expectations regarding the future prices, income and
supply position of goods play an important role in determining the
demand for goods and services in the short run. If consumers expect
a rise in the price of a storable good, they would buy more of it at its
current price with a view to avoiding the possibility of price rise
future. On the contrary, if consumers expect a fall in the price of
certain goods, they postpone their purchase with a view to take
advantage of lower prices in future, mainly in case of non-essential
goods. This behaviour of consumers reduces the current demand for
the goods whose prices are expected to decrease in future. Similarly,
an expected increase in income increases the demand for a product.
For example, announcement of dearness allowance, bonus and
revision of pay scale induces increase in current purchases. Besides, if
scarcity of certain goods is expected by the consumers on account of
reported fall in future production, strikes on a large scale and
diversion of civil supplies towards the military use causes the current
demand for such goods to increase more if their prices show an
upward trend. Consumer demand more for future consumption and
profiteers demand more to make money out of expected scarcity.
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7. Demonstration Effect
When new goods or new models of existing ones appear in the
market, rich people buy them first. For instance, when a new model
of car appears in the market, rich people would mostly be the first
buyer, Colour TV sets and VCRs were first seen in the houses of the
rich families some people buy new goods or new models of goods
because they have genuine need for them. Some others do so because
they want to exhibit their affluence. But once new goods come in
fashion, many households buy them not because they have a genuine
need for them but because their neighbors have bought the same
goods. The purchase made by the latter category of the buyers are
made out of such feelings' as jealousy, competition, equality in the
peer group, social inferiority and the desire to raise their social
status. Purchases made on account of these factors are the result of
what economists call 'demonstration effect' or the 'Band-wagoneffect.' These effects have a positive effect on demand. On the
contrary, when goods become the thing of common use, some people,
mostly rich, decrease or give up the consumption of such goods. This
is known as 'Snob Effect'. It has a negative effect'on the demand
for the related goods.
8. Consumer-Gredit Facility
Availability of credit to the cansumers fram the sellers, banks,
relatians and friends encourages the conSumers to buy more than
what they would buy in the aosence of credit availability. Therefore,
the consumers who can borrow more can consume more than those
who cannot borrow. Credit facility affects mostly the demand"for
durable goods, particularly those, which require bulk payment at the
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time of purchase. The car-loan facility may be one reason why Delhi
has more cars than Calcutta, Chennai and Mumbai. Therefore, the
managers who are assessing the prospective demand for their goods
should take into account the availability of credit to the consumers.
REVIEW QUESTIONS
1. Give short note on 'Demand Analysis'.
2. What are the determinants of market demand for a good? How
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LESSON - 3
COST CONCEPTS
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there are other costs, which neither take the form of cash outlays, nor
do they appear in the accounting system. Such costs are known as
implicit or imputed costs. Implicit costs may be defined as the earning
expected froin thesecond best alternative use of resources. For
example, suppose an entrepreneur does not utilise his services in his
own business and works as a manager in some other firm on a salary
basis. If he starts his own business, he foregoes his salary as a
manager. This loss of salary is the opportunity cost of income from his
business. This is an implicit cost of his business. The cost is implicit,
because the entrepreneur suffers the loss, but does not charge it as
the explicit cost of his own business. Implicit costs are not taken into
account while calculating the loss or gains of the business, but they
form an important consideration in whether or not a factor would
remain in its present occupation. The explicit and implicit costs
together make the economic cost.
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Fixed costs are those, which are fixed in volume for a given output.
Fixed cost does not vary with variation in the output between zero
and any certain level of output. The costs that do not vary for a
certain level of output are known as fixed cost. The fixed costs include
cost
of
managerial
and
administrative
staff,
depreciation
of
TC
Q
= average cost
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defined as
AC=
aTC
aQ
respectively,
and
often
appear
in
economic
analysi.s
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certain other costs, which arise due to functioning of the firm but do
not normally appear in business decisions. Such costs are neither
explicitly borne by the firms. The costs of this category are borne bythe society. Thus, the total cost generated by a firm's working may be
divided into two categories:
Those paid out or provided for by the firms,
Those not paid or borne by the firm.
The costs that are not borne by the firm include use of resouces
freely available and the disutility created in the process of production.
The costs of the former category are known as private costs and of the
latter category are known as external or social costs. A few examples
of social cost are: Mathura Oil Refinery discharging its wastage in the
Yamuna River causes water pollution. Mills and factories located in
city cause air pollution by emitting smoke. Similarly, plying cars,
buses, trucks, etc., cause both air and noise pollution; Such
pollutions cause tremendous health hazards, which involve health
cost to the society as it whole Thes'e costs are termed external costs
from the firm's point of view and social cost from the society's point of
view. The relevance of the social costs lies in understandipg the overall
impact of firm's working on the society as a whole and in working out
the social cost of private gains. A further distinction between private
cost and social cost therefore, requires discussion.
Private costs are those, which are actually incurred or provided
by an individual or a firm on the purchase of goods and services from
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the market. For a firm, all the actual costs both explicit and implicit
are private costs. Private costs are the internalised cost that is
incorporated in the firm's total cost of production.
Social costs, on thehand refer to the total cost for the society on
account of production ofa commodity. Social cost can be the private
cost or the external cost. It includes the cost of resources for which
the firm is not compelled to pay a price such as rivers and lakes, the
public, utility services like roadways and drainage system, the cost in
the form of disutility created in through air, water and noise pollution.
This category is generally assumed to be equal to total private and
public expenditures. The private and public expenditures, however,
serve only as an indicator of public disutility. They do not give exact
measure of the public disutility or the social costs.
COST-OUTPUT RELATIONS
The previous section discussed the variou cost concepts, which help
in the business decisions. The following section contains the
discussion of the behaviour of costs in relation to the change in
output. This is, in fact, the theory of production cost.
Cost-output relations play an importai)t role in business
decisions relating to cost minirnisalioil"Of'profiHnaximisation and
optimisation of output. Cost-output relations are specified through a
cost function expressed as
T(C) = f(Q)
(1)
where,
TC = total cost
Q = quantity produced
Cost functions depend on production function and marketsupply function of inputs. Production function specifies the technical
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(2)
AC =
TC
TFC + TVC
=
Q
TFC
AFC =
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TVC
AVC =
and
AC = AFC +AVC
(3)
Marginal cost (MC) is defined as the change in the total cost divided
by the change in the total output, i.e.,
MC =
TC
Q
aTC
or
aQ
(4)
TVC.
Cost Function and Cost-output Relations
The concepts AC, AFC and AVC give only a static relationship between
cost and output in the sense that they are related to a given output.
These cost concepts do not tell us anything about cost behaviour, i.e.,
how AC, A VC and AFC behave when output changes. This can be
understood better with a cost function of empirical nature.
Suppose the cost function (I) is specified as
TC = a + bQ - CQ2 + dQ3
(5)
(6)
(7)
The TC and TVC, based on equations (6) and (7), respectively, have
been calculated for Q = I to 16 and is presented in Table 3.1. The TFC,
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FC
(2)
10
10
10
10
10
10
10
10
10
10
10
10
10
10
10
10
10
TVC
(3)
0.0
5.15
8.80
11.25
12.80
13.75
14.40
15.05
16.00
17.55
20.00
23.65
28,80
35.75
44.80
56.25
70.40
TC
(4)
10.00
15.15
18.80
21.25
22.80
23.75
24.40
25.05
26.00
27.55
30.00
33.65
38.80
45.75
54.80
66.25
80.40
AFC
(5)
10.00
5:00
3.33
2.50
2.00
1.67
1.43
1.25
1.11
1.00
0.90
0.83
0.77
0.71
0.67
0.62
AVC
AC
(6)
(7)
5.15 15.15
4.40 9.40
3.75 7.08
3.20 5.70
2.75 4.75
2.40 4.07
2.15 3.58
2.00 3.25
1.95 3.06
2.00 3.00
2.15 3.05
2.40 3.23
2.75 3.52
3.20 3.91
3.75 4.42
4.40 5.02
MC
(8)
5.15
3.65
2.45
1.55
0.95
0.65
0.65
0.95
1.55
2.45
3.65
5.15
6.95
9.05
11.45
14.15
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AFC =
TFC
Q
(8)
AFC =
10
Q
(9)
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As defined above,
AVC =
TVC
Q
AVC =
6Q-0.9Q2+0.05Q3
Q
= 6- 0.9Q+0.05Q3
(10)
aAVC
aQ
Q=
= 0.9+0.10Q=0
(11)
Thus, the critical value of Q=9. This can be verified from Table
3.1
Average Cost (AC)
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AC =
(12a)
10
=
+ 6-0.9Q+0.05Q2
10
Q2
- 0.9 + 0.1Q = 0
(12b)
Q3 9Q2 = 100 = 0
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MC =
aTC
aQ
= 6-1.8Q+0.15Q2
(13)
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Q3 9Q2 100 = 0
(Q 10) (Q2 + Q + 10) = 0
(Q2 + Q + 10) = 0
Q 10 = 0 and Q = 10.
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constant, AC = MC.
Optimum Output in Short-run
An optimum level of output is the one, which can be produced at a
minimum or least average cost, given the required technology is
available. Here, the least'tcost' combination of inputs can be
understood with the help of isoquants and isocosts. The least-cost
combination of inputs also indicates the optimum level of output at
given investment and factor prices. The AC and MC cost Curves can
also be used to find the optimum level of output, given the size of the
plant in the short-run. The point of intersection between AC and MC
curves deterinines the minimum level of AC. At this level of output AC
= MC. Production beloW or beyond thislevelwill be in optimal. If
production is less than 10 units (Figure 3.2) it will leave some scope
for reducing AC by producing more, because MC < AC. Similarly, if
production is greater than 10 units, reducing output can reduce AC.
Thus, the cost curves can be useful in finding the optimum level of
output. It may be noted here that optimum level of output is not
necessarily the maximum profit output. Profits cannot be known
unless the revenue curves of firms are known.
Long-run Cost-output Relations
By definition, in the long-run, all the inputs become variable. The
variability of inputs is based on the assumption that, in the long run,
supply of all the inputs, including those held constant in the shortrun, becomes elastic. The firms are, therefore, in a position to expand
the scale of their production by hiring a larger quantity of all the
inputs. The long-run cost-output relations, therefore, imply the
relationship between the changing scale of the firm and the total
output; conversely in the short-run this relationship is essentially one
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The SAC curves can be derived from the data given in the STC
schedule, from STC function or straightaway from the LTC-curve.
Similarly, LAC can be derived from LTC-schedule, LTC function or
from LTC-curve. The relationship between LTC and output, and
between LAC and output can now be easily derived. It is obvious.
from the LTC that the long-run cost-output relationship is similar to
the short-run cost-output relationship. With the subsequent increase
in the output, LTC first increases at a decreasing rate, and then at an
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SAC
>
LAC.
Similarly,
for
all
levels
of
outout
corresponding to LAC = SAC, the LMC = SMC. For all other levels
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output, i:he LMC is either greater or less than the SMC. Another
important point to notice is that the LMC intersects LAC when the
latter is at its minimum, i.e., point B. There, is one and only one
short-run plant size whose minimum SAC coincides with the
minimum LAC. This point is B where, SAC2 = SMC2 = LAC = LMC.
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example,
Hind
Cycles,
unlike
small
mariufacturers,
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cost control, as most of the costs become controllable costs for the
enterprise. Transport' costs may also be reduced by planning
transportation in such a way that cross hauling is reduced to the
minimum.
Financial Economies: A large firm can offer better security and is,
therefore, in a position to secure better and easier credit facilities
both from its suppliers and its bankers. Due to a better image, it
enjoys easier access to the capital market.
Economies of Risk-spreading: The larger the size of the business,
the
greater
is
the
scope
for
spreading
of
risks
through
example,
armaments,
Vickers
Ltd.,
food-processing
make
plant,
aircrafts,
rubber,
ships,
plastics,
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best utilise all the machines the plant size must be of at least
6,000 units or any of its multiples.
Economies of Scale and Empirical Evidence
According to the surveys conducted by the Pre-investment Survey
Group (FAG) and later on by the NCAER, it has been pf()Ved that in
paper industry, profitability decreases with lower scaly of operations
and bigger plants beneht from economies of scale. The report of the
Pre-investment Survey Group (FAG) reveals that the manufacturing
cost of writing and printing paper would fall from Rs. 1,489 in a 100tonne per day plant to Rs. 1,238 in a 200-tonne per day plant and
further to Rs. 1,104 in a 300-tonne per day plant. The following Table
3.2 further shows the capital cost of raw materials and operating cost
per tonne of paper according to the size of the unit, as estimated by
the NCAER.
Table 3.2: Paper Industry: Investment and Other
Costs of Paper Mills according to Size
Size Tonnes
per day)
'.
100
200
250
Fixed
investment cost
per tonne
4,473
4,070
3,945
Cost of raw
Operating
ma terials per cost per tonne
tonne of paper
of paper
324
1,307
263
1,116
258
1,056
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over a 400 TPD plant. The difference between the cost of production of
a tonne of cement by a 3,000 TPD plant and of a50 TPD plant is as
high as Rs. 100 per tonne. In fact, there has been a perceptible
increase in the size of cement plants in India. For example, the 600
tonnes per day capacity cement plants during the early 1960s gave
way with their size going up to 1,200 tonnes per day. The latest
preference is for 3,200 tonnes per day capacity plants. A significant
policy implication of economics of scale is that in order to earn a
reasonable return and at the same time ensure a fair deal to the
consumers, the industry should go in for larger plants and expand the
existing plants to .the optimum level.
so, the
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6a1/2
a1/2
6a0/2
a0
a1/3
a1/3
a0/3
a0
a1/2
M0
a1/3.2/3
a0/2
a0
V 1 2/3
=
V0
2V0 or
V0
=2
Then,
M1
M0
V1 2/3
=
= (20) 2/3
V0
= 1.59
M1 = 1.59 M0
In other words, doubling the volume requires 59 per cent
increase in material. This is rouJded off as 60 per cent, which is the
same as 6/1O. It may be added that, if in place of a cubical container,
we had taken the example of a spherical or a rectangular or a
cylindricai or for that matter a conical container, we would have aijived
at the same relationship, viz.,
M1
V12/3
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M0
V0
World Sdale
With recent trends towards globalisation of industries in India, the
concept of "World Scale" has emerged. The term 'World Scale' refers to
that scale or size of the enterprise, which is large enough to enable the
firm to reap various large-scale economies so as to compete
successfully on the world basis with global rivals. Thus Reliance
Industries Limited has recently announced to build a world scale
polyester facility at Hnzira and a cracker project with capacity
expanding from earlier 40,000 tonnesto the world scale of 7,50,000
tonnes per annum.
Diseconomies of Scale
Economies of increasing size do not continue indefinitely. After a
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course,
that
the
businessman
in
his
planning
decisions
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blanking, notching and final assembly. The rest of the work is subcontracted to neighbouring small-scale units, which over a period or
time have become almost integral parts of each plant. Loans for the
purchase of machinery are also advanced and technical know-how
and sometimes-eve training is provided to these ancillary units.
Payments are made promptly. The whole system operates like
families within a larger family. Managers in the US, who are always
quick in innovating, have also begun adopting this blended system
during the past few years. General Motors encourages the creation ofa
cluster of independent enterprises in an area, with adequate
autonomy granted to the company's area chief to encourage their
growth and developm.ent. Consequently, though a giant in the
automobile industry, General Motors enjoys a large number of the
privileges that acerue to small units and also reaps the special
benefits accruing to large business firms.
Economies of Scope
This concept is of recent development and is different from the
concept of economies of scale. Here, the cost efficiency in production
process is brought out by variety rather than volume, that is, the cost
advantages follow from variety of output, for example, product
diversification within the given scale of plant as against increase in
volume of production or scale 6f output. A firm can add new and
newer products if the size of plant and type of technology make it
possible. Here, the firm will enjoy scope-economies instead of scale
economies.
COST CONTROL AND COST REDUCTION
Cost Control
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action
is certainly
possible
on
higher
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provide
standards
of
comparison
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for
appraising
the
these
comparisons
reveal
any
significant
differences,
costs/production
costs.
Overhead/prqduction costs.
Value Analysis: Value analysis is an approach to cost saving
that deals with product design. Here, before making or buying any
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department
does
in-this
direction
whereas
value
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planning,
rejects
due
to
faulty
materials
or
poor
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and
training,
improvement
in
productivity
and
by
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advantage
of
truck
or
wagonloads
may
reduce
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carefully,
and
keeping
an
eye
on
the
receivables.
and
giving
faster
deliveries
to
the
customers.
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personnel.
Every
business
operation
should
be
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individual
within
the
firm
should
recognise
his
resistance
to
change
should
be
minimised
by
base.
Shortages
of
raw
materials
are
usual
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There are delays in the issue of licences and by the time licences
are issued, cost of equipment goes up. The number of industries
subject to licensing has now been drastically reduced.
Increase in administered prices for many items crucial to the
industrial production by the Government from time to time also
pushes up costs.
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now
with
the
advent
of
recession
tendencies,
and
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APPENDIX - I
Calculation of Variances
The difference between the standard cost and the comparable actual,
cost for the same element and for the same period is known as cost
variance. The total of the variances consequently represents the
difference between the actual profits and the standard profits, i.e., the
profits that ought to have been made. The variances are said to be
favourable or credit Variances when the actual performance exceeds
the standard performance or the actual costs are lower than the
standard costs. On the other hand, the variances are unfavourableor
debit variances when the actual, performance falls short of the
standard performance or the actual costs exceed the standard costs.
All variances must state the direction of the variance as well as the
amoUnt. Calculation of cost variances is an important feature of
standard costing. The formulae for calculating the various variances
are given below:
Material Cost Variance
(Actual Quantity x Actual Price) - (Standard Quanity x Standard
Price)
or,
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(AQ - SQ) x SP
Material usage variance can be further sub-divided into (i) Mix
variance and (ii) Yield variance. When the process uses several
different materials that are supposed to be combined in a standard
proportion, mix variance shows the effeclofvariations from the
standard proportion. The formula for calculating the mix variance is:
(Actual Quantity - Standard Proportion) x Standard Price
Yield variance shows the loss due to the actual loss being more or
less than the standard loss. The formula for calculating the yield
variance is:
(Actual Loss - Standard Loss) x Average Standard Input Price
Labour CostVariance
(Actual Hours x Actual Rate)-(Standard Hours x Standard Rate)
or,
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APPENDIX II
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adjustments
in
prices
by
merely
varying
the
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to
different
channels
and
opportunities
for
market
segmentation.
Services to be performed by the distributors at different
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for
market
segmentation:
Trade
channel
strength
ofthe
buyers
and
by
big
cyclicaJ
fluctuations in demand.
o Individual consumer replacement. Market characterise by
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within fairly regroups limits set by the age of the product, say tyre.
Here because of brand preferences, buyers' responsiveness to price
differences is lower than in other markets where buyers' knowledge is
greater.
Another
pricing
problem
relating
to
individual
consumer
to
allow
the
dealer
large
discounts
and
thereby
considerable latitude where the unit cost of the article is high, where
service concessions and trade-ins are provided to the customers by
way of veiled price concessions and where the customer is not tied
strictly to the dealer by continuity of service or by customer relations.
A related pricing problem of the manufacturer is to decide
whether different distributor margins should be fixed for high-quality
high-price commodities, on the one hand, and low-quality low-price
products, on the other. The manufacturer has to consider whether he'
is to concentrate more on high quality or on low quality products in
view of their respective profitability. Market segmentation achieved
through differential distributors' discounts enables building big
plants' to reap economies of size. Manufacturers have sometimes built
bigger plants and to work them to full capacity, they have taken up
private label business (manufacturing _ goods to order with private
and exclusive brarids), allowing greater discounts till their own brand
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demand
for
the
competing
brand
of
different
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Quantity Discounts
Quantity discounts are price reductions related to the quantities
purchased. Quantity discounts may take several forms and may be
related to the size of the order being measured in terms of physical
units of a particular commodity. This is practicable where the
commodities are homogeneous or identical in nature, or where they
may be measured in terms of truckloads. However, this method is not
possible in case of heterogeneous commodities, which are hard to add
in terms of physical units, or truckloads. Drug industry and textile
industry offers examples of this type. Here, quantity discounts are
based upon the rupee value of the quantity ordered. Rupee becomes a
common denominator of value.
Quantity discounts based on physical units become important
where the cost of packing is a significant factor and orders of less than
standard quantities, say, less than a case of 6 pressure cookers, may
involve higher packing charges per cooker. Since the space remains
unutilised, the quantity discounts may be employed to induce fullcase purchasing. In some cases, sellers may clearly mention that
packing charges will be the same whether you purchase a full case or
less than a full case. Here also, the buyer may like to go for a full case
and in essence avail himself of the quantity discounts. Discounts
based on physical units are less likely to be distorted by changes in
prices.
In some cases, to prompt large orders, it may he specified that
orders up to a certain size will not be entitled to any discount. But
beyond this size, the customer would be entitled to a discount for his
extra purchases over and above the minimum size. The discount rates
may vary with successive slabs of quantities ordered. Alternatively,
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ways:
A given set of customers is encouraged tbbuy the same quantity
batiste bigger lots.
The customers may be 'induced to give the seller a larger: ihare of
their total requirements by giving preference over, competitors.
Small size purchasers may be discouraged and bigger size
customers may' be attracted.
Quantity discount system enables the dealer to reap economies
of buying in lager lots. These economies may enable the dealer to
charge lowler prices from the customers thereby benefiting the
customers. Finally, lower prices to customers may increase the
demand for the commodities, which in turn may enable the dealer to
purchase larger quantities, reaping still greater discounts, and the
manufacturer to reap economies of large-scale production, The
advantages to the manufacturer, dealer and customer are as such
circular. In fact, in many cases discounts become a matter of trade
custom.
A noted disadvantage of quantity discounts is that dealers may
often
find
it
cheaper
to
purchase
from
wholesalers
availing
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Cash Discounts
Cash discounts are price reductions based on promptness of
payment. An example of discount can be "2 per yent off if paid in ten
days, full invoice price in 30 days." In practice, the size of cash
discount may vary widely. Cash discount is a convenient device to
identify and overcome bad credit risks. In certain trades where credit
risk is high, cash discount would be high. If a buyer decides to
purchase goods on credit, this reflects his weak bargaining position,
and he has to pay a higher price by forgoing the cash discount. There
is another way to look at cash dis.counts. Though cash discounts
encourage prompt payment, yet allowing of cash discount also
involves certain costs.
These costs have to be compared with the cost of carrying the
account, viz., locking up of working capital, expense of operating a
credit and collection department- and risk of bad debts and
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alternative
ways
of
attaining
prompt
settlements.
By
prompt
Time Differentials
Charging different prices on the basis of time is another kind of price
discrimination. Here the objective of the seller is to take advantage of
the fact that buyer' demand elasticity varies over time. Two broad
types of time differentials may be distinguished:
Clock-time differentials,
Calendar-time differentials.
Clock-time Differentials: When different prices are charged for
the sMne service or commodity at different times within a 24 hours
period, the price differentials are known as clock-time differentials.
The common examples of these are the differences between the day
and night rates on trunk calls, differences between morning and
regular shows in cinema houses, and different tates charged' for
electricity sold to industrial users during peak load hours (day time)
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and offpeak load hours. In the case of telephone services, day timing
is the period of more inelastic demand and the night time is the more
elastic demand period. Two conditions, which make the clock-time
differentials profitable are as follows:
Buyers must have a definite and strong preference for purchasing
at certain timings over others giving rise to significant differences
in demand elasticity.
The product or service must be non-storable either wholly or in
parts, i.e., the buyer must consume the entire product at one
time when and for which he pays. In case the product is storable,
it will be purchased at lower rates to be used later when needed
making price differential a losing proposition.
Calendar-time Differentials: Here price differences are based
on a period longer than 24 hours; for example, seasonal price
variations in the case of winter clothing's, or betel accommodation at
hill and tourist stations. Here, the objective is also to exploit the time
preferences of the buyers.
Geographical Price Differentials
Geographical price differentials refer to price differentials based on
buyers location. The objective here again is to minimise the
differences in transport costs due to the varying distances between
the locations of the plants and the customers. There are various
types of geographical price differential, which are explained below:
FOB factory pricing: It implies that the buyer pays all the freight
and is responsible for the risks occurring during transport except
those that are assumed by the carrier. The advantages of FOB
factory pricing are as follows:
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into zones and regions and charges the same delivered price within
each zone, but different prices between different zones. For example,
Parle Company has divided the country into 9 zones, the intraregional price differentials ranging between 5 and 15 per cent
approximately. Generally speaking, zone pricing is preferred where the
transportation cost on goods is too high to permit their sale
throughout the country at uniform price. The more significant the
transportation costs, the greater the number of zones and smaller
their size. Conversely, for product involving lower transportation costs,
zones are generally few but big in size. In India, zone pricing has been
widely used invanaspati and sugar industries.
Basing point pricing a basing point price consists of a factory price
plus transportation charges calculated with reference to a particular
basing point. Under this system, the delivered price may be computed
by using either single basing point or multiple basing points. In the
single basing point system, all sellers (irrespective of the locations)
quote delivered prices, which arc the sum of the basing point price
and cost of transport from the basing point to the particular point of
delivery. Thus, the delivered prices quoted by all sellers for a given
point of delivey are uniform regardless of the point from which delivery
is made. In the multiple point pricing system, two or more producing
centres are selected as basing points, and the seller then quotes a
delivered price equal to the factory price plus transportation costs
from the basing point nearest to the buyer. Rasing-point pricing has
been widely used in the USA, especially in the steel industry where at
first the single basing-point system known as Pitts burgh plus was
employed. It was followed by mulliple basing point pricing when
Pittsburgh plus was declared illegal.
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etc.
Electricity
firms
quote
different
rates
for
2.
3.
4.
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may
be technical, managerial, financial or risk-bearing." Elucidate.
8.
9.
10.
11.
What are
the essentials for the succcss of a cost reduction programmc?
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LESSON 4
PRODUCTION FUNCTION
Labour (X)
(Number of
workers)
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input:
The
variable
input
employed
is
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Stage I
The figure 4.1 shows stage 1 as the segment from the origin to
pointX2. Here, total product (TP) rises at an increasing rate. At this
point, the marginal product (MP) of X equals its average product (AP).
X2 is, also the point at which the average product is maximised. In
this stage, the production function is characterised first by increasing
marginal returns from the origin to point X1and then by diminishing
marginal returns, from X1to X2. It should not be assumed that in stage
1, only increasing marginal returns take place. Because increasing
returns may occur until a certain point, and thereafter diminishing
returns may take place. Stage I should not therefore be identified with
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Marginal Physical
Product
Average Physical
Product
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increasing rate
Stage II
Increases at diminishing Is diminishing and
Starts diminishing
rate till it reaches
becomes equal to zero
maximum
Stage III
Starts declining
Becomes negative
Continues to decline
From this stage-wise description of the production function we
can reach two conclusions, which are as follows:
Stage II is Rational
Only stage II is rational and denotes the relevant range-within which a
rationai firm should operate. In Stage I, it is profitable for the fiim to
keep on increasing the use of labour and in Stage, III, MP is negative
and hence it is inadvisable to use additional labour. The firm,
therefore, has a strong incentive to expand through Stage I into Stage
II.
Stages I and /II are Irrational
Stages I and III are described as irrational stages. They are called so
because management, if it is to maxi mise profits will never
intentionally
apply
the
variable
to
the
fixed
factors
in
any
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Isoquants
An isoquant is also known as an 'iso-product curve', 'equal product
curve' or a 'production indifferent curve'. These curves show the
various combinations of two variable inputs resulting in the same
level of output. Table 4.3 shows how different pairs of labour and
capital result in the same output.
Capital
(Units)
5
Output
(Units)
10
10
10
10
10
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Substitutability of Inputs
An important assumption regarding the isoquant diagram is that the
inputs can be substituted for each other. For example a particular
combination of X and Y results in output quantity of 600 units. By
moving along the isoquant 600, one finds other quantities of the
inputs resulting in the same output. Let us suppose that X
represents labour and Y represents machinery. If the quantity of the
labour (X) is reduced, the quantity of machinery (Y) must be
increased in order to produce the same output. The following Figure
4.2 shows a typical isoquant.
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Right
Angle
Isoquant:
When
there
is
complete
non-
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For example, exactly two wheels and one frame are required to
produce a bicycle and in no way can wheels be substituted for
frames or vice-versa. Likewise, two wheels and one chassis (The
rectangular, steel frame, supported on springs and attached to
the axles, that holds thepody and motor of an automotive
vehicle) are required for acooter. This is also known as 'Leontief
Isoquant' or Input-output isoquant. The following Figure 4.4
shows the isoquant for chasis and wheels.
Convex
Isoquant:
This
form
of
isoquants
assumes
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when only one input is varied, holding all others constant. These
returns may be increasing,' diminishing, or constant.
Isocost Curves
In this connection, one has to consider yet another but important
diagram consisting of isocost curves. Here also, the axes represent
quantities of the inputs X and Y. Suppose that the prices of the inputs
are given, and there are no quantity discounts for the firm to get larger
quantities at lower prices. The next step will be to plot the various
quantities of X and Y which may be obtained from the given monetary
outlays. Figure 4.10 shows the resulting isocost curyes, which are
straight lines under the assumption made here. One isocost showing
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the quantities of X and Y that can be purchased for Rs. 1,000 and
another isocost curve showing the quantities of X and Y which can be
purchased for an expenditure of Rs. 2,000 and so on.
Now we can easily superimpose the isocost diagram on the
isoquant diagram (as the axes in both the cases represent the same
variables). With the help of Figure 4.11, it can be ascertained that the
maximum output for a given outlay, is say Rs. 2,000. The isoquant
tangent represents this maximum output, which is possible with this
outlay, to the isocost curve. The optimum combination of inputs is
represented by point E, the point of tangency. At this point, the
marginal rate6f substitution (MRS, sometimes known as the rate of
technical substitution), between the inputs is equal to the ratio
between the prices of the inputs.
Likewise, in order to mini mise the cost for a given output, one
may again refer to the isoquant and isocost curves in Figure 4.11. In
this case one moves along the isoquant representing the desired
output. It should be clear that the minimum cost for this input is
represented by isocost line tangent to the isoquant.
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The equation allows for decreasing marginal product but not for
both inerellsing and decreasing marginal products.
The elasticity of production is not constant at all points along
the curve as in a power function, but declineswiih input
magnitude.
The equaItion never allows fotan increasing marginal product
When X = 0, Y = a, this means that there is some output even
when no variable input is applied.
The quadratic equation has only one bend as compared with a
linear equation, which has no bends.
(4) Cubic Production Function
The cubic production [unction is expressed as follows:
Y = a -I- bX -I- cX2 dX3
Some important distinctivc properties of a cubic production
function arc as follows:
It
allows
for
both
increasing
and
decreasing
marginal
productivity.
The elasticity of production varies at each point along the curve.
Marginal productivity decreases at an increasing rate in the later
stages.
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Criticism
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actually
used
in
production,
while
capital
was
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analysis suggests that the optimal ratio depends on the inptlt prices.
For instance, if we draw isoquantsrelating various quantities of grain
and roughage, to various levels of milk output and then superimpose
isocost curves on the isoquant diagram, the optimum point of largest
output for a given outlay or of minimum outlay for a given outputwould depend on the prices of the factors of production, and it would
change as these prices change. The dairy farmer can use such
analysis for increasing the return from his expenditure on feeds.
Certain economists have focused especially on the application of
their findings. For instance, Earl Heady and his associates have
developed a mechaniclIl device known as Pork Postulator, which
facilitates the farmer to determine the most profitable ration for
feeding pigs under different price conditions.
Production functions thus are not just theoretical and futile
devices. They can also be used as aids in decision-making because
they can give guidance in two directions regarding:
Obtainfng the maximum output from a given set of inputs
Obtaining a given output from the minimum aggregation of
inputs
Of course, in more complex problems, with larger numbers of
inputs and outputs, the mathematics of optimisation becomes
complicated. But recently, the development of linear programming has
made it possible to handle these complex problems. The use of
complex production functions in managerial decisiull making is going
to be further facilitated with the development of electrollic computers.
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Given a production function for a certain output, one can derive all
the combinations of the factors of production that will yield the same
output. This can be illustrated as follows:
IIIustration
Suppose the production function is:
0= 0.196 H 0.880 N 1.815
Where,
0= output oftransformers in terms of kilovolt-ampere (kVA)
produced
H = average hours worked per day
N = number of men.
Now, to derive the input combinations for an output level of
1,200 kVA, we will have to set the above equation equal to 1,200:
1,200 = 0.196 H 0.880 N 1.815
Then, substituting any value of H (or N) in the equation, we can
obtain the associated value of N (or H). We compute below the number
of hours required (H) for an output of 1,200 kVA, if 38 men are
employed.
1,200 = 0.196 H 0.880 N 1.815
log 1,200 = log 0.196 + 0.880 log H + 1.815 log N
= log 1,200 = log 0.196+ 0.880 log H + 1.815 log 38
In the same way, we can derive the value of H, if N is 40, 42, 44
and so on, if the desired output level is 1,200 KVA. We can also derive
various combinations ofH and N for other levels, say, 1,300 KVA or
1,400 KVA.
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prices
and
technologically
determined
production
function.
The theory or lhe firm deals with the role of business firms in
the resource allocation process. It uses aggregation as a tactic
and attempts to specify total market supply and demand curves.
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Perfect competition.
Imperfect competition
o Monopoly and monopsony
o Monopolistic competition
o Oligopoly and oligopsony.
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The market iil which the commodity is bought and sold is well
organised and trading is continuous. Therefore, buyers and
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Firms also have equal access to all their inputs, which are
available on similar terms.
Thus, perfect competition in an extreme case and is rarely to be
safeguards
the
consumer
against
exploitation
by
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Determination of Price
The forces of demand and supply determine prices under perfect
competition. The equilibrium price is obtained at the intersection of
demand and supply curves as shown in following Figure 4.14. The
equilibrium price will change only with changes in forces of demand
and supply.
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If demand rises then price goes up and vice versa. For example,
in Figure. 4.15, the demand curve shifts. upwards, to the right
from DD to DD whereas the supply curve remains the same. As
a result, the price goes up from OP to OP1. Thus, the sales
increase from OQ to OQ1. If supply rises then the price
decreases and vice versa. For example, in Figure. 4.16, the
supply curve shifts downward to the right from SS to SS while
the demand curve remains unchanged. The result is that price
falls from OP to OP1. Dul the sales increase from OQ to OQ 1.
The following Figures 4.15 and 4.16 shows shift in demand
curve and shift in supply curve due to increase in price,
respectively.
Price will rise less or falllcss if the supply curve is elastic (flat)
Price will rise more or fall more if the supply curve is inelastic
(steep)
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If the rise in price is more than the rise in sales will be less
If the rise in price is less than the rise in sales will be more
In the same way the following will occur when there is a shift in
the supply curve
o The price will rise less or fall less if demand curve is
elastic
o The price will rise more or fall more if demand curve is
inelastic.
For example, in Figure 4.18, SS is the original supply curve, S'S'
is the new supply curve, D'D' is the steep demand curve (indicating
relatively inelastic demand) and DD is the flat curve intersecting the
supply curve at point E. After the shift in the supply curve, however,
the S'S' cuts the D'D' curve at point E' giving OP' as the equilibrium
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price. But the SS curve cuts the D"D" curve at point E giving the
equilibrium price as OP which is higher than OP'.
will
rise
if
the
amount,
which
will
be
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assume that the equilibrium price of sugar is Rs. 10.00 per kilo
but price has been controlled at Rs. 7.00. The suppliers would
hold back their supplies and this would leave a large body of
unsatisficd consumers. The problem would arise as to who
should get a sharclof the limited supply of sugar. There would
be long queues for the available supply. In short, lots of
difficulties would arise. The government would have t.o adopt
both-or either of the following measures:
o Introduction of rationing
o Payment of subsidey to sugar producers to neutralise the
effects of low prices and to encourage them to produce
more.
In this way, the Government would substitute ration cards for
the rationing mechanism of a free-market system and it would
substitute subsidies for the price incentive of a free market the
following Figure 4.21 and 4.22 shows the demand for wheat and
sugar, respectively.
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takes time to make those adjustmcl'lts ill the size and organisation of
a factory, which are necessary for greater production. For the purpose
of analysis in this connection, it is usual to follow the method of
analysis used by Marshall. Marshall suggested three periods of time
namely market period, short period and long period. Marshall
considered the market period as being only a single day or few days.
The fundamental feature of the market period is that it is supposed to
be so short that supplies of the commodity in question will be limited
to the existing stocks or at the most to the supplies in sight.
Graphically, the supply curve will be vertical, i.e., the supply remains
fixed irrespective of the price.
The 'market period' supply curve is not applicable in all cases. lt
is particularly important in the case of perishable goods, which are
difficult or impossible to store, and in case of demand, which is
subject to short-run fluctuations.
Marshall defined short period as "a period long enough for the
supplies of a commodity to be altered by increase or decrease in
current output but not long enough for the fixed equipment to be
changed to produce a larger or a smaller output." In other words; the
short-run cost curve remains the same. Here, the supply curve would
be a slopmg lme, moving upward Irom left to right thereby indicating
that as price goes up, supply increases.
In the long period, as defined by Marshall, there is time to build
additional plants or clear more land for crops; or alternatively, old
machines and factories can be closed down. A firm producing at
overtime rates or by using standby equipment will usually plan to
increase output by buying new plants and machinery. It will do so
when provided that it thinks the increased demand will be
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Illustration
To take an example, in Figure 4.23 DD shows the demand for fish
whereas SS, S'S', and S"S" represent the market-period, short-period
and long-period supply curves respectively. Suppose the demand for
fish in the market shifts to D'D'.
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At this given price, it can sell all the products, which it desires but at
any higherprice, it cannot sell anything. If the market price is below
its cost, it has to either take the loss or withdraw from the market. As
a result, any single firm in a purely competitive situation has to adjust
its production and sales policies to the given market price. However,
the market prices arc determined through the mutual consent of all
the individual competitive buyers and sellers together. But any
individual firm has no control over the price. Since a purely
competitive seller has no control over the price at which he sells, his
average marginal revenue schedule is infinitely elastic. In perfect
competition, marginal revenue is equal to the average re.xenue,
because every unit is sold at the same market price, irrespective of
the' quantity sold. Graphically, a horizontal line at the market price
represents it. As expansion of sales does not require any reduction in
the price at all; the greater the quantity sold, the larger is the revenue.
Under ordinary circumstances, the owner of a linn will not question
whether to produce or not to produce. Rather he will have to decide
whether it will be bettcr to producc, say, 10,000 units or 11,000 units.
In order to answer this question, hc will compare thc incremental cost
and tIll' incremental revenue resulting (i'om thc altcrnative courses of
action. To express in technical terms, the maximum profit (or the
minimum loss) position can be attained by in.creasing output so long
as the marginal revenue continues to exceed the marginal cost. When
marginal cost is above the marginal revenue, an increase in output
would reduce profits and it would be better to decrease the output. If
the amount of marginal rcvenuc is greater than the marginal cost, it
would be beneficial to increase the output. Thus, profit is maximised,
or the loss is minimised, by increasing the output just up to the point
a.t which marginal cost equals marginal revenue.
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recover even its variable costs and would certainly shut down. To
conclude, therefore, the shutdown point is whcre AVC=AR.
Consequences of Pure Competition
The consequences of pure competition can be enlisted as follows:
Equilibrium of Industry
The short-term and long-term adjustment processes can be clearly
identified by understanding the concept of equilibrium of an industry.
These are explained as follow.
Meaning of Industry
The term industries are sometimes used in a broad sense so as to
include all the producers of a similar type of commodity such as
vanaspati industry or cigarette industry. It is sometimes used in a
narrow sense to include only the producers of commodities, which are
identical from the point of view of purchasers such as wheat or more
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Collusion
among
producers
on
prices,
market
shares,
tendering, etc.
Until 1991, the Indian economy was regulated by numerous
Government decisions on wages, price, size and scope of production,
industrial relations, foreign exchange, etc. Due to these Government
regulations, hardly any industry was free to decide on its scale and
methods of production, wage policies retrenchment, equipment etc.
Again, the Indian industrialist operated in a completely sheltered
market. He was protected against external (foreign) competition by
import and exchange controls. The requirement of a licence before
starting a large-scale unit further protected him from internal (Indian)
competition. Thus, entry and withdrawal of firms was highly restricted
in Indian conditions. However, now the entrepreneurs are free to
decide about the industry they want to establish and its size except in
a limited number of industries, which are still subject to Government
regulation.
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essential
precondition
for
potential
competition
is
the
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new
entrants
encouraging
mare
production
and
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the monopolist is in a position to set the price himself and also enjoys
the market power.
The strength of a monopolist lies in his power to raise his prices
without the fear to loose his customers. However, the extent to which
he can raise depends on the elasticity of demand for his particular
product. This, in turn, depends on the extent to which substitutes for
his products are available. In most cases, there is an endless series of
closely competing substitutes. Therefore, exclusive monopolies like
railways or telephones also consider the possible competition by
alternative services. In this case, any increase in the rates by railways,
may lead to their substitution by motor transport and of telephone
calls by telegrams. In fact, it is very difficult to draw a line between
what is and what is not a monopoly. The truth is that there is a
continuous shift between competition and monopoly, just as there is
between light and darkness, or between health and sickness.
Even in those industries, which appear to be monopolised at
any time, monopoly has a constant tendency to break down. First,
there have been shifts in consumer demand. Secondly, inventions may
develop numerous substitutes for the monopolist's product. Thirdly,
the monopolist may suffer from lack of stimulus to efficiency provided
by competition. He may not devote attention to the improvement of his
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product. In addition, new competitors may arise to fill the gap. Finally,
the Government may intervene.
Causes of Monopoly
The government may grant a licence to any particular person or
persons for operating public utilities such as gas company, an
electricity undertaking, etc. In public utility services, economies
of scale are so prominent that it seems almost unbelievable to
have several firms performing the same service again. In such a
case, the Government may reserve the right of foreign trade
related to any commodity for itself or may give the right to any
other person. In all these cases, the statutory grant of special
privileges by the State creates the condition of monopoly.
The use of certain scarce raw materials, patent rights, special
methods of production or specialised skill, might also give a
producer
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revenue
(demand curve)
will slope
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that
commodity.
This
will
result
in
decreased
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primarily
on
unfair
competition
and
uncclillin
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MONOPSONY
It is a market situation in which there is single buyer to buy the
commodities but there may be many sellers to sell the identical or
homogeneous commodity.
Features of Monopsony
The essential features of monopsony are as follows:
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--
--
... _. _.-
.. ~- .... - .- -
Averange
Total
Marginal
Expenditure
Expenditure Expenditure
per Worker
(TE)
(ME)
(AE)
(Rs.)
(Rs.)
(Rs.)
6
500
3,000
550
3,850
850
600
4,800
950
650
5,850
1,050
10
700
7,000
1, 150
11
750
8,250
1,250
Price Discrimination
Price discrimination, may be defined as the practice by a seller of
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by
between
quantity
large
of
and
purchase:
small
Traders
purchasers,
often
offering
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by
social
or
professional
status
of
the
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to
Ihc
wishes
of
the
seller
adopting
price
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Sales
(Rs.)
100
200
300
400
500
700
1,000
1,400
2,000
2,800
3,600
Total Cost
(Rs.)
1,400
1,750
2,050
2,300
2,500
3,000
3,400
4,100
5,000
6,400
8,000
The above Table gives the number of units, a monopolist can sell
at various prices and the total cost involved in producing them.
Answer the following questions related to the table.
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Price
(Rs.)
Sales
(Uuits)
9.00
100
8.00
7.00
6.00
5.00
4.00
3.00
2.50
2.00
1.50
1.00
200
300
400
500
700
1,000
1,400
2,000
2,800
3.600
Total
Revenue
(Rs.)
1,600
Total
Cost
(Rs.)
1,400
2,100
2,400
2,500
2,SOO
3,000
3,500
4,000
4,200
3,600
1,750
2,050
2,300
2,500
3,000
3,400
4,100
5,000
6,400
8,000
Profit or
Loss
(Rs.)
-500
-150
50
100
0
-200
-400
-600
-1.000
-2,200
-4,400
Sales
(Units)
Sales
each
Categor
(units)
3
Revenue
from each
category
(Rs.)
4
Total
Revenue
(Rs.)
9.00
8.00
7.00
6.00
5.00
4.00
3.00
2.50
2.00
100
200
300
400
500
700
1,000
1,400
2,000
100
100
100
100
200
300
400
600
800
900
800
700
600
500
800
900
1,000
1,200
900
1,600
2,100
2,400
2,500
2,800
3,000
3,500
4,000
1,400 -500
1,750 -150
2,050 "
50
2,300 1000
2,500 -200
3,000 -400
3,400 -600
4,100 -1,000
5,000 -2,200
1.50
1.00
2,800
3,600
800
1,200
800
4,200
3,600
6,400 4,400
.8,000
Total
Cost
(Rs.)
6
Profit or
Loss
(Rs.)
7
Here, the prices, sales and total costs are the same as they were
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in Table 4.5. But the monopolist divides his customers into separate
groups and charges different prices from each group. The basis of
dividing the customers is as follows:
When price is Rs. 9 per unit, 100 units are sold, when the price is
Rs. 8 per unit, 200 units are sold. This means that 100 units can be
sold for Rs. 9 per unit and another 100 for Rs. 9 per unit. Similarly, by
charging Rs. 7 per unit, the monopolist can sell another 100 units. In
this way, other categories have also been formed as shown in column
3. Column 4 gives revenue from each category, which is calculated by
multiplying the figures of column 3 with the corresponding figures of
column 1. Column 5 gives tot21 revenue obtained by selling goods to
various categories of the customers. Column 6 gives total cost and
column 7 gives profit or loss.
In this situation, a. discriminating monopolist will also seek the
maximum profit, which cen be obtained by creating a category of
customers and charging Rs. 9 from those on the top class and Rs. 2
from those in the bottom of the category. With such a differential price
structure, the monopolist will sell 2,000 units and earn a maximum
profit of Rs. 2,400.
The monopolist will be better off by Rs. 2,300 by charging the
discriminating prices he will earn as much as Rs. 2,400 as
against a maximum of Rs. 100 by charging the single price of
Rs. 6.
The policy of discriminating prices is in the interest of the
customers as well. Larger output of 2,000 units, is beneficial to
a larger number of customers. Moreover, each customer is
charged according to his ability to pay. Therefore, the policy is
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Sales
(Units)
Sales in
each
Category
(units)
Revenue
from
each
category
(Rs.)
Total
Revenue
(Rs.)
Total
Cost
(Rs.)
Profit or
Loss
(Rs.)
3.00
1,000
1,000
3,000
3,000
3,400
-400
2.50
2.00
1.50
1.00
1,400
2,000
2,800
3,600
400
600
800
800
1,000
1,200
1,200
800
4,100
5,200
6,400
7,200
4,100
5,000
6,400
8,000
-100
200
0
-800
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APPENDIX 1
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APPENDIX 2
Measures of Monopoly Power
Several economistS have given different measures of monopoly power.
These are discussed below:
Lerner's measure: According to Lerner, the difference between
price dnd marginal cost, measures the gegree of monopoly power. In
other words, a seller's monopoly power depends upon his ability to sell
the commodity at a price above its marginal cost. A perfectly
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= 0.4
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REVIEW QUESTIONS
1.
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2.
3.
4.
Distinguish
function.
between
How
would
production
you
function
develop
the
and
cost
production
6.
What
is
the
short-down
point?
Explain
why
8.
9.
What
steps
are
necessary
to
make
this
intervention effective?
10.
11.
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13.
14.
15.
16.
Explain
and
illustrate
the
conditions
for
the
from
the
point
organisation.
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of
view
of
an
individual
LESSON - 5
PROFIT
MEANNING
Profit means different things to different people. The word profit has
different meanings to business, accountants, tax collectors workers
and economists. In a general sense, profit is regarded as income of the
equity shareholders. Similarly wages getting accumulated of a labor,
rent accruing to the owners of any land or building and interest
getting due to the investors of capital of a business, are a kind of profit
for labours, land owners and investors. To an account, profit means
the excess of revenue over all paid out costs including both
manufacturing and overhead expenses. It is much similar to net profit.
In accountancy, profit or business income means profit of a business
including its non allowance expenses. In economic, Profit is called
pure profit, which may be defined as a residual left after all
contractual costs have been met, including the transfer costs of
management
insurable
risks,
depreciation
and
payment
to
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Homogeneous goods
Increase in population
Increase In capital
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strategies
of
the
competitors
may
not
be
precisely
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MONOPLOY PROFIT
Monopoly is a market situation in which there is a single seller of a
commodity without a close substitute. Monopoly may arise due to
economies of scale, sole ownership of raw materials, legal sanction,
protection, mergers and takeovers. A monopolist may earn pure
profit, which is also called monopoly profit in the case of a monopoly,
and maintain it in the long run by using its monopoly powers.
Monopoly powers are as follows:
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revenue and cost data are, in general, obtained from the firm books of
account. It must, however, be noted that accounting profit may
present an overstatement or understand of actual profit, if it is based
on illogical allocation of revnues and costs to a given accounting
period.
On the other hand, if the objective is to measure true profit, the
concept of economic profit should be used. However true profitability
of any investment or business has been completely done. But then the
life of a business firm is unending therefore , true profit can be
measured only in terms of maximum amount that can be distributed
as dividends without harming the earning power of the firm. This
concept of business income is however, unattainable and therefore, is
of little practical use. It helps in income measurement even from
businessman point of view. From the above discussion, it is clear that,
for all practical purpose, profits have to be measured on the basis of
accounting concept. But measuring even the accounting profit is not
an easy task. The main problem is to decide as to what should be and
what should not be included in the cost one might feel that profit and
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loss accounts and balance sheet of the firms provide all the necessary
data to measure accounting profit there are, however three specific
items
of
cost
and
revenue
which
cause
problems,
such
as
depreciation, capital gains and losses and current vs. historical costs.
These problems are related to measurement and may arise because of
the differences between economists and accountants view on these
items. The concept of current costs can be used understood from the
following description.
Money
spent
in
the
acquisition
of
the
asset
including
reasons
for
using
historical
costs
for
calculating
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is
understated
during
deflation.
The
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Annuity Method
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(1)
The total cost includes fixed cost and variable cost. The cost,
which remains same at different levels or output, is called fixed cost.
The sum of all t~ose costs, which vary directly with the level of output,
is called variable cost. In context with the profit maximisation
objective, the total profit or the difference between total cost and total
profit is to be maximised. There are two conditions that must be
fulfilled for TR- TC to be maximum. These conditions are divided into
two categories, which are necessary or first order condition and
secondary
or
supplementary
condition.
These
conditions
are
explained as below:
The secondary or the second order condition states that the first
order condition must show the decreasing MR and rising MC.
The secondary condition is fulfilled only when both the MC is
rising as well as the MR is decreasing. This condition is
illustrated by point P2 in Figure 5.1.
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Let us suppose that the total revenue and total cost functions
are, respectively given as below:
TR = TC = f (Q)
where, Q = quantity produced and sold.
Substituting total revenue and total cost functions In
Equation (I), profit function can be written as below:
TP = f(Q)TR - f(Q)TC
(2)
With the help of equation (2), The first order condition and the
secondary. Condition can be understood easily.
First-order Condition
The first-order condition of maximising a function is that the first
derivative of the profit function must be equal to zero. By
differentiating the total profit function and equating it to zero, the
following equation is obtained:
aTP
aQ
aTR
=
aQ
aTC
-
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aQ
=0
(3)
aTR
aTC
=
aQ
aQ
a2TR
aQ2
a2TP
aQ2
a2TR
aQ2
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a2TC
aQ2
<0
(4)
But it requires:
a2TR
aQ2
a2TR
aQ2
a2TC
aQ2
<
a2TC
aQ2 < 0
<0
Since & TR/aQ2 is the slope of MR and & a2 TC/aQ2 is the slope
of MC, the second-order condition can also be written as:
Slope of MR < Slope of MC. It implies that MC curve must
intersect the MR curve. To conclude, profit is maximised where both
the first and second order conditions are satisfied.
Example
It is known that:
TR = P.Q
where,
(5)
P = Price of a single quantity and
Q = Total quantity.
Suppose price (P) function is given as
P = 100 2Q
Then
TR = (100 2Q) Q
Or,
TR = 100Q 2Q2
(6)
(7)
(8)
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or,
aTR
aQ
aTC
aQ
(9)
aTR
aQ
aTC
aQ
<
= 100 4Q
aTC
MC =
aQ
=Q
<
a2TC
aQ2
<0
aMR
Q
aMC
Q
<0
Or
a(100 40)
aQ
a(Q)
aQ
- 4 1 <0
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<0
large
business
maximisation
is
the
firms,
pursuing
distinction
goals
between
other
the
thon
ownership
profit
and
mllximisulioll
of
lilllllagcrial
utility
function,
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weaknesses.
He
further
argued
that
there
has
been
becausc
of
lack
of
communication
between
the
IN
FAVOUR
OF
PROFIT
MAXIMISATION
HYPOTHESIS
The traditional theory supports the profit maximisation hypothesis
also on the following grounds:
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out
the
distinction
between
the
ownership
and
the
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especially
of
large
business
corporations
are
also
discussed.
Baumol's Hypothesis of Sales Revenue Maximisation
According to Baumol, "maximisation of sales revenue is an alternative
to profitmaximisation objective". The reason behind this objective is to
clearly distinct ownership and management in large business firms.
This distinction helps the managers to set their goals other than profit
maximisation goal. Under this situation, managers maxi mise their
own utility function. According to Baumol, the most reasonable factor
in managers' utility functions is maximisation of the sales revenue.
The factors, which help in explaining these goals by the
managers, are following:
Salary and other earnings of managers are more closely related
to seals revenue than to profits.
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of
oligopolistic
interdependence.
Another
serious
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workers,
input
supplier,
customers,
bankers,
tax
authorities, and so on. All these groups have some expectations from
the firm, which are needed to be satisfied by the business firms. In
order to clear up the conflicting interests and goals, managers fonn an
objective level of the firm by taking into consideration goals such as
production, sales and market, inventory and profit.
These goals and objective level are set on the basis of the managers
past experience and their assessment of the future market conditions.
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and
changing
business
environment.
But
the
alternative
objective
of
firms
as
suggested
by
some
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separate
from
the
ownership,
the
possibility
of
profit
maximisation is reduced. This means that only those firms with the
objective of profit maximisation can survive in the long run. A
business firm can achieve all other subsidiary goals easily by
maximising its profits. The motive of business firms behind entryprevention is also to secure a constant share in the market. Securing
constant market share also favours the main objective of business
firms of profit maximisation.
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Under imperfect
profit
but
higher
enough
to
ensure
reasonable profit.
3. Restraining trade union demands: High profits make
trade unions feel that they have a share in the high profit
and therefore they demand for wage-hike. Wage-hike may
interrupt the firms objective of maximising profit. Any
delay in profit is sometimes used as a weapon against
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Intensity of mechanisation
Capital structure
Turnover
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eamings,
which
are
under
the
control
or
the
marketing
and
management
the
abilities
of
the
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firms.
towards
the
profit
objective,
the
top
management
uses
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Either the profit goals are set in terms of total net profit for the
divisions or they should be restricted to their share in the total
net profit.
profits, the organisations will use up their own capital and close
down. It also helps in replacing obsolete machinery and equipment
and thus ensures the continuity of a business.
Conclusion
Profit maximisation is the most popular hypothesis in economic
analysis, but there are many other important objectives, which are not
to be avoided by any firm. Modem business firms pursue multiple
objectives. The economists consider a number of alternative objectives
of business firms. The main factor behind the multiplicity of the
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the diverse
nature of
is
related
to
either
product,
price
or
to
both
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continuous
technological
improvements
may
make
production
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units has been sold so that the total contribution margin of the units
sold is equal to the fixed costs. The formula for calculating the breakeven point is:
Fixed costs
BEP =
Where the contribution margin is: selling price Variable costs per unit.
Example 1: Suppose the fixed costs of a Factory are Rs. 10,000 per
yenr, the variable costs are Rs. 2.00 per unit and the selling price is
Rs. 4.00 per unit. The break~even point would be:
Rs. 10,000
BEP =
= 5,000 units
(4-2)
In other words, the company would not make any loss or profit at
a sales volume of 5,000 units as shown below:
Sales
Cost of goods sold:
Variable cost @
Rs.2.00
Fixed costs
Net Profit
RS.20,000
Rs 10,000
Rs. 10,000
Rs.20,OOO
Nil
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Example 2:
Sales
Variable costs
Fixed costs
Rs. 10,000
Rs. 6,000
RS. 3,000
3,000
= Rs. 7 500
0.4
Sales value
Less: Variable costs
(0.6 x 7,500)
Fixed costs
Net profit
Rs.7,500
Rs.4,500
Rs.3,000
Nil
Increase in profit
1,200 - 400 =
Rs. 800
15,000 x 0.80
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12,000
Profit
VC + Profit
Sales value
Fixed cost
SV
S
400
12,400
15,000
2,600
15,000 12,000
15,000
3,000
15,000
= 0.2
FC
Contribution margin ratio
Now, BEP =
2,600
0.2
= Rs. 13,000
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Product
Selling Price
VC
% of rupee
Per unit
Sales volume
Rs.
Rs.
Tables
40
30
20
Lamps
50
40
30
Chairs
70
50
50
Selling price - VC
Selling price
x 100
50 - 40
70 - 50
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70
% of Sales
Tables
25.00 %
20 % = 5.00 %
Lamps
20.00 %
30 % = 6.00 %
Chairs
28.57 %
50%= 14.28%
25.28 % say 25 %
--
This 25 per cent is the total contribution per rupee of overall sales
given the present product sales mix. The calculations required in the
question are as follows:
BEP =
Fixed costs
Contribution marginper unit =
20,000
Rs. 80,000
25%
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= Rs. 10,000
Break-even Charts
Break-even analysis is very commonly presented by means of
break even charts. Break-even charts are also known as profit-graphs.
A break-even chart prepared on the basis of example 1 above is given
in Figure 5.2. In this figure, units of product are shown on the
horizontal axis OX while revenues and costs are shown on the vertical
axis OY. The fixed costs of Rs. 10,000 are shown by a straight line
parallel to the horizontal axis. Variable costs are then plotted over and
above the fixed costs. The resultant line is the total cost line,
combining both variable and fixed costs. There is no variable cost line
in the graph. The vertical distance between the fixed cost and th~ total
cost lines represents variable costs. The total cost at any point is the
SU!TI of Rs. 10,000 plus Rs. 2.00 per unit of variable cost multiplied
by the number of units sold at that point. Total revenue at any point is
the unit price of Rs. 4.00 multiplied by the number of units sold. The
break-even point corresponds to the point of intersection of the total
revenue and the total cost lines. A perpendicular from the BEP to the
horizontal axis shows the break-even point in units of the product.
Dropping a perpendicular from BEP to the vertical axis shows the
break-even sales value in rupees. The firm would suffer a loss at any
point below the BEP. Total costs are more than total revenue. Above
the BEP, total revenue exceeds total costs and the firm makes profits.
Since profit or loss occurs between costs and revenue lines, the space
between them is known as the profit zone, which is to the right of the
BEP, and the loss zone, which is to the len of the BEP. The following
Figure 5.2 shows Break-even Chart.
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Profit-Volume Analysis
It is very similar to the break-even analysis and is based on the
relationship of profits to sales volume. The profit-volume graph shows
the relationship ofa firm's profit to its volume. Total profit or loss is
measured on the vertical axis above the X-axis and the loss below it.
The volume is measured on the X-axis, which is drawn at the point of
'Zero-Profit'. Volume is usually expressed in tenns of percentage of full
capacity. The maximum loss, which occurs at zero sales volume, is
equal to the fixed cost and is shown on the vertical axis below the Xaxis. The maximum profit is earned when the firm works at full
capacity. The point of maximum profit is shown on the vertical axis
above the X-axis. The two points of maximum loss and the maximum
profit are joined by a line, which is known as the profit line, also called
PN line. The profit line can also be established by detennining the
profit at any two points within the given range of volume and drawing
a straight line through these points. The point, at which the profit line
intersects the X-axis, is the break-even point. The space between the
X-axis and the profit line shows the profit zone, which is to the right of
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BEP, and the loss zone, which is to the left of BEP. The usefulness of
the graph lise in the fact that it shows the profit or loss earned by the
firm by working at different levels of its full capacity. The following
Figure 5.4 shows the profit volume analysis.
Assumptions
1. All costs are either variable or fixed over the entire range of the
volume of production. But in practice, this assumption may not
hold well over the entire range of production.
2. All revenue is variable in nature. This assumption may Lot be
valid in all cases such as the case where lower prices are
charged to large customers.
3. The volume of sales and the volume of production are equal. The
total products, produced by the firm, are sold and here is no
change
in the
closing
inventory.
In practice,
sales
and
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life,
the
assumption
of
stable
product-mix
is
somewhat
unrealistic.
Safety margin
Expansion of capacity
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Choosing promotion-mix
Equipment selection
Production planning
Safety Margin
The break-even chart helps the management to know the profits
generated at the various levels of sales. But while deciding the volume
at which the firm would operate, apart from the demand, the
management should consider the safety margin associated with the
proposed volume. The safety margin refers to the extent to which the
firm can afford a decline in sales before it starts occurring losses. The
formula to determine the safety margin is:
Safety Margin =
(8,000-5,000) x 100
8,000
= 37.5%
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(4,000-5,000) x 100
4,000
Safety Margin =
= 25%
In other words, the management must strive to increase sales at
least by 25 per cent to avoid losses.
Volume Needed to Attain Target Profit
Break-even analysis is also utilised for determining the volume of
sales, necessary to achieve a target profit. The formula for target sales
volume is:
Target Sales Volume =
.
= 8000 units
Change in Price
The management is also faced with a problem whether to reduce the
prices or not. The management will have to consider a number of
points before taking a decision related to the change in the prices. A
reduction in price results in a reduction in the contribution margin as
well. This means that the volume of sales will have to be increased to
maintain the previous level of profit. The higher the reduction in the
contribution margin, the higher will be the increase in sales needed to
maintain the previous level of profit. However, reduction in prices may
not always lead to an equal increase in the sales volume, which is
affected by the elasticity of demand. But the information about
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FC + P
SPn - VC
16, 000
1.60
= 10,000 units
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16, 000
2.50
= 6,400 units
FC +P
SP - VC n
Q2=
15, 000
1.50
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= 10,667 units
FCn FC
SP - VC
SPn = SP +
FCn FC
Q
2.
Expansion of Capacity
The management may also be interested in knowing whether to
expand
production
capacity
or
not,
through
the
installation
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Sales
Costs and expenses:
Fixed
Variable
Net profit
Rs. 50,00,000
Rs. 15,00,000
Rs. 32,00,000
Rs. 47,00,000
Rs. 3,00,000
Capacity
Sales
Fixed costs
Variable costs
Profit (Loss)
Existing Plant
0%
100 %
Rs. (in Lakhs)
60
15
15
38.4
(15)
6.6
Expanded Plant
0%
100 %
Rs. (in Lakhs)
80
20
20
51.2
(20)
8.8
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In order to arrive at the data to plot on the figure, the sales, cost
and profit at either 100 per cent or nil capacity for both existing and
expanded plants should be calculated:
As can be seen from Figure 5.4, the break-even point for both the
plants lies above 70 per cent capacity utilisation. The capacity
utilisation of the expanded plant, which gives the same profit as 100
per cent capacity utilisation of the existing plant, can be easily found.
At 92 per cent of capacity utilisation, the expanded plant will give a
profit of Rs. 6,60,000.
Effect of Alternative Prices
The break-even chart can be modified to show the profit position at
difTerent price levels under assumed conditions of demand and costs.
Figure 5.5 shows the pr,ofit position at alternative prices for the firm
in example 1. As can be seen from the figure, the break-even point
becomes lower as the price increases. But it is not necessary that the
profit potential at higher prices may actually be achieved by the firm.
A price of Rs. 4 per unit with a demand at 7,000 units will give a
higher profit than a price of Rs. 5 with a demand at 4,000 units. It is
not desirable for a firm to take every price into consideration. The
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of
product
from
the
product-line
keeping
in
PrLe
(Rs.)
60
Variable costs
Per unit
(Rs.)
40
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% of
sales
30
Tables
Beds
100
200
60
120
20
50
Price
(Rs.)
Variable costs
Per unit
(Rs.)
40
60
120
60
160
200
% of sales
50
10
40
Rs. 60 - 40
60
x 30% = 0.10
Rs. 100 - 60
100
x 20% = 0.08
x 50% = 0.20/0.38
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x 50% = 0.17
Rs. 160 - 60
160
x 10% = 0.06
x 40% = 0.16
from
outside
suppliers.
For
instance,
an
automobile
9:
manufacturer
of
sc.ooters
buys
certain
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10,000
=
8-3
10,000
=
= 2,000
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Choosing Promotion-mix
Sellers often use several methods of sales promotion, such as
personal selling, advertising, etc. But the proportion of all these
methods in the promotion mix varies from seller to seller. A retail shop
may have to consider whether or not to employ a certain number, say,
five additional salesmen. Similarly, a manufacturer may have to decide
if he should spend an additional sum of Rs. 20,000 on advertising his
product or not. Break-even analysis enables him to take appropriate
decisions by showing how the additional fixed costs influence the
break-even points. This can be explained with the help of the following
illustration:
Example 10: A manufacturer sells his product at Rs. 5 each.
Variable costs are Rs. 2 per unit and the fixed costs amount to Rs.
60,000. Find the following:
1. The break-even point.
2. The profit if the firm sells 30,000 units.
3. The BEP if the firm spends Rs. 3,000 on advertising.
4. The sale of manufacturer to make a profit of Rs. 30,000 after
spending Rs. 3,000 for advertisement.
Solution: Tle calculations are as follows:
FC
BEP =
SP - VC
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60,000
=
= 20,000 units
5-2
Profit = Total revenue - Fixed cost - Variable cost
= (5 x 30,000) - 60,000 - (2 x 30,000)
= 1,50,000 - 60,000 - 60,000
= Rs.30,000
If the firm spends Rs. 3,000 on advertising, fixed costs would
rIse by Rs. 3,000, i.e., Rs. 63,000. Hence, BEP would be:
FC
BEP =
SP - VC
63,000
5-2
= 21,000 units
Contribution margin
63,000 + 30,000
3
93,000
3
= 31,000 units
Equipment Selection
Break-even analysis can also be used to compare different ways
o(doing jobs. For instance, use of simple machines, is usually best for
small quantities. But when bigger quantities are to be produced, faster
but usually costlier machines are to be employed. Sometimes, a choice
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Cost formula
Rs. 20,000 + 0.40 S
Rs. 8,000 + 2.00 S
Rs. 2,000 + 4.00 S
= Rs. 8,000 + 2S
or, 1.60S
= 12,000
or, S =
12000
1.60
= 7,500 units
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= Rs. 2,000 + 4S
or, 2S
= 6,000
or, 8
= 3,000 units
3.60S = 18,000
8 = 5,000 units.
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Production planning
Break-even analysis can also help in production is planning so as to
give maximum contribution towards profit and fixed costs. This will
be clearly understood from-the following illustration:
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Variable cost
Pcr mctrc
Cloth X Cloth Y
Rs.2.00 RS.3.00
Selling price
RS.2.60
Particulars
RS.3.80
The total expenses for one week are estimatcd at Rs. 21,400. Find
out the production plan, which the, company should follow. How
much profit shall be earned by following this production plan?
Solution. The contributions of Cloth X and Yare Re. 0.60 and Re.
0.80 per metre respectively, which are calculated by subtracting
variable cost of each from selling price. Hence, priority should be
gi~en to the production of cloth Y as it contributes more towards
meeting the fixed cost. The maximum of cloth Y that can be sold is
40,000 metres, which would require 10,000 hours. However, the total
hours available are 9,600. Hence, the maximum of cloth Y that can be
produced is 38,400 metres (9,600 x 4). The production plan to be
followed is given below:
_._-Cloth X
Cloth Y
Nil
38,400 metres
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Rs. 1,45,920
Total cost:
21,400
Net porfit
1,36,600
Rs. 9,320
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Business A
Re. 1.00
Business B
Re.I.OO
Re.0.20
Re.0.60
RS.5,000
Rs.2,500
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A basic assumption in break-even analysis is that the costrevenue-volume relationship is linear. This is realistic only over
narrow ranges of output. For example, this type of analysis is
worthwhile in deciding if the selling price should be 50 or 60
paise, volume should be attempted at 80 per cent of capacity
rather than 85 per cent, advertising expenditure should total
Rs. 1,00,000 or Rs. 1,15,000 or the product should be put in a
package costing 70 paise rather than 90 paise.
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forecasting
means
projection
of
future
earnings
after
considering all the factors affecting the siz.e of business profits, such
as firm's pricing policies, costing policies, depreciation policy, and so
on. A thorough study including a proper estimation of both economic
as well as non-economic variables may be necessary for a firm to
project its sales volume, costs and subsequently the profits in future.
According to joel Dean, a famous cconomist, there are three
approaches to profit forecasting, which are as follows:
Projecting
of
profit
land
loss
statement
means
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All those factors that control profits move in regular and related
patterns such as the rate of output, prices, wages, material costs and
efficiency, which are all inter-related by their connections with the
national markets and also by their interactions in business activity.
Theories of business cycles are based on the hypothesis, which is
shown by the national values of production, employment, wages and
prices during any fluctuation in business activities. There is no clear
pattern in detailed analysis. These patterns helps in increasing the
possibility that the profits of a business firm, can be forecast directly
by finding a relation to key variables. The need is to find a direct
functional relation between profits of a business firm and activities at
national level that shows statistical signi ticance.
In practice, these three approaches need not be mutually
exclusive. Theses approaches can also be used jointly for maximum
information. In projecting the profit and lo.ss statement, the
functional relations can be used, arising out of the ratio of cost to
output and to its other determinants. In the same way, by measuring
the impact of outside economic forces upon the firms' profit helps in
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LESSON NO-6
NATIONAL INCOME
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at
factor
cost
GOP
at
market
price
less
depreciation
Methods of Measuring National Income
For mcasuring the national income, the national economy is viewed as
follows:
units
combining
different
sectors
such
as
and
investing
units
(individuals,
households
and
government).
The above notions of a national economy helps to measure
national Income by following three different methods:
Factor-income method
Expenditure method
These methods are followed in measuring national income in a
closed economy',
Net Output Method
This is also called as net product method or value-added method. This
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from
which
they
originate.
The
output
(i)
the
nature
of
domestic
activities,
(ii)
their
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2.
used
arid depreciation of physical assets: The next step in
estimating the net national income is to estimate (he cost
of production including depreciation. Estimating cost of
production is, however, a relatively more complicated
and difficult task because of non-availability of adequate
and requisite data. Much morc difficult task is to
estimate depreciation since it involves both conceptual
and
statistical
problems.
For
this
reason,
many
However,
countries
adopting
net-
terms
(where
input
data
are
adequately
In
some
estimates
of
national
income,
the
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Factor-Income Method
This method is also known as income method and factor-share
method. factorincome method is used when national economy is
considerl:d as a combination of factor-owners and users. Under this
method, the national income is calculated by adding up all the
inconlcs accruing to the basic factors of production used in producing
the national product. Factors of production are c1assi ficd as land,
labour, capital and organisation. Accordingly,
National income = Rent + Wages + Interest + Profits
However, it is conceptually very difficult in a modern economy to
make a distinction between earnings from land and capital and
between the (;arnings from ordinary labour and organisational efforts
including entrepreneurship. Therefore, for estimating national income
factors of production arc broadly grouped as labour lInd capital.
Accordingly, national income is supposed to originate from two
primary factors, viz., labour and capital. However, in some activities,
labour and capital are jointly supplied and it is difficult to separate
labour and capital from the total earnings of the supplier. Such
incomes are termed as mixed incomes. Thus, the total factor-incomes
are grouped under three categories:
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Labour incomes
Capital income
Mixed incomes.
(excluding
interests on bonds and on consumer credit)
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generally
pertain
to
(i)
Excessive
allowance
of
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Second Method: Under this method the value of all the products
finally disposed of are computed and added up to arrive at the
total national expenditure. Under the second method, the
following items are considered
Private consumer goods and services
Private investment goods
Public goods and services
Net investment from aboard.
This method is extensively used because the requisite da!J
required by this method can be collected with greater ease and
accuracy.
Treatment of Net Income from Abroad
Net Factor Income From Abroad (NFIA); We have so far discussed
the methods of measuring national income of a 'closed economy'.
However, most modem economics are 'open economy'. These
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methods arc suitable for all economies and purposes. Hence, the
problem of choice of method anses.
The two main considerations on the basis of which a particular
method is chosen are:
The
purpose
of
national
income
analysis
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CSO followed the methodology laid down by the NIC. Thereafter, the
CSO adopted a relatively improved methodology and procedure, which
had become possible due to increased availability of data. The
improvements pertain mainly to the industrial classification of the
activities. The CSO publishes its estimates in its publication
Estimates of National Income.
Methodology
Currently, output and income methods are used by the CSO to
estimate national income of our country. The output method is used
for agriculture and manufacturing sectors, i.e., the commodity
producing sectors. Income method is used for the service sec(ors
including trade, commerce, transport and governmeni' services. In its
conventional series of national income statistics from 1950-51 to
1966-67, the fSO had categorised the income in 13 sectors. However,
in the revised series, it had adopted the following 15 break-ups of the
national economy for estimating the national income.
(i) Agriculture (ii) Forestry and logging (iii) rishing. (iv) Mining and
quarrying
(v)
Large-scale
manufacturing
(vi)
Small-scale
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2.
3.
4.
National
1960Income
Aggregates
61
(At
F:actor C
Jst)
Gross
Domestic
15,254
Prodllct (GDP
Fixed Capital
Consumption
Net Domestic
Product
(NDP)
= (1-2)
Net Factor
Income from
Abroad
1970-
1980-81
1990-91
1992-93
71
39,708
1,22,427
940
2,921
12,087
14,314
35,787
1,10,340
-72
-284
345
4,27,600
51,884
4,20,775
06,833
6,27,600
71,569
5,56,344
-11409
Contd....
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Indirect
947
3,455
Taxes
Less
Subsideis
Gross
6.
15,182
39,424
National
Product
(GNP)
= (1 + 4)
Net National
14,242
36,503
7.
Profit (NNP)
= (6-2)
GDP (at
16,201
43,163
8.
market
prices)
= (1+5)
GNP (at
16,129
42,879
9.
Market
price) = (8 +
3)
NDP (at
15,261
40,292
10.
Market
price) = (8
2)
NNP (at
15,189
39,958
11.
market
price) = (9
2)
Source : CMIE, Basic Statistics Relating
5.
13,586
58,205
122,772
4,65,827
1,10,685
1,36,013
1,36,358
1,23,926
1,24,271
77,653
4,13,943
5,30,865
5,24,032
4,78,981
4,72,148
6,16,504
5,44,935
705,566
9,31,016
6,63,997
6,22,588
Table 13.3
1.
Sectors
Agricuitural and
Allied sectors
1960-
1970-
61
71
81
91
45.8
45.2
38.1
31.8
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1980- 1990-
1994-95
at 198081
prices
31.3
2.
3.
4.
5.
6.
7.
8.
Manufacturing
and Mining, etc.
Transport,
Trade and
Communication
Finance and
Real Estate
Community and
Personal
Services
Commodity
Sector (1 + 2)
Non-commodity
Sector (3 + 4 +
5)
All Sectors
20.7
21.9
25.9
12.1
13.2
16.7
11.9
10.0
8.8
9.4
9.7
10.5
11.6
66.5
67.1
64.0
60.5
33.5
32.9
100.0
28.8
19.6
8.3
36.0
39.5
100.0 100.0
100.0
27.5
19.0
11.1
11.1
58.8
42.2
100.0
Tavie 6.3: Annual Average Growth Rate of GNP and GDP (AT
Current Prices)(% share in GDP)
Period
GNP (%)
GDP (%)
1950-51 to 1960-61
4.08
4.09
1960-61 to 1970-71
3.74
3.78
1970-71 to 1980-81
3.47
3.34
1980-81 to 1990-91
5.57
5.76
1990-91 to 1994,-95
3:95
4.08
1950-51 to 1994-95
4.04
4.07
-- -----------
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This
will
continue
until
all
unemployed
men
tind
employment arid capital and other resources are more fully utilised,
i.e., the stage of full employment. Beyond this stage, however, any
increase in the volume of money or rise in demand will lead to a rise
in prices but lIO corresponding rise in production or employment.
Keynes states that the initial rise in prices up to the stage of full
employment is a good thing far the country 'since there is an
increase in. output and employment. Reflation or partial inflation is
used to designate such a rise in the price level. The rise in prices
aller the stage of full employment is bad far the country since there
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to
Keynes,
"inflation"
can
be
applied
to
an
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lilnllip"l1llllli\('lilry
IIIll!
1i""'111
Ill,'lli",h,
aimcd
at
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coming
under
inflationary
pressure
will
experience
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control.
and
rationing
to
those
whose
prices
are
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sell
hope of
getting higher prices
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during
inflation because of the emergence of windfall profits. The prices
of
goods rise at a far greater rate than costs of production whereas
wages,
interest rates and insurance premium are all mere or less fixed.
Besides, the producers keep such assets, as commodities, real
estate, etc., whose prices rise much more than the general level
of prices. Thus, the producing and trading classes gain
enormously during an inflationary period. However, farmers may
gain only if their output is maintained or increased.
Fixed Income Groups: Inflation is very severe on those who arc
living on past savings, fixed rents, pensions and other fixed
income groups called as the middle classes. Those persons who
are working in government and private concerns find their money
incomes more or less fixed while the prices of the goods and
services, which they buy are rising very rapidly. Those with
absolui~ly fixed incomes derived from interest and rent-known as
the renter class, realise that their money income is absolutely
worthless and their past savings have insignificant value in front
of high prices. In fact, the worst sufferers in inflation are the
middle classes who are considered as the backbone of any stable
society.
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unsound,
politically
dangerous
and
morally
Monetary policy
Fiscal policy
Other methods
Monetary Policy
It is the policy of the central bank of the country, which is the
supreme monetary and banking authority in a country. The central
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bank may use such methods as the bank rate, open market
operations, the reserve ratio and selective controls in order to
control the credit creation operation of commercial banks and thus
restrict the amounts of bank deposits in the country. 'this is known
as tight money policy. .\ Monetary policy to control inflation is
based on the assumption that a rise in prices is due to a larger
demand for goods and services, which is the direct result of
expansion of bank credit. To the extent this is true, the central
bank's policy wi}1 be successful.
Fiscal Policy
It is the policy of a government with regard to taxation, expenditure
and public borrowing. It has a very important influence on business
and economic activity. Taxes determine the size or the volume of
disposable income in the hands of the public. The proper tax policy
to control inflation will avoid tax cuts, introduce new taxes and
raise the rates of existing taxes. The purpose being to reduce the
volume of purchasing power in the hands of the public and thus
reduces their demand. A precisely similar effect will be achieved if
voluntary or compulsory savings are increased. Savings will reduce
current demand for goods and thus reduce the inflationary rise in
prices.
As an anti-inflationary measure, government expenditure
should be reduced. This .indicates that demand for goods and
services will be further reduced. This policy of increasing public
revenue through taxation and decreasing public expenditure is
known as surplus budgeting. However, there is one important
difficulty is this policy. It may be easy to increase revenue in times of
inflation when people have more money ineome !:Jut difficult to
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useless
during
this
period.
Price
control
implies
the
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Other Methods
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all men are employed that a rise in the price level will not be
accompanied
by
an
increase
in
production
and
employment.
India,
which
has
both
widespread
unemployment
and
underemployment is raised.
Bottleneck Inflation
It is interesting to observe that Keynes himself visualised the
possibility of an inflationary situation even before full employ.lent
was reached. Such: a situation can arise even in advanced countries,
if there are difficulties in perfect G\lasticity of supply of goods and
services. It is possible that full employment is not reached but even
then, there is no scope for increased production. The factors
responsible for imperfect ela<;ticity of supply are law of diminishing
returns, absence of homogeneous factors and unemployed resources,
which cannot be used to increase production. All these factors are
lumped together and are known as bottlenecks. As monetary demand
increases with the increase in money supply, supply of goods does not
increase in proportion, due to imperfect elasticity. The difficulties or
handicaps, which prevent supply from increasing in the face of rising
demand, are known as bottlenecks. The result is that the cost of
production is pushed up and price level is raised. Apart from these,
other bottlenecks are as follows:
Market imperfections' in underdeveloped countries, such as
imperfect knowledge on the part of producers and consumers,
mobility
of
factors,
divisibility
of
factors
and
lack
of
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According
to
or.V.K.R.V.
Rao,
disguised
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Effects of Deflation
The following are the adverse effects of deflation:
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unemployment.
Therefore,
only
those
who
are
successful in keeping their jobs will be able to gain from the rise
in the value of money. As a matter of fact, during deflation, there
is great suffering and mystery all round and millions of families
are literally thrown onto the streets to make their living through
begging. The only group of people who may really gain is that
small minority, known as the renter class who get their income
by way of fixed interest and rents.
Methods of Control
Anti-deflation measures are the opposite of those, which are used to
combat inflation. Monetary policy aimed at controlling deflation
consists of using the discount rate, open-market operations and other
weapons of control available to the central bank of a country to raise
volume of credit of commercial banks. This policy is known as cheap
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money policy. This is based on an idea that with the increase in the
volume of credit, there will be an increase in investment, production
and employment. However, monetary policy is basically weak, for it
assumes that the volume of credit can be expanded by the central
bank. This may not be so, because even when commercial banks are
prepared to lend more to businesses to enable them to expand their
investment, the latter may not be willing to do so for fear of possible
failure of their investments.
Fiscal policy to fight deflation is known as deficit financing, i.e.,
expenditure in excess of tax revenues. On one hand government
attempts to reduce the level of taxation to provide large amount of
purchasing power with the public. While, on the 'other hand, the
government increases its expenditure on public work programmes
such as irrigation, construction of roads and railways. By this
programme government will (:I) provide employment for those who
may be thrown out of employment in the private sector, (b) add tei
national wealth, and (c) counteract the deficiency of private demand
for goods and services. The budget deficit can be financed through
borrowing from the public of their idle cash balances or banks. The
basic idea of fiscal policy is to expand demand for goods or to
counteract the decline in private demand. Therefore, fiscal policy is
the most important policy for economic stabilisation.
Other
measures
to
control
deflation
include
price
support
cost
of
production.
Price
support
programme
has
been
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deflation
is
fall
in
prices
accompanied
by
increasing
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20,000
2.
5,000
3.
4.
5.
15,000
1,500
13,500
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20,000
8,000
3.
12,000
Now the net disposable income, which the community will like to
spend is Rs. 13,500 crores but the available output for civilian
consumption is only Rs. 12,000 crores. There is excess of demand
o'Ver available supply ~') tne extent of Rs. 1,500 crores, which is
referred to as the inflationary gap. The basic fact is that so long as the
amount of disposable income with the people and the volume of goods
and services available for them are the same, there will be price
stability;
is Illore' thnllthe
lillieI', nn
i1t1llllinllllry lJ.lIp willllppc\;\r :ll\d IIIl' price level will rise; il~ 011
Ihe olher hUlld. the volume of goods llnd services is InrgN 1111\11
lht' VI""I1I\' Ill' dhl'".'lld"ll 1111'111111', "dI1lllllilllllll,\' gllp \\'ill
i'l'llI'lll,
Though Keynes assoeialed un inflationary gap with war, we cun
I\lso spcak of inflationary gap during periods of economic
development
Since
1951,
India
has
undertaken
economic
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The government may use the tax system to mop up the surplus
purchasing power with people; this will reduce C + I by the same
amount as the increase in government expenditure.
The output of goods and services may be increased so as to
absorb the excess demand. In Figure 6.2, such an increase in
real income should be YY1 But, as mentioned already, there is
no scope for such an increase in real income, as the economy is
already at full employment level.
Deflationary Gap
Deflationary gap is the opposite of inflationary gap. If the volume
of goods and services is larger than the aggregate demand for them, a
deflationary gap will arise. Deflationary gap arises when the C + I ofG line is pushed down to C' + I' + G'. The decline in demand may be
because of reduction in government expenditure or decline in private
investment or fall in private consumption demand. This is shown in
Figure 6.3. OY, = Volume of real income available for the community
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on
commercial
basis.
The
noun
'cycles'
bars
out
characterised
by
rising
prices
and
low
unemployment
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From the above definition, it should ,be clear that trade cy~les is
rhythmic fluctuations of the economy, that is, periods of prosperity
followed by periods of depression. However, the waves of prosperity
and depression need not always be of the same length and amplitude.
Further, trade cycles varied tremendously in magnitude. Whde some
have smaller cyclical fluctuations in economic activity, others have
great intensity of fluctuations. Expansion in some cycles reaches the
full employment level and stays there. However, in some cycles, the
peak is reached even before full employment. Sometimes, the cyclical
fluctuations may be prolonged for one reason or the other.
The American Economic Association emphasised the following
important characteristics of trade cycle:
Prices IInd production gencrnlly risc 01' 1111\ togctht.'r, Till'
C:\l'l:ptl(\l\ i~ agricultllre, where during 1I dowllwlIrd phllsc or
business ey(k~, ",h,'1\ prices are falling. (he agricullurists may
tend to produce more, so liS to onset the loss of lillling prices
11I1l1 thus 11I1I1IIlH11I tht' SilIlI\: 11"\'c1 <If income.
The total output and employment Jluctuate by a larger
percentage in durable and capital goods industries than in
non-durable and consumption goods industries.
Large changes in total output, employment and the price level
are normally accompanied by large changes in currency, credit
and velocity of circulation of Illoney.
Prices of manufactures are comparatively rigid while prices of
agricultural goods are normally flexible.
Profits fluctuate by a much larger percentage than other types of
income.
Industries are so inter-connected that fluctuations in one will
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goods
and
services
and
consequently
there
is
greater
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rapidly.
The
process
of
revival
and
recovery
becomes
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interest rates go up. The demand for bank credit increases and
there is all round optimism. At the same time, bottlen~.cks begin to
appear in the economy. Factors of production, particularly' raw
materials and labour becon~e scarce, commanding higher prices
and wages and thereby distort the cost calculations of the
entrepreneurs. They now realise that they have overstepped the
mark and become overcautious. Their over-optimism paves way for
their pessimism. Generally, the failure 01' a firm or bank bursts
boom and lead to recession.
Recession: The entrepreneurs realise their mistakes and find that
many of tht: ventures started in the rosy anticipation of the boom
are not profitable. The over oplimism of the boom gives way to
pessimism characterised by feelings of hesitation, doubt and fear.
Fresh enterprises are postponed for some remote future date and
those in hand are abandoned. Credit is suddenly curtailed sharply
as the banks are afraid of failure. Business l:xrnnsion stars. order~;
:1re cancelled and workers are laid off. Liquidity preference
suddenly rises and people pref~r to hoard rather thail invest
Building activity slows down and unemployment appears in
construction industries. Unemployment spreads to other sectors
also because the multiplier effect begins to work in the downward
direction. Uncmployment leads to fall in income, expenditure,
prices, profits and industrial and trade activities. Panic prevai l~" in
the stock market and the prices of shares fall rapidly., Once
business and economic activity start declining, it becomes almost
difficult to stop this decline and finally ,ends in a hopeless
depression.
We have described the various phases of a trade cycle, but we
should note, that all these phases rarely display smoothness and
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picks up,
it becomes rapid.
The boom period of the trade' cycle is marked by high level of
business activity.
The crash of the boom is always sudden and sharp.
The downward trend of the trade cycle is rather very' rapid.
The depression period is prolonged and is painful because of
widespread unemployment.
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theories of
tradc cycle. The climatic theory, also known as the sunspot
theory because the spots that appear, on the face of the sun
largely influence climatic conditions. A bad climate causes the
failure of harvests, which in turn lead:i to depression in
business conditions because of a fall in the incomc of" farmers
and consequent fall in their demand for the products of
industries, A good climate, on the contrary, has quite the
opposite effect on trade and industry. The variations of climate
are said to be so regular that periods of good harvest are
followed by periods of bad Ones and consequently booms and
slumps follow each other just as the days and nights, This
theory has been discarded in modern times. While it is difficult
to deny the fact that the prospects of agriculture affect the
pwspects of industries, it is not easy to correlate such a complex
phenomenon of trade cycle exclusively with the climatic
conditions. If the theory has to be correct, then it should accept
th"t trade cycles are less important in non-agricultural areas
and when a nation becomes more completely industrialised,
trade cycles would disappear or at least diminish in importance.
This, however, is not the case; in fact, it is advanced countries,
which seem to suffer most from the trade cycles.
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the rate of credit expansion by mising the market rate of interest above
the equilibrium rate, causing illvt'~;tment to (all abruptly. Thus, on
the one hand, investment is unattractive because of lower yield, and
on the other, investment is made more expensive because of higher
rate of interest. The business expansion and boom brought about by
IbW market rate of interest and heavy investment activity crashes
when the banking system puts a stop to additiorlal lending to firms by
raising the rate of interest. Investment and production will decline and
depression will rise.
Hayek(basic thesis can now be summarised as follows. Alternating
stages of prosperity and depression are due to lengthening and
shortening processes of production brought about by a change in the
money supply, which causes a change in the market rate of interest
away from the natural rate of interest. The lengthening of the process
of production is brought about by increase in moncy supply, which
causes the market rate of interest to fall below the natural rate of
interest. Shortening of the process of production is brought about by a
Lleel ine in the supply of bank money, which raises the market rate of
interest above the natural rate of interest. Therefore, the failure of the
banking system to keep the supply of money constant is responsible
for business cycles. Therefore, to control cyclical fluctuations, Hayek's
solution is simple, i.e., to keep constant supply of bank money,
making allowance for such increases or decreases in the velocity of
circulation of money.
Weaknesses of Hayek's Approach
According to Von Hayek, a low rate of interest and large bank lending
to entrepreneurs result into expansion of investment and production
whereas a high rate of interest puts a stop to this expansion and
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inC'Juencing
the
volume
of
investment.
Further,
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Some economists like Arthur Spiethofr and D.H. Robertson have also
subscribed to the over-investment theory but in a modified form. Their
approach is based on the assumption that Say's law of markets, which
oenies the possibility of overproduction, is valid in a barter economy
but not valid to a money economy in which transactions are not direct
but indirect through money.
Spiethoff believes that over-investment is a basic cause of business
slump but this is not due to low rate of interest or to expansion of
money supply, as Von Hayek has asserted. According to Spiethoff,
over-investment and over-production in one sector may be passed on
to others. For instance, during a business depression there is excess
capacity of durable capital goods. There will be no investment in these
or other related industries. When business recovery starts, capital
goods industries start expanding, and with that other industries that
serve capital goods industries also expand. For example, expansion of
iron and steel industry will lead to expansion of coal, mining,
manganese and transportation. When these industries expand,
income will increase and consequently demand for consumption goqds
will also increase. The upswing continues till the investment in all
industries has reached the optimum point and in certain lines of
production, there is even over-investment. This leads to the crash of
boom conditions.
D.H. Robertson believes that over-investment in some industries is
the result of indivisibilities and this imbalance is worsened by the
banking system, which brings in more money. In his opinion, the
course of economic progress is not generally smooth and as a malleI'
of (act, some degree of fluctuations may be necessary. The real
problem, however, is that the desirable fluctuations may create
excessive responses creating unstable conditions in the economy.
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over-investment
and
over-production
ale
results
of
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Hawtrey's theory would have been all right in those days when
the gold standard was universal and when the volume of money
supply was fixed to gold reserves. Currency and credit could
expand only when gold reserves increases. These days, gold
standard does not exist clnd, therefore, Hawtrey's theory is
really weak.
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in
business
activity.
Now,
according
to
Keynes,
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money available. In the short period, the rate of interest will be stable
and hence it is not responsible for causing cyclical fluctuations in
trade cycles. According to Keynes the fluctuations in the marginal
efficiency of capital are the fundamental cause of fluctuation in trade
cycles.
The following Figure 6.5 shows how trade cycle depends upon the
marginal efficiency of capital, which according to Keynes, is the villain
of the piece. The substance of Keynes' theory is that an initial
investment outlay will generate multiplc amount of income and
employment under the int1uence of the multiplier and acceleration
effects. On the other hand, 'co;ntraction of investment will similarly
lead to multiple contractions of incom~and employment. But whether
a fresh investment will be Lindertaken will depend upon the marginal
efficiency of capital. We can explain these pOint$ a little more
elaborately.
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stocks and necessity to replace capital goods. At the same time, the
rate of interest may be low because of large cash balances with
commercial banks or due to fall in the public liquidity preference. As
a result, the entrepreneurs may borrow fu~ds from banks and make
fresh
investments.
Under
acceleration effects,
the
impact
the process
of
the
multiplier
of increased investment
an<i
and
Very
soon
goods
are
accumulated
beyond
the
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prices and wages. The rate of interest goes up due to a rise in the
liquidity preference of the people. The marginal efficiency of capital
falls below the current rate of interest and thus, the decline of
investment is aggravated. Keynes believes that at this stage a
reduction in the rate of interest is neither easy nor adequate to
restore confidence and revive investment. In Keynes' theory of trade
cycles, the margina~ efficiency of capital has great significance than
the rate of interest. In fact, it disturbs the equilibrium of the economy
and thereby causes fluctuations in the economy. The other factor
that occupies an equally important place in Keynes theory is the
"investment
multiplier".
However,
for
the
active
operation
of
theory
of
trade
cycles
approaches
close
to
Pigou's
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The above Figure 6.6 shows the influence of the two types of
investment on the level of income and cyclical fluctuations. The
horizontal axis represents the number of years and the vertical axis
represents the level of economic activity. Line AA' represents the
progress of autonomous investment over thc years and it slants
upward at a uniform rate to indicate that autonomous investment
grows over time at a constant rate. Line EE' represents the income (or
output) corresponding to the aUlononious investment line AA. EE' IS
at a higher level than AI\" because it rerresents the eomhined
innllellce of mllitiplk'r flnd flccelerrllioll effects n.~ n result or
,lulollOlllllUS illvestl:lellt (AA '), III fact, the distallce bC1WL'Cil A/\'
lIlld EE' will depend upon the combined inlluence of the multiplier
and acceleration effects. Finally, line FF' represents the level of full
employment.
The Process of Cyclical Fluctuation
Suppose the economy is at point P in the Figure 6,6 and at this
.point, a certain invention is introduced. As a result, there is burst of
autonomous investment, which may be short-lived. But the induced
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investment will push output and employment upward along the path
marked PP1, away from the EE' line. Th,e upward trend touches full
employment ceiling at PI and cannot ~ise further. At the most, the
expansion can "creep along" the' ceiling but only for a limited time.
When the path has encountered the edling, it must bounce off from it
and begin to move in a downward direction.
According to Hicks, this downward swing is predictable. The
initial burst of autonomous investment is short-lived and after a stagc,
it will fall to the usual level. But the induced investment, which was
the result of the initial autonomous investment and the initial
increase in output, would continue and push ahead on path PP 1 But
the induced investment is not sufficient to support a growth of output
along the path FF' but it is sufficient to support an output which
expands along the equilibrium path EE', Output, therefore, will
bounce back from FF' towards EE'.
The downward swing is gradual along the path P2RRI and rapid
along P2RR2. At first, the downward swing may appear. to be
gradual but, in practice, it will be rapid. The reason is that once the
decline in output is initiated, it gathers momentum and tends to
proceed at a fast rdte. Hicks give a monetary explanation to this
phenomenon. As the downward movement starts, it becomes
increasingly di fficult to sell goods and consequently the burden of
fixed cost becomcs oppressive. Therefore, firm after firm becomes
bankrupt and liquidity preference records a sudden and abrupt rise
and reacts most adversely on credit situation. At [he same time the
stringent conditions in the credit market, forces business activity to
fall to the lowest ebb and thereby aggravate the situation. Thus,
Hicks' theory of trade cycles makes use of multiplier and
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the
new
product
introduced
in
the
mark~,
becomes
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firms may even incur losses and close down their businesses, thus
layoff labour and other agents of production. Therrfore, the demand
for goods is reduced. A similar deflationary effect is experienced whcn
the innovating firms return their bank loans out of their profits and
thus reduce the volume of money supply in the economy. The "vicious
circle of deflation" is generated in this manner.
Criticism
First, Schumpeter's theory is based upon two assumptions regarding
full employments of rf'sources in the economic system and financing
of innovation by means of bank loans. If an economy is working below
full employment, the introduction of an innovation need not cause
diversion of factors of production from older industries and thus
cause prices of goods to go up or their supply to iecline. Again,
innovation is generally financed by the promoter themselves and
hence, resort to bank .finance does not arise at all. Secondly,
innovation.s may be regarded as one cause for business fluctuations
but not the only cause, as there are many other causes also. As Hayek
correctly
points
phenomenon
of
out,
trade
innovations
cycles
alone
without
cannot
explain
substantive
the
monetary
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bankruptcy.
Similarly.
continuous
large-scalc
gove.-I1ll1cnt
attention
to
the
need
for
corrective
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transactions:
Capital
transactions
arc
those
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Transactions
Credit
Debit
Export.
Import
2. Foreign travel
Earnings
Payments
3. Transportation
Earnings
Payments
4. Insurance
(premium)
5. Investment
Income
6. Government
Cr;:rchase and
sales of goods
and services)
Receipts
Payments
Dividend
Dividends
Receipts
Payments
Receipts
Payments
I. Merchandise
7. Miscellaneous*
Current Account
Net Balance
Payments
Balance
Surplus (+)
Deficit (-)
(a)
short-term
capital
movements;
(b)
long-term
capital
movements; and (c) changes in the gold and exchange reserves. Shortterm capital movements include (i) purchase of shortterm securities
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such as treasury. bills, commercial bills and acceptance bills, etc.; (ii)
speculative purchase of foreign currency; and (iii) cash balances held
by foreigners for suchfeasons as fear of war and political instability. An
item of short-term capital results often from the net balances (positive
or negative) in the Cljrrent Account. Long-term capital movements
include: (i) direct investment in shares, bonds, real estate and physical
assets such as plant, building and equipments, in which investors
hold a controlling power; (ii) portfolio investments including all other
stocks and bonds such as government securities, securities of firms
which do not entitle the holder with a controlling power; and (iii)
amortisation of capital, i.e., repurchase and resale of securities carlier
sold to or purchased from the foreigners. Direct export or import of
capital goods fall under the category of direct investment. It should be
noted that export of capital is a debit item whereas export of
merchandise is a credit item. Export of goods result in inflow of foreign
currency, which is an addition to the circular flow of money income,
whereas export of capital results in outflow of foreign exchange which,
amounts to withdrawal from the foreign exchange reserves. Geld and
foreign exchange reserves make the third major category of items in
the capital account. Gofd and foreign exchange
reserves
are
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value
for
non-economic
purposes.
Besides,
these
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autonomous
transactions
are
induced
transactions.
These
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to
to
large.
The
import
countries
accumulate
with
larger
higher
deficits
marginal
during
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Other
Factors:
In
addition
to
the
fundamental
factors
certain
other
factors,
which
may
cause
temporal
of
advanced
countries
on
the
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excess
demand
orby
using
the
two
methods
any
or
all
of
these
instruments
amI
adopt
them
simultttneously.
To solve the problem of deficit in the balance of payments, a 'tight
maney policy' or 'dear money.p6Iicy' is ,idoptl:d. Under 'dear money'
policy,
raise
"[ilc
discount
rate.
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and
public
expenditure.
Taxation
reduces
household
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can
be
changed
through
exchange
depreciation
and
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currency and foreign demand for its goods increases provided foreign
demand for imports is price elastic. Thus, if devaluation or exchange
depreciation is effective, imports will decrease and exports will
increase. Country's payments for imports would decrease and export
earnings would increase. This ultimately decreases the deficits in the
balance of payments in due course of time. However, whether
expected results of devaluation or exchange depreciation are achieved
or not depends on the following condition5.
The most important condition in this regard is the MarshallLerner conditidh. The Marshall-Lerner condition states that
devaluation will . improve the balance of payments only if the
sum of elasticises of home demand for imports and foreign
demand for exports is greater than unity. If (he sum of elasticises
is less than unity, the balance of payments can be improved
through revaluation instead of devaluation.
Devaluation can be successful only if the alTectcd countries do
nol devalue their currency in retaliation.
Devaluation must not change the cost-price structure in favour of
imports.
Finally, the government ensures that inflation. which may be the
result of deyaluation, is kept undcr control, so that the effect of
devaluatibn is not counter-balanced by the effect of inflation.
Direct Measure: Exchange Control
The exchange control refers to a set of restrictions imposed on the
international transactions and payments, by the government or the
exchange cotHrol authority. Exchange control may be partial, confined
to only few kinds of transactions or payments, or total covering all
kinds of international transactions depending on the requirement of
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the country.
The main features of a full-fledged exchange control system are as
follows:
The government acquires, through the legislative measures, a
exchange.
Law el iminates the sale and purchase of foreign exchange by
the
routed
through the exchange control authority or the authorised
agents.
import
of essential goods and service such as food items, raw
materials,
petroleum products.
A system of rationing is adopted in the foreign exchange
allocation
for essential imports.
and to
prevent the possible evasion, strict, stringent laws like FERA
and/COFEPOSA in India arc enactec.
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supply
conditions.
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clearly
between
demand-pull,
cost-push
and
sectoral infl~ltion.
10. "Inflation
is
unjust
and
in~quitable
and
deflation
is
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QUESTION PAPER
Paper 1.3: MANAGERIAL ECONOMICS
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Time: 3 Hours
Max. Ma
SECTION~A
(5 x 8 = 40)
Answer any Five questions
SECTION -B
(4 x 15 = 60)
Answer any Four questions
9. Discuss
some
of
the
important
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economic
concepts
and
12. Explain
the
first
and
second
order
conditions
of
profit
maximization
13. Explain the effects of government interve.ntion in price fixation.
WI necessary to make this intervention effective?
14. "The Business Cycle is purely a monetary, phenomenon."
Discuss.
15. Define Inflation. Explain its effect on
(a) Total output
(b) Distribution of income between, different economic classes.
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