MANAGERIAL ECONOMICS

SYLLABUS
Unit 1

Managerial economics: Meaning, nature and scope;

Economic theory and managerial economic; Managerial
economics and business decision making; Role of

Unit 2

managerial economics.
Demand Analysis: Meaning, types and determinants of

Unit 3

demand.
Cost Concepts:

Cost

function

and

cost

output

relationship; Economics and diseconomies of scale; Cost

Unit 4

control and cost reduction.

Production Functions: Pricing and output decisions
under competitive conditions; Government control over
pricing;

Unit 5

Price

discrimination;

Price

discount

and

differentials.
Profit: Measurement of profit; Profit planning and
forecasting; Profit maximization; Cost volume profit

Unit 6

analysis; Investment analysis.

National Income: Business cycle; Inflation and deflation;
Balance of payment; Their implications in managerial
decision.

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LESSON 1

NATURE & SCOPE OF MANAGERIAL ECONOMICS

The terms Managerial Economics and Business Economics are often

used interchangeably. However, the terms Managerial Economics has
become more popular and seems to displace Business Economics.

DECISION-MAKING AND FORWARD PLANNING

The chief function of a management executive in a business firm is
decision-making and forward planning. Decision-making refers to the
process of selecting one action from two or more alternative courses of
action. Forward planning on the other hand is arranging plans for the
future. In the functioning of a firm the question of choice arises
because the available resources such as capital, land, labour and
management, are limited and can be employed in alternative uses. The
decision-making function thus involves making choices or decisions
that

will

provide

the

most

efficient

means

of

attaining

an

organisational objectives, for example profit maximization. Once a

decision is made about the particular goal to be achieved, plans for
the future regarding production, pricing, capital, raw materials and
labour are prepared. Forward planning thus goes hand in hand with
decision-making. The conditions in which firms work and take
decisions, is characterised with uncertainty. And this uncertainty not
only makes the function of decision-making and forward planning
complicated but also adds a different dimension to it. If the knowledge

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of the future were perfect, plans could be formulated without error

and hence without any need for subsequent revision. In the real world,
however, the business manager rarely has complete information about
the future sales, costs, profits, capital conditions. etc. Hence,
decisions are made and plans are formulated on the basis of past
data, current information and the estimates about future that are
predicted as accurately as possible. While the plans are implemented
over time, more facts come into the knowledge of the businessman. In
accordance with these facts the plans may have to be revised, and a
different course of action needs to be adopted. Managers are thus
engaged n a continuous process of decision-making through an
uncertain future and the overall problem that they deal with is
adjusting to uncertainty.
To execute the function of decision-making in an uncertain
frame-work, economic theory can be applied with considerable
advantage. Economic theory deals with a number of concepts and
principles relating to profit, demand, cost, pricing, production,
competition, business cycles and national income, which are aided by
allied disciplines like accounting. Statistics and Mathematics also can
be used to solve or at least throw some light upon the problems of
business management. The way economic analysis can be used
towards solving business problems constitutes the subject matter of
Managerial Economics.

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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purpose of facilitating decision-making and forward planning by

management.
The above definitions suggest that Managerial economics is the
discipline, which deals with the application of economic theory to
business management. Managerial Economics thus lies on the margin
between economics and business management and serves as the
bridge between the two disciplines. The following Figure 1.1 shows the
relationship

between

economics,

business

management

and

managerial economics.

APPLICATION OF ECONOMICS TO BUSINESS MANAGEMENT

The application of economics to business management or the
integration of economic theory with business practice, as Spencer and
Siegelman have put it, has the following aspects :

Reconciling traditional theoretical concepts of economics

in relation to the actual business behavior and conditions:
In economic theory, the technique of analysis is that of model
building. This involves making some assumptions and, drawing
conclusions on the basis of the assumptions about the behavior
of the firms. The assumptions, however, make the theory of the

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firm

unrealistic

since

it

fails

to

provide

satisfactory

explanation of what the firms actually do. Hence, there is need

to reconcile the theoretical principles based on simplified
assumptions

with

actual

business

practice

and

develop

appropriate extensions and reformulation of economic theory.

For example, it is usually assumed that firms aim at
maximising profits. Based on this, the theory of the firm
suggests how much the firm will produce and at what price it
would sell. In practice, however, firms do not always aim at
maximum profits (as they may think of diversifying or
introducing new product etc.) To that extent, the theory of the
firm fails to provide a satisfactory explanation of the firms
actual behavior. Moreover, in actual business language, certain
terms like profits and costs have accounting concepts as
distinguished

from

economic

concepts.

In

managerial

economics, an attempt is made to merge the accounting

concepts with the economics, an attempt is made to merge the
accounting concepts with the economic concepts. This helps in
a more effective use of financial data related to profits and costs
to suit the needs of decision-making and forward planning.

Estimating

economic

relationships:

This

involves

the

measurement of various types of elasticities of demand such as

price elasticity, income elasticity, cross-elasticity, promotional
elasticity and cost-output relationships. The estimates of these
economic relationships are to be used for the purpose of
forecasting.

Predicting relevant economic quantities: Economic quantities

such as profit, demand, production, costs, pricing and capital
are

predicated

in

numerical

terms

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together

with

their

probabilities. As the business manager has to work in an

environment of uncertainty, the future needs to be foreseen so
that in the light of the predicted estimates, decision-making and
forward planning may be possible.

Using economic quantities in decision-making and forward

planning: This involves formulating business policies for
establishing future business plans. This nature of economic
forecasting indicates the degree of probability of various possible
outcomes, i.e., losses or gains that will occur as a result of
following each one of the available strategies. Thus, a quantified
picture gets set up, that indicates the number of courses open,
their possible outcomes and the quantified probability of each
outcome. Keeping this picture in view, the business manager is
able to decide about which strategy should be chosen.

Understanding significant external forces: Applying economic

theory to business management also involves understanding the
important

external

forces

that

constitute

the

business

environment and with which a business must adjust. Business

cycles, fluctuations in national income and government policies
pertaining

to

taxation,

foreign

trade,

labour

relations,

antimonopoly measures, industrial licensing and price controls

are typical examples. The business manager has to appraise the
relevance and impact of these external forces in relation to the
particular business unit and its business policies.

CHARACTERISTICS OF MANAGERIAL ECONOMICS

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There are certain chief characteristics of managerial economics, which

can help to understand the nature of the subject matter and help in a
clear understanding of the following terms:

Managerial economics is micro-economic in character. This is

because the unit of study is a firm and its problems. Managerial
economics does not deal with the entire economy as a unit of
study.

Managerial economics largely uses that body of economic

concepts and principles, which is known as Theory of the Firm
or Economics of the Firm. In addition, it also seeks to apply
profit theory, which forms part of distribution theories in
economics.

Managerial economics is concrete and realistic. I avoids difficult

abstract issues of economic theory. But it also involves
complications ignored in economic theory in order to face the
overall situation in which decisions are made. Economic theory
ignores the variety of backgrounds and training found in
individual

firms.

Conversely,

managerial

economics

is

concerned more with the particular environment that influences

decision-making.

Managerial economics belongs to normative economics rather

than positive economics. Normative economy is the branch of
economics in which judgments about the desirability of various
policies are made. Positive economics describes how the
economy behaves and predicts how it might change. In other
words,

managerial economics

is prescriptive

rather

than

descriptive. It remains confined to descriptive hypothesis.

Managerial economics also simplifies the relations among

different

variables

without

judging

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what

is

desirable

or

undesirable. For instance, the law of demand states that as

price increases, demand goes down or vice-versa but this
statement does not imply if the result is desirable or not.
Managerial

economics,

however,

is

concerned

with

what

decisions ought to be made and hence involves value judgments.

This further has two aspects: first, it tells what aims and
objectives a firm should pursue; and secondly, how best to
achieve

these

economics,

aims

in

therefore,

particular

has

been

situations.

described

as

Managerial
normative

microeconomics of the firm.

Macroeconomics is also useful to managerial economics since it

provides

an

intelligent

understanding

of

the

business

environment. This understanding enables a business executive

to adjust with the external forces that are beyond the
managements control but which play a crucial role in the well
being of the firm. The important forces are: business cycles,
national income accounting, and economic policies of the
government like those relating to taxation foreign trade, antimonopoly measures and labour relations.

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

principles to the problems of a business firm whereas;

economics deals with the study of these principles only.
Economics ignores the application of economic principles to the
problems of a business firm.

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Managerial economics is micro-economic in character, however,

Economics is both macro-economic and micro-economic.

Managerial economics, though micro in character, deals only

with a firm and has nothing to do with an individuals economic
problems. But microeconomics as a branch of economics deals
with both economics of the individual as well as economics of a
firm.

Under microeconomics, the distribution theories, viz., wages,

interest and profit, are also dealt with. Managerial economics on
the contrary is mainly concerned with profit theory and does
not consider other distribution theories. Thus, the scope of
economics is wider than that of managerial economics.

Economic theory assumes economic relationships and builds

economic models. Managerial economics adopts, modifies and
reformulates the economic models to suit the specific conditions
and

serves

the

specific

problem

solving

process.

Thus,

economics gives the simplified model, whereas managerial

economics modifies and enlarges it.

Economics involves the study of certain assumptions like in the

law of proportion where it is assumed that The variable input
as applied, unit by unit is homogeneous or identical in amount
and quality. Managerial economics on the other hand,
introduces certain feedbacks. These feedbacks are in the form of
objectives of the firm, multi-product nature of manufacture,
behavioral constraints, environmental aspects, legal constraints,
constraints on resource availability, etc. Thus managerial
economics, attempts to solve the complexities in real life, which
are assumed in economics. this is done with the help of

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mathematics, statistics, econometrics, accounting, operations

research, etc.

OTHER TERMS FOR MANAGERIAL ECONOMICS

Certain other expressions like economic analysis for business
decisions and economics of business management have also been
used instead of managerial economics but they are not so popular.
Sometimes expressions like Economics of the Enterprise, Theory of
the Firm or Economics of the Firm have also been used for
managerial economics. It is, however, not appropriate t use theses
terms because managerial economics, though primarily related to the
economics of the firm, differs from it in the following respects:

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.

Secondly, the term Economics of the firm is too simple in its

assumptions whereas managerial economics has to reckon with
actual business behaviour, which is much more complex.

SCOPE OF MANAGERIAL ECONOMICS

As regards the scope of managerial economics, there is no general
uniform pattern. However, the following aspects may be said to be
inclusive under managerial economics:

Demand analysis and forecasting.

Cost and production analysis.

Pricing decisions, policies and practices.

Profit management.

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Capital management.
These aspects may also be defined as the Subject-Matter of

Managerial Economics. In recent years, there is a trend towards

integrations of managerial economics and operations research. Hence,
techniques such as linear programming, inventory models and theory
of games have also been regarded as a part of managerial economics.

Demand Analysis and Forecasting

A business firm is an economic Organisation, which transforms
productive resources into goods that are to be sold in a market. A
major part of managerial decision-making depends on accurate
estimates of demand. This is because before production schedules can
be prepared and resources are employed, a forecast of future sales is
essential. This forecast can also guide the management in maintaining
or strengthening the market position and enlarging profits. The
demand analysis helps to identify the various factors influencing
demand for a firms product and thus provides guidelines to
manipulate demand. Demand analysis and forecasting, thus, is
essential for business planning and occupies a strategic place in
managerial

economics.

It

comprises

of

discovering

the

forces

determining sales and their measurement. The chief topics covered in

this are:

Demand determinants

Demand distinctions

Demand forecasting.

Cost and Production Analysis

A study of economic costs, combined with the data drawn from the
firms accounting records, can yield significant cost estimates. These

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estimates are useful for management decisions. The factors causing

variations in costs must be recognised and thereby should be used for
taking management decisions. This facilitates the management to
arrive at cost estimates, which are significant for planning purposes.
An element of cost uncertainty exists in this because all the factors
determining costs are not always known or controllable. Therefore, it
is essential to discover economic costs and measure them for effective
profit planning, cost control and sound pricing practices. Production
analysis is narrower in scope than cost analysis. The chief topics
covered under cost and production analysis are:

Cost concepts and classifications

Cost-output relationships

Economics of scale

Production functions

Cost control.

Pricing Decisions, Policies and Practices

Pricing is a very important area of managerial economics. In fact price
is the origin of the revenue of a firm. As such the success of a usiness
firm largely depends on the accuracy of price decisions of that firm.
The important aspects dealt under area, are as follows:

Price determination in various market forms

Pricing methods

Differential pricing product-line pricing and price forecasting.

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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factors such as internal and external. If knowledge about the future

were perfect, profit analysis would have been a very easy task.
However, in a world of uncertainty, expectations are not always
realised. Thus profit planning and measurement make up the difficult
area of managerial economics. The important aspects covered under
this area are:

Nature and measurement of profit.

Profit policies and techniques of profit planning.

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

Rate of return and selection of projects.

The various aspects outlined above represent the major

uncertainties, which a business firm has to consider viz., demand

uncertainty, cost uncertainty, price uncertainty, profit uncertainty
and capital uncertainty. We can, therefore, conclude that managerial
economics is mainly concerned with applying economic principles and
concepts to adjust with the various uncertainties faced by a business
firm.
MANAGERIAL ECONOMICS AND OTHER SUBJECTS
Yet another useful method of explaining the nature and scope of
managerial economics is to examine its relationship with other

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subjects. The following discussion helps to understand relationship

between

managerial

economics

and

economics,

statistics,

mathematics, accounting and operations research.

Managerial Economics and Economics

Managerial economics is defined as a subdivision of economics that
deals with decision-making. It may be viewed as a special branch of
economics bridging the gulf between pure economic theory and
managerial

practice.

Economics

has

two

main

divisions-

microeconomics and Macroeconomics. Microeconomics has been

defined as that branch where the unit of study is an individual or a
firm. It is also called price theory (or Marshallian economics) and is
the main source of concepts and analytical tools for managerial
economics. To illustrate, various micro-economic concepts such as
elasticity of demand, marginal cost, the short and the long runs,
various market forms, etc., are all of great significance to managerial
economics.
Macroeconomics, on the other hand, is aggregative in character
and has the entire economy as a unit of study. The chief contribution
of macroeconomics to managerial economics is in the area of
forecasting. The modern theory of income and employment has direct
implications for forecasting general business conditions. As the
prospects of an individual firm often depend greatly on general
business conditions, individual firm forecasts rely on general business
forecasts.
A survey in the U.K. has shown that business economists have
found the following economic concepts quite useful and of frequent
application:

Price elasticity of demand

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Income elasticity of demand

Opportunity cost

Multiplier

Propensity to consume

Marginal revenue product

Speculative motive

Production function

Liquidity preference

Business economists have also found the following main areas

of economics as useful in their work. Demand theory

Theory of firms price, output and investment decisions

Business financing

Public finance and fiscal policy

Money and banking

National income and social accounting

Theory of international trade

Economies of developing countries.

Thus, it is obvious that Managerial Economics is very closely

related to Economics.

Managerial Economics and Statistics

Statistics is important to managerial economics in several ways.
Managerial economics calls for the organising quantitative data and
deriving a useful measure of appropriate functional relationships
involved in decision-making. For instance, in order to base its pricing
decisions on demand and cost considerations, a firm should have
statistically derived or calculated demand and cost functions.
Managerial

economics

also

employs

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statistical

methods

for

experimental testing of economic generalisations. The generalisations

can be accepted in practice only when they are checked against the
data from the world of reality and are found valid. Managers do not
have exact information about the variables affecting decisions and
have to deal with the uncertainty of future events. The theory of
probability, upon which statistics is based, provides logic for dealing
with such uncertainties.

Managerial Economics and Mathematics

Mathematics is yet another important subject closely related to
managerial economics. This is because managerial economics is
mathematical in character, as it involves estimating various economic
relationships, predicting relevant economic quantities and using them
in decision-making and forward planning. Knowledge of geometry,
trigonometry ad algebra is not only essential but also certain
mathematical tools and concepts such as logarithms and exponential,
vectors, determinants, matrix, algebra, calculus, differential as well as
integral, are the most commonly used devices. Further, operations
research, which is closely related to managerial economics, is
mathematical in character. It provides and analyses data ad develops
models, benefiting from the experiences of experts drawn from
different

disciplines,

viz.,

psychology,

sociology,

statistics

and

engineering.

MANAGERIAL ECONOMICS AND ACCOUNTING

Managerial economics is also closely related to accounting, which is
concerned with recording the financial operations of a business firm.
In fact, a managerial economist depends chiefly on the accounting
information as an important source of data required for his decision-

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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.

Managerial Economics and Operations Research

Operations research is a subject field that emerged during the Second
World War and the years thereafter. A good deal of interdisciplinary
research was done in the USA. as well as other western countries to
solve the complex operational problems of planning and resource
allocation in defence and basic industries. Several experts like
mathematicians, statisticians, engineers and others teamed up
together and developed models and analytical tools leading to the
emergence of this specialised subject. Much of the development of
techniques and concepts, such as linear programming, inventory
models, game theory, etc., emerged from the working of the operation
researchers. Several problems of managerial economics are solved by
the operation research techniques. These highlight the significant
relationship between managerial economics and operations research.
The problems solved by operation research are as follows:

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Allocation problems: An allocation problem confronts with the

issue that men, machines and other resources are scarce,
related to the number sand size of the jobs that need to be
completed. The examples are production programming and
transportation problems.

Competitive

problems:

competitive

problems

deal

with

situations where managerial decision-making is to be made in

the face of competitive action. That is, one of the factors to be
considered is: What will competitors do if certain steps are
taken? Price reduction, for example, will not lead to increased
market share if rivals follow suit.

Waiting line problems : Waiting line problems arise when a

firm wants to know how many machines it should install in
order to ensure that the amount of work-in-progress waiting to
be machined is neither too small nor too large. Such situations
arise when for example, a post office, or a bank wants to know
how many cash desks or counter clerks it should employ in
order to balance the business lost through long guesses against
the cost of installing more equipment or hiring more labour.

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

combines concepts and methods from all these subjects by bringing

them together to solve business problems. In particular, operations
research and management accounting are getting very close to
managerial economics.

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USES OF MANAGERIAL ECONOMICS

Managerial economics achieves several objectives. The principal
objectives are as follows:

It presents those aspects of traditional economics, which are

relevant for business decision-making in real life. For this
purpose, it picks from economic theory those concepts,
principles and techniques of analysis, which are concerned with
the decision-making process. These are adapted or modified in
such a way that it enables the manager to take better decisions.
Thus, managerial economics attains the objective of building a
suitable tool kit from traditional economics.

Managerial economics also incorporates useful ideas from other

disciplines such as psychology, sociology, etc. If they are found
relevant for decision-making. In fact, managerial economics
takes the aid of other academic disciplines that are concerned
with the business decisions of a manager in view of the various
explicit and implicit constraints subject to which resource
allocation is to be optimised.

It helps in reaching a variety of business decisions even in a

complicated environment. Certain examples of such decisions
are those decisions concerned with:
o The products and services to be produced
o The inputs and production techniques to be used
o The quantity of output to be produced and the selling
prices to be subscribed
o The best sizes and locations of new plants
o Time of replacing the equipment
o Allocation of the available capital

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Managerial economics helps a manager to become a more

competent model builder. Thus, he can pick out the essential
relationships, which characterise a situation and leave out the
other unwanted details and minor relationships.

At the level of the firm, functional specialists or functional

departments

exist,

e.g.,

finance,

marketing,

personnel,

production etc. For these various functional areas, managerial

economics serves as an integrating agent by co-ordinating the
different areas. It then applies the decisions of each department
or specialist, those implications, which are pertaining to other
functional areas. Thus managerial economics enables business
decision-making to operate not with an inflexible and rigid but
with an integrated perspective. This integration is important
because the functional departments or specialists often enjoy
considerable autonomy and achieve conflicting goals.Managerial
economics keeps in mind the interaction between the firm and
society and accomplishes the key role of business as an agent
in attaining social economic welfare. There is a growing
awareness that besides its obligations to shareholders, business
enterprise has certain social obligations as well. Managerial
economics focuses on these social obligations while taking
business decisions. By doing so, it serves as an instrument of
furthering the economic welfare of the society through socially
oriented business decisions.
Thus, it is evident that the applicability and usefulness of
managerial economics is obtained by performing the following
activates:

Borrowing and adopting the tool-kit from economic theory.

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Incorporating relevant ideas from other disciplines to achieve

better business decisions.

Serving as a catalytic agent in the course of decision-making by

different functional departments/specialists at the firms level.

Accomplishing a social purpose by adjusting business decisions

to social obligations.

ECONOMIC THEORY AND MANAGERIAL ECONOMICS

Economic theory offers a variety of concepts and analytical tools that
can assist the manager in the decision-making practices. Problem
solving in business has, however, found that there exists a wide
disparity between the economic theory of a firm and actual observed
practice, thus necessitating the use of many skills and be quite useful
to examine two aspects in this regard:

The basic tools of managerial economics which it has borrowed

from economics, and

The nature and extent of gap between the economic theory of

the firm and the managerial theory of the firm.

Basic Economic Tools in Managerial Economics

The most significant contribution of economics to managerial
economics lies in certain principles, which are basic to the entire
range of managerial economics. The basic principles may be identified
as follows:

1. Opportunity Cost Principle

The opportunity cost of a decision means the sacrifice of alternatives
required by that decision. This can be best understood with the help
of a few illustrations, which are as follows:

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The opportunity cost of the funds employed in ones own

business is equal to the interest that could be earned on those
funds if they were employed in other ventures.

The opportunity cost of the time as an entrepreneur devotes to

his own business is equal to the salary he could earn by seeking
employment.

The opportunity cost of using a machine to produce one product

is equal to the earnings forgone which would have been possible
from other products.

The opportunity cost of using a machine that is useless for any

other purpose is zero since its use requires no sacrifice of other
opportunities.

If a machine can produce either X or Y, the opportunity cost of

producing a given quantity of X is equal to the quantity of Y,
which it would have produced. If that machine can produce 10
units of X or 20 units of Y, the opportunity cost of 1 X is equal
to 2 Y.

If no information is provided about quantities produced, except

about their prices then the opportunity cost can be computed in
terms of the ratio of their respective prices, say Px/Py.

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

costs. The opportunity cost principle may be stated as under:

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The cost involved in any decision consists of the sacrifices of

alternatives required by that decision. If there are no sacrifices, there
is no cost.
Thus in macro sense, the opportunity cost of more guns in an
economy is less butter. That is the expenditure to national fund for
buying armour has cost the nation of losing an opportunity of buying
more butter. Similarly, a continued diversion of funds towards defence
spending, amounts to a heavy tax on alternative spending required for
growth and development.
2. Incremental Principle
The incremental concept is closely related to the marginal costs and
marginal revenues of economic theory. Incremental concept involves
two important activities which are as follows:

Estimating the impact of decision alternatives on costs and

revenues.

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.

The two basic components of incremental reasoning are as follows:

Incremental cost: Incremental cost may be defined as the

change in total cost resulting from a particular decision.

Incremental revenue: Incremental revenue means the change in

total revenue resulting from a particular decision.

The incremental principle may be stated as under:

A decision is obviously a profitable one if:
o It increases revenue more than costs
o It decreases some costs to a greater extent than it
increases other costs

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o It increases some revenues more than it decreases other

revenues
o It reduces costs more that revenues.
Some businessmen hold the view that to make an overall profit,
they must make a profit on every job. Consequently, they refuse
orders that do not cover full cost (labour, materials and overhead) plus
a provision for profit. Incremental reasoning indicates that this rule
may be inconsistent with profit maximisation in the short run. A
refusal to accept business below full cost may mean rejection of a
possibility of adding more to revenue than cost. The relevant cost is
not the full cost but rather the incremental cost. A simple problem will
illustrate this point.
IIIustration
Suppose a new order is estimated to bring in additional revenue of Rs.
5,000. The costs are estimated as under:
Labour
Material
Overhead (Allocated at 120% of labour cost)
Selling administrative expenses
(Allocated at 20% of labour and material cost)
Total Cost

Rs. 1,500
Rs. 2,000
Rs. 1,800
Rs. 700
Rs. 6,000

The order at first appears to be unprofitable. However, suppose,

if there is idle capacity, which can be, utilised to execute this order
then the order can be accepted. If the order adds only Rs. 500 of
overhead (that is, the added use of heat, power and light, the added
wear and tear on machinery, the added costs of supervision, and so
on), Rs. 1,000 by way of labour cost because some of the idle workers
already on the payroll will be deployed without added pay and no extra
selling and administrative cost then the incremental cost of accepting
the order will be as follows.

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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.

3. Principle of Time Perspective

The economic concepts of the long run and the short run have become
part of everyday language. Managerial economists are also concerned
with the short-run and long-run effects of decisions on revenues as
well as on costs. The actual problem in decision-making is to maintain
the right balance between the long-run and short-run considerations.
A decision may be made on the basis of short-run considerations, but
may in the course of time offer long-run repercussions, which make it
more or less profitable than it appeared at first. An illustration will
make this point clear.

IIIustration

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Suppose there is a firm with temporary idle capacity. An order for

5,000 units comes to managements attention. The customer is willing
to pay Rs. 4.00 per unit or Rs. 20,000 for the whole lot but not more.
The short-run incremental cost (ignoring the fixed cost) is only Rs.
3.00. Therefore, the contribution to overhead and profit is Re. 1.00 per
unit (Rs. 5,000 for the lot. However, the long-run repercussions of the
order ought to be taken into account are as follows:

If the management commits itself with too much of business at

lower prices or with a small contribution, it may not have
sufficient

capacity

to

take

up

business

with

higher

contributions when the opportunity arises. The management

may be compelled to consider the question of expansion of
capacity and in such cases; even the so-called fixed costs may
become variable.

If any particular set of customers come to know about this low

price, they may demand a similar low price. Such customers
may complain of being treated unfairly and feel discriminated.
In response, they may opt to patronise manufacturers with
more decent views on pricing. The reduction or prices under
conditions of excess capacity may adversely affect the image of
the company in the minds of its clientele, which will in turn
affect its sales.
It is, therefore, important to give due consideration to the time

perspective. The principle of time perspective may be stated as under:

A decision should take into account both the short-run and long-run
effects on revenues and costs and maintain the right balance between
the long-run and short-run perspectives.
Haynes, Mote and Paul have cited the case of a printing
company. This company pursued the policy of never quoting prices

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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

If we multiply Rs. 92.59 by 1.08, we shall get the amount of money,

which will accumulate at 8 per cent after one year.
92.59 x 1.08 = 99.0072
= 1.00
The same reasoning applies to longer periods. A sum of Rs. 100
two years from now is worth:

V=

Rs. 100
(1+i)2

Rs. 100
(1.08)2

Rs. 100
1.1664

Similarly, we can also check by computing how much the

cumulative interest will be after two years. The principle involved in
the above discussion is called the discounting principle and is stated
as follows: If a decision affects costs and revenues at future dates, it
is necessary to discount those costs and revenues to present values
before a valid comparison of alternatives is possible.

5. Equi-marginal Principle

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This principle deals with the allocation of the available resource

among the alternative activities. According to this principle, an input
should be allocated in such a way that the value added by the last
unit is the same in all cases. This generalisation is called the equimarginal principle.
Suppose a firm has 100 units of labour at its disposal. The firm
is engaged in four activities, which need labour services, viz., A, B, C
and D. It can enhance any one of these activities by adding more
labour but sacrificing in return the cost of other activities. If the value
of the marginal product is higher in one activity than another, then it
should be assumed that an optimum allocation has not been attained.
Hence it would, be profitable to shift labour from low marginal value
activity to high marginal value activity, thus increasing the total value
of all products taken together. For example, if the values of certain two
activities are as follows:
Value of Marginal Product of labour
Activity A = Rs. 20
Activity B = Rs. 30
In this case it will be profitable to shift labour from A to activity
B thereby expanding activity B and reducing activity A. The optimum
will be reach when the value of the marginal product is equal in all the
four activities or, when in symbolic terms:
VMPLA = VMPLB = VMPLC = VMPLD
Where the subscripts indicate labour in respective activities.
Certain

aspects

of

the

equi-marginal

principle

need

clarifications, which are as follows:

First, the values of marginal products are net of incremental

costs. In activity B, we may add one unit of labour with an
increase in physical output of 100 units. Each unit is worth 50

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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.

Secondly, if the revenues resulting from the addition of labour

are to occur in future, these revenues should be discounted
before comparisons in the alternative activities are possible.
Activity A may produce revenue immediately but activities B, C
and D may take 2, 3 and 5 years respectively. Here the
discounting of these revenues will make them equivalent.

Thirdly, the measurement of value of the marginal product may

have to be corrected if the expansion of an activity requires an
alternative reduction in the prices of the output. If activity B
represents the production of radios and it is not possible to sell
more radios without a reduction in price, it is necessary to
make adjustment for the fall in price.

Fourthly,

the

equi-marginal

principle

may

break

under

sociological pressures. For instance, du to inertia, activities are

continued simply because they exist. Similarly, due to their
empire building ambitions, managers may keep on expanding
activities to fulfil their desire for power. Department, which are
already over-budgeted often, use some of their excess resources
to build up propaganda machines (public relations offices) to
win additional support. Governmental agencies are more prone
to bureaucratic self-perpetuation and inertia.
Gaps between Theory of the Firm and managerial Economics

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The theory of the firm is a body of theory, which contains certain

assumptions, theorems and conclusions. These theorems deal with
the way in which businessmen make decisions about pricing, and
production under prescribed market conditions. It is concerned with
the study of the optimisation process.
For optimality to exist profit must be maximised and this can
occur only when marginal cost equals marginal revenue. Thus, the
optimum position of the firm is that which maximises net revenue.
Managerial economics, on the other hand, aims at developing a
managerial theory of the firm and for the purpose it takes the help of
economic theory of the firm. However, there are certain difficulties in
using economic theory as an aid to the study of decision-making at
the level of the firm. This is because for the purposes of business
decision-making it fails to provide sufficient analytical tools that are
useful to managers. Some of the reasons are as follows:

Underlying all economic theory is the assumption that the

decision-maker is omniscient and rational or simply that he is
an economic man. Thus being omniscient means that he knows
the alternatives that are available to him as well as the outcome
of any action he chooses. The model of economic man however
as an omniscient person who is confronted with a compete set of
known or probabilistic outcomes is a distorted representation of
reality. The typical business decision-maker usually has limited
information at his disposal, limited computing ability and a
limited number of feasible alternatives involving varying degrees
of risk. Further, the net revenue function, which he is expected
to maximise, and the marginal cost and marginal revenue
functions, which he is expected to equate, require excessive
knowledge of information, which is not known and cannot be

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obtained even by the most careful analysis. Hence, it is absurd

to expect a manager to maximise and equalise certain critical
functional relationships, which he does not know and cannot
find out.

In micro-economic theory, the most profitable output is where

marginal cost (MC) and marginal revenue (MR) are equal. In
Figure 1.2, the most profitable output will be at ON where
MR=MC. This is the point at which the slope of the profit
function or marginal profit is zero. This is highlighted in Figure
1.3 where the most profitable output will be again at ON. In
economic theory, the decision-maker has to identify this unique
output level, which maximises profit.

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In real world, however, a complexity often arises, viz., certain

resource limitations exist. As a result, it is not possible to attain the
maximum output level (ON). In practical terms the maximum output
possible as a result of resource limitations is, say, OM. Now the
problem before the decision-maker is to find out whether the output,
which maximises profit, is OM or some other level of output to the left
of OM. It is obvious that economic theory is of no help for ON level of
output because it is not relevant in view of the resource limitations. A
managerial economist here has to take the aid of linear programming,

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which enables the manager to optimise or search for the best values
within the limits set by inequality conditions.

Another central assumption in the economic theory of the

firm is that the entrepreneur strives to maximise his residual
share, or profit. Several criticisms of this assumption have
been made:
o The theory is ambiguous, as it doesnt clarify. Whether
it is short or long run profit that is to be maximised.
For example, in the short run, profits could be
maximised by firing all research and development
personnel

and

thereby

eliminating

considerable

immediate expenses. This decision would, however,

have a substantial impact on long-run profitability.
o Certain questions create some confusion around the
concept of profit maximisation. Should the firm seek to
maximise the amount of profit or the rate of profit?
What is the rate of profit? Is it profit in relation to total
capital or profit in relation to shareholders equity?
o There is no allowance for the existence of psychic
income (Income other than monetary, power, prestige,
or fame), which the entrepreneur might obtain from
the firm, quite apart from his monetary income.
o The theory does not recognise that under modern
conditions, owners and managers are separate and
distinct groups of people and the latter may not be
motivated to maximise profits.
o Under imperfect competition, maximisation is an
ambiguous goal, because actions that are optimal for
one will depend on the actions of the other firms.

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o The entrepreneur may not care to receive maximum

profits but may simply want to earn satisfactory
profits. This last point is particularly relevant from the
behavioural science standpoint because it introduces a
concept of satiation. The notion of satiation plays no
role in classical economic theory. To explain business
behaviour in terms of this theory, it is necessary to
assume that the firms goals are not concerned with
maximising profit, but with attaining a certain level or
rate of profit, holding a certain share of the market or a
certain level of sales. Firms would try to satisfy rather
than maximise. But according to Simon the satisfying
model damages all the conclusions that can be derived
concerning

resource

allocation

under

perfect

competition. It focuses on the fact that the classical

theory of the firm is empirically incorrect as a
description of the decision-making process. Based on
this notion of satiation, it appears that one of the main
strengths of classical economic theory has been
seriously weakened.

Most corporate undertakings involve the investment of funds,

which are expect to produce revenues over a number of
years. The profit maximisation criterion provides no basis for
comparing alternatives that can promise varying flows of
revenue and expenditure over time.

The practical application of profit maximisation concept also

has another limitation. It provides no explicit way of
considering the risk associated with alternative decisions.
Two projects generating similar expected revenues in the

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future and requiring similar outlays might differ vastly as

regarding the degree of uncertainty with which the benefits
to be generated. The greater the uncertainty associated with
the benefits, the greater the risk associated with the project.

Baumol on the other hand is of the view that firms do not

devote all their energies to maximising profit. Rather a
company will seek to maximise its sales revenue as long as a
satisfactory level of profit is maintained. Thus Baumol has
substituted Total sales revenue for profits. Also, two
decision criteria or objectives have been advanced viz., a
satisfactory level of profit and the highest sales possible. In
other words, the firm is no longer viewed as working towards
one objective alone. Instead, it is portrayed as aiming at
balancing two competing and non-consistent goals. Baumols
model is based on the view that managers salaries, their
status and other rewards often appear as closely related to
the companies size in which they work and is measured by
sales revenue rather than their profitability. As such,
managers may be more concerned to increased size than
profits.

And

the

firms

objective

thus

becomes

sales

maximisation rather than profits maximisation.

Empirical studies of pricing behaviour also give results that

differ from those of the economic theory of firm as can be
seen from the following examples:
o

Several studies of the pricing practices of business

firms have indicated that managers tend to set prices
by applying some sort of a standard mark-up on
costs. They do not attempt to estimate marginal

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costs, marginal revenues or demand elasticities, even

if these could be accurately measured.
o

For many firms, prices are more often set to attain, a

particular target return on investment, say, 10 per
cent, than to maximise short or long-run profits.

There is some evidence that firms experiencing

declining market shares in their industry strive more
vigorously to increase their sales than do competing
firms, which are experiencing steady or increasing
market shares.

An alternative model to profit maximisation is the concept of

wealth maximisation, which assumes that firms seek to
maximise the present value of expected net revenues over all
periods within the forecasted future.

As pointed out by Haynes and Henry, a study of the

behaviour of actual firms shows that their decisions are not
completely determined by the market. These firms have some
freedom to develop decisions, strategies or rules, which
become part of the decision-making system within the firm.
This gap in economic theory has led to what has come to be
known as Behavioural Theory of the Firm. This theory,
however, does not replace the former but rather powerfully
supplements it. The behavioural theory represents the firm
as an adoptive institution. It learns from experience and has
a memory. Organisational behaviour, is embodies into
decision rules and standard operating procedures. These
may be altered over long run as the firm reacts to feedback
from experience. However, in the short run, decisions of the

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organisation are dominated by its rules of thumb and

standard methods.

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.

MANAGERIAL ECONOMIST: ROLE AND RESPONSIBILITIES

A managerial economist can play a very important role by assisting
the management in using the increasingly specialised skills and
sophisticated techniques, required to solve the difficult problems of
successful decision-making and forward planning. In business
concerns, the importance of the managerial economist is therefore
recognised a lot today. In advanced countries like the USA, large
companies employ one or more economists. In our country too, big
industrial

houses

have

understood

the

need

for

managerial

economists. Such business firms like the Tatas, DCM and Hindustan

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Lever employ economists. A managerial economist can contribute to

decision-making in business in specific terms. In this connection, two
important questions need be considered:
1. What role does he play in business, that is, what particular
management problems lend themselves to solution through
economic analysis?
2. How can the managerial economist best serve management,
that is, what are the responsibilities of a successful managerial
economist?

Role of a Managerial Economist

One of the principal objectives of any management in its decisionmaking process is to determine the key factors, which will influence
the business over the period ahead. In general, these factors can be
divided into two categories:

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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Environmental Studies of a Business Firm

An analysis and forecast of external factors constituting general
business conditions, for example, prices, national income and output,
volume of trade, etc., are of great significance since they affect every
business firm. Certain important relevant factors to be considered in
this connection are as follows:

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.

Population shifts and the resultant ups and downs in regional

purchasing power.

The demand prospects in new as well as established markets.

Impact of changes in social behaviour and fashions, i.e.,
whether they will tend to expand or limit the sales of a
companys products, or possibly make the products obsolete?

The areas in which the market and customer opportunities are

likely to expand or contract most rapidly.

Whether overseas markets expand or contract and the affect of

new foreign government legislations on the operation of the
overseas plants?

Whether the availability and cost of credit tend to increase or

decrease buying, and whether money or credit conditions ahead
are likely to easy or tight?

The prices of raw materials and finished products.

Whether the competition will increase or decrease.

The main components of the five-year plan, the areas where

outlays have been increased and the segments, which have
suffered a cut in their outlays.

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The outlook to governments economic policies and regulations

and changes in defence expenditure, tax rates tariffs and import
restrictions.

Whether the Reserve Banks decisions will stimulate or depress

industrial production and consumer spending and how will
these decisions affect the companys cost, credit, sales and
profits.

Reasonably accurate data regarding these factors can enable the

management to chalk out the scope and direction of their own
business plans effectively. It will also help them to determine the
timing of their specific actions. And it is these factors, which present
some of the areas where a managerial economist can make effective
contribution. The managerial economist has not only to study the
economic trends at the micro-level but also must interpret their
relevance to the particular industry or firm where he works. He has to
digest

the

ever-growing

economic

literature

and

advise

top

management by means of short, business-like practical notes. In

mixed

economy

like

that

of India,

the managerial

economist

pragmatically interprets the intentions of controls and evaluates their

impact. He acts as a bridge between the government and the industry,
translating the governments intentions and transmitting the reactions
of the industry. In fact, the government policies emerge out of the
performance of industry, the expectations of the people and political
expediency.

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,

BSPATIL

expansion or contraction. Certain relevant questions in this context

would be as follows:

What will be a reasonable sales and profit budget for the next
year?

What will be the most appropriate production schedules and

inventory policies for the next six months?

What changes in wage and price policies should be made

now?

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.

Industrial market research.

Economic analysis of competing companies.

Pricing problems of industry.

Capital projects.

Production programmes.

Security / Investment analysis and forecasts.

Advice on trade and public relations.

Advice on primary commodities.

Advice on foreign exchange.

Economic analysis of agriculture.

Analysis of underdeveloped economics.

Environmental forecasting.

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The managerial economist has to gather economic data, analyse all

relevant information about the business environment and prepare
position papers on issues facing the firm and the industry. In the case
of industries prone to rapid theological advances, the manager may
have to make continuous assessment of tl1e impact of changing
technology. The manager' may need to evaluate the capital budget in
the light of short and long-range financial, profit and market
potentialities. Very often, he also needs to prepare speeches for the
corporate executives. It is thus clear that in practice, managerial
economists perform many and various functions. However, of all
these, the marketing functions, i.e., sales force listing an industrial
market research, are the most important.
For this purpose, the managers may collect statistical records of
the sales performance of their own business and those rehiring to
their rivals, carry out analysis of these records and report on trends
in demand, their market shares, and the relative efficiency of their
retail outlets. Thus, while carrying out heir functions, the managers
may have to undertake detailed statistical analysis. There are, of
course, differences in the relative importance of the various functions
performed from firm to firm and in the degree of sophistication of the
methods used in performing these functions. But there is no doubt
that the job of a managerial economist requires alertness and the
ability to work uriderpressure.

Economic Intelligence
Besides these functions involving sophisticated analysis, managerial
economist may also provide general intelligence service. Thus the

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economist may supply the management with economic information of

general interest such as competitors
prices and products, tax rates, tariff rates, etc.
Participating in Public Debates
Many well-known business economists participate in public debates.
The government and society alike are seeking their advice and views.
Their practical experience in business and industry adds prestige to
their views. Their public recognition enhances their protg in the
.firm itself.
Indian Context
In the Indian context, a managerial economist is expected to perform
the following functions:
Macro-forecasting for

demand and supply.

Production planning at macro and micro levels.

Capacity planning and product-mix determination.
Economics of various production lines.
Economic feasibility of new production lines / processes and
projects.
Assistance in preparation of overall development plans.
Preparation of periodical economic reports bearing on various
matters such as the company's product-lines, future growth
opportunities, market pricing situation, general business,. and
various national/international factors affecting industry and
business.
Preparing

briefs;

speeches,

articles

and

papers

for

top

management for various chambers, Committees, Seminars,

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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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is rather uncertain. It is, therefore, absolutely essential that a

managerial

economist

recognises

his

responsibility

to

make

successful forecast. By making the best possible forecasts and

through constant efforts to improve, a managerial' ng, the risks
involved in uncertainties. This enables the management to follow a
more orderly course of business planning. At times, it is required for
the managerial economist to reassure the management that an
important trend will continue. In other cases, it is necessary to point
out the probabilities of a turning point in some activity of importance
to management. In any case, managerial economist must be willing to
make

fairly

positive

developments.

These

statements
can

be

about

based

impending

upon

the

economic

best

possible

information and analysis. The management's confidence in a

managerial economist increases more quickly and thoroughly with
a record of successful forecasts, well documented in advance and
modestly evaluated when the actual results become available.
A few consequences to the above proposition need also be
emphasised here.
First, a managerial economist has a major responsibility to alert
managelI1ent at the earliest possible moment in' case there is an
err6r' in his forecast. This will assist the mallagement in making
appropriate

adjustment

in

policies

and

programmes

and

strengthen his oWn position as a member of the management

team by keeplrighis fingers on the economic pulse of the
business.
Secondly, a managerial economist must establish and maintain
many contacts with individuals and data sources: which would
not be immediately available to the other members of the
management. Extensive familiarity with reference sources and

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material is essential. It is still more important that the known

individuals who are specialists in particular fields have a bearing
on tpe managerial economist's work. For this purpose, it is
required

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

executives is also an essential role so as to win approval.

To conclude, a managerial economist has a very important role to
play by helping management in successful decision-making and
forward planning. But to discharge his role successfully, it is
necessary to recognise the 'relevant responsibilities and obligations.
To some business executives, however, a managerial economist is still

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a luxury or perhaps even a necessary evil. It is not surprising,

therefore, to find that while tneir status is improving and their
impor;ance is gradually rising, managerial economists in certain firms
still 'feel quite insecure. Nevertheless, there is a definite and growing
realisation that they can contribute significantly to the profitable
growth of firms and effective solution oftMir problems, and this'
promises them a positive future.
REVIEW QUESTIONS
1. What is managerial economics? How does it differ from
traditional economics?
2. Discuss the nature and scopeofmanagerial economics.
3. Show

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

techniques that help busirless management.

9. Explain the various functions of a managerial economist. How
can he best serve the management?

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LESSON 2

DEMAND ANALYSIS

Demand is one of the crucial requirements for the existence of any

business firm. Firms are interested in their profit and sales, both
of which depend partially upon the demand for the product. The
decisions, which management makes with respect to production,
advertising, cost allocation, pricing, inventory holdings, etc. call
for an analysis of demand. While how much a firm can produce
depends upon its capacity and demand for its products. If there is
no demand for a product, its production is unworthy. If demand
falls short of production, one way to balance the two is to create
new demand through more and better advertisements. The more
the future demand for a product, the more inventories the firm
would hold. The larger the demand for a firm's product, the higher
is the price it can charge.
Demand analysis seeks to identify and measure the forces that
determine sales. Once this is done the alternative ways of
manipulating or managing demand can easily be inferred.
Although, demand for a finri's

product

reflects

what

the

consumers buy, this can be influenced through manipulating the

factors on which consumers base their demands. Demand
analysis attempts to estiinate the demand for a product in future,
which further helps to plan production based on the estimated
demand.
MEANING OF DEMAND
Demand for a good implies the desire of an individual to acquire the

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product. It also includes willingness and ability of ail individual to

pay for the product. For example, a miser's desire for and his ability
to pay for a car is not demand, for he does not have the necessary
will to pay for the car. Similarly, a poor person's desire for and his
willingness to pay for a car is not demand because he lacks the
necessary purchasing power. One can also imagine an individual,
who possesses both the will and the purchasing power to pay for a
good. But this purchasing power is not the demand for that good,
this is because he does not have the desire to buy that product.
Therefore, demand is successful when there are all the three factors:
desire, willingness and ability. It should also be noted that demand
for any goods or services has no meaning unless it is stated with
reference to time, price, competing product, consumer's incomes,
tastes and preferences. This is because demand varies with
fluctuations in these factors. For example, the demand for an
Ambassador car in India is 40,000 is meaningless unless it is stated
that this was the demand in 1976 when an Ambassador car's price
was around thirty thousand rupees. The price of the competing cars
prices were around the same, a Bajaj scooter's price was around five
thousand rupees and petrol price was around three and a half
rupees per litre. In 1977, the demand for Ambassador cars could be
different if any of the above factors happened to be different.
Furthermore, it should be noted that a product is defined with
reference to its particular quality. If its quality changes it can be
deemed as another product. Thus, the demand for any product is
the desire, wi1lihigness and ability to buy the product with reference
to a partkular time and given values of variables on which it
depends.

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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.

Demand for Firm's Product and Industry's Products

The quantity of a firm's yield, that can be disposed of at a given price
over a period refers to the demand for firm's product. The aggregate
demand for the product of all firms of an industry is known as the

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market-demand or demand for industry's product. This distinction

between the two kinds of demand is not of much use in a highly
competitive market since it merely signifies the distinction between a
sum and its parts. However, where market structure is oligopolistic, a
distinction between the demand for firm's product and industry's
product is useful from managerial point of view. The product of each
firm is so differentiated from the products of the rival firms that
consumers treat each product different from the other. This gives
firms an opportunity to plan the price of a product, advertise it in
order to capture a larger market share thereby to enhance profits. For
instance, market of cars, radios, TV sets, refrigerators, scooters, toilet
soaps and toothpaste, all belong to this category of markets.
In case of monopoly and perfect competition, the distinction
between demand for a firm's product and industry's product is not
of much use from managerial point of view. In case of monopoly,
industry is one-firmindustiy andthe demand for firm's product is the
same as that of the industry. In case of perfect competition,
products of all firms .of the industry are homogeneous and price for
each firm is determined by industry. Firms have little opportunity to
plan

the

prices

permissible

under

local

conditions

and

advertisement by a firm becomes effective for the whole industry.

Therefore, conceptual distinction between demand for film's product
and industry's product is not much use in business decisions
making.
Autonomous and Derived Demand
An

Autonomous

demand

for

product

is

one

that

arises

independently of the demand for any other good whereas a derived

demand is one, which is derived from demand of some other good. To

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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

demonstration effect, rise in income, and increase in population and

advertisement of new produCts. On the other hand, the demand for a
good that arises because of the demand for some other good is called
derived demand. For instance, demand for land, fertiliser and
agricultural tools and implements are derived demand, since the
demand of goods, depends on the demand of food. Similarly, demand
for steel, bricks, cement etc., is a derived demand because it is
derived from the demand for houses and other kind of buildings. [n
general, the demand for, producer goods or industrial inputs is a
derived one. Besides, demand for complementary goods (which
complement the use of other goods) or for supplementary goods
(which supplement or provide additional utility from the use of other
goods) is a derived demand. For instance petrol is a complementary
goods for automobiles and a chair is a complement to a table.
Consider some examples of supplement goods. Butter is supplement
to bread, mattress is supplement to cot and sugar is supplement to
tea. Therefore, demand for petrol, chair, and sugar would be
considered as derived demand. The conceptual distinction between
autonomous demand and derived demand would be useful according
to the point of view of a bllsinessman to the extent the former can
serve as an indicator of the latter.
Demand for Durable and Non-durable Goods
Demand is often classified under demand for durable and non-durable

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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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suppose that the annual demand for cigarettes in a city is 10 million

packets and it increases at the rate of half-a-million packets per
annum on account of increase in population when other factors
remain constant. Thus, the total demand for cigarettes in the next
year will be 10.5 million packets and 11 million packets in the next to
next year and so on. This is a linear increase in the demand for a nondurable good like cigarette. Now consider the demand for a durable
good, e.g., automobiles. Let us suppose: (i1 the existing number of
automobiles in a city, in a year is 10,000, (ii) the annual replacement
demand equals 10 per cent of the total demand, and (iii) the annual
autonomous increase in demand is 1000 automobiles. As such, the
total annual clemand for automobiles in four subsequent years is
calculated and presented in Table 2.1.
Table 2.1: Annual Demand for Automobiles
Beginning Total no. of Replacement
Annual
Total Annual
of the year automobiles
demand
autonomous demand increase
(Stock)
demand
in
,
demand
10,000
1st year
10,000
2nd year

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

Stock + Replacement + Autonomous demand = TotalDemand

It may be seen from the Table 2.1 that the total demand for
automobiles is increasing at an increasing rate due to acceleration
in the replacement demand. Another factor, which might accelerate
the demand for automobiles and such durable goods, is the rate of
obsolescence of this category of goods.
Short-term and Long-term Demand
Short-term demand refers to the demand for goods that are demanoed

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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,

gumboots, cold drinks and ice creams is of seasonal nature; 'The

demand for such goods lasts till the season lasts. Some goods of this
category are demanded for a very short period, i.e., 1-2 week, for
example, new greeting cards, candles and crackers on occasion of
diwali.
Although some goods are used only seasonally but are durable in
pature, e.g., electric fans, woollen garments, etc. The demand for such
goods is of also durable in nature but it is subject to seasonal
fluctuations. Sometimes, demand for certain gools suddenly increases
because of scarcity of their superior substitutes. For examp1e, when
supply of cooking gas suddenly decreases, demand for kerosene,
cooking coal and charcoal increases. In such cases, additional
demand is of shGrtterm nature. The long-term demand, on the hand,
refers to the demand, which exists over a long-period. The change in
long-term demand is visible only after a long period. Most generic
goods have long-term demand. For example, demand for consumer
and producer goods, durable and non-durable goods, is long-term
demand, though their different varieties or brands may have only
short-term demand. Short-term demand depends, by and large, on
the price of commodities, price of their substitutes, current disposable
income of the consumer, their ability to adjust their consumption
pattern and their susceptibility to advertisement of a new product.
The long-term demand depends on the long-term income trends,

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availability of better substitutes, sales promotion, and consumer credit

facility. The short-term and lcmg-term concepts of demand are useful
in designing new products for established producers, choice of
products for the new entrepreneurs, in pricing policy and in
determining advertisement expenditure.
DETERMIN!\NTS OF MARKET DEMAND
The knowledge of the determinants of market demand for a product
and the nature of relationship between the demand and its
determinants proves very helpful in analysing and estimating demand
for the product. It may be noted at the very outset that a host of
factors determines the demand for a product. In general, following
factors determine market demand for a good:

Price of the good- .

Price of the related goods-substitutes, complements and

supplements

Level of consumers' income

Consumers' taste and preference

Advertisement of the product

Consumers' expectations about future price and supply

position

Demonstration effect and 'bend-wagon effect

Consumer-credit facility

Population of the country

Distribution pattern of national income.
These factors also include factors such as off-season discounts
and gifts on purchase of a good, level of taxation and general social
and political environment of the country. However, all these factors
are

not

equally

important.

Besides,

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some

of

them

are

not

quantifiable.

For

example,

consumer's

preferences,

utility,

demonstration effect and expectations, are difficult to measure.

However, both quantifiable and non-quantifiable determinants of
demand for a product will be discussed.
1. Price of the Product
The price of a product is one of the most important determinants of
demand in the long run and the only determinant in the short run.
The price and quantity demanded are inversely related to each other.
The law of demand states that the quantity demanded of a good or a
product, which its consumers would like to buy per unit of time,
increases when its price falls, and decreases when its price increases,
provided the other factors remain' same. The assumption 'other
factors remaining same' implies that income of the consumers, prices
of the substitutes and complementary goods, consumer's taste and
preference and number of consumers remain unchanged. The pricedemand relationship assumes a much greater significance in the
oligopolistic market in which outcome of price war between a firm and
its rivals determines the level of success of the firm. The firms have to
be fully aware of price elasticity of demand for their own products and
that of rival firm's goods.

2. Price of the Related Goods or Products

The demand for a good is also affected by the change in the price of
its related goods. The related goods may be the substitutes or
complementary goods.
Substitutes
Two goods are said to. be substitutes of each other if a change in price
of one good affects the deinand for the other in the same direction. For

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instance goods X and Y are considered as substitutes for each other if

a rise in the price of X increase demand for Y, and vice versa. Tea and
coffee, hamburgers and hot-dog, alcohol and drugs are some examples
of substitutes in case of consumer goods by definition, the relation
between demand for a product and price of its substitute is of positive
nature. When, price of the substitute of a product (tea) falls (or
increase), the demand for the product falls (or increases). The
relationship of this nature is shown in Figure 2.1 and 2.2.

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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)

simultaneously. For example, petrol is a complement to car and

scooter, butter and jam to bread, milk and sugar to tea and 1 coffee,
mattress to cot, etc. Two goods are termed as complementary to each
other -i if an increase in the price of one causes a decrease in demand
for the other. By definition, there is an inverse relation between the
demand for a good and the price of its complement. For instance, an
increase in the price of petrol causes a decrease in the demand for car
and other petrol-run vehicles and vice versa while other thing's
remaining constant. The nature of relationship between the demand
for a product and the price of its complement is given in Figure 2.2.
3. Consume's Income
Income is the basic determinant of market demand since it
determines the purchasing power of a consumer. Therefore, people
with higher current disposable income spend a larger amount on
goods and services than those with lower income. Income-demand

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relationship is of more varied nature than that between demand

and its other determinants. While other determinants of demand,
e.g., product's own price and the price ohts substitutes, are more
significant in the short-run, income as a determinant of demand is
equally important in both short run and long run. Before
proceeding further to discuss income-demand relationships, it will
be useful to note that consumer goods of different nature have
different kinds of relationship with consumers having different
levels of income. Hence, the managers need to be fully aware of the
kinds of goods they are dealing with and their relationship with the
income of consumers, particularly about the assessment of both
existing and prospective demand for a product.
For the purpose of income-demand analysis, goods and serv:ices
maybe grouped under four broad categories, which ate: (a) essential
consumer goods, (b) inferior goods, (c) normal goods, and (d) prestige
or luxury goods. To understand all these terms, it is essential to
understand the relationship between income and different kinds of
goods.
Esscntial Consumcr Goods (ECG): The goods and services of this
category are called 'basic needs' and are consumed by all
persons of a society such as food-grains, salt, vegetable oils,
matches, cooking fuel, a minimum clothing and housing.
Quantity demanded for these goods increases with increase in
consumer's income but only up to certain limit, even though the
total expenditure may increase in accordance with the quality of
goods consumed, other factors remaining the same. The
relationship between goods of this category and consumer's
income is shown by the curve ECG in Figure 2.3. As the curve
shows, consumer's demand for essential goods increases only

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until his income rises to OY2. It tends to saturate beyond this

level of income.
Inferior goods: Inferior goods are those goods whose demand
decreases with the increase in consumer's income. For example
millet is inferior to wheat and rice; bidi (indigenous cigarette) is
inferior to cigarette, coarse, textiles are inferior to refined ones,
kerosene is inferior to cooking gas and travelling by bus is
inferior to travelling by taxi. The relation between income and
demand for an inferior good is shown by the curve IG in Figure
2.3 under the assumption that other determinants of demand
remain the same demand for such goods rises only up to a
certain level of income, i.e., OY1 and declines as income
increases beyond this level.

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Normal goods: Normal goods are those goods whose demand

increases with increaseiri the consumer income. For example,
clothings, household furniture and automobiles. The relation
between income and demand for normal goods is shown by the
curve NG in Figure 2.3. As the curve shows, demand for such
goods increases with the increases in consumer income but at
different rates at different levels of income. Demand for normal
goods increases rapidly with the increase in the consumer's
income but slows down with further increase in income. It
should be noted froms Figure 2.3 that up to certain level of
income (YI) the relation between income and demand for all type
of goods is similar. The difference is of only degree. The relation
becomes distinctly different beyond YI level of income. Therefore,
it is important to view the income-demand relations in the light
of the nature of product and the level fconsumer's income.
Prestige and luxury goods: Prestige goods are those goods,
which are consu!TIed mostly by rich section of the society, e.g.,
precious stones, antiques, rare paintings, luxury cars and such
other items of show-bff. Whereas luxury goods include jewellery,
costly brands of cosmetics, TV sets, refrigerators, electrical
gadgets and cars. Demand for such goods arises beyond a certain
level of consumer's income, i.e., consumption enters the area of
luxury goods. Producers of such goods, while assessing the
demand for their goods, should consider the income changes in
the richer section of the society and not only the per capita
income. The relation between income and demand for such goods
is shown by the curve LG in Figure 2.3.

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4. Consumer's taste and preference

Consumer's

taste

and preference

play

an important

role

in

detennihing demand for a product. Taste and preference depend,

generally, on the changing. life-style, social customs, religious values
attached to a good, habi of the people, the general levels of living of
the society and age and sex of the consumers. Change in these
factors changes consumer's taste and preferences. As a result,
consumers reduce or give up the consumption of some goods and
add new ones to their consumption pattern. For example, following
the change in fashion, people switch their consumption pattern from
cheaper, old-fashioned goods to costlier mod goods, as long as price
differentials are proportionate with their preferences. Consumers are
prepared to pay higher prices for 'mod goods' even if their virtual
utility is the same as that of old-fashioned goods. The manufacturers
of goods and services that are subject to frequent change in fashion
and style, can take advantage of this situation in two ways: (i) they
can make quick profits by designing new models of their goods and
popularising them through advertisement, and (ii) they can plan
production in abetter way and can even avoid over-productiorlifthey
keep an eye on the changing fashions.

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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 By setting fashions and changing tastes.

The impact of such effects shifts the demand curve upward to the
right.
In other words, when other factors' remain same, the expenditure
on advertisement increases the volume of sales to the same extent.
The relation between advertisement outlay and sales is shown in
Figure 2.4.

Assumptions
Therelatiqnship between demand and advertisement cost as shown in
Figure 2.4 is based on the following assumptions:

Consumers are fairly sensitive and responsive to various modes

of advertisement.

The rival firms do not react to the advertisements made by a

firm.

The level of demand has not already reached the saturation

point. Advertisement beyond this point will make only marginal

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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.

Others determinants of demand, e.g., income and tastes, etc.,

are not operating in the reverse direction.

In the absence of these conditions, the advertisement effect on

sales may be unpredictable.

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.

9. Population of the Country

The Jotal domestic demand for a good of mass consumption depends
also on the size' of the population. Therefore, larger the population
larger will be the demand for a product, when price, per capita
income, taste and preference are given. With an increase or decrease
in the size of population, employment percentage remaining the
same, demand for the product will either increase or decrease.
10. Distribution of National Income
The level of national income is the basic determinant of the market
demand for a good. Therefore, pig her the national income higher will
be the demand for all normal goods and services. Apart from this, the
distribution pattern of the national income is also an important
determinant for demand of a good. If national income is evenly
distributed, market demand for normal goods will be the largest. If
national income is unevenly distributed, i.e., if majority of population
belongs to the lower income groups, market demand for essential
goods, including inferior ones, will be the largest whereas the
demand for other kinds of goods will be relatively less.

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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do the changes in the following factors affect the demand for a

good?
A. Price
B. Income
C. Price of the substitute
D. Advertisement
E. Population.
Also describe the nature of relationship between demand for a
good and these factors (consider one factor at a time assuming
other factors to remain constant).
3. Explain different types of determinants of demand.

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LESSON - 3

COST CONCEPTS

Business decisions are generally taken on the basis of money values of

the inputs and outputs. The cost production expressed in monetary
terms is an important factor in almost all business decisions, specially
those pertaining to (a) locating the weak points in production
management; (b), minimising the cost; (c) finding out the optjmum
level of output; and (d) estimating or projecting the cost of business
operations. Besides, the term 'cost' has different meanings under
different settings and is subject to varying interpretations. It is
therefore essential that only relevant concept of costs is used in the
business decisions.
CONCEPT OF COST
The concepts of cost, which are relevant to business operations and
decisions, can be grouped, on the basis of their purpose, under two
overlapping categories such as concepts used for accounting purposes
and concepts used in economic analysis of business activities.
SOME ACCOUNTING CONCEPTS OF COST
Opportunity Cost and Actual Cost
Opportunity cost is the loss incurred due to the unavoidable
situations such as scarcity of resources. If resources were unlimited,
there would be no need to forego any income yielding opportunity and,
therefore, there would be no opportunity cost. Resources are scarce
but have alternative uses with different returns, Resource owners who

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aim at maximising of income put their scarce resources to their most

productive use and forego the income expected from the second best
use of the resources. Thus, the opportunity cost may be defined as the
expected returns from the second best use of the resources foregone
due to the scarcity of resources. The opportunity cost is also called the
alternative cost.
For example, suppose that a person hps a sum of Rs. lOO,OOO
for which he has only two alternative uses. He can buy either a
printing machine or, alternatively, a lathe machine. From printing
machine, he expects an annual income of Rs. 20,000 and from the
lathe, Rs. 15,000. If he is a profit maximising investor, he would
invest his tnoney in printing machine and forego the expected income
from the lathe. The opportunity cost of his income from printing
machine is, the expected income from the lathe machine, i.e., Rs.
l5,000. The opportunity cost arises because of the foregone
opportunities. Thus, the opportunity cost of using resources in
the'Printing business is the best opportunity ahdthe expected return
from the lathe machine is the second best alternative. In assessing
the alternative cost, both explicit and implicit costs are taken into
account.
Associated with the concept of opportunity cost is the concept of
economic rent or economic profit. In our example, economic rent of
the printing machine is the excess of its earning over the income
expected from the lathe machine (i.e., Rs. 20,000 - Rs. 15,000 = Rs.
5,000). The implication of this concept for a businessman is that
investing in printing machine is preferable as long as its economic
rent is greater than zero. Also, if firms have knowledge of the
economic rent of the various alternative uses of their resources, it
will be helpful for them to choose the best Investment A venue. In

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contrast to opportunity cost, actual costs are those which are

actually incurred by the firm in the payment for labour, material,
plant, building, machinery, equipments, travelling and transport,
advertisement, etc. The total money expenditures, recorded in the'
books of accounts are, the actual costs, Therefore, the actual cost
comes under the accounting concept.
Business Costs and Full Costs
Business.costs include all the expenses, which are incurred to carry
out a business. The concept of business costs is similar to the actual
or the real costs. Business costs include all the payments and'
contractual obligations made by the firm together with the book cost
of depreciation on plant and equipment. These cost concepts are used
for calculating business profits and losses, for filing returns for
income tax and for other legal purposes. The concept of full costs,
include business costs, opportunity cost and. normal profit. As stated
earlier the opportunity cost includes the expected earning from the
second best use of the resources, or the market rate of interest on the
total money capital and the value of entrepreneur's own services,
which are not charged for'in the current business. Normal profit is a
necessary minimum earning in addition to the opportunity cost,
which a firm must get to remain in its present occupation.

Explicit and Implicit or Imputed Costs

Explicit costs are those, which fall under actual or business costs
entered in the books of accounts. For example, the payments for
wages and salaries, materials, licence fee, insurance premium and
depreciation charges etc. These costs involve cash payment and, are
recorded in normal accounting practices. In contrast with these costs,

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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.

Out-of-Pocket and Book Costs

The items of expenditure, which involve cash payments or cash
transfers recurring and non-recurring are known as out-of-pocket
costs. All the explicit costs such as wage, rent, interest and transport
expenditure. On the contrary, there are actual business costs, which
do not involve cash payments, but a provision is made for them in the
books of account. Thes costs are taken into account while finalising
the profit and loss accounts. Such expenses are known as book costs.
In a way, these are payments that the firm needs to pay itself such as
depreciation allowances and unpaid interest on the businessman's
own fund.
Fixed and Variable Costs

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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

machinery, building and other fixed assets and maintenance of land,

etc.
Variable costs are those, which vary with the variation in the total
output. They are a function of output. Variable costs inclue cost of
raw materials, running cost on fixed capital, such as fuel, repairs,
routine maintenance expenditure, direct labour charges associated
with the level of output and the costs of all other inputs that vary
with the output.
Total, Average and Marginal Costs
Total cost represents the value of the total resource requirement for
the production of goods and services. It refers to the total outlays of
money expenditure, both explicit and implicit, on the resources used
to produce a given level of output. It includes both fixed and variable
costs. The total cost for a given output is given by the cost function.
The Average Cost (AC) of a firm is of statistical nature and is not
the actual cost. It is obtained by dividing the total cost (TC) by the
total output (Q), i.e.,
AC =

TC
Q

= average cost

Marginal cost is the addition to the total cost on account of

producing an additional unit of the product. Or marginal cost is the
cost of marginal unit produced. Given the cost function, it may be

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defined as
AC=

aTC
aQ

These cost concepts are discussed in further detail in the

following section. Total, average and marginal cost concepts are used
in economic analysis of firm's producti on activities.
Short-run and Long-run Costs
Short-run and long-run cost concepts are related to variable and fixed
costs,

respectively,

and

often

appear

in

economic

analysi.s

interchangeably. Short-run costs are those costs, which change with

the variation in output, the size of the firm remaining the same. In
other words, short-run costs are the same as variable costs. Long-run
costs, on the other hand, are the costs, which are incurred on the
fixed assets like plant, building, machinery, etc. Such costs have longrun implication in the sense that these are not used up in the single
batch of production.
Long-run costs are, by implication, same as fixed costs. In the
long-run, however, even the fixed costs become variable costs as the
size of the firm or scale of production increases. Broadly speaking, the
short-run costs are those associated with variables in the utilisation
of fixed plant or other facilities whereas long-run costs are associated
with the changes in the size and type of plant.
Incremental Costs and Sunk Costs
Conceptually, increment natal costs are closely related to the concept
of marginal sot. Whereas marginal cost refers to the cost of the
macgmalunit of output, incremental cost refers to the total additional

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cost associated with the marginal batch of output. The concept of

incremental cost is based on a specific and factual principle. In the
real world, it is not practicable for lack of perfect divisibility of inputs
to employ factors for each unit of output separately. Besides, in the
long run, firms expand their production; hire more men, materials,
machinery, and equipments. The expenditures of this nature are the
incremental costs, anq not the marginal cost. Incremental costs also
arise owing to the change in product lines, addition or introduction of
a new product, replacement of worn out plan and machinery,
replacement of old technique of production with a new one, etc.
The sunk costs are those, which cannot be altered, increased or
decreased, by varying the rate of output. For example, once it is
decided to make incremental investment expenditure and the funds
are allocated and spent, all the preceding costs are considered to be
the sunk costs since they accord to the prior commitment and
cannot be revised or reversed when there is change in market
conditions orchange in business decisions.
Historical and Replacement Costs
Historical cost refers to the cost of an asset acquired in the past
whereas replacement cost refers to the outlay, which has to be made
for replacing an old asset. These concepts own their sigtlificance to
unstable nature of price behaviour. Stable prices over a period of
time, other things given, keep historical and replacement costs on
par with each other. Instability in asset prices, however, makes the
two costs differ from each other.
Historical cost of assets is used for accounting purposes, in the
assessment of net worth of the firm.

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Private and Social Costs

We have so far discussed the cost concepts that are related to the
working of the firm and those which are used in the cost-benefit
analysis of the business decision process.

There are, however,

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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relationship between the input, and the output. Production function of

a firm combined with the supply function of inputs or prices of inputs
determines the cost function of the firm. Precisely, cost function is a
function derived from the production function and the market supply
function. 'Depending on whether short or long-run is considered for
the production, there are two kinds of cost functions: such as shortrun cost-function and long-run cost function. Cost-output relations in
relation to the changing level of output will be discussed here u.nder
both kinds of cost-functions.
Short-run Cost Output Relations
The basic analytical cost concepts used in the analysis of cost
behaviour are total average and marginal costs. The totalcost (TC) is
defined as the actual cost that must be incurred to produce a given
quantity of output. The short-run TC is composed of two major
elements: total fixed cost (TFC) and total variable cost (TVC). That is,
in the short-run,
TC = TFC + TVC

(2)

As mentioned earlier, TFC (i.e" the costof plant, building,

equipment, etc.) remains fixed in the short-run, where as TVC varies
with the variation in the output.
For a given quantity of output (Q), the average total cost, (AC),
average fixed cost (AFC) and, average var!able cost (AVC) can 'be
defined as follows:

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)

Since TC = TFC + TVC and, in the short-run, TFC = 0,

therefore, TC=TVC
Furthermore, under marginality concept, where Q = 1,MC =

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)

(where a = TFC and b, c and d are variable-cost parameters)

And also the cost function is empirically estimated as
TC = 10 + 6Q - 0.9Q2 + 0.05Q3
and

TVC = 6Q - 0.9Q2 + 0.05Q3

(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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TVC and TC have been graphically presented in Figure 3.1. As the

figure shows, TFC remains fixed for the whole range of output, and
hghce, takes the form of a horizontal line, i.e., TFC. The TVCcurve
shows that the total variable cost first increases ata'i decreasing rate
and then at an increasing rate with the increase it the total output.
The rate of increase can be obtained from the slope of TVC curve. The
pattemof change in the TVC stems directly from the law of increasing
and diminishing returns to the variable inputs. As output increases,
larger quantities of variable inputs are required to produce the same
quantity of output due to diminishing returns. This causes a
subsequent increase in the variable cost for producing the same
output. The following Table 3.1 shows the cost output relationship.
Table 3.1: Cost Output Relations
Q
(I)
0
I
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16

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

From equations (6) and (7), we may derive the behavioural

equations for AFC, AVC and AC. Let us first consider AFC.

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Average Fixed Cost (AFC)

As already mentioned, the costs that remain fixed for a certain level of
output make the total fixed cost in the short-run. The fixed cost is
represented by the constant term 'a' in equation (6). We know that

AFC =

TFC
Q

(8)

Substituting 10 for TFC in equation (8), we get

AFC =

10
Q

(9)

Equation (9) expresses the behaviour of AFC in relation to

change in Q. The behaviour of AFC for Q from 1 to 16 is given in
Table 3.1 (col. 5) and is presented graphically by the AFC curve in
the Figure 3.1. The AFC curve is a rectangular hyperbola.

Average Variable Cost (AVC)

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As defined above,

AVC =

TVC
Q

Given the TVC function in equation 7, we may express AVC as

follows:

AVC =

6Q-0.9Q2+0.05Q3
Q

= 6- 0.9Q+0.05Q3

(10)

Having derived the A VC function (equation 10), we may easily

obtain the behaviour of A VC in response to change in Q. The
behaviour of A VC for Q from I to 16 is given in Table 3.1 (co 1. 6),
and is graphically presented in Figure 3.2 by the A VC curve.
Critical Value of A VC
From equation (10), we may compute the critical value or Q in respect
of A Vc. The critical value of Q (in respect of A VC) is that value of Q
at which A VCis minimum. The Ave will be minimum when its
decreasing rate of change is equal to zero. This can be accomplished
by differentiating equation (10) and setting it equal to zero. Thus,
critical value of Q can be obtained as
Q=

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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The average cost in defined as

TC
Q

AC =

Substituting equation (6) for TC in above equation, we get

10+6Q-09Q2+0.05Q3
AC =

(12a)

10
=

+ 6-0.9Q+0.05Q2

The equation (l2a) gives the behaviour of AC in response to

change in Q. The behaviour of AC for Q from I to 16 is given in Table
3.1 and graphically presented in Figure 3.2 by the AC-curve. Note that
AC-curve is U-shaped.
From equation (12a), we may easily obtain the critical value of Q in
respect of AC. Here, the critical valuepf Q in respect of AC is one at
which AC is minimum. This can be obtained by differentiating
equation (l2a) and setting it equal to zero. This, critical vallie of Q in
respect of AC is given by
aAC
aQ

10
Q2

- 0.9 + 0.1Q = 0

(12b)

This equation takes the form of a quadratic equation as

-10 0.9Q2 + 0.1Q3 = 0
or,

Q3 9Q2 = 100 = 0

By solving equation (12b), we get

Q = 10
Thus, the critical value of output in respect of AC is 10. That is,

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AC reaches its minimum at Q = 10. This can be verified from Table.

3.1 shows short-run cost curves.

Marginal Cost (MC)

The concept of marginal cost (MC) is particularly useful in economic
analysis. MC is technically the first derivative of TC function. That is,

MC =

aTC
aQ

Given the TC function as in equation (6), the MC function can be

obtained as
aTC
aQ

= 6-1.8Q+0.15Q2

(13)

Equation (13) represents the behaviour of MC. The behaviour of

MC for Q from 1 to 16 computed as MC = TC n - TCn- i is given in
Table 3.1 (col. 8) and graphically presented by MC-curve in Figure

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3'.2. The critical 'value of Q in respect of MC is 6 or 7. It can be seen

from Table 3.1.
One method of solving quadratic equation is to factorise it and
find the solution.
Thus,

Q3 9Q2 100 = 0
(Q 10) (Q2 + Q + 10) = 0

For this to hold, one of the terms must be equal to zero,

Suppose
Then,

(Q2 + Q + 10) = 0
Q 10 = 0 and Q = 10.

COST CURVES AND THE LAWS OF DIMINISHING RETURNS

We now return to the laws of variable proportions and explain it
through the .cost curves. Figures 3.1 and 3.2 clearly bring out the
short-term laws of production, i.e., the laws of diminishing returns.
Let us recall the law: it states that when more and more units of a
variable input are applied to those inputs which are held constant, the
returns from the marginal units of the variable input may initially
increase but will eventually decrease. The same law can also be
interpreted in term's of decreasing and increasing costs. The law can
then be stated as, if more and more units of a variable inputs are
applied to the given amount of a fixed input, the' marginal cost
initially decreases, but eventually increases. Both interpretations of
the law yield the same information: one in terms of marginal
productivity of the variable input, and the other, in terms of the
marginal cost. The former is expressed through production function
and the latter through a cost function.
Figure 3.2 represents the short-run laws of returns in terms of
cost of production. As the figure shows, in the initial stage of

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production, both AFC and AVC are declining because of internal

economies. Since AC = AFC + AVC, AC is also declining, this shows the
operation of the law of increasing returns. But beyond a certain level
of output (i.e., 9 units in out example), while AFC continues to fall,
AVC starts increasing because of a faster increase in the TVC.
Consequently, the rate of fall in AC decreases. The AC reaches its
minimum when output increases to 10 units. Beyond this level of
output, AC starts increasing which shows that the law of diminishing
returns comes in operation. The MC, curve represents the pattern of
change in both the TVC and TC curves due to change in output. A
downward trend in the MC shows increasing marginal productivity of
the variable input mainly due to internal economy resulting from
increase in production. Similarly, an upward trend in the MC shows
increase in TVC, on the one hand, and decreasing marginal
productivity of the variable input, on the other.

SOME IMPORTANT COST RELATIONSHIPS

Some important relationships between costs used in analysing the
short-run cost behaviour may now be summed up as follows:

As long as AFC and AVC fall, AC also falls because AC = AFC

+AVC.

When AFC falls but A VC increases, change in AC depends on

the rate of change in AFC and AVC then any of the following
happens:
ifthereisdecrease in AFC and increase in A VC, AC falls,
if the decrease on AFC is equal to increase in Ave, AC remains
constant, and

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 if the d~crease in AFC is less than increase in A VC, AC

increases.
The relationship between AC and MC is of varied nature. It may
be described as follows:
When MC falls, AC follows, over a certain range of initial
output. When MCis failing, the rate of fall in MC is greater
than that of AC This is because in case of MC the decreasing
marginal cost is attributed, : to a single marginal unit while;
in case of AC, the decreasing marginal cost is distributed
overall the entire output. Therefore, AC decreases at a lower
rate than MC.

Similarly, when MC increase, AC also increases but at a lower

rate fbr the reason given in'the above point. There is however
a range of output over which this relationship does not exist.
For example, compare the behaviour of MC and AC over the
range of output frbm 6 units to 10 units (see Figure 3.2). Over
this range of ~utput, MC begins to increase while AC
continues to decrease. The reason for this can be seen in
Table. 3.1. When MC starts increasing, it increases at a
relatively lower rate, which is sufficient only to reduce the rate
of decrease in AC, i.e., not sufficient to push the AC up. That
is why AC continues to fall over some range of output even, if
MC falls.
MC iJ1tetsects AC at its minimum point. This is simply a
mathematical relationship between MC and AC curves when
both of them are obtained from the same TC function. In
simple words, when AC is at its minimum, then it is neither
increasing nor decreasing it is constant. When AC is

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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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between the total output and, the variable cost (labour). To

understand the long-run costoutput relations (lnd to derive long-run
cost curves it will be helpful to imagine that a long run is composed of
a series of short-run production decisions. As a' corollary of this,
long-run cost curves are composed of a series of short-run cost
curves. We may now derive the long-run cost curves and study their'
relationship with output.
Long-run Total Cost Curve (LTC)
In order to draw the long-run total cost curve, let us begin with a
short-run situation. Suppose that a firm having only one-plant has
its short-mn total cost curve as given-by STC l in panel (a) of Figure
3.3. In this example if the firm decides to add two more plants to its
size over time, one after the other then in accordance two more shortrun total cost curves are added to STC l in the manner shown by STC 2
and STC3 in Figure 3.3 (a):. The LTC can now be drawn through the
minimum points of STCl, STC2 and STC3 as shown by the LTC curve
corresponding to each STC.
Long-run Average Cost Curve (LAC)
Combining the short-run average cost curves (SACs) derives the longrun average cost curve (LAC). Note that there is one SAC associated
with each STC. Given the STC 1 STC2, and STC3 curves in panel (a) of
Figure 3.3, there are three corresponding SAC curves as given by
SAC1 SAC2 arid SAC3 curves in panel (b) of Figure 3.3. Thus, the firm
has a series of SAC curves, each having a bottom point showing the
minimum SAC. For instance, C1Q1 is the minimum AC when the firm
has only one plant. The AC decreases to C 2Q2 when the second plant
is added and then rises to C3Q3after the inclusion of the third plant.
The LAC carl be drawn through the bottom of SAC 1 SAC2 and SAC3 as

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shown in Figure3.3 (b) The LAC curve is also known as Envelope

Curve' or 'Planning Curve' as it serves as a guide to the entrepreneur
in his planning to expand production.

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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increasing rate. As a result, LAC initially decreases until the optimum

utilisation of the second plant and then it begins to increase. From
these relations are drawn the 'laws of returns to scale'. When the
scale of the firm expands, unit cost of production initially decreases,
but it ultimately increases as shown in Figure 3.3 (b).
Long-run Marginal Cost Curve
The long-run marginal, cost curve (LMC) is derived from the short-run
marginal cost curves (SMCs). The derivation of LMC is illustrated in
Figure 3.4 in which SAC3'and LAC arethe same as'in Figure 3.3(b). To
derive the LMC3, consider the points of tangency between SAC 3 and
the LAC, i.e., points A, Band C. In the long-run production planning,
these points determine the output levels at the different levels of
production. For example, if we draw perpendiculars from points A,
Band C to the X-axis, the corresponding output levels will be OQ 1 OQ2
and OQ3 The perpendicular AQ1 intersects the SMC1 at point M. It
means that at output BQ2, LMC, is MQ1. If output increases to OQ2,
LMC rises to BQ2. Similarly, CQ3 measures the LMC at output OQ 3. A
curve drawn through points M 3B and N, as shown by the LMC,
represents the behaviour of the marginal cost in the long run. This
curve is known as the long-run marginal cost curve, LMC. It shows
the trends in the marginal cost in response to the change in the scale
of production.
Some important inferences may be drawn from Figure 3.4. The
LMC must be equal to SMC for the output at which the
corresponding SAC is tangent to the LAC. At the point of tangency,
LAC = SAC. For all other levels of output (considering each SAC
separately),

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.

Optimum Plant Size and Long-run Cost Curves

The short-run cost curves are helpful in showing how a firm can
decide on the optimum utilisation of the plant-which is the fixed
factor; or how it can determine the least-cost output level. Long-run
cost curves, on the other hand, can be used to show how the
management can decide on the optimum size of the firm. An Optimum
size of a firm is the one, which ensures the most efficient utilisation of
resources. Given the state: of technology overtime, there is technically
a unique size of the firm and lever of output associated with the least
cost Concept. This uriique size of the firm can be obtained with the
help of LAC and LMCIn Figur 3.4 the optimum size consists of two
plants, which produce OQ2 units of a produd, at minimum long-run
average cost (LAC) of BQ2.

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The downtrend in the LAC ihdicates that until output reaches

the level of OQ2, the firm is of non-optimal size. Similarly, expansion of
the firm beyond production capacity OQ2 causes a rise in SMC as well
as LAC. It follows that given the technology, a firm trying to mini mise
its average cost over time must choose a plant which gives minimum
LAC where SAC = SMC = LAC = LMC. This size of plant assures most
efficient utilisation of the resource. Any change in output level, i.e.,
increase or decrease, will make the firm enter the area of in optimality.
ECONOMIES AND DISECONOMIES OF SCALE
Scale of enterprise or size of plant means the amount of investment in
relatively fixed factors of production (plant and fixed equipment).
Costs of production are generally lower in larger plants than in the
smaller ones. This is so because there are a number of economies of
large-scale production.
Economies of Scale
Marshall classified the economies of large-scale production into two
types:
1. ExternalEconomies
2. Internal Economies

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External Economies are those, which are available to all the

firms in an industry, for example, the construction of a railway line in
a certain region, which would reduce transport cost for all the firms,
the discovery of a new machine, which can be purchased by all the
firms, the emergence of repair industries, rise of industries utilising
by-products, and the establishment of special technical schools for
training skilled labour and research institutes, etc. These economies
arise from the expansion in the size of an industry involving an
increase in the number and size of the firms engaged in it.
Internal Ecnomies are the economies, which are available to a
particular firm and give it an advantage over other firms engaged in
the industry. Internal economies arise from the expansion of the size
of a particular firm. From the managerial point of view, internal
economies are more important as they can be affected by managerial
decisions of an individual firm to change its size or scale.

Types of Internal Economies

There are various types of internal economies such as labour,
technical, managerial, marketing and so on. We will discuss the types
of internal economies in detail in the following section:

Labour Economies: If an firm decides to expand its scale of

output, it will be possible for it to reduce the labour costs per
unit by practising division of labour. Economies of division of
labour arise due to increase in the skill of workers, and the
saving of time involved in changing from one operation to the
other. Again, in many cases, a large firm may find it economical
to have a number of operations performed mechanically rather
than manuaily. These economies will be of great use in firms

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where the product is complex and the manufacturing processes

can be sub-divided.

Technical Economies: These are economies derived from the

use of subsize machines and such scientific processes like those
which can be carried out in large production units. A small
establishment cannot afford to use such machines and
processes, because their use would bring a saving only when
they are used intensively. On the other hand, their use will be
quite uneconomical if they were to lie idle over a considerable
part of the time. For example, a large electroplating plant costs a
great deal to keep it in operation. Therefore, the cost per unit
will be low only if the output is large. Similarly, a machine that
facilitates the pressing out a side of a motorcar will take a week
or more to be put ready for operation to produce a particular
design. The greater the output of cars of this particular designs
the lower the cost per unit of getting the machine ready for
operation. Similarly, if a dye is made to produce a particular
model of cars, the cost of dye per unit of cars will depend upon
the output of the cars. Very often large firms may find it
economical to produce or manufacture parts and components
for their products rather than buy them from outside sources.
For

example,

Hind

Cycles,

unlike

small

mariufacturers,

produced parts and components themselves. Moreover, large

firms may find it profitable to utilise their by-products and
waste products. For example, Tata use the smoke from their
furnaces to manufacture coal tar, naphthalene, etc. A small
firm's output of smoke would not be large enough to justifY
setting up the .equipment necessary to do so.

Managerial Economies: When the size of the fern increases,

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the efficiency of the management usually increases because

there can be greater specialisationin managerial staff. In a large
firm, experts can be appointed to look after the various sections
or divisions of the business, such as purchasing, sales,
production, financing, personnel, etc. But a small firm cannot
provide full-time employmentto these experts naturally, the
various aspects of the business have to be looked after by few
people only who may not necessarily be experts. Moreover, a
large firm can afford to set up data processing and mechanised
accounting, etc., whereas small firms cannot afford to do so.
Marketing Economies: A large firm can secure economies in its
purchasing and sales. It can purchase its requirements in bulk
and thereby get better terms. It usually receives prompt
deliveries, careful attention and special facilities from its
suppliers. This is sometimes due to the fact that a large buyer
can exert more pressure, at times compulsive in nature, for
specially favoured treatment. It can also get concessions from
transport agencies. Moreover, it can appoint expert buyers and
expert salesmen. Finally, a large firm can spread its advertising
cost over bigger output because advertising costs do not rise in
proportion to a rise in sales.
Economies of Vertical integration: A large firm may decide to
have vertical integration by combining a number of stages of
production. Thisintegration has the advantage that the flow of
goods through various stages in production processes is more
readily controlled. Steady supplies of raw materials, on the one
hand, and steady outlets for these raw materials, on the other,
make production planning more certain and less subject to erratic
and unpredictable changes. Vertical integration may also facilitate

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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

diversification. Diversification is possible.on two lines as follows:

o Diversification of Output: If there are many products,
the loss in the sale of one product may be covered by the
profits from others. By diversification, the firm avoids
what may be called putting all eggs in the same basket.
For

example,

armaments,

Vickers

Ltd.,

food-processing

make
plant,

aircrafts,
rubber,

ships,
plastics,

paints, instruments arid a wide range of other products.

Many of the larger firms have taken to diversification. ITC
diversified to include marine products and hotel business
in its operations.
o Diversification of Markets: The larger producer is
glenerally in a position to sell his goods in many different
and even far-off places. By depending upon one market,
he runs the risk of heavy loss if sales in that market
decline for one reason or the other.
Sargant Floren'ce and Economies of Scale
Sargant Florence has attributed the economies of scale the three

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principles, which are in operation in a large-sized business, namely,

the principle of bulk transactions, the principle of massed reserves,
and the principle of multiples.
Principle of Bulk Transactions: This principle implies that the
cost of dealing with a large batch is often no greater than the cost
of dealing with a small batch, for example,' the cost of placing an
order, large or small; availability of discounts on bulk orders, or
annual purchase contracts; economies in the use or'large
containers such as tanks or trucks of special design, for a
container holding, say, twice as much as the other one, does not
cost double the amount.
Principle of Massed Reserves: A large firm has a number of
departments or sections and its overall demand for services, say,
transport services, is likely to be fairly large. But it is unlikely
that all departments will make heavy demands of the particular
service at the saine time. Thus the firm can afford to have its own
transport fleet and fully utilise it and thereby ultimately reduce
its costs. The larger the firm, the greater are the advantages.
Principle of Multiples: This principle was first raised by Babbage
in 1832 and has also been referred to as 'Balancing of Processes'.
The principle can be better explained through an example.
Suppose a manufacturing, operation involves three processes,
first in which a machine (:an make 30 units a week; second in
which an automatic machine can make 1,000 units per week; and
a third in which a semi-automatic machine can make 400 units
per week. Unles~ the output of the plant is some common
multiple of 30,1,000 anti 400, one or more of the processes will
have unutilised capacity. Their LCM is 6,000 and, therefore, to

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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

Another study of cement industry by the Economic and

Scientific Research undation-shows that the per unit of capacity
capital investment of a 3,000 tonne per' day (TPD) capacity cement
plant islower than the plants of 50 TPD size. Thus a single cement
plant producing 3,200 TPD requires 46 per cent less capital
investment than 8 plants of 400 TPD productions would. As regards
cost of production, a 800 TPD plant has a 15 per cent cost advantage

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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.

The 6/10 Rule

A useful rule that seeks to measure economies of scale is the 6/1 0
rule. According to this rule, if we want to double the volume of a
container, the material needed to make it will have to be increased by
6/10, i.e., 60 per cent. A proofofthe'6/l0 rule is easy and can be given
here with its advantage. Let us begin with the volume of a container
and the material required to make it. Suppose the container is of the
shape of a Gube with its side. The volume of the container then is:
Vo = ao x ao x ao = ao3
Now, to find out the area of material needed, we know that the
container will have six equal square faces, each of area an

so, the

area of total material needed IS:

Mo = 6 x ao2 = 6ao2
Suppose now, that the container's dimension increases from an to
all the volume of the container will then increase to al 3 and the area
of t~e material needed will increase to 6a12.

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Thus, for two containers of dimensions an and al the ratio of the

areas of material needed will be:
M1
M0

6a1/2

a1/2

6a0/2

a0

The corresponding ratio of the volumes will be:

V1
V0

a1/3

a1/3

a0/3

a0

From the above, it follows that:

M1

a1/2

M0

a1/3.2/3

a0/2

a0

V 1 2/3
=

V0

Now, if we double the volume, i.e., if

V1
V1 =

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

The 6/10 rule is of great practical significance. Its significance can

well be realised if we visualise, for example, blast furnaces as boxes
containing the ingredients needed to produce iron, or tankers as large
boxes containing oil.
Minimum Economic Capacity (MEC) Scheme
Small size firms do not enjoy economies of scale. As such, in
pursuance of government's policy to encourage minimum efficient
capacity in industrial und~i1akings, the Government of India has
introduced' MEC Scheme to petrochemical industries, for example,
Naphtha / Gas Cracker (3 to 4 lakhs tonnes), Bopp Film (56,000
tonnes), Polyster Film (5,000 tonnes), Polyster Filament Yam (25,000
tonnes), Acrylic Fibre (20,000 tonnes), MEG (One lakh tonnes), PTA
(2lakh tonnes), etc.

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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certain point, any further expansion of the size leads to diseconomies

of scale. For example, after the division of labour has reached its most
efficient point, further increase in the number of workers will lead to a
duplication of workers. There will be too many workers per machine
for really efficient production. Moreover, the problem of co-ordination
of different processes may become difficult. There may be divergence
of views concerning policy problems among specialists in management
and reconciliation may be difficult to arrive. Decision-making process
becomes slow resulting in missed opportunities. There may be too
much of formality, too many individuals between the managers and
workers, and supervision may' become difficult. The management
problems thus get out of hand with consequent adverse effects on
managerial efficiency.
The limit of scale economics is also often explained in terms of the
possible loss of control and consequent inefficiency. With the growth
in the size of the firm, the control by those at the top becomes
weaker. Adding one more hierarchical level removes the superior
further away from the subordinates. Again, as the firm expands, the
incidence of wrong judgements increases and errors in judgement
become costly.
Last be not the least, is the limitation where the larger the plant,
the larger is the attendant risks of loss from technological changes as
technologies are changing fast in modern times.
Diseconomies of Scale and Empirical Evidence
Large petro-chemical plants achieve economies in both full usage and
in utilisation of a wider range ofby-products, which would otherwise,
be wasted. But above 5,00,000 tonnes, diseconomies of scale sets in
because of the following occurrences:

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 The plant becomes so large that on-site fabrication of some

parts is required which is much more expensive;
Starting up costs are much higher, more capital is tied up and
delays in commissioning can be extremely expensive; and
The technical limit to compressor size has been reached.
There is, however, no substantial evidence of diseconomies of
large-scale production. In the final analysis, however, a significant
test of efficiency is survival. If small firms tend to disappear and
large ones survive, as in the automobile industry, we must conclude
that small firms are relatively inefficient. If small firms survive and
large ones tend to disappear as in the textile industry, then large
firms are relatively inefficient. In reality, we find that in most
industries, firms of very different sizes tend to survive. Hence, it can
be concluded that usually there is no significant advantage or
disadvantage to size over a very wide range of outputs. It may mean,
of

course,

that

the

businessman

in

his

planning

decisions

determines that beyond a certain size, plants do have higher costs

and, therefore, does not build them.
Somewhat surprisingly, some Indian entrepreneurs have been
perceptive enough to attempt to derive the advantages of both large
and small-scale enterprises. In the late sixties, the Jay Engineering
Co. Ltd. evolved a strategy of blending large units with small
enterprises to obtain the best of both worlds. It manufactures its
Usha fans in three different plants (Calcutta, Hyderabad and Agra),
with each plant' manu facturing the same or a similar range of
products. Each unit is autonomous and is free to take operational
decisions except in highly strategic areas. Within each unit, the workforce is kept small to carry out vital operations such as forgoing,

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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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The long-run prosperity of a firm depends upon its ability to eam

sustaid profits. Profit depends upon the difference between the selling
price and the cost of production. Very often, the selling price is not
within the control of a firm but many costs are under its control. The
firm should therefore aim at doing whatever is done at the minimum
cost. In fact, cost control is ail essential element for the successful
operation of a business, Cost control by management means a search
for better and more economical ways of completing each operation. In
effect, cost control would mean a reduction in the percentage of costs
and, in turn, an increase in the percentage of profits. Naturally, cost
control is and will continue to be of perpetual concern to the industry.
Cost control has two aspects' such as a reduction in specific
expenses and a more efficient use of every rupee spent. For example,
if sales can be increased with the same amount of expenditure, say,
on advertising and saTesmen, the cost as a percentage of sales is cut
down. In practice, cost control will ultimately be achieved by looking
into both these aspects and it is impossible to assess the
contribution, which each has made to the overall savings. Potential
savings in individual businesses will, however, vary between wide
extremes depending upon the levels of efficiency already achieved
before cost controls are introduced.
It is useful to bear in mind the following rules covering cost control
activities:
It is easier to keep costs down than it is to bring costs down.
The amount of effort put into cost control tends to increase
when business is bad and decrease when business is good.
There is more profit in cost control when business is. good than
when I business is bad. Therefore, one should not be slack when
conditions are good.

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Cost control helps a firm to improve its profitability and

competitiveness. Profits may be drastically reduced despite a large and
increasing sales volume in the absence of cost control. A big sales
volume does not necessarily mean a big profit. On the other hand, it
may create a false sense of prosperity while in reality; increasing costs
are eating up profits. Profit is in danger-when good merchantdising
and cost control do not go hand in hand. Cost control may also help a
firm in reducing its costs and thus reduce its prices. A reduction in
prices of a firm would lead to an increase in its competitiveness. The
aspect is of particular relevance to Indian conditions because of high
costs, India is being priced out of the world markets.
Tools of Cost Control
Following ar.e the tools that are used for the cost control:
Standard Costs and Budgets: The technique of standard, costing
has been developed to establish standards of performance for
producing gvuus and services. These standards serve "as a goal for
the attainment and as basis of comparison with actual costs in
checking performance. The analysis of variance between actual and
standard costs will: (i) help fix the responsibility for non-standard
performance and (ii) focus attention on areas in which cost
improvement should be sought by pinpointing the source of loss and
inefficiency. The principle here is that or controlling by exception.
Instead of attempting to follow a mass of cost data, the attention of
those responsible for cost control is concentrated on significant
variances from the standard. If effective action is to be taken, the
cause and responsibility of a variance, as well as its amount, must be
established.
The prime objective of standard costs is to generate greater cost

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consciousness and help in cost control by directing attention to

specific areas where action is needed. To those who are immediately
concerned, variances wou1d indicate whether any action is required
on their part. It must be noted that
Costs are controlled at the points where they are incurred and
at the time of occurrence of events, and
At the same time they may be uncontrolled at some points.
It is, therefore, necessary to understand the difference between
controllable and uncontrollable costs. The variances may also be
controllable and uncontrollable. For example, if the material cost
variance is due to rise in prices, it is not within the control of the
production manager. But if the variance is due to greater usage,
control

action

is certainly

possible

on

his part. The

higher

management can also deCide whether or not they should intervene in

the matter. Sometimes, variances may be so significant that a
complete reapRraisal of the standard costs themselves may be needed.
For example, if the variances are always favourable, it may point
to the fact that the standards have not been properly fixed. Standard
costing can also provide the means for actual and standard cost
comparison by type of expense, by departments or cost centres. Yields
and spoilage can be compared with the standard allowance for loss.
Labour operations and overheads also can be checked for efficiency.
Flexible budgets constitute yet another effective technique of cost
control, especially control of factory overheads. Flexible budgets, also
known as variable budgets; provide a basis for determining costs that
are anticipated at various levels of activity. It provides a flexible
standard for comparing the costs of an actual volume of activity with
the cost that should be or should have been. The variances can then
be analysed and necessary action can be taken in the matter. Table

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3.3 gives a specimen flexible budget.

Table 3.3: Finishing Department, Modern Manufacturing Co.

Standard hours of direct labour

35,000
40,000
45,000
Labour cost hour at Rs. 3 per Rs. 1,05,000 Rs. 1,20,000 Rs. 1,35,000
Other variable costs
17500
20.000
22,500
Semi-variable costs
9,250
10,000
10,250
Fixed costs
50,000
50,000
50,000
Total
Rs.l,81,75Q Rs. 2,00,000 Rs.2,17,750

The scientific establishment of standards of performance through

standard costs and budgets has not only provided better cost control
but has led to cost reduction in a number of companies. This has
been the case especiilIIy in companies where standards were tied to
wage-incentive plans and improyement in control is part of a general
programme of better management. The above table shows three
budgets, one each for 35,000, 40,000 and '45,000 standard hours of
work. In practice, one may come across 50 or more cost items in the
budget and not just four as shown in the table.
Ratio Analysis
RatIo is a statistical yardstick that provides a measure of the
relationship betweeri two figures. This relationship may be expressed
as a rate (costs per rupee of sales), as a per cent (cost of sales as a
percentage of sales), or as a quotient (sales as a certain number of
time the inventory). Ratios are commonly used in the analysis of
operations because the use of absolute figures might be misleading.
Ratios

provide

standards

of

comparison

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for

appraising

the

performance of a business firm. They can be used for cost control

purposes in two ways:
A businessman may compare his firm's ratios for the period
under scrutiny with similar ratios of the previous periods. Such
a comparison would help him identify areas that need his
attention.
The businessman can compare his ratios with the standard
ratios in his jndustry. Standard ratios are averages of the results
achieved by thousands, of firms in the same line of business.
If

these

comparisons

reveal

any

significant

differences,

thtYmanagement call analyse the reasons for these differences and

can take appropriate action to remove' the causeS responsible for
increase in costs. Some of the most commonly used ratios for cost
corrtparisons are given below:
Not profits/sales.
Gross profits/sales.
Net profits/total assets.
Sales/totaLassets.
Production costs/costs of sales.
Selling Costs/costs of sales.
Admiriistration costs/costs of sales.
Sahes/iriventory or inventory turnover.
Material costs/prod1, Jction costs.
Labour

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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equipment or materials, a study is made of the purpose to which

these things serve. Would other lower-cost designs work as well?
Could another less costly item fill the need? Will less expensive
material, do the job? Can scrap be reduced by changing the design or
the type of raw materiaJ? Are the seller's costs as low as they ought to
be? Suppliers of alternative materIals can provide the ample data to
make the appropriate choice. Of course, absorbing and reviewing the
data will need some time. Thus the objective of value analysis is the
identification of such costs in a product that do not in any manner
contribute to its specifications or functional value. Hence, value
analysis is the process of reducing the cost of the prescribed function
without sacrificing the required standard of performance. The
emphasis is, first, on identificatiqn of the required function and,
secondly, on determination of the best way to perform it at a lower
cost. This novel method of cost reduction is not yet seriously exploited,
in our country. Value analysis is a supplementary device in addition to
the con~entional cost reduction methods.
Value analysis is closely related to value engineering, though
they are not identical. Value analysis refers to the work that
purchasing

department

does

in-this

direction

whereas

value

engineering usually refers to what engineers are doing in this area.

The purchasing department raises questions and consults the
engineering department and even the vendor company's department.
Value analysis thus requires wholehearted co-operation of not only the
firm's expertise in design, purchase, production and costing but also
that of the vendor and other company expertise, if necessary. Some
examples of savings through value analysis are given below:
Discarding tailored products where standard components can
do.

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 Dispensing with facilities not specified or not required by the

customer, for example, doing away with headphone in a radio
set.
Use ofnewly-deyeloped, better and cheaper materials in place of
traditional materials.
Taking the specific case of TV industry, there are various
components of cost, which can be questioned. The various items are
as under:
Whether to have vertical holding chassis or the chassis should
be tied down horizontally. In case, chassis is held vertically,
additional expenditure in terms of holding clamps is required.
Whether to have plastic cabinet or wooden cabinet.
Whether to have two speakers or one speaker.
Whether to have sliding switches or stationary switches.
Whether to have PVC back cover or wooden back cover.
Whether to have costly knobs or cheaper knobs.
Whether to have moulded mask or extruded plask.
Whether to have Electronic Tuner or Turret Tuner.
Whether to have digital operating unit or noble operating unit.
Cost control is applicable only to such costs, which can be
altered by the management on their own initiative. It may be noted in
this context that, by and large, non-controllable costs exceed far more
than controllable ones thereby restricting the scope of profit
impfoyement through cost, control. Of course, attempts may be made
to convert an uncontrollable cost into a controllable one. Vertical
combinations to secure control over sources of supply provide an
example. So also instead of buying a component, a firm may decide to
make the conversion possible.

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AREAS OF COST CONTROL

Folloviing are the areas where the cost can be controlled:
1. Materials
There area number of ways that help in reducing the cost ofmatenals.
Ifbuying is done properly, a firm avails itself of quantity discounts.
While buying from a particular source, in addition to the cost of
materials, consideration should be given to freight charges. In some
cases, lower prices of materials may be offset by higher freiight to the
firm's godown. Whiie buying, one may attempt to buy from the
cheapbt source by inviting bids. At times, it may be possible to have
more economical substitutes for raw materials that the firm is using.
Many a times, improvell1ent in product design may lead to reduction
in material usage. It is desirable to concentrate attention on the areas
where saving potential is the highest.
Another area, which needs examination in this respect, is
whether to make or buy components from outside source. Very often
firm may find it advantageous to manufacture certain parts and
components in one's own factory rather than buying them. Yet in
many cases there are specific advantages in purchasing spares and
components from outside because suppliers may deliver goods at low
cost with high quality. For example, Ford and Chrysler of the US Auto
Industry purchase their components from outside source. But
General Motors could not do so because the firm has its own
departments for handling the process of production. This type of firm
is referred as vertically integrated firm where it owns the various
aspects of making seIling and delivering a product Hind Cycles, which
has now been taken over by the Government, manufactures all its

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components. But manufacturers of Hero and Avon Cycles purchased

most of their components from outside source and successfully
competed with Hind Cycles.
Continuous Research and Development (R & D) may also lead to
a reduction in raw material costs. For example, Asian Paints made
high savings in costs of raw materials by its phenomenal success on
Research and Development front, by manufacturing synthetic resins
for captive consumption. Total materials consumed as a ratio of value
of production fell from 67.66 per cent in 1973 to 60-67 per cent in
1977. General Motors have reduced the weight of their cars to make
them more fuel-efficient. Better utilisation of materials' may also save
the cost of materials by avoiding wastes in storing, handling and
processing. Some of the factors, responsible for excessive wastage of
materials are: lack of laid down requirements for raw materials, bad
process

planning,

rejects

due

to

faulty

materials

or

poor

workmanship, lack of proper tools, jigs and fixtures, poor quality of

materials, loose packing, careless and negligent handling and careless
storage.
Exploration of the possibilities of the use of standardised parts
and components and the utilisation of waste and by-products, may
also lead to a significant reduction in the cost of materials.
Inventory control is yet another area for reducing materials
cost. Thro inventory control, it is possible to maintain the
investment in inventories at lowest amount consistent with the
production and the sales requirements of firm. The cost of carrying
inventories ranges from 15 to 20 per cent per annum account of
interest on capital, insurance, storage and handling charges, spilla
breakage, physical deterioration, pilferage and obsolescence. Again

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50 per cent the gross working capital may be locked up in

inventories.
Some important ways of reducing inventories are:
Improved production planning.
Having dependable sources of supplies, which can ensure
prompt deliver of materials at short notice.
Elimination of slow-moving stocks and dropping of obsolete
items.
Improved flow of part and materials leading to increased machine
utilisation and shorter manufacturing cycles.
Packaging constitutes a significant proportion of raw materials
(9 to 24 per cent) and of the total manufacturing expenses (7 to 22
per cent). Firm should mal attempts to reduce the packaging costs to
the minimum. For example, instead discarding containers that the
materials come in it may be used for shipping tl goods and thus, the
packaging cost can be saved. The manufacturing firms such; cars
and motor bikes may request its customers to return the containers
in whic are goods were sent so that they could be used in future. This
is because packin of such goods as well as the materials used for
packing is very expensive.
2. Labour
Reduction in wages for reducing labour costs is out of question. On
the other hand, wages might have to be increased to provide
incentives to workers. Yet there is good scope for reduction in the wage
cost per unit. A reduction in labour costs is possible by proper
selection

and

training,

improvement

in

productivity

and

by

automation, where possible. A study by cn (Confederation of Indian

Industry) showed that Hero Cycles improved their productivity per

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employee by 6.4 per cent. 'Purolators' were able to increase their

productivity by 100 per cent. Work study might result in a lot of
savings by reducing overtime and idle time and providing better
workloads. Labour productivity might increase if frequent change of
tools is avoided. Improvement in working conditions may reduce
absenteeism and thus reduce costs per unit. Scrutiny of overtime may
reveal substantial scope for savings.
All efforts must be made to redllce wastage of human effort.
Wastage of human effort may be due to lack of co-ordination among
various departments by having more workers than necessary, underutilisation of existing manpower, shortage of materials, improper
scheduling, absenteeism, poor methods and poor morale. For
example, Metal Box adopted a Voluntary Severance Scheme in 197576
to reduce their work force by 950 workers after they faced a huge
operating loss ofRs. 2.4 crores. General Motors eliminated 14,000
white-collar jobs through attrition to reduce cost. Japan's big 5 steel
producers announced substantial retrenchment programmes and
workers co-operated with the management. Attempts must be made to
secure co-operation of employees in cost reduction by inviting
suggestions from them. These suggestions should be carefully
examined and implemented if found satisfactory. Hindustan Lever has
a suggestion box scheme and employees who come out with good
suggestions receive awards. These suggestions may either lead to
savings or improve safety and work convenJence. The basic idea is to
motivate workers and make them perceive working in the firm as a
participative endeavour.
3. Overheads
Factory overheads may be reduced by proper selection of equipment,

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effective utilisation of space and .equipment, proper maintenance of

equipment and reduction in power cost, lighting cost, etc. For
example, fluorescent lighting can reduce lighting cost. Faulty designs
may lead to excessive use of materials or multiplicity of components,
waste of steam, electricity, gas, lubricants, etc. A British team invited
by the Government of India to report on standards of fuel efficiency in
Indian industry found that fuel wastages might be as high as an
average of 25 per cent. Keeping them in check even in the face of
increasing sales may reduce overhead costs per unit. For example,
Metal Box maintained their fixed costs in 1976-77 even when there
was an increase in sales of over 18 per cent.
Taking

advantage

of

truck

or

wagonloads

may

reduce

transportation cost. Careful planning of movements may also save

transportation cost. Another point to be examined is whether it would
be economical to use one's own transport or hire a transport. For
reasons of economy, many transport companies hire trucks rather
than owning them. This is because purchase and maintemince of
trucks can be more expensive. By chartering vehicles the problems of
maintenance is left to the owner who in turn Cuts cost for the firm.
Thus by keeping a smaller work force on rolls and by introducing a
contract rate linked to a safe delivery schedule it is possible to ensure
speedy point-to-point delivery of goods. Many firms now prefer to use
private taxis rather than have their own staff cars.
Reduction of wastes in general can also reduce manufacturing
costs considerably. Of course, a certain amount of waste and spoilage
is unavoidable because employees do make mistakes, machines do get
out of order and sometimes raw materials are faulty. However,
attempts can be made to reduce these mistakes and faulty handling to
the minimum. The normal figure for the waste and spoilage depends

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upon the complexity of the product, the age of the manufacturing

plant, and the skill and experience of the workers. Once normal
wastage is found out, production reports must be watched carefully to
find out whether the wastages are excessive. Wastes can be reduced
considerably by educating operators in the causes and cures of the
wastes. Bad debt losses can be reduced considerably by selecting
customers

carefully,

and

keeping

an

eye

on

the

receivables.

Concentrating on areas and media can reduce advertising costs,

which give the best results.
Selling costs can be controlled by improving the supervision and
training of salesmen, rearrangement of sales territories, replanting
salesmen's routes and calls and redirecting of the sales efforts, to
achieve a more economic product mix. It may be possible to save
selling costs by the use of warehouses, making bulk shipments to the
warehouses

and

giving

faster

deliveries

to

the

customers.

Centralisation, reduction, clerical and accounting work may also lead

to cost savings. A look at the telephone bills and the communication
cost in general may also reveal areas for substantial savings. For
example a telegram may be sent in place of a trunk call.
(a) Cost Reduction
The Institute of Cost and Works Accounts of London has defined cost
reduction as "the achievement of real and permanent reductions in
the unit costs of goods manufactured or services rendered without
impairing their suitability for the use intended". Thus, cost reduction
is confined to savings in the cost of manufacture, administration,
distribution and selling by eliminating wasteful and unnecessary
elements from the product design and from the techniques and
practices carried out in coilOection with cost reduction?

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(b) Cost Contro/and Cost Reduction

According to the Institute of Cost and Works Accounts, London, "cost
control, as generally practised, lacks the dynamic approach to many
factors affecting costs, which determine the need of cost reduction."
For example, under cost control, the tendency is to accept standards
once they are fixed and leave them unchallenged over a period. In cost
reduction, on the other hand, standards must be constantly
challenged for improvement. And there is no phase of business, which
is exempted from the cost reduction. Products, processes, procedures
and personnel are subjected to continuous scrutiny to see where and
how they can be reduced in cost.
To achieve success in cost reduction, the management must be
convinced of the need for cost reduction. The formulation of a detailed
and co-ordinated plan of cost reduction demands a systematic
approach to the problem. The first step would be the institution of a
Cost Reduction Committee consisting of all the departmental heads to
locate the areas of potential savings and to determine the priorities.
The Committee should review progress and assign responsibilities to
appropriate

personnel.

Every

business

operation

should

be

approached in the belief that it is a potential source of economy and

may benefit from a completely new appraisal. Often, it may be possible
to dispense entirely with routines, which, by tradition, have come to
be regarded as a permanent feature of concern. Cost reduction is just
as much concerned with the stoppage of unnecessary activity as with
the curtailing of expenditure. It is imperative that the cost of
administering any scheme of cost reduction must be kept within
reasonable limits. What is reasonable must be determined in all cases
from the relationship between the expenditure and the savings, which

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result from it.

Essentials for the Success of a Cost Reduction Programme

Following are the some of the points that firms should take care in
order to achieve success in the cost reduction programme:
Every

individual

within

the

firm

should

recognise

his

responsibility. The co-operation of every individual requires a careful

dissemination of the objectives and interest of the employees in the
achievement of the firm's goals.
Employee

resistance

to

change

should

be

minimised

by

disseminating complete information about the proposed changes

and convincing the emplcyees that the changes are concerned
with the problems faced by the firm and that they would
ultimately benefit.
Efforts should be concentrated in the areas where the savings are
likely to be the maximum.
Cost reduction efforts should be continuously maintained.
There should be periodic meetings with the employees to review
the progress made towards cost reduction.

(c) Factors Hampering Cost Control in India

The cost of raw material and other intermediate products is generally
high. In many cases: the cost of raw materials is substantially higher
than their international prices, which makes it difficult for the Indian
firms to compete in foreign markets. The sharp rise in oil prices in
recent years also gave a severe push to the cost of raw materials with
petrochemical

base.

Shortages

of

raw

materials

are

usual

phenomenon. With a view to insuring against these shortages,

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manufacturers keep larger inventories, which result in increase in

their costs. This occurs especially in case of imported raw materials.
Wages are always being linked to cost of living. There are wage boards
for almost every industry and management has little control on wage
rates.
Overheads are also higher in India due to the following reasons:
The size of the plant is very often uneconomic due to the
Government's desire to prevent concentration of economic power.
However, there is now a marked change in the policy. In 1986,
the Government announced that 65 industries would be started
with minimum economic capacity so as to 'make India's
products competitive. This process got a boost after the new
Industrial Policy was announced in July 1991.

There is under-utilisation of capacities due to lack of raw

materials and power shortage. However a manufacturer can
exceed his capacity by improving the techniques of production
process. Even after making improvements, a manufacturer lacks
the way to completely minimise the possibilities of increase in
the overheads.

Machinery and equipment obtained under tied credits usually

cost 30 to 40 per cent more than what it wouid cost if purchased
in the open market.

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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 Finally, there is what lis called by businessmen as 'unseen

overheads' in the nature of demands for illegitl gratification by
various Government officials at different administrative levels.
There are indirect taxes, which also tend to raise the overall
costs of production in India. Excise duties and saies taxes also
heighten the impact of indirect taxes on the cost of production. India
is perhaps the only country where basic raw materials carry heavy
excise duties. According to an estimate by Mr. S. Moolgaokar,
Chairman, TELCO, as much as Rs. 25 crores of working capital is
locked up in inventories and work-in-progress with TELCO and its
suppliers solely due to the present tax structure.
Until recent times the Indian industrialists operated in a
sheltered domestic market. They were protected against foreign
competition by import controls and against domestic competition due
to industrial licensing. So long as this sellers' market prevailed
competition among sellers was absent and there was no compelling
reason for the industrialists to pay any attention to cost reduction.
Cost consciousness was thus by and large absent in India. The price
fixation for products under price control ensured that the rise in costs
was fully reflected in the prices. This made it possible for the
industrialists to pass on any increase in costs to the consumers.
However,

now

with

the

advent

of

recession

tendencies,

and

liberalisation in licensing policies, the Indian industrialist is compelled

to pay greater attention to cost reduction and cost control.

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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,

(AQ x AP) - (SQ x SP)

Material Price Variance

(Actual Price - Standard Price) x Actual Quantity
or, (AP - SP) x AQ
Material Usage or Quantity Variance

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(Actual Quantity - Standard Quantity) x Standard Price

or,

(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,

(AH x AR) - (SH x SR)

Labour Rate (Price) Variance

(Actual Rate - Standard Rate) x Actual Number of Hours
or, (AR- SR) x AH
Overhead Efficiency Variance
The object is to test the efficiency achieved from the actual
production. The variance is thus, analogous in nature to the labour
efficiency variance. The formula for calculation of the variance is:
(Actual Hours - Standard Hours for Actual Production)
x Standard Overhead Rate
or,

(AH - SH) x SOlt

Cost control ultimately depends on action, which is based on

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variances. However, these actions can be taken only by people who

have the appropriate authority. It is, therefore, futile to present
variances to a person if those variances are related to matters, which
fall outside his guthority. Such variances are called uncontrollable
whereas those relating to matters within his authority ilre termed as
controllable variance.

APPENDIX II

Cost Control Drive in Coal India Limited (Cll)

CIL closed in 1984-85 with a provisionally estimated profit of Rs. 20
pro res after fully discharging its depreciation and loan repayment
obligations. The company had to initiate a series of stringent
measures to achieve the profit figure, the thrust being on controlling
costs. Four specific areas chosen include: salary and wages,
administration expenditure, stores and realisation of dues. In 198384, the incidence of salary and wages being what it was, the cost of
manpower, per tonne of coal worked out to Rs. 97.04. In 1984-85, the
rise was contained at 88 paisa and the cost of manpower per tonne
came to Rs. 97.92.This was despite the fact that there was a rise of 51
points in the consumer price index. And then factors would have
justifledan increase of Rs. 6.44 in the cost of manpower per tonne of
coal but it was contained at 88 paisa.
The CIL Chairman pointed out that a major effort was made to
ensure gainful redeployment of manpower through persuasion and

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motivation and at times even by force:' Empowered teams of senior

executives were sent to interview people and persuade them to accept
jobs that would suit them. Local redeployment was insisted upon
although in some places non-availability of residential accommodation
caused a problem. Secondly, increase of manpower was controlled very
strictly. Instructions were issued to subsidiary companies that no new
appointment was to be made without Director of Finance and the
Chairman approving it. Thirdly, a drastic reduction was made in
overtime allowance and for achieving this objective even threat of
sacking had to be administered.
In the sphere of administration expenditure, the thrust was on
cutting down the expenses on account of travelling allowance.
However, cost control measures were most effective in the sphere of
stores management. The system of 'fortress checks', introduced in
1984-85 resulted in straight saving of Rs. 30 crores. CIL's profit in
1984-85 would have been about Rs. 80 crores, ,if only there was an
appropriate system of pricing.

PRICE DISCOUNTS AND DIFFERENTIALS

Distributors' Discounts
Distributors' discounts are the price reductions that systematically
make the net price vary according to buyers' position in the chain of
distribution. They are called so because these discounts are given to
various distributors in the trade channel, for example, wholesale
factors, dealers and retailers. For the same reason, they are also called
as trade channel discounts. As these discoUnts create differential
prices for different customers on the basis of marketing functions
performed by them for example, whether they are wholesalers or

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retailers, they are also called as functional discounts. However, it must

be pointed out that the special discounts may also be given to persons
other than distributors and not, associated with distribution function.
For example, special discounts may be given to manufacturers who
incorporate the product in their own product. Tyres and tubes sold; to
cycle manufactUrers for use in their bicycles, is a typical example.
Special prices may be charged to members of the same industry; for
example, one company may exchange petroleum with another
company at a special price. Again, special prices may be quoted to
Central and State Governments and to the Universities; for example,
Remington typewriters, Godrej safes, etc., are sold at low prices to
these places.
Forms of Distributors Discounts
Distributors' discounts take different forms determined mainly by the
consent of all the business firms in an industry. Nevertheless, at
times firms may have to decide about the form in which discount is to
be offered. There are mainly three forms:

Different net prices for different distributor levels. Net prices

are rarely used for quoting differential prices to distributors.
Manufacturers give them to certaii1iliithorised dealers. The
simplicity of this method enables some savings in invoicing and
accounting.

A uniform list price modified by a structure of discounts, each

rate applicable to a different level of distributor, List prices with
discounts are more common. This method makes it easy to deal
with diverse trade channels. It also facilitates cyclical 'and
seasonal

adjustments

in

prices

by

merely

varying

the

discounts. This may also help in keeping actual prices a secret,

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not only among distributors but also from competitors and

customers secret, not only among distributors but also from
competitors and customers.

A single discount combined with different supplementary

discounts to different levels of distributors. For example, 5 per
cent to regional distributors.
Thus, the chief advantage of the prices with discounts is greater

flexibility. Further, this method helps the manufacturers to exercise

greater control over the realised' margin of different categories of
distributors. But real control is achieved only when such discounts
are coupled with resale price maintenance. A supplementary discount
gives the manufacturers, a picture of the entire trade channel
structure. These discounts may be intended to reflect distributors cost
at' different stages and competition between different kinds of
distributors. The supplementary discounts are very descriptive in
nature while their accounting is expensive. Distributors' discounts
differ widely in industries. They also differ among the various
business firms within industry.
How to Determine Distributors' Discounts
The economic function of distributors' discounts is to induce different
categories of distributors to perform their respective marketing
functions. As such, to build up a discount structure on sound
economic lines, it is essential to know the services to be performed by
the distributors, distributors' operating costs, discount structure of
competitors, effects of discounts on distributor population, cost of
selling

to

different

channels

and

opportunities

for

market

segmentation.
Services to be performed by the distributors at different

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levels: The main objective of the manufacturer is to get the

distributor function performed most econoiIlically and effectively.
For this purpose, he may decide upon the various types of
services to be performed by the various types of distributors. The
larger is the number of services' to be performed by the
distributor concerned, the larger is the discount allowed to him,
and. vice versa. For example, a sewing machine manufacturer
might deidethat the dealer will only display the various models
of the machine manufactured by the firm and settle the terms of
sale. The delivery and servicing of the machines may be given to
one distributor in the city. Naturally, in such a cast the discount
given to the dealer will be lower than in the case where he has to
stock the commodity and provide after-sales services as well.
Distributors operating costs: Trade discounts should naturally
cover the operllting costs and the normal profits of the
distributors. In case of high margins, distributers would be
induced to make extra selling efforts. If margins do not cover
costs, the distributors concerned would not be interested in
pushing up the sale of the product. Sometimes distributors
belonging to the same category by name may be performing
widely diflcl'ing functions, Their operating cost is, therefore,
determined by the funel ions they perform, For example, if a
distributor is required to warehouse and ship the goods as and
when required by the actual users, he would require greater
discounts than a distributor who receives the consignments in
truckloads and merely reships them to the different actual users
without having to warehouse' them. Even when distributors are
pcrforming identical services, operating costs'may differ among
individual distrihutors depending upon variations in their

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operating efficiency. In such cases, the manufacturer has to

determine as to whose costs will he try to cover through trade
discounts. There are two possible alternatives: (I) the costs or the
most efficient two-thirds of the dealers plus normal profits, or (2)
an estimate of his own cost of performing the distribution
function. This is very oncn used when the manufacturer is
already engaged in some sort or distribution runction.
Competitors discount structure: The discounts granted by
competitors arc usel'lII guides in framing the structure of
discounts. Their relevance becomes still greater when it is
realised that distributors' discounts are given in order to scek the
dealers' sales assist~nce in a, competitive market. In quite a good
number of trades, discount rates are fixed by custom and
manufacturers have no option but to fall in line. In many
industries, the actual discounts' granted by rival sellers vary. In
such a case, the manufacturer has to decide whether he should
be guided by the higher or the lower discounts. In case the
product of the manufacturer is' at some disadvantage in
consumer acceptance, he may decide to allow 'larger margins
than those of his competitors. The success of the policy, however,
would depend upon the following conditions: (a) whether this
high margin of discount merely, compensates for the low turnover
and whether the distributor gets any real economic in~entive? (b)
Whether the discount margin will be adequate to induce the
distributor to push the product? (c) How much influence does the
distributor have in pushing a particular brand over that of the
competitor? (d) Whether the dealer has scope for profitable
market segmentation and personal price discrimination? And (e)
Whether competitor are likely to meet the wider discount margi

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varying their own? Thus, in general, the success of a particular

dis scheme requires that the consumers are considerably
indifferent to bl have great confidence in the distributor and the
manufacturers' IT share is so small that large competitors will not
feel compelled to cI their own wider margins. A related question
is: should a lower p~i, offered to dealers who handle a certain
brand exclusively? Naturall exclusive dealer in general will get a
higher discount in addition to price advantage arising from
quantity discounts.
Effect of discounts on distributors' population: Very often, I
discounts may be allowed to encourage the entry of new
distribute push up the sales of a new product line. Similarly,
smaller discounts In allowed when the number of distributors
has to be restricted.
Costs of selling to different channels: There is asaving in
overheat selling to retailers as compared to consumers and to
wholesalel compared to retailers and the regular system of
discounts has somethil do with this saving in overheads.
Opportunities

for

market

segmentation:

Trade

channel

discounts C2 used to achieve profitable market segmentation. In

some industries market is divided into several fairly distinct submarkets, each havin own peculiar competitive and demand
characteristics. For example, il tyre market, the following submarkets may be distinguished:
o Original equipment market characterised by skill and
bargai

strength

ofthe

buyers

and

by

big

cyclicaJ

fluctuations in demand.
o Individual consumer replacement. Market characterise by

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unskilled buying, brand preferences, and cyclical stability.

o Commercial operators' replacement market characterised
by I buyers who are price-wise and quality-wise, for
example, munic transport undertakings.
o Government sale in market characterised by large orders,
foil bids and publication of successful bidders' price.
o Export market characterised by international competition.
Each one of these sub-markets .has different elasticity of,
demand. There! The need to charge different prices in each market
segment arises from difference in the elasticities of demand in these
submarkets. The disc (structure can be so devised as to produce the
relevant differential prices suitable for each market segment. For
example, in the case of original equipment market, price has little
influence on the total number of tyres purchased because the price of
the tyrespaid by automobile manufacturers would form very small
percentage of the wholesale price of the car, say, less than 5 per cent.
As such, no feasible reduction in tyre prices would affect cat prices
enough to increase perceptibly the demand for cars and hence of
tyres. Very often, while pricing a product which is to be used as a
component of the finished product of another manufacturer, e.g.,
pricing of spark plugs or tyres, their manufacturers may be influenced
by such considerations as earning prestige through associating the
component with the finished product, getting replacement business if
the product is used as a component with some well-known product,
etc. Hence, while selling the component product to the manufacturer
of finished product; lower prices and for that purpose higher
discounts may be allowed. In case of individual consumer replacement
market, i.e., where buyers are consumers demanding the product for
replacement. The level of price affects the timing of the demand

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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

replacement market arises because the manufacturer has to decide

whether to allow high discounts as to permit dealers to makeindividual concessions to customers. Here, a dealer can charge full
price from some customers who are averse to shopping and bargaining
but quite substantially lower prices to more careful and bargaining
type of customers. Thus, allowing high discounts to dealers provides
them sufficient leeway to charge higher or lower prices from their own
customers according to their demand elasticity. It is normally
appropriate

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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becomes sufficiently popular and its demand increases sufficiently to

work the big plant fully. If so, they can discontinue the private label
business.
Distributors' demand elasticity higher than that of consumers:
Distributors'

demand

for

the

competing

brand

of

different

manufacturers is more elastic than the corresponding demand of

final consumers. The distributor is generally more capable of judging
price and quality than ultimate consumers who have insufficient
knowledge of the competing brands, and apprehend that a low price
may be synonymous with inferior quality. The consumer finds it
difficult to choose between different competing brands, and he often
allows himself to be guided by the retailers. It may be safely asserted
that even the smallest difference in price may cause a dealer to
switch over from one brand to another whereas an even greater price
change might not cause any reaction on the ultimate consumers. It
is, therefore, of decisive importance to the manufacturers that they
secure the goodwill of the distributors. In. fact, the distributors'
potential selling power is great and the manufacturers should try to
gain their promotional support.
However, in the case of a few highly advertised branded products,
which occupy a firm's position in the minds of the consumers,
distributors have to be content with very small margins. For example,
the retailer's margin in a 5-kilo Dalda tin comes to 1.5 per cent only.
It would be better for a manufacturer to adopt a standard discount
policy. With latitude in discount policy, there is much danger of
confusion, inequity, loss of goodwill and loss of sales. It may also be
noted that distributor discounts do not matter much in industrial
goods.

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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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discount may be allowed on the entire purchases provided they exceed

a certain minimum. In some cases, quantity discounts mflY be based
on the cumulative purchases made during the particular period,
usually at year or a. season, e.g., Diwali discounts may be given on
the basis of cumulative purchases made during the Diwali season
spread over September to Novembe'r. This is different from quantity
discounts based upon individual lots ordered at a time. These
discountS ensure customer loyalty and discourage purchasing from
several competitors simultaneously, but the limitation of cumulative
discounts is that, they do not tackle the problem of high cost of
servicing small orders, because, buyers get no incentive to order for
bigger lots and to avoid hand-to-mouth purchasing. Buyers may be
inclined to place larger orders towards the end of the discount period
to qualify for higher discounts. This may disrupt the production
schedule of the manufacture .
The following genital conclusions can be reached:
Individual order size is a' better basis than cumulative
purchases made during a particular period.
Discounts based on the quantity of individual commodities
ordered have advantages over those based on the total size of
mixed commodities ordered.
Physical units are preferable to rupee value as a measure of
order size on which to base quantity discounts.
Objectives of Quantity Discounts
One important objective of quuntity discountS' is to reduce the
number of small orders and thereby avoid the high cost of servicing
them. Quantity discounts can facilitate economic size orders in three

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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

themselves of these quantity , discounts than from the manufacturer

directly. This is because the wholesalers may pass on some of their
discounts to the dealers. This may ultimately affect the image of the
manufacturer in the minds of the dealers. Again, if the seller
becomes dependent upon a few buyers, they may be able to dictate,
his policies ap.d practices. But if his product is sufficiently
differentiated or his service' is unique, he may find it possible and
worthwhile to pursue an independent discount policy. Quantity
discounts are most useful in the marketing of materials and Applies

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but are rarely used for marketing equipment and components.

Quantity discounts have attracted the attention of the Monopolies
and Restrictive Trade Practices Commission. The Commission
conceded the claim of Reckitt and Coleman of India Ltd., that it was
entitled to gateway under Section, 38(1) (h) of tlie Act in respect of
discounts given on larger orders. It was held that the Companys
price structure did not directly or indirectly restricts competition to
any material degree. However, some time later, the Commission
extnicted an assutance from the five manufacturers of grinding
wheels that they would give up the practice of discounts based on the
quantity. Their practice of pricing on slab Basis' was alleged to give
advantage to buyers of larger quantities compared to Players of
smaller quantities.

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

collections, manufacturers reduce their working capital requirements

and thus save their interest costs. However, allowing discounts may
involve paying 36.5 per cent in order to save 15 per cent. Thus it is
the reduction in collection expenses and in risks rather than savings
on interest, which should be the guiding consideration for cash
discounts. The main point of distinction between cash discounts and
quantity discounts is that the former are price reductions based on
promptness of payment whereas the latter are price reductions
depending on the quantities purchased (physical units or rupee value
of the quantity purchased). As such, cash discounts induce prompt
payments or collections whereas quantity discounts induce buying in
large quantities.

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:

It assures u uniform net price on nIl shipments regardless of

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where they go.

No risk is assumed by the seller.

The seller is not responsible for delay in carriage.

Postage stamp pricing: Postage stamp pric1rg means charging

the same delivered price for all destinations irrespective of buyers'
location. The quoted price naturally includes the estimated average
transportation costs. In effect, these prices become discriminatory,
that the short distance buyers have to pay more for transportation
than the actual costs involved while long distance buyers have to pay
less than the actual costs of transporting goods. Postage stamp
pricing is most Hnmonly employed for goods of popular brands and
having nation wide distribution. The basic idea is to maintain a
uniform retail price at all places. This common retail price can also be
advertised throughout the country. Bata footwears provide the best
example of postage stamp pricing other examples are Usha sewing
machines and fans, radios, pressure cookers, typewriters, drugs and
medicines, newspapers and magazines, etc.,
Postage stamp pricing is most suitable in case of products
where transportation costs are significant. It can also be used with
advantage by manufacturers to avoid the disadvantage of location
being far away from the main customers who if charged on the basis of
actual costs might have to pay much more and hence refrain from
purchasing. This advantage is particularly striking in the case of
products involving high transportation costs. This pricing gives a
manufacturer access to all markets regardless of his location. Market
access is particularly important when products of the rivals are
substantially the same.
Zone pricing: Under zone pricing, the seller divides the country

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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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Consumer Category Price Differentials

Price discrimination is frequently practised according to consumer
categories in the case of public utilities, for examples, electricity,
transportation,

etc.

Electricity

firms

quote

different

rates

for

residential consumers and industrial consumers. The rates may also

differ for domestic power, light and fan. Railways also charge
differently from children to adults. They also charge differently -on
different classes of goods and different classes of passengers.
Personal Price Discrimination
Price concessions are commonly made to individuals at times for
personal considerations. For instance, special prices may be given to
companies own employees, shareholders or personal acquaintances.
These special prices may take several forms such as additional
services free of cost, leniency in fixation of prices for used goods in
exchange of new ones and extending credit, interest-free credit.
REVIEW QUESTIONS
1.

Explain with illustration the distinction between the following:

A. Fixed cost and variable costs
B. Acquisition cost and opportunity cost.

2.

What is opportunity cost? Give some examples. How are these

costs relevant for managerial decisions?

3.

When MC changes, AC changes (a) at the sane rate, (b) as a

higher rate, or (c) at a lower rate? Illustrate your answer with
the help of diagrams.

4.

Explain the relationship between marginal cost, average cost,

and total cost.

5. Distinguish between the following:

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A. Marginal cost rind incremental cost;

B. Business cost and full cost;
C. Actual cost and imputed cost;
D. Private cost and social cost of private business.
6. Discuss the various economies or scale. Also discuss Sargent
Florence's principles in this regard.
7.

"Economics of scale may be either external or internal; they

may
be technical, managerial, financial or risk-bearing." Elucidate.
8.

Discuss the various economies of scale. Do they result in

monopolies?

9.

What are the advantages and limitations of large-scale

production?

10.

State the importance of cost control in profit planning and

discuss the various areas of cost control.

11.

Distinguish between cost control and cost reduction.

What are
the essentials for the succcss of a cost reduction programmc?

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LESSON 4

PRODUCTION FUNCTION

The term "production function" refers to the relationship between

inputs used and outputs produced by a firm. The terms "factors of
production" and "resources" are used interchangeably with the term
"inputs". The relationship is purely physical or technological in
character and therefore it ignores the prices of inputs and outputs.
The study of the production function is aimed at achieving the
maximum output. This can be done with a given set of resources or
inputs, and with a given state of technology. The production function
can be expressed in the form of a schedule. Table 4.1 shows two
inputs viz; labour [X], i.e., number of workers, and capital [Y], i;e., size
of machine in terms of horsepower, and one output (Q), i.e., the
number of tonnes of iron produced with the various combinations of
inputs.
Table 4.1: Production Function

Labour (X)
(Number of
workers)

Capital (Y) - Size of machines (in horse power)

250
1,000
1,500
2,000
1
2
20
32
26
2
4
48
58
88
3
8
88
110
100
4
12
110
120
110
5
32
120
124
120
6
58
124
126
124
7
88
126
128
128
8
100
126
130
130
9
110
126
130
132
10
104
124
130
134

The production function can also be stated in a form of an eqation:

Q = f (X1, X2, etc.),

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Where Q = A function ofthedesired output as a result of utili sing

the quantity of two or more inputs
Xl = units of labour,
X2 = units of machinery.
Some factors of production are assumed to be fixed (i.e., not
varying with changes in output); and hence are not included in the
equation. The production function is estimated by the method of least
squares.
In economic theory, we are concerned with three types of
production functions, viz.,
Production function with one variable input.
Production function with two variable inputs.
Production function with all variable inputs.

PROPUCTION FUNCTION WITH ONE VARIABLE INPUT

In economics, the production function with one variable input is
explained with the help of'Law of Variable Proportions', which is as
follows:
Law of Variable Proportions
The law of variable proportion is one of the fundamental laws of
economics. It is also known as the 'Law of Diminishing Marginal
Returns' or the 'Law of Diminishing Marginal Productivity.' This Law of
variable proportion shows the input-outPut relationship or production
function with one variable factor, i.e., a factor, which can be changed,
while other factors of production are kept constant. This is explained
with the help of the following example:
Suppose a farmer has 20 acres of land to cultivate. The land
has some fixed investment, Le., capital in the form of a tube well,

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farmhouse and farm maehinery. The amount of land and capital is

supposed to be fixed factors of production. However, the farmer can
vary the number of workers employed on its land. Labour is thus the
variable factor of production. The change in the number of workers
will change the output.
The point worth noting here is that the law does not state that
each and every increase in the amount of the variable factor that is
employed in the production process will yield diminishing marginal
returns. It is, however, possible that preliminary increases in the
amount of a variable factor may yield increasing marginal returns.
While increasing the amount of the variable factor, a point will " be
reached though, where the; marginal increases in total output or the
marginal retums will begin declining.
Assumptions for Law of Variable Proportions
The law of variable proportions functions is based on following
assumptions:
Constant technology: The technology is assumed to be
constant because technological changes will result into rise of
marginal and average product.
Snort-run: The law operates in the short-run because it is here
that some factors are fixed and others are variable. In the longrun, all factors are variable.
Homogeneous

input:

The

variable

input

employed

is

homogeneous or identical in amount and quality.

Use of varying amount of variable factor: It is possible to use
various amounts of a variable factor on the fixed factors of
production.

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Three Stages of Production

A graphic description of the production function is shown in following
figure 4.1. The total, marginal and average product curves in Figure
4.1, demonstrates the law of variable proportions. The figure also
shows three stages of production associated with law of variable
proportions. The total product curve is divided info three segments
popularly known as three stages of production, which are as follows:

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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increasing marginal returns only. Here, both AP and MP increase. In

this stage, a firm can move towards optimum combination of factors of
production and increasing returns, by adding more and more variable
units to fixed factors.
Stage II
The stage II is depicted by the figure in the range from X 2 to X3. In
othcr words, stage II begins where the average product of the variable
factor is maximised. It continues till the point at which total product
is maximised and marginal product is zero. Here, TP rises at
diminishing rate. This stage is thus, called the stage of diminishing
returns, where a firm decides its level of production.
Stage III
Finally, we have stage III, which is depicted by the area beyond X 3
where the total product curve starts decreasing. Here, too much
variable input is being used as related to the available fixed inputs
and thus variable inputs' are overutilized. The efficiency of both
variable inputs and fixed inputs decline through out this stage. In this
range, the marginal product of the variable factor is negative. It starts
from the point where MP is nil and TP is maximum and covers the
whole range of negative marginal productivity. The following Table 4.2
shows the various stages.

Table 4.2: Stages of Production

Total Physical Product
Stage I
Increasing at an

Marginal Physical
Product

Average Physical
Product

Increases, reaches its Increases and reaches

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increasing rate

maxiIhum and then its maximum

declines till MR = AP

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

combination, which will yield a total product falling in either of these

two stages.

PRODUCTION FUNCTION WITH TWO VARIABLE INPUTS

To understand a production function with two variable inputs, it is
necessary to explain what is an ' Isoquant'.

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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.

Table 4.3: Different Pairs of Labour and Capital

Labour
(Units)
I

Capital
(Units)
5

Output
(Units)
10

10

10

10

10

It is evident that output is the same either when 4 units of

labour with 1 unit of capital or 5 units of labour with 0 units of
capital are employed. This relationship, when shown graphically
results in an isoquant. Thus, by graphing a production function with
two variable inputs, one can derive the isoquant that helps in tracing
all the combinations of the two factors of production that yield the
same output. Thus, an isoquant can be defined as "the curve passing
through the plotted points representing all the combinations of the
two factors of production, which will produce the given output." Figure
4.2 depicts a typical isoquant digram in which by an upward
movement to the right, one can obtain higher levels of outputs, using
larger quantities of output. For each level of output, there will be
different isoquant. When the whole array of isoquants is represented
on a graph, it is called 'isoquant map'.

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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.

Marginal Rate of Technical Substitution (MRTS)

The slope of the isoquant has a technical name; Marginal Rate of
Technical Substitution (MRTS) or sometimes, the marginal rate of
substitution in prodtltioti.) Thus, in terms of inputs of capital
services K and Labour L.
MRTS = aK/dL

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MRTS is similar to MRS, I.e., Marginal Rate of Substitution,

(which is slope, of an indifference curve).
Types of Isoquants
Isoquants assume different shapes depending upon the degree of
substitutability of inputs under consideration. Based on this the
types of isoquants can be enlisted as follows:

Linear Isoquants: In the case of linearisoquants, there is

perfect substitutability of inputs. For example, a given output
say 100 units can be produced by using only capital or only
labour or by a number of combinations of labour and capital,
say 1 unit of labour and 5 units of capital, or 2 units of labour
and 3 units of capital, and so on. Likewise, a giyen power plant
that is equipped to burn either oil or gas, for producing various
amounts of electric power can do so by burning either gas or oil,
or varying amounts of each. Gas and oil are perfect substitutes
here. Hence, the isoquants are straight lines. The following
Figure 4.3 shows the isoquant for oil and gas.

Right

Angle

Isoquant:

When

there

is

complete

non-

substitutability between the inputs (or strict complimentarily)

then the isoquant curves take the form of right angle isoquants.

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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

substitutability of inputs but the substitutability is not perfect.

For example, in Figure. 4.5 a shirt can be made with relatively
small amount of labour (L1) and a large amount of cloth (C 1).
The same shirt can be as well made with less cloth (C 2), if more,
labour (L2) is used because the tailor will have to cut the cloth
more carefully and reduce wastage. Finally, the shirt can be
made with still less cloth (C3) but the tailor must take extreme
pains" so that JabourinpiJt requirement increases to C3. So,
while a relatively small addition of labour from L 1 to L2 allows
the input of cloth to be reduced from C 1 to C2, a very large
increase in labour from L2 to L3 is needed to obtain a small

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reduction in cloth from C2 to C3. Thus the substitutability of

labour for cloth diminishes from L1 to L2 to L3. The following
Figure 4.5 shows isoquant for cloth and labour.

Main Properties of Isoquants

All the above-mentioned isoquants are featured with some common
properties, which are as follows:

An isoquant is downward sloping to the right, i.e., negatively

inclined. This implies that for the same level of output, the
quantity of one variable will have to be reduced in order to
increase the quantity of other variable.

A higher isoquant represents larger output. Jhat is, with the

same quantity, of one input and larger quantity of the other
input, larger output will be produced.

No two isoquants intersect or touch each other. If two

isoqua~tsinter.seCt or touch each other, this would mean that
there will be a common point the Two curves; and this would
imply that the 'same amount of two inputs could produce two
different levels of output (i.e., 400 and 500 units), which is
absurd.

Isoquant is convex to the origin. This means that its slope

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declines from left to right along the curve. In other words,

when we go on increasing the quantity of one input say labour
by reducing that quantity of other input say capital, we see
that less units of capital are sacrificed for the additional units
of labour.
PRODUCTION FUNCTIONS WITH ALL VARIABLE INPUTS
A closely related question in production .economics is how a
proportionate increase in all the input factors will affect total
production. This is the question of returns to scale, which brings to
mind three possible situations:

If the proportional increase in all inputs is equal to the

proportional increase in output, returns to scale are constant.
For instance, if a simultaneous doubling of all inputs results in
a doubling of production then returns to scale are constant. The
following figure 4.6 shows a constant rate to scale.

If the proportional increase in output is larger than that of the

inputs, then we have increasing returns to scale. The following
Figure 4.7 shows increasing returns to scale.

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If output increases less than proprotionally with input increase,

we have decreasing returns to scale. The following Figure 4.8
shows decreasing returns to scale.

The most typical situation is for a productin function to have

first increasing then decreasing returns to scale is shown in Figure
4.9.

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The increasing returns to scale attribute to specialisation. As

output increases, specialised labour can be used and efficient, largescale machinery can be employed in the production process. However
beyond some scale of operations further gains from specialisation are
limited, and co-ordination problems may begin to increase costs
substantially. When co-ordination price is more than offset additional
benefits of specialisation, decreasing returns to scale begin.

Returns to Scale and Returns to an Input

Two important features of production functions are returns to scale
and returns to input, which are explained as follows:
Returns to scale: These describe the impact on the output
when the same proportion increases each input rate. If output
increases by a larger percentage than the increase in each input then
there are increasing returns to scale. Conversely, if output increases
by a smaller percentage, there are diminishing returns to scale and if
it increases by the same proportions there are constant returns to
scale.
Returns to input: These describe the impact on the output

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when only one input is varied, holding all others constant. These
returns may be increasing,' diminishing, or constant.

Optimal Input Combinations

From the overall discussion so far itisobvious that production
function, has a pure 'physical or technological' character. However, it
does not tell which input combinations are optimal. For that purpose,
one has to take into account the input prices. The following Figure
4.10 shows the iscost curves.

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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Firm's Expansion Path

A firm's expansion path is defined by the cost-minimising combination
of several inputs for each output level. Thus the line representing least
cost combination for different levels of output is called firm's
expansion path or the scale line shown by line ABC in Figure 4.12.

MEASUREMENT OF PRODUCTION FUNCTION

Several types of mathematical functions are commonly used for

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measuring production function but in applied research, four types are

used extensively. These are linear functions, power functions,
quadratic functions and cubic functions.
(1) Linear Function
A linear production function is expressed as follows:
Total product: Y = a + bX, where Y = output and X = input. From
this function, equation for average product will be
Y/X=a/X+b
The equation for the marginal product will
be Y/X = b
(2) Power Function
A power function expresses output, Y, as a function of input X in the
form:
Y = aXb
Some important distinctive properties of such power functions are:
The exponents are the elasticities of production. Thus, in the
above function, the exponent 'b' represents the elasticity of
production.
The equation is linear in the logarithms, that is, it can be written
as: log Y = log a + b log X
When the power function is expressed in logarithmic form as
above, the coefficient represents the elasticity of production.
If one input is increased while all others are held constant,
marginal product will decline.
(3) Quadratic ProductionFunction
The production function may be quadratic and is expressed as follows:
Y = a + bX = cX2

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Where the dependent variable, Y, represents total output and the

independent variable, X, denotes input. The small letters are
parameters and their probable values are determined by a statistical
analysis ofthe data.
The distinctive properties of the quadratic production function are
as follows:

The minus sign in the last term denotes diminishing marginal

returns.

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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PRODUCTION FUNCTION AND EMPIRICAL STUDIES

The measurement of production function dates back to a century
when certain r pioneer studies were made in the field of agriculture.
And though economic concepts and statistical techniques have now
advanced a lot, its major work is still in agriculture.
Cobb-Douglas Function
A very popular production function, which deserves special mention,
is the CobbI Douglas function. It relates output in American
manufacturing industries from 1899 to 1922 to labour and capital
inputs, taking the form.
P = bLaC1 - a
Where,
P = Total output
L=Index of employment of labour in manufacturing
C = Index of fixed capital in manufacturing.
The exponents a and 1 a are the elasticity of production that
is, a and 1- a measure the percentage rexsponse of output to
percentage changes in labour and capital respectively. The function
estimated for the USA by Cobb and Douglas is:
P = 1.01L.75C25
R2 = .94.09
This production function shows that a 1 per cent change in
labour input, with the capital remaining constant, is associated with a
0.75 per cent change in output. Similarly, a 1 per cent change in
capital, with the labour remaining constant, is associated with a 0.25
per cent change in output. The coefficient of determination (R 2) means
that 94 per cent of the variations on the dependent variable (P) were

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accounted for, by the variations in the independent variables (L and

C).
An inportant point to note is that the Cobb-Douglas function
indicates constant returns to scale. That is, if factors of production
are each increased by 1 per cent, the output will increase by 1 per
cent. In other words, one can assume constant avberage and marginal
production costs for the US industries during the period. The
following Figure 4.13 shows the graph of Cobb-Douglas production.

Criticism

The production function ordianrily discussed in economics is a

rigorously developed micro-economic concept. However, Douglas
and his colleagues, estimated production function for nations
economies for manufacturing sectors and even for industries.
Thus they transferred strictly micro- economic concept to a
macro-econornic setting, without sufficiently justifying their act
on logical economic grounds. Therefore, the result of their
studies, in the form of equations which they derived, may be
incorrect, and hence the interpretations based on their
equations are uncertain.

The production function of economic theory assumes that the

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quantities of inputs used are those that are actually used in

production. Therefore no variable input is ever redundant. In the
Douglas studies however, only labour was measured by the
quantity

actually

used

in

production,

while

capital

was

measured by the capital investment, i.e., the quantity available

for production. Therefore, with the possible' exception of the
years in which full employment and prosperity prevailed and
industry made reasonably fuil use of the available inputs, the
measure of capital employed was not theoretically correct one. If
annual capital input always remained as a constant proportion
of total capital investment, then only the elasticity would be the
same. In spite of this criticism, the Cobb-Douglas type of
production function has been found useful for interpreting
economic results, since the elasticity of production; is given
directly by the exponents when the data are in original form, or
by the regression coefficients when the data are in logarithmic
form.
MANAGERIAL USE OF PRODUCTION FUNCTIONS
Though production functions may seem to be highly abstract and
unrealistic, in fact, they are both logical and useful. If the price of a
factor of production declines whereas that of another goes up, the
former is likely to substitute the latter. The usefulness of the
production function can be explained with the help of an example,
dairy economists are interested in minimising the cost of feeding cows
in milk production. Taking a cow as a single firm, and grain and
roughage as inputs, the question arises: What proportion of grain and
roughage would be economical in feeding the cow? In the past, there
has been some tendency to prescribe a fixed ratio, but economic

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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.

DERIVING INPUT COMBINATIONS FROM

PRODUCTION FUNCTION

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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.

PRICE AND OUTPUT DECISION UNDER

VARIOUS MARKET SITUATIONS

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To understand the concept of market and its various conditions, it is

necessary to study the thcory orthe firm. This is discussed as follows:
The Theory of the Firm
The basic, assumptions of the theory of the linn are as follows:

The objective of a firm is to maximise net revenue in the face of

given

prices

and

technologically

determined

production

function.

A price incrcase far a product raises its supply, whereas prices

increase for a factor reduccs its demand.

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.

The firm operates with perfect knowledge of all relevant variable

involved in making a decision and it acts rationally while doing
so.

Originally the theory assumed that the firm is operating within

a perfectly competitive market. But it has now been extended to
cover other market situutions.
The theory has been criticised in the context that profit

maximisation is not the only objective of a firm. It has been suggested

that long-run survival is the primary motive of an entrepreneur.
Though the importance of profit has not been denied, many
economists have argued that profit maximisation should be replaced
with a gonl of makll1g satisfactory profits. However, there is a general
agreement that the theory or the firm explains at a general level, the
way in which resources are alloclIted by the price system, when profit
is the main criterion used by the firms.
From the viewpoint of price analysis, it is very important for

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business management to gain a proper understanding of the nature

and process of competition in the modem industrial society. The
management should undcrstllnd the rationale of the free enterprise
system within which its own business decisions have to be made and
the purpose and limitations of that system. Next it musl hnve full
knowledge of the markets and market situations in which its own
business operates. It should be aware of the policies appropriate to
those market situations. The management should also have an
understanding of the competitive process and the way variables
involved in the process such as price; product innovnt ion and
promotional activity may be manipulated in enlarging the firm's
market share. The firms having monopoly power should be familiar
with the nature and llie purpose of the law relating to monopoly and
restrictive practices. The management must also be alert and should
be able to recognise when market conditions change. Experienced
executiv.es cannot gain the intimate knowledge of the ways or llicir
competitors. Consequently it is necessary to obtain, an understanding
of the nature of competition, which can provide an insight into the
probable behaviour pnlll'llls of the competitors. To study how prices
are determined the types of market situations need to be studied are
as follows:

Perfect competition.

Imperfect competition
o Monopoly and monopsony
o Monopolistic competition
o Oligopoly and oligopsony.

PURE AND PERFECT COMPETITION

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Perfect competition is a market situation where large number of

buyers and scllns operate freely and commodity sells at a uniform
price. In such a situation no seller or buyer has any influence on the
market price. In this market, a firm is the price taker and industry is
the price maker.
Main Features
The main features of perfect competition are as follows:

There are a large number of buyers and sellers. Each seller

must be small and the quantity supplied by any ne seller must
be so insignificant that no increase or decrease in his output
can appreciably affect the total supply and the market price.
So also, each buyer must be small and the quantity bought by
any of the buyers should be so insignificant that no increase
or decrease in his purchases can appreciably affect the total
demand and the price. As a result, each seller will accept the
market price as it is. So also each buyer will regard the price
as determined by forces beyond his control.

Each competitor offers a homogenous product, i.e. the

products are similar to ach other in terms of quality, size,
design and colour. Thus one product could be substituted for
the other if the price is lower. Again, the commodity dealt in
must be supplied in quantity.

There is no obstacle with regard to entry or exit of the firms.

When these aforesaid three conditions arc fulfilled there is a
market condition that can be defined as a pure competitive
market.

The market iil which the commodity is bought and sold is well
organised and trading is continuous. Therefore, buyers and

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sellers are well informed about the price of the commodities.

There are many competitors (whether buyers or sellers), each

acting independently. There must be no restraint upon the
independence of any seller or buyer, either by custom,
contract, collusion, and fear of reprisals by the competitors, or
by the imposition of government control.

The market price is flexible over a period of time. In other

words, it rises or falls constantly in response to the changing
conditions of supply and demand.

All the firms have equal access to production technologies and

techniques.

There are no patents, proprietary designs or special skills that

allow an individual firm to do the job better than its
competitors.

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

found. Actual competition always departs from the ideal of perfection

Perfect competition is a mere concept, a standard by which to measure
the varying degrees of imperfect competition.
Sometimes, a distinction is made between perfect competition
and pure I competition. But the line of distinction drawn between the
two is very fine. That is why many economists have preferred to use
the two terms synonymously. Hence, from managerial viewpoint, there
does not seem to be any difference between the two. The underlying
presumption in a free competition (close to perfect cmpetition) is that
it social interest interest unless the contrary can be proved.
Competition

safeguards

the

consumer

against

exploitation

by

providing the buyer with alternatives, and makes it unnecessary for

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the state to intervene by regulating process and production in order to

protect him.

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.

Price and Quantity Variability

Responses to a cnange in demand or to a change in supply may be
primarily in price or quantity. If the demand is highly elastic,
consumers will respond readily to price changes by dropping out of
the market when prices are lowered'a little. As a result, most of the
adjustments to changes in supply (an increase leading to a reduction
in price and a decrease leading to an increase.in price) would be those
in quantity purchased, if the demand is highly elastic. If the demand
is inelastic, the adjustments will take place primarily in price.
Similarly, if sellers respond readily by greatly increasing their offerings
on slight increases in price or by heavy withdrawals in slight price

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drops, the adjustments to changes in demand willbe largely in

quantity exchanged. If sellers are quite responsive to, price in their
offerihgs (if supply is very inelastic), the adjustments to changes in
demand, will take place largely through shifts in price. In view of the
above explanation, 'we may state thefollowing rules:

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.

Given a shin in the demand curve the following can occur:

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

For example, in Figure 4.17, the demand eurve shifts from DD to

DD.

The supply curve S"S" is steep. Another supply curve S'S' is

rather flat. Both the supply curves cut the original demand curve at
point E giving the equilibrium prices as OP. The flat supply curve S'S'
cuts the new demand curve D'D' at E2 giving the equilibrium price as
OP2, which is less than OP1 and more than OP.

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'.

If both demand and supply increase, sales are bound to

increase but the price mayor may not increase. In this case
there case can be two possibilities
o Price

will

rise

if

the

amount,

which

will

be

demandedattheold price exceeds the supply, which will be

made at that old price as shown in Figure 4.19.
o But the price will fall if the amount, which will be
supplied at the old price, is more than the amount
demanded currently at that price as shown in Figure
4.20. In other words, if at the old price, new demand
exceeds the new supply, the price will rise but if the new
demand is less than the new supply, the price will fall.

An increase in demand with a simultaneous decrease in supply

will raise price and increase sales if the new demand price for the old
equilibrium amount is higher than its new supply price. Similarly, the
price will rise and sales will dimfnish if the new supply price for the
old amount is higher than itsnew demand

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GOVERNMENT INTERVENTION IN PRICE FIXING

Quite often the government interferes with the normal process of price
determination by fixing prices either above the equilibrium level or
below it. In order to make these attempts by the government about
artificial price fixation successful, government intervention is required
with the forces of supply or demand or both, through elaborate
administrative regulations.
Difficulties in Price Fixing
The government has to face several difficulties while fixing prices due
to certain reasons. There can be elaborated as follows:

Attempts to fix prices above an equilibrium level are illustrated

by minimum wage legislation and price support policies. When
the Government undertakes the activity of fixing a minimum
price say, Rs. 375 per quintal for wheat much above the
equilibrium price say, Rs. 300 per quintal, consumers restrict
their consumption of 'wheat' (postpone their purchases at all
levels). Conversely, farmers are encouraged to increase their
production under the incentive of higher' prices. This results in
disequilibrium between the demand and supply. As such, there
are only two ways to maintain prices at a high level:
o The government can buy large quantities to absorb the
difference between the quantity supplied and quantity
demanded.
o The government can ask the farmers to limit their output.

The government also tries to set maximum prices below the

equilibrium level. This is illustrated by the price control on
sugar, on steel and a number of othcr commodities. Let us

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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.

Effect of Time Upon Supply

Economists find it important to discuss the way in which supply
changes in the course of time. The reason why such a study is
necessary lies in the technical conditions of production, i.e., it always

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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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maintained. The long-period supply curve will, therefore, tend to

have a flatter slope than the shortrun supply curve indicating
thereby that given a price increase, the supply tends lo be larger
than in the short-run period.

EQUILIBRIUM AND TIME

The following discussion now concentrates on how price would be
determined in different time periods, given a change in demand.

In the market period, an upward shift in the demand curve

would result in an immediate rise in price, as there will be no
increase in supply.

This will be followed by greater production during the short

period and a fall in the price as firms increase their output.
Later, as more capital equipment is installed the output would
increase still further and prices would again drop. Conversely, a
downward shift in the demand curve would not immediately
affect the quantity supplies but the price would drop sharply,
followed by some recovery as the firms reduce output in the
short period.
In the long period, firms would see more profitable uses for their
plants and would decide not to replace capital output as it wears
out. This would reduce equipment still further and permit some
recovery in price.

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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'.

Now, supply of fish cannot be increased immediately and hence

market or momentary equilibrium is established at price OP.

In the short run, however, fish supply can be increased by a

more intensive use of the existing equipment, viz., boats and nets and
by working for longer hours. As a result, the price drops to OP". In the
long run, supply can be fully adjusted to meet the demand conditions.
New fishermen would be attracted (entry of new firms), new boats;
nets and other equipment would be produced and employed in
service. As a result, supply would increase further and the long-run
equilibrium would take place at a still lower price OP".

The Firm in Pure Competition

In pure competition, the firm has to accept the given market price.

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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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Output Decisions and Consumer Interests

An entrepreneur will expand his output so long as the addition to his
cost is less than the worth of the incrcase in output price to the
consumers. In this respect, the entreprencur acts consistently with
the interests of the consumers though his purpose is merely to
maximise his own profits.
This rcquires continuing the hiring of additional workers and
buying additional raw materials so long as the wage paid for the
labour and the price paid for the matcrials is less than the amount
that every unit of output will add to his revenues. In this rcspect, the
entrepreneur acts in harmony with the interests of the sellers of
labour and raw materials though his purpose is to maximise his own
profits. A consistcney with the consumer preferences is also
maintained in bidding for the additional units of input for his firm.
Without being in the least a philanthropist, the purely competitive
entrepreneur seeking to maximise profits provides a very cffective
service in helping the allocation of resources in consistence with
consumer preferences and with the interests"of resource owners.
The Firm and Shutdown Point
The amount that a particular firm offers for scale in the short-run at
different prices for its product depends upon the cost conditions of
the firm. In case there is any price that is lower than the lowest
variable cost per unit, the firm will have to be shut down. It would not
be useful to operate even in the short run at a price lower than this,
sincc variablc costs are not covered. It is not held, however, that in the
short run, the average total costs play no role in the output decisions
of the prbfit-.seeking entrepreneur. This is because the fixed costs,
which are a component of the average total costs, would remain

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unaffected by the decision to shut down.

The Decision to Operate at Loss or Shut down
The above discussion shows that in the short run any firm may decide
to operate at a loss but try to minimise it. However, the question may
well arise: Why should a firm operate at all when it is suffering losses,
and why should it not.shut down? The explanation to the above
question lies in the fixed costs, which a firm has to incur any way. In
the short-run, certain costs, for example, rent, interest, etc., are fixed.
They continue to exist whether the firm operates or not. Even if the
firm shuts down, it cannot avoid these costs in the short-run. If, for
example, these fixed costs are Rs. 1,000 per month, the firm will lose
this amount every month even if it decides to cease operations.
Under these circumstances, it will be clearly beneficial to the firm
to continue operating if it can cover its variable costs and still have
something left to contribute towards its irreducible Rs. 1,000 every
month. Thus, supposing till' price is Rs. 40, output is 70 units and
the average variable cost is Rs. 35, the firm's receipts would be Rs.
800. Total variable cost will be Rs. 2,450 and the finll would be left
with Rs. 350 to meet part of its fixed costs. The net .loss to be suffered
would be RS.650 only. If the firm were to close down, its loss would
have been Rs. 1,000; hence it would decide to operate even at a loss
because by so doing, its losses would be less than they would have
been in the case of firm's shutdown.
If, however, the price comes down to Rs. 35 only and the average
variabe cost is Rs. 35, the sales receipts would just cover total variable
cost, leaving nothing towards covering the finn's fixed costs. Hence,
the firm would be indifferent and perhaps decide to shut down. If
price is below the average variable cost (Rs. 35), the firm would fail to

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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:

If the market price is below the cost of production of a

particular produccr, he can do nothing but to take a loss (in the
short run). If tbe price remains below his cost of production for
a sufficiently long period, he has no alternative but to go out of
business.

A firm can increase its profits by selling more units.

Products subject to a competitive market situation, face a

greater degree of price instability than is the case with
differentiated products.

No useful purpose is served by advertising. When products sold

by individual sellers are identical, advertising by anyone seller
would have a negligible effect on the demand for his product.

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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precisely still a particular grade of wheat. In a purely competitive

industry, however, the commodity is uniform and there is no product
differentiation, even in the slightest way. As such, under perfect
competition, an industry may be said to consist of all firms producing
a uniform commodity. It may be further added that a firm, which
produces more than one product, may be said to participate in more
than one industry. Strictly speaking, different brands of cigarettes
may be regarded as different commodities because there are set
consumer preferences for one brand over another. Yet, these consumer
preferences are so slight that for many purposes all the standard
brands may be regarded as one commodity and the industry as a
whole, for example, the cigarette industry. Of course, the industry is
said to be characterised by product differentiation as different brands
have different characteristics to attract consumers.
Adjustment Process Towards Long-run Equilibrium in Industry
An industry is said to be in equilibrium when there is no tendency on
the part of the firms within the industry to leave it or on the part of
the firms outside; to enter the industry. Long-run adjustments in an
industry take place through the entry or withdrawal of firms. These
are adjustments that take place over a time period I.ong enough to
permit such a shifting of firms and of relatively fixed productive agents
used by the firms. An industry is said to be in equilibrium when there
is no advantage to any productive agent in moving into or out of the
industry, or when there is no incentive for entrepreneurs to
inaugurate or withdraw firrtls from the industry.
Firms will move into or drop out of the .inqustry until expectations
of profits and losses have been roughly eliminated or until it is no
longer possible for anyone to better his position by moving into or out

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of the industry in question. Under pure competition, this equilibrium

will be reached when price is almost equal to the lowest cost on the
typical firm's total unit cost curve. Under competition, the price
cannot stay higher for long; and withdrawal of firms will keep it from
staying lower for a long period.
Survival of the Fittest
At any given time, there may be firms of varying sizes and efficiency in
an industry, possibly some making profits and others incurring
losses. Ellt so long as industry is open for anyone to enter freely, an
excess of price over the attainable average total costs will encourage
the entry of new firms. As such new firms move in, they compete with
existing firms and the most inefficient firms are eliminated. In the
long-run, therefore, only those firms will remain in the industry,
which have the lowest average total costs, as low as those, which
would be incurred by new enterprises in optimal scale adjustments. If
a long-run equilibrium position is linally attained, there might still be
many differences between firms but the lowest average total costs of
all firms would be the same. For instance, some entrcpr.eneurs may
be more efficient than others, some firms may be located near
markets and may be paying higher rents whereas others are more
distant and may be paying lower rents. Again, some firms may be
small with close personal supervision and hence with greater
efficiency whereas others may be large and with mass production
methods, In view of these differences, the firms may not be having
identical or similar cost curves. Still, each firm must produce at an
average cost as low as that of its competitors. In other words, though
there may be differences between firms, these may be balanced by
balancing advantages and disadvantages giving rise to uniformity of

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minimum average total costs.

To illustrate, two manufacturers of cotton textiles may be
differently located; one may qave the advantage of nearness to buyers
but the disadvantage of higher rent. The other may be located away
from the buyers and as such may have the advantage of lower rent but
the disadvantage of higher transport costs. Here the advantages and
disadvantages may balance so that the two firms have the same lowest
average costs. Another example is that of one firm having a more
efficient manager than the other. Here the efficient firm may have the
advantage of higher productivity but disadvantage of higher salary
payments as' compared to the less efficient firm. On balance, the two
firms may have the same lowest average costs.
In an industry adjustments towards long-run equilibrium do
not necessarily I take place smoothly. In fact, too many firms may
enter a profitable industry. Thus, by the time they are turning out
finished products, market price may drop below costs. As a result,
firms may start withdrawing from the industry so much so that too
many firms withdraw with opposite effects. This is most likely to occur
where initial investments are relatively small or where given fixed
equipment can be' utilised in other industries. This is because these
conditions facilitate quick entry as well as withdrawal. Agriculture
provides an example of this type where the same fixed assets can be
utilised alternatively as, for example, either for producing wheat or
cotton, jute or rice.

Restrictions on Firm's Entry and Withdrawal

Free entry'of new firms is usually restricted through

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Financial or technical barriers to entry into costly

and complex technological processes;

Government intervention and legal restrictions; and

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.

VARIANTS OF PERFECT COMPETITION

1. Effective or Workable Competition
Competition among the sellers, even though it may not be perfect, can
be regarded as effective if it offers real alternatives to consumers that
are sufficient to compel sellers to vary quality, service and price
substantially with a view to attract buyers.
The prerequisites of effective competition are as follows:

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 Ready substitution of one product for another.

General availability of essential information about a1ternati (its
significance lies in that buyers cannot influence the behaviour of
the sellers unless alternatives are known)
Presence of several sellers, each of them possessing the capacity
to survive and grow
Preservation of conditions which keep alive the basis or potential
competition from others
Substantial independence of action that is each selIn must be
able and willing constantly to reconsider his policy and to modify
it in the light or changing conditions of demand and supply.
Effective competition cannot be expected in fields where sellers are
so few ill number, capital requirements so large, and the pressure of
fixed charges so strong that price warfare, or its threat of will lead
almost inevitably to collusive (deceitful) understanding among the
members of the trade of. the industry concerned. In brief,
competition is said to be effective whenever it operates over time to
provide alternatives to buyers and to afford them substantial
protection against exploitation. The concept of effective competition,
though less definite, is more realistic and relevant than that of
perfect competition.
2. Potential Competition
Potential competition may restrain producers from overcharging those
to whom they sell or from underpaying those from whom they buy.
The

essential

precondition

for

potential

competition

is

the

preservation of freedom to enter or to leave the market. The exclusive

ownership of scarce resource, the heavy investment required for entry
into many fields, the fixed character of much of the existing

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equipment, high costs of transportation, restrictive tariffs, exclusive

franchises, and patent rights constantly operate to destroy the hasis
of potential' competition. Science, invention and the development of
technology constantly operate to keep this potentiality alive. Potential
competition, insofar as its basis continues, may compensate in part
for the shortcomings of the, lack of perfect competition.
Key Lessons of Perfect Competition of Managers
The key lessons of perfect competition or competitiveness for
managers in highly competitive market environment are as under:

It is important to enter a growing market as far ahead of the

competitors as possiblc. Smart managers should take advantage
well before the competitors enter the market when supply is low
and price is high. This requires entrepreneurial skill to take a
risk.

A firm, which is earning an economic profit (distinguished from

norm.al profit), cannot afford to be complacent or unprepared for
increasing cOlllpditioll hccausc cconomic profit will eventually
attract

new

entrants

encouraging

mare

production

and

enhancing supply, drive prices down down and reduce economic

profits. Here, it is impossible for a firm in a pcrkclly compclitive
market to compete based on product differentiation. Therefore,
the only way that it can earn or maintain profit in the face of
added supply and lower prices is to keep its costs as low as
possible. The lesson that one can learn from understanding the
perfectly competitive model is that a firm is to be amongst the
lowest cost producer to ensure its survival.
PRICE AND OUTPUT DECISIONS UNDER MONOPOLY

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Monopolistic market situation allows an individual seller or groups of

sellers, which arc acting as a unit, to exercise direct control over price.
Similarly, any such control on the part of buyers is called a
monopsonistic market situation. The monopo.listic and monopsonistic
market situations may be distinguished according to the nature and
extent of the deviation from the perfect competition. A useful
classification Can be: (i) monopoly and monopsony; (ii) monopolistic
competition; and (iii) oligopoly and oligopsony. However, in this
chapter, the discussion is confineclto monopoly only.
Main Features of Monopoly
The essential features of monopoly are as follows:

Single seller: There is only one producer or firm of a commodity

in the market. This is because there remains no distinction
between an industry and a firm in a monopolistic market. Here,
the firm itself becomes the industry and thus has full control
over supply of the commodity. The monopolist may be an
individual, a firm or a group of firms or even Government itself.
There are many buyers of the commodities produced by a
monopolist, against a single seller.

No close substitutes of the commodity: The commodity sold

by the monopolist has no close substitutes. This implies that
the cross-elasticity of demand between the monopofist'"s
product or commodity is very low. Though substitutes of
products are available but they are not close substitutes.

Difficult entry of a new firm: The monopolist controls the

market situation in such a way that it every new firm finds it to
be very difficult to enter the monopoly market and also to
compete with the monopolistic firm to produce either the

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homogeneous or identical product. This makes the monopolist,

the price maker himself.

Negatively sloped demand curve: The demand curve of a

monopolist firm is negatively sloped, which means that a
monopolist can sell more products only at a lower price and not
at a higher price.
Keeping in mind the features of a monopoly, it can be said that

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

monopoly power. For example, Hoechst, held a

monopoly for some time in oral medicines for diabetes because

they were the first to find out the methods of reducing blood
sugar by an oral dose.
Monopoly also arises where the minimum efficient scale of
operations is very large. For example, it is so for making some
chemicals In fact, monopoly tends to arise in industries
characterised by decreasing long-run costs.
Ignorance, laziness and injustice on the part of the buyers may
create monopoly in favour of a particular producer.
Revenue and Cost of Monopolists
The revenue and costs of monopolistic firm can be understood with
the following explanations:

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 Average Revenue: By raising the prices slightly, a monopolist

can sell less, but there will be some buyers of his product. He
can increase his sales only by reducing his price. In this
situation, his average

revenue

(demand curve)

will slope

downwards to the right. Such a change in AR curve shows that

larger quantities can be sold at lower prices whereas smaller
quantities can be sold at higher prices.
Marginal Revenue and the Sale Value of the Incremental
Output: In the market situation of pure competition, both
marginal revenue and the sale value of the incremental output
are identical. But this is not in the case of monopolly. A
monopolist needs to reduce his prices, to sell additional units of
his commodities. This reduction in price will apply both to old as
well as new customers. Lei us assume that a shirt manufacturer
retails his shirts at Rs. 40 per unit. Total sales are 1,000 shirts.
To sell 1,100 shirts, he reduces his price to Rs. 38. The sale
value of the additional output will be Rs. 3,800 where as the
marginal revenue will be Rs. 1,800 only. Thus, under monopoly
conditions marginal revenue will always be less than the sale
value of the additional output. However, after a stage, the
marginal revenue may even become negative.

Adjustments under Monopoly

A firm under this market situation can choose to sell many units at a
lower price or fewer units at a higher price. For maximisation of profit
or minirnisation of loss, a monopolistic firm would minimise or reduce
the use of inputs and outputs to the level at which the marginal
revenue equals the marginal cost. However, there is a significant

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difference between a purely competitive firm and a monopoly. The

difference lies in the fact that for a purely competitive firm, marginal
revenue equals the average revenue while in a monopolistic firm,
marginal revenue is less than the average revenue. Therefore, a
monopolist in purely competitive firm can only produce up to the point
where average revenue equals the marginal cost. This can be
understood with the help of the Figures 4.24 and 4.25 are givefl
below:

With reference to these figures, under perfect competition,

output would be OQP (Figure 4.24) as MR curve or the horizontal AR
curve, interesects the MC curve at point Ep. Butunder monopoly, MR
= MC at a point Em corresponding to output OQm (Figure 4.24),
which is less than OQP. Under monopoly, the MR curve is not equal
to AR curve, but lies below it. Thus, the monopolist's output will be
lower, and the use of productive services is also less than it that in
the case of pure comprtition, where adjustments are made to suit
consumers' preferences. In other words, in ll1uximising the profits,
the monopolist does not take into consideration the interests of the
consumers and the resource owners. It is the total profit that guides
the monopolist in his price and output policy. The total profit is

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calculated by multiplying the profit per unit by the number of units

sold. By using the process of trial uilci error with di fferent levels of
price and output, a monopolist fixes a price-output combination that
yields him the highest total profit.
Disadvantages of Monopoly

Under monopolistic condition, a monopolist exercises the

market power by restricting supplies. By doing so, he is likely
to become richer than he' would have been if he had no
market power. He also docs this even at the expense of those
who consume his products.

In a monopolistic situation, a consumer choice is restricted. A

consumer depends on the monopolists decisions on the
mutters related to price, and the amount the direction of
research and development in the industry, the services
offered, etc.

Under monopoly, there is a complete absence of competition,

which means that there will be no prcssure on the monopolist
firm to be economical and to keep its costs down. By keeping
its prices higher, a monopolist tends to wastc its cost or
production. This is a biggest drawback of a monopolistic tinn.

By exercising the monopolistic power, a monopolist is likely to

misalloeate the resources from society's point of view. As the
monopolist restricts output, his output becomes too small. He
employs too little of society's resources. As aresult, of this, too
much of these resources are used into the production of the
goods with low consumer preferences. Thus, resources are
mislilioclited or wasted.

A firm enjoying monopoly position in a strategic sector is a big

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a risk for an economy. For example, any failure related to the

power engineering facilities of a firm, is a hindrance for an
economy, In one BHEL, a firm is full of'risk, as any natural or
man made causes, which may lead to slowdown or stoppage of
production is a severe setback to the economy.
Long-run Considerations and Price Policies of a Monopolist
In deciding the current price policy, monopolists commonly take into
account' some long-run considerations, which may lead to a more
moderate price policy than would be followed by a firm taking into
account short-term factors only:

Price elasticity of demand: The ability to increase profits by

restricting supplies is the criterion of monopoly or market
power. In this respect, the more elastic the demalld for the
products, the weaker is the position or Ihc monopolist. But
there will always be a price, above which the demand is so
elastic that it will not cost anything to the monopolist to incur
the loss related to less sales by raising the prices higher. In the
long-run, consumer receptiveness to price may be much greater
than in the short run. Thererore, an intelligent monopolist must
consider this factor before exercising monopolistic power. If a
monopolist's prices are held at high lewis, consumers may stop
utilising

that

commodity.

This

will

result

in

decreased

consumption. On the other hand, if the prices remain lower

over extended periods, the consumers will get used to that
product, more people will be interested in it and those already
consuming it may increase their consumption as well.
Potential competition from new tirms: If a firm is very well
established, exercise strong and exclusive control over essential

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raw materials, possess indispensable patents, and licensing

regulations, it may pursue extremely high price policies without
great concern for the competition that these prices may attract.
If, on the other hand, its controls over firms are not so strong, it
depends

primarily

on

unfair

competition

and

uncclillin

manipulation, then the fear of potential competition may become

an important factor to modify the monopolist's policies.
State of public opinion: Public hostility to unfair practices and
exploitHI ion may appear in many forms like consumer boycotts,
both formal and informal, and legal restrictions and controls.
Hostile public opinion is wry important to be ignored irrespective
of the form in which it is. Many times it may temper the
behaviour of the monopolist seeking to maximise his profits.
If a monopolist is cautious, he needs not to work against public
interest. This is because the monopolists, being big concerns can
enjoy the economies of largescale production. They are in a better
position to maintain regular and satisfactory supplies. They can also
avail the benefits of large-scale buying ar1d selling. In fact they can
operate a better level of efficiency. If they restrain themselves and do
not exploit the consumers, they may not only build up a good image
in the market. By doing this, they are also likely to avoid potential
competition and Government interference.
Differenco between Monopoly and Pure Competition
The salient points of difference between monopoly and perfect
competition are as follows:

Under perfect competition, there are a large number of sellers

or firms whercns in monopoly, there is a single seller or firm.

Under perfect competition, the individual seller has no control

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over the market pries whereas under monopoly, the seller is in a

position to nlllnipulnte the output in order to control the prices.

Under perfect competition, the commodity produced by the

firms is homogeneous in nature whereas there is no close
substitute of the commodities produced by monopoly.

Under perfect competition, a firm is a price taker and not a price

maker whereas in monopoly a firm is a price maker.

Under perfect competition, there is free entry and exit of the

firms in the market whereas monopoly this is not so.

Under perfect competition, firms get only normal profits in the

long period whercas in monopoly, there is the possibility of
super-normal profits to take place.

Under perfect competition, there is no possibility of price

discrimination whereas in monopoly, price discrimination is
possible.

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:

There is only onc buyer or the goods or services.

Rivalry from buyers, who offer the close substitutes of the

product, is so remote to make it insignificant.

As a result, the buyer is in a position to determine the price,

which he pays for the goods or commodities.

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Actual causes closely approximating monopsony are rare. An,

example, approximating monopsony is that of Indian Railways in
relation to the wagon industry. Monopsony may also arise where
resources are immobile. If for reason, workers are unable to move to
other localities or other firms within same area, their existing
employer has, in effect, a inonopsony position over them.
Costs of Monopsonists
The monopsonist must choose between paying higher wages that will
enable him to employ more workers or limiting his working force to the
analler number workers, who can be employed at lower wages. This
means that when additional worker is added to the labour force, an
employer has to bear both, I wage of the new worker and also the total
increase in the wages to be paid to t old employees at the new rate.
Thus, in monopsonistic market situation, margir expenditure of each
input level exceeds average expenditure (Table I aild Figu 4.26).
Suppose a tailor employs six workers at Rs. 500 per month. To have I
additional worker, he must pay Rs. 550 per month to each worker. If
he employs the seventh worker, his total costs, thus, will increase by
Rs. 850. To represent the position graphically, two curves are needed,
one to show the average expenditur and the other to show the
marginal expenditure. The marginal expenditure (ME) is consistently
higher than the average expenditure (AE) and the slope of thl marginal
expenditure cutve is steeper than that of the average expenditure
curve.

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The following Table 4.4 shows the cost of a monopsonistic firm

hiring workers.

Table 4.4: Cost of a monopsonistic firm hiring workers

----Workers

--

--

... _. _.-

.. ~- .... - .- -

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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charging different prices to thL: samc buyer or to different buyers for

the same commodity or service without corresponding difference in
the cost. It is also known as differential pricing. Differences in rates
are somewhat related to the in costs. For example, it may cost less to
serve one class of customers than another to sell in large quantities
than in smaller lots. !frates or prices are proportional to cost, some
buyers will pay more and others less, but this will not take place in
price discrimination. In such a situation, charging uniform price will
amount to discriminat ion. There arc three classes of price
discrimination, which are as follows:
First-degree discrimination: The seller charges, the same buyer a
different price, for euch unit bought. For exumple, prices that
are determined by bargaining with individual customers or
prices, which are quoted for tenders floated by government
authorities.
Second degree discrimination: The seller charges different prices
for blocks of units, instead of, for individual units. For example,
different rates charged by an ekctrieity undertaking for light
and fan, for domestic power and for industrial use.

Third degree discrimination: The seller segregates buyers

according to income, geographic location, individual tastes,
kinds of uses for the product, etc. and charges different prices
to each group or market despite of charging equivalent costs
from them. If the demand elasticities among different buyers are
unequal, it will be profitable for the seller to put the buyer into
separate classes according to elasticity and thereby, to charge
each class a different price. It is also referred as market
segmentation and involves dividing the total market into

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homogeneous sub-groups according to some economic criterion,

usually the demand elasticity.
Conditions for Price Discrimination
The conditions for price discrimination arc as follows:
Multiple demand elasticities: There must be difference in
demand elasticities among buyers due to differences in income,
location, available alternatives, tastes, etc.
Market segmentation: The seller must be able to divide the total
market by separating the buyers into groups or sub-markets
according to elasticity.
Market sealing: The seller must be able to prevent any
significant resale of goods from the lower to the higher price submarket. Any resale by buyers among the sub-markets will,
beyond minimum critical levels, neutralisc the effect of different
prices.
Market Segmentation
Haynes, Mote and Paul have identified certain criteria according to
which market segmentation is practised. These criteria are given
below:
Segmentation by income and wealth: This can be understood
by considering an example, in which the doctors separate
patients with high incomes from patients with low incomes. The
fact that doctor's treatment is a direct personal service prevents
its resale.
Segmentation
distinguish

by

between

quantity
large

of

and

purchase:
small

Traders

purchasers,

often

offering

quantity discounts to large purchasers. The big buyers because

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of their bargaining power are able to extract special quantity

discounts. However, if the quantity discounts are in proportion to
the marginal costs of selling to big and small buyers, they will
not be counted in price discrimination.
Segmentation

by

social

or

professional

status

of

the

customer: Special prices may be quoted to Central and State

Governments or to Universities. Students are given concessions
in cinema tickets, railway fare and bus travel. Profes'sional
journals usually carry lower student subscription rates. Faculty
members or teachers are also sometimes offered books at special
discounts.
Segmentation by geography: This can be understood by
considering an example. For example, business houses, which
are sold abroad at prices, lower than the domestic price.
Segmentation by time of purchase: Reduced rates are often
quoted during festival seasons such as dussehra, diwali, etc. offseason discounts are also popuinr in case of fans, refrigerators,
etc.
Segmentation by preferences for brand names and other
sales promotion devices: Some firms sell the same type of
product under different branp names at, different prices. In this
case, ignorance on the part of consumer regarding similarity in
the quality of products prevents a large-scale of customcrs to
shift from one brand to another. Market segmentation also
ensures, the manufactures, a certain degree of flexibility in
pricing. Apart from this is also to be ensured that it should
remain present in every segment of market. For example,
Hindustan Lever supplies liril to satisfy the top-end of Ihe

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market, lifebuoy to the lowest end and lux to the middleend.

Objectives
The objectives of pricc discrimination are as follows:

To adjust the consumer's surplus in such a way that it accrues

to the producer and not to the consumer.

To dispose of occasional or irregula surpluses.

To develop a new market.

To make the maximum and proper use of the unutilised

capacity.

To earn monopoly profits.

To enter into or retain report markets.

To destroy or to forestall competition or to make the competition

amenable

to

Ihc

wishes

of

the

seller

adopting

price

discrimination. It may be called predatory or discriminatory

competition. The test of perdition of intent.

To raise the future sales. Quoting lower rates in the present

develop in future a taste for the similar commodities producecl
by the same manufacturer. For example, Reader's Digest sells
children's edition at lower rates. This develops the taste of
children towards the magazine and they are expected to
continue purchasing it even when they become adults.

Single Monopoly Price Vs. Price Discrimination

To examine the policy of price discrimination, is more useful rather
than to charge a single monopoly price. This can be done in following
ways:

First of all, a discriminating monopolist can increase his profits

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by charging different prices to different buyers or groups of

buyers rather than to charge a single price to all the buyers.

Secondly, the policy of price discrimination is in the interests of

the consumers as well. Bigger' output is made available to a
large number of customers. This is of special significance in the
case of public utility services. The larger the consumption of
these services, the greater is the economic welfare. Moreover,
the consumers may be charged according to their ability to pay,
which is quite fair and reasonable.

Finally, the policy of price discrimination enables better

utilisation of capacity, preventing waste of social resources. This
can be understood with the help of following Table 4.5.

Table 4.5: Costs, Prices and Sales of a Monopolist

Price
(Rs.)
9.00
8.00
7.00
6.00
5.00
4.00
3.00
2.50
2.00
1.50
1.00

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.

How much should the monopolist prodllce find what price

should be charge, if' he sells his entire output at a single price?

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How much profit will he earn?

How much should be produced if the monopolist fixes II

discriminatory price, dividing his customers into separate
groups according to their ability to pay and charging maximum
prices from each group? How much will be the profit, which the
monopolist will earn?

Will the monopolist be better off if he charges a single price or

discriminating prices and by how much?

Will it be in the interest of the consumers if the monopolist

charges discriminating prices? Explain.

Will the policy of price discrimination enable better utilisation of

capacity' as compared to a single price?
How much maximum profit would the monopolist earn if he is
allowed price discrimination but cannot charge more than RS.2?
Would it make any difference to capacity utilisation and
availability of supply the consumers?
Solution
If the monopolist sells the output at a single price, he will choose that
price, which will yield the largest profit, He will, therefore, produce
400 units and charge Rs. 6. The maximum profit he will earn is Rs.
100. This will be clear from the following Table 4.6:
Table 4.6: Monopolist Selling at a Single Price

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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

If the monopolist discriminates, dividing his customers into

groups according to their ability to pay and charging different prices
from each group, the results would be as given in the following
Table 4.7:
Table 4.7: Monopolist Selling at Discriminatory Prices
Price
(Rs.)

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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fair as well as reasonable.

The policy of price discrimination will enable better utilisation of
capacity. Assuming the monopolist has a capacity to produce
3,600 units, he would operate at a level of 2,000 units which is
much' closer to full capacity as against the level of 400 units,
where the monopolist will operate if he chmges the single price
of Rs. 6.
If the maximum price that can be charged is Rs. 2, the monopolist
will earn a maximum profit of Rs. 200 by practising price
discrimination as shown in the following Table 4.8.
Table 4.8.: A Regulated Monopolist Discriminating in
Price but Charging not more than Rs. 3
Price
(Rs.)

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

But capacity utilisation and availability of supplies will remain

unaltered.

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APPENDIX 1

Price Discrimination - Diagrammatic Exposition

A diagrammatic exposition of the theory of price discrimination is
shown below. Figure 4.27 presents the diagram of price discriminate
adopted in traditional economic theory.

Let us suppose that the market for a product consists of two

segments, one with a more elastic demand curve than the other D 1
shows the demand in the more elastic segment and D 2 shows the
demand in the less elastic segment. MR. and MR2 represent the
corresponding marginal revenue curves. The total marginal, revenue
cllrve MRT adds together the quantities in both market segments at
each marginal revenue. Thus MRT = MR1+ MR2. On the cost side, the
diagram shows a marginal cost curve MC, which alone is relevant. It
may be noted that only one I marginal cost curw exists because it
makes no difference from the cost point of view whethcr the products
sell in market segment 1 or market segment 2, since the product is
the same.

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As usual, profit will be maximised where marginal revenue is

cquallo marginal cost. Such equality exists at point E in the diagram
where 'the total margimil revel1lie curve (MRT) intersects the
ll1argin::d cost curve (MC). A horizontal line drawn from this point of
intersection E, back to the Y-axis cuts the two marginal revenue
curves MR, and MR2 at points F and G respectively. These roints
determine the quantities to be sold in each market segment and the
prices which shall prevail in each market segment. For this purpose
one should first draw a perpendicular line frolll point F on X-axis,
showing OX, as the quantity in market segment 1. Agai by extending
this perpendicular line upward to meet the demand curve 0 " one gets
p. as the price for this market segment. Similarly, frol1l point drawing
the perpendicular to X-axis and thereafter extending it to the demand
c.urve D2, we get OX2 asthe quantity to be sold and P2 as the price
to be charged in market segment 2. The quantity sold in market
segment 1 (OXI) plus the quantity sold in market segment 2 (OX2)
exhausts the total quantity OQ (i.e., OX1 + OX2 = OQ). Further, the
price PI is lower than the price P2 thus indicating that the price in
the more elastic market segment (DI) shall be less than the price in
the less elastic market segment (D2). The two prices PI and P2 provide
different margins of contribution to profit. It should also be noted that
(he solution equates the marginal revenue in each segment (i.e., X2G
= X.F) besides equating the total marginal revenue to marginal cost at
point F. If MR. was greater than MR2, the firm could increase profits
by transferring units of product from market segment 2 to-market
segments I. This is an illustration of the equi-marginal principle. If
either MR1 or MR2 were greater than me, an expansion of output
would be profitable. Optimisation thus requires that MR1 = MR2 =
Me.

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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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competitive seller enjoys no monopoly power and in his case:

Price = Marginal cost (or P - MC = 0).
But as monopoly po~er emerges, P - MC becomes greater than zero
and as the power increases, the gap between price and MC increases.
Thus, the degree or index of monopoly power can be measured as
being equal to:
MC
P=

For instance, if price is Rs. 20 and marginal cost is Rs.12, the

degree of monopoly power is
20-12
20

= 0.4

Lerner also relates the monopoly power to price-elasticity of

demand. Accordingly, higher the price-elasticity of demand, smaller is
the degree of monopoly power. Also, the degree of monopoly power is
the reciprocal of the price-elasticity of demand. That is, if elasticity is
2, the degree of monopoly is V*.
Bain's measure: Bain measures degree of monopoly power in
terms of supernormal profits. The supernormal profits are equal
to (P - AC) Q, where P = Price, AC = average cost, and Q is
output.
Rotbscbilds' measure: Rothschilos defines degree of monopoly
power, in terms of the proportion of the slopes of the firms and
industry demand curves, i.e.,

degree of monopoly power =

Slope of the firms demand curve

Slope of the industrys demand curve

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Triffin's measure: Trimn measures degree of monopoly power

in terms of price cross-elasticity of demand. Price crosselasticity of demand means the extent of substitution between
the products of two firms when one of them changes the price of
its product. If cross-elasticity of demand is zero, this implies
that the firm has an absolute monopoly power.

REVIEW QUESTIONS
1.

Define a production function. Explain and illustrate

isoquants and isocost curves.

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2.

Explain the nature mid managerial uses of production

function.

3.

Discuss the equilibrium of the organisation with the

technique of' isoquants.

4.

Distinguish
function.

between

How

would

production
you

function

develop

the

and

cost

production

function? What are its uses?

5.

What are the main features of pure competition? How

does an organisation adjust its policies to a purely
competitive situation?

6.

What

is

the

short-down

point?

Explain

why

organisation suffering losses still decides to operate and

not shut down.
7.

Explain the following propositions:

A. If demand rises, price goes up.
B. If supply rises, price goes down.
C. If both demand and supply increase, sales is bound to
increase but price mayor may not.

8.

Explain the possible effect of an increase in demand with

a simultaneous decrease in supply on sales and price.

9.

Explain the effects of government intervention in price

fixation.

What

steps

are

necessary

to

make

this

intervention effective?
10.

How does a company determiae the prices of its

products? Examine in this connection the validity of the
theory that long-period price is equal to cost.

11.

Explain very short period, short period and long period

BSPATIL

situations in a market. Show price equilibrium under

very short and iong periods.
12.

What is meant by 'price discrimination'? What are its

objectives? Is price discrimination anti-social?

13.

What does differential pricing mean? Discuss the various

types of geographical price differentials and explain how
they are determined.

14.

Comment on the various types of discounts and the

effects of each on sales.

15.

How does the equilibrium of the organisation under

perfect competition differ from that of a monopolist? Is it
true that in the long run II perfectly competitive
organisation earns no super-normal profits?

16.

Explain

and

illustrate

the

conditions

for

the

establishment of organisation's equilibrium under perfect

competition.
17.

Examine the weaknesses of the traditional theory of

pricing

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

shareholders, sufficient to maintain investment at its current level.

Therefore pure profit can be calculated with the help of following
formula.
Pure Profit = Total Revenue - (explicit costs + implicit costs).
Economic or pure profit also makes provision for insurable risks,
depreciation and necessary minimum payments to shareholders to
prevent them from withdrawing their capital. Pure profit is considered
to be a short term phenomenon. It does not exist in the long run,
especially under perfectly conditions. Because of this, they may either
be positive or negative for a single firm in a single year.

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The concept of economic profit differs from that of accounting

profit Economic profit takes into account also the implicit or imputed
costs. The implicit cost is also called opportunity cost. If an
entrepreneur uses his labor in his own business, he foregoes his
income or salary, which he might have earned by working as a
manager in another firm. Similarly, by using assets like and building
and his own business, he foregoes the market rent, which might have
earned otherwise. All these foregone incomes such as interest, salary
and rent, are called opportunity costs or transfer costs. Accounting
profit does not consider the opportunity cost.

THEORIES OF PROFIT AND SOURCES OF PROFIT

There are various theories of profit, given by several economists, which
are as follows:
Walkers Theory of: Profit as Rent of Ability
This theory is pounded by F.A. Walker. According to F.A. Walker,
Profit is the rent of exceptional abilities that an entrepreneur may
possess over others. Rent is the difference between the yields of the
least and the most efficient entrepreneurs. In formulating this theory,
Walker assumed a state of perfect completion in which all firms are
presumed to possess equal managerial ability each firm receives only
the wages which in Walker view forms no part of pure profit. Hen
considered wages of management as ordinary wages thus, under
perfectly competitive conditions, there would be no pure profit and all
firms would earn only wages, which is known as normal profit.

Clarks Dynamic Theory

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This theory is propounded by J.B. Clark According to him, profits

arise in a dynamic economy and not in static economy.
A static economy and the firms under it, has the following features:

Absolute freedom of completion

Population and capital are stationary

Production process remains unchanged over time.

Homogeneous goods

Factors of production enjoy freedom of mobility but do not move

because their marginal product in very industry is the same.

There is no uncertainly and risk. If there is any risk, It is

insurable

All firms make only normal profit

A dynamic economy is characterized by the following features:

Increase in population

Increase In capital

Improvement in production techniques.

Changes in the forms of business organization

The major function of entrepreneurs or managers in a dynamic

economic is to take the advantage of all of the above features and
promote their business by expanding their sales and reducing their
costs of production.
According to J.B. Clark, Profit is an elusive sum, which
entrepreneurs grasp but cannot hold. It slips through their fingers
and bestows itself on all members of the society. This result in rise in
demand for factors pf production and therefore rises in factor prices
and subsequent rise in the cost of production. On the other hand,
because of rise in cost of production and the subsequent fall in selling

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price of the commodities, the profit disappears. Disappearing of profit

does not mean that profit arise in dynamic economy once only, but it
means that the managers take the advantage of the changes taking
place in the economy and thereby making profits.

Howleys Risk Theory of Profit

The risk theory pf profit is propounded by F.B. Hawleys in 1893. Risk
in business may arise due to obsolescence of a product, sudden fall in
prices, non-availability of certain materials, introduction of a better
substitute by a competitor and risks due to fire, war, etc. Hawleys
considered risk taking as an inevitable element of production and
those who take risk are more likely to earn larger profits. According to
Hawley, Profit is simply the price paid by society assuming business
risks. In his opinion in excess of predetermined risk. They also look
for a return in excess of the wags for bearing risk is that the
assumption of risk is irrelevant and gives to trouble and anxiety.
According to Hawley, Profit consists of two part, which are as follows:

One Part represents compensation for actual or average loss

supplementing the various classes of risk.

The other part represents a penalty to suffer the consequences

of being exposed to risk in the entrepreneurial activities.
Hawley believed that profits arise from factor ownership as long

as ownership involves risk. According to Hawley an entrepreneur has

to assume risk to earn more and more profit. In case of absence of
risks, an entrepreneur would cease to be an entrepreneur and would
not receive any profit. In this theory, profits arise out of uninsured
risks. The amount of reward cannot be determined, until the
uncertainly ends with the sale of entrepreneur products profit in his

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opinion is a residue and therefore. Hawley theory is also called a

residential theory of Profit.

Knights Theory of Profit

This theory of profit is propounded by frank H. Knight who treated
profit as a residual return because of uncertainly, and not because of
risk bearing. Knight made a distinction between risk and uncertainly
by dividing risk into two categories, calculable and non-calculable
risks. They are explained as below:

Calculable risks are those, the prodigality of occurrence of

which van be calculated on the basis of available data. For
example risk, due to fire theft accidents etc. are calculable and
such risks are insurable.

Incalculable risks are those the probability of occurrence of

which cannot be calculated. For Instance there may be a certain
elements of cost, which may not be accurately calculable and
the

strategies

of

the

competitors

may

not

be

precisely

assessable. These risk are called includable risks. The risk

element of such incalculable costs is also insurable.
It is in the area of uncertainly which makes decision-making a
crucial function for an entrepreneur. If his decisions prove to be right,
the entrepreneur makes profit, Thus according to knight profit arises
from the decisions taken and implemented under the conditions of
uncertainly. The profits may arises as a result of decision related to
the state of market such as decision, which increase the degree of
monopoly, decisions regarding holding of stocks that give rise to
windfall gains and the decisions taken to introduce new techniques
or innovations.

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Schumpeters Innovation Theory of Profit

Joseph A. Schumpeter developed the innovation theory of Profit.
According to Joseph A. Schumpeter, factors like emergence of Interest
and profits, recurrence of trade cycles only supplement the distinct
process of economic development to explain the phenomenon of
economic development and profit, Schumpeter starts from the state of
a stationary equilibrium, which is characterized by the equilibrium in
all the spheres. Under these conditions stationary equilibrium, the
total receipts from the business are exactly equal to the cost. This
means that there will be no profit. The profit can be earned only by
introducing innovations in manufacturing technique and the methods
of supplying the goods innovations may include the following
activities.

Introduction of a new commodity or a new quality of goods.

Introduction of a new method of production.

Introduction of a new market.

Finding the new sources of raw material

Organizing the industry in an innovative manner with the new

techniques.
The factor prices tend to increase while the supply of factors

remains the same. As a result, cost of production increase. On the

other hand with other firms adopting innovations, supply of goods and
services increases resulting in a fall in their prices. Thus, on one
hand, cost per unit of output goes up and on the other revenue per
unit decrease. Finally, a stage comes when there is no difference
between costs and receipts. As a result there are no profits at all.
Here, economy has reached a state of equilibrium, but there is the
possibility of existence of profits. Such profits are in the nature of
Quasi-rent arising due to some special characteristics of productive

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services. Furthermore, where profits arise due to factors such as

patents, trusts, etc. they will be in the nature of monopoly revenue
rather than entrepreneurial profits.

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:

Powers to control supply and price.

Powers to prevent the entry of competitors by reducing the

prices.
The Monopoly powers help a monopoly firm to make pure profit

or monopoly profit. In such cases, monopoly is the source of pure

profit.

PROBLEMS IN PROFIT MEASURMENT

Accounting profit is the difference between all explicit costs and
economic profit or subtracting the difference of explicit and implicit
costs from revenue. Once profit is defined, it is easier for a firm to
measure the profit for a given period. The problems regarding the
measurement of profits are as follows:

The choice between the two concepts of profits, to be given

preference while using.

The determination of the various costs to be included in the

implicit and explicit costs.

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The solutions to these problems are as follows:

The use of a profit concept depends on the purpose of

measuring profit.

According concept of profit is used when the purpose is to

produce a profit figure for any of the following.
o The shareholders, to inform them of progress of the firm
o Financiers and creditors, who would be interested in the
firms progress
o The Managers to assess their own performance
o For computation of tax-liability.
To measure accounting profit for these purposes, necessary

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.

CURRENT vs. HISTORICAL COSTS

Meaning of Historical Costs
The income statements are prepared in terms of Historical costs and
not in terms of current price. Historical costs is the purchase price of
any asset ands includes the following.

Money

spent

in

the

acquisition

of

the

asset

including

transportation costs as well as the insurance cost.

Costs of installation such as wages paid for erection of

machinery and the amount spent on repairs at the time of
installation.
The

reasons

for

using

historical

costs

for

calculating

depreciation rather than current costs are as follows:

Historical costs produce more accurate measurement of Income.

Historical costs are easily determined and more objective than

the values based on the use of current value on asset.

Accountants also record historical costs and consider them to

be more relevant, The accountants approach ignores certain
important changes in earnings and looses of the firms, which
may be any of the following:

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o The value of asset pretended in the books of accounts is

understand at the time of inflation and overstated at the
time of deflation.
o Depreciation

is

understated

during

deflation.

The

historical cost recorded in the books of account does not

reflect these changes in values of assets and profits. This
problem becomes more critical in case of inventories and
stock. The problem is how to evaluate the value of
inventory and the stocks.

Methods of Inventory Valuation

There are three popular methods of Inventory valuation, first in first
out (FIFO), last in fist out (LIFO) and weighted average cost (WAC)
Under FIFO method, material is taken out of stock for further
processing in the order in which they are acquired. The stocks,
therefore, appear in firms balance sheet at their actual cost price. This
method overstates profits at the time of rising prices.
Under LIFO method, the stock purchased most recently become
the costs of the raw material in the current production under WAC
method, the weighted average of the costs of materials purchased at
different prices and different point of time is calculated to evaluate the
inventory.
All these methods have their own disadvantages and do not
reflect the true profit of the business. So the problem of evaluating
inventories to yield a true profit remains unsolved.

Problems is Measuring Depreciation

Economists consider depreciation as capital consumption. For them,
there are two distinct ways of charging depreciation either by

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assuming the value of depreciation of equipment to its opportunity

cost or to its replacement cost that will produce comparable earning.
Opportunity cost of equipment is the most profitable alternate
use of that is foregone by putting it to its present use. The problem is
to measure the opportunity cost. One method of measuring the
opportunity cost. One method of measuring the opportunity cost, as
suggested by Joel Dean, is to measure the fall in value during a year.
By using this method cannot be applied when capital equipment has
no alternative use, like a hydropower project In such cases,
replacement cost is an appropriate measure of depreciation. Under
this method, the cost of the new asset and the residual value of the
old asset are taken as the depreciation of the asset. But depreciation
is recorded only at the time of replacement of an asset. This method is
used in public utility concerns like railway, electricity companies. To
accountants, depreciation is an allocation of under expenditure over
time. Such allocation or charging depreciation is made under
unrealistic assumptions such as stable prices and a given rate of
obsolescence. There are different methods of charging depreciation,
which are of utmost importance. The use of different levels of profit
reported by the accountants. It will be clearer after considering the
following example: Suppose a firm purchases a machine for Rs.
10,000/- with an estimated life of 10 yrs. The firm can apply any of
the following four methods of charging depreciation and the amount of
depreciation for the given example by using the different methods is
as follows:

Straight Balance Method

Annuity Method

Sum-of the years digit approaches

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Under the straight line method, the amount of depreciation

remains the same throughout the life of the asset. Depreciation is
calculated according to a fixed percentage on the original cost. The
amount and rate of depreciation is calculated as under:
Amount of depreciation =

Historical cost-residual value

Economic life of the asset

Rate of depreciation = Amount of depreciation x 100/Historical

cost
Residual value is the realizable value of an asset at the end of
its economic life. Keeping in view the above example, the amount of
depreciation will be 10,000/10 = Rs. 1,000. It will be same for each
year. The rate of depreciation will be
1000 x 100/10,000 = 10
Under the reducing balance method, depreciation is charged at
a constant rate or percent of annually written down values of the
machine or any equipment. Assuming a depreciation rate of 20 per
cent, the amount of depreciation for different years will be calculated
as under :
Amount of Depreciation = Historical value x rate of depreciation /100

But the amount of depreciation for the first year will be

deducted from the successive years. Therefore Rs. 2000 in the first
year, Rs. 1600 in the second year, Rs. 1280 in the third year, and so
on.
Under annuity method, rate of depreciation is fixed and is calculated
as under:-

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d = (C + Cr )/n, where n is the total number of years of capital, C is

the total capital and r is the interest rate. The amount of depreciation
in this method is calculated with the help of annuity table.
Finally under sum-or-the years digits approach, the total years
of equipment life are aggregated. Depreciation is then charged at the
rate of the ratio of the last years digits to the total of the years. With
respect to the given example, the aggregated years of the equipments
lifes will be 1+ 2 + 3 +... +10 = 55. Depreciation in the 1 st year will be
10,000 x 10/55 = Rs. 1818.18, in the 2nd year it will be 1,000 x 9/55 =
Rs. 1636.36 and in 3rd year it will be 10,000 x 8/55 = Rs. 1454.54,
and so on. These four methods of depreciation results in different
methods of depreciation and subsequently different levels of profit.

TREATMENT OF CAPITAL GAINS AND LOSSES

Capital gains and losses arc regardea as windfalls. Fluctuation in the
stock market prices is one of the most common sources of wind Ellis.
According to Dean, capital losses are, greater than capital gains in a
progressive society. Many of the capital losses arc of insurable nature
and the excess becomes the capital gain.
Profit is also affeckd by the way capital gains and losses are
treated in accounting. According to Dean, "a sound accounting policy
to follow concerning windfalls is never to record them until they are
turned into cash by a purchase or sale of assets, since it is never clear
until then exactly how large they are". But, in practice, some firms do
not record capital gains until it is realised in money terms, but they
do write off capital losses from the current profit. The use of different
policies result in different profits. But an economist is not concerned
with the accounting practice or principle, which is followed in

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recording the past events. An economist is concerned mainly with

what happens in future. According to an economist, the management
should be aware of the approximate magnitude of such windfalls
before they are accepted by the accountants. This would be helpful in
taking the right decision with respect of those assets, which are
affected by the use of policies given by the economists.
PROFIT MAXIMISATION AS BUSINESS OBJECTIVE
Profit maximisation is the most important assumption, which helps
the economists to introduce the price and production theories. The
traditional economic theory assumes that the profit maximisation is
the only objective of business firms. According to this theory, profits
must be earned by business to provide for its own survival, coverage
of risks, growth and expansion. It is a necessary motivating force and
it is in terms of profits that the efficiency of a business is measured. It
forms the basis of conventional price theory. Profit maximisation is
regarded as the most reasonable and analytically the most productive
business objective.
The profit maximisation assumption in this theory helps in
predicting the behaviour of business firms and also the behaviour of
price and out pet under different market conditions. No alternative
hypothesis or assumption explains and predicts the behaviour of firms
better than the profit maximisation assumption. According to this
theory, total profit is the difference between total revenue and total
cost and is calculated as below:
TP = -TR TC
where,
TR = total revenue
TC = total cost

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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 necessary or the first order condition states that marginal

revenue (MR) must be equal to marginal cost (MC). Marginal
revenue is the revenue obtained from the production and sale of
one additional unit of output. Marginal cost is the cost arising
due to the production of one additional unit of output.

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
-

This condition holds only when

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aQ

=0

(3)

aTR

aTC
=

aQ

aQ

In Equation (3), the term aTR/aQ is the slope of the total

revenue curve, which is equal to the marginal revenue (MR).
Similarly, the term aTC/aQ is the slope of the total cost curve,
which is equal to the marginal cost (MC). Thus, the first-order
condition for profit maximisation can be stated as:
MR=MC
The first-order condition is also called necessary condition, as it
is so important that its non-fulfilment results in non-occurrence of
the secondary condition and thereby the profit maximisation
objective is not attained.
Second-order Condition
The second-order condition of profit maxirnisation requires that the
first order condition is satisfied under rising MC and decreasing MR.
This condition is illustrated in Fig. I. The MC and MR curves are the
usual marginal cost and marginal revenue curves, respectively. MC
and MR curves intersect at two points, PI and P 2. Thus, the first order
condition is satisfied at both the points but mathematically, the
second order condition requires that its second derivative of the profit
function is negative. When second derivative of profit function is
negative, it shows that the total profit curve has bent downward after
reaching the highest point on the profit scale. The second derivative of
the total profit function is given as:

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)

And also suppose that the total cost function as given as

TC = 10 + 0.5Q2

(8)

Applying the first order condition of profit maximisation and

finding the profit maximising output. It is known that profit is
maximum where:
MR MC

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or,
aTR
aQ

aTC
aQ

(9)

Putting the values of Equation (7) and (8) in (9)

MR
and

aTR
aQ

aTC
aQ

<

= 100 4Q

aTC
MC =

aQ

=Q

Thus, profit is maximum where

MR = MC
100 4Q = Q
5Q = 100
Q = 20
The output 20 satisfies the second order condition also. The
second order condition requires that:
a2TR
aQ2

<

a2TC
aQ2

<0

In order words, the second-order condition requires that

aMR
Q

aMC
Q

<0

Or
a(100 40)
aQ

a(Q)
aQ

- 4 1 <0

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<0

Thus, the second-order condition is also satisfied at output 20.

CONTROVERSY OVER PROFIT MAXIMISATION OBJECTIVE:

THEORY vs. PRACTICE
According to the traditional theory, profit maximisation is the sole
objective of a business firm. In practice, however, firms have been
found to be pursuing objectivies other than profit maximisation. For
the

large

business

maximisation

is

the

firms,

pursuing

distinction

goals

between

other
the

thon

ownership

profit
and

management. The separntion of manllgement from the ownership

gives managers an opportunity to set goals for the firms other than
protit maximisation. Large firms pursue goals such as sales
maximisalioll,

mllximisulioll

of

lilllllagcrial

utility

function,

maximisation of firm's growth rate, making a target profit, retaining

market share, building up the net worth of the firm, etc. Secondly,
traditionnl theory assumes perfect knowledge about current murket
conditions and the future developments in the business environment
of the firm. Thus a business firm is fully aware of its demand and cost
functions in both short and long runs. The market conditions (Ire
assumed to be certain. On the contrary, it is also recognised that the
firms do not possess the perfect knowledge of their costs, revenue,
and their environment. They operate in the world of uncertainty. Most
of the price and output decisions are based on probabilities.
Finally, the marginality principle in which MC and MR are same
has been found to be absent in the decision-making process of the
business firms. Hall and Hitch have found, in their study of pricing
practices in UK, that the firms do not pursue the objective of profit
maximisation and that they do not use the marginal principle of

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equalising MR and MC in their price and output decisions. Most firms

aim at long-run profit maximisation. In the short-run, they set the
price of their product on the basis of average cost principle to cover
average cost and its components, average variable cost and average
fixed cost.
It also takes into account normal profit usually 10 per cent.
Gordon, a famous economist, has concluded that the real business
world is much more complex than the one which is based on
hypothesis and assumptions. The extreme complexity of the real
business world and ever-changing conditions makes it difficult for a
business firm to use its past experience in order to forecast demand,
price and costs. The average-cost principle of Rricing is widely used by
the firms and the marginal costs and marginal revenu~ are ignored.
On the basis of many such studies, it can be said that the pricing
practices are related to pricing theories.
THE FAVOUR OF PROFIT MAXIMISATION
The arguments against the profit-maximisation assumption, however,
should not mean that pricing theory is not related to the actual
pricing policy of the business firms. Many economists has strongly
supported the profit maximisation objective and the marginal
principle of pricing and output decisions. The empirical and
theoretical policies support the marginal rule of pricing in the
following way:
In two empirical studies of 110 business firms, J.S.Earley has
concluded that the firms do apply the marginal rules in their pricing
and output decisions. Fritz Maclup has argued that empirical studies
by Hall and Hitch, and Lester do not provide conclusive evidence
against the marginal rule and these studies have their own

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weaknesses.

He

further

argued

that

there

has

been

misundestanding regarding the purpose of traditional theory. The

traditional theory explains market mechanism, resource allocation
through price mechanism and has a predictive valu. The significance
of marginal rules in actual pricing system of firms could not be
considcred

becausc

of

lack

of

communication

between

the

busincssmcn and the researchers as they use different terminology

like MR, Me and clasticitics. Also, Maclup is of the opinion that the
practices of setting price equal to the average variable cost plus a
profit margin, is not inequitable with the marginal rule of pricing.
ARGUMENTS

IN

FAVOUR

OF

PROFIT

MAXIMISATION

HYPOTHESIS
The traditional theory supports the profit maximisation hypothesis
also on the following grounds:

Profit is essential for survival of a business: The survival of

all the profitoriented firms in the long run depends on their
ability to make a reasonable profit depending on the business
conditions and the level of competitior. Profit is the biggest
incentive for work. It is the driving force behind the business
enterprise. It encourages a man to work to do the best of his
ability and capacity. Making a profit is a necessary condition
for the survival of the firm. Once the firms are able to make
profit, they try to maximise it.

Achieving other objectives depends on the ability of a

business to make profit: Many other objectives of business
are maximisation of managerial utility function, maximisation
of long-run growth, maximisation of sales revenue. The
achievement of such alternative objectives depends wholly or

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partly on the primary objective of making profit.

Profit maximisation objective has a greater predicting

power: As comparcd to other business objectives, profit
maximistion assumption has been found 10 be good in
predicting ccrtain aspects relatcd to a business. Friedman
supports this by saying that the profit maxilllisation is
considered to be good only if it predicts the business behaviour
and the business trends correctly.

Profit is a more reliable measure of efficiency of a

business: Thought not perfect, profit is the most efficient and
reliable measure of the efficiency of a firm. It is also the source
of internal finance. The recent trend shows a growing
dependence on the internal finance in the indlstrially advanced
countries. In fact, in developed countries, internal sources of
finance contribute more than three-fourths or lotal linance.
Keeping this in mind, it can be said that profit maximisation is
a more valid business objective.

Alternative objectives of Business Firms

The traditional theory does not distinguish between owners and
managers' interests. The recent theories of firm, which arc also called
managerial and behavioural theories of firm, assume owners and
managers to be separate entities in large corporations with different
goals and motivation. Berle and Means were the two economists, who
pointed

out

the

distinction

between

the

ownership

and

the

management, which is also known as Berle-Means-Galbraith (BMG)

hypothesis. The B-M-G hypothesis states the following:
The owners controlled business firms have higher profit rates than
manager controlled business firms, and

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The managers have no in::entive for profit maximisation. The

managers of large corporations, instead of maximising profits, set
goals for themselves that helps in controlling the owners also. In
this section, some important alternative objectives of business
firms,

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.

Banks and financial corporations look at sales revenue while

financing the corporation.

Trend in sale revenue is a good indicator of the performance of

the business firm. It also helps in handling the personnel
problems.

Increasing sales revenue helps in enhancing the prestige of

managers while profits go to the owners.

Managers find profit maximisation a difficult objective to fulfil

consistently over tillle and at the same level. Profits may
fluctuate with changing conditions.

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Growing sales strengthen competitive spirit of the business firm

in the nlilrkd and vice versa.
So far as cmpirical validity of sales revenue maximisation

objective is concerned, realistic evidences are unsatisfying. Most

empirical studies are, in fact, based on inadequate data because the
necessary data is mostly not available. If total cost lilllction intersects
the total revenue function (TR) function before it reaches its highest
point, Baumol's theory fails. It is also argued that, in the long run,
sales maximisation and profit maximisation objective can be merged
into one. In the long rnll, sales maximisation lends to yield only
normal levels of profit, which turns out to be the maximum under
competitive conditions. Thus, profit maximisation is not inequitab!c
with sales maximisation objective.

MARRIS's HYPOTHESIS OF MAXIMISATION OF FIRM'S GHOWTH

RATE
According to Robin Marris, managers maximise firm's growth rate
subject to managerial and financial constraints. Marris defines firms'
balanced growth rate (G) as follows:
G = Gd = Gc
where,
Jd = growth rate of dcmand for firms product.
Gc = growth rate of capital supply to the firm.
In simple words, a firm's growth rate is considered to be
balanced when demand for its product and supply of capital to the
firm increase at the same rate. The two growth rates according to

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Marris, are translated into two utility functions such as:

Managers ut i I ity function

Owners utility function
The managers utility function (Um) and owner's utility function

(Uo) may be specified as follows:

Um = f (salary, powcr, job security, prestige, status) and

Un = f (output, capital, market-share, profit, public esteem).
Owner's utility function (Vo) implies growth of demand for firms'

products and supply of capital. Therefore, maximisation of U o mcans

maximisation of demand for a firm's products or growth of supply of
capital.
According to Marris, by maximising these variables, managers
maximise both their utility function and that of the owner's. The,
managers can do so because most of the variables such as salarics,
status, job security, power, etc., appearing in their own utility function
and those appearing in the utility function of the owners such as
profit, capital market, share, etc. are positively and strongly correlated
with the size of the firm. These variables depend on the maximisation
of the growth rate of the firms. The managers, therefore, seek to
maximise a steady growth rate. Marris's theory, though more accurate
and sophisticated than Baumol's sales revenue maximisation, has its
own weaknesses. It fails to deal satisfactorily with the market
condition

of

oligopolistic

interdependence.

Another

serious

shortcoming is that it ignores price determination, which is the main

concern of profit maximisatioll hypothesis. In tbe opinion of many
economists, Marris's model too, does not seriously challenge the profit
maximisation hypothesis.

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Williamson's Hypothesis of Maximisation of Managerial Utility

Function
Like Baulmol and Marris, Willamson argues that managers are very
careful in pursuing the objectives other than profit maximisation. The
managers seek to maxi mise their own utility function subject to a
minimum level of profit. Managers' utility function (U) is expressed
below: V = f(S, M, ID)
where,
S = additional expenditure on staff
M = Managerial emoluments
ID = Discretionary investments
According to Williamson's hypothesis, managers maximise their
utility function subject to a satisfactory profit. A minimum profit is
necessary to satisfy the shareholders and also to secure the job of
managers. The utility fU'1ctions which managers seek to maximise,
include both quantifiable variables like salary and slack earnings anti
non-quantitative variable such as prestige power, status, job security,
professional excellence, etc. The non-quantifiable variables are
expressed in order to make them work effectively in terms of ex; ense
preference defined as satisfaction derived out of certain types of
expenditures. Like other alternative hypotheses, Williamson's theory
too suffers from certain weaknesses. His model fails to deal with the
problem of oligopolistic interdependcncc, Willinmsoli's theory is said
to hold only where rivalry between firms is not strong. In case there is
slrong rivalry, profit maximisation is claimed to be a more appropriate
hypothesis. Thus, Williamsons managerial utility function too does
not offer a more satisfactory hypothesis than profit maximisation.

Cyert-March Hypothesis of Satisfying Behaviour

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Cyert-March hypothesis is an extension of Simon's hypothesis of

firms' satisfying behaviour. Simon had argued that the real business
world is full of uncertainly liS accurate and adequate data are not
readily available, If data are available, managers have little time and
ability to process them, Managers alsc work under a number of
constraints. Under such conditions it is not possible for the firms to
act in terms of consistency assumed under profit maximisation
hypothesis. Nor do the firms seek to maximise sales and growth.
Instead they seek to achieve a satisfactory profit or a satisfactory
growth and so on. This behaviour of business firms is termed as
satisfaction behaviour.
Cyert and March added that, apart from dealing with uncertainty,
managers need to satisfy a variety of groups of people such as
managerial staff, labour, shareholders, customers, financiers, input
suppliers, accountants, lawyers, etc. All these groups have confiicting
interests in the business firms. The manager's responsibility is to
satisfy all of them. According to the Cyert-March, "firm's behaviour is
satisfying behaviour, which implies satisfying various interest groups
by sacrificing firm's interest or objectives." The basic assumption of
satisfying behaviour is that a firm is an association of different groups
related to various activities of the firms such as shareholders,
managers,

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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The objective level is also modified and revised on the basis of

achievements

and

changing

business

environment.

But

the

behaviouraI theory has been criticised on the following grounds:

Though the behavioural theory deals with the activities of the
business firms, it does not explain the firm's behaviour under
dynamic conditions in the long run.
It cannot be used to predict the firm's activities in the future.
This theory does not deal with the equilibrium of the business
industry.
This theory fails to deal with interdependecne or the linns and its
impact on linn's behaviour.
ROTHSCHILD's HYPOTHESIS

OF LONG-RUN SURVIVAL AND

MARKET SHARE GOALS

Rothschild suggested another alternative objective and alternative to
profit maximisation to a business firm. Accordingto Rothschild, the
primary goal of the firm is long-run survival. Some other economists
have suggested that attainment and 'retention of a market share
constantly, is an additional objective of the business firms. The
managers, therefore, seek to secure their market share and long-run
survival. The firms may seek to maxi mise their profit in the long run
though it is not certain.
Entry-prevention and Risk-avoidancel
Another

alternative

objective

of

firms

as

suggested

by

some

economists is to prevent the entry of new business firms into the

industry. The motive behind entry prevention may be any of the
following:

Profit maximisation in the long run.

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Securing a constant market share.

Avoidance of risk caused by the unpredictable behaviour of

new firms.

The evidence related to the firms to maximise their profits in the

long run, is not certain. Some economists argue that if management is
kept

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.

A Reasonable Profit Target

A business firm has variolls objectives to achieve. The survival of a
firmdepends on the profit it can make. So, whatever the goal of the
firm may be, it has to be a profitable firm. The other goals of a
business firm can be sales revenue maximisation, maximisation of
firm's growth, maximisation of managers utility function, long-run
survival, market share or entry-prevention. In technical sensc,
maximisation of profit, as a business objective, may not sound
practical , but profit has to be there in the objective function of the
firms for its survival. The firms may differ on the level of profit and
the extent to which it is to be achieved by various firms. Some firms
set standard profit as their objective, while some of them may set
target profit and some reasonable profit as their objective to be
achieved. A reasonable profit, as a business objective, is the most

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common objective. The policy question related to setting standard or

criteria for reasonable profits are as follows:
Why do modem corporations aim at a reasonable profit rather
than attempting to maximise profit?
What are the criteria for a reasonable profit?
How should reasonable profits be determined?
Following are the suggestions as given by various economists to
answer the above policy questions:
1. Preventing entry of competitors:

Under imperfect

market conditions, profit maximisation generally leads to

a high pure profit, which attracts competitors, especially
ill case of a weak monopoly. Therefore, the firms adopt a
pricing and a profit policy that assures them a reasonable
profit. At the same time, it also keeps the potential
competitors away.
2. Maintaining a good public image: It is often necessary
for large corporations to project and maintain a good
public image. This is because if public opinion turns
against it and government officials 'start questioning the
profit figures, firms may find it difficult to work smoothly.
So most firms set their prices lower than that to earn the
maximum

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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trade union activities.

4. Maintaining customer goodwill: Customer's goodwill
plays a significant role in maintaining and promoting
demand for the product of a firm. Customer's goodwill
depends on Jhe quality of the product and its fair price to
a large extent. Firms aiming at bcllcr profit prospects in
the long run, give up their short-run profit maximisation
objective in favour of a reasonable profit.
5. Other factors: The other factors that interrupts the profit
maximisation objective include the following:
A. Managerial utility function, which is preferable for,
profits maximisation to firms.
B. Friendly relations between executive levels within
the firm.
C. Maintaining internal control over management by
restricting firm's size and profit.
Standards of Reasonable Profits
Standards of reasonable profits are determined when a firm chooses
to make only reasonable profits rather than to maximise its profit. The
questions that arise in this regard are as follows:

What form of profit standards should be used?

How should reasonable profits be determined?

These questions can be understood after going through the

following explanatory points.

FORMS OF PROFIT STANDARDS
Profit standards is determined in terms of the following:

Aggregate money terms

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Percentage of sales, and

Percentage return on investment.

All these standards are determined for each product separately.

Among all the fonns of profit standards, the total net profit of the firm
is more common than other standards. But when the purpose is to
discourage the competitors, then the target rate of return on
investment is the appropriate profit standard, provided the cost
curves of competitors' are similar. The profit standard in terms of ratio
to sales is not an appropriate standard because this ratio varies
widely from linn to firm, evens irthey nil hove the snme return on
capital invested. These differences are following:

Vertieal integration of production process

Intensity of mechanisation

Capital structure

Turnover

SETTING THE PROFIT STANDARD

The following arc the important criteria that are considered while
selling the standards for a reasonable profit.
Capital-attracting standard: An important criterion of profit
standard is that it must be high enough to attract external
capital such as debt and equity. For example, if the firm's stocks
are sold in the market at 5 times their current earnings, it is
necessary for a firm to earn a profit of 20 per cent of the total
investment But there are certain problems associated with this
criterion, which are as follows:
Capital structure of the firms such as the proportions of
bonds, equity and preference shares, which affects the cost
of capital and thereby the rate of profit.

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 If the profit standard is based on current or long run

average cost of capital or not. The problem in this case
arises as it may also vary widely from company to company.

Plough-back' standard: This standard is appropriate in case

company depends on its own sources for financing its growth.

This standard involves the aggregate profit that provides for an
adequate plough-back for financing a desired growth of the
company without resorting to the capital market. This standard
of profit is used when liquidity is to be maintained by a firm and
a debt is to be avoided as per the profit policy of the firm. This
standard is socially less acceptable than capital attracting
standard. From society's point of view, it is more desirable that
all carnings are distributed to stockholders and they should
decide the further investment pattern. This is based on a belicf
that an individual is the best judge of his resource use and the
market forces allocate funds more efficiently, On the other hand,
retained

eamings,

which

are

under

the

control

or

the

managemcnt are likely to be wasted on low-earning projects

within a business firm. But to choose the most suitable policy
among

marketing

and

management

the

abilities

of

the

management and outside investors are to be considered. This

helps in estimating the earnings prospects of a firm.

Normal earnings standard: Another important criterion for

setting standard of reasonable profit is the normal earnings of
firms of an industry over a period. This serves as a valid
criterion of reasonable profit, provided it should take into
consider the following points:

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o Attracting external capital

o Discouraging growth of competition
o Keeping stockholders satisfied.
When average of normal earnings of a group of firms is used,
then only comparable firms are chosen. However, none of these
standards of profits is perfect. A standard should, therefore be chosen
after giving due consideration to the existing marke conditions and
public attitudes. Different standards arc used for different purposes
because no single criterion satisfies all conditions of the customers.
PROFIT AS CONTROL MEASURE
An important aspect of profit is its use in measuring and controlling
perfonnances

of the individuals of the large business

firms.

Researches have concluded that the business individuab of middle

and high ranks often deviate from profit objective and try 10
maximise their own utility functions. They give importance to job
security, personal ambitions for promotion, larger perks, etc. But this
often conflicts with firms' profit-making objective. The reasons for
conflicts as given by Keith Powlson are as follows:

More energy is spent in expanding sales volume and product

lines than in raising profitability.

Subordinates spend too much time and money doing jobs

perfectly regardless of its cost and usefulness.

Individuals depend more to the needs of job security in the

absence of any reward.
In order to control the conllicts and directing the individuals

towards

the

profit

objective,

the

top

management

uses

decentralisation and control-by-profit techniques. Decentralisation is

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achieved by changing over from functional division of business

activities such as production branch, sales division, purchase
department, etc. to a system of commodity wise division. By doing so,
managerial responsibilities are fixed in terms of profit. Under the
general policy framework, managers enjoy self-sufficiency in their
operations. They are allotted a certain amount to spend and a profit
target to be achieved by the particular division. Profit is then-the
measure of performance of each individual, not of the sales or quality.
This kind of reorganisation of management helps in assessing profitperformance of every individual. The two important problems that
arise in the determination of profits are as follows:

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.

Determination of divisional profits when there is a vertical

integration. The most appropriate profit standard of divisional
performance is calculated by deducting current expenses from
revenue of the firm.
Profit is essential for survival of a business. In the absence of

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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objectives, especially in case of large business firms, is the separation

of management from the- ownership. Moreover, profit maximisatjon
hypothesis is based on time. The empirical evidence against this
hypothesis is not conclU3ive and unambiguous. The alternative
hypotheses are also not so strong to repiace the profit maximisation
hypothesis. In addition to it, profit maximisation hypothesis has a
greater explanatory and predictive power than any of the alternative
hypotheses. Therefore, profil maximisation hypothesis still fornls the
basis of firms' behaviour.
PROFIT PLANNING AND FORECASTING
A business is considered to be sound if it includes consistency in
earning profit while considering the various risks as well. A firm is
faced with a number of untertainties. 1bese uncertainties are in
-terms

of nature of consumer needs,

the diverse

nature of

competition, the uncontrollable nature of most elements of cost and

the continuous technological developments. The uncertainty about
the pattern and extent of consumer demand for a particular product
increases the degree of risk faced by the firm. The nature of
competition

is

related

to

either

product,

price

or

to

both

simultaneously. Prodoct competition is more important till 'the

product reaches the stage of maturity. Price competition begins a fier
the product is established and reaches the maurity stage. During the
growth stage, the risk of obsolescence of a product and shortening of
the product life cycle is more. The degree of risk involved in product
competition is greater than in price competition. When the prices rise
continuously, no firm can be certain of its internal cost structure.
This is because it does not have any control over the prices of raw
materials or the wages to be paid to the individuals. In course of time,

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continuous

technological

improvements

may

make

production

completely obsolete. If an improved process is available, a firm can

restrict its risk by neglecting its fixed investment. If it does not have
an access to the improved processes, it may have to go out of
business. Unless a firm is prepared to face the uncertainties, as a
result of risk element, its profits will be changed. To plan for profits, a
thorough understanding of the relationship of cost, price and volume
is ext~emely helpful to business individuals. The most important
method of determining the cost-volumeprofit relationship is breakeven analysis, also known as cost-volume-profit (C-V-P) analysis.
Break-even analysis involves the study of revenues and costs of a firm
in relation to its volume of sales. It also includes the determination of
that volume at which the firm's costs and revenues will be equal. The
break-even point (BEP) may be defined as that level of sales at which
total revenue is equal to the total costs and the net income is zero.
This is known as no-profit no-loss point. The main objective of the
break-even analysis is not simply to find out the BEP, but to develop
an understanding between the relationships of cost, price and
volume.
DETERMINATION OF THE BREAK-EVEN POINT
It may be determined either in terms of physical units or in money
terms. This method is convenient for a firm producing single
prdducts only. The break-even volume is the number of units of the
product, which must be sold to earn revenue. This revenue should be
enough to cover all expenses, both fixed and variable. The selling
price of all units covers not only its variable cost but also leaves a
margin called contribution )l1argin to contribute towards the fixed
costs. The break-even point is reached when sufficient number of

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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 =

contribution margin per unit

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

Solution. Multi-product firms are not in a position to measure the

break-even point in terms of any common unit of product. It is
convenient for them to determine their break-even point in terms of
total rupee sales. The break-even point is the point where the
contribution margin is equal to the fixed costs. The contribution
margin is expressed as a ratio to sales. For example, if the sales is Rs.
200 and the variable costs of these sales is Rs. 140, the contribution
margin, ratio is (200 - 140)/200 or 0.3.
The formula for calculating the break-even point is:
Fixed costs
BEP =

contribution margin ratio

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Example 2:
Sales
Variable costs
Fixed costs

Rs. 10,000
Rs. 6,000
RS. 3,000

With the help of given information, calculate net profit.

Solution. The contribution margin ratio is (10,000-6,000)/10,000

= 0.4
Fixed costs
BEP =

contribution margin ratio

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

Example 3: Sales were Rs. 15,000 producing a profit of Rs. 400 in

a week. In the next week, sales amount to Rs. 19,000 producing a
profit of Rs. 1,200. Find out the BEP.
Solution.
Increase in sales

19,000 - 15,000 = Rs. 4,000

Increase in profit

1,200 - 400 =

Rs. 800

Increase in variable costs

4,000 - 800 = Rs. 3,200

Over sales of Rs. 4,000, variable costs are Rs. 3,200.

Hence VC per rupee of sale is 3,200 + 4,000 = 0.80.
Fixed costs will be as under:
Variable cost

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

Break-even Point as a Percentage of Full Capacity

Full capacity can be defined as the maximum possible volume
attainable with the firm's existing fixed equipment, operating policies
and practices. Break-even point is usually expressed as a percentage
of full capacity. Considering the example I, the full capacity of the firm
is 10,000 units; the break-even point at 5,000 units can be expressed
as 50 per cent of full capacity.
Multi-product Manufacturer and Break-even Analysis
Most manufacturers produce more than one type of product. The
determination of BEP in such cases is a little complicated and is
illustrated below:
Example 4: A manufacturer makes and sells tables, lamps and
chairs. The cost accounting department and the sales department
have supplied the following data:
~

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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

Capacity of the firm is Rs. 1,50,000 of total sales value.

Annual fixed cost - Rs. 20,000
Calculate (1) BEP and (2) Profit if firm works at 50 per cent of
capacity.

Solution. The contribution towards fixed cost in each case is:

.Table Rs. 10
Lamps Rs. 10
Chairs Rs. 20
Now, these contributions are to be converted into percentages of
selling prices, the formula to be applied is:
Contribution percentage =

Selling price - VC
Selling price

x 100

Thus, the contribution percentage for individual items is:

40 - 30

Table ---x 100 = - xl 00 = 25 per cent

40

50 - 40

---x 100 = - xl 00 = 20 per cent

50

70 - 50

---x 100 = -x 100 = 28.57 per cent

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70

Now, we multiply the contribution percentage of each of the

products by the percentage of sales volume for that particular
product and add the figures obtained. This gives the total
contribution per rupee of sales volume for tables, lamps and chairs.
This is done as follows:
Contribution

% 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:

1. BEP: The BEP orthe firm is calculated as under:

BEP =

Fixed costs
Contribution marginper unit =

20,000
Rs. 80,000
25%

2. Profit: Calculation of profit or loss at various volumes can also

be made easily. If the firm produces at 80 per cent of capacity,
the profit will be calculated as under:
Profit = Total revenue - Total costs
= 80% of (1,50,000) - Fixed costs - Variable costs
= 1,20,000 - 20,000 - 75% of (1,20,000)
= 1,20,000 - 20,000 - 90,000

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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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The break-even chart remains where the BEP is measured in

terms of sales value rather than in physical units. The only difference
is that the volume on the X-axis is measured in terms of sales value.
In that case, a perpendicular frqm the point BEP to either axis would
show the break-even rupee sales value. The same type of chart could
be used to depict the BEP in relation to full capacity. In this case the
horizontal axis would represent the percentage of full capacity, instead
of physical units or the sale value.
Break-even Chart-A Variation
The break-even chart is a variation of the traditional break-even
graph. This graph is prepared with the variable cost line instead of
fixed cost line, starting at the zero axis. On it is superimposed the
total cost, the line which includes the fixed cost and is, therefore,
parallel to the variable cost line. This graph is as much useful as the
contribution to fixed cost and profit. It is more deafly shown below in
the Figure 5.3.

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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

production volumes may differ significantly. However, these

assumptions are not so unrealistic so as to weaken the validity
of the break-even analysis.
4. In the case of multi-product firms, the product-mix shoulu be
stable. Fora multi-product firm, the BEP is determined by

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dividing total fixed costs by an average ratio of variable profit,

also called contribution to'sales. If each product has the same
contribution ratio, the BEP is not affected by changes in the
product-mix.
However, if different products have different contribution ratios,
shift in the product-mix may cause a shift in the break-even point. In
real

life,

the

assumption

of

stable

product-mix

is

somewhat

unrealistic.

Managerial Uses of Break-even Analysis

To the management, the utility of break-even analysis lies in the fact
that it presents a picture of the profit struture of a business firm.
Break-even analysis not only highlights the areas of economic strength
and weaknesses in the firm but also sharpens the focus on certaIn
leverages which cun be opernted upon to enhance its profitability.
Through brenk-even analysis, it is possible for the management to
examine the profit structure of a business firm to the possible
changes in business conditions. For example, sales prospects,
changes in Cust structure, etc. Through break-even analysis, it is
possible to use managerial actions to maintain and enhance
profitability of the firm. The break-even analysis can be used for the
following purposes:

Safety margin

Volume needed to attaintarget profit

Change in price Change in price

Expansion of capacity

Effect of alternative prices

Drop or add decision

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Make or buy decision

Choosing promotion-mix

Equipment selection

Improving profit performance

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 =

(Sales BEP) x 100

Sales

Example 5: Assume that our sales in Example 1 are 8,000 units.

Safety Margin =

(8,000-5,000) x 100
8,000

= 37.5%

Before incurring a loss, a business firm can afford to loose sales

up to 37.5 per cent of the present level. A decreasing safety margin
indicates that the firm's resistance capacity to avoid losses has
become poorer. A margin of safety can also be negative. A negative
safety margin is the percentage increase in sales necessary to reach
the BEP in order to avoid losses. Thus, it reveals the minimum extent
of effort in terms of sales expected by the management. Suppose in
the same example sales are us low as 4,000 units. The safety margin
would be:

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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 =
.

Fixed costs + Target profit

Contribution margin per unit

Example 6: Continuing with the same example, if the desired

profit is Rs. 6,000, the target sales volume would be calculated as
follows:
10,000 + 6,000
2

= 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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elasticity of demand may not be easily available. Breakeven analysis

helps the management to know the required sales volume to maintain
the previous level of profit. On the basis of this knowledge and
experience, it becomes much easier for -the management to judge
whether the required increase it sales will be feasible or not. The
formula to determine the new sales volume to maintain the same level
of profit, given a reduction in price, would be as under:
Qn =

FC + P
SPn - VC

where Qn = New volume of sales

FC = Fixed cost
P = Profit
SPn = New selling price
VC = Variable cost per unit (n denotes new)
Example 6(a): Continuing with the same example 6, if we propose
a reduction of 10 per cent in price from Rs. 4.00 to Rs. 3.60, the new
sales volume needed to maintain the previous profit ofRs. 6,000 will
be:
10, 000 + 6,000
3.60 2.00

16, 000
1.60

= 10,000 units

This shows that there is an increase of 2,000 units or 25 per cent

in sales. The management can also easily decide whether this increase
in sales volume is profitable for t~e business firm or not.
If a firm proposes the price increase, the question to be considered
is by how much the sales volume should decline before profitable
effect of the price increase gets eliminated.
Example 6(b): If the firm in example 6 considers an increase in
price by 12Y2per cent to Rs. 4.50, the new volume to maintain the old

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profit would be:

Q2=

10, 000 + 6,000

4.50 2.00

16, 000
2.50

= 6,400 units

In other words, if the fall in sales, due to an increase in price, were

less than 1,600 units or 20 per cent, it would be profitable for the firm
to increase the price. But if the decline were more than 1,600 units,
the proposed price increase would reduce the profit.
Change in Costs
Break-even analysis' helps to analyse the changes in variable
cost and fixed cost, which are explained as follows.
Change in variable cost: An increase in variable costs leads to
a reduction in the contribution margin. In such a situation, a firm
determines the total sales volume needed to maintain the prescnt
profits withcut any increase in price. A firm also determines the price
lhut should be set to maintain the present level of profit without any
change in sales volume. The formulae to determine the new quantity
or the new selling price, given a change in variable costs, are:
1. The new quantity will be:
Qn =

FC +P
SP - VC n

2. The new selling price will be:

SPn = SP + (VCn- VC)
Example 6(c): Continuing with the example 6, if variable cost
increases from Rs. 2 to Rs. 2.50 per unit.

Q2=

10, 000 + 6,000

4 2.50

15, 000
1.50

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= 10,667 units

SPn = 4 + (2.50 - 2) = Rs. 4.50

Change in fixed cost: An increase in fixed costs of a firm is
caused either by external circumstances such as an increase in
property taxes or by a managerial decision such as an increase in
executive salaries. In both the cases, the affect is to raise the breakeven point of the firm, while keeping the prices unchanged. The same
determination is undertaken by the firm regarding the sales volume
while keeping the profit level same as before. The formulae to
determine the new quantity or the new price, given a change in fixed
costs, would be:
1.
Qn= Q +

FCn FC
SP - VC

SPn = SP +

FCn FC
Q

2.

Example 6 (d): Continuing with the same example 6, if fixed

cost increases from Rs. 10,000 to Rs. 15,000.

Expansion of Capacity
The management may also be interested in knowing whether to
expand

production

capacity

or

not,

through

the

installation

equipment. Though even analysis, it wuuld be possible to examine the

various applkutions of this proposal or installation of the additional
equipment. The following example illustrates the points involved.
Example 7: A textile mill is considering a proposal to increase
its investment in fixed assets. If it decides to do so, fixed expenses will

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go up by Rs. 5,00,000 per year without affecting the percentage of

variable expenses. With the present plant, the maximum production is
estimated at an amount, which would enable the company to make
annual sales of Rs. 60,00,000. The increased production with the
additional plant would permit the company to make annual sales of
Rs. 80,00,000. The relevant cost, sales and profit data for 1997 are:

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

There are a number of points involved in the decision on

expansion of capacity. The information regarding the expansion of
capacity is as follows:

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

The expansion of capacity, to enable the firm so as to expand its

sales potential from Rs. 60,00,000 to Rs. 80,00,000, will increase
the maximum profit potential of the firm from Rs. 6,60,000 to Rs.
8,80,000. But there are certain risks involved. Answer the following
on the basis of above information:
1. How will the expansion of the firm's capacity will affect the
break-even point?
2. What would be the sales volume required to maintain the
present profit with the increased fixed costs?

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Solution. It is evident that the break-even point of the firm would

be pushed up from Rs. 41, 66,667 to Rs. 55, 55,556. This means that
if the sales remain at the present level, the firm would operate at a
loss.
The minimum sales volume needed to maintain the present profit
would be Rs. 63,88,889, i.e., an increase of about 28 per cent there is
another aspect. To earn the maximum profit possible at the present
sales capacity, i.e., Rs. 6,60,000 with the increase in fixed costs, the
minimum sales volume needed would be Rs. 73,88,889, i.e., an
increase of 48 per cent. So the decision on the question of expanding
capacity hinges on the possibilities of expanding sales by the various
percentages indicated above. The fact that the present sales volume is
20 per cent less than the maximum possible sales volume of the
existing plant may be an indication that if may be difficult to expand
sales. Another way of presenting the same infonnation is the profitvolume chart. On the assumption that production efficiency and
prices will remain unchanged, the profit-volume chart can help in
presenting the following:
The break-even points before and after expansion, and
At what capacity utilisation, the profit will be the same as at 100
percent capacity utilisation before expansion. The following
Figure 5.5. shows the profit volume chart.

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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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analyst, while choosing a trial price, relies largely upon their

experience and judgement. Customary price is one such price. The
following Figure 5.6 shows the effect of BEP in alternative prices.

Drop or Add Decision

An economist takes the decisions regarding the following:
Addition of a new product keeping in consideration, its cslimated
revenue and cost.
Deletion

of

product

from

the

product-line

keeping

in

consideration, its consequent effects on revenue and cost.

Break-even analysis is also useful in taking decisions related to
product planning. It can be understood with the help of following
example:
Example 8: The following are the present cost and output data of a
manufacturer:
Product
Book-cases

PrLe
(Rs.)
60

Variable costs
Per unit
(Rs.)
40

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% of
sales
30

Tables
Beds

100
200

60
120

20
50

Total fixed costs per year: Rs. 75,000

Sales last year: Rs. 2,50,000.
The manufacturer is considering whether to drop the line of taoles
and replace it with cabinets. If this drop-and-add decision is taken,
the cost and output data would be as follows:
Product
Book-cases
Tables
Beds

Price
(Rs.)

Variable costs
Per unit
(Rs.)
40
60
120

60
160
200

% of sales
50
10
40

Total fixed cost per year: Rs. 75,000

Sales this year: Rs. 2,60,000.
On the basis of ubove informntion delermine if the change worth
undertaking by the business firm?
Solution. On the basis of the information given in the question,
the profit on the present product line is computed as follows:

Rs. 60 - 40
60

x 30% = 0.10

Rs. 100 - 60
100

x 20% = 0.08

Rs. 200 - 120

200

x 50% = 0.20/0.38

Thus, the contribution ratio is 0.38, by adding 0.10, 0.08 and

0.20.

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Total contribution = Rs. 2,50,000 x 0.38 = Rs. 95,000.

Profit = Rs. 95,000 - Rs. 75,000 = Rs. 20,000.
Profit on the proposed product line would be as under:
Rs. 60 - 40
60

x 50% = 0.17

Rs. 160 - 60
160

x 10% = 0.06

Rs. 200 - 120

200

x 40% = 0.16

Thus, the contribution ratio is 0.39.

Total contribution = Rs. 2,60,000 x 0.39 = Rs. 1,01,400.
Profit = Rs. 1, 01,400 - 75,000 - Rs. 26,400.
Hence the proposed change is worth undertaking.
Make or Buy Decision
Many business firms may opt to produce certain components or
ingredients, which are part of there finished products, or purchasing
them

from

outside

suppliers.

For

instance,

an

automobile

manufacturer can make spark plugs or buy them. Breakeven analysis

can enable the manufacturer to decide whether to make or buy. With
the help of following example, this can be easily understood:
Example

9:

manufacturer

of

sc.ooters

buys

certain

components at Rs. 8 each. In case he makes it himself, his fixed and

variable costs would be Rs. 10,000 and Rs. 3 per component
respectively. Should the manufacturer make or buy the component?
If the manufacturer needs more than 2,000 components per year,
to make or produce the components is more profitable than to buy.

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There are some special considerations, which helps in choosing the

best option, are as follows:
Solution. This can be detennined after calculating break-even
point of the manufacturer's firm, The break-even point is as follows:
Fixed costs
BEP =

Purchse price Variable Cost

10,000
=

8-3

10,000
=

= 2,000

Quality: By manufacturing a certain part of the product itself,

the firm is able to exercise control over quality. This may also
lead to reduction in assembly costs and increase in consumer
goodwill. This helps in enhancing the future sales. The outside
suppliers may also possess a highly specialised knowledge,
which may outshine the know-how of the firm. In this situation
a firm, a firm may feel that it cannot match with the quality
assured by outsiders. Here, a firm is advisable to buy the high
quality products from other firms so as to avoid the loss due to
poor quality. This could also result in fewer sales.

Assurance of supply: By producing a product itself, a firm may

secure the advantage of co-ordinating the flow of parts more
effectively. Sometimes, the suppliers are unable to meet the
demand or make deliveries within the required time period. So,
this is also an advantage for the firm to produce high quality
products and to give its best for the betterment of society.

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Defence against monopoly: A firm can also manufacture parts

to protect itself against a monopoly in supply. If a firm produces
some of it products itself, the other firms are less likely to
overcharge or dictate thelT: in any respect. So producing a part
of the product is also beneficial for a firm.

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

The formula for finding out the volume of sales necessary to

achieve the age! Profit is:
Fixed cost + Target profit
Target sales volume =

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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is to be made in between three or more methods, depending upon the

most economical one. The following example explains how to
determine these ranges.
Example 11: A manufacturer has to choose from amongst three
machines for his factory. The conditions, which he wants to be fulfilled
regarding the three machines, are as follows:
1. An automatic machine which will add Rs. 20,000 a year to his
fixed costs but the variable costs per unit will be only 40 p.
2. A semi-automatic machine which will add Rs. 8,000 a year to
his fixed costs but variable cost$ per unit will be Rs. 2 and
3. A hand-operated machine which will add only Rs. 2,000 a year
to his fixed costs but will cause variable costs per unit of Rs. 4.
Calculate the range of output over which automatic, semiautomatic and hand-operated machines would be most economical.
How would you choose between hand-operated and automatic
machines, supposing the semi automatic machine does not exist?
Solution. The cost formulae for the three machines would be,
Machine
Automatic
Semi-automatic
Hand-operated

Cost formula
Rs. 20,000 + 0.40 S
Rs. 8,000 + 2.00 S
Rs. 2,000 + 4.00 S

Now setting pairs of equations to each other, and solving them

to final the Value of S:
1. Automatic vs. Semi- Nutomatie
Rs. 20,000 + 0. 40S

= Rs. 8,000 + 2S

or, 1.60S

= 12,000

or, S =

12000
1.60

= 7,500 units

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2. Semi-automatic vs. Hand-operated:

Rs. 8,000 + 2.00S

= Rs. 2,000 + 4S

or, 2S

= 6,000

or, 8

= 3,000 units

Thus, up to 3,000 units, hand-operated machine is to be used.

The semiautomatic machine is to be used over the range of 3,000 7,500 units.
Beyond 7,500 units, automatic machine should be used. If,
however, the choice is to be made between hand-operated and
automatic machines, the former; is to be used up to 5,000 units and,
thereafter, the latter would be more economical. This is calculated as
under:
2,000 + 48 = Rs. 20,000 + 0.40
or,
or,

3.60S = 18,000
8 = 5,000 units.

IMPROVING PROFIT PERFORMANCE

There are four specific ways in which profit performance of a
business can be improved, which are as follows:

Increasing the volume of sales: Considering the example I,

the present volume of sales is 8,000 units and the maximum
production capacity 10,000 units. If the sales are increased to
the maximum production capacity, there will be an increase in
variable expenses only. The profit will increase from, Rs.6,000
to Rs. 10,000. It will be seen that though the increase in sales
volume has been only to the extent of 25 per cent, profit has
increased by 67 per cent.

Increasing the seIling price: An increase in the price

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increases the contribution margin and reduces the break-even

point. Continuing with Example I, if the selling price is
increased by 10 per cent, the profit will increase from Rs. 6,000
to Rs. 9,200 showing an increase of more than 50 per cent.

Reducing the variable expenses per unit: If the variable

expenses are reduced by 10 per cent to Rs. 1.80, the profit will
increase from Rs. 6,000 to Rs. 7,600 at the present volume of
sales. This increase is more than 25 per cent, which is more
than the percentage reduction in variable expenses. In costvolume-profit relationship, the higher proportionate increase in
profit than the change in selling price or the volume of sales or
the variable expenses is called the leverage effect. At times, it is
not possible to increase the prices, but to increase the volume
of sales and to reduce the variable expenses is possible.

Reducing the fixed cost: A reduction in fixed costs, without a

change in variable expenses and the selling price, would lead to
an equal change in the profits. For example, if the fixed
expenses are reduced from Rs. 10,000 to Rs. 9,000 in the
above illustration, profit will increase from Rs. 6,000 to Rs.
7,000. As a change in the fixed costs does not change the
contribution margin per unit, there is no leverage effect.

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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Example 12: The management of Swadeshi Cotton Mills, Kanpur,

is interested in finding out the quantities of cloth X and Y for
production in a week in order to maximiese profits. The total hours
required to produce 100 metres of each cloth are 20 and 25
respectively. The total hours available per week are 9,600. The
maximum possible sales of cloth X and Y for one week as estimated
are: X = 30,000 metres, Y for 40,000 metres.
The following table shows, the variable costs and selling price per
metre:

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

This plan shall provide profits as shown below:

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Total Revenue = Rs. 38,400 x 3.80 =

Rs. 1,45,920

Total cost:

Variable cost = Rs. 38,400 x 3 = Rs. 1,15,200

Fixed cost

21,400
Net porfit

1,36,600
Rs. 9,320

Policy Guidelines Originating from Break-even Analysis

There are certain useful conclusions in terms of policy guidelines,
which may be drawn from break-even analysis as a result of the effect
of changing conditions on a firm's operations, policies and actions. A
high BEP indicates the weakness regarding the profit position of the
firm. To reduce the BEI therefore, the selling price should be
increased, variable and fixed costs should be reduced. If the variable
costs per unit asre large (Business 8 in Example 13), an increase in
selling price or a reduction in variable costs would be morc eLective.
Whether it is more desirable to raise prices or practicable to cut down
variable costs, depends upon competitive market conditions, the
elasticity of demand for firm's product and the efficiency of its
operations. When the cOi.lribution margin rer unit is comparatively
large (Business A in Example 13), the firm is advised to lower the BEP
by reducing the level of fixed costs.

The higher the contribution margin, the higher is the survival of

business or vice-versa. Business A with a higher contribution margin
can survive even if the prices drop to 50 paise per unit. Business B
with a lower contribution margin will have to close down its
operations if prices drop to 50 paise. In a period of boom, whcn both
the prices as well as sales rise, a firm with a higher percentage of

BSPATIL

fixed costs to sales earns higher profits as compared to a business

with a higher percentage of variable expenses to sales. On the other
hand, in a period of depression, when both the prices as well as sales
decrease, the business with a higher percentage of fixed costs to sales
suffers greater losses than the business with a higher percentage of
variable expenses.
Example 13: The following example of two businesses, A and B,
illustrates some of the points contained in the text above.

Selling price per unit

Business A
Re. 1.00

Business B
Re.I.OO

Variable cost per unit

Re.0.20

Re.0.60

RS.5,000

Rs.2,500

Fixed costs per year

With the help of above infonnation, find which of the businesses

among A and B is profitable for the business firm to suspend
operations? Give explanations to support your answer.
Solution. The break-even point of both the businesses is 6,250
units or Rs. 6,250. If the sales are 10 pefcent above the BEP,
business A gains Rs. 500 while business B gains only Rs. 250. If the
sales are below the BEP, say 5,000 units, business A loses Rs. 1,000
and business B loses only.
Rs. 500. If the market collapses and the prices also go down to
50 paise per unit and sales drop to, say, 3,000, business A suffers a
loss of Rs. 4, 100 while business B suffers a loss of only Rs. 2.500
(the amount of fixed expenses only ns it would find it unprofitable to
continue operntions). But one signifiennt point is that whilc business
A can continue to operate and contribute 30 paise per unit, sold
towards fixed expenses. Business B will find it profitable to suspend
operations.

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Limitation of Break-even Analysis

There arc some important limitations of break-even analysis, which
arc to be kept in mind while using break-even analysis. These
limitations are as follows:

When break-even analysis is based on accounting data, it may

suffer from various limitations of such data, such as
negligence towards imputed costs, arbitrary depreciation
estimates and inappropriate allocation of overhead costs.
Break-even analysis, therefore, can be sound and useful only
if the firm in question maintains a good accounting system
and uses proper managerial accounting techniques and
procedures. The figures must also be adequate and sound. If
break-even analysis is based on past data, the same should be
adjusted for changes in wages and price of raw materials.

Break-even analysis is static in character. It is based on the

assumption of given relationship between costs and revenues.
On the one hand and input, on the other. Costs and revenues
may change over time making the projection, based on past
data wrong. Therefore, break-even analysis is more useful only
in situations relatively stable while it does not work effectively
in volatile, erratic and widely changing ones.

Costs in a particular period may not be caused entirely by the

output in that period. For example, maintenance expenses
may be the result of past output or a preparation for future
output. It may therefore, be difficult to relate them to a
particular period.

Selling costs are especially difficult to handle in break-even

analysis. This is because changes in selling costs are a cause

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and not a result of changes in output and sales.

A straight-line total revenue curve prcsumcs that any quantity
should be sold at onc price only. This implies a horizonwl
demand curve and is true only under conditions of perfect
competition. The situation of perfect ~ competition is rare in real
world, which restricts the application of many total revenue
curves.

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.

Break-even analysis is not an effective tool for long-range use

and its use should be restricted to the short run only. The
break-even analysis should better be limited to the budget
period of the firm, which is usually the calendar year.

The area included in the break-even analysis should be limited

if too many products, departments and plants are taken
together and graphed on a single break-even chart: it will be
difficult for the fim1 to distinguish between the good and bad
performances of the business firm.

Break-even analysis assumes that profits arc a function of

output ignoring the fact that they arc also caused by other
factors such as technological change, improved management,
changes in the scale of the fixed factors of production and so on.

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To conclude, it can be said that break-even analysis is a device,

simple, easy to understand and inexpensive and is there fore, useful
to management. Its usefulness varies from a firm to another firm and
also among industries. Industries suffering from frequent and
unpredictable changes in input prices, rapid technological changes
and constant shifts in product mix will not benefit much from breakeven analysis. Finally, break-even analysis should be viewed as a
guide to decision-making and not as a substitute for judgement,
logical thinking.
PROFIT FORECASTING
Profit planning cannot be done without proper profit forecasting.
Profit

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:

Spot Projection: Spot projection includes projecting the profit

and loss statement of a business firm for a specified future
period.

Projecting

of

profit

land

loss

statement

means

forecasting each important element separately. Forecasts are

made about sales volume, prices and costs of producing the
expected sales. The prediction of profits of a firm is subject to
wide margins of error, from forecasting revenues to the interrelation of the various components of the income statement.

Brcak-even analysis: It helps in identifying functional relations

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of both revenues and costs to output rate, kecping in

consideration the way in which output is related to the prolits.
It also helps in doing so by relating profits fo output directly by
th.e usual data used in break-even analysis.

Environmcntal analysis: It helps in relating the company's

profits to key variabk, in the economic environment such as the
general business activity and the general price level. These
variables are not considered by a business firm.

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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facilitating good spot guesses. It can also enhance the accuracy of

break-even analysis.
REVIEW QUESTIONS
1. Distinguish between the following concepts or profit:
A. Accounting profit and economic profit.
B. Normal profit and monopoly profit.
C. Pure profit and opportunity cost.
2. Examine critically profit maximisation as the objective of
business firms. What are the alternative objectives of business
firms?
3. Explain the first and second order conditions of profit
maximisation.

4. Profit maximisation is theoretically the most sound but

practically unattainable objective of business firms. Do your
agree with this statement? Give reasons for your answer.
5. Explain how profit is used as a control measure. 'What
problems are associated with the use of profit figures as a
control measure?

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LESSON NO-6

NATIONAL INCOME

National income is the final outcome of total economic activities of a

nation. Economic activities generate two kinds of flow in a modern
economy namely, product-flow and money-flow. Product-flow refers to
flow of goods and services from producers to final consumers. Money
flow refers to flow of money in exchange of goods and services. In this
exchange of goods and services, money income is generated in the
form of wages, rent, interest and profits, which is known as factor
earning. Based on these two kinds of flows, national income is defined
in terms of:
Product flow
Money flow
DEFINITION OF NATIONAL INCOME
National Income in Terms of Product Flow
National income is the sum of money value of goods and services
generated from total economic activities of a nation. Economic
activities result into production of goods and services and make net
addition to the national stock of capital. These together constitute the
national income of closed economy'. Closed economy refers to an
economy, which has no economic transactions with the rest of the
world. I lowcvcr, in an opcn ecollomy, natiollul incomc ulso includes
the net results of its transactions with the rest of the world, i.e.,
exports less imports.
Economic activities should be distinguished from the noneconomic activities from national income point of view. Broadly

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speaking, economic activities include all human activities, which

create goods and services that can be valued at market price.
Economic activities include production by farmers (whether for
household consumption or for market), production by firms in
industrial sector, production of goods and scrvices by thc govcfl1ment
cntcrpriscs, and services produced by business intermediaries
(wholesaler and retailcr), banks and other financial organisations,
universities, colleges and hospitals. On the other hand, noneconomic
activities arc those activities, which produce goods and serviccs that
do 110t have economic value. The non-economic activities include
spiritual, psychological, social and political services, hobbies, service
to selr serviccs of housewives services of members of family to other
mcmbers and cxchangc of mutual services between neighbours.
National Income in Terms of Money Flow
While economic activities generate flow of goods and services, on the
other hand, they also generate money-flow in the form of f~lctor
payments such as, wages, interest, rent, prolits and earnings of selfemployed. Thus, national insome can also be obtained by adding the
factor earnings after adjusting the sum for indirect taxes, and
subsidies. The national income thus obtained is known as national
income at factor cost.
The concept of national income is linked to the society as a whole.
However, it differs fundamentally from the concept of private income.
Conceptually, national income refers to the money value of the final
goods and services resulting from all economic activities of a country.
However, this is 110t true for the private income in addition, there are
certain receipts of money or of goods and services that are not
ordinarily included in private incomes but are included in the national

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incomes and vice versa. National income includes items such as

employer's contribution to the social security and welfare funds for the
benefit of employees, profits of public enterprises and servIces of
owner occupied houses. However, it excludes the interest on warloans, social security benefits and pensions. Instead, these items are
included in the private incomes. The national income is therefore, not
merely an aggregation of the private incomes. However, an estimate of
national income can be obtain by summing up the private incomes
after making necessary adjustment for the items excluded from the
national income.
MEASURES OF NATIONAL INCOME
The various measures of national income are as follows:
Gross National Product (GNP)
There are several measures of national income used in the analysis of
national income. GNP is the most important and widely used measure
of national income. GNP is defined as the value of final goods and
services produced during a specific period, usually one ycar, plus the
diflcrence between foreign receipts and" pnyment. The GNP so defined
is identical to the concept of 'Gross National Income (GNl)', Thus, GNP
= GNI. The difference between the two is that while GNP is estimated
on the basis of product-flows, the GNI is estimated on the basis of
money flows.
Net National Product (NNP)
Net National Product (NNP) is the total market value of all final goods
and services produced by citizens of an economy during a given
period of time minus depreciation, i.e., Gross Nationnl Product less
depreciation.

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NNP = GNP - Depreciation

Depreciation is that part of total productive assets, which is used
to replace the capital worn out in the process of creating GNP. In
other words, while producing goods and services including capital
goods, a part of total stock of capital is used up. This part of capital
that is used up is termed as depreciation. An estimated value of
depreciation is deducted from the GNP to arrive at NNP.
The NNP, as defined above, gives the measure of net output
available for consumptionhy the society (including consumers,
producers and the government), NNP is the real measure of the
national income. In other words, NNP is same as the national income
at factor cost. It should be noted that NNP is measured at market
prices including direct taxes. However, indirect taxes are not included
in the actual cost of production. Therefore, to obtain real national
income, indirect taxes are deducted from the NNP. Thus,
National income = NNP - Indirect taxes
National income: Some accounting relationships

Relations at market price GNP = GNI

o Gross Domestic Product (GDP) = GNP less net income
from abroad
o NNP = GNP less depreciation
o NDP (Net Domestic Product) == NNP less net income from
abroad

Relations at factor cost

o GNP at factor cost = GNP at market price less net indirect
taxes.
o NNP at factor cost = NNP at market price less net indirect
taxes

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o NDP at factor cost = NNP at market price less net income

from ahroad
o NOP at factor cost = NDP at market price less net indirect
taxes
o NOP

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:

The national economy is considered as an aggregate of

producing

units

combining

different

sectors

such

as

agriculture, mining, manufacturing and trade and commerce.

The whole national economy is viewed as a combination of

individuals and household owning different kinds of factors of
production, which they use themselves or sell-their factor
services to make their livelihood.

National economy is also viewed as a collection of consuming,

saving

and

investing

units

(individuals,

households

and

government).
The above notions of a national economy helps to measure
national Income by following three different methods:

Net output method

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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method is used when whole national economy is considered as an

aggregate of producing units. In its standard form, this method
consists of three stages:
1. Measurement of gross value of domestic output in the
various branches of production: For measuring the
gross value of domestic product, output is classified
under various categories on the basis of the nature of
activities

from

which

they

originate.

The

output

classification varics from country to country dey'ending

on

(i)

the

nature

of

domestic

activities,

(ii)

their

significance in aggregate economic activities and (iii)

availability ofrecjuisite data. For example, in USA, about
seventy-one divisions and sub-divisions are used to
classify the national output, in Canada and Netherlands,
classification ranges from a dozen to a score and in
Russia, only half-a-dozen divisions are used. According to
the CSO publication, If fleen sub-categories are currently
used in India. After the output is classified under the
various categories the value of gross output is is
computed in two alternative ways by:
A. Multiplying the output of each earegory of acctor
by their respective market price and adding them
together.
B. Collecting data regarding the gross sales and
changes in inventories from the account of the
manufacturing firms to compute the value of GDP.
If there arc gaps in data then some estimates are
made to fill the gaps.

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2.

Estimation of cost of materials and services

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

countries adopt faclorincome method for estimating their

national income.

However,

countries

adopting

net-

product method find some means to calculate the

deductible cost. The costs are estimated either in
absolute

terms

(where

input

data

are

adequately

available) or as an overall ratio of input to the total

output. The general practice in estimatmg depreciation is
to follow the usual business practice of depreciation
accounting. Traditionally, depreciation is calculated at
some percentage of capital, permissible under the taxlaws.

In

some

estimates

of

national

income,

the

estimators have deviated from the traditional practice

and have instead estimated depreciation as some ratio of
the currenL output of final goods. FoI1owing a suitable
method, deductible costs including depreciation are
estimated for each sector. The cost estimates are then
deducted from the sectoral gross output to ohtain the
net sectoral products. The net sectoral products are then
added together. The total thus obtained is taken to be

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the measure of net nationa I products or national

income by product method.
3. Deduction of these costs and depreciation from gross value to
obtain the net value of domestic product: Net value of domestic
product is often called the value added or income product. Income
product is equal to the sum of wages, salaries, supplementary
labour incomes, interest, profits, and net rent paid or accrued.

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.

Labour Income: Labour incomes included in the national income

have five components:
Wages and salaries paid to the residents of the country including
bonus, commission and social security payments.
Supplementary labour incomes including employer's contribution
to social security and employee's welfare funds and direct
pension payments to retired employees.
Supplementary labour incomes in kind such as free health,
education, food, clothing and accommodation.
Compensations in kind in the form of domestic sr-rvants and
other free ofcost services provided to the employees arc included
in labour income.
Bonuses, pensions, service grants are not included in labour
income as they are regarded as 'transfer payments'. Certain other
categories of income such as incomes from incidental jobs,
gratuities and tips are ignored because of non-availability of data.

Capital Incomes: According to Studenski, capital incomes include

following Incomes:

Dividends excluding inter-corporate dividends

Undistributed profits of corporation before-tax
Interests on bonds, mortgages and savings deposits

(excluding
interests on bonds and on consumer credit)

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 Interest. earned by insurance companies and credited to the

insurance policy reserves
Net interest paid by commercial banks
Net rents from land and buildings including imputed net rents
on owneroccupied dwellings
Royalties
Profits of government enterprises.
The data for the first two incomes is obtained from the firms'
accounts submitted for taxation purposes. There exist difference in
definition of profit for national accounting purposes and taxation
purposes. Therefore, it is necessary to make some adjm.ments in the
income-tax data for obtaining these incomes. The income-tax data
adjustments

generally

pertain

to

(i)

Excessive

allowance

of

depreciation made by tax authorities, (ii) Elimination of capital gains

and losses since these do not reflect the changes in current income,
and (iii) Elimination of under 0,' overvaluation of ir:ventories on
book-value,
Mixed Income: Mixed incomes include income from (a) fanning (b)
sole proprietorship (not included ,Ilnder profit or capital income) (c)
other professions such as legal and l.ledical practices, consultancy
services, trading and transporting. Mixed income also includes
incomes of those who earn their living through various sources such
as wages, rent on own property and interest on own capital.
All the three kinds of incomes, viz., labour incomes, capital
incomes and Inixed incomes added together give the measure of
national income by factorincome method.
Expendit4re Method
The expenditure method, is also known as final product method. This

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method is used when national economy is viewed as a collection of

spending units. It measures national income at the final expenditure
stages. In other words, this method measures final expenditure on
'GDP at market prices' at the stage of disposal of GDP during an
accounting year. In estimating the total national expenditure, any of
the following two methods are followed:

First method: Undcr this mcthod all the 111011';y cxpcnditurc

III IIlllrkc( prkc arc computed and added up to arrive at total
national expenditure. The items of expenditure which are taken
into account under the first method are (a) private consumption
expenditure, (b) direct tax payments, (c) payment? to the nonpro;it-making institutions and charitable organisations like
schools, hospitals and orphanage, and (d) private savings.

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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open economics exchange goods and services with rest of the

world. In this exchange of goods and services, som\: nations
make net income through foreign trade through exports while
some lose their income to the foreign nations through imports.
These incomes are called as Net Factor Income from Abroa:d
(NFIA). The net earnings or losses in foreign trade affect the
national income. Therefore, in measuring national income the
net results of external transactions are adjusted to the total
national income arrived through any of the three methods. The
total income from abroad is added and net losses to the
foreigners are deducted from the total national income. All the
exports of merchandise and of services such as, shipping,
insurance, banking, tourism and gifts are added to the national
income. On the contrary, all the imports of the corresponding
items are deducted from the value of national output to arrive at
the approximate measure of national income.
Net Investment From Abroad: Net investment from abroad refers
to the di ITerllliee between investment a nation made abroad and
the in vcst mcnt 111nde h~, thc rc~t or Ill(' world ill Ihnt
1If1liOIl. Thi'1'\\ ill\',\~tll"\I1I~ <I' \ mldeu (0 the l\lIt i01l1l1 i
Ilcume clllcullllcd II lieI' addillg or deduct illg N I: 1..\ from it.
Choice of Methods
As discussed above, there are standard methods of measuring the
national incOJ11I.: such as net output method, factor-income method
and expenditure method. 1\11 the I three methods would give the
same measure of national income, provided rcquisitc data for each
method arc adequately available. Therefore, any of the three methods
can be adopted to measure the national income. However, not all the

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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

Availability of necessary data.

If objective is to analyse the net output, then the net output

method would be more suitable. In case, objective is to analyse the
factor-income distribution then, suitable method would be income
method. If objective at hand is to find out the expenditure pattern of
the national income then the expenditure method is more suitable.
However, availability of adequate and appropriate data is relatively
more important considerations in"selecting a method of estimating
national income.
However, the most common method is the net output method
because of the following reasons:
It requires classification of economic activities and output,
which is much easier to classifY than the income or expenditure.
The most common practice is to collect and organise the
national illcom!.; data by the division of economic activities.
Therefore, easy availability of data on economic activities is the
main reason for the popularity of the .output method.
However, it should he borne in mind that no single method can
give an accurate measure of national income. This is because no
country's statistical system provides the total data requirements for a
particular method.
The usual practice is therefore, to combine two or more methods to

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measure the national income. The combination of methods again

depends on the nature of required data and the sectoral breakdown of
the available data.
Measurement of National Income in India
In India, a systematic measurement of national income was first
attempted in 1949. Earlier, some individuals and institutions made
many attempts. Dadabh'\i Narojoji made the earliest estimate of
India's national income in 1876 for the year 1867-68. Since then,
mostly the economists and the government authurities made many
attempts to estimate India's national income.
These estimates differ in coverage, concepts and methodology and
they are not comparable. Besides, earlier estimates were made mostly
for one year, only some estimates covered a period of 3-4 years. It was
therefore, not possible to construct a consistent series of national
income and assess the pcrforniance of the economy over a period of
time. It was only in 1949 that National Income Committee (NIC) was
appointed with PC. Mahalanobis, as its Chairman and D.R. Gadgil
and V.K.R.V. Rao as its members. The NIC not only highlighted the
limitations of the statistical system that existed at that time but also
suggested ways and means to improve data collectiol1' systems. On
the recommendation of the Committee, the Directorate of National
Sample Survey was set up to collect additional data required for
estimating national income. Besides, the NIC estimated country's
national income for the period from 1948-49 to 1950-52. In its
estimates, NIC also provided the methodology for estimating national
income, which was followed until 1967.
After the NIC, the task of estimating national income was taken
over by the Central Statistical Organisation (CSO). Until 1967, the

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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

manufacturing (vii) Construction (viii) Electricity, gas and water

supply (ix) Transport and communication (x) Real estate and
dwellings (xi) Public Administration and Defence (xii) Other services
and (xiii) External transactions. The national income is estimated at
both constant ar.d current prices.
Growth and Composition of India's NaConallncome
The following Tables present the growth and change in composition of
India's national income, both at factor cost and current prices. Table.
6.1 presents the decennial trends in national income aggregates like

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GDP, GNP, NDP, NNP, Netfactor income from abroad, capital

consumption and indirect tax and subsidies. Table 6.2 presents the
change in the composition of national income classified under five
broad categories. Table 6.3 presents the decennial annual average
growth rate of GNP and GDP at constant prices. It can be seen from
Table 6.2 that the composition of India's national income has changed
considerably over the past four decades. The share of ~griculture has
declined from 55.8% in GDP in 195051 to 31.3% in 1994-95 and that
of industrial sector increased from 15.26 to 27.5 % during th; same
period.

Table 6.1: National Income Aggregates-1960-61 to 1994-95

(Decennial) (At current prices) (Rs. Crores)
A

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

to Indian Economy, Aug 1994

Table 13.3

Table 6.2: Change in Composition of National Income (GDP) (At

current prices) (Rs. Crores)
Sectors

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

Inflation and Deflation

The term 'inflation' is used in many senses and it is difficult to give a

generally accepted, precise and scientific definition of the term.
Popularly, inflation refers 1O a rise in price level. Kemmerer states,
"Inflation is too much money and deposit currency that is too much
currency in relation to the physical volume of business being done."
This is what Coulburn also means when he defines inflation as, "Too
much money chasing too few goods". According to T.E. Gregory,

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inflation is "abnormal increase in the quantity of money".

The implication in these definitions is that prices rise due to an
increase in the volume of money as compared to the supply of goods.
This is the quantity approach to the rise in the price level. However, it
should be noted that prices may rise due to other factors also such
as rise in wages and profits. Besides, there can be an inflationary
pressure on prices without actually rising of the prices.
Keynesian Definition
Kl:YlH:S rdales inl1ation to a price level that comes into existence
after the stage of full employment. While, the quantity approach
emphasises the volume of money to be responsible for rise in the
price level. Keynes distinguishes between two types of rise in prices
(a) rise in prices accompanied by increase in production (h) rise in
prices not accompanied by incrl:ase in production. If an economy is
working at a low level, with a large number of unemployed men and
unutilised resources then expansion of money or some other. factors
leading to an increase in demand will result not only in a rise in the
price level but also rise in the volume of goods and services in an
economy.

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

BSPATIL

is no corresponding increase in production or employment. Inflation

is used to express such a rise in the price level. Therefore, inllation
refers
to a rise in the price level after full employment has been attained.
(
According

to

Keynes,

"inflation"

can

be

applied

to

an

underdeveloped country like India where unemployment of men and

resources exist side by side with inflationary rise in prices. This is
due to the existence of bottlenecks, such as limited amount of
capital, machinery, transport facilities and absence of technical
know-how. As a result of these bottlenecks and shortages, a rise in
the price level may not lead to increase output beyond a certain
stage, even though the country may not have reached the stage of
full employment. We can distinguish between three kinds of inflation
on the basis of their causes, viz., demand-pull, cost-push and
sectoral inflation.
Demand-pull Inflation
The most common cal;lse for inflation is the pressure of ever-rising
demand on a stagnant or less rapidly increasing supply of goods and
services. The expansion in aggregate demand may be due to rapidly
increasing private investment or expanding government expenditure
for war or economic development. At a time whe.n demand is
expanding and exerting pressure on prices'cattempts are made to
expand production. However, this may not be possible either due to
nonavailability o(uqemployed resources or shortages of transport,
power, capital and equipment. Expansion in aggregate demand, after
the level of full employment, results into rf~e in the price level. In a
developing economy I ike India, resources are used for growth, for

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creating fixed assets and production of consumer goods. Necessarily,

large expenditure will create. large money income and large demand
but without a corresponding increase in supply of real output.
We should emphasise here the role played by deficit financing and
increase in money supply on the level of prices in a developing
COU1Hry. Ollen. the government of a developing country resorts to
deficit spending Lo finance economic development i.e., borrowing from
the central bunk und cOllllllercial banks, which, in turn, leads to
increase in money supply in the country. This exerts a strong
pressure on the level of prices. An increase in" foreign demand for the
exports of a country may also raise the price level in a country.
Expansion in foreign demand aM consequent expansion in exports
will raise income of the people. This will push up demand for goods
and services within a country. In case the additional money income is
used to buy imports or is hoarded then it will not have inflationary
effect in the country. Thus, inflationary pressure is built by increasing
aggregate demand in excess of the available resources. The increase in
aggregate demand can be due to increase in government expenditure
or increase in private investment and private consumption or release
of pent up demand of consumers immediately after a war or increase
in exports and so on. Deficit financing and increase in money supply
further aggregate the situation by boosting demand still further. In all
these cases, inflation is the result of demand-pull factors. It must be
emphasised here that demand-pull inflation cannot be sustained
unless there is increase in money supply.
Cost-push Inflation
In certain circumstances, prices are pushed up by wage increases,
forced upon the economy by labour leaders under the threat of strike.

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Costs can also be raised by manufacturers through a system of fixing

a higher margin of profit. The common man generally blames
profiteers, speculators, hoards and others for pushing up the costs
and prices. Again, the government is responsible for raising the costs
by imposing new taxes and continuously raising the tax rates of
existing commodity. Therefore, rising rates of commodity taxes, in a
sellers market, will enable the producers to raise the prices by the full
amount of taxes. Under conditions of rising prices, business and
industrial units find it easy to pass on the burden of higher wages to
the consumers by raising the prices. 1 II us, rise in wages; profit
margin and taxation are responsible for cost-push inflation.
In periods when wages, prices and aggregate demand are all rising
and creating an inflationary situation, it is d-ifficult to find out active
and passive factor. In many cases, it is neither demand-pull inflation
nor cOSt-push inflation, but it is a combination of both. However, it is
possible and often useful to separate the dominant factors. If
aggregate de~and is responsible for the inflationary situation, it may
persist so long as excess demand persists and in the extreme case, it
may develop into hyperint1alion cwn thoug.h (osl-push fOt'\'l'S nl".'
nhsl'llt. t)11 the other hand, cost-push inllation cannot pcrsist for
long, unless thcrc is increase ill aggrcg:llc <lClll:1I\(1. I r illf1ntillll is
cOlllrolled

lilnllip"l1llllli\('lilry

IIIll!

1i""'111

Ill,'lli",h,

aimcd

at

controlling aggregate dCllland then we have demand-pull inllation. Un

thc other hand, if wages and prices continue to rise even whcn
demand ceases to grow, we have cost-push int1ation.
Sectoral Demand Shift Theory of Inflation
Under dcmand-pull inflation, we have shown how expansion in
aggregatc demand without a proportionate increase in the supply of

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goods and services leads to an inflationary situation. However, it is

not necessary to have a general increase in demand to bring about
inflationary pressure. Sometimes, the increase in demand may be
confined to some sector of the economy and this increase in demand
and the consequent rise in the price in a particular sector may spread
to other sectors Suppose the demand for agricultural goods rises
because of inadequate supplies of' these goods. There would be a
consequent rise in the price' of agricultural goods. Thus, the rise in
prices spreads to all other sectors in the economy, through rise in the
prices of raw materials and wages. The rise in prices in the
agricultural sector may push up prices in the industrial sector.
Therefore, the inflationary rise in the price level is due to sectoral
shifts in demand.
The "sectoral demand" emphasises the fact that prices are highly
flexible upwards but relatively rigid downwards, for example, there
may be rise in prices in the agricultural sector where there is scarcity
whereas price stability in the industrial sector where there .. is an
excess supply. However, in course of time, prices all over the economy
will assume an upward trend. The "sectoral demand" is also useful to
explain the simultaneous existence of inflation and recession, i.e.,
inflation in some sectors and recession in certain other sectors.
Industries

coming

under

inflationary

pressure

will

experience

persistent rise in price but industries suffering from recession may

not experience a fall in the price level. Modern economists have coined
the word "Stagflation" to refer to this situation in which stagnation in
some sectors of the economy is present while other sectors are subject
to a highly inflationary situation.
Other Classifications of Inflation

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Open Inflation: Inflation is said to be open when prices rise

without any interruption. It may ultimately end into hyperinflation.

Suppressed inflation: Suppressed inflation refers to a situation in

which price level is not allowed to rise with the use of price
controls and rationing, even though conditions exist for rise in
the price levcl. The price level may rise when the control
measures are lifted.
Suppressed inflation results in (a) postponement of present
demand to a future date (b) diversion of demand from one kind of
goods to another, i.e., from those goods which are subject to
price

control.

and

rationing

to

those

whose

prices

are

uncontrolled and non-rationed. Suppressed inflation has many

dangers. First, it creates administrative problems of controls and
rationing. Secondly, it leads to corruption of the price control
administration and risc of hlack IIlarkcls. Thirdly. it CHllses
1I1leCOIIOlllic diversion of productive resources from essential
goods industries whose prices are tixed or controllable to those .
industries whose products are less essential but prices are
uncontrollable.
Creeping, Running and Galloping Inflation: In the initial stage of
rise in the price level, prices may be rising slowly and this is
referred as creeping inflation. In course of time, the rise in the
price level becomes more marked and alarming. This is referred
as running inflation. Ho.vcver, when the rise in the price level is
staggering and extremely rapid, it is often referred to as galloping
inflation or hyper-inflation, which a country should avoid at all
costs.

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Consequences of Inflation on Production and Employment

Inflation affects both production and distribution of income in a
country. Inflationary rise in prices may not affect adversely the
production of national income. When all aV2.ilabk men and materials
are employed then the stock of real wealth in the form of land and
building is not diminished and the total real income or output
available for distribution between the different sections of people
remains the same. However, in course of time when inflation has gone
beyond a certain limit, it may lead to reduction in production and
increase in unemployment due to the following reasons:
Firms may find it profitable to hoard rather than produce and

sell

Agriculturists may refuse to sell their surplus stocks in the

hope of
getting higher prices

Production may be interrupted by bitter labour strikes.

Therefore, beyond a certain stage, surplus stocks accumulate,

profits decline and invcstmcnt. prodllClillll and incomc rail and
lIncmpl()ymcnll\li~l's.
On Distribution of Income
It is true that in times of general rise in the price level, if all groups of
prices, such as agricultural prices, industrial prices, prices of
minerals, wages, rent and profit rise in the same direction and by the
same extent, there will be no net effect on any section of people in the
community. For example, if the prices of goods and services, which a
worker quys rises by 50 per cent and if the wage of the worker also
rises by 50 per cent then there is no change in the real income of the
worker, i:e., his standard of living will remain constant. However, in

BSPATIL

practice, all prices do not move in same direction and- by saine

percentage. Hence, some classes of reople in the community are
affected more favourably than others. This is explained as follows:

Producing Classes: All producers, traders and specu!.ators gain

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.

BSPATIL

Working Classe~: During inflation, the working classes also

suffer, firstly because wages do not rise as much as the prices of
those commodities and services, which the workers buy.
Secondly, there is also time lag between rise in th~.price level
and wages. However, these days, many groups of workers are
organised in trade unions and their wages rise simultaneously
with rise, in the cost of living. Therefore, it can be presumed that
organised workers may not suffer much during inflation.
However, there are many grOlIl)S of workers who arc not
organised for example, the agricultural labourers, who find no
way of pushing up their wages in the face of rising prices and
cost of living.
Inflation, lilus, brings shi fts in the distribution of incomc hctwccn
di !Tcrellt sections of people. The producing classes such as
agriculturists, manufacturers and traders gain at the expense of
salaried and working classes. The rich become richer and the poor
becomes poorer. Thus, there is a transfer of income from poor to rich
classes. Inflation, therefore, is unjust. Besides, those who are hard hit
by inflation are the young, old, widows and-small savers, i.e., all those
who are unable to protect themselves. But the most unfortunate thing
is that monetary arid fiscal authorities which are entrusted with the
task of maintaining price stability are often responsible for creating
inhltionary conditions, for example, a country at war resorts to
printing of currency notes as one of the methods of financing war.
Similarly, the government of a developing economy may resort to
deficit financing as . one of the methods of financing development
projects; In these cases, inflationary finance, like taxation, brings in
additional revenue to the public authorities. However, taxation cannot
destroy an economy except in rare cases by eliminating whole groups

BSPATIL

of people. Inflation, on the other hand, can destroy fixed income

group, pauperise the middle classes and destroy the very foundations
of an economy. No wonder inflation has been termed as "a species of
taxation, cruellest of all" and "open robbery". Inflation, particularly
the hyperinflation of the German type, will therefore endanger the
very fow(jations of the existing social and economic system. It will
create a sense of frustration distrust, injustice and discontent and
may force people to revolt against the government. It is, therefore,
"economically

unsound,

politically

dangerous

and

morally

indefensible". Therefore, it should be avoided and even if it occurs it

should be controlled.
Control of Inflation
Inflation should be controlled in the beginning stage, otherwise it wiil
take the shape of hyper-inflation which will completely run the
country. The different methods used to control inflation are known as
anti-inflationary measures. These measures attempt mainly at
reducing aggregate demand for goods and services on the basic
assumption that inflationary rise in prices is due to an excess of
demand over a given supply of goods and services. Anti-inflationary
measures are of four types:

Monetary policy

Fiscal policy

Price controlnnd mtioning

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

BSPATIL

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

BSPATIL

reduce public expenditure. During war as well as during a period of

development expenditure it is absolutely impossible to reduce the
planned expenditure. If the government has already taken up a
scheme or a group of schemes, it is ruinous to give them up in the
middle.; Therefore, public expenditure cannot be used as an antiinflationary measure. Lastly, public debt, i.e., the debt of the
government may be managed in such a way that the supply of
money in the country may be controlled. The government should
avoid paying back any of its previous loans during inflation so as to
prevent an increase in the circulation of moneY: Moreover, ifthe
government manages to get a surplus budget it should be used to
cancel public debt held by the central bank. The result will be antiinflationary since money taken from the public and commercial
banks is being cancelled out and is removed from circulation. But
the problem is how to get abudgct surplus, \vhich is extremely
difficult, if not impossible.
Price Control and Rationing
This is the most important and effective method available during war
particularly oecause both monetary and fiscal policies are more or
less

useless

during

this

period.

Price

control

implies

the

establishment to legal upper limits beyond which prices of particular

goods should not risco The purpose of rationing, on the other hand, is
to distribute the goods in short supply in an equitable manner among
all people, irrespective of their wealth and social status. Price control
and rationing g.enerally go together. The chief objection behind use of
this method to fight inflation is that they restrict the freedom of the
consumers and thus limit their welfare. Besides, its success depends
on administrative efficiency, which in many underdeveloped countries
is very low.

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Other Methods

Another important anti-inflationary device is to increase the

supply of goods through either increased production or
imports. Production may be increased by shifting factors of
production from the production of less inflation sensitive
goods, which are in comparative abundance to the production
-of those goods which are in short supply and which are
inflation-sensitive~ Moreover, shortage of goods internally may
be relieved through imports of inflation sensitive goods, either
on credit or in exchange for export of luxury goods and other
non-essentials.

A word may be added about the measures to control cost-push

inflation. It is suggested that wages, salaries and profit
margins should be controlled and fixed through a system of
income freeze. Business units may particularly welcome wage
freeze. However, wage freeze is not so easy or just, unless
trade unions agree to the proposal and there is also freezing of
prices. At the same time, the Government should not raise the
rates of commodity taxes. Thus, it is difficult to control c'ost
push inflation through controlling wages and other incomes.
The best method is to bring a rapid increase in production,
which will automatically check prices and wages also.

Inflation in an: Underdeveloped Economy

Basically, inflation is supposed to occur after reaching the stage of full
employment, for till that stage is reached an increase in effective
demand and price level will,be fr)lowed by an increase in output,
income and employment. It is after the stage of fuli employment when

BSPATIL

all men are employed that a rise in the price level will not be
accompanied

by

an

increase

in

production

and

employment.

Theoret.ically, therefore, it is not possible to imagine an inflationary

situation existing side by side with full employment. It is in this
context that the question of inflation in an under developed country
like

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

specialisation. All these are responsible f9r inefficient use of

BSPATIL

resources. There is, thus, imperfect elasticity of supply in an

underdevelopeJ country.
Underdeveloped countries face shortage of technical labour,
capital, equipment and transport and power facilities. Therefore,
these countries are unable to grow becauserofthese.bottlenecks.
Unemployment and underemployment are extensively present in
an underdeveloped country. The existence of unemployment in
the advanced country helps increase' output, whenever there is
increased demand. However, this is not so in a country like India
with a large magnitude of disguised unemployment and open
unemployment.

According

to

or.V.K.R.V.

Rao,

disguised

unemployment is not so resrollsive to an increase in effective

demand.

Underdeveloped countries generally have II high mnrginul

propensity to consume. or.Rao believes that this factor prevents
an increase in the supply of goods and services. For instance, in
the field of agriculture, increased production may be _
consumed at home ~nd, therefor;-:, less may be forthcoming to
the market.

A special feature of underdeveloped countries is that a large

volume of primary production is exported. Therefore, the supply
available for home consumption is reduced. The problem of
inflationary rise in prices i~ worsened whenever the income
earned from exports is spent on domestiC goods and not on
imports.
Since World War II, many of the underdeveloped countries have
started resorting to extensive borrowing from the banks and
deficit fi.nrmcing with the idea of speed ing up economic develop!

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nent. For one thing, much of this expenditure is on social and

ccor:omic overheads, such as education, transport and powcr
and on capital goods industries such as development of iron and
steel industry. This implies that there is an increase in the
production of consumption goods. Therefore, the volume of
purchasing power with the general' public is increased, resulting
in increased demand for consumption goods.
All these factors explain the existence of inflationary pressure in
all underdeveloped country, even though the stage of full employment
has not been' reached. The existence of bottlenecks such as shortage
of technical know-how and scarcity of capital equipment has
worsened the various problems related to underdeveloped countries.
It is, therefore, correct to use th~ concept of inflation even in
underdeveloped countries, provided we remember the existence of
special bottlenecks.
Deflation
I I' prices an; abnormally high, it is indeed desirable to have a fall in
prices. Such a fall in the price level is good for the community, as it
will not lead to a fall in the level of production or employment. The
process designed to reverse the inllationary trend in prices, without
creating unemployment, is generally known as disinflation. But if
prices fall from the level of full employment, then income and
employment will be adversely affected and this situation is termed as
deflation. The foll0wing Figure 6.1. shows if the price level continues
to rise even after the stage of full employment has been reached, it is
cnlled intlntiol\. Decline in prkt' level as a result of anti-inl1ationary
measures is known as disinflation. If prices litll below 1'1111
OlllploYlIlt'lll. lho ~illlr,li\l11 i~ ~\nlh'd 11011,,111111. Whllt'

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11IC111lhlll IIIII,II\'~ excess demand over the avai lable supply.

uel1l1tion implies dcticiency of dcmand to lift what is supplied. While
inflation means rise in money incomes, deflation stands for fall in
money incomes.

Effects of Deflation
The following are the adverse effects of deflation:

On production: Deflation has an adverse effect on the level of

production, business activity and employment. During deflation,
prices fall due contracting demand for goods and services. Fall
in price results in losses' and sometimes forcing many firms to
go into liquidation. In the face of declining demand for goods,
firms arc forced to close down either completely or leave part of
their plants idle. Thus, production of income is curtailed and
unemployment is increased. 111is is a serious defect of
deflation, as compared to inflation in which normally there may
not be an adverse effect on production and employment.
On distribution: Deflation adversely affects distribution of

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income too. In the first place, producers, merchants and

speculators lose badly during this period because price~ of their
goods fall at a far greater rate than their costs, most of which
tend to be fixed or sticky. Besides, most of these people are
debtors who use borrowed funds in their businesses. They have
to repay their debts in money, which has now more value
because of deflation. For some debtors, who do not have
adequate means to repay their loans had to go into liquidation.
Deflation implies fall in price level or rise in the value of money:
All those who have fixed incomes will be far better off because
their money income is fixed. In other words, the fixed income
groups will enjoy a rise in their real income. Therefore, it is
assumed that salaried persons and wage C<llners wi II bcnefit by
denatioll. Ilowcvcr, this is not completely true since there is
increasing

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

programmes, i.e., to prevent prices from falling beyond certain levels

and lowering wage and other costs to bring adjustment between price
and

cost

of

production.

Price

support

programme

has

been

extensively used in the USA in recent years but it is very difficult to

carry it through. The government will have to fix the prices below
which the commodities will not be sold and undertake to buy the

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surplus stocks" It is difficult for the government to secure the

necessary funds for such transactions as well as to devise ways and
means to dispose of the surplus stocks in other countries. Therefore,
the best solution for deflation is to have a ready programme of public
works to be implemented as and when unemployment makes its
appearance.

Compariso!between Inflation and Deflation

Inflation is rise in prices unaccompanied by increase in employment,
while

deflation

is

fall

in

prices

accompanied

by

increasing

unemployment. Inflation distorts the distribution of income between

different groups of people in' the country in such an unjust manner
that the rich gain at the expense of the poor. Deflation, on the other
hand, reduces national income through contraction of production and
increas~ in unemployment.
Inflation is unjust and demoralising. Deflation, on the other hand,
inflicts on the people the harsh punishment of general unemployment.
There exist factories and mills on one hand and workers ready
to \';ork on the other hand, however, the whole team remaining idle,
on the other. Inflation at least implies that all factors are employed in
some way or the other. There is one more reason why deflation is
worse than inflation. Inflation can be controlled except occasionally it
gets out of control. However, deflation, if once started, injects so much
pessimism into businessmen and bankers that it is highly difficult to
control. However, there is nothing to choose between the two and the
proper objective should be to aim at economic stabilisation at the level
of full employment.

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Inflationary and Deflationary Gaps

Keynes developed the concept of inflationary gap'. InfliJtionary gap
refers to, "excess of anticipated expenditures over the availahle output
al base pril'.c.~." Inflationary gap occurs when there is an excess of
demand over available supplies. Let us take a simple and hypothetical
example to illustrate the eme~gence of inflationary gap.
During 'a period of war, the volume of money expenditure in a
country increases, because or" the government's expenditure on the
armed forces and armaments. Increased government expenditure
resulting in increased income with the community will lead to
increased consumption expenditure and investment. The disposable
income of the community, which constitutes aggregate demand for
goods and services, is as follows:
(Rs. Crores)
1. National income received during a given year:

20,000

2.

Taxes paid to the government:

5,000

3.

Gross disposable income (I -2):

4.

Saving by the community at 10% oft',e income:

5.

Net disposable income with the community:

15,000
1,500
13,500

The net disposable income with the people represents aggregate

demand for goods and services ofa community. As against the
aggregate demand, the aggregate supply comes from gross national
product. However, not all output is available for the community. The
government diverts some resources such as food grains, cloth, for war
purposes, then the total output available for civilian consumption is
less than the gross national pro,duct (GNP). For instance,
(Rs. CIJres)
1. National product (real income):
2.

Appropriated for war purposes:

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20,000
8,000

3.

Available for civilian consumption:

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;

but whcn thL~ forillcr

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

development, financed partly through created money. As a result,

there has been enormous increase in money expenditure and
money income but without a corresponding increase in the volume
of consumptioll goods (part of the increase in production has been
in capital goods). Besides, there is a ~' time interval or gap between
investment and output of goods and services. Naturally, there is
excess demand resulting in inflationary pressure on the general
price level. Inflationary gap can be illustrated by using the
Keynesian concepts of aggregate demand and aggregate supply, The
following Figure 6.2 shows the' inflationary gap.

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In Figure 6.2, the horizontal axis represents volunie of income

and the vertical axis represents volume of total expenditure (C + I +
G). The 450 vertical axis represents equilibrium line of Y = E and
line C + I + G represents the total expenditure. At point E, the
economy is in equilibrium because at E the supply of goods and
services or real income (OY) is equal to the demand for them at EY.
Therefore, OY is' regarded as equilibrium income as well as full
employment income at current prices.
Suppose, the Government increases its expenditure either for war or
development purposes, by an amount equal to EA. Then the new
aggregate demand is shifted upwards and beco~es C' +' l' + G'. C' of- l'
-\- G' is parallel to C + r + G line by the amount MEA. The real output
(or income)remains constant at OY but the mOlletary demand for this
output is not EY but Y A, there is, thus. an excess of demand and
equal. to.EA. EA, therefore, represents inflationary gap, which is
responsible for pushing up the price level.
Wiping out Inflationary Gap
The inflationary gap can be wiped out in various ways. Essentially, it

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starts with additional expenditure by the government, which in turn

calls for additional expenditure by the community. Through economy
in government expenditure, the excess of aggregate demand can be
reduced. However, this is not always possible in practice, as
government expenditure cannot be cut down during wartime or period
of economic devdopment. To remove this inflationary gap. various
mtlhods can be adopted, such as:

There cun be a rise ill voluntary saving by the community.

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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As regards wiping out the deflationary gap, the government should

increase its expenditures or help to raise the expenditure of the
general public. The government can raise its own expenditure by
investing in public works and financing them by borrowing from
banks. The expenditure of the community C + I can be raised by
reducing laxes and other incentives. If the C' + j' + G' is raised to the
original level then the deflationary gap will disappear.
Stagflation
Inflationary gap occurs when aggregate demands exceeds the available
supply and deflationary gap occurs when aggregate demand is less
than the available supply. These are two opposite situations. However,
we may show how deflationary forces follow inflation, which has not
been controlled. For instance, when inflation goes unchecked for
sometimes and priCes reach very high levels, aggregate demand
contracts and slumps follows. Consumption demand (C) declines
because of high price levels. The middle and lower income groups have
to curtail th<f" consumption of many of the goods. Increase in private
investment (I) does not take place because investors are afraid of
future and there is decline in consumer demand at the height of

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inflation. In fact, the decline in consumer demand and private

investment will reinforce each other and create a deflationary
situation. Further, un excessive rise in the price 'level will affect
exports adversely and thus create a slu1np in the export industries as
well. It is, thus, possible to visualise a situation in which inflationary
and deflationary pressures are present simultaneously. The existence
of an economic recession at the height of inflation has been called as
stagflation (stagnation + inflation).
Trade Cycles '
Wesley C. Mitchell, a noted American authority 011 business cycles,
wrote: "Business cycles are a species of fluctuations in the economic
activities of organised communities." The adjective ,'business' restricts
the concept to fluctuations in the activities, which are systematically
conducted

on

commercial

basis.

The

noun

'cycles'

bars

out

fluctuations, which do not recur with a measure of regularity. Mitchell

has, thus, described all the important features of a business cycle
admirably. According to him, features of trade cycle are:

It occurs only in organised communities, which are

money economies.

Refers to fluctuations or changes in business

conditions.

Implies regular and periodical changes in business and

economic activities.

According to Keynes, "A trade cycle is composed of periods of good

trade

characterised

by

rising

prices

and

low

unemployment

percentage, alternating with periods of bad trade characterised by

falling prices and high unemployment percentage. "
Characteristics of Trade Cycles

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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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be passed on to others also, Thus, cyclical fluctuations affect

all industries.
Cyclical fluctuations tend to be international, in the sense that
prosperity and depression spread from one country to another
through foreign trade,
Phases of a Trade Cycle
Every trade cycle is characterised by two main phases namely, the
upward phase and the downward phase of'the trade cycle. These two
phases further have four or five different sub-phases, such as
depression, recovery, full employment, boom and recession. In
monetary terminology, the same phases . correspond to depression,
deflation, full employment, disinflation and deflation.
The following Figure 6.4 shows the different stages of a trade
cycle. FE represents the full employment line-it may be taken as the
dividing line. Above this line, there is business prosperity and boom
and below this line, there is business depression. As a trade eycle is a
continuous phenomenon, it is essential to break it som~where. It is
customary to start at the lowest point of the upward " phase, namely,
the depression.

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 Depression: During depression, the level of economic activity is

extremely low. The price level is low, profit margins do not exist,
firms incur losses and unemployment is high. Interests, wages and
profits are all low. While all sections in the economy suffer, some
suffer more than others do. For instance, the producers of
agricultural goods suffer badly because the prices of agricultural
goods fall the most during depression. This is due to inability of the
farmers to adjust their output according to the market demilnd,
which is low. The worst hits are the working classes that suffer
heavily because of unemployment. The depression is thus, a period
of great suffering, low income and unemployment.
The phase of recovery: Depression gives place to recovery. There is
revival of business and economic activity. There is greater demand
for

goods

and

services

and

consequently

there

is

greater

production. Prices, wages, interests and profits all start rising.

Employment increases and so docs the national income. There is
increase in investment, bank loans and advances, velocity of

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circulation of money due to more brisk tnide. Through multiplier

and acceleration effects, the economy is proceeding upward steadily
and

rapidly.

The

process

of

revival

and

recovery

becomes

cumulative. Increased receipts result in increased expenditure

causing further incrcasc in n:ceipts. which in turn, rcsult in further
increased expendllure and so on. The wave of recovery on'ce
initi"ted soon begins to feed upon itself.
The phase of full employment: The cumulative process of recovery
continues until the economy reaches full employment. Full
employment implies that all the available men arc employed. The
economy has reached the optimum level of economic activity.
During this phase, there is an allround economic stability referring
to stability of output, wages, prices and income. Wages, interests
and profits are high, output is highest with the given technology
and employment is maximum. There may be small percentage of
unemployment, but it is not of an involuntary type but of voluntary
and frictional type. The period of full employment has become the
usual goal of most national economic policies.
The phase of boom or inflation: The phase of recovery frequently
ends not in a stable state of full employment o~ prosperity but
further leads to a boom or inflation. Beyond the stage of full
employment, the rise in investment results in increas~d pressure
for the available men and materials and rise in wages and prices.
During this period, there is hectic activity going on everywhere in
the economy such as new buildings come up, new factories are
commissioned and many new trades are started. In a matter of
weeks or months, full employment paves the way for overiiJlI
employment, i.e., a peculiar situation in which there are more jobs
than the available workers. Money wage rise, profits increase and

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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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regularity. The movement at times may be irregular in such a

manner that one phase may not easily follow the other. Nor is the
length of each phase by any means always defined. Thus it is quite
likely that a state of fairly stable business depression may lead to
recovery or it may decline to further recession, as was tlie case with
England in 1929. Similarly, a recovery may turn into a recession
without allo''/ing for either full employment or even boom, as
witnessed in the United States in J 937. Sometimes, the depression
may be unstable and recover very rapid. So, alsc at times prosperity
phase may be fairly stable as was the case during the period between
1924 and 1929.
Some of the important features of various phases 'of a trade cycle
should be 0 emphasised here. They are important when we have to
evaluate the worth of different trade cycle theories.

The process of revival is generally very gradual but once it

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.

Trade Cycle Theories

The complex phenomenon of a trade cycle has received the gr,eatest
attention from economist and there arc number of theories Oil trade
cyclc. The following theories on trade cycle are as follows:

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Monctary llnd Non-monctary Thcorics: Trade cycle theories

can he classified into monetary lInd nOIHllOnctnry theories. The

forll\el' llll\phasbl's monetary factors as thc main cause for, while
the Ialler elllphnsis 1l1l!1IlIllm'lllr)' Ihe!ll),:-I, :-Illl'lI ll:ll'lilllillll'
l'lllltllllll'IIS. psyl'll\\hlgy \II' hIlSIIll'~~llh'll and innovations as, thc
main cause for the recurrence or econOllllC fluctuations.

Climatic Theory: The climatic theory is one of the oldest

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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Psychological Theory: Pigou attempted to explain the trade

cycle with reference to the feeling of optimism and pessimism
among businessmen and bankers. Businessmen have their
moods. Sometimes they feel depressed and at other times, they
are jubilant and optimistic. Despair, hopelessness as well as
optimism are catching in nature. When 0ne businessman is
pessimistic, he passes it on to the others, similarly,. optimism
spreads 'from OIlC to another. Thus. lIccording 10 the
psychological thcory. industrial l1uctuations are thc outCOIllC
of" the waves or oplilllisl)/ among businessmen. Optimism
results in prosperity and - pessimism in recession and
depression. There is an element of truth in the psychological
theory in the sense that psychological waves of optimism and
pessimism do play an imp()rtant role ill trade cycles. But
busincss con !1dcncc or abSCIll"C of it is often the result rather
than the cause-ofbusiness conditions. Further, the theory
does /lot explain satisfactorily how depression starts or a
recovery begins.

Over-Investment Theory of Von Hayek and Others: Prof.Von

Hayek in his books "Monetary Theory and the Trade Cycle" and
"Prices and Production", has developed theory of business cycles
in terms of monetary over-investment and consequent overproduction. According to him. there is a "natural" or equilibrium
rate of interest at which the demand for loanable funds is equal
to the supply of funds through voluntary saving. At the same
time, there is also market rate of interest based on demand for
and supply of loanable funds in the market. According to
Hayek's thesis as long as the market rate of interest is same as
the natural rate of interest. there will hc stahility ill husillcss

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cOlldiliolls alld allY dispilrity bctwcen the two will lead to

busincss Iluctuations. For instance, a fall in the market rate of
interest below the natural rate wililcad to more investment and,
therclore, an upward swing in business activity. On the other
hand, a rise in the market rate of interest over the natural rate
of interest will lead to a fall in investment and, therefore, a
downward swing in business activity.
Now, the market rate of interest may fall below the natural rate of
interest because money supply increase in excess of demand for the
same. The banks lending to entrepreneurs; through whom it
eventually reaches the consumers bring about this increase in supply
of money. The increased money supply is made available to the
entrepreneurs by lowering the market rate of interest. There is a spurt
of investment activity. More capital intensive methods of production
are adopted. The demand for capital goods naturally increases and
accordingly their prices go up. As a direct consequence of this rise in
the prices of capital goods there is a diversion of resources from the
production of consumption goods to the production of capital goods
resulting in the reduction of the supply of consumer goods. But this
situation cannot continue for long, for increase in the production of
capital goods and higher prices for them will result in larger income
for the factor owners who, in turn, can normally be expected to
increase their consumption of goods. The demand for consumption
goods will also rise and their prices too will go up. There will now be a
competition between capital goods industries and consumption goods
industries for scarce resources. Naturally, the prices ofJactor series
will go up, raising the cost of production of capital goods industries.
The profit margins of capital goods industries will, therefore, become
unattractivc. At the same time the banking system decides to reduce

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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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brings about a depression. Hayek's theory is, therefore, referred to as

monetary over-investment theory of business cycles. The basic
weakness of Hayek's approach is its emphasis on the rate of interest
and complete neglect of real factors such as technological changes and
innovations

inC'Juencing

the

volume

of

investment.

Further,

according to Hayek, the sole cause for change in the volume of

investment is the change in the market rate of interest relative to the
equilibrium rate of interest. A lower market rate of interest in relation
to equilibrium rate of interest induces entrepreneurs to adopt more
:capital-intensivep;1ethods of production, i.e., to change the capitaloutput ratio. Hayek~;however, does not mention how investment is
related to consumer demand. Further more, the importance given to
the rate of interest by Hayek as the cause of change in the volume of
investment is also questioned. Keynes has shown that the rate of
interest is not an important factor for determining the' volume of
investment.
Finally, critics do not accept Hayek's rcmedy. to the problem of
business cyclcs. Hayck suggests that the volume of money supply
should be kept neutral, so that business fluctuations may be
controlled. I r moncy supply is nol nClllml, investment will be either
encouraged (expansion of money) or cliscouraged (contraction of
money supply) and as a result there will be business fluctuations.
This is based on the old quantity theory of money, which does not
command general accepta'1ce .. Moreover, a change in the volume of
investment is not responsible for busines's fluctuations whereas
investment financed by involuntary savings or expansion of bank
credit is to be blamed for fluctuation.
Non-monetary Over-investment Theory

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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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Robertson believes that part of this excessive response is due to

existence of indivisibility in certain investments. He cites the example
of a railway company that faced the problem of congestion on a single
tmck, wanted to go 1'01' a double track. I'll,' introduction of,i second
track would create excess capacity but the additlull:l1 traffic Illa)' not
he slIrticiclll 10 f,dly IItiiisc lill' secolld traele Ilo",('ver. lilc rnilll':IY
company has 110 allcllwlivL' hut 10 inll'tlducc Ihe Sl'l'(lIHI ll'lll.'k.
II\\'l'Slllll'l\IS h"il\~ lumpy in many hcavy capital-intensive industries
result in exceSs capacity. Besides such investmcnts arc timeconsuming because they have long gcst<ltiull periods, i.e., time gap
between the decision to undertake the project and the time project is
commissioned. Two problems are created as a result of such
investment. Firstly, undertaking heavy investment in excessive of
current demand would lead to blockage of capital and undertaking
smaller investment that would be insufficient to meet the current
demand. Secondly, in a competitive system, many entrepreneurs may
go in for investments with long gestation periods' that rt:sult into overinvestment, over-production and glut of goods in the market.
While

over-investment

and

over-production

ale

results

of

indivisibilities. they are encouraged by monetary factors. For instance,

the banking system may plJCC additional volume of money at the
disposal of entrepreneurs and thus increase the already existing state
of imbalance. Increase in money supply will cause prices to rise,
thereby misleading their appraisal of prospective profits. This price
rise encourages entrepreneurs to further over-investment. Thus, D.H.
Robertson successfully combines real and monetary factors to explain
business cycks. Overinvestment theory has definite merit in the sense
that the business boom is identified by too much investment in
general or particular industries. TIllS IS largely true. However, the real

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weakness of the theory is its failure to exp~ain revival from a business

depr~ssion.
Over-Saving or Under-Consumption Theory
This is one of the earliest theories of trade cycle and has been stated
in different forms at different times. Such "Yell-known names as
Malthus, Marx and Hobson are associated with this theory. According
to this theory, in free capitalist society rich people have large incomes
but they are unable to spend all their incomes and hence they save
automatically. These savings are usually invested in industry and
hence they increase the volume of goods produced. At the same time,
the majority of people in the country have low incomes and
consequently have low propensity to consume. Thus, consumption is
not increasing correspondingly to production. As a result, the market
is flooded with goods and will be followed bY,depression unless prices
fall to a very low level in order to allow the goods to be carried oll the
market. The fundamental idea of the under-consumption theory is
based upon the conflict, which arises from the double effect, that
saving has on consumption and production. It is the decrease in the
demand lor and the increase in t.he supply of consumer goods as a
res'jlt of saving which seems to create under-consumption and overproduction.
Like all other theories of trade cycles, this theory too is not free
from defects. It does not explain complete trade cycle. It is pointed out
that the theory concentrates too much on over-saving and its related
evils and too little on the others. It considers savings automatically
linding their way into investments while in reality this is not so. The
availability of savings does not guide entrepreneurs in t!lt.:ir
investment policies. Thus, a mere increase in savings is insufficient to

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explain occurrence of a boom.

Hawtroy's Monetary Theory
Hawtrey regards trade cycle as a purely monetary phenomenon.
According to him, non-monetary factors like wars, earthquakes,
strikes and crop failures may cause partial and temporary depression
in particular sectors of an economy. However, these non-monetary
factors cannot cause full and permanent depression involving general
unemployment of the factors of production in a trade cycle. On the
other hand, changes in the flow of money are the exclusive and
sufficient cause of changes in trade cycle. In Hawtrey's opinion, the
basic cause of trade cycle is the expansion and contraction of money
in a country. According to Hawtrey, changes in the volume of money
are brought about by changes in the rate of interest. For instance, if
banks reduce their rate of interest, producers and traders will be
induced to borrow more from banks so as to expand their business.
Borrowing from banks will lead to more bank money and rise in the
price level and business activity. On the other hand, if banks raise
their rate of interest, producers and traders will reduce their
borrowing from banks. This will reduce the price level and business
activity. Thus, in Hawtrey's analysis, changes in interest rates lead to
changes in borrowing from banks and, therefore, changes in the
supply of money. Changes in the supply of money lead to changes in
'Jusiness activity.
Trade Cycle in Just Inflation and Deflation
f-Iawtrey argues that the trade cycle is nothing but small-scale replica
of an outright money inflation and deflation. The upward phase of a
trade cycle, such as revival, prosperity and boom is brought about by
an expansion of money and bank credit and also by increase in

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circulation of money supply. On the other hand, the downward swing

of money supply is nothing but a monetary denatibn.
Expansion of bank loans is made possibk by fall in rute of interest,
which induces the merchants to' increase their stocks since banks
grants loan more liberally. Therefore, merchants begin to place more
orders and increase production by employing more resources. There is
greater demand for factors of production all round and consequently
higher income and employment leading to further increased demand
of goods. In course of time, a cumulative upward trend is set in
motion. As the volume of business expands and factors of production
arc rendered fully employed, prices rise further and further induce
upward business expansion. resulting in inflationary conditions or
boom conditions. However, the boom crashes when the ba'lking
authorities suspend their policy of credit expansion.
Why the Boom Crashes Suddenly?
The banks suspend credit and call on the borrowers to return the
loans, ci'ther because banks have reached the maximum point beyond
which they cannot givc any more loans or they are afraid that the
phase of business expansion has reached a saturation point and
hence a downward trend may set in the immediate future. Now the
sudden suspension of credit facilities by the banks comes as a shock
to entrepreneurs and merchants. Until now entrepreneurs and
merchants were enjoying liberal policy of the banks and now, contrary
to their expectations, they receive sudden notices of immediate callback of loans to dispose of their stocks at any price in order to repay
bank loans. This general desire of businessmen to dispose of their
stocks will definitely depress the market and bring down the prices.
With every fall in prices, the desire to dispose of the stocks as quickly

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as possible wi!! lead to confusion and collapse of the market. Marginal

and average fimls may even go into liq-uidation, thus worsening the
position still further and making the banks extremely nervous. Banks
will proceed to further contraction and like the period of expansion, it
will become cumulative. Producers curtail output and consumers'
income and outlays decrease and contraction spirals in a downward
direction, until it touches the lowest level possible.
How the revival takes place?
When the economy is working at the level of depression, the rate of
interest is low and the bank,....: have large cash reserves. On one
hand, low interest rates make it profitable to 'borrow and invest. On
the other hand, large cash reserves induce banks to lend. This starts
the phase of revival, which because of its cumulative character, leads
to prosperity and boom conditions. This, according to Hawtrey, the
inherently unstable nature of the modem monetary and credit system
is the mother or economic fluctuations. This monetary explanation of
the trade cycle has received powerful support from Milton Freidman,
who says, "In every deep depression, monetary factors playa criticai
role~" According to Freidman, there is a direct relation between the
volume of money supply and the level or business activity in a
country. If the money supply increases at a rate faster than the
economy's real output of goods and services, prices will decline and
the economy is bound to contract. Thus, there is direct relation
between the level of income and economic activity, on the one side and
the volume of money supply on the other. If the 'economy has to be
stable, monetary expansi9n and contraction has to be avoided.
Weaknesses of the Monetary Expansion

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The weakness of monetary expansion is as follows:

Finance is the soul of commerce and trade in modern times and

the banking system plays quite an important part in financing
trade activities. However, it is correct to say that banks cause
business crises.

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.

Borrowing and investment will not depend upon the rate of

interest, as Hawtrey believes. A high rate of interest will not deter
people from borrowing for investment, and a low rate of interest
will always induce people to borrow and invest.
Expansion and contraction of money alone cannot explain
prosperity and depression.
According to Hawtrey, expansion and boon'! are the result of
expansion of bank credit, but it is pointed out that the mere
expansion of bank credit by itself cannot initiate a boom.
Further, according to Hawtrey, a depression is marked by
contraction of bank loans and advances but actually, the
contraction of bank credit is the result of depression.

Lowering of interest rate and willingness of banks to - give loans

and advances cannot be a -sufficient reason to stimulate the
economy to revive. Businessmen will not borrow and invest
unless they are convinced that the economy will definitcly I"cvivc
1I11d il will he prnntllbk to bOl'rnw Hnt! invest.

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 In recenl years, lhe technique \It' tinlllll:ing has been changing

illlLl practically all finns, both big and small, havc becn resorting
to the policy or ploughing back of profits. The conclusion, which
follows, is that the banking system can accentuate a boom or a
depression but it cannot originate one. In other words, expansion
and contraction of bank credit can be a supplementary cause
but not the main cause of trade cycles.
Keynes' Theory of Trade Cycles
Keynes never worked out a pure theory of trade cycles, though he
made significant contributions to the trade cycle theory. Keynes
states, "The trade cycle can be described and ana lysed in terms of the
fluctuations of the marginal efficiency of capital relatively to the rate
of interest." According to Keynes, the level of income and employment
in a capitalist economy depends upon effective demand, comprising of
total consumption and investment expenditure. Changes in total
expenditure will imply changes in effective demand and will lead to
changes fn income and employment in the country. Therefore, in the
Keynesian system fluctuations in total expt(nditure are responsible for
fluctuations

in

business

activity.

Now,

according

to

Keynes,

consumption expenditure is relatively stable, and consequently it is

the fluctuations in the volume of investment that are responsible for
changes in the level of employment, income and output.
Investment depends up0l) two factors: (a) marginal efficiency of
capital, and (b) the rate of interest. Investment is carried on up to the
point where the marginal efficiency of capital (the profitability of
capital) is equal to the rate of interest (i.e., the cost of borrowing
capital). Keynes argues that the rate of interest will depend upon the
liquidity preference of the people in the country and the quantity of

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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.

How Recovery Starts?

Let us start at the bottom of a depression. At this point, the marginal
efficiency of capital will be high due to exhaustion of accumulated

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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

employment gets an upward trend. There is heavy economic activity

everywhere in the primary, secondary and tertiary sectors of the
economic system. This sudden shoot in investment activity gives rise
to boom and as long as it lasts, the economic situution appears very
easy and bright.
How the Boom Crashes?
The boom conditions thcmselves contain the very seeds;of their own
destruction.

Very

soon

goods

are

accumulated

beyond

the

expectations of entrepreneurs and competition among them to

dispose their accumulated stocks bring crash in prices. While the
prices of finished goods are declining, their costs of production
continuously rise because factors of production are bceoming scarce
and hence are commanding hi,!~her prices. The marginal efficiency
of capital is sandwiched between rising costs of production-on the one
side and falling prices of finished goods :In the other. The marginal
efficiency of capital, therefore, collapses and brings about a crash in
the investment market.
Ineffectiveness of the Rate of Interest
Keynes believes that the rate of interest could have prevented the
collapse of the marginal efficiency of the capital and revives the
confidence among the entrepreneurs, by exerting its pressure to
reduce cost. Uut then, the rate of interest is very high, like all other

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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

investment multiplier, the cycle needs to be milder in magnitude than

what it actually is.
Weaknesses of the Keynesian Analysis
Keynes' theory of the trade cycle has been regarded as quite
convincing since it explains cbm:ctly the cumulative processes, both
in the upswing as well as in the downswing. Besides, Keynes'
advocacy of fiscal policy to bring about business stability has been
widely used. However, critics have found some weaknesses in the
Keynesian analysis. First, according to Keynes, marginal efficiency of
capital is the most important factor that guides the investment
decisions of the entreprencurs. However, this important factor
depends on entrepreneurs' anticipation of future prospects that
further depend upon the psychology of investors. If'. such a .case,
Keynes'

theory

of

trade

cycles

approaches

close

to

Pigou's

psychological theory. Secondly, in Keynes' theory, the rate of interest

plays a minor role. Keynes expresses the opinion that sizeable fall in
the rate of interest can do something to. revive the confidence among

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the entrepreneurs by exerting pressure on the cost of production.

However, Keynes himself has pointed out that this has been
sufficiently proved to be correct that the rate of interest does not
have any influence on investment. Thirdly, his theory does not throw
light on the periodicity aspect of the trade cycle.
Finally, some critics like Hazlitt have pointed out that Keynes'
concept of the rate of interest does not tally with actual market
conditions. For instance, according to Keynes, in a period of recession
and depre~sion, the rate of ir:'erest ought to be high because of strong
liquidity preference but precisely during this period, the rate of
interest is low. Likewise during boom conditions, the rate of interest
ought to be lower because of the weak liquidity preference among the
people instead it is high.

Hicks' Theory of Trade Cycles

In his book "A Contribution to the Theory of the Trade Cycle," Hicks
has developed a theory mainly by combining the principles of the
'multipiier and acceleration, which he has borrowed from Keynes and
has combined the concepts of autonomous and induced investment, a
distinction originally made by Roy Harrod. The multiplier is related to
the autonomous investment of the Government. The acceleration
principle is based on induced investment.

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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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acceleration principles, which are combined, to the fluctuations of

autonomous and induced investment. It is induced investment,
which is finally rcsponsibleJor the upward push and downward
swing of output and income of prices and employment.
Schumpeter's Innovations Theory
Joseph Schumpeter has propounded a trade cycle theory in terms of
innovations. An innovation can be regarding new product or new
method of production, such as new machinery, new method of
organisation of factors of production, opening of a new market for the
product and development of new source of raw materials. In other
words, an innovation is anything that is introduced by a firm or an
industry to change the supply or demand conditions. An innovation
may be sufficient to cause changes in expectations of entrepreneurs
and their economic and business calculations. These changes may
cause the cost of production to change rapidly and continuously and
may shift the demand curve continuously in such a manner that the
final stage . becomes indeterminate. Any innovation, thus, causes
disequilibrium in the economic system, making it necessary for the
economic system to readjust itself at some new equilibrium position.
Thus, Schumpeter explains the un-rhythmic movements of an
economy by reference to innovations.
The Effect of Innovations
Suppose we start with an economy, which is functioning at full
employment level. Suppose an innovation in the form of a new
product has been introduced. The new industry will need to have new
plant and equipment. Since the economy is already working at full
employment level, the new plant and equipment required by the new
industry can be acquired only by withdrawing labour and other

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resources from old industries. As a result of higher cost of factor of

production, the old industries will experience both an increase in
their cost of production as well as j~crease in their output. The
promoters of the new product will have to attract all f(!ctors of
production by offering higher rewarqs and the necessary finance may
,:i: 'me out of additional bank loans. Since the factors of production,
both in the new ;tl'd the old industries, are getting higher money
remuneration therefore, they will ',~( 'nand more goods and services
and consequently will push up prices, Thus,'ill '<'::IS<:U ucmanu [or
anu the simultaneous decreased supply of the old goods will ~ It:"h
upward the prices of these goods. However, it is not necessary that
the in 'case in the demand alld costs of all industries should
nec~ssarily be equal. The i l_: industries, whose demand for products
rises more rapidly than production ~ lHS, will reap abnormal profits
and consequently will expand, To the extent the l (1',1 involved in
such expansion is financed by hank credit therefore. the i d1:qi"":1r\'
I'I'I":'nll'l' "11 I'rk"'l <111.1 ,'\1';1.'1 i .. : Illt\gllilkd.
The Process of Rising Prices
When

the

new

product

introduced

in

the

mark~,

becomes

commercially successful and brings in profit for promoters, the rival

competing firms quickly introduce similar products and imitations.
The production of many competing varieties of products sets in motion
expansion in many related industries. Therefore, resulting into a
period of cumulative prosperity.
The Process of Falling Prices
The deflationary effect follows when the novelty of the innovation is
lost with the production of so many competing varieties or brands of
the S3me product. Abnormal profits are competed away. Some of the

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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

explanation. We have described man;' theories of business cycles and

there are many morc. Therefore, none of the theories provides a
complete explanation of the causes of trade cycles. The reason for this
is that the trade cycle is not the result of anyone single factor but is
due to multiplicity of factors, of which sometimes one and sometimes
another becomes dominant.
Control of Trade Cycles
Thc trade cycle, which implies fluctuations in business activity, is not
beneficial to allY seetioll of a community. The period of expansion is

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accompanied by large profits to producers and speculators but it

brings loss to lixcd income groups. The period of depression is one of
acute unemployment, poverty, suffering and misery to the poor and of
distress to the busin(;ss dass(;s as a .result of exlensive hlltlk lIlId
firms failures. Thus all sections of people in a country, especially the
working classes, are interested in preventing and avoid ing busihess
cycles .. On/ of the 1110st important objectives of economic policy is
the elimination of cyclical fluctuations and attainment of stability at
the level of full employment. This has been, in fact, the main objective
of both monetary and fiscal policies. We have already explained the
use of monetary policy and fiscal policy as wel'l as direct control, to
check inflations and deflations.
There is no full proof method for solving the problem of trade
cycles.
Karl Marx considered trade cycles as inevitable in a capitalist system
and the only rational method to solve the problem was to throw it
overboard and introduce a socialist economy. Like every business firm
prepares its annual balance sheet of transactions with a view to know
its assets and liabilities, every nation carrying out economic
transactions with foreign countries prepares its Balance of Payment
(BOP) Accounts periodically with a view to know stock of its assets
and liabilities and its receipts from and payments to the rest of the
world.
THE BALANCE OF PAYMENT
Definition
The balance of paYlllent is defined as a systematic record of all
economic transactions between the residents of a country and
reside~ts of foreign countries during a certain period of time.

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Although the above definition of balance of payments is quite revealing

certain terms used in the definition may require some clarification.
The term's systematic record does not refer to any particular system.
However, the system generally adopted is double entry book-keeping
system. Economic transactions include all such transactions that
involve the transfer of title or ownership. While some transactions
involve physical transfer of goods, services, assets and money along
with the transfer of tille while other transactions do not involve
transfer of title. For example, suppose that a subsidiary company of a
foreign undertaking is operating in India and 'making profit. This
company may pay all its profits as dividend to the shareholders
abroad, or it may, alterilatively reinvest its profit in India instead of
paying dividends to its parent company abroad. Both kinds of
transactions arc recorded in the balance of payments accounts. The
trnnsl'l'I' 01' titk is important thlln lht: physi,l:l\llrl\nstl~r or
rCSlHlr\:cs. The term residcnts rcfcr to 'the nationals of thc rcporting
country, Tourists. diplllllll\t~;, IIlililmy I'cr:lllllllcl, 11'llIlHlmry "lid
llligrnllll)' IVllrl\l\I',~ 111111 Iii,' "n,,"I,,'n of foreign companies
operating in the reporting clHllltr)' do not rail in till' category or
residents, Thc timc period for balance of payments is not speci fically
delincd. it can be of any period, The generally period is one financial
year of calendar.
Purpose
The balance of payment serves a very useful purpose as it yields
necessary information for the future policy formulation in regard to
domestic monetary and fiscal pulicies and foreign trade policy.
Following are the important uses of balance of payments:

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It provides useful data for the economic analysis of country's

weakness and strength as a partner in the international trade.
By comparing the statements contained in the balance of
payments for several successive years, one can find out whether
international economic position of the country is improving or
deteriorating. In case it is deteriorating, necessary corrective
measures can be taken.

It reveals the changes in the composition and magnitude of

foreign trade. The changes that curb ~conomic well-being of a
country are taken care by the government.

It also pwvides indications of future repercussions based on

countries past trade performances. I f balance of payments
shows continuous and large deficits over time then it indicates
growing international indebtedness, which ultimately leads to
financial

bankruptcy.

Similarly.

continuous

large-scalc

surplus in the balance of payments, particularly wht:n its

magnitude goes beyond the absorption capacity of the country
indicates impending dangers of inflation.
Detailed balance of payments accounts also reveal weak and
strong points in the country's foreign trade rdationsund thereby
invite

gove.-I1ll1cnt

attention

to

the

need

for

corrective

measures against the weak spots.

Balance of Payments Accounts
The economic transactions between a country and the rest oCthe
world may be grouped under two broad categories:
1. Current transactions: Current transactions pertain to export
and import of goods and services that change the current level

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of consumption in the country or bring a change in the current

level of national income.
2. Capital

transactions:

Capital

transactions

arc

those

transactions, which increase or decrease counlry's Iota I stock

of capital, instead of affecting the current level of consumption
or national income. In other words, current transactions arc
flow transactions. In accordance with the two kinds of
transactions, balance of payments account is divided into two
major accounts:
A. Current account
B. Capital accounts
Current Account
The items, which are entered in the current account of balance of
payments, are listed in the Table. 6.4 -in the order of their
importance. The categories of items presented in the table were
published by the IMf and are currently followed in India. In the 'credit'
column values receivable are entered and in 'debt' column values
payable ar.e entered. The net balance shows the excess of credit over
the debit for each item, can be negative (-) or positive (+). The items
listed in current account can be further grouped into visible and
invisible items. Merchandise trade, i.e:, export and imports of goods,
fall under the visible items. Rest all other items in the current
account-payment and receipt for the services, such as banking,
insurance and shipping are termed as invisible. Sometimes another
category, i.e., un-required transfer, is created to give a separate
treatment to the items like gifts, donations, military aid, and technical
assistance. These are different from other invisible items since they
involve unilateral transfers.

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The net balance on the visible items, i.e., the excess of

merchandise exports (Xg) over the merchandise imports (Mg) is called
as balance of trade. If Xg < Mg it is unfavourable. The overall balance
on the Current Account is known as 'Balance on Current Account.'
The 'Balance on the Current Account' either surplus or deficit is
carried over to the Capital Account.
. Table 6.4: Balance of Pa}'ments Current Account

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 (-)

* Includes motion picture royalties, telephones and telegraph

services, consultancy fees, etc.
Capital Account
As mentioned earlier, the items entered in the capital account of
balance of payments are those items, which affect the existing stock of
capital of the country. The broad categories of capital account items
are:

(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

maintained to stabilise the exchange rate of the home currency and to

make payments to the creditors in case there exists payment deficits
on all other accounts.
Balance of Payments is always in Balances
The balance of payments accounting is based on the double-entry
book-keeping system in which both sides of a transaction, i.e.,
receipts and payments are recorded. For example, exports involve
outtlow of goods and inflow of foreign currency. Similarly, imports in

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volve inflo\\ of goods and outflow of foreign currency. Both, inflow

and outflow are recorded in this system. International borrowing and
lending give rise to credit to the lender and debit to the borrower. Both
are recorded in the balance of paymcnts. However, donations, gifts,
aids and assistance are unilateral transfers and do not involve
transfer of an equivalent value. In regard to these items, there is only
credit and no debit since they are nonrefundable. Yet, the receiving
country is debited to keep the record of nonrefundable amounts and
donator is credited for the record purposes. Such entries have
information

value

for

non-economic

purposes.

Besides,

these

transactions reduce the deficit in the current account of the reporting

country. Since in this system of balance of payments accounting
international transactions are entered on both debit and credit sides.
Balance of payments always balances from the accounting point of
view.
Disequilibrium in Balance of Payments
We have noted above that the balance-of payments is always in
balances from accounting point of view. Besides, in the accounting
procedure, a deficit in the current account is offset by a surplus in
capital account resulting from either borrowing from abroad or
running down the gold and foreign exchange reserves.
Similarly, a surplus in the current account is 011set by 1I
mlltdling Jl'licit in capital account resulting from loans llnd gills to
debtor country or by dcpklion (),' its gold and foreign exchange
reserves. In this sense also. lhe '11,lIallce (!I JlllYIJl!:lltS' 1IlwlI)'s
rcnlllills In hllllllll:C:. As :.udl. tbert' slllluid hc 1I11 qUC.Slll)11 1\1
disequilibrium in the balance of payments. However, disequilibrium
in lhe balall!:l: of payments does arise because total receipts during

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the reference pl:riod need 1I0t be necessarily equal to the total

payments. When total receipts do not m<lleh with total payment of
the accounting period, this is a position of disequilibrium in the
balance of payments. The final balance of payments position is
obtained in the manner described below.
For assessing the over-all balance of payments position, the total
receipt and total payments arising out of transfer of goods and
services and long-run capital ' movements are taken into account. All
the transactions are regrouped into autonomous and induced
transactions. Autonomous transactions take place on their own all
account of people's desire to consumc morl: or to makc a larger profit.
For example, export and imports of items in current account are
undcrtaken with a view to, make profit or consume more goods.
Another autonomous item in the current account is gift or donations.
They are voluntary and deliberate. In the capital account, export and
import of long-term capital are autonomous transactions. In addition,
the short-term capital movements motivated by the desire
to invest abroad for higher return fall in the category of autonomous
transactions. Thus. all exports and imports of goods and services,
long-term and short-term capital movements motivated by the desire
to earn higher returns abroad or to give
gi fts and donation are the autonomous transactions. Exports and
imports take place irrespective of other trans~ctions included in the
balance of payments accounts. !-!ence, these are autonomous
transactions. If exports (Xg) equal imports (Mg) in value, there will be
no other transaction. However, if Xg is less than Mg, it leads
to short-run capital movements, e.g., international borrowing or
lending. Such international borrowings or lending are not undertaken
for their own sake, but for making payment for the deficit in the

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balance of trade. Hence, these are called induced transactions. They

involve accommodating capital flows.
On the other hand, the short-term capital movemcnt's viz., gold
movemenls it and accommodating capital movements on accounts of
thc

autonomous

transactions

are

induced

transactions.

These

transactions lead to reduction in the <, gold and foreign exchange

reserves of the country.
In the assessment of balance of payments position only autonomous
transactions are taken into account. The total receipt and payments
resulting from the autonomous transaction determine the deficit or
surplus in the balance of payments. I f total receipts and payments
arc unequal, the balance of payments is in disequilibrium. I I' the total
payments exceed the lotal receipts, the balance or payment shows
deficit. On the contrary, if receipts from autonomous transactions
exceed the payments for autonomous transactions, the balance of
payments is in surplus. Naturally, if both are equal, there is neither
deficit nor surplus, and the balance of payments is i~1 equilibrium.
From the policy point of view, the depletion in the gold and foreign
exchange reserves is generally taken as an indicator of balance of
payments running into deficit, which is a matter of concern for the
government. However, if reserves are plentiful and the government has
adopted a deliberate policy to run it down, then the deficit in the
balance of payments is not an in he?lthy sign for the economy.
Besides, the disequilibrium of surplus nature except the one that
might cause inf1ation is not a serious matter as the disequilibrium of
deficit nature. We will be therefore, concerned here mainly with the
deficit kind of disequilibrium in the balance of payments.
Causes and Kinds of BOP Disequilibrium

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The deficit kind of disequilibrium in the balance of payments arises

when a country's autonomous payments exceed its autonomous
receipts. The autonomous payments arise out of imports of goods and
services and export of capital. Similarly, autonomous receipts result
from the merchandise exports and import of capital. It may therefore
be said that disequilibrium of deficit nature arises when total imports
exceed total exports. However, imports and exports do not determine
themselves. The volume and value of imports and exports are
determined by a host of other factors. As regards the determinants of
imports, the total import of country depends upon three factor: (i)
internal demand for foreign goods, which largely depends on the total
purchasing power of the residents of the importing country, (ii) the
prices of imports and their domestic substitutes, and (iii) people's
preference for foreign goods. Similarly, the total export of a country
depends on (i) foreign demand for its goods and services, (ii)
competitiveness of its price and quality, and (iii) exportable surplus.
Under static conditions, these factors remain constant. Therefore,
equilibrium in the balance of payments, once achieved, remains
stable. However, under dynamic conditions, factors that determine
imports and exports keep changing, sometimes gradually but often
violently and unexpectedly. The changes differ in their duration and
intensity from country to country and from time to time. The changes,
which occur as a result of disturbances ,in the domestic economy and
abroad, create conditions for dis-equilibrium in the balance of
payment.
Causes of Disequilibrium and the Associated Nature of
Imbalances

Price Changes and Disequilibrium: The first and the major

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cause of disequilibrium in the balance of payment is the change

in the price level. Price changes may be inflationary or
deflationary. Deflation normally causes surplus in the balance
of payment. The balance of payments surplus does no! cause a
serious concern from the country's point of view. It may,
however lead to wasteful expenditure and mal-allocation of
resources. On he C1ther hand, inflrtionary changes in prices
causes deficits in the balance of payments. The balance of
payments deficit result in increased indebtedness, depletion of
gold reserves. loss of employment. and disfort:ons in the
domestic economy and causes other economic problems in the
deficit countries. Therefore, we will discuss only the impact of
inflationary price changes on the balance of payments position.
Inflation causes a change in the relative prices of imports and
exports. While exchange rate remains same, inflation causes
increase in imports because domestic prices become relatively
higher than the impo;L prices. On the other hand, inflation
leads to decrease in exports because of decrease in foreign
demand due to increase in domestic prices. The increase in
imports depends also 011 price-elasticity of demand for imports
in the home market and decrease in the exports depends on the
price-elasticity of foreign demand for home-products. In case
price-elasticity of imports and exports is not equal to zero,
imports are bound to exceed the exports. As a result, there will
be a deficit in the balance of payments. If inflationary conditions
perpetuate, it will produce long-run disequilibrium. If the size of
deficit is large and disequilibrium is inflexible, it is termed as a
fundamental disequjJibrium. The price changes or fluctuations
may be local, confined to one or few countries or it may be

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global as it happened in the ec:(/y 1930s. If price fluctuations

take the form of business cycle, most countries face depression
and inflation almost simultaneously. Since economic size of the
nations differs, their imports are affected in varying degrees.
Deficits and surpluses in the balance of payment vary from
moderate
propensity

to
to

large.

The

import

countries

accumulate

with
larger

higher
deficits

marginal
during

inflationary phase of trade cycle and a moderate deficit or even

surplus, during depression. Such disequilibrium is known as;;'
cyclical disequilibrium. This is however only a theoretical
possibility. Since little is known about the marginal propensities
to import, any generalisation would be unwise.

Structural Changes and Dis-equilihriull1: Structural changes,

in an
economy arc caused by factors, such liS, (i) depletion orthe
cheap natural resources (ii) change in technology with which a
country is 110t in a position to keep pace, i.e., technology lag
and, (iii) change ill consulllers' !lIsle IInd preference. Such
changes incapacitate exporting countries and they lind it
difficult ,10 face competition in the intnnational market, due
toeither high cost of production or lack of foreign demand. To
quote the examples from P.T. ,Ellsworth the gradual exhaustion
of better coal in Great Britain resulted' in increased cost of coal
production despi!e improvement in technology. This factor
combined with labour problem converted Great Britain from a
net coal-exporting nation to a net-importing one.
All such changes bring change in demand and supply
conditions. If size of foreign trade is fairly large, then the

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balance of payments is adversely affected. The ultimate result is

disequilibrium in the balance of paym~nts. It is called
structural disequilibrium. The structural disequilibrium may
also originate from thc discovery of new resources, which may
invite foreign capital in a large measure. The large-scale capital
inflow may turn th~ balance of payments deficit into a surplus.

Other

Factors:

In

addition

to

the

fundamental

factors

responsible for disequilibrium in the balance of payments, there

are

certain

other

factors,

which

may

cause

temporal

disequilibrium, Some of them are as follows:

Disturbances or crop failure particularly in the countries,
producing primary goods, for examplc, India.
Rapid growth in population leading to large-scale imports of
food materials.
Ambitious developmen! projects requiring heavy imports of
technology, equipmenCs,machinery and technical know-how.
Demonstration-effect

of

advanced

countries

on

the

consumption patternof less developed countries.

Balance of Payments Adjustments

The short-term and small deficits in the balance of payments are quite
likely to cmcrge in wide range of international transactions. These
cleficits do not call for immediate corrective actions. More importantly,
irregular short-term changes in the domestic economic policies with a
view toremove the short-term deficit in the balance of payments may
do morc harms than good to the economy. Since these changes cause
dislocations in the process of reallocation of resour'ces and shortIcrm lluctUlItiolls in the cconomy, Therefore, short-term del1dts of

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snHllkr magnitude :lrc ,not II Ill:ltler or serious COlleCI'll I'or the

policy-nlllkers. 11()\\'rnl. const:lllt delicil or 1:l1'p.('1' 111:1p"llillllk
h:,,~ n wide 1':1111<1' or I'ClII\(lInie nlld 11Itlili.'n l implil:alions, i\
constant delicil indicates country turning inlo an l'tl'I'I\III h(\I'I'\I\I ,'(
or depiction of' its lim:ign exchange lint! gold resnves. These countries
los~ till'ir international liquidity and credibility. This situation often
leads to compromiSe with economic and political independence of
these countries. India faced a similar situation in July 1990.
Therefore, a country facing constant large deficits in ih balance of
payments is forced to adopt corrective measures, such as changes in
its internal economic policies for wiping out the deficits, or at leasl to
bring it l(l manageable size. It is a widely accepted view that the
conditions for an automatic corrcctive mcchanism visualised under
gold standard, bascd on international pricemechanism do not exist.
Therefore, the government has no option but to intervene . ~ with the
market conditions of demand and supply with the policy measures
available (0 them. It should be borne in mind that policy-mix in this
regard may vary from country to country and from time to time
depending on the prevailing economic conditions.
Measures used to Correct Deficits in Balance of Payments
The various measures used to correct deficits in balance of
payments are as follows:

Indirect measures to correct adverse BOP: Under free trade

system, the deficits in the balance of payments arise either due
to greater aggregate domestic demand for goods and services
than the total domestic supply of goods and services or domestic
prices are significantly higher than the foreign prices. Thus, the
deficit may be removed either by increasing domestic production

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at an internationally comparable cost of production or by

reducing

excess

demand

orby

using

the

two

methods

simultaneously. It may be very difficult to increase the output in

the short-run, specially when a country is close to fullemployment or when there ~re other limiting factors to its
industrial growth. Thcrcforl.:, thl.: only way to rcducl.: ddicil is I
to reduce the demand for foreign goods.

Income and Expenditure Policies:

Here we discuss how

reduction in . income can lead to reduction in demand and how

it helps reducing the deficit in the balance of payments. The
t'.vo policy tools to change disposable income are monetary llnd
fiscal policies. Monetary policy operates on the demand for and
supply of money while fiscal policy operates on the disppsable
income of the people. The working and efficacy on these policies
as i,nstruments of solving balance of payment problem is
described below.
Monetary Policy
The instruments of mon~tary policy include discount 01" bank rate
policy, open market operations, statutory reserve ratios and selective
credit controls. Of these, first two instruments are adopted in the
context of balance of payment policy. This however should not mean
that other instruments are not relevant. The government is free to
choose

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,

central Ilwlll:lar'y Clulil()ritics

raise

"[ilc

discount

rate.

Consequently, under nonna1 conditions, the demand 'for institutional

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funds for investment decreases. With the fall in investment and

through its multiplier effect, income of the people decreases. lf
lnarginal propensity to consume is greater than zero, demand for
goods and services decreases. The decrease in demand also implies a
simultaneous decrease in imports while other things remain same.
This is how 'a tight money policy' corrects deficit in balance of
payments.
The effcacy of 'tig:,t money policy' is however doubtful under
following conditions: (i) when rates of returns are much higher than
the increased bank rate due to inflationary conditions, (ii) when
investors have already affected their investment in anticipation of
increase in the rate of interest. The tight money policy is then
combined with open market operation, i.e., sale of government bonds
and securities. These two instruments together help to reduce
demand for capital and other goods. Therefore, if all goes well then the
deficit in the balance of payments is bound to decrease.
Fiscal Policy
Fiscal policy as a tool of income regulation includes vanatlon in
taxation

and

public

expenditure.

Taxation

reduces

household

disposable income. Direct taxes directly transfer the houseilOld

income to the public reserves while indirectlaxes serve the same
purpose through increased prices of the taxed commodities. Direct
taxes reduce personal savings directly in a greater amount while
indirect taxe~ do it in a relatively smaller amount. Taxation reduces
the disposable income ofthe household and thereby the aggregate
demand including the demand for imports. Taxation also helps to
curtail investment by taxing capital at progressive rates.
The g~veinmeht can reduce income and demand also by adopting

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the policy of surplus budgding in which the government keeps its

expenditure less than its revenue. Ll'~:>tion reduces disposable
income of household and public expenditure increases household's
income and their purchasing power. However, multiplier effect of
public expenditure is greater by one than the multiolier effect of
taxation. Therefore, while adopting surplus-budget policy due
consideration should be given to this fact. To account for this fact, it
is necessary that surplus is so largi.: that the total cumulative effect
of taxati?n on disposable income exceeds the effect of public
expenditure. The reduction in income that will be necessary to
achieve a certain given target of reducinG balance of payments deficit
depends on the rate foreign trade multiplier.

Exchange Depreciation and Devaluation

Reducing 'excess demand through price measures involves changing
relative prices of imports and exports. Relati';e prices of imports and
exports

can

be

changed

through

exchange

depreciation

and

devaluation. Exchange depreciation refers to fall in the value of home

currency in terms of foreign currency and devaluation refers to fall in
the value of home currency in terms of gold. However, ill terms of
purchasing power, parity between devaluation and depreciation turns
out to be the same and its impact on foreign demand is also the
same. Therefore, we shall consider them as one in their role of
correcting adverse balance of payments.
Devaluation and exchange depreciation change the relative prices
of imports and exports, i.e., import prices increase and export prices
decrease, though not necessarily in the proportion of devaluation. As
a result of change in relative prices of exports and imports, the
demand for imports decreases in the country, which devalues its

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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

Complete domination over the foreign exchange transactions.

The government monopolises the purchase and sale of foreign

exchange.
Law el iminates the sale and purchase of foreign exchange by

the

resid~nt individuals. Even holding foreign exchange without

informing the exchange control authority ;s declared illegal.
All payments to the foreigners and receipts from them are

routed
through the exchange control authority or the authorised
agents.

Foreign exchange payments arc restricted, generally, to the

import
of essential goods and service such as food items, raw
materials,

other essential industrial inputs like

petroleum products.
A system of rationing is adopted in the foreign exchange

allocation
for essential imports.

To ensure the effectiveness of the exchange control system

and to
prevent the possible evasion, strict, stringent laws like FERA
and/COFEPOSA in India arc enactec.

The circuitous legal procedure of acquiring

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import amI export

licences is brought in force. In the process, the convertibility
of the
home-currency is sacri ficed.
Why Exchange Control?
The cxchange' control systcm as a mcasurc of' adjusting adverse
halance 01 plIYlllcnl diffcrs I'IldiclIlly (hllil lhe Indirect elHTt'di\'l'
nll'IISlIrl'S. Wllik till" 1"lkl works through the markct forccs, the
fonncr works through a cOlllrol lIIechanism based on adhoc rules
and regulations. In contrast to the self-sustained and automatic
functioning of the market system, the exchange control requires a
cumbersome bureaucratic system of checks and controls. Yet, many
countries facing balance of payment deficits opt for exchange control
for lack of options. In fact, automatic adjustment in the balance of
payments requires the existence 0 I' thc following conditions.

International competitive strength of the deficit countries.

A fairly high elasticity of demand for imports.
Perfectly competitive international market mechanism.
Absence of government intervention with the demand and

supply
conditions.

The existence of these conditions has always been doubted.

Owing to differences in resource endowments technology, and the
level of industrial growth, countries differ in their economic strength
and their industries lack the competitiveness. The protectionist
policies adopted by various countries intervene with international
market mechanism. Besides, automatic method of balance of
payments adjustment requires a strict discipline, economic strength

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and political will to bear the destabilising shocks which the

automatic method is expected to bring to a country in the process of
adjustment. Since these conditions rarely exist, the efficacy of
internati'onal market mechUl1ism to bring automatic balance of
payments adjustment is orten doubted.
For these reasons, exchange control remains the last resort for the
countries under severe str<lin of balancc or payments dclicits. The
e:-:ch:\llge contn)1 is qid to possess a superior effectiveness in
providing solutions to the deficit problem. Besides, it insulates an
economy against thc impact of eeonOl'nir. nlleluOItioliS i'1' "~I foreign
countries. Another positive advantage or exchange control lies II' \lS
cfrcctivcness in dealing with the problem or capital movements. The
governlllCnl'S I monopoly over the roreign exchange can eflectively
stop or reduce the eapit:li t"i movements by simply refusing to release
foreign exchange for capital transrcr. Many countries, i.e., Germany,
Denmark and Argentina, adopted exchange control during 1930s
because of this advantage. Although the exchange control is positively
a superior method of dealing with disequilibrium in th~ balance of
payments, it docs not pro' -ide a perman<.:nt solution to the basic cau~es of
deficit problem.
Exchange control may no doubt provide solution to balance of payment
deficits, but it also creates following problems:
When restrictions on exchange control becomes wide spread then large
number of currencies are rendered inconvertible. This restricts foreign
trade and the gains from foreign 1rade are either lost or reduced to a
minimum.
Even after the interest of an economy is secured, i.e., external deficit is
rCll1ov<.:d and insulation of e<.:onomy against external influence is

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complete; the exchange-control countries instead of giving up exchange

control feel lITe to gear their int<.:rnal policks, monetary and fiscal,
towards the promotion of economic growth, a<.:hieving full employment
and its maintenance. In doing so, they adopt easy monetary and
promotional fiscal policies. Consequently, income and prices tend to
rise, and inflationary trend is set in the economy.
Price also tends to rise, since in an insulted economy, import-competing
industries are not under compulsion to check cost increases and to
improve efficiency. As a result, exports become relatively costlier and
imports relatively cheaper and hence, exports tend to shrink and
imports tend to expand. These are the first outcome of overvaluation of
home-currency. The balance of payments is no doubt maintained in
equilibrium, but the init.ial advantage gradually disappears.
The countries confronted with the problems arising out of exchange
control ,II'C forced to find new outlets for their exports and new sources of
imports. The dTorts in this direction give rise to bilateral trade agreements
between the countries having common interest. The basic feature of the
bilateral trade ;Igreements is to accept each other's inconvertible currency for
exports and use the same Jor imports. Under the trade agreements, the
commodities and their quan~ilt'es or values should I also be specified.
Another outcome of exchange contr leading to bilateral trade agreement is the
emergence of disorderly cross cxcl ,anl',1.: r[lte~, i.e., the multiplicity of
inconsistent exchange rates. In other words, i .. IlIhl(;rii~)1<; currencies have
different exchange ratep betweeI: them. ''l(in'illeonvertible currency has different exchange relation with the
countries .. ~ p,\ty to the bilateral trade agreement therefore, exchange rates
are not consis fent with each other. The multiplicity of inconsistent exchange
rates occom;;;s inevitable when countries having trade surplus and deficits fix
up official r;llt's frnlll timc to time dq1l'ndin!-,- nn their requirelllents ,ll1d

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1ll,Iintain it through arbitrary rules. Exchange rates beconie multiple

also because 'exchange arbitrage', i.e., the simultaneous purchase and
sale of exchange in di fferent markets, becomes impossible.
Under the multiple exchange rate system, there may be a dual
exchange rate policy. In dual exchange rate policy, there is an official
rate for permissible private transactions and official transactions and
a market rate for all other kinds of transactions. However, the multiple
exchange rate system has its own shortcomings .. The system adds
complexity and uncertainty to international transactions. Besides, it
requires efficient and honest administrative machinery in the absence
of which it often leads to inefficient use of resources. It is, therefore,
desirable for the deficit countries to first evaluate the consequence:>,
efficacy and pract'::ability of exchanre control and then decide on the
course of action. It has been suggested that exchange control, if
adopted, should be moderate and as temporary measure until the
basic solution to the problems of balance of payments deficit is
obtaired. The exchange control problem does not provide permanent
solution to the balance-of-payments deficit and therefore, it should be
adopted only with proper understanding.
REVIEW QUESTIONS
I. What is the relevance of national income statistics in business
decisions?
2. What kinds of business decisions are influenced by the change
in national income?
3. Describe the various methods of measuring national income.
How is a method chosen for measurfng national income?
4. Distinguish between net-product method and factor-income
method.

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Which of these methods is followed in India?

5. What is value-added? Explain the value-added method of
estimating national income.
6. Define inflation. Explain its effect on (a) total output, and (b)
distribution of income between, different economic classes.
7. What are the causes of price inflation? Is it inevitable in the
course of economic developm.ent?
8. What is an inflationary gap? Explain methods used to close this
gap.
9. Distinguish

clearly

between

demand-pull,

cost-push

and

sectoral infl~ltion.
10. "Inflation

is

unjust

and

in~quitable

and

deflation

is

inexpedient." Discuss this statement fully.

11. What is meant by a trade cycle? Describe carefully the di
fTcrcnt phuses of a trade cycle.
12: Distinguish trade cycles from other economic fluctuations.
What, in your opinion; is the most adequate explanation of a
trade cycle?
13. Describe the various phases of the trade cycle. What courses
can the Government ~dopt to control a boom?
14. "T,he business cycle is purely a monetary phenomenon."
~iscuss.
15. Discuss the view that innovations alone cannot explain the
phenomenon of trade cycles without a substantial monetary
explanation.
16. Define balance of payments. If balances of payments always
balance, how is the deficit or surplus in balance of payments
known?

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17. What are the causes of different kinds of disequilibrium in the

balance of payments? Suggest measure to correct an adverse
balance of payments.
18. What is the purpose of exchange control? Examine the efficacy
of exchange control as a measure to correct adverse balance of
payments.
19. What is meant by devaluation? What are the conditions for its
effectiveness as a corrective measure of un favourable balance
of payments?
20. What is the difference hetween balance of trade and balance of
payment?

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

Note: All questions carry equal marks

1. What is Managerial Ecor.omics? How does it differ from

traditional ece
2. Give short note on "Demand Analysis".
3. Explain the relationship between marginal cost, average cost, and
tot
4. What are the main features of pure competition? How does an
organisatil
its policies to a purely competitive situation?
5. Distinguish between the Pure Profit and opportunity Cost.
6. What is meant by Price discrimination? What are its objectives?
7. What is the difference between balance of trade and balance
ofpaymCi
8. What is value-added? Explain the value-added method of
estimating Income.

SECTION -B
(4 x 15 = 60)
Answer any Four questions

9. Discuss

some

of

the

important

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economic

concepts

and

techniques busines~. management.

10.

What are the advantages and limitations of large-scale

production', II. Distinguish between 'Production function' and
Cost filllc{ion', I iow \' dcvclop tllC production fUllction? Whlltun:
its uscs'!.

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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