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MBA PAPER 1.

3 MANAGERIAL ECONOMICS SYLLABUS Managerial economics: Meaning, nature and scope; Economic theory and managerial economic; Managerial economics and business decision making; Unit 2 Unit 3 Role of managerial economics. Demand Analysis: Meaning, types and determinants of demand. Cost Concepts: Cost function and cost output

Unit 1

relationship; Economics and diseconomies of scale; Unit 4 Cost control and cost reduction. Production Functions: Pricing and output decisions under competitive conditions; Government control over pricing; Price discrimination; Price discount and Unit 5 differentials. Profit: Measurement of profit; Profit planning and forecasting; Profit maximization; Cost volume profit Unit 6 analysis; Investment analysis. National Income: Business managerial decision. cycle; Inflation and

deflation; Balance of payment; Their implications in

REFERENCE BOOKS: 1. Gupta G S, Managrial Economics, Tata McGraw-Hill

2. Varshney and Maheswari, Managerial Economics, Sultan Chand and Sons. 3. Mehta P L, Managerial Economics, Sultan Chand and Sons. 4. Joel Dean, Managerial Economics, Prentice-Hall. 5. Rangarajan, Principles of Macro Economics, Tata McGraw-Hill.

CONTENTS 0. SYLLABUS 1. NATURE & SCOPE OF MANAGERIAL 2. ECONOMICS DEMAND ANALYSIS

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3. 4. 5. 6.

COST CONCEPTS PRODUCTION FUNCTION PROFIT NATIONAL INCOME

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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 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 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 firm unrealistic since it fails to provide a 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 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 This in decision-making and formulating business forward planning: involves

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 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 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 aims in particular situations. Managerial economics, therefore, has been described as 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, anti-monopoly measures and labour relations. DIFFFFERENCE ECONOMICS BETWEEN MANAGERIAL ECONOMICS AND

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. Managerial 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, economics is micro-economic in character, however, Economics is both macro-economic and micro-

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 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. 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 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 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 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 divisionsmicroeconomics 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 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 experimental economics testing also of employs economic statistical methods for The generalisations.

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 decisionmaking 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: 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 raw-materials, 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. A 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. 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 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 pertaining areas. to It then applies the areas. decisions Thus of each are department or specialist, those implications, other functional which

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. 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

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: 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: 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 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 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. resulting from changes in prices, products, procedures, investments or whatever may be at stake in the

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 Rs. 1,500 Material Rs. 2,000 Overhead (Allocated at 120% of labour cost) Rs. 1,800 Selling administrative expenses (Allocated at 20% of labour and material Rs. 700 cost) Total Cost 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. 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 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 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 short-run 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 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= where, V = present value i = rate of interest. Now, applying the formula, we get V= = Rs. 100 1+i 100 1.08 Rs. 100 1+i

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 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 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 selfperpetuation and inertia.

Gaps between Theory of the Firm and managerial Economics 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 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.

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, 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 considerable personnel immediate and thereby eliminating decision expenses. This

would, however, have a substantial impact on longrun 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.

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 expected 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 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 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. o 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 from supplements and it. a The behavioural theory represents the firm as an adoptive institution. It learns experience has 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 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 decisionmaking. 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 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. 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.

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, 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.

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 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: 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, 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 Macro-forecasting for

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 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 statements about impending economic developments. These can be based upon the 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 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 and attempting to minimise the use of technical terminology while communJcating his ideas to 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 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?

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 estimated demand. MEANING OF DEMAND Demand for a good implies the desire of an individual to acquire the 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 for a product in future, which further helps to plan production based on 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.

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 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 a 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 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 nondurable 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 nondurable 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 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 automobilesdemand autonomous demand increas (Stock) demand in , demand st 10,000 1 year 10,000 2nd year -3id year 10,000 12,000 1000 1200 1000 1000 _ 12,000 2000 14,200 2200

4th year

14,200

1420

1000

16,620 2420

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 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, availability of better substitutes, sales promotion, and consumer credit facility. The established expenditure. DETERMINANTS 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 producers, choice of short-term products and lcmg-term for the new concepts of demand are useful in designing new products for entrepreneurs, in pricing policy and in determining advertisement

Advertisement of the product Consumers' expectations about future price and Demonstration effect and 'bend-wagon effect Consumer-credit facility supply position

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, 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 price-demand 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 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.

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 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 incomedemand 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 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.

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 incomedemand 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.

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 oldfashioned 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 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 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. 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-wagon-effect.' 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 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 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.

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 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 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, 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 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 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. Longrun costs, on the other hand, are the costs, which are incurred on the fixed assets like plant, building, machinery, etc. Such costs have long-run 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 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. 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 by-the 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 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) where, TC = total cost Q = quantity produced (1)

Cost functions depend on production function and marketsupply function of inputs. Production function specifies the technical 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 short-run cost-function and long-run cost function. Costoutput 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 Q TFC Q TVC

TFC + TVC Q

AFC =

AVC = and

Q (3)

AC = AFC +AVC

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 (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) (5)

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, 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 (6) 5.15 4.40 3.75 3.20 2.75 2.40 2.15 2.00 1.95 2.00 2.15 2.40 2.75 3.20 3.75 4.40 AC (7) 15.15 9.40 7.08 5.70 4.75 4.07 3.58 3.25 3.06 3.00 3.05 3.23 3.52 3.91 4.42 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. 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 TFC Q (8)

AFC =

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) 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 (10) 60.9Q+0.05Q3

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 = (11) Q= 9 0.9+0.10Q=0

Thus, the critical value of Q=9. This can be verified from Table 3.1 Average Cost (AC) The average cost in defined as AC = TC Q

Substituting equation (6) for TC in above equation, we get 10+6Q-09Q2+0.05Q3 AC = Q (12a)

10 = Q + 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 Q = 10 Thus, the critical value of output in respect of AC is 10. That is, AC reaches its minimum at Q = 10. This can be verified from Table. 3.1 shows short-run cost curves. By solving equation (12b), we get

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, aTC aQ

MC =

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 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 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 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 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 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 STCl 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 short-run total cost curves are added to STCl in the manner shown by STC2 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 long-run average cost curve (LAC). Note that there is one SAC associated with each STC. Given the STC1 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 C2Q2 when the second plant is added and then rises to C 3Q3after the inclusion of the third plant. The LAC carl be drawn through the bottom of SAC1 SAC2 and SAC3 as 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 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 shortrun 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 SAC3 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 OQ1 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 OQ3. A curve drawn through points M3B 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 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.

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 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 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 byproducts 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, 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 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, Vickers Ltd., make aircrafts, ships, armaments, food-processing plant, rubber, 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 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 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 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 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 al3 and the area of t~e material needed will increase to 6a12. Thus, for two containers of dimensions an and al the ratio of the areas of material needed will be: M1 M0 6a1/2 6a0/2 a1/2 a0
2

so, the

The corresponding ratio of the volumes will be: V1 V0 a1/3 a0/3 a1/3 a0

From the above, it follows that: M1 M0 a1/2 a0/2 a1/3.2/3 a0 = V 1 2/3 V0

Now, if we double the volume, i.e., if V1 V1 = Then, M1 V1 2/3 = V0 M0 M1 = 1.59 M0 = (20) 2/3 = 1.59 2V0 or V0 =2

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 M0 = V12/3 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 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: 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 work-force is kept small to carry out vital operations such as forgoing, blanking, notching and final assembly. The rest of the work is sub-contracted 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 scopeeconomies instead of scale economies. COST CONTROL AND COST REDUCTION Cost Control 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. 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 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 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 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. 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 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 Labour costs/production

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. 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.

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 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 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

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, under-utilisation 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, 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 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? (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 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 a usual phenomenon. With a view to insuring against these shortages, 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 also pushes up costs. 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. from time to time

However, now with the advent of recession tendencies, and liberalisation control. in licensing policies, the Indian industrialist is compelled to pay greater attention to cost reduction and cost

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 (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

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. those Such variances to matters are called his uncontrollable whereas relating within

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 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 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 give them to certaii1iliithorised dealers. The

are rarely used for quoting differential prices to distributors. Manufacturers accounting. A uniform list price modified by a structure of discounts, each simplicity of this method enables some savings in invoicing and

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, 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 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 are having to warehouse' identical them. Even when distributors pcrforming services, operating

costs'may differ among individual distrihutors depending upon variations in their 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 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 sub-markets, each havin own peculiar competitive and

demand characteristics. For example, il tyre market, the following sub-markets 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 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 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 highquality 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 enables in view of big their plants' respective to reap profitability. economies of Market size. segmentation achieved through differential distributors' discounts building 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 becomes sufficiently

popular and its demand increases sufficiently to work the big plant fully. If so, they can discontinue the private label business. Distributors' consumers: Distributors' demand for the competing brand of different demand elasticity higher than that of

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. 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 full-case 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, 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 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 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 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) 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

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 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 intra-regional 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. 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, interestfree 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: 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. may be technical, managerial, financial or risk-bearing." Elucidate. 8. 9. 10. and discuss the various areas of cost control. 11. Distinguish between cost control and cost reduction. the essentials for the succcss of a cost reduction programmc? What are Discuss the various economies of scale. Do they result in monopolies? What are the advantages and limitations of large-scale production? State the importance of cost control in profit planning "Economics of scale may be either external or internal; they

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 Capital (Y) - Size 250 Labour (X) 1 2 (Number of 2 4 workers) 3 8 4 12 5 32 6 58 7 88 8 100 9 110 10 104 of machines (in horse power) 1,000 1,500 2,000 20 32 26 48 58 88 88 110 100 110 120 110 120 124 120 124 126 124 126 128 128 126 130 130 126 130 132 124 130 134

The production function can also be stated in a form of an eqation: Q = f (X1, X2, etc.), 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, 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 long-run, 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. 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 X 1and 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 increasing marginal returns only. Here, both AP and MP increase. In this stage, a firm can move towards factors. Stage II The stage II is depicted by the figure in the range from X2 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 optimum combination of factors of production and increasing returns, by adding more and more variable units to fixed

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 X3 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 Product Stage I Increasing at an increasing rate PhysicalMarginal Physical Product Average Physical Product

Increases, reaches Increases and reaches 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 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'.

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 2 3 4 5 Capital (Units) 5 3 2 1 0 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'.

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 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. 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 (C1). The same shirt can be as well made with less cloth (C2), 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 L1 to L2 allows the input of cloth to be reduced from C1 to C2, a very large increase in labour from L2 to L3 is needed to obtain a small 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

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.

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.

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 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 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.

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 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 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 Marginal productivity decreases at an increasing rate in the curve. later stages. 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 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 macroeconornic 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 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 exception for production. Therefore, with the possible' 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 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 output-would 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 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 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 The theory or lhe firm deals with the role of business firms in

increase for a factor reduccs its demand. 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 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 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 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 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 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 OQ1. 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: (flat) DD. Price will rise more or fall more if the supply curve is 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 inelastic (steep) Price will rise less or falllcss if the supply curve is elastic

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 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 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 output. The government also tries to set maximum prices below the The government can ask the farmers to limit their

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

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, shortperiod 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. 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. 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 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 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 degree of price instability than is the case with

greater

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 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 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 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 Process Towards Long-run Equilibrium in

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 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 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: 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 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 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 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 competition; and (iii) oligopoly and oligopsony. However, in this chapter, the discussion is confineclto monopoly

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 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 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: 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 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 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 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 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: sellers or firms whercns in monopoly, there is a single seller or firm. Under perfect competition, the individual seller has no control Under perfect competition, there are a large number of

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. 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 Under perfect competition, firms get only normal profits in

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. 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.

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 Expenditure per Worker (AE) (Rs.) 500 550 600 650 700 750 ... _. _.Total Expenditure (TE) (Rs.) 3,000 3,850 4,800 5,850 7,000 8,250 .. ~- .... - .- Marginal Expenditure (ME) (Rs.) 850 950 1,050 1, 150 1,250

6 7 8 9 10 11

Price Discrimination Price discrimination, may be defined as the practice by a seller of 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 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 submarkets according to elasticity. Market sealing: The seller must be able to prevent any significant resale of goods from the lower to the higher price sub-market. 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 by quantity of purchase: Traders often distinguish between large and small purchasers, offering quantity discounts to large purchasers. The big buyers because 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. off-season 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 largescale 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 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 dispose of occasional or irregula surpluses. To develop a new market. To make the maximum and proper use of the unutilised To earn monopoly profits.

to the producer and not to the consumer.

capacity.

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

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.) 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

9.00

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? 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 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 (Uuits) 100 200 300 400 500 700 1,000 1,400 2,000 2,800 3.600 Total Revenue (Rs.) 1,600 2,100 2,400 2,500 2,SOO 3,000 3,500 4,000 4,200 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 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.) 1 9.00 8.00 7.00 6.00 5.00 4.00 3.00 2.50 2.00 1.50 1.00 Sales Sales (Units) each Catego (units) 2 3 100 200 300 400 500 700 1,000 1,400 2,000 2,800 3,600 100 100 100 100 200 300 400 600 800 800 Revenue from each category (Rs.) 4 900 800 700 600 500 800 900 1,000 1,200 1,200 800 Total Revenue (Rs.) 5 900 1,600 2,100 2,400 2,500 2,800 3,000 3,500 4,000 4,200 3,600 6 Total Cost (Rs.) Profit or Loss (Rs.) 7 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 6,400 4,400 .8,000

Here, the prices, sales and total costs are the same as they were 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 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 Revenue Total Total each from Revenue Cost Category each (Rs.) (Rs.) (units) category (Rs.) 3 1,000 400 4 3,000 1,000 5 3,000 4,100 6 3,400 4,100 Profit or Loss (Rs.)

1 3.00 2.50

2 1,000 1,400

7 -400 -100

2.00 1.50 1.00

2,000 2,800 3,600

600 800 800

1,200 1,200 800

5,200 6,400 7,200

5,000 6,400 8,000

200 0 -800

But capacity utilisation and availability of supplies will remain unaltered.

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 D1 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. 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.

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 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: P= 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., Slope of the firms demand curve degree of monopoly power Slope of the industrys demand = curve 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. 2. function. 3. Discuss the equilibrium of the organisation with the technique of' isoquants. 4. Distinguish between production function and cost function. How would you develop the 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 Explain the nature mid managerial uses of production

situation? 6. 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. 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 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. 15. Comment on the various types of discounts and the effects of each on sales. 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 superExplain the effects of government intervention in price fixation. What steps are necessary to make this intervention What is the short-down point? Explain why a

organisation suffering losses still decides to operate and not shut

normal profits? 16. Explain establishment competition. 17. Examine the weaknesses of the traditional theory of pricing from the point of view of an individual organisation. of and illustrate the conditions under for the organisation's equilibrium perfect

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. 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 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 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 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 noncalculable 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. 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 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. 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 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: 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

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 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 = Rate of depreciation

Historical cost-residual value Economic life of the asset

Amount

of

depreciation

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: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 1st 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 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 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. (1)

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.

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 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: (2) With the help of equation (2), The first order condition and the

aTP aQ

aTR aQ

aTC aQ

=0 (3)

This condition holds only when aTR aQ = aTC 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 P2. 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 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 (6) Then Or, (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 or, TR = (100 2Q) Q TR = 100Q 2Q2

aTR aQ

aTC aQ (9)

Putting the values of Equation (7) and (8) in (9) MR and aTC MC = aQ =Q = aTR aQ < aTC aQ = 100 4Q

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 <0

- 4 1 <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 is the firms, pursuing goals other the thon profit and maximisation distinction between ownership

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 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 weaknesses. He further argued that there has been a 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 HYPOTHESIS IN FAVOUR OF PROFIT MAXIMISATION

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 longrun growth, maximisation of sales revenue. The achievement of such alternative objectives depends wholly or partly on the primary objective of making profit. Profit maximisation objective has a greater predicting As comparcd to other business objectives, profit

power:

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

consistently over tillle and at the same level. Profits may fluctuate with changing conditions. 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 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 Uo 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 price with the market is the condition main of oligopolistic of profit interdependence. Another serious shortcoming is that it ignores determination, which concern

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

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, confiicting accountants, interests in lawyers, the etc. All these groups have 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. 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. 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 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 a 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 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. A. B. the firm. C. Maintaining internal control over management by restricting firm's size and profit. Standards of Reasonable Profits Other factors: The other factors that interrupts the Managerial utility function, which is preferable for, Friendly relations between executive levels within profit maximisation objective include the following: profits maximisation to firms.

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 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. 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: o o o Attracting external capital Discouraging growth of competition 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 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 profit-performance 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 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, 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 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 break-even 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: BEP = Rs. 10,000 (4-2) = 5,000 units

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: BEP = Example 2: Sales Variable costs Fixed costs Rs. 10,000 Rs. 6,000 RS. 3,000 Fixed costs contribution margin ratio

With the help of given information, calculate net profit. Solution. The contribution margin ratio is (10,000-

6,000)/10,000 = 0.4 BEP = Fixed costs contribution margin ratio

3,000 0.4

= Rs. 7 500

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 Increase in profit Increase in variable costs 19,000 - 15,000 = Rs. 4,000 1,200 - 400 = Rs. 800 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 Profit VC + Profit Sales value Fixed cost SV S 15,000 x 0.80 12,000 400 12,400 15,000 2,600 3,000 15,000

15,000 12,000 15,000

= 0.2

Now, BEP =

FC Contribution margin ratio

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: ~ Product Selling Price Rs. Tables Lamps Chairs 40 50 70 VC Per unit Rs. 30 40 50 20 30 50 % of rupee Sales volume

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: Selling price - VC

Contribution percentage = Selling price

x 100

Thus, the contribution percentage for individual items is: 40 - 30 40 50 - 40 50 70 - 50 70 1 4 1 5 2 7

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

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

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

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 Tables Lamps Chairs 25.00 % 20.00 % 28.57 % X X X % of Sales 20 % = 5.00 % 30 % = 6.00 % 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: Fixed costs Contribution marginper unit 20,000 = 25%

BEP =

Rs. 80,000

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 = 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 profitgraphs. 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.

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.

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 X-axis. 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 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 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 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 = Example 5: Assume that our sales in Example 1 are 8,000 units. Safety = 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: Safety = = 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: (4,000-5,000) x 100 Margin 4,000 (8,000-5,000) x 100 Margin 8,000 = 37.5% (Sales BEP) x 100 Margin Sales

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 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 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: FC + P SPn - VC where Qn = New volume of sales Qn = FC = Fixed cost P = Profit SPn = New selling price = 8000 units

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 + = 1.60 16, 000 = 10,000 units 6,000 3.60 2.00

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 profit would be: 10, Q
2

000

6,000 4.50 2.00

16, 000 = 6,400 units 2.50

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 = 2. FC +P SP - VC n

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. 10, Q
2

000

+ =

15, 000 = 10,667 units 1.50

6,000 4 2.50

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 + 2. SPn = SP + FCn FC Q FCn FC SP - VC

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 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: Existing Plant 0% 100 % Rs. (in Lakhs) Sales 60 Fixed costs 15 15 Variable costs 38.4 Capacity Expanded Plant 0% 100 % Rs. (in Lakhs) 80 20 20 51.2

Profit (Loss)

(15)

6.6

(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. the break-even point? 2. What would be the sales volume required to maintain the How will the expansion of the firm's capacity will affect

present profit with the increased fixed costs? 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 profit-volume chart. On the assumption that production efficiency and prices will remain unchanged, the profitvolume 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.

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 breakeven 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 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 a 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 Tables Beds Total fixed PrLe (Rs.) 100 200 60 Variable costs % of Per unit sales (Rs.) 40 30 60 20 120 50 year: Rs.

costs

per

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 Total 75,000 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: fixed Price (Rs.) 60 160 200 cost per Variable costs Per unit (Rs.) 40 60 120 year: year: Rs. Rs. % of sales 50 10 40

Sales

this

Rs. 60 - 40 60 Rs. 100 - 60 100 Rs. 200 - 120 200

x 30% = 0.10

x 20% = 0.08

x 50% = 0.20/0.38

Thus, the contribution ratio is 0.38, by adding 0.10, 0.08 and 0.20. 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: A 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. 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

= Quality:

10,000 5

= 2,000

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. 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

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 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 or, 1.60S 12000 or, S = 1.60 = Rs. 8,000 + 2S = 12,000 = 7,500 units

2. Semi-automatic vs. Hand-operated: Rs. 8,000 + 2.00S or, 2S or, 8 = Rs. 2,000 + 4S = 6,000 = 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

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 cost-volumeprofit 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: 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: Particulars Variable cost Selling price Pcr mctrc Cloth X Rs.2.00 RS.2.60 Cloth Y RS.3.00 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: 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 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. Business A Re. 1.00 Re.0.20 RS.5,000 Business B Re.I.OO Re.0.60 Rs.2,500

Selling price per unit Variable cost per unit 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. 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 towards imputed costs, arbitrary depreciation

may suffer from various limitations of such data, such as negligence estimates and inappropriate allocation of overhead costs. Breakeven 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 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 cost-

revenue-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 breakeven 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. 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 break-even 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 inter-relation of the various components of the income statement. Brcak-even analysis: It helps in identifying functional

relations 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 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?

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 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 and

of

goods

and

scrvices by

by

thc

govcfl1ment

cntcrpriscs,

services

produced

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 noneconomic 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 self-employed. 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 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 war-loans, 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. 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 o o o o o o o o Relations at market price GNP = GNI Gross Domestic Product (GDP) = GNP less net income NNP = GNP less depreciation NDP (Net Domestic Product) == NNP less net income

from abroad

from abroad Relations at factor cost GNP at factor cost = GNP at market price less net NNP at factor cost = NNP at market price less net NDP at factor cost = NNP at market price less net NOP at factor cost = NDP at market price less net NOP at factor cost = GOP at market price less

indirect taxes. indirect taxes income from ahroad indirect taxes 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, and investing units (individuals, households and saving

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 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. 2. used arid depreciation of physical assets: The next step in estimating the net national income is to estimate (he cost of production including depreciation. Estimating cost of production is, however, a relatively more complicated and difficult task because of nonavailability 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 tax-laws. In some estimates of national income, the estimators and have have deviated instead from the traditional practice estimated Estimation of cost of materials and services

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 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 factorincomes are grouped under three categories: 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)

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 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 non-pro;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 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 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 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 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 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 199495 (Decennial) (At current prices) (Rs. Crores) A National Income Aggregates (At F:actor C Jst) 1960-61 197071 198081 199091 1992-93

Gross Domestic Prodllct (GDP

15,254

39,708

1,22,42 7

4,27,60 0

6,27,60 0

2. 3.

4.

Fixed Capital Consumption Net Domestic Product (NDP) = (1-2) Net Factor Income from Abroad

940 14,314

2,921 35,787

12,087 1,10,34 0 345

51,884 4,20,77 5

71,569 5,56,34 4 -11409

-72

-284

06,833

Contd.... Indirect 947 3,455 13,586 58,205 77,653 Taxes Less Subsideis Gross 6,16,50 6. 15,182 39,424 122,772 4,65,82 4 National Product 7 (GNP) = (1 + 4) Net National 14,242 36,503 1,10,68 5,44,93 7. 4,13,94 5 Profit (NNP) 5 = (6-2) 3 GDP (at 16,201 43,163 1,36,01 705,56 8. 5,30,86 6 market 3 prices) 5 = (1+5) GNP (at 16,129 42,879 1,36,35 9,31,01 9. 5,24,03 6 Market 8 price) = (8 + 2 3) NDP (at 15,261 40,292 1,23,92 6,63,99 10 4,78,98 7 Market 6 price) = (8 . 1 2) NNP (at 15,189 39,958 1,24,27 6,22,58 11 4,72,14 8 market 1 price) = (9 . 8 2) Source : CMIE, Basic Statistics Relating to Indian Economy, Aug 5. 1994 Table 13.3

Table 6.2: Change in Composition of National Income (GDP) (At current prices) (Rs. Crores) Sector s Sectors 196061 Agricuitural and 45.8 Allied sectors Manufacturing 20.7 and Mining, etc. Transport, 12.1 Trade and Communication Finance and 11.9 Real Estate Community and 9.4 Personal Services Commodity 66.5 Sector (1 + 2) Non-commodity 33.5 Sector (3 + 4 + 5) All Sectors 100. 0 197071 45.2 21.9 13.2 10.0 9.7 67.1 32.9 100. 0 198081 38.1 25.9 16.7 8.8 10.5 64.0 36.0 100. 0 1990 91 1. 2. 3. 4. 5. 6. 7. 8. 31.8 28.8 19.6 8.3 11.6 60.5 39.5 100.0 1994-95 at 198081 prices 31.3 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 1950-51 to 1960-61 1960-61 to 1970-71 1970-71 to 1980-81 1980-81 to 1990-91 1990-91 to 1994,-95 1950-51 to 1994-95 Inflation and Deflation GNP (%) 4.08 3.74 3.47 5.57 3:95 4.04 GDP (%) 4.09 3.78 3.34 5.76 4.08 4.07 -- -----------

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, 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 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 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. 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 costpush 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 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 Open Inflation: Inflation is said to be open when prices rise

without any interruption. It may ultimately end into hyper-inflation. 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. 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 getting higher prices

hope of

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 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. 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 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 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 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 anti-inflationary 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. 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 costpush 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 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 unemployed returns, absence which of homogeneous be used factors to and resources, cannot 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 resources. There is, thus, imperfect elasticity of supply in an underdevelopeJ country. Underdeveloped countries face shortage of technical labour, capital, equipment these and transport are and power facilities. to grow Therefore, countries unable

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!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' 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 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 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 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.

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. 3. 4. 5. Taxes paid to the government: Gross disposable income (I -2): Saving by the community at 10% oft',e income: Net disposable income with the community: 5,000 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. 3. Appropriated for war purposes: Available for civilian consumption: 20,000 8,000 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.

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 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 of- G 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

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 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 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 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.

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

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 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 raw in the economy. and Factors of production, scarce, particularly' materials labour becon~e

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 overoptimism 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 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: 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 tradc cycle. The climatic theory, also known as the sunspot theory because the spots that appear, on the face of the sun theories of

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 nonagricultural 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. 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 over-production. 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 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 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 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 :capitalintensivep;1ethods of production, i.e., to change the capital-output 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 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 overinvestment. 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. 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 capitalintensive industries result in exceSs capacity. Besides such investmcnts arc time-consuming 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 over-investment, 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 further prices to rise, thereby Thus, misleading D.H. their appraisal of prospective profits. This price rise encourages entrepreneurs to over-investment. 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 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 over-production. 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 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 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 call-back 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 as possible wi!! lead to confusion and collapse of the market. Marginal and average fimls may even go into liquidation, 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 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. 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 the expenditure is relatively stable, and consequently it is

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 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 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 the impact of the multiplier an<i acceleration effects, the process of increased investment 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 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 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.

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 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 PP1 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 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 unrhythmic 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 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 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 out, innovations alone cannot explain the phenomenon of trade cycles without a substantive 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 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. 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: 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. a 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 of consumption in the country or bring a change in the current level of national income. 2. Capital of transactions: instead of Capital transactions the arc those of

transactions, which increase or decrease counlry's Iota I stock capital, affecting current level 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. 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 I. Merchandise 2. Foreign travel 3. Transportation 4. Insurance (premium) 5. Investment Income 6. Government Cr;:rchase and sales of goods and services) 7. Miscellaneous* Current Account Balance

Credit Export. Earnings Earnings Receipts Dividend Receipts

Debit Import Payments Payments Payments Dividends Payments

Net Balance -

Receipts -

Payments Payments

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.

Short-term capital movements include (i) purchase of shortterm securities 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. Longterm 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 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 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 In of long-term the capital are capital autonomous movements transactions. addition, short-term

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 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 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

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 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 to large. The countries with higher marginal propensity to import accumulate larger deficits 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 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 knowhow. 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 short- Icrm lluctUlItiolls in the cconomy, Therefore, short-term del1dts of 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 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 full-employment 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 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 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 surplusbudget 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 imports 'excess and demand can through be price measures through involves exchange

changing relative prices of imports and exports. Relati';e prices of exports changed 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 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 the country. The main features of a full-fledged exchange control system are as follows: The government acquires, through the legislative Complete transactions. The government monopolises the purchase and sale of exchange. foreign domination over the foreign exchange measures, a

Law el iminates the sale and purchase of foreign exchange resid~nt without individuals. Even holding foreign exchange

by the informing the exchange control authority ;s

declared illegal. All payments to the foreigners and receipts from them are through the exchange control authority or the authorised agents. Foreign exchange payments arc restricted, generally, to routed

the import of essential goods and service such as food items, raw materials, petroleum products. A system of rationing is adopted in the foreign exchange for essential imports. To ensure the effectiveness of the exchange control allocation other essential industrial inputs like

system and to prevent the possible evasion, strict, stringent laws like FERA and/COFEPOSA in India arc enactec. 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 The circuitous legal procedure of acquiring

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 conditions. .

supply

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 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 complete; the exchange-control countries instead of giving up exchange control feel to gear their int<.:rnal policks, monetary lITe 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, importcompeting 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 outcom e 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 ;Igreem ents 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, IlIhl(;rii~)1<; currencies i .. have different exchange ratep betweeI: them. ''l(in'illeonvertible currency has different exchange relation with the countries .. ~ p,\tto the bilateral trade agreement therefore, exchange y 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 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 system and has official its own transactions and a market rate for all other kinds of transactions. However, the multiple exchange rate 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. 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? 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: MANAGI;:HIAL ECONOMICS Time: 3 Hours SECTION~A (5 x 8 = 40) Answer any Five questions Max. Ma

Note: All questions carry equal marks 1. What is Managerial Ecor.omics? How does it differ from 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.

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SECTION -B (4 x 15 = 60) Answer any Four questions 9. Discuss some of the important 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.