EEFA

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UNIT I
INTRODUCTION - Managerial Economics - Relationship with other disciplines - Firms:
Types, objectives and goals - Managerial decisions - Decision analysis.
ECONOMICS
Economics is the study of how societies use scarce resources to produce valuable commodities and
distribute them among different people.
SCOPE OF ECONOMICS
1. Consumption: Satisfaction of human wants is called consumption which forms one of the important
branches of economics. This tells how people behave in consumption of goods and services in order to
maximize their satisfaction.
2. Production: Goods and services have to be produced with the help of factors of production. So,
production is another branch of economics. It concerned with how maximum goods are produced with
minimum cost or how the scarce factors could be utilized economically for better results.
3. Exchange: Goods and services cannot be produced at one place or at one point of time. Goods
produced by one are exchanged for the goods produced by the others. So, exchange forms another branch
of study in economics.
4. Distribution: Goods and services are produced with efforts, i.e., by combining the factors of production.
These efforts have to be paid for or rewarded. The land gets rent, the labor get wages, the capital gets
interest and the organizer gets profit. This branch of study is called distribution in economics.
5. Public Finance: This branch of study in economics studies about the sources of revenue to the
government and the principles governing the expenditure for the benefit of the people. It also studies about
public debt and financial administration.
ECONOMICS IS A SCIENCE OR AN ART
Economics as a Science: A science is a systematized body of knowledge ascertainable by observation
experimentation. It is a body of generalizations, principles, theories or laws which traces out a casual
relationship between cause and effect.
Economics is a systematized body of knowledge in which economic facts are studied and analyzed in a
systematic manner. For instance, economics is divided into consumption, production, exchange,

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distribution and public finance which have their laws are theories on whose basis these departments are
studied and analyzed in a systematic manner. Hence economics is a science like any other science which
has its own theories and laws which establish a relation between cause and effect. Economics is also a
science because its laws possess universal validity such as the law of diminishing returns, the law of
diminishing marginal utility the law of demand, Greshams law, etc.
Again, economics is a science because of its self corrective nature. It goes on revising its conclusions in
the light of new facts based on observations. Economic theories or principles are being revised in the fields
of macro economics, monetary economics, international economics, public finance and economic
development.
Economics as an Art:
Unlike natural science, there is no scope for experimentation in economics because economics is
related to man, his problems and activities. Economic phenomena are very complex as they related to man
whose activities are bound by his tastes, habits, and social and legal institutions of the society in which he
lives.
Economics is thus concerned with human beings who act irrationally and there is no scope for
experimentation in economics. Even though economics possess statistical, mathematical and econometric
methods of testing its phenomena but these are not so accurate as to judge the true validity of economic
laws and theories. As a result, exact quantitative predication is not possible in economics.
Economics as both a Science and an Art:
Economics is not only a science but also an art. It is a science in its methodology and an art in its
application. It has a theoretical aspect and is also an applied science in its practical aspects
FUNDAMENTAL ECONOMIC PROBLEMS
Economic Problem: Due to the scarcity of means and the multiplicity of ends, the economic problem lies
in making the best possible use of our resources so as to get maximum output satisfaction in the case of a
consumer and maximum output or profit for a producer. Hence economic problem consists in making
decisions regarding the ends to be pursued and the goods to be produced and the means to be used for
the achievement of certain ends.
Fundamental problems facing the economy:
1. What to produce: The first major decision relates to the quantity and the range of goods to be
produced. Since resources are limited, we must choose between different alternative collection of goods

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and services that may be produced. It also implies the allocation of resources between the different types of
goods. Example: Consumer goods and capital goods.
2. How to produce: Having decided the quantity and the type of goods to be produced, we must next
determine the techniques of production to be used. Example: labor intensive or capital intensive.
3. For whom to produce: This means how the national product is to distributed, i.e., who should get how
much. This is the problem of the sharing the national product.
4. Are the Resources Economically Used? This is the problem of economic efficiency or welfare
maximization. There is to be no waste or misuse of resources since they are limited.
5. Problem of Full employment: Fullest possible use must be made of the available resources. In other
words, an economy must endeavor to achieve full employment not only of labor but of all its resources.
6. Problem of Growth: Another problem for an economy is to make sure that it keeps expanding or
developing so that it maintains conditions of stability. It is not to be static. Its productive capacity must
continue to increase. If it is an under developed economy, it must accelerate its process of growth.

CAPITALIST SYSTEM
Capitalism is that profit-oriented system which is characterized by private ownership of objects of labor
instruments of labor and means of labor. Production is mainly carried out with the help of labor services
rendered by the working class in return for wages and the class of capitalists has the right to whatever
output is produced within the system.
Characteristics of the capitalist system:
1. Private ownership of means of production:
Under the capitalist system anything which helps man in the production process like machinery, tools, land,
raw-materials, etc. is owned by the capitalist class.
2. Production for the market: Under capitalism business firms produce mainly with the aim of selling the
output in the market. Wherever any good is produced for the market it is termed as a commodity and any
economy in which production is undertaken with the sole object of exchange is call a commodity economy.
3. Price mechanism: In a capitalist economy neither an individual nor any institution takes decisions in a
planned manner concerning its day-to-day functioning. That is, there is no conscious effort to arrive at
some kind of solution to its central problems.
4. Labor power as a commodity: In a capitalist economy, majority of the people own only on thing viz.,
their capacity to work or their labor power.

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5. Exploitation of labor: Workers are exploited under capitalism. Very often due to the freedom granted to
the workers at a formal level, many people are wrongly given to believe that the workers by bargaining in
the free market are able to get a fair price in return for their labor power.
6. Growing wealth of the capitalists: In a capitalist economy the wealth of the capitalist class increases in
a sustained manner.
7. Emergence of the working class: Under capitalism the increasing used of machinery leads to
widespread unemployment and an increase in the rate of exploitation of workers which implies a decline in
the share of workers in the national income over time.
8. Class contradiction: Hence, the two major classes found in a capitalist society are those of the
capitalists and the workers. The clash of interests of the capitalists and the workers take the form of the
class conflict with the further development of capitalism.

SOCIALISM
Under socialism not only is there social ownership of the means of production but also the functioning of
the economy is such so as to maximize social benefit rather than private benefit. Unlike capitalism in a
socialist society the market mechanism does not play the all dominating role of determining the type and
quantity of various commodities produces their priority sequence and the necessary allocation of resources.
Characteristics (or) Salient features of the socialist economic system:
1. Social ownership of the means of production: In a socialist society private ownership of the means of
production is abolished in the various sectors of the economy.
2. Predominance of public sector: An important precondition for the establishment of socialism is the
existence of the public sector which is founded on the principle of social ownership of the means of
production
3. Decisive role of economic planning: Economic planning under socialism plays exactly the same role
as is played by the price mechanism in a capitalist economy.
4. Production guided by social benefit: In a socialist economy, however, income inequalities are
drastically reduced so that everyone has an adequate amount of disposable income. While determining the
pattern and size of output the planning commission has to see to it that its decisions in this regard are such
that they ensure the availability of commodities for all in the market.
5. Abolition of exploitation of labor: Once the development of human society reaches the stage of
socialism. Exploitation of man by man comes to an end.

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ENGINEERING ECONOMICS
It is the application of economic principles to engineering problems. For example, in comparing the
comparative costs of two alternative capital projects.
IMPORTANCE OF ENGINEERING ECONOMICS:
1. Engineering economics is concerned with the monetary consequences (or) financial analysis of the
projects, products and processes that engineers design.
2. Engineers are required to use economic concepts in the major fields such as increasing production,
improving productivity, reducing human efforts, increasing wealth by maximizing profit, controlling and
reducing cost.
3. Engineering economics provides has very important role to play in all engineering decisions.
4. Engineering economics provides a number of tools and techniques to solve engineering problems
related to product-mix, output level, pricing the product, investment, quantum of advertisement, etc.
5. Engineering economics helps in understanding the market conditions, general economic environment in
which the firm is working.
6. Engineering economics provide basis for resource allocation problem.
7. Engineering economics deals with identification of economic choices, and is concerned with the decision
making of engineering problems of economic nature.

APPLICATIONS OF ENGINEERING ECONOMICS
1. Selection of location and site for a new plant-It is concerned with comparing the cost of establishment
and operation of various locations and sites.
2. Production Planning and Control.
3. Selection of equipment and their replacement analysis.
4. Selection of a material handling system.
5. Determination of plant capacity. It is associated with investment of funds such as initial outlay and
operating expenses which determines the capacity of a plant. The capacity is a measure of ability to
produce goods and services or rate of output.
6. Determination of wage structure of the workers.
7. Selection of choice between a concrete structure and a steel structure, between various insulation
thickness, and between prices at which to sell a product.

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8. It can be applied by a major corporation to analyze plans for a new manufacturing facility or a new
research and development (R&D) thrust.

CHARACTERISTICS OF ENGINEERING ECONOMICS
1. Engineering economics is a traditional and important part of engineering practice.
2. Engineering economics is concerned with application of economic principles in technical and managerial
decision making.
3. Engineering economics embarrasses both micro and macroeconomic principles when applied to
engineering problems. For example, the study of demand analysis is mostly concerned with individual or
household as a small unit of study. Whereas, the study of impact of taxes on raw-materials will influence
engineers to look for alternative materials for manufacturing or designing a product or processes which is of
course a macro economic issue. The demand analysis is microeconomic principle.
Engineering economics also take in its fold certain concepts and principles from other fields such as
statistics, accounting, management, etc.
5. Engineering economics aids decision making aspect of an engineer and it avoids the abstract nature of
economic theory.
6. Engineering economics is mostly an application tool, whereas economics is a social science with broad
characteristics.
7. Economic theory conveniently ignores the significant backgrounds which are common to individual firms
but engineering economics take in to consideration the individual firms environment of decision making.
8. Engineering economics provides an analytical and scientific approach resulting in qualitative decisions

ADVANTAGES OF ENGINEERING ECONOMICS
1. Better decision making on the part of engineers.
2. Efficient use of resources results in better output and economic advancement.
3. Cost of production can be reduced.
4. Alternative courses of action using economic principles may result in reduction of prices of goods and
services.
5. Elimination of waste can result in application of engineering economics.
6. Competitive strength on the part of the firm in adopting engineering economics.
7. More capital will be made available for investment and growth.

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8. Improves the standard of living with the result of better products, more wages and salaries, more output,
etc. From the firm applying economics.

MANAGERIAL ECONOMICS
Managerial Economics has been described as economics applied to decision-making. It may be viewed as
a special branch of economics bridging the gulf between pure economic theory and managerial practice.
CHIEF CHARACTERISTIS
1. Managerial Economics is micro-economic in character. This is because the unit of study is a firm; it is the
problems of a business firm which are studied in it. Managerial Economics does not deal with the entire
economy as a unit of study.
2. 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.
3. Managerial Economics is pragmatic. It avoids difficult abstract issues of economic theory but involves
complications ignored in economic theory to face the overall situation in which decisions are made.
Economic theory appropriately ignores the variety of backgrounds and training found in individual firms but
Managerial Economics considers the particular environment of decision-making.
4. Managerial Economics belongs to normative economics rather than positive economics (also sometimes
known as descriptive economics). In other words, it is prescriptive rather than descriptive. The main body of
economic theory confines itself to descriptive hypothesis, attempting to generalize about the relations
among different variables without judgment about what is desirable or undesirable.
5. Macro-economics is also useful to Managerial Economics since it provides an intelligent understanding
of the environment in which the business must operate. This understanding enables a business executive
to adjust in the best possible manner with external forces over which he has no control but which play a
crucial role in the well-being of his concern.

SCOPE OF MANAGERIAL ECONOMICS
1. Demand Analysis and Forecasting: A major part of managerial decision-making depends on accurate
estimates of demand. Before production schedules can be prepared and resources employed, a forecast of
future sales is essential.

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2. Cost Analysis: A study of economic costs, combined with the data drawn from the firms accounting
records, can yield significant cost estimates that are useful for management decisions.
3. Production and Supply Analysis: Production analysis mainly deals with different production function
and their managerial uses. Supply analysis deals with various aspects of supply of a commodity. Certain
important aspects of supply analysis are: Supply schedule, curves and function. Law of supply and its
limitations, Elasticity of supply and Factors influencing supply.
4. Pricing Decisions, Policies and Practices: The important aspects dealt with under this area are: Price
Determination in various Market Forms, Pricing Methods, Differential Pricing, Product-line Pricing and Price
Forecasting.
5. Profit Management: Business firms are generally organized for the purpose of making profits and, 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 because of variations in costs and revenues
which, in turn, are caused by factors both internal and external to the firm.
6. Capital Management: Capital management implies planning and control of capital expenditure. The
topics dealt with are: Cost of Capital, Rate of Return and Selection of projects.

BASIC ECONOMIC TOOLS IN MANAGERIAL ECONOMICS
1. Opportunity Cost Principle: By the opportunity cost of a decision is meant the sacrifice of alternatives
required by that decision. Thus, it should be clear that opportunity costs require ascertainment 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.
2. Incremental Principle: Incremental concept involves estimating the impact of decision alternatives on
costs and revenues, emphasizing the changes in total cost and total revenue resulting from changes in
prices, products, procedures, investments or whatever may be at stake in the decision. The two basic
components of incremental reasoning are: Incremental cost and incremental revenue. Incremental cost
may be defined as the change in total cost resulting from a particular decision. Incremental revenue is the
change in total revenue resulting from a particular decision.
3. Principle of Time Perspective: The economic concepts of the long run and the short run have become
part of everyday language. Managerial economics are also concerned with the short-run and long-run

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effects of decisions on revenues as well as costs. The really important problem in decision- making is to
maintain the right balance between the long-run and the short-run considerations. A decision may be made
on the basis of short-run considerations, but may as time elapses have long- run repercussions which
make it more or less profitable than it at first appeared.
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 saying that a bird in hand is worth two in the bush. 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 resources among the
alternative activities. According to this principle, an input should be so allocated that the value added by the
last unit is the same in all cases. This generalization is called the equi-marginalprinciple

RELATIONSHIP OF MANAGERIAL ECONOMICS WITH OTHER DISCIPLINES
1. Managerial Economics and Economics: Managerial Economics has been described as economics
applied to decision-making. It may be viewed as a special branch of economics bridging the gulf between
pure economic theory and managerial practice. Economics has two main divisions: micro-economics and
macro-economics. Micro-economics has been defined as that branch where the unit of study is an
individual or a firm. Macro-economics, on the other hand, is aggregative in character and has the entire
economy as a unity of study.
2. Managerial Economics and statistics: Managerial Economics employs statistical methods for
empirical testing of economic generalizations. These generalizations can be accepted in practice oly when
they are checked against the data from the world of reality and are found valid.
3. Managerial Economics and Mathematics: Mathematics is yet another important tool-subject closely
related to Managerial Economics. This is because Managerial Economics is metrical in character,
estimating various economics relationships, predicting relevant economic quantities and using them in
decision-making and forward planning.
4. Managerial Economics and Accounting: Managerial Economics is also closely related to accounting
which is concerned with recording the financial operations of a business firms. Indeed, accounting
information is one of the principal sources of data required by a managerial economist for his decision-
making purpose.

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5. Managerial Economics and Operations Research: The significant relationship between managerial
economics and operations research can be highlighted with reference to certain important problems of
managerial economics which are solved with the help of or techniques. The problems are: allocation
problems, competitive problems, waiting line problems and inventory problems.

DIFFERENCE BETWEEN MANAGERIAL ECONOMICS AND ECONOMICS
1. Managerial Economics involves application of economic principles to the problems of the firm.
Economics deals with the body of the principles itself.
2. Managerial Economics is micro-economic in character; Economics is both macro-economic and micro-
economic.
3. Managerial Economics, though micro in character, deals only with firms and has nothing to do with an
individuals economic problems. But micro-Economics as a branch of Economics deals with both
economics of the individual as well as economics of the firm.
4. Under Micro-Economics as a branch of Economics, distribution theories, viz., wages, interest and profit,
are also dealt with but in Managerial Economics, mainly Profit Theory is used: other distribution theories
have not much use in Managerial Economics. Thus, the scope of Economics is wider than that of
Managerial Economics.
5. Economic theory hypothesizes economic relationships and builds economic models but Managerial
Economics adopts, modifies and reformulates 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.
6. Economic theory makes certain assumptions whereas Managerial Economics introduces certain
feedbacks such as objectives of the firm, multi-product nature of manufacture, behavioral constraints,
environmental aspects, legal constraints, constraints on resource availability, etc., thus embodying a
combination of certain complexities assumed away in economic theory and then attempts to solve the real-
life, complex business problems with the aid of tool subjects, e.g., mathematics, statistics, econometrics,
accounting, operations research, marketing research and so on.

ROLE OF MANAGERIAL ECONOMISTS IN BUSINESS
1. Decision Making and Forward Planning: Managerial economists play a vital role in managerial
decision making and forward planning.

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2. Inventory Schedules of the Firm: He plays an effective role in price fixation, location of a plant, quality
improvement, etc. and inventory schedules of the firm.
3. Demand Forecasting: The most important role of the managerial economist relates to demand
forecasting.
4. Economic Analysis: The managerial economists undertake an economic analysis of the industry.
5. Price Fixation: Another role played by a managerial economist is to fixing prices for new as well as
existing products of a firm.
6. Environmental Issues: A managerial economist is also undertakes the analysis of environmental
issues.
7. Cost of the Firm: He is also responsible and playing a vital role in input cost of the firm.
8. Governments Economic Policies: Lastly, managerial economist has also to keep in touch with the
governments economic policies and the central banks monetary policies annual budgets of the
government.

DECISION MAKING ENVIRONMENTS
The decisions are also categorized in terms of the degree of certainty that exists in a situation. Thus every
decision making situation falls into one of the four categories that exist along a certainty continuum namely
Certainty, Risk, Uncertainty and Ambiguity
1. Certainty: This is a state of certainty that exists only when the decision maker knows the available
alternatives and the conditions and consequences of those actions. Making decisions under certainty
assumes that the decision maker has all the necessary information about the problem situation.
2. Risk: A state of risk exists when the decision maker is aware of all the alternatives, but is unaware of
their consequences. In this situation, the decision maker at best can make guess as to which alternative to
choose. The decision in order risk usually involves clear and precise goals and good information, but future
outcomes of the alternatives are just not known to a degree of certainty. However, sufficient information is
available to allow the decision maker to ascribe the probability of successful outcomes for each alternative.
3. Uncertainty: Most significant decisions made in todays complex environment are formulated under a
state of uncertainty, where there is an unawareness of all the alternatives and so also the outcomes even
for the known alternatives. Such decisions demand creativity and the willingness to take a chance in the
face of such uncertainties. In such situations, decision makers do not even have enough information to
calculate degree of risk.

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4. Ambiguity: The most difficult decision situation is the state of ambiguity, in which the decision problems
are not at all clear. The alternative courses of action are difficult to identify, and the information about
consequences is not available. In this state, nothing is known for sure and the risk of failure is quite high.

ROFIT MAXIMIZATION AS BUSINESS OBJECTIVE
Profit maximization objective of the firm has been the traditional approach to the study of a firm in
equilibrium analysis. Profit maximization means the largest absolute amount of profits over a time period,
both short-term. And long term. The short run is a period where adjustments cannot be made quickly in
matters of supply and demand. Long run however enables adjustment to changed conditions. Profit can be
defined as the difference between total revenue (TR) and total cost (TC).Profit=TR-TC

CRITISIMS OF PROFIT-MAXIMISING THEORIES
1. Separation of Ownership from Control: The rise of corporate firm of organization has resulted in a
separation of ownership and control. Ownership is vested with the shareholders and control is wielded by
the managers. It has not been empirically proved that shareholders are more concerned with profitability
than anything else.
2. Difficulties in Pursuing Profit Maximization: The modern firm faces lot uncertainties. As a result, short
run profit maximizing behavior is subordinated to the more important objective of long-run survival of the
firm, for example, the firms objective to pursue good-will in the long-run may clash with short-run profit
objective.
3. Problems in the Measurement of Profit: There are some problems about the measurement of profit as
a measure of firms efficiency. Profit may be the result of imperfection in the market and profits may be the
reward of monopolistic exploitation. Worse still, profit measurement process itself is dubious.
4. Social responsibility of the firm: he firm is now-a-days not just an economic entity concerned with
production or sales alone. The firm owes a responsibility to offer good, well paid jobs for employees, to
provide efficient services to customers. In short the firm has a social responsibility beyond profit
maximization.
5. Deliberate limitation of profits: Firms may deliberately show lesser profits in the short run in order to
discourage laborers from asking for higher wages or to discourage entry of new firms. Limited profits may
be shown to prevent the government from taking over the business.

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6. Aversion for business expansion: Profit maximization requires business expansion and it means
additional risk and responsibility. Businessmen may be satisfied with the prevent level of profit and may not
expand.

ARGUMENTS IN FAVOUR OF PROFIT MAXIMIZATION
1. Profit is indispensable for firms survival: The survival of all the profit-oriented firms in the long run
depends on their ability to make a reasonable profit depending on the business conditions and the level of
competition.
2. Achieving other objectives depends on firms ability to make profit: Many other objectives of
business firms have been cited in economic literature, e.g., maximization of managerial utility function,
maximization of long-run growth, maximization of sales revenue, satisfying all the concerned parties,
increasing and retaining market share, etc. the achievement of such alternative objectives depends wholly
or partly on the primary objective of making profit.
3. Evidence against profit maximization objective not conclusive: Profit maximization is a time-
honored objective of business firms. Although this objective has been questioned by many researchers, the
evidence against it is not conclusive or unambiguous.
4. Profit maximization objective has a greater predicting power Compared to other business
objectives, profit maximization assumption has been found to be a much more powerful premise in
predicting certain aspects of firms behaviour.
5. Profit is a more reliable measure of firms efficiency: Thought not perfect, profit is the most efficient
and reliable measure of the efficiency of a firm.

ALTERNATIVE OBJECTIVE OF FIRMS
Baumols Theory of Sales Revenue Maximization
Prof. J. Baumols has postulated seller revenue maximization approach as an alternative to profit
maximization objective. The factors which explain the pursuance of this objective are following:
1. Financial institutions evaluate the success and strength of the firm in terms of rate of growth of its sales
revenue.
2. Empirical evidence shows that the stock earnings and salaries of top management are correlated more
closely with sales than with profits.

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3. Increasing sales revenue over a period of time gives prestige to the top management, but profits are
enjoyed only by the shareholders.
4. Growing sales means higher salaries and better terms. Hence sales revenue maximizations results in a
healthy personnel policy.
5. It is seen that managers prefer a steady performance with satisfactory profits than spectacular profits
year after year. They will be criticized if spectacular profits decline. Hence they may prefer a safe and
steady performance with satisfactory profits but good sales.
6. Large and increasing sales help the firm to obtain a bigger market share which gives it a greater
competitive power.

SSUMPTIONS OF BAUMOLS SALE MAXIMIZATION MODEL
i. Sales maximization goal is subject to a minimum profit constrain.
ii. Advertisement is a major instrument of sales maximization i.e., advertisement will shift the demand curve
to the right.
iii. Advertisement costs are independent of production costs.
iv. Price of the product is assumed to be constant.

IMPLICATIONS OF BAUMOLS THEORY
i. His theory is more consistent with observed behavior. In the traditional theory changes in fixed costs do
not influence output or prices except for fixing the breakeven point. But according to Baumol a firm which
experiences any increase in fixed costs will try to reduce them or pass them on to the consumer in the form
of higher prices, through large scales.
ii. This theory also establishes that businessmen may consider non-price competition through sales
maximization to be the more advantageous alternative.
iii. However, Baumols theory does not explain how the firms maximize their sales volume within a profit
constraint. Further it explains business behavior, without elaborating the mechanism by whichthey try to
find new alternative.

MARRIS THEORY OF MAXIMISATION OF FIRMS GROWTH RATE
According to Robin Marris, managers maximize firms balanced growth rate subject to managerial and
financial constraints. He defines firms balanced growth rate (G) as, G= GD=GC Where GD=growth rate of

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demand for firms product and GC=growth rate of capital supply to the firm. In simple words, a firms growth
rate is balance when demand for its product and supply of capital to the firm increase at the same rate. The
two growth rates are according to Marris, translated into utility functions:
(i) Managers utility function:
The managers utility function (Um) and owners utility(Uo) may be satisfied as follows. Um=f(salary,
power, job security, prestige, status).
(ii) Owners utility function Owners utility function (Uo):
Uo=f (output, capital, market-share, profit, public esteem), implies growth of demand for firms product
and supply of capital. Therefore, maximization of Uo means maximization of demand for firms product or
growth of capital supply. According to Marris, by maximizing these variables, managers maximize both their
own utility function and that of the owners. The managers can do so because most of the variables (e.g.,
salaries, status, job security, power, etc) appearing in their own utility function and those appearing in the
utility function of the owners (e.g., profit, capital market, share, etc) are positively and strongly correlated
with a single variable, i.e., size of the firm. Maximization of these variables depends on the maximization of
the growth rate of the firms. The managers, therefore, seek to maximize a steady growth rate. Marriss
theory, though more rigorous and sophisticated than Baumols sales revenue maximization, has its own
weaknesses. It fails to deal to deal satisfactorily with oligopolistic interdependence & it ignores price
determination which is the main concern of profit maximization hypothesis

WILLIAMSONS THEORY OF MAXIMIZATION OF MANAGERIAL UTILITY
FUNCTION
Like Baumol and Marris, Willamson argues that managers have discretion to pursue objectives otherthan
profit maximization. The managers seek to maximize their own utility function subject to aminimum level of
profit. Managers utility function (U) is expresses as: U = f(S, M, ID)Where S= additional expenditure on
staff, M= managerial emoluments, ID= discretionary investments.
According to Williamsons theory managers maximize their utility function subject to a satisfactoryprofit. A
minimum profit is necessary to satisfy the shareholders or else managers job security isendangered. The
utility functions which managers seek to maximize include both quantifiablevariables like salary and slack
earnings, and non-quantitative variable such as prestige power, status,job security, professional
excellence, etc. The non-quantifiable variables are expresses, in order to make them operational, in terms
of expense preference defined as satisfaction derived out of certain types of expenditures (such as slack
payments), and ready availability of funds for discretionary investments.

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Williamsons theory suffers from certain weakness. His model fails to deal with problem of oligopolistic
interdependence. Williamsons theory is said to hold only where rivalry between firms is not strong. In case
of strong rivalry, profit maximization is claimed to be a more appropriate hypothesis. Thus, Williamsons
managerial utility function too does not offer a more satisfactory hypothesis than profit maximization.

CYERT-MARCH THEORY OF SATISFICING BEHAVIOUR
Cyert-March theory is an extension of Simons theory or firms. Satisfying behavior or satisfying
behavior. Simon had argued that the real business world is full of uncertainly; accurate and adequate data
are not readily available; where data are available managers have little time and ability to process them;
and managers work under a number of terms of rationality postulated under profit maximization hypothesis.
Nor do the firms seek to maximize sales, growth or anything else. Instead they seek to achieve a
satisfactory profit a satisfactory growth, and so on. This behavior of firms is termed as Satisfaction
Behavior.
Cyert and March added that, apart from dealing with an uncertain business world, managers have to satisfy
a variety of groups of people-managerial staff, labor, shareholders, customers, financiers, input suppliers,
accountants, lawyers, authorities etc. All these groups have their interest in the firms-often conflicting. The
managers responsibility is to satisfy them all. Thus, according to the Cyert-March, firms behavior is
satisfying behavior. The satisfying behavior implies satisfying various interest groups by sacrificing firms
interest or objective. The underlying assumption of Satisfying Behavior is that a firm is a coalition of
different groups connected with various activities of the firms, e.g., shareholders, managers, workers, input
supplier, customers, bankers, tax authorities, and so on. All these groups have some kind of expectations-
high and low- from the firm, and the firm seeks to satisfy all of them in one way or another in sacrificing
some of its interest.
In order to reconcile between the conflicting interests and goals, managers form an aspiration level of the
firm combining the following goals: (a) Production goal, (b) Sales and market share goals, (c) Inventory
goal, and (d) Profit goal. These goals and aspiration level are set on the basis of the managers past
experience and their assessment of the future market conditions. The aspiration levels are modified and
revised on the basis of achievements and changing business environment.
The behavioral theory has, however, been criticized on the following grounds. First, though the behavioral
theory deals realistically with the firms activity, it does not explain the firms behavior under dynamic
conditions in the long run. Secondly, it cannot be used to predict exactly the future course of firms

17

activities; thirdly, this theory does not deal with the equilibrium of the industry. Fourthly, like other
alternative hypotheses, this theory too fails to deal with interdependence of the firms and its impact on
firms behavior.

SOURCES OF BUSINESS RISK
1. Risk of Market Fluctuation: General economic conditions are rarely stable. Firms face booms and
depressions. Though with the help of certain forecasting techniques the firm can somewhat hedge itself
against cyclical fluctuation, but there is no way the firm can generally know with certainty the timing and
volatility of changes. The firm is, therefore, unstable to completely prepare itself for these changes.
2. Risk of Industry Fluctuations: There may be fluctuations specific to the industry, which are least as
uncertain and may not always coincide with those of the overall market.
3. Competition risks: These are the risk arising from the policy changes of the rivals, which include things
like changes in prices, product line, advertisement expenditure, etc.
4. Risk of technological change: This is also called the risk of obsolescence, which grows with
advancement of an economy. These risks arise from the possibility of newly installed machinery becoming
obsolete with the discovery of new and more economical process of production.
5. Risk of taste fluctuation: In many cases, vagaries of consumer demand create uncertain conditions.
Successful product of one season may become discarded in the next season. These risks are most
common in fashion and entertainment industries.
6. Risk of cost fluctuation: Unless contractually agreed upon, the future prices of labor, material etc. may
change. Thus estimates of future expenditure are subject to uncertainty.
7. Risk of public policy: Government policy regarding business undergoes a change over time, some of
which cannot be precisely predicted. These relate to price control, foreign trade policy, corporate taxation
etc.

THE THREE CATEGORIES OF DECISION-MAKERS
1. Risk-neutral: A decision-maker is risk-neutral if each added rupee of wealth gives him the same
additional utility.
2. Risk-averse: A decision-maker is considered risk-averse if addition of each successive rupee to his
wealth gives him lesser utility than the earlier rupee.

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3. Risk-preferer: A decision-maker is considered as risk-preferred when addition of each successive rupee
to decision-makers wealth gives him greater utility each time.

DECISION MAKING
Decision making is the process of selection from a set of alternative courses of action which is thought to
fulfill the objective of the decision problem more satisfactorily than other.

FEATURES OF DECISION MAKING
1. Selection process: Decision making is a selection process. The best alternative is selected out of many
available alternatives.
2. Goal-oriented process: Decision making is goal-oriented process. Decisions are made to achieve some
goal or objective.
3. End process: Decision making is the end process. It is preceded by detailed discussion and selection of
alternatives.
4. Human and Rational process: Decision making is a human and rational process involving the
application of intellectual abilities. It involves deep thinking and foreseeing things.
5. Dynamic process: Decision making is a dynamic process. An individual takes a number of decisions
each day.
6. Situational: Decision making is situational. A particular problem may have different decisions at different
times, depending upon the situation.
7. Continues or Ongoing process: Decision making is a continuous or ongoing process. Managers have
to take a series of decisions on particular problems.
8. Freedom to the decision makers: Decision making implies freedom to the decision makers regarding
the final choice. It also involves the using of resources in specified ways.
9. Positive or Negative: Decision may be positive or negative. A decision may direct others to do or not to
do.
10. Gives happiness to an Endeavour: Decision making gives happiness to an Endeavour who takes
various steps to collect all the information which is likely to affect decisions.

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STEPS IN DECISION MAKING PROCESS IN AN ORGANIZATION
1. Identification of problem: Decision making process begins with the identification of problem that means
recognition of a problem. The managers have to use imagination, experience, and judgment in order to
identify the real nature of the problem.
2. Diagnosis and analysis of the problem: In order to diagnose the problem correctly, a manager must
obtain all pertinent facts and analyze them correctly. The most important part of the diagnosing problem is
to find out the real cause or source of the problem. After analyzing the problem next phase of the decision
making is to analyze problem. This process involves classifying the problem and gathering information.
3. Search for alternatives: A problem can be solved in many ways. All possible ways cannot be equally
satisfying. Managers are advice to limit him to the discovery of the alternatives which are strategic or critical
to the problem. The principle of limiting factor is given as By recognizing and overcoming that factor that
stand critically in the way of a goal, the best alternative course of action can be selected. Creative thinking
is necessary to develop alternatives such as decision makers past experience, practices followed by
others, and using creative techniques.
4. Evaluation of alternatives: Evaluation is the process of measuring the positive and negative
consequences of each alternative. Some alternatives offer maximum benefit than others. An alternative is
compared with the others. Management must set some criteria against which the alternatives can be
evaluated. Criteria to weigh the alternative courses of action includes Risk-Degree of risk involved in each
alternative, Economy of effort- Cost, time and effort involved in each alternative, Timing or Situation-
Whether the problem is urgent & Limitation of resources- Physical, financial and human resources available
with the organization.
5. Selecting an alternative: In this stage, decision makers can select the best alternatives. Optimum
alternative is one which maximizes the results under given conditions.
6. Implementation and follow-up: Once an alternative is selected, it is put into action in systematic way.
The future course of action is scheduled on the basis of selected alternatives. When a decision is put into
action, it may yield certain results. These results provide the indication whether decision making and its
implementation is proper. The follow-up action should be in the light of feedback received from the results.

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RATIONAL DECISION MAKING
Decision making is the process of selection from a set of alternative courses of action which is thought to
fulfill the objective of the decision problem more satisfactorily than other. The concept of rationality is
defined in terms of objective and intelligent action.

TYPES OF DECISION MAKING DEPENDING UPON RATIONALITY
1. Major and supplementary decisions: Major decisions refer to the decisions with regard to the quality of
the product, price of the product, developing a new product etc. These decisions have direct bearing on the
achievement of the goals of the concern and so these decisions should be made very carefully. Minor or
supplementary decisions, on the other hand, are made in the course of conversion of major decisions into
action.
2. Organizational and personal decision: Organizational decisions are made by the executive in his
capacity as manager in order to achieve the best interests of the organization. These decisions can be
delegated to the other members in the organization. Personal decisions, on the other hand, are made by
the manager in his personal capacity and not in his capacity as a member of the organization. These
decisions are not delegated. These decisions relate to the executives personal work.
3. Basic and routine decisions: Basic decisions involve long range commitment and large funds.
Decisions with regard to selection of a location, selection of a product line, merger of the business are
known as basic decisions. As these decisions affect the entire organization, they are considered as basic
decisions. They are also now as vital decisions. Decisions that are taken to carry out the day-today
activities are called routine decisions. These decisions are repetitive in nature. They have
only a minor impact on the business. These decisions are made at middle and lower levels of management.
For eg., purchase of sundry materials.
4. Group and individual decisions: If the decision is taken by one person, it is called individual decision.
Group decisions are taken by a group of persons.
5. Policy and operating decisions: Policy decisions are made at top management levels. These
decisions are taken to determine the basic policies and goals of the organization. Operating decisions are
taken to execute the policy decisions. These decisions are taken at the middle and lower management
levels and are related to routine activities of business.
6. Programmed decision: Programmed decision is otherwise called routine decision or structured
decision. The reason is that these types of decision are taken frequently and they are repetitive in nature.

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Such decision is generally taken by middle or lower level managers, and has a short term impact. This
decision is taken within the preview of the policy of the organization.
7. Non-Programmed decision: Non programmed structures are otherwise called strategic decisions or
basic decision or policy decision or unstructured decisions. This decision is taken by top management
people whenever the need arises. This decision deals with unique or unusual or non- routine problems.
Such problems cannot be tackled in a predetermined manner. There are no established methods or
readymade answers for such problems.
8. Organizational decisions: Organizational decisions are decisions taken by an individual in his official
capacity to further the interest of the organization known as organizational decision. These decisions are
based on rationality, judgment and experience.
9. Personal decisions: Personal decisions are decisions taken by an individual based on his personal
interest. it is oriented to the individuals goals. These decisions are based on self ego, self prestige etc.
10. Objectively rational decision: If the decision is really the correct behavior for maximizing given values
in a given situation, then it is called objectively rational decision.
11. Subjectively rational decision: If a decision maximizes attainment relative to the actual knowledge of
the subject, then it is called subjectively rational decision.
12. Consciously rational decision: A decision is consciously rational to extend that he adjustment of
means to ends is a conscious process.
13. Economic model: Economic rationality implies that decision making tries to maximize the values in a
given situation by choosing the most suitable course of action. A rational business decision is one which
effectively and efficiently assures the attainment of aims for which the means are selected.

RATIONAL DECISION MAKING PROCESS
1. Clear and well defined goal: The decision makers has clear and well defined goal that he is trying to
maximize.
2. Uninfluenced by emotions: He is fully objective and rational uninfluenced by emotions.
3. Identification of the problem: The decision makers can identify the problem clearly and precisely.
4. Alternative course of action: He must have clear understanding of alternative course of action by
which a goal can be reached under existing circumstances.
5. Analyze and evaluate alternatives: He must have the ability to analyze and evaluate alternatives in the
light of the goals.

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6. Effectively satisfies goal achievement: He must have a desire to come to the best solution by
selecting the alternative that most effectively satisfies goal achievement.

ADMINISTRATIVE PROBLEMS IN DECISION MAKING
1. The decisions taken by the management should be of sound one. The soundness of the decisions refers
to its quality and reliability. If the decisions taken are not sound then it will mean waste of efforts and funds.
The soundness of decision depends upon the sophistication of the decision maker, the information
available to him and the techniques that he can make use of.
2. Another problem that is faced by the management is timing of decision. If it is not properly timed, there is
no use in taking a useful decision.
3. The physical and psychological environments have their influence on decision making. If the
environment is satisfactory then there will be co-operation, proper understanding among the members of
the organization. This will provide better scope for research and analysis.
4. Effective communication of the decision is another important administrative problem of the management.
Decisions taken should be clear, simple and unambiguous. Decision made should be communicated to the
concerned persons in the language understandable by the receiver.
5. All members of an organization should be encouraged to give their opinion on various aspects while
arriving at important decisions. In most cases, top executives feel that it is below their dignity to get their
views. In such cases, decisions are taken by a few persons at the top management level. But this is not a
good practice because making decision by a few at the top level will create some problem in its
implementation.
6. Another problem faced by the management is implementation of decision. Once a decision is made,
executive and his subordinates should take all possible steps to implement it. While making decision, the
manager may have consulted hired specialist but the finals decision will be of his own. Therefore, final
responsibility lies on him. Implementation of decision involves several steps which brings a number of
problems. Manager should handle it very carefully so that the problems can be tackled easily.

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UNIT II
DEMAND & SUPPLY ANALYSIS: Demand - Types of demand - Determinants of demand - Demand
function Demand elasticity - Demand forecasting - Supply - Determinants of supply - Supply function -
Supply elasticity.
DEMAND
The demand for a commodity is its quantity which consumers are able and willing to buy at various
prices during a given period of time. Demand is a function of Price (P), Income (Y), Prices of related
goods(PR) and tastes (T) and expressed as D=f(P,Y,PR,T). When income, prices of related goods and
tastes are given, the demand function is D=f (P). It shows quantities of a commodity purchased at given
prices.

THE VARIOUS TYPES OF DEMAND
i. Price demand: Price demand refers to various quantities of a commodity or service that a consumer
would purchase at a given time in a market at various hypothetical prices. It is assumed that other things,
such as consumers income, his tastes and prices of inter- related goods, remain unchanged. The demand
of the individual consumer is called individual demand and the total demand of the entire consumer
combined for the commodity or service is called industry demand. The total demand for the product of an
individual firm at various prices is known as firms demand or individual sellers demand.
ii. Income demand: Income demand indicates the relationship between income and the quantity of
commodity demanded. It relates to the various quantities of a commodity or service that will be bought by
the consumer at various level of income in a given period of time, other things equal. The income demand
function for a commodity increases with the rises in income and decreases with fall income. The income
demand curve has a positive slope. But this slope is in the case of normal goods. In the case of inferior
goods the demand curve id is backward sloping
iii. Cross demand: In case of related goods the change in the price of one affects the demand of the
other this known as cross demand and its written as d=f(pr). Related goods are of two types, substitutes
and complementary. In the case of the substitutes or competitive goods, a rise in the price of one good a
raises the demand, arise in the price of one good a raises the demand for the other good b, the price of
remaining the same the opposite holds in the case of a fall in the price of a when demand for b falls.

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INDIVIDUAL DEMAND SCHEDULE AND CURVE AND MARKET DEMAND SCHEDULE
Individuals demand schedule and curve:
An individual consumers demand refers to the quantities of a commodity demanded by him at various
prices. A demand schedule is a list of prices and quantities and its graphic representation is a demand
curve

X axis-quantity demanded
Y axis- price
DD- demand curve
Explanation
i. The demand schedule reveals that when the price is Rs.P2, quantity demanded is Q2 units. As the
price decreases to P, the quantity demanded increases t o Q.
ii. The individual demand curve focuses on the effects of a fall or rise in the price of one commodity on the
consumers behavior. They are the substation and income effects.
Market demand schedule and curve:
In a market, there is not one consumer but many consumers of a commodity. The market demand of a
commodity is depicted on a demand schedule and demand curve. They show the sum total of various
quantities demanded by all the individuals at various prices. Suppose there are three individuals A,B and C
in a market who purchase the commodity. The demand schedule for the commodity is depicted in table
below.

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Y axis- price
DD- demand curve

Explanation
i. Suppose there are three individuals A,B and C in a market who buy OA,OB and OC quantities of
the commodity at the price OP, as shown in panels (A),(B) and (C) respectively.
ii. In the market OQ quantity will be bought which is made up by adding together the quantities OA,
OB and OC.
iii. The market demand curve DM is obtained by the lateral summation of the individual demand
curves DA, DB and Dc

DIFFERENCE BETWEEN CHANGES IN DEMAND AND CHANGES IN QUANTITY DEMANDED
Change in Quantity demanded:
A demand curve is the graphic representation of the law of demand. Movement along a demand curve is
caused by a change in the own price of the commodity. Such as change is called extension and contraction
of demand. This means movement on the demand curve resulting in extension of demand. Demand
contracts as price of good increases. This movement on a demand curve is known as change in quantity
demanded. This is be explained with the help of a diagram
X axis ------- Quantity of X
Y axis--------- price of X
DD ------------ demand curve

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Explanation
The figure shows that as the price increases the demand decreases & as the price decreases the demand
for the commodity increases.
Change in demand
A shift of the demand curve is brought about by change in factors other than the ownprice eg. It changes
in factor like incomes of the consumer prices of substitute products, percentage of women going out to
work etc, this is known as change in demand. This is explained with the help ofdiagram.

X axis ------- Quantity of X
Y axis--------- price of X
DD ------------ demand curve
DD1 ------------ Shift in Demand curve
Explanation
The purchasing power of the consumer increases at each given price he starts buying more of the
commodity. This tendency of the consumer leads to shifts in this demand curve. Similar results will emerge

27

if other determinants like price of related goods, tastes, etc, change. All the other determinants are
therefore, called shift factors, which lead to change in demand.

THE NATURE OF THE DEMAND OR THE VARIOUS DEMAND DISTINCTIONS
i. Derived demand and autonomous: Those inputs or commodities which are demanded to help in further
production of commodities are said to have in further production of commodities are said to have derived
demand. For example, raw material, labour machines etc are demanded not because they serve only direct
consumption need of the purchaser but because they are needed for the production of goods having direct
demand (say , food , scooter . building ,etc)
ii. Demand for producers goods and consumers goods: The difference in these two types of demand
is that consumers goods are needed for producing other goods (consumers goods or further producers
goods)
iii. Demand for durable goods non durable goods: Durable goods whether producers durable or
consumers durable are the ones which can be stored and whose replacement can be postponed. On the
other hand, the non durables are needed as a routine and their demand is their fore made largely to meet
day today needs.
iv. Industry demand and firm or company demand: The term company demand denotes demand for a
particular product of a particular firm Industry demand refers to the total demand for the product of a
particular industry.
v. Total demand and market segment demand: Demand for the market segments is to be studied by
breaking the total demand into different segments like geographical areas , sub-products, product use,
distribution channels, size of customer groups, sensitivity to price etc.
The market segments are so demarcated that each segment has its own homogenous demand
characteristics. Further, each of these market segments must differ significantly in terms of delivered
prices, net profit margins, and number of substitutes, competition, seasonal, patterns and cyclical
sensitivity.
vi. Short run demand and long run demand: Short run demand refers to demand with its immediate
reactions to price changes, Income fluctuations etc. Whereas long run demand is that which will ultimately
exist as a result demand of the change in pricing promotion or products improvement , after enough time is
allowed to lat the market adjust itself to the new situation.

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THE CAUSES FOR THE DOWN WARD SLOPING OF THE DEMAND CURVE
i. Based on the law of diminishing marginal utility:
The law of demand is based on the law of diminishing marginal utility. According to this law, when
a consumer buys more units of a commodity, the marginal utility of that commodity continues to decline
therefore the consumer will buy more units of that commodity only when its price falls. When less units are
available, utility and the consumer will be prepared to pay more for the commodity.
ii. Price effect: With the increase in the price as of the product many consumers will either reduce or stop
its consumption and the demand will be reduced. Thus to the price effect when consumer consume more or
less of the commodity, the demand curve slope downward.
iii. Income effect: When the price of a commodity falls the real income of the consumer increase because
he quantity. On the contrary with the rise in the price of the commodity the real income of the consumer
falls. This is called the income effect.
iv. Substitution effect: The other effect of change in the prices of the commodity is the substitution effect.
With the falls in the price of a commodity the prices of its substitutes remaining the same consumer will buy
more of this commodity rather that the substitutes. As a result its demand will increase.
v. Persons in different income groups: There are person in different income groups in every society but
the majority is in low income group. The downward sloping demand curve depends upon this group.
Ordinary people buy more when price falls and less when prices rise. The rich do not have any some
quantity even at a higher price.
vi. Different uses of certain commodities: There are different uses of certain commodities and service
that are responsible for the negative slope of the demand curve with the increase in the price of such
products they will be used only for more important uses and their demand will fall.

THE REASON FOR THE EXCEPTIONAL DEMAND CURVE
i. War: If a short age is feared in anticipation of war people may start buying for building stocks, for
hoarding even when the price rises.
ii. Depression: During a depression, the prices of commodities are very low and demand for them is
also less. This is because of the lack of purchasing power with consumer.
iii. Giffen paradox: If a commodity happens to be necessity of life like wheat and its price goes up,
consumer are forced to curtail the consumption of more expensive foods like meat and fish and wheat

29

being still the cheapest they will consume more for it. The marshallion example is applicable to developed
economies. In the case of underdevelopment economy, with the fall in the price of an inferior commodity
like maize. Consumers will start consuming more of the superior commodity like wheat. As a result, the
demand for maize will fall .this is what Marshall called giffen paradox which makes the demand curve to
have a positive slope.
iv. Demonstration effect: It consumers are affected by the principle of conspicuous consumption or
demonstration effect they will like to buy more of those commodities which confer distinction on the
possessor, when their prices rise. On the other hand, with the fall in the prices of such articles, their
demand falls, as is the case with diamonds.
v. Ignorance effect: Consumers buy more at a higher price under goods the influences of the ignorance
effect where a commodity may be mistaken for some other commodity, due to its price, deceptive packing,
label, etc.
vi. Speculation: Marshall mentions speculation as one of the important exception to the downward
sloping demand curve. According to him the law of the demand does not apply to the demand in a
campaign between groups of speculators. A group, which desire to upload a great quantity of a thing on to
the market, often begins by buying some of it openly; it arranges to sell a great deal quietly and through
unaccustomed channels.

THE VARIOUS DETERMINATS OF MARKET DEMAND
i. Price of the product: The law of demand states that the quantity demanded of a product which
its consumers users would like to buy per unit of time, increases when its price falls and decreases when
its price increases other factors remaining constant.
ii. Price of the related goods: The demand for a commodity is also affected by the changes in the
price of its related goods. Related goods may be substitutes or complementary goods
iii. Consumer income: Income is the basic determinant of quantity of a product demanded since it
determines the purchasing power of the consumer. That is why higher current disposable incomes spend a
larger amount on consumer goods and services than those with lower income.
iv. Consumer taste and preferences: Taste and preferences generally depend on the life style
social customs religious value attached to a commodity, habit of the people, the general levels of living of
the society and age and sex of the consumers taste and preferences. As a result, consumers reduce or
give up the consumption of the some goods and add new ones to their consumption pattern

30

v. Advertisement expenditure: Advertisement costs are incurred with the objective of promoting sale of
the product. Advertisement helps in increasing demand for the product.
vi. Consumers exceptions: Consumers exceptions regarding the future prices incomes and supply
position of goods, etc play an important role in determining the demand for goods and services in the short
run.
vii. Demonstration effect: When new commodities or new models of existing one appear in the market
rich people buy them first.
viii. Consumer credit facility: Availability of credit to the consumers from to the seller banks relation and
friends, or from other source encourages the consumer to buy more that what
They are why consumers who can borrow more can consume more than those who cannot borrow.
Credit facility mostly affects the demand for durable goods, particularly those which requires bulk payment
at the time of purchase.
ix. Population of the country: The total domestic demand for a product of mass consumption depends
also on the size of the population. Give n the price, per capita income taste and preference etc, the larger
the population the larger and demand for a product. With an increase (or decrease) in the size of population
and with the employment percentage remaining the same demand for the product tends to increase (or
decrease).
x. Distribution of National Income: The level of national income is the basic determinant of the market
demands for a productthe higher the national income, the higher the demand for all normal goods and
services. A past from its level the distribution pattern of national income is also an important determinant of
a product.

ELASTICITY OF DEMAND
Elasticity of demand may be defined as the ratio of the percentage change in demand to the percentage
change in price. Ep= Percentage change in amount demanded Percentage change in price
TYPES OF ELASTICITY DEMAND
i. Price elasticity of demand: Elasticity of demand may be defined as the ratio of the percentage
change in price. Ep = percentage change in quantity demanded / percentage change in price
ii. Income elasticity of demand: The income elasticity of demand (Ey) express the
responsiveness of a consumer demand or expenditure or consumption) for any good to the change in his
income .it may be defined as the ratio of percentage change in the quantity demanded of a commodity to

31

the percentage in income. Thus Ey = percentage change in quantity demanded / percentage change in
income
iii. Cross elasticity of demand: The cross elasticity of demand is the relation between percentage
change in the quantity demanded of a good to the percentage change in the price of a related good. The
cross elasticity good A and good B is Eba= percentage change in the quantity demanded of B/ percentage
change in price of A

TYPES OF PRICE ELASTICITY OF DEMAND
i. Perfectly elastic demand: Where no reduction in price is needed to cause an increase in quantity
demanded. This is explained with the help of a diagram.

Y axis- price
DD1- demand curve
Explanation
Price elasticity of demand is infinity when a small change in price leads to an infinitely large change in the
amount demanded. It is perfectly elastic demand. [E=]
ii. Perfectly in elastic demand
Here a large change in price causes no change in quantity demanded. It is zero elastic demand [E=0]. This
is explained with the help of a diagram.

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Y axis- price
DD1- demand curve
Explanation
The figure shows that even if the price decrease from p to p1 there is no change in the quantity demand.
This happens in case of necessities like salt.
iii. Unitary elastic
Where a given proportionate change in price causes an equally proportionate change in quantity demand.
This is explained with the help of a diagram.

Y axis- price
DD1- demand curve

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Explanation

Price elasticity of demand is unity when the change in demand is exactly proportionate to the change in
price. [E=1].
iv. Relatively elastic
Where a small change in price causes a more than proportionate change in quantity demanded. The price
elasticity of demand is greater than unity [E >1].This is explained with the help of a diagram.
X axis quantity demanded
Y axis price
DD demand curve

Explanation
The figure shows that there is a small decrease in price from P to P1, but it has resulted in a large increase
in quantity demanded from Q to Q1. It is also known as relatively elastic demand.
v. Relatively inelastic demand
Where a change in price causes a less than proportionate change in quantity demanded. The price
elasticity of demand is lesser than unity [E <1]. This is explained with the help of a diagram.

34

Y axis price
DD- demand curve
Explanation
The figure shows that there is a large decrease in price from P to P1, but it has resulted in only a small
increase in quantity demanded from Q to Q1. It is also known as relatively elastic demand.

TYPES OF INCOME ELASTICITY OF DEMAND
i. Positive and elastic income demanded: The value of the coefficient E is greater than unity, which
means that quantity demanded of good X increases by a larger percentage than the income of the
consumer. This is explained with the help of a diagram.

Y axis Income
DD- demand curve
Explanation
The curve Ey shows a positive and elastic income demanded. In the case of necessities, the coefficient
of income of income elasticity is positive but low, Ey=1. Income elasticity of demanded is low when the
demand for a commodity rises less than proportionate to the rise in the income.
ii. Positive but inelastic income demand: It is low if the relative change in quantity demanded is less than
the relative change in money income. Ey<1. This is explained with the help of a diagram.

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Y axis Income
DD- demand curve
Explanation
The curve Ey shows a positive but in elastic income demand. In the case of necessities, the coefficient of
income elasticity is positive but low, Ey<1. Income elasticity of demand is low when the demand for a
commodity rises less than proportionate to the rises less than proportionate to the rise income.
iii. Unitary income elasticity of demand
The percentage change in quantity demanded is equal to the percentage change in money income. This is
explained with the help of a diagram.

Y axis Income
DD- demand curve

36

Explanation
The curve Ey shows unitary income elasticity of demand. In the case of comforts, the coefficient of income
elasticity is unity (Ey=1) when the demand for a commodity rises in the same proportions as the increases
in income.
iv. Zero income elasticity
A change in income will have no effect on the quantity demanded. The value of the coefficient Ey is equal
to zero. This is explained with the help of a diagram.

Y axis Income
DD- demand curve
Explanation
The curve shows a vertical income, elasticity demand curve Ey with zero elasticity If with the increases in
income, the quantity demanded remains unchanged the coefficient of income elasticity, Ey=0.
v. Inferior goods
Inferior goods have negative income elasticity of demand. It explains that less is bought at higher incomes
and more is bought at lower incomes. The value of the coefficient Ey is less than zero or negative in this
case. This is explained with the help of a diagram.

37

Y axis Income
DD- demand curve
Explanation
The coefficient of income elasticity of demand in the case of inferior goods is negative. In the case of an
inferior good, the consumer will reduce his purchases of it, when his income increases.

DIFFERENT TYPES OF CROSS ELASTICITY OF DEMAND
A. CROSS ELASTICITY OF SUBSTITUTES:
In case of substitutes, as the price of one good increases the demand for the other good also
increase at the same time.
i. Relatively elastic: Where a small change in price of good A causes a large change in quantity
demanded of good B. The elasticity of substitutes is greater than unity [E >1].This is explained with the help
of a diagram.

X axis quantity demanded of B
Y axis price of A
DD demand curve
Explanation
The figure shows that there is a small increase in price of good A from a to a1, but it has resulted in a large
increase in quantity demanded of B from b to b1. It is also known as relatively elastic demand.

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ii. Relatively inelastic demand
Where a large change in price of good A causes a small change in quantity demanded of good B. The
elasticity of substitutes is lesser than unity [E <1]. This is explained with the help of a diagram.

X axis quantity demanded of good B
Y axis price of good A
DD- demand curve
Explanation
The figure shows that there is a large increase in price of good A from a to a1, but it has resulted in only a
small increase in quantity demanded of good B from b to b1. It is also known as relatively in elastic
demand.
Here a given proportionate change in price causes an equally proportionate change in quantity
demand. This is explained with the help of a diagram.

X axis-quantity demanded of good B
Y axis- price of good A
DD- demand curve

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Explanation
price. [E=1].
iv. Perfectly in elastic demand
Here a large change in price causes no change in quantity demanded. It is zero elastic demand [E=0]. This

X axis-quantity demanded of good B.
Y axis- price of good A.
DD- demand curve
Explanation
The figure shows that even if the price increases from a to a1 there is no change in the quantity demand.
This happens in case of necessities like salt.
v. Unrelated goods
If two goods are not at all related then they have negative elasticity of demand. This is explained with the
help of a diagram.

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X axis quantity demanded of good B.
Y axis Price of good A.
DD- demand curve
Explanation
The figure shows that in case on unrelated goods if the price of good A increase from a to a1, then the
demand for good B will decrease from b to b1.

B. CROSS ELASTICITY OF COMPLIMENTARY GOODS:
In case of complimentary goods, as the price of one good increases the demand for the other good
decreases at the same time.
i. Perfectly elastic demand
Where no reduction in price is needed to cause an increase in quantity demanded. This is explained with
the help of a diagram.

DD- demand curve
Explanation
Price elasticity of demand is infinity when a small change or no change in price of good A leads to an
infinitely large change in the amount demanded of good B. It is perfectly elastic demand. [E=]

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ii. Perfectly in elastic demand
Here a large change in price of good B causes no change in quantity demanded of good B. It is zero
elastic demand [E=0]. This is explained with the help of a diagram.

DD- demand curve
Explanation
The figure shows that even if the price of good B decreases from a to a1 there is no change in the quantity
demand of good A. This happens in case of necessities like salt.
Where a given proportionate change in price causes an equally proportionate change in quantity demand.

DD- demand curve

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Explanation
price. [E=1].
Where a small change in price of good B causes a more than proportionate change in quantity demanded
of good A. The price elasticity of demand is greater than unity [E >1].This is explained with the help of a
diagram.

DD demand curve
Explanation
The figure shows that there is a small decrease in price from a to a1, but it has resulted in a large increase
in quantity demanded from b to b1. It is also known as relatively elastic demand.
v. Relatively inelastic demand
Where a change in price causes a less than proportionate change in quantity demanded. The price
elasticity of demand is lesser than unity [E <1]. This is explained with the help of a diagram.

DD- demand curve

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Explanation
The figure shows that there is a large decrease in price from a to a1, but it has resulted in only a small
increase in quantity demanded from b to b1. It is also known as relatively elastic demand.

DIFFERENT METHODS OF MEASURING ELASTICITY OF DEMAND
1. Total outlay: According to this method, we compare the total outlay of the purchases or total revenue,
i.e, total value of sales from the point of view of the seller before and after the variations in price. This is

X axis -------Quantity of X
Y axis---------price of X
DD ------------demand curve
Explanation
If the elasticity of demand is equal to unity for all prices of the commodity only fall in price will cause a
proportionate increases in the amount bought, and therefore will make no change in the total outlay which
purchases make for the commodity thus one is the dividing point. If the elasticity is greater than one it is
said to be elastic and it is less than it is inelastic curve having same elasticity throughout:-
2. Point elasticity
The concept of price elasticity can be used in comparing the sensitivity of the different types of goods e.g.,
luxuries and necessaries) to changes in their prices. The elasticity of demand is always negative because
change in quantity demanded is in opposite direction to the change in price that is a fall in price is followed
by rise in demanded and vice versa hence elasticity less than zero.

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DD ------------demand curve
Explanation
Elasticity is represented by fraction distance from d to a point on the curve divided by the distance from the
other end to that point. Thus elasticity of demand is seen on the points P3, P2and P1 respectively. It is
seen that elasticity at a lower point on the curve is less than at a higher point.
3. Arc elasticity: Arc elasticity is a measure of the average responsiveness to price changes exhibited by
a demand curve over some finite stretch of the curve. This is explained with the help of a diagram below.

DD------------demandcurve
Explanation
i. Any two points on a demand curve make an arc the area between p and m on the DD curve is an
arc which measures elasticity over a certain range of prices and quantities.
ii. On any two points of a demand curve the price elasticitys of demand are likely to be different
depending upon how we calculate them.
iii. The closer the two pointsp and m are, the more accurate will be the measure of elasticity.

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iv. The arc elasticity is in fact the elasticity of the midpoint between p and m on the demand curve .
v. If there is no difference between the two points and they merge into each other or coincide, arc
elasticity becomes point elasticity.

THE FACTORS DETERMING PRICE ELASTICITY OF DEMAND
i. Necessaries and conventional necessaries: people buy fixed quantities of such commodity whatever
is the price. The change in the price of wheat may be immaterial for upper classes, but its consumption will
certainly increase among the poor when the price falls. It may be noted that demand for a necessity life as
a whole may be inelastic, but in a competitive market, demand for the output of any particular firm is highly
elastic. If it raises the price a bit, it may lose the entire market.
ii. Demand for luxuries is elastic: It stands to reason that lowering of the price of things like radio will lead
to more bring bought i.e. the demand is elastic. Thus for the same article the demand may be elastic for
some people and inelastic for others elastic in one country and inelastic in another and elastic at one time
and inelastic at another.
iii. Proportion of total expenditure: It a consumption good absorbs only a small proportion of total
expenditure, eg, salt the demand will not be much affected by a change in price hence, it will be inelastic.
iv. Substitutes: The main cause of difference in the responsiveness of the demand for that there are more
completing substitutes for some goods than for others. When the price of tea rises, we may curtail its
purchase and take of coffee, and vice versa. In a case like this a change in price will lead to expansion or
contraction in demand.
v. Goods having several uses: Coal is such a commodity when it will be used for several purposes e.g,
cooking heating and industrial purposes; and its demand will increase. But , when the price goes up, it use
will be restricted only to very urgent uses and consequently less will be purchased when the prices rises
the demand will thus contract when wheat becomes very cheap it can be used even as cattle feed hence
demand for a commodity having several uses is elastic
vi. Joint demand: If for instance, carriages become cheap but the prices of horses continue to rule high,
demand for carriage will not extend much. In other words the demand for jointly demanded goods is less
elastic.
vii. Goods the use of which can be postponed: Most of us during the war postponed our purchases
where we could e.g. building a house, buying furniture or having a number of warm suits. We go in for such
things in a large measure when they are cheap demand for such goods is elastic.

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viii. Level of prices: If a thing is either very experience or very cheap, the demand will be in elastic. If the
price is too high, a fall in it will not increase the demand much. If on the other hand, it is too low, people will
have already purchased as much as they wanted: any further fall will not increase the demand.
ix. Market imperfections: Owing to ignorance about market trends the demand for a good may not
increase hen its price falls for the simple reasons that consumers may not be aware of the fall in price.
x. Technological factors: Low price elasticity may be due o some technical reasons. For example
lowering of elasticity may be electricity rates may not increase consumption because the consumers are
unable to buy the necessary electric appliances.
xi. Time period: The elasticity of demand is greater in the long run than in the short run for the simple
reasons that the consumer has more time to make adjustment in his scheme of consumption. In other word
he is able to increase or decrease his demand for a commodity

PRACTICAL APPLICATION (OR) IMPORTANCE (OR) SIGNIFICANCE OF ELASTICITY OF DEMAND
i. Taxation: The tax will no doubt raises the prices but the demand being in elastic, people must continue
to buy the same quantity of the commodity. Thus the demand will not decrease.
ii. Monopoly prices: In the same manner, the businessman, especially if he is a monopolist, will have to
consider the nature of demand while fixing his price. In case I is in elastic, it will pay him to him to change a
higher price and sell a smaller quantity. If, on the other hand, the demand is elastic he will lower the prices,
stimulate demand and thus maximize his monopoly net revenue
iii. Joint products: In such cases separate costs are not ascertainable the producers will be guided mostly
by demand and its nature fixing his price. The transport authorities fix their rates according to this principle
when we say that they charge what the traffic will bear
iv. Increasing returns: When an industry is subject to increasing returns the manufacturer lowers the
price4 to develop the market so that he may be able to produce more and take full advantage of the
economies of large scale production.
v. Output: Elasticity of demand affects industrial output reduction in price will certainly increases the sale in
the market as a whole.
vi. Wages: Elasticity of demand also exerts its influence on wages. If demand for a particular type of labour
is relatively inelastic, it is easy to raise wages, but not otherwise.
vii. Poverty in plenty: The concept of elasticity explains the paradox of poverty in the midst of plenty. This
is specially so if produce is perishable. A rich harvest may actually fetch less money a poor one.

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viii. Effect on the economy: The working of the economy in general is affected by the nature of consumer
demand. It affects the total volume of goods and services produced in the country. It also affects producers
demand for different factors of production their allocation and remuneration.
ix. Economies policies: Modern governments regulate output and prices. The government can create
public utilities where demand is inelastic and monopoly element is present.
x. International trade: The nature of demand for the internationally traded goods is helpful in determining
the quantum of again of gain accruing to the respective countries. Thus is how it determines the terms of
trade.
xi. Price determination: The concept of elasticity of demand is used in explaining the determination of
price under various market conditions.
xii. Rate of foreign exchange: With fixing the rate of exchange, the government has to consider the
elasticity or otherwise of its imports and exports.
xiii. Relation between price elasticity average revenue and marginal revenue: This relationship
enables us to understand and compare the conditions of equilibrium under different market conditions.
xiv. Price determination: Price determination is forced to be profitable if elasticity of demand in another.
The monopolist can charge a higher price in the market where elasticity of demand is less and a lower price
where elasticity of demand is greater
xv. Measuring degree of monopoly power: The less is the elasticity of demand higher will be the price
and wider the difference between the marginal cost and greater the monopoly power, and vice versa.
xvi. Classification of goods as substitutes and complements: Goods are classified as substitutes on
the basis of cross elasticity. Two commodities may be considered as substitutes if cross elasticity is
positive and complements when elasticity is negative.
xvii. Boundary between industries: Cross elasticity of demand is also useful in indicating boundaries
between industries. Goods with high cross elasticitys constitute one industry, where as goods with lower
elasticity constitute different industries.
xviii. Market forms: The concept of cross elasticity help[s to understand different market forms infinite
cross elasticity indicates perfect market forms infinite cross elasticity indicates perfect competitions, where
as zero or hear zero elasticity indicates pure monopoly and high elasticity indicates imperfect competition
xix. Incidence of taxes: The concept of elasticity of demand is used in explaining the incidence of indirect
taxes like sales tax and excise duty. less is the elasticity of demand higher the incidence, and vice versa. In
case of inelastic demand the consumer have to buy the commodity and must bear the tax.

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xx. Theory of distribution: Elasticity of demand is useful in the determination of relative shares of the
various factors determination of relative shares of the various factors of production is loss elastic, its share
in the national dividend is higher, and vice versa. If elasticity of substitution is high the share will be low.

SUPPLY
The supply of a commodity means the amount of that commodity which producers are able and willing to
offer for sale at a given price. The supply curve is explained with the help of a diagram.

X axis-----Quantity Supplied
Y axis------Price
Explanation
The figure shows that as the price of a commodity increases from P to P1, the supply also increases from
Q to Q1. It means that price & supply are directly related.
Reserve Price If the price falls too much, supply may dry up altogether. The price below which the seller
will refuse to sell is called Reserve Price. At this price, the seller is said to buy his own stock.
Law of Supply Other things remaining the same, as the price of a commodity rises, its supply increases;
and as the price falls, its supply declines.

Supply Function
Supply function of a firm or an industry (a group of firms) is an algebrate expression relating the quantity of
a commodity which a seller is willing and able to supply. The supply function can be written as: x=f (Px,
FE, FP, PR, W, E, N) Where certain important determinants of supply are: Product price (Px), Factor
productivities or State of Technology(FE), Factor prices(FP), rises of other products related in

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production(PR), Weather, strikes and other short-run forces(W), Firms expectations about future prospects
for prices, costs, sales and the sate of economy in general(E), Number (N)
Limitations of Law of Supply
i. Future Prices: When the price rises and the seller expects the future price to rise further, supply will
decline as the seller will be induced to withhold supplies so as to sell later and earn larger profits then.
ii. Agricultural Output: Law of supply may not apply in case of agricultural commodities as their
production cannot be increased at once following price increase.
iii. Subsistence Farmers: In underdeveloped countries where agriculture is characterised with
subsistence farmers, law of supply may not apply.
iv. Factors other than Price not Remaining Constant: The law of supply is stated on the assumption that
factors other than the price of the commodity remain constant.

FACTORS INFLUENCING SUPPLY
i. Goals of firms: The supply of a commodity depends upon the goals of firms.
ii. Price of the commodity: The supply of a commodity depends upon the price of that commodity. Ceteris
paribus the higher the price of the commodity the more profitable it will be to make that commodity. One
expects, therefore, that the higher the price, the greater will be the supply.
iii. Prices of all other commodities: The supply of a commodity depends upon the prices of all other
commodities. Generally, an increase in the price of other commodities will make production of the
commodity whose price does not rise relatively less attractive than it was previously. We thus expect that
ceteris paribus, the supply of one commodity would fall as the price of other commodities rises.
iv. Prices of factors of production: The supply of a commodity depends upon the prices of factors of
production. A rise in the price of one factor of production will cause a large increase in the costs of making
those goods which use a great deal of that factor, and only a small increase in the cost of producing those
commodities which use a small amount of the factor.
v. State of technology: The supply of a commodity depends upon the state of technology.
vi. Time factor: Time factor can also determine elasticity of supply. Time can be broadly classified into
three categories: Market period is the one where supply is fixed as no factor of production can be altered.
vii. Short period is the time period when it is possible to adjust supply only by changing the variable factors
like raw-material, labor, etc., and Long period where supply can be changed at will because all the factors
can be changed.

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viii. Agreement among the producers: Supply may be consciously decreased by agreement among the
producers.
ix. To raise price: Supply may also be destroyed to raise price.
x. Taxation on output or imports: Supply may also be affected by taxation on output or imports.
Government may also restrict production of certain commodities on grounds of health (e.g., opium in India).
xi. Political disturbances or war may also create scarcity of certain goods.

CHANGE IN SUPPLY AND SHIFT IN SUPPLY
Change in supply means increase or decrease in quantity supplied at the same price. This is explained
with the help of a diagram.

Y axis------Price
SS- Supply Curve
Explanation
The figure shows that as the price of a commodity increases from P to P1, the supply also increases from
Q to Q1. It means that price & supply are directly related. The movement of the supply is along the same
curve. In other words increase in supply is known as extension of supply & decrease in supply is known as
contraction of supply.

SHIFT IN SUPPLY CURVE
Shift in supply means shifting the entire supply curve due to various reasons other than price like changes
in technology, government policies etc. This is explained with the help of a diagram.

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Y axis------Price
Explanation
The figure shows that as the price of a commodity does not change but still the supply curve shifts from SS
TO S1S1 OR S2S2. It means shifting the entire supply curve is due to various reasons other than price like
changes in technology, government policies etc.

ELASTICITY OF SUPPLY
It can be defined as the degree of responsiveness of supply to a given change in price. The formula to
find out the elasticity of supply is:
Es = percentage change in quantity supplied / percentage change in price
TYPES OF ELASTICITY OF SUPPLY
i. Perfectly elastic supply: Where no change in price is needed to cause an increase in quantity
supplied. This is explained with the help of a diagram.

X axis-quantity supplied
Y axis- price
SS- supply curve

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Explanation
The elasticity of supply is infinity when a small change in price leads to an infinitely large change in the
quantity supplied. It is perfectly elastic supply. [E=]
ii. Perfectly in elastic supply: Here a large change in price causes no change in quantity supplied. It is
zero elastic supply [E=0]. This is explained with the help of a diagram.

Y axis- price
SS- supply curve
Explanation
The figure shows that even if the price increases from p to p1 there is no change in the quantity supplied.
iii. Unitary elastic: Where a given proportionate change in price causes an equally proportionate change
in quantity supplied. This is explained with the help of a diagram.

Y axis- price
SS- supply curve

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Explanation
Elasticity of supply is unity when the change in supply is exactly proportionate to the change in price. [E=1].
Where a small change in price causes a more than proportionate change in quantity supplied. The price
elasticity of supply is greater than unity [E >1].This is explained with the help of a diagram.

Y axis- price
SS-supplycurve
Explanation
The figure shows that there is a small increase in price from P to P1, but it has resulted in a large increase
in quantity supplied from Q to Q1. It is also known as relatively elastic supply.
v. Relatively inelastic Supply
Where a large change in price causes a less than proportionate change in quantity supplied. The elasticity
of supply is lesser than unity [E <1]. This is explained with the help of a diagram.

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Y axis- price
SS- supply curve
Explanation
The figure shows that there is a large increase in price from P to P1, but it has resulted in only a small
increase in quantity supplied from Q to Q1. It is also known as relatively inelastic supply.

THE LAW OF DIMINISHING MARGINAL UTILITY
The law of diminishing marginal utility states that as the quantity consumed of a commodity increases, the
utility derived from each successive unit decreases, consumption of all other commodities remaining the
same.
Assumptions of diminishing marginal utility
i. The utility analysis is based on the cardinal concept which assumes that utility is measurable and additive
like weights and lengths of goods.
ii. Utility is measurable in terms of money.
iii. The marginal utility of money is assumed to be constant.
iv. The consumer is rational who measures, calculates, chooses and compares the utilities of different units
of the various commodities and aims at the maximization of utility.
v. He has full knowledge of the availability of commodities and their technical qualities.
vi. He possesses perfect knowledge of the choices of commodities open to him and his choices are certain.
vii. He knows the exact prices of various commodities and their utilities are not influenced by variations in
their price.
viii. There are no substitutes.
X axis Quantity demanded
Y axis Utility
TU-Total Utility
DMU-Diminishing Marginal Utility

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Explanation
i. With the increases in the number of units consumed per unit of time, TU increases but at a diminishing
rate.
ii. The downward sloping Mu curve shows that marginal utility goes on decreasing as consumption
increases.
iii. At 4 units consumed, the TU reaches its maximum level the point of saturation and mu becomes zero.
beyond this MU become negative and TU begins to decline .

IMPORTANCE OF THE LAW OF DIMINISHING MARGINAL UTILITY
i. Taxation: Progressive system of taxation, imposing a heavier burden on the rich people, is a practical
application of this principle in the field of public finance. Richer a person the higher is the rate of the tax he
has to pay since to him the marginal utility of money is less.
ii. Price determination: The law explains why with increase in its supply, the value of a commodity must
fall. It thus forms a basis of the theory of value.
iii. Household expenditure: The law of diminishing marginal utility governs our daily expenditure. Since
one knows that a larger purchase will mean lower marginal utility, one will restrict their purchase of a
particular commodity, because they cannot afford to waste our limited resources.
iv. Downward sloping demand curve: It is this law which tells us why demand curve slope downwards. It
is due to this law that smaller utility lines cut larger portions of the commodity line, i.e., X-axis.
v. Value-in-use and value-in-exchange: It also explains the divergence between value-in-use and value-
in-exchange.

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vi. Socialism: The marginal utility to the rich of the wealth, that they might lose, is not so great as the
marginal utility of the wealth which is transferred to the poor.
vii. Basis if some economic laws: Some very important laws of economics are based on the law of
diminishing marginal utility, ex. Law of demand, the concept of consumers surplus, the concept of elasticity
of demand, the law of substitution, etc. These laws and concepts have ultimately been derived from the law
of diminishing marginal utility.

LIMITATIONS OF DIMINISHING MARGINAL UTILITY
i. Utility cannot be measured cardinally: The basis of the utility analysis- that it is measurable- is
defective because utility is a subjective and psychological concept which cannot be measured cardinally. In
really, it can be measured ordinally.
ii. Single commodity model is unrealistic: The utility analysis is a single commodity model in which the
utility of one commodity is regarded independent of the other. Marshall considered substitutes and
complementary as one commodity, but it makes the utility analysis unrealistic.
iii. Money is an imperfect measure of utility: Marshall measures utility in terms of money, but money is
an incorrect and imperfect measure of utility because the value of money often changes.
iv. Marginal utility of money is not constant: The fact is that a consumer does not buy only one
commodity but a number of commodities at a time. In this way when a major part of his income is spent on
buying commodities, the marginal utility of the remaining stock of money increases.
v. Man is not rational: This assumption is also unrealistic because no consumer compares the utility and
disutility from each unit of a commodity while buying it. Rather, he buys them under the influence of his
desires, tastes or habits. Moreover, consumers income and prices of commodities also influence his
purchases. Thus the consumer does not buy commodities rationally. This makes the utility analysis
unrealistic and impracticable.
vi. Utility analysis does not study income effect, substitution effect and price effect: The utility
analysis does not explain the effect of a rise or fall in the income of the consumer on the demand for the
commodities. It thus neglects the income effect. Again when with the change in the price of one commodity
there is a relative change in the price of the other commodity, the consumer substitutes one for the other.
This is the substitution effect which the utility analysis fails to discuss.

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vii. Utility analysis fails to clarify the study of inferior and giffen goods: Marshalls utility analysis of
demand does not clarify the fact as to why a fall in the price of inferior and giffen goods leads to a decline in
its demand.
viii. The assumption that the consumer buys more units of a commodity when its price falls is
unrealistic: It may be true in the case of food products like oranges, bananas, apples, etc. but not in the
case of durable goods.
ix. It fails to explain the demand for Indivisible goods: The utility analysis breaks down in the case of
durable consumer goods like scooters, transistors, radio, etc. because they are indivisible. The consumer
buys only one unit of such commodities at a time so the it is neither possible to calculate the marginal utility
of one unit nor can the demand schedule and the demand curve for that good be drawn. Hence the utility
analysis is not applicable to indivisible goods.

THE LAW OF EQUI- MARGINAL UTILITY
It is also called as the law of substitution, or the law of indifference, or the law of maximum satisfaction.
It is called the law of substitution because when we substitute the more useful one. It is known as the law of
maximum satisfaction, because through its application we are able to maximize our satisfaction. According
to the law of equi- marginal utility, it is only when marginal utilities have been equalized, through the
process of substitution. That one gets maximum satisfaction.
Assumptions of law of equi- marginal utility
i. The utility analysis is bases on the cardinal concept which assumes that utility is measurable and additive
like weights and length of goods.
ii. Utility is measurable in terms of money.
iii. The marginal utility of money is assumed to be constant.
iv. The consumer is rational who measures, calculates, chooses and compares the utilities of different units
of the various commodities and aims at the maximization of utility.
v. He has full knowledge of the availability of commodities and their technical qualities.
vi. He possesses perfect knowledge of the choices of commodities open to him and his choices are certain.
vii. He knows the exact prices of various commodities and their utilities are not influenced by variations in
their prices.
viii. There are no substitutes.

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X axis Quantity demanded
Y axis Income
Ua-Total Utility of a
Ub-Total Utility of b

Explanation
i. The curve Ua slopes downwards from left to right. This curve shows the marginal utility of the money
spent on commodity A.
ii. The curve Ub which slopes downwards from right to the left.
iii. This curve shows the marginal utility of the money spent on the good B.
iv. Suppose our hypothetical consumer has rs.10 to spend on the two goods a and b it will be clear from the
diagram that if he spend rs.6 on a good and rs.4 on b good , the marginal utilities of both goods are equal
(cd=ef)
v. In this way, he will derive maximum satisfaction and any other arrangement will only reduce the
aggregate satisfaction
vi. Suppose the consumer spends Re.1 more on the goods a and consequently Re.1 less on the good b. as
a result, the marginal utilities will become unequal (gh is greater than qr).In this case the gain in utility is
less than before. The gain in utility and loss thereof are shown in the shaded area
vii. Hence we may conclude that the consumer will get maximum satisfaction and will be in equilibrium if the
marginal utilities of money spent on the various goods that he rays equal.

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IMPORTANCE OF THE LAW OF EQUI-MARGINAL UTILITY
i. It applies to consumption: Every consumer, if he is wise wants to get maximum satisfaction out of his
limited resource. In arranging his expenditure to that end he must substitute the thing till marginal utilities
are equalized. In this way, the consumers satisfaction is maximized.
ii. Its application to production: To the business man the manufactures the law is of special importance.
He works towards the most economical combination of the factors of production employed by him for this
purpose; he will substitute one factor for another till their marginal productivities are made the same. In
case he finds that marginal productivity of one factor, say labour is greater than that of capital it will pay him
to substitute the former for the latter in this way he will be able to maximize his profit.
iii. Its application to exchange: In all our exchanger this principle work for exchange is nothing else but
substitution of one thing for another. The substitution character of our exchange is sufficient to basic
economic principle.
iv. Price determination: This principle has an important bearing on the determination of value. When there
is scarcity of a commodity the law of substitution to our help. We commodity, the law substitution comes to
our help. We start substituting the less, scarce goods for the more scarce ones. The scarcity of the latter is
thus relived and its price comes down.
v. Its application to distribution: In distribution we are concerned with the determination of the rewards of
the various agents of productions, determination of rent wages interest and profit these shares are
determined-- according to the principle of marginal productivity. The use of each agent of producing is
pushed by the entrepreneur to the margin of profitableness till the marginal product in each case in the
same in case it is not the same the law of substitution will come into play to equalize their marginal
productivity this is how the law of substitution proves useful in the field of distribution of the national
dividend among the various agents of production.
vi. Public finance: Public expenditure of the government conforms to this law even a government is under
the necessity of deriving maximum amount of the benefit from its public expenditure it must try to maximize
welfare of the commodity. For this purpose it must cut down all wasteful expenditure.

LIMITATION OF THE LAW OF EQUI MARGINAL UTILITY
i. The law of equi marginal utility involves very careful calculation of the excepted satisfaction: The
fact is that most of our expenditure is governed by habit. There is not much of conscious calculation and
careful weighing of the utilities.

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ii. Not applicable in case of small purchases: Only in the case of big expenditure a prudent persons
goes through a certain amount of thinking here we may take it that this expenditure does roughly conforms
to the law of maximum satisfaction but not applicable in case of small purchases
iii. Law will not hold good in irrational purchases: All the rational and prudent persons are excepted to
act upon this law consciously or un consciously.
iv. Ignorance of consumer: The consumer may not be aware of other more useful alternatives. Hence, no
substitution does not operate.
v. Incapable of rational consumption: People are sometimes slaves of customs or fashion and are
incapable of rational consumption. Without being rational and calculating, a consumer cannot substitute
one thing for another.
vi. Goods are not divisible into small bits: Another limitation arises from the fact that goods are not
divisible into small bots to enable consumers to equalize marginal utilities cannot be equalisied.

vii. Resource are unlimited: The law of substitution has no place when the resource are unlimited as in
the case of free goods in such cases there is no need to re-arrange expenditure because no price is to be
paid whatever the quantity used.
viii. No definite budget period: There is no definite budget period in the case of individuals
ix. It rest on same questionable assumptions: The difference curve approach to the theory of
consumers equilibrium is based on this basic criticism of the marshallian analysis.

THE CONCEPT OF INDIFFERENCE CURVE TECHNIQUE (OR) THE PRINCIPLE OF DIMINISHING
MARGINAL RATE OF SUBSTITUTION
An indifference curve represents satisfaction of a consumer from tow commodities. It is drawn on the
assumptions that for all possible points or combinations of the tow commodities on indifference curve the
total satisfaction or utility remains the same. Hence, the consumer is indifferent as to the combinations lying
on an indifference curve. It is an iso utility curve.

INDIFFERENCE MAP
A set of indifference curves is called an indifference map. This is explained with the help of a diagram.

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X axis Good X
Y axis Good Y
IC1-IC5Indifference Curves

MARGINAL RATE OF SUBSTITUTION
The marginal rate of substitution shows at what rate a consumer is willing to substitute one commodity for
another in his consumption pattern. This is explained with the help of a diagram.

X axis Good X
Y axis Good Y
ICIndifference Curve

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Explanation
The figure shows that the consumer sacrifices of Good Y in every step in order to consume more of Good X
which is otherwise called as Marginal rate of substitution.
Assumptions of Indifference Curve
i. Completeness: We assume that the consumers scale of preferences is so complete that he is able to
choose any one of the two combinations o commodities presented to him or is indifferent between them.
ii. Non-satiation: A consumer prefers more to less.
iii. Consistency or Transitivity: If a consumer regards Q better than R and R better than S, obviously he
will prefer Q to S, if this choice is open. Consumers choice has to be consistent.
iv. Continuity or Substitutability: Unless one combination can be substituted for another, the consumers
preference will not be possible.
v. Convexity: The indifference curve is convex to the origin and shows the diminishing rate of marginal
rate of substitution to be explained presently.
This can be explained with the help of diagram.

Y axis- price
IC- indifference curve
Explanation
i. If the consumer were a point A on the curve IC, he would be just as satisfied as at point B or at
point C or at point D and so on.

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ii. These combinations give him the same satisfaction. If we join the points A, B, C, D and E we get
a continuous curve IC, each point on it showing equal satisfaction or the indifference of the consumer
towards the various combinations.
iii. This is an indifference curve. Each point on it shows a combination of apples and mangoes
which yields the same total satisfaction to our consumer.

PROPERTIES OF INDIFFERENCE CURVE
i. Downward sloping (or) negatively sloped: To begin with, an indifference curve slopes downwards from
left to right. It is because when the consumer decides to have more units of one of the two goods, he will
have to reduce the number of the units of the other good,if he is to remain on the same indifferences
curve.i.e., if level of his satisfaction is to remain the same.
ii. Non- intersecting: The second property or characteristic of indifference is that no two such curves will
never cut each other.
iii. Convexity: The third property of indifference curve is that they are normally convex to the origin. The
implication of this convexity rule is that as we have more and more of good x and less and less of y. the
marginal rate of substitution of x and y goes on falling.

APPLICATIONS OF INDIFFERENCE CURVE TECHNIQUE
i. Application in consumption: The indifference curve technique can be used by the householder in
setting his purchase plan. A consumer endeavors to reach an equilibrium position, i.e., a position in which
he derives maximum satisfaction from his scheme of purchases.
ii. Measurement of National Income: The indifference curve technique also lends itself for measuring
national income. National income is the aggregate value of the net output of an economy. Each individual
attaches the same relative importance to the commodities as their price ratio. National income is produced
by the members of the community and so also it is consumed by them.
iii. Rationing: Rationing is another field in which the indifferent curve technique can be applied. Suppose in
rationed commodity is allotted to each individual.
iv. Cost of living index: If the combinations of good purchased in two successive years are allotted on the
indifference curve, it can be shown whether the standard of living has risen of fallen.

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v. Price discrimination: It can be shown with the help of indifference curves that two individuals will derive
greater satisfaction from the purchase of two commodities on a single price system instead of under price
discrimination.
vi. Taxation: Direct Vs Indirect Taxes: In the field of taxation too the indifference curve technique can be
usefully employed.
vii. Effect of a subsidiary: Suppose the low-income groups are supplied by the govt. some necessaries
(say, housing accommodation) at subsidized rates, (i.e., lower prices). Most welfare states like to help poor
citizens in this manner.
viii. Effect of Taxation on willingness to work: A tax may induce a man to work more or work less.
ix. Effect of increase in wages on supply or labour: In the case of poorly-paid workers, and rise in the
wage rate will not lead to a reduction in working time; it will only result in larger income which will be utilized
in purchasing more goods.
x. Other uses of Indifference curve: The use of indifference curve technique is not merely confined to the
cases mentioned above. This technique is how being very widely used in almost the entire economic
theory.

CRITICISM (OR) DRAWBACKS OF INDIFFERENCE CURVE ANALYSIS
i. Old wine in new bottles: It substitutes the concept of preference for utility. It replaces introspective
cardinalism by introspective ordinalism.
ii. Away from Reality: The fact that the indifference hypothesis, the more complication of the two
psychologically, happens to be more economical logically, affords no guarantee that it is nearer to the truth.
iii. Cardinal Measurement implicit in I.C Technique: The cardinal measurement of utility is implicit in the
difference hypothesis when we analyze substitutes and complements.
iv. Midway house: Indifference curves are hypothetical because they are not subject to direct
measurements,
v. Fails to explain the observed behavior of the consumer: Knight argues that the observed market
behavior of the consumer cannot be explained objectively with the help of the indifference analysis.
vi. Indifference curves are non-transitive: The consumer is indifferent not because he has complete
knowledge of the various combinations available to him but because of his inability to judge the difference
between alternative combinations.

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vii. The consumer is not rational: The indifference analysis, like the utility theory, assumes that the
consumer acts rationally.
viii. Combinations are not based on any principle: Since the combinations are made irrespective of the
nature of goods, they often become absurd.
ix. Limited analysis of consumers behavior: Further, the assumption that the consumer buys more units
of the same good when its price falls is unwarranted.
x. Failure to consider some other factors concerning customer behavior: The indifference curve
analysis does not consider speculative demand, interdependence of the preferences of consumers in the
form of Snob, Veblen and Band wagon effects, the effects of advertising of stocks, etc.
xi. Two-goods Model Unrealistic: Again the two-goods model on which the indifference analysis is based
makes the theory unrealistic because a consumer buys not two but a large number of commodities to
satisfy his innumerable wants.
xii. Fails to explain consumers behavior in choices involving risk or uncertainty: Another serious
criticism leveled against the preference hypothesis is that it fails to explain consumer behavior when the
individual is faced with choices involving risk of uncertainty of expectations.
xiii. Based on unrealistic assumption of perfect competition: The indifference curve technique is based
on the unrealistic assumptions of perfect competition and homogeneity of goods where as in reality the
consumer is confronted with differentiated products and monopolistic competition.
xiv. All commodities are not divisible: When indivisible goods are taken in a combination they cannot be
substituted without dividing them. Thus the consumer cannot get maximum satisfaction from the use of
individual goods.

CONSUMER SURPLUS
The excess of the price which he would be willing to pay rather than go without thing, over that which he
actually does pay, is the economic measure of this surplus satisfaction. It may be the called consumers
surplus. This is explained with the help of a diagram.

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X axis-Units of commodity
Y axis- price that the consumer is willing to pay
Explanation
The figure shows that at OA price OM units of commodity is sold, but sometimes the consumer is also
willing to buy even less commodity i.e OM1 at a high price of OA1 rather than going without buying that
commodity & this is called as consumer surplus.

IMPORTANCE OF PRACTICAL UTILITY OF CONSUMERS SURPLUS
i. Conjectural Importance: It enables is to compare and advantages of environment and opportunities, or
conjunctural benefits.
ii. Public Finance: The finance minister considers while proposing fresh taxation, how much the people
are willing to pay for a thing and how they will be affected by a rise in price resulting from the imposition of
a tax.
iii. Monopoly Value: Similarly, a businessman, especially a monopolist, will find that he can easily raise
price of his product if the commodity is yielding surplus of satisfaction to the consumers.
iv. Value-in-use and Value-in-exchange: The doctrine of consumers surplus, therefore, clearly brings out
the distinction between value-in-use and value-in-exchange. It is large where the value-in-use is large even
though the value-in-exchange may be small.
v. Benefits from International trade: The larger this surplus, the more beneficial is international trade.
vi. Cost-Benefit Analysis: The concept of consumers surplus is found useful in working out cost-benefit
analysis of an investment.

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DIFFICULTIES OF CONSUMER SURPLUS (OR) DIFFICULTIES OF MEASUREMENT OF CONSUMER
SURPLUS
i. A complete list of demand prices is not available: As we do not know what prices we are prepared to
pay for every one of the units, the whole of the consumers surplus cannot be ascertained.
ii. Necessaries: Consumers surplus in the case of necessaries of life and conventional necessaries is
indefinite and immeasurable.
iii. Consumers circumstances: Some consumers are rich while others are poor. A rich man is prepared
to pay much more for a thing than go without it. This difference in the consumers circumstances makes the
measurement of consumers surplus difficult and in exact.
iv. Consumers sensibilities: Every consumer has his own tastes and sensibilities. Some desire a
commodity more ardently than others, and are, therefore prepared to offer more. This difficulty is also met,
as in the above case, by the idea of average.
v. Change in marginal utility of money: As we o on buying a commodity, less and less amount of money
is left with us. Hence, the marginal utility of each unit of money increases. But, when we measure
consumers surplus, we do not make any allowance for this change in the marginal utility of money.
vi. Change in earlier units: There is the further difficulty, viz., that with every increase in the purchase of a
commodity, the urgency of the need for the earlier purchase is diminished and their utility decreases. This
decrease in the utility of earlier units is not taken into account when calculating the consumers surplus. To
measure consumers surplus precisely, it is suggested that the earlier parts of the list of demand prices
should be continually redrawn.
vii. Substitutes: Then, there is the difficulty arising out of the presence of substitutes.
viii. Commodities used for distinction: In such cases, ex: diamonds, the fall in price will not lead to
increase in demand. The demand for them, therefore, may fall off. Hence, a fall in price in such cases will
not increase consumers surplus.

THE EFFECT OF PRICES ON CONSUMER EQUILIBRIUM (OR) DERIVE PRICE CONSUMPTION
CURVE
Price consumption curve: Now we shall describe how a consumers equilibrium shifts as a result of a
change in the price of one of the goods, while his income and the price of the other good remain the same
(i.e., the price effect). This can be explained with the help of a diagram

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X axis-Good X
Y axis- Money
PCC---Price Consumption curve
Explanation
i. With a certain fixed income and given market prices of the two goods X and Y represented by the price-
income line ML1, the consumer is in equilibrium at point P1.
ii. Suppose the price of X falls, income and price of Y remaining unchanged, so that new price-income line
becomes ML2, the consumer will be in equilibrium a point P2 on the higher indifference curve C2. In this
position, he will be buying OH2 of commodity X.
iii. If the price of X falls further, so that the relevant price line is ML3, the consumer will be in equilibrium at
point P3 and will be buying OH3 of commodity X.
iv. When all the points such as P1, P2, P3, P4 are joined together we have the price consumption curve
shows how the consumption of commodity X changes as its price changes, the consumers income and
price of Y remaining the same.

THE SUBSTITUTION EFFECT ON CONSUMERS EQUILIBRIUM
Substitution Effect
Substitution effect means he changes in the quantity of a good purchased which is due only to the
change in relative prices, money income remaining constant. This is be explained with the help of diagram.

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X axis-Good X
Y axis- Good Y
Explanation
i. The consumer is in equilibrium at point Q where the given price line PL is tangent to indifference curve
C1.
ii. When the price of X falls while the price of Y remains the same, the price line will shift to PH (because
now more of X is purchased) and the consumer will be in equilibrium at R, where the new price line PH
touches the indifference curve C2.
iii. To find out the substitution effect, we draw a hypothetical price line AB parallel to the price line PH so
that it (i.e., AB) should touch the indifference curve C1.
iv. With price line AB, the consumer is in equilibrium at T on indifference curve C1.
v. At the point T, he gets the same satisfaction as at Q, because both Q and T are situated as on the same
indifference curve C1.
vi. Movement from Q to T on the same indifference curve C1 is due only to the relative fall in the price of X.
vii. At the point T, the consumer buys MK more (at q he bought OM but at T h buys OK) of X than at Q as X
is now relatively cheaper.
viii. This MK is the substitution effect which involves movement from Q to T.

THE EFFECT OF INCOME ON CONSUMERS EQUILIBRIUM (OR) DERIVE THE INCOME
CONSUMPTION CURVE
Income Consumption curve
Income effect is the effect on the quantity demanded exclusively as a result of change in money income,
all prices remaining constant. This is be explained with the help of diagram.

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X axis-Good X
Y axis- Money
ICC---Income Consumption curve
Explanation
i. With price-income line L1M1, the consumer is in equilibrium at point P1.
ii. Now suppose the income of the consumer increases so that his new price-income line is L2M2. As a
result of this increase in income, the consumer will move to a new equilibrium position, at the point P2, on a
higher indifference curve C2 and will be buying OH2 of commodity X and OQ2 of commodity Y.
iii. Thus we get various points of equilibrium such as P1, P2, P3 for different levels of income, prices of the
commodities remaining the same. If the points P1, P2, P3, P4, etc., are joined together by a line passing
from the origin, we get, what is called Income consumption curve (ICC).

CONSUMERS EQUILIBRIUM (OR) MAXIMISING SATISFACTION
The consumer is said to be in equilibrium when he obtains the maximum possible satisfaction from his
purchase, gives the prices in the market and the amount of money he has for making purchases.
Assumption
i. Our consumer has an indifference map showing his scale of preferences for various combinations of the
two goods.

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ii. He has a given and constant amount of money to spend on the goods and if he does not spend it on one
good, he must spend it on the other.
iii. Prices of the goods in the market are given and constant.
iv. Each of the goods is homogeneous and divisible and
v. The consumer acts rationally, that is, he tries to maximize his satisfaction.

TWO CONDITIONS OF EQUILIBRIUM
i. The price line should be tangent to an indifference curve or MRS of one commodity for another should be
equal to their relative prices.
ii. At the point of equilibrium an indifference curve must be convex to the origin.
This can be explained by the diagram.
X axis Good x
Y-axis Good y
IC1, IC2, IC3, IC4, - Indifference curve

Explanation
i. The consumer will be in equilibrium at the point p. the consumer will maximize his satisfaction and be in
equilibrium at a point where the price line touches (or its tangent to) an indifference curve.
ii. Any combination other than p on the given price line can be shown to give less satisfaction to the
consumer, for all other points on the price line must lie on indifference curves of a lower order than that on
which p lies.

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FORECASTING
Forecasting is the process of estimating the future, based on the analysis of their past and present
behavior. A forecast tries to define wheat one believers will happen in the future. Its aim is to provide
information for planning and decision making.

FEATURES OF FORECASTING
i.Relates to future events: Forecasting relates to future events which are needed for planning process.
ii.Best use of available data: Forecasting uses the best available data and makes the best informed
guess. There will be errors involved, so that all forecasts should state a plus or minus margin of error.
iii.Take account of discontinuities: The further away the forecast the less accurate it is likely to be. In all
forecasts, it is important to take account of discontinuities, which can affect the data trend.
iv.Statistical tools and techniques: The analysis of various factors may require the use of various
statistical tools and techniques.
V.Feedback mechanism: All forecasting system should include a feedback mechanism where the actual
results are compared with the forecast values and the forecasting system is modified to make it more
accurate in future.

IMPORTANCE OR NEED OF FORECASTING OR APPLICATIONS OF FORECASTING WITHIN
INDUSTRY
I .Inventory control/production planning: forecasting the demand for a product enables us to control the
stock of raw materials and finished goods, plan the production schedule, etc
ii.Investment policy: forecasting financial information such as interest rates, exchange rates, share prices,
the price of gold, etc. This is an area in which no one has yet developed a reliable (consistently accurate)
forecasting technique (at least if they have or they havent told anybody)
iii.Economic policy: forecasting economic information such as the growth in economy, unemployment, the
inflation rate, etc is vital both to government and business in planning for the future.
iv.Compel to think ahead: The process of making forecast and their review by authorities compel them to
think ahead, looking to the future, and providing for it.
v.Disclose the areas where necessary control is lacking: Preparation of the forecast may disclose the
areas where necessary control is lacking in the organization for its future course of action.

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vi.Helps to unity and coordinate plans: Forecasting, especially when there is participation throughout the
organization, helps to unity and coordinate plans.
vii.Helps in promotion of organization: Forecasting certainly helps in promotion of organization by
achieving its objectives in best possible way, since forecasting of future events is of direct relevance in
achieving an objective.
viii.Key to planning process: Forecasting is the essential step in planning process. So, it is a key to
planning process. Planning decides the future course of action but forecasting to decide it. Therefore,
forecasting generates the planning process.

LIMITATIONS OF FORECASTING
i .Based on wrong assumptions: Forecasting is based on some assumptions. It assumes that events do
not change rapidly or haphazardly but change on a regular pattern. These assumptions may not hold good
for all conditions or situations.
ii.Indicate the trend of future happening: they are not always true: Forecasts merely indicate the trend
of future happening: they are not always true. This is so because of the factors taken into account for
making the forecast. These factors are affected by human who are highly unpredictable. Period of
forecasting is also one of the factors affecting the forecast. Degree of error increases with increases in
period of forecast.
iii.Take and cost factor: Another important of forecasting is time and cost factor, forecasting requires past
data and information. The collection and proper arrangement of such information and data requires lot of
time and money. Moreover, it requires lot of calculations and selection of proper calculation method which
requires lot of manpower and money. Therefore, most of the smaller organization does not go for formal
system forecasting.

VARIOUS TYPES OF FORECASTING
i.Long-range forecast: The long-range forecast usually covers a period of three to more years and is used
in areas such as planning for new products, facility location or expectation, research and development, and
capital expenditures.
ii.Short- range forecast: The short- range forecast covers a time span of up to one year, but often it is less
than three months. It is used in areas such as purchasing, planning, job assignments and scheduling, and
levels of work force.

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iii.Medium-range forecast: The medium-range forecast usually covers a time period from three months to
three years and finds applications in many areas including sales planning, budgeting, and production
planning.

VARIOUS STEPS IN FORECASTING
i.Determine the objective: Determine the forecast applications and objective.
ii.Choose the items: Choose with care the items to be forecasted.
iii.Time horizon: Determine the forecast time horizon (i.e., long, short, or medium)
iv.Forecasting models: Chose appropriate forecasting models.
v.Collect data: Collect the appropriate data required to make the forecasting under consideration.
vi.Validate forecasting model: Validate the forecasting model with care.
vii.Relevant forecasts: Make all relevant forecasts.
viii.Implement results: Implement the appropriate results.

VARIOUS METHODS OF FORECASTING
A.Qualitative Method:
The qualitative methods provide forecasts that incorporate factors such as the decision makers emotions,
personal experiences, and intuition. Some examples of the qualitative methods are jury of executive
opinions, Delphi method, consumer market survey, and sales force opinion composite
i.Jury of Executive Opinion: This is the simplest method, in that the executive of the organization each
provides an estimate of future volume, and the president provides a considered average of these
estimates.
ii.Delphi Method: The Delphi method makes use of a panel of experts, selected based on the areas of
expertise required. The Delphi method is an exercise in group communication among a panel of
geographically dispersed experts. The technique allows experts to deal systematically with a complex
problem or task.
iii.Consumer Market Survey: This method is mainly useful for predicting the sales forecast when it is
introduced in the market. For a new product, there will be no historic or past data available to forecast. In
this method, field surveys are conducted to gather information on the intentions of the concerned people.
iv.Sales Force Opinion Composite: In this method, members of the sales force estimate sales in their
own territory, regional sales managers adjust these estimates for their opinion or permission of individual

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sales people, and the general sales mangers massages the figures to account for new products or
factors of which individual salesman are unaware.
v.Scenario Building: In this method, the parameters of importance to the company are first recorded. A
number of assumptions are then followed through on how these parameters may change. Several
scenarios are developed based on the assumptions.
vi.Judgment Decomposition: The idea behind judgmental decomposition is to divide the forecasting
problem into parts that are easier to forecast than the whole. One then forecasts the parts individually,
using methods appropriate to each part. Finally, the parts are combined to obtain a forecast.
B.Quantitative Method:
The quantitative methods provide forecasts that were obtained by employing various mathematical
models that use past data or causal variables to forecast demand.
i.Time series Methods/Analysis: Methods of this type are concerned with variable that changes with time
and which can be said to depend only upon the current time and the previous values that it took.
ii.Simple Moving Average: This method uses the average of the previous N periods to estimate the
demand in any future period.
iii.Weighted Moving Average: In the weighted moving average method, for computing the average of the
most recent N periods, the recent observations are typically given more weight than older observations.
iv.Exponential Smoothing: This is frequently used and sophisticated weighted moving-average
forecasting method. The method is fairly easy to use and requires very little record keeping of past data.
C.Econometric Forecasting:
In this method of forecasting, the analyst finds the cause-and-effect relationship between the demand and
some other phenomena that are related to the demand. There are many dependent variables that interact
with each other via series of equations, the form of which is given by economic theory. Economic theory
gives some insight into the basic structural relationship between variables. The precise numeric relationship
between variables must often be deduced by examining data. This process is called economic forecasting.
Econometric analysis utilizes correlation and regression techniques.
i.Correlation Analysis: In this method, correlation coefficient is measures of the extension to which
variables (e.g. number of trucks sold and clutch plates sold) are associated.
ii.Regression Analysis: Regression models assume that a linear relationship exists between a variable
designated the dependent (unknown) variable and one or more dependent (known) variable.

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D.Technological forecasting:
Technological forecasting may be defined as the forecasting the future technology may affect the
operations of the enterprise. It is a prediction, based on confidence that certain developments can occur
within a specified time period with a given level or resource allocation. Two types of technological
forecasting should be considered: normative and exploratory.
i.Normative forecasting: In normative forecasting, some desired future goal is selected, and a process is
developed, working backward from the future to the present, designed to achieve this goal.
ii.Exploratory forecast: An exploratory forecast begins with the present stage of technology and
explicates into the future assuming some expected rate of technical progress. Delphi method is one such a
technique which is already discussed elaborately in topic Delphi Method.
iii.Technology S-curve: Another useful model for technological forecasting is the technology S-curve. The
performance gained from a new technology tends to start slowly, and then raise almost exponentially as
many scientists and engineers begin applying themselves to product improvement. Ultimately, as the
technology becomes mature, performance gains become more and more difficult to attain, and
performance approaches some natural limit.
iv.Internet: Another tool for forecasting is the internet, which has become a powerful tool at a companys
disposal for evaluating the composition, predicting the market, and establishing trend, one method is that
company web pages may be equipped with counters to keep track of visitors and even set feedback forms
to gather additional information. This information allows a company to evaluate their customers habits and
determine the most appropriate and beneficial way to deal with each one. This activity also provides
database information for trending and predicting future responses.

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UNIT III
PRODUCTION AND COST ANALYSIS
Production function - Returns to scale - Production optimization - Least cost input -Isoquants- Managerial
uses of production function.Cost Concepts - Cost function - Determinants of cost - Short run and Long run
cost curves - Cost Output Decision - Estimation of Cost.

PRODUCTION POSSIBILITY CURVE
The Production Possibility curve is the laws of output combinations which can be obtained from given
quantities of factors or inputs. This curve not only shows production possibilities but also the rate of
transformation of one product into the other when the economy moves from one possibility point to the
other.
Assumptions
i. Only two goods X (Consumer goods) and Y (Capital goods) are produced in different proportions in the
economy.
ii. The same resources can be used to produce either or both of the two goods and can be shifted freely
between them.
iii. The supplies of factors are fixed. But they can be re-allocated for the production of the tow goods within
limits.
iv. The production techniques are given and constant.
v. The economys resources are fully employed and technically efficient.
vi. The time period is short.


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X axis- Product X
Y-axis-ProductY

PPC-ProductionPossibilityCurve
Explanation
i. The curve production possibility (PP1) depicts the various possible combinations of the two goods,
P,B,C,D and P1. This is also known as the transformation curve or production possibility frontier.
ii. The production possibility curve further shows that when the society moves from the possibility point B to
C or to D, it transfers resources from the production of good X. It is concern as the optimum product =
mix of a society.
iii. Again, all possibility curve combinations lying on the production possibility curve (such as B, C and D)
show the combinations of the tow goods that can be produced by existing resources and technology of the
society. Such combinations are said to be technologically efficient.
iv. Any combination lying inside the production possibility curve, such as R implies that the society is not
using its existing resources fully. Such a combination is said to be technologically inefficient.
v. Any combination lying outside the production possibility frontier, such as K, implies that the economy
does not possess sufficient resources to produce this combination. It is said to be technologically
infeasible or unobtainable.

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THE USES OR APPLICATIONS OF THE PRODUCTION POSSIBILITY CURVE
i. Unemployment: The production possibility curve helps in knowing the level of unemployment of
resources in the economy.
ii. Technological Progress: The production possibility curve helps in showing technical progress enables
an economy to get more output from the same quantities of resources.
iii. Economic growth: The production possibility curve helps in explaining how an economy grows.
iv. Present goods vs. Future goods: An economy that allocates more resources in the present to the
production of capital goods than to consumer goods will have more of both kinds of goods in the future. It
will there, experience higher economic growth. This is because consumer goods satisfy the present wants
while capital goods satisfy future wants.
v. Economic efficiency: The production possibility curve is also used to explain the three efficiencies
namely efficient selection of the goods to be produced, efficient allocation of resources in the production of
these goods and efficient choice of methods of production, efficient allotment of the goods produced among
consumers
vi. Basic fact of human life: The production possibility curve tells us about the basic fact of human life that
the resources available to mankind in terms of factors, goods, money or time are scarce in relation to
wants, and the solution lies in economizing these resources.

ISO-QUANT OR EQUAL PRODUCT CURVE
An iso product curve also shows all possible combinations of the two inputs physically capable of producing
a given level of output. Since an iso product curve represents those combinations which will allow the
production of an equal quantity of output, the producer
would be indifferent between them. Iso product curve are therefore, called product indifference curves.
They are also known as Iso quants or equal product curve. This is explained with the help of a diagram.

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X axis Units of labor
Y Units of capital
IP Iso quant curve (or) Equal product curve
Explanation
IP represents all those combinations with which the units of the product can be produced. The shape of
the Isoquants shows the degree of substitutability between the two factors used in production.

EQUAL PRODUCT MAP (OR) ISO PRODUCT MAP
An iso product map showing various iso product curves, it is possible to say by how much production is
greater or less on one iso product curve than on another. This is explained with the help of a diagram.

X axis Units of labor
Y Units of capital
IP1-IP111 Iso quant curves (or) Equal product curves

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Explanation
An iso product map showing various iso product curves, it is possible to say by how much production is
greater or less on one iso product curve than on another. Higher the iso product curve higher is the level of
production & vice versa.

PROPERTIES OF EQUAL PRODUCT CURVES
i. Sloping downwards: Iso product curves slope downwards from left to right. This is so because if the
quantity of a factor X is increase, the quantity of factor Y must be decreased so as to maintain the same
level of output.
ii. Convexity: Iso product curves are convex to the origin. This is due to the fact that marginal rate of
technical substitution falls as more and more of X is substituted for Y.
iii. Perfect Substitutes: When the factors of production are perfect substitutes then one factor can
completely take the place of the other. They may, in fact, be regarded as on factor. In their case, the
marginal rate of technical substitution is constant. Hence, the equal product curves will be a horizontal
straight line instead of being convex to the origin.
iv. Complements: The complementary factors are those which are jointly used in production in a fixed
proportion. If one of these factors in increased, the other must also be increased at the same time
otherwise no additional output will be obtained, In this case, the equal product curves will be right angled
(i.e. One of the two arms being vertical and the other horizontal) at the combination of the two factors used
in fixed proportion.
v. Non-intersecting: Two iso product curves cannot cut each other

APPLICATION OF EQUAL PRODUCT CURVES
i. Applicable to agriculture: The Isoquants technique is applicable to agriculture and to all lines of
manufacture.
ii. Substitution of some units: The marginal rate of technical substitution guides in the substitution of
some units of one input for some units of another input.
iii. Reduction in use of raw materials: In some cases, increased use of labor can help in making a
reduction in the use of raw materials because spoilage and wastage of material may be cut to the
minimum.

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iv. Supervisory staff: Similarly, by adding to the supervisory staff, labor may be economized of\r the
introduction of machinery may cut down the use of labor.
v. Economical combination: The business man tries various permutations and combinations and the
Isoquant technique helps him in reaching the most economical combinations.

MARGINAL RATE OF TECHNICAL SUBSTITUTION
Marginal rate of technical substitution of X for Y is the number of units of factor Y which can be replaced by
one unit of factor X, quantity of output remaining unchanged. This can be explained with the help of a
diagram.

X axis Factor X
Y axis Factor Y
IP Iso product curve
Explanation
i. The marginal rate of technical substitution at point R will be equal to the slope of the tangent DE. Slope of
the tangent DE is equal to OD/DE.
ii. Hence, the marginal rate of technical substitution at point R will be equal to OD/DE: Likewise, Marginal
rate of technical substitution at point S of the iso product curve will be OG/OH.

THE LAW OF VARIABLE PROPORTIONS
The law states that as the quantity of a variable input is increased by equal doses keeping the quantities
of other inputs constant, total product will increase, but after a point at a diminishing rate. This principle can
also be defined thus, when more and more units of the variable factor are use, holding the quantities of

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fixed factors constant, a point is reached beyond which the marginal product, then the average and finally
the total product will diminish.
Assumptions
i. It is possible to vary the proportions in which the various factors (inputs) are combined.
ii. Only one factor is variable while others are held constant.
iii. All units of the variable factor are homogenous.
iv. There is no change in technology. If the technique of production undergoes a change the
product curves will be shifted accordingly but the law will ultimately operate.
v. It assumes a short-run situation, for in the long-run all factors are variable.
vi. The product is measured in physical units i.e., in quintals, tones etc.

This is explained with the help of a diagram

X axis Units of Variable factor
Y axis TP, AP, MP
TP Total Product curve
AP Average Product curve
MP Marginal Product curve

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Explanation
Increasing Returns
In this stage, the total product curve also increases rapidly. Thus this stage relates to increasing
average returns. Here land is too much in relation to the workers employed. It is, therefore, uneconomical
to cultivate land in this stage. The main reason for increasing returns in the first stage is that in the
beginning the fixed factors are large in quantity than the variable factor. When more units of the variable
factor are applied to a fixed factor, the fixed factor is used more intensively and production increases
rapidly. The TP curve first rises at an increasing rate up to point A where its slope is the highest. From point
A upwards the total product increases at diminishing rate till it reaches its highest point C and then it starts
falling. The marginal product curve (MP) and the average product curve (AP) also rise with TP. The MP
curve reaches its maximum point D when the slope of the TP curve is the maximum at point A.
Negative marginal returns
Production cannot take place in Stage III either. For, in this stage, total product starts declining and
the marginal product becomes negative. Here the workers are too many in relation to the available land,
making it absolutely impossible to cultivate it. When production takes place to the left of point E the fixed
factor is in excess quality in relation to the variable factor. To the right of point F, the variable input is used
excessively.
Diminishing returns
Stage II starts when the AP is at its maximum to the zero point of the marginal product. At the latter
point, the total product is the highest. Here land is scarce and is used intensively. More and more workers
are employed in order to have a larger output. Thus the total product increases at a diminishing rate and
the average and marginal products decline. Throughout this stage marginal product is below the average
product. As the proportion of one factor is a combination of factors in a combination of factors is increased,
after a point, the average and marginal product of that factor will diminish. Point A where the tangent
touches the TP curve is called the inflection point up to which the total product increases at an increasing
rate and from where it starts increasing at a diminishing rate.

LAWS OF RETURNS TO SCALE
The law of returns to scale describes the relationship between outputs and the scale of inputs in
the long-run when all the inputs are increased in the same proportions. To meet a long-run change in

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demand the firm increases its scale of production by using more space, more machines and laborers in the
factory.
Assumptions
i. All factors (inputs are variable but enterprises is fixed.
ii. A worker works with given tools and implements.
iii. Technological changes are absent
iv. There is perfect competition.
v. The product is measured in quantities.
This is explained with the help of a diagram

X axis Scale of production
Y axis Marginal Returns
RC Increasing returns
DS Decreasing returns
CD Constant returns
Explanation
Increasing Returns to Scale: Returns to scale increases because of the indivisibility of the factors of
production. Indivisibility means that machines, management, labor, finance, etc. cannot be available in very
small sizes. They are available only in certain minimum sizes. When a business unit expands the returns to
scale increase because the indivisible factors are employed to their maximum capacity. Increasing returns
to scale also result from specialization and division of labor. RS is the returns to scale curve where from R
to C returns are increasing.

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Constant Returns to scale: Returns increase in the same proportion so that there are constant returns to
scale is horizontal. It means that the increments of each input are constant at all levels of output. The
returns to scale are constant when internal diseconomies and economies are neutralized and output
increases in the same production. Another reason is the balancing of external economies and
diseconomies. Further, when factors of production are perfectly divisible, substitutable and homogeneous
with perfectly elastic supplies at given prices, returns to scale are constant. From C to D, they are constant
Diminishing Returns to scale: Ultimately returns to scale. Indivisible factors may become inefficient and
less productive. Business may become unwidely and produce problems of
supervision and coordination. Large management creates difficulties of control and rigidities. To these
internal diseconomies are added external diseconomies of scale. And from D onwards they are diminishing.

MANAGERIAL USES OF PRODUCTION FUNCTION
1. Calculate the least cost input combination: It can be used to calculate the least cost input
combination for a given output.
2. Calculate the maximum-input-output combination: It can be used to calculate the maximum-
input-output combination for a given cost.
3. Deciding on the value of employing a variable input factor: Knowledge of production
function is useful in deciding on the value of employing a variable input factor in the production process. As
long as the marginal revenue productivity of a variable input factor exceeds its price, it is worthwhile to
increase its usage. When the marginal revenue productivity just equals the price of input factors then the
additional use of input factors must be stopped.
4. Aid in long run decision making: Production functions also aid in long run decision making. If
the return to scale is increasing, one can increase production through a proportionate increase in all the
input factors of production. The opposite is true if there is decreasing returns to scale. The producer will be
indifferent about increasing or decreasing the production in case of constant returns to scale provided the
demand is of no constraint

ISO COST LINE
The combination of factors with which a firm produces the product also depends on the prices of
the factors and the amount of money which a firm wants to spend; Iso cost line represents these two things.
The prices of productive factors and the amount of money which a firm wants to spend, Each iso cost line

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will show various combinations of tow factors which can be purchased with a given amount of total money.
The iso cost line is also known as price line (or) outlay line. This can be explained with the help of a figure
below:

X axis Factor X
Y axis Factor Y

Explanation
The slope of the iso cost line represents the ratio of the price of a unit of input X to the price of a
unit of input Y. In case the price of any one of them changes, there would be a corresponding change in the
slope of the iso cost curve and the equilibrium would shift too.

THE CHOICE OF OPTIMAL FACTOR COMBINATION (OR) LEAST COST COMBINATION OF
FACTORS (OR) PRODUCER EQUILIBRIUM
The choice of optimal expansion path refers to the Combinations of factors of production that
enable the firm to produce various levels of outputs at the least cost while relative factor prices remain
constant. Its analysis is done in relation to the short run and the long run.
Assumptions
i. There are two factors, labor and capital.
ii. All units of labor and capital are homogeneous.
iii. The prices of units of labor (W) and that of capital (v) are given and constant.
iv. The cost outlay is given
v. The firm produces a single product.
vi. The price of the product is given and constant.

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vii. The firm aims at profit maximization.
viii. There is perfect competition in the factor market.

X axis Factor X
Y axis Factor Y
OS Expansion path
IP Iso product curve
Explanation
i. In order to maximize its profits or to have the least cost combination, the firm combines labor and capital
in such a way that the ratio of their MP is equal to the ratio of their prices, i.e. MPL/MPC = w/r. This equality
occurs at the point of tangency between an iso cost line and an iso quant curve.
ii. The line C2L2 shows higher total outlay than the line C1L1 and C3L3 still higher total outlay than the line
C2L2. They are shown parallel to each other there by reflecting constant factor prices.
iii. The firm Is in equilibrium at point P where the isoquant IQ1 is tangent to its corresponding iso cost line
C1L1 and similarly the other tow iso quants IQ2 and IQ3 are tangent to isocost lines C2L3 and C3L3
respectively at points Q and R.
iv. Each point of tangency implies optimal combination of labor and capital that produces an optimal output
level. The line OS joining these equilibrium point P,Q and R through the origin is the expansion path of the
firm.

PRODUCTION FUNCTION
The Production function expresses a functional relationship between quantities of inputs and
outputs. It shows how and to what extent output changes with variations inputs during a specified period of
time.

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ECONOMIES AND DISECONOMIES OF SCALE OR OF LARGE SCALE PRODUCTION
Economies of Scale:
An economy of scale exists when larger output is associated with lower per unit cost.
Diseconomies of Scale:
A diseconomy of scale exists when larger output leads to higher per unit cost.

ECONOMIES (OR) ADVANTAGES OF LARGE SCALE PRODUCTION
i. Efficient use of capital equipment: There is a large scope for the use of machinery which results in
lower costs.
ii. Economy of specialized labour: Specialized labour produces a large amount of output and of better
quality.
iii. Better utilization and greater specialization in management: When the scale of production is
enlarged, there is fuller use of the managers time and ability. Also, he is able to delegate some of his less
important functions to his assistants and increasingly specialize in the jobs where his ability is most fruitful.
iv. Economics of buying and selling: While purchasing raw material and others accessories, a big
business can secure specially favorable terms on account of its large custom.
v. Economics of the overhead charges: The expenses of administration and distribution per unit of
output in a big business are much less.
vi. Economy in Rent: A large-scale producer makes a savings in rent too.
vii. Experiments and Research: A large concern can afford to spent liberally on research and
experiments.
viii. Advertisement and Salesmanship: A big concern can afford to spend large amounts of money on
advertisement and salesmanship.
ix. Utilization of By-products: A big business will not have to throw away any of its by-products or waste
products.
x. Meeting Adversity: A big business can secure credit facilities at cheap rates.

DISECONOMIES (OR) DISADVANTAGES OF LARGE SCALE PRODUCTION
i. Over-Worked management: A large-scale producer cannot pay full attention to every detail.
ii. Individual tastes ignored: Large-scale production is a mass production or standardized production.
This results in a loss of custom.

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iii. No personal element: The sympathy and personal touch, which ought to exist between the master, and
the men, are missing.
iv. Possibility of depression: Large-scale production may result in over-production. Production may
exceed demand and cause depression and unemployment.
v. Dependence on foreign markets: A large-scale producer has generally to depend on foreign markets.
This makes the business risky.
vi. Cut-throat competition: Large-scale producers must fight for the markets. There is wasteful
competition which does no good to society.
vii. International complications and war: When the large-scale produces operate on an international
scale, their interests clash either on the score of markets or of materials.
viii. Lack of adaptability: A large-scale producing unit finds it very difficult to switch on from one business
to another.

ECONOMIES (OR) ADVANTAGES OF SMALL SCALE PRODUCTION:
i. Prompt decision: The small manufacturer is capable of prompt decision and quick execution.
ii. Close Supervision: The initiative and sense of responsibility of a small producer have not been sapped
by routine.
iii. Personal contact with the employees: Personal contact with the employees, and a kind word thrown
now and then, will rule.
iv. Personal contact with the customers: Personal contact with the customers, again, sends them away
well satisfied and is productive of good results.
v. Demand is limited: The small-scale producers advantage is the greatest where the demand is limited
and fluctuating.
vi. Self-interest: The small businessman is usually the sole proprietor. Self interest is a strong spur to his
activity.

DISECONOMIES (OR) DISADVANTAGES OF SMALL SCALE PRODUCTION
i. Modern machinery: There is less scope for the use of modern machinery and labour-saving devices.
Hence cost per unit is high.
ii. Production is uneconomical: There is little scope for division of labour. The advantages of division of
labour are, therefore, lost of him. Hence production is uneconomical.

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iii. Pushes up the cost: The small-scale producer is at a disadvantage in the purchase of raw materials
and other accessories. This pushes up the cost.
iv. No innovations: He cannot afford to spend large sums of money on research and experiments. Hence
he cannot make no innovations and thus reduce costs.
v. Higher overhead charges: Cost of rent, interest, advertisement, etc., per unit of output is higher. That
is, he has higher overhead changes.
vi. Instability: With his limited resources he cannot meet bad times.
vii. No cheap credit: He cannot secure cheap credit. This means higher costs.
viii. Wastage: By-products have to be thrown away as so much waste.

TYPES OF ECONOMIES AND DISECONOMIES OF SCALE TYPES OF ECONOMIES
A. Real Internal Economies: Real internal economies are associated with a reduction in the physical
quantity of inputs, raw materials, various types of capital (fixed or circulating) used by a large firm.
i. Labour economies: When a firm expands in size this necessitates division of labour whereby each
worker is assigned one particular job, and the splitting of processes into sub-processes for greater
efficiency and productivity.
ii. Technical Economies: Technical economies are associated with all types of machines and equipments
used by a large firm. They arise from the use of better machines and techniques of production which
increase output and reduce per unit cost of production. It includes, economies of indivisibility, economies of
increased dimensions, economies of linked processes, economies of the use of By-products, economies in
power consumption.
iii. Marketing Economies: A large firm also reaps the economies of buying and selling. It buy its
requirements of various inputs in bulk and is, therefore, able to secure them at favorable terms in the form
of better quality inputs, prompt delivery, transport concessions, etc.
iv. Managerial Economies: A large firm can afford to put specialists to supervise and manage the various
departments. There may be a separate head for manufacturing, assembling, packing, marketing, general
administration, etc.
v. Risk-Bearing Economies: A large firm is in a better position than a small firm in spreading its risks. It
can produce a variety of products, and sell them in different areas.
vi. Economies of Research: A large firm possesses larger resources than a small firm and can establish
its own research laboratory and employ trained research workers.

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vii. Economies of welfare: All firms have to provide welfare facilities to their workers. But a large firm, with
its large resources, can provide better working conditions in and outside the factory. It may run subsidized
canteens, provide crches for the infants of women workers and recreation rooms for the workers within the
factory premises.

B. Pecuniary Internal Economies: Pecuniary or monetary internal economies accrue to a large firm solely
through reductions in the market prices of its inputs.
i. It purchases raw materials in bulk at lower prices from its suppliers.
ii. It gets loans from banks and other financial institutions at low interest rates because it possesses large
assets and good reputation.
iii. It raises capital by floating shares at a premium and debentures at low interest rates in the capital
market.
iv. It advertises at concessional rates on a large scale in different media.
v. It transports large quantities of its commodity at concessional transport rates. Thus pecuniary economics
are realized from paying lower prices for the factors used in the production and distribution of the product,
due to bulk-buying by the firm as its size increases.

C. Real External Economies: Real external economies accrue to a firm in an industry due to technological
influences on its output which reduce its real cost of production.
i. Technical Economies: Technical external economies arise from specialization. When an industry
expands in size, firms start specializing in different processes and the industry benefits on the whole.
ii. Economies of Information: As an industry expands, it specializes in collecting and disseminating
market information, in marketing the industry product and in supplying the firms with consultant services.
iii. Economies of By-products: When an industry is localized, it turns out large quantities of waste
materials, such as molasses in sugar industry and iron scrap in steel industry.
D. Pecuniary External Economies: Pecuniary external economies arise to firms in an industry from
reductions in factor prices.

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TYPES OF DISECONOMIES
A. Real Internal Diseconomy: When a firm expands beyond an optimum level, a number of problems
arise such as factor shortages, lack of coordination and management, marketing and technological
difficulties, etc.
i. Managerial Diseconomy: There is a limit beyond which a firm becomes unwidely and hence
unmanageable. Supervision becomes less. Workers do not work efficiently, wastages arise, decision-
making becomes difficult, co-ordination between workers and management disappears and per unit cost
increases.
ii. Marketing Diseconomy: The expansion of a firm beyond a certain limit may also involve marketing
problems. Raw materials may not be available in sufficient quantities due to their scarcities. The demand
for the products of the firm may fall as a result of changes in tastes of the people and the firm may not be in
a position to change accordingly in the short period.
iii. Technical Diseconomy: A large scale firm often operates heavy capital equipment which is indivisible.
As the firm expands its size beyond the optimum level, there are repeated breakdowns in plants and
equipments and the firm may fail to operate its plant to its maximum capacity. It may have excess capacity
or idle capacity. As a result, per unit cost increases.
iv. Diseconomy of Risk-taking: As the scale of production of a firm expands, risks also increase with it.
An error of judgment on the part of the sales manager or the production manager may adversely affect
sales or production which may lead to a great loss.

B. Pecuniary Internal Diseconomy: Pecuniary internal diseconomy arises when the prices of factors used
in the production and distribution of the commodity increase.

C. Pecuniary External Diseconomy: Pecuniary external diseconomy arises solely through increases in
the market prices of inputs of an industry.

COST CONCEPT
i. Money Cost: The cost may be nominal cost or real cost.
ii. Nominal Cost: Nominal Cost is the money cost of production. It is also called expenses of production.
These expenses are important from the point of view of the producer. He must make sure that the price of

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the product, in the long run, covers these expenses including normal profit, otherwise he cannot afford to
carry on the business.
iii. Real Cost: Attempts have been made to pierce the monetary veil and to establish cost on a real basis.
The real cost of production has been variously interpreted. Adam smith regarded pains and sacrifices of
labour as real cost. Marshall includes under it real cost of efforts of various qualities and real cost of
waiting. This is called the social cost by Marshall.
iv. Opportunity Cost: The Austrian school of economists and their followers gave a new concept of real
costs. According to them, the real cost of production of a given commodity is the next best alternative
sacrificed in order to obtain that commodity. It is also called opportunity cost or displacement cost.
v. Economic Cost: By economic costs is meant those payments which must be received by resource
owners in order to ensure that they will continue to supply them in the process of production. This definition
is based on the fact that resources are scarce and they have alternative uses. To use them in one process
is to deny their use in other processes. Economic Cost includes normal profit.
vi. Implicit Cost: Implicit costs are costs of self-owned and self-employed resources such as salary of the
proprietor or return on the entrepreneurs own investment. These costs are frequently ignored in calculating
the expenses of production.
vii. Explicit Cost: Explicit costs are the paid-out costs, i.e., payments made for productive resources
purchased or hired by the firm. They consist of the salaries and wages paid to the employees, prices of raw
and semi-finished materials, overhead costs and payments into depreciation and sinking fund accounts.
These are firms accounting expenses.
viii. Full Cost: If we add to the money expenses two item, viz., alternative or opportunity costs and normal
profits, we get the full costs.
ix. Business Cost: Business costs are synonymous with firms total money expenses as computed by
ordinary accounting methods. The entrepreneur must be sure of normal profit if he is to continue in
business. In this sense normal profit too is a cost.
x. Social Cost: It is the amount of cost the society bears due to industrialization. Industrialization has
certain economic and social merits, but along with the merits, they bring about certain demerits also. They
are like, development of slums, air-pollution, noise pollution, land pollution, social inequalities, and so on.
The amount of cost the society bears due to industrialization is referred as Social Cost.
xi. Entrepreneurs Cost: In what follows, we shall use the term cost of production in the sense of money
cost or expenses of production. This is entrepreneurs cost. The entrepreneurs cost of production

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includes the following element: (i) Wages of labour; (ii) Interest on capital; (iii) Rent or royalties paid to the
owners of land or other property used; (iv) Cost of raw materials; (v) Replacement and repairing charges of
machinery;(vi)Depreciation of capital goods; and (vii) Profits if the manufacturer sufficient to induce him to
carry on the production of the commodity.
xii. Classification of Entrepreneurs Cost: Entrepreneurs costs may be classified as: Production costs,
including material costs, wage costs, interest costs, etc., both direct and indirect costs. Selling costs,
including costs of advertising and salesmanship, Managerial costs, Other costs, including insurance
charges, rates, taxes, etc.
xiii. Short run: Short run is a period of time within which the firms can its output by varying only the
amount of variable factors, such as labour and raw materials. In the short run, fixed factors, such as capital
equipment, top management personnel, etc., cannot be varied.
xiv. Long run: Long run is a period of time during which the quantities of all factors, variable as well as
fixed, can be adjusted.
xv. Prime Cost & Overhead Cost: Some costs vary more or less proportionately with the output, while
others are fixed and do not vary with the output in the same way. The former are known as prime costs and
the latter as supplementary costs of production or overhead costs.
xvi. Total Cost: Total Cost is the sum of Fixed cost (Factory land, building and machinery) plus the total
variable cost (raw material charges, electricity)
xvii. Average Cost: Average Cost per unit is the total cost divided by the number of units produced. It is
the sum of average fixed cost and the average variable cost.
xviii. Marginal Cost: Marginal cost is the addition to total cost caused by a small increment in output.
Marginal cost may be defined as the change in total cost resulting from the unit change in the quantity
produced. Thus, it can be expressed by the formula:
MC=Change in Q Change in TC

COST-OUTPUT FUNCTION
Cost function express the relationship between cost and determinants, like the size of plant, level of output,
input prices, technology, etc. in ma mathematical form it can be expressed as, c=f(S, O,P,T,...), Where
C=refers to cost(unit cost or total cost) S=refers to size of plant O=means level of output P=denotes the
price of inputs used in production T=refers to the nature of technology.

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METHODS OF ESTIMATING COST FUNCTIONS
1. Accounting method: this method is used by the cost accountants. Essentially, in this method the data is
classified into various cost categories. Observations of cast are then taken at the extreme and the various
intermediate levels of output. By plotting the output levels and the corresponding costs on a graph and
joining them by a line the cost functions are estimated. The cost functions, thus found, may be linear or
non-linear. It must be noted that while finding cost functions from basic data in this wat, no attention is
generally paid to build up a hypothesis or to find out the changes in conditions which influence cost.
2. Statistical or econometric method: this method uses statistical techniques on economic data to find
the nature of cost-output relationship. The economic data may relate to past records of the firm or to the
different firms in the same business at a point of time. If we use the series data we generally get a short-run
cost function, while if we take resources to the cross section data we derive a long-run cost function.
3. Survivorship Method: this method is based on the rationale that overtime competition tends to
eliminate firms of inefficient size and that only the firms with efficient size will survive as these will have
lower average cost. The size-group whose share in the industry grows the most during the specified time
period is considered the most efficient size-group. For example, if the share of small firms in the industry
increases at the cost of the share of large firms, it implies that the optimum size of a firm in the present
case is the small one.
4. Engineering method: In the engineering approach, the cost functions are estimated with the help of
physical relationships, such as weight of supplies and materials used in a process, rated capacity of
equipment, etc. emphasis is placed primarily on the physical relationship of production and these are then
converted into money terms to arrive at an estimate of costs. This method may be useful if good historical
data is difficult to obtain. But this method requires a sound understanding of engineering and a detailed
sampling of the different process under controlled conditions, which may not always be possible.

PROBLEMS IN THE ESTIMATION OF COST
i. Time Period: We must choose an appropriate time period for the analysis of cost. The choice of such a
time period involves the following important considerations:
a. Normality: The time period of study should be normal. A period during which the changes in technology,
plant size, efficiency, other dynamic events are non-existent or are at their minimum.
b. Variety: the length of period should be such that it includes sufficiently wide variation in output, so that
enough observation is available for getting a reliable cost function.

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c. Recent period: since the results of the cost function are to be used as a guide for future planning, the
period chosen should be recent enough to include data which will be relevant for the future.
d. Units of observation: The value-and-effect relationship between cost and output would be more useful
if the data pertains to a shorter length of time. For example, by taking weekly or monthly data we average
out smaller changes in cost and output than by talking yearly data.
ii. Technical Homogeneity: To eliminate or minimize the impact of technical differences on cost, the
plants chosen for the study of the cost-output relationship should be characterized by homogenous input
and output structures. Homogeneity of inputs will ensure that the variations in cost due to different
machines and equipment used in production at different output levels are eliminated. Homogeneity in
output reduces the problem of additively that exists in case of heterogeneous product measurement.
iii. Cost Adjustment
a. The choice of a proper data for cost measurement is obviously necessary: Generally, the cost data
is not available in the form which can be readily used it needs certain adjustment and precautions, which
are the following:
b. Selection of cost data: In order to find cost output relationship, one must select only those elements of
cost that vary with output. Overhead costs and allocated expenses that do not bear any relation to changes
in output must be excluded. Further , it is always better to use date on total cost rather than unit cost
because(1) the unit cost being a ratio of cost to output, the impact of the output on cost will not be very
revealing and there may be basic problems in interpretation of results. And (2) average and marginal cost
functions can be derived from the total cost functions. No additional purpose is, therefore, served in using
unit cost data.
c. Cost deflation: since prices change over time, any money value cost would therefore relate partly to
output changes and partly to price changes. In order to estimate the cost-output relationship, the impact of
price change on cost needs to be eliminated by deflating the cost data by price indices. Wages and
equipment price indices are readily available and frequently used to deflate the money cost.
iv. Economic Versus Accounting Cost Data: Accounting data is relatively more easily available and is
therefore, used in most of the empirical studies. This data records the actual expenses on historical basis.
v. Changes in Accounting Practices: In case we are using time series of accounting data is necessary
that we find out whether accounting methods and procedures have changed or not during that period.
These changes may be related to say depreciation method, timing of recording expenses, etc. if there are
any such changes they merit proper adjustment before being used for cost analysis.

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PRICING
Price is defined as the exchange value of product or a service quantified in monetary terms.

OBJECTIVES OF PRICING
i. Satisfactory return on investment.
ii. Maintaining the market share.
iii. Meeting a specified profit goal.
iv. Attaining largest possible market share.
v. Profit maximization.
vi. Meeting competition.
vii. Discouraging entry of the new firms.
viii. Flexibility to vary prices to meet change in economic conditions.
ix. Prices set at a high level and then lowered after a certain period has elapsed.
x. The ultimate objective of the firm is to maximize profits. Hence the firm should strive to blend the
different objectives mentioned above to achieve this.

DETERMINANTS OF PRICE
A. Internal Factors
i. Organizational factors: Pricing decisions occur on two level in the organization. Overall price strategy is
dealt with by top executives and the actual mechanics of pricing are dealt with the lower levels in the firm.
Usually some combination of production and marketing specialists are involved in choosing the price.
ii. Marketing mix factors: Marketing experts view price as only one of the many important elements of the
marketing mix. (product, price, place and promotion). A shift in any one of the elements has an immediate
effect on the otherthree. Thus, all pricing decisions must be viewed in the context of a total marketing
strategy and must be coordinated with elements of production, promotions and distribution
iii. Product differentiation: Generally, the more differentiated a product is from competitve offerings, the
more leeways a firm has in setting prices.
iv. Costs: Price are determined solely by costs in that the firm wishes to take its relevant costs that goes in
it. However, in deciding the price of a new product, the firm should think what prices are realistic,
considering current demand and competition in the market.

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v. Objectives: The variety of possible pricing objectives was discussed earlier in this chapter. A firm should
define its objectives as specifically as possible so that they can be acted upon.

B. External Factors
i. Demand: The market of demand for a product or service obviously has a big impact on pricing. Demand
in turn in affected by the number and size of competitors. What they are charging for similar products. The
most likely buyers. How much they are willing to pay, and what their particular preferences are in deciding
upon a price, marketers must study all of these factors and then gauge the total effect
ii. Competition: Before a firm cam make pricing decisions. It must have a sense of not on the price of a
product. The fluctuations in price of their supplies to firm may have an impact on the prices of finished
goods.
iii. Suppliers: Suppliers of raw materials and other goods can have a significant effect on the price of a
product. The fluctuations in prices of their supplies to the firm may an impact on the prices of finished
goods.
iv. Buyers: The various buyers that buy a firms products and service may have an influence in the pricing
decision.
v. Economic conditions: Inflation, recession, shortage and stagflation all have an impact on prices in
most decision.
vi. Government: The government keeps a close watch on pricing in the private sector. Regulatory
pressure effectively discourages private companies from winning too large a share of the market and
controlling prices. Also, in many case, special committees or commissions were appointed by the
government to recommend fair selling prices. Tariff commission (abolished with effect from august 1, 1976),
bureau of industrial costs and prices, essential commodities act, are some of the few instances were a
government can intervene in price fixation.

PRICING UNDER DIFFERENT OBJECTIVES
i. Need based Pricing: Not much managerial thinking has been devoted to this kind of pricing. However, in
a system where economic policy is activity used to promote social goals, need-based pricing is quite
important. Four different approaches are available to arrive at a need-based price:

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ii. Ability to pay: The price may be determined according to the ability of consumer to pay. This method of
pricing is used in the pricing of state health service, some of the schooling services, housing provided by
government or public sector companies, etc.
iii. Comparative reasonable price: In some case, price is determined by using a comparative and
reasonable open market, price as
iv. Pricing by norm: A norm may be developed. For example, food in an institutional cafeteria may be
priced on the basis of a price per caloric norm.
v. Poorest can afford: Sometimes pricing of an essential commodity or service is done on the basis that
the poorest section of society should be able to afford the product. Rationed sugar or grain and controlled
cloth are priced based on such consideration.
vi. Cost-based Pricing: Cost consideration is the fundamental driving force in setting the price. When
other factor which influences pricing, such as government regulations, competitors pricing strategies,
market demand, technology are not dominant, the sole criteria on which the price is set may be costs.
vii. Market-based Pricing: Any pricing policy which takes demand factors into consideration and seeks to
maximize revenues or profits is called market-based pricing. Most consumer packaged goods and many
industrial products have market-based prices. Since market-based prices is fraught with uncertainties of
demand estimation and market response, the problem is often divided into small, structured manageable
steps, each of which the executive into small, structured manageable steps, each of which the executive
can hope to tackle with judgment.

PRICING POLICIES
Pricing policies are the decisions by a company determining prices to be charged for its products. There
are a number of different pricing policies or strategies which a firm may adopt in order to achieve its pricing
objectives.
i. Skim pricing: uses high prices to obtain a high profit and quick recovery of the development costs in the
early stages of a products life before competition intensities.
ii. Penetration pricing: Is the use of lower than normal prices to increase market share. It is also used to
establish a new product in a market which is expected to have a long-life and potential for growth.
iii. Mixed pricing: is a policy which initially uses skim pricing and then, as competition increases, price
cutting, sometimes even below cost, to penetrate the market, increases market share and eliminate
competition.

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iv. Destructive pricing: involves reducing the price of an existing product or selling a new product at an
artificially low price in order to destroy competitors sales.
v. Differential or discrimination pricing: is the use of different prices for the same product when it is sold
in different locations or market segments. Large buyers for example. Often receive quantity discounts.
Whilst small buyers or those located in remote areas may be charged a higher price to cover the additional
distribution costs. Electricity, gas is sold at different prices to domestic and industrial consumers.
vi. Absorption pricing: involves the use of lower than normal prices ether to launch a new product or to
periodically boost the sales of existing products. Regular special offers by traders and businesses use loss
leaders where everyday goods are sold at less than cost to attract customers.
vii. Marginal cost pricing: is something used when a firm has some spare capacity which it wishes to use
without diverting a way from its regular business. Essentially, a firm incurs fixed costs such as rent, whether
or not it is operating at full capacity. These costs are covered by the firms regular products. Therefore,
sometimes a firm is prepared to accept additional business provided that the marginal (i.e, additional)
revenue covers the marginal costs (i.e. materials and labour) involved and makes at least some
contribution to the fixed cost which represents the profit.
viii. Negotiable pricing: is common in industrial markers. The price is individually calculated to take
account of costs, demand and any specific customer requirement.
ix. Single pricing: involves a policy of charging one price to everyone. Examples include standard bus
fares, prices of books etc.
x. Market pricing: is determined by the interaction of demand and supply. The seller has little control over
the price in this situation which is likely to fluctuate daily. Examples include commodity markets such as
gold, silver, wheat and wool and stock exchange.
xi. Sealed-bid pricing: is widely used in government, public sector and other private sector markets
whereby suppliers are invited to tender(offer a fixed price) for the supply of specified goods or services.
Tenders must normally be submitted by a specified date in a sealed envelope. The contract is than usually
awarded to the lowest bidder. A business will calculate a tender price based on its own costs and analysis
from knowledge and experience of competitors likely bids.

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I. COST-ORIENTED PRICING
a. Cost-plus Pricing: In this method the price is determined by adding a fixed mark-up to the cost of
acquiring or producing the product.
b. Marginal cost (or direct cost) pricing: The marginal cost pricing implies that the price of the product is
based on the incremental cost of production. Unlike the full-cost pricing which is based on average cost, the
incremental or marginal cost pricing is based on variable cost only- the difference between the two being
fixed cost only. This makes it apply clear that whereas the full-cost pricing is a long period phenomenon;
the incremental-cost pricing is a short period phenomenon.
c. Rate of Return (or Target) Pricing: It is a refined version of cost-plus pricing. When, due to certain
reasons, the firm has to revise its prices it needs to ensure that the prices so revised would allow it to
maintain either a fixed percentage mark-up over cost; Profit as a fixed percentage of total sales; or a fixed
return on existing investments.

II. COMPETITION-ORIENTED PRICING
a. Going-rate pricing: The going-rate pricing is, in a sense, opposite to full-cost pricing. In case of the
latter the emphasis is on cost of production, while in case of the former it is on the market situation. The
simplest form of the going-rate pricing is where the firm simply examines the general pricing structure in the
industry and fixes the price of its own product accordingly.
b. Loss leaders:A loss leader is an item which produces a less than customary contribution or a negative
contribution to overhead but which is expected to create profits on increased future sales or sales of other
items.
c. Trade association pricing: To avoid un certainties of pricing decisions and the downward pressure on
prices which competition exerts, firms frequently come to the express or implied agreements to maintain
prices at a similar level. Though express (or, overt) agreements are generally declared as illegal, the firms
can easily and safely enter into an implied (or, tacit) collusion.
d. Customary pricing: In case of some commodities the prices get fixed because they have prevailed over
a long period of time. Any change in costs for such products gets reflected in quality or quantity of the
product rather than its price.

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e. Price leadership: It often happens that in an industry there is one or many big firms whose cost of
production is low and they dominate the industry. In such a situation, the small firms will not like to enter
into price war with these big firms. The former may, therefore, follow the price fixed by the leader.
f. Cyclical pricing: We are aware of various methods of pricing employed in various kinds of market
structures like perfect and imperfect competition. However, there are considerations other than market
structure that operate to influence the pricing decisions, viz., seasonal and cyclical fluctuations in economic
activity. Whereas seasonal factors operate on short-term basis, the cyclical factors influence the economic
activity for a long run (up to 3 or more years).
g. Imitative pricing and suggested prices: This approach is often used in retail business. In oligopolistic
market conditions, the firms often follow a price-leader. But in non-oligopoly situations also, it is many a
time considered useful to imitate the price set by other firms. This approach makes decision-making quite
easy, as the decision-maker does not have to undertake the demand and cost analysis.

PRICING BASED ON OTHER ECONOMIC CONSIDERATIONS
i. Administered prices: These are those prices which are statutorily fixed by the government, taking into
account the cost and the stipulated profit per unit. The purpose of introducing administered prices is to
control prices of essential goods and inputs as well as to provide them at economic prices to weaker
sections of consumers and producers. The public distribution system, whereby fair price shops sell
essential goods to public, is based on administered prices. Prices of certain goods like steel, fertilizer, coal,
etc., are generally statutorily fixed.
ii. Dual pricing: A market, where a commodity is covered simultaneously under the administered price as
well as market price, is said to have dual prices. Here, part of the output of a firm is subjected to
administered price, while the rest of its output is sold in the free market.
iii. Price Discrimination or Differential Pricing: In an open price discrimination situation the market is
sub-divided on some systematic basis, such that it is almost impossible for the group of buyers to whom a
high price is quoted to take advantage by shifting and joining the group to which a lower price is quoted.
There are many bases on which the open price discrimination is practiced. These are discussed below.
a. Time Price Differentials: It is a general practice to use the expression the demand for a product or
service, but it is important to note that demand also has a time dimension. The demand may shift in fairly
short-time intervals.

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b. Clock-time price differentials: When demand elasticities of buyers undergo a change within 24-hour
period, the seller can discriminate between the buyers demanding services at different points of time within
the 24-hour time period. These price differentials are called clock-time differentials and its object is to
charge higher price for the product or service during the period of relatively inelastic demand and lower
price during the period of relatively elastic demand. The oft quoted example of clock-time differentials is the
differences between day and night rates of long-distance telephone calls.
c. Calendar-time price differentials: When price differentials are not based on demand elasticity
differences but simply on time differences like days, weeks, months, etc., we call them calendar-time
differentials. These differences are often found in recreational activities.
d. Use-price Differential: Different buyers have different uses of a product or a service. For example,
Electricity can, similarly, be used for industrial or residential purposes. Charges for these different
segments according to demand elasticity based on buyers use of the product or service, and then he
charges different prices from these different segments.
e. Quality Price Differentials: If the product caters to that group of consumers who are concerned about
its quality, then the quality becomes a significant determinant of demand elasticity. The seller has,
therefore, to create differences in quality to sell his product. It must be emphasized here that the
differences in quality basically depend upon the buyers understanding of the quality. Sellers use many
decides to create quality appearance of the product, by restricting a particular type of the product to a
region or to a sale channel, etc. It is also found that consumers judge quality by the price of the product.
f. Quantity Differentials: When the seller discriminates on the basis of the quantity of purchase, it is
known as quantity differentials. In business practice there are three types of quantity differentials which are
of significance.

PRICING STRATEGIES
a. Stay-out Pricing: When a firm is not certain about the price at which it will be able to sell its product, it
starts with a very high price. If at this high price quotation it is not able to sell, it then lowers the price of i ts
product. It will keep on lowering the price till it is able to sell the targeted amount of the product. This
approach helps the firm to ascertain the maximum possible price it can charge from its customers.
b. Price lining: Here, price of one product in the total range of the products is fixed. Price of rest of the
commodities is automatically determined by the relationship between the commodity whose price has been
fixed and the rest of the commodities in the range. For example, if a firm producing shoes or shirts fixes up

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the price for a particular size, price of rest of the sizes is then fixed simultaneously on the basis of the
differences in their sizes. Also, when price of one size of shoes or shirts changes, prices of rest in the line
of the product get automatically adjusted.
c. Psychological Pricing (or, Odd number and round number pricing): This is not truly a method of
pricing but of price-tagging. Here a firm fixes the price of its product in a manner which gives the impression
of being low. For example, if the price of a product is fixed at Rs. 89.90 rather than Rs. 90, it may have the
psychological impact on consumers that price is in 80s rather than in 90s. This may have some impact on
sales. For example, the shoe companies have been following this price policy with some success. On the
other hand, some firms round their prices to the next higher rupee so that accounts can be kept easily.
d. Limit Pricing: A firm (or firms) may also try to establish a price that reduces or eliminates the threat of
entry of new firms into the industry. This is called limit pricing. For limit price to be effective some of
collusion is necessary among existing firms.
e. Resale Price Maintenance: Resale price maintenance is common in cases of popular or branded
products. The manufacturers of such products fix and stipulate the price of the products at which the
product is to be resold by the individual retailer. This is done to maintain a uniform selling price of the
branded produces at all the outlets of their sale. Since such a price is handed down from the manufacturer
to the retailer, it is kind of vertical price control.
f. Peak-load pricing: A firm that uses the same facility to supply many markets at different points of time
can increase its profits by the use of peak-load pricing. Peak-load pricing essentially involves charging
higher price from consumers wanting to consume the service during the peak demand period and lower
price from those who consume during off-peak period.
g. Multi-product Pricing: Pricing that reflects the inter-relationship among multiple products of a firm that
are complements or substitute of each other.
h. Public Utility Rate Regulation: The method of pricing a service owned and operated by the State.

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UNIT IV
Determinants of Price - Pricing under different objectives and different market
structures - Price discrimination - Pricing methods in practice.

MARKET
Market is a place where buyers & sellers meet in order to buy & sell goods at a price.

CLASSIFICATION OF MARKETS BASED ON TIME PERIODS
A. Very Short Period or Market period: This type of market is for perishable goods where the time period
is very short & the supply of goods is perfectly inelastic. It means that the price alone will change according
to demand but the supply will not change.
B. Short Period: This type of market is for Reproducible goods or durable goods where the businessman
has got enough time to wait for the right price & the supply of goods is normal in the beginning & it
becomes perfectly inelastic only in the later stage.
C. Long Period: During this period all the firms will try to earn normal profits by charging a low price, so
that they can be stable in the market.

EQUILIBRIUM PRICE The price at which quantity demanded is equal to the quantity supplied is the
equilibrium price. This is explained with the help of a diagram.

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X axis Quantity
Y axis Price
DD Demand curve
SS Supply curve

Explanation
i. Price is determined in the market at the level where demand and supply curve interest each
other.
ii. R is the equilibrium point, where OP is the price & OM is the output.
iii. The equilibrium between and supply, or market equilibrium, determines the price in the market.

THE CHANGE IN EQUILIBRIUM PRICE
Changes in equilibrium price: The equilibrium price will be change if either the demand or supply curve
change due to a change in demand or supply conditions., demand curve remaining the same will lower the
price and a decrease in supply (i.e., shift in the supply curve to the left) will raise the price.
(A) Change in equilibrium price as a result of shifts in demand curve & supply curve remaining
constant:
Given the supply curve as constant, an increase in demand (i.e., shift of the demand curve to the right
upwards) will increase the price and a decrease in demand (i.e., shift of the demand curve to the right
downwards) will decrease the price. This is explained with the help of a diagram.

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X axis Quantity or Output
Y axis Price
SS Supply curve
D, D'D',D''D''- Demand curve
Explanation
i. When the demand curve DD cuts the supply curve at point R, the price is OP & the output is OM.
ii. When the demand increases to D'D', it cuts the supply curve at R', which is the new equilibrium
point. The price will rise to OP'& the output will also increase to OM'.
iii. If the demand decreases from to D''D'', it cuts the supply curve at R'', which is the new
equilibrium point. The price will decrease to OP''& the output will also decrease to OM''.
iv. It means that if supply is constant, both the price & output will increase with increase in demand
& vice versa.
(B) Change in equilibrium price due to shifts in supply curve & demand curve remaining the same:
Given the Demand curve as constant, an increase in supply (i.e., shift of the supply curve to the right
downwards) will reduce the price and a decrease in supply (i.e., shift of the supply curve to the left
upwards) will increase the price. This is explained with the help of a diagram.

Y axis Price
S, S' S' ,S''S'' Supply curve
DD Demand curve

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Explanation
i. When the supply curve SS cuts the demand curve at point R, the price is OP & the output is OM.
ii. When the supply increases to S'S', it cuts the demand curve at R', which is the new equilibrium point.
The price will decrease to OP'& the output will increase to OM'.
iii. If the supply decreases from to S''S'', it cuts the demand curve at R'', which is the new equilibrium point.
The price will increase to OP''& the output will decrease to OM''.
iv. It means that if demand is constant, then there will be inverse relationship between rice & quantity or
output.

THE DETERMINATION OF MARKET PRICE AT DIFFERENT TIME PERIODS
(A) Very short period or market period:
During this period the supply is fixed or is limited. This happens in case of perishable goods. In the case of
a perishable commodity like fish, the supply is limited by the quantity available or stock in a day and which
cannot be kept back for the next period. Hence, the whole of it must be sold away on the same day
whatever may be the price. This is explained with the help of a diagram.

Y axis Price
SM Vertical or Perfectly Inelastic supply curve
DD,D'D',D''D''-Demandcurve

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Explanation
i. The figure shows that the supply is fixed. When the demand curve DD cuts the supply curve at point E,
the price is OP & the supply is SM.
ii. It is seen that when the demand increases to D'D', it cuts the supply curve at point E', & only the price
increases to is OP' & where as the supply remains constant.
iii. Similarly, when the demand decreases to D''D'', it cuts the supply curve at point E'', & only the price
decreases to is OP'' & where as the supply remains constant.
iv. It means that during the very short period or the market period, the price alone will change due to the
changes in demand, whereas the supply will remain fixed.

(B) Short period: This is the case of durable goods or reproducible goods where, If a sudden and once-
for-all increase in demand takes place, there will be a sharp rise in market price but, there can be no
change in the amount supplied, because in the market period, firms can sell only what they have already
produced, i.e., what is in stock. In case of non-perishable but reproducible goods, the supply curve cannot
be a vertical straight line throughout its length, because some of the goods can be preserved or kept back
from the market, and carried over to the next market period. There will be then two critical price levels. The
first, it price is very high, the seller will be prepared to sell the whole stock. The second level is set by a very
low price at which seller would not sell any amount in the present market period, but will hold back the
whole stock for some better time. This is explained with the help of a diagram.

Y axis Price
SS Supply curve
DD Demand curve

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Explanation
i. When the demand curve DD cuts the supply curve at point R, the price is OP & the output is OM.
ii. When the demand increases to D'D', it cuts the supply curve at F, which is the new equilibrium point. The
price will rise to OP'& the output will also increase to Q.
iii. If the demand decreases from to D''D'', it cuts the supply curve at R'', which is the new equilibrium point.
The price will decrease to OP''& the output will also decrease to OM''.
iv. It means that if supply is constant, both the price & output will increase with increase in demand & vice
versa.
v. Up to the price OP1 (=QF), the quantity supplied varies with price. At the price OS, nothing is sold, the
whole stock being held back. Therefore, SF portion of the supply curve slopes upwards from left to right.
vi. At the price OP1 (=QF), the whole of the stock is offered for sale, and beyond OP1, the quantity supplied
remains the same the same whatever the price. Therefore, beyond price OP1, the market supply curve has
been shown as a vertical straight line.

BREAK EVEN POINT ANALYSIS OF THE FIRM OR THE EQUILIBRIUM OF THE FIRM BY USING
TOTAL REVENUES AND TOTAL COST Equilibrium of the firm: A firm is said to be in equilibrium when
it has no incentive either to expand or to contract its output only when its total profits are the maximum. A
rational entrepreneur will expand output if he thinks he can increase his total profits by doing so, and
likewise, he will contract his output if he thinks he can avoid losses and thus increase his total profits.
Therefore, a firm is an equilibrium position when it is earning maximum money profits.
Assumptions
i. The owner of the firm is rational. It implies that he tries to maximize his money profits.
ii. Whatever output the firm produces, it produces as cheaply as possible given the existing
production techniques.
iii. The firm produces only one product.

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X axis Output
Y axis Revenue/cost
TR Total Revenue
TC Total Cost
Breakeven point explanation:
i. At any output smaller than OL, total cost exceeds total revenue and the firm is having losses.
ii. At the output OL total cost equals total revenue and the firm is having neither losses nor profits. This
point L is called Break-even points.
iii. At the outputs larger than ON, the total revenue is less than total cost so that the firm is having losses.
iv. Point N is again a break-even point. Between OL and ON will lie the optimum point of maximum profits.

LIMITATIONS OF BREAKEVEN POINT ANALYSIS
i. Difficult to see at a glance: Maximum vertical distance between the total revenue and total cost curve is
difficult to see at a glance. Many tangents have to be drawn before one reaches the appropriate one
corresponding to the maximum profit point.
ii. Not possible to discover price per unit: It is not possible to discover price per unit at various outputs
at first sight. Total revenue has to be divided by total number of units produced in order to get the price per
unit.
iii. Complicated problems cannot be discussed: Complicated problems of equilibrium analysis cannot
be discussed easily and clearly in this way of representing equilibrium of the firm.

THE EQUILIBRIUM OF THE FIRM UNDER PERFECT COMPETITION OR THE EQUILIBRIUM OF THE
FIRM USING MARGINAL REVENUES CURVES
A firm will be in equilibrium when it is earning maximum profits, to make maximum profits, two conditions
are essential:
i. Marginal revenue = Marginal cost, and
ii. MC curve should cut MR curve from below at the equilibrium point.

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Conditions of equilibrium: The demand curve or average revenue curve facing a firm under perfect
competition is perfectly elastic at the ruling price. Since a perfectly competitive firm can sell as much as it
wants without affecting the price, addition made to total revenue by an extra unit of output, i.e., marginal
revenue, is equal to the price (average revenue) of the commodity. Hence, the average revenue (or
demand) curve, (AR) and marginal revenue curve (MR) must coincide with each other for a firm under
perfect competition. This is explained with the help of a diagram.

X axis Output
Y axis Revenue/cost
MR=AR Marginal revenue= Average revenue
Explanation
i. Under perfect competition, a firms MC curve is also its supply curve. Profits are the greatest at
the level of output for which marginal cost is equal to marginal revenue and marginal cost curve cuts the
marginal revenue curve form below.
ii. At point T though MC is equal to MR but MC is cutting MR from above rather than from below.
Therefore, T cannot be a position of equilibrium.
iii. At point P or output OM, the marginal cost equals MR and marginal cost equals MR and
marginal cost curve is also cutting MR curve from below.
iv. Hence, at the output OM or point P, the profit would be maximum and the firm would be in
equilibrium position.

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THE EQUILIBRIUM OF THE FIRM DURING SHORT RUN UNDER PERFECT COMPETITION
Equilibrium in short run: The short run has been has been defined as a period of time sufficient to allow
the firm to adjust its output by increasing or decreasing the amount of variable factors of production cannot
be altered. Thus in the short run; the size and kind of plant cannot be changed, nor can new firms enter the
industry.
Assumptions
i. All firms are working under identical conditions.
ii. The factors of production used by the different firms are homogeneous and are available at given
and constant prices.

X axis =Output Y axis= Revenue/cost SAC= Short run average cost curve SMC = Short run marginal cost
curve L,L1,L2 = AR=MR (Average Revenue = Marginal Revenue)
Explanation
i. When the firm makes supernormal profits in the short-run: The firm makes supernormal profits in the
short-run when the price is OP1, because only at this price the average cost is less than the price.
ii. The firm just makes normal profit: The firm makes normal profits in the short-run when the price is
OP, because only at this price the average cost is equal to the price.
iii. The firm incurring losses, but does not shut down: The firm incurs loss in the short-run when the
price is OP2, because only at this price the average cost is more than the price. Even if the firm is incurring
losses but still the firm will not shut down.

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THE SHUT DOWN POINT OF THE FIRM The point at which when the firm is not able to cover even its
average variable cost is called the shut down point of a firm. This is explained with the help of a diagram.

X axis = Output
Y axis = revenue/cost
AC = Average cost curve
MC = Marginal cost curve
AVC = Average variable cost curve
L,L1,L2 = AR=MR
Explanation
i. If price is OP2, the firm is incurring losses, because the price is less than the average cost.
ii. But if the price happens to be OP3, the firm will be in equilibrium at point D. At point D, the firm would be
covering total variable costs but no part of the fixed costs, since price OP3 is equal to average variable cost
MD at the equilibrium output OM.
iii. But if the price is OP4, the firm would shut down, as in this situation the firm is not able to cover even
variable costs, since the price will be less than the average variable cost. Point D is therefore called shut
down point.

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THE EQUILIBRIUM OF THE FIRM DURING LONG RUN UNDER PERFECT COMPETITION Equilibrium
in the long run
The long run is a period of time long enough to permit changes in the variable as well as in the fixed
factors. In the long run, accordingly, all factors are the variable and none fixed. Thus, in the long run, firms
can change their output by increasing their fixed equipment.
Conditions of equilibrium: Price = Marginal cost Price = Average cost Thus, the conditions for long-run
equilibrium of perfectly competitive firm can be written as: Price = Marginal cost = Minimum Average Cost.

X axis = Output
Y axis = revenue/cost
LAC = Long run average cost curve
LMC = Long run marginal cost curve
L,L1,L2= LAR=LMR
Explanation
i. The firm under perfect competition cannot be in long run equilibrium at price OP1 because it is greater
than the average cost & point the firm will be earning supernormal profits. Hence, there will be incentives
for the new firms to enter the industry. As a result, the price will be forced down to the level OP at which
price, the firm is in equilibrium at R and will produce OM output.
ii. The firm under perfect competition cannot be in long run equilibrium at price OP2 because it is less than
the average cost & point the firm will be incurring loss. To avoid these losses, some of the firms will leave
the industry. As a result, the price will be rise to OP, where again all firms are making normal profits. When
the price OP is reached, the firms would have no further tendency to quit.

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iii. Therefore the firm under perfect competition will be in long run equilibrium at price OP. At point R the
equilibrium output is OM, the price is equal to average cost, and hence the firm will be earning only normal
profits. Therefore at price OP, there will be no tendency for the outside firms to enter. Hence, the firm will
be in equilibrium at OP price and OM output.

THE SHORT RUN SUPPLY OF PERFECT COMPETITIVE INDUSTRY OR DERIVATION SHORT RUN
SUPPLY CURVE OF PERFECTLY COMPETITIVE INDUSTRY Short run supply curve: The short run is
a period in which the capital equipment is fixed and the increased demand is possible only by the intensive
use of the given plant, i.e., by increasing the amount of the variable factors. This is explained with the help
of diagram.

[Both Panels (a) & Panel (b)] Panel (a) = Shows the production level Panel (b) = Shows the supply of
output at different prices X axis Output Y axis Price SMC Short run average cost curve SAC Short
run average cost curve SAVC Short run average variable cost curve SRS Short run supply curve The
short run supply curve for the perfectly competitive industry is derived by adding up both panel (a) & panel
(b). Explanation for Panel (a)
i. Panel (a) explains about the various equilibrium points & the different levels of output being produced at
various prices.
ii. At price OP0, the SMC cuts the price at pt.E0, hence the firm will produce OM0 amount of output, since
only at this output the price OP0 equals marginal cost.
iii. Similarly, at prices OP1, OP2, OP3 & OP4, the SMC cuts the price at points E1, E2, E3 & E4, hence the
firm will produceOM1, OM2, OM3, & OM4 amount of output respectively, since only at these outputs the
prices are equal to their marginal costs.

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Explanation for Panel (b)
i. Panel (b) explains about the supply of output at various prices.
ii. It shows that at price OP0, the firm will supply OM0 amount of output.
iii. As the price increases from OP1 to OP4, the supply of output also increases from OM1 to OM4
respectively.
iv. It means that as the price increases the supply also increases. Thus, the short run supply curve of the
perfectly competitive industry slopes upwards.

THE LONG RUN SUPPLY AT DIFFERENT COST CONDITIONS
Long run supply curve: Long run supply is defined as supplies offered at various prices by the existing as
well as the potential procedures in the long run.
(A) Supply curve of the constant cost industry: An industry is a constant cost industry if its expansion
generates neither external economies nor external diseconomies. This is explained with the help of a
diagram.
Panel (a) = Shows the production level Panel (b) = Shows the supply of output at different prices X axis
Output Y axis Price LAC long run average cost curve LMC long run marginal cost curve LSC - long
run supply curve

Explanation
i. In the case of constant cost industry, the long run supply curve will be a horizontal straight line.
ii. Every firm will be in long run equilibrium at the minimum point of the long run average cost.

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iii. In the long run, new firms will enter the industry without raising or lowering the cost curves of the
firms in the industry so that the industry so that the industry would supply any amount of commodity at the
price of OP which is equal to the minimum long run average cost.
iv. The long run supply curve is horizontal straight line (i.e., perfectly elastic) at price OP, which is
equal to the minimum average cost.

(B) Supply curve of the increasing cost industry: If the industry is of a big size, then sometimes due to
the disadvantages of large scale production the cost of production will rise resulting in increase in prices of
the product. Therefore it will shift both the average and marginal cost curves to upwards towards the left. It
means that less output will be produced at high cost. This is explained with the help of a diagram.

Panel (a) Panel (b) Panel (a) = Shows the production level Panel (b) = Shows the supply of output at
different prices X axis Output Y axis Price LAC long run average cost curve LMC long run marginal
cost curve LSC - long run supply curve
Explanation for Panel (a)
i. Panel (a) explains about the various equilibrium points & the different levels of output being
produced at various prices.
ii. It shows that at OP price, OM level amount of output is produced.
iii. It is seen that when the price is increased to OP1, the output is decreased to OM1 & the LAC &
LMC curves are shifted upwards towards the left side.
iv. It means that both the cost & price have increased & the production of output has decreased.

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ii. It shows that as the price increases from OP0 to OP1, the supply also increases from ON to ON1
respectively.
iii. It means that in an increasing cost industry more output will be supplied at higher price.
iv. Thus the long run supply curve (LSC) of the increasing cost industry will slope upwards as
shown in panel (b) of the figure.

(C) Supply curve of the decreasing cost industry: An industry might have decreasing costs due to
advantages of large scale production so that, with the expansion of the industry, the cost of production will
be reduced. Therefore it will shift both the average and marginal cost curves to downwards towards the
right. It means that more output will be produced at less cost. This is explained with the help of a diagram.

Output Y axis Price LAC long run average cost curve LMC long run marginal cost curve LSC - long
run supply curve
ii. It shows that at OP price, OM level amount of output is produced.
iii. It is seen that when the price is decreased to OP1, the output is increased to OM1 & the LAC &
LMC curves are shifted downwards towards the right side.
iv. It means that both the cost & price have decreased & the production of output has increased.

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ii. It shows that as the price decreases from OP0 to OP1, the supply also increases from ON to
ON1 respectively.
iii. It means that in a decreasing cost industry more output will be supplied at less price.
iv. Thus the long run supply curve (LSC) of the increasing cost industry will slope downwards as
shown in panel (b) of the figure.

THE PRICE-OUTPUT DETERMINATION UNDER PERFECT COMPETITION DURING THE SHORT-RUN
Short-run period:
This period is sufficient only to make limited output adjustment with the existing equipment by
expanding output along the short-run marginal cost curves. This is explained with the help of a diagram.

Panel (a) Panel (b) Panel (a) = Shows the production level Panel (b) = Shows the supply of output at
different prices X axis Output Y axis Price MC Marginal cost curve AC Average cost curve AVC
Average variable cost curve SRS Short-run supply curve MPS Market period supply curve DD
Demand curve
ii. At price OP, the firm will produces ON amount of output, since only at this output the price OP
equals marginal cost.
iii. Similarly, when the price increases to OR the firm will increase its output to ON' amount of
output & when the price decreases to OT the firm will decrease its output to ON'' amount of output &
respectively, since only at these outputs the prices are equal to their marginal costs.

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i. Panel (b) explains about the changes in price & output at different demands during the market
period & short period supply.
ii. It is seen that when the DD curve cuts the MPS curve & SRS curve, the price is OP & the output
is OM.
iii. When the increased demand curve D'D' cuts the MPS curve, the price alone increase to OK, but
the output does not change Again when the decreased demand curve D''D'' cuts the MPS curve, the price
alone decreases to OL, but the output does not change. It means that during the market period only the
price changes & the output remain fixed.
iv. When the increased demand curve D'D' cuts the SRS curve, the price increases to OR & the
output increases to OM'. Again when the decreased demand curve D''D'' cuts the SRS curve, the price
decreases to OT & the output also decreases to OM''. It means during the short run more output will be
supplied at a higher price & vice versa.

THE PRICE-OUTPUT DETERMINATION UNDER PERFECT COMPETITION DURING THE LONG-RUN
Long-run period: In the long run, the time is long enough for the firms to change the size of their plants or
build new plants. Also, new firms can enter the industry. In the long-run the firms can a band on old plants
or build new ones and when the new firms can enter the industry or old ones can leave it. This is explained
with help of a diagram.

X axis Output
Y axis Cost & Revenue
LMC Long-run marginal cost curve
LAC Long-run average cost curve

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Explanation
i. If the price is above the minimum long-run average cost, the firm will be making supernormal profits.
Therefore, in the long-run new firms will enter the industry to compete away their extra profits and the price
will fall to the level where it is equal to the minimum long-run average cost.
ii. Neither can the price will fall below the minimum average cost since in that case the firms will be
incurring losses. In long-run, if these losses persist, some of the firms will leave the industry. As a result,
the price will rise to the level of minimum average cost, so that in the long-run firms are earning only normal
profits.
iii. Therefore during the long run the firms will be earning only normal profits & will be in equilibrium at point
S, where the long run average cost is equal to the long run average revenue.

THE PRICE-OUTPUT DETERMINATION UNDER PERFECT COMPETITION DURING THE LONG-RUN
UNDER DIFFERENT COST CONDITIONS THE PRICE OUTPUT DETERMINATION OF THE LONG-RUN
NORMAL PRICE IN INCREASING COST INDUSTRY
Long-run normal price in increasing-cost industry: Supply curve of an increasing-cost industry slopes
upwards from left to right. This is so because when a full-sized industry expands as a result of the
increased demand for its product, it experiences certain external
economies and diseconomies. But external diseconomies in the case of an increasing-cost industry
outweigh the external economies and this brings about an upward shift in the cost curves of all firms. This

Panel (a) = Shows the production level Panel
(b) = Shows the supply of output at different prices
X axis Output

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Y axis Price/Cost
DD Demand curve
MPS Market-period supply curve
SRS Short-run supply curve
LRS Long-run supply curve
i. Panel (a) explains about the cost & output at different levels of prices.
ii. It shows that OP is the basic price. In the increasing cost industry, the cost of production is
increased, which increases the price to OP''', thereby shifting the LAC & LMC curves upwards towards the
left side.
period supply, short run supply & long run supply.
ii. It is seen that when the DD curve cuts the MPS curve, SRS curve & LRS curve, the basic price
is OP & the output remains the same i.e OM.
iii. When the increased demand curve D'D' cuts the MPS curve, the price alone increase to OP',
but the output remains the same i.e OM. It means that during the market period only the price changes &
the output remain fixed.
iv. When the increased demand curve D'D' cuts the SRS curve, the price increases to OP'' & the
output increases to OM'. It means during the short run more output will be supplied at a higher price.
v. When the increased demand curve D'D' cuts the LRS curve, the price increases to OP''' & the
output increases to OM''. It means that in increasing cost industry during the long run more output will be
supplied at a higher price.

THE PRICE OUTPUT DETERMINATION OF LONG RUN NORMAL PRICE IN CONSTANT-COST
INDUSTRY
Long run normal price in constant-cost industry:
Industry will be a constant-sot industry if, on its expansion, external economies and diseconomies cancel
each other so that the constituent firms of an enlarged industry do not experience shift in their cost curves.

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An industry can also be a constant-cost industry if its expansion breeds neither external economies nor
external diseconomies. This is explained with the help of a diagram.

Panel (a) = Shows the production level Panel
(b) = Shows the supply of output at different prices
X axis Output
Y axis Price/Cost
DD Demand curve
MPS Market-period supply curve
SRS Short-run supply curve
LRS Long-run supply curve
ii. It shows that OP is the basic price. In the constant cost industry, the cost of production will remain the
same & the price will also be to OP, thereby LAC & LMC curves will not be shifted anywhere.
i. Panel (b) explains about the changes in price & output at different demands during the market period
supply, short run supply & long run supply.
ii. It is seen that when the DD curve cuts the MPS curve, SRS curve & LRS curve, the basic price is OP &
the output remains the same i.e OM.
iii. When the increased demand curve D'D' cuts the MPS curve, the price alone increase to OP', but the
output remains the same i.e OM. It means that during the market period only the price changes & the
output remain fixed.

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iv. When the increased demand curve D'D' cuts the SRS curve, the price increases to OP'' & the output
increases to OM'. It means during the short run more output will be supplied at a higher price.
v. When the increased demand curve D'D' cuts the LRS curve, the price does not change, it remains the
basic price as OP but the output alone increases to OM''. It means in the constant cost industry during the
long run more output will be supplied at the same price.

THE PRICE-OUTPUT DETERMINATION OF LONG-RUN NORMAL PRICE IN DECREASING-COST
INDUSTRY
Long-run normal price in decreasing-cost industry
In the case of a young industry in its early stages of growth, the external economies may overweigh the
external diseconomies. This phenomenon of net external economies lowers the cost curves of all firms. In
the case of a decreasing-cost industry, the additional supplies of the product will forth coming at reduced
costs and, therefore, the long-run supply curve of the industry will slope downwards from left to right. This is

Output Y axis Price DD Demand curve LMC Long-run marginal cost curve LAC Long-run average
cost curve MPS Market-period supply curve SRS Short-run supply curve LRS Long-run supply curve

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ii. It shows that OP is the basic price. In the increasing cost industry, the cost of production is
decreased, which decreases the price to OP''', thereby shifting the LAC & LMC curves downwards towards
the right side.
period supply, short run supply & long run supply.
ii. It is seen that when the DD curve cuts the MPS curve, SRS curve & LRS curve, the basic price
is OP & the output remains the same i.e OM.
iii. When the increased demand curve D'D' cuts the MPS curve, the price alone increase to OP',
but the output remains the same i.e OM. It means that during the market period only the price changes &
the output remain fixed.
iv. When the increased demand curve D'D' cuts the SRS curve, the price increases to OP'' & the
output increases to OM'. It means during the short run more output will be supplied at a higher price.
v. When the increased demand curve D'D' cuts the LRS curve, the price decreases to OP''' & the
output increases to OM''. It means that in decreasing cost industry during the long run more output will be
supplied at a lesser price.

MONOPOLY
The monopoly is that market form in which a single producer controls the whole supply of a single
commodity which has no close substitutes

PRICE-OUT DETERMINATION UNDER MONOPOLY OR THE EQUILIBRIUM OF THE FIRM AND
INDUSTRY UNDER MONOPOLY
Assumptions
i. There is one seller or producer of a homogeneous product
ii. There are no close substitutes for the product
iii. There is pure competition in the factor market so that the price of each input he buys is given to him
iv. The monopolist is a rational being who aims at maximum profit with the minimum of costs.
v. There are many buyers on the demand side but none is in a position to influence the price of the product
by his individual actions. Thus the price of the product is given for the consumer.

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vi. The monopolist does not charge discriminating price. He treats all consumers alike and charges a
uniform price for his product.
vii. The monopoly price is uncontrolled. There are no restrictions on the power of the monopolist.
viii. There is no threat of entry of other firms.
Price output equilibrium under monopoly [monopoly earning super normal profits]

X axis = output
Y axis = Revenue / cost
AR = Average revenue
MR = Marginal Revenue
AC=Average cost
MC=Marginalcost
Explanation
i. E is the equilibrium point where the MC curve cuts the MR curve from below
ii. It is seen that the average cost is less than the average revenue. It means that the monopolist is earning
super normal profits in the short run.

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Price output equilibrium under monopoly [monopoly incurring losses]

X Axis = output
Y Axis = Revenue / cost
MR = Marginal Revenue
AC = Average cost
MC = Marginal cost
Explanation
i. E is the equilibrium point where the MC curve cuts the MR curve from below
ii. It is seen that the average cost is more than the average revenue. It means that the monopolist is
incurring losses in the short-run.

PRICE DISCRIMINATION
Price discrimination means charging different prices from different customers or for different units of the
same product.

CONDITIONS OF PRICE DISCRIMINATION
i. The aim of the monopolist is to maximize his profits. He, therefore, produces that output at which his
marginal revenue equals marginal cost.
ii. The number of buyers in each market is very large and there is perfect competition among them
iii. There is no possibility of resale from one market to the other
iv. The monopolists demand curve in each market is downward sloping which implies that his monopoly in
selling the commodity is well established in the two markets.

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v. The most important condition for price discrimination is that the elasticities of demand in the two markets
must be different. If the elasticities of demand are the same, marginal revenues will also be the same.

WHEN IS PRICE DISCRIMINATION PROFITABLE
(A) Price discrimination not profitable when the demand curves are iso-elastic:
We shall take the two markets where the demand curves are iso-elastic, i.e., where at every price, elasticity
of demand curve is the same. When in two markets elasticity of demand is the same, then the marginal
revenue will also be the same. Marginal revenue in the two markets being the same, it will not be profitable
from one market to another in order to change a different price. This is explained with the help of a
diagram.

X axis = output
Y axis = Revenue / cost Markets
A & B=Markets having same elasticties
ARa & ARb = Average revenue curve of market A & B
MRa & MRb = Marginal Revenue curve of market A & B
Explanation
i. The demand curves ARa and ARb have the same elasticity at the price OP. At this price, marginal
revenue in the two markets is the same.

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ii. Now if the monopolist increases the price in market A from OP to OP' to earn profit, the output will be
reduced from OM toON1. Thus the monopolist incurs loss in market A.
iii. In order to compensate loss the monopolist decreases the price from OP to OP'' in market B & the output
also increases from OM2 to ON2. Thus the monopolist earns profit in market B.
iv. But the profit in Market B is less than the loss in market A.
v. This shows that when the demand curve have the same elasticity then price discrimination will not be
profitable.
(B) Price discrimination profitable when elasticities differ: The monopolist will find it profitable to
charge discriminating prices, when the elasticities of demand in the two markets are different. Rather, this
is the only way for him to maximize profits. If elasticity of demand is different in the two markets, he would
charge higher price in the market where elasticity is low and low price where it is high.

X axis = output
Y axis = Revenue / cost Markets
A & B=Markets having different elasticities
ARa & ARb = Average revenue curve of market A & B
MRa & MRb = Marginal Revenue curve of market A & B
Explanation
i. The demand curves ARa and ARb have the different elasticity at the price OP. At this price, marginal
revenue in the two markets is different.
ii. Now if the monopolist increases the price in market A from OP to OP' to earn profit, the output will be
reduced from OM1 toON1. Thus the monopolist incurs loss in market A.

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iii. In order to compensate loss the monopolist decreases the price from OP to OP'' in market B & the
output also increases from OM to ON2. Thus the monopolist earns profit in market B.
iv. Now the profit in Market B is greater than the loss in market A.
v. This shows that when the demand curve have different elasticity then price discrimination will t be
profitable.

PRICE-OUTPUT EQUILIBRIUM UNDER DISCRIMINATING MONOPOLY
A Discriminating monopoly is the one who charges different prices from different customers or for
different units of the same product. This is explained with help of a diagram.

X axis = output
Y axis = Revenue / cost
AR & AR' = Average revenue curves of markets A & B
MR& MR ' = Marginal Revenue curves of markets A & B
MC= Marginal Cost curve CMR= Combined Marginal Revenue curves of markets A & B
Explanation
i. The equilibrium of the discriminating monopolist is established at the output OM at which MC cuts MR.
ii. Now the output OM of the Total Market has therefore to be distributed between the two markets A & B in
such a way that marginal revenue in each is equal to ME which is the marginal cost being on the MC curve.
iii. The output OM1 will be sold in market A, because only at this output marginal revenue MR1 in market A
is equal to ME. The price charged in the market for output OM1 is equal to M1 P1.

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iv. The output OM2 will be sold in market B as only at this output, marginal revenue in market B ,that is
MR2 is equal to ME.Price charged in market B for output OM2 is M2 P2 which is lower than the M1 P1
which is charged in market A.
v. Thus in market B in which elasticity of demand is greater, the price charged is lower than that in market
A, where the elasticity of demand is less.

THE VARIOUS SOURCES AND TYPES OF MONOPOLY
i. Grant of a patent right to a firm by the government to make, use or sell its own invention.
ii. Control of a strategic raw material for an exclusive production process.
iii. A natural monopoly enjoyed by a firm when it supplies the entire market at a lower unit cost due to
increasing economies of scale just as in the supply of electricity, gas etc.
iv. Government may grant exclusive right to a private firm to operate under its regulation. Such privately
owned and government regulated monopolies are mostly in public utilities and are called legal monopolies
such as in transport communications, etc.
v. There may be government owned and regulated monopoly such as postal services, water, and sever
systems of municipal corporation etc.
vi. Government may grant license to a sole firm and protect it to exclude foreign rivals.
vii. The sole manufacturer of a product may adopt a limit pricing policy in order top prevent the entry of new
firms.

THE VARIOUS TYPES OF PRICE DISCRIMINATION
i. Personal price discrimination based on the income of the customer: For example, doctors and
lawyers charge different fees from different customers on the basis of their incomes. Higher fees are
charged to rich persons and lower to the poor.
ii. Price discrimination based on the nature of the product: Paperback is cheaper than the deluxe
edition of the same book, for the former is bought by the majority of readers, and the latter by libraries.
Unbranded products, like open tea are sold at lower prices than branded products like brooke bond or
lipton tea. Economy size tooth pastes are relatively cheaper than ordinary sized tooth pastes. In the case of
services too, such price discrimination is practiced when off-season rates of holds at hill stations are very
low as compared to the peak season.

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Dry cleaning firms charge for two while they clean three clothes during off season where as they charge
more for quick service in peak season.
iii. Price discrimination related to the age, gender and status: price discrimination is also related to the
age, gender and status of the customers. Barbers charge less for childrens haircuts. Certain cinema halls
admit ladies only at lower rates. Military personnel in uniform are admitted at concessional rates in all
cinema houses.
iv. Discrimination is also based on the time of service: Cinema houses at certain places, like new delhi,
charge half the rates in the morning show than in the afternoon shows.
v. Geographical or local discrimination: There is geographical or local discrimination when a monopolist
sells in one market at a higher price than in the other market.
vi. Discrimination based on the use of the product: Railways charge different rates for different
compartments or for different services. Less is charged for the transportation of coal than for bales of cloth
on the same route. State power boards charge low rates for industrial use than for domestic consumption of
electricity.

THE VARIOUS CONDITIONS OF PRICE DISCRIMINATION
i. Market imperfection: The individual seller is able to divide and keep his market into separate parts only
if it is imperfect. Customers do not move readily from one market to the other because of ignorance.
ii. Agreement between rival sellers: price discrimination also takes place when the seller of a commodity
is a monopolist or when rivals enter into an agreement for the sale of the product at different prices to
different customers. This is usually possible in the sale of direct services.
iii. Geographical and tariff barriers: The monopolist may discriminate between home and foreign buyers
by selling at a lower price in the foreign market than in the domestic market. This type of discrimination is
known as dumping
iv. Differential products: Discrimination is possible when buyers need the same service in connection with
differential products.
v. Ignorance of buyers: Discrimination also occurs when small manufacturers sell goods made to order.
They charge different rates to different buyers depending upon the intensity of their demand for the product
vi. Artificial difference between goods: A monopolist may create artificial difference by presenting the
same commodity in different quantities. He may present it under different names and lables, one for rich

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and snobbish buyers and the other for the ordinary. Thus he may charge different prices for substantially
the same product.
vii. Difference in demand: For price discrimination, the demand in the separate markets must be
considerably different. Different prices can be charged in separate markets based on differences of
elasticity of demand, low price is charged where demand is more elastic and high price in the market with
the less elastic demand.

METHODS TO CONTROL AND REGULATE MONOPOLY
(A) Fear that prevent the monopolist from charging a very high price in order to earn large super-
normal profits.
i. Fear of potential rivals: The fear of potential competitors may prevent a monopolist to charge a very
high price to his customers. If he sets a very high price he will earn large super normal profits. Attracted by
these monopoly profits new entrants may force themselves into the monopolized industry. The monopolist
being averse to the entry of new firms would prefer to charge a reasonable price and thus earn only a
modest profit.
ii. Fear of government regulation: Same consideration applies to potential government regulation. The
monopolist is well aware that charging unusually high price or profits would attracts the attention of the
government. Rather than risk government regulation he may voluntarily fix a low price and earn less
monopoly profits.
iii. Fear of nationalization: The fear of nationalization also prevents the monopolist to wield an absolute
monopoly power. If the products or service which monopolist produces is a public utility service, that is
every likelihood of the states taking over the monopoly organization in public interest. This consideration
may prevent the monopolist from charging too high a price.
iv. Fear of public reaction: The monopolist is also aware of public reaction he charges a very high price
and earns huge profits. Voices may be raised against the monopoly firm in parliament to press for anti-
monopoly legislation.
v. Fear of boycott: People may even boycott the use of monopolized product or service and start their own
service instead. For instance, if in a big city taxi operators combine to charge high rates, people may
boycott taxi services and even start operating their own services by forming a cooperative society. Naturally
such a fear compels monopoly firms to charge reasonable prices and earn only nominal profits.

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vi. Fear of substitutes: Then there is the fear of substitutes. In fact the fear of substitutes is the most
potent-factor which prevents monopoly firms from charging very high prices and thereby earning huge
super-normal profits. It is only under pure monopoly that there are absolutely no substitutes for the product.
But pure monopoly like pure competition being unreal, the monopoly product has some substitute though it
is not a close substitutes is always uppermost in the mind of the monopolist which acts as a restraint on his
absolute power.
vii. Difference in elasticity of demand: The difference in the short and long run elasticities of demand for
monopoly product also limit monopoly power. In the short run the monopolist can charge a very high price
because customers take time to adjust their habits tastes, and income to some other substitutes. The
demand for the monopoly products is, therefore less elastic in the short run but in the long run the fear of
public opinion emergence of substitutes, government regulations etc will force the monopolist to set a low
price. He will view his demand curve as elastic and sell more at a low price.
(B) Control of monopoly through legislation: Government tries to control monopoly by anti-monopoly
lows and restrictive trade practices legislation. These measures tend to:
i. Remove restrictive trade practices and fix high prices.
ii. Reduce the incidence of market-sharing agreements.
iii. Remove unfair competition.
iv. Restrict the control of very large share of the market.
v. Prevent unfair price discrimination.
vi. Restrict mergers in order to avoid market domination.
vii. Prohibit exclusive agreements between the producer and retailer to the detriment of other
traders.
(C) Control of monopoly through price regulation and taxation:
I.Regulated monopoly pricing: To regulate monopoly the government imposes price ceiling so that
monopoly price should be near or equal to competitive price. This done when the government appoints a
regulating authority or commission which fixes a prices for the monopoly product below the monopoly price,
thereby increasing output and lowering the price for the consumer.
ii.Taxation: Taxation is another way of controlling monopoly power. The tax may be levied lump sum
without any regard to the output of the monopolist or it may be proportional to the output the amount of tax
rising with the increase in output.

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iii.Lump sum tax: By levying a lump sum tax, the government can reduce or even eliminate monopoly
profits without affecting either the price or output of the product.
iv.Specific tax: The government can also reduce monopoly profits by levying a specific or a per unit tax on
the monopolists product.

MONOPOLISTIC COMPETITION
Monopolistic competition refers to a market situation where are many firms selling a differentiated product.

THE VARIOUS FEATURES OF MONOPOLISTIC COMPETITION
i. Large number of sellers: In monopolistic competition the number of sellers is large. No seller by
changing its price-output policy can have any perceptible effect on the sales of others and in turn be
influenced by them.
ii. Product Differentiation: One of the most important features of the monopolistic competition is product
differentiation. A general class of product is differentiated if any significant basis exists for distinguishing
the goods(or services) of one seller from those of another .
iii. Freedom of Entry and Exit of firms: Another features of monopolistic competition is the freedom of
entry and exit of firms. The fact that firms are small size and are capable of producing close subsitiutes
make it possible for them to leave or enter the industry or group in the long run. In fact, product
differentiation tends to increase rather than reduce the entry of new firms in the group, for each firm
produces a distinct product from the other.
iv. Nature of Demand Curve: Under monopolistic competition no single firm controls more than a small
portion of the total output of a product. No doubt there is an element of differentiation, nevertheless the
products are close substitutes. As a result, a reduction in its price will increase the sales of the firm but it
will have little effect on the price-output conditions of other firms, each will lose only a few of its customers.
Likewise, an increase in its price will reduce its demand substantially but each of its rivals will attracts only
a few of its customers. Therefore, the demand curve(average revenue curve) of a firm under monopolistic
competition slopes downward to the right.

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PRICE OUTPUT DETERMINATION UNDER MONOPOLISTIC COMPETITION DURING THE SHORT
RUN
Assumptions:
i. The number of sellers is large and they act independently of each other. Each is a monopolist in his own
sphere.
ii. The product of each seller is differentiated from the other product.
iii. The firm has a determinate demand curve (AR) which is elastic.
iv. The factor services are in perfectly elastic supply for the production of the product in questions.
v. The short-run cost curves of each firm differ from each other.
vi. No new firms enter the industry.
(A) Equilibrium under monopolistic competition during the short run [Monopolistic firm earning
profits]:
The monolopolistic firm will earn profits when the Average cost will be less than average revenue.

X axis = output
Y-axis = cost/revenue
AR = Average revenue curve
MR = Marginal revenue curve
SAC = Short-run average cost curve
SMC = Short-run marginal cost curve

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Explanation
It is seen that during the short run average cost is less than the average revenue. It means that the
monopolistic firm is earning super normal profits during the short run.
(B) Equilibrium under monopolistic competition during the short-run [Monopolistic firm incurring
losses]: The monolopolistic firm will incur losses when the Average cost will be greater than average
revenue. This is explained with the help of a diagram.

X axis = output
Y-axis = cost/revenue
SAC = Short-run average cost curve
SMC = Short-run marginal cost curve
Explanation
It is seen that during the short run average cost is more than the average revenue. It means that
the monopolistic firm is incurring losses during the short run.

THE LONG-RUN EQUILIBRIUM OF THE FIRM
The firms under monopolistic competition can earn supernormal profits in the short run. But, in the long-run,
such profits disappear. This is because we assume that entry is free and new firms will enter the industry, if
the existing firms are making supernormal profits. As new firms enter and start production, supply will
increase and the price will fall. The supernormal profits will be competed away and the firms will be earning
only normal profits. If in the short run, firms are realizing losses, then, in the long run, some firms will leave

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the industry so that the remaining firms will be earning normal profits. Therefore, there is equilibrium in the
long run under monopolistic competition when, Average Revenue= Average cost. This is explained with the
diagram.

X axis = output
Y axis = cost/revenue
MR = Marginal revenue
LAC = Long-run average cost curve
LMC = Long-run marginal cost curve
Explanation
i. Average revenue curve(AR) is a tangent to the average cost curve (LAC) at P.
ii. Therefore, the equilibrium output in the long run is OM and the corresponding price is MP.
iii. At this point average cost is also MP and so is average revenue.
iv. Therefore, there are no supernormal profits; there are only the normal profits which form part of the cost
of production.

CHAMBERLINTS GROUP EQUILIBRIUM OF THE FIRM UNDER MONOPOLISTIC COMPETITION
Group equilibrium means price-output adjustment of a number of firms, instead of an individual firm, whose
products are close substitutes. Within the group, if a firm has successfully designed a popular brand, it will
be making supernormal profit but, in the long run, other firms will imitate the design so that extra profits will

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tend to disappear. This is what happens within the monopolistically competitive groups. But if the group as
a whole is making supernormal profits in the short run, outside firms will enter into the group, unless the
entry is legally or economically barred. In this way extra profits will be competed away.
Assumptions
i. The number of firms is large.
ii. Each firm produces a differentiated product which is a close substitute for the others product.
iii. There is a large number of buyers.
iv. Each firm has an independent price policy and faces a fairly elastic demand curve at the same
time excepting its rivals not to take any notice of its actions.
v. Each firm knows its demand and cost curves.
vi. Factors prices and technology remain constant.
vii. Each firm aims at profit maximization both in the short run and the long run.
viii. Any adjustment of price by a single firm produces its effect on the entire group so that the
impact felt by any one firm is negligible. This is the symmetry assumption.
ix. As put forth by chamberlin, there is the heroic assumption that both demand and cost curves
for all the products are uniform throughout the group.
Short run equilibrium Long run equilibrium

X axis-> output
Y axis-> price
SMR and SAR->Short run marginal revenue curve, Short run average revenue curve

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SMC and SAC->Short run marginal cost curve & Short run average cost curve
LAR and LMR->Long run average revenue curve & Long run marginal revenue curve
LAC and LMC->Long run average cost curve & Long run marginal cost curve
Explanation
Short run equilibrium
i. In the short run, the price is OP; whereas average cost is MN at the output OM where marginal
revenue is equal to the marginal cost.
ii. Hence there is supernormal profit represented by the shaded area PRNP1.
Long run equilibrium:
i. But in the long run, the surplus profit will be competed away.
ii. The marginal revenue equals marginal cost at the output level OM1.
iii. The average revenue curve(LAR) is a tangent to the average cost curve(LAC) which means that
the average revenue(ie., price) is equal to average cost and there is no extra profit, i.e., only normal profit is
being made.

SELLING COST
The costs incurred on advertising, publicity and salesmanship are known as selling costs. Selling
costs have been defined as the costs necessary to persuade a buyer to buy one product rather than
another or to buy from one seller rather than another. The intervention of selling costs adds to the difficulty
of determining the most profitable output. It is obvious that higher total selling costs will be necessary to sell
a larger output at the same price or the same output at a higher price. This is explained with the help of a
diagram.

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X axis = output
Y axis = price
MC = Marginal Cost curve
AUTC = Average Total Unit Cost
Explanation
i. DP is the net return per unit of the output OM.
ii. Thus, area DEFP indicates the maximum net return in the case i.e., Total revenue OMPF-total cost
OMDE.

THE WASTES OF MONOPOLISTIC COMPETITION (OR) THE CONCEPT OF EXCESS CAPACITY A
firm under monopolistic competition or imperfect competition produces an output in the long run equilibrium
which is less than socially optimum or ideal output. In other words, they do not produce that level of output
at which long-run average cost is minimum. They do not increase their output, because their profits have
already been maximized at the level of output smaller than at which their long-run average cost would be
minimum. This happens at a point where equality between marginal revenue and marginal cost has been
attained. The productive resources of the community are fully utilized only when they are used to produce
that level of output which brings down the long-run average cost to the lowest point. But the monopolistic
firms produce less than that level of output which is socially optimum or ideal output. This is explained with
the help of a diagram.
Monopolistic Competition Perfect Competition

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X axis = output
Y axis = cost/revenue
MR = Marginal revenue
LMC = Long-run marginal cost curve
LAC = Long-run average cost curve
Explanation
Figure (a): The long-run position of a firm under Monopolistic competition
i. In this case, the long-run equilibrium is achieved at OM output at which the marginal revenue is equal to
marginal cost and price is equal to average cost.
ii. Here average revenue curve AR is tangential to average cost curve AC at point F corresponding to
output OM.
iii. It can be seen that at output OM, average cost is still falling and it continues to fall up to ON which
means that the firm can produce maximum output till ON but it produces only less output till OM.
iv. This shows that the capacity to produce MN quantity of output has been wasted or unutilized. Hence, the
ideal output is ON where the long-run average cost is minimum.
v. This means that this firm is producing MN quantity less than the ideal output. Hence MN output
represents excess capacity which emerges under monopolistic competition.

Figure (b): The long-run position of a perfectly competitive firm.
i. The firm is in long-run equilibrium at the level of ON output where the long-run average cost is minimum.
ii. At this point, price=MC=AC which means that the double condition of long-run equilibrium is satisfied.
This represents the socially ideal output.
iii. It means that there is no waste or excess capacity under perfect competition.

CRITICISM OF EXCESS CAPACITY OR WASTES OF MONOPOLISTIC COMPETITION
i. Restriction of output: One of the workers of imperfect competition is the restriction of output so that
price is kept higher than the marginal cost.
ii. Competitive advertisement: Expenditure on competitive advertisement is usually regarded as a waste
of competition.
iii. Cross-Transport: Another similar waste is expenditure on cross-transport.

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iv. Specialization: The failure of each firm is an industry to specialization in the production of those things
for which it is best suited.
v. Valuable resources are wasted: Valuable resources are wasted because of excess capacity resulting
in idle plant and manpower in each firm.
vi. Prevent Standardization: Imperfect competition may prevent that standardization of commodities which
is essential if the most efficient methods of production are to be adopted.
vii. Excess capacity: Monopolistic competition has also been criticized on the ground that the firms under
this type of market operate with excess capacity.

OLIGOPOLY
It is a market situation in which there are a few firms selling homogenous or differentiated products. It is
difficult to pinpoint the number of firms in the oligopolistic market. There may be three, four or five firms. It is
also known as competition among the few.

CHARACTERISTIC FEATURES OF OLIGOPOLY
i. Interdependence: There is a recognized interdependence among the sellers in the oligopolistic market.
ii. Advertisement: One producers fortunes are dependent on the policies and fortunes of the other
producers in the industry. It is for this reason that oligopolistic firms spend much on advertisement and
customer services.
iii. Competition: In oligopolistic market, each seller is always on the alert over the moves of its rivals in
order to have a counter-move.
iv. Barriers to Entry of Firms: As there is keen competition in an oligopolistic industry, there are no
barriers to entry into or exit from it.
v. Lack of Uniformity: In oligopoly market, there is a lack of uniformity in the size of firms.
vi. Demand Curve: Under oligopoly, the exact behavior pattern of a producer cannot be ascertained with
certainty his demand curve cannot be drawn accurately.
vii. No Unique Pattern of Pricing Behavior: The rivalry arising from interdependence among the
oligopolists leads to two conflicting motives. So it is not possible to predict any unique pattern of pricing
behavior in oligopoly markets.

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THE PRICE-OUTPUT DETERMINATION UNDER OLIGOLOPOLY OR THE SWEEZY MODEL OF
KINKED DEMAND CURVE (RIGID PRICES) Assumptions
i. There are few firms in the oligopolistic industry.
ii. The product produced by one firm is a close substitute for the other firms.
iii. The product is of the same quality. There is no product differentiation.
iv. There are no advertising expenditures
v. There is an establishment or prevailing market price for the product at which all the sellers are satisfied.
vi. Each sellers attitude depends on the attitude of his rivals.
vii. Any attempt on the part of a seller to push up his sales by reducing the price of his product will be
counteracted by the other sellers who will follow his move.
viii. If he raises the price others will not follow him, rather they will stick to the prevailing price and cater to
the customers, leaving the price-raising seller.
ix. The marginal cost curve passes through the dotted portion of the marginal revenue curve so that
changes in marginal cost do not affect output and price.

X axis = output
Y axis = Price
DD= Demand Curve/ Average revenue
MC = Marginal cost curve

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Explanation
i. There are two oligopolistic firms, one facing the elastic demand & the other one facing inelastic demand.
ii. The fixing of prices under oligopoly is a very difficult situation as the oligopolists will not agree for a
common price.
iii. Therefore, it is said that under oligopoly price is fixed at the kink, where the MC curve cuts the MR curve
from below.

EFFECTS OF OLIGOPOLY
i. Small output and higher prices: Oligopoly results in the restriction of output and changing of higher
prices.
ii. Prices exceed average costs: Owing to restrictions, partial or complete, on the entry of new firms, the
prices fixed, under oligopoly, are higher than the average cost. The consumers have to pay more than is
necessary to retain the resources in the industry.
iii. Lower efficiency: There is no tendency under oligopoly, for the firms in the industry to build optimum
scales of plant and operate them at the optimum rates of output. They do not, therefore attain maximum
potential economic efficiency.
iv. Selling costs: In order to snatch markets form their rivals the oligopolistic firms engage in aggressive
and extensive sales promotion effort by means of advertisement and by changing the design and improving
the quality of their products.
v. Wider range of products: Oligopoly places at the consumers disposal a wider range of commodities.
To this extent, it promotes consumers welfare.
vi. Welfare effect: Under oligopoly, since output does not generally correspond to the minimum long-run
unit cost, more units of resources per unit of output are utilized than it its necessary.

EVILS OF OILGOPOLY
i. Price war: There is generally a continuous price war which finally results in disastrously low level of
prices.
ii. Cut-throat competition: Such cut-throat competition in industries characterized by heavy overheads
and increasing costs proves ruinous to all producers.
iii. Price agreements: There may tacitly or explicitly enter into price agreements, which may results in the
exploitation of the consumers.

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iv. Earn a fair return on past investments: A tendency to earn a fair return on past investments, resulting
in the excessive plant capacity, is detrimental to consumers welfare, because they face scarce output and
high prices.
v. Liquidate excess capacity: Hence, cut-throat competition may be, essential to liquidate excess
capacity through losses or sub-normal profits.
vi. Idle plants: oligopoly, prices stay firm and only output varies resulting in idle plants. This is bad for the
society and bad for the government.

REMEDIAL MEASURES TO CONTROL EVILS OF OLIGOPOLY
i. Government regulation is necessary to pull down barriers: To pull down barriers to the entry to new
firms.
ii. Government regulation is necessary to grown on collusions: To grown on collusions to maintain
prices and restrict supply.
iii. Government regulation is necessary to break big firms: To break big firms or to prevent them from
becoming bigger.

PRICE LEADERSHIP
Under price leadership, one firm assumes the role of a price leader and fixes the price of the product for the
entire industry. The other firms in the industry simply follow the price leader and accept the price fixed by
him and adjust their output to this price. The price leader is generally a very large or a dominant firm or a
firm with the lowest cost of production. It often happens that price leadership is established as a result of
price war in which one firm emerges as the winner.

THE PRICE-OUTPUT DETERMINATION UNDER PRICE LEADERSHIP
Assumptions:
i. There are only two firms A and B and firm A has a lower cost of production than B
ii. The product of the firms is homogenous or identical so that the consumers are indifferent as
between the firms.
iii. Both A and B have equal share in the market, i.e., they are facing the same demand curve
which will be half of the total market demand curve.

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X axis = Quantity
Y axis = Price and cost
MCa, & MCb = Marginal cost curve of firms A & B
DD = Demand curve

Explanation
i. Let us take the firm A first. A will be maximizing its profits by selling output OM and setting price MP,
because at the output OM its marginal cost is equal to its marginal revenue.
ii. As regards the firm B, the profits will be maximum when it sells ON output and fixes NK price, because at
this output its marginal cost is equal to its marginal revenue.
iii. It can be seen that the profit-maximizing price MP of the firm A is lower than the profit-maximizing price
NK of the firm B.
iv. The two firms will have to charge the same price since the products of the two firms have been assumed
to be homogenous
v. This means that the firm A, whose price MP is lower, will dictate the price to the firm B whose profit-
maximizing price NK is higher.
vi. In case the firm B refuses to fall in line, it can be ousted by the firm A which will be charging the lower
price.
vii. This shows that in this situation, the firm A is the price leader and the firm B has to follow it.

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DUOPOLY
Duopoly is a special case of the theory of oligopoly in which there are only two sellers. Both the sellers
are completely independent and no agreement exists between them. Even though they are independent, a
change in the price and output of one will affect the other, and may set a chain of reactions. A sell er may
however, assume that his rival is unaffected by what he does, in that case he takes only his own direct
influence on the price.

COURNOT MODEL OF DUOPOLY
Assumptions
i. There are two independent sellers. In other words, interdependence of the duopolists is ignored.
ii. They produce and sell a homogenous product- mineral water.
iii. The total output must be sold out, being perishable and non-storable.
iv. The number of buyers is large.
v. Each seller knows the market demand curve for the product.
vi. The cost of production is assumed to be zero.
vii. Both have identical costs and identical demands.
viii. Each seller decides about the quantity he wants to produce and sell in each period.
ix. But each is ignorant about his rivals plan about output.
x. At the same time, each seller takes the supply output of its rival as constant.
xi. Neither of them fixes the price for its product, but each accepts the market demand price at which the
product can be sold.
xii. The entry of firms is blocked.
xiii. Each seller aims at obtaining the maximum net revenue or profit.
This is explained with the help of a diagram:

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X axis = output
Y axis = Price
Explanation:
i. It shows how A and B producers share the total market and adjust output and how they maximize their
profits.
ii. SB is the total demand. Let the unit cost be zero i.e., MC=0. Therefore MR is also zero at A.
iii. Before B enters the market, A produces OA=Half of OB. The price is OC giving maximum profits OAPC.
iv. Then B enters the market and produces AH = Half of AB, i.e the remaining market.
v. This process will continue till equilibrium output and price are achieved. As more and more firms enter,
they will produce output approaching the competitive output. If the number of firms goes up to N they will
produce N+1 (N) OB.

THE EDGE WORTH MODEL OF DUOPOLY:

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X axis = output
Y axis = Price
Explanation
i. It is assumed that each producers capacity is limited to 3/4th of his entire market and each is confronted
with his own demand curve made up of one half of the consumers. The maximum output that A can
produce is OB and B can produce OB.
ii. The demand curves of A and B respectively are DT and DH.
iii. The A first enters the market and sets his price P1 he sells the total output aP1.Then B enters the
market and sells at price slightly lower than A and thus captures his market.
iv. B then sells the whole output at P2 and snatches from Abb of sales. Now A reacts and captures Bs
market to the extent of CC.
v. This process of price-cutting continues until one of them say B fixes his prices at P4.At this point none
can snatch the market from the other by lowering the price.
vi. Then A raises the price back to P1 to maximize his profits from his share of the market knowing that B
has already thrown his entire supply, B then follows suit.
vii. There is thus continual oscillation of price between P1 and P4 i.e., the upper and lower limits.

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CHAMBERLIN MODEL OF DUOPOLY:

X axis = output
Y axis = Price
Explanation
i. Suppose the producer A enters the market first DB is the demand curve and OL is the total output he
chooses to produce.
ii. It is sold at OA price and the total profit made is OLPA.
iii. Now the producer B enters the market and produces LH quantity.
iv. Now the total quantity produced is OL+LH=OH.

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UNIT V
FINANCIAL ACCOUNTING (ELEMENTARY TREATMENT)
Balance sheet and related concepts - Profit & Loss Statement and related concepts -
Financial Ratio analysis - Cash flow analysis - Funds flow analysis Comparative
financial statements - Analysis & Interpretation of financial statements.

INTRODUCTION
Accounting is the process of identifying, measuring and communicating economic information to
permit informed judgments and decisions by users of information.
Meaning and Scope of Accounting
Accounting is the language of business. The main objective of Accounting is to safeguard the
interest of the business, its properties and others connected with the business transactions. This is done by
providing suitable information to the owners, creditors, shareholders, Government, financial institutions and
others related agencies.
Definition of Accounting
The American Accounting Association defines accounting as the process of identifying, measuring
and communicating economic information to permit informed judgment and decisions by the users of the
information.According to AICPA (American Institute of Certified Public Accountants) it is defined as the
the art of recording, classifying and summarizing in a significant manner and in terms of money,
transactions and events which are in part at least of a financial character and interpreting the result
thereof.
Accounting principles:
Accounting principles are guidelines & standards, which have been accepted by the accounting
profession in preparation and presentation of accounts of the business. It is approved and normally
accepted by the government bodies & controlling authorities.

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Accounting principles are not universal and permanent as they are not discovered but are
developed by man from time to time. Thus the development of accounting principles is a continuous
process.
Accounting principles are of two parts,
Concepts
Conventions
Characteristics of Accounting Concepts:-
1. Accounting concepts are continuously changing and evolving: In the event of rapidly changing economic
activities, accounting concepts also undergo frequent changes. This is a healthy sign for the accounting
fields.
This is because of the following two main reasons.
It is relatively a new field and hence it is developing with time.
Some aspects tend to change with the changes in social, economic and commercial conditions.
2. Another important feature of accounting concepts is the interrelationship among the different concepts.
Most of the concepts do not stand by themselves; they depend on the other concepts to a large extent.
Golden Rules of Accounting:
Personal Account: Debit the Receiver and Credit the Giver.
Real Account: Debit what Comes In and Credit what Goes Out.
Nominal Account: Debit all Expenses and Losses and Credit all Gains and Incomes.

Understanding of financial statements:
Finance may be defined as the art and science of managing money. A financial statement is an
organized collection of data according to logical and consistent accounting procedures. Financial
statements are final results of accounting work done during the accounting period.
Financial management: Concerned with the duties of the financial managers in the business firm.
Financial managers: Actively manage the financial affairs of any type of business, namely, financial and
non-financial, private and public, large and small, profit seeking and not-for-profit.
Financial statement: Financial statement provides a summarized view of the financial position and
operations of a firm. Therefore, much can be learnt about a firm from careful examination of its financial

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statements as invaluable documents/performance reports. The analysis of financial statement is, thus, an
important aid to financial analysis.
Journal:-
Journal is the book of Original Entry or First Entry which is used for recording of all business
transaction in chronological order. Then it is posted to ledger. This process is known as Entering. In other
words record of the each transaction is called as Journal Entry. The process of recording in the journal is
called as Journalizing.
Ledger:-
A Ledger Account may be defined as a Summary statement of all transactions relating to a
person, asset, expense or income which have taken place during a given period of time and showing their
net effect. From the above definition, we can observe that Ledger is designed as the book of second
stage in the accounting cycle which is used for recorded transactions which are classified and grouped into
different head of accounts.
Trial Balance:-
To ensure the proof of completion and arithmetical correctness of the books of account, it is
essential to prepare the trial balance. In the first stage of accounting all business transactions are recorded
in Journal or Subsidiary books. Then they are transferred to ledger by posting to relevant accounts. The
fundamental principles of double entry system of accounting is that for every debit, there must be a
corresponding and equal credit. Therefore, when all the accounts of a concern are thus balanced in the
ledger at the end of the period, a statement is prepared to show the list of debit balances on one side and
credit balances on the other side. This list so prepared is called as Trial Balance. Accordingly the total of
the debit side of trial balance must be equal to that of its credit side.
MANAGEMENT ACCOUNTING
MEANING
The term management accounting refers to accounting for the management (i.e.) accounting which
provides necessary information to the management for discharging its function. The functions of the

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management are Planning, Organizing, Directing and Controlling of business operations can be done in an
orderly and effective manner.
DEFINITION
The definition given by the American Accounting Association is as follows;
Management Accounting is the application of appropriate techniques and concepts in processing
historical and projected economic data of an entity to assist management in establishing plans for
reasonable economic objectives and in the making of rational decisions with a view towards achieving
these objectives.
FUNCTIONS
A) PLANNING B) IMPLEMENTATION C) CONTROL
Planning
It is the process of deciding what action should be taken in the future. A plan may be made for any
segment or for the organization as the whole. An important form of planning is budgeting. Budgeting is the
process of planning the overall activities
Implementation
Implementation involves specific actions planned in advance to fulfill the budgets. It requires
supervision on the part of the managers. A key managerial responsibility is to change previous plans
appropriately to adjust for new conditions.
Control
It is the process to ensure that employees perform properly. Accounting information is used in the
control process as a means of communication, motivation getting attention and for appraisal.

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FINANCIAL ACCOUNTING
Meaning
Financial Accounting has a single, unified structure in the sense that the information relating to the
operations of various enterprise is presented on a more or less uniform basis.
Financial Accounting designed to serve parties external to the operating responsibility of the firm.
Eg Creditors, Investors, Employees, Banks etc.It is basically concerned with the recording, classifying and
summarizing in a significant manner and in terms of money transactions and events which are in part at
least of a financial character and interpreting the result there of.
FUNCTIONS
Recording
Financial accounting ensures that all financial transactions are properly recorded. Recording done
in the book of JOURNAL.
Classifying
Classification is concerned with the systematic analysis of the recorded data with a view to group
transactions or entries of nature at one place. The work of classification done in the book of LEDGER.
Summarising
This involves presenting the classified data in a manner which is understandable and useful to the
internal as well as external end users of accounting statements. This process lead to the preparation of
following statements.
a) Trial balance b) Income statement c) Balance sheet.
LIMITATIONS
1) Provides only limited information
2) Treats figures as single, simple and silent items.
3) Provides only a post-modem record of business transaction
4) Covers only quantifiable information
5) Fails to provide information needs of different levels of management.

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COST ACCOUNTING
Cost Accounting refers to the process of determining the cost of particular product or activity. It
provides useful data for both internal and external reporting. Internal report present details of cost
information regarding cost of specific product or services while external reports contain cost data in a
summarized and aggregate form.
E.g.: Internal report refers to manufacturing cost of product; External cost refers to sales volume of the
company
OBJECTS AND FUNCTIONS OF COST ACCOUNTING
The main objects or functions of costing are as follows:
1) Analysis and Ascertainment of costs:
The main object of costing is to ascertain the cost of each product, process, department, service
or operation. For the ascertainment of costs it involves further the study, analysis and classification of costs
such as Prime cost, works cost, production costs,etc.Various methods, systems and techniques of costing
have been developed for the purpose of recording and determining costs.
2) Presentation of costs for cost reduction and cost control:
Another important function of costing is to control and reduce costs. Unless efficiently
controlled,costs have a tendency to increase and cross the limits. Properly collected cost data helps in
controlling and maintaining cost at the lowest. The right and appropriate cost information is made available
to the right man, who needs them, at the right time and in a proper form.
3) Planning and Decision making
Cost accounting has developed beyond its traditional function of cost determination and cost
control. It has now developed as a tool in the hands of the management for planning and taking crucial
decisions like pricing of products, introduction of a new product in the market, make or buy decisions,
expansion or contraction, replacement of machinery, shut down decisions, wages compensation plan,
choice among various alternatives,etc.

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IMPORTANCE AND ADVANTAGES OF COST ACCOUNTING
a) Cost accounting as an Aid to Management:
Cost accounting helps the management in carrying out its functions, i.e.planning, organizing,
controlling, decision-making, budgeting and pricing efficiently by providing cost information to the
management.
b) Advantages to Employees
An efficient costing system reduces the cost and increases the profits of concern thus ensuring
greater security of service and increased wages to the employees. cost accounting also helps in
introducing incentive wage schemes and bonus plans which bring more reward to efficient
employees.
c) Advantages to the creditors, investors and bankers
Creditors, investors, bankers and others who lend money to the business are also benefited by the
introduction of cost accounting in a concern. It enables the creditors, bankers and investors to judge
the financial position and solvency of a concern by providing the reliable cost data.
d) Advantages to the government and the society
Cost accounting increases the efficiency of a concern, reduces cost and increases the profits.thus,it
promotes the overall economic development of the country.
LIMITATIONS
1) It is not an independent system of accounts.
2) It is based largely on estimates like absorption of indirect expenses or apportionment of
expenses on estimate basis.
3) There is a scope for subjectivity on items like depreciation, valuation of closing stock etc.
4) It does not take into consideration all items of expenses and incomes example: items of purely
financial nature such as interest, finance charges,etc.
GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAPs)
Financial accounting is prepared in accordance with the GAPPs. Accounting is the language of business
as it is the principal means by which information about a business is communicated to those interested in it.
If therefore, the information is to be communicated effectively and understood properly, it should be

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prepared in accordance with a mutually understood set of rules. These ground rules are referred to as
GAPPs.
Accounting principles are classified into two categories as i) Accounting concepts ii) Accounting
conventions.
I) ACCOUNTING CONCEPTS
The term accounting concepts is used to connot basic accounting postulates, i.e., necessary assumptions
and a condition upon which accounting is based. Some of the important accounting concepts are as
follows:
1) BUSINESS ENTITY CONCEPT
In accounting business is treated as a separate entity from its owners. Accounts are prepared to give
information about the business and not those who own it. A distinction is made between business
transactions and personal transaction and also between business property and personal property of the
owners. The business entity concept is necessary to ascertain the results of business operations. In case
the private and business transactions are not segregated, it will not be possible to determine true
protitability of the concern.
2) GOING CONCERN CONCEPT
It is presumed that the business concern will continue to exist indefinitely or at least in the near future. The
present resource of the concern is utilized to attain the long term objectives of the business. This concept is
very important in relation to the recording of transactions and preparation of financial statements. For
example, it is only this assumption that while preparing final accounts of the concern, fixed assets are
shown in the balance sheet at diminishing balance method, i.e. going concern value
3) THE COST CONCEPT
The accounting records are based on cost concept. This concept is closely related to the going concern
concept. The assets and liabilities of a business are shown at a cost which has been paid or agreed upon
between parties. The figures are recorded on objectivity basis. There is no room for personal assessment
or bias in showing the figures. If subjectivity is followed in records then same assets will be valued at
different figures by different individuals. Everybody will have his own view about various assets.so cost
concept is helpful in making truthful records. The records become more reliable and comparable.

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4) DUEL ASPECT CONCEPT
This concept lies at the heart of whole accounting system. Modern accounting system is based on dual
aspect concept. It is based on the principle that for every debit transaction. There must be giver of benefit
and also a taker of it. Suppose A purchase a building of Rs.20,000,he will get building and will part with the
cash for similar amount. So one account will be debited another account will be credited The debits will be
equal to credits. The dual aspect concept has credited the system of double entry book-keeping. It is
because of this concept that the total claims of outsiders and owners are always equal to total assets of the
concern. In form of accounting or balance sheet equation. External Liabilities + capital =Total Assets
or, Total Liabilities = Total Assets or, Assets Liabilities=Capital.
5) MONEY MEASUREMENT CONCEPT
According to this concept only those transactions are recorded in accounting which can be expressed in
terms of money. Money provides a mechanism by which real resources can be transferred among different
individuals. Money is accepted as a medium of exchange for goods and services. One is prepared to sel l
ones property in exchange for money. The debtors and creditors are willing to pay and receive money in
near future. Thus, money acts as a medium for immediate exchange for goods and services and also as a
standard for deferred payments. It is because of this concept that quantitative or non-monetary
things/transactions are either omitted or recorded separately and do not find any place in the financial
statements of a firm.
6) ACCOUNTING PERIOD/ACCURAL CONCEPT
Financial position and profitability of a concern are assessed at a interval called Accounting period. While
preparing profit and loss account of a concern all revenue items related to that period are taken into
consideration irrespective of the fact that whether these items are paid or payable. Similarly, a balance
sheet is prepared to reveal the financial position of the concern on a particular date.
7)REALISATION CONCEPT
This concept is related to the realization of revenue. The revenue is realized either from sale of
products or from rendering of services. The sale involves a number of stages such as receipt of order,
production or assembling of goods, dispatch of goods, transfer of ownership, and receipt of money. A
question arises as to when should the revenue be considered ? As a general principle, sales or profit on
sales will be considered to be realized when either money (cash) is realized or legal obligation is created,
i.e. ownership or title to the goods is transferred.

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8)MATCHING OF COST AND REVENUE CONCEPT
As a general principle, the costs are matched to revenues to measure the profits .A distinction
between present, past and future expenditure as well as capital and revenue expense is necessary. The
revenues and cost of the same period, product or service are matched. Similarily, the expense whose
utility is to be derived over a number of years are taken to the balance sheet as deferred revenue
expenditure. Capital expenditures become a part of cost over a number of years through depreciation.
ACCOUNTING CONVENTIONS
Accounting Conventions are the traditions, usage and customs which are in use since long. The most
important conventions which have been in use are disclosure, consistency, conservation and
materiality.
1. Convention of Disclosure:
The disclosure of all significant information is one of the important accounting conventions. It implies that
accounts should be prepared in such a way that all material information is clearly disclosed to the reader.
This information should not only include figures given in the final accounts but also information which
occurs after the preparation of balance sheet but before the presentation of financial statements. The idea
behind this convention is that anybody who wants to study the financial statements should not be
prejudiced by concealing any facts. He should be able to make a free judgment.
2. Convention of Consistency:
The convention of consistency means that same accounting principles should be used for preparing
financial statements for different periods. It enables management to draw important conclusions regarding
the working of the concern over a longer period. It allows a
Comparison in the different periods. If different accounting procedures and processes are Used for
preparing financial statements of different years then the results will not be comparable because these will
be based on different postulates.
3. Convention of Conservatism:
The conversion of conservatism means cautious approach or policy of play safe. This convention
ensures that the uncertainties and risks inherent in business transactions should be given proper

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consideration. If there is possibility of loss, it should be taken into account at the earliest. On the other
hand, a prospect of profit should be ignored upto the time it does not materialize.
4. Convention of Materiality:
According to this convention only those events should be recorded which have a significant bearing and
insignificant things should be ignored. The avoidance of insignificant things will not materiality affects the
records of the business. It should be seen that the efforts involved in recording the events should be worth
the labour involved in it. There is no formula in making a distinction between material and immaterial
events. It is a matter of judgment and it is left to the accountant for taking a decision.
BALANCE SHEET AND RELATED CONCEPTS
The balance sheet is a statement, which shows the financial position of a business on a particular date.
It is a statement of balance of all the accounts real, personal, Debit balances of all such accounts represent
assets and credit balances represent the liabilities. Thus, balance sheet shows the assets and liabilities
grouped properly classified and arranged in a specific manner.
Objectives of Preparing a Balance Sheet
Principal objective: The main purpose of preparing balance sheet is to know the financial position
of the business at a particular date.
Subsidiary Objectives: Though the main aim is to know the exact financial position of the firm at a
particular date, yet it serves other purpose as well.
It gives information about the actual and real owners equity, yet some other liabilities are to be
accounted for against it also.
It helps the firm to make provisions against possible future losses. A provision is made in the form
of the reser
What information does it convey to an outsider?
Balance sheet is prepared with a view to measure the true financial position of a business concern at a
particular point in time. It shows the financial position of a business in a systematic form.The various groups
interested in the company can draw useful inferences from an analysis of the information contained in the
balance sheet.

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Similarly, other interested parties like regulatory and developmental agencies of the government,
consumer, and welfare organizations can derive useful conclusions from a study of the balance sheet about
the working of the corporate sector and its contribution to the national economy.
CLASSIFICATION OF BALANCE SHEET ITEMS:
Owners Equity
Assets Fixed Assets
Accrued Liabilities
Contingent liability
Accounts Receivables
Owners Equity
Owners equity is the residual interest in the assets of the enterprise. Therefore the owners equity section
of the balance sheet shows the amount the owners have invested in the entity. However, the terminology
Owners Equity varies with different forms of organization depending upon whether the enterprise is a joint
stock company or sole proprietorship/partnership concern.
Assets
The entire property of all kinds possessed by or owing to a person or organization is called Assets.Assets
are valuable resources owned by a business and acquired at a measurable money cost. They may be
Fixed Assets:
These are those assets, which are acquired for relatively long periods for carrying on the business of the
enterprise. Such assets are not meant for resale. For example, Land and Building, plant and machinery etc.
Current Assets:
These assets are also termed as Floating or Circulating Assets. Such assets are acquired with the
intention of converting them into their values constantly. The essential difference between Current Assets
and Fixed Assets is that the current assets are held essentially for a short period and they are meant for
converting into cash. Unsold stock, debtors bills receivables, bank balance, cash in hand, etc are some of
the examples of current Assets.

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Fictitious Assets:
Assets of no real value but included in the balance sheet for legal or technical reasons, e.g., preliminary
expenses.
Tangible and Intangible Assets:
Tangible assets are those assets, which can be seen and touched i.e. assets having their physical
existence e.g. assets having their physical existence e.g. land and building, plant and machinery, furniture
and fixtures, stock-in-trade, cash, etc.
Intangible assets cannot be normally soli in the open market since they are not having any physical
existence e.g. Good will, patents, trademarks, prepaid expenses etc.
Liquid Assets:
Assets that can be easily converted into cash like Bank account, Bills receivable, etc. As a matter of fact, all
current assets excluding stock-in-hand and prepaid expenses are called liquid assets.
Wasting Assets:
These are the assets which are exhausted with, or which lose themselves in, the goods they produce.
Mines and quarries are common examples of such assets. Copyright, patents, trademarks, etc. are also
classified as wasting assets since they get exhausted with the lapse of time.
FIXED ASSETS
These are those assets, which are acquired for relatively long periods for carrying on the business of
the enterprise. Such assets are not meant for resale. For resale. For example, Land and Building, plant and
machinery, etc. Current Assets provide benefits to the organization by their exchange into cash. In the case
of fixed assets, value addition arises by facilitating the process of production or trade.
Fixed assets normally include assets such as land, building, plant, machinery, etc. All these items, with
exception of land are depreciated. Land is not subject to depreciate and hence shown separately from
other fixed assets.

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ACCRUED LIABILITIES
Accrued Liabilities represents expenses or obligations incurred in the previous accounting period but the
payment for the same will be made in the next period. In many cases where payments are made
periodically, such as wages, rent and similar items, the last months payment many appear as accured
liabilities.(especially if the practice is to pay the same on the first working day of a month. This obligation
shown on the balance sheet indicates that the firm owed the said amount on the balance sheet date.
ACCOUNTS RECEIVABLES
Accounts receivables are amounts owed to the company by debtors. This is the reason why we also use
the term sundry debtors to denote the amounts owed to the firm. This represents amounts usually arising
out of normal commercial transactions. In other words, accounts receivable or sundry debtors represents
unpaid customer accounts. These are also known as trade receivables, since they arise out of normal
trading transactions. Trade receivables arise directly from credit sales and as such provide important
information for management and outsiders. In most situations these accounts are unsecured and have only
the personal security of the customer.
PROFIT AND LOSS ACCOUNT CONCEPT
The determination of Gross profit or gross loss is done by preparation of Trading account. But it does not
reveal the Net profit or Net loss of a concern during the particular period. This is the second part of the
income statement and is called as Profit and Loss account. The purpose of preparing the profit and loss
account to calculate the Net profit or Net loss of a concern. Net profit refers to the surplus which remains
after deducting related trading expenses from the gross profit. The trading expenses refer to inclusive of
office and administrative expenses, selling and distribution expenses.
In other words, all operating expenses such as office and administrative expenses, selling and distribution
expenses and non operating expenses are shown on the debit side and all operating and non operating
gains and incomes are shown on the credit side of the profit and loss account. The difference of two sides
is either Net profit or Net loss. Accordingly, when total of all operating and non-operating expenses is more
than the Gross profit and other non-operating incomes, the difference is the Net profit and in the reverse
case it is known as Net loss. This Net profit or Net loss is transferred to the capital account of balance
sheet.

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PROFIT AND LOSS ACCOUNT RELATED CONCEPTS
Components appearing on debit side of the profit and loss A/c
Those expenses incurred during the manufacturing process of convention of raw materials into finished
goods will be treated as direct expenses which are recorded in the debit side of the Trading account. Any
expenditure incurred subsequent to that will be known as indirect expenses to be shown in the debit side of
the profit and loss account. The indirect expenses may be classified into 1) Operating Expenses and 2)
Non-Operating expenses.
1) Operating Expenses:
It refers those expenses as the day-to-day expenses of operating a business include office &
administrative expenses, selling and distribution expenses.
2) Non-Operating Expenses:
These expenses incurred other than operating expenses. Non-operating expenses which are
related to a financial nature. For example, interest payment on loans and overdrafts, loss on sale of
fixed assets, writing off fictitious assets such as preliminary expenses, under writing commission
etc.
Components appearing on credit side of profit & loss account
The following are the components are shown on the credit side:
1) Gross profit brought down from Trading Account
2) Operating Income: It refers to income earned from the operation of the business excluding Gross
profit and Non-operating incomes.
3) Non-Operating Income:
Non-Operating incomes refer to other than operating income. For example, interest on investment
of outside business, Profit on sale of fixed assets and dividend received etc.

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FORMAT
TRADING ACCOUNT FOR THE YEAR ENDED------------------

Particulars Amt Amt Particulars Amt Amt

To Opening stock By sales
To Purchase (-) sales returns
(-) Purchase return By closing stock
To carriage inward By gross loss
To Freight (balancing figure)
To clearing charges
To wages
To Direct Expenses
To Gross Profit
(Balancing Figure)

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P&L ACCOUNT FOR THE YEAR ENDED------------------
PARTICULARS Amt Amt Amt Amt
To gross loss By gross profit
To salaries By interest received
To office rent By discount received
To office expenses/general By commission received
Expenses/Administrative By bad debts recovered
Sundry expenses By net loss transferred to
To telephone charges/rents Balance sheet
To rent and taxes
To insurance
To printing and stationary
To audit fees
To postage and telegram
To interest paid
To bank charges
To commission paid
To discount allowed
To advertisement
To bad debts
To carriage outward
To depreciation
To net profit transferred
To balance sheet

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BALANCE SHEET

LIABILITIES ASSETS
Capital Goodwill
(+) Net profit Land
(-)Net loss Building
Drawing House holds
Reserves and surplus Railway sidings
Debentures Plant and machinery
Equity share Patents and trademarks
Preference shares Livestock
Loan and advances Vehicles
Short term loans Stock
Sundry creditors Sundry debtors
Bills payable cash and bank balance
Outstanding expenses Prepaid expenses
Provision for taxation Preliminary expenses
Prepaid dividend Closing stock

RATIO ANALYSIS
Ratio analysis is a widely-used tool of financial analysis. It can be used to compare the risk and
return relationships of firms of different sizes. It is defined as the systematic use of ratio to interpret the
financial statements so that the strengths and weaknesses of a firm as well as its historical performance
and current financial condition can be determined. The term ratio refers to the numerical or quantitative
relationship between two items/variables.

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Principles of Ratio selection:-
The following principles should be considered before selecting the ratio:
1. Ratio should be logically inter-related.
2. Pseudo ratio should be avoided.
3. Ratio must measure a material factor of business.
4. Ratio should be in minimum number.
5. Ratio should be facilities comparable.
Advantages of Ratios Analysis:
Ratio analysis is an important and age-old technique of financial analysis. The following are some of
the advantages / Benefits of ratio analysis:
1. Simplifies financial statements: It simplifies the comprehension of financial statements. Ratios
tell the whole story of changes in the financial condition of the business.
2. Facilitates inter-firm comparison: It provides data for inter-firm comparison. Ratios highlight the
factors associated with successful and unsuccessful firm. They also reveal strong firms and weak
firms, overvalued and undervalued firms.
3. Helps in planning: It helps in planning and forecasting. Ratios can assist management, in its basic
functions of forecasting. Planning, co-ordination, control and communications.
4. Makes inter-firm comparison possible: Ratios analysis also makes possible comparison of the
performance of different divisions of the firm. The ratios are helpful in deciding about their
efficiency or otherwise in the past and likely performance in the future.
5. Help in investment decisions: It helps in investment decisions in the case of investors and
lending decisions in the case of bankers etc.
Limitations of Ratios Analysis:
The ratios analysis is one of the most powerful tools of financial management. Though ratios are simple
to calculate and easy to understand, they suffer from serious limitations.
1. Limitations of financial statements: Ratios are based only on the information which has been
recorded in the financial statements. Financial statements themselves are subject to several

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limitations. Thus ratios derived, there from, are also subject to those limitations. For example, non-
financial changes though important for the business are not relevant by the financial statements.
Financial statements are affected to a very great extent by accounting conventions and concepts.
Personal judgment plays a great part in determining the figures for financial statements.
2. Comparative study required: Ratios are useful in judging the efficiency of the business only when
they are compared with past results of the business. However, such a comparison only provide
glimpse of the past performance and forecasts for future may not prove correct since several other
factors like market conditions, management policies, etc. may affect the future operations.
3. Ratios alone are not adequate: Ratios are only indicators, they cannot be taken as final regarding
good or bad financial position of the business. Other things have also to be seen.
4. Problems of price level changes: A change in price level can affect the validity of ratios
calculated for different time periods. In such a case the ratio analysis may not clearly indicate the
trend in solvency and profitability of the company. The financial statements, therefore, be adjusted
keeping in view the price level changes if a meaningful comparison is to be made through
accounting ratios.
5. Lack of adequate standard: No fixed standard can be laid down for ideal ratios. There are no well
accepted standards or rule of thumb for all ratios which can be accepted as norm. It renders
interpretation of the ratios difficult.
6. Limited use of single ratios: A single ratio, usually, does not convey much of a sense. To make a
better interpretation, a number of ratios have to be calculated which is likely to confuse the analyst
than help him in making any good decision.
7. Personal bias: Ratios are only means of financial analysis and not an end in itself. Ratios have to
interpret and different people may interpret the same ratio in different way.
8. Incomparable: Not only industries differ in their nature, but also the firms of the similar business
widely differ in their size and accounting procedures etc. It makes comparison of ratios difficult and
misleading.

CASH FLOW STATEMENT
Introduction
The balance sheet and income statement / profit&loss account are the traditional basic financial
statements of a business enterprise. A balance sheet shows the financial position of the firm as at the last

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day of the accounting period. An income statement focuses on the financial performance (profit or loss) due
to the operating activities of a firm during the period. Revenues recorded in income statement do not reflect
cash inflows as the debtors may pay later. Likewise, some of the expenses shown in the income statement
may be non-cash expenses (depreciation, amortization etc) and some may not be paid in full (goods
purchased on credit, salaries payable etc). Thus the periods profit&loss does not bear direct relationship to
the cash flows associated with the periods expirations.
Objective
The objective of the cash flow statement is to provide information about the cash flows associated with
operating, investing and financial activities of the firm during the accounting period. This information is
significant to the stakeholders of a company. Dividends payable to the shareholders obviously are
dependent on cash flow; interest payment and debt repayment to the lenders require the availability of
cash; payment to employees, suppliers and taxes in time is contingent up to the companys ability to
generate adequate cash flow to meet these financial obligations. For these reasons, cash flow statement is
the third major financial statement of a company.
Meaning
Cash flow statement is a statement which indicates source of cash inflows and transactions of cash
outflow of a firm during an accounting period. The activities/transactions which generate cash inflows are
known as sources of cash and activities which cause cash outflows are known as uses of cash.
Sources and uses of cash:
Business operations/operating activities.
Non-business/operating activities (interest/dividend received).
Sale of long term assets (plants, buildings and equipment).
Issue of additional long term securities (equity, preference shares and debentures).
Additional long term borrowings (banks and financial institutions).
Sources of cash outflow:
Purchase of long-term assets (plant & machinery, land & building, office equipment and furniture).
Redemption of preference shares and debentures.
Repurchase of equity shares.
Repayment of long term borrowings.
Cash dividends paid to shareholders.

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Advantage of cash flow statement
The profit and loss account sets out the revenue and expense rather than the cash receipts and
cash payments for the period.
When a company makes a sale on credit this will be reflected as an increase in the wealth in the
profit and loss account but there is no cash collected.
It shows the cash coming from the operation
It shows the cash used in the investing activities
It shows the cash used in the financing activities
Limitations of cash flow statement
It does not present true picture of the liquidity of a firm because the liquidity does not depend upon
cash alone.
The possibility of window-dressing is higher in case of cash position in comparison to the working
capital position of a firm.
Cash flow statement ignores non-cash charges.
It is prepared on cash basis and hence ignores one of the basic concepts of accounting, namely
accrual concept.

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FORMAT OF CASH FLOW STATEMENT

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FUND FLOW ANALYSIS

Fund
It means cash and wealth. It means cash in short term and working capital in long term.
Fund Flow Statement
Study the changes in the financial position of a business enterprise between beginning and ending financial
statement dates. It is a statement showing sources and uses of funds.
Definition
According to Antony the Fund Flow statement describes the sources from which addition funds where
desired and the uses to which these sources where put.
Parties interested in Fund Flow statement:
Management
Banks & Financial Institutions
Share holders and other investors
Debenture holders
Trade creditors

Importance / Advantages of FFS:
Helps in Analysis of financial operations
Through light on many confusing questions of general interest
Helps in the formation of a realistic dividend policy
Helps in proper allocation of sources
Act as a future guide
Helps in apprising the use of working capital
Help in knowing the overall credit worthiness of a firm.

Disadvantages
Fail to cover sufficient information
Secondary in nature
Ignore changes in working capital
Doubtful statement
Device
Fails to level changes

Procedure for preparing Fund Flow Statement
Statement are schedule of changes in working capital
Statement of sources and application of funds

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Calculation of fund from operation
In order to prepare a funds flow statement it is necessary to ascertain the sources and application of funds.
Main source of fund in a business is funds from operations

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Fund Flow Statement
Fund Flow Statement is prepared to show the changes in assets, liabilities and capital between the
dates of two balance sheets. It discloses the causes of changes in the items of balance sheet between the
end of the previous year and the end of current year. Thus, by preparing this statement, the management
can find out the basic reasons for changes in the assets, liabilities and capital of the firm between two
balance sheets.

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COMPARATIVE FINANCIAL STATEMENTS
Objectives of comparative financial statements
Changes taken place in the financial performance are taken into consideration for further analysis
To reveal qualitative information about the firms in terms of solvency, liquidity profitability and so on
are extracted from the analysis of financial statements
With reference to yester financial data of the enterprise, the firm is facilitated to undergo for the
preparation of forecasting and planning.
The major part of financial statement analysis is mainly focused on the comparative analysis.
The comparative analysis classified into four different analyses viz
Comparative Balance sheet
Comparative Profit and Loss account
Common Size statement
Trend percentage
The comparative Balance sheet.
The first and foremost important step is to have the following information and should take preparatory steps
i. While preparing the comparative statement of balance sheet, the particulars for the financial factors are
required
ii. The second most important for the preparation of the comparative balance sheet is yester financial data
extracted from the balance sheet or balance sheets

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iii. The next most important requirement to have an effective comparison with the yester financial data is
current year information extracted from the balance sheet or balance sheet of the firms.
iv. After having been procured the financial data pertaining to various time periods are ready for
comparison; to determine or identify the level of increase or decrease taken place in the financial position of
the firms
v. To determine the level of increase or decrease in financial position, the percentage analysis to carried
out in between them.
Comparative (Income) financial statement analysis:
This analysis is being carried out in between the income statements of the various accounting durations of
the firm, with other firms in the industry and with the industrial average.
This will facilitate the firm to know about the stature of itself regarding the financial performance. It
facilitates to understand about the changes pertaining to various financial data which closely relevantly
connected with the financial performance
Change in the gross sales
Change in the net sales
Change in gross profit and net profit
Change in operating profit
Change in operating expenses
Change in the volume of non operating income
Change in the non operating expenses
The ultimate purpose of the comparative (Income) financial statement analysis is as follows
i. To study the income earning and expenditure spending pattern of the firm for two or more years
ii. To identify the changing pattern of the income and expenditure of the firms. The preparatory steps for the
preparation of the comparative financial statement (Income) analysis
The first and foremost important step is to have the following information and should take preparatory steps
i. While preparing the comparative statement of Profit and Loss Account, the particulars for the financial
factors are required
ii. The second most important for the preparation of the comparative Profit & Loss account is yester
financial data extracted from the Profit & Loss A/c or Profit & Loss Accounts
iii. The next most important requirement to have an effective comparison with the yester financial data is
current year information extracted from the balance sheet of the firm or of the other firms

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iv. After having been procured the financial data pertaining to various time periods are ready for
comparison;
v To determine or identify the level of increase or decrease taken place in the operating financial
performance of the firms
vi. To determine the level of increase or decrease in financial performance, the percentage analysis to be
carried out in between them.

ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENT ANALYSIS

According to Kennedy and Muller
The analysis and interpretation of financial statements are an attempt to determine the significance and
meaning of financial statement data so that the forecast may be made of the prospects for future earnings,
ability to pay interest and debt maturities and profitability and sound dividend policy
The entire financial statement analysis can be classified into various categories
Comparative financial statements
Common size financial statements
Trend percentages
Fund flow statements
Cash flow statements
Ratio analysis
Fund Flow Statement
Study the changes in the financial position of a business enterprise between beginning and ending
financial statement dates. It is a statement showing sources and uses of funds.
Comparative (Income) financial statement analysis:
This analysis is being carried out in between the income statements of the various accounting durations
of the firm, with other firms in the industry and with the industrial average.
This will facilitate the firm to know about the stature of itself regarding the financial performance. It
facilitates to understand about the changes pertaining to various financial data which closely relevantly
connected with the financial performance
Change in the gross sales
Change in the net sales

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Change in gross profit and net profit
Change in operating profit
Change in operating expenses
Change in the volume of non operating income
Change in the non operating expenses

RATIO ANALYSIS
Ratio analysis is a widely-used tool of financial analysis. It can be used to compare the risk and return
relationships of firms of different sizes. It is defined as the systematic use of ratio to interpret the financial
statements so that the strengths and weaknesses of a firm as well as its historical performance and current
financial condition can be determined. The term ratio refers to the numerical or quantitative relationship
between two items/variables.
CASH FLOW STATEMENT
Introduction
The balance sheet and income statement / profit&loss account are the traditional basic financial statements
of a business enterprise. A balance sheet shows the financial position of the firm as at the last day of the
accounting period. An income statement focuses on the financial performance (profit or loss) due to the
operating activities of a firm during the period. Revenues recorded in income statement do not reflect cash
inflows as the debtors may pay later. Likewise, some of the expenses shown in the income statement may be
non-cash expenses (depreciation, amortization etc) and some may not be paid in full (goods purchased on
credit, salaries payable etc). Thus the periods profit&loss does not bear direct relationship to the cash flows
associated with the periods expirations.

TREND PERCENTAGE ANALYSIS
The next important tools of analysis is trend percentage which plays significant role in analyzing the
financial stature of the enterprise through base years performance rationcomputation. This not only
reveals the trend movement of the financial performance of the enterprise but also highlights the
strengths and weaknesses of the enterprise
The following ratio is being used to compute the trend percentage
100
Base year

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Current year
This trend ratio is being computed for every component for much number of years which not only
facilitates comparison but also guides the firm to understand the trend path of the firm.
Common size statement analysis of the Balance sheet of the firm ABC Ltd.
Its highlights the share of every component in the balance sheet out of the total volume of assets and
liabilities.
This will certainly facilitate the firm to easily understand not only the share of every component but also
facilitates to have a meaningful and relevant comparison with various time horizons.

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UNIT VI
CAPITAL BUDGETING (ELEMENTARY TREATMENT)
Investments - Risks and return evaluation of investment decision - Average rate of
return - Payback Period - Net Present Value - Internal rate of return.

RISK-RETURN EVALUATION OF INVESTMENT DECISION
The relationship between risk and return is a fundamental financial relationship that affects expected
rates of return on every existing asset investment. The Risk-Return relationship is characterized as being a
"positive" or "direct" relationship meaning that if there are expectations of higher levels of risk associated
with a particular investment then greater returns are required as compensation for that higher expected
risk. Alternatively, if an investment has relatively lower levels of expected risk then investors are satisfied
with relatively lower returns.
CONCEPT AND TYPES OF RISK
The variability of the actual return from the expected return which is associated with the investment
/asset known as risk of the investment.
Variability of return means that the Deviation in between actual return and expected return which is
in other words as variance i.e., the measure of statistics.
Greater the variability means that Riskier the security/ investment.
Lesser the variability means that More certain the returns, nothing but Least risky e.g. Treasury
Bills, Savings Deposit.
The risk can be further classified into six different categories
Interest rate risk
Inflation risk
Financial risk.
Market risk
Business risk and
Liquidity risk

186

Interest Rate Risk
- It is risk variability in a security's return resulting from the changes in the level of interest rates.
- Security prices - inverse relationship with
Market Risk
It refers to variability of returns due to fluctuations in the securities market which is more particularly to
equities market due to the effect from the wars, depressions etc.
Inflation Risk
- Rise in inflation leads to Reduction in the purchasing power which influences only few people to
invest due to
- Interest Rate Risk which is nothing but the variability of return of the investment due to oscillation of
interest rates due to deflationary and inflationary pressures.
Business Risk
Risk of doing business in a particular industry / environment is known as business risk. Business risk is
nothing but Operational risk which arises only due to the presence of the fixed cost of operations. The
Higher the fixed cost of operations requires the firm to have Greater BEP to avoid the firm to incur losses. It
is normally transferred to the investors who invest in the business or company, the major reason is that
EBIT of the firm is subject to the fixed cost of operations.
Financial Risk
Connected with the raising of fixed charge of funds viz Debt finance & Preference share capital. More the
application of fixed charge of financial will lead to Greater the financial Risk which is nothing but the Trading
on Equity.
Liquidity Risk
This is the risk pertaining to the secondary Market, in which the securities can be Bought and sold quickly
and without any concession in the price.

RELATIONSHIP BETWEEN THE RISK AND RETURN
Total Return - Risk free rate of return= Excess return (Risk premium)
Total return = Risk free return + Risk premium
Kj = Rf + bj (KmRf)
Bj is nothing but Beta of the security i.e., market responsiveness of the security. Beta differs from one security to
another.

187

It is normally expressed as a

CAPITAL BUDGETING
It is the process of making investment decision in capital expenditures.
Capital expenditure defined as an expenditure the benefits of which are expected to be received more than
one year. It is incurred in one point of time and the benefits are received in different point of time in future.
Eg.(1) cost of acquisition of permanent asset as land and building, plant and machinery, goodwill
(2) Cost of addition, expansion and improvement or alteration in fixed assets
(3) Cost of replacement of permanent assets
(4) Research and development project cost etc.

NATURE AND IMPORTANCE
(1) Large investment
- Involve large investment of funds
- Fund available is limited and the demand for funds exceeds the existing resources
- Important for firm to plan and control capital expenditure
(2) Long term commitment of funds
- Involves not only large amount of fund but also long term on permanent basis.
- It increases financial risk involved in investment decision.
- Greater the risk greater the need for planning capital expenditure.
(3) Irreversible Nature
- Capital expenditure decision are irreversible
- Once decision for acquiring permanent asset is taken, it become very difficult to dispose of these
assets without heavy losses.

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(4) Long-term effect on profitability
- Capital expenditure decision are long-term and have effect on profitability of a concern
- Not only present earning but also the future growth and profitability of the firm depends on
investment decision taken today
- Capital budgeting is needed to avoid over investment or under investment in fixed assets.
(5) Difficulties of investment decision
- Long term investment decision are difficult to take because (i) decision extends to a series of year
beyond the current accounting period
- (ii) uncertainties of future
- (iii) higher degree of risk
(6) National importance
- Investment decision taken by individual concern is of national importance because it determines
employment, economic activities and economic growth
PRINCIPLES OF CAPITAL BUDGETING
Capital expenditure decisions should be taken on the basis of the following factors:
i. creative search for profitable opportunities : profitable investment opportunities should be sought to
supplement existing proposals
ii. Long range capital planning: it indicates sectoral demand for funds to stimulate alternative proposals
before the aggregate demand for funds in finalized
iii. Short-range capital planning: it indicates sectoral demand for funds to stimulate alternative proposals
before the aggregate demand for fund is finalized
iv. Measurement of project work: here, the project is ranked with the other projects
v. Screening and selection: The project is examined on the basis of selection criteria, such as the supply
cost of capital, expected returns alternative investment opportunities etc
vi. Retirement and disposal: the expiry of the life cycle of a project is marked at this stage
vii. Forms and procedures: these involve the preparation of reports necessary for any capital expenditure
programmes.

189

METHODS OF CAPITAL BUDGETING / EVALUATION OF INVESTMENT PROPOSALS
(A) Traditional methods or Non-Discounted method
(i) pay-back period method or pay out or pay off method
(ii) Improvement of traditional approach to pay back period method
(iii) Rate of return method or accounting method

(B) Time-adjusted method or discounted methods
(i) Net Present Value method
(ii) Internal Rate of Return method
(iii)Profitability Index method

Pay-back period method
This method represent the period in which total investment in permanent asset pays back itself. It
measure the period of time for the original cost of a project to be recovered from the additional earning of a
project itself.
Investment are ranked according to the length of the payback period, investment with shorter
payback period is preferred.
The payback period is ascertained in the following manner
Calculate annual net earnings(profit) before depreciation and after taxes, these are called annual
cash inflow
Divide the initial outlay(cost) of the project by the annual cash inflow, where the project generates
constant annual cash inflow

Payback period = cash outlay of the project or original cost of the asset
Annual cash inflows
Where the annual cash inflows (profit before depreciation and after taxes) are unequal the payback
period is found by adding up the cash inflows until the total is equal to the initial cash outlay of the project.

190

Rate of Return method (ARR)
This method takes in to account the earnings expected from the investment over their whole life. It
is known as accounting rate of return.The project which gives the higher rate of return is selected when
compared to one with lower rate of return.
(a) Average rate of return method
= Total profit (after depreciation & Taxes) * 100
Net investment in the project * No of years of profits

(b) Return per unit of investment method
= Total profit (after depreciation & Taxes) * 100
Net investment in the project
(c) Return on average investment method
= Total profit after depreciation and taxes *100

Total net investment
2
(d) Average return on Average investment method
= Average annual profit after depreciation and taxes *100
Net investment
2
Net present value method(NPV)
It is a modern method of evaluating investment proposals. It takes into consideration time value of
money and calculates the return on investment by introducing the factor of time element.
The net present values of all inflows and outflows of cash occurring during the entire life of the project is
determined separately for each year by discounting these flow by firms cost of capital or predetermined
rate. First determine the rate of interest that should be selected as the minimum required rate of return

191

Compute the present value of total investment outlay
Compute the present value of total cash inflows
(i) Calculate Net Present Value by subtracting the present value of cash inflow by present value of
cash outflow.
(ii) NPV = is positive or zero the project is accepted
(iii) NPV= is negative then reject the proposal
In order for ranking the project the first preference is given to project having maximum positive net present
value
NPV= Present value of cash inflow present value of cash outflow/Initial investment

Profitability index method or Benefit cost Ratio (P.I)
It is also called Benefit cost ratio is the relationship between present value of cash inflow and
present value of cash outflow
PI (Gross) = present value of cash inflows
Present value of cash outflows/ Initial Investment
PI (net) = NPV (Net Present Value)
Initial investment
The proposal is accepted if the profitability index is more than one and is rejected the profitability index is
less than one.The various projects are ranked; the project with higher profitability index is ranked higher
than other.
Internal Rate of Return Method (IRR)
Under the internal rate of return method, the cash flows of a project are discounted at a suitable
rate by hit and trial method, which equates the net present value so calculated to the amount of investment.
Determine the future net cash flows during the entire economic life of the project. The cash inflows
are estimated for future profits before depreciation but after taxes
Determine the rate of discount at which the value of cash inflow is equal to the present value of
cash outflows

192

Accept the proposal if the internal rate of return is higher than or equal to the cost of capital or cut
off rate.
In case of alternative proposals select the proposal with the highest rate of return.

Definition of 'Discounted Cash Flow - DCF'
A valuation method used to estimate the attractiveness of an investment opportunity. Discounted cash
flow (DCF) analysis uses future free cash flow projections and discounts them (most often using the
weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for
investment.
Calculated as:

Also known as the Discounted Cash Flows Model.
'Discounted Cash Flow - DCF'
There are many variations when it comes to what you can use for your cash flows and discount
rate in a DCF analysis. Despite the complexity of the calculations involved, the purpose of DCF analysis is
just to estimate the money you'd receive from an investment and to adjust for the time value of money.

Discounted cash flow models are powerful, but they do have shortcomings. DCF is merely a
mechanical valuation tool, which makes it subject to the axiom "garbage in, garbage out". Small changes in
inputs can result in large changes in the value of a company. Instead of trying to project the cash flows to
infinity, terminal value techniques are often used. A simple annuity is used to estimate the terminal value
past 10 years, for example. This is done because it is harder to come to a realistic estimate of the cash
flows as time goes on.
DCF is what someone is willing to pay today in order to receive the anticipated cash flow in future
years. DCF means converting future earnings to todays money. The future cash flow must be discounted

193

in order to express their present values in order to properly determine the value of a company or a project
under consideration as a whole.
The DCF method is an approach to valuation, wherby projected future cash flows are discounted
at an interest rate also called rate of return that reflects the perceived riskiness of the cash flows. The
discount rate reflects two things:
1. The time value of money (investors would rather have cash immediately than having to wait and
must therefore be compensated by paying for the delay)
2. A risk premium that reflects the extra return investors demand because they want to be
compensated for the risk that the cash flow might not materialize after all.

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