MB0026- Unit 1- Meaning And

Importance Of Managerial Economics

Unit 1- Meaning And Importance Of Managerial Economics
Meaning
Managerial economics is a science that deals with the application of
various economic theories, principles, concepts and techniques to
business management in order to solve business and management
problems. It deals with the practical application of economic theory
and methodology to decision-making problems faced by private,
public and non-proft making organizations.
The same idea has been expressed by Spencer and Seigelman in the
following words. Managerial Economics is the integration of economic theory
with business practice for the purpose of facilitating decision making and
forward planning by the management.According to Mc air and Meriam!
Managerial economics is the use of economic modes of thought to analy"e
business situation. #righman and $appas de%ne managerial economics as!
the application of economic theory and methodology to business
administration practice.&oel dean is of the opinion that use of economic
analysis in formulating business and management policies is known as
managerial economics.
eatures of managerial !conomics
'. (t is a new discipline and of recent origin
). (t is a highly speciali"ed and separate branch by itself.
3. It is basically a branch of microeconomics and as such it studies the problems of
only one firm in detail.
'. (t is mainly a normati*e science and as such it is a goal oriented and
prescripti*e science.
). (t is more realistic! pragmatic and highlights on practical application of
*arious economic
The theories to sol*e business and management problems.
It is a science of decision-making. It concentrates on decision-making process,
decision-
o models and decision variables and their relationships.
It is both conceptual and metrical and it helps the decision-maker by providing
measurement of various economic variables and their interrelationships.
It uses various macro economic concepts like national income, inflation, deflation,
trade cycles etc to understand and adjust its policies to the environment in which the
firm operates.
It also gives importance to the study of non-economic variables having implications
of economic performance of the firm. For example, impact of technology,
environmental forces, socio-political and cultural factors etc.
It uses the services of many other sister sciences like mathematics, statistics,
engineering, accounting, operation research and psychology etc to find solutions to
business and management problems.
SCOPE O MA!A"E#IA$ ECO!OMICS
he term !scope" indicates the area of study, boundaries, subject matter and width of a
subject. he following topics are covered in this subject.
1% OB&EC'I(ES O A I#M
2% )EMA!) A!A$*SIS A!) O#ECAS'I!"
+% P#O)UC'IO! A!) COS' A!A$*SIS
,% P#ICI!" )ECISIO!S- PO$ICIES A!) P#AC'ICES
.% P#OI' MA!A"EME!'
6% CAPI'A$ MA!A"EME!'
/% $I!EA# P#O"#AMMI!" A!) '0E '0EO#* O "AMES
he term linear means that the relationships handled are the same as those represented by
straight lines and programming implies systematic planning or decision-making. It
implies maximi#ation or minimi#ation of a linear function of variables subject to a
constraint of linear ine$ualities. It offers actual numerical solution to the problems of
making optimum choices. It involves either maximi#ation of profits or minimi#ation of
costs. he theory of games basically attempts to explain what is the rational course of
action for an individual firm or an entrepreneur who is confronted with the a situation
where in the outcome depends not only on his own actions, but also on the actions of
others who are also confronted with the same problem of selecting a rational course of
action. %oth these techni$ues are extensively used in business economics to solve various
business and managerial problems.
1% MA#2E' S'#UC'U#E A!) CO!)I'IO!S
3% S'#A'E"IC P$A!!I!"
It provides a framework on which long term decisions can be made which have an impact
on the behavior of the firm. he perspective of strategic planning is global. In fact, the
integration of business economics and strategic planning has given rise to a new area of
study called corporate economics.
10% O'0E# A#EAS
&. 'acroeconomic management of the country relating to economic system, national
income, trade cycles (avings and investments and its impact on the working of a
firm.
). *nowledge and information about various government policies like monetary,
fiscal, physical, industrial, labor, foreign trade, foreign capital and technology,
'+,s etc and their impact on the working of a firm.
3. Impact of international changes, role of international financial and trade
institutions in formulating domestic polices of a firm.
Importance of the study of Managerial !conomics
The following points indicate the signi%cance of the study of this sub+ect in its
right perspecti*e.
'. (t gi*es guidance for identi%cation of key *ariables in decision,making
process.
). (t helps the business executi*es to understand the *arious intricacies
of business and managerial problems and to take right decision at the
right time.
-. (t pro*ides the necessary conceptual! technical skills! toolbox of
analysis and techni.ues of thinking and other such most modern tools
and instruments like elasticity of demand and supply! cost and
re*enue! income and expenditure! pro%t and *olume of production etc
to sol*e *arious business problems.
/. (t is both a science and an art. (n the context of globali"ation!
pri*ati"ation! liberali"ation and marketi"ation and a highly competiti*e
dynamic economy! it helps in identifying *arious business and
managerial problems! their causes and conse.uence! and suggests
*arious policies and programs to o*ercome them.
0. (t helps the business executi*es to become much more responsi*e!
realistic and competent to face the e*er changing challenges in the
modern business world.
1. (t helps in the optimum use of scarce resources of a %rm to maximi"e
its pro%ts.
2. (t also helps in achie*ing other ob+ecti*es a %rm like attaining industry
leadership! market share expansion and social responsibilities etc.
3. (t helps a %rm in forecasting the most important economic *ariables
like demand! supply! cost! re*enue! price! sales and pro%t etc and
formulate sound business polices
4. (t also helps in understanding the *arious external factors and forces
which a5ect the decision,making of a %rm.
Thus! it has become a highly useful and practical discipline in recent
years to analy"e and %nd solutions to *arious kinds of problems in a
systematic and rational manner.
"nowledge of decision making and forward planning
Managerial Economist is a specialist and an expert in analy"ing and %nding
answers to business and managerial problems. A Managerial Economist has
to perform se*eral functions in an organi"ation. Among them! decision,
making and forward planning are described as the two ma+or functions and all
other functions are deri*ed from these two basic functions.
#. $ecision-making
%he word &decision' suggests a deliberate choice made out of several
possible alternative courses of action after carefully considering
them. $ecision-making is essentially a process of selecting the best
out of many alternative opportunities or courses of action that are
open to a management.
(. orward planning
%he term &planning' implies a consciously directed activity with
certain predetermined goals and means to carry them out. (t is a
deliberate acti*ity. (t is a programmed action. #asically planning is concerned
with tackling future situations in a systematic manner.
orward planning implies planning in advance for the future. (t is
associated with deciding the future course of action of a %rm. (t is prepared
on the basis of past and current experience of a %rm.
)ummary
Managerial economics is a new and a highly speciali"ed branch of economics.
(t brings together economic theory and business practice. (t assists in
applying *arious economic theories and principles to %nd solutions to
business and management problems.

It is applied economics and makes an attempt to explain how various economic concepts
are usefully employed in business management. It is a practical subject. It opens up the
mind of a managerial economist to the complex and highly challenging business world.
he features of managerial economics throw light on the nature of the emerging subject
and the scope gives information about the wide coverage of the subject. he concepts of
decision- making and forward planning are the two basic functions of a managerial
economist. In a way the entire subject matter of managerial economics is to be
understood in the background of these two functions
MB0026- Unit-2-)emand Anal4sis
Unit- 2 )emand Anal4sis
Understand t5e concept of demand and its feat6res% *
he term demand is different from desire, want, will or wish. In the language of
economics, demand has different meaning. -ny want or desire will not constitute demand
.emand / .esire to buy
0 -bility to pay
0 1illingness to pay
'5e term demand refers to total or gi7en 86antit4 of a commodit4 or a ser7ice t5at
are p6rc5ased 94 t5e cons6mer in t5e mar:et at a partic6lar price and at a
partic6lar time
he following are some of the important $ualifications of demand-
It is backed up by ade$uate purchasing power.
It is always at a price.
It should always be expressed in terms of specific $uantity
It is created in the market.
It is related to a person, place and time.
,onsumers create demand. .emand basically depends on utility of a product. here is a
direct relation between the two i.e., higher the utility, higher would be demand and lower
the utility, lower would be the demand.
$emand +urve
A demand cur*e is a locus of points showing *arious alternati*e price 6
.uantity combinations. In short, the graphical presentation of the
demand schedule is called as a demand curve.
(t represents the functional relationship between .uantity demanded and
prices of a gi*en commodity. The demand cur*e has a negati*e slope or it
slope downwards to the right. The negati*e slope of the demand cur*e clearly
indicates that .uantity demanded goes on increasing as price falls and *ice
*ersa.
%he ,aw -f $emand
.-ther things being equal, a fall in price leads to e/pansion in
demand and a rise in price leads to contraction in demand0.
Important eatures of ,aw of $emand *
'. There is an in*erse relationship between price and demand.
). $rice is an independent *ariable and demand is a dependent *ariable
-. (t is only a .ualitati*e statement and as such it does not indicate
.uantitati*e changes in price and demand.
/. 7enerally! the demand cur*e slopes downwards from left to right.
The operation of the law is conditioned by the phrase .-ther things being
equal0. (t indicates that gi*en certain conditions certain results would follow.
The in*erse relationship between price and demand would be *alid only when
tastes and preferences! customs and habits of consumers! prices of related
goods! and income of consumers would remains constant.
!/ceptions %o %he ,aw -f $emand
7enerally speaking! customers would buy more when price falls in
accordance with the law of demand. !/ceptions to law of demand states
that with a fall in price, demand also falls and with a rise in price
demand also rises. This can be represented by rising demand cur*e. (n
other words! the demand cur*e slopes upwards from left to right. (t is known
as an exceptional demand cur*e or unusual demand cur*e.
8ollowing are the exception to the law of demand
#. 1i2en's 3arado/
4 parado/ is a foolish or absurd statement, but it will be true. Sir
9obert 7i5en! an (rish Economists! with the help of his own example :inferior
goods; dispro*ed the law of demand. The 7i5en<s paradox holds that
.$emand is strengthened with a rise in price or weakened with a fall
in price0. =e ga*e the example of poor people of (reland who were using
potatoes and meat as daily food articles. >hen price of potatoes declined!
customers instead of buying greater .uantities of potatoes started buying
more of meat :superior goods;. Thus! the demand for potatoes declined in
spite of fall in its price.
(. 5eblen's e2ect
Thorstein ?eblen! a noted American Economist contends that there are
certain commodities which are purchased by rich people not for their direct
satisfaction! but for their <snob 6 appeal< or @ostentation<.5eblen's e2ect
states that demand for status symbol goods would go up with a
arise in price and vice-versa. (n case of such status symbol commodities it
is not the price which is important but the prestige conferred by that
commodity on a person makes him to go for it. More commonly cited
examples of such goods are diamonds and precious stones! world famous
paintings! commodities used by world %gures! personalities etc. Therefore!
commodities ha*ing <snob 6 appeal< are to be considered as exceptions to the
law of demand.
6. ear of shortage
>hen serious shortages are anticipated by the people! :e.g.! during the war
period; they purchase more goods at present e*en though the current price is
higher.
7. ear of future rise in price
(f people expect future hike in prices! they buy more e*en though they feel
that current prices are higher. Atherwise! they ha*e to pay a still high price
for the same product.
8. )peculation
)peculation implies purchase or sale of an asset with the hope that
its price may rise of fall and make speculative proft. ormally
speculation is witnessed in the stock exchange market. $eople buy more
shares only when their prices show a rising trend. This is because they get
more pro%t! if they sell their shares when the prices actually rise. Thus!
speculation becomes an exception to the law of demand.
9 +onspicuous necessaries
+onspicuous necessaries are those items which are purchased by
consumers even though their prices are rising on account of their
special uses in our modern style of life.
(n case of articles like wrist watches! scooters! motorcycles! tape recorders!
mobile phones etc customers buy more in spite of their high prices.

:. !mergencies
Buring emergency periods like war! famine! Coods cyclone! accidents etc.!
people buy certain articles e*en though the prices are .uite high.
;. Ignorance
Sometimes people may not be aware of the prices pre*ailing in the market.
=ence! they buy more at higher prices because of sheer ignorance.
<. =ecessaries
=ecessaries are those items which are purchased by consumers
what ever may be the price. Donsumers would buy more necessaries in
spite of their higher prices.

+hanges -r )hifts In $emand
(t is to be clearly understood that if demand changes only because of
changes in the price of the gi*en commodity in that case there would be only
either expansion or contraction in demand. #oth of them can be explained
with the help of only one demand cur*e. If demand changes not because
of price changes but because of other factors or forces, then in that
case there would be either increase or decrease in demand. (f
demand increases! there would be forward shift in the demand cur*e to the
right and if demand decreases! then there would be backward shift in the
demand cure.
,earning ob>ective ? 6
@nderstand the various determinates demand and demand function
Bemand for a commodity or ser*ice is determined by a number of factors. All
such factors are called as @demand determinants<.
'. $rice of the gi*en commodity! prices of other substitutes andEor
complements! future expected trend in prices etc.
). 7eneral $rice le*el existing in the country, inCation or deCation.
-. Fe*el of income and li*ing standards of the people.
/. Si"e! rate of growth and composition of population. G
0. Tastes! preferences! customs! habits! fashion and styles
1. $ublicity! propaganda and ad*ertisements.
2. Huality of the product.
3. $ro%t margin kept by the sellers.
4. >eather and climatic conditions.
'I. Donditions of trade, boom or prosperity in the economy.
''. Terms J conditions of trade.
'). 7o*ernments< policy, taxation! liberal or restricti*e measures.
'-. Fe*el of sa*ings J pattern of consumer expenditure.
'/. Total supply of money circulation and li.uidity preference of the people.
'0. (mpro*ements in educational standards etc.
Thus! se*eral factors are responsible for bringing changes in the demand for
a product in the market. A business executi*e should ha*e the knowledge
and information about all these factors and forces in order to %nali"e his own
production marketing and other business strategies.
$emand function
%he demand function for a product e/plains the quantities of a
product demanded due to di2erent factors other than price in the
market at a particular point of time
G
Meaning And )efinition
'5e term elasticit4 is 9orro;ed from p54sics% It s5o;s t5e reaction of one 7aria9le
;it5 respect to a c5ange in ot5er 7aria9les on ;5ic5 it is dependent% Elasticit4 is an
inde< of reaction%
In economics the term elasticity refers to a ratio of the relative changes in two $uantities.
It measures the responsiveness of one variable to the changes in another variable. *
Elasticit4 of demand is generall4 defined as t5e responsi7eness or sensiti7eness of
demand to a gi7en c5ange in t5e price of a commodit4% It refers to the capacity of
demand either to stretch or shrink to a given change in price. 2lasticity of demand
indicates a ratio of relative changes in two $uantities.ie, price and demand. -ccording to
prof. %oulding. !2lasticity of demand measures the responsiveness of demand to changes
in price".& In the words of 'arshall," he elasticity 3or responsiveness4 of demand in a
market is great or small according to as the amount demanded much or little for a given
fall in price, and diminishes much or little for a given rise in price" )
2inds of elasticit4 of demand
%roadly speaking there are five kinds of elasticities of demand. 1e shall discuss each one
of them in some detail.
Price Elasticit4 Of )emand
5rice elasticity of demand is one of the important concepts of elasticity which is used to
describe the effect of change in price on $uantity demanded. In the words of
5rof. .(tonier and 6ague, price elasticity of demand is a technical term used by
economists to explain the degree of responsiveness of the demand for a product to a
change in its price. It is measured by using the following formula.

7riginal demand / )8 units original price / 9 : 88
+ew demand / 98 units +ew price / ; : 88
In the above example, price elasticity is : 9.
%ased on numerical values of the co-efficient of elasticity, we can have the following five
degrees of price elasticity of demand.


)ifferent )egree of Price Elasticit4 of )emand
&. Perfectl4 Elastic )emand= In this case, a very small change in price leads to an
infinite change in demand. he demand cure is a hori#ontal line and parallel to
7< axis. he numerical co-efficient of perfectly elastic demand is infinity
32./884
&. Perfectl4 Inelastic )emand= In this case, what ever may be the change in price,
$uantity demanded will remain perfectly constant. he demand curve is a vertical
straight line and parallel to 7= axis. >uantity demanded would be &8 units,
irrespective of price changes from ?s. &8.88 to ?s. ).88. 6ence, the numerical co-
efficient of perfectly inelastic demand is #ero. 2. / 8

&. #elati7e Elastic )emand= In this case, a slight change in price leads to more than
proportionate change in demand. 7ne can notice here that a change in demand is
more than that of change in price. 6ence, the elasticity is greater than one. For
e.g., price falls by 3 @ and demand rises by A @. 6ence, the numerical co-
efficient of demand is greater than one.



&. #elati7el4 Inelastic )emand In this case, a large change in price, say B @ fall
price, leads to less than proportionate change in demand, say ; @ rise in demand.
7ne can notice here that change in demand is less than that of change in price.
his can be represented by a steeper demand curve. 6ence, elasticity is less than
one.

In all economic discussion, relatively elastic demand is generally called as Celastic
demandD or Cmore elasticD demand while relatively inelastic demand is popularly known
as Cinelastic demandD or Cless elastic demandD.
&. Unitar4 elastic demandE In this case, proportionate change in price leads to e$ual
proportionate change in demand. For e.g., F @ fall in price leads to exactly F @
increase in demand. 6ence, elasticity is e$ual to unity. It is possible to come
across unitary elastic demand but it is a rare phenomenon.


7ut of five different degrees, the first two are theoretical and the last one is a rare
possibility. 6ence, in all our general discussion, we make reference only to two terms-
relatively elastic demand and relatively inelastic demand.

)eterminants Of Price Elasticit4 Of )emand
he elasticity of demand depends on several factors of which the following are some
of the important ones.
1% !at6re of t5e Commodit4
,ommodities coming under the category of necessaries and essentials tend to be inelastic
because people buy them whatever may be the price.
2% E<istence of S69stit6tes
S69stit6te goods are t5ose t5at are considered to 9e economicall4 interc5angea9le
94 964ers%
+% !6m9er of 6ses for t5e commodit4
Single-6se goods are t5ose items ;5ic5 can 9e 6sed for onl4 one p6rpose and
m6ltiple-6se goods can 9e 6sed for a 7ariet4 of p6rposes% If a commodity has only one
use 3singe use product4 then in that case, demand tends to be inelastic because people
have to pay more prices if they have to use that product for only one use.
,% )6ra9ilit4 and repara9ilit4 of a commodit4
)6ra9le goods are t5ose ;5ic5 can 9e 6sed for a long period of time% .emand tends
to be elastic in case of durable and repairable goods because people do not buy them
fre$uently.
.% Possi9ilit4 of postponing t5e 6se of a commodit4
In case there is no possibility to postpone the use of a commodity to future, the demand
tends to be inelastic because people have to buy them irrespective of their prices.
6% $e7el of Income of t5e people
Generally speaking, demand will be relatively inelastic in case of rich people because any
change in market price will not alter and affect their purchase plans. 7n the contrary,
demand tends to be elastic in case of poor.
/% #ange of Prices
here are certain goods or products like imported cars, computers, refrigerators, H etc,
which are costly in nature. (imilarly, a few other goods like nailsI needles etc. are low
priced goods. In all these case, a small fall or rise in prices will have insignificant effect
on their demand. 6ence, demand for them is inelastic in nature. 6owever, commodities
having normal prices are elastic in nature.
1% Proportion of t5e e<pendit6re on a commodit4
1hen the amount of money spent on buying a product is either too small or too big, in
that case demand tends to be inelastic. For example, salt, newspaper or a site or house.
7n the other hand, the amount of money spent is moderateI demand in that case tends to
be elastic. For example, vegetables and fruits, cloths, provision items etc.
3 0a9its
1hen people are habituated for the use of a commodity, they do not care for price
changes over a certain range. For example, in case of smoking, drinking, use of tobacco
etc. In that case, demand tends to be inelastic. If people are not habituated for the use of
any products, then demand generally tends to be elastic.
10% Period of time
5rice elasticity of demand varies with the length of the time period. Generally speaking,
in the short period, demand is inelastic because consumption habits of the people,
customs and traditions etc. do not change. 7n the contrary, demand tends to be elastic in
the long period where there is possibility of all kinds o f changes.
11% $e7el of 2no;ledge
.emand in case of enlightened customer would be elastic and in case of ignorant
customers, it would be inelastic.
12% E<istence of complementar4 goods
"oods or ser7ices ;5ose demands are interrelated so t5at an increase in t5e price of
one of t5e prod6cts res6lts in a fall in t5e demand for t5e ot5er% Goods which are
jointly demanded are inelastic in nature. For example, pen and ink, vehicles and petrol,
shoes and cocks etc have inelastic demand for this reason. If a product does not have
complements, in that case demand tends to be elastic. For example, biscuits, chocolates,
ice8creams etc. In this case the use of a product is not linked to any other products.
&. P6rc5ase fre86enc4 of a prod6ct
If the fre$uency of purchase is very high, the demand tends to be inelastic. For e.g.,
coffee, tea, milk, match box etc. on the other hand, if people buy a product occasionally,
in that case demand tends to be elastic for example, durable goods like radio, tape
recorders, refrigerators etc.
hus, the demand for a product is elastic or inelastic will depend on a number of factors.
Meas6rement of price elasticit4 of demand
here are different methods to measure the price elasticity of demand and among them
the following two methods are most important ones.
&. otal expenditure method.
). 5oint method.
3. -rc method.
1% 'otal E<pendit6re Met5od
Under t5is met5od- t5e price elasticit4 is meas6red 94 comparing t5e total
e<pendit6re of t5e cons6mers >or total re7en6e i%e%- total sales 7al6es from t5e point
of 7ie; of t5e seller? 9efore and after 7ariations in price% 1e measure price elasticity
by examining the change in total expenditure as a result of change in the price and
$uantity demanded for a commodity.

'otal e<pendit6re @ Price per 6nit < 'otal 86antit4 p6rc5ased

Price in >#s%? At4 )emanded 'otal e<pendit6re !at6re of PE)
I Case F.88 )888 &8888 J &

;.88 3888 &)888

).88 K888 &;888
II Case F.88 )888 &8888
/ & ;.88 )F88 &8888

).88 F888 &8888
III Case F.88 )888 &8888
L & ;.88 ))88 B888

).88 ;)88 B;88
!ote=
&. 1hen new outlay is greater than the original outlay, then 2. J &.
). 1hen new outlay is e$ual to the original outlay then 2. / &.
3. 1hen new outlay is less than the original outlay then 2. L &.
"rap5ical #epresentation

From the diagram it is clear that
&. From - to % price elasticity is greater than one.
). From % to , price elasticity is e$ual than one.
3. From , to . price elasticity is lesser than one.

(. 3oint MethodK
$rof. Marshall ad*ocated this method. %he point method measures price
elasticity of demand. at di2erent points on a demand curve. =ence! in
this case attempt is made to measure small changes in both price and
demand.
"rap5ical representation
he simplest way of explaining the point method is to consider a linear or straight- line
demand curve. Met the straight : line demand curve be extended to meet the two axis <
and = when a point is plotted on the demand curve, it divides the curve into two
segments. he point elasticity is measured by the ration of lower segment of the demand
curve below, the given point to the upper segment of the curve above the point. 6ence.

In short, e / M N O where e stands for 5oint elasticity, M for lower segment and O for
upper segment.
In the diagram -% is the straight line demand curve and 5 is is a given point. 5% is the
lower segment and 5- is the upper segment.


In the diagram, -% is the straight-line demand curve and 5 is a give point 5% is the
lower segment and 5- is the upper segment.
2 / M N O / 5% N 5-
If after the actual measurement of the two parts of the demand curve, we find that
5% / 3 ,'s and 5- / ) ,'s then elasticity at 5oint 5 is 3 N ) / &.F
If the demand curve is non:linear then we have to draw a tangent at the given point
extending it to intersect both axes. 5oint elasticity is measure by the ratio of the lower
part of the tangent below that given point to the upper part of the tangent above the point.
hen, elasticity at point 5 can be measured as 5% N 5-.
In case of point method, the demand function is continuous and hence, only marginal
changes can be measured. In short, 2p is measured only when changes in price and
$uantity demanded are small.
+% Arc Met5od
his method is suggested to measure large changes in both price and demand. B5en
elasticit4 is meas6red o7er an inter7al of a demand c6r7e- t5e elasticit4 is called as
an inter7al or Arc elasticit4% It is t5e a7erage elasticit4 o7er a segment or range of
t5e demand c6r7e% 6ence, it is also called as average elasticity of demand.
he following formula is used to measure -rc elasticity.

Ill6stration
5& / original price &8 : 88. >& / original $uantity / )88 units

5) / +ew price 8F : 88 >) / +ew $uantity / 388units %y substituting the
values in to the e$uation, we can find out -rc elasticity of demand. G

In the diagram, in order to measure arc elasticity between two points ' P + on the
demand curve, one has to take the average of prices 75& and 75) and also the average
$uantities of >& P >).
Practical application of price elasticit4 of demand
1% Prod6ction planning
It helps a producer to decide about the volume of production. If the demand for his
products is inelastic, specific $uantities can be produced while he has to produce different
$uantities, if the demand is elastic.
2% 0elps in fi<ing t5e prices of different goods
It helps a producer to fix the price of his product. If the demand for his product is
inelastic, he can fix a higher price and if the demand is elastic, he has to charge a lower
price. hus, price-increase policy is to be followed if the demand is inelastic in the
market and price-decrease policy is to be followed if the demand is elastic.
(imilarly, it helps a monopolist to practice price discrimination on the basis of elasticity
of demand.
2% 0elps in fi<ing t5e re;ards for factor inp6ts
actor re;ards refers to t5e price paid for t5eir ser7ices in t5e prod6ction process%
It helps the producer to determine the rewards for factors of production. If the demand for
any factor unit is inelastic, the producer has to pay higher reward for it and vice-versa.
+% 0elps in determining t5e foreign e<c5ange rates
E<c5ange rate refers to t5e rate at ;5ic5 c6rrenc4 of one co6ntr4 is con7erted in to
t5e c6rrenc4 of anot5er co6ntr4% It helps in the determination of the rate of exchange
between the currencies of two different nations. For e.g. if the demand for O( dollar to an
Indian rupee is inelastic, in that case, an Indian has to pay more Indian currency to get
one unit of O( dollar and vice-versa.
,% 0elps in determining t5e terms of trade
It is the basis for deciding the Cterms of tradeD between two nations. '5e terms of trade
implies t5e rate at ;5ic5 t5e domestic goods are e<c5anged to foreign goods% For e.g.
if the demand for QapanDs products in India is inelastic, in that case, we have to pay more
in terms of our commodities to get one unit of a commodity from Qapan and vice-versa.
.% 0elps in fi<ing t5e rate of ta<es
'a<es refer to t5e comp6lsor4 pa4ment made 94 a citiCen to t5e go7ernment
periodicall4 ;it5o6t e<pecting an4 direct ret6rn 9enfit from it% It helps the finance
minister to formulate sound taxation policy of the country. 6e can impose more taxes on
those goods for which the demand is inelastic and fewer taxes if the demand is elastic in
the market.
6% 0elps in )eclaration of P69lic Utilities
P69lic 6tilities are t5ose instit6tions ;5ic5 pro7ide certain essential goods to t5e
general p69lic at economical prices% he Government may declare a particular industry
as Cpublic utilityD or nationali#e it, if the demand for its products is inelastic.
/% Po7ert4 in t5e Midst of Plent4E
he concept explains the paradox of poverty in the midst of plenty. - bumper crop of
rice or wheat instead of bringing prosperity to farmers may actually bring poverty to them
because the demand for rice and wheat is inelastic.
hus, the concept of price elasticity of demand has great practical application in
economic theory.

I!COME E$AS'ICI'* O )EMA!)
Income elasticit4 of demand ma4 9e defined as t5e ratio or proportionate c5ange in
t5e 86antit4 demanded of a commodit4 to a gi7en proportionate c5ange in t5e
income% In short, it indicates the extent to which demand changes with a variation in
consumers income. he following formula helps to measure 2y.


7riginal demand / ;88 units 7riginal Income / ;888-88
+ew demand / K88 units +ew Income / 9888-88

Generally speaking, 2y is positive. his is because there is a direct relationship between
income and demand, i.e. higher the incomeI higher would be the demand and vice-versa.
7n the basis of the numerical value of the co-efficient, 2y is classified as greater than
one, less than one, e$ual to one, e$ual to #ero, and negative. he concept of 2y helps us
in classifying commodities into different categories.
&. 1hen 2y is positive, the commodity is normal Rused in day-to-day lifeS
). 1hen 2y is negative, the commodity is inferior. .For example Qowar, beedi etc.
3. 1hen 2y is positive and greater than one, the commodity is luxury.
;. 1hen 2y is positive, but less than one, the commodity is essential.
F. 1hen 2y is #ero, the commodity is neutral e.g. salt, match box etc.
Practical application of income elasticit4 of demand
&. 0elps in determining t5e rate of gro;t5 of t5e firm%
If the growth rate of the economy and income growth of the people is reasonably
forecasted, in that case it is possible to predict expected increase in the sales of a firm and
vice-versa%
2% 0elps in t5e demand forecasting of a firm%
It can be used in estimating future demand provided the rate of increase in income and 2y
for the products are known. hus, it helps in demand forecasting activities of a firm.
+% 0elps in prod6ction planning and mar:eting
he knowledge of 2y is essential for production planning, formulating marketing
strategy, deciding advertising expenditure and nature of distribution channel etc in the
long run.
,% 0elps in ens6ring sta9ilit4 in prod6ction
5roper estimation of different degrees of income elasticity of demand for different types
of products helps in avoiding over-production or under production of a firm. 7ne should
also know whether rise or fall in come is permanent or temporary.
.% 0elps in estimating constr6ction of 5o6ses%
he rate of growth in incomes of the people also helps in housing programs in a
country. hus, it helps a lot in managerial decisions of a firm.
Cross Elasticit4 Of )emand
It ma4 9e defined as t5e proportionate c5ange in t5e 86antit4 demanded of a
partic6lar commodit4 in response to a c5ange in t5e price of anot5er related
commodit4% In the words of 5rof. 1atson cross elasticity of demand is the percentage
change in $uantity associated with a percentage change in the price of related goods.
Generally speaking, it arises in case of substitutes and complements. he formula for
calculating cross elasticity of demand is as follows.

2c / 5ercentage change in $uantity demanded commodity <
5ercentage change in the price of =
5rice of ea rises from ?s. ;-88 to 9 -88 per cup
.emand for coffee rises from F8 cups to B8 cups.
,ross elasticity of coffee in this case is &.9.
It is to be noted that-
&. ,ross elasticity of demand is positive in case of good substitutes e.g. coffee and tea.
). 6igh cross elasticity of demand exists for those commodities which are close
substitutes. In other words, if commodities are perfect substitutes For example %ata or
,orona (hoes, close up or pepsodent tooth paste, %eans and ladies finger, 5epsi and coca
cola etc.
3. he cross elasticity is #ero when commodities are independent of each other. For
example, stainless steel, aluminum vessels etc.
;. ,ross elasticity between two goods is negative when they are complementaries. In
these cases, rise in the price of one will lead to fall in the $uantity demanded of another
commodity For example, car and petrol, pen and ink.etc.
Practical application of cross elasticit4 of demand
1% 0elps at t5e firm le7el
*nowledge of cross elasticity of demand is essential to study the impact of change in the
price of a commodity which possesses either substitutes or complementaries. If accurate
measures of cross elasticities are available, a firm can forecast the demand for its product
and can adopt necessary safe guard against fluctuating prices of substitutes and
complements. he pricing and marketing strategy of a firm would depend on the extent of
cross elasticities between different alternative goods.
2% 0elps at t5e ind6str4 le7el
*nowledge of cross elasticity would help the industry to know whether an industry has
any substitutes or complementaries in the market. his helps in formulating various
alternative business strategies to promote different items in the market.

Ad7ertising Or Promotional Elasticit4 Of )emand%
'ost of the firms, in the present marketing conditions spend considerable amounts of
money on advertisement and other such sales promotional activities with the object of
promoting its sales. Ad7ertising elasticit4 refers to t5e responsi7eness demand or
sales to c5ange in ad7ertising or ot5er promotional e<penses% he formula to calculate
the advertising elasticity is as follows.

G
7riginal sales / &8,888 units original advertisement expenditure / B88-88
+ew sales / F8,888 units new advertisement expenditure / )888-88
In the above example, advertising elasticity of demand is &.9K. it implies that for every
one time increase in advertising expenditure, the sales would go up &.9K times hus, 2a is
more than one.
Practical application of ad7ertising elasticit4 of demand
he study of advertising elasticity of demand is of paramount importance to a firm in
recent years because of fierce competition.
1% 0elps in determining t5e le7el of prices
he level of prices fixed by one firm for its product would depend on the amount of
advertisement expenditure incurred by it in the market.
2% 0elps in form6lating appropriate sales promotional strateg4 *
he volume of advertisement expenditure also throws light on the sales promotional
strategies adopted by a firm to push off its total sales in the market. hus, it helps a firm
to stimulate its total sales in the market.

+% 0elps in manip6lating t5e sales
It is useful in determining the optimum level of sales in the market. his is because the
sales made by one firm would also depend on the total amount of money spent on sales
promotion of other firms in the market.

S69stit6tion Elasticit4 Of )emand%
It measures the effects of the substitution of one commodity for another. It ma4 9e
defined as t5e proportionate c5ange in t5e demand ratios of t;o s69stit6te goods D
and 4 to t5e proportionate c5ange in t5e price ratio of t;o goods D and * he
following formulas is used to measure substitution elasticity of demand.


1here .x N .y is ratio of $uantity demanded of two goods < P =.
.elta .< N .y is the change in the $uantity ratio of two goods < P =.
5< N 5y is the price ratio of two goods < P =.
.elta 5< N 5= is change in price ratio of two goods < P =
Practical Application Of S69stit6tion Elasticit4 Of )emand
he concept of substitution elasticity is of great importance to a firm in the context of
availability of various kinds of substitutes for one factor inputs to another. For example,
let us assume one computer can do the job of &8 laborers and if the cost of computer
becomes cheaper than employing workers, in that case, a firm would certainly go for
substituting workers for computers. .-n employer would always compare the cost of
different alternative inputs and employ those inputs which are much cheaper than others
to cut down his cost of operations. hus, the concept of elasticity of demand has great
theoretical as well as practical application in economic theory.

S6mmar4
.emand is created by consumers. ,onsumers can create demand only when they have
ade$uate purchasing power and willingness to buy different goods and services. here is
a direct relationship between utility and demand. Maw of demand tells us that there is an
inverse relationship between price and demand in general. (ometimes customers buy
more in spite of rise in the prices of some commodities. hus, the law of demand has
certain exceptions. .emand for a product not only depends on price but also on a number
of other factors. In order to know the $uantitative changes in both price and demand, one
has to study elasticity of demand. 5rice elasticity of demand indicates the percentage
changes in demand as a conse$uence of changes in prices. he response from demand to
price changes is different. 6ence, we have elastic and inelastic demand. 7ne can exactly
measure the extent of price elasticity of demand with the help of different methods like
point and -rc methods. Income elasticity measures the $uantum of changes in demand
and changes in income of the customers. ,ross elasticity tells us the extent of change in
the price of one commodity and corresponding changes in the demand for another related
commodity. (ubstitution elasticity measures the amount of changes in demand ratio of
two substitute goods to changes in price ratio of two substitute goods in the market. he
concept of elasticity of demand has great theoretical and practical application in all
aspects of business life.
.
MB0026- Unit -+- )emand orecasting
Unit -+- )emand orecasting


Introd6ction
-n important aspect of demand analysis from the management point of view is concerned
with forecasting demand for products, either existing or new. .emand forecasting refers
to an estimate of most likely future demand for product under given conditions. (uch
forecasts are of immense use in making decisions with regard to production, sales,
investment, expansion, employment of manpower etc., both in the short run as well as in
the long run. Forecasts are made at micro level and macro level. here are different
methods of forecasts like survey methods and statistical methods generally for the
existing products and for new products depending upon the nature, number of methods
like evolutionary approach substitute approach, growth curve approach etc.

Meaning And eat6res

.emand forecasting seeks to investigate and measure the forces that determine sales for
existing and new products. )emand orecasting refers to an estimation of most li:el4
f6t6re demand for a prod6ct 6nder gi7en conditions%
Important features of demand forecasting
It is basically a guess work : but it is an educated and well thought out
guesswork.
It is in terms of specific $uantities
It is undertaken in an uncertain atmosphere.
- forecast is made for a specific period of time which would be sufficient to take
a decision and put it into action.
It is based on historical information and the past data.
It tells us only the approximate demand for a product in the future.
It is based on certain assumptions.
It cannot be &88@ precise as it deals with future expected demand
Bemand forecasting is needed to know whether the demand is sub+ect to
cyclical Cuctuations or not! so that the production and in*entory policies! etc!
can be suitably formulated
Managerial 6ses of demand forecasting=
In t5e s5ort r6n=
.emand forecasts for short periods are made on the assumption that the company has a
given production capacity and the period is too short to change the existing production
capacity. Generally it would be one year period.
Prod6ction planningE It helps in determining the level of output at various
periods and avoiding under or over production.
0elps to form6late rig5t p6rc5ase polic4= It helps in better material
management, of buying inputs and control its inventory level which cuts down
cost of operation.
0elps to frame realistic pricing polic4= - rational pricing policy can be
formulated to suit short run and seasonal variations in demand.
Sales forecasting= It helps the company to set realistic sales targets for each
individual salesman and for the company as a whole.
0elps in estimating s5ort r6n financial re86irements= It helps the company to
plan the finances re$uired for achieving the production and sales targets. he
company will be able to raise the re$uired finance well in advance at reasonable
rates of interest.
#ed6ce t5e dependence on c5ances= he firm would be able to plan its
production properly and face the challenges of competition efficiently.
0elps to e7ol7e a s6ita9le la9o6r polic4= - proper sales and production policies
help to determine the exact number of labourers to be employed in the short run.

In t5e long r6n=
Mong run forecasting of probable demand for a product of a company is generally for
a period of 3 to F or &8 years.
&. B6siness planning=
It helps to plan expansion of the existing unit or a new production unit. ,apital budgeting
of a firm is based on long run demand forecasting.
&. inancial planning=
It helps to plan long run financial re$uirements and investment programs by floating
shares and debentures in the open market.
&. Manpo;er planning =
It helps in preparing long term planning for imparting training to the existing staff and
recruit skilled and efficient labour force for its long run growth.
&. B6siness control =
2ffective control over total costs and revenues of a company helps to determine the value
and volume of business. his in its turn helps to estimate the total profits of the firm.
hus it is possible to regulate business effectively to meet the challenges of the market.
&. )etermination of t5e gro;t5 rate of t5e firm =
- steady and well conceived demand forecasting determine the speed at which the
company can grow.
&. Esta9lis5ment of sta9ilit4 in t5e ;or:ing of t5e firm =
Fluctuations in production cause ups and downs in business which retards smooth
functioning of the firm. .emand forecasting reduces production uncertainties and help in
stabili#ing the activities of the firm.
&. Indicates interdependence of different ind6stries =
.emand forecasts of particular products become the basis for demand forecasts of other
related industries, e.g., demand forecast for cotton textile industry supply information to
the most likely demand for textile machinery, colour, dye-stuff industry etc.,
&. More 6sef6l in case of de7eloped nations=
It is of great use in industrially advanced countries where demand conditions
fluctuate much more than supply conditions.
he above analysis clearly indicates the significance of demand forecasting in the
modern business set up.
$earning o9Eecti7e 2
,evels -f $emand orecasting
.emand forecasting may be undertaken at three different levels, vi#., micro level or firm
level, industry level and macro level.
Micro le7el or firm le7el
his refers to the demand forecasting by the firm for its product.
Ind6str4 le7el
.emand forecasting for the product of an industry as a whole is generally undertaken by
the trade associations and the results are made available to the members. - member firm
by using such data and information may determine its market share.
Macro-le7el
2stimating industry demand for the economy as a whole will be based on macro-
economic variables like national income, national expenditure, consumption function,
index of industrial production, aggregate demand, aggregate supply etc,
Criteria or "ood )emand orecasting
-part from being technically efficient and economically ideal a good method of demand
forecasting should satisfy a few broad economic criteria. hey are as followsE
Acc6rac4= -ccuracy is the most important criterion of a demand forecast, even though
cent percent accuracy about the future demand cannot be assured. It is generally
measured in terms of the past forecasts on the present sales and by the number of times it
is correct.
Pla6si9ilit4= he techni$ues used and the assumptions made should be intelligible to the
management. It is essential for a correct interpretation of the results.
Simplicit4= It should be simple, reasonable and consistent with the existing knowledge. -
simple method is always more comprehensive than the complicated one
)6ra9ilit4= .urability of demand forecast depends on the relationships of the variables
considered and the stability underlying such relationships, as for instance, the relation
between price and demand, between advertisement and sales, between the level of
income and the volume of sales, and so on.
le<i9ilit4= here should be scope for adjustments to meet the changing conditions. his
imparts durability to the techni$ue.
A7aila9ilit4 of data= Immediate availability of re$uired data is of vital importance to
business. It should be made available on an up-to-date basis. here should be scope for
making changes in the demand relationships as they occur.
Econom4= It should involve lesser costs as far as possible. Its costs must be compared
against the benefits of forecasts
A6ic:nessE It should be capable of yielding $uick and useful results. his helps the
management to take $uick and effective decisions.
$earning o9Eecti7e +

Anal4Ce different met5ods demand forecasting for 9ot5 old and ne; prod6cts
Met5ods or 'ec5ni86es of orecasting

%roadly speaking, there are two methods of demand forecasting. hey areE &.(urvey
methods and ) (tatistical methods.
S6r7e4 Met5ods
(urvey methods help us in obtaining information about the future purchase plans of
potential buyers through collecting the opinions of experts or by interviewing the
consumers. hese methods are extensively used in short run and estimating the demand
for new products. here are different approaches under survey methods. hey are
A% Cons6mersF inter7ie; met5od=
Under t5is met5od- efforts are made to collect t5e rele7ant information directl4
from t5e cons6mers ;it5 regard to t5eir f6t6re p6rc5ase plans%
S6r7e4 of 964erFs intentions or preferences= It is one of the oldest methods of demand
forecasting. It is also called as !7pinion surveys".
Under t5is met5od- cons6mer-964ers are re86ested to indicate t5eir preferences and
;illingness a9o6t partic6lar prod6cts% '5e4 are as:ed to re7eal t5eir Gf6t6re
p6rc5ase plans ;it5 respect to specific items.

)irect Inter7ie; Met5od
Under t5is met5od- c6stomers are directl4 contacted and inter7ie;ed% )irect and
simple 86estions are as:ed to t5em%
i% Complete en6meration met5od
Under t5is met5od- all potential c6stomers are inter7ie;ed in a partic6lar cit4 or a
region.
ii% Sample s6r7e4 met5od or t5e cons6mer panel met5od
2xperience of the expertsD show that it is impossible to approach all customersI as such
careful sampling of representative customers is essential. 6ence, another variant of
complete enumeration method has been developed, which is popularly known as sample
survey method. Under t5is met5od- different cross sections of c6stomers t5at ma:e
6p t5e 96l: of t5e mar:et are caref6ll4 c5osen% Onl4 s6c5 cons6mers selected from
t5e rele7ant mar:et t5ro6g5 some sampling met5od are inter7ie;ed or s6r7e4ed%
C% Collecti7e opinion met5od or opinion s6r7e4 met5od
This is a *ariant of the sur*ey method. This method is also known as Sales 6
force polling or Apinion poll method. @nder this method, sales
representatives, professional e/perts and the market consultants
and others are asked to e/press their considered opinions about the
volume of sales e/pected in the future.
)% )elp5i Met5od or E<perts Opinion Met5od
his method was originally developed at ?and ,orporation in the late &A;8Ds by 7laf
6elmer, .alkey and Gordon. his method was used to predict future technological
changes. It has proved more useful and popular in forecasting non: economic rather than
economical variables.
It is a variant of opinion poll and survey method of demand forecasting% Under t5is
met5od- o6tside e<perts are appointed% '5e4 are s6pplied ;it5 all :inds of
information and statistical data% '5e management re86ests t5e e<perts to e<press
t5eir considered opinions and 7ie;s a9o6t t5e e<pected f6t6re sales of t5e compan4%
E% End Use or Inp6t H O6tp6t Met5od
Under t5is met5od- t5e sale of t5e prod6ct 6nder consideration is proEected on t5e
9asis of demand s6r7e4s of t5e ind6stries 6sing t5e gi7en prod6ct as an intermediate
prod6ct.
Statistical Met5od
@nder this method, statistical, mathematical models, equations etc
are e/tensively used in order to estimate future demand of a
particular product.
A% 'rend ProEection Met5od
Time series is a set of obser*ations taken at speci%ed time! generally at e.ual
inter*als. (t depicts the historical pattern under normal conditions. This
method is not based on any particular theory as to what causes the *ariables
to change but merely assumes that whate*er forces contributed to change in
the recent past will continue to ha*e the same e5ect. -n the basis of time
series, it is possible to pro>ect the future sales of a company.
The heart of this method lies in the use of time series. Dhanges in time series
arise on account of the following reasonsK,
&. )ecular or long run movementsA Secular mo*ements indicate the
general conditions and direction in which graph of a time series mo*e
in relati*ely a long period of time.
). )easonal movementsA Time series also undergo changes during
seasonal sales of a company. Buring festi*al season! sales clearance
season etc.! we come across most unexpected changes.
3. +yclical MovementsA (t implies change in time series or Cuctuations
in the demand for a product during di5erent phases of a business cycle
like depression! re*i*al! boom etc.
;. Bandom movement. >hen changes take place at random! we call
them irregular or random mo*ements. These mo*ements imply
sporadic changes in time series occurring due to unforeseen e*ents
such as Coods! strikes! elections! earth .uakes! droughts and other
such natural calamities. Such changes take place only in the short run.
Still they ha*e their own impact on the sales of a company.

(n time series may make use of the following methods.
'. The Feast S.uares method.
). The 8ree hand method.
-. The mo*ing a*erage method.
/. The method of semi 6 a*erages.
The method of Feast S.uares is more scienti%c! popular and thus more
commonly used when compared to the other methods. (t uses the straight
line e.uation LM a N bx to %t the trend to the data.
o calculate the trend values i.e., =c, the regression e$uation used is :
=c / a0 bx.

-s the values of CaD and CbD are unknown, we can solve the following two normal
e$uations simultaneously.

1here,


?egression e$uation / =c / a 0 bx
.eriving trend line


rend projection method re$uires simple working knowledge of statistics, $uite
inexpensive and yields fairly reliable estimates of future course of demandT
B% Economic Indicators
2conomic indicators as a method of demand forecasting are developed recently. Onder
this method, a few economic indicators become the basis for forecasting the sales of a
company% An economic indicator indicates c5ange in t5e magnit6de of an economic
7aria9le% It gi7es t5e signal a9o6t t5e direction of c5ange in an economic 7aria9le%


)emand orecasting or A !e; Prod6ct
.emand forecasting for new products is $uite different from that for established
products. 6ere the firms will not have any past experience or past data for this purpose.
-n intensive study of the economic and competitive characteristics of the product
should be made to make efficient forecasts.
5rofessor Qoel .ean, however, has suggested a few guidelines to make forecasting of
demand for new products.
a% E7ol6tionar4 approac5
he demand for the new product may be considered as an outgrowth of an existing
product. For e.g., .emand for new ata Indica, which is a modified version of 7ld Indica
can most effectively be projected based on the sales of the old Indica, the demand for new
5ulsor can be forecasted based on the sales of the old 5ulsor. hus when a new product is
evolved from the old product, the demand conditions of the old product can be taken as a
basis for forecasting the demand for the new product.
9% S69stit6te approac5
If the new product developed serves as substitute for the existing product, the demand for
the new product may be worked out on the basis of a Cmarket shareD. he growths of
demand for all the products have to be worked out on the basis of intelligent forecasts for
independent variables that influence the demand for the substitutes. -fter that, a portion
of the market can be sliced out for the new product. For e.g., - moped as a substitute for
a scooter, a cell phone as a substitute for a land line. In some cases price plays an
important role in shaping future demand for the product.
c% Opinion Poll approac5
Onder this approach the potential buyers are directly contacted, or through the use of
samples of the new product and their responses are found out. hese are finally blown up
to forecast the demand for the new product%
d% Sales e<perience approac5
7ffer the new product for sale in a sample marketI say supermarkets or big ba#aars in big
cities, which are also big marketing centers. he product may be offered for sale through
one super market and the estimate of sales obtained may be Cblown upD to arrive at
estimated demand for the product%

e% "ro;t5 C6r7e approac5
-ccording to this, the rate of growth and the ultimate level of demand for the new
product are estimated on the basis of the pattern of growth of established products. For
e.g., -n -utomobile ,o., while introducing a new version of a car will study the level of
demand for the existing car.
f% (icario6s approac5
- firm will survey consumersD reactions to a new product indirectly through getting in
touch with some speciali#ed and informed dealers who have good knowledge about the
market, about the different varieties of the product already available in the market, the
consumersD preferences etc. his helps in making a more efficient estimation of future
demand.
hese methods are not mutually exclusive. he management can use a combination of
several of them supplement and cross check each other.

S6mmar4
-n important aspect of demand analysis from the management point of view is concerned
with forecasting demand either for existing or new products. .emand forecasting refers
to the estimation of future demand under given conditions. (uch forecasts have immense
managerial uses in the short run like production planning, formulating right purchase
policy, pricing policy, sales forecasting, estimating short run financial re$uirements,
reducing the dependence on chances, evolving suitable labor policy, control on stocks etc.
In the long run they help in efficient business planning, financial planning, regulating
business efficiently, determination of growth rate of firm, stabili#ing the activities of the
firm and help in the growth of industries dependent on each other providing re$uired
information particularly in the developed nations. .emand forecasts are done at micro
level, industry level and macro level. - good demand forecasting method must be
accurate, plausible, economical, durable, flexible, simple $uick yielding and permit
changes in the demand relationships on an up-to-date basis.
%roadly speaking there are two methods of demand forecasting : &. (urvey 'ethods, )
(tatistical 'ethods. Onder the survey methods there are a number of variants like
consumersD interview method, collective opinion method, expertsD opinion method and
end-use method. Onder the consumersD interview method demand forecasting is done
either by conducting a survey of buyersD intentions through $uestionnaire or by
interviewing directly all the consumers residing in a region or by forming a panel of
consumers. Onder the collective opinion method forecasts are made on the basis of the
information gathered from the sales men and market experts regarding the future demand
for the product. Onder the 2xpert opinion method assistance of outside experts are taken
to forecast future demand. he end use method is adopted to forecast the demand for the
intermediate products making use of the input-output coefficients for particular periods.
(tatistical methods like trend projection and economic indicators are generally used to
make long run demand forecasts. Onder the trend projection method, based on the past
data, adopting a regression analysis demand forecasts are made. (ometimes changes in
the magnitude of the economic variables too serve as a basis for demand forecasting. -
rise in the personal income indicates a rise in the demand for consumption goods.
In case of new products as the firm will not have any past experience or past sales data, it
will have to follow a few guidelines while making demand forecasts. .epending upon the
nature of the development of the product different approaches like evolutionary approach,
substitute, growth-curve, opinion poll, sales-experience, vicarious etc., are adopted.
hus a number of methods are being adopted to estimate the future demand for the
products, which is of very great importance in the efficient management of the business.
,opyright U )8&& SMU
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MB0026- Unit ,-Mar:et E86ili9ri6m
Unit ,-Mar:et E86ili9ri6m

SUPP$* A!A$*SIS
Introd6ction
he supply analysis is related to the behavior of producers or manufactures. (upply is
made by producers. 2ach firm has to make a careful calculation about its total supply in
the market. (upply analysis deals with mainly the different factors which bring about
changes in the supply of a product in the market. (upply of a product basically depends
on cost of production and the management decision. 6ence it covers such problems like
whereto sell, when to sell, for whom to sell, and how much to sell and at what price to
sell etc.
Meaning Of S6ppl4 And $a; Of S6ppl4
-ccording to homas, !he supply of goods is the $uantity offered for sale in a given
market at a given time at various prices. !-ccording to 5rof. 'acconnel : !supply may
be defined as a schedule which shows the various amounts of a product which a producer
is willing to and able to produce and make available for sale in the market at each
specific price in a set of possible prices during some given period." " o $uote 'eyers :
!1e may define supply as a schedule of the amount of a good that would be offered for
sale at all possible prices at any one instant of time, or during any one period of time, for
example, a day, a week and so on, in which the conditions of supply remain the same."
'56s s6ppl4 of a prod6ct refers to t5e 7ario6s amo6nts ;5ic5 are offered for sale at
a partic6lar price d6ring a gi7en period of time%
(upply is also different from stock% Stoc: is t5e total 7ol6me of a commodit4 ;5ic5
can 9e 9ro6g5t into t5e mar:et for sale at a s5ort notice and s6ppl4 means t5e
86antit4 ;5ic5 is act6all4 9ro6g5t in t5e mar:et. For perishable commodities, like
fish and fruits, supply and stock are the same because they cannot be stored. he
commodities which are not perishable can be held back, if prices are not favorable and
released in large $uantities when prices are favorable. In short, stock is potential supply.
S6ppl4 Sc5ed6le
S6ppl4 sc5ed6le is a ta96lar representation of different 86antities of a commodit4
s6pplied at 7ar4ing prices. It represents the functional relationship between $uantity
supplied and price. It is strictly prepared with reference to the price of a given
commodity.
he following imaginary supply schedule shows that as price rises, supply extends and as
price falls, supply contracts. (upply schedule is never absolute. It varies with different
prices and at different times. 8.KF paisa is the minimum price to be charged per unit
because it e$uals cost of production. +o producer would like to charge cost price to
customers. 6ence, supply is #ero at this price. It is called as reserve price.

Price in #s% A6antit4 s6pplied in Units
F-88 F88
;-88 ;88
3-88 388
)-88 )88
&-88 &88
8-KF 88
Mar:et s6ppl4 Sc5ed6le
'5e total 86antit4 of commodit4 s6pplied at different prices in a mar:et 94
t5e ;5ole 9od4 of sellers is called as mar:et s6ppl4 sc5ed6le% It refers to the aggregate
behavior of the market rather than mere totaling of all individual supply schedules.
Price in #s%
A6antit4 S6pplied in Units
'otal >AIBIC?
A B C
F.88 F88 988 K88 &B88
;.88 ;88 F88 988 &F88
3.88 388 ;88 F88 &)88
).88 )88 388 ;88 A88
&.88 &88 )88 388 988

he market supply schedule helps a firm to formulate its sales policy by manipulating the
prices. It helps the management to know how much sales can be increased by raising the
price without losing the demand for the product.
)upply +urve
%he supply curve is a geometrical representation of the supply
schedule. The upward sloping cur*e clearly indicates that as price rises!
.uantity supplied expands and *ice,*ersa.
'5e $a; of S6ppl4
It states t5at JOt5er t5ings remaining constant- t5e 86antit4 s6pplied 7aries directl4
;it5 t5e price i%e% ;5en t5e price falls- s6ppl4 ;ill contract and ;5en price rises-
s6ppl4 ;ill e<tend!. -ccording to (.2.homas, !a rise in price tends to increase supply
and a fall in price tends to reduce it." here is a functional relationship between supply
and price. 'athematically (/ F 354. he law of supply is based on a number of
assumptions.
he other things which should remain constant for the law to operate areE
&. +umber of firms, the scale of production and the speed of production.
). -vailability of other inputs.
3. echni$ues of production.
;. ,ost of production.
F. 'arket prices of other related goods. G
9. ,limate and weather conditions.
Special feat6res of la; of s6ppl4 *
&. here is a direct relationship between price and supply i.e., higher the prices
higher will be the supply and vice-versa.
). 5rice is an independent variable and supply is a dependent variable.
3. he applicability of the law is conditioned by the phrase !7ther things being
e$ual". hus the law is not universal in nature.
;. he supply curve normally rises from left to right.
F. It is only $ualitative statement.
E<ceptions 'o '5e $a; Of S6ppl4
7enerally supply expands with the rise in price and contract with the fall in
price. Cut under certain e/ceptional circumstances, in spite of rise in
price supply may not e/pand or at a lower rate more quantity may
be sold. This will happen under exceptional situations. (n this case! the
supply cur*e slopes backward.
In the diagram when price is ?s. F.88, &8 units are sold and when price is ?s. 9.88, 38
units are sold. %ut, when price rises to ?s. B.88 $uantity supplied falls from 38 units to )8
units.
he following are some of the exceptions to the law of supply.
&. If the seller is badly in need of money, he will sell more even at lower prices.
). If the seller wants to get rid of his products, then also he will sell more at reduced
rates.
3. 1hen further heavy fall in price is anticipated the seller may become panicky and
sell more at a current lower price.
;. In case of auction, the auctioneer is not interested in maximi#ing profits by selling
more units at a higher price. 6ere, the price is determined by the bidder while
selling an item in an auction, the auctioner may have some other motives to sell
the product. hus, an auction sale is an exception to the law of supply.

C5anges Or S5ifts In S6ppl4
B5en s6ppl4 of a prod6ct c5anges onl4 d6e to a c5ange in t5e price of t5at prod6ct
alone- it is called as eit5er e<pansion or contraction in s6ppl4% 2xpansion in supply
means, more $uantity is supplied at a higher price and contraction in supply means, less
$uantity is supplied at a lower price.
his tendency can be represented through a single supply curve. In this case, the seller
will be moving either in the upward or downward direction along with the same supply
curve. It is clear from the following diagram.

(n the diagram! we can notice that when price is 9s. ).II! )I units are sold
and when the price rises to 9s. /.II! /I units are sold :extension;. An the
other hand! when price falls from 9s. /.II to 9s. ).II .uantity supplied also
falls from /I to )I units.
(upply of a product may change due to changes in other factors. If supply changes not
because of changes in price, but because of changes in other determinants, then, it will be
a case of either increase or decrease in supply.
Increase in S6ppl4
It implies more s6ppl4 at t5e same price or same 86antit4 of s6ppl4 at a lo;er price%
In this case, we have to draw a new supply curve. In the diagram, 7riginal price / ?s
9.88
7riginal supply / &8 units 7riginal supply ,urve / ((
+ow the seller sells )8 units at the same price of ?s. 9/88.6ence, we get a new point 5D.
or same $uantity of &8 units are sold at a lower price of ?s. ;/88. 6ence, we get another
new point 5". If we join these two new points 5DP5" we get a new supply curve (D(D.
here is forward shift in the position of supply curve. Forward shift indicates increase in
supply.
)ecrease in s6ppl4
It implies t5at less 86antit4 is s6pplied at t5e same price or same 86antit4 is
s6pplied at a 5ig5er price. In this case also, we have to draw a new supply curve.

In the diagram,
7riginal price / ?s.;/88
7riginal supply / )8 units
7riginal supply ,urve / ((

>hen less .uantity of 'I units are supplied at the same price of 9s./.II! we
get a new point $. Similarly! when same .uantity of )I units is supplied at a
higher price of 9s.1 ,II! we get a new point $. (f we +oin these new points $<
J $ then we get a new supply cur*e S<SO! which is located to the left of the
original supply cur*e. There is backward shift in the position of supply cur*e.
#ackward shift in the cur*e indicates decrease in supply.
Managerial uses of the ,aw of supply
V 6elps a producer to take decisions with respect toE-
&. 1hat product he has to produce and sell.
i. 1hat $uantity he has to sell.
ii. -t what price he has to sell.
iii. 1hen he has to produce.
iv. 1here he has to sell.
v. For whom he has to sell etc.
&. 6elps him to maintain a balance between stock P supply.
). 6elps him in preparing the sales budget policy.
3. 6elps in estimating the present and future expected revenue and profit levels.
;. 6elps to analy#e the effects of taxes on total sales in the market.
F. 6elps to analy#e the impact of various govt. policies on the supply of a product.
9. 6elps in identifying the factors which affect supply of a product.

)eterminants Of S6ppl4
-part from price, many factors bring about changes in supply. -mong them the important
factors areE
&. !at6ral factors Favorable natural factors like good climatic conditions, timely,
ade$uate, well distributed rainfall results in higher production and expansion in
supply. 7n the other hand, adverse factors like bad weather conditions,
earth$uakes, droughts, untimely, ill-distributed, inade$uate rainfall, pests etc.,
may cause decline in production and contraction in supply.
). C5ange in tec5ni86es of prod6ction -n improvement in techni$ues of
production and use of modern highly sophisticated machines and e$uipments will
go a long way in raising the output and expansion in supply. 7n the contrary,
primitive techni$ues are responsible for lower output and hence lower supply.
3. Cost of prod6ction Given the market price of a product, if the cost of production
rises due to higher wages, interest and price of inputs, supply decreases. If the
cost of production falls, on account of lower wages, interest and price of inputs,
supply rises.
;. Prices of related goods If prices of related goods fall, the seller of a given
commodity offer more units in the market even though, the price of his product
has not gone up. 7pposite will be the case when the price of related goods rises.
F. "o7ernment polic4 1hen the government follows a positive policy, it
encourages production in the private sector. ,onse$uently, supply expands. For
example granting of subsidies, development rebates, tax concession, etc,. 7n the
other hand, output and supply cripples when the government adopts a negative
policy. For example withdrawal of all concessions and incentives, imposition of
high taxes, introduction of controls and $uota system etc.
9. Monopol4 po;er (upply tends to be low, when the market is controlled by
monopolists, or a few sellers as in the case of oligopoly. Generally supply would
be more under competitive conditions.
K. !6m9er of sellers or firms (upply would be more when there are a large number
of sellers. (imilarly production and supply tends to be more when production is
organi#ed on large scale basis. If rate or speed of production is high supply
expands. 7pposite will be the case when number of sellers is less, small scale
production and low rate of production.
B. Complementar4 goods In case of joint demand, the production P sale of one
product may lead to production and sale of other product also.
A. )isco7er4 of ne; so6rce of inp6ts .iscovery of new sources of inputs helps the
producers to supply more at the same price P vice-versa.
&8. Impro7ements in transport and comm6nication his will facilitate free and $uick
movements
of goods and services from production centers to marketing centers.
&&. 6t6re rise in prices 1hen sellers anticipate a further rise in price, in that case
current supply
tends to fall. 7pposite will be the case when, the seller expect a fall in price.
hus, many factors influence the supply of a product in the market. - firm should have a
thorough knowledge of all these factors because it helps in preparing its production plan
and sales strategy.
S6ppl4 6nction%
he law of supply and supply schedule explains only the direct relationship between
price and supply. 'athematically ( / f 354. %oth analyses the impact of change in price
on $uantity supplied. (upply of a product, apart from price changes also depends upon
many factors. 1hen we analy#e the influence of these factors on supply, supply schedule
will be converted into a supply function.
(upply function is a comprehensive one as it analyses the causes for changes in supply in
a detailed manner. 'athematically a supply function can be represented in the following
manner.
(x / f 35f, , ,p,Gp,+TTTetc4
1here
(x / supply of a given product x
5f / price of factor input
/ echnology
,p / cost of production
Gp / Government policy
+ / +umber of firms etc

(upply function is also described as shifts in supply.


$earning O9Eecti7e +
Understand elasticit4 and factors determining elasticit4 of s6ppl4
Elasticit4 Of S6ppl4
It is a parallel concept to elasticity of demand% It refers to t5e sensiti7eness or
responsi7eness of s6ppl4 to a gi7en c5ange in price% In short, it measures the degree of
adjustability of supply to a given change in price of a product.
. he formula to calculate elasticity of supply is as followsE
It implies that at the present level with every change in price one time, there will be a
change in supply four times directly.


'4pes of elasticit4 of s6ppl4
Qust like elasticity of demand, elasticity of supply is also e$ual to infinity, #ero, greater
than one, lower than one and e$ual to one.
&. Perfectl4 elastic s6ppl4
S6ppl4 is said to 9e perfectl4 elastic ;5en a slig5t c5ange in price leads to
immeas6ra9le
c5anges in s6ppl4% 6ence supply curve would be a hori#ontal or parallel line to 7<
axis.

2% Perfectl4 inelastic s6ppl4
B5en s6ppl4 of a commodit4 remains constant and does not c5ange ;5ate7er
ma4 9e t5e
c5ange in price- it is said to 9e a9sol6tel4 or perfectl4 inelastic s6ppl4% 6ere the
supply curve tends to be a vertical straight line. 2( / 88 3#ero4 .

+% #elati7el4 Elastic s6ppl4
If c5ange in t5e s6ppl4 is more t5an proportionate to t5e c5ange in price-
elasticit4 of s6ppl4
is greater t5an one. In that case, the supply curve is flatter and is more inclined to x
axis.

G

;. #elati7el4 Inelastic s6ppl4
If t5e c5ange in s6ppl4 is less t5an proportionate to a gi7en c5ange in price-
t5en- elasticit4 of
s6ppl4 is said to 9e less t5an one. 6ere the supply is a steeply rising one.


.% Unitar4 elastic s6ppl4
If proportionate c5ange in s6ppl4 is e<actl4 e86al and proportionate to t5e
c5ange in price-
t5en elasticit4 of s6ppl4 is e86al to one%

actors )etermining Elasticit4 Of S6ppl4 >)E'E#MI!A!'S?
&. 'ime period
ime has a greater influence on elasticity of supply than on demand. Generally supply
tends to be inelastic in the short run because time available to organi#e and adjust supply
to demand is insufficient. (upply would be more elastic in the long run.
&. A7aila9ilit4 and mo9ilit4 of factors of prod6ction
1hen factors of production are available in plenty and freely mobile from one
occupation to another, supply tends to be elastic and vice : versa.
&. 'ec5nological impro7ements
'odern methods of production expands output and hence supply tends to be elastic.
7ld methods reduce output and supply tends to be inelastic.
&. Cost of prod6ction
If cost of production rise rapidly as output expands, then there will not be much incentive
to increase output as the extra benefit will be choked off by increase in cost. 6ence
supply tends to be inelastic and vice-versa.
&. 2inds and nat6re of mar:ets
If the seller is selling his product in different markets, supply tends to be elastic in any
one of the market because, a fall in the price in one market will induce him to sell in
another market. -gain, if he is producing several types of goods and can switch over
easily from one to another, then each of his products will be elastic in supply.
&. Political conditions
5olitical conditions may disrupt production of a product. In that case, supply tends to
become inelastic.
&. !6m9er of sellers
(upply tends to become more elastic if there are more sellers freely selling their products
and vice-versa.
&. Prices of related goods
- firm can charge a higher price for its products, if prices of other products are higher
and vice-versa.
&. "oals of t5e firm
If the seller is happy with small output, supply tends to be inelastic and vice-versa.
hus, several factors influence the elasticity of supply.
Mar:et E86ili9ri6m And C5anges In Mar:et E86ili9ri6m

Meaning of e86ili9ri6m
he word e$uilibrium is derived from the Matin word !ae$uilibrium" which means e$ual
balance. It means a state of e7en 9alance in ;5ic5 opposing forces or tendencies
ne6traliCe eac5 ot5er% It is a position of rest c5aracteriCed 94 a9sence of c5ange% It is
a state ;5ere t5ere is complete agreement of t5e economic plans of t5e 7ario6s
mar:et participants so t5at no one 5as a tendenc4 to re7ise or alter 5is decision% In
the words of professor 'ehtaE !2$uilibrium denotes in economics absence of change in
movement."

E86ili9ri6m 9et;een demand and s6ppl4 price=
2$uilibrium between demand and supply price is obtained by the interaction of these two
forces. 5rice is an independent variable. .emand and supply are dependent variables.
hey depend on price. .emand varies inversely with price, a rise in price causes a fall in
demand and a fall in price causes a rise in demand. hus the demand curve will have a
downward slope indicating the expansion of demand with a fall in price and contraction
of demand with a rise in price. 7n the other hand supply varies directly with the changes
in price, a rise in price causes a rise in supply and a fall in price causes a fall in supply.
hus the supply curve will have an upward slope. At a point ;5ere t5ese t;o c6r7es
intersect ;it5 eac5 ot5er t5e e86ili9ri6m price is esta9lis5ed% At t5is price 86antit4
demanded e86als t5e 86antit4 s6pplied% his we can explain with the help of a table
and a diagram G

In the table at ?s. )8 the $uantity demanded is e$ual to the $uantity supplied. (ince this
price is agreeable to both the buyers and the sellers, there will be no tendency for it to
changeI this is called the e$uilibrium price. (uppose the price falls to ?s.F the buyers will
demand 38 units while the sellers will supply only F units. 2xcess of demand over supply
pushes the price upwards until it reaches the e$uilibrium position where supply is e$ual
to demand. 7n the other hand if the price rises to ?s. 38 the buyers will demand only F
units while the sellers are ready to supply )F units. (ellers compete with each other to sell
more units of the commodity. 2xcess of supply over demand pushes the price downwards
until it reaches the e$uilibrium. his process will continue till the e$uilibrium price of ?s.
)8 is reached. hus the interactions of supply and demand forces acting upon each other
restore the e$uilibrium position in the market.
In the diagram .. is the demand curve, (( is the supply curve. .emand and supply are
in e$uilibrium at point 2 where the two curves intersect each other. 7> is the e$uilibrium
output. 75 is the e$uilibrium price. (uppose the price is higher than the e$uilibrium price
i.e. 75). -t this price $uantity demanded is 5) .), while the $uantity supplied is 5) ().
hus .) () is the excess supply which the sellers want to push off in the market,
competition among sellers will bring down the price to the e$uilibrium level where the
supply is just e$ual to the demand. -t price 75&, the buyers will demand 5&.& $uantity
while the sellers are prepared to sell 5&(&. .emand exceeds supply. 2xcess demand for
goods pushes up the priceI this process will go on until the e$uilibrium is reached where
supply becomes e$ual to demand.

C5anges In Mar:et E86ili9ri6m
'5e c5anges in e86ili9ri6m price ;ill occ6r ;5en t5ere ;ill 9e s5ift eit5er in
demand c6r7e or in s6ppl4 c6r7e or 9ot5%
Effects of s5it in demand
.emand changes when there is a change in the determinants of demand like the income,
tastes, prices of substitutes and complements, si#e of the population etc. If demand raises
due to a change in any one of these conditions the demand curve shifts upward to the
right. If, on the other hand, demand falls, the demand curve shifts downward to the left.
(uch rise and fall in demand are referred to as increase and decrease in demand.

- change in the market e$uilibrium caused by the shifts in demand can be explained with
the help of a diagram
G
>uantity demanded and supplied is shown on 7< axis, 5rice is shown on 7= axis. (( is
the supply curve which remains unchanged. .. is the demand curve. .emand and
supply curves intersect each other at point 2. hus 75 is the e$uilibrium price and 7> is
the e$uilibrium $uantity demanded and supplied. +ow, suppose the demand increases.
he demand curve shifts forward to .&.&. he new demand curve intersects the supply
curve at point 2&, where the $uantity demanded increases to 7>& and price to 75&. In
the same way, if the demand curve shifts backwards and assumes the position .).), the
new e$uilibrium will be at 2) and the $uantity demanded will be 7>), price will be 75).
hus the market e$uilibrium price and $uantity demanded will change when there is an
increase or decrease in demand.


Effects Of S5ifts In S6ppl4
o study of the effects of changes in supply on market e$uilibrium we assume the
demand to remain constant. -n increase in supply is represented by a shift of the supply
curve to the right and a decrease in supply is represented by a shift to the left. he general
rule is, if supply increases, price falls and if supply decreases price rises.1e can show the
effects of shifts in supply with the help of a diagram
In the diagram supply and demand curves intersect each other at point 2, establishing
e$uilibrium price at 75 and e$uilibrium $uantity supplied and demanded at 7>.
(uppose, supply increases and the supply curve shifts from (( to (&(&. he new supply
curve intersects the demand curve at 2& reducing the e$uilibrium price to 5& and raising
the $uantity demanded to 7>&. 7n the other hand if the supply decreases and the supply
curve shifts backward to ()(), the e$uilibrium price is pushed upwards to 75) and the
$uantity demanded is reduced to 7>). hus changes in supply, demand remaining
constant will cause changes in the market e$uilibrium.
Effects Of C5anges In Bot5 )emand And S6ppl4
,hanges can occur in both demand and supply conditions. he effects of such
changes on the market e$uilibrium depend on the rate of change in the two variables. If
the rate of change in demand is matched with the rate of change in supply there will be no
change in the market e$uilibrium, the new e$uilibrium shows expanded market with
increased $uantity of both supply and demand at the same price.
his is made clear from the diagram belowE
If the increase in demand is greater than the increase in supply, the new market
e$uilibrium is at a higher level showing a rise in both the e$uilibrium price and the
e$uilibrium $uantity demanded and supplied. 7n the other hand if the increase in supply
is greater than the increase in demand, the new market e$uilibrium is at lower level,
showing a lower e$uilibrium price and a higher $uantity of good supplied and demanded.

(imilar will be the effects when the decrease in demand is greater than the decrease in
supply on the market e$uilibrium.
S6mmar4
he management should have a clear understanding of the supply and demand conditions
in the market to have an effective control on business. (upply refers to the $uantity of a
commodity offered for sale at a particular price during a given period of time. (upply is
different from production and stock.
(upply schedule is a tabular representation of different $uantities of a commodity
supplied at varying prices and the supply curve drawn on the basis of supply schedule
which shows the direct relationship that exists between price and supply. hus the supply
curve will have a positive slope. he law of supply states that Cother things being
constantD, a rise in price causes extension of supply and a fall in price causes contraction
of supply .here are a few exceptions to this law.
here will be a shift or a change in supply when the determinants of supply like the
natural factors, techni$ues of production, cost of production, government policy,
monopoly power, prices of related goods, number of sellers etc., change.
In order to regulate production and supply efficiently management should have proper
knowledge of the concept of elasticity of supply. 2lasticity of supply refers to the
responsiveness of supply to a change in price. It is influenced by a number of factors like
the period of time under consideration, availability and mobility of factors of production,
technological improvements, cost of production, number of sellers, prices of related
goods etc.
'odern economics is sometimes called e$uilibrium analysis. 'arket is in e$uilibrium
when there is a balance between supply and demand forces. he price and output
determined by the interaction of supply and demand forces are called the e$uilibrium
price and the e$uilibrium output. here will be a change in the e$uilibrium price and
output when there is a change in demand or change in supply or change in both demand
and supply. Onderstanding of the position of market e$uilibrium is of very great
importance in the decision making process of the firm.

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MB0026- Unit .-Prod6ction Anal4sis
Unit . Prod6ction Anal4sis
Meaning Of Prod6ction And Prod6ction 6nction
he concept of production can be represented in the following manner.
'5e term JProd6ctionK means transformation of p54sical JInp6tsK into p54sical
JO6tp6tsK%
he term !Inputs" refers to all those things or items which are re$uired by the firm to
produce a particular product. o6r factors of prod6ction are land- la9or- capital and
organiCation%
P#O)UC'IO! U!C'IO!
he entire theory of production centre round the concept of production function. !-
production Function" expresses the technological or engineering relationship between
physical $uantity of inputs employed and physical $uantity of outputs obtained by a firm.
It specifies a flow of output resulting from a flow of inputs during a specified period of
time. A production function can be represented in the form of a mathematical
model or e.uation as H M f :F! ! PQ.etc; where H stands for .uantity of
output per unit of time and F P etc are the *arious factor inputs like land!
capital labor etc which are used in the production of output. The rate of
output H is thus! a function of the factor inputs F P etc! employed by the
%rm per unit of time.
actor inp6ts are of t;o t4pes%
1% i<ed Inp6ts% i<ed inp6ts are t5ose factors t5e 86antit4 of ;5ic5 remains
constant irrespecti7e of t5e le7el of o6tp6t prod6ced 94 a firm% For example, land,
buildings, machines, tools, e$uipments, superior types of labor, top management etc.
2% (aria9le inp6ts% (aria9le inp6ts are t5ose factors t5e 86antit4 of ;5ic5 7aries
;it5 7ariations in t5e le7els of o6tp6t prod6ced 94 a firm For example, raw materials,
power, fuel, water, transport and communication etc.
he distinction between the two will hold good only in the short run. In the long run, all
factor inputs will become variable in nature.
S5ort r6n is a period of time in ;5ic5 onl4 t5e 7aria9le factors can 9e 7aried ;5ile
fi<ed factors li:e plants- mac5ineries- top management etc ;o6ld remain constant%
ime available at the disposal of a producer to make changes in the $uantum of factor
inputs is very much limited in the short run. $ong r6n is a period of time ;5ere in t5e
prod6cer ;ill 5a7e ade86ate time to ma:e an4 sort of c5anges in t5e factor
com9inations%
Generally speaking, there are two types of production functions. hey are as follows.
1% S5ort #6n Prod6ction 6nction
In this case, the producer will keep all fixed factors as constant and change only a few
variable factor inputs. In the short run, we come across two kinds of production
functions-
&. >uantities of all inputs both fixed and variable will be kept constant and only one
variable input will be varied. For example, Maw of Hariable 5roportions.
). >uantities of all factor inputs are kept constant and only two variable factor inputs are
varied. For example, Iso->uants and Iso- ,ost curves.
2% $ong #6n Prod6ction 6nction
In this case, the producer will vary the $uantities of all factor inputs, both fixed as well as
variable in the same proportion. For 2xample, he laws of returns to scale.
2ach firm has its own production function which is determined by the state of
technology, managerial ability, organi#ational skills etc of a firm. If there are any
improvements in them, the old production function is disturbed and a new one takes its
place. It may be in the following mannerE-
&. he $uantity of inputs may be reduced while the $uantity of output may remain
same.
). he $uantity of output may increase while the $uantity of inputs may remain
same.
3. he $uantity of output may increase and $uantity of inputs may decrease.
'0E $AB O (A#IAB$E P#OPO#'IO!S *
he law can be stated as the following. As t5e 86antit4 of different 6nits of onl4 one
factor inp6t is increased to a gi7en 86antit4 of fi<ed factors- 9e4ond a partic6lar
point- t5e marginal- a7erage and total o6tp6t e7ent6all4 decline
he law of variable proportions is the new name for the famous J$a; of )iminis5ing
#et6rnsK of classical economists. his law is stated by various economists in the
following manner : -ccording to 5rof. %enham, JAs t5e proportion of one factor in a
com9ination of factors is increased- after a point- first t5e marginal and t5en t5e
a7erage prod6ct of t5at factor ;ill diminis5K1. he same idea has been expressed by
5rof.'arshall in the following words. -n increase in the $uantity of a variable factor
added to fixed factors, at the end results in a less than proportionate increase in the
amount of product, given technical conditions.
ASSUMP'IO!S O '0E $AB
&. 7nly one variable factor unit is to be varied while all other factors should be kept
constant.
.ifferent units of a variable factor are homogeneous.
echni$ues of production remain constant.
he law will hold good only for a short and a given period.
here are possibilities for varying the proportion of factor inputs.

I,,@)%B4%I-=
A hypothetical production schedule is worked out to explain the operation of
the law.
Fixed factors / & -cre of land 0 ?s F888-88 capital. Hariable factor / labor.
%otal 3roduct or -utput K :T$; (t is the output deri*ed from all factors units!
both %xed J *ariable employed by the producer. (t is also a sum of marginal
output. G

4verage 3roduct or -utputK :A$;. (t can be obtained by di*iding total
output by the number of *ariable factors employed.

Marginal 3roduct or -utputK :M$; (t is the output deri*ed from the
employment of an additional unit of *ariable factor unit
'rends in o6tp6t
8rom the table! one can obser*e the following tendencies in the T$! A$! J M$.
&. otal output goes on increasing as long as '5 is positive. It is the highest when '5 is
#ero and 5 declines when '5 becomes negative.
). '5 increases in the beginning, reaches the highest point and diminishes at the end.
3. -5 will also have the same tendencies as the '5. In the beginning '5 will be higher
than -5 but at the end -5 will be higher than '5.
)iagrammatic #epresentation

(n the abo*e diagram along with AR axis! we measure the amount of
*ariable factors employed and along AL 6 axis! we measure T$! A$ J M$. 8rom
the diagram it is clear that there are ((( stages.

Stage !6m9er I% '5e $a; Of Increasing #et6rns
he total output increases at an increasing rate 3'ore than proportionately4 up to the
point 5 because corresponding to this point 5 the '5 is rising and reaches its highest
point. -fter the point 5, '5 decline and as such 5 increases gradually.
he first stage comes to an end at the point where '5 curve cuts the -5 curve when the
-5 is maximum at +.
he I stage is called as the law of increasing returns on account of the following reasons.
&. he proportion of fixed factors is greater than the $uantity of variable factors. 1hen
the producer increases the $uantity of variable factor, intensive and effective utili#ation of
fixed factors become possible leading to higher output.
). 1hen the producer increases the $uantity of variable factor, output increases due to the
complete utili#ation. of the !Indivisible Factors" 3. -s more units of the variable factor is
employed, the efficiency of variable factors will go up because it creates more
opportunity for the introduction of division of labor and speciali#ation resulting in higher
output.
Stage !6m9er II '5e $a; Of )iminis5ing #et6rns
(n this case as the .uantity of *ariable inputs is increased to a gi*en .uantity
of %xed factors! output increases less than proportionately. (n this stage! the
T.$ increases at a diminishing rate since both A$ J M$ are declining but they
are positi*e. The (( stage comes to an end at the point where T$ is the highest
at the point E and M$ is "ero at the point #. (t is known as the stage of
Biminishing 9eturns because both the A$ J M$ of the *ariable factor
continuously fall during this stage. (t is only in this stage! the %rm is
maximi"ing its total output.
)iminis5ing ret6rns arise due to the following reasonsE
&. he proportion of variable factors are greater than the $uantity of fixed factors.
6ence, both -5 P '5 decline.
). otal output diminishes because there is a limit to the full utili#ation of indivisible
factors and introduction of speciali#ation. 6ence, output declines.
3. .iseconomies of scale will operate beyond the stage of optimum production.
;. Imperfect substitutability of factor inputs is another cause. Op to certain point
substitution is beneficial. 7nce optimum point is reached, the fixed factors cannot
be compensated by the variable factor. .iminishing returns are bound to appear as
long as one or more factors are fixed and cannot be substituted by the others.

'5e III Stage '5e Stage Of !egati7e #et6rns%
(n this case! as the .uantity of *ariable input is increased to a gi*en .uantity
of %xed factors! output becomes negati*e. Buring this stage! T$ starts
diminishing! A$ continues to diminish and M$ becomes negati*e. The
negati*e returns are the result of excessi*e .uantity of *ariable factors to a
constant .uantity of %xed factors. =ence! output declines. The pro*erb Too
many cooks spoil the broth and Too much is too bad aptly applies to this
stage. 7enerally! the ((( stage is a theoretical possibility because no producer
would like to come to this stage.
The producer being rational will not select either the stage ( :because there is
opportunity for him to increase output by employing more units of *ariable
factor; or the ((( stage :because the M$ is negati*e;. The stage ( J ((( is
described as A,Economic 9egion or Sneconomic 9egion. =ence! the
producer will select the (( stage :which is described as the most economic
region; where he can maximi"e the output. The (( stage represents the range
of rational production decision.
It is clear t5at in t5e a9o7e e<ample- t5e most ideal or optim6m com9ination of
factor 6nits @ 1 Acre of landI #s% .000 H 00 capital and 3 la9orers%
All the - stages together constitute the law of *ariable proportions. Since the
second stage is the most important! in practice we normally refer this law as
the law of Biminishing 9eturns.
Prod6ction 6nction Bit5 ';o (aria9le Inp6ts
ISO-AUA!'S A!) ISO- COS'S
Iso-product curve is a techni$ue developed in recent years to show the e$uilibrium of a
producer with two variable factor inputs. It is a parallel concept to the indifference curve
in the theory of consumption.
(n the diagram! if we +oin points A#DBE :which represents di5erent
combinations of factor x and y; we get an (so,.uant cur*e (H. This cur*e
represents 'II units of output that may be produced by employing any one
of the combinations of two factor inputs mentioned abo*e. (t is to be noted
that an (so,$roduct Dur*e shows the exact physical units of output that can
be produced by alternati*e combinations of two factor inputs. =ence!
absolute measurement of output is possible.
Iso H A6ant Map
A catalogue of di5erent combinations of inputs with di5erent le*els of output
can be indicated in a graph which is called as e.ual product map or (so,.uant
map. (n other words! a number of Iso Duants representing di2erent
amount of out put are known as Iso-quant map.





Marginal Bate of %echnical )ubstitution EMB%)F
(t may be de%ned as the rate at which a factor of production can be
substituted for another at the margin without a2ecting any change
in the quantity of output.
Properties of Iso- A6ants%
&. -n Iso->uant curve slope downwards from left to right.
). Generally an Iso->uant curve is convex to the origin.
3. +o two Iso-product curves intersect each other.
;. -n Iso-product curve lying to the right represents higher output and vice-versa.
F. -lways one Iso->uant curve need not be parallel to other.
9. It will not touch either < or = : axis.

ISO-COS' $I!E O# CU#(E *
(t is a parallel concept to the budget or price line of the consumer. (t indicates
the di5erent combinations of the two inputs which the %rm can purchase at
gi*en prices with a gi*en outlay.

P#O)UCE#S EAUI$IB#IUM >Optim6m factor com9ination or least cost
com9ination?
he optimal combination of factor inputs may help in either minimi#ing cost for a given
level of output or maximi#ing output with a given amount of investment expenditure.

,ong Bun 3roduction unction G+hange In 4ll actor Inputs In %he
)ame 3roportionH
$ABS O #E'U#!S 'O SCA$E
he concept of returns to scale is a long run phenomenon. In this case, we study the
change in output when all factor inputs are changed or made available in re$uired
$uantity. -n increase in scale means that all factor inputs are increased in the same
proportion. In returns to scale, all the necessary factor inputs are increased or decreased
to the same extent so that what ever the scale of production, the proportion among the
factors remains the same.
'5ree P5ases of #et6rns to Scale
1hen the $uantity of all factor inputs are increased in a given proportion and output
increases more than proportionately, then the returns to scale are said to be increasingI
when the output increases in the same proportion, then the returns to scale are said to be
constantI when the output increases less than proportionately, then the returns to scale are
said to be diminishing.

Sl !o% Scale
'otal Prod6ct
in Units
Marginal Prod6ct in 6nits
& & -cre of land 0 3 labor F F
) ) -cre of land 0 F labor &) K
3 3 -cre of land 0 K labor )& A
; ; -cre of land 0 A labor 3) &&
F F -cre of land 0 && labor ;3 &&
9 9 -cre of land 0 &3labor F; &&
K K -cre of land 0 &F labor 93 A
B B -cre of land 0 &K labor K8 K

It is clear from the table that the $uantity of land and labor 3(cale4 is increasing in the
same proportion, i.e. by & acre of land and ) units of labor through out in our example.
he output increases more than proportionately when the producer is employing ; acres
of land and A units of labor. 7utput increases in the same proportion when the $uantity of
land is F acres and &&units of labor and 9 acres of land and &3 units of labor. In the later
stages, when he employs K P B acres of land and &F P &K units of labor, output increases
less than proportionately. hus, one can clearly understand the operation of the three
phases of the laws of returns to scale with the help of the table.

)iagrammatic representation
In the diagram, it is clear that the marginal returns curve slope upwards from - to %,
indicating increasing returns to scale. he curve is hori#ontal from % to , indicating
constant returns to scale and from , to ., the curve slope downwards from left to right
indicating the operation of diminishing returns to scale.





I!C#EASI!" #E'U#!S 'O SCA$E=
Increasing ret6rns to scale is said to operate ;5en t5e prod6cer is increasing t5e
86antit4 of all factors LscaleM in a gi7en proportion- o6tp6t increases more t5an
proportionatel4%

Ca6ses for Increasing #et6rns to Scale
Increasing returns to scale operate in a firm on account of several reasons. (ome of the
most important ones are as follows
&. 1ider scope for the use of latest tools, e$uipments, machineries, techni$ues etc to
increase production and reduce cost per unit.
). Marge-scale production leads to full and complete utili#ation of indivisible factor
inputs leading to further reduction in production cost.
3. -s the si#e of the plant increases, more output can be obtained at lower cost.
;. -s output increases, it is possible to introduce the principle of division of labor
and speciali#ation, effective supervision and scientific management of the firm etc
would help in reducing cost of operations.
F. -s output increases, it becomes possible to enjoy several other kinds of
economies of scale like overhead, financial, marketing and risk-bearing
economies etc, which is responsible for cost reduction.
It is important to note that economies of scale outweigh diseconomies of scale in case of
increasing returns to scale.
CO!S'A!' #E'U#!S 'O SCA$E
Constant ret6rns to scale is operating ;5en all factor inp6ts LscaleM are increased in
a gi7en proportion- o6tp6t also increases in t5e same proportion%


Ca6ses for Constant #et6rns to Scale
In case of constant returns to scale, the various internal and external economies of scale
are neutrali#ed by internal and external diseconomies. hus, when both internal and
external economies and diseconomies are exactly balanced with each other, constant
returns to scale will operate.

)IMI!IS0I!" #E'U#!S 'O SCA$E
)iminis5ing ret6rns to scale is operating ;5en o6tp6t increases less t5an
proportionatel4 ;5en compared t5e 86antit4 of inp6ts 6sed in t5e prod6ction
process%


Ca6ses for )iminis5ing #et6rns to Scale
.iminishing ?eturns to (cale operate due to the following reasons-
&. 2mergence of difficulties in co-ordination and control.
). .ifficulty in effective and better supervision.
3. .elays in management decisions.
;. Inefficient and mis-management due to over growth and expansion of the firm.
F. 5roductivity and efficiency declines unavoidably after a point.

2no;ledge of economies of scale and diseconomies of sale and economies and
diseconomies of scope
Economies Of Scale
hey are gain to a firm. hey help in reducing production cost and establishing an
optimum si#e of a firm. hus, they help a lot and go a long way in the development and
growth of a firm. -ccording to 5rof. 'arshall these economies are of two types, vi#
Internal 2conomies and 2xternal 2conomics +ow we shall study both of them in detail.

I Internal Economies or #eal Economies
(nternal Economies are those economies which arise because of the actions
of an indi*idual %rm to economi"e its cost. They arise due to increased
di*ision of labor or speciali"ation and complete utili"ation of indi*isible factor
inputs. $rof. Dairncross points out that internal economies are open to a
single factory or a single %rm independently of the actions of other %rms.
They arise on account of an increase in the scale of output of a %rm and
cannot be achie*ed unless output increases. The following are some of the
important aspects of internal economies.
&. hey arise !with in" or !inside" a firm.
). hey arise due to improvements in internal factors.
3. hey arise due to specific efforts of one firm.
;. hey are particular to a firm and enjoyed by only one firm.
F. hey arise due to increase in the scale of production.
9. hey are dependent on the si#e of the firm.
K. hey can be effectively controlled by the management of a firm.
B. hey are called as !%usiness (ecrets !of a firm.

2inds of Internal Economies%
1% 'ec5nical Economies
a% Economies of s6perior tec5ni86esE
9% Economies of increased dimension=
c% Economies of lin:ed process= It is $uite possible that a firm may not have various
processes of production with in its own premises. -lso it is possible that different firms
through mutual agreement may decide to work together and derive the benefits of linked
processes, for example, in diary farming, printing press, nursing homes etc.
d% Economies arising o6t of researc5 and 94 H prod6cts=
e% In7entor4 Economies% Inventory management is a part of better materials
management. - big firm can save a lot of money by adopting latest inventory
management techni$ues.
). Managerial Economies%
hey arise because of better, efficient, and scientific management of a firm. (uch
economies arise in two different ways.
a% )elegation of details he general manager of a firm cannot look after the working of
all processes of production. In order to keep an eye on each production process he has to
delegate some of his powers or functions to trained or speciali#ed personnel and thus
relieve himself for co-ordination, planning and executing the plans. his will enable him
to bring about improvements in production process and in bringing down the cost of
production.
9% 6nctional SpecialiCation% It is possible to secure economies of large scale production
by dividing the work of management into several separate departments. 2ach department
is placed under an expert and the rest of the work is left into the hands of specialists. his
will ensure better and more efficient productive management with scientific business
administration. his would lead to higher efficiency and reduction in the cost of
production.
3. Mar:eting or Commercial economiesE
'5ese economies ;ill arise on acco6nt of 964ing and selling goods on large scale
9asis at fa7ora9le terms%
;. inancial Economies
'5e4 arise 9eca6se of t5e ad7antages sec6red 94 a firm in mo9iliCing 56ge financial
reso6rces% - large firm on account of its reputation, name and fame can mobili#e huge
funds from money market, capital market, and other private financial institutions at
concessional interest rates. It can borrow from banks at relatively cheaper rates. It is also
possible to have large overdrafts from banks. - large firm can float debentures and issue
shares and get subscribed by the general public.
F $a9or Economies%
%hese economies will arise as a result of employing skilled, trained,
qualifed and highly e/perienced persons by o2ering higher wages
and salaries. As a %rm expands! it can employ a large number of highly
talented persons and get the bene%ts of speciali"ation and di*ision of labor.
9. 'ransport and Storage Economies
'5e4 arise on acco6nt of t5e pro7ision of 9etter- 5ig5l4 organiCed and c5eap
transport and storage facilities and t5eir complete 6tiliCation% - large company can
have its own fleet of vehicles or means of transport which are more economical than
hired ones. (imilarly, a firm can also have its own storage facilities which reduce cost of
operations.
K. O7er 0ead Economies
'5ese economies ;ill arise on acco6nt of large scale operations% he expenses on
establishment, administration, book-keeping, etc, are more or less the same whether
production is carried on small or large scale. 6ence, cost per unit will be low if
production is organi#ed on large scale. G
1% Economies of (ertical integration
A firm can also reap t5is 9enefit ;5en it s6cceeds in integrating a n6m9er of stages
of prod6ction% It secures the advantages that the flow of goods through various stages in
production processes is more readily controlled. %ecause of vertical integration, most of
the costs become controllable costs which help an enterprise to reduce cost of production.
A. #is:-9earing or s6r7i7al economies
'5ese economies ;ill arise as a res6lt of a7oiding or minimiCing se7eral :inds of
ris:s and 6ncertainties in a 96siness%
)i7ersification of o6tp6t Instead of producing only one particular variety, a firm has to
produce multiple products If there is loss in one item it can be made good in other items.
)i7ersification of mar:et= Instead of selling the goods in only one market, a firm
has to sell its products in different markets. If consumers in one market desert a
product, it can cover the losses in other markets.
)i7ersification of so6rce of s6ppl4= Instead of buying raw materials and other
inputs from only one source, it is better to purchase them from different sources.
If one person fails to supply, a firm can buy from several sources.
)i7ersification of t5e process of man6fact6re= Instead adopting only one
process of production to manufacture a commodity, it is better to use different
processes or methods to produce the same commodity so as to avoid the loss
arising out of the failure of any one process.

II. E<ternal Economies or Pec6niar4 Economies
E<ternal economies are t5ose economies ;5ic5 accr6e to t5e firms as a res6lt of t5e
e<pansion in t5e o6tp6t of ;5ole ind6str4 and t5e4 are not dependent on t5e o6tp6t
le7el of indi7id6al firms. hese economies or gains will arise on account of the over all
growth of an industry or a region or a particular area. hey arise due to benefit of
locali#ation and speciali#ed progress in the industry or region. 5rof. (tonier P 6ague
points out that external economies are those economies in production which depend on
increase in the output of the whole industry rather than increase in the output of the
individual firm he following are some of the important aspect of external economies.
&. hey arise CoutsideD the firm.
). hey arise due to improvement in external factors.
3. hey arise due to collective efforts of an industry.
;. hey are general, common P enjoyed by all firms.
F. hey arise due to overall development, expansion P growth of an industry or a region.
9. hey are dependent on the si#e of industry.
K. hey are beyond the control of management of a firm.
B. hey are called as !open secrets !of a firm.
2inds of E<ternal Economies
Economies of concentration or Agglomeration
'5e4 arise 9eca6se in a partic6lar area a 7er4 large n6m9er of firms ;5ic5 prod6ce
t5e same commodit4 are esta9lis5ed% In other words, this is an advantage which arises
from what is called CMocali#ation of IndustryD.
Economies of Information
'5ese economies ;ill arise as a res6lt of getting 86ic:- latest and 6p to date
information from 7ario6s so6rces%
Economies of )isintegration
'5ese economies ;ill arise as a res6lt of di7iding one 9ig 6nit in to different small
6nits for t5e sa:e of con7enience of management and administration%
Economies of "o7ernment Action
'5ese economies ;ill arise as a res6lt of acti7e s6pport and assistance gi7en 94 t5e
go7ernment to stim6late prod6ction in t5e pri7ate sector 6nits%
&. Economies of P54sical actors
'5ese economies ;ill arise d6e to t5e a7aila9ilit4 of fa7ora9le p54sical factors and
en7ironment%
Economies of Belfare
'5ese economies ;ill arise on acco6nt of 7ario6s ;elfare programs 6nder ta:en 94
an ind6str4 to 5elp its o;n staff%
)iseconomies Of Scale
1hen a firm expands beyond the optimum limit, economies of scale will be converted in
to diseconomies of scale. 7ver growth becomes a burden. 6ence, one should not cross
the limit. 7n account of diseconomies of scale, more output is obtained at higher cost of
production. he following are some of the main diseconomies of scale
&. inancial diseconomies. . -s there is over growth, the re$uired amount of fiancWe
may not be available to a firm. ,onse$uently, higher interest rates are to be paid
for additional funds%
). Managerial diseconomies 2xcess growth leads to loss of effective supervision,
control management, coordination of factors of production leading to all kinds of
wastages, indiscipline and rise in production and operating costs.
3. Mar:eting diseconomies% Onplanned excess production may lead to mismatch
between demand and supply of goods leading to fall in prices. (tocks may pile up,
sales may decline leading to fall in revenue and profits.
;. 'ec5nical diseconomies 1hen output is carried beyond the plant capacity, per
unit cost will certainly go up. here is a limit for division of labor and
speciali#ation. %eyond a point, they become negative. 6ence, operation costs
would go up.
F. )iseconomies of ris: and 6ncertaint4 9earing% If output expends beyond a
limit, investment increases. he level of inventory goes up. (ales do not go up
correspondingly. %usiness risks appear in all fields of activities. (upply of factor
inputs become inelastic leading to high prices.
9. $a9or diseconomies% -n unwieldy firm may become impersonal. ,ontact
between labor and management may disappear. 1orkers may demand higher
wages and salaries, bonus and other such benefits etc. Industrial disputes may
arise. Mabor unions may not cooperate with the management. -ll of them may
contribute for higher operation costs.
II E<ternal diseconomies% 1hen several business units are concentrated in only place or
locality, it may lead to congestion,, environmental pollution, scarcity of factor inputs like,
raw materials, water, power, fuel, transport and communications etc leading to higher
production and operational costs.
Internalisation Of E<ternal Economies
It implies that a firm will convert certain external benefits created by the government or
the entire society to its own favor with out making any additional investments.
E<ternalisation Of Internal )iseconomies
In this case, a particular firm on account of its regular operations will pass on certain
costs on the entire society.
Economies Of Scope
Economies of scope ma4 9e defined as t5ose 9enefits ;5ic5 arise to a firm ;5en it
prod6ces more t5an one prod6ct Eointl4 rat5er t5an prod6cing t;o items separatel4
94 t;o different 96siness 6nits%

)iseconomies Of Scope
)iseconomies of scope ma4 9e defined as t5ose disad7antages ;5ic5 occ6r ;5en cost
of prod6cing t;o prod6cts Eointl4 are costlier t5an prod6cing t5em indi7id6all4%
)ifference 9et;een Economies of Scale and Economies of Scope
Understand t5e meaning - importance and t5e determinants of 7ario6s cost concepts
Meaning of cost of prod6ction%
Cost of prod6ction refers to t5e total mone4 e<penses >Bot5 e<plicit and implicit?
inc6rred 94 t5e prod6cer in t5e process of transforming inp6ts into o6tp6ts% In short,
it refers total money expenses incurred to produce a particular $uantity of output by the
producer. he knowledge of various concepts of costs, cost-output relationship etc.
occupies a prominent place in cost analysis.
Managerial Uses Of Cost Anal4sis
- detailed study of cost analysis is very useful for managerial decisions. It helps the
management :
&. o find the most profitable rate of operation of the firm.
). o determine the optimum $uantity of output to be produced and supplied.
3. o determine in advance the cost of business operations.
;. o locate weak points in production management to minimi#e costs.
F. o fix the price of the product.
9. o decide what sales channel to use.
K. o have a clear understanding of alternative plans and the right costs involved in
them.
B. o have clarity about the various cost concepts.
A. o decide and determine the very existence of a firm in the production field.
&8. o regulate the number of firms engaged in production.
&&. o decide about the method of cost estimation or calculations.
&). o find out decision making costs by re-classifications of elements, reprising of input
factors etc, so as to fit the relevant costs into management planning, choice etc.
)ifferent 2inds Of Cost Concepts.
&. Mone4 Cost and #eal Cost
B5en cost is e<pressed in terms of mone4- it is called as mone4 cost It relates to
mone4 o6tla4s 94 a firm on 7ario6s factor inp6ts to prod6ce a commodit4% B5en
cost is e<pressed in terms of p54sical or mental efforts p6t in 94 a person in t5e
ma:ing of a prod6ct- it is called as real cost%
2% Implicit or Imp6ted Costs and E<plicit Costs
E<plicit costs are t5ose costs ;5ic5 are in t5e nat6re of contract6al pa4ments and
are paid 94 an entreprene6r to t5e factors of prod6ction Le<cl6ding 5imselfM in t5e
form of rent- ;ages- interest and profits- 6tilit4 e<penses- and pa4ments for ra;
materials etc%
+% Act6al costs and Opport6nit4 Costs
'5e4 are t5e act6al e<penses inc6rred for prod6cing or ac86iring a commodit4 or
ser7ice 94 a firm% Opport6nit4 cost of a good or ser7ice is meas6red in terms of
re7en6e ;5ic5 co6ld 5a7e 9een earned 94 emplo4ing t5at good or ser7ice in some
ot5er alternati7e 6ses%
7. $irect costs and indirect costs
$irect costs are those costs which can be specifcally attributed to a
particular product, a department, or a process of production.
8. 3ast and future costs.
$ast costs are those costs which are spent in the pre*ious periods. An the
other hand! future costs are those which are to be spent. in the future. $ast
helps in taking decisions for future.
9. Marginal and Incremental costs
Marginal cost refers to the cost incurred on the production of another or one
more unit .It implies additional cost incurred to produce an additional
unit of output (t has nothing to do with %xed cost and is always associated
with *ariable cost.
&. i/ed costs and variable costs.
i/ed costs are those costs which do not vary with either e/pansion
or contraction in output. %hey remain constant irrespective of the
level of output. They are positi*e e*en if there is no production. They are
also called as supplementary or o*er head costs.
An the other hand! variable costs are those costs which directly and
proportionately increase or decrease with the level of output
produced. They are also called as prime costs or direct costs.
;. 4ccounting costs and economic costs.
4ccounting costs are those costs which are already incurred on the
production of a particular commodity. (t includes only the ac.uisition
costs. They are the actual costs in*ol*ed in the making of a commodity. An
the other hand! economic costs are those costs that are to be incurred
by an entrepreneur on various alternative programs. (t in*ol*es the
application of opportunity costs in decision making.
$eterminants -f +osts
1% 'ec5nolog4
'odern technology leads to optimum utili#ation of resources, avoid all kinds of
wastages, saving of time, reduction in production costs and resulting in higher output. 7n
the other hand, primitive technology would lead to higher production costs.
2. #ate of o6tp6t= >t5e degree of 6tiliCation of t5e plant and mac5iner4?
,omplete and effective utili#ation of all kinds of plants and e$uipments would reduce
production costs and under utili#ation of existing plants and e$uipments would lead to
higher production costs.
+%SiCe of Plant and scale of prod6ction
Generally speaking big companies with huge plants and machineries organi#e production
on large scale basis and enjoy the economies of scale which reduce the cost per unit.
7. 3rices of input factors
. =igher market prices of *arious factor inputs result in higher cost of
production and *ice,*ersa.
8. !Iciency of factors of production and the management
=igher producti*ity and eTciency of factors of production would lead to lower
production costs and *ice,*ersa.
9. )tability of output
Stability in production would lead to optimum utili"ation of the existing
capacity of plants and e.uipments. (t also brings sa*ings of *arious kinds of
hidden costs of interruption and learning leading to higher output and
reduction in production costs.
:. ,aw of returns
(ncreasing returns would reduce cost of production and diminishing returns
increase cost.
;. %ime period
(n the short run! cost will be relati*ely high and in the long run! it will be low
as it is possible to make all kinds of ad+ustments and read+ustments in
production process.
Thus! many factors inCuence cost of production of a %rm.
,earning ob>ective ? 8
,earn short ? run and long ? run cost functions
Dost and output are correlated. Dost output relations play an important role in
almost all business decisions. (t throws light on cost minimi"ation or pro%t
maximi"ation and optimi"ation of output. %he relation between the cost
and output is technically described as the .+-)% @=+%I-=0. The
signi%cance of cost,output relationship is so great that in economic analysis
the cost function usually refers to the relationship between cost and rate of
output alone and we assume that all other independent *ariables are kept
constant. Mathematically speaking TD M f :H; where TD M Total cost and H
stands for output produced.
%ypes of cost function. G
7enerally speaking there are two types of cost functions.
'. Short run cost function.
). Fong run cost function.
M!4=I=1 - )J-B% B@=
)hort-run is a period of time in which only the variable factors can
be varied while f/ed factors like plant, machinery etc remains
constant.
#. i/ed costs
%hese costs are incurred on f/ed factors like land, buildings,
equipments, plants, superior type of labor, top management etc.
i/ed costs in the short run remain constant because the frm does
not change the size of plant and the amount of f/ed factors
employed. i/ed costs do not vary with either e/pansion or
contraction in output.
(. 5ariable costs
%he cost corresponding to variable factors are discussed as variable
costs. %hese costs are incurred on raw materials, ordinary labor,
transport, power, fuel, water etc, which directly vary in the short
run.
+ost-output relationship and nature and behavior of cost curves in
the short run
(n order to study the relationship between the le*el of output and
corresponding cost of production! we ha*e to prepare the cost schedule of
the %rm. 4 cost-schedule is a statement of a variation in costs
resulting from variations in the levels of output. It shows the
response of cost to changes in output. A hypothetical cost schedule of a
%rm has been represented in the following table.

O6tp6t in
Units
%+ %5+ %+ 4+ 45+ 4+ M+
8 -1I 6 -1I 6 6 6 6
& -1I '3I 0/I -1I '3I 0/I '3I
) -1I )/I 1II '3I ')I -II 1I
3 -1I )2I 1-I ')I 4I )'I -I
; -1I -'0 120 4I 23.20 '13.20 /0
F -1I /)I 23I 2) 3/ '01 'I0
9 -1I 1-I 44I 1I 'I0 '10 )'I

7n the basis of the above cost schedule, we can analyse the relationship between changes
in the level of output and cost of production. If we represent the relationship between the
two in a geometrical manner, we get different types of cost curves in the short run. In the
short run, generally we study the following kinds of cost concepts and cost curves.
1% 'otal fi<ed cost >'C?
%+ refers to total money e/penses incurred on f/ed inputs like
plant, machinery, tools K equipments in the short run.
2% 'otal 7aria9le cost >'(C?
%5+ refers to total money e/penses incurred on the variable
factors inputs like raw materials, power, fuel, water, transport and
communication etc, in the short run.
H, curve slope upwards from left to right. H, curve rises as output is expanded.
1hen out put is Xero, H, also will be #ero. 6ence, the H, curve starts from the
origin.
+% 'otal cost >'C?
'5e total cost refers to t5e aggregate mone4 e<pendit6re inc6rred 94 a firm to
prod6ce a gi7en 86antit4 of o6tp6t% , / F, 0H,.
, varies in the same proportion as H,. In other words, a variation in , is the result
of variation in H, since F, is always constant in the short run.

he total cost curve is rising upwards from left to right. In our example the , curve
starts form ?s. 388-88 because even if there is no output, F, is a positive amount. ,
and H, have same shape because an increase in output increases them both by the same
amount since F, is constant. , curve is derived by adding up vertically the H, and
F, curves. he vertical distance between H, curve and , curve is e$ual to F, and
is constant throughout because F, is constant.
,% A7erage fi<ed cost >AC?
A7erage fi<ed cost is t5e fi<ed cost per 6nit of o6tp6t% B5en 'C is di7ided 94 total
6nits of o6t p6t AC is o9tained- hus, -F, / F,N>
-F, and output have inverse relationship. It is higher at smaller level and lower at the
higher levels of output in a given plant. he reason is simple to understand. (ince -F, /
F,N>, it is a pure mathematical result that the numerator remaining unchanged, the
increasing denominator causes diminishing product. 6ence, F, spreads over each unit
of out put with the increase in output. ,onse$uently, -F, diminishes continuously. his
relationship between output and fixed cost is universal for all types of business concerns.

.% A7erage 7aria9le cost= >A(C? G
'5e a7erage 7aria9le cost is 7aria9le cost per 6nit of o6tp6t% A(C can 9e comp6ted
94 di7iding t5e '(C 94 total 6nits of o6tp6t% hus -H, / H,N>. he -H, will come
down in the beginning and then rise as more units of output are produced with a given
plant. his is because as we add more units of variable factors in a fixed plant, the
efficiency of the inputs first increases and then it decreases.
he -H, curve is a O-shaped cost curve.

6% A7erage total cost >A'C? or A7erage cost >AC?
Ac refers to cost per 6nit of o6tp6t% AC is also :no;n as t5e 6nit cost since it is t5e
cost per 6nit of o6tp6t prod6ced% -, is the sum of -F, and -H,. -verage total cost or
average cost is obtained by dividing the total cost by total output produced. -, / ,N>
-lso -, is the sum of -F, and -H,.
In the short run -, curve also tends to be O-shaped. he combined influence of -F, and
-H, curves will shape the nature of -, curve.
-s we observe, average fixed cost begin to fall with an increase in output while average
variable costs come down and rise. -s long as the falling effect of -F, is much more
than the rising effect of -H,, the -, tends to fall. -t this stage, increasing returns and
economies of scale operate and complete utili#ation of resources force the -, to fall.
1hen the firm produces the optimum output, -, becomes minimum. his is called as
least : cost output level. -gain, at the point where the rise in -H, exactly counter
balances the fall in -F,, the balancing effect causes -, to remain constant.
In the third stage when the rise in average variable cost is more than drop in -F,, then
the -, shows a rise, 1hen output is expanded beyond the optimum level of output,
diminishing returns set in and diseconomies of scale starts operating. -t this stage, the
indivisible factors are used in wrong proportions. hus, -, starts rising in the third stage.
he short run -, curve is also called as JPlant c6r7eK% It indicates the optimum
utili#ation of a given plant or optimum plant capacity.
/% Marginal Cost >MC?
Marginal cost ma4 9e defined as t5e net addition to t5e total cost as one more 6nit of
o6tp6t is prod6ced% In ot5er ;ords- it implies additional cost inc6rred to prod6ce an
additional 6nit. For example, if it costs ?s. &88 to produce F8 units of a commodity and
?s. &8F to produce F& units, then ', would be ?s. F. It is obtained by calculating the
change in total costs as a result of a change in the total output. -lso ', is the rate at
which total cost changes with output. 6ence,
It is necessary to note that ', is independent of F, and it is directly related to H, as
we calculate the cost of producing only one unit. In the short run, the ', curve also
tends to be O-shaped.
he shape of the ', curve is determined by the laws of returns. If ', is falling,
production will be under the conditions of increasing returns and if ', is rising,
production will be subject of diminishing returns.
'5e ta9le indicates t5e relations5ip 9et;een AC N MC

O6tp6t in
Units
'C in #s% AC in #s%
)ifference in #s%
MC
& &F8 &F8 :
) &A8 AF ;8
3 ))8 K3.3 38
; )39 FA &9
F )K8 F; 3;
9 3); F; F;
K ;&F FA.3 A&
B FB8 K).) &9F

#elation 9et;een AC and MC

From the diagram it is clear thatE

&. %oth ', and -, fall at a certain range of output and rise afterwards.
). 1hen -, falls, ', also falls but at certain range of output ', tends to rise even
though -, continues to fall. 6owever, ', would be less than -,. his is
because ', is attributed to a single unit where as in case of -,, the decreasing
-, is distributed over all the units of output produced.
3. (o long as -, is falling, ', is less than -,. 6ence, ', curve lies below -,
curve. It indicates that fall in ', is more than the fall in -,. ', reaches its
minimum point before -, reaches its minimum.
;. 1hen -, is rising, after the point of intersection, ', will be greater than -,.
his is because in case of ',, the increasing ', is attributed to a single unit,
where as in case of -,, the increasing -, is distributed over all the output
produced.
F. (o long as the -, is rising, ', is greater and -,. 6ence, -, curve lies to the
left side of the ', curve. It indicates that rise in ', is more than the rise in -,.
9. ', curve cuts the -, curve at the minimum point of the -, curve. his is
because, when ', decreases, it pulls -, down and when ', increases, it pushes
-, up. 1hen -, is at its minimum, it is neither being pulled down or being
pushed up by the ',. hus, 1hen -, is minimum, ', / -,. he point of
intersection indicates the least cost combination point or the optimum position of
the firm. -t output > the firm is working at its !7ptimum ,apacity" with lowest
-,. %eyond >, there is scope for !'aximum ,apacity" with rising cost.

Cost O6tp6t #elations5ip In '5e $ong #6n
$ong r6n is defined as a period of time ;5ere adE6stments to c5anged conditions are
complete% It is actually a period during which the $uantities of all factors, variable as
well as fixed factors can be adjusted. 6ence, there are no fixed costs in the long run. In
the short run, a firm has to carry on its production within the existing plant capacity, but
in the long run it is not tied up to a particular plant capacity. -s all costs are variable in
the long run, the total of these costs is total cost of production. 0ence- t5e distinction
9et;een fi<ed and 7aria9les costs in t5e total cost of prod6ction ;ill disappear in t5e
long r6n% In the long run only the average total cost is important and considered in taking
long term output decisions.
Mong run average cost is the long run total cost divided by the level of output. In brief, it
is the per unit cost of production of different levels of output by changing the si#e of the
plant or scale of production.
he long run cost : output relationship is explained by drawing a long run cost curve
through short : run curves as the long period is made up of many short : periods as the
day is made up of ); hours and a week is made out of K days. his curve explains how
costs will change when the scale of production is varied.
G

Prod6ction cost difference in t5e s5ort r6n and long r6n

Important feat6res of long r6n AC c6r7es
1% 'angent c6r7e
.ifferent (-, curves represent different operational capacities of different plants in the
short run. M-, curve is locus of all these points of tangency. he (-, curve can never
cut a M-, curve though they are tangential to each other. his implies that for any given
level of output, no (-, curve can ever be below the M-, curve. 6ence, (-, cannot be
lower than the M-, in the ling run. hus, M-, curve is tangential to various (-, curves.
2% En7elope c6r7e
It is known as 2nvelope curve because it envelopes a group of (-, curves appropriate to
different levels of output.
+% latter U-s5aped or dis5-s5aped c6r7e%
he M-, curve is also U s5aped or dis5 s5aped cost curve. %ut It is less pronounced
and much flatter in nature. M-, gradually falls and rises due to economies and
diseconomies of scale.
,% Planning c6r7e%
he M-, cure is described as the Planning C6r7e of the firm because it represents the
least cost of producing each possible level of output. his helps in producing optimum
level of output at the minimum M-,. his is possible when the entrepreneur is selecting
the optimum scale plant. 7ptimum scale plant is that si#e where the minimum point of
(-, is tangent to the minimum point of M-,.
.% Minim6m point of $AC c6r7e s5o6ld 9e al;a4s lo;er t5an t5e minim6m point of
SAC c6r7e%
his is because M-, can never be higher than (-, or (-, can never be lower than
M-,. he M-, curve will touch the optimum plant (-, curve at its minimum point.
- rational entrepreneur would select the optimum scale plant. 7ptimum scale plant is that
si#e at which (-, is tangent to M-,, such that both the curves have the minimum point
of tangency. In the diagram, 7') is regarded as the optimum scale of output, as it has the
least per unit cost. -t 7') output M-, / (-,.
M-, curve will be tangent to (-, curves lying to the left of the optimum scale or right
side of the optimum scale. %ut at these points of tangency, neither M-, is minimum nor
will (-, be minimum. (-, curves are either rising or falling indicating a higher cost

S6mmar4
In this unit-F we have discussed about the meaning of production, production function
and its managerial uses. 5roduction in economics implies transformation of inputs into
outputs for our final consumption. 5roduction function explains the $uantitative
relationship between the amounts of inputs used to.. get a particular physical $uantity of
outputs. he ratios between the two $uantities are of great importance to a producer to
take his decisions in the production process. here are two kinds of production functions
: short run and long run. In case of short run production function we come across a
change in either one or two variable factor inputs while all other inputs are kept constant.
he law of variable proportion explain how there will be variations in the $uantity of
output when there is change in only one variable factor inputs while all other inputs are
kept constant. 7n the other hand Iso->uants and Iso-cost curves explain how there will
be changes in output when only two variable inputs are changed while all other inputs are
kept constant. Onder long run production function, the laws of returns to scale explain
changes in output when all inputs, both variable as well as fixed changes in the same
proportion. 2conomies of scale give information about the various benefits that a firm
will get when it goes for large scale production. 2conomies of scope on the other hand
tells us how there will be certain specific advantages when one firm produces more than
two products jointly than two or three firms produce them separately. .iseconomies of
scale and diseconomies of scope tells us that there are certain limitations to expansion in
output ,ost analysis on the other hand, indicates the various amounts of costs incurred to
produce a particular $uantity of output in monetary terms. he various kinds of cost
concepts help a manager to take right decisions. ,ost function explains the relationship
between the amounts of costs to be incurred to produce a particular $uantity of output.
(hort run cost function gives information about the nature and behavior of various cost
curves. Mong run cost function tells us how it is possible to obtain more output at lower
costs in the long run. hus, the knowledge of both production function and cost functions
help a business executive to work out the best possible factor combinations to maximi#e
output with minimum costs.
MB0026- Unit 6-O9Eecti7es Of irms
Unit 6 O9Eecti7es Of irms


Economists o*er a period of time ha*e de*eloped *arious theories and
models to explain di5erent kinds of goals of modern %rms. #roadly speaking
they can be di*ed in to three groups. They are as follows,
'. The pro%t maximi"ation model.
). Managerial theories or models
-. #eha*ioral theories or models.
Fet us study some of the important theories under each category.
3roft Ma/imization Model
Main propositions of the proft-ma/imization model.
The model is based on the assumption that each %rm seeks to maximi"e its
pro%t gi*en certain technical and market constraints. The following are the
main propositions of the model.
'. A %rm is a producing unit and as such it con*erts *arious inputs into
outputs of higher *alue under a gi*en techni.ue of production.
). The basic ob+ecti*e of each %rm is to earn maximum pro%t.
-. A %rm operates under a gi*en market condition.
/. A %rm will select that alternati*e course of action which helps to
maximi"e consistent pro%ts
0. A %rm makes an attempt to change its prices! input and output
.uantity to maximi"e its pro%t.

+riticisms
#. 4mbiguous term. The term pro%t maximi"ation is ambiguous in nature.
There is no clear cut explanation whether a %rm has to maximi"e its net
pro%t! total pro%t or the rate of pro%t in a business unit. Again maximum
amount of pro%t cannot be precisely de%ned in .uantitati*e terms.
(. 4lways it may not be possible. $ro%t maximi"ation! no doubt is the
basic ob+ecti*e of a %rm. #ut in the context of highly competiti*e business
en*ironment! always it may not be possible for a %rm to achie*e this
ob+ecti*e. Ather ob+ecti*es like sales maximi"ation! market share expansion!
market leadership building its own image! name! fame and reputation!
spending more time with members of the family! en+oying leisure! de*eloping
better and cordial relationship with employees and customers etc. also has
assumed greater signi%cance in recent years.
6. )eparation of ownership and management. (n many cases! to,day we
come across the business units are organi"ed on partnership or +oint stock
company or cooperati*e basis. (n case of many large organi"ations!
ownership and management is clearly separated and they are run and
managed by salaried managers who ha*e their own self interests and as such
always pro%t maximi"ation may not become possible.
7. $iIculty in getting relevant information and data. (n spite of
re*olution in the %eld of information technology! always it may not be
possible to get ade.uate and rele*ant information to take right decisions in a
highly Cuctuating business scenario. =ence! pro%ts may not be maximi"ed.
8. +onLict in inter-departmental goals. A %rm has se*eral departments
and sections headed by experts in their own %elds. Each one of them will
ha*e its own independent goals and many a times there is possibility of
clashes between the interests of di5erent departments and as such always
pro%ts may not be maximi"ed.
9. +hanges in business environment. (n the context of highly competiti*e
and changing business en*ironment and changes in consumers< tastes and
re.uirements! a %rm may not be able to cope up with the expectations and
ad+ust its policies and as such pro%ts may not be maximi"ed.
:. 1rowth of oligopolistic frms. (n the context of globali"ation! growth of
oligopoly %rms has become so common through mergers! amalgamations and
takeo*ers. Feading %rms dominate the market and the small %rms ha*e to
follow the policies of the leading %rms. =ence! in many cases! there are
limited chances for making maximum pro%ts.
;. )ignifcance of other managerial gains. Salaried managers ha*e
limited freedom in decision making process. Some of them are unable to
forecast the right type of changes and meet the market challenges. They are
more worried about their salaries! promotions! per.uisites! security of +obs!
and other types of bene%ts. They may lack strong moti*ations to make higher
pro%ts as pro%ts would go to the organi"ation. They may be contented with
only satisfactory le*el of pro%ts rather than maximum pro%ts.
<. !mphasis on non-proft goals. Many organi"ations gi*e more stress on
non,pro%t goals. 8rom the point of *iew of today<s business en*ironment!
producti*ity! eTciency! better management! customer satisfaction! durability
of products! higher .uality of products and ser*ices etc ha*e gained
importance to cope with business competition. =ence! emphasis has been
shifted from pro%t maximi"ation to other practical aspects.
#M. 4version to reduction in power. (n case of se*eral small business
units! the owners do not want to share their powers with many new partners
and hence! they try to keep maximum powers in their hands. (n such cases!
keeping more power becomes more important than pro%t maximi"ation.
##. -Icial restrictions over profts of public utilities. $ublic utilities or
public corporations are legally prohibited to make huge pro%ts in many
de*eloping countries like (ndia.
Thus! it is clear that a %rm cannot maximi"e its pro%ts always. There are
many constraints in the background of multiple ob+ecti*es. Each one of the
ob+ecti*es has its own merits and demerits and a %rm has to strike a balance
between all kinds of ob+ecti*es. =owe*er! today it is the *iew of many experts
that in spite of se*eral alternati*e ob+ecti*es! a %rm has to make ade.uate
pro%ts. 8or undertaking any kind of welfare or other acti*ities to promote the
welfare of either consumers or workers! a %rm should ha*e suTcient re*enue.
Ather wise all other ob+ecti*es would remain only on paper and can ne*er be
implemented. on,pro%t goals ser*e as supplementary or complementary
ones to the primary ob+ecti*e of pro%t maximi"ation Thus! the traditional
ob+ecti*e of pro%t maximi"ation has rele*ance e*en today of course with
some modi%cations.
!conomist %heory -f irm
According to Economist theory of %rm! a %rm is a producing unit. (t transforms
or con*erts all kinds of inputs in to outputs. The basic function a %rm is to
produce those goods and ser*ices which are demanded by consumers in the
market. (t produces *arious kinds of goods and ser*ices and supplies them in
the market for the satisfaction of di5erent groups of people either directly or
indirectly. A %rm is a business unit and it is organi"ed on commercial
principles. (n the process of production and sale of di5erent goods and
ser*ices! it aims at making pro%ts.
4ccording to this theory, a traditional frm is a group with a
particular organizational and management structure having
command over its own property rights. (t is a legal entity on the basis of
ownership and contractual relationship organi"ed for production and sale of
goods and ser*ices. (n olden days a %rm was called by *arious names like
shops! %rms! enterprise! production and business concerns etc. #ut today! it
is organi"ed on *arious forms like a sole trader! partnership concern! &oint
Stock Dompany! cooperati*e society etc.
MB0026- Unit /- #e7en6e Anal4sis And
Pricing Policies
Unit / #e7en6e Anal4sis And Pricing Policies
Meaning And )ifferent '4pes Of #e7en6es
#e7en6e is t5e income recei7ed 94 t5e firm. here are three concepts of revenue :
'otal re7en6e- A7erage re7en6e and Marginal re7en6e
1% 'otal re7en6e >'#?=
'otal re7en6e refers to t5e total amo6nt of mone4 t5at t5e firm recei7es from
t5e sale of its prod6cts- i%e% %gross re7en6e..
2%A7erage re7en6e >A#?
A7erage re7en6e is t5e re7en6e per 6nit of t5e commodit4 sold. It can be obtained
by di*iding the T9 by the number of units sold. Then! A9 M T9EH A9 M
'0IE'0M 'I.
'56s a7erage re7en6e means price. '5erefore- a7erage re7en6e c6r7e of t5e firm is
t5e same as demand c6r7e of t5e cons6mer%
herefore, in economics we use -? and price as synonymous except in the context of
price discrimination by the seller. 'athematically 5 / -?.
+% Marginal #e7en6e >M#?
'arginal revenue is the net increase in total revenue reali#ed from selling one more unit
of a product. It is t5e additional re7en6e earned 94 selling an additional 6nit of
o6tp6t 94 t5e seller%
'? / / where ? represents change in ?

-nd indicates change in total $uantity sold.
-lso '? / ?n : ?n-&
'arginal revenue is e$ual to the change in total revenue over the change in $uantity
'arginal ?evenue / 3,hange in total revenue4 divided by 3,hange in sales4

Onits 5rice ? -? '?
& )8 )8 )8 -
) &B 39 &B &9
3 &9 ;B &9 &)
; &; F9 &; B
F &) 98 &) ;
#elations5ip 9et;een 'otal re7en6e- A7erage re7en6e and Marginal #e7en6e
concepts
In order to understand the relationship between ?, -? and '?, we can prepare a
hypothetical revenue schedule.

!6m9er of Units sold '# >#s%? A# >#s%? M# >#s%?
& &8 &8 :
) &B A B
3 ); B 9
; )B K ;
F 38 9 )
9 38 F 8
K )B ; -)

From the table, it is clear thatE

&. '? falls as more units are sold.
). ? increases as more units are sold but at a diminishing rate.
3. ? is the highest when '? is #ero
;. ? falls when '? become negative
F. -? and '? both falls, but fall in '? is greater than -? i.e., '? falls more
steeply than -?.

Belationship between 4B and MB and the nature of 4B and MB
curves under di2erence market conditions
#. @nder 3erfect Market
Snder perfect competition! an indi*idual %rm by its own action cannot
inCuence the market price. The market price is determined by the interaction
between demand and supply forces. 4 frm can sell any amount of goods
at the e/isting market prices. =ence! the T9 of the %rm would increase
proportionately with the output o5ered for sale. >hen the total re*enue
increases in direct proportion to the sale of output! the A9 would remain
constant. Since the market price of it is constant without any *ariation due to
changes in the units sold by the indi*idual %rm! the extra output would fetch
proportionate increase in the re*enue. =ence! MB K 4B will be equal to
each other and remain constant. This will be e.ual to price.

!6m9er of Units sold
3rice per @nit Bs.
;.MM
4B %B MB
& 3 3 3
) 3 '1 3
3 3 )/ 3
; 3 -) 3
F 3 /I 3
9 3 /3 3


Snder perfect market condition! the A9 cur*e will be a hori"ontal straight line
and parallel to AR axis. This is because a %rm has to sell its product at the
constant existing market price. The M9 cure also coincides with the A9 cur*e.
This is because additional units are sold at the same constant price in the
market.


(. @nder Imperfect Market
Snder all forms of imperfect markets! the relation between T9! A9! and M9 is
di5erent. This can be understood with the help of the following imaginary
re*enue schedule.
!6m9er of Units sold %B
4B or price in
Bs.
MB
& 'I 'I 'I
) '3 4 3
3 )/ 3 1
; )3 2 /
F -I 1 )
9 -I 0 I
K )3 / ,)

8rom the abo*e table it is clear thatK
(n order to increase the sales! a %rm is reducing its price! hence A9 falls.
'. As a result of fall in price! T9 increase but at a diminishing rate.
). T9 will be higher when M9 is "ero
-. T9 falls when M9 becomes negati*e
/. A9 and M9 both declines. #ut fall in M9 will be greater than the fall in
A9.
0. The relationship between A9 and M9 cur*es is determined by the
elasticity of demand on the a*erage re*enue cur*e.


@nder imperfect market, the 4B curve of an individual frm slope
downwards from left to right. This is becauseU a %rm can sell larger
.uantities only when it reduces the price. =ence! A9 cur*e has a negati*e
slope.
The M9 cur*e is similar to that of the A9 cur*e. #ut M9 is less than A9. A9
and M9 cur*es are di5erent. 7enerally M9 cur*e lies below the A9 cur*e.
%he 4B curve of the frm or the seller and the demand curve of the
buyer is the same
Since! the demand cur*e represents graphically the .uantities demanded by
the buyers at *arious prices it shows the A9 at which the *arious amounts of
the goods that are sold by the seller. This is because the price paid by the
buyer is the re*enue for the seller :Ane man<s expenditure is another man<s
income;. =ence! the A9 cur*e of the %rm is the same thing as that of the
demand cur*e of the consumers.

Suppose! a consumer buys 'I units of a product when the price per unit is
9s.0 per unit. =ence! the total expenditure is 'I x 0 M 9s.0IE,. The seller is
selling 'I units at the rate of 9s.0 per unit. =ence! his total income is 'I x 0
M 9s.0IE,. Thus! it is clear that A9 cur*e and demand cur*e is really one and
the same.

2in:ed )emand c6r7e and t5e corresponding Marginal #e7en6e c6r7e


In certain cases, the kinked demand curve may show a high elasticity in the lower portion
of the demand curve beyond the kink and low elasticity in higher portion of the demand
curve before the kink 'arginal revenue to such a demand curve will show a gap but
Instead of at a lower level, it will start at a higher level.
#elations5ip 9et;een A#- M#- '# and Elasticit4 of )emand
In the diagram -? is the average revenue curve, '? is the marginal revenue curve and
7. is the total revenue curve. -t the middle point , of average revenue curve elasticity
is e$ual to one. 7n its lower half it is less than one and on the upper half it is greater than
one. '? corresponding to the middle point , of the -? curve is #ero. his is shown by
the fact that '? curve cuts the x axis at > which corresponds to the point , on the -?
curve. If the $uantity is greater than 7> it will correspond to that portion of the -? curve
where eL& marginal revenue is negative because '? goes below the x axis. Mikewise for
a $uantity less than 7>, eJ& and the marginal revenue is positive. his means that if
$uantity greater than 7> is sold, the total revenue will be diminishing and for a $uantity
less than 7> the total revenue ? will be increasing. hus the total revenue ? will be
maximum at the point 6 where elasticity is e$ual to one and marginal revenue is #ero.
Pricing Policies
- detailed study of the market structure gives us information about the way in which
Pricing polic4 refers to t5e polic4 of setting t5e price of t5e prod6ct or prod6cts and
ser7ices 94 t5e management after ta:ing into acco6nt of 7ario6s internal and
e<ternal factors- forces and its o;n 96siness o9Eecti7es%

I E<ternal actors >O6tside factors?
&. .emand, supply and their determinants.
). 2lasticity of demand and supply.
3. .egree of competition in the market.
;. (i#e of the market.
F. Good will, name, fame and reputation of a firm in the market.
9. rends in the market.
K. 5urchasing power of the buyers.
B. %argaining power of customers
A. %uyers behavior in respect of particular product
&8. -vailability of substitutes and complements.
&&. GovernmentDs policy relating to various kinds of incentives, disincentives,
controls, restrictions and regulations, licensing, taxation, export P import, foreign
aid, foreign capital, foreign technology, '+,s etc.
&). ,ompetitors pricing policy.
&3. (ocial consideration.
&;. %argaining power of customers.
Internal actors >Inside actors?
&F. 7bjectives of the firm.
&9. 5roduction ,osts.
&K. >uality of the product and its characteristics.
&B. (cale of production.
&A. 2fficient management of resources.
)8. 5olicy towards percentage of profits and dividend distribution.
)&. -dvertising and sales promotion policies.
)). 1age policy and sales turn over policy etc.
)3. he stages of the product on the product life cycle.
);. Ose pattern of the product.
)F. 2xtent of the distinctiveness of the product and extent of product differentiation
practiced by the firm.
)9. ,omposition of the product and life of the firm.
O9Eecti7es Of '5e Price Polic4
&. Profit ma<imiCation in t5e s5ort term
he primary objective of the firm is to maximi#e its profits. 5ricing policy
as an instrument to achieve this objective should be formulated in such a
way as to maximi#e the sales revenue and profit% Ma<im6m profit refers
to t5e 5ig5est possi9le of profit% In the short run, a firm not only should
be able to recover its total costs, but also should get excess revenue over
costs. his will build the morale of the firm and instill the spirit of
confidence in its operations. It may follow skimming price policy, i.e.,
charging a very high price when the product is launched to cater to the
needs of only a few sections of people. It may exploit wide opportunities
in the beginning. %ut it may prove fatal in the long run. It may lose its
customers and business in the market. -lternatively, it may adopt
penetration pricing policy i.e., charging a relatively lower price in the
latter stages in the long run so as to attract more customers and capture the
market.
). Profit optimiCation in t5e long r6n
he traditional profit maximi#ation hypothesis may not prove beneficial in
the long run. 1ith the sole motive of profit making a firm may resort to
several kinds of unethical practices like charging exorbitant prices, follow
'onopoly rade 5ractices 3'54, ?estrictive rade 5ractices 3?54 and
Onfair rade 5ractices 3O54 etc. his may lead to opposition from the
people. In order to over come these evils, a firm instead of profit
maximi#ation, aims at profit optimi#ation. Optim6m profit refers to t5e
most ideal or desira9le le7el of profit% 6ence, earning the most
reasonable or optimum profit has become a part and parcel of a sound
pricing policy of a firm in recent years.
3. Price Sta9iliCation
5rice stabili#ation over a period of time is another objective. he prices as
far as possible should not fluctuate too often. 5rice instability creates
uncertain atmosphere in business circles. (ales plan becomes difficult
under such circumstances. 6ence, price stability is one of the pre re$uisite
conditions for steady and persistent growth of a firm. - stable price policy
only can win the confidence of customers and may add to the good will of
the concern. It builds up the reputation and image of the firm.
;. acing competiti7e sit6ation
7ne of the objectives of the pricing policy is to face the competitive
situations in the market. In many cases, this policy has been merely
influenced by the market share psychology. 1herever companies are
aware of specific competitive products, they try to match the prices of
their products with those of their rivals to expand the volume of their
business. 'ost of the firms are not merely interested in meeting
competition but are keen to prevent it. 6ence, a firm is always busy with
its counter business strategy.
F. Maintenance of mar:et s5are
Mar:et s5are refers to t5e s5are of a firmFs sales of a partic6lar
prod6ct in t5e total sales of all firms in t5e mar:et% he economic
strength and success of a firm is measured in terms of its market share. In
a competitive world, each firm makes a successful attempt to expand its
market share. If it is impossible, it has to maintain its existing market
share. -ny decline in market share is a symptom of the poor performance
of a firm. 6ence, the pricing policy has to assist a firm to maintain its
market share at any cost.
9. Capt6ring t5e Mar:et
-nother objective in recent years is to capture the market, dominate the
market, command and control the market in the long run. In order to
achieve this goal, sometimes the firm fixes a lower price for its product
and at other times even it may sell at a loss in the short term. It may prove
beneficial in the long run. (uch a pricing is generally followed in price
sensitive markets.
K. Entr4 into ne; mar:ets%
-part from growth, market share expansion, diversification in its activities
a firm makes a special attempt to enter into new markets. 2ntry into new
markets speaks about the successful story of the firm. ,onse$uently, it has
to bear the pioneering and subse$uent risks and uncertainties. he price set
by a firm has to be so attractive that the buyers in other markets have to
switch on to the products of the candidate firm.
B. )eeper penetration of t5e mar:et
he pricing policy has to be designed in such a manner that a firm can
make inroads into the market with minimum difficulties. .eeper
penetration is the first step in the direction of capturing and dominating the
market in the latter stages.
A. Ac5ie7ing a target ret6rn
- predetermined target return on capital investment and sales turnover is
another long run pricing objective of a firm. he targets are set according
to the position of individual firm. 6ence, prices of the products are so
calculated as to earn the target return on cost of production, sales and
capital investment. .ifferent target returns may be fixed for different
products or brands or markets but such returns should be related to a
single overall rate of return target.
&8. 'arget profit on t5e entire prod6ct line irrespecti7e of profit le7el of
indi7id6al prod6cts%
he price set by a firm should increase the sale of all the products rather
than yield a profit on one product only. - rational pricing policy should
always keep in view the entire product line and maximum total sales
revenue from the sale of all products% A prod6ct line ma4 9e defined as a
gro6p of prod6cts ;5ic5 5a7e similar p54sical feat6res and perform
generall4 similar f6nctions. In a product line, a few products are
regarded as less profit earning products and others are considered as more
profit earning. 6ence, a proper balance in pricing is re$uired.
&&. $ong r6n ;elfare of t5e firm
- firm has multiple objectives. hey are laid down on the basis of past
experience and future expectations. (imultaneous achievement of all
objectives are necessary for the over all growth of a firm. 7bjective of the
pricing policy has to be designed in such a way as to fulfill the long run
interests of the firm keeping internal conditions and external environment
in mind.
&). A9ilit4 to pa4
5ricing decisions are sometimes taken on the basis of the ability to pay of
the customers, i.e., higher price can be charged to those who can afford to
pay. (uch a policy is generally followed by those people who supply
different types of services to their customers.
&3. Et5ical Pricing
%asically, pricing policy should be based on certain ethical principles.
%usiness without ethics is a sin. 1hile setting the prices, some moral
standards are to be followed. -lthough profit is one of the most important
objectives, a firm cannot earn it in a moral vacuum. Instead of s$uee#ing
customer, a firm has to charge moderate prices for its products. he
pricing policy has to secure reasonable amount of profits to a firm to
preserve the interests of the community and promote its welfare.
%esides these goals, there are various other objectives such as promotion
of new items, steady working of plants, maintenance of comfortable
li$uidity position, making $uick money, maintaining regular income to the
company, continued survival, rapid growth of the firm etc which firms
may set while taking pricing decisions.

Pricing Met5ods

1% 6ll H Cost pricing or Cost Pl6s Pricing Met5od
Full cost pricing is one of the simplest and common methods of pricing adopted
by different firms. 6all and 6itch of the 7xford Oniversity in their empirical
study of actual business behavior found that business firms do not determine price
and output by comparing '? and ',. 7n the other hand, under 7ligopoly and
monopolistic conditions they base their market price on full cost conditions.
-ccording to this principle, businessmen charge price that cover their average
cost in which are included normal or conventional profits. ,ost refers to full
allocated costs. -ccording to Qoel .ean, it has three components -
I. -ctual cost which refers to the actual or total expenses incurred in
production. For e.g., wage bills, raw material cost, overhead charges etc.
ii. 2xpected cost refers to the forecast for the pricing period on the basis of
expected prices, output rate and productivity.
iii. (tandard cost refers to cost incurred at the normal level of output.

In 9rief- a firm comp6tes t5e selling price of its prod6ct 94 adding certain
percentage to t5e a7erage total cost of t5e prod6ct. he percentage added to
costs is called as margin or mark-ups. 6ence, this method is also called as 'argin
: pricing and 'ark : up pricing. Cost Ipricing @ Cost I air profit
Fair profit means a fixed percentage of profit markups. It is arbitrarily determined.
he margin of profits included in the price of a product differs from industry to
industry and commodity to commodity on account of differences in competitive
strength, cost of production, total turnover, accounting practices etc. 5ast
traditions, directives from trade associations, guidelines from the government may
also decide the percentage of profits.
2% #ate of #et6rn Pricing
?ate of return pricing is a modified form of full cost pricing% Under t5is met5od-
a prod6cer decides a predetermined target rate of ret6rn on capital in7ested%
Full : cost pricing considers the mark-ups or profit arbitrarily. Instead of setting
the percentage arbitrarily a firm will determine the average mark- up on costs
necessary to produce a desired rate of return on the companyDs investments. hus,
under this method, price is determined along a planned rate of return on
investment. In this case, a company estimates future sales, future costs and arrive
at a mark : up that will achieve a target return on a companyDs investment.
5rofessor .avies and 6ughes in their book, !'anagerial 2conomics" have used
the following formula to calculate the desired rate of return when a mark up is
applied on cost.
Met us suppose that the capital employed by a firm is ?s.&9 lacks and the total
cost is ?s.&) lacks with a planned rate of return of 38 percent. %y making use of
the above formula, we can find out the percentage mark-up of the firm in the
following way.

Ill6stration=

+% "oing #ate Pricing%
Going rate pricing is the opposite of full cost pricing. In this method, emphasis is
given on market conditions rather than on costs. Generally, we come across this
method of pricing under oligopoly market especially under price leadership%
Under t5is met5od- a firm- fi< its price according to t5e price fi<ed 94 t5e
leader% - firm has monopoly power over the product it produces and can charge
its own price and face all the conse$uences of monopoly. 6owever, a firm
c5ooses t5e price ;5ic5 is going in t5e mar:et and c5arge a partic6lar price
t5at t5e ot5er follo;ers are c5arging%
his type of pricing is not the same as accepting a price set in a perfectly
competitive market. - firm has some power to fix the price but instead of doing
so, it adjusts its own price to the general price structure in the industry. 6ence this
method of pricing is known as acceptance pricing. +ormally under this method,
the industry tries to determine the lowest prices that the sellers or followers can
afford to accept considering various alternatives.
his method of pricing is easy to adopt, economical and rational. It helps in
avoiding cut-throat competition among firms.
Imitation Pricing It is a variant of going rate pricing. he firms which join the
industry late just imitate the price fixed by the leader. his is the same as going
rate pricing.

,% Administered prices
he term administered prices was introduced by *eynes for the prices charged by
a monopolist and therefore determined by considerations other than marginal cost.
- monopolist being a price maker consciously administers the price of his
product.
Indian economists like M.*. Qha and 'alcolm -diseshaiah have, however, a
slightly different conception about administered prices. According to t5e Indian
economists- an administered price for a commodit4 is t5e one ;5ic5 is
decided and ar9itraril4 fi<ed 94 t5e go7ernment% It is not allowed to be
determined by the free play of market forces of demand and supply% In short,
administered prices are t5e prices ;5ic5 are fi<ed and enforced 94 t5e
go7ernment in t5e o7erall interest of t5e econom4%
-dministered prices are fixed by the government for a few carefully selected
goods like steel, coal, aluminum, fertili#ers, petroleum, cooking gas etc., these
products are the raw materials for other industries and as such there is great need
for establishing and stabili#ing the total output and their prices. he public
distribution system is also subject to administered prices.
C5aracteristics=
hey are fixed by the government.
hey are statutory in form.
hey are regulatory in nature.
hey are meant as corrective measures.
hey are the outcome of the pricing policy of the government.
O9Eecti7es=
o protect the interests of weaker sections against high prices.
o curb or encourage the consumption of certain commodities.
o contain inflation and ensure price stability.
o counter stagflation and the conse$uent recession.
o mobili#e revenue for the government
o ensure efficient allocation of resources among different users.
o improve living standards of the masses and promote their economic welfare.
o ensure e$uitable distribution of certain goods which are scarce in supply.
o achieve macro economic goals like welfare, e$uity and stability.
!eed for Administered Prices=
o correct imperfections in price mechanism in a free enterprise economy.
o prevent price escalation of essential commodities when their supply falls short
of demand.
o protect the interests of consumers against profit greedy monopolists.
o provide certain necessaries of life at least in minimum $uantities at fair prices
to poorer sections of the society
.% Marginal Cost Pricing
It is based on a pure economic concept of e$uilibrium of a firm, where marginal cost is
e$ual to marginal revenue% Under t5is met5od price is determined on t5e 9asis of
marginal cost ;5ic5 refers to t5e cost of prod6cing additional 6nits. 5rice based on
marginal cost will be much more aggressive than the one based on total cost. - firm with
large unused capacity will have to explore the possibility of producing and selling more.
If the price is sufficient to cover the marginal cost, particularly in times of recession the
firm should be able to produce and sell the commodity and can think of recovering the
total cost in the long run.
his method though sounds excellent theoretically has the serious limitation of
ascertaining the marginal cost.
6% C6stomar4 Pricing
5rices of certain goods are more or less fixed in the minds of consumersI these are known
as !,harm prices". e.g., prices of soft drinks and other beverages. In this case a moderate
change in cost of production will not have any influence on price.
hough this method has the advantage of stability, it is not cost reflective.
/% Pricing of a !e; Prod6ct
%asically the pricing policy of a new product is the same as that for an established
product. he price must cover the full costs in the long run and direct costs or prime costs
in the short run. In case of new products the degree of uncertainty would be more as the
firm is generally ignorant about the cost and the market conditions. here are two
alternative price strategies which a firm introducing a new product can adopt, vi#.,
skimming price policy and penetration pricing policy.
a% S:imming Price Polic4
'5e s4stem of c5arging 5ig5 prices for ne; prod6cts is :no;n as price s:imming for
t5e o9Eect is to Js:im t5e creamK from t5e mar:et% - firm would charge a high price
initially when it gets a feeling that initially the product will have relatively inelastic
demand, when the product life is expected to be short and when there is heavy investment
of capital e.g., electronic calculators,
9% Penetration price polic4
Instead of setting a 5ig5 price- t5e firm ma4 set a lo; price for a ne; prod6ct 94
adding a lo; mar:-6p to t5e f6ll cost% his is done to penetrate the market as $uickly as
possible. his method is generally adopted when there are already well known brands of
the product in the market, to maximi#e sales even in the short period and to prevent entry
of rival products.
S6mmar4
*nowledge of cost and revenue concepts is of very great importance in
understanding the various methods of price-output determination and pricing policies
under both perfect and imperfect markets. otal revenue refers to the total receipts from
the sale of the goods, -verage revenue refers to the revenue per unit of the commodity
sold and marginal revenue is the additional revenue earned by selling an additional unit
of output. he relationship between revenue and price elasticity of demand has practical
significance in real business life. hese two concepts help the management in taking a
right decision with regard to the si#e of the out put and the determination of price.
.ifferent pricing policies and methods give an insight into the actual functioning of a
firm. .ynamic conditions of the market necessitate fre$uent changes in the pricing
policies and methods followed by a firm. 1hile formulating its pricing policy a firm has
to keep in its view some of the external factors like elasticity of demand, si#e of the
market, government policy, etc., and internal factors like production costs, the stages of
the product on the product life cycle etc., here are a few considerations to be kept in
mind like the objectives of a firm, competitive situation in the market, cost of production,
elasticity of demand, economic environment, government policy etc. he main objectives
of the pricing policy are profit maximi#ation, price stabili#ation, facing competitive
situation, capturing the market etc. 'arket price of a product depends upon a number of
factors like production cost, demand, consumer psychology, profit policy of the
management, government policy etc.
here are different methods of pricing for both established products as well as new
products. Full cost pricing or cost plus pricing, is one of the simplest and common
method of pricing adopted by different firms. 6ere the price is determined by adding a
certain mark-up to the average total cost. ?ate of return pricing is a modified form of full
cost pricing where the mark-up is decided on the basis of capital employed. Going rate
pricing is the opposite of full cost pricing generally followed under oligopoly market.
6ere the firm just follows the price prevailing in the market without bothering about
other things. Imitative pricing is similar to going rate pricing. 'arginal cost pricing,
where price is determined on the basis of marginal cost is more theoretical than being
practical. -dministered prices are the prices statutorily determined by the government for
certain important goods like steel, cement etc. here are two schemes of pricing for a new
product vi#., skimming price and penetration price. %ased on the market conditions and
the cost conditions these two methods are adopted.

,opyright U )8&& SMU
5owered by Si::im Manipal Uni7ersit4
.
MB0026- Unit 1- Mar:et Anal4sis
Unit 1 Mar:et Anal4sis
Meaning Of Mar:et And Mar:et Str6ct6re
Mar:et in economics does not refer to a place or places 96t to a commodit4 and also
to 964ers and sellers of t5at commodit4 ;5o are in competition ;it5 one anot5er
-ccording to 5appas and 6irschey, !'arket structure refers to the number and si#e
distribution of buyers and sellers in the market for a good or serviceJ% It indicates a set
of mar:et c5aracteristics t5at determine t5e nat6re of mar:et in ;5ic5 a firm
operates. .ifferent market structures affect the behavior of sellers and buyers in different
manners.
'5e term mar:et 5ence implies=
i. 2xistence of a commodity to be traded.
ii. 2xistence of sellers and buyers.
iii. 2stablishment of contact between the sellers and
buyers.
iv. 1illingness and ability to buy and sell a commodity and
v. 2xistence of a price at which the given commodity is to be bought and sold.

-mong the different market situations, perfect competition and monopoly form the two
extremes. In between these two market situations we come across a number of market
situations which may be collectively termed as imperfect markets. In these imperfect
markets, we notice the elements of competition as well as monopoly. hey are bi-lateral
monopoly, monopsony 3one buyer4, duopoly 3two sellers4 duopsony 3two buyers4,
oligopoly 3few sellers4, oligopsony 3few buyers4 and monopolistic competition 3many
sellers4. his can be better understood by the following chart.

2inds Of Mar:ets
Perfect Competition
5erfect competition is a comprehensive term which includes pure competition also.
%efore we discuss the details of perfect competition, it is necessary to have a clear idea
regarding the nature and characteristics of pure competition.
P6re Competition is a part of perfect competition. ,ompetition in the market is said to
be pure when the following conditions are satisfiedE
&. 5revalence of a large number of buyers and sellers.
). he commodity supplied by each firm is homogeneous.
3. Free entry and exit of firms.
;. -bsence of any kind of monopoly element.

Onder these conditions no individual producer is in a position to influence the market
price of the product. -ccording to 5rof. 2.6. ,hamberline - JUnder P6re Competition-
t5e indi7id6al sellers mar:et 9eing completel4 merged ;it5 t5e general one- 5e can
sell as m6c5 as 5e please at t5e going priceK% Meaning and )efinition of Perfect
Competition
- perfectly competitive market is one in which the number of 964ers and sellers are
7er4 large- all engaged in 964ing and selling a 5omogeneo6s prod6ct ;it5o6t an4
artificial restriction and possessing perfect :no;ledge of mar:et at a time%
-ccording to %ilas, !the perfect competition is characteri#ed by the presence of many
firmsE hey all sell identically the same product. he seller is the price : taker".
eat6res of t5e Perfect Competition
1% E<istence of 7er4 large n6m9er of 964ers and sellers
2% 0omogeno6s prod6cts
.ifferent firms constituting the industry produce homogenous goods. hey are identical
in character. 6ence, no firm can raise its price above the general level.
+% ree entr4 and e<it of firms
here is absolute freedom to firms to get in or get out of the industry. If the industry is
making profits, new firms are attracted into the industry.
,% E<istence of single price
2ach unit bought and sold, in the market commands the same price since products are
homogeneous.
.% Perfect :no;ledge of t5e mar:et
-ll sellers and buyers will have perfect knowledge of the market. (ellers cannot influence
buyers and buyers cannot influence sellers.
6% Perfect mo9ilit4 of factors of Prod6ction
Factors of production are free to move into any use or occupation in order to earn higher
rewards. (imilarly, they are also free to come out of the occupation or industry if they
feel that they are under remunerated.
/% 6ll and 6nrestricted competition
5erfectly competitive market is free from all sorts of monopoly, oligopoly conditions.
(ince there are very large number of buyers and sellers, it is difficult for them to join
together and form cartels or some other forms of organi#ations. 6ence, each firm acts
independently.
1% A9sence of transport cost
-ll firms will have e$ual access to the market. 'arket price charged by the sellers should
not vary because of differences in the cost of transportation.
3% A9sence of artificial "o7ernment controls
he Government should not interfere in matters pertaining to supply and price. It should
not place any barriers in the way of smooth exchange. 5rice of a commodity must be
determined only by the interaction of supply and demand forces.
10% '5e mar:et price is fle<i9le o7er a period of time
'arket price changes only because of changes in either demand or supply force or both.
hus, price is not affected by the sellers, buyers, firm, industry or the Government.
11% !ormal Profit
-s the market price is e$ual to cost of production, the firm can earn only normal profits
under perfect competition. +ormal profits are those which are just sufficient to induce the
firms to stay in business. It is the minimum reasonable level of profit which the
entrepreneur must get in the long run. It is a part of total cost of production because it is
the price paid for the services of the entrepreneur, i.e., profit is an item of expenditure to a
firm.

Special eat6res of Perfect Competition
i. It is an extreme form of market situation rarely to be found in the real world.
ii. It is a mere concept, a myth, an illusion and purely theoretical in nature.
iii. It is a hypothetical model.
iv. It is an ideal market situation.

E86ili9ri6m of t5e Ind6str4 and irm 6nder Perfect Competition

1% E86ili9ri6m of t5e Ind6str4 in t5e s5ort r6n
he term C2$uilibriumD in physical science implies a state of balance or rest. In
economics, it refers to a position or situation from which there is no incentive to change.
At t5e e86ili9ri6m point- an economic 6nit is ma<imiCing its 9enefits or ad7antages%
6ence, always there will be a tendency on the part of each economic unit to move
towards the e$uilibrium condition. ?eaching the position of e$uilibrium is a basic
objective of all firms.
In the short period, time available is too short and hence all types of adjustments in the
production process are impossible. -s plant capacity is fixed, output can be increased
only by intensive utili#ation of existing plants and machineries or by having more shifts.
Fixed factors remain the same and only variable factors can be changed to expand output.
otal number of firms remains the same in the short period. 6ence, total supply of the
product can be adjusted to demand only to a limited extent.
In the short run, price is determined in the industry through the interaction of the forces
of demand and supply. his price is given to the firm. 6ence, the firm is a price taker and
not price maker. 7n the basis of this price, a firm adjusts its output depending on the cost
conditions.
-n industry under perfect competition in the short run, reaches the position of
e$uilibrium when the following conditions are fulfilledE
&. here is no scope for either expansion or contraction of the output in the entire
industry. his is possible when all firms in the industry are producing an e$uilibrium
level of output at which '? / ',. In brief, the total output remains constant in the
short run at the e$uilibrium point. hus a firm in the short run has only temporar4
e86ili9ri6m.
). here is no scope for the new firms to enter the industry or existing firms to leave
the industry.
3. (hort run demand should be e$ual to short run supply. he price so determined is
called as Fs69normal priceF% +ormal price is determined only in the long run. 6ence,
short run price is not a stable price.

E86ili9ri6m of t5e competiti7e firm in t5e s5ort r6n
- competitive firm will reach e$uilibrium position at the point where short run '?
e$uals ',. -t this point e$uilibrium output and price is determined.
he firm in the short run will have only temporary e$uilibrium. he short run e$uilibrium
price is not a stable price. It is also called as sub : normal price.
he competitive firm, in the short run, will not be in a position to cover its fixed costs.
%ut it must recover short run variable costs for its survival and to continue in the industry.
- firm will not produce any output unless the price is at least e$ual to the minimum -H,.
If short run price is just e$ual to -H,, it will not cover fixed costs and hence, there will
be losses. %ut it will continue in the industry with the hope that it will
recover the fixed costs in the future.

If price is above the -H, and below the -,, it is called as !Moss minimi#ation" #one. If
the price is lower than -H,, the firm is compelled to stop production altogether.
1hile analy#ing short term e$uilibrium output and price, apart from making reference to
(', and -H,, we have to look into -, also. If -, / price, there will be normal profits.
If -, is greater than price, there will be losses and if -, is lower than price, then there
will be super normal profits.
In the short run, a competitive firm can be in e$uilibrium at various points 2&, 2) and 23
depending upon cost conditions and market price. -t these various unstable e$uilibrium
points, though '? / ',, the firm will be earning either super normal profits or incurring
losses or earning normal profits.
In the case of the firmE



&. -t 75; price the firm will neither cover -F, nor -H, and hence it has to wind
up its operations. It is regarded as s56t-do;n point%
). -t 75& price, 7>& is the e$uilibrium output. 2& indicates the price or -? / -H,
only. It does not cover fixed costs. '5e firm is read4 to s6ffer t5is loss and
contin6e in 96siness ;it5 t5e 5ope t5at price ma4 go 6p in t5e f6t6re%
3. -t 75) price, 7>) is the e$uilibrium output. 2) indicates the price / -? / -,.
-t this point '? is also e$ual to ',. -t this level of output total average revenue /
total average cost hence, t5e firm is earning onl4 normal profits% It is also known as
%reak : even point of the firm, a #one of no loss or no profit. he distance between
two e$uilibrium points 2) and 2& indicates loss- minimi#ation #one.
;. -t 753 price, 7>3 is the output produced by the firm. -t 23, '? / ',. %ut -?
is greater than -,. For 7>3 output, the total cost is 7>3-%. he total revenue is
7>32353. 6ence, 5323-% is the total s6per normal profits.
hus in the short run, a firm can either incur losses or earn super normal profits. he
main reason for this is that the producer does not have ade$uate time to make all kinds of
adjustments to avoid losses in the short run.
In case of the industry, 2 indicates the position of e$uilibrium where short run demand is
e$ual to short run supply. 7? indicates short run price and 7> indicates short run
demand and supply.

E86ili9ri6m of t5e Ind6str4 in t5e long r6n
In the long run, there is ade$uate time to make all kinds of changes, adjustments and
readjustments in the productive process. -ll factor inputs become variable in the long
run. otal number of firms can be varied and plant capacity also can be changed
depending upon the nature of re$uirements. 2conomies of scale, technological
improvements, better management and organi#ation may reduce production costs
substantially in the long run. 6ence, production can be either increased or decreased
according to the needs of the individual firms and the industry as a whole. In short,
supply of the product can be fully adjusted to its demand in the long period.
-n industry, in the long run will be reaching the position of e$uilibrium under the
following conditionsE

&. -t the point of e$uilibrium, the long run demand and supply of the products of
the industry must be e$ual to each other. his will determine long run normal price.
). here will be no scope for the industry to either expand or contract output.
6ence, the total production remains stable in the long run.
3. -ll the firms in the industry should be in the position of e$uilibrium. -ll firms in
the industry must be producing an e$uilibrium level of output at which long run ',
is e$uated to long run '?. 3', / '?4.
;. here should be no scope for entry of new firms into the industry or exit of old
firms out of the industry. In brief, the total number of firms in the industry should
remain constant.
F. -ll firms should be earning only normal profits. his happens when all firms
e$uate -? 35rice4 with -,. his will help the industry in attaining a stable
e$uilibrium in the long run.

E86ili9ri6m of t5e firm in t5e long r6n
- competitive firm reaches the e$uilibrium position when it maximi#es its profits. his is
possible whenE
&. he firm would produce that level of output at which '? / ', and ', curve
cuts '? curve from below. he firm adjusts its output and the scale of its plant so as
to e$uate ', with market price.
). he firm in the long run must cover its full costs and should earn only normal
profits. his is possible when long run normal price is e$ual to long run average cost
of production. 6ence,

3. 1hen -? is greater than -,, there will be place for super normal profits. his
leads to entry of new firms : increase in total number of firms : expansion in output :
increase in supply : fall in price : fall in the ratio of profits. his process will
continue till supernormal profits are reduced to #ero. 7n the other hand, when -, is
greater than -? the industry will be incurring losses. his leads to exit of old firms,
number of firms decrease, contraction in output, rise in price, and rise in the ratio of
profits. hus, losses are avoided by automatic adjustments. (uch adjustments will
continue till the firm reaches the position of e$uilibrium when -, becomes e$ual to
-?. hus losses and profits are incompatible with the position of e$uilibrium. 6ence,

;. he firm is operating at its minimum -, making optimum use of available
resources.


In the case of the industry, 2 is the position of e$uilibrium at which M?( / M?.,
indicating 7? as the e$uilibrium price and 7> as the e$uilibrium $uantity demanded and
supplied.
In case of the firm 5 indicates the position of e$uilibrium. -t 5, M'? / M', and M',
curve cuts M'? curve from below. -t the same point 5 the minimum point of M-, is
tangent to M-? curve. 6ence,.


- competitive firm in the long run must operate at the minimum point of the M-, curve.
It cannot afford to operate at any other point on the M-, curve. 7ther wise, it cannot
produce the optimum output or it will incur losses.
ime will play an important role in determining the price of a product in the market. -s
the time under consideration is short, demand will have a more decisive role than supply
in the determination of price. Monger the time under consideration, supply becomes more
important than demand in the determination of price.
he price determined in the long run is called as normal price and it remains stable.
Mar:et price=
It refers to that price which is determined by the forces of demand and supply in the very
short period where demand plays a major role than supply. (upply plays a passive role.
'arket price is unstable.
!ormal price=
It is determined by demand and supply forces in the long period. It includes normal
profits also. It is stable in nature.


Anal4Ce monopol4 mar:et and price discrimination
Monopol4
Meaning and definition=
he word monopoly is made up of two syllables : C'7+7D means single and !57M="
means to sell. hus, monopoly means existence of a single seller in the market.
Monopol4 is t5at mar:et form in ;5ic5 a single prod6cer controls t5e ;5ole s6ppl4
of a single commodit4 ;5ic5 5as no close s69stit6tes% 'onopoly may be defined as a
condition of production in which a person or a number of persons acting in combination
have the power to fix the price of the commodity or the output of the commodity. It is a
situation where there exists a single control over the market producing a commodity
having no substitutes and no possibilities for any one to enter the industry to compete.
-ccording to 5rof. 1atson : !- monopolist is the only producer of a product that has no
close substitutes".
eat6res of monopol4
1% Anti-'5esis of competition
-bsence of competition in the market creates a situation of monopoly and hence
the seller faces no threat of competition.
2% E<istence of a single seller
here will be only one seller in the market who exercises single control over the
market.
+% A9sence of s69stit6tes
here are no close substitutes for his product with a strong cross elasticity of
demand. 6ence, buyers have no alternatives.
,% Control o7er s6ppl4
6e will have complete control over output and supply of the commodity.
.% Price Ma:er
he monopolist is the price : maker and in taking decisions on price fixation, he is
independent. 6e can set the price to the best of his advantage. 6ence, he can either
charge a high price for all customers or adopt price discrimination policy.
6% Entr4 9arriers
2ntry of other firms is barred somehow. 6ence, monopolist will not have direct
competitors or direct rivals in the market.
/% irm and ind6str4 is same
here will be no difference between firm and an industry.
1% !at6re of firm
he monopoly firm may be a proprietary concern, partnership concern, Qoint (tock
,ompany or a public utility which pursues an independent price-output policy.
3% E<istence of s6per normal profits
here will be place for supernormal profits under monopoly, because market price is
greater than cost of production.
here are different kinds of monopolies : 5rivate and public, pure monopoly, simple
monopoly and discriminatory monopoly. It is to be clearly understood that with the
exception of public utilities or institutions of a similar nature, whose price is set by
regulatory bodies, monopolies rarely exist. Qust like perfect competition, pure monopoly
does not exist. 6ence, we make a detailed study of simple monopoly and discriminatory
monopoly in the foregoing analysis.

Price H O6tp6t )etermination Under Monopol4
Ass6mptions
a. he monopoly firm aims at maximi#ing its total profit.
b. It is completely free from Govt. controls.
c. It charges a single P uniform high price to all customers.
It is necessary to note that the price output analysis and e$uilibrium of the firm and
industry is one and the same under monopoly.
-s output and supply are under the effective control of the monopolist, the market forces
of demand and supply do not work freely in the determination of e$uilibrium price and
output in case of the monopoly market. 1hile fixing the price and output, the monopoly
firm generally considers the following important aspects.
&. he monopolist can either fix the price of his product or its supply. 6e cannot fix
the price and control the supply simultaneously. 6e may fix the price of his product
and allow supply to be determined by the demand conditions or he may fix the output
and leave the price to be determined by the demand conditions.
). It would be more beneficial to the monopolist to fix the price of the product
rather than fixing the supply because it would be difficult to estimate the accurate
demand and elasticity of demand for the products.
3. 1hile determining the price, the monopolist has to consider the conditions of
demand, cost of the product, possibility of the emergence of substitutes, potential
competition, import possibilities, government control policies etc. G
;. If the demand for his product is inelastic, he can charge a relatively higher price
and if the demand is elastic, he has to charge a relatively lower price. G
F. 6e can sell larger $uantities at lower price or smaller $uantities at a higher price.
9. 6e should charge the most reasonable price which is neither too high nor too low.
K. he most ideal price is that under which the total profit of the monopolist is the
highest.

Price-O6tp6t )etermination in t5e S5ort Period%
(hort period is a time period in which there are two types of factors of production. 7ne is
the fixed factors and the other is the variable factors. In the short period, production can
be changed only by changing the variable factors of production. Fixed factors of
production cannot be changed. In other words, in the short period, supply can be changed
only to some extent. In this period volume of production can be changed but capacity of
the plant cannot be changed. 6e can increase the supply only with the help of existing
machines and plants. +ew factories and plant-e$uipment cannot be installed.
he aim of a monopolist is to earn maximum profits or suffer minimum losses if the
circumstances compel. 'onopolist, being single seller of his product, can fix his price
e$ual to, above or less than the short period average cost of the product. hus, he can
earn normal profits, supernormal profits or incur losses even in the short period. his
depends upon the nature and extent of the demand for his product. In order to earn
maximum profits or suffer minimum losses, a monopolist compares his marginal revenue
3'?4 with marginal cost 3',4. If marginal revenue exceeds marginal cost of a product,
the monopolist can increase his profit by increasing his production. 7n the contrary, if
', exceeds '? at a particular level of output, the monopolist can minimi#e his losses
by reducing his production. (o the monopolist is said to be in e$uilibrium where marginal
revenue is e$ual to marginal cost.
In the short period, a monopoly firm can earn supernormal profits, normal profits or incur
losses. In case of losses, price must be covering at least the average variable costs.
7therwise the firm will stop production. he maximum loss can be e$ual to fixed costs.
he three cases of monopoly e$uilibrium can be shown through the figures drawn below.

In figure 3a4 -? J -,. 6ence, super normal profits.
In figure 3b4 -? / -,. 6ence, normal profits.
In figure 3c4 -? L -,. 6ence, losses.

he figures explain how a monopoly firm can earn supernormal profits, normal profits or
incur losses in the short period.
Price-o6tp6t determination in t5e long r6n%
In the long run, there is ade$uate time to make all kinds of adjustments in both fixed as
well as variable factor inputs. (upply can be adjusted to demand conditions. he total
amount of long run profits will depend on the cost conditions under which the monopolist
has to operate and the demand curve he has to face in the long run.

Onder monopoly, the -? or demand curve slope downwards from left to right. his is
because the monopolist can increase his sales and maximi#e his profits only when he
reduces the price. '? is less than -? and hence, the '? curve lies below the -? curve.
his is in accordance with the usual relationship between -? P '?.

he cost curve of the monopoly firm is influenced by the laws of returns. he price he
has to charge for his product mainly depends on the nature of his cost curves.

he monopoly firm, in the long run, will continue its operations till it reaches the
e$uilibrium point where long run '? e$uals long run ',. he price charged at this level
of output is known as e$uilibrium price.

In the diagram, the monopoly firm reaches the position of e$uilibrium at 2. -t this point,
'? / ', and ', curve cuts '? curve from below. he monopolist will stop his output
before -, reaches its minimum point. 6e does not bother to reach the minimum point on
-,.
6e restricts his output in order to maximi#e his profit, 7> is the output. he price
charged by the firm is >? 35>4 which is e$ual to -?. his price is higher than average
cost >' per unit. he excess profit per unit of output is 5' and the total profits of the
firm is 5' < ?+ / +?5' . Onder monopoly, no doubt '? / ', but ' ? is less than
-?. 0ence- monopol4 price @ A# onl4% Price is greater t5an AC- MC and M#%
Generally speaking, monopoly price is slightly higher than that of competitive price
because market price is over and above ',, '? and -,. he single seller has complete
control over the supply as he can successfully prevent the entry of other new firms into
the market. hus, the monopoly power is reflected on its price. 'onopoly price is
generally higher than competitive price and thus detrimental to the interests of the
society.
'onopoly price need not be high always on account of the following reasonsE

&. .ue to the operation of both internal as well as external economies of scale, he
may reduce the cost of production and hence, price too.
). he monopolist need not spend more money on sales promotion programmes. 6e
can save $uite a lot of money and charge a lower price for his product.
3. 6e has the fear that consumers may boycott his product if he charges a very high
price.
;. here is the fear of discovery of new substitutes by other competitors in the
market. 6ence, he charges low prices.
F. 6e is afraid of the Govt. intervention in controlling monopoly power and hence,
he may charge a lower price.
9. 6e may spend lot of money on ?P. and reduce cost of operation. ,ost reduction
may facilitate price reduction.
hus, in order to maintain the good will of the consumers and to secure good business,
instead of charging high price, he may charge a relatively lower price.

Price )iscrimination
Generally, speaking the monopolist will not charge uniform price for all the customers in
the market. 6e will follow different methods under different circumstances. '5e polic4
of price discrimination refers to t5e practice of a seller to c5arge different prices for
different c6stomers for t5e same commodit4- prod6ced 6nder a single control
;it5o6t corresponding differences in cost% 1hen a monopoly firm adopts this policy, it
will become a discriminatory monopoly. -ccording to 5rof. %enham, !'onopolist may
be able however, to divide his sales among a number of different markets and to charge a
different price in each market."
-ccording to 'rs. Qoan ?obbinson !he act of selling the same article produced under a
single control at different prices to different customers is known as price discrimination."
P#ICE )ISC#IMI!A'IO! MA* 'A2E '0E O$$OBI!" O#MS= >BASIS O
P#ICE )ISC#IMI!A'IO!?
1% Personal differences=
his is nothing but charging different prices for the same commodity because of personal
differences arising out of ignorance and irrationality of consumers, preferences,
prejudices and needs.
2% Place=
'arkets may be divided on the basis of entry barriers, for e.g. price of goods will be high
in the place where taxes are imposed. 5rice will be low in the place where there are no
taxes or low taxes.
+% )ifferent 6ses of t5e same commodit4=
1hen a particular commodity or service is meant for different purposes, different rates
may be charged depending upon the nature of consumption. For e.g. different rates may
be charged for the consumption of electricity for lighting, heating and productive
purposes in industry and agriculture.
,% 'ime=
(pecial concessions or rebates may be given during festival seasons or on important
occasions.
.% )istance=
?ailway companies and other transporters, for e.g., charge lower rates per *' if the
distance is long and higher rates if the distance is short.
6% Special orders=
1hen the goods are made to order it is easy to charge different prices to different
customers. In this case, particular consumer will not know the price charged by the firm
for other consumers.
/% !at6re of t5e prod6ct=
5rices charged also depends on nature of products e.g., railway department charge higher
prices for carrying coal and luxuries and less prices for cotton, necessaries of life etc.
1% A6antit4 of p6rc5ase=
1hen customers buy large $uantities, discount will be allowed by the sellers. 1hen small
$uantities are purchased, discount may not be offered.
3% "eograp5ical area=
%usiness enterprises may charge different prices at the national and international markets.
For example, dumping : charging lower price in the competitive foreign market and
higher price in protected home market.
10% )iscrimination on t5e 9asis of income and ;ealt5=
For e.g., - doctor may charge higher fees for rich patients and lower fees for poor
patients.
11% Special classification of cons6mers=
For 2.g., ransport authorities such as ?ailway and ?oadways show concessions to
students and daily travelers. .ifferent charges for I class and II class traveling, ordinary
coach and air conditioned coaches, special rooms and ordinary rooms in hotels etc.
12% Age=
,inema houses in rural areas and transport authorities charge different rates for adults and
children.
1+% Preference or 9rands=
,ertain goods will be sold under different brand names or trade marks in order to attract
customers. .ifferent brands will be sold at different prices even though there is not much
difference in terms of costs.
1,% Social and or professional stat6s of t5e 964er=
- seller may charge a higher price for those customers who occupy higher positions and
have higher social status and less price to common man on the street.
1.% Con7enience of t5e 964er=
If a customer is in a hurry, higher price would be charged. 7therwise normal price would
be charged.
16% )iscrimination on t5e 9asis of se<=
In selling certain goods, producers may discriminate between male and female buyers by
charging low prices to females.
1/% If price differences are minor- c6stomers do not 9ot5er a9o6t s6c5
discrimination%
11% Pea: season and off pea: season ser7ices
6otel and transport authorities charge different rates during peak season and off-peak
seasons.

Pre-#e86isite Conditions for Price )iscrimination >;5en price descrimination is
possi9le?
1% E<istence of imperfect mar:et=
Onder perfect competition there is no scope for price discrimination because all the
buyers and sellers will have perfect knowledge of market. Onder monopoly, there will be
place for price discrimination as there are buyers with incomplete knowledge and
information about the market.
2% E<istence of different degrees of elasticit4 of demand in different mar:ets=
- 'onopolist will succeed in charging higher price in inelastic market and lower price in
the elastic market.
+% E<istence of different mar:ets for t5e same commodit4=
his will facilitate price discrimination because buyers in one market will not be knowing
the prices charged for the same commodity in other markets.

,% !o contact among 964ers=
If there is possibility of contact and communication among buyers, they will come to
know that discriminatory practices are followed by buyers.
.% !o possi9ilit4 of resale=
'onopoly product purchased by consumers in the low priced market should not be resold
in the high priced market. 5revention of re exchange of goods is a must for price
discrimination.
6% $egal sanction=
In some cases, price discrimination is legally allowed. For 2.g., he electricity
department will charge different rates per unit of electricity for different purposes.
(imilarly charges on trunk callsI book post, registered posts, insured parcel, and courier
parcel are different.
/% B64ers ill6sion=
1hen consumers have an irrational attitude that high priced goods are of high $uality, a
monopolist can resort to price-discrimination.
1% Ignorance and let5arg4=
.ue to la#iness and lethargy consumers may not compare the price of the same product in
different shops. Ignorance of consumers with regard to price variations would enable the
monopolist to charge different prices.
3% Preferences and PreE6dices of 964ers=
he monopolist may charge different prices for different varieties or brands of the same
product to different buyers. For e.g. low price for popular edition of the book and high
price for deluxe edition.
10% !on-'ransfera9ilit4 feat6res=
In case of direct personal services like private tuitions, hair-cuts, beauty and medical
treatments, a seller can conveniently charge different prices.
11% P6rpose of ser7ice=
he electricity department charges different rates per unit of electricity for different
purposes like lighting, -26, agriculture, industrial operations etc. railways charge
different rates for carrying perishable goods, durable goods, necessaries and luxuries etc.
12% "eograp5ical distance and tariff 9arriers=
1hen markets are separated by large distances and tariff barriers, the monopolist has to
charge different prices due to high transport cost and high rate of taxes etc.

)6mping polic4
It refers to selling of goods at lo;er prices in t5e competiti7e International mar:et
and at 5ig5er prices in t5e protected domestic mar:et% +ormal dumping policy is
justified because a commodity is sold in both national and international markets. 6ence,
output will be naturally high. Marge scale production enables the firm to reduce average
cost.
Monopolistic Competition
5erfect competition and monopoly are the two extreme forms of market situations, rarely
to be found in the real world. Generally, markets are imperfect. - number of attempts
have been made by different economists like 5iero (hraffa, 6otelling, Xeuthen and others
in the early &A)8Ds, 'rs Qoan ?obinson and 5rof ,hamberlin in &A38Ds to explain the
behavior of imperfect competition.
5rof. ,hamberlin is the main architect of the theory of 'onopolistic ,ompetition. his
market exhibits the characteristics of both competition and monopoly. (ince modern
markets are combined and integrated with monopoly power and competitive forces they
are called as 'onopolistic ,ompetition. It is a mar:et str6ct6re in ;5ic5 a large
n6m9er of small sellers sell differentiated prod6cts ;5ic5 are close- 96t not perfect
s69stit6tes for one anot5er% Onder this market, the products produced and sold are
different, but they are close substitutes for one another. his leads to competition among
different sellers. hus, in this market situation every producer is a sort of monopolist and
between such !mini-monopolists" there exists competition. It is one of most popular and
realistic market situation to be found in the present day world. - number of examples
may be given for this kind of market. ooth paste, blades, motor cycles and bicycles,
cigarettes, cosmetics, biscuits, soaps and detergents, shoes, ice : creams etc.

C5aracteristics of Monopolistic Competition
1% E<istence of a large !6m9er of firms=
Onder 'onopolistic competition, the number of firms producing a product will be large.
he si#e of each firm is small. +o individual firm can influence the market price. 6ence,
each firm will act independently without worrying about the policies followed by other
firms. 2ach firm follows an independent price-output policy.
2% Mar:et is c5aracteriCed 94 imperfections
Imperfections may arise due to advertisements, differences in transport cost, irrational
preferences of consumers, ignorance about the availability of different brands of products
and prices of products etc., sellers may also have inade$uate knowledge about market and
prices existing at different segments of markets.
+% ree entr4 and e<it of firms
2ach firm produces a very close substitute for the existing brands of a product. hus,
differentiation provides ample opportunity for a firm to enter with the group or industry.
7n the contrary, if the firm faces the problem of product obsolescence, it may be forced
to go out of the industry.
,% Element of monopol4 and competition
2very firm enjoys some sort of monopoly power over the product it produces. %ut it is
neither absolute nor complete because each product faces competition from rival sellers
selling different brands of the product.
.% Similar prod6cts 96t not identical
Onder monopolistic competition, the firm produces commodities which are similar to one
another but not identical or homogenous. For 2.g. toothpastes, blades, cigarettes, shoes
etc,
6% !on-price competition
In this market, there will be competition among !'ini-monopolists" for their products
and not for the price of the product. hus, there is !product competition" rather than
!price competition".
/% )efinite preference of t5e cons6mers
,onsumers will have definite preference for particular variety or brands loyalty owing to
the special features of a product produced by a particular firm.
1% Prod6ct differentiation
he most outstanding feature of monopolistic competition is product differentiation.
Firms adopt different techni$ues to differentiate their products from one another. It may
take mainly two formsE

a% #eal prod6ct difference=
It will arise :
i. 1hen they are produced out of materials of higher $uality, durability and
strength.
ii. 1hen they are extraordinary on the basis of workmanship, higher cost of
material, color, design, si#e, shape, style, fragrance etc.
iii. 1hen personal care is taken to produce it.

9% Imaginar4 prod6ct difference=
5roducers adopt different methods to differentiate their products from that of other close
substitutes in the following manner.
i. 5roper location of sales depots in busy and prestigious commercial centers.
ii. (elling goods under different trade marks, patenting rights, different brands and
packing them in attractive wrappers or containers.
iii. 5roviding convenient 1orking hours to customers.
iv. 6ome delivery of goods with no extra cost.
v. ,ourteous treatment to customers, $uick and prompt delivery of goods in time
and developing cordial, personal and friendly relations with them.
vi. 7ffering gifts, discounts, lucky dip schemes, special prices, guarantee of repairs
and other free services, guarantee of products, fair dealings, sales on credit or credit
cards P debit cards etc.
vii. -greement to take back goods if they are unsatisfactory.
viii. -ir conditioned stores etc.

3% Selling Costs
All t5ose e<penses ;5ic5 are inc6rred on sales promotion of a prod6ct are called as
selling costs% In the words of 5rof. ,hamberlin : !selling ,osts are those which are
incurred by the producers 3sellers4 to alter the position or shape of the demand curve for a
product". In short, selling costs represents all those selling activities which are directed to
persuade buyers to change their preferences so as to maximi#ed the demand for a given
commodity. (elling costs include expenses on sales depots, decoration of the shop,
commission given to intermediaries, window displays, demonstrations, exhibitions, door
to door canvassing, distribution of free samples, printing P distributing pamphlets,
cinema slides, radio, .H., newspaper advertisements 3informative and manipulative
advertisements4 etc.

10% '5e concept of Ind6str4 N Prod6ct "ro6ps
5rof. ,hamberlin introduced the concept of group in place of industry. Industry in
economics refers to a number of firms producing similar products. Onder monopolistic
competition no doubt, different firms produce similar products but they are not identical.
6ence, 5rof. ,hamberlin has made an attempt to redefine the industry. -ccording to him,
the monopolistically competitive industry is a CgroupDof firms producing a !closely
related" commodity referred to as !product group" thus group refers to a collection of
firms that produce closely related but not identical products.

11% More elastic demand c6r7e
5roduct differentiation makes the demand curve of the firm much more elastic. It implies
that a slight reduction in the price of one product assuming the price of all other products
remaining constant leads to a large increase in the demand for the given product.
P#ICE H OU'PU' )E'E#MI!A'IO!
S5ort r6n e86ili9ri6m
(hort period is a period of time where time is inade$uate to make all sorts of changes and
adjustments in the productive process. he demand P cost conditions may vary
substantially forcing the firm either to charge a higher or lower price leading to
supernormal profits or losses. 6owever, each firm fixes such price and produce output
which maximi#es its profit. he e$uilibrium price and output is determined at the point
where (hort run 'arginal cost e$uals 'arginal revenue. hus, the first condition for
(hort run e$uilibrium is ', / '? in both diagrams.
he first diagram shows supernormal profits. In this case, price 3-?4 is greater than -,
3cost 5er Onit4. '> is the cost per unit and total cost for 7> output is / '> < 7> /
7+'>. 5> is the price or revenue per unit and the total revenue for 7> output is / 5>
< 7> / 7?5>. (upernormal profit / ? 37?5>4 : , 37+'>4. 6ence, +?5' is the
total profit.
he second diagram shows losses. In this case, -, is greater than -?. 5> is the cost per
unit and the total cost is 5> x 7> / 7?5>. '> is the revenue per unit P the total
revenue for 7> output is '> < 7> / 7+'>.
otal losses / , 37?5>4 : ? 37+'>4 / +?5'. hus, in the (hort run, there will be
place for supernormal profits or losses.
Price o6tp6t determination in t5e long r6n
Mong run is a period of time where a firm will get ade$uate time to make any changes in
the productive process or business. - firm can initiate several measures to minimi#e its
production costs and enjoy all the benefits of large scale production.he cost conditions,
as a result differ slightly in the long run. 1hile fixing the price, a firm in the long run
should consider its -, P -?.
Generally speaking in the long run a firm can earn only normal profits. If -? is greater
than -,, there will be super normal profits. his leads to entry of new firms : increase in
the total number of firms : total production : fall in prices : decline in profit ratio. 7n
the other hand, if -, is greater than -?, there will be losses. his leads to exit of old
firms : decrease in the number of firms : total production : rise in prices : increase in
profit ratio. hus, the entry and exit of firms continue till -? becomes e$ual to -,. hus,
in the long run, two conditions are re$uired for the e$uilibrium of the firm :
&4 '?/', and
)4 -?/-,. 6owever, it should be noted that price is greater than '? P ',.
In the diagram 2 is the e$uilibrium position where '? / ', and ', curve cuts '?
curve from below. -t 5, -? / -, / price.
It is necessary to understand that a firm under monopolistic competition in the long run
also can earn supernormal normal profits. 5rof. (tonier P 6ague suggest that a firm can
go for innovation to introduce new changes in the context of a modern competitive
business. his appears to be more realistic because today almost all firms make heavy
profits. 6ence, it is regarded as one of the most practical forms of market situations in the
present day world.
2xistence of oligopoly ,duopoly, bilateral monopoly , monopsony , duopsony ,
oligopsony
Oligopol4
he term oligopoly is derived from two Greek words !7ligoi" means a few and C5olyD
means to sell. Under oligopol4- ;e come across a fe; prod6cers specialiCing in t5e
prod6ction of identical goods or differentiated goods competing ;it5 one anot5er%
he products traded by the oligopolists may be differentiated or homogeneous. In the
case of former, we can give the e.g., of automobile industry where different model of
cars, ambassador, fiat etc., are manufactured. 7ther examples are cigarettes, refrigerators,
.H. sets etc., pure or homogeneous oligopoly includes such industries as cooking and
commercial gas cement, food, vegetable oils, cable wires, dry batteries, petroleum etc., In
the modern industrial set up there is a strong tendency towards oligopoly market
situation. o avoid the wastes of competition in case of competitive industries and to face
the emergence of new substitutes in case of monopoly industries, oligopoly market is
developed. e.g., an electric refrigerator, automatic washing machines, radios etc.

C5aracteristics of Oligopol4
1% Interdependence=
2ach and every firm has to be conscious of the reactions of its rivals. (ince the number of
firms is very few, any change in price, output, product etc., by one firm will have direct
effect on the policy of other firms. herefore, economic calculations must be made
always with reference to the reactions of the rival firms, as they have a high degree of
cross elasticityDs of demand for their products.
2% Indeterminateness of t5e demand c6r7e=
Onder oligopoly, there will be the element of uncertainty. Firms will not be knowing the
particular factors which could affect demand. +aturally rise or fall in the demand for the
product cannot be speculated. ,hanges that would be taking place may be contrary to the
expected changes in the product curve.. hus, the demand curve for the product will be
indeterminate or indefinite. 5rof. (wee#y explains it as a kinky demand curve.

+% Conflicting attit6de of firms=
Onder oligopoly, on the one hand, firms may reali#e the disadvantages of competition
and rivalry and desire to unite together to maximi#e their profits. 7n the other hand firms
guided by individualistic considerations may continuously come in clash and conflict
with one another. his creates uncertainty in the market.
,% Element of monopol4 and competition=
Onder oligopoly, a firm has some monopoly power over the product it produces but not
on the entire market. %ut monopoly power enjoyed by the firm will be limited by the
extent of competition.
.% Price rigidit4=
Generally, prices tend to be sticky or rigid under oligopoly. his is because of the fact
that if one firm changes its price, other firms may also resort to the same techni$ue.
6% Aggressi7e or defensi7e mar:eting met5ods=
Firms resort to aggressive and sometimes defensive marketing methods in order to either
increase their share of the market or to prevent a decline of their share in the market. If
one adopts extensive advertisement and sales promotion policy it provokes others to do
the same. 5rof. %oumal rightly remarks in this connection- !Onder oligopoly, advertising
can become a life and death matter where a firm which fails to keep up with the
advertising budget of its competitors may find its customers drifting off to rival firms".
/% Constant str6ggle=
,ompetition is of uni$ue type in an oligopolistic market. 6ence, competition consists of
constant struggle of rivals against rivals.
1% $ac: of 6niformit4=
Mack of uniformity in the rise of different oligopolies is another remarkable feature.
3% Small n6m9er of large firms=
he numbers of firms in the market are small. %ut the si#e of each firm is big. he market
share of each firm is sufficiently large to dominate the market.
10%E<istence of :in:ed demand c6r7e =
- kinked demand curve is said to occur when there is a sudden change in the
slope of the demand curve. It explains price rigidity under oligopoly.

Price H O6tp6t )etermination 6nder Oligopol4
It is necessary to note that there is no one system of pricing under oligopoly market.
5ricing policy followed by a firm depends on the nature of oligopoly and rivals reactions.
6owever, we can think of three popular types of pricing under oligopoly. hey are as
followsE
Independent Pricing= >!on-coll6si7e oligopol4?
1hen goods produced by different oligopolists are more or less similar or homogeneous
in nature, there will be a tendency for the firms to fix a common pricing. - firm generally
accepts the !Going price" and adjusts itself to this price. (o long as the firm earns
ade$uate profits at this price, it may not endeavor to change this price, as any effort to do
so may create uncertainty. 6ence, a firm follows what is called is !-cceptance pricing" in
the market.
1hen goods produced by different firms are different in nature 3differentiated oligopoly4,
each firm will be following an independent pricing policy as in the case of monopoly. In
this case, each firm is aware of the fact that what it does would be closely watched by
other oligopolists in the industry. 6owever, due to product differentiation, each firm has
some monopoly power. It is referred, to as monopoly behavior of the 7ligopolist. 7n the
contrary, it may lead to 5rice-wars between different firms and each firm may fix price at
the competitive level. - firm tends to charge prices even below their variable costs. hey
occur as a result of one firm cutting the prices and others following the same. It is due to
cut-throat competition in oligopoly. he actual price fixed by a firm may fall in between
the upper limit laid down by the monopoly price and the lower limit fixed by the
competitive price. It may be similar to that of the pricing under monopolistic competition.
6owever, independent pricing in reality leads to antagonism, friction, rivalry, infighting,
price-wars etc., which may bring undesirable changes in the market. he 7ligopolist may
reali#e the harmful effects of competition and may decide to avoid all kinds of wastes. It
encourages a tendency to come together. his leads to pricing under collusion. In other
words independent pricing can be followed only for a short period and it cannot last for a
long period of time.

Pricing Under Coll6sion
,ollusion is just opposite of competition. he term collusion means to !play together" in
economics. It means that the firms co-operate with each other in taking joint actions to
keep their bargaining position stronger against the consumer. Firms give place for
collusion when they join their hands in order to put an end to antagonism, uncertainty and
its evils.
1hen the government action is responsible for brining the firms together, there will be
place for 2<5MI,I ,7MMO(I7+. 7n the other hand, when restrictions are introduced,
firms may form themselves into secret societies resulting in I'5MI,I ,7MMO(I7+.
,ollusion may be based on either oral or written agreements. ,ollusion based on oral
agreement leads to the creation of what is called as !GentlemanDs -greement !. It does
not consist of any records. 7n the other hand, collusion based on written agreement
creates what is known as ,-?2M(.
here are different types of cartel agreements. 7n the one extreme, the firms surrender all
their rights to a central authority which sets prices, determine output, marketing $uotas
for each firm, distributes profits etc. his is called as centrali#ed cartels. - centrali#ed or
perfect cartel is an arrangement where the firms in an industry reach an agreement which
maximi#es joint profits. 6ence, the cartel can act as a monopolist. (ince the firms in the
cartel are assumed to produce homogeneous goods, the market demand for the product is
the cartelDs demand. It is also assumed that the cartel management knows the demand at
each possible price and also the marginal costs of all its firms, it can therefore, find out
the '? and ', for the industry. he desire of the firms to have large joint profits gives
impulse to form cartels. %ut such a desire is short lived and therefore, the formal
arrangement or cartels cannot be a long term phenomenon.
Onder the second type of cartel agreement, market : sharing cartel, the firms in the
industry produce homogeneous products and agree upon the share each firm is going to
have. 2ach firm sells at the same price but sells with in a given region. (uch a system can
function only if the firms having identical costs.
'arket sharing model has a very restrictive assumption of identical costs for all firms.
(ince in practice the firms have une$ual costs and every firm wants to have some degree
of independent action, the market-sharing cartels are not long-lived.

Price $eaders5ip
5erfect collusion is not possible in practice. 'utual suspicision and distrust among
member-firms and their unwillingness to surrender all their sovereignty makes the
collusion imperfect. here are a number of imperfect collusions and one of the most
important form is 5?I,2 M2-.2?(6I5. -ccording to 5rof. %ain, : !If changes are
usually or always price changes by other sellers, price competition may be said to involve
price leadership".
Price H #igidit4 and 2in:ed )emand C6r7e 6nder Oligopol4
*inked demand curve was first used by 5rof. '. (wee#y to explain price rigidity under
oligopoly. It represents the behavior of an oligopoly firm which has no incentive either to
increase or decrease its price. 2ach firm by its experience has learnt what will be the
reactions of rivals to actions on her part and may voluntarily avoid any activity that will
lead to the situation of price-war. 2ach firm is content with present price-output and
profits and it does not want to make any change. 6ence, they do not change their price-
$uantity combinations in response to small shifts in their cost curves.

)6opol4
eat6res
)6opol4 is a mar:et ;it5 t;o sellers e<ercising control o7er t5e s6ppl4 of
commodities% It is a two-firm industry. In the words of ,ohen and ,yret : !1hen there
are exactly two sellers in the market, there is a special case of oligopoly called .uopoly".
2ach seller knows what ever he does will affect his rivalDs policies. 2ach seller attempts
to make a correct guess of his rivals motives and actions. he action by one will have a
reaction from the other.
Bilateral Monopol4
%ilateral monopoly is a special type of market situation in which a single seller faces a
single buyer, i.e., a monopsonist is facing a monopolist. (uppose that in a town, there is
only one steel factory offering employment for labor in the area and suppose a trade
union controls the entire labor supply, the trade union which controls the supply of lab
our is the monopoly and the steel factory which is the sole buyer of labor is the
monopsony.
Monopson4
'onopsony refers to a market with a single buyer who buys the entire amount produced.
- monopsony may be created when all the consumers of commodity are organi#ed
together. (uppose there is only one cotton mill in a region. It becomes a monopsonist
buyer of raw cotton, while the suppliers of cotton to the mill will be the large number of
cotton growers.Qust as the monopolist aims at maximi#ing his profit, in the same manner
the monopsonist aims at maximi#ing his consumerDs surplus, and the consumerDs surplus
is maximum when the marginal cost is e$ual to marginal utility. - monopsonist too can
adopt price discrimination paying different prices to different sellers according to the
elasticity of supply.

)6opson4
.uopsony is an economic condition similar to a duopoly, in which there are only two
large buyers for a specific product or service. 'embers of a duopsony have great
influence over sellers and can effectively lower market prices for their advantage.
For example, letDs imagine a town in which only two restaurants operate. here are only
two employment options for waiters and chefs. %ecause the restaurants have less
competition for finding employees, they can offer lower wages. he chefs and waiters
have no choice but to accept the low pay, unless they choose not to work. his shows that
firms that are part of a duopsony have the power not only to lower the cost of supplies,
but also to lower the price of labor.

Oligopson4
(imilar to an oligopoly, this is a market in which there are a few large buyers for a
product or service. his allows the buyers to have a great deal of control over the sellers
and can effectively push down the prices.
S6mmar4
he organi#ation and functioning of a firm is determined by the type of market in which
it is operating. - market structure is characteri#ed by the number of buyers and sellers,
nature of the commodity dealt with, the scope for entry and exit of firms and the
determination of price. 5erfect competition exhibits an ideal market situation, where there
are a large number of buyers and sellers, the commodity dealt with is homogeneous and
there is free entry and exit of firms into and out of the industry, a uniform price prevails
in the market. In the long run 5rice is e$ual to '?/-?/',/-,. he firms can make
only normal profit in the long run.
'onopoly is a market situation where a single seller has total control over the price and
output. here is scope for price discrimination. 6e can charge different prices to different
customers at different places for different uses at different periods of time for the
commodity produced under same cost conditions.
7ligopoly is a market condition where a few big sellers producing either homogeneous or
differentiated goods control the market. 5opular methods of pricing under oligopoly are
collusive pricing or price leadership.
%ilateral monopoly is a situation where a monopolist faces a 'onopsonist. 'onopsony is
a case of single buyer, .uopsony explains a situation of two buyers and 7ligopsony, a
situation of a few big buyers controlling the market, Industry analysis explains how the
entire market is closely knit and how the structure of the market, conduct of the buyers
and sellers performance of the industry as a whole are inter related.
,opyright U )8&& SMU
5owered by Si::im Manipal Uni7ersit4
.
MB0026- U!I' -3-OPE#A'IO!A$
SI"!IICA!CE O CO!SUME#S
SU#P$US
@=I% < -3!B4%I-=4, )I1=II+4=+! - +-=)@M!B)'
)@B3,@)
Meaning -f +onsumers' )urplus
%he e/cess or surplus satisfaction en>oyed by a consumer over and
above the price he is paying for the product rather than go without
it is technically described as consumers' surplus in economics. (t is
essentially found in the purchase of useful and *ery cheap articles like salt!
postcard! newspaper! matchbox and many other such durable and non,
durable articles etc. (n all these cases! we recei*e more than we pay for
them.
Donsumer<s Surplus may be de%ned as the excess of what a consumer is
willing to pay o*er what he actually does pay. According to $rof. Marshall!
The excess of price which a person would be willing to pay rather than go
without the thing o*er which what he actually does pay is the economic
measure of this surplus satisfaction. (t may be called consumer surplus. (n the
words of $rof. #ilas! The di5erence between what the consumer does pay for
the commodity and what he would be willing to pay rather than do without it
is called consignment surplus.
The concept may be explained with the help of a formula,
+onsumers' surplus N what we are prepared to pay ? GminusH what
we actually pay.
Jence, it is the di2erence between the value of the total utility that
may be derived from the consumption of a product and the total
amount of money spent on that product.

-perational )ignifcance -f +onsumers' )urplus
'. +on>ectural 4dvantages
The concept enables us to compare the ad*antages of en*ironment and
opportunities or con+ectural bene%ts. The con+ectural bene%ts deri*ed by
people enable us to compare the standards of li*ing in di5erent parts of the
world. (f consumers< surplus is more in any country! then li*ing standards of
the people are high and *ice 6 *ersa. 8or example! the li*ing standards of the
people of SSA or &apan is certainly more when compared to (ndia because in
those countries the national output! national income and per capita income of
the people are high Thus! it helps to measure the *olume of economic welfare
of the people who li*e in di5erent parts of the world.
(. @se in cost-beneft analysis
To day the concept is extensi*ely used in estimating the cost,bene%ts of
*arious in*estment pro+ects both in the pri*ate and public sectors. Dosts and
bene%ts do not merely mean money costs and monetary bene%ts but also
real costs and real bene%ts in terms of satisfaction and the amount of
resource utili"ation. The .uantum of consumers< surplus deri*ed from social
pro+ects like railways! roads! bridges! dams! Cyo*ers! parks! libraries! water
and electricity supply etc by consumers are de%nitely higher when compared
to the amount of money spent on them. 8or example! a consumer would pay
a *ery little amount of money to tra*el in a public transport *ehicle than what
he has to pay if he were to tra*el in an autorikshaw or taxi. The cost sa*ings
from these pro+ects are directly deri*ed from consumers< surplus.
6. @se in public inance
a. (t is the basis to impose taxes on people. (f consumer<s surplus is high in
case of any product or ser*ice! then the %nance minister can impose higher
taxes on them and *ice 6 *ersa. This is because people are ready to pay more
price for such products rather than go with out them.
b. (t is the basis to declare whether taxation policy of a go*ernment is good
or bad. (f the gain to the go*ernment on account of tax collection is greater
than the losses to the consumers on account of tax payment! it is a good
taxation policy and *ice 6 *ersa. (n this case! the total tax amount collected
by the go*ernment is greater than that of the total amount of sacri%ce made
by the people on account of tax payments.
c. (t is the basis to grant subsidy by the go*ernment to pri*ate entrepreneurs.
(f the amount of gain to the people on account of subsidy is greater than the
%nancial loss to the go*ernment owing to the grant of subsidy! we can +ustify
such subsidy and *ice 6 *ersa. 8or example! if go*ernment grants subsidy to
sugar! market price of sugar declines and conse.uently! more consumers
would buy more .uantity of sugar and en+oy greater amount of satisfaction.
7. 3ricing of public utilities.
The concept helps in determining prices of public utilities. (n case of
construction of railway lines! air ports! roads! bridges! generation and supply
of electricity! water supply etc! people en+oy enormous amount of surplus
satisfaction. >hile %xing the prices of these ser*ices! or commodities! the
go*ernment does not look into its production and supply cost. As they are
public utilities! the go*ernment follows the policy of price discrimination.
8. Jelps to resolve the parado/ of value
7enerally speaking market *alue of product depends on its demand and
supply. (n case of certain essential commodities like water etc supply will be
more and as such its market price will be low. (n these cases! marginal utility
will be low whate*er may be the *alue of total utility. (n case there is scarcity
of a product in the market! its price would go up. (n this case! marginal utility
will be high whate*er may be *alue of total utility. Dommodities which ha*e
more *alue in use gi*e more satisfaction than others which ha*e more *alue
in exchange. 8or example! in case of salt! match box! news paper etc total
utility is more but marginal utility is less and as such we pay much less
money for them. ?alue,in,use in case of such goods is much higher than their
*alue,in,exchange. Dommodities which ha*e more *alue, in, exchange gi*e
less satisfaction than others which ha*e more *alue in use. 8or example! in
case of diamond! *alue 6 in 6exchange is more than *alue,in,use because in
these cases! marginal utility is higher than total utility. Thus! the concept
helps to distinguish between *alue,in,use and *alue,in 6exchange.
9. @se monopoly 3ricing
(t helps the monopolist to practice price discrimination. (f consumers< surplus
is high! in case of any commodity or ser*ice! then the monopolist can charge
higher prices and *ice 6 *ersa.
:. @se in international %rade
(t is the basis to import certain items from other countries. (f consumers<
surplus is more in case of imported goods than domestically manufactured
goods! in that case it is better to import. Similarly! if consumers< surplus is
low with in the country and high in other nations! in that case! it is better to
export them to other nations.
;. @se in welfare !conomics
(t is used as a tool in welfare economics. The doctrine emphasis the
ad*antages deri*ed due to a fall in the prices of the commodities. 8all in price
leads to rise in the real income of the consumer and this will de%nitely raise
the le*el of welfare of the people! the le*el of economic well being of the
people is higher in those countries. According to Br. Fittle! the go*ernment
should adopt those economic policies which promote consumers< surplus.
Such policies will certainly help to increase the economic welfare of the
people to the maximum extent.
<. @se in introduction of new products
(f consumers< surplus is greater in the case of introduction of a new product
than the disappearance of the old product! we can +ustify the introduction of a
new product into the market. This helps the consumers to maximi"e their
satisfaction.
Thus the concept of consumers< surplus has great practical application in all
most all %elds of economic acti*ities.
,earning ob>ective- (
@nderstand the concept of producers' surplus
3roducers' )urplus
(t is parallel concept to consumers< surplus. $roducers< surplus is owners<
surplus. It may be defned as the e/cess or surplus income received
by a seller over above the price at which he is willing to sell a
product. (t is the di5erent between the actual price at which he is selling and
the price at which he is willing to sell =ence! it arises when the actual price
recei*ed exceeds the minimum price that the seller is ready to accept.
3roducers' surplus N what the seller is actually receiving ? what the
seller is ready to receive. (t is the di5erence between ex,post and ex,ante
income recei*ed.
.
MB0026- Unit-10-Macro Economics And
B6siness )ecisions
@nit-#M-Macro !conomics 4nd Cusiness $ecisions
Macroeconomics is t5at 9ranc5 of economics- ;5ic5 deals ;it5 t5e st6d4 of
aggregati7e or a7erage 9e5a7ior of t5e entire econom4. In it we study the collective
functioning of the whole economy. It deals with the great aggregates of the economic
system rather than with individual parts of it. It is the study of the entire forest rather than
the study of individual trees. 6ence, it is called as JAggregati7e Economics%K It splits up
the economy into big lumps for the purpose of the convenience of the study. 6ence, it is
called as J$6mping Met5odK. It gives a detailed description about the performance and
achievements of different sectors of the economy like agriculture, industry, export and
import etc In it we study how the entire economy reaches the position of e$uilibrium.
6ence, it is called as J"eneral E86ili9ri6m Anal4sisK. It is called as JIncome t5eor4K
as it explains how e$uilibrium level of national income is determined in an economy. he
scope of macro economics covers the following topics.
&. '5e t5eor4 of Income and emplo4ment with consumption function, saving and
investment function and trade cycles.
2% '5e general t5eor4 of price le7el- which includes inflation and deflation.
+% '5e t5eor4 of economic gro;t5- de7elopment and planning.
,% '5e t5eor4 of macroeconomic distri96tion- which includes the study of relative
shares of rent, wages, interest and profits in the national income of a country.
(n general we study aggregate demand! aggregate supply! aggregate sa*ing
and in*estment! aggregate income and expenditure! unemployment and
po*erty problems etc in macro economics.
Casic Macro !conomic +oncepts
#. 5ariables
4 variable is a symbol or quantity which during a specifed time
period under consideration, may assume di2erent values or a set of
admissible values. (t is something that can take on di5erent *alues. (t is a
changing .uantity. There are two types of *ariables. They are
a. !ndogenous variables. (n this case! *alues of a *ariable are to be
determined with in the system.
b. !/ogenous variables. (n this case! *alues of a *ariable are inCuenced
by outside or external factors or forces.
There are micro economic *ariable as well as macro economic *ariables.
Microeconomic variables deal with the study of individual units.
Some of the microeconomic *ariables are demand! supply! price! cost etc
which deals with only indi*idual units.
An the other hand macroeconomic variables deal with aggregates like
gross national product! national income! consumption function! sa*ing
function! in*estment function! general price le*el! total money supply and
general le*el of employment or unemployment in the country etc. These
*ariables are further di*ided in to two parts.,
a. )tock variable
A stock *ariable is a .uantity measured at a speci%c point of time. It may be
referred to as a certain amount or quantity at
a specifc point of time.
b. low variable
4 Low variable is a quantity which can be measured in terms of
specifc period of time and not at a point of time.
(. Batio variables
Economic *ariables are measured in terms of ratio *ariables. 4 ratio
variable e/presses quantitative relationship between two di2erent
variables at a certain time.

These tow examples come under Low ratio. Fi.uidity ratio shows
relationship between li.uid assets and total assets where as ,everage ratio
shows *alue of debts and total assets. =ence!
These two examples come under stock ratio.
&. unctional variables
8unctional *ariables explain the functional relationship between di5erent
*ariables under consideration. They are further di*ided in to two kinds. They
are,
&. $ependent variable
4 variable is dependent if its value varies as a result of variations in
the value of some other independent variables. (n short *alue of one
*ariable depends on the *alue of another *ariable or *ariables.
b. Independent variable
(n this case! the *alue of one *ariable will inCuence the *alue of another
*ariable. If a change in one variable cause changes in another
variable, it is called as independent variable. An independent *ariable
cause changes in another *ariable.
8or example! consumption function explains the relationship between
changes in the le*el of consumption as a result of changes in the le*el of
income of consumers. (t indicates how consumption *aries as income
changes. (t is expressed as D M f VLW where D refers to consumption and L
implies (ncome of consumers. (n this case! consumption is dependent
*ariable and income is dependent *ariable.
(t is to be noted that functional relationship may be related to either two or
more *ariables. (n case of micro analysis! we explain that B M f V$W where
demand depends on price of the commodity concerned only. Similarly! we can
explain that economic de*elopment! EB M f VD! F! T Q..W. This implies that
economic de*elopment depends on se*eral factors like capital! labor!
technology etc
8. unctions
8unctions suggest that the value of something depends on the value of
one or more other things. There are uncountable numbers of functional
relationships in the real world. B M 8 V$W or S M f V$W at the micro le*el and D
M f V LW or S M f VLW at the macro le*el.
9. +onstant
A constant is a magnitude or *alue the .uantity of which does not change.

:. 3arameter
A parameter is a .uantity which when *aries a5ects the *alue of another
*ariable.
;. +apital and investment
(n the ordinary language! the term capital refers to cash or money held by a
person. (t is measured at a point of time. #ut in economics! it has a wider
meaning. It is defned as all man-made aids that are used for further
production of wealth. (t includes all kinds of producers< goods! in*entory of
materials! machine tools! e.uipments! instruments! factories! dams! transport
and communications etc which are used for further production of goods and
ser*ices.
The term in*estment in the ordinary language refers to %nancial in*estment.
(t means purchase of stocks shares! bonds debentures etc where there is only
transfer of titles or rights from one person to another. %he term investment
in economics refers to creation of new capital assets or additions to
the e/isting stock of productive assets. Dreation of income,earning
assets is called as in*estment in economics. (n*estment is the change in the
capital stock o*er a period of time. =ence the term capital and in*estment
are used as synonymous words.
<. !/-post and !/-4nte
These are the two Fatin phrases. (t implies before hand and afterwards. !/-
4nte means anything planned, anticipated, e/pected or intended. 8or
example! Ex,Ante sa*ing is an amount that the people intend to sa*e out of
their income. !/-3ost refers to actual or realized value. #M.
!quilibrium and disequilibrium
These are the two terms which are fre.uently used in economic discussions.
It is a position where in two opposing forces tend to balance with
each other so that there will be no further changes.
$isequilibrium on the other hand is a position where in the forces
operating in the system is not in balance. There is imbalance in di5erent
forces which are working in the system. =ence! there are disturbances and
disorders in the system.
##. !conomic models
4n economic model shows the relationship among di2erent
economic variables in a precise manner.
+apital output ratio
&. '5e concept of capital o6tp6t ratio e<plains t5e relations5ip 9et;een t5e
7al6e of capital in7estment and t5e 7al6e of o6tp6t% It is a ratio of increase in
o6tp6t or real income to an increase in capital%

MB0026- Unit-11-Cons6mption 6nction
And In7estment 6nction
@nit ## +onsumption unction 4nd Investment unction

Meaning of +onsumption unction
The consumption function indicates the relationship between consumption
and income.
(n the diagram! the L axis measures consumption and the R axis real
income. The DD cur*e
represents the consumption function.
3sychological ,aw -f +onsumption
(n the words of Peynes Men are disposed! as a rule and on the a*erage! to
increase their consumption as their income increases! but not by as much as
the increase in their incomes. (n the short period! as the le*el of income of
the people remains the same! the le*el of consumption also remains the
same. G
1enerally it is observed that when income increases, consumption
also increases but by a less proportion than the increase in income.
&. 1hen the aggregate income increases, expenditure on consumption will also
increase but by a smaller amount.
). he increased income is distributed over both spending and saving.
3. -s income increases, both consumption spending and saving will go up.
hese three prepositions form *eynes psychological law of consumption.
-s consumption expenditure progressively diminishes when income increases, a gap
between income and expenditure arises. his tendency is so deep rooted in peopleDs
habits, customs, and the psychological set up that it is difficult to change in the short run.
6ence, it is impossible to raise the propensity to consume of the people so as to increase
the national output, income and employment. Increasing the volume of investment in an
economy can only fill up the gap between income and ,onsumption.

'5e A7erage Propensit4 to cons6me and '5e Marginal Propensit4 to
Cons6me .
1% '5e A7erage Propensit4 to cons6me
The relationship between income and consumption is measured by the
a*erage and marginal propensity to consume. %he 43+ e/plains the
relationship between total consumption and total income. At a certain
period of time! it indicates the ratio of aggregate consumption expenditure to
aggregate income. %hus, it is the ratio of consumption to income and
is e/pressed as +OP.

Suppose the income of the community is 9s.'I! III crore and consumption
expenditure is 9s. 3!III crore! then the A$D is 3IIIE'I!III M 3IX or I.3.
Thus! we can deri*e A$D by di*iding consumption expenditure by the total
income.
(. Marginal 3ropensity to consume
M3+ may be defned as the incremental change in consumption as a
result of a given increment in income. It refers to the ratio of the
change in aggregate consumption to the change in the level of
aggregate income. (t may be deri*ed by di*iding an increment in
consumption by an increment in income. Symbolically
(uppose total income increases from ?s.&8,888 crore to ?s. )8,888 crore
and total consumption increases from ?sB888 crore to ?s &F,888 crore, then,
'ec5nical c5aracteristics of MPC
1 '5e 7al6e of MPC is al;a4s positi7e 96t less t5an one%
his means that when income increases, the whole income is not spent on
consumption. (imilarly, when income declines, consumption expenditure does not
decline in the same proportion. ,onsumption expenditure never becomes #ero.
2% MPC is greater t5an Cero%
It is always positive.
his means that an increase in income will lead to an increase in consumption. '5,
cannot be negative.
+% MPC goes do;n as income increases.
,% MPC ma4 rise- fall or remain constant- depending on man4 factors- 9ot5
s69Eecti7e and o9Eecti7e.
.% MPC of t5e poor is greater t5an t5at of t5e ric5%
6% In t5e s5ort-r6n MPC is sta9le%
'5e concept of MPC
t5ro;s lig5t on t5e possi9le di7ision of additional income 9et;een cons6mption and
sa7ing% It also tells us how the extra income will be divided in the *eynesian system.
(aving, in the ultimate analysis is e$ual to investment. In our example, '5, is K8@ and
as such the '5( must be38@. he reason is that the income of a community is divided
between saving and spending. '5e s6m of MPC and MPS e86als 1%

actors determining cons6mption f6nction
%roadly speaking, there are two factors, which influence consumption function in the
long run. hey are 1% S69Eecti7e actors% 2% O9Eecti7e factors%
1% S69Eecti7e factors= (ubjective factors basically underlie
and determine the form of the consumptionI the subjective factors are internal or
endogenous in nature. '5e4 mainl4 depend 6pon t5e personal decisions ta:en 94
t5e people% *eynes has listed eight main motives, which compel people to refrain
from current spending. hey are the motives of preca6tion- foresig5t- calc6lation-
impro7ement- independence- enterprise- pride and a7arice%
II% O9Eecti7e factors
O9Eecti7e factors are t5ose- ;5ic5 depends on merits and facts% In this case
personal factors will not come into picture. he following are some of the important
objective factors, which influence consumption.

11%2% In7estment 6nction
(n*estment is the second important component of e5ecti*e demand. (n
Peynesian economics! the term in*estment has a di5erent meaning. In the
ordinary language, it refers to fnancial investment. It means
purchase of stocks, shares, debentures, bonds etc. (n this case! there
is only transfer of rights or titles from one person to another. (t is an
in*estment by one and disin*estment by another and as such the *alue
transaction mutually cancels out each other. They do not add anything to the
total stock of capital of the nation.
(n*estment! according to Peynes! refers to real in*estment. It implies
creation of new capital assets or additions to the e/isting stock of
productive assets. It refers to that part of the aggregate income,
which is used for the creation of new structures, new capital
equipments, machines etc that help in the production of fnal goods
and services in an economy. +reation of income ? earning assets is
called investment.
%ypes -f Investment
Peynes speaks of 0 types of in*estment.
&. 3rivate Investment.
(t is made by pri*ate entrepreneurs on the purchase of di5erent capital assets
like machinery! plants! construction of houses and factories! oTces! shops!
etc. It is inLuenced by M!+ and interest rate. It is proft ? elastic.
$ro%t moti*e is the basis for pri*ate in*estment. $ri*ate entrepreneurs would
take up only those pro+ects! which yield .uick results and generally ha*e
small gestation period.
(. 3ublic investment.
It is undertaken by the public authorities like +entral, )tate and
,ocal authorities. (t is made on building up of infrastructure of the
economy! public utilities and on social goods. 8or example expenditure on
basic industries! defense industries! construction of multi purpose ri*er *alley
pro+ects! etc. (n this case the basic criterion and motto is social net gain,
social welfare and not proft motive. The principle of maximum social
ad*antage would go*ern public expenditure. (t is inCuenced by social and
political considerations also.
6. oreign Investment. *
It consists of e<cess of e<ports o7er t5e imports of a co6ntr4% It depends upon many
factors such as propensity to export of a given country, foreignerDs capacity to import,
prices of exports and imports, state trading and other factors.
&. Ind6ced in7estment
It is another name for private investment. In7estment- ;5ic5 7aries ;it5 t5e c5anges in
t5e le7el of national income- is called ind6ced in7estment% 1hen national income
increases, the aggregate demand and level of consumption of the community also
increases. In order to meet this increased demand, investment has to be stepped up in
capital goods sector which finally leads to increase in the production of consumption
goods herefore, we can say that ind6ced in7estment is income Helastic i.e., it increases
as income increases and vice-versa.
hus, it is sensitive to changes in income and is go7erned 94 profit H moti7e% he shape
of the induced investment curve has been shown as rising upwards to the right. his
means that as income increases, investment also increases and vice-versa.

.% A6tonomo6s In7estment
It is another name for public investment. '5e in7estment- ;5ic5 is independent of t5e
le7el of income- is called as a6tonomo6s in7estment% (uch investments do not vary
with the level of income. herefore it is called income-inelastic. It does not depend on
changes in the level of income, consumption, rate of interest or expected profit.
-utonomous investment depends upon population growth, technological progress,
discovery of new resources etc for example expenditure on public buildings, transport
and communications, defense, public utilities, water supply, generation of electricity etc
are considered as autonomous investment. It is g6ided 94 social ;elfare rat5er t5an
profit moti7e%
he investment curve is perfectly elastic. -nd as such it indicates that though income
changes, investment more or less remains constant.
here are a few other concepts of investment. hey are as follows
&. "ross In7estment=
Gross investment refers to the total real investment or an addition to capital stock of the
country.
2% #eplacement In7estment= - part of gross investment that is used for replacing the old
capital e$uipments is called replacement investment.
+% !et in7estment= he net investment is e$ual to the gross investment minus
replacement investment. 6ence, +et Investment / Gross investment : capital
consumption or replacement investment.
,%E<-ante in7estment= he investment that is intended or expected or planned is known
as ex-ante investment.
.% E<-post in7estment= he actual or reali#ed investment is known as ex-post
investment.

)eterminants Of In7estment
It is necessary to note that in7estment is more 7olatile and 6npredicta9le% It is 5ig5l4
6nsta9le in t5e s5ort r6n because the factors determining it are highly complex and
uncertain in their nature. he above-mentioned factors no doubt generally affect the
volume of investment. 6owever, the most important inducement to invest is the
consideration of the profit. he profitability of investment depends mainly on two factors
: &. 'arginal 2fficiency of capital 3'2,4 and ). Interest ?ate 3I?4. It relates to the cost-
benefit analysis. he businessman while investing capital has to calculate the cost of
borrowing and the expected rate of profits from it.

Marginal Effecienc4 Of Capital And B6siness E<pectations
Marginal Efficienc4 of Capital
It refers to productivity of capital. It may be defned as the highest
rate of return over cost accruing from an additional unit of capital
asset. 4lso it refers to the yield e/pected from a new unit of capital.
The MED in its turn depends on two important factors.
&. 5rospective yield from the capital asset and
). The supply price of the capital asset.

'5e MEC is t5e ratio of t5ese t;o factors%
'5e prospecti7e 4ield of a capital asset means t5e total net ret6rns e<pected from t5e
asset o7er its lifetime% -fter deducting the variable costs like cost of raw materials,
wages, etc from the marginal revenue productivity of capital, an investor can estimate the
prospective income 3expected annual returns and not the actual returns4 from the capital
asset. -long with it he also has to consider the supply price or replacement cost of the
capital asset.
S6ppl4 price of a capital asset is t5e cost of prod6cing a 9rand ne; asset of t5at
:ind- not t5e s6ppl4 price of an e<isting asset% It is the actual amount of money spent
by an investor while purchasing new machinery or erecting a new factory.
The MED of a particular type of asset means what an in*estor expects to earn
from an additional unit of it compared with what it costs him. To be more
speci%c! MED is the rate of discount! which will make the present *alue of the
capital assets e.ual to their future *alue :prospecti*e yield; in their lifetime.
Supply price M discounted prospecti*e yield.
he '2, can be calculated with the help of the following formula.
In the above formula ,r represents (upply price or replacement cost of the new capital
asset. >&, >), >3 indicate the prospective yields in the various years & ) 3 T and n.
represents the rate of discount which will make the present value of the series of the
annual returns just e$ual to the supply price of capital asset. hus, r
denotes the rate of discount or '2,.
1e can illustrate the meaning of '2, as a rate of discount by means of a simple
arithmetical example. (uppose, the supply price of a capital asset is ?s.3888N- and the
asset will become useless after two years. Further suppose that capital asset is expected to
yield ?s.&&88N- at the end of one year and ?s.);)8N- at the end of ) years. +ow, it is
obvious that the rate of discount of &8@ will e$uate the future yields of the asset with its
current supply price. -t &8@ discount rate the present value of ?s&&88N- discounted for
one year plus ?s.);)8N- discounted for ) years amounts to an aggregate sum of ?s.3888N-
which is as pointed out above the supply price of the capital asset. he above-mentioned
formula can be used to explain the same point.
In this case, the discounted prospective yield is e$ual to the current supply price of the
capital asset. If the expected rate of yield is greater than the supply price, then only it
becomes profitable to invest and otherwise not. he volume of induced investment
depends on '2, and I?. It is necessary to note that :
B5en MEC > I#- t5e effect on in7estment is fa7ora9le%
B5en MEC < I#- t5e effect on in7estment is ad7erse%
B5en MEC @ I#- t5e effect on in7estment is ne6tral%
)E'E#MI!A!'S O MEC
(everal factors that affect '2, are given below.
1% S5ort r6n factors= 2xpectation of increased demand, higher '2, leads to larger
investment and vice-versa.
2% Cost and Price= If the production costs are expected to decline and market prices
to go up in future, '2, will be high leading to a rise in investment and vice-versa.
+% 0ig5er Propensit4 to cons6me leading to a rise in '2,
encourages higher investment.
,% C5anges in income=
-n increase in income will simulate investment and '2, while a decline in the level
of incomes will discourage investment.
.% C6rrent state of e<pectations=
If the current rates of returns are high, the '2, is bound to be high for new projects
of investment and vice-versa. his is because the future expectations to a very great
extent depend on the current rate of earnings.
6% State of 96siness confidence=
.uring the period of optimism 3boom4 the '2, will be generally high and during
period of pessimism 3depression4, it will be generally less.
II $ong r6n factors%
1% #ate of gro;t5 of pop6lation=
In a capitalist economy, a high rate of population growth leads to an increase in '2,
because it leads to an increase in the demand for both consumption and investment
goods. 7n the contrary, a decline in the population growth depresses '2,.
2% )e7elopment of ne; areas=
.evelopment activities in the new fields like transport and communications,
generation of electricity, construction of irrigation projects, ports etc would lead to a
rise in '2,.


+% 'ec5nological progress=
echnological progress would lead to the development and use of highly sophisticated
and latest machines, e$uipments and instruments. his will add to the productive capacity
of the economy leading to an increase in '2,.
,% Prod6cti7e capacit4 of e<isting capital e86ipments=
Onder utilised existing capital assets may be fully utili#ed if the demand for goods
increases in the economy. In that case the '2, of the same asset will definitely rise.
.% '5e rate of c6rrent in7estment=
If the current rate of investment is already high, there would be little scope for further
investment and as such the '2, declines.
hus, several factors both in the short run and in the long run affect the '2, of a capital
asset.
hus, several measures are to be taken to stimulate private investment in an economy.
(n the Peynesian theory! in*estment is a *ery important and strategic
*ariable. (n order to increase the *olume of national output! income and to
tackle the problem of unemployment! the remedial measure suggested by
Ford Peynes is to raise the le*el of in*estment in an economy. (n this
connection $rof. Billard remarks 6A fundamental principle is that as the
income of the community increases! consumption also increase but by less
than the increase in income. =ence! in order to ha*e suTcient demand to
sustain an increase in employment! there must be increase in real in*estment
e.ual to the gap between income and consumption out of income. (n other
words! employment cannot increase unless in*estment increases.
Appreciate t5e ;or:ing of t5e m6ltiplier
M6ltiplier
Meaning and working of Multiplier
$rof. Pahn de*eloped the concept of .Multiplier0 with reference to
employment. Ford Peynes! on the lines of employment multiplier! de*eloped
an .Investment Multiplier0. (t is deri*ed from the concept of marginal
propensity to consume and refers to the e5ects of changes in in*estment
outlays on aggregate income through consumption expenditure. (t has
ac.uired greater signi%cance in recent years to explain the process of income
generation in an economy when the *olume of in*estment changes.
here are various types of 'ultiplier such as Income multiplier, investment multiplier,
employment multiplier and foreign trade multiplier etc.
*eynesD investment multiplier is based on !he fundamental psychological law of
,onsumption". It states that as income increases, consumption also increases but less
than proportionately. ,onse$uently, the consumption demand in the short run remains
constant and it cannot be increased. he alternative to increase the output is to increase
the volume of investment. 2ven though consumption function is a major determinant of
aggregate demand, it is not the prime initiator of changes in income and output. he
changes in the volume of investment will bring about changes in the level of income and
output. 6ow changes in income are affected can be understood with the help of
investment multiplier.
M6ltiplier ma4 9e defined as a ratio of c5ange in income to a c5ange in in7estment%
It expresses the relationship between an initial increment in investment and the final
increment in income. It s5o;s 94 5o; man4 times t5e effect of an initial c5ange in
in7estment is m6ltiplied 94 ca6sing c5anges in cons6mption and finall4 in t5e
aggregate income% ,hange in investment
generally gives rise to change in income by a multiple amount. 1henever an additional
investment is made in the economy, it increases the aggregate income not only by an
amount e$ual to the additional investment but by somewhat greater than that. he logic is
simple. he original investment increases income not only in the industry where
investment is made but also in certain other industries whose products are demanded by
men employed in investment goods industries. For example, if an increase in investment
of ?s.F Makhs causes an increase in income of ?s.)F Makhs, then the multiplier would be
F. If the increase in income is ?s.38 Makhs, then the multiplier would be 9. -lgebraically,
this relationship can be expressed as-
>here delta stands for change or increase! P for multiplier and L for income
and ( for (n*estment respecti*ely.
The si"e of the multiplier is directly deri*ed from the si"e of M$D. =igher the
M$D! higher would be the si"e of multiplier and *ice,*ersa. The multiplier is
e.ual to the reciprocal of ' minus M$D. The formula to calculate the si"e of
the multiplier is as follows.
& : '5,. can be easily found out. If '5, is ) N 3, then multiplier would be as
follows.
1e know that '5, 0 '5( /&. If we deduct '5, from & we get '5(. 6ence, the
above e$uation can be expressed in the following manner.
If the '5, is A N &8, deducting A N &8 from &, we get & N &8. his is the '5(. he
reciprocal of & N &8 is &8, which is the value of multiplier. In short, the multiplier is
the reciprocal of the '5(, which is always e$ual to & minus the '5,.
From the above explanation, it is clear that :

&. 6igher the value of '5,, higher would be the value of * and vice : versa.
). 1hen '5( / 8 and '5, /&, then there will be a &88 percent increase in income
every time or the multiplier effect will be continuous.
3. 1hen '5( /& and '5, / 8, then what is earned will be saved and the value of
multiplier will be e$ual to 8.

ASSUMP'IO!S A!) $IMI'AIO!S O '0E MU$'IP$E#=
&. A7aila9ilit4 of cons6mer goods=
'ultiplier works satisfactorily if the volume of goods and services on which the
additional income may be spent are available in plenty. 7therwise, people are
unable to spend their income on them. ,onse$uently, '5, falls leading to a
decline in the value of *.
). Maintenance of In7estment=
(n order to reali"e the full *alue of P! it is necessary that the *arious
increments in in*estment be repeated at regular inter*als. (n case! it is
not done! it will not be possible to raise the income to the multiplier
le*el.
3. !et Increase in In7estment=
In order to get the full value of *, there should be a net increase in investment.
Increase in investment in one sector of the economy should not be neutrali#ed by
decrease in investment in another sector of economy. 7therwise, the working of
the multiplier is obstructed.
;. !o c5ange in siCe of MPC=
In the process of income generation, there should not be any change in the value
of '5,. If there is any change in the si#e of '5,, then the value of * also
changes.
F. !o in7estment from ind6ced cons6mption%
In the multiplier theory we analy#e only the impact of investment on
consumption. %ut the reverse, vi#., accelerator is totally ignored. If the accelerator
is allowed to operate and effects of induced consumption on investment are also
taken into account, then the value of the multiplier would be far greater and would
also be achieved at an earlier stage in the process of income generation.
9. !o time gap 9et;een s6ccessi7e e<pendit6re on cons6mption%
If there is a gap between receipt of income and expenditure even in the short run,
the full value of the * cannot be reali#ed because as '5, falls, the si#e of the *
also declines.
K. E<istence of a closed econom4%
If there is trade between different countries, the value of * may be restricted by
the amount of excess of imports over exports. - part of the total money will go
out of the country if there are imports and to that extent the value of the *
declines.
B. E<istence of less t5an f6ll emplo4ment condition%
If the economy is working at full employment level, in that case there is no scope
for increase in output, income and employment even though investment increases.
A. It is 9ased on n6m9er of ass6mptions%
hese assumptions may not be found in practice. ,onse$uently, the Gact6alF
multiplier may be greatly restricted and will be different from the GidealF
multiplier.
&8. !o direct relation 9et;een in7estment and income=
-ccording to 5rof. 6a#ilitt, there is no precise, pre-determinable or mechanical
relationship between social income, consumption, investment and extent of
employment.
&&. 2e4nes m6ltiplier is a static concept=
It shows the process of income propagation from one point of e$uilibrium to
another and that too under static conditions. It gives little insight into the actual
process by which the economy achieves a new e$uilibrium.

P#E #EAUSI'E CO!)I'IO!S O# '0E BO#2I!" O '0E MU$'IP$IE#
&. E<istence of in7ol6ntar4 6nemplo4ment%
ational output! income and expenditure can be increased by
additional in*estment only when there is in*oluntary unemployment
condition in an economy. Atherwise! there will be no scope for
expansion in employment e*en if in*estment increases.
). E<istence of an Ind6strial Econom4%
Multiplier can freely operate in an industrial economy rather than in an
agricultural economy because the demand for industrial goods is
relati*ely stable than that of agricultural goods and as such the M$D
and the *alue of P will be high.
3. E<istence of e<cess capacit4 in cons6mer goods ind6stries%
A high le*el of in*estment will succeed in utili"ing the unutili"ed and
under utili"ed excess capacity to the extent possible. This leads to the
creation of more employment.
;. !/istence of elastic supply of other factor inputs in the market.
A higher in*estment would result in higher output! income and
employment only when the other supplemental factor inputs are
a*ailable in abundance.
,!4"41!) I= %J! M@,%I3,I!B
(ncome not spent on consumption is called &leakage' in the
cumulati*e income stream. This leakage obstructs the increase in
output and income. These leakages will arise on account of the
following reasons.
F. )avingsA
=igher the le*el of sa*ings! the lower would be the *alue of P and *ice,
*ersa.
9. 4ccumulation of idle cash balancesA
(f people keep more idle cash balances with them! then the M$D
declines and the *alue of P declines.
K. $ebt cancellationsA
(f people use a part of their income to repay their old debts! then the
current M$D declines and the *alue of P also declines.

B. 3urchase of old shares and stocksA
A part of the income may be spent on buying old stocks! shares and
other securities in the market. This would lead to a decline in current
M$D and a decline in the *alue of P also.
A. ImportsA
$ayments on imports would reduce domestic consumption leading to a
decline in the *alue of P.
&8. 3rice inLationA
(nCation would reduce the purchasing power of the people and
conse.uently the M$D and the *alue of the P also.

&&. %a/esA
=igher taxes would reduce the incomes of the people! M$D and also
the *alue of P.
&). +orporate savingsA
Sndistributed pro%ts of +oint stock companies would reduce the
incomes of the shareholders! their M$D and thus the *alue of the P.
(f all these leakages are properly plugged in the income stream! the
e5ect of multiplier in the process of income generation would be
higher! taking the economy towards full employment le*el.
3B4%I+4, IM3-B%4=+! - %J! M@,%I3,I!B
'-.(t is a ma+or tool of macro economic theory focusing attention on
in*estment as the signi%cant element in increasing the le*el of
employment.
'/.(t summari"es the working of the entire Peynesian model.
'0.(t describes how income is generated in an economic system like stone
causing ripples in a lake.
'1.(t is a *aluable guide to public in*estment policy.
'2.(t is helpful for framing a suitable full employment policy.
'3.(t has great practical signi%cance in formulating anti,cyclical policy to
smoothen business Cuctuations in an economy. Thus! it is necessary for
the study of trade cycle! its trends and control.
'4.According to $rof. Samuelson! the multiplier theory explains why an
easy money policy is ine5ecti*e and de%cit spending is e5ecti*e during
the period of depression.
)I.8or increasing the income and employment! in*estment should be
started in a sector where the multiplier may be greater.
)'.(t is used for explaining expansion in di5erent %elds of economic
acti*ities. 8or example credit multiplier! budget multiplier etc.
)).(t upholds the 7o*ernment inter*ention! acti*e participation and macro
economic management relating to income! output and employment
etc.
)-.(t helps to understand how e.uality between sa*ing and in*estment is
brought about. An increase in in*estment leads to increase in income.
Donse.uently! sa*ing also increases and becomes e.ual to in*estment.
)/.(t emphasi"es the signi%cance of de%cit %nancing. (ncrease in public
expenditure by creating de%cit budget help in creating income and
employment multiple times the initial increase in expenditure.
Thus! the concept of multiplier has not only brought about a re*olution
in economic theory but also in framing *arious economic policies.
Peynes regards it as a path,breaking contribution to economic theory.


,earning -b>ective 7
@nderstand the magnifcation of derived demand
4ccelerator
The principle of .accelerator or acceleration0 is another important tool of
economic analysis. (t is older than multiplier. The accelerator dates back to
'4'/ or e*en before. (t is associated with the name of $rof. &.M. Dlark! an
American economist who was mainly responsible for populari"ing it in '4'2
Multiplier and accelerator are the two parallel concepts. The multiplier
concept is inade.uate to explain the process of income generation in a
complete manner. (t shows the e5ect of in*estment only on consumption
expenditure and how the increase in in*estment will bring about increase in
national income through multiplier e5ect. (n short! multiplier explains the
e5ects of in*estment on consumption and how the *olume of consumption
depends on the *olume of in*estment.
4ccelerator shows the e2ect of changes in consumption on induced
investment and tells us how the volume of investment depends on
the level of consumption. >hen incomes of the people increase!
purchasing power and the demand for consumption goods increase. (n order
to produce more consumption goods! more capital goods are re.uired. This
leads to an increase in the demand for in*estment in capital goods industries.
Thus! a rise in income leads to a rise induced in*estment in capital goods
industries. $roduction of consumer goods re.uires a particular amount of
capital goods. Accelerator is called as .Magnifcation of derived demand0
because in*estment depends on employment.
(n order to understand the e5ect of accelerator! it is necessary to know the
acceleration co,eTcient. The ratio between the net change in consumption
expenditure and the induced in*estment is called @Acceleration Do,eTcient.
Symbolically!
where!
a stands for acceleration co,eTcient
net change in in*estment expenditure
net change in consumption expenditure.
The working of the accelerator can be explained with the following imaginary
example. Fet us suppose that in order to produce 'III units of consumer
goods! 'II machines are re.uired. The capital output ratio in this case is
'K'I. 8urther suppose that the working life of a machine is 'I years and after
'I years the machine has to be replaced. (t implies that e*ery year 'I
machines ha*e to be replaced in order to maintain the constant Cow of 'III
units of consumer goods. =ence! the acceleration coeTcient in this case is '.
=ence! the annual demand for machines will be 'I. This is called
.Beplacement $emand0.
,imitations of accelerator
'. There should be no excess capacity in capital goods industries. (f there
is excess capacity in that case! additional production of consumer goods
does not re.uire additional capital goods.
). (f there is excessi*e number of machines! in that case there is no need
for further in*estment in capital goods industries.
-. (f the demand for consumption goods is purely temporary in nature in
that case producers will not make any additional in*estment in capital
goods industries. An the other hand! they make use of existing machines
more intensi*ely.
/. (n many cases! in*estments made in capital goods industries do not
await changes or increase in consumption! e.g.! in*estment in public
sector industries.
0. (f ade.uate %nancial resources are not forthcoming to capital goods
industries! in that case in spite of increase in consumption! production of
capital goods cannot be increased.
1. (t is always wrong on our part to expect constant ratio between
production of consumer goods and capital goods.
(n all these cases! the *alue of the accelerator may not be fully reali"ed.
3ractical Importance
'. (t explains the process of income generation more clearly as it takes
into account of the e5ect of consumption on in*estment.
). (t explains why Cuctuations in income and employment occur rather
*iolently.
-. (t tells us why capital goods industries Cuctuate much more than
consumption goods industries.
&. It helps in understanding of the different phases of business cycles very
clearly. %ut accelerator left to it, cannot completely explain the entire
cause for trade cycles.

.
MB0026- Unit 12-Sta9ilisation Policies
Unit 12 Sta9ilisation Policies
Concept Of Economic Sta9ilit4
2conomic stability implies avoiding fluctuations in the level of economic activities a
&88@ stability is neither possible nor desirable. It implies only relative stability in the
over all level of economic activities.
It can also refer to measures taken to resolve a specific economic crisis for instance an
exchange rate crisis or stock market crash, in order to prevent the economy developing
recession or inflation.
he initiative is taken by the government or ,entral %ank or both. .epending on the goal
to be achieved it involves some combination of restrictive fiscal measures and monetary
tightening.
(uch stabili#ation policies can be painful, in the short run, for the economy because of
lower output and higher unemployment. hey are designed to be a platform for
successful long run growth and reform.
)ifferent Instr6ments Of Economic Sta9ilit4
&. 'onetary 5olicy. ). Fiscal 5olicy P 3. 5hysical policy or .irect ,ontrols.
he ,entral %ank and the Government have developed these instruments to correct the
discrepancies that occur in the process of economic growth.
Monetar4 Polic4
Meaning and definition=
'onetary 5olicy deals with the total money supply and its management in an economy. It
is essentially a programme of action undertaken by the monetary authorities generally the
central bank to control and regulate the supply of money with the public and the flow of
credit with a view to achieving economic stability and certain predetermined macro
economic goals.
'onetary policy can be explained in two different ways% In a narro; sense- it is
concerned ;it5 administering and controlling a co6ntr4Fs mone4 s6ppl4 incl6ding
c6rrenc4 notes and coins- credit mone4- le7el of interest rates and managing t5e
e<c5ange rates% In a 9roader sense- monetar4 polic4 deals ;it5 all t5ose monetar4
and non-monetar4 meas6res and decisions t5at affect t5e total mone4 s6ppl4 and its
circ6lation in an econom4% It also incl6des se7eral non-monetar4 meas6res li:e
;ages and price control- income polic4- 96dgetar4 operations ta:en 94 t5e
go7ernment ;5ic5 indirectl4 infl6ence t5e monetar4 sit6ations in an econom4%
.ifferent writers have defined monetary policy in different ways. (ome of the important
ones are as follows.
'onetary policy basically deals with total supply of legal tender money, i.e., currency
notes and coins, total amount of credit money, level of interest rates, exchange rate policy
and general li$uidity position of the country.
,redit policy which is different from the monetary policy affects allocation of bank credit
according to the objective of monetary policy.
he government in consultation with the central bank formulates monetary policy and it
is generally carried out and implemented by the central bank. It is evolved over a period
of time on the basis of the experience of a nation. It is structured and operated with in the
institutional framework and money market of the country. Its objectives, scope and nature
of working etc is collectively conditioned by the economic environment and philosophy
of time. 'onetary policy along with fiscal policy and debt management lumped together
form the financial policy of the country.
'onetary policy is passi7e when the central bank decides to abstain deliberately from
applying monetary measures. It is acti7e when the central bank makes use of certain
instruments to achieve the desired objectives. It may be positive or negative. It is positi7e
when it promotes economic activities and it is negati7e when it restricts or curbs
economic activities. (imilarly, it is li9eral when there is expansion in credit money and it
is restricti7e when it leads to contraction in money supply. -gain, a c5eap mone4 polic4
may be followed by cutting down the interest rates or a dear mone4 polic4 by raising the
rate of interest%
he (cope and effectiveness of monetary policy depends on the moneti#ation of the
economy and the development of the money market.
Parameters of monetar4 polic4=
%roadly speaking there are three parameters of monetary policy of a country. It is through
these parameters, the monetary policy has to operate. hey are
&. otal money supply available in a country.
). ,ost of borrowings or the level of interest rates.
3. he nature of credit control measures.
-ll the three put together determine the nature of working of monetary policy.
O9Eecti7es Of Monetar4 Polic4
7bjectives of monetary policy must be regarded as a part of overall economic objectives
of the government. It should be designed and directed to achieve different macro
economic goals. he objectives may be manifold in relation to the general economic
policy of a nation. he various objectives may be inter related, inter dependent and
mutually complementary to each other. hey may also be mutually inconsistent and clash
with each other. 6ence, very often the monetary authorities are concerned with a careful
choice between alternative ends. he priorities of the objectives depend on the nature of
economic problems, its magnitude and economic policy of a nation. he various
objectives also change over a time period.
2conomists have conflicting and divergent views with regard to the objectives of
monetary policy in a developed and developing economy. here are certain general
objectives for which there is common consent and certain other objectives are laid down
to suit to the special conditions of a developing economy. he main objective in a
developed economy is to ensure economic stability and help in maintaining e$uilibrium
in different sectors of the economy where as in a developing economy it has to give a big
push to a slowly developing economy and accelerate the rate of economic growth.
"eneral o9Eecti7es of monetar4 polic4%
1% !e6tral mone4 polic4=
5rof. 1icksteed, 6ayak, ?obertson and others have advocated this policy. his objective
was in vogue during the days of gold standard. -ccording to this policy, money is only a
technical devise having no other role to play. It should be a passive factor having only
one function, namely to facilitate exchange. It should not inject any disturbances. It
s5o6ld 9e ne6tral in its effects on prices- income- o6tp6t- and emplo4ment% hey
considered that changes in total money supply are the root cause for all kinds of
economic fluctuations and as such if money supply is stabili#ed and money becomes
neutral, the price level will vary inversely with the productive power of the economy. 2%
Price sta9ilit4=
It refers to t5e a9sence of s5arp 7ariations or fl6ct6ations in t5e a7erage price le7el
in t5e co6ntr4% - hundred percent price stability is neither possible nor desirable in any
economy. It simply implies relative price stability. A polic4 of price sta9ilit4 c5ec:s
c4clical fl6ct6ations and smoot5en prod6ction and distri96tion- :eeps t5e 7al6e of
mone4 sta9le- pre7ent artificial scarcit4 or prosperit4- ma:es economic calc6lations
possi9le- introd6ces an element of certaint4- eliminate socio-economic dist6r9ances-
ens6re e86ita9le distri96tion of income and ;ealt5- sec6re social E6stice and
promote economic ;elfare%
+% E<c5ange rate sta9ilit4=
0o;e7er- in order to 5a7e smoot5 and 6n5indered international trade and free flo;
of foreign capital in to a co6ntr4- it 9ecomes imperati7e for a co6nt4 to maintain
e<c5ange rate sta9ilit4% ,hanges in domestic prices would affect exchange rates and as
such there is great need for stabili#ing both internal price level and exchange rates.
Fre$uent changes in exchange rates would adversely affect imports, exports, inflow of
foreign capital etc. 6ence, it should be controlled properly.
,% Control of trade c4cles=
7peration of trade cycles has become very common in modern economies. - very high
degree of fluctuations in over all economic activities is detrimental to the smooth growth
of any economy. 2conomic instability in the form of inflation, deflation or stagflation etc
would serve as great obstacles to the normal functioning of an economy. %asically,
changes in total supply of money are the root cause for business cycles and its dampening
effects on the entire economy. 6ence, it 5as 9ecome one of t5e maEor o9Eecti7es of
monetar4 a6t5orities to control t5e operation of trade c4cles and ens6re economic
sta9ilit4 94 reg6lating total mone4 s6ppl4 effecti7el4% .uring the period of inflation, a
policy of contraction in money supply and during the period of deflation, a policy of
expansion in money supply has to be adopted. his would create the necessary economic
stability for rapid economic development.
.% 6ll emplo4ment=
In recent years it has become another major goal of monetary policy all over the world
especially with the publication of general theory by Mord *eynes. 'any well-known
economists like ,rowther, 6alm. Gardner -ckley, 1illiam, %everidge and Mord *eynes
have strongly advocated this objective in the context of present day situations in most of
the countries. -dvanced countries normally work at near full employment conditions.
heir major problem is to maintain this high level of employment situation through
various economic polices. his object has become much more important and crucial in
developing countries as there is unemployment and under employment of most of the
resources% )eli9erate efforts are to 9e made 94 t5e monetar4 a6t5orities to ens6re
ade86ate s6ppl4 of financial reso6rces to e<ploit and 6tiliCe reso6rces in t5e 9est
possi9le manner so as to raise t5e le7el of aggregate effecti7e demand in t5e
econom4% It should also help to maintain balance between aggregate savings and
aggregate investments. his would ensure optimum utili#ation of all kinds of resources,
higher national output, income and higher living standards to the common man.
6% E86ili9ri6m in t5e 9alance of pa4ments=
his objective has assumed greater importance in the context of expanding international
trade and globali#ation. o day most of the countries of the world are experiencing
adverse balance of payments on account of various reasons. It is a situation where in the
import payments are in excess of export earnings. 'ost of the countries which have
embarked on the road to economic development cannot do away with imports on a large
scale. Imports of several items have become indispensable and without these imports
their development process will be halted. 0ence- monetar4 a6t5orities 5a7e to ta:e
appropriate monetar4 meas6res li:e deflation- e<c5ange depreciation- de7al6ation-
e<c5ange control- c6rrent acco6nt and capital acco6nt con7erti9ilit4- reg6late credit
facilities and interest rate str6ct6res and e<c5ange rates etc% In order to achieve a
higher rate of economic growth, balance of payments e$uilibrium is very much re$uired
and as such monetary authorities have to take suitable action in this direction.
/% #apid economic gro;t5=
his is comparatively a recent objective of monetary policy. -chieving a higher rate of
per capita output and income over a long period of time has become one of the supreme
goals of monetary policy in recent years. A 5ig5er rate of economic gro;t5 ;o6ld
ens6re f6ll emplo4ment condition- 5ig5er o6tp6t- income and 9etter li7ing standards
to t5e people% ,onse$uently, monetary authorities have to take the necessary steps to
raise the productive capacity of the economy, increase the level of effective demand for
various kinds of goods and services and ensure balance between demand for and supply
of goods and services in the economy. -lso they should take measures to increase the rate
of savings, capital formation, step up the volume of investment, direct credit money into
desired directions, regulate interest rate structure, minimi#e economic and business
fluctuations by balancing demand for money and supply of money, ensure price and
overall economic stability, better and full utili#ation of resources, remove imperfections
in money and capital markets, maintain exchange rate stability, allow the inflow of
foreign capital into the country, maintain the growth of money supply in consistent with
the rate of growth of output minimi#e adversity in balance of payments condition, etc.
.epending upon the conditions of the economy money supply has to be changed from
time to time. - flexible policy of monetary expansion or contraction has to be adopted to
meet a particular situation. hus, a growth-friendly monetary policy has to be pursued by
monetary authorities in order to stimulate economic growth.
It is to be noted that the above-mentioned objectives are inter related, inter dependent and
inter connected with each other. 2ach one of the objectives would affect the other and in
its turn is influenced by the others. 'any objectives would come in clash with others
under certain circumstances. - proper balance between different objectives becomes
imperative. 'onetary authorities have to determine the priorities depending upon the
economic environment in a country. hus, there is great need for compromise between
different objectives
O9Eecti7es of monetar4 polic4 in de7eloping co6ntriesE
-s the development problems of developing countries are different from that of
developed countries, the objectives of monetary policy also changes. he following
objectives may be considered in the context of developing countries.
1% )e7elopment role=
It has to promote economic development by creating, mobili#ing and providing ade$uate
credit to different sectors of the economy. (upply of sufficient financial resources, its
proper direction, canali#ation and utili#ation, control of inflation and deflation etc would
create proper background for laying a solid foundation for rapid economic development.
2% Effecti7e central 9an:ing=
In order to achieve various objectives of monetary policy and to meet the ever-growing
development re$uirements of the economy, the central bank of the country has to operate
effectively. It has to control the volume of credit money and its distribution through the
use of various $uantitative and $ualitative credit instruments. ,entral bank of the country
should act as an effective leader to control the activities of all other financial institutions
in the country. It should command the respect of other institutions.
+% Ind6cement to sa7ings=
It has to encourage the saving habits of the common man by providing all kinds of
monetary incentives. It has to take the necessary steps to expand the banking facilities in
the country and mobili#e savings made by them. (pecial steps are to be taken to mobili#e
rural small savings.
,% In7estment of sa7ings=
It should help in converting savings into productive investments. For this purpose, it has
to create an institutional base and investment climate in the country. 5eople should have
variety of opportunities to invest their hard earned money and earn ade$uate retunes on
them.
.% )e7eloping 9an:ing 5a9its=
'onetary authorities have to take effective and imaginary steps to populari#e the use of
various credit instruments by the common man. %anking transactions should become the
part of their day-to-day life.
6% MagnetiCation of t5e econom4=
he monetary authorities have to take different measures to convert non-moneti#ed sector
or barter sector into moneti#ed sector and make people use credit money extensively in
their day-to-day life. Increase in total money supply should be in accordance with the
degree of moneti#ation of the economy.
/% Monetar4 e86ili9ri6m=
It is the responsibility of the monetary authorities to maintain a proper balance between
demand for money and supply of money and ensure ade$uate li$uidity position in the
economy so that neither there will be excess supply of money nor shortage in the
circulation of money.
1% Maintaining e86ili9ri6m in t5e 9alance of pa4ments=
It is the job of the monetary authorities to employ suitable monetary measures to set right
dise$uilibrium in the balance of payments of a country.
10% Creation and e<pansion of financial instit6tions=
'onetary authorities of the country have to take effective steps to improve the existing
currency and credit system. hey should help in developing banking industry, credit
institutions, cooperative societies, development banks and other types of financial
institutions, to mobili#e more savings and direct them to productive activities.
11% Integration of organiCed and 6norganiCed mone4 mar:ets=
he money markets are under developed, undeveloped, highly unorgani#ed and they are
not functioning on any well laid down principles. In fact, there is no proper integration
between organi#ed and unorgani#ed money markets. his has come in the way of well-
developed money markets in these countries. 6ence, money markets are to be brought
under the purview of the central bank of the country.
12% Integrated interest rate str6ct6re=
he monetary authorities have to minimi#e the existence of different interest rates in
different segments of the money market and ensure an integrated interest rate structure.
1+% )e9t management=
'onetary authorities have to decide the total volume of internal as well as external
borrowings, timing of the issue of bonds, stabili#ing their prices, the interest rates to be
paid for them, nature of debt servicing, time and methods of debt redemption, the number
of installments, time of repayment etc. he primary aim of the debt management policy is
to create conditions in which public borrowing is increased from year to year on a big
scale without giving any jolt to the system and this must be at cheap rates to keep the
burden of the debt as low as possible. hus, debt management of the country is to be
successfully organi#ed by the monetary authorities.
1,% $ong term loan for ind6strial de7elopment=
he monetary policy should be framed in such a way as to promote rapid industrial
development in a country by providing ade$uate finance for them.
1.% #eforming r6ral credit s4stem=
he existing rural credit system is defective and as such it has to be reformed to assist the
rural masses.
16% 'o create a 9road and contin6o6s mar:et for go7ernment sec6rities=
It is the responsibility of the monetary authorities of the country to develop a well-
organi#ed securities market so that funds are easily available for the needy people.
hus, the objectives of monetary policy are manifold in nature in developing countries
and a proper balance between them is re$uired very much to achieve desired goals of the
government.
Monetar4 polic4 and economic de7elopment=
'onetary policy has to play a major and constructive role in developing countries in
order to accelerate and promote economic development. he rate of economic growth of
a country depends on the volume of investment. 6igher the investment higher would the
growth rate and vice-versa. In order to raise the level of investment, the monetary
authori#es have to take a number of steps like giving incentives to savings, increase the
rate of capital formation, mobili#e more funds, both in urban and rural areas, set up
various financial institutions, channalise them in to productive areas, offer reasonable
interest rates, etc. It has to follow a flexible and elastic monetary policy to suit particular
conditions. he various objectives have already highlighted the significance of each one
of them and how they contribute for economic development of a country. -ll kinds of
monetary instruments are to be used in the right proportion so as to fulfill the desired
goals. -n appropriate monetary policy will certainly help in achieving full employment
condition and ensure rapid economic growth. 6ence, a growth promoting monetary
policy has to be formulated in the context of a developing economy.
Instr6ments Of Monetar4 Polic4
%roadly speaking there are two instruments through which monetary policy
operates.hey are also called techni$ues of credit control.
I% A6antitati7e tec5ni86es of credit control=
hey include bank rate policy, open market operations and variable reserve ratio.
II% A6alitati7e tec5ni86es of credit controls=
hey include change in margin re$uirements, rationing of credit, regulation of consumers
credit, moral suasion, issue of directives, direct action and publicity etc.
1% A6antitati7e tec5ni86es of credit control=
he operation of the $uantitative techni$ues or general methods will have a general
impact on the entire economy regulating the supply of credit made available to different
activities.
he %ank ?ate is the rate at which the central bank of a country is willing to discount
first class bills. If the %ank ?ate is raised, the market rates and other lending rates of the
money market also go up. ,onversely, the lending rates go down when the central bank
lowers its bank rate. hese changes affect the supply and demand for money. %orrowing
is discouraged when the rates go up and encouraged when they go down.
he flow of foreign short term capital also is affected. here is an inflow of foreign funds
when the rates are raised and an outflow when they are reduced.
Internal price level tends to fall with the contraction of credit. -nd it tends to rise with its
expansion.
%usiness activity, both industrial and commercial, is stimulated when the rates of interest
are low, and discouraged when they are high.
-dverse balance of payments in foreign trade can be corrected through lowering of costs
and prices.
hus bank rate through its influence on supply of and demand for money helps in the
establishment of stability in the economy.
7pen 'arket 7perations refer to the purchase or sale of government securities, short-
term as well as long-term, by the central bank. 1hen the central bank sells securities cash
balances with the commercial banks decline, they are compelled to reduce their lending.
hus credit contracts. 7n the other hand purchases of securities enable commercial banks
to expand credit.
his method is sometimes adopted to make the bank rate effective.
Harying ?eserve ?atio : Hariations of reserve re$uirements affect the li$uidity position of
the banks and hence their ability to lend. %y raising the reserve re$uirements inflationary
trend can be kept under control. he lowering of the reserve ratio makes more cash
available with the banks. he ?eserve %ank of India has been empowered to vary the
,ash reserve ratio from the minimum re$uirement of 3 @ to &F @ of the aggregate
liabilities. ,ash ?eserves maintained by commercial banks is called statutory reserve and
the reserve over and above the statutory reserves is called excess reserve.
A6alitati7e 'ec5ni86es of Credit Control
,hanges in the margin re$uirements, direct action, moral suasion, rationing of credit,
issue of directives, and regulation of consumer credit are some of the $ualitative
techni$ues which are in practice generally.
1hile lending money against securities banks keep a certain margin. ,entral %ank can
issue directives to commercial banks to maintain higher margins when it wants to curtail
credit and lower the margin re$uirements to expand credit.
.irect action implies a coercive measure like, central bank refusing to provide the benefit
of rediscounting of bills for such banks whose credit policy is not in accordance with the
wishes of the central bank.
he central bank on the other may follow a mild policy of moral suasion where it
re$uests and persuades a member bank to refrain from lending for speculative or non
essential activities.
he ,redit is rationed by limiting the amount available to each applicant. ,entral bank
may also restrict its discounts to bills maturing after short periods.
,entral bank, in the form of directives to commercial banks can see that the available
funds are utili#ed in a proper manner.
?egulation of consumer credit can have a direct impact on the demand for various
consumer durables.
hus ,rowther concludes that the policy 8f the central bank using its free discretion
within limits that are normally very broad can control the volume of money and credit, in
its own field the central bank is clearly a dictator.
Monetar4 Polic4 'o Control Inflation
he best remedy for fighting inflation is to reduce the aggregate spending. 'onetary
policy can help in reducing the pressure on demand. .uring inflation, the central bank
can raise the cost of borrowing and reduce the credit creation capacity of the commercial
banks. his makes banks to become more cautious in their lending policies. he rise in
the 9an: rate- raising the interest rates not only makes borrowing costly but also will
have an adverse psychological effect on business confidence. - rise in the rate of interest
may also encourage saving and discourage spending. he central bank can reduce the
credit creation capacity of the commercial banks through the open mar:et sale of
securities and raising the cas5 reser7e ratio to be maintained with the central bank.
(ome of the selective credit control measures can also be adopted, like varying margin
re$uirements, moral suasion, direct action etc. to regulate credit.
'onetary policy has its own limitations in controlling inflation.
-n increase in the bank rate may be ineffective if commercial banks do not follow the
rise in the bank rate by raising their own interest rates. 2ven if there is a rise in the
interest rate it may not be able to curb spending significantly. For the open market
operations to be effective there should be a well developed and closely knit money
market. If the commercial banks are in the habit of maintaining excess reserves with the
central bank rising of the statutory reserve ratio will not have any impact on their lending.
- major difficulty arises because of the dichotomy in the money market. In our country
the ?eserve %ank can control only the organi#ed sector which constitutes only a very
small portion of the money market. Indigenous bankers and money lenders who do bulk
of lending lie outside the control of the ?eserve %ank.
hus effectiveness of monetary policy in controlling inflation particularly in a developing
economy is very much limited.
Monetar4 Polic4 'o C5ec: )eflation
.eflation is the opposite of inflation. It is essentially a matter of falling prices. .eflation
arises when the total expenditure of the community is not e$ual to the value of the output
at the existing prices. ,onse$uently the value of money goes up and prices fall. .eflation
has an adverse effect on the level of production, business activity and employment. It also
adversely affects distribution of wealth and income. In this sense, deflation is worse than
inflation. %oth inflation and deflation are socially bad, but inflation may be considered to
be the lesser of the two evils.
'onetary measures like %ank ?ate, 7pen 'arket 7perations, Hariable ?eserve ?atio and
selective techni$ues of credit control may be used to expand credit, stimulate bank
advances for various schemes. 1hen the business community is in the grip of pessimism,
substantial reduction in interest rates do not induce them to venture into new investments
and expand production. he horse may be taken to water, but it may refuse to drink. he
monetary authority can only encourage business enterprises. he lower interest rate may
only improve the state of li$uidity in the economy.
6ence, 'odern economists do not give much importance to monetary policy as a tool to
keep economic activity in proper trim.
$earning O9Eecti7e +
$earn a9o6t iscal Polic4 and its Instr6ments
iscal polic4 H instr6ments- o9Eecti7es- its role in economic de7elopment and control
of inflation and deflation
iscal Polic4
Fiscal policy is an important part of the over all economic policy of a nation. It is being
increasingly used in modern times to achieve economic stability and growth throughout
the world. Mord *eynes for the first time emphasi#ed the significance of fiscal policy as
an instrument of economic control. It exerts deep impact on the level of economic
activity of a nation.
Meaning
he term !fisc" in 2nglish language means !treasury", and as such, policy related to
treasury or government exche$uer is known as fiscal policy. Fiscal policy is a package of
economic measures of the government regarding its public expenditure, public revenue,
public debt or public borrowings. It concerns itself with the aggregate effects of
government expenditure and taxation on income, production and employment. In short it
refers to the budgetary policy of the government.
)efinitions
&. In the words of Orsula 6icks, " Fiscal policy is concerned with the manner in which all
the different elements of public finance, while still primarily concerned with carrying out
their own duties Ras the first duty of a tax is to raise revenueS may collectively be geared
to forward the aims of economic policy".
). Gardner -ckley points out, !Fiscal policy involves alterations in government
expenditures for goods and services or the level of tax rates. Onlike monetary policy,
these measures involve direct government interference in to the market for goods and
services Rin case of public expenditureS and direct impact on private demand Rin case of
taxesS.

Instr6ments Of iscal Polic4
1 P69lic #e7en6e= It refers to the income or receipts of public authorities. It is classified
into two parts : ax-revenue and non-tax revenue. axes are the main source of revenue
to a government. here are two types of taxes. hey are direct taxes like personal and
corporate income tax, property tax and expenditure tax etc and indirect taxes like customs
duties, excise duties, sales tax now called H- etc. -dministrative revenues are the bi-
products of administrate functions of the government. hey include Fees, license fees,
price of public goods and services, fines, escheats, special assessment etc.
2% P69lic e<pendit6re polic4= It refers to the expenditure incurred by the public
authorities like central, state and local governments. It is of two kinds, development or
plan expenditure and non-development or non-plan expenditure. 5lan expenditure include
income-generating projects like development of basic industries, generation of electricity,
development of transport and communications, construction of dams etc +on-plan
expenditure include defense expenditure, subsidies, interest payments and debt servicing
changes etc.
+% P69lic de9t or p69lic 9orro;ing polic4= -ll loans taken by the government
constitutes public debt. It refers to the borrowings made by the government to meet the
ever-rising expenditure. It is of two types, internal borrowings and external borrowings.
,% )eficit financing= It is an extraordinary techni$ue of financing the deficits in the
budgets. It implies printing of fresh and new currency notes by the government by
running down the cash balances with the central bank. he amount of new money printed
by the government depends on the absorption capacity of the economy.
.. B6ilt in sta9iliCers or a6tomatic sta9iliCers= LBISM he automatic or built in
stabili#ers imply, automatic changes in tax collections and transfer payments or public
expenditure programmes so that it may reduce destabili#ing effect on aggregate effective
demand. 1hen income expands, automatic increase in taxes or reduction in transfer
payments or government expenditures will tend to moderate the rise in income. 7n the
contrary, when the income declines, tax falls automatically and transfers and government
expenditure will rise and thus built in stabilisers cushions the fall in income.
iscal tools= (ubsidies, development rebates, tax reliefDs, tax concessions, tax
exemptions, and tax holidays, freight concessions, relief expenditures, debt reliefDs,
transfer payments, public works programmes etc. are some of the main tools of the fiscal
policy.
*eynes insisted that public finance should be adjusted to the changing conditions of the
economy, to fight inflationary pressures and deflationary tendencies. he role of fiscal
policy can be compared to the driving of a car. 1hile driving up a gradient 3i.e., stepping
up production and productivity4, what is needed is an increase in power 3promotion of
higher savings and investment through fiscal measures4.7n the other hand, when it moves
against the national interest, it is necessary to control the supply of power 3to combat
inflationary and foreign exchange crisis through higher taxation4 and also to apply brakes
judiciously to ensure that the vehicle does not slip out of control but keeps on moving all
the same. he national exche$uer should see that the brakes are not pressed so much as to
bring the vehicle to a stop.
In short, it is the function of public finance to make economy growI maintain it in good
health and to protect it from internal and external dangers.

O9Eecti7es Of iscal Polic4
1 'o 5elp in optim6m allocation of scarce reso6rces and its ma<im6m 6tiliCation=
Idle are to be mobili#ed and allocated to different sectors of the economy in accordance
with national priorities. 6ence, suitable fiscal policy is to be formulated in this direction.
2% 'o accelerate t5e rate of capital formation%
Fiscal policy should help in mobili#ing the small savings both in rural and urban areas so
as to raise the level of capital formation in the country.
+. 'o enco6rage in7estment=
Fiscal policy should direct investment in the desired channels both in the public and in
the private sectors by providing suitable incentives.
,% 'o ens6re price sta9ilit4=
-ppropriate fiscal policy has to be formulated in order to control the demon of inflation,
deflation and stagflation and ensure a reasonable degree of price stability in the country.
.% 'o control t5e operation of 96siness c4cles=
-n appropriate fiscal policy has to be formulated so as to counteract the adverse and
dampening effects of trade cycles, to minimi#e business fluctuations and achieve a
reasonable degree of economic stability in the economy.
6% 'o ens6re f6ll emplo4ment condition=
Fiscal policy should help in exploiting all kinds of resources available in the country in
the best possible manner and ensure full employment condition in the economy.
/% 'o accelerate t5e rate of economic gro;t5%
he main objective of the fiscal policy is to stimulate and accelerate the rate of economic
growth in the country. -ll instruments of fiscal policy have to be employed in order to
give a big push to the process of development in the country.
1 'o ens6re e86ita9le distri96tion of income and ;ealt5=
In the course of economic development, it is $uite possible that monopoly houses would
grow and income and wealth gets concentrated in the hands of only a few powerful and
influential persons. 6ence, suitable fiscal policy has to be adopted to reduce income
disparities and ensure distributive justice to the common man.
3% 'o red6ce and minimiCe regional and sectoral im9alances=
In most of the countries there is wide spread disparities in the levels of development in
different regions of the country. (uitable fiscal policy has to be designed to avoid,
minimi#e and reduce regional and sectoral imbalances and ensures balanced growth in
the country.
10% 'o mo9iliCe real and financial reso6rces for p69lic sector in larger 86antit4
5ublic sector has assumed greater significance in planned economic development of a
country in recent years. 6ence, an appropriate fiscal policy is to be designed to mobili#e
all kinds of real and financial resources for the successful working of the public sector.
O9Eecti7es in de7eloping co6ntries G
he development problems of developing countries are totally different from that of
developed countries and as such the objectives of fiscal policy also changes in such
economies. hese objectives are listed below.
1% 0elp to 9rea: t5e 7icio6s circle of po7ert4=
'ost of the developing countries are caught in the grip of vicious circle of poverty for the
past several decades and centuries. hey are struggling very hard to come out of this
vicious circle and create the background for normal economic growth. It is possible only
through increasing the rate of investments in all sectors simultaneously. 6ence, suitable
fiscal policy has to be formulated to mobili#e financial resources re$uired for heavy
doses of investments.
2% 0elp to form6late a rational cons6mption polic4=
In order to reduce '5, and increase '5(, it becomes inevitable to pursue a rational
consumption policy, which helps in curbing conspicuous consumption, and release the
resources for saving purposes.
+% 0elp to raise t5e rate of sa7ings=
Fiscal policy should help in mobili#ing both voluntary and forced savings. Harious kinds
of incentives may be offered to encourage savings.
,% 0elp to increase t5e 7ol6me of in7estment=
2conomic development directly depends on the amount of money invested in different
sectors of the economy. Fiscal policy should help in converting the savings made by the
people into investments and create the re$uired economic environment to promote
investment activity in the country.
.% 0elp to di7ersif4 t5e flo; of reso6rces=
he existing scarce resources are to be diverted from unproductive and speculative areas
and directed towards the most productive uses and socially desirable channels so as to
maximi#e net social gains to the common man.
6% 0elp to raise li7ing standards=
7ne of the main growth parameters is that the common man in the country should be in a
position to enjoy the basic necessaries of life in ade$uate $uantity. 6ence, the
government has to take concrete measures to ensure the supply of social goods on a large-
scale. In order to achieve this objectiveI suitable fiscal policy has to be formulated. For
example, through public distribution system, minimum $uantities of certain items are to
be supplied at subsidi#ed rates.
/% 0elp to ac5ie7e f6ll emplo4ment and stim6late gro;t5 rates=
he supreme goal of developing countries is to achieve higher rates of economic growth.
(uitable fiscal policy has to be formulated to exploit all kinds of resources so that the
economy can reach the stage of full employment condition. Full employment condition
results in optimum national output, higher aggregate demand, and income.
1% 0elp to red6ce economic ine86alitiesE
hrough a rational fiscal policy, the government has to take ade$uate measures to control
the growth of monopoly houses, minimi#e economic ine$ualities and ensure distributive
justice to all.
3% 0elp to control inflation and deflation=
?apid economic growth re$uires price stability. It is the duty of the government to adopt
all kinds of measures through suitable fiscal instruments to control inflation, deflation
and stagflation so as to achieve a reasonable degree of price stability. It should also help
in mobili#ing excess purchasing power in the hands of people through suitable taxation
policy.
10 0elp to create more Eo9 opport6nitiesE
In most of the developing nations, there is an army of unemployed people. he services
of these people are to be utili#ed by creating more productive jobs on a large-scale to
absorb them. he government through appropriate fiscal policy has to mobili#e huge
funds and invest them in different sectors of the economy. 6igher investment results in
higher economic growth rate and creation of more employment opportunities.
It is $uite clear that the objectives of fiscal policy are different for developed and
developing countries. It is to be noted that the various objectives listed above are
mutually interrelated and inter connected to each other. (ome of the objectives are
common to both developed and developing countries. In some cases, one objective may
come in clash with the other. For example, growth objective may come in clash with
controlling inflation. -gain, with rapid development, there may be growth of monopolies
and concentration of income and wealth and this will come in clash with the objective of
minimi#ing economic ine$ualities in the country. 6ence, the government has to maintain
harmony and balance between different objectives and determine the priorities from time
to time to meet the changing re$uirement of the economy

$earning O9Eecti7e ,
2no; t5e #ole of iscal Polic4 in t5e Economic )e7elopment
#ole of fiscal polic4 in t5e economic de7elopment=
In order to achieve the above listed objectives, fiscal policy has to play a positive and
constructive role both in developed and developing nations. he specific role to be played
by fiscal policy can be discussed as follows.
1% 'o act as optim6m allocator of reso6rces%
-s most of the resources are scarce in their supply, careful planning is needed in its
allocation so as to achieve the set targets. ?ational allocation would ensure fulfillment of
various objectives.
2% 'o act as a sa7er%
a. It should follow a rational consumption policy which reduces the '5, and raises the
'5(.
b. axation policy has to be modified to raise the rates of old taxes, introduce new and
additional
taxes, and extend the tax-net.
c. 5rofit earning capacity of public sector units are to be raise substantially to mop-up
financial
resources.
d. he government should borrow more money both with in the country and outside the
country.
e. 6igher rates of interests are to be offered for government bonds and securities.
f. Introduction and populari#ation of small savings schemes
g. Introduction of various kinds of Insurance schemes.
h. 2nlarging banking facilities to the nook and corner of the country and adopting a
rational credit
policy.
i. .evelopment and promotion of private financial institutions.
j. 'obili#ation of hoarded wealth in the country through imaginative schemes.
k. Going for moderate doses of deficit financing
l. 2ffective exercise of various kinds of physical control measures so as to release more
resources
for development purposes etc%
+% 'o act as an in7estor%
'ere mobili#ation of financial resources is not an end in itself. It should result in the
creation of real resources which are more important in accelerating the growth process.
?apid economic growth depends on the volume of investment. 6ence, fiscal policy has to
ensure higher volume of investment in both public and private sectors. In the public
sector the government has to increase its investment so as to build up the re$uired
infrastructure in the country on the principle of social marginal productivity. his would
automatically stimulate investments in private sectors. In its $ualitative aspect, it should
aim at changing the composition and flow of investments in the country. It should
discourage the flow of investments in to unproductive, non-essential and speculative
activities in the private sector and help in diverting these scarce resources in to highly
productive areas
,% 'o act as price sta9iliCer
5rice stability is of paramount importance in an economy. 2xtreme levels of both
inflation and defilation would disrupt and disturb the normal and regular working of an
economic system. his would come in the way of stable and persistent growth. 6ence, all
measures are to be taken to check these two dangerous situations so as to create the
necessary congenial atmosphere to prepare the background for rapid economic growth.
.% 'o act as an economic sta9iliCer%
5rice stability would create the necessary background for over all economic stability.
Opswings and downswings in the level of economic activities are to be avoided. If an
economy is subject to fre$uent fluctuations in the form of trade cycles, certainly, it would
undermine and disturb the growth process. Instability would come in the way of
persistent and consistent growth in a country. 6ence, all out measures are to taken to
ensure economic stability.
6% 'o act as an emplo4ment generator.
Fiscal policy should help in mobili#ing more financial resources, convert them in to
investment and create more employment opportunities to absorb the huge unemployed
man power.
/% 'o act as 9alancer%
here must be proper balance between aggregate savings and aggregate investments,
demand and supply, income, output and expenditure, economic over head capital and
social overhead capital etc. -ny sort of imbalance would result in either surpluses or
scarcity in different sectors of the economy leading to fast growth in some sectors
followed by lagging of some other sectorsI thus, disturbing the process of smooth
economic growth.
1% 'o act as gro;t5 promoter%
he basic objective of any economic policy is to ensure higher economic growth rates.
his is possible when there is higher national savings, investment, production,
employment and income. 6ence, fiscal policy is to be designed in such a manner so as to
promote higher growth in an economy%
3% 'o act as an income redistri96tor%
Fiscal policy has to minimi#e economic ine$ualities and ensure distributive justice in an
economy. his is possible when a rational taxation and public expenditure policy is
adopted. 'ore money is to be collected from richer sections of the society through
various imaginative taxation policies and a larger amount of money is to be spent in favor
of poorer sections of the society. hus, ine$uality is to be reduced to the minimum.
10% 'o act as stim6lator of li7ing standards of people%
he final objective is to raise the level of living standards of the people. his is possible
when there is higher output, income and employment leading to higher purchasing power
in the hands of common man. 6ence, fiscal policy should help in creating more wealth in
an economy. If there is economic prosperity, then it is possible to have a satisfactory,
contented and peaceful life.
hus, fiscal policy has to play a major role in promoting economic growth in a country.

$earning O9Eecti7e .
2no; t5e #ole of iscal Polic4 to Control Inflation and )epression
iscal Polic4 'o Control Inflation
Inflation is caused either by an increase in demand or increase in costs. - rise in prices
generally gives rise to demand for rise in wages and if these demands are met, the rise in
wages causes costs and prices to rise further, thus worsening the inflationary situation.
axation as an anti-inflationary measure should be used carefully choosing different types
of taxes. .irect taxes like income tax, expenditure tax, and excess profit tax etc., take
away from the public in a very progressive manner a part of the purchasing power. hese
will have discouraging effect on consumption. Indirect taxes carefully chosen on a few
commodities may suppress the demand for such commodities and thereby reduce the
inflationary pressure to some extent.
-ll inessential and unproductive expenses of the government should be cut down. %ut as
most of the public expenditure is for the planned economic development and for the well
being of the people the scope for reducing public expenditure to dampen the inflationary
pressure is very much limited.
5ublic borrowing particularly from the non banking lenders will have disinflationary
effect by reducing their cash reserves and thereby keeping down the demand for goods
and services.
If the government succeeds in raising revenue and reducing public expenditure, it will
create a budget surplus. If the government uses this surplus to buy off the government
securities held by the general public or the banking system there would be an expansion
in the cash reserves with the public and the credit creation capacity of the commercial
banks offsetting the favourable anti-inflationary effect of higher taxation. It should be
used to redeem the debt held by the central bank of the country. his would have the
effect of reducing the supply of money in the community and, in turn, reducing the
pressure on the price level. In practice, however, the scope for surplus budgeting is
extremely limited.
-ppraisal of anti-inflationary fiscal policyE
Fiscal measures are not wholly successful in preventing inflation in times of war or in
periods of rapid economic development. Marge government expenditure is inevitable in
such conditions and a certain amount of deficit financing may have to be allowed. In case
of developing countries because of heavy investments in long term projects incomes are
generated much ahead of the availability of goods and services. he reduction of demand
through control of public expenditure has thus limited scope.
Increase in tax rates may discourage production and public borrowing also has its own
limitations. otal effect of all these measures may just help in reducing the inflationary
pressure but not in complete elimination of it.
iscal Polic4 'o Control )epression
Mord *eynes maintains that a business depression and unemployment are due to
deficiency of aggregate demand and strongly advocates the use of fiscal policy to make
up this deficiency.
here should be a reduction in personal income tax and corporate tax which will promote
saving and investment and excise and sales taxes which will promote consumption.
.uring depression tax reduction alone is not ade$uate to push up consumption and
investment to appropriate levels, the government can make up this shortage through
increase in public expenditure. Government by investing in public works programmes,
social and economic overheads can encourage businessmen and industrialists to take up
new investment activity. (ince public works programmes cannot be continued for a long
period and beyond certain limits some social security schemes, unemployment insurance,
pension, subsidies of various types can also be provided to raise the level of consumption.
5ublic borrowing, debt servicing and debt repayment also serve as important measures to
fight depression and cyclical unemployment.
Fiscal policy as an instrument to fight depression and create full employment conditions
is much more effective than monetary policy, since it affects the level of effective
demand directly, while monetary policy attempts to do it only indirectly.

$earning O9Eecti7e 6
2no; a9o6t P54sical polic4 in t5e reg6lation of cons6mptions- in7estment and
foreign trade
P54sical Polic4 or )irect Controls
Government interference with the forces of demand and supply in the market and state
regulation of prices of commodities are common features in these days. hus when
monetary and fiscal measures are inade$uate to control prices government resorts to
direct control. .uring the war, when inflationary forces are strong price control involve,
imposing ceilings in respect of certain prices and prices are to be stopped from rising too
high. In a planned economy, the objective of price control is to bring about allocation of
resources in accordance with the objects of plan. 5rice control normally involves some
control of supply or demand or both. hese are done by control of distribution of
commodities through rationing. ?ationing is, therefore, an essential part of price control
policy. In the O.(. price control takes the form of price support programme in which
prices are prevented from falling below certain levels considered fair. Onder certain
circumstances government may resort to dual pricing, which is yet another form of price
control by the government.
Instr6ments Of P54sical Polic4
.irect controls are imposed by government to ensure proper allocation of scarce
resources like food, raw materials, consumer goods, capital goods etc. Government can
strictly forbid or restrict certain kinds of investments or economic activity. .uring the
period of inflation government can directly exercise control over prices and wages.
.uring 1orld 1ar II, price-wage controls were employed along with consumer rationing
to curb excess demand. 'onetary and fiscal controls will have a general impact on the
economy while physical controls can be employed to affect specific scarcity areas.
Generally .irect ,ontrols are of three formsE
,ontrol over consumption and distribution through price control and rationing.
,ontrol over investment and production through licensing and fixing of $uotas
etc.
,ontrol over foreign trade through import control, import $uotas, export control,
etc.
.uring the war period there will be a terrific increase in the demand for certain
commodities causing a steep rise in prices of such commodities, further, this is intensified
by the war financing, allowing surplus purchasing power in the economy. 5rice control
attempts to check the inflationary rise in prices, enable all citi#ens to get a minimum of
certain basic necessaries of life and serves as an effective instrument of resource
mobili#ation.
Government may fix ceiling prices for various commodities. If government is forced to
revise such prices from time to time, it may lead to hoarding and black-marketing. It
re$uires government to exercise some control over supply and demand. he state may
have to compulsorily ac$uire some stocks of controlled commodities and distribute them
through !fair price shops", known as public .istribution (ystem.
(ince there is a close link between commodity market and factor market, under
emergency conditions, government may resort to control of profit, interest, rent and
wages.
1hen prices are falling in time of depression, there is pressure for government to fix
minimum prices. In case of some farm products, when there is a bumper harvest, farmers
demand for minimum support prices to avoid excessive loss. (ubsidies are granted to
some farm as well as industrial products to enable them to meet their costs.
Onder certain special circumstances C.ual 5ricingD is adopted, there are two prices for the
same commodity at the same time : one is a controlled price fixed by the government for
the benefit of lower income groups and the other is a free market price determined by the
conditions of demand and supply, which enables the producers to make up their loss in
the controlled market.
-part from these there are !-dministered 5rices !, fixed by the government on a few
carefully selected goods like steel, aluminium, fertili#ers, cement etc. which serve as raw
materials for other industries and fluctuations in their prices is dangerous for the growth
of such industries.
,ontrol over investment and production is e$ually essential. Factors of production are
allocated to industrial concerns in accordance with their re$uirements. 5riorities are laid
down in accordance with the importance of commodities produced by different
industries.
(tringent measures are taken against hoarding and black-marketing. o overcome the
short term scarcity generally essential goods are imported to meet the excess demand.
?eduction of excise duties, granting of tax concessions, credit facilities, supply of raw
materials are some of the measures adopted to encourage production, in the long run.
Globali#ation and liberali#ation policies have made control over foreign trade a more
sensitive issue. Intervention of the government in the foreign exchange market
neutrali#ing the forces of demand and supply now has lost its significance. Import duties,
i.e., levying tariffs on imports to discourage such imports, Import >uotas, i.e., fixing of
maximum $uantity of a commodity to be imported during a given period have become
more popular as direct control measures. %esides exports may be promoted, through
reduction of export duties, use of export bounties and subsidies and so on, if certain
goods are found essential for domestic consumption, then export of such goods can be
prohibited.
Ad7antages of direct controls
hey can be introduced $uickly and easilyI hence the effects of these can be rapid.
.irect controls can be more discriminatory than monetary and fiscal controls.
here can be variation in the intensity of the operation of controls from time to
time in different sectors.
)isad7antages
.irect controls suppress individual initiative and enterprise.
hey tend to inhibit innovations, such as new techni$ues of production, new
products etc.
.irect controls may induce speculation which may have destabili#ing effect. It
thus encourages the creation of artificial scarcity through large scale hoardings.
.irect controls need a cumbersome, honest and efficient administrative
organi#ation if they are to work effectively.
Gross disturbances may appear when the controls are removed.
In brief, direct controls are to be used only in extraordinary circumstances like
emergencies and not in a peacetime economy.
-ll measures suggested above must be carefully coordinated and implemented to achieve
economic stabili#ation. It may not be possible to eliminate all fluctuations in
employment, output and prices but can be controlled reasonably if measures are
effectively adopted.



S6mmar4
(table economic conditions are a pre re$uisite for a systematic and smooth economic
growth. (ince fluctuations are inherent in a dynamic set up, deliberate policy measures
become necessary to establish stable conditions in the economy. (tabili#ation policies
include monetary policy, fiscal policy and physical policy.
'onetary policy is the policy of the central bank, it consists if using such instruments as
bank rate, open market operations, variable reserve ratio and selective credit controls like
margin re$uirements, moral suasion, direct action, rationing of consumer credit, etc. to
regulate the supply of money in accordance with the re$uirements of the economy. he
principal objectives of monetary policy are price stability, exchange stability, elimination
of cyclical fluctuations, achievement of full employment and in case of underdeveloped
countries, accelerating economic growth, controlling inflation deflation etc. 'onetary
policy to be effective in imparting economic stability there should be a well organi#ed
and well developed money market.
Fiscal policy or the budgetary policy of the government refers to the policy of the
government regarding taxation, public expenditure, and management of public debt.
here is a general belief that government can influence economic and business activity
through fiscal measures. he major objectives of fiscal policy are to achieve optimum
allocation of economic resources, bring about e$ual distribution of income and wealth,
maintain price stability, 5romote and achieve full employment, promote saving and
investment, control inflation, control depression etc. Harious instruments of fiscal policy
like taxation and public expenditure have their own limitations in stabili#ing the
economic growth.
5hysical policy refers to direct control on different activities by the government to
achieve the desired goal. It is more specific, simple and direct compared to the monetary
and fiscal policies. Government, controls consumption and distribution of essential goods
like food and raw material through price control and rationing. .irect controls are used
generally to tide over a situation of shortage or surplus, to avoid large fluctuations in the
prices of essential commodities. Investments in certain fields and foreign trade is
regulated through licensing, fixing of $uotas, import controls, export controls, export
promotion, etc.


,opyright U )8&& SMU
5owered by Si::im Manipal Uni7ersit4
.
MB0026- Unit 1+-B6siness C4cles
Unit 1+ B6siness C4cles

,yclical fluctuations have become a regular feature of a capitalist system. - capitalist
economy is guided by competition and profit motive. here is freedom of private
enterprise, private ownership of property and free play of market forces of supply and
demand. %usinessmen in their anxiety to earn more and amass wealth, produce much in
excess of the absorption capacity of the economy causing imbalances in the supply and
demand conditions. hus, the smooth functioning of the economy is disturbed and subject
to many ups and downs. (uch ups and downs have been termed as business cycles.
he world has registered remarkable progress especially after the Industrial ?evolution.
%ut the course of world economic growth has not been a steady upward movement. he
economic history of several economies is essentially the history of upswings and
downswings. ?arely one can witness steady and stable growth. 7n the other hand,
economic evolution is characteri#ed by :
&. - period of upswing followed by a period of downswing.
). - period of prosperity alternating with poverty and adversity.
3. - period of boom followed by a period of slump.
;. - period of expansion followed by a period of contraction.
F. - period of recession followed by a period of revival.
9. - period of optimism followed by a period of pessimism.
K. - period of inflation followed by a period of deflation.
B. - period of favorable condition by an adverse condition.
A. - 5eriod of rise followed by a period of fall in the level of economic activity etc.
hus, cyclical oscillations are a part of the structure of a modern dynamic economy. hey
are periodical changes in the level of business activities differing in intensity and
changing in their coverage. hese fluctuations occur in a more or less regular time
se$uence. hey arise in some sectors and spread over to entire economy. (ome of these
fluctuations are abrupt, isolated, discontinuous and catastrophic. (ome are regular,
continuous, persistent and mild, lasting for long periods of time in the same direction.
(ome are rhythmic and recurrent in nature. hus, a trade cycle is a highly complex
phenomenon. It is associated with sweeping, violent and sudden fluctuations in economic
activity. he duration of a business cycle has not been of the same length. It has varied
from a minimum of two years to a maximum of &8 : &) years.
'5e term 96siness c4cle refers to a ;a7e li:e fl6ct6ation in t5e o7er all le7el of
economic acti7it4 partic6larl4 in national o6tp6t- income- emplo4ment and prices
t5at occ6r in a more or less reg6lar time se86ence% It is not5ing 96t r54t5mic
fl6ct6ations in t5e aggregate le7el of economic acti7it4 of a nation% .ifferent writers
have defined business cycles in different ways. -ccording to 5rof. 6aberler, !he
business cycle in the general sense may be defined as an alternation of periods of
prosperity and depression of good and bad trade". In the words of 5rof.
Gordon, !%usiness cycles consists of recurring alternations of expansion and contraction
in aggregate economic activity, the alternating movements in each direction being self-
reinforcing and pervading virtually all parts of the economy". -ccording to *eynes !-
trade cycle is composed of periods of good trade characteri#ed by rising prices and low
unemployment percentages, alternating with periods of bad trade characteri#ed by falling
prices and high unemployment percentages." hus, one can notice a common feature in
all these definitions, i.e., variations in the aggregate level of economic activities in
different magnitudes.
C5aracteristics of B6siness C4cle
&. It is a wave-like movement and it is not a random fluctuation.
). It is synchronic in nature. It is all embracing, it covers the entire economy. he
entire business of the economy acts like a living organism. 6ence, any change in
one part of the economy affects the entire economy.
3. It occurs periodically and hence recurrent in nature. It is repetitive in the sense
that it has some recogni#ed pattern.
;. It is to be noted that different trade cycles are similar but not identical in their
nature. 5rof. 5igou points out that all recorded trade cycles are the members of the
same family but among them there are no twins.
F. he effects of different trade cycles are different on different activities.
9. It is self : generating. he process is cumulative and self-reinforcing. he self-
generating forces terminate one phase and start another phase. +o phase is
permanent.
K. It is international in character.
B. he prosperity phase takes double the time taken by the depression phase.
A. he downward movement is more sudden and violent than the change from
downward to upward.
&8. 5rofits fluctuate more than the other incomes.
&&. 2mployment and output in durable goods and capital goods industries fluctuate
more than in the consumption goods industries.
&). It is characteri#ed by the presence of a crisis according to Mord *eynes. +o two
phases are $uite symmetrical. 2ach phase distinctly represent a crisis of different
nature.
CAUSES O BUSI!ESS C*C$ES
he following are some of the important causes, which deserve our attention.
&. 1illiam (tanley Qevons points out that climatic conditions- good or 9ad create
boom and depression
). 5igou is of the opinion that 7ariations in 96siness confidence- o7er optimism
and o7er pessimism and ot5er ps4c5ological factors cause fluctuations in
business.
3. (chumpeter highlights that cyclical fluctuations are ca6sed 94 inno7ations
carried o6t in ind6strial and commercial organiCations%
;. -ccording to Q- 6obson business cycles are d6e to eit5er 6nder cons6mption
or o7er cons6mption%
F. In the opinion of 6awtrey non-monetar4 factors s6c5 as ;ars- eart586a:es-
stri:es- crop fail6res etc%- may only cause partial or temporary fluctuations. %ut
substantial changes in total money supply in an economy are one of the major
causes for cyclical oscillations or alternate phase of prosperity and depression of
good and bad trade conditions.
9. -ccording to 5rof.6ayek business cycles are caused 94 t5e e<cess of in7estment
o7er 7ol6ntar4 sa7ings%
K. -ccording to Mord *eynes business cycles are caused by variations in the rate of
investment, which are caused by fl6ct6ations in Marginal Efficienc4 of Capital
and Interest rate%
B. Q? 6icks is of the opinion that a6tonomo6s In7estment and Ind6ced
In7estment cause cyclical fluctuations in economic activity via. 'ultiplier and
accelerator respectively.
A. 'itchell recogni#es the fact that different parts of an economy are inter-related
and inter-connected and as such any maladjustment started in one-part spreads
out to the entire economy.
&8. *aldor stresses that c5anges in t5e stoc: of capital brings about changes in the
level of savings and investment which in its turn causes variations in the level of
output, income and employment in an economy.
&&. (amuelson is of the opinion that either multiplier or accelerator can explain the
process of cyclical fluctuations in any economy. 7n the other hand, t5ese t;o
forces ;or:ing toget5er Rsuper multiplierS can satisfactorily explain the whole
income generation and income fluctuations.
&). Friedman and (chwart# observe that a c5ange in t5e total stoc: of mone4
s6ppl4 will have its rapid transmission effect on the level of income and prices in
an economy.
hus, it is very clear that several factors and forces are collectively responsible
for the emergence of trade cycles in an economy.

P5ases of 'rade C4cle%
%asically, a business cycle has only two parts- expansion and contraction or prosperity
and depression. %urns and 'itchell observe that peaks and troughs are the two main
mark-off points of a business cycle. he expansion phase starts from revival and includes
prosperity and boom. ,ontraction phase includes recession, depression and trough. In
between these two main parts, we come across a few other interrelated transitional
phases. In its broader perspective, a business cycle has five phases. hey are as follows.


1% )epression- contraction or do;ns;ing
It is the first phase of a trade cycle. It is a protracted period in ;5ic5 96siness acti7it4
is far 9elo; t5e normal le7el and is e<tremel4 lo;% -ccording to 5rof. 6aberler
depression is a !state of affairs in which the real income consumed or volume of
production per head and the rate of employment are falling and are sub-normal in the
sense that there are idle resources and unused capacity, especially unused labor".
'5is period is c5aracteriCed 94=
a. - sharp reduction in the volume of output, trade and other transactions.
b. -n increase in the level of unemployment.
c. - sharp reduction in the aggregate income of the community especially wages and
profits. In a few cases, profits turns out to be negative.
d. - drop in prices of most of the products and fall in interest rates.
e. - steep decline in consumption expenditure and fall in the level of aggregative
effective demand.
f. - decline in marginal efficiency of capital and hence the volume of investment.
g. -bsence of incentives for production as the market has become dull.
h. - low demand for Moanable funds, surplus cash balances with banks leading to a
contraction in the creation of bank credit.
i. - high rate of business failures.
j. -n increasing difficulty in returning old debts by the debtors. his forces them to sell
their inventories in the market where prices are already falling. his deepens depression
further.
k. - decline in the level of investment in stocks as it becomes less attractive and less
profitable. his reduces the deposits with the banks and other financial institutions
leading to a contraction in bank credit.
l. - lot of excess capacity exists in capital and consumer goods industries which work
much below their capacity due to lack of demand.
.uring depression, all construction activities come to a more or less halting stage.
,apital goods industries suffer more than consumer goods industries. (ince costs are
DstickyD and do not fall as rapidly as prices, the producers suffer heavy losses. 5rices of
agricultural goods fall rapidly than industrial goods. .uring this period purchasing power
of money is very high but the general purchasing power of the community is very low.
hus, the aggregate level of economic activity reaches its rock bottom position. It is t5e
stage of tro6g5% he economy enters the phase of depression, as the process of
depression is complete. It is also called- t5e period of sl6mp%
.uring this period, there is disorder, demorali#ation, dislocation and disturbances in
the normal working of the economic system. ,onse$uently, one can notice all-round
pessimism, frustration and despair. he entire atmosphere is gloomy and hopes are less. It
is a period of great suffering and hardship to the people. hus, it is the worst and most
fearful phase of the business cycle. O(- experienced depression two times, between
&BK3- &BKA and &A)A : &A33.

2% #eco7er4 or re7i7al I
.epression cannot last long, forever. -fter a period of depression, recovery starts.
It is a period where in, economic activities receive stimulus and recover from the shocks.
his is the lower turning point from depression to revival towards upswing. .epression
carries with itself the seeds of its own recovery. -fter sometime, the rays of hope appear
on the business hori#on. 5essimism is slowly replaced by optimism. ?ecovery helps to
restore the confidence of the business people and create a favorable climate for business
ventures.
he recovery may be initiated by the following factorsE
a. Increase in government expenditure so as to increase purchasing power in the
hands of consumers.
b. ,hanges in production techni$ues and business strategies.
c. .iversification in investments or Investment in new regions.
d. 2xplorations and exploitation of new sources of energy etc.
e. +ew innovations- developing new products or services, new marketing strategy
etc.
-s a result of these factors, business people take more risks and invest more. Mow
wages and low interest rates, low production costs, recovery in marginal efficiency of
capital etc induce the business people to take up new ventures. In the early phase of the
revival, there is considerable excess capacity in the economy so, the output increases
without a proportionate increase in total costs. ?epairs, renewals and replacement of
plants take place. Increase in government expenditure stimulates the demand for
consumption goods, which in its turn pushes up the demand for capital goods.
,onstruction activity receives an impetus. -s a result, the level of output, income,
employment, wages, prices, profits, start rising. ?ise in dividends induce the producers to
float fresh investment proposals in the stock market. ?ecovery in stock market begins.
(hare prices go up. 7ptimistic expectations generate a favorable climate for new
investment. -ttracted by the profits, banks lend more money leading to a high level of
investment. he upward trends in business give a sort of fillip to economic activity.
hrough multiplier and acceleration effects, the economy moves upward rapidly. It is to
be noted that revival may be slow or fast, weak or strongI the wave of recovery once
initiated begins to feed upon itself. Generally, the process of recovery once started takes
the economy to the peak of prosperity.
+% Prosperit4 or 6ll-emplo4ment
he recovery once started gathers momentum. he cumulative process of
recovery continues till the economy reaches full employment. Full employment may
be defined as a situation where in all available resources are fully employed at the
current wage rate. 6ence, achieving full employment has become the most important
objective of all most all economies. +ow, there is all round stability in output, wages,
prices, income, etc. -ccording to 5rof. 6aberler !Prosperit4 is a state of affair in
;5ic5 t5e real income cons6med- prod6ced and t5e le7el of emplo4ment are 5ig5
or rising and t5ere are no idle reso6rces or 6nemplo4ed ;or:ers or 7er4 fe; of
eit5er%K .uring the period of prosperity an economy experiences-
a. - high level of output, income, employment and trade.
b. - high level of purchasing power, consumption expenditure and effective
demand.
c. - high level of 'arginal 2fficiency of ,apital and volume of investment.
d. - period of mild inflation sets in leading to a feeling of optimism among
businessmen and industrialists.
e. -n increase in the level of inventories of both inputs and outputs.
f. - rise in Interest ?ate.
g. - large expansion in bank credit and financial institutions lend more money to
business men.
h. Firms operate almost at full capacity along with its production possibility
frontier.
i. (hare markets give handsome gains to investors as dividends and share prices go
up. ,onse$uently, idle funds find their way to productive investments.
j. - state of exuberance and enthusiasm exists in business community.
k. Industrial and commercial activity, both speculative and non-speculative show
remarkable expansion.
l. here is all round expansion, development, growth and prosperity in the economy.
2very one seems to be happy during this period.
he O(- experienced the longest period of prosperity between &A)3 P)A.
,% Boom or O7er f6ll Emplo4ment or Inflation
he prosperity phase does not stop at full employment. It gives way to the emergence of a
boom. It is a p5ase ;5ere in t5ere ;ill 9e an artificial and temporar4 prosperit4 in
an econom4% %usiness optimism stimulates further investment leading to rapid expansion
in all spheres of business activities during the stage of full employment, unutili#ed
capacity gradually disappears. Idle resources are fully employed. 6ence, rise in
investment can only mean increased pressure for the available men and materials. Factor
inputs become scarce commanding higher remuneration. his leads to a rise in wages and
prices. 5roduction costs go up. ,onse$uently, higher output is obtained only at a higher
cost of production. 7nce full employment is reached, a further increase in the demand for
factor inputs will lead to an increase in prices rather than an increase in output and
income. .emand for Moanable funds increases leading to a rise in interest rates. +ow
there will be hectic economic activity. (oon a situation develops in which the number of
jobs exceed the number of workers available in the market. (uch a situation is known as
o7erf6ll emplo4ment or 54per-emplo4ment% .uring this phaseE
a. 5rices, wages, interest, incomes, profits etc move in the upward direction.
b. '2, raises leading to business expansion.
c. %usiness people borrow more and invest. his adds fuel to the fire. he tempo of
boom reaches new heights.
d. here is higher output, income and employment. Miving standards of the people
also increases.
e. here is higher purchasing power and the level of effective demand will reach
new heights.
f. here is an atmosphere of !over optimism" all round, which results in over
investment. ,ost of living increases at a rate relatively higher than the increase in
household incomes.
g. It is a symptom of the end of prosperity phase and the beginning of recession.
he boom carries with it the gems of its own destruction. he prosperity phase comes to
an end when the forces favoring expansion becomes progressively weak. %ottlenecks
begin to appear. (carcity of factor inputs and rise in their prices disturb the cost
calculations of the entrepreneurs. +ow the entrepreneurs reali#e that they have over
stepped the mark and become over cautious and their over-optimism paves the way for
their pessimism. hus, prosperity digs its own grave. Generally the failure of a company
or a bank bursts the boom and ushers in a recession. O(- experienced prosperity between
&A)3 and &A)A.
.% #ecession H A t6rn from prosperit4 to )epression
he period of recession begins when the phase of prosperity ends. It is a period of
time ;5ere in t5e aggregate le7el of economic acti7it4 starts declining% '5ere is
contraction or slo;ing do;n of 96siness acti7ities% -fter reaching the peak point,
demand for goods decline. 7ver investment and production creates imbalance between
supply and demand. Inventories of finished goods pile up. Future investment plans are
given up. 7rders placed for new e$uipments and raw materials and other inputs are
cancelled. ?eplacement of worn out capital is postponed. he cancellation of orders for
the inputs by the producers of consumer goods creates a chain reaction in the input
market. Incomes of the factor inputs decline this creates demand recession. In order to get
rid of their high inventories, and to clear off their bank obligations, producers reduce
market prices. In anticipation of further fall in prices, consumers postpone their
purchases. 5roduction schedules by firms are curtailed and workers are laid-off. %anks
curtail credit. (hare prices decline and there will be slackness in stock and financial
market. ,onse$uently, there will be a decline in investment, employment, income and
consumption. Mi$uidity preference suddenly develops. 'ultiplier and accelerator work in
the reverse direction. Onemployment sets in the capital goods industries and with the
passage of time, it spreads to other industries also. he process of recession is complete.
he wave of pessimism gets transmitted to other sectors of the economy. he whole
economic system thereby runs in to a crisis.
Failure of some business creates panic among businessmen and their confidence is
shaken. %usiness pessimism during this period is characteri#ed by a feeling of hesitation,
nervousness, doubt and fear. 5rof. '. 1. Mee remarks, !- recession, once started, tends
to build upon itself much as forest fire. 7nce under way, it tends to create its own drafts
and find internal impetus to its destructive ability". 7nce the recession starts, it becomes
almost difficult to stop the rot. It goes on gathering momentum and finally converts itself
in to a full- fledged depression, which is the period of utmost suffering for businessmen.
hus, now we have a full description about a business cycle. he O(- experienced one
of the severe recessions during &AFK-FB.
$ord O7erstone describes the course of business cycle in the following words :
!- state of $uiescence 3inert or silent4 : next improvement : growing confidence :
prosperity : excitement : overtrading : convulsion : pressure : distress : ending :
again in $uiescence"
- detailed study of the various phases of a business cycle is of paramount
importance to the management. It helps the management to formulate various anti-
cyclical measures to be taken up to check the adverse effects of a trade cycle and
create the necessary conditions for ensuring stability in business.

$earning O9Eecti7e 2
0a7e t5e :no;ledge of 7ario6s t5eories of 96siness c4cles and t5e meas6res to
control 96siness c4cles
'5eories of B6siness C4cles%
2conomists have put forward a number of theories to explain the causes of %usiness
,ycles. 1e will discuss some important theories.
Sc56mpeterFs Inno7ations '5eor4 of B6siness C4cles
-ccording to (chumpeter, innovations are the source of business fluctuations% An
inno7ation is defined as t5e de7elopment of a ne; prod6ct- or t5e introd6ction of a
ne; met5od of prod6ction- a ne; process of prod6ction- de7elopment of a ne;
mar:et- de7elopment of a ne; so6rce of ra; material- a c5ange in t5e organiCation
of 96siness- and so on% In other words an innovation is anything which is introduced by a
firm to change the position of supply andNor demand curves. -ny innovation, thus, results
in the establishment of a new e$uilibrium in the system.
Met us assume that there is full employment in the economy. (uppose that an innovation
in the form of a new product has been introduced. he new plant and e$uipment re$uired
to produce the new product has to be drawn from the old industries paying higher
rewards. his compels old industries too to raise the factor rewards. For this banks
provide additional loans. here will be a rise in the cost of production in both the old and
the new industries. Factor services earning higher remuneration will push up the demand
for both old and new goods. (uch of the industries whose cost of production is less and
the prices of products go high enough to fetch abnormal profits expand their production.
1hen the new product introduced becomes commercially successful and promoters earn
abnormal profit, many similar products and imitations crop up in the market. 1ith the
result employment, output and incomes raise leading to expansion in the market. - period
of cumulative prosperity sets in motion.
he new product loses its novelty with the introduction of many competing varieties of
product being introduced in the market. -bnormal profits are competed away. (ome of
the firms may incur losses and $uit the market. 1orkers are laid off. .emand for goods
fall, employment falls, incomes fall pushing down the prices and profits further. %anks
pressuri#e for the repayment of loans, with the result money in circulation falls setting in
a deflationary situation.
hus (chumpeter attributes business expansion and contraction to the innovations of
various kinds.
he assumption of full employment and the financing of innovations by means of bank
loans are subject to criticism. -gain Innovations cannot be considered as the only cause
of business fluctuations.
O7er H In7estment t5eor4 of (on 0a4e:
-ccording to 5rofessor 6ayek business cycles are caused by overinvestment and
conse$uent overproduction. -ccording to him, there is a !natural" or e$uilibrium rate of
interest at which the demand for loanable funds is e$ual to the supply of the same through
voluntary savings. here is yet another rate of interest called the market rate of interest
based on demand for and supply of loanable funds in the market. -ccording to him when
bothD naturalD and Cmarket rate of interestD are the same, there will be stability in business
conditions. -ny disparity between the two will lead to business fluctuations.
he market rate of interest may fall below the natural rate when there is an increase in the
supply of money and bank credit. his encourages investment activity causing an
increase in the demand for capital goods. his leads to a rise in the prices of capital goods
inducing the entrepreneurs to divert the resources from the production of consumption
goods to the production of capital goods : resulting in the reduction of the supply of
consumption goods. -s the people engaged in capital goods industry earn larger incomes
the demand for consumption goods will increase causing a rise in their prices. here will
now be a competition between the capital goods industries and consumption goods
industries for the use of scarce resources, leading to a rise in their prices. his will result
in a fall in the profit margins of the capital goods industries. -t the same time banks
decide to reduce the rate of credit expansion by raising the market rate of interest above
the natural rate. hus, on the one hand profit margins are low, and, on the other, credit has
become costly. he business expansion and boom brought about by low market rate of
interest and heavy investment activity crashes when banking system puts a stop on
additional lending to entrepreneurs.
hus excess supply of money and bank credit leading to a fall in the market rate below
the e$uilibrium rate is responsible for business fluctuations. 6ayekDs solution to control
the cyclical fluctuations is simpleI *eep the supply of money and bank credit stable to
maintain stable economic activity.
he basic weakness of the theory is its emphasis on the rate of interest and complete
neglect of such real factors as technological changes and innovations influencing the
volume of investment. Further his suggestion to maintain a constant supply of money to
avoid fluctuations in business is based on the discarded $uantity theory of money. he
theory also fails to offer a convincing explanation as to why fluctuations in investment
take place almost regularly. It does not provide explanation to all the characteristics of a
trade cycle and its duration.
0a;tre4Fs P6re Monetar4 '5eor4 of 'rade C4cles
5rofessor
6awtrey regards trade cycle as a purely monetary phenomenon. ,hanges in the flow of
money are mainly responsible for creating business fluctuations in an economy.
-ccording to him the main factor affecting the flow of money supply is the credit
creation by the banking system. 1hen the central bank reduces the %ank ?ate, the
commercial banks in the country reduce their lending rates. - reduction in the lending
rates induce traders and businessmen to borrow more from banks and hold larger stocks
and place more orders with the manufacturers. 5roducers to meet the increased demand
purchase more materials and employ more men. Incomes increase and prices show an
upward trend. here is boom in the economy. %ut soon when banks find that they have
created too much credit and their cash reserves are too small in relation to their deposits,
they restrict credit and call back loans. he central bank raises the %ank ?ate to tighten
the supply of money. his compels the commercial banks to raise their lending rates and
contract their credit. his comes as a big shock to the businessmen. hey are then forced
to sell their stocks and cancel new orders for products. here will be a fall in the level of
investment resulting in a fall in the level of employment and incomes. his will lead to a
steep fall in the aggregate demand causing a fall in the prices. he prosperity phase
comes to an end when credit expansion ends. .epression sets in.
hus, the monetary phenomena of hoarding and dishoarding , credit expansion and credit
contraction have a lot to do with business cycles, since they represent a succession of
inflationary and deflationary processes.
6awtrey has not explained how the initial expansion or contraction of credit starts and
why bank policy gets unstable. here is also no explanation why booms and depression
occur with such regularity. +o doubt banking system plays an important role in financing
trade activities. %ut it is not always correct to say that banks cause business cycles. hey
may aggravate matters. 'oreover, borrowing and investment will not depend upon the
rate of interest. 2xpansion and contraction of bank credit alone cannot explain prosperity
and depression.

Modern '5eor4= Interaction of M6ltiplier and Acceleration Principle
-ccording to (amuelson the interaction between multiplier and accelerator gives rise to
cyclical fluctuations in economic activity. 6e constructed a multiplier : accelerator model
assuming one period lag and different values for the '5, and the accelerator. he
changes in the level of income caused by the operation of the super multiplier have been
explained in five different types of fluctuations. : &. ,ycle less path based only on the
multiplier effect, ). - damped cyclical path fluctuating around the static multiplier level
and gradually subsiding to that level. 3. ,ycles of constant amplitude repeating
themselves around the multiplier level ;. 2xplosive cycles F. ,ycle less explosive
approaching an upward path. 7ut of the five types explained only the second and the
fourth have been experienced in a milder form over the first half century. Generally,
cycles in the post-war period have been relatively damped compared to those in the
interwar period.
7ne-period lag means that an increase in income in one period induces an increase in the
consumption in the succeeding period. -n autonomous increase in the level of investment
gives rise to an increase in the income according to the value of the multiplier. his
increase in the income will induce further increase in investment through acceleration
effect. he Increase in consumption, income and investment caused by an increase in
initial investment through the interaction between the multiplier and accelerator is linked
round a CloopD. he table makes the concept clear

-utonomous Induced Induced otal deviation of income
%ase period investment
consumption investment from base period
8
& &8 8 8 &8
) &8 F &8 )F
3 &8 &).F &F 3K.F
; &8 &B.KF &).F8 ;&.)F
F &8 )8.9B 3.B9 3;.F;

In the table we have assumed that the 'arginal propensity to consume is Y, the
accelerator is ).and that there is one period lag. 1e have further assumed that an
autonomous investment of ?s.&8 crores is added in each period which is continuously
maintained in the succeeding periods. It will be noticed from the table that, when
autonomous increase in investment of ?s.&8 crores is added in period &, it gives rise to an
increase in income of only ?s.&8 crores. It does not induce increase in consumption in
period &, as we have assumed a lag of one period.. +ow with '5, of Y, the increase in
income of ?s.&8 crores in period & induces an increase in consumption of ?s.F crores in
period ). 1ith the value of accelerator as ), there will be induced investment of ?s.&8
crores in period ). +ow the total increase in income in period ) over the base period will
be e$ual to the autonomous investment of ?s.&8 crores which is maintained in the second
period plus the induced consumption of ?s.F crores plus the induced investment of ?s &8
crores3total increase in income in period ) / )F4. +ow, in the third period, the
consumption would be e$ual to ?s. &).F crores. he increase in consumption in period 3
over period ) is ?s.K.F crores, this increase in consumption of ?s.K.F crores will induce
investment of the value of ?s.&F crores in period 3. hus the total increase in income in
period 3 over the base period is e$ual to ?s.3K.F crores. In the same manner, the changes
in income for the succeeding periods will be determined. - glance at the table will show
that there are great fluctuations in total income. Onder the combined effect of the
multiplier and accelerator, the income increases up to a certain period, but beyond that
period, it begins to decrease. First to fourth is the stage of expansion or upswing. he
fifth one is a turning point and from fifth onward is the phase of contraction or
downswing.
hus, an initial increase in investment through the multiplier and acceleration effects
causes fluctuations in income, employment and output causing upswings and
downswings in economic activity.
he principle of multiplier : acceleration interaction serves as a useful tool not only for
explaining business cycles but also as a guide to stabili#ation policy. -s pointed out by
professor *urihara, !it is in conjunction with the multiplier analysis based on the concept
of the marginal propensity to consume3being less than one4 that the acceleration principle
serves as a useful tool of business cycle analysis and a helpful guide to business cycle
policies". he multiplier and the accelerator combined together produce cyclical
fluctuations. he greater the value of the multiplier, the greater is the chance of a cycle
less path. he greater the value of the accelerator, the greater is the chance of an
explosive cycle. 1e may conclude with professor 2stey, !hus the combination of the
multiplier and the accelerator seems capable of producing cyclical fluctuations. he
multiplier alone produces no cycles from any given impulse but only a gradual increase
to a constant level of income determined by the propensity to consume. %ut if the
principle of acceleration is introduced, the result is a series of oscillation about what
might be called the multiplier level. he accelerator first carries total income above its
level, but as the rate of increase of income diminishes, the accelerator introduces a
downturn which carries total income below the multiplier level, then up again, and so
on."
.espite its usefulness, it suffers from a few limitations. (amuelson does not say anything
about the length of the period in the different cycles. 6e assumes the marginal propensity
to consume and the accelerator to remain constantI he also has ignored the growth aspect.
his has led 6icks to formulate his theory of the trade cycles in a growing economy.
6icks classified investment into autonomous and induced. -utonomous investment an
exogenous factor, through the multiplier and Induced investment an endogenous factor
through the accelerator cause cyclical fluctuations in business activity. -n autonomous
investment of some amount will expand output and income to the degree indicated by the
multiplier. his expansion of income and output will result in induced investment via
accelerator which gives rise to further expansion of income and further induced
investment and so on. In this process output raises faster than the e$uilibrium rate,
investment also increases beyond its normal rate. he expansion of income and output
will continue till it reaches the upper limit or the ceiling determined by full employment.
-n expanding income and output hit the ceiling and as such the expansionist force is
bound to be checked. he rate of expansion is slowed down to the natural rate which it
had been exceeding till now. he rate of induced investment is also reduced because the
spurt of autonomous investment was short lived. %ut now the multiplier accelerator
mechanism sets in the reverse order, causing a fall in income and investment. he output
may plunge downward below the e$uilibrium level and touch the floor level.
5rofessor 6icks has, built a model of the trade cycle assuming values that would make
for Cexplosive cyclesD kept in check by CceilingsD and CfloorsD. 6e assumes full
employment as the ceiling which grows at the same rate as autonomous investment and
checks expansion of income further. 1hen the economy reaches this point national
income ceases to increase at a rapid rate, the induced investment via accelerator falls off
to the level consistent with the modest rate of growth. %ut the economy cannot crawl
along its full employment ceiling for a long time. he sharp decline in induced
investment, when national income and hence consumption, ceases to increase rapidly,
initiates a contraction in the level of income and business activity. he fall in national
income and output resulting from the sharp fall in induced investment will go on until the
floor has been reached. he economy may crawl along for some time, in doing soI there
is a growth in the level of national income. his rate of growth as before induces
investment and both the multiplier and accelerator come into operation and the economy
will move towards full employment ceiling. -ccording to 6icks, this is how the
interaction between multiplier and accelerator causes economic fluctuations. (uch
fluctuations are caused mainly by the operation of the monetary factors like expansion
and contraction of credit by the banking system.
6icks explanation of the ceiling or the upper limit of the cycle fails to explain ade$uately
the onset of depression. he floor and the lower turning point is not convincinghe model
can be used to explain especially in a capitalist economy with a substantial amount of
durable e$uipment, how a period of contraction inevitably follows expansion.
Meas6res 'o Control B6siness C4cles
,ontrol of business cycles has become an important objective of all most all economies at
present. %roadly speaking, the remedial measures can be classified under three heads,
vi#., monetary, fiscal and miscellaneous measures.
1% Monetar4 meas6res=
-ccording to 6awtrey, 6icks and many others expansion and contraction of supply of
money is the major cause for the operation of business cycles.
Monetar4 polic4 and t5e e<pansionar4 p5ase= when the economy is moving fast in the
upward direction, the monetary measures should aim at 3i4 restricting the issue of legal
tender money 3ii4 putting restrictions to the expansion of bank credit by adopting both
$uantitative and $ualitative techni$ues of credit control. -s expansionary phase is mainly
supported by bank credit, adoption of a dear money policy can put an effective check on
further expansion. - rise in the %ank ?ate, by raising the lending rates of the commercial
banks, making credit costly will have a discouraging effect on more borrowings. - check
can be imposed on the li$uidity position of the commercial banks by raising the ,ash
?eserve ?atio and (tatutory Mi$uidity ?atio. 7pen market sale of securities can also be
conducted to make bank rate more effective. (elective techni$ues, like raising of margin
re$uirements, rationing of credit, moral suasion, direct action, publicity etc., can also be
used efficiently to tighten the credit situation in the economy.
-part from these direct measures indirect measures like wage control, price control etc.,
can also be adopted to put a check on the inflationary trend in the economy. (uch
monetary measures are found fairly successful in controlling unwieldy expansion of the
economy. 'any countries like O.*., O.(.-., France, Germany and India have used
monetary measures to control inflation.
Monetar4 Polic4 and t5e P5ase of )epression=
.uring the period of depression, to enlarge employment opportunities and raise the level
of income all out measures are to be adopted to increase the level of investment. o
encourage investment activity the central bank has to follow a cheap money policy. he
bank rate and the lending rates of the commercial banks should be reducedI money
should be made available freely by reducing the ,?? and (M?. hrough open market
sale of securities, ,ash reserves with the banks should be increased to enable them to
lend money easily for various investment activities. Harious $ualitative techni$ues of
credit control like reducing the margin re$uirements, moral suasion etc., may be adopted
to encourage businessmen to borrow and invest.
,heap money policy, to induce businessmen to borrow and invest is not very effective as
investment is more guided by the marginal efficiency of capital than the rate of interest.
%ecause of low level of income and low prices and the low profit margins entrepreneurs
do not come forward to borrow and invest in spite of the low rates of interest. 7ne can
take a horse to the water but cannot force to have itI a plethora of money cannot induce
the public horse to have it. hus monetary policy as a remedy to solve depression has its
own limitations.
2% iscal polic4=
.uring the period of inflation or uptrend in the economy, when the private enterprise is
over enthusiastic and there is over expansion and over production government can use
taxation and licensing policy as very effective instruments to check such unwieldy
growth. 5rice control measures can be adopted. Government should adopt surplus budget,
reduce public expenditure and resort to public borrowing. he cumulative result of these
measures would reduce the supply of money in circulation, purchasing power and
demand.
7n the contrary,
during the period of depression government should adopt deficit budget, Increase the
volume of public expenditure, redeem public debt and resort to external borrowings,
indulge in a moderate dose of deficit financing, reduce tax rates, grant subsidies,
development rebates, tax-concessions, tax-reliefDs and freight concessions etc. -s a result
of these measures, supply of money in circulation will increase. his in its turn would
raise the purchasing power, demand for goods and services, production and employment
etc. Q.'. *eynes recommended a number of public works programmes to be launched by
the government to cure depression. he +ew .eal policy of 5resident ?oosevelt in the
O.(.-. and %lum experiment in France were based on this very belief.
+% P54sical controls=
.uring the period of inflation, a price control policy has to be adopted where as during
depression a price-support policy has to be followed. .uring the period of contraction
unemployment insurance schemes, 5roper management of savings, investments,
production, distribution, expansion of income and employment etc., are needed
depending upon the nature of economic fluctuations.
,% Miscellaneo6s Meas6res=
3i4 Introduction of automatic stabili#ersE
-n automatic stabili#er 3or built in stabili#er4 is an economic shock absorber that helps to
smoothen the cyclical business fluctuations of its own accord, without re$uiring
deliberate action on the part of the government e.g., progressive taxation policy,
unemployment Insurance scheme adopted in he O.(.-.
3ii4 5rice support policy followed in the O.(.-. during the post war period to fight the
prospects of depression.
3iii4 he policy of stabili#ation of the prices of agricultural products in India through
procurement and building up of buffer stocks aim at economic stability.
3iv4 Foreign aid is also used for influencing the aggregate demand and supply of goods in
a country.
3v4 Granting of aid might help in recovering from slump.

In addition to these, some of the measures can be adopted at international level to
mitigate the adverse effects of business cycles and promote stability in the world
economic growth like control of private investment, control and distribution of essential
goods, regulation of international investments in developing nations, creation of
international buffer stocks etc.
hus, several measures are to be taken to smoothen the cyclical movements and to ensure
economic stability in an economy.

$earning O9Eecti7e +
2no; a9o6t t5e B6siness decisions to 9e ta:en d6ring different p5ases of 96siness
c4cles
B6siness C4cles And B6siness )ecisions
%usiness cycles affect the smooth growth of an economy. 2xpansionary phase has,
however, a favorable impact on income, output and employment. %ut recession and
depression imply slackness in growth, contraction of economic activity, increasing
unemployment, falling incomes and so on.
%usiness cycles have their effects on individual business firms, as well. .uring
expansionary phase, there is a business boom. he firm gains due to rising demand, rising
prices and increasing profits. 5rosperity makes the business firms prosperous. %ut in a
capitalist economy prosperity digs its own grave.
.uring this period, a firm may have to face some adverse effects. ?ising prices and
optimism in the market may encourage many new firms to enter the market and the
existing firms to expand their output. ,ompetition becomes intense. Increased demand
for factors may cause a rise in their prices. 'arketing and distribution costs may go up.
.emand for investment funds increase. -ll these may result in raising the cost of
production causing a rise in the product price.
.uring this period a business unit should be extraordinarily cautious. %usiness decisions
are to be made carefully after estimating the market situation properly. 2xpansion in
production and sale of goods should be so organi#ed that they take full advantage of the
situation without involving themselves into any kind of risk. - prudent businessman
should adopt all possible precautionary measures to avoid and minimi#e business
problems as much as possible. 6e should have knowledge of the economic characteristics
of the trade cycles and usual se$uence of events during such periods, the phase of the
trade cycle through which business is then passing, relation between cyclical changes and
general business and cyclical changes and the business of the given enterprise, in
particular, cyclical movements in production and sales and in the prices of commodities
purchased and sold. - business firm should have a comprehensive view of the entire
market : internal and external factors affecting business in order to adopt an efficient
business programme and prevent the adverse effects of cyclical changes on business. 6e
should mainly see that the costs are kept under control, avoid over investment,
overproduction and over expansion, excessive inventories of raw materials and finished
goods. 2mploy a flexible credit standard, avoid excessive borrowing. ,heck temporary
diversification programme, avoid purchase commitments, maintain satisfactory labour
conditions and create si#able reserve fund. Harious such measures may help a firm in
avoiding the harmful effects of business expansion.
.uring the phase of contraction, recession and depression the basic objective is to fight
against pessimism and to give a big boost to all kinds of business activities. here must
be a strong psychological shift during this period. - few measures are to be adopted to
mitigate the harmful effects of contraction. 3&4>uick li$uidation of inventories.3)4
?eduction of cost of production. 334 Improvement in $uality 3;4 adoption of new selling
methods.3F4 .evelopment of new methods of organi#ation etc.394'anagement of the
labour force carefully.
-part from these measures a businessman may also take up a few important steps in the
best interest of the firm. %y adopting a very cautious policy of planning during the period
of contraction when all costs are low a firm can take up the expansion and extension
programmes. he firm will have to restructure its advertising policy to suit the
circumstances. ,yclical price adjustment poses the most challenging job for the firm. It
will have to choose a right pricing policy keeping in view various factors like changing
costs, prices of substitutes, market share, changes in general price level etc.
hus during different phases of trade cycles a firm has to make careful decisions with
regard to finance,
,apital budgeting, investment, production, distribution, marketing, purchasing, pricing
etc. - firm should gear up itself to face the challenges of cyclical changes in a most
befitting manner.
.
MB0026- Unit 1,-Inflation And )eflation
Unit 1, Inflation And )eflation

Introd6ction
Inflation refers to a period of steady rise in price level. It is generally considered as a
monetary phenomenon caused by excess supply of money. here are different kinds of
inflation : Cdemand pull inflation and cost push inflation, etc..
.eflation is just the opposite of inflation. It is essentially a period of falling prices and
rise in the value of money. .eflation is more dangerous than inflation.
Meaning and 2inds of Inflation
Inflation has become a global phenomenon in recent years. !Inflation is a sinI every
government denounces it and every government practices it". 5rof. 'M.(tigum.
.evelopment economics is very much associated with inflation. -n in-depth study of
inflation is of paramount importance to a student of managerial economics.

Inflation is commonl4 6nderstood as a sit6ation of s69stantial and rapid general
increase in t5e le7el of prices and conse86ent deterioration in t5e 7al6e of mone4
o7er a period of time% It refers to t5e a7erage rise in t5e general le7el of prices and
fall in t5e 7al6e of mone4. 5rof.,rowther defines inflation as !a state in which the value
of money is falling i.e. 5rices are rising". 5rof. (amuelson puts it thus, !inflation occurs
when the general level of prices and the cost is rising". -ccording to 5rof. 5arkin and
%ade, !Inflation is an upward movement in the average level of prices. Its opposite is
deflation, a downward movement in the average level of prices". hus, the common
feature of inflation is rise in prices and the degree of inflation may be measured by price
indices.
Inflation is statisticall4 meas6red in terms of percentage increase in t5e price inde<-
as a rate percent per 6nit of time- 6s6all4 a 4ear or a mont5% he trend of price
indices reveals the course of inflation in the economy. Osually, the B5olesale price
Inde< R15IS numbers are used to measure inflation. -lternatively, the Cons6mer price
Inde< LCPIM or t5e cost of li7ing Inde< can be adopted in measuring the rate of
inflation. In order to measure the percentage rate of inflation, 5rof, ?owan suggests the
following formula
,hange in price RtS / 5 RtS : 5 Rt-&S. 6ere, 5 / price level and RtS, Rt-&S are the periods of
calendar time to which the observations are made.
'*PES O I!$A'IO!
.epending upon the rate of rise in prices and the prevailing situation inflation has been
classified under different headsE
1% Creeping inflation= 1hen the rise in prices is very slow like that of a snail or creeper,
3less than 3 @4 it is called creeping inflation.
2% Bal:ing inflation= 1hen the price rise is moderate 3is in the range of 3 to K @4 and
the annual inflation rate is of a single digit, it is called walking inflation. It is a warning
signal for the government to control it before it turns into running inflation.
+% #6nning inflation= 1hen the prices rise rapidly, at a rate of speed of &8 to )8 percent
per annum, it is called running inflation. (uch inflation affects the poor and middle
classes adversely. Its control re$uires strong monetary and fiscal measuresI otherwise it
leads to hyper inflation.
,% 04per Inflation= 6yper inflation is also called by various names like jumping,
runaway, or galloping inflation. .uring this period prices rise very fast, at double or triple
digit rates from more than )8 to &88 percent per annum or more and becomes absolutely
uncontrollable. (uch a situation brings a total collapse of the monetary system because of
the continuous fall in the purchasing power of money.
.% )emand p6ll Inflation
It may be defned as a situation where the total monetary demand
persistently e/ceeds total supply of goods and services at current
prices, so that prices are pulled upwards by the continuous upward
shift of the aggregate demand function.
&. .emand for higher wages by the labour class.
). Fixing up of higher profit margins by the manufacturers.
3. Introduction of new taxes and raising the level of old taxes.
;. Increase in the prices of different inputs in the market.
F. ?ise in administrative prices by the government etc.,
Ca6ses of Inflation
)emand side
Increase in aggregative effective demand is responsible for inflation. In this case,
aggregate demand exceeds aggregate supply of goods and services. .emand rises
much faster than the supply. 1e can enumerate the following reasons for increase
in effective demand.
1% Increase in mone4 s6ppl4
(upply of money in circulation increases on account of the following reasons :
deficit financing by the government, expansion in public expenditure, expansion
in bank credit and repayment of past debt by the government to the people,
increase in legal tender money and public borrowing.
2% Increase in disposa9le income
-ggregate effective demand rises when disposable income of the people
increases. .isposable income rises on account of the following reasons :
reduction in the rates of taxes, increase in national income while tax level remains
constant and decline in the level of savings.
+% Increase in pri7ate cons6mption e<pendit6re and in7estment e<pendit6re
-n increase in private expenditure both on consumption and on investment leads
to emergence of excess demand in an economy. 1hen business is prosperous,
business expectations are optimistic and prices are rising, more investment is
made by private entrepreneurs causing an increase in factor prices. 1hen the
incomes of the factors rise, there is more expenditure on consumer goods.
,% Increase in E<ports
-n increase in the foreign demand for a countryDs exports reduces the stock of
goods available for home consumption. his creates shortages in the country
leading to rise in price level.
.% E<istence of Blac: Mone4
he existence of black money in a country due to corruption, tax evasion, black-
marketing etc, increases the aggregate demand. 5eople spend such unaccounted
money extravagantly thereby creating un-necessary demand for goods and
services causing inflation.
9. Increase in oreign !/change BeservesA (t may increase on
account of the inCow of foreign money in to the country. 8oreign Birect
(n*estment may increase and non,resident deposits may also increase
due to the policy of the go*ernment.
/% Increase in pop6lation gro;t5 creates increase in demand for every thing in a
country.
1% 0ig5 rates of indirect taxes would lead to rise in prices.
3% #ed6ction in t5e rates of direct ta<es would leave more cash in the hands of
people inducing them to buy more goods and services leading to an increase in
prices.
10% #ed6ction in t5e le7el of sa7ings creates more demand for goods and
services.

II% S6ppl4 side
Generally, the supply of goods and services do not keep pace with the ever-
increasing demand for goods and services. hus, supply does not match with the
demand. (upply falls short of demand. Increase in supply of goods and services
may be limited because of the following reasons.
1% S5ortage in t5e s6ppl4 of factors of prod6ction
1hen there is shortage in the supply of factors of production like raw materials,
labor, capital e$uipments etc. there will be a rise in their prices. hus, when
supply falls short of demand, a situation of excess demand emerges creating
inflationary pressures in an economy.
2% Operation of la; of diminis5ing ret6rns
1hen the law of diminishing returns operate, increase in production is possible
only at a higher cost which de motivates the producers to invest in large amounts.
hus production will not increase proportionately to meet the increase in demand.
6ence, supply falls short of demand.
+% 0oardings 94 'raders and spec6lators
.uring the period of shortage and rise in prices, hoarding of essential
commodities by traders and speculators with the object of earning extra profits in
future creates artificial scarcity of commodities. his creates a situation of excess
demand paving the way for further inflation.
,% 0oarding 94 Cons6mers
,onsumers may also hoard essential goods to avoid payment of higher prices in
future. his leads to increase in current demand, which in turn stimulate prices.
.% #ole of 'rade 6nions
rade union activities leading to industrial unrest in the form of strikes and
lockouts also reduce production. his will lead to creation of excess demand that
eventually brings a rise in the price level.
6% #ole of nat6ral Calamities
+atural calamities such as earth$uake, floods and drought conditions also affect
adversely the supplies of agricultural products and create shortage of food grains
and raw materials, which in turn creates inflationary conditions.
/% Bar% .uring the period of war, shortage of essential goods create rise in prices.
1% International factors also would cause either shortage of goods and services
or rise in the prices of factor inputs leading to inflation. 2.g., 6igh prices of
imports.
3% Increase in prices of inp6ts ;it5 in t5e co6ntr4%

III% #ole of E<pectations
2xpectations also play a significant role in accentuating inflation. he following
points are worth mentioningE
&. If people expect further rise in price, the current aggregate demand increases
which in its turn causes a raise in the prices.
). 2xpectations about higher wages and salaries affect very much the prices of
related goods.
3. 2xpectations of wage increase often induce some business houses to increase
prices even before upward wage revisions are actually made.
hus, many factors are responsible for escalation of prices.

Positi7e side of effects of inflation=
9. $eads to rise in in7estment= ?ise in prices leads to a rise in profits, incomes,
savings, and finally the volume of investment by the businessmen.
K. Creates 9etter opport6nities= ?ise in prices, which is much higher than the
production costs, creates better and more opportunities in new fields of business
activities.
B. Enco6rage entreprene6rs5ip= -s profits rise, it encourages entrepreneurs to
enter in to business field in an increasing manner
A. Inflation ta<= Government in order to cover the deficit in the budget may resort
to inflation- tax.
&8. 6ll 6tiliCation of reso6rces= It helps in fuller utili#ation of all kinds of economic
resources in an economy as the efforts of entrepreneurs are suitably rewarded in
the form of higher profits.
&&. $eads to increase in t5e demand for mone4= -s price rises, people re$uire more
money to buy the same $uantity of goods and services. 6ence, it leads to
expansion in money supply in the country, which leads to higher growth rate in
the economy.
&). It is a necessar4 cost of de7elopment= It becomes inevitable during the process
of economic development. In fact, inflation promotes economic development and
economic development results in inflation. hus, both of them go together.
Effects on prod6ction=
1% A lo; inflation rate stim6lates economic gro;t5= - small amount of inflation
is often viewed as having a positive effect on the economy. For example, a mild
inflation has a stimulating or tonic effect on the economy. ?ise in price leads to
increase in profit ratio H investment : output : employment and incomes in an
economy.
2%
)ist6r9s t5e ;or:ing of price- mec5anism= he most harmful effect of inflation
is that it disrupts the smooth working of the price mechanism and economic
system and as a conse$uence, economic adjustments become very difficult.
+% Ad7erse effects on in7estment and prod6ction= ?ise in price leads to fall in
the value of money : reduction in purchasing power : reduction in savings :
reduction in investment and production.
,% Ad7erse effects on sa7ings and capital formation= ,apital formation suffers
as a conse$uence of depreciation in the value of money and it may be driven out
of the country. (imilarly, it discourages the inflow of foreign capital into the
country.
.% Creates 96siness 6ncertaint4= 5roduction will be adversely affected on
account of business uncertainty. - sort of tension prevails during the period of
inflation, which discourages the entrepreneurs from taking risks involved in
production.
6% #ed6ces prod6ction= 7n account of fall in the rate of capital formation and
uncertainty in business, total volume of production declines.
/% $eads to c5ange in t5e pattern of prod6ction= It affects the pattern of
production. ?esources will be diverted from the production of essential goods to
luxury goods to reap higher profit margins.
B. $eads to 5oardings and 9lac: mar:eting= .uring inflation, the traders hoard
essential goods with a view to get higher profits. he buyers also hoard essential
goods for the fear of paying higher prices in future. hus it also leads to the
growth of black marketing.
3% )e7elops a sellers mar:et= .uring inflation the sellers market develop. -s
prices are rising people want to sell away their goods rather than buy them.
>uality of goods and services also will be affected by inflation.
10% Enco6rages spec6lati7e acti7ities= (peculative activities gain momentum
during inflation.
11% )istortion in reso6rce allocation= It leads to diversion of resources from
productive uses to unproductive uses with the sole objective of earning more
profits by the entrepreneurs. 1ith rise in prices, the costs of development projects
also will go up leading to more diversion of resources to complete the same
project by the government.
B? Effects on distri96tion
1% $eads to 6ne86al distri96tion of income and ;ealt5= 5rolonged and
persistent inflation leads to ine$uitable distribution of wealth and income in the
society. Inflation robs the poor to enrich the rich. ?ich entrepreneurs earn more
profits at the cost of customers. his leads to une$ual distribution of income and
wealth as rich becomes richer and poor becomes much poorer.
2% Inflation creates 5ards5ips for fi<ed income earners= ?entiers, bond holders
with fixed rates of interest, holders of government securities, persons who live on
past savings, pensioners etc, are adversely affected as their monetary income
remains the same while the value of money falls.
+% )e9tors gain and creditors lose= .uring inflation generally debtors gain as
they return the borrowed money when its face value is less and creditors lose
because they get back their money with depreciation in its value.
,% Ad7erse effects on ;age-earners and salaried class= he wage earners,
salaried class and middle class people are worst affected as their living standards
deteriorate due to escalation of prices while their money incomes remain the
same.
8. !ntrepreneurs and business community gainA Cusinessmen
welcome inCation as they stand to gain by rising prices. Their in*entory
*alue rises. $rice of %nished products rise much faster than the
production costs. =ence their pro%t margins also would go up
substantially.
6% Effects on in7estors= If investors invest their capital on e$uity shares and
debentures, they stand to gain because their prices are rising. 7n the other hand, if
they invest on bonds and securities, they lose because their incomes from them
remain the same.
/% Effects on farmers= Hirtually farmers are the gainers because prices of
agricultural goods rise on the one hand P cost of cultivation lags behind prices
received.
Inflation favors one group at the expense of other groups. It is generally
regressive in nature, as many people cannot protect their own self-interest.
C? Social and political effects of inflation
#. )ocial e2ectsA (nCation is a powerful engine of wealth distributor in
fa*or of the rich. (t widens the gap between the rich and the poor and
thus hampers social +ustice. (t creates a sense of heart burning in
poorer sections of the society. (t leads to social conCicts between the
rich and poor.
2%Moral and et5ical effects= In order to earn higher profits, business people
resort to black marketing, adulteration, smuggling, hoarding, $uality deterioration
and other such anti-social tactics. 6ence, inflation gives a serious blow to
business morality and ethics. he general morality declines, corruption increases.
his leads to over all discontentments among people.
+% Political effects= .eterioration in social and ethical standards and
discontentment among the people reflects in political uncertainty. 5eople loose
faith in the administrative ability of the Govt., which gives place for an explosive
political situation in the country. 6yper inflation in Germany during &A)8Ds is a
glaring example for the rise of 6itler as a director. It has been rightly said that,
!6itler is the foster-child of inflation".
,% Impact of demonstration effect= It encourages consumerism and a country
may have to suffer on account of demonstration effects.
)? E<ternal effects of Inflation
#. Beduces the volume of e/portsA (t reduces the *olume of exports
of a nation! as domestic prices are much higher than international
prices.
2% Create e<c5ange rate diffic6lties= Fall in the value of home currency may
reduce external value of a currency and thus create problems in the determination
of rate exchange between the currencies of different countries.
+% )isco6rage t5e inflo; of foreign capital= It discourages the inflow of foreign
capital into a country. hus inflation has far-reaching conse$uences on an
economy.
,% )ecline in international competiti7eness= If a country experiences a high rate
of inflation compared to other nations, in that case, the international
competitiveness of the given country will decline.
hus, inflation has far-reaching conse$uences on an economy.

$earning O9Eecti7e ,
2no; a9o6t t5e Meas6res t5at can 9e adopted to control inflation%
Anti-Inflationar4 Meas6res Or Meas6res 'o Control Inflation
he anti-inflationary measures are broadly classified into 3 categories.
I% MO!E'A#* MEASU#ES
Inflation is basically a monetary phenomenon. 2xcess money supply over the
$uantity of goods and services is mainly responsible for rise in prices.
6ence, monetary authorities
aim at reducing and absorbing excess supply of money in an economy. he
following are some of the anti-inflationary monetary measuresE -
&. he volume of legal tender money may be reduced either by withdrawing a part
of the notes already issued or by avoiding large-scale issue of notes.
). ?estrictions on bank credits.
3. Free#ing and blocking particular type of assets.
;. Increasing bank rate and other interest rates.
F. (ale of Govt., securities in the open market by central bank.
9. ?aising the legal reserve re$uirements like ,?? and (M?
K. 5rescribing a higher margin that bank and other lenders must maintain for the
loans granted by them against stocks and shares.
B. ?egulation of consumerDs credit.
A. ?ationing of credit etc.
hus, the government to control inflation may exercise various $uantitative and
$ualitative techni$ues of credit controls.
II% ISCA$ MEASU#ES
he following are some of the important anti-inflationary fiscal measuresE -
&. ?eduction in the volume of public expenditure.
). ?ise in the levels of taxes, introduction of new taxes and bringing more people
under the coverage of taxes.
3. 'ore internal borrowings by public authorities.
;. 5ostponing the repayment of debt to people.
F. ,ontrol on the volume of deficit financing.
9. 5reparation of a surplus budget.
K. Introduction of compulsory deposit schemes.
B. Incentive to savings.
A. .iverting the public expenditure towards the projects where the time gap
between investment and production is least, 3small gestation period4.
&8. ariffs should be reduced to increase imports and thus allow a part of the
increased domestic money income to Cleak-outD.
&&. Inducing wage earners to buy voluntarily Govt., bonds and securities etc.
hus, Fiscal measures succeed to a greater extent to contain inflation in its own
way.
III% O'0E# MEASU#ES- direct or administrati7e meas6res
.irect controls refer to the regulatory or administrative measures taken by the
government directly with an objective of controlling rise in prices. 'odern
governments directly intervene in the working of the economy in several ways.
6ence, the governments take several concrete measures to check the rise in prices.
he following are some of these direct measures taken by modern governments.
'. Expansion in the *olume of domestic output so as to meet the e*er,
increasing rise in the demand for them.
). .irect control of prices and introduction of rationing.
3. ,ontrol of speculative and gambling activities.
;. 1age : profit free#e by adopting appropriate wage- profit policy.
F. -dopting an appropriate income policy.
9. 7vervaluation of currency. 7ver valuation of domestic currency in terms of
foreign currencies in order to increase imports to add to the stocks with in the
country and decrease in exports so that more goods will become available for
domestic consumption.
K. IndexingE It refers to monetary corrections by periodic adjustments in money
incomes of the people and in the value of financial assets, saving deposits, etc
held by the public in accordance with the changes in price level. For if price rises
by &F@, the money incomes and the value of the financial assets should be
increased by &F@ under the system of indexing.
B. ,ontrol of population. It is considered as one of the most important methods
because if population is controlled, it is possible to keep a check on demand for
goods and services.
A. 2xhortations : it implies authoritative persuasions, publicity campaigns etc.,
+ational saving campaign, re$uests to trade union for voluntary resistance to
demand for rise in wagescompanies to restrict dividend distributions to workers
and management to increase productivity and output etc.
he above said measures are to be employed in a judicious manner in order to
combat the demon of inflation in a country.
.
MB0026- Unit-1.-!at6ral En7ironment
And B6siness
Unit 1. !at6ral En7ironment And B6siness
E<ternalities
2xternalities are an effect of one economic agentDs action on another in such a way that
one agentDs decisions make another better or worse-off by changing their utility or cost.
In short, externalities occur when business firms or people impose costs or benefits
outside the market place. '5e term e<ternalities refer to a 9enefit or cost associated
;it5 an economic transaction- ;5ic5 is not ta:en into acco6nt 94 t5ose directl4
in7ol7ed in ma:ing it% E<ternal costs and 9enefits toget5er are called e<ternalities%
2xternalities are of two types. hey may be either positive or beneficial and negative or
harmful. 5ositive externalities confer external benefits while negative externalities
involve external costs. hese externalities arise in case of both consumption and
production. Met us take some simple illustration to explain both of them.
1% Positi7e e<ternalit4 in cons6mption
1hen the government makes arrangement for various kinds of vaccinations, in that case
they not only help the person vaccinated but also the entire neighborhood where the
person lives in by preventing the spread of different kinds of contagious diseases.

2% !egati7e e<ternalit4 in cons6mption
1hen a young man rides a noisy motor cycle, he will get greater amount of enjoyment if
he create more noise. %ut this will disturb the peace and tran$uility in the near by areas
and create displeasure among the people
+% Positi7e e<ternalit4 in prod6ction
%eekeepers try to put their beehives on farms because the nectar from the plants increases
the production of honey. he farmers also receive advantages from the beehives because
the bees aid pollination of the plants.
,% !egati7e e<ternalit4 in prod6ction
1hen an industrial unit dumps its industrial wastages in to the near by river, in that case
people cannot use the water for drinking purposes.
+ow let us discuss these two kinds of externalities in some detail.
1% Positi7e or 9eneficial e<ternalities
A positi7e e<ternalit4 arises ;5en d6e to t5e action of one person or firm ot5ers get
t5e 9enefits%
2% !egati7e or 5armf6l e<ternalities
A negati7e e<ternalit4 arises ;5en one personFs or firmFs actions 5arm ot5ers in t5e
societ4%
Marginal social 9enefits are t5ose additional 9enefits ;5ic5 are enEo4ed 94 t5e
entire societ4 on acco6nt of an additional economic acti7it4 and marginal social cost
refers to t5e cost inc6rred 94 t5e people or t5e go7ernment d6e to an additional
economic acti7it4%
'arginal (ocial %enefit R'(%S / 'arginal 5rivate %enefit 0 'arginal 2xternal %enefit.
6ence, '(% / '5% 0 '2%.
'arginal (ocial ,ost R'(,S / 'arginal 5rivate ,ost 0 'arginal 2xternal ,ost.
6ence, '(, / '5, 0 '2,.
S6staina9le economic de7elopment see:s to meet t5e needs and aspirations of t5e
present ;it5o6t compromising t5e a9ilit4 of f6t6re generations to meet t5eir o;n
needs%
2nvironmental damages may be in the following categories. hey are as follows.
1% Bater poll6tion
2% Air poll6tion
+% Soil poll6tion
,% )eforestation
.% $oss of 9iodi7ersit4
6% Solid and 5aCardo6s ;astes
B6siness And !at6ral En7ironment
!at6ral en7ironment incl6des land form- location aspects- topograp5ical conditions-
mo6ntains- ri7ers- oceans- coast lines- forests- soil- ;eat5er and climatic conditions-
nat6ral endo;ments- flora and fa6na etc%
E<ternalities- En7ironmental )egradation And Mar:et ail6re
Hilifredo 5areto, an Italian economist has laid down an objective test of social welfare on
the basis of best allocation of resources in a free and perfectly competitive economy.
-ccording to him, maximum social welfare is possible only when the resources are
allocated in the most ideal manner. (ocial welfare is said to be optimum when nobody
can be made better off without making somebody worse-off. In short, it is impossible to
make any one better off without making some one worse off because already there is
optimum allocation of resources. hus, there is no scope for any sort of reallocation or
reorgani#ation of resources in the system. %ut it is to be remembered that in many cases,
the market mechanism fails to achieve an efficient allocation of resources on account of
several constraints. his is often called as market failure in economics.
Mar:et fail6res
'arket failures arise on account of the following reasons.
1% '5e ass6mption of perfect competition in t5e mar:et is ;rong%
2% '5e ass6mption t5at t5ere is no difference 9et;een pri7ate and social 7al6ations
is ;rong
+% ail6re to s6ppl4 p69lic goods
,% ail6re to s6ppl4 merit goods
.% ail6re to s6ppl4 a fe; ot5er goods
1% !E"A'I(E ED'E#!A$I'* I! CO!SUMP'IO!
,onsumers create negative externalities by purchasing and consuming certain
commodities and services. - few examples are given below for our understanding.
,reating noise pollution by using the car stereos, peculiar horns, smoking in public places
and drinking alcohol, indulging in various types of crimes, ill-treating animals, litter on
public places and on streets, pollution from cars and bikes, use of narcotic drugs etc.
). POSI'I(E ED'E#!A$I'* I! CO!SUMP'IO!%
(ome times in order to encourage consumption, the government may have to grant
subsidy to consumers. 7therwise, the total consumption in the society will be relatively
lower.
3. !E"A'I(E ED'E#!A$I'* I! P#O)UC'IO!
5roducers while producing certain types of goods like chemicals, fertili#ers,
pharmaceuticals etc create negative externalities. hese externalities are responsible for
environmental degradation. Onless the government takes certain concrete measures, the
negative effects are minimi#ed or controlled. 6ence, there is great need for state
intervention in these cases. ts for the units which are eliminated by the tax.

,% POSI'I(E ED'E#!A$I'* I! P#O)UC'IO!%
-ll externalities are not negative. (ome economic activities benefit the others and as such
these activities are to be encouraged by the government by giving various kinds of
monetary and fiscal incentives like subsidies or tax-concessions.

Internalising E<ternalities
Internali#ing externality occurs when an individual business unit takes external cost or
benefits in to account. 1% "o7ernment ta<es and s69sidies
a. If '(, J '5, of an activity, the government has to tax on producers.
b. If '(, L '5, of an activity, the government has to subsidi#e producers.
c. If '(% L '5% of an activity, the government has to tax on consumers.
d. If '(% J '5% of an activity, the government has to subsidi#e consumers.
2% )irect go7ernment reg6lations
In case of all kinds of pollution and other health and security externalities, the
government may introduce direct regulatory controls Rsocial regulationsS over the
externality by setting certain rules and regulations regarding pollution, which every
industry should follow.
+% Introd6ction of emission standards
-n emission standard is a legal limit on how much pollution a firm can emit. If the firm
exceeds the limit, it can face monetary and even criminal penalties. he standard
prescribed by the government ensures that the firm produces efficiently. he firm meets
the standard by installing pollution abatement or reducing e$uipment. he cost incurred
by the firm to install the new e$uipment is included in its final market price and thus it
internali#es the externalities.
,% Prescri9ing emission fees
-n emission fee is a charge levied on each unit of a firmDs emissions. (uch emission fees
would re$uire that firms pay a tax on their pollution e$ual to the amount of external
damage it causes. If a firm is imposing external marginal costs of ?s. )88-88 per ton on
the surroundings, in that case, the appropriate emissions charge would be ?s. )88-88 per
ton. his is another way of internali#ing the externality by making the firm to include the
social costs of its activities in total cost of production.
.% Introd6ction of transfera9le emissions permits
Onder this system, each firm must have a permit to generate emissions. 2ach permit
specifies exactly how much the firm is allowed to emit. -ny firm that generates
emissions that are not allowed by permit is subject to substantial monetary sanctions.
5ermits are allocated among firms, with the number of permits chosen to achieve the
desired maximum level of emissions. he permits are marketable-they can be bought and
sold.
6% Introd6ction of $ia9ilit4 r6les
Instead of direct government regulations, a government may come out with the
introduction of liability rules or laws. Onder this approach, the legal system makes the
generators of externalities legally liable for any damages caused to other persons. In
effect, by imposing an appropriate liability system, the externality is internali#ed.
/% )efining propert4 rig5ts
.efining individual property rights to some extent solve the problem of externalities.
5roperty rights are the legal rules that describe what people or firms may do with their
property. 1hen people have property rights to land for example, they may build on it or
sell it or protect it from interference by others. - factory constructed near a lake starts
throwing wastes and toxic chemicals in the river. his leads to water pollution as people
have an attitude that lake is nobodyDs property and convenient to dump the wastes and
garbage. ,leaning of such a polluted lake either by a private institution or the government
involves a free-rider problem if no one owns the lake. he benefits of a clean lake are
enjoyed by many people and no one can be charged for these benefits. 6owever, if the
same lake is owned by a person or institution, they can charge higher prices to fishermen,
boaters, recreation users and others who benefit from the lake
1% !egotiation and t5e Coase t5eorem
5rof. ?onald 6. ,oase has suggested an alternative approach to tackle the problem of
externalities. 2conomic efficiency can be achieved without government intervention
when the externality affects relatively few parties and when property rights are clearly
specified. he ,oase theorem states that when the parties affected by externalities can
negotiate costlessly with one another, an efficient outcome results no matter how the law
assigns responsibility for damages. In other words, when parties bargain without cost and
to their mutual advantage the resulting outcome will be efficient, regardless of how the
property rights are specified. For example, if a steel factoryDs effluent reduces the
fishermanDs profit. +ow they have two alternatives to solve the problem. he factory can
install a filter system to reduce its effluent or the fisherman can pay for the installation of
a water treatment plant. he efficient solution should maximi#e the joint profit of the
factory and the fishermen also. his can happen when the factory installs a filter and the
fishermen do not build a treatment plant. he optimum solution can be found out by
mutual negotiations and bargaining between the two parties in an amicable manner so as
to benefit both the parties.
hus, there are several techni$ues to internali#e the externalities.
$earning o9Eecti7e H .
Understand glo9al en7ironmental t5reats
'5e "lo9al En7ironmental '5reats.
?apid industriali#ation, urbani#ation and economic growth have created innumerable
global environmental problems in recent years. hey have posed severe threats to the
very survival of the mankind. (ome of the important threats are as follows- change in
climate, global warming, acid rain, o#one layer depletion, nuclear accidents and
holocaust etc. Met us study them in some detail.
1% Climate c5ange
2% "lo9al ;arming or green 5o6se effect%

Ad7erse effects of glo9al ;arming
&. It causes climatic changes. 2xtreme weather conditions like floods and droughts
are likely to occur more fre$uently.
). It results in melting of ice and glaciers leading to rise in sea levels and flooding of
coastal areas.
3. (mall islands may even disappear due to submergence.
;. It leads to a change in crop pattern.
F. It creates adverse effects on eco systems biodiversity.
9. It results in changes in hydrological cycle and storms will be more fre$uent and
intense.
K. 1eather pattern becomes more unpredictable and crops are affected by different
varieties of insects and plant diseases.
B. -nimals find it difficult to adjust to the changed environment leading to
migration.
A. 'ore people become sick due to global warming
&8. ropical diseases such as malaria, dengue fever, yellow fever etc will spread to
other parts of the world etc.
+% Acid rain
Ad7erse effects of acid rain
&. 6ave ill-effects on vegetation.
). 6ave ill-effects on soils and crop productivity.
3. 6ave effects on monuments statues and buildings.
;. 6ave adverse effects due to acidification of lakes and streams and ac$uatic life
F. 6ave ill-effects on man. 6uman health may be affected by increased respiratory
and skin problems etc.
,% OCone la4er depletion
Ad7erse effects of oCone depletion
&. 'ore ultra violet radiations are harmful to the life system on the earth and natural
vegetation.
). ,reate adverse effects of productivity and crop yield
3. ,reate adverse effects on animal life and cause damage to wild life and marine
life.
;. ,reate adverse effects on human health. It is responsible for sunburn, skin cancer,
blindness etc.
.% !6clear accidents and 5oloca6st.
!6clear accidents refer to accidents res6lting from n6clear de7ices and radio-acti7e
materials% It also incl6des accidents res6lting from t5e release of radio acti7e
contamination% 7ne can recollect a few nuclear accidents in some parts of the world.

!6clear 5oloca6st refers to ;5ole sale destr6ction ca6sed 94 f6ll4 96rnt n6clear
;eapons or 9om9s%