KG COLLEGE OF ARTS & SCIENCE COLLEGE, COIMBATORE

STAFF NAME : J. GAYATHRI

CLASS : I. B.COM
SUBJECT : ECONOMIC ANALYSIS

Syllabus

Economic Analysis
Unit I
Scope of Methodology: Definition of Economics – Nature and Scope of Economics – Utility
Analysis – Law of Diminishing Marginal Utility – Law of Equi-marginal utility – Indifference Curve –
Approaches of Economic Analysis – Methodology of Economics Maximization and other objectives –
Marshall‘s Utility Analysis – Law of Diminishing Marginal Utility – Social Responsibilities.

Unit II
Theory of Consumer Behaviour: Demand Analysis – Demand Schedule – Law of demand – Demand
curves – Elasticity of Demand – Consumer‘s Surplus – Analysis Schedule.

Unit III
Production – Factors of Production – Law of Diminishing Returns – Law of Variable Proportions –
Returns of Scale – Scale of Production – Law of Supply- Cost and Revenue: Concepts and curves – Theory
of Production : Production function – Factors of Production – Enterprise as a factor.

Unit IV
Product Pricing: Market- Definition, Types, Equilibrium under perfect competition of firm and
industry – Pricing – Pricing under perfect competition – Monopoly – Price Discrimination – Pricing under
Monopolistic Competition – Pricing under Oligopoly.

Unit V
Factor Pricing: Marginal Productivity Theory – Theories of wages, rent, interest and profit.

Reference Books:
1. Principles of Economics – Seth M.L.
2. A Text Book of Economic Theory – Stonier and Hague
3. Macro Economics – Jhingan.

UNIT - I
Scope of methodology: Definition of Economics

Introduction to Economics:
Prof. Samuelson called economics as the ‗queen of social sciences‘. Today, economics is called ‗the
superpower of the social sciences‘, possibly because it influences greatly on the lives of people, albeit, an
ordinary public.
The term ‗economics‘ which is very popular today is originally derived from the Greek word ‗oiks‘
which means household and ‗Nemein‘ which means management. Thus, it refers to managing of a
household using the limited funds. The Greek then applied this term to the city-state, which they called
‗Polis‘. Earlier Writers, the classical and the neo classical economists developed it into ‗Political economy‘.
The great philosopher, Aristotle used the term as management of family and the state. Similarly, Indian
Statesman, Kautilya used the term both as economic and political activities.
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 In order to understand the nature and scope of economics, it is necessary to analyze the definition of
economics. Economic definitions can conveniently be grouped into Fair.
(i) Wealth Definition.
(ii) Welfare Definition.
(iii) Scarcity Definition.
(iv) Growth Definition.

Adam smith’s Wealth Definition.

According to Adam Smith (1723-90), ―Economics is the science of wealth.‖ Adam Smith the
founder of the classical school of Economics, emphasis on wealth as a subject matter of economics is
implicit in his great book – ―An Enquiry into the nature and causes of the wealth of Nations‖ – Published in
1776. it means that Economics deals with wealth. It deals with the acquisition, accumulation and
expenditure of wealth. It examines how people acquire wealth and spend wealth.
Feature:
 Economics is the study of wealth only. It deals with the activities of man related to production,
consumption, exchange and distribution.
 It constitutes only material commodities while it ignores nonmaterial goods as air and water.
 Economics is considered as the study of causes of wealth accumulation which brings economic
development.
 It gives more stress on wealth not on anything else.
 This theory is based on the man who is always aware of his ‗Self-interest‘. Self-interest leads to
material gains. Therefore, such a creature is called Economic Man.
Merits:
 It separates economics from politics and thereby makes it an independent subject and science. Earlier
economics was called only political economy which made no distinction between economics and
politics. The credit of making a separate subject and a science goes to Adam Smith and for this
reason he is rightly called ‗the father of political economy‘.
 This definition seeks to examine the causes which lead to increase wealth.
 Wealth definition is used to signify the material goods which are scarce.
 This definition has the clear cut idea about man.
Demerits
 This definition explains that wealth is the sole end of all human beings. But in reality, wealth is not
an end in itself. It is only a mean and that to one of the many means for man‘s happiness and welfare.
 The definition makes this as the only subject matter of economics. That is why Ruskin and Carlyle
criticized Economics as a ‗dark and dismal science‘.
 The subject matter of economics is ambiguous as the meaning of the term is not very clear.
 The definition places wealth in the forefront and means in the background ignoring the most
fundamental aspect of economics, viz, welfare.
 Wealth definition is based on the concept of economic man only.
 It ignores the problem of scarcity and choice.
 It gives of undue stress on wealth while secondary place has been given to human beings.
 This definition is static which is based on deductive method.
Since wealth definition concentrated too much on the production of wealth and ignored both immaterial
wealth like services of doctors, chartered accountants etc and social welfare, this definition considered as
incomplete and inadequate.

Marshall’s definition of Welfare Economics.

Alfred Marshall (1842-1924) in his book ‗Principles of Economics‘ (1890) has defined Economics
Thus: ―Economics is a study of mankind in the ordinary business of life, it examines that part of individual
and social action which is most closely connected with the attainment and with the use of material requisites
of well being. Thus, it is one side a study of wealth; on the other the more important side a part of the study
of man‖.
The above definition implies three important aspects:
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  Economics is the study of man and his ordinary business of life
 It examines the economic aspect of an individual and his social actions.
 The attainment of material welfare as the end of economics.
Features:
 Economics is the study of mankind than wealth.
 Economics studies the individual and social man who is always concerned with material gains.
 Economics does not study a man who is selfish but studies a real man who possesses several
qualities and is influenced by economic and non-economic factors in society.
 It studies the material means which promote human welfare.
 Material definition deals with economics both as a science and an art.
 This definition considers material or economic welfare as a part of social welfare which can be easily
measured with the measuring rod of money.

Merits:
 Welfare definition completes Adam Smith‘s wealth definition by adding men and welfare to wealth
as the subject matter of economics.
 This definition has clearly mentioned economics as a social science. It is not a pure science but one
among the social sciences.
 Marshall defines economics as a noble science. His definition clearly classifies economic activities.
Economics is not only a science but also a social and normative science.
Criticisms:
 Impracticable in nature. The classification of activities not economic is not sound because in one way
or the other are economic. Hence it is invalid.
 Unscientific one. Marshall explains one kind of behaviour as distinct from another in a haphazard
manner. This makes the subject matter highly variable, indefinite and uncertain.
 Term welfare is vague. Welfare is material happiness. But in reality welfare is a mental make up of a
person which depends much upon his psychological feelings. Thus it is highly subjective.
 Uncertain concept of welfare. All material means do not always promote welfare.
 It is a narrow definition. Economics is the study of only the material means of welfare.
 This definition fails to explain the main economic problems of how to satisfy the unlimited wants
with limited means which have alterative uses.

Inspite of the above criticisms against Marshall‘s definition it should not be forgotten that the fact
that Marshall has widened the scope of economics by taking into account wealth as a part of the study of
economics in relationship with the welfare mankind.

Lionel Robbins’ Scarcity Definition.

Lionel Robbins in his excellent book, ―An Essay on the Nature and significance of Economic
Science‖ (1932), defined ―Economics is the science which studies human behaviour as a relationship
between ends and scarce means which have alternative uses‖.
Features:

 Multiplicity of ends or unlimited wants. End means human wants. When one want is satisfied,
another want crops up in it place and so on in endless succession. The human wants are unlimited;
man is compelled to select the most urgent wants for immediate satisfaction.
 Scarcity of means. Human wants are unlimited and means to satisfy them are limited.
 The Scarce means are capable for alternative uses. They can be used for several purposes.
 The theory explains how to satisfy the unlimited scarce resources with limited means which have
alternatives, uses. Thus, Robbins describes this problem as the choice of making of an economic
activity. Economics is thus a study of certain kind of economics that is economizing the resources.
 The problem of economizing resources leads to another problem viz, the problem of choice wants are
numerous and means are scarce, we have to choose the most urgent wants from the numerous needs.

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 In the sense the scarcity of means makes the choice necessary. That is why Economics is described
as ‗Science of Choice‘.

Merits of scarcity definition:

1. More scientific than Marshall’s welfare definition:

The scarcity definition analyzing human behaviour explains any behaviour under one aspect. In this way,
this definition is more scientific.
2. Scarcity definition is more wider:
Robbins by studying any behaviour connected with the problem of scarcity widens the scope of
economics from the boundaries of material welfare.
3. Free from all confusion:
When economics is neutral between ends it becomes free from all controversies and confusions
regarding value judgement.
4. Universal:
Robbins definition is considered universal. It is applicable to all individuals, groups and society.
5. Study of human behaviour
This definition studies the human behaviour of an individual as well as of a society.
6. More Logical Explanation of Economic Problem
Robbin‘s definition is more logical in explaining the economic problem. Accoding to this, economic
problem arises due to scarcity of means in relation to their demand.

Demerits:
Robinson‘s definition is too wide.
 Scarcity definition makes Economics meaningless.
 It is colourless and impersonal; Robbin‘s definition lacks human and realistic touch which
characterizes as Marshall‘s welfare definition.
 When Economics is not concerned with ends, economics becomes both theoretical and abstract.
 Economic problem does not always arise from scarcity.
 Impractical Economics becomes merely an intellectual exercise. But in practical life, man is always
interested to solve many problems. In this way, Robin‘s definition is a departure for reality.
 Not applicable for rich countries which have plentiful resources.
 Robin‘s definition is static as he studies present means, forgets the future where both ends and means
are subject to change. Robins ignores growth economics.

Samuelson’s modern definition of Economics.

Samuelson‘s definition is know as a modern definition of Economics. According to Prof. Samuelson,

―Economics is a social science concerned chiefly with the way society chooses to employ its resources,
which have alternative uses, to produce goods and services for present and future consumption‖.
C.E. Ferguson has defined economics as, ―Economics is a study of the economics allocation of
scarce physical and human means among competing ends, an allocation that achieves a stipulated optimizing
a maximizing objective‖.
Features:
 This definition deals with the economic resources which are natural, human or physical. They are
used to satisfy human wants. They are scarce but have alternative uses.
 The resources have alternative uses and the resources should be efficiently utilised for maximum
welfare.
 This definition explains the full utilization of resources.
 Increase in productivity. Another feature of this definition is that it must increase productivity
resulting in an increase in economic growth, employment and higher standard of living.
Merits:
 This definition provides realistic explanation of economic problems.
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  Economics is the oldest among arts and newest among the group of sciences. In fact, it is the ‗Queen
of Social Sciences‘. This definition concurs with the statement that economics studies both its
theoretical and practical aspects.
 This definition has made economics more practical.
 Economic welfare forms part of the study of economics according to this definition.
 This definition imparted dynamism to economics.
 It is a universal definition.
 This definition studies the forces that determine the quantities and their mutual relations. This
definition is called more scientific and definite.
Demerits of Growth definition:
1. The definition is very comprehensive because it does not restrict to material well-being or money
measure as a limiting factor.
2. It considers economic growth over time.

Scope of Economics.
Scope of Economics

Subject Nature Limitations Relationship with

Matter other Sciences

Science Art

Prof. Keynes in his popular book ―The Scope and method of Economics‖ has studied four aspects under the
scope of economics. They are,

 Subject Matter
 Nature of Economics
 Relationship of Economics with other sciences.
 Limitations.
Subject Matter
The subject matter of economics is connected to those economic activities of human beings which
they perform for a proper utilization of the scarce resources in order to get the maximum satisfaction of their
wants. These economic activities are called consumption, production, exchange and distribution.

Consumption:
The existence of human wants is the starting point of economic activity. Consumption deals with the
satisfaction of human wants. In this subdivision, we study about the nature of wants, the classification of
wants and some of the laws dealing with consumption such as the law of diminishing marginal utility,
Engle‘s law of family expenditure, consumer‘s surplus and the law of demand.
Production:
Production refers to the creation of wealth, production refers to all activities which are undertaken to
produce goods which satisfy human wants. Land, labour, capital and organization are the four factors of
production. The law of returns, theories of production, Theories of Rent, Theories of wages, Mobility of
factors and role of factors are also studies in this division.

Exchange:
In modern times, no one person or country can be self, sufficient. This gives rise to exchange. In this
division, we study about trade and commerce, money and banking, consumption will be possible only if the

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produced commodity is placed in the hands of the consumer. For this trade and commerce are essential for
the movement of goods and services from one place to another.
Exchange connects consumption and production. It deals with the exchange of goods for one
another, under exchange, we study price determination under different kinds of markets, functions and
characteristics of money, the role of International Trade etc.

Distribution:
Production is the result of the cooperation of factors of production. Wealth is produced by the
combination of land, labour, capital and organization. And it is distributed in the form of rent, wages,
interest and profits. In this division, we study the distribution of National Income among people and factors
of production. The marginal productivity theory of distribution. The Theories of rent, wage, interest and
profit etc, are analyzed.

Public Finance:
This division studies about the income, expenditure and financial administration of the state. The
canons of taxation, principles and types of taxes, public debts, public policies and budgets, public finance
have been separated from Economics and is treated as an independent branch.

The subject matter of economics is divided into tow areas which in turn are very broad : Micro
Economics and Macro economics. The term Micro and Macro Economics were coined by Ragnar Frisch of
Oslo University, for the first time in 1933.

Macro Economics:
The word ‗Macro‘ has greek origin which means ‗large‘. One of the chief objectives of macro
economic theory is to explain the working of the economy as a whole. That is why Macro Economics is
described as the economics of aggregates under Macro Economics, subjects like the level of employment,
national income, economic development, price level, revenue, money, banking, international trade etc., are
studied.

Micro Economics:
‗Micro‘ in Greek language means small, Micro Economics is the analysis of the constituent elements
of an economy. Therefore Micro Economics is not aggregative but selective. Micro Economics is concerned
with the fair distribution of means, laws of production, price determination, factor pricing such as rent,
interest, wages, profit, economic welfare etc, are studied.

Nature of Economics

Science Art

Positive Normative

Economics is a science or an art:

The term science means a systematized body of knowledge. Whereas an ‗art‘ lays down precepts or
formulae to guide people who want to achieve a certain aim. Many English economists consider that
economics is a pure science and not an art. Yet many other are of the opinion that economics is also an art.
Economics does undoubtedly help us in solving many practical problems of the day. It is not a mere theory;
it has great practical use. It is both light-giving and fruit-bearing. Hence, Economics is both a science and an
art. According to Samuelson, ―Economics is the oldest of arts, the newest of science, indeed the queen of all
the social sciences‖.

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Economics as a science:
A science is commonly defined as a systematic body of knowledge concerning the relationship
between cause and effect of a particular phenomenon. Much in the same way as in science; in economics
also the activities and laws are also true, exact the verifiable.
Robbins, Robertson and Jordon defined economics is a science because it has universal laws built
upon facts, analysed and systemized by economists.

Economics as an art:
Marshall, Pigou and others are of the view that economics is also an art. An art is completely
different from science. Art is the practical use of knowledge for the achievement of definite ends. According
to J.M. Keynes, ―An art is a system of rules for the attainment of a given end‖. Cossa rightly said, ―A
Science teaches us to know, an art teaches us to do. He also said, ―Science requires art, art requires science
each being complementary to the others‖.

Economics-Pure and Applied Science:

Pure Science furnishes the tools with which applied science works. They go hand-in-hand, but
former must proceed, for without it the latter is without the proper means for the accomplishment of its task.

Economics-Positive and Normative Science:

Positive economics is mainly concerned with the description of economic events and it tries to
formulate theories to explain them. But in normative economics, we give more importance to ethical
judgments. Normative economics is concerned with the ideal rather than the actual situations.
Positive science explains the real nature of a subject. It establishes the relationship between the
causes and effects of a particular event as it happens. According to Lord. J.M. Keynes, ―A positive Science
may be defined as a According to body of systematized knowledge concerning what is‖.
According to R.T.Bye, ―Positive Science confines itself to accurate description of a phenomenon, it
explains what is, how it works, and what are its effects‖. Normative science is one which explains the events
or facts as they ought to be.
According to Keynes, ―A normative science is a body of systematized knowledge relating to the
criteria of what ought to be and concerned with the ideal as distinguished from the actual. Normative science
gives decisions regarding value judgment. Thus the science of economics can be classified as positive and
normative. Disagreements over positive science can be verified by appealing to facts. But in normative
science a mere appealing to facts is not enough.

Limitations:
In Economics, economic activities are of social, rational behaviour and real men are studied.
Economics is a social science. Its law does not remain constant like those for natural sciences. Thus the law
has limitations also. It studies only about normal and social man. It does not study about pure science.
Economic laws are more uncertain as they are related with human activities.

Relationship with other sciences:

The subject of economics is related to the subjects like History, Political Science, Sociology, Ethics,
Psychology, Geography, Mathematics and statistics.

Utility analysis
THE LAW OF DIMINISHING MARGINAL UTILITY
The law of diminishing marginal utility states that ―additional benefit which a person derives from a
given increase of his stock of a thing diminishes with every increase in the stock that he already has.‖
(Marshall). In plain language, all that the law means is that the more and more of a thing we have, the less
and less we want it. For example, take the case of a child, which finds itself with a number of sweets, say,
chocolates. The child will eat the first chocolate with great delight. It may give the child to pleasure. She

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may eat some more chocolates. But sooner or later, an additional chocolate will give less satisfaction than
the first chocolate. In other words, the marginal utility of the good diminishes.
The law of diminishing marginal utility is derived from important characteristics of wants, namely, that
wants are satiable. It means that though wants are many, any particular wants are many, any particular wants
to satiable. It means that though wants are many , any particular want may be satisfied at a time. That is why
the law of diminishing utility is also known as the law of satiable wants.
Utility is measured through th price that a man is willing to pay for a commodity. In this connation, we
may remember that in economics we are interested only in marginal utility and not in total utility. Marginal
utility is the addition to the total utility is the addition to the total utility caused by an increase of one unit in
the rate of consumption. The marginal unit gives a person the least satisfaction. It is marginal utility and not
total utility that is measured by money.
We may illustrate the law of diminishing marginal utility by taking the case of a starving man. Suppose a
starving man finds an apple, it will have great utility for him. If he finds a second apple,it will be welcome.
But he may not want it so badly as the first one. With every additional apple, he will get less and less utility.
He will go on consuming apples until a point is reached where he will be on the margin of doubt whether to
consume any more. The apple which he consumes after the margin of doubt is the marginal unit. The utility
of such an apple is marginal utility. It may be illustrated by a table:

TABLE
Total Utility and Marginal Utility
Number of apples Total utility Marginal utility
1 40 40
2 65 25
3 85 20
4 95 10
5 100 5

We can see from the above table that total utility increases but marginal utility diminishes.

The horizontal axis OX represents the units of th commodity (apple) and the vertical axis (OY) represents
utility. The curve joining points ABCDE represents the law of diminishing utility. In the diagram, the utility
of the first unit is given as 4 (point ‗A‘). for every addiotional unit, the utility diminishes until it reache point
‗E‘ or the marginal unit (In case, the fifth unit).

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ASSUMPTIONS OF THE LAW
1.The law refers only to given period of time. In other words, the units of the commodity must be consumed
successively without a long interval.
2.If we take units which are very small, marginal utility may increase. Hence we must take reasonable units.
3.All units of a good are identical. For example, if you take mangoes, they must be of the same variety, that
is, of the same size, colour and taste.

LIMITATIONS OF THE LAW

1.The law does not apply to those abnormal persons who have a mad desire for certain things (e.g.,
drunkards and misers). For a drunkards, intoxication may increase wth every additional dose.
2.Sometimes,it is said that in certain cases, marginal utility does not diminish with every additional unit; on
the other hand, it may increase. For example, some persons have the hobby of collecting old coins and
stamps.
3.Some economists argue that the law does not apply to money. There is no doubt some truth in it.

EQUILIBRIUM OF THE CONSUMER

The consumer is in equilibrium when the marginal utility of the commodity is equated to its market
price (P) In symbols, we have MUX = PX
If there are more commodities, the condition for the equilibrium of the consumer is the equality of
the ratios pf the marginal utilities of the individual commodities to their prices.

In other words, the utility derived from spending and additionalunit of money must be the same for
all commodities. This is the law of eaui-marginal utility.
Law of Equi – Marginal Utility
A consumer will spend his income on different goods in such a way that the marginal of each good
will be exactly proportional to its price. Only when he acts like that, the consumer, with a fixed income and
given market prices, will be in eauilibrium. That is, he will get maximum satisfaction or utility. According to
the law of eaui-marginal uti;ity, each good will be demanded upto the point where the marginal utility per
rupee spent on it (e.g. sugar) is exactly the same as the marginal utility of a rupee spent on any other
good(e.g. salt). If any one good gave more marginal utility per rupee, the consumer would gain by taking
money away from other goods and spending more on that good upto the point where the law of diminshing
marginal utility brought its marginal utility per rupee down to equality. If any good gave less marginal
utility per rupee than common level, the consumer would buy less until the marginal uti;ity of the last rupee
spent on it had risen back to the common level.
We may express the fundamental condition of consumer equibrium in terms of marginal utilities and
prices of the different goods as follows :
= = = Common MU per rupee of income
ie.,
= Common MU per rupee of income.
The law of equi-marginal utility applies not only to money, it applies to all scarce resources (e.g.,
time).
Marshall has stated the law of equi-marginal utility as ―If a person has a thing which he can put to
several uses, he will distribute it among these uses in such a way that it has the same marginal utility in all‖.
Critique of the Cardinalist Approach
1. We cannot measure objectively the satisfaction derived from various commodities.

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 2. The assumption of constant utility of money is also unrealistic
3. Lastly, the axion of diminishing marginal utility is based on introspection. It is a psychological law
which must be taken for granted.

Indifference Curve Analysis

The indifference curve analysis was introduced into the economic literature in the nineteenth century
by the English economist F.W. Edgeworth. Vilfredo pareto, the Italian economist put it to extensive use.
Later on , the English economist R.G.D.Allen and J.R. Hicks attacked the cardinal utility approach. They
argued that the theory of consumer behaviour should be studied on the basis of ordinal utility.
A indifference curve shows the various combinations of commodity X and commodity Y which will
give equal level of satisfaction to the consumer. Thus an indifference curve is a locus of points – or
commodity bundles – among which the consumer is indifferent. We may also note that each point on an
indifference curve yields the same total utility as any other point on that same indifference curve.
Indifference Schedule
An indifference schedules is a list of combinations of two commodities where the list is so arranged
that the consumer is indifferent to the conbinations. He does not prefer this combination or that combination.
All are same for him.
Table contains an indifference schedule. There are two commodities, X and Y with different
combinations. In the schedule, the combinations are so arranged that the consumer is indifferent among the
combinations. In other words, each one is equally desirable.

Indifference Schedule

X Y
7 1
The
5 next step is go to from indifference schedules to indifference
2 curves.
As
4 we have already noted , an indifference curve is a locus
4 of points – of commodity bundles – among which
Fig 3.2 represents an indifference curve. In the diagram, the horizantal axis measures physical units of a comm
Then next step is to go from indifference schedules to indifference curves.

One can draw similar indifference curves showing different combinations of commodities X and Y
which represent higher and lower levels of satisfaction.
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 For example, in Figure 3.3, all points on indifference curve 3, represent preferred positions to those
on indifference curve 2. Indifference curve1, on the other hand, represents a lower level of satisfaction than
on indifference curve 2 and 3. We may note here that we can only say whether one indifference
curve represents a higher or lower level of satisfaction than another, but we cannot say by low much,
saisfaction is higher or lower. Thus, the consumer‘s scale of preferences can be represented by a set of
indifference curves or an indifference map.

Assumptions about
the shape of
Indifference Curves
An
indifference curve
always slopes
downwar-ds from left to right. This is a reasonable assumption.
It is assumed that all indifference curves are convex to the origin O. The indifference curve analysis
is based on the axiom of diminishing marginal rate of substitution.
Marginal Rate of Substitution
The marginal rate of substitution of X for Y measures the number of units of Y that must be
sacrified per unit of X gained so as to maintain a constant level of satisfaction.

The assumption that indifference curves are convex to the origin implies that the marginal rate of
substitution of X for Y diminishes as X is substituted for Y along an indifference curve.
Point A is on indifference curve2, it represents a higher level of satisfaction to the consumer than that
at point B which is no indifference curve1. But point C lies on both curves, It implies that two levels of

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satisfaction, A and B, which are by definition unequal, have managed to become equal at point C. This is not
acceptable. So indifference curves can never cut each other.

CONSUMER’S EQUILIBRIUM

In studying consumer‘s equilibrium, by making use of indifference curves, we make the following
assumptions:

1. The consumer has an indifference map showing his scaleof preferences for combinations of the
good in question and money. This scale of preferences remains the same throughout the analysis.
2. He has a given amount of money to spend and he spends all the money on one good or another.
3. He is one of many buyers and knows the prices of all goods. The prices of all goods are assumed to be
given and constant.
4. All goods are homogeneous and divisible.

5.The consumer acts in a rational manner and maximizes his level of satisfaction.
We may add one more assumption and that is the assumption of consistency and transitivity of choice.
6. Consistency and Transitivity of choice:

It is assumed that the consumer is consistent in his choice. That is, if in one period, he chooses
bundle A over bundle B, he will not choose B over A in another period, if both bundles are available to him.
Symbolically, we may write if A>B, then B>A
Similarly, it is assumed that a consumer‘s choice is characterised by transitivity. It means that if
bundle A is preferred to B, and B is preferred to C, then bundle A is preferred to C. Symbolically, we may
write
IfA> B,and B>C,thenA >C
To define the equilibrium of the consumer (that is, his choice of the bundles that gives him the
maximum level of satisfaction), we need the concept of indifference curves and their slope (the marginal
rate of substitution) and the concept of the budget line. These are the basic tools of the indifference curve
approach.
The consumer‘s indifference map is shown in Figure 3.5. Figure 3.6 shows the way in which the size
of the consumer‘s income and price of mangoes influence his purchases. The consumer has a fixed amotmt
of money, OA Rupees, which he can spend. The market price of mangoes is such that if he spends all his
money on mangoes, he can obtain OB dozens of mangoes. In other words, the price of a dozen mangoes is
OA/OB and is shown by the slope of the line AB. The slope of such a line is usually referred to as the price
slope.

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We have assumed that the consumer spends all his income on one good or another. He must, therefore,
either spend it on mangoes or keep it in money to be spent on other goods. The line AB is known as price-
opportunity line or price-line or budget (constraint) line. The consumer cannot go beyond the budget line,
say to point T for he is not rich enough. Nor will he remain below the price Iine, say at point S, for he would
not then be spending all his income and we have assumed that he spends it on one good or another. The
price Iine thus represents the opportunities open to the consumer in the market. We have assumed that the
price and his income are given. But the indifference curves show his tastes independently of rnarket
conditions. It is important to note that the indifference map and the price line are quite independent of one
another. The consumer has a scale of preferences which does not depend upon prices. Similarly, under
competitive conditions, prices are given and cannot be affected by the action of an individual consumer.
We have to show how, given his indifference map on the one hand and market conditions on the
other, the consumer reaches an- equilibrium position. This is done in Figure 3.7 where we superim- pose the
price line from Figure 3.6 on the indifference màp from Figure 3.5.
We have assumed that the consumer always aims at obtaining the greatest possible satisfaction.
Naturally, he will attempt to reach the highest possible indifference curve. But in doing this, he will have to
act within the limiis imposed by the budget (constraint) Iine.

In the diagram, at point P on indifference curve 3, the consumer is in an optimum equilibrium

position, where he is maximising his satisfaction. Only at point P, the consumers marginal significance of
mangoes in terms of money is equal to the price of mangoes in the market, and he is, therefore, in
equilibrium. This happens because the slope of the price line and the slope of the indifference curve 3 are the
same at point P. The consumer in Figure 3.7 is in equilibrium where the price line AB is tangent to an
indifference curve. At any such point of tangency, the price Iine and the indifference curve have the same
slope and the marginal significance of the good in terms of money (shown on the indifference curve) will
equal price which is shown on the price line. The consumer will retain the combination of the two ‗goods‘
appropriate to this point on his indifference map.
Indifference curve analysis of the kind described above can be extended to cover many kinds of
economic problems. The goods in question can be consumption goods, capital goods. work, leisure or
money. In this way, we can study the consumer‘s indifference maps between all possible commodities. We
can show that for the consumer to be in equilibrium with respect to all goods, the marginal significance of
all goods in terms of money must equal their money prices. However, it is important to note that
diagrammatic representation of consumer equilibrium cannot deal adequately with more than three goods. If
we have more than three goods, we must have recourse to algebra and all that. That is why we usually
confine our attention to situations where there are only two goods. However, it is a1ways possible to deal by
implication with many goods by putting one good on one axis and money on the other. That is a simple and

13
useful way of studying consumers equilibrium.

The Income Effect:

So far, we have studied consumers equilibrium on the assumption. that a consumer has a given
money income and prices are also given. But sometimes, his money income or the prices of goods or both
may change. We .have made the assumption that the consumer acts rationally. On the basis of this
assumption, the consumer will try to reach a new equilibrium position where he will once again maximize
his satisfaction. There are three main wàys in which the conditions underlying the equilibrium position can
a1ter. They can be explained in terms of income effect, substitution effect and price effect.
There is the possibility that the consumer may become betteror worse off because his income
changes but prices remain constant. The consumer‘s satisfaction wïll be either increased or decreased for he
has a larger or smaller income to- spend. The result of this type of change is known as an income effect.
When prices remain constant, changes in money income, usually result in changes in the quantities
of commodities bought. For most goods, an increase in money income leads to an inc.rease irt consumption
and a decrease in money income leads to a decrease in consumption. Goods for which changes in
consumption are positively related to changes in income are said to be normal or superior goods.
The effect of a change in consumer‘s income can be shown on an indifference curve diagram. It will,
however, be convenient to carry out this analysis in terms of two goods rather than in terms of one good and
money. The income effect is shown in Figure 3.8.
An increase in money income shifts the budget line upward and to the right. We may note that the
movement isa parallel shift because nominal prices are assumed. to be constant.

In Figure, to begin with, money income is represented by NM. The consumer is in equilibrium at
point Q on indifference curve 1. consuming OA units of X and OB units of Y. Now, let money income rise
to the level represented by NM. The consumer moves to a new equilibrium at point Q on indifference curve
2. The consumer has gained now. The consumer also gains when money income shifts to the level
corresponding to NM. The new equilibrium is at point Q on indifference curve 3.

Fig. 3.8. Income-Consumption Curve

As income shifts, there is shift in the point of coiisumer equilibriuin as well. The line connecting the
successive equilibrium points (e.g.,Q-Q’-Q”) is called the income-consumption curve. It shows how
consumption of two goods reacts to changing income when prices of both goods are given and constant. An
income-consumption curve thus traces out tke income effct as the consumers income changes, with given
relative prices of the two goods. A normal income- consumption curve slopes upwards to the right. This
means that as arule, a rise in consumers íncome will make him buy more of each of any two goods he is

14
consuming.
Income-Consumption Curve of an Inferior Good

Sometimes, over some ranges, the income-consumption curve might slope upwards to the left as with
the curve ICC’ or downwards to the right as with the curve ICC” (in Figure 3.9). In these cases, the income-
consumption curve shows that, after a point, even though the consumer is becoming richer, he consumes less
of one of the goods. This can happen if one of the goods is art inferior good. An inferior good is one that is
consumed in large amounts when the consumer is poor and is replaced (wholly or partially) by goods of
higher quality when he becomes richer. For example, in Figure 3.9, if the income-consumption curve is ICC,
X is. an inferior good. If the income-consumption curve is ICC, Y is an inferior good. If the income-
consumption curve slopes upwards to the right, we say that

The income effect is positive for both the goods. If it slopes backwards or downwards, we can say that the
income effect for one good is negative after a certain point. For example, in the case of good Y, the income
effect. is negative beyond point N on income-consumption curve ICC.

Gould .and Ferguson have defined an inferior good as. follows:

―An inferior good is one for which the quantity demanded varies inversely with real income-
increases in real income reduce the quantity . demanded, and decreases in real income increase the quantity
demanded of inferior goods.
The Substitution effect

Sometimes, it is possible that prices may change, but that the consumers money income may also
change in such a way that he is neither better nor worse off as a result of the change. He will, however, find
it. worthwhile to buy more of those goods whose relative price has fallen. He will substitute the. relatively
chëaper goods for relatively dearer goods. The result of this type. of change is described as a substitution
effect.
The substitution effect is shown in figure.

15
 In the original situation shown in Figure 3.10, the consumer is in equilibrium at point Q on
indifference curve 2. He buys OD of good X and O.E of good Y. Now the relative prices of X and Y have
changed. The re1ative price of Y has gone up. But in :order to compensate the consumer for the rise .in the
price of Y, there is increase in the consumer income in terms of X. The consumers income in terms of X is
increased to the extent needed to allow him to remain just as well off as he was before. In other words, he
remains on the same indifferene curve. There has been compensating variation in the consurners income, in
terms of X, of AA’. This canceis out the adverse effect of the rise in the priceof Y. -So he remains on the
same indifference curve. As a result of these changes, we have a substitution ëffect. .The compensating
variationin income has ensured that the consumer is neither bëtternor worse off than he was before. ,We
Theory of Consumer.Behaviour may note that although the consumer remains on the same indifference
curve, he is now on it at a different position. Instead of being at point Q, he is now at point Q. This move
along the indifference curve from Q to Q represents a substitution effect.

The Price Effect

The price effect dea1s with a situation where prices may change with money income constant, so that
the consumer is made either better or worse off. When there is a change of price, there will be change in his
real income, that is, his income in terms of goods. Not only that, he will rearrange his purchases as under
substitution effect. So, we may look at the price effect as a combination of an income effect on the one hand
and a substjtution effect on the other.
The price effect is shown in Figure 3.11.
By changing the price of X, while keeping constant the price of Y and the money income (and tastes), we
can derive the consumers price consumption curve (see Figure 3.11).
Let us assume that the consumer has a money income of Rs. 10 to spend.

To begin with, the price of X is eqiial to the pi,ice öf Y, i.e., P,.=P) (Rs 2 per unit of each commodity) The
orignal equilibrium position in Figure 3.11 is at P where the consumer has 2 units of X and 3 units of Y. Let
us assume that the consumer‘s money income remanis constant, but that the price of X falls. (He can buy 10
urus of X now with Ius money Ircome) Since their is no change in the price of Y, the consumers mcoiie in
terms of Y will be 5 units all th time The new equilibrium position will be at P where the consumer has 6
units of X and 2 units of Y. We may note that the change m the price of X alters the slope of the price Iine by
altering the ratio of the prices of X and Y. The line connecting P, P is known as price-consumption curve. In
other words, the price-consumption curve for commodity X is the locus of points of consumer equilibrium
resulting when only the price o X changes. It shows the rice effect.
We can derive the demand curveof an individual by màking use of the indifference curve approach.

16
Demand Curve

Derivation of demand curve

The price-consumption curve car be used to derive the demand curve.

In Figure 3.11, at point P, the consumer buys 2 units of commodity X at the price of Rs. 2 per unit. At point
P the price is rupee one (Re. 1) per unit and the quantity demanded has increased to 6 units. In Figure 3.12,
we have plotted the price-quantity pairs defined by the points of equilibrium on the price-consumption curve
to obtain the demand curve DD.
The demand curve for a normal commodity will have a negative slope. A commodity is defined as a
normal good when its demand changes in the same direction as income. If the demand for a commodity
decreases when income increases, the commodity is called an inferior good. It denotes the law ofdemand
which states that other thmgs bemg euqual, demand mcreases hen price fa1ls and decrease when price rises.

An Appraisal of the Indifference Curve Approach

Indifference curve analysis offers alternative approach to utility theory for describmg mdtvidual
consumer behaviour It can also be used for deriving mdividual demand cur,,ves for particular commodities.
Since the appearance of J R Hicks Value and Capital, the indifference curve analysis has been widely
accepted by economists. Indifference Curves are used in the analysis of many economic phenomena. Those
who prefer indifference curve analysis claim that it is superior to the marginal utility theory because it
avoids the assumptions that utility is measurable and that marginal utility is diminishing The indifference
curve analysis assumes only that the consumer is able to decide whether two combinations of goods are
equivalent or whether he prefers one to the other; but it is not assumed that he can tell by how much he
prefers one combination to the other. (George J Stigler: The Theory ofPrice (1946) p. 76).
There are some who consjder this a dubjous claim. An indifference curve represents the consumer as
being able to tell exactly how many more units of commodity x will compensate him for the loss of one unit
of commodity Y (or vice versa). He is supposed to be able to do this for any two goods, orfor any good as
against all the others put together. This would appear to necessitate his measuring the amounts of utility in
every econoinic good. Critics of this theory say that there is as much measurement implied in the
indifference theory as m the marginal utility theory. The concept of marginal utility is implicit in the
definition of the marginal rate of substitution.
Another point of criticism agaimst the indifference curve theory is that both the terminology and the
mechanics of the theory are more awkward than the marginal utility theory.
Further, this theory has retained most of the weaknesses of the marginal utility approach. For
example, it assumes that consumes are entirely rational in Spending their money. But it is doubtful whether
the consumer is able to order his preference as precisely or rationally as the theory implies. Not only that,
the preferences of the comsumer would change Continuously under the influence of various factors. So, any
ordering of these preferences, even if possible, should be considered as valid on1y for a short period.
Another defect of the indifference curve approach is that it does not analyse the effects of advertising
17
and of past behaviour of consumers whjch result in habit formation. Further, the indifference theory cannot
explain speculatjve demand. Yet it is very important for the pricing and output decisions of a firm. That is
why some econots believe that as a complete and realistic explanation of how co umer purchases are
actually determined, both theories are actually determined, both theories are inadequate.

Approaches of Economic Analysis

METHODS OF ECONOMICS
Broadly, in economics we make use of two methods. They are (1) deductive method and (2)
inductive method.
The deductive method is also known as abstract method or analytical method or a priori method.
This method is based on a priori reasoning and the drawing of conclusions from certain fundamental
assumptions. Aristotle and the Greeks were the first to make use of the deductive method. Here is a
simple and typical example of method adopted by socrates:-
All men are mortal
socrates is a man,
socrates is mortal.
This deductive method, moving from the general assumption to the specific application, made an important
contribution to the development of science in general. But it was not fruitful in arriving at new truths. For
examples, before the discovery of the law of gravitation by Newton, the early philosophers like Aristole,
seemed to have explained away from the tree as follows:
All fruits fall to the ground
Apple is a fruit
Apple falls to the ground.
But Newton taught us that the apple falls to the ground because of the gravitation pull of the earth.
Ricardo made use of the deductive method. J.S. Mill, another eminent classical economist, combined factual
study and verification with abstract reasoning and called it the ‗concrete deductive method.‘
Francis bacon advocated the inductive method in scientific enquiry. He advocated the application of
direct observation of phenomena, arriving at conclusions or generalisations through the evidence of many
individual observations. This inductive method of moving from specific observations to generalisation freed
logic from some of the hazards and limitations of deductive thinking. But the inductive solution of problems.
In the nineteenth century, the deductive method of Aristotle and the inductive method of bacon were fully
integrated in the work of Charles Darwin. In it, the major premise of the older deductive method was
gradually replaced by an assumption or hypothesis which was subsequently tested by the collection and
logical analysis of data. The deductive - inductive method is now recognized as an example of a scientific
process.
The following are the important elements of a deductive - inductive process:
1. Identification and definition of the problem.
2. Formulation of a hypothesis- a hunch, an assumption or an intelligent guess.
3. Collection, organisation and analysis of data.
4. Formulation of conclusions.
5. Verification, rejection or modification of the hypothesis by the test of its consequences in a specific
situation.

In economics, the historical school emphasized the inductive method of reasoning from concrete
historical data. Even among the classical economics, Malthus collected a lot of historical data to illustrate
his theory. So in a way he may be regarded as one of the founders of historical economics.
It may be interesting to note here that Menger, one of the founders of the marginal revolution advocated
deductive method in economic analysis. In fact, he entered into a great debate with Schmoller, the leader of
the ―Newer Historical School‖ over the question of method. While Schmoller advocated inductive method,
Menger supported deductive method. The debate was called the ―Battle of Methods.‖ Of course, the
18
controversy over method no longer exists today. Discussion of method is considered today as a pure waste
of time. According to Pareto, ―the aim of the science is to discover economic uniformities, and it is always
right to follow any path or to pursue any method that is likely to lead to the end.‖ In fact, after a long debate
over method, Schmoller himself has said that ―induction and deduction are both necessary for the science,
just as right and left foot are needed for walking.‖
Over the past fifty years the character of economics as a discipline has very greatly changed. World war
II (1939-45) was in many respects a dividing line. Before 1939, economic decision were made largely on the
basis of rational, but essentially non-quantitative, argument reinforced by judgement of the relative
importance of the relevant consideration. The task of the contemporary economist was to perfect the
rationality of the argument. Today, decisions are in the very great majority of the class made on the basic of
quantitative evidence. The task contemporary economist is not only to insist on the rationality of the
arguments but also collect, systematise, analyse and present the quantitative evidence and to see what
conclusions can reasonably be drawn from the data. Today, no professional applied economist is is
employable who cannot handle with competence and confidence the quantitative evidence that is relevant to
the range of decisions with which he is concerned. At the same time, professional economist has become
increasingky mathematical in the forms in which its arguments are conducted. It has become increasingly
difficult for anyone who cannot read a book or an article employing mathematical symbols or processes to
leep abreast of current thought and development of the subject.
Economic Theory
Economic theory has been broadly divided into microeconomics and macroeconomics.
Microeconomics deals with the theory of decision-making by individual customers, resource owners and
business firms in a free market economy. Macroeconomics, on the other hand, focuses on the study of
economy as whole and its various aggregates such as national income, aggregate level of employment,
general price level. It is important to note that though managerial economics draws on both microeconomic
and macroeconomics. Managerial economics is however essentially a course in applied microeconomics.
Managerial economics is however essentially a course in applied microeconomics, macroeconomic
conditions of the economy such as level of aggregate demand (which determines whether recessionary or
boom conditions prevail in the economy), rate of inflation, rate of economic growth, that make up
macroeconomic environment within which firms work are also very important for decision making by
business firms.
Microeconomics has built models which explain how an individual consumer chooses among goods
so as to maximise his satisfaction and individual business firm decides to fix price and output of its products
to maximise profits and what factor combination it uses for producing them so as to minimise cost for a
given level of output. The parts of microeconomics which deal with demand theory, analysis of cost and
production, theory of determination of price and output under different market structures are particularly
useful in making business decisions about such matters.
The study of macro economics which focus on the economy as whole is also highly useful for
management economist who is faced with various decision-making problems. This is because firms do not
work in a vacuum. The level of overall economic activity, national income and employment, aggregate
demand conditions, government policies (both fiscal and monetary), interest rate, the changes in price level
greatly affect business firms. These aggregates of the economy make up the macroeconomic environment
which affects business decisions of managers. Therefore, in recent year macroeconomics for management
which is particularly relevant for business decision making has been developed. Forecasts of future demand,
investment decisions by business firms are especially based on the overall situation of the economy and its
growth prospects. Macro-theories of consumption, investment demand, the general price level and business
cycles are particularly relevant for making capital investment expenditure which yields returns in future
years.

Objectives of Profit Maximisation:

In a competitive world the main measure of business efficiency is the profit made by a firm. In
highly dynamic societies, profitability is ‗sine quo none‘ for the survival of the business. The inability of
some firms to make sufficient profits has often resulted in their gradual elimination.
In tradition economic theory, a business firm as an economic entity had only one objective i.e., to
maximize profits. The firm tries to achieve it by the best combination of inputs. A firm under conditions of
19
perfect competition achieves this goal when it equates marginal cost with marginal revenue. Figure shows
the profit maximization behaviour of the firm.

Figure (A) shows the firm under perfect competition which is a price taker. The price determined by
supply and demand conditions in the market is OP and the firm is at equilibrium when its marginal cost is
equal to marginal revenue at E. It sells OM and enjoys normal profit. It is possible that a firm under perfect
competition may enjoy abnormal profits in the short run. But entry of new firms under perfectly competitive
conditions will wipe away such abnormal profits as shown in figure A.
However a monopoly firm as shown in figure (B) is a price maker i.e., he is the sole seller and so he
can control the price subject to the law of demand. Thus the equality of marginal cost and marginal revenue
at E results in supernormal profits when he produces and sells OM, enjoying abnormal profits monopoly
firm can enjoy.
However profit maximization as the primary objective of a business firm has met with criticism. The
attitude of the society to profits is often less indulgent. Profit is sometimes considered to be socially
unacceptable and even immoral. The criticism of profit motive has been done on various grounds.

Separation of ownership from control

In a joint stock firm the ownership is with the shareholders while the mangers control the business.
Several empirical studies in western countries have revealed that the mangers are often not aware of
shareholders‘ goals. The study made it clear that profitability alone is not the sole criterion by which
shareholders appraise the performance of a company.
Difficulties of pursuing profit- maximization
Due to uncertainties, the firm may subordinate its short-run profit- maximizing bahaviour to the
more important objective of long-run survival of the company. The firm may prefer to have a larger market
share or diversification of business rather than aim at profit maximization in the short run.
After Second World War, technological revolution in industry has necessitated large scale
investment. Firms have to think of recovering this investment at least in the long-run. Hence they may aim at
profit maximization in the long-run. Hence they may aim at profit maximization in the long-run rather than
short-run.
Problems in the measurement of profit:
Traditional economic theory recognizes profitability as the main measure of business efficiency. But
it may not be a good indicator since profits may be the result of imperfections in the market which have
resulted in monopolistic exploitation. Different firms follow different systems of valuation. Profits are often
recorded at a particular moment of time.

20
 The problem is made worse by the fact that the value of the assets may be so large in comparison
with trading profit that relatively small variations in valuation can make a massive difference to the size of
the profit in the report.
Deliberate limitation of profit
Firms may deliberately show lesser profits in the short-run in order to discourage labourers from
asking for higher wages or to discourage entry of new firms. Limited profits may be shown to prevent the
government from taking over the business.
Importance of non-financial considerations
Though business firms are considered to be profit maximizing units, it is found that it is often one of many
goals. Non-financial considerations like the desire to achieve something, aspirations of personal freedom,
service to society, have also been important motives for business.
Aversion for business expansion
Profit maximization may require business expansion but such expansion involves additional risk and
troubles which some businessmen may not like to undertake. If they are satisfied with the present level of
profits and standard of living they may not expand their business at all even if it means larger profits.
Therefore profit maximization alone cannot be the overriding criterion.
Profit versus growth
If profits are the means to expand business, then the goals of profit maximization merges with the
goal of growth of the firms. If however the owners of the firm reveal strong preference for current profits
and dividends than future profits and dividends, then growth objective differs from profit maximization goal.
This time preference by the owners of the firm exercises food influence on whether it is the profit
maximization or growth which should be pursued by the firm.
On the whole, profit maximization theory works well under the conditions of competitive market.
Hence it is possible that profit maximization may be only one among several objectives and not the sole
criterion followed by a firm.

Sales maximization:
Economists who do not accept profit maximization as the sole goal objective of the firm has suggested
alternative goals. These may be classified into two:
1. Explanations where something other than profit is maximised. These are known as optimising models.
2. Explanation where non-maximising behaviour is described.

Sales Revenue maximization approach given by Prof. Baumol belongs to the first category.
Firms used to prefer sales revenue for many reasons, like,
1. In terms of rate of growth of sales revenue the success and strength of the firm is evaluated by the financial
institutions.
2. Empirical evidence shows that the stock earnings and salaries of top management are correlated more
closely with sales than with profits.
3. Increasing sales revenue over a period of time gives prestige to the top management, but profits are enjoyed
only by the shareholders.
4. Growing sales means higher salaries and better terms. Hence sales revenue maximisations results in a
healthy personnel policy.
5. It is seen that managers prefer a ‘steady performance with satisfactory profits’ than spectacular profit-
maximisation.
6. Large and increasing sales help the firm to obtain a bigger market share which gives it a greater competitive
power.

Baumol‘s sales maximisation model is based on the following assumptions.

a. Sales maximisation goal is subject to minimum profit constraint. Prof.Baumol does not give a clear
definition of minimum profit.
b. Advertising is a major instrument of sales maximisation.
c. Advertising costs are independent of production cost
d. Price of the product is assumed to be constant.
21
 Total revenue, cost and profits are measured on Y axis and output on X axis. TR is the total revenue
curve and TC is the total cost curve. TP shows the total profit curve which rises upon E and then starts
declining. MP denotes Minimum Profit Line. If the firm‘s objective is to maximize profit it will produce
OA output because at this level it gets the maximize profit EA. But the firm wants to achieve sales
maximization.
This can be done up to the point where its marginal revenue becomes zero. This is R2 on the total
revenue curve. Hence OC is the sales maximization output which is larger than the profit maximization
output of OA. But the total profits are only GC which is less than EA the maximum profits possible. But
the firm operates with a constraint that is must make a minimum profit of OM. The total profits earned by
the firms are equal to minimum profit goal at D. Hence sales maximisation firm will produce OB output.
Baumol‘s explanation has more implications that the traditional profit maximisation principle. His
theory is more consistent with observed behaviour. In the traditional theory changes in fixed costs do not
influence output or prices except for fixing the break-even point. But according to Baumol a firm which
experiences any increase in fixed costs will try to reduce them or pass them on to the consumer in the form
of higher prices, through large sales. This theory also establishes that businessman may consider non-price
competition through sales maximisation to be the more advantageous alternative.
However, Baumol‘s theory does not explain how the firms maximise their sales volume within a
profit constraint. Further it explains business behaviour, without elaborating the mechanisms by which they
try to find new alternative.

Other objectives: Economic objectives:

1. Maximum growth rate:

This objective is consistent with profit constraint. Kenneth E. Boulding has traced the various stages in
the life cycle of a firm. In the early stage, the main aim of a firm is to establish itself is new markets for
which it may introduce new products. In the second stage, when it is well established it may focus its
attention on the goal of improving internal efficiency to achieve high growth rates. Boulding points out that
at a later stage ―as the industry approaches maturity the near term potential becomes dimmed partly through
saturation of demand and partly because of the very high costs of further market penetration at the expense
of competition is placed on long term growth and flexibility‖. Finally in the long run, the firm may face
adverse conditions such as falling demand for its products or rising prices for its inputs. As a result, if it
incurs losses, it may continue for a short while but will eventually go out of business because the resources
can find more profitable employment elsewhere.

2. Desire for liquidity

Prof.Joel Dean considers the liquidity criterion to be more important than that of profit maximisation.
This refers to the desire of a firm to keep adequate amount of cash so that it can avoid a liquidity crisis. This

22
is referred as ―Banker Mentality‖ i.e the fear of financial crisis and the fear if bankruptcy is very powerful
factors in influencing the firm to keep adequate cash.

Non Economic objectives:

1. Survival:

Peter F. Drucker says that survival is the main and long term goal of any firm. Of course
profitability is required for survival. But it need not be maximum profit but reasonable profits. It can survive
only if it wins the good will of the people by producing goods and services of good quality. A good name
earned would help the firm to enjoy a bigger share of the market and this will enable it in its aspirations of
survival over a long period. This may be considered as a conservative objective by some economists.

2. Building up public confidence for the product:

The primary aim of some firms may be to build up the customer confidence for its product and
services. It may also adopt vigorous advertising techniques.

3. Welfare:

First and foremost the welfare of the workers has to be considered. They should be provided good
working conditions, fair wages, and other benefits to increase their involvement in the firm. Labour welfare
goal is very important as it can improve labour efficiency and productivity. Such labour welfare schemes
may include subsidised canteen, medical care, schools and housing for the workers. The business firm
depends upon the patronage of the society for its survival. Hence it owes some moral responsibilities toward
social welfare for which it may undertake charitable works like construction of hospitals, schools, etc.

4. Sound business practices

A firm may give more importance to business ethics. This will make it adopt only sound business
practices like providing price lists, replacement or refund for defective products, which again will go a
long way in building up the goodwill for the company.

5. Progressive management:

It is very essential for dynamic growth of the firm. Hence as a part of this goal the firm may
implement suitable policies like worker‘s participation in management, workers training programme etc.
Different firms prefer different objectives at different points of time. They may continue different
economic and non-economic objectives within a framework of social responsibilities.

The social Responsibility of business or firm:

The concept of ―social responsibility‖ traditionally has been defined interms of social and economic
goals of business units.
The economic responsibility involves efficiency in production, which in turn can be interpreted as
utilization of the resources in an economic way rendering serving to the people by efficiently distributing
them at the lowest possible price, and then the firm can achieve its goal of profit maximization. In modern
days, social responsibility to customers, shareholders and the community, the concept of social
responsibility is defined in two ways.
1. Conceptual angle. 2. Social programme Angle.
According to Kenneth Andrews, social responsibility refers to in the intelligent and objective concern for
the welfare of the society, that restraints individual and corporate behaviour from ultimately destructive
activities, no matter how immediately profitable, and leads to the betterment, variously as the latter may be
defined.

23
 The definition of social responsibility brings out the importance of decision making which results in
human betterment. Specific corporate programmes may undertake social measures at the operational level.
This may include education, training. Medical care, health, cultural activities and pollution control.

Full implementation of social responsibilities will save the society from the morass of inefficiency,
literacy and disease and more the society stranger and more productive which will in turn help the
organization.

Arguments for Social responsibilities of a firm:

1. The business community is expected to undertake social responsibility.
2. The self interest of the business community will be better served only if it undertakes the social
responsibilities.
3. If business firms undertake social responsibilities, it may reduce the work of the state.
4. The businessmen are citizens of the country and they are expected to use their corporate power to
develop a better society.

Arguments against assumption of social responsibilities:

Milton Friedman and his followers strongly appose the idea of assuming social responsibility by
business organization. According to them, the businessman has no social responsibility except their classical
function. The managers are responsible to the owners and shareholders. If the intention of the shareholders is
to maximize profits, the managers have option to deviate. The Board of Directorates and managers have no
right to squander the money of the shareholders.
According to Milton Friedman, the business executives and trained for getting maximum return and
not trained for undertaken social responsibilities.
Many individual companies have chosen a number of social programmes in response to the demand
of the society in recent years. Recently the Sanchar committee by the Government of India recommended
wide ranging major programmes for companies.
The above arguments against completely set aside the social aspects of the business and emphasize
only profit maximization whatever be the argument organist in the social responsibility to attend, In a
planned economy, some of the resources have to be utilized for the betterment of society though profit is
still apart of the business.

UNIT- II

Demand Analysis
Meaning of Law of demand
Demand in common parlance means the desire for an object. According to stonier and Hague,
―Demand in economics means demand backed up by enough money to pay for the goods demanded‖.
Demand has three essentials price, Quantity demanded and time.

Definition:
In the words of Benham, ―The demand for anything at a given price is the amount of it which will be
bought per unit time at that price‖. The demand function is usually expressed in terms of the fo0llowing
equation. Dx=f(Px) where d refers Demand, p-price state and illustrate the law of demand, gives its
assumptions and importance.

Law of Demand:
The law of demand expresses to functional relationship between price and commodity demanded.
According to the law of demand, other things being equal, if the price of a commodity falls, the Quantity
demanded of it will rise, and if the price of the commodity rises, its Quantity demanded will decline.
In the words of Marshall, ―The amount demanded increases with a fall in price and diminishes with a
rise in price‖.
24
 Demand for a commodity can be expressed in the following functional form,

Qd = f(Px,I,Pr,T,A)

Where Qd refers Quantity demanded

Px=own price of a commodity
I=Income of the Individual
Pr=Prices of related commodities.
T=Tastes and preferences of the individual consumer
A= Advertising expenditure made by the producers of the commodity.

Basic Assumptions:
Law of demand is based on certain assumptions:
1. There is no change in consumers‘ taste and preferences.
2. Income should remain constant.
3. Prices of other goods should not change.
4. There should be no substitute for the commodity.
5. The commodity should not confer any distinction.
6. The demand for the commodity should be continuous.
7. People should not expect any change in the price of the commodity.

Demand Schedule:
The inverse relationship between the price and demand for a commodity is explained with the help of
a demand schedule.
Demand Schedule

Price of Apples (in Rs) Quantity Demanded

10 1
8 2
6 3
4 4
2 5

When the price falls from Rs.10 to Rs. 8 Quantity demanded increases from once to two. In the same
way as price falls, Quantity demanded increases. On the basis of the demand schedule we can draw the
demand curve.

In the diagram x axis depicts demand for Apple and

y axis depicts the price of apple. When the price is Rs.10,
Quantity demanded is 1, and if price falls to Rs.2 Quantity
demanded increases to 5. by joining the different price
Quantity combinations i.e., A,B,C,D,E we will get the
demand curve DD, which slopes downward from left to
right.

Changes in Demand:
A change in demand solely due to a change in price is
called extension and contraction in demand. When the Quantity
demanded of a commodity rises due to a fall in price it is called
extension of demand. On the other hand, when the Quantity
demanded falls due to a rise in price, is called as contraction of

25
demand. The extension and contraction of demand is illustrated in the following figure.

When the price of the commodity is OP, the Quantity demanded is OM. If the price of the good falls
to P1, quantity demanded increases to ON. Thus, extension in demand is equal to MN. On the other hand,
when the price of goods rises to P2, Quantity demanded decreases to OL. Thus there is contraction of
demand by ML. As a result of a change in the price of a good, the consumer moves along the same demand
curve.

Increase and Decreases in Demand:

When OH, demand changes due to a change in other factors

like taste and preferences, income, price of the related goods etc is
called increase and decrease in demand. This is shown in the
Figure.

DD is the initial demand curve. Demand curve shifts

upwards due to a change in income, taste and preferences. The
Quantity demanded increases to Oil, at the same price, like wise,
when the demand curve shifts downwards to D2D2, the Quantity
demanded decreases to OL.

It is clear from the above analysis that in case of extension and contraction in demand, the consumer
moves along the same demand curve. But in the case of increase and decrease in demand the consumer
moves to a higher demand curve or to a lower demand curve.

The reasons for the down ward slope of Demand Curve

Reasons for the Law of Demand:
Demand curve has a ergative slope i.e., it slopes downwards. There are many causes fro the
downward sloping nature of the demand curve:
1. Law of Diminishing Marginal Utility
Demand curve slopes downwards to the right because the law of demand is based on the law of
diminishing marginal utility. As the consumer buys more and more of a commodity, the marginal utility of
the additional unit falls. Therefore, the consumer is willing to pay lower prices for additional units. That is
why the demand curve slopes downwards.
2. Law of Equi-Marginal Utility
The demand curve slopes downwards because of the operation of the principle of equi-marginal
utility. The consumers will arrange their purchases in such a way that marginal utility is equal in all his
purchases. When the price of one commodity falls, they will buy more thus reaching a new equilibrium, at
which marginal utilities are equal.
3. Income Effect:
Different income levels of the consumers also is also responsible for the downward sloping nature of
the demand curve. If the supply of the commodity is less. It can be sold to the rich people at a higher price.
If the supply is more it can be sold to the poor people at a low price.
4. Substitution Effect:
When the price of commodity falls, it becomes cheaper as compared to the other commodities which
the consumer is purchasing. As a result the consumer would like to substitute this cheaper commodity for
other commodities whose prices remain the same. For example, with the fall in price of tea, coffee‘s price
remaining the same, tea will substituted for coffee.
5. Different uses of the commodity:
Some commodities have several uses. If the price of the commodity is high, its use will be restricted
only for important uses, when price falls, it will be used for less important uses. For eg. When the price of

26
tomato is high, it will be used only for cooking purposes. When it is cheaper it will be used for preparing
jam, pickles etc.
6. New consumers:
When the price of a commodity is reduced then many other consumers who were not consuming the
commodity earlier will start purchasing it now because it is within their reach now. Ex: Radio sets have
become cheaper and even poor people can easily buy a set.
7. Psychological Effects:
Psychologically people buy more of a commodity when its price falls. Hence the demand curve
slopes downwards.

Determinants of demand:
There are factors on which the demand for a commodity depends. The effect of all the factors on the
amount demanded for the commodity is called Demand Function. These factors are as follows.
1. Price of the commodity:
The most important factor affecting amount demanded is the price of the commodity. It is not only
the existing price but also the expected changes in price which affect demand.
2. Income of the consumer:
The demand for a normal commodity goes up when income rises and falls down when income falls.
But in case of Giffen goods the relationship is the opposite.
3. Prices of related goods:
The demand for a commodity is also affected by the changes in price of the related goods also.
Related goods can be of two types: (1) Substitutes and (2) Complementary. The effect of chages in price of a
commodity on amounts demanded of related commodities is called cross demand.
4. Tastes of the consumers:
The amount demanded also depends on consumer‘s taste. Taste include fashion, habit, customer, etc.
A consumer‘s taste is also affected by advertisement.
5. Wealth:
The wealthier are the people, higher is the demand for normal commodities. If wealth is more
equally distributed, the demand for necessaries and comforts is more.
6. Population:
The composition of population also affects demand. A change in composition of population has an
effect on the nature of demand for different commodities.
7. Government Policy:
Government policy affects the demands for commodities through taxation.
8. Expectations regarding the future:
If consumers expect changes in price of a commodity in future, they will change the demand at
present even when the present price remains the same.
9. Climate and weather:
The climate of an area and the weather prevailing there has a decision effect on consumer‘s demand.
10. State of Business:
The level of demand for different commodities also depends upon the business conditions in the
country.

Importance of Law of Demand

The law has some theoretical as well as practical advantages. These are as follows:
1. Price determination
2. Importance to the consumer.
3. Importance to Finance Minister.
4. Importance for Planning.
5. Importance for Formers.

Price Determination:

27
 A monopolist gets the help of the Law of Demand in fixing his price. The demand schedule tells him
the demand at different price in the whole market. He is able to decide the most profitable amount of output
for himself.
Importance to Finance Minister:
The finance minister while imposing the tax keeps in mind the Law of Demand. It is the Law
through which he comes to know the effect of tax on amount demanded for various commodities. Thus, the
consumer maximizes satisfaction.
To the Finance Minister:
The Finance Minister can know the effect of his taxes on the amount demanded for different
commodities. If increasing the rate of taxation of a commodity reduces its sale to a large extent, it is not
good policy to tax this commodity.
Importance for Planning.
Demand Schedule has great importance in Planning for individual commodities and industries.
Importance for producers:
Generally, the Law of Demand States that other things being equal with the rise in price, quantity
demanded falls, and with the fall in price, quantity demanded increase. Therefore, it is the welfare of the
producers to concentrate on the production of those goods whose prices have been reduced.
Importance for farmers:
How far shall a good or bad crop affect the economic condition of the farmer can be known from
the law of demand.

Exceptional demand curve:

Sometimes the demand curve slopes upward from left to right. In this case the demand curve has a
positive slope. When price increases from OP to OP1 quantity demanded also increases from OQ to OQ1 and
vice versa. The reasons for the exceptional demand curve are as follows.

1. Giffen paradox:
The Giffen good or inferior good is an exception to the law of
demand, when the price of an inferior good falls, the poor will buy less
and vice versa. For example, when the price of maize falls, the poor
are willing to spend more on superior goods than on maize. This was
first explained by Giffen and therefore it is called as Giffen‘s paradox.

2. Veblon or Demonstration Effect:

Veblon has explained the exceptional demand curve through his doctrine of conspicuous
consumption. Rich people buy certain goods because it gives social distinction or prestige. For example,
diamonds are bought by the richer class for the prestige it possess. If the price of diamonds falls, rich people
may stop buying this commodity.
3. Ignorance:
Sometimes, the quality of the commodity is judged by its prices consumers think that the product is
superior if the price is high. As such they buy more at a higher price.
4. Speculative effect:
If the price of the commodity is increasing then the consumers will buy more of it because of the fear
that it will increase still further. Thus, increase in price may not be accompanied by a decrease in demand.
5. Fear of Shortage:
During times of emergency or war, people may expect shortage of a commodity. At that time, they
may buy more at a higher price to keep stocks for the future.
6. Necessaries
In the case of necessaries like rice, vegetables etc. People buy more even at a higher price.

Elasticity of Demand
Elasticity of demand shows the extent of change in quantity demanded to a change in price.
28
Elastic Demand:
Small change in price may lead to a great change in quantity. In this case, demand is elastic.
Inelastic demand:
If a big change in price is followed by a small change in demand then the demand is inelastic.
Definition of Elasticity of Demand:
The concept of elasticity of demand was introduced by Marshall. In the words of Marshall, ―The
elasticity of demand in a market is great or small according as the amount demanded increases much or little
for a given fall in the price and diminishes much or little for a given rise in price.‖

Types of Elasticity of Demand

There are three types of elasticity of demand. Price elasticity of demand, Income elasticity of
demand and cross elasticity of demand.
Price elasticity arises due to change in price. Income elasticity arises due to change in income. Cross
elasticity arises due to availability of substitutes and change in their prices.
Price Elasticity of Demand:
Marshall was the first economist to define price elasticity of demand. Price elasticity of demand
measures changes in quantity demanded to a change in price. It is the ration of percentage in quantity
demanded to a percentage change in price.
Pr oportionateChangein Quantity Demanded
Pr ice Elasticity 
Pr oportionateChangein Pr ice
Q p
  .
P q

Where Q  change in Quantity demand, P -change in price.

Definition of Income Elasticity of Demand:

The percent change in amount demanded as a result of a given percentage change in income of a
consumer is called Income Elasticity of Demand.
Pr oportionate Changein Demand
EY 
Pr oportionate Changein Income
q y y q
   
q y q y
Where Ey is income elasticity of demand, q is the change in demand, q is original demand, y –
original income and y change in income.

Definition of Cross Elasticity of Demand

When the demand for a commodity changes with a change in the price of another related commodity,
the case is of cross demand.
Pr oportionateChangein demand of x
E xy 
Pr oportionateChangein the priceof y
Writing in symbols
qx Py
E xy  
qy py
Where p and q have their meaning of price and quantity and  is the small change in it.

Factors determining the elasticity of demand:

29
Elasticity of demand depends on many factors:
1. Nature of the commodity:
Elasticity or inelasticity of demand depends on the nature of the commodity. i.e., whether a
commodity is a necessity, comfort or luxury.
2. Availability of Substitutes:
In case of commodities which have substitutes, demand is elastic. But for goods which have no
substitutes, demand is inelastic.
3. Verity of uses.
If a commodity can be used for several purposes then it will have elastic demand e.g. electricity. On
the other hand, demand is inelastic for a commodity which can be put to only one use.
4. Postponement of Demand:
If the consumption of a commodity can be postponed, then it will have elastic demand. On the
contrary, if the demand for a commodity cannot be postponed, then demand is inelastic.
5. Amount of money spent:
Elasticity of demand depends on the amount of money spent on the commodity. If the consumer
spends a smaller proportion of his income on a commodity, then demand is inelastic, and vice versa.
6. Time
Elasticity of demand varies with time. Generally, demand is inelastic during short period.

7. Range of prices:
Range of Prices exerts an important influence on elasticity of demand. At a very high and at low
price demand is inelastic.
8. Luxury commodities.
The demand for luxury is usually elastic as people buy more of them at a lower price and less at
higher price. For example, the demand of luxuries like sick, perfumes and ornaments increase at a lower
price and diminish at a higher price.
9. Substitutes:
Demand is elastic for those goods which have substitutes and inelastic for those goods which have no
substitutes. The availability of substitutes, thus determines the elasticity of demand. For instance, tea and
coffee are substitutes. The change in the price of tea affects the demand for coffee. Hence the demand for
coffee and tea is elastic.
10. Raw materials and finished goods:
The demand for raw materials is inelastic but the demand for finished good is elastic. For instance,
raw cotton has inelastic demand but cloth has demand. In the same way. Petrol has inelastic demand but car
itself has only elastic demand.
11. Price level:
The demand is elastic for moderate price but inelastic for lower and higher prices. The rich and the
poor do no bother about the goods that they buy. For example, rich buy Beneras silk and diamonds etc. any
price. But the poor buy coarse rice, cloth etc whatever their prices are.
12. Income Level:
The diamond is inelastic for higher and lower income groups and elastic for middle income groups.
The rich people with their higher income do not bother about the price. They may continue to buy the same
amount whatever the price. The poor people with lower incomes buy always only the minimum
requirements and therefore, they are induced neither to buy more at a lower price nor less at a higher price.
13. Nature of Expenditure:
The elasticity of demand for a commodity also depends as to how much part of the income is spend
on that particular commodity. The demand for such commodities where a small part of income is spent is
generally highly inelastic. Ex: Newspaper.
14. Distribution of Income:
If the income is uniformly distributed in the society, a small change in price will affect the demand
of the society a small change in price will be elastic. In case of unequal distribution of income and wealth, a
change in price will hardly influence the poor section of the society so the demand will be relatively
inelastic.

30
The role or Importance of Elasticity of Demand:
The concept of elasticity of demand is of much practical importance.

Price Fixation:
Each seller under monopoly and imperfect competition has to take into account elasticity of demand
while fixing the price for his product.

Production:
Elasticity of demand helps the producers to take correct decision regarding the level of output to be
produced.

Distribution:
Elasticity of demand also helps in the determination of rewards for factors of production.

International Trade:
Terms of trade depends upon the elasticity of demand of the two countries for each other‘s goods.

Public finance:
It helps the government in formulating tax polices

Nationalization:
The concept of elasticity of demand enables the government to decide about nationalization of
industries.
Price determinations in case of joint supply:
Jointly supplied goods are these which are the products of the same production process. For
Eg: wool and mutton. If the demand for wool is inelastic as compared to the demand for mutton, a higher
price for wool is charged, while mutton is sold cheaper.
Determination of wages:
Elasticity can also influence wages. It demand for a particular type of labour is inelastic, it can
succeed in raising wages.
Price discrimination:
A monopolist adopts price discrimination only when the elasticity of demand for his commodity
from different consumers or sub markers is different. The consumers whose demand is relatively inelastic
can be charged a higher price then these with more elastic demand.
Determination of sale policy for super markers:
Super markets are a combined set of shops run by a single organization. So the are supposed to sell
commodities at lower prices than are charged by shopkeepers in the bazaar. The costs of marketing have
also to be lowered. Therefore, the policy adopted in the super market is to charge a slightly lower price for
goods whose demand is quite elastic.
Pricing policy for public utilities:
Such enterprises as provide services of mass consumption like water, electricity, postal services,
railways and communication are known as public utilities. A suitable price policy for these enterprises is to
charge consumers according to their elasticity of demand for the public utility.

The various degrees of elasticity of demand.

For all types of commodities the rate of change of quantity demanded to a change in own price is not
uniform. For some commodities, demand is said to be more responsive to price changes compared to other
commodities. That is why. There are various types of elasticities of demand. They are of the following five
types.
1. Perfectly or infinitely elastic demand
2. Perfectly inelastic demand.
3. Relatively inelastic demand.
4. Relatively inelastic demand.
31
 5. Unit elasticity demand.

1. Perfectly or infinitely elastic demand:

When a small change in price leads to an infinitely large change in quantity demanded, it is called
perfectly or infinitely elastic demand.

The demand curve DD1 is horizontal straight line. It shows that at OP

price any amount is demanded and is price increaser, the consumer will not
purchase the commodity.

2. Perfectly inelastic demand:

In this case, even a large change in price Fails to bring about a change in quantity demanded.
When price increases from OP to OP1 .

The quantity demanded remains the same in other words,

the response of demand to a change in price is nil. In this case E=0.

3. Relatively elastic demand:

Demand changes more than proportionately to a change in
price i.e., a small change in price leads to a very big change in the
quantity demanded.

In this case E>1. The demand curve will be batter.

4. Relatively inelastic demand:

Quantity demanded changes less than proportionately to a change

in price. A large change in price leads to a small change in amount
demanded. Here E<1. Demand curve will be steeper.

When price falls from OP to OP1 amount demanded increases

from OQ to OQ1 which is smaller then the change in price.

5. Unit elasticity of demand:

The change in demand is exactly equal to the change in price.

When both are equal E=1 and elasticity is said to be unitary.

When price falls from OP to OP1 , Quantity demanded increases

from OQ to OQ1 . Thus a change in price has resulted in an equal change
in quantity demanded. So price elasticity of demand is equal to unity.
Explain the measurement of elasticity of demand.

The Measurement of Elasticity of demand.

For practical purposes, it is not enough to know whether the demand is elastic or inelastic. It is more
useful to find out the extent to which demand is elastic or inelastic. Generally, four methods are used to
measure elasticity of demand. They are (i) Percentage method. (ii) Total outlay method (iii) Point method
(iv) Arc method.

32
Proportionate/Percentage method:
It measures elasticity of demand by comparing the ration of percentage of change in the amount
demanded to the percentage of change in the price of a commodity. Marshall gives the following formula for
measuring elasticity of demand.

Re lative changein amount demanded

Ed 
Re lative changein price

It is also called as formula method or co-effective of price elasticity of demand. All the five types of
price elasticity of demand can be illustrated in the following way.

D1  Ed  1
D 2  Ed  1
D3  Ed  
D 4  Ed  0
D5  Ed  1

Total outlay method:

This method was given by Alfred Marshall. In this method we consider the change in expenditure on
commodities due to change in price. If a given change in price does not cause any change in the total amount
of money spent on commodity, then elasticity of demand is equal to unity.

It the total expenditure increases due to a fall it price, elasticity of demand is greater then unity. If a
given change in price results in a fall in the amount spend, then elasticity of demand is less than unity.

Demand schedule showing Different Elasticities Outlay method

Price in Rupees Quantity Total expenditure Elasticity

demanded or outlay in
in units purchasing that
quantity (in
Rupees)
I Rs.6 1,000 6,000 Elastic
Rs.5 1,500 7,500 Demand
Rs.4 2,000 8,000 E>1
II Rs.6 1,000 6,000 Unit
Rs.5 1,200 6,000 Elasticity
Rs.4 1,500 6,000 E=1
III Rs.6 1,000 6,000 Inelastic
Rs.5 1,100 5,500 Demand
Rs.4 1,300 5.200 E<1

Total outlay (or) expenditure is measured in x axis and price is

shown in X axis. When price falls from P1 to P2, total expenditure
remains the same. Therefore, elasticity is equal to one. When price
falls to P4 total expenditure decreases from E2 to E4. Hence elasticity is
less than one. When price decreases from P3 to P1 total outlay increases
from E3 to E2. In this case, electricity is greater then one.

33
 This method which is also known as total revenue method simply classifies demand into 3 types.

Point Method:
This method was also given by Marshall. In a straight line demand curve, elasticity is measured at
different points on that curve.
Y

P k
P1 k1

Q Q1 X
In the diagram, Rs is the straight – line demand curve. Under this point method, the elasticity of
demand can be measured with help of the formula.

Lower segment of the demand curve

Pr ice Elasticity 
Upper segment of the demand curve

If the price falls from OP to OP1, the Quantity demanded increases from OQ to OQ1. Elasticity at
point on the Rs demand curve. According to the formula.

KS
Elasticity at point K 
KR
Arc Method:
Since point method gives of different results for the same change in price, economists have devised.
‗Arc method‘ for measuring price elasticity of demand. The formulae for Arc elasticity of demand is

Pr oportionate Changein the quantity

Elasticity of Demand 
Pr oportionate Changein price

According to Prof. Baumol, ―Arc elasticity is a measure of the average responsiveness to price
change exhibited by a demand curve over some finite stretch of the curve‖.
The method of measuring elasticity of demand is also know as ―Average Elasticity.‖ In this method,
P P a a
we use 1 2 rather than P. thus, we apply 1 2 rather than q. the formulae for Arc elasticity of demand
2 2
as follows. Arc elasticity of demand in national form can be expressed as

Q2  Q1 P1  P2
E 
Q2  Q1 P1  P2

P1 A
Price

P2 B
D

O Q Q2 x
Quantity Demanded
34
 In Figure, the quantity is measured on x axis while the price on y – axis. DD is the demand curve.
Now if we wan tot measure the arc elasticity between A and B on the demand curve DD, we will have to
take the average of prices OP1 and OP2 as of quantities Q1 and Q 2 .
 P   P  P   Q
EA    .
Q   Q  Q   P
Influence of Diminishing Marginal Utility:
When the utility falls, we consume more and more units but not in a uniform way. In case utility falls
rapidly, it means that the consumer has not other near substitutes. As a result, demand is elastic. Conversely,
if quantity falls slowly, demand for such commodity should be elastic and rises much for a fall in price.
Time : The demand for a commodity is always related to some period of time. This implies Ed varies with
the length of time period. In case of long period. Ed will be elastic while in Sp, it will be elastic.

Demand Forecasting:
Meaning of demand forecasting
Demand forecast refers to the prediction or estimation of a future situation under given constraints.
In recent times, forecasting plays an important role in business decision making. The survival and prosperity
of a business firm depend on its ability to meet the consumers‘ needs efficiency and adequately. Demand
forecasting has an important influence on production planning. It is essential for a firm to produce the
required quantities at the right time.

Types of Demand Forecasting

Passive and Active Forecasting.
Passive forecasting assumes a static business environment in future. It refers that the current external
and internal dimensions of the demand for his products will continue in the future without a change.
The active forecasting on the contrary assumes a change in the future business environment through
policies of the firm, its competitors and governments.

Objectives of Demand Forecasting

The Objectives of demand forecasting may be recorded as; short term objectives, long term
objectives.

The short term objectives of demand forecasting:

(i) Regular Availability of labour: Demand forecasting enables us to properly arrange the skilled as
well as unskilled workers to meet the production requirement scheduled during a given period of time.
(ii) Price Policy Formulation: Sales forecast enables the management to evolve a suitable price
strategy. It is so that price does not fluctuate so much during the period of inflation.
(iii) Proper control of sales: It also help in formulating suitable sales strategy according to the
changing pattern of demand as well as the extent of competition prevalent among the firms.
(iv) Arrangement of finance: Demand Forecasting enables to forecast the financial requirements of
the enterprise to have the desired output.
(v) Regular supply of Raw material: By determining the volume of production during a given period
of time the entrepreneur can forecast the raw material required in future.
(vi) Formulation of Production Policy: Sales forecasting enables to formulate the appropriate
production policy to overcome to problems related to over-production and under-production.

Long term objectives of demand forecasting:

If the period of forecasting is more than one year then it is termed as long term forecasting. The
objectives of long-term forecasting are as below:

35
(i) Labour Requirements:
In the long-run, techniques of production may change. Therefore, trained and skilled labour are
needed for new types of job responsibilities. Thus, demand forecasting helps to arrange the skilled labour.
(ii) Arrangement of Finance:
Assessing the long financial needs, the long term demand forecasting enables the management to
arrange the long-term finances on reasonable conditions.
(iii) To Decide about Expansion:
The long-term demand forecasting enables to plan for a new project, as well as expansion and
modernization of the existing unit.

The types of demand forecasting:

Generally, there are three types of demand forecasting as:
1. Short-term demand forecasting.
2. Long-term demand forecasting.
3. Medium-term demand forecasting.

1. Short-term demand forecasting.

Short-term forecasting is concerned with the short time period. Usually of less than one year. This is
required for current production scheduling, purchases of raw materials and inventory of stocks etc.
2. Long-term demand forecasting:
Long-term forecasting of demand is needed for capacity expansion i.e., growth of the firm,
recruitment and diversification policies, for all these decisions have long-run implications.
3. Medium-Term Demand forecasting:
Medium-term forecasting‘s need is felt by a firm when the industry to which the firm belongs, is
subjected to the trade cycle of a medium term ( Varying between say, two to five years). Engineering goods
industries and garment manufacturers often find such pattern of demand behaviour in the market.

Various methods/Techniques of demand forecasting.

Demand forecasting is motivated and influenced by multiplicity of factors. An objective method of
demand forecasting provides the projection of demand using a statistical or mathematic technique. On the
other hand, in subjective method, estimates are made about the demand using intuition i.e., using experience,
intelligence and judgment. An ideal forecasting combines both these methods depending on the market
situation. The various methods can be illustrated with the help of chart.

Methods of Demand Forecasting

Survey Method Statistical Method

(i) Consumer‘s Survey (i) Trend Method

(ii) Collective Survey (ii) Regression Method
(iii) Least square method
(iv) Leading Indicator
Method
(v) Simultaneous Equation
Method.

Consumer’s Survey Method:

36
 According to consumer‘s survey method, the experts on a particular product approach the buyers to
know about the particular product under study. In this method the burden of forecasting goes to the buyers.
This method is very simple end is free from Leavy Statistical work.
Collective Opinion Method:
Collective opinion method is also known as the ‗Sales Force Opinion Method‘. Under this method,
the company as its salesmen to submit estimates of future sales in their respective territories.

Advantages:
1. This method is simple and straight forward.
2. It involves minimum statistical work.
3. This method is less costly.
4. This method is useful in forecasting the sales of new products.
Disadvantages:
1. It is almost completely subjective.
2. It is suitable only for short-term forecasting.
3. Salesmen may not be aware of the changes that affect future demand.
Statistical Method:
Statistical Method is used for long run forecasting. In this method, statistical and mathematical
techniques are used to forecast demand. This method relies on past data.
(i) Graphic Method:
It is the most simple technique to determine the trend. According to this method all the values of
output and sale for different years are plotted on a graph and a smooth freehand curve is drawn passing
through as many points as possible. The direction of the curve may be upward or downward.

Merits:
1. It is very simple method.
2. It is more flexible then that of the rigid mathematical function.
3. This method is more dynamic and dramatic.
4. Graphs are attractive and impressive method.
5. Comparison is easy.
6. To understand, it requires no much knowledge.
Demerits:
1. This method is highly subjective.
2. Mathematical curves can be expressed through formulae.
3. It requires a skill analysist to draw curves with reasonable accuracy.
4. It gives misleading results.
5. Graphs cannot be quoted in support of some important statements.
Regression Method:
In the theory of demand forecasting regression method is very frequently used. This method
establishes relationship between quantity demanded and one or more independent variables viz,
advertisement cost, price of the commodity, price of related goods etc.
It can be expressed as follows:
y = a + bx.
Where x, y = variables
a, b = constants.
In short, regression is a very useful technique, as (i) In economic theory, it helps to know functional
relations – demand depends on the price (law of Demand), supply depends on price (Law of Supply)
consumption depends on Income (Psychological law of consumption function) and rate of interest depends
on demand for money (Liquidity Preference Theory of Interest)
Merits:
(i) It helps to study the dependence of one variable on the other variables.
(ii) It is used in any policy formation to solve various problems.
(iii) Regression is used in prediction of any problem.
(iv) It is highly useful method for research.

37
Demerits:
1. The applicability of regression is only possible in linear dependence.
2. In research also, there are not accurate results from the method of regression.
While using regression Line for estimation, it is generally assumed that the same relationship still
exists between the variables under study.
Least Square Method:
It is a mathematical procedure of fitting a curve. It is a very simple and practical method which
provides best fit according to reasonable criteria. It is given the name of least square because it gives certain
properties. The equation for the line of best fit is
y = a + bx
where y = sales, a, b = value to be estimated. x = unit of time. In order to solve the equation, we have
to make use of the following normal equations.
 y  na  b x
 y  a  x  b x 2

Merits:
1. This method has the property that   y  y   0 and   y  y   least.
2

2. There is no change of subjectivity because the fitting of the trend depends on a

mathematical equation.
Demerits :
1. It requires a great care to select the trend.
2. Predictions are based only on long-term variation. An carelessness causes false results in such a
long period.
3. This method is rigid.
4. Leading Indicator Method: There are three types of time series method i.e., leading series,
coincident series and logging theories. The leading series are the data on the variables that move up or down,
ahead of some other series. The coincident series moves along with some other series a bank-rates (the rates
at which commercial banks accept deposits. The rate at which private money lenders accepts deposits and
lend to individuals are logging series.
5. Simultaneous Equation method: This method is a very much sophisticated statistical method of
forecasting. It refers to the development of a complete model which explain the behaviours of all the
variables that the decision unit control.

Forecasting demand for a new product:

For forecasting demand for a new product, Joel Dean has suggested six approaches
1. Evolutionary approach:
In this method the demand for a new product is estimated on the basis of an existing old
product. For Example: the demand forecasting for colour television is based on the demand for Black
and White T.V.sets. But this approach is useful only when the new product is closed to the old
product or an improvement over the existing product.
2. Substitute approach:
Under this technique the demand for the new product is analysed a substitute for the existing
product.
3. Growth curve approach:
On the basis of the growth of an established product the demand for a new product may be
estimated. For example, by analyzing the growth curves of all two wheelers an empirical law of
market development applicable to a new brand of a two wheeler may be formulated. This method has
narrow applicability and useful only in the later stages of demand forecasting.
4. Opinion polling approach:
Under this approach the demand for the new product is established by enquiring directly from
the customers. This is done by simple survery method.This method is widely used. But there is a
problem of sampling.
5. Sales experience approach:

38
 In this method the demand is established by suppling the new product, in a sample market by
direct mail or through a chain store like departmental store or co-operative society. However
allowance has to be made for the immaturity of the simple market and its peculiar characteristics.
6. Vicarious approach:
Customers‘ reactions for a new product are found out indirectly with the help of specialized
dealers. These dealers are well informed about customers need, taste and preferences. This method is
easy.
The various methods of forecasting demand for the new product are not mutually exclusive.
The combinations of several of them are often desirable when they can supplement and check each
other.

The Qualities or Features of a good demand forecasting.

As there are several methods of demand forecasting. It is essential to notice some qualities of a good
forecasting. However, following criteria should be adopted for forecasting.
1. Simplicity:
Any mathematical techniques of demand forecasting may be simple so that it may deliver better
results.
2. Accuracy:
For forecasting, statistical data is pre-requisite. Therefore data may be undertaken which is accurate,
correct and dependable.
3. Easy Availability:
The results of a demand forecast must be easily available and well understand.
4. Economy:
Generally, a firm keeps a balance between the benefits and the extra cost of providing the improved
forecasting.
5. Capacity to update forecasts:
A sound forecasting is one which keeps the management to maintain the forecasts up-to-date. It
consists of three aspects:
(i) The relationship underlying the forecasting techniques should be fairly stable overtime.
(ii) The data required for use in the forecasting procedure should be available at different intervals of
time.
(iii) The forecasting procedure should allow some changes in its structure as new factors appear in the
market.

The importance of Demand Forecasting.

Demand forecasting is a great significance for decision-making in modern business. The main points
of importance are summarized below.
I) Planning of Production:
It is a pre-requisite for planning of production in a firm. A firm has to expand its capacity according
to the likely demand for it output.
II) Sales Forecasting: Sales forecasting depends much on the demand forecast.
III) Control of Business: Demand forecasting helps in controlling business through well-planned budgeting
of costs sales revenue.
IV) Control on Business Activities: For satisfactory control of business inventories (raw materials,
intermediate goods, semi-finished products and finished products) needs regular estimates of future
requirements which can be derived only form the demand forecasts.
V) Decision/Policy Making:
Demand forecasting is necessary for st deciding about the growth rate of the firm, its long-term
investment programmes and financial planning.
VI) Useful for Stability:
Demand forecasting is useful for stability the production and employment within the firm.

The determinants of demand forecasting:

39
 Demand forecasting requires a detailed understanding of the current and future conditions of
the market in which the firms producing the commodity operate. For easy understanding the elements
of basic requirements of demand forecasting are listed below.
(a) Elements connected to consumers:
 Total number of consumers
 Distribution of consumer product
 Total purchasing power & per capita/ household income
 Income elasticities
 Consumer tastes, social customs etc.
(b) Elements concerning the suppliers
 Current level of sales
 Current stcok of goods
 Trends in sales and stocks
 Market share
 Pattern of seasonal fluctuations
 Research & development trends
 Company strength and weaknesses
 Product life cycle
 New product possibilities
( c) Elements concerning the market
 The effect of price change i.e. price elasticity
 Product characteristics
 Identification of competitive and complementary products.
 Number and nature of competitors
 Forms of market competition
 General price levels
 Prices of similar goods
(d) Miscellaneous elements
 Economic environment showing economic activities, employment, national income population,
trends of income.
 General Government policies
 Taxation levels
 International environment.

CONSUMER’S SURPLUS
The concept of consumer‘s surplus has been added to economic literature by Alfred Marshall.
Consumer‘s surplus measures the difference between the potentiaI price which a consumer is prepared to
pay and the actual price he pays.
Marshall has defined the concept as follows: The excess of the price which a person would be
willing to pay for a thing rather than go without the thing, over that which he actually does pay, is the
economic measure of . this surplus satisfaction. It may be called consumers surplus.
The concept ofconsumers surplus has been derived from the law of
diminishing marginal utility. According to the law of diminishing utility, utility will diminish for every
additional unit And price is proportional to marginal utility. Marginal utility is the least utility.

In a market, there will be only one price for a good at a time. Suppose a consumer buys four-units of
a good, say oranges, he will pay the same price for all the units according to the marginal utility even though
he may get higher satisfaction from the earlier units.
The concept is based on real experience. We have so many instances in Iife where one would be
willing to pay a price higher than what one actually pays. Suppose, a student happens to be at a village on
the day his examination results are published. For the newspaper which contains the results, he would be
willing to pay a price much higher than its actual price if the village is a remote one far away frqm towns

40
and cities. We can give another example. Suppose a vèy rich man .is involved in an aeroplane accident and
he is the sole survivor of the party. Suppose he finds himself in a desert. For a loaf of bread, he would be
willing to pay even Rs. 100 (Rupees one hundred). . But if he gets it for the usual price of say Rs. 2 or so, he
would certainly get additional satisfaction. Marshall calls such additional satisfaction, consumers surplus.
The main point about the concept is that it underlines the fact that prices do not always reflect the actual
satisfaction we get from the goods we buy. Often we get highersatisfaction than the. price we pay for them.
Of course, there are some practical difficulties in measuring consumers surplus in quantitative terms. The
following Table illustrates the concept clearly.

Commodily Potential Actual Consumers

(Oranges) price price surplus

Units (paise) (paise)

1 80 50 30

2 70 50 20

3 55 50 5

4 50 50 —

255 200 55

Total Utility =255

No. of units = 4, Marginal utility = 50
Consumers surplus = Total utility-Marginal utility x Number of units
=255-50x4=55

Diagrammatic Representation of Consumers Surplus

In figure 3.13, the units of the commodity (oranges) are represented along the X-axis and marginal utility is
represented up the Y- axis The shaded area m the diagram shows the consumers surplus.

41
Criticism
The doctrine of consumer‘s surplus has come in for a good deal of criticism. The following are the
main points of criticism:
1. Utility is a subjective concept It cannot be measured exactly in terms of money. So the entire
concept of consumers surplus is vague and misleading.
2. Though one may get a feeling of surplus satisfaction in the case of some goods, it is very difficu1t
to measure it in terms of the price which one would be willing to pay for it.
3. The doctrine does not explain why we do not get a feeling of consumers surplus in the case of necessaries.
And with regard to luxuries which have ―prestige value‖, one seems to get higher satisfaction by paying a
higher and not a lower price. Of course, this concept should not be applied to cases of extreme scarcity or
great
abundance.

Usefulness of the Concept

Economists differ in their views on the usefulness of the concept of consumers surplus. For example,
two Nobel Prize winners in economics disagree fundamentally about the usefulness of the concept. John
Hicks believes that the concept can be used as a cornerstone of welfare economics whereas Paul Samuelson
believes that we can discard the concept without much loss.

In spite of the strong criticism against the concept, it has been found to be useful in many fields.
1. The doctrine helps us to differentiate between value-in-use and value-in-exchange. There are
certain goods which have great value- in-use (e.g., water, salt). But we do not pay any price for water and if
at all we pay, we pay only a small price for them because they are normally, available in plenty. But we pay
higher price for diamonds and things like that because they have great value-in-exchange.
2. It is useful in comparing the standards of living in different regions. Suppose two persons, one in
Madras and the other in a jungle town of the country get the same income, say Rs. 1000 a month, and the
price level is also the same in both the places. The person in Madras will enjoy a higher standard of living
than the other man living in the jungle town because there are so many good things of life ,which one can
enjoy here and these things may not be available in the jungle town for any price.
3. The concept is useful in the study of value under monopoly. The aim of a monopolist is to make
maximum profit. In fixing the price of his goods, he will try to exploit the consumers as much as possible.
But he has to make some allowance for consumer‘s surplus. Other- wise, he will lose the goodwill of his
customers. It may result in consumer resistance and government interference.
4. It is useful in the field of taxation. It helps us to study the effects of taxes on costs, prices and
profits.
5. Finally, the concept helps us to estimate the gains from inter- national trade. Generally, foreign
goods are cheaper than home- made goods. So naturally people get larger consumers surplus from imported
goods. In intetional trade, where the game is played fairly, all countries gain and no one country loses
anything. The larger the volume of international trade, the greater will be the benefits received by the
consumers.

Unit III
Meaning of production:
In Economics, production refers to the creation of utilities, production can takeplace only with the
combination of factors of production, viz, Land, Labour, Capital and Organization.
Definition of Production.
Production according to Hicks is, ―any activity directed to the satisfaction of other people‘s wants
through exchange‖.
Land and its characteristics.
In the ordinary language land means earth and soil, but in economics it includes not only the solid
surface of the earth, but also anything which man derives from nature such as mines, forests, rivers etc. since

42
no production can take place without the gift of nature it is known as on original factor of production. Land
possess certain peculiarities which are not found in other factors of production.
Characteristics of land.
1. Land is a gift of nature.
2. The supply of land is fixed or inelastic, because human beings cannot increase or decrease its
supply.
3. Land is a static factor of production. This immobility of land results in differences in the
price of land in different places.
4. Land is heterogeneous in character i.e., some lands ere fertile while other may be less fertile
or barren. As a result the rent paid for land differs from to place.
5. Land is permanent in the sense, it cannot be destroyed by man. Ricardo called this as the
‗original and indestructible powers‘ of land.
6. Land is a passive factor of production i.e., land by itself cannot produce anything. It becomes
productive wire the application of capital and labour.
7. Production from land is subject to the law of diminishing returns i.e., if more and more units
of capital and labour are applied to land, the production does not increase in the same
proportion.

Characteristics of labour
Labour is considered the active factor of production. In ordinary parlance, labour means manual
labour or unskilled work. But in economics, it refers to any work undertaken for securing an income or
reward.
Characteristics of labour:
1. Labour is inseparable from labourer. The labourer has to render his labour in person i.e., he has
to be present physically at the place where production takes place. Thus the nature of the place
where he works can influence his efficiency.
2. Labour is perishable and has no reserve price. He has to accept the wages paid based upon
several factors like supply, demand etc.
3. Labour has weak bargaining power because it cannot be stored.
4. Supply of labour is inelastic in the short-run. If there is a sudden increases in demand for labour.
Labour supply cannot be increased suddenly, if all adult population is fully employed. Increase in
supply of labour be brought about only through an increase in population in the long-run.
5. Supply of labour reacts in a peculiar way to changes in its price.
6. Labour differs in productivity or efficiency. Even those who have the same qualification and
training may be different in their efficiency.
7. Productivity of labour can be improved through education and training.
8. Labour is capable of self-employment.
9. Mobility of labour is another characteristic of labour which is unique compared to other factors.
Labour is mobile than capital and land hence it can easily more from one place to another.

Capital and state its characteristics.

Capital can be defined as that part of wealth of an individual or community, other than land, which is
used in the production of goods. Capital is man made resources, which include physical capital assets or
equipments, tools, machines factories, raw materials. According to Marshall, ―Capital consists of those kinds
of wealth, other than the free gifts of nature, which yields income‖.
Characteristics:
Capital has certain peculiar characteristics:
1. Capital is a man-made factor of production. Capital is produced out of savings.
2. Capital is passive factor of production. Like land, capital becomes inactive without labour.
3. Capital is more mobile than other factors of production. It has both place and occupational mobility.
4. Supply of capital is more elastic than other factors of production.
5. Capital increases the productivity of other factors of production.
6. Capital lasts over period of time. It does not disappear.

43
 7. Capital is created out of present sacrifice in the form of savings to produce something in future. Thus
the present sacrifice is the cost of capital which should be related to the future return or productivity
of capital.

Entrepreneur and the functions of an entrepreneur.

Professor Schumpeter defines, ―an entrepreneur is associated with innovations‖. Innovations mean
the practical application of new ideas to reduce the cost of production on to improve the quality of product.
Functions:
An entrepreneur performs three types of functions, namely,
1. Risk & Uncertainty bearing.
2. Control and Management
3. Co-ordination
Bearing of risks:
The entrepreneur bears a variety of risks, which nobody else is prepared. Prof. knight distinguished
between insurable risks and non-insurable risks.
Insurable risks are those of that and fire or accident, which can be ensured against. The entrepreneur
need not bear them. There are other risks, which are not insurable because they are unforeseen risk
following any pattern. Knight called these uninsurable risks as uncertainties.
Control and Management:
The duties of an entrepreneur are
1. Choice of line of production. 5. Scale of production
2. Selection of design and equality 6. Place of Production
3. size of the plant 7. Organisation of sales.
8. Application of innovations
Co-ordination and supervision:
The functions under this are,
1. Obtaining row materials.
2. Selection of proper tools and machinery.
3. Assignment o jobs to workers.
4. Relation with competitive.
5. Distribution of rewards.
6. Relation with Government.

Production Decision:
The theory of production lies at the heart of managerial economics. It forms the foundation for the
theory of supply . Managers are required to make four different but interrelated production decisions:
1.Whether or not to actually produce or to shut down, 2. How much to produce 3. What input combination
to use and 4. What type of technology to use.
Production involves the transformation of inputs- such as capital equipment, labour, and land – into
output of goods and services. In this production process, the manager is concerned with efficiency- technical
and economic in the use of these inputs. And the efficiency goal provides us with some basic rules about the
manner in which firms should utilise inputs to produce desirable goods and services.
In fact the theory of production is just an application of the constrained optimisation technique. The
firm seeks either to minimise the cost of producing a given level of output or to maximise the output
attainable with a given level of cost. It will be evident that both optimisation problems lead to the same rule
for the allocation of inputs and the choice of technology. And the rule is applicable to variable resource
allocation problems.
In fact, the key concept in the theory of production is the production function, which is a technical
relation showing how inputs are converted into output. It is also an economic relation indicating the
maximum amount of output that can be obtained from a fixed amount of resources (inputs).
Definition production function.
The production function expresses a functional relationship between physical inputs and physical
outputs of a firm at any particular time period. Mathematically production function can be written as,
Q  f  A, B,C, D 
44
 Where Q stands for the quantity of output and A, B, C, D are the various input factor such as land,
labour, capital and organisation. Hence output becomes the dependent variable and inputs are the
independent variables.
In order to express the quantitative relationship between inputs and output, production function has
to be expressed in a precise mathematical equation Y  a  bx which shows that there is a constant
relationship between application of input and the amount of output produced.
Assumptions of production functions
The production function is related to a particular period of time.
1. There is no change in technology.
2. The produces is using the best technique available.
3. The factors of production are divisible.
4. Production function can be fitted to short run or to a long run.

Short run and long run production function

Short run production function:
The short run production function is related to the situation where some input factors [e.g. plant,
equipment and land) are fixed and the quantities of one input factor (e.g. labour) are varied. The short run
corresponds to the period of time in which one or more of the inputs are fixed. This input-output relationship
gives rise to the operation of the law of variable proportion.
Long run production function:
The term long run is defined as a sufficiently long period of time in which all factors of production
are varied. In the long period, there is no distinction between short period and long periods. Adjustments
among the various inputs can be easily made in the long period.
The size of the plant, technology etc., which are fixed in short period can be varied in the long
period. In the long run, the firm operations with the changing scale of output and the whole programme can
be manipulated.
Uses of production function.
1. The production function explains how the maximum quantity of output can be produced.
2. It also states the minimum quantities of inputs required to produce a given quantity of output.
3. The knowledge of production function is very much indispensable to managers.
4. The iso-quant curve, iso-cost curves are necessary to choose the optimum factor combination.
5. The iso-cost line plays an important role in determining the combination of factor inputs.
6. The knowledge of production function is very much useful to business economics. It helps in better
management of the industry, better sales and better profitability.

Changes in production.
In order to increase the output of a commodity, either the amount of factors of production is to be
improved upon. Assuming that technique of production remains constant, change in the amount of
production will depend exclusively on change in the amount of factors of production.
When the producer effects a change in his production by increasing or decreasing only one factor of
production and as a result there is a change in the ratio of the factors used, then this proportional relationship
between output and factor input is referred to as Return to a factor.
On the other hand, when the producers changes all the factors of production in the same proportion,
the proportional relationship between output & factor inputs is known as Return to the Scale.

Change in production

Return to sales

Return to a factors

45
Law of Diminishing Returns. (or) Law of increasing cost:
The law of diminishing return is one of the very old laws in economics. Edward West was the first
economist who explained the law. Then classical economists namely AdamSmith, Malthus and Ricardo
studied it with particular reference to agriculture.
The law of diminishing returns states that when an additional variable factor is applied keeping other
factors fixed the marginal return from it must eventually diminish.
Definition of law of diminishing return.
According to Marshall, ―An increase in the amount of capital, and labour applied in the cultivation
of land causes in general a less than proportionate increase in the amount of produce raised, unless it
happens to coincide with an improvement in the art of agriculture‖.
In the words of Boulding, ―As we increase the quantity for any one input which is combined with
fixed quantity of other inputs, the marginal physical productivity of the variable input most eventually
decline‖.
Assumptions:
The main assumptions of the law are:
1. No change in Technology:
First of all, the law is based on the assumption that there is no change in the techniques of
production. If the techniques of production undergo a change, in that case the efficiency of production would
increase.
2. Short Period:
The law is applicable in the short run as supply of one or the other cannot be increased within the
short span of time.
3. Homogeneous units:
All units of variable factors of production are assumed to be homogeneous.
4. Measurement of product:
The output is measured in physical units like tonnes, kilograms etc.
The law of Diminishing returns can be explained with the help of table and diagram.

Units of Units of Labour Total Product Average Product Marginal Product

Land and Capital (TP) (AP) (MP)
10 acres 1 20 20 20
10 acres 2 38 19 18
10 acres 3 54 18 16
10 acres 4 68 17 14
10 acres 5 80 16 12
10 acres 6 90 15 10
10 acres 7 90 12.9 0
10 acres 8 80 10 -10

The above table shows that as more and more units of labour as well as capital are employed on a
given piece of land total product increases at a diminishing rate and the marginal product falls. The marginal
product is 20, 18, 16, 14, 12 respectively in case of units 1 to 5. However, at 7 th unit, marginal product
becomes zero & at 8th it is negative. ie., -10. The average product declines at a very slow rate.

46
 It is clear from the diagram that marginal product decreases with every successive increase of units.
Here OX-axis shows units of labour and capital while OY-axis shows marginal product. It slopes downward
from left to right.
This means that as more and more units of labour and capital are employed, at every successive unit,
yield (marginal product) goes on declining. At 7th unit, marginal product is zero and further declines to the
extent of 10th at 8th unit. Thus, DR slopes from left to right indicating the law of diminishing returns.

Causes for the operation of law of Diminishing Returns:

The causes for the operation of law of diminishing returns are discussed below:
1. Fixed Factors of production:
The law of diminishing returns applies because certain factors of production are kept fixed.
Production is the result of the effective combination of factors of production. Every factor will have to be
increased for obtaining production at an increased rate. If certain factor becomes fixed the adjustment of
factor of production will be disturbed and the production will not increase at increasing rates this law of
diminishing returns will apply.
2. Scarce Factors:
In case of certain factors, particularly land which is itself limited cannot be increased and hence the
law of diminishing returns will apply. It may also happen in case of other factors of production. As a result,
the adjustment of factors of production will be disturbed and the output cannot be achieved at increasing
rate.
3. Lack of perfect substitutes:
There is another reason due to which the law of diminishing returns does apply i.e., lack of perfect
substitutes of factors of production.
4. Optimum production:
After the optimum level of production, more and more variable factors will result in less efficient
combination of fixed as well as variable factors of production. This will reduce the marginal product and
hence the law of diminishing returns will operate.

Law of diminishing returns applicable to agriculture

The law of diminishing returns has a vast application, but it specially applies to agriculture sector.
The most important factors responsible due to which the law is applicable in agriculture are,
1. Limited Land:
The most important factor due to which this law applies to agriculture is the limited size of land.
Production is sought to be increased by employing more and more units of variable factors. This will result
in diminishing returns.
2. Less Use of Machinery:
In agriculture, there is limited use of machinery resulting in low productivity. Thus, the law of
diminishing returns applies to agricultural sector.
3. Natural Factors:
Another reason due is which the law of diminishing returns applies is the natural influence like
rainfall, climate, flood etc.
47
4. Seasonal occupation:
Agriculture is a seasonal occupation. People who engage in farming activities like ploughing and
harvesting remain busy for only six months. For the remaining period, both farmers and cattle remain idle
which reduces the productivity per worker. Thus the law of diminishing returns quickly applies to
agricultural sector.
5. Difference in the Fertility of Land:
When demand for land increases even less fertile land are also brought under cultivation. It means
less marginal returns and high cost of production.
6. Ineffective supervision:
Agricultural operations are spread over the vast areas. Therefore, effective supervision becomes most
risky and difficult. The result is the law of diminishing returns.
7. Less chances of Division of Labour:
In agricultural sector, there are very less chances of division of labour. It also results into the
operation of the law of diminishing returns.
Importance of the law of diminishing returns:
The law of diminishing returns is universal which applies every where. Marshall was of the view
that this law is applicable in every branch of industry or even in all human affairs.
1. Theory of population:
Malthusian theory of population is based on the law of diminishing returns. According to
Malthusian theory, production of foodgrains increases in arithmetical ratio (1, 2, 3, 4, 5, …..) where as
population increases in geometrical ratio (2, 4,8, 16, 32, 64). The reason is that agriculture follows the law of
diminishing returns.
2. Basis of the Theory of production:
The law of diminishing returns helps the producer to calculate the optimum production.
3. Basis of Innovation:
When the new methods of production, new tools, raw materials etc, are innovated, these factors put
a check on the operation of the law of diminishing returns.
4. Basis of the theory of Rent:
According to Ricardian theory, rent arises due to difference in fertility. First dose of labour and
capital applied to land yields more return as compared to second dose. The difference between first and
second dose is called the rent.
5. Basis of the theory of Distribution:
According to marginal productivity theory of distribution, the producer employs more and more
factors of production; the marginal productivity of each factor of production goes on diminishing. Thus, we
can conclude that this law is the basis of the theory of distribution.
6. Importance to industry:
The manufacturing industry has a great significance of the law of diminishing returns in the field of
production. In this industry, the operation of this law can be prevented for a very long period.
Hence, it is clear that the law of diminishing marginal returns plays a significant role in economic
analysis
Limitations of law of diminishing returns
Marshall has explained the law in general terms is not applicable in all cases. Such cases are
discussed as under:
1. New soil:
The law of diminishing returns does not hold good in case of new soil i.e., when the land is
cultivated for the first time because in that production will be certainly high.
2. Improved methods of cultivation:
When the improved methods of production like cropping pattern new seeds, fertilizer,
mechanization and irrigation facilities are used, there are good chances of more production. Thus, there are
chances of increasing returns and not decreasing returns.
3. Shortage of capital:
It we have ample stock of capital, the law of increasing returns would operate and not the law of
diminishing returns.
Law of Increasing Returns.

48
 The law of Increasing Returns was propounded in the seventeenth century by Antonia Seera.
According to this law, ―Production of a commodity increases in a larger proportion as compared to the
increase in the units of factors of production‖.
For instance, we want to increase the production of shoes. The producer increases factors of
production by 20 percent and as a result the production of shoes increases by 35 percent. Thus, we can say
that the production of shoes obeys the law of Increasing Returns. This law is also known as the Law of
Diminishing costs. It means cost per unit of the extra output falls as the industry expands.
Definition
According to Marshall, ―An increase of labour and capital leads generally to improved organization,
which increases the efficiency of the work of labour and capital. Therefore, an increase of labour and capital
generally gives returns which increases more than in proportion‖.
According to Benham, ―As the production of one factor in a combination of factors is increased upto a
point, the marginal productivity of the factors will increase‖.
Assumptions:
The law of increasing return is based on the following assumptions:
1. Some factors of production should be divisible or variable.
2. Arrangement of fixed as well as variable factors can be made more effective.
3. At least one factor of production is divisible.
Explanation of the law:
The law can be explained with the help of following table and diagram.

Units of Labour Total Average Marginal

& Capital Production Production Production
1 16 16 16
2 40 20 24
3 72 24 32
4 112 28 40
5 160 22 48
6 220 36.6 60
.
The above table exhibits that as more and more variable factors are employed, total product
increases at an increasing rate. When we employ one unit of labour and capital, the total production of shoes
is 16 units.
Suppose an additional unit of labour and capital is employed, total production increases to 40 units.
In this way, marginal production of second dose is 24 units. In short, due to the increase in the units of
labour and capital, total, marginal and average production goes on increasing at an increasing rate.

The diagram shows that 4 units labour and capital has been measured on horizontal axis while
marginal productivity on the vertical axis. MP curve slopes upwards from left to right. It shows as we
employ more and more unit of labour & capital marginal product of each factor of production goes an
increasing. It goes upward as shown by IR. This IR curve explains the law of increasing returns.

49
Causes of increasing returns:
Law of increasing returns applies due to the following reasons:

1. Indivisibility of factors of production:

One of the main reason which gives rise to the law of increasing returns is the indivisibility of
lumpiness of factors of production.
2. Division of Labour:
Law of Increasing Returns operates on account of division of labour. When production is carried on
large scale basis, it is possible for a firm to have more complex division of labour and better machinery, i.e.,
it is possible to have complex division of labour and advantageous combination of factors of production
which brings down the cost of production which means the operation of law of increasing returns.
Thus, it can be concluded that the law of increasing returns operates as a result of division of labour
and specialization.
3. Internal and External Economies:
The law of increasing returns operates on account of internal and external economies available in
large scale production.
Law of increasing returns operates in industry:
According to Dr. Marshall, the law of increasing returns is generally applicable to manufacturing
industries as these units are dominated by man. Thus, its main reasons are under stated:
1. Economies of Large Scale:
Initially, more and more units of variable factors with fixed factors are employed, hence productivity
of both the factors increases. On account of several external as well as internal economies accrue to the
producer in the form of innovations, marketing, publicity, management etc. Due to these economies total
cost per unit falls while the total product increases at an increasing rate.
2. Elastic supply:
Generally, in the manufacturing industry, factors of production have elastic supply. It means demand
of each factor can be increased whenever required, which leads to the operation of this law.
3. Division of Labour:
In the manufacturing industry, there is a wider scope for the division of labour. It means production
can be divided and sub-divided in a number of processes. Due to this advantage production is more then the
proportionate increase in factors. Therefore, cost per unit goes on decreasing.
4. More use of machinery:
Another reason for the operation of this law in the manufacturing industry is that there is more use of
machinery than in the agricultural sector. The use of machinery reduces the cost per unit.
5. Innovation:
In the manufacturing industry, new inventions also play a positive role for the operation of the Law
of Increasing returns.
6. Less Impact of Nature:
In manufacturing sector, the nature is not as strong as it is in agricultural sector. Rain, winter and
summer have no effect on industries.
7. Man is supreme:
Man by his technical knowledge and farsightedness has succeeded in deferring the operation of the
law of diminishing returns for a long period. He plays a vital role for using the factors of production in a
more proper way.
8. Proper Management:
In manufacturing sector, more emphasis is given on better management. As a result the production
will rise and cost per unit will decrease.
Law of constant returns.
Prof. Douglas and Cobb in 1928 after studying the industries of America stated that over large
areas of manufacturing industries and agriculture the law of constant returns operates. According to the Law,
when in order to increase output, units of labour and capital are increased, output and cost also increase in
the same proportion.
Definition:

50
 According to Marshall, ―If the actions of law of increasing and diminishing returns are balanced we
have the law of constant returns‖.
Explanation of the law:
The law can be explained with the help of the following table and diagram.

Units of Labour Total Average Marginal

Product Product Product
1 15 15 15
2 30 15 15
3 45 15 15
4 60 15 15
5 75 15 15

The table shows that as the firm increases the factors of production, production also increases in the
same proportion. In this situation, average production and marginal production remain constant. when we
employ labour and capital with fixed factors of production, i.e., 1 to 5 units, total product increases
continuously from 15 to 75 but average product and marginal product remains constant as 15 at every unit.
i.e., 1 to 5.

In the figure units of labour and capital are measured on x-axis whereas marginal production on y-
axis. MP is the marginal product curve is the straight line. It signifies the fact that total production and
marginal increases at a constant rate. The marginal product (CC) curve is parallel to x-axis.
Law of Variable Proportion.
This is the fundamental law of production which consists of three phases namely, the increasing
returns, diminishing returns and negative returns stages of production. This law explains how the amount of
the output changes as the amount of one of the input is varied, keeping other inputs as fixed.
Definition
Marshall likes to refer to the law as ―An increase in the capital and labour applied in the cultivation
of land causes in general a less than proportionate increase in the amount of the produce raised unless it
happens to coincide with an improvement in the art of agriculture‖
Assumptions:
1. The rate of technology remains constant.
2. Only one factor of input is variable and other factors are kept constant.
3. All Units of the variable factor are homogeneous.
4. It is possible to change the proportion of the factors of production.
5. It assumes a short-run situation for in the ling run all productive services are variable.
6. The product is measured in physical units.

Three stages of law:

The behaviour of the output when the varying quantity of one factor is combined with a fixed
quantity of the other can be divided into three distinct stages. These three stages can be understood with the
help of the table.
51
 Fixed Variable Total product Average Marginal
Factor Factor product product
1 1 100 100  
1 2 220 110 
120  Stage I
1 3 270 90
50 
1 4 300 75 30 
1 5 320 64 
20  Stage II
1 6 330 55
10 
1 7 330 47 0
1 8 320 40  Stage III
10 

If the producer hires only 4 labourers, his total product would be 300 units. If instead of 4, he hires 5,
the product will increase to 320 and so on. Both average product and marginal product drops of faster than
average product.
The law is illustrated by means of a figure.

Stage – I
In this stage, the total product increases at an increasing rate. Total product curve (TP) increases
sharply upto the point F, i.e, fourth combination where the marginal product (MP) is at the maximum.
Afterwards ie, beyond F, the total product curve increases at a diminishing rate, as the marginal product
falls, but is positive. So stage- 1 refers to the increasing stage where the total product, the marginal
product and average product are increasing. It is the increasing returns stage.
Stage – II
In the second stage, the total product continues to increase, but at the diminishing rate until it reaches
the points. The marginal product and average products are declining but are positive. The second stage
is the stage of diminishing returns,
Stage – III
In this stage, the total product declines and therefore the TP curve slopes downwards. The marginal
product becomes negative cutting the X axis. This stage is called the negative returns stage.
Thus, the total product, marginal product and average product pass through three phrases viz,
increasing, diminishing and negative returns stage. The law of variable proportion is nothing but the
combination of the law of increasing and diminishing returns.
Law of returns to scale.
In the long run, all factors of production are variable. No factor is fixed. Accordingly, the scale of
production can be changed by changing the quantity of all factors of production.
Definition:
In the words of Koutsoyiannis, ―The term returns to scale refers to the change in output as all factors
change by the same proportion‖.
Assumptions:
The law assumes that
52
 1. All factors are variable and whatever the scale of production the proportion among the factors
remains the same.
2. A worker works with given tools and implements.
3. There is no change in technology.
4. There is perfect competition.
5. The product is measured in physical units.
The law of returns to scale is illustrated in the Table.

S. No Scale Total product of Marginal production or

corn in units Returns in units
1 1 labour + 2 Acres of Land 4 4
Stage I
2 2 labour + 4 Acres of Land 10 6
Increasing
3 3 labour + 6 Acres of Land 18 8
Returns
4 4 labour + 8 Acres of Land 28 10
5 5 labour + 10 Acres of Land 38 10 Stage II
6 6 labour + 12 Acres of Land 48 10 Constant
Returns
7 7 labour + 14 Acres of Land 56 8 Stage III
8 8 labour + 16 Acres of Land 62 6 Decreasing
Returns.

In the above table, 1 labour and 2 acres of land are employed, the total product is 4 units of corn. The
input is doubled, i.e., 2 labourers and 4 acres are employed, and the output of corn is more than double as the
marginal output goes up from 4 units to 6 units.
When the scale is trebled, the total output is more than trebled, the total output is more than treble
and the marginal output goes up from 6 units to 8 units.
When the output is at 4 labourers and 8 acres of land the total output reaches 28 units and the
marginal output has reached 10 units increasing from 8 units. Upto this stage, we have increasing returns.
Till the S. No. 6 the marginal output remains constant at 10 units. This is the second stage or constant
returns stage. Afterwards the marginal output declines to 8 and 6 units. This is the third stage or the
decreasing returns stage. The date presented in the table is shown in the diagram.

Determinition the producer’s equilibrium with the help of iso-cost and iso-quant curves. Or least cost
combination of factors of production.
Meaning of Least cost combination.
In the production process, it is generally possible to change the proportion of the factors of
production. Even this possibility, a firm can have a certain fixed amount of output by using the different
combinations of factor inputs.
For example, if a firm wants to produce 100 metres of cloth daily, it may either employ 15 workers
on one machine or may employ 10 workers using two machines. In this way, a producer may produce the
same amount of output by applying different factor combinations.
The producer of a firm aims at maximization of his profits. This is possible only when the firm‘s
costs are the minimum. So every firm aims at utilizing that combination of factors of production at which its

53
costs are the least. Such a combination is called ‗Least cost combination‘. The producer is in equilibrium
only when he is producing with the least cost combination of factors of production.
Producer’s Equilibrium:
A producer is in equilibrium when his is producing the desired output at the least – possible cost. A
producers iso quant map and his iso-cost lines helps in finding a producer‘s equilibrium..
An iso – product may shows a set of iso-product curve shows different combination of the factors of
production each of which can produce a specified level of output.
An iso – cost line represents the various levels of outlay given by the prices of the two factors. The
producer aims at producing the level of output at which his costs are the least.
The producer o profit maximization firm is in equilibrium when.
a. The slope of the iso-quant curves is tangent to the iso-cost line.
b. At the point of tangency, the iso-quant curve must be convex to the origin.
Assumptions.
1. Labour and capital are the two factors.
2. All the units of labour and capital are homogeneous.
3. The prices of units of labour and capital are given constant.
4. The cost outlay is given.
5. The firm produces a single product.
6. The firm aims at profit maximization.
7. The producer‘s equilibrium point in the least cost combination of two factors of production.
The equilibrium of a producer regarding the choice of combinations of inputs for producing a given
output is shown with the help of diagram.

The above diagram shows that the producer wants to produce 500 units of output. This output can be
obtained by any combination of labour and capital lying on IQ. But the producer will be in equilibrium only
when he will be producing the output at the minimum costs. This he does when the iso-product line P1L1. is
tangent to IQ. Therefore point E is the optimum point or the equilibrium point because here the output of
500 units can be obtained at the least cost.
At other points such as H,K,R & S lie on the IQ, cost is not a minimum. All points on the iso-quant
IQ such as H,K,R, & S lie on iso-cost lines higher than P1L1. It means the production of the same level of
ouput ie, 500 units at higher costs. So the producer will not choose any such combinations as H,K,R and S.
The factor combination E is the least cost combination for producing an output of 500 units. In this
way the tangency point of the given iso-quant with an iso-cost line shows the least cost combination of
factors for producing a given output.
Since the point E in the diagram is lying on IQ, it shows the MRTS of labour for capital. The point E
is on the iso-cost line P1L1. It shows the ratio of the prices of labour and capital. A producer is in equilibrium
where the marginal rate of technical substitution of the two inputs is equal to the ratio of prices of these
inputs. The point E is the figure satisfies the condition that Marginal technical rate of substitution of labour
(L) for capital (K) is
Pr ice of Labour MPPL
MRTKL  
Pr ice of Capital MPPK

54
 It means that the slope of the iso-quant (MRT) must be equal the slope of the iso-cost line.

SUPPLY DETERMINATION
Meaning of supply:
Supply means the commodity offered for sale at a price. Supply is the willingness and ability of
producers to produce for sale various amounts of goods and services at each specific price in a set of
possible prices during a specified period of time.
Definition of Supply.
According to Dooley, ―The law of supply states that the higher the price, the greater the quantity
supplied or the lower the price the smaller the quantity supplied.‖
The law of supply.
The law of supply states that quantity supplied is positively related to price. Firms offer smaller
amounts for sale per time period at lower prices and larger amount at higher prices in search of greater
profits. Thus supply has functional relationship with price. ―Other things remaining the same as the price of
a commodity rises, its supply is extended and as the price falls, its supply is contracted‖.
The law of supply is explained with the help of a schedule called supply schedule. A supply schedule
is a statement of the various quantities of a given commodity offered for sale at various prices per unit of
time. The law of supply can be represented with the help of table.
Price per Kg (Rs) Quantity supplied (In Kg)
1 5
2 10
3 15
4 20
5 25
The schedule represents the prices and quantities offered for sale. As the price of potato per kg rises
from 5 to 25 kg, it can also be shown with the help of a diagram.

In the diagram, OY axis measures price and OX axis quantity supplied. The cure SS is the supply
curve. It slopes upward to the right showing expansion of supply for a rise in price.
Q. What are the exceptions to the law of supply?
Though the case of upward sloping curve is true in all cases, it has its limitations.
1. The law of supply does not apply to rare articles like ancient coins etc. their supply being fixed
cannot change with change in price.
2. The law of supply does not hold good to speculators. They sell less and more at higher and lower
prices respectively in anticipation of profit.
3. Seller will be ready to sell in case of perishable goods.
4. In case seller is hard pressed for cash he will like to sell his stock at the lower price. He may also
lower the price further to attract the purchases.
Changes in supply:-
Extension and contraction of supply in economics do not indicate a change in supply. A change in
supply in economics always means an increase in supply or a decrease in supply.
Extension in Supply.
It is a situation where more units are supplied at higher price. In this case the produces moves along
the same supply curve.
55
 When the price is OD,OA units are supplied. If price rises from OD to OC, the producer would
supply OB units of the commodity. The arrow mark along the vertical axis from D to C shows a rise in the
price level and the arrow mark along the horizontal axis from A to B indicates the extension in supply.
Contraction in supply.
It refers to a condition where less units of the commodity are supplied at a lower price.

Originally the price of the commodity is OC and quantity supplied is OB when the price falls from
OC to OD, only OA quantity is supplied. It means with the fall in price of the commodity, supply has
contracted from OB to OA.
Increase in Supply.
Increase in supply is a situation when more units are supplied at the same price or same quantity is
supplied at a lower price. This is shown by a shift in the supply curve upwards to the right.

In the diagram at the OP price, ON2 units are supplied. That is supply has increased from ON1 to
ON2.
Decrease in Supply:
Decrease in supply show that less units of the commodity are supplied at the same price or the same
quantity is supplied at a higher price. With decrease in supply, the supply curve gets shifted upwards to the
left.
With the shift in the supply curve from SS to S2 S2 , less units (OM1) are supplied at OP price or the
same quantity (OM2)is supplied at a higher price.

56
Factors determining supply.
1. Number of firms or sellers:
Supply in a market depends on the number of firms or sellers producing and selling in the market.
When the sellers are few, the supply will be small, if they are in large numbers, the supply will also be a
large.
2. State of Technology: It is assumed that the level of technology of production remains constant.
Generally, any improvement in technology will reduce the cost of production and consequently there will be
an increase in supply.
3. Cost of production: The cost of production is an important item affecting the supply and so this is
assumed to remain constant wages, rate of interest, prices of machinery and equipment, raw materials etc.
remain unchanged. If the cost of production gets reduced, the supply curve will shift down.
4. Prices of related goods: It is assumed that supply of a commodity depends purely on its price and not on
the prices of other commodities related to it. If prices of related products fall, the firm producing many
goods may increase the supply of a particular product even though its price has not gone up.
5. Price Expectations: It is assumed that the seller sells the commodity or supplies commodity on the basis
of the prevailing prices and he does not expect any change in prices of the commodity.
4. Natural factors: It is assumed that there is no change in natural factor as the supply is governed by
natural factors like rain drought etc. This is so in agro industries.
7. Labour trouble: It is assumed that there is no labour trouble and consequent strike or lock out reducing
the quantity of supply.
8. Change in Government Policy: Any change in government policy will affect the supply. A fresh tax or
levy of excise duty on a commodity will affect the price of the commodity and as a result the supply will get
affected. Hence it is assumed that there is no change in the government policy.

COST CURVES
Meaning of cost:
Cost generally refers to the outlay of funds for productive services. It means the actual expenditure
incurred for acquiring or producing a good or service.
The term “Cost of production‖ means the expenses incurred in the production of a commodity.
The terms cost of production may be used in three different senses. It may mean (i) Money cost (ii) Real
cost, (iii) opportunity cost.

Money Cost:
Money cost of product for the producer would mean the aggregate money expenditure incurred by the
producer on various items entering into the production of a product. E.g. actual wages paid, prices of raw-
materials, full cost, rent for building, rent paid for machinery hired, interest on money bonded. Apart from
the above, there are other items which bought to be included in the money cost. They are,
 Wages for the work performed by the entrepreneur
 Interest on the capital supplied by him
 Rent on land and building belonging to him used for production
 Profits considered normal in that line of business (imputed cost)
 Account considers the cost which involves each payment by the entrepreneur. But economist takes
into account all the cost and it is implicit cost.
57
 Economic cost = Explicit cost + Implicit cost
Economic profit = Total revenue – Economic cost
Real Cost:
The real cost of product would be the efforts and sacrifices undergone by the producer in
producing that commodity but the main difficulty with this concept is that efforts and sacrifices are
subjective phenomenon and this cannot be subjected to accurate measurement. The real cost is useful in
making long run decisions involving problems of major strategy.
Opportunity cost or alternative Cost:
Definition:-
Benham defines opportunity cost as, ―The opportunity cost of anything is the next best alternative
that could be produced instead of the same factors of buy an equivalent group of factors consisting the same
amount of money‖.
Opportunity cost refers to the loss of earnings due to opportunities foregone due to scarcity of
resources. Resources are scarce but have alternative uses with different returns. Income maximizing
resource owners put their scarce resources to their most productive use and foregoes the income expected
from the second best use of the resources.
Therefore, the opportunity cost may be defined as the expected returns from the second best use of
the resources foregone due to the scarcity of resources. The opportunity cost is also called as alternative
cost.
For example, suppose that a person has a sum of Rs.1, 00,000 for which he has only two alternative
uses. He can buy either a printing machine or alternatively, a lather machine. From printing machine, he
expects an annual income of Rs. 20,000 and from the lather, Rs.15, 000. If he is a profit maximizing
investor, he would invest his money in printing machine and forego the expected income from the lathe.
The opportunity cost of his income from printing machine is the expected income from the lathe i.e.
Rs.15, 000. The opportunity cost arises because of the foregone opportunities. In assessing the alternative
cost, both explicit and implicit costs are taken into account.
kinds of cost.
Different types of cost
Total cost of production means the total money expenses incurred for buying the input required for
producing a commodity or a service. In the words of Dooley, ―Total cost of production is the sum of all
expenditure incurred in producing a given volume of output‖.
In other words, total cost includes all payments made in cash to various factors of production and all
those charges which would have otherwise been paid for the use of owner‘s factors of production in
producing a commodity or service.
Total cost is composed of two major elements:
Total Fixed Cost (TFC) and Total Variable Cost (TVC), so TC = TFC +TVC.
Total fixed cost is the expenditure incurred on the purchase of fixed inputs whereas total variable
cost is the sum spent for the variable inputs.
The concept of total fixed cost and total variable cost and total cost can be illustrated with the help of
the following table.

Output TFC (Rs) TVC (Rs) TC (Rs)

0 60 0 60
1 60 100 160
2 60 180 240
3 60 240 300
4 60 340 400
5 60 500 560
6 60 720 780

The following figure illustrates the behaviour of these costs.

58
 Total fixed cost is a horizontal straight line parallel to X axis and it is constant regardless of output
per unit of time. The total cost curve starts from a point on the Y axis. This means that the total fixed cost
will be incurred even if the output is zero.
The total variable cost starts from the origin showing that when output is zero the variable cost is
also nil. The total variable cost curve increases with an increase in output through the rate of variable and
fixed costs. It lies above TVC curve by an amount equal to TFC at all output levels.
Average cost:
Average cost (AC) is the cost per unit of output. It is obtained by dividing the total cost by the total
quantity produced. According to Dooley, ―The average cost of production is the total cost per unit of
output‖.

TC
AC 
Q
Average total cost or average cost is the sum of average fixed cost, and the average variable costs.
The per unit fixed costs are known as the average fixed cost.
TFC
AFC 
Q
Average variable cost refers to the variable cost per unit of output.
TVC
AVC 
Q
The behaviour of ATC curve depends upon the behaviour of AVC and AFC curves. The following
table expresses their relationship

Units TFC AFC TVC AVC AC(AFC+AVC)

0 100 - - - -
1 100 100 50 50 150
2 100 50 90 45 95
3 100 33.33 120 45 73.33
4 100 25.00 140 35 60.00
5 100 20.00 175 35 55
6 100 16.66 230 38.3 54.99
7 100 14.29 310 44.28 58.57
8 100 12.50 400 50.00 62.50

The following figure shows the shape of AFC, AVC and ATC

59
 In the beginning both AVC and ATC fall. So ATC curve also falls. When AVC curve begins rising
but AFC curve is falling steeply, the ATC curve continues to fall. Because during this stage the fall in AFC
is heavier than the rise in AVC, But as output increases further there is a sharp rise in AVC which more than
offsets the fall in AFC. Therefore, the ATC curve rises after a point. The ATC curve like AVC curve falls
first reaches the minimum value and then rises. Hence it has taken U-shape.
Marginal Cost:
Marginal cost is the addition to the total cost by the last unit of output. It is addition to the total cost
of producing ‗n‘ units instead of n-1 units. Symbolically,

MCn = TCn – TC n-1

According to Dooley, ―Marginal cost is the change in total cost associated with a change in output‖.
Changein total cos t TC
Marginal cost = =
Changein output Q

Units of output TC = TFC + TVC Mc = (TCn – TCn-1)

1 60 -
2 70 10
3 76 6
4 78 2
5 84 6
6 90 6
7 108 18
8 130 22

Three important points are to be remembered in the analysis of marginal cost.

1. The shape of the cost curve is determined by the law of variable proportion. If increasing returns
is in operation, the marginal cost curve will be declining as the cost will be decreasing with the
increase in output. When the diminishing return is in operation the MC curve will be ascending
as it is a situation of increasing cost.

60
 2. The change in the marginal cost is due to changes in the variable cost when the output is
increased or decreased and MC is independent of the fixed cost.
3. The price of the variable factor remains constant as the firm expands its output. Otherwise, a
change in factor price may disturb our conclusions.

Cost classification.
Opportunity costs Vs Outlay costs.
Opportunity costs are the costs of displaced alternatives. Opportunity costs are the costs of displaced
alternatives. They represent only sacrificed alternatives and hence are not recorded in any financial accounts.
Outlay costs on the other hand, are those costs which involve financial expenditure at some time and
hence are recorded in the books of account. For example, actual wages paid cost of materials purchased,
interest paid etc.
Real costs Vs Money cost.
Money cost of product for the producer would mean the aggregate money expenditure incurred by the
product on various items entering into the production of a product.
The real cost of a product would be the efforts and sacrifices undergone by the producer in producing
that commodity but the main difficulty with this concept is that efforts and sacrifices are subjective
phenomenon and this cannot be subjected to accurate measurement. The real cost is useful in making long
run decisions involving problems of major strategy.
Past Vs Future costs
Past costs are actual costs incurred in the past and generally find place in the books of the accounts.
These costs are incurred by the firms at the time of purchase of specialized plant or equipment past costs are
beyond the control of management.
Future costs are costs that are likely to be incurred in future periods. Managerial decisions are
always forward looking and therefore, they require estimates of future costs and not past costs. The
management can have control over future costs and hence these costs can be planned or avoided.
Traceable Vs Common Cost
A traceable cost is one which can be identified easily and indisputably with a unit of operation, e.g.
product, a department or a process.
Common costs are used broadly to cover costs that are not traceable to individual final products.
For example, electricity charges may not be separable, department-wise in a single product firm or even
product wise in a multiple product firm.
Out –of pocket Vs Book Costs.
Out-of packets cost or cash costs refer to those costs which require immediate and current payments
to outsiders. Example, Salaries paid to the staff, electricity bill, payments made to other productive
services, the purchase price of a new equipment etc.
Book cost on the other hand, are those costs which do not require current cash expenditure. For
example, wages and salaries paid to the employees are out-of-pockets costs while salary of the owner
manager, if not paid, is a book cost.
Incremental Costs Vs sunk costs.
Incremental costs refer to the additional costs incurred due to a change in the level or nature of
activity. A change in the activity may occur in various forms such as addition of a new product, change in
the distribution channels, addition of new machine, expansion of market area etc. Incremental costs are also
known as differential costs.
Sunk cost is one which is not affected or altered by a change in the level or nature of business
activity. It will remain the same whatever the level or nature of business activity. It will remain the same
whatever the level of activity. It is also known as specific cost. The best example of sunk cost is
depreciation allowance.
Escapable Vs Unavoidable costs.
The distinction between escapable and unavoidable costs is based on the contraction of business
activity. Escapable costs refers to those costs which can be avoided by a reduction in the business
activities of a firm unavoidable costs are those costs which cannot be avoided by reduction in the business
activities of a firm.
Shut down Vs Abandonment Costs.

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 Shut down costs are those costs which would be incurred in the event of suspension of the plant
operations and which would be saved if the operations are continued. Example, of such costs are the costs
of sheltering the plant and equipment and construction of sheds for storing exposed property, abandonment
costs on the other hand, are those costs which are incurred in abandonment costs, on the other hand, are
those costs which are incurred in abandoning a particular fixed asset from service. For example on has to
abandon the activity on such mines which do not yield any minerals after a certain stage.
Urgent and Postponable Costs
Urgent costs are those costs which must be incurred in order to continue operations of the firm. For
example, the costs of raw materials and labour must be incurred if production is to take place. Postponable
costs, on the other hands, are those costs which can be postponed for the time being. For example, painting
and white washing the factory building, replacing an old machine by a new one can be postponed.
Controllable and Non-Controllable Costs
Controllable costs are those costs which can be controlled by an executive on whom the
responsibility of cost is vested. It depends on the level of management. Non-Controllable costs, on the other
hand, are those costs which are beyond regulation.
Historical Cost Vs Replacement cost.
The historical cost of an asses is the actual cost incurred at the time that asset was originally
acquired. In contrast to this replacement cost is the cost which will have to be incurred if that asset is
purchased now.
Private Vs Social Cost.
Private costs are those which are actually incurred or provided for by an individual or a firm on the
purchase of goods and services from the market. Social costs on the other hand imply the total cost to the
society on account of production of a commodity.
Cost and output relation in the short run cost analysis.
The cost of production depends on many forces and an understanding of the functional relationship
of cost to various forces will help us to provide the informational foundation for different cost forecasts.
The relation between the cost and output is technically described as the cost function. In economic
theory there are mainly two types of cost functions viz,
(i) The short run cost function and
(ii) The long run cost function.
SHORT- RUN COST – OUTPUT RELATIONSHIP:
The short-run cost – output relationship refers to a particular scale of operation or to a fixed plant.
That is it indicates variations in cost over output for the plant of a given capacity and this relationship will
vary with plants of varying capacity. Hence, the short run function relating cost to output variations is of the
following type:
TC = f(x) + A

Where TC = Total cost

A = Total fixed cost
F(x) = Total variable cost.
The short –run cost out put relationship needs to be studied in terms of
(a) Fixed cost and output.
(b) Variable cost and output
(c) Total cost and output.

Fixed cost does not vary with output. The larger the quantity produced, the lower will be the fixed cost
per unit and marginal fixed cost will always be zero. The following table shows that the total fixed cost is
same irrespective of the units of output and the average cost declines monotonically as output increases.
Rate of TFC TVC TC AFC AVC AC MC
Output Rs. Rs. Rs. Rs. Rs. Rs. Rs.
Units
0 1000 0 1000 - - - -
1 1000 200 1200 1000 200 1200 200
2 1000 367 1367 500 184 684 167
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 3 1000 510 1510 333 170 503 143
4 1000 677 1677 250 169 419 167
5 1000 877 1877 200 175 375 200
6 1000 1127 2127 167 188 355 250
7 1000 1460 2460 143 209 351 333
8 1000 2460 3460 125 307 432 1000

The total variable cost increases as output increases. However the relationship may not be linear i.e
cost may not increase by the same amount for every unit increase in output.
The behaviour of average variable cost function will be such that it will first fall as output increases,
and then remain constant for some output range and it will eventually rise with every increase in output.
Since the total fixed cost does not change with output, marginal cost equals change in total variable
cost. The variations in marginal cost in relation to output will be similar to that in average variable cost.
The total cost increases as output increases for one of its components TVC is an increasing function
of output and its only other component TFC takes a given value at all levels of output.
The average total cost (ATC) also called AC, first falls as output increases, then remains constant for
some output range and eventually rises with every increase in output. This is due to the behaviour of its two
components AFC and AVC and AVC,
At very low quantities. ATC is high because fixed costs are spread over a few units. As quantity
increases, variable factors can be used more efficiently and a point is reached for any given plant size where
ATC is at a minimum. This point gives the optimum level of output from the cost point of view. After this
point, ATC increases. The increase occurs because variable factors cannot be used as efficiently as before.
When the advantage of lower AFC is out weighted by the increase of AVC, ATC increases.
The relationship among AVC, ATC and MC can be explained with a help of a following figure.

The short-run cost output relationship can be established as.

1) AFC falls as output rises from lower levels to higher levels.
2) AFC first falls and then rises, so also the ATC curve.
3) The AVC curve starts rising earlier than ATC curve.
4) The least cost level of output corresponds to the point ‗L‘ on ATC curve.
5) The marginal cost curve intersects both the AVC curve and the ATC at their minimum points.

Long run cost-output relationship.

Firms operate in the short run but plan in the long run. In the long run, all the inputs become
variable. There is no fixed factor of production and hence there is no fixed cost. The long run output
relations therefore imply the relationship between the total costs and the total output.
In the long run, the firm can choose the combination of inputs that minimizes the cost of producing a
desired level of output. Input – output relations in the production function are those of returns to scale. The
long run costs would refer to the cost of producing different levels of output by changes in the size of plant
or scale of production.
The long-run cost output relationship is shown by drawing a long run cost curve as the long period is
made up of many short periods. The long run cost function contains a family of short-run cost functions.
The pertinent question here is, what is the relationship between total cost for a given output and plant
size. This relationship is not unidirectional. If the output is small, the total cost is less for a small plant size.
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This relationship is not unidirectional. If the output is small, the total cost is less for a small plant size than
for a large plant size and quite the reverse holds good for large outputs.
This is so because of a large plant is installed it will remain under-utilize, when output is small while
a small plant will be inadequate or insufficient for large outputs. Thus, the family of short-run average cost
curve forms the long run cost curve. Hence, the long-run cost curve is an envelope of the family of short run
cost curves.

In the long run the firm moves from one plant to another plant, as the scale of operation is altered, a
new plant is added. The long run cost of production is the least possible cost of production of producing any
given level of output, when all inputs become variable, including the size of the plant. The curve LAC
depicts the least possible average cost of production at different levels of output. It is the cumulative picture
of short run average cost curves. The short run average cost curves are also called plant curves, since in the
short run SAC curve corresponds to a particular plant. The existence of economies and diseconomies of
scale are responsible for the ‗U‘ shaped LATC curve.
But the empirical evidence shows that modern firms face L shaped cost curve than U shaped. The
long run L- shaped cost curve is shown in the following figure.

In the above figure, over AB range the curve is perfectly flat. Over this range all sizes of plant have
the same minimum cost.
In managerial decision making the usefulness of the LAC curve lies in its ability to assist the
management in the determination of the best size of the plant to construct when a new one is being built or
an old one is being expanded. As the long run cost curve can help the entrepreneur in planning the best scale
of plant, or the best size of the firm for his purposes, it is also known as the planning curve.
Relationship between the different cost concepts in the short period.
In the short period we have a set of cost concepts which are interrelated with each other.
1. Average fixed cost.
2. Average variable cost.
3. Short run average cost.
4. Short run marginal cost.

1. Average fixed cost:

Fixed cost is a fixed amount that does not change with variations in output. As output increases,
average fixed cost goes on falling. AFC curve is shown as rectangular hyperbola.
2Average variable cost:

64
 Dividing total variable costs with corresponding ou6tput gives us average variable cost. On account
of the operation of the low of variable proportions, the AVC curve is U-shaped.
3. Short-run Average cost (SAC)
The addition of fixed and variable costs gives us total costs, which when divided by output, give us
average cost in the short run. The shape of SAC is governed by AVC. Being dependent on AVC mainly, the
SAC curve is also U-shaped.
4. Short-run marginal cost (SMC)
Marginal cost means the addition made to total cost on account of the production of one more unit of
output. The marginal cost curve falls faster than the average cost curve and also rises faster than the average
cost curve. The marginal cost curve always intersects the average cost curve from below at its minimum
point.

Distinction between short run and long run average cost.

 The long run average cost can‘t be higher than the short run average cost for a given output.
 The long run average cost can‘t cut any short run average cost but they will be only tangential to
each other.
 LAC curve is not tangent to the short run average cost at the minimum point except in the case of
lowest short run average cost curve.
 The LAC and SAC both are ‗U‘ shaped, LAC is boat shaped.
 The relationship between the two shows that it is not possible to produce a given output in the
short run, it can be done only in the long run.

Internal economies and External economies or the role of internal and external economies in
promoting the maximum production in a firm.
Prof. Stigler defines economies of scale as synonymous with returns to scale. As the scale of
production is increased, upto a certain point, one gets economies of scale. Economies of scale can be
classified as internal economies and external economies.
Internal Economies.
As a firm increases its scale of production, the firm enjoys several economies named as internal
economies. Basically internal economies are those which are special to each firm. These solely depend on
the size of firm and will be different for different firms. For example, one firm will enjoy the advantage of
good management; the other may have the advantage of specialization in the techniques of production and
so on. Prof. Koutsoyannis has divided the internal economies into two parts.
(B) Real Economies and (B) Pecuniary Economies.
(A) Real Economies:-
Real economies are those which are associated with the reduction of physical quantity of inputs, raw
materials, various types of labour and capital etc. Some of these economies are,
Technical Economies:
Technical economies accrue to large firms which enjoy higher efficiency from capital goods or
machinery. Technical economies are of three kinds:
(i) Economies of Dimensions: A firm by increasing the scale of production can enjoy the technical
economies. When a firm increases its scale of production, average cost of production falls but its
average return will be more.
(ii) Economies of linked Process: A big firm carries all productive activities. These activities get
economies. These linked activities save time and transport costs to the firm.
(iii) Economies of the use of By-products: All the large sized firms are in a position to use its by
products and waste material to produce another material and thus, supplement their income. For
instance, sugar industries make power alcohol out of the molasses.
2. Marketing Economies
When the scale of production of a firm is increased, it enjoys numerous selling or marketing
economies. In the marketing economies, advertisement economies, opening up of show rooms, appointment
of sole distributors etc are included.
3. Managerial Economies:

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 Managerial economies refer to production in managerial costs and proper management of large scale
firm. Under this, work is divided and sub divided into different departments. Each department is headed by
an expert who keeps a vigil on the minute details of his department. Experts are able to reduce the costs of
production under their supervision. These also arise due to specialization of management and mechanization
of managerial functions.
4. Labour Economies;
As the scale of production is expanded there accrue many labour economies, like new inventions,
specialization, time saving production etc.
5. Economies of Transport and storage:
A big firm can have its own means of transportation to carry finished as well as raw material from
one place to another. Moreover, big firms also enjoy the economies of storage facilities.
(B) Pecuniary Economies.
Pecuniary Economies are those which can be had after paying less prices for the factors used in the
process of production and distribution. But firms can get raw material at the low price because they buy the
same in the large bulk. In the same way, they enjoy a lot of concessions in bank borrowing and
advertisements. These economies accrue to a large firm in the following way.
1. The firms producing output on a large scale purchase raw material in bulk quantity and get a
special discount from suppliers. This is a monetary gain to the firm.
2. The large scale firms are offered loans by the banks at a low interest rate and other favourable
terms.
3. The large scale firms are offered concessional transportation facilities.
4. The large scale firms advertise their products on large scales and they are offered advertising
facilities at lower prices.
External Economies:
External economies refer to all those benefits which accrue to all the firms operating in a given
industry. These economies accrue due to the expansion of industry and other facilities expanded by the
government. Prof. Cairn cross has divided the external economies into the following parts namely,
1. Economies of Concentration:
As the number of firms in an area increases each firm enjoys some benefits like, transport and
communication, availability of raw materials, research and invention etc.
2. Economies of Information:
When the number of firms in an industry expands they become mutually dependent on each other.
Many scientific and trade journals are published. These journals provide information to all the firms which
relates to new markets, sources of raw materials, latest techniques of production etc.
3. Economies of Disintegration:
An industry develops, all the firms engaged in it decide to divide and sub-divided the process of
production among themselves. For instance, incase of moped industry, some firms specialize in rims, hubs
and still others in chains, pedals, types etc. It is of two types‘ horizontal disintegration and vertical
disintegration.
In case of horizontal disintegration each firm in the industry tries to specialize in one particular item
whereas under vertical disintegration every firm endeavors to specialize in different types of item.
4. Economics of localization:
The localization of an industry means the concentration of firm predicting identical product in a
particular area. In such an industrial area, railways establish an outer parcel agency, post and telegraph
department sets up the post office, state electricity department installs a powerful transformer and transport
companies also establish their good booking officer. As a result, all the firms get these facilities at low
price, and the average cost of production in the industry declines.
5. Economics of By-products.
The growth and expansion of an industry would enable the firms to reduce their cost of production by
making use of waste materials. These wastes are conversed into by-products. The selling firms reduce their
cost of production by realizing something for their wastes. The buying firms gain by getting other firm‘s
wastes as raw materials at cheaper rates. As a result of this the average cost of production declines.
Q. Explain in detail the external and internal diseconomies of scale of production.

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 The word diseconomies refer to all those losses which accrue to the firm in the industry due to the
expansion of their output to a certain limit. These diseconomies arise due to the use of unskilled labourers,
outdated methods of production etc. Diseconomies are also of two types, viz.
1) Internal Diseconomies 2) External Diseconomies
Internal Diseconomies:
Internal diseconomies implies to all those factors which raise the cost of production of a particular firm
when its output increases beyond the certain limit.
(a)Inefficient Management:
The main cause of the internal diseconomies is the lack of efficient or skilled management. When a firm
expands beyond a certain limit, it becomes difficult for the managers to manage it efficiently or to co-
ordinate the process of production.
(b) Technical difficulties.
If a firm operates beyond optimum point, technical diseconomies will emerge out . for instance, if an
electricity generating plant has the optimum capacity of 1 million kilowatts of power, it will have lowest
cost per unit when it produces 1 million kilowatts, beyond, this optimum point, technical economies will
stop and technical diseconomies will result.
(c) Production diseconomies:
These diseconomies of production manifest themselves, when the expansion of a firm‘s production
leads to rise in the cost per unit of output. It may be due to the use of interior or less efficient factors as the
efficient factors are in scarcity.
(d) Marketing Diseconomies: After an optimum scale, the further rise in the scale of introduction is
accompanied by selling diseconomies. It is due to many reasons. For example, the advertisement
expenditure is bound to increase more than proportionately with scale.
(e) Financial Diseconomies: If the scale of production increases beyond the optimum scale, the cost of
financial capital rises. It may be due to relatively more dependence on external finances.
External Diseconomies:
External diseconomies are not suffered by a single firm but by the firms operating in a given
industry. These diseconomies arise due to much concentration and localization of industries beyond a certain
stage. For example, localization leads to increased demand for transport and therefore transport costs rise.
The external diseconomies are as follows.
(a) Diseconomies of pollution: The localization of an industry in a particular place or region pollutes the
environment. The polluted environment acts as health hazard for the labourers. Thus the social cost of
production rises.
(b) Diseconomies of strains on Infrastructure: The localization of an industry puts excessive pressure on
transportation facilities in the region. As as result of this, the transportation of raw materials and finished
goods gets delayed. As a result of the strains on infrastructure, monetary as well as real costs of production
rise.
(c ) Diseconomies of High Factor Prices: The excessive concentration of an industry in a particular
industrial area leads to increase in price of the factors of production go up. Hence, the expansion and growth
of an industry would lead to rise in costs of production.

REVENUE CURVES

Q. What do you mean by revenue?

The amount of money which the firm receives by the sale of its output in the market is known as its
revenue.

Q. What is total revenue?

Total revenue refers to the total amount of money that the firm receives from the sale of its products.
It is the gross revenue realized by the firm in selling the output. The total revenue can be calculated by
multiplying the quantity of output by the price per unit over a period of time.

Q. What is Average Revenue?

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 Average revenue is total revenue divided by output. It is nothing but the sale price of the product.

Total Re venue
Average Revenue  Pr ice 
Total Output
Q. What is Marginal revenue?
Marginal revenue is the change in total revenue resulting from an increase in sale by an additional
unit of the product in a particular time.

MR n  TR n  TR n 1
Q. Explain the relationship between TR, MR and MR under perfect and imperfect
competition.
In perfect competition, the individual firm cannot influence the market price and whatever quantity is
produced and sold, it will be for the prevailing market price. Hence the total revenue of the firm would
increase proportionately with the output offered for sale. When the total revenue increases in direct
proportion to the sale of output, the average revenue would remain constant.
Since the market price is constant without any variation due to the changes in units sold by the
individual firm, the extra output would fetch the proportionate revenue, so the MR and AR will be equal and
constant. This will be equal to the price. In such a case, the marginal revenue curve will be a straight line
parallel to x axis. The same curve denotes average revenue and it represents the price of the unit sold.
The following table and diagram shows the AR and MR under perfect competition.

Number of units sold Price of Average revenue. Total Revenue Marginal Revenue.
1 5 5 5
2 5 10 5
3 5 15 5
4 5 20 5
5 5 25 5
6 5 30 5

The table shows that the price and AR are equal and constant. The total revenue proportionately
varies with the output. The marginal revenue is equal to average revenue and price. This is the case under
perfect competition. The AR and MR curves are depicted in the following diagram. OP is the price which is
equal to AR & MR.

Revenue curves of the firm under imperfect competition

In the case of imperfect competition, be it monopoly, monopolistic competition or oligopoly. The

AR curve of an individual firm will slope downwards. Under imperfect competition, a firm can sell large
quantities only when it reduces the price. When the output is increased for selling, the average revenue or
the price will be declining. So the AR curve will be a declining curve. It will decline in the same fashion as
the demand curve.

The table gives the table revenue, average and marginal revenue under imperfect competition.

Number of Total revenue Average Revenue or Marginal Revenue

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 units sold
1 10
2 18
3 24
4 28
5 30
6 30
price
10 10
9 8
8 6
7 4
6 2
5 0

The table indicates the average revenue or price as the output is increased from 1 to 2, 3, 4 etc, the
price has to be reduced to get adequate demand and consequently the AR is continuously falling from 10 to
9,8,7 etc.

When the price comes down, the total revenue realized is increasing at a diminishing rate and after
the 5th unit, the total revenue does not change. Consequently the marginal revenue diminishes with increase
in output. As the sixth unit the MR comes to zero.

If seventh unit is produced and sold, it will result in negative marginal revenue.

Based on the table, the AR curves are given in the following diagram.

The curves show that AR is declining and MR is also declining. The MR curve lies below the AR
curve. When AR is falling, MR is also falling and it is falling very steeply.

The AR and MR curves need not be a straight line. They may be either convex or concave to origin.
But in all cases the MR curve will always lie below the AR curve.

Q. Explain and illustrate a Break – even analysis And Point out the
usefulness and also its limitations.
Meaning of Break – Even Analysis:
Break even analysis studies the relationship between the volume and cost of production on the one
hand, and the revenue and profits obtained from the sales on the other hand.
In the break – even analysis, the role of break-even point is of particular importance. The break-even
point is the point at which total revenue and total costs are equal. Net income is zero.

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 In case the firm produces and sells less than that suggested by the break-even point, it would incur
losses, if it produces more than the level suggested by the break even point, it makes profits.

Assumptions

The break-even analysis is based on a set of assumptions as following.

 It assumes that cost can be classified into fixed and variable cost. It ignores semi-variable cost.
 All revenue is perfectly variable with the physical volume of production.
 The volume of sales and the volume of production are equal.
 The price of the product is assumed to be constant.
 It assumes constant technology and no improvement in labour efficiency.
 It assumes constant rate of increase in variable cost, thereby giving rise to a linear total cost
curve.
 Changes in input prices are ruled out

Determination of Break-even point:

The Break Even chart:

Break-even chart is very useful in the break-even analysis as it helps the management in predicting
the profit or loss implications at different levels of sales. A break-even chart is a graphical technique to
show the short-run relation of total cost and revenue to output as shown in the following diagram.

The horizontal axis shows output and the vertical axis indicates costs and revenue. Both the total cost
(TC) and total revenue (TR) curves are shown as linear. TR curve is linear because of the assumption of
constant valuable costs. TR curve is drawn as a straight line from the origin because every unit of output
contributes constant amount to total revenue. TC curve is a straight line starting from the y axis because
total cost includes fixed and variable costs. The break-even point is the point of intersection between TR and
TC curves.

Below the break-even point, total costs are more than total revenue and the firm would suffer a loss.
Above the break-even point, total revenue exceeds total cost and the firm would be making profits. Since
profit or loss occurs between cost and revenue lines, the space between them is known as the profit zone and
the loss zone.

Calculation of the Break-even point:

Break-even point may also be analyzed in terms of volume of output. The break-even point is the
number of units of the commodity that should be sold to earn enough revenue just to cover all the expenses
without incurring a loss. The break-even point is illustrated by means of table.

Total Revenue, Total cost and BEP.

Output in Units Total Revenue Total Fixed Cost Total variable Cost Total Cost
0 0 150 0 150
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 50 200 150 150 300
100 400 150 300 450
150 600 150 450 600
200 800 150 600 750
250 1000 150 750 900
300 1200 150 900 1050
(Selling price = Rs 4 per unit)

When the output is zero, the firm incurs only fixed cost. When the output is 50, the total cost is Rs.
300. The total revenue is Rs.200. The firm incurs a loss of Rs. 100. Similarly when the output is 100, the
firm incurs a loss of Rs.50. At the level of output 150 units the total revenue is equal to total cost. At this
level the firm is working at a point where there is no profit or loss. This is the break-even point. From the
level of output of 200, the firm is making profit.

BEP in terms of physical units of output.

There is another way of finding out BEP in terms of physical units of output. Instead of using total
revenue and total cost, we can use average revenue and average cost. The break-even point is that level of
output at which the price of the product (AR) covers the average cost.

The price should cover average variable cost and a portion of average fixed cost. The excess of
selling price over average variable cost goes towards meeting some portion of the fixed cost. This excess
cost is called contribution margin. So, the BEP will be at a point where the total contribution margin is equal
to the total fixed cost
Total fixed costs
BEP 
Contribution margin per unit

Contribution margin can be found out by deducting the average variable cost from the selling price, so

Total fixed costs

BEP 
Selling price - AVC

For example, the total fixed cost is Rs.150. the selling price is Rs.4. and the average variable cost is Rs.1.
So,.
150
BEP   150
4 1
The break-even point on the basis of formula comes to 150 units of output.

The break-even point in terms of physical output is suitable only in the case of single product firm.
In case of multi product firms, the break-even point can be analyzed only in terms of money value, or total
sale value or total revenue. The contribution margin is expressed as a ratio to sales

Total Re venue  Total Variable cos t 600  450 150

The Contribution Ratio     0.25
Total Re venue 600 600
The contribution ratio is 0.25

Total Fixed Cost 150

The Break  even Point    Rs.600
Contribution Ratio 0.25

The firm actives its BEP when its sales are Rs. 600
Total Revenue = Rs.600
Total Cost = Rs. 600
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 Net profit/loss = Nil

Contribution margin is the difference between receipts and variable expenses.

Total contribution margin (TCM) = Total Revenue (TR) – Total variable cost (TVC)

Limitations:
1. Break-even analysis is based on past data. It is based on the assumption that input price like material
price, wage etc, remain constant. But change over time.
2. The break-even analysis assumes that the product prices are given. In fact, the product price changes
frequently.
3. The break-even analysis is static as it assumes a constant relationship of output to costs & revenue.
4. The relative share of different products is the total output is assumed to be constant. But in practice,
there occurs frequent changes in the composition of demand and product mix.
5. The break-even analysis assumes that profits depend on output alone. But profit depends on various
factors like technological improvement.
6. The break-even analysis is based on accounting data. Hence it suffers from many limitations like
omission of imputed costs.
7. The break-even analysis ignores selling costs and only concentrates over the production costs.
8. Selling costs are especially difficult to handle in break-even analysis. This is because changes in
selling costs are a causes and not a result of changes in output & sales.
9. A straight-line total revenues curve implies that any quantity might be sold at that one price. But
calculations are often made at several price levels.
10. The area included in the break even analysis should be limited. If too many products, too many
departments or too many plants are lumped together in a single break-even chart, it will not give a
clear picture.

Q. Explain the Usefulness of Break-Even Analysis.

The break-even analysis provides a microscopic picture of the profitability of a business enterprise.
The break-even analysis may be used for the following purposes.

1. Safety Margin:

The break-even chart helps the management to know the profits generated at the various levels of
sales. While deciding about the volume of output and sales, the management should consider the safety
margin. Safety margin refers to the extent to which the firm can afford a decline in sales before it starts
incurring losses. The safety margin can be found out by the following formula

Sales  BEP
Safty M arg in  100
Sales
From the numerical example, at the level of 250 units of output and sales, the firm is earning profit.
Safety margin can be found out by applying the above formula.

250  150
Safty M arg in  100  40%
250
This means, that the firm can afford to lose sales upto 40% of the present level before incurring a
loss. A margin of safety may be negative also. In such case, it tells the extent of sales that should be
increased in order to reach the point at which there will be no loss.

2. Target Profit:
The break-even analysis may be used for determining the volume of sales necessary to achieve a
target profit. The formula is

72
 Fixed cost + Target profit
Target Sales Volume=
Contribution Margin per unit
Suppose the firm fixes the profit as Rs.100, then the volume of output and sales should be 250 units.
Only at that level it gets a profit of Rs.100.

3. Change in Price:

The firm will have to take decision regarding a reduction in price for the commodity. A reduction in
price will lead to a reduction in contribution margin. Therefore, volume of sales will have to be increased to
get the previous level of profit.
Reduction in price may not lead to increased sales as it depends on the elasticity of demand for the
product. Assuming that the elasticity of demand remains constant the management has to take decision
regarding the increase of volume of output in order to maintain the previous level of profit. The formula for
determining the new volume of sales to maintain the same profit, given a reduction in price, will be as
follows.

Total fixed cost + Target profit

New Sales Volume=
New selling price - Average variable cost

If the total fixed cost of a firm is Rs.8000. the profit target RS.20, 000, the sales price is Rs.8 and the
average variable cost is Rs.4, then total volume of sales should be 7000 units. On the basis of the formula
given for target profit. Suppose the firm decides to reduce the price from Rs.8 to RS.7, the new sales volume
would be,
8,000+20,000 28, 000
New Sales Volume=   9,333
7-4 3
Thus, the firm has to increase its sales to 9333 units to maintain the target profit Rs.20,000.
4. Change in Costs:
When costs change, selling price and the quantity produced and sold undergo changes. Changes in
costs can be in two ways.
1. Change in variable costs and
2. Change in non-variable costs of fixed costs.

The impact of an increase in variable cost is to push up the total cost. As a result, contribution
margin declines. This decline in the contribution margin will shift the break-even point downwards.
Conversely, with the fall in the proportion of variable costs, contribution margin increase and the break even
point moves upwards. When the variable cost changes the business executives has to decide about the new
price or the new sale volume to maintain at least the previous levels of profit.

Contribution Margin
The New sale volume =
Present selling price - New variable cost per unit
And the

New Sales price = (present sale price + new variable cost- present variable cost).

5. Make or buy decision:

The break-even analysis also helps to decide whether components which are part of their finished
products should be manufactured by themselves or bought from outside firms. For example, a manufacturer
of car buys a certain part at Rs.40 each. If he decides to manufacture it himself his fixed cost would be
Rs.48000/- variable cost Rs.16/- per unit.

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 Fixed Cost 48, 000 48, 000
BEP=    2, 000 units
Purchase price - variable cost 40  16 24

The manufacturer can produce the parts himself if he needs more than 2000 units per year. If his
requirement is less than 2000, it is better to buy from outside the firm.

6. Advertising decisions:

The management has to examine the effects of different levels of advertising expenditure and
different modes of advertisement. The break even concept helps the management to know about the
circumstances under which the decision has to be taken. Thus it helps the management to decide about the
best promotion – mix policy. The effect of additional advertisement expenditure is show in the following
diagram.

The advertisement cost pushes up the total cost curve by the amount of advertisement expenditure. It
is evidence, that after advertisement expenditure, the break-even sales have increased from Q to Q1.
7. Expansion of productive capacity:

The break-even analysis may be utilized to find out the effect of a change in operating conditions on
cost, volume and profits. For example, a company has the capacity to produce goods worth Rs.40 crores a
year, with a fixed cost of RS.10 crores the variable cost being 60% of sales revenue. It decides to expand its
productive capacity from Rs.40 crores to Rs.60 crores at an additional cost of Rs.6 cores. By doing so, the
firms sales can be increased from Rs.40 cores to Rs.50 cores within a reasonably short period of time. In this
situation, the break-even analysis helps the firm to take a decision regarding expansion

Fixed Cost Rs.10crores

Break even point at present capacity=   Rs.25 crores
Marginal Contribution % 40%

Rs.16crores
Break even point at proposed capacity=  Rs.40 crores
40%

Increase in break even point = Rs.15 Cores

Thus the firm should go in for expansion only if its sales expand by more than Rs.15 cores from its
earlier level of Rs.40 cores.

8. Plant shut-down decision:

In the shut-down decisions a distinction should be made between out of packet and sunk cost. Out of
pocket costs include all the variable cost plus those fixed costs which do not vary with output. Sunk fixed
costs are the expenditures previously made but from which benefits still remain to be obtained e.g.
depreciation. The out of pocket cost line and the total cost line is shown in the following diagram.

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 If the firm operates at any point below the shut down point, it will be desirable to close down the
plant.

Cost control and cost Reduction

Cost control is an important pre-requisite for the successful operation of a business. The competitive
ability of the firm depends upon the ability to produce the commodity at the minimum cost. Cost control by
management means a search of better and more economics base completing each operation. It aims at
keeping the cost down thereby increasing the profitability and competence of the firm for making best use of
every rupee spent in producing a commodity in effect cost control wouldmean a reduction in the percentage
of cost and in the turn increase in percentage of profit. In the absence of cost control profit would come
down due to increasing cost even though quantum of sales may increase. Hence it is necessary for the
modern business firms to exercise control on costs.
Cost control has two aspects: 1. A reduction in specific expenses, and ii. A more efficient use of
every rupee spent. Unless the managers know the nature of costs they will not be able to control costs for
achieving company objectives at minimum cost. IF a company wants to produce a certain amount of output
during a given period then control must be exerted to ensure that this output is produced at the minimum
possible cst.
It is useful to beat in mind the following rules covering cost control activities. 1. It is easier to keep
costs down than it is to bring costs down (ii. The amount of effort put into cost control tends to increase
when business is bad and decrease when business is god and (ii.There is more profit in cost control when
business is good than when business is bad. Therefore, one should not be slack when conditions are good.
Techniques of cost control:
There are two distinct but inter related techniques of cost control. They use 1. Budgetary control and
2. Standard costing . Budgetary control is concerned with the cost and running individual departments
within the company. Standard costing is concerned with the cost of making particular products.
Budgetary control:
It is a system of controlling costs which includes the preparation of budgets, coordinating the
department and the establishing responsibilities comparing the actual performance with that budgeted and
acting upon results to achieve maximum profitability. Budgets provide eyardstick for comparison. Budgets
are prepared on the basis of some considerations viz, 1. Selling and distribution cost, detailed planned sales
force, advertising, warehousing and transport costs. 2. Administration costs detailed planned personal
department cost, accounting department costs etc. and 3. Production cost specifying planned materials,
labour and factory overhead cost for each product department. Costs with cost and revenue budgets , capital
expensiture budget will have to be prepared which is nothing but detailed planned expenditure , on plant,
machinery, tools and so on. All these budgets influence the company‘s cash position and to traceout effects,
a cash budget must be prepared for the coming year so that the cash outflow are expected to exceed inflows
at any time during the year, necessary steps may be thought of to get credit facilities, to bridge the gap.
When once the departmental budget have been prepared, they can be aggregated to produce a master
budget showing the overall effects of individual departmental plans. IT will incorporate the planned profit
and loss account and balance sheet and serve to show what profit will be earned and what the end of the year
asset position will be, provide actual operations, go accoding to plan. If these results seems adequate in the
light of the companies long term goals, then the budget would be finalised and accepted as a basis for cost
control.
75
 When the actual budget period starts, the actual data must be collected for comparison with the
budgets to facilitate cost control. When a cost difference cannot be reflected , e.g. an excess of actual
material cost over budget caused by rise in the material prices, rather than excess usagae of materials, then
the budget itself may have to be revised.
Budgetary control takes into consideration further developments , and tries to forecast business
situations which lend reality to cost. In a business in rapidly changing siutaions as well as activities which
are non respective in character , estimated costs are the only feasibility standard for control purposes.
Intangible operations like public relations, moral, and R&D are not subject to control by any other standard
except by esteemed cost.
The determination of accurate esteemd cost is though job and depends upon the skilled analyst,
which is difficult to set esteemed cost are necessarily the best costs.

Standard costing
Standard costing is one of the prominent systems of cost control. It aims at establishing standards of
performance and target costs which are to be achieved under a given set of working conditions. The
standard cost is a predetermined cost which determines what each product or service should cost under given
circumstances. In other words standard costing starts with an estimate of what a product ought to cost
during a future period given reasonably efficient working. Once standard costs have been prepared for
products,Actual product cost should be determined with compared with standard. Any adverse difference or
variance from standard could be due to excess usage of materialsl higher material prices, lower labour
efficiency, higher wage rates, a similar output than planned or greater expenditure on overhead items, then
the budgeted for . Standard costing makes it possible to isolate which of the these causes has given rise to
higher costs and who is responsible for this in the organisation.
Standard cost is not rigid, but it is revised from time to time as conditions changed. Standard cost provide a
yardstick against which the actual cost may be measured since the standard cost is determined against
efficient operating conditions, it is a good yearstick for measuring efficiency. If actual cost is much below
the standard cost, there is need for urgent investigation. The setting of standards involves determining the
best methods and mateials which may be lead toe conomics. The target of efficiency, is set for employees to
reach and cost consequences is stimulated. Stnadardcost provide a valuable aid to management in
dertermining prices and formulating policies. Standard cost not only keeps in you the target but also indicate
at what points and in what items in performance is unsatisfactory. Since weaker points are deducted, specific
actions can be taken.
Standard costs are expensive and difficult to operate. As a basis of comparison, standard costs are
effective whenever changes in operating conditions occur. Standard cost give an illusory definiteness to the
cost standards. Converting physical standards into financial standards is likely to be arbitrary and presents
great difficulty.
Other techniques for cost reduction
Other techniques followed to achieve cost reduction are 1. Marginal costing b. Value analysis 3. Work
study standardization and 4. Simplification and variety reduction.
1. Marginal costing
Marginal costing is another important syste m of cost control. Marginal costing accounting refers to
fixed and variable components of the costs and emphasis that fixed costs be treated as periodical
costs and variable costs alone be directly attached to the product.
2. Value analysis:
Value analysis is the application of the technique of method of study to the product design function.
Value is defined here as the least cost for reliability providing the correct function, at the correct time
and plac and at a standard quality. Value analysisn is in essence a procedure which specified the
functions of products or compoentes, establishes the appropriate cost, creates alternatives and
evaluates them. This technique finds useful where very large quantities of an item are being
produced, so that fractional amounts saved on the manufacturing cost can result in substantial
savings.
Some examples of savings through value analysis are

76
 1. Discarding tailored products where standard components can do
2. Use of newly developed better and cheaper facilities in place of traditional materials.
3. Work study :

The primary objective of work study is analysis of all the factors which affect the performance of a
task to develop and install work methods which make optimum use of a task to develop and install work
methods which make optimum use of the human and material resources available and also to establich
suitable standards by which the performance of this work can be measured.
Method study is a systematic recording and critical examination of existing and proposed way of
doing work, as a means of developing and applying easier and more effective methods of reducing costs.
Method study is the creative aspect of work study. By means of a defined procedure either improved
methods of doing existing job or efficient methods of doing new jobs are developed in order to achieve near
optimum use of men., materials and machines. Frequently work measurement may be necessary in order to
compare alaternative work method. Standardisation reduces cost through reduction of capital investment (e.g
by elimination of unnecessary stock) reliability by product and improvement in quality.
4 Simpification and variety reduction: Simplification and reduction in variety also result in lower costs due
to a number of reasons viz., 1. Concentration on administration sales, advertising and distribution for fewer
products and 2. Refused inventory of raw materials, components and finished goods.

Areas of cost control:

1.Materials:
There are number of ways to reduce material cost. While buying from a particular source, in addition
to the cost of material, consideration should be given to freight charges. In some cases, lower prices of
materials may be offset by higher freight to the firmsgodowns. While buying one may attempt to buy from
the cheapest source by inviting bids. It may be advantageous to explore the possibility of manufacturing
certain parts in one‘s own factory rather than buying them. Many a time, improvement in product design
may lead to reduction in material usage. Better utilization of materials may also save materials cost by
avoiding wastes in storing, handling and processing.
2Inventory control:
It is an another area for reducing material cost. 90% of the working capitl may be locked up in
inventories. Some major ways of reducing inventories are:
1. Improved production planning.
2.Having dependable sources of supplies which can ensure prompt deliveries of materials at short notice.
3. Elimination of slow-moving stocks and droppinf of obsolete items.
3.Labour:
Reduction in wages for reducing labour costs is out of the question. On the other hand, wages might
have to be increased to provide incentives to workers.Yet there is a good scope for reduction in the wage
cost per unit. A reduction in labour cost is possible by proper selection and training, improvements in
productivity and by automation where possible. Work study might result in a lot of savings by reducing
overtime and idle tme and better workloads. Improvement in working conditions may reduce absenteeism
and thus reduce costs per unit. Wastage of human effort maybe due to lack of co-ordiatuon among various
departments, by having more men than necessary under utilization of existing man power shortage of
materials, improper scheduling absenteeism poor methods and poor morals.
4.Factory overheads may be reduced by proper selection of equipment and reduction in power costs, lighting
costs etc. Transport cost may be reduced by using one‘s own transport. Careful planning of movements may
also save transport cost. A certain amount of wastage and spoilage is unavoidable because employees do
make mistakes, machine do get out of order and sometimes raw materials are faulty. However attempt cab
be make to reduce this to the minimum. Wastages can be reduced considerably by educating operators in the
causes and cures of wastes. Bad debts losses reduced by concentrating on areas and media which give the
nest results. Selling costs can be controlled by improved supervision and training of salesmen, re-
arragnement of sales territories, replanning of salesmen‘s routes and calls and redirecting of the sales efforts
to achiee a more economic product misture. It may be possible to save selling costs by the use of warehouses

77
making bulk shipments to the warehouses and giving fater deliveries to the customers therefrom.
Centralisation and reduction of clerical and accounting work may also lead to cost saings.

Cost reduction and cost control:

Cost reduction has been defined by the Institute of Cost and Works Accountants of London as ― the
achievement of real and permanent reductions in the unit costs of goods manufactured or services rendered
without impaiting their suitability for the useintended‖. Thus cost reduction is confined to genueine saving
in the cost of manufactures administration distribution and selling, brought about by the elimination of
wasteful and inessential elements from the product design and from the techniques and practices carried out
in connection therewith.
On the other hand, cost control lacks the dynamic approach, to many of the factors affecting costs
which planned cost reduction demands.
For example, under cost control the tendency is to accept standards once they have been fixed and elavethem
unchanged over a period. In cost reduction standards must be constantly changed for improvement. There is
no phase of business which is exempt from cost reduction.
Essential for the success of a cost reduction programme:
1. Everyone in the fir should understand and recognize his responsibilities.
2. Employee‘s resistance to cost reduction programmes should be minimized by disseminating
complete information about the proposed chages and also convicing the workers that the changes are
concerned with problems faced by the firm and that the worker‘s would be the ultimate beneficiaries.
3. Cost reduction efforts should be continuously maintained and efforts should be made to explore new
areas where savings could be achieved to the maximum.
4. There shoule be periodic meeting with the workers to review the progress made towards cost
reduction.

Factors hindering cost control in India: Cost of raw material and other intermediate products s generally
high. Inventory control is also not possible. Shortage of raw materials are a ususal phenomenon. Wages are
always rising being linked to csot of living. There are wage boards for almost every industry and
management has little control on wage rates. Overheads are also higher in India because the size of the plant
is very often uneconomic and there is under utilization of capacities due to lack of rawmaterials and power
shortage. Tehre are delays in the issue of licenses and by the time licenses are issued, cost of equipment goes
up. The Indian industries operate in a sheltereddomestic market. Cost consciousness is by and large absent in
India.

UNIT – IV

Product pricing
Meaning of Market:

In ordinary language ‗market’ refers to a place where goods are bought and sold. But in economics,
the term ‗market‘ does not refer to a place. In economics, market refers to a group of buyers and sellers
dealing in a particular commodity (e.g. gold market, oil market, car market, fruit market etc.).
A market is thus a trading zone where buyers and seller are in such close contact, that a single price
for commodities of uniform quantity prevails. A market is created when ever sellers of a good or service are
brought into contact with buyers and a means of exchange is available.
The medium of exchange may be money or goods itself (i.e barter). Whatever the medium of
exchange, exchange agreements between buyers and sellers are reached through the operation of the forces
of demand and supply. Thus a market is an arrangement or institution that enables buyers and sellers to get
information and to do business with each other.
Thus, five elements of market mechanism can be identified as (1) buyers, (2) sellers (3) interaction
between buyers & sellers on (4) existence of a commodity or service to be traded (5) price.

Definition of Market.

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 According to Benham, ―Market is any area over which buyers and sellers are in close touch with one
another, either directly or through dealers that the price obtainable in one part of the market affects the prices
paid in other parts‖.
In the words of Ely, ―Market means the general field within which the forces determining the price
of particular product operate.‖

Forms or Classification of Market:

Market can be classified into different types on the basis of various criteria.

1. On the basis of area:

Market can be classified on the basis of area into local, national and international markets. If the
buyers and sellers are located in a particular locality, it is called as a local market. E.g. fruits, vegetables etc.
These goods are perishable, they cannot be stored for a long time, they cannot be taken to distant places
when a commodity is demanded and supplied all over the country, national market is said to exist when a
commodity commands international market or buyers and sellers all over the world, it is called international
market.

Whether a market will be local, national or international in character will depend upon the following
factors. (a) nature of commodity (b) tastes & preference of the people, (c) availability of storage (d) method
of business (e) political stability at home and abroad, (f) portability of the commodity.

2. On the basis of time:

The element has been used by Marshallfor classifying the market. On the basis of time, market has
been classified into very short period, short period, long period and very long period.
Very short period market refers to the market in which commodities that are fixed in supply or are
perishable are transacted. Since supply is fixed only the changes in demand influence the price.
The short period markets are those where supply can be increased but only to a limited extent.
Long period market refers to a market where adequate time is available for changing the supply by
changing the fixed factors production. The supply of commodities may be increased by installing a new
plant or machinery and the output can be changed accordingly.
Very long period or secular period is one in which changes take place in factors like population,
supply of capital and raw material etc.
3. On the basis of nature of transactions:
Markets are classified on the basis of nature of transactions into two broad categories viz. spot
market and future market. When goods are physically transacted on the spot, the market is called as spot
market. Incase the transactions involve the agreements of future exchange of goods, such market are known
as future markets.
4. On the basis of volume of business.
Based on the volume of business, markets are broadly classified into whole sale and retail markets.
In the wholesale markets, goods are transacted in large quantities. Wholesale markets are in fact a link
between the producer and the retailer while the retailer is a link between the wholesaler and the consumer.

5. On the basis of Status of sellers.

During the process of marketing a commodity passes through a chain of sellers and middleman.
Markets can be classified into primary, secondary and terminal markets. The primary market consists of
manufacturers who produce and sell the product to the wholesalers. The wholesalers who are an
international link between the manufacturers and retailers constitute secondary markets while the retailers
who sell it to the ultimate consumer constitute the terminal market.

6. On the basis of regulation:

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 On the basis, market is classified into regulated and unregulated market. For some goods and
services, the government stipulates certain conditions and regulations for their transactions. Market of goods
and services is called regulated market. On the other hand, goods.
7. On the basis of Competition.
Markets are classified on the basis of competition among buyers and sellers. The nature of
competition results in distortions in price, nature of the product, freedom to enter to leave the market etc.
(a) Pure Competition.
Competition is said to be pure when there are large numbers of buyers and sellers, the commodity
dealt with homogeneous or uniform quality.
(b) Perfect competition.
Perfect competition has wider meaning than pure competition. It must satisfy a few more conditions
than under pure competitions, viz,
1. Under perfect competition there exists large number of buyers and sellers, who have perfect
knowledge of the price, and no seller or buyer can individually quote a higher price.
2. Perfect competition makes the assumption of no transport costs.
3. There is perfect mobility of factors of production.
4. There is free entry of firms‘ i.e, any firm can leave the industry or a new firm can enter it.
(c) Monopoly.
Monopoly refers toa market where there is only one seller or producer for a commodity though there
are many buyers.
(d) Monopsony.
If there are large numbers of firms producing a commodity, but there is only one buyer, it is known
as monopsony. Here the single buyer becomes powerful to control the prices.
(e) Bilateral monopoly.
Bilateral Monopoly refers to a market model where there is one buyer facing one seller. Price in such
a market is determined by the relative strength of the bargaining power of the buyer and seller.
(f) Duopoly.
In this market form two sellers confront large number of buyer, each producing homogeneous or
differentiated products.
(g) Oligopoly.
Oligopoly is a market form where a few firms, control the supply. Each firm will be producing a
substantial proportion of output in the industry. They produce goods which may be close substitutes.

Factors responsible for the extent of the market:

The extent of the market refers to the size of the market, i.e, whether a commodity has local, national
or international markets. This depends upon several considerations.
1. Nature of the commodity:
A Durable commodity usually has a wide market, as in the case of gold, silver etc. Perishable or
bulky goods will have limited markets. Improved means of refrigeration and processing have made it
possible to have a wider market for even perishable goods like fruits, flower etc, Denmark cheese and butter,
Australian mutton have a wide market today.
2. Extent of demand: A commodity that has universal demand will have a wider market, as in the case of
gold.
3. Portability:
Some goods can be easily sent from one place to another. The market for such portable goods tends
to be wider, e.g. cosmetics.
4. Cognisability:
Certain commodities are standardized or can be easily classified even if there are different grades. If
the samples of the commodities can be sent, the buyer in distant places can place orders on the basis of
samples such goods will have a wider market.
5. Means of transport and communication.
There are better prospects for expansion of markets on account of development of quick means of
transport. What stream ships did in the 19th century is done by air transport facilities in the 20th century.

80
Similarly expansion of telephone, telegraph, and fax services increase the contact between buyers and
sellers.
6. The level of national income.
Countries having a high level of national income or per capita income offer a large market for their
products. In this respect Western countries offer an attractive market for exports.
7. Large population
A large population is sure to create wide market. Thus countries like India and China accounting for
nearly two seventh of the world population offer a wide market for a variety of goods.
8. Law and order
Good conditions of law and order are conducive to have wider market. Similarly world peace and
security contribute to the expansion of markets. For instance, the political upheaval in U.S.S.R and break up
of that country into smaller constituting units has reduced the market for several goods from India.
9. Currency and credit system
A sound currency and credit system helps the expansion of trade and commerce. International
liquidity based on gold and silver under the aegis of International Monetary Fund has helped in the
expansion of world trade.
10. Trade Policy
Extent of the market depends on the restrictive or expansionary trade policies followed by the
countries.

PRICING UNDER PERFECT COMPETITION.

Meaning of perfect competition:

Perfect competition refers to a market situation in which there are large number of buyers and sellers
of homogeneous products. The price of the product is determined by industry with the forces of demand and
supply. Perfect competition is a market structure characterized by the complete absence of rivalry among
individual firms.

Definition of perfect competition

According to Bilas, ―The perfect competition is characterized by the presence of many firms, they all
sell identically the same product. The seller is a price taker.‖
According to Ferguson, ―Perfect competition describes a market in which there is complete absence
of direct competition among economic groups.‖

Features of perfect competition.

1. Large number of buyers and sellers.
There must be a large number of firms in the industry. Similarly, the buyers are also numerous.
Hence, no individual buyer has any influence on the market price. The price of the product is determined by
the collective forces of industry demand and industry supply. The firm is only a ‗price taker‖.
2. Homogeneity of products.
In a perfectly competitive industry, the product of any one firm is identical to the products of all
other firms. The technical characteristics of the product as well as the services associated with its sale and
delivery are identical.

3. Free Entry-Exist
There is no barrier to entry or exit from the industry. Entry or exit may take time but firms have
freedom of movement in and out of the industry. If the industry earns abnormal profits, new firms will enter
the industry and incurring losses some of them will leave the industry which will reduce the supply of the
industry and will thus raise the price and wipe away the losses.
4. Absence of Government Regulation
There is no government intervention in the form of tariffs, subsidies, relationship of production or
demand.

5. Perfect mobility of factors of production

81
 The factors of production are free to move from one firm to another throughout the economy. It is
also assumed that workers can move between different jobs. Raw materials and other factors are not
monopolized and labour is not unionized. In short, there is perfect competition in the factor market.
6. Perfect knowledge.
It is assumed that all sellers and buyers have complete knowledge of the conditions of the market.
This knowledge refers not only to the prevailing conditions in the current period but in all future periods as
well. Information is free and costless. Under these conditions uncertainty about future developments in the
market is ruled out.
7. Absence of transport costs.
In a perfectly competitive market, it is assumed that there are no transport costs.

Price – output determination under perfect competition in short run and long run.
Short run equilibrium of the firm
The firm is in equilibrium at the point of intersection of
the marginal cost and marginal revenue curves. The first condition for
the equilibrium of the firm is that marginal cost should be equal to
marginal revenue. This second condition for equilibrium requires that
marginal cost curve should cut the marginal revenue curve from below.

The diagram represents that the average revenue curve and

marginal revenue curve coincide with each other at the ruling price OP.
Given OP price, the firm will fix its output only at OM. This is so
because at output OM, MR = MC and MC curve will cut MR curve
from below. At point R, profit would be maximum and the firm would
be in equilibrium.

The figure (A) shows that the SATC is below the price at equilibrium, the firm earns excess profits.
In part (B) the SATC is above the price, the firm makes a loss.
Generally, in the short run a firm keeps on producing even
when it is incurring losses. This is so because by producing and
earning some revenue, the firm is able to cover a part of its fixed
costs. As long as the firm covers up its variable cost plus at least a
part of annual fixed cost, it is advisable for the firm to continue
production. It is only when it is unable to cover any portion of its
fixed cost, it should stop producing. Such a situation is denoted as
shout down point.

In the diagram, the shut down point of the firm is denoted by

W. If price falls below P, the firm does not cover its variable costs
and is better off, of it closes down.

Short run equilibrium of the industry

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 The industry is in equilibrium at that price at which the quantity demanded is equal to the quantity
supplied.

The industry is in equilibrium at price P at which the quantity demanded and supplied is OQ.
However, in the short run industry may earn abnormal profit or may incur losses.

Long run Equilibrium of the firm:

In the long run firms are in equilibrium when they have adjusted their plant so as to produce at the
minimum point of their long run AC curve, which is tangent to the demand curve. In the long run the firm
will be earning just normal profits which are included in the LAC.

At the price of OP, the firm is making excess profits. It will

have an incentive to build new capacity and hence it will move along
its LAC. At the same time, attracted by excess profits new firms will
be entering the industry. As the quantity supplied increases, the price
will fall at P1 at which the firm and the industry are in long run
equilibrium. The condition for the long run equilibrium of the firm is
that the marginal cost be equal to the price and to the long run
average cost LMC = LAC = P.
The firm adjusts its plant size to produce that level of output
at which the LAC is the minimum. At equilibrium the short run
marginal cost is equal to the long run average cost.

Long Run Equilibrium of the Industry.

The industry is in long run equilibrium when price is reached at which all firms are in equilibrium
producing at the minimum point of their LAC curve and making just normal profits. Under these conditions,
there is no further entry or exit of firms in the industry. The long run equilibrium is shown as

At the market price P the firms produce at their minimum cost, earning just normal profits. The firm
is in equilibrium because at the level of output X.
LMC = SMC = P = MR.
This equality ensures that the firm maximizes its profit. At the price P the industry is in equilibrium
because profits are normal and all costs are covered so that there is no incentive for entry or exit.
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 Role of Time in Price determination under perfect competition
Price of a commodity in an industry is determined at that point where industry demand is equal to
industry supply. Marshall laid emphasis on the role of time element in the determination of price. He
distinguished three periods in which equilibrium between demand and supply was brought about viz, very
short period or market period, short run equilibrium and long run equilibrium.
Market Period:
Price is determined by the equilibrium between demand and supply in market period. This market
period may be an hour a day or few days or even few weeks depending upon the nature of the product so far
as the supply curve in a market period is concerned, two cases are prominent one is that of perishable goods
and the other is that of non-perishable durable goods.

Pershiable goods: It refers to those goods which perish very quickly. In simple terms goods which cannot
be stored for some time are called the perishable goods.
In the above figure, quantity of perishable goods is measured on
horizontal axis, price on vertical axis. SS is the supply curve; it signifies
the fact that supply of perishable goods remains fixed. DD is the original
demand curve which shows the equilibrium at point E. Thus, OP is the
equilibrium price.
Now, suppose, if in the very short period demand increases and
assumes the form of D2D2. The equilibrium will also shift E2. It depicts
that with the increase in demand the price increases to OP2. On the
contrary, if the demand falls from DD to D1D1. The equilibrium will
shift to E1 from E side by side price will fall from OP to OP1.

2. Durable Goods: Durable goods are those which can be reproduced or those can be stored. Like perishable
goods, the supply of durable goods is not vertical throughout the length.
In the diagram, MPS is the market period supply curve where OQ0 is of the commodity. To start with
the demand for the commodity is shown by D1D1 where the price is OP1 and quantity supplied is OQ1. Q1Q0
stock will be held back. If the demand supplied is OQ1, Q1Q0 stock will be held back. But from R to E0 as
the price rises, the quantity supplied also rises.
Factors affecting Reserve Price:
The factors which affect the reserve price are as follows.
1. Price in Future:
If the seller expects that a high price will prevail in the market in
future, the reserve price will be higher and vice-versa.
2. Liquidity preference:
If the seller is in urgent need of money, his reserve price will be
lower. Thus higher the liquidity preference will be the reserved price and
vice versa.
3. Future cost of production:
If the seller expects that in future, the cost of production will fall; his
reserve price will be lower and vice-versa.
4. Storage Expenses:
If the seller finds that the storage expenses are higher and the times for which the stocks have to be
held are longer, his reserve price will be lower and vice-versa.
5. Durability of Commodity
The Durability of the commodity influences the reserved price. The more durable a commodity is the
higher will be the reserved price.
6. Demand Future:
The future demand of the commodity also influences the reserve price of the producer. If the
producer expects a higher demand in future, his reserve price will also be higher.
Short period price determination:
Price determination in the short period has been explained with the help of the diagram.

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 The diagram shows the process of price determination in the short period. DD is the demand curve of
the industry; MPS is the market period supply curve while SRS is the short run supply curve of the industry.

Initially, OP is both the market price as well as the short run price. At price OP, the individual firm
will adjust its output OX. At equilibrium level of output OX, price is equal to its marginal cost and marginal
cost curve cuts the MR curve from below. The firm enjoys normal profits.

If demand increases from DD to D1D1 and the industry is in equilibrium at point E1 which determines
the price OP1. The new price OP1 is less than the new market price i.e. OH. The individual firm will take
price OP, and will produce OX level of output at which price OP1 equals the marginal cost and the firm
enjoys supernormal profit.

On the other hand, if the demand curve fall to D2D2. The new equilibrium will be established at E2
and the price will fall to OP. but in the short period the firm will contract output by reducing the
employment of labour and other variable factors. Therefore, the new equilibrium level established at E2 will
determine the price OP2 and the firms will produce OX2 level of output. But, it is worth mentioning here that
price OP2 does not cover the SAC and the firms operating in the industry incur losses.

Determination of long period normal price.

Normal price comes to prevail in the long period. Normal price is influenced more by supply than
demand. Under perfect competition, in the long run supply gets sufficient period to adjust itself to the
changed conditions in demand. If supply is less than demand, price will rise and so the industry. Thus, total
supply will increase and all the producers will get normal profits only. If supply is more than demand, price
will fall and producers suffer losses. Some of the producers may leave the industry under pain of loss. Thus
total supply will decrease and once again price will rise to its normal level, this has been illustrated in the
diagram.

Output is shown in X- axis and price in Y-axis. Industry‘s demand curve DD and long run SS curve
LRS cut at point E, which determines OP price and OM output. If price by the industry is raised to OP 1the
demand is OM2 and supply is OM1, since D<S price will fall to OP. on the other hand if price is OP2, S<D,
because that at OP2 price supply is ON1 and demand is ON2. This will raise price to OP.

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 A firm under perfect competition, in the long run is in equilibrium at output where price = MC =
Minimum LAC. This point is shown by E and it indicates normal profits. If the price is above the minimum
long run average cost, the firm will be making super normal profit. If the price is OP 1, in that case the firm
will be producing OQ1 output and would be making super normal profits. These super normal profits will
lure the new firms to enter the industry, with this, the supply of the industry would increase which would
reduce the price and hence the existing firms will be left only with normal profits.
On the other hand, if the price is OP2, the firms will be equilibrium at E2 and hence the firm would
be producing OQ2. At this stage, the firm will be sustaining losses as AR<AC. Because of losses, some of
the firms will exist from the industry. This will reduce the supply which in turn would raise the price and
hence the existing firms will be left with normal profits only.
MONOPOLY

Meaning of monopoly:
The word monopoly has been derived from the combination of two words, i.e. ‗mono‘ and ‗poly‘.
Mono refers to a single and poly to control. In this way, monopoly refers to a market situation in which there
is only one seller of a commodity.
Definition of Monopoly.
According to Koutsoyiannis, ―Monopoly is a market situation in which there is a single seller. There
are no close substitutes of commodity it produces, there are barriers to entry.‖
In the words of Ferguson, ―A pure monopoly exists when there is only one producer in the market.
There are no dire competitions.‖
Features of Monopoly:
Some of the features of monopoly are,
1. One seller and large number of buyers: The monopolist‘s firm is the only firm, it is an industry. But the
number of buyers is assumed to be large.
2. No close substitutes: There shall not be any close substitutes for the product sold by the monopolist. The
cross elasticity of demand between the product of the monopolist and others must be negligible or zero.
3. Difficulty of Entry of New firms: There are either natural or artificial restrictions on the entry of firms
into the industry, even when the firm is making abnormal profits.
4. Monopoly is also an industry: Under monopoly there is only one firm which constitutes the industry.
Difference between firm and industry comes to an end.
5. Price maker: Under monopoly, monopolist has full control over the supply of the commodity. But due to
large number of buyers, demand of any one buyer constitutes an infinitely small part of the total demand.
Therefore, buyers have to buy the price fixed by the monopolist.

Types of Monopoly.
Monopoly may be of different types. It may be private monopoly, public or state monopoly, pure
monopoly, simple monopoly, and discriminating monopoly, absolute and limited monopolies.
Private and Public monopolies:
When monopolistic control exists in private sector, we can call it as private monopoly. If the state
controls the production and pricing of the commodity, it is public or state monopoly. Many of the public
sector undertakings come under this category.
Pure Monopoly:
It is a phenomenon which exists only in a public sector. Production of a particular commodity will be
the exclusive privilege of the state or state sponsored undertaking. For example, the telephone industry in
India, is the pure monopoly of the government.
Simple Monopoly:
There are larger possibilities of simple monopoly in the real world. It is a situation where the single
producer produces a commodity having only a remote substitute.
Discriminating Monopoly:
The monopolist may charge different prices for different customers or markets. He has not only the
power to fix the price of the commodity but also charge different prices from different customers. The
monopolist will be discriminating between the markets.
Monopoly power:

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 In practice no monopolist will have absolute monopoly power. The monopoly control or power
enjoyed will be limited and partial. Monopoly power is ensured due to certain factors like,
(1) Power given by the Government
Monopoly power to produce a commodity or service can be given by the government through its
statutes. Public sector undertakings, corporations or any control of the existing industry by a single agency
get the monopoly power granted by the act of parliament or legislature.
(2) Legal Power:
Partial monopoly through ‗Trade Mark‘, ‗Patent rights‘, ‗copy right‘ etc. is enjoyed by the producers
or traders as they are protected by legal rights.
(3) Technical Power:
In certain cases, monopoly power may be enjoyed due to technical reasons. The firm may have
control over raw material exclusively and it will be producing a commodity on monopolistic basis.
Technical knowledge, superior and special know how, scientific secrets or formula may enable traders to
produce a commodity which may not have close substitute.
(4) Combinations:
Combinations of different firms producing the same commodity will result in single control. Trusts,
cartels, etc. will come to have monopoly power
(5) Bias of the consumer:
The bias and laziness or ignorance of the consumers may give some monopolistic privilege to the
producer. But those are not monopoly in the real sense of the term.

Price output determination under monopoly:

Monopoly price output determination can be studied under the different time periods: (1) short
period, (ii) long period.
Price output determination in the short period.
In the short period, production can be changed only by changing the variable factors of production.
Fixed factors of production cannot be changed. In this period, volume of production can be changed but
capacity of the plant cannot be changed. We can increase the supply only with the help of existing machines
and plants. New factories and plant equipment cannot be installed.
Monopolist, being sellers of his product, can fix his price equal to, above or less than the short period
average cost of the product. Thus he can earn normal profits, super normal profits or losses even in the short
period. This 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 (MR) and Marginal cost (MC). If marginal revenue exceeds the marginal cost of a product, the
producer of monopolist can minimize his profit by increasing his production. On the other hand, if MC
exceeds MR at a particular level of output, the monopolist can increase his losses by reducing his
production. So the monopolies is said to be in equilibrium when his MC curve cuts the MR curve.
In the short period, a monopolist firm can earn supernormal profits, normal profits or supernormal
losses. In case of losses, price must be covering at least the average variable cost otherwise the firm will stop
production. The maximum loss can be equal to fixed costs. The three cases of monopoly equilibrium are
illustrated in the diagram.

In the diagram, (a) a monopolist is in equilibrium at point E. His equilibrium output is OM. In this
situation, he is earning supernormal profits shown by the shaded area PQRS since the AR exceeds SAC
which is equal to QM.

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 In the diagram (b) E is the point equilibrium where MR=MC. OM is the equilibrium output. Price
PM is equal to the SAC. The firm is earning normal profit since normal profits are included in SAC.
In diagram (c) The firm shows that it is earning losses. Minimization of losses is achieved by the
equality between MR & MC at point E, OM is the equilibrium output. Price is fixed at PM. Monopolist firm
is earning losses shown by the shaded area PQRS since SAC exceeds price. At this price (PM) the firm will
continue production since price is higher than AVC.

Price – output determination in the long period

In the long period all factors of production are variable. Volume
as well as capacity of production can be changed. The monopolist firm in
the long run is also in equilibrium at a point where his marginal revenue
is equal to its marginal cost. In the long period, a monopolist firm strives
and plans to earn only profits. Firms can make all necessary changes in
its costs where there are strict barriers on the entry of new firms.
The long period equilibrium or price output determination of a
monopolist firm can be depicted in the diagram.

Under the given market conditions price PM is fixed by the equality between MR and LMC at point
E. OM is the output determined in the equilibrium state. Firm is earning supernormal profits equals to PQRS
since its AC exceeds AR by PQ. It is earning profits even in the long period. This is due to the monopoly
power of the firm. This is why the long period supernormal profits are sometimes called monopoly profits.

PRICE DISCRIMINATIN UNDER MONOPOLY

Meaning of price discrimination.

Price discrimination can be defined as the act of selling the same article produced under single
control at different prices to different buyers.

Definition of price discrimination.

According to Koutsoyiannis, ―Price discrimination exists when the same product is sold at different
prices to different buyers‖.

Types of price discrimination

Price discrimination is of different types. It is personal discrimination if a monopolist charges
different prices for different individuals. For example, firms sell the same product under two name brands
one at a higher and the other at a lower price to increase sales among rich and poor buyers.
Secondly, there can be local discrimination. This involves different prices being charged over
different localities. Universities in U.S.A charge higher tuition fees for foreign students only.
The third type is trade discrimination. Here the monopolist charges different prices from different
trades or occupations. Firms offer lower prices for whole sale or bulk purchasers and higher prices from
retailers.

Conditions necessary for price discrimination.

For price discrimination to exist, it requires the basic conditions. These are
1. Difference in Elasticity of demand:
Price discrimination is possible only when elasticity of demand will be different in different markets.
The monopolist will fix higher price where demand is inelastic and low price where the demand will be
elastic. In this way, he will be able to increase his total revenue.
2. Market imperfections:
Generally, price discrimination is possible only when there is some degree of market imperfections.
The individual seller is able to divide his market into separate parts only if it is imperfect.
3. Differential product:
Price discrimination is possible when buyers need the same service in connection with differentiated
products. For example, railways charges different rtes for the transport of coal and copper.

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4. Legal sanction:
In some cases price discrimination is legally sanctioned. As Electricity Board charges lowest for
domestic use and highest for commercial houses.
5. Monopoly existence:
Price discrimination is also called discrimination monopoly. It is evident that price discrimination is
possible only under conditions of monopoly.

Degrees of price discrimination.

Prof. A.C. Pigou has given the three degrees of discriminating monopoly

1. Price discrimination of first degree:

Price discrimination of first degree is said to exist when the monopolist is able to sell each separate
unit of his product at different prices. It is also known as the perfect price discrimination. Under this, a seller
charges a price equal to what the consumer is willing to pay, which means the seller leaves no consumer‘s
surplus with the consumer.
2. Price discrimination of second degree:
In the price discrimination of second degree buyers are divided into different groups and from
different groups a different price is charged which is the lowest demand price of that group. This type of
price discrimination would occur if each individual buyer had a perfectly inelastic element curve for good
below and above a certain price.
3. Price discrimination of third degree:
Price discrimination of third degree is said to exist when the seller divides his buyers into two or
more than two submarkets and from each group a different price is charged. The price charged in each sub-
market depends on the output sold in that sub-market along with demand conditions of that sub-market. In
the real world, it is the third degree price discrimination which exists.

Objectives of price discrimination.

1. To maximize monopoly profits

2. To convert consumer‘s surplus into producers profits
3. To capture new markets.
4. To keep hold on the export markets
5. To export the unutilized capacity by widening the size of market through price discrimination.
6. To clear off the surplus of output
7. To augment future sales by quoting lower rates at present to the potential buyers who may develop
the taste for the product in future.
8. To weed out the possibility of potential competition from a market or to destroy a rival firm.

Price and output determination under discriminating monopoly.

The aim monopolist is to increase total revenue and profit. Under price discrimination, the
monopolist will charge different prices in different sub-markets. If the monopolist has two different markets
having different elasticity of demand, he should decide about the level of output to be produced. Distribution
of total output between two markets and price fixation in each market is shown with the help of the diagram.

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The Level of Total Output to Be Produced
It is assumed that the product is homogeneous the monopolist must consider his marginal cost (MC)
for the whole output irrespective of which market it is sold in. He equates this marginal cost (MC) with the
composite marginal revenue curve (MR) from both Markets – Market I and II. The composite marginal
revenue curve is represented as MR or CMR. Thus total output is fixed at the point where MC=CMR. The
monopolist will produce OM amount of output. At this output, the addition to his cost of producing the best
unit is just equal to the addition to his revenues from selling that unit in either market.
Distribution of total output between two markets
The monopolist will maximize his profits by equating the MC of the whole output with the MR in
market I (MQ1) and MC of the whole output with the MR in market II (MR2)
The total output (OM) is divided between two markets in such a way that marginal revenue in each is
equal to the marginal cost for the whole output which is also equal to the composite marginal revenues at
OR. This means he will sell OM. Output in market – I and OM2 output in market II and the combined output
at price OR is obtained by adding the output in Market – I and market – II at OR. MR must be the same in
both the markets i.e., (MR1=MR2) for it has to be equated with the same MC which is also equal to OR. In
any case if it were not the same, the monopolist could increase profits by transferring output from where
marginal revenue was lower to where it was higher.
Charging price in each market:
The elasticity of demand are different in each market, the monopolist will charge different prices in
both the markets to maximize his profits. The price in market – I with less elastic demand will be higher
then the price in market – II with more elastic demand. An output OM will be sold at OP1 price in market – I
an output OM2 will be sold at OP2 price in market – II. The prices are different in both the markets since the
demand is less elastic in market – I than in market – II, hence, a smaller quantity can be sold and at higher
price in market – I than the market – II.
The monopolist will be in equilibrium where MR1=MR2=CMR=MC, it is this distribution where the
monopolist maximizes his profits or it is this point where the monopolist earns maximum profits. The
monopolist is said to be in equilibrium.

Monopolistic competition

Meaning of monopolistic competition:

Perfect competition and monopoly are rarely found in the real world. Hence Prof. Edward H.
Chamberlin of Harvard University brought about a synthesis of the two theories and put forth, “Theory of
monopolistic competition” in 1933.
Monopolistic competition is more realistic than either pure competition or monopoly. It is a blending
of perfect competition and monopoly. Thus monopolistic competition refers to competition among a large
number of sellers producing close but not perfect substitutes.

Definition monopolistic competition.

In the words of Lim Chong Yah, ―Monopolistic competition is a market situation where there are
many producers but each offers a slightly differentiated product.

Features of monopolistic competition.

1. Large number of sellers:
The numbers of sellers is sufficiently large that there is no feeling of mutual interdependence among
them. Each firm acts independently without caring for any effect which its action may have upon those of its
competitors.
2. Differentiated products:
There is large number of buyers who are offered differentiated products and consequently have
preference for the products of particular sellers. Different sellers may use different methods for creating
preference for their own products in the minds of buyers.
Differentiation of the product may be real or fancied. Real or physical differentiation is done through
differences in materials used, design, colour or workmanship or physical product may be the same and
imaginary differences can be built up through packaging, advertising, use of trade marks and brand names.
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Further differentiation of a particular product may be linked with the conditions of his sale: the location of
his shop, the courteous and smiling disposition of its salesman or a reputation for fair dealing etc.
3. Unrestricted entry:
New firms are able to commence production of very close substitutes for the existing brands of the
product even though they cannot make items which are exactly identical in the eyes of the purchasers of the
existing brands.
4. Selling cost:
It is an important feature of monopolistic competition. As there is keen competition among the firms,
they advertise their products in order to attract the customers and sell more. Thus selling cost has a bearing
on price determination under monopolistic competition.
5. Group equilibrium
Chamberlin introduced the concept of group in the place of industry. Industry refers to a number of
firms producing homogeneous products. But firms under monopolistic competition produce similar but not
identical to include firms producing goods which are close substitutes.
6. Price policy of a firm:
Another feature which distinguishes monopolistic competition from perfect competition is that the
firm has a price policy under monopolistic competition. In perfect competition a firm is only a price taker. It
has no price policy of its own. It has to adjust its output to given price.
7. Imperfect knowledge
The existence of monopolistic competition depends upon imperfections in the knowledge of the
buyers. The products may really be the same but consumers may come to know a particular brand name
more than the others. This divides the whole market into submarket where individual firms have
monopolistic conditions.
8. Non – price competition:
Another very importance feature of monopolistic competition is the non – price competition through
which firms in the market try to win over customers. There are definite methods of competing rivals other
than in price. It may be a guarantee for repairs within a particular time, alter sales service, a gift scheme with
particular purchases, a discount not declared in the price list or transport free of cost. All these methods are
secret ways of attracting customers to particular brands.
9. Nature of demand curve:
Though there is product differentiation, as products are close substitutes, a reduction in price leads to
increase in sales and vice – versa. It will have little effect on the price – output conditions of other firms.
Hence each will loose only few customers, due to an increase in price. Similarly, reduction in price will
increase sales.
Therefore the demand curve of a firm under monopolistic competition slopes downwards to the right.
It is highly elastic but not perfectly elastic. It means that it has some control over price due to product
differentiation and there are price differentials between the firms.

Types of monopolistic competition

Monopolistic competition has two faces.
1. Price competition
2. Non – price competition
In this kind of market, the firms compete with each other on the price issue. They also compete on
non – price issues to expand their sale. Non – price competition is in terms of product variation and selling
costs incurred by each seller to capture his share in the market.

Price output determination of the firm under short run and long run in monopolistic competition.
The firm under monopolistic competition has to make a wider range of decision than under perfect
competition. The firm may vary its price and with it, its sales and output, it may vary the quality of its
product and it may engage in sales promotion activities such as advertisement, publicity and propaganda etc.
Thus there are 3 variables under monopolistic competition viz., (1) price (2) product and (3) selling
outlay. The equilibrium of individual firm is discussed here with reference to prices and output adjustments
assuming that the selling costs are absent.
Individual equilibrium

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 For maximum profits two conditions are to be satisfied under perfect competition and monopoly (1)
MC = MR and (2) MC must cut MR from below. Under monopolistic competition also, a firm will make the
maximum profits when these two conditions are satisfied.
The elasticity of demand curve under monopolistic competition depends upon the attachment of the
buyers. It is stated that there may be three equilibrium conditions of a firm in the short period under
monopolistic competition viz. (1) it may earn abnormal profits (2) it may undergo losses; (3) it may earn
only normal profits.

(1) Supernormal profit:

The firm is in equilibrium at OX1, level of output and at the point E, at which MR and MC are equal
and MC cuts MR from below. The firm is earning super – normal profits or abnormal profits since average
revenue is greater than average cost AR>AC.
AR and MR are the average and marginal revenue curves respectively. The firm is in equilibrium at
point E. Corresponding to this price average cost is MX1, i.e., profit per unit is LM whereas average revenue
is equal to LX1, the firm enjoys super normal profits equal to the shaded area PLMN.
(2) Normal profit:
If figure (B) MC is equal to MR at point E. This is the equilibrium point. At equilibrium point, the
equilibrium output is OX and price is OP1. At this point AC is NX1, and AR is also NX1, i.e., AC=AR. Thus
the firm will be earning only normal profits.
(3) Sustaining losses.
The firm is in equilibrium at point E, where MC=MQ. At his equilibrium level the output is OX1 at
price OP the average cost LX1, is greater than average revenue MX1. Since revenue is less than cost. The
firm will sustain losses equal to the shaded area PLMN.

Long run individual equilibrium

Long period refers to that time period in which each firm can change its
production capacity. New firms can enter in to the industry. The entry of new
firms will result into over production which will have a depressing effect on
price. Hence all the firms in the long run will get normal profits.
The diagram measures output in x-axis whereas price on y-axis LAC is
the long run average cost and LMC is the long run marginal cost curve. The
firm is in equilibrium because at point E, MC=MR. The equilibrium output is
OX1 and price is OP. Average revenue curve is tangent to long run average cost
curve at point M. Hence the firms are earning normal profits.

Group equilibrium in monopolistic competition:

The word ―group‖ is used for industry in monopolistic competition. There is a difference between an
industry and a group. A group is composed of firms which produce a differentiated product. For example,
shoe making firms like Bata, ‗Carona‘, ‗Liberty‘ are a group. To know the equilibrium certain assumptions
we assume like.
1. Demand and cost curves of all firms are identical
2. No firm can influences the price and output decisions of its rivals.

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 DD1 is the group demand curve and CC is the cost curves. Firm would like to fix up OP price
because at this price the difference between price and cost is the maximum and producer sets supernormal
profit gets equal to PBMT. If the new firm enters, demand curve shift as DD2 at point ‗k‘ demand curve is
tangent to the cost curves. At this point firms will be earning only normal profit.

OLIGOPOLY
Meaning of oligopoly.
Oligopoly is a situation in which few large firms compete against each other and there is an element
of interdependences in the decision making of these firms. A policy change on the part of one firm will have
immediate effects on competitors, who react with their counter policies.
Definition of oligopoly
In the other words of P.C. Dooley, ―An oligopoly is a market of only a few sellers, offering either
homogeneous or differentiated products. There are so few sellers that they recognize their mutual
dependence.

Classification of oligopoly.

Oligopoly may be classified in the following manner,

1. Perfect and imperfect oligopoly:
On the basis of the nature of product, oligopoly may be classified into perfect and imperfect
oligopoly. If the products are homogeneous, then oligopoly is called as perfect or pure oligopoly. If the
products are differentiated and are close substitutes then it is called as imperfect or differentiated oligopoly.
2. Open or closed oligopoly:
When new firms are free to enter it is open oligopoly. When new firms dominate the market and new
firms do not have a free entry into the industry, it is called closed oligopoly.
3. Partial and full oligopoly:
Partial oligopoly refers to a situation where one firm acts as the leader and others follow it. On the
other hand full oligopoly exists where no firms is dominating as the price leader.
4. Collusive and non-collusive oligopoly:
Instead of competition with each other if the firms follow a common price policy, it is called
collusive oligopoly. If there is no agreement or understanding between oligopoly firms, it is known as non-
collusive oligopoly.
5. Syndicated and organized oligopoly:
Syndicated oligopoly is one in which the firms sell their products through a centralized syndicate.
Organized oligopoly refers to the situation where the firms organize themselves into a central association for
fixing prices, output, quota etc.

Characteristics of oligopoly.
1. Small number of large sellers.
The number of sellers dealing in a homogeneous or differentiated product is small. The policy of one
seller will have a noticeable impact on market, mainly on price and output.
2. Interdependence

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 The oligopolist is not independent to take decisions. He has to take into account the actions and
reactions of his rivals while deciding his price and output policies.
3. Price rigidity
Any change in price by one oligopolist invites retaliation and counter action from others, the
oligopolist normally sticks to one price.
4. Monopoly element:
As products are differentiated the firm enjoys some monopoly power. Further when firm colludes
with each other, they can work together to raise the price and earn some monopoly income.
5. Advertising:
Usually both advertisements as well as variations in designs and quality are used simultaneously to
maintain and increase the market share of an oligopolist.
6. Group behaviour:
The firms under oligopoly recognize their interdependence and realize the importance of mutual co-
operation.
7. Indeterminate demand curve
The firms cannot estimate the sales when it decides to reduce the price. Hence the demand curve
under oligopoly is indeterminate.

Short –run and long run equilibrium of the oligopolist

The short run equilibrium for the firm is much the same as that for the
monopolist. The firm‘s demand curve will have a downward slop because of the
existence of differentiated products and/or brand identification. The price and
output level are determined by the equating of marginal cost and marginal
revenue.

To maximize profits, the firm will produce at a level of output indicated

by OX. It is at this level of output only that MC=MR. The demand curve (AR)
tells us what price will be charged at any level of output.
At the equilibrium level of output OX, the price will be set at OP. since
the price per unit (OP) exceeds the cost per unit (OA), the firm enjoys a per unit
economic profit of the difference between the two. The total economic profit
represented by the area APBC.
Long-run equilibrium for the oligopolist
Since we have assumed the oligopolistic industry to have rigid prices and since there are strict
barriers to entry into the industry, the long run equilibrium for the firm need not differ from that of the short-
run there is inducement for new firms to enter the industry to share the existing profit, but barriers to entry
prevent such an event.

Kinked demand curve

In 1939, Prof. Sweezy presented the kinked demand curve analysis to explain price rigidities in
oligopolistic markets. If the oligopolistic firm lowers its price, its rivals will lower the price in order to avoid
losing their customers. The firms lowering the price will not be able to increase its demand much. This
portion of its demand curve is relatively inelastic.
Contrary to this, if the oligopolistic firm increases it price, its rivals will not follow it and change
their prices. Thus the quantity demanded of this firm will falls considerably. This portion of the demand
curve of the oligopolistic firm has a kink at the prevailing market price which explains price rigidity.

Assumptions:
1. There is an established market price for the product of the oligopoly industry at which all the sellers
are satisfied.
2. Each seller‘s attitude depends on the attitude of his rivals.

94
 3. Any attempt on the part of the seller to push up his sales by reducing the price of his product will be
counteracted by the other sellers who will follow his move.
4. If he raises the prices. Others will not follow him.
5. The marginal cost curve passes through the dotted position of the marginal revenue curve so that
changes in marginal cost do not affect output and price.
Price rigidity under oligopoly is better explained by kinked demand curve as shown in the following
diagram.

The diagram shows that the firm is producing or units of output at OP price
level. Above the price P the demand curve as anticipated by the firm is DP. The
curve is elastic.Below the price P the anticipated demand will be PB which is
inelastic. When the demand curve is DP the marginal revenue curve is positive.
When the demand curve is PB the marginal curve becomes negative when there
is no scope of better profit, price remains rigid at PN.
The peculiarity shown in the diagram is a gap or discontinuity in MR
curve below the point of kink. KL shows the gap or extent of discontinuity
between MR and MR. This gap will depend on the elasticity of demand above
and below the kink. The gap will be large if the elasticity is greater above the
kink and inelasticity is also greater below the kink. Price will not change in
oligopoly unless there is a drastic change in demand and cost conditions.

Equilibrium price under pure oligopoly

In this case, the seller will neither raise the price nor reduces the price
because both ways he will lose. The following figure makes it clear.
As a consequence of a price war among the firms, the price has come
down to ON. At this price, the firm sells an output of OM earning just normal
profits. OM output is the optimum output as it is being produced at the lowest
average cost. If the firm raises its price beyond ON, it will lose all it customers
because its product is not differentiated. If it lowers its price below ON, it will
go out of business in the long run because it will not be earning even normal
profits.

Equilibrium price under differentiated oligopoly

The equilibrium in the case of product differentiation under

oligopoly is similar to monopolistic competition.
After the price war, the price has come down to ON. The firm sells
OM output and earns just normal profits the firm is producing less than the
optimum output.

Duopoly

95
Meaning of duopoly.
Duopoly is the special form of oligopoly in which there are only two sellers. It refers to a market
situation in which there are two competing sellers and each takes into account the price – output policy of
his rivals to determine his own price – output.

Pricing under duopoly.

The duopoly price in the long run may be a monopoly price or competitive price, or it may settle at
any levels between the monopoly price and the perfectly competitive price. In the short run the duopoly
price may even fall below the level of competitive price with both the firms earning less than even the
normal profits. Economists like Cournot, Bertrand, Edge worth and Chamberlin have given their models to
explain the price output determination in the market.
Cournot model:
Cournot model shows how two firms share the total market and
adjust output and how they maximize their profit. In the diagram, MC and
MR are assumed to be zero. Before B enters the market, A produces
1
OA  OB . The price is OC giving maximum profit OAPC. Then B enters
2
1 1
the market and produces AH i.e., AB or OB . The price falls from OC
2 4
to OZ. B gets total profit AHQR, A‘s profit falls from OAPC to OARZ the
1
total profit being OHQZ. When B produces AH which is of the whole.
4
1 1 3
The total output left for A is 1    . A may now react by
2 4 8

producing 1    . This process will continue till equilibrium output

1 3 5
2 8 6
and price are achieved.

Chamberlin model:

Chamberlin model is based on the assumption that both the

producers recognize their mutual interdependence.
Suppose the producer A enters the market first DB is the demand
curve and OL is the total output he chooses to produce. It is sold at OA
price and the total profit made is OLPA. Now the producer B enters the
market and produces LH quantity. Now the total quantity produced is
OL+LA=OH. As a result price falls to OZ. Now A realizes that his rival
will react to his action. Therefore he decides to reduce the output to OK.
The industry output is new OK+LH=OL. Thus by recognizing their
interdependence the firm reaches the monopoly solution. The market will
be shared equally.

Bertrand model

Under this model, producer A goes to business first. As he is the only producer he will get maximum
profit. Now B enters into the business and assumes that A will keep his price constant. B sets a price slightly
lower than A‘s price and as a result he captures the entire market.
Seller A in order to regain all the customers lost to B, will fix a price slightly below that fixed by B
and price cutting may continue until the price becomes zero. Thus, Bertrand argued that there would not be
any limit to the all in price since each seller could by doubling his produce, underbid his rival. Competition
will become quite cut throat under the Bertrand system, perhaps ultimately during one duopolistic out and
then learning the other free to operate as a monopolist.

96
Edgeworth model
The basic difference between this model and the Cournot model is that
in Cournot model, the output of the rival firm is assumed to remain
unchanged. Here the rival firm is supposed to keep the price unchanged.
3 th
It is assumed that each producer‘s capacity is limited to of his
4
entire market and each is confronted with his own demand curve made up of
one half of the consumers. The maximum output that A can produce is OB
and B can produce OB1.
The demand curves of A and B respectively are DT and DH. ‗A‘ first
enters the market and sets his price P1, and he sells the total output AP1. Then B enters the market and sells
at price slightly lower than A and thus captures his market. B then sells, the whole output at P 2 and snatches
from Abb1 of sales. Now A reacts and captures B‘s market to the extent of cc1.
This process of price-cutting continues until one of them say B fixes his price at P4. At this point
none can snatch the market from the other by lowering the price. Then A raises the price back to P, to
maximize his profit from his share of the market knowing that B has already thrown his entire supply. B
then follow suit. There is thus continual oscillations of price between P1 and P4 i.e., the upper and lower
limits.

Unit V

FACTOR PRICING
Distribution is an important division of economics. The theory of distribution deals with the
determination of the shares of the factors of production in the total output produced in the economy, over a
given‘period of time. In other words, it deals with the division of the national income of the country among,
the various factors of production. The total volume of commodities and services produced in a country
during a given period, say a year, may be roughly called its national income. National income is the result of
the cooperation of the factors of production namely land, labour, capital and organization. Since the factors
of production are scarce, we have to pay a price for them. Rent is the reward for land; wages are the reward
for labour; interest is the price we pay for capital and profits are the reward for organization.

The marginal productivity theory is the general theory of distribution. The theory explains how the
prices of the various factors production would be determined under conditions of perfect competition and
full employment. The theory has been developed by economists such as Wicksteed, Wicksell and Clark.
They have emphasized that any variable factor must obtain a reward equal to its marginal product.

According to the marginal productivity theory, the price of any factor will be equal to the value of its
marginal product. For example, we know that a consumer will demand a commodity upto the point at which
its marginal utility is proportional to the price he pays for it. Similarly, a firm will go on employing more
and more units of a factor until the price of that factor is equal to the value of the marginal product.

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 The marginal productivity is equal to the value of the additional product which an employer gets
when he employs an additional unit of that factor, the supply of all other factors remaining constant. In
theory at least, all units of a factor are uniform and are interchangeable. So the productivity of the marginal
unit of a factor determines the rate that is to be paid to all units of the factor. The employer adopts what is
known as the principle of substitution and combines land, labour and capital in such a way that the cost of
production is minimum. Then the reward for each factor is determined by its marginal productivity. The
marginal productivity theory of distribution has been used to explain the determination of rent, wages,
interest and profits. That is why, it is called the general theory of distribution.

Assumptions of the Theory

The theory is based on the following assumptions:
(1) There is perfect competition.
(2) All units of a factor are homogeneous. It means that one unit is the same as the other units in all
respects.
(3) One factor of production can be substituted for another
(4) The theory is based on the law of diminishing returns as applied business organization.
(5) There is full employment

Criticism of the Theory

The marginal productivity theory has been criticized on many grounds. The following are some of
the points of criticism:

1. Every product is a joint product and its value cannot separately attributed to either capital or labour
cir lan It is most impossible to measure the specific product of each of factors.

2. The theory takes into account only the factors operating on the side of demand and does not say
anything about the supply side in factor markets. But this cannot be the case always.

3. The theory assumes perfect competition and full employment. But in the real world imperfect
competition is the rule

4. One of the objections against the theory is that it is based on the assumption of continuous
substitution of factors. The critics point out that factor inputs are not usually fully variable. In other

5. Bohm-Bawerk has raised the following objection against the marginal productivity theory of
distribution. If the product of the marginal unit of labour governs the wage rate, and labour works
subject to diminishing returns, the intra-marginal worker will receive less than the amount that he

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 contributes to the total product. To the extent that labour fails to receive the intra-marginal surplus,
marginal productivity theory pictures the worker as subject to ―exploitation.

6. Normative Implications. The theory does not carry with it any ethical justification. It should not be
used to justify the existing gross inequalities of income in market economies. If the theory is
accepted, means that factors get the value of what they produce. Suppose, wages are low in a firm.
The employer may say wages are low because productivity of labour is low. But the real cause of
low wages might exploitation of labour by the employer. Hence the theory should not be used to
justify the present system of income distribution.

7. Hobson‘s objection: The marginal productivity theory of wages assumes a constant amount of capital
as the quantity of labour- is varied. But Hobson has argued that if the quantity of labour, is increased,
the quality of capital will always almost undergo some change.

8. There is also a criticism that the marginal productivity theory sheds no direct light on the problem of
relative shares because if fails to demonstrate the effects of technical change.

9. There is no doubt that the marginal productivity theory is an incomplete explanation of the problem
of distribution. But as Marshall puts it ―the doctrine throws into clear light one of the causes that
govern wage‖.

Modern Theory of Distribution

Keynes recognized, ―arbitrary and inequitable distribution of wealth and income‖ and massive
unemployment as the two major weaknesses of modern capitalism. The modem theory of distribution has
been developed by the Neo-Keynesians. Kalecki is a leading exponent of neo-Keynesian theory of
distribution.

The neo-Keynesians divide Keynes‘ consumption function into two parts: (1) the-propensity to
consume out of wages and (2) the Marginal Productivity Theory of Distribution propensity to consume out
of profits. In the simplest neo-Keynesian model, it is assumed that workers spend all their wages on current
consumption. The decisions of the capitalists to invest and to consume will determine their profits.
Capitalists can increase their share of national income by investing more or by consuming more. This
conclusion has been summed up in Kalecki‘s theory of profits (1968) as ―workers-spend what they earn and
capitalists earn what they spend.‖ Thus in neo-Keynesian economics, investment plays a key role in
determining the distribution of income between wages and profits. It plays an equally important role in
determining the level of national income to be determined.

99
 The neo-Keynesian theory considers the neoclassical assumption of perfect competition as
unrealistic. It is of the view that the degree of monopoly directly affects income distribution. An increase in
the degree of monopoly will result in a larger relative share of total national income going to profits at the
expense of wages.

The neo-Keynesian theory is macroeconomic theory of income distribution. But the neoclassical
theory -is microeconomic theory of distribution and is based on the view that income distribution is
essentially a matter of applying a general theory of pricing to-the factors of production (labour and capital)
according to marginal productivity principles. Mrs.Joan Robinson challenged the marginal productivity
theory of distribution during the 1950s, and questioned the view that the interest rate is based on the
marginal productivity of capital. According to her, the neoclassical production function is not meaningful
because it is based on the assumption that capital is homogeneous and is capable of quantification and
measurement.

The neo-Keynesians are of the view that the marginal productivity theory of distribution is not
meaningful, except as an apology to justify the existing gross inequalities of income in market economies
and the receipt of large incomes by owners of capital. The neo-Keynesian theory of distribution emphasizes
the struggle between workers and capitalists over the relative shares of national income going to wages- and
profits. This in a way is similar to the view of Ricardo and Marx that when wages rise, profits fall and vice
versa.

Marginal productivity is one of the pillars of neoclassical economics. The neo - Keynesian theory
strikes at this foundation.

Wages
INTRODUCTION
Wages are the reward for labour. There are two main kinds of wages:
(1) Nominal wages and (2) Real wages The term ‗nominal wages‘ refers to money wages. But the
term ‗real wages‘ refers to the commodities and services that the money wages command. The standard of
living of workers depends on real wages and not on money wages. Real wages depend on many things like
the purchasing power of money, additional benefits the workers get such as free boarding and lodging,
regularity of employment, working conditions and so on. Real wages do not always increase with money
wages. Sometimes, the money wages in a country will increase. But the real wages may not increase. In
spite of an increase in money wages, workers may be worse off if prices rise faster than money wages. So
we cannot say that workers in a particular country are well off merely by looking into their money wages. In

100
some countries like India, payment of wages in kind is not uncommon. But, generally when we refer to
wages, we mean money wages.
Factors determining Real Wages
1. Real wages depend upon the purchasing power of money. The purchasing power of money in turn
depends upon the level of prices. It changes with changes in the price level. For instance, money wages of
almost all classes of labour in India hav increased since Independence. But there has not been any
considerable increase in their real wages because most of the prices have gone up. Prices have increased
faster than money wages.
2. The form of payment is another factor that influences real wages. For instance, an agricultural
worker might be paid very low wages in money. But he may get other things besides money wages. He
might be getting free boarding and lodging Once in a year on a festival day, he may receive some clothes
from his employer. Similarly, railway employees may get a free pas to travel. These things should be taken
into account while considering real wages.
3. While considering real wages, we have to look into the nature of the job arid the regularity of
employment. We have to see whether the job is permanent or not. In some occupations, employment is only
seasonal. Agriculture in India provides only seasonal employment We may say .that a person who has a
regular job enjoys more real wages than one who has seasonal employment.
4. In some occupations there is possibifity of earning extra income. For example, a doctor may have
private practice or a teacher may undertake some private tuition to supplement his income.
5. The nature of work and also the conditions of work should be taken into consideration in any
discussion on real wages. Some jobs are pleasant and some are unpleasant and dangerous.. Further, some
jobs enjoy social prestige. For example, a lecturer in a college may not get more income than a clerk in some
foreign private firm. But the latter generally may not enjoy the same amount of social prestige as that of a
college lecturer. Though wages are low in the teaching profession, many prefer it because they can enjoy
long holidays.
6. Lastly, the scope for promotion and prospects of a higher wages in the future may induce a man to
work for a low wage in the beginning. Thus, many factors govern real wages.
Theories of Wages
The theories of wages explain how wages are determined. There are many theories of wages but no
theory is free from criticism. A major difficulty in formulating a theory of wages is that while considering
the remuneration for labour, we should take into account the human factor involved in labour. In other
words, any realistic theory of wages should take into account even some non-economic factors which have a
great influence on the determination of wages. Some of the early theories of wages are:
1. The Subsistence Theory of Wages or the Iron Law of Wages,
2. The Standard of Living Theory,
3. The Wages-fund Theory, and

101
 4. The Residual Claimant Theory.
Among the recent theories, the most important are:
.1. The Marginal Productivity Theory of Wages,
2. The Market Theory of Wages, and
3. The Bargaining Theory of Wages.
Early Theories of Wages
1. The Subsistence Theory of Wages: According to the subsistence theory, the sum that is paid to the
worker as wages must be just enough to cover his bare needs of subsistence. The followers of the theory
believed that in the interests of the workers, the level of wages at any time should not exceed the subsistence
level. they argued that if workers were paid higher wages, population This, in turn, would increase the
supply of labour On account of competition for jobs, wages would fall once again. Their argument seems to
be that an increase in wages would sooner or later result in a fall in wages. So in order to prevent a fall in
wages, workers should not be paid more than what is necessary to keep them at subsistence level. And wags
cannot be paid below the subsistence level because it would cause starvation, disease and death among
workers. So, there will be shortage in the supply of labour and wages will go up. In the past, economists
believed that the value of a commodity was determined by its cost of production. They regarded labour as a
commodity and the subsistence wages as ‗the cost of producing labour. The subsistence theory is also
known as the Iron Law of Wages.
Criticism: First, the theory is based on the assumption that an ncre4se in wages will result in an increase of
population. it is not a correct view. Second, a worker is a human being. Man is different from the animal.
Apart from providing the minimum needs like food, clothing and shelter, the wages of a worker should
enable him to enjoy some good things of life. Third, the theory is one-sided. it looks at wages only from the
side of supply and ignores the influences acting on the side of demand for labour. Fourth, it cannot explain
why there are wage differences Fifth it is rather difficult to define the term subsistence level‘ precisely What
is considered to be bare minimum for human existence differs from period to period Things that were
considered to be luxuries of the rich in due course because necessaries even for the poor. Tea and electricity
axe good examples. Lastly, the theory does not carry with it any ‗ethical justification.‘
2. The Standard of Living Theory: The Standard of living theory is an improvement on the
subsistence theory. While the subsistence theory tells that wages paid to a worker must be jiIst sufficient to
provide for his subsistence, the standard of living theory makes allowance for some comforts and a few
luxuries besides the basic needs. The theory tells that wages are determined by the standard of living of
workers. If standard of living is high, wages will be high (e.g. the USA). If standard of living is low, wages
will be low (e.g. India).
Criticism
1. ‗it is true that there is some connection betweenstandard of living and wages. But it is rather difficult
to Say which is the cause and which is the result. The theory tells that standard of living determines

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 wages. But it may not be wrong to say that wages determine the standard ‗of living In fact, one of the
main causes for the low standard of living of Indian workers is low wages. All that we can say is
that both Wages and standard of living are interdependent A great difficulty with regard to the theory
is that the standard of living cannot be measured correctly because it is a vague thing. Since it is
always changing, it will be difficult to measure it.
The Wages Fund Theory: The wages-fund theory is associated with the name of J. S. Mill. Instead of
saying that Mill originated the Wage Fund Doctrine, it may be right to say that he popularized the doctrine.
According to this theory, ―Wages depend upon the proportion between population and capital.‖
The argument of the theory runs more or less in the following manner. At any time, a fixed amount of
capital is allotted for payment of wages to labour. This is the wages fund. It represents the demand for
labour.
By population, Mill means here the number of the labouring class rather those who work for hire. At
any time, there will be a fixed number of workers willing to work. It represents the supply of labour.
Wages at any time are determined by the ratio between the amount of wages-fund and the total supply
of labour. In other words, wages depend upon the proportion between the number of workers and the
capital that forms the wages fund. The fund remaining the same, if there is an increase in the supply
of labour, wages will fall. The advocates of this theory under the influence of Malthus, believed that
general rise in wages would increase the population, which in turn would lead to a fall in wages.
Certain things follow from the wage-ftmd doc&ine The wage-fund doctrine was used to show the
atttempts made by workers by means trade union activity are useless. If workers in a section of
industry managed to get an increase in wages by trade union activity, workers employed in other
firms would be affected. The Wage fund remaimg same, they would be affected. The wage-fund
remaining the same, they would get lower wages. Further, wages can raise profits. When profits fail,
savings will fall and this will affect the growth of capital. This, in turn would affect the demand for
labour the only way by which workers can improve their lot is by discouraging the growth of
population. So a general rise in wages is impossible unless, the supply of labour is regulated by
controlling the increase of population. The influence of the Malthusian theory can‘be here quite
clearly.
The wages-fund doctrine was used as a basis for Opposing trade unionism. But Mill believed that
workers had every right to combine raise their wages. So he abandoned the doctrine in later life.
Criticism: The theory has been subject to many points of‘criticism. First, the wage-fund concept itself
is wrong because the is no predetermined proportion of capital that must go to labour. Second, the
theory assumes that a rise in wages will result in an increase in population. But there is no direct
relationship between the two. Third, it does not explain inequality of wages in different occupations.
Lastly, the theory believes that if wages rise, profits will fall. This is not a correct view. For, in times
of good trade, both wages and profits will increase.

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4. The Residual Claimant Theory: According to this theory, wages are paid out of the residue that is
left over after paying rent, interest and profits. In the words of Professor Walker, an American
economist, wages ―equal the whole product minus rent, interest and profits.‖
Criticism: A great merit of the theory is that it takes into account productivity as a factor in
determining wages. But it tells that a worker gets the residual share in the product of an industry. It is
like putting the cart before the horse. Wages are in the nature of. advance payment and they have to
be paid first. Usually, profits are taken at the end. It is the entrepreneur who gets‘profits at the end by
taking the residual share of industry.
Recent Theories of Wages
1. The Marginal Productivity Theory of Wages: The marginal productivity theory of wages is nothing
but an application of the marginal productivity theory of distribution (i.e. the general theory of
distribution). The theory tells how wages would be determined under conditions of perfect
competition. According to this theory, wages will be equal to the value of the marginal, product of
labour.
The demand for labour is derived demand. That is, an employer demands the services of a worker
because his services are needed for the production of some goads In other words, he demands labour
because it is productive. As an employer goes on increasing the units of a factor, the returns from
additional units will diminish sooner or later. This is on account of the influence of the law of
diminishing returns. An employer will go on increasing more and more units of labour until the wages
he pays are equal to the value of the marginal product. In other words, wages are determined by the
marginal product of labour. The marginal (revenue) product of labour is equal to the value of the
additional product, which an employer gets when he employs an additional unit of labour, the supply
of all other factors remaining constant. it is assumed that all ‗inits of labour ar uniform. So
theproductivity of the marginal unit of labour settles the rate which is to be paid to all units of labour.
This, in short, is the marginal
productivity theory of wages..
Criticism: (1) Every product is a joint product and its value cannot be separately attributed to either
capital or labour or land. it is almost impossible to measure the specific product of each of the
factors. The problem becomes more complex when we have to measure the productivity of certain
categories of labour who render services (e.g. doctors, actors and teachers). (2) The theory assumes
perfect competition. But in the real world, imperfect competition is the general rule. (3) Under
conditions of monopoly, where there is exploitation of labour, wages will be much less than the
marginal productivity of labour. (4) An entrepreneur pays wages for many months before his
products are made and can be sold. So he cannot afford to pay them the full value of their marginal
product. He pays only their discounted value because he has to deduct interest on the capital he has
invested from the marginal product, until he sells his product. This, in short, is the discounted

104
marginal productivity theory of wages: ―Wages are the discounted marginal product of labour.‖ (5)
The theory does not carry with it any ethical justification. It may be used by the employers to show
that wages are low because productivity is low. But exploitation of labour might also be a main cause
of low wages. (6) The productivity of labour does not depend on its own effort and efficiency alone.
To a very great extent, it depends on the quantity of the other factors of production employed,
especially capital and the entrepreneur. (7) According to Keynes, the theory is valid only in static
conditions. He argued that lowering the wage rate in a trade depression would not necessarily
increase the demand for labour. (8) Lastly, it does not pay much attention to influences acting on the
side of supply. Nevertheless, the marginal productivity theory explains the role of. productivity in the
determination of wages. As Marshall puts it, ―the doctrine throws into clear light, the action of one of
the causes that govern wages.‖
None of the above theories taken by itself can explain how wages are determined. Wages are
governed by many causes. Each theory lays stress on one or two points but does not explain aji the
factors that govern wages. Any realistic theory of wages must take into account both the supply of
labour and the demand for it. Where there is scarcity of labour, wages will be high. Trade unions also
exercise a great influence on the determination of wages. In all those industries where trade unionism
is strohg, wages are generally high. We shall now study the. market theory of wages and the
bargaining theory of wages, one by one.
2. The Market Theory of Wages: The market theory regards wages as a price—the price of labour.
Like all other prices, wages are also
determined by the market forces of supply and demand. So we must consider supply and demand
conditions in the labour market.
The Supply of Labour
There is a certain amount of ambiguity about the concept of supply of labour. It may mean either the
total number of people available for employment or the total number of hours worked. In the case of
a commodity, its supply depends on its cost of production. It is rather difficult to apply cost of
production to labour in general. But still, we can apply it to the various forms of specific labour.
Some types of labour require long periods of training. That means sacrifice of earnings during the
period of training. Thus foregone earnings becomes an important factor in the estimation of the cost
of labour.
The Demand for Labour
Demand for labour is a derived demand. That too, anticipated demand. Modern production is carried
on largely on the basis of anticipation of demand for goods. If business expectations are high, it will
stimulate demand for labour. Demand for labour also depends on the possibifity of substitution of
labour by capital. That depends on the relative prices of these two factors and the type of
technological change. An increase in investment wifi increase the demand for labour.

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 The Price Mechanism and the Labour Market
In a competitive labour market, equilibrium will be established at the wage that equates the demand
for labour with the supply of labour.
Wages will be high if demand is high relative to sup5ly. This can happen if there is scarcity of
qualified workers, or if the productivity on the job is high or if the demand for the product is great.
By contrast, wages will be low where supply is high relative to demand. This can result from an
abundant supply of skilled workers or low productivity or weak demand for the product.
In the real world, there are many imperfections in the labour market, both on the supply side and on
the demand side. On the supply side, there is geographical immobility and occupational inimobffity.
The need for etensive training and further education act as a further check on the supply of labour ‗to
certain trades and professions. Supply can also be restrictedby restricting the number of places. For
example, only a fbed number of places exist in Engineering, Medical and Law colleges so that onlr
this number -of engineers, doctOrs and lawyers can enter the market each year. Financial barriers
may also restrit entiy to o&upations where initial capital is required. Trade unions cah also influence
the supply of labour: In many labour markets, the
supply of labouriscontrolled by aunion..
-Backward-bending supply curve -•
According to the general law of supply, an increase in price will increase the‘ supply of a good.
Accordingly, a rise in wages should increase the supply of labour. This may be generally true. But
the supply of labour cannot always be increased, by an offer of higher wages. That is because, after
wages have reached a certam level, workers may prefer leisure to ‗further income. This provides an
example of backward-bending supply curve (or regressive supply curve). And it is one of the
peculiarities of supply of labour.
The Backward Berdmg Labour Supply Curve

In Figure wage rate is represented up the vertical axis and hours worked per week is represented
along the horizontal axis. At a wage OW, the worker is willing to work ON hours. At any lower wage, he is
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willing to work only for a- shorter -period. However, if his wages rise above OW, his willingness to work
declines and at the wage OV‘4, ,he would work only ON1 hours.
We shall now look at the, imperfections on the demand side (i.e. demand for labour). Sometimes,
there m.y be only, one buyer and many sellers in the labour market. It is a case of monopsony. Monopsony
may be thought of as ―buyer‘s monopoly.‖ For example, - there may be only. one spinning mill in a town.
Then, it becomes the sole employer ,for those who work in that industry. Usually, a -monopsonistwffl
employ less number of workers and pay them lower wages in comparison with competitive wage.
We have already noted that in many labour markets, th\supply of labour is,controlled by a‘trade
union. Wecan thinkçf the union as a monopoly seller of labour.. Like the monopolist, the union will
have the power to choose either the price (wages) or quantity (number employed given market
demand). The union will try to restrict the supply of labour in order to command a high wage rate as
compared to competitive wage.

In the case of a bilateral monopolymodel of labour market, there will be one buyer and one seller.
The buyer may be government and the seller a trade union. In the case of bilateral monopoly, both the buyer
and the seller will try to get maximum benefits from the transaction. The buyer and seller may agree on
some quantity of labour but the theory does not predict the exact price that is the wage rate. At best, we can
only say that the price of labour will be somewhere between the monopolist‘s (or union‘s) preferred wage
and, the monopsonist‘s (or government‘s) preferred wage.
3. The Bargaining Theory of Wages: Most of the earlier theories of wages did not take note of the influence
of trade unions on wages through collective bargaining. For example, the marginal productivity theory of
wages is based on the assumption of perfect competition, whereas collective bargaining makes competition
imperfect. Collective bargaining provides the example of bilateral monopoly where the trade union is the
monopolist supplier of labour and the employers‘ association is the monopsonist buyer of a particular kind
of labour.
The advocates of the bargaining theory of wages argue that the level of wages in an industry depends on the
bargaining strength of the trade union concerned. They attribute the differences in wages in different
occupations to differences in the strength of the respective trade unions. The power of a trade union depends
on a number of things like the size of its membership, the size of its ―fighting‖ fund and the extent of the
dislocation it can cause to the national economy by a strike: If there is a strike by transport workers, doctors
and nurses, it will cause a lot of dislocation. The abffity of the trade unions, to influence wages also depends
upon the prevailing economic conditions. During a period of prosperity and full employment, the trade
unions will be m a strong position and during periods of depression, they will be in a weaker position.
To what extent a trade union can raise the wages of its members?
To answer this question, ve must keep in mind, the distinction between real and nominal (money) wages.
The advocates of the marginal productivity theory of wages argue that real wages can be increased only if

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they are below the value of the marginal product of labour. Real wages cannot exceed this limit for long.
They argue further that real wages can be increased only by employing less labour in relation to other factors
of production or by increasing the efficiency of labour. During a period of inflation, it is easy to increase
nominal wages. But it is not so easy to raise real wages. Even if a trade union succeeds in increasing the
wages of its members, there will be a sympathetic rise in wages in other industhes and prices will rise. A
permanent increase in real wages can be achieved only by an increase in the volume of production and the
productivity of workers. Since World War II, efforts have been made to increase real wages and not merely
money wages. With this end in view, sometimes unions have been persuaded by government to accept wage
freeze and ‗incomes policy.‘
A trade union has many ‗goals such as increasing wages of its members, safeguarding their jobs, reduction
of working hours and improvement of working conditions. But we are interested mainly in the goals relating
to wages and employment. Generally, a trade union gives priority for increasing wages and for maximizing
the number of workers employed. But it is rather difficult for it to achieve both the things at the same time.
There has to be a trade off between higher wages and lower levels of employment
The union strategies include the following things:
1. It may increase wages by restricting the supply of labour. (This is similar to a monopolist raising the price
of his product by restricting the output). The union can resthct the supply by some form of closed shop
policy, that is, only the members of the union can.be employed.
2. The union can impose a minimum by threatening to goon strike. If a minimum wage is not paid, no
workers will be available for employment

Shift in the Demand Curve

3. Sometimes, the union can succeed in increasing both wages and employment This is possible by shifting
the demand curve for labour the right. To do this; the union could either increase the productivity of
its members or increase the demand for the final product.
Wage Differences . -
Wages differ from one occupation to another and within the same ocëupation too There are many causes for
differences in wages:
1. Wages differ according to the conditions of supply. Where the supply of labour is relatively abundant,
wages tend to be low. The 10w wages paid to an agricultural worker in India is a good example.
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2. Sometimes, on account of ignorance, workers may fail to move
from ill-paid jobs to better jobs. . .. ..
3 Wages differ according to agreeableness or disagreeableness of work. People who are employd
to‘do‘dangerous jobs and unpleasant work have tO be paid more than:those who do pleasant work. Spies, for
example, are paid high wage But sometimes people who do. the! most unpleasant jobs are badly paid. For
example, scavengers in our country are paid very low wages. The reason is that disagreeable work like
scavenging requires little skill and generally the supply of labour available for this kind: of work-is greater
than the demand for it, and
so it is often poorly paid. . . .. . . . . . .
4. The period of training for some jobs is long and expensive. So- only a few can undergo such training.
Such persons. get high wages. For example, doctors and engineers get higher wages than typist&
5. Wages in those occupations where trade unionism is strong will be higher than in those occupations where
trade unionism is weak.
6. Even within the same trade, wages may differ because men differ in their ability. Some workers will earn
more.. For example, there are doctors. But only a few doctors earn very, large incomes. That is sometimes
described as the rent of ability.
• 7. Some occupations possess advantages of non-monetary kind. The non-monetary (or net) advantages and
disadvantages also influence wages and cause wage differences. For example, in some employments, the
worker has a greater degree of independence than in others; in some occupations, the worker enjoys a high
degree of security from dismissal He cannot be dismissed except for gross misconduct (e.g. civil service).
And some jobs may carry a degree of prestige. Some occupations are subject to seasonal unemployment
(e.g.kIaye) Sometimes, the hours of work, rnay be. inconvenient. In some occupations,-may be necessary. to
.work on Sundays or public holidays (eg. ,workers, .especially drivers and conductors). In some jobs it may
be necessary to-spend long periods away from home (for example, sales representatives and navy rneii). All
these factors also cause wage differences.
8. Generally, women earn less than men. To some extent, it is true that there is discrimination against
women in the labour market. There are other socjo-economic reasons too.
9. Lastly, wages also differ on account of geographical immobility of labour, besides occupational
immobility Eventhough, workers in a particular trade wifi get better wages if they go to another place, they
will not do so for many reasons such as the fear of the unknown, language barrier and housing problem. ―Of
all forms of luggage, labour
the most difficult to transport.‖ . . -
SYSTEMS OF WAGE PAYMENr
Wages Rate
Standard rate :.Jt refers to the payment of a standard rate to all workers engaged in similar work. Standard
rate, whether it is time rate or piece rate, is a convenient measure, both for the employer and employee .

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Time-rate and Piece-rate
There are different methods of calculating wages. But the time-rate the piece-rate are the best known
systems of payment. Where time-rates are in operation, all employees engaged in similar work are paid an
agreed sum per hour. A great demerit at the system that all workers good, bad and indifferent receive equal
payment they work the same number of hours. Of course, whenever production, is curtailed, the less
efficient workers will be dismissed first.
Piece-rates
In the piece-rate system, wages received by the worker Will depend the amount of work,done That,is, the
worker will receive a fixed payment for a definite, measurable amount of work. Piece-rate system be
operated only where the work of each worker can be easily measured. Sometimes, the system can be
extended to a group of workers where the group of employees work together. But if the work cannot be
standardized and measured (e.g. the work of shopkeepers, drivers and teachers) and if the work is of a
Continuous nature, payment by piece-rate is not possible. We have tO, adopt only time- or standarclrate
system If the quality of work is more‘important the quantity, piece-rate system becomes an Unsuitable
method.
Advantages of Piece-rate System
1. Quick workers can earn more. They will not waste time while on work.
2. Output can be increased. Even the cost of production may be reduced because more output will be
produced for a given fixed cost, only variable cost will increase.
3. The cost of supervision will go down. If the worker does not produce results, his wages will be affected.
Disadvantages of piece-rate system
1. There is danger of deterioration of the quality of the good. The accent will be more on quantity than on
quality. So it will be necessary to appoint inspectors to check the quality of the work done and to reject
unsatisfactory work.
2. Sometimes, the really good workers, who .take a longer time over their work, may earn less than those
whose work is just satisfactory.
. The system may make workers to work too fast so that they can earn more. That is not always good. It
maybe injurious to their health. Of course, by experience, the worker will find out the optimum speed
at which he must work. -
4. There is scope for exploitation of workers by fixing low piecerates. Nowadays, care is taken to fix piece-
rates on a scientific basis, espedall where the work varies greatly in difficulty.
Bonus system
Bonus is a payment in addition to wages. Bonus is paid to employees to encourage them to put forward
greater effort Born‘s is based on the modification of simple piece-rate systems of wage payments. There are
different bonus systems. The best known is the premium bonus system

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Premium bonus is a system of wage payment under which a bonus is added to the hourly rate of pay. A
standard time will be assigned to each piece of won, and the bonus paid to workers is based on the
percentage of.time saved.
There is another bonus system known as task bonus. It is a system of wage payment whereá task is
set, a bonus being paid if the task is completed by the worker within the standard time.
Wages and the cost of living Some trade unions have entered into agreements with their
managements whereby the wages of their members will be adjusted according to the cost of living.

RENT
In common language, the word ‗rent‘ refers to any periodic payment me for the use of a good. For
example, we pay rent for houses, shops and the like. This rent may be called contract rent. Suppose, we pay
rent for a house.
This (contract) rent includes besides the payment for the use of land, interest for the capital invested
in the construction the house, wages and profit. The classical economists like Ricardo used the term ‗rent‘ to
refer to the payment made for the use of agricultural land as such. Rent arises on account of the peculiar
characteristics of land, namely that its supply is inelastic and it differs fertility.

The Ricardian theory of rent has been the basis for all discussions on the problem of rent. The theory
is named after David Ricardo, an eminent economist of the 19th century. It is one of the earliest and popular
explanations of the nature of rent.
According to Ricardo, “rent is that portion of the produce of the earth which is paid to the landlord
for the use of the original and indestructible powers of the soil.” So, according to him, rent is a payment
made for the use of the “original and indestructible powers of the soil.” In other words, in the strict sense,
rent is a payment made for the use of land. Ricardo believed that rent arose on account of the differences in
the fertility of land. All lands are not equally fertile and so lands of superior fertility command an advantage
over the others. Superior lands get rent. Rent is a differential surplus.

Ricardo explained his theory of rent with, the aid of an example of colonization. Suppose, some
people go to a new country and settle down there. To begin with, they will cultivate all the best lands
available. There may be no need to pay rent so long as such best lands are freely available. Suppose
another batch of people goes and settles down in the new country after sometime. Naturally, the demand for
agricultural produce will increase. And in course of time, the first- grade lands alone cannot produce all the
food grains that are needed, on account of the operation of the law of diminishing returns. The law of
diminishing returns is the basis of the Ricardian theory of rent. So the second-grade lands, will have to be
cultivated in order to meet the needs of the growing population. If the second-grade lands are to be brought
under cultivation, the price of the grain prevailing in the market must be sufficient enough to meet the cost

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of production in the second-grade land. Otherwise, the second-grade lands will go out of cultivation. Since
under conditions of comeptition, there will be only one price for a con‘unodity, all the produce, whether it is
from the first-grade lands‘ or from the second-grade lands will‘ have the same price. Wben the second-grade
lands are cultivated, the first- grade lands will yield a surplus over and above their expenses of production.
This surplus is called rent. In our present example, only the first-grade land yields rent. The second-grade
land covers only the expenses of production. But suppose the demand for foodgrains further increases. Then,
inferior lands (in our example, third-grade lands) will be brought under cultivation. Now, even the second-
grade land will yield rent and the rent of the first-grade lands will increase further. The land that is just able
to meet its expenses of production is known as no-rent land. Rent indicates the differential advantage of the
superior land over the marginal.land. While discussing the relationship between rent and price, Ricardo has
stated that rent does not enter price. According to him rent is price-determined, i.e. it is determined by price.
Rent is high because price is high and price is high not because rent is high. Ricardo came to the conclusion
that rent did not enter price because according to him, there are some no- rent lands. But still their produce
has a price on the market and rent does not enter price here because the marginal lands do not get any rent at
all.
Rent arises on account of differences in the fertility of land. Besides differences in fertility, rent may also
arise on account of situational advantage. Some lands enjoy situational advantage. For example, they may be
nearer to the market. That may help them in saving a lot of transport costs. Even if all lands are equally
fertile, lands possessing situational advantage command some superiority over other lands. Thus rent arises
on account of differences in fertility and situation.

Diagrammatic Illustration of the Ricardian Theory of Rent

In Figure 19.1, grades of land are shown along the X-axis and the output up the Y-axis. Suppose, a farmer
by incurring the same expenses of production (say Rs. 5000 on each of the three grades of land) gets 100
units, 50 units and 25 units from the first, the second and the third grade land respectively. Then the first two
grades of land will yield a rent equal to the value of 75 units and 25 units respectively. It can be explained in
detail. Now, in the cultivation of the first-grade land, the farmer spends Rs. 5000 and gets 100 units. The
cost of each unit then is P.s. 50. So price should not be less than Rs. 50 with regard to the first-grade land.
On the seond-grade land too, production expenses are the same, that is Rs. 5000. But it yields an output of
50 units only Hence cost per unit beomes Rs. 100. So, if a farmer has to be persuaded to cultivate the second
grade land, he must get a price of at least P.s. 100 per unit. Only then, it wifi cover his cost of production.
(In this connection, it may be remembered that most of the early economists believed that the value of a
thing is determined by its cost of production). Since there will be only one price for a commodity at a time,,
even the farmer who cultivated the first-grade land gets a price of R. 100 per unit. So he will get a surplus
amount equal to the value of 50 units (i.e. P.s. 5000). When‘the third- grade land is cultivated, the second-
grade land will also get rent since price goes up and the farmer who cultivates the first-grade land, now that

112
the price is higher, will get a higher rent. That is why Ricardo said, ―rent is high because price is high and
price is high not because rent is high.‖ In our diagram, the first and the second‘ grade lands will yield rent
and the third grade land yields no rent. Rent is shown by the shaded area in the diagram.

1. According to Ricardo, the best lands are cultivated first. But there is n‘storicaI proof for this. Best lands
ae not always cultivated first.
2. (Objection has been raised against the use of the phrase‘―originaTh-nd indestructible powers of the soil.‖
It is argued that there are no sucn orignial powers or the soil and its powers are not indestructible. For, the
fertility of land may decrease in course of time by‘ continuous cultivation
Modern Theory of Rent
According to the modern theory of rent, the term ‗rent‘ is applied to ―payments made for factors of
product-ion which are in imperfectly elastic supply.‖ Thus the term ‗rent‘ includes besides payment for the
use of land, other payments for labour and capital as weil Rent.does not apply to land alone. Just as land
differs in fertility, men differ in their natural abilities. Men of superior ability will earn a very large income
in their occupation. For example, a surgeon with rare skill may get a very large income. There is an element
of rent in it. It represents rent of ability. In fact, there is a theory of profits known as ―Rent theory of profits.‖
Again, we can speak of rent with reference to manmade appliances too. Professor Marshallhas mtoduced the
concept of quasi-rent with regard to machines and other man-made appliances. So, the modem trend is that
rent can be applied to all factors of production. The condition for the emergence of rent is that the supply of
a factor should be inelastic in relation to the demand for
it. Scarcity is another thing that gives rise to rent.
Modern economists. make use of the term ‗transfer earnings‘ to explain rent with reference to a particular
industry. ―Transfer earnings refer to the aniount that a factor could earn in its best paid alternative
employment.‖ The transfer earnings represent the opportunity cost of its present employment. Any payment
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in excess of this amount is a surplus above what is necessary, to retain the factor in its best-paid employment
and so is rent.‖ (J. L. Hanson). Thus, any income in excess of the transfer earnings is known as economic
rent. For example, consider a popular South Indian cinema actress who demands Rs. 5 lakhs to act in a Hindi
film. If she acts in a Tamil Film, say, she usually gets Rs. 3 lakhs. Tn a Malayalam film, she may earn still
less. In the present case, her transfer earnings are Rs. 3 lakhs. Rs. 2 lakhs may be considered as economic
rent for acting in a Hindi film.
Mrs. Joan Robinson has also expressed more or less the same view on rent. ―The essence of the conception
of rent is the conception of a surplus earned by a particular part of a factor of production over. and above‘
the minimum earnings necessary to induce it to do its work.‖ (Joan Robinson: Economics of Imperfrct
Competition. Chapter 8). She has also said in the same context that ―particular units of factors of production
which belong to the other three broad categories, labour, entrepreneurship and capital may also earn rent.‖
Thus, the main point in the modern approach is that rent is not peculiar to land alone. The rent aspect can be
seen in other factor incomes as well. That. is why Marshall has said that.... ―even the rent of land is seen, not
as a thing by itself, but as the leading species of a lage genus; though indeed it has peculiarities of its own
which are of vital importance from the point of view of theory as well as practice.‖1
The traditional theory. of rent (Ricardian theory) overlooks two main facts regarding the use of land;
1. A given area of .Iand may have yarious uses, and
2. Land can be converted from one use to another.
If a piece of land has alternative use, only part of the rent is actually pure economic. rent. Only the income
earned in excess of transfer earnings will be economic rent.
Quasi-Rent
1. The concept of quasi-rent has been introduced in economics by Marshall. According to him,
―quasi-rent is the income derived from machines and other appliances for production made by
man.‖
2. In economics, the term rent is generally used to denote the income from factors whose supply is
permanently inelastic. Land is the main example of such factor. It supply is fixed both in the
short-run as well as in the long-run, In the short-run, the supply of machines and other man-made
goods also is inelastic. Suppose there is an increased demand for machines. In the short-run, the
supply of neither land nor machines can be increased to meet changes in demand. So in the short-
run, whenever there is a rise in demand for machines and other man-made appliances, they wifi
earn an income something similar
3. This surplus income which is earned by machines in the short- run and which will disappear in the
long run has been described as quasi-rent. The difference between land and man-made appliances
that the supply of land is permanently fixed while that of the latter fixed only in the short-run, In
the long-nm, the supply of machines and other man-made goods can be adjusted to meet changes
in demand.

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 4. For example, suppose the demand for fish increases during a given period. It means an increase in
demand for boats and nets. But the supply of boats and nets cannot be increased immediately. So
for some time they may earn some extra income similar to rent. if demand for fish continues to
remain at the higher level, in course of time, .new boats and nets will be produced and their supply
will adjusted to changes in demand. Incomes from boats and nets will once again fall to the
normal level. Then quasi-rent disappears.
5. Thus the increase in incomes of machines and other man-made appliances over a short period is
known as quasi-rent. It is rent because it is income from a factor whose supply is fixed and it is
‗quasi‘ because the inelasticity of supply is a temporary feature and rent that arises out of such a
condition is only a temporary Phenomenon.

INTEREST
Interest is the price paid for the use of capital. This is net interest or pure interest. The word interest
is generafly used to refer to the payment made for money. But we should remember thàt money is not capital
as such. It is used to buy capital. In other words, we can classify capital into real capital and money capital.
The former refers to capital or investment goods and the latter refers to the money (i.e. sags) that is used to
fmance the production or acquisition of real capj
Interest op. money capiÎ1 is simply the price at which funds are Ient and borrowed in order to finance
investment in real capital.

Gross Interest ànd Net Interest

Net interest is the price paid for the use of capital without any allowance for risk or anyother factor.
For example, the interest we get on some government securaties may be regarded as the net interest. Gross
interest includes besides net interest, othet things such as rrd for risk, remuneration for inconvenience and
pament for services. For example, when a money lender lends money to an Indian farmer, usually he charges
a high rate of interest because there is the risk of the non-payment ofthe capital, let alone interest There are
trade risks and personal risks. Further, lending money to others means inconvenience to the lender. It is
generally advantageous for a person to keep ready cash on hand.
That is why people prefer to have cash balances. This is known as liquidity preference. When you
lend money to someone, it means you cannot get it for some time. Not only that, you may not get it in the
right time also. Just to compensate for the inconvenience, one must be paid some extra income. Further, a
money lender has to perform a number of things before you get money from him. He has to pay for services,
keep accounts and all that. So gross interest includes some compensation for all the above things besides net
interest.

THEORIES OF INTEREST
There are many theories of interest. Some of them are (1) The Abstinence or Waiting Theory; (2)
The Agio Theory and the Eime Preference Theory; (3) The Marginal Productivity Theory; (4) Saving and
Investient Theory (TheClassical..Theory); (5) Loanable Funds Theory (Neo-classicalTheory); and (6) The
Liquidity Preference Theory (Keynesian Theory).

1. The Abstinence Theory or WaitingTheory According.to the Abstinence Theory of .Nassau Senior,
interest is reward for abstaining from the immediate consurnption of wea1th.
Marsha1l has accepted the abstinence theory of interest. But he preferred the word waiting for
‗abstinence‘. According to him, interest is the reward for waiting. Saving involves waiting, and almost as a
rule, people do not like to wait. So in order to make them save, we have to pay them some reward.

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Criticism : The main criticism against the theory is that savings do
not always involve suffering. When rich peoplesave, they do not practise abstinence. Further, it is a negative
theory. It tells that we have to interset to those who do not spend away all their money. If a man saves and
simply waits, he cannot get interest. Suppose a
man saves a thousand rupees, puts it in a pot, digs a hole in the ground and buries the pot in the ground. And
suppose he waits for one year, he cannot get any interest on the money. In other words, he does not take into
account productivity as a factor in the determination of interset.
2. The Agio Theory and the-Time Preference Theory: The ‗Agio‘ theory of interest was developed by
Bohm-Bawerk, an Austrian economist. His theory is built on the concept of ‗agio‘. It means a premium
which the present always carries as compared with the future. Generally, a man prefers present satisfaction
to future satisfaction is considered that the present goods are more valuable than future
goods, just as bird in hand is worth two in the bush. So, when people save, they have to postpone their
enjoyment of goods. Since people generally do not like postponement of satisfaction, if you want theui to
postpone their present satisfaction, you have to pay them some comensation and that compensation is
interest.
People prefer present consumption to future consumption for the following psychological and
technical reasons. The psychological reasons are they overestimate future resources and underestimate
future wants. Hope is the cause of the former and lack of imagination and weakness of will are the cause of
the latter. These two causes operate to increase the marginäl utility of goods in the present compared with
their marginal utility in the future. They create an agio (premium); and to call forth a supply of present in
return for futiire goods, that agio has tobe paid. .
The third factor is of a technical nature. According to Bohm-Bawerk, the whole progress of
civilization on its technical side consists in he adoption of more ‗roundabout‘ methods of production. From
he making of simple tools and instruments, to the production of most elaborate modern machines, progress
has meant more and more intermediate stag between the original factors and the finished consumption
goods.

TIME PREFERENCE THEROY

The Time-preference theory of Irving Fisher is basically 1he same as the Agio theorypf Bohm-
Bawerk. But it may be wrong to say that Bohm-Bawerk has completely ignored marginal productivity of
capital as a factor in the determination of interset.
According to Fisher, people have time-preference. They prefer present to future. That means, they
want to spend tlie current income in the present. But if they save, they cannot enjoy in the present. So
interest has to be paid to overcome the time-preference. Thus, interest is the price of time.
Time-preference is not the same for aIl classes of people. It differs according to different socio-
economic groups. There is a direct relationship between time-preference and the rate of interest. The greater
the time-preference, the higher the rate of interest and vice- versa. And time-preference depends on a
number of factors : (1) .The larger the income, the lesser the time-preference; (2) Peoplewith regular and
continuous income will have lesser tinie preference than those with irregular income; (3) those who earn
their incomè by wages will have greater time-prefernce than those who earn income from investment and
lastly (4) time-preference also depends on ones idiosyncrasies. For example, a spendthrift will have no tiirie
preference in a conventional sense. Thus, time-preference depends on the size of income, reguiarity or
irregularity of income, source of income and on the personal characteristics of the individual
Criticism : The main defect with the time-preference theory is that it pays too much attention to t1ie supply
side and ignores the influences actíng on the side of demand.
3. Marginal Prodictivity Theory of Distribution:The marginal productivity theory is nothing but the
application of the general theory of distributionccording to the marginal productivity theory, interest arises
ori accouitÓf the productivity of capital Capital is borrowed generally for investxnent. A person wìll
borrow.capital so long as the productivity of capital is higher than tbe rte of interest. On accotmt of the
operatíon of the law of diniììiishing réturns at some stage or other, beyond a certain point, it will not i,e
profitable for an. employer to. invest further capital. Thus tterest tends ‚to equal the marginal. productivity
of capital.

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Criticism: The main dement of the theory as that it takes into account oraly the factors.operating on the sÍde
of deniaA11 loans arenot borrowed for productive puxposes. Ançl ‚it carinot expláin why anterest is paid on
loaras borrowed for unproductzve purposes But its ment lies m the fact that it explaans why capital as
demanded It throws into clear light one of tlie causes that govèrn interest.

4. C1assical Theory (or Saving and Investment Theory) of Interest Interest is the price of capital. According
to the classìcai theory of interest, the rate of interest is determíned by the supply of capital which depends
upon sávings and the demand for capital for investment. The theory assumes that there is a direct
relatíonship between the rate of interest, savings and ìnvestment.
The classica1 economists believed that saving and supply of capital would íncrease whenever the
rate of interest went up. In other words, classical theory treated savíng as a direct function of the rate of
interest. As rate of interest was tonsidered a measure of the reward for saving, the classica1 economists
believed that the higher the rate of ínterest, the greater wou1d be the volume òf savíng. Not only that, they
treated investment as an inverse function of the rate of interest. In other words, as interest was treated as the
price of capital goods, whenever there was a fall in the rate of interest, there was increase in investment and
vice versa. The rate of interest is determined by the intersection of saving and investment functions. The
classical economists also believed that equilibrium between saving and investment.was brought about by the
rate of interest.
Diagrammatic Illustration of Classical Theory of Interest
From Figure 21.1 we can see that m1y when the rate of interest is r1 there is equilibrium between savíng and
investment. Any rate above or below that results in disequilibrium.

Fig. 21.1 Classical Theoiy of Interest

Criticism: Firstly, the classical theory is .based on the unrealistic assumption of full einploymçnt. Seiondly,
the theory does not take into account the effect of investment on income and,saving. In fact, according to
Keynes, saving is a direct function of income. When t1e rate of interest goes up, saving cannot a1ways
increase. When rate of interest rises, investxnent falls. When investinent falls, employment falls, income
falls and saving decreases. Thirdly, besides the rate of interest, savings depend upon other factors such time-
preference and liquidity preference. Fourthly, the theory assumès.that whenthere iŠ a fall in the rate of
interest, there will bé an automatic increase in demand for capital for investment purposes. This, however, is
not always the case. For, during a period of depression, the rate of interest may by low. I3ut it will not result
in an.increase in demand for capital because marginal efficiency of capital (expected rateof profit) will be
low duringsuch periods. Lastly, when we .consider the supply of. capital, we must also take into account
bank credit. The loanable funds
thory includes it
Loanab1e Funds Theory (or theNeo-classical Theory) of Interest: The Loanable-funds theory, ;alsp. known
as,the Neo-classicai theory, was developed by-ecpnomists Iike KUt Wicksell, Bertil Ohlin and Dennis
Robertson.
The loanable funds theory is an improvenient over classical theory because the term supply of
loanable fu,dsis vider in its scope and it includes not only saving. out of current incoipe, but also bank credit,
dishoarding and disinvestment The CIassica1 theory regarded.interest as a function of saving and
-. investment [r =f(S.I.)]. The Ioanabié funds theory, on the other hand, considered interest as a function not
on1y óf šaving and investment, but a1so of bank credit, òn the supply side nd of the desire to hoard .on the
demand side. Thus, according to the loanable funds theory, the rate of interest is a function of four variableš,
i.e. r =f(I,S,M,L), where I = Investment, S = srItig;M=bark treditnd L the desire to hoard

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or the desire for liquidity. The classicäl theàrý expláìnëd thëinterest rate in terms of real factors —real
savingai4 real yes ntsI lidnot.inc1ude monetar fact Qrs.Hence, it is nownas real theory of ìnterést. But the
Ioanable fuiids theory exp1aued mterest m terms of iot only real factors but also monery factors
Hence,smeansat aseferred to as the rèal as well aš.he înonetarý theory of interest the curve S represents
saving at different rates of interest. The curve represents the supply of bank credit (including the dishoarded
and disìnvested wealth). The curve S+ M represented by the dotted line refers to the total supply of loanable
funds at different rates of interest. It has been obtained by coinbining S and M curves. It slopes upwards and
it means that the higher the rate of interest, th.e greater the supply of loanable funds.

On the demand side,the curve I represents demand for investment. The curve L represents the deinand for
idle cash balances or the desire to hoard money at different leve1s of interest. The curve I +.L (dotted line)
has been obtaìned by combining the curves I and L. I + L represents the total demand for loanable funds at
different Iévelsof interest.
We have now two consolidated curves. The curve S + M reprcsents the total supply of loanable funds and
the curve I + L represents tfte total demand for funds. The market rate of ìnterest rrn is determined. by the
intersection of S + M curve and I ± L curve. At this rate of ìnterest (rm), the aggregate demand for loanable
funds .is equal to the aggregate supply of loanable funds.
We can now note the difference between the classica1 and the neo- classical theories of interest. According
to the classical theory, rate of interestis determined by the intersection of I artd S curves. Accordingly, when
the rate of interest is rn, the demand for investnient is equa1 to the supply of saving. . But according to the
loanable funds theory,
. . interest is determined by.the intersection of S + M and I + L curves. And according to loanäble funds
theory, the rate of interest. or example, is rm, Wicksell has made distinction between the nafsï rate of
inferest and the market rate of interest. Accordingto him, rn is the natural rate of interest and rin is the
market rate of interest.
Criticism 1.Like the classical theory, it also assumes that saving is a functìon of rate of interest.
2. It ignores the influence of the changes in the level of iiwestment on income and so on saving.
3. According to Hansen, the loanable funds theory is indetermi) In other words, it does not say precisely
how interest is determined. (marginal efficiency of capital. j expected rate of profits, remaining the same).
But keynes thought saving depended much more on the Ievel of income. Not orily that, he argued that
money is dernanded not only for spending on capita1 goods, There was also demand to hold. money in the
form of cash rather than in any other type, securities, buildings etc. Cašh is a liquid
• asset. It is readily accepted in exchange for goods and services.
According to Keynes, interest is the reward paid for parting with liquidity. In other words, ít is the reward
for not hoarding
the Keynesian theory of interest is a1so known as Monetary. Theory Ínterest
Motives for Liquidity Preference .•
Keynes has given three important motives.for liquidity preference:
(1) the transaction motive; (2) the precautionary motive; and (3) the speculativè motìve..
l. .Transaction Motive: This money isheld to finaïLce day-to-day spending. The amount of mGneÿ held for
transactìort motive will vary normally. with changes in both the income and the price level.
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 2. PrecautiànaryMotive: This rnoney is held to meet án unforesèen
expenditure
keynes defines speculative motive as the object of securing profit fm knowing better than the market what
the future will bring forth

Of the three motives, speculative motìve is more important in re1tion to the rate of interest.

TheSupp1y of Money
After introducing the concept of liquidity preference, Keynes said that rate of interest was determined by
liquidity preference on the one hand and the supply of money on the other. The classical economists looked
at the supply of money only in terms of the level of current saving. But in addition to saving, Government
can print money and banks also can create money (credit) within certain limits. Keynes was of the view that
the supply of money at any time was determined by the monetary authorities and it was rmore or less fixed
in the short run. .
Keynes explained the determination of the rate of interest in terms of the intersection between the
demand curve fr money (liquidity preference curve) and the supply curve of money.
Diagrammatic Illustration of Keynèsian liquidity Preference Theory

The determination of interest and the effects of chaxtges in liquidity

preference and the money supply are shown iri Figure 21.3 begin with, with liquidity preference represented
by curve L and supply of money represented by ,M,. the rate of interest is r. It is deterrnined by the
intersectioiL of L and M curves. An increase in the rate of interest r1, cou1d have been caused either by an
increase in , the demand for money to L1 or by a fall in supply of money to M)
fCriticism: There is no doubt that the Keynesian theory is far spe.c (o the earliër iheories of interest. It is a
general theory of. interçs. However, it has been criticised on certain grounds.

First of all, Keynes considered interest purely as a monetary phenomenoen. the neo-classical theory as
developed by Wicksell, real as well as monetary factors were taken into account to explain the determination
of rate of interest .
Second, the Keynesian argument that interešt is the reward for parting with liquïdity has been questionsed.

PROFIT THEORIES

Q. What do you mean by profit?

In economic theory of profit, it is defined as the reward for enterprise or organization, the fourth
factor of production. Profit is associated with entrepreneur and his functions. Though profit is an income for
the entrepreneur for his work, it cannot be said for what kind of work he is getting the income called profit.

Q. Define Profit.

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 Prof. Knight has rightly observed that, ―No term or concept in economic discussion is used with a
more bewildering variety of well established meaning than profit‖.
Profit is the return on investment of capital, and it is the reward for taking risk in business. It is a
residual income for the entrepreneur after paying off other factors. It is the difference between the total sale
proceeds obtained and the total expenses of production.

Q. What are the kinds of Profit?

I. Gross profit and Net profit:
Profit is classified into gross profit and net profit. Gross profit refers to the total earnings of the
entrepreneur. It includes the following terms.
1. Remuneration for factors of production contributed by entrepreneur himself:
In many business enterprises the entrepreneur contributes his own capital or land and works as
manager. In such cases the rent, interest and wages according to the entrepreneur will be included in the
gross profit.
2. Depreciation and maintenance charges:
The depreciation undergone by the machinery and plant during production process is treated as an
item of expenditure, is to be deducted from gross profit to arrive at net profit.
3. Extra-personal profit:
Monopoly profit is not due to the entrepreneur‘s ability but on account of his position in the market.
He also earns profit due to some favorable chance. For example a sudden increase in price of the commodity
due to outbreak of war the producer will get windfall incomes. These are all chance profits and have to be
deducted from the gross profit.
4. Gain as superior bargaining:
Certain gains accrue to entrepreneur when he bargains with labourers, capitalists, landlords, suppliers
of raw materials and consumers with whom he has dealing. These gains are mixed up with gross profit.
5. Reward for entrepreneurial functions.
Net profit is the reward for the functions performed by the entrepreneur. He performs the following
three important functions.
a) Reward for coordination of the factors:
The entrepreneur coordinates the factors production, draws up the plan of the business and gives full
shape. He also organizes and coordinates the production work.
b) Reward for risk taking:
The entrepreneur undertakes the risk of the business. He estimates costs and revenue and if anything
goes wrong, he will be the ultimate bearer of loss.

c) Reward for innovation:

The entrepreneur may originate new production technique, or bring new products and thereby reduce
cost of production and earn huge profit for himself. Thus net profit is the exclusive reward for the
entrepreneur for these three functions performed by the entrepreneur.
6. Monopoly gains:
Being a monopolist the entrepreneurs charge higher prices or pays lower rewards to the factors and
thus increase his profits. This forms part of gross profit.
7. Windfall gains:
Due to favorable circumstances the entrepreneur gets huge profits. Profits may also arise on account
of sudden increase in demand due to changes in tastes or discovery of new uses of a product.
Thus net profit is one of the constituents of gross profit. It is accrued by deducting all the contractual
and non-contractual payment from gross profit. It is to be noted that the net profits may be either positive or
negative.
II. Normal profit and Super normal profit:-
Normal profit is that profit which accrues to an entrepreneur in the long run. Stonier and Hague
defines normal profit ‗as those which are first sufficient to induce an entrepreneur to stay in the industry‘.
From the point of view of an industry normal profit is that profit which neither attracts a new firm to enter

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into the industry nor obligates the existing firms to go out of the industry. Thus normal profit is an element
of the cost of production and it is a reward to the entrepreneur.
Super-normal profit is the surplus over normal profit. Normal profits are earned by marginal firms
and super-normal profit is earned by intra marginal firms. Super normal profits do not enter into cost of
production.

Q. Explain the theories of Profit.

Several theories of profit have been propounded by the economists. No one theory of profit offers a
comprehensive explanation of the phenomenon of profit. Therefore, efforts should be made to evolve a
comprehensive theory of profit which will touch all aspects of profit.

Rent Theory of Profit

This theory was first propounded by the American Economist Walker. It is based on the index of
Senior and J.S. Mill. Walker says that profits are of the same gene as rent. He states that profit is the rent of
superior entrepreneur over marginal or less efficient entrepreneur. According to him, there was a good deal
of similarity between rent and profit. Rent was the reward for the use of land while profit was the reward for
the ability of the entrepreneur. Just as land differs from one another in fertility, entrepreneurs differ from one
another in ability.
Rent of superior land is determined by the difference in productivity of the marginal and super-
marginal lands, similarly the profits of the superior entrepreneur are determined by the difference in the
ability of the marginal land, there is the marginal entrepreneur. The marginal land yields no rent; so also
marginal entrepreneur is no profit entrepreneur.
The marginal entrepreneur sells his product at cost price and gets no profit. He secures only the
wages of management not profit. Thus profit does not enter into cost of production. Like rent profit also
dose not enter into price. Profit is thus a surplus.

Criticisms
1. There is no perfect similarity between rent and profit. Rent is generally positive, and never be
negative. But when entrepreneur suffers losses,profit can be negative.
2. The theory explains profit as the differential surplus rather than a record for an entrepreneur.
3. Profit is not always the reward for business ability. It may be due to monopoly or favorable chances
to the entrepreneur.
4. There is no marginal entrepreneur because whether the entrepreneur has ability or not he gets profit
as his reward.
5. The system of joint stock enterprise has become more important in the modern economy. Both dull
and intelligent shareholders enjoy the same dividends. In fact the less able may secure more
dividends if they possess more shares.
6. This theory assumes that profits do not enter into price. But this is unrealistic because profit as a part
of the cost of production does enter into price.
7. Rent is a known and expected surplus where as profit is unknown.
8. Walker has analyzed only surplus profit. But profit can be of several other types.
9. Profit is not the reward for undertaking risk but it is the reward for the avoidance of risk.

Wage theory of profit.

This theory was propounded by Taussig, the American economist. According to this theory, profit is
also a type of wage which is given to the entrepreneur for the services rendered by him. Just as labourer who
receives wages for his services, the entrepreneur works hard, gets profit for the past played by him in the
production. The only difference is that while labourer renders physical services, entrepreneur puts in mental
work.
Criticisms:
1. The main defect of this theory is that it does not make a distinction between wage and profit.
2. The entrepreneurs undergo risk in production, but the labourer undertakes no such risk.
3. Entrepreneur bears the entire responsibility to organize the business, but labourer need not do so.
4. Profits lend to very with price but wages do not vary so.
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 5. Profit may include chance gain while wages do not include such an element.

Risk Theory of profit:

This theory was given by Prof. Hawley in 1907. According to him, profit is the reward for risk-
taking. Drucker mentions four kinds of risks: replacement, risk proper, uncertainty and obsolescence.
Replacement is for depreciation and is calculable. Obsolescence is least calculable.
Risk proper and uncertainty are unknown and unforeseeable. Every entrepreneur produces goods in
anticipation of demand. If the anticipation fails, there will be loss. Entrepreneur takes this risk and for
bearing such risks profit is paid to entrepreneur. Higher the risk, greater is profit. Risk taking cannot be
delegated to others. It has to borne by the entrepreneurs. Hence, Prof. Hawley remarks, ―Profit is the
reward for the risk and responsibilities that the undertaker subjects himself to‖.
This theory is not free from defects.
1. According to Prof. Carver, ―Profit is the reward for risk-avoidance and not for risk taking.
2. This theory assumes that there exists a direct relation between profit and risk-taking. But in reality, it
is not so.
3. Profit is not due to all types of risk. Prof. Knight divides the risks into two types – foreseeable and
unforeseeable risk. Foreseeable risks are those which can be foreseen and insured. Unforseeable risks
are those which cannot be foreseen by the entrepreneur and hence cannot be insured. According to
Prof. Knight, profit is due to unforeseeable risk.
4. This theory considers risk as the only determinant of profit. But profit is determined by other factors
also.

Dynamic Theory of Profit

This theory was developed by an American Economist J.B.Clark. According to Clark, profit is due
to dynamic changes in society. He believed that profit cannot arise in static society as there is no uncertainty.
Price would be equal to cost of production. Hence there is no profit. If price is higher than the cost,
competition would bring the price equal to the cost of production. According to Clark, profit does not arise
in a static society. Even if it arises, it is fractional.
But society is always dynamic as several changes are taking place. According to Clark, five changes
are constantly taking place in society-changes in the size of population, supply of capital, production
techniques, forms of industrial organization and human wants. These changes affect demand and supply of
commodities leading to the emergence of profit.

The dynamic theory of profit has been criticized on the following grounds.
1. According to Prof. Knight two types of changes take place in a society. Foreseeable and
unforeseeable changes. Foreseeable changes are those which can be foreseen by the entrepreneur
and he can make provision for them. The changes which cannot be foreseen by the entrepreneur are
unforeseeable changes. Prof. Knight says that profit is due to unforeseeable changes.
2. Critics points out that the dynamics of Clark is, in reality, comparative statics. Dynamics refers to
continuous change. Profit arising in the dynamic society to Clark is only frictional and not profit
proper.
3. Prof. Taussig is of the opinion that the dynamic theory has created an artificial distinction between
‗profit‘ and ‗wages of management‘.
4. Clark has rejected the risk theory of profit on the ground that the risk is borne by the capitalist and
not the entrepreneur. But the risk theory cannot be summarily rejected as risk is an important
element in profit.
Schumpeter Innovation Theory of profit
This theory was propounded by Prof. Joseph. A. Schumpeter. He explains profit as a reward for
innovations. According to him, innovations refer to those changes which reduce the cost of production. It
may be the introduction of a new production technique or a new machine or a new plant, use of new source
of raw material, or a new form of energy, change in the quality of the product or in the method of
salesmanship.

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 Profit is the cause and effect of innovations. Innovation is introduced only with the desire to earn
profit. If it is successful it will result in emergence of profit only for a temporary period. When an
innovation is known and is being adopted by others, excess profits will be competed away. When profit
ceases, another innovation may take place, resulting in fresh profit. So profit due to innovation may appear,
disappear and reappear.

Schumpeter is of the view that reward for functions of the entrepreneur. It is only innovation which
yields profit. Profit does not arise in a static society, because innovations are not possible in such a society.
Innovation Theory is also defective.
1. This theory considers profit as a reward for innovation. It does not take into account several other
factors which cause profits.
2. This theory does not give importance to risk-taking. Schumpeter believes that the entrepreneur is
never the risk-bearer. It is the capitalist who undertakes risk. But in reality, it is the entrepreneur
who takes risk.
3. Profit is not merely due to innovations. It is also due to the organizational work performed by the
entrepreneur.

Uncertainty bearing theory of profit

This theory was propounded by an American Economist Prof. Frank.H.Knight. This theory, starts
on the foundation of Hawley‘s risk bearing theory. Knight agrees with Hawley that profit is a reward for risk
taking. There are two types of risks viz, foreseeable risk and unforeseeable risk.
According to Knight, regards profit as the reward of bearing non-insurable risks and uncertainties.
He distinguishes between insurable risks and uncertainties. He distinguishes between insurable and non-
insurable risks.
Certain risks are measurable; the probability of their occurrence can be statistically calculated. The
risks of fire, theft, flood and death by accident are insurable. These risks are borne by the insurance
company. The premium paid for insurance is including in the cost of production. According to Knight,
these foreseen risks are not genuine economic risks eligible for any remuneration of profit. In other wards
insurable risk does not give rise to profit.
According to him, profit is due to non-insurable risk or unforeseeable risk. Some of the non-
insurable risks which arise in modern business are as follows:
a) Competitive risk:
The existing firms may have to face serious competition from new firms.
b) Old Machineries:
This risk arises from the possibility of machinery becoming obsolete due to the discovery of new
processes.
c) Risk of Government Intervention.
The government in course of time interferes into the affairs of the industry such as price control, tax
policy, import and export restrictions etc, which might reduce the profits of the firm.
d) Cyclical risk:
The risk emerges from business cycles. Due to business recession or depression, consumer‘s
purchasing power is reduced; consequently demand for the product of the firm also falls.
e) Risk of demand:
This is generated by a shift or change of demand in the market.
Prof. Knight calls these risks as ‗uncertainties‘. These risks cannot be foreseen and measured, they
become non-insurable and the uncertainties have to be borne by the entrepreneur.
According to this theory there is a direct relationship between profit and uncertainty bearing. Greater the
uncertainty bearing, the higher will be the level of profits. Uncertainty bearing has become so important in
business enterprise in modern days; it has come to be considered as a separate factor of production. Like
other factors it has a supply price and entrepreneurs undertake uncertainty bearing in the expectation of
earning certain level of profit. Profit is thus reward of assuming uncertainty.

Criticisms:

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 1. Some times an entrepreneur earns no profit in spite of uncertainty bearing.
2. Uncertainty bearing is one of the determinants of profit and it is not the only determinant. The
profit is also a reward for many other activities performed by entrepreneur like initiating,
coordinating and bar gaining, etc.
3. It is not possible to measure uncertainty in quantitative terms as depicted in this theory.
4. This theory does not explain monopoly profit.
5. In modern business corporations ownership is separate from control. Knight does not separate
ownership and control and this theory becomes unrealistic.
6. Uncertainty bearing is a psychological concept which form part of the real cost of production.

Knight‘s theory of profit is more elaborate than the other theories because it combines the conception of
risk, of economic change and the role of business ability.

Marginal Productivity theory of profit

According to this theory, profit is determined by marginal productivity. The marginal revenue
productivity curve is the demand curve for the entrepreneur. The supply of entrepreneur depends on their
revenue productivity or earnings of the entrepreneur. Marginal revenue productivity of the entrepreneur
cannot be calculated because there is only one entrepreneur in a firm. It cannot be increased to two and it
cannot be reduced to half. Since there is only one entrepreneur, it is not possible to find MRP. However,
the MRP of entrepreneurship can be found out in an industry as their number can be varied.

MRP curve shows the marginal revenue productivity of the entrepreneur in an industry. It slopes
downwards because as the number of entrepreneurs in an industry increase, profit will decrease. SS is the
supply curve of the entrepreneur in that industry. The two curves intersect each other at P. The profit is OS.
This is a long-run situation.

In the short run the entrepreneurs will earn abnormal profits OQ. This abnormal profit will be
competed away in the long run when new firms enter the industry. In the long run, under conditions of
perfect competition, the entrepreneurs will earn only normal profits.

The marginal productivity theory of profit though better than other theories is not fully satisfactory.
The main defect of the theory is the difficulty of calculating the marginal revenue productivity of
entrepreneur to a single firm.

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