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NON-PRICE COMPETITION?

Definition and meaning

Non-price competition refers to competition between companies that focuses on benefits,


extra services, good workmanship, product quality – plus all other features and measures
that do not involve altering prices. It contrasts with price competition, in which rivals try
to gain market share by reducing their prices. Non-price competition is often adopted by
the competing players in a sector in order to prevent a price war, which can lead to a
damaging spiral of price cuts.

Non-price competition is a marketing strategy that typically includes promotional


expenditures such as sales staff, sales promotions, special orders, free gifts, coupons, and
advertising.

Put simply, it means marketing a firm’s brand and quality of products, rather than
lowering prices. Most companies across the world are involved in either non-price
competition, price competition, or both.

Non-price competition strategies include comparing your product to a rival’s, showing


that what you sell has been certified by a well-known ecological organization, and
constantly promoting your brand name and logo.

Non-price competition – oligopolies

Non-price competition is more common in markets where there is imperfect competition,


such as those with very few competitors – oligopolies – maybe because it can give an
impression of a very competitive market, when in fact the rivals are colluding to keep
their prices high.
According to ft.com/lexicon, the Financial Times’ glossary of terms, non-price
competition is:

“Competing not on the basis of price but by other means, such as the quality of the
product, what is on offer, packaging, customer service, etc.”

Non-price competition – two phases

There are typically two phases to a non-price competition strategy.

 The first implements new aspects of production or services,


 while the second lets consumers know about them.

The Economist describes non-price competition as follows: “Trying to win business from
rivals other than by charging a lower price. Methods include advertising, slightly
differentiating your product, improving its quality, or offering free gifts or discounts on
subsequent purchases. Non-price competition is particularly common when there is an
oligopoly, perhaps because it can give an impression of fierce rivalry while the firms are
actually colluding to keep prices high.”

CARTEL FORMATION
A cartel is a grouping of producers that work together to protect their interests. Cartels
are created when a few large producers decide to co-operate with respect to aspects of
their market. Once formed, cartels can fix prices for members, so that competition on
price is avoided. In this case cartels are also called price rings. They can also restrict
output released onto the market, such as with OPEC and oil production quotas, and set
rules governing other aspects of the behaviour of members. Setting rules is especially
important in oligopolistic markets, as predicted in game theory. A significant attraction of
cartels to producers is that they set rules that members follow, thus reducing risks that
would exist without the cartel.

The negative effects on consumers include:

1. Higher prices - cartel members can all raise prices together, which reduces
the elasticity of demand for any single member.
2. Lack of transparency - members may agree to hide prices or withhold
information, such as the hidden charges in credit card transactions.
3. Restricted output - members may agree to limit output onto the market, as
with OPEC and its oil quotas.
4. Carving up a market - cartel members may collectively agree to break up a
market into regions or territories and not compete in each other's territory.

When are cartels most powerful?

They are at their most powerful when there are high barriers to entry into the market or
industry, and when all members can be ‘policed’ by a dominant member.
Cartel-like behaviour

Some firms may act as though there is a cartel and undertake cartel-like’ behaviour, even
though there is no formal cartel, and this may be subject to investigation by the regulators

EXAMPLE

The Competition Commission of India (CCI) in a preliminary investigation has found six
leading cement companies have formed a cartel, this time in the northeastern region.The
competition watchdog had earlier imposed heavy fines on cement companies and the
Cement Manufacturers’ Association (CMA). The Commission had imposed a penalty of
more than Rs 60 billion on cement firms in 2012. In 2016, 11 companies and the cement
association were penalised Rs 67 billion.

Price Leadership
Price leadership occurs when a pre-eminent firm (the price leader) sets the price of goods
or services in its market. This control can leave the leading firm's rivals with little choice
but to follow its lead and match the prices if they are to hold on to their market
share. Price leadership is common in oligopolies, such as the airline industry, in which a
dominant company sets the prices and other airlines feel compelled to adjust their prices
to match.

More About Price Leadership


Price leadership has a greater impact on goods or services that offer
little differentiation from one producer to another. Price leadership is also apparent
where levels of consumer demand make a particular price selected by the market leader
viable because consumers are drawn from competing products. Price leadership is
assumed to stabilize prices and maintain pricing discipline. In general, effective price
leadership works when

 The number of companies involved is small


 Entry to the industry is restricted
 Products are homogeneous
 Demand is inelastic, or less elastic
 Organizations have a similar long-run average total cost (LRATC)

LRATC, an economics metric, is the minimum or lowest average total cost at which a
firm can produce any given level of output in the long run, when all inputs are variable.
Types of Price Leadership

In business economics, there are three primary models of price leadership:

 Barometric
 Collusive
 Dominant

'Pricing Strategies'

Definition: Price is the value that is put to a product or service and is the result of a
complex set of calculations, research and understanding and risk taking ability. A pricing
strategy takes into account segments, ability to pay, market conditions, competitor
actions, trade margins and input costs, amongst others. It is targeted at the defined
customers and against competitors.

TYPES OF PRICING STRATEGIES :-


 Premium pricing: high price is used as a defining criterion. Such pricing
strategies work in segments and industries where a strong competitive advantage
exists for the company. Example: Porche in cars, I phones in mobile and Gillette
in blades.
 Penetration pricing: price is set artificially low to gain market share quickly.
This is done when a new product is being launched. It is understood that prices
will be raised once the promotion period is over and market share objectives are
achieved. Example: Mobile phone rates in India; housing loans etc.
 Economy pricing: no-frills price. Margins are wafer thin; overheads like
marketing and advertising costs are very low. Targets the mass market and high
market share. Example: Friendly wash detergents; Nirma; local tea producers.
 Skimming strategy: high price is charged for a product till such time as
competitors allow after which prices can be dropped. The idea is to recover
maximum money before the product or segment attracts more competitors who
will lower profits for all concerned. Example: the earliest prices for mobile
phones, VCRs and other electronic items where a few players ruled attracted lower
cost Asian players.
 Psychological pricing. Setting price at important psychological levels to trigger
purchase, e.g. selling good at Rs 999 to make it appear cheaper. Some firms use reverse
psychology and charge exact prices, e.g. clothes for Rs 40 to indicate quality rather than
cheapness.
 Premium decoy pricing. Where a firm sets the price of one good deliberately high to
encourage demand for a lower price. e.g. a car company may bring out a top of the range
sports car, which is very expensive to make the general brand more attractive.
 Pay what you want. A situation where consumers are left free to decide how much to
pay, e.g. restaurants cafe where there is no cost – only tipping. When music companies
release a new recording and ask for donations.
Perfect Competition Market

Definition:
The Perfect Competition is a market structure where a large number of buyers and
sellers are present, and all are engaged in the buying and selling of the homogeneous
products at a single price prevailing in the market.
In other words, perfect competition also referred to as a pure competition, exists when
there is no direct competition between the rivals and all sell identically the same products
at a single price.

Features of Perfect Competition

1.Large number of buyers and sellers: In perfect competition, the buyers and sellers are

large enough, that no individual can influence the price and the output of the industry. An
individual customer cannot influence the price of the product, as he is too small in
relation to the whole market. Similarly, a single seller cannot influence the levels of
output, who is too small in relation to the gamut of sellers operating in the market.
2.Homogeneous Product: Each competing firm offers the homogeneous product, such

that no individual has a preference for a particular seller over the others. Salt, wheat, coal,
etc. are some of the homogeneous products for which customers are indifferent and buy
these from the one who charges a less price. Thus, an increase in the price would let the
customer go to some other supplier.
3.Free Entry and Exit: Under the perfect competition, the firms are free to enter or exit

the industry. This implies, If a firm suffers from a huge loss due to the intense
competition in the industry, then it is free to leave that industry and begin its business
operations in any of the industry, it wants. Thus, there is no restriction on the mobility of
sellers.
4.Perfect knowledge of prices and technology: This implies, that both the buyers and

sellers have complete knowledge of the market conditions such as the prices of products
and the latest technology being used to produce it. Hence, they can buy or sell the
products anywhere and anytime they want.
5.No transportation cost: There is an absence of transportation cost, i.e. incurred in

carrying the goods from one market to another. This is an essential condition of the
perfect competition since the homogeneous product should have the same price across the
market and if the transportation cost is added to it, then the prices may differ.
6.Absence of Government and Artificial Restrictions: Under the perfect competition,

both the buyers and sellers are free to buy and sell the goods and services. This means
any customer can buy from any seller, and any seller can sell to any buyer.Thus, no
restriction is imposed on either party. Also, the prices are liable to change freely as per
the demand-supply conditions. In such a situation, no big producer and the government
can intervene and control the demand, supply or price of the goods and services.
Thus, under the perfect competition, a seller is the price taker and cannot influence the
market price.

Price and Output Determination under Perfect Competition

Perfect competition refers to a market situation where there are a large number of buyers
and sellers dealing in homogenous products.
Moreover, under perfect competition, there are no legal, social, or technological barriers
on the entry or exit of organizations.
In perfect competition, sellers and buyers are fully aware about the current market price
of a product. Therefore, none of them sell or buy at a higher rate. As a result, the same
price prevails in the market under perfect competition.
Equilibrium under Perfect Competition:
As discussed earlier, in perfect competition, the price of a product is determined at a
point at which the demand and supply curve intersect each other. This point is known as
equilibrium point. At this point, the quantity demanded and supplied is called equilibrium
quantity.
Figure-3 shows the equilibrium under perfect competition:

In Figure-3, it can be seen that at price OP1, supply is more than the demand. Therefore,
prices will fall down to OP. Similarly, at price OP2, demand is more than the supply.
Similarly, in such a case, the prices will rise to OP. Thus, E is the equilibrium at which
equilibrium price is OP and equilibrium quantity is OQ.
Monopolistic Competition

In monopolistic competition, the market has features of both perfect competition


and monopoly. A monopolistic competition is more common than pure competition or
pure monopoly. In this article, we will understand monopolistic competition and look at
the features, price-output determination, and conditions for equilibrium.

Monopolistic Competition

In order to understand monopolistic competition, let’s look at the market for soaps and
detergents in India. There are many well-known brands like Lux, Rexona, Dettol, Dove,
Pears, etc. in this segment.

Since all manufacturers produce soaps, it appears to be an example of perfect


competition. However, on close scrutiny, we find that each seller varies the product
slightly to make it different from its competitors.

Hence, Lux focuses on making beauty soaps, Liril on freshness, Dettol on antiseptic
properties, Dove on smooth skin, etc. This allows each seller to attract buyers to itself
based on some factor other than price.

This market has a mix of both perfect competition and monopoly and is a classic example
of monopolistic competition.

Features of Monopolistic Competition

1. Large number of sellers: In a market with monopolistic competition, there are a

large number of sellers who have a small share of the market.


2. Product differentiation: In monopolistic competition, all brands try to
create product differentiation to add an element of monopoly over the competing
products. This ensures that the product offered by the brand does not have a perfect
substitute. Therefore, the manufacturer can raise the price of the product without
having to worry about losing all its customers to other brands. However, in such a
market, while all brands are not perfect substitutes, they are close substitutes for each
other. Hence, the seller might lose at least some customers to his competitors.

3. Freedom of entry or exit: Like in perfect competition, firms can enter and exit the

market freely.

4. Non-price competition: In monopolistic competition, sellers compete on factors other

than price. These factors include aggressive advertising, product development,


better distribution, after sale services, etc. Sellers don’t cut the price of their
products but incur high costs for the promotion of their goods. If the firms indulge in
price-wars, which is the possibility under perfect competition, some firms might get
thrown out of the market.

Price-output determination under Monopolistic Competition: Equilibrium of a firm

In monopolistic competition, since the product is differentiated between firms, each firm
does not have a perfectly elastic demand for its products. In such a market, all firms
determine the price of their own products. Therefore, it faces a downward sloping
demand curve. Overall, we can say that the elasticity of demand increases as the
differentiation between products decreases.
Fig. 1 above depicts a firm facing a downward sloping, but flat demand curve. It also has
a U-shaped short-run cost curve.

Conditions for the Equilibrium of an individual firm

The conditions for price-output determination and equilibrium of an individual firm are
as follows:

1. MC = MR

2. The MC curve cuts the MR curve from below.

In Fig. 1, we can see that the MC curve cuts the MR curve at point E. At this point,

 Equilibrium price = OP and

 Equilibrium output = OQ
Now, since the per unit cost is BQ, we have
 Per unit super-normal profit (price-cost) = AB or PC.

 Total super-normal profit = APCB

Monopoly Market

The term Monopoly means ‘alone to sell’. In a monopoly market, there is a single seller
of a particular product with no strong competition from any other seller. In this article,
we will look at the features of a monopoly market.

Features of a Monopoly Market

1. Single Seller of the Product

In a monopoly market, usually, there is a single firm which produces and/or supplies a
particular product/ commodity. It is fair to say that such a firm constitutes the entire
industry. Also, there is no distinction between the firm and the industry.

2. Entry Restrictions

Another feature of a monopoly market is restrictions of entry. These restrictions can be of


any form like economical, legal, institutional, artificial, etc.

3. No Close Substitutes

Usually, a monopolist sells a product which does not have any close substitutes.
Therefore, the cross elasticity of demand for such a product is either zero or very small.
Also, the price elasticity of demand for the monopolist’s product is less than one. Hence,
in the monopoly market, the monopolist faces a downward sloping demand curve.
Now, to a certain extent, all goods are substitutes for one another. However, certain
essential characteristics in a commodity or a group of commodities can lead to gaps in
this chain of substitution.

A monopolist or a single seller is one who identifies these gaps, excludes the competition,
and controls the supply of a particular commodity. Such a monopolist can use his single-
selling power in any manner to realize maximum revenue. This
includes price discrimination.

It is important to note that in real life, complete monopoly is extremely rare. However,
one firm can dominate the supply of a good or a group of goods. For example, in public
utilities, like transport, water, electricity, etc., monopolistic markets usually exist to reap
the benefits of large-scale production.

4. Price Maker

Since there is only one firm selling the product, it becomes the price maker for the
whole industry. The consumers have to accept the price set by the firm as there are no
other sellers or close substitutes.

Price-Output Determination under Monopoly:

A firm under monopoly faces a downward sloping demand curve or average revenue
cum. Further, in monopoly, since average revenue falls as more units of output are sold,
the marginal revenue is less than the average revenue. In other words, under monopoly
the MR curve lies below the AR curve.
The equilibrium level in monopoly is that level of output in which marginal revenue
equals marginal cost. The producer will continue producer as long as marginal revenue
exceeds the marginal cost. At the point where MR is equal to MC the profit will be
maximum and beyond this point the producer will stop producing.

It can be seen from the diagram that up till OM output, marginal revenue is greater than
marginal cost, but beyond OM the marginal revenue is less than marginal cost. Therefore,
the monopolist will be in equilibrium at output OM where marginal revenue is equal to
marginal cost and the profits are the greatest.
The corresponding price in the diagram is MP or OP. It can be seen from the diagram at
output OM, while MP’ is the average revenue, ML is the average cost, therefore, P’L is
the profit per unit. Now the total profit is equal to P’L (profit per unit) multiply by OM
(total output). In the short run, the monopolist has to keep an eye on the variable cost,
otherwise he will stop producing.
In the long run, the monopolist can change the size of plant in response to a change in
demand. In the long run, he will make adjustment in the amount of the factors, fixed and
variable, so that MR equals not only to short run MC but also long run MC.
The Sweezy Model of Kinked Demand Curve (Rigid Prices) (Non-Collusive
Oligopoly):
In his article published in 1939, Prof. Sweezy presented the kinked demand curve
analysis to explain price rigidities often observed in oligopolistic markets. Sweezy
assumes that if the oligopolistic firm lowers its price, its rivals will react by matching that
price cut in order to avoid losing their customers.
Thus the firm lowering the price will not be able to increase its demand much. This
portion of its demand curve is relatively inelastic.
On the other hand, if the oligopolistic firm increases its price, its rivals will not follow it
and change their prices. Thus the quantity demanded of this firm will fall considerably.
This portion of the demand curve is relatively elastic. In these two situations, the demand
curve of the oligopolistic firm has a kink at the prevailing market price which explains
price rigidity.
Its Assumptions:
The kinked demand curve hypothesis of price rigidity is based on the following
assumptions:
(1) There are few firms in the oligopolistic industry.
(2) The product produced by one firm is a close substitute for the other firms.
ADVERTISEMENTS:
(3) The product is of the same quality. There is no product differentiation.
(4) There are no advertising expenditures.
(5) There is an established or prevailing market price for the product at which all the
sellers are satisfied.
(6) Each seller’s attitude depends on the attitude of his rivals.
ADVERTISEMENTS:
(7) Any attempt on the part of a seller to push up his sales by reducing the price of his
product will be counteracted by other sellers who will follow his move.
(8) If he raises the price, others will not follow him; rather they will stick to the
prevailing price and cater to the customers, leaving the price-raising seller.
(9) The marginal cost curve passes through the dotted portion of the marginal revenue
curve so that changes in marginal cost do not affect output and price.
Kinked-Demand Curve

 P1 = Product Price of the Oligopoly


 If a firm raises its price (D1), but the others do not match the increase, then
revenue will decline in spite of the price increase.
 If the firm lowers its price (D2), then the other firms will match the decrease to
avoid losing market share.
 Because there is a kink in the demand curve, there is a gap in the marginal revenue
curve (MR1 - MR2). Since firms maximize profit by producing that quantity
where marginal cost = marginal revenue, the firms will not change the price of
their product as long as the marginal cost is between MC1 and MC2, which
explains why oligopolistic firms change prices less frequently than firms operating
under other market models.
The kinked-demand curve explains why firms in an oligopoly resist changes to price. If
one of them raises the price, then it will lose market share to the others. If it lowers its
price, then the other firms will match the lower price, causing all the firms to earn less
profit.
OLIGOPOLY MARKET
Definition: The Oligopoly Market characterized by few sellers, selling the
homogeneous or differentiated products. In other words, the Oligopoly market structure
lies between the pure monopoly and monopolistic competition, where few sellers
dominate the market and have control over the price of the product.
Under the Oligopoly market, a firm either produces:
 Homogeneous product: The firms producing the homogeneous products are called as

Pure or Perfect Oligopoly. It is found in the producers of industrial products such as


aluminum, copper, steel, zinc, iron, etc.

 Heterogeneous Product: The firms producing the heterogeneous products are called

as Imperfect or Differentiated Oligopoly. Such type of Oligopoly is found in the


producers of consumer goods such as automobiles, soaps, detergents, television,
refrigerators, etc.

There are five types of oligopoly market, for detailed description, click on the link below:
Types of Oligopoly Market

Features of Oligopoly Market

1. Few Sellers: Under the Oligopoly market, the sellers are few, and the customers are

many. Few firms dominating the market enjoys a considerable control over the price of
the product.
2. Interdependence: it is one of the most important features of an Oligopoly market,

wherein, the seller has to be cautious with respect to any action taken by the competing
firms. Since there are few sellers in the market, if any firm makes the change in the price
or promotional scheme, all other firms in the industry have to comply with it, to remain in
the competition.
Thus, every firm remains alert to the actions of others and plan their counterattack
beforehand, to escape the turmoil. Hence, there is a complete interdependence among the
sellers with respect to their price-output policies.
3. Advertising: Under Oligopoly market, every firm advertises their products on a frequent

basis, with the intention to reach more and more customers and increase their customer
base.This is due to the advertising that makes the competition intense.
If any firm does a lot of advertisement while the other remained silent, then he will
observe that his customers are going to that firm who is continuously promoting its
product. Thus, in order to be in the race, each firm spends lots of money on advertisement
activities.
4. Competition: It is genuine that with a few players in the market, there will be an intense

competition among the sellers. Any move taken by the firm will have a considerable
impact on its rivals. Thus, every seller keeps an eye over its rival and be ready with the
counterattack.
5. Entry and Exit Barriers: The firms can easily exit the industry whenever it wants, but

has to face certain barriers to entering into it. These barriers could be Government
license, Patent, large firm’s economies of scale, high capital requirement, complex
technology, etc. Also, sometimes the government regulations favor the existing large
firms, thereby acting as a barrier for the new entrants.
6. Lack of Uniformity: There is a lack of uniformity among the firms in terms of their size,

some are big, and some are small.


Since there are less number of firms, any action taken by one firm has a considerable
effect on the other. Thus, every firm must keep a close eye on its counterpart and plan the
promotional activities accordingly.
Profit: Types, Theories and Functions of Profit
The term profit has distinct meaning for different people, such as businessmen,
accountants, policymakers, workers and economists.

Profit simply means a positive gain generated from business operations or


investment after subtracting all expenses or costs.

In economic terms profit is defined as a reward received by an entrepreneur by


combining all the factors of production to serve the need of individuals in the
economy faced with uncertainties. In a layman language, profit refers to an income
that flow to investor. In accountancy, profit implies excess of revenue over all
paid-out costs. Profit in economics is termed as a pure profit or economic profit or
just profit.

Types of Profit:
Different people have described profit differently. Individuals have associated
profit with additional income revenue, and reward. However, none of the
description of profit is said to be right or wrong; it only depends on the field which
the word profit is described.

On the basis of fields, profit can be classified into two types, which are
explained as follows:
i. Accounting Profit:
Refers to the total earnings of an organization. It is a return that is calculated as a
difference between revenue and costs, including both manufacturing and overhead
expenses. The costs are generally explicit costs, which refer to cash payments
made by the organization to outsiders for its goods and services. In other words,
explicit costs can be defined as payments incurred by an organization in return for
labor, material, plant, advertisements, and machinery.

The accounting profit is calculated as:


Accounting Profit= TR-(W + R + I + M) = TR- Explicit Costs

TR = Total Revenue

W = Wages and Salaries


R = Rent

I = Interest

M = Cost of Materials

ii. Economic Profit:


Takes into account both explicit costs and implicit costs or imputed costs. Implicit
that is foregone which an entrepreneur can gain from the next best alternative use
of resources. Thus, implicit costs are also known as opportunity cost. The
examples of implicit costs are rents on own land, salary of proprietor, and interest
on entrepreneur’s own investment.

Let us understand the concept of economic profit. Suppose an individual A is


undertaking his own business manager in an organization. In such a case, he
sacrifices his salary as a manager because of his business. This loss of salary will
opportunity cost for him from his own business.

The economic profit is calculated as:


Economic profit = Total revenue-(Explicit costs + implicit costs)

Alternatively, economic profit can be defined as follows:


Pure profit = Accounting profit-(opportunity cost + unauthorized payments, such
as bribes)

Economic profit is not always positive; it can also be negative, which is called
economic loss. Economic profit indicates that resources of a business are
efficiently utilized, whereas economic loss indicates that business resources can be
better employed elsewhere.

THEORIES OF PROFIT

Walker’s Theory:
An American economist, Prof F. A. Walker propounded the theory of profit,
known as rent theory of profit. According to him “as rent is the difference between
least and most fertile land similarly, profit is the difference between earnings of the
least and most efficient entrepreneurs.” He advocated that profit is the rent of
exceptional abilities that an entrepreneur possesses over others.

According to Walker; profit is the difference between the earnings of the least and
most efficient entrepreneurs. An entrepreneur with the least efficiency generally
strives to cover only the cost of production. On the other hand, an efficient
entrepreneur is rewarded with profit for his differential ability.

Thus, profit is also said to be the reward for differential ability of the entrepreneur.
While formulating this theory, Walker assumed the condition of perfect
competition in which all organizations are supposed to have equal managerial
ability. In this case, there is no pure profit and all the organizations earn only
managerial wages known as normal profit.

The rent theory was mainly criticized for its inability to explain the real nature of
profits.

Apart from this, the theory failed on the following aspects:


a. Provides only a measure of profit. The theory does not focus on the nature of
profit, which is of utmost importance.

b. Assumes that profits arise because of the superior or exceptional ability of the
entrepreneur, which is not always true. Profit can also be the result of the
monopolistic position of the entrepreneur.

Clark’s Dynamic Theory:


Clark’s dynamic theory was introduced by an American economist, J.B. Clark.
According to him, profit does not arise in a static economy, but arise in a dynamic
economy. A static economy is characterized as the one where the size of
population, the amount of capital, nature of human wants, the methods of
production remain the same and there is no risk and uncertainty. Therefore,
according to Clark, only normal profits are earned in the static economy. However,
an economy is always dynamic in nature that changes from time to time.

A dynamic economy is characterized by increase in population, increase in capital,


multiplication of consumer wants, advancement in production techniques, and
changes in the form of business organizations. The dynamic world offers
opportunities to entrepreneurs to make pure profits.

According to Clark, the role of entrepreneurs in a dynamic environment is to take


advantage of changes that help in promoting businesses, expanding sales, and
reducing costs. The entrepreneurs, who successfully take advantage of changing
conditions in a dynamic economy, make pure profit.

There are internal and external factors that make the world dynamic. The internal
changes are changes that take place within the organization, such as layoff and
hiring of employees, product changes, and changes in infrastructure. The external
changes are of two kinds, namely, regular changes and irregular changes.

Regular changes involve fluctuations in trades that affect profits On the other hand;
irregular changes include contingencies, such fire, earthquake, floods, and war.
Thus, according to Clark, profits are a result of changes and no profit is generated
in case of static economy.

However Prof Knight criticized the dynamic theory on the basis that only those
changes that cannot be foreseen yield profits. He further says, “It cannot, then, be
change, which is the cause of profit, since if the law of change is known, as in fact
is largely the case, no profits can arise. Change may cause a situation out of which
profit will be made, if it brings about ignorance of the future.”

Hawley’s Risk Theory:


The risk theory of profit was given by F. B. Hawley in 1893. According to Hawley,
“profit is the reward of risk taking in a business. During the conduct of any
business activity, all other factors of production i.e. land, labor, capital have
guaranteed incomes from the entrepreneur. They are least concerned whether the
entrepreneur makes the profit or undergoes losses.”

Hawley refers profit as a reward for taking risk. According to him, the greater the
risk, the higher is the expected profit. The risks arise in the business due to various
reasons, such as non-availability of crucial raw materials, introduction of better
substitutes by competitors, obsolescence of a technology, fall in the market prices,
and natural and manmade disasters. Risks in businesses are inevitable and cannot
be predicted. According to Hawley, an entrepreneur is rewarded for undertaking
risks.

There is a criticism against this theory that profits arise not because risks are borne,
but because the superior entrepreneurs are able to reduce them. The profits arise
only because of better management and supervision by entrepreneurs. Another
criticism is that profits are never in the proportion to the risk undertaken. Profits
may be more in enterprises with low risks and less in enterprises with high risks.

Knight’s Theory:
Prof Knight propounded the theory known as uncertainty-bearing theory of profits.
According to the theory, profit is a reward for the uncertainty bearing and not the
risk taking. Knight divided the risks into calculable and non-calculable risks.
Calculable risks are those risks whose probability of occurrence can be easily
estimated with the help of the given data, such as risks due to fire and theft.

The calculable risks can be insured. On the other hand, non-calculable risks are
those risks that cannot be accurately calculated and insured such as shifts in
demand of a product. These non-calculable risks are uncertain, while calculable
risks are certain and can be anticipated.

According to Knight, “risks are foreseen in nature and can be insured”. Thus, risk
taking is not a function of an entrepreneur, but of insurance organizations.
Therefore, an entrepreneur gets profit as a reward for bearing uncertainties and not
for risks that are borne by insurance organizations.

The theory of uncertainty bearing is criticized on the following grounds:


a. Assumes that profit is the result of uncertainty bearing ability of an entrepreneur,
which does not always hold true. The profit can also be the reward for other
aspects, such as strong co-ordination and market share.

b. Fails to show any relevance with the real world.

Schumpeter’s Innovation Theory:


Joseph Schumpeter propounded a theory called innovation according to which
profits are the reward for innovation He advocated that innovation is the
introduction of a new product, new technology, new method of production, and
new sources of raw materials. This helps in lowering the cost of production or
improving the quality of production. Innovation also includes new policy or
measure by an entrepreneur for an organization.

In general, innovation can take place in two ways, which are as follows:
a. Reducing the cost of production and earning high profit. The cost of production
can be reduced by introducing new machines and improving production
techniques.

b. Stimulating the demand by enhancing the existing improvement or finding new


markets.

According to innovation theory, profit is the cause and effect of innovations. In


other words, it acts as a necessary incentive for making innovation.

Schumpeter’s innovation theory is criticized on two aspects, which are as


follows:
a. Ignores uncertainty as a source of profit

b. Denies the role of risk in profit

Profit Planning and Control


Profit is considered as a significant element of a business activity. According to
Peter Drucker, “profit is a condition of survival.

It is the cost of the future, the cost of staying in a business.” Thus, profit should be
planned and managed properly.

An organization should plan profits by taking into consideration its capabilities and
resources. Profit planning lays foundation for the future income statement of the
organization. The profit planning process begins with the forecasting of Les and
estimating the desired level of profit taking in view the market conditions.

Figure-6 shows the steps involved in the profit planning process:


The steps involved in profit planning process (as shown in Figure-6) are
explained as follows:
1. Establishing profit goals:
Implies that profit goals should be set in alignment with the strategic plans of the
organization. Moreover, the profit goals of an organization should be realistic in
nature based on the capabilities and resources of the organization.

2. Determining expected sales volume:


Constitutes the most important step of the profit planning process. An organization
needs to forecast its sales volume so that it can achieve its profit goals. The sales
volume can be anticipated by taking into account the market and industry trends
and performing competitive analysis.

3. Estimating expenses:
Requires that an organization needs to estimate its expenses for the planned sales
volume. Expenses can be determined from the past data. If an organization is new,
then the data of similar organization in same industry can be taken. The expense
forecasts should be adjusted to the economic conditions of the country.

4. Determining profit:
Helps in estimating the exact value of sales.

It is calculated as:
Estimated Profit = Projected Sales Income – Expected Expenses

Profit Control
After planning profit successfully, an organization needs to control profit. Profit
control involves measuring the gap between the estimated level and actual level of
profit achieved by an organization. If there is any deviation, the necessary actions
are taken by the organization.
Profit control involves two steps, which are as follows:
1. Comparing estimates with the goal:
Involves comparing the estimated profit with the expected profit. If there is a large
gap between the estimated profits and the expected profits, the measures should be
taken.

2. Using alternatives to achieve the desired profit:


Includes the following:
a. Making changes in planned sales volume by increasing sales promotion,
improving product quality, providing better service, and providing after sales
support to customers.

b. Reducing planned expenses by minimizing losses, implementing better control


systems, improving product quality, and increasing the productivity of human
resource and machines.

Business Cycles: Meaning & Phases


Meaning of Business Cycle:
The period of high income, output and employment has been called the period of
expansion, upswing or prosperity, and the period of low income, output and
employment has been described as contraction, recession, downswing or
depression.

The economic history of the free market capitalist countries has shown that the
period of economic prosperity or expansion alternates with the period of
contraction or recession. These alternating periods of expansion and contraction in
economic activity has been called business cycles.

They are also known as trade cycles. J.M. Keynes writes, “A trade cycle is
composed of periods of good trade characterized by rising prices and low
unemployment percentages with periods of bad trade characterized by falling
prices and high unemployment percentages.”
Phases of Business Cycles:
Business cycles have shown distinct phases the study of which is useful to
understand their underlying causes. These phases have been called by different
names by different economists.

Generally, the following phases of business cycles have been distinguished:


1. Expansion (Boom, Upswing or Prosperity)

2. Peak (upper turning point)

3. Contraction (Downswing, Recession or Depression)

4. Trough (lower turning point)

The four phases of business cycles have been shown in Fig. 13.1 where we start
from trough or depression when the level of economic activity i.e., level of
production and employment is at the lowest level.

With the revival of economic activity the economy moves into the expansion
phase, but due to the causes explained below, the expansion cannot continue
indefinitely, and after reaching peak, contraction or downswing starts. When the
contraction gathers momentum, we have a depression. The downswing continues
till the lowest turning point which is also called trough is reached.

In this way cycle is complete. However, after remaining at the trough for some
time the economy revives and again the new cycle starts.
Expansion and Prosperity:
In its expansion phase, both output and employment increase till we have full
employment of resources and production is at the highest possible level with the
given productive resources. There is no involuntary unemployment and whatever
unemployment prevails is only of frictional and structural types.

Contraction and Depression:


As stated above, expansion or prosperity is followed by contraction or depression.
During contraction, not only there is a fall in GNP but also level of employment is
reduced. As a result, involuntary unemployment appears on a large scale.
Investment also decreases causing further fall in consumption of goods and
services.

At times of contraction or depression prices also generally fall due to fall in


aggregate demand. A significant feature of depression phase is the fall in rate of
interest. With lower rate of interest people’s demand for money holdings increases.
There is a lot of excess capacity as industries producing capital goods and
consumer goods work much below their capacity due to lack of demand.

Capital goods and durable consumer goods industries are especially hit hard during
depression. Depression, it may be noted, occurs when there is a severe contraction
or recession of economic activities. The depression of 1929-33 is still remembered
because of its great intensity which caused a lot of human suffering.

Trough and Revival:


There is a limit to which level of economic activity can fall. The lowest level of
economic activity, generally called trough, lasts for some time. Capital stock is
allowed to depreciate without replacement. The progress in technology makes the
existing capital stock obsolete. If the banking system starts expanding credit or
there is a spurt in investment activity due to the emergence of scarcity of capital as
a result of non-replacement of depreciated capital and also because of new
technology coming into existence requiring new types of machines and other
capital goods.

.
Economic stabilization & Role of government
:Monetary Policy, Fiscal Policy and Direct
Controls
Economic stabilisation is one of the main remedies to effectively control or
eliminate the periodic trade cycles which plague capitalist economy. Economic
stabilisation, it should be noted, is not merely confined to a single individual sector
of an economy but embraces all its facts. In order to ensure economic stability, a
number of economic measures have to be devised and implemented.

In modem times, a programme of economic stabilisation is usually directed


towards the attainment of three objectives: (i) controlling or moderating cyclical
fluctuations; (ii) encouraging and sustaining economic growth at full employment
level; and (iii) maintaining the value of money through price stabilisation. Thus,
the goal of economic stability can be easily resolved into the twin objectives of
sustained full employment and the achievement of a degree of price stability.

The following instruments are used to attain the objectives of economic


stabilisation, particularly control of trade cycles, relative price stability and
attainment of economic growth:
(1) Monetary policy

(2) Fiscal policy; and

3. Direct Controls:
Broadly speaking, direct controls are imposed by government which expressly
forbid or restricts certain kinds of investment or economic activity. Sometimes,
direct government controls over prices and wages as a measure against inflation
have been advocated and implemented.
During World War II, price-wage controls were employed in conjunction with
consumer rationing and materials allocation to curb generalised total excess
demand and to direct productive resources into channels desired by the
government. Monetary-fiscal controls may be used to curb excess demand in
general but direct controls can be more useful when they are applied to specific
scarcity areas.