Mba I Economics For Managers (14mba12) Notes

Economics for Managers 14MBA12
Subject Code : 14MBA12

IA Marks : 50
No. of Lecture Hours / Week : 04
Exam Hours : 03
Total Number of Lecture Hours : 56 Exam
Marks : 100
Practical Component : 01 Hour / Week
SYLLABUS
Module 1: Managerial Economics: Meaning, Nature, Scope. & Significance, Uses of

Managerial Economics, Law of Demand, Exception to Law of Demand, Elasticity of Demand-
Price, Income and Cross Elasticity, Uses of Elasticity of Demand for Managerial Decision
Making, Advertising and Promotional Elasticity of Demand- Demand Forecasting: Meaning and
Significance. Problems on elasticity of demand.
Module 2: Production Analysis: Concept, Production Function: Single Variable Law of

Variable Proportions & Two Variable Function, ISO-Quants & ISO Costs & Equilibrium, Total,
Average, & Marginal Product, Return to Scale, Technological Progress & Production Function.
Module 3: Cost and Revenue Profit Functions: Cost Concepts, Total Cost, Average Cost,
Marginal Cost, Opportunity Cost etc. Short-run and Long-run Cost Curves, Combination,
Economies and Diseconomies of Scale. Cost Analysis with Mathematical Problems.
Profits: Determinants of Short-Term & Long Term Profits, Measurement of Profit.
Break Even Analysis- Meaning, Assumptions, Determination of BEA, Limitations and Uses of
BEA in Managerial Economics. (Problems on BEP)
Module 4: Market Structure: Perfect Competition: Features, Determination of Price under

Perfect Competition - Monopoly: Features, Pricing under Monopoly, Price Discrimination -
Oligopoly: Features, Kinked Demand Curve, Cartel, Price Leadership Monopolistic
Competition: Features, Pricing under Monopolistic Competition, Product Differentiation Pricing
- Descriptive Pricing- Price Skimming, Price Penetration.
Module 5: Indian Economic Environment: Overview of Indian Economy, Recent Changes in

Indian Economy.
Measurement of National Income: Basic Concepts, Components of GDP- Measuring GDP and
GNP, Measurement Problems in National Income, Growth Rate.
Business Cycle Features, Phases, Economic Indicator, Inflation : Types, Measurement , Kinds
of Price Indices, Primary, Secondary and Tertiary Sector and their contribution to the
Economy, SWOT Analysis of Indian Economy.
Module 6: Industrial Policies and Structure: Classification of Industries based on Ownership,

Industrial Policies, New Industrial Policy 1991; Private Sector- Growth, Problems and Prospects,
SSI- Role in Indian Economy.
Department of MBA, SJBIT Page 1

Industry Analysis: Textiles, Electronics, Automobile, FMCG, Telecom, Pharm. FDI in Retail,
Infrastructure, Pharma, Insurance, Banking & Finance and Automobile.
Globalization and Indian Business Environment: Meaning and Implications, Phases, Impact
of Globalization on Indian Economy across Sectors.
Foreign Trade: Trends in Indias Foreign Trade, Impact of WTO on Indias Foreign Trade.
Module 7: Economic Policies: Fiscal Policy: Objectives, Instruments, Union Budget,

Monetary Policy: functions of money, Measures of Money Supply, Monetary Policy in India
objectives, tools for Credit Control. Role and functions of Planning Commission.

INDEX
Module No. Contents Page Number
1 Managerial Economics 4
2 Production Analysis 51
3 Cost and Revenue Profit Functions 66
4 Market Structure 116
5 Indian Economic Environment 154
6 Industrial Policies and Structure 190
7 Economic Policies 236

Module 1
Managerial Economics
Meaning, Nature, Scope. & Significance, Uses of Managerial Economics, Law of Demand,
Exception to Law of Demand, Elasticity of Demand- Price, Income and Cross Elasticity,
Uses of Elasticity of Demand for Managerial Decision Making, Advertising and
Promotional Elasticity of Demand- Demand Forecasting: Meaning and Significance.
Problems on elasticity of demand.
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What is Economics?
One standard definition for economics is the study of the production, distribution, and
consumption of goods and services. A second definition is the study of choice related to the
allocation of scarce resources. The first definition indicates that economics includes any
business, nonprofit organization, or administrative unit. The second definition establishes that
economics is at the core of what managers of these organizations do.
The two different conceptual approaches to the study of economics: microeconomics and
macroeconomics. Microeconomics studies phenomena related to goods and services from the
perspective of individual decision-making entitiesthat is, households and businesses.
Macroeconomics approaches the same phenomena at an aggregate level, for example, the total
consumption and production of a region. Microeconomics and macroeconomics each have their
merits. The microeconomic approach is essential for understanding the behavior of atomic
entities in an economy. However, understanding the systematic interaction of the many
households and businesses would be too complex to derive from descriptions of the individual
units. The macroeconomic approach provides measures and theories to understand the overall
systematic behavior of an economy.
Managerial Economics: Definition, Nature, Scope
Managerial economics is a discipline which deals with the application of economic theory to
business management. It deals with the use of economic concepts and principles of business
decision making. Formerly it was known as Business Economics but the term has now been
discarded in favour of Managerial Economics.
Managerial Economics may be defined as the study of economic theories, logic and methodology
which are generally applied to seek solution to the practical problems of business. Managerial
Economics is thus constituted of that part of economic knowledge or economic theories which is
used as a tool of analysing business problems for rational business decisions. Managerial
Economics is often called as Business Economics or Economic for Firms.

Definition of Managerial Economics:
Managerial Economics is economics applied in decision making. It is a special branch of

economics bridging the gap between abstract theory and managerial practice. Haynes,
Mote and Paul.
Business Economics consists of the use of economic modes of thought to analyse business
situations. - McNair and Meriam
Business Economics (Managerial Economics) is the integration of economic theory with
business practice for the purpose of facilitating decision making and forward planning by
management. - Spencerand Seegelman.
Managerial economics is concerned with application of economic concepts and economic
analysis to the problems of formulating rational managerial decision. Mansfield
Nature of Managerial Economics

It involves an application of Economic theory especially, micro economic analysis to
practical problem solving in real business life. It is essentially applied micro economics.
It is a science as well as art facilitating better managerial discipline. It explores and
enhances economic mindfulness and awareness of business problems and managerial
decisions.
It is concerned with firms behaviour in optimum allocation of resources. It provides
tools to help in identifying the best course among the alternatives and competing
activities in any productive sector whether private or public.
For the sake of clear understanding of the nature and subject matter of managerial economics, the
main characteristics of managerial economics is given below:
Micro economic analysis: The main part of the study of managerial economics is the
behavior of business firm/s, which is micro economic unit. Therefore, managerial
economics is essentially a micro economic analysis. Under the study of managerial
economics, the problems of firm are analyzed and solved through the application of
economic methods and tools. It does not study the whole economy.
Economics of the firm: According to Norman F. Dufty, Managerial Economics includes,
that portion of Economics known as the theory of firm, a body of the theory which can
be of considerable assistance to the businessman in his decision-making. For instance,
the study of managerial economics includes the study of the cost and revenue analysis,
price and output determination, profit planning , demand analysis and demand forecasting
of a firm. As already stated earlier, the another name of managerial economics is
Economics of the Firm.

Science as well as an Art: Managerial Economics is both knowledge acquiring and

knowledge applying discipline. Thus, it can be concluded that managerial economics is
science and arts both .
Managerial economics a positive and normative science both:It is positive when it is

confined to statements about causes and effects and to functional relationships of
economic variables. It is normative when it involves norms and standards, mixing them
with cause and effect analysis. Managerial economics is not only a tool making, but also
a tool using science . It not only studies facts of an economic problem, but also suggests
its optimum solution.
Positive Science is a systematic knowledge of a particular subject wherein we study the cause
and effect of an event. In other words, it explains the phenomenon as: What is, what was and
what will be. Under the study of positive science, principles are formulated and they are tested
on the yardstick of truth. Forecasts are made on the basis of them. From this point of view,
managerial economics is also a positive science as it has its own principles/theories/laws by
which cause and effect analysis of business events/activities is done, forecasts are made and their
validities are also examined. For instance, on the basis of various methods of forecasting,
demand forecasts of a product is made in managerial economics and the element of truth in
forecast is also examined/tested.
Normative Science studies things as they ought to be. Ethics, for example, is a normative
science. The focus of study is What should be . In other words, it involves value judgment or
good and bad aspects of an event. Therefore, normative science is perspective rather than
descriptive . It cannot not be neutral between ends.
Managerial economics is also a normative science as it suggests the best course of an action after
comparing pros and cons of various alternatives available to a firm. It also helps in formulating
business policies after considering all positives and negatives, all good and bad and all favours
and a disfavours. Besides conceptual/theoretical study of business problems, practical useful
solutions are also found . For instance, if a firm wants to raise 10% price of its product, it will
examine the consequences of it before raising its price. The hike in price will be made only after
ascertaining that 10% rise in price will not have any adverse impact on the sale of the firm. On
the basis of the above arguments and facts, it can be said that managerial economics is a blending
of positive science with normative science.
It is pragmatic and realistic in nature. It is concerned with analytical tools which are
useful and helpful for decision making.
It is both conceptual and metrical. It studied theory and applies to a particular problem
. It applies quantitative techniques to achieve at decision making and forward
planning.

Acceptance of use & utility of macroeconomic variables: In understanding the overall

economic environment of an economy and its influence on a particular firm, the study
and knowledge of macroeconomic variables or macro economics is a must. For example,
the study of Monetary, Fiscal, Industrial, Labor and Employment and EXIM policy,
National Income, Inflation etc. is done in managerial economics as to know the
influences of these on the business of a firm. The study of macroeconomic variables
helps in understanding the influence of exogenous factors on business activities of a firm.
Without the study of important macro economic variables, proper environmental
scanning is not possible.
Normative approach: Managerial Economics is basically concerned with value
judgment, which focuses on what ought to be. It is determinative rather than
descriptive in its approach as it examines any decision of a firm from the point of view of
its good and bad impact on it. It means that a firm takes only those decisions which are
favorable to it and avoids those which are unfavourable to it. The emphasis is on
Prescriptive models rather than on Descriptive models.
Emphasis on case study: In place of purely theoretical and academic exercise,
managerial economics lays more emphasis on case study method. Hence, it is a practical
and useful discipline for a business firm. It diagnoses and solves the business problems.
Therefore, it serves as lamp post of knowledge and guidance to business professionals /
organizations in arriving at optimum solutions.
Sophisticated and developing discipline: Managerial Economics is more refined and
sophisticated discipline as compared to Economics because it uses modern scientific
methods of statistics and mathematics. Not only this, the methods of Operational
Research and Computers are also used in it for building scientific and practical models
for analyzing and solving the real business problems under uncertain and risky
environment.
Applied Business Economics: Managerial Economics is an application of economics
into business practices and decision-making process; therefore, it is an applied
economics/business economics. The concepts of economic theory that are widely used in
managerial economics are the following:
Demand and Elasticity of demand
Demand forecasting
Production Theory
Cost Analysis
Revenue Analysis

Price determination under different market conditions/structures
Pricing methods in actual practice
Break-even analysis
Linear Programming
Game Theory
Product and Project Planning
Capital Budgeting and Management
The primary function of management executive in a business organisation is decision

making and forward planning.Decision making and forward planning go hand in hand
with each other. Decision making means the process of selecting one action from two or
more alternative courses of action. Forward planning means establishing plans for the
future to carry out the decision so taken. The problem of choice arises because resources
at the disposal of a business unit (land, labour, capital, and managerial capacity) are
limited and the firm has to make the most profitable use of these resources. A business
managers task is made difficult by the uncertainty which surrounds business decision-
making. Nobody can predict the future course of business conditions. He prepares the
best possible plans for the future depending on past experience and future outlook and yet
he has to go on revising his plans in the light of new experience to minimise the failure.
Managers are thus engaged in a continuous process of decision-making through an
uncertain future and the overall problem confronting them is one of adjusting to
uncertainty.
Scope of Managerial Economics
Managerial Economics plays a vital role in managerial decision making and prescribes
specific solutions to the problems of the firm.
ME helps in the following :
1. Estimation of product demand
2. Analysis of product demand
3. Planning of production schedule
4. Deciding the input combination
5. Estimation of cost of product
6. Achieving economies of scale
7. Determination of price of product
8. Analysis of price of product

9. Analysis of market structures

10. Profit estimation and planning
11. Planning and control of capital expenditure
1. Estimation & Analysis of product demand: basis for planning how production has to be
carried out.
i. EX: deciding what quantities of goods have to be produced i.e. how
capacity utilization has to be achieved.
2. Planning of production schedule: Excess production production beyond reasonable level

could cause the firm to incur wastage and unnecessary cost.
3. Deciding the input combination: A product may be manufactured using different
combinations of input factors- land, labor, capital and technology than cloth produced
on an automatic power loom.
i. EX: handloom produced cloth will require a different combination of
inputs
4. Estimation of cost & determination of product: ME and its cost concepts can be
employed to analyze the cost of a product. Profits can be maximized either by
increasing the revenues or decreasing the costs. Revenue depends on the market, cost is
basically a function of the firm.
5. Achieving economies of scale: ME enables one to calculate the optimal level of output
where minimum average cost can be obtained.
6. Analysis and Determination of price of product: Important aspect of managerial

decision-making is the price of a product. It is essential to understand the market
structure within which product is being sold.
7. Analysis of market structures: calls for knowledge of the nature of the product, number of
buyers and sellers, entry/exit barriers etc.,
8. Profit estimation and planning: ME helps one to understand the nature of profit, &
represents the logical basis for the various theories that explain reasons for the emergence
of profit.
9. Planning and control of capital expenditure: ME provides a framework for planning the
capital expenditure decisions of a firm. It gives the criteria to appraise capital budgeting
decisions and choose the best out of the available investment alternatives.
The scope of managerial economics is not yet clearly laid out because it is a developing
science. Even then the following fields may be said to generally fall under
Managerial Economics:
1. Demand Analysis and Forecasting

2. Cost and Production Analysis

3. Pricing Decisions, Policies and Practices
4. Profit Management
5. Capital Management
These divisions of business economics constitute its subject matter.
Recently, managerial economists have started making increased use of Operation Research
methods like Linear programming, inventory models, Games theory, queuing up theory etc.,
have also come to be regarded as part of Managerial Economics.
1. Demand Analysis and Forecasting: A business firm is an economic organisation which is
engaged in transforming productive resources into goods that are to be sold in the market. A
major part of managerial decision making depends on accurate estimates of demand. A forecast
of future sales serves as a guide to management for preparing production schedules and
employing resources. It will help management to maintain or strengthen its market position and
profit base. Demand analysis also identifies a number of other factors influencing the demand for
a product. Demand analysis and forecasting occupies a strategic place in Managerial Economics.
2. Cost and production analysis: A firms profitability depends much on its cost of production. A
wise manager would prepare cost estimates of a range of output, identify the factors causing are
cause variations in cost estimates and choose the cost-minimising output level, taking also into
consideration the degree of uncertainty in production and cost calculations. Production
processes are under the charge of engineers but the business manager is supposed to carry out the
production function analysis in order to avoid wastages of materials and time. Sound pricing
practices depend much on cost control. The main topics discussed under cost and production
analysis are: Cost concepts, cost-output relationships, Economics and Diseconomies of scale and
cost control.
3. Pricing decisions, policies and practices: Pricing is a very important area of Managerial
Economics. In fact, price is the genesis of the revenue of a firm ad as such the success of a
business firm largely depends on the correctness of the price decisions taken by it. The important
aspects dealt with this area are: Price determination in various market forms, pricing methods,
differential pricing, product-line pricing and price forecasting.
4. Profit management: Business firms are generally organized for earning profit and in the long
period, it is profit which provides the chief measure of success of a firm. Economics tells us that
profits are the reward for uncertainty bearing and risk taking. A successful business manager is
one who can form more or less correct estimates of costs and revenues likely to accrue to the
firm at different levels of output. The more successful a manager is in reducing uncertainty, the
higher are the profits earned by him. In fact, profit-planning and profit measurement constitute
the most challenging area of Managerial Economics.
5. Capital management: The problems relating to firms capital investments are perhaps the most
complex and troublesome. Capital management implies planning and control of capital
expenditure because it involves a large sum and moreover the problems in disposing the capital

assets off are so complex that they require considerable time and labour. The main topics dealt
with under capital management are cost of capital, rate of return and selection of projects.
Difference between Economic Theory Vs Managerial Theory
Economic theory deals with the body of principles. But managerial theory deals with the
application of certain principles to solve the problem of the firm.
Economic theory has the characteristics of both micro and macroeconomics. But
managerial theory has only micro characteristics.
Economic theory deals with the study of individual firm as well as individual consumer.
But managerial theory studies only individual firm.
Economic theory deals with a study of distribution theories of rent, wages interest and
profits. But managerial theory deals with a study of only profit theories.
Economic theory is based on certain assumptions. But in managerial theory these

assumptions disappear due to practical situations.
Economic theory is both positive and normative in character but managerial theory is
essentially normative in nature.
Economic theory studies only economic aspects of the problem whereas managerial
theory studies both economic and non economic aspects.
Significance of Managerial Economics

It enables to learn practical implications of concepts in micro- and macro-economic
theory such as demand, supply, price, profit, income, output employment, sales etc.,
It is also helpful in making short term and long term decisions such as what to produce?
How to produce? How much to produce? & How to price the product?etc
It provides the management with a strategic planning tool that can be fruitfully utilized to
gain mileage in the market.
It also teaches the managers as to what can be done to maintain profitability in an ever
changing environment.
It offers decision makers a way of thinking about changes in a framework for analyzing
the consequences of strategic options.
It helps the managers to take appropriate policy decisions in all types of business
enterprises like

o a) Selection of the product or service to be offered for sale.

o b) Choice of production methods and optimum combination of the substitutable
resources.
o c) Determination of the best combination of price and quantity
o d) Promotional strategy and activities (determination of optimum advertising
budget.
o e) Selection of plant location and distribution centers-from which to sell the
goods or services
Forward Planning: It helps in continuous decision making and forward planning is
required to overcome uncertainties.
In the real world situation, business manager comes across many changes
which causes uncertainty and it therefore, changes in his forward planning
is needed from time to time.
EX: Uncertainties- Govt. Policy might change, Consumer taste and

preference might change.
Decision making is integral part of todays business management. Making a decision is

one of the most difficult tasks faced by a professional manager. Managerial decisions are
based on the flow of information. Decision making is both managerial function and
organizational process. A good decision is one that is based on logic, considers all
available data and possible alternatives and applies the quantitative approach.
Uses of Managerial Economics
Managerial economics applies to:

o Businesses (such as decisions in relation to customers including pricing and advertising;
suppliers; competitors or the internal workings of the organization), nonprofit
organizations, and households.
o The old economy and new economy in essentially the same way except for two
distinctive aspects of the new economy: the importance of network effects and scale and
scope economies.
o Network effects in demand the benefit provided by a service depends on the
total number of other users, e.g., when only one person had email, she had no one
to communicate with, but with 100 mm users on line, the demand for Internet
services mushroomed.
o Scale and scope economies scalability is the degree to which scale and scope of
a business can be increased without a corresponding increase in costs, e.g., the
information in Yahoo is eminently scalable (the same information can serve 100

as well as 100 mm users) and to serve a larger number of users, Yahoo needs only
increase the capacity of its computers and links.
o Both global and local markets.
Demand Analysis
Introduction
Without understanding the concept of demand, economic analysis is incomplete and
meaningless. Demand is one of the most important economic decision variables. The analysis of
demand for a firms product plays a crucial role in business decision-making. Demand
determines the size and pattern of market. All business activities are mostly demand driven. For
instance, the inducement to investment and production is limited by the size of the market of
products. The profit of a firm is influenced and determined by the demand and supply conditions
of its output and inputs. Even if a firm pursues other objectives than the profit maximization,
demand concepts are still relevant. For instance, the objective of firm is customer service or
discharging social responsibility. Without analyzing the needs of customers and evaluating
social preferences, these objectives cannot be achieved. All these variables are an integral part of
the concept of demand. Thus, the demand is the mother of all economic activities. The firms
Production planning, sales and profit targeting, revenue maximization, pricing policies, inventory
management, advertisement and marketing strategy all are dependent on the demand of its
product. Not only this, the survival and growth of a firm also depends on the demand for its
product. In this unit, we shall be examining various concepts of demand and the law of demand.
Concept of Demand
Demand is a technical economic concept. It is a different and broader concept than the desire
and want. The following five elements are inclusive in it:
1. Desire to acquire a product-willingness to have it,
2. Ability to pay for it-purchasing power to buy it,
3. Willingness to spend on it,
4. Given/particular price, and
5. Given/particular time period.
The presence of first three elements constitute the want . Thus, it is evident that without
reference to specific price and time period, demand has no meaning. For instance, Ram is
desirous of buying a car, but he does not have sufficient money to buy it, it cant be termed
demand as he does not have sufficient purchasing power to buy a car. Suppose, Ram is has
sufficient money to buy a car, but he does not want to spend on it-even in such a situation, the
desire of Ram for a car will remain a desire. What is required for being a demand is sufficient
purchasing power and willingness to spend on that product for which he has desire to acquire.
Not only this, the demand for a product must be expressed in reference to certain given price and
time period, otherwise it wont be a demand. Thus, the concept of demand has following
characteristics:

1. It is effective desire / want,

2. It is related with certain price, and
3. It is related with specific time period.
According to Benham , The demand for anything at a given price is that amount of it, which
will be bought at a time at that price. The complete definition of demand has been given by
Prof. Meyers According to him, The demand for a good is a schedule of the amount that buyers
would be willing to purchase at all possible prices at any one instant of time.
Types of demand
1.Direct and derived demand:
Direct demand refers to the demand for goods meant for final consumption . It is the demand for
consumer goods such as sugar, milk, tea, food items etc. On the contrary to it, derived demand
refers to the demand for those goods which are needed for further production of a particular
good. For instance, the demand for cotton for producing cotton textiles is a case of derived
demand. Indeed, derived demand is the demand for producers goods;i.e., the demand for raw
materials, intermediate goods and machine tools and equipment. The another example of derived
demand is the demand for factors of production . The derived demand for inputs also depends
upon the degree of substitutability/complementarities between inputs used in production process.
For example, the degree of substitutability between gas and coal for fertilizer production.
2.Domestic and industrial demand:

The distinction between domestic and industrial demand is very important from the pricing and
distribution point of view of a product. For instance, the price of water, electricity, coal etc. is
deliberately kept low for domestic use as compared to their price for industrial use.
3.Perishable and durable goods demand:

Perishable goods are also known as non-durable /single use goods, while durable goods are also
known as non- perishable/ repeated use goods .Bread, butter, ice-cream etc are the fine example
of perishable goods, while mobiles and bikes are the good examples of durable goods. Both
consumers and producers goods may be of perishable and non-perishable nature . Perishable
goods are used for meeting immediate demand, while durable goods are meant for current as
well as future demand. Durable goods demand is influenced by the replacement of old products
and expansion of stock. Such demand fluctuates with business conditions, speculation and price
expectations. Real wealth effect has strong influence on demand for consumers durables.
4.New and replacement demand:

New demand is meant for an addition to stock , while replacement demand is meant for
maintaining the old stock of capital /asset intact. The demand for spare parts of a machine is a
good example of replacement demand, but the demand for new models of a particular item [say

computer or machine] is a fine example of new demand. Generally, new demand is of an

autonomous type , while the replacement demand is induced one-induced by the quantity and
quality of existing stock. However, such distinction is more of a degree than of kind.
5.Final and intermediate demand:

The demand for semi-finished goods and raw materials is derived and induced demand as it is
dependent on the demand for final goods. The demand for final goods is a direct demand. This
type of distinction is based on types of goods- final or intermediate and is often employed in the
context of input-output models.
6.Short run and long run demand:

The distinction between these two types of demand is made with specific reference to time
element. Short- run demand is immediate demand based on available taste and technology,
products improvement and promotional measures and such other factors. Price-income
fluctuations are more relevant in case of short- run demand, while changes in consumption
pattern , urbanization and work culture etc. do have significant influence on long run demand.
Generally, long-run demand is for future consumption.
7.Autonomous and induced demand:

The demand for complementary goods such as bread and butter, pen and ink, tea, sugar milk
illustrate the case of induced demand. In case of induced demand, the demand for a product is
dependent on the demand/purchase of some main product.For instance, the demand for sugar is
induced by the demand for tea. Autonomous demand for a product is totally independent of the
use of other product , which is rarely found in the present world of dependence. These days we
all consume bundles of commodities. Even then, all direct demands may be loosely called
autonomous. The following equation illustrates the determinants of demand.
8.Individual and Market Demand:

The demand of an individual for a product over a period of time is called as an individual
demand, whereas the sum total of demand for a product by all individuals in a market is known
as market/collective demand. This can be illustrated with the help of the following table:
Individual and Market Demand Schedule
Price of Commodity (Rs.) Units of X Commodity Purchased by Market (Total)
A B C
6 5 10 12 27
7 4 8 9 21
8 3 5 7 15

The distinction between individual and market demand is very useful for personalized
service/target group planning as a part of sales strategy formulation.
9.Total market and segmented market demand:

A market for a product may have different segments based on location, age, sex, income,
nationality etc. The demand for a product in a particular market segment is called as segmented
market demand. Total market demand is a sum total of demand in all segments of a market
of that particular product. Segmented market demand takes care of different patterns of buying
behaviour and consumer preferences in different segments of the market. Each market segment
may differ with respect to delivery prices, net profit margins, element of competition, seasonal
pattern and cyclical sensitivity. When these differences are glaring, demand analysis is done
segment-wise, and accordingly, different marketing strategies are followed for different
segments. For instance, airlines charge different fares from different passengers based on their
class-economy class and executive/business class.
10.Company and industry demand:

A company is a single firm engaged in the production of a particular product, while an industry
is the aggregate / group of firms engaged in the production of the same product. Thus, the
companys demand is similar to an individual demand, whereas the industrys demand is similar
to the total demand. For instance, the demand for iron and steel produced by Bokaro plant is an
example of companys demand, but the demand for iron and steel produced by all iron and steel
companies including the Bokaro plant is the example of industry demand. The determinants of a
companys demand may be different from industrys demand . There may be the inter-company
differences with regard to technology, product quality, financial position, market share &
leadership and competitiveness. The understanding and knowledge of the relation between
company and industry demand is of great significance in understanding the different market
structures/forms based on nature and degree of competition. For example, under perfect
competition,a firms demand curve is parallel to ox-axis, while under monopoly and
monopolistic competition, it is downward sloping to the right.
11. Joint demand and Collective/Composite demand:

Many times, we use two or more goods together for satisfying a particular want, the demand for
such goods is called as joint demand. The demand for complementary goods is a fine example.
When a commodity is put to several uses, its total demand in all uses is termed as
composite demand. Electricity and water bills are good examples of such a demand.
INDIVIDUAL DEMAND AND MARKET DEMAND

Consumer demand for a product may be viewed at two levels:
1. Individual demand
2. Market demand.

Individual demand refers to the demand for a commodity from the individual point of view.
The quantity of a product consumer would buy at a given price over a given period of time is
his individual demand for that particular product. Individual demand is considered from one
persons point of view or from that of a family or households point of view. Individual
demand is a single consuming entitys demand.
Market demand for a product, on the other hand, refers to the total demand of all the buyers,
taken together. Market demand is an aggregate of the quantities of a product demanded by all
the individual buyers at a given price over a given period of the time.
Market demand function is the sum total of individual demand function. It is derived by
aggregating all individual buyers demand function in the market.
DETERMINANTS OF DEMAND
These are several factors influencing individual and market demand for different goods
and services.
FACTORS INFLUENCING INDIVIDUAL DEMAND

1. PRICE.is the basic factor. A consumer usually decides to buy with consideration of
price. More quantity is demanded at low prices and less is purchased at high price.
2. Income. A buyers income department his/her purchasing capacity. Income is,
therefore, an important determinant of demand. Obviously, with the increase in
income one can buy more goods. Rich consumers usually demand more and more
goods than poor customers. Demand for luxuries and expensive goods are related to
income.
3. Tastes, habits and preferences. Demand for many goods depends on the persons
tastes, habits and preferences. Demand for several products like ice-cream,
chocolates, beverages and so on depends on individuals tastes. Demand for tea, betel,
cigarettes, tobacco, etc. is a matter of habits.
4. People with different tastes and habits have different preferences for different
goods. A strict vegetarian will have no demand for meat at any price, whereas a non-
vegetarian who has liking for chicken may demand it even at a high price. Similar is
the case with demand for cigarettes by non-smokers and smokers.
5. Relative prices of other good-substitute and complementary products. How much
the consumer would like to buy of a given commodity, however, also depends on the
relative prices of other related goods such as substitute or complementary goods to a
commodity.
When a want can be satisfied by alternative similar goods, they are called substitutes.
For example, peas and beans, groundnut oil and til oil, tea and coffee, jowra and bajra,
etc., are substitutes of each other. The demand for a commodity depends on the
relative price of its substitutes. If the substitutes are relatively costly, then there will

be more demand for his commodity at a given price than in case its substitutes are
relatively cheaper.
Similarly, the demand for a commodity is also affected by its complementary product.
When in order to satisfy a given want, two or more goods needed in combination,
these goods are referred to as complementary goods. For example, car and petrol, pen
and ink, tea and sugar, shoes and socks, sarees and blouses, gun and bullets, etc. are
complementary to each other. Complementary goods are always in joint demand. If a
given product is complementary product, its demand will be relatively high when its
relatively commoditys price is lower than otherwise. Or, when the price of one
commodity decreases, the for its complementary will end to increase and vice versa.
For example, a fall in the price of cars will lead to an increase in the market demand
for petrol.
6. Consumers expectation. A consumers expectations about the future changes in the
prices of a given commodity also may its demand. When he expects its prices to fall
in future, he will tend to buy less at the present prevailing low price. Similarly, if he
expects its price to rise in future, he will tend to buy more at present.
7. Advertisement effect.In modern times, the preferences of a consumer can be altered
by advertisement and sales propaganda, albeit to a certain extent only. In fact, demand
for many products like toothpaste, toilet soap, washing powder, processed foods, etc.,
is partially caused by the advertisement effect in a modern mans life.
Factors influencing Market Demand
The market demand for a commodity originates and is affected by the form and change in
the general demand pattern of the community of the people at large. The following factor
affect the common demand pattern for product in the market:
1. Price of the product.At a low market price, market demand for the product tends to be
high and vice versa.
2. Distribution of income and wealth in the commodity. If there is a equal distribution of
income and wealth, the market demand for many products of common consumption tends
to be greater than in the case of unequal distribution.
3. Communitys common habits and scale of preferences: The market demand for a
product is greatly influenced by the scale of preferences of the buyers in general. For
example, when a large section of population shifts its preferences from vegetarian foods to
non-vegetarian foods, the demand for the former will tend to decrease and that for the latter
will increase.
4. General standards of living and spending habits of the people. When people in general
adopt a high standard of living and are ready to spend more, demand for many comforts and
luxury items will tend to be higher than otherwise.
5. Number of buyers in the market and the growth of population: The size of market
demand for a product obviously depends on the number of buyers in the market. A large
number of buyers will usually constitute a large demand and vice versa. As such, growth of

population over a period of time tends to imply a rising demand for essential goods and
services in general.
6. Age structure and sex ratio of the population: Age structure of population determines
market demand for many products in a relative sense. If the population pyramid of a country
is board based with a large proportion of juvenile pyramid of a demand for toys, school bags
etc.., goods and services required by children will be much higher than the market demand
for goods needed by the elderly people. Similarly, sex ratio has its impact on demand for
many goods. An adverse sex ratio, i.e., females exceeding males in number would mean a
greater demand for goods required by the female population than by the male population.
7. Future expectations: If buyers in general expect that prices of a commodity will rise in
future, then present market demand would be more as most of them would like to hoard the
commodity. The reverse happens if a fall in the future prices are expected.
8. Inventions and innovations: Introduction of new goods or substitutes as a result of
inventions and innovations in a dynamic modern economy tends to adversely affect the
demand for the existing products, which as a result of innovations, definitely become
obsolete. For example, the advent of electronic calculators has made adding machine
obsolete.
9. Fashions: Market demand for many products is affected by changing fashions. for
example, demand for commodities like jeans, salwar-kameej, etc., is based on current
fashions.
10. Customs: Demand for certain goods is determined by social customs, festivals etc., For
example, during dipawallidays, there is a greater demand for sweets & crackers, and during
Christmas , cakes are more in demand.
11. Climate or weather conditions :Demand for certain products is determined by climatic
or weather conditions . For example , in summer there is a greater demand for cold drinks,
fans, coolers, etc., Similarly , demand for umbrellas and raincoats is seasonal.
12. Advertisement and sales propaganda :Market demand for many products in the present
day is influenced by the sellers efforts through advertisements and sales propaganda.
Demand is manipulated through sales promotion . When these factors change, the general
demand pattern will be affected , causing a change in the market demand as a whole of
course, there is always a limit.
Demand function
Mathematical of expression of functional relationship between determinants (such as
price, income, etc., determining variables) and amount of demand of a given product.
In demand analysis, one should recognize that at any point in time the quantity of a given
product (good or service) that will be purchased by the consumers depends on a number of
key variables or determinants. In technical jargon, it is stated in terms of demand function for
the given product. A demand function in mathematical terms expresses the functional
relationships between the demand for the product and its various determining variables.

In composing the demand function for a product, therefore, one should identify and enlist
the most important factors (key variables) which affect its demand. To suggest a few, such
as:
The own price of the product itself (p)
The price of the substitute and complementary goods (Ps or Pc)
The level of disposable income (Yd) with the buyers (i.e., income left after direct
taxes)
Change in the buyers tastes and preferences (T)
The advertisement effect measured through level of advertising expenditure (A)
Changes in population number or the number of the buyers (N).
Using the symbolic notations, we may express the demand function, as follows:
Dx = f ( Px, Ps, Pc, Yd, T, A, N, u )
Here, We assumed commodity X; hence, Dx represents the amount demanded for the
commodity X and Px refers to the price of X. Further, u is incorporated to recognize other
unspecified unknown determinants of the demand for commodity X.
The symbolic notations in stating the demand function are arbitrarily chosen and there is
no hard and fast rule in there regard. In reality, the demand function is a complex
phenomenon. Utmost care is thus needed in identification of the key determinants. Besides
theoretical knowledge, long practical experience, correct perception and common sense play
an important role in arriving at an appropriate demand function for a given product.
In economic theory, however, a very simple statement of demand function is adopted
assigning all other determining variables, expect the own price of the product, to be
constant. An over-simplified and the most commonly stated demand function is, thus:
Dx = f ( Px )
Which connotes that the demand for commodity X is the function of its price. The
traditional demand theory this demand function specifically.
DEMAND SCHEDULE
A tabular statement of price/quantity relationship is called the demand schedule . It relates the
amount the consumer is willing to buy corresponding to each conceivable price for that given
commodity , per unit of time. There are, thus two types of demand schedule:
1. The individual demand schedule.

A tabular list showing the quantities of a commodity that will be purchased by an
individual at each alternative conceivable price in a given period of time is referred to as an
individual demand schedule. The following table illustrates a hypothetical demand schedule of
an individual consumer.

Price of Mangoes (Rs . per/kg ) Amount demanded per week (qty in kg)
80 2
70 4
60 6
50 10
40 16
The demand schedule has following characteristics :

The demand schedule does has not indicate any change in demanded by the individual
concerned but merely expresses his present behaviour in purchasing the commodity at
alternative prices.
It shows only the variation in demand at varying prices.
It seeks to illustrate the principle that more of a commodity is demanded at a lower price
than at a higher one. In fact , most of the demand schedules show an inverse relationship i
2. Market demand schedule.
The demand side of the market is represented by the demand schedule . It is tabular market
at different prices over a given period of time . A market demand schedule , thus represents the
total market demand at various prices. Theoretically , the demand schedule of all individual
consumers of a commodity can be complied and combined to form a composite demand
schedule, representing the total demand for the commodity at various alternative prices. The
deviation of market demand from individual demand schedules is illustrated in the following
table .Here , is it is assumed that the market
Price (in Rs) Units of Commodity X Demand per day Total or Darket Demand
by individuals . A + B + C =
4 1 + 1 + 3 5
3 2 + 3 + 5 10
2 3 + 5 + 7 15
1 5 + 9 + 10 24
Market demand function serves as the basis for knowing the revenue consequences of
alternative output and pricing policies of the firm.
Demand Equation And Demand Schedule:
A linear demand function may be stated as follows:
D = a bP.

Where, D stands for the amount demanded, a is constant parameter signifying initial demand
irrespective of the price. Similarly, b is a constant parameter which represents a functional
relationship between the price (p) and demand (d), b have a minus sign denotes a negative
function. It implies that the demand for a commodity is a decreasing function of its price in fact
b, measures slope of the demand curve. Indeed, b suggests that the demand curve is downward
sloping.
We may, now illustrate a demand equation and the competition of demand schedule,
assuming estimated demand functions, as :
Dx = 20 - 2Px
Where, D = Amount demanded for the commodity X.
Px = Price of X.
Suppose, the given prices per unit of the commodity X are: Rs 1,2,3,4 and 5 alternatively.
In relation to these prices, a demand schedule may be constructed.
When this schedule is represented graphically, a linear (straight line) demand curve is
drawn.
Law Of Demand
The demand for a commodity increases with a fall in its price and decreases with a rise in its
price, other things remaining the same.

The law of demand states an inverse relationship between the price of a commodity and its
quantity demanded, if other things remaining constant (Ceteris Paribus), i.e., at higher price, less
quantity is demanded and at lower price, larger quantity is demanded.
Prof. Paul Samuelson has lucidly defined the law of demand. According to him, if a greater
quantity of a good is thrown on the market then - other things being equal- it can be sold only at
a lower price.
From the view point of Managerial Economics, the law of demand should be referred to the
market demand. The law of demand can be illustrated with the help of a market demand
schedule, i.e., as the price of a commodity decreases the corresponding quantity demanded for
that commodity increases and vice versa.
Price of commodity X Quantity Demanded
(inrs.) (units per week)
5 100
4 200
3 300
2 400
1 500
Table represents a hypothetical demand schedule for commodity X. We can read from this table
that with a fall in price at each stage demand tends to rise. There is an inverse relationship
between price and the quantity demanded. Usually, economists draw a demand curve to give a
pictorial presentation of the law of demand. When the data of table are plotted graphically, a
demand is drawn curve is drawn as shown in figure .

In figure, DD is a downward sloping demand curve indicating an inverse relationship between

price and demand. Demand curve is a very convenient means of further economic analysis. From
the given market demand curve, one can easily locate the market demand for a product at a given
price. Further, the demand curve geometrically represents the mathematical demand function:
Dx = f(x).
Assumptions underlying the law of demand
The above stated law of demand is conditional. It is based on certain conditions as given. It is,
therefore, always stated with the other things being equal. It relates to the change in price
variable only, assuming other determinates of demand to be constant. The law of demand is,
thus, based on the following ceteris paribus assumption:
No change in consumers income. Throughout out the operation of the law, the
consumers income should remain the same. If the level of a buyers income changes, he
may buy more even at a higher price, invalidating the law of demand.
No change in consumers preference. The consumers taste, habits and preference
should remain constant.
No change in the fashion. If the commodity concerned goes out of the fashion, a buyer
may not buy more of it even at a substantial price of reduction.
No change in the price of related goods. Prices of other goods like substitute and
supportive, i.e., complementary or jointly demanded products remain unchanged. If the
prices of other related goods change, the consumers performances would change which
may invalidate the law of demand.

No expectation of future price changes or shortages: The law requires that the given
price change for the commodity is a normal one and has no speculative consideration.
That is to say, the buyers do not except any shortages in the supply of the commodity in
the market and consequent future changes in the prices. The given price change is
assumed to be final at a time.
No change in size, age composition and sex ratio of the population :for the operation
of the law in respect of total market demand, it is essential that the number of buyers and
their preferences should remain constant . This necessitates that the size of population as
well as the age, structure and sex ratio of the population should remain the same
throughout the operation of the law. Otherwise, if population changes, there will be
additional buyers in the market , so the total market demand may not contract with a rise
in price.
No change in the range of goods available to the consumers :This implies that there is
no innovation of incomes either, so that the levels of income of the consumers remain
the same.
No change in the government policy :the level of taxation and fiscal policy of
thegovernment remains the same throughout the operation of the law . Otherwise ,
changes in income tax, for instance, may cause changes in consumers income or
commodity taxes and lead to distortion in consumers preferences.
No change in the distribution of income and wealth of the community :There is no
redistribution of incomes either, so that the levels of income of the consumers remain the
same.
No change in weather conditions :It is assumed that climatic and weather conditions
are unchanged in affecting the demand for certain goods like woolen clothes , umbrella,
etc., In short , the law of demand presumes that except for the price of the product, all
other determinants of its demand are unchanged.
Exceptions to the Law of Demand

1. Giffen goods: In case of such goods, the income effect is negative and it is stronger than
positive substitution effect. Examples of such goods are coarse grain like jowar, bajra and coarse
cloth.
2. Articles of Distinction/Snob appeal: They satisfy aristocratic desire to preserve
exclusiveness for unique goods- such goods are purchased only by few highly rich people for
snob appeal. For instance, very costly diamonds, rare paintings, Rolls-Royce- cars and antique
items. These goods are called veblen goods after the name of an American economist.
3. Consumers psychological bias or illusion about the quality of commodity with price change.
They feel that high priced goods are better quality goods and low price goods are inferior goods.
Prof. Benham has given an example of a book of photographs during the First World War. The
sale of second edition of the book increased tremendously in spite of rise in its price, though the
book contained the same photographs without any change.
4. The law of demand does not apply in case of life saving essential goods and also in times of
extraordinary circumstances like inflation, deflation, war and other natural calamities. The law
also does not hold true in case of speculative demand. Stock markets are the fine examples of
speculative demand
Reasons behind downward sloping demand curves

As we know that most of the demand curves slope downward to the right because of an inverse
relationship between the price of a commodity and its quantity demanded. But the question is
why inverse relationship exists between the price and quantity demanded. Economists have
mentioned the following reasons of this relationship:
1. Application of the law of diminishing marginal utility:

The marginal utility curve slopes downward, hence the demand curve also slopes downward to
the right.
2. Substitution effect:
The commodity under question becomes cheaper with fall in its price in comparison to its
substitutes, therefore demand increases.
3. Income effect:
With fall in price of the commodity, demand increases due to increase in real income as a result
of positive income effect
.
4. Falling prices attract new consumers as the commodity now becomes affordable to them.
5. With fall in price of the commodity consumers start using it in less important uses,
therefore demand increases. Generally, commodities have different / varied uses.

Change in Quantity Demanded versus change in Demand
In economic analysis, the technical jargon changes in quantity demanded & changes in
demand altogether have different meanings.
The phrase changes in quantity demandedrelates to the law of demand. It refers to the
changes in the quantities purchased by the consumer on account of the changes in price. We may
say that the quantity demanded of a commodity increases when its price increases. But , it is
incorrect to say that demand decreases when price increases or demand increases when price
decreases. For increases and decreases in demand , refers to changes in demand caused by the
changes in various other determinants of demand, price remaining unchanged.
Extension and Contraction of Demand
A variation in demand implies extension or contraction of demand. When with a
fall in price more of a commodity is bought, there is an extension of demand. Similarly ,
when a lesser quantity is demanded with a rise in price, there is a contraction of demand.
In short, demand extends when the price rises. The terms extension and contraction
are technically used in stating the law of demand.
In graphically exposition, extension or contraction of demand is shown by the

movement along the curve. A downward movement from one point to another on the
movement froma tob in figure. It suggests that when the price reduces from op to op1,
demand extends from one point to another on the same demand curve implies
contraction of demand .
Increase and Decrease in Demand

These two terms are used to express changes in demand. Changes in demand are a result of the
change in the conditions or factors determining demand, other than the price. A change in

demand , thus implies an increase or decrease in demand. When more of a commodity is bought
than before at any given price, there is an increase in demand. For example , suppose a consumer
purchased yesterday 2 kg of apples at a price of Rs 50 p/kg. If today at the same price of Rs 50
p/kg , he buys 3 kg of apples , then it means there is an increase (by 1 kg) in his demand for
apples. Similarly, with price remaining unchanged less of a commodity is bought than before,
there is a decrease in demand. In our previous examples , if the consumer now buys only 1 kg , at
the same price of Rs 50 p/kg , it means decrease (by 1 kg) in his demand.
The terms increase and decrease in demand are graphically expressed by the movement from
one demand curve another. In other words, change in demand is denoted by the shifting of the
demand curve. In the case of an increase in demand, the demand curve is shifted to the right.
Thus, the shift of demand curve from DD to D1D1 shows an increase in demand. In the case, the
movement from point a to b indicates that the price remains the same at OP, but more quantity
(OQ1) is now demanded, instead of OQ. Here, increase in demand is QQ1. Similarly, a decrease
in demand is depicted by the shifting of the demand curve towards its left. Thus, the shift of
demand curve from DD to D2D2 shows a decrease in demand. In this case, the movement from
point a to c indicates that the price remains the same at OP, but less quantity QQ2 is how
demanded that before. Here decrease in demand is QQ2.
In short, a change in the quantity demanded due to change in the overall pattern of
demand results in an increase or decrease in demand. For a change in demand, the change in
factors other than price is responsible.
Reasons for Change (Increase or Decrease) in Demand

A change in demand occurs when the basic conditions of demand change. An alteration
in the demand pattern (increase or decrease in demand) is caused by many kinds of changes.
Some of the important changes are:
Changes in income. A change in the income of the consumer significantly
influences is demand for most commodities. The demand for superior

commodities in general and for comforts and luxury articles increase with a rise in
the consumers income. Similarly, overall demand generally decreases with a fail
in income. In estimating demand function for commodities such as cars, for
instance, changes in gross national product (GNP) or per captia real income is
considered as crucial factors by the researchers in general.
Changes in taste, habits and preference. When there is a change in taste, habits
or preference of the customer, his demand will change. For instance, when a
person gives up his smoking habit, his demand for cigarettes decreases.
Change in fashions and customs. Fashions and customs of our society determine
many of our demands. When these changes, demand also changes.
Change in the distribution of wealth. Through fiscal measures, government can
reduce inequality of income and wealth bring about a just distribution of wealth,
consequently the demand pattern may change in a dynamic welfare society.
Welfare programmes like free medical aid, free education, pension schemes, et.,
raise the purchasing power of the poorer section of the community and their
standard of living, so the overall demand pattern may change.
Change in substitutes. Changes in the supply of substitutes, change in their
prices, the development of new and better quality substitutes certainly affect the
demand for the given product. For instance, introduction of ballpoint pens has
caused a fall in the demand for fountain pens.
Change in demand position of complementary goods. When there is a change
in the demand conditions of a complementary good (which is jointly demanded),
there will be side-effects on demand. For instance, a change in the demand for
shoes will automatically bring about a similar change in the demand for shoe
laces.
Change in population. The market demand for a commodity substantially
changes when there is change in total population or change in its age or sex
composition. For, instance if the birth rate is high in a country, more toys and
chocolates will be demanded. But when the birth rate is substantially reduced
through overall family planning efforts, their demand will decrease. Similarly, if
the sex ratio of the country changes and if females outnumber males, demand for
skirts will increase and that for shirts will decrease.
Advertisement and publicity persuasion. A clever and persistent advertisement
and publicity programmes by the producers affects consumers preference and
causes alteration in the demand for products. Generally, demand for patent
medicines and toilet articles is very much determined by salesmanship and
publicity. Often a change in demand for a new brand of the article in question, or
the changed version of the former one (e.g., when chairman cigarettes became
Gold (charminar) it causes a spurt.

Change in the value of money:

When there are inflationary or deflationary tendencies developing in the general price level,
consequently the value of money falls or rises, and there may be change in the relative prices of
different goods, causing widespread changes in the demand pattern of various items.
Change in the level of taxation:

When the government changes its tax structure, especially if direct taxes such as income tax.
Wealth tax etc. are reduced, the disposable income of the people increases, which may lead to
changes in the overall demand. On this count usually, the government in order to decrease the
demand for foreign goods imposes high tariff duties on imports.
Expectation of future changes in prices:

When the consumer expects that there will be a rise in prices in future, he may buy more at the
present price and so his demand increases. In the reverse case, his demand decreases.
Elasticity of Demand
Background- Law of demand describes the qualitative aspect regarding the inverse relationship
between price and demand and elasticity of demand describes the quantitative aspects regarding
the inverse relationship between price & demand. We can explain qualitative and quantitative
aspects of price & demand with the help of the following chart
Other things remaining the same, due to certain percentage change in a price of the
commodity if certain percentage changes in demand of that commodity it is known as elasticity
of demand. The concept of elasticity of demand is generally associated with the name of Alfred
Marshal Though this idea was evolved much earlier by economists like Courrat and Duel
different economists have defined the elasticity of demand. Some of the definitions are given
below:-
Prof. Alfred Marshal, The elasticity (or Responsiveness) of demand in a market is large or
small according to the amount demanded increases much or little for a given rise in price.
Prof. K.E. Boulding, The elasticity of demand may be defined as the percentage change in the
quantity demand which would result in one percent change in price. Boulding gives the
following formula to calculate the elasticity of demand-

TYPES OF ELASTICITY OF DEMAND

Price Elasticity: Elasticity of demand for a commodity with respect to change in its price.
Cross Elasticity: Elasticity of demand for a commodity with respect to change in the price
of its substitutes.
Income Elasticity: Elasticity of demand with respect to change in consumers income.
Price Elasticity of Demand (EP)- Other things remaining the same due to certain
percentage change in price if certain percentage change in demand of commodity is there,
it is known as price elasticity of demand. It is measured as percentage change in quantity
demanded divided by the percentage change in price.
Ep =Percentage change in Quantity demanded

Percentage change in a price of the commodity
The measure of price elasticity (e) is called co-efficient of price elasticity. The measure of price
elasticity is converted into a more general formula for calculating coefficient of price elasticity
given as
Ep = % Q
% P
Where Ep = Price Elasticity

P = Price
Q = Quantity
= Change
Types of Price Elasticity

Unit elasticity of demand (e = 1)
Elastic demand (e > 1), i.e., elasticity is greater than unity.
Inelastic demand (e < 1 ), i.e., elasticity is less than unity.
Perfectly elastic demand;
Perfectly inelastic demand;
Relatively elastic demand;
Unitary inelastic demand; and
Relatively inelastic demand.
I Perfectly Elastic Demand (e=):

When minor, nothing or as good as zero percentage change in price results in tremendous
percentage change in demand, it is known as perfectly elastic demand. We can say in other

words that it is a situation in which demand of a commodity continuously changes without any
change in price. It can be explained with the help of following diagram.
Example:
0.25 or 0.10 % Change in price
10 % or 15 % Change in demand
II Relatively Elastic or Highly Elastic Demand (e>1):

When less percentage change in price of commodity and if as compared to that more percentage
change in demand is there, it is known as highly elastic demand. We can say in other words that
it refers to a situation in which percentage change in demand of commodity is higher than
percentage change in price of that commodity. We can explain this with the help of the example
and above diagram-
Example:
5 % Change in price
20 % or 25 % Change in demand
III Unitary Elastic Demand (e=1)

When equal percentage or a proportionate change in price of commodity and demand of
commodity is there, it is known as unitary elastic demand . It means that percentage change in

demand of a commodity is equal to percentage change in price. We can explain this with the help
of following example and above diagram-
Example:
10 % Change in price
10 % Change in demand
IV Relatively inelastic demand or Highly Inelastic Demand (e<1)

When as compared to price less percentage change in demand of that particular commodity is
there it is known as highly inelastic demand. It means when percentage change in demand of a
commodity is less than percentage change in demand in price. We can explain with the help of
following example and above diagram-
Example:
20 % Change in price
5 % Change in demand
V Perfectly Inelastic Demand (e=0)

When extreme percentage change in price of the commodity and if minor, nothing or as good on
zero percentage in demand is known as perfectly inelastic demand. We can explain with the help
of the following example and above diagram-
Example:
10% or 20 % Change in price
0.05 % Change in demand
Point and arc Elasticity of Demand

The elasticity of demand is conventionally measured either at a finite point or between any two
finite points, on the demand curve. The elasticity measured on a finite point of a demand curve is
called point elasticity and the elasticity measured between any two finite points is called arc
elasticity. Let us now look into the methods of measuring point and arc elasticity and their
relative usefulness.
(A) POINT ELASTICITY

The point elasticity of demand is defined as the proportionate change in quantity demanded in
response to a very small proportionate change in price. The concept of point elasticity is useful
where change in price and the consequent change in quantity demanded are very small.
Point elasticity
Elasticity measured at a given point on the demand curve (function).

(B) ARC ELASTICITY

The concept of point elasticity is pertinent where change in price and the resulting change in
quantity are infinite or small. However, where change in price and the consequent hunger in
demand is substantial, the concept of arc elasticity is the relevant concept. Arc elasticity is a
measure of the average of responsiveness of the quantity demanded to a substantial change in the
price. In other words, the measure of price elasticity of demand between two finite points on a
demand curve is known as arc elasticity.
Arc elasticity
Average elasticity measured over between a specific range (two points) of a demand
curve (function).
Factors Influencing Elasticity of Demand

Nature of commodity
Availability of substitutes
Number of uses
Consumers income
Height of price and range of price change
Proportion of expenditure
Durability of the commodity
Habit
Complementary goods
Time
Recurrence of demand
Possibility of postponement
2. Income Elasticity of Demand

Other things remaining the same due to certain percentage change in consumers income if there
is certain percentage change in demand it is known as income elasticity of demand. It means the
ratio of percentage change in quantity demanded due to percentage change in income of
consumers.
Ey =Percentage change in Quantity demanded

Percentage change in income
Ey = % Q
% y

Where Ey = Income Elasticity

y = Income
Q = Quantity
= Change
Types of Income Elasticity

Unitary income elasticity of demand; (em = 1);
Income elasticity of demand greater than unity; (em > 1);
Income elasticity of demand less than unity; (em < 1);
Zero income elasticity of demand; (em = 0); and
Negative income elasticity of demand. (em < 0);
I Positive Income Elasticity

Increase in normal/ luxury goods, there will be positive relation between income and demand
because as income increases demand increase and vice versa. Positive income elasticity may be
of three types-
EY=1, Ey>1, Ey<1
Unitary income elasticity of demand; (em = 1);
Income elasticity of demand greater than unity; (em > 1);
Income elasticity of demand less than unity; (em < 1);
II Negative Income Elasticity (EY<0)-

Incase of inferior goods, the income elasticity of demand is negative because there will be an
inverse relation between income and demand for inferior goods. As income increases demand for
inferior goods decreases and vice versa.
III Zero Income Elasticity (EY=0)

In case of necessary goods whether income increases or decreases the quantity demanded
remains the same. So Zero income is found here.
Applications of Income Elasticity

Long-term business planning. In the long run, demand for
comforts and luxury goods may tend to be highly income
elastic. Hence, prospects for long run growth in sales for
these goods are very bright. The firm can plan out its
business accordingly.
Market strategy. Income elasticity of demand is helpful in
developing market strategies.

Housing development strategies. On the basis of income

elasticity, housing development requirement can be
predicted and construction work can be effectively
launched upon.
Cross Elasticity of Demand

Other things remaining the same due to certain percentage change in price of one commodity
certain percentage change in demand of another commodity is known as cross elasticity of
demand.
EC = Percentage change in Quantity demanded y commodity

Percentage change in price x commodity
OR
EC =%QX
%PY
Types/ Degree of Cross Elasticity

I Positive Cross Elasticity- In case of substitute goods for example tea and coffee, there is
positive relation.
II Negative Cross Elasticity - Incase of complementary goods like car and petrol, there is
inverse relation. So negative cross elasticity is found here .
Factors influencing Elasticity of Demand

Demand is a function of price, income, taste, hobby, nature of consumer population, govt. policy
etc. Elasticity of demand tends to be different for different types of goods it will differ from
market to market with this background we can explain the factors influencing elasticity of
demand.
1. Nature of commodity - These who have no substitute goods will have an inelasticity of
demand. The consumers will buy almost a fixed demand whether the price is higher or lower.
Demand for luxuries, on the other hand, is elastic in nature.
2. Different uses of the commodity- A commodity that has several kinds of uses is apt to be
elastic in demand. For each single use demand may be inelastic so that when price of the
commodity goes down only a little more is purchased for every use.

3. Availability of substitute goods- When there exists a class substitute in the relevant price
range, its demand will tend to be elastic. But in respect of commodities having no substitutes,
their demand will be the same inelastic.
4. Consumers income - Generally larger the income, the overall demand for commodities tends
to be relatively inelastic. The redistribution of income in favour of low income people may tend
to make demand for some goods relatively inelastic.
5. Proportion of expenditure- Items that constitute a smaller amount of expenditure in a
consumers family budget tend to have a relatively inelastic demand, e.g., a cinegoer who sees a
film every fort night is not likely to give it up when the ticket rates are raised. But one who sees a
film every alternate day perhaps may cut down his number of films. So is the case with matches,
sugar etc.
6. Durability of the commodity- In the case of durable goods, the demand generally tends to be
inelastic in the short run, e.g., furniture. bicycle radio, etc. In the perishable commodities, on the
other hand, demand is relatively elastic, e.g., milk , vegetables, etc.
7. Influence of habit and customs- There are certain articles which have a demand on account
of conventions, customs or habit and in these cases, elasticity is less, e.g., Mangal Sutra to a
Hindu bride or cigarettes to a smoker have inelasticity of demand.
8. Complementary goods- Goods which are jointly demanded have less elasticity, e.g., ink,
petrol have inelastic demand for this reason.
9. Recurrence of demand- If the demand for a commodity is of a recurring nature, its price
elasticity is higher than that of a commodity which is purchased only once. For instance, bicycle,
tape recorders, radios, etc. are purchased only once, hence their price elasticity will be less. But
the demand for cassettes or tape spools would be more price elastic.
10.Possibility of postponement- When the demand for a product is postponable, it will tend to
be price elastic. In the case of consumption goods which are urgently and immediately required,
their demand will be inelastic.
Uses/ Importance of Elasticity of Demand

The concept of elasticity of demand is of considerable significance in various situations, which
we shall briefly summaries below:
1. Helpful to a monopolist in fixing price- The individual producer under imperfect

competition has to consider the demand for his product when he fixes its price. He has to take
into account the response of his customers in formulating his price policy. Likewise the
monopolist has to study the elasticity of demand of his product before he fixes its price.
2. Helpful to the Government in formulating Taxation Policies- The concept of elasticity of

demand also proves helpful to the Government in the formulation of its economic and taxation
policies, The finance minister has to consider the nature of the elasticity of demand for a
commodity before levying an excise tax on it.

3. Helpful in Determination of rewards for factors of Production- The concept of elasticity of

demand also influences the determination of the rewards for factors of production in a private
enterprise economy. If the demand for labour on a particular industry is relatively inelastic, it
will be easier for the trade union to get their wages raised. The same remarks apply to other
factors of production whose demands are relatively inelastic.
4. Helpful in determination of terms of trade- It is possible to calculate the terms of trade

between two countries only by taking into account the mutual elasticities of demand for each
others products.The term Terms of Trade implies the rate at which one unit of a domestic
commodity will exchange for units of commodity of a foreign country.
5. Helpful in determining the Rate of Exchange- The concept of elasticity of demand also
helps the government in fixing an appropriate foreign rate of exchange for its domestic currency
in relation to the currencies of other countries. Before deciding to devalue or revalue domestic
currency in relation to foreign currencies the government has to study carefully the elasticites of
demand for its imports and exports.
6. Helpful in declaring certain industries as Public Utilities- The concept of elasticity of

demand also enables the government to decide as to what particular industries should be declared
as public utilities and being consequently owned and operated by the state.
Practical Application
The concept of elasticity of demand has a wide range of practical application in economies
and business.
To businessmen
In decision making, the concept of elasticity of demand is of utmost practical use, for while
taking decision for pricing policy, the businessman has to know the likely effect of price changes
on the demand for his product in the market . He has to consider , for instance , whether a
lowering of price will cause an expansion for his product , and if so to what extent and thus to
what extent his total revenue would rise fetching what amount of profit. This he can know easily
if has an idea about the demand elasticity for his product. Most businessmen consciously or
unconsciously know by intuition something about the elasticity of demand for their product
while making, thus , one has to try to form as precise an idea as possible of the degree of
elasticity of demand , for it is a convenient short-hand way of expressing the effects of price
change on the demand.
To the government and finance minister
In determining fiscal policy also, the concept of elasticity of demand is very important to
the government. T he finance minister has to consider the elasticity of demand while selecting
commodities for taxation. Tax imposition on commodities for getting a substantial revenue

becomes worthwhile only if the taxed goods have an inelastic demand. Otherwise, if the demand
is more elastic, it will contact very much with a rise in price as a result of added taxation (like
sales tax or excise duty), hence the total revenue yield would not be much. That is why,
generally taxes are levied on commodities like kerosene, matches, cigrattes, sugar, etc which
have an inelasticity demand
In international Trade
The concept is also useful in formulating export and import policies of a country . Further,
in determining terms in the sphere of international trade, the relative elasticities of demand for
commodities in the two countries are very important.
To policy makers
In economic analysis, the concept is useful in solving the mystery of how farmers may
remain poor despite a bumper crop . Since agricultural products, particularly food grains, have
inelastic demand , when there is a bumper crop it can be sold only by cutting prices substantially.
Hence, the total income of farmers will be lower in spite of a bigger crop.
To Trade Unionists
The concept of price elasticity is useful to trade unions in wage bargaining. The unions
leader . When they find that demands for their industrys product is fairly elastic, will ask for a
higher wage to workers and use the producer to cut the price and increase sales which will
compensate for his loss in total profit. In this way, the concept of demand is of a great practical
significance to businessmen, economists, farmers, trade unions and government policy- maker.
Advertising or Promotional Elasticity of Demand

Firms spend considerable amounts of money on advertisement and other sales promotional
activities with the object of promoting its sales. Thus, sales differ in their responsiveness. It
refers to the responsiveness demand to change in advertising or other promotional expenses.
The formula to calculate the advertising elasticity is as follows:
Advertising elasticity of demand= Proportionate change in sales

Proportionate change in advertisement expenditure
Factors affecting AED
Product Stage
Competitors
Demand
The time gap between the advertising expenditure and the actual response of the sales
to such expenditure.
The delay affect of the firms past advertising and the extent of its effect on current and
future sales.
Illustration: Practical Application
In practice, the price variations and differentials in several businesses such as hotels, air-
lines, ferries, coaches, time to time, reflect differences in the level of demand, particularly

the varying elasticity of demand at different times such as peak seasons and off-seasons
over a year. A telephone company also decides its rate structure into peak rate, standard
rate, discount rate etc., at different times of the day. For example, during working day
8.00 a.m. to 7.00 p.m. peak rate is charged on calls, while lower or discount rates are
charged during night hours. On public holidays, discount rate is charged. In all such
cases, pricing is based on demand consideration rather than the cost element.
Network Externalities in Market Demand

Theoretically, in earlier discussion (Section 3.3) it is assumed that individual demands for the
product are independent, therefore, we desire market demand function/curve by simply summing
individual buyers In reality, however, there may be interdependence of demand, i.e., an
individual demand may be depending on the demands of the other people in the case of same
goods. This situation is described as network externalities which may be positive or negative in
effect.
Economists have identified two such network externalities:
Bandwagon Effect
Snob Effect or Veblen Effect.
1 The Bandwagon Effect
In todays life, demand for certain goods seems to be determined basically not by their
usefulness or utility but mostly on account of bandwagon effect or demonstration effect. Thus,
demand in such cases is influenced by the consumption of pace setters or trend setters (such as
film-stars, models, group leader, even friends and neighbors) in the community. That means
demand of an individual is conditioned by the consumption of others; hence, the price becomes a
minor consideration in this case.
Owing the bandwagon effect, the market demand curve tends to shift upwards, as depicted in
Figure
In figure , the initial demand curve DD is based on utility of the product. In this case, a price-cut
leads to a slight expansion of demand. In the diagram, for instance, PP1 price reduction implies

QQ1 increase in quantity demanded, in the absence of bandwagon effect. In the presence of
bandwagon effect, however, the demand curve shift upward, suggesting an increase in demand.
In our illustration, it is DD, thus, Q1 Q2 increase in demand is measured on account of the
bandwagon effect.
In short, the bandwagon effect on market demand for a product is the result of the buyers desire
to be in style or fashion that is, to have it because others have it. Demand for jeans and other
fashionable clothes; for instance, is caused by the bandwagon effect.
Bandwagon Effects; demonstration effect of consumption by the others lead to the bandwagon
effects of change in demand for a product in the market. Advertising and fashion play a
significant role in this regard.
For selling the clothes, therefore, marketing approach is to create a bandwagon effect.
Likewise in the case of childrens toys such as Barbie dolls demand arises on account or the
bandwagon effect. In advertising and marketing of man products, therefore, the object is to build
up a bandwagon effect. Bandwagon effect leads to the manipulation of the market demand. It
shifts the demand curve to the right as shown as Figure. Use of modern media such as TV,
Movies. Fashion Shows and so on in advertising strategies are meant to produce such
bandwagon or demonstration effect to manipulate market demand.
The bandwagon effect is essentially associated with stylishness, craze or dads of the people as
greater and greater number of people want to use a product due to demonstration effect
influencing on their desire through advertising media. The craze for compact disc (CD)
songs/albums of pop music is a good example of bandwagon effect that implies a positive
network externality on mark demand for the product. The bandwagon effect will be stronger
when the intrinsic value of the product is also high. In the case of personal computer (PC). For
instance, when more and more people tend to own it because of its usefulness, more software
will be written and supplied cheaper rates, then the PCs worth tends to rise further include more
buyers to buy the computers. In this way, the bandwagon effect may have its significance in
determining the pricing strategy of the business firm in such products.
2 The Snob Effect: Veblen Effect

The snob effect refers to the desire of a person (usually the rich one) to won exclusive unique
product-called snob good or Veblen good. It serves as a status symbol. When on a few people
could won a snob good, its demand tends to be high among the affluent ground. Designer clothes
and other products such as Rolls Royce cars, Ray Band goggles, a fancy restaurant an antique, a
rate painting, etc. are prestige goods and because of their snob value, the seller has to restrict the
supply of such snob appeal goods, in marketing and advertising strategies of such exclusive type
of goods, demand had to be made effective by creating a snob effect.
Rich buyers choices are usually governed by the snob appeal. The snob effect is also referred
to as Veblen effect. For the snobbish goods are described as Veblen goods (named after

Thorstein Veblen). The Veblen effect is associated with the goods of conspicuous consumption
or ostentation articles used by the affluent people.
Network externality of snob effect, however, is negative. A snob good loses its prestige when it
no longer remains exclusive and becomes a commonly used product. Though the market demand
for such a commodity, when its price falls tend to rise, the individual demand of the snobbish
buyer of the product will fall. That means, when a prestige good loses its snob value, its market
demand from the snobbish buyers will decrease with the fall in its price; and the demand may be
added up from the new common buyers. Maruti car in India, in the beginning, for instance has
gained status symbol among the richer sections of the society could have lost its snob appear
with the large expansion in its output.
In forming business strategies, such Veblen effect of snob appeal is gainfully exploited in
certain cases. Airlines, for instance, keep a much high ticket fare for the business class in
comparison to economy class. Similarly, in 5 star hotels, deluxe rooms are much higher as
compare to the standard rooms.
Land values in posh locality tend to be much higher than those of dwellings by the
ordinary people. For instance, the land price in Malabar hill in Mumbai is much more than in
moral and a construction company must be well aware of such facts in execution of its business
prospects
Veblen Effect paradox.

In certain branded goods such as Ray Ban or Levis products, i.e., exclusive or designer
products. There exists an inherent paradox p. Initially, these goods are meant to serve the Veblen
effect. At high prices, there is limited but high demand from the richer section of the buyers.
When these goods are produced in a large quantity, the prices will fall. It will carry a mass
appeal to upper middle income groups. So their demand will expand. But a further increase in
output will lead to further price reduction. At this price, however, the demand will tend to fall an
account of loss of exclusivity. The brand would lose its significance below this price and the
product would be purchased on account of its functional utility.
The demand curve for the branded or designer products, i.e., Veblen goods (jeans,
goggles, etc) is Z shaped (assuming for convenience).

The demand curve DD has changing slopes at a and b points. A further reduction of price
to P3 leads to a fall in demand as the brand loses its exclusivity appeal. After that, the product
demand is determined just by its functional utility. In case of Veblen paradox, thus, pricing the
Veblen product is an art under the situation of Z shaped demand curve. Traditional price theory
does not provide any clue when the demand curve contains both rising and falling segments.
Stretched Z demand curve implies that at very high price, the market demand is limited but less
elastic. When price is reduced, demand expands, as per the law of demand. And, when the
branded goods lose their exclusivity appeal, these goods have to compete with un branded goods
in the market. Such unbranded gods are than disposed off in shopping centers and super markets
at very high discounts to attract common buyers.
The network externalities play a significant role in influencing the market demand for
certain products such as computers, CD players, fax machines, headphones, etc. a positive
network externality causes an upward shift in the market demand curve. The producers may
experience a rapid growth in demand for such products, because of the bandwagon effect a
positive externality for quite a long time till the saturation point id reached.
Demand forecasting
In modern business, production is often made in anticipation of demand. Anticipation of

demand implies demand forecasting. Forecasting means expectations about the future course
of development. The future is uncertain. But, not entirely so. Hence one can hopefully predict
the future event and reasonably gain. Demand forcasting means expection about the future
course of the market demand for a product. Demand forecasting is based on the statistical
data about past behavior and empirical relationships of the demand determinants.
Demand forecasting is not a speculative exercise into the unknown. It is essentially a
reasonable judgment of future probabilities of the market events based on scientific

background. Demand forecasting is an estimate of the future demand. It cannot be hundred

percent precise. But it gives a reliable approximation regarding the possible outcome, with a
reasonable accuracy. It is based on the mathematical laws of probability.
Demand forecasting may be undertaken at the following levels:
I. Micro level
It refers to the demand forecasting by the individual business firm for estimating the
demand for its product.
II. Industry level

It refers to the demand estimate for the product of the industry as a whole.
III. Macro level

It refers to the aggregate demand for the industrial output by the nation as a whole. Its
based on the national income or aggregate expenditure of the country.
Significance of Demand Forecasting

Production planning
Sales forecasting
Control of business
Inventory control
Growth and long-term investment programs
Stability
Economic planning and policy making
General approach to Demand Forecasting

Specification of objectives
Identification of demand determinants
Choice of methods of forecasting
Interpretation
Short term and Long term forecasting

For business decision making purposes, a firm may undertake short term and long term
forecasting of demand and other variables.
Short term forecasting
Short term forecasting normally relates to a period not exceeding a year. Short term forecasts
relate to the day-to-day particulars which are concerned with tactical decisions under the given
resource constraints; as in the short run available resources, scale of operations, etc., are fixed or
unalterable, by and large. In the short term forecasting a firm is primarily concerned with the
optimum utilizationof its existing production capacity.
Long term forecasting

Long term forecasting refers to the forecast prepared for long period during which the firms
scale of operations or the production capacity may be expanded or reduced. Long term forecasts
are normally for the periods exceeding a year, usually 3-5 years or even a decade or more.
Functionally, the long term periods which permit alterations in the scale of production differ
from industry to industry and firm to firm.
A long term forecasting relates to those information which are vital for undertaking strategic
decisions of the business pertaining to its expansion or contraction over a period of time.
Need for short term forecasting

Evolving a sales policy
Determining price policy
Evolving a purchase policy
Fixation of sales target
Determining short term financial planning
Need for long term forecasting

1. Business planning
2. Manpower planning
3. Longterm financial planning
Sources of data collection for Demand forecasting

Though a market research, a variety of information- qualitative quantitative, called data have
to be collected prior to the estimation of demand and demand forecasting. These informations
may be pertaining to various aspects of the market and demand, such as effective demand in the
past and present, nature of product and type of consumer- whether domestic consumers or
industrial consumers, age sex and income of the consumers and their attitude, preferences, tastes,
habits, etc., price quotations in the retail and the whole sale markets, market territories- whether
urban, rural, local, national, international or global, nature of market structure on the basis of the
degree of competition, methods used for sales promotion, e.g., advertising, free samples,
discounts, window display , and so on as well as the expenditures so incurred or involved.
Primary and secondary data
The market research may be based on 2 types of sources of data collection. Viz., primary sources
and secondary sources, providing primary data and secondary data respectively.
Primary data are informations are original in character which are collected for the first
time for the purpose of analysis. Primary data are raw data and require statistical processing.
Secondary data or informations are those which are obtained from someone elses
records. These data are already in existence in the recorded or published forms. Secondary data
are like finished products since they have been processed statistically in some form or the other.
In a market research for the demand analysis, a beginning may be made with the
collection of secondary data, which would provide clues for further enquiry.

Secondary sources of data

There are ample secondary sources for collecting therequired information for market and
demand analysis. The main source of such data are:
Official publications of the Central, State and Local governments
Trade and technical or economic jounals and publications like the Economic and political
Weekly, Indian Economic jounal Stock exchange directory, etc.
Official publications like the RBI, e.g., Annual report on Finance and Currency
Market repors and trade bulletins published by stock exchange, trade associations,
chamber of commerce, etc.
Publications brought out by research institutions, universities, associations, etc.
Govt. publications and reports, surveys etc.
Primary sources/ Methods

For demand forecasting purposes, usually two primary methods are resorted to:
1. Market survey /studies or the survey method
2. Market experimentation
1. Market survey/ studies:

The market survey is the most important and direct approach to demand forecasting in the short
run. It may be a sample surveyor a census enquiry. A census market enquiry means the enquiry
of the entire universe or population. i.e., covering all units or items involved in the total market
field. It may be adopted in capital goods market where number of buyer firms is limited. In most
of consumer good items, however, it would be a costly affair and time consuming also. In
large cases, therefore, market survey is essentially a sample survey. In the same survey only a
few items are selected from the given field and their details are obtained. From the sample data,
however, statistical inferences are drawn for the entire population.
There are two variants of survey method:

A) The consumer survey
B) The collective opinion
1. The consumer survey

A sample survey of consumers may be undertaken questioning them about what they are
planning or intending to buy. A questionnaire may be prepared in this regard. This may be
mailed to the consumers. Or it may be sent through enumerators. (i.e., field investigators) .
In the questionnaire, the respondents(consumers) may be asked for their reactions to
hypothetical changes in demand determinants such as price, income, price of substitutes,
advertising, etc.

The information collected through questionnaires are to be thoroughly scrutinized and edited to
check inconsistencies, inaccuracy and incorrectness of the data supplied. These data may be
classified and tabulated for systematic presentation and analysis.
Sometimes, personal observations or the personal interview method may also be adopted to
collect information when there is a small sample size of consumer survey. On the basis of the
data/ information collected in the consumer survey, the managerial economist can construct
important demand relationships, such as price-demand, income-demand, advertisement
expenditure- demand, cross demand etc.
In short, consumer survey method is useful for obtaining short term forecasts based on peoples
intentions and expectations. Consumer survey is useful for knowing the demand for new
products where past data is available . it is useful in case of industrial products, engineering
goods, consumer durables, housing etc., where buyers usually plan their purchases much in
advance.
2.The collective opinion

It is also referred to as sales force polling and experts opinion survey. Under this method, the
sales man have to report to the head office their estimates of the expectations of sales in their
territories. Such information can also be obtained from the retailers and wholesalers by the
company. By aggregating these forecasts a generalization on an average is made, which is also
based on the value judgment and collective wisdom of top sales, executives, marketing manager,
business/ managerial economists all together. Sometimes, even experts opinion is obtained
from the dealers, distributors, suppliers or from the executives of the trade associations, or
marketing consultants.
The opinion method is cheaper and easy to handle, it is less time consuming also. Its main
drawback, however, is that it is subjective and subject to a high element of bias of the reporting
agency.
The opinion method is based on the value judgment of the salesmen. It can be used for
forecasting the sales for new products. It is also regarded as hunch method of business
forecasting since it is based on the hunches of experts. Its main drawback is that it is subjective.
Its accuracy depends on the intelligence of the reporting salesman. It cannot be relied upon for
long-term business planning.
3.Delphi Method
Olaf Helmer originated the Delhpi method in the late 1940s. Delphi method is used for
conducting opinion poll or survey. Under this method, a group of experts are repeatedly
questioned for their opinions or comments on some issues and their agreements and
disagreements are clearly identified. It is a time-saving device. It can be effectively used for the
heterogeneous group of experts with different backgrounds. Its major drawback is that it
presupposes that its conductors are objective in approach and possess great thinking ability and
power of reasoning.

II. Market Experimentation

Sometimes, market experiments may be conducted to make certain specific observations.
There may be two types of market experimentation : (1) experimentation in laboratory,
and (2) test marketing.
(i) Experimentation in Laboratory
It is also referred to as the consumer clinic method. In this method, a consumer clinic or
small laboratory is formed by creating an artificial market situation. To study consumer reaction
to a change in demand variables, in the controlled conditions of the consumer clinic, the selected
consumers are given a small amount of money and asked to buy certain items. The consumer
behaviour in the clinic is thus observed and inferences are drawn.It is expensive and time
consuming method. The stimulated market situation may not be fully representing the actual
market situation.
(ii) Test Marketing.
In this method, a market experiment is performed under actual market conditions. First, a
choice of the market for experiments is made and is segregated from the rest. The business firm
then conducts the experiment in this market, under controlled conditions, by varying one or more
of demand determinants like price, advertisement, packaging, etc., Consumer behaviour in the
market is then observed and recorded. This may help in assessing the effects of changes in the
determining variable on the consumer demands for the project.Unlike consumer survey, in this
case of market experiments, demand is estimated on the basis of actual purchase (and not
intentions or expectations) of the consumer under the given or partially known conditions. To
ensure valid results, it is necessary that market experiments be conducted on sufficiently large
scale.
The following are the major drawbacks of market testing experimentation :

It is a very expensive method
It is also quite a risky method, as experiments may be reacted upon by the consumers
as well as dealers. There are all possibilities that the consumer may be driven away
by price increase in the segmented market subject to experimentation.
It is also difficult to plan market experimentation under heterogeneous market
conditions.
Direct market experimentation are, however, very significant to provide best guidance for pricing
the new product in the absence of statistical data. These are also useful in determining a suitable
marketing strategy by verifying the results of statistical studies.
Market experimentations are, often conducted in advanced countries like the United States. In
India, however, a market experimentation is hardly tried.
Statistical Methods of Forecasting Demand

Once market demand data are collected by the market survey or from the sales records of the
firm demand forecasting can be possible from such information.There are various methods

adopted to estimate potential demand. Some people do rely on personal judgement and
experience. Some depend on statistical techniques. Statistical methods are obviously more
scientific, against crude value judgement used to estimate future demand.
For forecasting purposes, it is essential to estimate the structural form and parameters of the
demand function empirically. In modern times, however, for demand forecasting purpose,
statistical methods are preferred and commonly adopted. They are economical as well as more
reliable.
In statistical analysis, economists usually resort to two types of data for demand estimation (i)
time series data and (ii) cross-sectional data.
1. Time Series Data

Time series data refer to data collected over a period of time recording historical changes in
price, income and other relevant variables influencing demand for a commodity. Time series
analysis relate to the determination of change in a variable in relation to time. Usually, trend
projections are important in this regard.
2. Cross Sectional Data
Cross-sectional analysis is undertaken to determine the effects of changes in determining
variables like price, income, etc., on the demand for a commodity, at a point of time.
In time series analysis, for instance, for measuring income elasticity of demand, a sales income
relationship may be established from the historical data and their past variations. In cross-
sectional analysis, however, different levels of sales among different income groups may be
compared at a specific point of time. The income elasticity is then estimated on the basis of
differences so measured.
Sometimes, pooled data are also used. Pooled data implies a combination of time and cross-
sectional data.
The important demand forecasting methods are :

Consumption Level Method.
Trend Projection Method.
Regression Analysis and Econometric Method.
A. Consumption Level Method
Consumption level demand may be estimated on the basis of the co-efficient of income elasticity
and price elasticity of demand.
Viewing projected income level and income elasticity of demand relationship, demand
forecasting may be made as under :
D* = D (1 + M*.em )
Where D* = Projected per capita demand
D Per capita demand
M* = Projected relative/percentage change in per capita income
Em = Income elasticity of demand.

B. Trend Projections
A time series analysis of sales data over a period of time is considered to serve as a good guide
for sales or demand forecasting. For long-term demand forecasting, trend is computed from the
time based demand function data. Trends refer to the long-term persistent movement of data in
one direction upward or downward.
There are two important methods used for trend projections:
(i) the method as moving averages,
(ii) The least square method.
The Method of Moving Averages
A moving average forecast is based on the average of a certain number of most recent
periods. One can select the number of months or years or other period units in the moving
average according to how far back the data is relevant to future observations.
The moving average (trend) so obtained is plotted on a graph and from graphical
presentation forecasting is projected through the extension of the curve for the years ahead,
measured on the x-axis.
The least square method.
The method of least squares is more scientific as compared to the method of moving
averages. It uses the straight line equation Y = a + bX, to fit the trend to the data.
C. Regression Analysis and Econometric Model Building

Most commonly for demand forecasting purposes, the parameters of the demand function are
estimated with regression analysis. In demand regression equations relevant variables have to be
included with practical considerations and relevant data have to be obtained. To illustrate the
point we may cite a few examples :
(i) Personal disposables income towards demand for consumer product
(ii) Agricultural or farm incomes towards demand for the agricultural equipments, fertilizers,
etc.,
(iii)construction contracts for demand towards building material such as cement, bricks, steel,
tiles, etc., and
(iv) automobile registry over a period towards demand for car spare parts, petrol, etc.,
Collecting such information, demand parameters may be computed with the help of
regression analysis. Econometric models are very useful in this regard. Econometric models
identify functional relationship between variables.

Module 2
Production Analysis
Concept, Production Function: Single Variable Law of Variable Proportions & Two
Variable Function, ISO-Quants & ISO Costs & Equilibrium, Total, Average, & Marginal
Product, Return to Scale, Technological Progress & Production Function.
PRODUCTION ANALYSIS
Introduction
Production implies provision of goods and services often described as commodities. In
technical sense, production is the transformation of resources into commodities over time and/ or
space. To put it simply, production is the act of converting or transforming input into output. The
act of production is technically carried out by a firm. A firm is a business unit which undertakes
the activity of transforming inputs into outputs of goods and services. In the production process,
a firm combines various inputs in different quantities and proportions to produce different levels
of outputs. Production is a flow concept. It is measured as s rate of output per unit of time.
The Concept of Production Function

The rate of output of a commodity functionally depends on the quantity of inputs used per unit
of time. The technological-physical relationship between inputs and outputs is referred to as the
production function. Basically, production function is an engineering concept, but it is widely
used in business economics for studying production behavior. The production function is the
name given to the relationship between rates of input of productive services and the rate of
output of product. It is the economist's summary of technical knowledge.
Production Function refers to the physical relationship between the use of the inputs (factors
of production) and resulting output of a product.
Definition
A production function refers to functional relationship, under the given technology,
between physical rates of input and output of a firm, per unit of time.
Algebraic Statement of Production Function

In algebraic terms, the production function may be written as:
Q = f (a, b, c, d... n, T)
Q represents the physical quantity of output (commodity produced) per unit of time. f denotes
functional relationship. a, b, c, d, ..... , n represent the quantities of various inputs (productive
factors) per employed time period. T refers to the prevailing state of technology or know how.
The bar (-) is placed on T just to indicate that technology is assumed to be constant.

Attributes of Production Function

For a clear understanding of the concept of production function, its following attributes
should be carefully noted:
Flow concept. A production function is a flow concept. lt relates to the flow of inputs
and the resulting flows of output of a commodity during a period of time. Here, time is
taken to be functional or operational time period.
Physical production function is a technical relationship between inputs and outputs
expressed in physical terms and not in terms of a monetary unit, such as rupee or dollar.
State of technology and inputs. It implies that the production of a firm depends on the
state of technology and inputs. Technology refers to the sum total of knowledge of the
means and methods of producing goods and services. It is the societys knowledge
concerning the industrial and agricultural arts. It includes methods of organisation and
techniques of production. Input refers to anything that is used by the firm in the process
of production. Thus, inputs include every type of productive resource- land, labour,
capital, etc., also time and human energy as well as knowledge, which are employed by
the firm for producing a commodity.
Laws of Production
Production process involves the transformation of all inputs into output. In production
function, we study different combinations of inputs producing various quantities of output under
different technical conditions. The production function expresses such relationship between
inputs and outputs. The production function has been explained by different economists in
different ways to formulate laws relating to the relationship between inputs and outputs. These
can be studied in the following ways:
1. Output can be produced by keeping one factor or some factors fixed while other factors
are varied. This is the traditional production function which held sway over the
economists mind for well over two centuries. The law of diminishing marginal returns
is based upon this type of production function, which was originally explained by British
classical economists like Thomas Robert Malthus, David Ricardo and John Stuart Mill. It
was refined and elaborated at the hands of Alfred Marshall, leaders of the Neo-classical
schools.
2. Another type of production function is one in which only one factor is variable while
other factors are kept constant. Prof. Ben ham explained this type of production function
which has been described as the law of variable proportions. This is considered as the
modern version of the law of diminishing marginal returns.
3. In another type of production function, the quantities of every input in the combination of
inputs can be varied to produce different quantities of output. This is known as law of
return to scale. Since it is not possible to change the scale of operation in a short period,
the law of returns to scale is associated with the long period production process.

The Law of variable proportions

This is the modern version of the law of diminishing marginal returns. Under this law, it
is assumed that only one factor of production is variable while other factors are fixed. As we
increase the quantity of variable factor, while keeping other factors constant the output of
variable factor may increase more than proportionately in the initial stages of production but
finally, It will not increase proportionately. Prof. Ben ham states the law as follows:
As the proportion of one factor in a combination of factors is increased after a point, the average
and marginal production of that factor will diminish.
The conditions underlying the law are as follows:
Only one factor is varied and all other factors should remain constant.
The scale of output is unchanged, and the production plant or the size efficiency of the
firm remains constant.
The technique of production does not change.
All units of the factor input varied are homogeneous, i.e., all the units have identical
characteristics and equal efficiencies.
Under such circumstances, the physical relationship between input (variable factor
proportions) and output is described by the Law of Variable Factor Proportion or the Law of
Non-proportional Output.
The law of non-proportional output states that in the short run, the returns variable factors
will be more than proportionate initially, and after a point, returns will be less than proportionate.
This is what the law describes about the behaviour in total output resulting from increased
application of variable factors to fixed factors.
We shall once again state the law more elaborately thus: In the short run, as the amount
of variable factor increases, other things remaining equal, output (or the returns to the factors
varied) will increase more than proportionately to the amount of variable inputs in the beginning,
that it may increase in the same proportion and ultimately it will increase less proportionately.
To clarify the relationship further, we may adopt the following measurements of product:
Total Product (TP). Total number of units of output produced per unit of time by all
factor inputs is referred to as total product. In the short run, however, the total output
obviously increases with an increase in the variable factor input. Thus, TP = F(QVF),
where TP denotes total produce and QVF denotes the quantity of the variable factor.
Average Product (AP). The average product refers to the total product per unit of a
given variable factor, we get average product. Symbolically:
AP = TP / QVF
Suppose the total product of a commodity is 400 units per day with 25 workers employed, then,
AP = 400/25 = 16 units per worker.
Marginal Product (MP). Owing to the addition of a unit to a variable factor, all other
factors being held constant, the addition realised in the total product is technically
referred to as the marginal product. In formalised terms, the marginal product may be

defined as: (MPn = TPn TPn-1,) where, MPn stands for the marginal product when n
units of a variable factor are employed. TP refers to total output and refers to the number
of units of variable factor employed (n = QVF).
Suppose, when 26 workers are employed, the total product is increased to 440 units from 400
units but when 25 workers are employed, the marginal product of the twenty sixth worker is
measured as:
MP = TP26 TP25 = 440 _ 400 = 40 units.
It may be stated that the marginal product is the rate of measuring the change in the total product
in relation to a unit-wise change in the employment of the variable factor. Thus in mathematical
terms:
MP =
This ratio is, in fact, termed as incremental product.In graphical terms, in terms of calculus,
however, the marginal product is defined as
MP = where = a unit change measured by the derivative of the related to
variable.
To illustrate the working of this law, let us take a hypothetical production schedule of a
firm as given in Table.
It is assumed that the amount of fixed factors, land and capital, is given and held constant
throughout. To this, labour - the variable factor - is added unit-wise in order to increase the
production of commodity X. The rate of technology remains unchanged. The input-output
relationship is thus observed in Table.
Production Schedule
Units of variable Average Product Marginal Product
Total product (TP)
inputs (labour) (n) (AP) (TPn) (TPn - TPn-1)
1 20 20 20
2 50 25 30 Stage 1
3 90 30 40
4 120 30 30
5 135 27 15 Stage 2
6 144 24 9
7 147 21 3
8 148 18.5 1
9 148 16.4 0 Stage 3
10 145 14.5 -3
The law of diminishing returns becomes evident in the marginal product column. Initially
product of the variable input (labour) rises. The total product rises at an increasing rate

(=marginal product). Average product also rises. This is a analytically described as stage
of increasing return (stage 1).
Reaching a certain point the marginal product begins to diminish. Thus the rate of
increase in total product slows down. This is the stage of diminishing returns (Stage II).
When the average product is maximum, the marginal product is equal to average product.
In our illustration, when the 4th labour unit is employed, the average product is 30 and
the marginal product is also 30.
As the marginal product tends to diminish, it ultimately becomes aero and negative
thereafter (Stage III)
When the marginal product becomes zero, the total product is the maximum. In our
illustration. 148 is the highest amount of total product, when the marginal product is zero
9 units of labour are employed. Further, when the marginal product becomes negative,
the total product begins to decline in the same proportion. Even though the average
product is decreasing at this stage, it remains positive upon a certain point.
These points would be more explicit when the given production schedule is plotted graphically.
We represent a graphic illustration of the product curves and the law of diminishing returns in its
generalized form. So that smooth curves are drawn.
The product curve
In the above figure, the X-axis measures the units of a variable factor employed, the Y-axis
measures the output. The total product curve (TP) shows similar information about the behavior
or total output as in production schedule in table. The total product curve has an upward slope up
to point b, and then it moves downward. However, the slope of TP curve changes at each point.
the curve (TP),however ,becomes steeper up to point n2.After this point, TP curves slope

becomes negative Evidently, TP moves through three stages 1)the first stage of increase in the
rate of total output 2)the second stage of decrease in the rate of total output 3)the third stage of
decline in total output.
These three stages are: basically confined to the behavior of the marginal product. The marginal
product is rising, diminishing and eventually it becomes negative. Hence, the marginal product
curve MP has an upside down U shape. That means the MP curve is rising upward up to a point
and then it falls downward. The rate of change of slope of the TP curve has a bearing to the
formation of the MP curve. When the MP curve intercepts at point n2 on the X-axis, it
corresponds to point b on the TP curve, which signifies that when MP =0, TP =maximum.
Again, the declining part of the TP curve is in proportion to the negative part of MP curve.
Further, stages 1 and 2 pertaining to increasing and diminishing returns are regarded as rational
or practicable phases in the production process. Stages 3 of negative returns are, however,
considered as the irrational phase of production. Nevertheless, it is quite likely that a firm
lacking prefect knowledge may be operating in this stage. In agriculture, this may be very
common. For instance, evidences of overcrowding of boilers and layers in the poultry farms have
been recorded by some economists.
Explanation of the stages

The operation of the law of diminishing returns in the three stages is attributed to two
fundamental characteristics of factors of production
1) Indivisibility of certain fixed factors , and
2) Imperfect substitutability between factors.
Indivisibility of fixed factors implies that initially when a smaller quality of variable factor inputs
are employed along with a given set of factors, there is a bit of disproportionality between the
two sets of factor components. On technical grounds, thus, the fixed factors are not very
efficiently exploited. For instance, a factor like machinery, on account of its lumpiness, will be
grossly underutilized when only a very few units of a variable input like labour are applied.
Increasing Returns
When the employment of variable inputs increased. a combination of fixed and variable
factors tends to be near to be nearer the optimum. Thus, when the short run production function
is adjusted to optimization the resulting output tends to be in greater proportion to the increase in
the variable factors units. This phenomenon is also attributable to certain internal economics
such as managerial and technical economics as the productive services of indivisible factors like
manager and machines will be used more efficiently when greater inputs of variable factors like
labour and raw materials are applied. In short, the stage of increasing marginal product of a
variable factor is due to the greater inefficiency in the use of certain divisible fixed factors when
larger units of the variable factors are combined with them. Similarly, an increase in the units of
variable factors like labour, may lead to a better utilization of their services on account of
growing specialization.

It must be noted the increasing returns in the short run will be noticeable only if fixed
factors are indivisible, while the variable factors are obtainable in very small units. In some lines
of production, however, the firm may not visualize a stage of increasing returns very clearly if
the variable factor units are not obtainable in small units, say, for instance ,a worker cannot be
hired for less than a day or a month. Similarly, fixed factor units are not perfectly divisible into
small units, it is difficult to achieve increasing returns.
Diminishing returns
The reason for diminishing returns is nor far to seek. As in the short period, fixed factors cannot
be charged; the firm seeks to increase output by employing more and more units of variable
factors, thereby trying to substitute fixed factors. But due to imperfect and diminishing returns
(decrease in marginal product) follow. The marginal product decreases because a given quality
of fixed factors is combined with larger and larger amounts of variable factors. If the fixed
factors involved are very big size an indivisible , on technical grounds ,being inadaptable to
factors with the small amount of variable input, the marginal product of the variable input will
initially rise sharply and it will decline also very fast soon after the required units of variable
factors are employed for their efficient use.
Stage 2 is the only rational stage of production in the short run. It is area of operation in
which the firm can maximize its profits.
Negative Returns
Stage 3 is the stage of negative returns, when the input of a variable factor is much excessive in
relation to the fixed components In the production function. for instance, an excessive use of
chemical fertilizers on a farm may eventually spoil the farm output.
Significance of the law

The economic significance of the law of non potential outputs is obvious. It is useful to
businessman in their short run production planning at micro level a careful producer will not
move into third stage of negative returns rationally the ideal combination of factor proportion
(fixed values variable inputs)will be when the average product is at its maximum and it is the
maximum cost combination of factors.
THE LAWS IF RETURNS TO SCALE: THE TRADITIONAL APPROACH

Adjustment among different factors can be bought about in long period. Thus, all factors
become variable in the long run. That means, in the long run the size of a from can be expanded
as the scale of production is enhanced economists use the phase returns to scale to describe the
output behavior in the long run in the relation to variations in the factor inputs.
Assumptions: The law however assumes that:
1. Technique of production is unchanged.
2. All units of factors are homogenous.

3. Returns are measured in physical terms.

There are three phases of returns in the long run which may be separately described as:
1) the law of increasing returns
2) the law of constant returns
3) the law of decreasing returns
Lets us briefly describe these laws.
1. The laws of increasing Returns

The law of increasing returns describes increasing returns to scale. There are increasing
returns to scale when given percentage increase in input will lead to a greater relative
percentage increase in the resultant output.
In short increasing returns may be attributed to improvements in large scale operation
division of labour sue of sophisticated machinery, better technology, etc thus, increasing
returns to scale are due to invisibilities and economics of scale and technological
advancement.
2. The law of constant Returns

The process of increasing returns to scale, however, cannot go on forever. It may be
followed by constant returns to scale. As the firm continues to expand is scale of operations,
is gradually exhausts the economies responsible for the increasing returns. Then t, the
constant returns may occur. There are constant return to scale when a given percentage
increase in inputs leads to the same percentage increase in output.
Algebraically, it implies that the doubling of factor inputs soubles the output. Thus,
PFC = I under constant returns to scale.
Diagrammatically, the law of constant returns may be represented as in Figure 8.2 (B).

In Figure 8.2 (B), the curve CR is a horizontal straight line depicting constant returns to
emerging in certain factors is neutralized by internal economies that may result in some other
factors, so that the output increases in the same proportion as input. It must be noted that
constant returns to scale are relevant only for the time periods in which adjustment of all factors
is possible.
According to Marshall, the law of constant returns ends to operate when the actions of the
laws of increasing returns and decreasing returns are balanced out; or in other words, economies
and diseconomies of scale are exactly in balance over a range of output.
Constant returns to scale are quite often assumed in economic theoretical models for
simplification. Such an assumption is based on the following conditions:
1. All factors are homogeneous.
2. All factors are perfectly substitutable.
3. All factors are infinitely divisible.
4. The supply of all factors is perfectly elastic at the given prices.
3. The Law of Decreasing Returns

As the firm expand, it may encounter growing diseconomies of the factors employed. As
such when powerful diseconomies are met by feeble economies of certain factors, decreasing
returns to scale set in. there are decreasing returns to scale to scale when the percentage
increase in output is less than the percentage increase in input.
Algebraically, .Thus, PFC < 1 under decreasing returns to scale.
Diagrammatically, the law of decreasing returns may be presented as in Figure 8.2 (C).
In Figure 8.2(C), the curve DR is a downward sloping curve denoting decreasing returns to
scale.
Decreasing returns to scale are usually attributed to increased problems of organization and
complexities of large-scale management which may be physically very difficult to handle.
Economists generally consider the following causes for the decreasing returns to scale:
1. Though all physical factor inputs are increased proportionately, organization and
management as a factor cannot be increased in equal proportion.
2. Business risk increases more than proportionately when the scale of production is
enhanced. An entrepreneurial efficiency has its own physical limitations.
3. When scale of production increases beyond a limit, growing diseconomies of large-scale
production set in.
4. The increasing difficulties of managing a big enterprise. The problem of supervision and
co-ordination becomes complex and intractable in a large scale of production. A very
large enterprise may become unwieldy to manage.
5. Imperfect substitutability of factors of production causes diseconomies resulting in a
declining marginal output.

5 Stage II
2
Marginal product of returns
1
0 1 2 3 4 5 6 7 8 10
scale 9
Output Elasticity
Output elasticity is defined as the ratio of the percentage change in quantity produced to the
percentage change in factor input. Thus:
eQ=%Q/%F
Where eQ =output elasticity
Q=Quantity of a product
F=quantity of a factors employed.
Output elasticity is greater than 1, when (%Q)>(%F).It suggests increasing returns to scale.
Output elasticity (eq0 is equal to 1 when (%Q)=(%F). It suggests constant returns to scale.
Output elasticity (eq)is less than 1,when (%Q)<(%F).It suggest decreasing returns to scale.
Production function through Iso-quant curve
In the long run, as all factors are variable, .the firm has a wider choice of adopting productive
techniques and factors proportions, in relation to employed technology . Again, the basic
characteristic to productive resources is that they are substitutable , though imperfectly, by
another one to a certain extent. Thus , a given production function, the variability of different
factor input also implies their substitutability .In fact, one factor can be substituted for another
in a particular manner; so that a constant level of output may be maintained .To elucidate the
point , let us assume a production function with two variable inputs, say, Labour (L), and
capital (K); thus :Q=F(L,K) .

Now the firm can combine labour and capital in different proportions and can maintain
specified level pf output; say, 10 units of output of a product X, under the prevailing state of
technology and given organizational ability of the entrepreneur units of labour(L) and capital
(K) may combine alternatively, as follows:
2L + 9K
3L + 6K
4L + 4K
5L + 3K
The first combination implies greater use of capital and less of labour to have a given level of
output (say 10 units of x we assumed). In this factor combination, we have relative capital
intensity, while even by the last combination, by using more labour and less capital we can
produce the same level of output. We have illustrated only four alternative combinations of
labour and capital. However, there can be innumerable such combinations for producing the
same quantity of output. If we plot all these combinations graphically and join the loci of their
points, we derive a curve, as shown below:
Equal Product Curve ( Iso-quant)

The same specific output quantity most efficiently produced by the different input
combinations of two factors; say, labour and capital. Iso-quant means equal quantity.
Properties of Iso-Quants
1. An iso-quant is downward sloping to the right. i.e., negatively inclined. This implies that
for the same level of output, the quantity of one variable will have to be reduced in order
to increase the quantity of other variable.
2. A higher iso-quant represents larger output. That is with the same quantity of 0ne input
and larger quantity of the other input, larger output will be produced.
3. No two iso-quants intersect or touch each other. If the two iso-quants do touch or
intersect that means that a same amount of two inputs can produce two different levels of
output which is absurd.

4. Iso-quant is convex to the origin. This means that the slope declines from left to right
along the curve. That is when we go on increasing the quantity of one input say labour
by reducing the quantity of other input say capital; we see less units of capital are
sacrificed for the additional units of labour.
Iso-quant , Iso cost and Equilibrium
Introduction
A rational firm seeks maximization of its profit. Maximization of profit implies minimization of
cost. The cost is minimum, when the input combination is optimal. Therefore, choosing the right
input combination leads to cost minimization and hence ensures maximum profits. In the theory
of consumer behavior, we analyze the equilibrium of a consumer with the help of the
indifference curve analysis. Similarly, the producers equilibrium, which represents the least cost
combination of inputs, can be examined with the help of isoquants. It should be remembered that
the isoquants in the theory of production are, in fact, the counterpart of the indifference curves in
the theory of consumption.
Assumptions
The principle of least-cost combination rests on the following assumptions:
1. Capital and labor are the two factors involved in production.

2. All the units of both the factors are homogeneous
3. The prices of the factor units are given
4. The total money outlay is also given
5. There is perfect competition in the factor-market.
In order to analyze producers equilibrium, the firm under consideration should know its
isoquant map an its isocost line.
Isoquant Map
Isoquants indicate various possibilities of combining two inputs. For each level of output, there
will be a different isoquant. When a set of isoquants are depicted on a graph it is called an
Isoquant map.
Isocost Line
The concept of isocost line is not a new one. It is the counterpart of the budget line in the theory
of consumption. The isocost line is the producers resource line. In the words of Prof. Barthwal,

it is a locus of all combinations of two (or more) inputs which the producer can buy using his
fixed outlay at fixed input prices.
We shall now draw the isocost line on the basis of an imaginary example.
Let us assume that a firm has a sum of $500 to spend on two factors, labor and capital. Further,
let us assume that a unit of labor costs $10 and a unit of capital (machine) costs $100. With the
total outlay of $500, the firm could hire 50 units of labor and no capital, or it could hire 5 units of
capital and no labor; or some combination of labor and capital in between. OM in the diagram
represents 50 workers and ON represent 5 machines.
If we connect the two points N and M, we get the isocost line. Thus, an isocost line gives all
combinations of labor and capital at equal cost. The isocost line will shift when the prices of
factors change, the outlay remaining the same. Likewise, the isocost line will shift to the right if
the outlay of the firm increases. Hiring more of both inputs will cost more. When the total outlay
is $600, the isocost line is N1M1. N2M2 is the isocost line when the outlay is $700.
Thus, the isocost line depends upon two things:
1. The prices of the factors of production
2. The total outlay which the firm wants to make on the two factors of production.
The slope of an isocost line is PL/PK, which is the ratio of the price of labor to the price of
capital, when labor is shown on the X-axis and capital is shown on the Y-axis.

The Optimum Combination of Inputs
Let us consider the geometry of the producers equilibrium.
Now the problem confronting the firm is to reach the highest possible isoquant with its given
isocost line. In other words, it is the problem of getting the highest amount of output from the
given outlay. Towards this end, the equal product map has been super imposed on the isocost
line NM.
In figure 2, NM is the firms isocost line. Isoquants IQ1, IQ2 and IQ3 represent different levels of
output. Equilibrium is attained at the point where the isoquant is tangent to the isocost line. The
isocost line NM sets the upper boundary for the purchase of the inputs when outlay and input
prices are given.
Outlay is not sufficient to move to IQ3. Likewise, the segments of isoquants falling below the
isocost line indicate under-utilization of his outlay fully. Rationality on the part of the producer
requires full utilization of resources for optimization of output.
Points A and B also satisfy the tangency condition and they lie within the reach of the producer.
However, at these points the firm remains at a lower isoquant IQ1, which yields a lesser level of
output than that on IQ2. Thus, E is the point of equilibrium from where there is no tendency on
the part of the producer to move away. The firm will get its maximum output when it employs
OL0 units of labor and OK0 units of capital. The equilibrium position of the firm can also be
explained in terms of the equality between MRTS and the factor price ratio. The slope of the
isoquant is the marginal rate of technical substitution (MRTS) and the slope of the isocost line
indicates the factor price ratio. It follows that while in equilibrium,

MRTSLK = PL/PK
Thus, marginal rate of technical substitution can also be written as the ratio of the marginal
product of labor to that of the marginal product of capital.
MPL/MPK = PL/PK or MPL/PL = MPK/PK
TECHNOLOGICAL PROGRESS & PRODUCTION FUNCTION

Sometimes, technical change is analysed and estimated in production function. The technical
change may embody with improvement in factor efficiency. It is embodied with factor inputs. An
economic relation which seeks to explain changes in the level of economic output in terms of the
level of technical progress. Rather than looking at economic growth as a form of efficiently
allocating inputs, the technical progress function explains economic growth in terms of
investment in technological progress.
The production function assumes that, given a preset level of technical progress, output is
explained by the level of efficiency by which labor and capital are allocated to production. A
technical progress function looks at this production the other way around. Given that inputs are
allocated most efficiently, then the technical progress function assets that output is dependent on
the level of technical progress. Thus, the greater the level of investment in technical progress
over time, the greater the amount of output in the economy.

Module 3
Cost and Revenue Profit Functions
Cost Concepts, Total Cost, Average Cost, Marginal Cost, Opportunity Cost etc. Short-run
and Long-run Cost Curves, Combination, Economies and Diseconomies of Scale. Cost
Analysis with Mathematical Problems.
Profits: Determinants of Short-Term & Long Term Profits, Measurement of Profit.
Break Even Analysis- Meaning, Assumptions, Determination of BEA, Limitations and Uses
of BEA in Managerial Economics. (Problems on BEP)
---------------------------------------------------------------------------------------------------------------------
COST CONCEPTS
Introduction
In managerial economics, cost is normally considered from the producers or firms point of
view. In producing a commodity (or service), a firm has to employ and aggregate of various
factors of production such as land, labour, capital and entrepreneurship. These factors are to
compensated by firm for their efforts or contribution made in producing the commodity. This
compensation (usually in terms of factor price) is the cost. Thus, the cost of production of a
commodity is the aggregate of price paid for the factors of production used in producing that
commodity. Cost of production, therefore, denotes the value of the factors of production
employed, in short, thus, the value of inputs required in the production of a good determines its
cost of output. The term cost has various concepts. These are: (i) real cost; (ii) opportunity
cost; and (iii) money cost.
Real cost
The term real cost of production refers to the physical quantities of various factors used in
producing a commodity. For example, real cost of a tables is composed of a carpenters labour to
cubic feet of wood, a dozen of nails, half a bottle of varnish paint, depreciation of carpenters
tools etc., which go into the making of the table. Real cost, thus, signifies the aggregate of real
productive resources absorbed in the production of a commodity (or a service).
Definition
The real cost of production of a commodity refers to the exertion of labour, sacrifice involved in
the abstinence from present consumption by the savers to supply capital, and social effects of
pollution congestion, and environmental distortions.
In a much philosophical way, Marshall (1920), describes real cost as follows: the production
of a commodity requires many different kinds of a labor and the use of capital in many forms.
The exertions of all the different kinds of labour that are directly or indirectly involved in making
it together with the abstinences or rather the waiting required for saving the capital used in

making it___ all these efforts and sacrifices together will be called the real cost of production of
commodity.
According to Marshall, thus, the real cost of production signifies toils, troubles, sacrifices an
account of loss of consumption for savings, Social effects of pollution caused by factory smoke,
automobiles, etc.
Evidently, the concept of real cost is an abstract idea. Its exact measurement is not possible.
OPPORTUNITY COST OR ALTERNATIVE COST

Since the real production cost cannot be measured in an absolute sense, the concept of
opportunity cost is evolved to measure it in an objective sense. The concept of opportunity cost
is based on the scarcity and versatility (alternative applicabilities) characteristics of productive
resources. It is the most fundamental concept in econonics.
It is a known economic fact that our wants are multiple, while or resources are scarce but capable
of alternative uses. So the problem of choice is involved. We have to choose the use of a given
resources for a particular purpose out of it alternative applicabilities. When we choose the
resources in one use to have one commodity for satisfying a particular want, it is obvious that its
other use as some other commodity that can be produced by it cannot be available
simultaneously. This means, the second alternative use of the resources (or another commodity)
is to be sacrificed to have the resource employed in one particular way, i.e., to get a particular
commodity because the same resource cannot be employed in two ways at the same time.
Apparently, the employment of factors in producing a commodity always involves the loss of
opportunity of production of some other commodity. The sacrifice or loss of alternative use of a
given resource is termed as opportunity cost. Thus, the opportunity cost is measured in terms
of the forgone benefits from the next best alternative use of a given resources. In other words, the
opportunity cost of producing certain commodity is the value of the other commodity that the
resources used in its production could have instead. It should be noted that opportunity cost of
anything is just the next best alternative (the most valuable commodity) forgone in the use of
productive resources and not all alternative possible uses.
The real cost of production of something using a given resource in an objective sense is the
benefit forgone (or opportunity lost) of some other thing by not using the resource in its best
alternative use. Some economists, therefore, describe it as alternative cost of production. The
alternative or opportunity cost of one unit of product A is the amount of product B that has been
sacrificed by allocating the resources to product A rather than B.
Importance of the concept of opportunity cost

The concept of opportunity cost has greater economic significance.
Determination of relative price of goods. The concept of opportunity cost is useful in
explaining the determination of relative price of goods. For instance, if the same group of
factors can be produce either one car or six scooters, and then the price of one car will
tend to be at least six times more than that of one scooter.

Determination of normal remuneration to a factor. The opportunity cost sets the value
of productive factor for its best alternative use. It implies that if a productive factor is to
be retained in its next best alternative use, it must be compensated for or paid at least
what it can earn from its next best alternative use. For instance, if a college professor can
get an alternative employment in a bank as an officer at a salary of Rs. 20,000 per month,
the college has to pay at least Rs.20,000 salary to retain him in the college.
Decision making and effective resource allocation. The concept of opportunity cost is
essential in rational decision making by the producer. This can be explained with the help
of an example. Suppose, a producer in the automobile industry has to decide as to
whether he should produce motor cars or scooters out of his given resources. He can
arrive at a rational decision by measuring the opportunity costs of producing cars and
scooters and making a comparison with the prevailing market price of these goods.
Suppose, opportunity cost of 1motor car is 6 scooters. The price of scooter is Rs. 30,000,
while the price of car is Rs. 2,00,000. In this case, it is worthwhile to produce cars rather
than scooters. Because if he produces 6 scooters, he will get only Rs.1,80,000, whereas a
car fetches him Rs.2,00,000, that is, Rs.20,000 more. This would also mean an efficient
resource allocation. Likewise, a factor agent or owner will decide about the use of the
economic resources in that occupation where its opportunity cost is higher.
MONEY COST
Cost of production measured in terms of is called Money cost
Money cost is the monetary expenditure on input of various kinds__ raw materials,
labour, etc., required for the output. It is the money spent on purchasing the different
units of factor of production needed for producing a commodity. Money cost is,
obviously payment made for the factors in terms of money. Money cost is the outlay cost,
i.e., actual financial expenditure of the firm.
Explicit and Implicit costs

While analyzing total money cost, the economists speak of explicit and implicit costs. To
determine total cost, they include both explicit as well as implicit costs.
Definition
Explicit costs are direct contractual monetary payments incurred through market transactions.
Explicit cost refers to the actual money outlay or out-of-pocket expenditure of the firm to buy or
hire the productive resources it needs in the process of production. It is referred to as out-of-
pocket costs.
The following items of a firms expenditure are explicit money cost:
Costs of raw materials;
Wages and salaries;
Power charges;

Rent of business or factory premises;

Interest payments of capital invested;
Insurance premiums;
Taxes like property tax, duties, licence fees etc.,;
Miscellaneous business expenses like marketing and advertising expenses (selling costs),
transport cost, etc.
The above list of items included in money cost explicit payment made by the firm.
These are recoded expenditures during the process of production. It is, thus, known as
accounting cost or explicit money costs, as these are actual monetary expenditures incurred by
the firm.
To an economist, however, this is not enough for consideration. In the economic sense,
there are certain costs which are implicit in nature, such as when there is an imputed value of
goods and services used by the firm, but no direct payment is made for such use. Thus, from an
economists point of view, apart from explicit costs, there are implicit money cost (which are
generally not considered by the accountant unless some special provision is made for it).
Definition: Implicit costs are the opportunity costs of the use of factors which a firm does not
buy or hire but already owns.
Implicit costs are not directly incurred by the firm through market transactions, but
nevertheless are to be reckoned in the measurement of total money costs of production. These are
to be imputed or estimated on the bases of the opportunity costs, i.e., from what the factors
owned by the firm itself could earn in their next best alternative employment.
Implicit money costs are imputed payments which are directly or actually paid by the firm as no
contractual disbursement is fixed for that. Such implicit money cost arises when the firm or
entrepreneur supplies certain factors on by himself. For instance, the entrepreneur may have his
own land in production, for which no rent is to be paid in the actual sense. But this, however, he
would have definitely earned some rent. Hence, such rent is to be imputed regarded as implicit
cost. Thus implicit money costs are as follows.
Wages of labor rendered by the entrepreneur himself.
Interest on capital supplied by him.
Rent of land and premises belonging to the entrepreneur himself and used in his
production.
Normal returns (profits) of entrepreneur, a compensation needed for his management and
organizational activity.
These items are to be valued at current market rates for implicit money cost. These are implicit
money cost, because these go to the entrepreneur himself. These are self-recipient payments.
And they are, in practice, unrecorded expenditure of production. Implicit costs, unlike out-of-
pocket costs, dont required current cash expenditures. As such, they are also referred to as book
costs. In economic analysis, however, we need to determine total money costs as both are

composed of explicit and implicit expenses. For, the distinction between explicit and implicit
money costs is important in analyzing the concept of profit. In the accounting sense, profit is
calculated as the residual of total sales receipts minus total cost (in an explicit sense). In the
economic sense, however, normal profit is included in total cost of production which consists of
explicit or implicit expenses all taken together. Under implicit costs, normal profit-a written to
entrepreneur management function is included.
But in the economic sense, real business or economic profit is the surplus of total revenue over
total economic cost.
Economic cost = accounting cost (or explicit cost) + implicit cost.
Money cost is also regarded as the supply price of the factors needed for producing a
commodity. To some economists, thus the money cost of production of the commodity is the
money fund required to induce the factors of production to be allocated to this production, rather
than to seek employment.
Accounting and Economic Costs:

An economists idea of cost of production differs from that of an accountant. In economics, the
cost of production consists of remuneration to all the factors of production, viz., wages to labour,
rent to land, interest to capital and normal profit to the entrepreneur. An accountant, on the other
hand, would include in the cost of production only the cash payments to the factors of
production, made by the entrepreneur, for the services rendered by these factors in the productive
process. These cash payments are called the explicit costs. Thus, an accountants concepts of
cost includes wage, interest and rent payment but not the profits made by the entrepreneur
because no entrepreneur makes cash payment to himself. In common practice also, we dont tend
to regard profits as part of a firms costs of production. But in economic theory, however, normal
profits form a part of business firms cost of production.
Again in the calculation of normal profits which are in economic part of firms cost, implicit
costs must be included. Implicit costs are totally disregarded by an accountant. These costs
include rent on land owned by the entrepreneur himself since he would have received rent on his
land if he had rented it out to someone. Similarly, implicit costs also include wages of
management. If the entrepreneur had worked as manager elsewhere, he would have received
wages. So these must also form a part of firms cost of production. Thirdly, an entrepreneur
might have invested his own capital in his business. Had he lent out this capital to someone, he
would have received interest in it. So the interest on entrepreneurs own capital must also be
included in cost calculations. All these are implicit costs and while an economist takes them into
consideration in his cost calculation, an accountant doesnt
In sum, while an accountant include explicit costs in his cost calculation, an economic includes
in it explicit and implicit cost.

Fixed and Variable Costs(Prime and Supplementary Costs):

It may be recalled that the sort run period refers to the time interval during which some factors
units cannot be adjusted. The factors of production which cannot be adjusted during the short
period are together referred to as a plant and include capital equipment, top managerial personnel
and minimum of subordinate staff such as watch and ward, maintenance technicians etc. in other
word, sort period during which the plant of a firm cannot be changed.
The short run cost function relates to the sort run production function. A sort run production
function Q = f (a,b,c,d,..,n) stated in general implies two sets of input component. One is fixed
input & another is variable input. Thus, factors of production employed, in the short-run are
classified as fixed and variable factors. Fixed factors are unalterable which remain unchanged
over a period of time like machineries, factory, managerial staff etc. variable factors are labour,
raw materials, power etc which are varied to vary the output in the short run.
Fixed costs (or Supplementary costs):

Fixed costs are the amount spent by the firm on fixed inputs in sort run. Fixed costs are thus,
those costs which remain constants, irrespective of the level of output. These costs remain
unchanged even if the output of the firm is nil. Fixed cost, therefore, are known as
supplementary costs are over head costs.
Definition: Fixed costs are those cost that are incurred as a result as a use of fixed factor input.
They remain fixed at any level of output in the short-run.
Fixed cost are supplementary costs include
Payment of rent for building
Interest paid on capital
Insurance premium
Depreciation and maintenance allowances
Administrative expenses salaries of managerial and office staff etc.
Property and business taxes, license fees etc.
These costs are overhead costs in the sense that they are to be incurred even if the firm shut
down temporarily and the current production may be nil. Further, they do not change as the
output increases. Thus, fixed costs are also referred to as un avoidable contractual cost which
occur even if there is no output. In brief, the costs incurred on the business plant are called fixed
costs.
Fixed costs may be classified in to two categories; (i) Recurrent and (ii) Allocable
Recurrent Fixed costs are those costs which give rise to cash output as certain explicit
payments like rent, capital, staff salary etc. are to be made at a regular time interval by the firm.
The Allocable costs refer to implicit money costs like depreciation charges which involve no
direct cash outlays but are to be reckoned on the basis of time rather than usage.

Variable Costs (Or Prime Costs)

Variable costs are those costs that are incurred on variable factors. These costs vary directly with
the level of output. In other words, costs which rise when output expands and fall when output
contracts. When output is nil, they are reduced to zero.
Variable costs are referred to as direct costs or prime costs. Briefly, variable costs or prime costs
represent all those costs which can be altered in the short run as the output alters.
The short run variable cost includes:
Prices of raw materials,
Wages of labour,
Fuel and power charges,
Excise duties, sales tax,
Transport expenditure etc.
Besides, user costs are included in variable costs for analytical purposes. User cost is the
depreciation caused by the actual use of capital assets.
It is classified as (i) semi-variable cost (ii) fully variable costs.
Types of Production costs and their Measurement:

In economic analysis, the following types of costs are considered in studying cost data of a firm:
Total Cost (TC)
Total Fixed Cost (TFC)
Total Variable Cost (TVC)
Average Fixed Cost (AFC)
Average Variable Cost (AVC)
Average Total Cost (ATC)
Marginal Cost (MC)
Total Cost (TC):

Total cost is the aggregate of expenditure incurred by the firm in producing a given level of
output. Total cost is measured in relation to the production function by multiplying factor prices
with their quantities.
If the production function is: Q= f (a, b, c,.,n), then total cost is TC=f(Q) which means total
cost varies with output.
For measuring the total cost of a given level of output, thus, we have to aggregate the product of
factor quantities multiplied by their respective prices.
Conceptually, total cost includes all kinds of money costs, explicit as well as implicit. Thus,
normal profit also included in total cost. Normal profit is an implicit cost, it is a normal reward
made to the entrepreneur for his organizational services. It is just a minimum payment essential
to retain the entrepreneur in a given line of production. If this normal return is not realized by the
entrepreneur in the long-run, he will stop his present business and will sift his resources to some
other industry.

Now, an entrepreneur himself being the paymaster, he cannot pay himself, so he treats normal
profits as implicit costs and adds to the total cost.
In the short-run, total cost may be bifurcated into total fixed cost and total variable cost. Thus,
total cost may be viewed as the sum of total fixed cost and total variable cost at each level of
output. Symbolically, TC = TFC + TVC.
Total fixed cost (TFC):

A total fixed cost corresponds to fixed inputs in the short-run production function. It is obtained
by summing up the product of quantities of the fixed factors multiplied by their respective unit
prices. TFC remains the same at all levels of output in the short-run.
Suppose a small furniture proprietor starts his business by hiring a shop at monthly rent of Rs
1000/- borrowing Rs 50000/- from a bank at an interest rate of 10% and buys capital equipment
worth Rs 2000/-. Then his monthly total fixed cost is estimated to be:
Rs 1,000 + Rs 2,000 + Rs 500 = Rs 3,500
(Rent) (Equipment cost) (Monthly interest on the loan)
Total variable cost (TVC):
Corresponding two variables inputs in the short-run production, is the total variable cost. It is
obtained by summing of the product of the quantities of input multiplied by their prices.
Again, TVC = f (Q) which means, total variable costs is an increasing function of output.
suppose, in our illustration of the furniture shop proprietor, if he were to start with the production
of chairs he employs a carpenter on a wage of Rs200/- per chair. He buys wood worth Rs2000/-
rexine sheets worth Rs1500/-, spends Rs400/- for other requirement to produce 3 chairs. Then his
total costs for producing 3 chairs is measured as Rs2000/-(wood price) + Rs1500/-(rexine cost) +
Rs 400/-(allied costs) + Rs 600/- (labour charges) = Rs4500/-.
Average Fixed Costs (AFC):
Average fixed costs is total fixed cost divided by total units of output.
AFC = TFC
Q
Where Q stands for the number of units of the product.

Thus, average fixed costs is the fixed costs per unit of output.
In the above example, thus, when TFC = Rs3500/- and Q = 3.
Therefore AFC = 3500/3 = Rs1,166.67
Average Variable Cost (AVC):

AVC is TVC divided by total units of output.

AVC = TVC
Q
Thus, AVC is variable costs per unit per output. in the above example, TVC = Rs4500/- for Q =3
Therefore AVC = 4500/3 = 1500 .
Average Total Costs (ATC):

Average total cost or average cost is total cost divided by total units of output. Thus:
ATC or AC = TC
Q
In the short-run, since TC = TFC + TVC
ATC = TC/Q = (TFC+TVC)/Q = (TFC/Q) + (TVC/Q)
Since =TFC/Q = AFC and TVC/Q = AVC
Therefore ATC = AFC + AVC.
Hence, average total cost can be computed simply by adding average fixed cost and average
variable cost at each level of output. To take a above example, thus
ATC = Rs 1, 66.67 + Rs 1500 = Rs 2666.67
Marginal cost:
The marginal cost is also per unit cost of production. It is the addition made to the total cost by
producing 1 more unit of output. Symbolically, MCn = TCn TCn-1, that is, the marginal costs
of the nth unit of output is the total cost of producing. n units minus the total cost of producing
n-1(i.e., one less in the total) units of output.
Suppose, the total cost of producing 4 chairs (i.e., n=4) is rs 10,000 while that for 3 chairs (i.e.,
n-1 is rs 8,000.Marginal cost of producing the 4th chair, therefore, works out as under :
MC=TC-TC= RS 10,000- RS 8,000= RS 2,000.
Short-run Total Cost Schedule of a Firm

Functionally, the cost behavior, i.e., cost-output relationship, is observed in the short run as well
as long-run. We have, thus, short-run cost function which states cost-output relationship or the
behavior of costs under a given scale of output in the short-run. Similarly, there is the long-run
cost function which states cost-output relationship or the behavior of costs with the changing
scale of output in the long-run. The short-run and long-run cost functions are important for a firm
to consider the price or equilibrium level of output determination.
Cost function of a firm can be expressed statistically as cost schedule or graphically in the form
of a cost curve. A cost schedule is a statement of variation in the cost resulting from variations in
the level of output. it shows the response of costs to changes in output. Cost schedule depend
upon the length of the time interval. So they vary from short period to long period.

Short-run Total Costs:

To examine the cost behavior in the short-run, we may begin our analysis with consideration of
the following three total costs concepts:
Total Fixed Cost (TFC). It is the cost pertaining to all fixed inputs like machinery, etc. at any
given level of output.
Total Variable Cost (TVC). It is the cost preparing to all variable inputs like raw materials, etc at
any given level of output.
Total cost (TC). It is the cost preparing to the entire factor inputs at any given level of output. It
is the total cost of production derived by aggregating total fixed costs and variable costs together.
Thus, TC = TFC + TVC
Table No 10.1 contains a much simplified hypothetical production schedule of total costs of an
illustrative firm. Data in the table show the behavior of TFC, TVC and TC in the short-run.
The data are based on the following assumptions:
Labour and capital are the two factor inputs.
Labour is the variable cost.
Capital is the fixed factor.
Price of labour is Rs 10 per unit. Price of capital is Rs 25 per unit.
Since 4 unit of capital are used as fixed factors, the total fixed cost (TFC) Rs 100 remains
constant throughout. (See column 4 in table 10.1).
The total variable cost (TVC) varies with the variation in the labour units. (See column
5).
Column 6 measures the total costs. It is TFC and TVC at all levels of output.
The short-run total cost schedule of a firm(hypothetical data)
Units of Units of Total TFC TVC TC

capital labour product (Rs) (Rs) (Rs)
(fixed (variable (TP) (4) (5) (6)
factor) factor) (3)
(1) (2)
4 0 0 100 -- 100
4 1 2 100 10 110
4 2 5 100 20 120
4 3 10 100 30 130
4 4 15 100 40 140
4 5 18 100 50 150
4 6 20 100 60 160
4 7 21 100 70 170
Table 10.1

Behavior of Total Costs:

Examining costs schedules in table 10.1, we may observe the following interesting points
about the behavior of various total costs:
TFC remains constant at all levels of output. It is the same even when the
output is nil. Fixed costs are thus independent of output.
TVC varies with the output. It is nil when there is no output variable costs are
thus direct cost of the output.
TVC does not change in the same proportion. Initially it is the increasing at a
decreasing rate, but after a point, it increases at an increasing rate. This is due to
the operation of the law of variable proportion or non-proportional output. which
suggest that initial to obtain a given amount a output relatively, variation in
factors are needed in less proportion, but after a point when the diminishing
phase operates, variable factor, are to be employed in a greater proportion to
increase the same level of output.
TC varies in the same proportion as the TVC. Thus, in the short period the
changes in total cost are entirely due to changes in the total variable costs as fixed
costs. The other component of total cost, remain constant.
TFC, TVC and TC Curves:

Total costs curves are derived by plotting the total cost schedule graphically. The cost
curves depict cost output behavior of the firm in an explicit manner. In figure 10.1 we,
however, presented generalized smooth out types of total fixed, total variable and total
cost curves to explain the short-run cost behavior from the constant.
A careful observation of figure 10.1 reveals the following important characteristics of
cost behavior:
The Curve TFC is the Curves of Total Fixed Cost. It is a straight horizontal
line, parallel to the X-axis, denoting characteristics of fixed costs at all levels of
output.
The Curve TVC Represents Total Variable Costs. It reflects a typical behavior
of total variable costs, as it initially rises gradually, but eventually becomes
steeper denoting a sharp rise in total variable costs. The upward rising total
variable costs are related to the size of the output.
The Curve TC Represents Total Costs. It is derived by vertically adding up
TVC and TFC curves. It is easy to see that the shape of TC is largely influenced
by the shape of TVC. When the TVC curve becomes steeper, TC also becomes
steeper. Further, the vertical distance between TVC curve and TC curve is equal
to TFC and is constant throughout because TFC is constant. Evidently, the
vertical distance between TVC and TC curves represents the amount of total
fixed costs.

Fig. 10.1
Short-run Total Cost Curves
The TFC curve is horizontal indicating constant total fixed cost at each output level. The TVC
curve rises at a decreasing rate up to a point and at an increasing rate thereafter. It reflects the
operation of the law of diminishing returns. TC is drawn by vertical adding up of TFC and TVC.
SHORT-RUN PER UNIT COST

Per unit cost is the average cost. It refers to the cost per unit of output.
Following are the four important per unit costs in which a firm is always interested in the short
period:
Average Fixed Cost=Total Fixed Cost + Output (AFC=TFC/Q)
Average Variable Cost=Total Variable Cost + Output (AVC=TVC/Q)
Average Total Cost= Average Fixed Cost + Average Variable Cost (ATC=AFC + AVC)
Marginal Cost = (Total cost associated with a certain quantity of output)
Alternatively (Total cost associated with the quantity of output of one less).
Marginal Cost= Change in Total Cost+ one Unit Change in Output (MC=TC|Q).
It must be noted that abbreviations TVC, TFC, TC, AFC, AVC, ATC and Mc respectively, are
frequently used by economists to represent total variable cost, total fixed cost, total cost, average
fixed cost, average variable cost, average total cost and marginal cost. Hence, as we have also
used these abbreviations in the following sections so often without qualifications, the reader
should memorize the connotations of these abbreviations.
The computation of AFC, AVC, ATC and MC has been illustrated in Table. Here, we have
purposely taken some new data (rather than repeating those from Table) for taking the product
variation unit-wise and without going into the details of factor components and factor prices, in
order to make then computation simple and straightforward.
From the cost schedules given in Table, it is apparent that costs per unit are derived from the
total costs.

It is obvious that the firm will have four short period categories or unit costs: (i) Average Fixed
Cost (AFC), (ii) Average Variable Cost (AVC), (iii) Average Total Cost (ATC) and (iv)
Marginal Cost (MC).
T(Q) TFC TVC TC AFC= AVC= ATC=(TC/Q) MC

(TFC/Q) (TVC/Q)
(1) (2) (3) (4) (5) (6) (7) (8)
0 100 0 100 - - - -
1 100 25 125 100 25 125 25(125-100)
2 100 40 140 50 20 70 15(140-125)
3 100 50 150 33.3 16.6 50 10(150-140)
4 100 60 160 25 15 40 10(160-150)
5 100 80 180 20 16 36 20(180-160)
6 100 110 210 16.2 18.3 35 30(210-180)
7 100 150 250 14.2 21.4 35.7 40(250-210)
8 100 300 400 12.5 37.5 50 150(400-250)
9 100 500 600 11.1 55.6 66.7 200(600-400)
10 100 900 1000 10 90 100 400(1000-600)
Analyzing the various cost data, economists have generalized the following characteristic
features:
AFC decreases as the output increases. Since the total fixed costs remain the same, average fixed
costs decline continuously. It is the outcome of spreading the overhead over more units. Since
AFC=TFC/Q. it is the pure arithmetical result that the numerator remaining unchanged, the
increasing denomination causes a diminishing product. TFC thus spreads over each unit of
output with an increase in output (Q). Hence, AFC diminishes continuously.
AVC first decreases and then increases as the output increases.
ATC decreases initially, it remains constant at a point for a while, but then goes on increasing as
output increases.
Marginal Cost (MC) decreases initially but then increases as the output is increased.
The MC is determined by the rate of increase in the total various costs (TVC). In the beginning
for the very first unit, thus average variable cost and marginal cost are the same (because
AVC=TVC for the first unit).
When the average cost is minimum, MC=AC.
THE BEHAVIOUR OF SHORT-RUN AVERAGE COST CURVES

The behavior patterns and relations of short-run unit costs become more explicit when we plot
the cost data on a graph and draw the respective cost curves.

However, depicts a generalized form of cost behavior in the short run. Here, the cost curves are
drawn as the idealized or smoothed out versions of the cost data.
Figure illustrates four short period cost curves, namely;
AFC curves
AVC curve
ATC curve, and
MC curve.
Average Fixed Cost Curve (AFC Curve)

As the output increases, the total fixed costs get spread over a large and larger output and
therefore, the average fixed cost goes on progressively declining. Consequently, the average
fixed curve slopes downwards from the left to the right throughout its entire stretch. In
mathematical terms, AFC curve approaches both the axes asymptotically, i.e., it gets very close
to but never touches either axis.
An important characteristic of average fixed cost is that the product of average fixed cost for a
given level of output multiplied by the given level of output always remains constant. In our
illustrative cost schedule, if we multiply the average fixed cost for chairs by the corresponding
number of chairs, the product would be in all cases Rs200 which is the total fixed cost.
Geometrically, a curve representing such data is always a rectangular hyperbola. Hence, the AFC
curve is a rectangular hyperbola. It thus, implies that any point on the curve gives the same total
cost as the product of multiplication of average fixed cost by the units of output. This property of
the curve signifies the fact that total fixed cost is constant throughout.
The AFC curve is rectangular hyperbola curve indicating that overheads costs are spread out
when output is increased. The AVC is a U-shaped curve indicating that AVC initially falls and
then rises with increased output. It reflects the law of diminishing returns. ATC curve is viewed

as the sum of the AFC curve and AVC curve is viewed as the sum of the AFC and AVC curves.
The ATC curve is U-shaped. It is derived from the TVC curve.
AVERAGE VARIABLE COST CURVE (AVC CURVE)

The average variable cost generally declines in the initial stages as the firm expands and
approaches the optimum level of output. After the plant capacity output is reached, the average
variable cost begins to rise sharply. Thus, usually, the average variable cost curve declines
initially, reaches the minimum and then goes on rising. The AVC curve is, thus, slightly U-
shaped, indicating that as the output increases initially, the average variable cost is decreasing,
and then it remains constant for a while and again starts increasing. There are, thus, three phases
of AVC curve: (i) decreasing phase, (ii) constant phase and (iii) increasing phase. These stages in
the AVC curves correspond to the stages of increasing, constant and decreasing average product
(returns to the variable factors) underlying the law of variable proportions.
AVERAGE TOTAL COST CURVE (ATC CURVE)

Since the average total cost is the sum of average fixed and average variable costs, the ATC
curve is also a vertical summation of the AFC and AVC curves. Hence, the curve ATC is derived
by the superimposition of the AVC curve over the AFC curve. As such, the ATC curve is U-
shaped, indicating that if the output of the firm is increased, initially the average total cost
decreases up to a point, then it remains constant for a while and thereafter, and it starts rising.
EXPLANATION OF THE U-SHAPE OF ATC CURVE

The reasons why the ATC curve is U-shaped are not far to seek. Since ATC= AFC+ATC, it
follows that the behavior of the ATC curve is determined by the AVC curve and AFC curve. The
AFC curve is a rectangular hyperbola, which implies that the average fixed cost diminishes
continuously as output expands. In the initial stage, the AVC curve also slopes downward. As
such, in the beginning the ATC curve tends to fall when output expands. At a certain point,
however the AVC starts rising, so the AVC curve has a positive slope, yet the ATC curve
continues to fall. This is due to the predominant influence of the falling AFC curve. Since the
falling effect of AFC curve is stronger than the rising effect of AVC curve at this stage, the net
effect causes ATC to fall. But, as the output expands. At a certain point, however, the AVC
starts rising, so the AVC curve has a positive slope, yet the ATC curve continues to fall. This is
due to the predominant influence of the falling AFC curve. Tends to the rise sharply due to the
operation of the law of diminishing returns. Now, the rising effect of AVC being predominant, it
more than discounts the falling effects of AFC curve, so the net effect is that the ATC starts
rising. Indeed, at the point where that rise of AVC exactly nullifies the fall of AFC, the balancing
effect causes ATC to remain constant first and then when the rising effect of AVC becomes more
pronounced the ATC starts rising. As such, the overall ATC curve assumes U-shape. The falling
path of ATC is largely due to the falling AFC curve, while its rising path is largely influenced by
the rising AVC curve. It may be noted that the distance between ATC and AVC curve becomes

narrow as the curves move up word. This is a clear indication of the increasing influence of AVC
on ATC in the later stage. In this way, the slopes of the ATC curve, initially negative and
thereafter positive, reflect the combined influence of fixed and variable cost curves. The
economic reason underlying the U-shape of the average cost curve is that there is greater
importance of fixed costs in any firm till the normal capacity is exhausted and the normal point
or the point of least-cost combination of various factors (fixed and variable) is reached. The
average cost, therefore, declines in the beginning. But once the normal output of the plant is
reached, more and more variable factors are to be employed due to the diminishing returns so
that the variable cost rises sharply to increase the output further which outweighs the effect of
falling average fixed cost so that the ATC starts moving. In fact, the combination of increasing
and the diminishing marginal product makes the AVC. In fact, the combination of increasing and
diminishing marginal products makes the AVC curve U-shaped. This is how the ATC curve
assumes U-shape in the short run period.
Again, as we have already seen, the ATC curve is the reciprocal of the AP curve. The AP curve
formed by the operation of the law of diminishing returns in the short run. The occurrence of non
proportional output is basically due to the indivisibility of fixed factors and imperfect
substitutability between fixed and variable factors.
THE MARGINAL COST CURVE (MC CURVE)

The marginal cost curve also assumes U-shape indicating that in the beginning the marginal cost
declines as output expands, thereafter, it remains constant for a while and then starts rising up
word.
Marginal cost is the rate of change in total costs when output is increased by one unit. In a
geometrical sense, marginal cost at any output is the slope of the total cost curve at the
corresponding point.
Apparently, the slope of the MC curve also reflects the law of diminishing returns.
In the short-run, the marginal cost is dependent on fixed cost and is directly related to the
variable cost. Hence, the Mc curve can also be derived from the TVC curve. In fact, the TC and
TVC curves have an identical slope at each level of output, because TC curve is derived just by
shifting TVC curve at TVC level. Thus, MC can be derived from the TVC curve and AVC curve
is also derived from the TVC curve. However, MC will not be the same as AVC. As a matter of
fact, AVC curve and MC curve are the reflection and the consequence of the law of non-
proportional output operating in the short-run.
Thus, the AVC curve is exactly the reverse of AP. Whereas MC curve is exactly the reverse of
MP curve.
THE RELATIONSHIP BETWEEN MARGINAL COST AND AVERAGE COST

Focusing their attention on average and marginal costs data, economists have observed a unique
relationship between the two as follows:

When AC is minimum, the MC is equal to AC. Thus, MC curve must intersect at the
minimum point of ATC curve.
When AC is falling, MC is also falling initially, after a point MC may start rising but AC
continues to fall. However, AC is greater than MC(AC>MC). Hence , ultimately at a
point both costs will be equal. Thus, when AC and MC are failing, MC curve lies below
the AC curve.
Once MC is equal to AC, Then as the output increases AC will start rising and MC
continues to rise further but now MC will be greater than AC. Therefore, when both the
costs are raising, MC curve will always lie above the AC curve.
The above stated relationship is easy to see through geometry of AC and MC curves, as
shown in the figure.
It can be seen that:
o Initially, both MC and AC curves are sloping downward. When AC curve is

falling, MC
curve lies below it.
o When AC curve is rising ,after the point of intersection ,MC curve lies above it .
It follows thus, that when MC is less than AC, it exerts a down ward pull on the AC curve. When
MC is more than AC it exerts an up word pull on the AC curve. Consequently, MC must equal
AC, while AC is at the minimum. Hence,, MC curve interests at the lowest point of AC curve. It
may be recalled that MC curve also intersects the lowest point of AVC curve. Thus, it is a
significant mathematical property of MC curve that i8t always cuts both the AVC and ATC
curves at their minimum points.
The figure thus, MC curve crosses the AC curve at point P. at this point P, for OQ level of output
the average cost is PQ which is the minimum.
The MC curve intersects the AC curve at its minimum point from below.

It should be noted that no such relationship can ever be traced between the MC curve and the
AFC curve simply because by definition, the MC curve is independent.
Further, the area underlying the MC curve is equal to the total variable cost of a given output.
In fact, the point on each average cost curve measures the average cost but the area underlying
them denote total costs as under:
Total area underlying the AFC curve measures the cost total fixed cost.
The area underlying the AVC curve measures the total variable cost.
The area underlying the MC curve measures the total marginal cost.
The area underlying the ATC curve measures the total cost.
Finally, the MC curve is important because it is the cost concept relevant to rational decision
making. It has greater significance in determining the equilibrium of the firm. In fact, the
increasing MC due to diminishing returns sets a limit to the expansion of a firm during the
period. Further, it is the MC curve which acts on the supply curve of the firm.
From the above discussion of cost behavior, we may conclude that short-run average cost curves
(AVC, ATC and MC curves) are U-shaped, except the AFC curve, which is an asymptotic and
down ward sloping curve.
Long-Run Average Costs Curve

It relates to the cost-output relation in the long-run. It is a flatter U-shaped curve.
Features of LAC Curve

Tangent curve
Envelope curve
Planning curve
Minimum cost combinations
Flatter u shaped
Characteristics of Long-run Costs

The long-run period is long enough to enable a firm to vary all its factor inputs. In the long-
run, a firm is not tied to a particular plant capacity. It can move from one plant capacity to
another whenever it is obliged to do so in the light of changes in demand for its products.
The firm can expand its plant in order to meet the long-term increase in demand or reduce
plant capacity if there is a drop in demand.
In the long-run, thus, are only the variable costs or direct costs as total cost. There is no
dichotomy of total cost into fixed and variable costs as we see in the short-run analysis.
In the long-run, when we examine the unit cost of a firm, we come across only the average
marginal costs. Hence, we have only to study the shape and relationships of the long-run
average cost curve and the long-run marginal cost curve.
As a matter of fact, the long-run is a planning horizon. All economic activity actually
operates in the short-run; the long-run is only a perspective view for the future course of action.

Thus, run, but in the real course of operation chooses actually numerous aspects of the short-run.
This means, the long-run comprises all possible short-run situations from which a choice is made
for the actual course of operation.
In reality, thus, the long-run consists of perspective planning for the expansion of the firm;
hence, it involves various short-run adjustments visualized over a period of time.
Derivation of the LAC Curve

Methodologically, the long-run average cost curve (LAC) is the envelope of the various
short-run average cost curves. It is drawn as tangent to the SACs as depicted in Figure 10.7.
In Figure 10.7, the LAC is derived as tangent to SAC1, SAC2 and SAC3. The MC is, thus, a
flatter U-shaped curve.
Fig.10.8
Features of the LAC Curve
Following are the main features of the LAC curve:
1. Tangent Curve. By joining the loci of various plant curves relating to different
operational short-run phases, the LAC curve is drawn as a tangent curve.
The LAC approximates a smooth curve, if the plant sizes can be varied by infinitesimally
capacities and there are numerous short-run average cost curves to each of which the MC is a
tangent. In other words, the long-run average cost curve is the locus of all these points of
tangency (See Fig).
2. Envelope Curve. The LAC curve is also referred to as the envelope curve; because it
is the envelope of a group of short-run average cost curves appropriate to different levels
of output.
In Figure, the LAC curve is enveloping or tangential to a number of plant sizes and the related
SACs.

In Figure the LAC curve is drawn on the basis of three possible plant sizes. This is a much
simplified assumption. Normally, however, the firm may come across with a choice among a
large variety of plants. Thus, more realistically, the LAC is to be drawn with reference to a large
number of possible plant sizes, as shown in Figure.
3. Planning Curve. LAC curve is regarded as the long-run planning device, as it denotes
the least unit cost of producing each possible level output and the size of the plant in
relation to the LAC curve. A rational entrepreneur would select the optimum scale of
plant. The optimum scale of plant is that plant size at which a SAC is tangent to the
LAC, such that both the curves have the minimum point of tangency. In Fig. 10.9, at
OQ2 level of output, SAC is tangent to LAC at both the minimum points.
Fig.10.9
Thus, OQ2 is regarded as the optimum scale of output, as it has the minimum per unit cost. It
should be noted that, there will be only one such point on the LAC curve to which a SAC curve
is tangent as well as both have the minimum points at the point tangency. And as such, this
particular SAC phase is regarded as the most efficient one. All other SAC curves are tangent to
the LAC but at the point of tangency neither LAC nor SAC curve has the minimum point. In
fact, at all these points SAC curves are either rising or falling, showing a higher cost.
Anyway, the optimum scale of plant will inevitably be adopted in the long-run by the firm under
perfect competition. But the firms under monopoly and monopolistic competition are less likely
to select the optimum plant size.
4. Minimum cost combinations. Since LAC is derived as the tangent to various SAC
curves under consideration, the cost levels presented by the LAC curve for different
levels of output reflect minimum cost combinations of resource inputs to be adopted by
the firm at each long-run level of output.

5. Flatter U-shaped. The LAC curve is less U-shaped or rather dish-shaped. This means
that in the beginning it gradually slopes downwards and then, after reaching a creation
point, it gradually begins to slope upwards. This implies that in the long-run when the
firm adopts a larger scale of output, its remains constant, and then rises. This behavior
of long-run average costs is attributed to the operation of return to scale. Increasing
returns in the beginning cause decreasing costs, constant returns, constant costs, and then
decreasing returns, increasing costs.
Economies of Scale and the LAC

The LAC curve is the mirror image of the returns to the scale in the long-run.
It is apparent that since returns to the scale are based on the internal economies and
diseconomies of scale, the long-run average cost curve traces these economies of scale. As a
matter of fact, increasing returns to scale can be largely traced to the economies which become
available to a firm when it expands its scale of operations. As a result of these economies, the
firm enjoys a number of cost advantages and return in terms of total output. Thus, economies of
scale explain the falling segment of the LAC curve. This shows that the declining average cost
of output in the long-run is due to economies of large scale enjoyed by the firm.
Increasing LAC is attributed to the diseconomies of scale after a certain point of further
expansion.
In short, economies and diseconomies of large scale play a significant role in determining
the shape of the LAC curve. Again the structure of an industry is also affected by the cost
consideration which is conditioned by the economies and diseconomies of scale. Of the many
determinants of the number and size of firms in an industry, these cost consideration and relevant
economies and diseconomies are a significant determining factor.
Increasing average costs in the long-run, attributed to the growing diseconomies of scale,
set a limit to the further expansion of the firm.
Economies and diseconomies of scale reflect upon the behavior of the LAC curve.
Analytically speaking, the downward slope of the LAC curve may be attributed to the internal
economies of scale. Similarly, the upward slope of the LAC curve is caused by the internal
diseconomies of scale and the horizontal slope of the LAC curve may be explained in terms of
the balance between internal economies and diseconomies (see Fig. 10.10).

Fig.10.10
Internal economies cause LAC curve to fall. It remains constant when economies equal
diseconomies of scale. Net diseconomies cause LAC to rise.
In short, the internal economies and diseconomies have their significance in determining the
shape of the LAC curve of a firm. However, the shift in the LAC curve may be attributed to the
external economies and diseconomies. External economies reflect in reducing the overall cost
function of the firm. Thus, a downward shift in the LAC may be caused by external economies
as shown in Fig. 10.11.
Fig.10.11- The Effect of External Economies

In Figure 10.10, ABCD is the LAC curve. Its AB portion-the downward slope-is subject to the
internal economies. Its BC portion-the horizontal slope-is due to the balance between economies
and diseconomies. Its CD portion-the upward slope-is subject to internal diseconomies.
In Figure 10.11, the original LAC1 curve shifts downwards as LAC2 on account of external
economies.

Similarly, an upward shift in the LAC curve may be attributed to the external diseconomies, as
shown in Figure 10.12.
Fig.10.12 -The Effect of External Diseconomies
In Figure 10.12, the original LAC1 curve shifts up as LAC2 owing to the external diseconomies.
Long-run Marginal Cost Curve (LMC)

Like the short-run marginal cost curve, the long-run marginal cost curve is also derived
from the slope of total cost curve at the various points relating to the given output each time.
The shape of LMC curve has also a flatter U-shape, indicating that initially as output expands in
the long-run with the increasing scale of production tends to decline. At a certain stage,
however, LMC tends to increase. The behavior of the curve is shown in Figure 10.15.
In Figure 10.15, the LAC refers to the long-run average cost curve and the LMC refers to
the long-run marginal cost curve.
From Figure 10.15, the relationship between LAC and LMC may be traced as follows:
When LAC curve decreases. LMC CURVE also decreased and LMC<LAC.

At a certain stage, LMC tends to rise, though LAC continues to fall. Indeed, LMC is
still less than LAC.
When LAC is the minimum, LMC-LAC. Thus, the LMC curve intersects, at the
lowest point of the LAC curve.
Thereafter both the LAC and LMC curves slope upwards. Now LMC>LAC. So, the
LMC curve lies above the LAC curve.
ECONOMIES OF SCALE AND SCOPE

LARGE-SCALE OF PRODUCTION
The scale of production means, the size of the production unit of a firm or a business
establishment. The scale of production can vary from very small to very large. Depending on the
quantity of output per unit of time of the firm. Thus the scale of production positively varies
with the size of the firm.
Large scale production refers to the production of a commodity on a large scale, with a
large plant size firm. Large production or output requires large-scale input, i.e., the use of the
efforts of the factors of production on a large-scale. On the other hand production of a
commodity with a small plant size firm will have the production of a commodity on a small
scale.

Motives behind large-scale production

A notable feature of production in the modern industrial economy is that production takes policy
on large-scale firms production commodities. The principal motives leading to the expansion of
the size of a firm are:
1. Desire for economy. Generally,, a large-scale of output is more economical.

2. Desire for large profit. Business on a large-scale certainly yields more profits.
3. Desire fore economic power and prestige. A large firm can command and control a large
section of the business in general and has a high reputation in the market.
4. Desire for increase of demand. When the demand for a product increases and the size of
its market expands, the firm will have to increase its scale of production to adjust its
supply to demand. Alternatively, by increasing the scaled of output and by resorting to
greater specialization and division of labor, the firm an increase its productivity as a
whole and lower its cost of production so that it can supply more at a lower price as a
result of which the demand for its product increases.
5. Desire for self-defame in a competitive market. Owing to cut-throat competition in
business, the firm may be forced to enlarge its scale of production for its vary survival.
THE SIZE OF FIRM AND INDUSTRY

Production in modern economy is carried on by a large number of firms of different
types and sizes. He firm may be defined as an independently administered enterprise-a
business unit, whether a sole proprietor, partnership, or a joint-stock company-producing
a particular commodity. All such firms taken together constitute the industry. Thus, an
industry is composed of all the firms-individual business units producing similar
commodities. For example, Sony is a firm; Samsung is also a firm producing electronic
goods. Likewise, there are several electronic goods manufacturers in India. All of them
together constitute the electronic industry.
A firm or a business establishment may be large or small. Usually, the size of an

establishment is measured by value of its output or by the number of labourers it
employs, or by the amount and value of its fixed capital such as buildings, plant and
equipment. The size of a firm increases when it uses more and more of capital labor and
other factors of production.
An industry may consist of bother large and small firms at a time. Like firms, the size of
an industry also may be large or small. The size of an industry depends on the size of
firms it constitutes and hires number. Thus, the size of an industry increases when:
1. There is an increase in the number of firms in it: or
2. There is an increase in the size of firms comprising it.

ECONOMIES OF SCALE:
Large scale production is economical in the sense that the cost of production is low. The low
cost is a result of what is called economies of scale.
Definition: Ina broad sense, anything which serves to minimize average cost of production in the
long run as the scale of output increases is referred to as economies of scale. It is measured in
many terms.
The concept economies of scale may be viewed in two senses: broad and narrow.
In a narrow sense however, the term economies of scale relates to the characteristics of the
production process by which average productivity is enhanced with the expanding scale of
output. Real economies are measured in physical terms. Increasing returns to scale are caused by
these real economies.
The economies of scale may be classified as :
i) Internal economies, and
ii) External economies.
Internal Economies
Internal economies are those economies which are open to an individual firm when its size
expands. They emerge within the firm itself as its scale of production increases. Internal
economies in the scale of its output cannot be realisedunless the firm increases its output i.e.,
expands its size.
External Economies
External economies are those economies which are shared by all the firms in an industry or in a
group of industries when their size expands. They are available o all firms from outside,
irrespective of their size and scale of production. They art h result of the growth and expansion
of any particular industry or a group of)in an industry when its size expands, Thus industries as a
whole. Hus, external economies are the function of the size of the industry. They are not
confined to one or two firms, but shared by all the firms (irrespective of their size in an industry
when its size expands. Thus, external economics can never be monopolized by any one firm in
an industry.
In fact, external economies arise mainly due to the localization of industries. Thus, external
economies are enjoyed by a firm when some other firms grow large: these arise as a result of the
cost reducing effect of expansion and growth elsewhere. Briefly, thus, economies of size of a
firm are internal economies and those of the size of industry are external economies.
In pecuniary sense, both internal and external economies imply cost reduction. It is, however,
difficult to draw a line of demarcation between internal and external economies because of their
overlapping nature. /when the size of a firm increases, it nous internal economies, but its
expanding size also causes the growth of industry which, in turn, leads to some external
economies. External economies, in turn, reduce the cost of production simultaneously with the
cost economies caused by the increasing scale of output in the firm. In practice, internal and
external economies arise in an overlapping or rewoven manners the distinction between the two
cannot be easily measured from a given cost function of a firm.

Forms of internal Economies

The principal types of internal economies of scale can broadly be grouped under six headings:
labor, technical, managerial, marketing, financial and risk-spreading.
i) Labor economies
Increased division of labor is a major source of labor economies. The exn of division of labor
is preconditioned by the scale of output. As output increases and labor force grows, a more
and more complex division of labor with a greater degree of specialization with all its
advantages, may become possible. Moreover, a large firm can react more efficient lab our, as
a can offer a wide vertical mobility, better prospects of promotion, as a slit of increasing
specialization in the production processes. As such, the skill, efficiency and productivity of
labour as a whole in such large firms rise, reducing the cot pr unit of output.
ii) Technical Economies
Technical economies \refer to reductions in the cost of the manufacturing process itself.
These relate to the methods and techniques of production, especially to the nature and forms
of capital employed.
Following Prof.Carincross, w may classify the various kinds of technical economies as
follows.
Economies of superior technique. As a firm expends, it can use superior techniques and
capital goods. A small firm cannot install a high quality mach in or other capital goods
which a big firm can. Small firms generally make increasing us of ordinary machines
operated by hand while large firms make synchronized applications of big automatic
machines worked by same or electricity. Such automatic machines a quicker and more
efficient, and their output are large as compared to the ordinary machines. Thus ,for
instance, an automatic loom is more economical than a handloom . but a villager weaver
cannot afford to have an automatic loom, which a testily mill obviously can. Similarly a
rotary printing press, linotype machine, etc., are more economical then hand composing.
But a small job printer cannot afford to have such big machines which only a well
established newspaper organization like The times of indiacan.
Economies of increased dimensions.
Certain technical economies may become available just on account of increased
dimensions. This is purely a mechanical advantage of using large machines. Large pieces
of equipment are relatively more economical than smaller one and usually there is an
optimal minimum of size of any piece of equipment. The reason for this lies in the laws
of physical universe which govern the rate of increase of a various properties of
inanimate bodies with an increase in their size .for example a big ship is more economical
than a small on. Similarly, a double deck bus is more economical than a single Dekker
.for only one driver is needed, whether it is a double Decker or single deker bus.
Moreover the size of unit of machine can usually b doubled without doubling labour and
other material costs.

Economies of linked process. A large plant usually enjoys the advantage of the linking
of process, by arranging production activities in a continuous sequence without any loss
of time. Prof.cairncross points out, There is generally saving in time and saving in
transport costs, since two departments of the same factory are closer together than
separate factories. For the same reason, processes of editing and printing of newspapers
are generally carried out in the same premises.
Similarly, in the iron and steel industry, the main production stages like melting iron ore
into pig iron, convening pig iron into mild steel, rolling still into sheet plate, etc., are
linked together to avoid waste of po Large units of machines and their continuous
running bay large firm are often more economical in their were, heating process, etc.,and
thus, to achieve economies.
Economies in power. Large units of mahines and their continuous running by a large
firm are often more economical in their power consumption as compared to a small
machine.
Economies of by-product. Large firms can make a more economical use of their raw
materials.
A large firm can avoid waste of its raw materials, which it can economically use for
manufacturing certain by-products. Large chemical companies are, for instance,
constantly developing new varieties of by-products in this way. Similarly, cane pulp and
molasses of big sugar factories can be effectively used by the paper industry and liquor
distilleries.
Economies of continuation. Technical economy is also realized due to long run
continuation of the process of production. For example, in the printing press industry,
there is an apparent economy to be realized by printing more copies of a composed sht.
Thus, if composing and printing cost of 1,000 copies per page is Rs.12, for 2,000 copies
it would cost only Rs. 14, that is, just Rs. 2 more for the extra 1,000 copies, because the
same sheet plate which is composed once will remain in use for printing extra copies.
Hence there is only additional printing cost involved, while the composing cost remains
the same.
iii) Managerial Economies: As a result of the indivisibility of managerial factors, the cost
per unit of management will fall as output increases, thus, with the increasing scale of
output, greater managerial economist are enjoyed by and expanding firm. For, a good
manager can organize a large output with the same efficiency as he can organize a
small output and his remuneration normally remains the same whether the output is
large or small. Moreover, a large firm can hire a first-rate manager by paying a
handsome salary, so its overall administrating will be more efficient as well as
economical. An entrepreneur can delegate some of his functions to trained and
specialized personnel in his variant departments and can get better and more efficient

productive management with scientific business administration. But economies in

management can be realized only when production is one large-scale. A small
producer cannot afford to have all such personnel with knowledge of scientific
business administration.
iv) Marketing Economies: Marketing economies are economies of buying (of raw
materials) and selling (goods produced). A large firm can generally buy more cheaply
than a small one, because it can purchase its raw materials on a large scale at a low
cost(paying wholesale price.) Further, a big firm also employs purchasing experts to
purchase the required raw materials more economically and in time.
Similarly, on the sales side, a big firm can reap advantages of large-scale marketing.
Selling is generally less expensive per unit when large quantities are distributed,
because a selling organization should b of an optimum size whatever be the volume
of sales handled.
v) Financial economies: In financial matters, a large firm has relatively greater advantages
than a smaller one. Usually,, it has a wider reputation and greater influence in the
money market. Big firms are usually regarded less risky by investors; hence, they
may be willing to lend capital to such firms even at a lower rate of interest than to
small firms. Thus, the cost of obtaining credit and capital is lower to a large concern
than to a smaller one. Further, big firms can easily raise their capital by issuing shares
and debentures. The shares of a big concern number in millions and are held by
thousands of people. But a firm having no recognition in the capital market cannot
command such capital. It can only raise a modest capital from the personal resources
or loans from relatives or a bank or from moneylenders. And it cannot procure money
from the general public by offering shares for sale on the stock exchange. Briefly,
thus, the important financial advantage enjoyed by a large firm is the existence of a
ready market for its shares and its sound reputation in the capital market.
vi) Risk minimizing Economies: A large firm by producing a wide range of products is in
a position to eliminate or minimize business risks by spreading them over. Risk
spreading advantages are sought by a big firm in the following ways:
By diversification of output. As a big firm can produce a number of items and in
different varieties, the loss in one can be compensated by gain in others, .g: godrej soaps
ltd. Is producing soap, talcum powder, shaving cream, etc, various types of cosmetic
products and thereby spreading its business risks.
By diversification of market: When a product is produced on a large-scale, it can
have an extended market throughout the country so that the danger of fluctuations in
demand is reduced market throughout the country so that the danger of in demand is
reduced to the minimum. Thus, demand for nationwide, popular product is more stable
than a locally supplied article.

By diversification of sources of supply as well as of process of manufacturing. In a

large firm, there are less chances of disruption of output as a result of scarcity of raw
material or breakdown of a particular process.
Forms of External Economies:

By external economies, we mean gains accruing to all the firms in an industry from the growth of
that industry. External economies are enjoyable by all the firms in th industry, irrespective of
their size. External economies are, in essence, the advantages of localization. An industry
expands when the number of firms increases or their size expands in a particular region. Thus,
localization of industry takes place and all the advantages of localization accrue to firms in that
industry.
The chief types of external economies ar:1) Economies of localization (2) Economies of
information (3) Economies of disintegration and (4) Economies of byproducts.
I. Economies of Localization: When a number of firms are located in one place, all of
them derive mutual advantages through the training of skilled labour, provision of
better transport facilities, stimulation of improvmens.ec These are in fact the benefits
of localization. Concentration of a particular industry in one area, in course of time,
results in the development of conditions helpful to the industry. And all the firms in
that area reap mutual benefits. Moreover, when there is an increasing concentration of
firms, arrangement can be mad for repairs and maintenance and special services
required by the industry. he cost of production is thereby reduced.
II. Economies of information or Technical and market intelligence: A large and
growing industry can bring out trade and technical publications to which every firm
can have access. Producers, are, thus, saved from independent research which is very
costly, in a large industry, research work is done jointly. There can be a research.
Statistical, technical and other market information becomes more readily available to
all firms in a growing industry. As such, when the industry progresses, the cost of
production falls.
III. Economies of Vertical Disintegration: The growth of industry will make it possible to
split up production and some subsidiary jobs can be left to be done more efficiently
by specialize firms. New subsidiary industries may grow up to serve the needs of the
main industry, e.g., in the textile industry, the color manufacturing process may be
taken up by a specialized chemical firm and the mills may get better products at low
costs. When a particular process is split up and performed on a large-scale by a
specialized firm, it can yield all the internal economies of large-scale production.
Hence, all firms in the industry will b able o get this process done at a lower cost
instead of attempting to meet their own needs by carrying it out them on a small scale
at a high cost. But the subsidiary, industry or specialized firm in a particular process
may spring up only when the industry is large enough o support it.

IV. Economies of By-products: A large industry can make use of waste materials for
manufacturing by-products,. The firms using it can flourish when waste material
available in the industry is converting into by-product. For example, in a sugar
factory belt, sugarcane pulp can be used by the paper mill in producing paper. Sugar
factory will gt some return for the sugarcane pulp by selling it to the paper mill in the
Vicinity. This means and indirect economy in cost.
DISECONOMIES AS LIMITS TO LARGE-SCALE PRODUCTION

Beyond a particular limit, however, certain disadvantages of large-scale production emerge.
When there is an expansion of the firm beyond an optimum limit, the very internal and external
economies turn out to b diseconomies. These diseconomies, by raising the average cost of
production, act as a limiting factor on the further expansion of the firm. Since economies of
large-scale are not available beyond a certain point, a firm cannot expand its size indefinitely.
Generally, the following factors of diseconomies of scale limit the size of a firm:
Difficulties of Management: As a firm expands, complexities and problems of
management increase. Thus, after a point, the manager finds it difficult to control the
whole production organization. The entrepreneur and management will not be able to
maintain contact with each other and check on all the departments of a very large
concern. The problem of supervision becomes complex and intractable, thus leading to
increasing possibilities of mistakes and mismanagement. All these prove to be
uneconomical , for the defects in organization will lead to waste and result in rising
average costs.
Difficulties of Coordination: The tasks of organization and co-ordination become
progressively more and more difficult with the increasing size of the firm. The
management of the firm will gradually face numerous problems of decision making and
organization. I may, therefore, not finding enough time to give careful thought out
individual problems. Decisions so taken in a hurry result in inefficacy and increase in the
cost of goods.
Difficulties in Decision making: A large firm cannot tale decisions and makes quick
changes as and when they are need, for it has to consult various departments for making
any decisions and so urgent matters requiring timely decisions are inevitably delayed. His
may sometimes cause loss to the firm.
Increased Risks: As the scale of production increases, investments also increases, so too
the risks of business. The large r he output, obviously the greater will be the loss. To bar
greater risks is an important limitation to the expansion of the size of a firm from an error
of judgment or misfortune in business, therefore, unwilling to bear greater risks is an
important limitation to the expansion of the size of a firm.
Labour Diseconomies: Extreme division of labour with a growing scale of output results
in lack of initiative and drive in the executive personnel. Thus, a large firm becomes
more impersonal and contact between management and workers become less. As such

there are more chances of occurrence of grievances and industrial disputes which prove
out be costly to the large firm.
Scarcity of factor supplies:Due to the increase in the concentration of firms in a
particular locality, each firm will find scarcity of available factors. Hence, competition
among firms in purchasing labour,, raw materials, etc, will result in increased factor
prices. Thus, extreme concentration of external economies becomes of sort of
diseconomies in further form of high factor prices.
Financial Difficulties:
A big concern needs huge capital which cannot always be easily obtainable. Hence, the
difficulty in obtaining sufficient capital frequently prevents s the further expansion of
such firms.
Marketing Diseconomies:
When the industry expands and the firms grow, competition in the market tends to
become stiff. Thus, firms under monopolistic competition (which is the most realistic
market situation in many lines of production) will have to undertake extensive advertising
and sales promotion efforts and expenditure which ultimately lead to higher costs.
Managers per Operative Ratio:

Empirical evidence usually shows that unit costs tend to decrees with the increasing scale of
output, thus, supporting the hypothesis of economies of scale. The empirical evidence of
diseconomies of scale may not be easy to detect on account of changing state of technology
existence of managerial diseconomies, however, can be infer by comparing the managers per
operative ratios (mores), in different organizations with different sizes. It si observed that the
large the firm the great number of managerial staff relative to the number of employees is and
indications of possible managerial diseconomies present schemers.
Business monitor (1988),suggest that with bigger firms the number of managerial/office
staff(administrative, technical and clerically)is higher in a relative sense than with the smaller
size firms. A bigger firm is top heavy Dennett.
Economies of scope:
In business parlance, the concept of economies of scope is often used somewhat differently than
the concept of economies of scale. It regress to the reduction in unit cost relied when the firm
products two or more products jointly rather than separately. That is to say, a multi-product firm
often experiences economies of scope leading to the lowering of costs.
Economies of scope exist when a firm produces two products together under the same
production facilities as against producing them under separate facilities. It is reflected in the
lesser cost or cost economy,. Thus,:
TC(qx,qy)<TC(qx,0)+TC(0,Qy)
Where, TC=total cost, Qx=Output quantity of product x and Qy=output quantity of product Y.

For example, it may prove to be less expensive or more economical, for Philips to produce TV
set and DVD players by more intensively utilizing a single assembly of scope is thus realized by
avoiding duplicator of the factor inputs in certain ways under a joint operation as compared
separate operations.
In short, economies of scope is airbus to the multi=product cost function. The multi product cost
function of a firm refer to the cost of producing a given quantity of two of more products
simultaneously 9say q1units of output of product x and q2 units of product y) under the same
process of plants operations, assuming all factor-inputs are used optimally (efficiently), today,
one May com9e across several multi-product firms domestically s well as internationally.
Hewlett Packard (HP), for example, produces computer as well as printers of various types. So is
the case with international business machines (IBM) inc. Likewise, Honda produces both cars
and motorbikes, and so on.
PROFITS
INTRODUCTION
One of the basic objectives of an organisation is to earn profit. Sufficient amount of profit is
necessary for future growth and expansion of an organisation. It also ensures payment of
attractive dividend to shareholder.
Profit is a positive gain from an investment or a business operation after subtracting all the
expenses. In economic terms, Profit is a reward to an entrepreneur for his effort. It is a reward for
capital invested by an entrepreneur. Profit is calculated after subtracting the costs of maintaining
land, labour & capital from earnings. It is also known as net income.
Profit is the reward of the entrepreneur rather than on account of the entrepreneurial function.
Profit differs from the returns on other factors of production such as land, labour & capital. Profit
is residual income & not contractual income. Land, labour &capital are used in contracts where
they receive pre-determined income, whereas profit is the amount of money received by the firm
after meeting all costs and contractual payments. A company may receive higher profits or no
profits , but it is not so in the case of land, labour & capital.
It is necessary to understand that profit are residual income left after the payment of contractual
rewards to the other factors of production. The entrepreneur cannot undertake the production of
any commodity without using the factor input such as land, labour & capital. He pays rent to the
lands, wage to the workers & interest to capital. In fact, the entrepreneur makes payment to those
factors well in advance of the realisation of the value of the output. What is left after paying
contractual rent to land, wages to workers & interest to capital borrowed , is called profits. The
profits are non-contractual income & therefore they may be negative or positive, whereas the
interest is always positive. It should be noted that pure profits of the entrepreneur are found by
subtracting from the gross residual income the imputed values of rent and interest on the self-
owned land & capital employed by the entrepreneur & also the imputed wages for his work of
routine management. Business profits are, therefore, specially contingent upon the successful
management of risk. Modern industry is faced with a number of uncertainties. The entrepreneur

receives a reward for combining the factors of the production to meet economic needs of the
people faced with various uncertainties. He gets profits because he selects the risks & manages
them skilfully.
MEANING AND DEFINITION

The share of income that goes to the organiser or the entrepreneur is known as profit. It is a
residual income after payment of all factors of production.
The term profit has been defined in different ways by different economies:
According to J.S.Mill, profit can notes the aggregate remuneration of the capitalist
entrepreneur.
In the words of Prof.Knight, profit is a reward for uncertainty bearing.
According to Hawley, profit is a reward for risk bearing.
According to Prof.J.K.Mehta, The element of uncertainty introduces a fourth category of
sacrifice in the productive activities of men in a dynamic world. This category is risk taking or
uncertainty bearing. It is remuneration by profit.
FEATURES/NATURE OF PROFIT
From the above discussion it is clear that profit as a reward for factor of production namely, the
organisation, possess the following feature:
1. Profit is the reward for the entrepreneur.
2. Profit is a residual income left after the payment of contractual rewards to the other
factors of production.
3. Profit is a non-contractual income.
4. Profit may be negative or positive, i.e. its not fixed.
5. Profit depends upon the successful management of risks by the entrepreneur.
CONCEPTS OF PROFIT
i) GROSS PROFIT
Generally, profits refer to gross profits. Gross profit stands for the total earnings of the
entrepreneur. It is a mixture composed of several elements. From the total receipts of business
must be taken out the monies paid to various factors of production engaged on a contract basis.
Thus, the rent , wages& interests have to be deducted out of the total earnings of the
entrepreneur.
Gross profits includes the following items:
a) Interest on entrepreneurs owns capital.
b) Rent f land owned by the entrepreneur.
c) Entrepreneurs wages of management.
d) Reward for risk taken by the entrepreneur.
e) Gains as a superior bargainer.
f) Monopoly gains & windfall profits.

ii) NET PROFIT

Net profit is the pure profit which is the amount that accrues to the entrepreneur for baring the
risk. It is inseparable from all businesses under a system in which production is done in the
anticipation of demand. Pure profit is the profit made exclusively for baring risks. Net profit is
the income received by the entrepreneur after all the factor of production are paid off .
The concepts of gross & net profit can be analysed as follows
Gross profit= Total revenue-Total explicit cost (cost incurred in hiring factors of production)
Net profit = Total gross profit Total explicit costs plus total implicit cost.(Cost for his own
labour & capital)
The following example makes the above concepts clear.
Total revenue of a company manufacturing cloth=10lakhs
a) Rent of factory premises = 500000
b) Interest on bank loans = 500000
c) Wages & salaries = 250000
d) Raw materials = 250000
Total explicit cost or paid cost = 600000
The implicit cost of the firm
a) Wages for the personal labour of the
Entrepreneur = 60000
b) Interest on his own capital = 10000
c) Depreciation of machinery & equipment = 50000
d) Taxes paid to the government = 125000
Total implicit cost = 245000
Now,(1) Gross profit = Total revenue Total explicit cost.

=Rs.1000000-Rs.600000
= Rs.400000
(2)Net profit = Gross profit-Implicit costs
= Rs.400000-Rs.245000
= Rs.155000
In a big company, all cost are explicit costs. The large firm calculates gross profit by taking
difference between total revenue & total costs. Then the depreciation & taxes paid are deducted
from the gross profit to calculate net profit.
The meaning of net profit is shown more clearly through the following chart.

iii) Accounting profit &Economic profit

Accounting profit is defined as the revenue realised in a given period after providing for
expenses incurred during the production of a commodity. Accounting profit is also called
Residual profit. For the business firm accounting profit is very important. In the balance sheet of
a firm, accounting profit occupies an important place. The accountant deducts explicit costs from
the revenue in order to determine profit. But this attitude does not satisfy the economist. The
economists say that both explicit &imputed costs (i.e., the cost that would have been incurred in
the absence of self owned factors) are to be deducted from the total revenue to determine
economic profits. The entrepreneurs wages, interests on his own capital rent for the use of his
own premises to be taken into consideration in calculating economic profits. Thus, after arrived
at after deducting explicit and imputed costs may be called Economic profit. From the
managerial point of view, economic profit is very important because this alone shows the
viability of a firm. A firm may show accounting profit but it may incur economic losses. Such a
firm cannot be considered viable.
iv) Normal Profit and Super Normal Profit
Normal profit is defined as that portion of profit which is absolutely necessary for the business
firm to continue its operation. In other words, normal profits refer to the profit normally expected
in any business. Normal profit is regarded as the reward for management. Hence, of forms a part
of cost of production and price.
Super normal profit or abnormal profit is defined as any return above the normal profit. Super
normal profit is a residual surplus, after paying for both explicit and implicit costs and also
normal profit. It is not a prerequisite or necessary condition for the existence of the firm.
v) Optimum Profit and Maximum Profit
In the existing business environment, if the firm makes a reasonable profit, the profit is called as
optimum profit. This is the most favourable or desirable profit.
Maximum profit is the highest level of profit earned by a firm. It is not possible for all the firms
to earn maximum profit due to competition and its existence has become myth. In recent years,
the business firms are aiming at optimum profit only.

Functions of Profit
Profit is an essential factor for capital formation. Whenever a firm gets profits continuously over
a long period, its economic strength increases. The entrepreneur will be in a position to make
great improvements of his business. This will be an incentive for hard work and innovation.
Peter Drucker says that a profit serves the following objectives of the business.
1. Profit reflects the level of performance of the firm. It indicates the soundness of the
business. A higher profit suggests that the firm is being managed efficiently. Profit is a
true measure of performance. It shows that the organisation is an sound financial
condition.
2. It serves as a premium which covers the costs of business firm. Profits indicate economic
strength of business. The company can stay on in business and produce the product
continuously. Profit is thus stated as the cost of being and staying in business. The
management of a company is required to provide for these costs by earning sufficient
profit.
3. Ensuring of the supply of capital is the most important function of profit. A certain
percentage of net profit is set apart for innovation, better management and modernisation
or the renovation of business.
4. The fundamental objective of firm is to ensure its own survival. In order to survive, it
should earn a substantial profit. When firm is making good profit, it can make changes
when ever required. It can plan for reasonable growth. It is stated that profits are a natural
concomitant of the growth of business over time. In fact, profits are for the continuity and
growth of the firm.
Determinants of Profit
In practise profits of a business firm arise from various sources due to various reasons. They
are as follows
Excess of income over costs.

Reward for risk management and better management
For uncertainty bearing

SOURCE Due to innovation
OF
PROFIT Due to increase in the price level
1. In ordinary language, the term profit is understood as an excess of income over
costs. Due to imperfect competition and monopoly
2. In economics, profit is regarded as a reward for entrepreneurial function of risk
Due to correct estimation of future
management and better management. The entrepreneur earns profit because he

manages risk for his price-output polices which may prove to be incorrect in view of
the future business movements.
3. Schumpeter has assigned to the entrepreneur the role of an innovator and profits as a
reward for his introducing innovations.
4. Prof. F.H.Knight has emphasised in the country as a factor which gives rise to profits
and bearing uncertainty is the task of entrepreneur.
5. J.M.Keynes has expressed the view that profits resulted from the favourable
movements of general price level. If the general price level rises, with the costs being
unchanged, then the businessman earns profits.
6. Professors. Joan Robinson, E.H.Chamberlin and M.Kalecki have associated profits
with imperfect competition and monopoly. According to them, greater the degree of
monopoly power, greater is the profit. As a matter of fact, profits arise from all these
sources.
7. Prof. B.S.Keinstead observed that profit originate from monopolys successful
innovations and a correct estimate of the uncertain future. He has said that, profit may
come to exist as result of monopoly or monopsony, as reward for innovation, as
reward for the corrective estimate of uncertain factors, either particular to the industry
or general to the whole economy.
Classifications of profits
1. Accounting profit: A companys total earnings, calculated according to the
Generally Accepted Accounting Principles (GAAP) and includes the explicit
costs of doing business, such as depreciation, interest and taxes.
2. Economic Profit: The difference between the revenue received from the sale of an
output and the opportunity cost of the inputs used. Opportunity costs are the
returns not realised by using the chosen inputs. Economic profit is, sometimes
referred to economic value added (EVA).
3. Normal Profit: Economic theorists generally make a distinction between two
types of profits viz. normal profit and super normal profit. Normal profit is
minimum necessary amount of profit to encourage entrepreneur to open or stay
in particular business and super normal profit is a profit which exceeds normal
profit. The level of super normal profit available to a firm is largely determined
by the level of competition in a market. Normal profit enables the firm to pay a
reasonable salary to its works and managers. The definition of normal profit
occurs when average revenue is equal to average total cost. Supernormal profit
helps an organisation to make plans for future development and growth.
Supernormal profit is also known as abnormal profit. Abnormal profit
encourages other firms to enter the industry.
4. Marginal Profit: It is an additional profit and by selling an extra unit. Profit per
unit will be achieved when marginal revenue (MR) is greater than marginal costs
(MC).

5. Retained profit and Distributed profit: When an organisation retains part or whole
amount of profit earned for developmental purposes, the amount so retained is
called retained profit. The part of profit distributed to the shareholders in the
form of dividend is called distributed profit.
6. Gross profit: It is also called gross margin. It represents the companys profit from
selling merchandise before deducting operating expenses such as salaries, rent
and delivery expenses. Gross profit equals to net sales minus the cost of goods
sold. In other words, gross profit is a profit calculated as sales minus all costs
directly related to those sales. These costs include manufacturing expenses, raw
material and labour.
7. Net profit: Net profit or net income is a measure of the profitability of a business
after accounting for all costs. Met profit is equal to the gross profit minus
overheads and interest payable for a given period of time.
8. Operating profit: The profit earned from a firms normal core business operations.
This value does not include any profit earned from the firms investments. It is
also known as earning before interest and taxes (EBIT).
9. Social profit: It is an tangible benefit provided to a society by an organisation. It
may include educational institution, hospitals, parks etc. Developed by an
organisation as a part of social responsibility.
10. Optimum profit: Level of profit which encourages an organisation to go for
desired level expansion. This happens when an organisation enjoys economies of
large scale operations.
Reasons for limiting profit

Earning of excess profit is not prohibited. But it is not possible to earn super profits.
Every business firms works with the aim of earning huge profits. But there are
several uncontrollable factors which restrict the firm to earn maximum profit or
super profit. When we analyse the profit curve of an enterprise for a long period of
five to ten years, we observed that the firm will be earning only normal or optimum
profit or even below optimum level. Continuous earning of super profit even by
monopoly firms will not be possible as uncontrollable factors influence such profits
to come down. In real situations, profit earned will be a normal profit. The reasons
for normal profit are as follows:
i. Threat of entry of rival to the market.
ii. Government policies on tax matters, quote policies, monetary policies etc.
iii. Resource crunch.
iv. Disturbance in distribution channels.
v. Market behaviour.
vi. Consumer behaviour and to retain customer goodwill.
vii. Rapid change in production technology.

viii. Weak promotion policy of the firm.

ix. To keep labour cool.
These are the major factors which cause the reduction in profit. One or some of the above factors
came in the way of making extra profit or even to earn optimum profit.
Measurement of profit
Measurement of profit is one of the vital objectives of any organisation. There are 2 approaches
to measure profit of an enterprise. They are:
1. Accounting profit
2. Economic profit
These concepts are already explained under the heading classification of profit.
Determinants of Short-Term & Long Term Profits
Maximizing profits is said to be the objective of all firms. Indeed, it's not always easy for the
management to find out which are the right decisions that would maximize them. For instance,
short-run profits can be easily pumped up by avoiding maintenance, discretionary costs,
investments, that however are necessary of on-going competitiveness
Moreover, what maximizes the "overall profits" is not necessary what allows to attain the
maximum of "profitability", i.e. the percentage of profits to turn-over and comparing two
policies: (i) extremely high prices (= high profitability), (ii) a price set from a mark-up of 15% on
costs.
In reality, firms do have profits targets, and sometimes they pay managers for reaching them,
but the goals of firms are broader than profits alone.
Proceeding with other determinants of profits, rising prices of competitors, better sales
conditions and skills, a higher overall price level allow for higher prices of the considered firm's
products, thus increase nominal profits to the extent that costs are inelastic, i.e. they rise less
than proportionally to revenues.
Cost structure and its general elasticity to production level is thus relevant to profits. Economies
of scale increase profits more than proportionally when sales grow. Conversely, a recession with
falling sales levels will hit profits particularly hard in industries where there are economies of
scales and high fixed costs.
Rising wages directly reduce profits. If, however, on a macro-economic level, these wages will
be spent on domestic goods, higher consumption will boost business revenues, partially
counteracting the previous dynamics. Depending on the dynamics of exports and
other GDP components, higher wages are compatible with higher profits.

In other terms, productivity gains determine rising profits.
High trade profits can prompt other people to entry the market and begin to compete with current
traders. In manufacture, this effect, although still present, crucially depends on the easy
of imitation of product features and production processes. It's often difficult to enter into highly
profitable markets.
If markets were all perfectly competitive in their long run equilibrium, all firms in the economy
would have the same constant level of profits: zero. By contrast, in the real world, firms have
different profits with certain sectors and certain firms systematically reaching better profits than
others.
This is due to ubiquitous imperfect competition, barriers to entry, innovation and product
differentiation.
Profits from process innovation
Consider the case of a competitive market where many firms sell basically the same product at
the same price. If they had the same technology and faced the same input prices (e.g. wages),
they would enjoy similar profit levels. Let's assume that one specialized supplier introduce a new
machine that is better than the state-of-art, say a faster machine. The suppler sells it to one of the
firms on the market. This will result in lower costs per unit of output, thus higher profits. These
profits are used, retrospectively, to pay for the investment in the new machine but after the pay-
back period they can be distributed to firm's owners.
The specialized supplier would like to sell again the new machine, either to its first adopter or to
its competitors. If not legally restrained, earlier or later, in fact, the competitors will pay attention
to the innovation and would like to imitatethe first adopter. Slower or faster, innovation will
diffuse throughout the market. Possibly some of the reduced costs will reach the consumers in
terms of lower prices. If demand is elastic and there are economies of scale a self-sustained
positive feedback loop enlarges production capacity, production levels, profits and consumption.
If labour is not too weak, also wages will rise.
In a certain point on time, firms that did not adopt the new machine will see their profits
seriously hit by competition and will have to choose whether to exit the market, to adopt, or to
find other competitive advantages. Pressure to reduce wages in failing firms can be an example
of these short-term defensive strategy.
Profits from product innovation

Consider a market with product differentiation. An R&D investment over the years leads to an
improvement of one product features and the management decides to substitute this new model
to the existing one. Let's imagine for simplicity's sake that costs of product are the same as the
previous version.
Three main effects will increase sales:
1. consumers who did not buy the good because it did not satisfied their minimum requirements
on this feature can now buy, to the extend the improvement is sufficient at their eyes;
2. consumers who decides by a "top-quality" rule and positively value the feature could switch
from their current provider, to the extend the overall quality of the new good becomes superior;
3. consumers who decides by a "value-for-money" rule could switch from their current provider,
to the extend the price / quality relationships of the new good becomes more convenient.
At the same time, the price of this new version could be set higher than before, so that sales
would be braken, unit profits boosted. Overall profits would soar.
Long-term trends
There is no long-term trend in profitability. Absolute profits rise with GDP. The share of profits
on value added depends on social groups compromises and conflicts. A certain tendence to a rise
of this share can be noticed in Western countries, without being an automatical consequence of
development or technology.
Behaviour during the business cycle
Profits are extremely pro-cyclical. At the early stages of recovery, inventories go down,
with sales surpassing production and injecting new liquidity to the business. The
following increase in production is obtained by a higher production utilization of plants
and employment. Productivity steeply rise and profits as well.
During recovery and boom, employment and capital accumulation (investments) can go
hand in hand, increasing absolute profits if not profitability.
At the end of the boom phase, high interest rates on loans (taken for funding investment
and discretionary costs) hurt profits, as well as higher wages can do.
Often unexpected, the demand downturn make inventories piling up, freezing resources
and forcing a fall in production. Before this adjustment takes place, profits plunge even
into negative values.
Profit maximisation

Firms achieve maximum profits when marginal revenue (MR) is equal to marginal cost (MC),
that is when the cost of producing one more unit of a good or service is exactly equal to the
revenue derived from selling one extra unit.
If marginal profit is greater than zero
If the firm stops short of producing Q, (at Q1 below) then MR is greater than MC, and marginal
profit is still greater than zero. Hence, the firm should increase output.

If marginal profit is less than zero
If the firm produces greater than Q, (at Q2 below) MC is greater than MR and marginal profit is
negative. Hence, the firm should reduce its output. Only when MR = MC, at Q, will total profits
be maximised.
A firm is said to be in equilibrium when it has no inclination to expand or to contract its output.
The firm will reach such a state when it maximizes its residual profits. Residual profits are the
difference between total revenue and total cost. The firm will, therefore, reach equilibrium when
it maximizes the difference between its total revenue and total cost.
Rule of Thumb: Equal MC with MR to maximize profit.
The Marginal cost-marginal revenue Equality Approach
An informative and useful method of determining a firms equilibrium output is the comparison
of Marginal Cost (MC) with Marginal Revenue (MR) at each successive unit of output, instead
of total Revenue (TR) and Total Cost (TC).

Market Units of Total Total Cost Profit Marginal Marginal

Price Output Revenue (+) (Rs) OR Revenue Cost (Rs)
Rs. Per Sold Rs (TC) Loss(-)= (Rs) (MC)
Unit (P) (Q) (TR=PQ) (TR-TC) (MR)
10 0 0 10 -10 0 0
10 1 10 16 -6 10 >6
10 2 20 20 0 10 >4
10 3 30 21 +9 10 >1
10 4 40 22 +18 10 >1
10 5 50 25 +25 10 >3
10 6 60 30 +30 10 >5
10 7 70 37 +33 10 >7
10 8 80 47 +33 10 =10
10 9 90 61 +29 10 <14
10 10 100 81 +19 10 <20
Revenue, Cost and Profit of a Hypothetical Competitive Firm
The Marginal cost-marginal revenue (MR: MC) approach clearly shows the behavioral role of
profit maximization by using price as an explicit variable.
Essentially, the MC: MR approach is the corollary of the TC: TR approach.
According to the TR: TC approach, at equilibrium level of output, the slope of TR curve =
slope of TC curve. The slope of TR curve, i.e. TR is the marginal revenue.
Q
(MR; and the slope of the TC curve, i.e., TC is the marginal cost (MC)> this means,
MR=MC. Q
Hence, the profit maximizing condition may be stated as the rate of output which the
difference between TR and TC is the greatest, or the point at which MR = MC.
To sum up the firms equilibrium or profit maximization condition are:
First order condition: MR = MC. Graphically, it is the point of intersection of the MC
curve and the MR curve.
Second order condition: MC must be rising with expansion of output. Graphically, the
MC curve must intersect the MR curve from below.
BREAK-EVEN ANALYSIS
The break-even analysis (BEA) has considerable significance for economic research, business
decision making, company management, investment analysis and public policy.The BEA is an
important technique to trace the relationship between cost, revenue and profits at the varying

level of output or sales.As Joel Dean (1976) puts it, the BEA presents flexible projections of the
impact of the volume of output upon cost, revenue and profits. As such, it provides an important
bridge between business behaviors and economic theory of the firm.In BEA, the break-even
point is located at the level of the output or sales at which the net income or profit is zero. At this
point, total cost is equal to total revenue. Hence, the break-even point is the no-point-no loss
zone.However, the object of the BEA is not just to determine the break-even point (BEP), but to
understand the functional relationship among cost, revenue and the rate of output.
The Break - Even Chart
In recent years, the break-even charts have been widely used by business economists, company
executives. Investments analysts, government agencies and even trade unions. A break-even
chart (BEC) is a group of the short-run relation of total cost and total revenue to the rate of
output and sales. The BEC graphically shows cost and revenue relation to the volume of output.
It thus depicts profit-output relationship. Hence, the BEC is also called profit group.
Figure illstrates a typical break-even chart.
In Figure the volume of output is measured along the X-axis; cost and revenue are measured
along the Y-axis. For the sake of simplicity, assuming constant factors, a liner revenue function
is drawn. Similarly, a linear total cost function is assumed. It is composed of the fixed cost which
is represented by the horizontal curve (TFC) on the chart. The variable cost function is also
assumed to change linearly in a constant proportion to the change in output rate. In the chart, the
break-even point (B) is the point at which total revenue equals total cost, so net profit is zero at

OQ level of output. The area between the TR curve and TC curve depicts the profit function. It
fallows that the firm incurs loss, when it produces output below OQ level. OQ level of output is
at break-even point of no profit, no loss. When it expands further output, it makes profit. The
break-even chart is an excellent instrument panel for guidance of the business manager or
businessman in determining the profitable output and controlling the business.
An Alternative Form of the Break-even Chart
Sometime, an alternative form of the break-even chart is drawn by starting with the variable cost
function from the horizontal axis and then adding total fixed cost to determine the total cost
function or curve, as shown In Figure 16.32.
We get similar information in Figure as in the above traditional Figure However, this alternative
from of BEC is better for providing a ready reference to the contribution to fixed (overhead) cost
and profits.
Formula Method for Determining BEP

There are two ways of determining the break-even point (BEP) by means of a formula. It can be
determined either in terms of physical units of output or in terms of sale value of the output, i.e.,
in money terms.
BEP in Terms of physical units
Viewing in terms of per unit cost and revenue, the break-even point (BEP) is located at that level
of output at which the price or average (AR) is equal to the average cost (AC). Thus, the selling
price should cover the average variable cost (AVC) in full as well as a part of the fixed cost. The
price of the excess other (AVC) is spotted at a point where a sufficient number of units of output
are produced so that its total contribution margin becomes equal to the total fixed cost.
BEP = TFC
P-AVC
Where,
BEP = the break-even point
TFC = the total fixed cost
P = the selling price
AVC = the average variable cost
Obviously, P-AVC measures the contribution margin per unit.
BEP in terms of sales Value

When the firm is a multi-product firm, the BEP is to be measured in terms of sales value, by
expressing the contribution margin as a ratio to sales. Thus,
BEP=Total Fixed Cost

Contribution Ratio
Assumptions of Break-even Analysis
The validity of the BEA is conditioned by a number of assumptions as follows:

1. The cost function and the revenue function are linear.

2. The total cost is divided into fixed and variable cost.
3. The selling price is constant.
4. The volume of sales and the volume of production are identical.
5. Average and marginal productivity of factors are constant.
6. The product-mix is stable in the case of a multi-product firm.
7. Factor price is constant.
In practice, all these assumptions are unlikely to be fulfilled.
Limitations of BEA
The break-even analysis has certain major limitation as follows:
It is static: In the BEA, everything is assumed to be constant. This implies a static

condition. It is not suited to a dynamic situation.
It is unrealistic: It is based on many assumptions which do not hold goods in practice.
Linearity of cost and revenue function is true only for a limited range of output.
It has many shortcomings: The BEA regards profit as a function of output only. It fails
to consider the impact of technological change, better management, division of labour ,
improved productivity and such other factors influencing profits.
It scope is limited to the short-run only: The BEA is not an effective tool for a long-run
analysis.
It assumes horizontal demand curves with the given price of the product: But this is
not so in the case of monopoly firm.
It is difficult to handle selling costs in the BEA: Selling costs do not vary with output.
They manipulate sales and affect the volume of output.
The traditional BEA is very simple: It makes no provision for corporate income tax,
etc.
Despite these limitations, however, the BEA serves some useful purpose in business decision
making. The BEA provides a rough guideline for the alternative possibilities and arriving at a
better decision. Of course, the BEA is not a perfect substitute for judgments of commonsense
and intuition possessed by the businessman. But, it can be a good supplement to the value
judgment and logical deduction made with commonsense.
Usefulness of BEA
The BEA provides useful for decision in regard to pricing, cost control, product mix, channels of
distribution, etc.
The BEA provides microscopic view of the profit structure of the firm.

Empirical cost function required in BEA can be of great help for cot control in business.
The BEA when it provides a flexible set of projections of cost and revenue under
expected future conditions can serve the purpose of profit prediction and becomes a tool
for profit making.
The BEA can be used for determining the safety margin regarding the extent to which
the firm can permit a decline in sales without causing losses.
Safety Margin = Sales-BEP *100
Sales
The BEA can be useful in determining the target profit-sales volume.
Target Sales volume = TFC- Target Profit

Contribution Margin
It is useful in arriving at make or buy decision.
In short, BEA highly significant in business decision making pertaining to pricing policy,
sales projection, capital budgeting, etc. However, the technique is to be used cautiously.

Module 4
Market Structure
Perfect Competition: Features, Determination of Price under Perfect Competition -
Monopoly: Features, Pricing under Monopoly, Price Discrimination - Oligopoly: Features,
Kinked Demand Curve, Cartel, Price Leadership Monopolistic Competition: Features,
Pricing under Monopolistic Competition, Product Differentiation Pricing - Descriptive
Pricing- Price Skimming, Price Penetration.
MARKET MORPHOLOGY
Meaning of Market
Ordinarily, a market is understood as a place where commodities are bought and sold at
retail or wholesale prices. Thus, a market place is thought to be a place consisting of a number
of big and small shops, stalls and even hawkers selling various types of goods.
In economics, however, the term market does not refer to a particular place as such but
it refers to a market for a commodity or commodities. Thus, economists speak of, say, a wheat
market, a tea market, a gold market and so on.
Definition: An arrangement whereby buyers and sellers come in close contact with each other
directly or indirectly, to sell and buy goods is described as market.
It follows that for the existence of a market, buyers and sellers need not personally meet
each other at a particular place. They may contact each other by any means such as telephone or
telex.
Thus, the term market is used in economics in a typical and a specialized sense:
It does not refer only to a fixed location. It refers to the whole area of operation of
demand and supply.
It refers to the conditions and commercial relationships facilitating transactions
between buyers and sellers. Thus, a market signifies any arrangement in which the
sale and purchase of goods take place.
Thus, to create a market for a commodity, what we need is only a group of
potential sellers and potential buyers; they may be at different places.
Market may be physically identifiable, e.g., the cutlery market in Mumbai situated
at Jumma Masjid Street or one which is identified in a general sense, without any
reference to a particular commodity, such as the labour market, the stock market,
etc
Existence of different prices for a specific commodity means existence of
different markets.
Product and Factor Markets

Analytically, markets may be categorized into: (i) product market, and (ii) factor market.

A product market or commodity market refers to an arrangement in effecting buying

and selling of commodities. In fact, each commodity has its market. We, thus, speak of the
cotton market, the wheat market, the rice market, the gold market, the tea market, the cloth
market, the automobile market, the tyre market, the fish market, the cutlery market, the timber
market and so on. Markets for precious metals such as gold and silver are called the Bullion
Exchanges or Bullion Markets. Markets for capital change such as government securities, bonds,
shares, etc. are called the Stock Exchanges, while markets for commodities are called Product
Exchanges.
Similarly, there are factors markets in which factors of production such as land, labour
and capital are transacted. There are, thus, markets called labour market, land market, and capital
market. The households or the consumers are the buyers in the product markets. Their demand is
the direct demand for the consumption goods.
The firms or the producers are the buyers in the factor markets. Their demand for
productive resources or factors of production is a derived demand. In the product market, the
commodity price of a specific commodity is determined individually in the concerned
commodity market by the interaction of demand for and supply of the commodity. The product
market facilitates exchange of goods in the society. Factor prices such as rent of land, wages of
labour and interest for capital are determined in the factor markets as the price of each factor is
determined by the interaction between its demand and supply in its respective market. Factor
markets, in essence, facilitate distribution of income, in the form of rents, wages, interest and
profits.
Classification of Market Structures
The market is a set of conditions in which buyers and sellers come in contact for the
purpose of exchange. The market situations vary in their structure. Different market structure
affects the behavior of buyers and sellers (firms). Further, different prices and trade volumes are
influenced by different market structures. Again, all kinds of markets are not equally efficient in
the exploitation of resources, and consumers welfare also varies accordingly. Hence, the
different aspects of the pricing process should be analysed in relation to the different types of
markets.
Markets may be classified on the basis of different criteria, such as geographical space or
area, time element and the nature of competition.
Chart pinpoints the classification of different types of market structures.

By and large, a market structure relates to the competitive situation of a business

identifying the number of competitive firms, the relative size and strength of the firms, demand
condition, cost and supply condition and the extend of entry business in the industries. These
factors pertaining to a market structure for given business play significant role in the process of
managerial economic decision making.
In view of the space element, or the geographical area covered by the market, we may
enlist the following types of markets:
Local Markets,
Regional Markets,
National Markets, and
World Markets.
I. Local Markets
Markets pertaining to local areas are called local markets. When commodities are bought
and sold at one place or in one locality only have local markets. Local market has a narrow
geographical coverage. It is confined to a particular village, town or city only. Retail trading has
a local market only. Perishable goods like milk, vegetables, fruits, etc. are mostly sold in local
markets. Tailoring shops, dispensaries, restaurants, coaching classes, etc. are confined to the
local markets. Goods supplied only in local markets are usually produced on a small scale.
II. Regional Markets

There are regional markets when goods are sold within a particular region only. For
example, most of the firms produced in regional languages in India have regional markets only.
Similarly, textbooks sanctioned by the Maharashtra State SSC Board have a regional market.
III. National Markets
When goods are demanded and sold on a nationwide scale, there is a national market. The
goods produced by large scale industries tend to have national markets. A large number of items
such as TV sets, cars, scoters, fans, vanaspati ghee, cosmetic products, etc., produced by big
companies have national markets. A good of network of transport and communication and
banking facilities help in promoting national markets.
IV. World markets
When goods are traded internationally, there exist world markets or international markets. In
international markets, goods are exchanged between buyers and sellers from different countries.
In the world market transactions, we use the term exports and imports of goods.
Multinational corporations have world markets for their products. Similarly, export business is
confined to the world market. Incidentally, on geographical or spatial consideration, trade and
markets may also be broadly classified into: (i) domestic or internal and (i) international. We
shall, thus, distinguish between internal trade and international trade.
Market structure crucially determines the business behavior of the firms as well as the conduct
and concentration in industry relating to the pricing policy, product differentiation and
improvements, the ease or difficulty for the entry of the new firms, economic prospects and
economic performance, typically measured in terms of profit earnings or price cost margins of
the firms subject to market conditions.
Market Based on Time Elements
Time element to the functional or operational time period pertaining to production
processes and market forces at work. The time element may be distinguished by the following
functional time periods of varying durations, namely:
Market period,
Short period,
Long period, and
Very long period or secular time.
Considering these time periods, markets may be distinguished as: (1) Very short period
market, (2) Short period market, (3) Long period market, and (4) Very long period market.
1. Very Short Period Market/ Market Period:
The market for a commodity during the market period is referred to as the very short period
market. On functional basis, the market period is regarded as a very short time period during
which it is physically impossible to change the stock of a commodity even by a single unit
further. The basic characteristics of a very short period (or market period) market is that, in this
market it is not possible to make any adjustments in the supply to the changing demand
conditions.

In a very short period market, the equilibrium price of a commodity is referred to as the
market price which is established by the intersection of market period demand and market
period supply.
2. Short period Market:
The market of a commodity during short period is referred to as the short period market. The
short period is a functional time period during which it is possible for a firm to expand output of
a commodity to some extent by changing the variable inputs such as labour, raw materials, etc.,
under its fixed plant size.
3. Long period Market:
The market for a commodity in the long period is referred to as the long period market. The
long period refers to a functional time period which is sufficient to permit changes in the scale of
production to a firm by changing its plant size.
4. Very Long Period Market:
The market for a commodity in the very long period is referred to as the very long period
Market. The very long period market is the secular time period which runs over a series of
decades. During such a very long functional time period, dynamic changes takes place in demand
and supply situations. However, the secular period is of little theoretical significance on account
of the too long period involved in its operations.
Type of Market Structures formed by the nature of Competition
i. Perfect Competition
ii. Monopoly
iii. Oligopoly
iv. Monopolistic Competition
1. Perfect Competition
Perfect Competition is a market structure where there is a perfect degree of competition and
single price prevails.The concept of Perfect Competition was introduced by Dr. Alfred
Marshall. Nothing is 100% perfect in this world. So, this states that perfect competition is only a
theoretical possibility and it does not exist in reality.
A perfect market is one where there is perfect competition. This is a model market. According to
Boulding, the competitive market may be defend as a large number of buyers and sellers all
engaged in the purchase and sale of identically similar commodity, who are in close contact with
one another and who buy and sell freely among themselves.
Main Features of Perfect Competition
The following are the characteristics or main features of perfect competition :-
1. Many Sellers

In this market, there are many sellers who form total of market supply. Individually, seller is a
firm and collectively, it is an industry. In perfect competition, price of commodity is decided by
market forces of demand and supply. i.e. by buyers and sellers collectively. Here, no individual
seller is in a position to change the price by controlling supply. Because individual seller's
individual supply is a very small part of total supply. So, if that seller alone raises the price, his
product will become costlier than other and automatically, he will be out of market. Hence, that
seller has to accept the price which is decided by market forces of demand and supply. This
ensures single price in the market and in this way, seller becomes price taker and not price
maker.
2. Many Buyers
Individual buyer cannot control the price by changing or controlling the demand. Because
individual buyer's individual demand is a very small part of total demand or market demand.
Every buyer has to accept the price decided by market forces of demand and supply. In this way,
all buyers are price takers and not price makers. This also ensures existence of single price in
market.
3. Homogenous Product
In this case, all sellers produce homogeneous i.e. perfectly identical products. All products are
perfectly same in terms of size, shape, taste, colour, ingredients, quality, trade marks etc. This
ensures the existence of single price in the market.
4. Zero Advertisement Cost
Since all products are identical in features like quality, taste, design etc., there is no scope for
product differentiation. So advertisement cost is nil.
5. Free Entry and Exit
There are no restrictions on entry and exit of firms. This feature ensures existence of normal
profit in perfect competition. When profit is more, new firms enter the market and this leads to
competition. Entry of new firms competing with each other results into increase in supply and
fall in price. So, this reduces profit from abnormal to normal level.
When profit is low (below normal level), some firms may exit the market. This leads to fall in
supply. So remaining firms raise their prices and their profits go up. So again this ensures normal
level of profit.
6. Perfect Knowledge

On the front of both, buyers and sellers, perfect knowledge regarding market and pricing
conditions is expected. So, no buyer will pay price higher than market price and no seller will
charge lower price than market price.
7. Perfect Mobility of Factors
This feature is essential to keep supply at par with demand. If all factors are easily mobile
(moveable) from one line of production to another, then it becomes easy to adjust supply as per
demand.
Whenever demand is more additional factors should be moved into industry to increase supply
and vice versa. In this way, with the help of stable demand and supply, we can maintain single
price in the Market.
8. No Government Intervention
Since market has been controlled by the forces of demand and supply, there is no government
intervention in the form of taxes, subsidies, licensing policy, control over the supply of raw
materials, etc.
9. No Transport Cost
It is assumed that buyers and sellers are close to market, so there is no transport cost. This
ensures existence of single price in market.
2. MONOPOLY
Monopoly means a market where there is only one seller of a particular good or service. The
term Monopoly has been derived from Greek term Monopolies which means a single seller.
Thus, monopoly is a market condition in which there is a single seller of a particular commodity
who is called monopolist and has complete control over the supply of his product. He is called a
monopolist. He is the only producer in the industry. There are no close substitutes for his
product. Thus, when there is only one seller of a commodity and there is no competition at all,
the situation is one of pure monopoly. A monopolist firm is itself an industry, for the distinction
between a firm and an industry disappears under monopoly. In technical language, pure
monopoly is a single firm-industry where the cross elasticity of demand between its product and
the products of the other industries is zero.
Pure monopoly rarely exists in reality. It is merely a theoretical concept, because even if there
were no close substitutes, some kind of competition would always be there, such as a choice
between decorating a house or buying a car. However, even though pure monopolies are a rare
phenomenon in developed countries, they are found in developing countries like India in the

form of State monopolies, e.g. the Mahanagar Telephone Nigam Ltd. (MTNL) and the Post and
Telegraph Department of the Government of India.
Characteristics
Only one single seller in the market. There is no competition.
There are many buyers in the market.
The firm enjoys abnormal profits.
The seller controls the prices in that particular product or service and is the price maker.
Consumers dont have perfect information.
There are barriers to entry. These barriers many be natural or artificial.
The product does not have close substitutes.
Salient Features of Monopoly
Single Seller
Under monopoly, there is a single producer of a particular commodity or service in the market
accruing to a rather large number of buyers. The mono manufacturer may be an individual, a
group of partners or a joint stock company or state, being the only source of supply for the goods
or services with no close substitute. In this market structure, the firm is the industry and, thus, the
market is referred to as 'pure monopoly', but, it is more of a theoretical concept. At times, close
substitutes are produced by few manufactures holding a substantial market share and this
imperfect form of extreme market is termed as monopolistic competition.
Restricted Entry
Free entry of new organizations in this market arrangement is prohibited, that is, other sellers
cannot enter the market of monopoly. Few of the primary barriers, constricting the entry of new
sellers are:
I. Government license or franchise

II. Resource ownership
III. Patents and copyrights
IV. High start-up cost
V. Decreasing average total cost
Homogeneous Product

A monopoly firm manufactures a commodity that has no close substitute and is a homogeneous
product. With the absence of availability of a substitute, the buyer is bound to purchase what is
available at the tagged price. For instance: there is no substitute for railways as the 'bulk carrier'.
Thus, to be the sole seller, in the monopolistic setup, a unique product must be produced.
Full Control Over Price
In a monopoly market, restricted entry constricts competition and the monopolist exhibits full
control over the market conditions. The absence of competition spares the monopolizing
company from price pressure and grants him the opportunity to charge the product as per his
advantage, targeting profit maximizing via predetermined quantity choice. Thus, a monopolist is
a 'price maker' and not a 'price taker', wherein he decides the price and the buyers have to accept
it. Nevertheless, to evade the entry from new market participants, the company needs to regulate
the set product or service price within the paradigms of the Monopoly Theorem.
Price Discrimination
Price discrimination can be defined as the 'practice by a seller of charging different prices from
different buyers for the same good or service'. A monopolist has the leverage to carry out price
discrimination as he is the market and acts as per his suitability.
Increased Scope for Mergers
Scope for vertical and/or horizontal mergers increase in lieu of control exhibited by a single
entity under a monopoly. The mergers efficiently absorb competition and maintain the supply
chain management.
Price Elasticity
With regards to the demand of the product or service offered by the monopolizing company or
individual, the price elasticity to absolute value ratio is dictated by price increase and market
demand. It is not uncommon to see surplus and/or a loss categorized as 'deadweight' within a
monopoly. The latter refers to gain that evades both, the consumer and the monopolist.
Lack of Innovation
On account of solitary market domination, monopolies exhibit an inclination towards losing

efficiency over a period of time; new designing and marketing dexterity takes a back seat.
Lack of Competition

When the market is designed to serve a monopoly, the lack of business competition or the
absence of viable goods and products shrinks the scope for 'perfect competition'.
Being the sole merchant of a eccentric good with no close imitation, a monopoly has no
opposition. The demand for turnout induced by a monopoly is the market demand, adhering
extensive market control. The incompetence resulting from market dominance also makes
monopoly a key type of market failure.
Advantages of monopoly
Monopoly avoids duplication and hence wastage of resources.
A monopoly enjoys economics of scale as it is the only supplier of product or service in
the market. The benefits can be passed on to the consumers.
Due to the fact that monopolies make lot of profits, it can be used for research and
development and to maintain their status as a monopoly.
Monopolies may use price discrimination which benefits the economically weaker
sections of the society. For example, Indian railways provide discounts to students
travelling through its network.
Monopolies can afford to invest in latest technology and machinery in order to be
efficient and to avoid competition.
Disadvantages of monopoly
Poor level of service.
No consumer sovereignty.
Consumers may be charged high prices for low quality of goods and services.
Lack of competition may lead to low quality and out dated goods and services.
Classification of Monopoly
1. Perfect Monopoly
It is also called as absolute monopoly. In this case, there is only a single seller of product having
no close substitute; not even remote one. There is absolutely zero level of competition. Such
monopoly is practically very rare.
2. Imperfect Monopoly
It is also called as relative monopoly or simple or limited monopoly. It refers to a single seller
market having no close substitute. It means in this market, a product may have a remote
substitute. So, there is fear of competition to some extent e.g. Mobile (Cellphone) telcom
industry (e.g. vodafone) is having competition from fixed landline phone service industry (e.g.
BSNL).
3. Private Monopoly

When production is owned, controlled and managed by the individual, or private body or private
organization, it is called private monopoly. e.g. Tata, Reliance, Bajaj, etc. groups in India. Such
type of monopoly is profit oriented.
4. Public Monopoly
When production is owned, controlled and managed by government, it is called public
monopoly. It is welfare and service oriented. So, it is also called as 'Welfare Monopoly' e.g.
Railways, Defence, etc.
5. Simple Monopoly
Simple monopoly firm charges a uniform price or single price to all the customers. He operates
in a single market.
6. Discriminating Monopoly
Such a monopoly firm charges different price to different customers for the same product. It
prevails in more than one market.
7. Legal Monopoly
When monopoly exists on account of trade marks, patents, copy rights, statutory regulation of
government etc., it is called legal monopoly. Music industry is an example of legal monopoly.
8. Natural Monopoly
It emerges as a result of natural advantages like good location, abundant mineral resources, etc.
e.g. Gulf countries are having monopoly in crude oil exploration activities because of plenty of
natural oil resources.
9. Technological Monopoly
It emerges as a result of economies of large scale production, use of capital goods, new
production methods, etc. E.g. engineering goods industry, automobile industry, software
industry, etc.
10. Joint Monopoly
A number of business firms acquire monopoly position through amalgamation, cartels,
syndicates, etc, it becomes joint monopoly. e.g. Actually, pizza making firm and burger making
firm are competitors of each other in fast food industry. But when they combine their business,
that leads to reduction in competition. So they can enjoy monopoly power in market.
Imperfect Competition
Theoretically, perfect competition is the simplest market situation assumed by the economists. In
reality, competition is never perfect. So, there is imperfect competition when perfect form of
competition among the sellers and the buyers does not exist. This happens as the number of firms
may be small or p[roducts may be differentiated by different sellers in actual practice. There is
no pure monopoly in reality, Imperfect competition covers all other forms of market structures
ranging from highly competitive in nature. Traditionaily, oligopoly and monopolistic
competition are categorized as the most realistic forms of market structures under imperfect
competition

3. Oligopoly:
Oligopoly refers to the market structures where are a few sellers (more than to but not too many)
in a given line of production. Fellner defines oligopoly as competition among the few. In an
oligopolistic market, firms may be producing either a homogeneous product or may have product
differentiation in a given line of production, the oligopoly model fits well in such industries as
automobile, manufacturing of electrical appliances, etc, in our country.
Following are the distinguishing of an oligopolistic market :
There are a few sellers supplying either homogeneous products or differentiated products.
Firms have a high degree of interdependence in their business policies in fixing price and
determining output
Firms under oligopoly have always the fear of retaliation by rivals
Competition is of a unique type in an oligopolistic market. Here, each oligopolist faces
competition, and has to wage a constant struggle against his rivals
Advertising and selling costs have strategic importance to oligopolist firms.
4. Monopolistic competition
Monopolistic competition refers to the market structure in wich there are a large number of
firms producing similar but not identical products. Monopolistic competition is a blend of
monopoly and competition. monopolistic competition is similar to perfect competition in that it
has a large number of sellers, but its dissimilarities lie in its product differentiation. In perfect
competition, goods are identical or homogeneous, while in monopolistic competition. Products
are differentiated through trade marks, brand names, etc. for example, in soft drink market
products are distinguished by brand names such as thums up, limca, etc product differentiation
confers a degree of monopoly to each seller in a market under Monopolistic competition. Thus,
in such a market, many monopolists compete with each other on the selling side. There are a
large number of buyers too but each buyer has preference for a particular seller or a brand of the
product in the market. For instance, a smoker may prefer panama brand cigarettes to wills.
Following are the major characteristics of monopolistic competition:
There are a large number of sellers.
There are a large number of buyers.
There is product differentiation. Each seller tries to distinguish his product from the rest.
Each seller resorts to advertising and sales promotion efforts. Thus selling costs are a
unique feature of Monopolistic competition
Monopolistic competition has two aspects:
(1) price competition, i.e,. sellers compete in price determination, and
(2) non price competition, i.e,. sellers compete through product improvements and
advertising sales promotion efforts.

COMPETITIVE EQUILIBRIUM PRICE

Perfect competition in practice :
Perfect competition is an ideal concept of market rather then an actual
market reality. By and large, the perfect competition model fits into the market for farm
products. For instance, in the markets for rice, wheat, cotton, millet and foodgrains, fruits,
vegetables, eggs, milk, etc., there is a large number of buyers and sellers and for all practical
purposes, the products are physically identical. But, outsider of agriculture, prefect competition
is a rare phenomenon. In fact, in present day economics , the competitive market is becoming
less and realistic even in agriculture products.
Theoretical importance of the perfect competitive market model
Despite perfect competition being regarded as not very realistic phenomenon, the beginning of
economic analysis is usually made with the competitive market model for the following reasons:
It is a simple and convenient form of market structure to understand.
It is also a near abstraction of the market economy when capitalism ruled supreme.
It provides us a clear insight into how a market economy works.
It helps us to form a clear perception of the basic principles governing the functioning of
the market economy
It serves as a first step in understanding the nature of more complex forms of market
structures.
It regarded as an ideal form of market on normative grounds.
In fact, people competition is honoured or its perfect efficiency and optimum allocation
of resources. It leads to such rational price determination at which total demand supply
are in the long- run optimally adjusted.
It provides a standard to judge the economic efficiency and welfare implication of less
competitive types of markets.
Competitive markets are not totally absent. Such markets are still found in some areas,
e.g. food grain markets in our country are highly competitive.
Perfect competition, though a limiting and much simplified model of market structure in
theory, is a very useful concept for studying the laws of markets as well as for understanding
the mechanics of business decision making in practice.
Price Determination Under Perfect Competition

In a market, the exchange value of a product expressed in terms of money is called price. In a
market economy, the equilibrium price is determined by the market forces.

Under perfect competition, there is a single ruling market price-the equilibrium price, determined
by the interaction of forces of total demand (of all the buyers) and total supply (of all the sellers)
in the market.
Thus, both the market or equilibrium price and the volume of production in a market under PE R
F E C T competition are determined by the intersection of total demand and total supply. To
elucidate the prices of intersection, let us consider hypothetical data on market demand for and
market supply of wheat, as in table 14.1.
Table.14.1: Market Demand and Supply Schedules for Wheat
Possible price Total Demand Total Supply Pressure on price
(Rs. Per kg) (Kg. per Week) (Kg. per week)
20 1,000 10,000 Downward
19 3,000 8,000 Downward
18 4,000 6,000 Downward
17 5,000 5,000 Neutral
16 7,000 4,000 Upward
15 10,000 2,000 Upward
Comparing the market demand and supply position at alternative possible prices, we find that
when the price is Rs 20, supply of wheat is 10,000 kg., but demand for wheat is only 1,000 kg.
Hence,9,000 kg., of wheat supply remains unsold. This would bring a downward pressure on
price, as the seller would compete and the force will push down the price. When the price falls to
Rs 19, Demand rises to 3,000 kg., while the supply will contract to 8,000 kg., Still the supply is
in excess of demand. Thus, the surplus of the supply causes a further downward pressure on
price. Eventually, the price will tend to fall. This process continues till the price settles at Rs 17
per kg. At which the same amount (5,000 kg) is demanded as well as supplied. This is termed as
equilibrium price. Equilibrium price is the market clearing price. In this price, market demand
tends to be equal to the market supply.
If, However, we begin from a low price (RS 15 per kg.), we find that the demand (10,000 kg)
exceeds the supply (2,000 kg). Thus, there is a shortage at Rs 15 per kg. This causes an upward
pressure on the price, so the price will tend to moveup. When the price rises, the demand
contracts and the supply expand. This process continues till the equilibrium price is reached,at
which the demand becomes equal to the supply. At equilibrium price, there is neutral pressure of
demand and supply forces as both are equal in quantity. In general, a pictorial depiction of price
is determined at the intersection point of the demand curve and the supply curve.
Fig.14.1: Market Price Determination

In figure 14.1 PM is the equilibrium price, at which OM is the quantity demanded as well as
supplied. At point P, The demand curve intersects the supply curve. To understand the process of
equilibrium, suppose the price is not at the equilibrium point. Now, if the price is higher than the
equilibrium price, as OP1, then at this price the supply is P1b, while the demand is P1a. Thus,
there is a surplus amounting ab. That is to say, more is offered for sale than what the people are
willing to buy at the prevailing price. Hence, to clear the stock of unsold output, the competing
sellers will be induced to reduce the price. Eventually, a downward movement and adjustment,
as shown by the downward pointed arrows, will begin, which would lead to (i) the contraction of
supply, as the firms will be prompted to reduce their resources in the industry, and (ii) the
expansion of demand, as the marginal buyers* and other potential buyers will be attracted to buy
in the marker and old buyers also may be induced to buy more at the falling price. Similarly, if
the price is below the equilibrium level, the demand tends to exceed the supply.
At OP2 price, for instance, the demand is P2d, while the supply is P2c. Thus, there is a shortfall of
supply amounting to cd. That is to say, buyers want to purchase more than what is available in
the market at the prevailing price. This induces the competing buyers to bid up the price. So, an
upward push and adjustment will develop as shown by the arrows pointed upwards. Thus, the
demand contracts as marginal buyers will be driven away from the market and some buyers will
buy less than before. On the other hand, the supply expands as the existing firms will increase
their output to which new firms will also add their output. Evidently, when the price is set at an
equilibrium point at which demand curveintersects the supply curve, shortages and surpluses,
disappear, hence there is perfect adjustment between demand and supply under the given
conditions. So long as demand and supply positions are unchanged, the ruling equilibrium price
will prolong over a period of time.
Significance of Time Element

The element of time occupies a pivotal place in the Marshallian theory of value. According to the
traditional value theory, the forces of demand and supply determine the price. The position of
supply is greatly influenced by the element of time taken into consideration. Here, time refers to
the operational time period pertaining to economic action and force at work. Functionally, the
supply of a commodity relates to his operational time involved regarding adaption of firms in
their production activity. Supply is thus adjusted in relation to the changing demand in view of
the time span given for such adjustment.
According to Marshall, the time element may be distinguished by the fallowing three time
periods of varying durations, namely: (1) market period (2) short period and (3) long period.
Price determination, in view of this time span,may be conceived as market period price, short
period price and long period price.
Market Period Price
The market period is a very short period. During this period, it is practically impossible to alter
output or increase stock. Thus, supply of the commodity tends to be perfectly inelastic. During
the market period, potential supply (the stock) and actual supply tend to be identical thus, the
market period or for brevity, the market price is determined by the iteration of market period
demand and supply as shown in figure 14.2.
Fig.14.3.1: Market Period Price

In a panel (A) of figure 14.2, the SS supply curve is vertical straight line, representing perfectly
inelastic supply. DD is the demand curve.
In figure 14.2 (A), the intersection between demand curve (DD) and supply curve (SS)
determines the equilibrium price OP at which demand is equal to supply (OQ).
Supply being fixed during the market period; the equilibrium price - the market period price
tends to be solely governed by the changes in demand condition. Evidently as demand increases,
the market price rises correspondingly and when demand decrease, the price also decreases to
that extent. The point is clarified in panel (B) of figure 14.2 (a) shifts in the demand curve from
DD to D1D1 means an increase in demand along with which the new equilibrium price rises from

OP to OP1. Similarly, there is a decrease in demand as presented by the curve D2D2, the new
price is also set at OP2 level.
Short Period Price
The short period is that functional time period during which the size of the firm and the scale of
production remain unchanged. Hence, during the short period, the stock of a given commodity
can be increased only to a limited extent. As such the supply curves of the existing firms will
tend to be relatively inelastic. Therefore, the supply curve of industry or the market will also be
relatively inelastic.
The short period price is determined by interaction of the forces of short run demand and
supply. In graphical terms, the short period equilibrium price is determined at the point of
intersection between the short run demand curve and short run supply curve as shown in fig.
14.3.
Fig.14.3:Short Period Price

In figure 14.3, SS is the short run market demand curve which has a steeper slope, indicating
relatively inelastic supply (es>1). DD is the Short run market demand curve. OP is the
equilibrium price, at which OQ is the quantity demanded as well as supplied.
Indeed, in short run price determination also, demand forces tend to have greater impact as
compared to the supply force. Thus, when the short run demand increases, there is some
variation in supply in the process of adjustment, but adjustment tends to be imperfect and much
less than the market requirement. Short period price is also referred to as subnormal price.
Long Period Price
Long period is the sufficient functional time period during which the firm can change its size and
the scale of production. Thus, in the long, therefore the supply curve of an industry tends to
become relatively elastic.

Consequently, interaction between long run supply and demand determines the long period
equilibrium price. Geographically, the long run price is determined at the point of intersection
between the long run demand and supply curves, as shown in fig. 14.4.
Fig.14.4: Long Period Price

In figure 14.3.SS is the long run supply curve which is flatter curve, indicating relatively
elastic supply (es>1). DD is the long run demand curve which is also more elastic OP is the
equilibrium price at which OQ is demanded as well as supply.
In the long run as compared to the demand force, the supply force becomes a dominant factor
in determining the equilibrium price. The Long run price is also described as normal price.
Concluding Remarks
The Marshallian time analysis suggests that the degree of elasticity of supply tends to vary in
relation to time. The supply tends to be relatively inelastic in the short run and relatively elastic
in the long run. Again, in the short period, the utility of the commodity concerned has greater
significance in the determination of its value (i.e., value in exchange or price). In the long run,
the supply factor bears greater influence upon the equilibrium price determination. The supply
factor is based on the cost element. Thus, in the long run, cost considerations has greater
significance in the determination of value in fine, we may quote Marshall Actual value at any
time, the market value as it is often called, is often influenced by passing events and causes
whose action is fitful and short lived than by those which work persistently. But in long
periods, these fitful and irregular causes, in a large measure, efface one anothers influence that
in the long run, persistent causes dominate values completely.
Market Price and Normal Price

A distinction is often made between market price and normal price. The fallowing points may be
enumerated in this regard.
Market price, in its strict sense, refers to the market period price. It is the equilibrium price
determined by the interaction of day to day demand and supply. Normal price on the other
hand, refers to the long period price. It is the equilibrium price determined by the forces of long
run demand supply.

MEANING OF MONOPOLY
Monopoly is a form of market structure in which a single seller or firm has control over the
entire market supply, as there are no close substitutes for his products and there are business to
the entry of rival producers. This sole seller in the market is called monopolist.
FEATURES OF MONOPOLY
1. Single firm: The monopolist is the single producer in the market. Thus, under monopoly
firm and industry are identical.
2. No substitutes: There are no closely competitive substitutes for the product. So, the
buyers have no alternative or choice. They have either to buy the product or go without
it.
3. Antithesis of competition: Being a single source of supply, monopoly is a complete
negation of competition.
4. Price maker: A monopolist is a price maker and not a price-taker. In fact, his price
fixing power is absolute. He is in a position to fix the price for the product as he likes.
He can vary the price from the buyer to buyer. Thus, in a competitive, there is single
ruling price, while in a monopoly, there may be price differentiations.
5. Downward sloping supply curve: A monopoly firm itself being the industry, it faces a
downward sloping demand curve for its product. That means it cannot sell more output
unless the price is lowered.
6. Entry barriers: A pure monopolist has no immediate rivals due to certain barriers to
entry in the field. There are legal, technological, economic or natural obstacles, which
may block the entry of new firms.
7. Price-cum-output determination: Since a monopolist has a complete control over the
market supply in the absence of a close or remote substitute for his product, he can fix the
price as well as quantity of output to be sold in the market.

The Benefits of monopoly

The benefits of monopoly power to the economic society depend, to the some extent upon the
attitude and behavior of the monopoly firm.
1. Workers may benefit. Workers in a monopoly firm will tend to be better off the
monopoly profits are shared with the workforce by provided better working condition and
facilities.
2. Growth of R&D. research and development may be facilitated by reinvestment of
monopoly profit.
3. Innovation & growth initiation. High concentration economic power or large firm size
may be more conducive to a higher rate of innovation.
4. Economies of scale and slope. This can be realized through the production of
innovation.
5. Capability. Large firm can easily bear the high cost involved in innovation.
6. Risk spreading. Through diversification of output. The large firm can spread the risk
R&D.
7. Availability of finance. Large firm can easily arrange for the financial requirements of
the R&D through internal as well as external sources.
8. Incentives. With a command over a greater market power, the large or monopolistic firm
can easily appropriate the returns from innovation. As such there are greater incentives
for the large firms to undertaken innovation.
9. Contribution to public revenue. The government can obtain good revenues through
high corporate taxes imposed on monopoly profits earnings of the firm. This may also
serve as a means curb the undue growth of monopoly power.
PRICE-OUTPUT DETERMINATION UNDER MONOPOLY:

A firm under monopoly faces a downward sloping demand curve or average revenue
curve. 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,
PL is the profit per unit. Now the total profit is equal to PL (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.
MONOPOLISTIC COMPETITION
MEANING:
Monopolistic competition is that form of the market in which there are many sellers of a
particular product, but each seller sells somewhat different products. It is also called as Imperfect
Competition.
For EX: SOAP MARKET, where LUX is exhibited to be beauty soap, LIRIL is more related
with freshness, while DETTOL is exhibited as an antiseptic soap.
CHARACTERISTICS OF MONOPOLISTIC COMPETITION

1. Large Number of Sellers:

A market organization characterized by monopolistic
competition must have a sufficiently large number of sellers or firms selling closely related, but
not identical products. The large number of firms, in the same line of production, leads to
competition. Since there is no homogeneity of goods supplied, competition tends to be pure but
keen. The number of firms being relatively large, there are less chances of collusion of business
combines to eliminate competition and to rig (arrange to gain) prices.
2. Product Differentiation:
It is one of the most important features of monopolistic competition.
Each firm produces a different brand or variety of the same products. The variety produced is
closed substitutes of one another. Since all the brands are close substitutes of one another, the
seller will lose some customers to his competitors. Products like toothpaste, soap and lipstick are
prominent examples.
3. Large Number of Buyers:

There are large numbers of buyers in this type of market. However,
each buyer has a preference for a specific brand of the product. He thus becomes a patron of a
particular seller. Unlike perfect competition, here buying is by choice and not by chance.
4. Free entry and exit :

There are free entry and exit firms. It implies that in the long run firm will
earn only normal profits.
5. Non Price Competition:

In this type of market sellers try to compete on basis other than price,
and it is called non-price competition. They incur advertising costs. It is because of the need to
maintain a perception in the mind of the potential customers that their respective brands are
different compared to other brands.
6. Every firm is price maker and taker of his own product:
In monopolistic competition product are
differentiated for every firms and so costs of every firm and the cost of products manufactured
by the firms are also different. Thus every firm is price maker and price taker for their products.
7. Imperfect Mobility:
Here factors of production are completely not mobile. Buyers have their
own preference and sellers have their own preference.
Examples of monopolistic competition

Examples of monopolistic competition can be found in every high street.Monopolistically
competitive firms are most common in industries where differentiation is possible, such as:

The restaurant business

Hotels and pubs
General specialist retailing
Consumer services, such as hairdressing
PRICE DETERMINATION UNDER MONOPOLISTIC COMPETITION:

Under monopolistic competition, the firm will be in equilibrium position when marginal revenue
is equal to marginal cost. So long the marginal revenue is greater than marginal cost, the seller
will find it profitable to expand his output, and if the MR is less than MC, it is obvious he will
reduce his output where the MR is equal to MC. In short run, therefore, the firm will be in
equilibrium when it is maximising profits, i.e., when MR = MC.
(a) Short Run Equilibrium: Short run equilibrium is illustrated in the following diagram:
Diagram: Monopolistic Competition Short Run Equilibrium
In the above diagram, the short run average cost is MT and short run average revenue is
MP. Since the AR curve is above the AC curve, therefore, the profit is shown as PT. PT is the
supernormal profit per unit of output. Total supernormal profit will be measured by multiplying
the supernormal profit to the total output, i.e. PT OM or PTTP as shown in figure (a). The
firm may also incur losses in the short run if it is facing AR curve below the AC curve. In figure
(b) MP is less than MT and TP is the loss per unit of output. Total loss will be measured by
multiplying loss per unit of output to the total output, i.e., TP OM or TPPT.
(b) Long Run Equilibrium: Under monopolistic competition, the supernormal profit in the long
run is disappeared as new firms are entered into the industry. As the new firms are entered into
the industry, the demand curve or AR curve will shift to the left, and therefore, the supernormal
profit will be competed away and the firms will be earning normal profits. If in the short run
firms are suffering from losses, then in the long run some firms will leave the industry so that
remaining firms are earning normal profits.

The AR curve in the long run will be more elastic, since a large number of substitutes will be
available in the long run. Therefore, in the long run, equilibrium is established when firms are
earning only normal profits. Now profits are normal only when AR = AC. It is further illustrated
in the following diagram:
OLIGOPOLY MARKET
Meaning of oligopoly:
It is a market situation comprising only a few firms in a given line of production. Their
products may be standardized or differentiated. The price and output policy of oligopolistic firms
are interdependent. The oligopoly model fits well into such industries as automobile,
manufacturing of electrical appliances, etc, in our country.
In fast food industry, for example, in case of burger, etc., we come across only a few
prominent brand suppliers such as McDonalds, KFC, King burger. Network of mobile phone
services are provided by Airtel, Vodafone, Tata and MTNL. Ready-to-eat breakfast industry is
dominated by Corn Flakes, Nestle, Kraft and Quaker Oats with a few others. There are only a
few prominent brands of television set in India, such as, Sony, Samsung, LG, and Videocon.
Feller defines oligopoly as competition among the few. In an oligopolistic market, the
firms may be producing either homogeneous products or may be having product different0iation
in a given line of production.
Features
The following are the distinguishing features of an oligopolistic market:
Few sellers : there are a few sellers supplying either homogeneous products or
differentiated products.

Homogeneous or distinctive product : the oligopoly firm may be selling a

homogeneous product. For example, Steel/Aluminium/Copper. these can be a unique or
distinctive product. For example, Automobile-Passenger Cars.
Blockading entry and exit : firms in the oligopoly market face strong restrictions on
entry or exit.
Imperfect dissemination of information : detailed market information relating to cost,
price and product quality are usually not publicized.
Interdependence : the firms have a high degree of interdependence in their business
policies about fixing of price and determination of output.
Advertising : advertising and selling costs have strategic importance to oligopoly firms.
it is only under oligopoly that advertising comes fully into its own. Each firm tries to
attract consumers towards its product by incurring excessive expenditure on
advertisements.
High cost elasticities : the firm under oligopoly have a high degree of cross elasticities of
demand for their products, so there is always a fear of retaliation by rivals. Each firm
consciously consider the possible action and reaction of its competitors while making any
changes in the price or output.
Constant struggle : competition is of unique type in an oligopolistic market. Here,
competition consist of constant struggle of rivals against rivals.
Lack of uniformity : lack of uniformity in the size of different oligopolies is also a
remarkable characteristic.
Lack of certainty : lack of certainty is also an important feature. In oligopolistic
competition, the firms have two conflicting motives. (i) to remain independent in decision
making, and (ii) to maximize profits, despite the fact that there is a high degree of
independence among rivals in determining their course of business. To pursue these ends,
they act and react to the price-output variation of one another in an unending atmosphere
of uncertainty.
Price rigidity : in an oligopolistic market, each firm sticks to its own price. This is
because, it is in constant fear of retaliation from rivals if it reduces the price. It, therefore,
resorts to advertisement competition rather than price-cut. Hence, there is price rigidity in
an oligopolistic market.
Kinked demand curve : According to Paul Sweezy, firms in an oligopolistic market
have a kinked demand curve for their product.
Kinked demand curve

The kinked demand curve or the average revenue curve is made of two
segments. (i) the relatively elastic demand curve and (ii) relatively inelastic demand
curve.

Corresponding to the given price OP, there is a kink at point K on the demand curve DD. Thus,
DK is the elastic segment and KD is the inelastic segment of the curve. Here, kink implies an
abrupt change in the slope of the demand curve. Before the kink point, the demand curve is
flatter. After the kink, it becomes steeper.
Above the kink at a given price, demand curve is more elastic and below the kink less elastic.
The kink leads to indeterminateness of the course of demand for the product of the seller
concerned. He thus, thinks it worthwhile to follow the prevailing price and not to make any
change in it, because raising of price would contract sales as demand tends to be more elastic at
this stage. There is also the fear of losing buyers to the rivals who would not raise their prices.
On the other hand, a lowering of price would imply an immediate retaliation from the rivals on
account of close interdependence of price-output movement in the oligopolistic market. Hence,
the seller will not expect much rise in his sale with price reduction.
Kinked Demand Curve Theory of Oligopoly Price

An important point involved in kinked demand curve is that it accounts for the kinked average
revenue curve to the oligopoly firm. The kinked average revenue curve, in turn, implies a
discontinuous marginal revenue curve MA-BR. Thus, the kinky marginal revenue curve explains
the phenomenon of price in the theory of oligopoly prices.

Because of discontinuous marginal revenue curve(MR), there is no change in equilibrium output,

even though marginal cost changes hence, there is price rigidity. OP does not change.
It is observed that quite often in oligopolistic markets, once a general price level is
reached whether by collusion or by price leadership or through some formal agreement, it tends
to remain unchanged over a period of time. This price rigidity is on account of conditions of
price interdependence explained by the kinky demand curve. Discontinuity of the oligopoly
firms marginal revenue curve at the point of equilibrium price, the price-output combination at
the kink tends to remain unchanged even though marginal cost may change.
It can be seen that the firms marginal cost curve can fluctuate between MC1 and MC2 within
the range of the gap in the MR curve. Without disturbing the equilibrium price and output

position of the firm. Hence, the price remains at the same level OP, and output OQ, despite
change in the marginal costs.
Pattern of behavior in oligopolistic markets

Haynes, Mote and Paul(1970), have enlisted the following important patterns of behavior
normally observed in oligopolistic markets:
Price leadership
A traditional leader in the oligopoly market announces price changes from time to time
which other competitors follow. The dominant firm may assume the price leadership. There is
barometric price leadership when a smaller firm tries out a new price, which may or may not be
recognized by the larger firms.
The price leadership of a firm depends on a number of factors, such as:
a) Dominance in the market : dominating position in the market is achieved by the firm
when it claims a substantial share of the market.
b) Initiative : when the firm develops a product or a new sales territory.
c) Aggressive pricing : when the firm charges lower prices aggressively and captures a
sizeable market.
d) Reputation : when the firm acquires reputation for sound pricing and accurate decisions
due to its long standing in the business, the other firms may accept its leadership.
In the oligopoly market, price leadership of a dominant firm is a unique phenomenon. A leader
firm usually is the most reputed firm in the circle, or the most efficient one or the dominating
firm determines with its own perception of the total industry profit maximizing price. Then, the
followers firms also set their price at the same level in a co-operative mood to avoid price
competition. Often in a oligopoly market, therefore, once the price is set by the leader firm, the
followers firm too set the same price and tend to compete on the layers of non-price
competition, such an advertising and other methods of marketing.
As such, the price of the price of the product in an oligopoly market tend to remain constant and
there is a least chance of price competition, unless and until the leader firm charges the price.
There is, however, no written agreement on this issue. But, there is an implicit practical norm
seen at times followed by the oligopolist firm in certain business such as the steel, cigarette, oil,
tyre, cellphones, tanks and so on.
Price wars
Under cut-throat competition among the rivals, price wars may emerge in an oligopolistic
market. Under price wars, firm tend to charge prices even below their variable cost. Price wars
are never planned. They occur as a consequence of one firm cutting the prices and others
following it.
Price-cuts to weed out competition

A financially strong firm may deliberately resort to price-cuts to eliminate competitors

from the market and secure its position.
Collusion
Business syndicates or trusts may be formed by the competing firms and agree to charge
a uniform price, thereby to eliminate price retaliation or price-cut competition. Such business
collusion implies conversion of an oligopoly into a monopoly. Business collusion is
considered illegal under anti-trust laws, such as the competition Act, 2002, in India.
Cartel
In some cases, business cartels are the unique feature of oligopoly. In this case, the
existing sellers forms an agreement on controlling market supply jointly and determining the
price for their output with the creation of monopoly power. The OPEC is an international cartel
in the worlds petroleum market.
Cartels are formed to enjoy a monopoly power. It is, however, regarded to be more
harmful than the monopoly by is itself. A monopoly is supposed to be creating some harms of
consumer exploitation only when the seller intends to exercise this monopoly power. Cartel, on
the other hand, is just designed to earn monopoly profit to the collaborating members by
restricting the output and using the monopoly power straight away to raise the price.
Cartels violates competitive spirit and the laws.
In a country, such as Korea, for instance, the cartel is, thus, regarded as the public enemy
number one in the market economy. The Korea Fair Trade Commission(KFTC) undertakes strict
actions against cartels. Cartels regulations is emphasized in the enactment at the Monopoly
Regulation and Fair Trade Act(MRFTA) of the Korean business law passed in 1981. In the new
millennium, there has been an increasing trend in the number of prosecution against cartel
members in Korean business.
In practice, however, detection of cartel is not an easy task. Often, information reward
system and insider information resorted to for the detection. Amnesty plus and leniency
programme are also introduced to increase the rate of detection.
By and large, relatively more a centralized Cartel then it is more powerful and effective in
raising the price due to its higher degree of monopoly power in the market (see, Griffin, 1989).
Determination of Cartel Duration and Success

Number of Firms : there is a negative relationship between the number of firms in the
Cartel and its duration. This is for the obvious reason of co-ordination problems and
intensities when the number of firms is large.
Industry concentration : Cartel duration tends to be longer lasting when there is a
higher degree of industry concentration. That is, when a large market share is controlled
by the Cartel members.

Large customer : Instability of Cartel would be more when selling to relatively large
buyers as they may provide incentive for a Cartel is presumed under an increase in
demand growth.
Demand growth : a negative effect on duration of Cartel is presumed under an increase
in demand growth.
Economic and demand stability : stable demand in an industry will sustain a Cartel for
a long duration. Cartels are destabilized by the instability of demand. Apparently, violent
economic changes create negative effect on stability and duration of Cartel in oligopoly
markets.
Organization features : the success and durability of Cartel is conditioned by its internal
organizational characteristics such as existence and execution of penalties on defector
firms, narrowness of product scope in the market, specialized and complex governance
structure.
Internal conflict : Cartels are destabilized or have breakdown due to internal conflicts
and defection by the member firms. Disagreement over market conflicts and defection by
the member firms. Disagreement over the market shares, bargaining and monitoring
prices wars have caused breakdown of Cartels in several cases of opportunistic behavior
of Cartel members.
Technological change : in some cases of technological change, such as rubber industry,
zinc, etc., cartel have natural breakdown.
To sum up, usually with larger duration in greater market shares are more concentrated
industries. Lesser concentration and lower market share is linked to a shorter duration of
Cartels. Cartels are destabilized by instability of economic and business situation in the
markets. By and large, external factors and their relationship exert influences on the
success and stability in Cartels in general (see, Levenstein Margaret and Valerie Suslow,
2001)
Secret Price Concessions

Sometimes, oligopolies may offer secret price concessions for selected buyer
instead of having an open price-cut, which is likely to be retaliated by their rivals.
Non-price Competition
Owing to the danger of retaliation in price-cut competition, the oligopolists may also
resort to non-price competition in sales promotion efforts, advertising, product improvement, etc.
Here, too, the rivals do retaliate.

PRICE DISCRIMINATION
Price discrimination refers to the practice of a seller of selling the same good at different prices
to different buyers. A seller makes price discrimination between different buyers when it is both
possible and profitable for him to do so. Price discrimination is not a very common phenomenon.
It is very difficult to charge different prices for the identical good from different customers.
Frequently, the product is slightly differentiated to successfully practice price discrimination.
In the words of Mrs. John Robinson The act of selling the same article, produced under single
control at different prices to different buyers is known as price discrimination. Also Prof. Stigler
defines Price discrimination as the sales of technically similar products at prices which are not
proportional to marginal cost As per this definition, a seller is indulging in price discrimination
when is charging different prices from different buyers for the different varieties of the same
good if the differences in prices are not the same as or proportional to the differences in the cost
of producing them. For Example, If the manufacturer of a mobile of a given variety sells at Rs.
10.000/- to one buyer and at Rs. 11,000/- to another buyer, (Specific Model) he is practicing
price discrimination.
Price discrimination is not possible under perfect competition, even if the two markets could be
kept separate. Since market demand in each market is perfectly elastic, every seller would try to
sell in that market in which could get the highest price. Competition would make the price equal
in both the markets. However, price discrimination is possible and profitable only when markets
are imperfect.
TYPES OF PRICE DISCRIMINATION
Price discrimination is of various types. Some of them are as follows:

1. Personal price discrimination: It may be personal based on the income of the customer.
For example, Doctors and Lawyers charge different fees from different customers on the
basis of their income. Higher fees are charged to rich persons and lower to the poor.
2. Geographical or Local discrimination: There is geographical price discrimination when a
monopolist sells in one market at a higher price than in the other market. For example, in
a posh locality, a beauty parlor may be charging more while charging lower rate for the
same service in a common locality.
3. Discrimination on the basis of Nature of the Product: Different prices are charged when
there is a difference in the quality of the product. For example, Unbranded products, like
open tea, are sold at lower prices than branded tea like Brooke Bond or Tata tea.
4. Discrimination on the basis of Age, Sex and Status: Here different prices are charged on
the basis of age, sex and status of consumers. For example, railways fare for children and
senior citizens are different, various states in India there is no fees for girls in schools and
in case of Toll tax all MLAs, MPs and Ministers are exempted.

5. Discrimination on the basis of Time: Different rates may be charged for a service
depending upon time. For example, Telephone STD call rates at day time and night.
Besides, advertising rates on TV based on prime time and non prime time.
6. Discrimination on the basis of Use of product / Service: Prices differ according to the use
to which the product is utilized. For example, electricity per Unit rates are different for
users as domestic use, Farm use and industrial use.
Degree of Price Discrimination

The extent and mode of price discrimination depend on circumstance. Prof A. C. Pigou has
distinguished between the three degrees of price discrimination.
1. Price discrimination of the First Degree
2. Price discrimination of the Second Degree
3. Price discrimination of the Third Degree.
1. First Degree Price Discrimination

It is the extreme case of price discrimination . Under this, the monopolist charges
different prices to different unit if the same product . The price charged for each unit, in
each buyers case , is set in accordance with the marginal utility the buyer estimates and
thus at what maximum price he is willing to pay for it . Under first degree price
discrimination, the entire consumers surplus of the buyer is converted into monopolists
revenue and profits.
Perfect Price Discrimination

First degree price discrimination may better be called perfect discrimination .

When a monopolist can charge each buyer the highest price that he/she is willing to pay ,
the price discrimination is perfect . The above figure illustrate perfect discrimination
through a diagrammatic model.
The monopoly firm equates its supply curve with demand curve and produces
OQ level output. The firm charges each buyer a price which he is willing to pay the
most highest say, he may be charging Rs 19 to a buyer which he is willing to pay utmost.
He charges Rs 9 to a buyer who is willing to pay only up to Rs 9 for the unit and so on.
There are two major problems encountered in resorting to perfect price
discrimination . First, the monopolist should know perfectly well as to how much
maximum price buyer is willing to pay.
In practice, these conditions cannot be perfectly well . Often, therefore, price
discrimination tends imperfect . It may be met practically well . It may be of a second
degree or third degree price discrimination.
2. Second Degree Price Discrimination

Under this category discrimination, the monopolist sells blocks of output at
different prices . Here, the possible maximum price is charged for some given minimum
block of output purchased by the buyer and then the additional blocks are sold at
successively lower prices.
Thus, when first degree price discrimination is case of unit-wise differing , the
second degree price discrimination is a case of block wise differing prices . In the
second degree price discrimination, the monopolist captures a part of the consumers
surplus and not the whole of it.

Thus, in the case of public utilities , like supply of electricity, telephone services,
gas services, rail and bus transport services, etc., the services are given in blocks of small
units, such as kilowatts of distance, etc.,
3. Third Degree Price Discrimination
Third degree price discrimination price discrimination is the most common type
of monopolist price discrimination in which the firm divides its total output into many
sub market and sets different prices for its product in market in relation to the demand
elastics . The third degree price discrimination , thus, crucially differs from the second
degree one in one respect that in the latter case, the price tends to be minimum as per the
marginal utility of the marginal buyers , while in the case of the former, price depends on
the allocation of the output.
The below figure represents the case of third degree price discrimination .Two
markets are taken into account . Demand curves for the market I and market curve II are
D1 and D2 respectively.D1 is less elastic and D2 is more elastic demand curve . When
the monopoly firm produces Q1Q2 total output , it distributes OQ amount in market I
and OQ2 in market II.
The Ingredients for Discriminating Monopoly: Conditions Essential for Price

Discrimination
Monopoly
Segmentation of the Market
Apparent Product Differentiation

Buyers Illusion
Prevention of resale or re-exchange of goods
Non-transferability characteristics of goods
Let-go attitude of buyers
Legal sanction
Product Differentiation Pricing

A marketing process that showcases the differences between products. Differentiation looks to
make a product more attractive by contrasting its unique qualities with other competing products.
Successful product differentiation creates a competitive advantage for the seller, as customers
view these products as unique or superior.
Firms seek to be unique along some dimension that is valued by consumers.
Differentiation can be based on the product itself, the delivery system, or the marketing
approach.
If the firm/product is unique in some respect, the firm can command a price greater than
cost.
Full cost (cost-plus) pricing

Under this method, the cost of product is calculated and a fair percentage of profit margin
is added hence, the price of the product is determined.that is
PRICE=COST+FAIR PROFIT MARGIN
Cost means full allocated cost at current output n wage levels. according to Joel
Dean(1972) there are 3 different concepts of cost used in the formula of full costing
pricing.
Actual cost usually means historical cost for the latest available period. It includes wages,
materials, overheads charges etc
Expected cost means forecast of actual cost for the pricing period on the basis of the
expected prices, output ratios, efficiency
Standard cost means normal cost at some normal rate of output with efficiency at some
standard level, which may be normal level or an optimum level
Fair profit means a fixed percentage of profit mark up. It differs from industry to industry
and among firms
Price skimming
Price skimming is a product pricing strategy by which a firm charges the highest initial price that
customers will pay. As the demand of the first customers is satisfied, the firm lowers the price to
attract another, more price-sensitive segment.
The causes for the adoption are:

1) Heavy expenditure on a new product

2) Absence of competition at the initial stage
3) Demand is relatively less elastic
4) Suitable for luxurious products
5) Early recovery of initial investment
6) Attracting the consumers of high income group
7) Earning high rate of profit at the initial stage
Price Penetration
A marketing strategy used by firms to attract customers to a new product or service. Penetration
pricing is the practice of offering a low price for a new product or service during its initial
offering in order to attract customers away from competitors. The reasoning behind this
marketing strategy is that customers will buy and become aware of the new product due to its
lower price in the marketplace relative to rivals.
Penetration pricing can be a successful marketing strategy when applied correctly. It can often
increase both market share and sales volume. Additionally, the high sales volume can also lead
to lower production costs and higher inventory turnover, both of which are positive for any firm
with fixed overhead. The chief disadvantage, however, is that the increase in sales volume may
not necessarily lead to a profit if prices are kept too low. As well, if the price is only an
introductory campaign, customers may leave the brand once prices begin to rise to levels more in
line with rivals.
The causes for the adopting are:

1) Low cost of production of a need product
2) Economies of a large scale production
3) Low expenditure on research advertisement and sales promotion programme
4) Enter and expand the market
5) Suitable when the demand for a product is relatively elastic
6) Discouraging competition
7) Attracting consumers of low income group
8) Discouraging government intervention
9) Earning maximum profit through maximum sales.
Pricing over a life cycle of a product
There are 6 stages in the life cycle of a product:

INTRODUCTION: this is the first stage in the life cycle of a product. A product is developed
and introduced in the market as a new one. There are 2 strategies in it:
1) High initial pricing strategy

2) Low initial pricing strategy

GROWTH: at this stage the product gets popularity among consumers and the demand for a
product increases steadily. Firms get the opportunity to earn maximum profits through
maximum sales. At this stage if there is no competition in the market, the firm can fix relatively
high price for the product. To sustain growth consumer satisfaction should be ensured at this
stage.
MATURITY: at this stage, though the sales of a product continue to increase the rate of increase
in sales declines .this is because of the fact that the number of potential consumers for the
product starts declining. Hence the product loses its popularity. A number of substitutes come to
the market. The product becomes a common one. There is no scope for improvement in the
quality of the product.
SATURATION: at this stage, the demand for the product stabilizes and there is in demand.
Advertisement and sales promotion activities should be intensively undertaken to maintain the
demand for the product. At this stage the level of sales of the product reaches a stage when
demand starts shifting to other products.
DECLINE: at this stage, the sales of the product start declining. Substitute products become
more popular. All efforts taken to increase or to maintain the demand for the product become
ineffective. At this stage, the firm should follow break-even point price policy so as to continue
its production activities.
OBSOLESCENCE: this is the last stage in the life cycle of a product. At this stage there are
almost no sales of the product. Practically the product is out of the market and its production
should be discontinued. The resources engaged in its production should be diverted to the
production of their product.
Price discount:
Price discounts the difference between the list price shown in the catalogue and the net price
charged by the producer. The price charged by the producer or the seller is always lower than the
list price.
There are 3 types of prices discounts as mentioned below:
1) Distributors discount
2) Buyers discount
3) Dealers discount
Peak load pricing:

Peak load pricing is a method of charging a higher price from consumers who require service
during periods of peak demand and a lower price for those who consume during off-peak
periods.
Peak load pricing may be suitable only if three conditions are met in producing a product:
1) The product cannot be storable. Pricing of long-distance telephone calls is an example of
peak-load pricing.

2) The same facilities must be used to provide the service during different periods of time.
3) There must be variation in demand characteristics of consumers at different periods of
time.
Transfer pricing:
Transfer pricing is a method of charging a price by different divisions of the same firm for goods
and services exchanged between them. Transfer prices are determined by the following methods:
1) Market price
2) Bargained market price
3) Full or marginal costs.

Module 5
Indian Economic Environment
Overview of Indian Economy, Recent Changes in Indian Economy.

Measurement of National Income: Basic Concepts, Components of GDP- Measuring GDP
and GNP, Measurement Problems in National Income, Growth Rate.
Business Cycle Features, Phases, Economic Indicator, Inflation : Types, Measurement ,
Kinds of Price Indices, Primary, Secondary and Tertiary Sector and their contribution to
the Economy, SWOT Analysis of Indian Economy.
---------------------------------------------------------------------------------------------------------------------
Overview of Indian Economy
With 1.2 billion people and the worlds fourth-largest economy, Indias recent growth
and development has been one of the most significant achievements of our times. Over
the six and half decades since independence, the country has brought about a landmark
agricultural revolution that has transformed the nation from chronic dependence on grain
imports into a global agricultural powerhouse that is now a net exporter of food. Life
expectancy has more than doubled, literacy rates have quadrupled, health conditions have
improved, and a sizeable middle class has emerged. India is now home to globally
recognized companies in pharmaceuticals and steel and information and space
technologies, and a growing voice on the international stage that is more in keeping with
its enormous size and potential.
Historic changes are unfolding, unleashing a host of new opportunities to forge a 21st-
century nation. India will soon have the largest and youngest workforce the world has
ever seen. At the same time, the country is in the midst of a massive wave of urbanization
as some 10 million people move to towns and cities each year in search of jobs and
opportunity. It is the largest rural-urban migration of this century.
The historic changes unfolding have placed the country at a unique juncture. How India
develops its significant human potential and lays down new models for the growth of its
burgeoning towns and cities will largely determine the shape of the future for the country
and its people in the years to come.
Massive investments will be needed to create the jobs, housing, and infrastructure to meet
soaring aspirations and make towns and cities more livable and green. Generating growth
that lifts all boats will be key, for more than 400 million of Indias peopleor one-third of
the worlds poorstill live in poverty. And, many of those who have recently escaped
poverty (53 million people between 2005-10 alone) are still highly vulnerable to falling
back into it. In fact, due to population growth, the absolute number of poor people in
some of Indias poorest states actually increased during the last decade.
Inequity in all dimensions, including region, caste and gender, will need to be addressed.
Poverty rates in Indias poorest states are three to four times higher than those in the more

advanced states. While Indias average annual per capita income was $1,410 in 2011
placing it among the poorest of the worlds middle-income countries it was just $436 in
Uttar Pradesh (which has more people than Brazil) and only $294 in Bihar, one of Indias
poorest states. Disadvantaged groups will need to be brought into the mainstream to reap
the benefits of economic growth, and womenwho hold up half the skyempowered
to take their rightful place in the socioeconomic fabric of the country.
Fostering greater levels of education and skills will be critical to promote prosperity in a
rapidly globalizing world. However, while primary education has largely been
universalized, learning outcomes remain low. Less than 10 percent of the working-age
population has completed a secondary education, and too many secondary graduates do
not have the knowledge and skills to compete in todays changing job market.
Improving health care will be equally important. Although Indias health indicators have
improved, maternal and child mortality rates remain very low and, in some states, are
comparable to those in the worlds poorest countries. Of particular concern is the
nutrition of Indias children whose well-being will determine the extent of Indias much-
awaited demographic dividend; at present, an overwhelming 40 percent (217 million) of
the worlds malnourished children are in India.
The countrys infrastructure needs are massive. One in three rural people lack access to
an all-weather road, and only one in five national highways is four-lane. Ports and
airports have inadequate capacity, and trains move very slowly. An estimated 300 million
people are not connected to the national electrical grid, and those who are face frequent
disruptions. And, the manufacturing sectorvital for job creationremains small and
underdeveloped.
Nonetheless, a number of Indias states are pioneering bold new initiatives to tackle many
of Indias long-standing challenges and are making great strides towards inclusive
growth. Their successes are leading the way forward for the rest of the country,
indicating what can be achieved if the poorer states were to learn from their more
prosperous counterparts.
India now has that rare window of opportunity to improve the quality of life for its 1.2
billion citizens and lay the foundations for a truly prosperous futurea future that will
impact the country and its people for generations to come.
Few Facts are as follows:

GDP Growth
India's economic growth remained below 5 percent mark second year in a row at 4.7 percent in
2013-14.As per government data, the economic growth remained below 5 percent for two
consecutive years after a gap of almost 25 years. Earlier from 1984-85 to 1987-88, the economic
growth rate remained below 5 percent. The country's economy, or gross domestic product
(GDP), had expanded at 4.5 percent in 2012-13, the slowest pace in the previous decade.

Inflation
Subdued prices of vegetables, cereals and dairy products pushed down retail inflation to a three-
month low of 8.28 percent in May 2014. Retail inflation, measured on consumer price index
(CPI), was 8.59 percent in April 2014. In February 2014, retail inflation was at 8.03 percent,
followed by consecutive rise in March (8.31 percent) and April. As per the data released by
government, food inflation also fell slightly to 9.56 percent in May against 9.66 percent in April
2014.
FISCAL HEALTH
Fiscal Deficit
The fiscal deficit for 2013-14 fiscal may finally turn out to be 4.5 percent of GDP. The fiscal
deficit, which is the gap between expenditure and revenue, was 4.9 percent of GDP in 2012-13.
The interim Budget for 2014 has projected the fiscal deficit for 2014-15 fiscal at 4.1 percent of
GDP or Rs 5.29 lakh crore.
Current Account Deficit
As per the latest data, Indias CAD sharply narrowed to 1.7 percent of the GDP or USD 32.4
billion in 2013-14 from a record high of 4.7 percent in FY13. For the JanuaryMarch quarter,
CAD - a measure of the inflow and outflow of foreign currency stood at USD 1.2 billion or
0.2 percent of GDP, as against USD 18.1 billion, or 3.6 percent of GDP in the same period of the
previous fiscal, according to the RBI. The highest ever CAD reported in 2013-14 had led to a
slew of problems, including a heavy drop in the value of the rupee, which touched an all-time
low of 68.85 against the US dollar last August. However the rupee has strengthened since then
and recovered up to about 58 vs dollar since then. It is, however, under pressure again due to the
Iraq crisis.
Foreign Direct Investment
Foreign Direct Investment into India grew 8 percent year-on-year to USD 24.3 billion in 2013-
14. Foreign investment inflows more than doubled to USD 3.53 billion in March this year from
USD 1.52 in the same month last year. The highest FDI came in services (USD 2.22 billion),
followed by automobiles (USD 1.51 billion), telecommunications (USD 1.3 billion),
pharmaceuticals (USD 1.27 billion) and construction development (USD 1.22 billion) in 2013-
14.

Foreign Institutional Investment
The net investments by FIIs into Indian equity markets since the beginning of 2014 have crossed
USD 5 billion over Rs 30,000 crore), while the same for debt markets also stands near USD 5
billion (about Rs 29,000 crore)- taking the total to close to Rs 60,000 crore. This includes net
investments of about Rs 1,500 crore so far in April. This is despite a net outflow of about Rs
7,000 crore from debt markets, as equity markets have seen a net inflow of over Rs 8,500 crore
this month till April 25, the latest trading session.
Trade
India's exports grew by 3.98 percent to USD 312.35 billion in FY 2013-14 while imports dipped
by 8.11 percent during the period. Imports declined to USD 450.94 billion, narrowing the trade
deficit to USD 138.59 billion in the last fiscal. In FY 2012-13, trade deficit stood at USD 190.33
billion. The overall shipments in 2013-14 fell short of the target of USD 325 billion fixed by the
government for the period.
Recent Changes in Indian Economy

Now India is free from poverty, malnutrition, illiteracy, under-employment, and civil strife. Most
importantly, India is a country of free people. In 2010, Indians were really not free in all senses
of the word. They had a degree of political freedom but economic and personal freedoms were
denied to all in principle, and only the rich had economic freedom in practice.
India is Rich
In India today, material deprivation is a thing of the past. But in 2010, half the poor people of the
world lived in India; half of Indias children below the age of five were malnourished; illiteracy
was 40 percent; around half of the working population was underemployed; agriculture related
labor accounted for around 60 percent of the employment, and agricultural wages were so dismal
that tens of thousands of farmers committed suicide. Organized labor was only 7 percent, as
opposed to todays 70 percent.
India today has a highly urbanized population. Seventy percent of Indians live and work in cities
and towns, and only 30 percent in rural areas. In 2010, those numbers were inverted. As a
consequence, most Indians work in the manufacturing and services sectors. In 2010, sixty
percent of the labor was in agriculture, as I mentioned before. Now only ten percent of labor is in
agriculture, and their productivity so high that India is not only food sufficient but is a net
exporter of food around the world.
India is an Economic Giant

India today is a manufacturing hub for sophisticated products from high technology such as
computers and spacecrafts, to hand crafted goods such as jewelry and high fashion clothes.
Indias labor is highly productive and therefore their income in real terms is over sixteen times
what it was in 2010.
In simple arithmetic, with 10 percent annual growth rate, income doubles in seven years. So in
26 years, starting with a $1,000 per capita annual income, Indian per capita annual income
became $15,000. The poorest people in India today have the standard of living that only the
upper middle class could afford in 2010.
World-class Infrastructure
Today Indias infrastructure is not just world-class, it is a class apart. We have the best public
transportation system of any major country in the world. Our cities are not congested with
pollution-spewing vehicles like before.
Our railways, which is the backbone of long distance transportation of goods and people today,
leads the world in speed, efficiency, and safety. Our passenger trains average 250 kms an hour,
and our express trains take you from Mumbai to Delhi, a distance of 1000 kms in four hours flat.
I remember when I graduated, the average speed of Indian trains used to be 40 kms an hour, and
it used to take 16 hours by the fastest train between Mumbai and Delhi.
Abundant Power
I am certain that none of you have ever seen the lights fail due to a shortage of power. You may
find it hard to believe that in 2010, power shortage was so severe that around 98 percent of
Indians did not have uninterrupted 24x7 power supply.
The poor which by our standards of today means 90 percent of the population of 2010 had
to just take what they could get and those of the rest who could afford it had diesel generator
sets. Today electricity is universally available, abundant and the supply is totally reliable.
Electric power in India is cheapest in the world and it powers our globally competitive
manufacturing sector.
Our Cities are Green
Today every Indian takes clean drinking water and sanitation for granted. But did you know that
in 2010, only five out of 100 Indians had indoor plumbing and 800 million Indians did not have
access to reasonable toilets? Cities were choked with garbage, water was undrinkable, and the air
was polluted with exhaust and the use of dirty fuel for cooking.
We created new cities. Indian cities today are clean, pollution free, and green. Our cities are
healthy and so is our population. Life expectancy matches those of the richest nations. In our
cities, parks and recreational areas are scattered around within walking distance. Our small towns

and the few remaining villages are tranquil places for relaxed living. Crime is not an issue in the
country.
Our Education System is Excellent
Indias educational system has changed, to say the least. Every Indian young and old has
equal opportunity to attend school and college today. Everyone has the opportunity to have life-
long learning. Life-long learning is critical for two reasons: first, the world is changing so fast
that there are always more things to learn. Second, life expectancy has increased so much that
multiple careers are common.
When you entered college four years ago, you took an entrance test. That test was designed to
help you assess your strengths and weaknesses. It helped you decide which discipline you should
enter and which subjects you should study. It was a test to help you, not to keep you out of
college.
But in 2010 and before, the test were weed out tests. The supply of college seats was so limited
that only a small percentage of students could be accommodated. The tests were designed to
keep people out of college. The Indian Institutes of Technology rejected 98 out of 100 who
wanted to study in them.
Our Education System Was Hell
There used to be coaching classes to help students pass those entrance exams. What boggles
the mind is this. The most successful coaching classes had their own entrance exams. So there
were coaching classes to help students pass the exams of the coaching classes which helped
students to pass the entrance exams of colleges.
Even getting into kindergarten was a problem. Only the rich and those who had influence could
get into good pre-primary schools. People had to give donations to get their children into
schools.
Peace and Tranquility
We live in a peaceful India today. There are no civil unrests. Indias 30 states are more or less
equally prosperous. It is unimaginable today that any state would even think of leaving the
union. But in 2010, it was a different story. The country was divided along many fault-lines that
India had the misfortune to have: caste, religion, language, and so on. These were cynically used
by vested interests in India and abroad to fracture the country.
A Country of Honest People
Indias economy continues to be one of the most rapidly growing and modernizing today. It has
maintained an average annual GDP per capita growth rate of around 10 percent for the last 26

years. India is today near the top of the Human Development Index but in 2010, it was stagnating
in 124th position.
Transparency International rates India as one of the least corrupt countries today. It has come a
long way since then when it was rated as one of the most corrupt. Around 2010, corruption was
so rampant that it used to be measured in billions of dollars, and it was estimated that the around
$1,500 billion of black money was stashed away in Swiss and other off-shore banks.
Today India is financially secure. Its bank balance looks good. In terms of external trade, the
figures are exciting. Indias share of world trade today stands at an impressive 20 percent
thats up from 2 percent in 2010. Indias foreign reserves are $1 trillion dollars. Indias public
debt is among the smallest in the world.
Proud to be Indian
You and I are extremely proud to be Indians. You are lucky that you were born in India. Aside
from the economic prosperity of today, you are the inheritors of one of the worlds most
enduring and deep civilizations. Indias cultural treasures are second to none. It is all yours to
enjoy, cherish and preserve for your children. India is a great place to live in today. What is
more, India is one of the favorite destinations of the world. More than 100 million people visit
India annually for vacation and for understanding first hand our deep and ancient culture.
We will leave out the details of how much India has changed since the time I graduated from
college 30 years ago. You know what India is today and some of you must have read the modern
history of India. I have only touched briefly on just a few of the amazing positive changes that
have happened in India over the past quarter century.
The Start: Quest for Freedom
Now lets briefly ask when the changes started and how. They began just a few years before
most of you were born. Those changes are therefore just about as old as you are. We all
appreciate that our material conditions have improved beyond the expectations of those who
brought about the change. But that is not all.
The greater and the more important change is the freedom we enjoy now. Then people were not
really free and what was worse, people thought that they were free when in fact they were not.
As Ram Dass pointed out, If you think youre free, theres no escape possible. The illusion of
freedom is as good a prison as ever constructed.
In the past, Indians had to get permission from the government to do things. Free people do not
have to seek permission from their government. People are not the servants of the government
but rather the government is their servant. To put it in other words, the people are the principal

and the government is their agent. The Indian government during the British Raj was of course
the principal and the people its agents. It was a master-servant relationship. That relationship did
not change after 1947 and the government continued to be the master. But after 2014, there was a
revolution in the peoples perception of their situation.
Realization of the Truth
The revolution began when people finally understood that they were in bondage. Thats always
the first step to freedom. While freedom is in itself an end, it is also a means to material
prosperity. No country has ever prospered without its people being truly and comprehensively
free.
Freedom allows change, and consequently growth and development. You are the children of
freedom and change, and growing up free in a world of change is what makes you so
wonderfully adapted to grow and prosper. So it is natural for you to ask this question. How was it
possible that within just one generation, a country which had stagnated for so long, both before
and after political independence, that India changed so radically?
Economic Policies Matter
Pause for a bit to consider the real import and meaning of that question. India is a very large
country. It is larger than all the Western European countries combined. How could it change so
fast? What happened? And why did it happen when it did rather than in the mid-20th century,
closer to the time of its political independence from Britain? What was it that was keeping India
chained?
What kept India chained for so long were bad economic policies. Milton Friedman said in a
speech in 1963 just a few years after the British left and into the British Raj 2.0 that the
correct explanation for Indias slow growth is in my view not to be found in its religious or social
attitudes, or in the quality of its people, but rather in the economic policy that India has adopted;
most especially in the extensive use of detailed physical controls by government.
Policy Changes Led to the India Miracle
Therefore it was policy change that led to what is now called the India Miracle. It was a
transformation the likes of which the world had never seen before. We will have to talk a little
about history, and a little about economics, and a little about technology. But most of all we will
have to talk about the transformational power of a handful of motivated people. People just like
you and me but powered by a special drive for freedom. Thats where we will find the answers to
those questions. It is important for us to know this since our ability to succeed in a world of
change depends on how well we learn the lessons from our past.
India has changed so much that you probably never heard the word liberalization. The word
has at its core the idea of freedom. Once upon a time just a generation ago, it was a much used

word in the context of the Indian economy. There were people crying out for the liberalization of
the economy. Strange thought it may seem to you today, they were opposed by many. You may
marvel that there were people who opposed freedom remember that is what liberalization
means and who were determined to keep people from economic freedom. The people who
opposed freedom were the people who stood to gain by continuing to keep India in bondage.
Comprehensive Freedom
Free people like yourselves dont have to fight for freedom. Therefore you take all your
freedoms for granted and dont have to cry out for freedom. The answer to the question about
what changed that transformed India in one word is Freedom.
There are different kinds of freedom. Broadly speaking, they can be classified as personal
freedom, economic freedom, and political freedom. A few sufficiently advanced societies enjoy
all three. Their prosperity is both a consequence and a cause of these freedoms. Other countries
deny some or all of these freedoms to their citizens, and usually the consequences are
understandably negative.
Only Political Freedom in 1947
India gained political freedom from British rule in 1947, nearly one hundred years ago. But India
continued to be chained and denied economic and personal freedoms even after independence.
India had to wait till 2014 for them. The economic liberalization of India is a story that will be
cited by historians for centuries to come.
Indias political freedom after 1947 was real enough in principle but it was not real in the
practical sense. When a very large segment of the population is denied economic freedom, they
become materially impoverished. Materially poor people subsisting on public handouts are not
free in any meaningful sense of the word. They had the political freedom to exercise their
franchise but in truth, they were constrained by their material needs to be subservient to those
who promised to give them hand-outs.
The relationship between human rights and economic freedom is inseparable. Economic freedom
flows from human rights, such as the right to property, to enter into voluntary transactions, the
right to economically compete and cooperate freely with others, and so on. Human rights are, of
course, an end in themselves but additionally they lead to economic prosperity because they are
consistent with economic freedom.
It is easy to understand why economic freedom was denied to Indians during the colonial period.
What is remarkable is that even after independence economic freedom was not a reality.
Poverty Due to Policy Mistakes

India was poor because the governments made wrong policy choices. Policy mistakes are not
mere academic abstractions. They have real world implications. Think for a moment about the
immense suffering those mistakes caused. Hundreds of millions of people were born in India
who did not have a chance to have a decent, humane existence.
Hundreds of millions of children were born under-weight, tens of millions of children died as
infants. Think of the terrible anguish of the parents. Hundreds of millions of children grew up
malnourished and stunted, hundreds of millions never saw the insides of a school, never had
access to any of the wonders of the modern world, and passed away into the great beyond after
leading Hobbesian lives: nasty, mean, brutish, and short.
In 2010, our estimate of the number of malnourished underweight uneducated children in India
would be of the order of about 100 million. They did not grow up to be productive members of
society, if they grew up at all. Think about it: 100 million. To put that number in perspective:
thats more than the population of many large countries around the world today.
Political Freedom Follows Economic Freedom
In an economy which produces too little to provide adequately for the material needs of all its
citizens, the desperate need to keep body and soul together trumps all other needs. Political
freedom is merely an abstract notion for people who are hungry. It was economic development
which itself is a consequence of economic freedom that made the political freedom of
India real. India gained economic freedom in 2014 and only after that did political freedom
became meaningful and a practical reality for the masses.
Personal Freedom
Indias personal freedom followed soon after. Personal freedom is the freedom to live your life
the way you want to. It encompasses such notions as the right to be left alone, the right to
privacy, the right to determining who you wish to associate with, whom you marry, where you
live and what you work at. It means you decide what you wish to read, what you wish to watch
and listen to. It means that someone in the government does not decide what you are allowed to
watch or read.
Personal freedom must include the freedom to express your own views and listen to others
views. India had freedom of press meaning specifically the printed word even during the
British colonial rule, and it continued after independence. Curiously though, there was a
prohibition on the use of radio for the dissemination of news and the government had a
monopoly in that regard.
One explanation could be this. The majority of Indians, as late as in mid last century, were
illiterate. Freedom of the press is an abstract concept with little real world meaning to people
who cannot read or write. The government could rest easy that a free press really could not get

the people stirred up. But even illiterate people can be persuaded by the spoken word broadcast
over radio. Therefore they disallowed the use of radio for anything other than songs and loose
chatter.
You all enjoy these personal rights but the generations before yours did not have them. They
were treated by the government as if they were immature, irresponsible children. The
government frequently banned books and movies clearly implying that the people lacked
judgment.
People were denied the right to choose in many spheres of their personal lives. The laws were
out-dated and irrational. Most of the laws were made during the British Raj 1.0 and continued to
be in force during British Raj 2.0. The laws were such that the balance of power was with the
government and stacked against the people. More about the genesis of that in a bit.
Struggle to Get Government Handouts
Since the government held most of the power and the people were dependent on the government
for handouts, there was a constant struggle by various groups to gain favors from the
government. The groups competed for government handouts and the token of exchange was their
votes.
It was the politics of divide and rule, a strategy that the British had employed with enormous
success, and those who inherited the government from the British saw obvious benefits for
themselves in continuing that tradition. Politicians cynically calculated which vote groups were
most valuable to them and would favor certain groups over others which inevitably led to two
mutually reinforcing bad outcomes.
Engineered Social Divisions
The first unfortunate outcome was that the country was socially divided. The government
routinely pitched groups based on caste or religion against one another. This led to frequent
clashes and sometimes violent riots. The second outcome was economic division. The
government would tax the productive segment of people which was of course small and give
handouts to the unproductive segment of the people which was large. This created a divide
between those who worked hard to create wealth and those who did not.
Basic Concepts
National Income
The NI of any period consists of the money value of the goods and services becoming available
for consumption during that period, reckoned at their current selling value. plus additions to
capital reckoned at the prices actually paid for the new capital goods minus depreciation and

obsolescence of existing capital goods and adding the net accretion of, or deducting the net
drawings upon, stock also reckoned at current prices.
Importance of national income: With NI we can chart the movement of the country from
depression to prosperity. The economic welfare of community can be measured with NI. It help
in finding standard of living. It helps in determining the pace economic development of
economy. It reveals the overall production in each year. It helps to understand the contribution
made by the different sectors to the economy. It helps in development planning of a country. It
provides the information of the savings, consumption and investment structure of the economy.
Concepts: There are five concepts of NI:
1. Gross National product (GNP)
2. Net National product (NNP)
3. National Income (NI)
4. Personal Income (PI)
5. Disposal Income
GNP = total market value of final goods and services produced in a year. It includes all
economic productions in the country in a year. It is monetary measure add with money
prices only. The money value of the final goods only to be considered not the value of
intermediate goods. The money value of the currently produced goods must be taken into
the calculation of NI. For e.g. if goods are produced in 1991 and not sold till 1992, they
would be considered for 1991 and not for 1992. Non productive transaction to be
excluded. Depreciation is not deducted. Two methods are used. Expenditure or output
approach method: it involves in calculating the value of the final goods consumed.
The following expenditures are added to in order to find out GDP:
I. Personal Consumption Expenditure
II. Gross Domestic Private Investment
III. Government purchase of goods and services
IV. Net Foreign investment
GNP = I+II+III+IV
Income approach method = Wages and salaries+ Income of non company business +Rental
income of the persons + Corporate profit + Income from net interest + Indirect taxes +
Depreciation of capital goods. GNP is a gross measure.

NNP = market value of all final goods and services after proving for depreciations. It is
also called as National income at market price. It is helpful in the analysis of long run
problems of maintaining and increasing the supply of physical capital in the country.
NNP = GNP - Depreciation
There the two concepts of national income namely:
NI at factor cost: Market price minus the indirect taxes plus subsidies.
NI at Market price : It includes the cost of four factors of production and indirect taxes and
subsidies.
NI = NNP (indirect taxes+ subsidies) profits accruing to the govt. For ex. a motor car costs Rs.
5 lakh which includes excise duty of Rs. 50,000. The market price of the car is Rs. 2 lakh, while
the factors engaged in production get Rs. 4.5 lakh.
Personal Income is that income actually received by the individuals or households in a

country during a year from all sources. Actually the whole NI earned by factors of
production in a year is not available to them as they have to pay corporate tax, social
security, Govt. may give some social security benefits such as old age pensions etc,
called as transfer payments.
PI = NI social security contribution, corporate income tax and undistributed corporate profits +
transfer payments. The whole PI is not available for the consumers to spend on consumption. The
reason is that out of the income received the individual has to pay personal income taxes. The
part of income which is left behind after the payment of direct taxes is called DPI which is spend
on consumption or savings.
DPI = Consumption + savings
DPI = PI - taxes
When the countrys income is expressed in terms of current prices it is called national income.
On the other hand when it is expressed in terms of constant prices prevailing in the base year it is
called real income. It is used as an index of changes in the standard of living of the people of a
country. It indicates the changes in economic progress in terms of goods and services available
per head of the population.
The formula for calculating PCI is:
PCI = National Income at constant prices/ Population

Components of GDP
GDP (Y) is a sum of Consumption (C), Investment (I), Government Spending (G) and Net
Exports (X M).
Y = C + I + G + (X M)
Here is a description of each GDP component:
C (consumption) is normally the largest GDP component in the economy, consisting of

private (household final consumption expenditure) in the economy. These personal
expenditures fall under one of the following categories: durable goods, non-durable
goods, and services. Examples include food, rent, jewelry, gasoline, and medical
expenses but does not include the purchase of new housing.
I (investment) includes, for instance, business investment in equipment, but does not
include exchanges of existing assets. Examples include construction of a new mine,
purchase of software, or purchase of machinery and equipment for a factory. Spending by
households (not government) on new houses is also included in Investment. In contrast to
its colloquial meaning, 'Investment' in GDP does not mean purchases of financial
products. Buying financial products is classed as 'saving', as opposed to investment. This
avoids double-counting: if one buys shares in a company, and the company uses the
money received to buy plant, equipment, etc., the amount will be counted toward GDP
when the company spends the money on those things; to also count it when one gives it
to the company would be to count two times an amount that only corresponds to one
group of products. Buying bonds or stocks is a swapping of deeds, a transfer of claims on
future production, not directly an expenditure on products.
G (government spending) is the sum of government expenditures on final goods and

services. It includes salaries of public servants, purchase of weapons for the military, and
any investment expenditure by a government. It does not include any transfer payments,
such as social security or unemployment benefits.
X (exports) represents gross exports. GDP captures the amount a country produces,
including goods and services produced for other nations' consumption, therefore exports
are added.
M (imports) represents gross imports. Imports are subtracted since imported goods will
be included in the terms G, I, or C, and must be deducted to avoid counting
foreign supply as domestic.

A fully equivalent definition is that GDP (Y) is the sum of final consumption
expenditure (FCE), gross capital formation (GCF), and net exports (X M).
Y = FCE + GCF+ (X M)
FCE can then be further broken down by three sectors (households, governments and non-profit
institutions serving households) and GCF by five sectors (non-financial corporations, financial
corporations, households, governments and non-profit institutions serving households). The
advantage of this second definition is that expenditure is systematically broken down, firstly, by
type of final use (final consumption or capital formation) and, secondly, by sectors making the
expenditure, whereas the first definition partly follows a mixed delimitation concept by type of
final use and sector.
Note that C, G, and I are expenditures on final goods and services; expenditures on intermediate
goods and services do not count. (Intermediate goods and services are those used by businesses
to produce other goods and services within the accounting year. )
Measuring GDP and GNP
Three Approaches to Measuring GDP and GNP.
1. Expenditures Approach:
The total spending on all final goods and services (Consumption goods and services (C) + Gross
Investments (I) + Government Purchases (G) + (Exports (X) - Imports (M))
GDP = C + I + G + (X-M)
2. Income approach (NY = National Income)
Using the Income Approach GDP is calculated by adding up the factor incomes to the factors of
production in the society. These include
National Income (NY) + Indirect Business Taxes (IBT) + Capital Consumption Allowance and
Depreciation (CCA) + Net Factor Payments to the rest of the world (NFP)
In this approach,
NY = Employee compensation + Corporate profits + Proprietor's Income + Rental income + Net

Interest
CCA = Igross + Inet (I= Investment)
NFP = Payments of factor income to the ROW minus the receipt of factor income from the rest
of the world.

Thus,
GDP + NFP = GNP GROSS NATIONAL PRODUCT)
GNP - CCA = NNP ( NET NATIONAL PRODUCT)
NNP - IBT = NY (NATIONAL INCOME)
3. Value added Approach:
The value of sales of goods - purchase of intermediate goods to produce the goods sold.
Measurement of National Income
1. Product Method:
In this method, national income is measured as a flow of goods and services. We calculate
money value of all final goods and services produced in an economy during a year. Final goods
here refer to those goods which are directly consumed and not used in further production
process.
Goods which are further used in production process are called intermediate goods. In the value of
final goods, value of intermediate goods is already included therefore we do not count value of
intermediate goods in national income otherwise there will be double counting of value of goods.
To avoid the problem of double counting we can use the value-addition method in which not the
whole value of a commodity but value-addition (i.e. value of final good value of intermediate
good) at each stage of production is calculated and these are summed up to arrive at GDP.
The money value is calculated at market prices so sum-total is the GDP at market prices. GDP at
market price can be converted into by methods discussed earlier.
2. Income Method:
Under this method, national income is measured as a flow of factor incomes. There are generally
four factors of production labour, capital, land and entrepreneurship. Labour gets wages and
salaries, capital gets interest, land gets rent and entrepreneurship gets profit as their
remuneration.
Besides, there are some self-employed persons who employ their own labour and capital such as
doctors, advocates, CAs, etc. Their income is called mixed income. The sum-total of all these
factor incomes is called NDP at factor costs.

3. Expenditure Method:
In this method, national income is measured as a flow of expenditure. GDP is sum-total of

private consumption expenditure. Government consumption expenditure, gross capital formation
(Government and private) and net exports (Export-Import).
Difficulties in Measurement of National Income
There are many difficulties when it comes to measuring national income, however these can be
grouped into conceptual difficulties and practical difficulties.
Conceptual Difficulties
Inclusion of Services: There has been some debate about whether to include services in
the counting of national income, and if it counts as output. Marxian economists are of the
belief that services should be excluded from national income, most other economists
though are in agreement that services should be included.
Identifying Intermediate Goods: The basic concept of national income is to only include
final goods, intermediate goods are never included, but in reality it is very hard to draw a
clear cut line as to what intermediate goods are. Many goods can be justified as
intermediate as well as final goods depending on their use.
Identifying Factor Incomes: Separating factor incomes and non factor incomes is also a
huge problem. Factor incomes are those paid in exchange for factor services like wages,
rent, interest etc. Non factor are sale of shares selling old cars property etc., but these are
made to look like factor incomes and hence are mistakenly included in national income.
Services of Housewives and other similar services: National income includes those goods
and services for which payment has been made, but there are scores of jobs, for which
money as such is not paid, also there are jobs which people do themselves like maintain
the gardens etc., so if they hired someone else to do this for them, then national income
would increase, the argument then is why are these acts not accounted for now, but the
bigger issue would be how to keep a track of these activities and include them in national
income.
Practical Difficulties
Unreported Illegal Income: Sometimes, people don't provide all the right information
about their incomes to evade taxes so this obviously causes disparities in the counting of
national income.
Non Monetized Sector: In many developing nations, there is this issue that goods and
services are traded through barter, i.e. without any money. Such goods and services

should be included in accounting of national income, but the absence of data makes this
inclusion difficult.
Precautions for Value added approach
There are certain precautions which are to be taken to avoid miscalculation of national income
using this method. These in brief are:
(i)Problem of double counting: When we add up the value of output of various sectors, we
should be careful to avoid double counting. This pitfall can be avoided by either counting the
final value of the output or by including the extra value that each firm adds to an item.
(ii) Value addition in particular year: While calculating national income, the values of goods
added in the particular year in question are added up. The values which had previously been
added to the stocks of raw material and goods have to be ignored. GDP thus includes only those
goods and services that are newly produced within the current period.
(iii) Stock appreciation: Stock appreciation, if any, must be deducted from value added. This is
necessary as there is no real increase in output
- (iv) Production for self consumption. The production of goods for self consumption should be
counted While measuring national income. In this method, the production of goods for self
consumption should be valued at the prevailing market prices.
Precautions in Expenditure Method
While estimating national income through expenditure method, the following precautions should
be taken.
(i) The expenditure on second hand goods should not be included as they do not contribute to
the current years production of goods.
(ii) Similarly, expenditure on purchase of old shares and bonds is not included as these also do
not represent expenditure on currently produced goods and services.
(iii) Expenditure on transfer payments by government such as unemployment benefit, old

age pensions, interest on public debt should also not be included because no productive service is
rendered in exchange by recipients of these payments.
Precautions in Income Method
While estimating national income through income method, the following precautions should be
undertaken.
(i) Transfer payments such as gifts, donations, scholarships, indirect taxes should not be
included in the estimation of national income.
(ii) Illegal money earned through smuggling and gambling should not be included.
(iii) Windfall gains such as -prizes won, lotteries etc. is not be included in the estimation of
national income.
(iv) Receipts from the sale of financial assets such as shares, bonds should not be included in
measuring national income as they are not related to generation of income in the current year
production of goods.
Growth Rate
Business Cycle
Concept Of Business Cycle: A Business Cycle can be defined as wavelike fluctuations of

business activity characterized by recurring phases of expansion and contraction in periods
varying from three to four years. Business cycle are a type of fluctuations found in the aggregate
economic activity of nations that organize their work mainly in business enterprises- Mitchell. A
cycle consists of expansions occurring at about the same time in many economic activities

followed by similarly general recessions, contractions and revivals which merge with the
expansion phase of the next cycle. This sequence of change is recurrent but not periodic.
Characteristics or Features of Business Cycle:
1. Recurring Fluctuations : Business cycle are characterized by fluctuation which occurs

periodically in a free rhythm. This implies that the recurrence of expansion and
contraction as no fixed or invariable period.
2. Period of Business Cycle is longer than a year : A typical business cycle completes
itself in a period of 3 to 4 years. A business cycle in its character is distinctly different
from seasonal fluctuations in economic activity which take place within a period of a
calendar year and due to causes connected directly or indirectly with the physical season.
3. Presence of alternating forces of expansion and contraction : A business cycle is

characterized by alternating forces leading an economy to prosperity and depression.
These forces are in-built in the system.
4. Phenomenon of the crisis : According to Keynes, an important characteristic of the

business cycle is the phenomenon of crisis. This implies that the peak and the trough are
asymmetrical. Normally the prosperity phase of business cycle comes to an end abruptly,
whereas recovery after the depression is gradual and slow.
Phases of Business Cycle:
According to Burns & Mitchell, every business cycle has the critical mark off points of peak and
trough, From trough to peak there is the expansion phase and from peak to trough the contraction
phase. The turning points characterized the other two stages.
Revival/Expansion/Recession/Contraction
Burns & Mitchell phases of Business Cycle: Peak Trough - Beginning of Recession -
Beginning of Revival.
Joseph Schumpeter does not agree with Burns and Mitchell on the phases of business cycle;
peak and trough cannot be regarded as the critical mark off points. According to him, the critical
mark-off points are neigbour hoods of equilibrium the upper half of the business cycle from A to B
is divided into two parts : 1) PROSPERITY / EXPANSION 2) RECESSION. The lower half of
the business cycle from B to C similarly consists of two parts namely : 3) DEPRESSION 4)
RECOVERY / STAGFLATION
1) Prosperity / expansion: this phase is also called as upswing . The prosperity or expansion
stage begins from an equilibrium position under the stimulus of certain forces. This forces create
expectations of rising profits. Wage disbursements increase rapidly, demand for consumption of
goods also grows rapidly. The demand for raw materials leads to larger employment in other

industries, as does the demand for consumption goods when workers spend their additional
earnings received from the entrepreneurs. If this position from which the expansion phase began
was one of less than full employment of resources, the increased demand for both consumption
goods and raw materials, would be satisfied by rapid increase in their supply. The marked feature
of prosperity is expansion in bank deposits and supply of currency, this leads to price rise.
Distortions of price relations: price do not rise uniformly during the prosperity phase.
Gradually wholesale prices rise more than retail prices. These distortions of the cost structure in
every prosperity phase increase the margin of profit. Expansion reaching its heights: the rising
profit and prevailing optimism about its continuance boost up the stock prices of stock exchange
securities. Entrepreneurs, observing that their profits are growing rapidly, make further
investments. The end of expansion: during the prosperity phase, expansion itself gradually
brings into play a series of forces which ultimately lead to the beginning of recession. The most
important of these factors is the gradual rise of costs relatively to prices.
Recession: The phase of recession, which is a turning period, is relatively shorter. In this period
while the forces of expansion is weekend, the forces that make for contraction get strengthened.
Recession phase is normally characterized by :- liquidation of stock market strains in banking
system; liquidation of bank loans; fall in prices; sharp reduction in demand for capital
equipment; abandoning of relatively new projects; slow fall in consumer goods; sharp decrease
in capital goods demand. Collapse in marginal efficiency of capital
Depression / contraction: Recession ultimately merges into depression which is the phase of
relatively low economic activity. When an economy moves from recession to depression, there is
a notable fall in production of goods and services and in employment. The least affected sectors
are Agricultural Activities in terms of both output & employment and Retail Business is also
little affected. The most affected sectors are manufacturing, mining and construction. The worst
affected industries are those which produce machines, tools, plants, equipments and steel.
During depression there is a substantial reduction in the incomes of the people and thus the
demand for consumer goods also declines. It has been observed that during depression when
incomes of most of the households drastically fall, they make substantial reduction in durable
goods. In this phase the general price level falls despite the reduction in output of goods and
services.
Recovery/stagflation: The recovery stage is gradual. It starts when the prices stop falling. At
this stage marginal efficiency of capital starts recovering. The firms begin making investment to
replace depreciated equipment. With business prospects improving, some firms opt for large
investments. Along with restoration of normal price relations, there is correction of distortions in
cost-price relations. Another sign of beginning of recovery is revival of stock exchange activities
manifested in the rising prices of securities. The upward movement of the prices of the securities
is taken to be a good indicator of the recovery of the profits. The cumulative process in the

business cycle builds up and the phase of recovery tends to move on into the phase of prosperity.
The cycle at this stage is ready to repeat itself.
Indicators of Business cycle: Indicators are the factors responsible for the changes in the
business cycle. GDP/Fixed Investment/Net Exports/Unemployment rate/Real Earning/Producers
price Index/CPI/Industrial production/Durable goods order/The Consumer Confidence
index/Industrial new order/Consumption of manufactured goods etc.
ECONOMIC INDICATORS:
How do we know when we are in a recession? Is there any way to predict that a recession will
soon occur? The NIPA data comes out with a lag after the end of a quarter and the NBER
certifies recessions after turning points occur. These two sources of information are thus not
going to be useful for learning about the current and future states of the economy. In addition, an
index number can be useful to policy makers if it reliably predicts the onset of a recession in
future. Therefore the timing of an economic time series can be useful for assessing the current
and future prospects of the economy.
The business cycle indicators compiled by the conference board are grouped into one of the three
categories- leading, coincident and lagging. These are described as follows:
1. Leading economic indicators: This group includes ten measures that generally indicate
business cycle Peaks and Troughs three to twelve months before they actually occur. The ten
leading indicators are:

- Manufactures new orders for consumer goods and materials.
- An index of vendor performance
- Manufacturers new orders for non-defence capital goods
- The standard and poors 500 index of stock prices
- New building permits for private housing
- The interest rate spread between U.S. treasury bonds and federal funds
- The M2 real money supply
- Average workweek in manufacturing
- An index of consumer expectations
- Average weekly initial claims for unemployment insurance
2. Coincident Economic Indicators: This category contains four measures that indicate the
actual incidence of business cycle peaks and troughs at the time they actually occur. In fact,
coincident economic indicators are a primary source of information used to document the official
business cycle turning points. The coincident indicators are:
- The number of employees on non-agricultural payrolls
- Industrial production
- Real personal income
- Real manufacturing and trade sales
3. Lagging Economic Indicators: This is a group of seven measures that generally indicate
business cycle peaks and troughs three to twelve months after they actually occur. The lagging
indicators are:
- Labor cost per unit of output in manufacturing
- The average prime interest rate
- The amount of outstanding commercial and industrial debt
- The consumer price index for services

- Consumer credit as a fraction of personal income
- The average duration of unemployment
- The ratio of inventories to sales for manufacturing and trade
Inflation
Inflation is the most experienced economic phenomenenon in India and in the rest of the world.
J.K Galbraith have confessed their inability to provide a solution to the problems of inflation that
could be implemented effectively in all countries.
Definition:
Geoffrey Crowther defines inflation as a state in which the value of money is, falling, i, e.prices
are rising are rising.
A.C.Pigou says, Inflation is a situation in which the communitys money income increases
faster than its real income.
Major Types of Inflation
1.Demand pull inflation :
A situation where in an increase in aggregate demand for output either from the government or
the entrepreneurs or the households exceeds the aggregate supply of output there by leading to an
increase in general price level (inflation). For instance, In Bangalore, normally the rent for
houses or commercial premises are always on the higher side due to the extreme demand, hence
who ever has more money would get.
2. Cost push inflation :
A situation where in the price level increases due to a rise in the cost or production. Even
though there is no increase in aggregate demand, prices may still rise, this may happen if the
costs particularly the wage cost increases for instance, in cities, most of the commodities are
costly as compared to rural areas as the wage / salary for the employees / workers for employees
/ workers is on the higher side.
3. Structural inflation :
In this situation, the rise in the prices occurs due to increasing investment expenditure and
expansion of money supply without a corresponding increase in the output level. For instance,

recently, car manufactures announced in the increase in car price as the increase in steel prices
that has proportionate relationship with overall increase of cost of manufacturing cars.
Types of Inflation in Economics
1. Types of Inflation on Coverage
Types of inflation on the basis of coverage and scope point of view:-
Comprehensive Inflation : When the prices of all commodities rise throughout the
economy it is known as Comprehensive Inflation. Another name for comprehensive
inflation is Economy Wide Inflation.
Sporadic Inflation : When prices of only few commodities in few regions (areas) rise, it is
known as Sporadic Inflation. It is sectional in nature. For example, rise in food prices due
to bad monsoon (winds bringing seasonal rains in India).
2. Types of Inflation on Time of Occurrence
Types of inflation on the basis of time (period) of occurrence:-
War-Time Inflation : Inflation that takes place during the period of a war-like situation is
known as War-Time inflation. During a war, scare productive resources are all diverted
and prioritized to produce military goods and equipments. This overall result in very

limited supply or extreme shortage (low availability) of resources (raw materials) to

produce essential commodities. Production and supply of basic goods slow down and can
no longer meet the soaring demand from people. Consequently, prices of essential goods
keep on rising in the market resulting in War-Time Inflation.
Post-War Inflation : Inflation that takes place soon after a war is known as Post-War
Inflation. After the war, government controls are relaxed, resulting in a faster hike in
prices than what experienced during the war.
Peace-Time Inflation : When prices rise during a normal period of peace, it is known as
Peace-Time Inflation. It is due to huge government expenditure or spending on capital
projects of a long gestation (development) period.
3. Types of Inflation on Government Reaction
Types of inflation on basis of Government's reaction or its degree of control:-
Open Inflation : When government does not attempt to restrict inflation, it is known as
Open Inflation. In a free market economy, where prices are allowed to take its own
course, open inflation occurs.
Suppressed Inflation : When government prevents price rise through price controls,
rationing, etc., it is known as Suppressed Inflation. It is also referred as Repressed
Inflation. However, when government controls are removed, Suppressed inflation
becomes Open Inflation. Suppressed Inflation leads to corruption, black marketing,
artificial scarcity, etc.
4. Types of Inflation on Rising Prices
Types of inflation on the basis of rising prices or rate of inflation:-
Creeping Inflation : When prices are gently rising, it is referred as Creeping Inflation. It
is the mildest form of inflation and also known as a Mild Inflation or Low Inflation.
According to R.P. Kent, when prices rise by not more than (upto) 3% per annum (year), it
is called Creeping Inflation.
Chronic Inflation : If creeping inflation persist (continues to increase) for a longer period
of time then it is often called as Chronic or Secular Inflation. Chronic Creeping Inflation
can be either Continuous (which remains consistent without any downward movement)
or Intermittent (which occurs at regular intervals). It is called chronic because if an
inflation rate continues to grow for a longer period without any downturn, then it possibly
leads to Hyperinflation.

Walking Inflation : When the rate of rising prices is more than the Creeping Inflation, it
is known as Walking Inflation. When prices rise by more than 3% but less than 10% per
annum (i.e between 3% and 10% per annum), it is called as Walking Inflation. According
to some economists, walking inflation must be taken seriously as it gives a cautionary
signal for the occurrence of Running inflation. Furthermore, if walking inflation is not
checked in due time it can eventually result in Galloping inflation.
Moderate Inflation : Prof. Samuelson clubbed together concept of Crepping and Walking
inflation into Moderate Inflation. When prices rise by less than 10% per annum (single
digit inflation rate), it is known as Moderate Inflation. According to Prof. Samuelson, it is
a stable inflation and not a serious economic problem.
Running Inflation : A rapid acceleration in the rate of rising prices is referred as Running
Inflation. When prices rise by more than 10% per annum, running inflation occurs.
Though economists have not suggested a fixed range for measuring running inflation, we
may consider price rise between 10% to 20% per annum (double digit inflation rate) as a
running inflation.
Galloping Inflation : According to Prof. Samuelson, if prices rise by double or triple digit
inflation rates like 30% or 400% or 999% per annum, then the situation can be termed as
Galloping Inflation. When prices rise by more than 20% but less than 1000% per annum
(i.e. between 20% to 1000% per annum), galloping inflation occurs. It is also referred as
Jumping inflation. India has been witnessing galloping inflation since the second five
year plan period.
Hyperinflation : Hyperinflation refers to a situation where the prices rise at an alarming

high rate. The prices rise so fast that it becomes very difficult to measure its magnitude.
However, in quantitative terms, when prices rise above 1000% per annum (quadruple or
four digit inflation rate), it is termed as Hyperinflation. During a worst case scenario of
hyperinflation, value of national currency (money) of an affected country reduces almost
to zero. Paper money becomes worthless and people start trading either in gold and silver
or sometimes even use the old barter system of commerce. Two worst examples of
hyperinflation recorded in world history are of those experienced by Hungary in year
1946 and Zimbabwe during 2004-2009 under Robert Mugabe's regime.
5. Types of Inflation on Causes
Types of inflation on the basis of different causes:-
Deficit Inflation : Deficit inflation takes place due to deficit financing.

Credit Inflation : Credit inflation takes place due to excessive bank credit or money
supply in the economy.
Scarcity Inflation : Scarcity inflation occurs due to hoarding. Hoarding is an excess

accumulation of basic commodities by unscrupulous traders and black marketers. It is
practised to create an artificial shortage of essential goods like food grains, kerosene, etc.
with an intension to sell them only at higher prices to make huge profits during scarcity
inflation. Though hoarding is an unfair trade practice and a punishable criminal offence
still some crooked merchants often get themselves engaged in it.
Profit Inflation : When entrepreneurs are interested in boosting their profit margins,
prices rise.
Pricing Power Inflation : It is often referred as Administered Price inflation. It occurs

when industries and business houses increase the price of their goods and services with
an objective to boost their profit margins. It does not occur during a financial crisis and
economic depression, and is not seen when there is a downturn in the economy. As
Oligopolies have the ability to set prices of their goods and services it is also called as
Oligopolistic Inflation.
Tax Inflation : Due to rise in indirect taxes, sellers charge high price to the consumers.
Wage Inflation : If the rise in wages in not accompanied by a rise in output, prices rise.
Build-In Inflation : Vicious cycle of Build-in inflation is induced by adaptive

expectations of workers or employees who try to keep their wages or salaries high in
anticipation of inflation. Employers and Organisations raise the prices of their respective
goods and services in anticipation of the workers or employees' demands. This overall
builds a vicious cycle of rising wages followed by an increase in general prices of
commodities. This cycle, if continues, keeps on accumulating inflation at each round turn
and thereby results into what is called as Build-in inflation.
Development Inflation : During the process of development of economy, incomes

increases, causing an increase in demand and rise in prices.
Fiscal Inflation : It occurs due to excess government expenditure or spending when there
is a budget deficit.
Population Inflation : Prices rise due to a rapid increase in population.
Foreign Trade Induced Inflation : It is divided into two categories, viz., (a) Export-Boom
Inflation, and (b) Import Price-Hike Inflation.

Export-Boom Inflation : Considerable increase in exports may cause a shortage at home

(within exporting country) and results in price rise (within exporting country). This is
known as Export-Boom Inflation.
Import Price-Hike Inflation : If a country imports goods from a foreign country, and the
prices of imported goods increases due to inflation abroad, then the prices of domestic
products using imported goods also rises. This is known as Import Price-Hike Inflation.
For e.g. India imports oil from Iran at $100 per barrel. Oil prices in the international
market suddenly increases to $150 per barrel. Now India to continue its oil imports from
Iran has to pay $50 more per barrel to get the same amount of crude oil. When the
imported expensive oil reaches India, the indian consumers also have to pay more and
bear the economic burden. Manufacturing and transportation costs also increase due to
hike in oil prices. This, consequently, results in a rise in the prices of domestic goods
being manufactured and transported. It is the end-consumer in India, who finally pays
and experiences the ultimate pinch of Import Price-Hike Inflation. If the oil prices in the
international market fall down then the import price-hike inflation also slows down, and
vice-versa.
Sectoral Inflation : It occurs when there is a rise in the prices of goods and services
produced by certain sector of the industries. For instance, if prices of crude oil increases
then it will also affect all other sectors (like aviation, road transportation, etc.) which are
directly related to the oil industry. For e.g. If oil prices are hiked, air ticket fares and road
transportation cost will increase.
Demand-Pull Inflation : Inflation which arises due to various factors like rising income,
exploding population, etc., leads to aggregate demand and exceeds aggregate supply, and
tends to raise prices of goods and services. This is known as Demand-Pull or Excess
Demand Inflation.

Cost-Push Inflation : When prices rise due to growing cost of production of goods and
services, it is known as Cost-Push (Supply-side) Inflation. For e.g. If wages of workers
are raised then the unit cost of production also increases. As a result, the prices of end-
products or end-services being produced and supplied are consequently hiked.
6. Types of Inflation on Expectation
Types of inflation on the basis of expectation or predictability:-

Anticipated Inflation : If the rate of inflation corresponds to what the majority of people
are expecting or predicting, then is called Anticipated Inflation. It is also referred as
Expected Inflation.
Unanticipated Inflation : If the rate of inflation corresponds to what the majority of

people are not expecting or predicting, then is called Unanticipated Inflation. It is also
referred as Unexpected Inflation
What is Stagflation :
Stagflation refers to economic condition where economic growth is very slow or stagnant and
prices are rising. The term stagflation was coined by British politician Iain Macleod, who used
the phrase in his speech to parliament in 1965, when he said: We now have the worst of both
worlds - not just inflation on the one side or stagnation on the other. We have a sort of
stagflation situation. The side effects of stagflation are increase in unemployment-
accompanied by a rise in prices, or inflation. Stagflation occurs when the economy isn't growing
but prices are going up. At international level, this happened during mid 1970s, when world oil
prices rose dramatically, fuelling sharp inflation in developed countries.
What is Hyperinflation :
Hyperinflation is a situation where the price increases are too sharp. Hyperinflation often occurs
when there is a large increase in the money supply, which is not supported by growth in Gross
Domestic Product (GDP). Such a situation results in an imbalance in the supply and demand for
the money. In this this remains unchecked; it results into sharp increase in prices and
depreciation of the domestic currency.
What is Headline Inflation
Headline inflation refers to inflation figure which is not adjusted for seasonality or for the often
volatile elements of food & energy prices, which are removed in the Core CPI. Headline
inflation will usually be quoted on an annualized basis, meaning that a monthly headline figure
of 4% inflation equates to a monthly rate that, if repeated for 12 months, would create 4%
inflation for the year. Comparisons of headline inflation are typically made on a year-over-year
basis. Also known as "top-line inflation".
Price Indices: The numerical value that summarizes price level is called as price indices. The
main purpose of Price Indices is it helps in explaining the purchasing Power or
Inflation/Deflation from one period to another.
Kinds of Price Indicies
There are two types of Price Indices: Wholesale Price Index (WPI): It is an indication of price
movements in all markets other than the retail market. It is worked out for a whole country or for

a very large area and the prices are collected from the wholesale dealers. Consumer Price
Index: is a price index with special reference to a class or category of people for whom it is
meant and the items to be included in calculating index numbers vary from one group to another.
Types of Consumer Price Index: At present in India apart from WPI, three different indices of
consumer prices are available: Consumer Price Index for Industrial Workers (CPI-IW);
Consumer Price Index for Urban Non-manual Employees (CPI UNME); Consumer Price Index
for agricultural Laborers (CPI AL). The inflation rate in economy varies from WPI to CPI. For
e.g. in 1998-99 the inflation rate as per WPI was 6.3% and as per CPI it was 15.3%. It also varies
between three type of CPI as mentioned above.
Relationship between Price Indices and inflation: Inflation is estimated through Price Indices.
Earlier inflation was estimated in terms of wholesale price. However from the point of view of
consumers, retail prices are far more relevant and thus today inflation is measured in terms of
CPI.
Causes of inflation: The basic cause of inflation normally occurs, when aggregate demand for
output tends to be excessive in relation to the supply of output: Increase in the money circulation;
Increase in the disposable income; Increase in communitys aggregate spending on consumption
and investment or in goods. Excessive speculation and tendency to hoarding and profiteering;
Increase in foreign demand the result in exports; Increase in population as the widening gap
between demand and supply. Deficiency in capital equipment that leads to a company to invest
more fund in renovating or buying new equipment that cost would be imposed on end users.
Drought, famine, earth quake, storm, volcano eruption and other natural calamities adversely
affecting agricultural production and output of other industries. Prolonged industrial unrest
(strike or lockout of a particularly industry or industries, nation wide truck strike that would
cause stagnation of goods that would result the increase in demand) affecting normal industrial
output that would ensure the match in demand and supply
Measures/Remedies of inflation:
Several monetary and non-monetary would prove to be appropriate measure to cure inflation.
All these measures aim at reducing aggregate monetary expenditure taking the available level of
output as given.
1. Monetary Measures : Reserve Bank of Indias measures through controlling costs and
credit the RBI could rise the costs of borrowing in turn, reduce the credit creations capacity of
banks. This would make borrowings more costly and their by, the demand for the funds would be
reduced. This would mainly be done to reduce the excess money circulation (main cost of
inflation). The mechanics of monetary measures are engineering credit control methods by
changing bank rate policy, open market operations, varying reserve ration and other selective
control methods.
2. Fiscal policy : Fiscal measures could be deployed to check inflationary pressures such as,
control over government spending, imposing new taxes or increasing old ones to curtail the size
of disposal income unto reduce the magnitude of the inflationary gap, encourage savings or
introduction of compulsory savings schemes or increase the interest rate in fixed deposits or
recurring over value of domestic currency against foreign currencies etc.
3.Direct controls: This executive policy refers to the regulatory measures adopted by a
government to contain the harmful effects of inflation. Important among these measures is price
control. This is an effective method during war time because both monetary and fiscal policies
are more or less 1ineffective during this period. Price control means pegging down the prices (of
goods) beyond which they should no rise. But this step is considered to be detrimental to the
consumers sovereignty, freedom and welfare.
4. Other measures : Usually, increasing output or increasing imports and decreasing exports so
as to increase the available supply of goods too domestic market in order to match the demand
and supply gap, control the money wages in order to keep down the costs., i.e., reduce the
spending power, prevent prices from rising (to impose price control) and rationing (restricting)
the supply of certain commodities.
Effects of inflation: Normally during inflation, the value of money comes down as the prices of
commodities and services. This would generally have a bearing on economic trend in a country.
For instance, when Mexican economy was opened to foreigners, the currency reached the
abysmal depth as the inflation reached the pinnacle. Many people left penniless as the
government had to print and issue currencies to manage the situation. It also happened in
Argentina. Hence, any government ought to exercise control over keeping the inflation under
check.
Effects on production and employment : Generally, the inflation boosts of the margin of
products as it motivates the companies expands its operations that would normally lead to
generation of employment opportunities. Normally, debtors gain benefits as creditors suffer
badly. Investors may face the currency depreciation that would lead to reduce outcome of their
savings. Wage earners and salaried would face the debacle. Farmers would benefit due to
increase in prices of crops. Inflation would provide a competitive edge to those who are rich and
poor would be affected.
Inflation and Growth : There are always different schools of thought about the role of inflation
(positive or negative). During early 90s, the Indian government was forced to de-value its
currency to boost exports in order to gain the competitive edge in prices in international markets
as to boost influx of foreign exchange that was need of the hour. Hence, inflation is like twin
edge knife that would cut for and against. 1. The increase inflation results the decrease in
currency value that would normally encourage people to spend on different products/ services
that would increase the money circulations and boost to expansion of business in turn generate

employment opportunities, increase in standard of living etc. 2. Rising prices generally

encourage people to invest in gold, real estates etc. 3. Inflation helps to distribute income in
favor of the rich, manufactures traders, land owners etc. 4. Working class belong to fixed
income earners, middle class and pensioners would suffer miserably during the period of rising
prices due to their in ability to cope up with. Though, the government would provide dearness
allowance to compensate , but unfortunately, normally that would not suffice the purpose. 5.
Inflation would also bring the increase in costs of projects that would results a havoc, if the
project goes beyond the stipulated duration. 6. It reduces the consumption pattern of the set of
population (salaried-wage class). Hence, rising prices as a goal of monetary has full of adverse
consequences rather than positive output, therefore, it ought not be followed as a desirable goal
the economic policy
Deflation
Deflation means a contraction of currency and credit leading to a fall in prices. It is the
opposite of inflation, another extreme currency situation, where prices fall and the value of
money rises. Deflation, according to Paul Einzig, is a state of disequilibrium in which a
contraction of purchasing power tends to cause, or is the effect of, the price level.
Contribution of Different Sectors to Indian Economy:
Primary Sector: The share of the primary sector which includes agriculture, forestry and fishery
has gone down from55.3 % in GDP in 1950-51 to 44.5 % in 1970-71 and to a still lower figure at
26.1 % in 1996-97 and 17.5% in 2009. Still it employs 52% of population. As agriculture
contributes the bulk share to the primary sector, it would be of interest to estimate the trend of
the contribution of agriculture to GDP. The share of fishing in GDP has remained stable at 0.8 %
throughout the 46 year period. It is really distressing that the share of forestry in GDP has shown
a continuous decline from 5 % in 1950-51 to 4 % in 1970-71 and further to barely 1.0 % in 1996-
97. This only underlines the fact that in the primary sector, agriculture alone is the most
important and the trend and change in agricultural output determines the share of the primary
sector in national output
Secondary Sector: The share of the secondary sector which includes mining, manufacturing,
construction, electricity, gas and water supply has shown a steady increase from 16.1 % GDP in
1950-51 to 31.1 % in 1996-97 and 29.5% in 2009. Two major components of the secondary
sector are manufacturing industries and construction. The share of manufacturing in GDP
increased from 11.4 % in 1950-51 to 22.5 % in 1996-97. It may also be noted that manufacturing
industries are grouped under registered and unregistered units. The share of registered units in
manufacturing industries more than doubled during the 45 year period i.e. from 5.4 % in 1950-51
to 14.5 % in 1995-96. But as against this, the share of the unregistered units marginally improved
from 6 % of GDP in 1950-51 to 8.0 % in 1996-97. Similarly, the share of construction improved
from 3.3 % in 1950-51 to 5.0 % in 1970-71 and thereafter it declined to 4.3 %in 1996-97

Tertiary Sector: The share of the tertiary sector which includes trade, transport, storage,
communications, banking, insurance, real estate and community and personal services improved
from 28.5 % in 1950-51 to 32 % in 1970-71 and further increased 42.9 % in 1995-96 and 53% in
2009. Tertiary sector is composed of three components. (a) the share of transport,
communications and trade improved from 11 % in 1950-51 to 20.2 % in 1996-97; (b) the share
of public administration and defence improved from 2.3 % of GDP in 1950-51 to 4.9 % in 1996-
97. The share of other services which was 6.4 % in 1950-51 remained more or less stable and
slightly declined to 5.8 % in 1996-97; (c) the share of finance and real estate which includes
banking and insurance improved marginally from 9 % in 1950-51 to 12.1 % in 1996-97. The
structural change in the composition of national income by industrial origin in the consequences
of the process of economic growth initiated during the plans.
SWOT ANALYSIS OF INDIAN ECONOMY:
STRENGTH:
Intelligent human resource .
Natural resource .
Comparatively other counties labor cost is less .
High percentage of cultivable land .
Huge English specking International language (English)
Growth of IT and BPO sectors bring in valuable foreign exchange .
High growth rate in GDP .
Diversified nature of economy .
Extensity higher education system .
3rd largest reservoir of engineers.
WEAKNESS :
Highest percentage of workforce involved in agriculture which contributes 25% on GDP.
High unemployment rate
Below poverty line , corruption , around 1/4th of population below the poverty line .
Socio economic conditions.
Poor infrastructure .

Import is more than experts .
Lack of technological invention .
Lack of domestic entrepreneurs .
Political instability .
Low literacy rate .
Rural and urban classification .
Poor leaving standard .
OPPORTUNITIES:
Entry of private firms in various centres of business .
Area of Bio-technology .
Inflow of FDI , likely to increase in many sectors .
Huge foreign exchange earning , prospect in IT sectors .
Huge natural gas found in India , Natural gas as tremendous opportunities.
Area of infrastructure .
Investment in R & D , engineering design .
THREATS:
Increase in the sick units , because of MNCs.
High physical depict.
Threat of government intervention in some states.
Volatile in the crude oil price and commodities.
Growing import bills.
Population explosion .
Political stability .
Agriculture majorly depend on monsoons .

Module 6
Industrial Policies and Structure
Classification of Industries based on Ownership, Industrial Policies, New Industrial Policy

1991; Private Sector- Growth, Problems and Prospects, SSI- Role in Indian Economy.
Industry Analysis: Textiles, Electronics, Automobile, FMCG, Telecom, Pharm. FDI in
Retail, Infrastructure, Pharma, Insurance, Banking & Finance and Automobile.
Globalization and Indian Business Environment: Meaning and Implications, Phases,
Impact of Globalization on Indian Economy across Sectors.
Foreign Trade: Trends in Indias Foreign Trade, Impact of WTO on Indias Foreign
Trade.
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TYPES OF COMPANIES ACCORDING TO OWNERSHIP OF THE COMPANY:

On the basis of ownership, companies are divided into
(1) Private sector companies or non-government companies and
(2) Government companies commonly known as public sector companies.
1. Private company:
As per Section 3(l) (iii) as amended by the Companies (Amendment) Act, 2000, a private
company is one which has a minimum paid up capital of Rs. One lakh or such
Higher paid up capital as may be prescribed. Such a company by its Articles of Association
.(i)restricts the rights of the members to transfer shares,(ii)limits the number of members to
fifty,(iii) prohibits any invitation to public to subscribe for any shares or debentures of the
company , and
(iv)prohibits invitation or acceptance of deposits from persons other than its members.
A private company can be formed by a minimum of two members.
2. Public company:
According to Section 3(l) (IV) as amended by the Companies (Amendment)
Act,2000, a public company is one that (i) is not a private company,(ii) has a minimum paid up
capital of Rs. Five lakh or such higher paid up capital , as may be prescribed , and (iii) is a
subsidiary of a public company. This public company must have a minimum of seven members.
Industrial Policies
The Industrial Policy plan of a country, sometimes shortened IP, is its official strategic effort to
encourage the development and growth of the manufacturing sector of the economy.The

government takes measures "aimed at improving the competitiveness and capabilities of

domestic firms and promoting structural transformation." A country's infrastructure
(transportation, telecommunications and energy industry) is a major part of the manufacturing
sector that usually has a key role in IP.
Industrial policies are sector specific, unlike broader macroeconomic policies. They are
sometimes labeled as interventionist as opposed to laissez-faire economics. Examples of
horizontal, economywide policies are tightening credit or taxing capital gain, while examples of
vertical, sector-specific policies comprise protecting textiles from imports or subsidizing export
industries. Free market advocates consider industrial policies as interventionist measures typical
of mixed economy countries.
Meaning of industrial policy: Industrial policy refers to governments policy towards industries
their establishment, functioning, growth and management. This indicates the respective areas
of large, medium and small sector industries, foreign capital, Labour tariff and other related
aspects.
Importance of IP: When India became independent in 1947, the industrial base of the economy
was very small and the industries were beset with many problems such as shortage of raw
material, deficiency of capital, bad industrial relations etc. The investors were not sure about the
industrial policy of the new national government and the industrial climate was wrought with
uncertainties and suspicious. The Government called an Industrial Conference in December 1947
to improve matters and remove the uncertainties and suspicious in the minds of investors and
entrepreneurs. The conference adopted a resolution for industrial peace and recommended a clear
cut division of industries into the public sector and private sector. The various Industrial
policies were passed from time to time to improve the industrialization of our country.
Overview of Policies:
1. Industrial Policy Resolution, 1948 The Policy aimed at outlining the approach to
Industrial growth & development. It emphasised the importance to the economy of
securing a continuous increase in production and ensuring its equitable distribution.
2. Industrial Policy Resolution, 1956 - Under the Policy the role of State was given more
importance as an engine for accelerating the economic growth and speeding up the
industrialization as a means of achieving a socialist pattern of society.
3. Industrial Policy Statement, 1973 The thrust of this Policy Statement was an
identification of high-priority industries where investment from large industrial houses
and foreign companies were permitted.

4. Industrial Policy Statement, 1977 - The Policy emphasized on decentralization and

growth of small scale industries.
5. Industrial Policy Statement, 1980 - The Policy einusaged promoting competition in

domestic market, technology upgradation and modernization. The policy laid the
foundation for an increasingly competitive export based and for encouraging foreign
investment in high-technology areas.
Industrial Policy 1991
Objectives
The main objectives of the Policy were as follows:
To maintain a sustained growth in productivity and gainful employment and attain international
competitiveness.
Self reliance or building up the ability to pay our import bills through our own foreign
exchange earnings and developing indigenous capacity in technology and manufacturing
Pursue sound policy framework encompassing encouragement to entrepreneurship, development
of indigenous technology, dismantling of the regulatory system.
Development of capital markets and increasing competitiveness
Spread of industrialization to backward areas through appropriate incentives, institutions and

infrastructure investments
Encourage foreign investment and technology collaboration
Abolish monopoly of any sector or any individual enterprise in any field of manufacture except
on strategic and military considerations and open all manufacturing activity to competition
Ensure that public sector plays its rightful role in strategic areas of national importance.
Protect the interests of labour, enhance their welfare and equip them to deal with technology
change
To attain these objectives, Government took a series of initiatives in regard to policies in the
following
areas.
a) Industrial Licensing
b) Foreign Investment
c) Foreign Technology agreements

d) Public Sector Policy
e) Monopolies and Restrictive Trade Practices (MRTP) Act, 1969
Features
Following are some of the main features of the industrial policy 1991
1. Dereservation of Public Sector: -The role of public sector has been reduced to a great extent.
The number of industries reserved for public sector was reduced to 8 industries. There was
further Dereservation. At present, there are only three industries reserved for public sector which
include. (a) Atomic energy (b) Railways, and (c) specified Minerals.
2. Delicensing: -The most important features of NIP, 1991 was the abolition of industrial
licensing of all industries except six industries. The six industries are of social and strategic
concern. The six industries are
1. Hazardous Chemicals. 2. Alcohol 3. Cigarettes 4. Industrial Explosives 5. Defence Products,

and 6. Drug and pharmaceuticals.
3. Disinvestment of public sector: -The NIP 1991 permitted disinvestment of public sector
units. Disinvestment is a process of selling government equity in PSUs in favour of private
parties. Disinvestments aim at certain objectives. (1) To provide better customer Service. (2) To
make effective use of disinvestment funds. (3) To overcome the problem of political
interference. (4) To enables the government to concentrate on social development. Etc,
4. Liberalisation of Foreign Investment: -Prior to this policy, it was necessary to obtain

approval from the government in respect of foreign investment. At present, 100% foreign equity
participation is allowed in select industries.
5. Liberalisation Foreign Technology: -The NIP 1991 liberalised foreign technology to bring
about technological improvement in Indian industry. (1) No Permission is required for hiring
foreign technicians and foreign testing of indigenously developed technologies.
6. Liberalisation of Industrial Location: -The IP 1991 stated that there is no need to obtain
approval from Central Government to locate industries in areas (other than cities of more than
one million populations). However, industries subject to compulsory licensing, approval need to
be obtained. In cities with a population of more than one million, polluting industries were
required to be located outside 25 Kms of the city area.
7. Removal of Mandatory Conversion Clause (MCC): - In India, banks and FIs provide a
large part of industrial finance. The banks and FIs have the option to convert the loans into
equity. This may create a threat of takeover by FIs. Therefore, the IP 1991 abolished MCC.

8. Abolition of phased Manufacturing Programme: - The IP 1991 has suggested for the
abolition of PMP, which was in force in engineering and electronic industries.
Private Sector
The private sector is a fraction of the economical market that is owned and controlled by private
individuals and businesses. Private sector businesses are not controlled by the government and
are responsible for allocating resources within the economy. These usually includes corporations
(both profit and non-profit), partnerships, and charities. Some examples of private sector
businesses are; sole traders, franchises and workers co-operatives.
Growth and Prospects in Private Sector
As of the figures of the last decade, India has had a remarkable growth in private sector
investment. The liberal trade and investment policies and the country's infrastructure have
provided the environment for higher investment and growth in private sector.
Recent Trends in Private Participation
Growth in Telecom Sector
As of the figures of 2001-06, there has been an incredible increase in the investment in the
telecommunication sector in India and as a result there has been immense growth in the telecom
industry. 64% of the investment in this sector in South Asia has been in this sector. Various
private telecom companies as Airtel, Reliance Communications, Tata Indicom etc have been the
major investors in this field. The subscriber base has increased as a result which is reflected in
their figures:
Bharti Airtel -3,280,658
Reliance Communications 1,232,060
Tata Teleservices 1, 289, 17
Growth in Energy and Water Sectors
This sector also has attracted a large investment from the private industries. Figures as of 2001-
06 registered 17% investment in the sector. However in the water sector there has not been any
major investment due to political issues, weak authority etc. In India, the power distribution has
been privatized in several cities as Delhi and states like Orissa. The western state of Maharashtra
is also keen on having larger investment from the private sector in the power division.
Growth in Transport Sector

This sector has also become an important area of investment by the private enterprises. As of
figures of the year 2006, there has been an investment of 34% alone in the transport sector. The
driving force behind this success has been India's initiatives and policies encouraging
partnerships of the private and the public sectors in transport.
Private Sector and Public Sector in India
As of the last decade, the growth and investment in the private sector has well surpassed the
growth in the public sector. Figures suggest that the share of the private sector in the net sales of
manufacturing and services industry augmented from 48.83% in 2001-01 to 68.55% in 2009-10.
Subsequently the share of the public sector reached to 31.45% from a higher percentage of
51.17%.The shares of private sector in the net profit in the non-agricultural economy rose to
63.86% from 39.17%. The share of the public sector subsequently declined to 36.14% from
60.83%.
This increase in the private sector's share is largely due to the higher foreign direct investment
over the last decade. Over the last decade or so, with the liberalisation of the economic policies,
India has been able to achieve higher investment from the private sector. For instance due to
modifications and changes in the economic policies the transport and telecommunication
industry witnesses a higher percentage of growth and investment in the private sector. - See more
at: http://business.mapsofindia.com/sectors/private/growth.html#sthash.KtiKYakh.dpuf
Problems of the private sector
1. Profit generation is the main motive- industrialists in the private sector operate with the
sole motive of maximizing profits. Consequently, they are interested in investing only in
those industrial sectors where quick profit generation is possible. Therefore, they tend to
invest in consumer goods industries and ignore investments that are crucial for building
up a proper industrial infrastructure.
2. Focus on consumer durable goods- even in the consumer goods sector, the focus of the
private sectors on the elite consumer groups since it is these groups that have ample
purchasing power. Thus, the production pattern is skewed in favors of the relatively small
richer sections of the society. As a result, while production of elite consumer durable
goods like consumer electronics and automobiles is encouraged, the production of mass
consumption goods is neglected.
3. Monopoly and concentration- it is general pattern of capitalist development that, as the
economy progresses, the monopoly organizations are strengthened and concentration of
wealth and economic power in a few hands increases.
4. Declining share of net value added in total output. Net value added is defined as the
amount generated over and above the cost of rawmaterials which go to the production
system after allowing for the depreciation charges. It thus indicates the efficiency of the
production process.

5. Infrastructure bottlenecks. Severe capacity shortfalls, poor quality and high cost of
infrastructure continue to constrain Indian businesses. The most important infrastructural
constraint is power. Industry surveys have found that acute power shortfalls, unscheduled
power cuts, erratic power quality (low voltage coupled with fluctuation) delays and
informal payments required to obtain new connections, and very high industrial energy
costs, hurt industry performance and competitiveness. Frequent and substantial power
cuts have forced many units to operate their own generators, further increasing the cost of
power for industry and reducing firm competitiveness.
6. Contribution to trade deficit. A large number of private sector companies have been
resorting to massive imports in the post-liberation phase to upgrade their technology in a
bid to brace up to global competition. As a result, their import expenditure has increased
at a much faster rate than their export earnings. This has pushed up the countrys trade
defect.
7. Industrial dispute. As compared to public sector enterprises, the private sector
enterprises suffer from more industrial dispute. Differences and conflicts between the
owners and employees regarding wages, bonus, retrenchment and other issues frequently
emerge. Although there is a provision for works committees. Arbitration boards, etc. for
settlement of industrial disputes, the employers have better bargaining strength.
8. Industrial sickness. This is a serious problem confronting the small, medium and large
units in the private sector. Substantial amount of loan able funds of the financial
institutions is locked up in sick industrial units causing not only wastage of resources but,
also affecting the healthy growth of the industrial economy adversely. As at the end of
March 2007, the total number of sick weak units in the portfolio of scheduled commercial
banks stood at 1.18 lakh involving a bank credit of Rs 30,333 crore. Causes of industrial
sickness are many and are generally divided into two categories external and internal.
9. Problems relating to finance and credit. Since the rate of capital formation in the
economy is low and the capital market is in an underdeveloped state, the private sector
enterprises have to encounter serious difficulties in arranging finance. Because of high
inflationary tendencies in the economy, people are attracted towards purchasing land,
gold and jeweler and are not willing to invest in industries. Inflationary conditions have
also given birth to black marketing and a large parallel economy which mean away funds
from productive activities. The industrial finance institutions have filled up this gap to
some extent but the problem continues to be enormous.
10. Threat from foreign competition. The process of liberation unleashed in 1991 has
opened up the gates to foreign investors and the government has progressively introduced
measures to open up the economy to foreign competition. This process of globalization
and integration of the Indian economy with the world economy has led to an unequal
competitiona competition between giant MNCs and dwarf Indian enterprises. In the
early euphoria of liberalization, the private sector welcomed the measures of the
government, but it soon came to realize that opening up the Indian economy to foreign

competition meant not only more and cheaper imports and more foreign investment but
also opportunities to the MNCs to raid and takeover their enterprises. Even the large
Indian enterprises are just pygmies compared to the multinational corporation and while
some of them have already been gobbled up by the later, some others are awaiting their
turn with bated breath.
SMALL SCALE INDUSTRY
A small scale industry (SSI) is an industrial undertaking in which the investment in fixed
assets in plant & machinery, whether held on ownership term or on lease or hire
purchase, does not exceed Rs. 1Crore. However, this investment limit is varied by the
Government from time to time.
Entrepreneurs in small scale sector are normally not required to obtain a license either
from the Central Government or the State Government for setting up units in any part of
the country. Registration of a small scale unit is also not compulsory. But, its registration
with the State Directorate or Commissioner of Industries or DIC's makes the unit eligible
for availing different types of Government assistance like financial assistance from the
Department of Industries, medium and long term loans from State Financial Corporations
and other commercial banks, machinery on hire-purchase basis from the National Small
Industries Corporation,etc. Registration is also an essential requirement for getting
benefits of special schemes for promotion of SSI viz. Credit guarantee Scheme, Capital
subsidy, Reduced custom duty on selected items, ISO-9000 Certification reimbursement
& several other benefits provided by the State Government.
The Ministry of Micro, Small and Medium Enterprises acts as the nodal agency for
growth and development of SSIs in the country. The ministry formulates and implements
policies and programmes in order to promote small scale industries and enhance their
competitiveness.
ROLE OF SSI IN INDIAN ECONOMY
Employment Generation :
o The SSI sector employed 264 lakh people in 2002-03 and this number rose to 332
lakh people in 2007-08 . Within the manufacturing sector itself, small and
decentralized sector creation of employment in India. Given the acute
unemployment problem in India , creation of employment opportunities will
depend crucially on the development of small-scale and cottage industries. This
would be clear from the fact that while employment in the factory sector as a
whole increased by only 2.21% per annum over the period 1972 to 1987-88,
employment in small-scale sector grew at the rate of 5.45% per annum.

Efficiency of small-scale industries.

o Whether large-scale industries are more efficient of small-scale industries are
more efficient, is a matter of debate. The problem arises because of the fact that
efficiency can be defined in many different ways. An important study on this
issue was conducted in 1999 by the SIDBI Team in association with National
Council of Applied Economic Research. The study covers the period 1980-94. It
reveals that the small-scale industries, by investing only 7% of 15% of the total
manufacturing sectors capital contribute to nearly one-fifth of the total industrial
output and 35 to 45 % of total employment in the industrial sector.
Equitable distribution of national income:
o One of the main arguments put forward in support of the small-scale and cottage
industries is that they ensure a more equitable distribution of national income and
wealth. This is accomplished because of the following two considerations:
The ownership of small-scale industries is more widespread than the ownership of large-
scale industries, and
They possess a much larger employment potential as compared to the large industries.
Mobilization of capital and entrepreneurial skill:
o The small-scale industries are at a distinct advantage as far as the mobilization of
capital and entrepreneurial skill is concerned. A number of entrepreneurs are
spread over small towns and villages of the country. Obviously, large-scale
industries cannot utilize them as effectively as the small-scale and village
industries distributed over the entire length and breadth of the country. Similarly,
large-scale industries cannot mobilize the savings done by people in areas far
flung from the urban centers. But this task can be effectively accomplished by
setting up a network of small-scale and cottage industries. In addition, a large
number of other resources spread over the country can be put to an effective use
by the small-scale and cottage industries.
Regional dispersal of industries:
o In our discussion on industrial licensing policy . We had pointed towards the
tendency if massive concentration of large-scale industries in the states of
Maharashtra, West Bengal, Gujarat & Tamilnadu. Thus , disparities in industrial
development have increased. Even within these industrialized states, industries
have tended to get concentrated in a few large cities like Mumbai, Kolkata &
Chennai. People migrate in large numbers from villages and lower order urban
centers to these centers of industrial development. This swells the population of
slums and creates various social and personal problems.
Less industrial disputes:
o Supporters of small-scale industries frequently argue that large-scale industries
are ridden with more industrial disputes than the small-scale industries. Because
of the tensions in the relations between workers of large-scale industries and the

mill-owners, such industries frequently face strikes and lockouts. As against this,
the small-scale industries are free from such hazards and there is consequently
less loss of output . However, this viewpoint is not totally correct. In capitalistic
form of production whether the unit is small or large, the mill owner does exploit
the workers.
Contribution to exports:
o With the establishment of a large number of modern small-scale industries in the
post-independence period, the contribution of the small-scale sector in export
earnings has increased by leaps and bounds. What is heartening to observe is that
the bulk of the exports of the small-scale industries consist of such non-traditional
items like readymade garments, sports-goods, finished leather, leather products,
woolen garments and knitwear\, processed foods, chemicals and allied products
and a large number of engineering goods. The total exports of the small-sector
industry products increased from Rs 155 crore during 1971-72 to Rs 177600 crore
in 2005-06. This meant an increase in the share of the small-scale industries in the
total exports of the country from 9.6% in 1971-72 to 31.1% in 2006-07.
INDUSTRY ANALYSIS
Textile industry
Indian textiles industry has rich heritage and a glorious tradition. The textiles industry
contributes more for exports as a traditional exportable item.
Structure and Policy Changes
Indian textiles Indus try contributes six percent to the gross domestic product and
earns 18 percentage of the total foreign exchange earned by the country. It directly employs
about 33lakh workers and in addition gives employment to several million families of workers
engaged in ancillary units. The textile industry is one of the major sectors of the Indian industry
with the production growing at a remarkable rate for the two decades.
The Indian textiles industry has been considered as an unorganized sector. The
scattered and small players entered the business to avail immediate gains that came in the form
of external demands in the past. The small players had got more boosts from reservation of
textiles for exclusive production in the small sector. Nearly 80% of the units in the industry are
very small and tiny units. In a majority of the cases pattern making cutting and finishing jobs are
done in house. As the industry consists of a large number of small scale units and there no entry
o exit barriers except in case of reserved items the industry structure approximates to perfect
competitive market conditions. The industry has been focusing on production in response to the
demand in the west, i.e., the export market, although exports of textiles were subjected to
quantitative restriction in many of the importing countries. A major proportion of Indian textiles
exports has so far been to countries like United States, United Kingdom and Germany, despite

the restrictions therein. However, the percentage. However, the percentage share of these
countries in Indian textiles exports has been declining over a period of time.
International scenario:
Changes in the rules of in the international trade in textiles and the ongoing domestic
policy reforms have provided more opportunities for Indian garments units in post-2004,with the
removal of the quantitative restriction on textiles and clothing as per the agreement of textiles
and clothing(ATC) of WTO. On the other hand India has already opened its domestic market to
textile imports. In addition liberalization of investment policies is bringing in multinational
companies to the domestic market. However India has strength and resources to become a
significant players in the global garment industry by way of exports.
SWOT Analysis:
The SWOT analysis of textile industry in India is given as
Strength:
(a) Traditional exports items of India
(b) Near perfect competition in the industry
Weakness:
80% units are very small and tiny in which the cost of production would be high compared to
large units. Small units cant achieve economies of scale
Opportunity:
Export demand is likely to increase with the removal of quantitative restrictions by all members
countries off WTO in 2005 as per the agreement on textile and clothing
Threat:
Competition from countries like Bangladesh and Vietnam.
Garments exports growth rate in India has slowed down in recent years.
The SWOT charts reveals that the textiles industry consists of many small units though the sector
has been contributing substantially to Indias exports value. On other hand world export demand
for textiles has increased with the implementation of agreement on textiles and clothing (ATC) in
the year 2005. However the exporters would face increased competition from other countries like
Bangladesh and Vietnam . Those who focus on export markets and leverage the opportunity
would emerge as winners.
AUTOMOBILE INDUSTRY
The business environment and the trends in the automobile industry have been discussed in the
context of three distinct phases, namely, (0 regime of licensing (ii) partial liberalization (iii) full
liberalization.
Policy Thrust and Phases

The arguments for globalization and market-oriented policies are relevant to the automobile
industry. The policy changes include exposing domestic producers to both internal and external
competition, which can lead to: (i) better utilization of capacity and (ii) cost reduction.
Enhancement in efficiency, along with openness, policies implemented by other countries helps
enlarge the size of the external market to compensate for any shortfall in domestic demand.
It can be seen that the Indian automobile industry has gone through three distinct phases. The
phases are elaborated subsequently.
(i) The Early Regime of Licensing Until 1983
The early regime was governed by regulations where imports, collaborations, and equity
ventures were severely restricted by the government. Capacity expansion was also restricted and
the government issued the required licenses. Technology transfer from foreign companies was
subject to government approvals. All these factors had an impact on the supply as well as the
prices of the vehicles. The prices were very high during this period.
(ii) Partial Liberalization of Rules in Mid 1980s
The partial liberalization rules by the government in the mid-1980s led to the entry of Maruti and
the proliferation of Two Wheelers and Light Commercial Vehicles (LCVs) into India. The
decision to allow foreign collaborations in all automotive segments was a milestone in the
history of the Indian automobile sector. Capacity constraints became a matter of past and the
auto industry was allowed to attain greater flexibility in their operations as a result of exemption
from MRTP notification procedures and with the freedom for importing technology and capital
goods. The entry of multinational companies into the automobile sector led to its substantial
growth. Suzuki Motor Company of Japan in collaboration with MarutiUdyog Limited led the
sector to its tremendous growth. In numerical terms, there had been a rise in the sales of car from
112,550 (including jeeps) in 1980 to 345,157 in 1990 registering a three-fold increase within a
decade. The government also encouraged the company through fiscal concessions by lowering
import and excise duties. The company was also forced to adopt a phased manufacturing
programme whereby it had to increase the indigenous content in the production process
gradually. The advent of the company had significant effects in terms of quality and price also.
They pioneered the concept of an affordable family car, and cashed in on demand. Thus, the
actual boom in the car market started when MarutiUdyog Limited entered the industry in 1984
with its small and fuel-efficient family ear models.
(iii) The Phase Dealing with Economic Reforms of 1990s
The recent measures of liberalization have led to a further increase in the domestic as well as
foreign investment in the automobile sector. Until the liberalization policies of the 1990s,
MarutiUdyogLimited had a free run in the Indian automobile market with very little competition.
But the scenario changed considerably with the introduction of the Structural Adjustment
Programme. Entry of new players increased the competition in the joint ventures in the country,
with each player targeting to manufacture between 20,000 to 150,000 cars per annum. In fact, for
the first time, the automobile sector had become competitive.

The policy changes were with respect to industrial licensing, foreign investment and technology,
fiscal, and foreign policy environments. As a result, government regulations or direct controls in
the sector has become substantially of lower degree compared to other developing countries in
Asia. The sector witnessed frequent release of new models over the recent years. The primary
beneficiary have been the consumers who are now reaping the advantage of enhanced choice,
better technology and decreased relative prices.
Salient Features of Liberalization Policies pertaining to Automobile sector
(i) Industrial Policy Production licensing was done away with for all types of automotive
vehicles, except motorcars, in July 1991. Production licensing for cars was abolished in April
1993. For all de-licensed industries, no approval is required from the central government. Only a
memorandum of information is required to be filed with the Secretariat of Industrial Approvals
(SIA), which is only meant for statistical purposes.
(ii) Foreign investment Automatic approval for foreign equity stake has now been allowed in
segments like commercial vehicle, public transport vehicles including automotive
Commercial three-wheelers, jeep type vehicles, industrial locomotives, automotive two-wheelers
and three-wheelers, automotive components/spares and ancillaries. For approval of projects in
the car segment, a further condition of dividend balancing has been imposed (i.e., outflow on
account of dividend payments has to be balanced by the foreign exchange earnings through
export over a period of time). Dividend balancing is spread over seven years from the
commencement of production. Balancing is not required beyond the seven-year period.
(iii) Foreign Technology Agreements There is automatic permission for technology purchases
of up to a lump sum payment of Rs 10 million,
(iv) Engaging Foreign Technicians No permission is now needed for hiring foreign technicians
or foreign testing of indigenously developed technologies. Payment through foreign exchange
transactions can be made according to the guidelines, without problems.
(v) EX1M Policy Capital goods, components, parts and consumables for the manufacture of
vehicles can be freely imported. The Government of India has removed the quantitative
restrictions on imports of hundreds of items. Second-hand cars import has been permitted, but
not with a left hand side steering.
(vi) Fiscal and Monetary Policies Indian Rupee has been made convertible on current account.
This simplified procedures for imports and exports. Since the import of automobiles and capital
goods like radiators requires large amount of foreign exchange, companies can greatly benefit
from the relaxed regime. Example: Tata Motors import capital goods from countries like Japan
to manufacture Indicaand Indigo cars.
SWOT Analysis
Economic reforms have had a positive effect on both demand and supply of automobiles. Many
foreign companies have invested in this sector, including major companies worldwide. There has
been a phenomenal growth rate in the passenger car and Light Commercial Vehicle segments.
Sales of both the segments have grown at the rate of over 20 per cent annually. Overall, the

automotive boom that started in the mid-80s got a further boost. The SWOT analysis of the
sector is presented in Chart 7.3.
Chart 7.3 SWOT Analysis of Automobile Industry in India

The SWOT chart reveals that the multinational corporations try to dominate Indian automobile
industry with the liberalization in trade and investment. However, the policy changes have
helped the consumers to get new models at an affordable price. The firms in the sector are
dependent on imports for machineries and components.
The SWOT chart reveals that the multinational corporations try to dominate Indian automobile
industry with the liberalization in trade and investment. However, the policy changes have
helped the consumers to get new models at an affordable price. The firms in the sector are
dependent on imports for machineries and components.
ELECTRONICS INDUSTRY
Market Structure
The electronics industry constitutes nearly 8 per cent of the manufacturing sector in India. It is
one of the fast growing and labour intensive industries in the country. Total employment in the
industry had increased from 1,30,000 persons in 1981 to 3,45,000 persons in 2000 (Guide to
Strength Weakness Opportunity Threat

Decline in prices (i) Dominance of MNCs Consumers sovereignty and Small players
(iii)
and more number producing over domestic firms big firms reap the
of models for benefits automotive components
consumers (ii) Dependent on imports
(iv) face
challenges for capital goods like
Electronics Industry in India, Government of India 2002, Page 120). In the industry, numerous
radiators
small-scale units are engaged in the manual assembly of imported kits/components of goods like
tape recorders. They have already been hit by the presence of multinationals, such as Sony, after
the removal of restrictions on imports.
The electronics industry comprises six categories, namely, (i) consumer electronics, (ii)
instrumentation and industrial electronics, (iii) data processing systems and other office
equipment, (iv) communication and broadcasting equipment (v) strategic electronics and (vi)
electronic components. Of all the segments, consumer electronics contributes a major proportion
of the industry's production followed by the components segment. Instrumentation and industrial
electronics, data processing system, communication and broadcasting equipment accounted for
about 14 per cent each in the total production of the industry. The growth of the electronics
industry is primarily due to the phenomenal expansion of the consumer electronics segment,

especially the television (TV) and audio systems during 1980s and personal computers during
1990s.
Recent Developments
The Indian electronics industry is undergoing transformation due to the new economic policy of
the 1990s and the rapid technological developments in the field.6As a part of the new economic
policy, the government has liberalized a wide spectrum of investment, trade and fiscal policies
relating to the industry. With the de-licensing of the entire consumer electronics industry and the
removal of restrictions on foreign trade and investments, most of the important global firms like
Thomson and Sony have entered the Indian industry either directly or through collaborations
with the local firms. Those multinational firms have brought in popular global brands and they
offer the consumers a wider choice in terms of product features, quality and competitive prices.
In addition, import of all the components, raw materials and capital goods relating to the industry
have been made free and the duties on the items are reduced (The Hindu Survey of Indian
Industry, 2000). Import duties were rationalized by fixing duties on raw materials at 35 per cent,
for processed parts at 50 per cent, for components and peripherals at 80 per cent and for final
products at 90 to 150 per cent in early 1990s. Government has reduced duty rates on select items
in the recent past. These changes have not only intensified the competition in the domestic
market, but are also expected to transform the domestic industry on the pattern of the
international electronics industry.
SWOT Analysis
Details of SWOT analysis for the electronics industry in India has been presented in Chart 7.2.
Chart 7.2 SWOT Analysis of Electronics Industry in India
Strength Weakness Opportunity Threat
Labour -intensiveindus-Transformation from man- Domestic firms get moti- Survival of Small Scale try,
which suits the re-ual assembly to automationvated to achieve internal- Industriesquirements of abundant may
reduce the employment tional competitiveness due
labourresource in India opportunities to trade liberalization
According to the SWOT chart, the electronic industry in India has been undergoing
transformation due to trade liberalization. The small-scale industrial units face challenges due to
the competition in the market. Only the firms, which achieve international competitiveness, can
survive in the days to come.
FAST MOVING CONSUMER GOODS (FMCG) INDUSTRY

The FMCG industry has been one of the dominant Indian industries as it is characterized by large
volume of sales. Generally, FMCG refers to consumer non-durable goods required for daily or
frequent use. It is a Rs800 billion industry and hence, it is important to domestic as well as

multinational firms. The FMCG industry consists mainly of sub segments relating to personal
care, oral care, and household products and so on.
The goods in the FMCG sector have been subjected to the removal of quantitative restrictions on
imports recently, the approach of impact analysis has been constrained by the availability of a
few reports only. Most of the observations are hunches of industrial consultants.
For multinational corporations, it has now become easier to import those products into India,
which could not be freely imported due to the QRs earlier. Such products would now be sold at
cheaper rates due to the economies of scale involved. Moreover, many of the brands, which had
their presence in the grey market and were sold at exorbitant rates, are now at normal retail
outlets at much cheaper rates due to the import liberation. This is likely to create a market for
imported products. This is an important factor that may work against the domestic players.
IMPACT ON PRODUCT CATEGORIES
(i)Tea and Coffee
(ii)Coconut Oil
(iii)Cheese and Butter
(iv)Poultry
(v)Cigarettes
(vi)Alcoholic beverages
(vii)Milk food for babies
(viii)Oral Hygiene products.
Tea and Coffee
After the QR removal, tea and coffee were allowed to be imported at a rate of 70 per cent
customs duty from April1,2001. Though this provided a shield to the domestic tea and coffee
industry, cheaper varieties were available from some countries. Hence, the government of India
increased the import duty to 100% in the year 2002-03 with the intention of protecting domestic
industry. Tea is a part of the normal staple diet at the Indian consumers and they develop a taste
for particular brand. In other words, the brand loyalty in this segment is high and hence, mere
availability of a foreign brand cannot ensure a switchover. Therefore, the impact is likely to be
felt only in the niche segments. The governments reduction of the exercise duty on tea from
rupees 2 per kilogram in the Union Budget 2002 would benefit manufacturers in India to offset
the adverse impact of QR removal.
Till about face years ago, coffee planters were subjected to the norms of coffee board. Hence, it
is only recently that this sector has actually started to develop on its own. Moreover the coffee
industry continues to be levied. On the whole, the coffee industry may continue to face immense
competition from global players.
Coconut oil
The coconut oil market is currently going through a phase of surplus supply and reducing trend
in per capita consumption. Copra growing areas are largely in south India. The surge of palm oil
import from Malaysia and Indonesia has skewed the pattern of consumption of edible oil from
coconut and ground nut oils to palm oil.

This has led to an oversupply situations of coconut oil. The market is witnessing a price level of
rs30, 000/per ton. Which is at its nine year low? After the removal of QRs. At present import
duty is 100 per cent if necessary, the government can increase it up to the bound rate of WTO.
Cheese and Butter
The cheese market in India has a market size of Rs.300/- crore with major producer being Amul,
Britannia, Verka, Vijaya and newer brands like Laughing cow, Happy cow and Kraft. The import
duty is 35% and there is a demand from the domestic industry to keep the tariff rates on milk
product at 60%, which is the WTO permitted bound rate. Over the year, domestic players like
Amul and Britannia have established name for themselves.
The Butter market is about 55,000 tons per annum. The growth observed has been 8 to 10%. The
QRs on the international butter brands have been removed, but an import duty of 40% have been
maintained. It may be noted that European and American countries provide export subsidies even
to the extent of 50%. This fact may turn out to be a significant deterrent for Indian firms. The
consumption of butter is basically concentrated in the urban market.
Poultry Product
The market size of the poultry industries is Rs.11,000 crores. The customers duty rate on
imports was 100%, along with the QRs before the year 2000. In 2000, mutton imports were put
under the OLG ( Open General List ) followed by the case of chicken in 2001. One use of the
imported poultry can be by the restaurants irrespective of cost consideration. Packaged and
Branded imports can make a dent in this segment.
Cigarettes
Foreign brands like Marlboro, Dunhill, 555, Benson and Hedges have flooded the market after
the QR removal. These can be imported at a normal custom rate of 35%. On the other hand, the
domestic cigarette industry is reeling under the pressure of high excise duties. Before 2001,
cigarette was on the restricted list. Another important aspect in case of this product is that during
QR regime, there used to be huge revenue loss to the government due to smuggling.
Alcoholic Beverages
In 2002, the custom duty on imported liquor was reduced to 182% from 220%. The government
is not imposing any countervailing duties. At the same time, the states have been given a free
hand to impose an additional duty. According to the intelligence team, the retail outlet driven
market is expected to increase to 1.5 lakh cases from the present 90,000 cases per annum.
Chocolates
The QR phase-out has, so far, had a limited impact on domestic chocolate industry; because of
the high impact duties and the substantial price difference at which imported product have been
available on the retail shelves. But it may only be a matter of time for some of the dominant
global players to decide to set up a manufacturing base in India. Though the entry of new players
will undoubtedly expand the market itself, in the near future, escalating competition is bound to
push up promotional outlays for the two players, Cadbury and nestle, who lead the market.

Milk food for babies

There are only two global players in India- Nestle and Heinz- and the major brands are cerelac,
Farex and Lactogen. Both the companies are multinationals and will benefit from the QR
removal, as they would be able to import a wider range of products from their parent companies.
Since the lifestyle has started undergoing changes, over a period the concept of such products
would percolate to the middle and lower income groups of the society as well.
Oral Hygiene Products
In this sector, almost all the top major firms, colgate Palmolive, Gillete, HLL and SmithKline
Beecham consumer health care have already established their bases in India and hence there is
unlikely to be any major impact. From the point of view of foreign companies although the
removal of QRs would provide them easy access to the Indian market there are two major
limiting factors namely: (a) A customs duty of 35% has to be paid (b) Oral hygiene market is
very sensitive to the quality of the product.
SWOT analysis of the FMCG sectors are provided
Strength:
Competition forces the firm not to increase the price
Provide employment directly and indirectly
Weakness:
Irrational domestic tax encourages imports
Opportunities:
Excise and customs duties rates have been slashed. More playing for producers and importers.
Threat:
Local unorganized players face challenges with the trade liberalization policies.
CHEMICAL INDUSTRIES
Chemical industries have been key to the economic development processes of a country.
In terms of raw material and finished goods imports, these industries shows higher volume.
However significance of this sector in terms of export growth is also noteworthy.
Petroleum Industries
The administrated price mechanism(APM) for petroleum and diesel was abolished with
effect from April 1 2002. The pricing of aviation turbine fuel (ATF) had already been
deregulated from April 1 2001. The APM was a complex cross-subsidized system under which
some petroleum products like kerosene and diesel were highly subsidized while the prices of
some products like petrol were fixed at a level higher than the import parity price.
Fertilizer Industry
Fertilizer companies produce 30,722 thousand tons annually, but there is a substantial need of
more than 3450 thousand tones of imports per annum. Therefore the industry has to take some

innovative steps which involve a high degree of modernization to increase production thereby
saving valuable foreign currency.
Plastic industries
Plastic industries constitute a major part of chemical industries. Plastic was placed on the open
general license list in April 2000. There is reasonable evidence of china flooding the Indian
market with plastic goods. China mass produces the goods on a scale not possible in India. The
reasons why the plastic industry unit in India is not in a position to compete with china are: i)
High import duty on raw material ii) Lack of cheap credit iii) lack of power iv) inspector rule.
SWOT analysis of chemical industries
Strength
Innovative steps taken by some of the companies
Weakness
High cost of production in India
Opportunity
Focus on R&D will pay dividend in form of patent
Threat
Imports from countries like china
PHARMACEUTICAL INDUSTRIES
In this section the pharmaceutical industries has been analyzed particularly based on the WTO
agreement Trade related intellectual property rights (TRIPS)
Industry structure and aspects related to globalization
India produces nearly 8.5% of the worlds drug requirements in terms of volumes. Currently the
Indian pharmaceutical industry is a vibrant high technology based and growth oriented industry.
The industry meets around 70% of the countries demand for bulk drugs, drug intermediates,
chemical, tablets etc. The industry is characterized by:
I. Very intense competition from about 24000 firms.
II. Continuous drug discovery and rapid introduction of new product.
III. Price control which are stiff and profits that are eroding
IV. Increasing health awareness among the people and importance given to the medic aim.
V. Increase dominance of trade associations and their constant demand for increase in trade
margins.
Patent protection for pharmaceutical raises the following distinct issues:

i. Impact on public health:

Patenting drugs as per WTO requirements raises costs, put them out of reach of the poor and
therefore damages public health. Others argue that it encourages the introduction new drug either
directly or indirectly.
ii. Impact on Indian pharmaceutical industry:
The small players who have been making copies fear that they will not sufficient capital or
technology to invent new drugs that can be patented. As a result, they feel that the market will be
polarized in favor of foreign multinationals. Larger firms on the other hand are in the full support
of patents, which they hope will attract foreign investments and there by simulate joint venture
and research.
TELECOMMUNICATIONS
Growth Trends and the Present Status.
In terms of growth, telecommunications has been among the best performing sector in recent
years. Teledensity in India over the period 1995-2001 had a compound average growth rate of
22.3%, compared to 17% in Brazil, 14 % in Indonesia, 6% in Pakistan and 6% in the world as a
whole. Teledensity which was just 1.1 in 1995 , stood at 3.6 in 2001. In recent years, there has
been a major shift of demand from fixed to cellular connections. Share of the cellular
connections created during April-December 2003 was 63 % compared to 43% over the
corresponding period of 2001.
At present, public sector predominates the fixed line and private sector predominates the
cellular mobile phone market. As on march 31 2002 there were about 45 million connections in
all, public sector accounting for 38.2 million connections and private sector for 6.8 million . the
total number of cellular phone subscribers which was only 0.3 million on march 1997 , stood at
6.4 million on march 31 2002 . among neighboring countries, India however lags behind china
and even sri lanka where compound annual growth rate in teledensity during 1995-2002 were
27% and 25% respectively. Some of the major factors behind the growth of the
telecommunications sector are:
Support of an enabling and progressive telecommunication policy;
Technological development particularly in information technology;
Development of the telecommunications sector around the world;
Opening up of the sector to private enterprise;
Fast growth of the cellular phone market; and
Sustained fall in telecom tariffs, leading to sustained increase in demand.
Retail sector:
The Indian retail industry is no more in a nascent stage today. From small street-corner groceries
to big super markets- a transition is happening. Though the unorganized sector still holds a
dominant position and the organized share today remains about 1.5% of the current
rs.10000000crores (US $245billion)retail market ,which is expected to almost double 2020, it
has been touted as the second most attractive retail investment destination after Russia, in the

recent studies. This has been possible only due to the increasing globalization of the sector and
the hordes of MNCs joining the market .
Foreign Direct Investment in India

In finance, foreign investment is investment originating from other countries. FDI plays a
important role in the development of every economy it helps in achieving a certain degree of
financial stability development and growth.
FDI in Retail Sector

Present Position:
Foreign Direct Investment (FDI) is prohibited in retail trading, except in single-brand product
retail trading, in which FDI, up to 100%, is permitted, under the Government route, subject to
specified conditions.
Revised Position:
The Government of India has reviewed the extant policy on FDI and decided to permit FDI,
up to 51%, under the Government route, in Multi-Brand Retail Trading, subject to specified
following conditions.
(i) Fresh agricultural produce, including fruits, vegetables, flowers, grains, pulses, fresh poultry,
fishery and meat products, may be unbranded.
G) Minimum amount to be brought in, as FDI, by the foreign investor, would be US $ 100
million.
(iii) At least 50% of total FDI brought in shall be invested in 'backend infrastructure' within three
years of the first tranche of FDI, where 'back-end infrastructure' will include capital expenditure
on all activities, excluding that on front-end units; for instance, back-end infrastructure will
include investment made towards processing, manufacturing, distribution, design improvement,
quality control, packaging, logistics, storage, ware-house, agriculture market produce
infrastructure etc. Expenditure on land cost and rentals, if any, will not be counted for purposes
of backend infrastructure.
(iv) At least 30% of the value of procurement of manufactured! Processed products purchased
shall be sourced from Indian 'small industries' which have a total investment in plant &
machinery not exceeding US $ .1.00 million. This valuation refers to the value at the time of
installation, without providing for depreciation. Further, if at any point in time, this valuation is
exceeded, the industry shall not qualify as a 'small industry' for this purpose. This procurement

requirement would have to be met, in the first instance, as an average of five years' total value of
the manufactured! processed products purchased, beginning 1st April of the year during which
the first tranche of FDI is received. Thereafter, it would have to be met on an annual basis.
(v) Self-certification by the company, to ensure compliance of the conditions at serial nos. (ii),
(iii) and (iv) above, which could be crosschecked, as and when required. Accordingly, the
investors shall maintain accounts, duly certified by statutory auditors.
(vi) Retail sales outlets may be set up only in cities with a population of more than 10 lakh as per
2011 Census and may also cover an area of 10 kms around the municipal/urban agglomeration
limits of such cities; retail locations will be restricted to conforming areas as per the
Master/Zonal Plans of the concerned cities and provision will be made for requisite facilities
such as transport connectivity and parking; In States/ Union Territories not having cities with
population of more than 10 lakh as per 2011 Census, retail sales outlets may be set up.
Government will have the first right to procurement of agricultural products. The cities of their
choice, preferably the largest city and may also cover an area of 10 kms around the
municipal/urban agglomeration limits of such cities. The locations of such outlets will be
restricted to conforming areas, as per the Master/Zonal Plans of the concerned cities and
provision will be made for requisite facilities such as transport connectivity and parking.
(viii) The above policy is an enabling policy only and the State GovernmentslUnion Territories
would be free to take their own decisions in regard to implementation of the policy. Therefore,
retail sales outlets may be set up in those StateslUnion Territories which have agreed, or agree in
future, to allow FDI in MBRT under this policy. The list of StateslUnion Territories which have
conveyed their agreement is annexed. Such agreement, in future, to permit establishment of retail
outlets under this policy, would be conveyed to the Government of India through the Department
of Industrial Policy & Promotion and additions would be made to the annexed list accordingly.
The establishment of the retail sales outlets will be in compliance of applicable State Union
Territory laws/ regulations, such as the Shops and Establishments Act etc.
(ix) Retail trading, in any form, by means of e-commerce, would not be permissible, for
companies with FDI, engaged in the activity of multibrand retail trading.
(x) Applications would be processed in the Department of Industrial Policy & Promotion, to
determine whether the proposed investment satisfies the notified guidelines, before being
considered by the FIPB for Government approval.
FDI in Infrastructure
Introduction
India's planning commission has projected an investment of US$ 1 trillion for the infrastructure
sector during the 12th Five Year Plan, with 40 per cent of the funds coming from the private

sector. India's focus on infrastructure over the last decade made the country the second fastest
growing economy in the world. India's constant growth gives investors a tremendous opportunity
in the transportation and power segments.
A strong infrastructure sector is vital to the development of a country's economy. Here, the
Indian government has played a major part by liberalising foreign direct investment (FDI) norms.
Also, it has taken up large-scale infrastructure ventures such as the DelhiMumbai Industrial
Corridor, for which it collaborated with Japan.
Infrastructure in India: Key Developments
The World Bank is in consultations with the ministries of finance and new and renewable energy
for funding solar projects under phase II of the National Solar Mission. The World Bank is
really impressed with the performance of phase I of the National Solar Mission, according to
Mr Ashish Khanna, lead energy specialist. The required funds will be around Rs 80,000 crore
(US$ 12.9 billion). Up to Rs 54,000 crore (US$ 8.7 billion) will be debt based on a 70:30 debt
equity ratio. The World Bank has stated that it is keen on partially financing the debt
requirement.
Bangalore-based GMR Infrastructure has bagged a bid along with a partner in the Philippines to
expand an international airport in the Southeast Asian country. GMR will partner Philippines-
based Megawide Construction Corporation in a 40:60 joint venture. The Megawide-GMR
consortium won the bid by a slim margin over another conglomerate.
UK-based construction equipment maker JC Bamford Excavators Ltd is ready to increase its
product portfolio in India to cater to the export and domestic market. JC Bamford is adding
manufacturing capability, in an effort to make India a key manufacturing hub for fully-built
equipment, engines and parts. India is today a strategic location for its potential and to serve
markets such as Malaysia and South Africa, said Mr Anthony Bamford, Chairman of JC
Bamford.
India's first monorail service will start in Mumbai early next year. The mass transport system
comprises several air-conditioned rakes that operate on an elevated corridor. In the first phase, it
will be ferrying passengers between Chembur and Wadala; in the second phase, it will be
transporting passengers between Wadala and Jacob Circle in central Mumbai. Upon completion
of the two phases, the corridor will be the second longest in the world. The Mumbai corridor,
which will have 17 stations, is estimated to cost around Rs 2460 crore (US$ 396.8 million).
Government Initiatives
State-owned NTPC Ltd has started filling up the reservoir of its first hydro power project, the
800-Megawatt (Mw) Koldam project in Himachal Pradesh. The 163-metre reservoir will most
likely be filled in the next 11 months and the project could be commissioned during the next

financial year. Koldam project, with four units of 200 Mw each, will provide peaking capacity
to the Northern Grid and generate 3,054-Gw-hour electricity annually, the company stated.
To enhance the flow of resources to the sector, the Reserve Bank of India (RBI) has allowed
holding companies and core investment companies to raise resources through the external
commercial borrowing (ECB) route. The RBI specified that the business activity of the special
purpose vehicle (SPV) should be in the infrastructure sector. ECB for the SPV can be taken up to
three years after the SPV's commercial operations date.
An investment of Rs 50,000 (US$ 806) on a rooftop solar plant will save the domestic electricity
consumer Rs 9,200 (US$ 148) a year according to the Tamil Nadu government. The Tamil
Nadu Energy Development Agency (TEDA), the renewable energy development arm of the State
Government, has set the cost of a 1 kW solar rooftop system at Rs 100,000 (US$ 1613). The
investor needs to bring in only Rs 50,000 (US$ 806) of that amount, with the rest being paid by
the Indian government and the Tamil Nadu government.
FDI in Pharmaceutical Industry
In this section the pharmaceutical industry has been analysed, particulary, based on the WTO
agreement trade related intellectual property rights.
Industry structure and aspect related to globalization
India produces nearly 8.5 percent of the worlds drug requirements in terms of volume.The
industry produces a wide range of bulk drugs and holds a prominent position in the world in the
world in the manufacture and export of basic drugs.
Currently ,the Indian pharmaceutical industry is a vibrant ,high technology based and growth
oriented industry. consequently, it attracts attention from the world over for its immense
potential to produce high quality drugs and pharmaceutical formulations.the industry is one of
the R & D intensive industries.
The industry is characterized by:
a) Very intense competiton from about 24,000 firms..

b) Continous drug discovery and rapid introduction of new products.
c) The seemingly ever increasing and almost never ending government regulations and
policy changes.
d) Increasing health awareness among people.
e) The Indian drug industry had been protected from foreign competition for two
decades.And ,yet it is one of the most competitive industry in the world.
i) Impact on public health
Some say, patenting drugs as per WTO requirements raises costs,puts them out of the
reach of the poorand therefore, damage public health.Others argue that it encourages

the introduction of new drugs,either directly, by encouraging invention in the country

or through newly invented imports that are protected or through forigen investments
in production in india.
ii) Impact of Indian pharmaceutical industry
The small players, who have been making copies,fear that they will not have
sufficient capital or technology to invent new drugs can be patented.as a result they
feel that the market will be polarized in favour of foreign multinationals .
Larger firms, on the other hand are in full support of patents,which they hope will
attract foreign investments and thereby stimulate joint ventures and research.The
government is keen to implement the TRIPS agreement though it has faced resistance
from local drug manufacturer and consumer.
FDI in Insurance
In the contentious insurance sector, it was decided to raise the sectoral FDI cap from 26 per cent
to 49 per cent under automatic route under which companies investing do not require prior
government approval. FDI limit in insurance sector raised to 49% from present 26%, subject to
Parliament approval.
The penetration of life insurance in India has increased from 2.15 per cent in 2001 to 3.17 per
cent in 2017 which is above Brazil, Russia, Malaysia, Pakistan, China, Sri Lanka, Australia and
Germany. However, the penetration is below France, Switzerland, the UK, the US, Japan,
Singapore, South Korea, Taiwan and Hong Kong. Insurance coverage in a country is generally
measured by insurance penetration, which is ratio of premium underwritten in a given year to the
Gross Domestic Product (GDP).
FDI in Banking and Finance
The aggregate foreign investment (FDI, FII and NRI) cannot exceed 74 per cent in private sector
banks while the ceiling is at 20 per cent for nationalised banks, State Bank of India and its
associate banks.
The framework for foreign banks has one major theme the formation of wholly-owned
subsidiaries (WOS) for furthering their business in India. The RBI guidelines make it clear that
the WOS model is what the regulator would prefer the foreign banks to have. Suitable incentives
are being given to new as well as existing players operating through their branches in India to
adopt the subsidiary route and incorporate locally.
Origin of policy
Like the new private bank licensing policy, the framework for foreign banks has passed through
several stages.

The origin of the new policy is to be traced to the year 2004 when the government relaxed the
foreign direct investment (FDI) limits to 74 per cent in private sector banks. Simultaneously,
foreign banks were permitted to set up a 100 per cent wholly-owned subsidiary in India subject
to certain conditions. A detailed roadmap for operationalising the FDI guidelines, in two stages,
was issued subsequently. Then, as now, the objective was to encourage foreign banks to take the
WOS route. But in the absence of any incentives, no bank came forward to set up or convert their
branches into WOS.
If the latest policy is to succeed and attract new foreign banks in the WOS route, the type of
incentives naturally matter. Great significance is attached to the proviso that a locally
incorporated WOS will be given near-national treatment, which, for all purposes, will place them
on a par with Indian banks.
For instance, they can open branches anywhere in the country (except in sensitive areas where
RBI prior approval will be required). It is expected that foreign banks already operating branches
in India will also see in the national treatment a big advantage and convert themselves into WOS
and participate in all financial sector activities. The WOS will have a minimum paid-up capital
of Rs.500 crore, which is what has been stipulated for the new private banks.
FDI in Automobile Sector
The argument for globalization and market oriented policies are relevant to automobile industry
Policy changes include exposing domestic producers to both internal and external competition
1. Better utilization of capacity
2. Cost reduction
It can be seen that Indian automobile industry has gone through 3b different phases
1.The early regime of licensing until 1983
The early regime was governed by regulations were imports collaborations, and equity ventures
were restricted by the government
Capacity expansion was also restricted and government issued the required licenses
2. Partial liberalization of rules in mid 1980s
The partial liberalization of rules by the government in the mid-1980s led to the entry of
Maruti and the proliferation of two wheelers and light commercial vehicles (lcvs) into
India

The decision to allow foreign automobile sector was milestone in the Indian automobile
sector
The entry of multinational companies into automobile sector led to substantial growth.
The company was also forced to adopt the phased manufacturing program whereby it led
to increase in indigenous content in the production process gradually
The advent of the company had significant effects in terms of quality and price also. They
pioneer adopted the concept of affordable family and cashed in demand. Thus the actual
boom in the car market started when Maruti Udyog limited with its small and fuel
efficient family cart models
3. The phase dealing with economic reforms of 1990s
The recent measures of liberalization have led to a further increase in the domestic as well as
foreign investment in automobile sector. Until the liberalization policies of 1990s Maruti Udyog
limited had a free run in the Indian automobile market with a very less competition. But also the
scenario changed with the interdiction of many structural adjustment program
Entry of new players increased the competition in the country and the joint venture in the country
Salient features of liberalization policies pertaining to Indian automobile sector
Industrial policy:
Production licensing was done away for all types of automobile vehicles accept motor
cars
For all deli censed industries no appraisal is required from the central government
Only memorandum of information is required which is only for statistical purposes
Foreign investments:
Automatic appraisal for foreign investment stake has been now allowed in segments
like commercial vehicle, automotive two wheelers transport vehicles including
automotive commercial three wheelers, jeep type vehicles, industrial locomotives a
further condition of dividend balancing has been imposed dividend balancing is spread
over seven years of production .balancing is not required beyond seven year of period
Foreign technology agreements:
There is automatic permission for technology purchases of up to a a lump sum
payment of 10 million
Engaging foreign technicians:
No permission is now needed for having foreign technicians or foreign testing of
indigenously developed technologies. Payment through foreign exchange transactions
can be made according to the guidelines, without problems

Globalization and Indian Business Environment
Meaning
Globalisation is the term used to describe the process of removal of restrictions on
foreign trade, investment, innovations in communication and transport system.
Globalisation of the economy means integrating the economy with the rest world. This involves
dismantling of high tariff walls i.e.., reduction of import duties thereby facilitating the transition
from a protected economy to an open economy, removal of non-tariff restrictions on trade such
as exchange control and import licensing, quotas allowing foreign direct investment (FDI) and
foreign portfolio investment (FPI), allowing companies to raise capital abroad and encouraging
domestic companies to grow beyond national boundaries.
Both foreign investment and international trade volume have grown rapidly over the last few
years. Firms go global as part of their business strategy mainly because of three reasons:
1. They get access to more markets and customers.

2. They can create better brand by way of expansion so that the acceptance at home
market also increases.
3. There could be a saturation point in the domestic business.
A global economy has the capacity to work as a unit, in real time, on planetary scale. Four
primary, interrelated factors have driven globalisation in the recent past.
Increased international trade

The growth of multinational corporations
The application of new technologies in all these operations, especially computer and
other information technologies
Two macro factors seen to underlie the trend towards greater globalisation. They are:
The decline in trade barriers to the free flow of goods, services, and capital that
has occurred since the end of world war.
The technological change, particularly the dramatic development that have
occurred in recent years in communications, information processing and
transportation technologies.
It is interesting to note that globalisation has not been a continuous process. The
countries have been back and forth with globalisation and nationalisation.

Implications
Introduction
Globalization-the most prevalent phenomenon during the 1990s and for the future means coming
together of various nations and their economies under a single umbrella.
It is a process where there is no restriction on the movement of capital, investment, funds,

profits, labour, information, ideas, politics and what not. If economics is the basis of every thing
then the process of globalization has been accelerated because of the ongoing economic reforms
started since 1991.
Implications of Globalization
Globalization is essentially an economic phenomenon which has strong implications. To

understand the effect of globalization on Indian economy, society, culture, religion and psyche, it
is essential for us to know how and when economic reforms were carried out.
IMF (International Monetary Fund) has prescribed a set of rules for the carrying out of economic
reforms. When the Chandra Sekhar's government was defeated at the hands of Congress, Indian
economy was undergoing through a chaotic situation.
The 1991 Gulf war aggravated the international oil prices, which seriously affected India's BoP
(Balance of Payment) situation. Exports were low and imports were high (due to high price of oil
and petroleum). India's economic performance was in doldrums because industrial production
plunged to the ground.
Fiscal deficit soared up to new heights, which earned nothing except high rate of inflation. Due
to the populist form of government spending in the 1980s, supported by huge borrowings
without sufficient return, India's internal and external debt touched the sky.
Short term commercial borrowings from abroad led to a difficult situation for the government.
India virtually came to the brink of default. Under this situation, the Government borrowed a
huge sum of conditional loan' from IMF. Thus India became obliged to follow IMF prescribed
'structural reforms'.
The IMF package consists of a set of economic policies for a debt-ridden and low performing
economy, for the short run which is called stabilization measures', and which includes:
(i) Monetary policies
Positive real interest rates

Increase in reserve rate

More vigorous open market operations
Credit controls
(ii) Realignment of the exchange rate to a near market determined rate.
(iii) Reduction of budgetary deficits
Increased revenue mobilization efforts

Review of public investment priorities and identification of a core programme of
investment.
(iv) Real wage restraint
Removal of formal indexation arrangements
The Long Term 'Structural Reforms' prescribed by IMF include
(i) Promotion of private sector (domestic-and foreign)
Definitive political commitment

Rapid improvement in infrastructure
Improvement in regulatory regimes
Facilitation of investment approval procedures
(ii) Commercialization of public enterprises-improvement in operational efficiency
Privatization programmes
(iii) Financial sectors reforms
Movement to market determined rates capital market development, including promotion

of stock exchanges
(iv) Liberalization of trade regime
Removal of import and exchange control and progress towards lower and less-dispersed band of
tariffs.
(v) Price-flexibility
(vi) Tax-reforms

Reduction of distortion effects on resource allocation

increased elasticity of tax-system
(vii) Administrative reforms
Reduction in size of public service

Safety net well targeted programmes of transfers to vulnerable groups.
Training, credit and employment programmes for vulnerable group. Impact of
Globalization on Indian Economy
Due to globalization, the export sector of the Indian economy received a big boost. The growth
performance of the exports improved during 1993-1996.
During the period April-September 2000, the export growth rate touched the figure of 22%,
while imports stood at around 15%. Thus India's current account situation improved due to
globalization led economic reforms.
Government investment expenditure has been reduced but not fiscal deficit which is still around
5% of GDP (Gross Domestic Product). This is because of high consumption expenditure on the
part of the government.
Government is stressing on disinvestment of public sector units. For the employees, government
has started VRS (Voluntary Retirement Scheme). Although defense expenditure has gone up, but
Government has reduced subsidies on food, fertilizer and electricity. Social sector investment as
a percentage of GDP has not increased.
Expenditure on health and education is not substantial. Although efforts of privatization has
given an impetus to the private sector, but employment generation by the private sector is
meager.
The NDA (National Democratic Alliance) government headed by BJP (Bharatiya Janata Party)
has started the 'second generation economic reforms', which includes reforms in all spheres
including political institutions, economic machinery, democratic set-up, judiciary, etc.
The proponents of globalization in India have argued that economic integration will improve the
locative efficiency of resources, reduce the capital output ratio, and increase the labour
productivity, help to develop the export spheres and e*port culture, increase the inflow of the
capital and updated technology into
the country, increase the degree of competition in the domestic economy, reduce the relative
prices of industrial and manufactured goods, improve terms of trade in agriculture and in general

give a boost to the average growth of the economy in the years to come. To some extent this has
proved true.
GLOBALISATION-PHASES
The three distinct stages of globalisation:
1870-1914:FIRST WAVE OF GLOBALISATION

Globalisation drivers during this period were:
Falling transportation costs
Lowering of tariff barriers
Impact of the wave of globalisation was reflected on the following
parameters:
Exports as a share of world income almost doubled
Total labour flows nearly 10% of the world population
Foreign capital stock in developing countries
Growth rate in per capita income of the world increased from
0.5%to1.3%.p.a.
1914-1945:Retreat to Nationalism
Globally, protectionism drove international trade back down due to world
war-1.
The retreat into nationalism produced anti-immigrant sentiment and
government imposed drastic reductions on newcomers.
1945-1980:Second Wave of Globalisation
Globalisation drivers during the post- world war stage (1945-80)
were:
Lack of growth with protective policies in nationalism
Reduction in transport cost
Reduction of the trade barriers and tariffs
The second wave of globalisation brought about a situation:
Overall trade doubled

Economies of scale opportunities for many multinational
corporations
Greater inequality between developed and developing countries
1980 onwards: Third Wave of Globalisation

This stage is distinctive mainly because of two reasons.

1. A large group of developing countries actively involved in global business.

2. International migration and capital movements, which were negligible during
second wave of globalisation, have become substantial.
The impact of this wave is visible in terms of:
Movement towards free trade

Creation of a global labour force
Economic interdependence among countries
Significant increase in cross-border investments
Capital flows to developing countries increased over ten times
Indian software industry serves the needs of Europe and American markets
China leverages its cost-effective manufacturing to lead consumer goods
Globalisation of financial markets
Interest rates, stock markets, currency values are all interconnected
Significant and sustained growth in the world GDP.
Standard Globalisation Menus

There are a few set procedures (menus) listed by the IMF, World bank and the WTO
which outlay how globalisation should be attained in any country. These are listed below:
IMF and WORLD BANK

Reduction of budgetary subsidies
Removal of subsidies for agricultural inputs
Pursuance of liberal economic polices
Promotion of foreign investment
Privatisation of the banking sector
WTO
Pursuance of free trade
Removal of restrictions on MNCs
Globalization Impact on Indian economy across Sectors
Business environment- Sector wise Analysis
Liberalisation era (1991 onwards)
Since July 1991, India has taken a series of measures to structure the economy and improve the
balance of payments position. The new economic policy (NEP-1991) introduced changes in
several areas .

The salient features of NEP-1991 are:
1. Liberalisation (internal and external)

2. Extending privatization
3. Globalisation of the economy
4. Market-friendly state.
The effects of globalization on India will become clearer when we study Indian economy
across different sectors. Analysis pertains to nine sectors \industries of the Indian
economy. The sectors covered are:
1. Telecom
2. Insurance
3. Banking and finance
4. Retail sector
5. Pharmaceutical
6. FMCG
7. Textiles
8. Agriculture
9. Automobile
1. Telecom Sector:
The effects of globalization are very visible in this sector of the Indian economy. This
sector has moved from being completely under public control to privatization and
now foreign investment up to 72% has been allowed. Post-Independence, the Indian
government had decided that the telecommunication systems would be entirely
managed under the public sector. Posts, Telephone and telegraph (PTT) was instituted
in1947 under the ministry of communications. India responded to the emerging wave
of globalization and technology: and introduced first telecom reforms in the 1980s.
2. Insurance sector:
Insurance sector used to be one of the most regulated sectors of the Indian economy.
But the sector has been opened up for the private sector in India, as part of the
liberalization programmes.
Earlier, the general insurance business was nationalized after the implementation of
general insurance business (Nationalisation) act, 1972. The post-nationalisation
general insurance business was undertaken by the general insurance corporation of
India (GIC) and its 4subsidiaries.
3. Banking and financial sector:
Financial sector can be considered as a most vulnerable sector with respect to
globalization. Indian reforms have taken a step wise approach in this sector rather
than the big bang approach like chili. This means that India has launched reforms in
this sector gradually. The content pf the reforms has been deregulation, liberalization

of interest rates and pro-market policies. The liberalization process started in1990s
with 10new private banks being set up.
The banking sector reforms were guided primarily by the recommendations of the
committee on Financial System (Narasimhahan committee, 1991) which related,
among others , to
1. Reduction in the levels of statutory pre-emptions ,
2. Dismantling the complex structure of administered interest rates,
3. Laying down of capital adequacy requirements
4. Intoduction ofprudential norms
5. Liberalisation of entry norms for domestic and foreign banks.
4. Retail sector:
The Indian retail industry is no more in a nascent stage today. From small street-
corner groceries to big super markets- a transition is happening. Though the
unorganized sector still holds a dominant position and the organized share today
remains about 1.5% of the current rs.10000000crores (US $245billion)retail market
,which is expected to almost double 2020, it has been touted as the second most
attractive retail investment destination after Russia, in the recent studies. This has
been possible only due to the increasing globalization of the sector and the hordes of
MNCs joining the market .
5. Pharmaceutical Sector
Despite restrictions such as the drug price control order (DPCO), the Indian pharmaceutical
industry has come a long way. But this is where the paradox lies. India has gained so much
ground that today drug exports exceed imports. However, even today, Indias per capita
consumption is the lowest in the world, as only 30% of the population has access to modern
pharmaceuticals. India has moved on to become a net foreign exchange earner, and is
increasingly making its presence felt in the global Pharmaceutical arena through companies
like Ranbaxy, Cipla and Dr. Reddys Laboratories. The MNC market share has dropped to
approximately 35% today with the rest being catered by the domestic companies. One
interesting aspect of the Indian drug policy is that the domestic companies that export,
formulations are eligible for duty-free imports of bulk drugs. This causes about 3/5th of
Indias bulk drug requirements to be imported while formulations represent about 83% of
the industry production. Under patent, drugs are primarily sent to developing nations such as
china, South Africa, and CIS countries, while the generics go to developed nations. This
makes India relatively self-sufficient in the formulation drugs with the exception of certain
new patented ones. The current Indian formulations market, growing at a rate of 15-16%
p.a, is today worth an astounding Rs 90 billion.
Recent Developments and the Impact

A committee headed by shri R.A. Mashelkar, former chairperson, CSIR, had recommended ways to
enhance R&D activity by Indian companies and its suggestions were as follows:
Need to increase cross border collaborative research practices

Immediate increase in funding and infrastructure by government for R&D
The WTO decided to enforce a product patent life of 20 years in all countries, causing drug prices
to remain high when protected by patents, The major negative fallouts of this decision are-(i)
approval takes, say 5 years, the remaining patented life would be only 15 more years, and this
results in hiked prices (ii) Not every R&D project is successful, causing the cost of these failures to
be absorbed by the marketed drugs.
The current world drug market is about $315 billion with Glaxo Smithkline & Pfizer being the top
two companies in the sector. Immediate goals of a developing country should be to-
Ensure that consumers are not subjected to huge prices and prevent the MNCs from
creating cartels.
Encouraging increasing investments in R&D projects from private and public sectors.
Support low-cost formulation manufacturers and small pharmaceutical companies.
6. FMCG Sector
The fast moving consumer goods or the FMCG sector has been the cornerstone of the Indian
economy, taking shape post-independence and recently emerging as one pillars of growth.
Generally, FMCG refers to consumer non-durable goods, like toothpaste, soaps and shampoos, etc.,
required for daily or frequent use. This industry is a low-margin business and here the profitability
stems from sheer volumes. These factors, coupled with fierce competition, lay stress on marketing
and distribution. The players in this field are not the companies or their employees, but the brands.
Brand perception influences purchase decisions and this results in heavy advertising to create
and/or retain that perception.
Recent Development and the Impact
As India opens its doors to globalization, stipulated by the WTO and treaties, it is exposing itself to
a completely new market field. The global corporations look forward eagerly to extend their
investments in India market. Unilever recently announced its intentions to rename its Indian arm
Hindustan Lever Limited, as Unilever India Ltd. Which was a surprising move, given the strong
reputation HLL enjoys. But these moves are gradual shifts towards consolidation and creating a
single identity. Another interesting development in the Indian FMCG sector has been that of brand
acquisitions. The Procter & Gambles acquisition of Balsara Company in 2005 are the most recent
examples. At the same time, the real challenge for all FMCG players is in ensuring that their
employees are not poached upon by competitors. This is one of the biggest worries of domestic
companies as MNCs have landed on Indian shores with fat paychecks.

Traditionally, the domestic FMCG companies were family businesses and thus shrouded in typical
mindsets and this hampered their growth trajectory. Here, the MNCs gain the edge over them. They
have extremely good product propositions, professional management and deep pockets to back
them. Their global products portfolio allows them to constantly offer variety and choices to the
consumer, at low costs and world quality standards. As a result of lifting of the QRs (Quantitative
Restrictions) by the government, the inflow of imported consumer goods has increased manifold,
especially from China, and this is a cause of concern for the domestic for the restricted list of
several items, is expected to have adverse impact on small scale industries (SSIs).
7. Textile Sector
Besides agriculture, textile and clothing is the only industry, which has a separate and independent
agreement, multilaterally negotiated under the aegis of WTO.
The international trade in textile and clothing has transformed significantly owing to the phasing out
of the multifibre arrangement (MFA-in force from 1 JAN. 1974 to 31 DEC 1994), and with the
quota-free trade. Each country/region has become busy preparing its own national/regional strategy
for competitiveness in the scheme of global trade.
Implications for textile and Clothing Industry
At present, the contribution of the textile industry to GDP is about 4 percent. The textile industry
provides direct employment to about more than 30 million people and is the second largest
employment provider in India after agriculture. The contribution to gross export earnings is about
37% and it adds less than 1.5% to the gross import bill of the country.
The textile industry is a self-reliant industry from the production of raw materials to the
delivery of final products with considerable value-addition at each stage of processing.
The industry was delicensed in 1991 and under the current policy, no prior government
approval is necessary to set up textile mills.
The per capita cloth availability in the country has increased from 24.1 square meters in 1991
to 30.7 square meters.
100% foreign equity participation is allowed in the sector.
Indias cotton textile industry has high export potential. Cost competitiveness is driving the
penetration of Indian basic yarns and grey fabrics in international commodity markets.
The world trade in textiles and clothing has grown 55 times between 1955 and 1995 whereas
Indian exports had grown only by 15 times in the same period.
Garment is the engine of growth in the is sector in the foreseeable future.
Given that the developed countries are likely to remain deficit countries, in this segment, it is
of paramount importance for the developing countries to ensure a meaningful market access
to the developed country markets.
Import of textile has grown remarkably in the last couple of years is a well known fact.

The export market has become more competitive post-2005, although the opportunities are
more in the global market.
The quota phase-out (2005) can be considered an opportunity as well as a threat. And with the
emerging trade patterns, the pressure to become globally competitive is stronger than ever before,
while the time to attain such global competitiveness is increasingly shorter now.
8. Agriculture Sector
Agriculture is a way if life in the most developing countries. Recent changes, especially the
technological changes and the processes of globalisation, pose new challenges to the agriculture
sector and livelihoods dependent on it,
Major Issues Related to the Agriculture Sector in the Era of globalisation are as follows
Preservation of biodiversity
Subsidised agriculture
Import/Export of food
Shift to cash crops
Use of water resources and chemicals
Role of governments and impact of WTO
Employment in rural areas
Food Chain: The role of super markets in food supply
Statistics
The important statistics pertaining to the agricultural sector would give you clear idea about the
structure and trends in the sector.
Employment of population: around 2/3 of population, small Farms: 60-70% of total farms,
Exports:21%of total exports.
Main Export Products from the Agricultural Sector
The main export products from the agricultural sector are tea, coffee, spices, cashews, basmati rice
and seafood, soybean meal, fruits and vegetables, processed food products and dairy and poultry
products.
Main Import Products
The main import products are pulses, rubber, sugar, vegetable oil, rice, wheat, cashew nuts, oilseed,
wool, silk, cotton. Various research studies and policy papers highlight that the Indian agricultural
sector faces resource constraints, infrastructure constraints, institutional constraints, technology
constraints and policy induced limitations. To achieve sustainable agricultural development, it is

essential to combine natural resources, capital resources, institutional resources and human resources.
Information Technology and Bio-Technology, which are the drivers of globalisation with their
complementarities of liberalisation, privatisation and tighter intellectual property rights (IPR) are
bound to create new risks of marginalisation and vulnerability in the Indian agricultural sector.
9. Automobile Sector
Automobile industry has universally emerged as an important driver in the economy. This industry
currently accounts for nearly 4% of the GNP and 17% of the indirect tax revenue in India.
Automobile Industry in India
The automobile industry in India is nearly six decades old.
Until 1982 Only three manufacturers, M/s. Hindustan Motors, M/s. Premier automobiles and M/s.
Standard motors. Owing to low volumes, it perpetuated obsolete technologies and was out of sync
with the world industry.
In 1982 Maruti Udyog Ltd. (MUL) came up as a government initiative in collaboration with Suzuki
of Japan to establish volume production of contemporary models.
In 1983 Delicensing and opening up of the sector to FDI took place due to which 17 new ventures
came up.
April, 2004 removal of Quantitative Restrictions on imports
With the removal of quantitative on imports in this sector, car manufacturing units were issued
licenses to import components in completely Knocked Down(CKD) or in Semi Knocked
Down(SKD) form only on executing a memorandum of understanding (MoU) with the Director
General foreign trade (DGFT). 11 companies signed MOUs with DGFT under which they agreed to:
1. Establish actual production of cars and not merely assemble vehicles;

2. Bring in a minimum foreign equity of US $ 50 million if a joint venture involved with
majority foreign equity ownership;
3. Indigenize components up to a minimum of 50% in the third and 70% in the fifth year or
earlier from the date of clearance of the first lot of imports. There after the MOU and import
licensing will abate;
4. Neutralize foreign exchange outgo on imports (CIF) by exports of cars, auto components and
so on (FOB). This obligation was to commence from the third year of start of production and
to be fulfilled during the currency of the MOU. From the fourth year, imports were to be
regulated in relation to the exports made in the previous year.

Trends in India's Foreign Trade
Indias Trade Performance
Indias merchandise exports reached a level of US $ 251.14 billion during 2010-11

registering a growth of 40.49 percent as compared to a negative growth of 3.53 percent
during the previous year. Indias export sector has exhibited remarkable resilience and
dynamism in the recent years. Despite the recent setback faced by Indias export sector due
to global slowdown, merchandise exports recorded a Compound Annual Growth Rate
(CAGR) of 20.0 per cent from 2004-05 to 2010-11.
World Trade Scenario
As per IMFs World Economic Outlook October, 2011, world trade recorded its largest
ever annual increase in 2010, as merchandise exports surged 14.4 per cent. The volume of
world trade (goods and services) in 2011 is expected to slow down to 7.5 per cent
compared to the 12.8 per cent achieved in 2010. Growth in the volume of world trade is
expected to decline in 2012 to 5.8 per cent as per IMF projections.
The IMF has moderated its growth projections of world output to 4 per cent in 2012. The
advanced economies are expected to grow at 1.9 per cent in 2012 while the emerging and
developing economies to grow at 6.1 per cent. The projected growth rates in different
countries are expected to determine the markets for our exports.
As per WTOs International Trade Statistics, 2010, in merchandise trade, India is the 20th
largest exporter in the world with a share of 1.4 per cent and the 13th largest importer with
a share of 2.1 per cent in 2010.
The year 2011 has been a difficult year with Japan facing a major earthquake and tsunami,
the swelling of unrest in the Middle East oil producing countries, the slowing down of US
economy and the Euro area facing major financial turbulence. The current global economic
slowdown has its epicenter in the Euro-region but the contagion is being witnessed in all
major economies of the world. As a result, Indias short-term growth prospects have also
been impacted.
Exports
Exports recorded a growth of 40.49 per cent during April-March 2010-11. The
Government has set an export target of US $ 300 billion for 2011-12. With merchandise
exports reaching US $ 217.66 billion in 2011-12(Apr-Dec), the export target of 300 US $

billion is expected to be achieved. Export target and achievement from 2004-05 to 2010-11
and 2011-12 (Apr-Dec) is given in the Chart 2.1 below:
Imports
Cumulative value of imports during 2011-12 (Apr-Dec) was US $ 350.94 billion as against
US $ 269.18 billion during the corresponding period of the previous year registering a
growth of 30.4 per cent in $ terms. Oil imports were valued at US $ 105.6 billion during
2011-12 (Apr-Dec) which was 40.39 per cent higher than oil imports valued US $ 75.2
billion in the corresponding period of previous year. Non-oil imports were valued at US $
245.35
Chart 2.1
Export Target &
Achievement
billion during 2011-12 (Apr-Dec) which was 26.49 per cent higher than non-oil imports of
US $ 194.0 billion in previous year.
Trade Balance
The Trade deficit in 2011-12 (Apr-Dec) was estimated at US $ 133.27 billion which was
higher than the deficit of US $ 96.21 billion during 2010-11 (Apr-Dec). Performance of
Exports, Imports and Balance of Trade during 2004-05 to 2011-12 (April-Dec) is given in
the table below:
(Values in Crores)
S.No Year Exports %Growth Imports %Growth Trade

Balance
1 2004-2005 3,75,340 27.94 5,01,065 39.53 -1,25,725
2 2005-2006 4,56,418 21.6 6,60,409 31.8 -2,03,991
3 2006-2007 5,71,779 25.28 8,40,506 27.27 -2,68,727

4 2007-2008 6,55,864 14.71 10,12,312 20.44 -3,56,448

5 2008-2009 8,40,755 28.19 13,74,436 35.77 -5,33,680
6 2009-2010 8,45,534 0.57 13,63,736 -0.78 -5,18,202
2010-2011
7 11,42,649 35.14 16,83,467 23.45 -5,40,818
(Provisional)
8 2010-11 (Apr-Dec) 7,89,069 12,28,074 -4,39,006
9 2011-12 (Apr-Dec) 10,24,707 29.86 16,51,240 34.46 -6,26,533
Data Source: DGCIS, Kolkata
S.No Year Exports %Growth Imports %Growth Trade Balance

1 2004-2005 83,536 30.85 1,11,517 42.7 -27,981
2 2005-2006 1,03,091 23.41 1,49,166 33.76 -46,075
3 2006-2007 1,26,414 22.62 1,85,735 24.52 -59,321
4 2007-2008 1,63,132 29.05 2,51,654 35.49 -88,522
5 2008-2009 1,85,295 13.59 3,03,696 20.68 -1,18,401
6 2009-2010 1,78,751 -3.53 2,88,373 -5.05 -1,09,621
2010-2011
7 2,51,136 40.49 3,69,769 28.23 -1,18,633
(Provisional)
8 2010-11 (Apr-Dec) 1,72,965 2,69,175 -96,210
9 2011-12 (Apr-Dec) 2,17,664 25.84 3,50,936 30.4 -1,33,272
Chart 2.2
Month-wise Growth during 2011-12 (April-Dec) over 2010-11 (April-
Dec)

Strategy for Doubling Exports
Global economic outlook is a major determinant of export performance of any country.

Export growth cannot, therefore, be viewed in isolation from economic outlook in the
world economy. Keeping in view the urgency of managing the growing trade deficit and
uncertain global economic scenario, Department of Commerce, in May 2011 finalized a
Strategy Paper for doubling merchandise exports in three years from US $ 246.00 billion
in 2010-11 to US $ 500 billion in 2013-14. Exports were envisaged to increase at
compounded average growth of 26.7% per annum.
Impact of WTO on Indias Foreign trade
The signing of WTO agreements will have far reaching effects not only on Indias foreign trade
but also on its internal economy. Although the ultimate goal of WTO is to free world trade in the
interest of all nations of the world, yet in reality the WTO agreements has benefitted the
developed nations more as compared to developing ones. The impact of WTO on Indias
economy is staged as follows :-
I. Positive Impact / Benefits / Advantages / Gains from WTO :-
The Positive impact of WTO on India's economy can be viewed from the following points:-
1) Increase In Export Earnings :-
Estimates made by World Bank, Organisation for Economic Co-operation and Development
(OECD) and the GATT Secretariat, shows that the income effects of the implementation of
Uruguay Round package will be an increase in traded merchandise goods. It is expected that
Indias share in world exports would improve.
2) Agricultural Exports :-
Reduction of trade barriers and domestic subsidies in agriculture is likely to raise international
prices of agricultural products. India hopes to benefit from this in form of higher export earnings
from agriculture. This seems to be possible because all major agriculture development
programmes in India will be exempted from the provisions of WTO Agreement.
3) Export Of Textiles And Clothing :-
With the phasing out of MFA (Multi - Fibre Arrangement), exports of textiles and clothing will
increase and this will be beneficial for India. The developed countries demanded a 15 year period
of phasing out of MFA, the developing countries, including India, insisted that it be done in 10

years. The Uruguay Round accepted the demand of the latter. But the phasing out Schedule
favours the developed countries because a major portion of quota regime is going to be removed
only in the tenth year, i.e. 2005. The removal of quotas will benefit not only India but also every
other country'.
4) Multilateral Rules And Disciplines :-
The Uruguay Round Agreement has strengthened Multilateral rules and disciplines. The most
important of these relate to anti - dumping, subsidies and countervailing measures, safeguards
and disputes settlement. This is likely to ensure greater security and predictability of the
international trading system and thus create a more favourable environment for India in the New
World Economic Order.
5) Growth To Services Exports :-
Under GATS agreement, member nations have liberalised service sector. India would benefit
from this agreement. For Eg:- Indias services exports have increased from about 5 billion US $
in 1995 to 96 billion US $ in 2009-10. Software services accounted for about 45% of service
exports.
6) Foreign Investment :-
India has withdrawn a number of measures against foreign investment, as er the commitments
made to WTO. As a result of this, foreign investment and FDI has increased over the years. A
number of initiatives has been taken to attract FDI in India between 2000 and 2002. In 2009-10,
the net FDI in India was US $ 18.8 billion.
II. Negative Impact / Problems I Disadvantages Of WTO Agreements on Indian Economy :-
1) TRIPs :-
The Agreement on TRIPs at Uruguay Round weights heavily in favour of Multinational

Corporations and developed countries as they hold a very large number of patents. Agreement on
TRIPs will work against India in several ways and will lead to rponopoly of patent holding
MNCs. As a member of WTO, India has to comply with standards of TRIPs.
The negative impact of agreement on TRIPs on Indian economy can be stated as follows
a) Pharmaceutical Sector :-
Under the Patents Act, 1970, only process patents were granted to chemicals, drugs and
medicines. This means an Indian pharmaceutical company only needed to develop and patent a

process to produce and sell that drug. This proved beneficial to Indian pharmaceutical companies
as they were in a position to sell quality medicines at low prices both in domestic as well as in
international markets. However, under the agreement on TRIPs, product patents needs to be
granted. This will benefit the MNCs and it is feared that they will increase the prices of
medicines heavily, keeping them out of reach of poor. Again many Indian pharmaceutical
companies may be closed down or taken over by large MNCs.
b) Agriculture :-
The Agreement on TRIPs extends to agriculture through the patenting of plant varieties. This
may have serious implications for Indian agriculture. Patenting of plant varieties may transfer all
gains in the hands of MNCs who will be in a position to develop almost all new varieties with
the help of their huge financial resources and expertise.
c) Microorganisms :-
The Agreement on TRIPs also extends to Microorganisms as well. Research in micro -

organisms is closely linked with the development of agriculture, pharmaceuticals and industrial
biotechnology. Patenting of micro - organisms will again benefit large MNCs as they already
have patents in several areas and will acquire more at a much faster rate.
2) TRIMs :-
Agreement on TRIMs provide for treatment of foreign investment on par with domestic
investment. This Agreement too weights in favour of developed countries. There are no
provisions in Agreement to formulate international rules for controlling restrictive business
practices of foreign investors. Jn case of developing countries like India, complying with
Agreement on TRIMs would mean giving up any plan or strategy of self - reliant growth based
on locally available technology and resources.
3) GATS :-
One of the main features of Uruguay Round was the inclusion of trade in services in
negotiations. This too will go in favour of developed countries. Under GATS agreements, the
member nations have to openup services sector for foreign companies. The developing countries
including India have opened up services sector in respect of banking, insurance, communication,
telecom, transport etc. to foreign firms. The domestic firms of developing countries may find it
difficult to compete with giant foreign firms due to lack of resources & professional skills.
4) Non - Tariff Barriers :-

Several countries have put up trade barriers and non - tariff barriers following the formation of
WTO. This has affected the exports from developing countries. The Union Commerce Ministry
has identified 13 different non - tariff barriers put up by 16 countries against India. For eg. MFA
(Multi - fibre arrangements) put by USA and European Union is a major barrier for Indian textile
exports.
5) Agreement On Agriculture (AOA)
The AOA is biased in favour of developed countries. The issue of food security to developing
countries is not addressed adequately in AOA. The existence of global surpluses of food grains
does not imply that the poor countries can afford to buy. The dependence on necessary item like
foodgrains would adversely affect the Balance of Payment position.
6) Inequality Within The Structure Of WTO
There is inequality within the structure of WTO because the agreements and amendments are in
favour of developed countries. The member countries have to accept all WTO agreements
irrespective of their level of economic development.
7) LDC Exports
The 6th Ministerial Conference took place at Hong Kong in December 2005. In this Conference,
it was agreed that all developed country members and all developing countries declaring
themselves in a position to do so, will provide duty - free and quota - free market access on a
lasting basis to all products originating from all Least Developed Countries (LDC). India has
agreed to this. Now India's export will have to compete with cheap LDC exports internationally.
Not only this, the cheap LDC exports will come to Indian market and compete with domestically
produced goods.
India will face several problems in the process of complying with WTO agreements, but it can
also reap benefits by taking advantage of changing international business environment. For this it
needs to develop and concentrate on its areas of core competencies.

Module 7
Economic Policies
Fiscal Policy:Objectives, Instruments, Union Budget, Monetary Policy: functions of money,

Measures of Money Supply, Monetary Policy in India objectives, tools for Credit Control.
Role and functions of Planning Commission.
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FISCAL POLICY
Fiscal policy is the governments schedule for spending and tax implementation to influence the
economy for the year. Government introduces fiscal policy every year to cope with problem
faced by its economy and for the betterment of society. The fiscal policy is concerned with the
raising of government revenue and incurring of government expenditure. To generate revenue
and to incur expenditure, the government frames a policy called budgetary policy or fiscal
policy.
Fiscal policy refers to the policy of the government as regards taxation, public borrowings and
public expenditure with specific objectives in view. These objectives are to produce desirable
effect and avoid undesirable effect on the national income, production, employment, and general
price level.
OBJECTIVES OF FISCAL POLICY
Development by effective Mobilization of Resources
The principal objective of fiscal policy is to ensure rapid economic growth and development.
This objective of economic growth and development can be achieved by Mobilization of
Financial Resources. The central and the state governments in India have used fiscal policy to
mobilize resources.
The financial resources can be mobilized by :-
1. Taxation : Through effective fiscal policies, the government aims to mobilise resources
by way of direct taxes as well as indirect taxes because most important source of resource
mobilisation in India is taxation.
2. Public Savings : The resources can be mobilised through public savings by reducing
government expenditure and increasing surpluses of public sector enterprises.
3. Private Savings : Through effective fiscal measures such as tax benefits, the government
can raise resources from private sector and households. Resources can be mobilised

through government borrowings by ways of treasury bills, issue of government bonds,

etc., loans from domestic and foreign parties and by deficit financing.
Efficient allocation of Financial Resources
The central and state governments have tried to make efficient allocation of financial resources.
These resources are allocated for Development Activities which includes expenditure on
railways, infrastructure, etc. While Non-development Activities includes expenditure on defense,
interest payments, subsidies, etc.
Reduction in inequalities of Income and Wealth
Fiscal policy aims at achieving equity or social justice by reducing income inequalities among
different sections of the society. The direct taxes such as income tax are charged more on the rich
people as compared to lower income groups. Indirect taxes are also more in the case of semi-
luxury and luxury items, which are mostly consumed by the upper middle class and the upper
class. The government invests a significant proportion of its tax revenue in the implementation of
Poverty Alleviation Programmes to improve the conditions of poor people in society.
Price Stability and Control of Inflation
One of the main objective of fiscal policy is to control inflation and stabilize price. Therefore, the
government always aims to control the inflation by Reducing fiscal deficits, introducing tax
savings schemes, Productive use of financial resources, etc.
Employment Generation
Investment in infrastructure has resulted in direct and indirect employment. Lower taxes and
duties on small-scale industrial (SSI) units encourage more investment and consequently
generates more employment. Various rural employment programmes have been undertaken by
the Government of India to solve problems in rural areas. Similarly, self employment scheme is
taken to provide employment to technically qualified persons in the urban areas.
Control of business cycles

Balanced growth
Export development

INSTRUMENTS OF FISCAL POLICY
1. Taxation
Taxation is the most important source of public revenue of both development and developing
countries. On account of this reason, the governments of developing countries are trrying to
increase the proportions of national income collected in taxes from 10 to 15 percent to 30 to 40
percent levels reached in developed countries like USA, UK, France, Germany etc.
Tax revenue is usually considered under two headings: direct taxes on individuals and firms, and
indirect (commodity) taxes on goods and services. Direct taxes includes taxes on personal
income, corporate income tax, taxes on property and wealth.
Indirect or commodity taxes include sales tax, excise duty and customs duties (import and
export). While developed countries depend on direct taxes more for their tax revenue, developing
countries depend more on the indirect taxes.
2. Public Borrowing
The second most important source of public revenue is public borrowing; it is different from
taxation, since all borrowing from public must be repaid.
Repayment will require the raising of resources in future when the time comes. On account of
this obligation of repayment it is customary to regard public borrowing as merely an exercise of
fund raising for government while taxation is income proper.
The government can raise public debt either in the form of voluntary loan or in the form of
compulsory loan. Voluntary loan is secured by the government by issue of various types of bills
and securities in the money market. In compulsory loan, bonds are issued by government for
periods ranging between five to ten years having tax free interest payment.
3. Forced savings or Deficit Financing
Deficit financing has become an important tool of financing government expenditure. In simple
terms it means the way the gap between excess of government expenditure over its receipts is
financed. However the concept of deficit financing is interpreted in different ways in the western
countries and in India.
In the western countries whenever the public expenditure is greater than its revenue receipts, it
is financed through public borrowing or creation of new money. Whenever there is deficit in the
current account, its financing becomes deficit financing. Even public borrowing is a way of
deficit financing.

In the modern sense public borrowings to finance excess of public expenditure over revenue is
included in the capital account of the budget. After including these borrowings in the capital
account, there may still be a deficit in the budget. The method adopted by the government to
finance this overall budget deficit in the current and capital account together is known as deficit
financing. India adopts deficit financing of this type.
The Planning Commission in India defines deficit financing as "the direct addition to gross
national expenditure through budget deficits whether the deficits are on revenue or capital
accounts".
In Developing countries like India, deficit financing is identical to printing more currency and
putting it into circulation.
4. Public Expenditure
After the Second World War, many underdeveloped countries embarked upon ambitious
programs of economic development. As private sector does not have either the willingness or the
resources to invest in infrastructure such as the laying of railway tracks, power generation,
development in communication etc. Therefore, the responsibility of building up the infrastructure
of the economy and large capital goods industries has be borne by the government.
In the modern day world, the state has also to fulfill social obligation like provision of cheap or
free public health service, education, cheap housing facility etc. therefore additional expenditure
have to be incurred towards the provision of these facilities. Many developed countries provided
monetary assistance to unemployment persons. This is known as unemployment compensation.
Pensions to senior citizens are also provided.
UNION BUDGET
The policy of government to promote economic growth and avoid undesirable effects on
economy through taxation, government expenditure and debt management is called as fiscal
policy. The implementation of fiscal policy is through annual union budget exercise. The budget
depicits a complete picture of estimated receipts and expenditure of government for ensuing
financial year
Union is an important event which has great significance for entire nation and is normally
introduced in the last week of February every year. The budget is prepared and presented by
finance minister before the parliament. The finance bill of budget has to be passed in the
parliament to approve the tax proposal and an appropriation bill has to be cleared to authorise
expenditure

In the budget, a distinction is made between revenue account and capital account. Revenue
account may be classified into Revenue receipt and Revenue expenditure. Similarly, capital
account can be classified into capital receipts and capital expenditure
Receipts which involve no disposal of assets or incurring of liabilities are revenue receipts.
The revenue receipts include direct taxes like corporation tax, income tax, wealth tax, gift tax
etc. Indirect taxes include customs duty , excise duty, sales tax etc. The non tax incomes like net
income by public sector undertakings are also accounted under Revenue receipts. On the other
hand the money raised through borrowings by government or sale of government property etc,
constitute capital receipts i.e. capital receipts include governments market borrowings,
provident fund, small savings etc. And external assistance like loans grants, etc
Likewise revenue expenditure are those which neither add to governments assets nor reduce the
liabilities. Salaries of government employees, purchase of stationeries, maintainence of public
utilities etc are part of revenue expenditure. Capital expenditure refers to items that involves
acquisition of assets ex:-investment in railways, roads, bridges, power projects and irrigation
works
When total expenditure exceeds total receipts, we call it as budget deficit. The excess of total
expenditure over revenue receipts are financed by borrowings from government which are
classified under Domestic capital receipts and external capital receipts.The market borrowings ,
small savings, provident funds etc come under domestic capital receipts.The loans and other
assistance received from international agencies come under external capital receipts.
In other words , we can say that greater part of budgetary gap is restored through Deficit
Financing. The tools of Deficit Financing are (i)borrowings by central government against
Treasury bills (ii) Withdrawl of accumulated cash balances of government from RBI (iii)issuance
of new currency by government . The deficit financing should be within manageable limit as
excess use of created money may fuel inflationary tendencies. It is worth nothing that some
amount of deficit financing is prevalent in developing countries also
BUDGET AT A GLANCE AND FISCAL DEFICIT
Fiscal deficit as a term is used in the union budget exercise. Fiscal deficit is the sum of amount
the central government borrows and the overall budget deficit in order to meet the excess
expenses over receipts during a financial year. It can also be defined as budgetary deficit plus
borrowings of government. On the other hand revenue deficit measures the gap between
governments tax and non tax receipts and expenditure on revenue account . the following table
would give you clear idea about how these figures can be calculated

Classification
yearly estimate
(1) Revenue receipts of which 84,209
(a)Tax revenue 62,739

(b)Non tax revenue 22,470
(2) capital receipts of which 42,800
(a)Recovery of loans 6,655

(b)other receipts 3,500
(c)Borrowings ,other liabilities 32,645
(3) Total receipts(1+2) 1,27,009

(4) Revenue expenditure 1,01,839
(5) Capital expenditure 29,484
(6 )Total expenditure(4+5) 1,31,323
(7) Budgetary deficit(6-3) 4,314
(8 )Revenue deficit(4-1) 17,630
(9) Fiscal deficit(7+2c) 36,959
Money
Definition: Money is a good that acts as a medium of exchange in transactions. Classically it is

said that money acts as a unit of account, a store of value, and a medium of exchange. Most
authors find that the first two are nonessential properties that follow from the third. In fact, other
goods are often better than money at being intertemporal stores of value, since most monies
degrade in value over time through inflation or the overthrow of governments.
According to Crowther,

"Anything that is generally acceptable as a means of exchange and which at the same time acts
as a measure and store of value."
Thus, Anything is Money, which is generally acceptable as a medium of exchange, and at the
same time it must act as a measure and a store of value. Anything implies a thing to be used as
money need not be necessarily composed of any precious metal. The only necessary condition is
that, it should be universally accepted by people as a medium of exchange.
Functions of Money
Money performs five important functions :-
1. Medium of exchange : Money acts as a medium of exchange as it's generally accepted.

On the payment of money, purchase of goods and services can be made i.e. goods and
services are exchanged for money. Money bifurcates buying and selling activities
separately so it facilitates the exchange transactions.
2. Measure of value : Money is a common measure of value so it is possible to determine
the rate of exchange between various goods and services purchased by the people.
Exchange value of commodity can be expressed in terms of money. For e.g. we can say
that 10 metres of Cotton Cloth cost $220 dollars or Rs.10,000 rupees only.
3. Store of value : Money acts as a store of value. Money being generally acceptable and its
value being more or less stable, it is ideal for use as a store of value. Being non-
perishable and also comparatively stable in value, the value of other assets can be stored
in the form of money. Property can be sold and its value can be held in money and
converted into other assets as and when necessary.
4. Standard or Deferred payment : Money is also inevitably used as the unit in terms of
which all future or deferred payments are stated. Future transactions can be carried on in
terms of money. The loans, which are taken at present, can be repaid in money in the
future. The value of the future payments is regulated by money.
5. Transfer of value : Value of any asset can be transferred from one person to another or
to any institution or to any place by transferring money. The transfer of money can take
place irrespective of places, time and circumstances. Transfer of purchasing power,
which is necessary in commerce and other transactions, has become available because of
money.

MEASURE OF MONEY SUPPLY
Narrow money (M1) and Broad money (M3)
This concept is known as narrow money (M1) because it consists of currency plus bank money
held by people. There are other liquid or monetary resources with the public. Hence, there is
another concept of money supply known as broad money- this is referred as M3 by RBI.
The Redcliffe Committee on the working of the English Monetary System clearly distinguishes
between money and liquidity through previously, we regarded money, cash and liquidity
as one and the same. According to Redcliffe Committee, Spending is not limited by the amount
of money in existence but it is related to the amount of money people think they can get hold of.
From this point of view, not only money but also bear money assets constitute liquid assets
in broad sense and are available for people to spend at any given time. In near money assets,
we include fixed deposits or time deposits with the banking system. Time deposits or fixed
deposits contribute to the liquidity of the general public in three ways:-
(a) The depositors can borrow from the banks against time or fixed deposits in the case of
emergency.
(b) They can encash their fixed deposits even before their maturity period by sacrificing
part of the interest; and
(c) They are allowed by some banks to withdraw, from out of their fixed deposits; i.e., use
fixed deposits as a form of savings deposits.
It was after Redcliffe Committee Report that RBI started using two concepts of money supply
the conventional money supply (M1) an d broad money supply (M3) which includes, besides
conventional money, fixed deposits with banks ( which were previously called income yielding
assets).
M2 and M4 are irrelevant
We may comment on M2 and M4 which are the money stock measures prepared by RBI. They
include post office savings accounts (M2) as well as all the other deposits with the post office
(M4). These savings and other deposits with the postal system should also part of the aggregate
monetary resources of the people in the country, since the people consider themselves as liquid
resources. However for some peculiar reason, RBI does not attach any importance to money
stock measures and has not updated figures of post offices from time to time.

Broad money (M3)
The basic distinction between narrow money (M1) and broad money (M3) is the treatment of
time deposits with banks. Narrow money excludes time deposits of the public with the banking
system on the ground that they are income-earning assets and as such are not liquid. On the other
hand, broad money includes time deposits of the public with the banking system, not as cash
proper but as part of the total monetary resources of the public.
Monetary Aggregates in India
Actually, the RBI now calculates four concepts of money supply in India. These are known as
Money stock measures or measures of monetary aggregates. The four concepts of money supply
are:-
M1 = Currency with the public, i.e., coins and currency notes + demand deposits of the
public; also known as narrow money.
M2 = M1 + Post office savings deposits
M3 = M1 + Time deposits of the public with banks: M3 is known as broad money.
M4 = M3 + Total post office deposits*
* People maintain fixed deposits of various maturities with post offices, apart from
savings deposits.
Money stock measures (as on March 31): amt in crores
1990-1991 2010-2011 2011-2012

1 Money supply with the 92,890 16,35,569 17,298.7
people(M1)
2 Post office saving bank 4,210 5,041 50.4
deposits*
3 M2(M1+Serial No.2) 97,100 16,40,610 17,349.1
4 Time deposits with banks 1,72,940 48,63,969 56,142.0
5 M3(M1+ Serial No.4) 2,65,830 64,99,548 73,440.7
6 Total post office deposits 14,680 25,969 259.7
7 M4(M3+ Serial No.6) 2,80,510 65,25,517 73,700.4

RBI had not cared to collect (up-to-date) statistics of post office saving (serial no.2)
and total deposits of the public with the post offices (serial no.6) and has given the
same figures for the number of years; accordingly, M2 and M4 became meaningless
and have no relevance. Only M1 and M3 are significant.
This above given table shows;-
(a) The calculation of the four concepts of money supply with the public, viz., M1, M2, M3
and M4.
(b) Comparison of these figures for three years, viz., 1990-91, 2010-2011 and 2011-2012.
(c) The broad money (M3) has been rising much faster than narrow money (M1). This is
because people are keeping bank money increasingly in the form of time deposits.


THE INDIAN MONETARY POLICY/SYSTEM
The monetary policy of Indiaa developing economyhas focused on accelerating

economic development, while maintaining price and financial stability. RBI has been
adopting a monetary policy that aims at controlled monetary expansion whose twin
objectives are (a) To ensure that there is no paucity of funds for all legitimate economic
activities and (b) The availability of funds is not excessive to cause inflation. This implies
that while there is expansion in the supply of money, there is restraint on the secondary
expansion of credit.
With regard to the expansion of money supply, it has to expand it to the extent that it
more than matches the growth in national income. This is because of two factors: (a)
With the growth in incomes, the demand for money to be set aside as savings tends to go
up, and (b) with the sizeable growth in the economy, there is a gradual reduction in non-
monetized sector that augments money supply.
BANK RATE
The bank rate is the rate at which bank borrow from RBI(reserve bank of india).it is also
defined as the rate of which reserve bank gives loans to banks by discounting bills.any
revision in the bank rate by the RBI is a signal to banks to banks to revise deposit rates as
well as prime lending rate.
.REPO RATE
The repo rate is the rate at which RBI borrows from the banks. This is also the floor rate
at which overnight deals are struck. Besides lowering the cost of funds ,a lower repo rate
will see the emergency of a short term yield curve.
CRR AND SLR
.CRR is the cash reserve ratio which is the percentage of net funds that commercial banks have
to park fortnightly with the RBI to do business. Lowering of CRR means means that more
money comes into circulation. In addition to the CRR requirement banks are supposed to
maintain a certain percent of net deposits in the government securities and similar instruments
specified. This is known as statutory liquidity ratio(SLR) which is 25% present.
MONETARY POLICY OPERATIONS
LIQUIDITY MANAGEMENT:
The reserve bank modulates market liquidity through a mix of repo operations.as a capital
flows persisted,the reserve bank portfolio necessited a switch from out right OMO TO
REPO operations.the monetary policy operations has emerged as a key instrument of
liquidity management.

INTEREST RATE POLICY
The reserve bank continued to take policy initiatives to impart a greater degree of
flexibility to the interest rate structure.it also follow credit policy.
MONETARY POLICY
Monetary policy refers to the policy adopted by the monetary authority of a country with respect
to the supply of money, the rate of interest and other matters. In other words, it is the process by
which the government, central bank or monetary authority of a country controls (i) the supply of
money, (ii) the availability of money, and (iii) the cost of money or the rate of interest in order to
attain a set of objectives oriented towards the growth and stability of the economy.
According to Torado and Smith, monetary policy refers to the activities of a central bank
designed to influence financial variables such as money supply and interest rates.
It can be explained as that component of economic policy that regulates the level of money
supply in the economy--with the view to achieving certain desired policy objective such as
control of inflation, an improvement in the export earnings, realization of a certain level of
employment, or growth in the countrys GDP. Monetary policy and fiscal policy are the two
policy instruments with the help of which the government can influence the functioning of the
economy.
Monetary policy is based on the assumption that money in a modern complex economic system,
wherein savings and investments are carried out by different groups of people, performs a
dynamic function, apart from serving as a medium of exchange. In such a scheme of things,
money becomes capable of influencing the size of national income, the level of employment, the
demand for consumers and producers goods and, therefore, the volume of both savings and
investment. Monetary policy, hence, is used to vary the supply of money and also to effect
changes in its liquidity. Monetary policy is referred to as expansionary when it increases the total
supply of money in the economy. It is traditionally used to combat unemployment during
recession by lowering interest rates.
Monetary policy deals with (i) the control of financial institutions, (ii) active purchase and sales
of paper assets by monetary authority as deliberate attempt to affect changes in monetary
conditions, and (iii) passive purchases and sales of paper assets resulting from the maintenance
of a particular interest structure, the stability of security prices or meeting other obligations and
commitments.

OBJECTIVES
1. Safeguarding the countrys gold and forex reserves.

2. Price stability.
3. Foreign exchange stability.
4. Managing cyclical fluctuations and adopting suitable stabilization measures.
5. Ensuring full employment
6. Ensuring balance of payments equilibrium (to the maximum possible extent).
7. Accelerating economic growth (primarily in developing economies).
FUNCTIONS
1. A most suitable interest structure.

2. A correct balance between the demand and supply of money.
3. The provision of adequate credit facilities for a growing economy, while preventing
undue expansion that may cause inflation, and overseeing the channeling of credit to user
as per per-planned investment decisions.
4. The establishment, functioning and growth of financial institutions of the economy.
5. Proper management of public debts.
TOOLS FOR CREDIT CONTROL
The monetary authority uses various tools to control the supply of money, these are known as
instruments or tools of credit control. These tools can be divided into two categories
quantitative and qualitative credit control. There are three main methods of quantitative credit
controlbank rate policy, open market operation and changes in statutory reserve requirements.
The qualitative methods of credit control are also known as selective credit control method.
These include rationing, direct action, changes in margin requirements, moral suasion, etc. the
quantitative control measures are also known as traditional credit control measures.
Traditional credit control measures:-
The following are the traditional or quantitative control measures that have been used by central
banks all over the world to control the supply of both money and credit.
1. Bank rate policy: It is the oldest and subtle method of credit control that operates
through changes in bank rate made by the central bank. Bank rate is defined as the
official minimum rate at which the central bank rediscounts approved bills of exchange.
It is the rate at which the central bank is ready to buy or rediscount eligible bills of
exchange and other commercial papers. The RBI gives large proportion of its advances to
commercial banks against government securities and as refinance. When the central bank

raises the bank rate, the obtaining fund from the central bank becomes costlier for
commercial banks. The reverse happens when the bank rate is lowered during the period
of depression.
2. Open-market operation: It is a primary tool of monetary policy which calls for
managing the quantity of money in circulation through the buying and selling of various
credit instruments, foreign currencies or commodities. All of these purchases or sales
result in more or less base currency entering or leaving market circulation. The open-
market operations refer to the purchase and sale of government securities and other
approved securities by the central bank. An open-market sale decreases the money supply
and a purchase increases the money supply. The RBI, which is our central bank, transacts
both with the public and other banks. During the boom, the RBI sells the government and
other approved securities from its portfolio in the open market in order to reduce the
aggregate supply of money in the economy. The reverse happens when there is a slump.
3. Cash reverse requirements: It refers to that portion of banks total cash reserve which
they are statutory required to hold with the RBI. The remaining portion of the total cash
reserves of the banks refers to excess reserves which banks keep them-selves to facilitate
their normal functioning. An increase in the legal cash reserves ratio decreases the banks
and their optimum credit creating capacity. The reserve is true when the RBI increases
the statutory cash reserve ratio.
4. Statutory liquidity ratio: Commercial banks in India are required to maintain a
particular level of liquidity. The main role of the statutory liquidity ratio is to allocate
bank credit between government and commercial sectors. This instrument is also used to
control the supply of money. Commercial banks are statutorily required to hold a
proportion of their total demand and time liabilities in the form of excess reserves,
investments in unencumbered government and other approved securities and current
account balances with other banks.
Selective credit control measures:
Selective credit control can be easily distinguished from the traditional methods of monetary
management in as much as they are directed towards particular uses of credit and not merely to
total volume outstanding. The selective credit control measures are very popular in developing
countries like India. These controls are exercised through official regulations. Section 21 of
Banking Regulation Act 1949 empowers the RBI to issue directives to banks with regard to
advances. These directives may be with regard to,
(a) The purpose for which banks may or may not give advances.
(b) The margins to be maintained with regard to secured advances.
(c) The maximum amount of advance to any particular borrower.
(d) The rate of interest and the other terms and conditions for granting advances.
(e) The maximum amount up to which guarantee may be given by the bank.

They aim at curtailing the flow of credit into unproductive channels and diverting them into
productive channels. They operate by means of official regulations issued and enforced by
Central Bank. Some of the important methods of Selective Credit control tools are:
Rationing of credit:
Central Bank may issue direction to commercial banks to restrict (ration) credit to certain
sectors or sections of the population. This method is useful in controlling inflationary pressures.
Variable Margin Requirements: This measure to thwart speculation and hoarding activities by
traders. Instance if traders hoard necessary commodities like food grains in an attempt to create
artificial scarcity and thereby push up prices, then the Central Bank can raise marginal
requirements with respect to such goods.If the margin requirement is 50% , than the trader can
get a loan of only Rs. 10 lakh against A security of Rs. 20 lakhs. If the margin requirements
raised to Rs. 75% , he can get a loan of only Rs. 5 lakhs against the same security.
Moral suasion:
Measure used by the Central Bank to put pressure upon the lending activities of commercial
banks by urging them to voluntarily adopt certain restrictive practices.
Role and Function of Planning Commission
The Planning Commission in India was set up on March 1950 to promote a rapid rise in the
standard of living of the people by utilizing the resources of the country, increasing production
and offering employment opportunities to all. The Planning Commission has the responsibility
for formulating plans as to how the resources can be used in the most effective way.
The Planning Commission has to make periodic assessment of all resources in the country, boost
up insufficient resources and formulate plans for the most efficient and judicious utilization of
resources. The Planning Commission is a separate organisation in the Central Government with a
whole-time Deputy Chairman and the Prime Minister as the part-time Chairman.
Jawaharlal Nehru was the first chairman of the Planning Commission.
Functions
The 1950 resolution setting up the Planning Commission outlined its functions as to:
a. Make an assessment of the material, capital and human resources of the country,
including technical personnel, and investigate the possibilities of augmenting such of
these resources as are found to be deficient in relation to the nations requirement;
b. Formulate a Plan for the most effective and balanced utilisation of country's resources;
c. On a determination of priorities, define the stages in which the Plan should be carried out
and propose the allocation of resources for the due completion of each stage;

d. Indicate the factors which are tending to retard economic development, and determine the
conditions which, in view of the current social and political situation, should be
established for the successful execution of the Plan;
e. Determine the nature of the machinery which will be necessary for securing the
successful implementation of each stage of the Plan in all its aspects;
f. Appraise from time to time the progress achieved in the execution of each stage of the
Plan and recommend the adjustments of policy and measures that such appraisal may
show to be necessary; and
g. Make such interim or ancillary recommendations as appear to it to be appropriate either
for facilitating the discharge of the duties assigned to it, or on a consideration of
prevailing economic conditions, current policies, measures and development programmes
or on an examination of such specific problems as may be referred to it for advice by
Central or State Governments.
Role of Planning Commission:

From a highly centralised planning system, the Indian economy is gradually moving
towards indicative planning where Planning Commission concerns itself with the
building of a long term strategic vision of the future and decide on priorities of nation. It
works out sectoral targets and provides promotional stimulus to the economy to grow in
the desired direction.
Planning Commission plays an integrative role in the development of a holistic approach
to the policy formulation in critical areas of human and economic development. In the
social sector, schemes which require coordination and synthesis like rural health,
drinking water, rural energy needs, literacy and environment protection have yet to be
subjected to coordinated policy formulation. It has led to multiplicity of agencies. An
integrated approach can lead to better results at much lower costs.
The emphasis of the Commission is on maximising the output by using our limited
resources optimally. Instead of looking for mere increase in the plan outlays, the effort is
to look for increases in the efficiency of utilisation of the allocations being made.
With the emergence of severe constraints on available budgetary resources, the resource
allocation system between the States and Ministries of the Central Government is under
strain. This requires the Planning Commission to play a mediatory and facilitating role,
keeping in view the best interest of all concerned. It has to ensure smooth management of
the change and help in creating a culture of high productivity and efficiency in the
Government.
The key to efficient utilization of resources lies in the creation of appropriate self-
managed organizations at all levels. In this area, Planning Commission attempts to play a
systems change role and provide consultancy within the Government for developing
better systems. In order to spread the gains of experience more widely, Planning
Commission also plays an information dissemination role.

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Economics for Managers 14MBA12

Subject Code : 14MBA12

Module 1: Managerial Economics: Meaning, Nature, Scope. & Significance, Uses of

Module 2: Production Analysis: Concept, Production Function: Single Variable Law of

Module 4: Market Structure: Perfect Competition: Features, Determination of Price under

Module 5: Indian Economic Environment: Overview of Indian Economy, Recent Changes in

Module 6: Industrial Policies and Structure: Classification of Industries based on Ownership,

Department of MBA, SJBIT Page 1

Module 7: Economic Policies: Fiscal Policy: Objectives, Instruments, Union Budget,

Department of MBA, SJBIT Page 2

Module No. Contents Page Number

3 Cost and Revenue Profit Functions 66

4 Market Structure 116

5 Indian Economic Environment 154

6 Industrial Policies and Structure 190

7 Economic Policies 236

Department of MBA, SJBIT Page 3

Managerial Economics: Definition, Nature, Scope

Department of MBA, SJBIT Page 4

Definition of Managerial Economics:

Managerial Economics is economics applied in decision making. It is a special branch of

Nature of Managerial Economics

Department of MBA, SJBIT Page 5

Science as well as an Art: Managerial Economics is both knowledge acquiring and

Managerial economics a positive and normative science both:It is positive when it is

Department of MBA, SJBIT Page 6

Acceptance of use & utility of macroeconomic variables: In understanding the overall

Demand and Elasticity of demand

Department of MBA, SJBIT Page 7

Price determination under different market conditions/structures

Pricing methods in actual practice

Product and Project Planning

Capital Budgeting and Management

The primary function of management executive in a business organisation is decision

Scope of Managerial Economics

Department of MBA, SJBIT Page 8

9. Analysis of market structures

2. Planning of production schedule: Excess production production beyond reasonable level

6. Analysis and Determination of price of product: Important aspect of managerial

1. Demand Analysis and Forecasting

Department of MBA, SJBIT Page 9

2. Cost and Production Analysis

Department of MBA, SJBIT Page 10

Difference between Economic Theory Vs Managerial Theory

Economic theory is based on certain assumptions. But in managerial theory these

Significance of Managerial Economics

Department of MBA, SJBIT Page 11

o a) Selection of the product or service to be offered for sale.

EX: Uncertainties- Govt. Policy might change, Consumer taste and

Decision making is integral part of todays business management. Making a decision is

Uses of Managerial Economics

Managerial economics applies to:

Department of MBA, SJBIT Page 12

Department of MBA, SJBIT Page 13

1. It is effective desire / want,

2.Domestic and industrial demand:

3.Perishable and durable goods demand:

4.New and replacement demand:

Department of MBA, SJBIT Page 14

computer or machine] is a fine example of new demand. Generally, new demand is of an

5.Final and intermediate demand:

6.Short run and long run demand:

7.Autonomous and induced demand: