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Managerial Economics Unit 1

Unit 1 Meaning and Importance of


Managerial Economics
Structure:
1.1 Introduction
Objectives
Case Let
1.2 Definitions
1.3 Scope of Managerial Economics
1.4 Significance of the Study of Managerial Economics
1.5 Functions of a Managerial Economist
1.6 Summary
1.7 Glossary
1.8 Terminal Questions
1.9 Answers
1.10 Case Study
Reference/E-Reference

1.1 Introduction
Economics impacts our day-to-day lives. Economics also influences the
decisions taken by managers of business firms. Any business is part of an
economy. As we know, economic conditions heavily impact business activities
and vice versa. The per capita income of the citizens will define the purchasing
power on the basis of which, the business enterprises will decide what
products to manufacture and sell. A new enterprise has to forecast the
demand for the product, which it wants to sell. The day to day product market
has to decide a viable price depending upon the interaction between the
demand and the supply. Thus, management practitioners and academicians
brought economics to their perspective and developed ‘Managerial
Economics’.
Objectives:
After studying this unit, you should be able to:
• describe the relevance and context for managerial economics
• explain the salient and distinguishing features of the subject
• recognise the role of the Managerial Economist in a business firm

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• assess the scope of the subject vis-à-vis business management


• explain the decision making process
• apply the decision making process in day-to-day business

Case Let
Slowdowns and booms in the global economy affect business firms either
negatively or positively. The recent slowdown in the global and Indian
economy has forced many Indian companies to revise their revenue
outlook for the current as well as the coming fiscal year. The impact of the
global turmoil has hit export-oriented firms the hardest, but the decline in
their sales is expected to be partly offset by the depreciation of the Rupee
against the US Dollar. In spite of the difficult business conditions, investors
in Indian firms are expecting the firms’ managers to achieve good returns
on investment by taking prudent decisions.
In this turbulent condition, how can managers take decisions that lead to
better utilisation of resources? How can the firms’ performance be
sustained in the prevailing conditions of volatile macroeconomic
conditions?

1.2 Definitions
In this section, we will discuss a few definitions. Managerial economics is a
science that deals with the application of various economic theories,
principles, concepts and techniques to business management in order to
solve business and management problems. It deals with the practical
application of economic theory and methodology in decision-making problems
faced by private, public and non-profit making organisations.
The same idea has been expressed by Spencer and Siegelman, in the
following words: “Managerial economics is the integration of economic theory
with business practice for the purpose of facilitating decision making and
forward planning by the management”1. Mc Nair and Meriam say, “Managerial
economics is the use of economic modes of thought to analyse business
situation”2. Brighman and Pappas define managerial economics as, “the
application of economic theory and methodology to business administration

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practice”3. Joel Dean is of the opinion that use of economic analysis in


formulating business and management policies is known as managerial
economics4.

Features of managerial economics


The features of managerial economics are as follows:
• It is more realistic, pragmatic and highlights the practical application of
various economic theories to solve business and management problems.
• It is a science of decision-making. It focuses on decision-making process,
decision models and decision variables and their relationships.
• It is both conceptual and metric in nature, and it assists the decisionmaker
through precise and evident measurement of various economic variables
and their interrelationships.
• It uses various macroeconomic concepts like national income, inflation,
deflation, trade cycles, etc. to understand and adjust its policies to the
environment in which the firm operates.
• It also gives importance to the study of non-economic variables having
implications on economic performance of the firm. For example, impact of
technology, environmental forces, socio-political and cultural factors, etc.
• It uses the services of many other related sciences like mathematics,
statistics, engineering, accounting, operation research and psychology to
find solutions to business and management problems.
It should be clearly remembered that managerial economics does not provide
ready-made solutions to all kinds of problems faced by a firm. It provides only
the logic and the methodology to find out the answers, but not the answers
themselves. It all depends on the manager’s ability, experience, expertise and
intelligence to use different tools of economic analysis to find out the correct
answers to business problems.

1.3 Scope of Managerial Economics


In this section we will discuss the scope of managerial economics. The scope
helps in understanding the subject, area of the study, boundaries and width
of the subject. Business economics is comparatively a new and upcoming

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subject. Consequently, there is no unanimity among different economists with


respect to the exact scope of business economics.
However, the following topics are explained in this subject:
1. Objectives of a firm
2. Demand analysis and Forecasting
3. Production and Cost Analysis
4. Pricing Decisions, Policies and Practices
5. Profit Management
6. Capital Management
7. Linear Programming and the Theory of Games
8. Market Structure and Conditions
9. Strategic Planning
10. External environment
Objectives of a firm
Historically, profit maximisation has been considered as the main objective of
a business unit. All business organisations have multiple objectives which are
multidimensional out of which some are supplementary and some are
competitive. Few others are inter-connected and few others are opposing.
There are various goals like social, economic, organisational, human, and
national. All the objectives are determined by various factors and forces such
as corporate environment, socio-economic conditions, nature of power in the
organisation and external constraints under which a firm operates. However,
in the midst of several objectives, even today, the traditional profit
maximisation objective has a very high place. All other policies and
programmes of a firm revolve round this objective.
Demand analysis and forecasting
Mostly, a firm is a producing unit. It produces different kinds of goods and
services. It has to meet the requirements of consumers in the market. The
basic problems like: what to produce; where to produce; for whom to produce;
how to produce; how much to produce and how to distribute them in the
market, are to be answered by a firm. Hence, the firm has to study in detail
about the various determinants of demand, nature, composition and
characteristics of demand, elasticity of demand, demand distinctions, demand

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forecasting, etc. The production plan prepared by a firm should include all
these points.
Production and cost analysis
Production means conversion of inputs into the final output. It may be either
in physical or in monetary terms. Physical production deals with the
production of outputs by a firm, by employing different factor inputs in proper
proportions. Always, the most basic goal of any firm is to increase the output.
Production analysis deals with production function, laws of returns, returns to
scale, economies of scale, etc. Production cost is concerned with estimation
of costs to produce a given quantity of output. Cost controls, cost reduction,
cost cutting and cost minimisation receive top most priority in production and
cost analysis. Maximisation of output with minimum cost is the basic goal of
any firm. Cost analysis deals with the study of various cost concepts, their
classification and cost-output relationship in the short run and long run.
Pricing decisions, policies and practices
Pricing decisions means to fix the prices for all the goods and services of any
firm. This is based on the pricing policy and practices of that particular firm.
Amongst all the policies the most important policy of any firm would be the
price setting policy. The pricing decision depends on the revenue (amount),
income (level) and profits (volume) earned by a firm. Hence, we have to study
price-output determination under different market conditions, objectives and
considerations of pricing policies, pricing methods, practices, policies, etc. We
also study price forecasting, marketing channel, distribution channel, sales
promotion policies, etc.
Profit management
Basically, a firm can be a commercial or a business unit. Consequently, its
success or failure is measured in terms of the amount of profit it is able to earn
in a competitive market. The management gives top most priority to this
aspect. There are many theories in profit management, like emergence of
profit, functions of profit and its measurement, profit policies, techniques, profit
planning, profit forecasting and break even point.
Capital management
This is one of the essential areas of business unit. The success of any
business is based on proper management and adequate capital investment.

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Business managers, as part of cost-benefit analysis, have to study the cost of


employing capital and the rate of return expected from each and every project.
Under capital management, managers should assess capital requirement,
methods of capital mobilisation, capital budgeting, optimal allocation of
capital, selection of highly profitable projects, cost of capital, return on capital,
planning and control of capital expenditure, etc.
Linear programming and theory of games
The term linear means that the relationships handled can be represented by
straight lines and the term programming implies systematic planning or
decision-making. It implies maximisation or minimisation of a linear function
of variables subject to a constraint of linear inequalities. It offers actual
numerical solution to the problems of making optimum choices. It involves
either maximisation of profits or minimisation of costs.
Basically, the theory of games attempts to explain the rational course of action
for an individual firm or an entrepreneur who is confronted with a situation,
wherein the outcome depends not only on his own actions, but also on the
actions of others who are also confronted with the same problem of selecting
a rational course of action. In short, under the conditions of conflicts and
uncertainty, a firm or an individual faces problem similar to that of the player
of any game. Both these techniques are extensively used in business
economics to solve various business and managerial problems.
Market structure and conditions
The information on market structure and conditions of various markets is the
most important part of the business. The nature, extent and degree of
competition, number of sellers and buyers, etc. determine the nature of
policies to be adopted by a firm in the market.
Strategic planning
It provides long term decisions, which will have a huge impact on the
behaviour of the firm. The firm fixes up some long-term goals and objectives
and selects a different strategy to achieve them. This framework is a recent
addition to the scope of business economics with the emergence of MNCs.
The perspective of strategic planning is global. In fact, the integration of
business economics and strategic planning has given rise to a new area of
study called corporate economics.

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External environment
The external environment has a significant role in managerial economics. Few
examples of external environment impacting managerial economics are as
follows:
1. Macroeconomic management of the country relating to economic system,
national income, trade cycles, savings and investments and its impact on
the working of a firm
2. Budgetary operations of the government and its implications on the firm
3. Knowledge and information about various government policies such as
monetary, fiscal, physical, industrial, labour, foreign trade, foreign capital
and technology, MNCs, etc. as well as their impact on the working of a
firm
4. Impact of liberalisation, globalisation, privatisation and marketisation on
the operations of a firm
5. Impact of international changes, role of international financial and trade
institutions in formulating domestic polices of a firm
6. Problems of environmental degradation and pollution and its impact on
the policies of a firm
7. Improvements in the field of science and technology and its impact on a
firm, etc
8. Socio-political, cultural and other external forces and their influence of
business operations
Thus, it is clear that the scope of managerial economics is expanding with the
growth of modern business and business environment.

1.4 Significance of the Study of Managerial Economics


This section elaborates on the significance of the study of managerial
economics. Managerial economics does not give importance to the study of
theoretical economic concepts. Its main concern is to apply theories to find
solutions to day-to-day practical problems faced by a firm. The following

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points indicate the significance of the study of this subject in its right
perspective:
1. It gives guidance for identification of key variables in decision-making
process.
2. It helps the business executives to understand the various intricacies of
business and managerial problems and to take right decisions at the right
time.
3. It provides the necessary conceptual, technical skills, toolbox of analysis
and techniques of thinking and other such modern tools and instruments
like elasticity of demand and supply, cost and revenue, income and
expenditure, profit and volume of production, etc to solve various business
problems.
4. It is both a science and an art. In the context of globalisation, privatisation,
liberalisation and marketisation and a highly competitive dynamic
economy, it helps in identifying various business and managerial
problems, their causes and consequence, and suggests various policies
and programmes to overcome them.
5. It helps the business executives to become much more responsive,
realistic and competent to face the dynamic challenges in the modern
business world.
6. It helps in the optimum use of scarce resources of a firm to maximise its
profits.
7. It also helps in achieving other objectives a firm likes attaining industry
leadership, market share expansion and social responsibilities, etc.
8. It helps a firm in forecasting the most important economic variables like
demand, supply, cost, revenue, price, sales and profit, etc and formulate
sound business policies
9. It also helps in understanding the various external factors and forces
which affect the decision-making of a firm.
Thus, it has become a highly useful and practical discipline in recent years to
analyse and find solutions to various kinds of problems in a systematic and
rational manner.

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1.5 Functions of a Managerial Economist


This section elaborates the functions of a managerial economist. Managerial
economist is a specialist and an expert in analysing and finding answers to
business and managerial problems. He has in-depth knowledge of the
subject. He is an authority and has total command over his subject.
A managerial economist has to perform several functions in an organisation.
Decisions making and forward planning are described as the two major (basic)
functions and remaining functions are derived from the two basic functions.
A detailed description of the basic functions is given below for better
understanding.
Decision-making
The word ‘decision’ suggests a deliberate choice made out of several possible
alternative courses of action after carefully considering them. The act of
making a choice that signifies a solution for an economic problem is economic
decision making. It involves making a choice amongst a set of alternative
courses of action.
Decision-making is essentially a process of selecting the best option out of
many alternative opportunities or courses of action that are open to a
manager.
The choice made by the business executives are difficult, crucial and have
far-reaching consequences. The basic aim of making a decision is to select
the best course of action which maximises the economic benefits and
minimises the use of scarce resources of a firm. Hence, each decision
involves cost-benefit analysis. A slight error or delay in decision making may
cause considerable economic and financial damage to a firm. It is for this
reason that the management experts are of the opinion that right
decisionmaking at the right time is the secret of a successful manager.
Forward planning
The term ‘planning’ implies a consciously directed activity with certain
predetermined goals and means to carry them out. It is a deliberate activity.
It is a programmed action. Basically, planning is concerned with tackling future
situations in a systematic manner.

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Forward planning implies planning in advance. It is associated with deciding


the future course-of-action of a firm. It is prepared on the basis of past and
current experience of a firm. It is prepared in the background of uncertain and
unpredictable environment and guess work. Future events and happenings
cannot be predicted accurately. Growing firms devote a significant share of
their current output to net capital formation for bolstering

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the future economic output. A business executive must be intelligent enough


to think in advance, prepare a sound plan and take all possible precautionary
measures to meet all types of challenges of the future business. Hence,
forward planning has acquired greater significance in business circles.

Activity 1:
Select any type of business and prepare a plan with the predetermined
goals and means to carry them out. List down any 2-3 goals.

Self Assessment Questions


Fill in the blanks:
1. Managerial economics is the integration of ________ with ____ for
solving business and management problems.
2. Managerial economics fills up the gap between _______ and _______.
3. Managerial economics is mainly a _______________ science.
4. Basic objective of a firm today is _______________________.
5. Managerial economics is basically a branch of __________ economics.
6. Two major functions of a managerial economist are ____ and ______.
True or False
1. Managerial economics includes concepts from both microeconomics and
macroeconomics.
2. Managerial economics includes some theoretical tools and techniques
which may not be applicable in the real world.
3. Managerial economics helps to take decisions that lead to an increase in
a business firm’s profits.
4. Managerial economics is not related to other functional areas of business
management.
5. Forecasting of business performance can be done by using certain tools
and techniques of managerial economics.

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1.6 Summary
Let us recapitulate the important concepts discussed in this unit:

• Managerial economics is a new and a highly specialised branch of


economics. It brings together economic theory and business practice. It
assists in applying various economic theories and principles to find
solutions to business and management problems.
• It is applied economics and makes an attempt to explain how various
economic concepts are usefully employed in business management. It is
a practical subject. It opens up the mind of a managerial economist to the
complex and highly challenging business world. The features of
managerial economics throw light on the nature of the emerging subject
and the scope gives information about the wide coverage of the subject.
The concepts of decision-making and forward planning are the two basic
functions of a managerial economist. In a way, the entire subject matter
of managerial economics is to be understood in the background of these
two functions.

1.7 Glossary
Decision: It is a deliberate choice made out of several possible alternative
courses of action after carefully considering them.
Managerial economics: Managerial economics is the integration of
economic theory with business practice for the purpose of facilitating decision
making and forward planning by the management.
Planning: It is a consciously directed activity with certain predetermined goals
and means to carry them out.

1.8 Terminal Questions


1. Define managerial economics and explain its main characteristics.
2. Discuss the scope of managerial economics.
3. Explain the importance of managerial economics.

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4. Discuss the functions of a managerial economist.

1.9 Answers

Self Assessment Questions


1. Economic theory, Business Practice
2. Economic theory Practice
3. Prescriptive
4. Profit Maximisation
5. Micro
6. Decision-making Forward Planning
True or False
1. True
2. False
3. True
4. False
5. True

Terminal Questions
1. Managerial economics is a science that deals with the application of
various economic theories, principles, concepts and techniques to
business management in order to solve business and management
problems. Refer to unit 1.2.
2. The scope helps in understanding the subject, area of the study,
boundaries and width of the subject. Refer to unit 1.3.
3. The main concern of the subject is to apply theories to find solutions to
day-to-day practical problems faced by a firm. Refer to unit 1.4.
4. A managerial economist has to perform several functions in an
organisation. Decisions making and forward planning are described as

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the two major (basic) functions and remaining functions are derived from
the two basic functions. Refer to unit 1.5.

1.10 Case Study: Economics in Action

Costlier inputs, weaker rupee dim CFL bulbs


Pramugdha Mamgain
NEW DELHI: Lighting companies like Philips, Havells and Bajaj Electricals,
have increased the prices of CFL (compact fluorescent lamp) bulbs by up
to 15% due to soaring prices of key raw material – rare earth element –
after the Chinese cut its production and exports.
Phosphor, the rare earth element, prices have shot up almost six times to
$300 per kg in the last few months because its supply fell short of demand
following the Chinese government's move to protect its CFL industry. An
entry level CFL bulb, which was selling at Rs. 80 a few weeks ago, now
costs Rs. 90 in the domestic market.
"Increase in rare earth prices diluted the advantage we had earned through
economies of scale," Havells India president, Sunil Sikka said. Weakening
rupee too, has made imports costlier. Sikka said his company has
proposed to the government to remove taxes on rare earth imports to keep
prices of the energy-efficient bulbs under check. Indian companies are
paying a tax of close to 20% on imports of rare earth.
About 97% of global rare earth is produced in China. The country also
dominates the global CFL production with a share of 70%. China's move
to limit rare earth exports makes the industry's movement towards clean
energy products difficult, because there are no alternatives for phosphor,
Philips Lighting India President Nirupam Sahay said.
Rising incomes, along with falling prices and increased awareness, have
helped CFL lighting to become a Rs. 2,000 crore industry, growing
25%30% a year. The total lighting market in the country is pegged at Rs.
7,000 crore, still dominated by incandescent lamps, or light bulbs. Philips

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Lighting has increased CFL prices by 7-10%, while Bajaj Electricals


increased them by 8-10%.
Philips Lighting's Sahay said that the cost component of phosphor in CFL
has increased to 18% from 5% till the second quarter of this year.
Companies have not revised the prices of LED, or light-emitting diode
lamps, because the cost component of rare earth in LED bulbs is low.

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Discussion Questions:
Imagine that you are a manager in one of the lighting companies.
1. How could the increase in prices of your company’s CFLs impact the
demand for your CFLs? How would you address any potential negative
impact?
2. How does the depreciating Rupee affect the cost of imported
phosphor?
3. How does taxation affect the cost of imported phosphor?
4. What strategies could you adopt to minimise the risks arising from
increase in the price of imported phosphor?
(Source: The Economic Times, Nov 24, 2011)

Hint: Use the theoretical concept and answer the questions

Reference:
• Spencer, Milton H. & Siegelman, Louis (1959), Managerial Economics,
Homewood, Illinois: Richard. D. Irwin, Inc.
• McNair, Malcolm P. & Meriam, Richard S., (1941), Problems in Business
Economics, New York & London: McGraw Hill Book Co. Inc.
• Pappas, James L., & Brigham, Eugene F., (1979), Managerial
Economics, Hinsdale: Ill Dryden Press.
• Dean Joel, (1951), Managerial Economics, Englewood Cliffs: N J,
Prentice Hall.

E-Reference:
• www.Economictimes.com – retrieved on 24th November 2011

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Managerial Economics Unit 2

Unit 2 Demand Analysis


Structure:
2.1 Introduction
Case Let
Objectives
2.2 Meaning and Law of Demand
2.3 Elasticity of Demand
2.4 Summary
2.5 Glossary
2.6 Terminal Questions
2.7 Answers
2.8 Case Study
Reference/E-reference

2.1 Introduction
In the previous unit, we learnt about the scope and importance of
managerial economics. We learnt that managerial economics helps
managers to arrive at decisions that effectively use the firm’s resources, and
thereby leading the firm to grow profitably. In this unit, we will study about
demand analysis. The sustenance and growth of a business firm is greatly
influenced by the demand for a firm’s offerings (goods or/and services). In
this unit, we shall explore the importance of demand and supply in business
decisions/processes like pricing and forecasting. We begin our in-depth
understanding of the subject with a foundation on ‘demand’.
Demand and supply are the two main concepts in economics. Some experts
are of the opinion that the entire subject of economics can be summarised in
terms of these two basic concepts.

Case Let
Ramesh, a fresh MBA graduate, had recently joined a small firm that was
involved in the manufacture and marketing of traverse rods that were
used to suspend window curtains. One week into his job, Ramesh’s
superior asked him to submit a report on the demand for traverse rods in
India. Ramesh was also expected to comment on the factors that
influenced the demand for traverse rods as well as the relative
importance of those factors. Ramesh’s report was expected to guide the
marketing/sales team in its activities.
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Managerial Economics Unit 2

Objectives:
After studying this unit, you should be able to:
 describe the concept of demand and its features
 define and interpret the demand schedule, law of demand and price-
quantity relationships and exceptions to the law of demand
 categorise the various factors which influence the demand for goods and
services
 apply the concept of elasticity of demand and different kinds of elasticity
of demand

2.2 Meaning and Law of Demand


In this section, we will discuss the meaning and the law of demand. The
term demand is different from desire, want, will or wish. In the language of
economics, demand has different meanings. Any want or desire will not
constitute demand.
Demand = Desire to buy + Ability to pay + Willingness to pay
The term demand refers to total or given quantity of a commodity or a
service that is purchased by the consumer in the market at a particular price
and at a particular time.
The following are some of the important features of demand:
 It is backed up by adequate purchasing power.
 It is always at a price.
 It should always be expressed in terms of specific quantity.
 It is related to time.
Consumers create demand. Demand basically depends on utility of a
product. There is a direct relation between the two i.e., higher the utility,
higher would be demand and lower the utility, lower would be the demand.
Individual demand schedule
The demand schedule explains the functional relationship between price
and quantity. It is a list of various amounts of a commodity that a consumer
is willing to buy (and so seller to sell) at different prices at a particular period
of time. The individual demand schedule portrayed in table 2.1 shows that
people buy more when price is low and buy less when price is high.

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Managerial Economics Unit 2

Table 2.1: Individual Demand Schedule


Price (in Rs.) Quantity demanded in Units
5.00 200
4.00 300
3.00 400
2.00 500
1.00 600

Market demand schedule


When the demand schedules of all buyers are taken together, we get the
aggregate or market demand schedule. In other words, the total quantity of
a commodity demanded at different prices in a market by the whole body of
consumers at a particular period of time is called market demand schedule.
It refers to the aggregate behaviour of the entire market rather than mere
totalling of individual demand schedules. It is the horizontal summation of
the individual demand schedule. Market demand schedule is more
continuous and smooth when compared to an individual demand schedule.
Table 2.2 gives an example of market demand schedule.
Table 2.2: Market Demand Schedule
Total Market
Price (Rs.) A B C
Demand
5.00 100 200 300 600
4.00 200 300 400 900
3.00 300 400 500 1200
2.00 400 500 600 1500
1.00 500 600 700 1800

Demand function
The demand for a product or service is affected by its price, the income of
the individual, the price of other substitutes, population, habit, etc. Thus, we
can say that demand is a function of the price of the product and other
factors, as mentioned above.

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Demand function is a comprehensive formulation which specifies the factors


that influence the demand for a product. Mathematically, a demand function
can be represented in the following manner.
Dx = f (Px, Ps, Pc, Ep, Y, Ey, T, W, A, U… etc)
Where,
Dx = Demand for commodity X Ps = Price of the substitutes
Px = Price of the commodity X
Pc = Price of the complements Ep = Expected future price
Y = Income of the consumer Ey = Expected income in future
T = Tastes and preferences W = Wealth of the consumer
A = Advertisement and its impact U = All other determinants

Determinants of demand (factors that affect or influence the demand)


Demand for a commodity or service is determined by a number of factors.
All such factors are called ‘demand determinants’. The demand
determinants are as follows:
1. Price of the given commodity, prices of other substitutes and/or
complements, future expected trend in prices etc
2. General Price level existing in the country-inflation or deflation
3. Level of income and living standards of the people
4. Size, rate of growth and composition of population
5. Tastes, preferences, customs, habits, fashion and styles
6. Publicity, propaganda and advertisements
7. Weather and climatic conditions
Thus, several factors are responsible for bringing changes in the demand for
a product in the market. A business executive should have the knowledge
and information about all these factors and forces in order to finalise his own
production, marketing and other business strategies.
Demand curve
A demand curve is a locus of points showing various alternative price-
quantity combinations. In short, the graphical presentation of the demand
schedule is called as a demand curve. Figure 2.1 depicts the demand curve.

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Managerial Economics Unit 2

10 A

8 B

Price 6 C
 E
4  F

D
2

X
0 100 200 300 400 500
Demand

Figure 2.1: Demand Curve

It represents the functional relationship between quantity demanded and


prices of a given commodity. The demand curve has a negative slope or it
slopes downwards to the right. The negative slope of the demand curve
clearly indicates that quantity demanded goes on increasing as price falls
and vice versa.

The law of demand


The law of demand explains the relationship between price and quantity
demanded of a commodity. It says that demand varies inversely with the
price. The law can be explained in the following manner, “Keeping other
factors that affect demand constant, a fall in price of a product leads to
increase in quantity demanded and a rise in price leads to decrease in
quantity demanded for the product”. The law can be expressed in
mathematical terms as “Demand is a function of price”. Thus, symbolically
D = F (p) where, D represents Demand, P stands for Price and F denotes
the Functional relationship. The law explains the cause and effect
relationship between the independent variable [price] and the dependent
variable [demand]. The law explains only the general tendency of
consumers while buying a product. A consumer would buy more when price
falls due to the following reasons:
1. A product becomes cheaper [Price effect]
2. Purchasing power of a consumer would go up [Income effect]

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3. Consumers can save some amount of money


4. Cheaper products are substituted for costly products [substitution effect]

Significant features of the law of demand


The significant features of the law of demand are as follows:
1. There is an inverse relationship between price and quantity demanded.
2. Price is an independent variable and demand is a dependent variable.
3. It is only a qualitative statement and as such it does not indicate
quantitative changes in price and demand.
4. Generally, the demand curve slopes downwards from left to right.
The operation of the law is conditioned by the phrase “Other things being
equal”. It indicates that given certain conditions, certain results would follow.
The inverse relationship between price and demand would be valid only
when tastes and preferences, customs and habits of consumers, prices of
related goods, and income of consumers would remain constant.

Exceptions to the law of demand


Generally speaking, customers would buy more when price falls in
accordance with the law of demand. Exceptions to law of demand states
that with a fall in price, demand also falls and with a rise in price demand
also rises. This can be represented by rising demand curve. In other words,
the demand curve slopes upwards from left to right. It is known as an
exceptional demand curve or unusual demand curve.
Figure 2.2 depicts the exceptional demand curve. It is clear from figure 2.2
that as price rises from Rs. 4.00 to Rs. 5.00, quantity demanded also
expands from 10 units to 20 units.
Y
D
Price

5.00

4.00

0 Demand 10 X
20
Figure 2.2: Exceptional Demand Curve

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Some examples that favour the unusual demand curve are as follows:
1. Giffen’s paradox – A paradox is an inconsistency or contrary. Sir
Robert Giffen, an Irish Economist, with the help of his own example
(inferior goods) disproved the law of demand. The Giffen’s paradox
holds that “Demand is strengthened with a rise in price or weakened
with a fall in price”. He gave the example of poor people of Ireland who
were using potatoes and meat as daily food articles. When price of
potatoes declined, customers instead of buying larger quantities of
potatoes started buying more of meat (superior goods). Thus, the
demand for potatoes declined in spite of fall in its price.
2. Veblen’s effect – Thorstein Veblen, a noted American economist
contends that there are certain commodities which are purchased by
rich people not for their direct satisfaction, but for their ‘snob-appeal’ or
‘ostentation’. Veblen’s effect states that demand for status symbol goods
would go up with a rise in price and vice-versa. In case of such status
symbol commodities, it is not the price which is important but the
prestige conferred by that commodity on a person makes him to go for it.
More commonly cited examples of such goods are diamonds and
precious stones, world famous paintings, commodities used by world
famous personalities, etc. Therefore, commodities having ‘snob-appeal’
are to be considered as exceptions to the law of demand.
3. Fear of shortage – When serious shortages are anticipated by the
people, (e.g., during the war period) they purchase more goods at
present even though the current price is higher.
4. Fear of future rise in price – If people expect future hike in prices,
they buy more even though they feel that current prices are higher.
Otherwise, they have to pay a still high price for the same product.
5. Speculation – Speculation implies purchase or sale of an asset with the
hope that its price may rise or fall and make speculative profit. Normally,
speculation is witnessed in the stock exchange market. People buy
more shares only when their prices show a rising trend. This is because
they get more profit, if they sell their shares when the prices actually
rise. Thus, speculation becomes an exception to the law of demand.

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6. Conspicuous consumption – Conspicuous consumption refers to


consumers’ purchase of some items though the items’ prices are rising
on account of their special uses in the modern style of life.
In case of articles like wrist watches, scooters, motorcycles, tape
recorders, mobile phones, etc., customers buy more in spite of their high
prices.
7. Emergencies – During emergency periods like war, famine, floods,
cyclone, accidents, etc., people buy certain articles even though the
prices are quite high.
8. Ignorance – Sometimes people may not be aware of the prices
prevailing in the market. Hence, they buy more at higher prices because
of sheer ignorance.
9. Necessaries – Necessaries are those items which are purchased by
consumers whatever may be the price. Consumers would buy more
necessaries in spite of their higher prices.
Changes or shifts in demand
Clearly understand that if demand changes only because of changes in the
price of the given commodity, in that case there would be either expansion
or contraction in demand. Both of them can be explained with the help of
only one demand curve. If demand changes, not because of price changes
but because of other factors or forces, then in that case there would be
either increase or decrease in demand. If demand increases, there would be
forward shift in the demand curve to the right and if demand decreases, then
there would be backward shift in the demand cure. Figure 2.3 depicts the
shift in demand.

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Y D1

D2
Forward
Shift
Price
D1

D
Backward
Shift D2
0 X

Demand

Figure 2.3: Shifts in Demand

Self Assessment Questions


1. In a typical demand schedule quantity demanded varies ___________
with price.
2. In case of Giffen’s goods, price and demand go in the ______
directions.
3. If demand changes as a result of price changes, then it is a case of
_____ and ____ in demand.
4. Law of demand is a _________ statement.
5. Demand function is much more _______ than law of demand.
6. In case of Veblen goods, a fall in price leads to a _______ in demand.
True or False
i) If the demand for a good decreases when income falls, the good is
called a luxury good.
ii) When an increase in the price of one good lowers the demand for
another good, the two goods are called complements.
iii) If the price of onions increases when the quantity of onions purchased
in a market falls, this could have been caused by a decrease in supply
and demand remaining constant.
iv) A change in a non-price determinant of demand leads to a movement
along the demand curve.

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v) Surplus of a good in a market increases its prices while shortage leads


to fall in its prices.

2.3 Elasticity of Demand


Earlier we have discussed the law of demand and its determinants. It tells
us only the direction of change in price and quantity demanded. But it does
not specify how much more is purchased when price falls or how much less
is bought when price rises. In order to understand the quantitative changes
or rate of changes in price and demand, we have to study the concept of
elasticity of demand. In this section, we will discuss the elasticity of demand.
Meaning and definition
The term elasticity is borrowed from physics. It shows the reaction of one
variable with respect to a change in other variables on which it is dependent.
Elasticity is an index of reaction.
In economics the term elasticity refers to a ratio of the relative changes in
two quantities. It measures the responsiveness of one variable to the
changes in another variable.
Elasticity of demand is generally defined as the responsiveness or
sensitiveness of demand to a given change in the price or non-price
determinant of a commodity. It refers to the capacity of demand either to
stretch or shrink to a given change in price or non-price determinant. For
e.g., demand for a good/service changes by some percentage due to
change in consumer income by some percentage, Measurement of these
changes can lead to calculation of elasticity of demand. Elasticity of demand
indicates a ratio of relative changes in two quantities, i.e., price and
demand. According to professor Boulding, elasticity of demand measures
the responsiveness of demand to changes in price1. In the words of
Marshall, “The elasticity (or responsiveness) of demand in a market is great
or small, according to the amount demanded much or little for a given fall in
price and diminishes much or little for a given rise in price”2.
Kinds of elasticity of demand
Broadly speaking, there are five kinds of elasticity of demand.
They are price elasticity, income elasticity, cross elasticity, promotional
elasticity and substitution elasticity. We shall discuss each one of them in
some detail.
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Price elasticity of demand


In the words of Prof. Stonier and Hague, price elasticity of demand is a
technical term used by economists to explain the degree of responsiveness
of the demand for a product to a change in its price.

Percentage change in quantity demanded


Ep 
Percentage change in price

Where, Ep is price elasticity

Demand rises by 80%, i .e.  80 Demand falls by 80%, i.e.  80


 4  4
Pr ices falls by 20%, i.e  20 price rises by 20%, i.e.  20
It implies that at the present level with every change in price, there will be a
change in demand four times inversely. Generally the co-efficient of price
elasticity of demand always holds a negative sign because there is an
inverse relation between the price and quantity demanded.
 D P 40 6
Symbolically, Ep =  P  D  2  20   6

Original demand = 20 units original price = 6 – 00


New demand = 60 units New price = 4 – 00
In the above example, price elasticity is – 6.
The rate of change in demand may not always be proportional to the change
in price. A small change in price may lead to very great change in demand
or a big change in price may not lead to a great change in demand.
Based on numerical values of the co-efficient of elasticity, we can have the
following five degrees of price elasticity of demand:
1. Perfectly elastic demand – In this case, a very small change in price
leads to an infinite change in demand. The demand curve is a horizontal
line and parallel to OX axis. The numerical co-efficient of perfectly elastic
demand is infinity (ED=  ). Figure 2.4 depicts the perfectly elastic
demand curve.

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ED = ∞

Price
D D

Quantity
0 X

Figure 2.4: Perfectly Elastic Demand


2. Perfectly inelastic demand – In case of any change in price, the
quantity demanded will be perfectly constant. The demand curve is a
vertical straight line and parallel to OY axis. Quantity demanded would
be 10 units, irrespective of price changes from Rs. 10.00 to Rs. 2.00.
Hence, the numerical co-efficient of perfectly inelastic demand is zero.
ED = 0. Figure 2.5 depicts perfectly inelastic demand curve.
Y

D
10.0
Price

0 ED = 0

2.00
0 D X
10
Quantity
Figure 2.5: Perfectly Inelastic Demand

3. Relatively elastic demand – Here, if there is a small change in price,


then it leads to proportional change in demand. Figure 2.6 depicts the
relatively elastic demand. In figure 2.6 you can see that change in
demand is more than that of change in price. Hence, the elasticity is
greater than one. For e.g., demand rises by 9 % and price falls by 3%.
Hence, the numerical co-efficient of demand is greater than one.

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D ED > 1
9% / 3% = -3

Price
3%
9% D

0 X

Demand
Figure 2.6: Relatively Elastic Demand
4. Relatively inelastic demand – Here a huge change in price, say 8 %
fall price, leads to less than proportional change in demand, say
4 % rise in demand. One can notice here that change in demand is less
than that of change in price. This can be represented by a steeper
demand curve. Hence, elasticity is less than one. Figure 2.7 depicts the
relatively inelastic demand curve.
Y
D
Price

ED < 1
8%
4% / 8% = 0.5

4%
0 D
X
Demand
Figure 2.7: Relatively Inelastic Demand

In all economic discussion, relatively elastic demand is generally called


as ‘elastic demand’ or ‘more elastic’ demand, while relatively inelastic
demand is popularly known as ‘inelastic demand’ or ‘less elastic
demand’.
5. Unitary elastic demand – Here, there is proportionate change in price
which leads to equal proportional change in demand. For e.g., 5 % fall in
price leads to exactly 5 % increase in demand. Hence, elasticity is equal
to unity. It is possible to come across unitary elastic demand but it is a
rare phenomenon. Figure 2.8 depicts the unitary elastic demand curve.
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D
ED = 1
Price 5% 5% / 5% = 1

D
5%
X
0 Demand
Figure 2.8: Unitary Elastic Demand

Out of five different degrees, the first two are theoretical and the last one is
a rare possibility. Hence, in all our general discussions, we make reference
only to two terms: relatively elastic demand and relatively inelastic demand.

Determinants of price elasticity of demand


You may observe that the elasticity of demand depends on several factors
of which the following are some of the important ones:
1. Nature of the commodity – Commodities coming under the category
of necessaries and essentials tend to be inelastic, because people buy
them whatever may be the price. For example, rice, wheat, sugar,
milk, vegetables, etc.; on the other hand, for comforts and luxuries,
demand tends to be elastic, e.g., TV sets, refrigerators, etc.
2. Existence of substitutes – Substitute goods are those that are
considered to be economically interchangeable by buyers. If a
commodity has no substitutes in the market, demand tends to be
inelastic because people have to pay higher price for such articles.
For example, salt, onions, garlic, ginger, etc. In case of commodities
having different substitutes, demand tends to be elastic. For example,
blades, tooth pastes, soaps, etc.
3. Number of uses for the commodity – Single-use goods are those,
which can be used for only one purpose and multiple-use goods can
be used for a variety of purposes. If a commodity has only one use
(singe use product), demand tends to be inelastic because people
have to pay more prices if they have to use that product for only one
use, for example, all kinds of eatables, seeds, fertilizers, pesticides,
etc. On the contrary, for commodities having several uses, [multiple-

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use-products] demand tends to be elastic, for example, coal,


electricity, steel, etc.
4. Durability and reparability of a commodity – Durable goods are
those, which can be used for a long period of time. Demand tends to
be elastic in case of durable and repairable goods, because people do
not buy them frequently, e.g., table, chair, vessels etc. On the other
hand, for perishable and non-repairable goods, demand tends to be
inelastic e.g., milk, vegetables, electronic watches, etc.
5. Possibility of postponing the use of a commodity – In case there
is no possibility to postpone the use of a commodity, demand tends to
be inelastic because people have to buy them irrespective of their
prices, e.g., medicines. If there is a possibility to postpone the use of a
commodity, demand tends to be elastic, e.g., buying TV set, motor
cycle, washing machine, car, etc.
6. Level of income of the people – Generally speaking, demand will be
relatively inelastic in case of rich people, because any change in
market price will not alter and affect their purchase plans. On the
contrary, demand tends to be elastic in case of poor.
7. Range of prices – There are certain goods or products like imported
cars, computers, refrigerators, TV, etc, which are costly in nature.
Similarly, a few other goods like nails, needles, etc. are low priced
goods. In all these cases, a small fall or rise in prices will have
insignificant effect on their demand. Hence, demand for them is
inelastic in nature. However, commodities having normal prices are
elastic in nature.
8. Proportion of the expenditure on a commodity – When the amount
of money spent on buying a product is either too small or too big,
demand tends to be inelastic. For example, salt, newspaper or a site
or house. On the other hand, if the amount of money spent is
moderate, demand tends to be elastic. For example, vegetables and
fruits, cloths, provision items etc.
9. Habits – When people are habituated to the use of a commodity, they
do not care for price changes over a certain range e.g., in case of
smoking, drinking, use of tobacco, etc. In that case, demand tends to

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be inelastic. If people are not habituated to the use of any product,


then demand generally tends to be elastic.
10. Period of time – Price elasticity of demand varies with the length of
the time period. Generally speaking, in the short period, demand is
inelastic because consumption habits of the people, customs and
traditions, etc. do not change. On the contrary, demand tends to be
elastic in the long period where there is possibility of all kinds of
changes.
11. Level of knowledge – Demand in case of enlightened customers
would be elastic and in case of ignorant customers, it would be
inelastic.
12. Existence of complementary goods – Goods or services whose
demands are interrelated such that an increase in the price of one of
the products results in a fall in the demand for the other are known as
complementary goods. Goods that are jointly demanded are inelastic
in nature. For example, pen and ink, vehicles and petrol, shoes and
socks, etc. have inelastic demand for this reason. If a product does not
have complements, in that case demand tends to be elastic. For
example, biscuits, chocolates, ice creams, etc. In this case, the use of
a product is not linked to any other product.
13. Purchase frequency of a product – If the frequency of purchase is
very high, the demand tends to be inelastic, e.g., coffee, tea, milk,
match-box, etc. On the other hand, if people buy a product
occasionally, demand tends to be elastic, e.g., durable goods like
radio, tape recorders, refrigerators, etc.
Thus, the demand for a product being elastic or inelastic will depend on a
number of factors.

Measurement of price elasticity of demand


There are different methods to measure the price elasticity of demand and
among them, the three most important methods are: total expenditure
method, point method and arc method.
Let us discuss these methods in detail.

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Total expenditure method


Under this method, the price elasticity is measured by comparing the total
expenditure of the consumers (or total revenue i.e., total sales values from
the point of view of the seller) before and after variations in price. Table 2.3
shows the total expenditure of consumers with variations in price and
quantity demanded. We measure price elasticity by examining the change in
total expenditure as a result of change in the price and quantity demanded
for a commodity.
Total expenditure = Price per unit x Total quantity purchased

Table 2.3: Total Expenditure of Consumers

Price in Qty. Total Nature of


(Rs.) Demanded Expenditure PED
I Case 5.00 2000 10000
4.00 3000 12000 >1
2.00 7000 14000
II Case 5.00 2000 10000
4.00 2500 10000 =1
2.00 5000 10000
III Case 5.00 2000 10000
4.00 2200 8000 <1
2.00 4200 8400

Note:
Variation in the value of ED can be summarised as:
1. When new outlay is greater than the original outlay, then ED > 1.
2. When new outlay is equal to the original outlay then ED = 1.
3. When new outlay is less than the original outlay then ED < 1.

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Graphical representation
Y

A
E>1
B
ABCD is total expenditure curve
Price

E=1
C
D E<1
0 X
Total Expenditure
Figure 2.9: Graphical Representation of Total Expenditure Method

From the diagram it is clear that:


1. From A to B, price elasticity is greater than one.
2. From B to C, price elasticity is equal to one.
3. From C to D, price elasticity is less than one.
Note:
Following points should be noted from the total expenditure method:
 When total expenditure increases with the fall in price and decreases
with a rise in price, then the PED is greater than one.
 When the total expenditure remains the same either due to a rise or fall
in price, the PED is equal to one.
 When total expenditure, decreases with a fall in price and increases with
a rise in price, PED is less than one.
Point method
Prof. Marshall advocated this method. The point method measures price
elasticity of demand at different points on a demand curve. Hence, in this
case, an attempt is made to measure small changes in both price and
demand. It can be explained either with the help of mathematical calculation
or with the help of a diagram or graphical representation. Table 2.4 shows
the relation between the price and the demand at two points: A and B.

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Mathematical illustrations
Table 2.4: Price-Demand in Point Method
Points Price in Rs. Demand in units
A 10 - 00 40
B 09 - 00 46

In order to measure price elasticity at two points, A and B, the following


formula is to be adopted.
Percentage change in demand
PED 
Percentage change in price

In order to find out percentage change in demand, the formula is –


Change in demand
 100
Original demand

In order to find out percentage change in price, the following formula is


employed
Change in price
 100
Original price
change in demand 6 600
At Point A, Ep =  100   15%
original demand 40 40

Change in price 1  100


 100   100    10%
Original price 10 10

15
Ep    1 .5
 10
Change in demand  6  600
At point B, ED =  100    13.04%
Original demand 46 46
Change in price 1 100
 100   11.11%
Original price 9 9
 13.04
Ep    1.17
11.11

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D
A – 1.5

Price
 B – 1.17
D
0 X
Demand

Figure 2.10: Demand Curve

Figure 2.10 depicts the demand curve for the considered case. It is clear
that on any straight line demand curve, price elasticity will be different at
different points since the demand curve represents the demand schedule
and the demand schedule has different elasticity at various alternative
prices.

Graphical representation
The simplest way of explaining the point method is to consider a linear or
straight line demand curve. Let the straight-line demand curve be extended
to meet the two axis X and Y when a point is plotted on the demand curve, it
divides the curve into two segments. The point elasticity is measured by the
ratio of lower segment of the demand curve below the given point to the
upper segment of the curve above the point. Hence,
Lower segment of the demand curve below the po int
Price elasticity =
Upper segment of the demand curve above the po int

In short, e = L / U where ‘e’ stands for Point elasticity, ‘L’ for lower segment
and ‘U’ for upper segment.
In the figure 2.11(a), AB is the straight line demand curve and P is a given
point. PB is the lower segment and PA is the upper segment.

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Y Y
D
A Upper Segment
A
P P

Price
Price

Lower D
Segment
B
 X 0 B X
0
Demand Demand
(a) (b)
Figure 2.11: Demand Curve

In the figure 2.11(b), AB is the straight-line demand curve and P is a given


point. PB is the lower segment and PA is the upper segment.
E = L / U = PB / PA
If after the actual measurement of the two parts of the demand curve, we
find that
PB = 3 cm and PA = 2 cm then elasticity at Point P is 3 / 2 = 1.5
If the demand curve is non–linear then we have to draw a tangent at the
given point extending it to intersect both axes. Point elasticity is measured
by the ratio of the lower part of the tangent below that given point to the
upper part of the tangent above the point. Then, elasticity at point P can be
measured as PB / PA.
In the case of point method, the demand function is continuous and hence,
only marginal changes can be measured. In short, Ep is measured only
when changes in price and quantity demanded are small.
Arc method
This method is suggested to measure large changes in both price and
demand. When elasticity is measured over an interval of a demand curve,
the elasticity is called as an interval or arc elasticity. It is the average
elasticity over a segment or range of the demand curve. Hence, it is also
called average elasticity of demand.

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The following formula is used to measure arc elasticity.


Q2  Q1 P2  P1
Arc elasticity = 
Q2  Q1 P2  P1
Illustration
P1 = original price 10 – 00. Q1 = original quantity = 200 units
P2 = New price 05 – 00 Q2 = New quantity = 300units

By substituting the values in to the equation, we can find out Arc elasticity of
demand.
300  200 5  10 100 15 1 3 3
        0 .6
300  200 5  10 500  5 5  1  5
Y

D
P1 M
Price

D P
N
82
P D D
% D
404 X
Q1 Q2
% Demand
/
Figure 2.12: Demand Curve
8
Figure 2.12 depicts the demand
% curve for the arc method. In the diagram, in
order to measure arc elasticity between two points M & N on the demand
=
curve, we have to take the average of prices OP1 and OP2 and also the
average quantities of Q1 &0.Q2.
5
Practical application of price elasticity of demand
Few examples on the practical application of price elasticity of demand are
%
as follows:
1. Production planning – It helps a producer to decide about the volume
of production. If the demand for his products is inelastic, specific
quantities can be produced while he has to produce different quantities,
if the demand is elastic.

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2. Helps in fixing the prices of different goods – It helps a producer to


fix the price of his product. If the demand for his product is inelastic, he
can fix a higher price and if the demand is elastic, he has to charge a
lower price. Thus, price-increase policy is to be followed if the demand is
inelastic in the market and price-decrease policy is to be followed if the
demand is elastic.
Similarly, it helps a monopolist to practise price discrimination on the
basis of elasticity of demand.
3. Helps in fixing the rewards for factor inputs – Factor rewards refer to
the price paid for their services in the production process. It helps the
producer to determine the rewards for factors of production. If the
demand for any factor unit is inelastic, the producer has to pay higher
reward for it and vice-versa.
4. Helps in determining the foreign exchange rates – Exchange rate
refers to the rate at which currency of one country is converted in to the
currency of another country. It helps in the determination of the rate of
exchange between the currencies of two different nations. For e.g. if the
demand for US dollar to an Indian rupee is inelastic, in that case, an
Indian has to pay more Indian currency to get one unit of US dollar and
vice-versa.
5. Helps in determining the terms of trade – t is the basis for deciding
the ‘terms of trade’ between two nations. The terms of trade implies the
rate at which the domestic goods are exchanged for foreign goods. For
e.g. if the demand for Japan’s products in India is inelastic, we have to
pay more in terms of our commodities to get one unit of a commodity
from Japan and vice-versa.
6. Helps in fixing the rate of taxes – Taxes refer to the compulsory
payment made by a citizen to the government periodically without
expecting any direct return benefit from it. It helps the Finance Minister
to formulate sound taxation policy of the country. He can impose more
taxes on those goods for which the demand is inelastic and lower taxes
if the demand is elastic in the market.
7. Helps in declaration of public utilities – Public utilities are those
institutions which provide certain essential goods to the general public at
economical prices. The government may declare a particular industry as
‘public utility’ or nationalise it, if the demand for its products is inelastic.

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8. Poverty in the midst of plenty – The concept explains the paradox of


poverty in the midst of plenty. A bumper crop of rice or wheat, instead of
bringing prosperity to farmers, may actually bring poverty to them
because the demand for rice and wheat is inelastic.
Thus, the concept of price elasticity of demand has great practical
application in economic theory.
Income elasticity of demand
Income elasticity of demand may be defined as the ratio or percentage
change in the quantity demanded of a commodity to a given percentage
change in the income. In short, it indicates the extent to which demand
changes with a variation in consumer’s income. The following formula helps
to measure Ey.
Percentage change in demand
Ey 
Percentage change in income
D Y 300 4000
Symbolically Ey     1 .5
Y D 2000 400
Original demand = 400 units Original Income = 4000-00
New demand = 700 units New Income = 6000-00
Generally speaking, Ey is positive. This is because there is a direct
relationship between income and demand, i.e. higher the income; higher
would be the demand and vice-versa. On the basis of the numerical value of
the co-efficient, Ey is classified as greater than one, less than one, equal to
one, equal to zero, and negative. The concept of Ey helps us in classifying
commodities into different categories. Based on value of Ey, the
commodities can be classified as:
1. When Ey is positive, the commodity is normal [used in day-to-day life]
2. When Ey is negative, the commodity is inferior, e.g., Jowar, beedi, etc.
3. When Ey is positive and greater than one, the commodity is luxury.
4. When Ey is positive, but less than one, the commodity is essential.
5. When Ey is zero, the commodity is neutral, e.g. salt, match-box, etc.
Practical application of income elasticity of demand
Few examples on the practical application of income elasticity of demand
are as follows:

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1. Helps in determining the rate of growth of the firm – If the growth


rate of the economy and income growth of the people is reasonably
forecasted, in that case, it is possible to predict expected increase in the
sales of a firm and vice-versa.
2. Helps in the demand forecasting of a firm – It can be used in
estimating future demand provided that the rate of increase in income
and the Ey for the products are known. Thus, it helps in demand
forecasting activities of a firm.
3. Helps in production planning and marketing – The knowledge of Ey
is essential for production planning, formulating marketing strategy,
deciding advertising expenditure and nature of distribution channel, etc.
in the long run.
4. Helps in ensuring stability in production – Proper estimation of
different degrees of income elasticity of demand for different types of
products helps in avoiding over-production or under production of a firm.
One should also know whether rise or fall in income is permanent or
temporary.
5. Helps in estimating construction of houses – The rate of growth in
incomes of the people also helps in housing programmes in a country.
Thus, it helps a lot in managerial decisions of a firm.
Cross elasticity of demand
Cross elasticity demand may be defined as the percentage change in the
quantity demanded of a particular commodity in response to a change in the
price of another related commodity. In the words of Prof. Watson cross
elasticity of demand is the percentage change in quantity associated with a
percentage change in the price of related goods. Generally speaking, it
arises in case of substitutes and complements. The formula for calculating
cross elasticity of demand is as follows:
Percentage change in quantity demanded of com mod ity X
Ec =
Percentage change in the price of Y
Dx Py 40 4
Symbolically, Ec =    1 .6
Py Dx 2 50
Price of tea rises from Rs. 4-00 to 6-00 per cup
Demand for coffee rises from 50 cups to 90 cups.
Cross elasticity of coffee in this case is 1.6.

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It should be noted that:


1. Cross elasticity of demand is positive in case of good substitutes,
e.g. coffee and tea.
2. High cross elasticity of demand exists for those commodities which are
close substitutes. In other words, if commodities are perfect substitutes,
for e.g., Bata or Corona shoes, Close-up or Pepsodent tooth paste,
beans and ladies finger, Pepsi and Coca-Cola, etc.
3. The cross elasticity is zero when commodities are independent of each
other, for e.g., stainless steel, aluminium vessels, etc.
4. Cross elasticity between two goods is negative when they are
complements. In these cases, rise in the price of one will lead to fall in
the quantity demanded of another commodity For example, car and
petrol, pen and ink, etc.

Practical application of cross elasticity of demand


Few examples on the practical application of cross elasticity of demand are
as follows:
1. Helps at the firm level – Knowledge of cross elasticity of demand is
essential to study the impact of change in the price of a commodity
which possesses either substitutes or complements. If accurate
measures of cross elasticity are available, a firm can forecast the
demand for its product and it can adopt necessary safeguards against
fluctuating prices of substitutes and complements. The pricing and
marketing strategy of a firm would depend on the extent of cross
elasticity between different alternative goods.
2. Helps at the industry level – Knowledge of cross elasticity would help
the industry to know whether an industry has any substitutes or
complements in the market. This helps in formulating various alternative
business strategies to promote different items in the market.
Advertising or promotional elasticity of demand
Most of the firms, in the present marketing conditions, spend considerable
amounts of money on advertisement and other such sales promotional
activities with the object of promoting its sales. Advertising elasticity refers to
the responsiveness of demand or sales to change in advertising or other
promotional expenses. The formula to calculate the advertising elasticity is
as follows:

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Percentage change in demand or sales


Ea =
Percentage change in Advertisem ent exp enditure

Symbolically,
D or Sales A 40,000 800
Ea =    2.67
A Demand or sales 1200 10,000

Original sales = 10,000 units Original advertisement expenditure = 800-00


New sales = 50,000 units New advertisement expenditure = 2000-00
In the above example, advertising elasticity of demand is 1.67. It implies that
for every one time increase in advertising expenditure, the sales would go
up 1.67 times. Thus, Ea is more than one.
Practical application of advertising elasticity of demand
The study of advertising elasticity of demand is of paramount importance to
a firm in recent years because of fierce competition. Few examples on the
practical application of advertising elasticity of demand are as follows:
1. Helps in determining the level of prices – The level of prices fixed by
one firm for its product would depend on the amount of advertisement
expenditure incurred by it in the market.
2. Helps in formulating appropriate sales promotional strategy – The
volume of advertisement expenditure also throw light on the sales
promotional strategies adopted by a firm to increase its total sales in the
market. Thus, it helps a firm to stimulate its total sales in the market.
3. Helps in manipulating the sales – It is useful in determining the
optimum level of sales in the market. This is because the sales made by
one firm would also depend on the total amount of money spent on
sales promotion of other firms in the market.
Substitution elasticity of demand
Substitution elasticity demand measures the effects of the substitution of
one commodity for another. It may be defined as the percentage change in
the demand ratios of two substitute goods X and Y to the percentage
change in the price ratio of two goods X and Y. The following formula is
used to measure substitution elasticity of demand.

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Percentage change in the ratio of 2 goods X and Y


Es 
Percentage change in the price ratio of 2 goods X and Y

  Dx / Dy    Px / Py 
Symbolically Es = 
 Dx / Dy  Px / Py

Where, Dx / Dy is ratio of quantity demanded of two goods X & Y.


Delta DX / Dy is the change in the quantity ratio of two goods X & Y.
PX / Py is the price ratio of two goods X & Y.
Delta PX / PY is change in price ratio of two goods X & Y.
The coefficient of substitution elasticity is equal to one when the percentage
change in demand ratio’s of two goods X and Y are exactly equal to the
percentage change in price ratios of two goods X and Y. It is greater than
one when the changes in the demand ratios of X and Y is more than
proportionate to change in their price ratios.

Practical application of substitution elasticity of demand


The concept of substitution elasticity is of great importance to a firm in the
context of availability of various kinds of substitutes for one factor inputs to
another. For example, let us assume one computer can do the job of 10
labourers and if the cost of computer becomes cheaper than employing
workers, in that case, a firm would certainly go for substituting workers for
computers. An employer would always compare the cost of different
alternative inputs and employ those inputs which are much cheaper than
others to cut down his cost of operations. Thus, the concept of substitution
elasticity of demand has great theoretical as well as practical application in
economic theory.

Activity:
From a local grocery shop find out the price changes during the last two
months on a set of ten products of common consumption and enquire
about the changes in quantity demanded for the products. On this basis,
find out the elasticity of demand.
Hint: Use the theoretical concept and apply the same in the given
scenario

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Self Assessment Questions


Fill in the blanks:
7. Law of demand explains the ______________change in demand and
elasticity of demand explains ______ change in demand.
8. According to Marshall, _________ is the degree of responsiveness of
demand to the change in price of that commodity.
9. The relatively elastic demand curve is ______.
10. When the quantity demanded increases with the increase in income,
we say that income elasticity of demand will be ____. When quantity
demanded decreases with increase in income, we say that the income
elasticity of demand is ____.
11. _______ helps the manager to decide the advertisement expense.
12. Point method helps to measure _________ quantity of change in
demand and arc methods helps to measure ____ changes in demand.
True or False
vi) A good faces inelastic demand if the quantity demanded increases
significantly when the price decreases slightly.
vii) Goods that have close substitutes have more elastic demand than
goods that do not have close substitutes
viii) The demand curve is vertical and elasticity is 0 when demand is
perfectly inelastic.
ix) Cross-price elasticity can be used to determine if goods are inferior or
normal goods.
x) The elasticity of a linear, downward-sloping demand curve is constant
while its slope is not constant.

2.4 Summary
Let us recapitulate the important concepts discussed in this unit:
 Demand is created by consumers. Consumers can create demand only
when they have adequate purchasing power and willingness to buy
different goods and services. There is a direct relationship between
utility and demand. Law of demand tells us that there is an inverse
relationship between price and demand in general. Sometimes,
customers buy more in spite of rise in the prices of some commodities.

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Thus, the law of demand has certain exceptions. Demand for a product
not only depends on price but also on a number of other factors. In
order to know the quantitative changes in both price and demand, one
has to study elasticity of demand.
 Price elasticity of demand indicates the percentage changes in demand
as a consequence of changes in prices. The response of demand to
price changes is different. Hence, we have elastic and inelastic demand.
One can exactly measure the extent of price elasticity of demand with
the help of different methods like point and arc methods. Income
elasticity measures the quantum of changes in demand in response to
changes in income of the customers.
 Cross elasticity tells us the extent of change in the price of one
commodity and corresponding changes in the demand for another
related commodity. Substitution elasticity measures the amount of
changes in demand ratio of two substitute goods to changes in price
ratio of two substitute goods in the market. The concept of elasticity of
demand has great theoretical and practical application in all aspects of
business life.

2.5 Glossary
Demand: It is the total or given quantity of a commodity or a service that is
purchased by the consumer in the market at a particular price and at a
particular time.
Demand curve: A locus of points showing various alternative price-quantity
combinations.
Demand function: A comprehensive formulation which specifies the factors
that influence the demand for a product.
Elasticity of demand: Responsiveness or sensitiveness of demand to a
given change in the price or non-price determinant of a commodity.
Law of Demand: Keeping other factors that affect demand constant, a fall
in price of a product leads to increase in quantity demanded and a rise in
price leads to decrease in quantity demanded for the product.

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Necessaries: Items which are purchased by consumers whatever may be


the price.
Speculation: Purchase or sale of an asset with the hope that its price may
rise or fall and make speculative profit.
Veblen’s effect: Demand for status symbol goods would go up with a rise in
price and vice-versa.

2.6 Terminal Questions


1. State and explain the law of demand.
2. Discuss the various exceptions to law of demand.
3. Explain the concepts of shifts in demand.
4. Explain the different degrees of price elasticity with suitable diagrams.
5. Discuss the determinants of price elasticity of demand.

2.7 Answers

Self Assessment Questions


1. Inversely
2. Same / upward
3. Expansion, contraction
4. Qualitative
5. Comprehensive / wider
6. Fall
7. Direction percentage
8. Price Elasticity of Demand
9. Flatter
10. Positive; negative
11. Advertisement Elasticity of Demand
12. Small, large
True or False
i) False
ii) True
iii) True

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iv) False
v) False
vi) False
vii) True
viii) True
ix) False
x) False

Terminal Questions
1. The term demand refers to total or given quantity of a commodity or a
service that is purchased by the consumer in the market at a particular
price and at a particular time. Refer to Section 2.2.
2. Exceptions to law of demand states that with a fall in price, demand also
falls and with a rise in price demand also rises. Refer to Section 2.2 for
more details.
3. If demand increases, there would be forward shift in the demand curve
to the right and if demand decreases, then there would be backward
shift in the demand cure. Refer to Section 2.2.
4. Elasticity of demand shows the reaction of one variable with respect to a
change in other variables on which it is dependent. Refer to Section 2.3.
5. The elasticity of demand depends on several factors Refer to
Sections 2.3.

2.9 Case Study – Economics in Action

Maruti Suzuki May See Volume Drop This Fiscal Year


Reuters
NEW DELHI: Maruti Suzuki may see declining sales volume in the
current fiscal year as the country's dominant carmaker suffered heavy
production losses due to a labour strike, while demand for cars remains
weak in Asia's third-largest economy.
"We'll be lucky if we break even with last year," Maruti Suzuki chairman
R.C. Bhargava said in an interview for the Reuters India Investment
Summit.

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Maruti Suzuki, which specialises in small models, sold 1.27 million cars in
the fiscal year that ended in March, with an increase of 25 percent. "So, it
might even be slightly less than last year. There are still four months to
go. Let's see how it goes but I doubt if we'll have any growth this year,"
he said. Bhargava had said in August that he expected Maruti, 54.2
percent-owned by Japan's Suzuki Motor Corp, to post single-digit sales
growth this fiscal year.
He said on Monday he expects the Indian automobile industry to grow 2-
3 percent this fiscal year, compared with the record 30 percent growth it
had clocked a year ago. Slowing economic growth, rising interest rates
and fuel prices, as well as falling stock markets have dampened
sentiment in the Indian auto market.
"While first-time car buyers...have continued to buy cars, the people who
used to replace cars or buy a second or a third car in their family, those
people have deferred buying decisions this year," Bhargava said. He
remained optimistic for a demand revival, but said it was difficult to give a
time frame.
Maruti, which until last year sold nearly every other car in India, faces a
tough competition from the global car makers such as: Hyundai Motor
Co, Ford Motor Co, General Motors Co and Honda Motor Co; and it has
seen its market share slide to just over 40 percent.
Bhargava said it was "a little bit unfair" to calculate this year's market
share as Maruti has been hit by one-off factors such as labour unrest and
inadequate capacity to meet a surge in demand for cars that run on less-
expensive diesel fuel. "Realistically, we would expect to keep around 42-
43 percent of the market," said Bhargava.
Maruti was hit by a labour strike at a key plant in the northern state of
Haryana, where workers wanted to leave their existing union to form one
of their own. The unrest led to a production loss of about 83,000 cars, or
almost half a billion dollars in output, while buyers were made to wait
longer for the cars they ordered.
Bhargava said recent rises in petrol prices have boosted demand for
diesel cars, but Maruti did not have capacity to meet the demand. "We

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have a waiting list of diesel cars and we have surplus capacity of petrol
cars," he said. Maruti is in advanced talks with Italian automaker Fiat SpA
to source diesel engines to boost its production and expects to receive
supplies starting in January, he said.
Europe has traditionally been the biggest export market for Maruti, but
the company is now trying to build the export market beyond the debt
crisis-racked continent, focusing on Southeast Asia, Africa and Latin
America, Bhargava said.
Discussion Questions:
1. How do macroeconomic conditions (such as slowing economic
growth) affect the demand for products such as cars?
2. What are the various segments that contribute to demand for cars?
3. What could be the relationship between petrol cars and diesel cars?
4. How can international economic conditions impact the export markets
for cars?
5. What steps could Maruti Suzuki take to increase its market share?
(Source: The Economic Times, Nov 21, 2011)
Hint: With the help of the theoretical concepts build your views in this
case study.

References:
 Veblen, T. B. (1899), The Theory of the Leisure Class. An Economic
Study of Institutions. London: Macmillan Publishers
 Boulding, Kenneth E. (1966), Economic Analysis, Microeconomics.
Vol. I, 4th Ed. New York: Harper & Row, Publishers.
 Marshall, Alfred. (1920), Principles of Economics., 8th edition.
 Stonier, Alfred William, Douglas, Chalmers Hague, (1980), A Textbook
of Economic Theory, Edition 5, Longman.
E-Reference:
 www.Economictimes.com – retrieved on 21st November 2011

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Unit 3 Demand Forecasting


Structure:
3.1 Introduction
Case Let
Objectives
3.2 Meaning and Features of Demand Forecasting
3.3 Levels of Demand Forecasting
3.4 Criteria for Good Demand Forecasting
3.5 Methods or Techniques of Demand Forecasting
3.6 Survey Methods
3.7 Statistical Methods
3.8 Demand Forecasting for New Products
3.9 Summary
3.10 Glossary
3.11 Terminal Questions
3.12 Answers
3.13 Case Study
Reference/ E-Reference

3.1 Introduction
While our understanding of demand is clear from the previous unit, we need
to go further and see how we can use this understanding. In the previous
unit, we learnt about how demand for a good or service is influenced by
various determinants of demand. We also learnt about measuring the
responsiveness of demand to changes in the determinants of demand.
Business firms are also expected to forecast demand in the short term,
medium term and long term so as to develop suitable business strategies.
An important aspect of demand analysis from the management point of view
is concerned with forecasting demand for products, either existing or new. In
this unit, we will discuss demand forecasting. Demand forecasting refers to
an estimate of most likely future demand for a product, under the given
conditions. Such forecasts are of immense use in making decisions with
regard to production, sales, investment, expansion, employment of
manpower etc., both in the short run as well as in the long run. Forecasts
are made at micro level and macro level. There are different methods of

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forecasts like survey methods and statistical methods which are generally
applied for the existing products. For new products, depending on their
nature, a number of methods like evolutionary approach, substitute
approach, growth curve approach, etc. can be applied.

Case Let
(continued from Unit 2)
After about 2 months, Ramesh used his knowledge of demand theory
and submitted a report on the demand for traverse rods in India. He
found that the demand for traverse rods was influenced by factors such
as consumer income, number of new houses / offices constructed, price
of traverse rods, etc. Impressed with his efforts, his superior asked him to
forecast the demand for traverse rods during the next year, the next three
years and for the next ten years. Ramesh’s superior also informed him
that the forecasts would be tabled in the next meeting of the board of
management during which capital investments during the next few years
were to be decided.

Objectives:
After studying this unit, you should be able to:
 identify the conditions under which the firms develop and use demand
forecasts
 distinguish between survey methods and statistical methods of
forecasting
 identify and apply suitable methods to forecast demand
 explain the approaches for demand forecasting of new products

3.2 Meaning and Features of Demand Forecasting


In this section, we will discuss the meaning and the features of demand
forecasting. Demand forecasting seeks to investigate and measure the
forces that determine sales for existing and new products. Generally
companies plan their business - production or sales in anticipation of future
demand. Hence, forecasting future demand becomes important. The art of
successful business lies in avoiding or minimizing the risks involved as far
as possible and facing the uncertainties in a most befitting manner. Thus,

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demand forecasting refers to an estimation of most likely future demand for


a product, under given conditions.
Important features of demand forecasting
The important features of demand forecasting are as follows:
 It is an informed and well thought out guesswork.
 It is in terms of specific quantities.
 A forecast is made for a specific period of time which would be sufficient
to take a decision and put it into action.
 It is based on historical information and the past data.
Demand forecasting is needed to know whether the demand is subject to
cyclical fluctuations or not, so that the production and inventory policies, etc,
can be suitably formulated.
Demand forecasting is generally associated with forecasting sales. A firm
can make use of the sales forecasts made by the industry as a powerful tool
for formulating sales policy and sales strategy. They can become action
guides to select the course of action which will maximise the firm’s earnings.
To use demand forecasting in an active rather than a passive way,
management must recognise the degree to which sales are a result not only
of external economic environment but also of the action of the company
itself.
Managerial uses of demand forecasting
Demand forecasting refers to an estimate of most likely future demand for a
product, under the given conditions. Such forecasts are of immense
managerial use, both in the short run as well as in the long run.
Now, we will discuss the managerial uses of demand forecasting in the short
run and the long run.
In the short run
Demand forecasts for short periods are made on the assumption that the
company has a given production capacity, and the period is too short to
change the existing production capacity. Generally, it would be one year
period. The impact of demand forecasting in the short run can be
summarised as:
 Production planning – It helps in determining the level of output at
various periods, avoiding under or over production.

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 Helps to formulate right purchase policy – It helps in better material


management of buying inputs and controlling inventory level, which cuts
down costs of operations.
 Helps to frame realistic pricing policy – A rational pricing policy can
be formulated to suit short run and seasonal variations in demand.
 Sales forecasting – It helps the company to set realistic sales targets
for each individual salesman and for the company as a whole.
 Helps in estimating short run financial requirements – It helps the
company to plan the finances required for achieving the production and
sales targets. The company will be able to raise the required finance
well in advance at reasonable rates of interest.
 Reduce the dependence on chances – The firm would be able to plan
its production properly and face the challenges of competition efficiently.
 Helps to evolve a suitable labour policy – Proper sales and
production policies help to determine the exact number of labourers to
be employed in the short run.
In the long run
Long run forecasting of probable demand for a product of a company is
generally for a period of 3 to 5 or 10 years.
 Business planning – It helps to plan expansion of the existing unit or a
new production unit. Capital budgeting of a firm is based on long run
demand forecasting.
 Financial planning – It helps to plan long run financial requirements
and investment programmes by floating shares and debentures in the
open market.
 Manpower planning – It helps in preparing long term planning for
imparting training to the existing staff and recruit skilled and efficient
labour force for its long run growth.
 Business control – Effective control over total costs and revenues of a
company helps to determine the value and volume of business. This, in
turn, helps to estimate the total profits of the firm. Thus, it is possible to
regulate business effectively to meet the challenges of the market.

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 Determination of the growth rate of the firm – A steady and well


conceived demand forecasting determines the speed at which the
company can grow.
 Establishment of stability in the working of the firm – Fluctuations in
production cause ups and downs in business, which retards smooth
functioning of the firm. Demand forecasting reduces production
uncertainties and helps in stabilising the activities of the firm.
 Indicates interdependence of different industries – Demand
forecasts of particular products become the basis for demand forecasts
of other related industries, e.g., demand forecast for cotton textile
industry, supply information to the most likely demand for textile
machinery, colour, dye-stuff industry, etc.
 More useful in case of developed nations – It is of great use in
industrially advanced countries where demand conditions fluctuate much
more than supply conditions.
The above analysis clearly indicates the significance of demand forecasting
in the modern business setup.

3.3 Levels of Demand Forecasting


In this section, we will discuss the levels of demand forecasting. Demand
forecasting may be undertaken at three levels, viz., micro level or firm level,
industry level and macro level.
Micro level or firm level
This refers to the demand forecasting by a firm for its product. The
management of a firm is really interested in such forecasting. Generally
speaking, demand forecasting refers to the forecasting of demand of a firm.
Industry level
Demand forecasting for the product of an industry as a whole is generally
undertaken by the trade associations and the results are made available to
the members. By using such data and information, a member firm may
determine its market share.
Macro-level
Estimating industry demand for the economy as a whole will be based on
macro-economic variables like national income, national expenditure,
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consumption function, index of industrial production, aggregate demand,


aggregate supply etc. Generally, it is undertaken by national institutes, govt.
agencies, etc. Such forecasts are helpful to the government in determining
the volume of exports and imports, control of prices, etc.
The managerial economist has to take into consideration the estimates of
aggregate demand and also industry demand, while making the demand
forecast for the product of a particular firm.

3.4 Criteria for Good Demand Forecasting


In this section, we will discuss the criteria for good demand forecasting.
Apart from being technically efficient and economically ideal, a good method
of demand forecasting should satisfy few broad economic criteria. They are
as follows:
 Accuracy – Accuracy is the most important criterion of a demand
forecast, even though cent percent accuracy about the future demand
cannot be assured. Generally, it is measured in terms of the past
forecasts on the present sales and by the number of times it is correct.
 Plausibility – The techniques used and the assumptions made should
be intelligible to the management. It is essential for correct interpretation
of the results.
 Simplicity – It should be simple, reasonable and consistent with the
existing knowledge. A simple method is always more comprehensive
than the complicated one.
 Durability – Durability of demand forecast depends on the relationships
of the variables considered and the stability underlying such
relationships, as for instance, the relation between price and demand,
between advertisement and sales, between the level of income and the
volume of sales, etc.
 Flexibility – There should be scope for adjustments to meet the
changing conditions. This imparts durability to the technique.
 Availability of data – Immediate availability of required data is of vital
importance to business. It should be made available on an up-to-date
basis. There should be scope for making changes in the demand
relationships, as they occur.

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 Economy – It should involve lesser costs as far as possible. Its costs


must be compared against the benefits of forecasts.
 Quickness – It should be capable of yielding quick and useful results.
This helps the management to take quick and effective decisions.
Thus, an ideal forecasting method should be accurate, plausible, durable,
flexible, make the data available readily, economical and quick in yielding
results.

3.5 Methods or Techniques of Demand Forecasting


In this section, we will discuss the methods and techniques of demand
forecasting. Demand forecasting is a highly complicated process as it deals
with the estimation of future demand. It requires the assistance and opinion
of experts in the field of sales management. While estimating future
demand, one should not give too much of importance to either statistical
information, past data or experience, intelligence and judgment of the
experts. To become more realistic, demand forecasting, should consider the
two aspects in a balanced manner. Application of common-sense is needed
to follow a pragmatic approach in demand forecasting.
Broadly speaking, there are two methods of demand forecasting namely,
survey methods and statistical methods. Figure 3.1 depicts the methods of
demand forecasting.

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METHODS OF DEMAND FORECASTING

SURVEY METHODS STATISTICAL METHODS

1. Consumers interview Method 1. Trend projection method


a) Survey of buyers’ intentions 2. Economic Indicators
through questionnaire
b) Direct Interview Method
i) Complete Enumeration
Method
ii) Sample Survey Method
2. Collective Opinion Method
3. Expert Opinion method
4. End-Use Method

Figure 3.1: Methods of Demand Forecasting

3.6 Survey Methods


In this section, we will discuss the survey methods. Survey methods help us
in obtaining information about the future purchase plans of potential buyers
through collecting the opinions of experts or by interviewing the consumers.
These methods are extensively used in short run and for estimating the
demand for new products. There are different approaches under survey
methods. Let us discuss them in detail.
Consumers’ interview method
Under this method, efforts are made to collect the relevant information
directly from the consumers with regard to their future purchase plans. In
order to gather information from consumers, a number of alternative
techniques are developed from time to time. Among them, the following are
some of the important ones:

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a) Survey of buyer’s intentions or preferences


It is one of the oldest methods of demand forecasting. It is also called
“Opinion surveys”.
Under this method, consumer-buyers are requested to indicate their
preferences and willingness about particular products. They are asked to
reveal their future purchase plans with respect to specific items. They are
expected to give answers to questions like what items they intend to buy,
how much quantity, why, where, when, what quality they expect, how much
money are they planning to spend, etc. Generally, the field survey is
conducted by the marketing research department of the company or by
hiring the services of outside research organizations consisting of learned
and highly qualified professionals.
The heart of a survey is the questionnaire. It is a comprehensive one,
covering almost all questions either directly or indirectly in a most intelligent
manner. It is prepared by an expert body who are specialists in the field of
marketing.
The questionnaire is distributed among the consumer buyers either through
mail or in person by the company. Consumers are requested to furnish all
relevant and correct information.
The next step is to collect the questionnaire from the consumers for the
purpose of evaluation. The material collected is classified, edited and
analysed. If any bias, prejudices, exaggerations, artificial or excess demand
creation, etc., are found at the time of answering, they are eliminated.
The information so collected is consolidated and reviewed by the top
executives with lot of experience. It is examined thoroughly. Inferences are
drawn and conclusions are arrived at. Finally, a report is prepared and
submitted to management for taking final decisions.
The success of the survey method depends on many factors including:
1. The nature of the questions asked
2. The ability of the surveyed
3. The representative of the samples
4. Nature of the product
5. Characteristics of the market

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6. Consumer-buyers’ behaviour, their intentions, attitudes, thoughts,


motives, honesty etc.
7. Techniques of analysis
8. Conclusions drawn, etc
The management should not entirely depend on the results of the survey
reports to project the future demand. Consumer buyers may not express
their honest and real views and they may give only the broad trends in the
market. In order to arrive at right conclusions, field surveys should be
regularly checked and supervised.
This method is simple and useful to the producers who produce goods in
bulk. Here, the burden of forecasting is put on customers.
However, this method is not very useful in estimating the future demand of
the households, as they run in large numbers and do not express their
future demand requirements, freely. It is expensive and difficult. Preparation
of a questionnaire is not an easy task. At best, it can be used for short term
forecasting.
b) Direct interview method
Experience shows that due to varied reasons, many customers do not
respond to questionnaires addressed to them, even if it is simple. Hence, an
alternative method is developed. Under this method, customers are directly
contacted and interviewed. Direct and simple questions are asked to them.
They are requested to answer specifically about their budget, expenditure
plans, particular items to be selected, the quality and quantity of products,
relative price preferences, etc. for a particular period of time. There are two
different methods of direct personal interviews. They are as follows:
i) Complete enumeration method
Under this method, all potential customers are interviewed in a particular city
or a region. The answers elicited are consolidated and carefully studied to
obtain the most probable demand for a product. The management can
safely project the future demand for its products. This method is free from all
types of prejudices. The result mainly depends on the nature of questions
asked and answers received from the customers.
However, this method cannot be used successfully by all sellers in all cases.
This method can be employed to only those products whose customers are

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concentrated in a small region or locality. In case consumers are widely


dispersed, this method may not be physically adopted or prove costly both
in terms of time and money. Hence, this method is highly cumbersome in
nature.
ii) Sample survey method or the consumer panel method
Experience of the experts show that it is impossible to approach all
customers therefore, careful sampling of representative customers is
essential. Hence, another variant of complete enumeration method has
been developed, which is popularly known as sample survey method. Under
this method, different cross sections of customers that make up the bulk of
the market are carefully chosen. Only such consumers, who are selected
from the relevant market through some sampling method, are interviewed or
surveyed. In other words, a group of consumers are chosen and queried
about their preferences in concrete situations. The selection of a few
customers is known as sampling. The selected consumers form a panel.
This method uses either random sampling or the stratified sampling
technique. The method of survey may be direct interview or mailed
questionnaire to the selected consumers. On the basis of the views
expressed by these selected consumers, the most likely demand may be
estimated. The advantage of a panel lies in the fact that the same panel is
continued and a new expensive panel does not have to be formulated, every
time a new product is investigated.
As compared to the complete enumeration method, the sample survey
method is less tedious, less expensive, much simpler and less time
consuming. This method is generally used to estimate short run demand by
government departments and business firms.
Success of this method depends upon the sincere co-operation of the
selected customers. Hence, selection of suitable consumers for the specific
purpose is of great importance.
Even with careful selection of customers and the truthful information about
their buying intention, the results of the survey can only be of limited use. A
sudden change in price, inconsistency in buying intentions of consumers,
number of sensible questions asked and dropouts from the panel for various
reasons put a serious limitation on the practical usefulness of the panel
method.

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c) Collective opinion method or opinion survey method


This is a variant of the survey method. This method is also known as “Sales-
force polling” or “Opinion poll method”. Under this method, sales
representatives, professional experts, the market consultants and others are
asked to express their considered opinions about the volume of sales
expected in the future. The logic and reasoning behind the method is that
these salesmen and other people connected with the sales department are
directly involved in the marketing and selling of the products in different
regions. Salesmen, being very close to the customers, will be in a position to
know and feel the customers’ reactions towards the product. They can study
the pulse of the people and identify the specific views of the customers.
These people are quite capable of estimating the likely demand for the
products with the help of their intimate and friendly contact with the
customers and their personal judgments based on the past experience.
Thus, they provide approximate, if not accurate estimates. Then, the views
of all salesmen are aggregated to get the overall probable demand for a
product.
Further, the opinions or estimates collected from the various experts are
considered, consolidated and reviewed by the top executives to eliminate
the bias, optimism or pessimism of different salesmen. These revised
estimates are further examined in the light of factors like proposed change
in selling prices, product designs, advertisement programs, expected
changes in the degree of competition, income distribution, population, etc.
The final sales forecast would emerge after these factors have been taken
into account. This method heavily depends on the collective wisdom of
salesmen, departmental heads and the top executives.
It is simple, less expensive and useful for short run forecasting, particularly
in case of new products.
The main drawback is that it is subjective and depends on the intelligence
and awareness of the salesmen. It cannot be relied upon for long term
business planning.
d) Delphi method or experts opinion method
This method was originally developed at Rand Corporation in the late 1940’s
by Olaf Helmer, Dalkey and Gordon. This method was used to predict future

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technological changes. It has proved more useful and popular in forecasting


non-economic rather than economic variables.
It is a variant of opinion poll and survey method of demand forecasting.
Under this method, outside experts are appointed. They are supplied with all
kinds of information and statistical data. The management requests the
experts to express their considered opinions and views about the expected
future sales of the company. Their views are generally regarded as most
objective ones. Their views generally avoid or reduce the “Halo – Effects”
and “Ego – Involvement” of the views of the others. Since experts’ opinions
are more valuable, a firm gives lot of importance to them and prepares their
future plan on the basis of the forecasts made by the experts.
e) End use or input – output method
Under this method, the sale of the product under consideration is projected
on the basis of demand surveys of the industries using the given product as
an intermediate product. The demand for the final product is the end-user
demand of the intermediate product used in the production of the final
product. An intermediate product may have many end-users, for e.g., steel
can be used for making various types of agricultural and industrial
machinery, for construction, for transportation, etc. It may have demand
both in the domestic market as well as the international market. Thus, end–
use demand estimation of an intermediate product may involve many final
goods’ industries using this product, at home and in abroad. After we know
the demand for final consumption of goods including their exports, we can
estimate the demand for the product which is used as intermediate goods in
the production of these final goods with the help of input–output coefficients.
The input–output table containing input–output coefficients for particular
periods is made available in every country either by the Government or by
research organizations.
This method is used to forecast the demand for intermediate products, only.
It is quite useful for industries which are large producers’ of goods, like
aluminium, steel, etc.
The main limitation of the method is that as the number of end-users of a
product increase, it becomes more inconvenient to use this method.

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3.7 Statistical Methods


In this section, we will discuss the statistical method. It is the second most
popular method of demand forecasting. It is the best available technique
and most commonly used method in recent years. Under this method,
statistical, mathematical models, equations, etc. are extensively used in
order to estimate future demand of a particular product. They are used for
estimating long term demand. They are highly complex and complicated in
nature. Some of them require considerable mathematical background and
competence.
They use historical data in estimating future demand. The analysis of the
past demand serves as the basis for present trends and both of them
become the basis for calculating the future demand of a commodity under
consideration, after taking into account the changes that are likely to occur
in future.
There are several statistical methods and their application should be done
by someone who is reasonably well versed in the methods of statistical
analysis and in the interpretation of the results of such analysis.
Trend projection method
An old firm operating in the market for a long period will have the
accumulated previous data on either production or sales pertaining to
different years. If we arrange them in chronological order, we get ‘time
series’. It is an ordered sequence of events over a period of time pertaining
to certain variables. It shows a series of values of a dependent variable e.g.,
sales, as it changes from one point of time to another. In short, a time series
is a set of observations taken at specified time, generally at equal intervals.
It depicts the historical pattern under normal conditions. This method is not
based on any particular theory, which explains the causes for the variables
to change; it merely assumes that whatever forces contributed to the
change in the recent past will continue to have the same effect. On the basis
of time series, it is possible to project the future sales of a company.
In addition, the statistics and information with regards to the sales call for
further analysis. When we represent the time series in the form of a graph,
we get a curve, the sales curve. It shows the trend in sales at different
periods of time. Also, it indicates fluctuations and turning points in demand.
If the turning points are few and their intervals are also widely spread, they
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yield acceptable results. Here, the time series show a persistent tendency to
move in the same direction. Frequency in turning points indicates uncertain
demand conditions and in this case, the trend projection breaks down.
The major task of a firm while estimating the future demand lies in the
prediction of turning points in the business rather than in the projection of
trends. When turning points occur more frequently, the firm has to make
radical changes in its basic policy with respect to future demand. It is for this
reason that the experts give importance to identification of turning points
while projecting the future demand for a product.
The heart of this method lies in the use of time series. Changes in time
series arise on account of the following reasons:
1. Secular or long run movements – Secular movements indicate the
general conditions and direction in which graph of a time series move in
relatively a long period of time.
2. Seasonal movements – Time series also undergo changes during
seasonal sales of a company. During festival season, sales clearance
season, etc., we come across most unexpected changes.
3. Cyclical Movements – It implies change in time series or fluctuations in
the demand for a product during different phases of a business cycle like
depression, revival, boom, etc.
4. Random movements – When changes take place at random, we call
them irregular or random movements. These movements imply sporadic
changes in time series occurring due to unforeseen events such as
floods, strikes, elections, earth quakes, droughts and similar natural
calamities. Such changes take place only in the short run. Still, they
have their own impact on the sales of a company.
An important question in this connection is how to ascertain the trend in time
series? A statistician, in order to find out the pattern of change in time
series, may make use of the following methods.
1. The least squares method
2. The free hand method
3. The moving average method
4. The method of semi-averages

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The method of least squares is more scientific, popular and thus, more
commonly used when compared to the other methods. It uses the straight
line equation Y= a + bx, to fit the trend to the data.
Illustration
Under this method, the past data of the company is taken into account to
assess the nature of present demand. On the basis of this information,
future demand is projected. For example, a businessman collects the data
pertaining to his sales over the last 5 years. The statistics regarding the past
sales of the company is given below.
The table 3.1 indicates that the sales fluctuate over a period of 5 years.
However, there is an uptrend in the business. The same can be represented
in a diagram.
Diagrammatic representation
Table 3.1 shows the sales fluctuation over 5 years and figure 3.2 depicts the
sales curve based on that fluctuation.

a) Deriving sales Curve

Table 3.1: Sales


Fluctuation
50
Year Sales 45 Sales curve
(Rs.) Sales 40
1990 30 35
1991 40 30
1992 35
0 X
90 91 92 93 94
1993 50
Years
1994 45
Figure 3.2: Sales Curve

We can find out the trend values for each of the 5 years and also for the
subsequent years making use of a statistical equation, the method of least
squares. In a time series, x denotes time and y denotes variable. With the
passage of time, we need to find out the value of the variable.

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To calculate the trend values i.e., Yc, the regression equation used is –
Yc = a+ bx.
As the values of ‘a’ and ‘b’ are unknown, we can solve the following two
normal equations, simultaneously.
i) Y = Na + bx
ii) XY = ax + bx2
Where,
Y = Total of the original value of sales (y)
N = Number of years,
X = Total of the deviations of the years taken from a central period.
XY = Total of the products of the deviations of years and
corresponding sales (y)
X = total of the squared deviations of X values.
2

When the total values of X. i.e., X = 0


Table 3.2 gives the values of x and y over a period of five years, in order to
compute the trend value, Yc.
Table 3.2: Trend Values Computation

Deviation Square of Product sales Computed


Sales in
from Deviation and time
Year = n Lakhs Rs. trend values
assumed
Y X2 Deviation XY Yc
year X
1990 30 -2 +4 -60 32
1991 40 -1 +1 -40 36
1992 35 0 0 0 40
1993 50 +1 +1 +50 44
1994 45 +2 +4 +90 48
N =5  Y=200 X=0 X 2 =10 XY = 40

Regression equation = Yc = a + bx
To find the value of a = Y/N = 200/5 = 40
To find out the value of b = XY/ X 2 = 40/10 = 4
For 1990 Y = 40 + (4 x –2)
Y = 40 – 8 = 32

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For 1991 Y = 40 + (4 x –1)


Y = 40 – 4 = 36
For 1992 Y = 40 + (40 x 0)
Y = 40 + 0 = 40
For 1993 Y = 40 + (4  1)
Y = 40 + 4 = 44
For 1994 Y = 40 + (4  2)
Y = 40 + 8 = 48
For the next two years, the estimated sales would be:
For 1995 Y = 40 + (4  3)
Y = 40 + 12 = 52
For 1996 Y = 40 + (4  4)
Y = 40 + 16 = 56
Finding trend values when even years are given
Table 3.3 gives the values of x and y over a period of four (even) years, in
order to compute the trend value, Yc.
Table 3.3: Computation of Trend Values over Even No. of Years

Deviation
Sales in Square of Product sales Computed
From
Year = N Rs. Lakhs = Deviation = and time trend
Assumed 2
Y X deviation = XY values Y c
year = X
1990 55 -3 9 -165 44

1991 25 -1 1 -25 48

1992 65 +1 1 +65 52

1993 55 +3 9 +165 56

N=4 Y=200 X=0 X2=20 XY=40

Note:
When even years are given, the base year would be in between the two
middle years. In this example, in between the two middle years is 1991.5
(one year = 1 where as 6 months = .5).
For the purpose of simple calculation, we assume the value for each.6
months i.e. 0.5 = 1

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To find out the value of a = 200/4 = 50


To find out the value of b = 40/20 = 2
a=50, b=2.
Calculation for each year
Finding trend values:
1991.5 = Base Year For 1990 Y = 50 + 2  – 3
Y = 50 – 6 = 44
90 = –3
90.5 = –2 For 1991 Y = 50 + 2  –1
91 = –1 Y = 50 – 2 = 48
91.5 = 0
92 = +1 For 1992 Y = 50 + 2  1
92.5 = +2 Y = 50 + 2 = 52
93 = +3
For 1993 Y = 50 + 2  3
Y = 50 + 6 = 56
Deriving trend line:
Figure 3.3 depicts the trend projection for estimating future demand.
X
Trend Line

Sales curve
Sales

0 90 91 Y
92 93 94
Years

Figure 3.3: Trend Projection

Trend projection method requires simple working knowledge of statistics,


which is quite inexpensive and yields fairly reliable estimates of future
course of demand.

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While estimating future demand, we assume that the past rate of change in
the dependent variable will continue to remain the same in future as well.
Hence, the method yields result only for that period where we assume there
are no changes. It does not explain the vital upturns and downturns in sales,
thus, it is not very useful in formulating business policies.
Economic indicators
Economic indicators as a method of demand forecasting are developed
recently. Under this method, a few economic indicators become the basis
for forecasting the sales of a company. An economic indicator indicates
change in the magnitude of an economic variable. It gives the signal about
the direction of change in an economic variable. This helps in the decision
making process of a company. We can mention a few economic indicators
in this context, as follows:
1. Construction contracts sanctioned for demand towards building
materials like cement.
2. Personal income towards demand for consumer goods.
3. Agriculture income towards the demand for agricultural inputs,
instruments, fertilizers, manure, etc.
4. Automobile registration towards demand for car spare-parts, petrol etc.
5. Personal income, consumer price index, money supply, etc., towards
demand for consumption goods.
The above mentioned and other types of economic indicators are published
by specialist organizations like the Central Statistical Office. The analyst
should establish relationship between the sales of the product and the
economic indicators to project the correct sales and to measure the extent
to which these indicators affect sales. The job of establishing relationship is
a highly difficult task, particularly in case of new products where there are no
past records.
Under this method, demand forecasting involves the following steps:
a. The forecaster has to ensure whether a relationship exists between the
demand for a product and certain specified economic indicators.
b. The forecaster has to establish the relationship through the method of
least square and derive the regression equation. Assuming the
relationship to be linear, the equation will be y = a + bx.

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c. After the regression equation is obtained by forecasting the value of x,


economic indicator can be applied to forecast the values of Y,
i.e., demand.
d. Past relationship between different factors may not be repeated.
Therefore, the value judgment is required to forecast the value of future
demand. In addition to it, many other new factors may also have to be
taken into consideration.
When economic indicators are used to forecast the demand, a firm should
know whether the forecasting is undertaken for a short period or long period.
It should collect adequate and appropriate data and select the ideal method
of demand forecasting. The next stage is to determine the most likely
relationship between the dependent variables and finally interpret the results
of the forecasting.
However, it is difficult to find out an appropriate economic indicator. This
method is not useful in forecasting demand for new products.

3.8 Demand Forecasting for New Products


In this section, we will discuss the demand forecasting for new products.
Demand forecasting for new products means the demand forecasting for a
different kind of product, which is totally different established products.
There is no past data or past experience available for any of the firms. An
intensive study of the economic and competitive characteristics of the
product should be made to make efficient forecasts.
Professor Joel Dean, however, has suggested a few guidelines for
forecasting the demand of new products, as follows:
a) Evolutionary approach – The demand for the new product may be
considered as an outgrowth of an existing product. For e.g., demand for new
Tata Indica, which is a modified version of old Indica can most effectively be
projected based on the sales of the old Indica, the demand for new Pulsar
can be forecasted based on the sales of the old Pulsar. Thus, when a new
product is evolved from the old product, the demand conditions of the old
product can be taken as a basis for forecasting the demand for the new
product.

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b) Substitute approach – If the new product developed serves as a


substitute for the existing product, the demand for the new product may be
worked out on the basis of ‘market share’. The growths of demand for all the
products have to be worked out on the basis of intelligent forecasts for
independent variables that influence the demand for the substitutes. After
that, a portion of the market can be sliced out for the new product, for e.g., a
moped as a substitute for a scooter, a cell phone as a substitute for a
landline. In some cases, price plays an important role in shaping future
demand for the product.
c) Opinion poll approach – Under this approach, the potential buyers are
directly contacted, or through the use of samples of the new product, their
responses are found out. Finally, these are extrapolated to forecast the
demand for the new product.
d) Sales experience approach – Offer the new product for sale in a sample
market; say supermarkets or big bazaars in big cities, which are also big
marketing centres. The product may be offered for sale through one super
market and the estimate of sales obtained may be extrapolated to arrive at
estimated demand for the product.
e) Growth curve approach – According to this, the rate of growth and the
ultimate level of demand for the new product are estimated on the basis of
the pattern of growth of established products. For e.g., an Automobile Co.,
while introducing a new version of a car will study the level of demand for
the existing car.
f) Vicarious approach – A firm will survey consumers’ reactions to a new
product indirectly by getting in touch with some specialised and informed
dealers who have good knowledge about the market, about the different
varieties of the product already available in the market, the consumers’
preferences, etc. This helps in making a more efficient estimation of future
demand.
These methods are not mutually exclusive. The management can use a
combination of several of them, supplement and cross check each other.

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Activity:
The construction industry registers the changes in the demand for various
products required in the industry more visibly. Identify changes in demand
for housing and trace the changes in demand for steel, cement, etc.
during the same period.

Self Assessment Questions


Fill in the blanks:
1. Demand forecasting refers to an estimate of __________________ for
the product under given condition.
2. The heart of the survey method is ___________________.
3. Collective opinion method is also known as ___________________.
4. Sample survey method of Demand forecasting is also called _________.
5. An economic indicator indicates changes in the magnitude of an
____________.
6. On the basis of___________________ it is possible of project future
sales of a company.
True or False
i. It is difficult to forecast the precise demand for a product in the medium
term or long term.
ii. As forecasts are not precise, management should not consider them in
decision making.
iii. Respondents to a survey may be biased in their responses and this
issue should be considered while designing a survey.
iv. The complete enumeration method is inexpensive and easy to
implement.
v. Time series methods assume that the conditions that influenced
demand in the previous time periods would continue to influence future
demand in the same manner.

3.9 Summary
Let us recapitulate the important concepts discussed in this unit:
 An important aspect of demand analysis from the management point of
view is forecasting demand, either for existing products or for new
products.
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 Demand forecasting refers to the estimation of future demand under


given conditions. Such forecasts have immense managerial uses in the
short run like production planning, formulating right purchase policy,
pricing policy, sales forecasting, estimating short run financial
requirements, reducing the dependence on chances, evolving suitable
labour policy, control on stocks, etc.
 In the long run they help in efficient business planning, financial
planning, regulating business efficiently, determination of growth rate of
firm, stabilizing the activities of the firm and help in the growth of
industries dependent on each other providing required information
particularly in the developed nations.
 Demand forecasts are done at micro level, industry level and macro
level. A good demand forecasting method must be accurate, plausible,
economical, durable, flexible, simple, quick yielding and it must permit
changes in the demand relationships on an up-to-date basis.
 Broadly speaking there are two methods of demand forecasting: survey
methods and statistical methods. Under the survey methods there are a
number of variants like consumers’ interview method, collective opinion
method, experts’ opinion method and end-use method. Under the
consumers’ interview method, demand forecasting is done either by
conducting a survey of buyers’ intentions through questionnaire or by
directly interviewing all the consumers residing in a region or by forming
a panel of consumers.
 Under the collective opinion method forecasts are made on the basis of
the information gathered from the sales men and market experts
regarding the future demand for the product. Under the Expert opinion
method, assistance of outside experts is taken to forecast future
demand. The end use method is adopted to forecast the demand for the
intermediate products making use of the input-output coefficients for
particular periods.
 Statistical methods like trend projection and economic indicators are
generally used to make long run demand forecasts. Under the trend
projection method, based on the past data, by adopting a regression
analysis, the demand forecasts are made. Sometimes, changes in the

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magnitude of the economic variables too serve as a basis for demand


forecasting. A rise in the personal income indicates a rise in the demand
for consumption goods.
 In case of new products as the firm will not have any past experience or
past sales data, it will have to follow a few guidelines while making
demand forecasts. Depending upon the nature of the development of
the product different approaches like evolutionary approach, substitute,
growth-curve, opinion poll, sales-experience, vicarious etc., are adopted.
Thus, a number of methods are being adopted to estimate the future
demand for the products, which is of very great importance in the efficient
management of the business.

3.10 Glossary
Vicarious approach – It is a survey done to know the customers Reactions
to the new products indirectly.

3.11 Terminal Questions


1. What is Demand Forecasting?
2. Explain in brief various methods of forecasting demand.
3. Explain trend projection method of demand forecasting with illustration.
4. Explain the guidelines for demand forecasting for a new product.

3.12 Answers

Self Assessment Questions


1. Most likely future demand
2. Questionnaire
3. Sales-force polling
4. Consumer panel
5. Economic variable
6. Time series
True or False
i. True
ii. False
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iii. True
iv. False
v. True

Terminal Questions

1. Demand forecasting seeks to investigate and measure the forces that


determine sales for existing and new products. Refer to section 3.2.
2. Broadly speaking, there are two methods of demand forecasting namely,
survey methods and statistical methods. Refer to section 3.5.
3. Trend projection or time series method is a set of observations taken at
specified time, generally at equal intervals. It depicts the historical
pattern under normal conditions. Refer section 3.7.
4. Some of the guidelines for forecasting the demand of new products-
Evolutionary approach, Substitute approach, Opinion poll approach,
Sales experience approach etc. Refer to section 3.8.

3.13 Case Study – Economics in Action

India steel demand, output to surge by 2020: JSW Reuters


MILAN: Indian steel consumption is seen rising to about 130 million
tonnes in 2020 from about 67 million tonnes this year, as growing
incomes and urbanisation drive demand, a senior executive at India's
leading steel producer JSW Steel Ltd said on Thursday.
India's steel output is expected to rise to more than 150 million tonnes in
2020 from close to 70 million tonnes this year and about 80 million
tonnes in 2012, JSW Steel senior vice president in charge of sales,
Sharad Mahendra, told at a steel conference organised by Metal Bulletin.
JSW Steel has cut its 2020 steel consumption forecast from an earlier
expectation of an about 200 million tonnes, in line with the government
forecast reduction, due to delays in some projects to boost production
capacity, Mahendra told Reuters on the sidelines of the conference.
JSW Steel total annual production capacity is expected to rise to 35.3
million tonnes in 2020 from 14.3 million tonnes this year, thanks to the
new green field projects in India, he said.

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India's total production of coated and galvanised steel, which is used in


environments requiring corrosion resistance, is expected to rise to more
than 6 million tonnes in 2013 from 4.7 million tonnes this year, Mahendra
said. India's current coated steel production capacity stands at 6.2 million
tonnes, he said. The construction sector, which accounts for about 50 per
cent of galvanised steel consumption, will be the main demand-growth
driver, with demand from white goods and automobile industries rising
too, he said.
Discussion Questions:
1. If you owned a steel production unit that is currently producing
2 million tonnes per annum, how would you use the above forecasts?
2. What are the factors that would affect the demand for steel in future?
3. If you were a producer of coated and galvanised steel, which sectors
would be your main sources of demand?
(Source: The Economic Times, 15th Sept 2011)
Hint: With the help of the theoretical concepts build your views in this
case study

References:
 Gordon, T. J., (1994), The Delphi method, Washington, DC: American
Council for the United Nations University.
 Joel Dean, (1951), Managerial Economics, pp. vii, Englewood Cliffs, NJ:
Prentice Hall.

E-Reference:
 www.Economictimes.com – retrieved on 15th September 2011

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Unit 4 Supply and Market Equilibrium


Structure:
4.1 Introduction
Case Let
Objectives
4.2 Meaning of Supply and Law of Supply
4.3 Exceptions to the Law of Supply
4.4 Changes or Shifts in Supply
4.5 Elasticity of Supply
4.6 Factors Determining Elasticity of Supply
4.7 Practical Importance of Elasticity of Supply
4.8 Market Equilibrium and Changes in Market Equilibrium
4.9 Consumer Surplus and Producer Surplus
4.10 Summary
4.11 Glossary
4.12 Terminal Questions
4.13 Answers
4.14 Case Study
Reference/E-Reference

4.1 Introduction
In the previous two units, we obtained an understanding of demand, the
factors that influence demand (demand determinants) and the
responsiveness of demand to changes in its determinants and, the
techniques to forecast demand. Demand for goods and/or services would be
met by supply by business firms. In this unit, we will study supply and
market equilibrium.
Now, we shall understand supply and its interaction with demand in
achieving market equilibrium. The supply analysis is related to the behaviour
of producers or manufacturers. Supply of a product basically depends on
cost of production and the management decision. Hence, it covers such
problems like where to sell, when to sell, to whom to sell, how much to sell,
at what price to sell, etc.
Demand and supply are two important concepts in economics, the
knowledge of which is very essential to a manufacturing firm for taking

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numerous decisions almost every day. These two concepts link the market
behaviour of consumers, producers and sellers with that of price.

Case Let (Continued from Unit 3)


In the previous unit, we saw that Ramesh was asked to prepare forecasts
of demand for traverse rods. After studying demand patterns of traverse
rods by collecting and analysing primary and secondary data, Ramesh
presented his forecasts of demand for traverse rods for the next year,
next three years and the next ten years. His forecasts were placed in the
meeting of the board of management of his company. Returning from the
meeting, Ramesh’s superior called Ramesh and told him that the board
had broadly accepted the forecasts made by Ramesh. Ramesh’s
superior then continued to say that the board was now interested in
knowing about the supply of traverse rods in the market. Ramesh was
asked to present a report on how the various companies supplied
traverse rods and the factors that influenced the supply of traverse rods.
The board was also interested in knowing about the interaction between
demand, supply and market price of specific types of traverse rods.
Ramesh thought that this assignment was quite challenging.

Objectives:
After studying this unit, you should be able to:
 describe the concept of supply and its determinants
 interpret how demand and supply determine the market equilibrium
 compare the different stages of market equilibrium
 apply the knowledge of equilibrium in understanding pricing in the real
world

4.2 Meaning of Supply and Law of Supply


In this section, we will discuss the meaning and supply and law of supply.
Supply is one of the two forces that determine the price of a commodity in
the market. Supply means the amount offered for sale at a given price.
According to Thomas, “The supply of goods is the quantity offered for sale in
a given market at a given time at various prices”. According to Prof.
McConnell – “supply may be defined as a schedule which shows the various
amounts of a product, which a producer is willing to and able to produce and

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make available for sale in the market at each specific price in a set of
possible prices, during some given period.” Thus, supply of a product refers
to the various amounts which are offered for sale at a particular price during
a given period of time.
Supply can be equal, more, or less than the current production depending
upon the nature of the commodity, price and the requirements of the
producers.
Supply is also different from stock. Stock is the total volume of a commodity
which can be brought into the market for sale at a short notice and supply
means the quantity which is actually brought in the market. For perishable
commodities, like fish and fruits, supply and stock are the same because
they cannot be stored. The commodities which are not perishable can be
held back, if prices are not favourable and released in large quantities when
prices are favourable. In short, stock is potential supply.

Supply function
The law of supply and supply schedule explains only the direct relationship
between price and supply. Mathematically, S = f (P). This relation analyses
the impact of change in price on quantity supplied. Supply of a product also
depends upon many factors apart from change in prices. When we analyse
the influence of these factors on supply, supply schedule will be converted
into a supply function.
Supply function is a comprehensive one as it analyses the causes for
changes in supply in a detailed manner. Mathematically, a supply function
can be represented in the following manner.
Sx = f (Pf, T, Cp, Gp, N………etc.)
Where,
Sx = supply of a given good x
Pf = price of factor input
T = Technology
Cp = cost of production
Gp = Government policy
N = Number of firms, etc

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Determinants of supply
Apart from price, many other factors bring about changes in supply. Among
them, the important factors are:
1. Natural factors – Favourable natural factors like good climatic
conditions and timely, adequate, well distributed rainfall results in
higher production and expansion in supply. On the other hand,
adverse factors like bad weather conditions, earthquakes, pests,
droughts and untimely, ill-distributed, inadequate rainfall, etc., may
cause decline in production and contraction in supply.
2. Change in techniques of production – An improvement in
techniques of production and use of modern, highly sophisticated
machines and equipments will go a long way in raising the output and
expansion in supply. On the contrary, primitive techniques are
responsible for lower output and hence lower supply.
3. Cost of production – Given the market price of a product, if the cost
of production rises due to higher wages, interest and price of inputs,
supply decreases. If the cost of production falls on account of lower
wages, interest and price of inputs, supply rises.
4. Prices of related goods – If prices of related goods fall, the seller of a
given commodity offers more units in the market even though, the
price of his product has not gone up. Opposite will be the case when
the price of related goods rises.
5. Government policy – When the government follows a positive policy,
it encourages production in the private sector. Consequently, supply
expands. For example granting of subsidies, development rebates, tax
concession, etc. On the other hand, output and supply cripples when
the government adopts a negative policy, for example, withdrawal of
all concessions and incentives, imposition of high taxes, introduction of
controls and quota system, etc.
6. Monopoly power – Supply tends to be low, when the market is
controlled by monopolists, or a few sellers as in the case of oligopoly.
Generally, supply would be more under competitive conditions.
7. Number of sellers or firms – Supply would be more when there are a
large number of sellers. Similarly, production and supply tends to be
more when production is organised on large scale basis. If rate or
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speed of production is high, supply expands. Opposite will be the case


when number of sellers is less, with small scale production and low
rate of production.
8. Complementary goods – In case of joint demand, the production and
sale of one product may lead to production and sale of other product
also.
9. Discovery of new source of inputs – Discovery of new sources of
inputs helps the producers to supply more at the same price and vice-
versa.
10. Improvements in transport and communication – This will facilitate
free and quick movements of goods and services from production
centres to marketing centres.
11. Future rise in prices – When sellers anticipate a further rise in price,
current supply tends to fall. Opposite will be the case when the seller
expects a fall in price.
Thus, many factors influence the supply of a product in the market. A firm
should have a thorough knowledge of all these factors, because it helps in
preparing its production plan and sales strategy.

Supply schedule
Supply schedule is a tabular representation of different quantities of a
commodity supplied at varying prices. It represents the functional
relationship between quantity supplied and price. It is strictly prepared with
reference to the price of a given commodity.
The imaginary supply schedule given in table 4.1 shows that as price rises,
supply extends and as price falls, supply contracts. For instance, 0.75 paisa
is the minimum price to be charged per unit, because it equals cost of
production. No producer would like to charge cost price to customers.
Hence, supply is zero at this price. It is called reserve price.

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Table 4.1: Supply Schedule


Price in Rs. Quantity supplied in Units
5-00 500
4-00 400
3-00 300
2-00 200
1-00 100
0-75 00

Market supply schedule


The total quantity of commodity supplied at different prices in a market by
the whole body of sellers is called market supply schedule. It refers to the
aggregate behaviour of the market rather than mere totalling of all individual
supply schedules. It is the horizontal summation of the individual supply
schedule. Table 4.2 shows the market supply schedule.
Table 4.2: Market Supply Schedule
Quantity Supplied in Units
Price in Rs. Total (A+B+C)
A B C
5.00 500 600 700 1800
4.00 400 500 600 1500
3.00 300 400 500 1200
2.00 200 300 400 900
1.00 100 200 300 600

The market supply schedule helps a firm to formulate its sales policy by
manipulating the prices. It helps the management to know how much sales
can be increased by raising the price without losing the demand for the
product.
Supply curve
The supply curve is a geometrical representation of the supply schedule.
The upward sloping curve clearly indicates that as price rises, quantity
supplied expands and vice-versa. Figure 4.1 depicts the supply curve.

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Figure 4.1: Supply Curve

The law of supply


Normally, a seller supplies more units of a commodity at a higher price and
vice-versa. Given the cost of production, profits are likely to be high at
higher prices. Higher the price, the greater is the inducement to the
producers to produce and sell more and appropriate more profits. Hence,
more quantity is supplied at higher prices and less is supplied at lower
prices. This relationship between the price and the quantity supplied is
popularly known as the law of supply. It states that “Other things remaining
constant, the quantity supplied varies directly with the price i.e. when the
price falls, supply will contract and when price rises, supply will extend”.
According to S.E.Thomas, “a rise in price tends to increase supply and a fall
in price tends to reduce it.” There is a functional relationship between supply
and price. Mathematically S = F (P). The law of supply is based on a
number of assumptions.

The other things which should remain constant for the law to operate are as
follows:
1. Number of firms, the scale of production and the speed of production
2. Availability of other inputs
3. Techniques of production
4. Cost of production
5. Market prices of other related goods
6. Climate and weather conditions
Thus, in this section, we have discussed the meaning and the law of supply.

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4.3 Exceptions to the Law of Supply


In this section, we will discuss the exceptions to the law of supply.
Generally, supply expands with the rise in price and contracts with the fall in
price. But under certain exceptional circumstances, in spite of rise in price,
supply may not expand or at a lower price, more quantity may be sold. In
this case, the supply curve slopes backward. Figure 4.2 depicts the change
in supply with respect to changes in price.

Figure 4.2: Supply Curve – Changes in Price

In figure 4.2, when price is Rs. 5.00, 10 units are sold and when price is
Rs. 6.00, 30 units are sold. But, when price rises to Rs. 8.00 quantity
supplied falls from 30 units to 20 units.
Some of the exceptions to the law of supply are as follows:
1. If the seller is badly in need of money, he will sell more even at lower
prices.
2. If the seller wants to get rid of his products, then also he will sell more at
reduced rates.
3. When further heavy fall in price is anticipated, the seller may become
panicky and sell more at a current lower price.
4. In case of auction, the auctioneer is not interested in maximising profits
by selling more units at a higher price. Here, the price is determined by
the bidder while selling an item in an auction, the auctioneer may have
some other motives to sell the product. Thus, an auction sale is an
exception to the law of supply.

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These were some circumstantial examples that are exceptions to the law of
supply.

4.4 Changes or Shifts in Supply


In this section, we will discuss the changes and shifts in supply. When
supply of a product changes only due to a change in the price of that
product alone, it is called as either expansion or contraction in supply.
Expansion in supply means, more quantity is supplied at a higher price and
contraction in supply means, less quantity is supplied at a lower price.
This tendency can be represented through a single supply curve. In this
case, the seller will be moving either in the upward or downward direction
along with the same supply curve. It is clear from figure 4.3, which depicts
the tendency of shifts in supply through a single supply curve.
Y S

PRICE

S
0 x
20 40
QUATITY
Figure 4.3: Single Supply Curve – Shifts in Supply

In figure 4.3, we can notice that when price is Rs. 2.00, 20 units are sold
and when the price rises to Rs. 4.00, 40 units are sold (extension). On the
other hand, when price falls from Rs. 4.00 to Rs. 2.00 quantity supplied also
falls from 40 units to 20 units.
Supply of a product may change due to changes in other factors. If supply
changes not because of changes in price, but because of changes in other
determinants, then, it will be a case of either increase or decrease in supply.

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Increase in supply
It implies more supply at the same price or same quantity of supply at a
lower price. In this case, we have to draw a new supply curve. Figure 4.4
depicts the supply curve with respect to increase in supply. In figure 4.4,
Original price = Rs 6.00;
Original supply = 10 units; Original supply Curve = SS
S
Y
S1

6 P
PI

PRICE
4
S PII
S1
0 x
10 20

QUANTITY

Figure 4.4: Supply Curve – Increase in Supply

Now the seller sells 20 units at the same price of Rs. 6. Hence, we get a
new point P’, or same quantity of 10 units are sold at a lower price of
Rs. 4=00. Hence, we get another new point P”. If we join these two new
points P’ and P” we get a new supply curve S1S1. There is forward shift in
the position of supply curve. Forward shift indicates increase in supply.
Decrease in supply
It implies that less quantity is supplied at the same price or same quantity is
supplied at a higher price. In this case also, we have to draw a new supply
curve. Figure 4.5 depicts the supply curve with respect to decrease in
supply.
In figure 4.5,
Original price = Rs. 4
Original supply = 20 units
Original supply Curve = SS

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Y S1

PII S
6

PRICE PI
4 P
S1
x
S
x
0 10 20

SUPPLY

Figure 4.5: Supply Curve – Decrease in Supply

When lower quantity of 10 units is supplied at the same price of Rs.4.00, we


get a new point P’. Similarly, when same quantity of 20 units is supplied at a
higher price of Rs. 6, we get a new point P”. If we join these new points P’
and P” then we get a new supply curve S1S1, which is located to the left of
the original supply curve. There is backward shift in the position of supply
curve. Backward shift in the curve indicates decrease in supply.

Managerial uses of the law of supply


The law of supply helps a producer to take decisions with respect to the
following points:
1. Identifying the product he has to produce and sell. This point
encapsulates answers for the following queries:
i) What quantity he has to sell.
ii) At what price he has to sell.
iii) When he has to produce.
iv) Where he has to sell.
v) For whom he has to sell, etc.
2. Maintaining a balance between stock and supply.
3. Preparing the sales budget policy.
4. Estimating the present and future expected revenue and profit levels.
5. Analysing the effects of taxes on total sales in the market.
6. Analysing the impact of various govt. policies on the supply of a product.
7. Identifying the factors which affect supply of a product.
Supply function is also described as shifts in supply.

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4.5 Elasticity of Supply


In this section, we will discuss the elasticity of supply. It is a parallel concept
to elasticity of demand. It refers to the sensitiveness or responsiveness of
supply to a given change in price. In short, it measures the degree of
adjustability of supply to a given change in price of a product.
The formula to calculate elasticity of supply is as follows:
% change in Supply 8%
ES  4
% change in Pr ice 2%

It implies that at the present level with every change in price by one unit,
there will be a change in supply by four units. Usually, elasticity of supply is
positive.
Types of elasticity of supply
Just like elasticity of demand, elasticity of supply can be equal to infinity,
zero, greater than one, lower than one and equal to one. Let us discuss the
types of elasticity of supply.
Perfectly elastic supply
Supply is said to be perfectly elastic when a slight change in price leads to
immeasurable changes in supply: Hence supply curve would be a horizontal
or parallel line to X axis. Figure 4.6 depicts a perfectly elastic supply curve,
Y

Price ES = 
S
S

X
0 Supply

Figure 4.6: Perfectly Elastic Supply Curve

Perfectly inelastic supply


When supply of a commodity remains constant and does not change,
whatever may be the change in price, it is said to be absolutely or perfectly
inelastic supply. Here the supply curve tends to be a vertical straight line.
ES = 0 (zero). Figure 4.7 depicts a perfectly inelastic supply curve.

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Y
S

Price

ES = 0

0 S X
Supply
Figure 4.7: Perfectly Inelastic Supply Curve

Relatively elastic supply


If change in the supply is more than proportional to the change in price,
elasticity of supply is greater than one. In that case, the supply curve is
flatter and is more inclined to X axis. Figure 4.8 depicts a relatively elastic
supply curve.

Y S

Price P
2
S% ES > 1

X
0
Supply

Figure 4.8: Relatively Elastic Supply Curve

Relatively inelastic supply


If the change in supply is less than proportional to a given change in price,
then, elasticity of supply is said to be less than one. Here, the supply curve
is a steeply rising one. Figure 4.9 depicts a relatively inelastic supply curve.

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Y
S

Price

P 4% ES < 1
S

0 X
Supply

Figure 4.9: Relatively Inelastic Supply Curve

Unitary elastic supply


If proportionate change in supply is exactly equal and proportional to the
change in price, then elasticity of supply is equal to one. Figure 4.10 depicts
the unitary elastic supply.

Y S

Price P 3
%
ES = 1

S
X
0
Supply

Figure 4.10: Unitary Elastic Supply

4.6 Factors Determining Elasticity of Supply (Determinants of


Elasticity of Supply)
In this section we will discuss the factors determining the elasticity of supply.
The factors determining the elasticity of supply are as follows:

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1. Time period – Time has a greater influence on elasticity of supply


than on demand. Generally, supply tends to be inelastic in the short
run because time available to organise and adjust supply to demand
would be insufficient. Supply would be more elastic in the long run.
2. Availability and mobility of factors of production – When factors of
production are available in plenty and freely mobile from one
occupation to another, supply tends to be elastic and vice-versa.
3. Technological improvements – Modern methods of production
expand output and hence supply tends to be elastic. Old methods
reduce output and supply tends to be inelastic.
4. Cost of production – If cost of production rises rapidly as output
expands, then there will not be much incentive to increase output as
the extra benefit will be choked off by the increase in cost. Hence,
supply tends to be inelastic and vice-versa.
5. Kinds and nature of markets – If the seller is selling his or her
product in different markets, supply tends to be elastic in any one of
the market because, a fall in the price in one market will induce him or
her to sell in another market. Again, if he or she is producing several
types of goods and can switch over easily from one to another, then
each of his or her products will be elastic in supply.
6. Political conditions – Political conditions may disrupt production of a
product. In that case, supply tends to become inelastic.
7. Number of sellers – Supply tends to become more elastic if there are
more sellers freely selling their products and vice-versa.
8. Prices of related goods – A firm can charge a higher price for its
products, if prices of other products are higher and vice-versa.
9. Goals of the firm – If the seller is happy with small output, supply
tends to be inelastic and vice-versa.
Thus, several factors influence the elasticity of supply.

4.7 Practical Importance of Elasticity of Supply


In this section we will discuss the practical importance of elasticity of supply.
The following points highlight the practical importance of elasticity of supply:

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1. The concept of elasticity of supply is of great importance to the finance


minister while formulating the taxation policy of the country. If the
supply is inelastic, the imposition of tax may not bring about any
change in the supply. If supply is elastic, reasonable taxes are to be
levied.
2. The price of a commodity depends upon the degree of elasticity of
demand and supply.
3. It is used in the theory of incidence of taxation. The money burden of
taxation is shared by the tax payers and the sellers in the ratio of
elasticity of supply and demand.
Thus, elasticity of supply has both theoretical as well as practical
applications.

Self Assessment Questions


Fill in the blanks
1. Stock is _______________________.
2. Supply curve generally slopes _________________.
3. ___________ shows the relationship between price and quantity
supplied of a particular product.
4. The supply curve shifts when there is a change in quantity supplied due
to the factors other than _______________.
5. When the supply increase the supply curve shifts to the
____________.
6. Supply tends to be _______________ in short run.
7. Tabular representation of different quantities of commodities supplied
at varying price is called ___________________.
True or False
i) Supply and stock have the same effect on quantity offered for sale.
ii) New technology will change the quantity supplied.
iii) Other things remaining the same, an increase in input costs leads to a
decrease in quantity supplied.
iv) Supply curve depicts the price of the good and quantity produced at
various levels of price.
v) Supply curve slopes downwards to the right.

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4.8 Market Equilibrium and Changes in Market Equilibrium


In this section, we will discuss the market equilibrium and change in market
equilibrium,

Meaning of equilibrium
The word equilibrium is derived from the Latin word “aequilibrium” which
means equal balance. This means that opposite forces and tendencies will
neutralise with each other when in the state of even balance. The position in
rest will be always characterised by absence of change. The economic
plans will be in complete agreement when it is in the state of even balance
at various market participants so that no one has the tendency to revise or
alter decisions. In the words of professor Mehta: “Equilibrium denotes in
economics absence of change in movement.”
Market equilibrium
There are two kinds of approaches in market equilibrium. They are as
follows:
1. Partial equilibrium approach
2. General equilibrium approach
The partial equilibrium approach means the price of a single commodity will
be determined keeping the prices of other commodities constant.
The general equilibrium approach means the price determination of all the
goods and factors will be mutual and simultaneous. Thus, it explains a multi
market equilibrium position.
Even before Marshall, there were some disputes among economists on
whether the force of demand or the force of supply is more important in
determining price. Marshall has given equal importance to both demand and
supply in the determination of value or price. He compared supply and
demand to a pair of scissors – “We might as reasonably dispute whether it
is the upper or the under blade of a pair of scissors that cuts a piece of
paper, as whether value is governed by utility or cost of production.” Thus,
neither the upper blade nor the lower blade taken separately can cut the
paper; both have their importance in the process of cutting. Likewise, neither
supply alone nor demand alone can determine the price of a commodity;
both are equally important in the determination of price. But the relative
importance of the two may vary depending upon the time under

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consideration. Thus, the demand of all consumers and the supply of all firms
together determine the price of a commodity in the market.
Equilibrium between demand and supply price
Equilibrium between demand and supply price is obtained by the interaction
of these two forces. Price is an independent variable. Demand and supply
are dependent variables. They depend on price. Demand varies inversely
with price, a rise in price causes a fall in demand and a fall in price causes a
rise in demand. Thus the demand curve will have a downward slope
indicating the expansion of demand with a fall in price and contraction of
demand with a rise in price. On the other hand, supply varies directly with
the changes in price, a rise in price causes a rise in supply and a fall in price
causes a fall in supply. Thus the supply curve will have an upward slope. At
a point where these two curves intersect with each other, the equilibrium
price is established. At this price, quantity demanded equals the quantity
supplied. This can be explained with the help of a table and a diagram.
Table 4.3 shows the impact of demand and supply on the price of a product.
Figure 4.11 depicts the interdependence between the demand curve and
the supply curve.
Table 4.3: Demand, Supply and Price Change
Price in Demand in Supply in Pressure on
State Of Market
Rs Units Units price
30 5 25 D>S P
25 10 20 D>S P
20 15 15 D=S Neutral
10 20 10 S>D P
5 30 5 S>D P

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D S
Y
S>D
P2 D2 S2
P E  S=D
S1 D1
Price

P1
S D>S
D

O X
Q
Quantity supplied and demanded
Figure 4.11: Inter-dependence of Demand Curve and Supply Curve

In table 4.3, at Rs. 20, the quantity demanded is equal to the quantity
supplied. As this price is agreeable to both the buyers and the sellers, there
will be no tendency for it to change; this is called the equilibrium price.
Suppose the price falls to Rs.5, the buyers will demand 30 units while the
sellers will supply only 5 units. Excess of demand over supply pushes the
price upwards until it reaches the equilibrium position where supply is equal
to demand. On the other hand, if the price rises to Rs. 30 the buyers will
demand only 5 units while the sellers are ready to supply 25 units. Sellers
compete with each other to sell more units of the commodity. Excess of
supply over demand pushes the price downwards until it reaches the
equilibrium. This process will continue till the equilibrium price of Rs. 20 is
reached. Thus the interactions of supply and demand forces acting upon
each other restore the equilibrium position in the market.
In the diagram DD is the demand curve, SS is the supply curve. Demand
and supply are in equilibrium at point E where the two curves intersect each
other. OQ is the equilibrium output. OP is the equilibrium price. Suppose the
price is higher than the equilibrium price, i.e. OP2. At this price, quantity
demanded is P2 D2, while the quantity supplied is P2 S2. Thus D2 S2 is the
excess supply which the sellers want to push off in the market. Competition
among sellers will bring down the price to the equilibrium level where the
supply is just equal to the demand. At price OP1, the buyers will demand
P1D1 quantity while the sellers are prepared to sell P1S1. Demand exceeds
supply. Excess demand for goods pushes up the price; this process will go
on until the equilibrium is reached where supply becomes equal to demand.
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Changes in market equilibrium


The changes in equilibrium price will occur when there will be shift either in
demand curve or in supply curve or in both.

Effects of shift in demand


Demand changes when there is a change in the determinants of demand
like the income, tastes, prices of substitutes and complements, size of the
population, etc. If demand rises due to a change in any one of these
conditions, the demand curve shifts upward to the right. If, on the other
hand, demand falls, the demand curve shifts downward to the left. Such rise
and fall in demand are referred to as increase and decrease in demand.
A change in the market equilibrium caused by the shifts in demand can be
explained with the help of a diagram. Figure 4.12 depicts the effects of shift
in demand on market equilibrium.

D1 S
D
Y
D2
E1
P1 
E
Price

P D1
P2 S  E2 D
0 D2
X
Q2 Q Q1
Demand and Supply
Figure 4.12: Effects of Shift in Demand on Market Equilibrium

Effects of changes in both demand and supply


Changes can occur in both demand and supply conditions. The effects of
such changes on the market equilibrium depend on the rate of change in the
two variables. If the rate of change in demand is matched with the rate of
change in supply, there will be no change in the market equilibrium, the new
equilibrium shows expanded market with increased quantity of both supply
and demand at the same price. This relationship can be made clear from the
following figures. Figure 4.13 depicts market equilibrium because of equal
change in demand and supply.

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D1 S
D S1
Y

Price
E E1
P 

S D1
S1
D
0 X
Q Q1
Demand and Supply

Figure 4.13: Equal Change in Demand and Supply

Similar will be the effects when the decrease in demand is greater than the
decrease in supply on the market equilibrium. Figure 4.13 depicts the effect
on market equilibrium when the decrease in demand is greater than the
decrease in supply.

D
S1
D1 S
Price
P
E  E1
P1 
D
S1
S
D1
0 X
Q Q1
Quantity
Figure 4.14: Decrease in Demand Greater Than Decrease in Supply

4.9 Consumer Surplus and Producer Surplus


In this section, we will discuss the consumer surplus and producer surplus.
In a monetary economy, we measure the utility of a commodity with the help

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of price. The price we pay for a commodity basically depends on its


worthiness and utility. If a product possesses higher utility, then it would
command a higher price and vice-versa. The law of equi-marginal utility
states that the price paid for a commodity should be equal to its marginal
utility. This is one of the basic conditions for consumer’s equilibrium. At the
point of equilibrium, neither there will be higher utility nor lower utility, but
Marginal Utility = Price.
In the real life, a consumer may not act according to the law of equi-
marginal utility, always. The balance between the price and utility may not
be maintained. Sometimes, he may get lower utility from a commodity when
compared to the price he is paying for it [M.U. < price]. In some other
cases, he may get higher utility [M.U. > price].
When the satisfaction obtained by the consumer is much more than the
price he is paying for the commodity, he will be enjoying a surplus. The
excess or surplus satisfaction enjoyed by a consumer over and above the
price he is paying for the product rather than go without it is technically
described as consumer’s surplus in economics. It is essentially found in the
purchase of useful and very cheap articles like salt, postcard, newspaper,
matchbox, and many other such durable and non-durable articles, etc. In all
these cases, we receive more utility than we pay for them.
Consumer’s surplus may be defined as the excess of what a consumer is
willing to pay over what he actually does pay (rather than go without the
good). It is the excess of price which a person would be willing to pay over
which what he actually does pay. Consumer surplus is the economic
measure of the surplus satisfaction.
The concept may be explained with the help of a formula:
Consumers’ surplus = What we are prepared to pay – [minus] What we
actually pay
It is the difference between ex-ante and ex-post satisfaction. Also it is the
difference between the potential price and actual price. Hence, it is the
difference between the value of the total utility that may be derived from the
consumption of a product and the total amount of money spent on that
product.

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It is essential to note that there is an inverse relationship between price and


consumer’s surplus. If price rises, consumer’s surplus falls and vice versa.
It is a product of opportunities and environment. For example, in developed
countries consumers’ surplus is high, because with a little amount of money
the consumers can buy larger quantities of goods and services. On the
contrary, in developing countries, consumers’ surplus is low because with
more amount of money, the consumers can purchase little amount of goods
and services.
The concept of consumer surplus helps in making various types of cost-
benefit analysis of public investments, which determines the amount of
public welfare. The concept is usefully employed in all most all branches of
economic activities.
Producer surplus is a parallel concept to consumer’s surplus. Producer’s
surplus is owner’s surplus. It may be defined as the excess or surplus
income received by a seller on the price at which he is willing to sell a
product. It is the difference between the actual price at which he is selling
and the price at which he is willing to sell. Hence, it arises when the actual
price received exceeds the minimum price that the seller is ready to accept.
Producer’s surplus is equal to the value that the seller is actually receiving
minus the value that the seller is ready to receive. It is the difference
between ex-post and ex-ante income received.
Depending on market situations, producers try to convert consumers’
surplus in to producers’ surplus and consumers would try to convert
producers’ surplus in to consumers’ surplus.

Self Assessment Questions


8. Absence of change in movement in economics is called ___________.
9. The quantity bought and sold at the equilibrium is called ___________.
10. There will be change in ______________ when there is a shift in either
demand curve or supply curve or both.
11. If the price increases there will be ____ in consumer surplus.
12. _____ is used to judge the desirability of public investment of any
public projects or investment.

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State if True or False


vi) With a given supply curve, a decrease in demand leads to a decrease
in equilibrium price and a decrease in equilibrium quantity.
vii) Increase in supply will always lead to a decrease in equilibrium price.
viii) If the actual market price is greater than the equilibrium price, there
would be a downward pressure on price.
ix) Equilibrium price and quantity can be calculated by equating the
demand-price and supply-price functions.
x) Equilibrium price is determined by the Government.

Activity:
From any nearby store, select ten products and identify which
determinants of supply have affected a change in the quantity supplied to
the store during the last couple of months.
Hint : Use the theoretical concept and work on it

4.10 Summary
Let us recapitulate the important concepts discussed in this unit:
 The management of a business firm should have a clear understanding
of the supply and demand conditions in the market to have an effective
control on business.
 Supply refers to the quantity of a commodity offered for sale at a
particular price during a given period of time. Supply is different from
production and stock. Supply schedule is a tabular representation of
different quantities of a commodity supplied at varying prices and the
supply curve is drawn on the basis of supply schedule which shows the
direct relationship that exists between price and supply.
 Thus, the supply curve will have a positive slope. The law of supply
states that ‘other things being constant’, a rise in price causes extension
of supply and a fall in price causes contraction of supply. There are a
few exceptions to this law. There will be a shift or a change in supply
when the determinants of supply like the natural factors, techniques of
production, cost of production, government policy, monopoly power,
prices of related goods, number of sellers, etc., change.

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 In order to regulate production and supply efficiently, management


should have proper knowledge of the concept of elasticity of supply.
Elasticity of supply refers to the responsiveness of supply to a change in
price. It is influenced by a number of factors like the period of time under
consideration, availability and mobility of factors of production,
technological improvements, cost of production, number of sellers,
prices of related goods, etc.
 Modern economics is sometimes called equilibrium analysis. Market is in
equilibrium when there is a balance between supply and demand forces.
The price and output determined by the interaction of supply and
demand forces are called the equilibrium price and the equilibrium
output. There will be a change in the equilibrium price and output when
there is a change in demand or change in supply or change in both
demand and supply.
 Understanding the position of market equilibrium is of very great
importance in the decision making process of the firm.

4.11 Glossary
Consumer surplus: Excess of what a consumer is willing to pay over what
he actually does pay.
Elasticity of demand: Sensitiveness or responsiveness of supply to a given
change in price.
Law of supply: Other things remaining constant, the quantity supplied
varies directly with the price.
Stock: Total volume of a commodity which can be brought into the market
for sale at a short notice.
Supply: Various amounts which are offered for sale at a particular price
during a given period of time.
Supply curve: Geometrical representation of the supply schedule.
Supply schedule: Tabular representation of different quantities of a
commodity supplied at varying prices.

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4.12 Terminal Questions


1. State the law of supply.
2. Explain the determinants of supply.
3. What is elasticity of supply?
4. Explain the factors determining elasticity of supply.
5. Define the term equilibrium.

4.13 Answers

Self Assessment Questions


1. Potential supply
2. Upwards
3. Law of supply
4. Price
5. Right
6. Inelastic
7. Supply schedule
8. Equilibrium
9. Equilibrium quantity
10. Equilibrium Price
11. Decrease
12. Cost Benefit Analysis
True or False
i) False
ii) False
iii) True
iv) False
v) False
vi) True
vii) False
viii) True
ix) True
x) False

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Terminal Questions
1. A rise in price tends to increase supply and a fall in price tends to reduce
it. There is a functional relationship between supply and price.
Mathematically S = F (P). Refer to Section 4.2.
2. There are many determinants that bring about changes in supply.
Among them, the important factors are: natural factors, change in
techniques of production, cost of production, prices of related goods
Refer to Section 4.2.
3. It refers to the sensitiveness or responsiveness of supply to a given
change in price. In short, it measures the degree of adjustability of
supply to a given change in price of a product. Refer to section 4.5.
4. The factors determining the elasticity of supply are as follows: Time
period, Availability and mobility of factors of production, Technological
improvements, Cost of production. Refer to Section 4.6.

4.14 Case Study – Economics in Action

Persistent Food Inflation Warrants Monetary Policy Responses


RBI
PUNE: Deputy Governor of Reserve Bank of India, Subir Gokarn said
that the drivers of food inflation have changed from the pair of sugar and
cereals during the last four decades of the previous century to proteins,
fruits and vegetables during last four years. He also asserted that the
situation of persistent high food inflation warrants monetary policy
responses to keep the overall inflation in check.
Mr. Gokarn said that, "The more worrying attribute of food inflation is
persistence. In the four decades in 1960's, the drivers of food inflation
were cereals and sugar with a supporting role being played by proteins
and fruits and vegetables in the second half of the period". Mr. Gokarn
added "While contribution from proteins has gone down somewhat in
2011-12, which is the basis of the declines we have seen in food inflation
in the most recent date releases, the pressure from fruits and vegetables
have sustained."

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Mr. Gokarn said on the demand side that people eat better as they get
richer is a simple assertion. But on the supply side, we have problems.
The productivity of pulses has oscillated around 600 kg/hectare for the
last decade and a half. "There are several states, in which pulses may
constitute an important part of the typical diet, whose productivity is
significantly below the national average. If overall productivity is to be
improved, a strategy which focuses on the specific bottlenecks in these
states is probably the best way to go about it" he said.
Mr. Gokarn pointed out the rising wages of agricultural labour and the
stocks of agricultural commodities as two important factors exerting
influence on their prices. "Wages rising faster than productivity can only
result in rising prices, if producers cannot substitute other inputs for
labour. There is an important relationship between price dynamics and
stocks. Periods in which stocks have been high show relatively low rates
of price increase," he said.
Lastly, he pointed out the declining trend in the long period average
(LPA) of monsoon rainfall. "This means that normal monsoons are
delivering less water than in the past”. He said that the implication of
persistent supply pressures on the economy are not very good for
maintaining balance between fast growth and low inflation. "While
transitory episodes of food inflation do not warrant a monetary policy
response, there are strong justifications for acting in the face of more
persistent ones, if the objective is to keep overall inflation in check”.
Discussion Questions:
1. What are the factors influencing the demand and supply of foods
such as fruits, vegetables and pulses?
2. What is the nature of impact of lower supply and stocks of food on
food prices?
3. What is the nature of impact of higher wages on food prices?
(Source: Economic Times, December 9, 2011)
Hint: With the help of the theoretical concepts build your views in this
case study.

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References:
 McConnell, Campbell R. (2005), Economics: Principles, Problems, and
Policies, Edition16, McGraw-Hill/Irwin.
E-References:
 www.economictimes – retrieved on- December 9, 2011

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Unit 5 Production Analysis

Structure:
5.1 Introduction
Case Let
Objectives
5.2 Production and Production Function
5.3 Production Function with One Variable Input
5.4 Production Function with Two Variable Inputs
5.5 Returns to Scale
5.6 Economies of Scale
5.7 Economies of Scope
5.8 Summary
5.9 Glossary
5.10 Terminal Questions
5.11 Answers
5.12 Case Study
Reference/E-Reference

5.1 Introduction
In the previous unit, we learnt about how demand and supply interact
leading to market equilibrium. You may realise that a good can be supplied
only after it is produced. The production process involves a series of steps
to convert some raw materials and/or other inputs into a good or service. In
this unit, we will study the issues involved in the processes of production of
a good or service.
A business firm is an economic unit. It is also a production unit. Production
is one of the most important activities of a firm in the circle of economic
activity. The main objective of production is to satisfy the demand for
different kinds of goods and services of the community.

Case Let (Continued from Unit 4)


In the previous unit, we learnt that Ramesh was asked to undertake
supply analysis of traverse rods and also examine pricing of traverse
rods in the market. Ramesh undertook detailed analyses of the supply of

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traverse rods and presented the findings to his superior. The findings
broadly indicated that various firms in the market supplied traverse rods
of different kinds with the prices of the rods varying across brands and
markets. Ramesh’s report had also observed that the demand for
traverse rods was expected to grow during the next few years due to
favourable market conditions. Ramesh’s superior discussed the report
with the head of the firm. The next day, Ramesh was informed that the
firm was now planning to increase the production of traverse rods by
increasing production capacity and by introducing new varieties of
traverse rods. Ramesh was asked by his superior to examine ways of
managing the higher production by using the available resources in a
highly efficient manner within budget constraints. This was a new
challenge for Ramesh who hadn’t carried out such an assignment in the
past.

Objectives:
After studying this unit, you should be able to:
 explain the concept of production, production function and its managerial
uses
 analyse short term and long term production function with illustrations
 describe the various dimensions, advantages and demerits of large
scale production

5.2 Production and Production Function


In this section, we will discuss the concept of production and the production
function. Figure 5.1 depicts the concept of production.

Inputs
Transformation
Process Outputs

Entry into
Firms Exit of Firms

Figure 5.1: Concept of Production

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The term “production” means transformation of physical “inputs” into


physical “outputs”.
The term “inputs” or “factors of production” includes all items or those things
which are required by the firm to produce a particular product. There are
four general factors in production like land, labour, capital and organisation.
Along with those four factors there are some more factors added to the
factors of production, for example inputs also include other items like raw
materials of all kinds, power, fuel, water, technology, time and services like
transport and communications, warehousing, marketing, banking, shipping
and insurance, etc. It also includes the ability, talents, capacities,
knowledge, experience and wisdom of human beings. Thus, the term
“inputs” has wider meaning in economics. What we get at the end of
productive process is called as “outputs”. In short, “outputs” refer to finished
products.
Always, the results after production will be either creation of new utilities or
addition of values. This is an activity which increases consumer satiability of
goods and services. Production will be taken over by all producers by
incurring costs of production. Then production analysis is made in physical
terms and it shows the relationship between physical inputs and physical
outputs.
It is to be noted that higher levels of production is an index of progress and
growth of an organisation and that of a society. It leads to higher income,
employment and economic prosperity. Production of different types of goods
and services in different nations indicates the nature of economic
interdependence between different nations.
Production function
The entire theory of production centres revolves around the concept of
production function. A “production function” expresses the technological or
engineering relationship between physical quantity of inputs employed and
physical quantity of outputs obtained by a firm. It specifies a flow of output
resulting from a flow of inputs during a specified period of time. It may be in
the form of a table, a graph or an equation specifying maximum output rate
from a given amount of inputs used. As it relates inputs to outputs, it is also
called “input-output relation.” The production is purely physical in nature and

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is determined by the quantum of technology, availability of equipments,


labour, raw materials, etc. employed by a firm.
A production function can be represented in the form of a mathematical
model or equation as Q = f (L, N, K….etc) where Q stands for quantity of
output per unit of time and L, N, K etc are the various factor inputs like land,
capital, labour, etc which are used in the production of output. The rate of
output Q is thus, a function of the factor inputs L, N, K etc, employed by the
firm per unit of time.
Factor inputs are of two types as follows:
1. Fixed inputs – Fixed inputs are those factors the quantity of which
remains constant irrespective of the level of output produced by a firm,
for example, land, buildings, machines, tools, equipments, superior
types of labour, top management, etc.
2. Variable inputs – Variable inputs are those factors the quantity of which
varies with variations in the levels of output produced by a firm, for
example, raw materials, power, fuel, water, transport, communication,
etc.
The distinction between the two will hold good only in the short run. In the
long run, all factor inputs will become variable in nature.
Short run is a period of time in which only the variable factors can be varied
while fixed factors like plants, machineries, top management etc would
remain constant. Time available at the disposal of a producer to make
changes in the quantum of factor inputs is limited in the short run. Long run
is a period of time wherein the producer will have adequate time to make
changes in the factor combinations.
It is necessary to note that production function is assumed to be a
continuous function, i.e. it is assumed that a change in any of the variable
factors produces corresponding changes in the output.
Generally speaking, there are two types of production functions. They are as
follows:
1. Short run production function – In this case, the producer will keep all
fixed factors as constant and change only a few variable factor inputs. In
the short run, we come across two kinds of production functions:

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 Quantities of all inputs both fixed and variable will be kept constant
and only one variable input will be varied, for example, law of
variable proportions.
 Quantities of all factor inputs are kept constant and only two variable
factor inputs are varied, for example, iso-quants and iso-cost curves.
2. Long run production function – In this case, the producer will vary the
quantities of all factor inputs, both fixed as well as variable in the same
proportion, for example, the laws of returns to scale.
Each firm has its own production function which is determined by the state
of technology, managerial ability, organisational skills, etc of a firm. It may
be in the following manner:
1. The quantity of inputs may be reduced while the quantity of output may
remain same.
2. The quantity of inputs may be reduced while the quantity of output may
increase.
3. The quantity of inputs may be kept constant while the quantity of output
may increase.
If there are any improvements in the firm, the old production function is
disturbed and a new one takes its place.
Uses of production function
Though production function may appear as highly abstract and unrealistic, in
reality, it is both logical and useful. It is of immense utility to the managers
and executives in the decision making process at the firm level.
There are several possible combinations of inputs and, decision makers
have to choose the most appropriate among them. The following are some
of the important uses of production function:
1. It can be used to calculate or work out the least cost input combination
for a given output or the maximum output-input combination for a given
cost.
2. It is useful in working out an optimal and economic combination of inputs
for getting a certain level of output. The utility of employing a unit of
variable factor input in the production process can be better judged with
the help of production function. Additional employment of a variable
factor input is desirable only when the marginal revenue productivity of

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that variable factor input is greater than or equal to cost of employing it


in an organisation.
3. Production function also helps in making long run decisions. If returns to
scale are increasing, it is wise to employ more factor units and increase
production. If returns to scale are diminishing, it is unwise to employ
more factor inputs & increase production. Managers will be indifferent
whether to increase or decrease production, if production is subject to
constant returns to scale.
Thus, production function helps both in the short run and long run decision -
making process.

5.3 Production Function with One Variable Input


In this section, we will discuss the concept of production function with single
variable input. This concept can be elaborated through the law of variable
proportions.
The law of variable proportions
This law is one of the most fundamental laws of production. It gives us some
key insights in determination of the ideal combination of factor inputs. All
factor inputs are not available in plenty. Hence, in order to expand the
output, scarce factors must be kept constant and variable factors are to be
increased in greater quantities. Additional units of a variable factor on the
fixed factors will certainly mean a variation in output. The law of variable
proportions or the law of non-proportional output will explain how variation in
one factor input leads to variations in output.
The law can be stated as follows: “As the quantity of only one factor input is
increased to a given quantity of fixed factors, beyond a particular point, the
marginal, average and total output eventually decline”.
The law of variable proportions is the new name for the famous “law of
diminishing returns” of classical economists. This law is stated by various
economists. According to Prof. Benham, “As the proportion of one factor in a
combination of factors is increased, after a point, first the marginal and then
the average product of that factor will diminish”.

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The same idea has been expressed by Prof. Marshall in the following words:
“An increase in the quantity of a variable factor added to fixed factors, at the
end results in a less than proportionate increase in the amount of product,
given technical conditions”.
Assumptions of the law
Some assumptions of the law of variable proportions are as follows:
 Only one variable factor unit is to be varied while all other factors should
be kept constant.
 Different units of a variable factor are homogeneous.
 Techniques of production remain constant.
 The law will hold good only for a short and a given period.
 There are possibilities for varying the proportion of factor inputs.
Let us see an illustration for better understanding.
Illustration
A hypothetical production schedule is worked out to explain the operation of
the law. Table 5.1 shows the hypothetical production schedule.
Fixed factors = 1 Acre of land + Rs 5000-00 capital. Variable factor =
labour.

Table 5.1: Hypothetical Production Schedule


Units of Variable inputs TP in AP in MP in
(Labour) units units units
0 0 0 0
1 10 10 10
I Stage
2 24 12 14
3 39 13 15
4 52 13 13
5 60 12 8
6 66 11 6 II Stage
7 70 10 4
8 72 9 2
9 72 8 0
III Stage
10 70 7 -2

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Total product or output (TP): It is the output derived from all units of
factors, both, fixed & variable, employed by the producer. It is also the sum
of marginal output.
Average product or output (AP): It can be obtained by dividing total output
by the number of variable factors employed.
Marginal product or output (MP): It is the output derived from the
employment of an additional unit of a variable factor.
Trends in output
From table 5.1, one can observe the following tendencies in the TP, AP, &
MP:
1. Total output goes on increasing as long as MP is positive. It is the
highest when MP is zero and TP declines when MP becomes negative.
2. MP increases in the beginning, reaches the highest point and diminishes
at the end.
3. AP will also have the same tendencies as the MP. In the beginning MP
will be higher than AP but at the end AP will be higher than MP.
Figure 5.2 – depicts the diagrammatic representation of the output trends.

80
E
70

60
TP

50
P
Level of Output

40 Series1
Series2
30 Series3
Stage 1 Stage 2 Stage 3
20
N
10
B AP
0
MP
1 2 3 4 5 6 7 8 9 10
-10
No. of Units of variable inputs

Figure 5.2: Diagrammatic Representation

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In figure 5.2, along the X axis, we measure the amount of variable factors
employed and, along the Y axis; we measure TP, AP & MP. From the
diagram it is clear that there are three stages.
Stage number I: Law of increasing returns
The total output increases at an increasing rate (More than proportionately)
up to the point P because corresponding to this point P the MP is rising and
reaches its highest point. After the point P, MP decline and as such TP
increases gradually. In figure 5.2, Point P does not correspond to maximum
MP. The figure has to be redrawn.
The first stage comes to an end at the point where MP curve cuts the AP
curve when the AP is maximum at N.
The stage l is called the law of increasing returns on account of the following
reasons:
1. The proportion of fixed factors is greater than the quantity of variable
factors. When the producer increases the quantity of the variable factor,
intensive and effective utilisation of fixed factors become possible
leading to higher output.
2. When the producer increases the quantity of the variable factor, output
increases due to the complete utilisation of the “indivisible factors”.
3. As more units of the variable factor are employed, the efficiency of
variable factors will go up because it creates more opportunity for the
introduction of division of labour and specialisation thereby resulting in
higher output.
Stage number II: Law of diminishing returns
In this case, as the quantity of variable inputs is increased to a given
quantity of fixed factors, output increases less than proportionately. In this
stage, the TP increases at a diminishing rate as both AP & MP are declining
but they are positive. The II stage comes to an end at the point where TP is
the highest at the point E and, MP is zero at the point B. It is known as the
stage of “diminishing returns” because both the AP & MP of the variable
factor continuously fall during this stage. It is only in this stage, the firm is
maximizing its total output.

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Diminishing returns arise due to the following reasons:


1. The proportion of variable factors is greater than the quantity of fixed
factors. Hence, both AP & MP decline.
2. Total output diminishes because there is a limit to the full utilisation of
indivisible factors and introduction of specialisation. Hence, output
declines.
3. Diseconomies of scale will operate beyond the stage of optimum
production.
4. Imperfect substitutability of factor inputs is another cause. Up to a
certain point, substitution is beneficial. Once the optimum point is
reached, the fixed factors cannot be compensated by the variable
factor. Diminishing returns are bound to appear as long as one or more
factors are fixed and cannot be substituted by the others.
Stage number III: Stage of negative returns
In this case, as the quantity of variable input is increased to a given quantity
of fixed factors, output becomes negative. During this stage, TP starts
diminishing, AP continues to diminish and MP becomes negative. The
negative returns are the result of excessive quantity of variable factors to a
constant quantity of fixed factors. Hence, output declines. Generally, the III
stage is a theoretical possibility because no producer would like to reach
this stage.
The producer, being rational, will not select either the stage I (because there
is an opportunity for him to increase output by employing more units of
variable factor) or the III stage (because the MP is negative). The
stage I & III are described as Non-Economic Region or Uneconomic Region.
Hence, the producer will select the II stage (which is described as the most
economic region) where he can maximise the output. The II stage
represents the range of rational production decision.
It is clear that in the example, the most ideal or optimum combination of
factor units = 1 Acre of land + Rs. 5000 - 00 capital and 9 labourers.
All the 3 stages together constitute the law of variable proportions. Because
the second stage is the most important, in practice we normally refer to this
law as the law of diminishing returns.

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Practical application of the law


1. It helps a producer to work out the most ideal combination of factor
inputs or the least cost combination of factor inputs.
2. It is useful to a businessman in the short run production planning at the
micro-level.
3. The law gives guidance that by making continuous improvements in
science and technology, the producer can postpone the occurrence of
diminishing returns.
Thus, we have discussed the concept of production function with single
variable input through the law of variable proportions.

5.4 Production Function with Two Variable Inputs


In this section we will discuss the concept of production function with two
variable inputs.
Isoquants and isocosts
The prime concern of a firm is to use the cheapest factor combinations to
produce a given quantity of output. There are a large number of alternative
combinations of factor inputs which can produce a given quantity of output
for a given amount of investment. Hence, a producer has to select the most
economical combination out of them. Isoproduct curve is a technique
developed in recent years to show the equilibrium of a producer with two
variable factor inputs. It is a parallel concept to the indifference curve in the
theory of consumption.
Meaning and definitions
The term “isoquant” has been derived from ‘Iso’ meaning equal and ‘Quant’
meaning quantity. Hence, isoquant is also called equal product curve or
product indifference curve or constant product curve. An isoproduct curve
represents all the possible combinations of two factor inputs which are
capable of producing the same level of output. It may be defined as – “a
curve which shows the different combinations of the two inputs producing
the same level of output”.
Each isoquant curve represents only one particular level of output. If there
are different isoquant curves, they represent different levels of output. Any
point on an isoquant curve represents the same level of output. Because

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each point indicates equal level of output, the producer becomes indifferent
with respect to any one of the input combinations.
Equal product combination
Table 5.2 shows the schedule for five factor combinations.
Table 5.2: Schedule – ‘Isoquant Schedule’
Combinations Factor X Factor Y Total Output in
(Labour) Capital units
A 12 1 100
B 8 2 100
C 5 3 100
D 3 4 100
E 2 5 100

In table 5.2, all the five factor combinations will produce an equal level of
output, i.e.100 units. Hence, the producer is indifferent with respect to any
one of the factor combinations mentioned in the table.
Graphic representation
Figure 5.3 depicts the graphical representation of factor combination.
Y

12 A

Factor 8 B
X
5 C
3 D
2
E
IQ

0 X

1 2 3 4 5
Factor Y
Figure 5.3: Graphical Representation of Factor Combination

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In figure 5.3, if we join points ABCDE (which represents different


combinations of factors x and y yielding the same level of output) we get an
isoquant curve IQ. This curve represents 100 units of output that may be
produced by employing any one of the combinations of two factor inputs as
mentioned in the example. It is to be noted that an isoproduct curve shows
the exact physical units of output that can be produced by alternative
combinations of two factor inputs. Hence, absolute measurement of output
is possible.
Isoquant map
A catalogue of different combinations of inputs with different levels of output
can be indicated in a graph which is called equal product map or isoquant
map. In other words, a number of isoquants representing different amount
of output are known as isoquant map. Figure 5.4 depicts an isoquant map.

Factor X Capital 3000 IQ3


2000
IQ2
1000
IQ1
0 Factor Y Labour X
Figure 5.4: Isoquant Map

Marginal rate of technical substitution (MRTS)


It may be defined as the rate at which a factor of production can be
substituted for another at the margin without affecting any change in the
quantity of output. For example, MRTS of X for Y is the number of units of
factor Y that can be replaced by one unit of factor X, quantity of output
remaining the same.

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Table 5.3 shows the MRTS of X for Y, for five different combinations.

Table 5.3: MRTS of X for Y


Combinations Factor X Factor Y MRTS of X for Y
A 12 1 Nil
B 8 2 4:1
C 5 3 3:1
D 3 4 2:1
E 2 5 1:1

In this example, we can notice that in the second combination the producer
is substituting 4 units of X for 1 unit of Y. Hence, in this case MRTS of
X for Y is 4:1.
Generally speaking, the MRTS will be diminishing. In the table 5.3, we can
observe that as the quantity of factor Y is increased relative to the quantity
of X, the number of units of X that will be required to be replaced by one unit
of factor Y will diminish, quantity of output remaining the same. This is
known as the law of diminishing marginal rate of technical substitution
(DMRTS).
The properties of iso-quants are as follows:
1. An isoquant curve slope downwards from left to right.
2. Generally, an isoquant curve is convex to the origin.
3. No two isoproduct curves intersect each other.
4. An isoproduct curve lying to the right represents higher output and vice-
versa.
5. Always, an isoquant curve need not be parallel to other.
6. Isoquant will not touch either X axis or Y axis.
Thus, we have learnt about MRTS, DMRTS and the isoquant.
Isocost line or curve
It is a parallel concept to the budget or price line of the consumer. It
indicates the different combinations of the two inputs which the firm can
purchase at given prices with a given outlay. It shows two things: (a) prices
of two inputs (b) total outlay of the firm. Each isocost line will show various
combinations of two factors which can be purchased with a given amount of

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money at the given price of each input. We can draw the isocost line on the
basis of an imaginary example.
Let us suppose that a producer wants to spend Rs. 3,000 to purchase factor
X and Y. If the price of X per unit Rs. 100 he can purchase 30 units of X.
Similarly if the price of factor Y is Rs. 50 then he can purchase 60 units of Y.
When 30 units of factor X are represented on OY – axis and 60 units of
factor Y are represented on OX- axis, we get two points A & B. If we join
these two points A and B, then we get the isocost line AB. This line
represents the different combinations of factor X and Y that can be
purchased with Rs. 3,000. Figure 5.5 depicts the isocost line.

A
3000/-
30 Units of Factor X

B
0 X
60 Units of Factor Y
Figure 5.5: Isocost Line

The isocost line will shift to the right if the producer increases the outlay
from Rs. 3,000 to Rs. 4,000. On the contrary, if the outlay decreases to
Rs. 2,000, there will be a backward shift in the position of isocost line.
The slope of the isocost line represents the ratio of the price of a unit of
factor X to the price of a unit of factor Y. In case, the price of any one of
them changes, there would be a corresponding change in the slope and
position of isocost line. Figure 5.6 depicts the change in the slope of the
isocost line with changes in any of the factors.

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Factor X Rs. 4,000/-


P

Rs. 3,000/-
A

Rs. 2,000/-

0 X

Factor Y

Figure 5.6: Effect of Changes in Factor on Isocost Line

Producer’s equilibrium (Optimum factor combination or least cost


combination)

The optimal combination of factor inputs may help in either minimizing cost
for a given level of output or maximizing output with a given amount of
investment expenditure (outlay). In order to explain producer’s equilibrium,
we have to integrate isoquant curve with the isocost line. isoproduct curve
represents different alternative possible combinations of two factor inputs
with the help of which, a given level of output can be produced. On the
other hand, isocost line shows the total outlay of the producer and the prices
of factors of production.

The intention of the producer is to maximise his profits. Profits can be


maximised when maximum output is produced with minimum production
cost. Hence, the producer selects the least cost combination of the factor
inputs. Maximum output with minimum cost is possible only when the
position of equilibrium is reached. The position of equilibrium is indicated at
the point where isoquant curve is tangential to the isocost line. Figure 5.7
explains how the producer reaches the position of equilibrium.

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M
E1
A

25 Units R
E Point of equilibrium
Factor “X”  E2
IQ

0 X
S B N
50 Units
Factor “Y”
Figure 5.7: Producer’s Equilibrium

It is quite clear from figure 5.7 that the producer will reach the position of
equilibrium at the point E where the isoquant curve IQ (for output of 500
units) and isocost line AB are at a tangent to each other. With a given total
outlay of Rs. 5,000 the producer will be producing the highest output,
i.e. 500 units by employing 25 units of factors X and 50 units of factor Y
(assuming Rs. 2,500 each is spent on X and Y).
The price of one unit of factor X is Rs.100 and that of Y is Rs. 50; Rs.100 x
25 units of X = 2500 and Rs. 50 x 50 units of Y = 2500. The producer will
not reach the position of equilibrium either at the point E1 and E2 because
they are on a higher isocost line. Similarly, the producer cannot move to the
left side of E, because they are on a lower isocost line and 500 units of
output cannot be produced by any combination that lies to the left of E.
Thus, the point at which the isoquant is tangent to the isocost line
represents the minimum cost or optimum factor combination for producing a
given level of output. At this point, MRTS between the two points is equal to
the ratio of the prices of the inputs.

5.5 Returns to Scale


In this section, we will discuss the long run production function.

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Laws of returns to scale


The concept of returns to scale is a long run phenomenon. In this case, we
study the change in output when all factor inputs are changed or made
available in required quantity. An increase in scale means that all factor
inputs are increased in the same proportion. In returns to scale, all the
necessary factor inputs are increased or decreased to the same extent so
that whatever the scale of production, the proportion among the factors
remains the same.
Three phases of returns to scale
Generally speaking, we study the behaviour pattern of output when all factor
inputs are increased in the same proportion under returns to scale. Many
economists have questioned the validity of returns to scale on the ground
that all factor inputs cannot be increased in the same proportion and the
proportion between the factor inputs cannot be kept uniform. But in some
cases, it is possible that all factor inputs can be changed in the same
proportion and the output is studied when the input is doubled or tripled or
increased five-fold or ten-fold. An ordinary person may think that when the
quantity of inputs is increased 10 times, output will also go up by 10 times.
But it may or may not happen as expected.
It may be noted that when the quantity of inputs are increased in the same
proportion, the scale of output or returns to scale may be either more than
equal, equal or less than equal. Thus, when the scale of output is increased,
we may get increasing returns, constant returns or diminishing returns.
When the quantity of all factor inputs are increased in a given proportion and
output increases more than proportionately, then the returns to scale are
said to be increasing; when the output increases in the same proportion,
then the returns to scale are said to be constant; when the output increases
less than proportionately, then the returns to scale are said to be
diminishing. Table 5.4 shows an example to explain the law of returns to
scale.

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Table 5.4: Laws of Returns to Scale


Sl. Total Product Marginal Product
Scale
No. in Units in units
1 1 Acre of land + 3 labour 5 5
2 2 Acre of land + 5 labour 12 7
3 3 Acre of land + 7 labour 21 9
4 4 Acre of land + 9 labour 32 11
5 5 Acre of land + 11 labour 43 11
6 6 Acre of land + 13 labour 54 11
7 7 Acre of land + 15 labour 63 9
8 8 Acre of land + 17 labour 70 7

It is clear from the table that the quantity of land and labour (scale) is
increasing in the same proportion, i.e. by 1 acre of land and 2 units of labour
throughout in our example. The output increases more than proportionately
up to the point where the producer is employing 4 acres of land and 9 units
of labour. Output increases in the same proportion when the quantity of land
is 5 acres and 11 units of labour and 6 acres of land and 13 units of labour.
In the later stages, when the producer employs 7 & 8 acres of land and
15 & 17 units of labour, output increases less than proportionately. Thus,
one can clearly understand the operation of the three phases of the laws of
returns to scale with the help of the table.
Diagrammatic representation
Figure 5.7 depicts the marginal returns curve. In the figure, it is clear that the
marginal returns curve slope upwards from A to B, indicating increasing
returns to scale. The curve is horizontal from B to C indicating constant
returns to scale and from C to D, the curve slope downwards from left to
right indicating the operation of diminishing returns to scale.

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II Stage
Y Constant returns
B C
10 

8  III Stage
Decreasing
6  I Stage returns
Increasing returns
Marginal Returns

D
4  A

2 

        X
1 2 3 4 5 6 7 8
Figure 5.8: Marginal Returns Curve

Increasing returns to scale


Increasing returns to scale is said to operate when the producer is
increasing the quantity of all factors [scale] in a given proportion leading to a
more than proportionate increase in output. For example, when the quantity
of all inputs are increased by 10%, and output increases by 15%, then we
say that increasing returns to scale is operating. In order to explain the
operation of this law, an equal product map has been drawn with the
assumption that only two factors X and Y are required. Figure 5.9 depicts
the operation of the law of increasing returns to scale. In the figure, Factor X
is represented along OX axis and factor Y is represented along OY axis.
The scale line OP is a straight line passing through the origin on the
isoquant map indicating the increase in scale as we move upward. The
scale line OP represent different quantities of inputs where the proportion
between factor X and factor Y is remains constant. When the scale is
increased from A to B, the return increases the output from 100 units to 200
units. The scale line OP passing through origin is called as the “expansion
path”. Any line passing through the origin will indicate the path of expansion
or increase in scale with definite proportion between the two factors. It is
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very clear that the increase in the quantities of factor X and Y [scale] is small
as we go up the scale and the output is larger. The distance between each
isoquant curve is progressively diminishing. It implies that in order to get an
increase in output by another 100 units, a producer is employing lesser
quantities of inputs and his production cost is declining. Thus, the law of
increasing returns to scale is operating.
Y

P
Factor ‘Y’ Capital)

Scale Line

F 600
E 500
D 400
C
300
B
200
A
100

X
0 Factor ‘X’ (Labour)

Figure 5.9: Operation of Increasing Returns of Scale

Causes for increasing returns to scale


Increasing returns to scale operate in a firm on account of several reasons.
Some of the most important ones are as follows:
1. Wider scope for the use of latest tools, equipments, machineries,
techniques etc to increase production and reduce cost per unit.
2. Large-scale production leads to full and complete utilisation of indivisible
factor inputs leading to further reduction in production cost.
3. As the size of the plant increases, more output can be obtained at lower
cost.
4. As output increases, it is possible to introduce the principle of division
of labour and specialisation, effective supervision and scientific
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management of the firm etc leading to reduction in average cost of


operations.
5. As output increases, it becomes possible to enjoy several other kinds of
economies of scale like overhead, financial, marketing and risk-bearing
economies, etc, which are responsible for cost reduction.
It is important to note that economies of scale outweigh diseconomies of
scale in case of increasing returns to scale.
Constant returns to scale
Constant returns to scale is operating when all factor inputs [scale] are
increased in a given proportion leading to an equi-proportional increase in
output. When the quantity of all inputs is increased by 10%, and output also
increases exactly by 10%, then we say that constant returns to scale are
operating. Figure 5.10 depicts a graph for constant returns to scale. In the
figure, it is clear that the successive isoquant curves are equidistant from
each other along the scale line OP. It indicates that as the producer
increases the quantity of both factors X and Y in a given proportion, output
also increases in the same proportion. Economists also describe constant
returns to scale as the linear homogeneous production function. It shows
that with constant returns to scale, there will be one input proportion which
does not change, whatever be the level of output.

P
Scale Line
Factor ‘Y’ (Capital)

E
D 500 units
C 400 units
B 300 units
A 200 units
100 units

0 X
Factor ‘X’ (Labour)

Figure 5.10: Constant Returns to Scale

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Causes for constant returns to scale


In case of constant returns to scale, the various internal and external
economies of scale are neutralized by internal and external diseconomies.
Thus, when both internal and external economies and diseconomies are
exactly balanced with each other, constant returns to scale will operate.
Diminishing returns to scale
Diminishing returns to scale is operating when output increases less than
proportionately when compared to the quantity of inputs used in the
production process. For example, when the quantity of all inputs are
increased by 10%, and output increases by 5%, then we say that
diminishing returns to scale is operating.
Figure 5.11 depicts the diminishing return to scales. In the figure, it is clear
that the distance between each successive isoquant curve is progressively
increasing along the scale line OP. It indicates that as the producer is
increasing the quantity of both factors X and Y, in a given proportion, output
increases less than proportionately. Thus, the law of diminishing returns to
scale is operating.

Y
P
Scale Line

F
Factor ‘Y’ (Capital)

E 600 units
D
500 units
C
B 400 units
A 300 units
200 units
100 units
0 X
Factor ‘X’ (Labour)

Figure 5.11: Diminishing Returns to Scale

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Causes for diminishing returns to scale


Diminishing Returns to Scale operate due to the following reasons:
1. Emergence of difficulties in co-ordination and control.
2. Difficulty in effective and better supervision.
3. Delays in management decisions.
4. Inefficient and mismanagement due to overgrowth and expansion of the
firm.
5. Productivity and efficiency declining unavoidably after a point.
Thus, in this case, diseconomies outweigh economies of scale. The result is
the operation of diminishing returns to scale.
The concept of returns to scale helps a producer to work out the most
desirable combination of factor inputs so as to maximise output and
minimise production cost. It also helps the producer to increase production,
maintain the same level or, decrease it depending on the demand for the
product.

5.6 Economies of Scale


In this section, we will study the economies of scale. The study of
economies of scale is associated with large scale production. Today there is
a general tendency to organize production on a large scale. Mass
production of standardized goods has become the order of the day. Large
scale production is beneficial and economical in nature. The advantages or
benefits that accrue to a firm as a result of increase in its scale of production
are called ‘economies of scale’. They have close relationship with the size of
the firm. They influence the average cost over different ranges of output.
They are beneficial to a firm. They help in reducing production cost and
establishing an optimum size of a firm. Thus, they help a lot and, go a long
way in the development and growth of a firm. According to Prof. Marshall,
such economies are of two types, viz., internal economies and external
economies. Now we shall study both of them in detail.
I. Internal economies or real economies
Internal economies are those economies which arise because of the actions
of an individual firm to economise its cost. They arise due to increased
division of labour or specialisation and complete utilisation of indivisible

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factor inputs. Prof. Cairncross points out that the internal economies are
open to a single factory or a single firm, independent of the actions of other
firms. Some of the important aspects of internal economies are as follows:
1. They arise “within” or “inside” a firm.
2. They arise due to improvements in internal factors.
3. They arise due to specific efforts of one firm.
4. They are particular to a firm and enjoyed by only one firm.
5. They arise due to increase in the scale of production.
6. They are dependent on the size of the firm.
7. They can be effectively controlled by the management of a firm.
8. They are called as “business secrets” of a firm.
Internal economies arise on account of an increase in the scale of output of
a firm and cannot be achieved unless output increases.
Kinds of internal economies
Now, let us discuss the kinds of internal economies.
Technical economies
These economies arise on account of technological improvements and their
practical application in the field of business. Economies of techniques or
technical economies are further subdivided into five heads as follows:
a) Economies of superior techniques – These economies are the result of
the application of the most modern techniques of production. When the size
of the firm grows, it becomes possible to employ bigger and better types of
machinery. The latest and improved techniques give place for specialized
production. It is bound to be cost reducing in nature, for example, cultivating
the land with modern tractors instead of using age old wooden ploughs and
bullock carts, use of computers instead of human labour, etc.
b) Economies of increased dimension – It is found that a firm enjoys the
reduction in cost when it increases its dimension. A large firm avoids
wastage of time and economizes its expenditure. Thus, an increase in
dimension of a firm will reduce the cost of production, for example, operation
of a double-decker bus instead of two separate buses.

c) Economies of linked processes – It is quite possible that a firm may not


have various processes of production within its own premises. Also, it is
possible that different firms through mutual agreement may decide to work

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together and derive the benefits of linked processes, for example, in dairy
farming, printing press, nursing homes, etc.
d) Economies arising out of research and by-products – A firm can
invest adequate funds for research and, the benefits of research and its
costs can be shared by that firm as well as all other firms in the industry.
Similarly, a large firm can make use of its wastes and by-products in the
most economical manner by producing other products. For example, cane
pulp, molasses, and bagasse of sugar factory can be used for the
production of paper, varnish, etc.

e) Inventory economies – Inventory management is a part of better


materials management. A big firm can save a lot of money by adopting
latest inventory management techniques. For example, Just-In-Time or zero
level inventory techniques. The rationale of the Just-In-Time technique is
that instead of having huge stocks worth of lakhs and crores of rupees, it
can ask the seller of the inputs to supply them just before the
commencement of work in the production department each day.
Managerial Economies
They arise because of better, efficient, and scientific management of a firm.
Such economies arise in two different ways as follows:
a) Delegation of details – The general manager of a firm cannot look after
the working of all processes of production. In order to keep an eye on each
production process he has to delegate some of his powers or functions to
trained or specialized personnel and thus relieve himself for co-ordination,
planning and executing the plans. This will enable him to bring about
improvements in production process and in bringing down the cost of
production.
b) Functional specialisation – It is possible to secure economies of large
scale production by dividing the work of management into several separate
departments. Each department is placed under an expert and the rest of the
work is left into the hands of specialists. This will ensure better and more
efficient productive management with scientific business administration. This
would lead to higher efficiency and reduction in the cost of production.
Thus managerial economies are mainly governed by proper delegation of
details and by functional specialisation.

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Marketing or commercial economies


These economies arise on account of buying and selling goods on large
scale basis at favourable terms. A large firm can buy raw materials and
other inputs in bulk at concessional rates. As the bargaining capacity of a
big firm is much greater than that of small firms, it can get quantity discounts
and rebates. In this way, economies may be secured in the purchase of
different inputs.
A firm can reduce its selling costs also. A large firm can have its sales
agency and channel. The firm can have a separate selling organisation,
marketing department manned by experts who are well-versed in the art of
pushing the products in the market. It can follow an aggressive sales
promotion policy to influence the decisions of the consumers.
Financial economies
They arise from advantages secured by a firm in mobilizing huge financial
resources. A large firm on account of its reputation, name and fame can
mobilize huge funds from money market, capital market, and other private
financial institutions at concessional interest rates. It can borrow from banks
at relatively cheaper rates. It is also possible to have large overdrafts from
banks. A large firm can float debentures and issue shares and get
subscriptions from the general public. Another advantage will be that the
raw material suppliers, machine suppliers etc., are willing to supply
materials and components at comparatively low prices, because they are
likely to get bulk orders. Thus, a big firm has an edge over small firms in
securing sufficient funds more easily and cheaply.
Labour economies
These economies arise as a result of employing skilled, trained, qualified
and highly experienced persons by offering higher wages and salaries. As a
firm expands, it can employ a large number of highly talented persons and
get the benefits of specialisation and division of labour. It can also impart
training to existing labour force in order to raise skills, efficiency and
productivity of workers. New schemes may be chalked out to speed up the
work, conserve scarce resources, economise on expenditure and save
labour time. It can provide better working conditions, promotional
opportunities, restrooms, sports rooms etc, and create facilities like
subsidised canteen, crèches for infants, recreations. All these measures will

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definitely raise the average productivity of a worker and reduce the cost per
unit of output.
Transport and storage economies
They arise on account of the provision of better, highly organised and cheap
transport and storage facilities and their complete utilisation. A large
company can have its own fleet of vehicles or means of transport which are
more economical than hired ones. Similarly, a firm can also have its own
storage facilities which reduce cost of operations.
Overhead economies
These economies arise on account of large scale operations. The expenses
on establishment, administration, book-keeping, etc, are more or less the
same whether production is carried out on a small or large scale. Hence,
cost per unit will be low if production is organised on a large scale.
Economies of vertical integration
A firm can also reap this benefit when it succeeds in integrating a number of
stages of production. It secures the advantage that the flow of goods
through various stages in production processes is more readily controlled.
Because of vertical integration, most of the costs become controllable costs
which help an enterprise to reduce cost of production.
Risk-bearing or survival economies
These economies arise as a result of avoiding or minimising several kinds of
risks and uncertainties in a business. A manufacturing unit has to face a
number of risks in the business. Unless these risks are effectively tackled,
the survival of the firm may become difficult. Hence, many steps are taken
by a firm to eliminate or to avoid or to minimise various kinds of risks. A
large firm secures risk-spreading advantages in either of the following four
ways or through all of them:
 Diversification of output – Instead of producing only one particular
product, a firm has to produce multiple products. If there is loss in one
product, it can be made good in other products.
 Diversification of market – Instead of selling the goods in only one
market, a firm has to sell its products in different markets. If consumers
in one market desert a product, it can cover the losses in other markets.
 Diversification of source of supply – Instead of buying raw materials
and other inputs from only one source, it is better to purchase them from
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different sources. If one person fails to supply, a firm can buy from
several sources.
 Diversification of the process of manufacture – Instead of adopting
only one process of production to manufacture a commodity, it is better
to use different processes or methods to produce the same commodity
so as to avoid the loss arising out of the failure of any one process.
Generally speaking, the risk-bearing capacity of a big firm will be much
greater than that of a small firm. Risk is avoided when few firms
amalgamate or join together or when competition between different firms is
either eliminated or reduced to the minimum by expanding the size of the
firm.
II. External economies or pecuniary economies
External economies are those economies which accrue to the firms as a
result of the expansion in the output of the whole industry and they are not
dependent on the output level of individual firms. These economies or gains
will arise on account of the overall growth of an industry or a region or a
particular area. They arise due to benefit of localisation and specialised
progress in the industry or region. Some of the important aspects of external
economies are as follows:
1. They arise ‘outside’ the firm.
2. They arise due to improvement in external factors.
3. They arise due to collective efforts of an industry.
4. They are general, common and enjoyed by all firms.
5. They arise due to overall development, expansion and growth of an
industry or a region.
6. They are dependent on the size of industry.
7. They are beyond the control of management of a firm.
8. They are called as “open secrets” of a firm.
Stonier & Hague point out that external economies are those economies in
production which depend on increase in the output of the whole industry
rather than increase in the output of the individual firm.
Kinds of external economies
Now, let us discuss the kinds of external economies.

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Economies of concentration or agglomeration


They arise due to a very large number of firms which produce the same
commodity being established in a particular area. In other words, this is an
advantage which arises from what is called ‘Localisation of Industry’. The
following benefits of localisation of industry are enjoyed by all the firms -
provision of better and cheap labour at low or reasonable rates, trained,
educated and skilled labour, transport and communication, water, power,
raw materials, financial assistance through private and public institutions at
low interest rates, marketing facilities, benefits of common repairs,
maintenance and service shops, services of specialists or outside experts,
better use of by-products and other such benefits. Thus, it helps in reducing
the cost of operation of a firm.
Economies of information
These economies arise as a result of getting quick, latest and up-to-date
information from various sources. Another form of benefit that arises due to
localisation of industry is economies of information. As a large number of
firms are located in a region, it becomes possible for them to exchange their
views frequently, to have discussions with others, to organise lectures,
symposiums, seminars, workshops, training camps, demonstrations on
topics of mutual interest, etc. Revolution in the field of information
technology, expansion in inter-net facilities, mobile phones, e-mails,
video conferences, etc, has helped in the free flow of latest information from
all parts of the globe in a very short span of time. Similarly, publication of
journals, magazines, information papers, etc. have helped in the
dissemination of quick information. Statistical, technical and other market
information becomes more readily available to all firms. This will help in
developing contacts between different firms. When inter-firm relationship
strengthens, it helps in economising the expenditure of a single firm.
Economies of disintegration
These economies arise as a result of dividing one big unit into different
small units for the sake of convenience of management and administration.
When an industry grows beyond a limit, in that case, it becomes necessary
to split it in to small units. New subsidiary units may grow to serve the needs
of the main industry. For example, in cotton textiles industry, some firms
may specialise in manufacturing threads, a few others in printing, and some

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others in dyeing and colouring, etc. This will certainly enhance the efficiency
in the working of a firm and cut down unit costs considerably.
Economies of government action
These economies arise as a result of active support and assistance given by
the government to stimulate production in the private sector units. In recent
years, the government in order to encourage the development of private
industries has come up with several kinds of assistance. It is granting tax-
concessions, tax-holidays, tax-exemptions, subsidies, development rebates,
financial assistance at low interest rates, etc.
It is quite clear from this detailed description that both internal and external
economies arise on account of large scale production and they are benefit
to firms by reducing costs.
Economies of physical factors
These economies arise due to the availability of favourable physical factors
and environment. As the size of an industry expands, positive physical
environment may help to reduce the costs of all firms working in the
industry. For example, climate, weather conditions, fertility of the soil,
physical environment in a particular place may help all firms to enjoy certain
physical benefits.
Economies of welfare
These economies arise on account of various welfare programmes
undertaken by an industry to help its own staff. A big industry is in a better
position to provide welfare facilities to the workers. It may get land at
concessional rates and procure special facilities from the local governments
for setting up housing colonies for the workers. It may also establish health
care units, training centres, computer centres and educational institutions of
all types. It may grant concessions to its workers. All these measures would
help in raising the overall efficiency and productivity of workers.
Diseconomies of scale
When a firm expands beyond the optimum limit, economies of scale will be
converted into diseconomies of scale. Some of the main diseconomies of
scale are as follows:

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1. Financial diseconomies – As there is overgrowth, the required amount


of finance may not be available to a firm. Consequently, higher interest
rates are to be paid for additional funds.
2. Managerial diseconomies – Excess growth leads to loss of effective
supervision, control, management, coordination of factors of production
leading to all kinds of wastages, indiscipline and rise in production and
operating costs.
3. Marketing diseconomies – Unplanned excess production may lead to
mismatch between demand and supply of goods leading to fall in prices.
Stocks may pile up; sales may decline leading to fall in revenue and
profits.
4. Technical diseconomies – When output is carried beyond the plant
capacity, per unit cost will certainly go up. There is a limit for division of
labour and specialisation. Beyond a point, they become negative.
Hence, operation costs would go up.
5. Diseconomies of risk and uncertainty bearing – If output expands
beyond a limit, investment increases. The level of inventory goes up.
Sales do not go up correspondingly. Business risks appear in all fields
of activities. Supply of factor inputs become inelastic leading to high
prices.
6. Labour diseconomies – An unwieldy firm may become impersonal.
Contact between labour and management may disappear. Workers
may demand higher wages and salaries, bonus and other such benefits,
etc. Industrial disputes may arise. Labour unions may not cooperate
with the management. All of them may contribute to higher operation
costs.
On account of diseconomies of scale, more output is obtained at higher cost
of production.
II. External diseconomies
When several business units are concentrated in one place or locality, it
may lead to congestion,, environmental pollution, scarcity of factor inputs
like, raw materials, water, power, fuel, transport and communications etc
leading to higher production and operational costs.
Thus, it is very clear that a firm can enjoy benefits of large scale production
only up to a limit. Beyond the optimum limit, it is bound to experience
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diseconomies of scale. Hence, there should be proper check on the growth


and expansion of a firm.
Internalisation of external economies
It implies that a firm will convert certain external benefits created by the
government or the entire society to its own favour without making any
additional investments. A firm may start a new unit between two big railway
stations or near the airport or near the national highways or a port so that it
can enjoy all the infrastructure benefits. Similarly, a new computer firm can
commence its operations where there is 24 hours supply of electricity.
Hence, they are also called as privatisation of public benefits. Such types of
efforts are to be encouraged by the government.
Externalisation of internal diseconomies
In this case, a particular firm on account of its regular operations will pass
on certain costs on the entire society. A firm instead of taking certain
precautionary measures by spending some amount of money will escape
and pass on this burden to the government or the society. For example, a
firm may throw chemical or industrial wastes, dirt and filth either to open air
or rivers leading to environmental pollution. In that case, the government is
forced to spend more money to clean river water or prevent environmental
pollution. This is a clear case of externalised internal diseconomies. It is to
be avoided at all costs.

5.7 Economies of Scope


In this section, we will discuss the economies of scope. It is a common fact
to observe that when a single-product firm expands its volume of output, it
would enjoy certain economies of scale. As a result, production cost per unit
declines and more output is obtained at lower cost of production.
Sometimes, they would enjoy certain other external benefits due to the
overall improvements in the entire area or city in they operate. Apart from
these two types of benefits, we also come across another type of benefit in
recent years. They are popularly known as economies of scope.

Economies of scope may be defined as those benefits which arise to a firm


when it produces more than one product jointly rather than producing two
items separately by two different business units. In this case, the benefits of
the joint output of a single firm are greater than the benefits if two products
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are produced separately by two different firms. Such benefits may arise on
account of joint use of production facilities, joint marketing efforts, or use of
the same administrative office and staff in an organisation. Sometimes,
production of one product automatically results in the production of another
by-product leading to a reduction in average cost of production.

Economies-of-scope results in saving production costs. It can be measured


with the help of the following equation.

C [Q1]  C [ Q2] - C [ Q1,Q2]


SC 
C [Q1, Q2]

Where SC = Saving Cost, C [Q1] = cost of producing output Q1, C [Q2] =


cost of producing output Q2 and C [Q1, Q2] = joint cost of producing both
outputs.

Illustration
A firm produces product A & B separately. Cost of producing 100 units of A
is Rs. 8000 and cost of producing 100 units of B is Rs. 5,000. If the firm
produces both products A & B jointly, in that case, its total cost would be
Rs. 10,000.

Now, one can find out saving cost by substituting the values to the above
mentioned formula.

8,000  5,000 - 10,000 3,000


SC    0 .3
10,000 10 ,000

In this case, the joint cost [10,000] is less than the sum of individual costs
[13,000]. Thus, a firm can save 30% cost if it produces both products A & B
jointly. Hence, the SC is more than zero.

Diseconomies of scope
Diseconomies of scope may be defined as those disadvantages which occur
when the cost of producing two products jointly is costlier than producing
them individually. In this case, it would be profitable to produce two goods
separately than jointly. For example, with the help of same machinery, it is
not possible to produce two goods together. It involves buying two different
machineries. Hence, production costs would certainly go up in this case.

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Difference between economies of scale and economies of scope


Table 5.5 shows the difference or the comparison between economies of
scale and economies of scope.

Table 5.5: Comparison of Two Economies


Economies of scale Economies of scope
1. It is connected with increase or 1. It is connected with increase or
decrease in scale of production decrease in distribution & marketing.
2. It shows change in output of a 2. It shows a change in output of more
single product than one product.
3. It is associated with supply side 3. It is associated with demand side
changes in output. changes in output
4. It indicates savings in cost 4. It indicates savings in cost due to
owing to increase in volume of production of more than one product.
output

5.8 Summary
Let us recapitulate the important concepts discussed in this unit:
 In this unit, we have discussed about the meaning of production,
production function and its managerial uses. Production in economics
implies transformation of inputs into outputs for our final consumption.
 Production function explains the quantitative relationship between the
amounts of inputs used to get a particular physical quantity of outputs.
The ratios between the two quantities are of great importance to a
producer to take his decisions in the production process.
 There are two kinds of production functions - short run and long run. In
case of short run production function we come across a change in either
one or two variable factor inputs while all other inputs are kept constant.
 The law of variable proportion explain how there will be variations in the
quantity of output when there is change in only one variable factor input
while all other inputs are kept constant. On the other hand, iso-quants
and iso-cost curves explain how there will be changes in output when
only two variable inputs are changed while all other inputs are kept

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constant. Under long run production function, the laws of returns to scale
explain changes in output when all inputs, both variable as well as fixed
changes in the same proportion.
 Economies of scale gives information about the various benefits that a
firm will get when it goes for large scale production. Economies of scope
on the other hand tells us how there will be certain specific advantages
when one firm produces more than two products jointly than two or three
firms produce them separately. Diseconomies of scale and
diseconomies of scope tell us that there are certain limitations to
expansion in output.

5.9 Glossary
Economies of scale: Advantages or benefits that accrue to a firm as a
result of increase in its scale of production.
Economies of scope: Benefits which arise to a firm when it produces more
than one product jointly rather than producing two items separately by two
different business units.
Isocost line: Indicates the different combinations of the two inputs which
the firm can purchase at given prices with a given outlay.
Isoquant/isoproduct curve: A curve which shows the different
combinations of the two inputs producing the same level of output.
Law of variable proportions: As the quantity of only one factor input is
increased to a given quantity of fixed factors, beyond a particular point, the
marginal, average and total output eventually decline.
Long run: Period of time wherein the producer will have adequate time to
make changes in the factor combinations.
Marginal rate of technical substitution: Rate at which a factor of
production can be substituted for another at the margin without affecting any
change in the quantity of output.
Production: Transformation of physical Inputs into physical outputs.
Production function: Technological or engineering relationship between
physical quantity of inputs employed and physical quantity of outputs
obtained by a firm.
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Short run: Period of time in which only the variable factors can be varied
while fixed factors like plants, machineries, top management, etc. would
remain constant.

Self Assessment Questions


1. Production creates ___________ or ___________ of value.
2. Production function explains _____________ or ________________
relationship between inputs and outputs.
3. In the short period only ___________ factor inputs are changed.
4. When marginal product is zero total product will be _________.
5. An iso-quant curve shows different alternative combinations of inputs
which helps to produce same level of output where as an iso-cost curve
shows ____________ combination of two inputs that can be purchased
with a given amount of investment expenditure while prices of two
factor inputs remain constant.
6. When all inputs are increased by 8% and output increases by 13% then
it is a case of law of ____________________.
7. Internal economies depend on the growth of a ___________ and
external economies depend on the growth of the ____________.
8. Economies of scope refer to the benefits which arise to a firm when it
produces more than _________________ rather than producing
________ separately by two firms.
9. A short-run production function assumes that the level of output is
fixed. (True/False)
10. When average product is increasing, then marginal product is greater
than average product. (True/False)
11. All inputs are fixed in the short run. (True/False)
12. If a firm is producing a given level of output in a technically efficient
manner, that level of output is the most that can be produced with the
given levels of inputs. (True/False)
13. Diminishing returns refer to the decrease in marginal product, which
results from increases in the variable input. (True/False)

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5.10 Terminal Questions


1. Define production function and distinguish between short run and long
run production function.
2. Discuss the uses of production function.
3. Explain the law of variable proportions.
4. Explain how a product would reach equilibrium position with the help
of –iso-quants and iso-cost curve.
5. Discuss any one law of returns to scale with example.

5.11 Answers

Self Assessment Questions


1. New utilities, addition
2. Technological, engineering
3. Variable
4. Highest
5. Various alternative, particular
6. Diminishing returns
7. Firms industry
8. One product jointly
9. False
10. True
11. False
12. True
13. True
Terminal Questions
1. The entire theory of production centres revolves around the concept of
production function. In short run Quantities of all inputs both fixed and
variable will be kept constant and only one variable input will be varied,
for example, law of variable proportions. In long run the producer will
vary the quantities of all factor inputs, both fixed as well as variable in
the same proportion Refer to section 5.2.
2. It is of immense utility to the managers and executives in the decision-
making process at the firm level Refer to section 5.2.

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3. Law of variable proportions gives a key insights in determination of the


ideal combination of factor inputs. All factor inputs are not available in
plenty Refer to section 5.3.
4. Isoquant is also called equal product curve or product indifference curve
or constant product curve. Isoquant curve represents only one particular
level of output. Refer to section 5.4.
5. The change in output when all factor inputs are changed or made
available in required quantity. Refer to section 5.5.

5.12 Case Study

Hua Hong, Grace Semiconductor to Merge


HONG KONG – Hua Hong Semiconductor Ltd. and Grace
Semiconductor Manufacturing Corp. agreed to merge, the companies
said Thursday, in a move that highlights consolidation in China's
fragmented semiconductor industry. The tie-up, which includes Hua
Hong's issuing new shares to existing shareholders of Grace in exchange
for all of Grace's outstanding shares, will create a stronger competitor to
China's largest chip foundry; Semiconductor Manufacturing International
Corp. SMIC has been struggling to compete against its Taiwan rivals.
It also shows the capital-intensive contract-chip-manufacturing industry is
forcing companies to look at ways to partner up and save costs on
investments to keep advanced production lines running. "By integrating
manufacturing facilities, process technologies and human resources, Hua
Hong and Grace are able to leverage their complementary strengths to
further expand their combined product range and customer coverage and
to improve economies of scale", said Fu Wenbiao, chairman of the
merged company.
For many years, China has looked to foster its semiconductor industry to
make it more competitive against rivals in Japan, Taiwan and Korea. Until
now, the only main competitor to companies like Taiwan Semiconductor
Manufacturing Co. and United Microelectronics Corp. – the world's two
biggest contract-chip manufacturers by revenue – was SMIC. But over
the past few years, SMIC has failed to upgrade its production technology,
putting the company in the red.

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In a bid to boost its chip industry, China has also given tax breaks to
foreign companies that are looking to set up advanced manufacturing
facilities in the mainland to take advantage of lower manufacturing costs.
Discussion Questions:
1. How can mergers and acquisitions help companies to achieve
economies of scale?
2. While the above example relates to the semiconductor industry, how
could business firms achieve economies of scale in sectors such as
the food processing sector and the voice-based business process
outsourcing sector?
(Source: The Wall Street Journal, 30th December 2011)
Hint: With the help of the theoretical concepts build your views in this
case study.

References:
 Benham F., (1960), Economics: A general introduction, Sir Isaac Pitman
& Sons.
 Marshall, Alfred (1920), Principles of Economics, 8th edition, Macmillan &
Co.
 Stonier Alfred William, & Hague Douglas Chalmers., (1980), A textbook
of economic theory, Edition 5, Longman.

E-Reference:
 www.economictimes.com – retrieved on 30th December 2011

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Unit 6 Cost Analysis


Structure:
6.1 Introduction
Case Let
Objectives
6.2 Types of Costs
6.3 Cost-Output Relationship: Cost Function
6.4 Cost-Output Relationships in the Short Run
6.5 Cost-Output Relationships in the Long Run
6.6 Summary
6.7 Glossary
6.8 Terminal Questions
6.9 Answers
6.10 Case Study
Reference/E-Reference

6.1 Introduction
In the previous unit, we learnt that output does not always increase
proportionately, with increase in the quantity of inputs employed in the
production process. We also learnt that certain tools exist to determine the
optimal combinations of inputs which can be employed to produce the
desired level of output. We saw that large scale production has some
advantages and disadvantages and, we also learnt about the various
economies that emerge with changes in internal and external conditions. As
production involves the use of inputs which are scarce, costs are incurred by
the business firm while producing and delivering a good or service. As the
primary objective of business firms is profit maximisation, costs need to be
controlled. In this unit, we shall explore topics in cost analysis and learn
about how firms can manage their costs. Costs are analysed from the
producer’s point of view. Cost estimates are made in terms of money. Cost
calculations are indispensable for management decisions.
In the production process, a producer employs different factor inputs. These
factor inputs are to be compensated by the producer for the services in the
production of a commodity. The compensation is the cost. The value of
inputs required in the production of a commodity determines the cost of

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output. Cost of production refers to the total monetary expenses (Both


explicit and implicit) incurred by the producer in the process of transforming
inputs into outputs. In short, it refers to total money expenses incurred to
produce a particular quantity of output by the producer. The knowledge of
various concepts of costs, cost-output relationship, etc. occupies a
prominent place in cost analysis.

Case Let (Continued from Unit 5)


In the previous unit, we learnt that Ramesh was asked to prepare a
production plan for the proposed expansion of production facilities of his
firm. Accordingly, Ramesh prepared the plan and submitted it to his
superior who browsed through the report. Subsequently, he called
Ramesh and told him that while the production plan had focused
adequately on technological issues and issues such as logistics, supply
chain for sourcing of inputs, etc, the report had missed out on the issue of
costs. Ramesh had completely overlooked the impact of increase in
production capacities and production quantities on the costs of
production. Ramesh replied that production costs would increase with
increase in production quantities. To this, Ramesh’s superior said that he
would be interested in knowing the impact of the proposals on the
average cost of production. Ramesh began exploring ways to assess the
impact of his proposals on costs of production.

Objectives:
After studying this unit, you should be able to:
 define concepts of production costs and assess their managerial
applications
 apply the short run and long run cost-output relationships in arriving at
the production decision
The case study is connected to the concepts of the said unit making the
reader in advance to understand the concepts and their relationship which
are to be covered.
Managerial uses of cost analysis
A detailed study of cost analysis is very useful for managerial decisions. It
helps the management to do the following:
1. Classify costs of production based on their nature

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2. Calculate the most profitable rate of operation of the firm


3. Prescribe the optimum quantity of output to be produced and supplied
4. Estimate in advance the cost of business operations
5. Apply methods of cost estimation
We will discuss the types of cost and its relationship with the output under
the influence of different factors, in the following sections.

6.2 Types of Costs


In this section we will discuss the types of costs. The types of costs are as
follows:
1. Money cost and real cost – When cost is expressed in terms of money,
it is called as money cost. It relates to money outlays by a firm on various
factor inputs to produce a commodity. In a monetary economy, all kinds of
cost estimations and calculations are made in terms of money only. Hence,
the knowledge of money cost is of great importance in economics. Exact
measurement of money cost is possible.
When cost is expressed in terms of physical or mental efforts put in by a
person in the making of a product, it is called as real cost. It refers to the
physical, mental or psychological efforts, the exertions, sacrifices, the pains,
the discomforts, displeasures and inconveniences which various members
of the society have to undergo to produce a commodity. It is a subjective
and relative concept and hence exact measurement is not possible.
2. Implicit or imputed costs and explicit costs – Explicit costs are those
costs which are in the nature of contractual payments and are paid by an
entrepreneur to the factors of production [excluding himself] in the form of
rent, wages, interest and profits, utility expenses, and payments for raw
materials, etc. They can be estimated and calculated exactly and recorded
in the books of accounts.
Implicit or imputed costs are implied costs. They do not take the form of
cash outlays and as such do not appear in the books of accounts. They are
the earnings of owner-employed resources. For example, the factor inputs
owned by the entrepreneur himself like capital that can be utilised by him or
can be supplied to others for a contractual sum. It is to be remembered that
the total cost is a sum of both implicit and explicit costs.

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3. Actual costs and opportunity costs – Actual costs are also called as
outlay costs, absolute costs and acquisition costs. They are those costs that
involve financial expenditures at some time and hence, are recorded in the
books of accounts. They are the actual expenses incurred for producing or
acquiring a commodity or service by a firm, for example, wages paid to
workers, expenses on raw materials, power, fuel and other types of inputs.
They can be exactly calculated and accounted without any difficulty.
Opportunity cost of a good or service is measured in terms of revenue which
could have been earned by employing that good or service in some other
alternative uses. In other words, opportunity cost of anything is the cost of
displaced alternatives or costs of sacrificed alternatives. It implies that
opportunity cost of anything is the alternative that has been foregone.
Hence, they are also called as alternative costs. Opportunity cost represents
only sacrificed alternatives. Hence, they can never be exactly measured and
recorded in the books of accounts.
The knowledge of opportunity cost is of great importance to managerial
decision-making. The concept of opportunity cost helps in taking decisions
to select the best alternative. While taking a decision among several
alternatives, a manager selects the best one which is more profitable or
beneficial by sacrificing other alternatives. For example, a firm may decide
to buy a computer which can do the work of 10 labourers. If the cost of
buying a computer is much lower than that of the total wages to be paid to
the workers over a period of time, it will be a wise decision. On the other
hand, if the total wage bill is much lower than that of the cost of the
computer, it is better to employ workers instead of buying a computer. Thus,
a firm has to take a number of decisions almost daily.
4. Direct costs and indirect costs – Direct costs are those costs which can
be specifically attributed to a particular product, a department, or a process
of production. For example, expenses on raw materials, fuel, wages to
workers, salary to a divisional manager, etc are direct costs. On the other
hand, indirect costs are those costs, which are not traceable to any one unit
of operation. They cannot be attributed to a product, a department or a
process. For example, expenses incurred on electricity bill, water bill,
telephone bill, administrative expenses, etc.

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5. Past and future costs – Past costs are those costs which are spent in
the previous periods. On the other hand, future costs are those which are to
be spent in the future.
6. Fixed costs and variable costs – Fixed costs are those costs which do
not vary with either expansion or contraction in output. They remain
constant irrespective of the level of output. They are positive even if there is
no production. They are also called as supplementary or overhead costs.
On the other hand, variable costs are those costs which directly and
proportionately increase or decrease with the level of output produced; they
are also called as prime costs or direct costs.
7. Marginal and incremental costs – Marginal cost refers to the cost
incurred on the production of another or one more unit. It implies the
additional cost incurred to produce an additional unit of output.
Incremental cost on the other hand refers to the costs involved in the
production of a batch or group of output. They are the added costs due to a
change in the level or nature of business activity. For example, cost involved
in the setting up of a new sales depot in another city or, cost involved in the
production of 100 extra units.
8. Accounting costs and economic costs – Accounting costs are those
costs which are already incurred on the production of a particular
commodity. It includes only the acquisition costs. They are the actual costs
involved in the making of a commodity. On the other hand, economic costs
are those costs that are to be incurred by an entrepreneur on various
alternative programmes. It involves the application of opportunity costs in
decision making.
Determinants of costs
Cost behaviour is the result of many factors and forces. But it is very difficult
to determine in general, the factors influencing costs, as they widely differ
from firm to firm and even industry to industry. However, economists have
given some factors considering them as general determinants of costs. They
have enough importance in modern businesses and decision making
processes. The following factors deserve our attention in this connection:
1. Technology – Modern technology leads to optimum utilisation of
resources, avoidance of all kinds of wastages, saving of time, reduction

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in production costs and results in higher output. On the other hand,


primitive technology would lead to higher production costs.
2. Rate of output (degree of utilisation of the plant and machinery) –
Complete and effective utilisation of all kinds of plants and equipments
would reduce production costs while, under-utilisation of existing plants
and equipments would lead to higher production costs.
3. Size of Plant and scale of production – Big companies with huge plant
and machineries organise production on large scale basis and enjoy
economies of scale which reduce the cost per unit.
4. Prices of factor inputs – Higher market prices of various factor inputs
result in higher cost of production and vice-versa.
5. Efficiency of factors of production and the management – Higher
productivity and efficiency of factors of production would lead to lower
production costs and vice-versa.
6. Stability of output – Stability in production would lead to optimum
utilisation of the existing capacity of plants and equipments. It also
brings savings of various kinds of hidden costs of interruption and
learning leading to higher output and reduction in production costs.
7. Law of returns – Increasing returns would reduce cost of production
and diminishing returns would increase costs.
8. Time period – In the short run, cost will be relatively high and in the
long run, it will be low as it is possible to undertake adjustments and
readjustments in production process.
Thus, many factors influence cost of production of a firm.

6.3 Cost-Output Relationship: Cost Function


In this section, we will discuss the cost-output relationship, i.e., the cost
function. Cost and output are correlated. Cost-output relations play an
important role in almost all business decisions. It throws light on cost
minimisation or profit maximisation and optimisation of output. The relation
between the cost and output is technically described as the “cost function”.
The significance of cost-output relationship is so great that in economic
analysis, the cost function usually refers to the relationship between cost
and rate of output alone and we assume that all other independent variables

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are kept constant. Mathematically speaking TC = f (Q) where TC = Total


cost and Q stands for output produced.
However, cost function depends on three important variables. These
variables are as follows:
1. Production function – If a firm is able to produce higher output with a
little quantity of inputs, in that case, the cost function becomes cheaper and
vice-versa.
2. The market prices of inputs – If market prices of different factor inputs
are high in that case, cost function becomes higher and vice-versa.
3. Period of time – Cost function becomes cheaper in the long run and it
would be relatively costlier in the short run.
These variables govern the behaviour of the cost function.
Types of cost functions
Generally speaking, there are two types of cost functions, namely, short run
cost function and long run cost function.

6.4 Cost-Output Relationships in the Short Run


In this section, we will discuss the cost-output relationship in the short run. It
is interesting to note that the relationship between the cost and output is
different at two different periods of time i.e. short-run and long run.
Generally speaking, cost of production will be relatively higher in the short-
run when compared to the long run. This is because a producer will get
enough time to make all kinds of adjustments in the productive process in
the long run than in the short run. When cost and output relationship is
represented with the help of diagrams, we get short run and long run cost
curves of the firm. Now we shall make a detailed study of cost output
relations both in the short-run as well as in the long run.
Meaning of short run
Short-run is a period of time in which only the variable factors can be varied
while fixed factors like plant, machinery, etc. remain constant. Hence, the
plant capacity is fixed in the short run. The total number of firms in an
industry will remain the same. Time is insufficient either for the entry of new
firms or exit of the old firms. If a firm wants to produce greater quantities of

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output, it can do so only by employing more units of variable factors or by


having additional shifts, or by having overtime work for the existing labour
force or by intensive utilisation of existing stock of capital assets, etc.
Hence, short run is defined as a period where adjustments to changed
conditions are only partial.
The short run cost function relates to the short run production function. It
implies two sets of input components: (a) fixed inputs and (b) variable
inputs. Fixed inputs are unalterable. They remain unchanged over a period
of time. On the other hand, variable factors are changed to vary the output
in the short run. Thus, in the short period, some inputs are fixed in amount
and a firm can expand or contract its output only by changing the amounts
of other variable inputs. The cost-output relationship in the short run refers
to a particular set of conditions where the scale of operations is limited by
the fixed plant and equipment. Hence, the costs of the firm in the short run
are divided into fixed cost and variable costs. We shall study these two
concepts of costs in some detail.
Fixed costs
These costs are incurred on fixed factors like land, buildings, equipments,
plants, superior type of labour, top management, etc. Fixed costs in the
short run remain constant because the firm does not change the size of
plant and the amount of fixed factors employed. Fixed costs do not vary with
either expansion or contraction in output. These costs are to be incurred by
a firm even if output is zero. Even if the firm closes down its operations for
some time temporarily in the short run, but remains in business, these costs
have to be borne by it. Hence, these costs are independent of output and
are referred to as unavoidable contractual cost.
Prof. Marshall called fixed costs as supplementary costs. They include items
such as contractual rent payment, interest on capital borrowed, insurance
premiums, depreciation and maintenance allowances, administrative
expenses like manager’s salary or salary of the permanent staff, property
and business taxes, license fees, etc. They are called as overhead costs
because these costs are to be incurred whether there is production or not.
These costs are to be distributed on each unit of output produced by a firm.
Hence, they are called as indirect costs.

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Variable costs
The costs corresponding to variable factors are discussed as variable costs.
These costs are incurred on raw materials, ordinary labour, transport,
power, fuel, water, etc, which directly vary in the short run. Variable costs
directly and proportionately increase or decrease with the level of output. If a
firm shuts down for some time in the short run; then it will not use the
variable factors of production and therefore, will not incur any variable costs.
Variable costs are incurred only when some amount of output is produced.
Total variable costs increase with increase in the level of production and
vice-versa. Prof. Marshall called variable costs as prime costs or direct costs
because the volume of output produced by a firm depends directly upon
them.
It is clear from the above description that production costs consist of both
fixed as well as variable costs. The difference between the two is
meaningful and relevant only in the short run. In the long run, all costs
become variable because all factors of production become adjustable and
variable in the long run.
However, the distinction between fixed and variable costs is very significant
in the short run because it influences the average cost behaviour of the firm.
In the short run, even if a firm wants to close down its operations but wants
to remain in business, it will have to incur fixed costs but it must cover at
least its variable costs.
Cost-output relationship and nature and behaviour of cost curves in
the short run
In order to study the relationship between the level of output and
corresponding cost of production, we have to prepare the cost schedule of
the firm. A cost-schedule is a statement of variations in costs resulting from
variations in the levels of output. It shows the response of costs to changes
in output. Table 6.1 represents a hypothetical cost schedule of a firm.

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Table 6.1: Hypothetical Cost Schedule

Output TFC TVC TC AFC AVC AC MC


in Units in Rs. in Rs. in Rs. in Rs. in Rs. In Rs. in Rs.
0 360 – 360 – – – –
1 360 180 540 360 180 540 180
2 360 240 600 180 120 300 60
3 360 270 630 120 90 210 30
4 360 315 675 90 78.75 168.7 45
5
5 360 420 780 72 84 156 105
6 360 630 990 60 105 165 210

On the basis of the cost schedule, we can analyse the relationship between
changes in the level of output and costs of production. If we represent the
relationship between the two in a graphical manner, we get different types of
cost curves in the short run.
In the short run, we will study the following kinds of cost concepts and cost
curves.
Total fixed cost (TFC)
TFC refers to total money expenses incurred on fixed inputs like plant,
machinery, tools and equipments in the short run. Total fixed cost
corresponds to the fixed inputs in the short run production function. TFC
remains the same at all levels of output in the short run. It is the same even
when output is nil. It indicates that whatever may be the quantity of output,
whether 1 to 6 units, TFC remains constant. Figure 6.1 depicts the total
fixed cost curve. The TFC curve is horizontal and parallel to OX-axis,
showing that it is constant regardless of output per unit of time. TFC starts
from a point on Y-axis indicating that the total fixed cost will be incurred
even if the output is zero. In our example, Rs. 360 is the TFC. It is obtained
by summing up the product or quantities of the fixed factors multiplied by
their respective unit price.

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TFC = TC - TVC.

Cost of production
TFC
360

X
0
Output
Figure 6.1: Total Fixed Cost Curve

Total Variable Cost (TVC)


TVC refers to total money expenses incurred on the variable factor inputs
like raw materials, power, fuel, water, transport and communication, etc, in
the short run. Total variable cost corresponds to variable inputs in the short
run production function. It is obtained by summing up the quantities of
variable inputs multiplied by their prices. The formula to calculate TVC is as
follows. TVC = TC - TFC. TVC = f (Q), i.e., TVC is an increasing function of
output. In other words TVC varies with output. It is nil, if there is no
production. Thus, it is a direct cost of output. Figure 6.2 depicts the total
variable cost curve. TVC rises sharply in the beginning, gradually in the
middle and sharply at the end in accordance with the law of variable
proportions. The law of variable proportions explains that in the initial
stages, to obtain a given quantity of output, the relative change (variation) in
variable factors that are needed are in lower proportion, but after a point
when the diminishing returns operate, variable factors are to be employed in
a larger proportion to increase the same level of output.
TVC curve slope upwards from left to right. TVC curve rises as output is
expanded. When output is zero, TVC also will be zero. Hence, the TVC
curve starts from the origin.

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TVC = TC - TFC

Cost of production
Y

TVC

0 X
Output

Figure 6.2: Total Variable Cost Curve

Total cost (TC)


Total cost refers to the aggregate money expenditure incurred by a firm to
produce a given quantity of output. The total cost is measured in relation to
the production function by multiplying the factor quantities with their prices.
TC = f (Q) which means that TC varies with output. Theoretically speaking,
TC includes all kinds of money costs, both explicit and implicit cost. Normal
profit is included in the total cost as it is an implicit cost. It includes fixed as
well as variable costs. Hence, TC = TFC +TVC. Figure 6.3 depicts the total
cost curve.
TC varies in the same proportion as TVC. In other words, a variation in TC
is the result of variation in TVC since TFC is always constant in the short
run.

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TC
Y TC = TFC + TVC
TVC
Cost of production

360 TFC

0 x
Output

Figure 6.3: Total Cost Curve

Total cost curve rises upwards from left to right. In our example, the TC
curve starts from Rs. 360 because even if there is no output, TFC is a
positive amount. TC and TVC have the same shape because an increase in
output increases them both by the same amount since TFC is constant. TC
curve is derived by adding up vertically the TVC and TFC curves. The
vertical distance between TVC curve and TC curve is equal to TFC and is
constant throughout because TFC is constant.
Average fixed cost (AFC)
Average fixed cost is the fixed cost per unit of output. When TFC is divided
by total units of output, AFC is obtained, Thus, AFC = TFC/Q. Figure 6.4
depicts the average fixed cost curve.
Y
Cost of Production

Figure 6.4: Average Fixed Cost Curve

AFC

0 X
Output

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AFC and output have inverse relationship. It is higher at smaller levels and
lower at higher levels of output in a given plant. The reason is simple to
understand. Since AFC = TFC/Q, it is a pure mathematical result that the
numerator remaining unchanged, the increasing denominator causes
diminishing cost. Hence, with the increase in output, TFC spreads over each
unit of output. Consequently, AFC diminishes continuously. This relationship
between output and fixed cost is universal for all types of business
concerns.
The AFC curve has a negative slope. The curve slopes downwards
throughout the length. The AFC curve goes very nearer to X axis, but never
touches the X-axis. Graphically, it will fall steeply in the beginning, gently in
middle and tend to become parallel to OX-axis. Mathematically speaking, as
output increases, AFC diminishes. But AFC will never become zero because
the TFC is a positive amount. AFC will never fall below a minimum amount
because in the short run, plant capacity is fixed and output cannot be
expanded to an unlimited extent.
Average variable cost (AVC)
The average variable cost is variable cost per unit of output. AVC can be
computed by dividing the TVC by total units of output. Thus, AVC = TVC/Q.
The AVC will come down in the beginning and then rise as more units of
output are produced with a given plant. This is because, as we add more
units of variable factors in a fixed plant, the efficiency of the inputs first
increases and then decreases. Figure 6.5 depicts the average variable cost
curve.
The AVC curve is a U-shaped cost curve. It has three phases.
AVC = TVC / Q
Y
Cost of production

AVC C
A

B

X
0 Output

Figure 6.5: Average Variable Cost Curve

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a) Decreasing phase – In the first phase from A to B, AVC declines. As the


output expands, the AVC declines because when we add more quantity of
variable factors to a given quantity of fixed factors, output increases more
efficiently and more than proportionately due to the operation of increasing
returns.
b) Constant phase – In the II phase, i.e. at B, AVC reaches its minimum
point. When the proportion of both fixed and variable factors are ideal, the
output will be optimal. After the firm operates at its normal full capacity,
output reaches its zenith and as such AVC will reach its minimum point.
c) Increasing phase – In the III phase, from B to C, AVC rises. After the
normal capacity is crossed, the AVC rises sharply. This is because
additional units of variable factors will not result in more than proportionate
output. Hence, greater output may be obtained but at much greater AVC. It
is clear that as long as increasing returns operate, AVC falls and when
diminishing returns set in, AVC tends to increase.
Average total cost (ATC) or average cost (AC)
AC refers to cost per unit of output. AC is also known as the unit cost since
it is the cost per unit of output produced. AC is the sum of AFC and AVC.
Average total cost or average cost is obtained by dividing the total cost by
total output produced. AC = TC/Q. Also, AC is the sum of AFC and AVC.
In the short run, AC curve also tends to be U-shaped. The combined
influence of AFC and AVC curves will shape the nature of AC curve. Figure
6.6 depicts the average cost curve.
ATC = AFC + AVC
Y
Cost of production

A AC

C

B
X
0 Output
Figure 6.6: Average Cost Curve

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As we observe, average fixed cost begins to fall with an increase in output


while average variable cost declines and subsequently rises. As long as the
falling effect of AFC is much more than the rising effect of AVC, the AC
tends to fall. At this stage, increasing returns and economies of scale
operate and complete utilisation of resources forces the AC to fall.
When the firm produces the optimum output, AC drops to its minimum. This
is called as least–cost output level. Again, at the point where the rise in AVC
exactly counterbalances the fall in AFC, the balancing effect causes AC to
remain constant.
In the third stage, when the rise in average variable cost is more than drop
in AFC, then the AC shows a rise, When output is expanded beyond the
optimum level of output, diminishing returns set in and diseconomies of
scale starts operating. At this stage, the indivisible factors are used in sub-
optimal proportions. Thus, AC starts rising in the third stage.
The short run AC curve is also called as “plant curve”. It indicates the
optimum utilisation of a given plant or optimum plant capacity.
Marginal cost (MC)
Marginal Cost may be defined as the net addition to the total cost as one
more unit of output is produced. In other words, it implies additional cost
incurred to produce an additional unit. For example, if it costs Rs. 100 to
produce 50 units of a commodity and Rs. 105 to produce 51 units, then MC
would be Rs. 5. It is obtained by calculating the change in total costs as a
result of a change in the total output. Also, MC is the rate at which total cost
changes with output. Hence, MC =  TC /  TQ. Where,  TC stands for
change in total cost and  TQ stands for change in total output. Also MCn =
TCn –TC n-1
It is necessary to note that MC is independent of TFC and it is directly
related to TVC as we calculate the cost of producing only one unit. In the
short run, the MC curve also tends to be U-shaped.
The shape of the MC curve is determined by the laws of returns. If MC is
falling, production will be under the conditions of increasing returns and if
MC is rising, production will be subject to diminishing returns. Figure 6.7
depicts the marginal cost curves.

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Cost of production

A MC

C
B

0 X
Output

Figure 6.7: Marginal Cost Curve

Table 6.2 indicates the relationship between AC and MC.


Table 6.2: Relationship between Average Cost and Marginal Cost

Output in Units TC in Rs. AC in Rs. Difference MC (Rs.)


1 150 150 –
2 190 95 40
3 220 73.3 30
4 236 59 16
5 270 54 34
6 324 54 54
7 415 59.3 91
8 580 72.5 165

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Relation between AC and MC


Figure 6.8 depicts the relationship between average cost and marginal cost.

AC

MC
Cost


AC=MC

X
Output

Figure 6.8: Relationship between Average cost and Marginal Cost

From the diagram, it is clear that:


1. Both MC and AC fall up to a certain range of output and rise afterwards.
2. When AC falls, MC also falls but at certain range of output, MC tends to
rise even though AC continues to fall. However, MC would be less than
AC. This is because MC is attributed to a single unit whereas in the
case of AC, the decreasing AC is distributed over all the units of output
produced.
3. As long as AC is falling, MC is less than AC. Hence, MC curve lies
below AC curve. It indicates that the fall in MC is more than the fall in
AC. MC reaches its minimum point before AC reaches its minimum.
4. When AC is rising, after the point of intersection, MC will be greater than
AC. This is because in case of MC, the increasing MC is attributed to a
single unit, whereas in case of AC, the increasing AC is distributed over
all the output produced.
5. So long as the AC is rising, MC is greater than AC. Hence, MC curve
lies to the left side of the AC curve. It indicates that rise in MC is more
than the rise in AC.

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6. MC curve intersects the AC curve at the minimum point of the AC curve.


This is because, when MC decreases, it pulls AC down and when MC
increases, it pushes AC up. When AC is at its minimum, it is neither
being pulled down nor being pushed up by the MC. Thus, when AC is
minimum, MC = AC. The point of intersection indicates the least cost
combination point or the optimum position of the firm. At output Q, the
firm is working at its “optimum capacity” with lowest AC. There is scope
for “maximum capacity” with rising cost, beyond Q.
Thus we have discussed the cost-output relationship in the short run.

6.5 Cost-Output Relationship in the Long Run


In this section, we will discuss the cost output relationship in the long run.
Long run is defined as a period of time where adjustments to changed
conditions are complete. It is actually a period during which the quantities of
all factors, variable as well as fixed factors, can be adjusted. Hence, there
are no fixed costs in the long run. In the short run, a firm has to carry on its
production within the existing plant capacity, but in the long run, it is not tied
up to a particular plant capacity. If demand for the product increases, it can
expand output by enlarging its plant capacity. It can construct new buildings
or hire them, install new machines, employ administrative and other
permanent staff. It can make use of the existing as well as new staff in the
most efficient way and, there is lot of scope for transforming indivisible
factors into divisible factors. On the other hand, if demand for the product
declines, a firm can cut down its production permanently. The size of the
plant can also be reduced and other expenditure can be minimized. Hence,
production cost comes down to a greater extent in the long run.
As all costs are variable in the long run, the total of these costs is the total
cost of production. Hence, the distinction between fixed and variables costs
in the total cost of production will disappear in the long run. In the long run,
only the average total cost is important and considered in taking long term
output decisions.
Long run average cost is the long run total cost divided by the level of
output. In brief, it is the per-unit cost of production of different levels of
output by changing the size of the plant or scale of production.

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The long run cost–output relationship is explained by drawing a long run


cost curve through short–run curves as the long period is made up of many
short–periods just as the day is made up of 24 hours and a week is made
out of 7 days. This curve explains how costs will change when the scale of
production is varied. Figure 6.9 depicts a long run average cost curve.

LAC

SAC 1
Cost of Production

SAC 2
SAC 3
SAC 4 SAC 5

0 Output Q X
Q

Figure 6.9: Changes in Cost with Variations on Scale of Production

The long run-cost curves are influenced by the law of returns to scale as
against the short run cost curves which are subject to the working of law of
variable proportions.
In the short run, the firm is tied with a given plant and as such, the scale of
operation remains constant. There will be only one AC curve to represent
one fixed scale of output in the short run. In the long run, as it is possible to
alter the scale of production, one can have as many AC curves as there are
changes in the scale of operations.
In order to derive LAC curve, one has to draw a number of SAC curves,
each curve representing a particular scale of output. The LAC curve will be
tangential to the entire family of SAC curves. It means that it will touch each
SAC curve at its minimum point.

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Production cost in short run and long run


Figure 6.10 depicts the production cost in the short run and in the long run.

SAC 2 SAC 1 SAC 3

LAC
Cost of Production

K3
K1

 
L1  L3
L2

0 X
M1 M2 M3
Output

Figure 6.10: Production Cost Curves

In the diagram, the LAC curve is drawn on the basis of three possible plant
sizes. Consequently, we have three different SAC curves – SAC1, SAC2
and SAC3. They represent three different scales of output. For output OM2,
the AC will be L2M2 in the short run as well as the long run.
When output is to be expanded to OM3, it can be obtained at a higher
average cost of production. K3M3 is the short run AC because scale of
production would remain constant in the short run. But the same output of
OM3 can be produced at a lower AC of L3M3 in the long run since the scale
of production can be modified according to the requirements. The distance
between K3L3 represent difference between the cost of production in the
short run and long run.
Similarly, when output is contracted to OM1 in the short run, K1M1 will
become the short run AC and L1M1 will be the long run AC. Hence, K1L1
indicates the difference between short run and long run cost of production.
If we join points L1, L2 and L3 we get LAC curve.

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Important features of long run AC curves


The important features of long run AC curves are as follows:
1. Tangent curve – Different SAC curves represent different operational
capacities of different plants in the short run. LAC curve is the locus of all
these points of tangency. The SAC curve can never cut a LAC curve
though they are tangential to each other. This implies that for any given level
of output, no SAC curve can ever be below the LAC curve. Hence, SAC
cannot be lower than the LAC in the long run. Thus, LAC curve is tangential
to various SAC curves.
2. Envelope curve – It is known as envelope curve because it envelops a
group of SAC curves appropriate to different levels of output.
3. Flatter U-shaped or dish-shaped curve – The LAC curve is also U
shaped or dish-shaped cost curve. But it is less pronounced and much
flatter in nature. LAC gradually falls and rises due to economies and
diseconomies of scale.
4. Planning curve – The LAC curve is described as the planning curve of
the firm because it represents the least cost of producing each possible
level of output. This helps in producing optimum level of output at the
minimum LAC. This is possible when the entrepreneur is selecting the
optimum scale plant. Optimum scale plant is that size where the minimum
point of SAC is tangent to the minimum point of LAC.
5. Minimum point of LAC curve – It should be always lower than the
minimum point of SAC curve. The LAC curve will touch the optimum plant
SAC curve at its minimum point.
A rational entrepreneur would select the plant of optimum scale. Optimum
scale plant is that size at which SAC is tangent to LAC, such that both the
curves have the minimum point of tangency. In the diagram, OM2 is
regarded as the optimum scale of output, as it has the least per unit cost. At
OM2 output LAC = SAC.
LAC curve will be tangent to SAC curves lying to the left of the optimum
scale or right side of the optimum scale. But at these points of tangency,
neither LAC nor SAC is at its minimum. SAC curves are either rising or
falling indicating a higher cost.

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Managerial use of LAC


The study of LAC is of great importance in managerial decision making
process. Few examples that quote the importance of studying LAC in the
managerial decision making process, are as follows:
1. It helps the management in the determination of the best size of the
plant to be constructed or, in getting the minimum cost output for a new
plant.
2. The LAC curve helps a firm to decide the size of the plant to be adopted
for producing the given output. For outputs less than cost lowering
combination at the optimum scale i.e., when the firm is working subject
to increasing returns to scale, it is more economical to use a slightly
large plant operating at less than its minimum cost – output than to use
a smaller unit. Conversely, at output beyond the optimum level, i.e.
when the firm experiences decreasing returns to scale, it is more
economical to use a slightly smaller plant than to use a slightly larger
one. Thus, it explains why it is more economical to use a slightly small
plant rather than to use a large plant.
3. LAC is used to show how a firm determines the optimum size of the
plant. An optimum size of plant is one that helps in best utilisation of
resources in the most economical manner.
Thus we have discussed features, importance and use of long run average
costs.

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Long run marginal cost


Figure 6.11 depicts the long run marginal cost curve.

LMC LAC

SMC 3
E

SMC 1 SAC 3
Cost of Production

SAC 1 D
SMC
A 2
SAC 2

B
C

0 X
N Q R
Output

Figure 6.11: Long Run Marginal Cost Curve

A long-run marginal cost curve can be derived from the long-run average
cost curve. Just as the SMC is related to the SAC, similarly the LMC is
related to the LAC and, therefore, we can derive the LMC directly from the
LAC. In the diagram we have taken three plant sizes and the corresponding
three SAC and SMC curves. The LAC curve is drawn by enveloping the
family of SAC curves. The points of tangency between the SAC and the
LAC curves indicate different outputs for different plant sizes.
If the firm wants to produce ON output in the long run, it will have to choose
the plant size corresponding to SAC1. The LAC curve is tangent to SAC1 at
point A. For ON output, the average cost is NA and the corresponding
marginal cost is NB. If LAC curve is tangent to SAC1 curve at point A, the
corresponding LMC curve will have to be equal to SMC1 curve at point B.
The LMC will pass through point B. In other words, where LAC is equal to
SAC curve (for a given output) the LMC will have to be equal to a given
SMC.

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If output OQ is to be produced in the long run, it will be done at point C


which is the point of tangency between SAC2 and the LAC. At point C, the
short –run average cost (SAC2) and the short-run marginal cost (SMC2) are
equal and, therefore, the LAC for output OQ is QC and the corresponding
LMC is also QC. The LMC curve will, therefore pass through point C.
Finally, for output OR, at point D the LAC is tangent to SAC3. For OR output
at point E, LMC is passing through SMC3. By connecting points B, C and E,
we can draw the long-run marginal cost curve.
Costs of production: formulae
TC = Cost per unit x Total production. Or TC = TFC + TVC
TFC = (TC – TVC) or (AFC x Q)
TVC = (TC – TFC) or (AVC x Q) or addition of MC
AFC = (AC – AVC) or (TFC/Q)
AVC = (AC – AFC) or (TVC/Q)
AC = (AFC + AVC) or (TC/Q)
MC = (TCn - TCn-1) or ( TC /  TQ)

6.6 Summary
Let us recapitulate the important concepts discussed in this unit:
 Cost analysis indicates the various amounts of costs incurred to produce
a particular quantity of output in monetary terms.
 The various kinds of cost concepts help a manager to take right
decisions. Cost function explains the relationship between the amounts
of costs to be incurred to produce a particular quantity of output.
 Short run cost function gives information about the nature and behaviour
of various cost curves. Long run cost function tells us how it is possible
to obtain more output at lower costs in the long run.
 Thus, the knowledge of both production function and cost functions help
a business executive to work out the best possible factor combinations
to maximise output with minimum costs.

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6.7 Glossary
Average cost: Cost per unit of output.
Average fixed cost: Fixed cost per unit of output.
Average variable cost: Variable cost per unit of output.
Cost function: Technical relationship between the cost and output.
Fixed costs: These are costs that do not vary with either expansion or
contraction in output.
Marginal cost: Additional cost incurred to produce an additional unit of
output. Net addition to the total cost as one more unit of output is produced.
Opportunity cost: Revenue which could have been earned by employing
that good or service in some other alternative uses.
Total cost: The aggregate money expenditure incurred by a firm to produce
a given quantity of output.
Total fixed cost: Total money expenses incurred on fixed inputs like plant,
machinery, tools and equipments in the short run.
Total variable cost: Total money expenses incurred on the variable factor
inputs like raw materials, power, fuel, water, transport and communication,
etc., in the short run.
Variable costs: Costs which directly and proportionately increase or
decrease with the level of output produced.

Self Assessment Questions


1. Opportunity cost of anything is the alternative that has been _____.
2. Marginal cost deals with changes in cost of ______ unit where as
incremental cost deals with changes in cost of ________.
3. AC minus AVC would give us _________.
4. Total cost includes ___________ profits.
5. Marginal cost is associated with _________ costs.
6. In the long run, all costs are ______________.
7. Average total cost increases if marginal cost is greater than average
total cost. (True/False)
8. Marginal cost measures how total cost changes when input prices
change. (True/False)

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9. A fixed cost is a cost the firm must pay even if output is zero.
(True/False)
10. A short-run cost function assumes that all inputs are fixed in supply
(True/False)

Activity:
Go to a local manufacturer producing goods for local consumption like tin
boxes, baskets, etc and find out how the manufacturer ascertains the
market price for his product after taking into consideration the costs of
manufacturing.

6.8 Terminal Questions


1. Give a brief description of the following:
a. Implicit and explicit cost
b. Actual and opportunity cost
2. Discuss the various determinants of costs.
3. Explain cost output relationship with reference to:
a. Total fixed cost and output
b. Total variable cost and output
4. Explain features of LAC curve with a diagram.

6.9 Answers

Self Assessment Questions


1. foregone
2. One, a group of units
3. AFC
4. Normal
5. Variable
6. Variable
7. True
8. False
9. True
10. False

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Terminal Questions
1. a. Explicit costs are those costs which are in the nature of contractual
payments and are paid by an entrepreneur to the factors of
production. Explicit cost are the earnings of owner-employed
resources Refer to section 6.2.
b. Actual cost are those costs that involve financial expenditures at
some time and hence, are recorded in the books of accounts.
Opportunity cost of anything is the cost of displaced alternatives or
costs of sacrificed alternatives. Refer to section 6.2.
2. The following factors deserve our attention in this connection:
technology, rate of output, size of Plant and scale of production, prices
of factor inputs. Refer to section 6.2.
3. a. Fixed costs in the short run remain constant because the firm does
not change the size of plant and the amount of fixed factors
employed.
b. The costs corresponding to variable factors are discussed as
variable costs. Refer to section 6.4.
4. The important features of long run AC curves are as follows: tangent
curve, envelope curve, flatter U-shaped or dish-shaped curve,
planning curve Refer to section 6.5.

6.10 Case Study

It May Get Worse for Aluminium


Kunal Bose
The market remains in the habit of springing surprises, occasionally
brutal. Otherwise, who could have thought as late as September that
aluminium, the metal next only to steel in production and use, would sink
below $2,000 a tonne in the third week of November to come close to its
lowest since July 2010? This is a shocker, as in the first nine months of
2011, aluminium realised an average price of $2,498 a tonne, about 18
per cent up year-on-year.

No doubt at prevailing prices, a large swathe of capacity has become


unprofitable to run. Estimates of loss making capacity range from 25 per
cent, according to Russia’s Rusal, to RBS banking group saying nearly

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half the world’s aluminium producers are not able to recover costs. What
is going to save the day for Hindalco, in the midst of major capacity
expansion of both alumina and aluminium and the largely government-
owned National Aluminium Company (Nalco), through with its second
phase of expansion, is that they remain in the lowest cost quartile of
global aluminium production costs. In recent periods, however, Nalco has
come under pressure because Mahanadi Coalfields, with which it has
mines linkage, has repeatedly tripped in redeeming supply commitments.
When Nalco buys coal through e-auction to bridge supply shortfall, it
pays up to three times more than what is charged by Mahanadi
Coalfields.

Cost effectiveness of a smelter depends largely on what price it gets


electricity and also whether it has ownership of bauxite mines. The
average share of electricity in aluminium production costs across the
world is 25 per cent, with the high of 40 per cent in China. Even while
Nalco’s electricity capacity of 1,200 Mw is in excess of power
requirements of its 460,000 tonne smelter, intermittent shortfall in coal
supply from the designated agency is not allowing the company to reap
full benefits of captive power.

This is happening at a time when aluminium prices are found to be well


below the world industry’s marginal cost of production. Tom Albanese,
CEO of Rio Tinto, which got its portfolio hugely expanded on its takeover
of Alcan in 2007, says “For the near term, I am concerned about general
softening of prices when we continue to see cost escalation.” Rio’s
problem got compounded by appreciating currencies in Canada and
Australia, where it has a majority of its operations.

Discussion Questions:
1. What can business firms do in such cases where they are unable to
recover their production costs due to uncontrollable factors?
2. Analyse the factors that influence costs in commodity-based
industries as compared to factors that influence costs incurred by
firms in the information technology sector.
(Source: Business Standard, New Delhi, December 6, 2011)
Hint: Use the theoretical concept and answer the questions

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Reference:
 Marshall, Alfred (1920), Principles of Economics, 8th edition, Macmillan
and Co.
 Business Standard, New Delhi, December 6, 2011

E-Reference:
 www.economictimes.com – retrieved on December 6th 2011

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Unit 7 Objectives of Firms


Structure:
7.1 Introduction
Case Let
Objectives
7.2 Profit Maximisation Model
7.3 Economist Theory of the Firm
7.4 Cyert and March’s Behaviour Theory
7.5 Marris’ Growth Maximisation Model
7.6 Baumol’s Static and Dynamic Models
7.7 Williamson’s Managerial Discretionary Theory
7.8 Summary
7.9 Glossary
7.10 Terminal Questions
7.11 Answers
7.12 Case Study
Reference/E-Reference

7.1 Introduction
In the previous unit, we learnt cost analysis. Cost analysis indicates the
various amounts of costs incurred to produce a particular quantity of output
in monetary terms. The various kinds of cost concepts help a manager to
take right decisions. Cost function explains the relationship between the
amounts of costs to be incurred to produce a particular quantity of output.
In this unit, we will discuss objectives of firms. A business firm is an
economic unit. It is a producing unit. It converts inputs into outputs. It is a
legal entity on the basis of ownership and contractual relationships
organised for production and sale of goods and services. All business units
are set up and managed by people and are called by various names like
shops, firms, enterprise, production and business concerns etc. They can
take several forms like sole trader, partnership concern, joint-stock
company, cooperatives or even public utilities. They produce and supply
different goods and services for the direct satisfaction of consumers.

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Each firm lays down its own objectives. They are fundamental to the very
existence of a firm. The objectives are the end-point towards which rational
activity is carried out. They indicate the very existence of a firm and guide
the actions of a firm. They indicate how a firm has to organise its activities
and perform its functions.
A modern business unit has multiple objectives and they are multi-
dimensional in nature. Some of them are competitive while others are
supplementary in nature. A few other objectives are mutually interconnected
and a few others are opposing in nature. These objectives are determined
by various factors and forces like corporate environment, socio-economic
conditions, the nature of power in the organisation and extraneous
conditions, and constraints under which a firm operates.

Case Let (Continued from Unit 6)


In the previous unit, we saw that Ramesh was asked to analyse the
changes in costs due to increase in production. Ramesh undertook the
cost analysis and presented the report to his superior. Ramesh had had
to rely on various estimates of costs to prepare his report. He realised
that it was practically very difficult to estimate the costs of some fixed
factors and variable factors and he had to rely on ballpark information/
data. Upon reading the report, Ramesh’s superior asked him to provide
estimates of revenue at different production and sales levels by
considering the sale price of various traverse rods which were sought to
be produced. While preparing his report, Ramesh met Akshay, who was
a consultant in business strategy. Akshay asked Ramesh about the
short-term and long-term goals and objectives of Ramesh’s firm. Ramesh
could not respond adequately and, this led him to realise that although he
was an employee of his firm for quite some time now, he was unaware of
the objectives of his firm. This set him thinking on why business firms
exist.

Objectives:
After studying this unit, you should be able to:
 explain the background under which a firm lays down its multiple
objectives

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 explain how modern business units have several objectives instead of


having a single objective
 analyse how profit-maximisation is the basic objective of a firm
 determine the suitable objectives from amongst the many objectives that
could be adopted by a firm
Economists, over a period of time, have developed various theories and
models to explain different kinds of goals of modern firms. Broadly speaking
they can be divided in to three groups. They are as follows:
1. Profit maximisation model
2. Managerial theories or models
3. Behavioural theories or models
Let us study some of the important theories under each category.

7.2 Profit Maximisation Model


In this section, we will discuss the profit maximisation model. Profit-making
is one of the most traditional, basic and major objectives of a firm. Profit-
motive is the driving force behind all business activities of a company. It is
the primary measure of success or failure of a firm in the market. Profit
earning capacity indicates the position, performance and status of a firm in
the market. In spite of several changes and development of several
alternative objectives, profit maximisation has remained as one of the single
most important objectives of the firm, even today.
Both small and large firms consistently make an attempt to maximise their
profit by adopting novel techniques in business. Specific efforts have been
made to maximise output and minimise production and other operating
costs. Cost reduction, cost cutting and cost minimisation has become the
slogan of a modern firm.
The profit maximisation model is a very simple and unambiguous model. It
is the ideal model to explain the normal behaviour of a firm.
Main propositions of the profit-maximisation model
The model is based on the assumption that each firm seeks to maximise its
profit given certain technical and market constraints. The following are the
main propositions of the model:

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1. A firm is a producing unit which converts various inputs into outputs of


higher value, by employing certain techniques of production.
2. The basic objective of each firm is to earn maximum profit.
3. A firm operates under given market conditions.
4. A firm selects that alternative course of action which helps to maximise
consistent profits.
5. A firm attempts to change its prices, input and output quantity to
maximise its profit.
The model
Profit-maximisation implies earning highest possible amount of profit during
a given period of time.
A firm should always give optimum productivity in order to get a huge
amount of profit both in the short run and long run depending upon various
factors like internal and external. The short run and long run objectives
should always be balanced. In the short run, a firm is able to make only
slight or minor adjustments in the production process as well as in business
conditions. The plant capacity in the short run is fixed and as such, it can
increase its production and sales by intensive utilisation of existing plants
and machineries, having overtime work for the existing staff, etc.
Thus, in the short run, a firm has its own technical and managerial
constraints. But in the long run, as there is plenty of time at the disposal of
a firm, it can expand and add to the existing capacities; build new plants;
employ additional workers; etc. to meet the rising demand in the market.
Thus, in the long run, a firm will have adequate time and ample opportunity
to make all kinds of adjustments and readjustments in production process
and in its marketing strategies.
It is to be noted with great care that a firm has to maximise its profits after
considering various factors. Such factors include:
1. Pricing and business strategies of rival firms and their impact on the
working of the given firm.
2. Aggressive sales promotion policies adopted by rival firms in the
market.
3. Demands of workers for payment of higher wages and salaries leading
to rise in operation costs.

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4. Government controls and takeovers on monopolistic and exploitative


business practices.
5. Maintaining the quality of the product and services to the customers.
6. Taking various kinds of risks and uncertainties in the changing
business environment.
7. Adopting a stable business policy.
8. Avoiding any sort of conflict between short run and long run profits in
the business policy and maintaining proper balance between them.
9. Maintaining the firm’s reputation, name, fame and image in the market.
10. Profit maximisation is necessary in both perfect and imperfect markets.
In a perfect market, a firm is a price-taker and under imperfect market,
it becomes a price-searcher.
A firm has to ensure that these factors do not get violated by any policy
adopted by the firm for maximising its profits.
Assumptions of the model
The profit maximisation model is based on three important assumptions.
They are as follows:
1. Profit maximisation is the main goal of the firm.
2. Rational behaviour on the part of the firm to achieve its goal of profit
maximisation.
3. The firm is managed by owner-entrepreneur.
Determination of profit – maximising price and output
Profit maximisation of a firm can be explained in two different ways.
a) Total revenue and total cost approach
b) Marginal revenue and marginal cost approach
Let us discuss the approaches in detail.
TR and TC approach
Profits of a firm are estimated by comparing total revenue and total costs.
Profit is the difference between TR and TC. In other words, excess of
revenue over costs is the profits. Profit = TR – TC. If TR is equal to TC, in
that case, there will be breakeven point. If TR is less than TC, in that case,
a firm will be incurring losses.
MR and MC approach
In this case, we compare the revenue earned from one additional unit and
cost incurred to produce one additional unit of output. A firm will be

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maximising its profits when MR = MC and MC curve cuts MR curve from


below. If MC curve intersects the MR curve from above, either under perfect
market or under imperfect market, then undoubtedly MR equals MC but,
total output will not be maximised and hence total profits also will not be
maximised. Hence, two conditions are necessary for profit maximisation:
1. MR = MC
2. MC curve intersects MR curve from below
It is clear from the following diagrams. Figures 7.1 and 7.2 depict the two
conditions necessary for profit maximisation, respectively.
Y

MC
Cost/Revenue

P P1
  MR

0 X

Q Output Q1

Figure 7.1: Cost/Revenue Curve: “MR = MC”

Y MC

N
Cost / Revenue


N1

MR

a0 X
Q Output Q1

Figure 7.2: Cost/Revenue Curve: “MC Intersecting MR from Below”

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Justification for profit maximisation


The model for profit maximisation can be justified on account of the
following reasons:
1. Basic objective of traditional economic theory – The traditional
economic theory assumes that a firm is owned and managed by the
entrepreneur himself and, the entrepreneur always aims at maximum
return on his capital invested in the business. Hence, profit-maximisation
becomes the natural principle of a firm.
2. Firm is not a charitable institution – A firm is a business unit. It is
organised on commercial principles. A firm is not a charitable institution.
Hence, it has to earn reasonable amount of profits.
3. Most realistic prediction of price-output behaviour – This model
helps to predict usual and general behaviour of business firms in the real
world as it provides a practical guidance. It also helps in predicting the
reasonable behaviour of a firm with more accuracy. Thus, it is a very
simple, plain, realistic, pragmatic and most useful hypothesis in
forecasting price output behaviour of a firm.
4. Necessary for survival – It is to be noted that the very existence and
survival of a firm depends on its capacity to earn maximum profits. It is
a time-honoured hypothesis and, there is common agreement among
businessmen to make highest possible profits both in the short run and
long run.
5. Achievement of other objectives – In recent years, several other
objectives have become much more popular and all these objectives
have become highly relevant in the context of modern business setup.
But it is to be remembered that they can be achieved only when a firm is
making maximum profits for e.g., a firm, in the initial stages of its
operations, may focus on maximising its market share by lowering its
prices and offering attractive entry offers to customers. Similarly, at other
points of time, the business firm may take decisions to maximise returns
over the long run (or value) while even compromising on immediate
profits, e.g., through mergers and acquisitions.

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Criticisms
There are certain short-comings in this model for which it has received
criticism. The reasons for criticism of the model are as follows:
1. Ambiguous term – The term profit maximisation is ambiguous in
nature. There is no clear cut explanation whether a firm has to
maximise its net profit, total profit or the rate of profit in a business unit.
Again, maximum amount of profit cannot be precisely defined in
quantitative terms.
2. It may not always be possible – Profit maximisation, no doubt, is the
basic objective of a firm. However, in the context of highly competitive
business environment, it may not be always possible for a firm to
achieve this objective. Other objectives like sales maximisation,
market share expansion, market leadership, building its own image,
name, fame and reputation, spending more time with members of the
family, enjoying leisure, developing better and cordial relationship with
employees and customers etc. also, have assumed greater
significance in recent years.
3. Separation of ownership and management – In many cases, we
come across business units which are organised on partnership or are
joint-stock companies or organised on cooperative basis. In case of
many large organisations, ownership and management is clearly
separated and they are run and managed by salaried managers who
have their own self interests and as such, profit maximisation may not
become possible.
4. Difficulty in getting relevant information and data – In spite of
revolution in the field of information technology, it may not be always
possible to get adequate and relevant information to take right
decisions in a highly fluctuating business scenario. Hence, profits may
not be maximised.
5. Conflict in inter-departmental goals – A firm has several
departments and sections headed by experts in their own fields. Each
of the departments will have its own independent goals and frequently,
there is a possibility of clashes between the interests of different
departments and profits may always not be maximised.

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6. Changes in business environment – In the context of highly


competitive and changing business environment and changes in
consumers’ tastes and requirements, a firm may not be able to cope
up with the expectations and adjust its policies and, profits may not be
maximised.
7. Growth of oligopolistic firms – In the context of globalisation, growth
of oligopoly firms has become so common through mergers,
amalgamations and takeovers. Leading firms dominate the market and
the small firms have to follow the policies of the leading firms. Hence,
in many cases, there are limited chances for making maximum profits.
8. Significance of other managerial gains – Salaried managers have
limited freedom in decision making process. Some of them are unable
to forecast the right type of changes and meet market challenges.
They are more worried about their salaries, promotions, perquisites,
security of jobs, and other types of benefits. They may lack strong
motivation to generate higher profits as profits would go to the
organisation. They may be contented with only satisfactory level of
profits rather than maximum profits.
9. Emphasis on non-profit goals – Many organisations stress on the
achievement of non-profit goals. From the point of view of today’s
business environment, productivity, efficiency, better management,
customer satisfaction, durability of products, higher quality of products
and services, etc. have gained importance to cope with business
competition. Hence, emphasis has shifted from profit maximisation to
other practical aspects.
10. Aversion to reduction in power – In case of several small
businesses, the owners do not want to share their powers with many
new partners and hence, they try to keep maximum powers in their
hands. In such cases, retaining more power becomes more important
than profit maximisation.
11. Official restrictions over profits of public utilities – Public utilities
or public corporations are legally prohibited to make huge profits in
many developing countries like India.
Thus, it is clear that a firm cannot maximise its profits always. There are
many constraints in the background of multiple objectives. Each one of the

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objectives has its own merits and demerits and a firm has to strike a balance
between all kinds of objectives.
The objectives and criticisms can be addressed with examples in two or
three places.

Self Assessment Questions


1. In _____________ model, the important assumption is that the
entrepreneur aims at maximising his profits.
2. _________ is the point where the firm has stopped incurring losses but
is yet to start gaining profit.
3. The full form of TR is ___________.
4. Profit maximisation is the most common and basic objective of
business firms. (True/False)
5. Sales maximisation automatically leads to profit maximisation.
(True/False)

7.3 Economist Theory of the Firm


In this section, we will discuss the economist theory of the firm. According to
the economist theory of the firm, a firm is a producing unit. It transforms or
converts all kinds of inputs into outputs. The basic function of a firm is to
produce those goods and services which are demanded by consumers in
the market. A firm is a business unit and it is organised on commercial
principles. By producing and selling different goods and services, the firm
aims at making profits.
According to this theory, a traditional firm is a group with a particular
organisational and management structure, having command over its own
property rights. It is a legal entity on the basis of ownership and contractual
relationship organised for production and sale of goods and services. In
olden days, a firm was called by various names such as shops, firms,
enterprise, production and business concerns, etc., but today, it is organised
on various forms like a sole trader, partnership concern, joint-stock
company, cooperative society, etc.

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A firm is formed, run and managed by an owner, employer or an


entrepreneur who has the following characteristics:
1. He has the legal permission to run an enterprise.
2. He can enter into contract with any group of people who supply
productive resources.
3. He can take his own decisions to maximise his economic gains.
4. He is entitled to enjoy the residual income after making payments to all
productive resources in the form of rent, wages and salaries and
interest.
5. He can transfer his rights and obligations to other individuals on the
basis of contracts.
6. He can direct and dictate the suppliers of productive resources in the
desired manner by entering into legal contracts.
7. He can change the nature of management according to his
convenience.
8. He has all the rights to make changes in his organisation which he feels
the best. He can consult others or he can take his own final decisions.
The traditional or classical firm basically engages itself in various kinds of
economic activities which help in maximising its profits. It concentrates on
wealth creation and through it, surplus creation. Surplus value is nothing but
the difference between the value of the final product and the value of
various inputs employed in the production process. Surplus generation is
possible when the firm produces maximum output with minimum costs.
Hence, a firm works out the ideal factor combination to avoid all kinds of
wastages, cut down costs and maximise its output. When the firm produces
maximum output with minimum costs, it reaches the equilibrium position.
This is possible when marginal revenue is equal to marginal cost. At the
equilibrium point, it is said that a firm will be maximising its profits. The
nature of working of a firm depends on several factors like number of firms
in the market, size of the firm, volume of production, entry and exit of firms,
degree of competition, existence of alternative substitutes, prices of goods,
etc.
Thus, the traditional or the classical firm aims at profit maximisation and
over the years, this objective has been replaced by profit optimisation.

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Self Assessment Questions


6. According to the economist theory of the firm, a firm is a ____ unit,
which converts input into output and while doing so, tries to create
surplus value.
7. The firm aiming for profit maximisation reaches its equilibrium only
when it produces _________.
8. Business decisions are made to cope with _____.
9. An entrepreneur is an individual who primarily bears the risk of the
enterprise. (True/False)
10. The level of output where MC = MR is the point where profits are
maximum. (True/False)

7.4 Cyert and March’s Behaviour Theory


In this section we will discuss about the behaviour theory. It is another
alternative non-profit maximising theory that has been developed by Cyert
and March. The theory makes an attempt to explain the behaviour of inter-
group conflicts and their multiple objectives in an organisation. Basically,
this theory explains the usual and normal behaviour of different groups of
people who work in an organisation having mutually opposite goals.
Prof. Simon has developed the initial behavioural model and, Prof. Cyert
and March have further elaborated the theory, in their book “Behavioural
Theory of the Firm”, published in 1963.
Cyert and March explain how complicated decisions are taken in big
industrial houses under various kinds of risks and uncertainties in an
imperfect market in the background of limited data and information. The
organisational structure, goals of different departments, behavioural pattern
and internal working of a big and multi-product firm differs from that of small
organisations. The various kinds of internal conflicts and problems faced by
these organisations would certainly affect the decision-making process of
these organisations. They also explain how there are certain common
problems faced by similar organisations in an industry and their effects on
the internal working of each individual organisation and their decision
making processes.

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Cyert and March consider the modern firm as a multi-product, multi-goal and
multi-decision making coalition business unit. Like a coalition government, it
is managed by a number of groups. The group consists of shareholders,
managers, workers, customers, suppliers, distributors, financiers, legal
experts, etc. Each group is independent by itself and has its own set of
objectives and they try to maximise their individual benefits. For example,
shareholders expect faster growth of the company and higher dividends;
workers expect maximum wages and minimum work, better working
conditions, welfare measures; managers want higher salary, greater power,
autonomy in day to day working, dominance, control, etc; suppliers expect
quick and immediate payments, etc. Contributions made by each one of the
group is equally important in carrying out the activities of a firm. In their
view, out of several groups, the most important ones are the shareholders,
workers and managers in an organisation.
It is quite clear that goals of each one of the group is multiple, conflicting
and opposite in their nature. Each one of the group, based on their past
experiences and success and, availability of limited resources at the
disposal of a firm, would arrange their demand on the basis of priorities.
Most urgent demands are highlighted and low priority demands are
postponed to later periods. The management may honour a few demands of
a few groups and postpone the demands of other groups in view of financial
constraints. This may create heart-burns and conflict between different
groups in the same organisation.
If actual performance and achievements of the organisation is much better
than expected aspirations and target level, there will be an upward revision
in their demands and vice-versa. Thus, there is a strong linkage between
the expected and actual demand of each group in the organisation, past
success and future environment. Each group makes an attempt to achieve
its demand in its own way. Through the process of hard bargaining, a
winning coalition is formed and the broad objectives are set out by the
management.
Cyert and March suggest the following methods to overcome the conflicts of
different groups and enable smooth working of the organisation. They are as
follows - Demands of each group may be separated from that of the other
and separate attempts must be made to fulfil them so that their impact on

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the whole organisation may be avoided. For example, they would grant
higher monetary rewards for various factor inputs like higher wages, salaries
and bonus to workers, grant of other perquisites to keep them happy. They
may also grant side payments to different departments to carry on their work
smoothly, e.g. more funds may be released to R&D for buying computers,
equipments, etc; share holders may be granted higher dividends; managers
given more powers, more autonomy, higher salaries, lavish and luxurious
air-conditioned offices, vehicles, and various kinds of facilities to keep them
happy. They are called as slack payments. The management may follow the
policy of sequential attention. The management may also tackle the problem
by decentralising the decision making process.
Cyert and March are of the opinion that out of several objectives, a firm has
five important goals. They are as follows:
1. Production goal – Production is to be organised on the basis of
demand in the market. Neither should there be overproduction nor
underproduction but a quantity that is just adequate to meet the market
demand. Development of excess capacity, over-utilisation of capital
assets and lay-off of workers, etc should be avoided.
2. Inventory goal – Inventory refers to stock of various inputs. In order to
ensure continuity in production and supply, a certain minimum level of
inventory has to be maintained by a firm. Neither surplus stock nor
shortage of different inputs should occur. Proper balance between
demand and supply is to be maintained.
3. Sales goal – There should be adequate sales in any organisation to
earn reasonable amount of profits. In order to create demand, sales
promotion policies may be adopted from time to time.
4. Market-share goal – Each firm has to make consistent effort to increase
its market share to compete successfully with other firms and make
sufficient profits.
5. Profit goal – This is one of the basic objectives of any firm. The very
survival and success of the firm would depend upon the volume of
profits earned by it.

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The above mentioned objectives would undergo changes over a period of


time in the background of modern business environment. Hence, decision
making would become complex and complicated.
It is quite clear that each business organisation has its own set of goals.
These goals would depend on the ever-changing demands of different
groups who have their own conflicting objectives.
Demerits
The demerits of Cyert and March’s behaviour theory are as follows:
1. The theory fails to analyse the behaviour of the firm, but it simply
predicts the future expected behaviour of different groups.
2. It does not explain equilibrium of the industry as a whole.
3. It fails to analyse the impact of the potential entry of new firms into the
industry and the behaviour of the well-established firms in the market.
4. It highlights short run goals rather than long run objectives of an
organisation.
Thus, there are certain limitations to this theory.

Self Assessment Questions


11. _______ is related to demand of sales management and sales
decision.
12. _______ is related to price and resource allocation decisions.
13. _______ works as a shock absorber.
14. _______ and ___ types of resolving conflicts are qualitative.
15. Cyert and March point out that the coalition group has multiple, _____
and ________ goals.

7.5 Marris’ Growth Maximisation Model


In this section, we will discuss the growth maximisation model by Prof.
Marris. Profit-maximisation is a traditional objective of a firm. Sales
maximisation objective is explained by Prof. Baumol. On similar lines, Prof.
Marris has developed an alternative growth maximisation model. It is
commonly seen that each firm aims at maximising its growth rate, because
this goal would answer many of the objectives of a firm. Marris points out
that a firm has to maximise its balanced growth rate over a period of time.

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Marris assumes that the ownership and control of the firm is in the hands of
two groups of people, i.e., owners and managers. He further points out that
both of them have two distinctive goals. Managers have a utility function in
which the amount of salary, status, position, power, prestige, security of job,
etc., are the most important variables whereas, owners are more concerned
about the size of output, volume of profits, market share, sales
maximisation, etc.
Utility function of the owners and that of the managers are expressed in the
following manner –
Uo = f [size of output, market share, volume of profit, capital, public esteem
etc.] Um = f [salaries, power, status, prestige, job security, etc.]
Where, Uo is the utility function of owner and Um is the utility function of
managers.
Marris notes that the realisation of these two functions would depend on the
size of the firm. Larger the firm, greater would be the realisation of these
functions and vice-versa. Size of the firm, according to Marris, depends on
the amount of corporate capital, which includes total volume of assets,
inventory levels, cash reserves, etc. He further points out that managers
always aim at maximising the rate of growth of the firm rather than
maximising the growth in absolute size of the firm. Generally, managers like
to stay in a growing firm. A higher growth rate of the firm satisfies the
promotional opportunities of managers and also the shareholders, as they
earn more dividends.
Marris identifies two constraints in the rate of growth of a firm as follows:
1. There is a limit up to which the output of a firm can be increased more
economically, limit to manage the firm efficiently, limit to employ highly
qualified and experienced managers, limit to research, development and
innovation, etc.
2. The ambition of job security puts a limit to the growth rate of the firm
itself, deliberately. If growth reaches the maximum, then there would be
no opportunity to expand further and then the managers may lose their
jobs. Rapid growth and financial soundness should go together.
Managers hesitate to take unwanted risks and uncertainties in the
organisation at the cost of their jobs. They would like to avoid risky

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investment projects, concentrate on generating more internal funds and


invest more resources on only those products and services which bring
more profits. Hence, managers would like to ensure their job security
through adoption of a cautious and prudent financial policy.
He further points out that a high risk-loving management would like to
maintain a relatively low amount of cash on hand and invest more on
business, borrow more external funds and invest more in business
expansion and, keep low profit levels. On the other hand, a highly risk-
averse management may have an exactly opposite policy. Ultimately, it is
the job security which puts a constraint on business decisions by the
managers.
The Marris’ growth maximisation model highlights the achievement of a
balanced growth rate of a firm. Maximum growth rate [g] is equal to two
important variables:
1. The rate of demand for the products [gd]
2. Growth rate of capital[gc]
Hence, Max g = gd = gc.
The growth rate of the firm depends on two factors- a] the rate of
diversification and b] the average profit margin.
The diversification rate depends on the number of new products introduced
per unit of time and the rate of success of new products in the market. The
success of new products is determined by changes in fashion, consumption
habits, the range of products offered, etc. Moreover, diminishing marginal
returns would operate in any business and thereafter, there is a limit to
diversification. Similarly, market price of the given product, availability of
alternative substitute products and their relative prices, publicity,
propaganda and advertisements, R&D expenses, utility and comparative
value of the product, etc. would decide the profit ratio. Higher expenditure
on sales promotion and R&D would certainly reduce profits level as there
are limits to them.
The rate of capital growth is determined by either issue of new shares to
obtain additional funds and external funds and generation of more internal
surplus. Generally, a firm would select the last one to avoid higher degrees
of risks in the business.

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The Marris’ model states that in order to maximise balanced growth rate or
reach equilibrium position, there should be equality between the growth rate
in demand for the products and growth rate in supply of capital. This implies
the satisfaction of the following three conditions:
1. The management has to maintain a low liquidity ratio, i.e., liquid asset /
total assets. But, this ratio should not create any financial
embarrassment to meet the required payments to all the concerned
parties.
2. The management has to maintain a proper leverage ratio between value
of debts / total assets, so that it will have enough money to invest in
order to stimulate growth.
3. The management has to keep a high level of retained profits for further
expansion and development but it should not displease the shareholders
Retained Profits
i.e. by giving low dividends.
Total Profits

In this case, the managers would maximise their utility function and the
owners would maximise their utility functions. The managers are able to get
their job security with a high rate of growth of the firm and shareholders
would be satisfied as they receive higher dividends.
Demerits
There are some demerits of Marris’ growth maximisation model. They are as
follows:
1. It is doubtful whether both managers and owners would maximise their
utility functions simultaneously, always.
2. The assumption of constant price and production costs are not correct.
3. It is difficult to achieve both growth maximisation and profit maximisation
together.
Thus, Marris’ growth maximisation model also has some drawbacks.

Self Assessment Questions


16. According to ________ modern firms are managed by both the
manager and the shareholders (owners).
17. In _______, the objective of the firm is balanced growth.

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18. In Marris’ growth maximisation model, the manager tries to maximise


his satisfaction and his satisfaction lies in the ______.
19. In ______ relationship, growth determines profit.

7.6 Baumol’s Static and Dynamic Models


In this section, we will discuss the static and the dynamic models by Prof.
W. J. Baumol. Sales maximisation model is an alternative model for profit
maximisation. This model is developed by Prof. W. J. Baumol, an American
economist. This alternative goal has assumed greater significance in the
context of the growth of Oligopolistic firms. The model highlights that the
primary objective of a firm is to maximise its sales rather than to maximise
its profits. It states that the goal of the firm is maximisation of sales revenue
subject to a minimum profit constraint. The minimum profit constraint is
determined by the expectations of the shareholders. This is because no
company can displease the shareholders. Here, it is to be noted that
maximisation of sales does not mean maximisation of physical sales but
maximisation of total sales revenue. Hence, the managers are more
interested in maximising sales rather than profit. The basic philosophy is
that, when sales are maximised, profits of the company would also go up.
Hence, in recent years, in the context of highly competitive markets,
attention is diverted towards increasing the sales of the company.
In defence of this model, the following arguments are given:
1. Increase in sales and expansion in its market share is a sign of healthy
growth of a normal company.
2. It increases the competitive ability of the firm and enhances its influence
in the market.
3. The amount of slack earnings and salaries of the top managers are
directly linked to it.
4. It helps in enhancing the prestige and reputation of top management, in
distributing more dividends to share holders and in increasing the wages
of workers to keep them satisfied.
5. The financial and other lending institutions always keep a watch on the
sales revenues of a firm, as it is an indicator of financial health of a firm.
6. It helps the managers to pursue a policy of steady performance with
satisfactory levels of profits rather than spectacular profit maximisation
over a period of time. Managers are reluctant to take up those kinds of
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projects which yield high level of profits while having a high degree of
risk and uncertainty. The risk-averse managers prefer to select those
projects which ensure steady and satisfactory levels of profits.
Prof. Baumol has developed two models. The first is the static model and
the second one is the dynamic model.
The static model
This model is based on the following assumptions:
1. The model is applicable to a particular time period
2. The firm aims at maximising its sales revenue subject to a minimum
profit constraint.
3. The demand curve of the firm slopes downwards from left to right.
4. The average cost curve of the firm is U-shaped.
With the help of the figure 7.3, we can explain sales maximisation model
subject to a minimum profit constraint.
TC
Y M Q


TC, TR, PROFIT

TR

Operative

Profit
Constraint

s L
P2 N P2

P1  P1
Non Operative
R K Profit
Constraint
P P

0
X1 X2 X3
Output
Profit curve
Figure 7.3: Sales Maximisation Model
At OX1 level of output, when profit is at maximum, TR is much in excess of
TC. If the firm chooses to produce OX3 output, profit will fall to X3K though
the TR is still in excess of TC. Profit constraint is less at OX 2 level of output
as the firm earns X2N profit. Depending upon the market conditions, a firm
can determine the level of output with minimum profit constraint.
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Sales maximisation [dynamic model]


In the real world, many changes take place which affect business decisions
of a firm. In order to include such changes, Baumol has developed another
model, the dynamic model. This model explains how changes in
advertisement expenditure, a major determinant of demand, would affect the
sales revenue of a firm under severe competition.
Assumptions
There are some assumptions in Baumol’s dynamic model. They are as
follows:
1. Higher advertisement expenditure would certainly increase sales
revenue of a firm.
2. Market price remains constant.
3. Demand and cost curves of the firm are conventional in nature.
Generally, under competitive conditions, a firm in order to increase its
volume of sales and sales revenue would go for aggressive advertising. This
leads to a shift in the demand curve to the right. Forward shift in demand
curve implies increased advertising expenditure resulting in higher sales and
sales revenue. A price cut may increase sales in general but increase in
sales mainly depends on whether the demand for a product is price-elastic
or price-inelastic. A price reduction policy may increase its sales only when
the demand is elastic and if the demand is inelastic; such a policy would
have adverse effects on sales. Hence, to promote sales, advertisements
have become an effective instrument today. It is the experience of most of
the firms that with an increase in advertisement expenditure, sales of the
company would also go up. A firm that maximises sales would generally
incur higher amounts of advertisement expenditure than a firm that
maximises profit. However, it is to be remembered that the amount allotted
for sales promotion should bring more-than-proportionate increase in sales
and total profits of a firm. Otherwise, it will have a negative effect on
business decisions.
Thus, by introducing a non-price variable into his model, Baumol makes a
successful attempt to analyse the behaviour of a competitive firm under
oligopoly market conditions. Under oligopoly conditions, as there are only a
few big firms competing with each other, producing either similar or
differentiated products, the firms would resort to extensive advertising as an

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effective means to increase their sales and sales revenue. This appears to
be more practical in the present day situation.

Activity:
Select any advertisement company and identify the advertisement
expenditure, sales revenue of a firm and market price of its products.

Self Assessment Questions


20. Sales maximisation model is an alternative for ____ model.
21. Baumol thinks managers are more interested in maximising ___ rather
than profit.
22. In oligopoly market structure, the firms compete more in terms of
advertisement, product variations, etc. rather than ____.

7.7 Williamson’s Managerial Discretionary Theory


In this section, we will discuss the managerial discretionary theory by Prof.
O. Williamson. He has developed a highly useful and most practical
managerial utility model to explain goals of a business firm in recent years.
In many organisations, we can see that when a firm achieves a certain
amount of growth, the top managers concentrate their attention on
maximising their self-interest and allow the growth rate to continue. Thus,
profit maximisation and managers’ utility maximisation go together.
Assumptions of the model
The managerial discretionary theory is based on the following assumptions:
1. Existence of imperfect markets
2. Ownership and management is separated
3. A minimum level of profit is to be achieved by a firm to pay dividends to
shareholders
Now, let us discuss the model in detail.

The model
Williamson is of the opinion that managers, as a powerful group in any
organisation, have their own set of utility functions. They have certain
expectations and demands. Generally, they aim at maximising their
managerial utility function rather than maximising total profits of the

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company. They feel that a firm is making profits on account of the efforts of
top management and so they are entitled to certain special privileges and
are eligible to enjoy special benefits. The various kinds of managerial
satisfaction includes the degree of freedom and autonomy given to them,
their status, prestige, power enjoyed by them, dominance, professional
excellence, security of their jobs, salary and other perquisites, etc. Out of
these variables, only salary is measurable and all other variables are non-
measurable. In order to measure other variables, Williamson introduces the
concept of “expense preference”. This concept helps to measure the level of
satisfaction which managers would derive from certain types of
expenditures. The managers’ utility function is expressed as U = f [S, M, Id],
where
S = Additional expenditure of staff
M = Managerial Emoluments
Id = Discretionary investment
The additional staff expenditure [S] includes the wages and salaries paid to
the additional staff-members, who have been employed to work under the
top management. Now, managers will have a larger team than before and
can allot the work to new staff as a firm expands. The managers now enjoy
more powers to control their subordinates. Higher wages or salaries are
paid in accordance with their productive ability and professional excellence
which certainly would motivate the workers to work more.
Managerial emoluments [M] include expenses on entertainment, luxurious
air-conditioned office, costly company cars and other allowances given to
managers. It has been pointed out that these expenses are justified by
managers as it would enhance their status, prestige, power, better working
environment and image of the company in the eyes of public, etc. This
would motivate the managers to do their work in a congenial atmosphere
and free manner.
Discretionary power of investment expenditure {Id] includes those
investment expenses which confer certain personal benefits and satisfaction
to managers, for example, expenditure on latest equipments, furniture,
decoration materials, etc. These expenses are expected to elevate the
status and esteem of managers. They satisfy their ego and sense of pride.

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Thus, all these expenditures are made by a firm to keep the managers
happy and motivate them to work more. The above mentioned expenditures
are measurable in terms of money and they can be used as proxy variables
to replace the non-operational concepts like power, status, prestige,
professional excellence, etc. appearing in the managerial utility function.
It is to be noted that all the expenses are included in total cost of operations
of a firm. The profits of the company are measured by taking into account
the total expenses and total revenue earned by a firm. The difference
between the TR and TC would measure the volume of profits. A minimum
amount of profits is required to distribute reasonable dividends to
shareholders. Otherwise, they demand a change in management. This
would create job insecurity to the managers. Hence, they can maximise their
utility functions only when they ensure reasonable profits to a company.
There is no direct relationship between managers’ utility function and better
performance, always. The empirical evidence is not enough for the
verification of the theory. Always, a firm cannot spend more money on only
improvements in the working conditions of managers. It has to look into the
interests of all groups in an organisation.

Self Assessment Questions


23. The expenditure which is incurred by the Manager’s indulgence in a
company car is termed by Williamson as _____.
24. In the equation U f (S, D) , S stands for ____ and D stands for ____.

7.8 Summary
Let us recapitulate the important concepts discussed in this unit:
 This unit provided a brief description of the various alternative objectives
of a firm. The traditional objective is that of profit maximisation. But in
recent years, economists have developed various alternative objectives
to suit the modern business environment.
 The theory of the firm highlights wealth-maximisation or creation of
maximum assets through which it can generate economic surpluses.
The profit maximisation theory stresses on earning maximum amount of
profits by a firm.

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 Cyert and March theory concentrates on the behaviour of various


coalition partners in an organisation and explain how opposite goals of
different groups would affect the decision making of a firm.
 Marris model analyses the rate of growth of a firm by maximising
managers’ powers and status.
 Baumol analyses the impact of advertisement expenditures incurred by
a firm on sales promotion and its impact on total sales revenue of a firm.
Williamson studies the impact of managerial utility functions on the
performance of a firm.
 Thus, a firm has several alternative goals and the selection of particular
goals depends on the management of a firm. It is to be remembered that
all other objectives of a firm can be realised only when a firm is making
reasonable amount of profits. Any organisation has to earn adequate
profits to please the shareholders.
 In order to earn more profits, a firm has to create more wealth, assets
and surpluses, and satisfy the expectations of top managers, workers,
while achieving a high growth rate of the firm. All objectives are
interconnected and supplement one another. Realisation of one
objective would depend on other objectives. Hence, there should be a
proper balance between different objectives.

7.9 Glossary
Ballpark data: An approximation, made with a degree of knowledge and
confidence that the estimated figure falls within a reasonable range of
values.
Baumol’s static and dynamic models: The primary objective of a firm is to
maximise its sales rather than to maximise its profits.
Economist theory of the firm: A traditional firm is a group with a particular
organisational and management structure having command over its own
property rights.
Profit-maximisation: Earning highest possible amount of profit during a
given period of time.

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7.10 Terminal Questions


1. Discuss profit maximising model.
2. Explain economist theory of firm.
3. Analyse Cyert and March’s behaviour theory.
4. Examine the Marris growth maximising model.
5. Critically examine Baumol’s static and dynamic models.

7.11 Answers

Self Assessment Questions

1. Profit Maximisation Model


2. Break Even point
3. Total Revenue
4. True
5. False
6. Transformation
7. Profit maximising output
8. Changes
9. True
10. True
11. Market share goal
12. Profit goal
13. Slack payment
14. Sequential hearing of demand and Decentralisation of decision making
15. Conflicting and opposite
16. Robin Marris
17. Marris Growth Maximisation Model
18. Growth rate of the firm
19. Differentiated diversification
20. Profit maximisation
21. Sales
22. Price
23. Management slack
24. Staff expenditure and discretionary profit

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Terminal Questions
1. Profit-maximisation implies earning highest possible amount of profit
during a given period of time. Refer to section 7.2.
2. Economist theory of a firm transforms or converts all kinds of inputs into
outputs Refer to section 7.3.
3. The theory makes an attempt to explain the behaviour of inter-group
conflicts and their multiple objectives in an organisation Refer to
section 7.4.
4. Marris assumes that the ownership and control of the firm is in the
hands of two groups of people, i.e., owners and managers. Refer to
section 7.5.
5. This model highlights that the primary objective of a firm is to maximise
its sales rather than to maximise its profits Refer to section 7.6.

7.12 Case Study

Cairn to Return $3.5 Billion to Shareholders


New Delhi: UK’s Cairn Energy on Thursday said it would return to
shareholders $3.5 billion or two-thirds of the proceeds from the majority
stake sale of its Indian arm to mining giant ‘Vedanta Resources’. The
new majority shareholder in Cairn India, in the meantime, said it would
strive to double the energy firm’s current capacity. Cairn India now
operates the largest on-shore oil field in the country located in Rajasthan
and has contracts to sell 1,55,000 barrels a day of crude from there.
Cairn Energy said the return of cash is expected to be made in a manner
that will give shareholders an element of choice as to when and in what
form they receive the cash.
This could cheer the Edinburgh explorer’s shareholders who were last
month told that the company failed to make a commercial hydrocarbon
discovery in Greenland in the first exploration phase but was encouraged
by evidence of future success. The company spent about £400 million so
far this year on Greenland exploration.
With Cairn India, Vedanta expands its significant presence in Rajasthan,
where it operates Hindustan Zinc, the world’s largest zinc-lead producer.

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“I am delighted to announce completion of this transaction. It crystallises


the very significant value creation that we have delivered from our Indian
business and allows us to return around three and a half billion dollars to
shareholders,” a Cairn Energy statement said quoting CEO Simon
Thomson.
Discussion Questions:
1. Which objective of Cairn energy is being met by returning the $ 3.5
billion to shareholders?
2. What strategy has Cairn energy adopted to create value from the
Indian business?
(Source: Financial Express, Dec 09, 2011)
Hint: Use the theoretical concept and answer the question

References:
 Baumol W.J, (1985), Economic theory and operational analysis, Prentice
Hall
 Cyert R.M. and March J, (1963), A behavioural theory of the firm,
Prentice Hall
 Simon H.A, (1957), Models of man: Social and Rational, Wiley
 Marris R, (1964). The Economic Theory of Managerial Capitalism,
London: Macmillan.,
 Williamson O, (1963), Managerial Discretion and Business Behaviour,
American Economic Review, 53, 1032-57.
 Financial Express, Dec 09, 2011
E-Reference:
 www.economictimes.com – retrieved on December 9th 2011

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Unit 8 Revenue Analysis and Pricing Policies


Structure:
8.1 Introduction
Case Let
Objectives
8.2 Revenue: Meaning and Types
8.3 Relationship between Revenues and Price Elasticity of Demand
8.4 Pricing Policies
8.5 Objectives of Pricing Policies
8.6 Pricing Methods
8.7 Summary
8.8 Glossary
8.9 Terminal Questions
8.10 Answers
8.11 Case Study
Reference/E-Reference

8.1 Introduction
In the previous unit, we learnt the objectives of firms. The previous unit
provided a brief description of the various alternative objectives of a firm.
The traditional objective is that of profit maximisation. But in recent years,
economists have developed various alternative objectives to suit the modern
business environment. The theory of the firm highlights wealth-maximisation
or creation of maximum assets through which it can generate economic
surpluses. The profit maximisation theory stresses on earning maximum
amount of profits by a firm.
In this unit, we will study revenue analysis and pricing policies. The
awareness of both revenue and cost concepts are important to a managerial
economist. Revenue means the sale receipts of the output produced by the
firm. It depends on the market price. The amount of money, which the firm
receives by the sale of its output in the market, is known as its revenue.

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Case Let (Continued from Unit 7)


In the previous unit, we saw that Ramesh was unable to respond
adequately to Akshay’s query about the purpose of his firm. This led
Ramesh to discuss the issue with his superior. Subsequently, Ramesh
learnt that his firm operated on the basic objective of profit maximisation.
Towards maximising its profits, the firm took various decisions regarding
production, sales and all other functions. Ramesh was now required to
arrive at revenue estimates by considering prices that reflected the profit
maximisation objective. He found that although he was aware of the
existing prices of the traverse rods produced by his firm and by his firm’s
competitors, defining prices for revenue analysis in the future was quite
tough. He had to consider various factors that influenced product price
and revenues.

Objectives:
After studying this unit, you should be able to:
 explain the concepts of revenue
 differentiate between different types of revenues
 identify critically the relationship between total revenue and price
elasticity of demand
 elaborate different types of pricing practices and methods
 evaluate various guidelines for successful pricing policy
 analyse and judge pricing policies’ impact on socio-economic conditions

8.2 Revenue: Meaning and Types


In this section, we will discuss the meaning of revenue along with its types.
Revenue is the income received by the firm. There are three concepts of
revenue – total revenue, average revenue and marginal revenue.
Total Revenue (TR)
Total revenue refers to the total amount of money that the firm receives from
the sale of its products, i.e. .gross revenue.
In other words, it is the total sales receipts earned from the sale of its total
output produced over a given period of time. We may show total revenue as
a function of the total quantity sold at a given price. Figure 8.1 depicts the
graph for total revenue.
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TR = f (Q). It implies that higher the sales, larger would be the TR. Thus,
TR = P X Q. For e.g. a firm sells 5000 units of a commodity at the rate of
Rs. 5 per unit, then TR would be
TR = P x Q = 5 x 5000 = 25,000

TR
Price

0 X
Sales
Figure 8.1: Graph for Total Revenue

Average revenue (AR)


Average revenue is the revenue per unit of the commodity sold. It can be
obtained by dividing the TR by the number of units sold. Then
AR = TR/Q, e.g. If TR is 150 by selling 10 units, AR = 150/15= 10.
Thus, average revenue means price. Since the demand curve shows the
relationship between price and the quantity demanded, it also represents
the average revenue or price at which the various amounts of a commodity
are sold, because the price offered by the buyer is the revenue from the
seller’s point of view. Therefore, average revenue curve of the firm is the
same as demand curve of the consumer.
Therefore, in economics, we use AR and price as synonymous except in the
context of price discrimination by the seller. Mathematically, P = AR.
Marginal Revenue (MR)
Marginal revenue is the net increase in total revenue realised from selling
one more unit of a product. It is the additional revenue earned by selling an
additional unit of output by the seller.
Suppose a firm is selling 4 units of the output at the price of Rs.14 per unit.
Now, if it wants to sell 5 units instead of 4 units and thereby the price of the

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product falls to Rs.12 per unit, then the marginal revenue will not be equal to
Rs.12 at which the 5th unit is sold. 4 units, which were sold at the price of
Rs.14 before, will all have to be sold at the reduced price of Rs.12 and that
will mean the loss of 2 rupees on each of the previous 4 units. The total loss
on the previous units will be equal to Rs. 8. Therefore, this loss of 8 rupees
should be deducted from the price of Rs. 12 of the 5th unit while calculating
the marginal revenue. The marginal revenue in this case, therefore, will be
Rs. 12 – Rs. 8 = Rs. 4 and not Rs. 12 which is the average revenue.
Marginal revenue can also be directly calculated by finding out the
difference between the total revenue before and after selling the additional
unit of the product.
Total revenue when 4 units are sold at the price of Rs.14 = 4 X 14 = Rs. 56
Total revenue when 5 units are sold at the price of Rs.12 = 5 X 12 = Rs. 60
Therefore, Marginal revenue or the net revenue earned by the 5th unit = 60-
56 = Rs.4.
Thus, Marginal revenue of the nth unit = difference in total revenue in
increasing the sale from n-1 to n units or
Marginal revenue = price of nth unit minus loss in revenue on previous units
resulting from price reduction.
The concept is important in microeconomics because a firm's optimal output
(most profitable output) is where its marginal revenue equals its marginal
cost i.e., as long as the extra revenue from selling one more unit is greater
than the extra cost of making it, it is profitable to do so.
It is usual for marginal revenue to fall as output goes up both at the level of
a firm and that of a market because, lower prices are needed to achieve
higher sales or demand respectively.

TR
MR = = where  TR represents change in TR
Q

And  Q indicates change in total quantity sold.


Also MR = TRn – TRn-1

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Marginal revenue is equal to the change in total revenue over the change in
quantity.
Marginal Revenue = (Change in total revenue) divided by (Change in sales)
Table 8.1 represents the price – revenue sheet.

Table 8.1: Price Revenue Sheet

Units Price TR AR MR
1 20 20 20 -
2 18 36 18 16
3 16 48 16 12
4 14 56 14 8
5 12 60 12 4

There is another way to see why marginal revenue will be less than price
when a demand curve slopes downward. Price is average revenue. If the
firm sells 4 units for Rs.14, the average revenue for each unit is Rs.14.00.
But as seller sells more, the average revenue (or price) drops, and this can
only happen if the marginal revenue is below price, pulling the average
revenue down.
If one knows marginal revenue, one can tell what happens to total revenue if
sales change. If selling another unit increases total revenue, the marginal
revenue must be greater than zero. If marginal revenue is less than zero,
then selling another unit reduces total revenue. If marginal revenue is zero,
than selling another unit does not change total revenue. This relationship
exists because marginal revenue measures the slope of the total revenue
curve.
Relationship between total revenue, average revenue and marginal
revenue concepts
In order to understand the relationship between TR, AR and MR, we can
prepare a hypothetical revenue schedule. Table 8.2 represents a
hypothetical revenue schedule that shows the relationship between TR, AR
and MR.

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Table 8.2: Hypothetical Revenue Schedule

Number of TR (Rs.) AR (Rs.) MR (Rs.)


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

From the table, it is clear that:


1. MR falls as more units are sold.
2. TR increases as more units are sold but at a diminishing rate.
3. TR is the highest when MR is zero.
4. TR falls when MR becomes negative.
5. AR and MR both fall, but fall in MR is greater than AR i.e., MR falls more
steeply than AR.
Thus we have discussed the relationship between total revenue, average
revenue and marginal revenue concept.
Relationship between AR and MR and the nature of AR and MR curves
under different market conditions
Now, we will discuss the relationship between AR and MR and the nature of
AR and MR curves under different market conditions.
Under perfect market
Under perfect competition, an individual firm by its own action cannot
influence the market price. The market price is determined by the interaction
between demand and supply forces. A firm can sell any amount of goods at
the existing market prices. Hence, the TR of the firm would increase
proportionately with the output offered for sale. When the total revenue
increases in direct proportion to the sale of output, the AR would remain
constant. As the good’s market price is constant without any variation due
to changes in the units sold by the individual firm, the extra output would

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fetch proportionate increase in the revenue. Hence, MR and AR will be


equal to each other and remain constant. This will be equal to price.
Table 8.3 shows revenue comparison chart under perfect market conditions.
Figure 8.2 shows a graphical representation of the data in table 8.2.
Table 8.3: Revenue Comparison Chart under Perfect Market

Price per Unit Rs. 8.00


Number of Units sold
AR TR MR
1 8 8 8
2 8 16 8
3 8 24 8
4 8 32 8
5 8 40 8
6 8 48 8

AR = MR = Price
Price

X
0 Output

Hence, AR = MR = Price

Figure 8.2: Price Graph under Perfect Market

Under perfect market conditions, the AR curve will be a horizontal straight


line and parallel to OX axis. This is because a firm has to sell its product at
the constant existing market price. The MR curve also coincides with the AR
curve. This is because additional units are sold at the same constant price
in the market.

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Under imperfect market


Under all forms of imperfect markets, the relation between TR, AR, and MR
is different. This can be understood with the help of the following imaginary
revenue schedule.
Table 8.4 shows revenue comparison chart under imperfect market
conditions. Figure 8.3 shows a graphical representation of the data in table
8.4
Table 8.4: Revenue Comparison Chart under Imperfect Market

Number of Units AR or Price in


TR MR
sold Rs.
1 10 10 10
2 18 9 8
3 24 8 6
4 28 7 4
5 30 6 2
6 30 5 0
7 28 4 -2
From table 8.4, it is clear that:
In order to increase the sales, a firm has to reduce its price, hence AR falls.
1. As a result of fall in price, TR increases but at a diminishing rate.
2. TR will be higher when MR is zero
3. TR falls when MR becomes negative
4. AR and MR both decline but, fall in MR will be greater than the fall in AR
5. The relationship between AR and MR curves is determined by the
elasticity of demand on the average revenue curve
Y

REVENUE

AR
MR
X
0
OUTPUT
Figure 8.3: Revenue Graph under Imperfect Market

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Under imperfect market conditions, the AR curve of an individual firm slopes


downward from left to right. This is because; a firm can sell larger quantities
only when it reduces the price. Hence, AR curve has a negative slope.
The MR curve is similar to that of the AR curve, but MR is less than AR. AR
and MR curves are different. Generally, MR curve lies below the AR curve.
The AR curve of the firm or the seller and the demand curve of the buyer
are similar.
Because the demand curve graphically represents the quantities demanded
by the buyers at various prices, it shows the AR at which the various
amounts of goods are sold by the seller. This is because the price paid by
the buyer is the revenue for the seller (One man’s expenditure is another
man’s income). Hence, the AR curve of the firm is the same thing as that of
the demand curve of the consumers. Figure 8.4 depicts the relationship
between the AR curve and the demand curve.
Y
Price

AR / D
0 X
10 a
Quantity
Figure 8.4: Relationship Between AR Curve and Demand Curve

Suppose that a consumer buys 10 units of a product, when the price of the
product is Rs. 5 per unit. Hence, the total expenditure is 10 x 5 = Rs. 50/-.
The seller is selling 10 units at the rate of Rs.5 per unit. Hence, his total
income is 10 x 5 = Rs. 50/-. Thus, it is clear that AR curve and demand
curve are really one and the same.

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8.3 Relationship between Revenues and Price Elasticity of


Demand
In this section, we will discuss the relationship between revenues and price
elasticity of demand.
Elasticity of demand, average revenue and marginal revenue
A very useful relationship exists between elasticity of demand, average
revenue and marginal revenue at any level of output. Elasticity of demand at
any point on a consumer’s demand curve is the same as the elasticity on
the given point on the firm’s average revenue curve. With the help of the
point elasticity of demand, we can study the relationship between average
revenue, marginal revenue and elasticity of demand at any level of output.
Figure 8.5 depicts the effect of elasticity of demand on AR and MR curves.

R
Price

P
K

Q AR
0 X
M MR T
Output

Figure 8.5: Effect of Elasticity of Demand on AR and MR Curves

In the diagram, AR and MR respectively are the average revenue and the
marginal revenue curves. Elasticity of demand at point R on the average
revenue curve = RT/Rt. Now, in the triangles PtR and MRT
tPR = RMT (right angles)
tRP = RTM (corresponding angles)
PtR = MRT (being the third angle)
Therefore, triangles PtR and MRT are equiangular.
Hence RT / Rt = RM / tP
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In the triangles PtK and KRQ


PK = RK
PKt = RKQ (vertically opposite)
tPK = KRQ (right angles)
Therefore, triangles PtK and RQK are congruent (i.e., equal in all respects).
Hence Pt = RQ
Elasticity at R = RT / Rt = RM / tP = RM / RQ
RM RM
It is clear from the diagram that 
RQ RM  QM

Hence, elasticity at R = RM / RM – QM
It is also clear from figure 8.5 that RM is average revenue and QM is the
marginal revenue at the output OM which corresponds to the point R on the
average revenue curve.
Therefore elasticity at R = Average Revenue / Average Revenue – Marginal
Revenue
If A stands for average revenue, M stands for marginal revenue and e
stands for point elasticity on the average revenue curve then, e = A / A – M.
Thus, elasticity of demand is equal to AR divided by AR minus MR.
By using the above elasticity formula, we can derive the formula for AR and
MR separately.
A
e= This can be changed into (through cross multiplication)
A M
eA – eM = A; bringing all 'A' together, we have
eA – A = eM
A (e – 1) = eM
A = eM / e – 1
A =M (e / e – 1)
Therefore Average Revenue or price = M (e / e – 1)

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Thus the price per unit (i.e., AR) is equal to marginal revenue x elasticity
over elasticity minus one. The marginal revenue formula can be written
straight away as
M = A ((e – 1) / e)
The general rule therefore is: at any output,
Average Revenue = Marginal Revenue x (e / e – 1) and
Marginal Revenue = Average Revenue x (e – 1 / e)
Where, e stands for point elasticity of demand on the average revenue
curve. With the help of these formulae, we can find marginal revenue at any
point from average revenue at the same point, provided we know the point
elasticity of demand on the average revenue curve. Suppose that the price
of a product is Rs.8 and the elasticity is 4 at that price. Marginal revenue will
be:
M = A ((e – 1) / e)
= 8 ((4 – 1) / 4)
= 8 x 3 /4
= 24 / 4
= 6. Marginal Revenue is Rs. 6.
Suppose that the price of a product is Rs. 4 and the elasticity coefficient is 2
then the corresponding MR will be:
M = A ( ( e-1) / e)
= 4 ( ( 2 – 1) / 4)
=4x1/4
=4/4
= 1. Marginal revenue is Rs. 1
Suppose that the price of commodity is Rs.10 and the elasticity coefficient at
that price is 1, MR will be:
M = A ( ( e-1) / e)
=10 ( (1-1) /1)
=10 x 0/1
=0

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Whenever elasticity of demand is unity, marginal revenue will be zero,


whatever may be the price (or AR). It follows from this that if a demand
curve shows unitary elasticity throughout its length, the corresponding
marginal revenue will be zero throughout, i.e., the X axis itself will be the
marginal revenue curve.
Thus, the higher the elasticity coefficient, the closer is the MR to AR or
price. When elasticity coefficient is one for any given price, the
corresponding marginal revenue will be zero; marginal revenue is always
positive when the elasticity coefficient is greater than one and, marginal
revenue is always negative when the elasticity coefficient is less than one.
Kinked demand curve and the corresponding marginal revenue curve
Figure 8.6 depicts a kinked demand curve corresponding to the marginal
revenue curve.

10  A

9

8

7 B

6

5
Price

G
4

3

2
L
1 D
0 ‫׀‬ ‫׀‬ ‫׀‬ ‫׀‬ ‫׀‬ X X
100 200 300 400 500
Output

Figure 8.6: Kinked Demand Curve

We measure quantity on the X axis and price on the Y axis. The demand
curve AD has a kink at point B, thus exhibiting two different characteristics.

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From A to B it is elastic but from B to D it is inelastic. Because the demand


is elastic from A to B. a very small fall in price causes a very big rise in
demand, but to realise the same increase in demand, a very big fall in price
is required as the demand curve assumes inelastic shape after point B. The
corresponding marginal revenue curve initially falls smoothly, though at a
greater rate. In the figure 8.6 there is a gap in MR between output 300 and
350.
Generally, an oligopolistic firm that faces a kinked demand curve will make a
good gain when it reduces the price a little before the kink (point B), but if it
lowers the price below B; the rival firms will lower their prices too;
accordingly, the price cutting firm will not be able to increase its sales
correspondingly or may not be able to increase its sales at all. As a result,
the demand curve of price cutting firm below B is more inelastic. The
corresponding MR curve is not smooth but has a gap or discontinuity
between G and L. In certain cases, the kinked demand curve may show a
high elasticity in the lower portion of the demand curve beyond the kink and
low elasticity in higher portion of the demand curve before the kink. Marginal
revenue in such a demand curve will show a gap but instead of at a lower
level, it will start at a higher level. Figure 8.7 depicts the relationship
between AR, MR, TR and elasticity of demand.

Y
P H
E>1

TR
Price

E=1
C
E<1

AR
0 Q X
D
Output
MR
Figure 8.7: Relationship Between AR, MR, TR and Elasticity of Demand

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In the figure 8.7, AR is the average revenue curve, MR is the marginal


revenue curve and OD is the total revenue curve. At the middle point C of
average revenue curve, elasticity is equal to one. On its lower half, it is less
than one and on the upper half, it is greater than one. MR corresponding to
the middle point C of the AR curve is zero. This is shown by the fact that MR
curve cuts the x axis at Q which corresponds to the point C on the AR curve.
If the quantity is greater than OQ it will correspond to that portion of the AR
curve where e<1 and marginal revenue is negative because MR goes below
the X axis. Similarly, for a quantity less than OQ, e>1 and the marginal
revenue is positive. This means that if quantity greater than OQ is sold, the
total revenue will be diminishing and for a quantity less than OQ, the total
revenue TR will be increasing. Thus, the total revenue TR will be at its
maximum at the point H, where elasticity is equal to one and marginal
revenue is zero.
Significance of revenue curves
The relationship between price elasticity of demand and total revenue is
important because every firm has to decide whether to increase or decrease
the price depending on the price elasticity of demand of the product. If the
price elasticity of demand for the firm’s product is relatively elastic, it will be
advantageous to reduce price as it increases the firm’s total revenue. On the
other hand, if the price elasticity of demand for the firm’s product is relatively
inelastic, it should raise the price as it increases total revenue.
Average revenue, which is the price per unit, when considered along with
average cost will show the firm whether it is profitable to produce and sell. If
average revenue is greater than average cost, the firm is getting excess
profit; if it is less than average cost, the firm is running at a loss.
Firm’s profit is at its maximum at a point where Marginal revenue is equal to
Marginal cost. Any increase in output beyond that point will mean loss on
additional units produced; restriction of output before that point will mean
lower profit. Thus, the concept of average revenue is relevant to find out
whether the firm is running on profit or loss; the concept of marginal revenue
together with marginal cost will show profit maximising output for the firm.

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Self Assessment Questions


Fill in the blanks:
1. ____________ is the total income realised from the sale of its output at
a price.
2. TR / Q = ___________________.
3. Additional revenue earned by selling an additional unit of output is
called ________.
4. AR curve coincides with the MR curve and run parallel to OX axis
under ________ competition.
5. AR and MR curves slope downwards under condition of __________
competition.
True or false:
6. Total revenue is maximum when marginal revenue is the highest.
(True/False)
7. TR increases when price is increased if price elasticity of demand is
greater than 1. (True/False)
8. The AR curve of the firm or the seller and the demand curve of the
buyer are similar. (True/False)
9. With increase in Q, AR and MR both fall, but fall in MR is greater than
AR i.e., MR falls more steeply than AR. (True/False)
10. MR and AR behave similarly with change in prices and output.
(True/False)

8.4 Pricing Policies


In this section, we will discuss the pricing policies. A detailed study of the
market structure gives us information about the way in which prices are
determined under different market conditions. However, in reality, a firm
adopts different policies and methods to fix the price of its products. Pricing
policy refers to the policy of setting the price of the product or products and
services by the management after taking into account various internal and
external factors, forces and its own business objectives. Pricing Policy
basically depends on price theory that is the cornerstone of economic
theory. Pricing is considered as one of the basic and central problems of
economic theory in a modern economy. Fixing prices is the most important
function of managerial decision making because market price changed by

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the company affects the present and future production plans, pattern of
distribution, nature of marketing etc. Above all, the sales revenue and profit
ratio of the producer directly depend upon the prices. Hence, a firm has to
charge the most appropriate price to the customers. Charging an ideal
price, which is neither too high nor too low, would depend on a number of
factors and forces. There are no standard formulae or equations in
economics to fix the best possible price for a product. The dynamic nature
of the economy forces a firm to raise and reduce the prices continuously.
Hence, prices fluctuate over a period of time.
Generally speaking, in economic theory, we take into account only two
parties, i.e., buyers and sellers, while fixing the prices. However, in practice,
many parties are associated with pricing of a product. They are rival
competitors, potential rivals, middlemen, wholesalers, retailers, commission
agents and above all the Government. Hence, we should give due
consideration to the influence exerted by these parties in the process of
price determination.
Broadly speaking, the various factors and forces that affect the price are
divided into two categories. They are as follows:
I. External Factors – There are several external factors that affect the
price. They are as follows:
1. Demand, supply and their determinants
2. Elasticity of demand and supply
3. Size of the market
4. Goodwill, name, fame and reputation of a firm in the market
5. Purchasing power of the buyers
6. Buyers’ behaviour in respect of particular product
7. Availability of substitutes and complements
8. Government’s policy relating to various kinds of incentives,
disincentives, controls, restrictions and regulations, licensing, taxation,
export and import, foreign aid, foreign capital, foreign technology
9. Competitors pricing policy
10. Social considerations
II. Internal Factors – There are several internal factors that affect the
price. They are as follows:
1. Objectives of the firm

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2. Production Costs
3. Quality of the product and its characteristics
4. Scale of production
5. Efficient management of resources
6. Policy towards percentage of profits and dividend distribution
7. Advertising and sales promotion policies
8. Wage policy and sales turnover policy, etc
9. The stages of the product on the product lifecycle
10. Use pattern of the product
11. Extent of the distinctiveness of the product and extent of product
differentiation practiced by the firm
12. Composition of the product and life of the firm
Thus, multiple factors and forces affect the pricing policy of a firm.

8.5 Objectives of Pricing Policies


In this section, we will discuss the objectives of pricing policies. While
formulating its pricing policy, a firm has to consider various economic,
social, political and other factors. The following objectives are to be
considered while fixing the prices of the product:
1. Profit maximisation in the short term – The primary objective of the
firm is to maximise its profits. Pricing policy as an instrument to
achieve this objective should be formulated in such a way as to
maximise the sales revenue and profit. Maximum profit refers to the
highest possible profit. In the short run, a firm not only should be able
to recover its total costs, but also should get excess revenue over
costs. It may follow skimming price policy, i.e., charging a very high
price when the product is launched to cater to the needs of only a few
sections of people. Alternatively, it may adopt penetration pricing
policy i.e., charging a relatively lower price in the later stages in the
long run so as to attract more customers and capture the market.
2. Profit optimisation in the long run – The traditional profit maximisation
hypothesis may not prove beneficial in the long run. Optimum profit
refers to the most ideal or desirable level of profit. Hence, earning the
most reasonable or optimum profit has become a part and parcel of a
sound pricing policy of a firm in recent years.
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3. Price stabilisation – Price stabilisation over a period of time is another


objective. A stable price policy only can win the confidence of customers
and may add to the goodwill of the concern. It builds up the reputation
and image of the firm.
4. Preventing entry of competition – Firms try to match the prices of their
products with those of their rivals to expand the volume of their
business. Most of the firms are not merely interested in meeting
competition but are keen to prevent it.
5. Maintenance of market share – Market share refers to the share of a
firm’s sales of a particular product in the total sales of all firms in the
market. The economic strength and success of a firm is measured in
terms of its market share. Hence, the pricing policy has to assist a firm to
maintain its market share.
6. Capturing the market – Another objective in recent years is to capture
the market, dominate the market and, command and control the market
in the long run. In order to achieve this goal, sometimes, the firm fixes a
lower price for its product and at other times, it may even sell at a loss in
the short term. It may prove beneficial in the long run. Such a pricing is
generally followed in price sensitive markets.
7. Entry into new markets – Apart from growth, market share expansion,
diversification in its activities, firms make special attempts to enter into
new markets. The price set by a firm has to be so attractive that the
buyers in other markets have to switch over to the products of the
candidate firm.
8. Deeper penetration of the market – The pricing policy has to be
designed in such a manner that a firm can make inroads into the market
with minimum difficulties. Deeper penetration is the first step in the
direction of capturing and dominating the market in the later stages.
9. Achieving a target return – A predetermined target return on capital
investment and sales turnover is another long run pricing objective of a
firm. The targets are set according to the position of the individual firm.
Hence, prices of the products are so calculated as to earn the target
return on cost of production, sales and capital investment. Different
target returns may be fixed for different products or brands or markets

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but, such returns should be related to a single overall rate of return


target.
10. Target profit on the entire product line irrespective of profit level
of individual products – The price set by a firm should increase the
sale of all the products rather than yield a profit on one product only. A
rational pricing policy should always keep in view the entire product line
and maximum total sales revenue from the sale of all products. A
product line may be defined as a group of products which have similar
physical features and perform generally similar functions. In a product
line, a few products are regarded as less profit earning products and
others are considered as more profit earning. Hence, a proper balance
in pricing is required.
11. Long run welfare of the firm – A firm has multiple objectives. They are
laid down on the basis of past experience and future expectations.
Simultaneous achievement of all objectives is necessary for the overall
growth of a firm. Objective of the pricing policy has to be designed in
such a way as to fulfil the long run interests of the firm keeping internal
conditions and external environment in mind.
12. Ability to pay – Pricing decisions are sometimes taken on the basis of
the ability to pay of the customers, i.e., higher price can be charged to
those who can afford to pay. Such a policy is generally followed by
those people who supply different types of services to their customers.
13. Ethical pricing – Basically, pricing policy should be based on certain
ethical principles. Business without ethics is a sin. While setting the
prices, some moral standards are to be followed. Although profit is one
of the most important objectives, a firm cannot earn it in a moral
vacuum. Instead of squeezing customers, a firm has to charge moderate
prices for its products. The pricing policy has to secure reasonable
amount of profits to a firm to preserve the interests of the community and
promote its welfare.
Besides these goals, there are various other objectives such as promotion
of new items, steady working of plants, maintenance of comfortable liquidity
position, making quick money, maintaining regular income to the company,
continued survival, rapid growth of the firm etc., which firms may consider
while taking pricing decisions.

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8.6 Pricing Methods


In this section, we will discuss the pricing methods. The traditional theory of
value and pricing policies, etc. provide a theoretical base to the
management to take decision on setting the right price. The actual pricing of
products depend upon various factors and considerations. Hence, there are
several methods of pricing.
Full – cost pricing or cost - plus pricing method
Full cost pricing is one of the simplest and common methods of pricing
adopted by different firms. Hall and Hitch of the Oxford University in their
empirical study of actual business behaviour found that business firms do
not determine price and output by comparing MR and MC. On the other
hand, under oligopoly and monopolistic conditions, they base their market
price on full cost conditions. According to this principle, businessmen charge
price that covers their average cost in which are included normal or
conventional profits. Cost refers to full allocated costs. According to Joel
Dean, it has three components –
i) Actual cost which refers to the actual or total expenses incurred in
production, for e.g., wage bills, raw material cost, overhead charges,
etc.
ii) Expected cost which refers to the forecast for the pricing period on
the basis of expected prices, output rate and productivity.
iii) Standard cost which refers to cost incurred at the normal level of
output.
In brief, a firm computes the selling price of its product by adding a certain
percentage to the average total cost of the product. The percentage added
to costs is called margin or mark-ups. Hence, this method is also called
margin – pricing and mark – up pricing.
Cost-plus Pricing = Cost + Fair Profit
Fair profit means a fixed percentage of profit mark-ups. It is arbitrarily
determined. The margin of profits included in the price of a product differs
from industry to industry and from commodity to commodity on account of
differences in competitive strength, cost of production, total turnover,
accounting practices, etc. Past traditions, directives from trade associations
and, guidelines from the government may also decide the percentage of
profits.
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This method envisages covering the total costs incurred in producing and
selling a commodity. In this case, businessmen do not seek supernormal
profits. Hence, a price based on full average cost is the ‘right cost’, the one
which ought to be charged based on the idea of fairness under oligopoly
and monopolistic competition.
Illustration
Production = 8000 units.
Total Fixed Cost = Rs. 30,000
Total Variable Cost = Rs. 50,000
Total Cost = Rs. 80,000
Per Unit Cost = 80,000 / 8000 = Rs. 10
20% Net Profit Margin
20
On Cost =  10  Rs. 2
100
Cost Price = Rs. 10
20% NPM on Cost = Rs. 10
Selling Price = + Rs. 2
Rs. 12
Evaluation of the full cost pricing method
Generally, the firms will not have information about demand conditions,
nature and degree of competition, technology used, etc. Further, modern
business conditions are extremely uncertain. Besides, a firm may be
producing or selling innumerable varieties of goods and to calculate prices
on the basis of profit maximisation may be almost impossible. The cost plus
method is convenient, as the firms have to only add some standard mark-up
to their cost. Over a period of time, through trial and error, they can find out
the proper mark–up. The supreme merit of this method lies in its mechanical
simplicity and its apparent fairness.
It is safer, cheaper and imparts competitive stability particularly when there
is tough competition in the market. It is useful particularly in product tailoring
and public utility pricing. It is justified on moral grounds because price based
on costs is a just price.

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According to Professor Joel Dean, it is the best method of pricing in case of


new products because if the firm is able to realise its normal profits, only
then can it take a decision to produce and market a product.
This method attaches too much of significance to allotted costs and mark-
ups. It tends to diminish the interest of the producer in cost control.
However, many firms adopt this method of pricing due to its inherent
benefits.
Rate of return pricing
Rate of return pricing is a modified form of full cost pricing. Under this
method, a producer decides a predetermined target rate of return on capital
invested. Full–cost pricing considers the mark-ups or profit arbitrarily.
Instead of setting the percentage arbitrarily, a firm will determine the
average mark-up on costs necessary to produce a desired rate of return on
the company’s investments. Thus, under this method, price is determined
along a planned rate of return on investment. In this case, a company
estimates future sales, future costs and arrives at a mark–up that will
achieve a target return on a company’s investment.
Professor Davies and Hughes in their book, “Managerial Economics” have
used the following formula to calculate the desired rate of return when a
mark-up is applied on cost.
Capital employed
Percentage mark–up =  Planned rate of return
Total annual cost
Let us suppose that the capital employed by a firm is Rs. 16 lakhs and the
total cost is Rs. 12 lakhs with a planned rate of return of 30 percent. By
making use of the above formula, we can find out the percentage mark-up of
the firm in the following way.
Capital employed 16
 planned rate of return   30  40%
Total annual cos t 12

Illustration
Production = 10,000 units
Total Cost = 4,00,000
Per Unit Cost = 4,00,000 / 10,000 = Rs. 40

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30
30% of Rs. 40 is  40  Rs . 12
100
Now, if the total cost per unit is = 40
30% mark-up = 12
The selling price would be = 52

The mark-up is thus carefully planned and calculated, as different from the
arbitrary percentage used in the cost plus pricing.

Price = Total cost per unit + Mark-up

The management will regard this price as the base price applicable over a
period of time. However, when cost of production changes as a result of
changes in the prices of raw materials or due to changes in the levels of
wages, the management can change the price suitably. Besides, the base
price can be modified suitably according to changes in demand and
competitive conditions in the market.
Evaluation of rate of return pricing
As it is a refined version of cost plus pricing, it is superior to cost plus pricing
in the following two ways:
i) The analysis is based on standard cost which is computed on the
basis of normal output; and,
ii) The profit mark-up is based on a planned rate of return on investment
and not on any arbitrary figure.
As it is a refined form of cost plus pricing method, all the merits and
demerits of cost plus pricing method apply to rate of return pricing too.
Going rate pricing
Going rate pricing is the opposite of full cost pricing. In this method,
emphasis is given on market conditions rather than on costs. Generally, we
come across this method of pricing under oligopoly market especially under
price leadership. Under this method, a firm fixes its price according to the
price fixed by the leader. A firm has monopoly power over the product it
produces and can charge its own price and face all the consequences of

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monopoly. However, a firm chooses the price which is going in the market
and charge a particular price that the other followers are charging.
This type of pricing is not the same as accepting a price that is set in a
perfectly competitive market. A firm has some power to fix the price but
instead of doing so, it adjusts its own price to the general price structure in
the industry. Hence, this method of pricing is known as acceptance pricing.
Normally, under this method, the industry tries to determine the lowest
prices that the sellers or followers can afford to accept considering various
alternatives.
The price follower firms, however, compare the price of the leader and the
leader firm’s cost-revenue conditions and long run profitability. As small
firms recognize the big firm as their leader, they try to imitate their leader in
pricing decisions. Since a price leader is a firm with a successful profit
history, significant market share and long experience in market matters, the
imitating firms follow the leader in the hope of earning larger profits under
the shelter of the leader’s price umbrella.
Imitation is the easy way of decision making. The follower uses another
firm’s market analysis without worrying about demand and cost estimates.
Many executives desire to devote minimum time for pricing decisions and
hence, they follow this method.
This policy is not confined to only small business firms. Even large firms
follow a price set by a price leader or by the market. Some firms adjust their
costs to a predetermined price by keeping their costs within certain
percentage limits of their selling prices in order to achieve the targeted
profit. This policy suits those products which have reached a mature stage
and where both customers and rivals have come to accept a stable price.
The going rate pricing is generally adopted when:
a. Costs are difficult to measure
b. The firm wants to avoid tension of price rivalry in the market
c. There is price leadership of a dominant firm in the market
This method of pricing is easy to adopt, economical and rational. It helps in
avoiding cut-throat competition among firms.

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‘Imitation pricing it’ is a variant of going rate pricing. The firms which join the
industry late just imitate the price fixed by the leader. This is the same as
going rate pricing.
Administered prices
The term administered prices was introduced by Keynes for the prices
charged by a monopolist and therefore it is determined by considerations
other than marginal cost. A monopolist being a price maker consciously
administers the price of his product.
Indian economists like L.K. Jha and Malcolm Adiseshaiah, however, have a
slightly different conception about administered prices. According to the
Indian economists, an administered price for a commodity is the one which
is decided and arbitrarily fixed by the government. It is not allowed to be
determined by the free play of market forces of demand and supply. In
short, administered prices are the prices which are fixed and enforced by
the government in the overall interest of the economy.
Administered prices are fixed by the government for a few carefully selected
goods like steel, coal, aluminium, fertilizers, petroleum, cooking gas, etc.
These products are the raw materials for other industries and there is great
need for establishing and stabilising the total output and their prices. The
public distribution system is also subject to administered prices.
Administered prices are normally set on the basis of cost plus a stipulated
margin of profit. They represent a pool price where individuals producing
units are being granted retention prices. These retention prices may either
be uniform or different for different units. As cost of production changes,
administered prices also would be modified. This is the right method of
pricing and it is based on logical considerations.
Objectives of administered pricing
The main objectives of administered pricing are as follows:
1. To protect the interests of weaker sections against high prices
2. To curb or to encourage the consumption of certain commodities
3. To contain inflation and ensure price stability
4. To counter stagflation and the consequent recession
5. To mobilize revenue for the government
6. To ensure efficient allocation of resources among different users

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7. To improve living standards of the masses and promote their economic


welfare
8. To ensure equitable distribution of certain goods which are scarce in
supply
9. To achieve macroeconomic goals like welfare, equity and stability
It is quite clear from the above discussion that administered prices have
certain defects. In order to make administered prices more realistic, they
should reflect the cost realities from time to time and, quickly respond to
these changes in the most pragmatic manner. The government
administration should be active and prompt at the decision making level.
This will bring a reputation to administered prices and they may be accepted
without much criticism.
Marginal Cost Pricing
It is based on a purely economic concept of equilibrium of a firm, where
marginal cost is equal to marginal revenue. Under this method, price is
determined on the basis of marginal cost, which refers to the cost of
producing additional units. Price based on marginal cost will be much more
aggressive than the one based on total cost. A firm with large unused
capacity will have to explore the possibility of producing and selling more. If
the price is sufficient to cover the marginal cost, particularly in times of
recession, the firm should be able to produce and sell the commodity and
can think of recovering the total cost in the long run.
Although this method sounds excellent theoretically, it has the serious
limitation of ascertaining the marginal cost.
Customary Pricing
Prices of certain goods are more or less fixed in the minds of consumers;
these are known as “charm prices”, for e.g., prices of soft drinks and other
beverages. In this case, a moderate change in cost of production will not
have any influence on price. Though this method has the advantage of
stability, it does not reflect costs.
Pricing of a New Product
Basically, the pricing policy of a new product is the same as that for an
established product. The price must cover the full costs in the long run and
direct costs or prime costs in the short run. In case of new products, the
degree of uncertainty would be more as the firm is generally ignorant about
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the cost and the market conditions. There are two alternative price
strategies which a firm introducing a new product can adopt, viz., skimming
price policy and penetration pricing policy.
a) Skimming Price Policy
The system of charging high prices for new products is known as price
skimming for the object is to “skim the cream” from the market. A firm would
charge a high price initially when it gets a feeling that initially, the product
will have relatively inelastic demand, when the product life is expected to be
short and when there is heavy investment of capital, for e.g., electronic
calculators.
b) Penetration price policy
Instead of setting a high price, the firm may set a low price for a new product
by adding a low mark-up to the full cost. This is done to penetrate the
market as quickly as possible. This method is generally adopted when there
are already well known brands of the product in the market, to maximise
sales even in the short period and to prevent entry of rival products.

Self Assessment Questions


Fill in the blanks:
11. Cost plus pricing = cost + ______________.
12. We come across going rate pricing generally under ________ market.
13. The objective of charging high prices for new products is to
__________ from market.
14. The rate of return pricing = Total cost per unit + _________________.
15. Administered prices are the prices which are fixed and enforced by the
_________ in the overall interested of community.
True or False:
16. When an individual firm in a competitive market increases its
production, it is likely that the market price will fall. (True/False)
17. For a firm in a competitive market, marginal revenue is always equal to
average revenue. (True/False)
18. A profit-maximising firm in a competitive market will increase
production when average revenue exceeds marginal cost. (True/False)

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19. After comparing the marginal revenue and marginal cost from each
unit produced, a firm in a competitive market can determine the profit-
maximising level of production. (True/False)
20. When a firm in a monopoly charges a higher price, fewer of its goods
are sold. (True/False)

8.7 Summary
Let us recapitulate the important concepts discussed in this unit:
 Knowledge of cost and revenue concepts is of very great importance in
understanding the various methods of price-output determination and
pricing policies under both perfect and imperfect markets.
 Total revenue refers to the total receipts from the sale of the goods,
Average revenue refers to the revenue per unit of the commodity sold
and marginal revenue is the additional revenue earned by selling an
additional unit of output.
 The relationship between revenue and price elasticity of demand has
practical significance in real business life. These two concepts help the
management in taking a right decision with regard to the size of the
output and the determination of price.
 Different pricing policies and methods give an insight into the actual
functioning of a firm. Dynamic conditions of the market necessitate
frequent changes in the pricing policies and methods followed by a firm.
While formulating its pricing policy a firm has to keep in its view some of
the external factors like elasticity of demand, size of the market,
government policy, etc., and internal factors like production costs, the
stages of the product on the product life cycle etc.
 There are a few considerations to be kept in mind like the objectives of
a firm, competitive situation in the market, cost of production, elasticity of
demand, economic environment, government policy etc.
 The main objectives of the pricing policy are profit maximisation, price
stabilization, facing competitive situation, capturing the market etc.
Market price of a product depends upon a number of factors like
production cost, demand, consumer psychology, profit policy of the
management, government policy, etc.

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 There are different methods of pricing for both established products as


well as new products. Full cost pricing or cost plus pricing, is one of the
simplest and common method of pricing adopted by different firms. Here
the price is determined by adding a certain mark-up to the average total
cost.
 Rate of return pricing is a modified form of full cost pricing where the
mark-up is decided on the basis of capital employed. Going rate pricing
is the opposite of full cost pricing generally followed under oligopoly
market.
Here the firm just follows the price prevailing in the market without bothering
about other things.
 Imitative pricing is similar to going rate pricing. Marginal cost pricing,
where price is determined on the basis of marginal cost is more
theoretical than being practical. Administered prices are the prices
statutorily determined by the government for certain important goods like
steel, cement etc.
 There are two schemes of pricing for a new product viz., skimming price
and penetration price. Based on the market conditions and the cost
conditions, these two methods are adopted.

8.8 Glossary
Administered prices: Prices which are fixed and enforced by the
government in the overall interest of the economy.
Average revenue: Revenue per unit of the commodity sold.
Full – cost pricing or cost - plus pricing: Firm computes the selling price
of its product by adding a certain percentage to the average total cost of the
product.
Going rate pricing: Firm fixes its price according to the price fixed by the
leader.
Marginal cost pricing: Price is determined on the basis of marginal cost
which refers to the cost of producing additional units.
Marginal revenue: Additional revenue earned by selling an additional unit
of output by the seller.

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Market share: Share of a firm’s sales of a particular product in the total


sales of all firms in the market.
Optimum profit: Ideal or desirable level of profit.
Penetration price policy: Instead of setting a high price, the firm may set a
low price for a new product by adding a low mark-up to the full cost.
Pricing policy: Policy of setting the price of the product or products and
services by the management after taking into account various internal and
external factors, forces and its own business objectives.
Product line: A group of products which have similar physical features and
perform generally similar functions.
Rate of return pricing: Producer decides a predetermined target rate of
return on capital invested.
Revenue: Amount of money which the firm receives by the sale of its output
in the market.
Skimming price policy: The system of charging high prices for new
products.

8.9 Terminal Questions


1. Explain in brief the relationship between TR, AR and MR under perfect
market conditions.
2. What do you mean by pricing policy?
3. What are the objectives of pricing policies?
4. Explain the various methods of pricing.

8.10 Answers

Self Assessment Questions


1. Total revenue
2. AR
3. Marginal revenue
4. Perfect
5. Imperfect
6. False
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7. False
8. True
9. True
10. False
11. Fair profits
12. Oligopoly market
13. Skim the cream from the market
14. Mark-up
15. Government
16. False
17. True
18. True
19. True
20. True
Terminal Questions
1. Under perfect competition, a firm can sell any amount of goods at the
existing market prices. Hence, the TR of the firm would increase
proportionately with the output offered for sale. When the total revenue
increases in direct proportion to the sale of output, the AR would
remain constant. As the good’s market price is constant without any
variation due to changes in the units sold by the individual firm, the
extra output would fetch proportionate increase in the revenue. Hence,
MR and AR will be equal to each other and remain constant. This will
be equal to price. Refer to section 8.2.
2. Pricing policy refers to the policy of setting the price of the product or
products and services by the management after taking into account
various internal and external factors, forces and its own business
objectives. Refer to section 8.4.
3. The following objectives are to be considered while fixing the prices of
the product: profit maximisation in the short term, profit optimisation in
the long run, price stabilisation, preventing entry of competition. Refer
to section 8.5.
4. There are several methods of pricing such as full – cost pricing or cost -
plus pricing method, rate of return pricing, going rate pricing,
administered prices, marginal cost pricing, customary pricing etc. Refer
to section 8.6.
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8.11 Case Study

Real Steel in the Making


During the last two decades, post-initial liberalisation of the national
economy and the steel industry sector, India's steel production and
corresponding domestic steel consumption, in tandem, has increased
from around 16 mtpa to around 65 mtpa.
During the last 20 years, the Indian steel sector, in general, has become
significantly cost competitive and increasingly quality competitive,
globally. This growth phenomenon is directly linked to the establishment
of a few relatively large integrated iron and steel plants, namely, Essar,
Jindal Vijayanagar (now JSW Steel) and Ispat (now JSW Ispat). Each
took front-end innovative technology routes, and triggered global
competitiveness. Tata Steel (India), SAIL and Vizag Steel have also
improved their performance and growth phenomenally.
Incidentally, unlike pre-liberalisation, when each of the integrated steel
plants was provided with captive iron ore mines – the only domestic
resource input for competitiveness of the steel business in India – post-
liberalisation, no integrated steel plant was provided with captive iron ore
mines. Incidentally, the international trade prices of high-quality iron ore
and coking coal in particular, are disproportionately high, largely because
of significant monopolisation of these resources by 3 to 4 multi-national
conglomerates.
In India, coking coal quality is poor to very poor, and quantity is
insignificant, compared to the expanding needs of our steel sector. This
coal is largely owned by Coal India Ltd. and older steel companies, set
up prior to liberalisation in India. All the steel plants situated away from
this only, meagre, coking coal resource in India in the east have to import
coking coal from Australia, CIS and USA.
Among the major steel plants established post-liberalisation, Essar and
Ispat are largely linked with natural gas, and the price is controlled by the
government, due to their location in western India. JSW Steel, the steel
plant with the largest capacity in one location in India, is linked to 100 per
cent coking and steam coal import.

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The present iron ore crisis in Karnataka gets partly linked to this key
issue. The differential between the selling price of iron ore and its cost of
production is a few times. No commodity or bulk mined product, such as
iron ore should have super gross profit margins usurping the significant
part of value in the supply chain, making investments in further
downstream units unviable and unattractive.

The differential, if any, gets harmonised by combination of market forces


and government legislations from time to time. This precisely didn't
happen, and it got perpetuated by the governments and bureaucracy for
obvious reasons for the last eight years or so.

In Karnataka, while ‘subsistence'-level iron ore supply is being resumed


from the ‘dumps', the reserve price for auction has been fixed, linked to
export price. The issue which isn't getting focus is that the iron and steel
industry, even the sponge iron sector, cannot sustain itself in Karnataka
or elsewhere, unless the iron ore comes on cost-plus-reasonable gross
margin basis.

The reserve price for the present iron ore dumps for auction to steel
plants has been fixed at around Rs. 3,000 for high-grade ore, and was
sold at a premium to reserve price, solely for the reason of acute
shortage created in the past few months. Under total duress, these steel
companies are buying. Media attention is getting focused on the
government that is earning correspondingly more revenue and a great
service to the nation is being performed. Simultaneously, the exchequer
is losing much more in the form of excise duties, service tax, CST, and
VAT on the loss of steel production, since these taxes amount to Rs.
6000 per tonne of steel, as against a small amount of incremental royalty
on the higher iron ore price.

However, this will directly impact on the cost of production of steel in


Karnataka. Correspondingly, it will reduce the competitiveness and
stakeholders' value of all the steel companies in the region. If this duress
pricing is established, then as and when some of the mines are allowed
to resume their operation, after due correction of their environmental and
other onslaughts, price to the industry can be an issue of dispute.

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While the basic logic of pricing of iron ore in India on cost-plus-


reasonable gross margin basis for inter se competitiveness of Indian
steel industry has rationale, considering the prevailing system and
compatibility with international trade practice, this system can hardly be
adopted. Therefore, all the iron and steel industries in India should have
captive iron ore resources expeditiously corresponding to their capacity,
to not only have level playing fields, but also sustain the growth rate of
our steel industry for national economic sustainability.
Besides, export of iron ore may be restrained, in the national interest of
conservation. All the integrated steel plants, capable of undertaking
viable, scientific and efficient iron ore mining, should have access to
captive iron ore mines. Give your observations on the case study.
(Source: Based on an article that appeared in the Hindu Business Line,
January 3, 2012)

References:
 Hall, R. & Hitch, C. (1939). "Price Theory and Business Behaviour",
Oxford Economic Papers (Oxford University Press) 2 (1): 12–45.
 Dean, Joel, (1951), Managerial Economic s, Englewood Cliffs, NJ:
Prentice Hall.
 Davies, J.R., and Hughes. S. (1977). Managerial Economics, Plymouth:
Macdonald and Evans.
 Hindu Business Line, January 3, 2012

E-Reference:
 www.thehindubusinessline.com – retrieved on January 3rd 2012

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Unit 9 Price Determination under Perfect Competition


Structure:
9.1 Introduction
Case Let
Objectives
9.2 Market and Market Structure
9.3 Perfect Competition
9.4 Price-Output Determination under Perfect Competition
9.5 Short-run Industry Equilibrium under Perfect Competition
9.6 Short-run Firm Equilibrium under Perfect Competition
9.7 Long-run Industry Equilibrium under Perfect Competition
9.8 Long-run Firm Equilibrium under Perfect Competition
9.9 Summary
9.10 Glossary
9.11 Terminal Questions
9.12 Answers
9.13 Case Study
Reference/E-Reference

9.1 Introduction
In the previous unit, we studied revenue analysis and pricing policies. We
saw how costs can influence the pricing behaviour of a firm. In recent years,
where firms are finding it difficult to differentiate themselves from their
competitors, the price fixed by a firm is highly influenced by the pricing
behaviour of its competitors. Effectiveness of a firm’s management lies in its
capacity to analyse the market. Knowledge of market structure and different
kinds of markets is of utmost importance to a business manager in taking
right pricing decisions and planning business activities efficiently. In this unit,
we will be studying price determination under perfect competition.

Case Let (Continued from Unit 8)


Ramesh presented the revenue analysis of his firm; which showed that to
meet its expansion plans, the firm’s profits would be affected by the
interest costs arising from borrowings. However, Ramesh was unable to
explain convincingly the impact of competitors’ pricing strategies on the

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prices charged by his firm and consequent revenues. He doubted the


feasibility of forecasting revenues when competitors’ pricing decisions
could not be predicted with adequate levels of confidence. He met his
superior about this issue. Discussions indicated that, in the past few
years, Ramesh’s firm was able to sell higher quantities of its outputs by
responding suitably to competitors’ pricing moves. Ramesh’s superior
stated that this was possible as some of the products sold by his firm
were different from the products sold by other firms in the market. This
set Ramesh thinking about how product differentiation influenced product
pricing in different markets.

Objectives:
After studying this unit, you should be able to:
 analyse the market with respect to its structure of competition
 differentiate between different types of market structures
 explain how firms under perfectly competitive markets maximise their
output
 apply short-run and long-run concepts to price determination in perfectly
competitive markets

9.2 Market and Market Structure

Market, in economics, does not refer to a place or places but to a


commodity and also to buyers and sellers of that commodity who are in
competition with one another, for example, the cotton market may not be
confined to a particular place, but may cover the entire country and, in fact,
even the entire world. Buyers and sellers of cotton may be spread all over
the world.
Thus in common parlance, market refers to a place where sellers and
buyers meet for exchanging goods, but in the language of economics it has
a wider meaning. It refers to a context where buyers and sellers come into
close contact with one another for the settlement of their transactions.
According to Prof. Cournot, the term market is, “not any particular market
place in which things are bought or sold, but the whole of any region in
which buyers and sellers are in such free interaction with one another that
the price of the same goods tend to equalise easily and quickly”. In the
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words of Prof. Benham, Market is, “any area over which buyers and sellers
are in such close touch with one another, either directly or through dealers
that the prices obtainable in one part of the market affects the prices paid in
other parts of the market”. For the existence of a market, there is no need
for face-to-face contact between the buyers and sellers to conclude their
transactions. In recent years, means of transport and communication have
developed so fast that buyers and sellers can easily come into close contact
with each other for the settlement of their transactions without establishing a
face-to-face relationship.
The term market hence implies to:
i) Existence of a commodity to be traded.
ii) Existence of sellers and buyers.
iii) Establishment of contact between the sellers and buyers.
iv) Willingness and ability to buy and sell a commodity and
v) Existence of a price at which the given commodity is to be bought and
sold.
Market situation varies in its structure. Market structure refers to
economically significant features of a market, which affect the behaviour,
and working of firms in the industry. It tells us how a market is built up and
what its basic features are. According to Pappas and Hirschey, “Market
structure refers to the number and size distribution of buyers and sellers in
the market for a good or service”. It indicates a set of market characteristics
that determine the nature of market in which a firm operates. Different
market structures affect the behaviour of sellers and buyers in different
ways.
The primary characteristics of markets are as follows:
 The number and size distribution of sellers
 The number and size distribution of buyers
 Product differentiation
 Conditions of entry and exit
The number and size distribution of sellers
A market may consist of many, few or very few sellers. There may be a few
big firms with huge investments or a large number of small firms with limited
investments. Thus, the operating size of the firm may be large or small in a
market. The number and size of sellers influence the working of a market.

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The number and size distribution of buyers


In a market, there may be large number of buyers. Similarly, a market may
consist of many small buyers or only a few buyers. The total number of
buyers influences the nature of transactions in the market.
Product differentiation
Products sold in the market may be homogeneous, or have substitutes,
close substitutes or remote substitutes. A firm may deliberately differentiate
its product with that of the products of other firms by adopting several
techniques.
Conditions of entry and exit
In a few market situations, new firms may enter the industry or, old firms
may leave the industry at their own free will. In case of other market
situations, there will be deliberate entry barriers.
Thus, the characteristics of market structure give us information about the
nature of working of different markets.
Among the different market situations, perfect competition and monopoly
form the two extremes. In between these two market situations, we come
across a number of market situations which may be collectively termed as
imperfect markets. In these imperfect markets, we notice the elements of
competition as well as monopoly. They are bi-lateral monopoly, monopsony
(one buyer), duopoly (two sellers) duopsony (two buyers), oligopoly
(few sellers), oligopsony (few buyers) and monopolistic competition
(many sellers). Figure 9.1 shows the types of competition.

Market Situation

Perfect Imperfect
Competition Competition

Monopolistic Competition, Oligopoly, Duopoly, Bilateral


Monopoly, Monopsony, Duopsony, Oligopsony

Figure 9.1: Types of Competition

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The market situations vary in their structure. Different market structures


affect the behaviour of buyers and sellers and firms. Further, prices and
trade volumes are influenced by different types of markets and price - output
determination under different market conditions.

9.3 Perfect Competition


Perfect competition is a comprehensive term which includes pure
competition too. Before we discuss the details of perfect competition, it is
necessary to have a clear idea regarding the nature and characteristics of
pure competition.
Pure Competition is a part of perfect competition. Competition in the
market is said to be pure when the following conditions are satisfied:
 Prevalence of a large number of buyers and sellers.
 The commodity supplied by each firm is homogeneous.
 Free entry and exit of firms.
 Absence of any kind of monopoly element.
Under these conditions, no individual producer is in a position to influence
the market price of the product. According to Prof. E.H. Chamberlin –
“Under Pure Competition, as the individual seller’s market is
completely merged with the general one, he can sell as much as he
pleases at the going price”. Further, he remarks, “Pure competition means
unalloyed by monopoly elements. It is a much simpler and less exclusive
concept than perfect competition”.
Prof. Joel Dean, after going through the features of pure competition,
observes that, “Pure competition does exist in reality but it is a rare
phenomenon”. Hence, it is stated that it is possible to come across pure
competition in our life, for example, in the markets for rice, wheat, cotton,
jowar, fruits, vegetables, eggs, etc., where there are a large number of
sellers and buyers and practically all goods are identical. If we look at the
present market, we notice that even in these cases, there is a possibility of
forming cartels by sellers to influence the market price. Now, we shall turn
our attention to perfect competition.

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Meaning and definition of perfect competition


A perfectly competitive market is one in which the number of buyers and
sellers are large, all engaged in buying and selling a homogeneous
product without any artificial restriction and, possessing perfect
knowledge of the market at a time. According to Bilas, “the perfect
competition is characterised by the presence of many firms; they all sell the
same product which is identical. The seller is the price-taker”. According to
Prof. F. Knight, perfect competition entails “Rational conduct on the part of
buyers and sellers, full knowledge, absence of friction, perfect mobility and
perfect divisibility of factors of production and completely static conditions”.
Features of perfect competition
1. Existence of a large number of buyers and sellers
A perfectly competitive market will have large number of sellers and buyers.
Output of a seller (firm) will be so small that it is a negligible fraction of the
output of the industry. Hence, changes in supply made by a particular firm
will not affect the total output and price. Similarly, no single buyer can
influence the price of the commodity because the quantity purchased by him
is a small fraction of the total quantity.
2. Homogenous products
Different firms constituting the industry produce homogenous goods. They
are identical in character. Hence, no firm can raise its price above the
general level.
3. Free entry and exit of firms
There is absolute freedom for firms to get in or get out of the industry. If the
industry is making profits, new firms are attracted into the industry.
Conversely, firms will quit the industry if there are losses. This results in the
realisation of normal profits by all the firms in the long run.
4. Existence of single price
Each unit bought and sold in the market commands the same price since
products are homogeneous.
5. Perfect knowledge of the market
All sellers and buyers will have perfect knowledge of the market. Sellers
cannot influence buyers and, vice versa.

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6. Perfect mobility of factors of production


Factors of production are free to move into any industry or occupation in
order to earn higher rewards. Similarly, they are also free to come out of the
occupation or industry if they feel that they are under remunerated.
7. Full and unrestricted competition
Perfectly competitive market is free from all sorts of monopoly and oligopoly
conditions. Since there are a large number of buyers and sellers, it is difficult
for them to join together and form cartels or form organisations. Hence,
each firm acts independently.
8. Absence of transport cost
All firms will have equal access to the market. Market price charged by the
sellers should not vary because of the difference in the cost of
transportation.
9. Absence of artificial government controls
The government should not interfere in matters pertaining to supply and
price. It should not place any barriers in the way of smooth exchange. Price
of a commodity must be determined only by the interaction of supply and
demand forces.
10. The market price is flexible over a period of time
Market price changes only because of changes in either demand or supply
force or both. Thus, price is not affected by the sellers, buyers, firm, industry
or the government.
11. Normal profit
As the market price is equal to the cost of production, firms in perfectly
competitive markets can earn only normal profits. Normal profits are those
which are just sufficient to ensure the firms stay in business. It is the
minimum reasonable level of profit which the entrepreneur must get in the
long run. It is a part of the total cost of production because it is the price
paid for the services of the entrepreneur, i.e., profit is an item of expenditure
for a firm.
Special features of perfect competition
i) It is an extreme form of market situation rarely found in the real world.
ii) It is a mere concept, a myth, an illusion and purely theoretical in
nature.

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iii) It is a hypothetical model.


iv) It is an ideal market situation.
Reasons for the study of perfect competition
1. It is used as a yardstick against which all other models can be compared
and evaluated.
2. It is quite accurate and useful in explaining and predicting the behaviour
of a market and a firm under certain circumstances.
3. It is a good simplified model for beginners to start with. Its study is
useful to prepare a ground for future study of imperfect markets.
4. It is a useful model to compare the actual with the ideal; what is and
what ought to be.
5. It helps us to understand optimum allocation of resources in an ideal
market.
9.4 Price – Output Determination under Perfect Competition
(General Model)
Studying the price - output model under perfect competition is quite
interesting. In case of the industry, under a perfectly competitive market,
market price of the product is determined by the interaction of supply and
demand. The market price is not fixed by the buyer or the seller, firm,
industry or by the government. It is only the market forces, i.e., demand and
supply determines the equilibrium price of the product. This peculiar feature
is seen only under perfect competition.
Alfred Marshall compared supply and demand to the blades of a scissor.
Just as both the blades work together to cut a piece of cloth, both supply
and demand interact with each other to determine the market price at which
exchange takes place. In the process of price determination, supply is not
more important than demand or, demand is not more important than supply.
Both forces play an equally important role.
Table 9.1 depicts how the price is determined in the market by the
interaction of demand and supply.

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Table 9.1: Price Determination Based on Demand and Supply


Price in Demand Supply in Pressure on
State of Market
Rs. in Units Units Price
10 1000 9000 Surplus S > D Downward
8 3000 7000 Surplus S > D Downward
6 5000 5000 Equilibrium S =D Neutral
4 7000 3000 Shortage D > S Upward
2 9000 1000 Shortage D > S Upward

From the table, it is clear that equilibrium price is determined at Rs. 6.00
where demanded quantity is exactly equal to quantity supplied i.e., 5000
units. Figure 9.2 shows the equilibrium output.

Figure 9.2: Equilibrium Output

In the case of any industry, interaction of supply and demand will determine
the equilibrium market price. In Figure 9.2, P indicates OR as equilibrium
price and OQ as equilibrium output. The price at which demand and
supply are equal is known as equilibrium price. The quantity bought
and sold at the equilibrium price is known as equilibrium output.
In the figure, equilibrium price is determined at the point P where both
demand and supply are equal. The upper limit of the price of a
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product/service is determined by the demand. This price should not exceed


‘what the market can bear’. In short, the price of the product / service should
not exceed the value of its benefit to the buyers (price should not be more
than the utility of product / service).
The lower limit of the price is determined by the production cost. In the long
run, the price should not fall below production costs of making and
distributing the product / service. With reference to the industry, the point P
can be regarded as the position of stable equilibrium. Even if there are
changes in the price, there will be automatic adjustments in supply and
demand, restoring the original equilibrium position. When the price rises
from OR to OR1 supply exceeds demand, there will be excess supply over
demand. The excess supply of goods pushes down the price from OR1 to
OR, the original price.
Similarly, when price falls from OR to OR2, demand exceeds supply, excess
demand over supply in its turn pushes up the prices from OR2 to OR - the
original price. Thus, interaction between demand and supply determines the
market price.
Under perfect competition, a firm will not have any independence to fix the
price of its own product. The industry is the price - maker or giver and a firm
is a price - taker or price acceptor and quantity adjuster. As a part of the
industry, it has to simply charge the price which is determined by the
industry. If it charges a higher price it will lose its sales and, if it charges a
lesser price, it will incur losses.
In case of a firm, the price line which is equal to AR and MR, will be
horizontal and parallel to OX - axis. This is because; the same price has to
be charged by the firm for all the units supplied, irrespective of changes in
the demand. Hence,

Equilibrium or Market Price = AR = MR

Difference between a firm and an industry


Basically, there is a difference between a firm and an industry. A firm is a
single manufacturing unit producing and selling either a commodity or
a service. It is a part of the industry and is called as a business enterprise.
Business is an economic activity and a business unit is an economic unit

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and an individual producing unit. It converts inputs into outputs. These


production units are organised and run by people either as individuals or as
members of households or, as a group of people. It is basically an
income-generating unit. It buys inputs like raw materials, labour, capital,
power, fuel, etc and produces goods and services for the consumers. It
organises and combines all kinds of resources and plans for the use of
these resources in the best possible manner.
Profit making is the basic objective of a firm. The traditional and
conventional objective of a firm was profit maximisation and now, the main
objective is profit optimisation.
A business firm is a legal entity on the basis of ownership and contractual
relationship organised for the production and for the sale of goods and
services.
Many firms producing similar or homogeneous goods or services
collectively make an industry. The term industry refers to a set or group
of firms engaged in the production of a particular product or a service. For
example, Reid and Taylor, Digjam, Reliance Industries, Raymond Ltd., etc
are all firms producing textiles. Such firms put together constitute the textile
industry in India. Thus, an industry is engaged in the production of
homogeneous goods that are substitutes for each other, use common raw
materials, have similar processes, etc. All firms engaged in providing the
same kind of services or doing a common trade or business constitute
an industry, for example, banks, hotels, etc. An industry is a particular line
of productive activity in which many firms are engaged, each adopting its
own production and pricing policies to its best advantage.
9.5 Equilibrium of the industry and the firm under perfect
competition
Short-run Industry Equilibrium under Perfect Competition
The term ‘Equilibrium’ in physical science implies a state of balance or rest.
In economics, it refers to a position or situation from which there is no
incentive to change. At the equilibrium point, an economic unit is
maximising its benefits or advantages. Hence, there will always be a
tendency on the part of each economic unit to move towards the equilibrium
condition. Reaching the position of equilibrium is a basic objective of all
firms.

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In the short period, time available is too short and hence all types of
adjustments in the production process are impossible. As a plant capacity is
fixed, output can be increased only by intensive utilisation of existing plants
and machineries or by having more shifts. Fixed factors remain the same
and only variable factors can be changed to expand output. Total number of
firms remains the same in the short period. Hence, total supply of the
product can be adjusted to demand only to a limited extent.
In the short run, price is determined in the industry through the interaction of
the forces of demand and supply. This price is given to the firm. Hence, the
firm is a price taker and not a price maker. On the basis of this price, a firm
adjusts its output depending on the cost conditions.
An industry under perfect competition in the short run, reaches the position
of equilibrium when the following conditions are fulfilled:
1. There is no scope for either expansion or contraction of the output in the
entire industry. This is possible when all firms in the industry are
producing an equilibrium level of output at which MR = MC. In brief, the
total output remains constant in the short run at the equilibrium point.
Thus, a firm in the short run has only temporary equilibrium.
2. There is no scope for the new firms to enter the industry or existing firms
to leave the industry.
3. Short run demand should be equal to short run supply. The price so
determined is called as ‘subnormal price’. Normal price is determined
only in the long run. Hence, short run price is not a stable price.

9.6 Short-run Firm Equilibrium under Perfect Competition


A competitive firm will reach equilibrium position at a point where short run
MR equals MC. At this point, equilibrium output and price is determined.
The firm in the short run will have only temporary equilibrium. The short run
equilibrium price is not a stable price. It is also called as a sub - normal
price.

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Y
Cost & Revenue

MC

P MR = MC P1
 
AR = MR

0 X
Output

Figure 9.3: Short term equilibrium

The competitive firm, in the short run, will not be in a position to cover its
fixed costs. But it must recover short run variable costs for its survival and
continuance in the industry. A firm will not produce any output unless the
price is at least equal to the minimum AVC. If short run price is just equal to
AVC, it will not cover fixed costs and hence, there will be losses. However,
it will continue in the industry with the hope that it will recover the fixed costs
in the future.

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Y
Y SMC
Industry Firm

E3 AR3=MR3
P3 SAC
D S
  AVC
B
Price

A
Cost / Revenue
E E2
R P2  AR2=MR2

E1 AR1=MR1
P1 
D AR=MR
P4
S
0
Q 0 Q1 Q2 Q3
Demand & Supply Output

Figure 9.4: Short term equilibrium

If price is above the AVC and below the AC, it is called as “Loss
minimisation” zone. If the price is lower than AVC, the firm is compelled to
stop production altogether.
While analysing short term equilibrium output and price, apart from making
reference to SMC and AVC, we have to consider AC also. If AC = price,
there will be normal profits. If AC is greater than price, there will be losses
and, if AC is lower than price, then there will be supernormal profits.
In the short run, a competitive firm can be in equilibrium at various points
E1, E2 and E3 depending upon cost conditions and market price. At these
various unstable equilibrium points, though MR = MC, the firm will be
earning either supernormal profits or incurring losses or earning normal
profits.
In the case of the firm:
1. At OP4 price, the firm will neither cover AFC nor AVC and hence it has
to wind up its operations. It is regarded as shut-down point.
2. At OP1 price, OQ1 is the equilibrium output. E1 indicates the price or
AR = AVC only. It does not cover fixed costs. The firm is ready to
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suffer this loss and continue in business with the hope that the
price may go up in the future.
3. At OP2 price, OQ2 is the equilibrium output. E2 indicates the
price = AR = AC. At this point MR is also equal to MC. At this level of
output, total average revenue = total average cost. Hence, the firm is
earning only normal profits. It is also known as Break - even point of
the firm, a zone of no loss or no profit. The distance between two
equilibrium points E2 and E1 indicates loss-minimisation zone.
4. At OP3 price, OQ3 is the output produced by the firm. At E3, MR = MC.
But AR is greater than AC. For OQ3 output, the total cost is OQ3AB.
The total revenue is OQ3E3P3. Hence, P3E3AB is the total
supernormal profits.
Thus, in the short run, a firm can either incur losses or earn supernormal
profits. The main reason for this is that the producer does not have
adequate time to make all kinds of adjustments to avoid losses in the short
run.
In case of the industry, E indicates the position of equilibrium where short
run demand is equal to short run supply. OR indicates short run price and
OQ indicates short run demand and supply.

9.7 Long-run Industry Equilibrium under Perfect Competition


In the long run, there is adequate time to make all kinds of changes,
adjustments and readjustments in the production process. All factor inputs
become variable in the long run. Total number of firms can be varied and
plant capacity also can be changed depending upon the nature of
requirements. Economies of scale, technological improvements, better
management and organisation may reduce production costs substantially in
the long run. Hence, production can be either increased or decreased
according to the needs of the individual firms and the industry as a whole. In
short, supply of the product can be fully adjusted to meet its demand in the
long period.
In the long run, an industry, will be reaching the position of equilibrium under
the following conditions:
1. At the point of equilibrium, the long run demand and supply of the

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products of the industry must be equal to each other. This will determine
the long run normal price.
2. There will be no scope for the industry to either expand or contract
output. Hence, the total production remains stable in the long run.
3. All the firms in the industry should be in the position of equilibrium. All
firms in the industry must be producing an equilibrium level of output at
which long run MC is equated to long run MR. (MC = MR).
4. There should be no scope for entry of new firms into the industry or exit
of old firms from the industry. In brief, the total number of firms in the
industry should remain constant.
5. All firms should be earning only normal profits. This happens when all
firms equate AR (Price) with AC. This will help the industry in attaining a
stable equilibrium in the long run.

9.8 Long-run Firm Equilibrium under Perfect Competition


A competitive firm reaches the equilibrium position when it maximises its
profits. This is possible when:
1. The firm would produce that level of output at which MR = MC and MC
curve cuts MR curve from below. The firm adjusts its output and the
scale of its plant so as to equate MC with market price.

Price = MC = MR

2. The firm in the long run must cover its full costs and should earn only
normal profits. This is possible when long run normal price is equal to
long run average cost of production. Hence,

Price = AR = AC
3. When AR is greater than AC, supernormal profits are earned. This leads
to the entry of new firms, increase in the total number of firms,
expansion in the output, increase in the supply, fall in the price and fall in
the ratio of profits. This process will continue till supernormal profits are
reduced to zero. On the other hand, when AC is greater than AR, the
industry will be incurring losses. This leads to the exit of old firms,

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decrease in the number of firms, contraction in output, rise in price, and


rise in the ratio of profits. Thus, losses are avoided by automatic
adjustments. Such adjustments will continue till the firm reaches the
position of equilibrium when AC becomes equal to AR. Thus, losses and
profits are incompatible with the position of equilibrium. Hence,

Price = MR = MC = AR = AC

4. The firm is operating at its minimum AC making optimum use of


available resources.
Y
Industry Firm LMC
Y LAC

LRS
LRD
Cost / Revenue
Price

E P AR=MR
R  

S D

X
0 Q 0 Q
Output
Demand & Supply

Figure 9.5: Long run equillibrium

In the case of the industry, E is the position of equilibrium at which LRS =


LRD, indicating OR as the equilibrium price and OQ as the equilibrium
quantity demanded and supplied.
In case of the firm, P indicates the position of equilibrium. At P, LMR = LMC
and LMC curve cuts LMR curve from below. At the same point P, the
minimum point of LAC is tangent to LAR curve. Hence,

LAR = LAC

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A competitive firm in the long run must operate at the minimum point of the
LAC curve. It cannot afford to operate at any other point on the LAC curve.
Otherwise, it cannot produce the optimum output or, it will incur losses.
Time plays an important role in determining the price of a product in the
market. As the time under consideration is short, demand will have a more
decisive role than supply in the determination of price. Longer the time
under consideration, supply becomes more important than demand in the
determination of price.
The price determined in the long run is called as normal price and it remains
stable.
Market price
Market price refers to that price which is determined by the forces of
demand and supply in a short period where demand plays a major role and
supply plays a passive role. Market price is unstable.
Normal price
Normal price is determined by demand and supply forces in the long period.
It includes normal profits also and it is stable in nature.

Activity:
Select a competitive firm and determine the price of a product in the
market and check its equilibrium position when it maximises its profits.
Hint: Refer section 9.8

Self Assessment Questions


Fill in the blanks:
1. The firms can earn only normal profit under ___________ competition.
2. Under perfect competition, demand curve is a ______________ line.
3. Regardless of the cost structure of firms in a competitive market, in the
long run, the marginal firm will earn __________ profit.
4. When new firms enter a perfectly competitive market the short-run
market supply curve shifts ______.
5. For any given price, a firm in a competitive market will maximise profit
by selecting the level of output at which price intersects the ______
curve.

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True or false:
6. In competitive markets, firms increasing their product prices earn larger
profits. (True/False)
7. In perfectly competitive markets, firms are unable to differentiate their
product from that of other producers. (True/False)
8. For a firm in a perfectly competitive market, marginal revenue is always
equal to average revenue. (True/False)
9. A profit-maximising firm in a perfectly competitive market will earn zero
accounting profits in the long run. (True/False)
10. The marginal firm in a competitive market will earn zero economic profit
in the long run. (True/False)

9.9 Summary
Let us recapitulate the important concepts discussed in this unit:
 The organisation and functioning of a firm is determined by the type of
market in which it is operating.
 A market structure is characterised by the number of buyers and sellers,
nature of the commodity dealt with, the scope for entry and exit of firms
and the determination of price.
 Perfect competition exhibits an ideal market situation, where there are a
large number of buyers and sellers, the commodity dealt with is
homogeneous, there is free entry and exit of firms into and out of the
industry, and a uniform price prevails in the market.
 In the long run Price is equal to MR=AR=MC=AC. The firms can make
normal profit only in the long run.

9.10 Glossary
Firm: A single manufacturing unit producing and selling either a commodity
or service.
Industry: All firms engaged in providing the same kind of service or doing a
common trade or business.
Market: A commodity and buyers and sellers of that commodity who are in
competition with one another.

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Market structure: Economically significant features of a market, which


affect the behaviour, and working of firms in the industry.
Normal profits: Profits which are just sufficient to ensure the firms stay in
business.
Perfectly competitive market: Market in which the number of buyers and
sellers are large, all engaged in buying and selling a homogeneous product
without any artificial restriction and, possessing a perfect knowledge of the
market at a time.

9.11 Terminal Questions


1. What are the primary characteristics of markets that categorise the
market’s structure?
2. Distinguish between a firm and an industry.
3. What is perfect competition? Explain how an industry’s equilibrium price
is determined under perfect competition in the short run.
4. When should a firm in perfectly competitive market shut down its
operation?
5. Explain the equilibrium of a firm under perfect competition in the long
run.

9.12 Answers

Self Assessment Questions


1. Perfect
2. Horizontal
3. Zero Economic
4. Right
5. Marginal cost
6. False
7. True
8. True
9. False
10. True

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Terminal Questions
1. The number and size distribution of sellers, the number and size
distribution of buyers, product differentiation, conditions of entry and exit
are all primary characteristics of market structure. Refer to section 9.2.
2. A firm is a single manufacturing unit producing and selling either a
commodity or a service. Many firms producing similar or homogeneous
goods or services collectively make an industry. Refer to section 9.4.
3. A perfectly competitive market is one in which the number of buyers and
sellers are large, all engaged in buying and selling a homogeneous
product without any artificial restriction and, possessing perfect
knowledge of the market at a time. Refer to section 9.5.
4. At OP4 price, the firm will neither cover AFC nor AVC and hence it has
to wind up its operations. It is regarded as shut-down point. Refer to
section 9.6.
5. A competitive firm reaches the equilibrium position when it maximises its
profits. Time plays an important role in determining the price of a product
in the market. Refer to section 9.8.

9.13 Case Study

The growing market economies have virtually eliminated markets which


operate under perfect competition conditions. The presence of brands,
government regulations and controls, dominance of a few large players
and increasing focus on product differentiation has led more markets
towards imperfect competition conditions. However, a few examples that
approximate perfect competition can be seen.
In the modern world, stock markets are commonly quoted as an example
of a scenario where perfect competition conditions exist. For a given
stock, various bidders quote their prices and a market price is identified.
In most cases, individual buyers and sellers have no impact on the
market price of the stock. The stock can be bought and sold easily
indicating that the resource is liquid in nature. However, the perfect
competition conditions are compromised by the presence of large
institutional buyers and insider trading that occurs due to imperfect
information among buyers.

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Another example of a market that approximates perfect competition is


street markets for commodities such as vegetables. However, a pre-
condition for perfect competition is that the product characteristics
(quality, grade, variety, etc.) should be undifferentiated. Street food
markets are another example wherein perfect competition conditions
could exist.
Discussion Questions:
1. Why do firms have to explore ways (for example, by differentiating
their offerings) to move away from perfect competition conditions?
2. Exercise: In your town, can you identify certain conditions that
approximate perfectly competitive markets?
3. Are they moving towards imperfect competition?
Source: Author-created

References:
 Chamberlin E. H. (1957). Towards a More General Theory of Value,
New York: Oxford University Press.
 Dean J. (1951). Managerial Economics, Englewood Cliffs, NJ, Prentice
Hall.
 Bilas R. A., (1971). Microeconomic Theory, Tokyo, McGraw-Hill
Kogakusha.
 Alfred M. (1920). Principles of Economics, 8th Ed, Macmillan & Co.
E-Reference:
 www.economictimes.com – retrieved on 15th January 2012

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Unit 10 Pricing under Imperfect Competition


Structure:
10.1 Introduction
Case Let
Objectives
10.2 Monopoly
10.3 Price Discrimination under Monopoly
10.4 Bilateral Monopoly
10.5 Monopolistic Competition
10.6 Oligopoly
10.7 Collusive Oligopoly and Price Leadership
10.8 Duopoly
10.9 Industry Analysis
10.10 Summary
10.11 Glossary
10.12 Terminal Questions
10.13 Answers
10.14 Case Study
Reference/E-Reference

10.1 Introduction
In the previous unit, we studied about price determination under perfect
competition. We learnt how prices are determined in markets that are
perfectly competitive. We also learnt about the functions of markets and how
individual firms are different from industry. Although the theory of perfectly
competitive markets is well rounded and robust, such markets are seldom
found in the real world. Most markets are imperfect due to the variations in
market characteristics. Conditions of entry and exit are quite different across
markets and consumers possess dissimilar levels of information. The strong
emergence of brands, proprietary technologies, increasing influence of
media, government regulations and relative concentration of financial power
have contributed to the prevalence of imperfect markets. In this unit, we will
learn about pricing under imperfect competition and how prices are
determined in imperfect markets. We will also explore related issues that
influence business firms and consumers.

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Case Let (Continued from Unit 9)


Ramesh made attempts to learn the pricing practices that were prevalent
in the industry in which his firm operated. He learnt that, in most
instances, firms fixed their product prices by considering the prices of
competitors’ products and the costs incurred in producing and delivering
the products. However, he could not understand why the same product,
with a few minor enhancements, was priced differently in different
markets. He also observed that products which were sold only by one or
two firms were priced relatively higher than those products which were
sold by most firms. He met his superior, who asked him to learn about
pricing practices in markets that were not perfectly competitive, and
where customers did not have full information on all the products in the
market and their prices.

Objectives:
After studying this unit, you should be able to:
 explain how firms operating in imperfectly competitive markets maximise
their out put
 formulate realistic estimates of profit maximisation
 examine how price discrimination can be applied
 describe the working of oligopoly in practice

10.2 Monopoly
Meaning and definition
Monopoly means existence of a single seller in the market. Monopoly is
that market form in which a single producer controls the whole supply
of a single commodity which has no close substitutes. Monopoly may
be defined, as a condition of production in which a single firm has the power
to fix the price of the commodity or the output of the commodity. It is a
situation there exists a single control over the market producing a
commodity having no substitutes with no possibilities for any one to enter
the industry to compete.

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Features of monopoly
 Anti-thesis of competition – Absence of competition in the market
creates a situation of monopoly and hence, the seller faces no threat of
competition.
 Existence of a single seller – There will be only one seller in the
market who exercises single control over the market.
 Absence of substitutes – There are no close substitutes for the seller’s
product with a strong cross elasticity of demand. Hence, buyers have no
alternatives.
 Control over supply – Seller will have complete control over output and
supply of the commodity.
 Price maker – The monopolist is the price maker and in taking
decisions on price fixation, he or she is independent. He or she can set
the price to the best of his or her advantage. Hence, the monopolist can
either charge a high price for all customers or adopt price discrimination
policy if there are different types of buyers.
 Entry barriers – Entry of new firms is difficult. Hence, monopolist will
not have direct competitors in the market.
 Firm and industry is same – There will be no difference between the
firm and an industry.
 Nature of firm – The monopoly firm may be a proprietary concern,
partnership concern, Joint Stock Company or a public utility which
pursues an independent price-output policy.
 Existence of super normal profits – There will be opportunities for
supernormal profits under monopoly, because market price is greater
than the cost of production.
There are different kinds of monopolies; private and public, pure monopoly,
simple monopoly and discriminatory monopoly. It is to be clearly understood
that with the exception of public utilities or institutions of a similar nature,
whose price is set by regulatory bodies, monopolies rarely exist. Just like
perfect competition, pure monopoly also does not exist. Hence, we make a
detailed study of simple monopoly and discriminatory monopoly in the
foregoing analysis.

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Price – output determination under monopoly


Assumptions
 The monopoly firm aims at maximising its total profit.
 It is completely free from government controls.
 It charges a single and uniform high price to all customers.
It is necessary to note that the price output analysis and equilibrium of the
firm and industry is one and the same under monopoly.
As output and supply are under the effective control of the monopolist, the
market forces of demand and supply do not work freely in the determination
of equilibrium price and output in case of the monopoly market. While fixing
the price and output, the monopoly firm generally considers the following
important aspects:
1. The monopolist can either fix the price of his/her product or its supply.
The price and control of the supply cannot be fixed simultaneously. The
price of the product maybe fixed and supply can be determined by the
demand conditions, or the output maybe fixed and leaves the price to be
determined by the demand conditions.
2. It would be more beneficial to the monopolist to fix the price of the
product rather than fixing the supply, because it would be difficult to
estimate the accurate demand and elasticity of demand for the products.
3. While determining the price, the monopolist has to consider the
conditions of demand, cost of the product, possibility of the emergence
of substitutes, potential competition, import possibilities, government
control policies, etc.
4. If the demand for the product is inelastic, a relatively higher price can be
charged and if the demand is elastic, a relatively lower price has to be
charged.
5. Larger quantities can be sold at lower price or smaller quantities at a
higher price.
6. The most reasonable price should be charged which is neither too high
nor too low.
7. The most ideal price is that under which the total profit of the monopolist
is the highest.

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Price - output determination in the short run


Short run is a time period in which there are two types of factors of
production. One is the fixed factors and the other is the variable factors. In
the short period, production can be changed only by changing the variable
factors of production. In other words, in the short period, supply can be
changed only to some extent, which is determined essentially by the
capacity created. In this period, volume of production can be changed but
capacity of the plant cannot be changed. The firm can increase the supply
only with the help of existing machines and plants. New factories and plant-
equipment cannot be installed.
The aim of a monopolist is to earn maximum profits or suffer minimum
losses if the circumstances compel. Monopolist, being a single seller of
his/her product, can fix the price equal to, above or less than the short
period average cost of the product. Thus, normal profits or supernormal
profits can be earned, or even incur losses in the short period.
The level of profit depends upon the nature and extent of the demand for the
product. In order to earn maximum profits or suffer minimum losses, a
monopolist compares the marginal revenue (MR) with marginal cost (MC). If
marginal revenue exceeds marginal cost of a product, the monopolist can
increase the profit by increasing the production. On the contrary, if MC
exceeds MR at a particular level of output, the monopolist can minimise the
losses by reducing the production. So, the monopolist is said to be in
equilibrium, where marginal revenue is equal to marginal cost.
In the short period, a monopoly firm can earn supernormal profits, normal
profits or incur losses. In case of losses, price must cover at least the
average variable costs. Otherwise, the firm will stop production. The
maximum loss can be equal to fixed costs. Figure 10.1, 10.2 and 10.3 depict
the three cases of monopoly equilibrium.

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Three Cases of Monopoly Equilibrium

Y
AR > AC
SAC
Super Normal Profits
SMC

P
Price

S
AR
Q
R 
E
MR
0 X
M
Output
Figure 10.1: AR > AC

Y Normal Profit

AR = AC

SMC
SAC
P

R
Price

AR
E
MR
0 X
M
Output

Figure 10.2: AR = AC

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Y AR < AC

Losses SMC SAC

Q AVC
R

S P
Price

AR

MR
0 X
M
Output

Figure 10.3: AR < AC

In figure 10.1: AR > AC. Hence, super normal profits.


In figure 10.2: AR = AC. Therefore, normal profits are incurred.
In figure 10.3: AR < AC. Therefore, losses are incurred.
The figures explain how a monopoly firm can earn supernormal profits,
normal profits or incur losses in the short period.
Price – output determination in the long run
In the long run, there is adequate time to make all kinds of adjustments in
both fixed as well as variable factor inputs. Supply can be adjusted to
demand conditions. The total amount of long run profits will depend, on the
cost conditions under which the monopolist has to operate and the demand
curve to be faced in the long run.
Under monopoly, the AR or demand curve drops downwards from left to
right. This is because the monopolist can increase the sales and maximise
the profits only when the price is reduced. MR is less than AR and hence,
the MR curve lies below the AR curve. This is in accordance with the usual
relationship between AR & MR.

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The cost curve of the monopoly firm is influenced by the law of returns. The
price to be charged for the product mainly depends on the nature of the cost
curves.
The monopoly firm, in the long run, will continue its operations till it reaches
the equilibrium point where long run MR equals long run MC. The price
charged at this level of output is known as equilibrium price. In figure 10.4,
the monopoly firm reaches the position of equilibrium at E.
Long-run Price Determination in Monopoly

LMC

P LAC
R
Price

M
N
AR
E
MR

0 X
Output Q

Figure 10.4

At this point, MR = MC and MC curve cuts MR curve from below. The


monopolist will stop the output before AC reaches its minimum point. He/she
does not bother to reach the minimum point on AC.
The output is restricted in order to maximise the profit, OQ is the output. The
price charged by the firm is QR (PQ) which is equal to AR. This price is
higher than average cost QM per unit. The excess profit per unit of output is
PM and the total profits of the firm is PM X RN = NRPM. Under monopoly,
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no doubt MR = MC but MR is less than AR. Hence, under monopoly, price


= AR only. Price is greater than AC, MC and MR.
Generally speaking, monopoly price is slightly higher than that of
competitive price because market price is over and above MC, MR and AC.
The single seller has complete control over the supply as he/she can
successfully prevent the entry of other new firms into the market. Thus, the
monopoly power is reflected on its price. Monopoly price is generally higher
than competitive price and thus detrimental to the interests of the society.
Monopoly price need not always be high on account of the following
reasons:
 Due to the operation of both internal as well as external economies of
scale, the monopolist may reduce the cost of production and hence,
price too.
 The monopolist need not spend more money on sales promotion
programmes. A lower price can be charged for the product and quite a
lot of money can be saved.
 Monopolist has the fear that consumers may boycott the product if a
high price is charged.
 There is the fear of discovery of new substitutes by other competitors in
the market. Hence, low prices are charged.
 Fear of government intervention in controlling monopoly power leads to
a lower price being charged.
 A lot of money maybe spend on R&D and thus reduce cost of operation.
Cost reduction may facilitate price reduction.
Thus, in order to maintain the goodwill of the consumers and to secure good
business, instead of charging high price, the monopolist may charge a
relatively lower price.

10.3 Price Discrimination under Monopoly


Generally, the monopolist will not charge a uniform price for all the
customers in the market. If it is beneficial to segment the market into
homogenous groups, different methods will be followed under different
circumstances. The policy of price discrimination refers to, the practice
of a seller to charge different prices for different customers for the
same commodity, produced under a single control without

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corresponding differences in cost. When a monopoly firm adopts this


policy, it will become a discriminatory monopoly.
Kinds of price discrimination:
Three kinds of price discrimination are commonly seen. It is as follows:
 Discrimination of the first degree – Under price discrimination of the
first degree, the producer exploits the consumers to the maximum
possible extent, by asking to pay the maximum he/she is prepared to
pay rather than go without the commodity. In this case, the monopolist
will not allow any consumer’s surplus to the consumer. This type of price
discrimination is called perfect discrimination.
 Discrimination of the second degree – In case of discrimination of the
second degree, the monopolist charges different prices for markets of
the same commodity, but not at a maximum possible rate but at a lower
rate. The monopolist will leave a certain amount of consumer’s surplus
with the consumers. This is done to keep the consumers satisfied and
prevent the entry of potential rivals. This method is adopted by railway
companies.
 Discrimination of the third degree – In case of discrimination of the
third degree, the markets are divided into many sub-markets or sub-
groups. The price charged in each case roughly depends on the ability
to pay of different subgroups in the market. This is the most common
type of discrimination followed by a monopolist.
Price discrimination may take the following forms: (Basis of price
discrimination)
1. Personal differences
This refers to charging different prices for the same commodity due to
personal differences arising out of ignorance and irrationality of consumers,
preferences, prejudices and needs.
2. Place
Markets may be divided on the basis of entry barriers, for example, price of
goods will be high in the place where taxes are imposed. Price will be low in
the place where there are no taxes or low taxes.

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3. Different uses of the same commodity


When a particular commodity or service is meant for different purposes,
different rates may be charged depending upon the nature of consumption.
For example, different rates may be charged for the consumption of
electricity for lighting, heating and productive purposes in the industry and in
agriculture.
4. Time
Special concessions or rebates may be given during festival seasons or on
important occasions.
5. Distance
Railway companies and other transporters, for example, charge lower
rates/km if the distance is long and higher rates if the distance is short.
6. Special orders
When the goods are made to order, it is easy to charge different prices to
different customers. In this case, a particular consumer will not know the
price charged by the firm for other consumers.
7. Nature of the product
Prices charged also depends on the nature of products, for example,
railways charge higher prices for carrying coal and luxuries and lower prices
for cotton, necessities of life, etc.
8. Quantity of purchase
When customers buy large quantities, discount will be allowed by the
sellers. When small quantities are purchased, discount may not be offered.
9. Geographical area
Business enterprises may charge different prices at the national and
international markets. For example, dumping – they charge a lower price in
the competitive foreign market and a higher price in the protected home
market.
10. Discrimination on the basis of income and wealth
For example, a doctor may charge higher fees for rich patients and lower
fees for poor patients.
11. Special classification of consumers
For example, transport authorities such as railways and roadways show
concessions to students and daily travelers. Different charges for I class and

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II class traveling, ordinary coach and air conditioned coaches, special rooms
and ordinary rooms in hotels, etc.
12. Age
Cinema houses in rural areas and transport authorities charge different
rates for adults and children.
13. Preference or brands
Certain goods will be sold under different brand names or trademarks in
order to attract customers. Different brands will be sold at different prices
even though there is not much difference in the terms of costs.
14. Social and/or professional status of the buyer
A seller may charge a higher price, for those customers who occupy higher
positions and have a higher social status and a lower price for others.
15. Urgency of the buyer
If a customer is in a hurry, higher price would be charged. Otherwise,
normal price would be charged.
16. Discrimination on the basis of sex
In selling certain goods, producers may discriminate between male and
female buyers by charging low prices to females.
17. Peak season and off peak season services
Hotel and transport authorities charge different rates during peak season
and off-peak seasons.
If price differences are minor, customers do not bother about such
discrimination.
Pre-requisite conditions for price discrimination (when price
discrimination is possible)
1. Existence of imperfect market
Under monopoly, price discrimination occurs as there are buyers with
incomplete knowledge and information about the market.
2. Existence of different degrees of elasticity of demand in different
markets
A monopolist will succeed in charging higher price in inelastic market and
lower price in the elastic market.

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3. Existence of different markets for the same commodity


This will facilitate price discrimination because buyers in one market will not
know the prices charged for the same commodity in other markets.
4. No contact among buyers
If there is a possibility of contact and communication among buyers,
discriminatory practices followed by buyers will be known.
5. No possibility of a resale
Monopoly product purchased by consumers in the low priced market should
not be resold in the high priced market. Prevention of re exchange of goods
is a must for price discrimination.
6. Legal sanction
In some cases, price discrimination is legally allowed. For example, the
electricity department will charge different rates per unit of electricity for
different purposes. Similarly, charges on trunk calls, book post, registered
posts, insured parcel, and courier parcel are different.
7. Buyers’ illusion
When consumers have an irrational attitude that high priced goods are of
high quality, a monopolist can resort to price-discrimination.
8. Ignorance and lethargy
Due to laziness and lethargy, consumers may not compare the price of the
same product in different shops. Ignorance of consumers with regard to
price variations would enable the monopolist to charge different prices.
9. Preferences and Prejudices of buyers
The monopolist may charge different prices for different varieties or brands
of the same product to different buyers. For example, low price for popular
edition of the book and high price for deluxe edition.
10. Non-transferability features
In case of direct personal services like private tuitions, hair-cuts, beauty and
medical treatments, a seller can conveniently charge different prices.
11. Purpose of service
The electricity department charges different rates per unit of electricity for
different purposes like lighting, AEH, agriculture, industrial operations, etc.
Railways charge different rates for carrying perishable goods, durable
goods, necessaries and luxuries, etc.
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12. Geographical distance and tariff barriers


When markets are separated by large distances and tariff barriers, the
monopolist has to charge different prices due to the high transport cost,
high rate of taxes, etc.

Figure 10.5: Pricing under discriminatory monopoly

Prices to be charged by the monopolist under price discrimination depend


upon elasticity of demand for the products in different markets. The total
output to be produced and supplied depends on marginal revenue and
marginal cost. The principle of equilibrium under price discrimination is that
marginal revenues in different markets are equal to marginal cost of the total
output.
MR1 = MR2 = MC of the total output.
The monopolist, in order to exploit the market to the fullest extent, divides
the market into two sub-markets, sub-market A and sub-market B, on the
basis of price elasticity of demand. The total sales are distributed in these
two markets. In the sub-market A, the demand for the product is inelastic
and hence a relatively higher price is charged of P1 & M1. The output sold
in this market is OM1. E1 is the equilibrium position where MR = MC. P1
and E1 indicates the price over and above MR and MC.

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In the sub-market B, the demand for the product is relatively more elastic. A
relatively lower price of P2 and M2 is charged. The output, sold in this
market is OM2. E2 is the equilibrium position where MR = MC. The distance
between P2 & E2 indicates the excess of price over MR and MC.
The third diagram represents the total market for the product of the
monopolist. AMR is the aggregate MR in both the markets and AAR is the
aggregate AR in both the markets. MC is the marginal cost curve. At E, MR
= MC, the equilibrium position of the monopoly firm. The total output sold in
the two sub-markets is represented by OM.
The above description clearly shows that the monopolist has discriminated
the two markets and charged different prices in these two markets.
When price discrimination is profitable and justified:
 It is profitable for a monopolist when he or she charges a relatively
higher price for those products having inelastic demand and lower price
for those having elastic demand. In this case, the total profits would be
certainly high when compared to a simple monopolist who charges a
single price.
 It is profitable to the general public only when price discrimination is
allowed in public utility services and public sector where total receipts
are lower than total costs. For example, railways, P & T, telephones,
news paper, housing, electricity department, water supply department,
etc. Otherwise, common man and economically weaker section will not
get certain products and services at cheaper rates. In such cases, from
the point of view of their survival, growth and social welfare, price
discrimination is justified.
 It is profitable when community’s welfare requires price discrimination.
For example, a doctor, or a lawyer, or a chartered accountant will charge
a relatively higher fees for rich customers and lower fees for common
man and poor people; this policy has redistributive effect. Inequalities in
income and wealth distribution can be reduced through price
discrimination. On the other hand, rich people can also get better service
by paying higher fees or price.
 It is profitable when the monopolist is organising the production on a
large scale basis, increase the total output, reduce the production cost
and charge a lower price in one market and a higher price in another
market.
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 It is profitable when the monopolist is sharing a part of the total profits


with co-workers in the form of higher wages, salaries, bonus, etc.
 It is profitable to the entire society when price discrimination leads to
fuller utilisation of national resources, higher output, income and
employment and promote the welfare of the general public.
 Normal dumping is profitable to a society, because surplus production is
cleared off in foreign markets at lower prices and thus promotes export
of the country.
 It is not profitable in cases where it leads to exploitation of the poor,
common man, elimination of small entrepreneurs from the field of
business, over investments in business, under utilisation of resources
and all other kinds of wastages, etc.

10.4 Bilateral Monopoly


Bilateral monopoly is a special type of market situation in which a single
seller faces a single buyer, i.e., a monopsonist is facing a monopolist. For
example, in a town, there is only one steel factory offering employment for
labour in the area and suppose a trade union controls the entire labour
supply, the trade union which controls the supply of labour is the monopoly
and the steel factory which is the sole buyer of labour is the monopsony.
In principle, the monopolist wishes to operate on a scale where the marginal
cost is equal to marginal revenue, which will bring him or her the maximum
monopoly profit. On the other hand, the monopsonist wishes to purchase an
amount at which marginal cost is equal to marginal utility. This indicates one
optimum price for the buyer and another for the seller. There is, thus,
indeterminateness in price fixation in bilateral monopoly. The two parties
must enter into negotiations and the final price and quantity will depend
upon the relative bargaining strength of the two parties. If the monopsonist
is more powerful, the price will tend to be low; but if the monopolist is more
powerful, the actual price will tend to be high.
Monopsony
Monopsony refers to a market with a single buyer who buys the entire
amount produced. A Monopsony may be created when all the consumers of
a commodity are organised together. For example, if there is only one cotton
mill in a region, it becomes a monopsonist buyer of raw cotton, while the

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suppliers of cotton to the mill will be the large number of cotton growers.
Just as the monopolist aims at maximising profits, in the same manner, the
monopsonist aims at maximising consumer’s surplus, and the consumer’s
surplus is maximum when the marginal cost is equal to marginal utility. A
monopsonist too can adopt price discrimination, paying different prices to
different sellers according to the elasticity of supply.

10.5 Monopolistic Competition


Perfect competition and monopoly are two extreme forms of market
situations, rarely to be found in the real world. Generally, markets are
imperfect.
Prof. Chamberlin is the main architect of the theory of Monopolistic
Competition. This market exhibits the characteristics of both perfect
competition and monopoly. Since modern markets are combined and
integrated with monopoly power and competitive forces, they are called as
Monopolistic Competition. It is a market structure in which a large
number of small sellers sell differentiated products which are close,
but not perfect substitutes for one another. Under this market, the
products produced and sold are different, but they are close substitutes for
one another. This leads to competition among different sellers. Thus, in
this market situation, every producer is a sort of monopolist and between
such “mini-monopolists” competition exists. It is one of the most popular and
realistic market situations to be found in the present day world. A number of
examples may be given for this kind of market. Toothpaste, blades,
motorcycles and bicycles, cigarettes, cosmetics, biscuits, soaps and
detergents, shoes, ice – creams, suppliers of cane to a sugarcane factory in
an isolated location where only one sugar factory exists, etc.
Characteristics of monopolistic competition
1. Existence of a large number of firms
Under Monopolistic Competition, the number of firms producing a product
will be large. The size of each firm is small. No individual firm can influence
the market price. Hence, each firm will act independently without worrying
about the policies followed by other firms. Each firm follows an independent
price-output policy.

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2. Market is characterised by imperfections


Imperfections may arise due to advertisements, differences in transport
cost, irrational preferences of consumers, ignorance about the availability of
different brands of products and prices of products, etc., Sellers may also
have inadequate knowledge about market and prices existing at different
segments of markets.
3. Free entry and exit of firms
Each firm produces a very close substitute for the existing brands of a
product. Thus, differentiation provides ample opportunity for a firm to enter
with the group or an industry. On the contrary, if the firm faces the problem
of product obsolescence, it may be forced to go out of the industry.
4. Element of monopoly and competition
Every firm enjoys some sort of monopoly power over the product it
produces. However, it is neither absolute nor complete because each
product faces competition from rival sellers selling different brands of the
product.
5. Similar products but not identical
Under monopolistic competition, the firm produces commodities which are
similar to one another but not identical or homogenous. For example,
toothpastes, blades, cigarettes, shoes, etc.,
6. Non-price competition
In this market, there will be competition among “Mini-monopolists” for their
products and not for the price of the product. Thus, there is “product
competition” rather than “price competition”.
7. Definite preference of the consumers
Consumers will have definite preference for particular variety or brands
loyalty owing to the special features of a product produced by a particular
firm.
8. Product differentiation
The most outstanding feature of monopolistic competition is product
differentiation. Firms adopt different techniques to differentiate their products
from one another. It may take mainly two forms:

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a. Real product difference:


It will arise –
i. When products are produced from materials of higher quality,
durability and strength.
ii. When products are extraordinary on the basis of workmanship, higher
cost of material, colour, design, size, shape, style, fragrance, etc.
iii. When personal care is taken to produce the products.
b. Imaginary product difference:
Producers adopt different methods to differentiate their products from that of
other close substitutes in the following manner:
i. Proper location of sales depots in busy and prestigious commercial
centres.
ii. Selling goods under different trade marks, patenting rights, different
brands and packing them in attractive wrappers or containers.
iii. Providing convenient working hours to customers.
iv. Home delivery of goods with no extra cost.
v. Courteous treatment to customers, quick and prompt delivery of goods
in time and developing cordial, personal and friendly relations with
them.
vi. Offering gifts, discounts, lucky dip schemes, special prices, guarantee
of repairs and other free services, guarantee of products, fair dealings,
sales on credit or credit cards and debit cards, etc.
vii. Agreement to take back goods if they are unsatisfactory.
viii. Air conditioned stores, etc.
9. Selling costs
All those expenses which are incurred on sales promotion of a product
are called as selling costs. In the words of Prof. Chamberlin – “selling
costs are those which are incurred by the producers (sellers) to alter the
position or shape of the demand curve for a product”. In short, selling costs
represents all those selling activities which are directed to persuade buyers
to change their preferences so as to maximise the demand for a given
commodity. Selling costs include expenses on sales depots, decoration of
the shop, commission given to intermediaries, window displays,
demonstrations, exhibitions, door to door canvassing, distribution of free

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samples, printing and distributing pamphlets, cinema slides, radio, T.V.,


newspaper advertisements (informative and manipulative advertisements),
etc.
10. The concept of industry and product groups
Prof. Chamberlin introduced the concept of group in place of industry.
Industry in economics refers to a number of firms producing similar
products. Under monopolistic competition, no doubt, different firms produce
similar products but they are not identical. Hence, Prof. Chamberlin has
made an attempt to redefine the industry. According to him, the
monopolistically competitive industry is a ‘group‘of firms producing a ‘closely
related’ commodity referred to as “product group”. Thus, group refers to a
collection of firms that produce closely related but not identical products.
11. More elastic demand curve
Product differentiation makes the demand curve of the firm much more
elastic. It implies that a slight reduction in the price of one product, assuming
the price of all other products remaining constant leads, to a large increase
in the demand for the given product.
Price – output determination
Short run equilibrium
Short period is a period of time where time is inadequate to make all sorts of
changes and adjustments in the production process. The demand and cost
conditions may vary substantially forcing the firm either to charge a higher or
lower price leading to supernormal profits or losses. However, each firm
fixes the price and produce output which maximises its profit. The
equilibrium price and output is determined at the point where short run
marginal cost equals marginal revenue. Thus, the first condition for short run
equilibrium is MC = MR in both diagrams.

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AR > AC AR < AC
Profits Y Losses

Y
SMC
SMC
SAC
SAC
P
P R

Price
Price

R
N M
M
N a AR
E 
E 
AR
MR
MR
0 X 0 X
Q Q
Output Output

Figure 10.6: Short-run price determination in Monopolistic Competition

The first diagram shows supernormal profits. In this case, price (AR) is
greater than AC (cost Per Unit). MQ is the cost per unit and total cost for OQ
output is = MQ X OQ = ONMQ. PQ is the price or revenue per unit and the
total revenue for OQ output is = PQ X OQ = ORPQ. Supernormal profit =
TR (ORPQ) – TC (ONMQ). Hence, NRPM is the total profit.
The second diagram shows losses. In this case, AC is greater than AR. PQ
is the cost per unit and the total cost is PQ x OQ = ORPQ. MQ is the
revenue per unit and the total revenue for OQ output is MQ X OQ = ONMQ.
Total losses = TC (ORPQ) - TR (ONMQ) = NRPM. Thus, in the short run,
there will be place for supernormal profits or losses.
Price output determination in the long run
Long run is a period of time where a firm will get adequate time to make any
changes in the productive process or business. A firm can initiate several
measures to minimise its production costs and enjoy all the benefits of large
scale production. The cost conditions, as a result, differ slightly in the long
run. While fixing the price, a firm in the long run should consider its AC and
AR.

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Generally, in the long run, a firm can earn only normal profits. If AR is
greater than AC, there will be supernormal profits. This leads to entry of new
firms – increase in the total number of firms - total production – fall in prices
- decline in profit ratio. On the other hand, if AC is greater than AR, there will
be losses. This leads to the exit of old firms - decrease in the number of
firms - total production - rise in prices – increase in profit ratio. Thus, the
entry and exit of firms continue till AR becomes equal to AC. Thus, in the
long run, two conditions are required for the equilibrium of the firm –
1) MR = MC and
2) AR = AC. However, it should be noted that price is greater than MR and
MC.

LMC LAC
Price

P
R 


E AR
MR
0 X
Q
Output

Figure 10.7: Long-run Price determination in Monopolistic Competition

In the diagram, E is the equilibrium position where MR = MC and MC curve


cuts MR curve from below. At P, AR = AC = price.
It is necessary to understand that a firm under monopolistic competition in
the long run also can earn supernormal normal profits. Prof. Stonier and
Hague suggest that a firm can innovate, to introduce new changes in the
context of a modern competitive business. This appears to be more realistic
because today almost all firms make heavy profits. Hence, it is regarded as
one of the most practical forms of market situations in the present day.

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10.6 Oligopoly
The term oligopoly is derived from two Greek words “Oligoi” means a few
and ‘Poly’ means to sell. Under oligopoly, we come across a few
producers specialising in the production of identical goods or
differentiated goods competing with one another. The products traded
by the oligopolists may be differentiated or homogeneous. In the case of the
former, we can give the example of the automobile industry where different
model of cars, ambassador, fiat, etc., are manufactured. Other examples
are cigarettes, refrigerators, T.V. sets, etc. Pure or homogeneous oligopoly
includes such industries as cooking and commercial gas, cement, food,
vegetable oils, cable wires, dry batteries, petroleum, etc. In the modern
industrial setup, there is a strong tendency towards oligopoly market
situation. To avoid the impacts of competition in case of competitive
industries and to face the emergence of new substitutes in case of
monopoly industries, oligopoly market is developed. For example, electric
refrigerators, automatic washing machines, radio, etc.
Characteristics of oligopoly
1. Interdependence
Each and every firm has to be conscious of the reactions of its rivals. Since
the number of firms is very few, any change in price, output, product, etc. by
one firm will have direct effect on the policy of other firms. Therefore,
economic calculations must be made always with reference to the reactions
of the rival firms, as they have a high degree of cross elasticity of demand
for their products.
2. Indeterminateness of the demand curve
Under oligopoly, there will be an element of uncertainty. Firms will not be
aware of the specific factors which could affect demand. Naturally, rise or
fall in the demand for the product cannot be speculated. Changes that would
be taking place may be contrary to the expected changes in the product
curve. Thus, the demand curve for the product will be indeterminate or
indefinite. Prof. Sweezy explains it as a kinky demand curve.
3. Conflicting attitude of firms
Under oligopoly, on one hand, firms may realise the disadvantages of
competition and rivalry and desire to unite together to maximise their profits.
On the other hand, firms guided by individualistic considerations may
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continuously come in clash with one another. This creates uncertainty in the
market.
4. Element of monopoly and competition
Under oligopoly, a firm has some monopoly power over the product it
produces but not on the entire market. However, monopoly power enjoyed
by the firm will be limited by the extent of competition.
5. Price rigidity
Generally, prices tend to be sticky or rigid under oligopoly. This is because
of the fact that if one firm changes its price, other firms may also resort to
the same technique.
6. Aggressive or defensive marketing methods -
Firms resort to aggressive and sometimes defensive marketing methods in
order to either increase their share of the market or to prevent a decline of
their share in the market. If one adopts extensive advertisement and sales
promotion policy it provokes others to do the same.
7. Constant struggle
Competition is of unique type in an oligopolistic market. Hence, competition
consists of constant struggle of firms against rivals.
8. Lack of uniformity
Lack of uniformity in the rise of different oligopolies is another remarkable
feature.
9. Small number of large firms
The number of firms in the market is small; but the size of each firm is big.
The market share of each firm is sufficiently large to dominate the market.
10. Existence of kinked demand curve
A kinked demand curve is said to occur when there is a sudden change in
the slope of the demand curve. It explains price rigidity under oligopoly.
Price – output determination under oligopoly
There is no one system of pricing under oligopoly market. Pricing policy
followed by a firm depends on the nature of oligopoly and rivals’ reactions.
However, we can think of three popular types of pricing under oligopoly.
They are as follows:

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Independent pricing: (non-collusive oligopoly)


When goods produced by different oligopolists are more or less similar or
homogeneous in nature, there will be a tendency for the firms to fix a
common price. A firm generally accepts the “going price” and adjusts itself
to this price. As long as the firm earns adequate profits at this price, it may
not endeavour to change this price, as any effort to do so may create
uncertainty. Hence, a firm follows what is called as “acceptance pricing” in
the market.
When goods produced by different firms are different in nature
(differentiated oligopoly), each firm will be following an independent pricing
policy as in the case of monopoly. In this case, each firm is aware of the fact
that what it does would be closely watched by other oligopolists in the
industry. However, due to product differentiation, each firm has some
monopoly power. It is referred to as monopoly behaviour of the Oligopolist.
On the contrary, it may lead to price wars between different firms and each
firm may fix price at the competitive level. A firm tends to charge prices even
below its variable costs. This occurs as a result of one firm cutting the prices
and others following the same. It is due to cut-throat competition in
oligopoly. The actual price fixed by a firm may fall in between the upper limit
laid down by the monopoly price and the lower limit fixed by the competitive
price. It may be similar to that of the pricing under monopolistic competition.
However, independent pricing in reality leads to antagonism, friction, rivalry,
in-fighting, price-wars, etc., which may bring undesirable changes in the
market. The oligopolist may realise the harmful effects of competition and
may decide to avoid all kinds of wastes. It encourages a tendency to come
together. This leads to pricing under collusion. In other words, independent
pricing can be followed only for a short period and it cannot last for a long
period of time.

10.7 Collusive Oligopoly and Price Leadership


Pricing under collusion
Collusion is just the opposite of competition. The term collusion means to
“play together” in economics. It means that the firms cooperate with each
other in taking joint actions to keep their bargaining position stronger against
the consumer. Firms give place for collusion when they join their hands in
order to put an end to antagonism, uncertainty and its evils.
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When government action is responsible for bringing the firms together, there
will be place for explicit collusion. On the other hand, when restrictions are
introduced, firms may form themselves into secret societies resulting in
implicit collusion.
Collusion may be based on either oral or written agreements. Collusion
based on oral agreement leads to the creation of what is called as
“Gentlemen’s Agreement “. It does not consist of any records. On the other
hand, collusion based on written agreement creates what is known as
cartels.
There are different types of cartel agreements. On one extreme, the firms
surrender all their rights to a central authority which sets prices, determine
output, marketing quotas for each firm, distributes profits, etc. This is called
as centralised cartels. A centralised or perfect cartel is an arrangement,
wherein the firms in an industry reach an agreement which maximises joint
profits. Hence, the cartel can act as a monopolist. Since the firms in the
cartel are assumed to produce homogeneous goods, the market demand for
the product is the cartel’s demand. It is also assumed that the cartel
management knows the demand at each possible price and also the
marginal costs of all its firms. It can therefore, find out the MR and MC for
the industry. The desire of the firms to have large joint profits gives impulse
to form cartels. But such a desire is short lived and therefore, the formal
arrangement or cartels cannot be a long term phenomenon.
Under the second type of cartel agreement, market – sharing cartel, the
firms in the industry produce homogeneous products and agree upon the
share each firm is going to have. Each firm sells at the same price but sells
within a given region. Such a system can function only if the firms have
identical costs.
Market sharing model has a very restrictive assumption of identical costs for
all firms. Since, in practice, the firms have unequal costs and every firm
wants to have some degree of independent action, the market-sharing
cartels are not long-lived.
Price leadership
Perfect collusion is not possible in practice. Mutual suspicion and distrust
among member-firms and their unwillingness to surrender all their

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sovereignty makes the collusion imperfect. There are a number of imperfect


collusions and one of the most important one is price leadership.
In this case, a particular strong firm which is enjoying the benefits of large
scale production will dominate the smaller firms. The price fixed by the
dominating firm will be followed by all other small firms. Hence, the
dominating firm becomes the price leader. All other firms following the price
policy of the dominating firm in the industry are called as price followers.
The price leader is generally a leader in all markets. However, the same firm
may become a follower in one market and a price leader in other markets.
The leadership may emerge spontaneously due to technical reasons or out
of tacit or explicit agreement between different firms to assign leadership
role to one of them. They may be either dominant-firm leadership or
collusive-firm leadership.
Generally the leadership arises in a market on account of the following
reasons:
 The leading firm will be enjoying the benefits of lower cost of production
and possess huge financial resources at its disposal.
 It may have substantial share in the market.
 It will have reputation for sound pricing policy.
 It may take the initiative in dominating and controlling other firms in the
industry as a normal method of functioning.
 It may follow aggressive price policy and there by it can acquire control
over other firms.
 If a dominant firm is unable to perform its role as a leader either due to
inherent deficiencies or government restrictions, it will assign the
leadership role to other firms. This is called as barometric price
leadership.
The price leader has to make the following calculations before fixing the
price of a given product:
 Reaction from rival firms for the product
 Elasticity of substitution between his/hers and others’ product
 The price leader should follow an appropriate price policy whereby the
leadership can be retained in the market. The support and loyalty of
followers or price-takers should be taken. The guess work of the leading
firm while fixing the price should reflect the real condition in the market.

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The price leader should be able to prevent other small firms from
reducing the price to attract the customers in the market.
 The price leader should remember that the power of the leader rests on
the differences in costs. This type of price-leadership is called as partial
monopoly.
Features of price leadership
 The price leader should be able to bear the risks of price-wars in order
to establish and maintain leadership. Once leadership is established,
there should be persistent efforts to continue the lead.
 The price-leader normally takes the lead in increasing prices and in the
case of price reductions; the leader becomes only a follower.
 Instead of thinking only about the short-term gains, the leader normally
thinks about the long-term gains.
 The price leader has an important part in forecasting the demand, and
cost condition in order to play his/her role effectively to win the
confidence of the followers.
 Normally, the leader changes the price when change in cost and
demand conditions are permanent.
 The leader follows a definite and consistent pricing policy in a most
intelligent manner so as to capture the market and to win over the small
firms.
 An important aspect of price leadership is that it often serves as a
means to price discipline and price stabilisations.
Advantages of price leadership: (for both leader and followers)
 Price leadership helps the small firms to formulate their price policy on
the basis of leader’s price, as they do not normally possess complete
information regarding various types of costs
 It is a simple and economical method of pricing because it does not
involve any expenditure on market survey, etc
 It ensures stability in the market by avoiding price-wars as much as
possible
 It will put an end to the operation of wide fluctuations in the market
(operation of trade cycles)
 It reduces the number of reactions from different small firms and thus
ensures certainty in the market

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 It ensures the spirit of live and let live


Thus, price leadership has become an important method of pricing under
oligopoly market conditions at present. It exists for a short period only. It is
one of the most convenient methods of pricing for oligopoly firms which
intend to stay and grow in the market.
Price - rigidity and kinked demand curve under oligopoly
Kinked demand curve was first used by Prof. M. Sweezy to explain price
rigidity under oligopoly. It represents the behaviour of an oligopoly firm
which has no incentive either to increase or decrease its price. Each firm, by
its experience, has learnt what will be the reactions of rivals to actions on its
part and may voluntarily avoid any activity that will lead to the situation of
price-war. Each firm is content with present price-output and profits and it
does not want to make any change. Hence, they do not change their price-
quantity combinations in response to small shifts in their cost curves.
When there are significant differences in quality, service and reputation in
an industry, the price-leader operates in the upper quality stratum with a rich
mixture of service, and charges some price premium for this superiority.
After a situation of price leadership is established, it is probably maintained
fully as much by the followers as by the leader. The price-leader should
make a temporary drop in price by informal concessions from the official
price, because frequent changes in announced prices disrupt followers’
adjustments and undermine the leader’s prestige. Prices are changed only
when changes in demand conditions and cost are permanent.
The price-leader plays an important part in forecasting the demand and cost
conditions to play the role effectively, accurately and in conformity with the
confidence of followers.
The term ‘Kink’ refers to a short backward twist to cause obstructions. A
kinked demand curve is said to occur when there is a sudden change in the
slope of the demand curve. This gives rise to a kink, that is, a sharp corner
in the demand curve. It arises when it is assumed that the rivals will lower
their prices when the oligopolist lowers his/her own price; but the rivals will
not raise their prices when the oligopolist raises his/her price.
Kinked demand curve analysis does not explain how price and output are
determined under oligopoly rather, it seeks to explain why once a price-
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quantity combination has been established, a firm will avoid changing it, i.e.
why the price becomes sticky. Hence, it provides an explanation to price
rigidity under oligopoly conditions. In figure 10.8, E represents the firm’s
original price-quantity combination.

Price Change
d Unmatched
E
Price

d
Price Change
Matched
D
0 X
Quantity

Figure 10.8: Firm’s Original Price-Quantity Combination

When the oligopolist changes the price, the reaction of rivals will be as
follows:
 Reaction to price reduction
 Reaction to price increase
Reaction to price reduction – If the oligopolist reduces the price while
followers keep their price as constant, rival firms will experience a reduction
in their demand and sales and a drift of customers to the oligopolist. So they
will also reduce their price to match the price reduction of the oligopolist.
Even though, the oligopolist reduces the price, there will not be any
appreciable increase in demand for the product and also the sales. ED is
the new demand curve which is inelastic. Even though price falls, demand
and sales will not go up considerably. Thus, this policy of price cut will not
yield good results.
Reaction to price increase – When the oligopolist increases the price, the
followers do not increase their prices. Now, rival firms get more customers
because their prices are much lower than the oligopolist’s price. Hence,
without increasing their prices, the followers will earn more income. Now,
the oligopolist due to increase in his/her price, loses the demand and sales.

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The demand curve will be the elastic segment DE.


An oligopolist faced with a kinked demand curve will be extremely unwilling
to change the price; for a price decrease will cause no large increase in
sales, and a price increase will cause a substantial fall in the sales. Thus,
neither a price increase nor price reduction will be an attractive proposition
for the oligopolist.

10.8 Duopoly
Features
Many economists are of the opinion that ‘duopoly’ is only a form of simple
oligopoly. In other words, duopoly is only a limited oligopoly. Duopoly is a
market with two sellers exercising control over the supply of
commodities. It is a two-firm industry. Each seller knows that whatever
he/she does will affect the rival’s policies. Each seller attempts to make a
correct guess of the rivals motives and actions. The action by one will have
a reaction from the other.
The two firms may either resort to competition or they may join together. On
one extreme, the two rivals may go in for cut-throat competition with a view
of eliminating the other from the market and setting themselves as a
monopolist. Such a type of competition may be disastrous for both. On the
other extreme, the rivals may realise that competition between them will ruin
both and hence, they may fix the same price and restrict competition to
advertisement only.
Duopsony
Duopsony is an economic condition similar to a duopoly in which there are
only two large buyers for a specific product or service. Members of a
duopsony have great influence over sellers and can effectively lower market
prices for their advantage.
For example, let's imagine a town in which only two restaurants
operate. There are only two employment options for waiters and chefs.
Since the restaurants have less competition for finding employees, they can
offer lower wages. The chefs and waiters have no choice but to accept the
low pay, unless they choose not to work. This shows that firms that are part
of a duopsony have the power not only to lower the cost of supplies, but
also to lower the price of labour.
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Oligopsony
Similar to an oligopoly, this is a market in which there are a few large buyers
for a product or service. This allows the buyers to have a great deal of
control over the sellers and can effectively push down the prices.

10.9 Industry Analysis


A detailed study of the market analysis enables us to understand how the
business organisation is influenced by the market structure, conduct of the
buyers and sellers and the overall performance of the market.
Structure
Under perfect competition, there are a large number of buyers and sellers,
commodity dealt with is homogeneous and there is a free entry and exit of
firms into and out of the industry. Since the buyers and the sellers possess
perfect knowledge of the market conditions, the same price prevails for the
same commodity at the same time throughout the market. Such a situation
promotes welfare of both the buyers and the sellers and establishes ideal
conditions of a market. It serves as a yardstick to measure the functioning of
other markets.
Under monopoly, a single seller controls the entire market and has the
power to control supply and price. Generally, a high price is charged by
restricting the output. Product differentiation and selling costs dominate a
monopolistic market. Intense competition prevails among the firms to
promote the sale of their products. Oligopoly describes a situation where
there are a few firms producing either homogeneous or differentiated
products. Tough competition prevails among firms. Thus, different market
structure explains different conditions under which a firm has to operate.
Conduct
Conduct of a firm depends upon the market structure in which it is operating.
A firm under imperfect competition conducts more efficiently than under
perfect competition. Under perfect competition, an individual firm has no
control over price; it will have to adjust its output to the existing price in the
market. Thus, the firm need not struggle much. Under imperfect competition,
because of product differentiation and imperfect knowledge about the
market, firms generally adopt aggressive sales promotion measures to
survive and grow. Heavy investment is also made on research and
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development. Thus, there is incentive for growth and development. Welfare


of the community is the highest.
Performance
Firms under perfect competition will have to perform efficiently to stay in the
market. In the long run, price=MR=AR=MC=AC. As a rule, they cannot
make abnormal profits. Under imperfect competition, price is equal only to
AR and AC in the long run; MC and MR are less than AR and AC. Thus
there is scope for supernormal profits. Under imperfect competition, firms
perform better than the firms under perfect competition. Such an analysis of
structure–conduct–performance of an industry is explained as structure-
conduct-performance paradigm. Structure affects the conduct; conduct
determines the performance. They are mutually interlinked.

Activity:
Select any industry and analyse its market structure , conduct of the
buyers and sellers and the overall performance of the market.

Self Assessment Questions


1. _________ seller is the price maker and can restrict the output to
increase the price.
2. ___________ monopoly is a situation in which a single seller faces a
single buyer.
3. Under __________ there are only two large buyers for a specific
product or service.
4. ______ is the market situation where there is a monopoly element in
case of the buyer.
5. ______________ is a situation in which there are a few large buyers.
6. ______________ costs are very important in monopolistic market.
7. A monopolist who suffers losses in the short run; will exit in the long run
if there is no plant size that will result in economic profit, that is greater
than or equal to zero. (True/False)
8. If a monopolist is producing a level of output at which demand is
inelastic, then the firm is not maximising profit. (True/False)
9. If a monopolistically competitive market is in long-run equilibrium, each
firm earns economic profits. (True/False)

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10. Oligopolists face interdependent profits because industry sales are


large. (True/False)

10.10 Summary
Let us recapitulate the important concepts discussed in this unit:
 The organisation and functioning of a firm is determined by the type of
market in which it is operating.
 A market structure is characterised by the number of buyers and sellers,
nature of the commodity dealt with, the scope for entry and exit of firms
and the determination of price.
 Perfect competition exhibits an ideal market situation, where there are a
large number of buyers and sellers, the commodity dealt with is
homogeneous, there is a free entry and exit of firms into and out of the
industry, and a uniform price prevails in the market. In the long run price
is equal to MR=AR=MC=AC. The firms can make only normal profit in
the long run.
 Monopoly is a market situation where a single seller has total control
over the price and output. There is scope for price discrimination.
Different prices can be charged to different customers at different
places; for different uses at different periods of time, for the commodity
produced under same cost conditions.
 Oligopoly is a market condition where a few big sellers producing either
homogeneous or differentiated goods control the market. Popular
methods of pricing under oligopoly are collusive pricing or price
leadership.
 Bilateral monopoly is a situation where a monopolist faces a
Monopsonist. Monopsony is a case of single buyer; Duopsony explains
a situation of two buyers and Oligopsony, a situation of a few big buyers
controlling the market.
 Industry analysis explains how the entire market is closely knit and how
the structure of the market, conduct of the buyers and sellers,
performance of the industry as a whole are all interrelated.

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10.11 Glossary
Bilateral monopoly: A market situation in which a single seller faces a
single buyer.
Dumping policy: This is the selling of goods at lower prices in the
competitive international market and at higher prices in the protected
domestic market.
Duopoly: A market with two sellers exercising control over the supply of
commodities.
Duopsony: An economic condition in which there are only two large buyers
for a specific product or service.
Monopolistic competition; A market structure in which a large number of
small sellers sell differentiated products which are close, but not perfect
substitutes for one another.
Monopoly: A market form in which a single producer controls the whole
supply of a single commodity which has no close substitutes.
Monopsony: A market with a single buyer who buys the entire amount
produced.
Oligopoly: A few producers specialising in the production of identical goods
or differentiated goods competing with one another.
Price discrimination: The practices of a seller to charge different prices for
different customers for the same commodity, produced under a single
control without corresponding differences in cost.

10.12 Terminal Questions


1. What is monopoly?
2. What is price discrimination? Explain various kinds of price
discrimination.
3. Define monopolistic competition and explain its characteristics.
4. What is oligopoly? Explain the features of oligopoly market.

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10.13 Answers

Self Assessment Questions


1. Monopoly
2. Bilateral
3. Duopsony
4. Monopsony
5. Oligopsony
6. Selling
7. True
8. True
9. False
10. False

Terminal Questions

1. Monopoly is that market form in which a single producer controls the


whole supply of a single commodity which has no close substitutes.
Refer to section10.2.
2. The policy of price discrimination refers to, the practice of a seller to
charge different prices for different customers for the same commodity,
produced under a single control without corresponding differences in
cost. Three kinds of price discrimination are Discrimination of the first
degree, Discrimination of the second degree, Discrimination of the third
degree. Refer to section 10.3
3. Monopolistic Competition is a market structure in which a large number
of small sellers sell differentiated products which are close, but not
perfect substitutes for one another. Its characteristics are definite
preference of the consumers, market is characterised by imperfections,
Existence of a large number of firms, free entry and exit of firms,
Element of monopoly and competition, Product differentiation etc. Refer
to section 10.5.
4. Under oligopoly, we come across a few producers specialising in the
production of identical goods or differentiated goods competing with one
another. Its features are interdependence, indeterminateness of the

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demand curve, conflicting attitude of firms, lack of uniformity, constant


struggle, aggressive or defensive marketing methods, price rigidity,
small number of large firms etc. Refer to section 10.6.

10.14 Case Study

It is all black
Free markets work best when there is competition. They don't work when
there are monopolies with power to ‘freely' set product prices without the
risk of losing customers to competition. This certainly applies to coal,
where Coal India Ltd (CIL) enjoys a virtual monopoly in the domestic
commercial mining space. Since 2009-10, CIL's annual coal production
has been stuck at some 431 million tons (mt), even though its profit
margins have gone up, mainly due to upward revisions in coal prices.
The company had, only in February 2011, made 30 percent price hikes
and now, it has announced migration to a new pricing system based on
‘gross calorific value' (GCV), against the existing so-called ‘useful heat
value' (UHV) method.
There is nothing wrong in shifting to GCV, which is the globally accepted
norm to measure the inherent energy value of the coal that is burnt.
However, what raises eyebrows is the timing and the implicit opportunism
in the adoption of the new system of grading and pricing of coal. What it
has done is to bring about across-the-board price increases effective
from January 1 – the second time in 10 months. The new system has
basically replaced the earlier seven grades of coal (A to G) with 14
categories, with per-kg GCVs ranging from 3,100 to 4,900 kilo-calories
(kcal). While the prices of these 14 grades (on a rough corresponding
basis) earlier ranged from Rs. 430 to Rs. 3,690 a ton, now they start at
Rs. 620 and go up to Rs. 4,900 a ton. There are GCV range segments
such as 5,800-6,100 kcal (earlier ‘C' grade) and 4,600-4,900 kcal (‘E'),
where prices have been nearly doubled!
All this is not to argue that CIL must not make profits (it is a listed
company, after all), or should be prevented from raising prices. What is of
concern is the lack of transparency in its dealings, whether it is in fixing
prices or modalities of sale. Consumers today are not given the option of

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even joint or third-party sampling for testing the actual calorific value of
the coal grade supplied and billed to them. This is unlike imported coal
where there are independent quality inspectors for individual shipments.
Given the country's growing coal consumption requirement and limits to
meeting it through imports (projected to touch 115 mt this fiscal), there is
little basis for preserving CIL's domestic mining monopoly. The Coal
Mines (Nationalisation) Amendment Bill to throw open the sector to
competition has not seen the light of day for over a decade. The least
that the government could do is to have a regulator for the sector, to
whom consumers can take their complaints. Despite mentioning this in
successive budgets since 2008, the Coal Regulatory Authority Bill is yet
to even be placed in the Parliament.
(Source: An article of the same title published in the Hindu Business Line
on January 3, 2012)
Discussion Questions:
1. How has CIL’s decision to migrate to a new pricing system impacted
coal prices?
2. What could be the role of the government in regulating the behaviour
of monopoly firms such as CIL?
3. What strategies could coal buyers adopt to protect themselves
against the price fluctuations in a monopoly market situation?
Hint: Use the theoretical concept and answer the questions

References:
 Chamberlin, E. H. (1957). Towards a More General Theory of Value,
New York: Oxford University Press.
 Stonier, A.W. and Hague, D.C. (1980). A textbook of economic theory,
5th Ed, Longman, (1980).
 Sweezy, P. (1939). "Demand Under Conditions of Oligopoly" The
Journal of Political Economy, Vol. 4, pp. 568-573.
E-Reference:
 www.thehindubusinessline.com – retrieved on January 3rd 2012

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Unit 11 Macroeconomics and


Some of its Measures

Structure:
11.1 Introduction
Case Let
Objectives
11.2 Basic Concepts
11.3 Macroeconomic Ratios
11.4 Index Numbers
11.5 National Income Deflators
11.6 Summary
11.7 Glossary
11.8 Terminal Questions
11.9 Answers
11.10 Case Study
Reference/E-Reference

11.1 Introduction
In the previous unit, we studied about pricing under imperfect competition.
We learnt about how prices are determined in markets with varying
structures. The structure of a market is influenced by the environment in
which it operates. In this unit, we will learn about macroeconomics and
some of its measures. We shall understand how the environment (primarily
the external environment) impacts business firms.
Macroeconomics is that branch of economics, which deals with the
study of aggregative or average behavior of the entire economy. In
macroeconomics, we study the collective functioning of the whole economy.
It deals with the gross aggregates of the economic system rather than with
individual parts of it. It is the study of the entire forest rather than the study
of individual trees. Hence, it is called as “Aggregative Economics.” It
splits up the economy into big lumps for the purpose of convenience of the
study and therefore, it is called as “Lumping Method”. It gives a detailed
description about the performance and achievements of different sectors of
the economy like agriculture, industry, export and import, etc. As part of

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macroeconomics, we also study how the entire economy reaches the


position of equilibrium. Hence, it is called as “General Equilibrium
Analysis”. It explains how the equilibrium level of national income is
determined in an economy and so it is called as “Income Theory”. The
scope of macroeconomics covers the following topics:
 The theory of income and employment with consumption function,
saving and investment function and trade cycles.
 The general theory of price level, which includes inflation and deflation.
 The theory of economic growth, development and planning.
 The theory of macroeconomic distribution, which includes the study of
relative shares of rent, wages, interest and profits in the national income
of a country.
In general, as part of macroeconomics, we study aggregate demand,
aggregate supply, aggregate saving and investment, aggregate income and
expenditure, unemployment, poverty problems, etc.
Managerial economics is a part of microeconomics. It is to be noted that a
business unit carries on its business operations in the midst of the society
and not in isolation. It has to meet the requirements of the members of the
society. Hence, knowledge about the macroeconomic environment is very
essential. Macroeconomic concepts, principles, and policies greatly
influence the decision making process of a firm. Changes in the level of
incomes of the people, their purchasing power, consumption habits, general
price level, business fluctuations are all factors that influence the decision
making process. Further, government economic policies like monetary,
fiscal, financial, physical, industrial, labour, import and export, foreign capital
and investment, etc would certainly affect the decision-making and forward
planning of the firm. Therefore, macroeconomic background provides a solid
basis for the working of a micro unit.

Case Let (Continued from Unit 10)


In the previous unit, we saw that Ramesh was asked to explore pricing
where firms had market power. He saw that the traverse rods industry
was oligopolistic in nature with a few firms garnering most of the market
share. He was surprised to learn that most buyers of traverse rods were
unaware of all the products, their prices and sellers in the market. He

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realised that firms were able to identify niche markets and sell their
produce. However, some industry experts mentioned to him that although
the sales of traverse rods was highly influenced by factors such as
consumer incomes and construction activities, those factors themselves
were influenced by general economic conditions. He also learnt that
house construction activities and wages were determined by factors such
as the investment rates and consumption rates prevailing in the
economy. Ramesh could not understand how overall economic
conditions such as, interest rate regimes influenced demand for the
traverse rods that were sold by his firm. He discussed the same with his
superior who encouraged him to recollect macroeconomic concepts
which he had learnt in college.
Objectives:
After studying this unit, you should be able to:
 relate the concepts of macroeconomics to their impact on business
activities
 analyse basic macroeconomic concepts and the mechanisms to
manage them
 define important macroeconomic ratios and examine their relevance
 explain index numbers and its practical importance
 describe national income deflators
 judge how macroeconomic measures explain the state of the economy

11.2 Basic Concepts


1. Variables
A variable is a symbol or quantity which during a specified time period
under consideration, may assume different values or a set of
admissible values. Macroeconomic variables deal with aggregates like
gross national product, national income, consumption function, saving
function, investment function, general price level, total money supply and
general level of employment or unemployment in the country, etc. These
variables are further divided into two parts -
a) Stock variable: A stock variable is a quantity measured at a specific
point of time. It may be referred to as a certain amount or quantity at
a specific point of time. For example, we can say that total money

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supply in India as on 27-2-2008 is Rs. 80,000 crores. Stock variable has


a time reference. In this case, both time and quantity is specified in
clear terms and there is no ambiguity.
b) Flow variable: A flow variable is a quantity which can be measured
in terms of a specific period of time and not at a point of time. For
example, GNP during the period 2004-05 was Rs. 90,000 crores. It is
clear that goods and services worth Rs. 90,000 crores is produced in
India during the period covering 2004-05. Thus, flow variable has a time
dimension.
2. Ratio variables
Economic variables are measured in terms of ratio variables. A ratio
variable expresses quantitative relationship between two different
variables at a certain time. For example, average propensity to save
expresses the ratio of total savings to total income. Similarly, average
propensity to consume expresses the relationship between total
consumption to total income. Hence,
Total savings Total Consumptio n
APS  APC 
Total income Total income

These two examples come under flow ratio. Liquidity ratio shows
relationship between liquid assets and total assets whereas leverage ratio
shows value of debts and total assets. Hence,
Liquid Assets Value of Debts
Liquidity Ratio  Leverage Ratio 
Total Assets Total Assets
These two examples come under stock ratio.
3. Functional variables
Functional variables explain the functional relationship between different
variables under consideration. They are further divided into two kinds. They
are as follows:
a) Dependent variable: A variable is dependent if its value varies as a
result of variations in the value of some other independent variable.
In short, value of one variable depends on the value of another variable
or variables.

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b) Independent variable: In this case, the value of one variable will


influence the value of another variable. If a change in one variable
causes change in another variable, it is called as independent
variable.
For example, consumption function explains the relationship between
changes in the level of consumption as a result of changes in the level of
income of consumers. It indicates how consumption varies as income
changes. It is expressed as C = f [Y] where C refers to consumption and Y
implies income of consumers. In this case, consumption is dependent
variable and income is independent variable.
It is to be noted that functional relationship may be related to either two or
more variables. In case of microanalysis, we explain that D = f [P] where
demand depends on price of the commodity concerned only. Similarly, we
can explain that economic development, ED = f [C, L, T …..]. This implies
that economic development depends on several factors like capital, labour,
technology, etc.
4. Functions
Functions suggest that the value of something depends on the value of
one or more things. There are uncountable numbers of functional
relationships in the real world. D = f [P] or S = f [P] at the micro level and
C = f [Y] or S = f [Y] at the macro level.
5. Constant
A constant is a magnitude or value, the quantity of which does not change.
6. Parameter
A parameter is a quantity which when varied affects the value of another
variable.
7. Capital and investment
In the ordinary language, the term capital refers to cash or money held by a
person. It is measured at a point of time, however, in economics, it has a
wider meaning. It is defined as all man-made aids that are used for
further production of wealth. It includes all kinds of producers’ goods,
inventory of materials, machine tools, equipments, instruments, factories,
dams, transport and communications, etc which are used for further
production of goods and services.

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The term investment in the ordinary language refers to financial investment.


It means purchase of stocks shares, bonds debentures, etc where there is
only transfer of titles or rights from one person to another. The term
investment in economics refers to creation of new capital assets or
additions to the existing stock of productive assets. Creation of income-
earning assets is called as investment in economics. Investment is the
change in the capital stock over a period of time. Hence, the term capital
and investment are synonymous.
8. Ex-ante and Ex-post
These are two Latin phrases. It implies before-hand and afterwards.
Ex-ante means anything planned, anticipated, expected or intended.
For example, Ex-ante saving is an amount that the people intend to save out
of their income. Ex-post refers to actual or realised value. For example,
Ex-post saving is the exact amount that the people actually save in a
particular time period. These two terms have great significance in
macroeconomic forecasts. One has to compare the expected rate of
economic growth in a particular year and the actual achieved growth rate in
that year. If the actual growth rate is more or equal to the expected rate, the
government assumes that the various economic policies are in the right
direction. On the other hand, if the actual growth rate is less than expected,
the government has to modify its economic policies.
9. Equilibrium and disequilibrium
These are the two terms which are frequently used in economic discussions.
It is a position wherein two opposing forces tend to balance each other
so that there will be no further changes. Hence, it is described as a
position of rest in general, however, in economics, it has a different
meaning. A state of rest implies that the various quantities used in the
economic system remain constant and with the help of these constant
quantities, the economy continues to churn over. There is movement or
activity and this movement is regular, smooth, certain and constant. The
equilibrium position is free from violent fluctuations, frequent variations and
sudden changes. At the point of equilibrium, an economic unit is
maximising its benefits or gains. Hence, it is described as the coziest
position of an economic unit. There will be a tendency always to move
towards this equilibrium position.

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Disequilibrium on the other hand is a position wherein the forces


operating in the system are not in balance. There is imbalance in
different forces which are working in the system. Hence, there are
disturbances and disorders in the system.
Generally speaking, in microeconomics, we make reference to partial
equilibrium analysis and in macroeconomics; we make reference to general
equilibrium analysis. We can explain these two concepts with the help of two
simple examples. When demand for a particular commodity is equal to its
supply in the market, equilibrium price is established at the micro level. Any
imbalance between either demand or supply would create disequilibrium. At
macro level, an economy is said to be in equilibrium when, aggregate
demand for goods and services is equal to aggregate supply and total
investment is equal to total savings. If aggregate demand is either greater
than aggregate supply or aggregate supply is greater than aggregate
demand, it would disturb the equilibrium in the economic system.
10. Economic models
An economic model shows the relationship among different economic
variables in a precise manner. Its purpose is to explain causal relations
among different variables in the real world, avoiding all kinds of complexities
in order to get a clear picture of how an economy operates. It is a method of
analysis which presents an over-simplification of the real world. It is just a
precise formal statement of one or more economic relationships. It is a
quantitative hypothesis based on certain assumptions framed to
achieve a set of objectives. An economic model is presented in the form of
a statement, logical statement of economic theory, geometrical form or in
mathematical or statistical equations. Any economic model cannot give a
perfect answer to any economic problem. It can give only a rough solution
because we have to make certain assumptions which are not to be found in
the real world. Hence, it helps in arriving at a probable conclusion. An
economic model is essentially based on some institutional frame work- a
free enterprise economy, a socialist economy, a mixed economy, etc.
A simple demand and supply model is prepared to explain the determination
of market price in a microeconomic model. A macroeconomic model
explains relationships between different macroeconomic variables and their
impact on the working of the economy. Harrod-Domar model of economic
growth is one such example.
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Self Assessment Questions


1. Inventory, Capital stock are Macro _________ variables.
2. National Income and output are Macro _________ variables.
3. Investment is the _________ in the capital stock over a period of time.
4. _______ means planned and desired whereas _________means actual
or realised value.
5. A variable is __________, if its value varies as a result of variations in
the value of some other independent variable.

11.3 Macroeconomic Ratios


In this section, let us try to understand some of the important
macroeconomic ratios. There are several macroeconomic ratios and an
attempt is made to explain twelve such macroeconomic ratios. For a
business firm, the knowledge of these macroeconomic ratios is
indispensable for taking microeconomic decisions.
Consumption income ratio
Y= C + S. Out of a given income (Y); people can either spend or save (S),
or they can consume (C) their entire income. Hence,
C = Y – S.
The consumption income ratio explains the relationship between two
variables, i.e., the amount of income and the amount of consumption.
1. In other words, it tells us about the percentage of consumption out
of a given level of income.
This can be expressed as C = f [Y] where C = consumption, Y = income and
f = function. Consumption is an increasing function of income. Higher the
income, higher would be the consumption and vice-versa. There is a direct
relationship between the two. For example, out of Rs. 100, a person can
consume Rs. 80, and save Rs 20. In this case, the consumption income
ratio is 1:0.8. This ratio helps business personnel to forecast his/her sales in
the market.
2. Saving income ratio
Excess of income over expenditure is saving. The saving function can be
easily derived by subtracting spending from income. Hence, S = Y – C

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where S = saving, Y = income and C = consumption. It is a function of


income.
S = f [Y]. It implies that there is a direct relationship between the two.
Higher the income, higher would be the savings and vice-versa. The
saving-income ratio indicates the amount of savings made out of a
given level of income. In the above example, saving income ratio is 1:0.2.
The consumption income ratio and saving income ratio enable a business to
plan its production schedule and derive sales forecasts.
3. Capital output ratio
There is a close relationship between capital investment and income-growth
in any economy. Capital is regarded as the lifeblood of all economic
activities and as such, it constitutes a major determinant of economic growth
rate in an economy. The volume of investment generally determines the rate
of growth in the real income of the people in an economy.
The concept of capital output ratio explains the relationship between
the value of capital investment and the value of output. It is a ratio of
increase in output or real income to an increase in capital. The Capital
Output Ratio (COR) may be defined as “the ratio of investment in a given
economy or industry for a given time period to the output of that economy or
industry for a similar time period”. It refers to the amount of capital
required to produce a unit of output. When we say that COR is 4:1, it
implies that a capital investment of Rs. 4 is required to produce an output of
Rs. 1. It is to be noted that COR would differ from one sector to another and
even from one industry to another. Generally, it would be higher in the case
of capital goods industries, and in industries using capital intensive
techniques of production, and lower in the case of consumer goods
industries and industries using labour intensive techniques of production.
COR depends on several factors. However, a decrease in COR is an
indication of economic efficiency and progress of an economy.
4. Capital labour ratio
This ratio indicates the proportion of two factor inputs. It tells us the ratio
between the numbers of labourers required for a given amount of
capital invested in any business. This ratio is useful to work out the least
cost combination by substituting one factor input to another. This ratio can
be expressed as

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K
Where K  capital and L  labour
L
5. Output-labour ratio
The term productivity in general is defined as a ratio of what comes out of a
business to what goes in to the business, i.e., it is the ratio of ‘outcome’ to
the ‘efforts’ of the business. Hence, productivity would mean the value of
output divided by the value of inputs employed. There are different kinds of
productivity ratios.
Output labour ratio expresses the relationship between the quantity of
output produced and the number of labourers employed for a specific
time period. It indicates productivity of labour. It can be obtained from
dividing total output by the number of labourers employed. Hence,

Total output Q
Output labour ratio  or
Number of labourers employed L

This ratio widely varies from industry to industry. Labour productivity


depends on a number of factors like; capital endowment of labour, quality of
labour, organisation of work, hours of work, incentives to work, methods of
payments, industrial climate, quality of management and quality of raw
materials used, etc. Increase in labour productivity implies increase of the
ratio of output to labour. The knowledge of this ratio would help the
management of an organisation to employ the right types of labour in the
right quantity.
6. Input- output ratio
This ratio explains the relationship between two variables of inputs and
outputs. Input-output ratio indicates the quantity of inputs employed
and the quantity of outputs obtained. It is also called as production
function in economics. Production is purely physical in nature and as such,
the ratio between inputs and outputs is determined by technology,
availability of equipments, labour, materials, etc. It can be expressed in the
form of a mathematical equation.
Q = f [ L,N,K -------- etc] where Q = quantity of output per unit of time and,
L,N,K etc are different factor inputs like land, capital, labour, etc which are
used in the production process. Thus, the rate of output is a function of the

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factor inputs L,N,K etc, employed by the firm per unit of time. The
knowledge of production function would help a producer to work out the
most ideal combinations to maximise output and minimise cost.
7. Value added output ratio
Value added output is the difference between the value of output produced
and the value of inputs employed. In other words, it is a ratio of increase
in the quantity of inputs employed and the corresponding increase in
the output obtained. It is very much necessary to find out the difference
between the value of inputs used and the output obtained. This will help in
deciding whether to increase the employment of additional factor input units
in the production process.
8. Cash reserve ratio
A commercial bank mobilises deposits from the general public and the entire
amount of deposits is not kept in the form of cash. An experienced banker
knows that all depositors will not withdraw their entire deposits on the same
day at the same time. Hence, only a fraction of total deposits is kept in the
form of liquid cash to honour the cheques drawn on demand deposit by the
customers. The remaining excess deposits are used for lending and
investment purposes by the bank.
Thus, each commercial bank, with a view to make profits, follows a
customary cash reserve ratio for the sake of liquidity and safety. The
percentage of total deposits which the bank is required to hold in the
form of cash reserves for meeting the depositors’ demand for cash is
called cash reserve ratio. Thus, CRR indicates the ratio between the liquid
cash with that of the total deposits of the bank. For example, if CRR is 20%,
in that case for every Rs.100 of deposits collected, the bank has to keep
Rs.20 as cash reserves requirement.
9. Cash income ratio
A bank is a commercial institution based on business principles. Its main
objective is to make profits. This depends on its portfolio management. A
bank has to keep adequate amount of cash in order to meet the
requirements of its customers. How much deposits it will keep in the form of
liquid cash and how much money it will lend and invest on various assets
will depend on its CRR. This ratio helps the banker to know the income
earning capacity during a financial year. The cash - income ratio tells us

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the amount of cash, held by a bank in liquid form and the percentage
of income earned during an accounting year through its investments.
This ratio gives us information about the income–earning capacity of an
institution during an accounting year.
10. Labour’s share of income
Production is the result of combined and cooperative efforts put in by all the
factors of production in the production process. All factors of production
which are involved in this process of production are entitled to enjoy their
respective rewards in the form of rent, wages, interest and profits. If we add
all factor incomes, we derive national income at factor cost. Hence, NI at
factor cost = a sum of total rent + total wages + total interest + total profits.
For example, if national income is Rs. 1000; the share of rent could be Rs.
200-00, the share of wages at Rs. 300, the share of capital at Rs. 150 and
the share of profit could be Rs. 350.
The labour’s share of income indicated by the percentage of income
earned by labourers, in the form of wages out of the total national
income is called as labour’s share of income. In the above example, the
share of labourers’ income is Rs. 300. This ratio gives information about the
contribution made by workers, in the generation of total national income of
the country and it indicates various levels of wages and their living
standards.
11. Capital’s share of income
Capital is a very powerful and important input in the production process.
Capital is described as the lifeblood of all economic activities. Without
adequate capital, no economic activity can be undertaken. Capital as a
factor of production is earning interest as its income in the total national
income generation.
Capital’s share of income indicated, by the percentage of income
earned by capital in the form of interest, out of total national income is
called as capital’s share of income. In the above example, the share of
capital in total income is Rs. 150. This ratio gives information about the
contribution made by capital in the generation of total national income of the
country. Also, it indicates the level of interest rate and the ability of
capitalists to earn their income.

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12. Land’s share of income


Land is one of the primary factors of production. It is a free gift of nature. It is
an immovable factor input. The landlord supplies this factor input and earns
income in the form of rent. Land’s share of income indicated, by the
percentage of income earned by the landlord in the form of rent, out of
total national income is called as land’s share of income. In the above
example, the share of land’s income is Rs. 200.This ratio gives information
about the contribution made by the landlord in the generation of total
national income of the country. Also, it indicates the level of rent and the
ability of the landlords to earn their income.

11.4 Index Numbers


The days of barter are gone. We are living in a monetary economy where
every thing is measured in terms of money. It is to be noted that money by
its substance is quite value less or worthless. Its value to its possessor
arises out of its acceptability as a means of payment. Its value to its
possessors lies in its capacity to purchase other goods and services which
are useful in themselves. Thus, the value of money and the purchasing
power of money is derivative.
In a monetary economy, the exchange value of everything is measured by
its price expressed in terms of money. The purchasing power of money
depends on the level of prices of goods and services to be purchased. The
lower the price level, the greater would be the value of money and the
higher the price level, the lower would be the value of money. There is an
inverse relationship between the two. The value of money is thus inversely
related with the general price level. It is to be noted that prices of all goods
and services do not change in a uniform manner. Price of some goods may
rise while price of some other goods may fall. In order to bring an element
of uniformity to price change, the concept of general price level is used.
Index numbers explain this concept.
The value of everything is measured in terms of money because money acts
as a measuring rod or measure of value. However, the value of money
cannot be measured in terms of money itself. Hence, economists have
developed index numbers to measure the changes in the value of money
over a period of time.
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When a number of commodities and their prices at two different


periods are arranged in a tabular form, it is called as an index
schedule. Index number is a statistical measure by which changes in
the prices of the same articles at different periods are calculated and
computed. It is to be remembered that index number helps us to measure
only the extent by which the value of money has changed between two
different periods of time and not the value money itself.
There are different kinds of index numbers. Some of them are: wholesale
price index, consumer or retail price index, cost of living index, wage index
numbers, industrial index numbers, etc. Out of them, the most important
ones are:
 Consumer price index (CPI)
 Wholesale price index (WPI).
Consumer price index (CPI) – In this case, we include the prices of a
basket of consumption goods and services. Generally speaking, goods and
services which are commonly consumed are included in this basket. The
goods and services consumed by consumers widely differ from group to
group and place to place. It also varies as tastes and preferences of
consumers change. In order to measure the changes in prices of consumer
goods and services, we take into account prices existing at the base year
and the prices in the current year. The formula to calculate CPI is as follows-
Prices existing at the current year
CPI   100
Prices at the base year

The consumption basket data comes from family budget surveys conducted
from time to time and price data are taken from retail outlets. The base year
is changed every few years in order to take into account changes in
consumption habits, prices, etc in the market. Such updating is required so
that the usefulness is not lost.
In a simple model index number, we have assumed a total weightage of 20
units and each commodity is given a certain weight according to its
influence or importance. To get the index, the actual price in the base year
is reduced to 100, which is multiplied by the approximate weight.
For example, the price of rice in the base year is Rs.50 per quintal. The
weight assigned to rice is 8, so the index for 1960 will be equivalent to

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100 x 8= 800. Similarly the index numbers for other items is calculated. The
simple arithmetic average is used to calculate the index. In 1976, the price
of rice is Rs.125 i.e. two and half times the 1960’s price. If the 1960’s price
is 100, then the 1976’s price is equal to Rs.250. This is multiplied by the
weight to get the index for 1976.
Between 1960 and 1976, the price level has risen by 2.2 times. To state the
same thing in a different manner, what Rs.100 could buy in 1960, Rs 220
can buy in 1976. In 1976, the purchasing power of money or the value of
money has fallen to 45.5% or (100/200 X100) as compared to 1960.
Thus, the fluctuations in prices or the degrees of inflation are measured with
the help of index number of prices. Table 11.1 shows a model of weighted
price index number.
Table 11.1: A Model of Weighted Price Index Number
Base Current
1960 1976
Year Year
Wei-
Articles Price Index Price % Change Index
ghts
50.00 125.00
100 X 8
Rice 8 per per 2.5 250 x 8 2000
=800
quintal quintal
30.00 75.00
100 X 5
Wheat 5 per per 2.5 250 X 5 1250
=500
quintal quintal
100.00 150.00
100 X 3
Sugar 3 per per 1.5 150 X 3 450
=300
quintal quintal
2.50 per 100 X 2 3.75 per
Cloth 2 1.5 150 X 2 300
meter =200 meter
3.00 per 100 X 1 6.00 per
Vanaspathi 1 2.0 200 X 1 200
Kg =100 Kg
0.40 per 100 X 1 0.80 per
Cigarettes 1 2.0 200 x 1 200
packet =100 packet
2000/100 = 4400/20
Total 20 20
20 = 220

Value of money has


In 1960 – G P L – 100 2.2 times 100/220 X 100 =
fallen by 45.5%
In 1976 – G P L – 220 increased 45.5 %
between 1960-1976

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Whole sale price index [WPI] – These index numbers are constructed on
the basis of the wholesale prices of certain important commodities. The
items included in WPI are totally different from those included in CPI. The
items included are fertilisers, industrial raw materials, minerals, semi-
finished goods, machineries, etc. It is an index of prices paid by producers
for their inputs. Wholesale prices are published by various government
agencies at regular intervals and are collected for the purpose of calculating
variations in their prices for different periods. The method of calculating WPI
is same as that of the CPI.
Practical importance of index numbers
 They help us to measure the level of changes in prices and the value of
money over a period of time.
 They help us to measure the degree of inflation and deflation which
enable the government to come out with suitable price stabilisation
policies.
 They help us to know the extent of changes, in the cost of living of
different sections of people and thus help the government, to adjust the
wages and salaries of workers and avoid strikes and lockouts.
 They help us to know the purchasing power of two currencies and thus
help in the determination of exchange rates of the currencies of two
countries.
 They also help us to know the economic progress achieved in different
sectors of the economy through economic planning.

11.5 National Income Deflators


National income of a country can be either calculated in terms of Nominal
GNP or Real GNP. If we calculate GNP at current market prices, it is
called as Nominal GNP and if we measure GNP at constant prices,
i.e., prices prevailing at the base year, it is described as Real GNP. In
economics, we give importance to Real GNP rather than Nominal GNP.
This is because, GNP at current prices depicts a misleading picture of
economic performance when prices are continuously rising or falling. For
example, if prices are rising and the gross national output is remaining the
same; the nominal GNP represents an inflated estimate of the national
income, and creates a sense of false economic growth in the country. In

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order to avoid this kind of misleading estimates of national income; the


economists use a simple adjustment factor called GNP Deflator or National
Income Deflator, to eliminate the effect of rising prices on the GNP and to
work out Real GNP at the price level of the base year.
The GNP Deflator acts as an adjustment factor which is used to
convert nominal GNP into Real GNP. The GNP Deflator is the ratio of
price index number [PIN] of a chosen year to the price index number of the
base year [PIN of the base year = 100]. Hence,
PIN of the chosen year
GNP Deflator 
100
We can calculate the Real GNP by dividing nominal GNP by the GNP
Deflator. This can be expressed in the following formula -
Nominal GNP Nominal GNP
Real GNP  or Real GNP 
GNP Deflator PINcy / 100
where PINcy is the price index number of the chosen year.
Application of GNP Deflator
In order to estimate the Real GNP for the year 2005 and 2006, we can make
use of the GNP Deflator.
Nominal GNP for the year 2005-06 = Rs. 15, 00,000
WPI for the same year = 120
Base year PIN = 100.
120
Given the data, GNP Deflator for the year 2005-06 =  1.2
100

1.2 is the GNP Deflator for the 2005-06. We can now calculate real GNP for
2005-06 as follows:
15,00,000
Real GNP for 2005-06 = Rs  Rs. 12,50,000
1.2
Deflator can also be calculated for GDP, NDP or NNP, etc.
Activity:
Examine changes in India’s National Income aggregates overtime.
Analyse in terms of growth rates, contributing factors and other
dimentions.
(Hint: Time series data on National Income aggregates and related
analysis is available in economic survey of Government of India.

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Self Assessment Questions

6. ________ is a statistical measure, which indicates relative changes of


a variable over a period of time.
7. A flow variable is a quantity which can be measured in terms of a
specific period of time and not at a __________.
8. ________ is an index of prices paid by producers for their inputs.
9. ________ tells us the percentage of consumption out of a given level of
income.
10. When a number of commodities and their prices at two different periods
are arranged in a tabular form, it is called as _____________.
11. Macroeconomics is the study of economy-wide phenomena.
(True/False)
12. Microeconomics and macroeconomics are two distinct but closely
intertwined fields of economics. (True/False)
13. An increase in the overall level of prices in an economy is referred to as
Economic Growth. (True/False)
14. Wholesale price index measures the prices paid by consumers for all
goods and services they consume. (True/False)
15. GDP Deflator measures the increase in quantity of goods produced in
an economy. (True/False)

Activity:
Select any sector (e.g. Steel, IT, mining, banking, real estate, education
and analyse the sector’s performance withrespect to macroeconomic
conditions over a period of time.

11.6 Summary

Let us recapitulate the important concepts discussed in this unit:


 The knowledge of the various fundamental macroeconomic concepts is
essential to take several practical decisions by a business unit.
 A business unit may be a micro unit but the macroeconomic
environment is of great importance in the present day competitive world.

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 Macroeconomic concepts and macroeconomic ratios help, business


managers to understand the relationship between different
macroeconomic variables and their application in day-to-day business.
 Index numbers help us, to measure the degree of price changes or
inflation, and deflation, and point out the different price stabilisation
policies to be taken by the government in advance.
 National Income Deflator helps us to know the actual value of either
GDP or GNP during a given period of time.
 All these concepts help in business planning and business forecasting
and to take appropriate decisions well in advance.

11.7 Glossary
Capital labour ratio: It tells us the ratio between the numbers of labourers
required for a given amount of capital invested in any business.
Capital output ratio: It explains the relationship between the value of
capital investment and the value of output.
Capital’s share of income: Percentage of income earned by capital in the
form of interest out of total national income.
Cash - income ratio: It tells us the amount of cash held by a bank in liquid
form and the percentage of income earned during an accounting year
through its investments.
Cash reserve ratio: The percentage of total deposits which the bank is
required to hold in the form of cash reserves for meeting the depositors’
demand for cash.
Consumption income ratio: It explains the relationship between the
amount of income and the amount of consumption.
GNP deflator: An adjustment factor which is used to convert nominal GNP
into Real GNP.
Index number: A statistical measure by which changes in prices of the
same articles at different periods are calculated and computed.
Input-output ratio: It indicates the quantity of inputs employed and the
quantity of outputs obtained.
Labour’s share of income: Percentage of income earned by labourers in
the form of wages out of total national income.

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Land’s share of income: Percentage of income earned by the landlord in


the form of rent out of total national income.
Macroeconomics: Branch of economics which deals with the study of
aggregative or average behaviour of the entire economy.
Output labour ratio: It expresses the relationship between the quantity of
output produced and the number of labourers employed for a specific time
period.
Saving-income ratio: It indicates the amount of savings made out of a
given level of income.
Value added output ratio: It is a ratio of increase in the quantity of inputs
employed and the corresponding increase in the output obtained.

11.8 Terminal Questions


1. Give a brief note on stock and ratio variables.
2. Explain the concepts of ex-ante and ex-post, equilibrium and
disequilibrium.
3. Discuss any four macroeconomic ratios.
4. Explain wholesale price index with suitable illustration.
5. Explain National Income Deflator with its application.

11.9 Answers

Self Assessment Questions


1. Stock
2. Flow
3. Change
4. Ex-ante; Ex-post
5. Dependent
6. Index number
7. Point of time
8. Wholesale price index
9. Consumption income ratio
10. Index number
11. True
12. True

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13. False
14. False
15. False
Terminal Questions
1. A stock variable is a quantity measured at a specific point of time. It
may be referred to as a certain amount or quantity at a specific point of
time. A ratio variable expresses quantitative relationship between two
different variables at a certain time. Refer to section 11.2.
2. Ex-ante means anything planned, anticipated, expected or intended. For
example, Ex-ante saving is an amount that the people intend to save out
of their income. Ex-post refers to actual or realised value. At the point of
equilibrium, an economic unit is maximising its benefits or gains.
Disequilibrium on the other hand is a position wherein the forces
operating in the system are not in balance. Refer to section 11.2.
3. The consumption income ratio explains the relationship between two
variables, the amount of income and the amount of consumption. The
saving-income ratio indicates the amount of savings made out of a given
level of income. Capital output ratio is a ratio of increase in output or real
income to an increase in capital. Capital labour ratio tells us the ratio
between the numbers of labourers required for a given amount of capital
invested in any business. Refer to section 11.3.
4. For more details, Whole sale price indexes [WPI] are index numbers are
constructed on the basis of the wholesale prices of certain important
commodities. The items included are fertilisers, industrial raw materials,
minerals, semi-finished goods, machineries, etc. It is an index of prices
paid by producers for their inputs. Refer to section 11.4.
5. The GNP Deflator acts as an adjustment factor which is used to convert
nominal GNP into Real GNP. The GNP Deflator is the ratio of price
index number [PIN] of a chosen year to the price index number of the
base year [PIN of the base year = 100].
PIN of the chosen year
GNP Deflator 
100
Refer to section 11.5

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11.10 Case Study

Discretionary Dullness
Shailaja Sharma
The usually buoyant Indian consumer is in suspended animation; pushed
by the forces of macroeconomic woes, high food inflation and shrinking
net incomes – all the usual suspects – on one hand, and pulled by rapidly
escalating desires and aspirations for premium products and services on
the other. Until prosperity returns, the consumer is happy to make do with
inexpensive Indian brands and products.
The Credit Suisse India Consumer Survey 2012 shows that the lower
income group in cities has felt the pinch of high inflation more than
others. This has resulted in reduced surplus income and infrequent
spending.
The survey, conducted on 2,512 consumers across 10 Indian cities, finds
that few consumers expect inflation to fall. They also fear personal
finances would likely get worse. So, many people have postponed their
major purchases. Pressing priorities like children’s educational expenses,
entertainment cravings and personal care habits take precedence over
desires for cars, apparel and durables.
“Last year, we had noted the broad-based optimism among Indian
consumers across categories. This year, not surprisingly, consumers are
worried due to adverse macro conditions. Quantum of wage increases
has decreased and major buying decisions have been deferred,” state
Credit Suisse analysts in their report about the survey findings.
All this gloom-doom talk, however, has not affected sales of food,
personal care and household care or FMCG items.
Colgate Palmolive’s sales are up 20%, with 15% volume growth in
toothpastes, and 13% growth in toothbrushes. Only toothpowders have
declined, may be because some consumers are graduating to
toothpaste.
Elsewhere, Asian Paints is growing higher in small towns than cities
(where demand is becoming moderate). While the demand for decorative

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paints has not fallen drastically, the gap in growth from rural and urban
India is increasing. Sales growth of 20% was attained on just 5% growth
in volumes and 15% growth in price hikes. Prolonged 2011 monsoon
caused consumers to defer painting of their homes. Worse, the
macroeconomic worries and price hikes over the last 18 months could
mean moderation in demand.
The 20% sales growth of the soap-maker Godrej Consumer Products
was on a 12% volume growth with price hikes accounting for the rest.
Toilet soaps gained market-share from competitors and saw volume
growth as high as 18% since consumers shifted to more value-for-money
products.
ITC saw sales growth by 14.2% with its FMCG business growing by
almost 25%, driven by high consumption of snacks, biscuits and personal
care products like soap and shampoo.
Cigarette business grew by 11% with 5% growth coming from volume
and rest from price hikes. This 5% growth in cigarettes was lower than
the 7% growth anticipated by analysts, suggesting that consumers spend
on cigarettes did see some moderation. Likewise, Jyothy Laboratories,
the maker of Ujala fabric whitener, Exo diswash bars and Maxo mosquito
repellents, recorded 12% sales growth on 7% volume growth.
Come rain or shine, FMCG rules in India. However, for the low-and
middle-income Indian consumers; to gratify their desires for cars,
branded apparel, smartphones and smart fridges, they first need release
from the state of suspended animation and that may be later than sooner.
Discussion Questions:
1. How does inflation impact the demand for goods?
2. How does inflation influence the demand for consumer durables?
3. According to you, why has the demand for FMCGs not been
negatively impacted due to inflation?
(Source: An article of the same title published in the DNA on Jan 25,
2012)

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References:
 Spencer, Milton H. & Siegelman, Louis (1959), Managerial Economics,
Homewood, Illinois: Richard. D. Irwin, Inc.
 McNair, Malcolm P. & Meriam, Richard S., (1941), Problems in Business
Economics, New York & London: McGraw Hill Book Co. Inc.
 Pappas, James L., & Brigham, Eugene F., (1979), Managerial
Economics, Hinsdale: Ill Dryden Press.
 Dean Joel, (1951), Managerial Economics, Englewood Cliffs: NJ,
Prentice Hall.
E-Reference:
 www.dnaindia.com – retrieved on January 4th, 2012

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Unit 12 Consumption Function and


Investment Function
Structure:
12.1 Introduction
Case Let
Objectives
12.2 Consumption Function
12.3 Investment Function
12.4 Marginal efficiency of capital and business expectations
12.5 Multiplier
12.6 Accelerator
12.7 Summary
12.8 Glossary
12.9 Terminal Questions
12.10 Answers
12.11 Case Study

12.1 Introduction
In the previous unit, we learnt about macroeconomics and some of its
measures. We also briefly examined the relation between income,
consumption and savings. An increase in income leads to an increase in the
level of consumption. However, the increase in consumption is normally not
proportionate to the increase in the level of income. In this unit, we will study
about consumption function and investment function.
Consumption function explains the functional relationship that exists
between income and the level of consumption. Psychological law of
consumption, the average propensity to consume and the marginal
propensity to consume help us to understand the community behaviour.
Investment function explains the relationship between aggregate income
and aggregate investment. Various types of investment like; gross
investment and net investment, public investment and private investment,
autonomous investment and induced investment, marginal efficiency of
capital and the rate of interest as the determinants of investment, give us an
insight into the nature of investment activity.

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Multiplier is the ratio of change in income to a change in investment.


Accelerator explains the increase in the level of investment as a
consequence of the increase in the level of income and consumption.

Case Let (Continued from Unit 11)


In the previous unit, we saw that Ramesh’s superior asked him to
recollect macroeconomic concepts to appreciate the impact of the
external environment on the performance of business firms. Ramesh
browsed through his books and found that certain relationships existed
between macroeconomic conditions and the performance of business
firms. He then discussed the issues with his superior. During the
discussions, his superior casually mentioned that the market for traverse
rods was getting tougher due to the slowdown which had crept into the
economy. He mentioned that construction activities had slowed down due
to the higher interest rates that were prevailing. He also said that
inflationary conditions had made people to postpone their decisions and
stated that consumption and investment would have to be supported by
Government interventions. Ramesh knew that the economy was growing
at about 7% per annum. In that case, he wondered about the relationship
between income, consumption, investment, etc and their impact on
business firms.

Objectives:
After studying this unit, you should be able to:
 recognise and appreciate the aggregative behaviour of the economy as
a whole
 elucidate the Keynes psychological law of consumption
 evaluate the working of the multiplier and explain the importance of
consumption in increasing the level of investment
 apply the principle of acceleration, and judge the role of business
expectations in determining marginal efficiency of capital and therefore
investment

12.2 Consumption Function


The consumption function indicates the relationship between consumption
and income. Consumption is an increasing function of income. Lord Keynes

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in his theory of income and employment has given a very significant place to
this concept. According to him, the level of national output, income and
employment directly depends on effective demand in an economy. Higher
the level of effective demand, higher would be the level of income and
employment and vice-versa. Effective demand consists of consumption
expenditure and investment expenditure.
Consumption expenditure depends on the size of income and the
consumers’ propensity to consume while; investment expenditure depends
on the marginal efficiency of capital and the rate of interest. Keynes
suggested a high propensity to consume to tackle the problem of
unemployment in an economy as one of the remedial measures. To
understand the concept clearly it is necessary to distinguish between
consumption and consumption function.
The term consumption refers to a particular amount of consumption
out of a given amount of income. On the other hand, consumption
function refers to different amounts of consumption at different levels
of income. It explains a functional relationship between changes in the level
of consumption as a result of changes in the levels of income. It indicates
how consumption varies as income changes. If consumption is represented
by C and income by Y then, the propensity to consume is C= f (Y). It implies
that consumption is an increasing function of income. There is a direct
relationship between the two. Higher the income, higher would be the
consumption and vice-versa. Table 12.1 shows the relationship between
income and consumption.

Table 12.1: Income versus Consumption

Income (Y) in Rs. crores Consumption (C)


10 10
15 14
20 18
25 22
30 26

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The table shows consumption as an increasing function of income and both


the variables, Y and C, move in the same direction. Further, consumption is
shown to change by Rs. 4 crores for each change of Rs. 5 crores in income.
It is assumed that in the short run, the propensity to consume will remain
stable. Increase in consumption is less than proportionate to the increase in
income.
When we represent this on a diagram we get a curve rising upwards but
less steeply. Figure 12.1 shows that the increase in consumption is smaller
than the increase in income.

Y
Consumption

C
0 X
Income

Figure 12.1: Graphical Representation of Income versus Consumption

In the diagram, the Y axis measures consumption and the X axis real
income. The CC curve represents the consumption function.
Psychological law of consumption
In the words of Keynes “Men are disposed, as a rule and on the average, to
increase their consumption as their income increases, but not by as much
as the increase in their incomes”. In the short period, as the level of income
of the people remains the same, the level of consumption also remains the
same.
Generally it is observed that when income increases, consumption
also increases, but by a lesser proportion than the increase in income.

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Suppose the total income of the community is Rs. 10 crore and the
consumption expenditure is also Rs. 10 crore. In this case, there is no
saving and investment. Further, the income increases to Rs.15 crore. Then,
consumption also increases, but not to the extent of Rs. 15 crore. It may
increase to Rs. 14 crore and Rs. 1 crore constitutes the savings. This
savings create a gap between income and consumption. This gap is in
conformity with Keynes psychological law of consumption, which states
that, “when aggregate income increases, consumption expenditure
shall also increase but by a somewhat smaller amount”. This law tells
us that people fail to spend on consumption, the full amount of increment in
income. As income increases, the wants of the people get satisfied and
they save more than what they spend. This law may be considered as a
rough indication of the actual macro-behaviour of consumers in the short-
run. This is the fundamental principle of the the Keynesian consumption
function.
It is based upon his observations and conclusions derived from the study of
consumption function. This law is also called the fundamental law of
consumption. It consists of three interrelated propositions: -
 When the aggregate income increases, expenditure on consumption will
also increase but by a smaller amount.
 The increased income is distributed over both spending and saving.
 As income increases, consumption, spending and saving will go up.
As consumption expenditure progressively diminishes when income
increases, a gap between income and expenditure arises. This tendency is
so deep rooted in people’s habits, customs, and the psychological set up
that it is difficult to change in the short run. Hence, it is impossible to raise
the propensity to consume of the people, so as to increase the national
output, income and employment. Increasing the volume of investment in an
economy can only fill up the gap between income and consumption.
The average propensity to consume and the marginal propensity to
consume
 The average propensity to consume (APC) – The relationship
between income and consumption is measured by the average and
marginal propensity to consume. The APC explains the relationship
between total consumption and total income. At a certain period of

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time, it indicates the ratio of aggregate consumption expenditure to


aggregate income. Thus, it is the ratio of consumption to income
and is expressed as C/Y.
Total consumptio n C 8000
Thus, APC = APC  APC   0.8 or 80%
Total income Y 10,000
Suppose the income of the community is Rs.10, 000 crore and
consumption expenditure is Rs. 8,000 crore, then the APC is
8000/10,000 = 80% or 0.8. Thus, we can derive APC by dividing
consumption expenditure by the total income.
 Marginal propensity to consume (MPC) – MPC may be defined as
the incremental change in consumption as a result of a given
increment in income. It refers to the ratio of the change in
aggregate consumption to the change in the level of aggregate
income. It may be derived by dividing an increment in consumption by
an increment in income. Symbolically
C
MPC =
Y
Suppose total income increases from Rs.10, 000 crore to Rs. 20,000
crore and total consumption increases from Rs. 8000 crore to Rs 15,000
crore, then,
7000
MPC = = 0.7 or 70%
10,000

Technical characteristics of MPC


1. The value of MPC is always positive but less than one
This means that when income increases, the whole income is not spent
on consumption. Similarly, when income declines, consumption
expenditure does not decline in the same proportion. Consumption
expenditure never becomes zero.
2. MPC is greater than zero
It is always positive. This means that an increase in income will lead to
an increase in consumption. MPC cannot be negative.
3. MPC goes down as income increases.
4. MPC may rise, fall or remain constant, depending on many factors, both
subjective and objective.
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5. MPC of the poor is greater than that of the rich.


6. In the short-run, MPC is stable.
The concept of MPC throws light on the possible allocation of additional
income between consumption and saving. It also tells us how the extra
income will be divided in the Keynesian system. Saving, in the ultimate
analysis, is equal to investment. In our example, MPC is 70% and as such,
the MPS must be 30%. The reason is that the income of a community is
divided between saving and spending. The sum of MPC and MPS equals 1.
Relationship between MPC and APC
Table 12.2 shows the relationship between APC and MPC.
Table 12.2: Relationship between APC and MPC
Rs. In crores
Income Consumption APC MPC
100 100 100 % –
200 180 90 % 80 %
300 240 80 % 60 %
400 280 70 % 40 %
500 300 60 % 20 %

1. Generally speaking, when income increases, APC as well as MPC


declines but the decline in MPC is greater than APC.
2. As income increases, MPC falls and APC also falls but at a slower rate.
3. If MPC is rising, the APC will also be rising although at a slower rate.
4. When MPC is constant, APC may also remain constant.
5. APC, in some cases, may be equal to MPC. It is quite possible that
50% of increased income is consumed and the remaining 50% is saved.
6. MPC is generally high in poor countries when compared to rich
countries. In rich countries, the basic requirements are satisfied and
therefore, the MPC would be less and MPS would be high. However, in
poor countries, majority of the people have to satisfy their basic needs
and hence as income increases, the MPC also increases while MPS is
generally low.

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Factors determining consumption function


Broadly speaking, there are two factors, which influence consumption
function in the long run. They are:
 Subjective factors
 Objective factors
 Subjective factors – Subjective factors basically underlie and
determine the form of the consumption. The subjective factors are either
internal or endogenous in nature. They mainly depend upon the
personal decisions taken by the people. Keynes has listed eight
main motives, which compel people to refrain from current spending.
They are the motives of precaution, foresight, calculation,
improvement, independence, enterprise, pride and avarice.
In addition to these factors, Keynes has also added a list of motives,
which leads to consumption. “We could also draw up a corresponding
list of motives to consumption such as enjoyment, shortsightedness,
generosity, miscalculation, ostentation and extravagance”.
 Objective factors – Objective factors are those which depend on merits
and facts. In this case, personal factors will not come into picture. The
following are some of the important objective factors which influence
consumption:
1. Distribution of national income
2. Fiscal policy
3. Money income
4. Real income
5. Price and wage level
6. Changes in tastes and fashion
7. Changes in expectations
8. Wind fall (sudden) gains and losses
9. The level of consumer indebtedness
10. Attitude towards thrift
11. Liquid assets
12. Social and life insurances
13. Rate of interest
14. Business policies of corporations
15. Demonstration effect
16. Changes in expectations
17. Installment buying, etc.

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The objective factors generally remain unchanged in the short period. Thus,
propensity to consume in the short period is generally stable. It is because
of this, Keynes relies on investment for the purpose of increasing
employment during depression.
Importance of consumption function
It has got great theoretical as well as practical importance. Almost all
countries of the world aim at removing unemployment raise their national
income and enjoy prosperity. For this purpose, a policy of planned economic
development is essential. In the formulation of this policy, consumption
function plays a very important role.
1. It invalidates Say’s law of markets
Say’ law of markets which is the fundamental basis of classical theory of
income and employment, states that” Supply creates its own demand”. As a
result, there is no possibility of overproduction and unemployment.
Consumption function tells us that the entire increase in additional income is
not spent on consumption goods. Hence, according to Keynes, supply,
instead of creating its own demand, very often exceeds it and creates a glut
of goods leading directly to overproduction and mass unemployment.
2. It highlights the importance of investment in employment theory
According to Keynes, in order to increase the volume of employment, both
consumption and investment must be stepped up. However, consumption
function in the short run remains more or less constant and, as such, it may
be taken as given. Hence, investment plays a crucial role in determining the
level of employment.
3. It helps to explain the turning points of the business cycle
During the boom period, though income increases, consumption
expenditure fails to match the increased incomes. Hence, saving increases-
demand declines-and ultimately the slump develops. Similarly, during the
period of slump, income contracts, people fail to reduce their expenditure on
consumption to the full extent of the decrease in incomes. This tendency
ultimately leads to boom.
4. It helps to explain the declining tendency of marginal efficiency of
capital (MEC)
In rich advanced nations, the MPC is less than one. Hence, marginal
efficiency of capital (MEC) shows a declining trend. This is because as
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income increases, expenditure falls, savings rise, demand declines and


production moves in the downward direction. Profits fall leading to a decline
in MEC. Hence, investment declines and economic growth declines.
5. It helps to explain the concept of secular stagnation
Generally speaking, the MPC is low and MPS is high in most of the
industrialised nations. The gap between income and consumption continues
to raise necessitating increase in investment. As propensity to consume is
stable, propensity to save also tends to be stable. On the other hand, it
becomes lesser with the lapse of time. The economy may sooner or later
reach a stage where it finds itself unable to utilise fully and effectively its
savings for the task of promoting full employment. Keynes calls such a
situation as “secular stagnation”.
6. It helps to find out the value of multiplier
The value of multiplier is derived from consumption function.
1
K= this helps us to understand the process of multiplication
1  MPC
Since the MPC is less than unity, the increase in national income is not in
proportion to investment. The magnifying effect of multiplier declines due to
a fall in consumption expenditure in an economy.
7. It helps to explain the concept of underemployment equilibrium
As MPC is less than one, the consumers fail to spend the full increased
income on consumption. Effective demand becomes inadequate to bring
about full employment equilibrium. Thus, the economy remains at
underemployment equilibrium
8. It upholds the state intervention
Since overproduction and unemployment are possible owing to the
deficiency of consumption, the economy cannot be a self-adjusting system
by itself. Hence, state intervention is a must.
Thus, consumption function helps us to analyse the process of income
generation, expansion in employment opportunities, need for the state
intervention and a very high level of investment to maintain the national
income and employment.

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Self Assessment Questions


1. The relationship between consumption and income is called
_____________.
2. __________ is the ratio of change in total consumption to change in
total income.
3. Two groups of factors that affect consumption function are ________
and ______.
4. For the economy as a whole, consumption must equal saving.
(True/False)
5. When a country saves a large portion of its income, it will have more
capital and more productivity. (True/False)
6. Consumption, in economics, refers to household spending on durable
and nondurable goods as well as household spending on services.
(True/False)

12.3 Investment Function


Investment is the second important component of effective demand. In
Keynesian economics, the term investment has a different meaning. In the
ordinary language, it refers to financial investment. i.e. purchase of stocks,
shares, debentures, bonds, etc. In this case, there is only transfer of rights
or titles from one person to another. It is an investment by one and
disinvestment by another and as such, the value transaction mutually
cancels out each other. They do not add anything to the total stock of capital
of the nation.
Investment, according to Keynes, refers to real investment. It implies
creation of new capital assets or additions to the existing stock of productive
assets. It refers to that part of the aggregate income, which is used for the
creation of new structures, new capital equipments, machines, etc that help
in the production of final goods and services in an economy. Creation of
income – earning assets is called investment. Thus, investment must
generate income in the economy. Investment also refers to an addition to
capital with such investment occurring when a new house is built or a new
factory is built. Investment means making an addition to the stock of goods
in existence. These activities necessitate the employment of more labour
and thus result in an increase in national income and employment.

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Investment is not a stock but a flow variable because; it highlights the


additions to the existing stock of capital. The productive ability of an
economy is measured in terms of its stock of capital and its capacity to add
to the existing stock of capital. Hence, it is a crucial factor in the economic
development of any nation.
Types of investment
Keynes speaks of 5 types of investment. They are as follows:
1. Private investment
It is made by private entrepreneurs on the purchase of different capital
assets like machinery, plants, construction of houses and factories, offices,
shops, etc. It is influenced by MEC and interest rate. It is profit –
elastic. Profit motive is the basis for private investment. Private
entrepreneurs would take up only those projects which yield quick results
and generally those that have a small gestation period.
2. Public investment
It is undertaken by the public authorities like central, state and local
authorities. It is made on building infrastructure of the economy, public
utilities and on social goods, for example, expenditure on basic industries,
defense industries, construction of multipurpose river valley projects, etc. In
this case, the basic criterion and motto is social net gain, social welfare
and not profits. The principle of maximum social advantage would govern
public expenditure. It is also influenced by social and political
considerations.
3. Foreign investment
It consists of excess of exports over the imports of a country. It
depends on many factors such as propensity to export of a given country,
foreigners’ capacity to import, prices of exports and imports, state trading
and other factors.
Induced investment
Figure 12.2 shows that as income increases, investment also increases and
vice-versa.

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Investment

0 X
Income
Figure 12.2: Graphical Representation of Investment versus Income

Induced investment is another name for private investment. Investment,


which varies with the changes in the level of national income, is called
induced investment. When national income increases, the aggregate
demand and level of consumption of the community also increases. In order
to meet this increased demand, investment has to be stepped up in capital
goods sector which finally leads to increase in the production of
consumption goods Therefore, we can say that induced investment is
income – elastic i.e., it increases as income increases and vice-versa.
Thus, it is sensitive to changes in income and is governed by profit –
motive. The shape of the induced investment curve has been shown as
rising upwards to the right. This means that as income increases,
investment also increases and vice-versa.
5. Autonomous investment
Autonomous investment is another name for public investment. The
investment, which is independent of the level of income, is called as
autonomous investment. Such investments do not vary with the level of
income. Therefore it is called income-inelastic. It does not depend on
changes in the level of income, consumption, rate of interest or expected
profit. Figure 12.3 depicts that though income changes, investment more or
less remains constant.

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I I

Investment

X
Income
Figure 12.3: Autonomous Investment Curve

Autonomous investment depends upon population growth, technological


progress, discovery of new resources, etc. For example, expenditure on
public buildings, transport and communications, defense, public utilities,
water supply, generation of electricity, etc are considered as autonomous
investment. It is guided by social welfare rather than profit motive.
The autonomous investment curve is perfectly inelastic. And as such it
indicates that though income changes, investment more or less remains
constant.
There are a few other concepts of investment. They are as follows:
 Gross investment – Gross investment refers to the total real investment
or addition to capital stock of the country.
 Replacement investment – A part of gross investment that is used for
replacing the old capital equipments is called replacement investment.
 Net investment – The net investment is equal to the gross investment
minus replacement investment. Hence, net investment = gross
investment – capital consumption or replacement investment.
 Ex-ante investment – The investment that is intended or expected or
planned is known as ex-ante investment.
 Ex-post investment – The actual or realised investment is known as
ex-post investment.

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Determinants of investment
Investment decisions taken by entrepreneurs depend upon a number of
factors like; interest rate, level of uncertainty, political environment, rate of
growth of population, level of existing stock of capital, and the necessity of
new products. It also depends on investors’ level of income, level of
inventions and innovations, level of consumer demand, availability of capital
and liquid assets of the investors, government policy, etc.
It is necessary to note that investment is more volatile and unpredictable. It
is highly unstable in the short run because the factors determining it are
highly complex and uncertain in their nature. The above-mentioned factors
no doubt generally affect the volume of investment. However, the most
important inducement to invest is the consideration of the profit. The
profitability of investment depends mainly on two factors:
 Marginal efficiency of capital (MEC)
 Interest rate (IR).
It relates to the cost-benefit analysis. The businessman while investing
capital has to calculate the cost of borrowing and the expected rate of profits
from it.

12.4 Marginal efficiency of capital and business expectations


Marginal efficiency of capital
It refers to productivity of capital. It may be defined as the highest rate
of return over cost accruing from an additional unit of capital asset. It
also refers to the yield expected from a new unit of capital. The MEC in
its turn depends on two important factors:
 Prospective yield from the capital asset and
 Supply price of the capital asset.
The MEC is the ratio of these two factors. The prospective yield of a
capital asset means the total net returns expected from the asset over
its lifetime. After deducting the variable costs like cost of raw materials,
wages, etc from the marginal revenue productivity of capital, an investor can
estimate the prospective income (expected annual returns and not the
actual returns) from the capital asset. Along with it, the investor also has to
consider the supply price or replacement cost of the capital asset.

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Supply price of a capital asset is the cost of producing a brand new


asset of that kind, not the supply price of an existing asset. It is the
actual amount of money spent by an investor while purchasing new
machinery or erecting a new factory.
The MEC of a particular type of asset means what an investor expects to
earn from an additional unit of it compared with what it costs him. To be
more specific, MEC is the rate of discount, which will make the present
value of the capital assets equal to their future value (prospective yield) in
their lifetime i.e. Supply price = discounted prospective yield.
The MEC can be calculated with the help of the following formula:
Q1 Q2 Q3 Qn
Cr =
(1  r )1 (1  r ) 2 (1  r ) 3 (1  r ) n

In the above formula Cr represents supply price or replacement cost of the


new capital asset. Q1, Q2, Q3 indicate the prospective yields in the various
years 1 2 3 … n and r represent the rate of discount which will make the
present value of the series of annual returns just equal to the supply price of
capital asset. Thus, r denotes the rate of discount or MEC.
We can illustrate the meaning of MEC as a rate of discount by means of a
simple arithmetical example. Lets assume that the supply price of a capital
asset is Rs.3000/- and the asset will become useless after two years.
Furthermore, the capital asset is expected to yield Rs.1100/- at the end of
one year and Rs.2420/- at the end of 2 years. Now, it is obvious that the rate
of discount of 10% will equate the future yields of the asset with its current
supply price. At 10% discount rate, the present value of Rs.1100/-
discounted for one year plus Rs.2420/- discounted for 2 years amounts to
an aggregate sum of Rs.3000/- which is the supply price of the capital asset.
The above-mentioned formula can be used to explain the same point.
Q1 Q2 1100 2420
Cr =  3000 
(1  r )1
(1  r ) 2
(1  0.1)1
(1  0.1) 2

Rs. 1100 Rs. 2420 1100 2420


3000 =  2
 
[1.10 ] [1.10 ] 1 .1 1.21

3000 = Rs.1000+ Rs.2000

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In this case, the discounted prospective yield is equal to the current supply
price of the capital asset. If the expected rate of yield is greater than the
supply price, it becomes profitable to invest and otherwise not.
The volume of induced investment depends on MEC and IR. It is necessary
to note that:
 When MEC  IR, the effect on investment is favourable
 When MEC  IR, the effect on investment is adverse
 When MEC = IR, the effect on investment is neutral
Generally speaking, the MEC of a capital falls as investment increases
and the reasons for this are as follows:
1. The prospective yields of the asset will fall as more and more units of it
are produced. This happens because as more assets are produced,
they will compete with each other to meet the demand for the product
and consequently, their general earnings will decline.
2. The operation of the law of diminishing marginal returns.
3. Higher investments create higher demand for capital assets leading to
an increase in supply price of capital assets. Consequently, the total
production cost rises. Thus, MEC declines with an increase in
investment either as a result of decreasing prospective yield or
increasing supply price of capital asset.
4. Higher investment results in higher production, reduction in per unit cost,
lower price for the products and lower earnings from the sales.
Thus, the MEC falls as investment increases because costs go up and
earnings fall. The fall in MEC will be different at different levels of
investment. The MEC curve drops downwards from left to right and this
tendency can be explained with the help of the following example. Table
12.2 depicts an example of changes in MEC in relation to IR and
Investment.

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Table 12.2: Changes in MEC of capital in relation to IR and Investment

Volume of
The IR in % p.a investment in MEC of capital in % p.a
crores
13% 5000 13%
11% 7000 11%
9% 9000 9%
7% 11000 7%
5% 13000 5%
3% 15000 3%

On the OX axis, we represent different amounts of investment and on OY


axis, we represent MEC and IR. The ME curve indicates the MEC. It can be
seen that as investment increases, the ME curve slope downward. It is clear
that if the current IR is 9 %, then the entrepreneurs will invest Rs. 9000
crores because at this point the MEC is also 9% i.e. MEC = IR. If the IR falls
to 7%, then the entrepreneurs will invest Rs 11000/-. This is because the
MEC is also 7% at this point. Figure 12.4 shows Investor’s return

IR

11

9
E
MEC
O Y

7000 9000
Investment
Figure 12.4

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The MEC represents an investor’s return and the IR is the cost. Obviously,
the return on capital must be equal to its cost. Thus, the MEC and IR are
closely related to each other and they move together. We can conclude that
given a MEC curve, the investment will depend on the existing IR in the
market.
Determinants of MEC
Several factors that affect MEC are as follows:
I. Short run factors
1. With expectation of increased demand, higher MEC leads to larger
investment and vice-versa.
2. Cost and price: If the production costs are expected to decline and
market prices to go up in future, MEC will be high leading to a rise in
investment and vice-versa.
3. Higher propensity to consume, leading to a rise in MEC encourages
higher investment.
4. Changes in income: An increase in income will simulate investment
and MEC while a decline in the level of incomes will discourage
investment.
5. Current state of expectations: If the current rates of returns are high,
the MEC is bound to be high for new projects of investment and vice-
versa. This is because the future expectations to a very great extent
depend on the current rate of earnings.
6. State of business confidence:
During the period of optimism (boom), the MEC will be generally high
and during period of pessimism (depression), it will be generally less.
II Long run factors
1. Rate of growth of population: In a capitalist economy, a high rate of
population growth leads to an increase in MEC because it leads to an
increase in the demand for both consumption and investment goods. On
the contrary, a decline in the population growth depresses MEC.
2. Development of new areas: Development activities in the new fields
like transport and communications, generation of electricity, construction
of irrigation projects, ports, etc would lead to a rise in MEC.

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3. Technological progress: Technological progress would lead to the


development and use of highly sophisticated and latest machines,
equipments and instruments. This will add to the productive capacity of
the economy leading to an increase in MEC.
4. Productive capacity of existing capital equipments: Underutilised
existing capital assets may be fully utilised if the demand for goods
increases in the economy. In that case, the MEC of the same asset will
definitely rise.
5. The rate of current investment: If the current rate of investment is
already high, there would be little scope for further investment and as
such the MEC declines.
Thus, several factors both in the short run and in the long run affect the
MEC of a capital asset.
Hence, several measures are to be taken to stimulate private investment in
an economy.
In the Keynesian theory, investment is a very important and strategic
variable. In order to increase the volume of national output, income and to
tackle the problem of unemployment, the remedial measure suggested by
Lord Keynes is to raise the level of investment in an economy. It is seen that
as the income of the community increases, consumption also increase but
by less than the increase in income. Hence, in order to have sufficient
demand to sustain an increase in employment, there must be increase in
real investment equal to the gap between income and consumption out of
income. In other words, employment cannot increase unless investment
increases.
Role of business expectations in determining MEC
Business expectations play a vital role in determining MEC and therefore
investment. Level of income and employment in an economy are
determined by two factors: propensity to consume and inducement to invest.
Of the two, propensity to consume is more or less stable. Fluctuations in
income and employment, therefore, depend mainly on the inducement to
invest. The inducement to invest in turn depends on the rate of interest and
the marginal efficiency of the capital. Since the rate of interest is relatively
stable or sticky, fluctuations in investment depend primarily upon the

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changes in the MEC. There are two determinants of the MEC: the cost of
the capital asset and, the rate of return from the asset.
Uncertainty in the prospective yield or business expectations causes
instability in MEC. As business expectations change, the volume of
investment changes and this causes changes in business activity and
employment.
Expectations regarding the prospective yield of capital assets are of two
types: (a) Short - term expectations (b) Long - term expectations.
Short-term expectations are based on the existing stock of capital and the
intensity of consumers’ demand for the goods, which are known and remain
more or less stable.
On the other hand, long-term expectations relate to future changes in the
size of the stock of capital assets and changes in the level of aggregate
demand which are uncertain. Thus, the long term expectations are highly
unstable, but are more important in explaining fluctuations in investment and
employment.
The long term expectations are influenced by the following factors:
1. The state of confidence – How certain and confident are businessmen
with regard to the future change.
2. Stock exchange valuation – The value attached to it by the dealers in
stock exchange.
3. Irrevocable decisions – Decisions made by bold and dynamic
entrepreneurs.
4. Elements of instability – Frequent changes in the assessment of the
prospects of various investments have introduced lot of changes in the
investment activity.
5. Link with investments – Stock exchange dealings influence new
investments by, establishing links between the new investments and the
present investments.
6. Behaviour of investors – Since there is mass valuation of assets on
the stock exchange, there are alternating waves of pessimism and
optimism.
Apart from these, political events like war, elections, etc. also influence the
prospective yield of the capital assets.

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Thus, investment decisions are made in an uncertain atmosphere, based on


business expectations with regard to the marginal efficiency of capital.

Self Assessment Questions


7. Investment made by government and departmental undertakings is
called ______ investment.
8. Depreciation is part of ____________________.
9. ________ investment does not depend on the changes in the national
income.
10. ________ varies with the changes in the level of national income.
11. In macroeconomics, investment refers to purchase of mutual funds,
stocks, or bonds. (True/False)
12. If the government encourages savings, it would lead to lower interest
rates and higher investments. (True/False)
13. When the government has a deficit, it leads to lower investment and
higher interest rates. (True/False)

12.5 Multiplier
Meaning and working of multiplier
Prof. Kahn developed the concept of “Multiplier” with reference to
employment. Lord Keynes, on the lines of employment multiplier, developed
an “Investment Multiplier”. It is derived from the concept of marginal
propensity to consume, and refers to the effects of changes in investment
outlays, on aggregate income through consumption expenditure. It has
acquired greater significance in recent years to explain the process of
income generation in an economy when the volume of investment changes.
There are various types of multiplier such as; income multiplier, investment
multiplier, employment multiplier, foreign trade multiplier, etc.
Keynes’ investment multiplier is based on the fundamental psychological
law of consumption. It states that as income increases, consumption also
increases but less than proportionately. Consequently, the consumption
demand in the short run remains constant and it cannot be increased. The
alternative to increase the output is to increase the volume of investment.
Even though consumption function is a major determinant of aggregate

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demand, it is not the prime initiator of changes in income and output. The
changes in the volume of investment will bring about changes in the level of
income and output. How changes in income are affected can be understood
with the help of investment multiplier.
Multiplier may be defined as a ratio of change in income to a change in
investment. It expresses the relationship between an initial increment in
investment and the final increment in income. It shows by how many times,
the effect of an initial change in investment is multiplied by causing changes
in consumption and finally in the aggregate income. Change in investment
generally gives rise to change in income by a multiple amount. Whenever an
additional investment is made in the economy, it increases the aggregate
income not only by an amount equal to the additional investment but by
somewhat greater than that. The logic is simple. The original investment
increases income not only in the industry where investment is made, but
also in certain other industries whose products are demanded by people
employed in investment goods industries. For example, if an increase in
investment of Rs. 5 lakhs causes an increase in income of Rs. 25 lakhs,
then the multiplier would be 5. If the increase in income is Rs. 30 lakhs, then
the multiplier would be 6. Algebraically, this relationship can be expressed
as follows:
Change [ ] in income 25
K= K 5
Change [ ] in investment 5

where delta (∆) stands for change or increase, K for multiplier, Y for income
and I for investment respectively.
The size of the multiplier is directly derived from the size of the MPC. Higher
the MPC, higher would be the size of multiplier and vice-versa. The
multiplier is equal to the reciprocal of 1 minus MPC. The formula to calculate
the size of the multiplier is as follows:
1
K=
1  MPC
If we know the size of the MPC, the value of the multiplier can be easily
found out. If MPC is 2 / 3, then multiplier would be as follows:
1 1 1
K=   3
1  MPC 1  2 / 3 1  1/ 3

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We know that MPC + MPS =1. If we deduct MPC from 1 we get MPS.
Hence, the above equation can be expressed in the following manner:
1
K=
MPS
If the MPC is 9 / 10, deducting 9 / 10 from 1, we get 1 / 10. This is the MPS.
The reciprocal of 1 / 10 is 10, which is the value of the multiplier. In short,
the multiplier is the reciprocal of the MPS, which is always equal to 1 minus
the MPC.
From the above explanation, it is clear that:
 Higher the value of MPC, higher would be the value of K and vice-
versa.
 When MPS = 0 and MPC =1, then there will be a 100 percent increase
in income every time or the multiplier effect will be continuous.
 When MPS =1 and MPC = 0, then what is earned will be saved and the
value of multiplier will be equal to 0.
Working of the multiplier and the process of income generation
The process of income generation through the working of the multiplier can
be expressed in the following manner:
Assumptions
 MPC = ½ or K = 2.
 An investment of Rs 10 crores will generate an income of Rs 20 crores.
Table 12.3 shows Impact of Multiplier on Incomes.
Table 12.3: Impact of Multiplier on Incomes

Period or rounds Investment in Change in income in


crores (Rs) crores (Rs)
1 10 10
2 10 05
3 10 2.50
4 10 1.25
5 10 0.62
6 10 0.31
Total 20

The multiplier process is based on the principle that one man’s expenditure
is another man’s income. If MPC of one individual is high, the income of

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another man is also high. From the respective table it is clear that as we
move from one round to another, the initial investment gives rise to a
dwindling series of successive increments in income because MPC is
generally less than one.
Assumptions
 MPC = 2 / 3 or MPS = 1 / 3 or K = 3.
 Original investment is Rs 30 crores.
 Additional investment is Rs 10 crores.
As the multiplier is 3, the additional investment of Rs.10 crores leads to an
increase in the income of the community to Rs.30 crores. This can be
understood with the help of the following diagram.
In the respective diagram, QR represents original investment of Rs 30
crores. SS is the saving curve, which intersects the investment curve at the
point M, which indicates the original income of the community at Rs 130
Crores. Q1R1 is the new investment line, which indicates an additional
investment of Rs 10 crores. The new investment curve Q1R1 intersects the
same saving curve at M1. At this new equilibrium point, the income of the
community is Rs 160 crores. It is clear that as a result of an additional
investment of Rs 10 crores, income has gone up by 3 times (from Rs 130
crores to Rs 160 crores).Figure 12.5 shows Results of investments

Y S

M`
Saving & Investment

Q` R`

Q M
R

0 X
130 160
Income

Fig. 12.5: Impact of multiplier on Savings and Investments

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Assumptions and limitations of the multiplier


1. Availability of consumer goods
Multiplier works satisfactorily if the volume of goods and services on
which the additional income may be spent are available in plenty.
Otherwise, people are unable to spend their income on them.
Consequently, MPC falls leading to a decline in the value of K.
2. Maintenance of investment
In order to realise the full value of K, it is necessary that the various
increments in investment be repeated at regular intervals. In case, it is
not done, it will not be possible to raise the income to the multiplier level.
3. Net Increase in investment
In order to get the full value of K, there should be a net increase in
investment. Increase in investment in one sector of the economy should
not be neutralised by decrease in investment in another sector of the
economy. Otherwise, the working of the multiplier is obstructed.
4. No change in the size of MPC
In the process of income generation, there should not be any change in
the value of MPC. If there is any change in the size of MPC, then the
value of K also changes.
5. No investment from induced consumption
In the multiplier theory we analyse only the impact of investment on
consumption, but the reverse, accelerator is totally ignored. If the
accelerator is allowed to operate and effects of induced consumption on
investment are also taken into account, then the value of the multiplier
would be far greater and would also be achieved at an earlier stage in
the process of income generation.
6. No time gap between successive expenditure on consumption
If there is a gap between receipt of income and expenditure even in the
short run, the full value of the K cannot be realised because as MPC
falls, the size of the K also declines.
7. Existence of a closed economy
If there is trade between different countries, the value of K may be
restricted by the amount of excess of imports over exports. A part of the
total money will go out of the country if there are imports and to that
extent, the value of the K declines.

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8. Existence of less than full employment condition


If the economy is working at full employment level, there is no scope for
increase in output, income and employment even though investment
increases.
9. It is based on the number of assumptions
These assumptions may not be found in practice. Consequently, the
‘actual’ multiplier may be greatly restricted and will be different from the
‘ideal’ multiplier.
10. No direct relation between investment and income
There is no precise, pre-determinable or mechanical relationship
between social income, consumption, investment and extent of
employment.
11. Keynes multiplier is a static concept
It shows the process of income propagation from one point of
equilibrium to another and that too under static conditions. It gives little
insight into the actual process by which the economy achieves a new
equilibrium.
Prerequisite conditions for the working of the multiplier
1. Existence of involuntary unemployment
National output, income and expenditure can be increased by additional
investment only when there is involuntary unemployment condition in an
economy. Otherwise, there will be no scope for expansion in
employment even if investment increases.
2. Existence of an industrial economy
Multiplier can freely operate in an industrial economy rather than, in an
agricultural economy because the demand for industrial goods is
relatively stable than that of agricultural goods and as such, the MPC
and the value of K will be high.
3. Existence of excess capacity in consumer goods industries
A high level of investment will succeed in, utilising the unutilised and
underutilised excess capacity to the extent possible. This leads to the
creation of more employment.

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4. Existence of elastic supply of other factor inputs in the market


A higher investment would result in higher output, income and
employment only when the other supplemental factor inputs are
available in abundance.
Leakages in the multiplier
Income not spent on consumption is called ‘leakage’ in the cumulative
income stream. This leakage obstructs the increase in output and income.
These leakages will arise on account of the following reasons:
 Savings – Higher the level of savings, the lower would be the value of K
and vice-versa.
 Accumulation of idle cash balances – If people keep more idle cash
balances with them, then the MPC declines and the value of K declines.
 Debt cancellations – If people use a part of their income to repay their
old debts, then the current MPC declines and the value of K also
declines.
 Purchase of old shares and stocks – A part of the income may be
spent on buying old stocks, shares and other securities in the market.
This would lead to a decline in the current MPC and a decline in the
value of K also.
 Imports – Payments on imports would reduce domestic consumption
leading to a decline in the value of K.
 Price inflation – Inflation would reduce the purchasing power of the
people and consequently the MPC and also the value of K.
 Taxes – Higher taxes would reduce the income of the people, MPC and
also the value of K.
 Corporate savings – Undistributed profits of joint stock companies
would reduce the incomes of the shareholders, their MPC and thus the
value of K.
If all these leakages are properly plugged in the income stream, the effect of
multiplier in the process of income generation would be higher, taking the
economy towards full employment level.
Practical importance of the multiplier
1. It is a major tool of macroeconomic theory focusing attention on
investment as the significant element in increasing the level of
employment.

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2. It summarizes the working of the entire Keynesian model.


3. It describes how income is generated in an economic system like stone
causing ripples in a lake.
4. It is a valuable guide to public investment policy.
5. It is helpful for framing a suitable full employment policy.
6. It has great practical significance in formulating anti-cyclical policy to
smoothen business fluctuations in an economy. Thus, it is necessary
for the study of trade cycle, its trends and control.
7. According to Prof. Samuelson, the multiplier theory explains why an
easy money policy is ineffective and deficit spending is effective during
the period of depression.
8. For increasing the income and employment, investment should be
started in a sector where the multiplier may be greater.
9. It is used for explaining expansion in different fields of economic
activities, for example; credit multiplier, budget multiplier, etc.
10. It upholds the government intervention, active participation and macro
economic management relating to income, output, employment, etc.
11. It helps to understand how equality between saving and investment is
brought about. An increase in investment leads to increase in income.
Consequently, saving also increases and becomes equal to
investment.
12. It emphasises the significance of deficit financing. Increase in public
expenditure by creating deficit budget helps, in creating income and
employment by multiple times the initial increase in expenditure.
Thus, the concept of multiplier has not only brought about a revolution in
economic theory but also in framing various economic policies. Keynes
regards it as a path-breaking contribution to economic theory.

12.6 Accelerator
The principle of “accelerator or acceleration” is another important tool of
economic analysis. It is older than multiplier. The accelerator dates back to
1914 or even before. It is associated with the name of Prof. J. M. Clark, an
American economist who was mainly responsible for popularising it in 1917.
Multiplier and accelerator are two parallel concepts. The multiplier concept
is inadequate to explain the process of income generation in a complete

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manner. It shows the effect of investment only on consumption expenditure


and how the increase in investment, will bring about increase in national
income through multiplier effect. In short, multiplier explains the effects of
investment on consumption and how the volume of consumption depends
on the volume of investment. The multiplier fails to analyse the effect of
increase in consumption on investment. In order to know how consumption
affects the volume of investment, we have to study the concept of
accelerator.
Accelerator shows the effect of changes in consumption on induced
investment and tells us how the volume of investment depends on the level
of consumption. The combined action of both multiplier and accelerator will
clearly explain how the aggregate national income increases as a result of
increase in the volume of investment in an economy. When incomes of the
people increase, purchasing power and the demand for consumption goods
increase. In order to produce more consumption goods, more capital goods
are required. This leads to an increase in the demand for investment in
capital goods industries. Thus, a rise in income leads to a rise in induced
investment in capital goods industries. For example, if an expenditure of
Rs.4 crores on consumption goods industries, leads to an investment of
Rs.12 crores in capital goods industries, then, we can say that the
accelerator is 3. Production of consumer goods requires a particular amount
of capital goods. Therefore, the accelerator is generally more than one. In
order to produce consumption goods sometimes, more capital is not needed
and sometimes, it is not required at all because the existing stock of capital
goods become sufficient. Hence, accelerator may be less than one or zero.
Accelerator is called as “Magnification of derived demand” because
investment depends on employment.
In order to understand the effect of accelerator, it is necessary to know the
acceleration co-efficient. The ratio between the net change in consumption
expenditure and the induced investment is called ‘Acceleration Co-efficient”.
Symbolically,
a =  I /  C where,
a stands for acceleration co-efficient
 I = net change in investment expenditure
C = net change in consumption expenditure

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The working of the accelerator can be explained with the following imaginary
example. Let us assume, that in order to produce 1000 units of consumer
goods, 100 machines are required. The capital output ratio in this case is
1:10. Further assume that the working life of a machine is 10 years and
after 10 years the machine has to be replaced. It implies that every year, 10
machines have to be replaced in order to maintain the constant flow of 1000
units of consumer goods. Hence, the acceleration coefficient in this case is
1 and the annual demand for machines will be 10. This is called
“Replacement Demand”.
Now let us assume that the demand for consumer goods goes up by 10%.
Consequently, more machines are required now to meet the increased
demand for consumer goods. Now we require 10% or 10 new machines.
(10% of 100 machines are 10. Hence, the total demand for machines will
now be 20. It means a 100% increase in the demand for machines (10 for
replacement and another 10 for meeting the increased demand). The
investment in capital goods industry has doubled, because in our example,
the value of the accelerator is 10.
Acceleration effects on investment
Table 12.4 depicts Total investments
Table 12.4: Impact of accelerator on induced and total investments
Consump- Capital Investment Induced Total % change in
Perio
tion goods needed for invest- invest- total
d
goods required replacement ment ment investment
0 1000 100 10 Nil 10 –
1 1000 110 10 10 20 100

From the table it is clear that a 10% increase in demand for consumption
goods has resulted in a 100% increase in total investment outlay, as
accelerator is one. Figure 12.6 shows the working of the accelerator.

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Y
S
II

E2
I4 14
I
Savings and Investment

E1
I3 Q 13

E 12
I2
II
Multiplier
Effect Accelerator Effect
I

0 X
S Q Q1 Q2

Income
Fig. 12.6: Effect of accelerator in investments

In the diagram, SS and II represent saving and investment curves. E


indicates the original equilibrium position where S and I meet each other.
OQ is the original equilibrium income.
Now, investment increases from I2 to I4. Consequently, the national income
increases from OQ to OQ2. The jump in income is Q to Q2. If the increase
in investment from I2 to I4 had been purely public investment, then the entire
increase in income Q to Q2 would have been due to only the multiplier
effect. However, Q to Q1 increase in national income is due to the multiplier
effect because increase in investment from I2 to I3 is public investment.
Increase in national income from Q1 to Q2 is due to the acceleration effect
because increase in investment from I3 to I4 is due to induced investment.
The total multiplier and accelerator effect on income is measured by QQ2
(QQ1 due to multiplier effect and Q1 Q2 due to acceleration effect).
Limitations of accelerator
1. There should be no excess capacity in capital goods industries. If there
is excess capacity, additional production of consumer goods does not
require additional capital goods.

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2. If there is excessive number of machines, there is no need for further


investment in capital goods industries.
3. If the demand for consumption goods is purely temporary in nature,
producers will not make any additional investment in capital goods
industries. On the other hand, they make use of existing machines more
intensively.
4. In many cases, investments made in capital goods industries do not
await changes or increase in consumption, for example, investment in
public sector industries.
5. If adequate financial resources are not forthcoming to capital goods
industries, in spite of increase in consumption, production of capital
goods cannot be increased.
6. It is always wrong on our part to expect constant ratio between
production of consumer goods and capital goods.
In all these cases, the value of the accelerator may not be fully realised.
Practical importance
1. It explains the process of income generation more clearly as it takes into
account the effect of consumption on investment.
2. It explains why fluctuations in income and employment occur rather
violently.
3. It tells us why capital goods industries fluctuate much more than
consumption goods industries.
4. It helps in understanding the different phases of business cycles very
clearly. However, accelerator, by itself, cannot completely explain the
entire reason for trade cycles.

Self Assessment Questions


14. The ratio of change in national income resulting from a change in
autonomous investment is called _________________.
15. When MPC = 1, multiplier will be ___________.
16. __________ shows the effects of consumption on investment; whereas
__________ shows the effect of investment on consumption.
17. Accelerator is called ____________________.
18. As the cash reserve ratio increases, the money multiplier increases.
(True/False)

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19. The amount of money in the economy partly depends on the behaviour
of banks. (True/False)
20. If the reserve ratio is 20%, Rs. 500 can be created from Rs. 100 of
reserves. (True/False)

Activity:
Collect the information on investments made by any company and study
its various factors like the rate of interest, marginal efficiency of capital,
level of uncertainty, political environment, rate of growth of population,
level of existing stock of capital, inventions, consumers’ demand, etc.

12.7 Summary
Let us recapitulate the important concepts discussed in this unit:
 Macroeconomic concepts of consumption function, investment function,
multiplier, accelerator, etc. explain vividly the functioning of an economy.
 Consumption function refers to the schedule of propensity to consume at
various levels of income.
 The psychological law of consumption states that consumption tends to
rise with income, but less proportionately.
 Average propensity to consume is the ratio of consumption to income
and is expressed as C/Y. Marginal propensity to consume is the ratio of
the change in consumption to the change in the level of income and is
expressed as ∆ C/ ∆ Y.
 Consumption function is determined by a number of subjective and
objective factors. The concept explains the obstacles in the attainment
of full employment equilibrium. It explains the turning points of the
business cycles, declining tendency of MEC, secular stagnation,
underemployment equilibrium and upholds the importance of state
intervention and increased investment in the generation of employment
and income. The value of the multiplier is derived from consumption
function.
 Investment refers to real investment, denoting an addition to real capital
assets as well as to the wealth of the society. There are various kinds of
investment like private investment, public investment, foreign, induced,
autonomous, gross, net, etc.

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 Investment is determined by a number of factors like the rate of interest,


marginal efficiency of capital, level of uncertainty, political environment,
rate of growth of population, level of existing stock of capital, inventions,
consumers’ demand, etc. Investment is highly unstable in the short run.
Inducement to invest mainly depends on the rate of interest and the
marginal efficiency of capital.
 The MEC depends on (a) the prospective yields i.e., expected
profitability of the capital assets, and (b) the replacement cost of these
assets. Business expectations play a very important role in determining
MEC and therefore investment.
 Multiplier is the ratio of change in income to a given change in
investment. There are a number of limitations to the working of the
multiplier and it presupposes the existence of involuntary
unemployment, industrial economy, excess capacity in consumer goods
industry, etc.
 A number of leakages like savings, imports, taxes, etc. obstruct the
increase in output and income. It describes how income is generated in
an economic system like stone causing ripples in a lake. It is a valuable
guide to public investment policy.
 Accelerator explains the effect of increase in consumption to the
demand for capital goods and the related investment. Acceleration
depends on the capital output ratio and the durability of the capital
assets. It explains the process of income generation more clearly as it
takes into account the effect of consumption on investment.

12.8 Glossary
Accelerator: Changes in induced investment due to change in
consumption.
Autonomous investment: The investment which is independent of the
level of income.
Induced investment: Investment, which varies with the changes in the level
of national income.
Marginal efficiency of capital: The highest rate of return over cost
accruing from an additional unit of capital asset.

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Marginal propensity to consume: The incremental change in consumption


as a result of a given increment in income.
Multiplier: Ratio of change in income to a change in investment.

12.9 Terminal Questions


1. What is consumption function?
2. State the importance of consumption function.
3. What is investment function; discuss the various factors that determine
the investment function.
4. Discuss the working of the multiplier and explain the various leakages in
multiplier.
5. Discuss the concept of accelerator and explain its working and what its
uses are.

12.10 Answers

Self Assessment Questions


1. Consumption function
2. Marginal propensity to consume
3. Subjective and objective factors
4. False
5. True
6. True
7. Public
8. Gross investment
9. Autonomous
10. Induced investment
11. False
12. True
13. True
14. Multiplier
15. Infinite
16. Multiplier; accelerator

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17. Magnification of derived demand


18. False
19. True
20. True

Terminal Questions
1. Consumption function refers to different amounts of consumption at
different levels of income. It explains a functional relationship between
changes in the level of consumption as a result of changes in the levels
of income. Refer to section 12.2.
2. Importance of consumption function is that it invalidates Say’s law of
markets, highlights the importance of investment in employment theory,
explains the turning points of the business cycle, the declining tendency
of marginal efficiency of capital (MEC), the concept of secular
stagnation, upholds the state intervention, finds out the value of
multiplier etc. Refer to section 12.2.
3. Investment, according to Keynes, refers to real investment. It implies
creation of new capital assets or additions to the existing stock of
productive assets. It refers to that part of the aggregate income, which is
used for the creation of new structures, new capital equipments,
machines, etc that help in the production of final goods and services in
an economy. Investment decisions taken by entrepreneurs depend upon
a number of factors like; interest rate, level of uncertainty, political
environment, rate of growth of population, level of existing stock of
capital, and the necessity of new products. It also depends on investors’
level of income, level of inventions and innovations, level of consumer
demand, availability of capital and liquid assets of the investors,
government policy, etc. Refer 12.3.
4. Multiplier is the ratio of change in income to a given change in
investment. A number of leakages like savings, imports, taxes, etc.
obstruct the increase in output and income. It describes how income is
generated in an economic system like stone causing ripples in a lake. It
is a valuable guide to public investment policy. Refer section 12.4.

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5. Accelerator explains the effect of increase in consumption to the


demand for capital goods and the related investment. Acceleration
depends on the capital output ratio and the durability of the capital
assets. It explains the process of income generation more clearly as it
takes into account the effect of consumption on investment. Refer
section 12.5.

12.11 Case Study

Looking Ahead
Alok Ray
A low and stable inflation may reduce uncertainty about the future cost
and profitability of investment projects in India.
Despite all the hype about returning to a 9 per cent growth path, all
important policy makers have now got resigned to the fact that the GDP
growth rate of India would, at best, be in the neighbourhood of 7 per cent
in the fiscal year 2011-12 and 7.5-8 per cent in 2012-13.
Even this is contingent tn the global economic situation not worsening
further. Both international and domestic factors have contributed to this
step-down. First, the global slowdown (especially in EU, USA and Japan)
has adversely hurt our exports, despite some diversification of our export
markets away from the western world in recent years.
Second, the anti-inflationary monetary policy has hurt growth by raising
the cost of loan-financed investment and consumption expenditure. Third,
the global uncertainty along with the policy paralysis in India, (thanks to
the various scams and the consequent unwillingness of officials to clear
projects and the coalition politics standing in the way of taking policy
decisions like; allowing FDI in retail and hiking prices of diesel and
power) has made investors – both domestic and foreign – to a ‘wait and
see’ attitude towards investing in India.
Inflation (WPI), staying at around 10 per cent for most of the last year,
has moderated to some extent, mainly because of a very substantial
decline in food inflation (which at one time reached 20 per cent) in recent
weeks. Though the current negative food inflation may not last long as

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this is primarily due to seasonal factors, the government officials are


hoping that the headline (WPI) inflation would stabilise to below 7 per
cent by March 2012. If this materialises, the RBI may ease its monetary
policy which would help growth. A low and stable inflation may also
reduce some of the uncertainty about, the future cost and profitability of
investment projects in India, thereby encouraging more capital
investment.
Our balance of payments is under severe stress due to steady rise in the
international price of petroleum products, slowing of export growth and
net outflow of portfolio funds.
The rupee fell by some 14 per cent against the dollar in 2011, making the
rupee the worst performing currency in the emerging world. The
depreciation of the rupee has further contributed to inflation (cost-push)
by raising the rupee cost of imported crude and raw materials. It also
increased the government’s oil and fertiliser subsidy bill, worsening the
already bad fiscal deficit situation. The food security bill to be introduced
soon will further add to the fiscal woes. The depressed stock market does
not leave room for any substantial disinvestment proceeds to finance the
fiscal deficit. Additional government borrowing from the market (about Rs
50,000 crores) to finance the unanticipated rise in deficit would exert an
upward pressure on interest rates.
Major Hurdles
Some of the big banks are in trouble, after lending money to loss making
airlines which have eventually become bad loans. In addition, PSU banks
have financed 70 per cent of accumulated Rs. 82,000 crore losses of
power distribution companies. Power companies are not generating
power to capacity; either because they do not have money to pay for coal
or the coal companies are unable to supply the required quantity of coal.
The mining output has gone down after many scams involving illegal
mining have come to light. Big power and mining projects are stalled due
to problems in land acquisition and environmental concerns. Overall, the
infrastructure – especially power and water – remains the major hurdle in
realising our growth potential.
Are these temporary issues? Well, one can always point to the
investment ratio of 36 per cent and savings ratio of 34 per cent (along

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with a capital output ratio of 4:1) to argue that India can potentially
achieve a 9 per cent growth on a sustained basis, even without the help
of foreign capital. India has the further advantage of having an abundant
supply of skilled manpower at relatively low cost and the demographic
advantage of a higher ratio of young people in the population.
China, after growing at double digit for more than two decades, may now
slow down due to rising labour cost (as their supply of cheap labour is
being exhausted) and an appreciating yuan as China, is gradually forced
(by western political pressures and domestic pressures to give a better
standard of living to Chinese workers) to switch from export-led to
domestic consumption-led growth. All these may open up new
opportunities for India to fill up some of the vacuum left by China,
especially in the global market for low-cost manufacturing goods.
Burgeoning subsidy bill is crowding out much needed public investment
in irrigation, roads, rural electrification, education, health and extension
services in agriculture which would have helped both growth and
inclusion in a sustained manner.
(Source: Based on an article of the same title that appeared in the
Deccan Herald on Jan 19, 2012)
Discussion Questions:
1. What is the relation between inflation and profitability of projects?
2. How has the rupee’s depreciation impacted interest rates?
3. How have subsidies influenced investments in India?
Hint : Use the theoretical concept and answer the questions

References:
 Keynes, J.M., (1935). The general theory of employment, interest and
money, Harcourt, Brace and Company.
 Samuelson, P. A. (1939). Interactions between the Multiplier Analysis
and the Principle of Acceleration. Review of Economics and Statistics
21:75–78.
E-Reference:
 www.deccanherald.com

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Unit 13 Stabilisation Policies


Structure:
13.1 Introduction
Case Let
Objectives
13.2 Economic Stability
13.3 Instruments of Economic Stability
13.4 Monetary Policy
13.5 Fiscal Policy
13.6 Physical Policy or Direct Controls
13.7 Summary
13.8 Glossary
13.9 Terminal Questions
13.10 Answers
13.11 Case Study
Reference/E-Reference

13.1 Introduction
In the previous unit, we discussed the relationship between consumption,
investment and savings, and their impact on the economy. It must be
remembered that macroeconomics deals with aggregates which influence
and mould economic growth. The study of aggregate demand, aggregate
supply, aggregate saving, aggregate investment, aggregate output,
aggregate income, aggregate employment, money supply, inflation,
deflation, etc. give an insight into the functioning of an economy. It also
includes policies such as monetary policy, fiscal policy, exchange rate
policy, physical control etc. to achieve growth with stability and to maintain
stable conditions in the economy. Economic development is subject to
disturbances necessitating various kinds of corrective measures. In this unit,
we will discuss economic stability and the instruments of economic stability.
We will also learn the different stabilisation policies such as monetary policy,
fiscal policy and physical policy.

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Case Let (Continued from Unit 12)


Ramesh explored the relationships between consumption, investment,
savings, etc. with the performance of business firms. He learnt that, vis-à-
vis a business firm, the impact of these economic variables changed over
time, depending on the nature of the business and specific market
conditions. In the traverse rods market, Ramesh assessed that the rate of
construction activities had a strong influence on demand for the rods. The
rate of construction activities was influenced by interest rates on home
loans which were determined by the interest rate policies of the
Government. Ramesh felt that the Government should always keep the
interest rates low so that more construction activities could be initiated
and completed. Low interest rates, he felt, would encourage people to
borrow and construct/buy houses. He met his superior about this who
said that while Ramesh’s ideas were good, an extended period of low
interest rates would influence liquidity and inflation in the economy.
Ramesh thought that he had to learn more about these issues if he were
to understand how businesses responded to their environments.

Objectives:
After studying this unit, you should be able to:
 analyse the concept of economic stability and the instruments of
economic stability
 examine the effectiveness of monetary policy
 analyse the effectiveness of fiscal policy
 evaluate the role of physical policy or direct controls

13.2 Economic Stability


Promoting economic stability is partly a matter of avoiding economic and
financial crisis. A dynamic market economy necessarily involves some
degree of instability, as well as gradual structural change. The challenge for
policy makers is to minimise this instability without reducing the ability of the
economic system to raise living standards through increasing productivity,
efficiency and employment. Economic stability is fostered by robust
economic and financial institutions and regulatory frameworks.

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Economic stability implies avoiding fluctuations in the level of economic


activities as 100% stability is neither possible nor desirable. It implies only
relative stability in the overall level of economic activities.
A stabilisation policy is a set of measures introduced to stabilise a financial
system or economy. It can refer to correcting the normal behaviour of
business cycles. In this case, the term generally refers to demand
management by monetary and fiscal policy to reduce normal fluctuations in
output, sometimes referred to as “keeping the economy on an even
keel.” The policy changes in these circumstances are usually
countercyclical, compensating for the predicted changes in employment and
output to increase short run and medium run welfare.
It can also refer to measures taken to resolve a specific economic crisis, for
instance, an exchange rate crisis or stock market crash, in order to prevent
the economy developing recession or inflation.
The initiative is taken by the government or the central bank or both.
Depending on the goal to be achieved, it involves some combination of
restrictive fiscal measures and monetary tightening. Such stabilisation
policies can be painful, in the short run, for the economy because of lower
output and higher unemployment. They are designed to be a platform for
successful long run growth and reform.

13.3 Instruments of Economic Stability


Following are the instruments of economic stability:
1. Monetary Policy. 2. Fiscal Policy 3. Physical policy or Direct Controls.
The central bank and the government have developed these instruments to
correct the discrepancies that occur in the process of economic growth.

13.4 Monetary Policy


In the previous sections, we discussed about economic stability and the
instruments developed for economic stability. Let us now discuss monetary
policy.
Monetary policy is a part of the overall economic policy of a country. It is
employed by the government as an effective tool to promote economic
stability and achieve certain predetermined objectives.
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Meaning and definition:


Monetary policy deals with the total money supply and its management in an
economy. It is essentially a programme of action undertaken by the
monetary authorities, generally the central bank, to control and regulate the
supply of money with the public, and the flow of credit with a view to
achieving economic stability and certain predetermined macroeconomic
goals.
Monetary policy can be explained in two different ways. In a narrow sense,
it is concerned with administering and controlling a country’s money supply
including currency notes and coins, credit money, level of interest rates and
managing the exchange rates. In a broader sense, monetary policy deals
with all those monetary and non-monetary measures and decisions that
affect the total money supply and its circulation in an economy. It also
includes several non-monetary measures like wages and price control,
income policy, budgetary operations taken by the Government which
indirectly influence the monetary situations in an economy.
Monetary policy basically deals with total supply of legal tender money,
i.e., currency notes and coins, total amount of credit money, level of interest
rates, exchange rate policy and general liquidity position of the country.
Credit policy, which is different from the monetary policy, affects allocation
of bank credit according to the objective of the monetary policy.
The government, in consultation with the central bank, formulates a
monetary policy and it is generally carried out and implemented by the
central bank. It is evolved over a period of time on the basis of the
experience of a nation. It is structured and operated within the institutional
framework and money market of the country. Its objectives, scope and
nature of working is collectively conditioned by the economic environment
and philosophy of time. Monetary policy along with fiscal policy and debt
management lumped together form the financial policy of the country.
Monetary policy is passive when the central bank decides to abstain
deliberately from applying monetary measures. It is active when the central
bank makes use of certain instruments to achieve the desired objectives. It
may be positive or negative. It is positive when it promotes economic
activities and it is negative when it restricts or curbs economic activities.

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Similarly, it is liberal when there is expansion in credit money and it is


restrictive when it leads to contraction in money supply. Again, a cheap
money policy may be followed by cutting down the interest rates or a dear
money policy may be followed by raising the rate of interest.
The scope and effectiveness of a monetary policy depends on the
monetisation of the economy and the development of the money market.

Parameters of monetary policy:


Broadly speaking, there are three parameters of monetary policy of a
country. It is through these parameters that the monetary policy has to
operate. They are:
1. Total money supply available in a country.
2. Cost of borrowings or the level of interest rates.
3. The nature of credit control measures.
All the three put together determine the nature of working of monetary
policy.
Objectives of monetary policy
Objectives of monetary policy must be regarded as part of the overall
economic objectives of the government. It should be designed and directed
to achieve different macroeconomic goals. The objectives may be manifold
in relation to the general economic policy of a nation. The various objectives
may be interrelated, interdependent and mutually complementary to each
other. They may also be mutually inconsistent and clash with each other.
Hence, very often, the monetary authorities are concerned with a careful
choice between alternative ends. The priorities of the objectives depend on
the nature of economic problems, its magnitude and economic policy of a
nation. The various objectives also change over a time period.
Economists have conflicting and diverging views with regard to the
objectives of monetary policy in a developed and developing economy.
There are certain general objectives for which there is common consent and
certain other objectives are laid down to suit to the special conditions of a
developing economy. The main objective in a developed economy is to
ensure economic stability and help in maintaining an equilibrium in different
sectors of the economy where as in a developing economy, it has to give a
big push to a slowly developing economy and accelerate the rate of
economic growth.
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Following are the general objectives of monetary policy:


1. Neutral money policy:
This objective was in vogue during the days of gold standard. According to
this policy, money is only a technical device having no other role to play. It
should be a passive factor having only one function, namely to facilitate
exchange. It should not inject any disturbances. It should be neutral in its
effects on prices, income, output and employment. They consider that
changes in total money supply are the root cause for all kinds of economic
fluctuations and if money supply is stabilised and money becomes neutral,
then the price level will vary inversely with the productive power of the
economy. If productivity increases, cost per unit of output declines and
prices fall and vice-versa. According to this policy, money supply is not
rigidly fixed. It will change whenever there are changes in productivity,
population, improvements in technology to neutralise fundamental changes
in the economy. Under these conditions, increase or decrease in money
supply is allowed to result in either a fall or rise in the general price level. In
a dynamic economy, this policy cannot be continued and it is highly
impracticable in the present day economy.
2. Price stability:
With the suspension of the gold standard, maintenance of domestic price
level has become an important aim of the monetary policy all over the world.
The bitter experience of 1920’s and 1930’s has made almost all economies
to focus on price stability. Both inflation and deflation can be dangerous and
detrimental to a smooth economic growth. They distort and disturb the
working of the economic system and create chaos. Both of them can bring
unnecessary loss to some groups and undue advantage to some others.
They have potential power to create economic inequality, political upheavals
and social unrest in any economy. In view of this, price stability is
considered as one of the main objectives of monetary policy in recent years.
It is to be remembered that price stability does not mean that prices of all
commodities are kept constant or fixed over a period of time. It refers to the
absence of sharp variations or fluctuations in the average price level in
the country. A hundred percent price stability is neither possible nor
desirable in any economy. It simply implies relative price stability. A policy
of price stability checks cyclical fluctuations and smoothens
production and distribution, keeps the value of money stable, prevents
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artificial scarcity or prosperity, makes economic calculations possible,


introduces an element of certainty, eliminates socio-economic
disturbances, ensures equitable distribution of income and wealth,
secures social justice and promotes economic welfare. On account of
all these benefits, monetary authorities have to take concrete steps to check
price oscillations. Price stability is considered as one of the prerequisite
conditions for economic development and it contributes positively to the
attainment of a steady rate of growth in an economy. This is because price
stability will build up public morale and instill confidence in the minds of
people, boost business activity, expand various kinds of economic activities
and ensure distributive justice in the country. A monetary policy that can
maintain a reasonable degree of price stability and keep employment
reasonably full sets the stage of economic development.
3. Exchange rate stability:
Maintenance of a stable or fixed exchange rate was one of the major objects
of monetary policy for a long time under the gold standard. The stability of
national output and internal price level was considered secondary and
subservient to the former. It was through free and automatic imports and
exports of gold that the country was able to remove the disequilibrium in the
balance of payments and ensure stability of exchange rates with other
countries. The Government followed the policy of expanding currency and
credit with the inflow of gold, and contracting currency and credit with the
outflow of gold. In view of the suspension of gold standard and IMF
mechanism, this object has lost its significance. However, in order to have
a smooth and unhindered international trade and free flow of foreign
capital into a country, it becomes imperative for a county to maintain
exchange rate stability. Changes in domestic prices affect exchange rates
and there is a great need for stabilising both internal price level and
exchange rates. Frequent changes in exchange rates would adversely affect
imports, exports, inflow of foreign capital, etc. Hence, it should be controlled
properly.
4. Control of trade cycles:
Operation of trade cycles has become very common in modern economies.
High levels of fluctuations in overall economic activities are detrimental to
the smooth growth of any economy. Economic instability in the form of
inflation, deflation or stagflation would serve as great obstacles to the
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normal functioning of an economy. Basically, changes in total supply of


money are the root cause for business cycles and its dampening effects on
the entire economy. Hence, it has become one of the major objectives of
monetary authorities to control the operation of trade cycles and
ensure economic stability by effectively regulating total money supply.
During a period of inflation, a policy of contraction in money supply and
during a period of deflation, a policy of expansion in money supply has to be
adopted. This would create the necessary economic stability for rapid
economic development.
5. Full employment:
In recent years, full employment has become another major goal of
monetary policy all over the world, especially with the publication of the
general theory by Lord Keynes. Many well-known economists like Crowther,
Halm, Gardner Ackley, William, Beveridge and Lord Keynes have strongly
advocated this objective in the context of present day situation in most of the
countries. Developed countries normally work at near full employment
conditions. Their major problem is to maintain this high level of employment
situation through various economic policies. This object has become much
more important and crucial in developing countries as there is
unemployment and underemployment of most of the resources. Deliberate
efforts are to be made by the monetary authorities to ensure adequate
supply of financial resources to exploit and utilise resources in the
best possible manner so as to raise the level of aggregate effective
demand in the economy. It should also help to maintain a balance
between aggregate savings and aggregate investments. This would ensure
optimum utilisation of all kinds of resources, higher national output, income
and higher living standards to the common man.
6. Equilibrium in the balance of payments:
This objective has assumed greater importance in the context of expanding
international trade and globalisation. Today, most of the countries are
experiencing adverse balance of payments on account of various reasons. It
is a situation wherein the import payments are in excess of export earnings.
Most of the countries who have embarked on the road to economic
development cannot do away with imports on a large scale. Imports of
several items have become indispensable and without these imports, their
development process will be halted. Hence, monetary authorities have to
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take appropriate monetary measures like deflation, exchange rate


depreciation, devaluation, exchange control, current account and
capital account convertibility, regulate credit facilities and interest rate
structures and exchange rates etc. In order to achieve a higher rate of
economic growth, balance of payments, equilibrium is very much required
and monetary authorities have to take suitable action in this direction.
7. Rapid economic growth:
This is comparatively a recent objective of the monetary policy. Achieving a
higher rate of per capita output and income over a long period of time has
become one of the supreme goals of monetary policies in recent years. A
higher rate of economic growth would ensure full employment
condition, higher output, income and better living standards to the
people. Consequently, monetary authorities have to take necessary steps
to raise the productive capacity of the economy, increase the level of
effective demand for various kinds of goods and services, and ensure
balance between demand for and supply of goods and services in the
economy. Also, they should take measures to increase the rate of savings,
capital formation, increase the volume of investment, direct credit money
into desired directions, regulate interest rate structure, minimise economic
and business fluctuations by balancing demand for money and supply of
money, ensure price and overall economic stability, better and full utilisation
of resources, remove imperfections in money and capital markets, maintain
exchange rate stability, allow the inflow of foreign capital into the country,
maintain that the growth of money supply is consistent with the rate of
growth of output and minimise adversity in balance of payments condition.
Depending upon the conditions of the economy, money supply has to be
changed from time to time. A flexible policy of monetary expansion or
contraction has to be adopted to meet a particular situation. Thus, a growth-
friendly monetary policy has to be pursued by monetary authorities in order
to stimulate economic growth.
It is to be noted that the objectives mentioned are interrelated,
interdependent and interconnected with each other. Each one of the
objectives would affect the other and in turn is influenced by the others.
Many objectives would come in conflict with others under certain
circumstances. A proper balance between different objectives becomes
imperative. Monetary authorities have to determine the priorities depending
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upon the economic environment in a country. Thus, there is a great need for
compromise between different objectives.
Objectives of monetary policy in developing countries
As the development problems of developing countries are different from that
of developed countries, the objectives of monetary policy also change. The
following objectives may be considered in the context of developing
countries:
1. Development role
It has to promote economic development by creating, mobilising and
providing adequate credit to different sectors of the economy. Supply of
sufficient financial resources, its proper direction, canalisation and
utilisation, control of inflation and deflation would create a proper
background for laying a solid foundation for rapid economic development.
2. Effective central banking
In order to achieve various objectives of monetary policy and to meet the
ever-growing development requirements of the economy, the central bank of
the country has to operate effectively. It has to control the volume of credit
money and its distribution through the use of various quantitative and
qualitative credit instruments. The central bank of the country should act as
an effective leader to control the activities of all other financial institutions in
the country. It should command the respect of other institutions.
3. Inducement to savings
It has to encourage the saving habits of the common man by providing all
kinds of monetary incentives. It has to take necessary steps to expand the
banking facilities in the country and mobilise savings made by them. Special
steps are to be taken to mobilise rural small savings.
4. Investment of savings
It should help in converting savings into productive investments. For this
purpose, it has to create an institutional base and investment climate in the
country. People should have a variety of opportunities to invest their hard
earned money and earn adequate returns on them.
5. Developing banking habits
Monetary authorities have to take effective and imaginary steps to
popularise the use of various credit instruments by the common man.
Banking transactions should become a part of their day-to-day life.

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6. Monetisation of the economy


The monetary authorities have to take different measures to convert non-
monetised sector or barter sector into monetised sector and make people
use credit money extensively in their day-to-day life. Increase in total money
supply should be in accordance with the degree of monetisation of the
economy.
7. Monetary equilibrium
It is the responsibility of the monetary authorities to maintain a proper
balance between demand for money and supply of money, and ensure
adequate liquidity position in the economy so that neither will there be an
excess supply of money nor shortage in the circulation of money.
8. Maintaining equilibrium in the balance of payments
It is the job of the monetary authorities to employ suitable monetary
measures to set right any disequilibrium in the balance of payments of a
country.
9. Creation and expansion of financial institutions
Monetary authorities of the country have to take effective steps to improve
the existing currency and credit system. They should help in developing
banking industry, credit institutions, cooperative societies, development
banks and other types of financial institutions to mobilise more savings and
direct them to productive activities.
10. Integration of organised and unorganised money markets
The money markets are underdeveloped, undeveloped, highly unorganised
and they are not functioning on any well laid down principles. In fact, there is
no proper integration between organised and unorganised money markets.
This has come in the way of well-developed money markets in these
countries. Hence, money markets are to be brought under the purview of the
central bank of the country.
11. Integrated interest rate structure
The monetary authorities have to minimise the existence of different interest
rates in different segments of the money market and ensure an integrated
interest rate structure.

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12. Debt management


Monetary authorities have to decide the total volume of internal as well as
external borrowings, timing of the issue of bonds, stabilising their prices, the
interest rates to be paid for them, nature of debt servicing, time and
methods of debt redemption, the number of installments and time of
repayment. The primary aim of the debt management policy is to create
conditions in which public borrowing is increased from year to year on a big
scale without giving any jolt to the system and this must be at cheap rates to
keep the burden of the debt as low as possible. Thus, debt management of
the country is to be successfully organised by the monetary authorities.
13. Long term loan for industrial development
The monetary policy should be framed in such a way as to promote rapid
industrial development in a country by providing adequate finance for them.
14. Reforming rural credit system
The existing rural credit system is defective and it has to be reformed to
assist the rural masses.
15. To create a broad and continuous market for government securities
It is the responsibility of the monetary authorities of the country to develop a
well-organised securities market so that funds are easily available for the
people.
Thus, the objectives of monetary policy are manifold in nature in developing
countries and a proper balance between them is required to achieve the
desired goals of the government.
Monetary policy and economic development:
Monetary policy has to play a major and constructive role in developing
countries in order to accelerate and promote economic development. The
rate of economic growth of a country depends on the volume of investment.
Higher the investment higher would be the growth rate and vice-versa. In
order to raise the level of investment, the monetary authorities have to take
a number of steps such as provide incentives to savings, increase the rate
of capital formation, mobilise more funds, both in urban and rural areas, set
up various financial institutions, channelise them into productive areas and
offer reasonable interest rates. It has to follow a flexible and elastic
monetary policy to suit particular conditions. The various objectives have

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already highlighted the significance of each one of them and how they
contribute for economic development of a country. All kinds of monetary
instruments are to be used in the right proportion so as to fulfill the desired
goals. An appropriate monetary policy will certainly help in achieving full
employment condition and ensure rapid economic growth. Hence, a growth
promoting monetary policy has to be formulated in the context of a
developing economy.
Instruments of monetary policy
Broadly speaking, there are two instruments through which monetary policy
operates. They are also called techniques of credit control:
I. Quantitative techniques of credit control:
They include Bank Rate policy, open market operations and variable
reserve ratio.
II. Qualitative techniques of credit controls:
They include change in margin requirements, rationing of credit, regulation
of consumers credit, moral suasion, issue of directives, direct action and
publicity etc.
Quantitative techniques of credit control
The operation of the quantitative techniques or general methods will have a
general impact on the entire economy by regulating the supply of credit
made available to different activities.
The Bank Rate is the rate at which the central bank of a country is willing to
discount first class bills. If the Bank Rate is raised, the market rates and
other lending rates of the money market also increase. Conversely, the
lending rates go down when the central bank lowers the Bank Rate. These
changes affect the supply and demand for money. Borrowing is discouraged
when the rates go up and encouraged when they go down.
The flow of foreign short term capital also is affected. There is an inflow of
foreign funds when the rates are raised and an outflow when they are
reduced.
Internal price level tends to fall with the contraction of credit and it tends to
rise with its expansion.

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Business activity, both industrial and commercial, is stimulated when the


rates of interest are low, and discouraged when they are high.
Adverse balance of payments in foreign trade can be corrected through
lowering of costs and prices.
Thus, Bank Rate through its influence on supply of and demand for money
helps in the establishment of stability in the economy.
Open Market Operations refer to the purchase or sale of government
securities, short-term as well as long-term, by the central bank. When the
central bank sells securities, cash balances with the commercial banks
decline and they are compelled to reduce their lending. Thus credit
contracts. On the other hand, purchases of securities enable commercial
banks to expand credit.
This method is sometimes adopted to make the Bank Rate effective.
Varying Reserve Ratio – Variations of reserve requirements affect the
liquidity position of the banks and hence their ability to lend. By raising the
reserve requirements, inflationary trend can be kept under control. The
lowering of the reserve ratio makes more cash available with the banks. The
Reserve Bank of India has been empowered to vary the Cash Reserve
Ratio from the minimum requirement of 3% to 15% of the aggregate
liabilities. Cash Reserves maintained by commercial banks is called
statutory reserve and the reserve over and above the statutory reserves is
called excess reserve.
Qualitative techniques of credit control
Changes in the margin requirements, direct action, moral suasion, rationing
of credit, issue of directives, and regulation of consumer credit are some of
the qualitative techniques which are generally in practice.
While lending money against securities, banks keep a certain margin. The
central bank can issue directives to commercial banks to maintain higher
margins when it wants to curtail credit and lower the margin requirements to
expand credit.
Direct action implies a coercive measure, for example, central bank refusing
to provide the benefit of rediscounting of bills for such banks whose credit
policy is not in accordance with the wishes of the central bank.

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The central bank on the other hand may follow a mild policy of moral
suasion where it requests and persuades a member bank to refrain from
lending for speculative or nonessential activities.
The credit is rationed by limiting the amount available to each applicant. The
central bank may also restrict its discount to bills maturing after short
periods.
The central bank, in the form of directives to commercial banks, can see that
the available funds are utilised in a proper manner.
Regulation of consumer credit can have a direct impact on the demand for
various consumer durables.
Thus, the policy of the central bank of using its free discretion within limits
that are normally very broad can control the volume of money and credit.
Monetary policy to control inflation
The best remedy for fighting inflation is to reduce the aggregate spending in
an economy. Monetary policy can help in reducing the pressure on demand.
During inflation, the central bank can raise the cost of borrowing and reduce
the credit creation capacity of the commercial banks. This makes banks to
become more cautious in their lending policies. The rise in the Bank Rate
and consequent rise in interest rates not only makes borrowing costly but
will also have an adverse psychological effect on business confidence. A
rise in the rate of interest may also encourage saving and discourage
spending. The central bank can reduce the credit creation capacity of the
commercial banks through the open market sale of securities and raising
the cash reserve ratio to be maintained with the central bank. Some of the
selective credit control measures can also be adopted, like varying margin
requirements, moral suasion, direct action to regulate credit.
Monetary policy has its own limitations in controlling inflation.
An increase in the Bank Rate may be ineffective if commercial banks do not
follow the rise in the Bank Rate by raising their own interest rates. Even if
there is a rise in the interest rate it may not be able to curb spending
significantly. For the open market operations to be effective, there should be
a well developed and a closely knit money market. If the commercial banks
are in the habit of maintaining excess reserves with the central bank,

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increase in the statutory reserve ratio will not have any impact on their
lending.
A major difficulty arises because of the dichotomy in the money market. In
our country, the Reserve Bank can control only the organised sector which
constitutes only a very small portion of the money market. Indigenous
bankers and money lenders who do bulk of lending lie outside the control of
the Reserve Bank.
Thus effectiveness of monetary policy in controlling inflation particularly in a
developing economy is very much limited.
Monetary policy to check deflation
Deflation is the opposite of inflation. It is essentially a matter of falling prices.
Deflation arises when the total expenditure of the community is not equal to
the value of the output at the existing prices. Consequently, the value of
money goes up and prices fall. Deflation has an adverse effect on the level
of production, business activity and employment. It also adversely affects
distribution of wealth and income. In this sense, deflation is worse than
inflation. Both inflation and deflation are socially bad, but inflation may be
considered to be the lesser of the two evils.
Monetary measures like Bank Rate, Open Market Operations, Variable
Reserve Ratio and selective techniques of credit control may be used to
expand credit and stimulate bank advances for various schemes. When the
business community is in the grip of pessimism, substantial reduction in
interest rates do not induce them to venture into new investments and
expand production. The monetary authority can only encourage business
enterprises. The lower interest rate may only improve the state of liquidity in
the economy.
Hence, modern economists do not give much importance to monetary policy
as a tool to keep economic activity in proper trim.
Self Assessment Questions
1. ________ means constant price, over a period of time.
2. _____, by regulating its credit policy, can control the credit as per the
requirement of the economy.
3. The two instruments of monetary policy are ____ and _____.

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4. The oldest method of controlling credit is _____________.


5. Cash reserves maintained by commercial bank is called ___________.
6. Reserve over and above the Statutory Reserve is called _______.
7. ________ are also known as selective instruments of credit control.
8. Liquidity refers to the ease with which an asset is converted to the
medium of exchange. (True/False)
9. When the Federal Reserve conducts open-market operations to
increase the money supply, it buys government bonds from the public.
(True/False)
10. Under a fractional reserve banking system, banks generally lend out a
majority of the funds deposited. (True/False)
11. If the Federal bank wanted to increase the money supply, it would
make open market purchases and lower the discount rate. (True/False)
12. Increasing the deficit is a tool of monetary policy. (True/False)

13.5 Fiscal Policy


In the previous section, we discussed about monetary policy. Let us now
discuss fiscal policy. Fiscal policy is an important part of the overall
economic policy of a nation. It is being increasingly used in modern times to
achieve economic stability and growth throughout the world. Lord Keynes,
for the first time, emphasised the significance of fiscal policy as an
instrument of economic control. It exerts deep impact on the level of
economic activity of a nation.
Meaning
The term “fisc” in English language means “treasury”, and the policy related
to treasury or government exchequer is known as fiscal policy. Fiscal policy
is a package of economic measures of the Government regarding public
expenditure, public revenue, public debt or public borrowings. It concerns
itself with the aggregate effects of government expenditure and taxation on
income, production and employment. In short, it refers to the budgetary
policy of the government.
Fiscal policy is concerned with the manner in which all the different
elements of public finance, while still primarily concerned with carrying out
their own duties (as the first duty of a tax is to raise revenue), may
collectively be geared to forward the aims of economic policy.” It involves
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alterations in government expenditures for goods and services or the level


of tax rates. Unlike monetary policy, these measures involve direct
government interference in the market for goods and services (in case of
public expenditure) and direct impact on private demand (in case of taxes).
Instruments of fiscal policy
The instruments of fiscal policy include:
1. Public revenue: It refers to the income or receipts of public authorities.
It is classified into two parts - tax-revenue and non-tax revenue. Taxes
are the main source of revenue to a government. There are two types of
taxes. They are direct taxes such as personal and corporate income tax,
property tax, expenditure tax, and indirect taxes such as customs duties,
excise duties, sales tax (now called VAT). Administrative revenues are
the bi-products of administrate functions of the government. They
include fees, licence fees, price of public goods and services, fines,
escheats and special assessment.
2. Public expenditure policy: It refers to the expenditure incurred by the
public authorities like central, state and local governments. It is of two
kinds: development or plan expenditure and non-development or non-
plan expenditure. Plan expenditure includes income-generating projects
like development of basic industries, generation of electricity,
development of transport and communications and construction of
dams. Non-plan expenditure includes defence expenditure, subsidies,
interest payments and debt servicing changes.
3. Public debt or public borrowing policy: All loans taken by the
government constitutes public debt. It refers to the borrowings made by
the government to meet the ever-rising expenditure. It is of two types,
internal borrowings and external borrowings.
4. Deficit financing: It is an extraordinary technique of financing the
deficits in the budgets. It implies printing of fresh and new currency
notes by the government by running down the cash balances with the
central bank. The amount of new money printed by the government
depends on the absorption capacity of the economy.
5. Built in stabilisers or automatic stabilisers (BIS): The automatic or
built-in stabilisers imply automatic changes in tax collections and transfer
payments or public expenditure programmes so that it may reduce the
destabilising effect on aggregate effective demand. When income

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expands, automatic increase in taxes or reduction in transfer payments


or government expenditures will tend to moderate the rise in income. On
the contrary, when the income declines, tax falls automatically and
transfers and government expenditure will rise and thus built-in
stabilisers cushion the fall in income.
Fiscal tools: Subsidies, development rebates, tax reliefs, tax concessions,
tax exemptions and tax holidays, freight concessions, relief expenditures,
debt reliefs, transfer payments and public works programmes are some of
the main tools of fiscal policy.
Keynes insisted that public finance should be adjusted to the changing
conditions of the economy, to fight inflationary pressures and deflationary
tendencies. The role of fiscal policy can be compared to the driving of a car.
While driving up a gradient (i.e., stepping up production and productivity),
what is needed is an increase in power (promotion of higher savings and
investment through fiscal measures). On the other hand, when it moves
against the national interest, it is necessary to control the supply of power
(to combat inflationary and foreign exchange crisis through higher taxation)
and also to apply brakes judiciously to ensure that the vehicle does not slip
out of control but keeps on moving all the same without stopping.
In short, it is the function of the public finance to make economy grow,
maintain it in good health and to protect it from internal and external
dangers.
The objectives of fiscal policy are:
1. To help in optimum allocation of scarce resources and its
maximum utilisation:
Idle resources are to be mobilised and allocated to different sectors of
the economy in accordance with national priorities. Hence, suitable
fiscal policy is to be formulated in this direction.
2. To accelerate the rate of capital formation:
Fiscal policy should help in mobilising the small savings both in rural
and urban areas so as to raise the level of capital formation in the
country.

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3. To encourage investment:
Fiscal policy should direct investment in the desired channels both in
public and in private sectors by providing suitable incentives.
4. To ensure price stability:
Appropriate fiscal policy has to be formulated in order to control the
inflation, deflation and stagflation, and ensure a reasonable degree of
price stability in the country.
5. To control the operation of business cycles:
An appropriate fiscal policy has to be formulated so as to counteract
the adverse and dampening effects of trade cycles, to minimise
business fluctuations and achieve a reasonable degree of economic
stability in the economy.
6. To ensure full employment condition:
Fiscal policy should help in exploiting all kinds of resources available in
the country in the best possible manner and ensure full employment
condition in the economy.
7. To accelerate the rate of economic growth:
The main objective of the fiscal policy is to stimulate and accelerate
the rate of economic growth in the country. All instruments of fiscal
policy have to be employed in order to boost the process of
development in the country.
8. To ensure equitable distribution of income and wealth:
In the course of economic development, it is quite possible that
monopoly houses would grow and income and wealth gets
concentrated in the hands of only a few powerful and influential
people. Hence, suitable fiscal policy has to be adopted to reduce
income disparities and ensure distributive justice to the common man.
9. To reduce and minimise regional and sectoral imbalances:
In most countries, there are widespread disparities in the levels of
development in different regions of the country. Suitable fiscal policy
has to be designed to avoid, minimise and reduce regional and
sectoral imbalances and ensure balanced growth in the country.

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10. To mobilise real and financial resources for public sector in larger
quantity
Public sector has assumed a greater significance in planned economic
development of a country in recent years. Hence, an appropriate fiscal
policy is to be designed to mobilise all kinds of real and financial
resources for the successful working of the public sector.
Objectives in developing countries
The development problems of developing countries are totally different from
that of developed countries and the objectives of the fiscal policy also
changes in such economies. These objectives are as follows:
1. Help to break the vicious circle of poverty
Most of the developing countries are caught in the grip of a vicious circle of
poverty for the past several decades and centuries. They are struggling very
hard to come out of this vicious circle and create the background for normal
economic growth. It is possible only through increasing the rate of
investments in all sectors simultaneously. Hence, suitable fiscal policy has
to be formulated to mobilise financial resources required for heavy doses of
investments.
2. Help to formulate a rational consumption policy
In order to reduce MPC and increase MPS, it becomes inevitable to pursue
a rational consumption policy, which helps in curbing conspicuous
consumption and release the resources for saving purposes.
3. Help to raise the rate of savings
Fiscal policy should help in mobilising both voluntary and forced savings.
Various kinds of incentives may be offered to encourage savings.
4. Help to increase the volume of investment
Economic development directly depends on the amount of money invested
in different sectors of the economy. Fiscal policy should help in converting
the savings made by the people into investments and create the required
economic environment to promote investment activity in the country.
5. Help to diversify the flow of resources
The existing scarce resources are to be diverted from unproductive and
speculative areas, towards the most productive uses and socially desirable
channels so as to maximise net social gains to the common man.

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6. Help to raise living standards


One of the main growth parameters is that the common man in the country
should be in a position to enjoy the basic necessaries of life in adequate
quantity. Hence, the government has to take concrete measures to ensure
the supply of social goods on a large-scale. In order to achieve this
objective, suitable fiscal policy has to be formulated. For example, through
public distribution system, minimum quantities of certain items are to be
supplied at subsidised rates.
7. Help to achieve full employment and stimulate growth rates
The supreme goal of developing countries is to achieve higher rates of
economic growth. Suitable fiscal policy has to be formulated to exploit all
kinds of resources so that the economy can reach the stage of full
employment condition. Full employment condition results in optimum
national output, higher aggregate demand and income.
8. Help to reduce economic inequalities
Through a rational fiscal policy, the government has to take adequate
measures to control the growth of monopoly houses, minimise economic
inequalities and ensure distributive justice to all.
9. Help to control inflation and deflation
Rapid economic growth requires price stability. It is the duty of the
government to adopt all kinds of measures through suitable fiscal
instruments to control inflation, deflation and stagflation so as to achieve a
reasonable degree of price stability. It should also help in mobilising excess
purchasing power in the hands of people through suitable taxation policy.
10. Help to create more job opportunities
In most developing nations, there is an army of unemployed people. The
services of these people are to be utilised by creating more productive jobs
on a large-scale to absorb them. The government through appropriate fiscal
policy, has to mobilise huge funds and invest them in different sectors of the
economy. Higher investment results in higher economic growth rate and
creation of more employment opportunities.
It is quite clear that the objectives of fiscal policy are different for developed
and developing countries. It is to be noted that the various objectives listed
above are mutually interrelated and interconnected to each other. Some of

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the objectives are common to both developed and developing countries. For
example, growth objective may clash with controlling inflation. Again, with
rapid development, there may be a growth of monopolies and concentration
of income and wealth and this will clash with the objective of minimising
economic inequalities in the country. Hence, the government has to
maintain harmony and balance between different objectives and determine
the priorities from time to time to meet the changing requirement of the
economy.
Role of fiscal policy in economic development
In order to achieve the objectives, a fiscal policy has to play a positive and
constructive role both in developed and developing nations. The specific
role to be played by fiscal policy can be discussed as follows:
1. To act as optimum allocator of resources
As most of the resources are scarce in their supply, careful planning is
needed in its allocation so as to achieve the set targets. Rational allocation
would ensure fulfillment of various objectives.
2. To act as a saver
a) It should follow a rational consumption policy which reduces the MPC
and raises the MPS.
b) Taxation policy has to be modified to raise the rates of old taxes,
introduce new and additional taxes, and extend the tax-net.
c) Profit earning capacity of public sector units has to be raised
substantially to mop-up financial resources.
d) The government should borrow more money both within the country and
outside the country.
e) Higher rates of interests are to be offered for government bonds and
securities.
f) Introduction and popularisation of small savings schemes.
g) Introduction of various kinds of insurance schemes.
h) Enlarging banking facilities across the country and adopting a rational
credit policy.
i) Development and promotion of private financial institutions.
j) Mobilisation of hoarded wealth in the country through imaginative
schemes.
k) Going for moderate doses of deficit financing.

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l) Effective exercise of various kinds of physical control measures so as to


release more resources for development purposes.
3. To act as an investor
Mere mobilisation of financial resources is not an end in itself. It should
result in the creation of real resources which are more important in
accelerating the growth process. Rapid economic growth depends on the
volume of investment. Hence, fiscal policy has to ensure higher volume of
investment in both public and private sectors. In the public sector, the
government has to increase its investment so as to build the required
infrastructure in the country on the principle of social marginal productivity.
This would automatically stimulate investments in private sectors. In its
qualitative aspect, it should aim at changing the composition and flow of
investments in the country. It should discourage the flow of investments into
unproductive, non-essential and speculative activities in the private sector
and help in diverting these scarce resources into highly productive areas.
4. To act as price stabiliser
Price stability is of paramount importance in an economy. Extreme levels of
both inflation and deflation would disrupt and disturb the normal and regular
working of an economic system. This would come in the way of stable and
persistent growth. Hence, all measures are to be taken to check these two
situations so as to create the necessary congenial atmosphere to prepare
the background for rapid economic growth.
5. To act as an economic stabiliser
Price stability would create the necessary background for overall economic
stability. Upswings and downswings in the level of economic activities are to
be avoided. If an economy is subject to frequent fluctuations in the form of
trade cycles, certainly, it would undermine and disturb the growth process.
Instability would come in the way of persistent and consistent growth in a
country. Hence, measures are to taken to ensure economic stability.
6. To act as an employment generator
Fiscal policy should help in mobilising more financial resources, convert
them into investment and create more employment opportunities to absorb
the huge unemployed manpower.

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7. To act as balancer
There must be a proper balance between aggregate savings and aggregate
investments, demand and supply, income, output and expenditure,
economic overhead capital and social overhead capital. Any sort of
imbalance would result in either surpluses or scarcity in different sectors of
the economy leading to fast growth in some sectors followed by lagging of
some other sectors thus disturbing the process of smooth economic growth.
8. To act as growth promoter
The basic objective of any economic policy is to ensure higher economic
growth rates. This is possible when there is higher national savings,
investment, production, employment and income. Hence, fiscal policy is to
be designed in such a manner so as to promote higher growth in an
economy.
9. To act as an income redistributors
Fiscal policy has to minimise economic inequalities and ensure distributive
justice in an economy. This is possible when a rational taxation and public
expenditure policy is adopted. More money is to be collected from richer
sections of the society through various imaginative taxation policies and a
larger amount of money is to be spent in favour of poorer sections of the
society. Thus, inequality is to be reduced to the minimum.
10. To act as stimulator of living standards of people.
The final objective is to raise the level of living standards of the people. This
is possible when there is higher output, income and employment leading to
higher purchasing power in the hands of the common man. Hence, fiscal
policy should help in creating more wealth in an economy. If there is
economic prosperity, then it is possible to have a satisfactory, contented and
peaceful life.
Thus, fiscal policy has to play a major role in promoting the economic
growth in a country.
Fiscal policy to control inflation
Inflation is caused either by an increase in demand or by an increase in
costs. A rise in prices generally gives rise to demand for rise in wages and if
these demands are met, causes costs and prices to rise further, thus
worsening the inflationary situation. Taxation as an anti-inflationary measure

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should be used carefully by choosing different types of taxes. Direct taxes


like income tax, expenditure tax and excess profit tax, take away a part of
the purchasing power from the public in a very progressive manner. These
will have a discouraging effect on consumption. Indirect taxes carefully
chosen on a few commodities may suppress the demand for such
commodities and thereby reduce the inflationary pressure to some extent.
All inessential and unproductive expenses of the government should be cut
down. But as most of the public expenditure is for the planned economic
development and for the wellbeing of the people, the scope for reducing
public expenditure to dampen the inflationary pressure is limited.
Public borrowing particularly from the non-banking lenders will have
disinflationary effect by reducing their cash reserves and thereby keeping
down the demand for goods and services.
If the government succeeds in raising revenue and reducing public
expenditure, it will create a budget surplus. If the government uses this
surplus to buy off the government securities held by the general public or
the banking system, there would be an expansion in the cash reserves with
the public and the credit creation capacity of the commercial banks offsets
the favourable anti-inflationary effect of higher taxation. It should be used to
redeem the debt held by the central bank of the country. This would have
the effect of reducing the supply of money in the community and, in turn,
reducing the pressure on the price level. In practice, however, the scope for
surplus budgeting is extremely limited.
Appraisal of anti-inflationary fiscal policy:
Fiscal measures are not wholly successful in preventing inflation in times of
war or in periods of rapid economic development. Large government
expenditure is inevitable in such conditions and a certain amount of deficit
financing may have to be allowed. In case of developing countries, because
of heavy investments in long term projects, incomes are generated much
ahead of the availability of goods and services. The reduction of demand
through control of public expenditure thus has limited scope.
Increase in tax rates may discourage production and public borrowing also
has its own limitations. Total effect of all these measures may just help in
reducing the inflationary pressure but not in its complete elimination.

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Fiscal policy to control depression


Lord Keynes maintains that business depression and unemployment are
due to deficiency of aggregate demand and strongly advocates the use of
fiscal policy to make up for this deficiency.
There should be a reduction in personal income tax and corporate tax which
will promote saving and investment, and excise and sales taxes which will
promote consumption.
During depression, tax reduction alone is not adequate to increase
consumption and investment to appropriate levels. The government can
compensate for this shortage through increase in public expenditure.
Government, by investing in public works programmes, social and economic
overheads, can encourage businessmen and industrialists to take up new
investment activities. Since public works programmes cannot be continued
for a long period and beyond certain limits, some social security schemes,
unemployment insurance, pension, subsidies of various types can also be
provided to raise the level of consumption.
Public borrowing, debt servicing and debt repayment also serve as
important measures to fight depression and cyclical unemployment.
Fiscal policy as an instrument to fight depression and create full
employment conditions is much more effective than monetary policy since it
affects the level of effective demand directly, while monetary policy attempts
to do it only indirectly.
Self Assessment Questions
13. The importance of fiscal policy as an economic tool was realised only
after _____ in 1930s.
14. ______ are called built-in-stabilisers to correct and, thus restore
economic stability.
15. Tax on individual is called ___ and tax on commodity is called ___.
16. ______ leads to a reduction in the unequal distribution of income.
17. Taxes determined on the basis of the value of a particular product are
called ____.
18. Fiscal policy affects the economy in both the short and long run.
(True/False)

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19. Fiscal policy refers to the idea that aggregate demand is changed by
changes in government spending and taxes. (True/False)
20. In the short run an increase in government expenditures raises real
GDP and the price level. (True/False)
21. An increase in government purchases is likely to crowd out investment
spending by business. (True/False)
22. Automatic stabilisers are changes in taxes or government spending
that increase aggregate demand without requiring policy makers to act
when the economy goes into recession. (True/False)

13.6 Physical Policy or Direct Controls


In the previous section, we discussed about fiscal policy. Let us now discuss
physical policy or direct controls. Government interference with the forces of
demand and supply in the market, and state regulation of prices of
commodities are common features in these days. Thus, when monetary and
fiscal measures are inadequate to control prices, government resorts to
direct control. During wars, when inflationary forces are strong, price control
involves imposing ceilings in respect of certain prices and prices are to be
stopped from rising too high. In a planned economy, the objective of price
control is to bring about allocation of resources in accordance with the
objects of plan. Price control normally involves some control of supply or
demand or both. These are done by control of distribution of commodities
through rationing. Rationing is, therefore, an essential part of the price
control policy. In the U.S., price control takes the form of price support
programme in which prices are prevented from falling below certain levels
considered fair. Under certain circumstances, government may resort to
dual pricing which is yet another form of price control by the government.

Instruments of physical policy


Direct controls are imposed by government to ensure proper allocation of
scarce resources like food, raw materials, consumer goods and capital
goods. Government can strictly forbid or restrict certain kinds of investments
or economic activity. During the period of inflation, government can directly
exercise control over prices and wages. During World War II, price-wage
controls were employed along with consumer rationing to curb excess
demand. Monetary and fiscal controls will have a general impact on the

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economy while physical controls can be employed to affect specific scarcity


areas.
Generally, direct controls are of three forms:
 Control over consumption and distribution through price control and
rationing.
 Control over investment and production through licensing and fixing of
quotas etc.
 Control over foreign trade through import control, import quotas, export
control.
During wars, there will be a drastic increase in the demand for certain
commodities causing a steep rise in prices of such commodities. Further,
this is intensified by the war financing, allowing surplus purchasing power in
the economy. Price control attempts to check the inflationary rise in prices
enable all citizens to get a minimum of certain basic necessaries of life and
serves as an effective instrument of resource mobilisation.
Government may fix ceiling prices for various commodities. If the
government is forced to revise such prices from time to time, it may lead to
hoarding and black-marketing. It requires government to exercise some
control over supply and demand. The state may have to compulsorily
acquire some stocks of controlled commodities and distribute them through
“fair price shops”, known as Public Distribution System (PDS).
Since there is a close link between commodity market and factor market,
under emergency conditions, government may resort to control of profit,
interest, rent and wages.
When prices are falling in times of depression, there is pressure for
government to fix minimum prices. In case of some farm products, when
there is a bumper harvest, farmers demand minimum support prices to
avoid excessive loss. Subsidies are granted to some farm as well as
industrial products to enable them to meet their costs.
Under certain special circumstances, ‘Dual Pricing’ is adopted i.e., there are
two prices for the same commodity at the same time – one is a controlled
price fixed by the government for the benefit of lower income groups and the
other is a free market price determined by the conditions of demand and
supply, which enables the producers to make up their loss in the controlled
market.
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Apart from these, there are “Administered Prices“, fixed by the government
on a few carefully selected goods like steel, aluminium, fertilisers, cement
which serve as raw materials for other industries and, fluctuations in their
prices is dangerous for the growth of such industries.
Control over investment and production is equally essential. Factors of
production are allocated to industrial concerns in accordance with their
requirements. Priorities are laid down in accordance with the importance of
commodities produced by different industries.
Stringent measures are taken against hoarding and black-marketing. To
overcome the short term scarcity generally, essential goods are imported to
meet the excess demand. Reduction of excise duties, granting of tax
concessions, credit facilities, supply of raw materials are some of the
measures adopted to encourage production in the long run.
Globalisation and liberalisation policies have made control over foreign trade
a more sensitive issue. Intervention of the government in the foreign
exchange market, neutralising the forces of demand and supply, has lost its
significance now. Import duties, i.e., levying tariffs on imports to discourage
such imports, Import quotas, i.e., fixing of maximum quantity of a commodity
to be imported during a given period have become more popular as direct
control measures. Besides, exports may be promoted through reduction of
export duties, use of export bounties and subsidies and so on. If certain
goods are found essential for domestic consumption, the export of such
goods can be prohibited.
The advantages of direct controls are:
1. They can be introduced quickly and easily, hence the effects of these
can be rapid.
2. Direct controls can be more discriminatory than monetary and fiscal
controls.
3. There can be variation in the intensity of the operation of controls from
time to time in different sectors.
The disadvantages of direct controls are:
1. Direct controls suppress individual initiative and enterprise.
2. They tend to inhibit innovations, such as new techniques of production,
new products, etc.

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3. Direct controls may induce speculation which may have destabilising


effects. It thus encourages the creation of artificial scarcity through large
scale hoardings.
4. Direct controls need a cumbersome, honest and efficient administrative
organisation if they are to work effectively.
5. Gross disturbances may appear when the controls are removed.
In brief, direct controls are to be used only in extraordinary circumstances
like emergencies and not in a peacetime economy.
All measures suggested must be carefully coordinated and implemented to
achieve economic stabilisation. It may not be possible to eliminate all
fluctuations in employment, output and prices but can be controlled
reasonably if measures are effectively adopted.

Self Assessment Questions


23. Distribution of essential commodities through fair price shops is known
as ___________.
24. Import controls are executed through a system of _________ and
_________.
25. Existence of two prices for the same commodity at the same time one
controlled price another free market price is called
_____________________.

Activity:
Visit the RBI website and study the monetary policy framed by the
government and various other activities

13.7 Summary
Let us recapitulate the important concepts discussed in this unit:
 Stable economic conditions are a prerequisite for a systematic and
smooth economic growth. Since fluctuations are inherent in a dynamic
setup, deliberate policy measures become necessary to establish stable
conditions in the economy. Stabilisation policies include monetary policy,
fiscal policy and physical policy.

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 Monetary policy is the policy of the central bank. It consists of using


such instruments as Bank Rate, open market operations, variable
reserve ratio and selective credit controls like margin requirements,
moral suasion, direct action and rationing of consumer credit to regulate
the supply of money in accordance with the requirements of the
economy.
 The principal objectives of monetary policy are price stability, exchange
stability, elimination of cyclical fluctuations, achievement of full
employment and in case of underdeveloped countries, accelerating
economic growth, controlling inflation, deflation etc. For monetary policy
to be effective in imparting economic stability there should be a well-
organised and well-developed money market.
 Fiscal policy or the budgetary policy of the government refers to the
policy of the government regarding taxation, public expenditure and
management of public debt. There is a general belief that the
government can influence economic and business activities through
fiscal measures.
 The major objectives of fiscal policy are to achieve optimum allocation of
economic resources, bring about equal distribution of income and
wealth, maintain price stability, promote and achieve full employment,
promote savings and investments, control inflation and control
depression.
 Physical policy refers to direct control on different activities by the
government to achieve the desired goal. It is more specific, simple and
direct compared to the monetary and fiscal policies. Government
controls consumption and distribution of essential goods like food and
raw material through price control and rationing.
 Direct controls are used generally to tide over a situation of shortage or
surplus and, to avoid large fluctuations in the prices of essential
commodities. Investments in certain fields and foreign trade are
regulated through licensing, fixing of quotas, import controls, export
controls and export promotion.

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13.8 Glossary
Bank Rate: The rate at which the central bank of a country is willing to
discount first class bills.
Fiscal policy: A package of economic measures of the Government
regarding public expenditure, public revenue, public debt or public
borrowings.
Monetary policy: A programme of action undertaken by the monetary
authorities, generally the central bank, to control and regulate the supply of
money with the public and the flow of credit with a view to achieving
economic stability and certain predetermined macroeconomic goals.
Open Market Operations: The purchase or sale of government securities,
short-term as well as long-term, by the central bank.
Stabilisation policy: A set of measures introduced to stabilise a financial
system or economy.

13.9 Terminal Questions


1. Explain the general objectives of monetary policy.
2. Explain the various instruments through which monetary policy operates.
3. Discuss the objectives and instruments of fiscal policy.
4. Write a short note on physical policy.

13.10 Answers

Self Assessment Questions


1. Price stability
2. Central bank
3. Quantitative and Qualitative techniques
4. Bank Rate or Discount Rate
5. Statutory reserve
6. Excess reserve
7. Qualitative instruments of monetary
8. True
9. True
10. True
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11. True
12. False
13. Great Depression
14. Automatic stabilisers
15. Direct tax and indirect tax or commodity tax
16. Regressive tax
17. Ad valorem tax
18. True
19. True
20. True
21. True
22. True
23. Public distribution system
24. Quotas and licences
25. Dual pricing

Terminal Questions
1. The main objective in a developed economy is to ensure economic
stability and help in maintaining an equilibrium in different sectors of the
economy where as in a developing economy. Refer to section 13.4.
2. Refer to section 13.4 for the various instruments through monetary
policy.
3. To help in optimum allocation of scarce resources and its maximum
utilization. Refer to section 13.5.
4. Price control involves imposing ceilings in respect of certain prices and
prices are to be stopped from rising too high. Refer to section 13.6.

13.11 Case Study

Fiscal dominance over monetary policy


R. K. Pattnaik
The Governor of Reserve Bank of India (RBI), Dr D. Subbarao, while
addressing the Second International Research Conference (SIRC)
organised by the RBI on February 1, 2012, raised concerns on the ‘new
trilemma' – price stability, financial stability and sovereign debt

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sustainability. In this context he raised a pertinent question, “Are we


seeing a return of fiscal dominance of monetary policy?'' In the Indian
context, the answer is ‘yes'. This article, while analysing the contributory
factors to fiscal dominance of monetary policy, also sets out a few policy
options.
Contributory factors
Large revenue deficit: The Fiscal Responsibility and Budget
Management (FRBM) Act has lost its relevance as the revenue deficit is
not showing any signs of containment. As a result, borrowings are being
resorted to, resulting in a higher fiscal deficit. This is clearly evident in the
fiscal position during the first nine months of the current fiscal, as
reported by the data released by Controller General of Accounts (CGA).
There has been an overshooting of revenue deficit (93 per cent of budget
estimates) and fiscal deficit (92 per cent). These levels were substantially
higher than the mid-year FRBM benchmarks of 45 per cent of Budget
estimates. There has been a large recourse to market borrowings (the
budgeted net amount was increased by Rs 92,872 crore, first by Rs.
52,872 crore, and subsequently by Rs. 40,000 crore in the event of
negative net collections from the small savings schemes.
The budgeted target of key deficit indicators will definitely not be adhered
to and there will be a substantially higher fiscal deficit, questioning the
letter and spirit of the FRBM Act.
RBI financing of fiscal deficit: A substantial upward revision of market
borrowings from the budgeted level was not adequate to finance
increased levels of fiscal deficit. Accordingly, there has been unabated
recourse to Ways and Means Advances (WMA) from RBI at higher
levels. Under the FRBM Act beginning April 2006, RBI was prohibited
from participating in the primary market auction for market borrowing. In
order to smoothen the transition, the WMA limits were enhanced for that
fiscal. It is unfortunate that what should have been a one-time relaxation,
however, emerged as a permanent feature. As per the latest available
data in the public domain on January 20, 2012, RBI's accommodation
was Rs. 16,177 crore, which could have included Rs. 6,117 crore of
overdraft from RBI, besides WMA of Rs. 10,000 crore, unless the WMA
limits have been revised otherwise.

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WMA, which is meant to be used for temporary mismatch in the receipts


and expenditure of the government, has been used as a resource. This
leads to monetisation of the fiscal deficit.
Market borrowing and Open Market Operations (OMO): It has been
decided that there would be simultaneous market borrowing (Rs. 13,000
crore) and OMOs (Rs. 10,000 crore) on February 3, 2012. On the face of
it, this action could be justified in the present liquidity deficit situation.
However, this development reflects fiscal dominance over monetary
policy. As the Governor, in his speech, has aptly remarked, “Central
banks do, of course, resort to Open Market Operations (OMOs) – buying
and selling government paper – for purposes of liquidity management.
But if the motivation for the OMO is to help out a fiscally vulnerable
sovereign or to reduce the cost of borrowing for the sovereign, central
banks could end up holding price stability hostage to sovereign debt
concerns.”
From this, it could be concluded that fiscal dominance of monetary policy
has resurfaced in the Indian context.
It was expected that with the abolition of the instrument of ad hoc
Treasury Bills and implementation of FRBM Act, there could be relief
from fiscal dominance of monetary policy. But recent trend has showed
contrary evidence. There is an urgent need to free monetary policy from
fiscal dominance to ensure price stability, financial stability and sovereign
debt sustainability.
Policy options
How does one get rid of the fiscal dominance of monetary policy? It is
certainly a difficult task as democracy has a built-in fiscal deficit bias.
However, as the Governor has rightly observed: There is an inflexion
point beyond which fiscal deficits militate against growth. Government
borrowing is not bad per se, but excessive borrowing is. Thus, the
following policy options could be considered by the central government.
First, cap the total public debt as a proportion of GDP, including a cap on
net market borrowing of the government.
Second, revisit the public account borrowing, particularly, small savings.

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Third, the revised FRBM Act may include the quality of public
expenditure. To quote the RBI Governor, “If the government borrows and
squanders that money away on unproductive current expenditure, both
fiscal sustainability and growth would be jeopardised. Governments need
to spend on merit goods and public goods, in particular on improving
human and social capital and on physical infrastructure.”
Fourth, the RBI and central government may consider appointing a
working group under the institutional framework of Cash and Debt
Management Committee to review the entire WMA System.
(Source: An article of the same title published in the Hindu Business Line
on February 6, 2012)
Discussion Question:
1. According to the article, how has the fiscal dominance affected India’s
monetary policy?

References:
 Spencer, Milton H. & Siegelman, Louis (1959), Managerial Economics,
Homewood, Illinois: Richard. D. Irwin, Inc.,
 McNair, Malcolm P. & Meriam, Richard S., (1941), Problems in Business
Economics, New York & London: McGraw Hill Book Co. Inc.,
 Pappas, James L., & Brigham, Eugene F., (1979), Managerial
Economics, Hinsdale: Ill Dryden Press.
 Dean Joel, (1951), Managerial Economics, Englewood Cliffs: NJ,
Prentice Hall.

E-Reference:
 www.thehindubusinessline.com – retrieved on January 16th, 2012

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Unit 14 Business Cycles


Structure:
14.1 Introduction
Case Let
Objectives
14.2 Meaning and Features
14.3 Theories of Business Cycles
14.4 Measures to Control Business Cycles
14.5 Business Cycles and Business Decisions
14.6 Summary
14.7 Glossary
14.8 Case Study
14.9 Terminal Questions
14.10 Answers
Reference/E-Reference

14.1 Introduction
In the previous unit, we dealt with the concepts of economic stability,
instruments of economic stability, monetary policy, fiscal policy, and physical
policy or direct controls. In this unit, we will deal with the meaning and
features of business cycles, theories of business cycles, measures to
control business cycles, and business cycles and business decisions.
We have learnt that the government can undertake policy interventions to
stabilise the processes of economic growth. However, while the world has
registered remarkable economic progress, especially during the last 100-
150 years, the course of the economic growth has seldom run smooth.
There have been many upswings and downswings in the process, causing
enormous impact on the economic development. Such upswings and
downswings are termed as business cycles or trade cycles. They are
characterised by recurring periods of depression followed by recovery, full
employment, boom, and recession. The economists have put forward a
number of theories giving explanations to such cyclical fluctuations.
Suggestions have been made to redress their adverse effects on economic
development. Business firms will have to make the right decisions during the
different phases of trade cycles to counteract the impact of business cycles.

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Case Let (Continued from Unit 13)


Ramesh learnt about the impact of monetary policy on interest rates in
the economy. He was especially interested in the impact on interest rates
on housing loans which affected construction activities and the demand
for traverse rods. He discussed with his superior about the growth
strategies that could be adopted by his firm. He realised that the growth
strategies could be dynamic with the specific strategies changing over
time, considering the changes in the business environment. Upon
analysing some monthly data on sales of traverse rods of all the firms in
the industry, Ramesh observed that a pattern in those sales were
increasing for some period of time and this phase was followed by a
phase of low sales. He saw a wave-like movement around the mean
sales. He wondered about why such fluctuations should occur when all
the firms were always trying to increase their output and sales.

Objectives:
After studying this unit, you should be able to:
1. analyse the different phases of business cycles
2. describe the business conditions during the different phases of
business cycles in a more pragmatic manner
3. explain the impact of cyclical fluctuations on the growth of business
4. apply the stabilisation policies that can be adopted to address such
cyclical fluctuations

14.2 Meaning and Features


Cyclical fluctuations have become a regular feature of a capitalist system. A
capitalist economy is guided by competition and profit motive. There are
freedom of private enterprise, private ownership of property, and free play of
market forces of supply and demand. Businessmen, in their anxiety to earn
more and amass wealth, produce much in excess of the absorption capacity
of the economy causing imbalances in the supply and demand conditions.
Thus, the smooth functioning of the economy is disturbed and subjected to
many ups and downs. Such ups and downs have been termed as business
cycles.

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The world has registered remarkable progress especially after the industrial
revolution. But the course of world economic growth has not been a steady
upward movement. The economic history of several economies is
essentially the history of upswings and downswings. Rarely can one witness
steady and stable growth. Economic evolution is characterised by a number
of factors. They are:
1. A period of upswing followed by a period of downswing.
2. A period of prosperity alternating with poverty and adversity.
3. A period of boom followed by a period of slump.
4. A period of expansion followed by a period of contraction.
5. A period of recession followed by a period of revival.
6. A period of optimism followed by a period of pessimism.
7. A period of inflation followed by a period of deflation.
8. A period of favorable condition followed by an adverse condition.
9. A Period of rise followed by a period of fall in the level of economic
activity, etc.
Thus, cyclical oscillations are a part of the structure of a modern dynamic
economy. They are periodical changes in the level of business activities
differing in intensity and changing in their coverage. These fluctuations
occur in a more or less regular time sequence. They arise in some sectors
and spread over to the entire economy. Some of these fluctuations are
abrupt, isolated, discontinuous, and catastrophic. Some are regular,
continuous, persistent, and mild, lasting for long periods of time in the same
direction. Some are rhythmic and recurrent in nature. Thus, a trade cycle is
a highly complex phenomenon. It is associated with sweeping, violent, and
sudden fluctuations in economic activity. The duration of a business cycle
has not been of the same length. It has varied from a minimum of two years
to a maximum of 10-12 years.
The term business cycle refers to a wave-like fluctuation in the overall
level of economic activity; particularly in national output, income,
employment, and prices that occur in a more or less regular time
sequence. It is the rhythmic fluctuations in the aggregate level of
economic activity of a nation. Different writers have defined business
cycles in different ways. Business cycles are an alternation of periods of
prosperity and depression of good and bad trade. Such cycles consist of
recurring alternations of expansion and contraction in the aggregate
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economic activity, the alternating movements in each direction being self-


reinforcing and pervading virtually all parts of the economy. A trade cycle is
composed of periods of good trade characterised by rising prices and low
unemployment percentages, alternating with periods of bad trade
characterised by falling prices and high unemployment percentages.
Characteristics of business cycles
1. It is a wave-like movement, and it is not a random fluctuation.
2. It is synchronic in nature. It is all embracing; it covers the entire
economy. Any change in one part of the economy affects the entire
economy.
3. It occurs periodically and hence is recurrent in nature. It is repetitive in
the sense that it has some recognised pattern.
4. It is to be noted that different trade cycles are similar but not identical in
their nature.
5. The effects of different trade cycles are different on different activities.
6. It is self-generating. The process is cumulative and self-reinforcing.
The self-generating forces terminate one phase and start another
phase. No phase is permanent.
7. It is international in character.
8. The prosperity phase takes double the time taken by the depression
phase.
9. The downward movement is more sudden and violent than the change
from downward to upward.
10. Profits fluctuate more than the other incomes.
11. Employment and output in durable goods and capital goods industries
fluctuate more than in the consumption goods industries.
12. It is characterised by the presence of a crisis. No two phases are
symmetrical. Each phase distinctly represent a crisis of different nature.
Causes of business cycles
The following are some of the important causes, which deserve our
attention.
1. Climatic conditions – good or bad create boom and depression.
2. Variations in business confidence, over-optimism and over-
pessimism and other psychological factors cause fluctuations in
business.

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3. Innovations carried out in industrial and commercial


organisations.
4. Under-consumption or over-consumption.
5. Non-monetary factors such as wars, earthquakes, strikes, crop
failures, etc may only cause partial or temporary fluctuations. But
substantial changes in the total money supply in an economy is one of
the major causes for cyclical oscillations or alternate phase of
prosperity and depression of good and bad trade conditions.
6. Excess of investment over voluntary savings.
7. Variations in the rate of investment, which are caused by fluctuations
in marginal efficiency of capital and interest rate.
8. Autonomous investment and induced investment cause cyclical
fluctuations in economic activity via multiplier and accelerator
respectively.
9. Inter-related and inter-connected components and sectors of an
economy.
10. Changes in the stock of capital bring about changes in the level of
savings and investment which, in turn, causes variations in the level of
output, income, and employment in an economy.
11. Multiplier or accelerator can explain the process of cyclical fluctuations
in any economy. On the other hand, these two forces working
together [super multiplier] can satisfactorily explain the whole income
generation and income fluctuations.
12. A change in the total stock of money supply will have its rapid
transmission effect on the level of income and prices in an economy.
Thus, it is very clear that several factors and forces are collectively
responsible for the emergence of trade cycles in an economy.
Phases of trade cycle
Basically, a business cycle has only two parts - expansion and contraction
or prosperity and depression. Peaks and troughs are the two main mark-off
points of a business cycle. The expansion phase starts from revival and
includes prosperity and boom. The contraction phase includes recession,
depression, and trough. In between these two main parts, we come across a
few other interrelated transitional phases. In its broader perspective, a
business cycle has five phases. They are as follows.

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Boom
Peak
Y

Full Employment Line


Q
Boom
Level of Business Activity

Recession
Recovery
Recession

P Depression
Recovery

 Trough
Depression
0 X
Number of Years

Figure 14.1: Business cycle

1. Depression, contraction, or downswing


It is the first phase of a trade cycle. It is a protracted period in which
business activity is far below the normal level and is extremely low.
Depression is a state of affairs in which the real income consumed or
volume of production per head and the rate of employment are falling and
are sub-normal in the sense that there are idle resources and unused
capacity, especially unused labor.
This period is characterised by:
a. A sharp reduction in the volume of output, trade, and other transactions.
b. An increase in the level of unemployment.
c. A sharp reduction in the aggregate income of the community, especially
wages and profits. In a few cases, profits turns out to be negative.
d. A drop in the prices of most of the products and fall in interest rates.
e. A steep decline in the consumption expenditure and fall in the level of
aggregative effective demand.
f. A decline in the marginal efficiency of capital and hence the volume of
investment.

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g. Absence of incentives for production as the market has become dull.


h. Low demand for loanable funds and surplus cash balances with banks
leading to a contraction in the creation of bank credit.
i. High rate of business failures.
j. An increasing difficulty in returning old debts by the debtors. This forces
them to sell their inventories in the market where prices are already
falling. This deepens depression further.
k. A decline in the level of investment in stocks as it becomes less
attractive and less profitable. This reduces the deposits with the banks
and other financial institutions leading to a contraction in bank credit.
l. A lot of excess capacity exists in capital and consumer goods industries
which work much below their capacity due to lack of demand.
During depression, all construction activities come to a more-or-less halting
stage. Capital goods industries suffer more than consumer goods industries.
Since costs are ‘sticky’ and do not fall as rapidly as prices, the producers
suffer heavy losses. The prices of agricultural goods fall rapidly than
industrial goods. During this period, the purchasing power of money is very
high but the general purchasing power of the community is very low. Thus,
the aggregate level of economic activity reaches its rock bottom position. It
is the stage of trough. The economy enters the phase of depression as the
process of depression is complete. It is also called the period of slump.
During this period, there is disorder, demoralisation, dislocation and
disturbances in the normal working of the economic system. Consequently,
one can notice all-round pessimism, frustration, and despair. The entire
atmosphere is gloomy and hopes are less. It is a period of great suffering
and hardship to the people. Thus, it is the worst and most fearful phase of
the business cycle. The USA experienced depression twice, between 1873-
1879 and 1929–1933.
2. Recovery or revival
Depression cannot last long. After a period of depression, recovery starts. It
is a period wherein economic activities receive stimulus and recover from
the shocks. This is the lower turning point from depression to revival
towards upswing. Depression carries with itself the seeds of its own
recovery. After sometime, the rays of hope appear on the business horizon.
Pessimism is slowly replaced by optimism. Recovery helps to restore the

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confidence of the entrepreneurs and create a favorable climate for business


ventures.
The recovery may be initiated by the following factors:
a. An increase in government expenditure so as to increase the purchasing
power in the hands of consumers.
b. Changes in production techniques and business strategies.
c. Diversification in investments or Investment in new regions.
d. Explorations and exploitation of new sources of energy, etc.
e. New innovations - developing new products or services, new marketing
strategy, etc.
As a result of these factors, people take more risks and invest more. Low
wages and low interest rates, low production costs, recovery in marginal
efficiency of capital, etc induce people to take up new ventures. In the early
phase of the revival, there is considerable excess capacity in the economy
and so, the output increases without a proportionate increase in total costs.
Repairs, renewals, and replacement of plants take place. The increase in
government expenditure stimulates the demand for consumption goods,
which, in turn, pushes up the demand for capital goods. Construction activity
receives an impetus. As a result, the level of output, income, employment,
wages, prices, and profits start rising. Rise in dividends induce the
producers to float fresh investment proposals in the stock market. Recovery
in stock market begins. Share prices go up. Optimistic expectations
generate a favorable climate for new investment. Attracted by the profits,
banks lend more money leading to a high level of investment. The upward
trends in business give a sort of boost to the economic activities. Through
multiplier and acceleration effects, the economy moves upward rapidly. It is
to be noted that revival may be slow or fast, weak or strong; the wave of
recovery once initiated begins to feed upon itself. Generally, the process of
recovery once started takes the economy to the peak of prosperity.
3. Prosperity or full-employment
The recovery once started gathers momentum. The cumulative process of
recovery continues till the economy reaches full employment. Full
employment may be defined as a situation wherein all available resources
are fully employed at the current wage rate. Hence, achieving full
employment has become the most important objective of almost all

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economies. Now, there is all-round stability in output, wages, prices,


income, etc. Prosperity is a state of affair in which the real income
consumed and produced and the level of employment are high or
rising and there are no idle resources or unemployed workers or very
few of either. During the period of prosperity, an economy experiences a lot
of changes. They are:
a. A high level of output, income, employment, and trade.
b. A high level of purchasing power, consumption expenditure, and
effective demand.
c. A high level of marginal efficiency of capital and volume of investment.
d. A period of mild inflation leading to a feeling of optimism among
businessmen and industrialists.
e. An increase in the level of inventories of both inputs and outputs.
f. A rise in interest rate.
g. A large expansion in bank credit and financial institutions lending more
money to businessmen.
h. Firms operate almost at full capacity along with its production possibility
frontier.
i. Share markets give handsome gains to investors as dividends and
share prices go up. Consequently, idle funds find their way to productive
investments.
j. A state of exuberance and enthusiasm in business community.
k. Industrial and commercial activity with both speculative and non-
speculative showing remarkable expansion.
l. All round expansion, development, growth, and prosperity in the
economy.
The USA experienced the longest period of prosperity between 1923 and
1929.
4. Boom or overfull employment or inflation
The prosperity phase does not stop at full employment. It gives way to the
emergence of a boom. It is a phase wherein there will be an artificial and
temporary prosperity in an economy. Business optimism stimulates
further investment leading to rapid expansion in all spheres of business
activities during the stage of full employment, and unutilised capacity
gradually disappears. Idle resources are fully employed. Hence, a rise in
investment can only mean increased pressure for the available workforce
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and materials. Factor inputs become scarce commanding higher


remuneration. This leads to a rise in wages and prices. The production costs
go up. Consequently, higher output is obtained only at a higher cost of
production.
Once full employment is reached, a further increase in the demand for factor
inputs will lead to an increase in prices rather than an increase in output and
income. The demand for loanable funds increases, leading to a rise in the
interest rates. Now, there will be hectic economic activity. Soon a situation
develops in which the number of jobs exceed the number of workers
available in the market. Such a situation is known as overfull employment
or hyper-employment. During this phase:
a. The prices, wages, interests, incomes, profits, etc. move in the upward
direction.
b. MEC raises leading to business expansion.
c. Business people borrow more and invest. This adds fuel to the fire. The
tempo of boom reaches new heights.
d. There is higher output, income, and employment. The living standards of
the people also increase.
e. There is higher purchasing power and the level of effective demand will
reach new heights.
f. There is an atmosphere of “over-optimism” all around, which results in
over-investment. The cost of living increases at a rate relatively higher
than the increase in household incomes.
e. It is a symptom of the end of prosperity phase and the beginning of
recession.
The boom carries with it the germs of its own destruction. The prosperity
phase comes to an end when the forces favoring expansion becomes
progressively weak. Bottlenecks begin to appear. Scarcity of factor inputs
and rise in their prices disturb the cost calculations of the entrepreneurs.
Now, the entrepreneurs realise that they have overstepped the mark and
become overcautious and their over-optimism paves the way for their
pessimism. Thus, prosperity digs its own grave. Generally, the failure of a
company or a bank bursts the boom and ushers in a recession.

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5. Recession – a turn from prosperity to depression


The period of recession begins when the phase of prosperity ends. It is a
period of time during which the aggregate level of economic activity
starts declining. There is contraction or slowing down of business
activities. After reaching the peak point, demand for goods decline. Over-
investment and production creates imbalance between supply and demand.
Inventories of finished goods pile up. Future investment plans are given up.
Orders placed for new equipments and raw materials and other inputs are
cancelled. Replacement of worn out capital is postponed. The cancellation
of orders for the inputs by the producers of consumer goods creates a chain
reaction in the input market. Incomes of the factor inputs decline creating
demand recession. In order to get rid of their high inventories and to clear
off their bank obligations, producers reduce market prices. In anticipation of
further fall in prices, consumers postpone their purchases. Production
schedules by firms are curtailed and workers are laid-off. The banks curtail
credit. Share prices decline, and there will be slackness in stock and
financial market. Consequently, there will be a decline in investment,
employment, income, and consumption. Liquidity preference suddenly
develops. Multiplier and accelerator work in the reverse direction.
Unemployment sets in the capital goods industries and with the passage of
time, it spreads to other industries also. The process of recession is
complete. The wave of pessimism gets transmitted to other sectors of the
economy. The whole economic system thereby runs into a crisis.
The failure of some businesses creates panic among businessmen and their
confidence is shaken. Business pessimism during this period is
characterised by a feeling of hesitation, nervousness, doubt, and fear. Once
the recession starts, it becomes almost difficult to stop the rot. It goes on
gathering momentum and finally converts itself into a full-fledged
depression, which is the period of utmost suffering for businessmen. The
USA experienced one of the severe recessions during 1957-1958.
A detailed study of the various phases of a business cycle is of paramount
importance to the management of a business. It helps the management to
formulate various anti-cyclical measures to be taken up to check the
adverse effects of a trade cycle and create the necessary conditions for
ensuring stability in business.

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14.3 Theories of Business Cycles


Economists have put forward a number of theories to explain the causes of
business cycles. We will discuss some of the important theories.
Schumpeter’s Innovations Theory of business cycles
According to Schumpeter, innovations are the source of business
fluctuations. An innovation is defined as the development of a new
product or the introduction of a new method of production, a new
process of production, development of a new market, development of
a new source of raw material, a change in the organisation of
business, etc. In other words an innovation is anything which is introduced
by a firm to change the position of supply and/or demand curves. Any
innovation, thus, results in the establishment of a new equilibrium in the
system.
Let us assume that there is full employment in the economy. Suppose that
an innovation in the form of a new product has been introduced. The new
plant and equipment required to produce the new product has to be drawn
from the old industries paying higher rewards. This compels the old
industries too to raise the factor rewards. For this, the banks provide
additional loans. There will be a rise in the cost of production in both the old
and the new industries. Factor services earning higher remuneration will
push up the demand for both the old and new goods. Such industries,
whose cost of production is less and the prices of products go high enough
to fetch abnormal profits, expand their production.
When the new product introduced becomes commercially successful and
promoters earn abnormal profit, many similar products and imitations crop
up in the market and as a result, employment, output, and income rise,
leading to expansion in the market. A period of cumulative prosperity is set
in motion.
The new product loses its novelty with the introduction of many competing
varieties of product being introduced in the market. Abnormal profits are
competed away. Some of the firms may incur losses and quit the market.
Workers are laid off. Demand for goods fall, employment falls, and income
falls pushing down the prices and profits further. The banks pressurise for
the repayment of loans and as a result, the money in circulation falls, setting
in a deflationary situation.

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Thus Schumpeter attributes business expansion and contraction to the


innovations of various kinds.
The assumption of full employment and the financing of innovations by
means of bank loans are subject to criticism. Again Innovations cannot be
considered as the only cause of business fluctuations.
Over– investment theory of Von Hayek
According to Professor Hayek, business cycles are caused by
overinvestment and consequent overproduction. According to him, there is a
“natural” or equilibrium rate of interest at which the demand for loanable
funds is equal to the supply of the same through voluntary savings. There is
yet another rate of interest called the market rate of interest based on
demand for and supply of loanable funds in the market. According to him,
when both’ natural’ and ’market rate of interest’ are the same, there will be
stability in business conditions. Any disparity between the two will lead to
business fluctuations.
The market rate of interest may fall below the natural rate when there is an
increase in the supply of money and bank credit. This encourages
investment activity causing an increase in the demand for capital goods.
This leads to a rise in the prices of capital goods inducing the entrepreneurs
to divert the resources from the production of consumption goods to the
production of capital goods, resulting in the reduction of the supply of
consumption goods. As the people engaged in capital goods industry earn
larger incomes, the demand for consumption goods will increase causing a
rise in their prices. There will now be a competition between the capital
goods industries and consumption goods industries for the use of scarce
resources, leading to a rise in their prices. This will result in a fall in the profit
margins of the capital goods industries. At the same time, the banks decide
to reduce the rate of credit expansion by raising the market rate of interest
above the natural rate. Thus, on the one hand, profit margins are low, and,
on the other, credit has become costly. The business expansion and boom
brought about by low market rate of interest and heavy investment activity
crashes when banking system puts a stop on additional lending to
entrepreneurs.
Thus, excess supply of money and bank credit leading to a fall in the market
rate below the equilibrium rate is responsible for business fluctuations.

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Hayek’s solution to control the cyclical fluctuations is simple; keep the


supply of money and bank credit stable to maintain stable economic activity.
The basic weakness of the theory is its emphasis on the rate of interest and
complete neglect of such real factors as technological changes and
innovations influencing the volume of investment. Further, his suggestion to
maintain a constant supply of money to avoid fluctuations in business is
based on the discarded quantity theory of money. The theory also fails to
offer a convincing explanation as to why fluctuations in investment take
place almost regularly. It does not provide explanations to all the
characteristics of a trade cycle and its duration.
Hawtrey’s Pure Monetary Theory of trade cycles
Professor Hawtrey regards trade cycle as a purely monetary phenomenon.
Changes in the flow of money are mainly responsible for creating business
fluctuations in an economy. According to him, the main factor affecting the
flow of money supply is the credit creation by the banking system. When the
central bank reduces the bank rate, the commercial banks in the country
reduce their lending rates. A reduction in the lending rates induce the
traders and businessmen to borrow more from banks and hold larger stocks
and place more orders with the manufacturers. The producers, to meet the
increasing demand, purchase more materials and employ more workforce.
Incomes increase and prices show an upward trend. There is boom in the
economy. But soon when banks find that they have created too much credit
and their cash reserves are too small in relation to their deposits, they
restrict credit and call back loans. The central bank raises the bank rate to
tighten the supply of money. This compels the commercial banks to raise
their lending rates and contract their credit. This comes as a big shock to the
businessmen. They are then forced to sell their stocks and cancel new
orders for products. There will be a fall in the level of investment resulting in
a fall in the level of employment and incomes. This will lead to a steep fall in
the aggregate demand causing a fall in the prices. The prosperity phase
comes to an end when credit expansion ends. Depression sets in.
Thus, the monetary phenomena of hoarding and dishoarding, credit
expansion and credit contraction have a lot to do with business cycles since
they represent a succession of inflationary and deflationary processes.

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Hawtrey has not explained how the initial expansion or contraction of credit
starts and why bank policy gets unstable. There is also no explanation why
booms and depression occur with such regularity. There is no doubt that the
banking system plays an important role in financing trade activities, but it is
not always correct to say that banks cause business cycles. Moreover,
borrowing and investment will not depend only upon the rate of interest. The
expansion and contraction of bank credit alone cannot explain prosperity
and depression.
Modern Theory: Interaction of multiplier and acceleration principle
According to Samuelson, the interaction between multiplier and accelerator
gives rise to cyclical fluctuations in the economic activities. He constructed a
multiplier-accelerator model assuming one-period lag and different values
for the MPC and the accelerator. The changes in the level of income caused
by the operation of the multiplier have been explained in five different types
of fluctuations. 1. Cycle less path based only on the multiplier effect. 2. A
damped cyclical path fluctuating around the static multiplier level and
gradually subsiding to that level. 3. Cycles of constant amplitude repeating
them around the multiplier level. 4. Explosive cycles. 5. Cycle less explosive
approaching an upward path. Out of the five types explained, only the
second and the fourth have been experienced in a milder form over the first
half of the 20th century. Generally, the cycles in the post-war period have
been relatively damped compared to those in the interwar period.
One-period lag means that an increase in income in one period induces an
increase in the consumption in the succeeding period. An autonomous
increase in the level of investment gives rise to an increase in the income
according to the value of the multiplier. This increase in the income will
induce further increase in investment through acceleration effect. The
Increase in consumption, income, and investment caused by an increase in
initial investment through the interaction between the multiplier and
accelerator is linked around a ‘loop’. The table makes the concept clear.

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Table 14.1: ‘Interaction of multiplier and accelerator’

Total deviation
Autonomous Induced Induced of income
Investment
base period Investment consumption from base
period

1 10 0 0 10

2 10 5 10 25

3 10 12.5 15 37.5

4 10 18.75 12.50 41.25

5 10 20.68 3.86 34.54

In the table, we have assumed that the marginal propensity to consume is


½, the accelerator is 2, and that there is one-period lag. We have further
assumed that an autonomous investment of Rs. 10 crore is added in each
period which is continuously maintained in the succeeding periods. It will be
noticed from the table that, when autonomous increase in investment of Rs.
10 crore is added in period 1, it gives rise to an increase in income of only
Rs. 10 crore. It does not induce increase in consumption in period 1, as we
have assumed a lag of one-period. Now with MPC of ½, the increase in
income of Rs. 10 crore in period 1 induces an increase in consumption of
Rs. 5 crore in period 2. With the value of accelerator as 2, there will be
induced investment of Rs. 10 crore in period 2. Now the total increase in
income in period 2 over the base period will be equal to the autonomous
investment of Rs. 10 crore which is maintained in the second period plus the
induced consumption of Rs. 5 crore plus the induced investment of Rs. 10
crore (total increase in income in period 2 = 25).
Now, in the third period, the consumption would be equal to Rs. 12.5 crore.
The increase in consumption in period 3 over period 2 is Rs. 7.5 crore. This
increase in consumption of Rs. 7.5 crore will induce investment of the value
of Rs. 15 crore in period 3. Thus, the total increase in income in period 3
over the base period is equal to Rs. 37.5 crore. In the same manner, the
changes in income for the succeeding periods will be determined. A glance
at the table will show that there are great fluctuations in total income. Under
the combined effect of the multiplier and accelerator, the income increases

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up to a certain period, but beyond that period, it begins to decrease. First to


fourth is the stage of expansion or upswing. The fifth one is a turning point
and from fifth onward is the phase of contraction or downswing.
Thus, an initial increase in investment through the multiplier and
acceleration effects causes fluctuations in income, employment, and output
causing upswings and downswings in economic activity.
The principle of multiplier–acceleration interaction serves as a useful tool
not only for explaining business cycles but also as a guide to stabilisation
policy. This principle is in conjunction with the multiplier analysis based on
the concept of the marginal propensity to consume (being less than one)
and that the acceleration principle serves as a useful tool of business cycle
analysis and a helpful guide to business cycle policies. The multiplier and
the accelerator combined together produce cyclical fluctuations. The greater
the value of the multiplier, the greater is the chance of a cycleless path. The
greater the value of the accelerator, the greater is the chance of an
explosive cycle. The combination of the multiplier and the accelerator seems
capable of producing cyclical fluctuations.
The multiplier alone produces no cycles from any given impulse but only a
gradual increase to a constant level of income determined by the propensity
to consume. But if the principle of acceleration is introduced, the result is a
series of oscillation which might be called the multiplier level. The
accelerator first carries the total income above its level, but as the rate of
increase of income diminishes, the accelerator introduces a downturn which
carries the total income below the multiplier level, then up again, etc.
Despite its usefulness, it suffers from a few limitations. Samuelson does not
say anything about the length of the period in the different cycles. He
assumes the marginal propensity to consume and the accelerator to remain
constant; he has also ignored the growth aspect. This has led Hicks to
formulate his theory of the trade cycles in a growing economy.
Hicks classified investment into autonomous and induced. Autonomous
investment, an exogenous factor, through the multiplier and Induced
investment, an endogenous factor, through the accelerator cause cyclical
fluctuations in business activity. An autonomous investment of some amount
will expand output and income to the degree indicated by the multiplier. This

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expansion of income and output will result in induced investment via


accelerator which gives rise to further expansion of income and further
induced investment, etc. In this process, output rises faster than the
equilibrium rate and investment also increases beyond its normal rate. The
expansion of income and output will continue till it reaches the upper limit or
the ceiling determined by full employment. An expanding income and output
hit the ceiling and as such the expansionist force is bound to be checked.
The rate of expansion is slowed down to the natural rate which had been
exceeding till now. The rate of induced investment is also reduced because
the spurt of autonomous investment was short-lived. But now, the multiplier-
accelerator mechanism sets in the reverse order, causing a fall in income
and investment. The output may plunge downward below the equilibrium
level and touch the floor level.
Professor Hicks has built a model of the trade cycle assuming values that
would make for ‘explosive cycles’ kept in check by ‘ceilings’ and ’floors’. He
assumes full employment as the ceiling which grows at the same rate as
autonomous investment and checks expansion of income further. When the
economy reaches this point, the national income ceases to increase at a
rapid rate and the induced investment via accelerator falls off to the level
consistent with the modest rate of growth. But the economy cannot crawl
along its full employment ceiling for a long time. The sharp decline in
induced investment, when national income and hence consumption, ceases
to increase rapidly, initiates a contraction in the level of income and
business activity. The fall in national income and output resulting from the
sharp fall in induced investment will go on until the floor has been reached.
The economy may crawl along for some time. In doing so, there is a growth
in the level of national income. This rate of growth induces investment and
both the multiplier and accelerator come into operation and the economy will
move towards full employment ceiling. According to Hicks, this is how the
interaction between multiplier and accelerator causes economic fluctuations.
Such fluctuations are caused mainly by the operation of the monetary
factors like expansion and contraction of credit by the banking system.
Hicks’ explanation of the ceiling or the upper limit of the cycle fails to explain
adequately the onset of depression. The floor and the lower turning point
are not convincing. The model can be used to explain especially in a

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capitalist economy with a substantial amount of durable equipment how a


period of contraction inevitably follows expansion.

14.4 Measures to Control Business Cycles


Control of business cycles has become an important objective of almost all
economies at present. Broadly speaking, the remedial measures can be
classified under three heads, viz, monetary, fiscal, and miscellaneous
measures.
1. Monetary measures
According to Hawtrey, Hicks, and many others, expansion and contraction
of supply of money is the major cause for the operation of business cycles.
Monetary policy and the expansionary phase
When the economy is moving fast in the upward direction, the monetary
measures should aim at (i) restricting the issue of legal tender money and
(ii) putting restrictions to the expansion of bank credit by adopting both
quantitative and qualitative techniques of credit control. As expansionary
phase is mainly supported by bank credit, adoption of a dear money policy
can put an effective check on further expansion. A rise in the bank rate, by
raising the lending rates of the commercial banks, and making credit costly
will have a discouraging effect on more borrowings. A check can be
imposed on the liquidity position of the commercial banks by raising the
Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR). Open
market sale of securities can also be conducted to make bank rate more
effective. Selective techniques like raising the margin of requirements,
rationing of credit, moral suasion, direct action, publicity, etc can also be
used efficiently to tighten the credit situation in the economy. Apart from
these direct measures, indirect measures like wage control, price control,
etc can also be adopted to put a check on the inflationary trend in the
economy. Such monetary measures are found to be fairly successful in
controlling unwieldy expansion of the economy. Many countries like the
U.K., the U.S.A., France, Germany, and India have used monetary
measures to control inflation.
Monetary policy and the phase of depression
During the period of depression, to enlarge employment opportunities and
raise the level of income, all-out measures are to be adopted to increase the
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level of investment. To encourage investment activity, the central bank has


to follow a cheap money policy. The bank rate and the lending rates of the
commercial banks should be reduced; money should be made available
freely by reducing the CRR and SLR. Through open market sale of
securities, cash reserves with the banks should be increased to enable them
to lend money easily for various investment activities. Various qualitative
techniques of credit control like reducing the margin requirements, moral
suasion, etc may be adopted to encourage businessmen to borrow and
invest.
Cheap money policy, to induce businessmen to borrow and invest, is not
very effective as investment is more guided by the marginal efficiency of
capital than the rate of interest. Because of low level of income and low
prices and the low profit margins, entrepreneurs do not come forward to
borrow and invest in spite of the low rates of interest. Thus, monetary policy
as a remedy to solve depression has its own limitations.
2. Fiscal policy
During the period of inflation or uptrend in the economy, when the private
enterprise is overenthusiastic and there is overexpansion and
overproduction, the government can use taxation and licensing policy as
very effective instruments to check such unwieldy growth. Price control
measures can be adopted. The government should adopt surplus budget,
reduce public expenditure, and resort to public borrowing. The cumulative
result of these measures would reduce the supply of money in circulation,
purchasing power, and demand.
On the contrary, during the period of depression, the government should
adopt deficit budget; increase the volume of public expenditure; redeem
public debt and resort to external borrowings; indulge in a moderate dose of
deficit financing; reduce tax rates; grant subsidies, development rebates,
tax-concessions, tax-reliefs, and freight concessions, etc. As a result of
these measures, the supply of money in circulation will increase. This, in
turn, would raise the purchasing power, demand for goods and services,
production and employment, etc. J.M. Keynes recommended a number of
public works programmes to be launched by the government to cure
depression. The New Deal Policy of President Roosevelt in the U.S.A. and
Blum Experiment in France were based on this very belief.

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3. Physical controls
During the period of inflation, a price control policy has to be adopted
whereas during depression, a price-support policy has to be followed.
During the period of contraction, unemployment insurance schemes, proper
management of savings, investments, production, distribution, expansion of
income and employment, etc are needed depending upon the nature of
economic fluctuations.
4. Miscellaneous measures
i) Introduction of automatic stabilisers: An automatic stabiliser (or built-
in stabiliser) is an economic shock absorber that helps the cyclical
business fluctuations to operate smoothly of its own accord, without
requiring deliberate action on the part of the government. For
example, progressive taxation policy, unemployment Insurance
scheme adopted in the U.S.A, etc.
ii) Price support policy followed in the U.S.A. during the post war period
to fight the prospects of depression.
iii) The policy of stabilisation of the prices of agricultural products in
India through procurement and building up of buffer stocks aim at
economic stability.
iv) Foreign aid is also used for influencing the aggregate demand and
supply of goods in a country.
v) Granting of aid might help in recovering from slump.
In addition to these, some of the measures that can be adopted at
international level to mitigate the adverse effects of business cycles and to
promote stability in economic growth are control of private investment,
control and distribution of essential goods, regulation of international
investments in developing nations, creation of international buffer stocks,
etc.
Thus, several measures are to be taken to make the cyclical movements
smooth and to ensure economic stability in an economy.

14.5 Business Cycles and Business Decisions


Business cycles affect the smooth growth of an economy. The expansionary
phase has, however, a favorable impact on income, output, and

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employment. But recession and depression imply slackness in growth,


contraction of economic activity, increasing unemployment, falling incomes,
etc.
Business cycles have their effects on individual business firms as well.
During the expansionary phase, there is a business boom. The firm gains
due to rising demand, rising prices, and increasing profits. Prosperity makes
the business firms prosperous. But in a capitalist economy, prosperity digs
its own grave.
During this expansionary period, a firm may have to face some adverse
effects. The rising prices and optimism in the market may encourage many
new firms to enter the market and the existing firms to expand their output.
The competition becomes intense. Increased demand for factors may cause
a rise in their prices. The marketing and distribution costs may go up. The
demand for investment funds increase. All these may result in raising the
cost of production causing a rise in the product price.
During this period, a business unit should be extraordinarily cautious.
Business decisions are to be made carefully after assessing the market
situation properly. An expansion in production and sale of goods should be
so organised that they take full advantage of the situation without involving
themselves into any kind of risk. A prudent businessman/businesswoman
should adopt all possible precautionary measures to avoid and minimise the
business problems as much as possible. He should have knowledge of the
economic characteristics of the trade cycles and usual sequence of events
during such periods, the phase of the trade cycle through which business is
then passing, relation between cyclical changes and general business, and
cyclical changes and the business of the given enterprise, in particular,
cyclical movements in production and sales and in the prices of
commodities purchased and sold. A business firm should have a
comprehensive view of the entire market – internal and external factors
affecting the business in order to adopt an efficient business programme
and prevent the adverse effects of cyclical changes on business. He/she
should mainly see that the costs are kept under control. He/she should
avoid overinvestment, overproduction, and overexpansion and also avoid
excessive inventories of raw materials and finished goods. He/she should
employ a flexible credit standard and avoid excessive borrowing. He/she

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should check temporary diversification programme, avoid purchase


commitments, maintain satisfactory labour conditions, and create a sizable
reserve fund. Various such measures may help a firm in avoiding the
harmful effects of business expansion.
During the phase of contraction, recession, and depression, the basic
objective is to fight against pessimism and to give a big boost to all kinds of
business activities. There must be a strong psychological shift during this
period. A few measures are to be adopted to mitigate the harmful effects of
contraction. (1) Quick liquidation of inventories. (2) Reduction of cost of
production. (3) Improvement in quality. (4) Adoption of new selling methods.
(5) Development of new methods of organisation, etc. (6) Careful
management of the labour force.
Apart from these measures, a businessman/businesswoman may also take
up a few important steps in the best interest of the firm. By adopting a very
cautious policy of planning during the period of contraction when all costs
are low, a firm can take up the expansion and extension programmes. The
firm will have to restructure its advertising policy to suit the circumstances.
Cyclical price adjustment poses the most challenging job for the firm. It will
have to choose a right pricing policy keeping in view the various factors like
changing costs, prices of substitutes, market share, changes in general
price level, etc.
Thus, during the different phases of trade cycles, a firm has to make careful
decisions with regard to finance, capital budgeting, investment, production,
distribution, marketing, purchasing, pricing, etc. A firm should gear up itself
to face the challenges of cyclical changes in a most befitting manner.

Self Assessment Questions


1. The cyclical movement of the business, both upwards and downwards
is commonly called ________.
2. The five phases of business cycle are ______, _____, ________,
______, and_______.
3. ____ phase of the business cycle is called the upswing.
4. _______ is the phase of highest level of economic activity.
5. ____ phase is the phase of low economic activity.

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6. ________ theory says that the economic fluctuations are due to


innovation in the industry.
7. According to Professor Hayek, discrepancy between the ____ and ___
of interest cause business fluctuation.
8. According to R G Hawtrey, _____ is the sole cause for business
fluctuations.
9. According to ________, the interaction between multiplier and
accelerator gives rise to cyclical fluctuation in economic activity.
10. Prof Hicks explains cyclical fluctuations in terms of _______ and
______.
11. Business cycle is the irregular fluctuations in economic activity.
(True/False)
12. A short period of falling income and rising unemployment is called a
recession. (True/False)
13. Economic fluctuations are easily predicted by competent economists.
(True/False)
14. Investment expenditure’s part of real GDP fluctuates most over the
course of the business cycle as compared to consumption
expenditures and government expenditures. (True/False)

14.6 Summary
Let us recapitulate the important concepts discussed in this unit:
 Cyclical fluctuations have become a regular feature of a capitalist
system. A business cycle refers to wave-like fluctuations in the
aggregate economic activity, particularly in the level of employment,
output, and income. There are five phases of a trade cycle – depression,
recovery, full employment, boom, and recession.
 Depression is characterised by falling prices, falling profits, large scale
unemployment, and a pessimistic atmosphere spread all over. This
phase comes to an end with the recovery programmes introduced like
public works, reduction in the rate of interest, etc. The recovery helps to
restore the confidence of the business people and create a favorable
climate for business ventures.

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 Growth becomes automatic, and prosperity sets in. The economic


development starts in full swing, and there will be fuller utilisation of
resources, high level of employment, output, and incomes. This stage is
characterised by rising prices, interest rate, and expansion of bank credit
and confidence and optimism in the environment. This gives rise to a
state of overfull employment or boom, over-enthusiasm and a hectic
business activity taking the economy beyond limits. The boom carries
with it the germs of its own destruction; the bubble of prosperity bursts
and recession sets in, a turn from prosperity to depression. This phase
is characterised by hesitation, doubt, and fear, which results in stock
market crash.
 There are a number of theories of trade cycles giving different
explanations for the occurrence of business cycles. According to
Schumpeter, innovations in the field of production are responsible for the
cyclical fluctuations. Von Hayek attributes business cycles to the over
investment financed by bank credit. In the opinion of Hawtrey, business
cycles are purely a monetary phenomenon caused by the expansion
and contraction in the supply of money and credit. Professor Samuelson
and Professor Hicks explain cyclical fluctuations in terms of the
interaction of multiplier–accelerator.
 Thus, in conclusion, we can say, in a dynamic economy, cyclical
fluctuations are caused by any one of these factors or some of these
factors or all these factors put together.
 It is essential for a business manager to be aware of the causes for
cyclical fluctuations, the nature of fluctuations, and their impact on the
general business and on his/her business in particular in order to take
appropriate decisions at the appropriate time.
 The expansionary phase provides ample opportunities to expand and
make good profit, at the same time, he/she should be careful while
formulating business policies as prosperity is only a temporary
phenomenon. Again, when there is contraction, he/she should adopt
suitable measures in the field of advertisement, pricing, inventory, the
employment of labour, etc to safeguard his/her business against the
harmful effects of depression. Thus, he/she should gear up to face the
challenges in a befitting manner.
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14.7 Glossary
Business cycle: A wave-like fluctuation in the overall level of economic
activity particularly in national output, income, employment, and prices that
occur in a more or less regular time sequence.
Depression, contraction or downswing: A protracted period in which
business activity is far below the normal level and is extremely low.
Prosperity: A state in which the real income consumed and produced and
the level of employment are high or rising, and there are no idle resources
or unemployed workers or very few of either.
Recession: It is a period of time during which the aggregate level of
economic activity starts declining.

14.8 Case Study

Is the Economy at an Inflection Point?


Sanjiv Shankaran
A part of recent economic data suggests the outlook is not uniformly
gloomy. Are the mixed signals, however, enough to conclude the business
cycle has turned and the economic momentum is again building up?
Finance ministry's chief economic advisor Kaushik Basu believes recent
economic data signals a cyclical upswing. "We are at an inflection point,"
Basu said during a meeting with journalists on Tuesday. "We are beginning
to turnaround," he added. Basu's case rests on recent readings of four key
indicators, which are categorised as lead indicators of the Indian economy.
Basu identified the recent data on industrial output, bank credit to industry,
performance of core sectors such as steel, and surveys of business
managers as reasons for his optimism.
In November and December, the data of lead indicators improved as
compared to the preceding two months. In November, industrial output
rose 5.9% one year after having contracted 4.7% the month before. Year-
on-year bank credit to manufacturing in November grew 21.8%, higher
than the corresponding period of the previous year, and manufacturing
surveys moved up in December.

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In addition, there are indications that headline inflation is finally beginning


to dip. It was 7.5% in December and Basu forecast it would drop below 7%
in January.
Basu's call may have been premature. The signals remain mixed.
Another economist felt that mixed signals from some lead indicators and
Reserve Bank of India's apprehension about inflation meant it was too
early to confidently conclude that the cycle has begun to reverse.
The latest data set to be released sent mixed signals and suggests it may
be too early to take a call on a cyclical upswing. On January 30, the
government released the core sector data for December. The growth rate
was 3.1%, a decline compared to the previous month's growth rate of
6.7%. Core sector (made up of coal, steel, cement, fertilisers, electricity,
natural gas, crude oil, and refinery products) has a weightage of 37.9% in
the industrial output. The dip in December growth rate means the overall
industrial output for the month could well fall.
Another important lead indicator, output of capital goods, continues to be
negative. For three consecutive months, September to December 2011,
output of capital goods has contracted.
Given the patchy performance of lead indicators, it seems premature to
conclude the economy has turned the corner. The inflection point may be
some time away.
(Source: Based on an article as appeared in
http://businesstoday.intoday.in/story/india-economy-inflection-
point/1/22061.html). Retrieved on January 31, 2012.
Discussion Questions:
a. How can lead indicators be used to assess the position of an economy
in a certain phase of a business cycle?
b. Evaluate the specific lead indicators that can be used to assess the
inflection point for an economy that is at the peak of a business cycle.
Hint: Use the theoretical concept and answer the questions.

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14.9 Terminal Questions


1. Describe the different phases of a business cycle.
2. Discuss the various measures that may be taken by a firm to counteract
the evil effects of a trade cycle.
3. Explain the innovations theory of business cycles.

14.10 Answers

Self Assessment Questions


1. Trade cycle
2. Depression, recovery, full employment, boom, and recession
3. Prosperity
4. Boom
5. Depression/contraction
6. Schumpeter’s
7. Natural and the market rate
8. Flow of money supply
9. Prof. Samuelson
10. Ceilings and floors
11. True
12. True
13. False
14. True

Terminal Questions
1. Basically, a business cycle has only two parts - expansion and
contraction or prosperity and depression. Refer to Section 14.2.
2. It is a protracted period in which business activity is far below the
normal level and is extremely low. Refer to Section 14.4.
3. An innovation is anything which is introduced by a firm to change the
position of supply and/or demand curves.Refer to Section 14.3.

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References:
 Spencer, Milton H. & Siegelman, Louis (1959), Managerial Economics,
Homewood, Illinois: Richard. D. Irwin, Inc.,
 McNair, Malcolm P. & Meriam, Richard S., (1941), Problems in Business
Economics, New York & London: McGraw Hill Book Co. Inc.,
 Pappas, James L., & Brigham, Eugene F., (1979), Managerial
Economics, Hinsdale: Ill Dryden Press.
 Dean Joel, (1951), Managerial Economics, Englewood Cliffs: NJ,
Prentice Hall.

E-Reference:
 http://businesstoday.intoday.in/story/india-economy-inflection-
point/1/22061.html). Retrieved on January 31, 2012.

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Unit 15 Inflation and Deflation


Structure:
15.1 Introduction
Case Let
Objectives
15.2 Inflation - Meaning and Kinds
15.3 Measures to Control Inflation
15.4 Deflation
15.5 Summary
15.6 Glossary
15.7 Terminal Questions
15.8 Answers
15.9 Case Study
Reference/e-reference

15.1 Introduction
In the previous unit, we analysed the meaning, features, and theories of
business cycles. We learnt the measures to control business cycles and the
relationship between business cycles and business decisions. Business
cycles have significant impacts on the prices of goods and services that are
supplied by firms, as well as the inputs used by the firms in their production
processes. The level of prices is determined by various factors. A steady
rise in price level is termed as inflation. Inflation is generally considered as a
monetary phenomenon caused by excess supply of money. There are
different kinds of inflation – demand pull inflation, cost push inflation, etc.
Inflation is caused by a number of factors such as increase in the supply of
money, income, exports, consumption, etc., on the demand side. On the
supply side, inflation is caused by shortage in the supply of factors of
production, operation of the law of diminishing returns, war, hoarding, etc.,
The effects of inflation are different on different sections of society. A mild
inflation is beneficial to the economic growth as producers and business
men are benefited by it. But when it assumes larger proportions, it becomes
dangerous to the growth of the economy and is painful to the consumers
and labourers. A number of anti-inflationary measures like monetary, fiscal,
and administrative are adopted to control inflation. The concept of

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inflationary gap was first developed by J.M. Keynes, which means ‘an
excess of anticipated expenditure over available output at a base price’.
Phillips curve explains the relationship between inflation and unemployment.
Stagflation is a new concept developed to explain the situation of stagnant
conditions in economic activity when there is inflation in the economy.
Deflation is just the opposite of inflation. It is essentially a period of falling
prices and rise in the value of money. Deflation is more dangerous than
inflation.

Case Let (Continued from Unit 14)


Ramesh discussed the issue of fluctuating sales with his superiors who
told him that macroeconomic conditions in the economy affected the
industry’s performance at the economy level, while various internal
factors and competitions impacted the performance of individual firms.
While analysing the price data for various periods of time, Ramesh felt
that the impact of rising prices should be discounted from the nominal
prices to calculate the real prices. He felt that this would be necessary to
know if the increase in prices, if any, matched/exceeded/trailed the
change in the overall price levels. He collected the price level data that
was published by the government authorities. However, he wasn’t sure
whether he should use numbers that were labelled as wholesale price
index or those labelled as consumer price index. He tried to collect the
price index for traverse rods for the entire country but found that such
data was not available. He then approached his former teacher of
economics who explained the practical relevance of the concepts of
inflation/deflation and price index.

Objectives:
After studying this unit, you should be able to:
 define inflation and distinguish between different kinds of inflation
 describe the causes of inflation and its effects on different sections of
the society
 explain different measures that can be adopted to control inflation
 analyse the concept of inflationary gap
 evaluate suitable measures to tackle the situation of stagnation
 examine the impact of deflation on performance of business firms

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15.2 Inflation - Meaning and Kinds


Inflation has become a global phenomenon in recent years. Development
economics is very much associated with inflation. An in-depth study of
inflation is of paramount importance to a student of managerial economics.
The term inflation is used in many senses and hence it is very difficult to
give a generally accepted, universally agreeable, and precise definition to
the term inflation. Popularly, inflation is associated with high prices, which
causes a decline in the value of money.
Inflation is commonly understood as a situation of substantial and
rapid increase in the level of prices and consequent deterioration in
the value of money over a period of time. It refers to the average rise in
the general level of prices and fall in the value of money. Inflation is an
upward movement in the average level of prices. The opposite of inflation is
deflation, a downward movement in the average level of prices. The
common feature of inflation is rise in prices and the degree of inflation may
be measured by price indices.
Inflation is statistically measured in terms of percentage increase in
the price index, as a rate (percent) per unit of time- usually a year or a
month. The trend of price indices reveals the course of inflation in the
economy. Usually, the Wholesale Price Index (WPI) numbers are used to
measure inflation. Alternatively, the Consumer Price Index (CPI) or the
cost of living index can be adopted to measure the rate of inflation. In
order to measure the percentage rate of inflation, the following formula can
be used:
Change in Pr ice [ t]
Percentage rate of inflation, P[t] =  100
Pr ice [ t  1]

Change in price [t] = P [t] – P [t-1].


Here, P = price level
[t], [t-1] = periods of calendar time in which the observations are made.
Most of the economists considered inflation as a purely monetary
phenomenon. According to this approach, it is the increase in the quantity
of money which causes an inflationary rise in the price level. An expansion
in money supply unaccompanied by an expansion in the supply of goods

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and services inevitably results in price rise. Inflation exists when the amount
of money in the country is in excess of the physical volume of goods and
services. It is a situation where too much of money chases too few goods.
Money supply and rising price level are both causes and effects by
themselves.
Inflation is that state of disequilibrium in which an expansion of purchasing
power tends to cause or is the effect of an increase of the price level. Some
economists state that inflation is always and everywhere a monetary
phenomenon. The classical economists advocated quantity theory of money
and they analysed the causes of inflation in terms of money. This approach
failed to explain the causes of hyperinflation, which appeared in Germany
after the First World War. This theory is not applicable to an economy
suffering from depression and unemployment.
The Cambridge economists such as Lord Keynes and A.C Pigou viewed
inflation as a phenomenon of full employment. According to Keynes “an
inflationary rise in price cannot take place before the point of full
employment”. An expansion of money supply in a situation of under
employment equilibrium, leads to increased production of goods and
services and expansion in employment by using unemployed resources.
Any rise in price level before the point of full employment is called “semi-
inflation” or “bottleneck inflation”. This will continue till all unemployed men
and other resources are employed. Beyond this stage, any increase in
money supply will lead to only rise in prices, but not rise in production and
employment. Hence, according to Keynes, the rise in price level after the
point of full employment is the true inflation.
According to another approach, the sole cause of inflation is the existence
of a persistent excess demand in the economy. Inflation is the excess
demand over the supply of everything after the limits of the supply have
been reached.
Types of inflation
Depending upon the rate of rise in prices and the prevailing situation,
inflation has been classified into the following six types:
 Creeping inflation – When the rise in prices is very slow (less than 3%)
like that of a snail or creeper it is called creeping inflation.

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 Walking inflation – When the rise in prices is moderate (in the range of
3 to 7%) and the annual inflation rate is of single digit it is called walking
inflation. It is a warning signal for the government to control it before it
turns into running inflation.
 Running inflation – When the prices rise rapidly at a rate of 10 to 20%
per annum it is called running inflation. Such inflation affects the poor
and middle classes adversely. Its control requires strong monetary and
fiscal measures; otherwise, it can lead to hyperinflation.
 Hyperinflation – Hyperinflation is also called by various names like
jumping, runaway, or galloping inflation. During this period, prices rise
very fast (double or triple digit rates) at a rate of more than 20 to 100%
per annum and become absolutely uncontrollable. Such a situation
brings a total collapse of the monetary system because of the
continuous fall in the purchasing power of money.
 Demand-pull Inflation – The total monetary demand persistently
exceeds the total supply of goods and services at current prices so that
prices are pulled upwards by the continuous upward shift of the
aggregate demand function. It arises as a result of an excessive
aggregate effective demand over aggregate supply of goods and
services in a slowly growing economy.
Supply of goods and services will not match the rising demand. The
productive ability of the economy is so poor that it is difficult to increase
the supply at a quicker rate to match the increase in demand for goods
and services.
When exports increase, the money income of people rises. With excess
money income, purchasing power, demand, and prices move in the
upward direction.
It is essential to note that the demand-pull inflation is the result of
increase in money supply. This leads to the following:
 Decrease in the interest rate,
 Increase in investment
 Increase in production
 Increase in the incomes of factors of production
 Increase in the demand for goods and services
 Increase in the level of prices
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Thus, excess supply of money results in escalation of prices.


Again, when there is a diversion of productive resources from the
production of consumer goods to either capital or defence goods or non-
essential goods, prices start rising in view of scarcity of consumer goods
and excess income in the hands of people. It is clear from the figure
15.1.
Y
S

P2

P1
D2
Price Level

F
P D1

S
0 X
Y
Output

Figure 15.1: Demand-pull inflation

In the figure, the point F indicates the equilibrium position where


aggregate demand is equal to aggregate supply of goods and services.
OP is the price level and OY indicates the supply of goods and services.
As demand increases, supply being constant, the price level rises from
OP to OP1 and OP2.
 Cost-push inflation – Prices rise on account of increasing cost of
production. Thus, in this case, rise in price is initiated by growing
factor costs. Hence, such a price rise is termed as ‘cost-push’
inflation as prices are being pushed up by rising factor costs. A
number of factors contribute to the increase in cost of production.
They are:
 Demand for higher wages by the labour class.
 Fixing of higher profit margins by the manufacturers.
 Introduction of new taxes and raising the level of old taxes.

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 Increase in the prices of different inputs in the market.


 Rise in administrative prices by the government.
These factors, in turn, cause prices to rise in the market. Out of the many
causes, rise in wages is the most important one. It is estimated and believed
that wages constitute nearly 70% of the total cost of production. A rise in
wages leads to a rise in the total cost of production and a consequent rise in
the price level. Thus, cost-push inflation occurs due to wage-push or profit-
push.
We can explain the cost-push inflation with the help of figure 15.2.
In the figure, the point F indicates the original equilibrium position where
demand and supply are equal to each other. OP is the original price level
and OY is the supply. A is the new equilibrium point when the supply curve
shifts upwards on account of cost-push factors. OP1 will be the new price
level, which is higher than the original one. OY1 will be the new supply.

Y
S
P4 H

P3 G D2
Price Level

P2 B
S3 A
P1 D1
P F
S1 D
S

0 X
Y2 Y1 Y
Real Output

Figure 15.2: Cost-push inflation

Causes of inflation
I. Demand side
Increase in aggregative effective demand is responsible for inflation. In this
case, aggregate demand exceeds aggregate supply of goods and services.

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Demand rises much faster than supply. We can enumerate the following
reasons for increase in effective demand.
 Increase in money supply – Supply of money in circulation increases
on account of the following reasons: deficit financing by the government,
expansion in public expenditure, expansion in bank credit and
repayment of past debt by the government to the people, increase in
legal tender money and public borrowing.
 Increase in disposable income – Aggregate effective demand rises
when disposable income of the people increases. Disposable income
rises on account of the following reasons: reduction in the rates of taxes,
increase in national income while tax level remains constant, and
decline in the level of savings.
 Increase in private consumption expenditure and investment
expenditure – An increase in private expenditure both on consumption
and on investment leads to emergence of excess demand in an
economy. When business is prosperous, business expectations are
optimistic and prices are rising. More investments are made by private
entrepreneurs causing an increase in factor prices. When the income of
the factors rise, there is more expenditure on consumer goods.
 Increase in exports – An increase in the foreign demand for a country’s
exports reduces the stock of goods available for home consumption.
This creates shortages in the country leading to a rise in price level.
 Existence of black money – The existence of black money in a country
due to corruption, tax evasion, black-marketing, etc. increases the
aggregate demand. People spend such unaccounted money
extravagantly and create unnecessary demand for goods and services
thus causing inflation.
 Increase in foreign exchange reserves – This may increase on the
account of inflow of foreign money into the country. Foreign direct
investment may increase and non-resident deposits may also increase
due to the policy of the government.
 Increase in population growth – This creates an increase in demand
for many types of goods and services in a country.
 High rates – Higher rates of indirect taxes would lead to a rise in prices.

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 Reduction in the rates of direct taxes – This would leave more cash in
the hands of people inducing them to buy more goods and services
leading to an increase in prices.
 Reduction in the level of savings – This creates more demand for
goods and services.
II. Supply side
Generally, the supply of goods and services do not keep pace with the ever-
increasing demand for goods and services. Thus, supply does not match the
demand. Supply falls short of demand. Increase in supply of goods and
services may be limited because of the following reasons.
 Shortage in the supply of factors of production – When there is
shortage in the supply of factors of production like raw materials, labour,
capital equipments, etc. there will be a rise in their prices. Thus, when
supply falls short of demand, a situation of excess demand emerges
creating inflationary pressures in an economy.
 Operation of law of diminishing returns – When the law of
diminishing returns operates, increase in production is possible only at a
higher cost which demotivates the producers to invest in large amounts.
Thus, production will not increase proportionately to meet the increase in
demand. Hence, supply falls short of demand.
 Hoardings by traders and speculators – During the period of shortage
and rise in prices, hoardings of essential commodities by traders and
speculators with the objective of earning extra profits in the future
creates an artificial scarcity of commodities. This creates a situation of
excess demand paving the way for further inflation.
 Hoardings by consumers – Consumers may also hoard essential
goods to avoid payment of higher prices in the future. This leads to an
increase in the current demand, which in turn stimulates prices.
 Role of trade unions – Trade union activities leading to industrial unrest
in the form of strikes and lockouts also reduce production. This will lead
to creation of excess demand that eventually brings a rise in the price
level.
 Role of natural calamities – Natural calamities such as earthquake,
floods, and drought conditions also affect the supplies of agricultural

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products adversely. They also create shortage of food grains and raw
materials, which in turn creates inflationary conditions.
 War – During the period of war, shortage of essential goods creates a
rise in prices.
 International factors – These factors would cause either shortage of
goods and services or rise in the prices of factor inputs leading to
inflation. E.g., higher prices of imports.
 Increase in prices of inputs within the country
III. Role of expectations
Expectations also play a significant role in accentuating inflation. The
following points are worth mentioning:
 If people expect further rise in price, the current aggregate demand
increases, which in turn causes a rise in the prices.
 Expectations about higher wages and salaries affect the prices of
related goods.
 Expectations of wage increase often induce some business houses to
increase prices even before upward wage revisions are actually made.
Thus, many factors are responsible for escalation of prices.
Effects of inflation
The positive effects of inflation are as follows:
 Rise in investment – Rise in prices leads to a rise in profits, incomes,
savings, and finally the volume of investment by entrepreneurs.
 Better opportunities – Rise in prices, which is much higher than the
production costs, creates better and more opportunities in new fields of
business activities.
 Encourages entrepreneurship – As profits rise, it encourages
entrepreneurs to enter into business in an increasing manner.
 Inflation tax – Government, in order to cover the deficit in the budget,
may resort to inflation tax.
 Full utilisation of resources – It helps in the complete utilisation of all
kinds of economic resources in an economy as the efforts of
entrepreneurs are suitably rewarded in the form of higher profits.

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 Increase in the demand for money – As prices rise, people require


more money to buy the same quantity of goods and services. Hence, it
leads to an expansion in money supply in the country, which leads to a
higher growth rate in the economy.
 Necessary cost of development – It becomes inevitable during the
process of economic development. In fact, inflation promotes economic
development and economic development results in inflation. Thus, both
of them go together.
Effects on production
 A low inflation rate stimulates economic growth – A small amount of
inflation is often viewed as having a positive effect on the economy. For
example, a mild inflation has a stimulating or tonic effect on the
economy. Rise in price leads to increase in profit ratio, investment,
output, employment, and income in an economy.
 Disturbs the working of price mechanism – The most harmful effect
of inflation is that it disrupts the smooth working of the price mechanism
and economic system and as a consequence, economic adjustments
become very difficult.
 Adverse effects on investment and production – Rise in price leads
to a fall in the value of money, reduction in purchasing power, savings,
investment, and production.
 Adverse effects on savings and capital formation – Capital formation
suffers as a consequence of depreciation in the value of money and it
may be driven out of the country. Similarly, it discourages the inflow of
foreign capital into the country.
 Business uncertainty – Production will be adversely affected on
account of business uncertainty. A sort of tension prevails during the
period of inflation which discourages entrepreneurs from taking risks
involved in production.
 Reduces production – On account of fall in the rate of capital formation
and uncertainty in business, total volume of production declines.
 Change in the pattern of production – It affects the pattern of
production. Resources will be diverted from the production of essential
goods to luxury goods to reap higher profit margins.

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 Hoardings and black marketing – During inflation, traders hoard


essential goods with a view to get higher profits. The buyers also hoard
essential goods for the fear of paying higher prices in the future. Thus, it
also leads to the growth of black marketing.
 Sellers’ market – During inflation, a sellers’ market develops. As prices
are rising, people want to sell their goods rather than buy them. Quality
of goods and services also will be affected by inflation.
 Speculative activity – Speculative activities gain momentum during
inflation.
 Distortion in resource allocation – It leads to diversion of resources
from productive uses to unproductive uses with the sole objective of
earning more profits by the entrepreneurs. With the rise in prices, the
costs of development projects will also go up leading to more diversion
of resources to complete the same project by the government.
Effects on distribution
 Unequal distribution of income and wealth – Prolonged and
persistent inflation leads to inequitable distribution of wealth and income
in the society. Inflation robs the poor to enrich the rich. Rich
entrepreneurs earn more profits at the cost of customers. This leads to
unequal distribution of income and wealth as the rich become richer and
poor become poorer.
 Hardships for fixed income earners – Rentiers and bond holders with
fixed rates of interest, holders of government securities, persons who
live on past savings, pensioners, etc, are adversely affected as their
monetary income remains the same while the value of money falls.
 Debtors gain and creditors lose – Generally, during inflation, debtors
gain as they return the borrowed money when its face value is less and
creditors lose because they get back their money with depreciation in its
value.
 Adverse effects on wage-earners and salaried class – The wage
earners, salaried class, and middle class people are worst affected as
their living standards deteriorate due to escalation of prices while their
incomes remain the same.

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 Entrepreneurs and business community gain – Businessmen


welcome inflation as they gain from the rising prices. Their inventory
value rises. Price of finished products rise much faster than the
production costs. Hence, their profit margins also would go up
substantially.
 Effects on investors – If investors invest their capital on equity shares
and debentures, they stand to gain because their prices are rising. On
the other hand, if they invest on bonds and securities, they lose because
their incomes from them remain the same.
 Effects on farmers – Virtually, farmers are the gainers because prices
of agricultural goods rise on one hand. On the other hand, cost of
cultivation lags behind prices received.
Inflation favours one group at the expense of other groups. It is generally
regressive in nature as many people cannot protect their own self-interests.
Social and political effects of inflation
 Social effects – Inflation is a powerful engine of wealth distribution in
favour of the rich. It widens the gap between the rich and the poor and
thus hampers social justice. It creates a sense of heart burning in poorer
sections of the society. It leads to social conflicts between the rich and
poor.
 Moral and ethical effects – In order to earn higher profits, businesses
resort to black marketing, adulteration, smuggling, hoarding, quality
deterioration, and other anti-social tactics. Hence, inflation gives a
serious blow to business morality and ethics. The general morality
declines and corruption increases. This leads to an overall
discontentment among people.
 Political effects – Deterioration in social and ethical standards and
discontentment among the people reflects in political uncertainty. People
lose faith in the administrative ability of the government, which gives
place to an explosive political situation in the country. Hyperinflation in
Germany during the 1920s is a glaring example of the rise of Hitler as a
dictator. It has been rightly said that, “Hitler is the foster-child of
inflation”.

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 Demonstration effect – It encourages consumerism and a country may


have to suffer on account of demonstration effects.
External effects of inflation
 Volume of exports – It reduces the volume of exports of a nation as
domestic prices are much higher than international prices.
 Exchange rate difficulties – Fall in the value of home currency may
reduce external value of a currency and thus create problems in the
determination of exchange rate between the currencies of different
countries.
 Inflow of foreign capital – It discourages the inflow of foreign capital
into a country.
 International competitiveness – If a country experiences a higher rate
of inflation as compared to other nations, the international
competitiveness of the given country will decline.
Thus, inflation has far-reaching consequences on the economy of a country.

15.3 Measures to Control Inflation


The measures to control inflation (anti-inflationary measures) are broadly
classified into three categories.
I. Monetary measures
Inflation is basically a monetary phenomenon. Excess money supply over
the quantity of goods and services is mainly responsible for rise in prices.
Hence, monetary authorities aim at reducing and absorbing excess supply
of money in an economy. The following are some of the anti-inflationary
monetary measures:
1. The volume of legal tender money may be reduced either by
withdrawing a part of the notes already issued or by avoiding large-scale
issue of notes.
2. Restrictions on bank credits.
3. Freezing and blocking particular type of assets.
4. Increasing bank rate and other interest rates.
5. Sale of government securities in the open market by the central bank.
6. Raising the legal reserve requirements like CRR and SLR.

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7. Prescribing a higher margin that bank and other lenders must maintain
for the loans granted by them against stocks and shares.
8. Regulation of consumer credit.
9. Rationing of credit.
Thus, the government may exercise various quantitative and qualitative
techniques of credit controls to control inflation.
II. Fiscal measures
The following are some of the important anti-inflationary fiscal measures:
1. Reduction in the volume of public expenditure.
2. Rise in the levels of taxes, introduction of new taxes, and bringing more
people under the coverage of taxes.
3. More internal borrowings by public authorities.
4. Postponing the repayment of debt.
5. Control on the volume of deficit financing.
6. Preparation of a surplus budget.
7. Introduction of compulsory deposit schemes.
8. Incentive to savings.
9. Diverting the public expenditure towards the projects where the time
gap between investment and production is least (small gestation
period).
10. Tariffs should be reduced to increase imports and thus allow a part of
the increased domestic money income to ‘leak-out’.
11. Inducing wage earners to voluntarily buy government bonds, securities,
etc.
Thus, fiscal measures succeed to a greater extent to contain inflation in its
own way.
III. Other measures – direct or administrative measures
Direct controls refer to the regulatory or administrative measures taken by
the government directly with an objective of controlling the rise in prices.
Modern governments directly intervene in the working of the economy in
several ways. Hence, the governments take several concrete measures to
check the rise in prices. The following are some of the direct measures
taken by the modern governments.
1. Expansion in the volume of domestic output so as to meet the ever-
increasing rise in the demand for them.

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2. Direct control of prices and introduction of rationing.


3. Control of speculative and gambling activities.
4. Wage – profit freeze by adopting appropriate wage-profit policy.
5. Adopting an appropriate income policy.
6. Overvaluation of currency
Overvaluation of domestic currency in terms of foreign currencies in
order to increase imports to add to the stocks within the country and
decrease in exports so that more goods will become available for
domestic consumption.
7. Indexing
Indexing refers to monetary corrections by periodic adjustments in
money income of the people and in the value of financial assets, saving
deposits, etc. held by the public in accordance with the changes in price
level. E.g., if prices rise by 15%, the money income and the value of the
financial assets should be increased by 15% under the system of
indexing.
8. Control of population
This is considered as one of the most important methods because if
population is controlled it is possible to keep a check on the demand for
goods and services.
9. Exhortations
This implies authoritative persuasions, publicity campaigns, national
savings campaign, requests to trade union for voluntary resistance to
demand for rise in wages, companies to restrict dividend distributions to
workers, and management to increase productivity and output, etc.
The above said measures are to be employed in a judicious manner in order
to combat inflation in a country.
The inflationary gap
J. M. Keynes invented the term ‘inflationary gap’ to describe a situation
when there is “excess of anticipated expenditure over the available output at
base prices.” It is a gap between money incomes of the community and the
available supply of output of goods and services.

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According to Lipsey “The inflationary gap is the amount by which


aggregate expenditure would exceed aggregate output at the full
employment level of income.” The larger the aggregate expenditure, the
larger is the gap and more rapid the inflation.
During a war, the volume of money expenditure by the government
increases resulting in increased income within the community. This leads to
increased consumption expenditure and investment. Given a constant
average propensity to save, rising money incomes at full employment level
lead to an excess of demand over supply and result in the development of
inflationary gap.
We can explain this with an illustration:
(Rs. crore)
1. Gross national income at current prices ---------------------- 20,000
2. Less taxes --------------------- 5,000
3. Personal income (gross disposable income) -------------------- 15,000
4. Less savings of the community --------------------- 3,000
5. Disposable income ---------------------- 12,000
6. Gross national product at pre-inflation prices ---------------- 15,000
7. Government expenditure (to meet the war requirements) --- 6,000
8. Output available for consumption at pre-inflation prices --- 9,000
9. Inflationary gap (12,000 – 9,000) ---------------------- 3,000
Now, the net disposable income with the community is 12,000, but the
available output for civilian consumption is only 9,000. There is an excess of
demand over the available supply to the extent of Rs.3000 crore. This is
referred to as the inflationary gap. Though Keynes associated an inflationary
gap with war, such a gap can arise even during the period of economic
development.
We can show the inflationary gap diagrammatically using the Keynesian
concepts of aggregate supply and aggregate demand:

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Y
AS

AD

E (C+I+G)
A
Expenditure

0 X
YF Y1
Income
Figure 15.3: ‘Interaction of aggregate demand and aggregate supply’

YF is the full employment level of income. The 45 degree line represents


aggregate supply (AS) and C+I+G line (AD).The community’s aggregate
demand curve intersects the aggregate supply curve at E, at OY1 level of
income, which is greater than the full employment level of income YF. The
amount by which aggregate demand (YFA) exceeds the aggregate supply
(YFB) at the full employment level of income is the inflationary gap (AB).
Measures to wipe out inflationary gap
The following are the measures to wipe out inflationary gap:
1. Increase in savings to reduce aggregate demand.
2. Raise the output to match the disposable income.
3. Raise the taxes to clear the excess purchasing power.
The first two measures have a limited scope. Monetary policy also cannot
be very effective and so the government will have to rely more on fiscal
measures like taxation to wipe out the inflationary gap.
Stagflation
The present day inflation is the best explanation for stagflation in the whole
world. It is inflation accompanied by stagnation on the development front in
an economy. Instead of leading to full employment, inflation has resulted in
unemployment in most of the countries of the world. It is a global

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phenomenon today. Both developed and developing countries are not free
from its clutches.
Stagflation is a portmanteau term in macroeconomics used to describe
a period with a high rate of inflation combined with unemployment and
economic recession. Inflationary gap occurs when aggregate demand
exceeds the available supply and deflationary gap occurs when aggregate
demand is less than the aggregate supply. These are two opposite
situations. For instance, when inflation goes unchecked for sometime, and
prices reach very high level, aggregate demand contracts and a slump
follows. Private investment is discouraged. Inflationary and deflationary
pressures exist simultaneously. The existence of an economic recession at
the height of inflation is called ‘stagflation’.
The effects of rising inflation and unemployment are especially hard to
counteract for the government and the central bank. If monetary and fiscal
measures are adopted to redress one problem, the other gets aggravated.
Say, if a cheap money policy and public works programme are adopted to
remedy unemployment, inflation gets aggravated. On the other hand, if a
dear money policy and stringent fiscal measures are followed,
unemployment gets aggravated. It is the most difficult type of inflation that
the world is facing today. Keynesian remedial measures have not
succeeded in containing inflation but actually have aggravated
unemployment. Thus, the world today stands between the devil (inflation)
and deep sea (unemployment).
Phillips curve
A.W. Phillips, the British economist was the first to identify the inverse
relationship between the rate of unemployment and the rate of increase in
money wages. Phillips, in his empirical study, found that when
unemployment was high, the rate of increase in money wage rates was low
and when unemployment was low, the rate of increase in money wage rates
was high.
Phillips calls it as the trade-off between unemployment and money wages.
This is illustrated in figure 15.4.

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Y
Growth of Money wages (%)

0 X
Unemployment PC

Figure 15.4: Phillips Curve

In the figure, the horizontal axis represents the rate of unemployment and
the vertical axis represents the rate of money wages. PC represents the
Phillips curve; PC is sloping downwards and is convex to the origin of the
two axes and cuts the horizontal axis. The convexity of PC shows that
money wages fall with increase in the rate of unemployment or conversely,
money wages rise with decrease in the rate of unemployment.
This inverse relationship between money wage rates and unemployment is
based on the nature of business activity. During the period of rising business
activity, wage rate is high and the rate of unemployment is low and during
periods of declining business activity, wage rate is low and the rate of
unemployment is high. Paul Samuelson and Robert Solow extended the
Phillips curve analysis to the relationship between the rate of change in
prices and the rate of unemployment and concluded that there is a trade-off
between the level of unemployment in a country and the rate of inflation.

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P1

P2
Rate of inflation

P3

0 X
U1 U2 U3
Unemployment
Figure 15.5: Inflation and unemployment

We can use the same figure to illustrate this concept. Instead of money
wages, we show rise in the price level on the OY axis. It will be clear from
figure 15.5 that higher the rate of inflation, lower is the rate of unemployment
in the country; and lower the rate of inflation, the higher the rate of
unemployment in the country. It implies that one can be achieved at the cost
of the other. Phillips curve analysis can be a guide to the government in
striking a balance between the measures to be adopted to solve the
problem of unemployment and inflation.

15.4 Deflation
Meaning
Deflation is just the opposite of inflation. It is essentially a period of falling
prices, fall in incomes, and rise in the value of money. Deflation is that state
of the economy where the value of money is rising or the prices are falling.
But every fall in price level is not deflation. Deflation is that state of falling
prices which occurs at the time when output of goods and services
increases more rapidly than the value of money income in the economy.
Deflation is a state of disequilibrium in which a contraction of purchasing

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power tends to cause or is the effect of a decline of price level. Thus, a fall
in price level is both the result as well as the cause of fall in money supply.
Effects of deflation
Deflation, like inflation, will have both dampening and encouraging effects
on different sections of the society.
On production
Deflation has an adverse effect on the level of production, business, and
employment. Fall in demand and fall in prices force many firms to quit the
industry or operate partially. Wages are reduced or workers are retrenched.
It creates a hopeless situation in the area of production.
On distribution
Deflation adversely affects distribution of income too. In the first place,
producers, merchants, and speculators badly lose during this period
because prices of the goods fall at a much greater rate and faster than their
costs. Being unable to manage with the situation, many are compelled to
quit the industry.
Failure of business and inability to repay the loans incurred with the banks
worsen the position of the merchants and the producers.
Debtors lose while the creditors gain. Fixed income groups enjoy a better
standard of living because as the money income is fixed. There will be a
rise in their real incomes. The salaried persons and wage earners will
benefit by deflation.
However, the beneficial effects of deflation are far less compared to its
adverse effects. During this period, because of unemployment, falling
incomes, and output, a kind of pessimistic atmosphere is established in the
entire economy.
Methods to control deflation
Anti-deflationary measures are opposite of those used to control inflation.
 Monetary policy – Central bank will have to follow a cheap money
policy – reducing the bank rate, organising open market purchase of
securities, reducing the margin requirements, etc. to encourage
borrowing. But because of falling prices and low marginal efficiency of

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capital, cheap money policy of the central bank may not be very
effective in controlling deflation.
 Fiscal policy – Fiscal measures like deficit financing, reduction in tax
rates, tax concessions, public works programmes, may prove to be more
efficient in improving the situation than the monetary measures.
 Other measures – Price support programmes, rationing of essential
commodities, import of essential goods, grant of subsidies, development
of infrastructure, marketing facilities, etc., may ease the situation to
some extent.
Both inflation and deflation are dangerous. Of the two, deflation is more
dangerous as it cripples the system and establishes a hopeless situation
everywhere.
8th Recession of 2008
‘There was once a Great Depression’. This is what everybody would like to
believe. The Depression of 1929 wreaked enormous damage across the
world. In the United States of America, the government started the
rebuilding exercise with President Roosevelt’s announcement of holiday for
the banks for four days. The depression did end and the world moved at a
greater pace and the third world countries were catching up on the
‘developed ones’. Complacency was bound to step in. The rapidity and the
magnitude of growth forced governments, corporate, and the top brass of
institutions to look askance to the reckless manipulation of instruments of
this growth during the early part of 21st century.
Starting August 2007, the world was in the grip of a financial whirlpool which
was slowly but surely sucking in the hitherto unassailable giants of the
industry. The icons of the financial sector, Fannie Mae, Freddie Mac, which
sound more like fast food chains, Lehman Brothers and the likes, were set
to collapse like nine pins when the American government stepped in. The
latter took upon itself a liability of $1 trillion. What triggered this collapse was
a mix of highly complex financial instruments which the best brains were
paid hugely to develop and the false assumption that they could do no
wrong.

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What kind of collapse did the above lead to?

 The benchmark index of the Indian stock market, the SENSEX,


came down from a high of 21000 to 8000 in less than a year.
 Unemployment rates:
 In U.S.A, it went up from 4.9% (Jan-Mar 2008) to 6.8% (Oct-Dec
2008)
 In Japan, it declined to 3.7% (Oct-Dec 2008) from 3.8% (Jan-Mar
2008)
 In UK, it rose to 6.1% (Oct-Dec 2008) from 5.2% (Jan-Mar 2008)
 The growth rate of National Income (GDP):
 In U.S.A, it came down to -6.4% (Oct-Dec 2008) from 0.9% (Jan-
Mar2008)
 In Japan, it came down to -4.6% (Oct-Dec 2008) from 1.5% (Jan-
Mar 2008)
 In UK, it came down to -1.8% (Oct-Dec 2008) from 2.6% (Jan-Mar
2008)
 In China, it it came down to 6.8% (Oct-Dec 2008) from 10.6% (Jan-
Mar 2008)
 In India, it it came down to 7.8% (Apr-Jun 2008) and came down to
5.8% (Jan-Mar 2009)
 The Stock Market Index:
 In U.S.A, Dow Jones index came down to 8,776 (Oct-Dec 2008)
from 12,263 (Jan-Mar 2008)
 In Japan, it came down to 8,860 (Oct-Dec 2008) from 12,526 (Jan-
Mar 2008)
 In UK, it came down to 4,434 (Oct-Dec 2008) from 5,702 (Jan-Mar
2008)
 In China, it came down to 1,943 (Oct-Dec 2008) from 3,784 (Jan-
Mar 2008)
 In India, the SENSEX fell to 8,427 (Jan-Mar 2009) from 13,462
(Apr-Jun 2008)
 The Foreign Direct Investments (in US$ Bn.) and the growth rate of
FDI:
 In China, it came down to 18.0 (Oct-Dec 2008) from 27.4 (Jan-Mar

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2008) while the FDI growth rate went down to -16.2% (Oct-Dec
2008) from 61.3% (Jan-Mar 2008)
 In India, it declined to 6.2 (Jan-Mar 2009) from 10.1 (Apr-Jun 2008)
while the growth rate of FDI was -48.1% (Jan-Mar 2009) from
101.4% (Apr-Jun 2008)

What did the governments do to stabilise the economies?


 In U.S.A, the government announced fiscal stimulus packages worth
about US$1.5 trillion. The Federal Reserve reduced different interest
rates several times in the past six months. The Obama government
advocated protectionist policies like Buy American goods, etc.
 In Japan, it led to quantitative easing by Bank of Japan under which
the Central Bank increased the outright purchase of government
bonds. Other measures included injecting liquidity through purchase of
commercial papers, and short-term corporate bonds.
 In UK, protectionist policies were adopted apart from reducing different
interest rates several times in the past six months to its present level of
0.5%. BoE announced plans to ease quantitative easing.
 The People’s Bank of China, the Central Bank of China, affected five
interest rate cuts in four months. The Central Bank also lowered the
reserve requirement ratio for lenders by 0.5% to 13.5%. In November
2008, Chinese central government announced a 4 trillion Yuan
economic stimulus package. In January 2009, FDI inflow was US$
7.54 bn. The benchmark one-year lending and deposit rates were
reduced by 0.27% to 5.31% and 2.25% respectively.
 Indian government announced three fiscal stimulus packages worth
Rs. 70,000 crore (US$ 15bn.) between December 2008 and February
2009. These mainly included cut in indirect taxes and higher market
borrowings. The RBI reduced repo and reverse rates (rates at which
the RBI lends to banks and absorbs liquidity respectively) five times
since October 2008. Trade facilitation measures were announced to
boost foreign trade. A survey by RBI indicated optimism from the
respondents about the business scenario.
(Source: Statistical Outline of India 2008-09 – TATA Services Ltd.,
Department of Economics and Statistics)

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Self Assessment Questions


1. The value of money and price level is _________________ related.
2. The state of steady rise in price level is called __________________.
3. According to ____________ inflation is a phenomenon where too much
money chases too few goods.
4. The inflationary situation where people go with basketful of money and
come home with pocketful of commodities is ________________.
5. The governments go for ____ financing to finance public expenditure.
6. The concept of inflationary gap was introduced by _________.
7. The trade-off between inflation and unemployment is called the ____
curve.
8. A situation where inflation is accompanied by stagnation is called
_____.
9. A state of steady fall in price is called ________________.
10. An increase in the overall level of prices in an economy is referred to as
economic growth. (True/False)
11. Large or persistent inflation is almost always caused by excessive
growth in the quantity of money. (True/False)
12. In the short run, falling inflation is associated with rising unemployment.
(True/False)
13. If the price index in some country was falling over time, economists
would say that the country had deflation. (True/False)
14. Deflation is negative inflation, not just a decrease in the inflation rate.
(True/False)
15. Stagflation would result from the aggregate supply curve shifting to the
left. (True/False)

15.5 Summary
Let us recapitulate the important concepts discussed in this unit:
 Inflation refers to a general rise in price level. There are different types
of inflation like demand pull inflation, cost push inflation, etc. Inflation is
caused by a number of factors like rise in the supply of money, increase
in exports, black money, rise in the coast of production, hoarding, war,
etc. It affects different sections of the population differently.

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 Producers, merchants, and debtors gain while the consumers,


labourers, and fixed income groups suffer. A number of measures like
monetary, fiscal, and physical controls are adopted to control inflation.
 Inflationary gap is a Keynesian concept; it arises when the expenditure
is in excess of the goods available in the economy.
 Phillips curve explains the inverse relationship that exists between the
rate of unemployment and the rate of increase in money wages. Paul
Samuelson and Robert Solow using Phillips curve explain how at a
higher rate of inflation, unemployment is low and how at a lower rate of
inflation, the unemployment rate is high. It serves as a good guide to the
government and the monetary authorities to adopt appropriate policies
to tackle the problem of unemployment and inflation.
 Deflation is a state of falling prices, incomes, output, and employment.
As deflation has the danger of creating conditions of depression, it must
be cured adopting various monetary and fiscal measures.

15.6 Glossary

Cost-push inflation: A situation wherein prices rise on account of


increasing cost of production.
Deflation: State of the economy where the value of money is rising or
prices are falling.
Demand-pull Inflation: A situation where the total monetary demand
persistently exceeds total supply of goods and services at current prices so
that prices are pulled upwards by the continuous upward shift of the
aggregate demand function.
Inflation: A situation of substantial and rapid general increase in the level of
prices and consequent deterioration in the value of money over a period of
time. It refers to the average rise in the general level of prices and fall in the
value of money.
Inflationary gap: Amount by which aggregate expenditure would exceed
aggregate output at the full employment level of income.
Phillips curve: Indicates the inverse relationship between the rate of
unemployment and the rate of increase in money wages.

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Stagflation: A high rate of inflation combined with unemployment and


economic recession.

15.7 Terminal Questions


1. Discuss different kinds of inflation.
2. Explain the causes of inflation.
3. Describe the effects of inflation and the measures adopted to control it.
4. Explain the concept of inflationary gap.
5. Explain the effects of deflation and the methods adopted to control it.

15.8 Answers

Self Assessment Questions


1. Inversely
2. Inflation
3. Coulborn
4. Jumping / galloping / hyper inflation
5. Deficit
6. Keynes
7. Philips
8. Stagflation
9. Deflation
10. False
11. True
12. True
13. True
14. True
15. True
Terminal Questions
1. Depending upon the rate of rise in prices and the prevailing situation,
inflation has been classified into six types. Refer to section 15.2.
2. Increase in aggregative effective demand is responsible for inflation
Refer to section 15.2.
3. The positive effects of inflation are as many like social effect. Refer to
section 15.2.
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4. It is a gap between money incomes of the community and the available


supply of output of goods and services. Refer to section 15.3.
5. Deflation, like inflation, will have both dampening and encouraging
effects on different sections of the society. Refer to section 15.4

15.9 Case Study

A Price Balm for the Economy


The annual wholesale price inflation rate fell to 6.55% in January,
marking a fourth straight month of decline from the 10% high of
September 2011. Much of it, which is probably in line with the Reserve
Bank of India's (RBI) view, has to do with softening food prices from a
bumper kharif harvest aided by good monsoon rains. Food inflation has,
indeed, fallen far more spectacularly than the general inflation rate - from
a level of 9.62% in September 2011 to -0.52% in January 2012. If this is
more of a one-time phenomenon, it could be reversed if the next
monsoon turns out to be bad (which some of the global weather models
indicate). That, in addition to likely price increases of diesel and urea
after the current state assembly elections, can reignite inflationary
pressures all over again. This view has also been reinforced by the RBI's
latest Inflation Expectations Survey of Households. It points to a higher
proportion of respondents who believe that prices would rise by “more
than the current rate” in the next three quarters, even while maintaining a
more favourable outlook for January-March 2012. In other words, the
inflation expectations beyond the near-term continue to be high.
The above view may not be wrong. One cannot rule out inflation
returning, which then explains the RBI's obvious reluctance to ease its
hard money stance. But the issue right now is about identifying the main
problem confronting the Indian economy. That perhaps is not inflation as
much as the virtual drying up of investments. One may even go further to
argue that the variable really worth monitoring today – more than the
wholesale price index – is the capital goods production index. That has
registered negative year-on-year growth for four consecutive months
from September to December, indicative of hardly any new orders for
plant and equipment being placed by companies. It has implications for

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not only future growth, but even inflation, which requires a durable cure
that can come only from augmenting supply. In the event of no extra
productive capacities being created, any revival in demand only
increases the chances of prices going up. It is all the more necessary,
then, not to have policies that in the name of fighting inflation actually end
up stifling supply response.
That being the case, the right policy to be adopted in the present
circumstances is one of fiscal consolidation, redirecting government
expenditures away from consumption to investment. This, in combination
with the much-needed lowering of interest rates and credible measures
signalling the government's commitment to reforms, would put an end to
the current ‘famine' as far as green field projects are concerned. A revival
of investment may ultimately have a benign impact on prices as well.
(Source: An article of the same title that was published in the Hindu
Business Line dated February 15, 2012)
Discussion Questions:
1. What is the relationship between fiscal policy and inflation?
2. How does inflation influence investments?
Hint: Use the theoretical concept and answer the questions

References:
 Spencer, Milton H. & Siegelman, Louis (1959), Managerial Economics,
Homewood, Illinois: Richard. D. Irwin, Inc.,
 McNair, Malcolm P. & Meriam, Richard S., (1941), Problems in Business
Economics, New York & London: McGraw Hill Book Co. Inc.,
 Pappas, James L., & Brigham, Eugene F., (1979), Managerial
Economics, Hinsdale: Ill Dryden Press.
 Dean Joel, (1951), Managerial Economics, Englewood Cliffs: NJ,
Prentice Hall. the Hindu Business Line dated February 15, 2012)

E-Reference:
 www.thehindubusinessline.com
______________________

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