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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
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
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.
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.
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.
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.
1.6 Summary
Let us recapitulate the important concepts discussed in this unit:
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.
1.9 Answers
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
the two major (basic) functions and remaining functions are derived from
the two basic functions. Refer to unit 1.5.
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
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.
Sikkim Manipal University Page No. 15
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
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.
10 A
8 B
Price 6 C
E
4 F
D
2
X
0 100 200 300 400 500
Demand
5.00
4.00
0 Demand 10 X
20
Figure 2.2: Exceptional Demand Curve
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.
Y D1
D2
Forward
Shift
Price
D1
D
Backward
Shift D2
0 X
Demand
ED = ∞
Price
D D
Quantity
0 X
D
10.0
Price
0 ED = 0
2.00
0 D X
10
Quantity
Figure 2.5: Perfectly Inelastic Demand
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
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.
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.
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
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
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
D
A – 1.5
Price
B – 1.17
D
0 X
Demand
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.
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
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.
Symbolically,
D or Sales A 40,000 800
Ea = 2.67
A Demand or sales 1200 10,000
Dx / Dy Px / Py
Symbolically Es =
Dx / Dy Px / Py
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
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.
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.
2.7 Answers
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.
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
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
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
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
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
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.
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.
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 + bx
ii) XY = ax + bx2
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
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
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
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
Sales curve
Sales
0 90 91 Y
92 93 94
Years
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.
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.
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.
Sikkim Manipal University Page No. 71
Managerial Economics Unit 3
3.10 Glossary
Vicarious approach – It is a survey done to know the customers Reactions
to the new products indirectly.
3.12 Answers
iii. True
iv. False
v. True
Terminal Questions
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
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
numerous decisions almost every day. These two concepts link the market
behaviour of consumers, producers and sellers with that of price.
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
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
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
Sikkim Manipal University Page No. 79
Managerial Economics Unit 4
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.
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.
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.
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.
These were some circumstantial examples that are exceptions to the law of
supply.
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.
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
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
Y S1
PII S
6
PRICE PI
4 P
S1
x
S
x
0 10 20
SUPPLY
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
Y
S
Price
ES = 0
0 S X
Supply
Figure 4.7: Perfectly Inelastic Supply Curve
Y S
Price P
2
S% ES > 1
X
0
Supply
Y
S
Price
P 4% ES < 1
S
0 X
Supply
Y S
Price P 3
%
ES = 1
S
X
0
Supply
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
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
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.
Sikkim Manipal University Page No. 94
Managerial Economics Unit 4
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
D1 S
D S1
Y
Price
E E1
P
S D1
S1
D
0 X
Q Q1
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
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.
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.
4.13 Answers
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.
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.
References:
McConnell, Campbell R. (2005), Economics: Principles, Problems, and
Policies, Edition16, McGraw-Hill/Irwin.
E-References:
www.economictimes – retrieved on- December 9, 2011
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.
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
Inputs
Transformation
Process Outputs
Entry into
Firms Exit of Firms
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
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.
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
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.
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
Table 5.3 shows the MRTS of X for Y, for five different combinations.
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
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.
Rs. 3,000/-
A
Rs. 2,000/-
0 X
Factor Y
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.
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.
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.
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
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)
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)
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)
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.
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.
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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Managerial Economics Unit 5
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.
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:
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.
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.
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.
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
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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Managerial Economics Unit 5
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.
5.11 Answers
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
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
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
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.
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
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.
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.
TFC = TC - TVC.
Cost of production
TFC
360
X
0
Output
Figure 6.1: Total Fixed Cost Curve
TVC = TC - TFC
Cost of production
Y
TVC
0 X
Output
TC
Y TC = TFC + TVC
TVC
Cost of production
360 TFC
0 x
Output
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
AFC
0 X
Output
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
A AC
C
B
X
0 Output
Figure 6.6: Average Cost Curve
Cost of production
A MC
C
B
0 X
Output
AC
MC
Cost
AC=MC
X
Output
LAC
SAC 1
Cost of Production
SAC 2
SAC 3
SAC 4 SAC 5
0 Output Q X
Q
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.
LAC
Cost of Production
K3
K1
L1 L3
L2
0 X
M1 M2 M3
Output
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.
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
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.
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.
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.
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.
6.9 Answers
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.
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.
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
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
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.
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.
Objectives:
After studying this unit, you should be able to:
explain the background under which a firm lays down its multiple
objectives
MC
Cost/Revenue
P P1
MR
0 X
Q Output Q1
Y MC
N
Cost / Revenue
N1
MR
a0 X
Q Output Q1
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.
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.
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
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.
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
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.
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.
Sikkim Manipal University Page No. 194
Managerial Economics Unit 7
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.
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
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.
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.
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.
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.
7.11 Answers
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.
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
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.
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
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
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
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.
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.
AR = MR = Price
Price
X
0 Output
Hence, AR = MR = Price
REVENUE
AR
MR
X
0
OUTPUT
Figure 8.3: Revenue Graph under Imperfect Market
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.
R
Price
P
K
Q AR
0 X
M MR T
Output
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
Sikkim Manipal University Page No. 212
Managerial Economics Unit 8
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)
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
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
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.
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
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
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.
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.
Illustration
Production = 10,000 units
Total Cost = 4,00,000
Per Unit Cost = 4,00,000 / 10,000 = Rs. 40
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.
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
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.
‘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
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.
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.
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.
8.10 Answers
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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Managerial Economics Unit 8
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 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.
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
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.
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
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.
Market Situation
Perfect Imperfect
Competition Competition
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.
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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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.
Y
Cost & Revenue
MC
P MR = MC P1
AR = MR
0 X
Output
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.
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
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.
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.
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,
Price = MR = MC = AR = AC
LRS
LRD
Cost / Revenue
Price
E P AR=MR
R
S D
X
0 Q 0 Q
Output
Demand & Supply
LAR = LAC
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
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.
9.12 Answers
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.
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
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.
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.
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.
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
Y AR < AC
Q AVC
R
S P
Price
AR
MR
0 X
M
Output
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
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.
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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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.
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
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.
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
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:
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
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
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
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.
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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Managerial Economics Unit 10
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.
Activity:
Select any industry and analyse its market structure , conduct of the
buyers and sellers and the overall performance of the market.
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.
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.
10.13 Answers
Terminal Questions
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
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
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
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
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.
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
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
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.
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
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
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.
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.
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
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.
11.9 Answers
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
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
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)
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
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.
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
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.
Y
Consumption
C
0 X
Income
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.
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
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
Sikkim Manipal University Page No. 330
Managerial Economics Unit 12
Investment
0 X
Income
Figure 12.2: Graphical Representation of Investment versus Income
I I
Investment
X
Income
Figure 12.3: Autonomous Investment Curve
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.
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.
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%
IR
11
9
E
MEC
O Y
7000 9000
Investment
Figure 12.4
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.
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.
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
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
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
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
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
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
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.
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
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.
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.
12.10 Answers
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.
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
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
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.
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
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.
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.
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,
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 _____.
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.
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.
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.
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
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)
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.
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.
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.
13.10 Answers
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.
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
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.
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
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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Boom
Peak
Y
Recession
Recovery
Recession
P Depression
Recovery
Trough
Depression
0 X
Number of Years
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.
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
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.
14.6 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.
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.
14.10 Answers
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.
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.
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
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.
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
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.
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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P2
P1
D2
Price Level
F
P D1
S
0 X
Y
Output
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
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.
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.
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
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.
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.
Y
AS
AD
E (C+I+G)
A
Expenditure
0 X
YF Y1
Income
Figure 15.3: ‘Interaction of aggregate demand and aggregate supply’
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.
Y
Growth of Money wages (%)
0 X
Unemployment PC
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.
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
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
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.
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)
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.
15.6 Glossary
15.8 Answers
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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