MANAGERIAL ECONOMICS

Notes
CHAPTER 1

INTRODUCTION TO MANAGERIAL ECONOMICS

Learning Objectives
After going through this unit, you will be able to:
Describe the meaning of Economics.
Distinguish various economics technological term.
Apply economic principles which help in making business decisions.
Compare the relationships of Managerial Economics with other
subjects.
Structure
1.1 Introduction
1.2 Definition of economics & Managerial Economics
1.3 Managerial economics, its nature & scope
1.4 Application of managerial economics in business decision making
1.5 Application of managerial Economics in business
1.6 Summary
1.7 Keywords
1.8 Self assessment questions
1.9 Further readings
1.10 Model Answer

1.1 Introduction

The business managers have to take appropriate decisions to reach their

goals and attain their objectives. The managers have to optimize the output at
the lowest cost and to earn more profit. The study of economics helps them in
applying economics logic, tools, methodology, concepts, and theories of
economic analysis, to achieve the objectives of the firm.
The world is dynamics and changing, hence the managers have to keep
abreast with the modern and latest knowledge.
The managers have to use the modern tools to get the desired results.
Now business has become very complex and many factors affect the
business.
The main features of modern business environments are, ever increasing
inter-firm and inter-industry competition with domestics as well as international
competition. Here China is the main example how China is selling mass
produced goods cheaply and trying to put the Indian market in a bad shape and
affecting the Indian economy.
Hence the study of Managerial economics and economics helps the managers
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to take proper decision to achieve their goals. Notes

1.1 Definitions
Managerial economics refers to the integration of Economic principles and
methodologies practices for the purpose of facilitating decision making and
forward planning by the management within the given situation. It focuses in
identifying the problems and solving the problems by taking proper decision.
For example a manager has to decide whether he should get the work done by
hiring labor or give it to an outside contractor.
Different economist have defined economics differently
Dr. Alfred Marshall: “Economics is the study of mankind in the ordinary
business of life; it examines the part of individual and social action which is
most closely connected with the attainment and with the use of material
requirements of well being”.
This definition gives more importance on the welfare of human being. In the
modern world there is need of human welfare and it has become the policies of
all the governments in the world.
Prof. Lionel Robins: “Economics is the science which studies human
behavior as a relationship between ends and scarce means which have
alternative uses.
This definition shows that wants are unlimited and means are limited and
scarce and the means can be put to other alternate uses.
Unlimited wants are natural for human beings and all wants cannot be satisfied
at a time, hence he has to adopt the method of choice. He tries to select that
choice, which gives him maximum satisfaction. .
Available means can be used in various ways. All the economic problems arise
due to scarce means and unlimited ways to use those means. This leads to
choice among most competing ends. This is the main cause of basic problems
for the study of economics
Economics deals with optimum utilization of scarce resources to achieve the
objectives and to maximize profit of the firm.
In nutshell economics is “the study of how people and society choose to
employ scarce resources that could have alternative uses in order to produce
various commodities and to distribute them for consumption, now or in future,
among various persons and groups. In nutshell economics is “the study of how
people and society choose to employ scarce resources that have alternative
uses in order to produce various commodities and to distribute them for
consumption, now or in future, among society.”
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Economics is applied in decision making. It is that branch of economics which Notes

operates as a link between abstract theory and managerial practices.. It is
based on economic analysis for identifying, problems, organizing, information
and evaluating alternatives. Suppose your have Rs.100/- to spend. You have
many choices, such as buy a book; or go to a picture or entertain friends. If you
make one of the choices, you cannot think of other choices at all. But you will
make a choice which will give you maximum satisfaction.

Unlimited Choice Limited Resources

SCARCITY

What to produce ? How to produce ? For whom to produce ?

Study of economics mainly divided into 2 broad sections:

MICRO-ECONOMICS & MACRO-ECONOMICS

MICRO-ECONOMICS: Micro Economics deals with the study of Micro organs
of the economy and their related matter. Following flow-chart explain the
elements covered under the study of micro-economics.

MICRO ECONOMICS

Theory of Commodity Theory of Factor Economics of Welfare

Pricing Pricing

Theory of Theory of Rent Wages Interest Profits

Demand Supply

Chart 1.1 Importance of Micro economics in the Managerial Economics

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· Micro economics has to study the performance of Individual units in the Notes
economy at present and in future. If the share of factors of production
increases, it means an increase in income of an individual. This will
lead to an increase in the demand of all the products and it will increase
the economic activities. In other words we can say that if the purchasing
power of an individual increases his demand of various goods and
services will also increase. Another example can further give the
picture of the consumer. With a fall in price of a product the demand for
that product increases and if the price rises the demand decreases.
· It also reveals the cost of production of a product and how is it priced.
Here we also study the concept of elasticity of demand.
· How different factors of production get their share in the nation income
It also gives the idea of welfare economics

MACRO ECONOMICS
Other part of economics is Macro Economics. The subject matter of Macro
Economics includes the total economic units of an economy. It is the study of
aggregates, i.e. aggregate employment, aggregate income, aggregate saving
and investment, trade cycles, government policies, imports and exports and
global effects on the economy of the country. Role of banking policies also
plays an important role in the economy. Savings and investments are
controlled by the monetary policy of the government through its central bank.
Recently the prices of petroleum products were increased by the govt. You can
study the effects of this increase on the economy and on the individual.
Similarly when prices are rising, causing inflation you can study the effects of it
on the poor who have to spend all the income on the demand of essential
goods and services. This reduces the total demand and affects the economy.

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Notes
MACRO ECONOMICS

Theory of Income Theory of General Theory of Macro

& Employment Price Level and Economic Economic
Inflation Growth Theory of
Distribution

Theory of Theory of
Consumption Investment

Theory of
Business
Cycles

Chart 1.2 Importance of Macro economics in the Managerial Economics meaning

· To use the scarce resources to obtain optimum output and profit.

· To use the tools to select the best alternatives to achieve the
objectives.
· To study the market regarding demand, supply availability of factors of
productions and risk management.
· To decide the pricing of the product after studying the market
conditions, income of the people and their taste, religion, and culture.
· To study the implication and effects of fiscal and monetary policies i.e.
Policy of taxation and subsidy and its effect on the price of the final
product. Recently the govt. increased the tax on petrol and the price of
petrol went up. Similarly cooking gas is subsidized by Rs. 400/- and the
people are paying less price for the cooking gas. Monetary policy
affects the cost of borrowing for investment
· To study the external forces such as business cycle, political situation,
social structure, these affect the business.
· To study labour relations in order to maintain productivity and
efficiency of labour by giving incentives and motivate them.
Government intervention through different laws in the country which
regulate, control the business activities. It has become necessary to
control the adverse effects of capitalism on the economy.

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Activity 1 Notes
Differentiate - wants and means
a) Purchase LCD TV
b) Import of crude oil
c) Promotion in the organization with salary hike -
d) Got a bonus payment
e) Foreign exchange reserve
f) Going for world tour
Name any current 4 Economics problems of world

Differentiate between Micro economic and Macro economics for

following
1. Unemployment
2. Inflation
3. Price revision of LG Refrigerator
4. RBI decision to increase interest rate

The demand for Bajaj DTSI bike will grow by 5% in year 2012-13

1.3 Managerial Economics - Nature And Scope

1.3.1 Nature of Managerial Economics

· It is essentially MICRO economics in nature.
· It is pragmatic.
· It is normative.
· It uses some of the theories of macro economics
· It is problems solving of business in nature.
· Economics has limited application and has to study multidimensional
areas which include social, cultural, religious, political and international
environment.
· Every happening in the world affect the economy of the country for
example recession in US has affected the economies of Europe, china,
Japan and still its effect is felt in the world.
Microeconomic deals with individual units of an economy such as an
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individual, or a firm and their related matter. It is a practical subject and goes Notes
beyond providing abstract theoretical framework for managers.
This main source of concepts and analytical tools for management is found in
the study of economics. It studies essentials of demand, and supply, marginal
cost, short run and long run cost, different forms of markets such as perfect
competitive, monopoly, monopolistic competition, and oligopoly and how
these markets operate regarding pricing of the product and output.
Macro economics deals in forecasting of demand in order to plan for future
needs of capital and investment. This is based on market demand at macro
level and individual, organization demand at micro level.
At Macro level we study the theory of income and employment, Trade cycle
and its effects of the economy. Different causes of inflation, recession and
depression. Further we have to study the role of the government and its
policies to meet these challenges in the economy.

1.3.2 Scope of Managerial Economics

Managerial Economics is a very useful subject. It explains and clarifies most of
the major business problems such as;
Estimation of product demand and source of supply of various factors.
Analysis of product demand and plan the production schedule.
Decide the input combination to obtain maximum output at minimum
cost.
Estimation and analysis cost of the product. And how the cost of the
product can be reduced
Analysis of price of the product and try to push the product in the
market as per the market conditions
Study of the market structure.
Profit maximization and planning.
To Plan and control capital expenditure
To evaluate the various policies adopted by the government and judge
the effects of it on the business.
1.4 Application Of Managerial Economics In Decision Making.
Demand is the origin of all economic activities hence it needs a special
attention. Here estimation of demand is very important. Estimation of
demand depends on various factors such as income, distribution of
income, likes and dislikes of the people, their culture and the way of
life.
When we are using inputs we have to use various scarce resources
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and their combination to get maximum output at a minimum costs by Notes

avoiding any wastage.
Pricing of the product is another important issue which has to be
decided after studying various factors such as elasticity of the demand
and the market structure i.e. completive market, monopoly,
monopolistic competition, and oligopoly. There is also a need to
estimate the demand and how long the demand will last.
It studies the concept of production function, optimum utilization of
resources, inventory management, and maximization of sale.
Market structure also decides pricing system based on elasticity of
demand of the product
To maximize profit and plan to maximize it depend on the decision of
the managers who base their decision after study of the market
How to utilize the capital so that it can bring maximum returns .This is a
very important.
Capital budgeting and study of relationship between inputs and
outputs.
Planning for future by using multi disciplinary approach by using tools
provided by accounting, finance, marketing, and quantitative analysis
by using scientific methods.
Activity- 2
Identify the type of market:
1 FMCG
2 Mobile service providers
3 Cement manufacturer and recent CCI decision to penalize 11 cement
companies

1.5 Application Of Managerial Economics In A Business

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Notes
Managerial Decision Problems

Economic theory Decision Sciences

Microeconomics Mathematical Economics
Macroeconomics Econometrics

MANAGERIAL ECONOMIC
Application of economic theory
and decision science tools to solve
managerial decision problems

OPTIMAL SOLUTIONS TO
MANAGERIAL DECISION PROBLEMS

Chart 1.3 Applications of Managerial Economics

Managerial Economics and Marketing.

- Planning for product demand in coming year.
- Forecast demand for different product and draft strategies and tap new
market.
Managerial Economics and Finance.
- Forecast the cash flow of the organization on the basis of demand and
supply
- Pricing strategy and earning and profit.
Managerial Economics and HR
- How much manpower required in coming days.
- Required skill availability
Managerial Economics is used all the streams directly or
indirectly.
Managerial economics and other social sciences
The part of Sociology, Psychology and other social sciences is equally
helpful in Managerial economics and are used for market research and
behavior of the society. Sociology shows the social effect of social life.
We have to use many conventional concepts have to be used as
society and social life needs them. E.g. Gifts at the time marriage is a
social custom. Lot of expenditure is done in marriage

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Notes

Goods and Services Product Goods and Services

Market

Consumers Firms

Economic Economic
Resources Resources

Income Factor Factor Payment

Market

Chart 1-4

1.6 Summary
Managerial Economics refers to the application of principles of economics in
decision making in the business. It uses the help from accounting and other
subjects like mathematics, statistics, .operational research, sociology
psychology etc.
It uses the help of account, production, marketing techniques and finance to
take decision. Managerial economics is applied economics and based on
normative economics Managerial economics has to decide:
What to produce?
How to produce?
How much to produce?
For whom to produce?
At what cost it is to be produced?
How to decide price?
Managerial economics has to study the market, determine the demand based
on forecasting and other circumstances. While pricing the product it has to
study elasticity of demand, income of the people and has to prepare strategy
for increasing its profit and its share in the market.
It has many tools given by other social and natural sciences such as social set
up, religion, mathematics, statistics, operational research, capital
management and pricing. Finance has greater role to play in the study of
managerial [Link] the scope of Economics is wider than the scope of
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managerial economics. Notes

1.7 Keywords
Aggregate demand: The expenditure that the households and firms
are undertaking on consumption and investment.
Consumption: act of satisfying one's wants.
Demand: The quantity of goods and services desired by a customer
duly supported by the ability and willingness to purchase by parting
with money.
Economics: The science of choice when faced with unlimited ends
and scarce resources having alternative uses.
Fiscal Policy: A set of guidelines for the government's earning and
spending.
Macro Economics: The branch of economics which studies the
aggregate behavior of the economic system.
Micro Economics: The branch of economics that deals with small
individual units of an economy.
Monetary Policy: A mechanism to regulate the money supply in an
economy. It is concerned with the cost and availability of credit.
Price: Value when expressed in terms of money.
Utility: The want satisfying quality of goods.

1.8 Self Assessment Questions

Explain various types of business decisions that a manager has to
make?
· How Managerial Economics is influenced by Economics?
· Discuss the nature and scope of managerial economics.
· How Managerial Economics is related to other subjects.
· Managerial Economics uses the theories of economics and the
methodologies of decision science for managerial decisions. Discuss
Discuss nature and scope of managerial economics.
Quiz:
Q1) Which of the following is true with reference to opportunity cost?
o It is the value of the next best use for an economic good.
o It is the value of a sacrificed alternative.
o It is useful in decision making.
o It is useful for valuing non marketed goods

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Q2)Economic problem arise because of Notes

o Abundant resources
o Resources are scarce
o Inefficiency of authority
o Inefficient use of Resources

Q3Which of the following is not a factor of production?

o labour
o land
o Profit
o Capital
Q4)You have two things you can do tonight. You can go to the movies with
friends or you can study for your economics quiz.
What is the opportunity cost of going to the movies with your friends? Having
fun with your friends.
o Getting a good grade on your economics quiz.
o Both a and b.
o Neither a nor b.

Q5) Which one is a quadratic equation?

o Q = a +bL- cL2
o Q = a +bL + cL2-dL3
o Q = aLb
o None of the above
o Show Score
1.9 Further Readings
Dr. [Link] Managerial Economics
Dr. [Link] Managerial Economics
Prof. Joel Dean Managerial Economics
Dr. Mukund Mahajan Managerial Economics

1.10 Model Answers

Activity no 1
Differentiate wants and means
Answer
a) Want
b) Means
c) Means
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d) Means Notes
e) Means
f) Wants
Name any current 4 economic problems of world
Main four economics problems of the world
1. Population explosion.
2. Recession
3. Least developed countries
4. Food
Differentiate between Micro economic and Macro for the following.
1. Unemployment Macro.
2. Inflation. Macro
3. Price revision of LG Refrigerator Micro.
4. RBI decision to increase interest rate. Macro
5. The demand for Bajaj DTSI bike will grow
by 5% in year 2012-13 Micro

Activity No.2
1. F.M.C.G. Market is competitive.
2. Mobile service provider Monopolistic competition.
3. Cement ICC decision Oligopoly

Quiz :
Q1. It is the value of the next best use for an economic good.
Q2. Resources are scarce.
Q3. Profit
Q4. Getting a good grade on your economics quiz.
Q5. None of the above

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Notes
CHAPTER 2

DEMAND ANALYSIS

Learning Objectives
After going through this unit, you will be able to:
Explain the concept of utility and its importance.
Explain the concept of demand
Study the law of demand
Draw demand schedule and curves
Discuss the exceptions to the law of demand.
Evaluate the importance of the law of demand.
State factors which affect demand other than price

Structure
2.1 Introduction
2.2 Concept of utility
2.2.1 Law of diminishing marginal utility.
2.2.2 Application of the law of DMU
2.2.3 Limitations of law of DMU
2.3 Meaning of demand.
2.3.1 Law of demand and exceptions
2.3.2 Demand schedule and demand curve.
2.3.3 Shifts in the demand curves
2.4 Types of demand
2.5 Determinants of demand (Missing)
2.6 Summary
2.7 Keywords
2.8 Self assessment questions
2.9 Further reading
2.10 Model answers

2.1 Introduction

In the first unit we have given the idea of managerial economics and how ME is
dependent upon economics. The managers have to study all the possibilities
of using scarce resources to get the maximum output at minimum cost. In this
unit we are going to study the idea of utility and how it is related to demand of a
product. We are also going to study the idea of demand. Demand is the origin
of all economic activities. Demand is affected by many factors apart from price.
The factors, which affect demand, are income of a consumer, population,
climate and government policies activities.

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2.1 The Concept Of Utility Notes

The concept of utility is very important because the demand of a product
depends upon its utility to the buyer. More utility means more demand and
more prices.
Meaning of utility
It is want satisfying power of a commodity. If man is thirsty he quenches his
thirst by taking a glass of water. Here water has UTILITY because it has the
power to satisfy human want and sometime a person is prepared to pay for it.
So we can define utility as satisfying power of a commodity.
2.2.1 Law of diminishing marginal utility.
The LAW OF DIMINISHING MARGINAL UTILITY was formulated by Prof.
Marshall. According to Prof. Marshall
The law means “more a person has anything the less he wants to have more of
it.” That means the value of that product goes on diminishing as a person
acquires more and more of it.
The Law of diminishing marginal utility
The law states that as a consumer increases the consumption of a product, the
utility gained from the successive units goes on decreasing.
For example if a man is thirsty he takes a glass of water which gives him good
satisfaction and if he takes the second glass of water he will get less
satisfaction than what he got from the first glass of water. If he continues to take
further the satisfaction he gets, goes on decreasing and a time will come when
instead of giving satisfaction he gets dissatisfaction.
Diminishing Marginal Utility schedule Total and Marginal utility

Table 2.1 diminishing marginal utility

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Notes
Graph 2.1 DMU Curve

Assumptions of Law of DMU

Rational Behavior. This means choosing those goods and that quantity
which gives maximum satisfaction.
No change in the taste and fashion, likes and dislikes
No change in income of the person
Consumer always prefers more quantity.
Constant utility of money.
2.2.2 Application of the Law of DMU
· It gives the ides of value-in-use and value-in-exchange. For example
Water has a very high value in use but less value in exchange because
water supply is very high hence its value is less. Similarly the price of
diamond is more in exchange but it has less value in use.
· Application to Money: the law of MDU applies to money also and the
tax system in the whole world is based on this concept. Man by nature
would like to have more and more money. But as the stock of money
goes on increasing its value goes on decreasing.
For example a person X has an income of Rs.3000/-PM and another
person Y has an income of Rs. 50,000/- P.M. If X loses 10/- he will
search for it but if Y loses 100/- he will not bother much because the
value of money to the poor is high and to the rich is low. Hence the rich
pay higher taxes than the poor.
· The Law of demand can be derived from the law of DMU and it also
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helps to analyze why price falls. The Law of demand clearly indicates Notes
that a fall in price of a commodity the demand for it increases and the
marginal utility goes on decreasing of the commodity.
This law explains the idea of redistribution of the national income in the
society and it has greater affect on the development of an economy
because the poor, if have money, go for purchasing the goods and
services more and more. This will increase demand. This will increase
more production and more economic activities and economic growth.
2.2.2 Limitation of the law of DMU or when the does not apply.
· Suitable unit - If a thirsty person is given a spoonful of water, he will like
to have more and more till he has consumed reasonable quantity and
till then this law will not apply here.
· Time gap - If a person has his breakfast at 8.00AM and next food he is
offered at 8 PM he will get more satisfaction by consuming food at 8 PM
because the time gap is longer.
· This law does not apply to eccentric person. For example a drunkard
would like to have more and more drinks. Similar is the case of a miser
who is not happy with what he has but would like to accumulate more
and more wealth.
· No change in the quality of the product it means the law will not apply if
successive units are of superior quality. For example if a person is
eating ordinary mangoes he gets some satisfaction. But if he given the
best quality of mango he will likely to get more satisfaction.

Activity A
Explain why water has less value in exchange but high value in use.

Explain the situation under which a miser is happier when he gets more and
more money.

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Notes

Justify the idea that the rich should pay higher taxes than the poor.

2.3 Demand

Meaning of demand
Demand means effective demand. Demand is defined as the quantity of goods
or services desired by an individual backed by the ability and willingness to pay
at particular time and at particular price.
The elements of demand are
Desire,
Backed by money
Willingness to pay and part with the money.
If any one of the elements is missing, it will not lead to demand.
A beggar has a desire to eat but he has no money so his demand
cannot be fulfilled.
Secondly if a man has desire and he has money but he is not prepared
to part with it. This will not be a demand, for example the case of a miser
who wants the goods but is not prepared to part with the money. So his
demand cannot be fulfilled
Thirdly a man has desire and prepared to pay for the product but has no
money. In this case his demand is fulfilled if he gets the goods on credit.
In the modem time most of the durable goods (white goods) are
purchased on EMI bases and the financial companies are prepared to
finance such transactions. This has completely changed the pattern of
demand in the market
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Demand is the core of almost all the major activities and decisions of a Notes
firm.
2.3.1 Law of Demand and exceptions to the law of demand.
All things remaining the constant (ceteris paribus) when the price of a product
increases the demand of the product decreases and if the price reduces the
demand increases.
It means that demand is the function of price i.e dd=f (p)
Demand and price are inversely related but not proportionally
The equation of demand is: DD=a-bP,
Here P is the price and a & b are constant. This shows that initial demand will
remain constant whatever be the price of the product may be for that we have
used sign a, b is again constant but it represents functional relationship
between demand and price. b is having (-) sign which denotes negative
function and shows downward slopping demand curve.
Exceptions to the Law of Demand
Under the following situations the law of demand is not applicable
Giffen goods.
Costly luxury items
Speculative goods
Out dated goods, out of fashion goods
Goods in short supply
There are certain goods whose demand increases with the rise in its price.
Giffen goods: These goods are inferior goods consumed mostly by the poor
as essential commodities e.g. BAJRA. The demand of these goods increases
as the price rises and vice versa. Consumers spend a considerable portion of
their limited income on these goods.
For example A poor man income is Rs. 200/- and he needs 30 kg of grains to
survive. The price of BAJRA is Rs 5/-Kg and of wheat Rs.10/- per kg. He
consumes 20kgs of BAJRA and 10 kgs of wheat. Now the price of BAJRA rises
to Rs.6/- per kg. Now he can buy 20 kg of BAJRA and 8 kg of wheat to meet his
needs. This happens because of Giffen goods.
Costly luxury goods: These are not essential goods and are consumed by
the rich only. Here when the price increases the demand for these goods also
increases. Because the rich people attach a lot of value to costly luxury goods
that distinguish them from the common people and these goods have prestige
value for the rich. If the price of gold falls, the demand from the rich will come
down and if the price of gold rises the demand will increase.

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Speculative goods: Such as shares which are traded in the share market Notes
which do not follow the law of demand. In speculation a further rise in price is
expected by the investor and the traders buy more and hold them to sell the
shares at a higher price later.
Outdated goods: These goods are generally desired by the people and
these are durable goods such as radio, TV, telephones. When anything
becomes outdated the people would not buy them. For example the demand
for black and white TV has become negligible even though the prices have
fallen. This also applies to seasonal goods, e.g. the demand of raincoat is
always in rainy season.
Goods in short supply: The supply of certain goods is uncertain; hence even
if the price is going up the people would like to buy them because of
[Link] example when the shortage of sugar is felt the people are
prepared to pay more to buy sugar to avoid inconvenience. Hence in above
circumstances the law of demand does not apply.

Fig.2.1 Table of Demand

Sr. Price of the Milk Per liter Quantity demanded in the market
(Liters)

1. Rs 10 500

2. Rs 15 300

3. Rs 18 200

4. Rs 20 100

5. Rs 25 50

Demand Graph

Fig.2.1 Demand Curve

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2.3.2 Demand Schedule Notes

This demand schedule and demand curve clearly indicates that as the price of
milk decrease the demand for milk increases and when the price increases the
demand for milk decreases.
2.3.3 Shift in the Demand Curve
Shift in demand curves happens when price has no role to play and other
factors other than price affect the demand of the product.
Sometimes even if there is no change in the price of a product the demand
increases or decreases.
For example if some guests visit you so you have to buy more goods and
services to serve the guests. You may buy more milk, tea leaves and sugar.
When some family members leave the house for a few days the demand is
reduced of some goods.
The shift can be due to reduction or increase in income of a person. Price of
substitute goods has fallen so the demand of the original goods is reduced.
The goods have become out of fashion and taste or there is a change in
technology.
I. Demand Shifts
Increase in Demand: We represent an increase in demand by an outward
shift in the curve (from D1 to D2). In the graph below at the price p1, demand
has increased from Q1 to Q2. At every price there will be a greater demand
than there was before the 'shock' of increased demand. We could expect this
to describe the effect of an increase in income or an increase in the size of
potential demanders if the economy was expanding rapidly and families had
more income to spend on education, or if high school grads were having real
problems finding jobs Increase/Decrease
Fig.2.2 Increase in
inQuantity
Demand

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Decrease in Demand: We represent a decrease in demand by an inward shift Notes

in the curve (from D1 to D2). In the graph below at p1, demand has decreased
from Q1 to Q2. At every price there will be a less demand than there was before
the 'shock' of decreased demand. We could expect this to describe the effect of
a decrease in the price of a substitute good, see the demand curve shift inward,
if the economy was falling into a recession and families had less income to
spend on education, or if high school grads were finding jobs quite easily.

Fig.2.2 Decrease in Demand

So we can say that in case of increase in demand of a product the demand

curve will move toward the right and in case of decrease in demand the
demand curve will move towards left.

ACTIVITY B
Price of vegetables in the vegetable market is high in the morning and as the
time passes on the price goes on decreasing. Give reason

During festival season the price of milk goes up and the demand is also
increasing, explain this situation under the law of demand.

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Notes

The demand for car has come down because the price of petrol has increased.
Study this situation under the law of demand.

2.4 Types Of Demand

2.4.1 Direct demand & indirect demand.
2.4.2 Derived and autonomous demand.
2.4.3 Price demand, income demand, cross demand.
2.4.4 Joint demand and composite demand.
2.4.5 Individual demand and market demand.
2.4.6 Demand for durable and non-durable Goods.
2.4.7 Demand for Perishable good and non- perishable goods.
2.4.1 Direct Demand and Indirect Demand:
Direct demand of goods is demand of those goods and services which are
directly consumed by the ultimate consumer. These goods are used for final
consumption by the consumers the examples of such goods are bread, butter,
milk, tea and readymade garments, service of a doctor etc.
Indirect demand consists of those goods which are not directly consumed by
the consumer but these are used by producers for the production of other
goods. These are also known as producers demand. Example - The demand
for machine, tools, raw material, is known as indirect demand.
Also sewing machine is demanded by a house wife to stitch clothes for the
family it is a direct demand but when a tailor uses the sewing machine for

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making shirts, blouses etc it is indirect demand for the machine. Notes
2.4.2 Derived and Autonomous Demand:
It is just like indirect and direct demand. The demand for cotton for making shirt
is a derived demand whereas the demand for milk is autonomous demand. Let
us say that the demand for shirts have gone up it will force the producers to
produce more by increasing the demand for cloth.
2.4.3 Price Demand:
It refers to different quantities of a product or service that a consumer would
like to buy at a given time, and at a given price, other things remaining
constant. It is related to price
Income Demand:
It refers to the situation where different quantity of goods or services would be
purchased by the consumer at various levels of income. If income increases
demand for various goods would also increase but the demand for basic food
shall remain the same. And with the higher income the consumer may
substitute superior quality of goods replacing inferior goods. For example the
income of a consumer increase he may demand more goods and secondly he
may substitute superior quality of rice to inferior quality of rice
Cross Demand:
This refers to the demand of interrelated good. E.g. tea & coffee .Increase in
the price of tea will increase the demand for coffee.
2.4.4 Joint Demand:
It means when more than one commodity is required to satisfy a demand. For
example to satisfy the demand for tea, consumer requires tea leaves, milk,
sugar etc.
Composite Demand:
Any commodity can be put to many uses, and the use of it depends upon its
price. For example water, where water is costly it is only used for drinking and
cooking purposes and if the price of water reduces it can be put for other uses
also.
2.4.5 Individual Demand and Market Demand
An individual in order to satisfy his want would like to have some vegetable and
he buys it. When the demand of all the people is taken together it is market
demand of vegetable it will be called market demand. For example X demand
depends upon his income and he may demand one kg of cabbage but all
people demand for cabbage may be 100 kg that will be market demand.
2.4.6 Demand for durable goods and No-durable goods
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Durable goods are those which can be used more than once over a period of Notes
time for example the use of TV, fan, furniture, car, and ready- made clothes etc.
· Whereas non-durable goods are those which can be used once and
consumed directly such as bread Policy of the government
· Change in the habits of savings
· Innovation and invention
· Special influence and climate
· Future expectation of consumers
· Change in the level of distribution of income.
2.4.7 Demand for Perishable good and non- perishable goods.

Activity C
a) Sewing machine is a consumer goods and it also a producer good.

b) In order to have a cup of tea you need tea leaves, milk and sugar it is called

c) Government policy affects demand. Give some example to prove it.

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d) EMI scheme has increased the demand for white goods. Agree. Notes

e) Change in the habit of saving more, will affect the demand of goods and
service.

2.5 Determinants Of Demand

The Determinants of Demand

o It is determined by
o Own Price - Po
o Price of other products, especially close substitutes and
complements, Pc,s
o Consumers' disposable incomes, Yd
o Consumers' tastes, T
o The amount spent on advertising the product, Ao
o The amount spent on advertising complements and substitutes, A
c,s
o Interest rates (i) and credit availability (C)
o Expectations of future prices and supply conditions(E)
A 'demand function' - the general mathematical form
Qd = f(Po,Po,Ps,Yd,Ao,Ac,As,I,C,E)

2.6 Summary
We have studied the idea of utility. We have also studied the law of diminishing
marginal utility. The idea of utility is useful in taxation also it gives the idea of
Value-in-use and Value-in-exchange. We also studied the meaning of demand
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and its law .i.e. how change in price affects the quantity demanded. We learnt Notes
how demand is determined and also exceptions to the law of demand .We also
got the idea of increase and decrease in demand.

2.7 Keywords

· Complementary goods: goods which are used along with some other
goods.
· Demand: The quantity of a good or service desired by a customer duly
supported by the ability and willingness to pay with reference to a point
of time and the price.
· Giffen goods: inferior goods, consumed mostly by the poor people as
essential commodities. The demand of these goods increases with a
rise in price.
· Law of demand: Other thins remaining the same the demand for
goods increases as the price decreases and vice-versa.
· Law of Diminishing Marginal Utility: As a consumer increases the
consumption of a product, the utility gained from successive units of
consumption goes on decreasing.
· Price: value expressed in terms of money.
· Utility: The want satisfying quality of goods.

2.8 Self Assessment Questions

List down the factors affecting demand and supply of goods? Explain how
technology affects the supply. Give one example.
What are the factors affecting elasticity of demand?
Discuss the law of diminishing marginal utility.
Under what conditions the law of DMU does not apply.
Explain the relationship between law of DMU and money.
Explain “demand and price are inversely related”.
State a few exceptions to the law of demand.
Discuss determinants of demand.
Quiz :
[Link] of demand states
o Positive relation between price and demand
o Negative relation between price and demand
o Symmetric relation between price and demand
o None of the above

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Q2. A flatter supply curve is Notes

o price elastic
o unit price elastic.
o none of these answers.
o price inelastic.
Q3. At the consumer's optimum consumption bundle,
o the slope of the indifference curve equals the slope of the budget
constraint.
o the indifference curve is tangent to the budget constraint.
o the relative prices of the two goods equals the marginal rate of
substitution.
o All of the above
Q4. Which of the following is not a property of indifference curves?
o Indifference curves are downward sloping.
o Indifference curves are bowed outward.
o Indifference curves do not cross each other.
o Higher indifference curves are preferred to lower ones.
2.9 Further Readings
Dr. [Link] Managerial Economics
Dr. [Link] Managerial Economics
Prof. Joel Dean Managerial Economics
Dr. Mukund Mahajan Managerial Economics

2.10 Model Answers

Activity A
· Water has less value because it has abundant supply and it is a gift of
nature. So its value in exchange is very less.
· A miser is happy as he gets more and more of wealth and money. The
of DMU has this exception.
· The value of money to the rich is less so they have to pay higher taxes.

Activity B
· The price of vegetable is high in the morning because fresh vegetable
is in demand and the consumers are prepared to pay more price . Since
vegetable is a perishable article it has to be disposed off hence the
vendors go on reducing the price to attract the customers and try to sell
the stock.
· In spite of an increase in price the demand for milk increases during
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festival seasons. This is known as increase in demand because the Notes

demand is independent of price..
· This is the case of complementary demand. The car cannot run without
petrol. If running of car is costly the demand is affected.
Activity C
· Sewing machine used by a household is a consumer good but if it used
by a tailor it is producer good.
· It is called joint demand.
· Increase of taxes by the govt. will increase the cost of the product
hence its demand will be affected similarly if subsidy is given by the
govt. this will reduce the price of the product and demand is increased
i.e. Cooking gas.
· Agree the person can make the payment in installment.
· Increase in saving habit will reduce the demand of the goods and
services.

Quiz :
Q1. Negative relation between price and demand
Q2. none of these answers.
Q3. the relative prices of the two goods equals the marginal rate of
substitution.
Q4. Indifference curves do not cross each other.

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Notes
CHAPTER 3

ELASTICITY OF DEMAND AND FORECASTING OF DEMAND

Learning Objectives
After going through this unit, you will be able to:
Explain the meaning of elasticity of demand.
Discuss how a small change in price affect the demand.
State different concepts of elasticity.
State Measurement, and uses of the concept of elasticity of demand.
Establish how demand is estimated.
State Methods of estimating.

Structure
3.1 Introduction
3.2 Concept of elasticity of demand.
3.2.1 Elastic demand.
3.2.2 Inelastic demand.
3.3 Classification of elasticity of demand.
3.3.1 Price elasticity of demand.
3.3.2 Income elasticity of demand.
3.3.3 Cross elasticity of demand
3.4 Measurement of elasticity of demand.
3.4.1 Total Outlay method.
3.4.2 Percentage method.
3.4.3 Point method
3.4.4 Arc method.
3.5 Application of elasticity of demand.
3.6 Factors determining elasticity of demand
3.7 Meaning of forecasting of demand.
3.7.1 Techniques of forecasting.
3.7.2 Forecasting of demand for a new product.
3.7.3 Uses of forecasting of demand.
3.8 Summary
3.9 Keywords
3.10 Self assessment questions
3.11 Further readings
3.12 Model Answers

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3.1 Introduction Notes

In the previous unit no 2 you are given the idea of marginal utility and its
importance. Secondly you learnt the idea of demand and other concepts
related to demand such as different types of demand. We know that demand is
the beginning of all economic [Link] this unit we are giving you some
ideas of edacity of demand. This is a very important component of business
decision making. It is a measure of responsiveness of demand of a product to
the change in the price of the product. Sometimes a small fall in the price of a
product may increase the demand of the product much more than expected for
example If the price of TV is reduced, it demand always increases. But the fall
in the price of salt will not increase its demand. Prof. Marshall “Elasticity of
demand in a market is great or small depending on whether the amount
demanded increases much or little for a given fall in price and diminishes much
or little for a given rise in price
In the second half we shall study the idea of estimation of the level of demand
of a product in future. The businessman has to plan for future production on the
basis of future estimates. The businessman has to arrange for Finance, space,
Manpower; material etc. This idea is known as forecasting of demand of a
product

3.2 Concept Of Elasticity Of Demand

The law of demand gives only the direction of change in the quantity
demanded of a commodity in response to a change in price. But law of demand
does not tell by how much and to what extend the quantity demanded of a
commodity will change in response to a change in price. This idea can be
explained with the help of price elasticity of demand.
3.2.1. Elastic Demand
Under elastic demand gives the idea that is if the price of a product changes
what will be its effect on the quantity demanded of the product. How much the
demand is responsive to change in price? For example if there is a fall in the
prices of white goods (TV, Washing Machines, A.C) the response of the market
will be in the form of more and more demand. This means that there is elastic
demand this idea is applicable to all non-essential goods.
3.2.2 Inelastic Demand
Inelastic demand is a situation even if there is a great fall in the price of a
product the quantity demanded will not increase much or it may not increase at
all. This is the idea of inelastic demand. For example if the price of wheat and
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rice fall the demand may not increase or there may be marginal increase. But in Notes
case of salt the demand may not increase at all. Generally these products
come under necessaries and are essential for human life.

3.3 Classification Of Elasticity Of Demand

The concept of elasticity of demand is put in three categories.
3.3.1 Price elasticity of demand.
3.3.2 Income elasticity of demand
3.3.3 Cross elasticity of demand
3.3.1 Price Elasticity of Demand.
When the demand of a commodity is responsive to price then it is known as
price elasticity of demand. If there is a fall in price demand may rise a little or
more depends upon whether the demand is elastic or inelastic.
This concept enables the manager to know the effects of change in the price of
a commodity on the total revenue which depends upon nature of product and
its elasticity.
Price elasticity of demand can be shown as under
Pe= % change in quantity demanded÷% change in price.
Pe= ∆q/q / ∆p/p
Pe=∆q/∆p*p/q
∆q means a small change in the quantity demanded ∆p means a small change
in the price of the commodity. Q means quantity demanded. P means price of
the commodity. Suppose he price of tea is Rs.20/-and the quantity demanded
by a house hold is 10 kg. Subsequently the price of tea has risen to Rs.22/- and
demand has come down to 9 kg.
Pe=- ∆q/∆p*p/q
Pe=1/2*20/10 = -1
Hence the elasticity is less elastic
Price elasticity of demand can range from 0 to ∞.Hence it can be seen
that Pe=1;Pe>1; Pe<1; Pe=0; and pe=∞

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Notes

1. Fig.1 shows the idea of inelastic demand. Here there is a fall in price but the
demand has not increased much. This happens in case of essential goods eg
wheat. Rice vegetables etc. Here elasticity of demand is less than one
2. Fig.2 gives the idea of elastic demand here with a fall in price the demand for

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the product has increased much. The example is TV; washing machines etc. Notes
here the elasticity of demand is greater than1
3. Fig.3 shows that the elasticity of demand is unity that is equal to one. It
means percentage change in price of the product and percentage change in
demand is equal.
4. Fig.4 shows that the elasticity of demand is zero. It means the demand
remains the same whatever the price may be. For example purchase of salt for
the household. Here elasticity of demand is zero
5. Fig.5 depict that at the same price any quantity of product can be bought.
The example is that of sugar. In this case the elasticity of demand is ∞.The
price elasticity of demand for cheap good that are generally consumed in fixed
quantity is inelastic, that is, the demand for salt has zero elasticity.

3.3.2. Income Elasticity of Demand

If the income of a consumer increases, he will demand more goods and
services. He may also substitute superior goods to inferior goods. So under
income elasticity of demand we have to study the measurement of the
percentage change in the demand for a commodity due to change in the
consumer's income other things remaining constant
Income elasticity of demand = proportionate change in demand of goods X÷
proportionate change in income
= ∆ D/D÷∆I/income
= ∆D/∆I÷I/D
∆D stands for a small change in demand
D stand for demand
I = stands for Income
∆I stands for change in income
The income elasticity of demand shows the responsiveness of demand for a
particular commodity to the change in the consumer's income.
When the income increase of a consumer he will demand more goods &
services. He may also shift his demand to superior quality goods and decrease
the demand of inferior good. For example if a consumer consumes inferior
quality of rice When his income increases he may start purchasing superior
quality rice.
So the income elasticity of demand is positive for superior goods or normal
goods and negative for inferior good.
Supose the income of X is Rs.10,000/ and his demand for fruit is 600 unit and if

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his income falls to Rs.8,000/- he may reduce the demand for fruit to 400 unit. Notes
So the income elasticity of demand will be
Ie = ∆dF/∆Income÷I/dF
Here the income elasticity is less and negative.
This concept is always used in determinating the effect of change in income on
the demand of the [Link] is used while studying the change in the national
income and its effects on demand of various goods and services. We always
talk of GDP (gross domestic prodct). If GDP is rising economic activities will
increase.
3.3.3 Cross Elasticity of Demand
Two goods may be related to each other in two ways.
1. when two good are used at the same time to fulfill the demand for
example car and [Link] goods are complementary goods
2. They can replace each other and are close sustitute ie tea and coffee.
The cross elasticity of demand measures the responsiveness of demand for
one product to the change in the price of another [Link] example if the
price of tea goes up the demand for coffee will increase.
Ce= percentage change in the demand of X product÷percentage change in the
price of Y product.
Ce= ∆dx/dx÷∆py/py
Ce= ∆dx/∆py÷dy/dx
Activity 1
a) Meaning of elasticity of demand.

b) Price elasticity of demand

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Notes

c) Income elasticity of demand

3.4 Measurement Of Elasticity Of Demand

Following are the different methods of measurement of elasticity of demand.

3.4.1. Total out lay method
3.4.2 Prcentage method.
3.4.3 Point elasticity method.
3.4.4 Arc method.
3.4.1 Total Outlay Method
Prof. Marshal had given this [Link] it is to be found out whether the total
expenditure is less, or more ,or equal to the original expenditure. If expenditure
is more than the previous expenditure then elasticity is greater than one or
elastic demand; if the expenditure is less than the previous expenditure then
the elasticity is less than one , in other words it is in elastic or less elastic
demand, If it equal to the previous expenditure then elasticity is unity.

ÎOriginal
ǾÒŊÒŌMÕ Price Rs. Quantity Total outlay Elasticity of demand
Rs.2 Demanded Rs.20 ___
10
I change 4 5 Rs.20
1 20 Rs.20 Pe=1

11 change 4 4 Rs.16
1 24 Rs.24 Pe>1 elastic demand
111 4 6 RS.24 Pe<1
Change Inelastic demand
1 16 Rs.16

The above table clearly explains the elasticity based on total expenditure.

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3.4.2 Percentage Method Notes

Price elasticity can be stated in the form of changes in percentage
Pe= percentage change in quantity demanded/ percentage change in price.
Pe= % ∆q/ %∆p
If the answer is more and positive and greater than 1 that is elastic demand
If the answer is less and negative and less than 1 it is inelastic demand.
If it is equal to 1 then it can be called elastic or inelastic demand.
3.4.3. Point Elasticity
Here elasticity is represented by fraction distance froma point on the line
drawn between the axis

P2

P
P1
0 x
B

Fig. 3.6

Point elasticity=Lower segment/upper segment

Therefore point elasticity= L/U=PB/PA
If PB is greater than PA then it is elastic demand and if it is less thanPA
then it is inelastic demand And if it is equal then elasticity is unity

3.4.4 Arc method

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3.4.4 Arc method Notes

If elasticity is to be measured over some portion of the demand curve rather

than at a point then the concept of Arc Elasticity is to be used

Arc method uses the mid points between the old and the new at time of
data collection in the case of price and quantity demanded

Arc elasticity=∆q/∆p * p1+p2/q1+q2

P1= original price, P2 is new price

Q1 is original quantity demanded Q2 is new quantity demanded.
Intial price P1=10/- and new price is =12/-and original quantity is Q1=100
and new quantity is Q2=90
Thendq is-10 and dp is2
Therefore the elascity is -10/2*10+2/100+90
=0.57 it means inelastic demand

3.5 Application Of Elasticity Of Demand In Decision Making

Taxation Policy
The finance minister has to decide how to increase the revenue to run the
government so he will tax those goods and services which have inelastic
deman. If he does so the poor will suffer and the welfare of the poor will be

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affected.. Hence the finance minister has to take a middle course of action Notes
where welfare and tax burden on the poor is not [Link] he will choose
those goods and sevices for increasing the tax which are consumed by the rich
and give subsidy to the poor.
Pricing of a Product
Here the producer of the product would like to know about the elascity of
demand of the [Link] he finds that the product has elastic demand he will
keep the price low and sell more. If his prodect has inelastic demand he can
keep the price at higher level and earn more profit. He will also study various
markets and set the price of the product based on elasticity and charge
different prices in different markets.
International Trade
This concept is allways used in international trade while deciding the terms of
trade between the two countries. If the product demand is inelastic the
exporter will charge higher prices . For example the prices of crude oil are
increasing day by day still the demand is increasing If the product has elastic
demand the exporter will keep the prices of the products low and sell more for
example the prices of the chineese goods are kept low and they are able to
compete in the market better and sell more

This concept is useful in the theory of distribution indicating diiferent

shares of the factors of production. During heavy demand of labour
they demand higher wages because their demand is less elastic.
This is useful to demand higher wages by the trade union when the
product produced by the unit has elastic demand the labour can
demand higher wages.
This concept is useful to the policy makers and expalins why the
farmers remain poor despite bumper [Link] more quantity the price
has to kept low to sell the stock of grains

3.6 Factors Deterimining Elasticity Of Demand

Necessaries and convetional necessaries and nature of commodity
the demand is alwys inelastic.
Luxurious good demand is elastic.
Demand for substituteable goods the demand is always elastic.
Goods having several uses the demand is elastic for example the use
of electricity, which always depends upon price.
Joint demand, the demand is less elastic. Example is car & petrol.

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Goods the use which can be postponed has elastic demand. Notes
Level of income spent on the product is very less it has inelasic demand
such as demand for tooth brush, tooth paste soap.
Time period. In case time is short the demand is inlastic for example a
person is to be taken to the hospital the demand for conveyance is
inelastic whereas if the is longer then the demand will be elastic.
Habit forming products have inelastic demand. The user of drug, liquor
etc.
Activity no.2
b) Methods of measuring elasticity of demand.

c) Low elasticity of demand is useful to the finance minister.

d) Effect of time factor on elasticity of demand

3.7 What Is Forecasting Of Demand

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It is an estimation of level of demand of a product in future. It is necessary part Notes

of business because a businessman has to plan to arrange finance, space,
manpower, raw material etc. The businessman has to decide the investment in
inventories. Major deciaions in the large firms are related with the forecasting
of demand of their product. For this forecasting should be acurate or near one
and this will help the firm to produce the product efficiently and at a lower cost
and it helps the firm to meet the market demand effi[Link] also help in
reducing the risk arising out of uncertainty and changes in the market.
The businessman can estimate the future course of action to meet the demand
for the commodity. Forecasting of demand is done for a short period that is for
a year or for a long period that is for 5 years.
3.7.1 Technique of Forecasting
While adopting the the technique it is desireable to consider cost factor,time
factor,and accuracy.
More accurate forecast needs complex data ,which is expensive and needs
more resources like finance, manpower and also the length of forecasting
period along with the cost and benefit.
The techniques ae divided in two categories
a) Qualitative technique and
b) Quantitative technique

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Notes

Qualitative Technique Chart 3.1

1. Opinion Poll which consists

a) Expert opinion method also known as DELPHI method,
b) Consumer survey method which has
i) Complete enummeration survey method,
ii) Sample survey,
iii) Opinion method based of sales staff
iv) End use method
a) Expert opinion
The experts who know the market ,are consulted. It is collective wisdom of
the top executives who give their ideas and estimation of the demand of the
product. If the opinion of several experts based on consensus of all is taken
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this will reduce the personal biases. A specialised form of panel opinion is is Notes
adoptd in Delphi method. Under it an attempt is made to have consensus on
estimation of demand of the products by questioning a group of experts
repeatedly until their responses appear in a single line. This method was
developed by Rand corporation of USA and is being used successfully in area
of technological product [Link] is used in USA and European countries
to estimate the demand for technical [Link] method is very popular in
USA and Europe
b) i) Complete Enumeration Survey Method
This method is also known as opinion polling. In this method all the
consumers of the product are interviewed and information regarding
their consumption of the product is collected. On the basis of this
information estimation is done for the [Link] method has many
advantages
1. It is accurate since all the consumers are approached
2. It is simple and is not affected by personal biases
3. It is based on collected data
But it some disadvantages that is
1. It is costly and time consuming
2. It is useful only for a product with limited number of consumers.
3. It is difficult and practically impossible to survey all the consumers.
b) ii) Sample survey
From the consumers only a few of them are selected and their ideas
are taken and demand is forecasted. But this method requires that the
sample should be representative. The sample will be small and less
costly and less time consuming. It also reduces the riskof error in data.
If used carefully it gives excellent result.
But this has limitation that is being based on only a few consumer
the opinion may not be appliclable and it may not be reprsentative.
b) iii) Opion Poll of Sales Staff
This is used to collect the information from the sales staff such as salesmen
who have direct contact with the dealers of the commodity. The salesmen are
expert and are expected to estimate sales in their operative [Link] is
collective wisdom of sales department and top executives. It is simple and
useful for short period forecasting and less [Link] is easy to collect the data
from their own staff. But this methods have some disadvamtages such as
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changes in the consumers' taste and preferenc are changing and the sale Notes
force may not give the real picture
b) iii) End Use Method
This method is used for sector wise or area area wise demand. The product
may be final or intermediate but this is used for the end users of the product.
Milk is a commodity which can be used as an intermediary good for the
production of ice cream, cheese and many other dairy products.
This method has certain advantages:-
It yields accurate forecast .
It provides sectorwise demand forecast for different industries and is more
useful for producers' goods.
But the disadvantage that it requires complete and diverse calculation and it is
more time consuming.
Industries data are not readily available.
Quantative Methods
1. Barometric method
2. Time series analysis
Regression method & corelated method.
1. Barometric Method
In an economy there are always turning points from inlation to recesssion this
method studies the turning point from one economic time series to another
time series by [Link] economic indicators are used which are
divided in to three categories.
a) Leading indicators
b) Coincident indicators
c) Lagging indicators
The corelation between two time series differs if the second series data are
ahead or move behind or move along with the first series data. If it moves
ahead of the first series it is known as leading series, while the first series is
called lagging series. If the second series moves along the first series it is
called coincident series
For example eartthquake in Jan 2001 led to the destruction of property and
required reconstruction of buildings this created huge demand for cement,
steel and other commodities. Here construction of building is the leading
indicator or barometer
Barometric analysis is a simple method and predicts directional changes, but it
fails to recognise the magnitude of [Link] it is difficult to find out
the leading indicator for any series. This method can be used for short term
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only, Notes
2. Time Series Analysis.
It has four categories. Trend, Seasonal variation, Cyclical variation and
random fluctuation Trend analysis can be studied from past data that is how
the changes in demand was moving from one period to another.
Seasonal variation. As the season changes the demand of certain goods
changes and so is the [Link] demand of woolen clothes increases in
winter season.
Cyclical [Link] variation are always there in a free economy that is
in the form of inflation, deflation,recession , and depression. This is caused by
changes in the economic activities in the form of trade cycle.
Random fl[Link] the demand changes due to natural calamities like
earthquakes, flood, famine and so on which affects the demand of different
products.
3. Regression Method
Here we have to go back and study how a factor helps in determining the co-
relation (co-efficient of co-relation) in forecasting of [Link] gives the line of
best fit as the equation goes Y=a+bx here we need past data and functional
relationship is established between the variable with the help of regression.
Once a relationship is established it is possible to project this into future
demand
3.7.2 Forecasting of Demand For A New Product
Joel Dean has suggested the following methods to forecast the demand of a
new product.
A) Evolutinary Method Many new product are evolved from already
established product for example demand for colour TV is based on the
demand for black & white TV
This method has some limitations.
a) The new product should have been evolved from the existing product.
b) It ignors the problems of showing how the new product differs from the
established product.
B) Substitution Method
Some new product are substitute of already established product for example
New LCD tv are substituteable of already established colour Tv. But this has
some limitations too
a) Some new products have many uses and each use has a different
substituability so forecasting becomes diffi[Link] the case of a computer we

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find different configerations and better support with less cost. When a non- Notes
sustitute is added the existing firms react in a different ways ( change in price,
more expenditure on advertisement) to cater to the demand for the new
product.
A) Growth Pattern Method
If there is some relationship between the new product and already
established product this method is useful. This method requires the study of
the demand pattern of the old product and the pattern of growth of the old
product will be useful for the new product
1. Opinion Polling Method
Individuals are not sure of their purchase. In this method the
consumers are contacted directly seeking their opinion by sample
survey. When a new drug is introduced the doctors are contacted and
their opinion is gathered about the drug and on the bases of the
information, forecasting of demand of that product is done.
Opinion poll method has some limitations.
a) Individuals are not sure of their purchase.
b) It is difficult to contact all the consumers.
c) It is costly and is useful for a short period.
2. Sales Experience Approach
In this method, the new product is put to sale in a sample market and
the response of the people is noted along with the reaction of the
consumers to the new product and estimation for the future demand is
done. Joel Dean has advised to combine more than one of the methods
1. Uses of Forecasting of Demand
· Production planning
· Sale forecasting and promotional efforts
· Control of business it means well conceived budgeting, cost
and profit.
· Inventory control.
· Growth and long term investment programme.
· Stability in production and employment.
Economic planning and policy making.
Activity no.3
a) Discuss the usefulness of forecasting of demand.

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Notes

b) Briefly discuss any two qualitative methods of forecasting of demand.

3.8 Summary
Elasticity of demand is the responsiveness of demand to change in its price
determinant. Price elasticity of demand is the responsiveness of demand for a
product with the change in its price. Elasticity of demand may be elastic or less
elastic. It is necessary to measure the effect of price on the demand of the
product ie.∆q/∆p×p/q.
Income elasticity of demand shows the effect of change in income of a person
and change in the demand of various products. Cross elasticity of demand
gives the idea of relationship of close substitute. e.g. if the price of coke is
increased the demand for Pepsi will increase depends on elasticity of demand.
We also get the idea of usefulness of the study of elasticity of demand in
business decision and the government decision regarding taxation and public
expenditure We also have learnt various factors which help to determine
elasticity of demand. In the second half we have studied the idea forecasting of
demand. Also we have study various techniques of forecasting. These are very
useful to guide the businessmen to take decisions. It is helpful in planning,
mobilization of resources etc. to meet the future demand.

3.9 Key Words

Consumers' survey: In this method consumers are contacted
personally to disclose their purchase plan in future.
Delphi method: A kind of expert opinion method for forecasting. it

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uses a series of questionnaires to obtain a consensus forecast. It is Notes

used for technical goods forecast.
Leading indicators: The variable whose movement precedes the
movement of some other related variable.
Opinion poll: A forecasting methods in which the whole population or
its sample are surveyed to determine the trends in deman
Trend projection: A method where trends are projected from the past
data.

Ø Elastic demand means a small change in the price of a product

changes the demand of a product more.
Ø Inelastic demand means a high fall in price may increase the
demand slightly or not at all.
Ø Income elasticity of demand. An increase or decrease in the income
of a person will increase or decrease in demand of a product.
Ø Cross elasticity when the price of a product increases, the demand
for its close substitute will increase.
Ø Survey to know the intention of the consumer in buying of a
particular product.
Ø Barometric depends upon the turning point from one economic time
series to another time series by observation.
Ø Theory of distribution gives the idea of the share of land, labour,
capital and entrepreneur in the national income.
Ø Inventory stock of finish, semi finish goods, raw material, spare
parts and other related items for production.

3.10 Self Assessment Questions

1. Explain the concept of elasticity of demand.

2. Differentiate between elastic demand and inelastic demand.
3. Explain different kinds of elasticity of demand.
4. Explain the concept of price elasticity of demand, income elasticity of
demand and cross elasticity of demand.
5. Study of elasticity of demand is useful in business decision making.
6. Discuss various methods of demand forecasting.
7. Forecasting of demand is useful in decision making in business.
Quiz :
[Link] surplus is
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o Difference between the maximum price a consumer would be willing Notes

to pay and the actual price.
o Difference between highest and lowest price
o Difference between ceiling and floor price
o Difference between cost of production and market price
Q2. Continuity in consumption is prerequisite for:
o Law of diminishing marginal utilities
o Revealed preference
o Indifference curve analysis
o Marginal rate of substitution
Q3.. Which one is not an indicator of barometric technique?
o Lagging indicator
o Leading indicator
o Coincidence indicator
o Smoothing indicator
[Link] in consumption is prerequisite for:
o Law of diminishing marginal utilities
o Revealed preference
o Indifference curve analysis
o Marginal rate of substitution

3.11 Further Readings

Dr. [Link] Managerial Economics
Dr. [Link] Managerial Economics
Prof. Joel Dean Managerial Economics
Dr. Mukund Mahajan Managerial Economics

3.12 Model Answers

Activity no.1
a) Responsiveness of demand for a product when its price changes. If
demand is more responsive, it is elastic demand and if it less
responsive then it is inelastic or less elastic demand.
b) Percentage change in quantity demanded caused by a percentage
change in price.
c) Percentage change in quantity demanded caused by a percentage
change in income.
Activity no.2
a) 1) Total outlay method. 2) Percentage method. 3) Point method
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b) The finance minister has to raise revenue by taxation. He will tax those Notes
goods and services which have inelastic demand.
c) Time factor decides the elasticity of demand. If time is short the demand
will be inelastic and if time period is long it will have elastic demand.
Activity no.3
a) Forecasting of demand is very important for business because they
have to plan for future and arrange for the resources if demand is expected
to rise.
b) Two qualitative methods are 1) Opinion poll method. 2) Delphi method.

Quiz :
Q1. Difference between cost of production and market price
Q2. Indifference curve analysis
Q3. Coincidence indicator
Q4. Marginal rate of substitution

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Notes
CHAPTER 4

PRODUCTION ANALYSIS

Learning Objectives
After going through this unit, you will be able to:
Define the role of fixed factors and variable factors.
Define the role of fixed factors and variable factors in the short run
and in the long run.
State that the fixed factors are not fixed in the long run, but all
factors are variable.
Draw the idea of law of diminishing return, increasing return, and
constant return.
Explain the law of variable proportion.
Judge when to stop production during different stages of
production.
Explain the idea of return to scale.

Structure
4.1 Introduction to production analysis
4.2 Factors determining production in short term and long term
4.3 Law of Return
4.3.1 Law of Variable Proportion
4.3.2 Law of Diminishing Return
4.3.3 Law of Increasing Return
4.3.4 Law of Constant Return
4.4 Return to Scale
4.5 Summary
4.6 Keywords
4.7 Self Assessment Questions
4.8 Further Readings
4.9 Model Answers

4.1 Introduction
We are going to give you the idea of Production Function. This concept is very
important in managerial economics in decision making.
· Production Function is a function that specifies the output of a firm for all
combinations of inputs. It gives the idea of relationship between inputs (various
combinations of factors of production) and maximum output. It states the
amount of product that can be obtained from every combination of factors and
is based on the most efficient available method of production.
· Production function is the flow concept because it relates to the flow of inputs
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and resulting flow of output of a commodity during a period of time. Notes

· Production function shows relationship between inputs and outputs, but
does not focus toward least cost combination or output maximization.
· A firm may not survive, if it does not utilize resources effectively and
economically so a firm has to be cost effective in the long run.
· By production we mean transformation of inputs to outputs. So production
function is relationship between inputs and outputs and it stresses on
maximization of output from any input. It also means minimum inputs to yield a
given quantity of output.
· A production function refers to the functional relationships under given
technology between rates of input of productive services and the rate of output.
It can be shown as under:
Q= f (a,b,c,…..n,T) Q is the function of a,b,c…..n and T
Q= quantity
A,b,c,n, represent the quantities of various inputs per employed time period. T
refers to prevailing rate of technology.
This equation is applicable in the long run.
In a simple form it can be represented as:
Qx= f(K,L )
Qx is the rate of output of commodity X per unit of time. K refers to the units
of capital used per worker. L is labor unit employed per unit of time.
This equation is used for a short period but for a very short period the equation
will be:
Qx= f (L)
It means that production can be increased by employing more labour since
fixed assets are fixed. So production function reveals various combinations of
different inputs resulting into desired output.
These combinations should be cost effective and should give maximum
results.
Practical importance of Production Function
a) P.F gives idea of optimum level of output and employment of variable
inputs. So we have to find out optimum proportion between fixed and
variable inputs which will give us more production at lower cost.

b) It guides the management about budget constraint for increase in

output.
c) It tells us the degree of substitution and complimentary of different

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factors of production so that a firm can fix expansion path. Notes

d) It explains why the rewards to different factors differ and the rate of
growth of industrial growth differs in all countries.
e) The theory of PF explains the possibility of disguised unemployment,
when a factories employed but it gives ZERO marginal production. It
shows the need of diversion of surplus labor to other field.

4.2 Factors Determining Production In Short Term And Long Term

Here we shall consider the time element and production function. Time
element shows the functional or operational time period relationship. Time
element is to be considered for short run and long run.
4.2.1 The short period
The short period is defined as a period of time over which the inputs of some
factors of production cannot be varied. These factors are called fixed factors
in the short run.
So in the short run some factors are fixed and some factors are variable.
Fixed factors are plant, machinery, equipments, building etc. These factors
are fixed for a short run. So in the short run the output can be increased, with
the help of variable inputs, if produced with a given scale of production and size
of the plant and this remain unchanged. But in the short run output is varied
only by changing variable factors like labour, raw material power and other
inputs.
For Example a unit has a machine. It has the capacity of producing 100 units a
day. The demand has increased so the owner employs intensive methods to
use the fixed factors that is more labor and raw materials and put the workers
on 3 shifts so the production can be raised to 300 units and he cannot produce
more than that since it has the fixed factor i.e. machine, which has the limited
capacity .If the demand still increases he has to put up a new plant to meet the
extra demand.
So we can say that in the short run, some of the factors remain fixed and some
factors are variable. The output can be increased only by increasing the
variable factors and intensive use of the fixed factors.
4.2.2 The Long Run
The term long run is defined as a period of time long enough to permit variation
in the inputs of the fixed factors of production. There are no distinction between
fixed factors and variable factors of production. All the factors become variable
factors.
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The size of the fixed assets such as plant, machinery, equipments are fixed in Notes
the short period. But these factors become variable in the long term. So in the
long run there is a full scope for adjustment between factors of production in
the production process. In Heavy industry like steel, chemicals the capital
equipments, machinery, which are used, are very complex and sophisticated
.It needs several years to erect a plant. Any rise in demand could be met only
by intensive use of existing plant capacity and by employing more labor and
capital etc. But if demand persists then a new plant has to be installed to meet
the increased demand. So the adjustment takes a long time
Very Long Term
When very long term is to be considered we have to give due consideration to
new, sophisticated and latest technology which has to be introduced and
production function itself will changed.
Activity no 1
a. State with example variable factors.

b. Explain the idea of fixed factors.

c. Fixed factors are fixed for short run but not for long run. Discuss.

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Give your opinion regarding input factors in very long run. Notes

4.3 Laws Of Returns

Before we take up the laws of return, certain concepts required to be

cleared. This will simplify the idea further.
a. Total physical product or total quantity of product. It means total
quantity of output produced by the physical unit of a firm during the
period of time. It increases as input increases.
b. Marginal product
It means the change in total output as a result of one additional unit of variable
factor employed in combination with fixed factor.
M.P = ∆TP/∆variable factor unit. ∆ indicates a small change in total output
and input.
M.P.= MPn=TPn-TPn-1
Average product
A.P= TP/Variable factors unit
The above concepts can be made easy as under

Table no 5.1

When we employ 2 unit of labor the

Average product is=3000/2=1500
When we employ 4 unit of labor we get =3800/4=950
Marginal product at 2 unit= 3000-2000=1000
And at 4 unit is=3800-3500=300

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Notes

Graph 4.1

4.3.1 Law of Variable Proportion

This is modern version of the law of diminishing return. The three laws of
returns are:
a) Law of diminishing return
b) Law of increasing return.
c) Law of constant return.
These are only three aspects of one law viz. Law of variable proportion
It is stated as under:
“As the proportion of one factor in combination of other factors is increased
after a point the average and marginal proportion of that factor will diminish”.
Prof. Samuelson “ An increase in some inputs relative to other fixed inputs will
in a given state of technology, causes output to increase but after some point
the extra output resulting from the same addition of inputs will become less.”
Assumptions
· Only one factor is varied and all other factors should remain constant.
· The scale of output does not change and the production plant or the size of
the plant and efficiency of the firm remain constant.
· The technique of production does not change.
· All the input factors are homogeneous.
Table no.4.2
Following table and graph will make the law clear

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ILabor
MNŎǾ(i.e. No of
of Workers) Total Product
Product Marginal
Marginal Product
Product Average Product
Notes

1 80 80 80

2 170 90 85

3 270 100 90

4 368 98 92

5 430 62 86

6 480 50 80

7 504 24 72

8 504 0 63

9 495 -9 55

10 480 -15 48

Graph no.4.2

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After seeing the table and the graph of Law of variable proportion we can Notes
say that
th th
Up to 7 unit of input some addition is made in production but at the 8 unit
th th
nothing is added and at 9 and 10 it is negative.
rd
Law of diminishing return is applicable. Up to 3 unit of input production is
th
increasing and it is high at the 4 unit of input. Now it starts falling due to
th
insufficient input and at 8 unit it is ZERO. Total output is maximum when
marginal output is zero.
Total production goes on increasing till it reaches the maximum where the
third stage begins.
Marginal return reaches the maximum the earliest and starts diminishing
and this is the first stage of production.
Average production starts diminishing next when second stage begins.
The third stage starts when M.P is zero and nobody is going to operate in
this stage. During the second stage AP is greater than the MP. It is also
clear that the total output curve is the steepest where marginal output in the
largest.
The first stage ends where the AP curve reaches its highest point.
Stage no.1 is known as the stage of increasing return because AP of the
variable factors increases throughout this stage. Here MP increases but in
the later part and it starts declining but remains greater than AP. So AP
continues to rise.
· In stage no 2 TP continues to rise and reaches maximum .Then here the
second stage starts and AP & MP fall. This is the stage of diminishing
return. At this stage the entrepreneur would like to make maximum use of
the fixed assets.
· The increase in both MP and AP has two implications.
a) Addition in the variable inputs can lead to more than proportionate
increase in the output.
b) There is no optimum utilization of the fixed factors.
4.3.2 Law of Diminishing Return
The law of diminishing return was explained with reference to agriculture. It
was studied with in relation to land, which was kept constant while other factors
were increased. A farmer knows that if he doubles the application of labour and
capital in the cultivation of land, the output would be less than double. Here a
given piece of land is kept constant and other factors are variable. Initially the
output may increase and be more than proportion but ultimately the output will
start diminishing. It is applicable in both intensive and extensive cultivation
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Prof. Marshall “An increase in capital & labor applied in the cultivation of land Notes
causes in general a less than proportionate increase in the amount of produce
raised unless it happens to coincide with an improvement in arts of
agriculture.”
Doses of input 1 labor + 1000/- capital (In quintal)

ŇŎŒÑŒ Total return Marginal return Average return Result

1 80 80 80 First
2 170 90 85 Stage
3 270 100 90 I.R
4 368 98 92
5 430 62 86 Second
6 480 50 80 stage
7 504 24 72 DR
8 504 0 63
9 495 -9 55 Third stage
10 440 -55 44 Negative stage

From the table above we find that as our input increases total output increase
th
in absolute term till 7 unit but after sometime the output increases but at
diminishing rate and at the end it becomes negative.
But this law has some limitations as under:
a) When barren land is brought under cultivation.
b) When earlier less capital/labor is applied.
c) When new technology is introduced.
During limitation the law will not apply initially but it will operate after achieving
the maximum output
But ultimately the law will apply, may be after some time. The law applies in
every field of production i.e. industry, agriculture, mining, fishery etc. In
Industry we find that this law applies also. The main idea is that if one of the
factors is kept constant and other factors are variable this law hold good. We
find an industrial unit which has been expanded becomes difficult to manage
and this leads to inefficiency and increase in the cost of production.

4.3.3 Law of Increasing Return

It gives the idea of increasing return to scale that means any increase in input
will lead to a greater relative increase in the output. The law of increasing
return means lowering of marginal cost as industry expands.
This increasing return is the result of internal economies of scale such as labor
economies, management economies, and technical economies. This
happens with the expansion of the size of the firm. This increasing return is due
to improvement in large scale operation, division of labor, use of highly
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to improvement in large scale operation, division of labor, use of highly Notes

sophisticated machinery, better technology. We find that big malls are able to
sell goods at a cheaper rate and their cost of inputs also is reduced due to large
scales economies.
For Example if one table is produced, it may cost Rs.1000/- but we produce two
tables then the average cost may be Rs.900/- each but we produce more and
more average cost per table will go down till all the fixed factors are used. So
we call this law as law of decreasing cost and increasing return
4.3.4 Law of Constant Return
Under the law of constant return any increase in inputs will increase the output
proportionately. For example if the input is increased by 5% the resultant
increase in output will be of 5% only. So the cost per unit remains unchanged.
This happens in case where an industry is subject to increasing return due to
economies of scale and it is also subject to decreasing return due to
diseconomies of scale. This is generally applicable to Blanket industry. The
wool the raw material is subject to decreasing return and machinery along with
labor is subject to increasing return. So law of constant return applies here.
Activity.2
a) Explain the concepts of marginal product, average product & total
product.

b) Explain the idea of return to scale.

c) The law of variable proportion has the combination of three Laws of

return.
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d) If MR is zero, whether the businessman should continue to produce Notes

Explain.

4.4 Returns To Scale

Here we study the affect of long term changes in input and how output
responds in the long run to the changes in the scale of the firm, when all the
inputs are increased in the same proportion say by 10% and how does the
output change.
Here there are three possibilities.
a) If output increases by more than an increase inputs that increase in
output is more than 10%.It will be the case of increasing returns to
scale.
b) If output increases by less than the increase in inputs ,then it is the
case of decreasing return.
In the third case output may increase by exactly by the same proportion as
inputs that means doubling of inputs may lead to doubling of output. This is
case of constant return to scale.
Increasing return to scale is caused by indivisibities of fixed factors which are
of minimum size. The indivisibility of machine should be employed with the
level, size and capacity etc. of variable factors which are associated with the
fixed the fixed factors as more and more of variable factors are used along with
the fixed factors (Machine) it will give more return till the capacity of the
machine is fully utilized.
Decreasing Return starts when the fixed factors are fully utilized and any
further production by increasing variable factors will bring decreasing return.
This is due to difficulties in co-ordination and control.
Constant Return when the proportionate of input increases and the output
also increases in the same proportion, this is the case of constant return.
Here internal and external economies are balanced

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Graph 5.3 Notes

4.5 Summary

A production function gives the idea of inputs and outputs relationship. The
managers need to select various inputs, their combination and out puts with a
view to have minimum cost and maximum output. Selection of inputs-outputs
combination with minimum cost is the function of the manager.
Further the idea of law of diminishing marginal return gives the idea that, if one
factor of production is kept constant and other factors are variable, the output
will increase but at diminishing rate.
Similarly we have studied the relationship between total product, average
product, and marginal product. In law of variable proportion we studied three
stages of production. Stage I
Where MP>0 & MP>AP
Stage II where MP > 0 but MP < AP
Stage III where MP<0
Here stage II is desirable. The profit is maximized where the value of
MP=the price of output.
We have also given the idea of Return to Scale and about increasing return,
constant return and decreasing return.

4.6 Keywords
Average product: Total product ÷number of units of inputs.
Marginal product: The change in output resulting from a unit change in
one of the firm's variable input.
Total product: the firm's output for a given level of inputs used.
Short run period of time for which the one factor of production is variable
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& all other FOP are fixed. Notes

Long run period of time for which the rate of Inputs are all variable and
there is no fixed factor of production.
Production function: The maximum quantity of good or service that can
be produced by a set of inputs. It is classified as short run and long run
production function.
Inputs: The resources used in production process. In economic analysis
involves two inputs th at are capital (Fixed) and labor (variable).

Quiz:
Q1. Which of the following is an example of a capital input?
a. Money.
b. Shares of stock.
c. Long-term bonds.
d. A hammer.

Q2. Which of the following is an assumption associated with the definition of a

production function?
a. Technology remains constant.
b. Both inputs and outputs are measured in monetary units.
c. The function shows the maximum level of output possible with a given
combination of inputs.
d. All units of the inputs are homogeneous.

Q3. The output elasticity of labor is

a. equal to one at the level of output where average product is at a maximum.
b. the percentage change in labor required to produce one more unit of output.
c. equal to the ratio of total product to the quantity of labor employed.
d. a measure of the percentage change in output that can result when the
quantity of labor is held constant.

Q4. The point of inflection on the total product curve corresponds to the level of
output where
a. Stage II of production begins.
b. average product is at a maximum.
c. marginal product is at a maximum.
d. All of the above are correct.
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Q5. The law of diminishing returns Notes

a. is reflected in the negatively sloped portion of the marginal product curve.
b. is the result of specialization and division of labor.
c. applies in both the short run and the long run.
d. All of the above are correct.

4.7 Self Assessment Questions

a) State the law of diminishing marginal return as applied to production.
b) An AP curve and the corresponding MP curve must intersect at the
maximum point on the AP curve. Discuss.
c) MP is greater than (less than) AP when AP is rising/falling. Give reasons.
d) Define return to scale. State the importance of increasing, decreasing and
constant return to scale.
e) State the law of variable proportion by showing the three stages of
production.

4.8 Further Readings

Dr. [Link] Managerial Economics

Dr. [Link] Managerial Economics
Prof. Joel Dean Managerial Economics
Dr. Mahajan Mukund Managerial Economics

4.9 Model Answers

Activity No.1
1. Variable factors of input are those which help in the production of
output. These are labor, raw material etc.
2. Fixed factors are fixed capital invested in machines, plant, equipments.
These factors have some capacity beyond which more production
becomes difficult.
3. Fixed factors are fixed for a short only because these have limited
capacity and any further production can only be done by intensive use
of variable factors and fixed factors are not fixed for a long period.
4. In very long period new inventions, innovations, inventions play a
very important role and the production function will be changed.
Activity no.2
1. See the key words for marginal, average and total product.
2. When we approach at zero marginal products, we enter in the third

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stage of production, where the businessman starts losing hence Notes

nobody like to produce further.
3. Law of variable proportion starts with the law of increasing return in the
first stage, then the law of diminishing return operates in the second
stage where the firm is still making profit and then it enters the third
stage where the unit is in negative stage.
Quiz :
Q1. Long-term bonds.
Q2. The function shows the maximum level of output possible with a given
combination of inputs.
Q3. a measure of the percentage change in output that can result when the
quantity of labor is held constant.
Q4. Stage II of production begins.
Q5. is reflected in the negatively sloped portion of the marginal product
curve.

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Notes
CHAPTER 5

COST ANALYSIS

Learning Objectives
After going through this unit, you will be able to:
Learn various types of cost concepts used in cost analysis.
Learn various factors that determine cost.
Analysis relationship between the short term output and long term
output.
Learn about economies of scale and diseconomies of scale.
Learn the idea of Break Even point.
Structure
5.1 Introduction to coast analysis.
5.2 Cost concepts
5.2.1 Actual cost and opportunity cost.
5.2.2 Explicit and implicit cost.
5.2.3 Fixed and variable cost
5.2.4 Total cost, Average cost and marginal cost
5.2.5 Short run and long run cost.
5.2.6 Private and social cost.
5.3 Short run and long run output relation
5.4 Economies of scale.
5.4.1 Economies of scale. Internal economies and External economies of
scale
5.4.2 Diseconomies of scale - Internal diseconomies and external
diseconomies of scale
5.5 Concept of Break Even analysis
5.6 Summary
5.7 Keywords
5.8 Self Assessment Questions
5.9 Further Readings
5.10 Model Answers

5.1 Introduction
In unit no.4 we have already discussed with the idea of:
· Variable and fixed factor of production.
· Input and out- put relationship.
· The role of fixed and variable factors in the short run and in the long run.
In this unit we will explain various cost concepts and explain the relationship
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between cost of production and output. You will also learn about various cost Notes
curves. Further you will learn about Break Even analysis.

5.2 Cost Concepts

The idea of cost of production is very important because he has to find out his
cost of production and the prevalent price of the product in the market so that
he can judge his profits.
5.2.1 Actual cost and Opportunity Cost.
Actual cost is the cost paid by the firm for labor, material, plant, building,
machinery, equipment, and transport etc. All these payments are recorded in
the account books of the firm. This concept comes under the accounting cost.
Opportunity cost. Opportunity cost is very important cost concept used in
business decisions. The opportunity cost is related to scarcity concept. It can
be explained as the return expected from second best use of the resources
which is forgone for availing the gains from the best use of the resources now.
For example a firm has to invest some amount. The firm has two option one
is to buy a printing machine costing Rs.20, 000/ or to buy a lathe machine
costing Rs.15, 000/-. If the firm decides to buy printing machine, the firm
loses the opportunity of buying lathe machine. Hence the opportunity cost
will be 20,000-15000=5000/- but this choice depends upon economic profit.
Investing in printing machine is preferable so long as it economic profit is
greater than zero. If the firm has the knowledge of economic rent of various
choices, there would not have been a problem but choice of the best
investment is a problem.
5.2.2 Explicit cost and implicit cost.
Explicit costs are those costs which are found in the books of accounts.
These costs are also called paid out cost or actual cost. The payments paid on
account of wages, salaries, raw material. Fees and taxes, interest, rent, power
charges etc.
Implicit cost These costs do not involve any cash payment and do not appear
in the accounting system. It can be defined as the earning of owner's resources
employed in the business in the form of capital investment, own premises used
for business, own services used in business instead of hiring a manager. So
these implicit costs include implicit wages, implicit rent, and implicit interest
etc. Implicit costs are not taken into account while calculating the profit or
losses of the business.
5.2.3 Fixed and variable cost

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Fixed costs are known as supplementary costs and indirect costs. These Notes
costs are on volume for certain given output. Fixed costs are not variable with a
certain level of output. Fixed costs are
a) Managerial and administrative staff.
b) Depreciation of machinery, building and other fixed assets.
c) Costs on plant, building, land etc. And other fittings.
These costs are fixed for a short period. These costs have to be incurred even
if the plant is closed for a short period.
Variable costs
These are also known as prime costs, and direct costs. These costs vary with
production, so it is the function of output. Variable costs are:
a) Cost of Raw materials.
b) Direct labor costs.
c) Running cost of fixed capital assets such as fuel, oil, lubricants,
repairs, maintenance expenditure and all other input costs.
d) Taxes, indirect taxes such as excise duties, sales tax, value added
tax, octroi duty etc.
5.2.4 Total, Average and Marginal costs
Total cost: This cost includes all the values of resources used in production of
goods and services. All explicit and implicit costs are included i.e. include
labour cost, capital, land and opportunity cost, that means all variable cost and
fixed costs are included in the total cost.
Average cost: is obtained by dividing the total cost (TC) by the total output (Q)
i.e.
Average cost= TC/Q .
Marginal cost (MC) is the addition to the total cost on account of producing
one additional unit of a product. For example if to produce 10 units total cost is
th
100/- and if 11 unit is produced and the total cost is 109/- then the marginal
cost is 9/- It can be shown as
∆TC ÷∆Q ∆ means a small change in TC and Q
5.2.5 Private and social cost
Private cost and public costs: These can be considered at micro and macro
level. The micro level economic costs are those which are generated by the
decisions of the firms , but are paid by the society and not by the firms, for
example if a firm expands its output it will lead to increase in the costs of the
firm these will be known as private cost . But this will also lead to certain costs
to society in the form of greater pollution, greater congestion etc. These costs
are external to the firm. These costs are also called social costs from the

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society's point of view. Private costs are those which are actually incurred or Notes
provided by an individual or by a firm for its business activities. Whereas social
costs are the total costs to the society which are incurred on account of
production of goods and services.
Some of the private costs are paid out or provided by the firm and other cost are
not paid by the firm but by the society The firms manufacturing paper and pulp
are discharging the affluent in the river. This causes water pollution It may also
cause air, and sound pollution the costs of which are paid by the society. It may
lead to health problems, and the society suffers Net social cost is total social
cost minus private cost.
Activity .1
a) Fixed cost and variable cost vary with output. Discuss.

b) In the short run Average cost and marginal cost are important to decide
the output.

c) Concept of opportunity cost.

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5.1 Short Run And Long Run Cost Factors Notes

Cost function and production function are important to study.
Cost function is important because it has to allocate the scarce resources for
production and also to fix the prices of the output taking in to consideration the
profit margin.
Production function studies the output by utilizing minimum inputs to get
maximum output. The firm chooses the combinations of inputs which gives
desired output by least cost combination.
5.3.1 Short run costs have two aspects; a) Fixed cost b) Variable cost.
The firm can vary its output by varying only the amount of variable factors such
as labor and raw material.
In short run the fixed factors such as capital equipments, machinery, plant,
management personals cannot be varied .If a firm wants to increase the output
it can do so only by overworking the existing plant or using the plant intensively
and by hiring more workers and buying more raw materials. Here only the
variable factors can be varied and not the fixed factors. But In the long run it is a
period of time during which output can be increased by varying the fixed factors
as well as variable factors. In order to meet increase demand it can put up a
new plant, new machinery and increase the capacity to produce.

Table.5.1 Short Run Cost of Production of a Firm

Col. 1 is showing the units of output

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Col.2 gives the fixed cost since it is fixed for a short period. Notes
Col.3 shows the total variable cost which goes on increasing as output
increases.
Col.4 shows the total costs that is col.2+col.3 i.e. total fixed cost+ total variable
cost.
Col.5 shows Average Fixed cost that is Col.2 ÷col.1. This cost goes on
decreasing as output increases.
Col.6 shows average variable cost that is col.3÷[Link] cost goes on
declining in the beginning due to economies of scale and starts rising due to
diseconomies of scale. Here the AC cost is declining up to 4th unit of output
then it starts rising.
Col.7. shows average cost that is col.4 ÷col.1. Or add col.5, col.6. This cost
goes on declining till it reaches the minimum and then it starts rising. Here AC is
declining till 4th unit and then starts rising.
Col.8. Marginal Cost (MC) is the additional cost of one extra unit produced.
This cost is declining till 3rd unit of output and then it starts rising.

Graph.5.1 Cost Curve

OUTPUT
Here T.F.C. remains constant for all units of output. When we want to
increase output we have to employ variable factors in the form of raw
materials, labor, and other consumable. When there is zero output total
variable cost is Zero. This cost increases with the increase in output. This
increase is not constant but in different proportions.

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Cost Curves Notes

Graph.5.2 Cost Curve

As production increases AFC goes on decreasing because more number of

unit will share TFC .It becomes somewhat parallel to the X axis but it will not be
Zero or touch X axis and it will remain positive.
AV cost first declines then it starts rising due to diseconomies of large scale of
production. AC is obtained by adding AFC+AVC. This is per unit cost. At first
the AC is high due to large fixed cost and small output. As output increases the
FIXED cost goes on decreasing because it is now shared by larger quantity of
output. This is caused due to internal economy and fuller use of indivisible
factors. Later on AC goes on rising due to diseconomies of scale and it gives
the curve U shape. So AC curve are always U shaped.
Marginal cost curve
In the beginning MC curve is declining and under the AVC curve and it starts
rising rapidly and bisects the AC curve from below at the lowest point. It rises
steeply because of diseconomies of scale.
Relation between Average cost and Marginal cost
a. When AC falls MC follows. But the rate of fall in MC is greater than that of
AC, because decreasing MC is due to a single marginal unit while in case of AC
the decreasing AC is distributed over the whole output.
b. When M.C. increases A.C also increases but at a lower rate. Further M.C. is
increasing while A.C. is falling.
c. M.C. intersects A.C. at the minimum point and where M.C. =A.C.
Optimum firm is the firm when A.C. is the minimum as at point M in the fig.
above. This is optimum level of output. If output is less than QO, the resources

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of the firm are under - utilized. If the output is more than OQ then the firm is Notes
over utilizing the plant.
Optimum output and cost curve
In the short run, optimum level of output is the one which can be provided at a
minimum Average cost, given the technology. The minimum level of AC is
determined by the point of intersection between Average Cost and Marginal
cost curves... At this level of output AC=MC
Here AC is the minimum. If production is less than this point or more than this
point the output will not be OPTIMAL
Here a point to be noted that optimum level of output is not necessarily the
Profitable output. In order to know the profit we should know firm's revenue
curves.
5.3.2 Long Run Cost Output Relation
The long run period is long enough to enable the firm to vary all its inputs i.e.
plant, machinery, equipments building and space. The firm is not tied to a
particular plant capacity. The firm can move from one plant capacity to another
plant capacity due to increase in demand of its product; similarly if the demand
persists the firm may put up another plant or expand the existing plant. In the
long run all costs are VARIABLE and no cost is fixed. Since new machinery,
plants can be added easily.

In The Long Run Firm Changes Production Level In Response To

(Expected) Economic Profit or Loss.
In the long run there are no fixed cost and all factors are variable as to reach
long term minimum average cost. So expansion of plant and investments in
equipments is a long term operation. So the long run cost curve will be a
composite of several short run cost curves. One each curve for a different plant
size. In each of the short run AVERAGE COST curves we can have each AC
curve for each different plant.

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In the fig. 5.3 above, AC1 curve has optimum point when the output is OM. Notes
Further when output is increased the optimum point is Omi and here the AC
cost is lesser than that at OM because of economies of scale and at output Mii
here again AC is higher due to diseconomies of scale.
When all these minimum average costs curves of all the plants are joined
we can get LAC (LARGE RUN AVERAGE COST CURVE), as shown in fig,
below

Fig. 5.4 LAC Curve: An Envelop

Long term AC curve is also called ENVELOPE CURVE and planning curve. It
guides the firm for planning to expand for production in future. We can say that
long term AC CURVE is a series of plants AC curve plants which are installed to
increase production. Hence we have to study AC curve and MC curve for each
plant. In the fig SAC1, SC2, SC3 are short run Average cost curves at the
optimum level of out and by joining the optimum points of each plant we can
draw LAC curve.

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Notes

Fig.5.5 As the productions increase a new set of plants is installed

STC1, STC2, and STC3 and at the tangency point we get LTC.
In fig2 we get the LMC &LAC Being tangents to Sac1, sac2 and sac3 here
again we find M.C.= A.C. This happens when law of constant return applies.
In figure above we have LAC enveloping at the points on SAC1, SAC2, SAC3,
SAC4.
Also we find MC curve interest the sac1 at the lowest and so are the others but
these curves show quantity Q1, Q2,Q3,and the MC at Q1 is mq1 at Q2 MC is
q2A and at Q3 MC EQ3.
If we join all the points of MC curve we can get long term Marginal cost curve.
Activity no.2
a) Explain short run average cost and marginal cost and discuss their
relationship.

b) How a firm reaches its optimum level.

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Notes

c) In the long run all costs are variable. Discuss.

5.4 Economies Of Scale

The scale of production has important bearing on the cost of production.
Larger the scale of production lower is the average cost of production. This low
cost is the result of economies of scale. These economies are classified as
internal and external economies
5.4.1 Internal economies
These economies are available to an individual firm which is related to
production and only the firm is benefitted when it expands its output or
enlarges its scale of production.
These economies are
a) Technical Economies
I. Large machine. A bigger boiler/ furnace having greater productive capacity
reduce the operating cost.
ii. Linking process: A large plant usually enjoys the linking of processes, a
dairy having its own feeder farm can reduce its cost similarly a sugar mill can
have its own paper making unit/alcohol making unit.
iii. Superior technique. A big newspaper can use Rotary machine, which can do
the work quickly and reduces the cost. Increased specialization and division of
labour. Specialists and experts are employed whose guidance can help the
unit reducing the cost and make the unit more efficient and productive.
b) Managerial Economies A large scale unit can manage a big unit by
adopting the policy of delegation of power, grouping of establishments on a
scientific way. The company hires the services of professionals and experts.
But the small unit can be managed by a manager hence it does not have the
benefit of reducing the cost.
b) Commercial Economies of Scale are in the form of
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Purchase of raw material. Notes

Sales of goods
Larger power in bargaining in buying and selling.
Freight concessions.
Cheap credit from banks.
Prompt delivery, careful attention. Proper treatment of customers.
Research and development that leads to innovation and inventions
Material testing.
It can raise capital easily by selling shares in the market. These are
having wider reputation in the market.
d) Financial Economies. Large scale unit enjoys financial
facilities in the form of letter of credit. Terms of credit, discounting of
commercial papers etc. from the financial institutions.
e) Risk bearing Economies
Risk is spread over and it can be eliminated. It can diversify source of
raw material, diversify market and process of manufacturing.
Internal economies can be classified as REAL economies and
pecuniary economies.
Real Economies arise from reduction in the physical quantity of
inputs. There may be economies in Production, Marketing, Managerial
due to specialization or decentralization in decision making and
mechanization (computer).
The large firm enjoys transport and storage economies also.
Pecuniary Economies: These economies arise from lower prices of
input, lower interest rate, lower rate of advertising, low transport cost.
External Economies
The meaning of external economies is the situation when the gains are
accruing to all the firms in an industry due to growth of the industry. It is
caused by expansion of industry as a whole such as availability of new
and cheaper source of raw material, tools, machinery, discoveries,
diffusion of superior technical knowledge and trade journals etc. These
economies are enjoyable by all the firms irrespective of their size.
External economies are due to advantages of localization of industry in
a local area for example hand loom; power loom industries are located
in Solapur, Malegaon, and Panipat.
So the external economies are:
a. Economies o f Localization Here skilled labor, better transport,
credit facilities, benefits from subsidies, common stock of knowledge,
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and stimulation of improvements are available to all units. Notes

b. Economies of Information A large growing industry can bring out
trade and technical journals. These are accessible to every firm. Many
associations come up and encourage research, disseminate technical
knowledge to the other firms. It also enlightens the industry about fiscal
policy of the government etc.
c. Economies of Disintegration some of the jobs can be given to some
other efficient subsidiary industry .Paper and pulp manufacturing units are
bifurcated. The paper manufacturing units are near the market and the
pulp manufacturing unit is established in the remote areas near the raw
material. Economies of Bye Product A large industry can make use of
waste material for manufacturing bye products. For example sugar
industry can use sugar cane juice for making sugar and it has waste like
bag gasses, and molasses which the industry can convert in to paper,
cardboard and molasses can be used for manufacturing industrial alcohol.
d. Economies of Bye Product A large industry can make use of waste
material for manufacturing bye products. For example sugar industry can
use sugar cane juice for making sugar and it has waste like bag gasses,
and molasses which the industry can convert in to paper, cardboard and
molasses can be used for manufacturing industrial alcohol.
5.4.2 Diseconomies of Scale
Diseconomies of scale can be classified in to
a) Internal diseconomies of scale
b) External diseconomies of scale
a. Managerial Inefficiency
Difficulties of Management: With expansion of a firm the problems of
management increase. After a point a manager finds it difficult to control the
unit. Personal contact with the subordinates and workers is lost. This leads to
impersonal relationship; similarly communication between owner/ manager
and workers gets rapidly reduced. There is no close supervision or control.
This creates rift between management and workers. Further there is lack of co-
ordination among various departments. There is no co-ordination between
workers, management and customers. The management becomes
bureaucratic.
Labor Inefficiency: These diseconomies are the cause of external
diseconomies such as natural constraint in agriculture, extractive industries.
Since all the firms are expanded naturally the concessions etc. given to the
larger firms are withdrawn. Non availability of skilled labor the management
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has to employ raw labour. Since input cost begins to rise the final product Notes
becomes costly.
Difficulty in Decision Making: The firm cannot take quick decision because
of dynamic market conditions; any quick decision to be taken by the firm needs
consultation with the various departments which delays the decision, Hence
the firm may incur losses.
Increased Risk: When scale of production increases investment also
increases so also the risk of business. To bear greater risks it is an important
limitation to the expansion of the size of the firm. An error in judgment may
bring losses to the firm.
b. External Diseconomies
Labor Diseconomies: Extreme division of labor may result in lack of initiative
and drive in the executive personals. Hence a large firm has to adopt
bureaucratic way of administration. This leads to impersonal relationship
between management and labor. This situation may lead to grievances and
industrial unrest.
Scarcity of Supply of Factors of Production: With the expansion of
business and concentration of business in a locality there may be a shortage of
skilled labour force, shortage of raw material. This will increase the cost of
production.
Neglect of Individual Taste Due to mass production, individual taste is
ignored.
Possibility of Depression: Due to un-coordination among the various firms
regarding production, there may be over production .This may lead to
depression. Over production is one of the main causes of depression
Cut throat Competition : price war and increasing advertisement expenditure
will lead to increase in the cost of production and lower the profitability.
Dependence on Foreign Market; With the expansion of business the firms
have to depend upon the foreign market for raw materials and marketing of
their product .Any war or political disturbances in any country will affect the
business in our country.
Lack of Adaptability: It is the common complaint about big business house
that they find it difficult to adapt with the new situation

5.5 Break Even Analysis

Break even analysis (BEA) is very important concept for economics research,
business decision making, company management, investment analysis and
public policy. It traces relationship between cost and revenue at every level of
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output. The breakeven point is located at that level of output or sales at which Notes
the net income or profit is ZERO. Here the total cost = total revenue and there is
no profit. BEA traces relationship between cost, revenue and profit at varying
level of output
TC=TR
So at B.E.P. is the point where the level of output and the level of revenue is
equal to the cost of production and marketing.
Fig BEP

In the fig. above if a firm produces less than OQ it will incur losses because the
cost will be higher than the revenue. In case the firm produces OQ quantity
here at point B, the cost and the revenue are equal and if production is
continued then the firm starts making profit. Every firm desires to reach BEP at
its earliest so that it can start making profit
BEP=TFC÷(P-AVC)
=Total Fixed cost/ price-Average variable cost.
P-avc= contribution margin per unit
Example
a) Fixed cost=Rs20,000/-; Variable cost= Rs.4/- per unit : selling
price=Rs8/- per unit
So BEP = 20000/8-4=5000 units
So the total cost is FC=20000/- + V.C 4×5000=20000 so the total cost
is Rs.40,000/-
Total Revenue = 8×5ooo=Rs.40,000/-
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So there is no profit and no loss. Notes

A firm has to know the value of sale required to achieve that point the
earliest so that the firm starts making profit.
b) If certain amount of profit to be obtained then we have to use the
following formulae
Volume of sale necessary= Fixed cost + profit (Target)/marginal
contribution per unit.
F.C.= Rs.15000/and profit target is Rs.5000/-
S.P=Rs.5/- V.C.=Rs.3/-
So in order to get target profit of Rs.5000/-
=15000+5000/2=10000 units
So the firm is to produce 10000 unit to get target profit of Rs.5000/-
c) If a firm wants to know the safety margin. The formulae is =sale-
BEP/sales ×100
Here we have to find the BEP =FC/margin contribution per
unit=15000/2=7500 units
Now sale is 10,000 unit BEP=37500
Safety margin= 10000×5-37500/50000=12500/5000=25%
A firm cans afford to lose sale up to 25% without any loss So BEP is very
important concept and useful in decision making of a firm. It is useful in pricing
policy, sales projection and capital budgeting.
Activity no.3
a) Explain the idea of internal and external economies.

b) Discuss various factors which lead to diseconomies of scale with

expanding of production.

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c) The study of Break Even point is necessary for every business man. Notes
Discuss

5.6 Summary
a) The concepts of various costs are made clear since these concepts are
very useful in managerial economics and firm's decision making.
b) The ideas of total cost, average cost, marginal cost, average fixed cost, and
average variable cost are made clear.
c) Further we have explained how these cost curves are interrelated. We have
discussed the concept of marginal cost and average cost and their
importance in decision making.
d) The idea of short run and long run cost is made clear with the help of figs
and tables.
e) Economies of scale and diseconomies of scale are explained in details and
how these affect the cost of production.
f) Finally you have learnt the idea of break even analysis. Every firm is
desirous to reach the BEP at earliest. After breakeven point the firm starts
making profits. And till BEP the firm is not making any profit

5.7 Keywords
AFC - Fixed cost per unit of output.
A.T.C. - (AC or ATC) Total cost per unit of output.
AVC - Variable cost per unit of output.
Economies of scale - The reduction in unit cost as the firm increase its
capacity. It is long run phenomena.
Economies of scope - The reduction in cost resulting from the joint
production or two or more products or services by the same firm.
Diseconomies of scale- As the firm increases its capacity the
management cannot exercise the same supervision or control and it
reduces coordination among various departments
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Historical cost - The cost which has been incurred in the past activity. Notes
Marginal cost (MC) - The cost to a firm of producing an additional unit of an
output.
Opportunity cost - The amount or subjective value foregone in choosing
one activity over the next best alternative.
Total cost - Total cost includes total variable cost + total fixed cost.
Total fixed cost - The cost that remains constant as the level of output
varies. It is short run analysis. Fixed cost is incurred even if the firm
produces no output.
Break Even analysis - It indicates the level of output and sales at
which cost and revenue are equilibrium.
Breakeven point - It is the point of zero profit.
Margin of safety - The excess of budgeted or actual sales over the
breakeven point.

5.8 Self Assessment Questions

1. Distinguish between:
a. Prime cost and supplementary cost.
b. Explicit cost and implicit cost.
c. Marginal cost and Average cost.
2. Explain the concept of opportunity cost.
3. Why short run cost curves are U shaped.
4. Discuss the cost and output relationship in the short period.
5. Meaning of Break Even point.
6. Explain the idea of economies of scale and economies of scope
7. Reasons of Diseconomies of scale.

Quiz :
Q1. Which of the following is a variable cost?
a. Interest payments
b. Raw materials costs
c. Property taxes
d. All of the above are variable costs.
[Link] the output levels at which short-run marginal and average cost curves
reach a minimum are listed in order from smallest to greatest, then the order
would be
a. AVC, MC, ATC
b. ATC, AVC, MC
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c. MC, AVC, ATC Notes

d. AVC, ATC, MC
[Link] curves represent the relationship between
a. average variable cost and the number of units produced per time
period.
b. average variable cost and the cumulative number of units produced.
c. total cost and technology.
d. average variable cost and the rate of increase in technology.
Q4. Short-run marginal cost is equal to
a. the change in total cost divided by the change in output.
b. the change in total variable cost divided by the change in output.
c. the cost per unit of the variable input divided by the marginal product of
the variable input.
d. all of the above.
Q5. Short-run average variable cost is equal to
a. total variable cost divided by output.
b. average total cost minus average fixed cost.
c. the cost per unit of the variable input divided by the average product of
the variable input.
d. all of the above.
Q6. Which of the following short-run cost curves declines continuously?
a. Average total cost
b. Marginal cost
c. Average fixed cost
d. Average variable cost
Q7. The law of diminishing returns begins at the level of output where
a. marginal cost is at a minimum.
b. average variable cost is at a minimum.
c. average fixed cost is at a maximum.
d. None of the above is correct..
Q8. he long-run average cost curve is at a minimum at a level of output where
a. the firm is experiencing constant returns to scale.
b. it is equal to long-run marginal cost.
c. the long-run average cost curve is tangent to the lowest point on a short-
run average total cost curve.
d. all of the above occur.
[Link] a firm has a downward sloping long-run average cost curve, then
a. it is experiencing decreasing returns to scale.
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b. it is experiencing decreasing returns. Notes

c. it is a natural monopoly.
d. marginal cost is greater than average cost.

5.9 Further Reading

1. Dr. [Link] Managerial Economics

2. Dr. [Link] Managerial Economics
3. Prof. Joel Dean Managerial Economics
4 .Dr. Mahajan Managerial Economics

5.10 Model Answers

Activity no.1
a) Fixed cost is fixed during short run because investment in machine,
plant, building etc is fixed. Even if there is no production. Variable cost
varies with production. It is in the form of Labor, raw material, power
and other consumables. If there is no production this cost will be nil.
And it varies with production.
b) Average cost and marginal cost are important because the firm will
make maximum profit or minimum loss when AC=MC. Hence it is
important to decide whether production to be continued or not.
c) Opportunity cost. The amount or subjective value foregone in choosing
one activity over the next best alternative.
Activity no. 2
a) AC is defined as TC/ Q It mean total cost divided by the number of unit
produced.
MC =∆TC÷∆Q It shows the extra cost incurred for the production one
more unit. A.C starts falling first with the increase of output and MC also
falls. But when AC is still falling MC starts rising and where these are
equal this is point out output which will bring maximum profit.
b) A firm is at optimum level when its average cost is minimum or the
lowest.
c) In the long run all costs are variable. In short term the plant, machinery
is fixed and production can be done to its capacity. If demand increases
then new plant, machinery etc have to be installed to meet the excess
demand. So in the long run all cost is variable.

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Activity no. 3 Notes

a) The main idea of internal economies and external economies are to
reduce the cost of production. Internal economies consist of a)
Economies of production; b) advantages of division of labor; c)
economies on marketing; d) managerial economies; e)economies in
transport etc.
b) Factors responsible for diseconomies with expanding output
Diseconomies of scale are caused because of managerial inefficiency.
Labor problem, increase cost of raw material and employment of
unskilled workers Breakeven point analysis is very important for
economic research, business decision making, company
management, investment analysis etc. It traces the relationship where
the firm starts making profit after the breakeven point.

Quiz :
Q1. Raw materials costs
Q2. MC, AVC, ATC
Q3. average variable cost and the number of units produced per time
period.
Q4. the change in total cost divided by the change in output.
Q5. the cost per unit of the variable input divided by the average product
of the variable input.
Q6. Average fixed cost
Q7. average fixed cost is at a maximum.
Q8. it is equal to long-run marginal cost.
Q9. it is a natural monopoly.

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Notes
CHAPTER 6

SUPPLY ANALYSIS

Learning Objectives
After going through this unit, you will be able to:
Learn the meaning of supply of various goods and services and the
meaning of stock.
Learn the law of supply and its exceptions.
Learn about the shift in the supply curve.
Explain the idea of elasticity of supply.

Structure
6.1 Introduction
6.2 Stock and supply
6.3 Determinant of supply
6.4 Law of supply & exception to the law of supply
6.4.1 Meaning of supply
6.4.2 Law of supply
6.4.3 Exceptions to the law of supply
6.5 Shift in the supply curve
6.6 Elasticity of supply .
6.6.1 Elastic Supply.
6.6.2 Inelastic supply.
6.6.3. Measurement of elasticity of supply
6.7 Summary
6.8 Keywords
6.9 Self assessment Questions
6.10 Further reading
6.11 Model Answers

6.1 Introduction To Stock And Supply

In last unit we have given the idea of elasticity of demand and forecasting of
demand. These two concepts are very essential in the study of Managerial
[Link] we shall be studying the idea of supply of goods and services
along with the idea of stock. Our demand will remain unsatisfied without these
two concepts. We shall be dealing with the law of supply and determinants of
supply. Further you will become aware of increase and decrease in supply of
goods and services.

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You will also learn the idea of elasticity of supply. Notes

6.2 Stock And Supply

The supply of goods is the quantity offered for sale, in a given market at a given
time at various prices. So it is defined as the amount of that commodity which
the sellers are able and willing to offer for sale at a particular price during
certain period of time.
Supply is relative term. It is referred to in relation to price and time.
Stock is the total of supply of a commodity which the seller is prepared to sell if
price is up to his expectation. If price offered is less the seller's expectation he
would bring a little of the supply. So stock is the determinant of supply and
stock is known as potential supply.
· Supply comes out of stock.
· Stock determines the potential supply.
Stock is the outcome of production. By increasing production the stock
can be increased as well as the potential supply will increase.
For example Mr. X gets 50 ltrs of milk from his cow. The price is Rs.30 a liter. He
takes out only 30 liter of milk to supply. One day he finds that the price of milk
has gone up to Rs.40/- per liter. He sells the whole stock of 50 liter of milk that
day. So we can say when the price was less he supplied only 30 liter of his
stock but when he got good price he brought the whole stock in the market.

6.3 Determinants Of Supply

Supply is dependent on many factors so
SS=f( Pn,Pr,F,T,G)
Pn = price, Pr= price of related goods
F = price of factors (Input prices) T = Technical knowhow
G= Goal of the producer.
Price of the product. When there is an increase in the price of a product its
supply also increases.
The cost of the factors of production. If the cost of any factor of production
goes up or goes down. It will affect the supply. If the wage rate goes up the
cost of production will increase and it will reduce the supply.
State of technology. Advanced technology increases the supply of the
product and reduces its cost. Most of the inventions and innovations in
electronic, chemistry and other sciences have increased the supply of
various products and have also brought down the cost. Cell phone is

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example where it has become necessary in life of man and cost has gone Notes
down and supply has increased.
Tax & subsidy. Here the government plays an important role. Tax on a
commodity will increase the cost of production. Hence the supply will be
reduced. Similarly subsidy provided by the govt. will give incentive to the
producer. This will reduce the price and will increase supply.
Factors other the economic factors will also affect the supply. For example
weather condition, flood, drought, war and disturbance due to political
reasons will affect the supply of goods and services.
Transportation and communication. Development of transport and
communication system will increase the supplies of goods and services.
Any breakdown in transport system will reduce the supply. Industry
depends upon raw material which is brought from other parts of the country
and different part of the world.
Scale of production. If large scale production method is adopted it will
increase the supply and the cost will less. If small scale production method
is adopted then the cost will be more and supply less .Multinational
companies can provide goods and services at lower cost with ample
supply because these are operating on a very large scale.
Mobility of factors of production. If factors of production are free mobile it
will increase the supply of goods and services.
Goals of the firm also affect the supply of goods and services.

6.4 Law Of Supply And Exceptions To The Law Of Supply

6.4.1 The law of supply gives the idea of the tendency of the sellers in offering
their stock of a commodity for sale in relation to change in prices. Supply is a
relative term of price and time. If the price is higher supply will increase. If
price is less supply will be less.
6.4.2 “other things remaining unchanged, the supply of a commodity
expands (rises) with a rise in it price and contracts (falls) with a fall in price.”
It means supply of a product will increase when the price rises and it falls when
the price falls. So supply varies directly with the changes in price. So a larger
amount is supplied at a higher price than at a lower price in the market. So
supply is the function of price.
SS=f (p) and supply varies directly with price

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Table.6.1 Supply Schedule Notes

Supply curve slopes upward from left to right

Other things remaining unchanged means that means the following

things should remain constant.
· No change in the cost of production / technique of production
· No change in the Size of the firm..
· Communication and transport system should be constant.
· No change in govt. policy.
· No change in prices of all goods
· No change in climate/ weather etc.
6.4.3 Exception to the law of supply
a. Control of the market by a few sellers under Monopoly, oligopoly.
b. Rare articles.
c. Inelastic goods.
d. Agricultural goods.
e. Future expectations.
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f. Goods on auctions Notes

g. Supply of labor as wages go higher and higher.

Activity No.1
a) Supply depends upon price. Explain.

b) Differentiate supply and stock.

c) State and explain some exceptions to the law of supply.

d) Describe the factors which affect the supply of food grains.

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e) Explain the effect of technology on the supply of a product. Notes

6.5 Shift In Supply Curve / Increase Or Decrease In Supply

Shift in the supply curve is due to price but other factors such as development
of new methods of production, govt. policy which relaxes the norms and tariffs
if Shift can be on the right side of the curve or on the left side of the curve. If the
shift is on the right side it is called increased in supply and if the shift is on the
left side of the curve it is called decrease in supply

Graph 6.2

S1 move toward right S3 it is called increase in supply.

S1 moves to left and to S2 it is called decrease in supply.
These shifts are caused by many factors i.e. development of technology,
scale of production and many other factors for example mobile phone, Laptop
etc the technology has increased its supply at reduced costs.
Any situation of famine or draught may decrease the supply of the product.
There is also the idea of extension in supply and contraction in supply which
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is caused by the movement of price. If price falls supply will be contracted Notes
(reduced) but if price raises supply will be extended (Increased).

6.6 Elasticity Of Supply

Elasticity of supply is a measure of the way in which a quantity supplied

responds to a change in price. If the price has risen the supply will also
increase and there is fall in price the supply will decrease.
6.6.1 Elastic Supply = A small increase in price leads to a larger increase in
output, i.e. supply
6.6.2 Inelastic supply = small increase in price causes a little change in the
supply of a product. Here we can give the example of antics and old
pictures etc.
6.6.3. Measurement of elasticity of supply.
Supply elasticity=proportionate change in quantity supplied / proportionate
change in price.
Se = ∆q/q÷∆p/p
Se = ∆q/∆p× p/q
Se =Elastic supply; ∆q =small change in quantity.
∆p= small change in price; Q= quantity; P = price
Degree of price elasticity of supply
E=∞, E=0, E=1, E>1, E<1

Graph.6.3

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Notes

Es=0 When the price is not affecting the supply, where there is no possibility to
increase the supply such is the case with rare articles, old paintings etc. There
is no supply price for these goods.
Es<1 this is inelastic supply. In this case the changes in price increase or
decrease will affect the supply but the effect will be very small.
Es>1 Elastic supply and elasticity is greater than one. Here if the price falls
supply will decrease much and if price raises supply will increase very
much.
Es= ∞ it means price has no effect on the supply of the [Link] supplier
is prepared to supply any quantity of the commodity on the prevailing price.
Activity no 2
a) If a supply curve shifts to the right , explain the effect of it on supply

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b) If a supply curve shifts to the left, what happens? Notes

c) Explain the idea of measurement of elasticity of supply.

d) Give some idea of inelastic supply with example.

6.7 Summary

You have learnt the difference between stock and supply. The meaning of
supply is, the quality that is offered at a given time and at a given price. You also
have learnt the law of supply. The law of supply tells you that a fall or rise in
price of a product will leads to fall or rise in the supply of goods and services.
Supply varies with price.
Further we have explained the exceptions to the law of supply. You have learnt
various factors which affect the supply of a commodity. Elasticity of supply
reflects the response of the supplier with a given rise or fall in supply and with a
given rise and fall in price.
We have also given the idea of measurement of elasticity of supply.
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6.8 Keywords Notes

Supply: Means the quantity of goods which are offered for sale at a given
price and at a given time.
Stock: Potential supply of a commodity.
MNC: Multinational companies which deals in many countries with huge
investments
Tax: Compulsory contribution made by the residents of a country to the
govt. to meet the cost of running the govt.
Subsidy: It is the assistance given by the govt. to economic sector,
agriculture sector or poor section of the society.
Elastic supply: When supply is very responsive to the change in price.
Inelastic supply: when supply is less or least responsive to price.

6.9 Self Assessment Questions

a. Explain the law of supply with its exceptions.

b. Describe various factors which determine the supply of a commodity.
c. Discuss the idea of elasticity of supply with illustration.
d. How to measure elasticity of supply?
e. Draw a supply curve with elasticity of supply is zero. Give the example.
f. Draw a supply curve with unitary elasticity.
g. Explain increase and decrease in supply.

Quiz :

Q1. The market supply curve shows

a. the effect on market demand of a change in the supply of a good or service.
b. the quantity of a good that firms would offer for sale at different prices.
c. the quantity of a good that consumers would be willing to buy at different
prices.
d. All of the above are correct.
Q2. During a recession, economies experience increased unemployment and
a reduced level of activity. How would a recession be likely to affect the market
demand for new cars?
a. Demand will shift to the right.
b. Demand will shift to the left.
c. Demand will not shift, but the quantity of cars sold per month will decrease.
d. Demand will not shift, but the quantity of cars sold per month will increase.

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Q3. Unionized workers may be able to negotiate with management for higher Notes
wages during periods of economic prosperity. Suppose that workers at
automobile assembly plants successfully negotiate a significant increase in
their wage package. How would the new wage contract be likely to affect the
market supply of new cars?
a. Supply will shift to the right.
b. Supply will shift to the left.
c. Supply will not shift, but the quantity of cars produced per month will
decrease.
d. Supply will not shift, but the quantity of cars produced per month will
increase
Q4. If automobile manufacturers are producing cars faster than people want to
buy them,
a. there is an excess supply and price can be expected to decrease.
b. there is an excess supply and price can be expected to increase.
c. there is an excess demand and price can be expected to decrease.
d. there is an excess demand and price can be expected to increase..
Q5. Market equilibrium refers to a situation in which market price
a. is high enough to allow firms to earn a fair profit.
b. is low enough for consumers to buy all that they want.
c. is at a level where there is neither a shortage nor a surplus.
d. is just above the intersection of the market supply and demand curves.
If the price of a good increases while the quanti

6.11 Further Readings

Dr. [Link] Managerial Economics
Dr. [Link] Managerial Economics
Prof. Joel Dean Managerial Economics
Dr. Mukund Mahajan Managerial Economics

6.12 Model Answers

Activity No 1
a. Law of supply is clear. This law states that if price of a commodity falls
quantity supplied will also be reduced and vice versa.
b. See 4.2 above
c. Exceptions to the law of supply are i) rare articles, ii) agriculture goods iii)
goods of auction

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d. Factors affecting supply of food grains are famine, drought, flood and Notes
sudden change in climate.
e. Technology increases the supply of a commodity and reduces its cost. For
example Mobile phone, computer, laptops etc.
Activity no 2
I. Shift of the supply curve to the right means increase in supply.
ii. Shift of the supply curve to the left means decrease in supply.
iii. Measurement of elasticity of supply means the relationship between
proportionate change in the price of a product and proportionate change in
the quantity supplied by the supplier. It is either elastic supply or inelastic
supply.
iv. In a vegetable market the supply of vegetables for a day is inelastic. Even if
the price is reduced supply cannot be reduced.

Quiz :
Q1. the quantity of a good that firms would offer for sale at different prices.
Q2. Demand will not shift, but the quantity of cars sold per month will decrease.
Q3. Supply will not shift, but the quantity of cars produced per month will
decrease.
Q4. there is an excess supply and price can be expected to decrease.
Q5. is at a level where there is neither a shortage nor a surplus.

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Notes
CHAPTER 7

PRICING PRACTICES

Learning Objectives
After going through this unit, you will be able to:
State the basis of pricing of different goods and services and
different methods of pricing
Define various pricing strategy followed by businessmen
Identify various pricing systems which are involve to fix the price of
a product
State the effects on pricing decision of a firm
Explain commonly used pricing methods in practice though devoid
of pricing theory but has an economic reason behind it.

Structure
7.1 Introduction
7.2 Factors involved in pricing policy
7.2.1 Concept of marginal cost prices
7.2.2 Cost plus pricing
7.2.3 Price leadership
7.2.4 Price skimming
7.2.5 Administrative prices
7.3 Summary
7.4 Self assessment questions
7.5 Keywords
7.6 Further readings
7.7 Model answers

7.1 Introduction
Pricing – In previous unit 7 you have learned about the market structure i.e.
firm and industry. How a firm and industry are in-equilibrium. You have also
learned the difference features of each market and how much they should
produce and at what price they sell to maximize their profits. Deciding pricing
policies is the most important role of managerial decision making. The firm has
to consider the cost of production, selling cost, production schedule, and
quality of the product.
In this unit how the prices of a product are fixed and what is the different
deciding factor which helps in pricing policy of a product. Pricing policy plays
the most important role of managerial decision making. The pricing have very
important role in the distribution of income in the society. The firm has to
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consider cost of production, selling cost, production schedule, and quality of a Notes
product. After considering all elements the firm has to decide the stagey of
fixing pricing of a product. Pricing policy is related to business objectives. The
factors prices are cost and it has to be minimized in order to earn maximum
profits.

7.2 Factors Involved In Pricing Policy

a) Cost of inputs and all explicit and implicit cost

b) Demand and consumer psychology
c) Competition in the market
d) Profit
e) Govt. policy
f) Demand of the people has to be studied and how the people will behave
when different prices are charged. It requires psychological studies of the
people.
g) Situation and condition of competition in the market has to be studied.
h) Every firm would like to earn maximum profit put before pricing its product, it
is necessary to know the disposable income, the purchasing power of the
people and their psychology.
I) Govt. policy is another factor which can affect the price. If Govt. decides to
give subsidy the prices of the product is reduced. For example the price of
cooking gas is being subsidized by the Govt. so it is sold at a lower price.
Further the taxes on goods and services will increase the prices.

Various Pricing Strategies

I. Marginal cost pricing

ii. Cost plus based in average pricing
iii. Penetration pricing
iv. Price leadership
v. Price skimming
vi. Administered pricing

7.3.1 Marginal Cost is the increment cost of production of an extra unit. The
firm should charge price which is equal to marginal cost. Marginal cost is
based on only variable cost. It is short term cost. Marginal cost concept is an
economics study but in business it is known as incremental cost. Marginal
cost can easily give us the idea of shut down point. The shut down point is
when the plan fails to cover even the average variable cost (AVC) and the price
is lower than average variable cost. In short period AVC may be above the
price. But in the long run (Average fixed cost) AFC + AVC have to be covered
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otherwise the unit will have to be shut down permanently If firms follow the Notes
marginal cost pricing it can put the firm in losses. So this is only a short term
concept when the price in the market is falling, but the price should be above
marginal cost otherwise the firm will have to be shut down.
If we study marginal cost pricing further we find that –
a) Marginal cost pricing is useful over the life cycle of the product
b) The firm having multi products, multi process, multi market firms, the
idea is full cost pricing which is absurd because different market,
different product, different process do not have equal input on the cost.
Marginal cost pricing has some limitation –
a) Increment cost pricing is useful for a short period and it can be used on
temporary basis
b) It does not guarantee that a firm will operate at breakeven point.
c) Sometime managers do not know marginal cost method of pricing.
But in spite of its limitation it can be used as under:
a) when a product is introduced in the new market
b) Firm facing stiff competition in the market
c) The firm has unutilized capacity. Mostly this method is used in
transport business by selling vacant seats at lower price in the
airlines.
7.2.2 Cost Plus pricing
It is called cost plus pricing or mark up pricing. . It includes total cost + selling
cost + some percentage of profit is added to the cost. It consists of variable
cost, fixed cost, fixed selling cost, administrative cost plus some added
percentage of profit. That will be price of the product –
Example
Fixed cost 20,000/-
Variable cost 30,000/-
Output 5000 units
Add 15% profit
So A.F.C = 20,000 divide 5000 = 4/=
A.V.C. = 30000 divide 5000 = 6/=
A.T.C= 4+6=10
Mark up price at 15% profit = 10 x 15% = 1.5
Mark up price=10.00 + 1.50 = 11.50
But this system has some draw back that is-
a) Market demand is not considered
b) Competitive forces are not considered
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c) It is based on unit cost which cannot help in fixing price. Notes

d) This system cannot apply to perishable goods.

Penetration Pricing –
If a firm wants to introduce a new product, the initial price of the product is kept
low to capture the market. There are some preconditions in the use of
penetration pricing:
(1) The market should be highly price sensitive and have high price
elasticity.
(2) Economics of scale, distribution; and ratio of variable cost to fixed cost
are low
(3) Low prices are likely to discourage competitors
(4) It should increase demand
(5) There is a heavy demand of the product
(6) The buyers are ready to pay higher price for the product
But this may lead to losses in the long run if continued for a long period.
Hence it is short term measure only.
7.2.3 Pricing leadership –
Price leadership is a situation where one firm is recognized as the leader of the
industry and all the other manufacturers follow and accept its pricing policy.
When one of the firms is very big, strong, has excellent brand image and have
very good sales. This industry will be the price leader. For example TISCO in
steel, Kellogg in cereals, Cadbury in chocolate, Hindustan lever in soap
industry etc are the price leader. This situation happens under oligopoly where
every firm is interdependent. So every firm has to follow the leader as these
firms are small. Every firm will keep an eye on the production and pricing policy
of the others.
7.2.4 Pricing skimming
Under this the price is fixed on the higher side and demand increases. But
before this policy is adopted it has to find out the large segment of people who
are having inelastic demand for the product and who are not sensitive to higher
prices. The products have low price elasticity of demand.
Secondly the unit cost relatively is unaffected by small volume of high ratio of
variable cost and fixed cost.
As the prices are high it is unlikely to attract competition. This enhances the
image of the product.
Here the example of mobile phone is suitable. In 1995 when mobile phone was
introduced in India the price was very high i.e. Rs 16/- for a call.

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7.2.5 Administered Pricing Notes

There are some products which are very essential for human consumption and
Govt. ensures that such products are available at a reasonable price to all.
The firm has to sell the product at the price fixed by the Govt. The main idea is
to control prices of essential goods and inputs. The public distribution systems
are those where fair price shops sell essential goods to public at the price fixed
by the Govt. Also Govt. follows dual pricing system one for the poor people and
the other for the rich. The price of sugar at ration shop is very less, which is
supplied to the poor people. The rich can buy sugar in open market at a higher
price. However, pricing of a product is based on the basis of the market
conditions and objectives of the firm. So this pricing system will enlighten you
about the way of pricing of various products and various factors which affect
the policies of pricing of the product.
Support pricing
Under this the govt. in order to control the exploitation of the poor farmers
announces the support prices of most of the agriculture products.
During the harvesting season a larger supply of agriculture produce comes in
the market and the market is flooded which brings the price of the product to a
low level and the merchants buy the produce at a lower price. This mean
exploitation of the poor farmers ,so the govt. declares the support price and
starts buying that produce at that price ,which is higher than the market price.
This helps the farmers. For example the govt. through Food Corporation of
India starts buying wheat at Rs.1100/- per quintal from the market during
harvesting season.

7.3 Summary
In this unit we have learnt the practical way of pricing of a product. The people,
who have no knowledge, try to fix the prices by rules of thumb. This practice is
based on the consideration of cost only and other related factors are not
considered such as demand condition or market competitiveness or some
other economic factors.
1. Cost plus pricing is very popular and based on full cost + some
percentage of profit. So the price includes AVC + AFC + net profit
margin.
2. Margin cost which is also accepted as incremental cost is used for
pricing. It considers variable cost and is able to give the idea of shut
down point when the unit is not able to recover its variable cost

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because price has gone down in the market. Notes

3. Administered price is ordered by the Govt. to make available essential
goods and services to the poor at a reasonable price. Similarly the
ideas of dual prices have also been discussed.
4. Skimming prices and penetration ideas have also been given to enable
you to know what these prices are. Hence the price is kept very low
and in other high.
5. Support pricing system shows the role of the govt. to control
exploitation of the poor farmers.

7.4 Self Assessment Question

1. Discuss various factors which affect the primary decision of a product

2. Discuss the uses and limitations of marginal cost pricing. How marginal
pricing is done?
3. Explain the method of cost – plus pricing and point out its limitations
4. Pricing is done on the higher side state under which pricing system.
Why this is followed?
5. Administered prices are essential to safeguard the interest of the poor
and to have proper distribution of essential commodities in to reach of
the poor.
6. Why the govt. announces the support prices. How does it help the
people?

Fill in the Blanks.

1. Marginal cost concept helps in knowing the shut down point.
2. Cost plus pricing is a simple way to fix the price
3. Govt. fixes the prices of essential goods in case of shortages to see
the welfare of the poor.
Quiz :
Q1. Carolina Berries manufactures many varieties of jams and jellies. An
increase in the price of their strawberry jam can be expected to
a. increase the demand for their strawberry jelly because the two are
complements.
b. increase the demand for their strawberry jelly because the two are
substitutes.
c. decrease the demand for their strawberry jelly because the two are
complements.

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d. decrease the demand for their strawberry jelly because the two are Notes
substitutes..
Q2. Which of the following is an example of price discrimination?
a. It costs more to make a long-distance phone call during the day than it
does late at night.
b. A ticket to the zoo costs less for a child than it does for an adult.
c. Regular gasoline costs less than premium gasoline.
d. All of the above are examples of price discrimination.
Q3. If there is no external market for an intermediate product, then the
transfer price should be set equal to
a. the marginal cost of producing the optimal quantity of the intermediate
product.
b. the marginal cost of producing the final product.
c. the selling price of the final product.
d. None of the above is correct..
Q4. Setting a high price when a product is first introduced and then
gradually lowering its price over time is referred to as
a. value pricing.
b. skimming.
c. price lining.
d. prestige pricing.
Q5. A pricing practice that requires buyers to purchase packages of different
goods and does not make the goods available separately is called
a. value pricing.
b. bundling.
c. a two-part tariff
d. skimming.

7.5 Keywords
Cost Plus Pricing - Here prices are calculated with the help of cost
(fixed+ variable + other cost) and mark up the price.
Penetration Pricing – Here a firm charges a lower price than that
indicated by economic analysis. The main aim is to enter the market.
Price skimming - When for a new product the firm charges a price higher
than that indicated by economic analysis.
Price leadership – One firm is recognized as the leader and all other firms
follow. It generally happens under oligopoly. The example is Cadbury in
chocolate. This firm fixes the price and other small units follow that price.
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Shut down point – When a seller is not able to recover his average Notes
variable cost and the price of the product is lower than average variable
cost.

7.6 Further Reading

1 Managerial Economics by Dr. HL Ahuja.
2 Managerial Economics by Dr. D.M. Mithani
3. Managerial Economics by Dr [Link]
4. Managerial Economics Joel Dean

7.7 Model Answers

Activity I
1 Marginal cost concept gives the idea that if any price is fixed at Marginal
cost level and if it is higher than the market. Then the unit has to be shut
down because of the losses.
2. In cost + pricing only all the costs are considered and some percentage of
profit is added and the price is decided.
3. When the prices are rising in the market and the poor suffer the govt.
fixes the prices of all essential goods and services to increase the
welfare of the poor.

Quiz :
Q1. increase the demand for their strawberry jelly because the two are
complements.
Q2. All of the above are examples of price discrimination.
Q3. the selling price of the final product.
Q4. skimming.
Q5. bundling.

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Notes
CHAPTER 8

FIRM INDUSTRY ANALYSIS

Learning Objectives
After going through this unit, you will be able to:
Define plant, firm and industry
Explain the objectives of the firm
State about price determination in a free competitive market
State about the market structure
Explain the main features of pure and perfect competition,monopoly,
monopolistic competition, Duopoly and oligopoly
Enumerate how equilibrium is achieved in each type of market i.e.
determination of output and cost / price

Structure
8.1 Introduction
8.2 What do you mean by plant, firm and industry?
8.2.1 Objectives of the firm
8.3 Price determination in the free market
8.3.1 Concept of equilibrium
8.3.2 Determination of equilibrium
8.3.3 Shift in the demand and supply curves
8.4 Types of Market
8.4.1 Pure and perfect competition and its features.
8.4.1 (i) equilibrium of a firm and industry under perfect competition
8.4.2 Monopoly and its features
8.4.2 (i) Equilibrium under Monopoly
8.4.2. (ii) Discrimination under monopoly
8.4.3 Monopolistic competition and its features
8.4.3 (i) Equilibrium under monopolistic competition of a firm and industry
8.4.4 Duopoly, oligopoly and their features.
8.5 Summary
8.6 Keywords
8.7 Self assessment questions
8.8 Further readings
8.9 Model Answers

8.1 Introduction
Under Unit No. 6 we have given you the basic idea of different cost concepts,

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and how costs will behave in the short run and in the long run. The break even Notes
analysis will give you the idea when a unit can start making profit and how
much to produce to reach that point at the earliest. In this unit we are going to
study the theory of the firm i.e. firm's decision analysis Behavior under different
market conditions such as perfect competition, Monopoly Monopolistic
competition and oligopoly .The behavior of the firms depends upon its
objectives. We shall also study how price is determined in the free market and
the role of demand and supply in determining the price of a product. Any
change in demand and supply has its effects on the price of the product is also
explained.
We also will study about perfect competitive monopoly, monopolistic
competition, Duopoly and oligopoly and their main features of these markets.
Equilibrium conditions under different markets conditions will give the idea of
output and price determination.

8.2 What Are Plant, Firm And Industry

Plant: Plant means an establishment for the production of goods and services
for a firm under which it is working for example a sugar plant. Plant is only a
technical unit. It is the part of a firm. The plant is under the control of the firm.
All decisions regarding productions, employment and purchases are taken at
the firm's office.
Firms: A business firm is an independent organization running a business. It
may be a shop or a manufacturing unit. A business firm has to take decision
regarding production finance, marketing and employment of man power. It
has to decide what to produce, how much to produce, and what price has to be
charged for its product. But the firm decisions regarding price and output
depends on the objectives of the firm and the kind of market structure in which
the firm does business.
Industry: It refers to the collection of firms which either use the same raw
material or manufacture the same product for example sugar industry, textile
industry automobiles industry.
Tata Motors has its plants in various places, but the firm is in Pune and Tata
motors are a part of automobile industry.
8.2.1 Objectives of the firm
A firm has generally the following objectives, but each firm has its own
objectives –
1. Maximization of profit.
2. Maximization of sales revenue and increase its share in the market.

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3. Maximization of firm growth rate. Notes

4. Maximization of managerial utility function.
5. Maximization of firm net worth.
6. Long run survival.
7. To create more goodwill and reputation.
There may be some conflict in objectives but the main objectives remain the
same i.e. maximization of profit/sales/reputation and to create goodwill in the
market. For example if the firm's objective is to maximize profit, it has to spend
a lot to make reputation which may reduce its profit.

8.3 Price Determination In The Free Market

In this part we shall learn how supply and demand strike a balance in the
market, how market attains equilibrium and how price is determined in the free
market. We have already studied the concepts of supply and demand in the
previous units and how supply and demand behaves in response to a change
in price. How price affects demand and supply of commodity. We have also
studied various determinants of demand and supply.
Now we shall study how a market attains equilibrium when demand and supply
behave differently, we shall also know how price is determined in free market.
8.3.1 Concept of Equilibrium
Equilibrium means state of rest. Equilibrium refers to a state of market in
which the quantity demanded of a commodity equals the quantity supplied
of the commodity. Where quantity supplied and quantity demanded are
equal that is equilibrium price. It is also known as market price for that
period of time.
8.3.2 Determination of Equilibrium
The market price is determined by the forces of demand and supply of the
product.

Table 8.1 Monthly demands and supply schedule of shirts

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In the table one price is 100/- for a shift quantity demanded is 80,000 shirts but Notes
supply is only 10,000 shirts. So there is a shortage of shirts. When price is
400/- the demand is 10,000 but supply is 80,000. This will create surplus in the
supply. But there is only one price i.e. Rs. 200/- where quantity supplied and
quantity demanded are equal i.e. 40,000 shirts. At all other prices either the
demand is more than supply or supply is more than demand. So there is
always a pressure either from supply side or from demand side to move
towards equilibrium price.

Graphically we can show the situation of equilibrium as under: Graph 8.1

In the graph the equilibrium price is Rs. 200/- and quantity demanded and
quantity supplied is 40,000 shirts. When the price is Rs. 100/- demand is
80,000 but supply is 10,000 shirts. When the price is Rs. 400/- the demand is
10,000 shirts but supply is 80,000.
8.3.1 Shift in Demand and Supply Census and the Market
Any shift in the demand and supply curves in going to affect the price of a
commodity. If demand curve shifts to the right it is increase in demand and if it
shifts to the left it is decrease in demand. Similarly if the supply curve shifts to
the right it is increase in supply and if supply curve shifts to the left it means a
decrease in supply. In the graph 7.2 we have kept the supply curve constant
equilibrium price is OP and quantity is OQ and the demand curve is moved to
the right. Since the demand has increased the price has risen to OP' and
quantity to OQ'. Secondly, the demand curve moves to the left the price has
fallen to OP'' and quantity to OQ''

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Graph 8.2 Notes

Graph 8.2

In Graph 7.3, the demand curve is kept constant but supply curve is shifting to
the right and the left. The equilibrium is OP price and quantity is OQ and now
the curve is shifted to the right increasing the quantity supplied from OQ
quantity to OQ' The equilibrium price after the shift of the curve is OP'. The
price has fallen to OP'. Now the supply is reduced to OQ” and the price has
risen to OP''.
So here the shift of demand and supply curves affects the price in the market.

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Activity 1 Notes
1) Price determination in the Free Market.

2) Describe the situation when the demand curve shifts to the right and the
supply curve remain stable.

3) Main objectives of the firm are to maximize the profit. Do you agree?

8.4 Types Of Market

Market is a place where buyers and sellers interact and decide the price of a
commodity. Market has three constituents:
a) Buyers and sellers
b) Interaction between them
c) Existence of a commodity
The terms market structure refers to the organizational features of an industry.
These features influence the firm's behavior in its choice of price and output.

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Market structure Notes

Market structure is classified as under:

The table above gives the picture of the structure of market such as Perfect
competition, monopolistic competition, oligopoly and monopoly.
Now we shall study their features.
8.4.1 Pure and perfect competition and its features.
Under perfect competition there are large number of buyers and sellers and no
one can influence the price. The price is determined by the forces of demand
of a product and the supply of that product. The firm is a price taker and has to
adjust itself as per the market price.
Perfect competition has the following special features:
a. Large number of buyers and sellers (firms) so no one can influence the
price.
b. Free entry and exit. Anybody can enter the business and anybody can
leave the business
c. No Government interference
d. Homogenous products
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e. Every buyer and seller is a price taker and not a price maker Notes
f. Perfect knowledge of the market
g. No cost of transport
h. All factors of production are freely mobile
i. Automatic price mechanism because the price of a product is determined by
the forces of demand and supply.

8.4.1(i) Equilibrium of a firm and industry under Perfect competition

Traditionally a firm is in equilibrium when it maximizes its profits. Maximization
of profit depends upon the cost conditions and the revenue depends upon the
market conditions. So the equilibrium is studied for short term and long run
condition.
8.4.1(ii) Equilibrium of a firm in the short period
Here there are three conditions for the short run period –
(a) Price of the product is given in the market and the firm can sell any
quantity at that price.
(b) The size of the plant of the firm is given
(c) The firm is faced with given short run cost curves.
In the short run price being given it will lead to the conclusion that
price = Average Revenue = Marginal Revenue
i.e. Price = Average Revenue = Marginal Revenue. So it is a straight
line parallel to X axis.
The cost curves are average cost curve and marginal cost curve. This concept
have already been discussed in Unit No. 6 where it was explained that profit is
maximized when MC = MR.
Graph 8.4

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In the graph price is given as OP and from P horizontal line is drawn which Notes
shows that any quantity of good can be sold at that price hence Price = AC =
MR because any increase in the sale of extra unit will bring the same price.
Then the cost curves are short term average cost curve and short term
Marginal cost curve.
It also explains that a firm will maximize profit where MC = MR. In the figs MC
and MR are equal at point E. This indicates that the output should be OQ and
price will be OP. Price has already been determined by the market forces of
demand and supply. Hence OP price is given as market price and MC = MR,
determines the output. A perpendicular is drawn to touch the X axis. Hence
The Revenue = Price x quantity. OP x OQ = OQEP.
Cost = AC x quantity OC x OQ = OQAC
Profit = AE OC. At output OQ and cost CP, the profit is CP x OQ and the
profit is PCAE.
So we find that the market price is determined by the forces of demand and
supply which is given under the condition of perfect competition. Now the aim
is to know how much output should be done to get maximum profit. In graph 8.4
the firm is getting abnormal profit since there is no restriction on entry and exit;
many firms will enter the business. This will increase the cost because the
suppliers of raw materials will raise their prices of raw materials and other
inputs. Further the new firms will increase the output. This will lead to
reduction in prices because of increase in supply. Now there will be losses to
the firm and they may decide to quit or leave the business.

Graph 8.5

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In Graph 8.5 the loss is PBAC, hence many firms will decide to exit the Notes
business because the output is OQ and the loss per unit is PC hence the loss
will compel them to leave the business. Now the final stage is when no firm
would like to quit or no firm is going to enter the business and the situation will
be when the firm is making normal profit. This will be the equilibrium of the firm
in short run

Graph 8.6

In graph 8.6 the market price is OP and quantity of output is OQ. In this way the
firm is making normal profit and is in equilibrium. Hence a firm is in equilibrium
under perfect competition and when
MC = MR = AR = AR and this condition is fulfilled.
However, a firm will be shut down if the price in the market is lower than
Average Variable Cost (A.C.)
8.4.1 (iii) Long run equilibrium of firm & industry
In the long run every firm gets sufficient time to adjust its output in relation to
demand. New machinery, new techniques of production are available and the
firm can change the composition of various inputs for production.
In short run MR = MC is the equilibrium position. It is also applicable in the
long run. Hence MR, MC; AC & AR = Price. If he price is more than the
average cost, the firm can earn super normal profit. So it will attract entry of
more firms, more output and reduction in normal profit.

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Graph 8.7 Notes

When all the firms are in equilibrium, the industry as a whole is in equilibrium.
Equilibrium of the industry is determined by total demand, and total supply.
The price is determined by total demand and total supply. Hence it is
necessary that size of production should be stabilized at a certain point and
when ideal size of output is achieved and there is no temptation for new firms to
enter the industry and there is no reason to exit from the industry. The output is
stabilized at the optimum point marginal cost is equal to Marginal Revenue and
the firm would earn only normal profit. Hence the industry is in equilibrium.
The equilibrium also in the long run is, when MC = MR = AR = AC so there is a
need to fulfill these four conditions.

Activity II
a) under perfect competition the seller is a price taker and not the price maker

b) Discuss the condition of equilibrium under perfect competition.

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Notes

8.4.2 Monopoly and its features

Monopoly is the condition where there is only one producer and has no
competitor. No substitute of the product and this type of monopoly is called
pure monopoly. There is no difference between a firm and industry. It is a
single firm industry. The cross elasticity of demand between the products of
the firm and that of other goods is zero.
Features of monopoly
a) Single producer
b) No close substitute
c) Barrier to entry of other firms
d) Demand curve slopping downward to the right
e) Monopolist is a price maker and not price taker
f) No difference between firm and industry
g) Power to influence the price
h) Discrimination of price, a monopolistic can charge different prices in
different markets and to different people.
Kind of monopoly
The emergence or survival of a Monopoly is due to the fact which prevents the
entry of other firm into the industry. The barriers to entry of other firms are a
main source of monopoly power. These barriers are as follow:
a) Legal restriction. These are controlled by the Govt. for the welfare of the
people. Public utilities are public monopolies. Public utilities are Railway,
Transport system, water supply, electricity generation and distribution, Post
and telegraph, Telephone roadways etc.
b) The state may grant monopoly power to the private sector by granting them
the permission and not allowing other firms to enter.
c) Control over key raw material. Some firms have traditional control of
some resources and key raw material. These raw materials are based on
production of different goods such as bauxite, graphite, diamond. These
monopolies also emerge because of monopoly over certain specific
knowledge or technique of product.
d) Patent right and copy right. These are monopoly because of a production
process. The firms have exclusive rights to produce the specified commodity,
copy rights are given to the writer or music composer, inventors and innovators

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so that they have the monopoly and enjoy the fruit of their labor. Notes
8.4.2(i) Equilibrium under Monopoly
Marginal cost and Marginal Revenue- Under monopoly the firm is a price
maker. So the firm can fix the price of the product. The demand curve (AR
curve) is therefore downward sloping and so the Marginal Revenue curve is
below the AR curve, because downward sloping curve shows the application
of law of demand.

Graph 8.8

A monopolist can make either normal profits or super normal profit in the short
run. A monopolist making sub normal profit will remain in production in the
short run so long as its AVC is covered.
Graph 8.9

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In the Graph 8.9 Marginal cost and Marginal Revenue equal at point E. Thus Notes
the point of equilibrium, the output is OM and the price is OP. AR = P'M Here
AC < AR and the firm makes a super normal profit. That is PTLP'. Here the
price is OP and the cost per unit is OT so the monopolist earns a profit of PT on
every unit of sale.
There is always a fear that the Govt. may intervene and control the price or may
nationalize the unit or the people may boycott the product. Hence the govt.
gets the chance to intervene.
During sub normal profit the firm may continue to produce because AVC is less
than the AR but if AVC is continue to be higher than AR the monopolist may
continue for some time but ultimately it may shut down.
In the long run the firm will be in equilibrium when MC = MR. These are the
basic conditions of the equilibrium. In the long run LRAC is flatter than the
short run average cost curve but conditions are the same i.e. MR = MC.

Graph 8.10

Long term equilibrium under monopoly

Equilibrium point is where LRMC = MR at point and OM is the output, OP', is

equilibrium price here the firm is making normal profit Hence it is clear that in
order to obtain the equilibrium point MC = MR and it will also give the output
which will give maximum point or minimum loss.
8.4.2 (i) Discrimination under Monopoly
A monopolist can charge any price to maximize his profit. Secondly he can
charge different prices for the same product from different people or different
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market to maximize monopoly profit. Notes

Consumers are charged different price by a monopolist by virtue of being a
monopolist. The basis of this differentiation is income age, time, sex, different
markets when a doctor charges different fee from different patients it is
discrimination. This charge is based on income of the person. Age is
considered in case of railway and transport system for charging different fare.
A child pays less fare than the adult. Electricity used for domestic purpose is
charged less but for commercial purposes it is charged more. Price
discrimination is also there when more quantity is purchased. Price
discrimination is also found in other type of market. For example if the product
has elastic demand in a market the price charged will be less. If the same
product has inelastic demand in the other market more price is charged.
Necessary condition for price discrimination
a) The buyers are located at different places so that it is not profitable to
transport the good to other market. Exclusive use of the commodity also
encourages discrimination in price. For example the services of a doctor,
or lawyer.

b) If the market is divided into sub market, the elastically of demand must
be different in each sub market.

c) The market must be imperfect.

When a monopolist faces separate two different markets having different

elasticity of demand, then he can charge high price in the market where the
demand for his product is inelastic and will charge less where the demand of
his product is elastic. But in each market he will maximize profit when MR =
MC, and in both the market the condition of MR = MC has to be fulfilled.
In each market he will maximize his profit when MC= MR.
In market A where the demand is inelastic he will charge more price and in
market B where the demand is elastic he will charge less price, but MC = MR in
both the market combined.

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Notes

Graph 8.11 (a) Graph 8.11 (b) Graph 8.11(c)

In Graph 3 the point of equilibrium where MC = MR, OM is the total output of the
firm. This is to be sold in two markets. In market B, E'' is the equilibrium where
MC = MR, OM” is the output of price is OP”
In market A, E1 is the equilibrium where MC = MR' and output OM' and
the price is OP'.
Thus OM = OM1+ OM2 and the price in market A is higher than the price in
market B, and sale in market A is less than sales in market B because in
market A demand of the product is inelastic and in the B market demand is
elastic because of price discrimination. This will increase the total revenue.
Degree of Price discrimination
There are three degrees of price discrimination –
a) In the first degree, the monopolist charges the highest price. This does not
leave consumers surplus to the buyers. This is applicable in the case of using
the services of a surgeon or a lawyer.
b) In the second degree the monopolist does not charge different prices to
individual customers. But may classify the customers into certain groups
according to their income. He my classify customer into the rich, the middle
income and the low income group. Example is that of Railway. The fare of
first class AC class II class are all different so this leaves some surplus to
other consumers with more better off than others in the group.
c) In the third degree –different prices are charged in different markets.
Example is that of lower price is charged in the international market and higher
price charged in the home market as is the case of Japan.
So a monopolist can charge different price for the same product to the different
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customers and in the different market. Notes

8.4.3 Monopolistic competition
The model of monopolistic competition was developed by E H Chamberlain.
He represented a realistic picture of the actual market structure.
Monopolistic competition is a market structure in which a large number of
sellers sell differentiated product which are close but not perfect substitutes for
one another. There are elements of monopoly and competition in monopolistic
competition. Here the products are differentiated from those of the others
firms. For example the consumers can differentiate between Colgate tooth
paste and Babul, Pepsodent tooth paste. Similarly mobiles are differentiated
in the market as Nokia, Sony, Samsung, Reliance etc. Each firm has a
monopoly power over its own products. The products are differentiated but
these remain close substitute of one another. So this creates a condition of
competition among the firms. Hence this sort of concept competition is called
monopolistic competition.
Feature of Monopolistic competition
a) Large number of sellers and Buyers. There may be 20-25 sellers
engaged in the same line of business. The commodities they produce are
close substitute for each other. Hence every seller has to compete with other
sellers to create his sales. This may lead to a cut throat competition.

b) Product differentiation. Under monopolistic competition every seller

tried to distinguish his product from the products manufactured by others or he
may produce different brands of the same products. The production
differentiation is in the form of brand name, trademarks, package of container,
design, colour or style. It also shows the surrounding of the shops, ambiance
and convenient location. Basically the process of production may not differ, but
the general public is made to believe that it is a new or better product. For
example soaps like Lux, Rexona basically contains the same ingredients, but
are differentiated by brand name. But the customers may develop loyalty to a
product.
a) Selling cost. Under monopolistic competition each seller incurs /spends
huge amount on advertisement to promote its product by publicity. He follows
all the media like advertisement in press, radio, TV, hoarding sites, neon signs
etc. Further he sees that the customers are treated very nicely. He may offer
non monetary concessions such as gifts, credit, service etc.
b) Multiplicity of prices. Single uniformed price cannot be established
because of immobility of factors of production such as transport costs,

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ignorance of the market. Many similar products having different brand name Notes
are sold at different prices. Every producer enjoys the freedom to price his own
products but still he has to depend upon the other producers to decide his
policy regarding production and pricing.

c) Elastic demand. The average revenue curve of a firm is not parallel to x

axis as is under perfect competition. This is so because the product is not
identical and buyers have preference under monopoly the AR curve is steep
because there is no substitute. But under monopolistic competition, a firm's
product has close substitute so the AR curve cannot be steep. It is shallow
indicating highly elastic demand. So if the firm reduced its price it can sell
more. Hence the demand is elastic.

d) Price war is common in order to extinguish the rival from the market. This
is done by reducing the prices to attract the new customers. The other
producers also follow and reduce their prices of their product. This lead to a
price war.

e) Gift articles. In this the producer instead of reducing the price offers some
different kinds of gifts to the customers. Tooth paste companies may offer free
tooth brushes along with tooth paste.

f) Unfair practices.

I. By snatching away good and skilled worker from the rival's company is very
common.

ii. Bribing the trade union leaders who control the rival's workers union to
interfere in rival company.

iii. False propaganda also affects the rival's company.

8.4.3 (I) Equilibrium under monopolistic competition of a firm and

industry
Under monopolistic competition every seller is selling his product under his
particular brand, or trade name. But before they fix the price, they will consider
the price of the rival of the product. So a new product charges lower prices.
But this price may not remain constant because the rivals may reduce the price
of their product. An individual producer is free to fix his price but he has to
consider the price charged by his rivals also.

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Short run equilibrium Notes

A firm will maximize its profit and decides his output when MC = MR
(Marginal cost is equal to Marginal Revenue).
Graph 8.12

Short run equilibrium under Monopolistic competition profit

In the Graph Marginal Revenue and Average Revenue are given. Similarly
Average Cost and Marginal cost curves are given.
Here the equilibrium condition is when Marginal Cost = Marginal Revenue at
point A. So draw a perpendicular on X axis and take it up to touch AR curve at
point P. So the equilibrium Quantity is OM and equilibrium prices is OP'.
The Revenue is OP'PM = P'O x OM (Price x Quantity)
The cost is OT'TM= OT' x OM (Cost x Quantity) and the profit is P'T'TP or it can
also be stated that T'P' profit is per unit and total profit will be T'P' x OM
The profit is super normal so it will attract other producers to produce the same
product.
The firm is having sub normal profit if it Average Cost curve is above Average
Revenue cure.

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Graph 8.13 Notes

In this graph Average Cost curve is higher than the Average Revenue curve.
Hence the firm is making losses. The equilibrium value MR & MC is at point E
and output is OM but cost per unit is OQ, so the producer is making a loss of RQ
x OM =QRSP, hence some firms will go out of business.
Long run equilibrium under Monopolistic Competition
Super normal profit has attracted many new firms to enter the business, but
sub-normal profit has made them to leave the business. Hence a situation has
come where no new firm is likely to enter the business and no old firm is going
to leave the business. All the firms are making normal profit in the long run.
Since there are a number of substitutes so the Marginal Revenue curve is
elastic.
Graph 8.14

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In this Graph, long run Average Cost output touches the Long Run Average Notes
Revenue curve at point P. The equilibrium is at Point E where LMR and LMC
are in equilibrium and equilibrium output is OM which is ideal and the firm is
making normal profit at the price OP.
No firm would like to enter the business and no firm will leave the business.
Disadvantage of Monopolistic Competition
1. Heavy expenditure on advertisement and other selling expenses.
2. Creating artificial or imaginary difference between the products.
Product differentiation is achieved with the help of advertisement cost.
3. There is a possibility of increasing expenditure on cross transportation
of a product when Delhi seller sells its product in Pune and Pune seller
sells his product in Delhi causing a lot of expenditure on transport.
4. Inefficient firms may also continue to be in the business on the strength
of their product differentiation.
5. It creates excess capacity. The main manufacture can product all the
parts but his competitors may make his machine idle creating idle
capacity.
6. The Average cost is higher under Monopolistic competition.

8.4.4 Duopoly and oligopoly

Duopoly- When there are only two sellers of the same product, it is called
duopoly. Here sellers' decision is not dependent on each other. A change in
the price and output by one seller affects the other seller who may react to this
change. It is limiting case of oligopoly. Suppose there are two sellers sharing
the market. But one wants to dominate the market, he may reduce his price to
attract more customers. The rival may react and reduce the price of his
product. If one of the sellers is financially strong, he may price out the rival and
this will lead to monopoly conditions. In case both the sellers are financially
well off, they may agree to charge the same price of their product. But they
may adopt the methods of non- monetary benefits by giving gifts, good service
and helpful nature.
Oligopoly- is defined as “Competition among the few”. Under oligopoly
number of sellers is very few and competition between firms is more intensive.
Number of sellers depends upon the size of the market. Each seller has
command over a sizeable proportion of the total market supply. The product
traded by the oligopolistic may be differentiated or homogeneous. There are
many different brands of car like Maruti car, Tata Indica. These are the
example of differentiated oligopoly. Similarly, cooking gas of Bharat
Petroleum and Hindustan Petroleum are examples of homogeneous
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oligopoly. Notes
Features of oligopoly
· Few sellers – producing homogenous or differentiated products.
· Interdependence. The firms are interdependent regarding their
policy of output and pricing.
· High cross elasticity. So there is a fear of retaliation by rivals
because each product can be substituted.
· Advertisement. Selling cost is very high and is on advertisements
publicity etc.
· Constant struggle. Among the various producers to expand the
market and increase their share in the market.
· Price rigidity. Each firm sticks to its price nobody reduces its price.
· Kinked demand curve of their product.
Barrier to entry due to economy of scale of production, absolute cost
advantages to old firms, patent right and licensing and other barriers.

Graph 8.15

Kinked demand curve or the Average Revenue curve has two segments (i) The
relatively elastic demand curve & (ii) Relatively inelastic demand cure as
shown in the Graph. At price OP, there is Kink at point K on the demand
segment. Here the kink implies an abrupt change in the slope of demand
curve. Before the Kink past, the demand curve is flatter and after the kink it
becomes steeper.
If the seller increases the price of his product he may lose his customers since
no other seller will raise the price of his product. If a seller reduces his price of
the product, the other sellers may follow suit and reduces the price of their
product which may not increase the sale of the original seller.
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8.5 Summary Notes

In the beginning of this unit, we have studied the meaning of plant, firm and
industry and the main objectives of a firm are also studied. The objectives are
conflicting in nature. How price is determined in a free market by the forces of
demand and supply. How a shift in demand curves and supply curves affects
the price in the market. The study of the structure of market is taken and how
market will be in equilibrium. The price has been determined by the free
market but the output is determined under the conditions, when Marginal Cost
= Marginal Revenue. This equilibrium point shows maximum profit or
minimum losses. The market is further classified as perfect market and
imperfect market. In perfect market we have discussed various features and
how the price and output is determined under perfect market. Under perfect
competition a firm has to be price taker which is determined by the market
force. In the short run a firm is in equilibrium when MC = MR cost in the long
run. The industry is in equilibrium when AR = MR = LAC = LMC. This condition
gives only normal profit. Also discussion is done when a firm has to be
shutdown the business. This situation comes when AVC is higher than the
market price so a firm has to shut down. Then a study of monopoly is done
along with its features and how a monopolist will earn maximum profit and how
a monopolist firm will be in equilibrium. Under what circumstances a
monopolist charges different price from different people and in different market
which is also known as price discrimination. The idea of degree of
discrimination is also given.
Then the idea of monopolistic competition is given with its features especially
product differentiation and selling cost. How the firm and industry will be in
equilibrium is also made clear.
Then the study of duopoly and oligopoly is taken up with its main features and
Kinky demand curve and rigidity of price. How this type of market is prevalent
in the developed countries. Most of the business is being run under oligopoly
condition. The examples are Pizza Hut, McDowall, Pepsi and Coco cola.

8.6 Keywords
Equilibrium Price. The price at which the quantity demanded by
consumers of a product, is equal to the quantity supplied by sellers of a
product.
Monopoly. Existence of one firm only. There is a complete barrier to
entry into the industry.
Normal Profit. The rate of profit just sufficient under condition of free
entry to keep the firms from leaving a given industry in the long run.
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Price taker. Firms that cannot influence the market price and is under Notes
the condition of perfect competition.
Price discrimination. Changing different prices for the same product from
different consumers in different market based on elasticity of demand.
Profit Maximization Rule. Produce up to the point where Marginal
Revenue is equal to Margin cost.
Shut down point. When the firm is considering to stop production when
the Average variable cost is higher than the market price.
Cartel. A group of firms that have joined together to make agreement on
pricing and market strategy.
Duopoly. Where there is large number of buyers but two sellers.
Kinked demand curve. Graphical representations of a situation wherein
rival firms do not follow the price increase of a firm but follow price cut.
This curve is more elastic for prices alone, but less elastic for prices below
the going price.
Oligopoly. Where a few dominant firms in an industry, having barrier to
entry.
Product differentiation. A wide variety of activities such as design
changes, advertising that rival firms employ to attract customers by
showing their product as different product.

8.7 Self Assessment Questions

1. Differentiate firms and industry

2. Discuss various objectives of a firm
3. Explain how the market price is determined in the free market.
4. How price and output is determined under perfect competition.
5. Explain the meaning of monopoly. How a monopolist will maximize his
profit.
6. How a monopolist can charge different prices from different consumers for
the same product.
7. Explain different features of monopolistic competition.
8. How a firm will be in equilibrium under monopolistic competition?
9. What do you mean by oligopoly? Describe various features of oligopoly.

Quiz :
Q1. If the market demand curve for a commodity has a negative slope then the
market structure must be
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a. perfect competition. Notes

b. monopoly.
c. imperfect competition.
d. The market structure cannot be determined from the information given..
Q2. If a firm sells its output on a market that is characterized by a single seller
and many buyers of a homogeneous product for which there are no close
substitutes and barriers to long-run resource mobility, then the firm is
a. a monopolist.
b. an oligopolist.
c. a perfect competitor.
d. a monopolistic competitor.
Q3. If one perfectly competitive firm increases its level of output, market supply
a. will increase and market price will fall.
b. will increase and market price will rise.
c. and market price will both remain constant.
d. will decrease and market price will rise.
[Link] of the following markets comes close to satisfying the assumptions
of a perfectly competitive market structure?
a. The stock market.
b. The market for agricultural commodities such as wheat or corn.
c. The market for petroleum and natural gas.
d. All of the above come close to satisfying the assumptions of perfect
competition.
Q5. The market demand curve for a perfectly competitive industry is QD = 12 -
2P. The market supply curve is QS = 3 + P. The market will be in equilibrium if
a. P = 6 and Q = 9.
b. P = 5 and Q = 2.
c. P = 4 and Q = 4.
d. P = 3 and Q = 6.
[Link] of the following is a barrier to entry that typically results in
monopoly?
a. The firm controls the entire supply of a raw material.
b. Production of the industry's product is subject to economies of scale over
a broad range of output.
c. Production of the industry's product requires a large initial capital
investment.
d. The firm holds an exclusive government franchise.
Q7. A natural monopolyrefers to a monopoly that is defended from direct
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competition by Notes
a. economies of scale over a broad range of output.
b. a government franchise.
c. control over a vital input.
d. a patent or copyright.
[Link] a perfectly competitive industry is in long-run equilibrium, all firms in
the industry
a. earn zero economic profits.
b. produce a level of output where short-run marginal cost is equal to short-
run average total cost.
c. produce a level of output where long-run marginal cost is equal to long-
run average cost.
d. All of the above are correct..
Q9. The long-run supply curve of a perfectly competitive firm
a. is equal to that portion of the long-run marginal cost curve that is above
the relevant short-run average variable cost curve.
b. is equal to that portion of the long-run marginal cost curve that is above
the relevant short-run average total cost curve.
c. is equal to that portion of the long-run average total cost curve that is
above the relevant short-run average variable cost curve.
d. None of the above is correct.
Q10. A monopolized market is in long-run equilibrium when
a. zero economic profit is earned by the monopolist.
b. production takes place where price is equal to long-run marginal cost
and long-run average cost.
c. production takes place where long-run marginal cost is equal to marginal
revenue and price is not below long-run average cost.
d. All of the above are correct.
8.8 Further Readings
a) [Link] Monopolistic competition
b) Dr. DM Mithani Managerial Economics
c) Dr. HL Ahuja Managerial Economics
d) Dr. PL Mehta Managerial Economics

8.9 Model Answers

Activity I
Q1 Price determination in the free market- Prices in the market are

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Being a monopolist he can charge different prices to different consumers and Notes
in different market after considering the elasticity of demand. If the demand of
a product is elastic in a market he will charge less price and sell more. If the
demand is inelastic he can charge higher price.
Activity IV
a. Explain the features of monopolistic competition specially product
differentiation and selling cost.
Under monopolistic competition there are many sellers and many
buyers. Different prices are charged on the same product which is
close substitute. But main characteristic is product differentiation by
name different brands, different packing and so the seller tries to
differentiate his products from others. The selling cost is also very
important because a lot of money is spent on advertisement,
commission and non monetary benefits to increase the sale.
b. How a firm is in equilibrium under Monopolistic competition
Here again when MR = MC the sellers get maximum profit or minimum
loses.
c. Discuss an feature of oligopoly why the price rigidity is applicable If a
seller increases the price of his product, his rivals will not follow. So he
will lose his customers. But if he reduces his price every rival will follow
so that he has not to lose his customers.

Quiz :
Q1. The market structure cannot be determined from the information
given.
Q2. a monopolist.
Q3. will increase and market price will fall.
Q4. The stock market.
Q5. P = 3 and Q = 6.
Q6. Production of the industry's product requires a large initial capital
investment.
Q7. control over a vital input.
Q8. produce a level of output where long-run marginal cost is equal to
long-run average cost.
Q9. None of the above is correct.
Q10. production takes place where price is equal to long-run marginal
cost and long-run average cost.

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Notes
CHAPTER 9

PROFIT MANAGEMENT

Learning Objectives
After going through this unit, you will be able to:
State the meaning of profit and its role in the economy
Explain the different kinds of profit
Discuss on measurement of profit
Describe different policy regarding profit
State the meaning of reasonable profit
Learn to know the standard of reasonable profit.

Structure
9.1 Introduction
9.2 Meaning of Profit
9.2.1 Kinds of profits
9.2.2 Role of Profit in the economy
9.2.3 Economic Profit and Accounting Profit
9.2.4 Gross profit and pure (Net) profit
9.3 Measurement of Profit
9.3.1 Economic concept of the net profit
9.3.2 Modern Method
1. Depreciation
2. Inventories
9.4 Profit Policy
9.4(a) Profit expectation
9.4 (b) External factors
9.5 Reasonable Profit target
9.6 Standard of reasonable profit
9.6.1 Setting the profit standard
9.7 Summary
9.8 Keywords
9.9 Self assessment questions
9.10 Further Readings
9.11 Model answers

9.1 Introduction
In Unit No. 10 you are given the idea of failure of the working of the private free
economy in controlling inflation, recession and depression and many other
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problems faced by the economy. So it is necessary that the Govt. should Notes
intervene to control the bad economic effects on the economy caused by the
free market economy and to assist the economy. The Govt. has legal and
social frame work to reduce the bad effects of trade cycle. So the Govt. has to
control and regulate the economy to achieve its objectives. In this unit you will
learn about profit and its role in the economy. Also you will know different kinds
of profit. Reasonable profit is desirable and its meaning will enable you to think
why reasonable profit is necessary. The standard of reasonable profit will also
be explained.

9.2 Meaning Of Profit

Generally profit means the net income of a businessman. It is calculated by

deducting from the total receipts and total expenditure incurred in the
business. But economists regard profit as a factor-return like wages, interest
and rent. So profit is a return to the entrepreneur for the use of his
entrepreneurial ability. Earning maximum profit is one of the main objectives of
a firm, but how much profit is to be earned, is a big question mark before
the businessman. The entrepreneur has to decide the ratio of profit. This
depends upon nature of the market and other constraints including legal,
statutory provisions, business convention, consumers' resistance.
Maximization of profit is the objective of every firm but the businessman
manages the factors of production which produce profit rather than managing
profitability directly
The profitability has been affected by internal factors and external factors
Profit is expressed as gross profit and net profit or as percentage return to the
capital invested.
The main job of an entrepreneur is to utilize available resources in such a way
as to get maximum output with minimum costs. He has to take many
decisions. The success of the decision brings him profit. He has also to
visualize the needs of the people and fulfill them.
Another job which he has to do is to adopt the spirit of innovation, by following
new methods of production or changing some inputs to reduce the costs.
He has to find a new market, a new source of raw materials etc. All these may
increase his profit. . Entrepreneur is the only factors who also can get negative
return i.e. losses.
9.2.1 Kinds of profits.
Economists discuss the following kinds of profit:
a) Earnings of management. To manage the business by judging
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uncertainty properly he can earn profit. Notes

b) Monopoly profit is earned when the entrepreneur acquires the position of a
monopolist. Now he controls the supply of the product which has no close
substitute. This profit depends upon his monopoly power in the market.

c) Windfall profit – This profit arises due to changes in the general price level
in the market. Suppose he buys the inputs when the prices are low and sell his
output when the prices are high. He earns a windfall profit. Sometime back
the prices of petrol were raised by Rs.5/- per liter, the sellers earned a windfall
profit.
The windfall profit just happens it is not planned.
9.2.2 Role of Profit in the economy
The major function of profit in an economy is enhancing the production in the
economy. Higher level of profit means higher investment, higher personal
involvement, higher employment opportunities in the economy, higher
purchasing power of the people. All these will lead to higher economic
activities in the economy. Low profit will have reverse effects on the economy.
We know that for production more investment is necessary. For investment
profit is necessary. Higher the profit, higher will be the investment. Profit
guides to direct resources to those sector, where they are more productive. So
profits are the incentive to use resource efficiently and to produce the goods
and services which are required by the society.
Adam Smith has said, “The pursuit of profit is the invisible hand that guides all
market participants to produce and consume what society needs.”
The expenditure on Research and Development also depend upon higher
Profit, so higher profit will lead to the use of higher, sophisticated technology
along with dynamic efficiency.
Profit plays a very important role in some industries like exploration of oil, gas
and car industry.
When we analyze the role of profit, weightage needs to be given not to the
amount of profits but to the use to which the earned profits are employed.
9.2.3 Economic Profit and Accounting Profit
Profit means different things to different people, i.e. Businessman,
accountant, tax collector, workers and economists.
For Accountant – Profit means excess of revenue over all paid cash including
manufacturing cost and overheads.
Profit for businessman – It is business income plus non allowable expenses.
Economic Profit, Profit over and above opportunity cost
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Accounting profit = TR (Total Revenue) - (W + R + I + M) Notes

W = wages, R = Rent, I = Interest, M = Material cost
In accounting profit only explicit costs are considered.
Economic profit = Implicit cost or imputed costs are to be considered so
economic
profit = TR – (Explicit cost + Implicit cost). It is not always that profit should
be positive but profit can also be negative that is (Losses) in a year.
9.2.4 Gross profit and pure (Net) profit
GP = Total expenditure – Total receipt
GP = TR – Total cost
We have also to make certain payments out of Gross Profit
The payments are
(i) Payment for the factors contributed by the entrepreneur himself in the
form of rent, interest and salary.
(ii) Depreciation and Maintenance charges
(iii) Extra Monopoly profit which accrues, not because of the business skill,
but he being monopolist, who is the sole seller or producer.
(iv) Chance profit. This profit arises due to circumstances beyond the
control of the entrepreneur but by chance deducting from the total
revenue of the year minus the total cost incurred during the year.
The example is war, calamities or bottlenecks.
Net profit = Gross profit – after making all the payments the balance is
known as net profit.
Activity I
a) Economic Profit

b) Accounting profit

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Notes

c) Gross profit and Net profit

9.3 Measurement Of Profit

It is a very difficult concept we also find that economic concept of profit and
legal concept of profit are two different concepts. If we want to find out net
profit, we can deduct all costs from the total revenue, again this is difficult
because the people are not aware how to select different cost to come to the
total cost.
9.3.1 Economic Profit and accounting profit.
Economic profit includes implicit cost plus explicit cost. But to determine
implicit cost is rather tricky and difficult. Also the entrepreneur may be using
his own factors of production like land and capital and rendering his own
services instead of a hired one. Since the uses of these factors are not paid so
it becomes difficult to value them.
According to accounting principles, the assets of a concern have claim from
two sides i.e. the owners and the lenders. So
Assets = Liabilities + Proprietorship of factors
Assets – Liabilities = Proprietorship contributions. While preparing the balance
sheet, which cost of the assets should be taken whether the purchased price or
the current value? Generally the current value is not considered.
Further we find a lot of changes in the value of money, which has to be ignored.
In financial accounts – To calculate the net profits by deducting from the total
revenue of the year minus the total cost incurred during the year.
The Economic concept of the net profit- The economic concept of the net
profit will have to be altogether different. In valuation of these assets, the
economist is guided by the concept of opportunity cost.
In accounting method the original price of a machine is considered, but in
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economic concept the replacement cost of the machine will be used. So it Notes
becomes difficult due to different meanings of cost concept.
9.3.2 In Modern Method - Valuation is based on the cash flows technique.
Factors responsible for leading to differences in economic and traditional
concepts of valuation- Main factors, which create difference in the economic
and accounting approaches to the problem, are as under:
9.3.2 a. Depreciation – Means loss of value caused by the continuous use of
assets. Every durable asset has a certain life, at the end of which it has got to
be replaced. This is done through the provision of depreciation in accounts.
There are various methods of calculating depreciation
Straight Line Method
D=P–S D = Depreciation P = Price of the assets
Y S = Scrap value of the assets
Y = Life of the machine
Let us assume the price of machine is Rs.25,000/- and life of the machine is 20
years and the scrap value of the machine is Rs. 5000/-
So D = 25000 – 5000 = 1000
20
(1) Diminishing Balance Method
If the depreciation is taken at 10% then during the beginning the depreciation
amount will be larger and in the second year it will be 10% of the balanced
value of the assets. Here the balance value of the machine will never be zero
and the amount of depreciation will go on diminishing. For example if the price
of assets is Rs.50,000/- and depreciation is 10% then in the first year the
depreciation will be Rs. 5,000/-. Now the value of the assets is Rs.45,000/.
Then in the second year the depreciation will be Rs.4,500/- and so on. The
depreciation amount will go on decreasing but it will never be zero.
(2) Annuity Method. In this method equal annual amount are first calculated
for the life of the assets. Along with the annual allowance the rate of interest
that can be earned is also calculated. Then the amount of depreciation is
decided on annual level.
(3) Service Method.
Here instead of considering the life of an asset in years. We calculate actual
working hours of the assets. This is the basic service method. Assuming the
machine can work for 1000 hrs then the value of the machine is divided by
1000 and it will be taken as an hourly rate of depreciation. So after calculating
the number of hours the machine worked, this will give us the idea of the
amount of depreciation.
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The original value of machine minus depreciation will give its value for the Notes
remaining period. For example if a machine is costing Rs.20,000/- and the life
of the machine is 1000 hrs. The depreciation per hour will be 20000÷1000 =
20/- per hour
If machine worked for 10 hours a day and 25 days a month then depreciation
would be - Daily 10 x 20 = 200/- x 25 days = 5,000/-
So after a month the depreciation will be Rs.5,000/- and the net value of the
machine shall be Rs. 15,000/-.

9.3.2 b. Inventory Valuation

A firm has to invest a lot of its capital in keeping inventories in the form of finish
goods, semi-finished goods, spare parts, raw material etc., so that the
production does not stop because of lack of inventories and materials. So
there is a need of inventory valuation. This is a difficult task since the prices
are always changing. This affects the cost of production. But still some
methods can be used to evaluate the cost of inventories –
a) First in first out (FlFO). The item which comes first should be used first
in production.
b) Last in First out (LIFO). In this method the item which has come last is
used first in production.
If calculated on the basis of FIFO, the profit would be high in the times of
inflation and low during deflation.
So it is difficult to evaluate inventories due to changes in the prices, cost
of maintaining, storing etc.
c) We also have that there are no unaccounted value changes in the
assets and the liabilities. Further there are assets, which are created
by Research and development to improve the quality of the product,
and profitability of the firm; Improvement in management's efficiency
will also increase profit All these steps involve heavy cost and these
cannot be valued correctly
Generally it is felt to use historical prices in calculating profit otherwise
it is difficult to assess the profit.
Some other points need to be considered in this connection are –
a) treatment of capital gains and losses;
b) proper evaluation of investment;
c) deferred revenue expenditure
a) treatment of capital gains and losses
By traditional accounting practice a capital gain is not made
until the property is sold either at gain or loss. So all the gains

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or losses to be calculated when it occurs in the ultimate year of Notes

ownership.
b) Evaluation of investment - should be considered in terms
of their return.
c) Deferred revenue expenditure - It can be handed while
a calculation profit is the time value of money and the
inflation accounting period.

Activity II
a) Need of Inventories

b) Depreciation for the development and growth of an economy

9.4 Profit Policy

Earning maximum profit is one of the main objectives of a firm. But how much
profit is to earn is a big question mark before the businessman. The
entrepreneur has to decide the ratio of profit which depends upon the nature of
the market and other constraints including legal, statutory provisions, business
convention, and consumers' resistance.
Maximization of profit is the objective of every firm but we manage the factors
of production which produce profit rather than managing profitability directly.
Proactive profit management allows you to know the effects in profitability of
different resources allocated before you make a decision as to which resource
to use and when it is to be used. Since business environments are variable
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and are changing constantly, so you have to decide how essential scarce Notes
resources be consistently reallocated to the most profitable [Link]
profitability has been affected by internal factors and external factors. Internal
factors profit is expressed as gross profit and net profit or as percentage return
to the capital invested. Now this norm has been accepted in the form of
percentage net return to capital.

9.4 (a) Profit expectation- Generally the investor expects some profit from
his investment. These expectations are subject to the following conditions –
(I) The rate of profit should be sufficient to attract share capital, if necessary.
So the rate of profit should be good enough to command a good price for the
new issue of shares.
(ii) Profit should be comparable to that in similar companies.
(iii) The rate of profit should be comparable to their rate of profit in the past.
(iv)He profit should be large enough to plough back for the expansion of
business.

9.4 (b) External factors are required to be considered because these factors
do affect the profit. Following are some of the important external factors which
affect profit –
(I) Full employment. When a firm is working at full employment level and the
relation between management and workers are cordial. It will increase profit of
the firm. But if the firm's profit is very high, it may create unrest among the
workers and they would like to demand some share in extra profit, if not given
this will create conflict and may reduce profit.
(ii) Potential Rivals. If there is excessive profit this may encourage new
entrants and rivals may emerge. This will wipe out profit. So there is a need to
control profit.
(iii) Consumer's confidence. Consumers' confidence and satisfaction is
very important for profit. If unreasonable prices are charged the consumer
may lose confidence in the firm and may shift to other firm's product. So in
order to keep the consumer satisfied it is necessary that reasonable profit
should be expected by the firm and the consumer have confidence in the
product.
(iv) Political climate. Peace, law and order, strong government is necessary
elements for profit. Any change in political climate may affect the profit.
Government is a big customer along with the public sector's purchasing it can
affect the profitability of the firm. Further Govt. interference is common if it
finds that a firm is making abnormal profit. Policy of taxes, subsidy and
incentives of the Govt. also affect profit of a firm.
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9.5 Reasonable Profit Target Notes

Now it has become more practical to look for reasonable profit. The question
arises why to go for a reasonable profit and the way how to determine it
because of the following reasons –
(1) To prevent entry of the competitors especially applicable in a weak
monopoly.
(2) It will help to project a favorable image and it will not attract the Govt.
attention.
(3) It will help to restrain trade union demands for higher wages. If a unit is
making larger profit the workers, if do not get some share in profits, will
feel exploited and will demand higher wages and this will cause labor
grievances and conflict.
(4) Maintaining customer goodwill is very essential. This depends on
quality and fair price of the product. So a firm aiming at better profit
prospects in the long run should sacrifice short run profit.
(5) It will bring congenial relation at the executive level.
(6) It will help in forestalling application of antitrust law.

9.6 Standard Of Reasonable Profit

In seeing the reality if the firm decides to restrain on profit there will be some
questions which need explanation –
a) What form of profit standard should be used?
b) How to determine the reasonable profit?
Form of Profit Standard
Profit standard can have different forms-
a) In aggregate terms
b) Percentage of sale
c) Percentage return on investment.
Whatever form of profit we may select it is usually the total net profit of the
enterprise which is more important and acceptable.
If we want to discourage the competitions then a target rate of return on
investment is better standard of profit.
9.6.1 Setting the profit standard
a) Capital attracting standard. The profit should be high enough to
attract external capital. May it be in the form of share capital?
b) Plough back standard If a company has to grow so it becomes
necessary to earn enough profit so that further investment can be
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done. This standard of profit is used by maintaining liquidity and Notes

avoiding debt.
Normal Earning standard
Normal earning of a company over a period of time, is a good criterion of
reasonable profit. It is necessary that under these criterion the company
should be able to attract external capital, discourage growth of competition and
keep the share holder satisfied. But after going through all above criteria, we
find that none of the standard is perfect. So the standard of profit should be
chosen by adopting different criterion after studying the market condition at a
particular moment.
Activity III
1) Describe external factors which affect profit

2) Profit should be reasonable if it is not so, discuss the consequences of it.

3) Profit is necessary for economic development

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9.7 Summary Notes

All economic activities are based on one of the most important objectives
that are to make more profit. Profit gives incentive to a person to work hard
and try to get maximum profit.
We have tried to define profit and explained different types of profit i.e. in
economic term and in accounting term.
Profit plays a very important role in the economy. Profit being the reward of the
entrepreneur can be negative also when losses are incurred. Profit helps in
expansion and growth of a firm and industry and the economy. Expansion of
the unit is possible if a part of profit generated in the past is ploughed back.
Further if very high profit is made it will have some effects on the economy and
will encourage competitors. The Govt. may start paying attention when there
is a higher profit. Similarly the consumers will feel exploited. The workers may
demand more and more wages causing conflict between management and
labor.
Hence it is felt that profit should be reasonable and why reasonable profit is
necessary.
Discussion has also been done on different policies regarding profit which can
be adopted. How to calculate profit is also discussed.
Also the idea of inventories and depreciation is given to enable a person to
calculate profit properly. While calculating profit the role of inventories and
depreciation has to be considered.

9.8 Keywords
Dynamic state. The economic state where the future is likely to be
different from the present rate. This change is unpredictable.
Gross profit. The difference between receipts and payments over a time
period.
Net Profit. Profit net of implicit cost.
Normal Profit. The minimum expected return to keep an entrepreneur in
his present business.
Monopoly Profit. Profit that arises due to dis-equilibrium and imperfection
in the market.
Depreciation. Depreciation is the loss in value caused by the continuous
use of assets, because every durable asset has a certain life. After this it
has to be replaced.
Inventory. Inventories are in the form of raw materials, semi finished
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goods, finished goods, spare parts. These are very important to keep the Notes
work/job working without any obstacle.

9.9 Self Assessment Questions

1) What do you mean by profit? Distinguish between accounting profit and

economic profit.
2) Explain with the help of example how gross profit and net profit is calculated.
3) Explain different practices for the measurement of profit.
4) Why a businessman should adopt profit policy.
5) What do you mean by reasonable profit? Why it is necessary in the
business?
6) Why profit is necessary in the economy?

Quiz :
Q1. Carolina Berries manufactures many varieties of jams and jellies. An
increase in the price of their strawberry jam can be expected to
a. increase the demand for their strawberry jelly because the two are
complements.
b. increase the demand for their strawberry jelly because the two are
substitutes.
c. decrease the demand for their strawberry jelly because the two are
complements.
d. decrease the demand for their strawberry jelly because the two are
substitutes.
Q2. Icarus Medical Supplies produces patented adhesives that are used to
reassemble broken bones. Pindrop Medical Products manufactures patented
pins that are also used to reassemble broken bones. Both of these imperfectly
competitive firms are maximizing profit. If Icarus merges with Pindrop, then the
merged firm will maximize profits if it
a. decreases the prices of pins and adhesives.
b. does not change the prices of pins or adhesives.
c. increases the prices of pins and adhesives.
d. None of the above is correct.
Q3. A single-plant, multi-product firm will introduce additional products
a. in order of diminishing price elasticities of demand.
b. until the marginal revenue from the last product introduced is equal to zero.
c. until 100% of unused plant capacity is employed.
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d. None of the above is correct. Notes

Q4. Which of the following is an example of price discrimination?
a. It costs more to make a long-distance phone call during the day than it does
late at night.
b. A ticket to the zoo costs less for a child than it does for an adult.
c. Regular gasoline costs less than premium gasoline.
d. All of the above are examples of price discrimination.
Q5. A firm will realize the highest level of profit if it is able to engage in
a. first-degree price discrimination.
b. second-degree price discrimination.
c. third-degree price discrimination.
d. The answer cannot be determined without additional information.
Q6. A movie theater that charges a lower price for matinees than for evening
showings is engaging in
a. first-degree price discrimination.
b. second-degree price discrimination.
c. third-degree price discrimination.
d. The answer cannot be determined without additional information.
Q7. If the external market for an intermediate product is perfectly competitive,
then the transfer price should be set equal to
a. the market price of the final product.
b. the competitive market price of the intermediate product.
c. the marginal cost of the final product.
d. None of the above is correct.

9.10 Further Readings

1) Management Economics by Dr. P. L. Mehta
2) Managerial economics by Dr. A. L. Ahuja

9.11 Model Answers

Activity I
a) Economic profit includes implicit cost plus explicit cost –
So Total Revenue – Implicit cost – explicit cost = Economic profit
b) Accounting profit deals with explicit costs only.
Total Revenue – (Wage + Interest + rent) – other explicit cost =
Accounting profit.
c) Gross profit and Net profit
Gross profit= total receipt - Total expenditure
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Net Profit = Implicit cost – Depreciation Notes

Activity II
a) Need of Inventories
Inventories are required to maintain continuous operation of business.
It consists of raw material, semi finish goods, spare parts, finish
partsand finish goods
b) Depreciation is the cost of the use of fixed assets which have limited life
so that these assets can be replaced when these stop working. So this
helps in keeping the assets intact and helps in economic growth.
Activity III
1. External factors which affect profit are –
a) Full employment when there is a full employment in the factory, and
cordial relation, it will increase profit.

b) Political factors. If there is peace and no law and order problem, this will
help the businessman a lot and will increase profit.

2. The consumers will be satisfied and not feel exploited. This will
improve the image of the firm. Further there is a possibility to attract the
rivals to compete.

3. Profit is necessary for economic development, because the surplus

generated can be utilized for expansion of the plant. Profit spent on
Research and Development will help to bring innovation, reduce cost
and improve the quality of the product.

Quiz :
Q1. increase the demand for their strawberry jelly because the two are
complements.
Q2. increases the prices of pins and adhesives.
Q3. until 100% of unused plant capacity is employed.
Q4. All of the above are examples of price discrimination.
Q5. first-degree price discrimination.
Q6. first-degree price discrimination.
Q7. the market price of the final product.

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Notes
CHAPTER 10

GOVERNMENT POLICIES

Learning Objectives
After going through this unit, you will be able to:
State the role of the government in handling National economic
affairs
Explain the monetary policy.
State use of monetary policy in controlling inflation and depression
to some extent,
Explain various methods used for the purpose
Describe monetary policy in the form of cheap money policy and
dear money policy and how it can control investment..
Explain about the fiscal policy i.e. the policy of taxation, public
expenditure and public borrowing.
Discuss how these policies can control inflation and depression and
help economic growth.
Discuss that during depression, fiscal policy is more effective than
monetary policy.
Structure
10.1 Introduction
10.2 Government policies
a) Monetary policy
b) Fiscal Policy
10.3 Monetary Policy Main purpose
10.3.1 Various tools used in Monetary Policy
10.3.1.(i) a contraction of money supply
10.3.1.(ii) Expansion Bank rate
10.3.1.(iii) Open market operation/statutory liquidity ratio (SLR)
10.3.1.(iv) Reserve ratio/Cash Reserve Ratio (CRR)
10.3.1.(v) Selective credit control
103.1.(vi) Margin
10.3.1.(vii) Control of credit
10.4 Fiscal Policy
10.4.1 Meaning and objective of Fiscal Policy
10.4.2 Tools of Fiscal Policy
10.4.3 Use of tools in various economic conditions in different economic
situation such as inflation, depression and unemployment
10.4.4 Limitation of Fiscal Policy
10.5 Summary
10.6 Keywords
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10.7 Self assessment questions Notes

10.8 Further reading
10.9 Model answers

10.1 Introduction
In Unit No. 9 we have given the idea of trade cycle. Trade cycles throw light on
ups and downs in economic activities of a country. You have learnt different
phases of trade cycle and also learnt about inflation, recession and depression
in the economy. Some ideas of Govt. control, can effect inflation, recession
and depression.
In Unit No. 10 we shall give you the idea of Government interference in
economic activities to overcome various problems faced by the economy and
to assist the economy.
Government interferences, when there are some problems in the economy ,is
essential to reduce the bad effects on the economy. The Govt. has legal and
social frame work to control and regulate the economy. There are other ways
also to be used by the Govt. to improve the economic positions, welfare of the
economy. The Govt. has to control and regulate the economy to achieve its
objectives.

10.2 Government Policies

The Government is using Monetary and Fiscal Policies to attain certain
objectives and to give a boost to the economy. Monetary policy deals with
expansion and contraction of money supply and of credit. There are many ups
and downs in the economy. So Govt. with the help of its central banks i.e. RBI,
follow the monetary policy to help the economy.

10.3 Monetary Policy Main Purpose

a) Price stability
b) Exchange stability
c) Full employment and maximum output
d) High rate of growth
But in India the main objectives of Monetary Price are –
a) Economic growth
b) Social justice
c) Price stability

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10.3.1 Various tools used in monetary policy are – Notes

(a) Quantitative
(b) Qualitative
(a) Quantitative methods
(I) Expansion and contraction of Money supply
(ii) Bank Rate Policy
(iii) Open Market operation/Statutory Liquidity Ratio (S.L.R.)
(iv) Reserve Ratio /Cash Reserve Ratio (CRR)
(v) Repo rate a reverse repo rate
(b) Qualitative method
(vi) Selective Credit Control
(vii) Rationing of Credit
(viii) Margin
(ix) Control of credit – consumer credit
10.3.1.(i) A contraction of money supply
10.3.1(ii) Bank Rate
Central Bank is lender of last resort. Bank rate is the rate which is
charged by the Central Bank to rediscount eligible commercial papers
of the commercial banks. Here the central bank can adopt any policy
such as cheap money policy and the dear money policy. If Central Bank
wishes to control credit it can raise the Bank rate and make the
borrowing costly. If Central Bank wants to adopt cheap money policy it
can decrease the Bank rate and make borrowing, by the banks,
cheaper. This will reduce the interest rate. The Bank rate policy does
not work effectively because –
(I) The commercial banks have excess liquidity (cash)
(ii) The banks have alternate source of revenue
(iii) The Bill-of-Exchange and commercial papers are not used for
borrowing from the Central Bank.
(iv) The efficiency of Bank rate policy depends on the psychology of
the borrowers (Pessimism or optimisms). Bank rate has limited
role to play to control deflation.
10.3.1(iiI) Open Market Operation
Open Market Operation refers to the purchase and sale by the Central Bank
(RBI) of different assets such as foreign exchange, government securities gold
etc. to the banks and the public. Under open market operation the Central
Bank would like to influence the economy by increasing or decreasing the
money supply. During inflation RBI sells the securities etc and takes away cash
from the people. This affects their disposable income and the demand of

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goods and services is reduced. This will also reduce the power of credit Notes
creation of the commercial banks, so the banks cannot lend more. This helps
to check the inflation. During depression R BI buys the securities etc and pay.
The cash is transferred to the public This will create the purchasing power of
the people and push the demand of goods and services and credit creation
power of the banks also increases and banks can lend more. This has many
benefits –
1. Influences internal prices and wages and affects the balance of payment
2. Open market operation gives good support to Bank rate policy and bank rate
policy become more effective.
3. It helps to fulfill needs of the economy during different seasons and different
situation.
But Open Market Operation has some limitations.
Lack of Securities Market which should be large and well organized. A well
developed security market is very essential for the effective working of Open
Market Operation.

Secondly Cash Reserve ratio is not stable, which is the need for the success of
Open Market Operation.
Thirdly there is a need of co-operation of the Banking Sector and the business
sector because when Central banks starts selling securities it is an indication
that credit control is necessary in the economy and the country.
1. Variation in the Reserve Ratio The Central Bank can change the reserve
ratio to control credit in India. CRR (Cash Reserve Ratio) is used to block at
least a part of the bank deposits and this amount is with the RBI and not
available to the banks for giving credit. The CRR is 5% and this controls the
credit creative power of the commercial banks.
Secondly the RBI has another tool such as SLR (Statutory Liquidity Ratio).
This refers to that portion of total deposits of commercial banks, which it has to
keep with itself in the form of liquid assets. At present 25% of the entire net
demand and time deposits are in this form.
Increasing the CRR/SLR means-
Reducing the commercial banks powers,
To create credit and lending capacity
When RBI wants expansion of credit during recession then this ratio is reduced
as was done in 2008.
This method has some limitations such as cash reserves with the commercial
banks are already very high. Further this CRR is applicable to all the banks in
India which is not good for the backward regions because the backward
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regions need a lot of credit to expand its economic activities and to create Notes
employment opportunities.

A backward region requires more for development. CRR should be used

by discretion and by assessing the needs of the different regions.
CRR may not be effective under depression when there is pessimistic
atmosphere.
CRR has depressive effect in the securities market.
So CRR should be used after going through the condition of the economy.

10.3.1(iv) Repo rate and Reverse Repo Rate

Whenever the commercial banks have shortage of funds they can borrow from
the RBI. Repo rate is the rate at which he commercial banks borrow funds from
the RBI. If Repo rate is less, the banks can get money at a cheaper rate of
interest. If Repo rate is increased borrowing from RBI will become more
expensive and this will discourage borrowing from the RBI.
Reverse Repo rate is the rate at which RBI borrows money from the
commercial banks. It is generally less than Repo Rate.

10.3.1(v) Selective Credit Controls are designed to regulate the direction of

credit, where it is needed. Here essential and non essential uses of credit can
be controlled and resources can be diverted to the essential and priority
sectors of the economy.
Rationing of Credit
Regulation and controlling is the purpose for which bank credit can be used. It
has to see that priority sector is not deprived of credit. This method curtails the
freedom and initiative of the commercial bank.
10.3.1(vi) Margin Requirement
Margin is the difference between the value of security and the amount
borrowed against these securities. For example if the margin against gold
security is 10% and you offered the security of gold worth Rs.10,000/- you are
likely to get Rs.9,000/- as a loan. Rs, 1,000/- is kept as a margin. RBI can fix
various margin limits for the uses of credit. So it can control lenders as well as
borrowers by prescribing different margin requirement for different uses. The
Central Bank can divert credit to the desired channel as per the needs of the
economy.
Variable interest Rates

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Variable interest Rates Notes

Under this different rate of interest are charged selectively for different uses.
So the Central Bank can follow cheap money or dear money policy at the same
time for different sectors of the economy.
10.3.1(vii) Regulate of consumer credit. Here RBI controls the bank credit
to finance various products in the market by regulating it. Down payment and
number of EMI can help the Central Bank to control credit. For example a bike
costing Rs.50,000/- the practice is to down payment 25% and balance in 10
installment but Central Bank can raise down payment to 40% and EMI
installation to 5. This will reduce demand. This is also used in leasing finance
to the companies for the purchase of machineries, equipments etc. The
method of selective credit control has certain limitation such as it is difficult to
determine essential and non essential factors to decide the lending to the
borrower. It needs a large staff to check whether the credit is used for the
desired purposes or not. There is no freedom to the lenders and the borrower
hence small borrowers may be badly affected. It also badly affects the
backward regions where development is necessary so that the resources are
utilized.

10.4 Fiscal Policy

Fiscal policy is defined as that part of the governmental economic policy, which
deal with taxation, public expenditure and public borrowings and management
of public debt. Fiscal policy is a policy under which the Govt. uses its power of
expenditure, raising of revenue to attain desired effect and avoid all
undesirable effects on the national income, production and employment
policy.
The Govt. exercises its power to tax the people and to draw expenditure
programmer and Govt. borrowings program through its budget and is known
as budgetary policy. The budgetary policy has tremendous effect on the
economy of the country.
10.4.1 Objectives of Fiscal Policy
a. Mobilization of Resources.
b. Economic development and growth.
c. Reduction in disparities of income that is to remove inequality in
distribution of income among the rich and the poor and social justice.
d. Expansion of employment opportunities
e. Price stability and control of business cycle.
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10.4.1 a) Mobilization of Resources Notes

The Govt. has to mobilize the resources through taxation and other ways and
means. The Govt. has to run the Govt. machinery. Main expenditure of the
Govt. is on –
a) Defense
b) Law and Order
c) Justice
d) Administration
e) Education
f) Development of infrastructure
g) to help the people during the time of natural calamities
So the Govt. needs a lot of revenue to run the state.
10.4.1 b) Economic development and growth
Country like India has to deploy its major part of the revenue and resources for
economic development and growth. The people are subject to various circle of
poverty. This vicious circle has to be broken by huge investment in infra
structure and incentives to the new investment. So Govt. has to raise extra
revenue for this. This revenue has to be invested in that area where it will bring
multiple results. Taxation policy should be conducive to growth and need not
affect the willingness to work and save and invest. Private sector should also
be encouraged to invest. So the investment and production should help the
general economic growth and removal of poverty.
10.4.1 c) Social Justice.
It is one of the main objectives of the fiscal policy. It can be done by equitable
distribution of Income and wealth. The poor should be provided free
medical care, free education, and subsidized essential goods and services.
The Govt. can adopt progressive taxation to raise the revenue and public
expenditure on the welfare of the poor.
10.4.1 d) Objective.
In order to achieve the objective of full employment the Govt. has to create
opportunities of different types of employment. For this the consumption and
investment of the people should not be affected. Govt. by following deficits
financing and tapping the unutilized resources can help in increating
employment. Rural employment scheme can help to keep the assets intact
and creating new assets in the rural areas. This will be a great help in creation
of jobs. The Govt. can undertake creation of infra structure such as
construction of road, bridges, dams and generation of power. These do help in
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creating jobs. The autonomous investment can help in creating induced Notes
investment by which the people become interested in private investment.
10.4.1 e) Price stability and control of business cycle
Price stability is very important objective of the fiscal policy. The Govt. has to
take measures so that it can control inflation and depression. Recession is
causing a lot of trouble in the world because it is accompanied by
unemployment and reduces the economic activities and National Income of
the country
10.4.2 Tools and instruments used in Fiscal Policy in different economic
situations such as inflation, depression and unemployment. The main tools
which are used in fiscal policy are as follows:
10.4.2 (I) Budgetary Policy
The Govt. uses its expenditure and revenue policy to produce desirable effects
and avoid bad effects on the National Income, production and employment.
The policy is also known as budgetary policy.
The budgetary policy deals with various situations of the [Link] case of
depression the budgetary policy should be of deficit financing that means to
increase the flow of income into the economy. This step will increase the
purchasing power in the economy and helps revival of the economy. Deficit
financing also helps in generation of employment. The Govt. undertakes civil
works, some projects and construction of infra structure where lot of
expenditure and investment has to be done. This will help in generating more
purchasing power in the hands of the people
During inflation budget should be surplus through taxation and curtaining the
purchasing power. The Govt. should reduce its expenditure. This will check the
purchasing power of the people so demand of goods and services is reduced.
This will helps in controlling inflation.
10.4.2 (ii) Taxation Policy
During depression the taxes should be reduced on essential goods to enable
the people below the poverty line to increase consumption. The Govt. should
also reduce direct tax which will increase disposable income of the people and
the demand of goods will increase. Taxation policy should be desired to
increase consumption and investment during depression period.
To check inflation the taxation policy should be to impose higher taxes i.e.
increase in direct and indirect taxes which will curtail consumption and helps
the Govt. to divert funds for creation of national assets and employment.
Further the Govt. can invest fund in a socially desirable manner. This will also
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help in reducing inequalities of income. Notes

10.4.2 (iii) Public debt
The Govt. can use the policy of Public borrowings to achieve some of the
economic goals. During depression Govt. should pay back the borrowed
money so that the people should have more disposable income to spend.
During depression investment should be increased. The rate of interest
should be lowered. This will encourage investment and employment.
In case of inflation the Govt. should borrow more to curb the purchasing power
of the people. It is necessary that borrowed fund should be used for productive
purposes only and used for creating national assets.
10.4.2 (iv) Public Expenditure
Public Expenditure under Fiscal policy is very important tool to control
inflation, depression and create employment.
Public expenditure should be increased during depression and unemployment
because it will help in creating purchasing power in the hands of the people.
This will help in reducing the effect of depression and also increase
employment opportunities if the Govt. undertakes some civil works. The
Govt. can adopt the policy of pump priming. That is when private investment is
less the Govt. should increase investment and the Govt. expenditure is to help
to revive the economic activities. Here the object is to increase private
investment through injection of purchasing power in the form of an increase in
public expenditure. Further it also encourages private investment if there is a
short fall in Govt. investment.
To curb inflation all non-essential expenditure should be reduced to the
minimum.
10.4.3 Use of tools in various economic conditions in different
economic situation such as inflation, depression and unemployment
Economic theories are formulated to explain different phenomenon. They try
to explain the relationship between two or more variables. While formulating
theories a number of tools are used by experts in this field. The tools of
economic analysis are found in the realm of Mathematics. Mathematics is
being profusely used in modern economic analysis. Mathematics is regarded
as the second language for the students of economics. Geometry is being
increasingly resorted to in order to provide pictorial presentation of economic
behavior. Diagrams and Graphs provide visual impact and help to grasp and
learn economics with interest and ease. A Chinese proverb says “A picture is
worth a thousand words”.Modern economists have turned to Calculus, Matrix,

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10.4.4 Limitation. There is a lot of time lag when the Govt. thinks of taking Notes
action. Before it is implemented after some time the situation has gone very
bad. Secondly in order to meet the challenge the purchasing powers should go
to the masses that mean redistribution of income. Again this measure still
takes a lot of time. The action taken by the Govt. must be supported by the
private sector. But this sector is reluctant to cooperate with the Govt.
Further there is a lack of cooperation and cooperate in different field of the
[Link] and Derivatives to use them as fundamental tools to
express complicated aspects of economic theories and models more precisely
and accurately. All these applications of mathematics are significant as a tools
and techniques to impart conciseness, precision and rigour to economic
analysis.
However, along with Monetary Policy the Fiscal policy has also to be used so
that some results can be achieved. Monetary policy may not be as effective as
the fiscal policy.

10.5 Summary

In this unit we have discussed different Govt. policies which affect the
economy of the country. Also we feel the role of the Govt. to support the
economy in the time of inflation and depression. Any fluctuation in the
economy has to be dealt with, by the Govt. The Govt. has already legal and
social frame will be control and regulate the economy.
The Govt. uses two measures that is (a) Monetary policy (b) Fiscal policy.
These two measures are mostly related to control or expansion of the supply of
money. When there is a rise in prices, that situation is called inflation and when
there is a fall in prices on large scale, unemployment and the economic
activities at very low level, this situation is called depression. Depression has
very bad effects on the economy so the Govt. has to adopt monetary measures
of expanding or contracting the supply of money. Similarly the Govt. uses the
Fiscal measures of taxation, Govt. expenditure and Public borrowing to tackle
inflation and depression when Govt. spends more money. This expenditure
increases the purchasing power of the common man and push up the demand,
of goods and service and the economy starts looking up. This is called
injection in the economy. During inflation Govt. tries to reduce the demand of
the people by taxation and can meet the challenge of inflation. This is called
withdrawal from the economy. But both the measures are to be used at the
same time to get better results. We have discussed all the measures in this
unit with their limitations.
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10.6 Keywords Notes

Depression. When there is over production demand in general starts

falling faster than the fall in production of goods. This leads to a fall in
prices, demand wages and employment. This leads to rise in inventories
which blocks the capital.
Inflation a general rise in prices in the economy.
Unemployment When large number of able bodied pressures of working
age, which are willing to work cannot get the work.
Monetary Policy. It is a mechanism to regulate the money supply in an
economy by the Central Bank.
Open Market When the Govt. through its central bank enters in the market
to buy and sell Govt. securities.
Bank Rate. This is rate changed by the Central Bank from the commercial
banks when the banks rediscount eligible commercial papers.
Reserve Ratio. The banks have to keep certain percentage of their time
deposits and demand deposits in reserve which is not available to the
banks for giving credit. Generally this is from 3% to 9%.
Fiscal Policy. The Govt. while preparing annual budget adopt the policy
of taxation public expenditure and public borrowing. It is a set of guide line
for the Govt's revenue, and its spending.

10.7 Self Assessment Question

1. Define inflation. What are the various types of inflation?
2. Suggest monetary measures to control inflation and depression.
3. Discuss the effects of inflation on the different sectors of the economy
4. Discuss various objectives of Fiscal Policy
5. Explain the instruments of Fiscal Policy
6. Discuss the role of taxation and public expenditure in controlling inflation.
7. How public expenditure is more effective in helping to reduce the bad effects
of depression.
QUIZ:
[Link] the volume of investment in an economy can only fill up the gap
between income and ____ A Saving B Rate of Interest C Marginal efficiency
of capital D ConsumptionQuestion
Q2. Physical policy is also known as __
A Monetary Policy B Direct Controls C Fiscal Policy D Stabilization policy
Q3.______ deals with the total money supply and its management in an
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economy. Notes
A Fiscal Policy B Direct Controls C Monetary Policy D Stabilization
PolicyQuestion
[Link] and Mitchell observe that peaks and _____ are the two main mark-
off points of a business cycle.A Expansion B Prosperity C Revival D TroughS
Q5.A ________expresses quantitative relationship between two different
variables at a certain time.
A Functional variables B Flow variable C Stock variable D Ratio variabl

10.8 Further Readings

1) Management Economics by Dr. P. L. Mehta

2) Managerial economics by Dr. A. L. Ahuja

10.9 Model Answers

Activity I
1. Objectives of Monetary Policy. See 10.3
2. Bank Rate is to be raised if there is inflation?
Yes it should be used. Bank rate is to be raised that means borrowing
from the central bank will costly.
3. Explain statutory Liquidity Ratio. Statutory Liquidity Ratio 25% of the
total deposits to be invested in the securities decided by the RBI.
4. Cash Reserve Ratio is reduced by the RBI. Explain. Cash Reserve
Ratio is used by the RBI to block a part of bank deposits. Reduction in
CRR mean more credit creation by bank.
5. Margin to be increased to control inflation. Discuss. It is difference
between the value of security and the amount borrowed against this
security. If margin is increased less credit will be given.
6. EMI and down payment to be reduced to effective of depression. This
will help in buying more goods on credit generally fixed by the financial
institution.
7. Explain dear money and cheap money policy. Dear money policy
means the borrowing will be costly to control inflation. Cheap money
policy is used in depression it makes borrowing cheaper to increase
investment.

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Activity II Notes
1. Discuss the tools of fiscal policy.
Tools of Fiscal Policy are Budgetary Policy, Taxation public expenditure
and public borrowing.
2. Withdrawn from the public is one of the ways to control inflation.
Explain.
Withdrawn means taxation policy to reduce the supply of money with
the people.
3. To increase employment during depression the Govt. should
undertake public works. Discuss.
During depression when there is lot of unemployment so the Govt. has
to adopt the policy of more public expenditure on construction of road,
buildings, dam etc., to create jobs and purchasing power of the people.
4. Govt. should adopt injection policy to reduce the ill effects of recession.
Govt. should increase public expenditure (known as injection) during
recession to create purchasing power of the people which will increase
demand.

Quiz :
Q1. Consumption Question.
Q2. Direct Controls.
Q3. Monetary Policy.
Q4. TroughS.
Q5. Functional variables.

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Notes
CHAPTER 11

BUSINESS CYCLES (MEANING AND PHASES)

Learning Objectives
After going through this unit, you will be able to:
Discuss about the general rise and fall in prices.
Describe business cycles and its phases.
Explain inflation, recession and depression.
State the reasons and causes of inflation and depression.
Discuss the kind of cyclical fluctuation in economic activities.
Suggest the measures to overcome cyclical conditions.

Structure
11.1 Introduction
11.2 Business cycles
11.2.1 Meaning
11.2.2 Phases
11.3 Inflation
11.3.1 Define inflation
11.3.2 Causes of inflation
11.3.3 Control of inflation
11.4 Recession and depression
11.4.1 Define recession
11.4.2 Causes of recession
11.4.3. Control of recession
11.5 Depression
11.5.1 Idea of depression
11.6 Summary
11.7 Keywords
11.8 Self Assessment Question
11.9 Further Readings
11.10 Model Answers

11.1 Introduction
In unit No.8 you have learnt different strategies of pricing of a product followed
by the businessmen. There are various methods of pricing of a product. Each
pricing system has its advantages and disadvantages. So we have tried to give
you the idea of pricing a product in different market and different areas

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In the present unit we shall explain the idea of trade cycle .This is always Notes
happening in a capitalist economy accompanied by fluctuation like ups and
downs in the economic activities. We find that this fluctuation in the economy
has affected the economic activities of the country. Phases of trade cycle are
also studied .Different methods are also explained to have some control or
reduce trade cycles bad effects to some extent. Business cycle is
accompanied by inflation; recession and depression are explained in details.

11.2 Business Cycle

Business cycle or trade cycle is very important happening in a capitalist
economy. There is a boom period when economic activities are at the highest
and there is a slowdown of economics activities, which brings depression.
During high economic activities there are great opportunities for employment
and trading, high income high purchasing power and more trading. This period
is called Boom period. Then suddenly economic activities receive a shock and
all economic activities receive a shock and it starts going down .This period is
called recession and ultimately it leads to the depression. This period causes a
lot of problems in the economy because there is unemployment, very low
purchasing power and all economic activities are at a low level.
11.2.1 Meaning of trade cycle
The trade cycle simply means the whole course of trade or business activities
which passes through all the phases of prosperity and adversity.
According to J.M. Keynes, “a trade cycle is composed of period of good trade
characterized by rising prices and low unemployment percentage and
followed by period of bad trade characterized by falling prices with high
percentage of unemployment percentage.”
The trade cycle are recurrent and have been occurring periodically more or
less in regular fashion. Some business cycle has been very short lasting i.e. for
only two to three years, while other may last for several years. There is a
famous example of great depression of 1930 which had affected the whole
world except Russia. During recession or depression there is large scale of
unemployment which reduces output. Many businesses go bankrupt and
suffer losses. The example is the great depression of 1930.
Boom creates inflation in the economy when there is rise in prices, increase in
employment opportunities and high level of economic activities. This erodes
the real incomes of the people and reduced saving. But the rich are benefitted
due to inflation.

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11.2.2 Phases of business cycle Notes

Phases of business cycle are divided into four as following:
a) Prosperity phase. ( Boom, expansion and upswing of the economy)
b) Recession phase. (Down swing recession or depression.)
c) Depression phase(contraction or downswing of economy)
d) Recovery phase ( lower turning point , from depression to prosperity

Fig. 11.1

During recovery stage, expansion starts playing its role and this leads to
prosperity. During recession we have contraction of all economic activities and
this causes depression.
The business cycle starts from trough (lower point) passes through recovery
phase followed by a period of expansion (upper turning point) and
prosperity. After the peak point is reached there is a declining phase of
recession followed by depression and it continues simply with upward and
downward swing.
Explanation of phases of business cycle
a) Prosperity phase
There is an expansion of economic activities. Prices, employment, income and
production move upward. Total output starts growing at a rapid pace due to
higher investment and more employment. The producers gain because wages
and the prices of raw materials are low initially and move later on. There is
higher level of effective demand. The rate of interest increases due to more
demand for capital. This causes inflation, expansion of bank credit. There is
rise in the GNP. This further increases inflation and higher profits. There is
upswing in the economic activity and the economy reaches its peak. This is
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known as BOOM period. Notes

b) Recession period.
The temporary point from prosperity to depression is termed as recession
phase. During this phase economic activities slow down when demands start
falling. Over production or future investment plan are given up. There is
steady decline in the output, income, employment, prices and profits. The
businessman becomes pessimistic and this reduces investment. During this
period the commercial banks call back loans to maintain liquidity. So are the
credit contracts.
People start losing jobs which leads to unemployment and sharp decline of
income and aggregate demand. Recession last for a short period.
c) Depression Phase:
During this phase output is decreasing, income employment, prices and profit
is also declining. Then the depression sets in.
In depression (a) there is a fall in output and trade (b) fall in income (c) Increase
in unemployment (d) decrease in consumption and demand; (e) fall in the
interest rate (f) deflation (g) contraction of bank credits (h) overall pessimism (i)
fall in marginal efficiency of capital.
The resources are underutilized which leads to a fall in GDP. Then this stage
leads to TROUGH (Lowest point).
d) Recovery Phase:
This is turning point from depression to expansion and is regarded as recovery
or revival stage. During this recovery period there is rise in economic activities
and the demands start rising, production increases and this encourages new
investments. The businessmen get confident. The banks expand credit
which leads to expansion of business and it affect stock market also which is
activated now. There is an increase in employment, production, income and
aggregate demand.

Activity 1
a) Name the different phases of trade cycle.

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b) Prosperity phase receives a setback due to overproduction. Discuss. Notes

c) Explain why depression is worst than inflation.

11.3 Inflation

Inflation may be defined as rise in the general price level. Inflation may occur
either due to increase in demand or increase in the cost of production. If it
caused by increase in demand of goods and services it is known as demand
pull inflation. Here the aggregate demand of goods and services exceeds the
available supply of the outputs and so causes the general rise in price level of
the economy.
The price may rise even when there is no increase in aggregate demand. This
could be due to rise in the cost of input. If the cost of any factor of production
increases the cost of goods is bound to go up. If the inflation is caused because
there is a rise in the cost of production as the inputs costs have gone up it is
known as cost pull inflation.
The producers pass on these cost to the consumers by increasing the price of
the product. For example with the rise in the price of diesel , this has increased
the price of different products.
11.3.1 Define Inflation
Inflation may be defined as general rise in prices in a persistent manner.
Prof. Crowther. He has defined inflation as a state in which the value of money

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is falling and prices are rising. Notes

Prof. Kemmerer defined inflation as too much currency in relation to physical
volume to business being done. That means too much money chasing too few
goods.
The price may rise even when there is no increase in aggregate demand. This
could happen due to rise in the cost of inputs. If the cost of any factor of
production increases the cost of final good is bound to go up. The producers
pass on this cost to the consumer by raising the prices of the product. The rise
in the prices in diesel has increased the prices of various products in India.
11.3.2 Types and Causes Of Inflation
a) Demand – pull inflation
b) Cost – push inflation
c) Excessive growth in money supply
d) Deficit financing
f) Credit inflation
e) Wartime/post war / peace time inflation
g) Tax inflation
h) Sectoral inflation
i) Pricing power inflation (oligopoly)
j) Stagflation
a) Demand- Pull Inflation
When the aggregate demand for goods and services exceeds the
available supply of output, this will increase the prices.
Aggregate Demand = C+I+G
C = consumption, I =Investment, G= Govt. expenditure
So we can say that the price rise is the direct result of an excess of
aggregate effective demand over the aggregate supply of goods and
serves.
b) Cost Push Inflation
This cost pull inflation happens due to the supply side of the factors of
production ease. If there is an increase in the prices of any production
it will increase and this will increase the price of the final output. It can
be in the form of increase in wages rate, interest rate or rise in the
prices of raw material. This increase is reflected in the cost of
production hence, it is called cost push inflation. For e.g. the
petroleum prices have raised we find an increase in the price of almost
all the goods.

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c) Excessive Grown In Money Supply Notes

In order to meet the expenses by the Govt. the Govt. has to resort
excess spending over its revenue and Govt. resort to deficit financing
i.e. (i) Borrowing from the Central Banks and Public (ii) Printing of new
currency notes (iii) Selling of Govt. assets. This will increase the
supply of money and this excess of money is used by the people to buy
goods and services. But the supply of goods and services does not
keep pace with the demand hence the prices begins to rise. If people
have more money they would demand more goods and services and
this will increase in the price level.
d) Deficit Financing
This is adopted by the Govt. through budgetary policy. If the resources
of the country are unexploited then the govt. has no source of raising
capital so the Govt. resorts to printing of new currency notes. This
mostly happens in the following situation
i) When Govt. revenue is less than the govt. expenditure
ii) When there are natural resources which are not exploited.
iii) When there are natural calamities like famine, flood, and
earthquake.
iv) Govt. has to spend a lot of resources to strengthen the defense
of the country.
In this situation the govt. adopts the policy of deficit financing. There
will be an increase in price level since the supply of goods and services
cannot pace with the new demand.
e) Credit Inflation
Under credit inflation, banks are encouraging the people to buy house
hold goods for which the banks are ready to finance. The banks
reduce the EMI and down payment to encourage the demand of white
goods such as cars, fridge, washing machine, mixtures etc. This leads
to increase in price level.
f) War Time Inflation
During war time the aim of the Govt. is to win the war so all the
resources of the country are diverted to meet the needs of the defense.
This create shortages of these goods for the civilian population, hence
the prices of all goods and services are increased.
g) Post War Inflation
During the war time the demand for goods and services is suppressed
but the earning power increases because of non availability of goods

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and services so after the war when all controls are removed the Notes
population uses that surplus funds to fulfill the suppressed demand
and this increases the price level.
h) Peace Time Inflation
During the peace time inflation the Govt. undertakes some projects like
construction of roads, bridges, dams etc. and uses the resource for
development of infrastructure to boost the economy. This excess
demand and excess expenditure causes inflation in the economy.
i) Tax Inflation
Tax inflation is caused by the Govt. under fiscal policy i.e. increasing
the tax on individual, goods and services. This will lead to rise in prices
and will cause inflation, for example Vat and service tax in India.
j) Sectoral Inflation
Sect oral inflation takes place when there is increase in prices of goods
and services produces by a certain section of industry for e.g. the
prices of agricultural produce are increasing and this is causing direct
effect on other sectors of the economy. Aviation industries are facing
inflation due to high rise in the crude oil [Link] inflation has
originated in one basic sector.
k) Pricing Power Inflation
It generally happens under the situation of oligopoly market for e.g.
pepsi, coke, Kellogg foods have increase the prices of their products,
because they have the power to fix the prices at a high level.
l) Stag Inflation
Under stage inflation we find that there is inflation in one sector of
economy where prices continue to rise but the whole economy is in
recession. For e.g. India is facing on one hand inflation and the prices
are rising but on the other hand the GDP of India is declining. This
situation causes financial crises in the economy.
Activity 2
a) Price rise is regarded as inflation.

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b) Demand Pull inflation is caused by an increase in purchasing power in the Notes

hands of the people. Discuss.

c) Explain the term deficit financing.

d) Credit inflation.

11.3.3 Control of Inflation

To some extent inflation can be controlled but not fully. Various measures
have been suggested by various experts but there is no one way which can
control inflation. Mostly it is related to increasing purchasing power of the
people. So the main emphasis is on controlling the supply of money and the
purchasing power of the people. Following are the measures to reduce
money incomes and control inflation.
11.3.3 (i)
(1) Monetary Measures
To control credit
The credit can be controlled by the central bank and the banking system. The

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methods used are raising the bank rates selling of Govt. securities in the open Notes
market, raising the reserve ratio so that banks will have less liquid. Similarly
the Repo rate has to be raised. Also the reverse Repo rate is to be raised. This
will discourage the commercial bank borrowing from the central bank. This will
also control the supply of money in the market. It also includes selective credit
control and raising the margin requirements and regulating the consumer
credit finance.
(2) Fiscal Measures
Monetary measure may not be so successful in controlling inflation, but fiscal
measures do have a better result because fiscal measures are highly effective
for controlling Govt. expenditure, personal consumption by increasing taxes
and private and public investment.
(a) Reduction in unnecessary expenditure on non-development activities.
This will put a check on private investment also. This will reduce the
supply of money held by the people.
(b) Increase in taxes i.e. direct and indirect taxes. The need is to increase
personal taxes, corporate taxes commodity taxes. This will reduce the
disposable income of the people.
(c) Encourage private savings so that consumption expenditure is
reduced. It may be in the form of compulsory saving as was done in
1978 in India. The people had to deposit 4% of their salary in the
nationalized banks for fixed period of five years.
(d) The Govt. should adopt the policy of surplus budget and reduce deficit
financing.
(e) Public debt means more borrowing from the bank and the public so that
their purchasing power in the hands of public is reduced and bank are
restrained to create credit.
Other Measures
a) To increase production of essential consumer goods like food clothing,
etc or import of essential goods which are short in supply?
b) To increase the supply of raw material.
c) Rational Wage Policy and income policy under hyper inflation; there
is a wage price spiral so the need is to freeze the wages, income,
profits, dividend etc. But this measure can be adopted only for a short
period. In England this was done during Second World War, when
wages were frozen.
d) Price Control & Rationing Here prices of essential goods are to be
fixed and scarce articles should be distributed through fair price shops

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through rationing. Notes

11.4 Recession
Recession It is the period of contraction in the business cycle. It is a general
slowdown in economic activities.
A decline in the GDP for two or more consecutive quarters is also called
recession.
Macro Economics indicators such as GDP, employment investment spending
etc., all fall and decline while rate of unemployment increases.
It happens when there is a wide spread drop in spending. It is often followed by
an adverse supply shock so Govt. has to follow expansionary macroeconomic
policies such as increasing money supply, increasing Govt. spending and
decreasing taxation. This will help in increase in disposable income in the
hands of the people. The people will demand more goods and services. This
will give a little push to the economy.
Causes of Recession - Over production by the firms ,which are independent
to take their decision. This lead to over production and it has to be sold either
at lower price or keep these in inventories and stop the production. . This will
lead to unemployment.
Secondly recession is caused by under consumption. The people consume
less and less.
Third cause is financial crises; here the bank would like to call back the loans.
This affects the firms and the firms have to sell their product at lower prices.
This results in heavy losses.
Impact of Recession – Recession will have following impact on the economy:
a) Bankruptcies
b) Credit crunch
c) Deflation
d) Foreclosure
Recession will cause bankruptcies in the market. Many firms will find it difficult
to repay the loans. This will crease credit crunch in the market. The banks
have no cash to lend but the banks have lot of mortgage properties and other
assets.
Further deflation will be caused which mean less of aggregate demand; This
will lead to unemployment, low wages, reduced purchasing power and reduce
the aggregate demand. The economic activities will be a lower level
When the customers fail to repay the loans, the banks opt for foreclosure a
legal process under which they can take the possession of mortgaged property
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and auction it to recover their loan amount. Notes

11.5 Depression

Any down turn in economic activities is referred to as a depression. So

depression is defined as a recession that lasts longer and has a larger decline
in business activity. A depression is any economic downturn where real GDP
declines by more than 10%. But a recession is an economic downturn that is
less severe.
1929-37 period was period of depression in the USA but from 2008 there is a
recession.
But depression when at its lowest level is called trough and from here the
economy starts moving towards recovery.
ACTIVITY III
a) Give two monetary measures to control inflation.

b) Explain the term Repo rate and its role in controlling inflation

c) Government injection is good during depression.

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d) Government withdrawal is good to control inflation. Notes

11.6 Summary
Business cycle refers to the fluctuation in economic activities. It is occurring
regularly in the capitalist societies. The phases are recovery, prosperity,
recession, and depression. Recovery means revival of economic activity as a
whole. Prosperity means a period of abnormal economic activity. It gives
momentum to increase in prices, income and employment. After this the
period of recession starts and economic activity starts going down turn which
leads to reduction in output, employment and the economy then leads to
depression and all the economic activities are at the lowest ebb. Income is
reduced along with employment. Business cycle creates a situation of
uncertainty for businessmen and affects the business. The quantum of
inflation is also taken. Inflation is defined and the causes are discussed of
inflation. Further we studied the effects of inflation on the economy along with
the different measures to control inflation. Similarly we discussed depression
and its effects.

11.7 Keywords
Boom - (Prosperity). Phase of business cycle where there is repaid
upwards movement in income and employment and a great incentive for
fresh investment.
Depression - A situation created by over production because demand
starts falling faster than the fall in production of goods.
Recession - Where the business cycle takes a downwards turn from the
state of boom. and Output, profits and employment starts falling gradually.
Recovery – Revival of demand for goods and services. Economic activity
starts picking up. Business Psychology is optimistic.
Trough – is the turning point under depression to recovery a form Boom to
recession.
Inflation - It is a process of a steady and sustained rise in the prices.
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Demand Pull Inflation – When the demand of goods and services Notes
increases with a less increase in supply of goods and services. It is called
a demand Pull Inflation.
Cost Push inflation – When the cost of any input increases it increases
the cost of production.
Fiscal Policy - The policy of the Govt. regarding taxation ,public spending
and public borrowing ,which is used to control inflation, depression and
trade cycle.
Monetary Policy - It is regarding the control of Money Supply to control
inflation and depression.

11.8 Self Assessment Questions

1) Describe various phases of business cycle.

2) State the difference between recession and depression
3) Define inflation. Explain the causes of inflation.
4) Explain the effects of inflation on the economy.
5) Monetary policy adopted by the Govt. will help to control inflation.
Discuss.
6) Fiscal policy is more effective in controlling inflation and depression.
Elaborate your answer.

Quiz:
Q1. total input cost / units of output
The total population of an economy is 175 million, the labor force is 125 million,
and the number of unemployed is 8 million. The unemployment rate for this
economy is:
Answer
4.6 percent.

5.8 percent.

6.4 percent.

7.8 percent.

Q2. The unemployment rate is subject to criticism due to:

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Per-unit production costs = Notes

Hyperinflation is:
the consumer price index.

[Link] percentage change in one's real income can be approximated by:

dividing real income by the price level, expressed as an index number.

dividing the price level, expressed as an index number, by nominal income.

the percentage change in price level minus the percentage change in nominal
income.

the percentage change in nominal income minus the percentage change in the
price level.

[Link] price level has doubled in 35 years. The approximate annual

percentage rate of increase in the price level over this period has been:

50 percent.

20 percent.

5 percent.

2 percent.

The main measure of inflation is:

part-time employment and discouraged workers.

The unemployment rate is subject to criticism due to:

Unemployment that is caused by a decline in total spending is called:

The unemployment rate is:

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The main measure of inflation is: Notes

part-time employment and discouraged workers.
The unemployment rate is subject to criticism due to:
Unemployment that is caused by a decline in total spending is called:
The unemployment rate is:

11.9 Further Readings

1. Dr. [Link] Managerial Economics
2. Dr. [Link] Managerial Economics
3. Prof. Joel Dean Managerial Economics
4 .Dr. Mahajan Mukund Managerial Economics

11.10 Model Answers

Activity I
a) Phases of trade cycle are Recovery, Peak, Contraction and depression
and Trough.
b) In a capitalist economy there is no coordination among different
producers which leads to over production, so the workers are laid off
which causes the beginning of contraction.
c) During depression money wages are less many people are
unemployed and income falls. But when inflation is there, there is a rise
in employment, increase in wages and income and the economy
becomes very active.
Activity II
a) In inflation there is going to be a rise in general price level because
people have more purchasing power hence demand increases and the
price rises.
b) Demand pull inflation is caused by increase in demand of goods and
service and available supply of output is less.
c) Deficit financing is the term used when Govt. expenditure is in excess
of its revenue and Govt. has to resort to printing of new currency notes
and borrowing.
d) Credit inflation is caused by increase in availability of credit from the
financial institutions. The system of hire-purchase is based on it.
Because of financial credit the demand of various goods and services
increases.

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Activity III Notes

a) Bank rate policy and open market operation are the two measures
apart from other.
b) When commercial bank borrows money from the central bank, the rate
of interest which is charged by the central bank is called Repo rate.
c) Injection means putting more money in the economy by increasing the
public expenditure on various projects etc. Further the Govt. gives
subsidy. . This increases the demand of other goods and services and
helps to tide over depression.
d) Withdrawal is a way by which the Govt. reduces the purchasing power
of the people. It collects money through taxes direct and indirect
taxes.

Quiz :
Q1. Cost per unit.
Q2. the consumer price index.
Q3. the percentage change in nominal income minus the percentage
change in the price level.
Q4. 20 percent.

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Notes
CHAPTER 12

COST BENEFIT ANALYSIS

Learning Objectives
After going through this unit, you will be able to:
Clarify the meaning of cost benefit analysis
Learn the need of such study
Explain various steps to be taken to get proper result.
Determine whether it is sound investment decision or not
Provide the basis for company projects on which the company
should take decision
Clarify the difference between social cost benefit and private cost
benefit.
Structure

12.1 Introduction
12.2 Steps involved in Cost Benefit Analysis
12.3 Cost Benefit Analysis Private And Social
12.4 Advantages of Cost Benefit Analysis
12.5 Limitation of cost benefit analysis
12.4.1 Disadvantage of cost benefit analysis
12.6 Summary
12.7 Keywords
12.8 Self Assessment Questions
12.9 Further reading
12.10 Model Answers

12.1 Introduction

The cost benefit analysis will help to get the idea of the benefits and the costs of
various investment opportunities, which are available to the business houses
and the Govt. Here we have to find out whether it is worthwhile to invest in a
project and to study every alternative available. Further cost benefits analysis
refers to the analysis done to judge a project investment. It may be under the
Govt. or in the private sector. The cost benefit analysis is used to evaluate and
give a ranking to every project before it is undertaken for execution. Anybody,
who is thinking of investment, must try to get its cost benefit analysis done
before one takes the decision about the project. Cost Benefit Analysis focuses
on economic efficiency. It calculates the net benefits for each policy proposal.
It takes a long term to view and to incorporate all relevant factors regarding
costs and benefits.
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· It is an analytical frame work used to assess the benefit and cost of Notes
policy proposal.
· Cost Benefit Analysis focuses on economic efficiency
· It calculates the net benefit for each policy proposal.
· It takes a long term view and incorporates all relevant costs and
benefits.
· Allows benefits and cots to be comparative
· It can show the cost and benefit accruing to different groups within the
community.
In all cases the decisions are at micro level. In broader sense, the cost benefit
can be adopted on a macro level either at the level of the economy as a whole
or for the public sector activity where such analysis are very important and
guides the Govt. as well as the business world.

12.2 Steps Involved In Cost Benefit Analysis

The cost benefits analysis is a technique used for analyzing investment and for
ranking the alternative investment opportunities. It is a difficult process
because of the uncertainty of the elements and changing in the value of
money, because the economy is dynamic. These are always present under
every circumstance. When a big project having huge investment is
undertaken by the Govt. it is necessary to analyze its social costs and its social
benefits involved with it. It is also a part of capital budgeting from the point of
view of an individual investor.
Following are the steps involved in cost benefit analysis –
12.2 (i) a) Identification of project
b) Formulation of the project
c) Appraisal and selection of the project
d) Comparison of cash flow
e) Selection and implementation
f) Mid- term project evaluation
12.2.1 (a) First thing an investor has to do to do research on various
opportunities available to him for investment. Then the investor has to select
one of them, which is more feasible and viable as per investment and return on
investment. The investor can get necessary information and data from
already established organization. The investor has to make a list of different
viable projects and make a list of likely projects.
12.2.2 (b) Now the investor has to make a blue print in terms of requirements
for the project like land, building, Plant and machinery, raw material, fuel and
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power. He has to find technocrats, skilled labor. An estimate of cost has to be Notes
prepared for each of the inputs. He has to decide the capacity which is likely to
be created and utilization of that capacity. Then he has to decide the price at
which the product can be sold in the market by taking into consideration of
existing market and various producers of the product. After this he has to
decide whether the project is economically feasible and viable. Then he has to
consider technological feasibility which will consider the availability of various
inputs like machine, finance, land, power, manpower. Further a study of
economic feasibility to be considered that means, generation of employment
and development of backward areas and social groups. Next step is to study
Management feasibility i.e. availability of managerial personnel for
implementing the project.
If any one of the feasibility is not applicable then a project may be dropped.
So a project to be viable must be feasible in the following respect –
a) Technical feasibility;
b) Economic feasibility;
c) social feasibility;
d) Management feasibility.
12.2.3 c) Appraisal and selection of the project
Here economic viability has to be considered that means cash flows i.e. cash
out flows and cash infl[Link] this the selection will depend upon viability of
the project within the investment limit set by the investor. Here the investment
worth should also be considered.
12.2.4 (d) Comparison of cost flow
After the feasibility test, the next consideration is the need to compare the cash
flows by using the cost benefits ratio. This will help the investor to compare
the rates of return along with the risks involved and the interest rate. The
project may be selected having good return but having high risk and
uncertainty or low return with low risk. This depends on the investor's attitude.
12.2.5 (e) Selection and Implementation
After considering the availability of funds for investment, the project may be
selected for implementation. The project will be implemented as per the blue
prints which have already been prepared. There is a need to monitor the
project on regular basis after implementation of project has started. The
project must be completed according to the time frame and a watch is
necessary regarding quality and quantity of work being done. Any delay in
execution of the project will increase the cost of the project. Further there is a
need to maintain good industrial relations, and to see that repayment of loans
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is done in time. Notes

12.2.6 (f) Mid Term Project Evaluation
This is very necessary in order to keep the time schedule. If some drawbacks
are noticed, then alternation may be done to suit the project. If the project is
lagging behind necessary steps should be taken to see that the project is
completed in time. This will help in controlling unnecessary increase in the
cost of the project.
Some other easier ways for cost benefit analysis are –
1. List alternative projects/programs
2. Select measurements and measure all cost/benefits elements
3. Predict outcome of cost and benefits over relevant time period
4. Convert all costs and benefits into money
5. Apply discount rate
6. Net present value
7. Sensitivity analysis
8. Adopt recommended choice.

12.3 Cost Benefit Analysis Private And Social

In the private sector cost benefit analysis, the main accepted norm is to assess
the rate of return and how soon the cost of the project is recovered. In social
cost benefit analysis the main consideration is the benefits received by the
society, Rate of return and profit are secondary consideration.
Social cost benefit analysis has to be done keeping in mind the welfare and
economic objectives of the economy. Certain projects like construction of
dams, roads, bridges, generation of electricity are necessary for the economy.
Hence even if we are applying cost benefit analysis in such projects, we have
to keep in mind the role of these projects. These projects are to help in the
development of the economy and create net social assets. These will help in
rapid economic growth.
Similarly provisions of health and education facilities have different objectives
because it will bring intangible results by making the people healthy and
educated and the people will become more efficient and productive.
Now the social costs and benefits are regarded as externalities of the private
investment and production decisions. The private costs are nil but the effects
on the society is very high in the form of externalities. These are pollution of air,
water, noise. But the society suffers. We find divergence between social and
private costs benefits.

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12.3.1 Social Costs and Benefit Notes

The Govt. interference is necessary in private sector in order to provide the
safe guards to the society and to protect the interest of the society. It is also
accepted that the private firms must look for the social benefit and costs. And
the private sector must take necessary measures to reconcile the conflicting
interest.
These social costs are not included in the private firm's account. But if a
private project involves construction of a swimming pool, a play ground which
is open to public, social benefit exceeds private benefit. The firm does not care
much about social costs but only care of their private cost.
The study of private costs and benefits analysis will become irrelevant in the
modern business environment if the social aspect of business is neglected.
Here the Govt. takes up the responsibility to regulate and pass certain laws to
control the bad effects of industrialization on the society. For example
concentration of industries in a particular region is private cost effective. But
this creates a lot of social costs in terms of air, water and noise pollution,
emergency slums, traffic congestion, accidents, and strains on the civic
amenities and several health hazards.
The firms do not care much about social costs but only care of their private
cost. For example Bhopal gas tragedy entailed social sufferings for the people
of Bhopal for years. Lot of damage is done to various historical places by
private firms by pollution and other activities, coal extracting in forest area is
destroying the forest and this will affect the ecology of the area. So we can say
that private cost and benefits and social cost and benefits must be interrelated,
so that the ill effects of private cost benefit analyze are reduced to the
minimum.
Wherever the private sector fails to invest in these area where profit is less, and
cost is heavy they do not undertake such project. But society needs such
products such as water supply, health services, and electricity generation,
education, roads etc. Here social cost may be very heavy but the benefits will
be much more than the social costs. The Govt. can regulate some activities of
the private sectors by framing rules and regulations for example The Pollution
Control Act. Here the industry has to get no objection certificate from Pollution
Control Board before it starts functioning. The U.N.O. has provided more than
$500 million to Indian Government so that necessary affluent treatment plants
are installed by the industry in the [Link] Peace movement is based on
controlling the ill effects of industrialization and putting effects to control the
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bad effect of Plastic waste, lead ash, and metal scrap. Notes

12.4 Advantages Of Cost Benefit Analysis

In order to maximize the benefit over cost, the study of cost benefit analysis is
desirable in private and social cost benefit analysis. There are many
advantages of the study of Cost Benefit Analysis.
· It aims to maximize social welfare through maximization of net wealth,
because any move which increases net wealth, can increase social
benefit and social welfare.
· By Cost Benefit Analysis we can show the various measures
necessary for attaining maximum net wealth and optimal policy aiming
at these goals.
· Even if a target is partially achieved, the cost and benefit can be
calculated and whatever increase in net wealth can be ascertained at
that point of time.
· By adopting some suitable discounting method, the cost and benefit as
arising in different periods of time can be estimated.
· Cost Benefit Analysis compares costs and benefits using equal term
which provides a clear indication of net cost or net benefit in a specific
area or provides regulation or helping the project which will justify the
decision by studying various benefits.
· It simplifies complex concepts and processes accepted by the society
readily.
· Cost Benefit Analysis can be carried out at various level such as local
level, regional level and National level.

12.5 Limitation Of Cost Benefit Analysis

But the study of cost benefit analysis has some limitations:
· The usefulness of this analysis is limited by the fact that it is based on
the assumptions that maximization of net wealth will ensure
maximization of social welfare which is not true.
· It has nothing to say about the distribution of income in the society and
a change in income distribution. This does not lead to a change in net
wealth and social welfare.
· It has failed to consider private and social cost and its consequences
for the present and for future.
· Calculation of SCB/PCB is difficult. It is only an estimation of it, which
may not be true.
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12.5.1 Disadvantage of cost benefit analysis Notes

a) Inaccuracies Proper analysis of cost and expected profit is
mandatory. There are always some errors in some cost estimation.
b) Cost Benefit Analysis is not exact - Various methods employed and
assigned economic costs to non economic benefits bring different
results.
c) Subjectivity Cost and benefit being intangible gives room to
subjectivity while doing analysis which gives unreal results.
d) Failed project Cost Benefit Analysis results influence the project. The
team may set unrealistic targets for a project. This may cause losses.

12.6 Summary
Cost benefits analysis is an analytical framework to assess the costs and
benefits of a project. It is used by the policy makers to decide about selecting a
project from many different proposals of the different projects.
The study of cost and benefit analysis is necessary to determine the selection
of a project. There is a need to study different steps to be undertaken to
determine a feasible and viable project. This study helps to determine whether
the investment in the project is a sound decision or not.
We have also studied social cost benefit project because this study affect a
major portion of the population and the society. There may not be any
monetary gain, but it is very beneficial to the society. The constructions of a
road will definitely help the surrounding areas as the people will be induced to
invest in different types of economic activities and movement of goods and
services will be easy. The idea of externalities is also given which explains the
ill effects of private projects in the form of pollution of air, water and noise,
congestion in the city. This may affect the health of the people as we find in
Chembur, Mumbai. The people are suffering due to R.C.F.; and other
refineries. This has polluted the air of that area. Here the govt. can play an
important role in minimizing the harm and maximizing the benefits to the
society by enforcing the laws.

12.7 Keywords
Cost Benefit Analysis - It is used to assess the benefits and the cost of
proposal and decide whether to undertake the project.
Private cost benefit analysis – Here the analysis of the cost and the
benefit accrue to the investor. Here maximum profit is the main

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consideration Notes
Social cost benefits analysis. Here the Govt. undertakes the project and
find out the benefit and the cost. Here the main consideration is the
benefits accrue to the society and not benefit in the form of profit or in terms
of money.
Technological feasibility means to consider the availability of
technology, its feasibility and availability of technical people.
Social cost. The cost incurred by the Government for the welfare of the
people and which improves the life of the people, such as water supply,
drainage system, construction of dams, canal, roads etc.

12.8 Self Assessment Questions

1. Explain the idea why there is a need of Govt. intervention in the private
sector.
2. Explain various steps to be taken in the study of Cost Benefit Analysis
3. State advantages and disadvantages of cost benefit analysis
4. Describe the limitation of cost benefit analysis
5. Social cost benefit analysis is different from private cost benefit analysis.
Discuss
6. What is the need of midterm appraisal
7. Why state has to budget large sum of money to education, public health.

QUIZ:
Q1. Which of the following is a disadvantage of cost-benefit analysis:
[Link] does not consider the time value of money.
[Link] is too complex to implement.
[Link] projects cannot be easily compared.
D. Not all costs and benefits can easily be assigned monetary values.
Q2. Which costs are excluded from cost-benefit analysis?
[Link] costs
[Link] costs
[Link] costs
[Link] costs
Q3. What is the principle behind time value of money?
[Link] in and cash out.
[Link] tomorrow is worth more than money today.
[Link] today is worth more than money tomorrow.

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[Link] with more risk have a lower discount rate. Notes

12.9 Further Readings
1. Common wealth of Australia 2006, Handbook of Cost Benefit Analysis
January
2. [Link]

12.10 Model Answers

Activity I
a) Benefits of the study of social cost benefit analysis is a systematic process
for calculation and comprising benefits costs of a project – Two purposes –
1. To determine if it is a sound investment/decision
2. To provide a basis for comparing projects. It involves comparing the
total expected cost of each option against the total expected benefits,
to see whether the benefits outweigh the cost and by how much.
b) Various steps involved in Cost Benefit Analysis
Process Steps
1. List alternative projects / programs
2. Select measurements and measure all cost/benefits element
3. Predict outcome of cost and benefits over relevant time period
4. Convert all costs and benefits into money
5. Apply discount rate
6. Net present value
7. Sensitivity analysis
8. Adopt recommended choice
c) State some of the advantages of Cost Benefit Analysis – See 12.3
c) Give some disadvantages of Cost Benefit Analysis – See 12.4.1

Quiz :
Q1. Not all costs and benefits can easily be assigned monetary values.
Q2. Sunk costs
Q3. Money today is worth more than money tomorrow.

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Notes
CHAPTER 13

CAPITAL BUDGETING

Learning Objectives
After going through this unit, you will be able to:
Define capital budgeting and its meanings
Explain different steps involved in project evaluation
State different types of physical assets
Enumerate different methods of appraising investment proposal
Explain accounting rate of Return, Payback period and discounted
pay back
Describe net present value and time value of money.

Structure
13.1 Introduction
13.2 Idea of capital budgeting
13.2 (i) Classification of physical assets
13.2 (ii) Capital budgeting process
13.3 Methods of appraising an over view
13.3.1 Simple Methods
13.3.2 Scientific and complex method
13.4 Measurement Method
(i) Requirement of a good method
(ii) Principles of cash flows estimation
13.5 Time value of Money calculation
(a) Time concept of value of money
(b) Net Present value
(c) Internal Rate of Return
(d) Profitability Index
13.6 Summary
13.7 Keywords
13.8 Self Assessment questions
13.9 Further Readings
13.10 Model Answers

13.1 Introduction
In Unit No. 13, we have studied the idea of National Income and its importance.
We learnt about measurement of national income. We have explained certain
concepts which are generally used in the study of National Income especially

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the concept like Gross Domesticl Production (GDP); Gross National Product Notes
(GNP); Personal Income (PI); Disposable Income (D.I.). We have also
examined various difficulties faced in the measurement of National Income by
the experts. In this unit we are giving you the idea of capital budgeting, and all
related matters, especially steps involved in capital budgeting. You will come
to know the concept of time value of money. You will also learn the methods of
investment, discounted cash flow and Net Present Value and Internal Rate of
Return.

13.2 Idea Of Capital Budgeting

Capital budgeting is the planning process used to determine whether an

organization's long term investment plan such as purchase of new machinery
replacement of machinery, new plants, production of some new products, are
worthwhile in terms of budget. It needs major capital investment expenditure.
Capital Budgeting also refers to the process of planning capital project, raising
funds, efficiently allocating these funds to capital projects. Capital Budgeting
is made to reduce costs, increase output, and develop a new product or
expand in market and to meet Govt. regulations and provides for Research &
Development etc. So capital budgeting is long term planning for making and
financing investment. That affects financial results over more than just the
next year. It is an expenditure on capital assets so as to convert inputs into
output. The study of capital budgeting is necessary because it involves
substantial amount of capital to be used. Secondly once the decision is taken,
it is irreversible.
Thirdly it has a long term impact on the business.
Fourthly It involves a big out flows of funds in future for some period.
The study involves investment in physical assets because this investment will
bring return in future.
13.1.1 Classification of physical assets
We should also know about the types of physical assets and which need a lot of
investment and capital, which we intend to purchase.
Following are the types of physical assets which an entrepreneur is thinking of
acquiring.
(1) New Project. That means starting a new factory.
(2) Expansion of existing project. In order to increase production, more
machinery and equipments are to be installed and the building is
extended or a new building is required to be constructed. These are
challenging decisions.
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(3) Renewal and Renovation of Project. It is done by replacing obsolete Notes

machine and equipments. These needs to be replaced to keep the business
going and to avoid shut down of the unit.
(4) Research and development. Needs a lot of investment and the positive
results are not assured but still a lot of funds is needed for this. This can help in
innovation, idea of a new product, a new raw material and improvement in
existing product which will bring more return in future and is the cause of
growth and development of the economy.
(5) Exploration Project. Exploration project is necessary in order to fund
new resources especially in oil and gas exploration. We need constant
exploration which has to be done. Money spent now will help to reap the
benefits in future. Hence a constant investment has to be done.
(6) Some funds are diverted towards fulfilling the statutory requirements.
Such amounts are spent for providing safety, and health measures, and
Pollution control.
The pollution control board has made it mandatory for the new factories to
provide affluent plants. In the treatment of water before it is released in the
river or the sea. The supreme court of India had ordered the closure of all
polluting factories around Tajmahal in Agra. The Govt. has passed various
laws to regulate, and control business.

13.2.2 Capital budgeting process

To increase in the value of the firm, capital budgeting has to play a very
important role and it should be done successfully. Investment of fund is a long
term investment. This requires a lot of study and research. If this is done
properly it will be more profitable to the firm and its growth.
Following steps are needed to see so that the project is successful –
a) Generation of investment idea. This will make you think and start
exploring and finding new opportunities for the future.
b) Determining the cost of the project. It is necessary to estimate initial
cost, capital expenditure, guided by the price of the new equipment and
machinery and the required quantity. It is necessary to study the cash
outflows. For hiring engineers' experts and workmen we have to consider the
capital needed. There is a need to study marketing and financial outflows.
Further there is a need to have working capital. If there is need to import
machinery, equipment, technology, raw materials, there will be a lot of outflows
and the need of foreign exchange and permission from the authorities.
c) Estimation of the cash flow. Cash flow in a project over a number of

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years in future, need to be studied. Notes

d) It has also to be seen the riskiness of estimated cash flow, because there is
risk and uncertainty in the market and business.
e) Selecting a project after considering all pros and cons of the project and
evaluating its financial feasibility and viability.
f) Execution of the Project. Here again experts and professionals are taken
to see that the project is being executed as per the plans and time schedule.
Monitoring and appraising. There is a need to monitor the execution of the
project continuously and further it is necessary to appraise it whether it is being
executed as per time schedule, because any delay in execution of the project
will increase the cost of the project. This will affect the profitability of the project.

13.3 Methods Of Appraising A Project An Over View

Project appraisal is the analysis of costs and benefits of a proposed project

with a goal of assuring a rational allocation of limited financial resources
amongst alternate investment opportunities with the objective of achieving
specific goals. It is mainly the process of transmitting information accumulated
through feasibility studies. It involves cash flows. A large initial outflow is
followed by small but recurring outflows. The inflows will be small but for a long
period. It is necessary whether the value of inflows is greater than the outflows
or not. If greater value can be assigned, to the inflows/returns than the
outflows, and then the proposal may be treated as possible.
While doing capital investment appraisal, method should be sound. A good
appraisal method should have the following features –
a) It must have clear basis for distinguishing between acceptable and non
acceptable project.
b) Ranking the projects on the basis of desirability.
c) To make a choice among several alternatives.
d) Recognize the higher benefits projects which are preferable to smaller
benefits project ones and early benefit projects are preferable to the
later benefits proposal.
So if outflow is less than inflow then the project is viable.
There are various methods of appraisal. These methods are classified as –
(a) Simple Methods
(b) Scientific or complex methods.
13.3.1 Simple Methods These method are simple and do not involve
complex calculation and discount of cash flow.
13.3.(a) (i) Pay back Method
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In this method, the payback period is the time duration required to recover the Notes
initial cash flows. The people think in terms of initial expenditure/outflows and
the time duration in which this amount can be recovered.
If the cash flows are uniform then
Payback period = Initial cash outflows
Annual cash inflows
For example if initial investment is Rs.1,00,000/- cash inflows –
First year = Rs. 20,000/-
Second year = Rs. 30,000/-
Third year = Rs. 30,000/-
Fourth year = Rs. 40,000/-
Fifth year = Rs. 40,000/-
So cumulative cash inflow of five years is Rs. 1, 60,000/-.
Hence the payback period is between third and fourth year. Assuming a
uniform collection rate the amount of Rs.20,000/-can be recovered in half year
or 6 months. So the payback period is 3 + 20000 ÷40000 -= 3-1/2years
Payback period concept is very simple and a layman can understand it easily.
This sort of project put recovery in less time and the element of risk will also be
less.
But the main defect in this method is that it considers early cash flows which
determine the payback, but it ignores those inflows which come later on
after the recovery of the initial investment.
Payback method also ignores time value of Money which is very important
concept.
This is clear from the example –
For example
Cash inflows
Year Project X Project Y
Investment 0 ( -) - 60,000 ( -) 60,000
1 10,000 30,000
2 20,000 20,000
3 30,000 10,000

Both projects X and Y have 3 years payback period but project Y is better
because of higher cash inflow in the beginning and will have a higher value if
time value of money is considered.
Thirdly the payback period is considered only as a measure of capital recovery
and does not consider good profitability. But this method is used, because it is
simple and easy for calculation for the layman.
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13.3.(a) (ii) Accounting / Average Rate of Return Method. Notes

This method is also simple in calculation. It shows the ratio between net profit
after tax and the amount of initial investment –
So ARR = Average PAT÷ initial Investment
ARR = Average Rate of Return
PAT = Profit after Tax
For example: Investment Rs. 50,000/- in a machine which has life of 5
years. The profit after tax for next 5 years is Rs.75,00/, Rs. 8,200/-,
Rs. 7,900/-; Rs. 8.900/-; Rs. 6.500/-. Now calculate ARR
ARR = (7500 + 8200 + 79000 + 8900+ 6500) x 100
50,000
= 39000 / 5 ÷50000 x 100 = 7800 ÷50000 x 100 =
15.6%
13.3.a (iii) Average investment = (initial value + scrap value)
2
Here we use average level of investment for the project –
So ARR = APAT _______
Average Investment
Example – New project investment Rs. 1,00,000/- working life of machine is 5
years – scrap value of machine is Rs.10,000/- . Company is expecting
incremental Profit after Tax, which is expected to be Rs. 6000/-; Rs.7000/-; Rs.
8000/-, R. 7500/- Rs. 6500/- for next 5 years. Assuming depreciation is on
straight line basis and the tax rate is 40%. Find out the ARR.
Annual Depreciation = 1,00,000 – 10,000 ÷5 = Rs. 18,000/-
Calculation of Book Value for each year –

ARR = 7000 ÷100000 x 100 = 7%

Average investment = (initial value + Scrap Value)
2
= 100000 + 10000 = 55000
2
Project with a higher ARR should be considered over other project with a lower
ARR.
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13.3.2 Scientific method Notes

Scientific Methods need calculation, the time value of money and therefore
undertake discounting of cash flow. These methods are:
a) N P V (Net Present value)
b) Internal Rate of Return
c) Benefit cost (B.C.) ratio or profitability Index
The method which takes into consideration about the uncertainty of cash flows
is more realistic since future is uncertain.
So while adopting the methods we should be able to reduce the risk of
uncertainty.
13.3.3 Discounted Payback
The concept of discounted cash flows for calculating payback period is of
recent origin. Some suggested that we should use the discounted flows to
calculate the payback period. This period will be larger than simple payback
period.
It is measured by taking a discounted sum of the stream of net income (the
cash inflows) during the expanded life time of the project.
DPV = R1 + R2 + R3 + … + Rx
1+C (1+C)2 (1+C)3 (1+C)x
R = Annual Return
x = Life of the Project
C = Discount rate generally interest rate / cost of capital is taken as the
discount rate.
NPV = DPV – 1 (1 stands for initial investment outlay of the project)
Example initial Investment expenditure is Rs. 55,000/-. It discounted present
value is Rs.50,000/-
NPV = 6000000 – 55,000 = 5000
Since inflows are positive, the project is acceptable.

Activity I
a) Steps for capital budgeting

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b) Discuss payback method Notes

c) Idea of discounted payback

13.4 Measurement Method

13.4.1 Requirement of a good measurement method

1. It should be based on cash flows rather than profits or expenditure.
2. Cash flows to be covered over the entire expected life of the assets
rather than a few years only.
3. It should give absolute value of gains or losses
4. It should consider time value of money
5. Should indicate the degree of risk and the chance of getting profit.
13.4.2 Principles of cash flows estimation
All estimate of receipts and payments should be based on cash flows rather
than revenue and expenditure or profit and loss.
1) All calculation should be based on incremental basis rather than on
aggregate basis. A machine costing 1,00,000/- to replace old machine
which fetched 20,000/- as scrap value, then the cash outflow should be
Rs.80,000/- and not Rs. 1,00,000/-
2) Cash flow should be taken after tax basis (CF after Tax) (FAT)
3) Sink cost to be ignored. Cost had already been incurred and cannot be
recovered hence it should not be taken into account
4) Calculation of cash flows should also be taken into account. The
opportunity cost even though no actual cash inflows or outflows is

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there, if using own premises, rental cash outflow to be consider. Cash needs Notes
for working capital be treated as cash outflow at the time of commencement of
a project and should be treated as inflow, when that cash is released at the time
of closure – increase – inflow, decrease- outflow capital.

13.5 Time value of Money calculation

(a) Time value of money

The time value of money is the value of money figuring in a given amount of
interest earned over a given amount of time. The time value of money is the
central concept in finance theory. There is an inherent monetary value
attached to time. A rupee received to-day is worth more than a rupee received
to-morrow because it can be invested.
· It is invested to earn interest.
· The amount of interest earned depends on the rate of interest that can
be earned on investment.
So time value of money quantifies of a likely stream of income in future in such
a way that the annual incomes are discounted and then added together. This
will provide a lump sum present value of entire income stream. Time value of
money is able to carry out is discounted cash flow analysis to assess the
viability of a proposed investment.
The concept of the time value of money is useful in all aspects of finance area
especially in the following areas:
· Bond valuation
· Stock valuation
· Accept/regret decision for project management
· Financial analysis of a firm
It can help to interpret a discounted cash flow analysis in commercial terms
13.5. The time value of Money calculation
Present value of a lump sum:-
PV = CFt/ (1+r)t or PV = Fvt (1+r)t
How much Rs.100/- received five years from now to be worth today if the
rate of interest is 10%
PV = CFt / (1 + r)t
t
= 100 / (1 + .1)
= 62.09
That means the value of Rs.100/- after 5 years but its present value is Rs.62.09
[Link] = FV
(1 + i)n

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i) Here PV is the value at time = 0 Notes

ii) Fv is the future value at time n
iii) i – is the discount rate or the rate of interest at which the amount
will be compounded each period.
iv) n is number of period (years)
For example if the amount is Rs.100/- discount rate is 10% and the
period is 2 years
Then future value of PV = PV (1+ i)2
)2
= 100 (1 + .1
= 100 (1.21) = Rs121.

Activity II
a) Principle of cash flow estimation

b) Time value of money

(a) Net Present value

Positive Net Present Value means a net gain in value and negative NPV
means loss in value.
t
NPV= S A - Initial investment
2 2
t (1+i)
At = cash flow at time t
i = the rate of interest or cost of capital at which funds are to be discounted
investment. The initial amount spent on the project is as under
Investment proposal Rs. 80,000/- / Rate of
discount 10% CF AT
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1. 15000 Notes
n
2. 22000 NPV =s Ai
t
3. 27000 t=1 (1-i) -_Co
4. 29000
5. 21000 =15000 + 22000 + 22000 + 29000 + 21000 - 80000
2 3 4 5
1.1 (1.1) (1.1) (1.1) (1.1)
-13,636.36 + 18,181.82 + 20,285.50 + 19,807.39 + 13039.43 - 80000
= 84950.50 – 80000 = 4950.50 Here NPV is Rs.495.50 and NPV is
positive. So the project is viable.
NPV method is very scientific and appropriate technique of budgeting so it
is widely used, because of the following reasons –
1) It considers time value of money
2) It is an absolute value
3) It has the property of addition
4) NPV for different rate of interest can be found separately.
5) It allows different rates of interest in different time period in the life of
a project.
Limitation of NPV
It gives absolute value and therefore comparison between two different project
not easy, when they are of different sizes.
1) Not possible to know in advance the rate of interest so at any given time
NPV may not be appropriate if the rate of interest has changed.
2) It may lead to wrong decision making, when the funds are limited, and
have to choose between different options.
(a) Internal Rate of Return
The internal rate of interest (IRR) is the discount rate at which the NPV for a
project is equal to zero. This means that the present value of cash inflows for
the project would be equal to present value of its outflows. So it can be called
as the break even discount rate. Generally the Internal Rate of Return is found
by trial and error method.
This method is based on the technique of discounting cash flow.
The Internal Rate of Return is the rate of return or the discount rate which
equals the discounted present value of its expected future marginal yields with
the investment cost of project.
So NPV = - C + R1
(i + C)
C is the cost of the investment project in the current year so it is
negative.
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i = Market rate of interest Notes

R1 = The net cash flow in the next year
If project net present value is positive, (NPV > 0)
The project should be taken up.
In general form it is –
NPV = -C + R1 + R2 + + Rn
2 n
(1 + 1) (1 + i) (1+ i)
Let us say that the cost of the project is Rs. 10,000/-
Market rate of interest is 15% and its yields are net return Rs. 16,100/- next
year. Now decide if investment should be done?
NPV = -co + R1
(1 + I)
= -10000 + 16,100 = -10,000 + 16,100 X 100
1+ .15 115
= -10,000 + 14000 = Rs. 4000/-
Since NPV is positive, project will be profitable hence it should be done.
In another case, planning is done to purchase machine costing Rs.20, 000/- .
The rate of interest is 10% and the yield of the next year is Rs. 22,000/-
machine has no salvage value.
NPV = - co + R1 = -20,000 + 22000
i+I i + .1
= - 20,000 + = -22,000 + 20,000 = 0
1.1
So, since there is no profit, the project need not be done.

(a) Profitability Index

NPV has an absolute value hence it is not good for comparing profitability
between different projects –
PI or Benefit Cost Ratio (B – C ratio)
PI = Present value of inflows
Present value of outflows
If PI is greater than 1 then project is acceptable and if it is less than 1, it
should not be accepted.
Activity III
a) Concept of Profitability index
Profitability Index or Benefit cost ratio –
PI = Present value of inflow
Present value of outflow

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If PI is greater than 1, the project is acceptable otherwise not. Notes

b) Solve the problem the cost of the project is Rs.10,000/-. Market rate of
interest is 15% and net yield return is R.16, 100/- next year. Decide
whether investment should be done or not.
NPV = -C+ R1
(1 + I)
NPV = 16,000 + 16100 = -10000 + 16,100 x 100
1 + .15 115
= -10,000 + 14,000 = Rs. 4000-
Since NPV is positive, the project is profitable and should be done.

13.6 Summary

In Unit No. 14 (Capital budgeting) we have taken up a very important concept

which has to be used often to take any investment decision. The study of
capital budgeting becomes essential, when some new project or new
investment, has to be done.
The capital investment decisions are influence mainly by factors like
technological change, demand charge, competitor behavior, fiscal policy of the
Govt. and some non economic factors.
We have classified different types of physical assets and why these are
acquired. Then we put more emphasis on the process of capital budgeting.
Different methods are suggested to evaluate a project. This evaluation is
based on the objectives of the firm, condition of the market. We have stated
simple and complex methods of evaluation. . These are in the form of Net
Present Value, Internal Rate of Return and profitability index, cash inflows in
and cash flows out. Special mention has to be done on the price concept of
value of money. So study of this unit will enable you to have some basic
knowledge of finance.

13.7 Keywords
Capital [Link] is a decision making process concerned with
whether or not:
(1) The firm should invest funds in an attempt to make profit
(2) How to choose among competing projects.
Internal Rate of Return. (I.R.R.) it is a method of evaluating investment
proposals. It is the rate of discount (or interest rate) that equals the present

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value of outflow to the present value of inflows. Thus making NPV = O. Notes
Net present value (NPV). It is a method of evaluation consisting of
present value of all net cash flows (discounted by cost of capital as the
interest rate), to initial investment cost.
Capital in Physical form i.e. Plant, equipment, buildings, machinery.
Cash flows. It is cash transaction. Receipts are called cash flows in and
payments are known as cash flows out.
Opportunity cost. It is the possible earning that can be made from
resources from its alternative use.
Scrap value. It is the value which may be received from the sale of assets
after the project is over.
CFAT (Cash Flow after tax). It is cash receipt or cash payment after tax.
It is the net value of cash flow.
Payment period. A method of evaluation investment proposal which
determines the time a project's cash inflows will take to repay the original
investments of the project.

13.8 Self Assessment Questions

1. Briefly explain the major investment appraisal criteria

2. Discuss the traditional and modern techniques of capital investment
appraisal
3. What is the time value of money? Explain the method of calculating (a) N
P V; and (b) I.R.R.
4. When the net present value (NPV) is greater than zero what does this imply.
5. Explain the nature of capital expenditure decision? How does it involve
uncertainty?
6. What is meant by capital budgeting? Why is it of great importance?

Quiz:
Q1. All of the following influence capital budgeting cash flows EXCEPT:
a) accelerated depreciation.
b) salvage value.
c) tax rate changes.
d) method of project financing used.
Q2. The estimated benefits from a project are expressed as cash flows instead
of income flows because:
a) it is simpler to calculate cash flows than income flows.
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b) it is cash, not accounting income, that is central to the firm's capital Notes
budgeting decision.
c) this is required by the Internal Revenue Service.
d) this is required by the Securities and Exchange Commission.
Q3. A capital investment is one that
a) has the prospect of long-term benefits.
b) has the prospect of short-term benefits.
c) is only undertaken by large corporations.
d) applies only to investment in fixed assets.
Q4. In general, if a depreciable asset used in business is sold for more than its
depreciated (tax) book value, any amount realized in excess of book value but
less than the asset's depreciable basis is considered a
a) "capital gain" and is taxed at the corporate capital gains tax.
b) "recapture of depreciation" and is taxed at the corporate capital gains rate.
c) "capital gain" and is taxed at a rate equal to the firm's ordinary tax rate, or a
maximum of 35 percent.
d) "recapture of depreciation" and is taxed at the firm's ordinary income tax
rate.
Q5. A profitability index of .85 for a project means that:
a) the present value of benefits is 85% greater than the project's costs.
b) the project's NPV is greater than zero.
c) the project returns 85 cents in present value for each current dollar invested.
d) the payback period is less than one year.
Q6. Which of the following statements is correct?
a) If the NPV of a project is greater than 0, its PI will equal 0.
b) If the IRR of a project is 0%, its NPV, using a discount rate, k, greater than 0,
will be 0.
c) If the PI of a project is less than 1, its NPV should be less than 0.
d) If the IRR of a project is greater than the discount rate, k, its PI will be less
than 1 and its NPV will be greater than 0.

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13.9 Further Readings Notes

1. Managerial Economics by Dr. H. L. Ahuja
2. Managerial Economics by Dr. D. L. Mehta
3. Managerial Economics by Dr. D. M. Mithani
13.10 Model Answers
Activity I
a) Steps for capital budgeting
(1) Generation of investment idea
(2) Estimating the cost
(3) Estimating cash flows in and cash flows out
(4) Selecting a project after evaluation of its cost and likely benefits
b) Discuss Payback Method
In payback method we consider the time period needed to recover the
initial cash outflows.
c) Discounted payback is measured by taking discounted sum of stream
of net income (the cash inflows during the life time of the project - see
14.3 1(iii)
Activity II
1. Principal of cash flow estimation –See 14/4/(i)
2. Time value of money. Here inherent monetary value is attracted to
time. The value of Rs. 100/- is much more today than next year
because this can bring some income during this time.
Activity III
a) Concept of profitability Index.
Profitability index or benefit cost ratio
P I = Present value of inflows ÷present value of out flow.
If PI is greater than 1 the project is acceptable otherwise not.
b) Solve the problem
Cost of project Rs. 1000/- Market rate of interest 15% Net yield in
the next year 16,100/- Decide whether investment should be done
or not.
Quiz:
Q1. salvage value.
Q2. it is cash, not accounting income, that is central to the firm's capital
budgeting decision.
Q3. has the prospect of long-term benefits.
Q4. "capital gain" and is taxed at a rate equal to the firm's ordinary tax rate,
or a maximum of 35 percent.
[Link] project returns 85 cents in present value for each current dollar
invested.Q7. If the NPV of a project is greater than 0, its PI will equal 0.

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Notes
CHAPTER 14

NATIONAL INCOME AND ITS MEASUREMENT GDP; GNP; PI; DI

Learning Objectives
After going through this unit, you will be able to:
State the National income of a country
Discuss how to measure the National Income by different methods
Explain the difficulties in the measurement of National Income
State different concepts related to National Income such as GDP;
GNP; PI, DI

Structure
14.1 Introduction
14.2 Definition of National Income
14.2.1 Feature of National Income
14.3 Measurement of National Income – Method
14.3.1. Output method
14.3.2. Income method
14.3.3. Expenditure method
14.4 Difficulties in the measurement of National Income
14.5 Different concepts of National Income
14.5.1 G.D.P.
14.5.2 G.N.P.
14.5.3 Net National Income
14.5.4 P.I. (Personal Income)
14.5.5 D.I. (Disposable Income)
14.6 Importance of National Income estimates
14.7 Summary
14.8 Keywords
14.9 Self assessment questions
14.10 Further readings
14.11 Model Answers
14.1 Introduction
In Unit No. 12 we have tried to explain the concept of cost benefit which is very
essential to know the return on our investment. Also we have given the idea of
steps to be taken to get the full idea of costs benefits. How cost benefit
analysis helps the managers to take decision in selection of different projects.
In this unit you will learn something about National Income. Method of

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National Income measurement and what difficulties are faced when we try to Notes
measure the National Income. You will also learn some concepts of National
Income. These concepts are made clear and easy to understand about
National Income. You will also learn the importance of the study of national
income.

14.2 Definition Of National Income

National Income is the money value of all the goods and services produced in
an economy over a period of one year.
Prof. Pigou, “National Income as that part of objective income of the
community including income derived from abroad which can be measured in
money.
Prof J. R. Hicks – the National Income consists of a collection of goods and
services reduced to a common basis by being measured in terms of money.”

14.2.1 Features of National Income

· National Income is a flow and not a stock
· National Income in real terms is the flow of goods and services
produced during a particular period of time.
· The concept of National Income is linked with some economic
activities.
· In National Income accounting the concept of National Income is
visualized as a flow of national output, National Income and National
Expenditure.
Thus the three flows are equal to each other
i.e. National Income = National output = National Expenditure.
· No commodity or services should be counted twice for example if raw
cotton has been evaluated. It should not be counted in cotton textiles.
That means only the final product has to be taken in the National
Income.
Capital gain made by an individual should not be counted. Because
these capital gains do not represent any productive activity.

14.3 Measurement Of National Income

The concept of National Income involves three interpretations –
1. It represents the monetary value of aggregate annual production in an
economy i.e. National Output.
2. It represents the aggregate income of the country (National Income).
3. It represents the aggregate expenditure in the economy that is National
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The above interpretation has given three methods of measurement of National Notes
Income:
(i) Census of production method
(ii) Census of Income Method
(iii) Census of Expenditure Method
14.3.1 Production Method
GNP – It is the sum of the market value of all the final goods and services
produced in an economy during a given period of time.
This method is also called Net Product or Value added method.
Here the sum of value of goods and services produced at market price is
found. Here we have to take the gross product duly calculated by
summing up the money value of output in different sector of economy like
Agriculture, industry, transport. The money value of raw material and
services used in the production and the amount of depreciation of physical
assets involved in the production process are summed up. The Net output
or value added is found by subtracting the aggregate of cost of raw
material, services and depreciation from the gross product found above.
G N P = Gross National Product
G N P = Money value of total goods and services and income from
abroad.
N.I = GNP – Depreciation
Here the following steps to be considered -
a) Here in order to avoid double counting, intermediate goods must be
excluded and only the final good should be taken into account.
When the value of shirt is included the value of cloth is already
accounted for.
b) Only new net capital assets produced during the period under
consideration are included.
c) Net receipt from international trade in included (i.e. x –
m).Depreciation or replacement cost must be excluded.
14.3.2 Income Method
It is also known as factor share method. In this income received by all the
basic factors of production used in the production process are summed up i.e.
income received by Labour, capital and income of professional such as
doctors, lawyers etc. National Income is obtained by summing up of the
incomes of all individuals in the country.
National Income = Rent + wage + interest + Profit + income from abroad.
But transfer income is not to be included. This method indicates the
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distribution of National Income among different income groups. This is also Notes
known as National Income at factors cost.
GNP income method = wages and salaries + rent + interest + Dividends +
undistributed corporate profits + mixed income + Direct taxes and indirect tax +
depreciation + net income from abroad.
Some precautions must be taken while calculation in National Income by
Income method. These are –
a) Transfer payment should not be included i.e. Transfer payment means
relief payment like old age pension; pension etc. must not be included.
b) Payments due to owners' owned factors of production must be counted
on the basis of the market price
c) Goods and services for which no money payment is made must not be
included.
d) Profit not distributed by the corporate sector and kept in reserve fund
must be included in the National Income.
13.3.3 Expenditure Method
This method is used by adding up all the expenditure made on goods and
services during a year. Income can be spent either on consumer goods or
investment goods.
G.N.I. = Individual expenditure and Govt. expenditure.
GNP = Private consumption expenditure (c) + Gross domestic private
investment (I) +Net foreign Investment (x – m) + Govt. expenditure on
goods and services (G)
= C + I + (x – m) + G
Since this method is not reliable this is not popular in practice because without
earning a man has to survive and spend on goods and services. Secondly the
data are not available. Thirdly many people do not work and have to spend a lot
of money to themselves alive.

Activity I
a) Explain the idea of production method.

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b) Income method Notes

c) Expenditure method is difficult to give proper idea of national income.

14.4 Difficulties In The Measurement Of National Income

The measurement of National Income is a difficult task. This is due to non
availability of detailed and reliable data about different sectors of economy.
1) The data available in many countries are inadequate and unreliable
2) Existence of a large amount of non-monetized sector in under
developed countries. Most of the agriculture produce does not reach
the market because it is consumed at home or is exchanged for other
goods and services or stored.
3) Illiteracy and ignorance of the small producers creates difficulties
because they do not keep any account and they are not aware of its
advantages.
4) The people have many occupations at the same time. They undertake
more than one activity. For example a small farmer does farming and
also work somewhere during slack season, so no account is kept for
the income of such activity.
5) Existence of underground economy and illegal activities where black
money/Hawala system is used for transaction purposes and are not
reported. So how this amount can be counted. Most of the illegal
activities , which generate income, are not counted.
6) Depreciation system is not considered properly and many people are
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 not aware of such system. In order to maintain assets depreciation has Notes
to be provided for which can be used for replacement of obsolete
assets.
7) Free services rendered by the Govt. are not considered. Govt. spends
a lot money on police, military, judicial system administration and
provides street lighting, irrigation, education, public health, road etc.
8) Services of house wives are not considered since these are unpaid
services.
9) Capital Gains when the prices of capital assets increase and sold on
profit. This income is not considered in National Income.
10) Transfer payment is not considered in National Income. These
payments are in the form of Pension, unemployment allowance,
subsidies interest on national debt etc.

14.5 Different Concepts Of National Income

14.5.1 G D P ( gross domestic product)

14.5.2i G N P ( gross national product)
14.5.3 N N P ( Net national product)
14.5.4 N.N.P. at factors cost
14.5.5 P I ( Personal Income)
14.5.6 D.I. ( Disposable income)
14.5.1 G D P (Gross Domestic Product)
GDP is the money value of all final goods and services produced in the
domestic country in an accounting year. It is a measure of country's overall
economic output. It is the market value of all the final goods and services
made within the borders of a country in a year.
It includes all private and public consumption, Govt. expenditure, investment
and net of exports and Imports.
GDP = C + G + I +Nx
C = all private consumption
G = sum of Govt. spending
I = sum of all the country's business spending on capital
Nx = Nation's total net exports that is Exports – Imports.
GDP at Factor cost and GDP at market price
GDP at factor cost is estimated as the sum of net value added by different
producing units and the consumption of fixed capital.
GDP at market price, include indirect taxes and exclude subsidies given by the

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 Govt. Notes
So GDP at factor cost = GDP at market price – IT + S
IT = indirect taxes and S = Subsidies
14.5.2 GNP (Gross National Product)
Gross National Product is the sum of gross domestic product and net factor
incomes from abroad.
GNP = GDP + Net factor income from abroad
GNP is a monetary value of annual final output.
14.5.3 NNP (Net National Product)
It is the net production of goods and services in a country during the year.
NNP = GNP – Depreciation
It is also referred to as national income market prices. It is a very useful concept
for the study of growth of economies. It has a difficulty about fixing the
appropriate rate of deprecation.

14.5.4 Net National Product at Factor cost or National Income

National income is the total of all income payments received by the factors of
production
N.I. = Net National Product – Indirect taxes + subsidies- Profit accruing to the
Govt.
Because Indirect taxes and profit accruing to the Govt. are not available to the
factors hence this is reduced from the National Income.
14.5.5 Personal Income
It is that income which is actually received by the individuals or household in a
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country. It includes whole of the National Income earned by the factors of Notes
products in one year which is not available to them. So we have to reduce all
these elements which are not available for distribution among the factors of
production. We have to add to National Income the transfer payment made by
Govt. to some people.
P I = N.I – corporate Income Tax – undistributed profits – social security
contribution + transfer payments
P I is an important concept. It helps us in estimating the potential purchasing
power of the household in the economy. But this concept does not tell us the
actual amount of money that is available to the household for spending and
saving.
14.5.6 D.I. (Disposable Income)
D I = Personal income – Personal direct tax. After paying the personal direct
tax from Personal Income what is remaining is D.I. which the house hold can
spend on consumption.
So we have made clear most of the concepts relating to National Income clear
as above.
The full equation for GDP using this approach is
GDP = C + I + G + (X-M) where
C: Household spending on goods and services
I: Capital Investment spending
G: Government spending
X: Exports of Goods and Services
M: Imports of Goods and Services
The Income Method – adding together factor incomes
GDP is the sum of the incomes earned through the production of goods
and services. This is:
Income from people in jobs and in self-employment (e.g. wages and
salaries)
+
Profits of private sector businesses
+
Rent income from the ownership of land
=
Gross Domestic product (by sum of factor incomes)
4. If the India experienced a devastating earthquake, GDP would most
likely
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increase due to production necessary to repair the damage. Notes
decrease by the amount of the damage.
increase due to the foreign imports we would need to purchase in order to
sustain us through the crisis.
None of the Above.
5. A recession is loosely defined as
an unemployment rate above the natural rate of unemployment.
having more than 6 percent of the work force receiving unemployment
insurance.
more than two consecutive months of decline in the economy's level of
consumption spending.
six or more consecutive months of decline in the economy's level of output.
none of the above

14.6 Importance Of Estimates Of National Income

National Income is very important for an economy of a country. This gives the
idea of the condition of the economy of the country: Growth of GDP always
show that the economy is making progress.
1) It helps in analyzing the overall production performance of the
economy
2) It helps in analyzing the performance of the economy whether it is
growing, stagnant or declining.
3) It shows the contribution made by various sectors of the economy such
as agriculture, industrial production trade and service sector.
4) It gives the idea of distribution of National Income indifferent categories
such as wages, profits, rent and profits.
5) It is a valuable guide for the policy makers. It assists in comparing
National Income of different countries. We can compare the standard
of living of different countries by its study.
6) It also throws light on the volume of consumption, saving and
investment in the economy.

14.7 Summary
National Income is the indicator of economic activity. It is total market value of
all final products and services produced in a country during a year.
We have tried to explain about the National Income of the country. We have
explained different methods of measurement of National Income i.e. product

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method, income method, and expenditure method in details. We have given Notes
the idea of various difficulties faced while measuring the National Income. We
have explained the concepts which are related to the N.I. i.e. GDP, GNP, PI and
Disposable income. We have given the idea of GDP at factor cost and at
Market price. We have also given the importance of the study of nation income.

14.8 Keywords
Disposable Personal income - The total income earned by households in
the society less the personal taxes.
Gross National Product – The total market value of all final goods and
services produced in an economy in a year.
Net National Product – means GNP – Depreciation
GDP at Factor cost – is estimated as the sum of net value added by
different producing units and the consumption of fixed capital.
GDP at Market Price – the sum of domestic factor incomes and
consumption of fixed capital
Net domestic product (NDP) here depreciation allowance (capital
consumption allowance) is to be reduced from GDP.
Personal Income. Sum of all incomes actually received by all individual
or households during a year.
Depreciation – It is the cost of consumption of fixed capital.

14.9 Self Assessment Questions

1. What National Income? Describe the different methods used for

measurement of National Income
2. What are the difficulties in the measurement of National Income?
3. What are the constituents of GNP?
4. Distinguish between GNP at Market Price and GNP at Factor cost
5. Explain different concepts of National Income.
6. Discuss the usefulness of the study of National Income estimates.
Quiz:
1. Using the expenditure approach, GDP would include all the following
except:
a) The production of watches in the U.S.
b) The production of steel used to construct skyscrapers.
c) The production of software by a foreign-owned firm located in the U.S.
d) The production of education services by a high school..
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Q2. The main difference between GDP and GNP is that Notes
a) GDP counts only production of goods while GNP counts production of
services.
b) GDP counts only production of goods and services produced and sold in the
US, while GNP counts production of goods and services in the US, regardless
of where they are sold.
c) GDP counts production of final goods and services, while GNP counts
production of all goods and services, including intermediate goods.
d) GDP counts production of final goods and services produced in the US,
while GNP counts production of final goods and services by Indian citizens.
e) none of the above.
Q3. GDP is not a perfect measure of the health of the economy because
it fails to account for quality changes such as an improvement in air quality.
a) it fails to take into account the value of leisure time.
b)it fails to account for the non-production value of our stock of natural
resources.
c)it fails to distinguish, for example, between production of televisions and
production of bombs. Each is valued according to the market value of the
production.
d) all of the above
14.10 further readings

1. Managerial Economics by Dr. [Link]

2. Managerial Economics by Dr. [Link]
3. Managerial Economics by Dr. Mukund Mahajan
4. Managerial Economics by Dr. [Link]
14.11 Model Answers
Activity I
a) Production method is the Sum of the market value of all final products
and services produced in an economy during a given period of time.
Here we have to reduce the depreciation and we have to add new
capital assets.
b) In income Method we have to consider the income of all the factors of
production. It is the sum of the incomes of all individuals in the country.
It includes payment received by labor, land owner, capital owner and
entrepreneur and add to it the income received by professionals and
other people.
c) Expenditure Method includes all the expenditure made on goods and

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 services during a year. Notes
Y = C + I + G + Net of (X-M)
Y = National Income
C = Private consumption
I = Private Investment
G = Government expenditure
X = Export
M = Import
Activity II
a) Meaning of transfer earning. When Govt. spends money on pension, old
age pension and other expenditure without receiving a service
b) Non Monetized Sector when goods are exchanged for goods and no
money payment is involved. It is also known as barter system.
c) Meaning of depreciation. When fixed factors are used its life goes on
decreasing. So in order to replace those assets some amount of money from
profit is set aside which will be used at the time of replacement of assets.
d) Disposable Income – Personal income -Personal direct tax – whatever the
income remained in the hands of the person for his own spending is called
disposable income.
e) Explain the idea of Net National Product. It is the net production of goods
and services in a country during a year after excluding the deprecation.
f) National income
N.I = N. N .P – indirect taxes at subsidies - Profit accruing to the Govt.
g) Explain GDP = C+G + I + NX
h) Idea of GDP at factor cost
It is estimated on the sum of net value added by different producing units and
the consumption of fixed capital.
I) Idea of GDP at Market Price GDP at Market price include indirect taxes but
excludes subsidies by the Government.
Quiz:
Q1. salvage value.
Q2. GDP counts only production of goods and services produced and sold
in the US, while GNP counts
production of goods and services in the US, regardless of where they are
sold.
Q3. salvage value.

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Notes
CHAPTER 15

NEED OF GOVERNMENT INTERVENTION

Learning Objectives
After going through this unit, you will be able to:
Discuss the need of Government intervention in the free Market
State the need for price control
Explain support price and administered price
Clarify the meaning of dual prices
Express the need of preventing and controlling of monopolies.

Structure
15.1 Introduction
15.2 Failure of market mechanism
15.3 Need for Government Intervention
15.4 Meaning of price control
15.5 Methods of price control
15.5.1 Ideal of support and administered price
15.5.2 Meaning of dual price system
15.5.3 Prevention control of monopolies
15.6 Summary
15.7 Keywords
15.8 Self Assessment questions
15.9 Further readings
15.10 Model Answers

15.1 Introduction

In Unit No. 14we have tried to give you the idea of capital budgeting. What
steps are needed for project evaluation? We have explained about time value
of money. We have also explained how to appraise the investment and other
related concepts.
Now in this unit we shall explain the need of the Govt. intervention in business
because of failure of the market economy. In detail we shall study how Govt.
intervenes in the market. Some of the techniques which the Govt. adopts are
price control, support price, administered price etc. and also how to control and
prevent the formation of monopoly. Duel pricing system is also one of the ways
to help the weaker sector of the society to get the essential goods.
15.2 Failure Of Market Mechanism

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15.2 Failure Of Market Mechanism Notes

Adow Smith opposed any Govt. intervention in the private business. It may
hinder the free play of the market mechanism in a capitalist economy. Later he
accepted the same role of the Govt. is necessary in the market economy to
remove some of the failure of the market mechanism. The failure of market
mechanism has justified intervention of the Govt. in the market mechanism.
Following are the failures of Market Systems –
(i) Inequalities of income and wealth. Right to property and law of
intervention has given advantage to the people who get a good start in
life. Since they possess productive resources, which can be used to
earn more income and accumulate more wealth so it has resulted in
economic inequalities.
(ii) Economic instability. Market economy is fully dependent on the
level of demand. Any change in demand could upset an economy. A
fall in demand could bring down the prices, leading to retrenchment of
labour. This depression would engulf the whole economy. A rise in
demand will increase the productive activities and may lead to inflation.
This causes trade cycle which affect the economy because of
fluctuation in the economy.
(iii) Rise of Monopolies. Competition in the Market economy is healthy.
It will improve efficiency and quality of the product. But it also leads to a
cut throat competition which will help the strong and well established
producers to drive away the new comers from the market. It would lead
to creation of mo monopoly concentration of economic power in the
hands of a few producers. The monopolists can exploit the consumers
(iv) Failure to provide full employment. Market mechanism would
automatically establish equilibrium at the level of full employment. But
because of rigidity (especially wage rigidity due to trade union). The
economy will be in equilibrium at less than full employment so labor
force remains unemployed and hence wasted the chance of creative of
wealth.
(v) Sacrifice of Social welfare. In order to get maximum profit, the
producers produce these goods which have greater demand. So the
resources are diverted to produce luxury, semi luxury goods. The
goods are for mass consumption needed for the poor are neglected.
So the society is neglected.
(vi) Failure to satisfy all the needs. Market mechanism cannot satisfy

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the total needs of the society. Market economy can satisfy private wants but it Notes
cannot satisfy social wants. Market economy works on exclusion principle i.e.
who cannot pay are denied its benefits but social wants such as defence street
lights it is not possible to exclude a person who does not pay. So it is the
responsibility of the Govt. to provide these services.

Sluggish functioning of the price mechanism. Market being imperfect,

there is a lack of perfect knowledge or inability of factors of production. Price
mechanism may not function properly. So it is seen that free market economy
has some good achievements to its credit, but it suffers from various evils.

15.3 Need For Government Intervention

Seeing the failure of the capitalist free society, it is necessary that the Govt.
should intervene for smooth running of the economy.
To control cyclical fluctuations
The Govt. can adopt an anti-cyclical policy to control the economic in staturlity
The Govt. can increase expenditure during depression on the construction of
infrastructure. This helps to generate employment and stimulate aggregate
demand in the economy. In case of inflation the Govt. can exercise control
such as credit control and reduce Govt. expenditure and raise taxes. This will
reduce the supply of money in the society affecting aggregate demand.
Humanitarian consideration
Where market mechanism fails to serve the human needs, Govt. may
intervene. In developing countries allowance is given to the unemployed
destitute and the poor senior citizens. Similarly the Govt. can continue to
operate loss working unit so that the workers may not use their job.
Preventing Eco-inequality
The state can reduce economic inequality. The Govt. can adopt the policy of
progressive taxation such as income tax, estate duty and succession tax, more
taxes on higher income and revenue thus collected to be used for the welfare
schemes for the poor. It can pass the laws to curb monopoly. The Govt. can
spend money to create more opportunity for employment. The Govt. can
subsidize various essential goods for the poor and the weaker section of
society. For example the Govt. has adopted the policy of subsidizing gas,
kerosene oil, and fertilizer to enable the poor to use their essential
commodities.
So some of reasons stated above make the intervention of the Govt. desirable.
It will help to reduce the bad effect of market freedom to some extent.
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It will help to reduce the bad effect of market freedom to some extent. Notes

15.4 Meaning Of Price Control And Method Of Price Control

Meaning of Price Control Price control is a form of Govt. intervenes in the

economy in which Govt. agency uses its law making power to regulate the
prices.
Govt. enforces maximum or maximum price that can be charged for specified
goods such as food and consumer goods are increasing sharply. It is used to
keep cost of living within manageable range.
It is best for the short term. In the long term it can lead to shortages, falling
quality and black marketing.
It is mostly used in developing countries. Due to inflation the poor cannot
afford to buy food grin and other essential goods. So the Govt. has to play an
important role to reduce the bad effects of inflation by enforcing the system of
price control. Price control system will make the essential goods cheaper and
help the people and inflation will not have bad effect on the society.
The Govt. of India has reduced the prices of wheat, rice and oil for the poor
whereas the market prices are very high. The prices of gas, kerosene oil are
also higher subsidized to enable the people to consume these necessary
goods.

15.5 Method Of Price Control

The Govt. has the power to control the prices and following are some of ways
the Govt. control the prices by –
a) Fixing of minimum and maximum power
b) Break up of monopoly power
c) Direct state provisions of goods and services
d) Fiscal policy intervention
e) Rationing
f) Support and Administered prices
g) Dual price system.
a) Fixing of minimum and maximum power
The Govt. fixes the wholesale and retail prices of good grains and other
essential goods in India to see that food grains and other essential
goods are available to the common man at a low price. Similarly the
Govt. can fix the maximum price of different product. For example drug
prices are controlled and the maximum price, which a seller can

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charge, is fixed. The customer can negotiate and buy at less price also Notes
especially the prices of essential drugs are controlled.
b) Break up of monopoly power
Whenever monopoly power is exercised by the monopolist, and he
begins to exploit the people, the Govt. can break up it power for
encouraging the development of sure substitute. For this MRTP
(Monopoly Trade Practice Act) has been empowered to take action.
For example till 1982 in India Fiat/Ambassador cars had the monopoly
right from 1947 onward. The development of Maruti cars has broken
the monopoly power of these two car makers. In two wheeler industry
Bajaj, Rajdoot were dominating the market but introduction of Hero
Honda and other two wheelers have changed the scene fully. The
Monopoly power is broken.
c) Direct state provisions of goods and services
When certain goods and services are very essential but need large
capital investment and long period to receive the return. The state has
to invest funds to make the project operational. The private sector will
not enter such areas in India. Indian Railways has the monopoly and
providing service at reasonable charges. Post and telegraph,
telephone is other services but gradually the private sector is allowed
to enter but still the Govt. has dominantly position and has a last say.
d) Fiscal policy intervention
Fiscal policy which can affect the prices is taxation policy and public
expenditure. Indirect taxes (also known as commodity tax) can be
levied on luxuries and other non essential goods. This will make the
good costly. But it will tax the essential goods at a lower tax rate and
make these good affordable to the society. Further public expenditure
can definitely help in controlling the prices. It is done through subsidy
on various goods of mass consumption like gas, kerosene oil, fertilizer
etc. in India.
The state can also help the poor, the aged people through transfer
payment, by providing monetary assistance. For example the Govt.
provides unemployment allowances in some states in India. The
senior citizens are also receiving some monetary help and
concessions from the state. The state also undertakes civic works to
create employment. These steps help the unemployment to get some
purchasing power and fulfill their needs.
The Govt. is spending a lot of money to provide education and health
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services to the poor to make them more useful to the society. Notes
e) Rationing is the controlled distribution of scarce resources of goods
and services. It is an artificial restriction on demand to keep the price
low.
The Govt. is providing essential goods and services to the masses
through Rationing and Public Distribution System or Fair Price Shops.
Govt. also controls the prices of certain input so that the final output is
not costly.
This is necessary to maintain stable price conditions and efficient
management of the supplies of essential consumer goods. These
goods are agriculture based subject to seasonal variation. So the PDS
is very essential to serve the poor and to provide the essential goods to
them such as wheat, rice, oil, cloth, pulses etc. For this in India Food
Corporation of India is doing the work of procuring food grain, storing
them and make these available through PDS to the masses. The state
trading buffer stock operation on one hand and the PDS on the other
are essential in case of agriculture products. This keeps the prices
under check and assures of constant supply of goods.
f) Support and Administered prices
Support price may be either by a subsidy or by a price control. The state
gives subsidy on these goods which are essential for common man.
For example the Govt. gives subsidy on petroleum products to make
these cheaper for common man. The prices of gas and kerosene oil
are highly subsidized whereas the price of diesel is less subsidized.
Administered Prices- Under this the price of a good or service is
dictated by a Governmental or governing agency. Administered prices
are not determined by the market forces. Administered Prices are
often imposed to maintain certain goods affordable to the people to
prevent price going up during the period of shortages. In India
Administered Prices have stabilized the cost of commodities such as
sugar, staple food etc. Similarly the interest rates are fixed by the
central bank through monetary policy. This interest rate is one of the
deciding factors for investment.
g) Dual price system.
There are certain basic needs of the weaker section of the society,
which should be meet the Govt. should subsidize these goods; such
policy has to be in favour of vulnerable section of the society and
should not discourage the producers from expanding production and
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investment in the particular sector. It is mainly applied in case of sugar, Notes

food grains, edible oil, and cheaper variety of cloth. It is a short cut
price control. The Govt. acquires certain percentage of output of sugar
from the producer in the form of levy sugar at a lower price and
distributes it through some agencies such as PDS etc. For example
sugar is acquired under levy system and sold at a lower price to the
people below the poverty line by Fair Price Shops on Ration Card. The
higher income group has to pay higher price and buy sugar in the open
market.
15.5.1 Ideal of support and administered price (Missing)
15.5.2 Meaning of dual price system (Missing)
15.5.3 Prevention And Control Of Monopoly
In free market, where competition is fundamental it is found that these
producers who have resources and efficient can compel the smaller unit out of
business and become monopolist. If Govt. finds monopolistic tendencies,
either the Govt. can fix the price and quality of the product or nationalize it.
Especially state monopoly is necessary in the field of public utilities i.e. water
supply, electricity generates distribution and gas supply.
Rail and road transport may be subject to wasteful competition and so it has to
be under state monopoly. The Govt. of Indi has passed anti monopoly act
(MRTP) to control monopolistic tendencies. Under this act an officer is
appointed to look into this problem and recommend necessary action.
Activity II
a) Explain the idea o rationing

b) Support price

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15.6 Summary Notes

Unit 15 is regarding the need of the Govt. intervention in the free market and
economy. Free market has filed in many areas which has affected the
economy and has created many problems. Hence the Govt. intervention is felt
necessary to control and regenerate the free market. This intervention of the
Govt. is necessary to reduce the sufferings of the people and regulate its bad
effects on the economy. It is seen that there is a lot of fluctuation in the
economic activities in the free market. These fluctuations cause inflation and
depression in the economy which increase the sufferings of the people.
During inflation, the poor suffer and essential goods are beyond their reach.
Similarly during depression a large number of workers become unemployed
and economic activities are at lower level and wages are low.
So it is necessary to have some control over the prices of essential products
and service so that the poor can afford to buy these goods and services. So
the Govt. adopts various methods to control the prices by adopting price
control, fixing minimum and maximum prices. The Govt. also provides
subsidy on essential goods to make some goods cheaper. It adopts the policy
of dual price system. The main idea of govt. intervention is to make the
essential goods available to the masses at reasonable price.

15.7 Keywords
Administered Price is imposed by the Govt. or governing agency to make
some essential goods affordable to the poor.
Duel Price. Where different prices are charged for identical product from
different people
Support Price. It may be either subsidy or a price control in order to keep
the market price higher than the free market price.
Price control A price control is the minimum legal price a seller my chare.
It is fixed by the Government.
Rationing is the controlled distribution of scarce resources, goods or
services. It controls the size of the ration and everyone is assured of getting
certain amount of goods or services.
Exclusion Principle The owner of private goods may exclude others from
use unless they pay for it.

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15.8 Self Assessment Questions Notes

1. What is the need for Govt.'s intervention in a free market economy?

2. Discuss briefly various measures taken by the Govt. to control the
growing prices
3. Explain:
a) Dual Price
b) Support Price
c) Price control
d) Rationing
4. Explain different aspects of failure of free market system
5. Give in detail Govt. failure in the economy.
Quiz :
Q1. Which of the following is a variable cost?
a. Interest payments
b. Raw materials costs
c. Property taxes
d. All of the above are variable costs.
Q2. Which of the following is an implicit cost?
a. The salary earned by a corporate executive
b. Depreciation in the value of a company-owned car as it wears out
c. Property taxes
d. All of the above are implicit costs.
Q3. If the output levels at which short-run marginal and average cost curves
reach a minimum are listed in order from smallest to greatest, then the order
would be
a. AVC, MC, ATC
b. ATC, AVC, MC
c. MC, AVC, ATC
d. AVC, ATC, MC
Q4. Learning curves represent the relationship between
a. average variable cost and the number of units produced per time period.
b. average variable cost and the cumulative number of units produced.
c. total cost and technology.
d. average variable cost and the rate of increase in technology.
Q5. Short-run marginal cost is equal to
a. the change in total cost divided by the change in output.
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b. the change in total variable cost divided by the change in output. Notes
c. the cost per unit of the variable input divided by the marginal product of the
variable input.
d. all of the above.
Q6. Which of the following short-run cost curves declines continuously?
a. Average total cost
b. Marginal cost
c. Average fixed cost
d. Average variable cost
Q7. The long-run average cost curve is at a minimum at a level of output where
a. the firm is experiencing constant returns to scale.
b. it is equal to long-run marginal cost.
c. the long-run average cost curve is tangent to the lowest point on a short-run
average total cost curve.
d. all of the above occur.
Q8. If a firm has a downward sloping long-run average cost curve, then
a. it is experiencing decreasing returns to scale.
b. it is experiencing decreasing returns.
c. it is a natural monopoly.
d. marginal cost is greater than average cost.
Q9. Which of the following is an assumption of linear breakeven analysis?
a. Output price is constant
b. Average variable cost is constant
c. Average fixed cost is constant
d. All of the above are assumptions of linear breakeven analysis.

15.9 Further Readings

1. Managerial Economics by Dr. [Link]

2. Managerial Economics by Dr. [Link]
3. Managerial Economics by Dr. Mukund Mahajan
4. Managerial Economics by Dr. [Link]

15.10 Model Answers

Activity I
1. Govt. role to control cyclical fluctuation
Ans- Govt. role to control cyclical fluctuation when there is lot of
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fluctuations in the economic activities. These cause inflation or Notes

depression. The Govt. can adopt anti-cyclical policy. Such as increase
or decrease in taxation public expenditure. The main purpose is to
increase or decrease spending power of the people to meet the
challenges of inflation or depression.
2. Govt. can improve employment in the economy
Ans- Govt. can improve employment opportunities by increasing
expenditure on civic works giving subsidy/incentive to private sector to
increase investment and production. This will increase employment
opportunities.
Activity II
a) Explain idea of rationing – See 15.5 (e)
b) Support price
To make essential goods affordable to the people the Govt. may impose
price control or give subsidy. It will control a rise in price, and by giving
subsidy the makes particular good cheaper.
Quiz :
Q1. All of the above are variable costs.
Q2. Depreciation in the value of a company-owned car as it wears out .
Q3. MC, AVC, ATC.
Q4. average variable cost and the number of units produced per time
period.
Q5. the cost per unit of the variable input divided by the marginal
product of the variable input.
Q6. Average fixed cost.
Q7. the long-run average cost curve is tangent to the lowest point on a
short-run average total cost curve.
Q8. marginal cost is greater than average cost.
Q9. Output price is constant.

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