M.

COM- 1st Semester

Class:- [Link] 1st Semester

MANAGERIAL ECONOMICS

[Link] Punjab Technical University

Master of Commerce Batch 2018 Onwards
MCOP 102-18
MANAGERIAL ECONOMICS

Unit-I
Introduction to Managerial Economics: Managerial Economics: Meaning,
Nature, Scope & Relationship with other disciplines, Role of managerial
economics in decision Making, Opportunity Cost Principle, Production
Possibility Curve, Incremental Concept, Scarcity Concept.
Demand: Demand and its Determination: Demand function; Determinants of
demand; Demand elasticity – Price, Income and cross elasticity, Use of elasticity
for analyzing demand, Demand estimation. Demand forecasting, Demand
forecasting of new product.
Indifference Curve Analysis: Meaning, Assumptions, Properties, Consumer
Equilibrium, Importance of Indifference Analysis, Limitations of Indifference
Theory.

Unit-II
Production Function : Production function Meaning, Concept of productivity
and technology, Short Run and long run production function, Isoquants; Least
cost combination of inputs, Producer’s equilibrium; Returns to scale;
Estimation of production function.
Theory of Cost: Cost Concepts and Determinants of cost, short run and long
run cost theory, Modern Theory of Cost, Relationship between cost and
production function.
Revenue Curve: Concept of Revenue, Different Types of Revenues, concept and
shapes of Total Revenue ,Average revenue and marginal revenue, Relationship

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between Total Revenue ,Average revenue and marginal revenue, Elasticity of

Demand and Revenue relation.

Unit-III
Market Structure: Market Structure: Meaning, Assumptions and Equilibrium
of Perfect Competition, Monopoly, Monopolistic Competition, Oligopoly: Price
and output determination under collusive oligopoly, Price and output
determination under Non-collusive oligopoly, Price leadership model.
Supply: Introduction to supply and supply curves.
Pricing: Pricing practices; Commodity Pricing: Economics of advertisement
costs; Types of pricing practices. Factor Pricing: Demand and supply of factors
of production; Collective bargaining, Concept of rent, profit, interest- Rate of
return and interest rates; Real vs. Nominal interest rates. Basic capital theory–
Interest rate and return on capital, Measurement of profit.

Unit-IV
Product market: Saving and Investment function, Consumption function,
Aggregate supply and Aggregate demand, Investment multiplier, foreign trade
and budget multiplier.
Money market: Motive for holding money; Liquidity preference, Money
demand, Money market equilibrium. IS-LM Analysis: Derivation of nominal IS-
LM and equilibrium.
National Income: Conceptual Framework, Measures of National Income,
Methods of Measurement, Limitations of National Income.
Consumption Function: Meaning, and Nature, Determinants and Measures to
Raise Propensity to Consume. Keynes Psychological Law of Consumption -
Meaning, Properties and Implications,
Inflation: Meaning, Types, Theories, Causes, Effects and Control,
Unemployment Trade off, Trade Cycles: Concept and Theories of trade cycles.

Note: Relevant Case Studies will be discussed in class

Suggested Readings/ Books:

 D. M. Mithani, Managerial Economics Theory and Applications, Himalaya

 Publication
 Peterson and Lewis, Managerial Economic, Prentice Hall of India
 Gupta, Managerial Economics, Tata McGraw Hills
 Geetika, Managerial Economics, Tata McGraw Hills
 Froeb, Managerial Economics, Cengage Learning

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 Koutsoyiannis, A, Modern Micro Economics, Palgrave Macmillan Publishers, New

Delhi. 2.
 Thomas Christopher R., and Maurice S. Charles, Managerial Economics – Concepts and
Applications, 8th Edition,
 Peterson and Lewis, Managerial Economics, 4th Edition, Prentice Hall of India Pvt.
Ltd., New Delhi.
 Shapiro, Macro Economics, Galgotia Publications.
 H. L Ahuja Advanced Economic Analysis, S. Chand & Co. Ltd, New Delhi. 7.
 G.S Gupta, Managerial Economics, Tata McGraw Hill.
 Goel Dean, Managerial Economics, Prentice Hall of India, Pvt. Ltd., New Delhi
 K.K. Dewett, Modern Economic Theory, S. Chand Publication.
INDEX
SR.
NO. TOPICS
UNIT-I
1 Managerial Economics: Meaning, Nature, Scope & Relationship with other disciplines
2 Role of managerial economics in decision Making,
3 Opportunity Cost Principle.
4 Production Possibility Curve.
5 Incremental Concept.
6 Scarcity Concept.
7 Demand: Demand and its Determination: Demand function; Determinants of demand.
Demand elasticity – Price, Income and cross elasticity, Use of elasticity for analyzing
8 demand.
9 Demand estimation.
10 Demand forecasting, Demand forecasting of new product.
Indifference Curve Analysis: Meaning, Assumptions, Properties, Consumer Equilibrium,
11 Importance, Limitations.
12 Important Questions

UNIT-II
Production function Meaning, Concept of productivity and technology, Short Run and
13 long run production function.
14 Isoquants; Least cost combination of inputs.
15 Producer’s equilibrium; Returns to scale; Estimation of production function.
Theory of Cost: Cost Concepts and Determinants of cost, short run and long run cost
16 theory.
17 Modern Theory of Cost, Relationship between cost and production function.

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Revenue Curve: Meaning, Different Types of Revenues, concept and shapes of Total
Revenue ,Average revenue and marginal revenue, Relationship between Total Revenue
18 ,Average revenue and marginal revenue.
19 Elasticity of Demand and Revenue relation.
20 Important Questions

UNIT-III
Market Structure: Market Structure: Meaning, Assumptions and Equilibrium of Perfect
21
Competition.
22 Monopoly, Monopolistic Competition.
Oligopoly: Price and output determination under collusive oligopoly, Price and output
23
determination under Non-collusive oligopoly.
24 Price leadership model.
25 Supply: Introduction to supply and supply curves.
Pricing: Pricing practices; Commodity Pricing: Economics of advertisement costs; Types
26
of pricing practices.
27 Factor Pricing: Demand and supply of factors of production
28 Collective bargaining
29 Concept of Rent & Theories of Rent.
30 Concept of profit & Theories.
interest- Rate of return and interest rates; Real vs. Nominal interest rates. Basic capital
31
theory–Interest rate and return on
32 Important Questions

UNIT-IV
Product market: Saving and Investment function, Consumption function, Aggregate
33
supply and Aggregate demand.
34 Investment multiplier, foreign trade and budget multiplier.
Money market: Motive for holding money; Liquidity preference, Money demand, Money
35
market equilibrium. IS-LM Analysis: Derivation of nominal IS-LM and equilibrium.
National Income: Conceptual Framework, Measures of National Income, Methods of
36
Measurement, Limitations.
Consumption Function: Meaning, and Nature, Determinants and Measures to Raise
37
Propensity to Consume.
38 Keynes Psychological Law of Consumption - Meaning, Properties and Implications.
39 Inflation: Meaning, Types, Theories, Causes, Effects and Control.
40 Unemployment Trade off, Trade Cycles: Concept and Theories of trade cycles.
41 Trade Cycles: Concept and Theories of trade cycles.
42 Important Questions

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UNIT-I
MANAGERIAL ECONOMICS
 Introduction of Managerial Economics

Managerial Economics (also called Business Economics) a subject first

introduced by Joel Dean in 1951, is essentially concerned with the economic
decisions of business managers. It is a branch of Economics that applies
microeconomic analysis to specific business decisions (i.e. Economics applied
in business decision-making). Managerial Economics may be viewed as
Economics applied to problem solving at the level of the firm. The problems of
course relate to choices and allocation of resources, which are basically
economic in nature and are faced by managers all the time. It is that branch of
Economics, which serves as a link between abstract theory and managerial
practice. It is based on economic analysis for identifying problems, organizing
information and evaluating alternatives. In other words Managerial Economics
involves analysis of allocation of the resources available to a firm or a unit of
management among the activities of that unit. It is thus concerned with choice
or selection among alternatives. Managerial Economics is by nature goal-
oriented and prescriptive, and it aims at maximum achievement of objectives.

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 Meaning of Managerial Economics

MANAGERIAL
MANAGERIAL ECONOMICS
ECONOMICS

Managerial Economic is combination of two words Managerial & Economics.

Managerial means management & relating to Management & Managers.
Economics means Economic growth & relating to trade, industry, money.
Managerial economics is a discipline which deals with the application of
economic theory to business management. It deals with the use of economic
concepts and principles of business decision making. Formerly it was known as
“Business Economics” but the term has now been discarded in favour of
Managerial Economics.

Managerial Economics may be defined as the study of economic theories, logic

and methodology which are generally applied to seek solution to the practical
problems of business. Managerial Economics is thus constituted of that part of
economic knowledge or economic theories which is used as a tool of analysing
business problems for rational business decisions. Managerial Economics is
often called as Business Economics or Economic for Firms.

Definition of Managerial Economics:

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

branch of economics bridging the gap between abstract theory and managerial
practice.” – Haynes, Mote and Paul.

“Business Economics consists of the use of economic modes of thought to

analyse business situations.” - McNair and Meriam

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“Business Economics (Managerial Economics) is the integration of economic

theory with business practice for the purpose of facilitating decision making
and forward planning by management.” - Spencerand Seegelman.

“Managerial economics is concerned with application of economic concepts and

economic analysis to the problems of formulating rational managerial
decision.” – Mansfield

 Nature of Managerial Economics

To know more about managerial economics, we must know about its various
characteristics. Let us read about the nature of this concept in the following
points:

1] Art and Science: Managerial economics requires a lot of logical thinking and
creative skills for decision making or problem-solving. It is also considered to
be a stream of science by some economist claiming that it involves the
application of different economic principles, techniques and methods to solve
business problems.

2] Micro Economics: In managerial economics, managers generally deal with

the problems related to a particular organisation instead of the whole economy.
Therefore it is considered to be a part of microeconomics.

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3] Uses Macro Economics: A business functions in an external environment,

i.e. it serves the market which is a part of the economy as a whole. Therefore, it
is essential for managers to analyse the different factors of macroeconomics
such as market conditions, economic reforms, government policies, etc. and
their impact on the organisation.

4] Multi-disciplinary: It uses many tools and principles belonging to various

disciplines such as accounting, finance, statistics, mathematics, production,
operation research, human resource, marketing, etc.

5] Prescriptive / Normative Discipline: It aims at goal achievement and deals

with practical situations or problems by implementing corrective measures.
Management Oriented: It acts as a tool in the hands of managers to deal with
business-related problems and uncertainties appropriately. It also provides for
goal establishment, policy formulation and effective decision making.

6] Pragmatic: It is a practical and logical approach towards the day to day

business problems.

Scope of Managerial Economics

The scope of managerial economics is not yet clearly laid out because it is a
developing science. Even then the following fields may be said to generally fall
under Managerial Economics:

1. Analysis and Forecasting: A business firm is an economic organisation

which is engaged in transforming productive resources into goods that are to
be sold in the market. A major part of managerial decision making depends on
accurate estimates of demand. A forecast of future sales serves as a guide to
management for preparing production schedules and employing resources. It
will help management to maintain or strengthen its market position and profit
base. Demand analysis also identifies a number of other factors influencing the
demand for a product. Demand analysis and forecasting occupies a strategic
place in Managerial Economics.

2. Cost and production analysis: A firm’s profitability depends much on its cost
of production. A wise manager would prepare cost estimates of a range of
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output, identify the factors causing are cause variations in cost estimates and
choose the cost-minimising output level, taking also into consideration the
degree of uncertainty in production and cost calculations. Production
processes are under the charge of engineers but the business manager is
supposed to carry out the production function analysis in order to avoid
wastages of materials and time. Sound pricing practices depend much on cost
control. The main topics discussed under cost and production analysis are: Cost
concepts, cost-output relationships, Economics and Diseconomies of scale and
cost control.

3. Pricing decisions, policies and practices: Pricing is a very important area

of Managerial Economics. In fact, price is the genesis of the revenue of a firm ad
as such the success of a business firm largely depends on the correctness of the
price decisions taken by it. The important aspects dealt with this area are: Price
determination in various market forms, pricing methods, differential pricing,
product-line pricing and price forecasting.

4. Profit management: Business firms are generally organized for earning

profit and in the long period, it is profit which provides the chief measure of
success of a firm. Economics tells us that profits are the reward for uncertainty
bearing and risk taking. A successful business manager is one who can form
more or less correct estimates of costs and revenues likely to accrue to the firm
at different levels of output. The more successful a manager is in reducing
uncertainty, the higher are the profits earned by him. In fact, profit-planning
and profit measurement constitute the most challenging area of Managerial
Economics.

5. Capital management: The problems relating to firm’s capital investments

are perhaps the most complex and troublesome. Capital management implies
planning and control of capital expenditure because it involves a large sum and
moreover the problems in disposing the capital assets off are so complex that
they require considerable time and labour. The main topics dealt with under
capital management are cost of capital, rate of return and selection of projects.

6. Government Regulation:

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There are endless implications of government regulations on the business firm

and at times the legal environment of business is as important as the economic
environment. So, it is necessary to examine law-related applications of
economic principles.

7. Management of Public Sector Enterprises:

Managerial economics can also be applied to the decision making process of

non-profit seeking and public sector enterprises. Economists in various
government departments and public sector organizations are also concerned
with project evaluation and cost-benefit analysis.

 Managerial Economics in Relation with other Disciplines

Managerial economics has a close linkage with other disciplines and fields of
study. The subject has gained by the interaction with Economics, Mathematics
and Statistics and has drawn upon Management theory and Accounting
concepts. Managerial economics integrates concepts and methods from these
disciplines and brings them to bear on managerial problems.

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1. Managerial Economics and Economics:

Managerial Economics is economics applied to decision making. It is a special

branch of economics, bridging the gap between pure economic theory and
managerial practice. Economics has two main branches—micro-economics and
macro-economics.

Micro-economics:- ‘Micro’ means small. It studies the behaviour of the

individual units and small groups of units. It is a study of particular firms,
particular households, individual prices, wages, incomes, individual industries
and particular commodities. Thus micro-economics gives a microscopic view of
the economy.

The roots of managerial economics spring from micro-economic theory. In

price theory, demand concepts, elasticity of demand, marginal cost marginal
revenue, the short and long runs and theories of market structure are sources
of the elements of micro-economics which managerial economics draws upon.
It makes use of well known models in price theory such as the model for
monopoly price, the kinked demand theory and the model of price
discrimination.

Macro-economics:-‘Macro’ means large. It deals with the behaviour of the

large aggregates in the economy. The large aggregates are total saving, total
consumption, total income, total employment, general price level, wage level,
cost structure, etc. Thus macro-economics is aggregative economics.

It examines the interrelations among the various aggregates, and causes of

fluctuations in them. Problems of determination of total income, total
employment and general price level are the central problems in macro-
economics.

Macro-economies is also related to managerial economics. The environment, in

which a business operates, fluctuations in national income, changes in fiscal and
monetary measures and variations in the level of business activity have
relevance to business decisions. The understanding of the overall operation of
the economic system is very useful to the managerial economist in the
formulation of his policies.

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Macro-economics contributes to business forecasting. The most widely used

model in modern forecasting is the gross national product model.

2. Managerial Economics and Theory of Decision Making:

The theory of decision making is relatively a new subject that has a significance
for managerial economics. In the process of management such as planning,
organising, leading and controlling, decision making is always essential.
Decision making is an integral part of today’s business management. A manager
faces a number of problems connected with his/her business such as
production, inventory, cost, marketing, pricing, investment and personnel.

Economist are interested in the efficient use of scarce resources hence they are
naturally interested in business decision problems and they apply economics
in management of business problems. Hence managerial economics is
economics applied in decision making.

3. Managerial Economics and Operations Research:

Mathematicians, statisticians, engineers and others join together and

developed models and analytical tools which have grown into a specialised
subject known as operation research. The basic purpose of the approach is to
develop a scientific model of the system which may be utilised for policy
making.

The development of techniques and concepts such as Linear Programming,

Dynamic Programming, Input-output Analysis, Inventory Theory, Information
Theory, Probability Theory, Queuing Theory, Game Theory, Decision Theory
and Symbolic Logic.

4. Managerial Economics and Statistics:

Statistics is important to managerial economics. It provides the basis for the

empirical testing of theory. It provides the individual firm with measures of
appropriate functional relationship involved in decision making. Statistics is a
very useful science for business executives because a business runs on
estimates and probabilities.

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Statistics supplies many tools to managerial economics. Suppose forecasting

has to be done. For this purpose, trend projections are used. Similarly, multiple
regression technique is used. In managerial economics, measures of central
tendency like the mean, median, mode, and measures of dispersion, correlation,
regression, least square, estimators are widely used.

Statistical tools are widely used in the solution of managerial problems. For
example. sampling is very useful in data collection. Managerial economics
makes use of correlation and multiple regression in business problems
involving some kind of cause and effect relationship.

5. Managerial Economics and Accounting:

Managerial economics is closely related to accounting. It is recording the finan-

cial operation of a business firm. A business is started with the main aim of
earning profit. Capital is invested / employed for purchasing properties such as
building, furniture, etc and for meeting the current expenses of the business.

Goods are bought and sold for cash as well as credit. Cash is paid to credit
sellers. It is received from credit buyers. Expenses are met and incomes
derived. This goes on the daily routine work of the business. The buying of
goods, sale of goods, payment of cash, receipt of cash and similar dealings are
called business transactions.

The business transactions are varied and multifarious. This has given rise to the
necessity of recording business transaction in books. They are written in a set
of books in a systematic manner so as to facilitate proper study of their results.

There are three classes of accounts:

(i) Personal account,

(ii) Property accounts, and

(iii) Nominal accounts.

Management accounting provides the accounting data for taking business

decisions. The accounting techniques are very essential for the success of the
firm because profit maximisation is the major objective of the firm.

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6. Managerial Economics and Mathematics:

Mathematics is another important subject closely related to managerial

economics. For the derivation and exposition of economic analysis, we require
a set of mathematical tools. Mathematics has helped in the development of
economic theories and now mathematical economics has become a very
important branch of economics.

Mathematical approach to economic theories makes them more precise and

logical. For the estimation and prediction of economic factors for decision mak-
ing and forward planning, mathematical method is very helpful. The important
branches of mathematics generally used by a managerial economist are
geometry, algebra and calculus.

The mathematical concepts used by the managerial economists are the

logarithms and exponential, vectors and determinants, input-out tables.
Operations research which is closely related to managerial economics is
mathematical in character.

 MANAGERIAL ECONOMICS IN DECISION MAKING.

Managerial economics uses a wide variety of economic concepts, tools, and

techniques in the decision-making process. These concepts can be placed in
three broad categories:-

1. The theory of the firm, which describes how businesses make a variety of
decisions.
2. The theory of consumer behavior, which describes decision making by
consumers.
3. The theory of market structure and pricing, which describes the structure
and characteristics of different market forms under which business firms
operate.

 ROLE OF MANAGERIAL ECONOMICS IN DECISION MAKING

Managerial economics, or business economics, is a division of microeconomics

that focuses on applying economic theory directly to businesses. The
application of economic theory through statistical methods helps businesses
make decisions and determine strategy on pricing, operations, risk,

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investments and production. The overall role of managerial economics is to

increase the efficiency of decision making in businesses to increase profit

Role Of Managerial
Economics In Decision
Making

Elastic Operations
Pricing vs. Inelastic and Investments Risk
Goods Production

1) Pricing:- Managerial economics assists businesses in determining pricing

strategies and appropriate pricing levels for their products and services. Some
common analysis methods are price discrimination, value-based pricing and
cost-plus pricing.

2) Elastic vs. Inelastic Goods:- Economists can determine price sensitivity of

products through a price elasticity analysis. Some products, such as milk, are
consider a necessity rather than a luxury and will purchase at most price points.
This type of product is considered inelastic. When a business knows they are
selling an inelastic good, they can make marketing and pricing decisions easier

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3) Operations and Production:- Managerial economics uses quantitative

methods to analyze production and operational efficiency through schedule
optimization, economies of scale and resource analyses. Additional analysis
methods include marginal cost, marginal revenue and operating leverage.
Through tweaking the operations and production of a company, profits rise as
costs decline.

4) Investments:- Many managerial economic tools and analysis models are

used to help make investing decisions both for corporations and savvy
individual investors. These tools are use to make stock market investing
decisions and decisions on capital investments for a business. For example,
managerial economic theory can be used to help a company decide between
purchasing, building or leasing operational equipment.

5) Risk:- Uncertainty exits in every business and managerial economics can

help reduce risk through uncertainty model analysis and decision-theory
analysis. Heavy use of statistical probability theory helps provide potential
scenarios for businesses to use when making decisions.

 Managerial Decision Making Process (5 Steps)

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Decision making is crucial for running a business enterprise which faces a large
number of problems requiring decisions.

Which product to be produced, what price to be charged, what quantity of the

product to be produced, what and how much advertisement expenditure to be
made to promote the sales, how much investment expenditure to be incurred
are some of the problems which require decisions to be made by managers.

The five steps involved in managerial decision making process are

explained below:

1. Establishing the Objective:- The first step in the decision making process is
to establish the objective of the business enterprise. The important objective of
a private business enterprise is to maximise profits. However, a business firm
may have some other objectives such as maximisation of sales or growth of the
firm.

But the objective of a public enterprise is normally not of maximisation of

profits but to follow benefit-cost criterion. According to this criterion, a public

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enterprise should evaluate all social costs and benefits when making a decision
whether to build an airport, a power plant, a steel plant, etc.

2. Defining the Problem:- The second step in decision making process is one
of defining or identifying the problem. Defining the nature of the problem is
important because decision making is after all meant for solution of the
problem. For instance, a cotton textile firm may find that its profits are
declining.

It needs to be investigated what are the causes of the problem of decreasing

profits. Whether it is the wrong pricing policy, bad labour-management
relations or the use of outdated technology which is causing the problem of
declining profits. Once the source or reason for falling profits has been found,
the problem has been identified and defined.

3. Identifying Possible Alternative Solutions (i.e. Alternative Courses of

Action): Once the problem has been identified, the next step is to find out
alternative solutions to the problem. This will require considering the variables
that have an impact on the problem. In this way, relationship among the
variables and with the problems has to be established.

In regard to this, various hypotheses can be developed which will become

alternative courses for the solution of the problem. For example, in case of the
problem mentioned above, if it is identified that the problem of declining profits
is due to be use of technologically inefficient and outdated machinery in
production.

The two possible solutions of the problem are:

(1) Updating and replacing only the old machinery.

(2) Building entirely a new plant equipped with latest machinery.

The choice between these alternative courses of action depends on which will
bring about larger increase in profits.

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4. Evaluating Alternative Courses of Action:- The next step in business

decision making is to evaluate the alternative courses of action. This requires,
the collection and analysis of the relevant data. Some data will be available
within the various departments of the firm itself, the other may be obtained
from the industry and government.

The data and information so obtained can be used to evaluate the outcome or
results expected from each possible course of action. Methods such as
regression analysis, differential calculus, linear programming, cost- benefit
analysis are used to arrive at the optimal course. The optimum solution will be
one that helps to achieve the established objective of the firm. The course of
action which is optimum will be actually chosen. It may be further noted that
for the choice of an optimal solution to the problem, a manager works under
certain constraints.

The constraints may be legal such as laws regarding pollution and disposal of
harmful wastes; they way be financial (i.e. limited financial resources); they
may relate to the availability of physical infrastructure and raw materials, and
they may be technological in nature which set limits to the possible output to
be produced per unit of time. The crucial role of a business manager is to
determine optimal course of action and he has to make a decision under these
constraints.

5. Implementing the Decision:- After the alternative courses of action have

been evaluated and optimal course of action selected, the final step is to
implement the decision. The implementation of the decision requires constant
monitoring so that expected results from the optimal course of action are
obtained. Thus, if it is found that expected results are not forthcoming due to
the wrong implementation of the decision, then corrective measures should be
taken.

However, it should be noted that once a course of action is implemented to

achieve the established objective, changes in it may become necessary from
time to time in response in changes in conditions or firm’s operating
environment on the basis of which decisions were taken.

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 Role and Responsibilties of managerial economist

1. To make a reasonable profit on capital employed: - He must have a strong

conviction that profits are essential and his main obligation is to assist the
management in earning reasonable profits on capital employed in the firm.

2. He must make successful forecasts by making in depth study of the

internal and external factors:- This will have influence over the profitability
or the working of the firm. He must aim at lessening if not fully eliminating the
risks involved in uncertainties. He has a major responsibility to alert
management at the earliest possible time in case he discovers any error in his
forecast, so that the management can make necessary changes and adjustments
in the policies and programmes of the firm.

3. He must inform the management of all the economic trends:- A

managerial economist should keep himself in touch with the latest
developments of national economy and business environment so that he can
keep the management informed with these developments and expected trends
of the economy

4. He must establish and maintain contacts with individuals and data

sources:

(i) To establish and maintain contacts:

A managerial economist should establish and maintain contacts with

individuals and data sources in order to collect relevant and valuable
information in the field.

(ii) To develop personal relations:

To collect information he should develop personal relations with those having

specialised knowledge of the field.

(iii) To join professional associations and should take active part in their
activities:

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The success of this lies in how quickly he gathers additional information in the
best interest of the firm.

5. He must earn full status in the business and only then he can be helpful
to the management in good and successful decision-making:

For this:

(i) He must receive continuous support for himself and his professional ideas
by performing his function effectively.

(ii) He should express his ideas in simple and understandable language with the
minimum use of technical words, while communicating with his management
executives.

 Importance of Managerial Economics

Business and industrial enterprises aim at earning maximum proceeds. In

order to achieve this objective, a managerial executive has to take recourse in
decision making, which is the process of selecting a specified course of action
from a number of alternatives. A sound decision requires fair knowledge of the
aspects of economic theory and the tools of economic analysis, which are
directly involved in the process of decision-making. Since managerial
economics is concerned with such aspects and tools of analysis, it is pertinent
to the decision making process.

Spencer and Siegelman have described the importance of managerial

economics in a business and industrial enterprise as follows:

(i) Accommodating traditional theoretical concepts to the actual business

behavior and conditions:Managerial economics amalgamates tools,
techniques, models and theories of traditional economics with actual business
practices and with the environment in which a firm has to operate. According
to Edwin Mansfield, “Managerial Economics attempts to bridge the gap
between purely analytical problems that intrigue many economic theories and
the problems of policies that management must face”.

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(ii) Estimating economic relationships: Managerial economics estimates

economic relationships between different business factors such as income,
elasticity of demand, cost volume, profit analysis etc.

(iii) Predicting relevant economic quantities: Managerial economics assists

the management in predicting various economic quantities such as cost, profit,
demand, capital, production, price etc. As a business manager has to function in
an environment of uncertainty, it is imperative to anticipate the future working
environment in terms of the said quantities.

(iv) Understanding significant external forces: The management has to

identify all the important factors that influence a firm. These factors can
broadly be divided into two categories. Managerial economics plays an
important role by assisting management in understanding these factors.

(a) External factors: A firm cannot exercise any control over these factors. The
plans, policies and programs of the firm should be formulated in the light of
these factors. Significant external factors impinging on the decision making
process of a firm are economic system of the country, business cycles,
fluctuations in national income and national production, industrial policy of the
government, trade and fiscal policy of the government, taxation policy,
licensing policy, trends in foreign trade of the country, general industrial
relation in the country and so on.

(b) Internal factors: These factors fall under the control of a firm. These
factors are associated with business operation. Knowledge of these factors aids
the management in making sound business decisions.

(v) Basis of business policies: Managerial economics is the founding principle

of business policies. Business policies are prepared based on studies and
findings of managerial economics, which cautions the management against
potential upheavals in national as well as international economy. Thus,
managerial economics is helpful to the management in its decision-making
process.

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 Limitations of Managerial Economics

The limitations of managerial economics are as follows:

(a)Managerial economics focus on management analysis based on financial and

cost accounting data. Thus, the reliability of this data depends on the accuracy
of the financial accounting information.

(b)Such analysis is based on past information. But if a new scheme is to be

introduced, the circumstances change and the conclusions cannot be predicted
using this past information.

(c)Managerial economics is subjected to the personal preferences of the

individual manager which can influence the final decision of the manager to a
certain extent.

(d)It is an expensive process as a business firm generally requires a certain

number of managers to ensure proper functioning.

(e)The science of managerial economics is quite recent and is not fully

developed. Thus, it is subjected to ambiguity in certain scenarios.

The manager is required to have extensive knowledge in a variety of fields in

order to ensure that he completely comprehends the situation to be dealt with."

 Opportunity Cost Principle

Opportunity cost principle is related and applied to scarce resource. When

there are alternative uses of scarce resource, one should know which best
alternative is and which is not. We should know what gain by best alternative
is and what loss by left alternative is.

Definitions

In the words of Left witch, "Opportunity cost of a particular product is the value
of the foregone alternative products that resources used in its production, could
have produced."

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Opportunity cost is not what you choose when you make a choice —it is what
you did not choose in making a choice. Opportunity cost is the value of the
forgone alternative — what you gave up when you got something.

Example 1: If a person is having cash in hand Rs. 100000/-, he may think of

two alternatives to increase cash.

Option 1: Investing in bank. We will get returns amount 10000/-

Option 2: Investing in business. We get returns amount 17000/-

Generally we chose the option 2 because we will get more returns than the
option 1. Here the option 1 is the opportunity cost, that what we have not
chosen.

Example 2: I have a number of alternatives of how to spend my Friday night: I

can go to the movies; I can stay home and watch the baseball game on TV, or go
out for coffee with friends. If I choose to go to the movies, my opportunity cost
of that action is what I would have chosen if I had not gone to the movies - either
watching the baseball game or going out for coffee with friends. Note that an
opportunity cost only considers the next best alternative to an action, not the
entire set of alternatives.

The opportunity cost of a decision is based on what must be given up (the next
best alternative) as a result of the decision. Any decision that involves a choice
between two or more options has an opportunity cost.

 What is Production Possibility Curve?

Since human wants are unlimited and the means to satisfy them are limited,
every society is faced with the fundamental problem of choosing and allocating
its scarce resources among alternative uses. The production possibility curve
or frontier is an analytical tool which is used to illustrate and explain this
problem of choice.

Production Possibility Curve: Features, Schedule Representation and

Assumptions!

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The economic problem of scarcity and choice can be easily and clearly
explained with production possibility frontier or curve.

Production possibility curve or production frontier refers graphically to all the

possible combinations of maximum amounts of two goods which can be
produced with the available productive resources of an economy.

In short, production possibility curve is a curve which shows all possible

combinations of two goods that can be produced by making full use of given
resources and technology in an economy.

We know that an economy always faces the problem of resource allocation i.e.
making a choice of its resources. Again there is a maximum limit to the quantity
of goods and services which an economy can produce with full use of its
available resources and technology. We also know that an increase in the
production of one commodity reduces the production of other commodity. In
this way available resources can be used alternatively to produce different
combinations of goods and services. This is known as production possibility.
The curve that shows these alternatives is called production possibility curve.

Schedule Representation:

Let us assume that two commodities are to be produced say, cloth and wheat.
If all the resources are put to produce cloth, then the maximum of cloth will be
produced per year, depending on the quantitative and qualitative resources
and the technological efficiency. Let us, now further suppose that within the
existing conditions only 5 million meters of cloth can be produced, with all the
resources at our command.

Alternatively, if all the resources are used for the production of wheat, we can
produce 15 million tonnes of food grains. In between these two extreme
possibilities, there are many other alternatives. Thus we shall have to scarcities
one for the other. This fact is clear from the Table No. 1.

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Diagramme Representation:

With the help of above table, we can show production possibility curve in
respect of cloth and wheat. Economy can produce maximum 5 million metres
of cloth or 15 million quintals of wheat. In Fig. 1, on OX axis, we have measured
cloth in million metres while on OY axis; we have taken wheat in million
quintals.

The concave curve AF shows the join of various possible combinations which
gives a curve known as transformation curve or production possibility frontier.
Each production possibility curve is the locus of output combination which is
obtained from given factors or inputs. Similarly B, C, D and E show the different
combinations for two different goods i.e. cloth and wheat. The economy has to
choose out of these various combinations, which can be produced by existing
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resources and technology. They are also known as ‘Technologically Efficient’ or

‘Optimum Product Mix’. Here we should remember that any combination
beyond AF curve does not possess sufficient resources.

 Assumptions
The production possibility curve is based on certain assumptions:

(a) The economy produces two commodities only.

(b) The quantities and qualities of factors of production viz., land, labour capital
etc. are fixed.

(c) The techniques of production are constant.

(d) There is full employment in the economy and

(e) The prices of factors of production are constant.

 Features of Production Possibility Curve

Production possibility curve has two main features as explained under:

1. It Slopes Downwards to Right:

Production possibility curve slopes downwards to the right shows that

economy has to forgo some quantity of one commodity to get more quantity of
other commodity. In figure when the economy moves from combination B to C,
economy has to give up two million quintals of wheat to get one million metres
of additional cloth.

2. Concave to the Origin:

Production possibility curve is concave to the origin. It shows the operation of

the law of increasing opportunity cost. In figure when we move from A to B,
economy has to forgo one million quintals of wheat. Again when we move from
B to C, economy is required to give up two million quintals of wheat to get one
additional unit i.e. one million metres of cloth.

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Example:- XYZ Company, Ltd is known for producing and selling pens and
pencils. Their resources for producing the two products are fixed.
The company can produce 2,000 pencils if it doesn’t produce a single pen.
Likewise, it can produce 1,500 pens if it doesn’t produce a single pencil.
Currently, it is producing 1,000 pencils and 800 pens.

The company has recently received more demand for pencils, so management
decided to increase the production of pencils from 1,000 units to 1,500 units by
reducing the output of pens from 800 units to 5oo units. The opportunity cost
for producing 1,500 units of pencils becomes the 300 units of forgone pens.

 Shift in Production Possibility curve (PPC)

Production Possibility Curve shift either downward or upward. PPC shift
downward or upward due to following reasons: –

1. Change in capital.

Increase in capital increases the quantity of production due to which PPC shift
upward. And if capital investment decreases, then the production will also
decrease which causes downward shift in PPC.

2. Change in labour force.

If efficiency of labour force increases, then production of goods also increases,

as a result, burden of labour force production will decrease. As a result, PPC
shift downward.

3. Change in technology.

If the production technique is improved, then the production will increase

which brings upward shift in PPC. If old technology is used in production
process, production will decrease which brings downward shift in PPC.

4. Change in Time period.

PPC can shift due to the change in time period. In the long run, economy can
gain efficiency which results increase in productivity. As a result, PPC shift

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upward, but the economy can’t get efficiency in production, the production
decreases and PPC shift downward.

Similarly, proper management of available resources, increase in economic

growth, new raw materials, education, trainings to labour etc. increase the
production which will shift the PPC upward. But mismanagement of available
resources, decrease in economic growth, adequate raw materials, etc. decrease
the production which will shift the PPC downward.

Why PPC expands outwards?

PPC expands outwards due to different factors. Investment in new plants and
machinery will increase the stock of capital. New raw materials may be
discovered. Technological advances take place through new inventions;
education and training make labour more productive. All these factors lead to
increase the production possibility of the country and while illustrating this
growth of potential output in PPC, there will be an outward expansion of PPC.

 Incremental Concept
The incremental concept is probably the most important concept in economics
and is certainly the most frequently used in Managerial Economics. Incremental
concept is closely related to the mar-ginal cost and marginal revenues of
economic theory.

The two major concepts in this analysis are incremental cost and incremental
revenue. Incremental cost denotes change in total cost, whereas incremental
revenue means change in total revenue resulting from a decision of the firm.

The incremental principle may be stated as follows:-

A decision is clearly a profitable one if

(i) It increases revenue more than costs.

(ii) It decreases some cost to a greater extent than it increases others.

(iii) It increases some revenues more than it decreases others.

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(iv) It reduces costs more than revenues.

Illustration:

Some businessmen hold the view that to make an overall profit, they must make
a profit on every job. The result is that they refuse orders that do not cover full
costs plus a provision of profit. This will lead to rejection of an order which
prevents short run profit. A simple problem will illustrate this point. Suppose a
new order is estimated to bring in an additional revenue of Rs. 10,000. The costs
are estimated as under:

Labour Rs. 3,000

Materials Rs. 4,000

Overhead charges Rs. 3,600

Selling and administrative expenses Rs. 1,400

Full Cost Rs.12, 000

The order appears to be unprofitable. For it results in a loss of Rs. 2,000.

However, suppose there is idle capacity which can be utilised to execute this
order. If order adds only Rs. 1,000 to overhead charges, and Rs. 2000 by way of
labour cost because some of the idle workers already on the pay roll will be
deployed without added pay and no extra selling and administrative costs, then
the actual incremental cost is as follows:

Labour Rs. 2,000

Materials’ Rs. 4,000

Overhead charges Rs. 1,000

Total Incremental Cost Rs. 7,000

Thus there is a profit of Rs. 3,000. The order can be accepted on the basis of
incremental reasoning. Incremental reasoning does not mean that the firm
should accept all orders at prices which cover merely their incremental costs.

Limitations
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The concept is mainly used by the progressive concerns. Even though it is a

widely followed concept, it has certain limitations:

(a) The concept cannot be generalised because observed behaviour of the firm
is always vari-able.

(b) The concept can be applied only when there is excess capacity in the
concern.

(c) The concept is applicable only during the short period.

 Concepts of Scarcity
Scarcity refers to the limited availability of a commodity, which may be in
demand in the market.

The concept of scarcity was first given by Lionel Robbins. This explains an
individual’s capacity to buy all or some of the commodities as per the available
resources with that individual.

Robbins is famous for his definition of economics: "Economics is the science

which studies human behaviour as a relationship between ends and scarce
means which have alternative uses."

Scarcity is the fundamental economic problem of having seemingly unlimited

human wants in a world of limited resources. It states that society has
insufficient productive resources to fulfill all human wants and needs.

Scarcity refers to the condition of insufficiency where the human beings are
incapable to fulfill their wants in sufficient manner. In other words, it is a
situation of fewer resources in comparison to unlimited human wants. Human
wants are unlimited. We may satisfy some of our wants but soon new wants
arise. It is impossible to produce goods and services so as to satisfy all wants of
people. Thus scarcity explains this relationship between limited resources and
unlimited wants and the problem there in.

Economic problems arise due to the scare goods. These scare goods have many
alternative uses. For example: a land can be used to construct a factory building
or to make a beautiful park or to raise agricultural crops. So, it is very essential
to think how limited resources can be used alternatively to satisfy some wants
of people to get maximum satisfaction as possible.
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The problem of scarcity is present not only in developing countries but also in
highly developed countries such as Japan, Canada, etc. Thus, scarcity is the
heart of all economic problems.

Concept of Choice
Choice is the process of selecting few goods or wants from the bundles of goods
or wants. Human wants are unlimited. So, they are unable to fulfill all their
wants at once. They can satisfy only some their wants. Some wants should be
sacrificed to get some other wants. Hence, people postponed less urgent wants
to satisfy more urgent wants. For example: a boy desiring to buy a book does
not visit cinema hall. Thus, the problem of choice deals with utilization of scare
resources in such a way that it satisfies human wants in the best possible way.
If human wants were limited or resources were unlimited, then, there would be
no scarcity and there would be no problem of choice. Because of scarcity we are
forced to choose. Unlimited wants and limited resources lead economic
problem and problem of choice which can be shown as follows:

Allocation of Resources
Allocation of resource means scientific management of resources in the
production, distribution and exchange. It deals with how much of resource is
necessary in what sector. It is the basic problem of every economy. We can
satisfy only limited wants because we have limited resources. So, these limited
resources are used in such a manner that the satisfaction derived from it is
maximum. As the resources are limited in comparison to wants, the proper
allocation of resources is necessary. The proper allocation of resources deals
with the following fundamental problems of an economy.

1. What to produce: This means what amount of goods to be produced. Every

demand of every individual can’t be satisfied. So, before producing anything, a
decision should be made what goods are to be produced and to what extent.

2. How to produce: This means which techniques of production (labour

intensive or capital intensive technique to be selected). After the decision of

what to produce we must next determine what techniques should be adopted

to produce goods.

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3. For whom to produce: This means how the produced goods and services
are to be distributed among different income groups of people that is who
should get how much. This is the problem of sharing of the national product.

4. Problem of full employment: This means the efficient use of scare

resources that is no waste or misuse of resources. Since, resources are scare in
relation to human wants. It is necessary to utilize the available resources to
achieve full employment for maximum possible satisfaction.

5. Problem of growth: This means how to achieve the growth of resources.

The growth of resources is related to increase the level of production. Each
economy faced the problem of how to increase its production capacity. For this,
the economy has to decide about the rate of capital formation, investment, and
savings.

Demand
Demand in terms of economics may be explained as the consumers’ willingness
and ability to purchase or consume a given item/good. Furthermore, the
determinants of demand go a long way in explaining the demand for a particular
good.

For instance, an increase in the price of a good will lead to a decrease in the
quantity that may be demanded by consumers. Similarly, a decrease in the cost
or selling price of a good will most likely lead to an increase in the demanded
quantity of the goods.

This indicates the existence of an inverse relationship between the price of the
article and the quantity demanded by consumers. This is commonly known as the
law of demand and can be graphically represented by a line with a downward
slope.

The graphical representation is known as the demand curve. The determinants

of demand are factors that cause fluctuations in the economic demand for a
product or a service.

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Demand in economics means a desire to possess a good supported by

willingness and ability to pay for it. If your have a desire to buy a certain
commodity, say a car, but you do not have the adequate means to pay for it, it
will simply be a wish, a desire or a want and not demand. Demand is an effective
desire, i.e., a desire which is backed by willingness and ability to pay for a
commodity in order to obtain it.

In the words of Prof. Hibdon:

"Demand means the various quantities of goods that would be purchased per
time period at different prices in a given market".

 Characteristics of Demand

There are thus three main characteristic's of demand in economics.

(i) Willingness and ability to pay. Demand is the amount of a commodity for
which a consumer has the willingness and also the ability to buy.

(ii) Demand is always at a price. If we talk of demand without reference to

price, it will be meaningless. The consumer must know both the price and the
commodity. He will then be able to tell the quantity demanded by him.

(iii) Demand is always per unit of time. The time may be a day, a week, a
month, or a year.

 Types of Demand
The demand can be classified on the following basis:

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1. Individual Demand and Market Demand: The individual demand refers to

the demand for goods and services by the single consumer, whereas the market
demand is the demand for a product by all the consumers who buy that product.
Thus, the market demand is the aggregate of the individual demand.
2. Total Market Demand and Market Segment Demand: The total market
demand refers to the aggregate demand for a product by all the consumers in
the market who purchase a specific kind of a product. Further, this aggregate
demand can be sub-divided into the segments on the basis of geographical
areas, price sensitivity, customer size, age, sex, etc. are called as the market
segment demand.
3. Derived Demand and Direct Demand: When the demand for a
product/outcome is associated with the demand for another product/outcome
is called as the derived demand or induced demand. Such as the demand for
cotton yarn is derived from the demand for cotton cloth. Whereas, when the
demand for the products/outcomes is independent of the demand for another
product/outcome is called as the direct demand or autonomous demand. Such
as, in the above example the demand for a cotton cloth is autonomous.
4. Industry Demand and Company Demand: The industry demand refers to the
total aggregate demand for the products of a particular industry, such as
demand for cement in the construction industry. While the company demand is
a demand for the product which is particular to the company and is a part of
that industry. Such as demand for tyres manufactured by the Goodyear. Thus,
the company demand can be expressed as the percentage of the industry
demand.
5. Short-Run Demand and Long-Run Demand: The short term demand is more
elastic which means that the changes in price or income are reflected
immediately on the quantity demanded. Whereas, the long run demand is
inelastic, which shows that demand for commodity exists as a result of
adjustments following changes in pricing, promotional strategies, consumption
patterns, etc.
6. Price Demand: The demand is often studied in parlance to price, and is
therefore called as a price demand. The price demand means the amount of
commodity a person is willing to purchase at a given price. While studying the
demand, we often assume that the other factors such as income of the
consumer, their tastes, and preferences, the prices of other related goods
remain unchanged. There is a negative relationship between the price and
demand Viz. As the price increases the demand decreases and as the price
decreases the demand increases.

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7. Income Demand: The income demand refers to the willingness of an

individual to buy a certain quantity at a given income level. Here the price of
the product, customer’s tastes and preferences and the price of the related
goods are expected to remain unchanged. There is a positive relationship
between the income and demand. As the income increases the demand for the
commodity also increases and vice-versa.
8. Cross Demand: It is one of the important types of demand wherein the demand
for a commodity depends not on its own price, but on the price of other related
products is called as the cross demand. Such as with the increase in the price of
coffee the consumption of tea increases, since tea and coffee are substitutes to
each other. Also, when the price of cars increases the demand for petrol
decreases, as the car and petrol are complimentary to each other.

 Demand Schedule:
The demand schedule in economics is a table of quantity demanded of a good
at different price levels. Given the price level, it is easy to determine the
expected quantity demanded. This demand schedule can be graphed as a
continuous demand curve on a chart where the Y-axis represents price and the
X-axis represents the quantity.

According to PROF. ALFRED MARSHALL, “Demand schedule is a list of prices

and quantities”. In other words, a tabular statement of price-quantity
relationship between two variables is known as the demand schedule.

The demand schedule in the table represents different quantities of

commodities that are purchased at different prices during a certain specified
period (it can be a day or a week or a month).

The demand schedule can be classified into two categories:

1. Individual demand schedule;

2. Market demand schedule.

1. Individual Demand Schedule:

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It represents the demand of an individual’ for a commodity at different prices

at a particular time period. The adjoining table 7.1 shows a demand schedule
for oranges on 7th July, 2009.

2. Market Demand Schedule:

Market Demand Schedule is defined as the quantities of a given commodity

which all consumers will buy at all possible prices at given moment of time. In
a market, there are several consumers, and each has a different liking, taste,
preference and income. Every consumer has a different demand.

The market demand actually represents the demand of all the consumers
combined together. When a particular commodity has several brands or types
of commodities, the market demand schedule becomes very complicated
because of various factors. However, for a single item, the market demand
schedule is rather simple. Study the market demand schedule for milk in table
7.2.

Demand Curves (Diagram):

The demand curve is a graphic statement or presentation of the relationship

between product price and the quantity of the product demanded. It is drawn
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with price on the vertical axis of the graph and quantity demanded on the
horizontal axis.

Demand curve does not tell us the price. It only tells us how much quantity of
goods would be purchased by the consumer at various possible prices.

Depending upon the demand schedule, the demand curve can be as

follows:

1. Individual Demand Curve

2. Market Demand Curve

1. Individual Demand Curve:

An Individual Demand Curve is a graphical representation of the quantities of a

commodity that an individual (a particular consumer) stands ready to take off
the market at a given instant of time against different prices. In Fig. 7.1, an
Individual Demand Curve is drawn on the basis of Individual Demand Schedule
given above in table 7.1.

2. Market Demand Curve:

A Market Demand Curve is a graphical representation of the quantities of a

commodity which all the buyers in the market stand ready to take off at all

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possible prices at a given moment of time. In Figure 7.2 a Market Demand Curve
is drawn on the basis of Market Demand Schedule given in Table 7.2.

Both, the individual consumer’s demand curve is a straight line. A demand

curve will slope downward to the right.

It is not necessary, that the demand curve is a straight line. A demand curve
may be a convex curve or a concave curve. It may take any shape provided it is
negatively sloped.

 Determinants of Demand

Some of the important determinants of demand are as follows,

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1] Price of the Product

People use price as a parameter to make decisions if all other factors remain
constant or equal. According to the law of demand, this implies an increase in
demand follows a reduction in price and a decrease in demand follows an
increase in the price of similar goods.

The demand curve and the demand schedule help determine the demand
quantity at a price level. An elastic demand implies a robust change quantity
accompanied by a change in price. Similarly, an inelastic demand implies that
volume does not change much even when there is a change in price.

2] Income of the Consumers

Rising incomes lead to a rise in the number of goods demanded by consumers.
Similarly, a drop in income is accompanied by reduced consumption levels. This
relationship between income and demand is not linear in nature. Marginal utility
determines the proportion of change in the demand levels.

3] Prices of related goods or services

 Complementary products – An increase in the price of one product will

cause a decrease in the quantity demanded of a complementary product.
Example: Rise in the price of bread will reduce the demand for butter. This
arises because the products are complementary in nature.

 Substitute Product – An increase in the price of one product will cause an

increase in the demand for a substitute product. Example: Rise in price of
tea will increase the demand for coffee and decrease the demand for tea.
4] Consumer Expectations
Expectations of a higher income or expecting an increase in prices of goods will
lead to an increase the quantity demanded. Similarly, expectations of a reduced
income or a lowering in prices of goods will decrease the quantity demanded.

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5] Number of Buyers in the Market

The number of buyers has a major effect on the total or net demand. As the
number increases, the demand rises. Furthermore, this is true irrespective of
changes in the price of commodities.

 Law of demand

There is an inverse relationship between quantity demanded and its price. The
people know that when price of a commodity goes up its demand comes down.
When there is decrease in price the demand for a commodity goes up. There is
inverse relation between price and demand . The law refers to the direction in
which quantity demanded changes due to change in price.

A consumer may demand one dozen oranges at $5 per dozen . He may demand
two dozens when the price is $4 per dozen. A person generally buys more at a
lower price. He buys less at higher price. It is not the case with one person but
all people liken to buy more due to fall in price and vice versa. This is true for
all commodities and under all conditions. The economists call it as law of
demand. In simple words the law of demand states that other things being
equal more will be demanded at lower price and lower will be demanded at
higher price.

Definition

1. Alfred Marshal says that the amount demanded increase with a fall in
price, diminishes with a rise in price.
2. C.E. Ferguson says that according to law of demand, the quantity
demanded varies inversely with price.
3. Paul A. Samuelson says that law of demand states that people will buy
more at a lower prices and buy less at higher prices, other things
remaining the same.

 Assumptions of the law

1. There is no change in income of consumers.

2. There is no change in the price of product.
3. There is no change in quality of product.
4. There is no substitute of the commodity.

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5. The prices of related commodities remain the same.

6. There is no change in customs.
7. There is no change in taste and preference of consumers.
8. The size of population remains the same.
9. The climate and weather conditions are same.
10. The tax rates and other fiscal measures remain the same.

Explanation of the law

The relationship between price of a commodity and its demand depends upon
many factors. The most important factor is nature of commodity. The demand
schedule shows response of quantity demanded to change in price of that
commodity. This is the table that shows prices per unit of commodity ands
amount demanded per period of time. The demand of one person is called
individual demand. The demand of many persons is known as market demand.
The experts are concerned with market demand schedule. The market demand
schedule means 'quantities of given commodity which all consumers want to
buy at all possible prices at a given moment of time'. The demand schedules of
all individuals can be added up to find out market demand schedule.

Demand schedule
Price in dollars. Demand in Kg.

5 100

4 200

3 300

2 400

The table shows the demand of all the consumers in a market. When the price
decreases there is increase in demand for goods and vice versa. When price is
$5 demand is 100 kilograms. When the price is $4 demand is 200 kilograms.
Thus the table shows the total amount demanded by all consumers various
price levels.

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Diagram

There is same price in the market. All consumers purchase commodity

according to their needs. The market demand curve is the total amount
demanded by all consumers at different prices. The market demand curve
slopes from left down to the right.

 Types of Demand Function

Based on whether the demand function is in relation to an individual consumer
or to all consumers in the market, the demand function cab be categorized as

 Individual Demand Function

 Market Demand Function

 Individual Demand Function

Individual demand function refers to the functional relationship between

demand made by an individual consumer and the factors affecting the
individual demand. It shows how demand made by an individual in the market
is related to its determinants.

Mathematically, individual demand function can be expressed as,

Dx= f (Px, Pr, Y, T, F)

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Where,

Dx= Demand for commodity x;.

Px= Price of the given commodity x;

Pr= Price of related goods;

Y= Income of the individual consumer;

T= Tastes and preferences;

F= Expectation of change in price in the future.

1] Price of the given commodity

Other things remaining constant, the rise in price of the commodity, the
demand for the commodity contracts, and with the fall in price, its demand
increases.

2] Price of related goods

Demand for the given commodity is affected by price of the related goods,
which is called cross price demand.

3] Income of the individual consumer

Change in consumer’s level of income also influences their demand for different
commodities. Normally, the demand for certain goods increase with the
increasing level of income and vice versa.

4] Tastes and preferences

The taste and preferences of individuals also determine the demand made for
certain goods and services. Factors such as climate, fashion, advertisement,
innovation, etc. affect the taste and preference of the consumers.

5] Expectation of change in price in the future

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If the price of the commodity is expected to rise in the future, the consumer will
be willing to purchase more of the commodity at the existing price. However, if
the future price is expected to fall, the demand for that commodity decreases at
present.

6] Size and composition of population

The market demand for a commodity increases with the increase in the size and
composition of the total population. For instance, with the increase in total
population size, there is an increase in the number of buyers. Likewise, with an
increase in the male composition of the population, the demand for goods
meant for male increases.

7] Season and weather

The market demand for a certain commodity is also affected by the current
weather conditions. For instance, the demand for cold beverages increase
during summer season.

8] Distribution of income

In case of equal distribution of income in the economy, the market demand for
a commodity remains less. With an increase in the unequal distribution of
income, the demand for certain goods increase as most people will have the
ability to buy certain goods and commodities, especially luxury goods.

 Market Demand Function

Market demand function refers to the functional relationship between market

demand and the factors affecting market demand. Market demand is affected
by all the factors that affect an individual demand. In addition to this, it is also
affected by size and composition of population, season and weather conditions,
and distribution of income.

Mathematically, market demand function can be expressed as,

Dx= f (Px, Pr, Y, T, F, Po, S, D)

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Where,

Dx= Demand for commodity x;

Px= Price of the given commodity x;

Pr= Price of related goods;

Y= Income of the individual consumer;

T= Tastes and preferences;

F= Expectation of change in price in the future;

Po= Size and composition of population;

S= Season and weather;

D= Distribution of income.

1. Pattern of Income Distribution:

If National income is equitably distributed, there will be more demand and vice-
versa. If income distribution moves in favour of downtrodden people, then
demand for such commodities, which are used by common people would
increase. On the other hand, if the major part of National income is
concentrated in the hands of only some rich people, the demand for luxury
goods will increase.

2. Demographic Structure:

Market demand is influenced by change in size and composition of population.

Increase in population leads to more demand for all types of goods and
decrease in population means less demand for them. Composition of population
also affects its demand. Composition refers to the number of children, adults,
males, females etc., in the population.

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When the composition changes, for example, when the number of females
exceeds to that of the males, then there will be more demand for goods required
by women folk.

3. Government Policy:

Government policy of a country can also affect the demand for a particular
commodity or commodities through taxation. Reduction in the taxes and duties
will allow more persons to enter a particular market and thus raising the
demand for a particular product.

4. Season and Weather:

Demands for commodities also depend upon the climate of an area and
weather. In cold hilly areas woolens are demanded. During summer and rainy
season demand for umbrellas may rise. In winter ice is not so much demanded.

5. State of Business:

The levels of demand in a market for different goods depend upon the business
condition of the country. If the country is passing through boom, the trade is
active and brisk. The demand for all commodities tends to rise. But in the days
of depression, when trade is dull and slow, demand tends to fall.

 Why demand curve falls

1] Marginal utility decreases:

When a consumer buys more units of a commodity, the marginal utility of such
commodity continue to decline. The consumer can buy more units of
commodity when its price falls and vice versa. The demand curve falls because
demand is more at lower price.

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2] Price effect:

When there is increase in price of commodity, the consumers reduce the

consumption of such commodity. The result is that there is decrease in demand
for that commodity. The consumers consume mo0re or less of a commodity due
to price effect. The demand curve slopes downward.

3] Income effect

Real income of consumer rises due to fall in prices. The consumer can buy more
quantity of same commodity. When there is increase in price, real income of
consumer falls. This is income effect that the consumer can spend increased
income on other commodities. The demand curve slopes downward due to
positive income effect.

4] Same price of substitutes

When the price of a commodity falls, the prices of substitutes remaining the
same, consumer can buy more of the commodity and vice versa. The demand
curve slopes downward due to substitution effect.

5] Demand of poor people

The income of people is not the same, The rich people have money to buy same
commodity at high prices. Large majority of people are poor, They buy more
when price fall and vice versa. The demand curve slopes due to poor people.

6]Different uses of goods

There are different uses of many goods. When prices of such goods increase
these goods are put into uses that are more important and their demand falls.
The demand curve slopes downward due to such goods.

 Exceptions to the law

1] Inferior goods

The law of demand does not apply in case of inferior goods. When price of
inferior commodity decreases and its demand also decrease and amount so

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saved in spent on superior commodity. The wheat and rice are superior food
grains while maize is inferior food grain.

2] Demonstration effect

The law of demand does not apply in case of diamond and jewelry. There is
more demand when prices are high. There is less demand due to low prices.
The rich people like to demonstrate such items that only they have such
commodities.

3] Ignorance of consumers

The consumer usually judge the quality of a commodity from its price. A low
priced commodity is considered as inferior and less quantity is purchased. A
high priced commodity is treated as superior and more quantity is purchased.
The law of demand does not apply in this case.

4] Less supply

The law of demand does not work when there is less supply of commodity. The
people buy more for stock purpose even at high price. They think that
commodity will become short.

5] Depression

The law of demand does not work during period of depression. The prices of
commodities are low but there is increase in demand. it is due to low
purchasing power of people.

6] Speculation

The law does not apply in case of speculation. The speculators start buying
share just to raise the price. Then they start selling large quantity of shares to
avoid losses.

7] Out of fashion

The law of demand is not applicable in case of goods out of fashion. The
decrease in prices cannot raise the demand of such goods. The quantity
purchased is less even though there is falls in prices.
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 Importance of the law

1] Price determination

A monopolist can determine price of a commodity on the basis of such law. He

can know the effect on demand due to increase or decrease in price. The
demand schedule can help him to determine the most suitable price level.

2] Tax on commodities

The law of demand is important for tax authorities. The effect of tax on different
commodities is checked. The commodity must be taxed if its demand is
relatively inelastic. A commodity cannot be taxed if its sales fall to great extent.

3] Agricultural prices

The law of demand is useful to determine agricultural prices. When there are
good crops, the prices come down due to change in demand. In case of bad
crops, the prices go up if demand remains the same. The poverty of farmers can
be determined.

4] Planning

Individual demand schedule is used in planning for individual goods and

industries. There is need to know the effect of change in price on the demand of
commodity at national and world level. The nature of demand schedule helps
to know such effect.

Elasticity of Demand
The law of demand indicates the direction of change in quantity demanded to a
change in price.

It states that when price falls, demand rises. But how much the quantity
demanded rises (or falls) following a certain fall (or rise) in prices cannot be
known from the law of demand. That is to say, how much quantity demanded

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changes following a change in the price of a commodity can be known from the
concept of elasticity of demand?

Meaning of Elasticity of Demand

The term ‘elasticity ‘of demand indicates responsiveness of quantity demanded

due to change in any of its determinants. This is a measure of how sensitive the
quantity demanded is to the change in any of the factors affecting demand.

There are three main types of elasticity of demand:

I. Price elasticity of demand.

II. Income elasticity of demand.

III. Cross elasticity of demand.

I. Price Elasticity of demand. Price elasticity of demand measure the degree

of responsiveness of demand for a commodity due to change in its price

Percentage Change in quantity demanded.

Ed= ------------------------------------------

Percentage Change in Price

The different kinds/ degree of Price Elasticity of demand

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1. Perfectly Elastic Demand:

When a small change in price of a product causes a major change in its demand,
it is said to be perfectly elastic demand. In perfectly elastic demand, a small rise
in price results in fall in demand to zero, while a small fall in price causes
increase in demand to infinity. In such a case, the demand is perfectly elastic or
ep = 00.

The degree of elasticity of demand helps in defining the shape and slope of a
demand curve. Therefore, the elasticity of demand can be determined by the
slope of the demand curve. Flatter the slope of the demand curve, higher the
elasticity of demand.

In perfectly elastic demand, the demand curve is represented as a

horizontal straight line, which is shown in Figure-2:

From Figure-2 it can be interpreted that at price OP, demand is infinite;

however, a slight rise in price would result in fall in demand to zero. It can also
be interpreted from Figure-2 that at price P consumers are ready to buy as
much quantity of the product as they want. However, a small rise in price would
resist consumers to buy the product.

Though, perfectly elastic demand is a theoretical concept and cannot be applied

in the real situation. However, it can be applied in cases, such as perfectly
competitive market and homogeneity products. In such cases, the demand for
a product of an organization is assumed to be perfectly elastic.

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From an organization’s point of view, in a perfectly elastic demand situation,

the organization can sell as much as much as it wants as consumers are ready
to purchase a large quantity of product. However, a slight increase in price
would stop the demand.

2. Perfectly Inelastic Demand:

A perfectly inelastic demand is one when there is no change produced in the

demand of a product with change in its price. The numerical value for perfectly
inelastic demand is zero (ep=0).

In case of perfectly inelastic demand, demand curve is represented as a

straight vertical line, which is shown in Figure-3:

It can be interpreted from Figure-3 that the movement in price from OP1 to OP2
and OP2 to OP3 does not show any change in the demand of a product (OQ).
The demand remains constant for any value of price. Perfectly inelastic demand
is a theoretical concept and cannot be applied in a practical situation. However,
in case of essential goods, such as salt, the demand does not change with change
in price. Therefore, the demand for essential goods is perfectly inelastic.

3. Relatively Elastic Demand:

Relatively elastic demand refers to the demand when the proportionate change
produced in demand is greater than the proportionate change in price of a
product. The numerical value of relatively elastic demand ranges between one
to infinity.

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Mathematically, relatively elastic demand is known as more than unit elastic

demand (ep>1). For example, if the price of a product increases by 20% and the
demand of the product decreases by 25%, then the demand would be relatively
elastic.

The demand curve of relatively elastic demand is gradually sloping, as

shown in Figure-4:

It can be interpreted from Figure-4 that the proportionate change in demand

from OQ1 to OQ2 is relatively larger than the proportionate change in price
from OP1 to OP2. Relatively elastic demand has a practical application as
demand for many of products respond in the same manner with respect to
change in their prices.

For example, the price of a particular brand of cold drink increases from Rs. 15
to Rs. 20. In such a case, consumers may switch to another brand of cold drink.
However, some of the consumers still consume the same brand. Therefore, a
small change in price produces a larger change in demand of the product.

4. Relatively Inelastic Demand:

Relatively inelastic demand is one when the percentage change produced in

demand is less than the percentage change in the price of a product. For
example, if the price of a product increases by 30% and the demand for the
product decreases only by 10%, then the demand would be called relatively
inelastic. The numerical value of relatively elastic demand ranges between zero
to one (ep<1). Marshall has termed relatively inelastic demand as elasticity
being less than unity.

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The demand curve of relatively inelastic demand is rapidly sloping, as

shown in Figure-5:

Example-3:

The demand schedule for milk is given in Table-3:

Calculate the price elasticity of demand and determine the type of price
elasticity.

Solution:

P= 15

Q = 100

P1 = 20

Q1 = 90

Therefore, change in the price of milk is:

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∆P = P1 – P

∆P = 20 – 15

∆P = 5

Similarly, change in quantity demanded of milk is:

∆Q = Q1 – Q

∆Q = 90 – 100

∆Q = -10

The change in demand shows a negative sign, which can be ignored. This is
because of the reason that the relationship between price and demand is
inverse that can yield a negative value of price or demand.

Price elasticity of demand for milk is:

ep = ∆Q/∆P * P/Q

ep = 10/5 * 15/100

ep = 0.3

The price elasticity of demand for milk is 0.3, which is less than one. Therefore,
in such a case, the demand for milk is relatively inelastic.

5. Unitary Elastic Demand:

When the proportionate change in demand produces the same change in the
price of the product, the demand is referred as unitary elastic demand. The
numerical value for unitary elastic demand is equal to one (ep=1).

The demand curve for unitary elastic demand is represented as a

rectangular hyperbola, as shown in Figure-6:

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From Figure-6, it can be interpreted that change in price OP1 to OP2 produces
the same change in demand from OQ1 to OQ2. Therefore, the demand is unitary
elastic.

The different types of price elasticity of demand are summarized in Table-

4

The income elasticity of demand:

The income elasticity is defined as the proportionate change in the quantity

demanded resulting from a proportionate change in income. Symbolically we
may write
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The income elasticity is positive for normal goods. Some writers have used
income elasticity in order to classify goods into ‘luxuries’ and ‘necessities’. A
commodity is considered to be a ‘luxury’ if its income elasticity is greater than
unity. A commodity is a ‘necessity’ if its income elasticity is small (less than
unity, usually).

The main determinants of income elasticity are:

1. The nature of the need that the commodity covers the percentage of income
spent on food declines as income increases (this is known as Engel’s Law and
has sometimes been used as a measure of welfare and of the development stage
of an economy).

2. The initial level of income of a country. For example, a TV set is a luxury in an

underdeveloped, poor country while it is a ‘necessity’ in a country with high per
capita income.

3. The time period, because consumption patterns adjust with a time-lag to

changes in income.

Types of Income Elasticity of demand

1. Positive income elasticity of demand (EY>0)

If there is direct relationship between income of the consumer and demand for
the commodity, then income elasticity will be positive. That is, if the quantity
demanded for a commodity increases with the rise in income of the consumer
and vice versa, it is said to be positive income elasticity of demand. For example:
as the income of consumer increases, they consume more of superior
(luxurious) goods. On the contrary, as the income of consumer decreases, they
consume less of luxurious goods.

Positive income elasticity can be further classified into three types:

 Income elasticity greater than unity (EY > 1)

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If the percentage change in quantity demanded for a commodity is greater than

percentage change in income of the consumer, it is said to be income greater
than unity. For example: When the consumer’s income rises by 3% and the
demand rises by 7%, it is the case of income elasticity greater than unity.

In the given figure, quantity demanded and consumer’s income is measured

along X-axis and Y-axis respectively. The small rise in income from OY to OY1
has caused greater rise in the quantity demanded from OQ to OQ1 and vice
versa. Thus, the demand curve DD shows income elasticity greater than unity.

 Income elasticity equal to unity (EY = 1)

If the percentage change in quantity demanded for a commodity is equal to

percentage change in income of the consumer, it is said to be income elasticity
equal to unity. For example: When the consumer’s income rises by 5% and the
demand rises by 5%, it is the case of income elasticity equal to unity.

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In the given figure, quantity demanded and consumer’s income is measured

along X-axis and Y-axis respectively. The small rise in income from OY to OY1
has caused equal rise in the quantity demanded from OQ to OQ1 and vice versa.
Thus, the demand curve DD shows income elasticity equal to unity.

 Income elasticity less than unity (EY < 1)

If the percentage change in quantity demanded for a commodity is less than

percentage change in income of the consumer, it is said to be income greater
than unity. For example: When the consumer’s income rises by 5% and the
demand rises by 3%, it is the case of income elasticity less than unity.

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In the given figure, quantity demanded and consumer’s income is measured

along X-axis and Y-axis respectively. The greater rise in income from OY to OY1
has caused small rise in the quantity demanded from OQ to OQ1 and vice versa.
Thus, the demand curve DD shows income elasticity less than unity.

2. Negative income elasticity of demand ( EY<0)

If there is inverse relationship between income of the consumer and demand

for the commodity, then income elasticity will be negative. That is, if the
quantity demanded for a commodity decreases with the rise in income of the
consumer and vice versa, it is said to be negative income elasticity of demand.
For example:

As the income of consumer increases, they either stop or consume less of

inferior goods.

In the given figure, quantity demanded and consumer’s income is measured

along X-axis and Y-axis respectively. When the consumer’s income rises from
OY to OY1 the quantity demanded of inferior goods falls from OQ to OQ1 and
vice versa. Thus, the demand curve DD shows negative income elasticity of
demand.

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3. Zero income elasticity of demand ( EY=0)

If the quantity demanded for a commodity remains constant with any rise or
fall in income of the consumer and, it is said to be zero income elasticity of
demand. For example: In case of basic necessary goods such as salt, kerosene,
electricity, etc. there is zero income elasticity of demand.

In the given figure, quantity demanded and consumer’s income is measured

along X-axis and Y-axis respectively. The consumer’s income may fall to OY1 or
rise to OY2 from OY, the quantity demanded remains the same at OQ. Thus, the
demand curve DD, which is vertical straight line parallel to Y-axis shows zero
income elasticity of demand.

Cross Elasticity of Demand

t is the ratio of proportionate change in the quantity demanded of Y to a given

proportionate change in the price of the related commodity X.

It is a measure of relative change in the quantity demanded of a commodity due

to a change in the price of its substitute/complement. It can be expressed as:

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Cross elasticity may be infinite or zero if the slightest change in the price of X
causes a substantial change in the quantity demanded of Y. It is always the case
with goods which have perfect substitutes for one another. Cross elasticity is
zero, if a change in the price of one commodity will not affect the quantity
demanded of the other. In the case of goods which are not related to each other,
cross elasticity of demand is zero.

Definition:

“The cross elasticity of demand is the proportional change in the quantity of X

good demanded resulting from a given relative change in the price of a related
good Y” Ferguson

“The cross elasticity of demand is a measure of the responsiveness of purchases

of Y to change in the price of X” Leibafsky

Types of Cross Elasticity of Demand:

1. Positive:

When goods are substitute of each other then cross elasticity of demand is
positive. In other words, when an increase in the price of Y leads to an increase
in the demand of X. For instance, with the increase in price of tea, demand of
coffee will increase.

In fig. 21 quantity has been measured on OX-axis and price on OY-axis. At price
OP of Y-commodity, demand of X-commodity is OM. Now as price of Y
commodity increases to OP1 demand of X-commodity increases to OM1 Thus,
cross elasticity of demand is positive.

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2. Negative:

In case of complementary goods, cross elasticity of demand is negative. A

proportionate increase in price of one commodity leads to a proportionate fall
in the demand of another commodity because both are demanded jointly. In fig.
22 quantity has been measured on OX-axis while price has been measured on
OY-axis. When the price of commodity increases from OP to OP1 quantity
demanded falls from OM to OM1. Thus, cross elasticity of demand is negative.

3. Zero:

Cross elasticity of demand is zero when two goods are not related to each other.
For instance, increase in price of car does not effect the demand of cloth. Thus,
cross elasticity of demand is zero. It has been shown in fig. 23.

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Therefore, it depends upon substitutability of goods. If substitutability is

perfect, cross elasticity is infinite; if on the other hand, substitutability does not
exist, cross elasticity is zero. In the case of complementary goods like jointly
demanded goods cross elasticity is negative. A rise in the price of one
commodity X will mean not only decrease in the quantity of X but also decrease
in the quantity demanded of Y because both are demanded together

Measurement of Cross Elasticity of Demand:

Cross elasticity of demand can be measured by the following formula

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Demand Forecasting
Definition: Demand forecasting refers to a scientific and creative approach for
anticipating the demand of a particular commodity in the market based on past
behaviour, experience, data and pattern of related events. It is not based on
mere guessing or prediction but is backed up by evidence and past trends.
Example: A printing press owner forecasts high demand for notebooks in June
and July due to the new session. Therefore, he plans for a large-scale production
during this time and arranges for the raw material, workforce, finance and
machinery accordingly.

Content: Demand Forecasting

1. Factors Affecting
2. Process
3. Objectives

Factors Affecting Demand Forecasting

Demand is never constant and fluctuates with the change in certain factors
related to the commodity and the market in which the business operates. With
the changing demand, it’s forecasting also varies.

Following are some of the factors which influence the demand forecasting of a
commodity:

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 Price of Goods: Demand estimation is highly dependant on the price of

goods or services. The pricing policy and fluctuation in the present price
can give an idea of change in demand for that particular commodity.
 Type of Goods: The type of commodity, its features and usability
determines the customer base it is going to cater. The demand for existing
goods can be easily estimated by following the previous sales trend,
competitors’ analysis and substitutes available. Whereas, the demand for
a new product on the market is difficult to predict.
 Competition: The level of competition in the market supports the process
of demand forecasting. It is easy to predict sales in a less competitive
market whereas the same becomes difficult in a market where the new
firms can freely enter.
 Technology: The demand for any product or service changes drastically
with the advancement in technology. Therefore, it is essential for an
organisation to be aware of technological development while forecasting
the demand for any commodity.
 Economic Perspective: Being updated with economic changes and
growth is necessary for demand forecasting. It assists the organisation in
preparing for future possibilities and analysing the impact of economic
development on sales.

 Process of Demand Forecasting

Demand forecasting is not based on assumptions but is a systematic and

scientific process of estimating future sales and performance as well as
directing the resources accordingly.

The steps involved in a standard demand forecasting process are as follows:

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 Setting the Objectives: The purpose for which the demand forecasting is
being done, must be clear. Whether it is for short-term or long-term, the
market share of the product, the market share of the organisation,
competitors share, etc. By all these aspects, the objectives for forecasting
are framed.
 Determining the Time Perspective: The defined objectives are
supported by the period for which the forecasting is being done. The
demand for a commodity varies with the change in its determinants over
the period.
There is a negligible change in price, income or other factors in the short
run. But, the organisation may notice a considerable difference in these
determinants over a long-term, affecting the demand of a commodity.
 Selecting a Suitable Demand Forecasting Method: Demand forecasting
is based on specific evidence and is determined using a particular
technique or method. The method of prediction must be selected wisely.
It is dependant on the information available, the purpose of predicting and
the period it is done for.
 Collecting the Data: Forecasting is based on past experiences and data.
This data or information can be primary or secondary. Primary data
comprises of the information directly collected by the analysts and
researchers; whereas secondary data includes the physical evidence of
the past performance, sales trend in the past years, financial reports, etc.
 Estimating the Results: The data so collected is arranged in a systematic
and meaningful manner. The past performance of a product in the market
is analysed on this basis. Accordingly, future sales prediction and demand
estimation are done. The results soo drew must be in a format which is
easy to understand and apply by the management.
 Objectives of Demand Forecasting
 Demand forecasting is one of the major components in the success of any
business. All organisational activities, whether they are short-term
business operations or long-term strategic decisions are dependant on it.
 These objectives are illustrated under the following categories further
sub-divided into points:

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Short-Term Objectives: To ensure the effective working of the organisation,

estimation of sales for the past six months is done. Let us now go through the
following purpose of demand forecasting in the short run:

 Formulation of Production Policy: Demand forecasting aims at meeting

the demand by ensuring uninterrupted production and supply of goods
and services.
 Formulation of Price Policy: It helps in formulating an effective price
mechanism to deal with the market fluctuations and conditions like
inflation.
 Maximum Utilization of Machines: It streamlines the production
process and operations such that there is the optimum utilisation of
machines.
 Proper Control of Sales: Forecasting the regional sales of a particular
product or service provides a base for setting a sales target and
evaluating the performance.
 Regular Supply of Material: Sales forecast determines the level of
production leading to the estimation of raw material. Thus, a continuous
supply of raw material and inventory management can be done.

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 Arrangement of Finance: To maintain short-term cash in the

organisation it is essential to forecast the sales as well as liquidity
requirement accordingly.
 Regular Availability of Labor: Estimation of the production capacity
provides for the acquisition of suitable skilled and unskilled labour.

1. Long-Term Objectives: Demand forecasting is inevitable for the long-

term existence of an organisation. Following objectives justify the
statement:
 Long-Term Finance Management: Forecasting sales for the long-
term contributes to long-term financial planning and acquisition of
funds at reasonable rates and suitable terms and conditions.
 Decisions Regarding Production Capacity: Demand forecast
determines the production level which provides a base for decisions
related to the expansion of the production unit or size of the plant.
 Labour Requirement: Demand forecasting initiates expansion of
business thus leading to the estimation of required human resource
to accomplish business goals and objectives.

Estimating demand with accuracy requires a lot of expertise and knowledge.

Therefore experts are hired by the business organizations to ensure better
results and proper utilization of resources

 Indifference curve
An indifference curve is a locus of all combinations of two goods which yield
the same level of satisfaction (utility) to the consumers.

Since any combination of the two goods on an indifference curve gives equal
level of satisfaction, the consumer is indifferent to any combination he
consumes. Thus, an indifference curve is also known as ‘equal satisfaction
curve’ or ‘iso-utility curve’.

On a graph, an indifference curve is a link between the combinations of

quantities which the consumer regards to yield equal utility. Simply, an
indifference curve is a graphical representation of indifference schedule.

The table given below is an example of indifference schedule and the graph that
follows is the illustration of that schedule.

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Table: Indifference schedule

Combination Mangoes Oranges
A 1 14
B 2 9
C 3 6
D 4 4
E 5 2.5

Figure: Graphical representation of indifference curve

 Assumptions of indifference curve

The indifference curve theory is based on few assumptions. These assumptions

are

1] Two commodities

It is assumed that the consumer has fixed amount of money, all of which is to
be spent only on two goods. It is also assumed that prices of both the
commodities are constant.

2] Non satiety

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Satiety means saturation. And, indifference curve theory assumes that the
consumer has not reached the point of satiety. It implies that the consumer still
has the willingness to consume more of both the goods. The consumer always
tends to move to a higher indifference curve seeking for higher satisfaction.

3] Ordinal utility

According to this theory, utility is a psychological phenomenon and thus it is

unquantifiable. However, the theory assumes that a consumer can express
utility in terms of rank. Consumer can rank his/her preferences on the basis of
satisfaction yielded from each combination of goods.

4] Diminishing marginal rate of substitution

Marginal rate of substitution may be defined as the amount of a commodity that

a consumer is willing to trade off for another commodity, as long as the second
commodity provides same level of utility as the first one.

And, diminishing marginal rate of substitution states that the rate by which a
person substitutes X for Y diminishes more and more with each successive
substitution of X for Y.

As indifference curve theory is based on the concept of diminishing marginal

rate of substitution, an indifference curve is convex to the origin.

5] Rational consumers

According to this theory, a consumer always behaves in a rational manner, i.e.

a consumer always aims to maximize his total satisfaction or total utility.

 Properties of indifference curve

There are four basic properties of an indifference curve. These properties are

1] Indifference curve slope downwards to right

An indifference curve can neither be horizontal line nor an upward sloping

curve. This is an important feature of an indifference curve.

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When a consumer wants to have more of a commodity, he/she will have to give
up some of the other commodity, given that the consumer remains on the same
level of utility at constant income. As a result, the indifference curve slopes
downward from left to right.

In the above diagram, IC is an indifference curve, and A and B are two points
which represent combination of goods yielding same level of satisfaction.

We can see that when X1 amount of commodity X was consumed, Y1 amount of

commodity Y was also consumed. When the consumer increased the
consumption of commodity X to X2, the amount of commodity Y fell to Y2. And,
thus the curve is sloping downward from left to right.

2] Indifference curve is convex to the origin

As mentioned previously, the concept of indifference curve is based on the

properties of diminishing marginal rate of substitution.

According to diminishing marginal rate of substitution, the rate of substitution

of commodity X for Y decreases more and more with each successive
substitution of X for Y.

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Also, two goods can never perfectly substitute each other. Therefore, the rate
of decrease in a commodity cannot be equal to the rate of increase in another
commodity.

Table: Indifference schedule

Combination Cigarette Coffee

A 1 12

B 2 8

C 3 5

D 4 3

E 5 2

The above table represents various combination of coffee and cigarette that
gives a man same level of utility. When the man drinks 12 cup of coffee, he
consumes 1 cigarette every day. When he started consuming two cigarettes a
day, his coffee consumption dropped to 8 cups a day. In the same way, we can
see other combinations as 3 cigarettes + 5 cup coffee, 4 cigarettes + 3 cup coffee
and 5 cigarettes + 2 cup coffee.

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We can clearly see that the rate of decrease in consumption of coffee is not the
same as rate of increase in consumption of cigarette. Similarly, rate of decrease
in consumption of coffee has gradually decreased even with constant increase
in consumption of cigarette.

Thus, indifference curve is always convex (neither concave nor straight).

3] Indifference curve cannot intersect each other

Each indifference curve is a representation of particular level of satisfaction.

The level of satisfaction of consumer for any given combination of two

commodities is same for a consumer throughout the curve. Thus, indifference
curves cannot intersect each other.

The following diagram will help you understand this property clearer.

In the above image, IC1 and IC2 are two indifference curves and C is the point
where both the curves intersect.

According to indifference curve theory, satisfaction at point C = satisfaction at

point A
Also, satisfaction at point C = satisfaction at point B
But, satisfaction at point B ≠ satisfaction at point A.

Therefore, two indifference curves cannot intersect. Yet, two indifference

curves need not be parallel to each other.

4] Higher indifference curve represents higher level of satisfaction

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Higher the indifference curves, higher will be the level of satisfaction. This
means, any combination of two goods on the higher curve give higher level of
satisfaction to the consumer than the combination of goods on the lower curve.

In the above figure, IC1 and IC2 are two indifference curves, and IC2 is higher
than IC1. We can also see that Q is a point on IC2 and S is a point on IC2.

Combination at point Q contains more of both the goods (X and Y) than that of
the combination at point S. We know that total utility of commodity tends to
increase with increase in stock of the commodity. Thus, utility at point Q is
greater than utility at point S, i.e. satisfaction yielded from higher curve is
greater than satisfaction yielded from lower curve.

 Uses of the Indifference Curve Approach

Indifference curve techniques were not developed just to confuse students of

economics. They do offer a more penetrating analysis of consumer demand
than simple demand curves and they are of considerable importance in the
study of advanced economic theory. So, it is worthwhile to make the effort and
really try to understand them. It is convenient at this point to examine two uses,

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other than the analysis of effects of changing prices and incomes, that may be
made of the curves.

(a) Inflation:

Indifference curves demonstrate the effects of inflation or the situation in

which prices and incomes are rising. When prices rise consumers must secure
a rise in money incomes in order to maintain their real income and their
standard of living. A 10 per cent rise in prices has to be accompanied by a 10
per cent rise in money income if consumers are not to suffer a fall in real
income. Fig.16 reveals a more subtle change.

With his original income OA the consumer had a budget line AB and chose to
buy OW units of clothes and spend OV on other goods. If his income rises by 10
per cent to compensate for a 10 per cent rise in prices he can still buy a
maximum of OB units of clothes but his budget line moves to CB, enabling him
to buy OX units of clothes and retain OY units of money. He therefore moves to
a higher indifference curve, even though his real income is constant.

The higher money income gives greater satisfaction. Although real incomes are
not higher, as the money incomes will buy only the same quantity of real goods,
the consumer is deluded into buying more as the extra money has less utility,
and he thinks the residue larger than it actually is. This is one way in which
inflation distorts the pattern of expenditure. Other effects of inflation are
considered in Unit Twenty- three.

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If the price of clothes rose and there was no compensating rise in income the
budget line would have become steeper and forced the consumer to a lower
indifference curve. This would reduce his living standards and this is the
normal effect of inflation.

(b) Taxation:

In Fig. 17 a comparison is made between the relative effects of income taxes

and expenditure taxes.

In this absence of taxation we can assume that the consumer is at a buying OB

units of clothes and OC units of other goods. If a tax is imposed on consumer to
point b on IC1. At this point he buys OG units of clothes and spends OD units on
other things. Before the tax was imposed the consumer could have combined
OG units of clothes with OL units of money income or other goods as we can see
from the budget line AE.

The tax has therefore reduced his real income by LD. This could equally well
have been achieved by the imposition of an income tax equivalent to LD, when
the consumer to move to c on IC2 which is preferable to the position b that the
expenditure tax leaves him in. He is able to enjoy GJ more of clothing than he
could when clothes were taxed.

While this is true for the individual whose indifference map we have drawn, it
is not necessarily true for all consumers and so we cannot on the basis of this
analysis argue that income taxes are preferable to expenditure taxes.

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 Important Applications of Indifference Curves

The technique of indifference curves has assumed special significance

because of its application in almost every sphere of economic activity. A few
such applications can be mentioned as follows:

1. In the theory of production:

The basic aim of a producer is to attain a low cost combination. Indifference

curves are useful in the realization of this objective.

When we use these curves in the theory of production, they are called iso-
product curves. Producer’s equilibrium i.e. low cost combination is obtained at
the point where producer’s budget line becomes tangent to one of the iso-
product curves on the map.

2. In the theory of Exchange:

Prof. Edge worth used the technique of indifference curves to show the mutual
gains from the exchange of two goods between two consumers.

Exchange makes it possible for both the consumers to reach a higher level of
satisfaction. The process of shifting to the higher level of satisfaction is
explained with the help of ‘contract curves.’

3. In the field of Rationing:

This technique can also be made use of in the field of rationing Ordinarily two
commodities are rationed out to different individuals, irrespective of their
preferences.

But if their respective preferences are considered and the amounts of the two
commodities be distributed among consumers in accordance with their scale of
preferences, each of them shall be in a position to search a higher indifference
curve and satisfaction.

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4. In the measurement of consumer’s surplus:

Indifference curve technique has rehabilitated the old Marshallian concept of

consumer’s surplus that has lain buried almost for decades under the weight of
unrealistic and illusory assumptions.

Consumer’s surplus can be measured with the help of this technique without
any need for making unralistic assumptions.

5. In the field of taxation:

The technique is also applied to test preference between a direct and indirect
tax. With the help of indifference curves it can be shown that a direct tax is
preferable to an indirect tax as regards its effects on consumption and
satisfaction of the tax payer.

In view of the above application of the technique, it may be asserted that it

forms an integral part of the modern welfare economics.

Application of Indifference Curves in Public Finance:

Indifference curves can be used to study the effects of direct and indirect taxes.
There are bad effects on the demand for goods when indirect tax (excise duty)
is levied by finance ministry than the direct tax in the form of income tax.

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We take an example of income tax and excise duty and their effects on the
demand for a commodity as shown in the Diagram 23. AB is the original budget
line where consumer is in equilibrium at point E and purchases OQx of
community X. When income tax is levied the budget line shifts below to A 1B1
where the consumer is in equilibrium at point E1 and purchases OQx1 of
commodity X.

If excise duty is levied in place of income tax then the consumer’s budget line
will shift downward to AB2 and the consumer will be in equilibrium at E2 point
with the amount of OQX2 of commodity X. OQx2 is lesser than OQX1. Hence the
impact of excise duty (indirect tax) on the demand for a good is bad than the
impact of income tax (direct tax).

Similarly, the effect or impact of government subsidy can also be studied with
the help of indifference curves. The subsidy makes the goods cheaper and its
effect is just like the effects of price effect.

 Limitations of Indifference Curve Analysis

(i) The indifference curve analysis is utility analysis in a new grab. It has simply
substituted new concepts and equations instead of the old ones. The old
principle of diminishing marginal utility has been replaced by the new principle
of diminishing marginal rate of substitution. The old equation of consumer
equilibrium.

MUA/PA = MUB/PB = MUM

is replaced by a new equation, which says that the consumer is in equilibrium,

when the marginal rate of substitution between the two commodities, which is
the ratio of their marginal utilities is equal to their price ratio. This is nothing
but the reformulation of previous equation in a modified form.

(ii) Indifference curve analysis assumes that consumers are familiar with their
preference schedules. But, it is not possible for a consumer to have a complete
knowledge of all the combinations of the two commodities, total satisfactions
from them, rates of substitutions and total incomes. At best he can tell his
preferences in the neighborhood of his existing position. Moreover, the
preferences of this consumer keep changing.
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(iii) This analysis is confined to the case of only two commodities. For covering
a large number of commodities, one commodity, say, ‘Y’ has to be taken as a
composite commodity (represented by money) such that prices of all the
commodities comprising the composite commodities increase or decrease
simultaneously and by the same proportion.

This may not happen in reality. It also becomes difficult to isolate the effect of
change in price of a particular commodity. For three goods case, we can also use
three – dimensional diagram, but, it is difficult to handle. Geometry fails all
together for dealing with the situation of more than three goods. In such
situation, we may have to fall back upon complicated algebraic methods.

(iv) This analysis assumes rationality of the consumer. In many situations,

however, consumer behaves in an irrational and thoughtless manner.

(v) Indifference curve analysis is introspective, as it studies consumer

behaviour on the basis of imaginary drawn indifference curves. Further, it is
based on weak ordering hypothesis. Thus, consumer is indifferent towards
some combinations. Samuelson criticised this analysis, since when a consumer
chooses one particular combination, he prefers it over all other combinations
Thus, and ‘choice reveals preference’. Samuelson enunciated demand theory
from observed consumer behaviour, which is more scientific.

(vi) This analysis assumes perfect divisibility of the commodities. But,

consumer is often faced by lumpy units. So, the continuity of indifference curves
is not ensured as assumed by indifference curves analysis, as also large number
of very closed placed indifference curves. Further, choices with extreme
combinations (too much of commodity ‘X’ and very little of ‘Y’ and vice-versa)
are not observed in the real world.

(vii) Indifference curve analysis is micro economic in character. It is not

possible to draw indifference curves indicating the choices of a group or a
country as a whole. In this respect, utility analysis has an edge over, as it goes
by a general opinion based on past experience and observation.

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(viii) Indifference curve analysis is not amenable to statistical investigation and

empirical research, as the entire analysis is based upon theoretically
formulated cross-effect relationships and not upon statistical observations. In
view of Samuelsson, indifference curves are imaginary.

(ix) Indifference curve analysis fails to explain consumer behaviour under risk
and uncertainty.

Thus, indifference curve analysis is not free from defects of its own. Even some
of these defects were appreciated by Hicks, who sought to remove them in his
later work ‘A Revision of Demand Theory’ published in 1956. The approach is
a considerable improvement over the conventional utility approach and has
gained popularity among economists.

 Consumer's Equilibrium Through Indifference Curve

Analysis

 Definition:

"The term consumer’s equilibrium refers to the amount of goods and services
which the consumer may buy in the market given his income and given prices
of goods in the market".

The aim of the consumer is to get maximum satisfaction from his money
income. Given the price line or budget line and the indifference map:

"A consumer is said to be in equilibrium at a point where the price line is

touching the highest attainable indifference curve from below".

 Conditions:
Thus the consumer’s equilibrium under the indifference curve theory must
meet the following two conditions:-

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First: A given price line should be tangent to an indifference curve or marginal

rate of satisfaction of good X for good Y (MRSxy) must be equal to the price ratio
of the two goods. i.e.

MRSxy = Px / Py

Second: The second order condition is that indifference curve must be convex
to the origin at the point of tangency.

 Assumptions:

The following assumptions are made to determine the consumer’s equilibrium

position.

(i) Rationality: The consumer is rational. He wants to obtain maximum

satisfaction given his income and prices.

(ii) Utility is ordinal: It is assumed that the consumer can rank his preference
according to the satisfaction of each combination of goods.

(iii) Consistency of choice: It is also assumed that the consumer is consistent

in the choice of goods.

(iv) Perfect competition: There is perfect competition in the market from

where the consumer is purchasing the goods.

(v) Total utility: The total utility of the consumer depends on the quantities of
the good consumed.

 Explanation:
The consumer’s consumption decision is explained by combining the budget
line and the indifference map. The consumer’s equilibrium position is only at a
point where the price line is tangent to the highest attainable indifference curve
from below.

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(1) Budget Line Should be Tangent to the Indifference Curve:

The consumer’s equilibrium in explained by combining the budget line and the
indifference map.

Diagram/Figure:

In the diagram 3.11, there are three indifference curves IC1, IC2 and IC3. The
price line PT is tangent to the indifference curve IC2 at point C. The consumer
gets the maximum satisfaction or is in equilibrium at point C by purchasing OE
units of good Y and OH units of good X with the given money income.

The consumer cannot be in equilibrium at any other point on indifference

curves. For instance, point R and S lie on lower indifference curve IC1 but yield
less satisfaction. As regards point U on indifference curve IC3, the consumer no
doubt gets higher satisfaction but that is outside the budget line and hence not
achievable to the consumer. The consumer’s equilibrium position is only at
point C where the price line is tangent to the highest attainable indifference
curve IC2 from below.

(2) Slope of the Price Line to be Equal to the Slope of Indifference Curve:

The second condition for the consumer to be in equilibrium and get the
maximum possible satisfaction is only at a point where the price line is a
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tangent to the highest possible indifference curve from below. In fig. 3.11, the
price line PT is touching the highest possible indifferent curve IC 2 at point C.
The point C shows the combination of the two commodities which the
consumer is maximized when he buys OH units of good X and OE units of good
Y.

Geometrically, at tangency point C, the consumer’s substitution ratio is equal to

price ratio Px / Py. It implies that at point C, what the consumer is willing to pay
i.e., his personal exchange rate between X and Y (MRSxy) is equal to what he
actually pays i.e., the market exchange rate. So the equilibrium condition
being Px / Py being satisfied at the point C is:

Price of X / Price of Y = MRS of X for Y

The equilibrium conditions given above states that the rate at which the
individual is willing to substitute commodity X for commodity Y must equal the
ratio at which he can substitute X for Y in the market at a given price.

(3) Indifference Curve Should be Convex to the Origin:

The third condition for the stable consumer equilibrium is that the indifference
curve must be convex to the origin at the point of equilibrium. In other words,
we can say that the MRS of X for Y must be diminishing at the point of
equilibrium. It may be noticed that in fig. 3.11, the indifference curve IC2 is
convex to the origin at point C. So at point C, all three conditions for the stable-
consumer’s equilibrium are satisfied.

Summing up, the consumer is in equilibrium at point C where the budget line
PT is tangent to the indifference IC2. The market basket OH of good X and OE of
good Y yields the greatest satisfaction because it is on the highest attainable
indifference curve. At point C:

MRSxy = Px / Py

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 Important Questions:-

 Short Questions (2 marks)

Q1. Define Managerial Economics?

Q2. Opportunity Cost Principle.

Q3. Production Possibility Curve
Q4. Incremental Principle
Q5. Scarcity Cost.
Q6. Demand Estimation.
Q7. Demand Forecasting.
Q8. Uses of Elasticity of Demand.
Q9. Price Elasticity of Demand.
Q10. Cross Elasticity of Demand.
Q11. Income Elasticity of Demand.
Q12. Define Indifference Curve?

 Long Questions (10 marks)

Q1:- Define Managerial Economics? Explain The Nature & Scope Of Managerial
Economics?

Q2:- Define Managerial Economics? Discuss The Relationship Between Other

Disciplines Of Managerial Economics?

Q3:- Discuss The Role Of Managerial Economics In Decision Making?

Q4:- Write the Short Note on Followings:-

A) Opportunity Cost Principle.

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B) Production Possibility Curve

C) Incremental Principle

D) Scarcity Cost.

Q5:- Define Demand? Discuss Its Characteristics, Schedule & Curve & Its
Determinants?
Q6:- Explain The Law Of Demand. Why Does Demand Curve Slopes
Downwards To The Right? Explain The Circumstances In Which Demand
Curve Slope?

Q7:-Explain The Methods Of Elasticity Of Demand?

Q8:- Write the Short Note on Followings:-

A) Demand Estimation.
B) Demand Forecasting.
C) Types Of Demand
Q9:- What Is Indifference Curve Analysis? Write Detailed Note On Consumer
Equilibrium?

Q10:- What Is Indifference Curve Analysis? Explain Its Assumptions, Properties,

and Importance & Limitations?

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UNIT-II
Production Function

 Meaning Of Production Function

The Production Function shows the relationship between the quantity of
output and the different quantities of inputs used in the production process. In
other words, it means, the total output produced from the chosen quantity of
various inputs.

Generally, production is the transformation of raw material into the finished

goods. These raw materials are classified as land, labor, capital or natural
resources. These may be fixed or variable depending upon the nature of the
business.

This function establishes the physical relationship between these inputs and
the output. The efficiency of this relationship depends on the different
quantities used in the production process, the quantities of output and the
productivity at each point. It can be shown algebraically:

Q = f( L, C, N )

Where Q = Quantity of output

L = Labour

C = Capital

N = Land.

Hence, the level of output (Q), depends on the quantities of different inputs (L,
C, N) available to the firm. In the simplest case, where there are only two inputs,
labour (L) and capital (C) and one output (Q), the production function becomes.

Q =f (L, C)

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“Production function is the relationship between inputs of productive services

per unit of time and outputs of product per unit of time.” Prof. George J. Stigler

“The relationship between inputs and outputs is summarized in what is called

the production function. This is a technological relation showing for a given
state of technological knowledge how much can be produced with given
amounts of inputs.” Prof. Richard J. Lipsey

 Assumptions Of Production Functions

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1. Perfect divisibility of both inputs and outputs

2. Limited substitution of one factor for another

3. Constant technology

4. Inelastic supply of fixed factors in the short run

 Uses Of Production Function

1. How to obtain Maximum output
2. Helps the producers to determine whether employing variable inputs /costs
are profitable
3. Highly useful in long run decisions
4. Least cost combination of inputs and to produce an output

 CHARACTERISTICS OF PRODUCTION FUNCTION

The function has the following characteristics

1) Production function always relates to a particular period.

2) It shows maximum output secured by combining the available technical

knowledge with the factors of production.

3) It reveals all the possibilities of combination of different factors needed for

the purpose of production. Production function is necessary for a producer for
knowing the quantity of different factors and their prices.

4) It explains about the relationship between physical inputs and physical

output only. It did not mention the prices of these units.

5) The method of utilizing the inputs in production depends on the technical

knowledge.

6) The nature of production is determined by whether the factors of production

are completely divisible or indivisible. Constant returns does not arise when
the factors of production are divisible.

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 Production function may be classified into two:

1. Short-run production function which is studied through Law of
Variable Proportions

2. Long-run production function which is explained by Returns to Scale

1] Short-run production function - The law of variable

proportions

The law examines the relationship between one variable factor and output,
keeping the quantities of other factors fixed.

Definition

As the proportion of one factor in a combination of factors is increased, after a

point, first the marginal and then the average product of that factor will
diminish.
Assumptions of the law

The law is based on the following assumptions

a. Only one factor is made variable and other factors are kept
constant.
b. This law does not apply in case all factors are proportionately
varied. i.e. where the factors must be used in rigidly fixed
proportions to yield a product.
c. The variable factor units are homogenous i.e. all the units of
variable factors are of equal efficiency.
d. Input prices remain unchanged
e. The state of technology does not change or remains the same at a
given point of time.

f. The entire operation is only for short-run, as in the long-run all

inputs are variable.

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 Three stages of law

Stage I: Stage of increasing returns

Stage I ends where the average product reaches its highest (maximum)
point. During this stage, the total product, the average product and the
marginal product are increasing. It is notable that the marginal product
in this stage increases but in a later part it starts declining. Though
marginal product starts declining, it is greater than the average product
so that the average product continues to rise.

Stage II: Stage of decreasing returns

Stage II ends at the point where the marginal product is zero. In the
second stage, the total product continues to increase but at a diminishing
rate. The marginal product and the average product are declining but are
positive. At the end of the second stage, the total product is maximum and
the marginal product is zero.

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Stage III: Stage of negative returns

In this stage the marginal product becomes negative. The total product
and the average product are declining.

The stage of Operation

In stage I the fixed factor is too much in relation to the variable factor.
Therefore in stage I, marginal product of the fixed factor is negative. On
the other hand, in stage III the marginal product of the variable factor is
negative. Therefore a rational producer will not choose to produce in
stages I and III. He will choose only the second stage to produce where
the marginal product of both the fixed factor and variable factor are
positive. At this stage the total product is maximum. The particular point
at which the producer will decide to produce in this stage depends upon
the prices of factors. The stage II represents the range of rational
production decisions.

2] Long-run production function - Returns to Scale

In the long run, all factors can be changed. Returns to scale studies the
changes in output when all factors or inputs are changed. An increase in
scale means that all inputs or factors are increased in the same
proportion.

 Three phases of returns to scale

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The changes in output as a result of changes in the scale can be studied in 3

phases. They are

1. Increasing returns to scale

If the increase in all factors leads to a more than proportionate increase
in output, it is called increasing returns to scale. For example, if all the
inputs are increased by 5%, the output increases by more than 5% i.e. by
10%. In this case the marginal product will be rising.

2. Constant returns to scale

If we increase all the factors (i.e. scale) in a given proportion, the output
will increase in the same proportion i.e. a 5% increase in all the factors
will result in an equal proportion of 5% increase in the output. Here the
marginal product is constant.
3. Decreasing returns to scale
If the increase in all factors leads to a less than proportionate increase in
output, it is called decreasing returns to scale i.e. if all the factors are
increased by 5%, the output will increase by less than 5% i.e. by 3%. In
this phase marginal product will be decreasing.

 Iso-Quant Curve
The term Iso-quant or Iso-product is composed of two words, Iso = equal, quant
= quantity or product = output.
Thus it means equal quantity or equal product. Different factors are needed to
produce a good. These factors may be substituted for one another.
A given quantity of output may be produced with different combinations of
factors. Iso-quant curves are also known as Equal-product or Iso-product or
Production Indifference curves. Since it is an extension of Indifference curve
analysis from the theory of consumption to the theory of production.
Thus, an Iso-product or Iso-quant curve is that curve which shows the different
combinations of two factors yielding the same total product. Like, indifference
curves, Iso- quant curves also slope downward from left to right. The slope of

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an Iso-quant curve expresses the marginal rate of technical substitution

(MRTS).

Definitions:

“The Iso-product curves show the different combinations of two resources with
which a firm can produce equal amount of product.” Bilas
“Iso-product curve shows the different input combinations that will produce a
given output.” Samuelson

“An Iso-quant curve may be defined as a curve showing the possible

combinations of two variable factors that can be used to produce the same total
product.” Peterson

“An Iso-quant is a curve showing all possible combinations of inputs physically

capable of producing a given level of output.” Ferguson

 Assumptions:

The main assumptions of Iso-quant curves are as follows:

1. Two Factors of Production:- Only two factors are used to produce a
commodity.
2. Divisible Factor: Factors of production can be divided into small parts.
3. Constant Technique:- Technique of production is constant or is known
before hand.
4. Possibility of Technical Substitution:- The substitution between the two
factors is technically possible. That is, production function is of ‘variable
proportion’ type rather than fixed proportion.
5. Efficient Combinations:- Under the given technique, factors of production
can be used with maximum efficiency.

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 Iso-Product Schedule:
Let us suppose that there are two factor inputs—labour and capital. An Iso-
product schedule shows the different combination of these two inputs that
yield the same level of output as shown in table 1.

The table 1 shows that the five combinations of labour units and units of
capital yield the same level of output, i.e., 200 metres of cloth. Thus, 200
metre cloth can be produced by combining.

(a) 1 units of labour and 15 units of capital

(b) 2 units of labour and 11 units of capital

(c) 3 units of labour and 8 units of capital

(d) 4 units of labour and 6 units of capital

(e) 5 units of labour and 5 units of capital

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Iso-Product Curve

From the above schedule iso-product curve can be drawn with the help
of a diagram. An. equal product curve represents all those combinations
of two inputs which are capable of producing the same level of output.
The Fig. 1 shows the various combinations of labour and capital which
give the same amount of output. A, B, C, D and E.

Iso-Product Map or Equal Product Map:

An Iso-product map shows a set of iso-product curves. They are just like
contour lines which show the different levels of output. A higher iso-
product curve represents a higher level of output. In Fig. 2 we have family
iso-product curves, each representing a particular level of output.

The iso-product map looks like the indifference of consumer behaviour

analysis. Each indifference curve represents particular level of
satisfaction which cannot be quantified. A higher indifference curve
represents a higher level of satisfaction but we cannot say by how much
the satisfaction is more or less. Satisfaction or utility cannot be measured.

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An iso-product curve, on the other hand, represents a particular level of

output. The level of output being a physical magnitude is measurable. We
can therefore know the distance between two equal product curves.
While indifference curves are labeled as IC1, IC2, IC3, etc., the iso-product
curves are labelled by the units of output they represent -100 metres, 200
metres, 300 metres of cloth and so on.

 Properties of Iso-Product Curves:

The properties of Iso-product curves are summarized below:

1. Iso-Product Curves Slope Downward from Left to Right:

They slope downward because MTRS of labour for capital diminishes.

When we increase labour, we have to decrease capital to produce a given
level of output.

The downward sloping iso-product curve can be explained with the help
of the following figure:

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The Fig. 3 shows that when the amount of labour is increased from OL to
OL1, the amount of capital has to be decreased from OK to OK1, The iso-
product curve (IQ) is falling as shown in the figure.

The possibilities of horizontal, vertical, upward sloping curves can be

ruled out with the help of the following figure 4:

(i) The figure (A) shows that the amounts of both the factors of
production are increased- labour from L to Li and capital from K to K1.
When the amounts of both factors increase, the output must increase.
Hence the IQ curve cannot slope upward from left to right.

(ii) The figure (B) shows that the amount of labour is kept constant while
the amount of capital is increased. The amount of capital is increased

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from K to K1. Then the output must increase. So IQ curve cannot be a

vertical straight line.

(iii) The figure (C) shows a horizontal curve. If it is horizontal the quantity
of labour increases, although the quantity of capital remains constant.
When the amount of capital is increased, the level of output must
increase. Thus, an IQ curve cannot be a horizontal line.

2. Isoquants are Convex to the Origin:

Like indifference curves, isoquants are convex to the origin. In order to

understand this fact, we have to understand the concept of diminishing
marginal rate of technical substitution (MRTS), because convexity of an
isoquant implies that the MRTS diminishes along the isoquant. The
marginal rate of technical substitution between L and K is defined as the
quantity of K which can be given up in exchange for an additional unit of
L. It can also be defined as the slope of an isoquant.

It can be expressed as:

MRTSLK = – ∆K/∆L = dK/ dL

Where ∆K is the change in capital and AL is the change in labour.

Equation (1) states that for an increase in the use of labour, fewer units
of capital will be used. In other words, a declining MRTS refers to the
falling marginal product of labour in relation to capital. To put it
differently, as more units of labour are used, and as certain units of capital
are given up, the marginal productivity of labour in relation to capital will
decline.

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This fact can be explained in Fig. 5. As we move from point A to B, from B

to C and from C to D along an isoquant, the marginal rate of technical
substitution (MRTS) of capital for labour diminishes. Everytime labour
units are increasing by an equal amount (AL) but the corresponding
decrease in the units of capital (AK) decreases.

Thus it may be observed that due to falling MRTS, the isoquant is always
convex to the origin.

3. Two Iso-Product Curves Never Cut Each Other:

As two indifference curves cannot cut each other, two iso-product curves
cannot cut each other. In Fig. 6, two Iso-product curves intersect each
other. Both curves IQ1 and IQ2 represent two levels of output. But they
intersect each other at point A. Then combination A = B and combination
A= C. Therefore B must be equal to C. This is absurd. B and C lie on two
different iso-product curves. Therefore two curves which represent two
levels of output cannot intersect each other.

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4. Higher Iso-Product Curves Represent Higher Level of Output:

A higher iso-product curve represents a higher level of output as shown

in the figure 7 given below:

In the Fig. 7, units of labour have been taken on OX axis while on OY, units
of capital. IQ1 represents an output level of 100 units whereas IQ2
represents 200 units of output.

5. Isoquants Need Not be Parallel to Each Other:

It so happens because the rate of substitution in different isoquant

schedules need not be necessarily equal. Usually they are found different
and, therefore, isoquants may not be parallel as shown in Fig. 8. We may
note that the isoquants Iq1 and Iq2 are parallel but the isoquants Iq3 and
Iq4 are not parallel to each other.

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6. No Isoquant can Touch Either Axis:

If an isoquant touches X-axis, it would mean that the product is being

produced with the help of labour alone without using capital at all. These
logical absurdities for OL units of labour alone are unable to produce
anything. Similarly, OC units of capital alone cannot produce anything
without the use of labour. Therefore as seen in figure 9, IQ and IQ1 cannot
be isoquants.

7. Each Isoquant is Oval-Shaped.

It means that at some point it begins to recede from each axis. This shape
is a consequence of the fact that if a producer uses more of capital or more
of labour or more of both than is necessary, the total product will
eventually decline. The firm will produce only in those segments of the
isoquants which are convex to the origin and lie between the ridge lines.
This is the economic region of production. In Figure 10, oval shaped
isoquants are shown.

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Curves OA and OB are the ridge lines and in between them only feasible
units of capital and labour can be employed to produce 100, 200, 300 and
400 units of the product. For example, OT units of labour and ST units of
the capital can produce 100 units of the product, but the same output can
be obtained by using the same quantity of labour T and less quantity of
capital VT.

Thus only an unwise entrepreneur will produce in the dotted region of

the iso-quant 100. The dotted segments of an isoquant are the waste-
bearing segments. They form the uneconomic regions of production. In
the up dotted portion, more capital and in the lower dotted portion more
labour than necessary is employed. Hence GH, JK, LM, and NP segments
of the elliptical curves are the isoquants.

 Optimum Factor Combination:

Definition:

In the long run, all factors of production can be varied. The profit
maximization firm will choose the least cost combination of factors to
produce at any given level of output. The least cost combination or the
optimum factor combination refers to the combination of factors with
which a firm can produce a specific quantity of output at the lowest
possible cost.

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Explanation:

There are two methods of explaining the optimum combination of factor:

(i) The marginal product approach.

(ii) The isoquant / isocost approach.

These two approaches are now explained in brief:

(i) The Marginal Product Approach:

In the long run, a firm can vary the amounts of factors which it uses for
the production of goods. It can choose what technique of production to
use, what design of factory to build, what type of machinery to buy. The
profit maximization will obviously want to use that mix of factors of
combination which is least costly to it. In search of higher profits, a firm
substitutes the factor whose gain is higher than the other. When the last
rupee spent on each factor brings equal revenue, the profit of the firm is
maximized. When a firm uses different factors of production or least cost
combination or the optimum combination of factors is achieved when:

Formula:

Mppa = Mppb = Mppc = Mppn

Pa Pb Pc Pn

In the above equation a, b, c, n are different factors of production. Mpp is

the marginal physical product. A firm compares the Mpp / P ratios with
that of another. A firm will reduce its cost by using more of those factors
with a high Mpp / P ratios and less of those with a low Mpp / P ratio until
they all become equal.

(ii) The Isoquant / Isocost Approach:

The least cost combination of-factors or producer's equilibrium is now

explained with the help of iso-product curves and isocosts. The optimum
factors combination or the least cost combination refers to the combination of

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factors with which a firm can produce a specific quantity of output at the lowest
possible cost.

As we know, there are a number of combinations of factors which can yield a

given level of output. The producer has to choose, one combination out of these
which yields a given level of output with least possible outlay. The least cost
combination of factors for any level of output is that where the iso-product
curve is tangent to an isocost curve. The analysis of producers equilibrium is
based on the following assumptions.

 Assumptions of Optimum Factor Combination:

The main assumptions on which this analysis is based areas under:

(a) There are two factors X and Y in the combinations.

(b) All the units of factor X are homogeneous and so is the case with units of
factor Y.

(c) The prices of factors X and Y are given and constants.

(d) The total money outlay is also given.

(e) In the factor market, it is the perfect completion which prevails. Under the
conditions assumed above, the producer is in equilibrium, when the following
two conditions are fulfilled.

(1) The isoquant must be convert to the origin.

(2) The slope of the Isoquant must be equal to the slope of isocost line.

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Diagram/Figure:

The least cost combination of factors is now explained with the help of figure
12.9.

Here the isocost line CD is tangent to the iso-product curve 400 units at point
Q. The firm employs OC units of factor Y and OD units of factor X to produce 400
units of output. This is the optimum output which the firm can get from the cost
outlay of Q. In this figure any point below Q on the price line AB is desirable as
it shows lower cost, but it is not attainable for producing 400 units of output.
As regards points RS above Q on isocost lines GH, EF, they show higher cost.

These are beyond the reach of the producer with CD outlay. Hence point Q is
the least cost point. It is the point which is the least cost factor combination for
producing 400 units of output with OC units of factor Y and OD units of factor
X. Point Q is the equilibrium of the producer.

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At this point, the slope of the isoquants equal to the slope of the isocost line. The
MRT of the two inputs equals their price ratio.

Thus we find that at point Q, the two conditions of producer's, equilibrium in

the choice of factor combinations, are satisfied.

(1) The isoquant (IP) is convex the origin.

(2) At point Q, the slope of the isoquant ΔY / ΔX (MTYSxy) is equal to the slope
of the isocost in Px / Py. The producer gets the optimum output at least cost
factor combination.

Producer’s Equilibrium:

Equilibrium refers to a state of rest when no change is required. A firm

(producer) is said to be in equilibrium when it has no inclination to expand or
to contract its output. This state either reflects maximum profits or minimum
losses.

There are two methods for determination of Producer’s Equilibrium:

1. Total Revenue and Total Cost Approach (TR-TC Approach)

2. Marginal Revenue and Marginal Cost Approach (MR-MC Approach)

It must be noted that scope of syllabus is restricted to “Producer’s Equilibrium

by MR- MC Approach”. Still, for better understanding, “Producer’s Equilibrium
by TR-TC approach” is given.

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Before we proceed further, we must be clear about one more point. Producer
can attain the equilibrium level under two different situations:

(i) When Price remains Constant (It happens under Perfect Competition). In
this situation, firm has to accept the same price as determined by the industry.
It means, any quantity of a commodity can be sold at that particular price.

(ii) When Price Falls with rise in output (It happens under Imperfect
Competition). In this situation, firm follows its own pricing policy. However, it
can increase sales only by reducing the price.

For detailed discussion on Perfect and Imperfect Competition, refer Chapter 10.
Let us now discuss determination of ‘Producer’s Equilibrium’ by both the
methods under the two situations separately.

Total Revenue-Total Cost Approach (TR-TC Approach):

A firm attains the stage of equilibrium when it maximises its profits, i.e. when
he maximises the difference between TR and TC. After reaching such a position,
there will be no incentive for the producer to increase or decrease the output
and the producer will be said to be at equilibrium.

According to TR-TC approach, producer’s equilibrium refers to stage of that

output level at which the difference between TR and TC is positively maximized
and total profits fall as more units of output are produced. So, two essential
conditions for producer’s equilibrium are:

The difference between TR and TC is positively maximized;

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Total profits fall after that level of output.

The first condition is an essential condition. But, it must be supplemented with

the second condition. So, both the conditions are necessary to attain the
producer’s equilibrium.

Producer’s Equilibrium (When Price remains Constant):

When price remains same at all output levels (like in case of perfect
competition), each producer aims to produce that level of output at which he
can earn maximum profits, i.e. when difference between TR and TC is the
maximum. Let us understand this with the help of Table 8.1, where market
price is fixed at Rs. 10 per unit:

Table 8.1: Producer’s Equilibrium (When Price remains Constant):

Output Price TR TC Profit = Remarks

(units) (Rs.) (Rs.) (Rs.) TR-TC
(Rs.)

0 10 0 5 -5 Profit rises
1 10 10 8 2 with increase

2 10 20 15 5 in output
3 10 30 21 9
4 10 40 31 9 Producer’s Equilibrium

5 10 50 42 8 Profit falls with

6 10 60 54 6 increase in output

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According to Table 8.1, the maximum profit of Rs. 9 can be achieved by

producing either 3 units or 4 units. But, the producer will be at equilibrium at
4 units of output because at this level, both the conditions of producer’s
equilibrium are satisfied:

1. Producer is earning maximum profit of Rs. 9;

2. Total profit falls to Rs. 8 after 4 units of output.

In Fig. 8.1, Producer’s equilibrium will be determined at P OQ level of output at

which the vertical distance between TR and TC curves is the greatest. At this
level of output, tangent to TC curve (at point G) is parallel to TR curve and
difference between both the curves (represented by distance GH) is maximum.

At quantities smaller or larger than OQ, such as OQ1 or OQ2 units, the tangent to
TC curve would not be parallel to the TR curve. So, the producer is at
equilibrium at OQ units of output.
Producer’s Equilibrium (When Price Falls with rise in output):
When price falls with rise in output (like in case of imperfect competition), each
producer aims to produce that level of output at which he can earn maximum

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profits, i.e. when difference between TR and TC is the maximum. Let us

understand this with the help of Table 8.2:

Table 8.2: Producer’s Equilibrium (When Price Falls with rise in output):

Output Price TR TC Profit = Remarks

(units) (Rs.) (Rs.) (Rs.) TR-TC
(Rs.)
0 10 0 2 -2 Profit rises
1 9 9 5 4 with increase
2 8 16 9 7 in output
3 7 21 11 10
4 6 24 14 10 Producer’s Equilibrium
5 5 25 20 5 Profit falls with
6 4 24 27 -3 increase in output

As seen in Table 8.2, producer will be at equilibrium at 4 units of output because

at this level, both the conditions of producer’s equilibrium are satisfied:

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Producer is earning maximum profit of Rs. 10;

Total profits fall to Rs. 5 after 4 units of output.

In Fig. 8.2, producer’s equilibrium will be determined at OQ level of output at

which the vertical distance between TR and TC curves is the greatest. At this
level of output, tangent to TR curve (at point H) is parallel to the tangent to TC
curve (at point G) and difference between both the curves (represented by
distance GH) is maximum.

Marginal Revenue-Marginal Cost Approach (MR-MC Approach):

According to MR-MC approach, producer’s equilibrium refers to stage of that
output level at which:

1. MC = MR:
 As long as MC is less than MR, it is profitable for the producer to go on
producing more because it adds to its profits. He stops producing more
only when MC becomes equal to MR.

 2. MC is greater than MR after MC = MR output level:

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When MC is greater than MR after equilibrium, it means producing more

will lead to decline in profits.

Both the conditions are needed for Producer’s Equilibrium:

1. MC = MR:
We know, MR is the addition to TR from sale of one more unit of output and MC
is addition to TC for increasing production by one unit. Every producer aims to
maximize the total profits. For this, a firm compares it’s MR with its MC. Profits
will increase as long as MR exceeds MC and profits will fall if MR is less than MC.

So, equilibrium is not achieved when MC < MR as it is possible to add to profits

by producing more. Producer is also not in equilibrium when MC > MR because
benefit is less than the cost. It means, the firm will be at equilibrium when MC
– MR.

2. MC is greater than MR after MC = MR output level:

MC = MR is a necessary condition, but not sufficient enough to ensure
equilibrium. It is because MC = MR may occur at more than one level of output.
However, out of these, only that output level is the equilibrium output when MC
becomes greater than MR after the equilibrium.

It is because if MC is greater than MR, then producing beyond MC = MR output

will reduce profits. On the other hand, if MC is less than MR beyond MC = MR
output, it is possible to add to profits by producing more. So, first condition
must be supplemented with the second condition to attain the producer’s
equilibrium.

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Producer’s Equilibrium (When Price remains Constant):

When price remains constant, firms can sell any quantity of output at the price
fixed by the market. Price or AR remains same at all levels of output. Also, the
revenue from every additional unit (MR) is equal to AR. It means, AR curve is
same as MR curve. Producer aims to produce that level of output at which MC
is equal to MR and MC is greater than MR after MC = MR output level.

Let us understand this with the help of Table 8.3, where market price is fixed at
Rs. 12 per unit:

 Table 8.3: Producer’s Equilibrium (When Price remains Constant)

Output Price TR TC MR MC Profit =
(units) (Rs.) (Rs.) (Rs.) (Rs.) (Rs.) TR-TC
(Rs.)

1 12 12 13 12 13 -1

2 12 24 25 12 12 -1
3 12 36 34 12 9 2
4 12 48 42 12 8 6
5 12 60 54 12 12 6
6 12 72 68 12 14 4

According to Table 8.3, MC = MR condition is satisfied at both the output levels

of 2 units and 5 units. But the second condition, ‘MC becomes greater than MR’
is satisfied only at 5 units of output. Therefore, Producer’s Equilibrium will be
achieved at 5 units of output. Let us now discuss determination of equilibrium
with the help of a diagram:

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Producer’s Equilibrium is determined at OQ level of output corresponding to

point K as at this point: (i) MC = MR; and (ii) MC is greater than MR after MC =
MR output level. In Fig. 8.3, output is shown on the X-axis and revenue and costs
on the Y-axis. Both AR and MR curves are straight line parallel to the X-axis. MC
curve is U-shaped. Producer’s equilibrium will be determined at OQ level of
output corresponding to point K because only at point K, the following two
conditions are met:
1. MC = MR; and

2. MC is greater than MR after MC = MR output level

Although MC = MR is also satisfied at point R, but it is not the point of

equilibrium as it satisfies only the first condition (i.e. MC = MR). So, the
producer will be at equilibrium at point K when both the conditions are
satisfied.

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Relation between Price and MC at Equilibrium (When Price remains

Constant):
When price remains same at all levels of output, then Price (or AR) = MR. As
equilibrium is achieved when MC = MR, it means, price is equal to MC at the
equilibrium level. For, “Gross Profits are Maximum at Point of Producer’s
Equilibrium”, refer Power Booster Section.

Producer’s Equilibrium (When Price Falls with rise in output):

When there is no fixed price and price falls with rise in output, MR curve slope
downwards. Producer aims to produce that level of output at which MC is equal
to MR and MC curve cuts the MR curve from below. Let us understand this with
the help of Table 8.4:

Table 8.4: Producer’s Equilibrium (When Price Falls with rise in output):
Output Price TR TC MR MC Profit =
(units) (Rs.) (Rs.) (Rs.) (Rs.) (Rs.) TR-TC
(Rs.)
1 8 8 6 8 6 2

2 7 14 11 6 5 3

3 6 18 15 4 4 3

4 5 20 20 2 .5 0

5 4 20 26 0 6 -6

According to Table 8.4, both the conditions of equilibrium are satisfied at 3

units of output. MC is equal to MR and MC is greater than MR when more output
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is produced after 3 units of output. So, Producer’s Equilibrium will be achieved

at 3 units of output. Let us understand the determination of equilibrium with
the help of a diagram:

Producer’s Equilibrium is determined at OM level of output corresponding to

point E as at this point: (i) MC = MR; and (ii) MC is greater than MR after MC =
MR output level.

In Fig. 8.4, output is shown on the X-axis and revenue and costs on the Y-axis.
Producer’s equilibrium will be determined at OM level of output corresponding
to point E because at this, the following two conditions are met:

1. MC = MR; and

2. MC is greater than MR after MC = MR output level.

So, the producer is at equilibrium at OM units of output.

Relation between Price and MC at Equilibrium (When Price Falls with rise
in output):

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When more output can be sold only by reducing the prices, then Price (or AR)
> MR. As equilibrium is achieved when MC = MR, it means, price is more than
MC at the equilibrium level.

 Meaning of Returns to Scale:

The changes in output on account of the change in the factors of production in

the same proportion are called the returns to scale. In the long run all the
factors of production are variable and even the scale of production can be
changed according to the demand for various goods and services in the
economy. The returns to scale are concerned with long run production function.
They are studied with the help of iso-product curves and iso-cost curves.

 Types of Returns to Scale:

Returns to scale are of three types as follows:

1. Increasing Returns to Scale:

When the change in output is more than in proportion to the equi-proportional

change in all the factors of production, then the operating law is called the
increasing returns to scale. Thus, the rate of increase in output is faster than the
increase in factors of production.

The distance between various iso-product curves decreases on the expansion

path or scale line then the increasing returns to scale will operate. It reveals
that the increase in output in the same proportion requires less ratio of labour
and capital. Thus, output increases more than in proportion to the units of
factors of production employed under this law. It can be explained with the help
of Diagram 9.

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Capital and labour are shown on OY-axis and OX-axis respectively. IP, IP1, IP2
and IP3 are different iso-product curves showing different levels of output, viz.,
10 units, 20 units, 30 units and 40 units. The distance between successive iso-
product curves diminishes as output is expanded by increasing the scale. The
distance OE>EE1>E1E2>E2E3 which reveals that for equal increase in output,
firm has to employ less and less amount of labour and capital.

 Causes of Operating the Law:

The increasing returns to scale operate on account of the following causes or

reasons:

(i) Indivisibilities of Inputs:

There are some factors of production which are indivisible. Indivisibility means
that they are available in a given shape or they cannot be divided into small
pieces. Machine, managers, research, finance and marketing are such examples
of individualities. With the increase in the scale of production the efficiency
increases and the output increases more than in proportion to the change in
inputs.

(ii) Division of Labour and Specialisation:

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When the scale of production is increased the division of labour and

specialisation is introduced. A process of production is divided into sub-
processes and each process is completed by each group of workers and at the
same time the specialist are appointed for different departments, viz., finance
manager, marketing manager, personnel manager, purchasing manager and so
on and so forth. Their services lead to increase in the production and the
increasing returns to scale operates.

(iii) Dimensional Efficiency:

Increasing returns to scale is the result of operating dimensional efficiency in a

business firm which is on account of the large size. The size increases the
efficiency of all inputs and the increasing returns operates. Thus the investment
in capital assets after a point will increase the output due to increased
dimension of efficiency.

(iv) Economies of Large Scale:

When the scale of production is increased the internal and external economies
of scale will operate and on account of it the increasing returns to scale will also
operate.

Internal economies are on account of firm’s size and organisation while

external economies are caused by the concentration and localisation of
industries. All these economies lead to increase in output more than in
proportion to the change in the ratio of two inputs.

2. Constant Returns to Scale:

When the output of a firm increases in the same proportion in which the change
in inputs takes place the law is called constant returns to scale. The proportion
of two inputs remains constant. When all iso-product curves showing the same
level of output have the equal distance between them on the expansion path or
scale line, the law operating is called constant returns to scale.

It is explained with the following diagram:

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Capital and labour are shown on OY-axis and OX-axis respectively. IP, IP1, IP2
and IP3 are different iso-product curves showing different levels of output, viz.,
10 units, 20 units, 30 units and 40 units.

The distance between iso-product curves is indicated by E, E1, E2 and E3. The
distance on scale line (OP) are equal. OE = EE1 = E1E2 = E2E3. The distance
between all iso-product curves remains constant which reveal that the
production increases in the same proportion in which inputs are changed.

Hence, it is constant returns to scale. This law operates at the point where
neither the internal and external economies nor internal and external
diseconomies are enjoyed by the firm during long period.

3. Diminishing Returns to Scale:

When proportionate change in output is less than the proportionate change in

all the factors of production their (inputs) ratio being equal, the diminishing
returns to scale will operate. The distance between various iso-product curves
on the scale line increases because for getting the same level of output we have
to employ more of all inputs.

It is explained with the help of the following diagram:

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Labour and capital are employed on OX-axis an OY-axis. OP is the scale line on
which E, E1, E2 and E3 different iso-product curves are showing different levels
of output. The distance between these curves are increasing on the scale line
which show that we have to employ more of inputs and the resultant output is
less than in proportion to the change in inputs. OE<EE1<E1E2<E2E3 which
show the diminishing returns to scale.

 Causes of Operating the Law:

The diminishing returns to scale operate on account of the following reasons:

(i) Diseconomies of Large Scale:

When the scale of production is increased the internal and external

diseconomies of scale operate. On account of these diseconomies the output
increases less than in proportion to the change in the inputs and the
diminishing returns to scale operates.

(ii) Delay in Decision-Making and Its Implementation:

With the size of scale of production the decisions are taken at different levels of
management. Delay in decision-making and its implementation lead to increase
in output less than in proportion to the change in all variable inputs. Pressure
from top management, red-tapism and diseconomies of managerial skill lead to
diminishing returns to scale.

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(iii) Managerial Inefficiency:

With the increase in the size and scale of production in the long period the
management becomes a complicated process. It results into managerial
inefficiency leading to operation of diminishing returns to scale.

(iv) Industrial Unrest:

With the increase in the size and scale of production the number of workers
increases. There will be political affiliation of trade unions leading to strikes,
lockouts, go slow tactics, gheraos, etc. These labour problems are not easily
solved by the management. It adversely affects the production of individual
firms or industries and diminishing returns to scale operates.

(v) Entrepreneur not Variable:

Entrepreneur is one of the factors of production. He is neither variable nor

divisible input. In practice he is fixed and indivisible input and on account of
change in other variable inputs the ratio under the large scale leads to
imbalances and the law of diminishing returns to scale operates.

(vi) Over-Exploitation of Scarce Inputs:

When the scale of production is increased and some of the scarce inputs are
exploited to unlimited extent the increase in output is less in proportion to
change in all inputs during long period and diminishing return to scale
operates.

 Variation in Returns to Scale:

We have explained the various phases or stages of returns to scale when the
long run production function operates. It is revealed in practice that with the
increase in the scale of production the firm gets the operation of increasing
returns to scale and thereafter constant returns to scale and ultimately the
diminishing returns to scale operates. These varying returns to scale or phases
of returns to scale can be seen from Diagram 12.

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The above diagram shows varying returns to scale, namely, increasing returns
to scale, constant returns to scale and diminishing returns to scale. Capital and
labour are shown on OY-axis and OX-axis respectively. IP to IP9 are different
iso-product curves showing different levels of output. E to E8 are different
points on the scale line (OP) showing the different distances among the product
curves.

From OE to OE2 the increasing returns to scale is operating while from E3 to

E5 the constant returns to scale operates and the last phase of production is the
diminishing returns to scale from E6 to E8 on the scale line.

The above diagram shows varying returns to scale, namely, increasing returns
to scale, constant returns to scale and diminishing returns to scale. Capital and
labour are shown on OY-axis and OX-axis respectively. IP to IP9 are different
iso-product curves showing different levels of output. E to E8 are different
points on the scale line (OP) showing the different distances among the product
curves.

From OE to OE2 the increasing returns to scale is operating while from E3 to

E5 the constant returns to scale operates and the last phase of production is the
diminishing returns to scale from E6 to E8 on the scale line.

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THEORY OF COST
 Meaning of Theory of Cost

The expenses incurred in the business activity of supplying goods and services
to consumers are defined as cost. In economics, the value of the price of an
object or condition is the cost of production which is determined by the total
cost of resources employed for producing it. The composition of the cost is the
factors of production that includes labour, land, capital and entrepreneur as
well as taxation.

According to Campbell,’’ Production costs are those which must be received

by resource owners in order to assume that they will continue to supply them
in a particular time of production.’’

 Types of Cost
(1) Actual Cost

Actual cost is defined as the cost or expenditure which a firm incurs for
producing or acquiring a good or service. The actual costs or expenditures are
recorded in the books of accounts of a business unit. Actual costs are also called
as "Outlay Costs" or "Absolute Costs" or "Acquisition Costs".
Examples: Cost of raw materials, Wage Bill etc.

(2) Opportunity Cost

Opportunity cost is concerned with the cost of forgone

opportunities/alternatives. In other words, it is the return from the second
best use of the firms resources which the firms forgoes in order to avail of the
return from the best use of the resources. It can also be said as the comparison
between the policy that was chosen and the policy that was rejected. The
concept of opportunity cost focuses on the net revenue that could be generated
in the next best use of a scare input. Opportunity cost is also called as
"Alternative Cost". If a firm owns a land, there is no cost of using the land (ie.,
the rent) in the firms account. But the firm has an opportunity cost of using the

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land, which is equal to the rent forgone by not letting the land out on rent.

(3) Sunk Cost

Sunk costs are those do not alter by varying the nature or level of business
activity. Sunk costs are generally not taken into consideration in decision -
making as they do not vary with the changes in the future. Sunk costs are a part
of the outlay/actual costs. Sunk costs are also called as "Non-Avoidable costs"
or "Inescapable costs". Examples: All the past costs are considered as sunk
costs. The best example is amortization of past expenses, like depreciation.

(4) Incremental Cost

Incremental costs are addition to costs resulting from a change in the nature of
level of business activity. As the costs can be avoided by not bringing any
variation in the activity in the activity, they are also called as "Avoidable Costs"
or "Escapable Costs". More ever incremental costs resulting from a
contemplated change is the Future, they are also called as "Differential Costs"
Example: Change in distribution channels adding or deleting a product in the
productline.

(5) Explicit Cost

Explicit costs are those expenses/expenditures that are actually paid by the
firm. These costs are recorded in the books of accounts. Explicit costs are
important for calculating the profit and loss accounts and guide in economic
decision-making. Explicit costs are also called as "Paid out costs" Example:
Interest payment on borrowed funds, rent payment, wages, utility expenses etc.

(6) Implicit Cost

Implicit costs are a part of opportunity cost. They are the theoretical costs ie.,
they are not recognised by the accounting system and are not recorded in the
books of accounts but are very important in certain decisions. They are also
called as the earnings of those employed resources which belong to the owner

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himself. Implicit costs are also called as "Imputed costs". Examples: Rent on
idle land, depreciation on dully depreciated property still in use, interest on
equity capital etc.

(7) Book Cost

Book costs are those business costs which don't involve any cash payments but
a provision is made in the books of accounts in order to include them in the
profit and loss account and take tax advantages, like provision for depreciation
and for unpaid amount of the interest on the owners capital.

(8) Out Of Pocket Costs

Out of pocket costs are those costs are expenses which are current payments to
the outsiders of the firm. All the explicit costs fall into the category of out of
pocket costs. Examples: Rent Paid, wages, salaries, interest etc

(9) Accounting Costs

Accounting costs are the actual or outlay costs that point out the amount of
expenditure that has already been incurred on a particular process or on
production as such accounting costs facilitate for managing the taxation need
and profitability of the firm. Examples: All Sunk costs are accounting costs

(10) Economic Costs

Economic costs are related to future. They play a vital role in business
decisions as the costs considered in decision - making are usually future
costs. They have the nature similar to that of incremental, imputed explicit and
opportunity costs.

(11) Direct Cost

Direct costs are those which have direct relationship with a unit of operation
like manufacturing a product, organizing a process or an activity etc. In other
words, direct costs are those which are directly and definitely identifiable. The
nature of the direct costs are related with a particular product/process, they

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vary with variations in them. Therefore all direct costs are variable in nature.
It is also called as "Traceable Costs"
Examples: In operating railway services, the costs of wagons, coaches and
engines are direct costs.

(12) Indirect Costs

Indirect costs are those which cannot be easily and definitely identifiable in
relation to a plant, a product, a process or a department. Like the direct costs
indirect costs, do not vary ie., they may or may not be variable in
nature. However, the nature of indirect costs depend upon the costing under
consideration. Indirect costs are both the fixed and the variable type as they
may or may not vary as a result of the proposed changes in the production
process etc. Indirect costs are also called as Non-traceable costs.
Example: The cost of factory building, the track of a railway system etc., are
fixed indirect costs and the costs of machinery, labour etc.

(13) Controllable Cost:

Cost which can control

Example: Usage of raw material, Human Resources.

(14) Uncontrollable Cost: Cost which cannot be control

Example: Obsolescence of machinery, repairs of the machinery.

(15)Original or Historical Cost:

Cost of equipment at the time of purchase.

(16)Replacement Cost:

The Cost incurred for replacing the new machinery in the place of old
machinery in the firm.

(17)Abandonment Cost:

Cost incurred for disposal of asset or machinery is called abandonment Cost.

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(18) Shutdown Cost:

Cost which would be incurred in the event of suspension of plant.

Example: Storage of plant or machinery, construction of buildings, training the

employees.

(19)Urgent Cost:

Must be incurred so that the production goes on.

Example: Raw material cost fuel, power and wages for the labour.

(20)Postpone able Cost:

Cost whose postponement does not effect at least for some time on the firm and
on production process and this coast can be paid after sometime.

Example: Transportation charges, rent, interest.

(21)Fixed Cost:

Cost which does not change when there is change in the production. It remains
constant.

Example: Rent of the building, interest on capital, salaries, and wages.

(22)Variable cost:

Cost which changes in accordance with production change.

Example: Raw material, power, fuel.

(23)Average Cost:

Cost incurred for single unit of production in the total production.

(24)Marginal Cost:

Additional cost incurred by the firm by producing one more units extra.

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(25)Long run Cost:

Cost incurred for the expansion of plant, for increase in the production of goods.

(26)Short run Cost:

Cost incurred for the production of extra units with the existing plant capacity
without purchasing new machinery.

 Theories of Cost

A. Traditional Theory

Traditional theory distinguishes between the short run and the long run. The
short run is the period during which some factors) is fixed; usually capital
equipment and entrepreneurship are considered as fixed in the short run.

The long run is the period over which all factors become variable.

1. Short-Run Costs of the Traditional Theory:

In the traditional theory of the firm total costs are split into two groups
total fixed costs and total variable costs:

TC = TFC + TVC

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The fixed costs include:

(a) Salaries of administrative staff

(b) Depreciation (wear and tear) of machinery

(c) Expenses for building depreciation and repairs

(d) Expenses for land maintenance and depreciation (if any).

Another element that may be treated in the same way as fixed costs is the
normal profit, which is a lump sum including a percentage return on fixed
capital and allowance for risk.

The variable costs include:

(a) The raw materials

(b) The cost of direct labour

(c) The running expenses of fixed capital, such as fuel, ordinary repairs and
routine maintenance.

The total fixed cost is graphically denoted by a straight line parallel to the
output axis (figure 4.1). The total variable cost in the traditional theory of the
firm has broadly an inverse-S shape (figure 4.2) which reflects the law of
variable proportions. According to this law, at the initial stages of production
with a given plant, as more of the variable factors) is employed, its productivity
increases and the average variable cost falls.

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This continues until the optimal combination of the fixed and variable factors
is reached. Beyond this point as increased quantities of the variable factors(s)
are combined with the fixed factors) the productivity of the variable factors)
declines (and the A VC rises). By adding the TFC and TVC we obtain the TC of
the firm (figure 4.3). From the total-cost curves we obtain average-cost curves.

The average fixed cost is found by dividing TFC by the level of output:

AFC = TFC / X

Graphically the AFC is a rectangular hyperbola, showing at all its points the
same magnitude, that is, the level of TFC (figure 4.4).

The average variable cost is similarly obtained by dividing the TVC with
the corresponding level of output:

AVC = TVC / X

Graphically the A VC at each level of output is derived from the slope of a line
drawn from the origin to the point on the TVC curve corresponding to the
particular level of output. For example, in figure 4.5 the AVC at X1 is the slope of
the ray 0a, the A VC at X2 is the slope of the ray Ob, and so on. It is clear from
figure 4.5 that the slope of a ray through the origin declines continuously until
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the ray becomes tangent to the TVC curve at c. To the right of this point the
slope of rays through the origin starts increasing. Thus the SA VC curve falls
initially as the productivity of the variable factors) increases, reaches a
minimum when the plant is operated optimally (with the optimal combination
of fixed and variable factors), and rises beyond that point (figure 4.6).

The ATC is obtained by dividing the TC by the corresponding level of

output:

ATC = TC / X = TFC + TVC / X = AFC + AVC

Graphically the ATC curve is derived in the same way as the SAVC. The ATC at
any level of output is the slope of the straight line from the origin to the point
on the TC curve corresponding to that particular level of output (figure 4.7).
The shape of the A TC is similar to that of the AVC (both being U-shaped).
Initially the ATC declines, it reaches a minimum at the level of optimal
operation of the plant (XM) and subsequently rises again (figure 4.8).

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The U shape of both the AVC and the ATC reflects the law of variable
proportions or law of eventually decreasing returns to the variable factor(s) of
production. The marginal cost is defined as the change in TC which results from
a unit change in output. Mathematically the marginal cost is the first derivative
of the TC function. Denoting total cost by C and output by X we have

MC = ∂C / ∂X

Graphically the MC is the slope of the TC curve (which of course is the same at
any point as the slope of the TVC). The slope of a curve at any one of its points
is the slope of the tangent at that point. With an inverse-S shape of the TC (and
TVC) the MC curve will be U-shaped. In figure 4.9 we observe that the slope of
the tangent to the total-cost curve declines gradually, until it becomes parallel
to the X-axis (with its slope being equal to zero at this point), and then starts
rising. Accordingly we picture the MC curve in figure 4.10 as U-shaped.

In summary: the traditional theory of costs postulates that in the short run the
cost curves (AVC, ATC and MC) is U-shaped, reflecting the law of variable
proportions. In the short run with a fixed plant there is a phase of increasing
productivity (falling unit costs) and a phase of decreasing productivity
(increasing unit costs) of the variable factor(s).

Between these two phases of plant operation there is a single point at which
unit costs are at a minimum. When this point on the SATC is reached the plant
is utilized optimally, that is, with the optimal combination (proportions) of
fixed and variable factors.

 The relationship between ATC and AVC:

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The AVC is a part of the ATC, given ATC = AFC + AVC. Both AVC and ATC are U-
shaped, reflecting the law of variable proportions. However, the minimum
point of the ATC occurs to the right of the minimum point of the AVC (figure
4.11). This is due to the fact that ATC includes AFC, and the latter falls
continuously with increases in output.

After the AVC has reached its lowest point and starts rising, its rise is over a
certain range offset by the fall in the AFC, so that the ATC continues to fall (over
that range) despite the increase in AVC. However, the rise in AVC eventually
becomes greater than the fall in the AFC so that the A TC starts increasing. The
A VC approaches the A TC asymptotically as X increases.

In figure 4.11 the minimum AVC is reached at X1 while the ATC is at its
minimum at X2. Between X1 and X2 the fall in AFC more than offsets the rise in
AVC so that the ATC continues to fall. Beyond X2 the increase in AVC is not offset
by the fall in AFC, so that ATC rises.

 The relationship between MC and ATC:

The MC cuts the ATC and the AVC at their lowest points. We will establish this
relation only for the ATC and MC, but the relation between MC and AVC can be
established on the same lines of reasoning.

We said that the MC is the change in the TC for producing an extra unit of
output. Assume that we start from a level of n units of output. If we increase the
output by one unit the MC is the change in total cost resulting from the
production of the (n + l)th unit.
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The AC at each level of output is found by dividing TC by X. Thus the AC at the

level of Xn is

Thus:

(a) If the MC of the (n + 1)th unit is less than ACn (the AC of the previous n units)
the AC n+1 will be smaller than the ACn.

(b) If the MC of the (n + 1)th unit is higher than ACn (the AC of the previous n
units) the ACn+1 will be higher than the ACn.

So long as the MC lies below the AC curve, it pulls the latter downwards; when
the MC rises above the AC, it pulls the latter upwards. In figure 4.11 to the left
of a the MC lies below the AC curve, and hence the latter falls downwards. To
the right of a the MC curve lie above the AC curve, so that AC rises. It follows
that at point a, where the intersection of the MC and AC occurs, the AC has
reached its minimum level.

1. Long-Run Costs of the Traditional Theory: The ‘Envelope’ Curve:

In the long run all factors are assumed to become variable. We said that the
long-run cost curve is a planning curve, in the sense that it is a guide to the
entrepreneur in his decision to plan the future expansion of his output. The
long-run average-cost curve is derived from short-run cost curves. Each point
on the LAC corresponds to a point on a short-run cost curve, which is tangent
to the LAC at that point. Let us examine in detail how the LAC is derived from
the SRC curves.

Assume, as a first approximation, that the available technology to the firm at a

particular point of time includes three methods of production, each with a

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different plant size: a small plant, medium plant and large plant. The small plant
operates with costs denoted by the curve SAC1, the medium-size plant operates
with the costs on SAC2 and the large-size plant gives rise to the costs shown on
SAC3 (figure 4.12). If the firm plans to produce output X3 it will choose the small
plant. If it plans to produce X2 it will choose the medium plant. If it wishes to
produce X1 it will choose the large- size plant.

If the firm starts with the small plant and its demand gradually increases, it will
produce at lower costs (up to level X’1). Beyond that point costs start increasing.
If its demand reaches the level X”1 the firm can either continue to produce with
the small plant or it can install the medium-size plant. The decision at this point
depends not on costs but on the firm’s expectations about its future demand. If
the firm expects that the demand will expand further than X”1 it will install the
medium plant, because with this plant outputs larger than X’1 are produced
with a lower cost.

Similar considerations hold for the decision of the firm when it reaches the level
X”2. If it expects its demand to stay constant at this level, the firm will not install
the large plant, given that it involves a larger investment which is profitable
only if demand expands beyond X”2. For example, the level of output X3 is
produced at a cost c3 with the large plant, while it costs c’2 if produced with the
medium-size plant (c’2 > c3).

Now if we relax the assumption of the existence of only three plants and assume
that the available technology includes many plant sizes, each suitable for a
certain level of output, the points of intersection of consecutive plants (which

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are the crucial points for the decision of whether to switch to a larger plant) are
more numerous. In the limit, if we assume that there is a very large number
(infinite number) of plants, we obtain a continuous curve, which is the planning
LAC curve of the firm.

Each point of this curve shows the minimum (optimal) cost for producing the
corresponding level of output. The LAC curve is the locus of points denoting the
least cost of producing the corresponding output. It is a planning curve because
on the basis of this curve the firm decides what plant to set up in order to
produce optimally (at minimum cost) the expected level of output.

The firm chooses the short-run plant which allows it to produce the anticipated
(in the long run) output at the least possible cost. In the traditional theory of
the firm the LAC curve is U-shaped and it is often called the ‘envelope curve’
because it ‘envelopes’ the SRC curves (figure 4.13).

Let us examine the U shape of the LAC. This shape reflects the laws of returns
to scale. According to these laws the unit costs of production decrease as plant
size increases, due to the economies of scale which the larger plant sizes make
possible. The traditional theory of the firm assumes that economies of scale
exist only up to a certain size of plant, which is known as the optimum plant
size, because with this plant size all possible economies of scale are fully
exploited.

If the plant increases further than this optimum size there are diseconomies of
scale, arising from managerial inefficiencies. It is argued that management
becomes highly complex, managers are overworked and the decision-making
process becomes less efficient. The turning-up of the LAC curve is due to

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managerial diseconomies of scale, since the technical diseconomies can be

avoided by duplicating the optimum technical plant size.

A serious implicit assumption of the traditional U-shaped cost curves is that

each plant size is designed to produce optimally a single level of output (e.g.
1000 units of X). Any departure from that X, no matter how small (e.g. an
increase by 1 unit of X) leads to increased costs. The plant is completely
inflexible. There is no reserve capacity, not even to meet seasonal variations in
demand.

As a consequence of this assumption the LAC curve ‘envelopes’ the SRAC. Each
point of the LAC is a point of tangency with the corresponding SRAC curve. The
point of tangency occurs to the falling part of the SRAC curves for points lying
to the left of the minimum point of the LAC since the slope of the LAC is negative
up to M (figure 4.13) the slope of the SRMC curves must also be negative, since
at the point of their tangency the two curves have the same slope.

The point of tangency for outputs larger than XM occurs to the rising part of the
SRAC curves since the LAC rises, the SAC must rise at the point of their tangency
with the LAC. Only at the minimum point M of the LAC is the corresponding SAC
also at a minimum. Thus at the falling part of the LAC the plants are not worked
to full capacity; to the rising part of the LAC the plants are overworked; only at
the minimum point M is the (short-run) plant optimally employed.

We stress once more the optimality implied by the LAC planning curve each
point represents the least unit-cost for producing the corresponding level of
output. Any point above the LAC is inefficient in that it shows a higher cost for
producing the corresponding level of output. Any point below the LAC is
economically desirable because it implies a lower unit-cost, but it is not
attainable in the current state of technology and with the prevailing market
prices of factors of production. (Recall that each cost curve is drawn under a
ceteris paribus clause, which implies given state of technology and given factor
prices.)

The long-run marginal cost is derived from the SRMC curves, but does not ‘en-
velope’ them. The LRMC is formed from points of intersection of the SRMC
curves with vertical lines (to the X-axis) drawn from the points of tangency of
the corresponding SAC curves and the LRA cost curve (figure 4.14). The LMC

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must be equal to the SMC for the output at which the corresponding SAC is
tangent to the LAC. For levels of X to the left of tangency a the SAC > LAC.

At the point of tangency SAC = LAC. As we move from point a’ to a, we actually

move from a position of inequality of SRAC and LRAC to a position of equality.
Hence the change in total cost (i.e. the MC) must be smaller for the short-run
curve than for the long-run curve. Thus LMC > SMC to the left of a. For an
increase in output beyond X, (e.g. X’1) the SAC > LAC. That is, we move from the
position a of equality of the two costs to the position b where SAC is greater
than LAC. Hence the addition to total cost (= MC) must be larger for the short-
run curve than for the long-run curve. Thus LMC < SMC to the right of a.

Since to the left of a, LMC > SMC, and to the right of a, LMC < SMC, it follows that
at a, LMC – SMC. If we draw a vertical line from a to the X-axis the point at which
it intersects the SMC (point A for SAC1) is a point of the LMC.

If we repeat this procedure for all points of tangency of SRAC and LAC curves
to the left of the minimum point of the LAC, we obtain points of the section of
the LMC which lies below the LAC. At the minimum point M the LMC intersects
the LAC. To the right of M the LMC lies above the LAC curve. At point M we have

SACM = SMCM = LAC = LMC

There are various mathematical forms which give rise to U-shaped unit cost
curves. The simplest total cost function which would incorporate the law of
variable proportions is the cubic polynomial

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The TC curve is roughly S-shaped , while the ATC, the AVC and the MC are all U-
shaped; the MC curve intersects the other two curves at their minimum points
(figure 4.11).

B. The Modern Theory of Costs

The modem theory of costs differs from the traditional theory of costs with
regard to the shapes of the cost curves. In the traditional theory, the cost curves
are U-shaped. But in the modem theory which is based on empirical evidences,
the short-run SAVC curve and the SMC curve coincide with each other and are
a horizontal straight line over a wide range of output. So far as the LAC and LMC
curves are concerned, they are L-shaped rather than U-shaped. We discuss
below the nature of short- run and long-run cost curves according to the
modem theory.

(1) Short-Run Cost Curves:

As in the traditional theory, the short-run cost curves in the modem theory of
costs are the AFC, SAVC, SAC and SMC curves. As usual, they are derived from
the total costs which are divided into total fixed costs and total variable costs.

But in the modem theory, the SAVC and SMC curves have a saucer-type shape
or bowl-shape rather than a U-shape. As the AFC curve is a rectangular
hyperbola, the SAC curve has a U-shape even in the modem version. Economists
have investigated on the basis of empirical studies this behaviour pattern of the
short-run cost curves.

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According to them, a modern firm chooses such a plant which it can operate
easily with the available variable direct factors. Such a plant possesses some
reserve capacity and much flexibility. The firm installs this type of plant in order
to produce the maximum rate of output over a wide range to meet any increase
in demand for its product.

The saucer-shaped SAVC and SMC curves are shown in Figure 7. To begin with,
both the curves first fall upto point A and the SMC curvelies below the SAVC
curve. “The falling part of the SAVC shows the reduction in costs due to the
better utilisation of the fixed factor and the consequent increase in skills and
productivity of the variable factor (labour).

With better skills, the wastes in raw materials are also being reduced and a
better utilisation of the whole plant is reached.” So far as the flat stretch of the
saucer-shaped SAVC curve over Q:1Q2 range of output is concerned, the
empirical evidence reveals that the operation of a plant within this wide range
exhibits constant returns to scale.

The reason for the saucer-shaped SAVC curve is that the fixed factor is divisible.
The SAV costs are constant over a large range, up to the point at which all of the
fixed factor is used. Moreover, the firm’s SAV costs tend to be constant over a
wide range of output because there is no need to depart from the optimal
combination of labour and capital in those plants that are kept in operation.

Thus there is a large range of output over which the SAVC curve will be flat.
Over that range, SMC and SAVC are equal and are constant per unit of output.
The firm will, therefore, continue to produce within Q1Q2 reserve capacity of
the plant, as shown in Figure 7.
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After point B, both the SAVC and SMC curves start rising. When the firm departs
from its normal or the load factor of the plant in order to obtain higher rates of
output beyond Q2, it leads to higher SAVC and SMC. The increase in costs may
be due to the overtime operations of the old and less efficient plant leading to
frequent breakdowns, wastage of raw materials, reduction in labour
productivity and increase in labour cost due to overtime operations. In the
rising portion of the SAVC curve beyond point B, the SMC curve lies above it.

The short-run average total cost curve (SATC or SAC) is obtained by adding
vertically the average fixed cost curve (AFC) and the SAVC curve at each level
of output. The SAC curve, as shown in Figure 8, continues to fall up to the OQ
level of output at which the reserve capacity of the plant is fully exhausted.

Beyond that output level, the SAC curve rises as output increases. The smooth
and continuous fall in the SAC curve upto the OQ level of output is due to the
fact that the AFC curve is a rectangular hyperbola and the SAVC curve first falls
and then becomes horizontal within the range of reserve capacity. Beyond the
OQ output level, it starts rising steeply. But the minimum point M of the SAC
curve where the SMC curve intersects it, is to the right of point E of the SAVC
curve. This is because the SAVC curve starts rising steeply from point E while
the AFC curve is falling at a very low rate.

(2) Long-Run Cost Curves:

Empirical evidence about the long-run average cost curve reveals that the LAC
curve is L-shaped rather than U-shaped. In the beginning, the LAC curve rapidly
falls but after a point “the curve remains flat, or may slope gently downwards,
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at its right-hand end.” Economists have assigned the following reasons for the
L-shape of the LAC curve.

1. Production and Managerial Costs:

In the long run, all costs being variable, production costs and managerial costs
of a firm are taken into account when considering the effect of expansion of
output on average costs. As output increases, production costs fall continuously
while managerial costs may rise at very large scales of output. But the fall in
production costs outweighs the increase in managerial costs so that the LAC
curve falls with increases in output. We analyse the behaviour of production
and managerial costs in explaining the L-shape of the LAC curve.

 Production Costs:

As a firm increases its scale of production, its production costs fall steeply in
the beginning and then gradually. The is due to the technical economies of large
scale production enjoyed by the firm. Initially, these economies are substantial.
But after a certain level of output when all or most of these economies have
been achieved, the firm reaches the minimum optimal scale or mini mum
efficient scale (MES).

Given the technology of the industry, the firm can continue to enjoy some
technical economies at outputs larger than the MES for the following reasons:

(a) from further decentralisation and improvement in skills and productivity of

labour;

(b) from lower repair costs after the firm reaches a certain size; and

(c) by itself producing some of the materials and equipment cheaply which the
firm needs instead of buying them from other firms.

 Managerial Costs:

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In modern firms, for each plant there is a corresponding managerial set-up for
its smooth operation. There are various levels of management, each having a
separate management technique applicable to a certain range of output. Thus,
given a managerial set-up for a plant, its managerial costs first fall with the
expansion of output and it is only at a very large scale output, they rise very
slowly.

To sum up, production costs fall smoothly and managerial costs rise slowly at
very large scales of output. But the fall in production costs more than offsets the
rise in managerial costs so that the LAC curve falls smoothly or becomes flat at
very large scales of output, thereby giving rise to the L-shape of the LAC curve.

In order to draw such an LAC curve, we take three short-run average cost
curves SAC1 SA С2, and SAC3representing three plants with the same technol-
ogy in Figure 9. Each SAC curve includes production costs, managerial costs,
other fixed costs and a margin for normal profits. Each scale of plant (SAC) is
subject to a typical load factor capacity so that points A, В and С represent the
minimal optimal scale of output of each plant.

By joining all such points as A, В and С of a large number of SACs, we trace out
a smooth and continuous LAC curve, as shown in Figure 9. This curve does not
turn up at very large scales of output. It does not envelope the SAC curves but
intersects them at the optimal level of output of each plant.

2. Technical Progress:

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Another reason for the existence of the L-shaped LAC curve in the modern
theory of costs is technical progress. The traditional theory of costs assumes no
technical progress while explaining the U-shaped LAC curve. The empirical
results on long-run costs conform the widespread existence of economies of
scale due to technical progress in firms.

The period between which technical progress has taken place, the long-run
average costs show a falling trend. The evidence of diseconomies is much less
certain. So an upturn of the LAC at the top end of the size scale has not been
observed. The L-shape of the LAC curve due to technical progress is explained
in Figure 10.

Suppose the firm is producing OQ1 output on LAC1curve at a per unit cost of
ОС1 If there is an increase in demand for the firm’s product to OQ2,with no
change in technology, the firm will produce OQ2 output along the LAC1 curve
at a per unit cost of ОС2. If, however, there is technical progress in the firm, it
will install a new plant having LAC2 as the long-run average cost curve. On this
plant, it produces OQ2 output at a lower cost OC2 per unit.

Similarly, if the firm decides to increase its output to OQ3 to meet further rise
in demand technical progress may have advanced to such a level that it installs
the plant with the LAC3 curve. Now it produces OQ3output at a still lower cost
OC3 per unit. If the minimum points, L, M and N of these U- shaped long-run
average cost curves LAC1, LAC2 and LAC3are joined by a line, it forms an L-
shaped gently sloping downward curve LAC.

3. Learning:

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Another reason for the L-shaped long- run average cost curve is the learning
process. Learning is the product of experience. If experience, in this context, can
be measured by the amount of a commodity produced, then higher the
production is, the lower is per unit cost.

The consequences of learning are similar to increasing returns. First, the

knowledge gained from working on a large scale cannot be forgotten. Second,
learning increases the rate of productivity. Third, experience is measured by
the aggregate output produced since the firm first started to produce the
product.

Learning-by-doing has been observed when firms start producing new

products. After they have produced the first unit, they are able to reduce the
time required for production and thus reduce their per unit costs. For example,
if a firm manufactures airframes, the fall observed in long-run average costs is
a function of experience in producing one particular kind of airframe, not
airframes in general.

One can, therefore, draw a “learning curve” which relates cost per airframe to
the aggregate number of airframes manufactured so far, since the firm started
manufacturing them. Figure 11 shows a learning curve LAC which relates the
cost of producing a given output to the total output over the entire time period.

Growing experience with making the product leads to falling costs as more and
more of it is produced. When the firm has exploited all learning possibilities,
costs reach a minimum level, M in the figure. Thus, the LAC curve is L-shaped
due to learning by doing.

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 Relation between LAC and LMC Curves:

In the modern theory of costs, if the LAC curve falls smoothly and continuously
even at very large scales of output, the LMC curve will lie below the LAC curve
throughout its length, as shown in Figure 12.

If the LAC curve is downward sloping up to the point of a minimum optimal

scale of plant or a minimum efficient scale (MES) of plant beyond which no
further scale economies exist, the LAC curve becomes horizontal. In this case,
the LMC curve lies below the LAC curve until the MES point M is reached, and
beyond this point the LMC curve coincides with the LA С curve, as shown in
Figure 13.

Conclusion:

The majority of empirical cost studies suggest that the U-shaped cost curves
postulated by the traditional theory are not observed in the real world. Two

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major results emerge predominantly from most studies. First, the SAVC and
SMC curves are constant over a wide-range of output.

Second, the LAC curve falls sharply over low levels of output, and subsequently
remains practically constant as the scale of output increases. This means that
the LAC curve is L-shaped rather than U-shaped. Only in very few cases
diseconomies of scale were observed, and these at very high levels of output.

 Meaning of Revenue:
The amount of money that a producer receives in exchange for the sale
proceeds is known as revenue.

For example, if a firm gets Rs. 16,000 from sale of 100 chairs, then the amount
of Rs. 16,000 is known as revenue.

Revenue refers to the amount received by a firm from the sale of a given
quantity of a commodity in the market.

Revenue is a very important concept in economic analysis. It is directly

influenced by sales level, i.e., as sales increases, revenue also increases.

 Features of Revenue

1) Revenue arises from the normal trading activities of a business.

2) Revenue eventually creates an inflow of funds into the business.
3) Revenue is measured in monetary terms.
4) Revenue must be allocated to a particular accounting period.
5) Revenue is earned as a result of revenue generating activities typically
expressed as expenses.

 Concept of Revenue:
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The concept of revenue consists of three important terms; Total Revenue,

Average Revenue and Marginal Revenue.

1. Total Revenue (TR):

Total Revenue refers to total receipts from the sale of a given quantity of a
commodity. It is the total income of a firm. Total revenue is obtained by
multiplying the quantity of the commodity sold with the price of the
commodity.

Total Revenue = Quantity × Price

For example, if a firm sells 10 chairs at a price of Rs. 160 per chair, then the
total revenue will be: 10 Chairs × Rs. 160 = Rs 1,600

2. Average Revenue (AR):

Average revenue refers to revenue per unit of output sold. It is obtained by

dividing the total revenue by the number of units sold.

Average Revenue = Total Revenue/Quantity

For example, if total revenue from the sale of 10 chairs @ Rs. 160 per chair is
Rs. 1,600, then:

Average Revenue = Total Revenue/Quantity

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AR= 1,600/10 = Rs 160

AR and Price are the Same:

We know, AR is equal to per unit sale receipts and price is always per unit. Since
sellers receive revenue according to price, price and AR are one and the same
thing.

This can be explained as under:

TR = Quantity × Price … (1)

AR = TR/Quantity …… (2)

Putting the value of TR from equation (1) in equation (2), we get

AR = Quantity × Price / Quantity

AR = Price

AR Curve and Demand Curve are the Same:

A buyer’s demand curve graphically represents the quantities demanded by a

buyer at various prices. In other words, it shows the various levels of average
revenue at which different quantities of the good are sold by the seller.
Therefore, in economics, it is customary to refer AR curve as the Demand Curve
of a firm.

3. Marginal Revenue (MR):

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Marginal revenue is the additional revenue generated from the sale of an

additional unit of output. It is the change in TR from sale of one more unit of a
commodity.

MRn = TRn-TRn-1

Where:

MRn = Marginal revenue of nth unit;

TRn = Total revenue from n units;

TR n-1 = Total revenue from (n – 1) units; n = number of units sold For example,
if the total revenue realised from sale of 10 chairs is Rs. 1,600 and that from
sale of 11 chairs is Rs. 1,780, then MR of the 11th chair will be:

MR11 = TR11 – TR10

MR11 = Rs. 1,780 – Rs. 1,600 = Rs. 180

One More way to Calculate MR:

We know, MR is the change in TR when one more unit is sold. However, when
change in units sold is more than one, then MR can also be calculated as:

MR = Change in Total Revenue/ Change in number of units = ∆TR/∆Q

Let us understand this with the help of an example: If the total revenue
realised from sale of 10 chairs is Rs. 1,600 and that from sale of 14 chairs is Rs.
2,200, then the marginal revenue will be:

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MR = TR of 14 chairs – TR of 10 chairs / 14 chairs -10 chairs = 600/4 = Rs. 150

TR is summation of MR:

Total Revenue can also be calculated as the sum of marginal revenues of all the
units sold.

It means, TRn = MR1 + M2 + MR3 + ……….MRn

or, TR = ∑MR

The concepts of TR, AR and MR can be better explained through Table 7.1.

Table 7.1: TR, AR and MR:

Marginal
Total Average Revenue
Units Price Revenue Revenue (Rs.)
Sold (Rs.) (Rs.) TR = (Rs.) AR = MRn=TRn-
(Q) (P) QxP TR+Q = P TRn-1
1 10 10=1×10 10 =10 + 1 10 =10-0
2 9 18 =2×9 9 =18 + 2 8 =18-10
3 8 24 =3×8 8 =24 + 3 6 =24-18
4 7 28 = 4×7 7 =28 + 4 4 =28-24
5 6 30 = 5×6 6 =30 + 5 2 =30-28
6 5 30 = 6 x 5 5 =30 + 6 0 =30-30
7 4 28 = 7×4 4 =28 + 7 -2 =28-30

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 Shapes of revenue curve

1. Total Revenue curve

TR is obtained by multiplying amount of output sold by the given price

determined in the market by intersection of market demand and market supply
curve.

i.e. TR = Q × P

Where, Q= amount of product sale

P= Market Price which is constant.

TR increases at the same rate because, every additional unit of the commodity
is sold at the same price. In this type of market firms are price taker not price
maker.

It can be explained with the help of following table and graph.

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In above table total revenue (TR ) is obtained by multiplying output (Q) and
Price (P). When output is zero TR also zero. TR is Rs. 10, 20, 30, 40 and 50for
the 1, 2, 3, 4 and 5 units of sale respectively, where price is constant at Rs. 10.

In the above table as increase in sell of output total revenue also increasing, but
the rate of increase in total revenue is constant.

2. Average Revenue curve

Average Revenue (AR):Per unit revenue obtained by a seller by selling product

at market price in the market in certain time period is known as AR for that
time period of that seller or producer.

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It is calculated by dividing total revenue (TR) by corresponding quantity sold

(Q) in the market at market price (P).

i.e. AR = TR/Q

i.e. AR =( P×Q)/Q

i.e. AR = P

Therefore, another name of AR is the average market price of the product. Since,
price is constant in perfect competition market and hence, AR is also constant .

It can be explained with the help of following table;

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In the above table as increase in sells of output of the product Average Revenue
(AR) remains constant i.e. Rs. 10 for first unit to fifth unit of output.

Above information shows that AR is constant and equal to the price for all level
of output.

In the following figure average revenue curve is found by plotting the

combination of points of the quantity sold on the horizontal axis and
corresponding AR on the vertical axis.

AR curve is a horizontal straight line at the different level of output sold at

given price. It shows that AR is constant and equal to the price for all level of
output, i.e. AR = P.

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3. Marginal Revenue curve

Marginal revenue is the change in total revenue in response to the change in

quantity sold. It is calculated by dividing the change in total revenue (ΔTR) by
the change in quantity sold (ΔQ).

In case of perfectly competitive market marginal revenue (MR) remains

constant and equal to the market price for all level of output sold, i.e. MR = P.

It can be explained with the help of following table and graph.

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In the above table as increase in output sold at market price TR increases at

constant rate. But MR remains constant i.e. Rs. 10. which is equal to price.

Form above table we conclude that Price, AR and MR are same i.e. Rs. 10. that
means P = AR = MR.

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In the above figure MR is the slope of the TR. The MR curve is found by plotting
the MR on y-axis and quantity sold on x-axis.

The MR curve is also horizontal to the x-axis as of the AR. It shows that AR and
MR are overlapped and equal to the price in perfectly competitive market.

 Significance of Revenue Curve

The main points of significance of revenue curves are as under:

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1. Estimation of Profits and Losses:

A producer aims at maximizing his profits. His profits will be maximum where
he finds AR > AC.

The maximum difference between AR and AC will show maximum profits. A

producer finds out whether he is making supernormal profits, normal profits
or sustaining losses.

2. Equilibrium:

The second point of the importance of AR and MR curves is to know how much
a producer should produce. In this case, the concept of MR is very important.
The firm will be in equilibrium at that point where MR = MC. This is a general
condition for the firm under all market situations. MR = MC determines output,
price, profits or loss.

3. Capacity Utilization:

It is through revenue curves that we come to know whether a firm is producing

at its full capacity or not. In other words, the firm will be producing at its full
capacity, if AR curve is tangent to AC curve at its minimum point. It is possible
only under perfect competition but not under imperfect competition like
monopoly, monopolistic competition etc.

4. Price Changes:

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The concepts of AR and MR are also useful to the factor services in determining
their price. In factor pricing like rent, wages, interest and profits, they become
inverted U-shaped. The AR and MR curves become ARP and MRP (Average
Revenue productivity and Marginal Revenue Productivity). It is an important
tool in explaining the equilibrium of the firm under different market conditions.

 Relationship of Total Revenue, Average Revenue and Marginal

Revenue:

The relation of total revenue, average revenue and marginal revenue can be
explained with the help of table and fig.

Table Representation:
The relationship between TR, AR and MR can be expressed with the help of a

table 1.
From the table 1 we can draw the idea that as the price falls from Rs. 10 to Re.
1, the output sold increases from 1 to 10. Total revenue increases from 10 to
30, at 5 units. However, at 6th unit it becomes constant and ultimately starts
falling at next unit i.e. 7th. In the same way, when AR falls, MR falls more and
becomes zero at 6th unit and then negative. Therefore, it is clear that when AR
falls, MR also falls more than that of AR: TR increases initially at a diminishing
rate, it reaches maximum and then starts falling.

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The formula to calculate TR, AR and MR is as under:

TR = P x q
Or TR = MR1 + MR2 + MR3 + MR3 +….. MR„
TR

AR = TR/q MR = TRn – TRn _ x

In fig. 1 three concepts of revenue have been explained. The units of output have
been shown on horizontal axis while revenue on vertical axis. Here TR, AR, MR
are total revenue, average revenue and marginal revenue curves respectively.

In figure 1 (A), a total revenue curve is sloping upward from the origin to point
K. From point K to K’ total revenue is constant. But at point K’ total revenue is
maximum and begins to fall. It means even by selling more units total revenue
is falling. In such a situation, marginal revenue becomes negative.

Similarly, in the figure 1 (B) average revenue curves are sloping downward. It
means average revenue falls as more and more units are sold.

In fig. 1 (B) MR is the marginal revenue curve which slopes downward. It

signifies the fact that MR with the sale of every additional unit tends to
diminish. Moreover, it is also clear from the fig. that when both AR and MR are
falling, MR is less than AR. MR can be zero, positive or negative but AR is always
positive.

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The relationship between TR, AR, and MR

In order to understand the basic concepts of revenue, it is also important to pay
attention to the relationship between TR, AR, and MR. When the first unit is sold,
TR, AR, and MR are equal.

Therefore, all three curves start from the same point. Further, as long as MR is
positive, the TR curve slopes upwards.

However, if MR is falling with the increase in the quantity of sale, then the TR
curve will gain height at a decreasing rate. When the MR curve touches the X-axis,
the TR curve reaches its maximum height.

Further, if the MR curve goes below the X-axis, the TR curve starts sloping
downwards.

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Any change in AR causes a much bigger change in MR. Therefore, if the AR curve
has a negative slope, then the MR curve has a greater slope and lies below it.

Similarly, if the AR curve has a positive slope, then the MR curve again has a
greater slope and lies above it. If the AR curve is parallel to the X-axis, then the
MR curve coincides with it.

Here is a graphical representation of the relationship between AR and MR:

In the left half, you can see that AR has a constant value (DD’). Therefore, the AR
curve starts from point D and runs parallel to the X-axis. Also, since AR is constant,
MR is equal to AR and the two curves coincide with each other.

In the right half, you can see that the AR curve starts from point D on the Y-axis
and is a straight line with a negative slope. This basically means that as the
number of goods sold increases, the price per unit falls

at a steady rate.

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Similarly, the MR curve also starts from point D and is a straight line as well.
However, it is a locus of all the points which bisect the perpendicular distance
between the AR curve and the Y-axis. In the figure above, FM=MA.

 THE RELATIONSHIP BETWEEN ELASTICITY OF DEMAND AND REVENUE

The proper estimation of price elasticity is of great significance for business
decision making. A firm’s revenue changes as a result of the change in price.

Total revenue (TR) earned from sales by a firm is obtained by multiplying

average unit price with the total quan-tity sold, i.e., TR = P x Q.

In Figure 8, the total revenue obtained from OQ quantity sold at OP price

is OPCQ. Here, three things are clear:-

The total revenue obtained from OQ quantity sold at OP price is OPCQ

(1) If the demand price is elastic, with an increase in price, there is a large fall
in sales so that the total rev-enue decreases. On the other hand, if the price falls,
the sales increase so much that the total revenue rises.

(2) If the elasticity of demand is equal to unity, there is no change in total

revenue earned from sales even with the change in price. For example, with the
fall in price by 5%, the sales will increase by 5% whereby the total revenue will
remain unchanged.

(3) If the demand price is inelastic, the sales will fall with the increase in price
but the Total Revenue will rise. On the other hand, with the fall in price, the
sales will increase but the total revenue will fall.

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In general, unity elasticity is not found in practice. When price changes in a

certain ratio, the sales normally change in a high or low ratio.

Thus, if the management wants to increase sales, it has to reduce the price. But
if the reduction in price is compensated by the additional sales, the total
revenue will increase or remain the same. Similarly, the management can raise
the price of product for increasing revenue.

But if the fall in revenue as a result of sales reduction is not compensated by the
increased price, the total revenue will fall. Hence, the effect of a change in price
on the sales determines the effect of the change in price on total revenue.
Moreover, the firm often remains in a fix as to whether the sales should increase
or decrease. In such a situation, the concept of the marginal revenue is decisive.

 Important Questions:-

 Short Questions (2 marks)

Q1. Average Cost.

Q2. Marginal Cost.

Q3. Total Cost.

Q4. Define Cost.

Q5. Define Revenue.

Q6. Total Revenue.
Q7. Average Revenue.
Q8. Marginal Revenue.
Q9. Relationship between TC, AC & MC.
Q10. Relationship between TR, AR & MR.
Q11. Define Production Function.
Q12. Define Return to Scale?

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Q13. Define Producer Equilibrium?

Q14. Isoquant.

 Long Questions (10 marks)

Q1:-What Is Production Function? Discuss Its Features, Classification & Why

Production & Technology Is Important?

Q2:-Define Isoquant Curve? Explain Its Properties & Limitations?

Q3:-Define Producer Equilibrium? Discuss Its Conditions & Methods?

Q4:-Write The Detailed Note On Least Cost Combination Of Production Function?

Q5:-Define Return To Scale? Discuss Its Types & Difference Between Laws Of
Return & Return To Scale?

Q6:- Define Theory Of Cost? Explain Its Types & Determinants?

Q7:- Define Modern Theory? Discuss Its Types & Importance?

Q8:- Discuss Relationship Between Cost And Production Function?

Q9:- Define Revenue? Explain Its Types, Shapes And Curves?

Q10: - Explain Relationship Between Marginal Revenue & Elasticity Of Demand?

UNIT-III

MARKET STRUCTURE
 Meaning of Market Structure

The Market Structure refers to the characteristics of the market either

organizational or competitive, that describes the nature of competition and the
pricing policy followed in the market.

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Thus, the market structure can be defined as, the number of firms producing
the identical goods and services in the market and whose structure is
determined on the basis of the competition prevailing in that market.

The term “ market” refers to a place where sellers and buyers meet and
facilitate the selling and buying of goods and services. But in economics, it is
much wider than just a place, It is a gamut of all the buyers and sellers, who are
spread out to perform the marketing activities.

 Types of Market Structure

1. Perfect Competition Market Structure

2. Monopolistic Competition Market Structure
3. Oligopoly Market Structure
4. Monopoly Market Structure

 DETERMINANTS OF THE MARKET STRUCTURE ARE:

1. The number of sellers operating in the market.

2. The number of buyers in the market.
3. The nature of goods and services offered by the firms.
4. The concentration ratio of the company, which shows the largest market shares
held by the companies.
5. The entry and exit barriers in a particular market.

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6. The economies of scale, i.e. how cost efficient a firm is in producing the goods
and services at a low cost. Also the sunk cost, the cost that has already been
spent on the business operations.
7. The degree of vertical integration, i.e. the combining of different stages of
production and distribution, managed by a single firm.
8. The level of product and service differentiation, i.e. how the company’s
offerings differ from the other company’s offerings.
9. The customer turnover, i.e. the number of customers willing to change their
choice with respect to the goods and services at the time of adverse market
conditions.

Thus, the structure of the market affects how firm price and supply their goods
and services, how they handle the exit and entry barriers, and how efficiently a
firm carry out its business operations.

 Perfect Competition
 Meaning of Perfect Competition:

The Perfect Competition is a market structure where a large number of

buyers and sellers are present, and all are engaged in the buying and selling of
the homogeneous products at a single price prevailing in the market.

In other words, perfect competition also referred to as a pure competition,

exists when there is no direct competition between the rivals and all sell
identically the same products at a single price.

 Features of Perfect Competition

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1. Large number of buyers and sellers:

In perfect competition, the buyers and sellers are large enough, that no
individual can influence the price and the output of the industry. An individual
customer cannot influence the price of the product, as he is too small in relation
to the whole market. Similarly, a single seller cannot influence the levels of
output, who is too small in relation to the gamut of sellers operating in the
market.

2. Homogeneous Product:

Each competing firm offers the homogeneous product, such that no individual
has a preference for a particular seller over the others. Salt, wheat, coal, etc. are
some of the homogeneous products for which customers are indifferent and
buy these from the one who charges a less price. Thus, an increase in the price
would let the customer go to some other supplier.

3. Free Entry and Exit:

Under the perfect competition, the firms are free to enter or exit the industry.
This implies, If a firm suffers from a huge loss due to the intense competition in
the industry, then it is free to leave that industry and begin its business
operations in any of the industry, it wants. Thus, there is no restriction on the
mobility of sellers.

4. Perfect knowledge of prices and technology:

This implies, that both the buyers and sellers have complete knowledge of the
market conditions such as the prices of products and the latest technology
being used to produce it. Hence, they can buy or sell the products anywhere and
anytime they want.

5. No transportation cost:

There is an absence of transportation cost, i.e. incurred in carrying the goods

from one market to another. This is an essential condition of the perfect
competition since the homogeneous product should have the same price across
the market and if the transportation cost is added to it, then the prices may
differ.

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6. Absence of Government and Artificial Restrictions:

Under the perfect competition, both the buyers and sellers are free to buy and
sell the goods and services. This means any customer can buy from any seller,
and any seller can sell to any [Link], no restriction is imposed on either
party. Also, the prices are liable to change freely as per the demand-supply
conditions. In such a situation, no big producer and the government can
intervene and control the demand, supply or price of the goods and services.

Thus, under the perfect competition, a seller is the price taker and cannot
influence the market price.

 Assumptions:
The model of perfect competition is based on the following assumptions.

1. Large numbers of sellers and buyers:

The industry or market includes a large number of firms (and buyers), so that
each individual firm, however large, supplies only a small part of the total
quantity offered in the market. The buyers are also numerous so that no
monopolistic power can affect the working of the market. Under these
conditions each firm alone cannot affect the price in the market by changing its
output.

2. Product homogeneity:
The industry is defined as a group of firms producing a homogeneous product.
The technical characteristics of the product as well as the services associated
with its sale and delivery are identical. There is no way in which a buyer could
differentiate among the products of different firms. If the product were
differentiated the firm would have some discretion in setting its price. This is
ruled out ex hypothesis in perfect competition.

The assumptions of large numbers of sellers and of product homogeneity imply

that the individual firm in pure competition is a price-taker: its demand curve
is infinitely elastic, indicating that the firm can sell any amount of output at the
prevailing market price (figure 5.1). The demand curve of the individual firm is
also its average revenue and its marginal revenue curve (see page 156).

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3. Free entry and exit of firms:

There is no barrier to entry or exit from the industry. Entry or exit may take
time, but firms have freedom of movement in and out of the industry. This
assumption is supplementary to the assumption of large numbers. If barriers
exist the number of firms in the industry may be reduced so that each one of
them may acquire power to affect the price in the market.

4. Profit maximization:
The goal of all firms is profit maximization. No other goals are pursued.

5. No government regulation:
There is no government intervention in the market (tariffs, subsidies, rationing
of production or demand and so on are ruled out). The above assumptions are
sufficient for the firm to be a price-taker and have an infinitely elastic demand
curve. The market structure in which the above assumptions are fulfilled is
called pure competition. It is different from perfect competition, which requires
the fulfillment of the following additional assumptions.

6. Perfect mobility of factors of production:

The factors of production are free to move from one firm to another throughout
the economy. It is also assumed that workers can move between different jobs,
which implies that skills can be learned easily. Finally, raw materials and other
factors are not monopolized and labour is not unionized. In short, there is
perfect competition in the markets of factors of production.

7. Perfect knowledge:
It is assumed that all sellers and buyers have complete knowledge of the
conditions of the market. This knowledge refers not only to the prevailing
conditions in the current period but in all future periods as well. Information is
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free and costless. Under these conditions uncertainty about future

developments in the market is ruled out. Under the above assumptions we will
examine the equilibrium of the firm and the industry in the short run and in the
long run.

 Monopoly Market
Definition: The Monopoly is a market structure characterized by a single
seller, selling the unique product with the restriction for a new firm to enter the
market. Simply, monopoly is a form of market where there is a single seller
selling a particular commodity for which there are no close substitutes.

 Features of Monopoly Market

1. Under monopoly, the firm has full control over the supply of a product. The
elasticity of demand is zero for the products.
2. There is a single seller or a producer of a particular product, and there is no
difference between the firm and the industry. The firm is itself an industry.
3. The firms can influence the price of a product and hence, these are price
makers, not the price takers.
4. There are barriers for the new entrants.
5. The demand curve under monopoly market is downward sloping, which means
the firm can earn more profits only by increasing the sales which are possible
by decreasing the price of a product.
6. There are no close substitutes for a monopolist’s product.

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Under a monopoly market, new firms cannot enter the market freely due to any
of the reasons such as Government license and regulations, huge capital
requirement, complex technology and economies of scale. These economic
barriers restrict the entry of new firms.

 Advantages of monopoly

1. Monopoly avoids duplication and hence avoids wastage of resources. (We

have to understand that duplicate and fake products are a real problem in
many countries).
2. A monopoly enjoys economies of scale as it is the only supplier of product
or service in the market. The benefits can be passed on to the consumers.
3. Due to the fact that monopolies make lots of profits, it can be used for
research and development and to maintain their status as a monopoly.
4. Monopolies may use price discrimination which benefits the economically
weaker sections of the society.
5. Monopolies can afford to invest in latest technology and machinery in order
to be efficient and to avoid competition.
6. Source of revenue for the government- the government gets revenue in
form of taxation from monopoly firms.

 Disadvantages of monopoly

1. Poor level of service.

2. No consumer sovereignty. A monopoly market is best known for consumer
exploitation. There are indeed no competing products and as a result the
consumer gets a raw deal in terms of quantity, quality and pricing.
3. Consumers may be charged high prices for low quality of goods and
services.
4. Lack of competition may lead to low quality and out dated goods and
services.

 Monopolistic Competition
Definition: Under, the Monopolistic Competition, there are a large number of
firms that produce differentiated products which are close substitutes for each
other. In other words, large sellers selling the products that are similar, but not
identical and compete with each other on other factors besides price.

 Features of Monopolistic Competition

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1. Product Differentiation: This is one of the major features of the firms

operating under the monopolistic competition, that produces the product
which is not identical but is slightly different from each other. The products
being slightly different from each other remain close substitutes of each other
and hence cannot be priced very differently from each other.
2. Large number of firms: A large number of firms operate under the
monopolistic competition, and there is a stiff competition between the existing
firms. Unlike the perfect competition, the firms produce the differentiated
products which are substitutes for each other, thus make the competition
among the firms a real and a tough one.
3. Free Entry and Exit: With an intense competition among the firms, the entity
incurring the loss can move out of the industry at any time it wants. Similarly,
the new firms can enter into the industry freely, provided it comes up with the
unique feature and different variety of products to outstand in the market and
meet with the competition already existing in the industry.
4. Some control over price: Since, the products are close substitutes for each
other, if a firm lowers the price of its product, then the customers of other
products will switch over to it. Conversely, with the increase in the price of the
product, it will lose its customers to others. Thus, under the monopolistic

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competition, an individual firm is not a price taker but has some influence over
the price of its product.
5. Heavy expenditure on Advertisement and other Selling Costs: Under the
monopolistic competition, the firms incur a huge cost on advertisements and
other selling costs to promote the sale of their products. Since the products are
different and are close substitutes for each other; the firms need to undertake
the promotional activities to capture a larger market share.
6. Product Variation: Under the monopolistic competition, there is a variation in
the products offered by several firms. To meet the needs of the customers, each
firm tries to adjust its product accordingly. The changes could be in the form of
new design, better quality, new packages or container, better materials, etc.
Thus, the amount of product a firm is selling in the market depends on the
uniqueness of its product and the extent to which it differs from the other
products.

The monopolistic competition is also called as imperfect competition because

this market structure lies between the pure monopoly and the pure
competition.

 Diagram monopolistic competition short run

In
the short run, the diagram for monopolistic competition is the same as for a
monopoly.

The firm maximises profit where MR=MC. This is at output Q1 and price P1,
leading to supernormal profit

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 Monopolistic competition long run

Demand curve shifts to the left due to new firms entering the market.

In the long-run, supernormal profit encourages new firms to enter. This

reduces demand for existing firms and leads to normal profit. I

Efficiency of firms in monopolistic competition

 Allocative inefficient. The above diagrams show a price set above marginal cost
 Productive inefficiency. The above diagram shows a firm not producing on the
lowest point of AC curve
 Dynamic efficiency. This is possible as firms have profit to invest in research
and development.
 X-efficiency. This is possible as the firm does face competitive pressures to cut
cost and provide better products.

 Examples of monopolistic competition

 Restaurants – restaurants compete on quality of food as much as price. Product

differentiation is a key element of the business. There are relatively low
barriers to entry in setting up a new restaurant.
 Hairdressers. A service which will give firms a reputation for the quality of their
hair-cutting.
 Clothing. Designer label clothes are about the brand and product differentiation
 TV programmes – globalisation has increased the diversity of tv programmes
from networks around the world. Consumers can choose between domestic

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channels but also imports from other countries and new services, such as
Netflix.

 Limitations of the model of monopolistic competition

1. Some firms will be better at brand differentiation and therefore, in the real
world, they will be able to make supernormal profit.
2. New firms will not be seen as a close substitute.
3. There is considerable overlap with oligopoly – except the model of
monopolistic competition assumes no barriers to entry. In the real world, there
are likely to be at least some barriers to entry
4. If a firm has strong brand loyalty and product differentiation – this itself
becomes a barrier to entry. A new firm can’t easily capture the brand loyalty.
5. Many industries, we may describe as monopolistically competitive are very
profitable, so the assumption of normal profits is too simplistic.

 Merits of Monopolistic Competition:

1. An important merit of monopolistic competition is that it is much closer to

reality than several other models of market structure. Firstly, it incorporates
the facts of product differentiation and selling costs. Secondly, it can be easily
used for the analysis of duopoly and oligopoly.

2. Under monopolistic competition it is possible to see that even when each

individual firm produces under conditions of increasing returns, not only the
firm under consideration but also the entire group of firms can be in
equilibrium.

3. Moreover, monopolistic competition is able to show that even when each

individual firm is producing under increasing returns, it still earns only normal
profit in the long run.

4. The theory of monopolistic competition helps us in bringing in the concept

of market share of an individual firm. This opens up the possibility of
considering those situations in which a firm may be pursuing a goal other than
profit maximization.

5. In monopolistic competition we are able to consider the interaction between

several interdependent variables on the basis of which a firm takes its
decisions.
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 Demerits of Monopolistic Competition:

1. The biggest conceptual difficulty with monopolistic competition is the

concept of age group of firms. There is no standard theoretical foundation for
deciding the boundaries of a group.

2. Related with the concept of a group of firms, we face the difficulty of defining
the meaning of a ‘close substitute’. We are not told at what values of cross
elasticity, two products become close substitutes of each other.

3. The theory of monopolistic competition fails to take into account the fact that
the demand by final consumers is largely influenced by the retail dealers
because the consumers themselves are not fully aware of the technical qualities
of the product.

4. Similarly, the theory fails to fully account for the determination of

equilibrium quantities and prices of goods like raw materials and other inputs.
To a large extent, their demand is governed by a combination of the technical
quality, price and timely availability rather than by brand name, etc. Given the
technical quality of an input, its demand is governed more by its price and
availability than its brand name

 Oligopoly Market:
Definition: The Oligopoly Market characterized by few sellers, selling the
homogeneous or differentiated products. In other words, the Oligopoly market
structure lies between the pure monopoly and monopolistic competition,
where few sellers dominate the market and have control over the price of the
product.

 Under the Oligopoly market, a firm either produces:

 Homogeneous product: The firms producing the homogeneous products

are called as Pure or Perfect Oligopoly. It is found in the producers of
industrial products such as aluminum, copper, steel, zinc, iron, etc.
 Heterogeneous Product: The firms producing the heterogeneous products
are called as Imperfect or Differentiated Oligopoly. Such type of Oligopoly is
found in the producers of consumer goods such as automobiles, soaps,
detergents, television, refrigerators, etc.

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 Features of Oligopoly Market

1. Few Sellers:

Under the Oligopoly market, the sellers are few, and the customers are many.
Few firms dominating the market enjoys a considerable control over the price
of the product

2. Interdependence:

it is one of the most important features of an Oligopoly market, wherein, the

seller has to be cautious with respect to any action taken by the competing
firms. Since there are few sellers in the market, if any firm makes the change in
the price or promotional scheme, all other firms in the industry have to comply
with it, to remain in the competition.

Thus, every firm remains alert to the actions of others and plan their
counterattack beforehand, to escape the turmoil. Hence, there is a complete
interdependence among the sellers with respect to their price-output policies.

3. Advertising:

Under Oligopoly market, every firm advertises their products on a frequent

basis, with the intention to reach more and more customers and increase their
customer [Link] is due to the advertising that makes the competition
intense.
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If any firm does a lot of advertisement while the other remained silent, then he
will observe that his customers are going to that firm who is continuously
promoting its product. Thus, in order to be in the race, each firm spends lots of
money on advertisement activities.

4. Competition:

It is genuine that with a few players in the market, there will be an intense
competition among the sellers. Any move taken by the firm will have a
considerable impact on its rivals. Thus, every seller keeps an eye over its rival
and be ready with the counterattack.

5. Entry and Exit Barriers:

The firms can easily exit the industry whenever it wants, but has to face certain
barriers to entering into it. These barriers could be Government license, Patent,
large firm’s economies of scale, high capital requirement, complex technology,
etc. Also, sometimes the government regulations favor the existing large firms,
thereby acting as a barrier for the new entrants.

6. Lack of Uniformity:

There is a lack of uniformity among the firms in terms of their size, some are
big, and some are small.

Since there are less number of firms, any action taken by one firm has a
considerable effect on the other. Thus, every firm must keep a close eye on its
counterpart and plan the promotional activities accordingly.

 Types of Oligopoly Market

Definition: The Oligopoly is a market structure wherein few sellers dominate
the market and sell the homogeneous or heterogeneous products.

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1. Open Vs Closed Oligopoly: This classification is made on the basis of freedom

to enter into the new industry. An open Oligopoly is the market situation
wherein firm can enter into the industry any time it wants, whereas, in the case
of a closed Oligopoly, there are certain restrictions that act as a barrier for a
new firm to enter into the industry.
2. Partial Vs Full Oligopoly: This classification is done on the basis of price
leadership. The partial Oligopoly refers to the market situation, wherein one
large firm dominates the market and is looked upon as a price leader. Whereas
in full Oligopoly, the price leadership is conspicuous by its absence.
3. Perfect (Pure) Vs Imperfect (Differential) Oligopoly: This classification is
made on the basis of product differentiation. The Oligopoly is perfect or pure
when the firms deal in the homogeneous products. Whereas the Oligopoly is
said to be imperfect, when the firms deal in heterogeneous products, i.e.
products that are close but are not perfect substitutes.
4. Syndicated Vs Organized Oligopoly: This classification is done on the basis of
a degree of coordination found among the firms. When the firms come together
and sell their products with the common interest is called as a Syndicate
Oligopoly. Whereas, in the case of an Organized Oligopoly, the firms have a
central association for fixing the prices, outputs, and quotas.

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5. Collusive Vs Non-Collusive Oligopoly: This classification is made on the basis

of agreement or understanding between the firms. In Collusive Oligopoly,
instead of competing with each other, the firms come together and with the
consensus of all fixes the price and the outputs. Whereas in the case of a non-
collusive Oligopoly, there is a lack of understanding among the firms and they
compete against each other to achieve their respective targets.

Thus, oligopoly market is a market structure that lies between the monopolistic
competition and a pure monopoly.

 List of Advantages of Oligopoly

1. It offers simple choices.

With only a few businesses offering products or services, it will be easy for
consumers to compare and choose the best option for their needs. In other
types of market, it can be very challenging to thoroughly look into all the
things offered by a huge group of companies and then compare prices.

2. It generates high profits.

Because there is only little competition in oligopoly, the businesses involved
in it enjoy the benefit of bringing in huge amounts of profits. Generally, the
products and services controlled through this type of market are highly
needed by a large majority of consumers.

3. It offers better information, products and services.

Along with fair price competition, competition among products also plays a
huge role in this market structure, where every business would scramble to
come out with best and latest items to attract consumers. The same goes to
the amount of information, advertising and support offered to consumers.

4. It creates competitive prices.

As already implied, the ability to easily compare prices coerces business to
keep their prices in competition with their competitors. This is a great perk
for consumers, as prices could continually go down.

 List of Disadvantages of Oligopoly

1. It offers fewer choices.

In many cases, choosing the best brand in an oligopoly is like going for the

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least evil. This means that consumers would have very limited options for the
products or services they are looking for.

2. It makes it difficult for smaller entities to establish a spot in the

market.
For smaller enterprises and creatives, their outlook for business in this type of
market is grim, as only the extremely advanced and large companies have
complete control over market. This makes it nearly impossible for smaller and
new entities to break into the market.

3. It eliminates motivation to compete.

Generally, companies in oligopoly become very settled with their ventures, as
their operations and profits are guaranteed. This means that they would no
longer feel the necessity to create new innovative ideas.

4. Its fixed prices can be bad for consumers.

While competitive prices are good, they are rarely far apart from those of
other companies they could go with, as businesses agree to fix prices, where
there is a set limit for how low prices could go.

Given the nature of an oligopoly form of market and the size of the businesses
that participates in it, it definitely has some benefits and drawbacks. By
weighing down the pros and cons listed above, you will be able to come up
with a well-informed opinion whether it is good to engage in or not.

 The Sweezy Model of Kinked Demand Curve (Rigid Prices) (Non-

Collusive Oligopoly):
In his article published in 1939, Prof. Sweezy presented the kinked demand
curve analysis to explain price rigidities often observed in oligopolistic
markets. Sweezy assumes that if the oligopolistic firm lowers its price, its rivals
will react by matching that price cut in order to avoid losing their customers.

Thus the firm lowering the price will not be able to increase its demand much.
This portion of its demand curve is relatively inelastic.

On the other hand, if the oligopolistic firm increases its price, its rivals will not
follow it and change their prices. Thus the quantity demanded of this firm will
fall considerably. This portion of the demand curve is relatively elastic. In these

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two situations, the demand curve of the oligopolistic firm has a kink at the
prevailing market price which explains price rigidity.

 Its Assumptions:
The kinked demand curve hypothesis of price rigidity is based on the
following assumptions:
(1) There are few firms in the oligopolistic industry.

(2) The product produced by one firm is a close substitute for the other firms.

(3) The product is of the same quality. There is no product differentiation.

(4) There are no advertising expenditures.

(5) There is an established or prevailing market price for the product at which
all the sellers are satisfied.

(6) Each seller’s attitude depends on the attitude of his rivals.

(7) Any attempt on the part of a seller to push up his sales by reducing the price
of his product will be counteracted by other sellers who will follow his move.

(8) If he raises the price, others will not follow him; rather they will stick to the
prevailing price and cater to the customers, leaving the price-raising seller.

(9) The marginal cost curve passes through the dotted portion of the marginal
revenue curve so that changes in marginal cost do not affect output and price.

The Model:
Given these assumptions, the price-output relationship in the oligopolist
market is explained in Figure 5 where KPD is the kinked demand curve and
OPo the prevailing price in the oligopoly market for the OR product of one seller.
Starting from point P, corresponding to the current price OPo, any increase in
price above it, will considerably reduce his sales, for his rivals are not expected
to follow his price increase.

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This is so because the KP portion of the kinked demand curve is elastic, and the
corresponding portion KA of the MR curve is positive. Therefore, any price –
increase will not only reduce his total sales but also his total revenue and profit.

On the other hand if the seller reduces the price of the product below OPo (or
P) his rivals will also reduce their prices. Though he will increase his sales, his
profit would be less than before. The reason is that the PD portion of the kinked
demand curve below P is less elastic and the corresponding part of marginal
revenue curve below R is negative.
Thus in both the price-raising and price-reducing situations the seller will be a
loser. He would stick to the prevailing market price OPo which remains rigid. In
order to study the working of the kinked demand curve, let us analyse the effect
of changes in cost and demand conditions on price stability in the oligopolistic
market.

 Changes in Costs:

In oligopoly under the kinked demand curve analysis, changes in costs within a
certain range do not affect the prevailing price. Suppose the cost of production
falls so that the new MC curve is MC1 to the right, as in Figure 6.
It cuts the MR curve in the gap AB so that the profit- maximising output is OR
which can be sold at OPo price. It should be noted that with any cost reduction
the new MC curve will always cut the MR curve in the gap because as costs fall
the gap AB continues to widen due to two reasons:
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1. As costs fall, the upper portion KP of the demand curve becomes more elastic
because of the greater certainty that a price rise by one seller will not be
followed by rivals and his sales would be considerably reduced.

2. With the reduction in costs the lower portion PD of the kinked curve becomes
more inelastic, because of the greater certainty that a price reduction by one
seller will be followed by the other rivals.
Thus the angle KPD tends to be a right angle at P and the gap AB widens so that
any AC curve below point A will cut the marginal revenue curve inside the gap.
The net result is the same output OR at the same price OPo and large profits for
the oligopolistic sellers.
In case the cost of production rises the marginal cost curve will shift to the left
of the old curve MC as MC2. So long as the higher MC curve intersects the MR
curve within the gap up to point A, the price situation will be rigid.
However, with the rise in costs the price is not likely to remain stable
indefinitely and if the Ml curve rises above point A, it will intersect the MC curve
in the portion KA so that a lesser quantity is sold at a higher price.

We may conclude that there may be price stability under oligopoly even when
costs change so long as the MC curve cuts the MR curve in its discontinuous
portion. However, chances of the existence of price-rigidity are greater where
there is a reduction in costs than there is a rise in costs.

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 Changes in Demand:
 We now explain price rigidity where there is a change in demand with the
help of Figure 7, D2 is the original demand curve, MR2 is its corresponding
marginal revenue curve and MC is the marginal cost curve. Suppose there is
a decrease in demand shown by D1 curve and MR1 is its marginal revenue
curve.
 When demand decreases, a price-reduction move by one seller will be
followed by other rivals. This will make LD1 the lower portion of the new
demand curve, more inelastic than the lower portion HD2 of the old demand
curve.

This will tend to make the angle at L approach a right angle. As a result, the gap
EF in MR1 curve is likely to be wider than the gap AB of the MR2 curve. The
marginal cost curve MC will, therefore, intersect the lower marginal revenue
curve MR1 inside the gap EF, thus indicating a stable price for the oligopolistic
industry.
Since the level of the kinks H and L of the two demand curves remains the same,
the same price OP is maintained after the decrease in demand. But the output
level falls from OQ2 to OQ1. This case can be reversed to show increase in
demand by taking D1 and MR1 as the original demand and marginal revenue
curves and D2 and MR2 as the higher demand and marginal revenue curves
respectively.
The price OP is maintained but the output rises from OQ1 to OQ. So long as the
MC curve continues to intersect the MR curve in the discontinuous portion,
there will be price rigidity.
However, if demand increases, it may lead to a higher price. When demand
increases, a seller would like to raise the price of the product and others are

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expected to follow him. This will tend to make the upper portion MH of the new
demand curve elastic than the NL portion of the old curve.

Thus the angle at H becomes obtuse, away from the right angle. The gap AB in
the MR2 curve becomes smaller and the MC curve intersects the MR2 curve
above the gap, indicating a higher price and lower output. If, however, the
marginal cost curve passes through the gap of MR2, there is price stability.
Conclusion:
The whole analysis of the kinked demand curve points out that price rigidity in
oligopolistic markets is likely to prevail if there is a price reduction move on the
part of all sellers. Changes in costs and demand also lead to price stability under
normal conditions so long as the MC curve intersects the MR curve in its
discontinuous portion.

But price increase rather than price rigidity may be found in response to rising
cost or increased demand.

 Reasons for Price Stability:

There are a number of reasons for price rigidity in certain oligopoly
markets.
(1) Individual sellers in an oligopolistic industry might have learnt through
experience the futility of price wars and thus prefer price stability.

(2) They may be content with the current prices, outputs and profits and avoid
any involvement in unnecessary insecurity and uncertainty.

(3) They may also prefer to stick to the present price level to prevent new firms
from entering the industry.

(4) The sellers may intensify their sales promotion efforts at the current price
instead of reducing it. They may view non-price competition better than price
rivalry.

(5) After spending a lot of money on advertising his product, a seller may not
like to raise its price to deprive himself of the fruits of his hard labour. Naturally,
he would stick to the going price of the product.

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(6) If a stable price has been set through agreement or collusion, no seller
would like to disturb it, for fear of unleashing a price war and thus engulfing
himself into an era of uncertainty and insecurity.

(7) It is the kinked demand curve analysis which is responsible for price rigidity
in oligopolistic markets.

 Its Shortcomings:
But the theory of kinked demand curve in oligopoly pricing is not without
shortcomings.

(1) Even if we accept all its assumptions it is not likely that the gap in the
marginal revenue curve will be wide enough for the marginal cost curve to pass
through it. It may be shortened even under conditions of fall in demand or costs,
thereby making price unstable.

(2) One of its major shortcomings, according to Professor Stigler, is that “the
theory does not explain why prices that have once changed should settle
down, again acquire stability, and gradually produce a new kink.” For
instance in Figure 6 the kink occurs at P because OPo is the prevailing price. But
the theory does not explain the forces that established the initial price OPo.

(3) Price stability may be illusory because it is not based on the actual market
behaviour. Sales do not always occur at list prices. There are often deviations
from posted prices because of trade-ins, allowances and secret price
concessions. The oligopolistic seller may outwardly keep the price stable but he
may reduce the quality or quantity of the product. Thus price stability becomes
illusory.

(4) Moreover, it is not possible to statistically compile actual sales prices in the
case of many products that may reflect stable prices for them. It is, therefore,
doubtful that price stability actually exists in oligopoly.

(5) Critics point out that the kinked demand curve analysis holds during the
short-run, when the knowledge about the reactions of rivals is low. But it is

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difficult to guess correctly the rivals’ reactions in the long-run. Thus the theory
is not applicable in the long-run.

(6) According to some economists, the kinked demand curve analysis applies
to an oligopolistic industry in its initial stages or to that industry in which new
and previously unknown rivals enter the market.

(7) The kinked demand curve analysis is based on two assumptions: first, other
firms will follow a price cut and, second, they will not follow a price rise. Stigler
has shown on empirical evidence that in an inflationary period the rise in
output prices is not confined only to one firm but is industry-wide. So all firms
having similar costs will follow one another in raising price.

(8) Economists have concluded from this that the kinked demand curve
analysis is applicable only under depression. For in an inflationary period when
demand increases, the oligopolistic firm will raise price and other firms will
also follow it.

In such a situation, the demand curve of the oligopolist will have an inverted
kink. This reverse kink is based on his expectation that all his competitors will
follow him when he raises the price of his product, but none will follow a price
cut because of inflationary condition.

This is illustrated in Figure where KPD is the reverse kinked demand curve. Its
corresponding marginal revenue curve is KABM which is composed of KA and

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BM, and the AB portion is its gap. The curve MC passes through all the three
portions of this curve at L, E and H respectively.

The areas ALE and ВНЕ are of uncertainty. Whether the firm decides to
continue production at L, E and H depends on the balance of gain and loss. A
movement from L to E results in a loss because MC>MR. A movement from E to
H results in a gain because MR>MC. If the firm raises the price to Q1P1 and
lowers the output to OQ1 and moves from E to L, it would reduce the loss. If it
lowers the price to Q2P2, and raises the output to OQ2 and moves from E to H, it
would increase the gain. The firm would move to the larger area of gain. Thus
there would be no price rigidity.
(9) Stigler’s empirical evidence further shows that cases in oligopoly industries
where the number of sellers is either very small or somewhat large, the kinked
demand curve is not likely to be there. Thus the empirical evidence does not
support the existence of a kink.

“However”, as pointed out by Professor Baumol, “the analysis does show how
the oligopolistic firm’s view of competitive reaction patterns can affect
the changeability of whatever price it happens to be charging.”

 Meaning of Supply:
In economics, supply during a given period of time means, the quantities of
goods which are offered for sale at particular prices.

The supply of a commodity is the amount of the commodity which the sellers
or producers are able and willing to offer for sale at a particular price, during a
certain period of time.

In other-words, we can say that supply is a relative term. It is always referred

to in relation of price and time. A statement of supply without reference to price
and time conveys no economic sense. For instance, a statement such as “the
supply of milk is 1,000 litres” is meaningless in economic analysis.

One must say, “the supply at such and such a price and during a specific period.”
Hence, the above statement becomes meaningful if it is said—”at the price of

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Rs. 12 per litre; a diary farm’s daily supply of milk is 1000 litres. Here both price
and time are referred with the quantity of milk supplied.”

Further, elasticity of supply explains to us the reaction of the sellers due to a

particular change in the price of a commodity. If due to a little rise in the price,
supply increases considerably we will call it elastic supply. On the other-hand,
supply changes a little or negligibly, it is less elastic.

 Definition of Supply:
According to J. L. Hanson – “By supply is meant that amount that will come into
the market over a range of prices.”
In short supply always means supply at a given price. At different prices, the
supply may be different. Normally the higher the price, the greater the supply
and vice-versa.

According to Prof. Thomas – “The supply of a commodity is said to be elastic

when as a result of a change in price the supply changes sufficiently as a quick
response. Contrary, if there is no change or negligible change in supply or
supply pays no response, it is inelastic.”

Prof. Thomas’s definition tells us proportionate changes in price and quantity

supplied is the concept of elasticity of supply. If as a result of small change in
price change in supply is more proportionately it will be higher elastic supply.

 Supply and Stock Relationship:

Supply and stock are related to each other in distinct terms:
1. Stock is the Determinant of Supply:
Supply is what the seller is able and willing to offer for sale. The ability of a
seller to supply a commodity depends on the stock available with him. Thus,
stock is the determinant of supply. Supply is the amount of stock offered for
sale at a given price. Therefore, stock is the basis of supply. Without stock
supply is not possible.

2. Stock Determines the Actual Supply:

Actual supply is the stock or quantity actually offered for sale by the seller at a
particular price during a certain period. The limit to maximum supply, at a time,

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is set by the given stock. Actual supply may be a part of the stock or the entire
stock at the most. Thus, the stock can exceed supply but supply cannot exceed
the given stock at a time.

3. Stock can be said as the Outcome of Production:

It is very common to understand that by increasing production as well as the
potential supply, the stock can be increased. Sometimes, an increase in the
actual supply can exceed the increase in current stock, when along with the
fresh stock, old accumulated stock is also released for sale at the prevailing
price.

In this way, supply can exceed the current stock, but it can never exceed the
total stock (old + new stock taken together) during a given period.

 Factors Affecting Supply:

There are a number of factors influencing the supply of a commodity. They are
known as the determinants of supply.

1. Price of the Commodity:

Price is the most important factor influencing the supply of a commodity. More
is supplied at a lower price and less is supplied at a higher price.

2. Seller’s Expectations about the Future Price:

Seller’s expectations about the future price affect the supply. If a seller expects
the price to rise in the future, he will withhold his stock at present and so there
will be less supply now. Besides change in price, change in the supply may be
in the form of increase or decrease in supply.

3. Nature of Goods:
The supply of every perishable goods is perfectly inelastic in a market period
because the entire stock of such goods must be disposed of within a very short
period, whatsoever may be the price. If not, they might get rotten. Further, if
the stock of goods can be easily stored its supply would be relatively elastic and
vice-versa.

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4. Natural Conditions:
The supply of some commodities, such as agricultural products depends on the
natural environment or climatic conditions like—rainfall, temperature etc. A
change in the natural conditions will cause a change in the supply.

5. Transport Conditions:
Difficulties in transport may cause a temporary decrease in supply as goods
cannot be brought in time to the market place. So even at the rising prices,
quantity supplied cannot be increased.

6. Cost of Production:
If there is a rise in the cost of production of a commodity, its supply will tend to
decrease. Similarly, with the rise in cost of production the supply curve tends
to shift downward. Conversely, a fall in the cost of production tends to decrease
the supply.

7. The State of Technology:

The supply of a commodity depends upon the methods of production. Advance
in technology and science are the most powerful forces influencing productivity
of the factors of production. Most of the inventions and innovations in
chemistry, electronics, atomic energy etc. have greatly contributed to increased
supplies of commodities at lower costs.

8. Government’s Policy:
Government’s economic policies like—industrial policy, fiscal policy etc.
influence the supply. If the industrial licensing policy of the government is
liberal, more firms are encouraged to enter the field of production, so that the
supply may increase.

Import restrictions and high customs duties may decrease the supply of
imposed goods but it would encourage the domestic industrial activity, so that
the supply of domestic products may increase. A tax on a commodity or a factor
of production raises its cost of production, consequently production is reduced.
A subsidy on the other-hand provides an incentive to production and augments
supply.

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 Types of Supply:
There are five types of supply:
1. Market Supply:
Market supply is also called very short period supply. Another name of market
supply is ‘day-to-day supply or ‘daily supply’. Under these goods like—fish,
vegetables, milk etc., are included. In this supply is not made according to the
demand of purchasers but as per availability of the goods.

2. Short-term Supply:
In short period supply, the demand cannot be met as per requirements of the
purchaser. The demand is met as according to the goods available.

3. Long-term Supply:
In this, if demand has been changed the supply can also be changed because
there is sufficient time to meet the demand by making manufacturing goods and
supplying them in the market.

4. Joint Supply:
Joint supply refers to the goods produced or supplied jointly e.g., cotton and
seed; mutton and wool. In joint supplied products one is the main product and
the other is the by-product of its subsidiary. By-product is mostly the automatic
outcome when the main product is produced.

For example:
When the sheep is slaughtered for mutton wool is obtained automatically.

5. Composite Supply:
In this, the supply of a commodity is made from various sources and is called
the composite supply. When there are different sources of supply of a
commodity or services, we say that its supply is composed of all these
resources. We normally get light from electricity, gas, kerosene and candles. All
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these resources go to make the supply of light. Thus, the way of supplying the
light is called composite supply.

 Supply schedule

Supply schedule shows a tabular representation of law of supply. It presents

the different quantities of a product that a seller is willing to sell at different
price levels of that product.

A supply schedule can be of two types, which are as follows:

1. Individual Supply Schedule:

Refers to a supply schedule that represents the different quantities of a product

supplied by an individual seller at different prices.

Table-8 shows the supply schedule for the different quantities of milk
supplied in the market at different prices:

2. Market Supply Schedule:

Refers to a supply schedule that represents the different quantities of a
product that all the suppliers in the market are willing to supply at
different prices. Market supply schedule can be drawn by aggregating the
individual supply schedules of all individual suppliers in the market.

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Table-9 shows the market supply schedule of a product supplied by

three suppliers. A, B, and C:

 Supply Curve:
The graphical representation of supply schedule is called supply curve. In
a graph, price of a product is represented on Y-axis and quantity supplied
is represented on X-axis. Supply curve can be of two types, individual
supply curve and market supply curve. Individual supply curve is the
graphical representation of individual supply schedule, whereas market
supply curve is the representation of market supply schedule.

Figure-14 shows the individual supply curve for the individual

supply schedule (represented in Table-8):

In Figure-14, the supply curve is showing a straight line and an upward

slope. This implies that the supply of a product increases with increase in
the price of a product.

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Figure-15 shows the market supply curve of market supply

schedule (represented in Table-9):

The slope of market supply curve can be obtained by calculating the

supply of the slopes of individual supply curves. Market supply curve also
represents the direct relationship between the quantity supplied and
price of a product.

Refers to a supply schedule that represents the different quantities of a product

supplied by an individual seller at different prices.

 Exceptions of law of supply are as follows:

i. Speculation:

Refers to the fact that the supply of a product decreases instead of increasing in
present when there is an expected increase in the price of the product. In such
a case, sellers would not supply the whole quantity of the product and would
wait for the increase in price in future to earn high profits. This case is an
exception to law of demand.

ii. Agricultural Products:

Imply that law of supply is not valid in case of agricultural products as the
supply of these products depends on particular seasons or climatic conditions.
Thus, the supply of these products cannot be increased after a certain limit in
spite of rise in their prices.

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iii. Changes in Other Situations:

Refers to the fact that law of supply ignores other factors (except price) that can
influence the supply of a product. These factors can be natural factors,
transportation conditions, and government policies.

PRICING PRACTICES:

 Pricing

 Pricing is one of the most important elements of the marketing, as it is the

only factor which generates a turnover for the organization. It can be defined
as "Activities aimed at finding a product’s optimum price, typically including
overall marketing objectives, consumer demand, product attributes,
competitors' pricing, and market and economic trends." It costs to produce
and design a product; it costs to distribute a product and costs to promote
it.

 Price must support these elements of the mix. Pricing is difficult and must
reflect supply and demand relationship. Pricing a product too high or too
low could mean a loss of sales for the organization.

 It is the value that is put to a product or service and is the result of a complex
set of calculations, research and understanding and risk taking ability.

 THE INFLUENCING FACTORS FOR A PRICING DECISION CAN BE

DIVIDED INTO TWO GROUPS:
(A) Internal Factors

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(B) External Factors.

(A) Internal Factors:

1. Organisational Factors:
Pricing decisions occur on two levels in the organisation. Over-all price strategy
is dealt with by top executives. They determine the basic ranges that the
product falls into in terms of market segments. The actual mechanics of pricing
are dealt with at lower levels in the firm and focus on individual product
strategies. Usually, some combination of production and marketing specialists
are involved in choosing the price.

2. Marketing Mix:
Marketing experts view price as only one of the many important elements of
the marketing mix. A shift in any one of the elements has an immediate effect
on the other three—Production, Promotion and Distribution. In some
industries, a firm may use price reduction as a marketing technique.

Other firms may raise prices as a deliberate strategy to build a high-prestige

product line. In either case, the effort will not succeed unless the price change
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is combined with a total marketing strategy that supports it. A firm that raises
its prices may add a more impressive looking package and may begin a new
advertising campaign.

3. Product Differentiation:
The price of the product also depends upon the characteristics of the product.
In order to attract the customers, different characteristics are added to the
product, such as quality, size, colour, attractive package, alternative uses etc.
Generally, customers pay more prices for the product which is of the new style,
fashion, better package etc.

4. Cost of the Product:

Cost and price of a product are closely related. The most important factor is the
cost of production. In deciding to market a product, a firm may try to decide
what prices are realistic, considering current demand and competition in the
market. The product ultimately goes to the public and their capacity to pay will
fix the cost, otherwise product would be flapped in the market.

5. Objectives of the Firm:

A firm may have various objectives and pricing contributes its share in
achieving such goals. Firms may pursue a variety of value-oriented objectives,
such as maximizing sales revenue, maximizing market share, maximizing
customer volume, minimizing customer volume, maintaining an image,
maintaining stable price etc. Pricing policy should be established only after
proper considerations of the objectives of the firm.

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(B) External Factors:

1. Demand:
The market demand for a product or service obviously has a big impact on
pricing. Since demand is affected by factors like, number and size of
competitors, the prospective buyers, their capacity and willingness to pay, their
preference etc. are taken into account while fixing the price.

A firm can determine the expected price in a few test-markets by trying

different prices in different markets and comparing the results with a
controlled market in which price is not altered. If the demand of the product is
inelastic, high prices may be fixed. On the other hand, if demand is elastic, the
firm should not fix high prices, rather it should fix lower prices than that of the
competitors.

2. Competition:
Competitive conditions affect the pricing decisions. Competition is a crucial
factor in price determination. A firm can fix the price equal to or lower than that
of the competitors, provided the quality of product, in no case, be lower than
that of the competitors.

3. Suppliers:
Suppliers of raw materials and other goods can have a significant effect on the
price of a product. If the price of cotton goes up, the increase is passed on by
suppliers to manufacturers. Manufacturers, in turn, pass it on to consumers.

Sometimes, however, when a manufacturer appears to be making large profits

on a particular product, suppliers will attempt to make profits by charging more
for their supplies. In other words, the price of a finished product is intimately
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linked up with the price of the raw materials. Scarcity or abundance of the raw
materials also determines pricing.

4. Economic Conditions:
The inflationary or deflationary tendency affects pricing. In recession period,
the prices are reduced to a sizeable extent to maintain the level of turnover. On
the other hand, the prices are increased in boom period to cover the increasing
cost of production and distribution. To meet the changes in demand, price etc.

Several pricing decisions are available:

(a) Prices can be boosted to protect profits against rising cost,

(b) Price protection systems can be developed to link the price on delivery to
current costs,

(c) Emphasis can be shifted from sales volume to profit margin and cost
reduction etc.

5. Buyers:
The various consumers and businesses that buy a company’s products or
services may have an influence in the pricing decision. Their nature and
behaviour for the purchase of a particular product, brand or service etc. affect
pricing when their number is large.

6. Government:
Price discretion is also affected by the price-control by the government through
enactment of legislation, when it is thought proper to arrest the inflationary
trend in prices of certain products. The prices cannot be fixed higher, as

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government keeps a close watch on pricing in the private sector. The marketers
obviously can exercise substantial control over the internal factors, while they
have little, if any, control over the external ones.

 WHILE SETTING THE PRICE, THE FIRM MAY AIM AT THE FOLLOWING
OBJECTIVES:

(i) Price-Profit Satisfaction:

The firms are interested in keeping their prices stable within certain period of
time irrespective of changes in demand and costs, so that they may get the
expected profit.

(ii) Sales Maximisation and Growth:

A firm has to set a price which assures maximum sales of the product. Firms set
a price which would enhance the sale of the entire product line. It is only then,
it can achieve growth.

(iii) Making Money:

Some firms want to use their special position in the industry by selling product
at a premium and make quick profit as much as possible.

(iv) Preventing Competition:

Unrestricted competition and lack of planning can result in wasteful
duplication of resources. The price system in a competitive economy might not
reflect society’s real needs. By adopting a suitable price policy the firm can
restrict the entry of rivals.

(v) Market Share:

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The firm wants to secure a large share in the market by following a suitable
price policy. It wants to acquire a dominating leadership position in the market.
Many managers believe that revenue maximisation will lead to long run profit
maximisation and market share growth.

(vi) Survival:
In these days of severe competition and business uncertainties, the firm must
set a price which would safeguard the welfare of the firm. A firm is always in its
survival stage. For the sake of its continued existence, it must tolerate all kinds
of obstacles and challenges from the rivals.

(vii) Market Penetration:

Some companies want to maximise unit sales. They believe that a higher sales
volume will lead to lower unit costs and higher long run profit. They set the
lowest price, assuming the market is price sensitive. This is called market
penetration pricing.

(viii) Marketing Skimming:

Many companies favour setting high prices to ‘skim’ the market. Dupont is a
prime practitioner of market skimming pricing. With each innovation, it
estimates the highest price it can charge given the comparative benefits of its
new product versus the available substitutes.

(ix) Early Cash Recovery:

Some firms set a price which will create a mad rush for the product and recover
cash early. They may also set a low price as a caution against uncertainty of the
future.

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(x) Satisfactory Rate of Return:

Many companies try to set the price that will maximise current profits. To
estimate the demand and costs associated with alternative prices, they choose
the price that produces maximum current profit, cash flow or rate of return on
investment.

 PRICING PRACTICES AND STRATEGY

It takes into account segments, ability to pay, market conditions, competitor

actions, trade margins and input costs, amongst others. It is targeted at the
defined customers and against competitors.

 TYPES OF PRICING PRACTICES:

1. Cost-plus pricing

It Refers to the simplest method of determining the price of a product. In cost-

plus pricing method, a fixed percentage, also called mark-up percentage, of the
total cost (as a profit) is added to the total cost to set the price. For example,
XYZ organization bears the total cost of Rs. 100 per unit for producing a
product. It adds Rs. 50 per unit to the price of product as’ profit. In such a case,
the final price of a product of the organization would be Rs. 150.

Cost-plus pricing is also known as average cost pricing. This is the most
commonly used method in manufacturing organizations.

 In economics, the general formula given for setting price in case of cost-plus
pricing is as follows:

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P = AVC + AVC (M)

AVC= Average Variable Cost

M = Mark-up percentage

AVC (m) = Gross profit margin

Mark-up percentage (M) is fixed in which AFC and net profit margin (NPM) are
covered.

AVC (m) = AFC+ NPM

i) For determining average variable cost, the first step is to fix prices. This is
done by estimating the volume of the output for a given period of time. The
planned output or normal level of production is taken into account to estimate
the output.

ii) The second step is to calculate Total Variable Cost (TVC) of the output. TVC
includes direct costs, such as cost incurred in labor, electricity, and
transportation. Once TVC is calculated, AVC is obtained by dividing TVC by
output, Q. [AVC= TVC/Q]. The price is then fixed by adding the mark-up of some
percentage of AVC to the profit [P = AVC + AVC (m)].

 Advantages of cost-plus pricing method are as follows:

a. Requires minimum information

b. Involves simplicity of calculation

c. Insures sellers against the unexpected changes in costs

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 Disadvantages of cost-plus pricing method are as follows:

a. Ignores price strategies of competitors

b. Ignores the role of customers

2. Markup Pricing:
It Refers to a pricing method in which the fixed amount or the percentage of
cost of the product is added to product’s price to get the selling price of the
product. Markup pricing is more common in retailing in which a retailer sells
the product to earn profit. For example, if a retailer has taken a product from
the wholesaler for Rs. 100, then he/she might add up a markup of Rs. 20 to gain
[Link] is mostly expressed by the following formulae:

a. Markup as the percentage of cost= (Markup/Cost) *100

b. Markup as the percentage of selling price= (Markup/ Selling Price)*100

c. For example, the product is sold for Rs. 500 whose cost was Rs. 400. The mark
up as a percentage to cost is equal to (100/400)*100 =25. The mark up as a
percentage of the selling price equals (100/500)*100= 20.

3. Demand-based Pricing:
Demand-based pricing refers to a pricing method in which the price of a
product is finalized according to its demand. If the demand of a product is more,
an organization prefers to set high prices for products to gain profit; whereas,
if the demand of a product is less, the low prices are charged to attract the
customers. The success of demand-based pricing depends on the ability of

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marketers to analyze the demand. This type of pricing can be seen in the
hospitality and travel industries

4. Competition-based Pricing:
Competition-based pricing refers to a method in which an organization
considers the prices of competitors’ products to set the prices of its own
products. The organization may charge higher, lower, or equal prices as
compared to the prices of its competitors.

The aviation industry is the best example of competition-based pricing where

airlines charge the same or fewer prices for same routes as charged by their
competitors. In addition, the introductory prices charged by publishing
organizations for textbooks are determined according to the competitors’
prices.

5. Value Pricing:
Implies a method in which an organization tries to win loyal customers by
charging low prices for their high- quality products. The organization aims to
become a low cost producer without sacrificing the quality. It can deliver high-
quality products at low prices by improving its research and development
process. Value pricing is also called value-optimized pricing.

6. Target Return Pricing:

It Helps in achieving the required rate of return on investment done for a
product. In other words, the price of a product is fixed on the basis of expected
profit.

7. Going Rate Pricing:

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It implies a method in which an organization sets the price of a product

according to the prevailing price trends in the market. Thus, the pricing
strategy adopted by the organization can be same or similar to other
organizations. However, in this type of pricing, the prices set by the market
leaders are followed by all the organizations in the industry.

8. Transfer Pricing:
It involves selling of goods and services within the departments of the
organization. It is done to manage the profit and loss ratios of different
departments within the organization. One department of an organization can
sell its products to other departments at low prices. Sometimes, transfer pricing
is used to show higher profits in the organization by showing fake sales of
products within departments

[Link] Skimming Pricing:

Skimming is adopted where a new product is launched and the seller has little
information on the acceptable price in the market. The seller, therefore, starts
by setting a high price on the launch of the product and then, over a period of
time, lowers the price to meet the varying price elasticities of demand.
This enables gradual expansion in capacity by the seller. This practice is
followed in the consumer durables market. The seller chooses to start by
setting at a high price to avoid the risk of losing on customers who are willing
to pay a high price.
10. Penetration Pricing:
Penetration pricing is a strategy employed by businesses introducing new
goods or services into the marketplace. With this policy, the initial price of the

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good or service is set relatively low in hopes of ‘penetrating’ into the

marketplace quickly and securing significant market share.
 A penetration policy is even more attractive if selling larger quantities
results in lower costs because of economies of scale. Penetration pricing may
be wise if the firm expects strong competition very soon after introduction.
 A low penetration price may be called a ‘stay out’ price. It discourages
competitors from entering the market. Once the product has secured a
desired market share, its producers can then review business conditions and
decide whether to gradually increase the price.
 Penetration pricing involves the setting of lower, rather than higher prices
in order to achieve a large, if not dominant, market share.
This strategy is most often used in businesses wishing to enter a new market or
build on a relatively small market share.

This will only be possible where demand for the product is believed to be highly
elastic, i.e., demand is price-sensitive and either new buyers will be attracted or
existing buyers will buy more of the product as a result of a low price.
[Link] Pricing:
It is a pricing practice when two or more products are sold as bundle. Also, the
constituent products of the bundle are not sold individually.
Price bundling is a strategy whereby a seller bundles together many different
goods/items being sold and offers the entire bundle at a single price.
There are two forms of price bundling—pure bundling, where the seller
does not offer buyers the option of buying the items separately, and mixed
bundling, where the seller offers the items separately at higher individual
prices. Mixed bundling is usually preferable to pure bundling, both because

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there are fewer legal regulations forbidding it, and because the reference price
effect makes it appear even more attractive to buyers.

Suppose there are two buyers, A and B, and two products, X and Y. Suppose
buyer A values product X at 20 units above the cost of production, and values 7
at 15 units above the cost of production. Suppose buyer B values Y at 20 units
above the cost of production, and X at 15 units above the cost of production.
The ideal thing for the seller would be to practice price discrimination: charge
each buyer the maximum that buyer is willing to pay. However, this may be
forbidden by law or otherwise difficult to implement.
Instead, the seller can pursue the following bundling strategy- charge slightly
under 35 units above production cost for the combination of X and Y. Since both
buyers value the combination at 35 units, this deal appeals to both buyers. This
allows the seller to obtain the entire social surplus as producer surplus.
The seller can even make this a mixed bundling strategy – offer both X and Y
individually for 20 units, and offer the combination for slightly less than 35
units.

12. Peak Load Pricing:

It is a pricing practice where price varies with time of the day. When demand
for a commodity or service varies at different periods of time, it has been
generally suggested that higher price of a commodity or service be charged for
the peak period when demand is greater and lower price be charged for off-
peak period when demand is lower. This dual pricing, that is higher price for
peak period and lower price for off-peak period is known as peak-load pricing.
For example. In India charges for trunk or STD calls during day time which is
the peak period is higher and charges for the off-peak period from 9 P.M. to 6
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A.M. are lower. In many countries, electric companies are permitted to charge
higher rates during the day time which is the peak period for the use of
electricity and lower rates for the night which is off-peak period for the use of
electricity. Similarly, airlines often follow peak-load pricing; in off season they
often lower their rates as compared to the peak periods of travel.

13. Limit Pricing:

Limit pricing refers to the pricing by incumbent firm(s) to deter or inhibit the
entry or the expansion of fringe firms.
Limit pricing implies that firms sacrifice current profits in order to deter entry
of new firms and earn future profits. It is not clear whether this strategy is
always superior to one where current prices (and profits) are higher, but
decline over time as an entry occurs.
Limit pricing thus involves charging prices below the monopoly price in order
to make entry appear unattractive (to limit entry). A low price would
discourage entry if prices had a commitment value. But they do not, because
prices can be changed quickly. Hence, if a potential entrant has complete
information about the incumbent, limit pricing would be useless.
It is the policy adopted by firms already in a market to reduce their prices so as
to make it unprofitable for other firms to try to enter the market. The price so
established is called an entry forestalling price.

14. Prestige Pricing

Prestige pricing is a marketing strategy where prices are set higher than normal
because lower prices will hurt instead of helping sales, such as for high-end

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perfumes, jewelry, clothing, cars, etc. It is also called image pricing or premium
pricing.

It is a price system that implies added value of a product because of its location
at the higher end of the price scale. Prices within this type of financial modeling
are artificially elevated for a psychological marketing advantage. This type of
pricing aims to capitalize on buyers' notions that one brand's high-priced item
is superior in quality to a similar item that could be purchased for significantly
less.

The strategy behind prestige pricing is not tied to its quality but more to its
image.

COLLECTIVE BARGAINING

 HISTORY OF COLLECTIVE BARGANING:-

The term of “Collective Bargaining” was first used in 1891 by Beatrics Webb, a
founder of field if industrial relation in Britain. It refers to a sort of collective of
negotiation and agreement that has existed. The concept of collective
bargaining was introduced very late in India, as trade union were formed only
in 1962.
 MEANING:-
Collective Bargaining is the agreement between the a single employer or an
association of the employers on the one hand and labor union on the other.
“Collective Bargaining is the processes in which the representative of a labor
organization and the representative of the business organization meet and
attempt to negotiate a contracts or agreement.” Edwin Flippo
 OBJECTIVES:-

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1. To provide an opportunity to the workers to voice.

2. To reaching a solution that is acceptable.
3. To maintain cordial relation.
4. To promote democracy. To prevent unilateral action to employees.
5. To preventing strike and enhance the productivity.
6. To Resolving and prevent all conflicts and disputes in a mutually agreeable
manner.
7. To develop a conducting atmosphere.
8. To provide stable and peaceful organization (hospital).

 TYPES OF COLLECTIVE BARGAINING:-

1. DISTRIBUTIVE OR COLLECTIVE BARGAINING: - Conjunctive bargaining is
the most common type of bargaining & involves zero-sum negotiations, in other
words, one side wins and the other loses. This involves bargaining over the
distribution of surplus. In this, economic issues like salaries, wages and
bonuses. Economic issues like wages, salaries and bonus are discussed. One
party’s gain is another party’s loss & More competitive. e.g. Unions negotiate
for maximum wages.
2. INTEGRATIVE OR CORPORATIVE BARGAINING:- Integrative bargaining is
similar to problem solving sessions in which both sides are trying to reach a
mutually beneficial alternative, i.e. a win-win situation. Both parties may gain
or neither party losses. Both the parties are trying to make more of something.
3. PRODUCTIVITY BARGAINING:- A form of collective bargaining leading to a
productivity agreement in which management offers a pay raise in exchange
for alterations to employee working practices designed to increase
productivity.

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4. COMPOSITE BARGAINING:- Wages with equity.

 PROCESS OF COLLECTIVE BARGAINING

1. PREPARATORY PHASE:- In this phase, following activities are carried out :-
Selection of negotiation team:- This phase involves composition of a
negotiation team. It consist of the representatives of the both parties. They
should have adequate knowledge and skills for the negotiation. Identification
of problem. Enough supporting data is kept ready
2. DISCUSSION PHASE:- Decide and appropriate time and set a proper climate
for negotiation. Maintenance of mutual trust and understanding. Involve in
active listening, asking questions, observation and summarizing decision.
3. PROPOSAL PHASE:- This phase could be described as brainstorming‘. The
exchange of messages takes place and opinion of both the parties. Initial
opening of statement. Possible alternative/opinion to resolve the issue by both
parties.
4. BARGAINING PHASE:- Both the parties will involve in the following
activities:- Problem solving & Proposal.
5. SETTLEMENT PHASE:- This stage is described as consisting of effective joint
implementation of the agreement through shared visions, strategic planning
and negotiated change. Agreement on common decision.
6. FORMALIZING AGREEMENT:-
 Drafting of agreement:-After good faith bargaining, a formal document
must prepare. It should be simple, clear and concise.
 Signing the agreement:- Both parties sign the agreement and abide by
its terms and conditions.
7. ENFORCING AGREEMENT:- To have the agreement effective and
meaningful, it should be enforced or implemented immediately

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 PRINCIPLES OF COLLECTIVE BARGAING:-

1. PRINCIPLES FOR THE MANAGEMENT:- The management should be
waiting for the trade union to bring employees grievances to its notice but
should rather create the condition in which the employees can approach
themselves without involving the trade union. The management should only
deal with the one trade in the organization. They must form and follow a
realistic labor policy. They should treat the trade union fairly. They should
regularly check the rules and regulations to determine the attitude and comfort
of its employees. Must agree to reform the trade union without any
reservations. The management should not wait for the trade union to bring
employees problems.
2. PRINCIPLES FOR THE TRADE UNIONS:- The trade union should eliminate
racketeering and other undemocratic practices within their own organization
Trade union leaders should resort to strike only when all other methods of the
settlement of a dispute have failed. Trade union leaders should not imagine that
their only function is to secure higher wages, shorter hours of work and better
working conditions for their members. Trade union leaders should assist in the
removal of such restrictive rules and regulations that are likely to increase costs
and prices and reduce the amount that can be paid out as wages.
3. PRINCIPAL OF UNION AND MANAGEMENT:- Collective bargaining should
be made an education well as a bargaining process. It should offer to trade
union leaders an opportunity to present to the managements. There should be
an honest, able and responsible leadership for only this kind of leadership
which make collective bargaining effective and meaningful. There must be
mutual confidence and good faith and a desire to make collective bargaining
effective in practice.
 ADVANCTAGE OF COLLECTIVE BARGAINING:-
1) PROVIDE SECURITY TO WORKERS:- Since collective bargaining contracts
are legally binding agreement the employee can be sure of their work condition.
As longs as all terms are followed the management cannot be go back or
changed of the condition.

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2) PROHIBITS THE STRIKES:- This is the security is provided by the

management. Collective bargaining agreement prevents any employees from
striking or not working try to get different benefits. Strikes can cause huge
problems within company. so this is a big draw for management for collective
bargaining.
3) GIVE EMPLOYEE A VOICE:- All the employee that the agreement will affects
are allowed to have a say in the condition. All voice are heard, which promotes
a much better moral in workplace. This also ensures that they want and need
of the majority are met.

4) REDUCED BIAS AND FAVORITISMS:- All too often you heard stories of
someone getting additional benefits simply because with their boss or other
irrelevant things. This is greatly reduced and possibly eliminated with the use
of collective bargaining

 DISADVANTAGE OF COLLECTIVE BARGAINING:-

1) NOT ALL PEOPLE WILL AGREE:- Collective bargaining cater to need of the
many and disagree the few. The terms in the agreement could negatively affects
employee who have special circumstances or simply do not agree.

2) A LOSS OF AUTHORITY:- When the employee knows the exactly how much
power management has, and has say in things that they can and cannot do, their
role as the authority figure is greatly diminished.

3) REDUCED MANAGEMENT HAND IN BUSSINESS:- Constructive

development is hindered when the collective bargaining is used. If the policy or
the terms of the agreements truly need to be received or removed, it is nearly
possible to do.

RENT OR THEORIES OF RENT

 MEANING
In simple words, ‘rent’ is used as a part of the produce which is paid to the
owner of land for the use of his goods and services.

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But, in economics, rent has been differently defined from time to time.
Thus rent refers only to make payments for factors of production which are in
imperfectly elastic supply. For instance, it is the price paid for the use of land.
Rent is the price or reward given for the use of land or house or a machine to
the owner. But, in Economics, “Rent” or “Economic Rent” refers to that part of
payment made by a tenant to his landlords for the use of land only.

“Rent is the income derived from the ownership of land and other free gifts of
Nature.” He further called it ‘Quasi Rent’ which arises on the manmade
equipment’s and machines in the short period and tend to disappear in the long
run. – Marshall

“Rent is the price paid for the use of land.” –Prof. Carver

 TYPES OF RENT

The main types of rent are as under:

1. Economic Rent:- Economic rent refers to the payment made for the use of
land alone. But in economics the term rent is used in the sense of economic rent.
In the words of Ricardo and other classical economists, economic rent refers to
the payment for the use of land alone It is also called Economic Surplus because
it emerges without any effort on the part of landlord. Prof. Boulding termed it
“Economic Surplus”.

2. Gross Rent:- Gross rent is the rent which is paid for the services of land
and the capital invested on it.
Gross rent consists of:
(1) Economic rent. It refers to payment made for the use of land.

(2) Interest on capital invested for improvement of land.

(3) Reward for risk taken by landlord in investing his capital.

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3. Scarcity Rent:- Scarcity rent refers to the price paid for the use of the
homogeneous land when its supply is limited in relation to demand. If all land
is homogeneous but demand for land exceeds its supply, the entire land will
earn economic rent by virtue of its scarcity. In this way, rent will arise when
supply of land is inelastic. Prof. Ricardo opined that land was beneficial but it
was also scarce. Productivity of land was indicative of the generosity of nature
but its total supply remaining more or less fixed symbolized niggardliness of
nature.

4. Differential Rent:- Differential rent refers to the rent which arises due to the
differences in the fertility of land. In every country, there exists a variety of land.
Some lands are more fertile and some are less fertile. When the farmer’s are
compelled to cultivate less fertile land the owners of more fertile land get
relatively more production. This surplus which arises due to difference in
fertility of land is called the differential rent. This type of rent arises under
extensive cultivation. According to Ricardo, “In order to increase production on
same type of land, more units of labour and capital are employed.”

5. Contract Rent:- Contract rent refers to that rent which is agreed upon
between the landowner and the user of the land. On the basis of some contract,
which may be verbal or written, contract rent may be more or less than the
economic rent.

 THEORIES OF RENT

1. Ricardian Theory of Rent:- The Classical Theory of Rent is called

“Ricardian Theory of Rent”. David Ricardo explained the theory of rent thus:
Assumptions
Ricardian theory of rent assumes the following:-
“Rent is that portion of the produce of the earth which is paid to the landlord
for the use of the original and indestructible powers of the soil”. - David
Ricardo

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1. Land differs in fertility.

2. The law of diminishing returns operates in agriculture.

3. Rent depends upon fertility and location of land.

4. Theory assumes perfect competition.

5. It is based on the assumption of long period.

6. There is existence of marginal land or no-rent land.

7. Land has certain “original and indestructible powers”.

8. Land is used for cultivation only.

9. Most fertile lands are cultivated first.

 Statement of the Theory with Illustration

Assume that some people go to a newly discovered island and settle down
there. There are three grades of land, namely A, B and C in that island. ‘A’ being
most fertile, ‘B’ less fertile and ‘C’ the least fertile. They will first cultivate all the
most fertile land (A grade) available. Since the land is abundant and idle, there
is no need to pay rent as long as such best lands are freely available. Given a
certain amount of labour and capital, the yield per acre on ‘A’ grade land is 40
bags of paddy.

Suppose another group of people goes and settles down in the same island after
some time. Hence the demand for agricultural produce will increase. The most
fertile lands [A grade] alone cannot produce all the food grains that are needed
on account of the operation of the law of diminishing returns. So the less fertile
lands [B grade] will have to be brought under cultivation in order to meet the
growing population. For the same amount labour and capital employed in ‘A’
grade land, the yield per acre on ‘B’ grade land is 30 bags of paddy. The surplus

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of 10 bags [40-30] per acre appears on ‘A’ grade land. This is “Economic Rent”
of ‘A’ grade land.

Suppose yet another group of people goes and settles down in the same island.
So the least fertile land (C grade) will have to be brought under cultivation. For
the same amount of labour and capital, the yield per acre on ‘C’ grade land is 20
bags of paddy. This surplus of ‘A’ grade land is now raised to 20 bags [40-20],
and it is the “Economic Rent” of ‘A’ grade land. The surplus of ‘B’ grade land is
10 bags [30-20]. This is the economic rent of ‘B’ grade land.

In the above illustration in ‘C’ grade land, cost of production is just equal to the
price of its produce and therefore does not yield any rent (20 - 20). Hence, ‘C’
grade land is called “no-rent land or marginal land”. Therefore, No-Rent Land
or Marginal Land is the land in which cost of production is just equal to the price
of its produce. The land which yields rent is called “intra –marginal land”.
Therefore, rent indicates the differential advantage of the superior land over
the marginal land.

 Diagrammatic Explanation

In diagram 6.3, X axis represents various grades of land and Y axis represents
yield per acre (in bags). OA, AB and BC are the ‘A’ grade, ‘B’ grade and ‘C’ grade
lands respectively. The application of equal amount of labour and capital on
each of them gives a yield represented by the rectangles standing just above the
respective bases. The ‘C’ grade land is the “no–rent land” ‘A’ and ‘B’ grade lands

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are “intra –marginal lands”. The economic rent yielded by ‘A’ and ‘B’ grade lands
is equal to the shaded area of their respective rectangles.

 Criticisms
Following are the limitations of Ricardian theory of rent.

1. The order of cultivation from most fertile to least fertile lands is

historically wrong.

2. This theory assumes that, rent does not enter into price. But in reality,
rent enters into price.

2. Quasi-Rent
Marshall introduced the concept of Quasi rent. Factors other than land say
plant and machinery are fixed in supply during short period. They earn surplus
income when demand rises. It is purely temporary as it disappears in long run
due to increase in supply. The quasi-rent is a surplus that a producer receives
in the short period over variable costs from the sale of output.

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 Distinction between “Rent” and “Quasi-Rent”

QR= Total Revenue – Total Variable Cost

“Quasi-Rent is the income derived from machines and other appliances made
by man”.-Alfred Marshall

3. The Modern Theory of Rent / Demand & Supply Theory of Rent

The classical economists’ thought that land as a factor of production was
different from other factors of production. But modern economists thought that
all the factors of production are alike and there is no basic difference between
them. Hence, a special theory was rent, developed by Ricardo is not necessary.
Therefore, economists like Joan Robinson and Boulding have contributed their
ideas for the determination of rent, which is known as the “Modern Theory of
Rent”
“The essence of the conception of rent is the conception of surplus earned by a
particular part of a factor of production over and above the minimum earnings
that is necessary to induce it to do work”-Joan Robinson

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Rent is the difference between the actual earnings of a factor of production and
its transfer earning.
Rent = Actual earning – Transfer earning.
The minimum payment that has to be made to a particular factor of production
to retain it in its present use is known as transfer earnings.

PROFIT
The entrepreneur coordinates all the other three factors (land, labour and
capital) of production. Entrepreneur is rewarded for his srvices in the form of
profit.
 Meaning of Profit
Profit is a return to the entrepreneur for the use of his entrepreneurial ability.
It is the net income of the organizer. In other words, profit is the amount left
with the entrepreneur after he has payments made for all the other factors
(land, labour and capital) used by him in the production process. However,
there are other versions also.
 Kinds of Profit

1. Monopoly Profit: Profit earned by the firm because of its monopoly

control.

2. Windfall Profit: Some times, profit arises due to changes in price level.
Profit is due to unforeseen factors.

3. Profit as functional reward: Just like rent, wage and interest, profit is
earned by the entrepreneur for his entrepreneurial function.
 Concepts of Profit

a. Gross Profit

Gross Profit is the surplus which accrues to a firm when it subtracts its Total
Expenditure from its Total Revenue.
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Gross Profit = Total Revenue-Total cost

Here cost implies explicit costs only (Normally economic cost, social cost and
environmental cost are not considered by the Accountants in India).

b. Net Profit or Pure Profit or Economic profit or True profit

Net or pure or economic or true profit is the residual left with entrepreneur
after deducting from Gross profit the remuneration for the self-owned factors
of production, which are called implicit cost.

Net Profit = Gross Profit-Implicit costs

c. Normal Profit

It refers to the minimum expected return to stay in business.

d. Super Normal Profit

Super normal profits are over and above the normal profit.

Super Normal Profit = Actual profit- Normal profit

 Theories of Profit

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1. Dynamic Theory of Profit

This theory was propounded by the American economist [Link] in 1900. To
him, profit is the difference between price and cost of production of the
commodity. Hence, profit is the reward for dynamic changes in society. Further
he points out that, profit cannot arise in a static society. Static society is one
where everything is stationary or stagnant and there is no change at all.
Therefore, there is no role for an entrepreneur in a static society. The price of
the commodities in a static society would be equal to their cost of production.
So, there would be no profit for the entrepreneur. The entrepreneur only gets
wages for management and interest on his capital.

At present several changes are taking place in a dynamic society. Changes are
permanent. According to Clark, the following five main changes are taking place
in a dynamic society.

1. Population is increasing

2. Volume of Capital is increasing.

3. Methods of production are improving.

4. Forms of industrial organization are changing.

5. The wants of consumer are multiplying.

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2. Innovation Theory of Profit

Innovation theory of profit was propounded by Joesph. [Link]. To
Schumpeter, an entrepreneur is not only an undertaker of a business, but also
an innovator in the process of production. To him, profit is the reward for
“innovation”. Innovation means invention put into commercial practice.

According to Schumpeter, an innovation may consist of the following:

1. Introduction of a new product.

2. Introduction of a new method of production.

3. Opening up of a new market.

4. Discovery of new raw materials

5. Reorganization of an industry / firm.

When any one of these innovations is introduced by an entrepreneur, it leads

to reduction in the cost of production and thereby brings profit to an
entrepreneur. To obtain profit continuously, the innovator needs to innovate
continuously. The real innovators do so. Imitative entrepreneurs cannot
innovate.

3. Risk Bearing Theory of Profit

Risk bearing theory of profit was propounded by the American economist
[Link] in 1907. According to him, profit is the reward for “risk taking” in
business. Risk taking is an essential function of the entrepreneur and is the
basis of profit. It is a well known fact that every business involves some risks.

Since the entrepreneur undertakes the risks, he receives profits. If the

entrepreneur does not receive the reward, he will not be prepared to undertake
the risks. Thus, higher the risks, the greater are the profit.

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Every entrepreneur produces goods in anticipation of demand. If his

anticipation of demand is correct, then there will be profit and if it is incorrect,
there will be loss. It is the profit that induces the entrepreneurs to undertake
such risks.

4. Uncertainty Bearing Theory of Profit

Uncertainty theory was propounded by the American economist Frank
[Link]. To him, profit is the reward for “uncertainty bearing”. He
distinguishes between “insurable” and “non-insurable” risks.
Insurable Risks:- Certain risks are measurable or calculable. Some of the
examples of these risks are the risk of fire, theft and natural disasters. Hence,
they are insurable. Such risks are compensated by the Insurance Companies.
Non-Insurable Risks:- There are some risks which are immeasurable or
incalculable. The probability of their occurrence cannot be anticipated because
of the presence of uncertainty in them. Some of the examples of these risks are
competition, market condition, technology change and public policy. No
Insurance Company can undertake these risks. Hence, they are non-insurable.
The term “risks” covers the first type of events (measurables - insurable) and
the term “uncertainty” covers the second type of events (unforeseeable or
incalculable or not measurable or non-insurable).
According to Knight, profit does not arise on account of risk taking, because the
entrepreneur can guard himself against a risk by taking a suitable insurance
policy. But uncertain events cannot be guarded against in that way. When an
entrepreneur takes himself the burden of facing an uncertain event, he secures
remuneration. That remuneration is “profit”.
INTEREST

 Meaning of Interest:

In simple meaning interest is a payment made by a borrower to the lender for

the money borrowed and is expressed as a rate percent per year.

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It is usually expressed as an annual rate in terms of money and is calculated on

the principal of the loan. It is the price paid for the use of other’s capital fund
for a certain period of time.

In the real economic sense, however, interest implies the return to capital as a
factor of production. But for all practical purposes, “interest is the price of
capital.” Capital as a factor of production, in real terms, refers to the stock of
capital goods (machinery, raw-materials, factory plant etc.).

In the money economy, however for all practical purposes capital refers to
finance or money capital i.e., the monetary fund’s lent or borrowed for any
purpose of expenditure from any source. In strict narrow sense, again, capital
may refer to only funds borrowed for real investment in business by the
business community from financial institutions.

 Definition of Interest:

1. As Prof. Marshall has said – “The payment made by borrower for the use of
a loan is called Interest.”

2. According to Prof. J. S. Mill – “Interest is the remuneration for mere

abstinences.”

3. As Prof. Keynes has said – “Interest is the reward of parting with liquidity
for a specified period.”

4. According to Seligman – “Interest is the return from the fund of capital.”

 Types of Interest:
There are two types or kinds of Interest:
(a) Net Interest,

(b) Gross Interest.

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(a) Net Interest:

The payment made exclusively for the use of capital is regarded as net Interest
or pure Interest. According to Prof. Chapman—“Net Interest is the payment
for the loan of capital when no risk, no inconveniences apart from that
involved in saving and no work is entailed on the lender.”

According to Prof. Marshall, “Net Interest is the earnings of capital simply

or the reward of waiting simply.”
ADVERTISEMENTS:

Thus, Net Interest = Gross Interest – (payment for risk + payment for
inconvenience + cost of administering credit)

i.e., Net Interest = Net Payment for the use of capital.

(b) Gross Interest:

Gross Interest according to Briggs and Jordan has said—“Gross Interest is the
payment made by the borrowers to the lenders is called Gross Interest or
Composite Interest.”

It includes payments for the loan of capital payment to cover risks for
loss which may be:
(i) A personal risks or

(ii) Business risks, payment for inconveniences of the investment and

payment for the work and worry involved in watching—investments, calling
them in and investing.

According to Prof. Marshall:

Gross Interest is that “Interest of which we speak when we say that interest is
the earning of capital simply or the reward of waiting simply, is net Interest
but what commonly passes by the name of interest, includes other elements
besides this and may be called gross interest.”

By seeing the above definitions when we add elements of payment for risk,
payment for inconvenience and the cost of administering credit to the net
Interest, it becomes gross interest.

Thus, Gross Interest = Net Interest + payment of risk + payment for

inconvenience + cost of administrating credit
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 Factors Influencing the Rate of Interest:

Interest rates vary from person to person and from place to place.

There are many factors which causes variations in Interest rates which
Eire as such:
1. Different Types of Borrowers:
There are different types of borrowers in the market. They offer different
types of securities. Their borrowing motives and urgency are different. Thus,
the risk elements differ in different cases, which have to be compensated for.

2. Due to Differences in Gross Interest:

Variations in the rate of Interest are due to differences in gross interest such
as risk and inconveniences involved, cost of keeping records and accounts and
collection of loans etc. The greater the risk and inconvenience and the cost of
management of loans, the higher will be the rate of Interest and vice-versa.

3. The Money Market is not Homogeneous:

There are different types of lenders and institutions, specialising in different
types of loans and the loan-able funds are not freely mobile between them.
The ideals of these institutions are also different. Again, there are
moneylenders and indigenous bankers in the unorganised sector of the money
market who follow their distinct lending policies and charge different interest
rates.

4. Duration of Loan or Period of Loan:

Rate of Interest also depends upon the duration or period of loan. Larger term
loans carry higher rate of Interest than short-term loans. In a long-term loan,
the money gets locked up for a longer duration. Naturally, the lender wants to
be compensated by a higher rate of Interest.

5. Nature of Security:
Interest rate varies with the type of security. Loans against the security of gold
carry less interest rates than loans against the security of gold carry less
interest rate than loans against the security of immovable property like land
or house. The more liquid are the assets the lower is the interest rate and vice-
versa.

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6. Goodwill or Credit of the Borrower:

Interest rate also depends upon the credit or goodwill of the borrower.
Persons of better goodwill and known integrity and credibility can get loans
on easy terms.

7. Amount of Loan:
The greater the amount of loan, the lower is the rate of Interest and vice-
versa.

8. Interest Policy of the Monetary Authorities:

Monetary policy of the authorities may also lead to differences in Interest
rates, e.g., the Reserve Bank of India has adopted differential interest rates
policy for the deployment of credit to the priority sectors.

9. Difference Due to Distance:

Distance between the lender and the borrower also causes differences
between Interest rates. People are willing to lend at a lower rate of Interest
nearer home than at a long distance.

10. Market Imperfections:

Differences in Interest rates are also due to market imperfections that may be
found in a loan market. Money-lenders indigenous banks, mutual funds,
commercial banks etc. follow different lending policies and charges various
Interest rates.

11. Differences in Productivity:

Productivity of capital differs from work to work or from venture to venture.
People are willing to borrow at a higher rate of Interest for productive
purposes or productive ventures and vice-versa.

 Theory of Interest

Theory of Interest # 1. Productivity Theory of Interest:

This theory of Interest was expounded by J. B. Clark and F. H. Knight. Further
Marshall, J. B. Say, Von-Thunen supported this theory.

According to this theory interest arises on account of the productivity of capital.

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The amount that labour produces with the help of capital goods is generally
larger than the amount it can produce when working by itself. Machinery and
tools invariably add to the income of those that use them. That is why they are
demanded by individual employers.

Further some classical economists hold that Interest is the reward paid to
capital because it is productive. In fact, Interest is paid out of the productivity
of capital. When more amount of capital is employed along with labour and
other resources, the over-all productivity improves.

By employing capital the borrower (entrepreneur) obtains higher production,

he ought to pay a part of this additional production to the owner of capital in
the form of Interest. The theory implies that capital is demanded because it is
productive. And, because is productive its price, i.e., Interest must be paid.

 Its Criticisms:
The important criticisms of this theory are as follows:
i. This theory is one sided:
Economists have called this theory as one-sided. It is half-truth, because it is
related only to the demand aspect of capital and it completely ignores the
supply side. If, however, the supply of capital is abundant, then, however great
the capital productivity may be, the question of Interest will not arise, or at-
least, Interest will be only normal.

ii. Considers only the higher productivity of capital:

Next, this theory suggests that when productivity of capital is higher, Interest
is payable. On the contrary if capital is in short supply, greater will be the
relative scarcity and higher will be the rate of Interest.

iii. Productivity of Capital Varies:

Again, productivity of capital varies in different industries and in different
trades. This means that Interest rates should differ from industry to industry.
However, the fact is that the pure Interest rate will be the same throughout the
market and the borrower may borrow capital for any use.

iv. Difficult to measure the exact productivity:

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It is difficult to measure the exact productivity of capital, as capital cannot

produce anything without the help of labour and other factors.

v. How much interest for consumption loans?

This theory fails to explain the Interest paid for consumption loans. Because in
practice we find that interest-bearing loans are also made for consumption
purposes.

Theory of Interest # 2. Abstinence or Waiting Theory of Interest:

This theory was expounded in 18th century by an eminent economist N. W.
Senior. According to him, “Capital is the result of Saving”. He was the first
economist to point-out that saving, which was later on embodied in capital
goods, involved a sacrifice, an ‘abstinence’ as he called it.
People may spend the whole of their income in consuming present goods. But
when they save they ‘abstain’ from present consumption. Such abstinence is
disagreeable. Hence, in order to induce people to save, we must offer them
some inducement as compensation for their sacrifice. Interest is therefore the
compensation for abstinence.

Marshall substituted the word ‘waiting’ for abstinence. Saving connotes

waiting, when an individual saves a part of his income, he does not thereby
eternally refrain from consumption. He only defers his consumption for a
certain period, i.e., till the fruits of his savings come in an increasing flow
afterwards.

Meanwhile he must wait, and as a rule people do not like to wait. Not only
saving, but all kinds of productive activity involve waiting. A farmer who sows
his crops must wait till crops are harvested. The gardener who plants a seed
must wait till it grows into a tree and begins yielding fruit.

Waiting is, therefore, a necessary condition for production. It is thus a separate

factor of production and can be substituted for other factors. Since waiting is a
factor of production, its price will be determined by the marginal analysis. That
is, the rate of interest tends to equal the reward necessary to call forth marginal
increment of saving.

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Its Criticisms:
This theory has been criticised on the following grounds:
i. This theory takes no consideration of the productivity of capital:
In fact, here the borrower uses and pays for the capital because it is productive.

ii. In this sacrifice cannot be measured:

In this theory the feeling of sacrifice or real cost of saving cannot be measured
so it is difficult to see how a given rate of Interest can be arrived at by this
theory. This theory is subjective and not amenable in practice.

iii. In this rich hardly experience any inconvenience as they have enough
money:
As we have experienced that a large part of capital comes from rich, wealthy
lenders who have a surplus of income so that they hardly experience any
inconvenience or sacrifice of consumption and they save because they do not
know what to do with their fabulous income. So mere sacrifice is no justification
for the payment of Interest.

iv. The intensity of feeling of sacrifice is also different for different

individuals:
It has been seen that many times, a person with small means gets pleasure in
saving, where as an extravagant, rich person may feel a great loss of pleasure if
he has to save. In answer to this criticism, Marshall has suggested the term
‘waiting’ to replace ‘abstinence’ in his theory which implies that a person gets
Interest as a reward for waiting i.e., by giving loans he passes on his resources
and thereby postpones his consumption for the time being, and this has to be
compensated. But Cannan was not in favour of the term ‘waiting’. In his opinion
‘waiting1 means inaction and inaction would never produce anything in real
life.
ADVERTISEMENTS:

v. This theory has been called one-sided:

Because it emphasises only the supply side, ignoring the factors leading to the
demand for saving or capital. Thus, Interest can be paid as a reward to abstain
from consumption and save resources for capital formation. Perhaps, this is
also true for certain backward modern economies.

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Theory of Interest # 3. The Austrian or Agio Theory of Interest or Bohm-

Bawerk’s “The Time- Preference Theory”:
John Rae expounded this theory in the year 1834. Further, Bohm Bawerk
developed this theory in an elaborate way. Bohm-Bawerk, an Austrian
economist, is the main exponent of this theory which seeks to explain Interest
on the basis of time-preference.

According to this theory, Interest is the price of time of reward for agio, i.e., time
preference. It has been argued that man generally prefers present income to a
future income and consumption. There is an ‘agio’ or premium on present
consumption as compared to a future one.

People prefer enjoyment of present goods to future goods because future

satisfaction, when viewed from the present, undergoes a discount. Interest is
this discount, which must be paid in order to induce people to lend money and
thereby to postpone present satisfaction to a future date. Thus, Interest is the
reward made for inducing people to change their time-preference from the
present to the future.

According to Bohm-Bawerk, the positive time-preference of people may

be attributed to the following reasons:
ADVERTISEMENTS:

a. As compared to the future or remote wants, present wants are more intensely
felt by the people.

b. Future wants are often under-estimated by people on account of various

factors like lack of will power to resist temptation, deficiency of imagination,
uncertainty about future as to whether they will be able to enjoy etc.

c. Present goods seem to have a technical superiority over future goods in a

capitalist method of production because the present goods can be invested and
re-invested immediately. Because of the higher productivity of capital, thus,
more goods can be accrued in the immediate future while the future goods can
be invested and re-invested in the remote future only.

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Theory of Interest # 4. Prof. Fisher’s Time Preference Theory:

Prof. Fisher’s Time Preference Theory is the modified theory of Bohm-Bawerk.
This theory is based on Bohm-Bawerk’s theory of Interest. While explaining this
theory Prof. Fisher has said that—Time preference theory stresses the idea that
the supply of loans depends on the fact that most people prefer to have a certain
sum of money now than at some future time.

People normally put a lower valuation on future goods than on present goods.
Because of their time preference (i.e., preference for the present than the
future) people are eager to spend their income on present consumption.
Therefore, when somebody lends to someone, he has to forgo his present
consumption.

He can be made prepared to leave his present consumption only when he is

offered some sort of reward. This reward is Interest. Higher, the eagerness to
spend on present consumption, higher will be the Interest rate. Thus, Interest
rate depends on time-preference or an eagerness to spend income on present
consumption.

In fact Fisher has defined Interest as “an index of the community’s preference
for a dollar of present over a dollar of future income.” As he has said that the
intensity of the people’s preference for present income depends on a host of
subjective and objective factors.

These have been grouped under:

(i) Willingness, and

(ii) Opportunity.

Thus, Fisher based his theory of Interest on two principles, viz.:

1. the impatience or the willingness principles, and

2. the investment opportunity principle.

He laid down that Interest is determined by the preference of the people for the
present income against future income, which in turn is determined by the
willingness principle and the investment opportunity principle.

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(a) Impatience or the willingness principles:

This depends on several factors, such as:
(i) Size of income,

(ii) Composition of income,

(iii) Distribution of income,

(iv) Uncertainty element in the future earnings,

(v) Personal attributes like foresight, precaution etc.

Some of these factors encourage people’s patience, some make them

impatience. Say, for example, when income is enough, people will be satisfied
more of current wants and discounting the future at a lower rate. If uncertainty
of future is highly estimated, the rate of impatience will tend to be high.

When the rate of willingness is lower than the market rate of Interest a person
will be willing to his income and wish to gain in future. But, if the market rate
of Interest is lower than the rate of willingness, the person would like to borrow
money and spend it on current consumption.

(b) The investment opportunity principle:

This principle is another determinant of the rate of Interest. This principle
refers to the rate of return over cost, viewed in a specific sense. To explain this
phenomenon, let us assume that an individual is confronted with alternative
investment proposals which imply two income streams that are substitutes.
Hence, when he withdraws one income stream to substitute it for another, the
loss experienced in the with-drawl is the ‘cost’, while the gain accruing from the
adopted new income stream is the ‘return’.

The rate of return over cost is, therefore, the rate of discount, which equalizes
the present net values of the investment opportunities. The rankings of
different investment proposals are decided in relation to the rate of Interest.

If the discount rate is higher than the market rate of Interest, one of the two
alternative proposals will be given up. The investment opportunity which

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carries a higher rate of return over cost will be accepted and the one which has
a lower return will be rejected.

In short, it can be said that the rate of willingness and the rate of marginal
return over cost, together determine the people’s preference for present
income rather than future income, which in turn, determines the Interest rate,
because Interest is the price paid for this preference. Fisher’s Theory, in this
way considers time-preference as the sole significant determinant of the supply
of capital and the rate of Interest.

Its criticisms:
This Time Preference Theory of Fisher has been severely criticised by many
eminent economists.

The important criticisms are as follows:

i. This theory is one sided:
Modern economists call this theory as one-sided. It explains why capital has a
supply price, but it fails to explain why capital has a demand. It completely
ignores the productivity aspect of capital.

ii. This theory fails to recognise the input of bank credit:

It considers and explains the supply of capital as the outcome of savings alone.
It does not recognise the impact of the banking system and credit creation by
commercial banks on investments and the rate of Interest.

iii. Here time-preference has little practical significance:

Economists like Erich Roll and others have stated that the very existence of
time-preference is questionable and even if it exists, it is very difficult to see
any precise significance of time-preference on the determination of Interest.

iv. This theory has been called as “Incorrect Visualization”:

To some critics, it is not proper or it is incorrect to say that a person always
prefers present consumption to the future one so that he always insist on a
premium to be paid for postponement. On the contrary, strangely enough, very
often a person is found to have realised greater satisfaction from future
consumption than the present one. Therefore, with these arguments

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economists do not call this theory as a correct principle of Interest

determination.

Theory of Interest # 5. Classical Theory of Interest or Demand and Supply

of Capital Theory of Interest:
This theory was expounded by eminent economists like Prof. Pigou, Prof.
Marshall, Walras, Knight etc. According to this theory, Interest is the reward for
the productive use of the capital which is equal to the marginal productivity of
physical capital.

Therefore, those economists who hold classical view have said that “the rate of
Interest is determined by the supply and demand of capital. The supply of
capital is governed by the time preference and the demand for capital by the
expected productivity of capital. Both time preference and productivity of
capital depend upon waiting or saving. The theory is, therefore, also known as
the supply and demand theory of waiting or saving.”

Demand for Capital:

Demand for capital implies the demand for savings. Investors agree to pay
interest on these savings because the capital projects which will be undertaken
with the use of these funds, will be so productive that the returns on investment
realised will be in excess of the cost of borrowing, i.e., Interest.

In short, capital is demanded because it is productive, i.e., it has the power to

yield an income even after covering its cost, i.e., Interest. The marginal
productivity curve of capital thus determines the demand curve for capital. This
curve after a point is a downward sloping curve. While deciding about an
investment, the entrepreneur, however, compares the marginal productivity of
capital with the prevailing market rate of Interest.

Marginal Productivity of Capital = the marginal physical product of capital x the

price of the product.

When, the rate of Interest falls, the entrepreneur will be induced to invest more
till marginal productivity of capital is equal to the rate of Interest. Thus, the
investment demand expands when the Interest rate falls and it contracts when

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the Interest rate rises. As such, investment demand is regarded as the inverse
function of the rate of Interest.

Supply of Capital:
Supply of capital depends basically on the availability of savings in the
economy. Savings emerge out of the people’s desire and capacity to save. To
some classical economists like Senior, abstinence from consumption is
essential for the act of saving while economists like Fisher. Stress that time
preference is the basic consideration of the people who save.

In both the views the rate of Interest plays an important role in the
determination of savings. The chemical economists commonly hold that the
rate of saving is the direct function of the rate of Interest. That is, savings
expand with the rise in the rate of Interest and when the rate of Interest falls,
savings contract. It must be noted that the saving-function or the supply of
savings curve is an upward-sloping curve.

Equilibrium Rate of Interest:

The equilibrium rate of Interest is determined at that point at which both
demand for and supply of capital are equal. In other words, at the point at which
investment equals savings, the equilibrium rate of Interest is determined.

This has been shown by the diagram given below:

In the figure given here OR is the equilibrium rate of Interest which is

determined at the point at which the supply of savings curve intersects the
investment demand curve, so that OQ amount of savings is supplied as well as

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invested. This implies that the demand for capital OQ is equal to the supply of
capital OQ at the equilibrium rate of Interest OR.

Indeed, the demand for capital is influenced by the productivity of capital and
the supply of capital. In turn savings are conditioned by the thrift habits of the
community. Thus, the classical theory of Interest implies that the real factor,
thrift and productivity in the economy are the fundamental determinants of the
rate of Interest.

Its Criticisms:
The theory of Interest of the classical economists has been severely criticised
by Keynes and others.

The important criticisms are as under:

i. Interest is purely a monetary phenomenon:
According to Keynes—Interest is purely a money phenomenon, a payment for
the use of money and that the rate of Interest is a reward for parting with liquid
cash (i.e., dishoarding) rather than a return on saving. Keynes has said that one
can get interest by lending money which has not been saved but has been
inherited from one’s forefathers.

It completely neglects the influence of monetary factors on the determination

of the rate of Interest. The classical economists regarded money as a ‘veil’ as a
medium of exchange over goods and services. They failed to take into account
money as a store of value.

ii. The theory of interest is confusing and indeterminate:

Keynes has said that the classical theory of Interest is confusing and
indeterminate. We cannot know the rate of Interest unless we know the savings
and investment schedules which again, cannot be known unless the rate of
Interest is known. Thus, it can be said that the theory fails to offer a determinate
solution.

iii. This theory is unrealistic and inapplicable in a dynamic economy:

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Because it assumes that income not spend on consumption should necessarily

be diverted to investment, it ignores the possibility of saving being hoarded. It
fails to integrate monetary theory into the general body of economic theory.

iv. Classicists have described the rate of interest as an equilibrating factor

between savings and investment:
But according to Keynes, “the rate of interest is not the price which brings into
equilibrium the demand for resources to invest with the readiness to abstain
from present consumption. It is the price which equilibrates the desire to hold
wealth in the form of cash.”

v. This theory is narrow in scope:

Because it ignores consumption loans and takes into account only the capital
used for productive purposes.

vi. Keynes differs with the classical economists even over the very
definition and determination of the rate of interest:
Keynes has said that Interest is the reward of parting with liquidity for a
specified period. He does not agree that Interest is determined by the demand
for and supply of capital. With these arguments Keynes has completely
dismissed the classical theory of Interest as absolutely wrong and inadequate.
He has never been agreeable with the view of classists.

Theory of Interest # 6. The Loan-Able Fund Theory of Interest:

The Neo-classical or the Loan-able Fund Theory was expounded by the famous
Swedish economist Knot Wick-sell. Further, this theory was elaborated by
Ohlin, Roberson, Pigou and other new-classical economists. This theory is an
attempt to improve upon the classical theory of Interest. According to this
theory, the rate of Interest is the price of credit which is determined by the
demand and supply for loanable funds.

In the words of Prof. Lerner:

“It is the price which equates the supply of ‘Credit’ or Saving Plus the Net
increase in the amount of money in a period, to the demand for ‘credit’ or
investment Plus net ‘hoarding’ in the period.”

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Demand for Loan-able Funds:

The demand for loanable funds has primarily three sources:
(i) Government,

(ii) Businessmen, and

(iii) Consumers who need them for purposes of investment, hoarding and
consumption.

The Government borrows funds for constructing public works or for war
preparations or for public consumption (to maintain law and order,
administration, justice, education, health, entertainment etc.). To compensate
deficit budget during depression or to invest in and for other development
purposes. Generally government demand for loanable funds is not affected by
the Interest rate.

The businessmen borrow for the purchase of capital goods and for starting
investment projects. The businessmen or firms require different types of
capital goods in order to run or expand their production. If the businessmen do
not possess sufficient money to purchase these capital goods, they take loans.

Businessmen investment demand for loanable funds depends on the quantity

of their production. Generally, the interest and firm’s investment demand for
loanable funds has also inverse relationship. It means there will be less demand
on higher Interest and more demand on lower Interest.

The consumers take loans for consumption purposes. They prefer present
consumption, they wish to purchase more consumption, goods than their
present income allows and for that they take loans. They take loans to purchase
mainly two types of consumption goods.

First, durable consumption goods and secondly to purchase consumption

goods of daily use and they generally open their accounts with the seller and go
on purchasing goods on credit basis. Besides these they take loans for
investment or speculative purposes also. Behind this they have profit motive.

Supply to Loanable Funds:

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The supply of loanable funds comes from savings, dis-hoardings and bank
credit. Private savings, individual and corporate are the main source of savings.
Though personal savings depend upon the income level, yet taking the level of
income as given, they are regarded as Interest elastic. The higher the rate of
Interest, the greater will be the inducement to save and vice-versa.

There is a positive relationship between Interest-rate and the supply of

loanable funds. It means there will be more supply of loanable funds at higher
interest and less supply on lower interest. Hence the supply curve of loanable
funds will be an upward sloping curve from left to right.

Determination of Interest Rate:

The equilibrium between the demand for and supply of loanable funds (or the
intersection between demand and supply curves of loanable funds) indicates
the determination of the market rate of interest. It has been shown in the
diagram given here.

In the diagram demand curve for loanable funds (DL) and supply curve of
loanable funds (SL) meet at point E. Therefore, E will be the equilibrium point
and OR will be the equilibrium rate of interest. At this rate of interest demand
for and supply of loanable funds both are equal to OL.

Given the supply of loanable funds, if the demand for loanable funds rises, the
Interest rate will also rise and if the demand for loanable funds falls, the Interest
rate will also fall. Similarly, given the demand for loanable funds, Interest rate
will rise with the fall in the supply of loanable funds and will fall with the rise
in the supply of loanable funds. The equilibrium rate of interest is thus
determined where SL = DL.

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Its Criticisms:
The important criticisms of this theory are as follows:
i. It has been called as indeterminate theory:
Prof. Hansen asserts that the loanable funds theory like the classical and the
Keynesian theories of Interest are indeterminate. Because according to this
theory Interest rate determination depends on savings. But saving depends on
income, income depends on investment and investment itself depends on
Interest rate.

ii. In this theory the equilibrium between demand for and supply of
loanable funds cannot be brought by the changes in interest rate:
Investment in the demand for loanable funds and savings in the supply of
loanable funds are important elements. Both saving and investment are not so
much influenced by Interest as they are influenced by the changes in income-
levels.

Besides this, it is not essential that banks would necessarily change their
Interest rate with the changes in demand for and supply of loan-able funds.
Banks determine their Interest rate keeping in view so many factors and they
would not like to make frequent changes in it. In this situation it would be
difficult to bring equilibrium in demand for and supply of loan-able funds
through the changes in the Interest rate.

iii. This theory exaggerates the effect of the rate of interest on savings:
Regarding this theory critics argue that people usually save not for the sake of
interest but out of precautionary motives and in that case, saving is Interest-
inelastic.

iv. Availability of Cash balance which is not elastic:

The loanable funds theory states that the supply of loanable hands can be
increased by releasing cash balances of savings and decreased by absorbing
cash balances into savings. This implies that the cash balances are fairly elastic.
But this does not seem to be correct view because the total cash balances
available with the community are fixed and equal the total supply of money at
any time. Whenever there are variations in the cash balances, they are, in fact,

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in the velocity of circulation of money, rather than in the amount of cash

balances with community.

v. Government influence on the demand:

Government has an important influence on the demand for and supply of
loanable funds. And it is not essential that government may always take the
decisions in view of Interest rate. Rather government generally takes the
decisions keeping in view the public Interest and not the Interest rate.

Is Loanable Funds Theory Superior over The Classical Theory?

In-spite of the weaknesses, the loanable funds theory is better and more
realistic than the classical theory on the following grounds:
a. The loanable-funds theory is more realistic than the classical theory:
The Loanable funds theory is stated in real as well as in money terms, whereas
the classical theory is stated only in real terms. The rate of interest is a
monetary phenomenon. Therefore, a theory stated in money terms seems more
realistic.

b. The loanable funds theory recognises the active role of money in a

modern economy:
To the classical school money is merely a ‘veil’, a passive factor influencing the
rate of interest. The loanable funds theory is superior because it regards money
as an active factor in the determination of the Interest rate.

c. Role of bank credit as a constituent of money supply:

Classical school of thought neglects the role of bank credit as a constituent of
money supply influencing the rate of Interest which is an important factor in
the loanable funds theory

d. Role of hoarding:
The classicists are also of this opinion and they also do not consider the role of
hoarding. By including the desire to hoard money in the demand for loanable
funds, the loanable funds theory becomes more realistic and brings us nearer
to Keynes’s liquidity preference theory.

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Theory of Interest # 7. Keynes’s Liquidity Preference Theory of Interest

or Interest is Purely a Monetary Phenomenon:
According to Keynes, Interest is purely a monetary phenomenon. It is the
reward of not hoarding but the reward for parting with liquidity for the
specified period. It is not the ‘Price’ which brings into equilibrium the demand
for resources to invest with the readiness to abstain from consumption. It is the
‘Price’ which equilibrates the desire to hold wealth in the form of cash with the
available quantity of cash.

Here Liquidity Preference Theory is determined by the supply of and demand

for money. Supply of money comes from banks and the government. On the
other hand, demand for money is the preference for liquidity. According to
Keynes people like to hoard money because it possesses liquidity.

Hence, when somebody lends money he has to sacrifice this liquidity. A reward
which is offered to make him prepared for parting with liquidity is called
Interest. Therefore, in the eyes of Keynes—”Interest is the reward for parting
with liquidity for a specific period.”

Liquidity Preference or Demand for Money:

Liquidity preference means demand for cash or money. People prefer to keep
their resources “Liquid”. It is because of this reason that among various forms
of assets money is the most liquid form. Money can easily and quickly be
changed in any form as and when we like. Suppose, you have a ten rupee note
now you can change it into either wheat, rice, sugar, milk, book or in any other
form you like. It is because of this feature of liquidity of money, people generally
prefer to have cash money.
The desire for liquidity arises because of three motives:
(i) The transaction motive;

(ii) The precautionary motive; and

(iii) The speculative motive.

(i) Transactions Motive:

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The transactions motive relates to “the need of cash for the current transactions
of personal and business exchanges”. It is further divided into the income and
business motives. The income motive is meant “to bridge the interval between
the receipt of income and its disbursement”, and similarly, the business motive
as “the interval between the time of incurring business costs and that of the
receipt of the sale proceeds.” If the time between the incurring of expenditure
and receipt of income is small, less cash will be held by the people for current
transactions and vice-versa.

(ii) Precautionary Motive:

The precautionary motive relates to “the desire to provide for contingencies
requiring sudden expenditures and for unforeseen opportunities of ad-
vantageous purchases.” Both individual and businessmen keep cash in
reserve to meet unexpected needs. Individual hold some cash to provide for
illness, accidents, unemployment and other unforeseen contingencies.
Similarly, businessmen keep cash in reserve to tide over unfavorable conditions
or to gain from unexpected deals.
(iii) Speculative Motive:
Money held under the speculative motive is for “securing profit from knowing
better than market what the future will bring forth.” Individuals and
businessmen have funds, after keeping enough for transactions and
precautionary purposes, like to gain by investing in bonds.

Money held for speculative purposes is a liquid store of value which can be
invested at an opportune moment in Interest bearing bonds on securities.
There is an inverse relationship between interest rate and the demand for
money i.e., more demands for money at lower Interest rate and less demand at
higher interest rate. Hence, the liquidity preferences curve becomes a
downward sloping curve.

Supply of Money:
The supply of money refers to the total quantity of money in the country for all
purposes at any time. Though the supply of money is a function of the rate of
Interest to a degree, yet it is considered to be fixed by the monetary authorities,
that is, the supply curve of money is taken as perfectly inelastic.

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The supply of money in an economy is determined by the policies of the

government and the Central Bank of the country. It consists of coins, currency
notes and bank deposits. The supply of money is not affected by the Interest
rate, hence, the supply of money remains constant in the short period.

Determination of Interest Rate:

According to the Liquidity-Preference Theory the equilibrium rate of interest is
determined by the interaction between the liquidity preference function (the
demand for money) and the supply of money, as presented in figure below:

OR is the equilibrium rate of interest. The theory further states that any change
in the liquidity preferences function (LP) or change in money supply or changes
in both respectively cause changes in the rate of interest. Thus as shown in
figure below, it given the money supply the liquidity preference curve (LP)
shifts from LP1 to LP2 implying thereby an increase in demand for money, the
equilibrium rate of interest also rises from to R%.

Similarly, assuming a given liquidity preference function (LP) as in fig. (b) when
the money supply increases from M1 to the rate of interest falls from R1 to R2.
Its Criticisms:

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The following major criticisms have been levelled against the Keynesian
Liquidity Preference theory of interest. By Hansen, Robertson, Knight and
Hazlitt etc. This theory has been characterised as “a college bursar’s theory”, “at
best an inadequate and at worst a misleading account”.

Important among them are as follows:

1. This theory is indeterminate, inadequate and misleading:
Prof. Hansen and Robertson maintain that the Keynesian theory of interest rate,
like the classical theory is indeterminate, inadequate and misleading. In the
Keynesian version, the liquidity preference function will shift up or down with
changes in the level of income. Particularly the liquidity preference for
transactions and out of precautionary motive. This being the function of income
and with this we know the income level. And to know the level of income we
must know the rate of interest. Robertson regards the liquidity preference
theory, “as at best inadequate and at worst a misleading account.”

2. Hazlitt’s Criticism:
Professor Hazlitt has vehemently criticised the Keynesian theory of
interest on the following grounds:
(i) It is one sided theory:
According to Hazlitt, the Keynesian theory of interest appeared to be one sided
as it ignored real factors. Keynes considered Interest to be a purely monetary
phenomenon and refused to believe that real factors like productivity and time
preference, had any influence on the rate of interest. Similarly, the classicists
also were wrong in considering Interest purely as a real phenomenon and
ignoring the monetary factors.

(ii) Role of saving has been ignored:

Keynes has ignored the element of saving, which he considered Interest as a
reward for parting with liquidity. Professor Jacob Viner has said that “without
saving there can be no liquidity to surrender. The rate of interest is the return
for saving without liquidity.” As such the element of saving cannot be ignored
in any theory of Interest.

(iii) The theory has completely failed to explain depressionary situation:

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It goes directly contrary to the facts that it presumes to explain. If the theory
were right, the rate of interest would be the highest precisely at the bottom of
a depression when, due to falling prices, people’s preference for liquidity is the
strongest. On the contrary the rate of interest is at the bottom during a
depression.

(iv) This theory is vague and confusing:

This concept is vague and confusing, because when a man holds funds in the
form of time deposits, he will be paid Interest on them; therefore he receives
both i.e., Interest cum Liquidity.

3. This theory furnishes narrow explanation of the rate of interest:

Keynes’ Liquidity-Preference Theory of Interest furnishes too narrow an
explanation of the rate of interest. In his view the desire for liquidity—an
important factor in determining the rate of interest—arises not only from three
main motives (transactions, precautionary and speculative) mentioned by
Keynes, but also from several other factors which he has not mentioned in his
theory.

4. This theory ignores productivity of capital:

Some critics are of this opinion that Interest is not a reward for parting with
liquidity as stressed by Keynes. They have written that Interest is the reward
paid to the lender for the productivity of capital. As such, Interest is mostly paid
because capital is productive.

5. It focuses attention on short-run ignores the long-period:

The Keynesian theory concentrates only on the short-run and completely
ignores the long-period of time. But from capital investment point, it is a long-
term rather than a short-term rate of interest which is of course significant.

6. There is fundamental error in Keynesian analysis:

There is confusion in Keynes’s analysis about the relation between rate of
interest and the amount of money. On the one hand, he says that the demand
for money is inversely dependent on the rate of interest and on the other, that
the equilibrium rate of Interest is inversely dependent upon the amount of

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money. Keynes has not made any distinction between the two propositions and
often uses them in an identical manner.

In the end it can be said that the Keynesian Theory of Interest is not only
indeterminate but is also an inadequate explanation of the determination of the
rate of interest. He has emphasised that Interest is purely monetary
phenomenon. That is why his theory has been named as “narrow and
unrealistic theory.

 Important Questions:-

 Short Questions (2marks):-

Q1:- Oligopoly
Q2:- Monopoly
Q3:- Price Leadership model.
Q4:- Collective Bargaining
Q5:- Profit
Q6:- Interest
Q7:- Rent
Q8:- Real v/s Nominal Interest
Q9:- Rate of Return.
Q10:- Pricing

 Long Questions (10marks):-

Q1:- What Is Market Structure? Discuss Its Types & Determinants?

Q2:- Discussed The Concept Of Perfect Competition Under Equilibrium?
Q3:- Define Monopoly? Explain Its Features & Types?
Q4:- Define Monopolistic Competition? Discuss It’s Under Short & Long Run?
Q5:- Discuss Price And Output Determination Under Collusive & Non-Collusive
Oligopoly?
Q6:- Write the detailed Note on Pricing?

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Q7:- What Is Rent? Write the detailed note on same?

Q8:- Define Interest? Discuss Its Features, Types, and Limitations?
Q9:- What Is Profit? Write the detailed note on same?

UNIT-IV

PRODUCT MARKET

 Saving and Investment

We showed previously how Crusoe could divide his GDP between

consumption and investment by dividing his time between the production
of goods he would consume immediately and goods that would yield future
benefits. In a modern society, the division is more complicated. We now
turn to the subject of what determines the division of GDP between
consumption and investment. We will also go beyond Crusoe and include
government borrowing and international trade in our discussion.

One thing that makes our task simple is that the resources for investment
come from saving. Therefore, rather than talk about how people decide
how much to consume, we will talk about how people determine how much
to save. Since income after taxes goes for either consumption or saving, it
is a matter of twiddle dee or twiddle dum.

Saving and Investment as Different Concepts

Many people confuse the concepts of saving and investment. The

differences are important, so we will spend some time on the issue.

Saving takes place when people abstain from consumption, that is, when
they consume less than their income. Investment takes place when we
purchase new capital equipment or other assets that make for future
productivity. Investment does not mean buying stocks or bonds. Here are
some important facts:

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For Robinson Cruse, the difference between saving and investment is a

distinction without a difference. Since he does all saving and all
investment, they are automatically equal. However, for the larger
economy, this is not true. Investment funds come either from our own
saving or from someone else's saving.
The motive for saving is one of deferring your consumption to a later
day. We save when we consume only part of our income now and save for
retirement, a rainy day, putting children through college, the summer
home, etc.
The motive for investment is to make money. Investment takes place
when we purchase plants or equipment, which make workers and
businesses more productive in the future.
Ultimately saving and investment must be equal, (subject to a couple of
complications that make for nice exam questions). As you will see in a
moment, you can think of saving as a supply of funds for investment and
investment as a demand for funds. We will later draw supply and demand
curves and show how saving and investment are equated.

Saving

We now want to discuss the consumer’s saving and consumption

decision. Saving is, after all income minus taxes minus consumption. Thus
S = Y – T – C.

That is,

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Saving = Income less Taxes less Consumption

 Aggregate supply curve

Firms make decisions about what quantity to supply based on the profits
they expect to earn. Profits, in turn, are also determined by the price of the
outputs the firm sells and by the price of the inputs—like labor or raw
materials—the firm needs to buy. Aggregate supply, or AS, refers to the
total quantity of output—in other words, real GDP—firms will produce and
sell. The aggregate supply curve shows the total quantity of output—real
GDP—that firms will produce and sell at each price level.

The graph below shows an aggregate supply curve. Let's begin by walking
through the elements of the diagram one at a time: the horizontal and
vertical axes, the aggregate supply curve itself, and the meaning of the
potential GDP vertical line.

The aggregate supply curve

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The graph shows an upward sloping aggregate supply curve. The slope is
gradual between 6,500 and 9,000 before become steeper, especially
between 9,500 and 9,900.

The horizontal axis of the diagram shows real GDP—that is, the level of
GDP adjusted for inflation. The vertical axis shows the price level. Price
level is the average price of all goods and services produced in the
economy. It's an index number, like the GDP deflator.

Potential GDP

If you look at our example graph above, you'll see that the slope of the AS
curve changes from nearly flat at its far left to nearly vertical at its far right.
At the far left of the aggregate supply curve, the level of output in the
economy is far below potential GDP—the quantity that an economy can
produce by fully employing its existing levels of labor, physical capital, and
technology, in the context of its existing market and legal institutions.

At these relatively low levels of output, levels of unemployment are high,

and many factories are running only part-time or have closed their doors.
In this situation, a relatively small increase in the prices of the outputs that
businesses sell—with no rise in input prices—can encourage a
considerable surge in the quantity of aggregate supply—real GDP—
because so many workers and factories are ready to swing into production.

As the quantity produced increases, however, certain firms and industries

will start running into limits—for example, nearly all of the expert workers
in a certain industry could have jobs or factories in certain geographic
areas or industries might be running at full speed.

In the intermediate area of the AS curve, a higher price level for outputs
continues to encourage a greater quantity of output, but as the increasingly
steep upward slope of the aggregate supply curve shows, the increase in

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quantity in response to a given rise in the price level will not be quite as
large.

At the far right, the aggregate supply curve becomes nearly vertical. At this
quantity, higher prices for outputs cannot encourage additional output
because even if firms want to expand output, the inputs of labor and
machinery in the economy are fully employed.

In our example AS curve, the vertical line in the exhibit shows that
potential GDP occurs at a total output of 9,500. When an economy is
operating at its potential GDP, machines and factories are running at
capacity, and the unemployment rate is relatively low at the natural rate of
unemployment. For this reason, potential GDP is sometimes also
called full-employment GDP.

Aggregate Demand Curve

Aggregate demand, or AD, refers to the amount of total spending on

domestic goods and services in an economy. Strictly speaking, AD is what
economists call total planned expenditure. We'll talk about that more in
other articles, but for now, just think of aggregate demand as total
spending.

Aggregate demand includes all four components of demand:

 Consumption
 Investment

 Government spending

 Net exports—exports minus imports

This demand is determined by a number of factors; one of them is the price

level. An aggregate demand curve shows the total spending on domestic
goods and services at each price level.

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You can see an example aggregate demand curve below. Just like in an
aggregate supply curve, the horizontal axis shows real GDP and the vertical
axis shows price level. But there's a big difference in the shape of the AD
curve—it slopes down. This downward slope indicates that increases in
the price level of outputs lead to a lower quantity of total spending.

The aggregate demand curve

The graph shows a downward sloping aggregate demand curve, showing

that, as the price level rises, the amount of total spending on domestic
goods and services declines.

Let's dig a little deeper. To fully understand why price level increases lead
to lower spending, we need to understand how changes in the price level
affect the different components of aggregate demand.

The wealth effect holds that as the price level increases, the buying power
of savings that people have stored up in bank accounts and other assets
will diminish, eaten away to some extent by inflation. Because a rise in the

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price level reduces people’s wealth, consumption spending will fall as the
price level rises.

The interest rate effect explains that as outputs rise, the same purchases
will take more money or credit to accomplish. This additional demand for
money and credit will push interest rates higher. In turn, higher interest
rates will reduce borrowing by businesses for investment purposes and
reduce borrowing by households for homes and cars—thus reducing both
consumption and investment spending.

The foreign price effect points out that if prices rise in the United States
while remaining fixed in other countries, then goods in the United States
will be relatively more expensive compared to goods in the rest of the
world. US exports will be relatively more expensive, and thus the quantity
of exports sold will fall. Imports from abroad will be relatively cheaper, so
the quantity of imports will rise. Thus, a higher domestic price level,
relative to price levels in other countries, will reduce net export
expenditures.

Truth be told, among economists, all three of these effects are

controversial, in part because they do not seem to be very large.

For this reason, the aggregate demand curve in our example aggregate
demand curve above slopes downward fairly steeply. The steep slope
indicates that a higher price level for final outputs does reduce aggregate
demand for all three of these reasons, but the change in the quantity of
aggregate demand as a result of changes in price level is not very large.

Multiplier

Introduction:

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The concept of multiplier was first developed by R.F. Kahn in his article “The
Relation of Home Investment to Unemployment” in the Economic Journal of
June 1931. Kahn’s multiplier was the Employment Multiplier. Keynes took the
idea from Kahn and formulated the Investment Multiplier.

CONCEPT OF MULTIPLIER

1. The Investment Multiplier:

Keynes considers his theory of multiplier as an integral part of his theory of

employment. The multiplier, according to Keynes, “establishes a precise
relationship, given the propensity to consume, between aggregate employment
and income and the rate of investment. It tells us that, when there is an
increment of investment, income will increase by an amount which is K times
the increment of investment” i.e., ∆Y=K∆I.

In the words of Hansen, Keynes’ investment multiplier is the coefficient relating

to an increment of investment to an increment of income, i.e., K=∆Y/∆I, where
Y is income, I is investment, ∆ is change (increment or decrement) and K is the
multiplier.

In the multiplier theory, the important element is the multiplier coefficient, K

which refers to the power by which any initial investment expenditure is
multiplied to obtain a final increase in income. The value of the multiplier is
determined by the marginal propensity to consume. The higher the marginal
propensity to consume, the higher is the value of the multiplier, and vice versa.

Assumptions of Multiplier:

Keynes’s theory of the multiplier works under certain assumptions which limit
the operation of the multiplier. They are as follows:

(1) There is change in autonomous investment and that induced investment is

absent.

(2) The marginal propensity to consume is constant.

(3) Consumption is a function of current income.

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(4) There are no time lags in the multiplier process. An increase (decrease) in
investment instantaneously leads to a multiple increase (decrease) in income.

(5) The new level of investment is maintained steadily for the completion of the
multiplier process.

(6) There is net increase in investment.

(7) Consumer goods are available in response to effective demand for them.

(8) There is surplus capacity in consumer goods industries to meet the

increased demand for consumer goods in response to a rise in income following
increased investment.

(9) Other resources of production are also easily available within the economy.

(10) There is an industrialised economy in which the multiplier process

operates.

(11) There is a closed economy unaffected by foreign influences.

(12) There are no changes in prices.

(13) The accelerator effect of consumption on investment is ignored.

(14) There is less than full employment level in the economy.

Leakages of Multiplier:

Leakages are the potential diversions from the income stream which tend to
weaken the multiplier effect of new investment. Given the marginal propensity
to consume, the increase in income in each round declines due to leakages in
the income stream and ultimately the process of income propagation “peters
out.”

The following are the important leakages:

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1. Saving:

Saving is the most important leakage of the multiplier process. Since the
marginal propensity to consume is less than one, the whole increment in
income is not spent on consumption. A part of it is saved which peters out of
the income stream and the increase in income in the next round declines.

Thus the higher the marginal propensity to save, the smaller the size of the
multiplier and the greater the amount of leakage out of the income stream, and
vice versa. For instance, if MPS = 1/6, the multiplier is 6, according to the
formula K = 1/MPS; and the MPS of 1/3 gives a multiplier of 3.

2. Strong Liquidity Preference:

If people prefer to hoard the increased income in the form of idle cash balances
to satisfy a strong liquidity preference for the transaction, precautionary and
speculative motives, that will act as a leakage out of the income stream. As
income increases people will hoard money in inactive bank deposits and the
multiplier process is checked.

3. Purchase of Old Stocks and Securities:

If a part of the increased income is used in buying old stocks and securities
instead of consumer goods, the consumption expenditure will fall and its
cumulative effect on income will be less than before. In other words, the size of
the multiplier will fall with a fall in consumption expenditure when people buy
old stocks and shares.

4. Debt Cancellation:

If a part of increased income is used to repay debts to banks, instead of spending

it for further consumption, that part of the income peters out of the income
stream. In case, this part of the increased income is repaid to other creditors
who save or hoard it, the multiplier process will be arrested.

5. Price Inflation:

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When increased investment leads to price inflation, the multiplier effect of

increased income may be dissipated on higher prices. A rise in the prices of
consumption goods implies increased expenditure on them. As a result,
increased income is absorbed by higher prices and the real consumption and
income fall. Thus price inflation is an important leakage which tends to
dissipate increase in income and consumption on higher prices rather than in
increasing output and employment.

6. Net Imports:

If increased income is spent on the purchase of imported goods it acts as a

leakage out of the domestic income stream. Such expenditure fails to effect the
consumption of domestic goods. This argument can be extended to net imports
when there is an excess of imports over exports thereby causing a net outflow
of funds to other countries.

7. Undistributed Profits:

If profits accruing to joint stock companies are not distributed to the

shareholders in the form of dividend but are kept in the reserve fund, it is a
leakage from the income stream. Undistributed profits with the companies tend
to reduce the income and hence further expenditure on consumption goods
thereby weakening the multiplier process.

8. Taxation:

Taxation policy is also an important factor in weakening the multiplier process.

Progressive taxes have the effect of lowering the disposable income of the
taxpayers and reducing their consumption expenditure. Similarly commodity
taxation tends to raise the prices of goods, and a part of increased income may
be dissipated on higher prices. Thus increased taxation reduces the income
stream and lowers the size of the multiplier.

9. Excess Stocks of Consumption Goods:

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If the increased demand for consumption goods is met from the existing excess
stocks of consumption goods there will be no further increase in output,
employment and income and the multiplier process will come to a halt till the
old stocks are exhausted.

10. Public Investment Programmes:

If the increase in income as a result of increased investment is affected by public

expenditures, it may fail to induce private enterprise to spend that income for
further investment due to the following reasons.

(a) Public investment programmes may raise the demand for labour and
materials leading to a rise in the costs of construction so as to make the
undertaking of some private projects unprofitable.

(b) Government borrowing may, if not accompanied by a sufficiently liberal

credit policy on the part of the monetary authority, increase the rate of interest
and thus discourage private investment.

(c) Government operations may also injure private investors’ confidence by

arousing animosity or fears of nationalisation.

Criticism of Multiplier:

The multiplier theory has been severely criticised by the post-Keynesian

economists on the following grounds:

1. Merely Tautological Concept. Prof. Haberler has criticised Keynes’

multiplier as tautological. It is a truism which defines the multiplier as
necessarily true as K = 1/1 – ∆C/∆Y. pointed by Professor Hansen, “Such a
coefficient is a mere arithmetic multiplied i.e., a truism) and not a true
behaviour multiplier based on a behaviour pattern which establishes a
verifiable relation between consumption and income. A mere arithmetic
multiplier, 1/1 – ∆C/∆Y is tautological.”

2. Timeless Analysis:

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Keynes’s logical theory of the multiplier is an instantaneous process without

time lag. It is a timeless static equilibrium analysis in which the total effect of a
change in investment on income is instantaneous so that consumption goods
are produced simultaneously and consumption expenditure is also incurred
instantaneously.

But this is not borne out by facts because a time lag is always involved between
the receipt of income and its expenditure on consumption goods and also in
producing consumption goods. Thus “the timeless multiplier analysis
disregards the transition and deals only with the new equilibrium income level”
and is therefore unrealistic.

3. Worthless Theoretical Toy:

According to Hazlitt, the Keynesian multiplier “is a strange concept about which
some Keynesians make more fuss than about anything else in the Keynesian
system.” It is a myth for there can never by any precise, predeterminable or
mechanical relationship between investment and income. Thus he regards it as
“a worthless theoretical toy.”

4. Acceleration Effect Ignored:

One of the weaknesses of the multiplier theory is that it studies the effects of
investment on income through changes in consumption expenditure. But it
ignores the effect of consumption on investment which is known as the
acceleration principle. Hicks, Samuelson and others have shown that it is the
interaction of the multiplier and the accelerator which helps in controlling
business fluctuations.

5. MPC does not Remain Constant:

Gordon points out that the greatest weakness of the multiplier concept is its
exclusive emphasis on consumption. He favours the use of the term ‘marginal
propensity to spend’ in place of marginal propensity to consume to make this
concept more realistic.

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He also objects to the constancy of the marginal propensity to spend (or

consume) because in a dynamic economy, it is not likely to remain constant. If
it is assumed to be constant, it is not possible “to predict with much accuracy
the multiplying effects over the cycle of a given increase in private investment
or public spending.”

6. Relation between Consumption and Income:

Keynes’s multiplier theory establishes a linear relation between consumption

and income with the hypothesis that the MPC is less than one and greater than
zero. Empirical studies of the behaviour of consumption in relation to income
show that the relationship between the two is complicated and non-linear.

As pointed out by Gardner Ackley, “The relationship does not run simply from
current income to current consumption, but rather involves some complex
average of past and expected income and consumption. There are other factors
than income to consider.”

Other economists have not been lagging behind in their criticism of the
multiplier concept. Prof. Hart considers it “a useless fifth wheel.” To Stigler, it is
the fuzziest part of Keynes’s theory. Prof. Hutt calls it a “rubbish apparatus”
which should be expunged from text books.

But despite its scathing criticism, the multiplier principle has considerable
practical applicability to economic problems as given below.

Importance of Multiplier:

The concept of multiplier is one of the important contributions of Keynes’s to

the income and employment theory. As aptly observed by Richard Goodwin
“Lord Keynes did not discover the multiplier; that honour goes to Mr. R.F. Kahn.
But he gave it the role it plays today by transforming it from an instrument for
the analysis of road building into one for the analysis of income building….It set
a fresh wind blowing through the structure of economic thought.”

Its importance lies in the following:

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1. Investment:

The multiplier theory highlights the importance of investment in income and

employment theory. Since the consumption function is stable during the short-
run fluctuations in income and employment are due to fluctuations in the rate
of investment.

A fall in investment leads to a cumulative decline in income and employment

by the multiplier process and vice versa. Thus it underlines the importance of
investment and explains the process of income propagation.

2. Trade Cycle:

As a corollary to the above, when there are fluctuations in the level of income
and employment due to variations in the rate of investment, the multiplier
process throws a spotlight on the different phases of the trade cycle.

When there is a fall in investment, income and employment decline in a

cumulative manner leading to recession and ultimately to depression. On the
contrary, an increase in investment leads to revival and, if this process
continues, to a boom. Thus the multiplier is regarded as an indispensable tool
in trade cycles.

3. Saving-Investment Equality:

It also helps in bringing the equality between saving and investment. If there is
a divergence between saving and investment, and increase in investment leads
to a rise in income via the multiplier process by more than the increase in initial
investment. As a result of the increase in income, saving also increases and
equals investment.

4. Formulation of Economic Policies:

The multiplier is an important tool in the hands of modern states in formulating

economic policies. Thus this principle pre-supposes state intervention in
economic affairs.

(a) To achieve full employment:

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The state decides upon the amount of investment to be injected into the
economy to remove unemployment and achieve full employment. An initial
increase in investment leads to the rise in income and employment by the
multiplier time the increase in investment. If a single dose of investment is
insufficient to bring full employment, the state can inject regular doses of
investment for this purpose till the full employment level is reached.

(b) To control trade cycles:

The state can control booms and depressions in a trade cycle on the basis of the
multiplier effect on income and employment. When the economy is
experiencing inflationary pressures, the state can control them by a reduction
in investment which leads to a cumulative decline in income and employment
via the multiplier process. On the other hand, in a deflationary situation, an
increase in investment can help increase the level of income and employment
through the multiplier process.

(c) Deficit financing:

The multiplier principle highlights the importance of deficit budgeting. In a

state of depression, cheap money policy of lowering the rate of interest is not
helpful because the marginal efficiency of capital is so low that a low rate of
interest fails to encourage private investment.

In such a situation, increased public expenditure through public investment

programmes by creating a budget deficit helps in increasing income and
employment by multiplier time the increase in investment.

(d) Public investment:The above discussion reveals the importance of the

multiplier in public investment policy. Public investment refers to the state
expenditure on public works and other works meant to increase public welfare.
It is autonomous and is free from profit motive.
It, therefore, applies with greater force in overcoming inflationary and
deflationary pressures in the economy, and in achieving and maintaining full
employment. Private investment being induced by profit motive can help only
when the public investment has created a favourable situation for the former.

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Moreover, economic activity cannot be left to the vagaries and uncertainties of

private enterprise. Hence, the importance of multiplier in public investment lies
in creating or controlling income and employment. The state can have the
greatest multiplier effect on income and employment by increasing public
investment during a depression where the MPC is high (or the MPS is low).

On the contrary, in periods of overfull employment, a decline in investment will

have a serious effect on the levels of income and employment where the MPS is
high (or MPC is low). The best policy is to reduce investment where the MPC is
low (or MPS is high), to have gradual decline in income and employment.

The important thing, however, is the timing of public investment in such a

manner that the multiplier is able to work with full force and there is little scope
for the income stream to peter out. Moreover, public investment should not
supplant but supplement private investment so that it could be increased
during depression and reduced during inflation. As a result, the forward and
backward operation of the multiplier will help in the two situations.

2. The Dynamic or Period Multiplier:

Keynes’s logical theory of the multiplier is an instantaneous process without

time lags. It is a timeless static equilibrium analysis in which the total effect of
a change in investment on income is instantaneous so that consumption goods
are produced simultaneously and consumption expenditure is also incurred
instantaneously.

But this is not borne out by facts because a time lag is always involved between
the receipt of income and its expenditure on consumption goods and also in
producing consumption goods. Thus “the timeless multiplier analysis
disregards the transition and deals only with the new equilibrium income level”
and is, therefore, unrealistic.

The dynamic multiplier relates to the time lags in the process of income
generation. The series of adjustments in income and consumption may take
months or even years for the multiplier process to complete, depending upon
the assumption made about the period involved.

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MONEY

 Meaning and Definitions of Money:

The word “money” is believed to originate from a temple of ‘Juno’, located on
Capitoline, one of Rome’s seven hills. In the ancient world Juno was often
associated with money. The temple of Juno Moneta at Rome was the place
where the mint of Ancient Rome was located.
Definitions of Money:
Money is one such concept which is very difficult to be restricted to some well-
defined set of words. It is very easy to understand but difficult to define. Still, a
large number of economists have given variety of definitions, some definitions
are too extensive while others are too narrow. Various economists like Prof.
Walker, Robertson, Seligman, etc., have used different characteristics for
defining it.

According to Prof. Walker, “Money is what money does”. It is associated with

the functions performed/roles played by money.
However, a suitable definition must be comprehensive and must emphasise not
only on the important functions of money but also on its basic characteristics,
namely general acceptability. Looking from this criterion, we find Crowther’s
definition to be the most suitable.
“Anything that is generally acceptable as a means of exchange (i.e., as a means
of settling debts) and that at the same time, acts as a measure and as a store of
value.” — Crowther

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This definition covers all the three important functions of money and also
stresses its basic characteristic, namely general acceptability.
Stages in the Evolution of Money:

(i) Animal Money:

In ancient India, Go-Dhan (cow wealth) was accepted as form of money.
Similarly, in the fourth century B.C., the Roman State had officially recognized
cow and sheep as money to collect fine and taxes.
(ii) Commodity Money:
The second stage in the evolution of money is the introduction of commodity
money. Commodity money is that money whose value comes from a
commodity, out of which it is made. The commodities that were used as
medium of exchange included cowrie shells, bows and arrows, gold, silver, food
grains, large stones, decorated belts, cigarettes, copper, etc.
However, the commodity money had various drawbacks such as there could be
no standardization of value for money, lacks the property of portability and
indivisibility. Therefore this form of money became an unsuitable medium of
exchange.
(iii) Coinage:
The next step is coinage. This is just like a commodity money but the commodity
is the metal that the money is made of. Thus, it can be seen that commodity
money is of two types i.e., metallic and non-metallic.

When the use of money was not so very extensive, copper could do the job but
when the number of transactions increased gradually, silver and then gold was
used as a main metal for money and coins of small denominations were
prepared either of copper or of silver.

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Metallic money at one stage were used as full bodied money, i.e., the full value
was equal to the intrinsic value of the metal.
Non-metallic commodity money was used on a large scale in our early days of
civilization.
(iv) Paper Money:
The next important stage in the evolution of money is the paper money which
replaced the metallic money. The transfer of sum of money in terms of metallic
money was both inconvenient and risky. Therefore, written documents were
used as temporary substitutes for money. Any person could deposit money
with a wealthy merchant or a goldsmith and get a receipt for the deposit.
These receipts and documents were not actual money but temporary
substitutes of money. This marked the development of paper money. These
paper notes gradually took the form of currency notes.
(v) Bank Money:
As the volume of transactions increased, paper money started becoming
inconvenient because of time involved in its counting and space required for its
safe-keeping. This led to the introduction of bank money (or credit money).
Bank money implies demand deposits with banks which are withdraw able
through cheques, drafts, etc. Cheques are widely accepted these days
particularly for business transactions. Debit and credit cards also fall under this
category.

Characteristics of Money:
1. General Acceptability:Money is accepted by all as a medium of exchange.
Thus, it has general acceptability. No one denies to accept money as a medium
of exchange. People do not hesitate to accept it as standard of payment.

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2. Measure of Value:Value of any good or service can easily be measured in

terms of money. It is accepted as a measure of value.
3. Active Agent:Money is an active agent of an economic system. In modern
economy, money is required in every commercial process. Process of
production cannot start without the participation of money.
4. Liquid Assets:Money is highly liquid asset. It can easily be converted in
goods and services. Debt, stock and bills, etc., are the other liquid assets but the
liquidity of money is highest than the other liquid assets. One has to first get to
convert other liquid assets into money, then it can be converted in desired
goods or services, while money can directly be converted.
5. Money is a Means and not an End:The word money is means to acquire
things desired. Money itself cannot be used to satisfy. It is indirectly used to get
any goods or services to satisfy human wants.
6. Voluntary Acceptability:Money is voluntarily accepted by people. There is
no requirement to get legal approval. People always wish to hold money.
7. Government Control:Reserve Bank of India and Govt, of India have an
authority to issue currency which is accepted as a form of money in India. No
other authority can issue currency notes. Thus, the government keeps control
over the money supply in the country.

Classification of Money:
Money assumes so many forms in real life that it is difficult to identify what
constitutes money and what not. Different economists have classified money in
different forms.
The more important classifications of money are as follows:

(i) Actual Money and Money of Account:

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Actual money is that which actually circulates in the economy. It is used as a

medium of exchange for goods and services in a country. For example, paper
notes of different denominations and coins in actual circulation in India
constitute the actual money. Money of account is that form of money in terms
of which the accounts of a country are maintained and transactions made.
For example, rupee is the money of account in India. Generally, actual money
and money of account are the same for a country; however, sometimes actual
money may be different from the money of account. For example, rupee and
paise is the money of account in India. In real practice, however, one paisa coin
is nowhere visible.

(ii) Commodity Money and Representative Money:Commodity money is

made up of a certain metal and its face value is equal to its intrinsic value. It is
also referred to as full-bodied money. Representative money, on the other hand,
is generally made either of cheap metals or paper notes. The intrinsic value of
the representative money is less than its face value. Currency notes and coins
are good examples of representative money in India. Representative money
may or may not be converted into full-bodied money.

(iii) Money and Near-Money:Money is anything that possesses 100 per cent
liquidity. Liquidity is the quality of being immediately and always exchangeable
in full value for money. Near-money refers to those objects which can be held
with little loss of liquidity. For example, National Savings Deposits, Building
Society Deposits and other similar deposits are not money because they are not
generally acceptable in paying debt; these, however, could be easily and quickly
exchanged for money without any loss or with minimum loss.

(iv) Metallic Money and Paper Money:This classification is based upon the
content of a unit of money. Money made of some metal like gold and silver is
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called metallic money. On the other hand, money made of paper, such as
currency notes, is called paper money.
Metallic money is sub-classified into:
(a) Standard Money, Standard money is one whose intrinsic value is equal to
its face value. It is made up of some precious metal and has free coinage.
(b) Token [Link] money is that form of money whose face value is
higher than its intrinsic value. Indian rupee coin is an example of token money.
Paper money comprises bank notes and government notes which circulate
without difficulty.

Paper money is classified into following parts:

(a) Representative paper money, which is 100 per cent backed and is fully
redeemable in some precious metal.
(b) Convertible paper money, which can be converted into standard coins at the
option of the holder. It is not fully backed by precious metals.
(c) Inconvertible paper money, which cannot be converted into full-bodied
money. Indian one rupee note is a good example of inconvertible paper money.
(d) Fiat money, which is issued by the government of the country under
emergency conditions. It does not have any backing of reserve.
(v) Credit Money:
It is also known as bank money. This consists of deposits of the people held with
the banks, which are payable on demand by the depositors. Cheques, drafts,
bills of exchange, etc., are examples of credit money.

Modern Forms of Money:

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1. Currency:The currency is a country’s unit of exchange issued by their

government or central bank whose value is the basis for trade. Currency
includes both metallic money (coins) and paper money that is in public
circulation.
(a) Metallic Money:Metallic money refers to the coins which are used for small
transactions. Coins are most often issued by the government. Examples of coins
are 50 paise coins, and 1, 2, 5 and 10 rupee coins.
(b) Paper Money:It refers to paper notes and used for large transactions. Each
currency note carries the legend, ‘I promise to pay the bearer the sum of 50/100
rupees’ depending on the value of note. The currency notes are duly signed by
the Governor of RBI.

Simply, the meaning of legend is that it can be converted into other notes or
coins of equal value. Examples of currency notes are 1, 2, 5, 10, 20, 50, 100, 500
and 2000 rupee notes.
2. Deposit Money or Bank Money:It refers to money deposited by people in
the bank on the basis of which cheques can be drawn. Customers of the bank
deposit coins and currency notes in the bank for safe-keeping, money
transferring and also to get interest on the deposited money.
This money is recorded as credit to the account of the bank’s customer which
can be withdrawn by him on his/her wish by cheques. Cheques are widely
accepted these days because transfer of money through cheques is convenient.

3. Legal Tender Money (Force Tender):Legal tender money is the currency

which has got legal sanction or approval by the government. It means that the
individual is bound to accept it in exchange for goods and services; it cannot be
refused in settlement of payments of any kind.

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Both coins and currency notes are legal tender. They have the backing of
government. They serve as money on the fiat (order) of the government. But a
person can legally refuse to accept payment through cheques because there is
no guarantee that a cheque will be honored by the bank in case of insufficient
deposits with it.
Currency is the most common form of legal tender. It is anything which when
offered in payment extinguishes the debt. Thus, personal cheques, credit cards,
debit cards and similar non-cash methods of payment are not usually legal
tenders.
Coins and notes are usually defined as a legal tender. The Indian Rupee is also
legal tender in Bhutan but Bhutanese Ngultrum is not legal tender in India.
4. Near Money:It is a term used for those which are not cash but highly liquid
assets and can easily be converted into cash on short notice such as bank
deposits and treasury bills. It does not function as a medium of exchange in
everyday purchases of goods and services.

5. Electronic Money:Electronic money (also known as e-money, electronic

cash, electronic currency, digital money, digital cash or digital currency)
involves computer networks to perform financial transactions electronically.
Electronic Funds Transfer (EFT) and direct deposit are examples of electronic
money. The financial institutions transfer the money from one bank account to
another by means of computers and communication links. A country wide
computer network would monitor the credits and debits of all individuals,
firms, and government as transactions take place in the economy.
It exchange funds every day without the physical movement of any paper
money. This would eliminate the use of cheques and reduce the need for
currency.

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6. Fiat Money:Fiat money is any money whose value is determined by legal

means. The term fiat currency and fiat money relate to types of currency or
money whose usefulness results not from any intrinsic value or guarantee that
it can be converted into gold or another currency but from a government’s
order (fiat) that it must be accepted as a means of payment.
A distinction between money and currency may be made here. The term
‘currency’ includes only metallic coins and paper notes which are legal tender
and are in actual circulation in the country. The term ‘money’ however includes
not only currency in circulation but also credit instruments. In other words, we
may say that all currency is money but all money is not currency.

Importance of Money:
Money plays a significant role in modern economy. It has an active role in
economic [Link] of money in an economy can be discussed as
below:

1. Money and Production:Money helps in various ways in the process of

production. Money can help producers to decide, plan, execute and manage the
production activities. Moreover, the existence of money helps the producers to
assess the quality and quantity of demand of a consumer.

2. Money and Consumption: Money has a great importance in consumption.

Consumers with the help of the money can easily decide, what they want and
how much. They have a ready command over the goods and services. Moreover,
they can postpone their demands, if required.
3. Money and Distribution :Money has made it possible to distribute the
reward accurately and conveniently among the various factors of production.

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The reward can be distributed in terms of wages, rent, interest and profit in the
form of money.
4. Removal of the Difficulties of Barter: There were some difficulties
attached to the barter system of exchange, i.e., lack of double coincidence of
wants, problem of measurement of value, problem of future payment, etc.
Invention of money has overcome all the difficulties of barter system. There is
no need to find double coincidence of wants and value can be measured easily
in terms of money.
5. Money and Capital Formation: Money is essential to facilitate capital
formation. Savings of people can be mobilized in the form of money and these
mobilized savings can be invested in more profitable ventures. Financial
institutions are the part of this process. They mobilize the savings and
channelize them in productive process.
6. Money and Public Finance: Public finance deals with the income and
expenditure of the government. Government receives its income in the form of
money through taxes and other means and make expenditures in development
and administrative processes.
7. External Trade: Money has facilitated trade not only inside the country but
also outside countries. With the use of money, goods and services can easily and
rapidly be exchanged. Though in external trade foreign currencies are used in
receipts and payments but they are exchanged with the help of domestic
currencies.
8. Money and Economic Development: Supply of money in a country affects
its economic development. If the money supply is more, then it may lead to
inflationary situation in the economy which may hamper growth. Similarly, if
the supply of money is lesser than what is required then there will be shortage
of liquidity which will lead to lesser investments and hence lesser employment.

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The solution of such problem has been found out on the following three
consecutions:

(1) Wholesale Value: Whatever value becomes prevalent in the wholesale

market is usually taken as wholesale value. So, the wholesale value is easy to be
found out because the value of money usually is displayed on this very base.
This is called the wholesale value of the money.
(2) Retail Value: The value prevalent in the retail market is called as retail
value. But the retail value may be perceived separately on different places. This
means the retail value will remain constant. The calculation of the retail value
is always different from one place to another and as such the base of retail price
is difficult in comparison to wholesale price.
(3) Labour Value: In order to make payment the money among the labourers
the value prevalent in such a market is usually called the value of labour. Now
the value of labour will never be constant and it will also vary from place to
place. So, it cannot be accepted as bases of value.

Evils of Money: Money is not an unmixed blessing. It is said that money is a

good servant but a bad master. Several evils of money are said to be:
(i) Economic Instability: Several economists are of the opinion that money is
responsible for economic instability in capitalist economies. In the absence of
money, saving was equal to investment. Those who saved also invested. But in
a monetized economy, saving is done by certain people and investment by some
other people. Hence, saving and investment need not be equal. When saving in
an economy exceeds investment, then national income, output and
employment decrease and economy falls into depression.
On the other hand, when investment exceeds saving, then national income,
output and employment increase and that leads to prosperity. But if the process

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of money creation and investment continues beyond the point of full

employment, inflationary pressures will be created. Thus inequality between
saving and investment are known to be main cause of economic fluctuations.

The main evil of money lies in its liability of being over-issued in the case of
inconvertible paper money. The over-issue of money may lead to hyper-
inflation. Excessive rise in prices brings suffering to the consuming public and
fixed income earners. It encourages speculation and inhibits productive
enterprises. It adversely affects distribution of income and wealth in the
community so that the gulf between the rich and poor increases.
(ii) Economic Inequalities: Money is a very convenience tool for accumulating
wealth and of the exploitation of the poor by the rich. It has created an
increasing gulf between the ‘haves’ and the ‘have-nots. The misery and
degradation of the poor is, thus, in no small measure due to the existence of
money.
(iii) Moral Depravity: Money has weakened the moral fiber of man. The evils
to be found in the affluent society are only too obvious. The rich monopolizes
all the social evils like corruption, the wine and the woman. In this case, money
has proved to be a soul-killing weapon.
(iv) Medium of Exploitation: Prominent socialist like Marx and Lenin
condemned money but it helps the rich to exploit the poor. When the
communists came to power in Russia, they tried to abolish money. But they
soon realized that to run a modern economy without money was impossible.
All economic activity has to be based on monetary calculations. Accordingly,
money is fully and firmly established in all Socialists States. Money performs
several functions like facilitating optimum allocation of the country’s resources,
functions as a medium of exchange and a measure of value, guides economic
activity and is essential for facilitating distribution of national income.
THEORIES OF MONEY

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a. Quantity Velocity Approach: Till now, the economists believed that the
price level show changes because of the changes in quantity (demand and
supply) of money. However, in the present scenario, most of the economists
have believed that quantity theory of money is not applicable in practical
situations. Quantity of money comprises cash (M) and its velocity (V).

The velocity of circulation of cash depends on various factors, such as frequency

of transactions, trade volume, type of business conditions, price levels, and
borrowing and lending policies. According to the quantity theory of money, the
changes in price level of a country occur due to changes in the quantity of
money in circulation, while keeping other factors at constant. In other words,
an increase or decrease in the price level would occur due to increase or
decrease in the quantity of money.

Therefore, it can be concluded that price level and quantity of money are
directly proportional to each other. However, in extreme conditions, an
increase in the quantity of money would lead to a proportional decrease in the
value of money, while keeping other factors at constant and vice versa.

In the quantity theory, the other factors that are kept constant are as
follows:
(a) Velocity of circulation of money:
Refers to the frequency at which a single money unit flows from one individual
to another. For example, if a ten-rupee note circulates through 10 individuals,
then the quantity of money would be 100, but not 10.

(b) Credit instruments:

Help in increasing the quantity of money. An increase in the use of credit
instruments, such as bank cheques and book credit, would lead to an increase
in the quantity of money.

(c) Barter system:

Involves transactions that take place without the use of money. Such
transactions are either discarded or considered to increase the quantity of
money.

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(d) Volume of transactions:

Requires to be constant. Volume of transactions refers not only to the amount
of goods and services exchanged, but the number of times money changes hand.

Prof. Irvin Fisher has provided a formula for explaining the relationship
between quantity of money and its value, which is as follows:
P = MV + M’V’/T

Where, P = Price level/Value of money

M = Metallic money

M’ = Credit money

V = Velocity of metallic money

V = Velocity of credit money

T = Transactions performed by money

In the preceding formula, the supply and demand of money becomes equal.
When the price level is multiplied by the transactions performed by money, it
provides the total value of transactions (PT). It is also termed as the demand
for money. PT is equal to the supply of money as it includes cash and credit
instruments along with their velocities (MV + M’V’), which is described as
follows:

PT= MV + M’V’

MV + M’V’/T

According to Fisher, in short-run, the values of T, V, and V remain constant. In

addition, the proportional change between M’ and M also remains constant.
Therefore, P and M are directly proportional to each other. In other words, the
value of money (I/P) is inversely proportional to quantity of money (M).

The other factors remain same due to various reasons. Prof. Fisher has
explained that in short run, there are no or negligible changes in the economic
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factors, such as population, consumption, production, production techniques,

technology, customer’s tastes and preferences, and circulation of money.

Therefore, the demand for money is constant in short run. With respect to the
supply of money, the circulation of money and credit is dependent on the habit
of people. The proportional change between M’ and M depends on bank
policies. Therefore, these factors also remain constant in short-run.

The quantity theory is criticized on a large scale due to its static nature. In
quantity theory, most of the factors remain constant, which is not true as real
world conditions are dynamic in nature. Therefore, all the factors in this
dynamic world keep on changing with time.

In short-run, factors, such a population, frequency of transactions, and velocity

of circulation, change either at a low rate or at high rate, but show changes.
Therefore, apart from the quantity of money, other factors may also produce
changes in level of price and consequently in the value of money.

For example, change in trade volume, better transport facilities, and increase in
credit facilities would also bring a change in the level of price. In addition, the
quantity theory has not explained the process by which the change in quantity
of money produces change in the price level. The theory also considers that
money is only used for the transaction purposes. However, it can also be held
by individuals as idle cash and savings.

Apart from this, other factors, such as M, V, M’, and V’, are not independent
factors. Among these factors, one factor can easily bring changes in other
factors. For example, change in M can produce changes in V, which further make
changes in the value of P.

b. Cash Balances Approach/Cambridge Equation:

Cash balances approach is the modification of quantity velocity approach and
is widely accepted in Europe. This approach is based on national income
approach and considers the concept of liquidity. According to cash balances
approach, the value of money depends on the demand and supply of cash
balances for a given period of time. The demand for money is not only

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dependent on the quantity of goods and services that would be exchanged, but
also on the time period at which the transaction takes place.

For example, an individual would not purchase food grains for the whole year
at once, but he/she would purchase on monthly basis. Therefore, he/she is
required to hold enough cash with him/her to buy food grains and other
products from month after month.

Thus, if in an economy individuals are habitual for holding money for

overcoming their expenditure for a longer period of time, then the demand for
money would be more. In such a case, only a small part of income is held by
individuals and rest of the amount is invested.

This is because holding a large amount of cash as idle cash would be a loss or
danger for the individual On the other hand, cash balances held by individuals
should also not be very low, so that contingencies cannot be overcome.

According to Marshall, “A man fixes the appropriate fraction (of his income)
after balancing one against another the advantages of a further ready command
and the disadvantages of putting more of his resources into a form in which
they yield him no direct income or other benefit.”

Therefore, an individual should hold a particular amount of cash with him/her

to fulfill his/her needs as well as overcome uncertainties. Let us express the
fraction of income that should be held by individuals ask.

Now, the equation usually used is as follows:

M = kpR

Where, M = quantity of money

R = real national income (total of final goods and services that are directly
consumed)

P = average price-level of real national income (average of price of clothes, food,

shelter, and services)

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pR represents the monetary national income. Now, a proportion of the

monetary national income is held in liquid form by individuals in an economy.
In addition, it also expresses the desire of individuals in an economy to have
liquid cash that is termed as liquidity for buying.

If the circulation of money takes place only once, the amount of money required
would be equal to the monetary national income. However, if circulation of
money takes place twice, then only half pR is required for buying national
product.

c. Income-Expenditure Approach:
The income-expenditure approach is given by Keynes. It is also termed as the
modern theory of money. Keynes was agreed with the concept that changes in
quantity of money produces changes in the price levels, as given in the quantity
theory of money.

However, he did not agree with the view that determining relationship between
quantity of money and price level is as easy as demonstrated by quantity
theory.

According to the modern theory of money, changes in price level are brought
by the changes in national income rather than quantity of money. The main
reason for the change in the price level is the changes that occur in the
aggregate income or expenditure. Therefore, change in quantity of money can
only bring changes in the price level when it can change the aggregate
expenditure with respect to the supply of output.

If there is no rise in the expenditure, then the demand for goods would not rise
and consequently, the price level would not increase. In case, the expenditure
rises but the supply of output is fairly elastic, then also the price level would not
rise.

Therefore, the impact of change in quantity of money would depend on

the following factors:
a. Effect of change in money supply on level of aggregate expenditure and
volume of production

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b. Type of relation between aggregate expenditure and volume of production

The amount of expenditure depends on the consumption function, investment

demand schedule, liquidity preference schedule, and supply of money. An
increase in the quantity of money would decrease the rate of interest. However,
in case the rate of interest is very low, then the increase in quantity of money
would not be able to reduce rate of interest further.

The reduced rate of interest would help in increasing the rate of investment by
individuals, which would further result in increase in income. The increase in
income would increase the aggregate expenditure of a nation. However, when
the increased quantity of money is not able to reduce the rate of interest as it is
already very low, the investment would not show any increase.

Thus, the income and aggregate expenditure would simultaneously fail to show
any type of increase. In such a case, the price level would not rise even with the
rise of quantity of money. However, it is also not guaranteed that if the increase
in quantity of money reduces the rate of interest, then price level would rise or
not.

This is because it may be possible that the proportional increase in price level
is very less as compared to increase in money supply. Therefore, it is hard to
determine relationship between changes in money supply and changes in price
level. This is because they are indirectly related to each other and depend on
aggregate expenditure and elasticity of supply of output.

National Income

 National Income

National Income is total amount of goods and services produced within the
nation during the given period say, 1 year. It is the total of factor income i.e.
wages, interest, rent, profit, received by factors of production i.e. labour, capital,
land and entrepreneurship of a nation.

Concepts of National Income

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There are various concepts of National Income, such as GDP, GNP, NNP, NI, PI,
DI, and PCI which explain the facts of economic activities.

1. GDP at market price: Is money value of all goods and services produced
within the domestic domain with the available resources during a year.
GDP = (P*Q)

Where,

GDP = gross domestic product

P = Price of goods and services

Q= Quantity of goods and services

GDP is made up of 4 Components

 consumption
 investment
 government expenditure
 net foreign exports of a country
GDP = C+I+G+(X-M)
Where,
C=Consumption
I=Investment
G=Government expenditure
(X-M) =Export minus import

[Link] National Product (GNP): Is market value of final goods and services
produced in a year by the residents of the country within the domestic
territory as well as abroad. GNP is the value of goods and services that the
country's citizens produce regardless of their location.
GNP=GDP+NFIA or,

GNP=C+I+G+(X-M) +NFIA

Where,
C=Consumption
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I=Investment
G=Government expenditure
(X-M) =Export minus import

NFIA= Net factor income from abroad.

[Link] National Product (NNP) at MP: Is market value of net output

of final goods and services produced by an economy during a year and net
factor income from abroad.
NNP=GNP-Depreciation

or, NNP=C+I+G+(X-M) +NFIA- IT-Depreciation

Where,
C=Consumption
I=Investment
G=Government expenditure
(X-M) =Export minus import

NFIA= Net factor income from abroad.

IT= Indirect Taxes

[Link] Income (NI): Is also known as National Income at factor cost

which means total income earned by resources for their contribution of land,
labour, capital and organisational ability. Hence, the sum of
the income received by factors of production in the form of rent, wages,
interest and profit is called National Income.
Symbolically,
NI=NNP +Subsidies-Interest Taxes
or, GNP-Depreciation +Subsidies-Indirect Taxes
or, NI=C+G+I+(X-M) +NFIA-Depreciation-Indirect Taxes +Subsidies

[Link] Income (PI): Is the total money income received by individuals

and households of a country from all possible sources before direct taxes.
Therefore, personal income can be expressed as follows:
PI=NI-Corporate Income Taxes-Undistributed Corporate Profits-
Social Security Contribution +Transfer Payments.

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[Link] Income (DI) : It is the income left with the individuals after the
payment of direct taxes from personal income. It is the actual income left for
disposal or that can be spent for consumption by individuals.
Thus, it can be expressed as:

DI=PI-Direct Taxes

[Link] Capita Income (PCI): Is calculated by dividing the national income of

the country by the total population of a country.
Thus, PCI=Total National Income/Total National Population

WHAT ARE THE FACTORS THAT AFFECT NATIONAL INCOME?

Several factors affect the national income of a country. Some of them have
been listed below:
1. Factors of Production
Normally, the more efficient and richer the resources, higher will be the level
of National Income or GNP
(a) Land
Resources like coal, iron and timber are essential for heavy industries so that
they must be available and accessible. In other words, the geographical
location of these natural resources affects the level of GNP.
(b) Capital
Capital is generally determined by investment. Investment in turn depends on
other factors like profitability, political stability etc.
(c) Labour
The quality or productivity of human resources is more important than
quantity. Manpower planning and education affect the productivity and
production capacity of an economy.
(d) Entrepreneur
(e) Technology
This factor is more important for Nations with fewer natural resources. The

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development in technology is affected by the level of invention and innovation

in production.
(f) Government
Government can help to provide a favourable business environment for
investment. It provides law and order, regulations.
(g) Political Stability
A stable economy and political system helps in appropriate allocation of
resources. Wars, strikes and social unrests will discourage investment and
business activities.
Methods of National Income Calculation
There are three approaches and methods of measuring National Income:
A. Income Method
• By this National Income is calculated compiling income of factors of
production viz., land, labour, capital and entrepreneur.
• National Income = Total Wage + Total Rent + Total Interest + Total
Profit
• In Indian context, since 1993 as per the System of National Accounts (SNA),
National Income is total of the following:
• GDP = Compensation of Employees + Consumption of Fixed Capital +
(Other Taxes on Production – Subsidies of Production) + Gross
Operating Surplus
• Compensation of employees: (Wage) salaries paid in cash and kind and other
benefits provided to employees.
• Consumption of Fixed Capital: wear and tear of machinery which are
replaced by new parts.
• Other Taxes on Production minus Subsidies: Net tax on production.
• There is a difference between tax on products and tax on production. Tax on
products includes taxes like sales tax and excise duty. Tax on production is tax
imposed irrespective of production like license fees and land tax.

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• Gross Operating Surplus: balance of value added after deducting the above
three components. It goes to pay rent of land and interest of capital.
B. Product Method (or Value Added Method, Output Method)
• It is used by economists to calculate GDP at market prices, which are the
total values of outputs produced at different stages of production.
Some of the goods and services included in production are:
• Goods and services actually sold in the market.
• Goods and services not sold but supplied free of cost. (No
Charge/Complementary)
Some of the goods and services not included in production are:
• Second hand items and purchase and sale of the same. Sale and purchase of
second cars, for example, are not a part of GDP calculation as no new
production takes place in the economy.
• Production due to unwarranted/ illegal activities.
• Non-economic goods or natural goods such as air and water.
• Transfer Payments such as scholarships, pensions etc. are excluded as there
is income received, but no good or service is produced in return.
• Imputed rental for owner-occupied housing is also excluded.
• Here the Gross Value of final goods and services produced in a country in
certain year is calculated.
• GDP is a concept of value added; it is the sum of gross value added of all
resident producer units (institutional sectors, or industries) plus that part of
taxes (total) less subsidies, on products which is not included in the valuation
of output.
• Gross Value Added = Output of Final Goods and Services – Intermediate
Consumption
• National Income = Gross Value Added + Indirect Taxes – Subsidies
C. Expenditure Method
• It measures all spending on currently-produced final goods and services
only in an economy.
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• In an economy, there are three main agencies which buy goods and services:
Households, Firms and the Government.
This final expenditure is made up of the sum of 4 expenditure items,
namely;
• Consumption (C): Personal Consumption made by households, the payment
of which is paid by households directly to the firms which produced the goods
and services desired by the households.
• Investment Expenditure (I): Investment is an addition to capital stock of
an economy in a given time period. This includes investments by firms as well
as governments sectors.
• Government Expenditure (G): This category includes the value of goods
and service purchased by Government. Government expenditure on pension
schemes, scholarships, unemployment allowances etc. are not included in this
as all of them come under transfer payments.
• Net Exports (X-IM): Expenditures on foreign made products (Imports) are
expenditure that escapes the system, and must be subtracted from total
expenditures. In turn, goods produced by domestic firms which are demanded
by foreign economies involve expenditure by other economies on our
production (Exports), and are included in total expenditure. The combination
of the two gives us Net Exports.
• National Income = Consumption (C) + Investment Expenditure (I) +
Government Expenditure (G) + Net Exports (X-IM)
• Calculating GDP (National Income) is extremely important as the
performance of the economy is fixed by means of this method. The results
would help the country to forecast the economic progress, determine the
demand and supply, understand the buying power of the people, the per
capita income, the position of the economy in the global arena. The Indian
GDP is calculated by the expenditure method.
Main uses of national income.
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1. Since income is a flow of wealth changes in the national income give some
indication of economic welfare.
2. National income is used to compare standards of living in different countries.
3. National income figures are used to measure the rate of growth of a country.
4. The national income accounts make it possible for an analysis of the
behaviour of the different sectors of the economy.
5. Inflationary and deflationary pressures can be estimated with the help of
national income statistics.
6 National income statistics can be used to forecast the level of business activity
at later date, and to find out trends in other annual data.
7. The national income figures are useful in providing a correct sense of
proportion about the structure of the economy.
8. In war time, the study of components of national income is of great
importance because they show the maximum possible production possibilities
of the country.
9. National income statistics can be used to determine how an international
financial burden should be an apportioned between different countries. The
quantum of national income measures the ability of a country to pay
contributions for international purposes, just as the income of a person
measures his ability to pay for the upkeep of his country.
10. Above all the national income statistics are used for planned economic
development of a country. In the absence of such data, planning will not be
possible.
Importance Of National Income
1. For the Economy:

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National income data are of great importance for the economy of a country.
These days the national income data are regarded as accounts of the economy,
which are known as social accounts.
2. National Policies:
National income data form the basis of national policies such as employment
policy because these figures enable us to know the direction in which the
industrial output, investment and savings’ etc. change, and proper measures
can be adopted to bring the economy to the right path.
3. Economic Planning:
In the present age of planning, the national data are of great importance. For
economic planning, it is essential that the data pertaining to a country’s gross
income, output, saving and consumption from different sources should be
available.
Without these, planning is not possible. Similarly, the economists propound
short-run as well long-run economic models or long-run investment models in
which the national income data are very widely used.
4. Economic Models:
Economists build short-run and long-run economic models in which the
national income data are widely used.
5. For Research:
The national income data are also made use of by the research scholars of
economics, they make use of the various data of the country’s input, output,
income, saving, consumption, investment employment, etc., which are obtained
from social accounts.
6. Per-Capita Income:

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National income data are significant for a country’s per capita income which
reflects the economic welfare of the country. The higher the per capita income,
the higher the economic welfare and vice versa.
7. Distribution of Income:
National income statistics enable us to know about the distribution of income
in the country. From the data pertaining to wages, rent, interest and profits we
learn of the disparities in the incomes of different sections of the society.
Similarly, the regional distribution of income is revealed it is only on the basis
of these that the government can adopt measures to remove the inequalities in
income distribution and to restore regional equilibrium. With a view to
removing these personal and regional disequilibria, the decisions to levy more
taxes and increase public expenditure also rest on national income statistics.

Consumption function By J.M Keynes:

J.M. Keynes, in his book ‘General Theory’ analyzed the consumption behavior
of the community on the basis of human psychology. He propounded a law
which is known as Psychological Law of Consumption.

Statement:

According to this law:

"The household sector spends a major part of its income on the purchase of
consumer goods and services such as food, clothing, medicines, shelter etc., for
personal satisfaction. The expenditure on consumption (C) is the largest
component of aggregate expenditure. Whatever is not consumed out of
disposable income is by definition called saving (S)".

Formula:

Disposable Income = Consumption + Saving

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I=C+S

Explanation:

According to Keynes, the level of consumption in a community depends upon

the level of disposable income. As income increases, consumption also
increases but it increases not as fast as income i.e., it increases at a diminishing
rate. This relationship between consumption and disposable income is
called consumption function.

In the words of Keynes:

“Men are disposable as a rule and on the average to increases their

consumption as their income increases, but hot by as much as the increases in
their income.”

Properties of Consumption Behavior of Community:

The psychological law of consumption brings out the following properties of

the consumption behavior of the community:

(i) The level of consumption is directly functionally related to the level of

disposable income = C = f(y)

(ii) With the rise in the level of income, the consumption level also rises, but at
a decreasing rate = ΔC < Δy

(iii) As the level of income increases, the households devote a part of the
increase saving. Symbolically: ΔY = ΔC + ΔS

The Keynesian consumption function is now explained with the help of

schedule and a curve.

Schedule:

($ in billion)
Disposable Consumption
Saving (S) APC (C/Y) MPC (ΔC/ΔY)
Income (Y) (C)

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0 50 -50

100 100 0 1.00 0.5

200 150 50 0.75 0.5

300 200 100 0.67 0.5

In the schedule, it is shown that as the nation’s disposable income increases, the
aggregate consumption at various levels of income also increases but at a
decreasing rate.

The same data is now shown in graph 30.1 below:

Diagram/Graph:

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Following are the observations about the functional relationship between the
national disposable income and the economy’s aggregate expenditure.

(i) At every point on the 450 line OY, a vertical line drawn to the income axis is
at the same distance from the origin as a horizontal line drawn to the
consumption axis. The 450 line thus is the line along which expenditure equals
real income.

(ii) The consumption function is represented by consumption line (C). The

consumption line C is positively sloped indicating that as the disposable income
increases, the expenditure in the economy also increases.

(iii) The consumption line (C) intercepts at Y axis showing negative saving of
$50 billion during a short period.

(iv) At point B the consumption line (C) intersects the 450 helping line (OY)
saving. At point B, consumption equals disposable income and there is zero
saving. B is called the break even point.

(v) Left to the point B, the consumption line C is above the income line Y. It
indicates negative saving.

(vi) Right to the point B, the consumption line C is below the income line Y. It
denotes positive savings.

Summing up, the relationship between consumption and disposable income

is referred to as consumption function. A consumption function tells how
much households plan to consume at various levels of disposable income.

Determinants/Factors of the Consumption Function:

There are a number of determinants/factors both subjective and objective

which determine the position of consumption function. The factors or causes of
shifts in consumption function are as fallows:

(1) Subjective Factors:

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(i) Psychological Characteristics of Human Nature: The subjective

factors affecting propensity to consume are internal to the economic system.
The subjective factors include characteristics of human nature, social practices
which lead households to refrain or activate to appending out of their income.

For example, religious belief of the people towards spending, their foresight
attitude towards life, level of education, etc. etc., directly affect propensity to
consume or determine the slope and position of the consumptions curve. The
subjective factors do not undergo a material change over a short period of time.
These remain constant in the short run.

(2) Objective Factors:

The objective factors are external to economic system. The undergo rapid
changes and bring market in the consumption function. The main objective
factors are as under:

(i) Real Income: Real income is the basic factor which determines
community’s propensity to consume. When real income of the community
increases, consumption expenditure also increases but by a smaller amount.
The consumption function shifts upward.

(ii) Distribution of wealth: If there is unequal distribution of wealth in a

country, the consumption function will also be unequal. People with low
income group have high propensity to consume and rich people low propensity
to consume. An equal distribution of wealth raises the propensity to consume.

(iii) Expectation Change in Price: If people expect prices are going to rise in
near future, they hasten to spend large sum out of a given income just after the
promulgation of first Martial Law in our country. So we can say that when prices
are expected to be high in future, the propensity to consume increases or the
consumption function shifts upward. When they are expected to be low, the
propensity to consume decreases or the consumption function shifts
downward.

(iv) Changes in Fiscal Policy: Taxes also play an important part in influencing
the propensity to consume. If the nature of taxes is such that they directly affect
the poor people and reduce their income, then the propensity to consume is
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high and if rich persons are not taxed at a progressive rate and they accumulate
more wealth, then the propensity to consume is low.

(v) Change in the Rate of Interest: A change in the rate of interest exercises
influence on the propensity to consume. When the interest rate is raised, it
generally induces people to decrease expenditure and save more for lending
purposes. On the other hand, when the interest rate is reduced, it usually
encourages expenditure as lending then becomes less attractive. So we
conclude that an increase in the rate of interest generally reduces propensity to
consume or shifts the consumption function downward and a fall in the rate of
interest usually helps to the increase of propensity to consume or shifts the
consumption function upward.

(vi) Availability of Goods: Propensity to consume is also affected by the

availability of consumption goods. If the goods are available in abundance, then
the propensity to consume increases. If they are scarce and are priced very high,
then the propensity to consume will decline.

(vii) Credit Facilities: cheap credit facilities are available in the country, the
consumption function will move upward.

(viii) Higher Living Standard: If the real income of the people increases in the
country and people adopt the use of new produce like television, washing
machines, refrigerators, care, etc., etc., the consumption function is high.

(ix) Stock of Liquid Assets: If the consumer have greater amounts of liquid
assets; there will be more desire for the households to spend out of disposable
income. The consumption function shifts upward and vice versa.

(x) Consumer Indebtedness: In case the consumer are heavily indebted and
they pay bigger monthly installments to replay the dept, then propensity to
consume is low or the consumption function shifts downward and vice versa.

(xi) Windfall Gains: If there are unexpected gains due to stock market boom
in the economy, it tends to shift the consumption function upward. They are
windfall gains. The unexpected losses in the stock market lead to the downward
shifting of the consumption curve.

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(xii) Demographic Factors: The consumption function is also influenced by

demographic factors like size of family, occupations, place of residence etc.
Persons living in cities, for instance, spend more than those living in rural areas.

(xiii) Attitude Towards Saving: If a community is consumption oriented,

there will be less saving in the country. The consumption function shifts
upward. In case, people save more and spend less, then the consumption
function will shift downward.

(ix) Demonstration Effect: If people are easily influenced by advertisements

on radio and television and seeing pattern of living of the rich neighbors, the
level of total consumption will go up.

Propensity to Consume:

Meaning and Definition of Propensity to Consume:

The classical economists were of the view that the supply of saving was
determined by the rate of interest prevailing in the country. According to them,
the higher the rate of interest, the larger is the saving and so less is the
consumption.

Keynes disagreed with the above view. According to him interest is not the
primary determinant of an individual’s saving and consumption decisions. It is
primarily the individual’s real income which determines his, saving and
consumption decisions. J.M. Keynes has developed two concepts:

(i) Average Propensity to Consume.

(ii) Marginal Propensity to Consume to Analyze the Consumption Function.

Explanation:

These two concepts are now explained in brief:

(1) Average Propensity to Consume (APC):

Average propensity to consume ( APC) may be defined as:

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Definition:

"A ratio of total consumption to total disposable income for different levels of
disposable income It is calculated by dividing the amount of consumption by
disposable income for any given level of income".

Example:

For instance, when nation’s disposable income is $2,000 billion, consumption

expenditure is $1,500 billion, the average propensity to consumption is
1500/2000 = 0.75.

This shows that out of the disposable income of $2,000 billion, 75% will be used
for consumption purposes. The APC declines as income increases because the
proportion of income spent on consumption decreases. The average propensity
to consume spent on consumption decreases. The average propensity to
consume at any level of income is expressed in equation as C/Y. Here C stands
for consumption Y for income.

Formula:

APC = C
Y

Diagram:

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In the Fig.(30.2) income is plotted on OX axis and consumption along OY. CC

curve represents the propensity to consume schedule. At point K, the average
propensity to consume is equal to 0.62.

KL/OL = (C/Y) i.e., 2500/4000 or 25/40 = 0.62

APC implies a point on the curve C which indicates the ratio of income
consumed. The C curve is made up of a series such points.

(2) Marginal Propensity to Consume (MPC):

Definition:

The concept of marginal propensity to consume is very important is macro

economics. J.M. Keynes has defined marginal propensity to consume (MPC):

"As the relationship between a change in consumption (ΔC) that resulted from
a change in disposable income (ΔY)".

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Formula:

It is found out by dividing change in consumption to a given change in

disposable Income.

MPC = Change in Consumption = ΔC

Change in Income ΔY

Example:

Thus we make this concept clear by taking an example, let us suppose the
disposable income rises from $2000 billion to $3000 billion ( by $1000 billion)
and the consumption expenditure increases from $1500 billion to $2000 billion
(by $500 billion). The marginal propensity to consume is:

ΔC/ΔY = 500/1000 = 1/2 = 0.5

All the concepts of consumption function are now explained whit help of
schedule and a diagram.

Schedule For Propensity to Consume:

($ in billion)
Disposal Income Consumption Average Marginal
(Y) Expenditure (C) Propensity to Propensity to
Consume (APC = Consume (MPC =
C/Y) ΔC/ΔY)

A 1000 1100 1.1 800/1000 = 0.9

B 2000 2000 1.0 600/1000 = 0.6

C 3000 2600 0.86 500/1000 = 0.5

D 4000 3100 0.77 300/1000 = 0.3

E 5000 3400 0.68 200/1000 = 0.2

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F 6000 3600 0.6 100/1000 = 0.1

G 7000 3700 0.53

The reader can easily understand from the above schedule that with the
increase in the disposable income, the propensity to consume decreases and
conversely with a fall in income, the propensity to consume and the marginal
propensity to consume increases. The consumption schedule can also be
explained with the help of a curve which is given below:

Diagram For Propensity to Consume:

In the figure (30.3), disposable income is measured along the horizontal axis
OX and consumption along the vertical axis OY. Let us now draw 450 helping
line from O to ON. If we take any point on the 450 helping line, income will be
exactly equal to expenditure. The curve AG represents the income consumption
schedule, indicating the propensity to consumer at various levels of income.

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Point A which is above 450 helping line, shows us that the expenditure is greater
than its income.

This deficit in income can be converted either by borrowing or from the sale of
assets. At point B, consumption expenditures exactly equal to disposable
income and there is neither saving nor dis-saving. This point is known is
as break even point.

 Inflation
The aggregate demand increases due to expenditure by the households, firms
and government (usually excessive spending by the government). This increase
in demand due to expenditure by either government or households can be
effectively controlled by fiscal measures. Thus, fiscal policy and budgetary
measures are the effective weapons to control demand-pull inflation.

In case, government expenditure is the main cause behind the demand-pull

inflation, then it can be controlled by cutting down the public expenditure.
With a cut in public expenditure, the government demand for goods and
services decreases along with a decrease in the private income and
consumption expenditure. In case, the demand rises due to the rise in private
expenditure, taxing income is the most appropriate way to control inflation.
The taxation on private income reduces the disposable income in hand, as a
result of which the consumption expenditure also reduces. This results in the
reduction in aggregate demand.

In case of a very high persistent inflation rate, the government may adopt
both these measures simultaneously to control inflation. Such as along with the
reduction in public expenditure the rate of taxation shall be raised on the
private income to keep the demand under control. This kind of policy of using
both the measures simultaneously is called as “ Policy of Surplus
Budgeting,” which says that “government should spend less than the tax
revenue.”

characteristics of inflation may be summarized as under:

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1. Inflation is always associated with a rise in prices which is continuous and

persistent. It should be distinguished from price rise which may occur
temporarily or during a cyclical upswing.

2. Inflation is a dynamic process which can be observed over the long period.

3. Inflation is basically an economic phenomenon. It originates within the

economic system and is fostered by interaction of economic forces.

4. Excess of demand over the available supply is the hall mark of inflation. It is
a condition of economic disequilibrium.

5. Inflation is generally considered a monetary phenomenon for it is normally

characterized by an excessive money supply. Though all increases in the stock
of money may not be inflationary yet a persistent rise in prices cannot be
sustained unless the quantity of money rises as well.

6. Inflation may be caused by ‘demand-pull’ factors or ‘cost push’ factors or both

working together.

7. Inflation is always cumulative in the sense that a mild inflation in the first
instance gathers momentum leading to rapid price rises. Its effects on an
economy depends on how rapid it is.

 Types of Inflation:

1. Creeping Inflation:
‘Creeping inflation occurs when there is a sustained rise in prices over time at
a mild rate, say around 2 to 3 percent per year. It is also known as ‘mild
inflation’. This type of inflation is not much of a problem.
It is generally known as conducive to economic progress and growth. In this
form the prices rise gradually over a long period.

2. Walking or Trotting Inflation:

When the rate of rise in inflation is of international range of 3 to 8 percent per
annum, it is called walking or trotting inflation. It is an alarming signal for the
government to control it before it worsens.

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3. Running Inflation:
When the sustained rise in prices is over 8 percent and generally around 10
percent per annum, it is called running inflation. It normally shows two-digit
inflation. Running inflation is a warning signal indicating the need for
controlling it. It affects the poor and middle class people adversely.

4. Hyper or Galloping Inflation:

Hyperinflation occurs when monthly increase in prices is 20 percent to 30
percent or more. At this stage there is no limit to price rise, and price rise goes
out of control. Money becomes almost worthless causing severe hardship to
people. There is complete collapse of currency, the monetary system collapses
and the economic and political life gets disrupted.

5. Open Inflation:
Inflation become open when there is no barrier to price rise. It occurs in the
economy where there are no control and checks on price rise. Rising prices by
large magnitude is the symptom of open inflation.

6. Suppressed Inflation:
Suppressed inflation refers to a situation when there exists inflationary
pressures in the economy but prices are controlled by certain administrative
measures, such as price-control and rationing. The increase in prices are
suppressed (or repressed) here. However, prices rise by large magnitude after
the price controls are removed.
The symptoms of suppressed inflation are long queues of buyers at government
controlled ration shops and the existence of excess demand and black- markets.
The controls ensued by the government on the prices of essential commodities
in times of war is an example of suppressed inflation.

Theories of Inflation
The theories of inflation try to explain the causes of inflation and can be studied
from the perspective of:

 Demand-pull Inflation
Definition: The Demand-pull Inflation occurs when, for a given level of
aggregate supply, the aggregate demand increases substantially. In other

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words, demand-pull inflation exists when the aggregate demand increases

rapidly than the aggregate supply.

The increase in aggregate demand may be due to:

 Monetary Factors, i.e., an increase in the supply of money

 Real Factors, i.e., an increase in the demand for real output
Demand-pull Inflation due to Monetary factors: The increase in money
supply more than the increase in potential output is one of the major reasons
for demand-pull inflation. Let’s see how the money supplies causes the
demand-pull inflation. At a given level of output, when the monetary and real
sectors are in equilibrium, then the economy is also in equilibrium. Since the
economy is in general equilibrium, the general price level corresponding to it is
called as equilibrium price level.

With an increase in the money supply, the other things remaining the same, the
real stock of money at each price level increases. As a result, the interest rate
decreases and the people’s desire to hold money increases. With a decrease in
the interest rates, the investment also increases, which leads to more income.

The increase in income causes an increase in the consumption expenditure and

thus, a rise in investment and consumption expenditure increases the
aggregate demand and aggregate supply, other things remaining the same.
This increase in the aggregate demand is exactly proportional to the
increase in the money stock. Thus, a rise in aggregate demand, for a given
level of aggregate supply, leads to an increase in the general price level in the
economy, which may be inflated.

Demand-pull Inflation due to Real Factors: The following are some of the
real factors that cause demand-pull inflation in the economy:

 Increase in government expenditure without any change in the tax

revenue.
 Cut in the tax rates without any change in the government expenditure.
 Upward shift in the Investment Function
 Downward shift in the Saving Function

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 Upward shift in the Export Function

 Downward shift in the Import Function.
The first four factors directly contribute towards an increase in the level of
disposable income. Since the aggregate demand being the function of
income, an increase in aggregate income leads to an increase in the aggregate
demand, thereby causing the demand-pull inflation. Let’s see how real factors
cause demand-pull inflation.

Suppose, the government increases its spending financed through external

borrowings from abroad. The rise in government expenditure generates
additional demand and thus, the aggregate demand increases. Since it is
assumed that there is full employment, then the additional resources can be
acquired only by bidding a higher price. As a result, the prices rise while the
output remains unchanged.

Thus, the transaction of demand for money increases and in order to meet the
increased demand for money people sell their financial assets such as bonds
and securities. Eventually, the prices of bonds and securities go down and the
rate of interest increases. In the product market, the price rises to such a level
that the additional spending by the government is absorbed by such price rise.
This shows that the real factors also cause inflation.

 Cost-push Inflation
Definition: The Cost-Push Inflation occurs when the price rise due to the
increase in the price of factors of production, Viz. Labor, raw materials, and
other inputs which are essential for the final production of a product. As a
result, the aggregate supply decreases, demand remaining the same, an
increase in the price of commodities leads to an overall increase in the general
price level.

Often, the cost-push inflation is caused by the monopolistic groups in the

society such as labor unions and firms operating in monopolistic and
oligopolistic market setting. The following are the major kinds of cost-push
inflation:

1. Wage-push Inflation: The Strong labor unions force the money wages to go
up, due to which the price increases. This kind of rise in the general price level

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is called as wage-push inflation. The powerful and well-organized labor

unions exercise their monopoly power and compel their employers to increase
their wages above the competitive level irrespective of their productivity
(output).

An increase in wage money brings a corresponding increase in the cost of

production and this increase in the cost of production causes an aggregate
supply curve to shift backward (aggregate supply decreases). A backward shift
in the aggregate supply causes the prices level to go up. It is to be noted that
every time a rise in the wage money is not considered to be inflationary. The
following conditions supplement this:

 Increase in wage rate due to an increase in the productivity.

 Rise in wage rate due to inflation caused by other factors.
 Rise in wage where the unionized wage bill is very small.
 Wage rises due to the shortage of labor.

2. Profit-push Inflation: The profit-push inflation is attributed to the monopoly

power exercised by the firms under the monopolistic and oligopolistic market
that tries to enhance their profit margins by keeping the prices relatively high.

The wage-push inflation and profit-push inflation goes hand-in-hand,

which means as the labor unions force their employer to increase their wage
money the cost of production also increases. And in order to meet the increased
cost, the monopolistic and oligopolistic firms raise the price level often more
than proportionately. This is done to enhance the profit margins of the firm. If
this process of; a hike in the price of the commodity following an increase in the
wage money continues, then this is called as ‘profit-wage spiral.’

3. Supply-Shock Inflation: This kind of cost-push inflation is caused due to

an unexpected decline in the supply of major consumer goods and key
industrial inputs. Such as the prices of food product shoots up due to a crop
failure and the prices of key industrial inputs Viz. Coal, iron, steel, etc., increases
because of the natural calamities, lockouts, labor strikes, etc.

Also, the prices may rise due to the supply bottlenecks in the domestic economy
or international events (generally, war), thereby restricting the movement of

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internationally traded goods. As a result, the supply decreases and the import
of industrial inputs increases.

 Measures to Control Inflation

 Monetary Measures to Control Inflation

The monetary measures which are widely used to control inflation are:

1. Bank Rate Policy: The bank rate policy is used as an important instrument to
control inflation. The Bank rate, also called as the Central Bank rediscount
rate is the rate at which the central bank buys or redsicounts the eligible bills
of exchange and other commercial papers presented by commercial banks to
build their reserves. Here, the central bank performs the function as “lender of
the last resort”.The bank rate policy as a monetary measure to control
inflation work in two ways:

 During inflation, the central bank raises the interest rates due to which
the borrowing costs go up. As a result, commercial bank borrowings from
the central bank reduces. With the reduced borrowings from the central
bank, the flow of money from the commercial bank to the public also gets
reduced. This is how the bank credit decides the extent to which the inflation
is controlled.
 The bank rate sets the trend for general market interest rate, specifically
in the short-run. As the central bank raises the interest rate with a view to
curtailing the money supply in the market, the commercial banks also raise
their commercial borrowing rates for the public, thereby making the
borrowings dear. Other general market rate follows the suit and with the
decreased borrowing capacity of individual, the inflation is controlled due to
reduced money flows to the society.

2. Variable Reserve Ratio: The variable reserve ratio, also called as the Cash
Reserve Ratio(CRR) is a certain proportion of total demand and time deposits
that the commercial banks are required to maintain in the form of cash reserves
with the central bank.

The cash reserve ratio is often determined and imposed by the central bank
with a view to controlling the money supply. When the central bank raises the
CRR, the lending capacity of the commercial banks reduces due to which the

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flow of money from the banks to the public also decreases. Thus, it helps in
controlling the rise in the price to the extent it is caused by the bank credit to
the public.

3. Open Market Operations: The open market operations are characterized by

the sale and purchase of government securities and bonds by the central
bank. The central bank buys and sells the government securities and bonds to
the public through commercial banks. The government securities are sold via
commercial banks such that a certain amount of bank deposits is transferred to
the central bank. As a result, the credit creation capacity of the commercial
banks reduces. Thus, the flow of money from the banks to the public also gets
reduced.

 Fiscal Measures to Control Inflation

Definition: The Fiscal Measures to Control Inflation is comprised of

government expenditure, public borrowings, and taxation. The Keynesian
economists, also called as “Fiscalist” assert that the demand-pull inflation is
caused due to an excess of aggregate demand over aggregate supply.

The aggregate demand increases due to expenditure by the households, firms

and government (usually excessive spending by the government). This increase
in demand due to expenditure by either government or households can be
effectively controlled by fiscal measures. Thus, fiscal policy and budgetary
measures are the effective weapons to control demand-pull inflation.

In case, government expenditure is the main cause behind the demand-pull

inflation, then it can be controlled by cutting down the public expenditure.
With a cut in public expenditure, the government demand for goods and
services decreases along with a decrease in the private income and
consumption expenditure. In case, the demand rises due to the rise in private
expenditure, taxing income is the most appropriate way to control inflation.
The taxation on private income reduces the disposable income in hand, as a
result of which the consumption expenditure also reduces. This results in the
reduction in aggregate demand.

In case of a very high persistent inflation rate, the government may adopt
both these measures simultaneously to control inflation. Such as along with the

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reduction in public expenditure the rate of taxation shall be raised on the

private income to keep the demand under control. This kind of policy of using
both the measures simultaneously is called as “ Policy of Surplus
Budgeting,” which says that “government should spend less than the tax
revenue.”

Effects of Inflation:

The main effects of inflation and higher prices in India are discussed
below:

(I) Effect on Production:

During inflation, the producers and businessmen gain in the short-period.
Usually the cost of production does not rise as fast as the price of their product
and so there is an artificial margin of profit. As against this, they may also be
affected adversely in the long run. If the price level goes on increasing, the total
consumption of their product would fall.
The reduced consumption will ultimately raise the cost of production per unit
and reduce the profits.

1. Misallocation of Resources and Disrupted Price Mechanism:

Inflation disrupts the smoothness of price mechanism. It finally ends in mal-
adjustments in production. Producers turn towards more production of luxury
goods which are non-essential over essential commodities, from which they
expect higher profits.

2. Hoarding:
In times of inflation, people, like traders hoard stocks of essential commodities
with an idea to earn more profits in the near future. As a result, the available
supply of goods in relation to increasing monetary demand, decreases. This
results in black marketing, i.e., artificial scarcity of goods in the market.

3. Encourages Speculation:
A non-anticipated steep rise in prices creates a situation of uncertainty in the
economy. People indulge more in speculative activities than in increasing
production.

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4. Lack of Quality Control:

Inflation tries to create a sellers’ market. Sellers get a command on prices
because of excessive demand in the market. In such conditions, the sellers
overlook the quality of their goods, instead they concentrate more on earning
great profits.

(II) Effect on Distribution of Income:

Inflation redistributes income because prices of all factors do not rise in the
same proportion. Here, prices rise faster but incomes do not. There is an
inequality in distribution of wealth. During inflation, producers and traders are
the gainers. As a result, rich get richer and poor get poorer. It leads to
concentration of wealth in the hands of a few rich people.

1. Effect on the Working Class:

Labour is the lowest paid class. This class is badly affected by inflation,
especially if the prices of the basic necessities of life rise steeply. It adversely
affects the family budget of the working class. Their consumption level goes
down tolling upon their health and lowering their efficiency. It may also create
unrest.
No doubt, through trade unions, workers may manage to get increased
dearness allowance but this does not provide them with desired relief. Price
hike generally precedes any increase in dearness allowance. In turn, the
increased wages further push up the price level owing to an increased demand.
A vicious circle is formed, resulting in wage-push or cost push inflation.

2. Effect on Fixed Income Groups:

This group includes pensioners, government servants, owners of government
securities and promissory notes and others who get a fixed money income.
They are known as renters. This class is worst affected by inflation because the
purchasing power of their fixed income goes on decreasing with rising prices.

3. Effect on Debtors and Creditors:

Debtors gain when they pay back their debt during inflation. It is because the
value of money was high when they borrowed but came down when they repaid
their debts. As against this, the creditors are losers during inflation. However,
if debtors take loans during inflationary period, the position is reversed. In that
case, the debtors are losers and the creditors are gainers.

(III) Other Effects:

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1. Cost Increases:
As prices increase, cost of projects both in private and public sectors goes-up.
Consequently, the total outlay of each plan exceeds the one provided as per
original plan yet physical targets are not fully achieved.

2. Effect on Economic Development and Reduction in Savings:

Due to rise in prices, economic development of a country has adverse effects on
savings and investments.

3. Wage Spiral:
A rapid increase in prices is not suitable as workers demand more wages. Under
such circumstances, wages are raised to compensate the workers. Thus, price
spiral affects the economy.

4. Effect on Foreign Investment:

A rapid increase in prices has an adverse effect on the foreign investment in the
country. Foreign investors do not invest their money in those countries where
the value of money is falling on account of rise in prices. Value of money falls
and the investors suffer losses.

5. Adverse Balance of Payment:

Price rise has an adverse effect on the export of the country. Exporters fail to
increase the exports to the desired extent. Actually, our exportable become
relatively expensive in the world market, resulting in the fall of export and our
importable become relatively cheaper, this increases our [Link] demand
for country’s exports decreased and imports increased. Therefore, balance of
payment continues to be unfavourable.

6. Lack of Confidence in the Currency:

Money stops functioning as money because people lose confidence in currency
and do not like to hold it. In 1923, during hyperinflation in Germany people
refused to accept ‘Marc’ as their unit of currency. Money was replaced by Barter
system because people preferred goods over money.

7. Social and Moral Degradation:

Inflation leads to thefts and robberies because some people would like to get
an income in undesirable ways so as to survive. Corruption breeds during
inflation and moral ethical values take a down stride.
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8. Effect on Political Stability:

Continued inflation results in shaking the foundation of any political system. It
even results in the fall of any government.

TRADE CYCLE

Business Cycle:- The term business cycle is referred to the recurrent ups and
downs in the level of economic activity that extend over a period of time. The
business fluctuations occur in aggregate variable such as national income,
employment and price level.

Business cycle is also called as “Trade Cycle” Business Cycle-Martin Thomas

Characteristics of Business Cycle

1. Movement in Economic Activity : A trade cycle is a wave-like movement

in economic activity showing an upward trend and a downward trend in
the economy.
2. Periodical : Trade cycles occur periodically but they do not show the
same regularity.
3. Different Phases : Trade cycles have different phases such as Prosperity,
Recession, Depression and Recovery.
4. Different Types : There are minor and major trade cycles. Minor trade
cycles operate for 3-4 years, while major trade cycles operate for 4-8
years or more. Though trade cycles differ in timing, they have a common
pattern of sequential phases.
5. Duration : The duration of trade cycles may vary from a minimum of 2
years to a maximum of 12 years.
6. Dynamic : Business cycles cause changes in all sectors of the economy.
Fluctuations occur not only in production and income but also in other
variables like employment, investment, consumption, rate of interest,
price level, etc.
7. Phases are Cumulative : Expansion and contraction in a trade cycle are
cumulative, in effect, i.e. increasing or decreasing progressively.

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8. Uncertainty to businessmen : There is uncertainty in the economy,

especially for the businessmen as profits fluctuate more than any other
type of income.
9. International Nature : Trade Cycles are international in character. For
e.g. Great Depression of 1930s.

 Types of Business Cycle

1. The Minor Cycle:-This is also known as Short Kitchin Cycle. This has gained
popularity after the name of the British economist Joseph Kitchin in the year
1923. He made a research and came to this conclusion that a cycle takes place
within duration of approximately 30 to 40 months.

2. The Major Cycle:-This has been emphasised as the fluctuation of business

activity between successive crises. This is also known as “The Long Jugler
Cycle.” A French economist Clement Jugler showed that the periods of
prosperity, crisis and liquidation followed each other always within a span of
the average of nine and half years.

3. The Very Long Period Cycle:-This is also known as Kondratieff Cycle. This
was propounded by N. D. Kondratieff the Russian economist in the year 1925.
He has written that there are longer waves of cycles of more than fifty years
duration.

4. Kuznets Cycle:-This type of business cycle was propounded by the famous

American economist Professor Simon Kuznet. His view was that the secular
swing of the cycle generally occurs in between 7 to 11 years and this can show
effect within that period.

5. Building Cycles:-Such cycles are associated with the name of two American
economists namely Warren and Pearson. They expressed their views in World
Prices and the Building Industry book in the year 1937. Their view was that
business cycle occurs in the duration of an average of 18 years and the cost of
such cycle has major effect on building construction and on the industrial
development.

Phases of Business Cycle

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1. Prosperity: Expansion & Peak When there is an expansion of output,

income, employment, prices and profits, there is also a rise in the
standard of living. This period is termed as Prosperity phase.

 Rise in the national output & trade

 Rise in consumer and capital expenditure
 Rise in the Price of raw materials and finished goods
 Rise in the level of income & employment Business Cycle-Martin
Thomas.

2. Recession & Turning Point During a recession period, the economic

activities slow down. When demand starts falling, the overproduction and
future investment plans are also given up. There is a steady decline in the
output, income, employment, prices and profits. Business Cycle-Martin Thomas

3. Depression & Trough When there is a continuous decrease of output,

income, employment, prices and profits, there is a fall in the standard of living
and depression sets in.

During the phase of Depression:

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 The growth rate become negative

 The level of national income and expenditure declines
 Price of consumer and capital goods decline
 Workers lose their job Business Cycle-Martin Thomas

4. Recovery Phase As the recovery gathers momentum, some firms plan

additional investment; some undertake renovation programmes, and some
undertake both. These activities generate construction activities in both
consumer & capital goods sector. As a result more employment is generated
and wage rates moving upward. Business Cycle-Martin Thomas.

 Causes of Business Cycle

 External Factors of Business Cycle

1. Wars. In war days all the available resources are utilized for the production
of weapons which greatly affect the product of both capital and consumer
goods. This fall in production decreases income, profits which further create
unemployment. These create contraction in the economic activity.

2. Postwar Period. In the post war period the level of consumption and
investment goes upward. Both the government and individuals involve the
construction (houses, roads, bridges etc). All these activities increases the
effective due to which the economic variables, output, income and employment
goes upward.

3. Scientific Development. Another cause of business cycle is scientific

development. Every day new products come to the markets like mobile phone,
laptops etc. These products require huge amount of investment through which
new technology of production is adopted. All this increases income,
employment and profit etc. and plays an important part in the revival of
economy.

4. Gold Discoveries. The discoveries of gold and mines stimulate the volume
of international trade and help in adjusting trade deficit, loans etc. the rising
income lead to expansion in economic activity.

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5. Surplus, Exports and Foreign Aid. Surplus, exports and foreign aid raises
the level of consumption and investment spending which helps in increasing
output, income and employment level.

6. Weather. Weather is one of the causes of business cycle. It is an important

factor which can cause economic activities. If in any year, weather is good the
output of agricultural sector will goes upward.

7. Population Growth Rate. Population growth rate is one the factors of

business cycle. If the population growth rate is higher than the economic
growth rate, income level and consumption expenditure and savings will be
low.

 Internal Factors of Business Cycle

Internal causes of business cycle are those, which are built in within economic
system. These are the internal factors of business cycle:

[Link] Factors. According to Pigou business cycle appears because

of the optimistic and pessimistic mood of the entrepreneur. When
entrepreneurs are in optimistic about future market conditions they take up
investment. Here the expanses phase of business cycle starts which ultimately
ends in a boom.

On the contrary, the pessimism reduces investment, production, employment

and shifts to downward trend in business activity.

[Link] Supply. Hawtrey and Friendman relate trade cycle to fluctuation in

money and credit supply. If there is expansion in money and credit supply,
there will be raise in economic activity. If there is contraction there will be
down fall in economic activity.

[Link] Investment. Hayek relates business cycle to variation in capital goods

industries. Excessive investment in capital goods industries brings upswing
and downswing when there is a fall in investment.

[Link] Efficiency of Capital (MEC). According to Keynes changes in the

rate of marginal efficiency of capital are responsible for business cycle. When

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the rate of marginal efficiency of capital gets higher the expansion phase of
trade cycle commences. There is a contraction phase when the rate of marginal
efficiency of capital is lower.

 Measures to Control Business Cycles or Stabilisation Policies:

Various measures have been suggested and put into practice from time to time
to control fluctuations in an economy. They aim at stabilising economic activity
so as to avoid the ill-effects of a boom and a depression. The following three
measures are adopted for this purpose.

1. Monetary Policy:

Monetary policy as a method to control business fluctuations is operated by the

central bank of a country. The central bank adopts a number of methods to
control the quantity and quality of credit. To control the expansion of money
supply during a boom, it raises its bank rate, sells securities in the open market,
raises the reserve ratio, and adopts a number of selective credit control
measures such as raising margin requirements and regulating consumer credit.
Thus the central bank adopts a dear money policy. Borrowings by business and
trade become dearer, difficult and selective. Efforts are made to control excess
money supply in the economy.

To control a recession or depression, the central bank follows an easy or cheap

monetary policy by increasing the reserves of commercial banks. It reduces the
bank rate and interest rates of banks. It buys securities in the open market. It
lowers margin requirements on loans and encourages banks to lend more to
consumers, businessmen, traders, etc.

 Limitations of Monetary Policy:

But monetary policy is not so effective as to control a boom and a depression. If

the boom is due to cost- push factors, it may not be effective in controlling
inflation, aggregate demand, output, income and employment. So far as
depression is concerned, the experience of the Great Depression of 1930s tells
us that when there is pessimism among businessmen, the success of monetary
policy is practically nil.

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In such a situation, they do not have any inclination to borrow even when the
interest rate is very low. Similarly, consumers who are faced with reduced
incomes and unemployment cut down their consumption expenditure. Neither
the central bank nor the commercial banks are able to induce businessmen and
consumers to raise the aggregate demand. Thus the success of monetary policy
to control economic fluctuations is severely limited.

1.. Fiscal Policy:

Monetary policy alone is not capable of controlling business cycles. It should,

therefore, be supplemented by compensatory fiscal policy. Fiscal measures are
highly effective for controlling excessive government expenditure, personal
consumption expenditure, and private and public investment during a boom.
On the other hand, they help in increasing government expenditure, personal
consumption expenditure and private and public investment during a
depression.

[Link] during Boom:

The following measures are adopted during a boom. During a boom, the
government tries to reduce unnecessary expenditure on non-development
activities in order to reduce its demand for goods and services. This also puts a
check on private expenditure which is dependent on the government demand
for goods and services. But it is difficult to cut government expenditure.
Moreover, it is not possible to distinguish between essential and non-essential
government expenditure. Therefore, this measure is supplemented by taxation.

 Important Questions:-

 Short Questions (2marks):-

Q1:- Money
Q2:- National Income
Q3:- inflation
Q4:- Trade Cycle
Q5:- Aggregate demand
Q6:- Investment Multiplier
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Q7:- Foreign Trade

Q8:- Liquidity preference
Q9:- unemployment
Q10:- What is Near Money?
Q11:- What is meant by quantity theory of Money?
Q12:- Define the concept of supply of money.
Q13:- GDP
Q14:- Uses of money?
Q15:- Explain Inside money and outside money?
Q16:- Re-statement of Quantity Theory of money?

 Long Questions (10marks):-

Q1. Define Business Cycle? Discuss the various phases and types of business
cycle?

Q2. Explain the features of Multiplier. Show it’s forward and backward working.
What are its main limitations?

Q3. What are the leakages of multiplier?

Q4. Distinguish between static multiplier and dynamic multiplier. Explain them
with the help of appropriate graphs?

Q5. Write the detailed note on Foreign Trade Multiplier?

Q6. What is Inflation? Discuss its Theories of Inflation & How to control it?

Q7. What are causes of Inflation? Critically examine the effects of Inflation on
different sections of society.

Q8. What is inflation? Distinguish between demand-pull inflation and cost-push

inflation. Suggest measures to control cost-push inflation.

Q9. Explain the various types of Unemployment in India? Suggest some

measures to overcome the problem of unemployment.

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Q10. What are the methods of measuring national income? What conceptual
problems arise in estimating national income?

Q11. What is the income method of estimation of national income? What

precautions should be taken while using income method?

Q12. Define Money? Discuss its functions, types & limitations of money?

Q13. Examine the liquidity preference theory of Interest. What are its main
defects?

Q14. Explain Cambridge cash balance approach of the quantity theory of

money. How does it differ from the Fisher's transactions approach?

Q15. Explain measures to control money supply in the economy.

Q16. What is the income method of estimation of national income? What

precautions should be taken while using income method?

Last page

Reference/Source:

o Managerial Economics, TR Jain, V.K Publications

o Managerial Economics, P.N Chopra, Kalyani Publishers
o Micro Economics, H.L Ahuja, S.C Chand
o Macro Economics, P.N Chopra, Kalyani Publishers
o [Link]
o [Link]
o [Link]
o [Link]
o [Link]

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