SUBJECT :MANAGERIAL ECONOMICS

UNIT 01 : INTRODUCTION TO MANGERIAL ECONOMICS

OBJECTIVES
After going through this unit, you will be able to:

 Describe the meaning of Economics.

 Distinguish various economics technological term.
 Apply economic principles which help in making business decisions.
 Compare the relationships of Managerial Economics with other subjects.

STRUCTURE
1.1 Introduction
1.2 Definition of economics & Managerial Economics
1.3 Managerial economics, its nature & scope
1.4 Application of managerial economics in business decision making
1.5 Application of managerial Economics in business
1.6 Summary
1.7 Keywords
1.1 INTRODUCTION
The business managers have to take appropriate decisions to reach their goals and
attain their objectives. The managers have to optimize the output at the lowest cost and to
earn more profit. The study of economics helps them in applying economic logic, tools,
methodology, concepts, and theories of economic analysis to achieve the objectives of the
firm. The world is dynamic and is ever changing, hence the managers have to keep abreast
with the modern and latest knowledge. The managers have to use the modern tools to get the
desired results to fight the complexities and challenges of business. The study of Managerial
economics helps the managers to take proper decision to achieve their goals.

1.2 DEFINITIONS
Managerial economics refers to the integration of Economic principles,
methodologies and practices for the purpose of facilitating decision making
and forward planning by the management within the given situation. It focuses
in identifying the problems and solving the problems by taking proper
decision. For example a manager has to decide whether he should get the work
done by hiring labor or give it to an outside contractor.

Different economist have defined economics differently

Dr. Alfred Marshall: “Economics is the study of mankind in the ordinary

business of life; it examines the part of individual and social action which is

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 most closely connected with the attainment and with the use of material
requirements of well being”. This definition gives more importance on the
welfare of human being. In the modern world there is need of human welfare
and it has become the policies of all the governments in the world.

Prof. Lionel Robins: “Economics is the science which studies human

behavior as a relationship between ends and scarce means which have
alternative uses. This definition shows that wants are unlimited and means are
limited and scarce and the means can be put to other alternate uses.

Unlimited wants are natural for human beings and all wants cannot be satisfied
at a time, hence he has to adopt the method of choice. He tries to select that
choice, which gives him maximum satisfaction. Available means can be used
in various ways. All the economic problems arise due to scarce means and
unlimited ways to use those means. This leads to choice among most
competing ends. This is the main cause of basic problems for the study of
economics. Economics deals with optimum utilization of scarce resources to
achieve the objectives and to maximize profit of the firm.

Economics is applied in decision making. It is that branch of economics which

operates as a link between abstract theory and managerial practices.. It is based
on economic analysis for identifying, problems, organizing, information and
evaluating alternatives. Suppose your have Rs.100/- to spend. You have many
choices, such as buy a book; or go to a picture or entertain friends. If you make
one of the choices, you cannot think of other choices at all. But you will make
a choice which will give you maximum satisfaction.
Study of economics mainly divided into 2 broad sections:

MICRO-ECONOMICS & MACRO-ECONOMICS

MICRO-ECONOMICS: 

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

 Micro economics has to study the performance of Individual units in the economy at
present and in future. If the share of factors of production increases, it means an
increase in income of an individual. This will lead to an increase in the demand of all

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 the products and it will increase the economic activities. In other words we can say that
if the purchasing power of an individual increases his demand of various goods and
services will also increase. Another example can further give the picture of the
consumer. With a fall in price of a product the demand for that product increases and if
the price rises the demand decreases.
 It also reveals the cost of production of a product and how is it priced. Here we also
study the concept of elasticity of demand.
 How different factors of production get their share in the nation income It also gives
the idea of welfare economics

MACRO-ECONOMICS: 

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

1.3 MANAGERIAL ECONOMICS - Nature And Scope

Nature of Managerial Economics

 It is essentially MICRO economics in nature.

 It is pragmatic.
 It is normative.
 It uses some of the theories of macro economics
 It is problems solving of business in nature.
 Economics has limited application and has to study multidimensional areas which
include social, cultural, religious, political and international environment.
 Every happening in the world affect the economy of the country for example
recession in US has affected the economies of Europe, china, Japan and still its effect
is felt in the world.
 Microeconomics deals with individual units of an economy such as an individual, or a
firm and their related matter. It is a practical subject and goes beyond providing
abstract theoretical framework for managers.
This main source of concepts and analytical tools for management is found in the study of
economics. It studies essentials of demand and supply, marginal cost, short run and long run
cost, different forms of markets such as perfect competitive, monopoly, monopolistic
competition, and oligopoly and how these markets operate regarding pricing of the product
and output.

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Macro economics deals in forecasting of demand in order to plan for future needs of capital
and investment. This is based on market demand at macro level and individual, organization
demand at micro level.
At Macro level we study the theory of income and employment, Trade cycle and its effects of
the economy. Different causes of inflation, recession and depression. Further we have to
study the role of the government and its policies to meet these challenges in the economy.
Scope of Managerial Economics

Managerial Economics is a very useful subject. It explains and clarifies most of the major business
problems such as:

 Estimation of product demand and source of supply of various factors. Analysis of product
demand and plan the production schedule.
 Decide the input combination to obtain maximum output at minimum cost.
 Estimation and analysis cost of the product. And how the cost of the product can be
reduced.
 Analysis of price of the product and try to push the product in the market as per the market
conditions.
 Study of the market structure. Profit maximization and planning.
 To Plan and control capital expenditure.
 To evaluate the various policies adopted by the government and judge the effects of it on
the business.

1.4 APPLICATION OF MANAGERIAL ECONOMICS IN DECISION

MAKING
 Demand is the origin of all economic activities hence it needs a special attention. Here
estimation of demand is very important. Estimation of demand depends on various
factors such as income, distribution of income, likes and dislikes of the people, their
culture and the way of life.

 When we are using inputs we have to use various scarce resources and their
combination to get maximum output at a minimum costs by avoiding any wastage.

 Pricing of the product is another important issue which has to be decided after
studying various factors such as elasticity of the demand and the market structure i.e.
competitive market, monopoly, monopolistic competition, and oligopoly. There is
also a need to estimate the demand and how long the demand will last.

 It studies the concept of production function, optimum utilization of resources,

inventory management, and maximization of sale.

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  Market structure also decides pricing system based on elasticity of demand of the
product

 To maximize profit and plan to maximize it depend on the decision of the managers
who base their decision after study of the market

 How to utilize the capital so that it can bring maximum returns .This is a very
important.

 Capital budgeting and study of relationship between inputs and outputs.

 Planning for future by using multi disciplinary approach by using tools provided by
accounting, finance, marketing, and quantitative analysis by using scientific methods.

1.5 APPLICATION OF MANAGERIAL ECONOMICS IN A BUSINESS

Managerial Economics and Marketing.

o Planning for product demand in coming year.

o Forecast demand for different product and draft strategies and tap new market.

Managerial Economics and Finance.

o Forecast the cash flow of the organization on the basis of demand and supply
o Pricing strategy and earning and profit.

Managerial Economics and HR.

o How much manpower required in coming days.

o Required skill availability

Managerial Economics is used all the streams directly or indirectly.

Managerial economics and other social sciences.
The part of Sociology, Psychology and other social sciences is equally helpful in Managerial
economics and are used for market research and behavior of the society. Sociology shows the
social effect of social life. We have to use many conventional concepts have to be used as
society and social life needs them. E.g. Gifts at the time marriage is a social custom. Lot of
expenditure is done in marriage.

1.6 SUMMARY
Managerial Economics refers to the application of principles of economics in decision making
in the business. It uses the help from accounting and other subjects like mathematics, statistics,

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.operational research, sociology psychology etc. It uses the help of account, production, marketing
techniques and finance to take decision. Managerial economics is applied economics and based on
normative economics Managerial economics has to decide:

What to produce? .
How to produce?
How much to produce? 
For whom to produce?
At what cost it is to be produced? 
How to decide price?
Managerial economics has to study the market, determine the demand based on forecasting
and other circumstances. While pricing the product it has to study elasticity of demand,
income of the people and has to prepare strategy for increasing its profit and its share in the
market.
It has many tools given by other social and natural sciences such as social set up, religion,
mathematics, statistics, operational research, capital management and pricing. Finance has
greater role to play in the study of managerial economics.But the scope of Economics is
wider than the scope of managerial economics.

UNIT 02 ;DEMAND ANALYSIS

OBJECTIVES
After going through this unit, you will be able to: 

 Explain the concept of utility and its importance. 

 Explain the concept of demand.
 Study the law of demand.
 Draw demand schedule and curves.
 Discuss the exceptions to the law of demand. 
 Evaluate the importance of the law of demand. 
 State factors which affect demand other than price.

STRUCTURE
   2.1  Introduction 
2.2  Concept of utility 
2.3  Meaning of demand
2.4  Types of demand
2.5  Determinants of demand
2.8  Summary 
2.9  Keywords 

2.1 INTRODUCTION

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

2.2 THE CONCEPT OF UTILITY

The concept of utility is very important because the demand of a product depends
upon its utility to the buyer. More utility means more demand and more prices.

Meaning of utility
It is want satisfying power of a commodity. If man is thirsty he quenches his
thirst by taking a glass of water. Here water has UTILITY because it has the power to satisfy
human want and sometime a person is prepared to pay for it. So we can define utility as
satisfying power of a commodity.

Law of diminishing marginal utility.

The LAW OF DIMINISHING MARGINAL UTILITY was formulated by
Prof. Marshall. According to Prof. Marshall
The law means “more a person has anything the less he wants to have more of it.” That
means the value of that product goes on diminishing as a person acquires more and more of
it.

Explanation of the law of diminishing marginal utility

The law states that as a consumer increases the consumption of a product, the
utility gained from the successive units goes on decreasing.
For example if a man is thirsty he takes a glass of water which gives him good satisfaction
and if he takes the second glass of water he will get less satisfaction than what he got from
the first glass of water. If he continues to take further the satisfaction he gets, goes on
decreasing and a time will come when instead of giving satisfaction he gets dissatisfaction.
Assumptions of Law of DMU

There should be Rational Behavior which means his means choosing those
goods and that quantity which gives maximum                            satisfaction.
No change in the taste and fashion, likes and dislikes 
No change in income of the person
Consumer always prefers more quantity. 
Constant utility of money.

Application of the Law of DMU

 It gives the idea of value-in-use and value-in-exchange. For example Water has a
very high value in use but less value in exchange because water supply is very high

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 hence its value is less. Similarly the price of diamond is more in exchange but it has
less value in use.
 Application to Money: The law of DMU applies to money also and the tax system in
the whole world is based on this concept. Man by nature would like to have more and
more money. But as the stock of money goes on increasing its value goes on
decreasing. For example a person X has an income of Rs.3000/-PM and another person
Y has an income of Rs. 50,000/- P.M. If X loses 10/- he will search for it but if Y loses
100/- he will not bother much because the value of money to the poor is high and to the
rich is low. Hence the rich pay higher taxes than the poor.
 The Law of demand can be derived from the law of DMU and it also helps to
analyze why price falls. The Law of demand clearly indicates that a fall in price of a
commodity the demand for it increases and the marginal utility goes on decreasing of
the commodity. This law explains the idea of redistribution of the national income in
the society and it has greater affect on the development of an economy because the
poor, if have money, go for purchasing the goods and services more and more. This
will increase demand. This will increase more production and more economic activities
and economic growth.

Limitations of the law of DMU or situations where DMU does not apply.

 Suitable unit - If a thirsty person is given a spoonful of water, he will like to have
more and more till he has consumed reasonable quantity and till then this law will not
apply here.
 Time gap - If a person has his breakfast at 8.00 AM and next food he is offered at 8
PM he will get more satisfaction by consuming food at 8 PM because the time gap is
longer.
 This law does not apply to eccentric person. For example a drunkard would like to
have more and more drinks. Similar is the case of a miser who is not happy with what
he has but would like to accumulate more and more wealth.
 No change in the quality of the product it means the law will not apply if successive
units are of superior quality. For example if a person is eating ordinary mangoes he
gets some satisfaction. But if he given the best quality of mango he will likely to get
more satisfaction.

2.3 DEMAND
Meaning of demand
Demand means effective demand. Demand is defined as the quantity of goods or
services desired by an individual backed by the ability and willingness to pay at particular
time and at particular price.

The elements of demand are

o Desire,
o Backed by money
o Willingness to pay and part with the money.

If any one of the elements is missing, it will not lead to demand.

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 o A beggar has a desire to eat but he has no money so his demand cannot be
fulfilled.

o Secondly if a man has desire and he has money but he is not prepared to
part with it. This will not be a demand, for example the case of a miser who
wants the goods but is not prepared to part with the money. So his demand
cannot be fulfilled.

o Thirdly a man has desire and prepared to pay for the product but has no
money. In this case his demand is fulfilled if he gets the goods on credit. In the
modem time most of the durable goods (white goods) are purchased on EMI
basis and the financial companies are prepared to finance such transactions. This
has completely changed the pattern of demand in the market.

Demand is the core of almost all the major activities and decisions of a firm.

Law of Demand and exceptions to the law of demand.

o All things remaining the constant (ceteris paribus) when the price of a
product increases the demand of the product decreases and if the price reduces
the demand increases.

It means that demand is the function of price i.e dd=f (p) 

Demand and price are inversely related but not proportionally 
The equation of demand is: DD=a-bP,

o Here P is the price and a & b are constant. This shows that initial demand
will remain constant whatever be the price of the product may be for that we
have used sign a, b is again constant but it represents functional relationship
between demand and price. b is having (-) sign which denotes negative function
and shows downward slopping demand curve.

Exceptions to the Law of Demand

Under the following situations the law of demand is not applicable

o Giffen goods
o Costly luxury items
o Speculative goods
o Out dated goods, out of fashion goods
o Goods in short supply

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There are certain goods whose demand increases with the rise in its price.

Giffen goods: 
These goods are inferior goods consumed mostly by the poor as essential
commodities e.g. BAJRA. The demand of these goods increases as the price rises and vice
versa. Consumers spend a considerable portion of their limited income on these goods.
For example A poor man income is Rs. 200/- and he needs 30 kg of grains to survive.
The price of BAJRA is Rs 5/-Kg and of wheat Rs.10/- per kg. He consumes 20kgs of BAJRA
and 10 kgs of wheat. Now the price of BAJRA rises to Rs.6/- per kg. Now he can buy 20 kg
of BAJRA and 8 kg of wheat to meet his needs. This happens because of Giffen goods.

Costly luxury goods: 

These are not essential goods and are consumed by the rich only. Here when the price
increases the demand for these goods also increases. Because the rich people attach a lot of
value to costly luxury goods that distinguish them from the common people and these goods
have prestige value for the rich. If the price of gold falls, the demand from the rich will come
down and if the price of gold rises the demand will increase.

Speculative goods: 
Such as shares which are traded in the share market which do not follow the law of
demand. In speculation a further rise in price is expected by the investor and the traders buy
more and hold them to sell the shares at a higher price later.

Outdated goods: 
These goods are generally desired by the people and these are durable goods such as
radio, TV, telephones. When anything becomes outdated the people would not buy them. For
example the demand for black and white TV has become negligible even though the prices
have fallen. This also applies to seasonal goods, e.g. the demand of raincoat is always in rainy
season.

Goods in short supply: 

The supply of certain goods is uncertain; hence even if the price is going up the
people would like to buy them because of uncertainty.For example when the shortage of
sugar is felt the people are prepared to pay more to buy sugar to avoid inconvenience. Hence
in above circumstances the law of demand does not apply.
Demand Schedule
This demand schedule and demand curve clearly indicates that as the price of milk
decrease the demand for milk increases and when the price increases the demand for milk
decreases.

Shift in the Demand Curve

Shift in demand curves happens when price has no role to play and other factors other
than price affect the demand of the product. Sometimes even if there is no change in the price
of a product the demand increases or decreases.
For example if some guests visit you so you have to buy more goods and services to
serve the guests. You may buy more milk, tea leaves and sugar. When some family members
leave the house for a few days the demand is reduced of some goods.

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 The shift can be due to reduction or increase in income of a person. Price of substitute
goods has fallen so the demand of the original goods is reduced. The goods have become out
of fashion and taste or there is a change in technology.

I. Demand Shifts

 Increase in Demand: We represent an increase in demand by an outward shift in

the curve (from D1 to D2). In the graph below at the price p1, demand has increased
from Q1 to Q2. At every price there will be a greater demand than there was before the
'shock' of increased demand. We could expect this to describe the effect of an increase
in income or an increase in the size of potential demanders. If the economy was
expanding rapidly and families had more income to spend on education, or if high
school grades were having real problems finding jobs Increase/Decrease in Quantity.

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

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

o Direct demand & indirect demand.

o Derived and autonomous demand.
o Price demand, income demand, cross demand.
o Joint demand and composite demand.
o Individual demand and market demand.
o Demand for durable and non-durable Goods.
o Demand for Perishable good and non- perishable goods.

Direct Demand and Indirect Demand

Direct demand of goods is demand of those goods and services which are directly
consumed by the ultimate consumer. These goods are used for final consumption by the
consumers the examples of such goods are bread, butter, milk, tea and ready-made garments,
service of a doctor etc.

Indirect demand consists of those goods which are not directly consumed by the
consumer but these are used by producers for the production of other goods. These are also
known as producers demand. Example - The demand for machine, tools, raw material, is
known as indirect demand.

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 Also sewing machine is demanded by a house wife to stitch clothes for the family it is
a direct demand but when a tailor uses the sewing machine for making shirts, blouses etc it is
indirect demand for the machine.
 
Derived and Autonomous Demand
It is just like indirect and direct demand. The demand for cotton for making shirt is a
derived demand whereas the demand for milk is autonomous demand. Let us say that the
demand for shirts have gone up it will force the producers to produce more by increasing the
demand for cloth.

Price Demand
It refers to different quantities of a product or service that a consumer would like to
buy at a given time, and at a given price, other things remaining constant. It is related to price

Income Demand
It refers to the situation where different quantity of goods or services would be
purchased by the consumer at various levels of income. If income increases demand for
various goods would also increase but the demand for basic food shall remain the same. And
with the higher income the consumer may substitute superior quality of goods replacing
inferior goods. For example the income of a consumer increase he may demand more goods
and secondly he may substitute superior quality of rice to inferior quality of rice

Cross Demand
This refers to the demand of interrelated good. E.g. tea & coffee .Increase in the price
of tea will increase the demand for coffee.

Joint Demand
It means when more than one commodity is required to satisfy a demand. For
example to satisfy the demand for tea, consumer requires tea leaves, milk, sugar etc.

Composite Demand:
Any commodity can be put to many uses, and the use of it depends upon its price. For
example water, where water is costly it is only used for drinking and cooking purposes and if
the price of water reduces it can be put for other uses also.

Individual Demand and Market Demand

An individual in order to satisfy his want would like to have some vegetable and he
buys it. When the demand of all the people is taken together it is market demand of vegetable
it will be called market demand. For example X demand depends upon his income and he
may demand one kg of cabbage but all people demand for cabbage may be 100 kg that will
be market demand.

Demand for durable goods and No-durable goods

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 Durable goods are those which can be used more than once over a period of time for
example the use of TV, fan, furniture, car, and ready- made clothes etc.

 Whereas non-durable goods are those which can be used once and consumed
directly such as bread Policy of the government
 Change in the habits of savings
 Innovation and invention
 Special influence and climate
 Future expectation of consumers
 Change in the level of distribution of income.

2.5 DETERMINANTS OF DEMAND
The Determinants of Demand o It is determined by

o Own Price - Po
o Price of other products, especially close substitutes and complements, Pc,s
o Consumers' disposable incomes, Yd
o Consumers' tastes, T
o The amount spent on advertising the product, Ao
o The amount spent on advertising complements and substitutes, A c,s
o Interest rates (i) and credit availability (C)
o Expectations of future prices and supply conditions(E)

A 'demand function' - the general mathematical form

Qd = f(Po,Po,Ps,Yd,Ao,Ac,As,I,C,E)
2.6 SUMMARY
We have studied the idea of utility. We have also studied the law of diminishing
marginal utility. The idea of utility is useful in taxation also it gives the idea of Value-in-use
and Value-in-exchange. We also studied the meaning of demand and its law .i.e. how change
in price affects the quantity demanded. We learnt how demand is determined and also
exceptions to the law of demand .We also got the idea of increase and decrease in demand.

UNIT 03 :ELASTICITY & FORECASTIONG OF DEMAND

OBJECTIVES
After going through this unit, you will be able to:

 Explain the meaning of elasticity of demand.

 Discuss how a small change in price affect the demand. State different concepts of
elasticity.
 State Measurement, and uses of the concept of elasticity of demand. Establish how
demand is estimated.
 State Methods of estimating.

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STRUCTURE
o 3.1 Introduction
o 3.2 Concept of elasticity of demand.
o 3.2.1 Elastic demand.
o 3.2.2 Inelastic demand.
o 3.3 Classification of elasticity of demand.
o 3.3.1 Price elasticity of demand.
o 3.3.2 Income elasticity of demand.
o 3.3.3 Cross elasticity of demand
o 3.4 Measurement of elasticity of demand.
o 3.4.1 Total Outlay method.
o 3.4.2 Percentage method.
o 3.4.3 Point method
o 3.4.4 Arc method.
o 3.5 Application of elasticity of demand.
o 3.6 Factors determining elasticity of demand
o 3.7 Meaning of forecasting of demand.
o 3.7.1 Techniques of forecasting.
o 3.7.2 Forecasting of demand for a new product.
o 3.7.3 Uses of forecasting of demand.
o 3.8 Summary
o 3.9 Keywords
3.1 INTRODUCTION
In the previous unit no 2 you are given the idea of marginal utility and its importance.
Secondly you learnt the idea of demand and other concepts related to demand such as
different types of demand. We know that demand is the beginning of all economic
activities.In this unit we are giving you some ideas of elasticity of demand. This is a very
important component of business decision making. It is a measure of responsiveness of
demand of a product to the change in the price of the product. Sometimes a small fall in the
price of a product may increase the demand of the product much more than expected for
example If the price of TV is reduced, it demand always increases. But the fall in the price of
salt will not increase its demand. Prof. Marshall “Elasticity of demand in a market is great or
small depending on whether the amount demanded increases much or little for a given fall in
price and diminishes much or little for a given rise in price"
In the second half we shall study the idea of estimation of the level of demand of a
product in future. The businessman has to plan for future production on the basis of future
estimates. The businessman has to arrange for Finance, space, Manpower; material etc. This
idea is known as forecasting of demand of a product.

3.2 CONCEPT OF ELASTICITY OF DEMAND

The law of demand gives only the direction of change in the quantity demanded of a
commodity in response to a change in price. But law of demand does not tell by how much
and to what extend the quantity demanded of a commodity will change in response to a
change in price. This idea can be explained with the help of price elasticity of demand.

3.2.1. Elastic Demand

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 Under elastic demand gives the idea that is if the price of a product changes what will
be its effect on the quantity demanded of the product. How much the demand is responsive to
change in price? For example if there is a fall in the prices of white goods (TV, Washing
Machines, A.C) the response of the market will be in the form of more and more demand.
This means that there is elastic demand this idea is applicable to all non-essential goods.

3.2.2 Inelastic Demand

Inelastic demand is a situation even if there is a great fall in the price of a product the
quantity demanded will not increase much or it may not increase at all. This is the idea of
inelastic demand. For example if the price of wheat and rice fall the demand may not increase
or there may be marginal increase. But in case of salt the demand may not increase at all.
Generally these products come under necessaries and are essential for human life.

3.3 CLASSIFICATION OF ELASTICITY OF DEMAND

The concept of elasticity of demand is put in three categories.
3.3.1 Price elasticity of demand.
3.3.2 Income elasticity of demand
3.3.3  Cross elasticity of demand.

3.3.1 Price Elasticity of Demand.

When the demand of a commodity is responsive to price then it is known as price
elasticity of demand. If there is a fall in price demand may rise a little or more depends upon
whether the demand is elastic or inelastic.
This concept enables the manager to know the effects of change in the price of a commodity
on the total revenue which depends upon nature of product and its elasticity.

Price elasticity of demand can be shown as under

Pe= % change in quantity demanded÷% change in price. Pe= ∆q/q /

∆p/p
Pe=∆q/∆p*p/q

∆q means a small change in the quantity demanded ∆p means a small change in the price of
the commodity. Q means quantity demanded. P means price of the commodity. Suppose he
price of tea is Rs.20/-and the quantity demanded by a house hold is 10 kg. Subsequently the
price of tea has risen to Rs.22/- and demand has come down to 9 kg.

Pe=- ∆q/∆p*p/q
Pe=1/2*20/10 = -1

Hence the elasticity is less elastic

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Price elasticity of demand can range from 0 to ∞.
Hence it can be seen that

Pe=1;Pe>1; Pe<1; Pe=0; and pe=∞

3.3.2 Income Elasticity of Demand.
If the income of a consumer increases, he will demand more goods and services. He
may also substitute superior goods to inferior goods. So under income elasticity of demand
we have to study the measurement of the percentage change in the demand for a commodity
due to change in the consumer's income other things remaining constant

Income elasticity of demand = proportionate change in demand of goods X÷ proportionate

change in income

= ∆ D/D÷∆I/income
= ∆D/∆I÷I/D
∆D stands for a small change in demand
D stand for demand
I = stands for Income
∆I stands for change in income

The income elasticity of demand shows the responsiveness of demand for a particular
commodity to the change in the consumer's income.
When the income increase of a consumer he will demand more goods & services. He may
also shift his demand to superior quality goods and decrease the demand of inferior good. For
example if a consumer consumes inferior quality of rice When his income increases he may
start purchasing superior quality rice.
So the income elasticity of demand is positive for superior goods or normal goods and
negative for inferior good.
Supose the income of X is Rs.10,000/ and his demand for fruit is 600 unit and if his income
falls to Rs.8,000/- he may reduce the demand for fruit to 400 unit. So the income elasticity of
demand will be

Ie = ∆dF/∆Income÷I/dF

Here the income elasticity is less and negative.

This concept is always used in determinating the effect of change in income on the demand of
the product.It is used while studying the change in the national income and its effects on
demand of various goods and services. We always talk of GDP (gross domestic prodct). If
GDP is rising economic activities will increase.

3.3.3 Cross Elasticity of Demand

Two goods may be related to each other in two ways.

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 1. when two good are used at the same time to fulfill the demand for example car and
petrol.These goods are complementary goods
2. They can replace each other and are close sustitute ie tea and coffee. The cross
elasticity of demand measures the responsiveness of demand for one product to the
change in the price of another product.For example if the price of tea goes up the
demand for coffee will increase.

Ce= percentage change in the demand of X product÷percentage change in the

price of Y product.

Ce = ∆dx/dx÷∆py/py
Ce = ∆dx/∆py÷dy/dx

Activity:
a) Meaning of elasticity of demand.
b) Price elasticity of demand.
c) Income elasticity of demand.
3.4 MEASUREMENT OF ELASTICITY OF DEMAND
Following are the different methods of measurement of elasticity of demand.
3.4.1. Total out lay method
3.4.2 Percentage method.
3.4.3 Point elasticity method.
3.4.4 Arc method.

3.4.1 Total Outlay Method

Prof. Marshal had given this method.Here it is to be found out whether the total
expenditure is less, or more ,or equal to the original expenditure. If expenditure is more than
the previous expenditure then elasticity is greater than one or elastic demand; if the
expenditure is less than the previous expenditure then the elasticity is less than one , in other
words it is in elastic or less elastic demand, If it equal to the previous expenditure then
elasticity is unity.
3.4.2 Percentage Method
Price elasticity can be stated in the form of changes in percentage

Pe= percentage change in quantity demanded/ percentage change in price.

Pe= % ∆q/ %∆p

If the answer is more and positive and greater than 1 that is elastic demand If the answer is
less and negative and less than 1 it is inelastic demand.
If it is equal to 1 then it can be called elastic or inelastic demand.

3.4.3. Point Elasticity

Here elasticity is represented by fraction distance from a point on the line drawn between the
axis

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Point elasticity=Lower segment/upper segment Therefore point elasticity= L/U=PB/PA
If PB is greater than PA then it is elastic demand and if it is less than PA then it is inelastic
demand And if it is equal then elasticity is unity
3.4.4. Arc Method
If elasticity is to be measured over some portion of the demand curve rather than at a point
then the concept of Arc Elasticity is to be used

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

Arc elasticity=∆q/∆p * p1+p2/q1+q2

P1= original price, P2 is new price

Q1 is original quantity demanded Q2 is new quantity demanded.
Intial price P1=10/- and new price is =12/-and original quantity is Q1=100 and new
quantity is Q2=90
Thendq is-10 and dp is2
Therefore the elascity is -10/2*10+2/100+90
=0.57 it means inelastic demand
3.5 APPLICATION OF ELASTICITY OF DEMAND IN DECISION
MAKING
Taxation Policy
The finance minister has to decide how to increase the revenue to run the government so he
will tax those goods and services which have inelastic deman. If he does so the poor will
suffer and the welfare of the poor will be affected.. Hence the finance minister has to take a
middle course of action where welfare and tax burden on the poor is not increase.So he will
choose those goods and sevices for increasing the tax which are consumed by the rich and
give subsidy to the poor.

Pricing of a Product
Here the producer of the product would like to know about the elascity of demand of the
produt.If he finds that the product has elastic demand he will keep the price low and sell
more. If his prodect has inelastic demand he can keep the price at higher level and earn more
profit. He will also study various markets and set the price of the product based on elasticity
and charge different prices in different markets.

International Trade
This concept is allways used in international trade while deciding the terms of trade between
the two countries. If the product demand is inelastic the exporter will charge higher prices .

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For example the prices of crude oil are increasing day by day still the demand is increasing If
the product has elastic demand the exporter will keep the prices of the products low and sell
more for example the prices of the chineese goods are kept low and they are able to compete
in the market better and sell more

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

3.6 FACTORS DETERMINING ELASTICITY OF DEMAND

 Necessaries and convetional necessaries and nature of commodity the demand is

alwys inelastic.

 Luxurious good demand is elastic.

 Demand for substitute able goods the demand is always elastic.

 Goods having several uses the demand is elastic for example the use of electricity,
which always depends upon price.

 Joint demand, the demand is less elastic. Example is car & petrol.

 Goods the use which can be postponed has elastic demand.

 Level of income spent on the product is very less it has inelastic demand such as
demand for tooth brush, tooth paste soap.

 Time period. In case time is short the demand is inelastic for example a person is to
be taken to the hospital the demand for conveyance is inelastic whereas if the is longer
then the demand will be elastic. Habit forming products have inelastic demand. The
user of drug, liquor etc.

3.7 WHAT IS FORECASTING OF DEMAND

It is an estimation of level of demand of a product in future. It is necessary part of business
because a businessman has to plan to arrange finance, space, manpower, raw material etc.
The businessman has to decide the investment in inventories. Major decisions in the large
firms are related with the forecasting of demand of their product. For this forecasting should
be accurate or near one and this will help the firm to produce the product efficiently and at a
lower cost and it helps the firm to meet the market demand efficiently.It also help in reducing
the risk arising out of uncertainty and changes in the market.

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The businessman can estimate the future course of action to meet the demand for the
commodity. Forecasting of demand is done for a short period that is for a year or for a long
period that is for 5 years.

3.7.1 Technique of Forecasting

While adopting the the technique it is desirable to consider cost factor,time factor,and
accuracy. More accurate forecast needs complex data ,which is expensive and needs more
resources like finance, manpower and also the length of forecasting period along with the cost
and benefit.

The techniques ae divided in two categories

a) Qualitative technique and
b) Quantitative technique
1. Opinion Poll which consists
a) Expert opinion method also known as DELPHI method,
b) Consumer survey method which has
i) Complete enumeration survey method,
ii) Sample survey,
iii) Opinion method based of sales staff
iv) End use method

a) Expert opinion
The experts who know the market ,are consulted. It is collective wisdom of the top
executives who give their ideas and estimation of the demand of the product. If the opinion of
several experts based on consensus of all is taken this will reduce the personal biases. A
specialized form of panel opinion is adopted in Delphi method. Under it an attempt is made
to have consensus on estimation of demand of the products by questioning a group of experts
repeatedly until their responses appear in a single line. This method was developed by Rand
corporation of USA and is being used successfully in area of technological product
forecasting.It is used in USA and European countries to estimate the demand for technical
goods.This method is very popular in USA and Europe.

b)
i) Complete Enumeration Survey Method
This method is also known as opinion polling. In this method all the consumers of the
product are interviewed and information regarding their consumption of the product is
collected. On the basis of this information estimation is done for the future.

This method has many advantages

1. It is accurate since all the consumers are approached
2. It is simple and is not affected by personal biases
3. It is based on collected data 

But it some disadvantages that is

1. It is costly and time consuming
2. It is useful only for a product with limited number of consumers.
3. It is difficult and practically impossible to survey all the consumers.

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b) 
ii) Sample survey
From the consumers only a few of them are selected and their ideas are taken and demand is
forecasted. But this method requires that the sample should be representative. The sample
will be small and less costly and less time consuming. It also reduces the risk of error in data.
If used carefully it gives excellent result. But this has limitation that is being based on only a
few consumer the opinion may not be applicable and it may not be representative.

b) 
iii) Opinion Poll of Sales Staff
This is used to collect the information from the sales staff such as salesmen who have direct
contact with the dealers of the commodity. The salesmen are expert and are expected to
estimate sales in their operative areas.It is collective wisdom of sales department and top
executives. It is simple and useful for short period forecasting and less costly.It is easy to
collect the data from their own staff. But this methods have some disadvantages such
as changes in the consumers' taste and preference are changing and the sale force may not
give the real picture.

b) 
iv) End Use Method
This method is used for sector wise or area area wise demand. The product may be final or
intermediate but this is used for the end users of the product. Milk is a commodity which can
be used as an intermediary good for the production of ice cream, cheese and many other dairy
products.

This method has certain advantages:-

It yields accurate forecast .
It provides sector wise demand forecast for different industries and is more useful for
producers' goods.
But the disadvantage that it requires complete and diverse calculation and it is more time
consuming.
Industries data are not readily available.

Quantitative Methods
1. Barometric method
2. Time series analysis
3. Regression method & correlated method.

1. Barometric Method

In an economy there are always turning points from inflation to recession this method
studies the turning point from one economic time series to another time series by
observation.Here economic indicators are used which are divided in to three categories.
a) Leading indicators
b) Coincident indicators

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 c) Lagging indicators

The correlation between two time series differs if the second series data are ahead or
move behind or move along with the first series data. If it moves ahead of the first series it is
known as leading series, while the first series is called lagging series. If the second series
moves along the first series it is called coincident series. For example earthquake in Jan 2001
led to the destruction of property and required reconstruction of buildings this created huge
demand for cement, steel and other commodities. Here construction of building is the leading
indicator or barometer.
Barometric analysis is a simple method and predicts directional changes, but it fails to
recognize the magnitude of changes.Secondly it is difficult to find out the leading indicator
for any series. This method can be used for short term only,

2. Time Series Analysis

It has four categories. Trend, Seasonal variation, Cyclical variation and random
fluctuation Trend analysis can be studied from past data that is how the changes in demand
was moving from one period to another.
Seasonal variation. As the season changes the demand of certain goods changes and so is the
production.The demand of woolen clothes increases in winter season. Cyclical
variation.Cyclical variation are always there in a free economy that is in the form of inflation,
deflation,recession , and depression. This is caused by changes in the economic activities in
the form of trade cycle. Random fluctuation.here the demand changes due to natural
calamities like earthquakes, flood, famine and so on which affects the demand of different
products.

3. Regression Method

Here we have to go back and study how a factor helps in determining the co- relation
(co-efficient of co-relation) in forecasting of demand.it gives the line of best fit as the
equation goes Y=a+bx here we need past data and functional relationship is established
between the variable with the help of regression. Once a relationship is established it is
possible to project this into future demand.

3.7.2 Forecasting of Demand For A New Product

Joel Dean has suggested the following methods to forecast the demand of a new product.

A) Evolutionary Method

Many new product are evolved from already established product for example demand

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for colour TV is based on the demand for black & white TV. 
This method has some limitations.
a) The new product should have been evolved from the existing product.
b) It ignores the problems of showing how the new product differs from the
established product.

B) Substitution Method

Some new product are substitute of already established product for  example New
LCD tv are substitute-able of already established colour Tv.
But this has some limitations too
a) Some new products have many uses and each use has a different suitability so
forecasting becomes difficult.Take the case of a computer we find different
configurations and better support with less cost. When a non- substitute is added the existing
firms react in a different ways ( change in price, more expenditure on advertisement) to cater
to the demand for the new product.

A) Growth Pattern Method

If there is some relationship between the new product and already established product
this method is useful. This method requires the study of the demand pattern of the old product
and the pattern of growth of the old product will be useful for the new product

 Opinion Polling Method

o Individuals are not sure of their purchase. In this method the consumers are
contacted directly seeking their opinion by sample survey. When a new drug is
introduced the doctors are contacted and their opinion is gathered about the drug
and on the bases of the information, forecasting of demand of that product is
done.

o Opinion poll method has some limitations.

 Individuals are not sure of their purchase.
 It is difficult to contact all the consumers.
 It is costly and is useful for a short period.

 Sales Experience Approach

o In this method, the new product is put to sale in a sample market and the
response of the people is noted along with the reaction of the consumers to the
new product and estimation for the future demand is done. Joel Dean has advised
to combine more than one of the methods
o Uses of Forecasting of Demand
 Production planning
 Sale forecasting and promotional efforts
 Control of business it means well conceived budgeting, cost and
profit.
 Inventory control.
 Growth and long term investment programme.
 Stability in production and employment. Economic planning and
policy making.

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

UNIT 04 :PRODUCTION ANALYSIS

OBJECTIVES
After going through this unit, you will be able to: 

 Define the role of fixed factors and variable factors in the short run and in the long
run.
 State that the fixed factors are not fixed in the long run, but all factors are variable.
 Draw the idea of law of diminishing return, increasing return, and constant return.
 Explain the law of variable proportion.
 Judge when to stop production during different stages of production.
 Explain the idea of return to scale.

STRUCTURE
4.1 Introduction to production analysis
4.2 Factors determining production in short term and long term
4.3 Law of Return
4.3.1 Law of Variable Proportion
4.3.2 Law of Diminishing Return
4.3.3 Law of Increasing Return
4.3.4 Law of Constant Return
4.4 Return to Scale
4.5 Summary
4.6 Keywords

4.1 INTRODUCTION
We are going to give you the idea of Production Function. This concept is very important in
managerial economics in decision making.

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  Production Function is a function that specifies the output of a firm for all
combinations of inputs. It gives the idea of relationship between inputs (various
combinations of factors of production) and maximum output. It states the amount of
product that can be obtained from every combination of factors and is based on the
most efficient available method of production.

 Production function is the flow concept because it relates to the flow of inputs and
resulting flow of output of a commodity during a period of time.

 Production function shows relationship between inputs and outputs, but does not
focus towards least cost combination or output maximization.

 A firm may not survive, if it does not utilize resources effectively and economically
so a firm has to be cost effective in the long run.

 By production we mean transformation of inputs into outputs. So production

function is the relationship between inputs and outputs and it stresses on maximization
of output from any input. It also means minimum inputs to yield a given quantity of
output.

 A production function refers to the functional relationships under given technology

between rates of input of productive services and the rate of output. It can be shown as
under:

Q= f (a,b,c,…..n,T) Q is the function of a,b,c…..n and T Q= quantity

A,b,c,n, represent the quantities of various inputs per employed time period.
T refers to prevailing rate of technology.

This equation is applicable in the long run. In a simple form it can be represented as:
Qx= f(K,L )
Qx is the rate of output of commodity X per unit of time. K refers to the units
of capital used per worker.
L is labor unit employed per unit of time.

This equation is used for a short period but for a very short period the equation will
be:
Qx= f (L)

It means that production can be increased by employing more labour since fixed
assets are fixed.
So production function reveals various combinations of different inputs resulting into
desired output.
These combinations should be cost effective and should give maximum results.

Practical importance of Production Function

1. P.F gives idea of optimum level of output and employment of variable inputs. So we
have to find out optimum proportion between fixed and variable inputs which will give
us more production at lower cost.
2. It guides the management about budget constraint for increase in output.
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 3. It tells us the degree of substitution and complimentary of different
4. Factors of production so that a firm can fix expansion path.
5. It explains why the rewards to different factors differ and the rate of growth of
industrial growth differs in all countries.
6. The theory of PF explains the possibility of disguised employment, when factories
gives employment but it gives ZERO marginal production. It shows the need of
diversion of surplus labor to other field.

4.2 FACTORS DETERMINING PRODUCTION IN SHORT TERM AND

LONG TERM
Here we shall consider the time element and production function. Time element shows the
functional or operational time period relationship. Time element is to be considered for short
run and long run.

4.2.1 The short period

The short period is defined as a period of time over which the inputs of some factors
of production cannot be varied. These factors are called fixed factors in the short run.
So in the short run some factors are fixed and some factors are variable.
Fixed factors are plant, machinery, equipment, building etc. These factors are fixed for a short
run. So in the short run the output can be increased, with the help of variable inputs, if
produced with a given scale of production and size of the plant and this remain unchanged.
But in the short run output is varied only by changing variable factors like labour, raw
material power and other inputs.

For Example a unit has a machine. It has the capacity of producing 100 units a day.
The demand has increased so the owner employs intensive methods to use the fixed factors
that is more labor and raw materials and put the workers on 3 shifts so that the production can
be raised to 300 units and he cannot produce more than that since it has the fixed factor i.e.
machine, which has the limited capacity .If the demand still increases he has to put up a new
plant to meet the extra demand.
So we can say that in the short run, some of the factors remain fixed and some factors are
variable. The output can be increased only by increasing the variable factors and intensive
use of the fixed factors.

4.2.2 The Long Run

The term long run is defined as a period of time long enough to permit variation in the
inputs of the fixed factors of production. There are no distinction between fixed factors and
variable factors of production. All the factors become variable factors. The size of the fixed
assets such as plant, machinery, equipment are fixed in the short period. But these factors
become variable in the long term. So in the long run there is a full scope for adjustment
between factors of production in the production process. In Heavy industries like steel,
chemicals the capital equipment, machinery, which are used, are very complex and
sophisticated.
It needs several years to erect a plant. Any rise in demand could be met only by intensive use
of existing plant capacity and by employing more labor and capital etc. But if demand
persists then a new plant has to be installed to meet the increased demand. So the adjustment
takes a long time.

Very Long Term

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When very long term is to be considered we have to give due consideration to new,
sophisticated and latest technology which has to be introduced and production function itself
will changed.
4.3 LAWS OF RETURNS
Before we take up the laws of return, certain concepts required to be cleared. This will
simplify the idea further.

1. Total physical product or total quantity of product. It means total quantity of output
produced by the physical unit of a firm during the period of time. It increases as input
increases.
2. Marginal product

It means the change in total output as a result of one additional unit of variable factor
employed in combination with fixed factor.

M.P = ∆TP/∆variable factor unit. ∆ indicates a small change in total output and input.
M.P.= MPn=TPn-TPn-1

Average product
A.P= TP/Variable factors unit

The above concepts can be made easy as under

.3.1 Law of variable proportion
This is modern version of the law of diminishing return. The three laws of returns are:
a) Law of diminishing return
b) Law of increasing return.
c) Law of constant return.

These are only three aspects of one law viz. Law of variable proportion. It is stated as
under:
“As the proportion of one factor in combination of other factors is increased after a point the
average and marginal proportion of that factor will diminish”. Prof. Samuelson “ An increase
in some inputs relative to other fixed inputs will in a given state of technology, causes output
to increase but after some point the extra output resulting from the same addition of inputs
will become less.” 

Assumptions

 Only one factor is varied and all other factors should remain constant.
 The scale of output does not change and the production plant or the size of the plant
and efficiency of the firm remain constant.
 The technique of production does not change.
 All the input factors are homogeneous.

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  After seeing the table and the graph of Law of variable proportion we can say that

 Up to 7th unit of input some addition is made in production but at the 8th unit
nothing is added and at 9th and 10th it is negative.

 Law of diminishing return is applicable. Up to 3rd unit of input production is

increasing and it is high at the 4th unit of input. Now it starts falling due to insufficient
input and at 8th unit it is ZERO. Total output is maximum when marginal output is
zero.

 Total production goes on increasing till it reaches the maximum where the third
stage begins.

 Marginal return reaches the maximum the earliest and starts diminishing and this is
the first stage of production.

 Average production starts diminishing next when second stage begins. 

 The third stage starts when M.P is zero and nobody is going to operate in this stage.
During the second stage AP is greater than the MP. It is also clear that the total output
curve is the steepest where marginal output in the largest.

 The first stage ends where the AP curve reaches its highest point.

 Stage no.1 is known as the stage of increasing return because AP of the variable
factors increases throughout this stage. Here MP increases but in the later part and it
starts declining but remains greater than AP. So AP continues to rise.

 In stage no 2 TP continues to rise and reaches maximum .Then here the second stage
starts and AP & MP fall. This is the stage of diminishing return. At this stage the
entrepreneur would like to make maximum use of the fixed assets.

 The increase in both MP and AP has two implications.

a) Addition in the variable inputs can lead to more than proportionate increase
in the output.
b) There is no optimum utilization of the fixed factors.

 After seeing the table and the graph of Law of variable proportion we can say that

 Up to 7th unit of input some addition is made in production but at the 8th unit
nothing is added and at 9th and 10th it is negative.

 Law of diminishing return is applicable. Up to 3rd unit of input production is

increasing and it is high at the 4th unit of input. Now it starts falling due to insufficient
input and at 8th unit it is ZERO. Total output is maximum when marginal output is
zero.

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  Total production goes on increasing till it reaches the maximum where the third
stage begins.

 Marginal return reaches the maximum the earliest and starts diminishing and this is
the first stage of production.

 Average production starts diminishing next when second stage begins. 

 The third stage starts when M.P is zero and nobody is going to operate in this stage.
During the second stage AP is greater than the MP. It is also clear that the total output
curve is the steepest where marginal output in the largest.

 The first stage ends where the AP curve reaches its highest point.

 Stage no.1 is known as the stage of increasing return because AP of the variable
factors increases throughout this stage. Here MP increases but in the later part and it
starts declining but remains greater than AP. So AP continues to rise.

 In stage no 2 TP continues to rise and reaches maximum .Then here the second stage
starts and AP & MP fall. This is the stage of diminishing return. At this stage the
entrepreneur would like to make maximum use of the fixed assets.

 The increase in both MP and AP has two implications.

a) Addition in the variable inputs can lead to more than proportionate increase
in the output.
b) There is no optimum utilization of the fixed factors.
From the table above we find that as our input increases total output increase in absolute term
till 7th unit but after sometime the output increases but at diminishing rate and at the end it
becomes negative.
But this law has some limitations as under:

a) When barren land is brought under cultivation.

b) When earlier less capital/labor is applied.
c) When new technology is introduced.

During limitation the law will not apply initially but it will operate after achieving the
maximum output. But ultimately the law will apply, may be after some time. The law applies
in every field of production i.e. industry, agriculture, mining, fishery etc. In Industry we find
that this law applies also. The main idea is that if one of the factors is kept constant and other
factors are variable this law hold good. We find an industrial unit which has been expanded
becomes difficult to manage and this leads to inefficiency and increase in the cost of
production.

4.3.3 Law of Increasing Return

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 It gives the idea of increasing return to scale that means any increase in input will lead
to a greater relative increase in the output. The law of increasing return means lowering of
marginal cost as industry expands.
This increasing return is the result of internal economies of scale such as labor economies,
management economies, and technical economies. This happens with the expansion of the
size of the firm. This increasing return is due to improvement in large scale operation,
division of labor, use of highly to improvement in large scale operation, division of labor, use
of highly sophisticated machinery, better technology. We find that big malls are able to sell
goods at a cheaper rate and their cost of inputs also is reduced due to large scales economies.
For Example if one table is produced, it may cost Rs.1000/- but we produce two
tables then the average cost may be Rs.900/- each but we produce more and more average
cost per table will go down till all the fixed factors are used. So we call this law as law of
decreasing cost and increasing return.

4.3.4 Law of Constant Return

Under the law of constant return any increase in inputs will increase the output
proportionately. For example if the input is increased by 5% the resultant increase in output
will be of 5% only. So the cost per unit remains unchanged. This happens in case where an
industry is subject to increasing return due to economies of scale and it is also subject to
decreasing return due to dis economies of scale. This is generally applicable to Blanket
industry. The wool the raw material is subject to decreasing return and machinery along with
labor is subject to increasing return. So law of constant return applies here.

4.4 RETURNS TO SCALE

Here we study the affect of long term changes in input and how output responds in the
long run to the changes in the scale of the firm, when all the inputs are increased in the same
proportion say by 10% and how does the output change. Here there are three possibilities.

1. If output increases by more than an increase inputs that increase in output is more
than 10%.It will be the case of increasing returns to scale.
2. If output increases by less than the increase in inputs ,then it is the case of
decreasing return.

3. In the third case output may increase by exactly by the same proportion as inputs
that means doubling of inputs may lead to doubling of output. This is case of constant
return to scale.

Increasing return to scale is caused by indivisible of fixed factors which are of minimum
size. The indivisibility of machine should be employed with the level, size and capacity etc.
of variable factors which are associated with the fixed the fixed factors as more and more of
variable factors are used along with the fixed factors (Machine) it will give more return till
the capacity of the machine is fully utilized.

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Decreasing Return starts when the fixed factors are fully utilized and any further production
by increasing variable factors will bring decreasing return. This is due to difficulties in co-
ordination and control.

Constant Return when the proportionate of input increases and the output also increases in
the same proportion, this is the case of constant return.
Here internal and external economies are balanced
4.5 SUMMARY
A production function gives the idea of inputs and outputs relationship. The managers
need to select various inputs, their combination and out puts with a view to have minimum
cost and maximum output. Selection of inputs-outputs combination with minimum cost is the
function of the manager.
Further the idea of law of diminishing marginal return gives the idea that, if one factor
of production is kept constant and other factors are variable, the output will increase but at
diminishing rate.
Similarly we have studied the relationship between total product, average product,
and marginal product. In law of variable proportion we studied three stages of production.

Stage I Where MP>0 & MP>AP

Stage II where MP > 0 but MP < AP

Stage III where MP<0
Here stage II is desirable.
The profit is maximized where the value of MP=the price of output.

We have also given the idea of Return to Scale and about increasing return, constant return
and decreasing return.

UNIT 05;COST ANALYSIS

Learning Objectives
After going through this unit, you will be able to:

 Learn various types of cost concepts used in cost analysis.

 Learn various factors that determine cost.
 Analysis relationship between the short term output and long term output.
 Learn about economies of scale and dis-economies of scale. 
 Learn the idea of Break Even point.

Structure
5.1 Introduction to cost analysis.
5.2 Cost concepts

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 5.2.1 Actual cost and Opportunity cost.
5.2.2 Explicit and Implicit cost.
5.2.3 Fixed and Variable cost
5.2.4 Total cost, Average cost and Marginal cost
5.2.5 Short run and Long run cost.
5.2.6 Private and Social cost.
5.3 Short run and Long run output relation
5.4 Economies of scale.
 5.4.1 Economies of scale. Internal economies and External economies of scale
  5.4.2 Dis-economies of scale - Internal dis-economies and external dis-
economies of scale
5.5 Concept of Break Even analysis
5.6 Summary
5.7 Keywords

5.1 Introduction
  In this unit we will explain various cost concepts and explain the relationship between
cost of production and output. You will also learn about various cost curves. Further you will
learn about Break Even analysis.

5.2 Cost Concepts

The idea of cost of production is very important because he has to find out his cost of
production and the prevalent price of the product in the market so that he can judge his
profits.

5.2.1 Actual cost and Opportunity Cost

Actual cost is the cost paid by the firm for labor, material, plant, building, machinery,
equipment, and transport etc. All these payments are recorded in the account books of the
firm. This concept comes under the accounting cost. Opportunity cost is very important cost
concept used in business decisions. The opportunity cost is related to scarcity concept. It can
be explained as the return expected from second best use of the resources which is forgone
for availing the gains from the best use of the resources now. For example a firm has to invest
some amount.

The firm has two option one is to buy a printing machine costing Rs.20, 000/ or to buy a lathe
machine costing Rs.15, 000/-. If the firm decides to buy printing machine, the firm loses the
opportunity of buying lathe machine. Hence the opportunity cost will be 20,000-
15000=5000/- but this choice depends upon economic profit. Investing in printing machine is
preferable so long as it economic profit is greater than zero. If the firm has the knowledge of
economic rent of various choices, there would not have been a problem but choice of the best
investment is a problem.

5.2.2 Explicit cost and implicit cost

Explicit costs are those costs which are found in the books of accounts. These costs
are also called paid out cost or actual cost. The payments paid on account of wages, salaries,
raw material. Fees and taxes, interest, rent, power charges etc.

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Implicit cost These costs do not involve any cash payment and do not appear in the
accounting system. It can be defined as the earning of owner's resources employed in the
business in the form of capital investment, own premises used for business, own services
used in business instead of hiring a manager. So these implicit costs include implicit wages,
implicit rent, and implicit interest etc. Implicit costs are not taken into account while
calculating the profit or losses of the business.

5.2.3 Fixed and variable cost 

Fixed costs are known as supplementary costs and indirect costs. These costs are on
volume for certain given output. Fixed costs are not variable with a certain level of output.
Fixed costs are
a) Managerial and administrative staff.
b) Depreciation of machinery, building and other fixed assets.
c) Costs on plant, building, land etc. And other fittings.
These costs are fixed for a short period. These costs have to be incurred even if the
plant is closed for a short period.

Variable costs are also known as prime costs, and direct costs. These costs vary with
production, so it is the function of output. Variable costs are:
a) Cost of Raw materials.
b) Direct labor costs.
c) Running cost of fixed capital assets such as fuel, oil, lubricants, repairs,
maintenance expenditure and all other input costs.
d) Taxes, indirect taxes such as excise duties, sales tax, value added tax, octroi
duty etc.

5.2.4 Total, Average and Marginal costs

Total cost includes all the values of resources used in production of goods and
services. All explicit and implicit costs are included i.e. include labour cost, capital, land and
opportunity cost, that means all variable cost and fixed costs are included in the total cost.
Average cost is obtained by dividing the total cost (TC) by the total output (Q)
i.e. Average cost= TC/Q.

Marginal cost (MC) is the addition to the total cost on account of producing one additional
unit of a product. For example if to produce 10 units total cost is 100/- and if 11th unit is
produced and the total cost is 109/- then the marginal cost is 9/- It can be shown as ∆TC
÷∆Q. ∆ means a small change in TC and Q.
5.2.5 Private and social cost

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 Private cost and public costs: These can be considered at micro and macro level. The
micro level economic costs are those which are generated by the decisions of the firms , but
are paid by the society and not by the firms, for example if a firm expands its output it will
lead to increase in the costs of the firm these will be known as private cost . But this will also
lead to certain costs to society in the form of greater pollution, greater congestion etc. These
costs are external to the firm. These costs are also called social costs from the society's point
of view. 

5.3 Short Run And Long Run Cost Factors 

Short run costs have two aspects; a) Fixed cost b) Variable cost.

The firm can vary its output by varying only the amount of variable factors
such as labor and raw material.
In short run the fixed factors such as capital equipment, machinery, plant,
management personals cannot be varied .If a firm wants to increase the output it can do so
only by overworking the existing plant or using the plant intensively and by hiring more
workers and buying more raw materials. Here only the variable factors can be varied and not
the fixed factors. But In the long run it is a period of time during which output can be
increased by varying the fixed factors as well as variable factors. In order to meet increase
demand it can put up a new plant, new machinery and increase the capacity to produce.

Output

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

As production increases AFC (Average Fixed Cost) goes on decreasing because cost
will Total Fixed Cost will be shared between more number of units .It becomes somewhat
parallel to the X axis but it will not be Zero or touch X axis and it will remain positive.

AV cost first declines then it starts rising due to dis-economies of large scale of
production. AC is obtained by adding AFC+AVC. This is per unit cost. At first the AC is
high due to large fixed cost and small output. As output increases the FIXED cost goes on
decreasing because it is now shared by larger quantity of output. This is caused due to
internal economy and fuller use of indivisible factors. Later on AC goes on rising due to dis-
economies of scale and it gives the curve U shape. So AC curve are always U shaped.

Marginal cost curve (M.C)

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In the beginning MC curve is declining and under the AVC curve and it starts rising rapidly
and bisects the AC curve from below at the lowest point. It rises steeply because of dis-
economies of scale.

Relation between Average cost (A.C) and Marginal cost (M.C)

a. When AC falls MC follows. But the rate of fall in MC is greater than that of AC, because
decreasing MC is due to a single marginal unit while in case of AC the decreasing AC is
distributed over the whole output.
b. When M.C. increases A.C also increases but at a lower rate. Further M.C. is
increasing while A.C. is falling.
c. M.C. intersects A.C. at the minimum point and where M.C. =A.C.
Optimum firm is the firm when A.C. is the minimum as at point M in the fig. above. This is
optimum level of output. If output is less than QO, the resources of the firm are under -
utilized. If the output is more than OQ then the firm is over utilizing the plant.

Optimum output and cost curve :

In the short run, optimum level of output is the one which can be provided at a
minimum Average cost, given the technology. The minimum level of AC is determined by
the point of intersection between Average Cost and Marginal cost curves... At this level of
output AC=MC
Here AC is the minimum. If production is less than this point or more than this point the
output will not be OPTIMAL
Here a point to be noted that optimum level of output is not necessarily the Profitable output.
In order to know the profit we should know firm's revenue curves.

5.3.2 Long Run Cost Output Relation

The long run period is long enough to enable the firm to vary all its inputs i.e. plant,
machinery, equipment building and space. The firm is not tied to a particular plant capacity.
The firm can move from one plant capacity to another plant capacity due to increase in
demand of its product; similarly if the demand persists the firm may put up another plant or
expand the existing plant. In the long run all costs are variable and no cost is fixed. Since new
machinery, plants can be added easily.

In The Long Run Firm Changes Production Level In Response To (Expected) Economic
Profit or Loss. In the long run there are no fixed cost and all factors are variable as to reach
long term minimum average cost. So expansion of plant and investments in equipment is a
long term operation. So the long run cost curve will be a composite of several short run cost
curves. One each curve for a different plant size. In each of the short run average cost curves
(SACC) we can have each AC curve for each different plant.

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In the fig. above, AC1 curve has optimum point when the output is OM. Further when output
is increased the optimum point is Omi and here the AC cost is lesser than that at OM because
of economies of scale and at output Mii here again AC is higher due to dis-economies of
scale.
When all these minimum average costs curves of all the plants are joined we can get LAC
(Long Run Average Cost Curve), as shown in fig, below:

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

5.4 Economies Of Scale 

The scale of production has important bearing on the cost of production. Larger the
scale of production lower is the average cost of production. This low cost is the result of
economies of scale. These economies are classified as internal and external economies.

5.4.1 Internal economies and External economies

Internal economies are available to an individual firm which is related to production
and only the firm is benefited when it expands its output or enlarges its scale of
production.These economies may be in the form of
a) Technical Economies

I. Large machine. A bigger boiler/ furnace having greater productive capacity

reduce the operating cost.
ii.Linking process: A large plant usually enjoys the linking of processes, a
dairy having its own feeder farm can reduce its cost similarly a sugar mill can have its own
paper making unit/alcohol making unit.
iii. Superior technique. A big newspaper can use Rotary machine, which can
do the work quickly and reduces the cost. Increased specialization and division of labour.
Specialists and experts are employed whose guidance can help the unit reducing the cost and
make the unit more efficient and productive.

b) Managerial Economies
A large scale unit can manage a big unit by adopting the policy of delegation
of power, grouping of establishments on a scientific way. The company hires the services of
professionals and experts. But the small unit can be managed by a manager hence it does not
have the benefit of reducing the cost.

c) Commercial Economies of Scale

These are in the form of Purchase of raw material, Sales of goods, Larger

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power in bargaining in buying and selling, Freight concessions, Cheap credit from
banks, Prompt delivery, careful attention. Proper treatment of customers, Research and
development that leads to innovation and inventions Material testing. It can raise capital
easily by selling shares in the market. These are having wider reputation in the market.

d) Financial Economies.

Large scale unit enjoys financial facilities in the form of letter of credit. Terms
of credit, discounting of commercial papers etc. from the financial institutions.

e) Risk bearing Economies

Risk is spread over and it can be eliminated. It can diversify source of raw material, diversify
market and process of manufacturing.
External economies refers to the situation when the gains are accruing to all the firms in an
industry due to growth of the industry. It is caused by expansion of industry as a whole such
as availability of new and cheaper source of raw material, tools, machinery, discoveries,
diffusion of superior technical knowledge and trade journals etc. 
So the external economies are:

a.Economies of Localization
Here skilled labor, better transport, credit facilities, benefits from subsidies,
common stock of knowledge, and stimulation of improvements are available to all units.
b. Economies of Information
A large growing industry can bring out trade and technical journals. These are
accessible to every firm. Many associations come up and encourage research, disseminate
technical knowledge to the other firms. It also enlightens the industry about fiscal policy of
the government etc.
c. Economies of Disintegration
Some of the jobs can be given to some other efficient subsidiary industry
.Paper and pulp manufacturing units are bifurcated. The paper manufacturing units are near
the market and the pulp manufacturing unit is established in the remote areas near the raw
material. Economies of Bye Product A large industry can make use of waste material for
manufacturing bye products. For example sugar industry can use sugar cane juice for making
sugar and it has waste like bag gasses, and molasses which the industry can convert in to
paper, cardboard and molasses can be used for manufacturing industrial alcohol.

d. Economies of Bye Product

 A large industry can make use of waste material for manufacturing bye
products. For example sugar industry can use sugar cane juice for making sugar and it has
waste like bag gasses, and molasses which the industry can convert in to paper, cardboard
and molasses can be used for manufacturing industrial alcohol.

5.4.2 Dis-economies of Scale

Dis-economies of scale can be classified into

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 a) Internal dis-economies of scale which may be in the form of managerial
inefficiency, labour inefficiency, difficulty in decision making, increased risk, etc
b) External dis-economies of scale may be in the form of scarcity of supply of
factors of production, possibility of depression, cut throat competition, dependence on foreign
market, lack of adaptability, etc.

5.5 Break Even Analysis 

Break even analysis (BEA) is very important concept for economics research,
business decision making, company management, investment analysis and public policy. It
traces relationship between cost and revenue at every level of output. The break-even point
(BEP) is located at that level of output or sales at which the net income or profit is ZERO.
Here the total cost = total revenue and there is no profit. BEP traces relationship between
cost, revenue and profit at varying level of output TC=TR. 
In the fig. above if a firm produces less than OQ it will incur losses because the cost will be
higher than the revenue. In case the firm produces OQ quantity here at point B, the cost and
the revenue are equal and if production is continued then the firm starts making profit. Every
firm desires to reach BEP at its earliest so that it can start making profit

BEP =TFC÷(P - AVC)

        =Total Fixed cost (TFC)/ price(P)-Average variable cost(AVC)
 
Again P - AVC= contribution margin per unit

 If a firm wants to know the safety margin. The formula is

Safety Margin = Sale- BEP/sales ×100

5.6 Summary 
a) The concepts of various costs are made clear since these concepts are very
useful in managerial economics and firm's decision making.
b) The ideas of total cost, average cost, marginal cost, average fixed cost, and
average variable cost are made clear.
c) Further we have explained how these cost curves are interrelated. We have
discussed the concept of marginal cost and average cost and their importance in decision
making.
d) The idea of short run and long run cost is made clear with the help of figs and
tables.
e) Economies of scale and dis-economies of scale are explained in details
and how these affect the cost of production.

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 f) Finally you have learnt the idea of break even analysis. Every firm is desirous
to reach the BEP at earliest. After break-even point the firm starts making profits. And till
BEP the firm is not making any profit

UNIT 06 : SUPPPLY ANALYSIS

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

STRUCTURE
  6.1 Introduction
  6.2 Stock and supply
  6.3 Determinant of supply
  6.4 Law of supply & exception to the law of supply
6.4.1 Meaning of supply
6.4.2 Law of supply
6.4.3 Exceptions to the law of supply
6.5 Shift in the supply curve
6.6 Elasticity of supply .
6.6.1 Elastic Supply.
6.6.2 Inelastic supply.
6.6.3 Measurement of elasticity of supply
6.7 Summary

6.1 Introduction To Stock And Supply 

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

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 The supply of goods is the quantity offered for sale, in a given market at a given time
at various prices. So it is defined as the amount of that commodity which the sellers are able
and willing to offer for sale at a particular price during certain period of time.Supply is
referred to in relation to price and time. Supply comes out of stock and stock determines the
potential supply.

6.3 Determinants Of Supply

Supply is dependent on many factors so SS=f( Pn,Pr,F,T,G)
Where,
Pn = price,
Pr = price of related goods
F = price of factors (Input prices)
T = Technical know how
G= Goal of the producer.

When there is an increase in the price of a product its supply also increases. If the cost of any
factor of production goes up or goes down, it will affect the supply. If the wage rate goes up
the cost of production will increase and it will reduce the supply. Advanced technological
increases the supply of the product and reduces its cost. Most of the inventions and
innovations in electronic, chemistry and other sciences have increased the supply of various
products and have also brought down the cost. Cell phone is example where it has become
necessary in life of man and cost has gone down and supply has increased.

6.4 Law Of Supply And Exceptions To The Law Of Supply   

6.4.1 The Law of Supply

The law of supply gives the idea of the tendency of the sellers in offering their stock of a
commodity for sale in relation to change in prices.Supply is a relative term of price and time.
If the price is higher supply will increase. If price is less supply will be less. "Other things
remaining unchanged, the supply of a commodity expands (rises) with a rise in it price and
contracts (falls) with a fall in price.”It means supply of a product will increase when the price
rises and it falls when the price falls. So supply varies directly with the changes price. So a
larger amount is supplied at a higher price than at a lower price in the market. So supply is
the function of price.
Other things remaining unchanged means that means the following things should remain
constant.
· No change in the cost of production / technique of production
· No change in the Size of the firm..
· Communication and transport system should be constant.

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 · No change in govt. policy.
· No change in prices of all goods
· No change in climate/ weather etc.
  
6.4.2 Exception to the law of supply
a. Control of the market by a few sellers under Monopoly, oligopoly.
b. Rare articles.
c. Inelastic goods.
d. Agricultural goods.
e. Future expectations.
f. Goods on auctions.
g. Supply of labor as wages go higher and higher.

6.5 Shift In Supply Curve / Increase Or Decrease In Supply

Shift in the supply curve is due to price but other factors such as development of new
methods of production, govt. policy which relaxes the norms and tariffs if Shift can be on the
right side of the curve or on the left side of the curve. If the shift is on the right side it is
called increased in supply and if the shift is on the left side of the curve it is called decrease in
supply
S1 move toward right S3 it is called increase in supply. S1 moves to left and to S2 it is called
decrease in supply.These shifts are caused by many factors i.e. development of technology,
scale of production and many other factors for example mobile phone, Laptop etc the
technology has increased its supply at reduced costs.
6.6 Elasticity Of Supply
Elasticity of supply is a measure of the way in which a quantity supplied responds to a
change in price. If the price has risen the supply will also increase and there is fall in price the
supply will decrease.

        6.6.1 Elastic Supply = A small increase in price leads to a larger increase in output, i.e.
supply

        6.6.2 Inelastic supply = small increase in price causes a little change in the supply of a
product. Here we can give the example of antics and old pictures etc.

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        6.6.3. Measurement of elasticity of supply.

       Supply elasticity=proportionate change in quantity supplied / proportionate change in

price.
       Se = ∆q/q÷∆p/p
       Se = ∆q/∆p× p/q
       Where, Se =Elastic supply,  ∆q =small change in quantity, ∆p= small change in price; Q=
quantity; P = price Degree of price elasticity of supply
    
Es=0 When the price is not affecting the supply, where there is no possibility to increase the
supply such is the case with rare articles, old paintings etc. There is no supply price for these
goods.

       Es<1 this is inelastic supply. In this case the changes in price increase or decrease will
affect the supply but the effect will be very small.

       Es>1 Elastic supply and elasticity is greater than one. Here if the price falls supply will
decrease much and if price raises supply will increase very much.

        Es= ∞ it means price has no effect on the supply of the product.The supplier is prepared
to supply any quantity of the commodity on the prevailing price.
6.7 Summary 
Supply is, the quality that is offered at a given time and at a given price. The law of
supply tells you that a fall or rise in price of a product will leads to fall or rise in the supply of
goods and services. Supply varies with price. Further we have explained the exceptions to the
supply. You have learnt various factors which affect the supply of a commodity. Elasticity of
supply reflects the response of the supplier with a given rise or fall in supply and with a given
rise and fall in price. We have also given the idea of measurement of elasticity of supply.

UNIT 07 :PRICING PRACTISES

LEARNING OBJECTIVES
   1. After going through this unit, you will be able to:
   2. State the basis of pricing of different goods and services and different methods of
pricing
  3. Define various pricing strategy followed by businessmen
  4. Identify various pricing systems which are involve to fix the price of a product
  5. State the effects on pricing decision of a firm

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  6. Explain commonly used pricing methods in practice though devoid of pricing
theory but has an economic reason behind it.

STRUCTURE
   7.1 Introduction
   7.2 Factors involved in pricing policy
   7.3 Various Pricing Strategies
        7.3.1 Concept of marginal cost prices
        7.3.2 Cost plus pricing
        7.3.3 Price leadership
        7.3.4 Price skimming
        7.3.5 Administrative prices
   7.4 Summary

7.1 INTRODUCTION 
Deciding pricing policies is the most important role of managerial decision making.
The firm has to consider the cost of production, selling cost, production schedule, and quality
of the product. In this unit how the prices of a product are fixed and what is the different
deciding factor which helps in pricing policy of a product. The pricing have very important
role in the distribution of income in the society. After considering all elements the firm has to
decide the strategy of fixing pricing of a product. Pricing policy is related to business
objectives. The factors prices are cost and it has to be minimized in order to earn maximum
profits.
7.2 FACTORS INVOLVED IN PRICING POLICY
a) Cost of inputs and all explicit and implicit cost.
b) Demand and consumer psychology.
c) Competition in the market.
d) Profit.
e) Govt. policy.
f) Demand of the people has to be studied and how the people will behave when
different prices are charged. It requires psychological
case studies of the people.
g) Situation and condition of competition in the market has to be studied.
h) Every firm would like to earn maximum profit put before pricing its product, it is
necessary to know the disposable income, the  purchasing power of the people and their

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psychology.
I) Govt. policy is another factor which can affect the price. If Govt. decides to give
subsidy the prices of the product is reduced. For
example the price of cooking gas is being subsidized by the Govt. so it is sold at a
lower price. Further the taxes on goods and services
will increase the prices.
7.3 VARIOUS PRICING STRATEGIES
I. Marginal cost pricing.
ii. Cost plus based in average pricing.
iii. Penetration pricing.
iv. Price leadership.
v. Price skimming.
vi. Administered pricing.
7.3.1 CONCEPT OF MARGINAL COST PRICES :
Marginal Cost is the increment cost of production of an extra unit. The firm should
charge price which is equal to marginal cost. Marginal cost is based on only variable cost. It
is short term cost. Marginal cost concept is an economics study but in business it is known as
incremental cost. Marginal cost can easily give us the idea of shut down point. The shut down
point is when the plan fails to cover even the average variable cost (AVC) and the price is
lower than average variable cost. In short period AVC may be above the price. But in the
long run (Average fixed cost) AFC + AVC have to be covered otherwise the unit will have to
be shut down permanently. If firms follow the marginal cost pricing it can put the firm in
losses.
 
7.3.2 COST PLUS PRICING:
It is called cost plus pricing or mark up pricing. . It includes total cost + selling cost +
some percentage of profit is added to the cost. It consists of variable cost, fixed cost, fixed
selling cost, administrative cost plus some added percentage of profit. That will be price of
the product –
       Example
       Fixed cost 20,000/- Variable cost30,000/- Output = 5000 units
       Add 15% profit
       So A.F.C = 20,000 divide 5000 = 4/=
            A.V.C = 30000 divide 5000 = 6/= A.T.C= 4+6=10
 
       Mark up price at 15% profit = 10 x 15% Mark up price=10.00 + 1.50 = 11.50

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7.3.3 PENETRATION PRICING:
If a firm wants to introduce a new product, the initial price of the product is kept low
to capture the market. There are some preconditions in the use of penetration pricing:
    (1) The market should be highly price sensitive and have high price elasticity.
    (2) Economics of scale, distribution; and ratio of variable cost to fixed cost are low
   (3) Low prices are likely to discourage competitors
   (4) It should increase demand
   (5) There is a heavy demand of the product
    (6) The buyers are ready to pay higher price for the product

7.3.4 PRICING LEADERSHIP

Price leadership is a situation where one firm is recognized as the leader of the
industry and all the other manufacturers follow and a accept its pricing policy. When one of
the firms is very big, strong, has excellent brand image and have very good sales. This
industry will be the price leader. For example TISCO in steel, Kellogg in cereals, Cadbury in
chocolate, Hindustan lever in soap industry etc are the price leader. This situation happens
under oligopoly where every firm is interdependent. So every firm has to follow the leader as
these firms are small. Every firm will keep an eye on the production and pricing policy of the
others.

7.3.5 PRICING SKIMMING

       Under this the price is fixed on the higher side and demand increases. But before this
policy is adopted it has to find out the large segment of people who are having inelastic
demand for the product and who are not sensitive to higher prices. The products have low 
price elasticity of demand. As the prices are high it is unlikely to attract competition. This
enhances the image of the product. Here the example of mobile phone is suitable. In 1995
when mobile phone was introduced in India the price was very high i.e. Rs 16/- for a call.
 
7.3.6 ADMINISTERED PRICING

      There are some products which are very essential for human consumption and Govt.
ensures that such products are available at a reasonable price to all. The firm has to sell the
product at the price fixed by the Govt. The main idea is to control prices of essential goods
and inputs. The public distribution systems are those where fair price shops sell essential

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goods to public at the price fixed by the Govt. Also Govt. follows dual pricing system one for
the poor people and the other for the rich. The price of sugar at ration shop is very less, which
is supplied to the poor people. The rich can buy sugar in open market at a higher price. 
7.4 SUMMARY
 
In this unit we have learnt the practical way of pricing of a product. The people, who
have no knowledge, try to fix the prices by rules of thumb. This practice is based on the
consideration of cost only and other related factors are not considered such as demand
condition or market competitiveness or some other economic factors:

1. Cost plus pricing is very popular and based on full cost + some percentage of profit. So the
price includes AVC + AFC + net profit margin.
2.Margin cost which is also accepted as incremental cost is used for pricing. It considers
variable cost and is able to give the idea of shut  down point when the unit is not able to
recover its variable cost because price has gone down in the market.
3. Administered price is ordered by the Govt. to make available essential goods and services
to the poor at a reasonable price. Similarly  the ideas of dual prices have also been discussed.
4. Skimming prices and penetration ideas have also been given to enable you to know what
these prices are. Hence the price is kept very low and in other high.
5. Support pricing system shows the role of the govt. to control exploitation of the poor
farmers.

UNIT 08: FIRM INDUSTORY ANALYSIS

LEARNING OBJECTIVE
After going through this unit, you will be able to:
1. Define plant, firm and industry Explain the objectives of the firm.
2. State about price determination in a free competitive market State about the
market structure.
3. Explain the main features of pure and perfect competition,monopoly,
monopolistic competition, Duopoly and oligopoly.
4. Enumerate how equilibrium is achieved in different market conditions.

STRUCTURE
8.1 Introduction
8.2 What do you mean by plant, firm and industry?
    8.2.1 Objectives of the firm
8.3 Price determination in the free market

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    8.3.1 Concept of equilibrium
   8.3.2 Determination of equilibrium
    8.3.3 Shift in the demand and supply curves
8.4 Types of Market
    8.4.1 Pure and perfect competition and its features.
        8.4.1 (i) equilibrium of a firm and industry under perfect competition
    8.4.2 Monopoly and its features
     8.4.2 (i) Equilibrium under Monopoly
     8.4.2 (ii) Discrimination under monopoly
    8.4.3 Monopolistic competition and its features
     8.4.3 (i) Equilibrium under monopolistic competition of a firm and industry
    8.4.4 Duopoly, oligopoly and their features.
8.5 Summary
8.1 INTRODUCTION
In this unit we are going to study the theory of the firm i.e. firm's decision analysis
Behavior under different market conditions such as perfect competition, Monopoly
Monopolistic competition and oligopoly .The behavior of the firms depends upon its
objectives. We shall also study how price is determined in the free market and the role of
demand and supply in determining the price of a product. Any change in demand and supply
has its effects on the price of the product is also explained. We also will study about perfect
competitive monopoly, monopolistic competition, Duopoly and oligopoly and their main
features of these markets. Equilibrium conditions under different markets conditions will give
the idea of output and price determination.

8.2 WHAT ARE PLANT, FIRM AND INDUSTRY 

Plant means an establishment for the production of goods and services for a firm
under which it is working for example a sugar plant. Plant is only a technical unit. It is the
part of a firm. The plant is under the control of the firm. All decisions regarding productions,
employment and purchases are taken at the firm's office.
A business firm is an independent organization running a business. It may be a shop or a
manufacturing unit. A business firm has to take decision regarding production finance,
marketing and employment of man power. It has to decide what to produce, how much to
produce, and what price has to be charged for its product. But the firm decisions regarding
price and output depends on the objectives of the firm and the kind of market structure in
which the firm does business.
It refers to the collection of firms which either use the same raw material or manufacture the
same product for example sugar industry, textile industry automobiles industry.

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For example: Tata Motors has its plants in various places, but the firm is in Pune and Tata
motors are a part of automobile industry.

8.2.1 OBJECTIVES OF THE FIRM

A firm has generally the following objectives, but each firm has its own objectives –
1. Maximization of profit.
2. Maximization of sales revenue and increase its share in the market. 
3. Maximization of firm growth rate.
4. Maximization of managerial utility function.
5. Maximization of firm net worth.
6. Long run survival.
7. To create more goodwill and reputation.

8.3 PRICE DETERMINATION IN THE FREE MARKET

 In this part we shall learn how supply and demand strike a balance in the market, how
market attains equilibrium and how price is determined in the free market. We have already
studied the concepts of supply and demand in the previous units and how supply and demand
behaves in response to a change in price. How price affects demand and supply of
commodity. We have also studied various determinants of demand and supply.
8.3.1 CONCEPT OF EQUILIBRIUM

Equilibrium means state of rest. Equilibrium refers to a state of market in which the quantity
demanded of a commodity equals the quantity supplied of the commodity. Where quantity
supplied and quantity demanded are equal that is equilibrium price. It is also known as
market price for that period of time.

8.3.2 DETERMINATION OF EQUILIBRIUM

The market price is determined by the forces of demand and supply of the product.

Table: Monthly demands and supply schedule of shirts

In the table one price is 100/- for a shift quantity demanded is 80,000 shirts but supply
is only 10,000 shirts. So there is a shortage of shirts. When price is 400/- the demand is
10,000 but supply is 80,000. This will create surplus in the supply. But there is only one price
i.e. Rs. 200/- where quantity supplied and quantity demanded are equal i.e. 40,000 shirts. At

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all other prices either the demand is more than supply or supply is more than demand. So
there is always a pressure either from supply side or from demand side to move towards
equilibrium price.
In the graph the equilibrium price is Rs. 200/- and quantity demanded and quantity supplied
is 40,000 shirts. When the price is Rs. 100/- demand is 80,000 but supply is 10,000 shirts.
When the price is Rs. 400/- the demand is 10,000 shirts but supply is 80,000

8.4 TYPES OF MARKET 

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

Under perfect competition there are large number of buyers and sellers and no one can
influence the price. The price is determined by the forces of demand of a product and the
supply of that product. The firm is a price taker and has to adjust itself as per the market
price.

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

Traditionally a firm is in equilibrium when it maximizes its profits. Maximization of

profit depends upon the cost conditions and the revenue depends upon the market conditions.
So the equilibrium is studied for short term and long run condition.

8.4.1(ii) Equilibrium of a firm in the short period

Here there are three conditions for the short run period –
(a) Price of the product is given in the market and the firm can sell any
quantity at that price.
(b) The size of the plant of the firm is given
(c) The firm is faced with given short run cost curves.
In the short run price being given it will lead to the conclusion that price = Average
Revenue = Marginal Revenue

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 i.e. Price = Average Revenue = Marginal Revenue. So it is a straight line parallel to X
axis.
8.4.1 (iii) Long run equilibrium of firm & industry

In the long run every firm gets sufficient time to adjust its output in relation to demand. New
machinery, new techniques of production are available and the firm can change the
composition of various inputs for production.

In short run MR = MC is the equilibrium position. It is also applicable in the long run. Hence
MR, MC; AC & AR = Price. If he price is more than the average cost, the firm can earn super
normal profit. So it will attract entry of more firms, more output and reduction in normal
profit.
  
When all the firms are in equilibrium, the industry as a whole is in equilibrium. Equilibrium
of the industry is determined by total demand, and total supply. 
 8.4.2 MONOPOLY 
Monopoly is the condition where there is only one producer and has no competitor. No
substitute of the product and this type of monopoly is called pure monopoly. There is no
difference between a firm and industry. It is a single firm industry. The cross elasticity of
demand between the products of the firm and that of other goods is zero.
8.4.2(i) Equilibrium under Monopoly

Under monopoly the firm is a price maker. So the firm can fix the price of the product. The
demand curve (AR curve) is therefore downward sloping and so the Marginal Revenue curve
is below the AR curve, because downward sloping curve shows the application of law of
demand.
A monopolist can make either normal profits or super normal profit in the short run. A
monopolist making sub normal profit will remain in production in the short run so long as its
AVC is covered.
 8.4.2 (ii) Discrimination under Monopoly

A monopolist can charge any price to maximize his profit. Secondly he can charge
different prices for the same product from different people or different market to maximize
monopoly profit. Consumers are charged different price by a monopolist by virtue of being a
monopolist. The basis of this differentiation is income age, time, sex, different markets when
a doctor charges different fee from different patients it is discrimination. This charge is based
on income of the person.

8.4.3 MONOPOLISTIC COMPETITION

The model of monopolistic competition was developed by E H Chamberlain. He
represented a realistic picture of the actual market structure.Monopolistic competition is a

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market structure in which a large number of sellers sell differentiated product which are close
but not perfect substitutes for one another. There are elements of monopoly and competition
in monopolistic competition. Here the products are differentiated from those of the others
firms. For example the consumers can differentiate between Colgate tooth paste and Babul,
Pepsodent tooth paste. Similarly mobiles are differentiated in the market as Nokia, Sony,
Samsung, Reliance etc. Each firm has a monopoly power over its own products. 

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

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

8.4.4 DUOPOLY AND OLIGOPOLY

When there are only two sellers of the same product, it is called duopoly. Here sellers'
decision is not dependent on each other. A change in the price and output by one seller affects
the other seller who may react to this change. It is limiting case of oligopoly. 

Oligopoly- is defined as “Competition among the few”. Under oligopoly number of sellers is
very few and competition between firms is more intensive. Number of sellers depends upon
the size of the market. Each seller has command over a sizeable proportion of the total market
supply. The product traded by the oligopolistic may be differentiated or homogeneous. There
are many different brands of car like Maruti car, Tata Indica. These are the example of
differentiated oligopoly. Similarly, cooking gas of Bharat Petroleum and Hindustan
Petroleum are examples of homogeneous
8.5 SUMMARY 
In the beginning of this unit, we have studied the meaning of plant, firm and industry
and the main objectives of a firm are also studied. The objectives are conflicting in nature.
How price is determined in a free market by the forces of demand and supply. How a shift in
demand curves and supply curves affects the price in the market. The study of the structure of
market is taken and how market will be in equilibrium. The price has been determined by the
free market but the output is determined under the conditions, when Marginal Cost =
Marginal Revenue. This equilibrium point shows maximum profit or minimum losses.

The market is further classified as perfect market and imperfect market. In perfect
market we have discussed various features and how the price and output is determined under
perfect market. Under perfect competition a firm has to be price taker which is determined by
the market force. In the short run a firm is in equilibrium when MC = MR cost in the long
run. The industry is in equilibrium when AR = MR = LAC = LMC. This condition gives only
normal profit.

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 Also discussion is done when a firm has to be shutdown the business. This situation
comes when AVC is higher than the market price so a firm has to shut down. Then a study of
monopoly is done along with its features and how a monopolist will earn maximum profit and
how a monopolist firm will be in equilibrium. Under what circumstances a monopolist
charges different price from different people and in different market which is also known as
price discrimination. The idea of degree of discrimination is also given.

Then the idea of monopolistic competition is given with its features especially product
differentiation and selling cost. How the firm and industry will be in equilibrium is also made
clear. Then the study of duopoly and oligopoly is taken up with its main features and Kinky
demand curve and rigidity of price. How this type of market is prevalent in the developed
countries. Most of the business is being run under oligopoly condition. The examples are
Pizza Hut, McDonald, Pepsi and Coco cola.

UNIT 09 :PROFIT MANAGEMENT

Learning Objectives
• After going through this unit, you will be able to:

• State the meaning of profit and its role in the economy

• Explain the different kinds of profit

• Discuss on measurement of profit

• Describe different policy regarding profit

• State the meaning of reasonable profit

• Learn to know the standard of reasonable profit.

Structure
9.1 Introduction

9.2 Meaning of Profit

    9.2.1  Kinds of profits

   9.2.2  Role of Profit in the economy

    9.2.3  Economic Profit and Accounting Profit

    9.2.4  Gross profit and pure (Net) profit

9.3 Measurement of Profit

    9.3.1  Economic concept of the net profit

    9.3.2  Modern Method

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       1.Depreciation

       2. Inventories

9.4 Profit Policy

  9.4.1 Profit expectation

    9.4.2 External factors

9.5 Reasonable Profit target

    9.5.1 Standard of reasonable profit

    9.5.2 Setting the profit standard

9.6 Summary

9.7 Keywords

9.1  Introduction

It is necessary for the Government to intervene to control the bad economic effects on
the economy caused by the free market economy and to assist the economy.  The Govt. has
legal and social frame work to reduce the bad effects of trade cycle.  So the Govt.  has to
control and regulate the economy to achieve its objectives. In this unit you will learn about
profit and its role in the economy.  Also you will know different kinds of profit.  Reasonable
profit is desirable and its meaning will enable you to think why reasonable profit is necessary.
The standard of reasonable profit will also be explained.

9.2   Meaning of Profit

Generally profit means the net income of a businessman.  It is calculated by deducting
from the total receipts and total expenditure incurred in the business.  But economists regard
profit as a factor-return like wages, interest and rent.  So profit is a return to the entrepreneur
for the use of his entrepreneurial ability. Earning maximum profit is one of the main
objectives of a firm, but how much profit is to be earned, is a big question mark before the
businessman. The entrepreneur has to decide the ratio of profit. This depends upon nature of
the market and other constraints including legal, statutory provisions, business convention,
consumers' resistance. Maximization of profit is the objective of every firm but the
businessman manages the factors of production which produce profit rather than managing
profitability directly.

9.2.1 Kinds of profits

Economists discuss the following  kinds of profit:
a) Earnings of management- To manage the business by judging
uncertainty properly he can earn profit.

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

c) Windfall profit – This profit arises due to changes in the general

price level in the market. Suppose he buys the inputs when the prices are low and sell his
output when the prices are high.  He earns a windfall profit. Sometime back the prices of
petrol were raised by Rs.5/- per liter, the sellers earned a windfall profit. The windfall profit
just happens it is not planned. 

9.2.2  Role of Profit in the economy  

The major function of profit in an economy is enhancing the production in the
economy.  Higher level of profit means higher investment, higher personal involvement,
higher employment opportunities in the economy, higher purchasing power of the people. 
All these will lead to higher economic activities in the economy.  Low profit will have
reverse effects on the economy. We know that for production more investment is necessary. 
For investment profit is necessary.  Higher the profit, higher will be the investment.  Profit
guides to direct resources to those sector, where they are more productive.  So profits are the
incentive to use resource efficiently and to produce the goods and services which are required
by the society. 

9.2.3 Economic Profit and Accounting Profit   

Profit means different things to different people,  i.e. Businessman,
accountant, tax collector, workers and economists.

For Accountant – Profit means excess of revenue over all paid cash including
manufacturing cost and overheads.

Profit for businessman – It is business income plus non allowable expenses.

Economic Profit, Profit over and above opportunity cost Accounting profit = TR (Total
Revenue) - (W + R + I + M)
W = wages, R = Rent, I = Interest, M = Material cost In accounting profit only explicit costs
are considered.
Economic profit = Implicit cost or imputed costs are to be considered so economic 
profit = TR – (Explicit cost + Implicit cost).  It is not always that profit should be positive but
profit can also be negative that is (Losses) in a year.

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 9.2.4 Gross profit and pure (Net) profit
GP = Total expenditure – Total receipt
GP = TR – Total cost
We have also to make certain payments out of Gross Profit

The payments are 

(i) Payment for the factors contributed by the entrepreneur himself in the form of rent,
interest and salary.

(ii) Depreciation and Maintenance charge

(iii) Extra Monopoly profit which accrues, not because of the business skill, but he being
monopolist, who is the sole seller or producer.

(iv) Chance profit.  This profit arises due to circumstances beyond the control of the
entrepreneur but by chance deducting from the total revenue of the year minus the total cost
incurred during the year. The example is war, calamities or bottlenecks.
Net profit = Gross profit – after making all the payments the balance is known as net profit.

9.3   Measurement of Profit

It is a very difficult concept we also find that economic concept of profit and legal
concept of profit are two different concepts. If we want to find out net profit, we can deduct
all costs from the total revenue, again this is difficult because the people are not aware how to
select different cost to come to the total cost.

9.3.1 Economic Profit and Accounting Profit - Economic profit includes implicit
cost plus explicit cost.  But to determine implicit cost is rather tricky and difficult.  Also the
entrepreneur may be using his own factors of production like land and capital and rendering
his own services instead of a hired one.  Since the uses of these factors are not paid so it
becomes difficult to value them.

The Economic concept of the net profit- The economic concept of the net profit will
have to be altogether different.  In valuation of these assets, the economist is guided by the
concept of opportunity cost. In accounting method the original price of a machine is
considered, but in economic concept the replacement cost of the machine will be used. So it
becomes difficult due to different meanings of cost concept.

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 9.3.2 Modern Method -  Valuation is based on the cash flows technique. Factors
responsible for leading to differences in economic and traditional concepts of valuation- Main
factors, which create difference in the economic and accounting approaches to the problem,
are as under:

9.3.2.a. Depreciation - Means loss of value caused by the continuous use of

assets.  Every durable asset has a certain life, at the end of which it has got to be replaced. 
This is done through the provision of depreciation in accounts.

9.3.2.b. Inventory Valuation - A firm has to invest a lot of its capital in
keeping inventories in the form of finish goods, semi-finished goods, spare parts, raw
material etc., so that the production does not stop because of lack of inventories and
materials.  So there is a need of inventory valuation.  This is a difficult task since the prices
are always changing.  This affects the cost of production.  But still some methods can be used
to evaluate the cost of inventories –

a) First in first out (FlFO)- The item which comes first should be used first
in production.

b) Last in First out (LIFO)- In this method the item which has come last is
used first in production.

9.4   Profit Policy

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

9.4 (a) Profit Expectation - Generally the investor expects some profit from his
investment. These expectations are subject to the following conditions – 
(I) The rate of profit should be sufficient to attract share capital, if necessary. So the
rate of profit should be good enough to command a good price for the new issue of shares.

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 (ii) Profit should be comparable to that in similar companies.

(iii) The rate of profit should be comparable to their rate of profit in the past.

(iv) He profit should be large enough to plough back for the expansion of business.

9.4 (b) External factors are required to  be considered because these factors do affect
the profit.  Following are some of the important external factors which affect profit –

(I) Full employment -  When a firm is working at full employment level and the
relation between management and workers are cordial.  It will increase profit of the firm.  But
if the firm's profit is very high, it may create unrest among the workers and they would like to
demand some share in extra profit, if not given this will create conflict and may reduce profit.

(ii) Potential Rivals-  If there is excessive profit this may encourage new entrants and
rivals may emerge.  This will wipe out profit. So there is a need to control profit.

(iii) Consumer's confidence-  Consumers' confidence and satisfaction is very

important for profit.  If unreasonable prices are charged the consumer may lose confidence in
the firm and may shift to other firm's product.  So in order to keep the consumer satisfied it is
necessary that reasonable profit should be expected by the firm and the consumer have
confidence in the product.

(iv) Political climate-   Peace, law and order, strong government is necessary
elements for profit.  Any change in political climate may affect the profit.  Government is a
big customer along with the public sector's purchasing it can affect the profitability of the
firm.  Further Govt. interference is common if it finds that a firm is making abnormal profit. 
Policy of taxes, subsidy and incentives of the Govt. also affect profit of a firm.

9.5   Reasonable Profit Target

Now it has become more practical to look for reasonable profit.  The question arises
why to go for a reasonable profit and the way how to determine it because of the following
reasons –

(1) To prevent entry of the competitors especially applicable in a weak monopoly.

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 (2) It will help to project a favorable image and it will not attract the Govt. attention.

(3) It will help to restrain trade union demands for higher wages.  If a unit is making
larger profit the workers, if do not get some share in profits, will feel exploited and will
demand higher wages and this will cause labor grievances and conflict.

(4) Maintaining customer goodwill is very essential.  This depends on quality and fair
price of the product.  So a firm aiming at better profit prospects in the long run should
sacrifice short run profit.

(5) It will bring congenial relation at the executive level.

(6) It will help in forestalling application of antitrust law.

9.5.1 Standard Of Reasonable Profit
In seeing the reality if the firm decides to restrain on profit there will be some
questions which need explanation –

a) What form of profit standard should be used?

b) How to determine the reasonable profit?

Form of Profit Standard  

Profit standard can have different forms-

a) In aggregate terms

b) Percentage of sale

c) Percentage return on investment.   

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 Whatever form of profit we may select it is usually the total net profit of the enterprise
which is more important and acceptable.
If we want to discourage the competitions then a target rate of return on investment is better
standard of profit.

9.5.2 Setting the profit standard

a) Capital attracting standard -The profit should be high enough to attract

external capital.    May it be in the form of share capital? 

b) Plough back standard - If a company has to grow so it becomes necessary

to earn enough profit so that further investment can be done. This standard of profit is used
by maintaining liquidity and avoiding debt.
c) Normal Earning standard- Normal earning of a company over a period of time, is
a good criterion of reasonable profit. It is necessary that under these criterion the company should be
able to attract external capital, discourage growth of competition and keep the share holder satisfied.
But after going through all above criteria, we find that none of the standard is perfect.  So the standard
of profit should be chosen by adopting different criterion after studying the market condition at a
particular moment.
9.6  Summary

All economic activities are based on one of the most important objectives that are to
make more profit.  Profit gives incentive to a person to work hard and try to get maximum
profit. We have tried to define profit and explained different types of profit i.e. in economic
term and in accounting term. Profit plays a very important role in the economy. Profit being
the reward of the entrepreneur can be negative also when losses are incurred. Profit helps in
expansion and growth of a firm and industry and the economy.  Expansion of the unit is
possible if a part of profit generated in the past is ploughed back. Further if very high profit is
made it will have some effects on the economy and will encourage competitors.  

The Govt. may start paying attention when there is a higher profit.  Similarly the
consumers will feel exploited.  The workers may demand more and more wages causing
conflict between management and labor. Hence it is felt that profit should be reasonable and
why reasonable profit is necessary. Discussion has also been done on different policies
regarding profit which can be adopted.  How to calculate profit is also discussed. Also the
idea of inventories and depreciation is given to enable a person to calculate profit properly. 
While calculating profit the role of inventories and depreciation has to be considered.

UNIT 10 :GOVERNMENT POLICIES

Learning Objectives
After going through this unit, you will be able to:

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  State the role of the government in handling National economic affairs
 Explain the monetary policy.  
 State use of monetary policy in controlling inflation and depression to some extent,
 Explain various methods used for the purpose
 Describe monetary policy in the form of cheap money policy and dear money policy
and how it can control investment..  Explain about the fiscal policy i.e. the policy of
taxation, public expenditure and public borrowing.
 Discuss how these policies can control inflation and depression and help economic
growth.
 Discuss that during depression, fiscal policy is more effective than monetary policy.

Structure
10.1 Introduction
10.2 Government policies

10.3 Monetary Policy Main purpose  

       10.3.1 Various tools used in Monetary Policy  
10.4 Fiscal Policy  
    10.4.1 Meaning and objective of Fiscal Policy
    10.4.2 Tools of Fiscal Policy
    10.4.3 Use of tools in various economic conditions in different economic
situation such as inflation, depression and                          unemployment
    10.4.4 Limitation of Fiscal Policy
10.5 Summary

10.1  Introduction
In this unit we shall give you the idea of Government interference in economic
activities to overcome various problems faced by the economy and to assist the economy.
Government interference's, when there are some problems in the economy ,is essential to
reduce the bad effects on the economy.  The Govt. has legal and social frame work to control
and regulate the economy. There are other ways also to be used by the Govt. to improve the
economic positions, welfare of the economy. The Govt. has to control and regulate the
economy to achieve its objectives.

10.2  Government Policies

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

10.3  Monetary Policy Main Purpose

a) Price stability
b) Exchange stability

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

10.3.1   Various tools used in monetary policy are –

 (a)  Quantitative methods

(I) Expansion and contraction of Money supply

(ii) Bank Rate Policy
(iii) Open Market operation/Statutory Liquidity Ratio (S.L.R.)
(iv) Reserve Ratio /Cash Reserve Ratio (CRR )
(v) Repo rate a reverse repo rate

( b) Qualitative method
(vi) Selective Credit Control
(vii) Rationing of Credit
(viii) Margin
(ix) Control of credit – consumer credit

10.3.1.(i) A contraction of money supply 

10.3.1(ii) Bank Rate -  Bank rate is the rate which is charged by the Central Bank to re-
discount eligible commercial papers of the commercial banks.  Here the central bank can
adopt any policy such as cheap money policy and the dear money policy. If Central Bank
wishes to control credit it can raise the Bank rate and make the borrowing costly.  If Central
Bank wants to adopt cheap money policy it can decrease the Bank rate and make borrowing,
by the banks, cheaper.  This will reduce the interest rate. 
10.3.1(iii) Open Market Operation - Open Market Operation refers to the purchase and sale
by the Central Bank (RBI) of different assets such as foreign exchange, government securities
gold etc. to the banks  and the public.  Under open market operation the Central Bank would
like to influence the economy by increasing or decreasing the money supply. ng securities it
is an indication that credit control is necessary in the economy and the country.
10.3.1(iv) Repo rate and Reverse Repo Rate - Whenever the commercial banks have
shortage of funds they can borrow from the RBI. Repo rate is the rate at which he commercial
banks borrow funds from the RBI.  If Repo rate is less, the banks can get money at a cheaper
rate of interest.  If Repo rate is increased borrowing from RBI will become more expensive

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and this will discourage borrowing from the RBI. Reverse Repo rate is the rate at which RBI
borrows money from the commercial banks.  It is generally less than Repo Rate.   
10.3.1(v) Selective Credit Controls are designed to regulate the direction of credit, where it is
needed.  Here essential and non essential uses of credit can be controlled and resources can
be diverted to the essential and priority sectors of the economy.
10.3.1(vi) Margin Requirement - Margin is the difference between the value of security and
the amount borrowed against these securities.  For example if the margin against gold
security is 10% and you offered the security of gold worth Rs.10,000/- you are likely to get
Rs.9,000/- as a loan.  Rs, 1,000/- is kept as a margin.  
10.3.1(vii) Regulate of consumer credit-  Here RBI controls the bank credit to finance
various products in the market by regulating it.  Down payment and number of EMI can help
the Central Bank to control credit. For example a bike costing Rs.50,000/- the practice is to
down payment 25% and balance in 10 installment but Central Bank can raise down payment
to 40% and EMI installation to 5.  This will reduce demand.

10.4  Fiscal Policy

Fiscal policy is defined as that part of the governmental economic policy, which deal
with taxation, public expenditure and public borrowings and management of public debt.
Fiscal policy is a policy under which the Govt. uses its power of expenditure, raising of
revenue to attain desired effect and avoid all undesirable effects on the national income,
production and employment policy. The Govt. exercises its power to tax the people and to
draw expenditure programmer and Govt. borrowings program through its budget and is
known as budgetary policy. The budgetary policy has tremendous effect on the economy of
the country.
10.4.1 Objectives of Fiscal Policy

a. Mobilization of Resources.
b. Economic development and growth. 
c. Reduction in disparities of income that is to remove inequality in distribution of income
among the rich and the poor and social justice.
d. Expansion of employment opportunities
e. Price stability and control of business cycle.
f. Development of infrastructure
g.To help the people during the time of natural calamities 
 
10.4.2  Tools and instruments used in Fiscal Policy in different economic situations such as
inflation, depression and unemployment.  
10.4.2 (I) Budgetary Policy - The Govt. uses its expenditure and revenue policy to produce
desirable effects and avoid bad effects on the National Income, production and employment. 
The policy is also known as budgetary policy. The budgetary policy deals with various
situations of the economy.In case of depression the budgetary policy should be of deficit

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financing that means to increase the flow of income into the economy.  This step will
increase the purchasing power in the economy and helps revival of the economy.  

10.4.2 (ii) Taxation Policy - During depression the taxes should be reduced on essential
goods to enable the people below the poverty line to increase consumption.  The Govt. should
also reduce direct tax which will increase disposable income of the people and the demand of
goods will increase. Taxation policy should be desired to increase consumption and
investment during depression period.
10.4.2 ( iii) Public debt - The Govt. can use the policy of Public borrowings to achieve some
of the economic goals.  During depression Govt. should pay back the borrowed money so that
the people should have more disposable income to spend.  During depression investment
should be increased.  The rate of interest should be lowered.  This will encourage investment
and employment.
10.4.2 (iv) Public Expenditure - Public Expenditure under Fiscal policy is very important
tool to control inflation, depression and create employment. Public expenditure should be
increased during depression and unemployment because it will help in creating purchasing
power in the hands of the people. This will help in reducing the effect of depression and also
increase employment opportunities if the Govt. undertakes some civil works.   
10.4.3 Use of tools in various economic conditions in different economic situation such
as inflation, depression and unemployment

Economic theories are formulated to explain different phenomenon. They try to

explain the relationship between two or more variables. While formulating theories a number
of tools are used by experts in this field. The tools of economic analysis are found in the
realm of Mathematics. Mathematics is being profusely used in modern economic analysis.
Mathematics is regarded as the second language for the students of economics. Geometry is
being increasingly resorted to in order to provide pictorial presentation of economic behavior.
Diagrams and Graphs provide visual impact and help to grasp and learn economics with
interest and ease.

10.4.4 Limitation- There is a lot of time lag when the Govt. thinks of taking action. 
Before it is implemented after some time the situation has gone very bad. Secondly in order
to meet the challenge the purchasing powers should go to the masses that mean redistribution
of income. Again this measure still takes a lot of time. The action taken by the Govt. must be
supported by the private sector.  But this sector is reluctant to cooperate with the Govt.
Further there is a lack of cooperation and cooperate in different field of the economy.

Algebra and Derivatives to use them as fundamental tools to express complicated

aspects of economic theories and models more precisely and accurately. All these
applications of mathematics are significant as a tools and techniques to impart conciseness,
precision and rigor to economic analysis.

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

Learning Objectives
After going through this unit, you will be able to:

 Discuss about the general rise and fall in prices.

 Describe business cycles and its phases.
 Explain inflation, recession and depression.
 State the reasons and causes of inflation and depression.
 Discuss the kind of cyclical fluctuation in economic activities. Suggest the measures to
overcome cyclical conditions. 

UNIT 11 :BUSINESS CYCLE (MEANING & PHASES)

Structure
11.1 Introduction
11.2 Business cycles 
    11.2.1 Meaning
    11.2.2 Phases
11.3 Inflation

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    11.3.1 Define inflation
    11.3.2 Causes of inflation
    11.3.3 Control of inflation
11.4 Recession and depression
    11.4.1  Define recession
    11.4.2 Causes of recession
    11.4.3. Control of recession
11.5 Depression
11.5.1 Idea of depression
11.6  Summary

11.1   Introduction
There are various methods of pricing of a product. Each pricing system has its
advantages and disadvantages. So we have tried to give you the idea of pricing a product in
different market and different areas In the present unit we shall explain the idea of trade cycle
.This is always happening in a capitalist economy accompanied by fluctuation like ups and
downs in the economic activities. We find that this fluctuation in the economy has affected
the economic activities of the country. Phases of trade cycle are also studied .Different
methods are also explained to have some control or reduce trade cycles bad effects to some
extent. Business cycle is accompanied by inflation; recession and depression are explained in
details.
11.2  Business Cycle
Business cycle or trade cycle is very important happening in a capitalist economy.
There is a boom period when economic activities are at the highest and there is a slowdown
of economics activities, which brings depression. During high economic activities there are
great opportunities for employment and trading, high income high purchasing power and
more trading. This period is called Boom period. Then suddenly economic activities receive a
shock and all economic activities receive a shock and it starts going down .This period is
called recession and ultimately it leads to the depression. This period causes a lot of problems
in the economy because there is unemployment, very low purchasing power and all economic
activities are at a low level.
11.2.1  Meaning of trade cycle
The trade cycle simply means the whole course of trade or business activities
which passes through all the phases of prosperity and adversity.
According to J.M. Keynes, “a trade cycle is composed of period of good trade characterized
by rising prices and low unemployment percentage and followed by period of bad trade
characterized by falling prices with high percentage of unemployment percentage.” The trade
cycle are recurrent and have been occurring periodically more or less in regular fashion.

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Some business cycle has been very short lasting i.e. for only two to three years, while other
may last for several years. 
11.2.2  Phases of business cycle
Phases of business cycle are divided into four as following:
a) Prosperity phase ( Boom, expansion and upswing of the economy)

b) Recession phase (Down swing recession or depression)

c) Depression phase (contraction or downswing of economy)
d) Recovery phase (lower turning point , from depression to prosperity)
During recovery stage, expansion starts playing its role and this leads to prosperity. During
recession we have contraction of all economic activities and this causes depression. The
business cycle starts from trough (lower point) passes through recovery phase followed by a
period of expansion (upper turning point) and prosperity. After the peak point is reached
there is a declining phase of recession followed by depression and it continues simply with
upward and downward swing.

a) Prosperity phase 
There is an expansion of economic activities. Prices, employment, income and
production move upward. Total output starts growing at a rapid pace due to higher
investment and more employment. The producers gain because wages and the prices of raw
materials are low initially and move later on. There is higher level of effective demand. The
rate of interest increases due to more demand for capital. This causes inflation, expansion of
bank credit. There is rise in the GNP. This further increases inflation and higher profits.
There is upswing in the economic activity and the economy reaches its peak. This is known
as BOOM period.

b) Recession period
The temporary point from prosperity to depression is termed as recession
phase.  During this phase economic activities slow down when demands start falling. Over
production or future investment plan are given up. There is steady decline in the output,
income, employment, prices and profits.  The businessman becomes pessimistic and this
reduces investment. During this period the commercial banks call back loans to maintain
liquidity.  So are the credit contracts.People start losing jobs which leads to unemployment
and sharp decline of income and aggregate demand.   Recession last for a short period.   

c) Depression Phase
During this phase output is decreasing, income employment, prices and profit
is also declining.  Then the depression sets in. In depression (a) there is a fall in output and
trade (b) fall in income (c) Increase in unemployment (d) decrease in consumption and
demand; (e) fall in the interest rate (f) deflation (g) contraction of bank credits (h) overall
pessimism (i) fall in marginal efficiency of capital. The resources are underutilized which
leads to a fall in GDP. Then this stage leads to TROUGH (Lowest point).  

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 d) Recovery Phase
This is turning point from depression to expansion and is regarded as recovery
or revival stage. During this recovery period there is rise in economic activities and the
demands start rising, production increases and this encourages new investments. The
businessmen get confident.  The banks expand credit which leads to expansion of business
and it affect stock market also which is activated now. There is an increase in employment,
production, income and aggregate demand.

11.3  Inflation
Inflation may be defined as rise in the general price level. Inflation may occur either
due to increase in demand or increase in the cost of production. If it caused by increase in
demand of goods and services it is known as demand pull inflation. Here the aggregate
demand of goods and services exceeds the available supply of the outputs and so causes the
general rise in price level of the economy. The price may rise even when there is no increase
in aggregate demand. This could be due to rise in the cost of input. If the cost of any factor of
production increases the cost of goods is bound to go up. If the inflation is caused because
there is a rise in the cost of production as the inputs costs have gone up it is known as cost
pull inflation.
11.3.1  Define Inflation
Inflation may be defined as general rise in prices in a persistent manner. Prof. Crowther.  He
has defined inflation as a state in which the value of money  is falling and prices are rising.
Prof. Kemmerer defined inflation as too much currency in relation to physical volume to
business being done.  That means too much money chasing too few goods.
11.3.2 Types and Causes Of Inflation

a) Demand – pull inflation

b) Cost – push inflation
c) Excessive growth in money supply
d) Deficit financing
f) Credit inflation
e) Wartime/post war / peace time inflation
g) Tax inflation
h) Sectoral inflation
i) Pricing power inflation (oligopoly)
j) Stagflation

11.3.3 Control of Inflation

To some extent inflation can be controlled but not fully.  Various measures
have been suggested by various experts but there is no one way which can control inflation. 
Mostly it is related to increasing purchasing power of the people.  So the main emphasis is on

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controlling the supply of money and the purchasing power of the people. Following are the
measures to reduce money incomes and control inflation:

(1) Monetary Measures for controlling credit

(2) Fiscal Measures for controlling Govt. expenditure, personal consumption

11.4  Recession
Recession It is the period of contraction in the business cycle. It is a general
slowdown in economic activities. A decline in the GDP for two or more consecutive quarters
is also called recession. Macro Economics indicators such as GDP, employment investment
spending etc., all fall and decline while rate of unemployment increases. It happens when
there is a wide spread drop in spending.  It is often followed by an adverse supply shock so
Govt. has to follow expansionary macroeconomic policies such as increasing money supply,
increasing Govt. spending and decreasing taxation. This will help in increase in disposable
income in the hands of the people.  The people will demand more goods and services.  This
will give a little push to the economy.

Causes of Recession - Over production by the firms ,which are independent to take their
decision. This lead to over production and it has to be sold either at lower price or keep these
in inventories and stop the production. This will lead to unemployment. Secondly recession is
caused by under consumption.  The people consume less and less. Third cause is financial
crises; here the bank would like to call back the loans.This affects the firms and the firms
have to sell their product at lower prices. This results in heavy losses.
Impact of Recession – Recession will have following impact on the economy:
a) Bankruptcies
b) Credit crunch
c) Deflation 
d) Foreclosure

11.5   Depression
Any down turn in economic activities is referred to as a depression. So depression is
defined as a recession that lasts longer and has a larger decline in business activity.  A
depression is any economic downturn where real GDP declines by more than 10%. But a
recession is an economic downturn that is less severe.1929-37 period was period of
depression in the USA but from 2008 there is a recession.But depression when at its lowest
level is called trough and from here the economy starts moving towards recovery.

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

UNIT 12 :COST BENFIT ANALYSIS

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

Structure
12.1 Introduction
12.2 Steps involved in Cost Benefit Analysis
12.3 Cost Benefit Analysis Private And Social
12.4 Advantages of Cost Benefit Analysis
12.5 Disadvantage of cost benefit analysis
12.6 Limitation of cost benefit analysis
12.6 Summary

12 .1 Introduction
The cost benefit analysis will help to get the idea of the benefits and the costs of
various investment opportunities, which are available to the business houses and the Govt.

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Here we have to find out whether it is worthwhile to invest in a project and to study every
alternative available. Further cost benefits analysis refers to the analysis done to judge a
project investment. It may be under the Govt. or in the private sector. The cost benefit
analysis is used to evaluate and give a ranking to every project before it is undertaken for
execution. Anybody, who is thinking of investment, must try to get its cost benefit analysis
done before one takes the decision about the project. Cost Benefit Analysis focuses on
economic efficiency. It calculates the net benefits for each policy proposal. It takes a long
term to view and to incorporate all relevant factors regarding costs and benefits.

12.2  Steps Involved In Cost Benefit Analysis

The cost benefits analysis is a technique used for analyzing investment and for
ranking the alternative investment opportunities.  It is a difficult process because of the
uncertainty of the elements and changing in the value of money, because the economy is
dynamic. These are always present under every circumstance.  When a big project having
huge investment is undertaken by the Govt. it is necessary to analyze its social costs and its
social benefits involved with it.   It is also a part of capital budgeting from the point of view
of an individual investor.  
Following are the steps involved in cost benefit analysis –
a) Identification of project

b) Formulation of the project

c) Appraisal and selection of the project

d) Comparison of cash flow

e) Selection and implementation

f) Mid- term project evaluation 

12.3  Cost Benefit Analysis Private And Social  

In the private sector cost benefit analysis, the main accepted norm is to assess the rate
of return and how soon the cost of the project is recovered.  In social cost benefit analysis the
main consideration is the benefits received by the society, Rate of return and profit are
secondary consideration. Social cost benefit analysis has to be done keeping in mind the
welfare and economic objectives of the economy. Certain projects like construction of dams,
roads, bridges, generation of electricity are necessary for the economy. Hence even if we are
applying cost benefit analysis in such projects, we have to keep in mind the role of these
projects. These projects are to help in the development of the economy and create net social
assets. These will help in rapid economic growth. 

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Similarly provisions of health and education facilities have different objectives because it will
bring intangible results by making the people healthy and educated and the people will
become more efficient and productive. Now the social costs and benefits are regarded as
externalities of the private investment and production decisions.  The private costs are nil but
the effects on the society is very high in the form of externalities. These are pollution of air,
water, noise.  But the society suffers.  We find divergence between social and private costs
benefits.

Social Costs and Benefit  

The Govt. interference is necessary in private sector in order to provide the safe guards to the
society and to protect the interest of the society.  It is also accepted that the private firms must
look for the social benefit and costs.  And the private sector must take necessary measures to
reconcile the conflicting interest. These social costs are not included in the private firm's
account.  But if a private project involves construction of a swimming pool, a play ground
which is open to public, social benefit exceeds private benefit.  The firm does not care much
about social costs but only care of their private cost. 

12.4 Advantages of cost benefit analysis

a) It aims to maximise social welfare through maximisation of net wealth.

b) By cost benefit analysis we can show the various measures necessary for attaining
maximum net wealth and optimal policy aiming at these goals.

c) Even if a target is partially achieved, the cost and benefit can be calculated and
whatever increase in net wealth can be ascertained at that point of time.

d) By adopting some suitable discounting method, the cost and benefit arising at
different points of time can be estimated.

e) Cost benefit analysis compares cost and benefits using equal term which provides a
clear indication of net cost or net benefit in a specific area or provides regulation or helping
the project which will justify the decision by studying various benefits.

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 f) It simplifies complex process and concepts accepted by the society readily.

g) Cost benefit analysis can be carried out at various level such as local level, regional
level and National level.

12.5 Disadvantage of cost benefit analysis  

a) Inaccuracies Proper analysis of cost and expected profit is mandatory.   There
are always some errors in some cost estimation.

b) Cost Benefit Analysis is not exact - Various methods employed and assigned
economic costs to non economic benefits bring different results.

c) Subjectivity Cost and benefit being intangible gives room to subjectivity while
doing analysis which gives unreal results.

d) Failed project Cost Benefit Analysis results influence the project.  The team
may set unrealistic targets for a project.  This may cause losses.

12.6 Limitation Of Cost Benefit Analysis

But the study of cost benefit analysis has some limitations:

a) The usefulness of this analysis is limited by the fact that it is based on the
assumptions that maximization of net wealth will ensure maximization of social welfare
which is not true.

b) It has nothing to say about the distribution of income in the society and a change in
income distribution. This does not lead to a change in net wealth and social welfare.

c) It has failed to consider private and social cost and its consequences for the present
and for future.

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 d) Calculation of SCB/PCB is difficult.  It is only an estimation of it, which may not
be true.

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

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

UNIT 13 :CAPITAL BUDGETING

Structure
13.1 Introduction
13.2 Idea of capital budgeting
     13.2.1 Classification of physical assets

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        13.2.2 Capital budgeting process
13.3 Methods of appraising an over view
     13.3.1 Simple Methods
     13.3.2 Scientific and complex method

13.4 Measurement Method

     13.4.1 Requirement of a good method
     13.4.2 Principles of cash flows estimation  

13.5 Time value of Money calculation     

  
13.6 Summary

13.1 Introduction
In this unit we are giving you the idea of capital budgeting, and all related matters,
especially steps involved in capital budgeting. You will come to know the concept of time
value of money. You will also learn the methods of investment, discounted cash flow and Net
Present Value and Internal Rate of Return.
13.2 Idea Of Capital Budgeting
Capital budgeting is the planning process used to determine whether an organization's
long term investment plan such as purchase of new machinery replacement of machinery,
new plants, production of some new products, are worthwhile in terms of budget. It needs
major capital investment expenditure. Capital Budgeting also refers to the process of
planning capital project, raising funds, efficiently allocating these funds to capital projects.
Capital Budgeting is made to reduce costs, increase output, and develop a new product or
expand in market and to meet Govt. regulations and provides for Research & Development
etc.  

13.2.1 Classification of physical assets

(1) New Project -  That means starting a new factory. 

(2) Expansion of existing project -  In order to increase production, more machinery and
equipments are to be installed and the building is extended or a new building is required to be
constructed. These are challenging decisions.
(3) Renewal and Renovation of Project -  It is done by replacing obsolete machine and
equipments.  These needs to be replaced to keep the business going and to avoid shut down of
the unit.

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(4) Research and development -  Needs a lot of investment and the positive results are not
assured but still a lot of funds is needed for this. This can help in innovation, idea of a new
product, a new raw material and improvement in existing product which will bring more
return in future and is the cause of growth and development of the economy.
(5) Exploration Project -  Exploration project is necessary in order to fund new resources
especially in oil and gas exploration.  We need constant exploration which has to be done.
Money spent now will help to reap the benefits in future.  Hence a constant investment has to
be done.
(6) Some funds are diverted towards fulfilling the statutory requirements. Such amounts are
spent for providing safety, and health measures, and Pollution control.

13.2.2 Capital budgeting process

Following steps are needed to see so that the project is successful –

a) Generation of investment idea -  This will make you think and start exploring and
finding new opportunities for the future.
b) Determining the cost of the project -  It is necessary to estimate initial cost, capital
expenditure, guided by the price of the new equipment and machinery and the required
quantity.  It is necessary to study the cash outflows. 
c) Estimation of the cash flow - Cash flow in a project over a number of years in future,
need to be studied.
It has also to be seen the riskiness of estimated cash flow, because there is risk and
uncertainty in the market and business.
Selecting a project after considering all pros and cons of the project and evaluating its
financial feasibility and viability.

f) Execution of the Project - Here again experts and professionals are taken to see that the
project is being executed as per the plans and time schedule. 
g) Monitoring and appraising -  There is a need to monitor the execution of the project
continuously and further it is necessary to appraise it whether it is being executed as per time
schedule, because any delay in execution of the project will increase the cost of the project.
This will affect the profitability of the project.

13.3 Methods Of Appraising A Project An Over View

Project appraisal is the analysis of costs and benefits of a proposed project with a goal
of assuring a rational allocation of limited financial resources amongst alternate investment
opportunities with the objective of achieving specific goals.  It is mainly the process of
transmitting information accumulated through feasibility studies. It involves cash flows.  A

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large initial outflow is followed by small but recurring outflows. The inflows will be small
but for a long period. It is necessary whether the value of inflows is greater than the outflows
or not. If greater value can be assigned, to the inflows/returns than the outflows, and then the
proposal may be treated as possible.
While doing capital investment appraisal, method should be sound.  A good appraisal method
should have the following features –

a) It must have clear basis for distinguishing between acceptable and non acceptable
project.

b) Ranking the projects on the basis of desirability.

c) To make a choice among several alternatives.

d) Recognize the higher benefits projects which are preferable to smaller benefits
project ones and early benefit projects are preferable to the later benefits proposal. So if
outflow is less than inflow then the project is viable. 

There are various methods of appraisal.  These methods are classified as –

13.3.1 Simple Methods   

These method are simple and do not involve complex calculation and discount
of cash flow.

 a) Pay back Method

In this method, the payback period is the time duration required to recover the initial cash
flows. The people think in terms of initial expenditure/outflows and the time duration in
which this amount can be recovered.

If the cash flows are uniform then 

Payback period =  Initial cash outflows /  Annual cash inflows

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b) Accounting / Average Rate of Return Method.

This method is also simple in calculation.  It shows the ratio between net profit after tax and
the amount of initial investment –

So,
        ARR = Average PAT÷   initial Investment
  ARR = Average Rate of Return
  PAT = Profit after tax  
13.3.2 Scientific method     

Scientific Methods need calculation, the time value of money and therefore
undertake discounting of cash flow.  These methods are:

a) N P V  (Net Present value)

b) Internal Rate of Return

c) Benefit cost (B.C.) ratio or profitability  Index

d) Discounted Payback  

13.4 Measurement Method

13.4.1 Requirement of a good measurement method

1. It should be based on cash flows rather than profits or expenditure.

2. Cash flows to be covered over the entire expected life of the assets rather
than a few years only.

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 3. It should give absolute value of gains or losses

4. It should consider time value of money

5. Should indicate the degree of risk and the chance of getting profit.

13.4.2 Principles of cash flows estimation

All estimate of receipts and payments should be based on cash flows rather than revenue and
expenditure or profit and loss.
1) All calculation should be based on incremental basis rather than on aggregate basis.  A
machine costing 1,00,000/- to replace old machine which fetched 20,000/- as scrap value,
then the cash outflow should be Rs.80,000/- and not Rs. 1,00,000/-

2) Cash flow should be taken after tax basis (CF after Tax) (FAT)

3) Sink cost to be ignored.  Cost had already been incurred and cannot be
recovered hence it should not be taken into account

4) Calculation of cash flows should also be taken into account.  The

opportunity cost even though no actual cash inflows or outflows is there, if using own
premises, rental cash outflow to be consider. Cash needs for working capital be treated as
cash outflow at the time of commencement of a project and should be treated as inflow, when
that cash is released at the time of closure – increase – inflow, decrease- outflow capital.

3.5 Time value of Money calculation 

The time value of money is the value of money figuring in a given amount of interest
earned over a given amount of time.  The time value of money is the central concept in
finance theory.  There is an inherent monetary value attached to time.  A rupee received to-
day is worth more than a rupee  received tomorrow because it can be invested.

The time value of Money calculation  

Present value of a lump sum:-

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PV  =  CFt/ (1+r)   or  PV =  Fvt (1+r)t

How much Rs.100/- received five years from now to be worth today if the rate of interest is
10%

  PV    =  CFt  / (1 + r)t

          =  100 / (1 + .1)t
          =   62.09
That means the value of Rs.100/- after 5 years but its present value is Rs.62.09 only.   PV =
FV (1 + i)n

i) Here PV is the value at time = 0

 
ii) Fv is the future value at time n

iii) "i"  is the discount rate or the rate of interest at which the amount will be
compounded each period.

iv) n is number of period (years)

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

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UNIT 14 :NATIONAL INCOME & ITS MESUREMENT

Learning Objectives
After going through this unit, you will be able to:

State the National income of a country

Discuss how to measure the National Income by different methods Explain the difficulties  in
the measurement of National Income
State different concepts related to National Income such as GDP; GNP; PI, DI 

Structure
14.1. Introduction 
14.2. Definition of National Income
   14.2.1. Feature of National Income
14.3. Measurement of National Income – Method
   14.3.1. Output method
    14.3.2. Income method
    14.3.3. Expenditure method
14.4. Difficulties in the measurement of National Income
14.5. Different concepts of National Income
    14.5.1. GDP (Gross Domestic Product)
    14.5.2. GNP (Gross National Product)
    14.5.3. Net National Income  
    14.5.4. P.I. (Personal Income)
    14.5.5. D.I. (Disposable Income)
14.6. Importance of National Income estimates
14.7. Summary
14.1  Introduction
  In this unit you will learn something about National Income, its measurement and
what difficulties are faced when we try to measure the National Income. You will also learn
some concepts of National Income. These concepts are made clear and easy to understand
about National Income. You will also learn the importance of the study of national income.

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14.2   Definition Of National Income
National Income is the money value of all the goods and services produced in an
economy over a period of one year.

Prof. Pigou, "National Income as that part of objective income of the community
including income derived from abroad which can be measured in money." 

Prof J. R. Hicks, "The National Income consists of a collection of goods and services
reduced to a common basis by being measured in terms of money."

14.2.1 Features of National Income   

 
National Income is a flow and not a stock
National Income in real terms is the flow of goods and services produced during a particular
period of time.

The concept of National Income is linked with some economic activities. 

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

14.3  Measurement Of National Income

The concept of National Income involves three interpretations –

1. It represents the monetary value of aggregate annual production in an

economy i.e. National Output.
2. It represents the aggregate income of the country (National Income).
3. It represents the aggregate expenditure in the economy that is National.

The above interpretation has given three methods of measurement of National Income:

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 14.3.1  Production Method  
GNP – It is the sum of the market value of all the final goods and services
produced in an economy during a given period of time. Production method is also called Net
Product or Value added method.Here the sum of value of goods and services produced at
market price is found. Then we have to take the gross product duly calculated by summing up
the money value of output in different sector of economy like agriculture, industry, transport.
The money value of raw material and services used in the production and the amount of
depreciation of physical assets involved in the production process are also summed up. Then
the Net output or value added is found by subtracting the aggregate of cost of raw material,
services and depreciation from the gross product found above.

  GNP = Gross National Product

        GNP = Money value of total goods and services and income from abroad.
  N.I. = GNP – Depreciation
14.3.2   Income Method   

It is also known as factor share method. In this income received by all the
basic factors of production used in the production process are summed up i.e. income
received by Labour, capital and income of professional such as doctors, lawyers etc. National
Income is obtained by summing up of the incomes of all individuals in the country.

National Income = Rent + wage + interest + Profit + income from abroad.

But transfer income is not to be included. This method indicates the distribution of
National Income among different income groups. This is also known as National Income at
factors cost.

13.3.3    Expenditure Method

This method is used by adding up all the expenditure made on goods and
services during a year.  Income can be spent either on consumer goods or investment goods.

     GNI = Individual expenditure and Govt. expenditure.

     GNP = Private consumption expenditure (c) + Gross domestic private investment (I)
+Net foreign Investment (x – m) + Govt. expenditure on goods and services (G) =  C + I +  (x
– m) + G

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14.4  Difficulties In The Measurement Of National Income
1. The data available in many countries are inadequate and unreliable.

2. Existence of a large amount of non-monetized sector in under developed countries.

Most of the agriculture produce does not reach the market because it is consumed at
home or is exchanged for other goods and services or stored.

3. Illiteracy and ignorance of the small producers creates difficulties because they do
not keep any account and they are not aware of its advantages.

4. The people have many occupations at the same time.  They undertake more than one
activity.  For example a small farmer does farming and also work somewhere during
slack season, so no account is kept for the income of such activity.

5. Existence of underground economy and illegal activities where black money/Hawala

system is used for transaction purposes and are not reported.  So how this amount can
be counted. Most of the illegal activities , which generate income, are not counted.

6. Depreciation system is not considered properly and many people are not aware of
such system. In order to maintain assets depreciation has to be provided for which can
be used for replacement of obsolete assets.

7. Free services rendered by the Govt. are not considered. Govt. spends a lot money on
police, military, judicial system administration and provides street lighting, irrigation,
education, public health, road etc.

8. Services of house wives are not considered since these are unpaid services. 

9. Capital Gains when the prices of capital assets increase and sold on profit.This
income is not considered in National Income.

10. Transfer payment is not considered in National Income.  These payments are in the
form of Pension, unemployment allowance, subsidies interest on national debt etc.

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14.5.   Different Concepts Of National Income
14.5.1. GDP (  gross domestic product )

GDP is the money value of all final goods and services produced in the
domestic country in an accounting year. It is a measure of country's overall economic output.
It is the market value of all the final goods and services made within the borders of a country
in a year. It includes all private and public consumption, Govt. expenditure, investment and
net of exports and Imports.
 
     GDP = C + G + I + Nx

  C = all private consumption

  G = sum of Govt. spending
  I = sum of all the country's business spending on capital
  Nx = Nation's total net exports that is  Exports – Imports.
  GDP at Factor cost and GDP at market price

  So GDP at factor cost = GDP at market price – IT + S

  IT = indirect taxes and S = Subsidies

14.5.2. GNP (Gross National Product) 

Gross National Product is the sum of gross domestic product and net factor
incomes from abroad.

     GNP = GDP + Net factor income from abroad

GNP is a monetary value of annual final output.

14.5.3. NNP (Net National Product)   

It is the net production of goods and services in a country during the year. 
    
     NNP = GNP – Depreciation

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 It is also referred to as national income market prices. It is a very useful
concept for the study of growth of economies.  It has a difficulty about fixing the appropriate
rate of deprecation.
 

14.5.4. NNP at Factor Cost

Net National Product or National Income National income is the total of all
income payments received by the factors of production  
   
     N.I. = Net National Product – Indirect taxes + subsidies- Profit accruing to the
Govt. 

Because Indirect taxes and profit accruing to the Govt. are not available to the factors hence
this is reduced from the National Income.

14.5.5. Personal Income

It is that income which is actually received by the individuals or household in

a country. It includes whole of the National Income earned by the factors of products in one
year which is not available to them. So we have to reduce all these elements which are not
available for distribution among the factors of production. We have to add to National
Income the transfer payment made by Govt. to some people.

     P.I. = N.I. – corporate Income Tax – undistributed profits – social security
contribution + transfer payments

14.5.6. D.I. (Disposable Income)  

      D.I. = Personal income – Personal direct tax. 

After paying the personal direct tax from Personal Income what is remaining
is D.I. which the house hold can spend on consumption. So we have made clear most of the
concepts relating to National Income clear as above.

14.6   Importance Of Estimates Of National Income

National Income is very important for an economy of a country. This gives the idea of
the condition of the economy of the country: Growth of GDP always show that the economy
is making progress. 

1. It helps in analyzing the overall production performance of the economy.

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 2. It helps in analyzing the performance of the economy whether it is growing,
stagnant or declining.

3. It shows the contribution made by various sectors of the economy such as

agriculture, industrial production trade and service sector.

4. It gives the idea of distribution of National Income indifferent categories such as

wages, profits, rent and profits.

5. It is a valuable guide for the policy makers. It assists in comparing National Income
of different countries. We can compare the standard of living of different countries by
its study.

6. It also throws light on the volume of consumption, saving and investment in the
economy.

14.7   Summary
National Income is the indicator of economic activity.  It is total market value of all
final products and services produced in a country during a year.
We have tried to explain about the National Income of the country. We have explained
different methods of measurement of National Income i.e. product method, income method,
and expenditure method in details. We have given the idea of various difficulties faced while
measuring the National Income. We have explained the concepts which are related to the N.I.
i.e. GDP, GNP, PI and Disposable income. We have given the idea of GDP at factor cost and
at Market price. We have also given the importance of the study of nation income.

UNIT 15:NEED OF GOVERNMENT VENTATION

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

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Structure
15.1 Introduction
15.2 Failure of market mechanism
15.3 Need for Government  Intervention
15.4 Meaning of price control
15.5 Methods of price control
    15.5.1 Prevention control of monopolies
15.6 Summary

15.1 Introduction
  In this unit we shall explain the need of the Govt. intervention in business because of
failure of the market economy. In detail we shall study how Govt. intervenes in the market.
Some of the techniques which the Govt. adopts are price control, support price, administered
price etc. and also how to control and prevent the formation of monopoly. Duel pricing
system is also one of the ways to help the weaker sector of the society to get the essential
goods.

15.2 Failure Of Market Mechanism

Following are the failures of Market Systems –

(i) Inequalities of income and wealth -  Right to property and law of

intervention has given advantage to the people who get a good start in life. Since they possess
productive resources, which can be used to earn more income and accumulate more wealth so
it has resulted in economic inequalities.

(ii) Economic instability -  Market economy is fully dependent on the

level of demand. Any change in demand could upset an economy. A fall in demand could
bring down the prices, leading to retrenchment of labour. This depression would engulf the
whole economy. A rise in demand will increase the productive activities and may lead to
inflation. This causes trade cycle which affect the economy because of fluctuation in the
economy.

(iii) Rise of Monopolies -  Competition in the Market economy is healthy.

It will improve efficiency and quality of the product. But it also leads to a cut throat
competition which will help the strong and well established producers to drive away the new
comers from the market. It would lead to creation of mo monopoly concentration of
economic power in the hands of a few producers. The monopolists can exploit the consumers.

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 (iv) Failure to provide full employment -  Market mechanism would
automatically establish equilibrium at the level of full employment. But because of rigidity
(especially wage rigidity due to trade union). The economy will be in equilibrium at less than
full employment so labor force remains unemployed and hence wasted the chance of creative
of wealth.

(v) Sacrifice of Social welfare -  In order to get maximum profit, the
producers produce these goods which have greater demand.  So the resources are diverted to
produce luxury, semi luxury goods.  The goods are for mass consumption needed for the poor
are neglected. So the society is neglected.

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

15.3  Need For Government Intervention

Seeing the failure of the capitalist free society, it is necessary that the Govt. should
intervene for smooth running of the economy.

a) To control cyclical fluctuations- The Govt. can adopt an anti-cyclical

policy to control the economic in staturlity. The Govt. can increase expenditure during
depression on the construction of infrastructure.  This helps to generate employment and
stimulate aggregate demand in the economy. In case of inflation the Govt. can exercise
control such as credit control and reduce Govt. expenditure and raise taxes.This will reduce
the supply of money in the society affecting aggregate demand.

b) Humanitarian consideration- Where market mechanism fails to serve the

human needs, Govt. may intervene.  In developing countries allowance is given to the
unemployed destitute and the poor senior citizens.  Similarly the Govt. can continue to
operate loss working unit so that the workers may not use their job.  

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c) Preventing Eco-inequality- The state can reduce economic inequality. The Govt. can
adopt the policy of progressive taxation such as income tax, estate duty and succession tax,
more taxes on higher income and revenue thus collected to be used for the welfare schemes
for the poor.  It can pass the laws to curb monopoly.  The Govt. can spend money to create
more opportunity for employment.  The Govt. can subsidize various essential goods for the
poor and the weaker section of society.  For example the Govt. has adopted the policy of
subsidizing gas, kerosene oil, and fertilizer to enable the poor to use their essential
commodities.
So some of reasons stated above make the intervention of the Govt. desirable.  

15.4 Meaning Of Price Control 

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

15.5   Method Of Price Control

The Govt. has the power to control the prices and following are some of ways the
Govt. control the prices by –

a) Fixing of minimum and maximum power 

b) Break up of monopoly power

c) Direct state provisions of goods and services

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 d) Fiscal policy intervention

e) Rationing

f) Support and Administered prices

g) Dual price system.

15.5.1 Prevention And Control Of Monopoly  

 
In free market, where competition is fundamental it is found that these
producers who have resources and efficient can compel the smaller unit out of business and
become monopolist. If Govt. finds monopolistic tendencies, either the Govt. can fix the price
and quality of the product or nationalize it.  Especially state monopoly is necessary in the
field of public utilities i.e. water supply, electricity generates distribution and gas supply. Rail
and road transport may be subject to wasteful competition and so it has to be under state
monopoly.The Govt. of Indi has passed anti monopoly act (MRTP) to control monopolistic
tendencies. Under this act an officer is appointed to look into this problem and recommend
necessary action. 

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

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