SCHOOL OF BUSINESS & PUBLIC MANAGEMENT

DEPARTMENT OF ACCOUNTS & FINANCE

COURSE CODE: MBA 605

COURSE TITLE: BUSINESS, ECONOMY & ENVIRONMENT

Instructional material for MBA-Distance Learning

MBA 605: BUSINESS, ECONOMY AND ENVIRONMENT
Contact hours: 42
Pre-requisites: None
Purpose: To provide fundamental aspects and phenomena of business economics and
illustrate the relationship between the environment and business management.
Expected Learning Outcomes of the Course
By the end of the course unit the learners should be able to:
i. Illustrate fundamental aspects and phenomena of business economics.
ii. Illustrate the relationship between environment and business management.
iii. Relate and apply the economic theory to business management
iv. Provide a comprehensive overview of key concepts in business economics in
particular, production theory, cost concepts, demand theory, competition,
inventory valuation, business environment and market structures.
Course Content:
WEEK ONE
CHAPTER ONE: THE SUBJECT MATTER OF BUSINESS ECONOMICS
 Characteristics of Business Economics
 Objectives of Business Economics
WEEK TWO
CHAPTER TWO: A FIRM AND ITS OBJECTIVES
 Objectives of a firm – Meaning
 Classification of Objectives of a firm
WEEK THREE
CHAPTER THREE: INVENTORY VALUATION
 First – In First – Out (FIFO)
 Last – In Last – Out (LIFO)
 Average Cost
WEEK FOUR
CHAPTER FOUR: PROFITS AND PROFITABILITY
 Introduction
 Concept of Profitability

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 Margin Ratios
 Returns Ratios
WEEK FIVE
CHAPTER FIVE: DEMAND ANALYSES
 The concept of demand and its features
 The Law of demand
 Exceptions to the Law of demand
 Elasticity of demand
WEEK SIX
Assignment 1

CHAPTER SIX: PRODUCER THEORY

 Introduction
 Meaning of Production
 Basic concepts in Production Theory
 Production Function
 Coub Douglas Production Function
WEEK SEVEN
CHAPTER SEVEN: COST CONCEPT
 Introduction
 Various concepts of costs
WEEK EIGHT
CHAPTER EIGHT: INVESTMENT DECISIONS
 Introduction
 Meaning and nature of Capital Budgeting
 Capital Budgeting/Investment decision Process
 Investment Methods
WEEK NINE
CHAPTER NINE: MARKET STRUCTURES AND COMPETITION
 Types of Market Structures

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 Means of Competition
 Forms of Competition
WEEK TEN
CHAPTER TEN: PRICING POLICY
 Introduction
 Importance of Price Policy
 Pricing Objectives
WEEK ELEVEN AND TWELVE
Assignment 2
CHAPTER ELEVEN: THE BUSINESS ENVIRONMENT
 Meaning of Business Environment
 Economic and Non-Economic Environment
 Kenya‟s Economic Structure
 Social Responsibility of a business and Ethics
 Economic Groupings
Teaching/ Learning Methodologies: Lectures and tutorials; Group discussion;
Demonstration; Individual assignments; Case Studies
Instructional Materials and Equipment: Projector; text books; design catalogues; computer
laboratory; design software; simulators
Course Assessment
Examination – 70%; Continuous Assessment Test (CATS) – 20%; Assignments – 10%; Total
– 100%
Recommended Text Books
i. Baye, M. (2005), Managerial Economics & Business Strategy. 5th edition revised
ii. Aras, G and Crowther, D. (2011), Governance in Business Environment
iii. Webster, J.T. (2003), Managerial Economy: Theory and Practice
Text Books for further Reading
i. Mcguigar, J. et al (2010), Managerial Economics
ii. Wilkinson, N. (2005), Managerial Economics
Module Author: Firtz Oketch

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 TABLE OF CONTENTS
Page
COURSE OUTLINE ....................................................................................................................... i
TABLE OF CONTENTS................................................................................................................ v
CHAPTER ONE: THE SUBJECT MATTER OF BUSINESS ECONOMICS ........................... 1
CHARACTERISTICS OF BUSINESS ECONOMICS .................................................................. 9
OBJECTIVES OF BUSINESS ECONOMICS ............................................................................ 11
SCOPE OF BUSINESS ECONOMICS ...................................................................................... 12
CHAPTER TWO: A FIRM AND ITS OBJECTIVES ................................................................ 15
OBJECTIVES OF A FIRM: MEANING .................................................................................... 15
CLASSIFICATION OF OBJECTIVES OF A FIRM................................................................... 15
CHAPTER THREE: INVENTORY VALUATION .................................................................... 25
FIRST-IN FIRST-OUT (FIFO) .................................................................................................. 28
LAST-IN FIRST-OUT (LIFO) .................................................................................................... 28
AVERAGE COST ....................................................................................................................... 29
CHAPTER FOUR: PROFITS AND PROFITABILITY ANALYSES ....................................... 31
CONCEPT OF PROFITABILITY .............................................................................................. 31
MARGIN RATIOS ...................................................................................................................... 33
RETURNS RATIOS .................................................................................................................... 34
CHAPTER FIVE: DEMAND ANALYSES ................................................................................. 37
THE CONCEPT OF DEMAND AND ITS FEATURES ............................................................. 37
THE LAW OF DEMAND ........................................................................................................... 40
DEMAND FUNCTION .............................................................................................................. 45
ELASTICITY OF DEMAND MEANING AND DEFINITION ................................................... 46
KINDS OF ELASTICITY OF DEMAND ................................................................................... 47
CHAPTER SIX: PRODUCTION THEORY ............................................................................... 67
INTRODUCTION ...................................................................................................................... 67
BASIC CONCEPTS IN PRODUCTION THEORY .................................................................... 68
PRODUCTION FUNCTION ..................................................................................................... 70
CHAPTER SEVEN: COST FUNCTION .................................................................................... 75
INTRODUCTION ...................................................................................................................... 75
VARIOUS CONCEPTS OF COST ............................................................................................. 75

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CHAPTER EIGHT: INVESTMENT DECISIONS ................................................................... 84
MEANING AND NATURE OF CAPITAL BUDGETING .......................................................... 84
INVESTMENT DECISION PROCESS ....................................................................................... 88
INVESTMENT METHODS ........................................................................................................ 90
CHAPTER: MARKET STRUCTURES AND COMPETITION .............................................. 103
TYPES OF MARKET STRUCTURES ...................................................................................... 103
MEANS OF COMPETITION ................................................................................................... 104
FORMS OF COMPETITION ................................................................................................... 106
CHAPTER TEN: PRICING POLICY ....................................................................................... 110
INTRODUCTION .................................................................................................................... 110
IMPORTANCE OF PRICE POLICY ....................................................................................... 111
PRICING OBJECTIVES .......................................................................................................... 113
FACTORS AFFECTING PRICING POLICY .......................................................................... 115
METHODS OF PRICING ........................................................................................................ 119
CHAPTER ELEVEN: BUSINESS ENVIRONMENT ............................................................ 132
MEANING OF BUSINESS ENVIRONMENT .......................................................................... 132
ECONOMIC ENVIRONMENT ................................................................................................ 135
NON-ECONOMIC ENVIRONMENT....................................................................................... 137
THE STRUCTURE OF KENYA ECONOMY ........................................................................... 156
SOCIAL RESPONSIBILITY OF A BUSINESS ........................................................................ 166
BUSINESS ETHICS ................................................................................................................. 168
ECONOMIC GROUPINGS ..................................................................................................... 185

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 CHAPTER ONE: THE SUBJECT MATTER OF BUSINESS ECONOMICS
Learning Objectives

By the end of this chapter the learner should be able to:

a) Define Business Economics

b) Describe characteristics and objectives of Business Economics

c) Explain the scope of Business Economics

The Subject Matter of Business Economics

Business Economics consists of that part of economic theory which helps the business
manager to take rational decisions. Economic theories help to analyze the practical problems
faced by a business firm. Business Economics integrates economic theory with business
practice. It is a special branch of economics that bridges the gap between abstract theory and
business practice. It deals with the use of economic concepts and principles for decision
making in a business unit. Business economics is that part of economic theory which focuses
on business enterprises and inquires into the factors contributing to the diversity of
organizational structures and to the relationships of firms with labour, capital and product
markets.
It is concerned with economic issue and problems related to business organization,
management and strategy. Issues and problems such as the following: an explanation of why
firms emerge and exist; why they expand: horizontally, vertically and spatially; the role of
entrepreneurs and entrepreneurship; the significance of organizational structure; the
relationship of firms with employees, the employees, the providers of capital, the customers,
the government; the interactions between firms and the business environment.
In simple words, business economics is the discipline which helps a business manager in
decision making for achieving the desired results. In other words, it deals with the application
of economic theory to business management.
According to Spencer and Siegelman, Business economics is "the integration of economic
theory with business practice for the purpose of facilitating decision-making and forward
planning by management".

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According to Mc Nair and Meriam, "Business economics deals with the use of economic
modes of thought to analyze business situation".
From the above said definitions, we can safely say that business economics makes in depth
study of the following objectives:
ii) Explanation of nature and form of economic analysis
(ii) Identification of the business areas where economic analysis can be applied
(iii) Spell out the relationship between business Economics and other disciplines and outline
the methodology of business economics.
Characteristics of Business Economics
The following characteristics of business economics will indicate its nature:
1. Micro economics: Business economics: micro economic in character. This is so because it
studies the problems of an individual business unit. It does not study the problems of the
entire economy.
2. Normative science: Business economics is a normative science. It is concerned with what
management should do under particular circumstances. It determines the goals of the
enterprise. Then it develops the ways to achieve these goals.
3. Pragmatic: Managerial economics is pragmatic. It concentrates on making economic
theory more application oriented. It tries to solve the managerial problems in their day-today
functioning.
4. Prescriptive: Managerial economics is prescriptive rather than descriptive. It prescribes
solutions to various business problems.
5. Uses macro economics: Marco economics is also useful to business economics. Macro-
economics provides an intelligent understanding of the environment in which the business
operates. Business economics takes the help of macro-economics to understand the external
conditions such as business cycle, national income, and economic policies of Government etc.
6. Uses theory of firm: Business economics largely uses the body of economic concepts and
principles towards solving the business problems. Business economics is a special branch of
economics to bridge the gap between economic theory and managerial practice.
7. Business oriented: The main aim of business economics is to help the business in taking
correct decisions and preparing plans and policies for future. Business economics analyses the
problems and give solutions just as doctor tries to give relief to the patient.

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8. Multi disciplinary: Business economics makes use of most modern tools of mathematics,
statistics and operation research. In decision making and planning principle - as accounting,
finance, marketing, production and personnel etc.
9. Art and science: Business economics is both a science and an art. As a science, it
establishes relationship between cause and effect by collecting, classifying and analyzing the
facts on the basis of certain principles. It points out to the objectives and also shows the way
to attain the said objectives.
Objectives of Business Economics
Business economics provides such tools necessary for business decisions. Business
economics answers the five fundamental problems of decision making. These problem are :
(a) what should be the product mix (b) which is the least cost production technique and input
mix (c) what should be the level of output and price of the product (d) how to take investment
decisions (e) how much should be the selling cost. In order to solve the problems of decision-
making, data are to be collected and analyzed in the light of business objectives. Business
economics supplies such data to the business economist.
The objectives of business economics are outlined as below:
1. To integrate economic theory with business practice.
2. To apply economic concepts: and principles to solve business problems.
3. To employ the most modern instruments and tools to solve business problems.
4. To allocate the scarce resources in the optimal manner.
5. To make overall development of a firm.
6. To help achieve other objectives of a firm like attaining industry leadership, expansion of
the market share etc.
7. To minimize risk and uncertainty
8. To help in demand and sales forecasting.
9. To help in operation of firm by helping in planning, organizing, controlling etc.
10. To help in formulating business policies.
11. To help in profit maximization.
Business economics is useful because: (i) It provides tools and techniques for managerial
decisions, (ii) It gives answers to the basic problems of business management, (iii) It supplies

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data for analysis and forecasting, (iv) It provides tools for demand forecasting and profit
planning, (v) It guides the business economist.
Scope of Business Economics
Business economics is a developing science which generates the countless problems to
determine its scope in a clear-cut way. From the following fields, we can examine the scope
of business economics.
1. Demand analysis and forecasting. The foremost aspect regarding scope is demand
analysis and forecasting. A business firm is an economic unit which transforms productive
resources into saleable goods. Since all output is meant to be sold, accurate estimates of
demand help a firm in minimizing its costs of production and storage. A firm must decide its
total output before preparing its production schedule and deciding on the resources to be
employed. Demand forecasts serves as a guide to the management for maintaining its market
share in competition with its rivals, thereby securing its profit.
2. Cost and production analysis. A firm's profitability depends much on its costs of
production. A wise manager would prepare cost estimates of a range of output, identify the
factors causing variations in costs and choose the cost-minimizing output level, taking also
into consideration the degree of uncertainty in production and cost calculations. Production
process is under the charge of engineers but the business manager works to carry out the
production function analysis in order to avoid wastages of materials and time. Sound pricing
policies depend much on cost control. The main topics discussed under cost and production
analysis are: Cost concepts, cost-output relationships, Economies and Diseconomies of scale
and cost control.
3. Pricing decisions, policies and practices. Another task before a business manager is the
pricing of a product. Since a firm's income and profit depend mainly on the price decision, the
pricing policies and all such decisions are to be taken after careful analysis of the nature of the
market in which the firm operates. The important topics covered in this field of study are:
Market Structure Analysis, Pricing Practices and Price Forecasting.
4. Profit management. Each and every business firms are tended for earning profit; it is
profit which provides the chief measure of success of a firm in the long period. Economists
tell us that profits are the reward for uncertainty bearing and risk taking. A successful
business manager is one who can form more or less correct estimates of costs and revenues at

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different levels of output. The more successful a manager is in reducing uncertainty, the
higher are the profits earned by him. It is therefore, profit-planning and profit measurement
constitutes the most challenging area of business economics.
5. Capital management. Still another most challenging problem for a modern business
manager is of planning capital investment. Investments are made in the plant and machinery
and buildings which are very high. Therefore, capital management requires top- level
decisions. It means capital management i.e., planning and control of capital expenditure. It
deals with Cost of capital, Rate of Return and Selection of projects.
6. Inventory management: A firm should always keep an ideal quantity of stock. If the stock
is too much, the capital is unnecessarily locked up in inventories at the same time if the level
of inventory is low, production will be interrupted due to non-availability of materials. Hence,
a firm always prefers to have an optimum quantity of stock. Therefore, managerial economics
will use some methods such as ABC analysis, inventory models with a view to minimizing
the inventory cost.
7. Environmental issues: There are certain issues of macroeconomics which also form a part
of business economics. These issues relate to general business, social and political
environment in which a business enterprise operates.
8. Business cycles: Business cycles affect business decisions. They refer to regular
fluctuations in economic activities in the country. The different phases of business cycle are
depression, recovery, prosperity, boom and recession. Thus, business economics comprises
both micro and macro-economic theories. The subject matter of business economics consists
of all those economic concepts, theories and tools of analysis which can be used to analyze
the business environment and to find out solution to practical business problems.

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 Review Questions
I. Explain the meaning of Business Economics

II. State the important characteristics of Business Economics

III. Explain the objectives of Business Economics

References:
1. Adhikary, M. (2002) Managerial Economics, Khosla Publishers
2. Joel Dean, (2001) Business Economics, Asia Publishing House

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 CHAPTER TWO: A FIRM AND ITS OBJECTIVES

Learning Objectives

At the end of this chapter a learner should be able:

 State the meaning of objectives of a firm

 Classify objectives of a firm into economic, social, human, national and global;

 Explain the nature of various objectives and their significance;

 State the meaning of business environment; and

 Recognize the various components of business environment.

Objectives of a Firm - Meaning

An objective is something you want to achieve. As a learner of MKU, you may have many
objectives in mind; one could be to perform well in the examination. Similarly, firm
objectives are something which a firm wants to achieve or accomplish over a specified period
of time. These may be to earn profit for its growth and development, to provide quality goods
to its customers, to protect the environment etc.
Classification of Objectives of a Firm
It is generally believed that a firm has a single objective, that is, to make profit. But it cannot
be the only objective of a firm. While pursuing the objective of earning profit, business units
do keep the interest of their owners in view. However, any firm cannot ignore the interests of
its employees, customers, the community, as well as the interests of society as a whole.
For instance, no firm can prosper in the long run unless fair wages are paid to the employees
and customer satisfaction is given due importance. Again a firm can prosper only if it enjoys
the support and goodwill of people in general. Firm objectives also need to be aimed at
contributing to national goals and aspirations as well as towards international well-being.
Thus, the objectives of a firm may be classified as -
a. Economic Objectives
b. Social Objectives

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c. Human Objectives
d. National Objectives
e. Global Objectives
Economic Objectives
Economic objectives of business refer to the objective of earning profit and also other
objectives that are necessary to be pursued to achieve the profit objectives, which include
creation of customers, regular innovations and best possible use of available resources.
i. Profit earning
Profit is the lifeblood of any firm, without which no firm can survive in a competitive market.
In fact profit making is the primary objective for which a firm is brought into existence.
Profits must be earned to ensure the survival of business, its growth and expansion over time.
Profits help businessmen not only to earn their living but also to expand their business
activities by reinvesting a part of the profits. In order to achieve this primary objective, certain
other objectives are also necessary to be pursued by business, which are as follows:
ii. Creation of customers
A business unit cannot survive unless there are customers to buy the products and services.
Again a businessman can earn profits only when he/she provides quality goods and services at
a reasonable price. For this it needs to attract more customers for its existing as well as new
products. This is achieved with the help of various marketing activities.
iii. Regular innovations
Innovation means changes, which bring about improvement in products, process of
production and distribution of goods. Business units, through innovation, are able to reduce
cost by adopting better methods of production and also increase their sales by attracting more
customers because of improved products. Reduction in cost and increase in sales gives more
profit to the businessman. Use of power-looms in place of handlooms, use of tractors in place
of hand implements in farms etc. are all the results of innovation.
iv. Best possible use of resources
As you know, to run any business you must have sufficient capital or funds. The amount of
capital may be used to buy machinery, raw materials, employ men and have cash to meet day-
to-day expenses. Thus, business activities require various resources like men, materials,
money and machines. The availability of these resources is usually limited. Thus, every

8
business should try to make the best possible use of these resources. This objective can be
achieved by employing efficient workers, making full use of machines and minimizing
wastage of raw materials.
Social Objectives
Social objectives are those objectives of business, which are desired to be achieved for the
benefit of the society. Since business operates in a society by utilizing its scarce resources, the
society expects something in return for its welfare. No activity of the business should be
aimed at giving any kind of trouble to the society. If business activities lead to socially
harmful effects, there is bound to be public reaction against the business sooner or later.
Social objectives of business include production and supply of quality goods and services,
adoption of fair trade practices and contribution to the general welfare of society and
provision of welfare amenities.
i. Production and supply of quality goods and services
Since the business utilizes the various resources of the society, the society expects to get
quality goods and services from the business. The objective of business should be to produce
better quality goods and supply them at the right time and at a right price. It is not desirable
on the part of the businessman to supply adulterated or inferior goods which cause injuries to
the customers. They should charge the price according to the quality of the goods and services
provided to the society. Again, the customers also expect timely supply of all their
requirements. So it is important for every business to supply those goods and services on a
regular basis.
ii. Adoption of fair trade practices
In every society, activities such as hoarding, black-marketing and over-charging are
considered undesirable. Besides, misleading advertisements often give a false impression
about the quality of products. Such advertisements deceive the customers and the
businessmen use them for the sake of making large profits. This is an unfair trade practice.
The business unit must not create artificial scarcity of essential goods or raise prices for the
sake of earning more profits. All these activities earn a bad name and sometimes make the
businessmen liable for penalty and even imprisonment under the law. Therefore, the objective
of business should be to adopt fair trade practices for the welfare of the consumers as well as
the society.

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iii. Contribution to the general welfare of the society
Business units should work for the general welfare and upliftment of the society. This is
possible through running of schools and colleges for better education, opening of vocational
training centres to train the people to earn their livelihood, establishing hospitals for medical
facilities and providing recreational facilities for the general public like parks, sports
complexes etc Human Objectives
Human objectives refer to the objectives aimed at the well-being as well as fulfillment of
expectations of employees as also of people who are disabled, handicapped and deprived of
proper education and training. The human objectives of business may thus include economic
well-being of the employees, social and psychological satisfaction of employees and
development of human resources.
i. Economic well being of the employees
In business employees must be provided with fair remuneration and incentives for
performance, benefits of provident fund, pension and other amenities like medical facilities,
housing facilities etc. By this they feel more satisfied at work and contribute more for the
business.
ii. Social and psychological satisfaction of employees
It is the duty of business units to provide social and psychological satisfaction to their
employees. This is possible by making the job interesting and challenging, putting the right
person in the right job and reducing the monotony of work. Opportunities for promotion and
advancement in career should also be provided to the employees. Further, grievances of
employees should be given prompt attention and their suggestions should be considered
seriously when decisions are made. If employees are happy and satisfied they can put their
best efforts in work.
iii. Development of human resources
Employees as human beings always want to grow. Their growth requires proper training as
well as development. Business can prosper if the people employed can improve their skills
and develop their abilities and competencies in course of time. Thus, it is important that
business should arrange training and development programmes for its employees.
iv. Well being of socially and economically backward people

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Business units being inseparable parts of society should help backward classes and also
people those are physically and mentally challenged. This can be done in many ways. For
instance, vocational training programme may be arranged to improve the earning capacity of
backward people in the community. While recruiting it staff, business should give preference
to physically and mentally challenged persons. Business units can also help and encourage
meritorious students by awarding scholarships for higher studies.
National Objectives
Being an important part of the country, every business must have the objective of fulfilling
national goals and aspirations. The goal of the country may be to provide employment
opportunity to its citizen, earn revenue for its exchequer, become self-sufficient in production
of goods and services, promote social justice, etc. Business activities should be conducted
keeping these goals of the country in mind, which may be called national objectives of
business. The following are the national objectives of business.
i. Creation of employment
One of the important national objectives of business is to create opportunities for gainful
employment of people. This can be achieved by establishing new business units, expanding
markets, widening distribution channels, etc.
ii. Promotion of social justice
As a responsible citizen, a businessman is expected to provide equal opportunities to all
persons with whom he/she deals. He/She is also expected to provide equal opportunities to all
the employees to work and progress. Towards this objective special attention must be paid to
weaker and backward sections of the society.
iii. Production according to national priority
Business units should produce and supply goods in accordance with the priorities laid down in
the plans and policies of the Government. One of the national objectives of business in our
country should be to increase the production and supply of essential goods at reasonable
prices.
iv. Contribute to the revenue of the country
The business owners should pay their taxes and dues honestly and regularly. This will
increase the revenue of the government, which can be used for the development of the nation.
v. Self-sufficiency and Export Promotion

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To help the country to become self-reliant, business units have the added responsibility of
restricting import of goods. Besides, every business units should aim at increasing exports and
adding to the foreign exchange reserves of the country.
Global Objectives
Earlier Kenya had a very restricted business relationship with other nations. There was a very
rigid policy for import and export of goods and services. But, now-a-days due to liberal
economic and export–import policy, restrictions on foreign investments have been largely
abolished and duties on imported goods have been substantially reduced. This change has
brought about increased competition in the market. Today because of globalization the entire
world has become a big market. Goods produced in one country are readily available in other
countries. So, to face the competition in the global market every business has certain
objectives in mind, which may be called the global objectives.
i. Raise general standard of living
Growth of business activities across national borders makes available quality goods at
reasonable prices all over the world. The people of one country get to use similar types of
goods that people in other countries are using. This improves the standard of living of people.
ii. Reduce disparities among nations
Business should help to reduce disparities among the rich and poor nations of the world by
expanding its operation. By way of capital investment in developing as well as
underdeveloped countries it can foster their industrial and economic growth.
iii. Make available globally competitive goods and services
Business should produce goods and services which are globally competitive and have huge
demand in foreign markets. This will improve the image of the exporting country and also
earn more foreign exchange for the country.
Business Environment
Conditions or situations that affect business activities may be regarded as the environment of
business. In other words, business environment refers to the surroundings and circumstances,
which influence business operations. This environment consists of forces and factors internal
or external to a business firm.
The skill and ability of employees, their attitude to work, relations between managers and
subordinates etc. may be regarded as internal environment of business. These are important

12
factors, which may affect business operations. But these are within the control of the
businessman. By taking suitable steps the conditions can be improved. On the other hand,
external environment refers to all those aspect of the surrounding of business, which are not
within the control of the managers and may affect business activities to a great extent. You
may have noticed that sometimes there is less demand of goods produced by a particular firm.
It may be due to better quality substitutes which customers find more useful. Again, if the
government policy changes so as to allow foreign goods to be imported at lower rates of
customs duty, similar good produced in India may not sell, as the prices of imported goods
may be lower. These conditions are generally not within the control of the businessmen.
External factors which influence or affect business activities and operations and are not
controllable by businessmen. We may classify these factors as economic factors, social
factors, political factors and technological factors.
(i) Economic factors
Economic factors include those factors which affect the business environment due to changes
in income level of the people, rates of interest on borrowing, availability of capital, tax rates,
demand and supply of goods and also changes in government economic policies, etc. For
example, you may have noticed that if the level of income of people goes up, there is
increased demand for goods and services. Similarly when interest rates on loans are lower
people spend more on buying durable goods like, car, home etc. Growth of business naturally
takes place as a result of increased spending by consumers.
(ii) Social factors
The nature of goods and services in demand depends upon the changes in habits and customs
of people in the society. With rise in population the demand for household as well as other
goods has increased. The nature of food and clothing has also changed to a great extent.
Demand for packaged food and ready-made garment has increased in recent times. All these
force the business to produce goods accordingly. So the social and cultural factors have also
affected the production pattern of business.
(iii) Political factors
Business environment is adversely affected by the absence of political stability. The workers‟
union may demand higher wages, may indulge in frequent strike etc., which affect the normal
functioning of business. Problems of law and order situation in border areas, conflicts

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between countries, absence of favourable economic as well as export– import policy also
affect the business activities. Business activities suffer serious setbacks under such
circumstances.
(iv) Technological factors
Technological advancement always leads to improvement in the process of production,
transportation and communication. Change in technology is mostly associated with better
service and cost efficiency. In recent years, information processing and storage with the use of
computers and telecommunication facilities have developed rapidly. People now prefer to use
mobile phones in place of landline phones. Now-a-days electronic appliances have replaced
electrical equipments vary widely. Business activities are bound to suffer if enterprises do not
adopt up to-date technology.

Review Questions
I. Profit earning is the main objective of a firm. Explain.

II. Explain the economic and social objectives of a firm.

III. Explain the importance of national objectives of a firm.

IV. Briefly describe the business environment.

References
1. Madura Jeff, (2007) Introduction to Business, 4th edition South Western
2. Haynes, W.W., (2001) Managerial Economics, Analysis and Cases, Business Publications,
Texas
3. Adhikary, M. (2002) Managerial Economics, Khosla Publishers.

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 CHAPTERTHREE: INVENTORY VALUATION

Learning Objectives
At the end of this chapter, a learner should be able to:

I. Define the term inventory and describe the process of inventory valuation

II. Differentiate between perpetual and periodic inventory system

III. Explain the various inventory valuation methods - FIFO/LIFO/AVERAGE COST

Inventory is defined as items of tangible personal property which are owned by the business
and are:
1. Held for resale in the normal course of business;
2. In the process of production for sale; or
3. Goods that will soon be used in the production process.
The process of inventory valuation is one of the most important processes in producing the
financial statements. The process involves sometimes conflicting goals: the accurate valuation
of inventories on the balance sheet and the proper matching of inventory costs against
revenues on the income statement. In addition, the cost of goods sold, a major component on
the income statement is affected by the proper valuation of inventories.
1. Effects of Inventory Errors:
a. Selection of an inventory system such as:
i. Periodic Inventory System
ii. Perpetual Inventory System
b. Selection of a cost flow assumption such as:
i. specific identification
ii. FIFO (First In First Out)
iii. LIFO (Last In First Out)
iv. Average Cost (Weighted or Moving Average Cost)
2. Determination of physical quantities on hand by taking a physical count or determination
from the accounting records.

15
3. Computing the value of ending inventory by multiplying the physical quantity on hand by
the value of the inventory based on historical cost.
4. Application of Lower of Cost or Market rule to insure that inventory is not overvalued on
the books.
Selection of the periodic or perpetual inventory system is becoming increasingly academic as
the cost of computer based inventory systems declines. The existence of low cost computer
based inventory systems coupled with laser bar code readers has virtually eliminated periodic
inventory systems in all but the smallest operations.
Advantages of Perpetual inventory systems:
a. Inventory quantities are maintained on a constant basis, normally on a per product basis;
b. Internal control is enhanced by allowing spot checks of inventory quantities on a random
basis at any time;
c. knowledge of inventory trends is produced in a timely manner so that management can
react to changing trends to avoid stock outs of fast moving items and unnecessary orders of
slow moving items;
d. due to timely knowledge of inventory trends it may be possible to reduce inventory costs
through better inventory control procedures.
Advantages of the Periodic Inventory System:
a. Allows firms to determine inventory and cost of goods sold at end of year without
recording the effect (on inventory) of every sale and purchase made throughout the year.
b. Requires no computer system and relatively simple record keeping
To determine how much inventory a company has on hand, the following formula can be
used. It is pretty straight forward, take the inventory at hand at the start of the reporting
period and add any new inventory purchases and then subtract the cost of any inventory that
has been sold.

16
Inventory Valuation
Inventory valuation and management is a very important part of managing the current assets
account on the balance sheet. If this aspect is not done properly, the ramifications are far
reaching; total assets and shareholders equity will be affected on the balance sheet while net
income will be affected on the income statement.
In order to properly manage and match up revenues derived from the cost of inventory,
companies use the following inventory valuation methodologies; First-In First-Out (FIFO),
Last-In Last-Out (LIFO), Average Cost, and Specific Identification.
First-in First-out (FIFO)
FIFO matches up sales with inventories in a sequential manner by matching the revenues
from the first sale with the costs associated with the first product that was made. For
example, assume that a textile company created 500 tablecloths at a cost of $1.00 per unit and
then created another 1000 with a unit cost of $1.25. The revenue from the sale of the first 500
table clothes will be matched up with the tablecloths which have a cost basis of $1.00.

Last-in First-Out (LIFO)

LIFO takes the opposite approach to FIFO; it matches in the reverse order. The first sale is
matched against the last product produced and therefore, the last good sold will be matched
up with the first good produced. Basically, LIFO is assuming that a company sells off its last
product produced, first.

17
Average Cost
The average cost method of inventory management is pretty straight forward. This method
values inventory costs as the average unit cost between the assets in the beginning inventory
and the newly acquired assets. There is no inventory matching required.
Specific Identification
Specific identification is more manually intensive method of managing inventory. Companies
will literally identify each item in inventory and record the capital gain(loss) when that
specific item is sold. Each item will remain in the inventory until it is sold.
Conclusion
Choosing the appropriate methodology is a difficult task as there are many unknown variables
that go into the decision, such as inflation or shelf life. With high inflation, or in markets with
prices increasing, companies will achieve higher profits by matching sales against inventory
which was produced at lower prices; earnings per share will increase but so will tax liability
due to an increase in profits. Using LIFO on the other hand will produce the opposite effect.
In essence, you will be matching new sales against higher production costs, thereby lowering
net income and EPS. Some companies may actually prefer this to keep their tax liability
down. Companies cannot use different methodologies when reporting to the government and
their shareholders so choosing either one may be a gift or a curse. Also remember, when
analyzing inventory valuations, it is important to compare one company against another
company in the same industry.

18
 Review Questions

i. Explain the difference between periodic and perpetual inventory system

highlighting the benefits of each system
ii. Differentiate between FIFO/LIFO/AVERAGE COST/SPECIFIC
IDENTIFICATION inventory valuation methods highlighting when each is
suitable

References for further Reading

1. Petersen, H. Craig and W. Chris Lewis, (2001) Managerial Economics
2. Mote, V.L., Samuel Paul and G.S Gupta, (2002) Managerial Economics, Concepts and
Cases, Tata McGraw Hill

19
 CHAPTER FOUR: PROFITS AND PROFITABILITY ANALYSES

Learning Objectives
At the end of this chapter, the learner should be able to:
i. Explain profits and concept of profitability
ii. Determine the various measures of profitability using the margin ratios and
returns ratios

Introduction
Profit is an excess of revenues over associated expenses for an activity over a period of time.
Terms with similar meanings include „earnings‟, „income‟, and „margin‟. Lord Keynes
remarked that „Profit is the engine that drives the business enterprise‟. Every business should
earn sufficient profits to survive and grow over a long period of time. It is the index to the
economic progress, improved national income and rising standard of living. No doubt, profit
is the legitimate object, but it should not be over emphasized. Management should try to
maximize its profit keeping in mind the welfare of the society. Thus, profit is not just the
reward to owners but it is also related with the interest of other segments of the society. Profit
is the yardstick for judging not just the economic, but the managerial efficiency and social
objectives also.
Concept of Profitability
Profitability means ability to make profit from all the business activities of an organization,
company, firm, or an enterprise. It shows how efficiently the management can make profit by
using all the resources available in the market. According to Harward & Upton, “profitability
is the „the ability of a given investment to earn a return from its use.”
However, the term „Profitability‟ is not synonymous to the term „Efficiency‟. Profitability is
an index of efficiency; and is regarded as a measure of efficiency and management guide to
greater efficiency. Though, profitability is an important yardstick for measuring the
efficiency, the extent of profitability cannot be taken as a final proof of efficiency. Sometimes
satisfactory profits can mark inefficiency and conversely, a proper degree of efficiency can be
accompanied by an absence of profit. The net profit figure simply reveals a satisfactory

20
balance between the values receive and value given. The change in operational efficiency is
merely one of the factors on which profitability of an enterprise largely depends. Moreover,
there are many other factors besides efficiency, which affect the profitability.
Profit and Profitability
Sometimes, the terms „Profit‟ and „Profitability‟ are used interchangeably. But in real sense,
there is a difference between the two. Profit is an absolute term, whereas, the profitability is a
relative concept. However, they are closely related and mutually interdependent, having
distinct roles in business.
Profit refers to the total income earned by the enterprise during the specified period of time,
while profitability refers to the operating efficiency of the enterprise. It is the ability of the
enterprise to make profit on sales. It is the ability of enterprise to get sufficient return on the
capital and employees used in the business operation.
As Weston and Brigham rightly notes “to the financial management profit is the test of
efficiency and a measure of control, to the owners a measure of the worth of their investment,
to the creditors the margin of safety, to the government a measure of taxable capacity and a
basis of legislative action and to the country profit is an index of economic progress, national
income generated and the rise in the standard of living”, while profitability is an outcome of
profit. In other words, no profit drives towards profitability.
Firms having same amount of profit may vary in terms of profitability. That is why R. S.
Kulshrestha has rightly stated, “Profit in two separate business concern may be identical, yet,
many a times, and it usually happens that their profitability varies when measured in terms of
size of investment”.
Profitability ratios show a company's overall efficiency and performance. We can divide
profitability ratios into two types: margins and returns. Ratios that show margins represent the
firm's ability to translate sales dollars into profits at various stages of measurement. Ratios
that show returns represent the firm's ability to measure the overall efficiency of the firm in
generating returns for its shareholders.
Margin Ratios
Gross Profit Margin
The gross profit margin looks at cost of goods sold as a percentage of sales. This ratio looks at
how well a company controls the cost of its inventory and the manufacturing of its products

21
and subsequently passes on the costs to its customers. The larger the gross profit margin, the
better for the company. The calculation is: Gross Profit/Net Sales = ____%. Both terms of
the equation come from the company's income statement.
Operating Profit Margin
Operating profit is also known as EBIT and is found on the company's income statement.
EBIT is earnings before interest and taxes. The operating profit margin looks at EBIT as a
percentage of sales. The operating profit margin ratio is a measure of overall operating
efficiency, incorporating all of the expenses of ordinary, daily business activity. The
calculation is: EBIT/Net Sales = _____%. Both terms of the equation come from the
company's income statement.
Net Profit Margin
When doing a simple profitability ratio analysis, net profit margin is the most often margin
ratio used. The net profit margin shows how much of each sales dollar shows up as net
income after all expenses are paid. For example, if the net profit margin is 5% that means that
5 cents of every dollar is profit.
The net profit margin measures profitability after consideration of all expenses including
taxes, interest, and depreciation. The calculation is: Net Income/Net Sales = _____%. Both
terms of the equation come from the income statement.
Cash Flow Margin
The Cash Flow Margin ratio is an important ratio as it expresses the relationship between cash
generated from operations and sales. The company needs cash to pay dividends, suppliers,
service debt, and invest in new capital assets, so cash is just as important as profit to a
business firm.
The Cash Flow Margin ratio measures the ability of a firm to translate sales into cash. The
calculation is: Cash flow from operating cash flows/Net sales = _____%. The numerator of
the equation comes from the firm's Statement of Cash Flows. The denominator comes from
the Income Statement. The larger the percentage, the better.
Returns Ratios
Return on Assets (also called Return on Investment)
The Return on Assets ratio is an important profitability ratio because it measures the
efficiency with which the company is managing its investment in assets and using them to

22
generate profit. It measures the amount of profit earned relative to the firm's level of
investment in total assets. The return on assets ratio is related to the asset management
category of financial ratios.
The calculation for the return on assets ratio is: Net Income/Total Assets = _____%. Net
Income is taken from the income statement and total assets are taken from the balance sheet.
The higher the percentage, the better, because that means the company is doing a good job
using its assets to generate sales.
Return on Equity
The Return on Equity ratio is perhaps the most important of all the financial ratios to investors
in the company. It measures the return on the money the investors have put into the company.
This is the ratio potential investors look at when deciding whether or not to invest in the
company. The calculation is: Net Income/Stockholder's Equity = _____%. Net income
comes from the income statement and stockholder's equity comes from the balance sheet. In
general, the higher the percentage, the better, with some exceptions, as it shows that the
company is doing a good job using the investors' money.
Cash Return on Assets
The cash return on assets ratio is generally used only in more advanced profitability ratio
analysis. It is used as a comparison to return on assets since it is a cash comparison to this
ratio as return on assets is stated on an accrual basis. Cash is required for future investments.
The calculation is: Cash flow from operating activities/Total Assets = _____%. The
numerator is taken from the Statement of Cash Flows and the denominator from the balance
sheet. The higher the percentage, the better.

23
 Review Questions

i) Explain the concept of profits and profitability giving suitable examples

ii) Explain the following profitability ratios highlighting what each one is used for:
Gross Profit margin
Return on Investments
Net profit margin
Cash flow margin

References for further Reading

1. M. Pandey, “Financial Management”, 2002, Vikas Publishing House Pvt. Ltd., New
Delhi.
2. Dr. S. N. Maheshwari, “Principles of Management Accounting”, Sultan Chand 7 Sons,
New Delhi, 2001.
3. James C. Van Horne & John M. Wachowicz, Jr., “Fundamentals of Financial
Management”, Pearson Education (Singapore) Pte. Ltd., Indian Branch, Delhi, 2005.

24
 CHAPTER FIVE: DEMAND ANALYSES

Learning Objectives

At the end of this lesson, the learner should be able to:

I. Understand the concept of demand

II. Explain the different kinds of elasticity of demand

III. Explain the Law of demand and the exceptions

The concept of demand and its features

The term demand is different from desire, want, will or wish. In the language of economics,
demand has different meaning. Any want or desire will not constitute demand.
Demand = Desire to buy + Ability to pay + Willingness to pay
The term demand refers to total or given quantity of a commodity or a service that are
purchased by the consumer in the market at a particular price and at a particular time.
The following are some of the important qualifications of demand-
· It is backed up by adequate purchasing power.
· It is always at a price.
· It should always be expressed in terms of specific quantity
· It is created in the market.
· It is related to a person, place and time.
Consumers create demand. Demand basically depends on utility of a product. There is a direct
relation between the two i.e., higher the utility, higher would be demand and lower the utility,
lower would be the demand.
The Demand Schedule
The demand schedule explains the functional relationship between price and quantity
variations, It is a list of various amounts of a commodity that a consumer is willing to buy
(and so seller to sell) at different prices at one instant of time. It is necessary to note that
the demand schedule is prepared with reference to the price of the given commodity alone.
We ignore the influence of all other determinants of demand on the purchase made by a
25
consumer. The following individual demand schedule shows that people buy more when price
is low and buy less when price is high.

Market Demand Schedule

When the demand schedules of all buyers are taken together, we get the aggregate or market
demand schedule. In other words, the total quantity of a commodity demanded at different
prices in a market by the whole body consumers at a particular period of time is called
market demand schedule. It refers to the aggregate behavior of the entire market rather than
mere totaling of individual demand schedules. Market demand schedule is more continuous
and smooth when compared to an individual demand schedule.

The study of the market demand schedule is of great importance to a business manager on
account of the following reasons:
1. It helps to make an intelligent forecast of the quantity to be sold at different prices.
2. It helps the business executives to know the various quantities that are likely to be
demanded at different prices.
3. It helps to study the effect of taxes on the total demand for goods in the market.
4. It helps to forecast the percentage of profits due to variation in prices and to arrange
production well in advance.
5 It helps the monopolist to manipulate prices to stimulate demand for a product.

26
6. It helps the managers to estimate its production plan in accordance with the market
demand.
Demand Curve
A demand curve is a locus of points showing various alternative prices – quantity
combinations. In short, the graphical presentation of the demand

It represents the functional relationship between quantity demanded and prices of a given
commodity. The demand curve has a negative slope or it slope downwards to the right. The
negative slope of the demand curve clearly indicates that quantity demanded goes on
increasing as price falls and vice versa.
The Law of Demand
It explains the relationship between price and quantity demanded of a commodity. It says that
demand varies inversely with the price. The law can be explained in the following manner:
“Other things being equal, a fall in price leads to expansion in demand and a rise in
price leads to contraction in demand”. The law can be expressed in mathematical terms as
“Demand is a decreasing function of price”. Symbolically, thus D = F (p) where, D represent
Demand, P stands for Price and F denotes the Functional relationships. The law explains the
cause and effect relationship between the independent variable [price] and the dependent
variable [demand]. There is no rule that a consumer has to buy more whenever price of the
commodity falls and vice-versa. The law explains only the general tendency of consumers
while buying a product. Thus, the law does not have universal validity.
A consumer would buy more when price falls due to the following reasons:

27
1. A product becomes cheaper. [Price effect]
2. Purchasing power of a consumer would go up. [Income effect]
3. Consumers can save some amount of money.
4. Cheaper products are substituted for costly products [substitution effect].
Important Features of Law of Demand
1. There is an inverse relationship between price and demand.
2. Price is an independent variable and demand is a dependent variable
3. It is only a qualitative statement and as such it does not indicate quantitative changes in
price and demand.
4. Generally, the demand curve slopes downwards from left to right. The operation of the law
is conditioned by the phrase “Other things being equal”. It indicates that given certain
conditions certain results would follow. The inverse relationship between price and demand
would be valid only when tastes and preferences, customs and habits of consumers, prices of
related goods, and income of consumers would remains constant.
Exceptions to the Law of Demand
Generally speaking, customers would buy more when price falls in accordance with the law of
demand. Exceptions to law of demand states that with a fall in price, demand also falls
and with a rise in price demand also rises. This can be represented by rising demand curve.
In other words, the demand curve slopes upwards from left to right. It is known as an
exceptional demand curve or unusual demand curve.

Following are the exception to the law of demand

1. Giffen‟s Paradox

28
A paradox is a foolish or absurd statement, but it will be true. Sir Robert Giffen, an Irish
Economists, with the help of his own example (inferior goods) disproved the law of demand.
The Giffen‟s paradox holds that “Demand is strengthened with a rise in price or weakened
with a fall in price”. He gave the example of poor people of Ireland who were using potatoes
and meat as daily food articles. When price of potatoes declined, customers instead of buying
greater quantities of potatoes started buying more of meat (superior goods). Thus, the demand
for potatoes declined in spite of fall in its price.
2. Veblen‟s effect
Thorstein Veblen, a noted American Economist contends that there are certain commodities
which are purchased by rich people not for their direct satisfaction, but for their ‟snob –
appeal‟ or „ostentation‟. Veblen‟s effect states that demand for status symbol goods would
go up with a arise in price and vice-versa. In case of such status symbol commodities it is
not the price which is important but the prestige conferred by that commodity on a person
makes him to go for it. More commonly cited examples of such goods are diamonds and
precious stones, world famous paintings, commodities used by world figures, personalities
etc. Therefore, commodities having ‟snob – appeal‟ are to be considered as exceptions to the
law of demand.
3. Fear of shortage
When serious shortages are anticipated by the people, (e.g., during the war period) they
purchase more goods at present even though the current price is higher.
4. Fear of future rise in price
If people expect future hike in prices, they buy more even though they feel that current prices
are higher. Otherwise, they have to pay a still high price for the same product.
5. Speculation implies purchase or sale of an asset with the hope that its price may rise
of fall and make speculative profit. Normally speculation is witnessed in the stock exchange
market. People buy more shares only when their prices show a rising trend. This is because
they get more profit, if they sell their shares when the prices actually rise. Thus, speculation
becomes an exception to the law of demand.
6 Conspicuous necessaries are those items which are purchased by consumers even
though their prices are rising on account of their special uses in our modern style of life.

29
In case of articles like wrist watches, scooters, motorcycles, tape recorders, mobile phones etc
customers buy more in spite of their high prices.
7. Emergencies
During emergency periods like war, famine, floods cyclone, accidents etc., people buy certain
articles even though the prices are quite high.
8. Ignorance
Sometimes people may not be aware of the prices prevailing in the market. Hence, they buy
more at higher prices because of sheer ignorance.
9. Necessaries
Necessaries are those items which are purchased by consumers whatever may be the
price. Consumers would buy more necessaries in spite of their higher prices.
Changes or Shifts in Demand
It is to be clearly understood that if demand changes only because of changes in the price of
the given commodity in that case there would be only either expansion or contraction in
demand. Both of them can be explained with the help of only one demand curve. If demand
changes not because of price changes but because of other factors or forces, then in that
case there would be either increase or decrease in demand. If demand increases, there
would be forward shift in the demand curve to the right and if demand decreases, then there
would be backward shift in the demand cure.

Demand determinants
Demand for a commodity or service is determined by a number of factors. All such factors are
called as „demand determinants‟:

30
1. Price of the given commodity, prices of other substitutes and/or complements, future
expected trend in prices etc.
2. General Price level existing in the country- inflation or deflation.
3. Level of income and living standards of the people.
4. Size, rate of growth and composition of population.
5. Tastes, preferences, customs, habits, fashion and styles
6. Publicity, propaganda and advertisements.
7. Quality of the product.
8. Profit margin kept by the sellers.
9. Weather and climatic conditions.
10. Conditions of trade- boom or prosperity in the economy.
11. Terms & conditions of trade.
12. Governments‟ policy- taxation, liberal or restrictive measures.
13. Level of savings & pattern of consumer expenditure.
14. Total supply of money circulation and liquidity preference of the people.
15. Improvements in educational standards etc.
Thus, several factors are responsible for bringing changes in the demand for a product in the
market. A business executive should have the knowledge and information about all these
factors and forces in order to finalize his own production marketing and other business
strategies.
Demand function
The law of demand and demand schedule explains only the price – quantity relations. It is
necessary to note that many factors and forces affect the demand.
It these factors are related to demand, the demand schedule is transformed into a demand
function.
The demand function for a product explains the quantities of a product demanded due
to different factors other than price in the market at a particular point of time
Demand function is a comprehensive formulation which specifies the factors that influence
the demand for a product other than price. Mathematically, a demand function can be
represented in the following manner.

31
The knowledge of demand function is more important for a firm than the law of demand.
Demand function explains the various factors and forces other than price that would affect the
demand for a commodity in the market. In accordance with changes in different factors or
forces, a firm can take suitable measures to prepare its production, distribution and marketing
programs scientifically.
Elasticity of Demand Meaning and Definition
The term elasticity is borrowed from physics. It shows the reaction of one variable with
respect to a change in other variables on which it is dependent. Elasticity is an index of
reaction. In economics the term elasticity refers to a ratio of the relative changes in two
quantities. It measures the responsiveness of one variable to the changes in another variable.
Elasticity of demand is generally defined as the responsiveness or sensitiveness of
demand to a given change in the price of a commodity. It refers to the capacity of demand
either to stretch or shrink to a given change in price. Elasticity of demand indicates a ratio of
relative changes in two quantities.ie, price and demand. According to proof. Boulding.
“Elasticity of demand measures the responsiveness of demand to changes in price”. In the
words of Marshall,” The elasticity (or responsiveness) of demand in a market is great or small
according to as the amount demanded much or little for a given fall in price, and diminishes
much or little for a given rise in price”
Kinds of elasticity of demand
Price Elasticity of Demand
Price elasticity of demand is one of the important concepts of elasticity which is used to
describe the effect of change in price on quantity demanded. In the words of Prof. Stonier and
Hague, price elasticity of demand is a technical term used by economists to explain the degree
of responsiveness of the demand for a product to a change in its price. Price elasticity of
demand is a ratio of two pure numbers, the numerator is the percentage change in quantity
demanded and the denominator is the percentage change in price of the commodity. It is

32
measured by using the following formula. It implies that at the present level with every
change in price, there will be a change in demand four times inversely.

Generally the co-efficient of price elasticity of demand always holds a negative sign because
there is an inverse relation between the price and quantity demanded.

Original demand = 20 units original price = 6 – 00

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

Perfectly Inelastic Demand: In this case, whatever may be the change in price, quantity
demanded will remain perfectly constant. The demand curve is a vertical straight line and

33
parallel to OY axis. Quantity demanded would be 10 units, irrespective of price changes from
Rs. 10.00 to Rs. 2.00. Hence, the numerical coefficient of perfectly inelastic demand is zero.
ED = 0

Relative Elastic Demand: In this case, a slight change in price leads to more than
proportionate change in demand. One can notice here that a change in demand is more than
that of change in price. Hence, the elasticity is greater than one. For e.g., price falls by 3 %
and demand rises by 9 %. Hence, the numerical co-efficient of demand is greater than one.

Relatively Inelastic Demand In this case, a large change in price, say 8 % fall price, leads to
less than proportionate change in demand, say 4 % rise in demand. One can notice here that
change in demand is less than that of change in price. This can be represented by a steeper
demand curve. Hence, elasticity is less than one.

In all economic discussion, relatively elastic demand is generally called as „elastic demand‟ or
„more elastic‟ demand while relatively inelastic demand is popularly known as „inelastic
demand‟ or „less elastic demand‟.

34
1. Unitary elastic demand: In this case, proportionate change in price leads to equal
proportionate change in demand. For e.g., 5 % fall in price leads to exactly 5 % increase in
demand. Hence, elasticity is equal to unity. It is possible to come across unitary elastic
demand but it is a rare phenomenon.

Determinants of Price Elasticity of Demand

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

35
Durable goods are those which can be used for a long period of time. Demand tends to be
elastic in case of durable and repairable goods because people do not buy them frequently.
For example, table, chair, vessels etc. On the other hand, for perishable and non- repairable
goods, demand tends to be inelastic e.g., milk, vegetables, electronic watches etc.
5. Possibility of postponing the use of a commodity
In case there is no possibility to postpone the use of a commodity to future, the demand tends
to be inelastic because people have to buy them irrespective of their prices. For example,
medicines. If there is possibility to postpone the use of a commodity, demand tends to be
elastic e.g., buying a TV set, motor cycle, washing machine or a car etc.
6. Level of Income of the people
Generally speaking, demand will be relatively inelastic in case of rich people because any
change in market price will not alter and affect their purchase plans. On the contrary, demand
tends to be elastic in case of poor.
7. Range of Prices
There are certain goods or products like imported cars, computers, refrigerators, TV etc,
which are costly in nature. Similarly, a few other goods like nails; needles etc. are low priced
goods. In all these case, a small fall or rise in prices will have insignificant effect on their
demand. Hence, demand for them is inelastic in nature. However, commodities having normal
prices are elastic in nature.
8. Proportion of the expenditure on a commodity
When the amount of money spent on buying a product is either too small or too big, in that
case demand tends to be inelastic. For example, salt, newspaper or a site or house. On the
other hand, the amount of money spent is moderate; demand in that case tends to be elastic.
For example, vegetables and fruits, cloths, provision items etc.
9 Habits
When people are habituated for the use of a commodity, they do not care for price changes
over a certain range. For example, in case of smoking, drinking, use of tobacco etc. In that
case, demand tends to be inelastic. If people are not habituated for the use of any products,
then demand generally tends to be elastic.
10. Period of time

36
Price elasticity of demand varies with the length of the time period. Generally speaking, in the
short period, demand is inelastic because consumption habits of the people, customs and
traditions etc. do not change. On the contrary, demand tends to be elastic in the long period
where there is possibility of all kinds of changes.
11. Level of Knowledge
Demand in case of enlightened customer would be elastic and in case of ignorant customers, it
would be inelastic.
12. Existence of complementary goods - Goods or services whose demands are
interrelated so that an increase in the price of one of the products results in a fall in the
demand for the other. Goods which are jointly demanded are inelastic in nature. For
example, pen and ink, vehicles and petrol, shoes and socks etc have inelastic demand for this
reason. If a product does not have complements, in that case demand tends to be elastic. For
example, biscuits, chocolates, ice creams etc. In this case the use of a product is not linked to
any other products.
1. Purchase frequency of a product
If the frequency of purchase is very high, the demand tends to be inelastic. For e.g., coffee,
tea, milk, match box etc. on the other hand, if people buy a product occasionally, in that case
demand tends to be elastic for example, durable goods like radio, tape recorders, refrigerators
etc. Thus, the demand for a product is elastic or inelastic will depend on a number of factors.
Measurement of price elasticity of demand
There are different methods to measure the price elasticity of demand and among them the
following two methods are most important ones.
1. Total expenditure method.
2. Point method.
3. Arc method.
1. Total Expenditure Method - under this method, the price elasticity is measured by
comparing the total expenditure of the consumers (or total revenue i.e., total sales values
from the point of view of the seller) before and after variations in price. We measure
price elasticity by examining the change in total expenditure as a result of change in the price
and quantity demanded for a commodity.
1. When new outlay is greater than the original outlay, then ED > 1.

37
2. When new outlay is equal to the original outlay then ED = 1.
3. When new outlay is less than the original outlay then ED < 1.
Graphical Representation

From the diagram it is clear that

1. From A to B price elasticity is greater than one.
2. From B to C price elasticity is equal than one.
3. From C to D price elasticity is lesser than one.az
Note:
It is to be noted that when total expenditure increases with the fall in price and decreases with
a rise in price, then the PED is greater that one.
When the total expenditure remains the same either due to a rise or fall in price, the PED is
equal to one.
When total expenditure, decrease with a fall in price and increase with a rise in price, PED is
said to be less than one.
2. Point Method:
Prof. Marshall advocated this method. The point method measures price elasticity of
demand at different points on a demand curve. Hence, in this case attempt is made to E
measure small changes in both price and demand. It can be explained either with the help of
mathematical calculation or with the help of a diagram or graphic representation. In order to
measure price elasticity at two points, A and B, the following formula is to be adopted.

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

38
In order to find out percentage change in price, the following formula is employed

It is clear that on any straight line demand curve, price elasticity will be different at different
points since the demand curve represents the demand schedule and the demand schedule has
different elasticity‟s at various alternatives prices.
Graphical representation
The simplest way of explaining the point method is to consider a linear or straight- line
demand curve. Let the straight – line demand curve be extended to meet the two axis X and Y
when a point is plotted on the demand curve, it divides the curve into two segments. The point

39
elasticity is measured by the ration of lower segment of the demand curve below, the given
point to the upper segment of the curve above the point. Hence.

In short, e = L / U where e stands for Point elasticity, L for lower segment and U for upper
segment.

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

40
Illustration
P1 = original price 10. Q1 = original quantity = 200 units P2 = New price 5 Q2 = New
quantity = 300units by substituting the values in to the equation, we can find out Arc elasticity
of demand.

In the diagram, in order to measure arc elasticity between two points M & N on the demand
curve, one has to take the average of prices OP1 and OP2 and also the average quantities of
Q1 & Q2.
Practical application of price elasticity of demand
1. Production planning
It helps a producer to decide about the volume of production. If the demand for his products is
inelastic, specific quantities can be produced while he has to produce different quantities, if
the demand is elastic.
2. Helps in fixing the prices of different goods
It helps a producer to fix the price of his product. If the demand for his product is inelastic, he
can fix a higher price and if the demand is elastic, he has to charge a lower price. Thus, price
increase policy is to be followed if the demand is inelastic in the market and price-decrease
policy is to be followed if the demand is elastic. Similarly, it helps a monopolist to practice
price discrimination on the basis of elasticity of demand.
2. Helps in fixing the rewards for factor inputs Factor rewards refer to the price paid for
their services in the production process. It helps the producer to determine the rewards for

41
factors of production. If the demand for any factor unit is inelastic, the producer has to pay
higher reward for it and vice-versa.
3. Helps in determining the foreign exchange rates
Exchange rate refers to the rate at which currency of one country is converted in to the
currency of another country. It helps in the determination of the rate of exchange between
the currencies of two different nations. For e.g. if the demand for US dollar to an Indian rupee
is inelastic, in that case, an Indian has to pay more Indian currency to get one unit of US
dollar and vice-versa.
4. Helps in determining the terms of trade
It is the basis for deciding the „terms of trade‟ between two nations. The terms of trade
implies the rate at which the domestic goods are exchanged to foreign goods. For e.g. if
the demand for Japan‟s products in India is inelastic, in that case, we have to pay more in
terms of our commodities to get one unit of a commodity from Japan and vice-versa.
5. Helps in fixing the rate of taxes
Taxes refer to the compulsory payment made by a citizen to the government periodically
without expecting any direct return benefit from it. It helps the finance minister to
formulate sound taxation policy of the country. He can impose more taxes on those goods for
which the demand is inelastic and fewer taxes if the demand is elastic in the market.
6. Helps in Declaration of Public Utilities
Public utilities are those institutions which provide certain essential goods to the general
public at economical prices. The Government may declare a particular industry as „public
utility‟ or nationalize it, if the demand for its products is inelastic.
7. Poverty in the Midst of Plenty:
The concept explains the paradox of poverty in the midst of plenty. A bumper crop of rice or
wheat instead of bringing prosperity to farmers may actually bring poverty to them because
the demand for rice and wheat is inelastic. Thus, the concept of price elasticity of demand has
great practical application in economic theory.
Income elasticity of Demand
Income elasticity of demand may be defined as the ratio or proportionate change in the
quantity demanded of a commodity to a given proportionate change in the income. In

42
short, it indicates the extent to which demand changes with a variation in consumer‟s income
the following formula helps to measure Ey.

Original demand = 400 units Original Income = 4000-00

New demand = 700 units New Income = 6000-00
Generally speaking, Ey is positive. This is because there is a direct relationship between
income and demand, i.e. higher the income; higher would be the demand and vice-versa. On
the basis of the numerical value of the co-efficient, Ey is classified as greater than one, less
than one, equal to one, equal to zero, and negative. The concept of Ey helps us in classifying
commodities into different categories.
1. When Ey is positive, the commodity is normal [used in day-to-day life]
2. When Ey is negative, the commodity is inferior.
3. When Ey is positive and greater than one, the commodity is luxury.
4. When Ey is positive, but less than one, the commodity is essential.
5. When Ey is zero, the commodity is neutral e.g. salt, match box etc.
Practical application of income elasticity of demand
1. Helps in determining the rate of growth of the firm.
If the growth rate of the economy and income growth of the people is reasonably forecasted,
in that case it is possible to predict expected increase in the sales of a firm and vice-versa.
2. Helps in the demand forecasting of a firm.
It can be used in estimating future demand provided the rate of increase in income and Ey for
the products are known. Thus, it helps in demand forecasting activities of a firm.
3. Helps in production planning and marketing
The knowledge of Ey is essential for production planning, formulating marketing strategy,
deciding advertising expenditure and nature of distribution channel etc in the long run.
4. Helps in ensuring stability in production

43
Proper estimation of different degrees of income elasticity of demand for different types of
products helps in avoiding over-production or under production of a firm. One should also
know whether rise or fall income is permanent or temporary.
5. Helps in estimating construction of houses.
The rate of growth in incomes of the people also helps in housing programs in a country.
Thus, it helps a lot in managerial decisions of a firm.
Cross Elasticity of Demand
It may be defined as the proportionate change in the quantity demanded of a particular
commodity in response to a change in the price of another related commodity. In the
words of Prof. Watson cross elasticity of demand is the percentage change in quantity
associated with a percentage change in the price of related goods. Generally speaking, it arises
in case of substitutes and complements. The formula for calculating cross elasticity of demand
is as follows.
Ec = Percentage change in quantity demanded commodity X
Percentage change in the price of Y

Price of Tea rises from Rs. 4-00 to 6 -00 per cup

Demand for coffee rises from 50 cups to 80 cups.
Cross elasticity of coffee in this case is 1.6.
It is to be noted that-
1. Cross elasticity of demand is positive in case of good substitutes e.g. coffee and tea.
2. High cross elasticity of demand exists for those commodities which are close substitutes. In
other words, if commodities are perfect substitutes for example Bata or Corona Shoes, close
up or pepsodent tooth paste, Beans and ladies finger, Pepsi and coca cola etc.
3. The cross elasticity is zero when commodities are independent of each other. For example,
stainless steel, aluminum vessels etc.
4. Cross elasticity between two goods is negative when they are complementary. In these
cases, rise in the price of one will lead to fall in the quantity demanded of another commodity
For example, car and petrol, pen and ink.etc.

44
Practical application of cross elasticity of demand
1. Helps at the firm level Knowledge of cross elasticity of demand is essential to study the
impact of change in the price of a commodity which possesses either substitutes or
complementary. If accurate measures of cross elasticities are available, a firm can forecast the
demand for its product and can adopt necessary safe guard against fluctuating prices of
substitutes and complements. The pricing and marketing strategy of a firm would depend on
the extent of cross elasticities between different alternative goods.
2. Helps at the industry level
Knowledge of cross elasticity would help the industry to know whether an industry has any
substitutes or complementary in the market. This helps in formulating various alternative
business strategies to promote different items in the market.
Advertising or Promotional Elasticity of Demand. Most of the firms, in the present
marketing conditions spend considerable amounts of money on advertisement and other such
sales promotional activities with the object of promoting its sales. Advertising elasticity
refers to the responsiveness demand or sales to change in advertising or other
promotional expenses. The formula to calculate the advertising elasticity is as follows.

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

New sales = 50,000 units new advertisement expenditure = 2000-00
In the above example, advertising elasticity of demand is 1.67. It implies that for every one
time increase in advertising expenditure, the sales would go up 1.67 times Thus, Ea is more
than one.
Practical application of advertising elasticity of demand
The study of advertising elasticity of demand is of paramount importance to a firm in recent
years because of fierce competition.
1. Helps in determining the level of prices

45
The level of prices fixed by one firm for its product would depend on the amount of
advertisement expenditure incurred by it in the market.
2. Helps in formulating appropriate sales promotional strategy
The volume of advertisement expenditure also throws light on the sales promotional strategies
adopted by a firm to push off its total sales in the market. Thus, it helps a firm to stimulate its
total sales in the market.
3. Helps in manipulating the sales
It is useful in determining the optimum level of sales in the market. This is because the sales
made by one firm would also depend on the total amount of money spent on sales promotion
of other firms in the market.
Substitution Elasticity of Demand.
It measures the effects of the substitution of one commodity for another. It may be defined as
the proportionate change in the demand ratios of two substitute goods X and y to the
proportionate change in the price ratio of two goods X and Y The following formulas is
used to measure substitution elasticity of demand.

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

Delta DX / Dy is the change in the quantity ratio of two goods X & Y.
PX / Py is the price ratio of two goods X & Y.
Delta PX / PY is change in price ratio of two goods X & Y
The coefficient of substitution elasticity is equal to one when the percentage change in
demand ratio‟s of two goods x and y are exactly equal to the percentage change in price ratios
of two goods x and y. It is greater than one when the changes in the demand ratios of x and y
is more than proportionate to change in their price ratios.
Practical Application of Substitution Elasticity of Demand
The concept of substitution elasticity is of great importance to a firm in the context of
availability of various kinds of substitutes for one factor inputs to another. For example, let us

46
assume one computer can do the job of 10 laborers and if the cost of computer becomes
cheaper than employing workers, in that case, a firm would certainly go for substituting
workers for computers. .An employer would always compare the cost of different alternative
inputs and employ those inputs which are much cheaper than others to cut down his cost of
operations. Thus, the concept of elasticity of demand has great theoretical as well as practical
application in economic theory.

Review Questions
i. State and explain the law of demand highlighting the exceptions to this law.
ii. Explain the concepts of shifts in demand
iii. Explain the various determinants of demand
iv. What is elasticity of demand? explain the different degree of price elasticity
with suitable diagrams
v. Discuss the determinants of price elasticity of demand.
vi. Discuss any one method of measuring price elasticity of demand.
vii. Explain the cross, income, advertising and substitution elasticity of demand.
viii. Discuss the practical importance of various trends of elasticity of demand.

References for further Reading

1. Petersen, H. Craig and W. Chris Lewis, Managerial Economics
2. Mote, V.L., Samuel Paul and G.S Gupta, Managerial Economics, Concepts and Cases,
Tata McGraw Hill

47
 CHAPTER SIX: PRODUCTION THEORY

Learning Objectives

By the end of this chapter the learner should be able to:

i. Understand the meaning of Production

ii. Know the factors and characteristics of Production

iii. Explain the basic concepts in production theory

iv. Understand the production function

Introduction
Production is an important economic activity. It directly or indirectly satisfies the wants and
needs of the people. Satisfaction of human wants is the objective of production. In this lesson
a general discussion of the concept of production and its functions are carried out.
Meaning of Production
Production is the conversion of input into output. The factors of production and all other
things which the producer buys to carry out production are called input. The goods and
services produced are known as output. Thus production is the activity that creates or adds
utility and value. In the words of Fraser, "If consuming means extracting utility from matter,
producing means creating utility into matter". According to Edwood Buffa, “Production is a
process by which goods and services are created".
Factors of Production
As already stated, production is a process of transformation of factors of production (input)
into goods and services (output). The factors of production may be defined as resources which
help the firms to produce goods or services. In other words, the resources required to produce
a given product are called factors of production. Production is done by combining the various
factors of production. Land, labour, capital and organization (or entrepreneurship) are the
factors of production (according to Marshall). We can use the word CELL to help us
remember the four factors of production: C. capital; Entrepreneurship; L land: and L labour.
Characteristics of Factors of Production
1. The ownership of the factors of production is vested in the households.
2. There is a basic distinction between factors of production and factor services.

48
It is these factor services, which are combined in the process of production.
3. The different units of a factor of production are not homogeneous. For example, different
plots of land have different level of fertility. Similarly laborers differ in efficiency.
4. Factors of production are complementary. This means their co-operation or combination is
necessary for production.
5. There is some degree of substitutability between factors of production. For example, labour
can be substituted for capital to a certain extent.
Basic Concepts in Production Theory
The firm is an organization that combines and organizes labour, capital and land or raw
materials for the purpose of producing goods and services for sale. The aim of the firm is to
maximize total profits or achieve some other related aim, such as maximizing sales or growth.
The basic production decision facing the firm is how much of the commodity or services to
produce and how much labour, capital and other resources or inputs to use to produce that
output most efficiently. To answer these questions, the firm requires engineering or
technological data on production possibilities (the so called production function) as well as
economic data on input and output prices.
Production refers to the transformation of inputs or resources into outputs of goods and
services. For example: IBM hires workers to use machinery, parts and raw materials in
factories to produce personal computers. The output of a firm can either be a final commodity
(such as personal computer) or an intermediate product such as semiconductors (which are
used in the production of computers and other goods). The output can also be a service rather
than a good. Examples of services are education, medicine, banking, communication,
transportation and many others. To be noted is, that production refers to all of the activities
involved in the production of goods and services, from borrowing to set up or expand
production facilities, to hiring workers, purchasing raw materials, running quality control, cost
accounting and so on, rather than referring merely to the physical transformation of inputs
into outputs of goods and services.
Inputs are the resources used in the production of goods and services. As a convenient way to
organize the discussion, inputs are classified into labour. (Including entrepreneurial talent),
capital and land or natural resources. Each of these broad categories however includes a great
variety of the basic input. For example, labour includes bus drivers, assembly line workers,

49
accountants, lawyers, doctor‟s scientists and many others. Inputs are also classified as fixed or
variable. Fixed inputs are those that cannot be readily changed during the time period under
consideration, except at very great expense. Examples of fixed inputs are the firm's plant and
specialized equipment. On the other land, variable inputs are those that can be varied easily
and on the very short notice. Examples of variable inputs are most raw materials and unskilled
labour.
The time period during which at least one input is fixed is called the short run, while the time
period when all inputs are variable is called the long run. The length of the long run depends
on the industry. For some, such as the setting up or expansion of a dry cleaning business, the
long run may be only few months or weeks. For others, much as the construction of new
electricity, generating plant, it may be many years. In the short run, a firm can increase output
only by using more of the variable inputs together with the fixed inputs. In the long run, the
same increase in output could very likely be obtained more efficiently by also expanding the
firm's production facilities. Thus we say that the firm operates in the short run and plans
increases or reductions in its scale of operation in the long run. In the long run, technology
usually improves, so that more output can be obtained from a given quantity of inputs or the
same output from less input.
Production Function
Production is the process by which inputs are transformed in to outputs. Thus there is relation
between input and output. The functional relationship between input and output is known as
production function. The production function states the maximum quantity of output which
can be produced from any selected combination of inputs. In other words, it states the
minimum quantities of input that are necessary to produce a given quantity of output.
The production function is largely determined by the level of technology. The production
function varies with the changes in technology. Whenever technology improves, a new
production function comes into existence. Therefore, in the modern times the output depends
not only on traditional factors of production but also on the level of technology.
The production function can be expressed in an equation in which the output is the dependent
variable and inputs are the independent variables. The equation is expressed as follows:
Q= f (L, K, T……………n)
Where, Q = output

50
L = labour
K = capital
T = level of technology
n = other inputs employed in production.
There are two types of production function - short run production function and long run
production function. In the short run production function the quantity of only one input varies
while all other inputs remain constant. In the long run production function all inputs are
variable.
Assumptions of Production Function
The production function is based on the following assumptions.
1. The level of technology remains constant.
2. The firm uses its inputs at maximum level of efficiency.
3. It relates to a particular unit of time.
4. A change in any of the variable factors produces a corresponding change in the output.
5. The inputs are divisible into most viable units.
Managerial Use of Production Function
The production function is of great help to a manager or business economist. The managerial
uses of production function are outlined as below:
1. It helps to determine least cost factor combination: The production function is a guide to
the entrepreneur to determine the least cost factor combination. Profit can be maximized only
by minimizing the cost of production. In order to minimize the cost of production, inputs are
to be substituted. The production function helps in substituting the inputs.
2. It helps to determine optimum level of output: The production function helps to
determine the optimum level of output from a given quantity of input. In other words, it helps
to arrive at the producer's equilibrium.
3. It enables to plan the production: The production function helps the entrepreneur (or
management) to plan the production.
4. It helps in decision-making: Production function is very useful to the management to
take decisions regarding cost and output. It also helps in cost control and cost reduction. In
short, production function helps both in the short run and long run decision-making process.
Cobb Douglas Production Function

51
Paul H. Douglas and C.W Cobb of the U.S.A have studied the production of the American
manufacturing industries and they formulated a statistical production function. It is popularly
known as Cobb-Douglas Production Function. It is stated as follows:
Q = KLaC,,a) where, Q = output
L = quantity of labour
C = quantity of capital
K and a = positive constants
In this production function the output (Q) is a function of two inputs L and C.
According to Cobb Douglas production function, about 3/4 of the increase in output is due to
labour and the remaining 1/4 is due to capital. On this basis, Cobb Douglas production
function can be expressed as under:
Q = KL3/4 C1/4
L+C=3/4 +1/4=1
An important point in Cobb Douglas production function is that it indicates constant returns to
scale. This means that if each input factor is increased by one percent, output will exactly
increase by one percent. In other words, there will be no economies or diseconomies of scale.
Although the Cobb Douglas production function is nonlinear, it can be transformed into a
linear function by converting all variables into logarithms. That is why this function is known
as a log linear function.
In 1937, David Duerentt suggested that it will be better to present Cobb-Douglas production
function in the form of following equation :
Q = KLaC j
In the above equation, 'a' and 'j' stand for elasticity of production of labour and capital
respectively.
Importance of Cobb-Douglas Production Function
Cobb-Douglas production function is most commonly used function in the field of economics.
It graduates data on output and input well. Many economists used it independently. Hence,
there are a number of varieties of the Cobb-Douglas form which yield variable elasticity‟s of
production and substitution.
It is useful in international or inter- industry comparisons.

52
Cobb-Douglas research has been a test of the marginal productivity theory of wages (or
theory of distribution) as well as descriptions of production technology.

Review Questions
i. What is a production function?
ii. Explain the characteristics of Production
iii. Discuss in detail the Cobb-Douglas Production function

References for further Reading

1. Mehtra, P.L. (2000)“Managerial Economics” Analysis, Problems and Cases. Sultan
Chand & Sons.
2. Mote, V.L. Samuel and G.S. Gupta(2001) “Managerial Economics”.
3. Maddala, G.S. and Ellen Miller, (2002) Micro Economics: Theory and Applications,
McGraw Hill, New York.

53
 CHAPTER SEVEN: COST FUNCTION

Learning Objectives

At the end of the chapter, the learner should be able to:

i. Familiarize the cost concept used in managerial decision making process.
ii. Understand about the various costs

Introduction
The word 'cost' has different meanings in different situations. The accounting cost concept or
the historical cost concept is not useful as such for business decision-making. The accounting
records end up with the balance sheet and income statements which are meant for legal,
financial and tax needs of the enterprise. The financial recordings reveal what has been
happening. It is a historical recording which is not of very much help to the managerial
economist in his business decision-making. The actual cost is not the relevant cost concept for
business decision-making because it only reveals what has been happening. The decision-
making concepts of cost aim at projecting what will happen in the alternative courses of
action. Business decisions involve plans for the future and require choices among different
plans. These decisions necessitate profitability calculations for which a comparison of future
revenues and future expenses of each alternative plan is needed.
Various Concepts of Costs
A managerial economist must have a proper understanding of the different cost concepts
which are essential for clear business thinking. The several alternative bases of classifying
cost and the relevance of each for different kinds of problems are to be studied. The various
relevant concepts of costs used in business decisions are given below.
Total, Average and Marginal Costs
Total cost is the total cash payment made for the input needed for production. It may be
explicit or implicit is the sum total of the fixed and variable costs.
Average cost is the cost per unit of output. It is obtained by dividing the total cost (TC) by the
total quantity produced (Q)
Average Cost =TC/Q

54
Marginal cost is the additional cost incurred to produce an additional unit of output. Or it is
the cost of the marginal unit produced.
Fixed and Variable Costs
This classification is made on the basis of the degree to which they vary with the changes in
volume. Fixed cost is that cost which remains constant up to a certain level of output. It is not
affected by the changes in the volume of production. Then fixed cost per unit varies with
output rate. When the production increases, fixed cost per unit decreases. Fixed cost includes
salary paid to administrative staff, depreciation of fixed assets, rent of factory etc. These costs
are fixed in the sense that they do not change in short-run.
Variable cost varies directly with the variation in output. An increase in total output results in
an increase in total variable costs and decrease in total output results in a proportionate
decline in the total variable costs. The variable cost per unit will be constant. Variable costs
include the costs of all inputs that vary with output like raw materials, running costs of fixed
assets such as fuel, ordinary repairs, routine maintenance expenditure, direct labour charges
etc.
The distinction of cost is important in forecasting the effect of short-run changes in volume
upon costs and profits.
Short-Run and Long-Run Costs
This cost distinction is based on the time element. Short-Run is a period during which the
physical capacity of the firm remains fixed. Any increase in output during this period is
possible only by using the existing physical capacity more intensively. Long- Run is a period
during which it is possible to change the firm's physical capacity. All the inputs become
variable in the long-term. Short-Run cost is that which varies with output when the physical I
capacity remains constant. Long-Run costs are those which vary with output when all the
inputs are variable. Short-Run costs are otherwise called variable costs. A firm wishing to
change output quickly can do it only by increasing the variable factors. Short- Run cost
concept helps the manager to take decision when a firm has to decide whether or not to
produce more or less with a given plant. Long-Run cost analysis helps to take investment
decisions. Long-Run increase in output may necessitate installation of more capital
equipment.
Opportunity Costs and Outlay Costs

55
This distinction is made on the basis of the nature of the sacrifice made. Outlay costs are those
expenses which are actually incurred by the firm. These are the actual payments made for
labour, material, plant, building, machinery, traveling, transporting etc. These are the expense
items that appear in the books of accounts. Outlay cost is an accounting cost concept. It is also
called absolute cost or actual cost. Whenever the inputs are to be bought for cash the outlay
concept is to be applied.
A businessman chooses an investment proposal from different investment opportunities.
Before taking the decision he has to compare all the opportunities and choose the best. When
he chooses the best he sacrifices the possibility of making profit from other investment
opportunities. The cost of his choice is the return that he could have earned from other
investment opportunities he has given up or sacrificed. A businessman decides to use his own
money to buy a machine for the business. The cost of that money is the probable return on the
money from the next most acceptable alternative investment. If he invested the money at 12
percent interest, the opportunity cost of investing in his own business would be the 12 percent
interest he has forgone.
The outlay concept is applied when the inputs are to be bought from the market. When a firm
decides to make the inputs rather than buying it from the market the opportunity cost concept
is to be applied. For example, in a cloth mill, instead‟ of buying the yarn from the market they
spin it themselves. The cost of this yam is really the price at which the yarn could be sold if it
were not used by them for weaving cloth.
The opportunity cost concept is made use of for long-run decisions. For example, the cost of
higher education of a student should not only be the tuition fees and book costs but it also
includes the earnings foregone by not working. This concept is very important in capital
expenditure budgeting. The cost of acquiring a petrol pump in Mombasa City by spending
Kes 1 million is not usually the interest for that borrowed money but it is the profit that would
have been made if that Kes 1 million had been invested in an offset printing press, which is
the next best investment opportunity.
Opportunity cost concept is useful for taking short-rum decisions also. In boom periods the
scarce lathe capacity used for making a product involves the opportunity cost of not using it to
make some other product that can also produce profit. Opportunity cost is the cost concept to

56
use when the supply of inputs is strictly limited. Estimates of cost of capital are essentially
founded on an opportunity cost concept of investment return.
Investment decision involves opportunity costs measurable in terms of sacrificed income from
alternative investments. The opportunity cost of any action is therefore measured by the value
of the most favorable alternative course which has to be foregone if that action is taken.
Opportunity cost arises only when there is an alternative. If there is no alternative, opportunity
cost is the estimated earnings of the next best use. Thus it represents only the sacrificed
alternative. Hence it does not appear in financial accounts. But this concept is of very great
use in managerial decision-making.
Out-of-pocket and Book Costs
Out-of-pocket costs are those costs that involve current cash payment. Wages, rent, interest
etc., are examples of this. The out-of-pocket costs are also called explicit costs. Book costs do
not require current cash expenditure. Unpaid salary of the owner manager, depreciation, and
unpaid interest cost of owner's own fund are examples of book costs. Book costs may be
called implicit costs. But the book costs are taken into account in determining the legal
dividend payable during a period. Both book costs and out-of-pocket costs are considered for
all decisions. Book cost is the cost of self owned factors of production. The book cost can be
converted into out-of-pocket cost. If self owned machinery is sold out and the service of the
same is hired, the hiring charges form the out-of-pocket cost the distinction is very helpful in
taking liquidity decisions.
Incremental and Sunk costs
Incremental cost is the additional cost due to a change in the level or nature of business
activity. The change may be caused by adding a new product, adding new machinery,
replacing machinery by a better one etc. Incremental or differential cost is not marginal cost.
Marginal cost is the cost of an added (marginal) unit of output.
Sunk costs are those which are not altered by any change. They are the costs incurred in the
past. This cost is the result of past decision, and cannot be changed by future decisions. Once
an asset has been bought or an investment made, the funds locked up represent sunk costs. As
these costs do not alter when any change in activity is made they are sunk and are irrelevant to
a decision being taken now. Investments in fixed assets are examples of sunk costs. As soon
as fixed assets have been installed, their cost is sunk. The amount of cost cannot be changed.

57
Incremental cost helps management to evaluate the alternatives. Incremental cost will be
different in the case of different alternatives. Sunk cost, on the other hand, will remain the
same irrespective of the alternative selected. Cost estimates of an incremental nature only
influence business decisions.
Explicit and Implicit or Imputed costs
Explicit costs are those expenses that involve cash payments. These are the actual or business
costs that appear in the books of accounts. Explicit cost is the payment made by the employer
for those factors of production hired by him from outside. These costs include wages and
salaries paid payments for raw materials, interest on borrowed capital funds, rent on hired
land, taxes paid to the government etc.
Implicit costs are the costs of the factor units that are owned by the employer himself. It does
not involve dash payment and hence does not appear in the books of accounts. These costs did
not actually incur but would have incurred in the absence of employment of self-owned
factors of production. The two normal implicit costs are depreciation and return on capital
contributed by shareholders. In small scale business unit the entrepreneur himself acts as the
manager of the business. If he were employed in another firm he would be given salary. The
salary he has thus forgone is the opportunity cost of his services utilized in his own firm. This
is an implicit cost of his business. Thus implicit wages, implicit rent and implicit interest are
the highest interest, rent and wages which self-owned capital, building and labour respectively
can earn from their next best use. Implicit costs are not considered for finding out the loss or
gains of the business, but help a lot in business decisions.
Replacement and Historical costs
These are the two methods of valuing assets for balance sheet purpose and to find out the cost
figures from which profit can be arrived at; Historical cost is the original cost of an asset.
Historical cost valuation shows the cost of an asset as the original price paid for the asset
acquired in the past. Historical valuation is the basis for financial accounts.
Replacement cost is the price that would have to be paid currently to replace the same asset.
For example, the price of a machine at the time of purchase was Kes. 17,000 and the present
price of the machine is Kes. 20,000. The original price Kes. 17,000 is the historical cost while
Kes. 20,000 is the replacement cost. During periods of substantial change in the price level,
historical valuation gives a poor projection of the future cost intended for managerial

58
decision. Replacement cost is a relevant cost concept when financial statements have to be
adjusted for inflation.
Controllable and Non-controllable costs
Controllable costs are the ones which can be regulated by the executive who is in charge of it.
The concept of controllability of cost varies with levels of management. If a cost is
uncontrollable at one level of management it may be controllable at some other level.
Similarly the controllability of certain costs may be shared by two or more executives. For
example, material cost, the price of which comes under the responsibility of the purchase
executive whereas its usage comes under the responsibility of the production executive. Direct
expenses like material, labour etc. are controllable costs. Some costs are not directly
identifiable with a process or product. They are apportioned to various processes or products
in some proportion. This cost varies with the variation in the basis of allocation and is
independent of the actions of the executive of that department. These apportioned costs are
called uncontrollable costs.
Business and Full costs
A firm's business cost is the total money expenses recorded in the books of accounts. This
includes the depreciation provided on plant and equipment. It is similar to the actual or real
cost. Full cost of a firm includes not only the business costs but also opportunity costs of the
firm and normal profits. The firm's opportunity cost includes interest on self-owned capital,
the salary forgone by the entrepreneur if he were, working in his firm. Normal profit is the
minimum returns which induces the entrepreneur to produce the same product.
Economic and Accounting Cost
Accounting costs are recorded with the intention of preparing the balance sheet and profit and
loss statements which are intended for the legal, financial and tax purposes of the company.
The accounting concept is a historical concept. It records what has happened. The past cost
data revealed by the books of accounts does not help very much in decision-making.
Decision-making needs future costs. Economic concept considers future costs and future
revenues which help future planning and choice. When the accountant describes what has
happened, the economist aims at projecting what will happen. Accounting data ignores
implicit or imputed cost. The economist considers decision-making costs. For this, different
cost classifications relevant to different kinds of problems are considered. The cost

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distinctions such as opportunity and outlay cost, short run and long-run cost and replacement
and historical cost are made from the economic viewpoint

Review Questions
i. Mention the importance of opportunity cost in managerial decision

making

ii. Bring out the relationship between TC, MC, and AC

iii. Differentiate Explicit and Implicit cost

iv. Distinguish between Incremental cost and sunk cost

References for further Reading

1. Mehtra, P.L. (2000)“Managerial Economics” Analysis, Problems and Cases. Sultan
Chand & Sons.
2. Mote, V.L. Samuel and G.S. Gupta(2001) “Managerial Economics”.
3. Maddala, G.S. and Ellen Miller, (2002) Micro Economics: Theory and Applications,
McGraw Hill, New York.

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 CHAPTER EIGHT: INVESTMENT DECISIONS

Learning Objectives
At the end of this lesson, the learner should be able to
i. Know the concept of Capital Budgeting

ii. Understand the importance of Capital Budgeting/Investment Decision making

iii. Familiarize the process involved in Capital Budgeting

iv. Compute the net present value of an investment proposal.

v. Explain why the NPV rule leads to optimal decisions

vi. Compute the internal rate of return of an investment proposal.

vii. Explain the limitations of the IRR as an investment appraisal criterion.

viii. Compute the payback period of an investment proposal.

ix. Determine whether a particular investment proposal should be undertaken.

Introduction
Every business has to decide upon its investment, as it involves high risk. An apt decision on
investment program leads a business firm to achieve its high profit; hence a methodology to
assist the management to take correct decision on its investment proposals is quintessential for
which capital budgeting technique would assist. Capital budgeting is concerned with
designing and carrying through a systematic investment program.
Meaning and nature of Capital Budgeting
Capital budgeting is the process of making investment decisions in capital expenditures. A
capital expenditure may be defined as an expenditure the benefits of which are expected to be
received over period of time exceeding one year. The main characteristic of a capital
expenditure is that the expenditure is incurred at one point of time whereas benefits of the
expenditure are realized at different points of time in future.

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The simple language we may say that a capital expenditure is an expenditure incurred for
acquiring or improving the fixed assets, the benefits of which are expected to be received
oven number of years in future. The following are some of the examples of capital
expenditure:
(1) Cost of acquisition of permanent assets as land and building, plant and machinery,
goodwill, etc
(2) Cost of addition, expansion, improvement or alteration in the fixed assets.
(3) Cost of replacement of permanent assets.
(4) Research aid development project cost, etc.
Capital expenditure involves non-flexible long-term commitment of funds. Thus, capital
expenditure decisions are also called as long term investment decisions. Capital budgeting
involves the planning and control of capital expenditure. It is the process of deciding whether
or not to commit resources to a particular long term project whose benefit are to be realized
over a period of time, longer than one year. Capital budgeting is also known as Investment
Decision Making, Capital Expenditure Decisions, Planning Capital Expenditure and Analysis
of Capital Expenditure.
Charles T. Horngreen has defined capital budgeting as, “Capital budgeting is long term
planning for making and financing proposed capital outlays”. According to G.C Philippatos,
"Capital budgeting is concerned with the allocation of the firm's scarce financial resources
among the available market opportunities”. The consideration of investment opportunities
involves the comparison of the expected future streams of earnings from a project with the
immediate and subsequent streams of earning from a project, with the immediate and
subsequent streams of expenditures for it". Richard and Great law have referred to capital
budgeting as acquiring inputs with long-run return." In the words of Lynch, "Capital
budgeting consists in planning development of available capital for the purpose of
maximizing the long term Profitability of the concern." From the above description, it may be
concluded that the important features which distinguish capital budgeting decision from the
ordinary day today business decisions are:
1. Capital budgeting decisions involve the exchange of current funds for the benefits to be
achieved in future.
2. The future benefits are expected to be realized over a series of years.

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3. The funds are invested in non-flexible and long term activities.
4. They have a long term and significant effect on the profitability of the concern.
5. They involve, generally, huge funds.
6. They are strategic' investment decisions, involving large sums of money, major departure
from the past practices of the firm, significant change of the firm's exported earnings
associated with high degree of risk, as compared to 'tactical' investment decisions which
involve a relatively small amount of funds that do not result in a major departure from the past
practices of the firm.
Need and Importance of Capital Budgeting
Capital budgeting means planning for capital assets. Capital budgeting decisions are vital to
any organizational as they include the decisions as to:
(a) Whether or not funds should be invested in long term projects such as setting of an
industry, purchase of plant and machinery etc.
(b) Analyze the proposal for expansion or creating additional capacities.
(c) To decide the replacement of permanent assets such as building and equipment.
(d) To make financial analysis of various proposals regarding capital investments so as to
choose the best out of many alternative proposals.
The importance capital budgeting can be well understood from the fact that an unsound
investing decision may prove to be fatal to the very existence of the concern. The need,
significance or importance of capital budgeting arises mainly due to the following:
1. Large Investment. Capital budgeting decisions, generally, involve large investment of
funds. But the funds available with the firm are always limited and the demand for funds far
exceeds the recourses. Hence, it is very important for a firm to plan and control its espial
expenditure.
2. Long-term Commitment of Funds. Capital expenditure involves not only large amount of
funds but also funds for long-term or more or less on permanent basis. The long-term,
commitment of funds increases the financial risk involved in the investment decision, greater
the risk involved, greater is the need for careful planning of capital expenditure i.e. Capital
budgeting.

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3. Irreversible nature. The capital expenditure decisions are of irreversible nature. Once the
decision for acquiring a permanent asset is taken, it becomes very difficult dispose of these
assets without incurring heavy losses.
4. Long-term effect on Profitability. Capital budgeting decisions have a long-term and
significant effect on the profitability of a concern. Not only the present earnings of the firm
are affected by the investments in capital assets but also the future growth and profitability of
the firm depends upon the investment decision taken today. An unwise decision may prove
disastrous and fatal to the very existence of the concern. Capital budgeting is of utmost
importance to avoid over investment or under investment in fixed assets.
5. Difficulties of investment Decisions. The long term investment decisions are difficult to
be taken because (i) decision extends to a series of years beyond the current accounting
period, (ii) uncertainties of future and (iii) higher degree of risk.
6. National Importance. Investment decision though taken by individual concern is of
national importance because it determines employment, economic activities and economic
growth. Thus, we may say that without using capital budgeting techniques a firm may involve
itself in a losing project. Proper timing of purchase, replacement, expansion and alternation of
assets is essential.
Investment Decision Making/ Capital Budgeting Process
Capital budgeting is a complex process as it involves decisions relating to the investment of
current funds for the benefit to the achieved in future and the future is always uncertain.
However, the following procedure may be adopted in the process of capital budgeting:
1. Identification of Investment Proposals. The capital budgeting process begins with the
identification of investment proposals. The proposal or the idea about potential investment
opportunities may originate from the top management or may come from the rank and file
worker of any department or from any officer of the organization. The departmental head
analyses the various proposals in the light of the corporate strategies and submits the suitable
proposals to the Capital Expenditure Planning Committee in case of large organizations or to
the officers concerned with the process of long-term investment decisions.
2. Screening the Proposals, The Expenditure Planning Committee screens the various us
proposals received from different departments. The committee views these Proposals from

64
various angles to ensure that these are in accordance with the corporate strategies or selection
criterion of the firm and also do not lead to departmental imbalances.
3. Evaluation of Various Proposals. The next step in the capital budgeting process is to
evaluate the profitability of various proposals. There are many methods which may be used
for this purpose such as payback period method, rate of return method, net present value
method, internal rate of return method etc.
It should, however, be noted that the various proposals to the evaluated may be classified as:
(i) Independent proposals (ii) Contingent or dependent proposals and (iii) Mutually exclusive
proposals.
Independent proposals are those which do not compete with one another and the same may be
either accepted or rejected on the basis of a minimum return on investment required. The
contingent proposals are those whose acceptance depends upon the acceptance of one or more
other proposals, e.g., further investment in building or machineries may have to under taken
as a result of expansion programme. Mutually exclusive proposals are those which compete
with each other and one of those may have to be selected at the cost of the other.
4. Fixing Priorities after evaluating various proposals, the unprofitable or uneconomic
proposals may be rejected straight away. But it may not be possible for the firm to invest
immediately in all the acceptable proposals due to limitation of funds. Hence, it is very
essential to rank the various proposals and to establish priorities after considering urgency,
risk and profitability involved therein.
5. Final approval and preparation of Capital Expenditure Budget. Proposals meeting the
evaluation and often criteria are finally approved to be included in the Capital Expenditure
Budget However; proposals involving smaller investment may be decided at the lower levels
for expeditious action. The capital expenditure budget lays down the amount of estimated
expenditure to be incurred on fixed assets during the budget period.
6. Implementing Proposal. Preparation of a capital expenditure budgeting and incorporation
of a particular proposal in the budget does not itself authorize to go ahead with the
implementation of the project. A request for authority to spend the amount should further be
made to the Capital Expenditure Committee which may like to review the profitability of the
project in the changed circumstances. Further, while implementing the project, it is better to
assign responsibilities for completing the project within the given time frame and cost limit so

65
as to avoid unnecessary delays and cost over runs. Network techniques used in the project
management such as PERT and CPM can also be applied to control and monitor the
implementation of the projects.
7. Performance Review The last stage in the process of capital budgeting is the evaluation of
the performance the project. The evaluation is made through post completion audit by way of
comparison of actual expenditure on the project with the budgeted one, and also by comparing
the actual return from the investment with the anticipated return. The unfavorable variances, if
any should be looked into and the causes of the same be identified so that corrective action
may be taken in future.
Investment Methods
There are many methods of evaluating profitability of capital investment proposals. The
various commonly used methods are as follows:
(A) Traditional methods:
(1) Pay-back Period method or Pay out or Pay off method.
(2) Rate of Return Method or Accounting Method.
(B) Time -adjusted method or discounted Methods:
(4) Net present Value Method.
(5) Internal Rate of Return Method.
(6) Profitability Index Method.
Traditional Methods:
1. Pay-Back Period Method
The 'Pay back' sometimes called as pay out or pay off period method represents the period in
which the total investment in permanent assets pays back itself. This method is based on the
principle that every capital expenditure pays itself back within a certain period out of the
additional earrings generated from the capital assets. Thus, it measures the period of time for
the original cost of a project to be recovered from the additional earnings of the project itself.
Under this method, various investments are ranked according to the length of their payback
period in such a manner that the investment with a shorter payback period is preferred to the
one which has longer pay back period.

66
In case of evaluation of a single project, it is adopted if it pays back for itself with in a period
specified by the management and if the project does not pay back itself with in the period
specified by the management then it is rejected.
The pay-back period can be ascertained in the following manner:
(1) Calculate annual net earnings (profits) before depreciation and after taxes; these are called
annual cash inflows.
(2) Divide the initial outlay (cost) of the project by the annual cash inflow, where the project
generates constant annual cash inflows. Thus, where the project generates constant cash
inflows.
Pay-back period
= Cash Outlay of the project or Original cost of the Asset
Annual Cash Inflows

(3) Where the annual cash inflows (Profit before depreciation and after taxes) are unequal, the
pay-back period can be found by adding up the cash inflows until the total is equal to the
initial cash outlay of project or original cost of the asset.
Advantages of Pay-back Period method
(1) The main advantage of this method is that it is simple to understand and easy to calculate.
(2) It saves in cost; it requires lesser time and labour as compared to other methods of capital
budgeting.
(3) In this method, as a project with a shorter pay-back period is preferred to the one having a
longer pay-back period it reduces the loss through obsolescence and is more suited to the
developing countries, like Kenya, which are in the process of development and have quick
obsolescence.
(4) Due to its short term approach, this method is particularly suited to a firm which has
shortage of cash or whose liquidity position is not particularly good.
Disadvantages of Pay-back Method
Though pay-back period method is the simplest, oldest and most frequently used method, it
suffers from the following limitations:
(1) It does not take into account the cash inflows earned after the payback period and hence
the true profitability of the projects cannot be correctly assessed.

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(2) This method ignores the time value of money and does not consider the magnitude and
timing of cash inflows. It treats all cash flows as equal though they occur in different periods.
It ignores the fact that cash received today is more important than the same amount of cash
received after, say 3 years.
(3) It does not take-into consideration the cost of capital which is a very important factor in
making sound investment decisions.
(4) It may be difficult to determine the minimum acceptable pay-back period; it is usually, a
subjective decision.
(5) It treats each asset individually in isolation with other assets which is not feasible in real
practice.
(6) Pay-back period method does not measure the true profitability of the project as the period
considered under this method is limited to a short period only and not the full life of the asset.
In spite of the above mentioned limitations, this method can be used in evaluating the
profitability of short term and medium term capital investment proposals.
2. Rate of Return Method: This method takes in to account the earnings expected from the
investment over their whole life. It is known as Accounting Rate of Return method for the
reason that under this method, the accounting concept of profit (net profit after tax and
depreciation) is used rather than cash inflows. According to this method, various projects are
ranked in order of the rate of earnings or rate of return. The project with the higher rate of
return is selected as compared to the one with lower rate of return. This method can also be
used to make decision as to accepting or rejecting a proposal. The expected return is
determined and the project which has a higher rate of return than the minimum rate specified
by the firm called the cut off rate is accepted and the one which gives a lower expected rate of
return than the minimum rate is rejected. The return on investment method can be used in
several ways as follows:
(a) Average Rate of Return Method. Under this method average profit after tax and
depreciation is calculated and then it is divided by the total capital outlay or total investment
in the project. In other words, it establishes the relationship between average annual profits to
total investments.
Thus: Average rate of return
Total profits After dep Tax x 100

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Net investment in the project X No of years
or
Average Annual profits x 100
Net investment in the project
(b) Return per unit of Investment Method. This method is small variation of the average
rate of return method. In this method the total profit after tax and depreciation is divided by
the total investment - Return per unit of Investment Method
Total profits after dep taxes x 100
Net investment in the project
(c) Return on Average Investment Method- In this method the return on average
investment is calculated. Using of average investment for the purpose of return on investment
is preferred because the original investment is recovered over the life of the asset on account
of depreciation charges.
(d) Average Return on Average Investment Method. This is the most appropriate method
of rate or return on investment. Under this method, average profit after depreciation and taxes
is divided by the average amount of investment; thus: Average Return on Average Investment
= Average annual profits after dep taxes x 100
Average investment

Advantages of Rate or Return Method

(1) It is very simple to understand and easy to operate.
(2) It uses the entire earnings of a project only the earnings unto pay-back period and hence
gives a better view of profitability as compared to pay-back period method.
(3) As this method is based upon accounting concept of profits, it can be readily calculated
from the financial data.
Disadvantages of Rate of Return Method
(1) This method also like pay-back period method ignores the time value of money as the
profits earned at different points of time are given equal weight by averaging the profits. It
ignores the fact that a shilling earned today is of more value than a shilling earned a year after,
or so.

69
(2) It does not take into consideration the cash flows which are more important than the
accounting profits.
(3) It ignores the period in which the profits are earned as a 20% rate of return in 27 years
may be considered to be better than 18% rate of return for 12 years. This is not proper because
longer the term of the project, greater is the risk involved.
(4) This method cannot be applied to a situation where investment in a project is to be made
in parts.
Time Adjusted or Discounted Cash Flow Method
The traditional methods of capital budgeting i.e. pay-back method as well as accounting rate
of return method, suffer from the serious limitations that give equal weight to present and
future flow of incomes. These methods do not take into consideration the time value of
money, the fact that a shilling earned today has more value than a rupee earned it after five
years. The time-adjusted or discounted cash flow methods take into amount the profitability
and also the time value of money. These methods also called modern methods of capital
budgeting are becoming increasingly popular day by day. Following are the discounted cash
flow methods:
Net present value method
The net present value method is a modern method of evaluating investment proposals. This
method takes into consideration the time value of money and attempts to calculate the return
on investments by introducing the factor of time element. It recognizes the fact that a shilling
earned today is worth more than the same shilling earned tomorrow. The net present values of
all inflows and outflows of cash occurring during the entire life of the project is determined
separately for each year by discounting these flows by the firm's cost of capital or a pre-
determined rate. The following are the necessary steps to be followed for adopting the net
present value method of evaluating investment proposals
 Add the amounts of the investment. This should include the initial cash outlay and any
additional investments expected during the defined period.
Example: $12,000 initial investment plus expected $1,000 future investments equals $13,000
in a five-year project.

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 Determine the rate of return for the project. This is the discount rate for each year's
cash flows. More elaborate calculations use the Required Rate of Return formula to find the
acceptable discount rate.
 Calculate Present Value (PV) for each year using the formula: cash flow (C) divided
by (1+rate(R))^number of years (N). Since the first year would be the same as the standard
discount rate (as it would be raised by itself), it would be the expected cash flow divided by
one plus the discount rate in the form of a decimal. So a 15 percent discount rate would be the
cash flow divided by 1 plus 0.15 or 1.15.
Example: $3,000 first year cash flow at 10 percent discount rate = $3,000 / (1+.10)^1 =
$2,727 PV.
 Find the present value for each subsequent year, raising the discount rate plus one to
the power of the number of years. If a Present Value table is available, simply cross-reference
the amount of cash flow with the discount rate and number of years to get the Present Value
amount.
Example: $3,500 second year; $4,000 third year; $4,500 fourth year; $5,000 fifth year
$3,500 / (1+.10)^2 = $2,893 PV
$4,000 / (1+.10)^3 = $3,005 PV
$4,500 / (1+.10)^4 = $3,074 PV
$5,000 / (1+.10)^5 = $3,105 PV
 Add the Present Value of all years together. Subtract the sum of the investments from
the total Present Value. If the amount is a positive number, the project is a beneficial one. If it
is negative, this indicates the return is less than desired.
Example: $2,727 + $2,893 + $3,005 + $3,074 + $3,105 = $14,804 Present Value.
$14,804 - $13,000 = $1,804 Net Present Value = good investment

 If the net present value is positive or zero, i.e., when present value of cash inflows
either exceeds of is equal to the present values of cash outflows, the proposal may be accepted
But in case the present value of inflows is less than the present value of cash outflows, the
proposal should be rejected.

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To select between mutually exclusive projects, projects should be ranked in order of net
present values, i. e. the first preference should be given to the project having the maximum
positive net present value.
Advantages of the Net Present Value Method
The advantages of the net present value method of evaluating investment proposals are as
follows:
(1) It recognizes the time value of money and is suitable to be applied in a situation with
uniform cash outflows and uneven cash inflows or cash flows at different periods of time.
(2) It takes into account the earnings over the entire life of the project and the true profitability
of the investment proposal can be evaluated.
(3) It takes into consideration the objective of maximum profitability.
Disadvantages of the Net Present Value Method
The net present value method suffers from the following limitations:
(1) As compared to the traditional methods, the net present value method is more difficult to
understand and operate.
(2) It may not give good results while comparing projects with unequal lives as the project
having higher net present value but realized in a longer life span may not be as desirable as a
project having something lesser net present value achieved in a much shorter span of life of
the asset.
(3) In the same way as above, it may not give good results while comparing projects with
unequal investment of funds.
(4) It is not easy to determine an appropriate discount rate.
Internal Rate of Return Method
The internal rate of return method is also a modern technique of capital budgeting that takes
into account the time value of money. It is also known as 'time adjusted rate of return'
discounted cash flow' 'discounted rate of return,' 'yield method,' and 'trial and error yield
method'. In the net present value method the net present value is determined by discounting
the future cash flows of a project at a predetermined or specified rate called the cut-off rate.
But under the internal rate of return method, the cash flows of a project are discounted at a
suitable rate by hit and: trial method, which equates the net present value so calculated to the
amount of the investment. Under this method, since the discount rate is determined internally,

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this method is called as the internal rate of return method. The internal rate of return can be
defined »that rate of discount at which the present value of cash-inflows is equal to the
present value of cash outflows.
The Internal Rate of Return (IRR) is the discount rate that generates a zero net present
value for a series of future cash flows. This essentially means that IRR is the rate of return
that makes the sum of present value of future cash flows and the final market value of a
project (or an investment) equal its current market value.
Internal Rate of Return provides a simple „hurdle rate‟, whereby any project should be
avoided if the cost of capital exceeds this rate. Usually a financial calculator has to be used to
calculate this IRR, though it can also be mathematically calculated using the following
formula:

In the above formula, CF is the Cash Flow generated in the specific period (the last period
being „n‟). IRR, denoted by „r‟ is to be calculated by employing trial and error method.
Internal Rate of Return is the flip side of Net Present Value (NPV), where NPV is the
discounted value of a stream of cash flows, generated from an investment. IRR thus computes
the break-even rate of return showing the discount rate, below which an investment results in
a positive NPV.
A simple decision-making criterion can be stated to accept a project if it‟s Internal Rate of
Return exceeds the cost of capital and rejected if this IRR is less than the cost of capital.
However, it should be kept in mind that the use of IRR may result in a number of
complexities such as a project with multiple IRRs or no IRR. Moreover, IRR neglects the size
of the project and assumes that cash flows are reinvested at a constant rate
Advantages of Internal Rate of Return Method
(i) Like the net present value method, it takes into account the turn value of money and be
usefully applied in situations with even as well as un even cash flow at different periods of
time.
(ii) It considers the profitability of the project for its entire economic life and hence enables
evaluation of true profitability.

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(iii) The determination of cost of capital is not a pre-requisite for the use of this method and
hence it is better than net present value method where the cost of capital cannot be determined
easily.
(iv) It provides for uniform ranking of various proposals due to the percentage rate of return.
(v) This method is also compatible with the objective of maximum profitability and is
considered to be a more reliable technique of capital budgeting.
Disadvantages of Internal Rate of Return Method
(i) It is difficult to understand and is the most difficult method of evaluation of investment
proposals.
(ii) This method is based upon the assumption that the earnings are reinvested at the internal
rate of return for the remaining life of the project, which is not a justified assumption
particularly when the average rate of return earned by the firm is not close to the internal rate
of return. In this sense, Net Present Value method seems to be better as it assumes that the
earnings are reinvested at the rate of firm's cost of capital.
(iii) The results of NPV method and IRR method may differ when the projects under
evaluation differ in their size, life and timings of cash flows.
Profitability Index Method or Benefit Cost Ratio
It is also a time -adjusted method of evaluating the investment proposals.
Profitability index also called as Benefit-Cost Ratio (B/C) or 'Desirability factor' is the
relationship between present value of cash inflows and the present value of cash outflows.
Profitability Index = (PV of future cash flows) ÷ Initial investment:
Or = (NPV + Initial investment) ÷ Initial Investment: As one would expect, the NPV stands
for the Net Present Value of the initial investment.
Example: a company invested $20,000 for a project and expected NPV of that project is
$5,000.
Profitability Index = (20,000 + 5,000) / 20,000 = 1.25
That means a company should perform the investment project because profitability index is
greater than 1.
The net profitability index can also be found as Profitability Index (gross) minus one. The
proposal is accepted if the profitability index is more than one and is rejected if index is less
than one. The various projects are ranked under this method in order of their profitability

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index, in such a manner that one with higher profitability index is ranked higher than the other
with lower profitability index.

Review Questions
i. Describe the various forms of competition giving relevant local examples.

ii. Explain the aspect of competition.

References for further Reading

1. Boone, Louis E., and Kurtz, David L. (1999). Contemporary Business, 9th ed.
Orlando, FL: Harcourt Brace.
2. Bounds, Gregory M., and Lamb, Charles W., Jr. (1998). Business. Cincinnati, OH:
South-Western College Publishing.

75
 CHAPTER NINE: MARKET STRUCTURES & COMPETITION

Learning Objectives
At the end of this lesson, the learner should be able to:
I. Know in detail the concept of pricing

II. Understand different methods and kinds of pricing

III. Identify the factors affecting pricing policy

IV. Apply pricing decision at the time of introducing new products

Types of Market Structures

In the real world there is a mind-boggling array of different markets. In some markets,
producers are extremely competitive (e.g. grain). In other markets, producers somehow
coordinate actions to avoid directly competing with each other (e.g. breakfast cereals). In
others, there is no competition (e.g. flights out of Tweed-New Haven airport). In general we
classify market structures into four types:
• Perfect competition – many producers of a single, unique good.
• Monopoly - single producer of a unique good (e.g. cable TV, diamonds, and particular
drugs)
• Monopolistic competition – many producers of slightly differentiated goods (e.g. fast food)
• Oligopoly – few producers, with a single or only slightly differentiated good (e.g. cigarettes,
cell phones, International flights)
What determines market structure?
• It really depends on how difficult it is to enter the market. That depends on control of the
necessary resources or inputs, government regulations, economies of scale, network
externalities, or technological superiority.
It also depends on how easy it is to differentiate goods:
• Soft drinks, economic textbooks, breakfast cereals can readily be made into different
varieties in the eyes and tastes of consumers.

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• Red roses are less easy to differentiate
Means of Competition
Competition is the battle between businesses to win consumer acceptance and loyalty. The
free-enterprise system ensures that businesses make decisions about what to produce, how to
produce it, and what price to charge for the product or service. Competition is a basic premise
of the free-enterprise system because it is believed that having more than one business
competing for the same consumers will cause the products and/or services to be provided at a
better quality and a lower cost than if there were no competitors. In other words, competition
should provide the consumers with the best value for their hard-earned dollar.
Aspects of Competition
To be successful in today's very competitive business world, it is important for businesses to
be aware of what their competitors are doing and to find a way to compete by matching or
improving on the competitors' product or service. For example, if Pepsi-Cola offers a new
caffeine-free soda, Coca-Cola may offer a new caffeine-free soda with only one calorie. By
offering an improvement on the competitor's product, Coca-Cola is trying to convince soft-
drink consumers to buy the new coke product because it is an improvement on Pepsi's
product.
While being aware of the competition and making a countermove is important, it is also very
important to pay attention to changing consumer wants, needs, and values and to make the
needed changes before the competition does. Doing research and development and being the
first to provide a new product or service can give a company a competitive advantage in the
marketplace. Once consumers purchase a product or service and are satisfied with it, they will
typically purchase the same product again. Having a competitive advantage means that a
company does something better than the competition. Having a competitive advantage might
mean inventing a new product; providing the best quality, the lowest prices, or the best
customer service; or having cutting-edge technology. To determine an area where a company
might have a competitive advantage, a SWOT analysis is often done to identify the company's
internal Strengths and Weaknesses and the external Opportunities and Threats. A SWOT
analysis lets the company know in which area(s) it has a competitive advantage so it can
concentrate on those areas in the production and marketing of its product(s) or service(s).

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In addition to staying on top of changing consumer preferences, companies must constantly
be looking for ways to cut costs and increase productivity. Companies must provide
consumers with the best-quality product at the lowest cost while still making a profit if they
are to be successful competitors in the long run. One way to remain competitive is through the
use of technology. Technology can help speed up production processes through the use of
robots or production lines, move information more accurately and more quickly through the
use of computer systems, and assist in research and development proceedings.
Global competition has made gaining consumer acceptance an even tougher challenge for
most businesses. Firms in other countries may be able to produce products and provide
services at a lower cost than American businesses. In order to compete, American businesses
must find other ways to win consumers. One way for businesses to accomplish this is through
competitive differentiation. Competitive differentiation occurs when a firm somehow
differentiates its product or service from that of competitors. Competitive differentiation may
be an actual difference, such as a longer warranty or a lower price, but often the difference is
only perceived. Difference in perception is usually accomplished through advertising, the
purpose of which is to convince consumers that one company's product is different from
another company's product. Common ways to differentiate a product or service include
advertising a better-quality product, better service, better taste, or just a better image.
Competitive differentiation is used extensively in the monopolistic form of competition,
discussed below.
Forms of Competition
Although each form has many aspects, not all of which can be considered here, competition
can generally be classified into four main categories: perfect competition, monopolistic
competition, oligopoly, and monopoly.
Perfect Competition
Perfect competition (also known as pure competition) exists when a large number of sellers
produce products or services that seem to be identical. These types of businesses are typically
run on a small scale, and participants have no control over the selling price of their product
because no one seller is large enough to dictate the price of the product. Instead, the price of
the product is set by the market. There are many competitors in a perfect competition
industry, and it is fairly easy to enter or leave the industry. While there are no ideal examples

78
of perfect competition, agricultural products are considered to be the closest example in
today's economy. The corn grown by one farmer is virtually identical to the corn grown by
another farmer, and the current market controls the price the farmers receive for their crops.
Perfect competition follows the law of supply and demand. If the price of a product is high,
consumers will demand less of the product while the suppliers will want to supply more. If the
price of a product is low, the consumers will demand more of the product, but the suppliers
will be unwilling to sell much at such a low price. The equilibrium point is where the supply
and the demand meet and determine the market price. For example, if the going market price
for wheat is $5 a bushel and a farmer tries to sell wheat for $6 a bushel, no one will buy
because they can get it for $5 a bushel from someone else. On the other hand, if a farmer
offers to sell wheat for $4 a bushel, the crop will sell, but the farmer has lost money because
the crop is worth $5 a bushel on the open market.
Monopolistic Competition
Monopolistic competition exists when a large number of sellers produce a product or service
that is perceived by consumers as being different from that of a competitor but is actually
quite similar. This perception of difference is the result of product differentiation, which is the
key to success in a monopolistic industry. Products can be differentiated based on price,
quality, image, or some other feature, depending on the product. For example, there are many
different brands of bath soap on the market today. Each brand of soap is similar because it is
designed to get the user clean; however, each soap product tries to differentiate itself from the
competition to attract consumers. One soap might claim that it leaves you with soft skin,
while another soap might claim that it has a clean, fresh scent. Each participant in this market
structure has some control over pricing, which means it can alter the selling price as long as
consumers are still willing to buy its product at the new price. If one product costs twice as
much as similar products on the market, chances are most consumers will avoid buying the
more expensive product and buy the competitors' products instead. There can be few or many
competitors (typically many) in a monopolistic industry, and it is somewhat difficult to enter
or leave such an industry. Monopolistic products are typically found in retailing businesses.
Some examples of monopolistic products and/or services are shampoo products,
extermination services, oil changes, toothpaste, and fast-food restaurants.

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Oligopoly
An oligopoly exists when there are few sellers in a certain industry. This occurs because a
large investment is required to enter the industry, which makes it difficult to enter or leave.
The businesses involved in an oligopoly type of industry are typically very large because they
have the financial ability to make the needed investment. The type of products sold in an
oligopoly can be similar or different, and each seller has some control over price. Examples of
oligopolies include the automobile, airplane, and steel industries.
Monopoly
A monopoly exists when a single seller controls the supply of a good or service and prevents
other businesses from entering the field. Being the only provider of a certain good or service
gives the seller considerable control over price. Monopolies do exist in some business areas
because of the huge up-front investment that must be made in order to provide some types of
services. Examples of monopolies in the Kenya are public utility companies that provide
services and/or products such as water and/ or electricity.

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Types of Competition
Perfect Monopolistic
Characteristics Oligopoly Monopoly
Competition Competition
Number of No direct
Many Few to many Very few
competitors competition
Ease of entry or exit Somewhat Regulated by
Easy Difficult
from industry difficult government
Similarity of Seemingly
Similar or No directly
goods/services offered Same different but may
different competing products
by competing firms be quite similar
Considerable (in
Individual firm's None (set by true monopoly)
Some Some
control over price the market) Little (in regulated
one)
Fast-food Automotive
Examples Farmer Power company
restaurant manufacturer

Review Questions
I. Describe the various forms of competition giving relevant local examples.

II. Explain the aspect of competition.

References for further Reading

1. Boone, Louis E., and Kurtz, David L. (1999). Contemporary Business, 9th ed.
Orlando, FL: Harcourt Brace.
2. Bounds, Gregory M., and Lamb, Charles W., Jr. (1998). Business. Cincinnati, OH:
South-Western College Publishing.

81
 CHAPTER TEN: PRICING POLICY

Learning Objectives
At the end of this chapter, the learner should be able to:
i. Know in detail the concept of pricing

ii. Understand different methods and kinds of pricing

iii. Identify the factors affecting pricing policy

iv. Apply pricing decision at the time of introducing new products

Introduction
Pricing assumes a significant role in a competitive economy. Price is the main factor which
affects the sales of an organization. A good price policy is of great importance to the
producers, wholesalers, retailers and the consumers. Marketers try to achieve their long-run
pricing objectives through both price policies and price strategies.
If the prices are high, few buyers purchase and if the prices are low, many buyers purchase.
Thus market may be reduced or increased. That is, the price increases in relation to the sales
revenue. Thus pricing is a critical situation. Therefore, a sound pricing policy must be adopted
to have maximum sales revenue.
In the early stages of men, prices were set by buyers and sellers negotiating with each other.
The seller may demand a higher price than expected and the buyer may offer a price less than
the expected one. Ultimately they arrive at an agreeable price through bargaining. Now in the
competitive economy, development of large business aims to have one price policy. In certain
cases, the buyer looks at the price as an indicator of product quality. If the price is higher, the
buyer believes the products to be of high quality.
In case the quality is not up to the mark he expects, he feels that the price is high. Hence, one
cannot say that the price is high or low, without considering the quality of the product to be
purchased. The price is greatly affected or influenced for future production and marketing.
Prices play an important role in the economy. The time within which the product is sold

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varies. The goods, which are of a perishable nature and frequent changes of style, may not be
stocked for long time. In the case of durable goods, they can be stocked for longer time, in the
hope of getting favorable price rise. Holding the stock depends upon the financial resources of
farmer, middleman, wholesaler etc., and the perish ability of the goods.
Price
Price may be defined as the exchange of goods or services in terms of money. Without price
there is no marketing in the society. If money is not there, exchange of goods can be
undertaken, but without price; i.e., there is no exchange value of a product or service agreed
upon in a market transaction, is the key factor which affects the sales operations. What you
pay is the price for what you get. Price is the exchange value of goods or services in terms of
money. Price of a product or service is what the seller feels it worth, in terms of money, to the
buyer.
Importance of Price Policy
A well formed price policy has special importance if price rise is a continuous process in
planned economy. It has not only the influenced the living standard of people but due to
increase in the expenditure of full planning, the prescribed aims and objectives of the planning
are shattered. As a result, there is obstruction of economic development. But in
underdeveloped countries, with economic development, price rise is quite natural. Till the
increase in monetary income of the public is more than price rise, there is no comprehension.
But when there is more price rise than investment and national income, there is a need to
protect from the defects of monetary fluctuations. It requires price regulation. In short, in
developing countries, the significance of price policy can be known from the following facts:
1. To Maintain Appropriate Living Standard. Price rise lets living standard of people fall
and economic development of the country is obstructed. To maintain the proper living
standard, price control is essential.
2. To Maintain Planning. As price rises, the work of planning increases which results in
obstruction in the prescribed aims and objectives of the planning. To maintain the planning
process in a fine manner, prices should be controlled at all costs.
3. Protection from Monetary Fluctuations. When price increase is more than investment
and national income increases, monetary fluctuation defects are created. To remove them
appropriate price control is required.

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4. Establishment of Balance in Demand and Supply. In a developing economy, due to
changing circumstances, balance of demand and supply disrupts by which consumer, producer
and investor have to take hardships. This shows that there is need to balance the demand and
supply in a proper way.
5.For Well Adjusted Distribution Management. With the view point of consumers for
quick supply of goods on less prices distribution management should be well adjusted. For
this, it is necessary to control the consumer price.
6.Multifaced Development of National Resources. The major objective of economic
planning is multifaceted development of national resources. Thus, price policy should be quite
independent as price regulation can adjust this motto.
Pricing Objectives
To perform the marketing job efficiently, the management has to set goals first pricing is no
exception. Before determining the price itself, the management must decide the objectives of
pricing. These objectives are logically related to the company's overall goal or objectives The
main goals in pricing may be classified as follows.
1. Pricing for Target Return (on investment) (ROI): Business needs capital, investment in
the shape of various types of assets and working capital. When a businessman invests capital
in a business, he calculates the probable return on his investment. A certain rate of return on
investment is aimed. Then, the price is fixed accordingly. The price-includes the
predetermined average return. This is seller-oriented policy. Many well-established firms
adopt the objective of pricing in terms of "return on investment." Firms want to secure a
certain percentage of return on their investment or on sales. The target of a firm is fixed in
terms of investment For instance a company may set a target at 10 or 15% return on
investment. Further this target may be for a long term or short term. Wholesalers and retailers
may follow the short term, usually a year they charge certain percentage over and above the
price, they purchased, which is enough to meet operational costs and a desired profit. This
target chosen, can revised from time to time. This objective of pricing is also known as
pricing for profit. Certain firms adopt this method as a satisfactory objective, in the sense they
are satisfied with a certain rate of return.
2. Market Share: The target share of the market and the expected volume of sales are the
most important consideration in pricing the products. Some companies adopt the main pricing

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objective so as to maintain or to improve the market share towards the product. A good
market share is a better indication of progress. For this, the firm may lower the price, in
comparison to the rival products with a view to capture the market. By reducing the price,
customers are not exploited rather benefited. The management can compare the present
market share with the past market share and can know well whether the market share is
increasing or decreasing When the market shares decreasing, low pricing policy can be
adopted by large scale manufacturers who produce goods needed daily by the consumers. So
margin of profit comes down because of low price, but the competitors are discouraged from
entering the market. By low pricing policy, no doubt, market share can be increased, besides
attracting new users.
3. To Meet or Prevent Competition: The pricing objective may be to meet or prevent
competition. While fixing the price, the price of similar products, produced by other firms,
will have to be considered. Generally, producers are not in a haste to fix a price at which the
goods can be sold out one has to look to the prices of rival products and the existing
competition and chalk out proper price policy so as to enable to face the market competition.
At the time of introduction of products to the market, a low price policy is likely to attract
customers, and can establish a good market share. The low price policy discourages the
competitors.
4. Profit Maximization: Business of all kinds is run with an idea of earning profit at the
maximum. Profit maximization can be enjoyed where monopolistic situation exists. The goal
should be to maximize profits on total output, rather than on every item- The scarcity
conditions offer chances for profit maximization by high pricing policy. The profit
maximization will develop an unhealthy image. When a short-run policy is adopted for
maximizing the profit, it will exploit the customers. The customers have a feeling of
monopoly and high price. But along run policy to maximize the profit has no drawbacks. A
short-run policy will attract competitors, who produce similar goods at low cost. As a result,
price control and government regulations will be introduced.
5. Stabilize Price: It is a long-time objective and aims at preventing frequent and violent
fluctuations in price. It also prevents price war amongst the competitors. When the price often
changes, there arises no confidence on the product. The prices are designed in such a way that
during the period of depression, the prices are not allowed to fall below a certain level and in

85
the boom period, the prices are not allowed to rise beyond a certain level. The goal is to give
and let live. Thus firms forego maximum profits during periods of short supply of products.
6. Customer Ability to Pay: The prices that are charged differ from person to person,
according to his capacity to pay. For instance, doctors charge fees for their services awarding
to the capacity of the patient.
7. Resource Mobilization: This is a pricing objective, the products are priced it such a way
that sufficient sources are made available for the firms' expansion, developmental investment
etc. Marketers are interested in getting back the amount invested as speedily as possible. The
management may fix a higher price and this trend will invite competitors with low priced
similar products.
8. Survival and growth: An important objective of pricing is survival and achieving the
expected rate of growth. Profits are less important than survival. According to P. Drucker,
avoidance of loss and ensuring survival are more important than maximization of profit.
9. Prestige and goodwill: Pricing also aims at maintaining the prestige and enhancing the
goodwill of the firm.
Factors affecting pricing policy
Price policy is government by external factors and internal factors. External factors are-
elasticity of demand and supply competition goodwill of firm, trend of the market, and
management policy. Keeping in view above facts, certain general considerations which must
be kept in view while formulating a suitable price policy are listed below:
(A) Internal Factors
(1) Organizational Factors
Pricing decisions occur on two levels in the organization. Over-all price strategy is dealt with
by top executives. They determine the basic ranges that the product falls into in terms of
market segments. The actual mechanics of pricing are dealt with at lower levels in the firm
and focus on individual product strategies. Usually, some combination of production and
marketing specialists are involved in choosing the price.
(2) Marketing Mix
Marketing experts view price as only one of the many important elements of the marketing
mix. A shift in any one of the elements has an immediate effect on the other three-Production,
Promotion and Distribution. In some industries, a firm may use price reduction as a marketing

86
technique. Other firms may raise prices as a deliberate strategy to build a high-prestige
product line. In either case, the effort will not succeed unless the price change is combined
with a total marketing strategy that supports it. A firm that raises its prices may add a more
impressive-looking package and may begin a new advertising campaign.
(3) Product Differentiation
The price of the product also depends upon the characteristics of the product. In order to
attract the customers, different characteristics are added to the product, such as quality, size,
colour, attractive package, alternative uses etc. Generally, customers pay more price for the
product which is of the new style, fashion, better package etc.
(4) Cost of the Product
Cost and price of a product are closely related. The most important factor is the cost of
production. In deciding to market a product, a firm may try to decide what prices are realistic,
considering current demand and competition in the market. The product ultimately goes to the
public and their capacity to pay will fix the cost; otherwise product would be flapped in the
market.
(5) Objectives of the Firm
A firm may have various objectives and pricing contributes its share in achieving such goals.
Firms may pursue a variety of value-oriented objectives, such as maximizing sales revenue,
maximizing market share, maximizing customer volume, minimizing customer volume,
maintaining an image, maintaining stable price etc. Pricing policy should be established only
after proper considerations of the objectives of the firm.
(B) External Factors
3. External Factors
External factors are those factors which are beyond the control of an organization. The
following external factors would affect the pricing decisions :
1. Demand: The nature and condition of demand should be considered when fixing the price.
Composition of the market, the nature of buyers, their psychology, their purchasing power,
standard of living, taste, preferences and customs have large influence on the demand.
Therefore the management has to weigh these factors thoroughly. If the demand for a product
is inelastic, it is better to fix a higher price for it. On the other hand, if demand is elastic,
lower price may be fixed.

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2. Competition: In modern marketing, a manufacturer cannot fix his own price without
considering the competition. A number of substitutes enter the market these days. Hence the
influence of substitutes has also to be considered when fixing a price. A firm must be vigilant
about the prices charged by competitors for the similar products. If prices are fixed higher
than the prices charged by competitors, the customers are likely to switch over to the products
of competitors. On the other hand, if the prices charged are much lower than the prices of the
rivals, the customers may become suspicious about the quality and hence lower price may not
lead to higher sales. To avoid competitive pricing, a firm may resort to product differentiation.
Sometimes a higher price may itself differentiate the product. In view of these, the
management must be very careful in determining the prices.
3. Distribution channels: Distribution channels also sometimes affect the price. The
consumer knows only the retail price. But there is a middleman working in the channel of
distribution. He charges his profit. Thus when the articles reach the hands of consumers, the
price becomes higher. It sometimes happens that the consumers reject it.
4. General Economic conditions: Price is affected by the general economic conditions such
as inflation, deflation, trade cycle etc. In the inflationary period the management is forced to
fix higher price. In recession period, the prices are reduced to maintain the level of turnover.
In boom period, prices are increased to cover the increasing cost of production and
distribution.
5. Govt. Policy: Pricing also depends on price control by the Govt, through enactment of
legislation. While fixing the price, a firm has to take into consideration the taxation and trade
policies of govt.
6. Reactions of consumers: An important factor affecting pricing decisions is the attitude of
consumers. If a firm fixes the price of its product unreasonably high, the consumers may
boycott the product.
Methods of Pricing
There are four basic pricing policies. They are:
1. Cost-based pricing policies.
2. Demand - based pricing policies.
3. Competition - based pricing policies.
4. Value-based pricing policies.

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Cost-based pricing policy
The policy of setting price essentially on the basis of the total cost per unit is known as cost-
oriented pricing policy. In about 68% of consumer goods companies and about 89% of
industrial products manufacturing companies take their pricing decision based on cost of
production. The following are the four methods of pricing which fall under cost-oriented
pricing policy.
1. Cost plus Pricing: The theory of full cost pricing has been developed by Hall and Mitch.
According to them, business firms under the conditions of oligopoly and monopolistic
competitive markets do not determine price and output with the help of the principle of MC =
MR. They determine price on the basis of full average cost of production AVC + AFC margin
of normal profit. This is the most common method used for pricing. Under the method, the
price is fixed to cover all costs and a predetermined percentage of profit. In other words, the
price is computed by adding a certain percentage to the cost of the product per unit. Under
this method, cost includes production cost (both variable and fixed) and administrative and
selling and distribution cost (both variable and fixed). This method is also known as margin
pricing or average cost pricing or full cost pricing or mark-up pricing. This method is very
popular in wholesale trade and retail trade.
Advantages of Cost plus Pricing
(l) This method is appropriate when it is difficult to forecast the future demand.
(2) This method guarantees recovery of cost. Hence it is the safest method.
(3) It helps to set the price easily.
(4) Both single product and multi product firms can apply this method for pricing.
(5) It ensures stability in pricing.
(6) If this method is adopted by all firms within the industry, the problem of price war can be
avoided.
(7) It is economical for decision making.
Disadvantages Of Cost Plus Pricing
(l)This method ignores the effect of demand.
(2) It does not consider the forces of market and competition.
(3)This method uses average costs, ignoring marginal or incremental costs.
(4) This method gives too much importance for the precision of allocation of costs.

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2. Target Pricing: This is a variant of full cost pricing. Under this method, the cost is added
with a predetermined target rate of return on capital invested. In this case, the company
estimates future rates, future cost and calculates a targeted rate of return on investment after
tax. This method is also known as rate of return pricing.
Advantages of Target or Rate of Return Pricing
(l)This method guarantees a certain rate of return on investment.
(2)This method can be used for pricing new products.
(3)Prevention is better than cure' principle is applied in this method.
(4) This is a long term price policy.
Disadvantages of Target Pricing
(1) His method is not practical when there is a tough competition in a market.
(2) This method ignores the demand of the product.
(3) It is difficult to predetermine the cost of products.
3. Marginal Cost Pricing: Under both full cost pricing and rate of return pricing, the prices
are set on the basis of total cost (variable cost + fixed cost). Under the marginal cost pricing,
the price is determined on the basis of marginal or variable cost. In this method, fixed costs
are totally excluded.
Advantages of Marginal Cost pricing
(1) This method is very useful in a competitive market.
(2) This method helps in optimum allocation of resources. It is particularly useful when the
products have low demand.
(3) This method is suitable to pricing over the life cycle of the product.
(4) It is the most suitable .method of short run pricing.
(5) The method is useful at the time of introducing a new product.
Disadvantages of Marginal cost pricing
(1) Firms may not be able to cover up costs and earn a fair return on capital employed.
(2) It requires a better understanding of marginal costing technique.
(3) When costs are decreasing this method is not suitable because it will result losses.
(4) This method is not suitable for long run.
4. Break even pricing: this is a form of target return pricing. In fact, it is a refinement to
cost-oriented pricing. Under break even pricing, break even analysis is used for point. Even

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pricing, break even analysis is used for pricing. The firm first determines the breakeven point.
It is the point at which the total sales are equal to total cost no profit no loss point at which the
total sales are equal to the average total cost of product. Thus, both variable cost and fixed
cost are covered under this methods but it does not include any profit.
Importance of break even pricing:
This method of pricing helps in understanding the relationship between revenue and cost of
the company in relation to its volume of sales. it helps in determining that volume at which
the company‟s cost and revenue are equal.
This method of pricing is very important in profit planning. It shows the effects on profit of
changing the amount invested in advertisement of changing the sales compensation methods
of adding a new product or of changing a marketing in focusing channel this methods of
pricing helps the marketer in a calculating output or sales to earn a desired profit calculating
margin of safety changes in price making decisions, and changes in cost and price et.
2. Demand - based Pricing Policy
Under this pricing policy, demand is the basic factor. Price is fixed simply adjusting it to the
market conditions. In short, the price is fixed according to the demand for a product. Where
the demand is heavy, a higher price is charged. When the demand is low, a low price is
charged. The following are the methods of pricing which fall under this policy:
1 Differential pricing: Under this method the same product is sold at different prices to
different customers, in different places and at different periods. For instance, a cinema house
charges different rates for different categories of seats. Telephone authorities charge less for
trunk calls at night than during day. This method is also called discriminatory pricing or price
discrimination.
2. Modified Break-even analysis: This is a combination of cost based and demand based
pricing techniques. This method reveals price-quantity mix that maximizes total profit. In
other words, under this method, prices are fixed to achieve highest profit over the BEP in
consideration of the amount demanded at alternative prices.
3. Premium Pricing: It is a phenomenon of the 1990s. It is based on the principle that the
product or brand should be positioned at the top of the market and must offer greater value in
qualitative terms than similar brands in other price segments. In short, it is called high pricing.

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4. Neutral Pricing: It means offering extra value or benefits with the brand cost or price
remaining competitive. Cadbury is offering 30 percent more chocolate in its 5 Star bar at
same price.
3. Competition-based Pricing Policy: It is the policy of fixing the prices mainly on the basis
of prices fixed by competitors. This policy does not necessarily mean setting of same price.
With a competition oriented pricing policy, the firm may keep its price higher or lower than
that of competitors. Actually this policy implies that the firms 'pricing decisions is not based
on cost or demand, prices are changed or maintained in line with the competitor's prices. The
following methods fall under this policy.
1. Going rate pricing: Under this method, prices are maintained at par with the average level
of prices in the industry. The firm adjusts its own prices to suit the general price structure in
the industry. In other words, it is the method of charging prices according to what competitors
are charging. This method is usually adopted by firms selling a homogeneous product in a
highly competitive market. Under this method a firm accepts the price prevailing in the
industry to avoid a price war. This method is also called acceptance pricing or market equated
pricing or parity pricing. LML Vespa was following this method for a number of years with
market leader Bajaj. This method is particularly useful where cost ascertainment is difficult.
This technique is adopted in the situation of price leadership.
Advantages of going rate pricing
1. It helps in avoiding cut-throat competition among the firm.
2. This method is found more suitable when costs are difficult to measure.
3. This method is less expensive because calculation of cost and demand is not necessary.
4. It is suitable to avoid price war in oligopoly.
5. This can be used for pricing new products.
Disadvantages of going rate pricing
1. This method is not suitable for long run pricing.
2. Cost of the product and other marketing factors are not considered at all under this policy.
2. Customary pricing: In case of some commodities the prices get fixed because they have
prevailed over a long period of time. For example, the price of a cup of tea or coffee is
customarily fixed. In short, these prices are fixed by custom. The price will change only when
the cost changes significantly. Before changing the customary prices, it is essential to study

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the prices of competitors. Customer prices may be maintained even when products are
changed. For example, the new model of a radio may be parked at the same level as the
discontinued model. Thus, under this method, the existing price is maintained as long as
possible.
3. Sealed bid pricing: In all business lines when the firms bid for jobs, competition based
pricing is followed. Costs and demand are not considered at all. The firm fixes its prices on
how the competitors price their products. It means that if the firm is to win a contract or job, it
should quote less than the competitors.
4. Value based Pricing
Under this policy the price is based on value to the customer. The following are the pricing
methods based on customer value.
1. Perceived - value pricing: Another method is judging demand on the basis of value
perceived by the consumers in the product. Thus perceived value pricing is concerned with
setting the price on the basis of value perceived by the buyer of the product rather than the
seller's cost. When a company develops a new product. it anticipates a particular position for
it in the market in respect of price, quality and service, 'Then it estimates the quality it can sell
at this price. The company then judges whether at this level of production and sale, it will
have a satisfactory return investment. If it appears to be so, the company goes ahead with
translating the perception into practice, otherwise it drops the proposal.
2. Value for money pricing: This is now seen as more than a pricing method. Under this
method price is based on the value which the consumers get from the product they buy. It is
used as a complete marketing strategy.
Pricing of New Products
The introduction of a new product will pose a challenging problem for any firm. In the case of
new products there is no past information for ascertaining trends and consumer reaction. If the
new product is with high distinctiveness among the existing products, then price should be
fixed on the basis of such factors as demand, market - target and the promotional strategy. In
the case of pioneer product, the estimation of its demand is very difficult. The estimate of
demand for such products should be made on the basis of the following factors:

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1. Product acceptability: The manufacturer should ascertain whether the new product will be
accepted by the consumers or whether the consumers are willing to buy the product. The
willingness to buy depends upon a factor like whether it would meet their requirements.
2. Range of prices: It is very essential to assess the reactions of the consumers at different
prices. For this, a market research will have to be undertaken. The core question that arises is
at what prices different quantities of the product are demanded.
3. Expected volume of sales: The next task is to determine the anticipated volume of sales at
different prices. This depends upon demand elasticity and cross elasticity.
4. Reaction to price: The assessment of the reaction of the consumers to the price is a very
tricky task. The company which introduces a new product will have to monitor the activities
of the rivals in order to find out the marketing strategies that they are going to adopt.
In short, the price of a new product should be fixed after taking into account the potential
demand, objectives, degree of competition and strategy of competitors etc.
Methods/Strategies for Pricing of New Products.
In pricing a new product, generally two types are followed -
(a) Price Skimming
When a new product is introduced in the market, the firm fixes a price much higher than the
cost of production. The consumers are ready to pay a high price to enjoy the pleasure of being
the first users of the product. The high price charged helps to skim the cream off the market at
a time when there is no competition this is possible because the newly introduced product
reached the hands of the consumers after a long waiting and by the time it comes to the
market a heavy demand for the same has accumulated. When fixing the price the producer
takes this advantage of the market. This market situation will not continue for long. In the
long run new firms will enter into the industry. In the long run the number of enthusiastic
buyers who are ready to buy at a high price will decrease. For example, when electronic
goods like TV, tape recorders, calculators, VCR etc, were introduced their prices were very
high. But gradually when more and more new producers imitated these products their price
came down.
The firm makes a huge profit by price skimming. The price skimming policy is followed as
long as there is heavy demand without any competition from a rival. The principle behind
price skimming is to make hay while sun shines. In the long run the possibility of making

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huge profit by price skimming disappears. The price, in fact, gets normalized around the cost
of production.
Under the following situations the price skimming policy can be easily followed.
(i) The new product is a novel item which can attract customers and is having no competitors
at present.
(ii) The product is meant for the higher income group whose demand is inelastic. The firm can
charge a high price which will help them to realize a good share of the heavy initial
investment in the form of research and development expense.
(iii) There are heavy initial promotion expenses and the firm wants to realize it from the
customers before other competitive firms-enter in. The firm, after squeezing the enthusiastic
buyers, goes on reducing the price step-by-step so that it can reach the various sections of
consumers who are willing to buy it at lower prices.
(b) Penetration Pricing
The price fixed is relatively a lower one. This pricing is resorted to when the new product
faces a strong competition from the existing substitute product. When the new firm enters an
existing market where there are a number of firms it has to penetrate the market and achieve
an acceptance for its product. In order o attain this it will charge only a very low price
initially, hoping to charge a normal price later when it is established in the market. For
example, a firm may, when it introduce a new bath soap in the market give a 100 gms Piece
free when consumers buy two 200 pieces at a time. Later when it picks up sales it takes out
the initial discount. In a foreign market a new country may have to penetrate through a highly
competitive price. The penetration price may be sometimes below the cost of production. This
can be justified in the following cases.
(a) The lead time in production is short.
(b) Increased production will result in reduced cost of production.
(c) The product is meant for mass consumption.
(d) The product is one where brand loyalty counts.
(e) The product cannot be protected by patent right.
(f) The fear of competition.
Kinds of Pricing

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By following the above principles, business firms may opt various kinds of pricing for
products. few, important of them are explained below.
1 Psychological Pricing: Many consumers use the price as an indicator of quality. Costs and
other factors are important in pricing. Yet, psychology of the price is also considered certain
people prefer high priced products, considered to be of high quality. Costly items diamond,
jewellery etc., reveal the status of the person who wears them. They demand highly priced
items.
2. Customary Pricing: Customers expect a particular price to be charged for certain
products. The prices are fixed to suit local conditions. The customers are familiar with the
market condition. Manufacturers cannot control the price. Such products are typically a
standardized one. Certain business people reduce the size of the product, if the cost of
manufacturing increases, Sometimes, the firm changes the price by adopting new package,
size etc. For example confectionary items.
3. Skimming Pricing: It involves a high introductory price in the initial stage to skim the
cream of demand. The products, when introduced in the market have a limited period free
from other manufacturers. During this period, it aims at profit Maximization, according to the
favorable market condition. Generally, the price moves downwards are when competitors
enter into the market field.
4. Penetration Pricing: A low price is designed in the initial stage with a view to capture
market share. That is if the pricing policy is to capture greater market share, then this is done
only by adoption of low prices in the initial stage. Because of the low price, sales value
increases, competition falls down.
5. Geographical Pricing: The distance between the seller and the buyer is considered
geographic pricing. In Kenya, the cost of transportation is an important pricing factor because
of vide geographical distance between the production centre and consuming centre. There are
three ways of charging transit
(a) F.O.B. Pricing: In FOB (original) pricing, the buyer will have to incur the cost of transit
and in FOB (destination) the price influences the cost of transit charges.
(b) Zone Pricing: Under this, the company divides the market into zones and quotes uniform
prices to all buyers who buy within a zone. The prices are not uniform all over Kenya. The

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price in one zone varies from that of another one. The prices are uniform within a zone. The
price is quoted by adding the transport cost.
(c) Base Point Pricing: Base point policy is characterized by partial absorption of transport
cost by the company. One or more cities are selected as points from which all shipping
charges are calculated
6. Administered Price: Administered price is defined as the price resulting from managerial
decision and not on the basis of cost, competition, demand etc. But this price is set by the
management after considering all relevant factors. There are many similar products
manifesting different firms and more or less the price tends to be uniform.
Usually the administered price remains unaltered for a considerable period of time.
7. Dual Pricing: under this dual pricing system, a producer is required compulsorily to sell a
part of his production to the government or its authorized agency at a substantially low price.
The rest of the product may be sold in the open market at a price fixed by the producer.
8. Mark up Pricing: This method is also known as cost plus pricing. This method is
generally adopted by wholesalers and retailers. When they set up the price initially, a certain
percentage is added to the cost before marking the price
9. Price Lining: T his method of pricing is generally followed by the retailers than
wholesalers this system consists of selecting a limited number of prices at which the store will
sell its merchandise. Pricing decisions are made initially and remain constant for a long
period. The firm should decide the number of lines and the level of each price line. Many
prices are not desired and the prices should not be too close to each other or too far from each
pair.
10. Negotiated Pricing: It is also known as variable pricing. The price is not fixed. The price
is fixed upon bargaining. In certain cases, the product may be prepared on the basis of
specification or design by the buyer. In such cases, the price has to be negotiated and then
fixed.
11. Competitive Bidding: Big firms or the government calls for competitive bids when they
went to purchase certain products or specialized items. The probable expenditure is worked
out then the after offer is made quoting the price, which is also known as contract price. The
lowest bidder gets the work.

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12. Monopoly Pricing: Monopolistic conditions exist where a product is sold exclusively by
one producer or a seller. When a new product moves to the market, its price is monopoly price
there no problem is no competition or no substitute. Monopoly price will maximize the
profits, as there is no pricing problem.

Review Questions
i. Define the term ‘Price’

ii. Critically examine price as a weapon of competition

iii. Discuss the alternative policies of pricing available to a firm

iv. Examine the internal and external factors that could affect the pricing policy

v. Explain the types of pricing that are followed while pricing a new product

vi. Describe the various kinds of pricing

References for further Reading

1. Boone, Louis E., and Kurtz, David L. (1999). Contemporary Business, 9th ed.
Orlando, FL: Harcourt Brace.
2. Bounds, Gregory M., and Lamb, Charles W., Jr. (1998). Business. Cincinnati, OH:
South-Western College Publishing.

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 CHAPTER ELEVEN: BUSINESS ENVIRONMENT

Learning Objectives

At the end of the chapter, the learner should be able to:

I. Explain the meaning of business environment
II. Identify the features of business environment
III. Describe the importance and types of business environment
IV. Explain the concept of social responsibility of business
V. State the social responsibility of business towards different interest groups
VI. Explain the concept of business ethics
VII. Discuss the various Economic Groupings

Understanding the environment within which the business has to operate is very important for
running a business unit successfully at any place. Because, the environmental factors
influence almost every aspect of business, be it its nature, its location, the prices of products,
the distribution system, or the personnel policies. Hence it is important to learn about the
various components of the business environment, which consists of the economic aspect, the
socio-cultural aspects, the political framework, the legal aspects and the technological aspects
.
Meaning of Business Environment
As stated earlier, the success of every business depends on adapting itself to the environment
within which it functions. For example, when there is a change in the government polices, the
business has to make the necessary changes to adapt itself to the new policies. Similarly, a
change in the technology may render the existing products obsolete, as we have seen that the
introduction of computer has replaced the typewriters; the colour television has made the
black and white television out of fashion. Again a change in the fashion or customers‟ taste
may shift the demand in the market for a particular product, e.g., the demand for jeans
reduced the sale of other traditional wear. All these aspects are external factors that are
beyond the control of the business. So the business units must have to adapt themselves to
these changes in order to survive and succeed in business. Hence, it is very necessary to have

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a clear understanding of the concept of business environment and the nature of its various
components.
The term „business environment‟ connotes external forces, factors and institutions that are
beyond the control of the business and they affect the functioning of a business enterprise.
These include customers, competitors, suppliers, government, and the social, political, legal
and technological factors etc. While some of these factors or forces may have direct influence
over the business firm, others may operate indirectly. Thus, business environment may be
defined as the total surroundings, which have a direct or indirect bearing on the functioning of
business. It may also be defined as the set of external factors, such as economic factors, social
factors, political and legal factors, demographic factors, and technical factors etc., which are
uncontrollable in nature and affects the business decisions of a firm.
Features of Business Environment
On the basis of the above discussion the features of business environment can be summarized
as follows.
(a) Business environment is the sum total of all factors external to the business firm and that
greatly influence their functioning.
(b) It covers factors and forces like customers, competitors, suppliers, government, and the
social, cultural, political, technological and legal conditions.
(c) The business environment is dynamic in nature that means, it keeps on changing.
(d) The changes in business environment are unpredictable. It is very difficult to predict the
exact nature of future happenings and the changes in economic and social environment. .
(e) Business Environment differs from place to place, region to region and country to country.
Importance of Business Environment
There is a close and continuous interaction between the business and its environment. This
interaction helps in strengthening the business firm and using its resources more effectively.
As stated above, the business environment is multifaceted, complex, and dynamic in nature
and has a far-reaching impact on the survival and growth of the business. To be more specific,
proper understanding of the social, political, legal and economic environment helps the
business in the following ways:

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(a) Determining Opportunities and Threats: The interaction between the business and its
environment would identify opportunities for and threats to the business. It helps the business
enterprises for meeting the challenges successfully.
(b) Giving Direction for Growth: The interaction with the environment leads to opening up
new frontiers of growth for the business firms. It enables the business to identify the areas for
growth and expansion of their activities.
(c) Continuous Learning: Environmental analysis makes the task of managers easier in
dealing with business challenges. The managers are motivated to continuously update their
knowledge, understanding and skills to meet the predicted changes in realm of business.
(d) Image Building: Environmental understanding helps the business organizations in
improving their image by showing their sensitivity to the environment within which they are
working. For example, in view of the shortage of power, many companies have set up Captive
Power Plants (CPP) in their factories to meet their own requirement of power.
(e) Meeting Competition: It helps the firms to analyze the competitors‟ strategies and
formulate their own strategies accordingly.
(f) Identifying Firm‟s Strength and Weakness: Business environment helps to identify the
individual strengths and weaknesses in view of the technological and global developments.
Types of Business Environment
Confining business environment to uncontrollable external factors, it may be classified as
(a) Economic environment
(b) Non-economic environment.
The economic environment includes economic conditions, economic policies and economic
system of the country. Non-economic environment comprises social, political, legal,
technological, demographic and natural environment. All these have a bearing on the
strategies adopted by the firms and any change in these areas is likely to have a far-reaching
impact on their operations.
Economic Environment
The survival and success of each and every business enterprise depend fully on its economic
environment. The main factors that affect the economic environment are:
(a) Economic Conditions: The economic conditions of a nation refer to a set of economic
factors that have great influence on business organizations and their operations. These include

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gross domestic product, per capita income, markets for goods and services, availability of
capital, foreign exchange reserve, growth of foreign trade, strength of capital market etc. All
these help in improving the pace of economic growth.
(b) Economic Policies: All business activities and operations are directly influenced by the
economic policies framed by the government from time to time. Some of the important
economic policies are:
(i) Industrial policy
(ii) Fiscal policy
(iii) Monetary policy
(iv) Foreign investment policy
(v) Export –Import policy (Exim policy)
The government keeps on changing these policies from time to time in view of the
developments taking place in the economic scenario, political expediency and the changing
requirement. Every business firm has to function strictly within the policy framework and
respond to the changes therein.
Important Economic Policies
(i) Industrial policy: The Industrial policy of the government covers all those principles,
policies, rules, regulations and procedures, which direct and control the industrial enterprises
of the country and shape the pattern of industrial development.
(ii) Fiscal policy: It includes government policy in respect of public expenditure, taxation and
public debt.
(iii) Monetary policy: It includes all those activities and interventions that aim at smooth
supply of credit to the business and a boost to trade and industry.
(iv) Foreign investment policy: This policy aims at regulating the inflow of foreign
investment in various sectors for speeding up industrial development and take advantage of
the modern technology.
(v) Export–Import policy (Exim policy): It aims at increasing exports and bridge the gap
between expert and import. Through this policy, the government announces various
duties/levies. The focus now-a-days lies on removing barriers and controls and lowering the
custom duties.

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(c) Economic System: The world economy is primarily governed by three types of economic
systems, viz., (i) Capitalist economy; (ii) Socialist economy; and (iii) Mixed economy. Kenya
has adopted the mixed economy system which implies co-existence of public sector and
private sector.
Non-Economic Environment
Technology Factors and Economy
Technology can be defined as the method or technique for converting inputs to outputs in
accomplishing a specific task. Thus, the terms 'method' and 'technique' refer not only to the
knowledge but also to the skills and the means for accomplishing a task. Technological
innovation, then, refers to the increase in knowledge, the improvement in skills, or the
discovery of a new or improved means that extends people's ability to achieve a given task.
Technology can be classified in several ways. For example, blueprints, machinery, equipment
and other capital goods are sometimes referred to as hard technology while soft technology
includes management know-how, finance, marketing and administrative techniques. When a
relatively primitive technology is used in the production process, the technology is usually
referred to as labour-intensive. A highly advanced technology, on the other hand, is generally
termed capital-intensive.
Changes in the technological environment have had some of the most dramatic effects on
business. A company may be thoroughly committed to a particular type of technology, and
may have made major investments in equipment and training only to see a new, more
innovative and cost-effective technology emerge.
Indeed, the managing director of a multinational organisation manufacturing heavy machinery
once said that the hardest part of his job had nothing to do with unions, pay or products, but
with whether or not to spend money on the latest technologically improved equipment.

Computer technology has had an enormous impact on education and health care, to name but
two areas affected. The advancements in medical technology, for example, have contributed
to longevity in many societies. In addition, the introduction of robots in many factories has
reduced the need for labour, and the use of VCR's and microcomputers has become
commonplace in many homes and businesses.
Unfortunately, there is a negative side to technological progress. The introduction of nuclear

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weapons, for example, has made the destruction of the human race a frightening possibility. In
addition, factories using modern technologies have polluted both air and water and
contributed to various environmental and health-related problems.

Technology is a critical factor in economic development. Because of the advances of

international communication, the increasing economic interdependence of nations, and the
serious scarcity of vital natural resources, the transfer of technology has become an important
preoccupation of both industrialised and developing countries. For many industrialised
countries, the changes in the technological environment over the last 30 years have been
immense particularly in such areas as chemicals, drugs, and electronics. It is vital that
organisations stay abreast of these changes - not only because this will allow them to
incorporate new and innovative designs into their products, but also because it will give them
a firmer base from which to anticipate and counteract competition from other organisations.
When the Gillette company developed a superior stainless steel razor blade, it feared that such
a superior product might mean fewer replacements and sales. Thus, the company decided not
to market it. Instead, Gillette sold the technology to Wilkinson, a British garden tool
manufacturer, thinking that Wilkinson would use the technology only in the production of
garden tools. When Wilkinson Sword Blades were introduced and sold quickly, Gillette
understood the magnitude of its mistake.
The transfer of technology is essential for attaining a high level of industrial capability and
competitiveness. Multinational corporations are playing an increasingly important role in
technology transfer because they invest abroad to expand production, marketing and research
activities. There is also a growing consciousness amongst governments of the need to increase
technology transfer to the developing countries to help stabilise their economic and social
conditions.
In spite of the many differences in social, political, cultural, geographic and economic
conditions, there are some common characteristics in the technological environments of
developing countries. The most common technology transfer from industrialised to
developing countries has been in agriculture and health care. As a result of improved health
care systems, infant mortality rates have been cut while the incidence of once common
diseases such as malaria and typhoid has been reduced in Latin America, south-east Asia and
Africa (although the incidents of the AIDS virus has increased alarmingly). Similarly,

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agricultural technology has increased agricultural productivity in Brazil, India and elsewhere.
However, in most developing countries, technology has made little impact on the productive
systems, income distribution and living conditions of the majority of the population.
Technology transfer is a complex, time-consuming and costly process, and the successful
implementation of such a process demands continuous communication and co-operation
between the parties involved. Furthermore, technology transfer cannot be effective if it
experiences conflict with the economic and social needs of the recipient country. The
agricultural development of north-eastern Brazil, for example, was largely financed by
international banks and financial organisations in the 1960's. Much of this region had been
inhabited by Brazilian aborigines but it was owned by a small number of wealthy landowners.
The introduction of large-scale mechanical agricultural technology in areas of the tropical rain
forest of the Amazon has caused serious environmental damage such as erosion of tropical
topsoil and the destruction of the natural environment of numerous birds and animals, and has
displaced a large number of the local inhabitants of the forests.
Technology transfer may become a serious source of conflict between donor and recipient
countries. The recipient country may feel that the donor is trying to dominate it through
technology, capital and production. Dependence on foreign technology can be viewed as a
serious threat to economic independence. Countries that export technology may experience
different problems. For the seller of technology, the technology transfer can result in
unemployment in the home country and future loss of technological superiority. For example,
Japan transferred modern steel production technology to South Korea in the early 1970's. As
labour and production costs in Japan increased, the Korean steel industry began to take over a
significant portion of the previously Japanese-controlled international market. Some Japanese
executives are now complaining that the cost of technology transfer has been much greater
than the income received through the sale of technology.
Technology can be transferred from person to person, industry to industry and government to
government, although the government of any country generally plays the most important role
in facilitating or impeding the transfer process. Contacts amongst students from different
countries are also a means of technology transfer as are journals, books, technical and
professional publications, trade magazines and product pamphlets. Furthermore, multinational
corporations play an important role in technology transfer by transferring information and

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technology from the parent company to subsidiaries in other countries, training foreign
employees, etc.
Socio Cultural Factors and Environment
Humans essentially create their own cultural and social environment. Customs, practices and
traditions for survival and development are passed down from one generation to the next. In
this way, the members of a particular society become conditioned to accept certain "truths"
about life around them. The increasingly competitive international business environment calls
upon exporters to tailor or adapt their business approach to the culture and traditions of
specific foreign markets. The inability or unwillingness to do so could become a serious
obstacle to success.
In the context of the socio-cultural environment, there are a number of factors that you will
need to consider. These are:
Language
Language is central to the expression of culture. Within each cultural group, the use of words
reflects the lifestyle, attitudes and many of the customs of that group. Language is not only a
key to understanding the group, it is the principal way of communicating within it.
A language usually defines the parameters of a particular culture. Thus if several languages
are spoken within the borders of a country, that country is seen to have as many cultures. In
Canada, for instance, both English and French are spoken; in Belgium, French and Flemish;
while in South Africa there are 11 official languages with a number of other African
languages also spoken by the population. In addition, there are often variations within a
language - different dialects, accents, pronunciations and terminology may distinguish one
cultural group from another, e.g. English-speaking South Africans, the British, Americans and
Australians.
The importance of being able to understand other languages cannot be over-emphasised - this
is particularly relevant when executives travel abroad and are negotiating with people of
different language groups. Because English is the predominant language of business in the
western world, people with English as a home language are usually reluctant to learn foreign
languages and tend to expect others to converse with them in English. In contrast, European
and Far Eastern businesspersons have been willing to learn and converse in the language of
their trading partners, leading inevitably to a better understanding and better rapport between

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the parties concerned. If exporters do not speak the language of the country they plan to visit,
they should at least establish the extent to which their own language is spoken there and, if
necessary, engages the services of an interpreter during discussions or negotiations.
If promotional material needs to be prepared in a foreign language, it is important to ensure
that none of the meaning is lost or distorted when the information is translated. Thus,
translations should be undertaken within the country concerned or at least by a native of the
country in question.
Material Culture
Material culture relates to the way in which a society organises and views its economic
activities. It includes the techniques and know-how used in the creation of goods and services,
the manner in which the people of the society use their capabilities, and the resulting benefits.
When one refers to an 'industrialised' or a 'developing' nation, one is really referring to a
material culture.
The material culture of a particular market will affect the nature and extent of demand for a
product. Whereas a luxury item, such as a sophisticated piece of computer hardware, may
have a ready market in a country such as France, demand for it may be non-existent in a
developing country which is hampered by inadequate facilities and/or foreign exchange
shortages. The material culture of a country may also necessitate modifications to the product.
Electrical appliances, for example, may have to be adapted to cater for differences in voltage
levels. To illustrate this: the United States operates under a system of 110V in contrast to
South Africa's 220V. Alternatively, weights and measurements may have to be converted to
those applicable in the importing country (again the US uses measures such as miles, gallons
and pounds, whereas most other parts of the world use the metric system - kilometres, litres
and kilograms).
Material culture can also have a significant effect on the proposed marketing and distribution
strategies. While highways and rail transport are the principal means of moving goods within
the United States, rivers and canals are used extensively in certain European countries. If the
company is planning to develop a manufacturing operation in a foreign market, aspects such
as the supply of raw materials, power, transportation and financing need to be investigated.
Aesthetics

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A culture's aesthetics refer to its ideas concerning good taste and beauty as expressed in the
fine arts - music, art, drama and dance - and in the appreciation of colour and form.
Insensitivity to aesthetic values can not only lead to ineffective advertising and package
design for products, it can also offend prospective customers. An example below is the
significance of different colours may vary considerably from one culture to another. For
example, in many societies, colours are often associated with emotions: "to see red", "to be
green with envy" or "to be feeling blue".
Green, a popular colour in many Moslem countries, is often associated with disease in
countries with dense, green jungles. It is associated with cosmetics by the French, Dutch and
Swedes and increasingly with an environmentally world.
Various colours represent death. Black signifies death to Americans and many Europeans, but
in Japan and many other Asian countries, white represents death. (Obviously, white wedding
gowns are not popular in parts of Asia.) Latin Americans generally associate purple with
death, but dark red is the appropriate mourning colour along the Ivory Coast. And even
though white is the colour representing death to some, it expresses joy to those living in
Ghana.
In many countries, bright colours such as yellow and orange express joy. To most of the
world, blue is thought to be a masculine colour but it is not as manly as red in the United
Kingdom or France. In Iran, blue represents a bad colour. Although pink is believed to be the
foremost feminine colour by Americans, most of the rest of the world considers yellow to be
the most feminine colour. Red is felt to be blasphemous in some African countries but is
generally considered to be a colour reflecting wealth or luxury elsewhere. A red circle has
been successfully used on many packages sold in Latin America. but it is unpopular in some
parts of Asia. To them, it conjures up images of the Japanese flag.
Aesthetics also embrace people's dress and appearance, i.e. their outward garments and
adornments or accessories. Distinctive national attire, for instance, includes the Japanese
kimono, Dutch clogs, and the Englishman's bowler hat and 'brollie'.
Social organization
This refers to the ways in which people relate to one another, form groups and organise their
activities, teach acceptable behaviour and govern themselves. It thus comprises the social,
educational and political systems of a society.

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The exporter's ability to communicate depends to some extent, on the educational level of the
foreign market. If the consumers are largely illiterate, advertising materials or package labels
may have to be adapted to the needs of the market. In this regard, however, a company
marketing baby food in a certain African country put the picture of a smiling child on the
outside of the jar. The local resident assuming there were preserved babies inside, avoided the
product! In addition, there are unspoken signals which identify cultural differences, from
certain taboos to less obvious practices like the time taken to answer a letter. In some
societies, for instance, an important issue is dealt with immediately; in others, promptness is
taken as a sign that the matter is regarded as unimportant, the time taken corresponding with
the gravity of the issue.
In a culture where great importance is attached to the family unit, promotional efforts should
be directed at the family rather than the individual. The size of the family unit differs from
one culture to another. It can range from the nuclear family, i.e. mother, father, and children,
to the extended family which includes many relatives and whose role is to provide protection,
support and economic security to its members. In the extended family, characteristic of
developing countries, consumption decision-making takes place in a larger unit and
purchasing power patterns may be different from those evident in western cultures.
In any society, certain occupations carry more prestige, social status and monetary reward
than others. In India, for example, there is a strong reluctance amongst people with university
education to perform 'menial' tasks using their hands, even answering the telephone. In many
countries, including France, Italy and Singapore, financial independence is considered
essential for occupation-related prestige. In Japan, however, the majority of university-
educated professionals tend to prefer working for large multinational firms than for
themselves.
Social organisation is also evidenced in the operation of the class system, e.g. the Hindu caste
system and the grouping of society members according to age, sex, political orientation, etc
Religious beliefs
A religious system refers to the spiritual side of a culture or its approach to the supernatural.
Western culture is accepted as having been largely influenced by the Judeo-Christian
traditions, while Eastern or Oriental cultures have been strongly influenced by Buddhism,
Confucianism, Taoism and Hinduism. Although very few religions influence business

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activities directly, the impact of religion on human value systems and decision-making is
significant. Thus, religion exerts a considerable influence on people's actions and outlook on
life, as well as on the products they buy. In certain part of the world, such as Latin America,
the influence of religion extends even beyond the individual or family and is manifested in a
whole community's deep involvement in, and devotion to, the church.
A society's religious belief system is often dependent on its stage of human or economic
development. Primitive tribesmen tend to be superstitious about life in general while people in
technologically advanced cultures seem to have dismissed the notion of traditional religious
worship and practice in favour of a more scientific approach to life and death.
To disregard the significance of religious beliefs or superstitions evident in a potential export
market could result in expensive mistakes.
The failure to consider specialised aspects of local religions has created a number of
difficulties for firms. Companies have encountered problems in Asia when they incorporated
a picture of a Buddha in their promotions. Religious ties are strong in this area, and the use of
local religious symbols in advertising is strongly resented - especially when words are
deliberately or even accidentally printed across the picture of a Buddha. One company was
nearly burned to the ground when it ignorantly tried such a strategy. The seemingly minor
incident led to a major international political conflict remembered for years.
Attitudes
Attitudes are psychological states that predispose people to behave in certain ways. Attitudes
may relate, for example, to work, wealth, achievement, change, the role of women in the
economy, etc.
Western cultures, for example, value individualism and promote the importance of autonomy
and personal achievement needs. In contrast, in many eastern and developing countries, there
is a strong sense of collectivism and the importance of social and security needs. For instance,
the Hindu religion imparts a type of work ethic that considers work central to one's life but
maintains that it must be performed as a service to others, not for one's own personal
achievement.
Stereotypes are sets of attitudes in which one attributes qualities or characteristics to a person
on the basis of the group to which that person belongs. An international businessperson's
tendency to judge others by his or her personal and cultural standards instead of attempting to

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understand others in the context of their unique historical, political, economic and social
backgrounds could, for example, be termed an undesirable attitude.
Values
Values are judgments regarding what is valuable or important in life, and they vary greatly
from one culture to another. People who are operating at a survival level will value food,
shelter and clothing. Those with high security needs, on the other hand, may value job
security, status, money, etc. From its value system, a culture sets norms, i.e. acceptable
standards of behaviour.

Space
The concept of space is different wherever one goes. In western corporate culture, the size and
location of an executive's office is usually determined by his level of seniority in the
company. The locality and size of an Arab business executive's office, on the other hand, are a
poor indication of the person's importance.
Conversation distance between two people is learned early in life - almost completely
unconsciously. A western business executive, conditioned to operating within a certain
amount of personal space, may feel uncomfortable or alarmed at the closeness and physical
contact displayed in the Middle East or Latin America, for example.
Time
Time also has a different meaning in each country. Western cultures tend to perceive time in
terms of past, present and future. They are orientated towards the future and in the process of
preparing for it, they save, waste, make up or spend time.
In South Africa, giving a person a deadline is a way of indicating the degree of urgency or
relative importance of the work. In the Middle East, however, time does not usually include
schedules and timetables. The time required to get something accomplished depends on the
relationship. With South Africans, the more important an event is, the earlier it is planned,
which is why last minute invitations are often regarded as an insult. In planning future events
with Arab businesspersons, it is often advisable to keep the lead time to a week or less,
because other factors may intervene and take precedence.
Some time ago, an American lost a major contract in Greece because he did not appreciate the
Greek concept of time. The Greek executive could not understand the American's insistence
on setting time limits on the length of their business meetings - he and his colleagues were

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prepared to spend as much time in discussion as they felt was necessary. The American also
insisted that the senior managers involved in the transaction be responsible only for working
out the general principles of the deal, with the actual details being left to subordinates.
Suspicious that this represented a lack of commitment on the part of the American, the Greek
called off the deal.
Many factors continuously produce cultural changes in a society - new technology, population
shifts, availability of scarce resources and changing values regarding the role of education or
women. Culture is thus dynamic, and exporters, particularly those involved in international
travel and marketing, need to regularly assess what new products and service needs have been
created, who the potential buyers and users are, and how best to reach them.
Legal Environment
The legal environment is derived partly from the political climate in a country and has three
distinct dimensions to it:
 The domestic laws of your home country
 The domestic laws of each of your foreign markets
 International law in general
Legal systems vary from country to country. You are likely to find that the legal systems in
operation in the buyers' country are in many respects different from that of Kenya.
Domestic laws govern marketing within a country, e.g. the physical attributes of a product
will be influenced by laws (designed to protect consumers) relating to the purity, safety or
performance of the product. Domestic laws might also constrain marketers in the areas of
product packaging, marking and labelling, and contracts with agents. Most countries also have
certain laws regulating advertising, e.g. Britain does not permit any cigarette or liquor
advertising on TV
Different legal systems
The legal systems of most of the non-socialist countries can be grouped into common law and
code law. Common law is generally based on precedents or past practices while a code, which
is a comprehensive set of volumes having statutory force and covering virtually the whole
spectrum of the country's law, is established by arbitrary methods - e.g. a speed limit of 80
kph or a three-day period for cancelling a contract.

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Kenya‟s commercial legal system has been influenced by English law. English courts create
and follow precedents just as Kenyan courts do. Furthermore, English cases are regularly
cited as authority in our courts in situations where there is no domestic decision on the point
and the particular case concerns an area of our law (such as insurance or negotiable
instruments) which derives from, or was considerably influenced by, English law.
Contracts
Central to all commercial activities is the contract. The purpose of a contract is to specify the
respective rights and obligations of the parties to an agreement and outline specific procedures
or actions that must take place. In this way, the possibility of disputes arising between the
parties is reduced. In the context of international business, with its inherent risks and
complexities, contracts assume a vital role. The principal legal arrangement underlying an
export transaction is the export sales contract. However, when a company obtains materials
from a local supplier, engages the services of a freight forwarder or insurer, or concludes
agreements with carriers, e.g. shipping lines, airlines and domestic road hauliers, it is also
entering contracts.
In many cases, a contract is entered into once agreement has been reached. It is important to
agree at the beginning of the negotiations that all agreements are reduced to writing before
contracts are formalised.
When an international commercial dispute occurs, the problem must be settled in one of the
countries involved according to the laws and regulations of that country unless the contract
states otherwise. If the dispute cannot be settled amongst the parties involved, resolution can
possibly be obtained through arbitration (i.e. through negotiations facilitated by a independent
third party). Where the process of arbitration fails, for one reason or another, the option of
litigation, i.e. going to court, might be considered. Disputes that go to court usually involve
either large monetary transactions or the ownership of patents, copyright (see chapter 4) or
physical property. Court actions can take from a few months to several years and can involve
large expenditure in legal fees and lost revenues.
International Law
Buyers and sellers are at times also subject to international law, which may be defined as that
body of rules which regulates relationships between countries or other international legal

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persons. There is neither an 'international parliament' empowered to create international law;
nor an 'international police force' to enforce it.
The principal sources of international law are treaties and conventions. These are created
when several countries reach agreement on a certain matter and bind themselves to it by
authorising their representatives to sign a document embodying that agreement. Essentially,
they have entered into a contract that obliges them to do something or to refrain from doing
something. Failure to comply is the equivalent of breach of contract.
Other sources of international law are custom (i.e. international practice that is accepted as
law) and the general principles of law recognised by civilised nations or natural law (the basis
of human co-existence). Although there is no organised body to 'enforce' international law,
there is an International Court of Justice situated at The Hague in The Netherlands. This court
decides any matter which the parties regard as suitable for submission to it for adjudication.
This means that a country approaches the court voluntarily; it cannot be 'brought' to the court
involuntarily.
Before a country is liable to comply with the provisions of a treaty or a convention, it must
have signed the original protocol (i.e. the original treaty document or minutes of the
convention). Once a country has signed the protocol, the method of enforcement depends on
the terms of the treaty or convention. A common way of bringing a defaulting country to heel
is by imposing sanctions against it. Sanctions may take many different forms and can be
applied with varying degrees of severity. Obviously, the more parties there are to the protocol,
the easier it is to enforce by virtue of the weight of opinion and the efficacy of any measures
that can be taken against an offender.
Political Factors and Environment
No matter how attractive the economic prospects of a particular country or region are, doing
business there might prove to be financially disastrous if the host government(s) inflict(s)
heavy financial penalties on a company or if unanticipated events in the political arena lead to
the loss of income-generating assets.
The political environment in which the firm operates (or plan to operate) will have a
significant impact on a company's international marketing activities. The greater the level of
involvement in a foreign markets, the greater the need to monitor the political climate of the
countries business is conducted. Changes in government often result in changes in policy and

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attitudes towards foreign business. Bearing in mind that a foreign company operates in a host
country at the discretion of the government concerned, the government can either encourage
foreign activities by offering attractive opportunities for investment and trade, or discourage
its activities by imposing restrictions such as import quotas, etc. An exporter that is
continuously aware of shifts in government attitude, will be able to adapt export marketing
strategies accordingly.
Nearly all governments today play active roles in their countries' economies. Although
evident to a greater or lesser extent in most countries, government ownership of economic
activities is still prevalent in the former centrally planned economies, as well as in certain
developing countries which lack a sufficiently well developed private sector to support a free
market system.
The implications of government ownership to a company marketing abroad might be that
certain sectors of the foreign market are the exclusive preserve of government enterprise or
that the company is obliged to sell directly to a state trading organisation. In either case, the
company's influence on the market is greatly reduced. Similarly, if an exporter is seeking to
establish a subsidiary in a country where there is a high degree of state influence over the
factors of production, the investor should bear in mind that marketing activities in the country
concerned may be restricted and that the so-called controllable elements of the marketing
mix) will be less controllable.
Of primary concern to an exporter should be the stability of the target country's political
environment. A loss of confidence in this respect could lead to a company having to reduce its
operations in the market or to withdraw from the market altogether. One of the surest
indicators of political instability is a frequent change in regime. Although a change in
government need not be accompanied by violence, it often heralds a change in policy towards
business, particularly international business. Such a development could impact harshly on a
firms long-term international marketing programme.
Reflected in a government's attitudes and policies towards foreign business are its ideas about
how best to promote national interest in the light of the country's economic and political
resources and objectives. Foreign products and investment seen to be vital to the growth and
development of the economy often receive favourable treatment from the government in the
form of reduced tax, exemption from quotas, etc. On the other hand, products considered by a

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government to be non-essential, undesirable, or a threat to local industry are frequently
subjected to a variety of import restrictions such as quotas and tariffs. It is also important to
be aware of the nature of the relationship between South Africa and the foreign target market.
This was a major consideration during South Africa's political isolation. Fortunately, South
Africa's international relations have normalised and today South Africa is viewed very
favourably, from a political perspective, by the rest of the world.
The political environment is connected to the international business environment through the
concept of political risk.
Political risk is determined differently for different companies, as not all of them will be
equally affected by political changes. For example, industries requiring heavy capital
investment are generally considered to be more vulnerable to political risk than those
requiring less capital investment. Vulnerability stems from the extent of capital invested in the
export market, e.g. capital-intensive extracting or energy-related businesses operating in the
foreign market are more vulnerable than manufacturing companies exporting from a Kenyan
base.
Political risk is of a macro nature when politically inspired environmental changes affect all
foreign investment. It is of a micro nature when the environmental changes are intended to
affect only selected fields of business activity or foreign firms with specific characteristics,
When business is conducted in developing countries, the risks of greatest concern are civil
disorder, war and expropriation. When business is conducted in industrialised countries,
labour disruptions and price controls are generally seen to pose the greatest threats to a
company's profitability.
All organisations doing business abroad should be aware of the fact that what they do could
be the object of some political action. Hence, they need to recognise that their success or
failure could depend on how well they cope with political decisions, and how well they
anticipate changes in political attitudes and policies.
Demographic Environment
This refers to the size, density, distribution and growth rate of population. All these factors
have a direct bearing on the demand for various goods and services. For example a country
where population rate is high and children constitute a large section of population, then there
is more demand for baby products. Similarly the demand of the people of cities and towns are

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different than the people of rural areas. The high rise of population indicates the easy
availability of labour. These encourage the business enterprises to use labour intensive
techniques of production. Moreover, availability of skill labour in certain areas motivates the
firms to set up their units in such area.
Natural Environment
The natural environment includes geographical and ecological factors that influence the
business operations. These factors include the availability of natural resources, weather and
climatic condition, location aspect, topographical factors, etc. Business is greatly influenced
by the nature of natural environment. For example, sugar factories are set up only at those
places where sugarcane can be grown. It is always considered better to establish
manufacturing unit near the sources of input. Further, government‟s policies to maintain
ecological balance, conservation of natural resources etc. put additional responsibility on the
business sector.
Kenya‟s Economic Structure
Kenya is the largest economy in east Africa and is a regional financial and transportation hub.
After independence, Kenya promoted rapid economic growth through public investment,
encouragement of smallholder agricultural production, and incentives for private (often
foreign) industrial investment. Gross domestic product (GDP) grew at an annual average of
6.6% from 1963 to 1973. Agricultural production grew by 4.7% annually during the same
period, stimulated by redistributing estates, diffusing new crop strains, and opening new
cultivation areas. After experiencing moderately high growth rates during the 1960s and
1970s, Kenya's economic performance during the 1980s and 1990s was far below its
potential. From 1991 to 1993, Kenya had its worst economic performance since
independence. Growth in GDP stagnated, and agricultural production shrank at an annual rate
of 3.9%. Inflation reached a record 100% in August 1993. In the mid-1990s, the government
implemented economic reform measures to stabilize the economy and restore sustainable
growth, including lifting nearly all administrative controls on producer and retail prices,
imports, foreign exchange, and grain marketing. Nevertheless, the economy grew by an
annual average of only 1.5% between 1997 and 2002, which was below the population growth
estimated at 2.5% per annum, leading to a decline in per capita incomes. The poor economic
performance was largely due to inappropriate agricultural, land, and industrial policies

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compounded by poor international terms of trade and governance weaknesses. Increased
government intrusion into the private sector and import substitution policies made the
manufacturing sector uncompetitive. The policy environment, along with tight import controls
and foreign exchange controls, made the domestic environment for investment unattractive or
both foreign and domestic investors. The Kenyan Government's failure to meet commitments
related to governance led to a stop-start relationship with the International Monetary Fund
(IMF) and World Bank, both of which suspended support in 1997 and again in 2001.
During President Kibaki's first term in office (2003-2007), the Government of Kenya began
an ambitious economic reform program and resumed its cooperation with the World Bank and
the IMF. There was some movement to reduce corruption in 2003, but the government did not
sustain that momentum. Economic growth began to recover in this period, with real GDP
growth registering 2.8% in 2003, 4.3% in 2004, 5.8% in 2005, 6.1% in 2006, and 7.0% in
2007. However, the economic effects of the violence that broke out after the December 27,
2007 general election, compounded by drought and the global financial crisis, brought growth
down to less than 2% in 2008. In 2009, there was modest improvement with 2.6% growth,
while the final 2010 growth figure should be about 5%. In May 2009, the IMF Board
approved a disbursement of approximately $200 million under its Exogenous Shock Facility
(ESF), which is designed to provide policy support and financial assistance to low-income
countries facing exogenous but temporary shocks. The ESF resources were meant to help
Kenya recover from the negative impact of higher food and international fuel and fertilizer
costs, and the slowdown in external demand associated with the global financial crisis. To a
considerable extent, the government's ability to stimulate economic demand through fiscal
and monetary policy is linked to the pace at which the government is pursuing reforms in
other key areas, which remains slow. The Privatization Law was enacted in 2005, but only
became operational as of January 1, 2008. Parastatals Kenya Electricity Generating Company
(KenGen), Telkom Kenya, and Kenya Re-Insurance have been privatized. The government
sold 25% of Safaricom (10 billion shares) in 2008, reducing its share to 35%. Accelerating
growth to achieve Kenya's potential and reduce the poverty that afflicts about 46% of its
population will require continued deregulation of business, improved delivery of government
services, addressing structural reforms, massive investment in new infrastructure (especially
roads), reduction of chronic insecurity caused by crime, and improved economic governance

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generally. Economic expansion is fairly broad-based and is built on a stable macro-
environment fostered by government, and the resilience, resourcefulness, and improved
confidence of the private sector. Despite the post-election crisis, Nairobi continues to be the
primary communication and financial hub of East Africa. It enjoys the region's best
transportation linkages, communications infrastructure, and trained personnel, although these
advantages are less prominent than in past years. In FY 2010, tea was Kenya's top export,
accounting for $1.15 billion. Fresh horticulture exports were $718 million, well short of the
record high of $1.12 billion in 2007, in part due to unfavorable global weather conditions that
affected air transportation. The sector is expected to rebound in 2011. Tourism has rebounded
from the drop experienced in 2008 after the post-election violence, bringing in $807 million in
2009, an increase of 19% from 2008. In the first 8 months of 2010, arrivals continued to
increase, registering 14.5% growth compared to the same period in 2009. Africa is Kenya's
largest export market, followed by the European Union (EU). Kenya benefits significantly
from the African Growth and Opportunity Act (AGOA), but the apparel industry is struggling
to hold its ground against Asian competition. Currently there are 19 apparel factories, 1
yarn/fabric company, and 6 accessory companies (labels, sewing supplies, hangers) operating
in the Export Processing Zones. Approximately 90% of Kenya's AGOA exports in 2010 were
garments, and Kenya‟s garment exports under AGOA totaled $202 million in 2010 (a slight
increase over 2009 but still well below the 2006 level of $265 million). Kenya does not
systematically collect foreign direct investment (FDI) statistics, and its historical performance
in attracting FDI has been relatively weak. The stock of FDI in 2005 was estimated to be
about $1.04 billion, less than half of that in neighboring Tanzania. Net foreign direct
investment was negative from 2000-2003, but started trickling back in 2004. The stock of
U.S. FDI (at historical prices) was estimated to be about U.S. $180 million as of 2010.
Remittances are Kenya‟s single largest source of foreign exchange and a key social safety net.
According to the Central Bank of Kenya, recorded remittances totaled about $640 million in
2010; however, the actual number may be as high as $1 billion. Kenya faces profound
environmental challenges brought on by high population growth, deforestation, shifting
climate patterns, and the overgrazing of cattle in marginal areas in the north and west of the
country. Significant portions of the population will continue to require emergency food
assistance in the coming years. Kenya is pursuing regional economic integration, which could

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enhance long-term growth prospects. The government is pursuing a strategy to reduce
unemployment by expanding its manufacturing base to export more value-added goods to the
region while enabling Kenya to develop its services hub. In March 1996, the Presidents of
Kenya, Tanzania, and Uganda re-established the East African Community (EAC). The EAC's
objectives include harmonizing tariffs and customs regimes, free movement of people, and
improving regional infrastructures. In March 2004, the three East African countries signed a
Customs Union Agreement paving the way for a common market. The Customs Union and a
Common External Tariff were established on January 1, 2005, but the EAC countries are still
working out exceptions to the tariff. Rwanda and Burundi joined the community in July 2007.
In May 2007, during a Common Market for Eastern and Southern Africa (COMESA) summit,
13 heads of state endorsed a move to adopt a COMESA customs union and set December 8,
2008 as the target date for its adoption. On July 1, 2010, the EAC Common Market Protocol,
which allows for the free movement of goods and services across the five member states, took
effect. In October 2008, the heads of state of EAC, COMESA, and the Southern African
Development Community (SADC) agreed to work toward a free trade area among all three
economic groups with the eventual goal of establishing a customs union. If realized, the
Tripartite Free Trade area would cover 26 countries.
Emerging Economic Partnerships
Kenya‟s historical trade partners are mainly located in Europe (the UK, Germany and the
Netherlands) and East Africa (Uganda and Tanzania). The US seems to have played a minor
role in trade relations prior to 1999. Pakistan and India have persistently increased their share
of trade over time. For its exports, Kenya has concentrated on the African markets with
Rwanda and Egypt as key targets. For imports, Kenya has of late increased its trade relations
with the US, South Africa, Saudi Arabia, the UAE, Iran, Japan, Singapore and China.
Regarding investment, the country has had one of the most open regimes for FDI in Africa
since its independence. The main historical sources of investment have been the UK,
Germany and India as well as other European countries such as Italy, the Netherlands and
France.
India‟s relations with Kenya started before independence with the voyages of merchants.
Indira Gandhi participated in the country‟s independence celebrations in 1963. In 1981, the
two countries granted each other Most Favoured Nation status under an India-Kenya trade

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agreement. In 1989, an India-Kenya Double Taxation Avoidance Agreement was signed.
Recently, investment and trade partnerships between the two countries have culminated in a
wave of new investment. Petrochemicals and chemicals, telecommunications and floriculture
are the sectors in which Indian firms have been investing the most. Recent investments by
Indian firms include Bharti Airtel (telecom), Essar (telecom and refining), Tata Africa (cars,
pharmaceuticals, information technologies, etc.) and Reliance (petroleum products).
In 2010, India is Kenya‟s sixth largest trading partner. Kenya mainly exports vegetables, soda
ash, tea, metal and leather to India and imports pharmaceuticals, machinery, steel products,
automobiles and power transmission devices. Indian official development assistance (ODA) is
limited and comes in the form of loans and credit. A loan of INR 50 million (Indian rupees)
was granted to the government of Kenya in 1982 in addition to lines of credit offered by
EXIM Bank of India to the Industrial Development Bank. In November 2010, during the visit
of the Kenyan prime minister to India, an agreement granting a line of credit of USD 61.6
million from EXIM Bank of India to the government of Kenya to be utilized in the power
transmission sector was signed. As part of the Indian co-operation, more than 100
scholarships are offered by the government of India each year to Kenyan nationals.
Since the early 2000s, Kenya has been building new economic partnerships with African,
Middle Eastern and Far Eastern countries. Since the Narc government took over in January
2003, its policy has targeted the intensification of trade relations with Eastern countries. The
government has entered into trade and economic partnerships with five countries in the
Middle East and Asia (China, Iran, UAE, Japan and Singapore) but the key economic partner
is China.
China was the fourth country to recognize Kenya‟s independence in 1963. It considers Kenya
as a gateway to Africa. New enhanced economic relations between Kenya and China began in
2005 with President Kibaki‟s visit to China. The trip culminated with a five-part agreement
covering: ODA for infrastructure and energy, extended aviation services, technical assistance
for assessment and industrial products‟ classification and standards, and modernization of
equipment at the Kenya Broadcasting Corporation (KBC). As a direct consequence of these
agreements, Kenya‟s imports from China grew by 224.5%, from KES 23.0 billion in 2005 to
KES 74.5 billion in 2009. Imports from China between January and November 2010

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amounted to KES 110.1 billion making China the first origin of imports before the UAE (KES
108.4 billion) and India (KES 82.9 billion).
Chinese direct investments in Kenya also escalated. Between 2004 and 2007, China invested a
capital of KES 2.5 billion. In 2009, FDI from China culminated to KES 530 million up from
KES 53.4 million in 2008. Chinese companies are active in construction, tourism and
manufacturing. There are currently 96 investment projects undertaken by the Chinese, mainly
road construction projects, employing a workforce of about 9 000 Kenyans. An increasing
number of small to medium-sized Chinese firms specializing in auto repair and maintenance,
home furnishings, construction equipment and agricultural machinery have also settled in
Kenya.
China provides monetary and non-monetary aid to Kenya, exclusively on a project basis. It
supports infrastructure, equipment and plants, academic and technical training, human relief
and tariff exemption. The share of Chinese aid became significant in 2002 when it exceeded
1% of total development assistance received by Kenya. In 2005, the share of Chinese
development assistance rose to 8.25%, placing China second among bilateral donors. China‟s
development aid policy differs from Kenya‟s traditional partners by its greater flexibility in
accommodating internal political constraints. No pre-conditions are imposed on the attribution
of aid. The assistance is only tied to the formal recognition of Chinese Taipei under the One
China Principle and to the use of Chinese companies and procurement of material.
Trade between the UAE and Kenya is growing very fast. Between 2004 and 2009, Kenyan
exports to the UAE have increased from KES 2.4 billion to KES 10.7 billion, representing a
347% increase. However, most of the trade favours the UAE since Kenya imports
significantly more. Between 2005 and 2009, imports from the UAE increased by 42.8% from
KES 62.8 billion to KES 89.7 billion. In addition to being Kenya‟s major supplier of oil, the
UAE has emerged as a favoured shopping destination. Kenyans travel there regularly to
purchase household and office electronic appliances, automobile spare parts and motor
vehicles. Even though the UAE largely contributes to imports and exports, it does not
contribute at all to foreign direct investments.
Israel is a notable emerging investment partner. While foreign direct investments coming
from Israel amounted to KES 800 million between 2004 and 2008, and to only
KES 78 million in 2009, these flows increased dramatically in 2010 – approaching

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KES 4 billion. Overall, Israel contributed to the creation of 701 local jobs between 2004 and
2010. It has continually invested in the agricultural sector over the years, mainly in
agricultural machinery and irrigation.
Trade and investment relations between Australia and Kenya have been limited but Australia
began to show an interest in Kenyan minerals and petroleum resources industry in 2010. Flow
Energy Limited entered the Kenyan coast to explore the possibility of oil and gas in Lamu.
This represented a large part of Australia‟s investment in Kenya in 2010, which amounted
overall to KES 16 billion. With the prospect of oil, Australia is posed to be a major investor in
Kenya. An oil agreement between Kenya and Iran, in which Iran offered to sell oil to Kenya
at better prices, caused an upward leap in trade in 2007.
Social Context and Human Resource Development
Modest progress has been made towards achieving most of the Millennium Development
Goals (MDGs). The country is considered off-track when it comes to eradicating extreme
poverty (MDG 1) by 2015 though the percentage of population below the poverty line did
drop from 56.0% in 2000 to 46.9% in 2008/09. High inflation rates between 2003 and 2009
have eroded the purchasing power of the population, dramatically affecting the poor and most
vulnerable. Persistent poverty and unemployment, particularly among youth, remain major
challenges.
Kenya‟s Human Development Index (HDI), where 0 is the lowest score and 1 the highest, has
increased from 0.464 in 2009 to 0.470 in 2010, compared with 0.389 in sub-Saharan Africa
and 0.624 in the world. The country belongs to the group of those where human development
is low ranking, 128th out of 169 countries. The Youth Development Index (YDI) evaluates
the degree of inclusion and social integration of youth in education, health and income.
Kenya‟s YDI is slightly above its HDI at 0.5817 in 2009. Looking at the composition of this
index, income appears to be the major challenge with Kenya‟s Youth Income Index at 0.44.
To address the issue of youth being unemployed and lacking skills, the government has
formulated the National Youth Policy and established the National Youth Council.
Kenya is very likely to achieve universal primary education (MDG 2) by 2015 with an adult
literacy rate of 73.6% in 2010 and a combined gross enrolment ratio in education of 59.6%.
The number of mean years of schooling for adults is 7 years and expected years of schooling
of children is 9.6 years. To improve access to quality education, the government invested in

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free primary education and free tuition in secondary schools in 2009/10 and plans to allocate
an additional KES 2 billion to these programmes in 2010/11. Kenya could possibly achieve
MDG 3 – to promote gender equality and empower women – if some changes are made. The
new constitution affirms the right for men and women to be treated equally and benefit from
equal opportunities. As part of the new constitution, each one of the 47 counties will elect a
woman MP. As a result, at least 16% of all members of parliament will be women. This
represents an improvement from the 2007 elections where only 15 women were elected as
members of parliament.
Kenya made progress towards reducing child mortality (MDG 4) even though it probably will
not be sufficient to achieve this goal fully by 2015. Infant mortality has been significantly
reduced – from 77 per 1 000 live births in 2003 to 52 per 1 000 in 2009 – and immunization
coverage increased to 77% in 2008/09 from 57% in 2003. When it comes to improving
maternal health (MDG 5), Kenya‟s maternal mortality rates actually worsened between 2003
and 2008/09, reaching 488 per 100 000 in 2008/09. Major progress is needed to get Kenya
back on track.
Despite the progress achieved towards combating HIV/AIDS and malaria (MDG 6), these
diseases remain major issues for Kenya. The overall prevalence of HIV in Kenya was
estimated to stand at 7.4% among persons aged 15-64 in 2008. Prevalence among women in
this group was 8.7% while among men the rate was 5.6%. It was estimated that Kenya has
1.33 million Kenyan adults infected with HIV. Since 2007, malaria has remained the most
common and severe ailment in terms of morbidity and mortality. It currently accounts for
20% of all admissions to health facilities in Kenya. Malaria was estimated to cause 20% of all
deaths in children under the age of 5 in 2010. Out of a population of 39 million Kenyans, 25
million are currently at risk of getting malaria.
Health care provision in Kenya is a central theme in the government‟s social sector
expenditure. Public expenditure on health has increased significantly since the fiscal year
2007/08. It increased from KES 23.8 billion in 2007/08 to KES 30.5 billion in 2009/10.
However, the provision of health services in Kenya remains generally suboptimal. It is
currently estimated that 50% of health facilities lack electrical power, water and sanitation
services. The doctor-patient ratio is 17 per 1 000 while the nurse-patient ratio is 120 per
1 000. Preliminary results for the Kenya health and demographic survey (KHDS), released in

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2009, indicated that the total fertility rate for Kenyan women aged between 15 and 49
declined from 8.1 in 1975 to 4.6 in 2008. In its 2010/11 budget, the government planned to
allocate KES 1 billion for the recruitment of 15 additional nurses and 5 public health
technicians in each constituency.
Social Responsibility of a Business
Every business enterprise is an integral part of the society. It uses the scarce resources of the
society to continue and grow. Hence, it is important that no activity of business is injurious to
the long run interests of the society. However, it is observed that, in practice, there are a few
socially undesirable aspects of business such as, polluting the environment, non-payment of
taxes, manufacturing and selling adulterated products, giving misleading advertisement and so
on. This has resulted in the development of the concept of social responsibility of business
whereby the owners and managers of business are made conscious about the responsibilities
of their business towards the community and its customers, workers etc.
Meaning of Social Responsibility
Social responsibility of business refers to the obligation of business enterprises to adopt
policies and plans of actions that are desirable in terms of the expectation, values and interest
of the society. It ensures that the interests of different groups of the public are not adversely
affected by the decisions and policies of the business.
Social Responsibilities towards different Groups
It needs to be noted that the responsibilities of those who manage the business cannot be
limited to the owners. They have to take into account the expectations of other stakeholders
like the workers, the consumers, the government and the community and public at large. Let
us now look at the responsibilities of the business towards all these groups.
(a) Responsibility towards the shareholders or owners: The shareholders or owners are
those who invest their money in the business. They should be provided with a fair return on
their investment. You know that in case of companies it takes the form dividends. It has to be
ensured that the rate of dividend is commensurable with the risk involved and the earnings
made. Besides dividends, the shareholders also expect an appreciation in the value of shares.
This is governed primarily by company‟s performance.
(b) Responsibility towards the Employees: A business enterprise must ensure a fair wage or
salary to the workers based on the nature of work involved and the prevailing rates in the

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market. The working conditions must be good in respect of safety, medical facilities, canteen,
housing, leave and retirement benefits etc. They should also be paid reasonable amount of
bonus based on the business earnings. Preferably, there should also be a provision for their
participation in management.
(c) Responsibility towards the Consumers: A business enterprise must supply quality goods
and services to the consumers at reasonable prices. It should avoid adulteration, poor
packaging, misleading and dishonest advertising, and ensure proper arrangement for attending
to customer complaints and grievances.
(d) Responsibility towards the Government: A business enterprise must follow the
guidelines of the government while setting up the business. It should conduct the business in
lawful manner, pay the taxes honestly and on time. It should not indulge in any corrupt
practices or unlawful activities.
(e) Responsibility towards the Community: Every business is a part and parcel of our
community. So it should contribute towards the general welfare of the community. It should
preserve and promote social and cultural values, generate employment opportunity and
contribute towards the upliftment of weaker sections of the society. It must take every step to
protect the physical and ecological environment of the society. It should contribute to the
community development programmes like public health care, sports, cultural programmes.
Business Ethics
The word „Ethics‟ originated from the Greek word „ethos‟ meaning character, conduct and
activities of the people based on moral principles. It is concerned with what is right and what
is wrong in human behaviour on the basis of standard behaviour or conduct accepted by the
society. Honesty, truthfulness, compassion, sympathy, feeling of brotherhood etc. are
considered ethical.
Similarly, ethics from business point of view or business ethics are the moral principles,
which guide the behaviour of businessmen or business activities in relation to the society. It
provides certain code of conduct to carry on the business in a morally justified manner.
Ethical investment is a useful aspect for considering ethical business, since large scale
investment is ultimately subject to market forces, which largely reflect public opinion. As
such ethical investment criteria and examples tend to be a good guide towards ethical attitudes
of large sections of people and society, rather than the 'expert' views of leaders and gurus.

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Ethical investment has been a growing aspect of business investment since the 1970s,
although arguably the first types of ethical businesses can be traced back to the Quaker and
Methodist movements of the 1800s.
Then as now ethical business and investments regard socially responsible activities and aims
with far greater priority and emphasis than the traditional profit and free market business
approach.
Traditional profit-based business models, which arose and came to dominate global
commerce from the beginnings of industrialization, inherently do not require a socially
responsible element, other than compliance with the law, and a reflection of public reaction
for pragmatic marketing (and ultimately profit) purposes.
Ethical business or investment is concerned with how profit is made and how much profit
is made, whereas traditional profit-centered free-market based business is essentially only
concerned with how much profit is made.
Traditional profit-centered business seeks to maximize profit and return on investment with
no particular regard for how the profits are made and what the social effects of the business
activities are.
The ethical approach to business and investment seeks to maximize profit and return on
investment while minimizing and avoiding where possible negative social effects.
In this context 'social' and 'socially responsible' include related factors such as:
 the environment
 sustainability
 globalization effects - e.g., exploitation, child-labour, social and environmental
damage anywhere in the world
 corruption, armed conflict and political issues
 staff and customers relations - for instance education and training, health and safety,
duty of care, etc
 local community
 and other social impacts on people's health and well-being
Typically the above are interpreted within ethical investment so as to regard the following
sectors and activities as being difficult to reconcile with profit and investment. As with other
perspectives on this page, this is not a definitive list or set of absolute criteria. It's a set of

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examples to illustrate typical (modern Western) concerns of ethical investors and ethical
business people:
 tobacco
 armaments
 nuclear power
 animal experimentation
 oppressive or corrupt national regimes
This is not an exhaustive list and is subject to change - as the world changes.
As stated, this is not a pronouncement of what's unethical. It's a reflection of current attitudes,
which you can use in your own way alongside the other information on this page to develop
your own ideas as to what's ethical and what's not.
Also as stated, things change with time and situation. For example if technology is developed
enabling nuclear power to be safer and less impactful on the future then obviously concerns in
this area would reduce and the ethical implications would decrease or disappear.
Standards of what is considered ethical change over time, and generally these standards
become more humane as humankind develops greater tolerance, awareness, and capacity for
forgiveness and compassion. Humankind's - or any society's - capacity for ethical behaviour
increases with its own safety and confidence of survival and procreation. Hence the human
tendency to become less ethically flexible when under threat. Thus ethical behaviour is a
relative judgment, as well as a subjective one. We cannot impose one society's moral code
onto another society with different needs and demands.
Interestingly what is considered unethical in present times commonly becomes unlawful in
the future. The leading ethical thinking of any time tends to pioneer social and civilization
change.
And so here lies substantial advantage for corporations and other groups and bodies which
anticipate such changes. They adapt quicker, and are seen generally to lead rather than follow.
They also manage change more successfully, since they have time to do it.
Organizations and institutions which fall behind public ethical expectations find catching up a
lot more difficult.
Ethics and law

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Many believe that the word ethical equates to lawful, and that by being lawful an organization
or activity is automatically ethical. This is not so. While many things that are unethical are
also unlawful, ethics do not equate to law. Many unethical things are entirely lawful
(although some can only be tested when/if they get to court). Moreover sometimes the law (of
any land) can produce extremely unethical effects. In fact while most unlawful actions will
also tend to be unethical, certain situations can contain a strong ethical justification for
breaking the law, or changing the law.
Notable examples are situations in which the law, or the way law is applied, is considered
unethical ('wrong' is the typical description) by sufficient numbers of people to pressure the
legal system to change. You can perhaps think of examples when this has happened, and such
cases are examples of an ethical viewpoint being ultimately more powerful than the law.
Examples of this happening through (Western) history illustrate the tendency for ethical
considerations to drive the law: women's suffrage (women's right to vote); the abolition of
slavery; and modern human rights and equality legislation are examples of ethical pressures
causing change in law.
The independence of nations and the break-up of colonial rule are further examples of ethical
pressures overwhelming the force of law. Unlawful acts are not always unethical. Ethical acts
are not always lawful. Lawful therefore does not equate to ethical, and unethical does not
equate to unlawful.
Ethics and religion
For many people, ethics and ethical judgments are based on a religious belief. However
religion is not a basis for arriving at consistent standards of ethics, any more than the law is.
To illustrate the point:
A particularly dangerous implication arising from mixing decision-making with religion is the
one which provides the decision-maker with a sort of safety net if everything goes wrong.
"God will be my judge..."
For people who are not religious, or who have a different religious faith to decision-maker,
these words are a little disturbing in the context of ethical decision-making.
Whose god? Your god? My god? Their god? All gods? The good gods? The collective gods
committee?

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And when? When will (the chosen) god be judging this decision? While the decision is being
made? Before the decision is implemented? Immediately after the decision's implementation
(when on Earth some serious monitoring, checking and managing needs to be happening)?
Far into the future when the decision-maker has expired and gone to whatever version of
heaven his (it's generally a man) particular faith promises him?
The inference is the latter of course. A bit late in other words.
And by what criteria will (the chosen) god is judging the decision? To whose and with
precisely what standards are we being asked to agree here?
And what will be the results of (whatever chosen) god's decision, especially if it's a mighty
god-like thumbs down? What are (the chosen) god's contingencies for putting it all straight
again? It's anyone's guess. Do you see how religion is not a brilliant aid for decision-making?
Religion is a personal matter. It has no place in decision-making affecting other people.
Worse, using religion as a personal safety net for serious decision-making is a reckless
desertion of leadership responsibility. Right-minded people want leaders to take ultimate full
absolute responsibility for decisions. They do not want a leader to seek refuge or personal
salvation in (whatever chosen) god or heaven or a confession box. This is an additional reason
for not mixing religion with leadership and ethical decision-making: too many people simply
do not accept the basic premise that a leader can delegate responsibility in such a very strange
and unaccountable way.
Aside from anything else, if religion were useful in leadership and decision-making then all
human organizations would be run by the clergy. Civilization tried that a few thousand years
ago and it doesn't work. Please note: If you are religious and believe that religion has a place
in leadership and decision-making then you might disagree with this section. If so please
understand that I am not berating religion or religious people. I accept that through
humankind's existence - especially in the last few hundred years - religion in various forms
has often provided an essential code (of ethics arguably) for civilizations and societies to live
positively, harmoniously, generously, peacefully, lovingly, etc. I am making a different point,
namely: reference to religion, and especially a strong personal faith, is not generally very
helpful towards achieving great objectivity, which is vital for ethical decision-making.
Moreover religion of certain types can be extremely divisive, which is obviously not useful

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for decision-making entailing diverse groups of people, as commonly arises in today's
increasingly diverse world.
Examples of unethical behaviours, activities, policies, etc
Instead of trying to arrive at a standard or all-encompassing rule of what is ethical, it is
helpful to illustrate the depth and variety of ethics through suitable examples.
This is an extension of the ethical business investment items listed above, and goes into far
greater detail of different behaviours which might often be regarded as unethical.
The first category might seem obvious and clear-cut, and actually it's a reasonable starting
point for the vast majority of ethical decisions, but this one point cannot be applied
exclusively in assessing whether something is ethical or not:
 Anything unlawful in the territory or area covered by such law - is probably unethical.
Not always - see ethics and law.
Conversely, and more importantly, very many legal activities and behaviours can be
extremely unethical. For example, behaviours that are not necessarily unlawful but which are
generally considered to be unethical to Western society would now typically include:
 dishonesty, withholding information, distortion of facts
 misleading or confusing communications or positioning or advertising
 manipulation of people's feelings
 deception, trickery, kidology, rule-bending, fooling people
 exploitation of weakness and vulnerability
 excessive profit
 greed
 anything liable to harm or endanger people
 breach of the Psychological Contract - the Psychological Contract represents trust and
expectations between people in a relationship - notably within employer/employee
relationships, extending to other organizational relationships too - (aside from Psychological
Contract theory, specialized theory within Transactional Analysis helps explain this aspect of
trust and expectations in human relationships)
 avoidance of blame or penalty or payment of compensation for wrong-doing
 inertia-based 'approvals' and 'agreements' (in which action proceeds unless objected
to)

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 failing to consult and notify people affected by change
 secrecy and lack of transparency and resistance to reasonable investigation
 coercion or inducement
 harming the environment or planet
 unnecessary waste or consumption
 invasion of privacy or anything causing privacy to be compromised
 recklessness or irresponsible use of authority, power, reputation
 nepotism (the appointment or preference of family members)
 favoritism or decision-making based on ulterior motives (e.g., secret affiliations, deals,
memberships, etc)
 alienation or marginalization of people or groups
 conflict of interests (having a foot in two or more competing camps)
 neglect of duty of care
 betrayal of trust
 breaking confidentiality
 causing suffering of animals
 'by standing' - failing to intervene or report wrong-doing within area of responsibility
(this does not give licence to interfere anywhere and everywhere, which is itself unethical for
various reasons)
 unfairness
 unkindness
 lack of compassion and humanity
Ethics and public opinion
Ethical considerations are not wholly determined by majority view, just as they are not wholly
defined by law or religion.
Ethics are not a matter of a referendum or vote.
Popular opinion alone is an unreliable measurement of what is ethical for several reasons:
 A poorly informed majority of people - or anyone poorly informed - is not able to
make an informed decision about the ethics of a particular decision. The extent to which
people are helped to understand longer-term consequences of a situation is also a limiting
factor in the value of majority opinion.

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 Democratic decision-making is vulnerable to whim and 'herding' instincts - especially
if the national press and other mainstream media have anything to do with it.
 Leadership - as a function within civilizations - features in the organization of human
systems and societies because people generally accept that many sorts of complex and large
scale decision-making are best made by full-time experts working in the areas concerned,
rather than such decisions being left to the vagaries of popular inexpert view. This is not to
say that people have no right to consultation or a vote on crucial issues (in fact generally
people need more involvement in decisions which affect them) - it is more to illustrate that
majority view, especially when coloured with apathy or misinformation or prejudice for
whatever reason, is not the only basis for deciding what's ethical or not.
Popular opinion is a significant factor in the consideration of what is ethical, but it is not the
only factor, and the significance of popular opinion in determining ethical decisions will vary
according to the situation.
'For the greater good' ethical considerations
A significant influence on ethical judgment is the 'flip-side' of whatever situation is under
question: the effects of the 'ethical' decision. Upholding an ethical principle might not be
sensible if the effect of doing so causes a wider or greater disadvantage. This sort of
justification when used for unethical actions and policies, etc., is often referred to as being 'for
the greater good'.
Such a viewpoint is associated with a 'utilitarianism' approach to ethics. Looking at the flip-
side and assessing the 'greater good' implications can be helpful, ideally leading to the
facilitation of a compromise solution. Considering the flip-side (or sides) is actually necessary
for relatively straight-forward uncontroversial decisions and actions, especially when opinions
on all sides can be aired, debated, and understood.
However the 'greater good' approach can be a risky angle if used subjectively and proactively,
not least because it tempts the decision-maker to play god, and to attempt a god-like
appreciation of a wide and complex situation, instead of adopting a less personal and more
detached approach.
The combination of the following factors in ethical decision-making is rarely effective:
 risk
 proactivity (decision-maker instigated)

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 borderline ethical/unethical
 Affecting lots of people.
'The greater good' argument is commonly used to support actions containing these elements,
when usually a less risky and aggressive stance is best.
Remember a significant inescapable part of ethical actions are the views and needs of the
rational majority, of the people affected by the action or decision.
If you don't know reliably what these (views and needs) are then you don't understand the
flip-side enough to justify anything, let alone a risky borderline decision.
Beware of this 'greater good' dimension also when you see it used by others, because the
defence of an unethical decision as being "...for the greater good..." is often used cynically
and dishonestly. The 'greater good' can be a big trap - especially for anyone prone to
subjective high-minded thinking... The 'greater good' angle also illustrates the dilemma aspect
within many ethical decisions. Ethics are not clear-cut, especially on a large scale. Ethical
leadership in the face of big ethical decisions is characterized by wisdom and objectivity, not
by subjective personal belief, worse still when it protected by control mechanisms and the
recklessness which often accompanies emotional insecurity, or a strong personal 'faith' or
power delusion.
Beware the leader for whom the personal victory of the decision appears to be more important
than the decision's outcome, whatever the scale and situation - and recognize these tendencies
in you if they arise.
Objectivity is the key to ethics, not personal belief or religion or personal power.
Leaders who make decisions subjectively and personally for reasons of building power,
reputation and wealth, entirely miss the point about ethics, and their fundamental philosophy
(or lack of) effectively prevents any real ethical objectivity.
If the motive is wrong, then everything else will be too.
Ethical objectivity
So, law alone is not a basis for ethical decision-making. Nor is religion. Nor is 'the greater
good'. And even the rational views and needs of the affected majority are not a basis alone for
ethical decision-making. So what is the basis of ethical decision-making?
Objectivity and fairness are the basis of ethical decision-making.

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In simple terms this means you must be able to see the other people's points of view. This
might seem a simple statement of the bleeding obvious, and it might be, but it is not often
practiced. True objectivity is quite difficult to achieve, especially for leaders under pressure.
Similarly, fairness is difficult to define, let alone apply. Detachment is a huge part of the
process. Objectivity is impossible without personal detachment. Fairness cannot begin to be
achieved without detachment, since it's about other people, not the leader, nor the leader's
supporters and environment. Being ethical is not a matter of evangelizing or imposing your
standards and views on other people. Being ethical is being fair. Being fair means
understanding implications from other people's perspectives - not your own. The more widely
and well you appreciate other people's issues and implications, then the easier you will find it
to be ethical.
Cybernetics is a really useful way to look at objectivity. Objectivity entails understanding
how systems work and inter-relate. But systems here mean merely the general sense of people
and the way life is organized. Systems do not refer to complex mathematics or scientific
formulae. Again, it requires you to step back - to detach yourself, resist personal bias and
emotion - step back, be objective, adult, mature - fair.
Objectivity is a wonderfully potent and extremely flexible ability to pursue especially if you
can combine it with the ability to facilitate rather than influence. Objectivity is flexible
because it can be approached and achieved in so many different ways - intuitively, logically,
systematically, creatively - anyone can do it. In the same way that the truth - purity, probity -
is available to anyone who cares to look for it.
Principles for ethical decision-making
1. Step back from every decision before you make it and look at it objectively. Use the
above list of examples of unethical behaviours as a check-list to see if you might possibly be
falling into one of these traps. It's easily done: to get swept along by excitement and urgency;
or by apparently demanding expectations, whether self-imposed or otherwise. Aim for
objectivity and fairness - not for personal power, 'winning', strategic plotting, high drama, etc.
2. Strive for fairness rather than polarized 'winner takes all' outcomes. Try to facilitate
solutions rather than actually deciding and imposing decisions, unless all parties are happy for
you to do so.

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3. Understand the Psychological Contract and how it applies to your situation. Concepts
such as Empathy and the Johari Window are useful in gaining appreciation of other people's
situations and feelings, which is central to managing the Psychological Contract.
4. Learn from history and previous situations. Reviewing how previous situations were
handled reduces the risks of making daft mistakes: not many things are fundamentally new in
this world, despite how unique you believe your situation to be. Also history is a superb store
of already invented wheels, which can often save you the time and agonies of trying
unsuccessfully to invent a new one.
5. Get the facts from all possible perspectives. Often a challenging issue offers three
main options: (a) your instinctive or personal view; (b) a main alternative option; and (c) the
commonly under-estimated ever-available third main option of doing nothing. Doing nothing
in times of real emergency can be disastrous, but for a very large number of situations doing
nothing is the only truly wise way. Doing nothing is not weakness or procrastination if it done
in the right way for the right reasons.
6. Understand the long-term consequences. Model or brainstorm the 'what if' scenarios.
Again look at previous examples and history.
7. Check the law. In whatever territories are affected by the decision. But do not base
your decision wholly on the law. See the ethics and law notes.
8. Consult widely - especially with critical people, and especially beyond your close
circle of (normally) biased and friendly advisors, colleagues, friends, etc. You have not
properly consulted if you merely seek and obtain confirmation from a tame advisor. After the
event such 'consultation' can very easily be interpreted as a conspiracy, in which your 'advisor'
is deemed not to have been an advisor but a co-conspirator. Consult especially the people
affected by the situation and potential actions, and if using a survey of any sort then ensure
the positioning and questions used are balanced and objective, because to be otherwise is
unethical in itself. You should even consult about how to frame the survey and wording of the
questions if the issue is anything but a minor one.
9. Consider cause and effect in the deepest possible sense. Life and all that surrounds it is
one huge interconnected system. If you are making big decisions - or even apparently little
fleeting decisions within a potentially big and sensitive environment - these decisions will
affect many people and aspects of life, now and especially into the future.

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10. Resist the delusion and arrogance that power and authority tends to foster. This is
especially important to guard against if you live and work in a protected, insulated or isolated
situation, as many large scale leaders and decision-makers tend to do. Being a leader for a
long time, or for any duration in a culture of arrogance, privilege and advantage, provides
great nourishment for personal delusion. Many unethical decisions are borne of arrogance and
delusion. Guard against becoming so dangerous.
11. Beware of justifying decisions according to religious faith. There is nothing wrong
with having a religious faith, but there are various risks in leaning too heavily on a god or
faith when making serious decisions. See the ethics and religion notes.
12. Aim for solutions and harmony, objectivity and detachment. Facilitate rather than
influence. Help, don't sell. Diffuse situations - find common ground - don't polarize or
inflame. Whenever you see a big swell of expectation looming (among your immediate team,
not those affected by your decision) which is borderline ethical/unethical, remember the ever-
available third option to decide clearly and firmly to do nothing, in the right way for the right
reason. The best ethical decisions are usually decided by people who are most affected by
them, rather than by leaders who don't trust the people.

Organizational outcomes and benefits from ethical leadership

More and more leaders of businesses and other organizations are now waking up to the reality
of social responsibility and organizational ethics. Public opinion, unleashed by the internet
particularly, is re-shaping expectations and standards.
Organizational behaviour - good and bad - is more transparent than ever - globally.
Injustice anywhere in the world is becoming more and more visible, and less and less
acceptable.
Reaction to corporate recklessness, exploitation, dishonesty and negligence it is becoming
more and more organized and potent.
Employers, businesses and organizations of all sorts - especially the big high profile ones - are
now recognizing that there are solid effects and outcomes driving organizational change.
There are now real incentives for doing the right thing, and real disincentives for doing the
wrong things.

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As never before, there are huge organizational advantages from behaving ethically, with
humanity, compassion, and with proper consideration for the world beyond the boardroom
and the shareholders:
Competitive advantage - customers are increasingly favoring providers and suppliers who
demonstrate responsibility and ethical practices. Failure to do so means lost market share, and
shrinking popularity, which reduces revenues, profits, or whatever other results the
organization seeks to achieve.
Better staff attraction and retention - the best staff want to work for truly responsible and
ethical employers. Failing to be a good employer means good staff leaves, and reduces the
likelihood of attracting good new-starters. This pushes up costs and undermines performance
and efficiency. Aside from this, good organizations simply can't function without good
people.
Investment - few and fewer investors want to invest in organizations which lack integrity and
responsibility, because they don't want the association, and because they know that for all the
other reasons here, performance will eventually decline, and who wants to invest in a lost
cause?
Morale and culture - staff who work in a high-integrity, socially responsible, globally
considerate organization are far less prone to stress, attrition and dissatisfaction. Therefore
they are happier and more productive. Happy productive people are a common feature in
highly successful organizations. Stressed unhappy staff is less productive, take more time off,
need more managing, and also take no interest in sorting out the organization‟s failings when
the whole thing implodes.
Reputation - it takes years, decades, to build organizational reputation - but only one scandal
to destroy it. Ethical responsible organizations are far less prone to scandals and disasters.
And if one does occur, an ethical responsible organization will automatically know how to
deal with it quickly and openly and honestly. People tend to forgive organizations who are
genuinely trying to do the right thing. People do not forgive, and are actually deeply insulted
by, organizations who fail and then fail again by not addressing the problem and the root
cause. Arrogant leaders share this weird delusion that no-one can see what they're up to.
Years ago maybe they could hide, but now there's absolutely no hiding place.

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Legal and regulatory reasons - soon there'll be no choice anyway - all organizations will
have to comply with proper ethical and socially responsible standards. And these standards
and compliance mechanisms will be global. Welcome to the age of transparency and
accountability. So it makes sense to change before you are forced to.
Legacy - even the most deluded leaders will admit in the cold light of day that they'd prefer to
be remembered for doing something good, rather than making a pile of money or building a
great big empire. It's human nature to be good. Humankind would not have survived were this
not so. The greedy and the deluded have traditionally been able to persist with unethical
irresponsible behaviour because there's been nothing much stopping them, or reminding them
that maybe there is another way. But no longer. Part of the re-shaping of attitudes and
expectations is that making a pile of money, and building a great big empire, are becoming
stigmatized. What's so great about leaving behind a pile of money or a great big empire if it's
been at the cost of others' well-being, or the health of the planet? The ethics and responsibility
zeitgeist is fundamentally changing the view of what a lifetime legacy should be and can be.
And this will change the deeper aspirations of leaders, present and future, who can now see
more clearly what a real legacy is.
Economic Groupings
Union du Maghreb Arabe/ Arab Maghreb Union (UMA)
The first Conference of Maghreb Economic Ministers in Tunis in 1964 established the
Conseil Permanent Consultatif du Maghreb (CPCM) between Algeria, Libya, Morocco, and
Tunisia, to coordinate and harmonize the development plans of the four countries as well as
inter regional trade and relations with the European Union. However, for a number of reasons,
the plans never came to fruition. It was not until the late 1980s that new impetus began to
bring the parties together again. The first Maghreb Summit of Heads of State, held at Zeralda
(Algeria) in June 1988, resulted in a decision to set up the Maghreb High Commission and
various specialized commissions. On February 17, 1989 in Marrakech, the Treaty establishing
the AMU was signed by the Heads of State of the five countries including Mauritania. The
AMU is currently dormant, but attempts are under way to revive it. The AMU has no relations
with the African Economic Community (AEC) and has not yet signed the Protocol on
Relations with the AEC. It has, however, been designated a pillar of the AEC.

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AMU‟s institutional structure includes: a Council of Heads of State; Consultative Assembly;
Council of Foreign Affairs Ministers; a Court of Justice and General Secretariat.
Objectives and mandate
AMU aims to safeguard the region‟s economic interests, foster and promote economic and
cultural co-operation, and intensify mutual commercial exchanges as a precursor for
integration and the creation of a North African Common Market (also referred to as Maghreb
Economic Space). Common defense and non-interference in the domestic affairs of the
partners are also key aspects of the AMU Treaty.
The Treaty highlights the broad economic strategy as: the development of agriculture,
industry, commerce, food security, and the setting up of joint projects and general economic
cooperation programs. It also provides the possibility for other Arab and African countries to
join the Union at a later stage.
Progress overview
Since 1990, the five countries have signed more than 30 multilateral agreements covering
diverse economic, social, and cultural areas. While member countries have ratified varying
numbers of these agreements, only five have been ratified by all Union members. These
include agreements on trade and tariffs (covering all industrial products); trade in agricultural
products, investment guarantees and avoidance of double taxation.
The AMU has not met at the level of Heads of State since April 1994, and has in effect been
paralyzed by the dispute over the status of Western Sahara, annexed by Morocco in 1975, but
claimed as an independent state by the Polisario Front with Algerian backing. AMU has no
working defense or conflict resolution structures. Its treaty states in Article 14: "any act of
aggression against any of the member countries will be considered as an act of aggression
against the other member countries”, but provides no definition of what would constitute
'aggression'. Common defense and non-interference in the domestic affairs of the partners are
important aspects of the Treaty but have not been translated into practice. While
disagreements over issues such as the Western Sahara still handicap cohesive regional
security arrangements, the member states have been able to aid one another in response to
natural disasters.
Intergovernmental Authority on Development (IGAD)

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The Intergovernmental Authority on Drought and Development (IGADD) was formed in
1986 with a very narrow mandate on issues of drought and desertification. In the 1990s,
IGADD became the accepted vehicle for regional security and political dialogue. The IGADD
Heads of State and Government met on 18 April 1995 at an Extraordinary Summit in Addis
Ababa and resolved to revitalize it into a fully-fledged regional political, economic,
development, trade and security entity similar to SADC and ECOWAS. It was envisaged that
the new IGADD would form the northern sector of COMESA with SADC representing the
southern sector. One of the principal motivations for the revitalization of IGADD was the
existence of many organizational and structural problems that made the implementation of its
goals and principles ineffective. On 21 March 1996, the Heads of State and Government at the
Second Extraordinary Summit in Nairobi approved and adopted an Agreement Establishing
the Intergovernmental Authority on Development (IGAD). Its activities in charge of peace
and security and of development issues as well as a recognition by the AU as one of the RECs
demonstrates that RECs also display an overlap in areas of activities.
Objectives and mandate
Article 7 of IGAD‟s establishing agreement stipulates its mandate as:
• the promotion of joint development strategies;
• the gradual harmonization of macroeconomic policies in the social, technological and
scientific fields;
• harmonization of trade, customs, transport, communications, agricultural and natural
resources policies;
• promoting programs and projects for sustainable development of natural resources and
environmental protection;
• Developing and improving a coordinated and complementary infrastructure (transport and
energy); and
• Promoting peace and security.
IGAD seven member countries: Djibouti, Eritrea, Ethiopia, Kenya, Somalia, Sudan and
Uganda. Its key organs are: the Assembly of Heads of State and Government; Council of
Ministers; Committee of Ambassadors and the Secretariat (with a staff of 44). It also has two
specialized institutions, the Conflict Early Warning and Response Mechanism (CEWARN)
and the IGAD Climate Prediction and Applications Centre (ICPAC) located in Addis Ababa

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and Nairobi respectively. An IGAD Business Forum was established in 2002 to ensure
effective implementation of its mandate.
Progress overview
IGAD signed the Protocol on Relations between the AEC and RECs on 25 February 1998. It
collaborates with COMESA and the EAC to avoid project duplication. Much of IGAD's
attention is directed at peace efforts in Somalia, Sudan and the tensions between Ethiopia and
Eritrea. It also focuses on capacity-building, awareness creation, and on the early warning of
conflicts. Other issues of importance include: food security; developing appropriate
modalities for regional peacekeeping; and terrorism. IGAD has steered mediation efforts to
solve some of the long lasting conflicts of the Horn of Africa. It played an instrumental role in
the signing of the Machakos Protocol between the Sudan People‟s Liberation
Movement/Army (SPLM/A) and the Sudanese and in 2005, the signing of the Comprehensive
Peace Agreement. Similarly IGAD has been very influential in the process towards the
formation of the Transitional Federal Government (TFG) in Somalia.
IGAD is very active in developing instruments to curtail conflicts in Eastern Africa. It has
instituted an early warning mechanism, the Conflict Early Warning Mechanism (CEWARN)
and been tasked to set up the Eastern African chapter of the African Union‟s stand-by force.
Southern African Development Community (SADC)
SADC was established as a development coordinating conference in 1980 and transformed
into a development community in 1992. The concept of a regional economic co-operation in
Southern Africa was first discussed at a meeting of the Frontline States foreign ministers in
May 1979 in Gaberone. The meeting led to an international conference in Arusha, Tanzania
two months later which brought together all independent countries (with the exception of the
then Rhodesia, South West Africa, and South Africa), and international donor agencies. The
Arusha conference in turn led to the Lusaka Summit of April 1980. After adopting the
declaration, which was to become known as „Southern Africa: Towards Economic
Liberation‟, Sir Seretse Khama was elected the first chairman of the SADCC. Its 15 members
are: Angola, Botswana, Democratic Republic of the Congo, Lesotho, Malawi, Madagascar,
Mauritius, Mozambique, Namibia, Seychelles, South Africa, Swaziland, Tanzania, Zambia,
and Zimbabwe.
SADC structures include the Heads of State and Government; Council of Ministers and

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SADC National Committees (for national coordination and implementation of SADC
programs). It covers a population of 248 million, and has a combined GDP of over US$ 375
billion.
Objective and mandate
SADC‟s regional integration agenda covers more than just trade, but the Trade Protocol,
signed in August 1996, seems to be driving the integration process. The Trade Protocol
entered into force on 25 January 2000, when 11 members signed it.
Progress overview
SADC achieved a free trade area in August 2008 with the next step being to develop a
program of cooperation aimed at expanding regional production capacity through provision
and rehabilitation of regional infrastructure to facilitate efficient movement of goods and
people.
In 2006, intra SADC trade accounted for about 20% of SADC‟s total trade. In 2007, the
region registered an average real GDP growth of about 6% and average inflation slowed to
8.3% (excluding Zimbabwe). Tariff liberalization within SADC is asymmetrical. Countries
are classified into three groups: SACU members (South Africa, Botswana, Lesotho, Namibia
and
Swaziland); developing countries (Mauritius and Zimbabwe); and less developed countries
(LDCs) (Malawi, Mozambique, Tanzania and Zambia). Ten SADC member states have now
ratified the Finance and Investment Protocol, which aims to harmonize policies on taxation,
investment, development finance, stock exchanges, insurance, exchange control payments,
and clearing systems and macroeconomic convergence.
The trade protocol also provides for rules of origin, which have been described as the most
contentious and unresolved issue on SADC‟s regional integration agenda, especially for
clothing and textiles. Member states agreed on product specific rules of origin on all goods.
These restrictive rules of origin could be a barrier to both regional trade and international
competitiveness as they will be costly to monitor and enforce.
SADC‟s future plans for deeper integration are spelled out in the Regional Indicative
Strategic Development Plan (RISDP)18. It spells out the broad agenda and targets for deeper
integration by 2015. The establishment of the FTA in 2008 is a step towards establishing a
SADC customs union by 2010 and common market by 2015.

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Communauté des Etats Sahélo- Sahariens (CEN-SAD)
The Community of Sahel-Saharan States CEN-SAD is a framework for Integration and
Complementarity. CEN-SAD was established on 4th February 1998 following the Conference
of Leaders and Heads of State held in Tripoli (Great Jahamiriya). The General Secretariat is
based in Tripoli and its operations entirely supported by Libya. About 60 officials constitute
the staff carrying out regular activities far below its estimated personnel requirement of 160 as
outlined in its organizational structure. Its institutional organs include the Conference of the
Heads of States and Government; the Executive Council; the General Secretariat; the
Development Bank; and the Economic, Social and Cultural Council.
It has 23 members with Mauritania geared to be the 24th member, “making it the flagship of
African RECs”. The Treaty on the establishment of the Community was signed by the Leader
of Great El-Fateh Revolution and the Heads of State of Burkina Faso, Mali, Niger, Chad and
Sudan. The Central African Republic and Eritrea joined the Community during the first
Summit of the organization held in Syrte in April 1999. Senegal, Djibouti and Gambia joined
during the N‟djamena Summit in February 2000. Other countries joined later, and still more
are in the process of joining the Organization.
Objectives and mandate
CEN-SAD‟s mandate is to establish knowledge-based economic union between member
countries to face drought and aridity that have severe consequences for the circum-Saharan
area. All its current members are directly threatened by the desert. It is built around the
economic objective of union beyond ecological, geo political and linguistic cleavages. It
intends to work, together with the other RECs to strengthen peace, security and stability and
achieve global economic and social development.
Progress overview
CEN-SAD is working to create a common market. Since its creation it has implemented a
number of sectoral policies and programs towards a common market and several legal and
political instruments have been designed to this end. The economic programs focus on
infrastructure, transport, mines, energy, telecommunications, social sector, agriculture, the
environment, water and animal health. The REC created the Special Funds for Solidarity and
drafted the Free Trade Area Treaty.
Common Market for Eastern and Southern Africa (COMESA)

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Formed in 1994, COMESA is the successor to the Preferential Trade Area (PTA) for Eastern
and Southern Africa established in 1981. The establishment of COMESA was a fulfillment of
the requirements of the PTA Treaty, which provided for the transformation of the PTA into a
common market ten years after the entry into force of the PTA Treaty.
It has 21 members: Angola, Burundi, Comoros, the DRC, Djibouti, Egypt, Eritrea, Ethiopia,
Kenya, Libya, Madagascar, Mauritius, Mozambique, Namibia, Rwanda, Seychelles, Sudan,
Swaziland, Uganda, Zambia and Zimbabwe.
COMESA main organs are: Authority of the Heads of State and Government; Council of
Ministers; Inter governmental and technical committees; and the secretariat which has nine
divisions, gender and resource mobilization units and six specialized institutes supporting the
secretariat. There are 36 professional staff.
Objectives and mandate
Its mandate is to create a fully integrated and internationally competitive REC in which
people enjoy high and rising standards of living, peace, political and social stability and in
which goods, services, capital and labor move freely across borders.
Progress overview
COMESA has implemented a wide range of programs and activities on trade liberalization
and facilitation, monetary integration, infrastructure development, information and
communication technology, investment promotion, private sector development, peace and
security, gender mainstreaming and women in business.
In October 2000, it launched a free trade area which now has 14 member states participating.
The 13th Summit of the COMESA Heads of State and Government officially launched the
COMESA Customs Union in Victoria Falls (Zimbabwe) on 8 June 2009. The community has
made significant progress in eliminating tariff and non tariff barriers to intra-regional trade
(adoption of a single customs document; simplifying rules of origin; installing Euro Trace19
in most member states; harmonized road transit charge, COMESA yellow card). It has
adopted two programs to boost intra-regional trade, dissemination of trade information and
building of productive capacities and competition in member states.
Key impediments include the poor state of its domestic and inter-regional transport and
communication structures, access to information on trade opportunities, and bottlenecks at

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border crossings. COMESA‟s revised draft Medium Term Strategic Plan (MTSP) for 2007 to
2011 outlines its integration targets.
East African Community (EAC
The EAC was re-launched in 2001 after the dissolution of the previous Cooperation Treaty in
1977. It is driven by a vision to build a prosperous, competitive, secure and politically united
East Africa. It seeks to deepen economic, political, social and cultural integration to improve
the region‟s people‟s quality of life.
EAC has five member states: Burundi, Kenya, Rwanda, Uganda and Tanzania. Its main
organs are the Summit of Heads of State; Council of Ministers; Coordination Committee;
Sectoral Committees; the East African Court of Justice; the East African Legislative
Assembly; and the Secretariat.
Objectives and mandate
The EAC is committed to cooperation in priority areas of transport and communication, trade
and industry, security, immigration and the promotion of investment in the region. Objectives
are to be realized incrementally through a Common Market, Monetary Union and ultimately a
Political Federation of the East African States.
It is keen to fast track its integration agenda and has set out a broad and ambitious program
aimed at achieving both an economic and political federation between its member states.
Political federation targets the establishment of a three-year revolving presidency by 2011 and
to have an elected president for the entire federation by 2013.
At present the EAC is the only REC negotiating an EPA (Economic Partnership Agreement)
with the European Union. An interim agreement between the EAC and the EU was already
signed in November 2008.
Progress overview
The EAC is already in a Customs Union. Unlike the other RECs in eastern and southern
Africa, which have adopted an evolutionary approach to attaining a customs union, the EAC
provides or it as the first stage in its integration process. The Customs Union Protocol was
signed in 2004 and came into force from 2005. In terms of the next steps in its integration
process, the final round of negotiations on the Common Market Protocol held in early April
2009 ended without agreement on three key aspects: land rights, the use of national identity
cards as travel documents within the region and the right to permanent residency owing to the

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reservations of one member state, Tanzania. These contentious articles were bracketed for the
decision of the EAC Summit of Heads of States held at the end of April 2009.
The Summit resolved to sign the Protocol for the EAC Common Market at the 11th Ordinary
Summit scheduled for the 30th November 2009 with the rider that the protocol will not
include provisions that give authority to override national policies and laws; access to land
will not be automatic and the Common Market Protocol will only lay the basis for access to
land, the rest will be governed by national laws; the use of National Identity Cards as valid
inter-state travel documents will not be universal throughout the EAC. Partner States that
wish to do so need to enter into bilateral negotiations to this effect; and that the Common
Market Protocol will stipulate and provide for full protection of cross-border investments for
East Africans. The contentions outlined above may well represent what lies at the heart of the
integration‟s greatest challenges.
Economic Community of Central African States (ECCAS)
ECCAS was established in 1983 within the framework of the AEC and seeks to create a
common market for Central African states. Its 11 members are: Angola, Burundi, Cameroon,
CAR, Gabon, Congo Republic, DRC, Equatorial Guinea, Rwanda, Sao Tome and Principe
and Chad. For over a decade seven of its member states experienced military conflicts and
civil strife. Between1992-97, ECCAS experienced economic decline, deteriorating social
conditions, and political instability and this stalled integration efforts. It was re launched in
1998 with a more focused mandate.
At a summit meeting in December 1981, the leaders of the Central African Customs and
Economic Union (UDEAC) agreed in principle to form a wider economic community of
Central African states. CEEAC/ECCAS was established on 18 October 1983 by the UDEAC
members and the members of the Economic Community of the Great Lakes States (CEPGL)
(Burundi, Rwanda and the then Zaire) as well as Sao Tome and Principe. Angola remained an
observer until 1999, when it became a full member. ECCAS began functioning in 1985, but
has been inactive since 1992 because of financial difficulties (non-payment of membership
fees) and the conflict in the Great Lakes area. The war in the DRC has been particularly
divisive, as Rwanda and Angola fought on opposing sides. The sub-region represents four
fifths of Africa‟s forests and is rich in mineral deposits and some oil reserves. Yet military
and civil conflicts have undermined the region‟s ability to exploit its potential.

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Objectives and mandate
Its mandate includes developing physical, economic and monetary integration of the sub
region; to enhance the region‟s capacity to maintain peace, security and stability and develop
capacity for analysis, policy interventions, entrepreneurial initiatives, communication and
collective negotiation. ECCAS took the mandate of implementing NEPAD‟s program of
action in Central Africa. It also has the additional responsibility of coordinating the sub
region‟s strategies for achieving the MDGs.
Progress overview
ECCAS is defined by weak institutional and organizational capacity. Its member states signed
a free trade area agreement in 2004 that was to come into force in 2006. This partly reflected
the member states‟ lack of political will to surrender aspects of their respective national
sovereignty to the supranational regional body which reflects the inherent weakness and
indecisiveness of states in conflict. Inter regional trade only stands at around 2 percent of its
total trade volume. Also due to pervasive conflicts, ECCAS has failed to mobilize the
necessary resources to execute its mandate.
ECOWAS
ECOWAS was established in 1975 to promote cooperation and achieve market integration.
The idea for a West African community goes back to President William Tubman of Liberia,
who made the call in 1964. An agreement was signed between Côte d'Ivoire, Guinea, Liberia
and Sierra Leone in February 1965, but this came to nothing. In April 1972, General Gowon
of Nigeria and General Eyadema of Togo re-launched the idea, drew up proposals and toured
12 countries, soliciting their plan from July to August 1973. A meeting was then called at
Lomé from 10-15 December 1973 to study a draft treaty. This was further examined at a
meeting of experts and jurists in Accra in January 1974 and by a ministerial meeting in
Monrovia in January 1975. Finally, 15 West African countries signed the treaty for an
Economic Community of West African States (Treaty of Lagos) on 28 May 1975. The
protocols launching ECOWAS were signed in Lomé, Togo on 5 November 1976. In July
1993, a revised ECOWAS Treaty designed to accelerate economic integration and to increase
political co-operation, was signed. It has 15 members: Benin, Burkina Faso, Cape Verde, Cote
d'Ivoire, The Gambia, Ghana, Guinea, Guinea-Bissau, Liberia, Mali, Niger, Nigeria, Senegal,
Sierra Leone, and Togo. The Executive Secretariat is the key organ facilitating, coordinating

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and monitoring the implementation of the REC‟s mandate. Its institutions include the
Commission; Community Parliament; Community Court of Justice and ECOWAS Bank for
Investment and Development (EBID).
Objectives and mandate
Its main objective is to promote regional economic cooperation and meet new developmental
challenges.
Progress overview
ECOWAS has internalized NEPAD/AU programs and projects as the most appropriate
instrument for the promotion of rapid and sustainable socio economic development in the sub
region. The ACBF assessment lauds progress stating that its performance in project
implementation has been satisfactory, but notes that the secretariat is hampered by a lack of
supranational authority. Member states carry out the Community‟s programs which makes
their political will and capacity very critical. The secretariat does not have adequate staff to
run programs or implement its growing mandate and is constrained by the inadequacy of
equipment and fiscal facilities in the implementation of regional integration programme.

Review Questions
Review Questions
I. Briefly explain the social responsibilities of a business giving relevant examples
II. You have been appointed as the strategy manager for one of the leading clothing
company; briefly describe the importance of understanding the role of the
environment to the success of the business
III. Discuss the Socio-Cultural factors that affect the business environment.
IV. Briefly describe the structure of the Kenya Economy indicating the latest
developments
V. Highlight the importance of ethics to a business

References
1. Aras, G. and Crowther, D (2011), Governance in Business Environment
2. Webster, J.T. (2003), Managerial Economics: Theory & Practice

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