PROFIT MANAGEMENT

THE CONCEPT OF PROFIT

The concept of profit entails several different meanings. Profit may mean the compensation
received by a firm for its managerial function. It is called normal profit which is a minimum sum
essential to induce the firm to remain in business. Profit may be looked upon as a reward for true
entrepreneurial function. It is the reward earned by the entrepreneur for bearing the risk. It is
termed as supernormal profit analysis. Profit may imply monopoly profit. It is earned by a firm
through extortion, because of its monopoly power in the market. It is not related to any useful
specific function. Thus monopoly profit is not a functional reward. Profit may sometimes be in
the nature of a windfall. It is an unexpected reward earned by a firm just by mere chance, an
inflationary boom.

Profit is the earning of an entrepreneur. To the economist, the most significant point about profit
is that it is a residual income. However, the term profit has different connotations. In short, the
following are the distinctive features of profit as a factor reward :

(i) It is not a predetermined contractual payment.

(ii) It is not a fixed remuneration.

(iii) It is a residual surplus.

(iv) It is uncertain.

(v) It may even be negative. Other factor rewards are always positive.

Gross Profit and Net Profit

In ordinary language, profit is the surplus of income over expenses of production according to a
businessman. It is the amount left with him after he has made payments for all factor services
used by him in the process of production. But he may not have been careful in calculating all
such expenses of production in the economic sense. Therefore, economists regard a
businessman’s profit as gross profit as distinct from pure or net profit because it includes the
following constituents.

(1) Rent on Land: The businessman may have used his own land for erecting the factory so that
he may be saved of the botheration of paying rent to some other landlord. This rent is included in
his profit. This is implicit or imputed rent which is not a part of his profit. Had he hired land
from some other person, he would have paid its rent. In calculating net profit, implicit rent
should be deducted from gross profit.

(2) Interest on Capital: Similarly, he may have used his own capital in his business in order to
avoid the inconvenience of borrowing from some other person. This implicit interest is again
included in his gross profit. If he had borrowed the same amount of capital for investment in his
business, he would have paid interest on it. This implicit interest should, therefore, be subtracted
from his gross profit to arrive at net profit.
(3) Wages of Management: The businessman may have been busy in organizing, coordinating
and managing the entire business himself. But he may have been contented with income received
after meeting all expenses of production. If he had not performed the work of management
himself, he would have employed a manager to whom he would have paid wages. Thus his gross
profit included implicit wages which are required to be deducted for calculating net profit. In all
joint-stock companies, profits are received by shareholders, but the managers and managing
directors are all salaried persons whose salaries are included in the expenses of the firms.

(4) Depreciation Charges: During the process of production, machinery and plants depreciate
and become obsolete. Expenses incurred on their repairs and replacements are a part of the cost
of production. Hence they should be excluded from gross profit for the purpose of calculating net
profit.

(5) Insurance Charges: Every firm gets itself insured against fire, accidents and losses of other
kinds for which it pays large premiums annually to insurance companies. They are a charge on
the revenue of the firm, and therefore do not form part of gross profit.

All these elements are present in gross profit even in the long-run, as they are relatively stable.
Frequent and violent changes occurring in gross profit are due to the presence of net
profit within the former. It is, therefore, net profit that may be positive or negative.

(6) Net Profit: Net, true, economic or pure profit is the residue left to the entrepreneur after
deducting all the items enumerated above from gross profit. Net profit, however, includes the
following elements within it.

(i) Reward for Uncertainty Bearing: Pure profit which an entrepreneur receives is the reward
of bearing uninsurable risks and uncertainties. Uncertainty-bearing is one of the main functions
of an entrepreneur in the present capitalist system which leads to profit.

(ii) Reward for Coordination: The present system of production is one of coordinating the right
quantity of factors in right proportions. An entrepreneur who combines them in the right way is
able to produce larger quantities of the product with the minimum of cost and thus earns the
largest amount of profit.

(iii) Rent of Ability: Net profit accruing to the businessman also includes the rent of his ability.
An entrepreneur with a superior business acumen is able to earn larger profit than the others.

(iv) Reward of Innovation: An entrepreneur who innovates by bringing out a new product or
technique of production earns higher profit than others.

(v) Monopoly Gains: The modern market system is characterised by the existence of imperfect
markets. Some of the shrewd entrepreneurs are able to push up their sales by making their
products appear distinct and superior to others. In this process, they also succeed in raising the
prices of their products. Thus their profits swell when they create semi-monopolistic conditions
for themselves.

(vi) Windfalls: Pure profit earned by an entrepreneur may also include fortuitous or chance gain.
The demand for his product may suddenly rise either due to the outbreak of war or as a result of
the closing down of some of the other firms for some time on account of labour trouble. He,
therefore, earns higher profit which is like a windfall.

We may conclude that an economist’s profit is quite distinct from a businessman’s profit. The
former is concerned with net profit which is arrived at by deducting from the businessman’s
gross profit the remuneration for the latter’s own land, labour and capital.

We may write in equation form:

Gross Profit=Net profit +Implicit Rent+ Implicit Interest + Implicit Wages +Depreciation
and Insurance Charges.

Net Profit=Gross profit-Implicit Rent + Implicit Interest + Implicit Wages +Depreciation

and Insurance Charges).

Functions of Profit
Profit plays a crucial role in the business world and serves certain social ends. As such, it
performs the following functions:

1 It also relates to the Role of Profit. Index of Performance. The goal of every business
manager is to earn a surplus above cost to carry on his firm. According to Prof. Ducker, it is an
index of the performance of the firm. High profits are a signal that buyers want more product of
that firm. These profits provide the incentive for the firm to increase output and for new firms to
enter the industry.

2. Regulator of Business Operations. Profits are a regulator of efficiency and effectiveness of

business operations. Those firms which produce with the least cost make the maximum profits.
They are able to use their human and material resources better than others.

3. A Premium to Stay in Business. The survival of a firm and the employment of labour and
management depend on the firm’s ability to cover its costs and make a profit. As pointed out by
Prof. Drucker, profit is a premium to cover costs of staying in a business.

4. Guiding Mechanism in Increasing Production. Profits are the guiding mechanism that
directs productive capacity towards what consumers want. As demand patterns change towards
certain goods, their prices rise relative to costs. When their demand increases, firms earn more
profits.

5. Supply of Reinvestable Funds. Another function of profit, according to Prof. Drucker, is

that it ensures supply of reinvestable funds. Profits influence the utilization and allocation of
funds among different uses. Profits supply funds for innovation and expansion which lead to
investment, more production and employment.

6.Encourages Expansion of Business. Profits encourage people who have spare capital to
invest that leads to the existence of business on a small scale. Gradually, as such business
expands, it leads to the establishment of business on a large scale. Ford in America and Ambani
in India are the famous examples.
7. Encourage Risk-taking. Another important function of profit is to reward entrepreneurs for
taking the risk associated with their business decisions. All business decisions carry the risk that
money will be lost. Such risks will not be taken, if there is no gain in the form of profit. Thus
business decisions are taken in anticipation of earning profit.

8. Social Functions. Profit also plays a very useful social functions. It encourages firms to
develop new products, to lower production costs and to provide better service by providing
employment opportunities to people.

9. Increase in Government Revenues. Last but not the least, profits are an important source of
income for the government because larger the business profits, larger the revenues to the
government from profits.

PROFIT MAXIMISATION
INTRODUCTION
Every firm in managerial economics is a single unit whose entire operations are carried out by an
entrepreneur. His main function is to bring together various factors of production, coordinate,
supervise and manage them in order to produce goods and services for the firm so as to
maximise profit. This is the principal objective of the firm in perfect competition, monopoly,
monopolistic competition and oligopoly markets. This is known as the traditional or new
classical theory of the firm.

But the profit maximization model of the firm is not based on the real behavior of the firm. In
1932. Berle and Means in their study of business firms in America came to the conclusion that
the operations of modern firms are so complex that they cannot think about profit maximization.
Their main problems are related to control and management. Their management is carried out
not by entrepreneurs but by managers and shareholders. They take more interest in their salary
and dividend. Since ownership and control in modern firms is in the hands of different persons, it
is unrealistic to accept that the sole objective of modern firms is profit maximization. Therefore,
economists have propounded a number of theories of the firm based on sales maximization,
output maximization, utility maximization, satisfaction maximization and growth maximization.

PROFIT MAXIMISATION THEORY

In the neo-classical theory of the firm, the main objective of a business firm is profit
maximisation. The firm maximises its profits when it satisfies the two rules:

(i) MC = MR and,

(ii) MC curve cuts the MR curve from below.

Maximum profits refer to pure profits which are a surplus above the average cost of production.
It is the amount left with the entrepreneur after he has made payments to all factors of
production, including his wages of management. In other words, it is a residual income over and
above his normal profits. The profit maximization condition of the firm can be expressed as:
Where (Q)= R(Q)-C(Q) where (Q) is profit, R(Q) is revenue, C (Q) are costs, and are the units of
output sold.

The two marginal rules and the profit maximization condition stated above are applicable both to
a perfectly competitive firm and to a monopoly firm.

Assumptions

The profit maximisation theory is based on the following assumptions:

1 The objective of the firm is to maximise its profits where profits are the difference between the
firm’s revenue and costs.

2. The entrepreneur is the sole owner of the firm.

3. Tastes and habits of consumers are given and constant.

4. Techniques of production are given.

5. The firm produces a single, perfectly divisible and standardised commodity.

6. The firm has complete knowledge about the amount of output which can be sold at each price.

7. The firm’s own demand and costs are known with certainty.

8. New firms can enter the industry only in the long run. Entry of firms in the short run is not
possible.

9. The firm maximises its profits over some time-horizon.

10. Profits are maximised both in the short run and the long run.

Given these assumptions, the profit maximising model of firm can be shown under perfect
competition and monopoly.

BREAK-EVEN ANALYSIS
INTRODUCTION
Break-even analysis is of vital importance in determining the practical application of cost
functions. It is a function of three factors, i.e. sales volume, cost and profit. It aims at classifying
the dynamic relationship existing between total cost and sale volume of a company. Hence it is
also known as “cost-volume-profit analysis”. It helps to know the operating condition that exists
when a company ‘breaks-even’, that is when sales reach a point equal to all expenses incurred in
attaining that level of sales. The break-even point may be defined as that level of sales in which
total revenues equal total costs and net income is equal to zero. This is also known as no-profit
no-loss point. This concept has been proved highly useful to the company executives in profit
forecasting and planning and also in examining the effect of alternative business management
decisions.
 Break-Even Point
The break-even point (B.E.P.) of a firm can be found out in two ways. It may be determined in
terms of physical units, i.e., volume of output or it may be determined in terms of money value,
i.e., value of sales.

BEP in terms of Physical Units

This method is convenient for a firm producing a product. The BEP is the number of units of a
product that should be sold to earn enough revenue just to cover all the expenses of production,
both fixed and variable. The firm does not earn any profit, nor does it incur any loss. It is the
meeting point of total revenue and total cost curve of the firm.

Some assumptions are made in illustrating the BEP. The price of the commodity is kept constant
at Rs. 4 per unit, i.e., perfect competition is assumed. Therefore, the total revenue is increasing
proportionately to the output. All the units of the output are sold out. The total fixed cost is kept
constant at Rs. 150 at all levels of output. The total variable cost is assumed to be increasing by a
given amount throughout. From the Table we can see that when the output is zero, the firm
incurs only fixed cost. When the output is 50, the total cost is Rs. 300. The total revenue is Rs.
200. The firm incurs a loss of Rs. 100. Similarly when the output is 100 the firm incurs a loss of
Rs. 50. At the level of output 150 units, the total revenue is equal to the total cost. At this level,
the firm is working at a point where there is no profit or loss. From the level of output of 200, the
firm is making profit

Break-Even Chart
Break-Even charts are being used in recent years by the managerial economists, company
executives and government agencies in order to find out the break-even point. In the breakeven
charts, the concepts like total fixed cost, total variable cost, and the total cost and total revenue
are shown separately. The break even chart shows the extent of profit or loss to the firm at
different levels of activity. The following Fig. 1 illustrates the typical break-even

In this diagram output is shown on the horizontal axis and costs and revenue on vertical axis.
Total revenue (TR) curve is shown Fixed as linear, as it is assumed that the Cost price is
constant, irrespective of the output. This assumption is appropriate only if the firm is operating
Units of output under perfectly competitive conditions. Linearity of the total cost (TC) curve
results from the assumption of constant variable cost. It should also be noted that the TR curve is
drawn as a straight line through the origin (i.e., every unit of the output contributes a constant
amount to total revenue), while the TC curve is a straight line originating from the vartical axis
because total cost comprises constant / fixed cost plus variable cost which rise linearly. In the
figure, B is the break-even point at OQ level of output.

Assumptions of Break-Even Analysis

The break-even analysis is based on the following set of assumptions:

(i) The total costs may be classified into fixed and variable costs. It ignores semivariable cost.

(ii) The cost and revenue functions remain linear.

(iii) The price of the product is assumed to be constant.

(iv) The volume of sales and volume of production are equal.

(V) The fixed costs remain constant over the volume under consideration.

(vi) It assumes constant rate of increase in variable cost.

(vii) It assumes constant technology and no improvement in labour efficiency.

(viii) The price of the product is assumed to be constant.

(ix) The factor price remains unaltered.

(x) Changes in input prices are ruled out.

(xi) In the case of multi-product firm, the product mix is stable.

Managerial Uses of Break-Even Analysis

To the management, the utility of break-even analysis lies in the fact that it presents a
microscopic picture of the profit structure of a business enterprise. The break-even analysis not
only highlights the area of economic strength and weakness in the firm but also sharpens the
focus on certain leverages which can be operated upon to enhance its profitability. It guides the
management to take effective decision in the context of changes in government policies of
taxation and subsidies. The break-even analysis can be used for the following purposes:

(i) Safety Margin. The break-even chart helps the management to know at a glance the profits
generated at the various levels of sales. The safety margin refers to the extent to which the firm
can afford a decline before it starts incurring losses. The formula to determine the sales safety
margin is:

(Sales – BEP) x 100 Safety Margin= Safety Margin

(ii) Target Profit. The break-even analysis can be utilised for the purpose of calculating the
volume of sales necessary to achieve a target profit. When a firm has some target profit, this
analysis will help in finding out the extent of increase in sales by using the following formula:

Fixed Cost + Target Profit Target Sales Volume =Contribution Margin Per Unit.

(iii) Change in Price. The management is often faced with a problem of whether to reduce
prices or not. Before taking a decision on this question, the management will have to consider a
profit. A reduction in price leads to a reduction in the contribution margin. This means that the
volume of sales will have to be increased even to maintain the previous level of profit. The
higher the reduction in the contribution margin, the higher is the increase in sales needed to
ensure the previous profit. The formula for determining the new volume of sales to maintain the
same profit, given a reduction in price, will be as follows:

Total Fixed Cost + Total Profit New Sales Volume = New Selling Price – Average Variable
Cost

For example, suppose a firm has a fixed cost of Rs. 8,000 and the profit target is pe 20.000. If the
sales price is Rs.8 and the average variable cost is Rs. 4, then the total Volume of sales should be
7,000 units on the basis of the formula given under target price. Suppose the firm decides to
reduce the selling price from Rs.8 to Rs. 7, then the new sales volume should be on the basis of
the above formula:

From this, we can infer that by reducing the price from Rs. 8 to Rs. 7, the firm has to increase the
sales from Rs. 7,000 to Rs 9,330 if it wants to maintain the target profit of Rs. 20,000. In the
same way, the sales executive can calculate the new volume of sales if it increases the price.
(iv) Change in Costs. When costs undergo change, the selling price and the quantity produced
and sold also undergo changes. Changes in cost can be in two ways:

(i) Change in variable cost, and

(ii) Change in fixed cost.

(v) Decision on Choice of Technique of Production. A firm has to decide about the most
economical production process both at the planning and expansion stages. There are many
techniques available to produce a product. These techniques will differ in terms of capacity and
costs. The break-even analysis is the most simple and helpful in the case of a decision on a
choice of technique of production. For example, for low levels of output, some conventional
methods may be most probable as they require a minimum fixed cost. For high levels of output,
only automatic machines may be most profitable. By showing the cost of different alternative
techniques at different levels of output, the break-even analysis helps the decision of the choice
among these techniques.

(vi) Make or Buy Decision. Firms often have the option of making certain components or for
purchasing them from outside the concern. Break-even analysis can enable the firm to decide
whether to make or buy.

(viii) Plant Shut Down Decisions. In the shutdown decisions, a distinction should be made
between out-of-pocket and sunk costs. Out of pocket costs include all the variable costs plus the
fixed cost which do not vary with output. Sunk fixed costs are the expenditures previously made
but from which benefits still remain to be obtained e.g. depreciation.

(ix) Advertising and Promotion Mix Decisions. The main objective of advertisement is to
stimulate or increase sales to all customers–former, present and future. If there is keen
competition, the firm has to undertake vigorous campaign of advertisement. The management
has to examine those marketing activities that stimulate consumer purchasing and dealer
effectiveness. The break-even point concept helps the management to know about the
circumstances. It enables him not only to take appropriate decision but by showing how these
additional fixed cost would influence BEPs. The advertisement cost pushes up the total cost
curve by the amount of advertisement expenditure.

(x) Decision Regarding Addition or Deletion of Product Line. If a product has outlived its
utility in the market immediately, the production must be abandoned by the management and
examined what would be its consequent effect on revenue and cost. Alternatively, the
management may like to add a product to its existing product line because it expects the product
as a potential profit spinner. The break-even analysis helps in such a decision.

Limitations
We may now mention some important limitations which ought to be kept in mind while using
break-even analysis.

1 In the break-even analysis, we keep everything constant. The selling price is assumed to be
constant and the cost function is linear. In practice, it will not be so.
2. In the break-even analysis since we keep the function constant, we project the future with the
help of past functions. This is not correct.

3. The assumption that the cost-revenue-output relationship is linear is true only over a small
range of output. It is not an effective tool for long-range use.

4. Profits are a function of not only output but also of other factors like technological change,
improvement in the art of management, etc., which have been overlooked in this analysis.

5. When break-even analysis is based on accounting data, as it usually happens, it may suffer
from various limitations of such data as neglect of imputed costs, arbitrary depreciation estimates
and inappropriate allocation of overheads. It can be sound and useful only if the firm in question
maintains a good accounting system.

6. Selling costs are especially difficult to handle break-even analysis. This is because changes in
selling costs are a cause and not a result of changes in output and sales.

7. The simple form of a break-even chart makes no provisions for taxes, particularly corporate
income tax.

8. It usually assumes that the price of the output is given. In other words, it assumes a horizontal
demand curve that is realistic under the conditions of perfect competition.

9. Matching cost with output imposes another limitation on break-even analysis. Cost in a
particular period need not be the result of the output in that period.

10. Because of so many restrictive assumptions underlying the technique, computation of a

break-even point is considered an approximation rather than a reality.

Uses
The main advantages or uses of break-even analysis in managerial decision-making are the
following:

1 It helps in determining the optimum level of output below which it would not be profitable for
a firm to produce.

2. It helps in determining the target capacity for a firm in order to get the benefit of the
minimum unit cost of production.

3. With the help of the break-even analysis, the firm can determine the minimum cost for a
given level of output.

4. It helps in deciding which products to be produced and bought by the firm.

5. Plant expansion or contraction decisions are often based on the break-even analysis of a
particular situation.
6. The impact of changes in prices and costs on the profits of the firm can also be analyzed with
the help of the break-even technique.

7. Sometimes the management has to take decisions regarding dropping or adding a product to
the product line. The break-even analysis helps in such situations.

8. It evaluates the percentage financial yield from a project, and thereby helps in the choice
between various alternative projects.

9. The break-even analysis can be used in finding the selling price which would be most
profitable for the firm.

10. By finding out the break-even point, the break-even analysis helps in establishing the point
where from the firm can start payment of dividends to its shareholders.

INFLATION
Inflation refers to a continuous rise in general price level which reduces the value of money or
purchasing power over a period of time. Inflation results in loss of value of money

Definition of Inflation

1. According to crowther,: "Inflation is a state in which the value of money is falling i.e.
the prices are rising."
2. According to coulbourn,: "Inflation is too much of money chasing too few goods."
3. According to shapiro-“Inflation is simply a persistent and appreciable rise in general
price level”
4. According to Paul Samuelson: “By inflation we mean a time of generally rising prices.”

Thus inflation can be defined as a sharp increase in the rate of change of a price index
above an acceptable level that lasts over a time period long enough to create expectat ions
of its future persistence.

Features of inflation

The characteristics or features of inflation are as follows:-

Inflation involves a process of the persistent rise in prices. It involves rising trend in price
level.
1. It is a state of disequilibrium.
2. It is scarcity oriented.
3. It is dynamic in nature.
4. Inflationary price rise is persistent and irreversible.
5. Inflation is caused by excess demand in relation to supply of all types of goods and services.
6. It is a purely monetary phenomenon.
 7. It is a post full employment phenomenon.
8. It is a long-term process.

Terms related to Inflation: The important terms related to inflation are as follows:-

1. Deflation is a condition of falling prices. It is just the opposite of inflation. In deflation,

the value of money goes up and prices fall down. Deflation brings a depression phase of
business in the economy.
2. Disinflation refers to lowering of prices through anti- inflationary measures without
causing unemployment and reduction in output.
3. Stagflation: Paul Samuelson describes stagflation as the paradox of rising prices with
increasing rate of unemployment. According to Brahmananda, rising prices in the middle
of a recession is known as stagflation.
4. Stagnation: stagnation in the rate of economic growth which may be a slow or no
economic growth at all.

Types of Inflation

1. Hyperinflation: Is the most extreme inflation phenomenon, with yearly price increases of
three-digit percentage points and an explosive acceleration. This is the worst form of price
rise
2. Running or extremely high inflation It could range anywhere between 50% and 100%.
High inflation is a situation of price increase of, say, 30%-50% a year. It adversely affects
the investors and lenders
3. Walking or moderate inflation It can be differently defined around the world, given the
different inflation histories. As an indication only, one could consider inflation as
moderate when it ranges from 5% to 25-30%. For some countries, the higher part of this
range is already "high inflation".
4. Creeping or low inflation- It can be characterized from 1-2% to 5%. Around zero there
is no inflation (price stability).this rise is favorable for the growth of economy. Such rise
functions as incentive for investment and production.

Causes of Inflation

(A) Factors responsible for increase in Money Income ( Demand Side )

1. Monetary and Credit policy of the Government: When the government of the under-
developed and developing countries fall short of financial resources for the
implementation of their development programme, then the government of these countries
float new currency into circulation. The circulation of new currency is the result of
monetary policy. The circulation of new currency increases monetary income but no
increase is noticed in the increase of real income. This creates inflationary situation in the
 economy.

2. Increase in the Velocity of Money: Increase in the propensity to consume in the

society and the fall in liquidity preference of the people increases velocity of money.
Increase in the velocity increases monetary income of the people, which creates
inflationary situation in the economy.

3. Credit Policy of Commercial Bank: Commercial banks with the help of their credit
policy create inflationary situation in the economy. When the demand of or credit
increases, commercial banks by reducing their cash reserve ratio can create the credit.
This credit creation policy of the bank increases quantity of money which further results
in inflation.

4. Deficit Financing: It refers to the financing of the excess expenditure over total
revenue receipts of the government. The financing of this excess expenditure is covered
with the help of issue of new currency in circulation. This issue of new currency increases
monetary income, which results in inflationary situation in the economy.
5. Increase in unproductive expenditure : Supply may suddenly decrease on account of
some natural calamities or some similar things. Flood, draught, diseases of crops, etc. can
reduce supply of essential goods and feed inflationary forces.

6. Import of Foreign Capital: When a country continuously imports foreign capital, or

borrows heavy loans from outside, the inflationary forces start emerging in the economy.
This results in increase in monetary income.

7. Financial Disorder: When the government fails to collect the full amount of levied
taxes, the quantity of unaccounted money increases. In the absence of any control on this
created unaccounted money, undue pressure is built on demand of goods and services.
This increases price level in the country and situation of inflation starts emerging.

8. Favorable Balance of Payments: As a result of favorable Balance of Payment

(exports>Imports), the supply of Foreign Exchange in surplus in country increases. The
increase in Foreign Exchange reserve creates inflationary situation in the economy.

9. Rise in Import Price: If prices of importable commodities rise, it leads to what is

called Imported Inflation. If the imported commodities are inputs or raw materials in
domestic production, cost of production would rise in general resulting in higher domestic
prices and inflation.

(B) Factors Responsible for Fall in Production( Supply Side)

1. Natural Factors: Floods, Draughts, Famine, Earthquake, and similar happenings

reduce supply of essential goods in the market. Due to these natural factors, production
goes down but the monetary income remains constant. This feeds inflationary forces in
the economy.
 2. Increase in population: When population of the country increases at a faster rate and
production of the goods and services remain constant, the scarcity of such goods is
realized. This scarcity results in increase of prices, and thus inflation.

3. Black Marketing and Hoarding: sometimes inflation is caused by socio-economic

reason viz. Black marketing and hoarding. The commodities which are in demand are
hoarded by the traders and businessmen, with the result that their prices rise which in turn
would lead to general rise in prices.

4. Shortage of Raw Material: Sometimes due to shortage of raw material, production

and supplies of goods is adversely affected. This results in increase in prices of such goods
and the occurrence of Inflation.

5. Industrial Unrest: Many a time production in the country is adversely affected by

industrial unrest like strikes and lockouts. This reduces supply of essential goods and feeds
inflationary forces.

6. Trade and Fiscal Policy of the government : To boost country's export and reduce the
imports, the government makes necessary changes in its trade policy. As a result of such
changes exports start increasing at the cost of domestic economy. This creates shortage of
essential goods in the economy and domestic price level starts rising.

7. Shortage and Bottlenecks in Productive process : In underdeveloped countries,

Structural inadequacies lead to shortage of inputs and resources, which in turn would result
in inflation.

Effects of Inflation

Inflation affects all the sections of the society. While for some it brings good fortune, for
others, it may prove to be disastrous. Inflation initially activates the economy. However,
continuous inflation shakes the foundation of the economic system. This system makes
the r ich richer and the poor poorer. Effects of inflation could be discussed under four
heads:

(A) Effect of inflation on different sections of society:

Inflation does not hit all sections of the society alike. While a section of society may tend
to gain, another section would invariably lose. The effect of inflation on different sections
of society can be discussed as follows:

a. Producers : In this category of people industrialist, traders, farmers, and employers are
included. Inflation is a boon to the producers because it serves as a tonic for business
enterprise. During inflation, corporate and non-corporate profits rise sharply and
businessmen react to this rising prices by building up inventories.

b. Investors: Investors could be classified in two categories:

a) Investors dealing in Speculative activities (Equity Shares )

b) Investors in fixed interest yielding securities ( Bonds, Debentures )

The former category of investors gains during inflation because dividend on equities
increases with increase in prices and corporate earnings. Investors in fixed interest yielding
securities have to be content with the fixed income and they cannot share the fruits of
prosperity in the economy arising as a result of inflation. Thus, investors in fixed interest
yielding securities tend to lose during inflation.

c. Consumers : Every individual in the society is consumer. Fixed income group consumer is
the worst sufferers during inflation because their purchasing power goes down with the
increase in price leveling the economy. Consumers, whose income increases during
inflation are not affected so much.

d. Wage and Salary Earners: People getting fixed income, i.e. wages and salaries,
pensioners, suffer most from inflation. Although, with increase in price level, wages and
salaries rise, but they do not rise in the same proportion in which the cost of living rises.
This results in fall in real wages and as a result, the living standard of fixed income class
declines.

(B) Other effect of inflation

a. Redistribution of wealth: During inflation, inequality in society arises. Wage and salary
earners and consumers had to suffer a lot during inflationary situations, because of
tremendous rise in prices. Thus, during inflation the rich become richer and the poor
become poorer.

b. Increase in Government expenditure: During inflation, government expenditure rises

tremendously. On the one hand, the government has to pay higher wages to its employees
and on the other hand, the cost of various projects under construction also increases..
c. Increase in Public Debts: During inflationary period, the government generally find that
their tax receipts are lagging behind their requirements of expenditure. As a result, the
government has to resort to borrowing. But it is found that with the progress of inflation, it
becomes increasingly difficult to borrow from the market.

d. Distortion of Financial Institutions: Inflation is a monetary phenomenon. Interest is an

integral part of monetary and credit structure. During inflation, when interest rate start
moving upwards, financial institution are put to great difficulties as they had to pay the
increased interest rates on the matured liabilities immediately. The revision of their
receipts from interest takes time, while their interest expenses start increasing more
rapidly. This disrupts the smooth functioning of financial institutions.

e. Hoarding of Goods : In anticipation of rise in prices, during inflationary situation, both

traders and consumers start hoarding essential goods. The traders hoard of stocks of
essential commodities with a view to making higher profits or with a view to selling scare
 items in the black market.

f. Stimulation to Speculative activities: On account of the uncertainty generated by a

continuous rising price level inflation gives stimulus to speculative activities. Producer
during this period try to maximize their profit with the help of speculative activities.

g. Fall in Saving Rate: Inflation is a great damper on saving activity. The savers find that
the value of their saving is getting eroded on account of inflation. Though rate of interest
also goes up, yet it is not able to keep pace with the fall in the value of money and the
savers suffer a net loser.

h. Adverse Balance of Payments: Inflation leads to balance of payment difficulties.

Because of increased prices, exports of the countries do not remain competitive in the
world market and the exports start declining. The rate of exchange also moves against the
home currency and increasing trade deficit. However, inflationary conditions can impose
severe balance of payment problems upon an underdeveloped country.

i. Employment effect: During inflation, more employment is generated because the

producers in anticipation of larger profits expand the size of output.

(C) Moral Effect:

Moral effect of inflation is very bad. Inflation when wipes out savings, the effected
persons oppose the government and the society. They try to adopt illegal and immoral
ways of collecting money. Inflation is said to be the powerful agent of evil. It is a paradise
for speculators and profiteers who are enriched through no effects of their own, partly at
the expense of wage earners because prices go up by the lift but wages by the stairs, but
still at the expense of those who have a fixed earning

(D) Social and Political Effect:

Inflation has not only economic and moral effect but it has certain social and political
effect .During inflation because of inequality, society divides into categories viz. rich and
poor. The rich becomes richer and poor becomes poorer. This creates class conflict. There
are many examples in history, when the governments are also shaken as a result of
inflation. The German hyperinflation was an important factor in the fall of Dr. Cuno' s
liberal government and in Hitler's coming to power after the first world war

Measures to Check Inflation

:
(A) Monetary Measures: These are adopted by the central bank (RBI) of the country.
Following are the monetary measures which help in controlling inflationary situation.
1. Making Note Issue Policy Strict: The central bank should adopt strict note issue policies
so that it may not issue additional money. For making note issue more stringent, the gold or
foreign exchange reserve should be enhanced. If there is no provision of keeping reserve, it
should be started. Adoption of such measures makes note issue system a difficult one.
These measures also check inflationary situation.
2. Issue of New Currency: When the inflation reaches to a uncontrollable situation, the
government issues new currency and squeeze out old currency out of circulation. These
measures are also called demonetization. It is an unusual method of controlling inflation.

3. Control on Credit Money: To controll inflation, it is essential to control credit money

also. For this purpose the central bank of the country adopts the following measures:

i) Increase in Bank Rate: Bank rate is the rate of which the central bank rediscounts the
bills of commercial bank or at which it extends financial accommodation to the
commercial banks. If there is much expansion of credit in the banking system, in such
cases to control credit central bank increases bank rate. Increase in bank rate will check
rising inflationary situation

ii) Open Market Operations: Another method to check inflation is that the central bank
of the country resorts to selling government securities to the public and the banks. When
the public and the banks purchase the securities, they have to make payments for these
securities to the central bank. The result is that the cash moves from the commercial banks
to the central bank. This reduces commercial bank ability to create credit

iii) High Reserve Requirement: The central bank in order to reduce the money supply in
the economy increases the limit of the reserve requirement of commerc ial banks. This
method prevents the commercial bank from forming a basis for further credit expansion

(B) Fiscal Measures: The following fiscal measures could be adopted by the government
for combating inflation:

(i) Taxation: During inflation, efforts should be made to reduce the size of disposable
income in the hands of public. This can be done either by imposing new taxes on by
increasing the existing rates of taxation. This will leave less money supply with the public

(ii) Government Expenditure: To control inflation, government should reduce its

expenditure especially unproductive expenditure. Any drastic cut in the government
expenditure to curb inflationary situation may land the economy in the slump.

(iii) Balanced Budget: To control inflationary situation, government should adopt the
policy of Balanced Budget because deficit budget further increases inflation in the
economy. In case of inflationary boon, government should also try to prepare surplus
budget

(iv) Increase in Savings : To provide a positive incentive to promote saving which will
reduce outlays and curb inflation, the government should have in its budgetary policy
incentives for savings also.

(v) Increase in Public Debts: To check inflation, the government should also issue
debentures and bonds and encourage the public for its purchase. By issue of debentures
and bonds, the government can take back additional purchasing power. The amount
collected by the government through these sources, should be utilized in productive
 channels.
(vi) Control on Investment: During inflation, in anticipation of future rise in prices,
traders and industrialists increase their investment activity. Such investment increases
money supply in the market and this increase in money supply further increases inflation.
Hence, to check inflation, the government should control unusual investments in the
economy.

(vii) Overvaluation of Currency: An overvaluation of domestic currency in terms of

foreign currencies also servs as anti- inflationary measure. This will discourage exports
and encourage imports, resulting g in increase in domestic supply of goods in the economy.
This will check rise in prices.

(viii) Income and Prices Policy: Another method to control inflation is to purchase a
policy of incomes and prices. The tendency for wages to rise beyond the marginal product
of labor has to be curbed by relating wages to productivity. Similarly, the factorial
incomes in general are to be related to their marginal product and an excessive rise in
factorial incomes has to be curbed. Close scrutiny on prices should also be pursued

(C) Other measures:

(i) Increase in Production: By increasing production the inflationary pressure can be

reduced. Increase in production increases the supply of goods, which helps in establishing
prices.

(ii) Price control and Rationing System: The government can control the rise in prices
by prohibiting any unwarranted price rises or by putting a ceiling on prices of selected
commodities. The government can also impose price control along with rationing of the
commodities.

(iii) Export-Import Control: By restricting exports and promoting imports, government

can increase the supply of goods in the country. This helps in controlling the rise in prices.

(iv) Improvement of Distribution System: The public distribution system in the country
should be strengthened. So that the commodities are made available at reasonable prices.

Theories of inflation
There are two major types of inflation:

Demand-pull Inflation,

Cost push Inflation.

1. Demand Pull Inflation

Demand-pull or excess demand inflation is a situation often described as, “too much money
chasing too few goods.”

Aggregate demand > Aggregate supply = Inflationary trend in prices

Causes of Demand-pull Inflation

1. Increase in the Money Supply: Money supply ↑ prices ↑

2. Increase in disposable income due to lowering of taxes Income Tax ↓ — Income ↑ Dd ↑- P↑

3. Increase in demand for foreign goods Dd↑—P↑

4. Decrease in business outputs Ds > SS—↑P

5. Keynes‟ reason for demand pull inflation : The Keynesian Theory of demand-pull inflation
is explained diagrammatically in figure

Suppose the economy is in equilibrium at C where the SS and D3D3 curves intersect with full
employment income level YF. The price level is OP3. Now the government increases its
expenditure. The increase in government expenditure implies an increase in aggregate demand
which is shown by the upward shift of the demand curve to D4D4 in the figure. This tends to
raise the price level to OP4, as aggregate supply of output cannot be increased after the full
employment level
2. Cost Push Inflation
Cost push theory of inflation refers to the new problem of price rise despite lesser demand and
output. Developed countries including America faced this problem of rising cost of production.
Price rise due to rising cost of production is called cost push inflation. In this situation there are
dual changes i.e., price rises despite fall in the demand and output.

According to 6. C. Ranlert, “The basis of cost push theory of inflation is that the organised
groups in business and labour establish higher prices for their product or services than that
would prevail in perfectly competitive markets.”

Causes:

(1) Wage-Push Inflation : The basic cause of cost-push inflation is that wages rise more rapidly
than the productivity of labour. In advanced countries, trade unions are very powerful. They
press employers to grant higher wages in excess of increases in their productivity, thereby,
raising the cost of production of commodities. Employers, in turn, raise prices of their products
(Wages ↑Costs of production↑, Prices ↑, Inflation ↑).

(2) Non-availability of basic inputs An increase in the prices of domestically produced or

imported raw materials may lead to cost-puss inflation. Since raw materials are used as inputs by
the manufacturers of finished goods, they enter into the cost of production of the latter. Thus a
continuous rise in the prices of raw materials tends to set off a cost-price-wage spiral.

(Prices of raw materials (domestic and imported)↑, Costs of Production ↑, Prices of Finished
Goods ↑Cost-Price-Wage Spiral... Inflation ↑)

(3) Profit-Push: Due to Monopolistic Price and Wage policies rather than monetary
policies: Another cause of cost-push inflation is profit-push inflation. Oligopolist and monopolist
firms raise the prices of their products to offset the rise in labour and production costs so as to
earn higher profits. There being imperfect competition in the case of such firms, they are able to
“administer prices” of their products, thus setting off inflation.

(Oligo-Monopolists desire more profits to offset costs of products—Imperfect Competition—

able to “administer” prices — Prices ↑Inflation ↑).

(4) The other causes of Cost-pull inflation are:

(i) Increase in indirect taxes — is usually passed down to the consumer by the producers and
middlemen in form of increased prices, e.g., sales tax-given example.

(ii) Increase in administered prices — i.e., govt. increases the prices of essential commodities
sold through its public distribution system or reduce the subsidy given on certain raw materials
or inputs like fertilizers, e.g., petroleum & petroleum products
The cost push theory of inflation is explained in the following diagram

Price levels and output levels are shown on y and x axis respectively. SS supply curve like other
supply curves S1S, S2S has two parts i.e., less than full employment and full employment. As
part shows that AS supply curve is inelastic M3 is full employment production level, prices rise
from OP to OP1 and OP2 as supply curves shift upwards to the left, intersecting DD atE,E1
andE2. The corresponding levels of output are smaller than OM3, i.e.,OM1 and OM2 with
higher costs of production as shown through higher supply curves.