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Course Ombc104 Me Sem I
Course Ombc104 Me Sem I
UNIT 1
Learning Objectives
After going through this unit, you will be able to:
Describe the meaning of Economics.
Distinguish various economics technological term.
Apply economic principles which help in making business decisions.
Compare the relationships of Managerial Economics with other
subjects.
Structure
1.1 Introduction
1.2 Definition of economics & Managerial Economics
1.3 Managerial economics, its nature & scope
1.4 Application of managerial economics in business decision making
1.5 Application of managerial Economics in business
1.6 Summary
1.7 Keywords
1.1 Introduction
1.1 Definitions
Managerial economics refers to the integration of Economic principles and
methodologies practices for the purpose of facilitating decision making and
forward planning by the management within the given situation. It focuses in
identifying the problems and solving the problems by taking proper decision.
For example a manager has to decide whether he should get the work done by
hiring labor or give it to an outside contractor.
Different economist have defined economics differently
Dr. Alfred Marshall: “Economics is the study of mankind in the ordinary
business of life; it examines the part of individual and social action which is
most closely connected with the attainment and with the use of material
requirements of well being”.
This definition gives more importance on the welfare of human being. In the
modern world there is need of human welfare and it has become the policies of
all the governments in the world.
Prof. Lionel Robins: “Economics is the science which studies human
behavior as a relationship between ends and scarce means which have
alternative uses.
This definition shows that wants are unlimited and means are limited and
scarce and the means can be put to other alternate uses.
Unlimited wants are natural for human beings and all wants cannot be satisfied
at a time, hence he has to adopt the method of choice. He tries to select that
choice, which gives him maximum satisfaction. .
Available means can be used in various ways. All the economic problems arise
due to scarce means and unlimited ways to use those means. This leads to
choice among most competing ends. This is the main cause of basic problems
for the study of economics
Economics deals with optimum utilization of scarce resources to achieve the
objectives and to maximize profit of the firm.
In nutshell economics is “the study of how people and society choose to
employ scarce resources that could have alternative uses in order to produce
various commodities and to distribute them for consumption, now or in future,
among various persons and groups. In nutshell economics is “the study of how
people and society choose to employ scarce resources that have alternative
uses in order to produce various commodities and to distribute them for
consumption, now or in future, among society.”
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SCARCITY
MICRO ECONOMICS
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Macro Economics
Other part of economics is Macro Economics. The subject matter of Macro
Economics includes the total economic units of an economy. It is the study of
aggregates, i.e. aggregate employment, aggregate income, aggregate saving
and investment, trade cycles, government policies, imports and exports and
global effects on the economy of the country. Role of banking policies also
plays an important role in the economy. Savings and investments are
controlled by the monetary policy of the government through its central bank.
Recently the prices of petroleum products were increased by the govt. You can
study the effects of this increase on the economy and on the individual.
Similarly when prices are rising, causing inflation you can study the effects of it
on the poor who have to spend all the income on the demand of essential
goods and services. This reduces the total demand and affects the economy.
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MACRO ECONOMICS
Theory of Theory of
Consumption Investment
Theory of
Business
Cycles
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Activity A:
Differentiate - wants and means
a) Purchase LCD TV______________________________________
b) Import of crude oil______________________________________
c) Promotion in the organization with salary hike -________________
d) Got a bonus payment___________________________________
e) Foreign exchange reserve_______________________________
f) Going for world tour____________________________________
The demand for Bajaj DTSI bike will grow by 5% in year 2012-13
individual, or a firm and their related matter. It is a practical subject and goes
beyond providing abstract theoretical framework for managers.
This main source of concepts and analytical tools for management is found in
the study of economics. It studies essentials of demand, and supply, marginal
cost, short run and long run cost, different forms of markets such as perfect
competitive, monopoly, monopolistic competition, and oligopoly and how
these markets operate regarding pricing of the product and output.
Macro economics deals in forecasting of demand in order to plan for future
needs of capital and investment. This is based on market demand at macro
level and individual, organization demand at micro level.
At Macro level we study the theory of income and employment, Trade cycle
and its effects of the economy. Different causes of inflation, recession and
depression. Further we have to study the role of the government and its
policies to meet these challenges in the economy.
Activity B:
Identify the type of market:
1 FMCG__________________________________________________
2 Mobile service providers____________________________________
3 Cement manufacturer and recent CCI decision to penalize 11 cement
companies
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Macroeconomics Econometrics
MANAGERIAL ECONOMIC
Application of economic theory
OPTIMAL SOLUTIONS TO
MANAGERIAL DECISION PROBLEMS
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Consumers Firms
Economic Economic
Resources Resources
Chart 1-4
1.6 Summary
Managerial Economics refers to the application of principles of economics in
decision making in the business. It uses the help from accounting and other
subjects like mathematics, statistics, .operational research, sociology
psychology etc.
It uses the help of account, production, marketing techniques and finance to
take decision. Managerial economics is applied economics and based on
normative economics Managerial economics has to decide:
What to produce?
How to produce?
How much to produce?
For whom to produce?
At what cost it is to be produced?
How to decide price?
Managerial economics has to study the market, determine the demand based
on forecasting and other circumstances. While pricing the product it has to
study elasticity of demand, income of the people and has to prepare strategy
for increasing its profit and its share in the market.
It has many tools given by other social and natural sciences such as social set
up, religion, mathematics, statistics, operational research, capital
management and pricing. Finance has greater role to play in the study of
managerial economics.But the scope of Economics is wider than the scope of
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managerial economics.
1.7 Keywords
Aggregate demand: The expenditure that the households and firms
are undertaking on consumption and investment.
Consumption: act of satisfying one's wants.
Demand: The quantity of goods and services desired by a customer
duly supported by the ability and willingness to purchase by parting
with money.
Economics: The science of choice when faced with unlimited ends
and scarce resources having alternative uses.
Fiscal Policy: A set of guidelines for the government's earning and
spending.
Macro Economics: The branch of economics which studies the
aggregate behavior of the economic system.
Micro Economics: The branch of economics that deals with small
individual units of an economy.
Monetary Policy: A mechanism to regulate the money supply in an
economy. It is concerned with the cost and availability of credit.
Price: Value when expressed in terms of money.
Utility: The want satisfying quality of goods.
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UNIT 2
DEMAND ANALYSIS
Learning Objectives
After going through this unit, you will be able to:
Structure
2.1 Introduction
2.2 Concept of utility
2.3 Meaning of demand.
2.4 Types of demand
2.5 Determinants of demand
2.6 Summary
2.7 Keywords
2.1 Introduction
In the first unit we have given the idea of managerial economics and how ME is
dependent upon economics. The managers have to study all the possibilities
of using scarce resources to get the maximum output at minimum cost. In this
unit we are going to study the idea of utility and how it is related to demand of a
product. We are also going to study the idea of demand. Demand is the origin
of all economic activities. Demand is affected by many factors apart from price.
The factors, which affect demand, are income of a consumer, population,
climate and government policies activities.
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Meaning of utility
It is want satisfying power of a commodity. If man is thirsty he quenches his
thirst by taking a glass of water. Here water has UTILITY because it has the
power to satisfy human want and sometime a person is prepared to pay for it.
So we can define utility as satisfying power of a commodity.
helps to analyze why price falls. The Law of demand clearly indicates
that a fall in price of a commodity the demand for it increases and the
marginal utility goes on decreasing of the commodity.
This law explains the idea of redistribution of the national income in the
society and it has greater affect on the development of an economy
because the poor, if have money, go for purchasing the goods and
services more and more. This will increase demand. This will increase
more production and more economic activities and economic growth.
Activity A:
Explain why water has less value in exchange but high value in use.
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Explain the situation under which a miser is happier when he gets more
and more money.
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Justify the idea that the rich should pay higher taxes than the poor.
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2.3 Demand
Meaning of demand
Demand means effective demand. Demand is defined as the quantity of goods
or services desired by an individual backed by the ability and willingness to pay
at particular time and at particular price.
Secondly if a man has desire and he has money but he is not prepared
to part with it. This will not be a demand, for example the case of a miser
who wants the goods but is not prepared to part with the money. So his
demand cannot be fulfilled
Thirdly a man has desire and prepared to pay for the product but has no
money. In this case his demand is fulfilled if he gets the goods on credit.
In the modem time most of the durable goods (white goods) are
purchased on EMI bases and the financial companies are prepared to
finance such transactions. This has completely changed the pattern of
demand in the market
Demand is the core of almost all the major activities and decisions of a firm.
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Speculative goods: Such as shares which are traded in the share market
which do not follow the law of demand. In speculation a further rise in price is
expected by the investor and the traders buy more and hold them to sell the
shares at a higher price later.
Outdated goods: These goods are generally desired by the people and
these are durable goods such as radio, TV, telephones. When anything
becomes outdated the people would not buy them. For example the demand
for black and white TV has become negligible even though the prices have
fallen. This also applies to seasonal goods, e.g. the demand of raincoat is
always in rainy season.
Goods in short supply: The supply of certain goods is uncertain; hence even
if the price is going up the people would like to buy them because of
uncertainty.For example when the shortage of sugar is felt the people are
prepared to pay more to buy sugar to avoid inconvenience. Hence in above
circumstances the law of demand does not apply.
1. Rs 10 500
2. Rs 15 300
3. Rs 18 200
4. Rs 20 100
5. Rs 25 50
Demand Graph
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Demand Schedule
This demand schedule and demand curve clearly indicates that as the price of
milk decrease the demand for milk increases and when the price increases the
demand for milk decreases.
I. Demand Shifts
Increase in Demand: We represent an increase in demand by an outward
shift in the curve (from D1 to D2). In the graph below at the price p1, demand
has increased from Q1 to Q2. At every price there will be a greater demand
than there was before the 'shock' of increased demand. We could expect this
to describe the effect of an increase in income or an increase in the size of
potential demanders if the economy was expanding rapidly and families had
more income to spend on education, or if high school grads were having real
problems finding jobs Increase/Decrease in Quantity
Fig.2.2 Increase in Demand
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Activity B:
Price of vegetables in the vegetable market is high in the morning and as
the time passes on the price goes on decreasing. Give reason
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During festival season the price of milk goes up and the demand is also
increasing, explain this situation under the law of demand.
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Activity B:
The demand for car has come down because the price of petrol has
increased. Study this situation under the law of demand.
_________________________________________________________
_________________________________________________________
_________________________________________________________
Indirect demand consists of those goods which are not directly consumed by
the consumer but these are used by producers for the production of other
goods. These are also known as producers demand. Example - The demand
for machine, tools, raw material, is known as indirect demand.
Also sewing machine is demanded by a house wife to stitch clothes for the
family it is a direct demand but when a tailor uses the sewing machine for
making shirts, blouses etc it is indirect demand for the machine.
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Price Demand
It refers to different quantities of a product or service that a consumer would
like to buy at a given time, and at a given price, other things remaining
constant. It is related to price
Income Demand
It refers to the situation where different quantity of goods or services would be
purchased by the consumer at various levels of income. If income increases
demand for various goods would also increase but the demand for basic food
shall remain the same. And with the higher income the consumer may
substitute superior quality of goods replacing inferior goods. For example the
income of a consumer increase he may demand more goods and secondly he
may substitute superior quality of rice to inferior quality of rice
Cross Demand
This refers to the demand of interrelated good. E.g. tea & coffee .Increase in
the price of tea will increase the demand for coffee.
Joint Demand:
It means when more than one commodity is required to satisfy a demand. For
example to satisfy the demand for tea, consumer requires tea leaves, milk,
sugar etc.
Composite Demand:
Any commodity can be put to many uses, and the use of it depends upon its
price. For example water, where water is costly it is only used for drinking and
cooking purposes and if the price of water reduces it can be put for other uses
also.
he buys it. When the demand of all the people is taken together it is market
demand of vegetable it will be called market demand. For example X demand
depends upon his income and he may demand one kg of cabbage but all
people demand for cabbage may be 100 kg that will be market demand.
Activity C
Activity C:
a) Sewing machine is a consumer goods and it also a producer good.
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b) In order to have a cup of tea you need tea leaves, milk and sugar it is
called
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d) EMI scheme has increased the demand for white goods. Agree.
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e) Change in the habit of saving more, will affect the demand of goods and
service.
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2.6 Summary
We have studied the idea of utility. We have also studied the law of diminishing
marginal utility. The idea of utility is useful in taxation also it gives the idea of
Value-in-use and Value-in-exchange. We also studied the meaning of demand
and its law .i.e. how change in price affects the quantity demanded. We learnt
how demand is determined and also exceptions to the law of demand .We also
got the idea of increase and decrease in demand.
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2.7 Keywords
Complementary goods: goods which are used along with some other
goods.
· Demand: The quantity of a good or service desired by a customer duly
supported by the ability and willingness to pay with reference to a point
of time and the price.
· Giffen goods: inferior goods, consumed mostly by the poor people as
essential commodities. The demand of these goods increases with a
rise in price.
· Law of demand: Other thins remaining the same the demand for
goods increases as the price decreases and vice-versa.
· Law of Diminishing Marginal Utility: As a consumer increases the
consumption of a product, the utility gained from successive units of
consumption goes on decreasing.
· Price: value expressed in terms of money.
· Utility: The want satisfying quality of goods.
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UNIT 3
Learning Objectives
After going through this unit, you will be able to:
Explain the meaning of elasticity of demand.
Discuss how a small change in price affect the demand.
State different concepts of elasticity.
State Measurement, and uses of the concept of elasticity of demand.
Establish how demand is estimated.
State Methods of estimating.
Structure
3.1 Introduction
3.2 Concept of elasticity of demand.
3.2.1 Elastic demand.
3.2.2 Inelastic demand.
3.3 Classification of elasticity of demand.
3.3.1 Price elasticity of demand.
3.3.2 Income elasticity of demand.
3.3.3 Cross elasticity of demand
3.4 Measurement of elasticity of demand.
3.4.1 Total Outlay method.
3.4.2 Percentage method.
3.4.3 Point method
3.4.4 Arc method.
3.5 Application of elasticity of demand.
3.6 Factors determining elasticity of demand
3.7 Meaning of forecasting of demand.
3.7.1 Techniques of forecasting.
3.7.2 Forecasting of demand for a new product.
3.7.3 Uses of forecasting of demand.
3.8 Summary
3.9 Keywords
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3.1 Introduction
In the previous unit no 2 you are given the idea of marginal utility and its
importance. Secondly you learnt the idea of demand and other concepts
related to demand such as different types of demand. We know that demand is
the beginning of all economic activities.In this unit we are giving you some
ideas of edacity of demand. This is a very important component of business
decision making. It is a measure of responsiveness of demand of a product to
the change in the price of the product. Sometimes a small fall in the price of a
product may increase the demand of the product much more than expected for
example If the price of TV is reduced, it demand always increases. But the fall
in the price of salt will not increase its demand. Prof. Marshall “Elasticity of
demand in a market is great or small depending on whether the amount
demanded increases much or little for a given fall in price and diminishes much
or little for a given rise in price
In the second half we shall study the idea of estimation of the level of demand
of a product in future. The businessman has to plan for future production on the
basis of future estimates. The businessman has to arrange for Finance, space,
Manpower; material etc. This idea is known as forecasting of demand of a
product
rice fall the demand may not increase or there may be marginal increase. But in
case of salt the demand may not increase at all. Generally these products
come under necessaries and are essential for human life.
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1. Fig.1 shows the idea of inelastic demand. Here there is a fall in price but the
demand has not increased much. This happens in case of essential goods eg
wheat. Rice vegetables etc. Here elasticity of demand is less than one
2. Fig.2 gives the idea of elastic demand here with a fall in price the demand for
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the product has increased much. The example is TV; washing machines etc.
here the elasticity of demand is greater than1
3. Fig.3 shows that the elasticity of demand is unity that is equal to one. It
means percentage change in price of the product and percentage change in
demand is equal.
4. Fig.4 shows that the elasticity of demand is zero. It means the demand
remains the same whatever the price may be. For example purchase of salt for
the household. Here elasticity of demand is zero
5. Fig.5 depict that at the same price any quantity of product can be bought.
The example is that of sugar. In this case the elasticity of demand is ∞.The
price elasticity of demand for cheap good that are generally consumed in fixed
quantity is inelastic, that is, the demand for salt has zero elasticity.
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his income falls to Rs.8,000/- he may reduce the demand for fruit to 400 unit.
So the income elasticity of demand will be
Ie = ∆dF/∆Income÷I/dF
Here the income elasticity is less and negative.
This concept is always used in determinating the effect of change in income on
the demand of the product.It is used while studying the change in the national
income and its effects on demand of various goods and services. We always
talk of GDP (gross domestic prodct). If GDP is rising economic activities will
increase.
3.3.3 Cross Elasticity of Demand
Two goods may be related to each other in two ways.
1. when two good are used at the same time to fulfill the demand for
example car and petrol.These goods are complementary goods
2. They can replace each other and are close sustitute ie tea and coffee.
The cross elasticity of demand measures the responsiveness of demand for
one product to the change in the price of another product.For example if the
price of tea goes up the demand for coffee will increase.
Ce= percentage change in the demand of X product÷percentage change in the
price of Y product.
Ce= ∆dx/dx÷∆py/py
Ce= ∆dx/∆py÷dy/dx
Activity A:
a) Meaning of elasticity of demand.
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The above table clearly explains the elasticity based on total expenditure.
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P2
P
P1
0 x
B
Fig. 3.6
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Arc method uses the mid points between the old and the new at time of
data collection in the case of price and quantity demanded
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affected.. Hence the finance minister has to take a middle course of action
where welfare and tax burden on the poor is not increase.So he will choose
those goods and sevices for increasing the tax which are consumed by the rich
and give subsidy to the poor.
Pricing of a Product
Here the producer of the product would like to know about the elascity of
demand of the produt.If he finds that the product has elastic demand he will
keep the price low and sell more. If his prodect has inelastic demand he can
keep the price at higher level and earn more profit. He will also study various
markets and set the price of the product based on elasticity and charge
different prices in different markets.
International Trade
This concept is allways used in international trade while deciding the terms of
trade between the two countries. If the product demand is inelastic the
exporter will charge higher prices . For example the prices of crude oil are
increasing day by day still the demand is increasing If the product has elastic
demand the exporter will keep the prices of the products low and sell more for
example the prices of the chineese goods are kept low and they are able to
compete in the market better and sell more
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Activity A:
b) Methods of measuring elasticity of demand.
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this will reduce the personal biases. A specialised form of panel opinion is is
adoptd in Delphi method. Under it an attempt is made to have consensus on
estimation of demand of the products by questioning a group of experts
repeatedly until their responses appear in a single line. This method was
developed by Rand corporation of USA and is being used successfully in area
of technological product forecasting.It is used in USA and European countries
to estimate the demand for technical goods.This method is very popular in
USA and Europe
b) i) Complete Enumeration Survey Method
This method is also known as opinion polling. In this method all the
consumers of the product are interviewed and information regarding
their consumption of the product is collected. On the basis of this
information estimation is done for the future.This method has many
advantages
1. It is accurate since all the consumers are approached
2. It is simple and is not affected by personal biases
3. It is based on collected data
But it some disadvantages that is
1. It is costly and time consuming
2. It is useful only for a product with limited number of consumers.
3. It is difficult and practically impossible to survey all the consumers.
b) ii) Sample survey
From the consumers only a few of them are selected and their ideas
are taken and demand is forecasted. But this method requires that the
sample should be representative. The sample will be small and less
costly and less time consuming. It also reduces the riskof error in data.
If used carefully it gives excellent result.
But this has limitation that is being based on only a few consumer
the opinion may not be appliclable and it may not be reprsentative.
b) iii) Opion Poll of Sales Staff
This is used to collect the information from the sales staff such as salesmen
who have direct contact with the dealers of the commodity. The salesmen are
expert and are expected to estimate sales in their operative areas.It is
collective wisdom of sales department and top executives. It is simple and
useful for short period forecasting and less costly.It is easy to collect the data
from their own staff. But this methods have some disadvamtages such as
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changes in the consumers' taste and preferenc are changing and the sale
force may not give the real picture
b) iii) End Use Method
This method is used for sector wise or area area wise demand. The product
may be final or intermediate but this is used for the end users of the product.
Milk is a commodity which can be used as an intermediary good for the
production of ice cream, cheese and many other dairy products.
This method has certain advantages:-
It yields accurate forecast .
It provides sectorwise demand forecast for different industries and is more
useful for producers' goods.
But the disadvantage that it requires complete and diverse calculation and it is
more time consuming.
Industries data are not readily available.
Quantative Methods
1. Barometric method
2. Time series analysis
Regression method & corelated method.
1. Barometric Method
In an economy there are always turning points from inlation to recesssion this
method studies the turning point from one economic time series to another
time series by observation.Here economic indicators are used which are
divided in to three categories.
a) Leading indicators
b) Coincident indicators
c) Lagging indicators
The corelation between two time series differs if the second series data are
ahead or move behind or move along with the first series data. If it moves
ahead of the first series it is known as leading series, while the first series is
called lagging series. If the second series moves along the first series it is
called coincident series
For example eartthquake in Jan 2001 led to the destruction of property and
required reconstruction of buildings this created huge demand for cement,
steel and other commodities. Here construction of building is the leading
indicator or barometer
Barometric analysis is a simple method and predicts directional changes, but it
fails to recognise the magnitude of changes.Secondly it is difficult to find out
the leading indicator for any series. This method can be used for short term
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only,
2. Time Series Analysis.
It has four categories. Trend, Seasonal variation, Cyclical variation and
random fluctuation Trend analysis can be studied from past data that is how
the changes in demand was moving from one period to another.
Seasonal variation. As the season changes the demand of certain goods
changes and so is the production.The demand of woolen clothes increases in
winter season.
Cyclical variation.Cyclical variation are always there in a free economy that is
in the form of inflation, deflation,recession , and depression. This is caused by
changes in the economic activities in the form of trade cycle.
Random fluctuation.here the demand changes due to natural calamities like
earthquakes, flood, famine and so on which affects the demand of different
products.
3. Regression Method
Here we have to go back and study how a factor helps in determining the co-
relation (co-efficient of co-relation) in forecasting of demand.it gives the line of
best fit as the equation goes Y=a+bx here we need past data and functional
relationship is established between the variable with the help of regression.
Once a relationship is established it is possible to project this into future
demand
3.7.2 Forecasting of Demand For A New Product
Joel Dean has suggested the following methods to forecast the demand of a
new product.
A) Evolutinary Method Many new product are evolved from already
established product for example demand for colour TV is based on the
demand for black & white TV
This method has some limitations.
a) The new product should have been evolved from the existing product.
b) It ignors the problems of showing how the new product differs from the
established product.
B) Substitution Method
Some new product are substitute of already established product for example
New LCD tv are substituteable of already established colour Tv. But this has
some limitations too
a) Some new products have many uses and each use has a different
substituability so forecasting becomes difficult.Take the case of a computer we
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find different configerations and better support with less cost. When a non-
sustitute is added the existing firms react in a different ways ( change in price,
more expenditure on advertisement) to cater to the demand for the new
product.
A) Growth Pattern Method
If there is some relationship between the new product and already
established product this method is useful. This method requires the study of
the demand pattern of the old product and the pattern of growth of the old
product will be useful for the new product
1. Opinion Polling Method
Individuals are not sure of their purchase. In this method the
consumers are contacted directly seeking their opinion by sample
survey. When a new drug is introduced the doctors are contacted and
their opinion is gathered about the drug and on the bases of the
information, forecasting of demand of that product is done.
Opinion poll method has some limitations.
a) Individuals are not sure of their purchase.
b) It is difficult to contact all the consumers.
c) It is costly and is useful for a short period.
2. Sales Experience Approach
In this method, the new product is put to sale in a sample market and
the response of the people is noted along with the reaction of the
consumers to the new product and estimation for the future demand is
done. Joel Dean has advised to combine more than one of the methods
1. Uses of Forecasting of Demand
· Production planning
· Sale forecasting and promotional efforts
· Control of business it means well conceived budgeting, cost
and profit.
· Inventory control.
· Growth and long term investment programme.
· Stability in production and employment.
Economic planning and policy making.
Activity C:
a) Discuss the usefulness of forecasting of demand.
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Activity C:
3.8 Summary
Elasticity of demand is the responsiveness of demand to change in its price
determinant. Price elasticity of demand is the responsiveness of demand for a
product with the change in its price. Elasticity of demand may be elastic or less
elastic. It is necessary to measure the effect of price on the demand of the
product ie.∆q/∆p×p/q.
Income elasticity of demand shows the effect of change in income of a person
and change in the demand of various products. Cross elasticity of demand
gives the idea of relationship of close substitute. e.g. if the price of coke is
increased the demand for Pepsi will increase depends on elasticity of demand.
We also get the idea of usefulness of the study of elasticity of demand in
business decision and the government decision regarding taxation and public
expenditure We also have learnt various factors which help to determine
elasticity of demand. In the second half we have studied the idea forecasting of
demand. Also we have study various techniques of forecasting. These are very
useful to guide the businessmen to take decisions. It is helpful in planning,
mobilization of resources etc. to meet the future demand.
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UNIT 4
PRODUCTION ANALYSIS
Learning Objectives
After going through this unit, you will be able to:
Define the role of fixed factors and variable factors.
Define the role of fixed factors and variable factors in the short run
and in the long run.
State that the fixed factors are not fixed in the long run, but all
factors are variable.
Draw the idea of law of diminishing return, increasing return, and
constant return.
Explain the law of variable proportion.
Judge when to stop production during different stages of
production.
Explain the idea of return to scale.
Structure
4.1 Introduction to production analysis
4.2 Factors determining production in short term and long term
4.3 Law of Return
4.3.1 Law of Variable Proportion
4.3.2 Law of Diminishing Return
4.3.3 Law of Increasing Return
4.3.4 Law of Constant Return
4.4 Return to Scale
4.5 Summary
4.6 Keywords
4.1 Introduction
We are going to give you the idea of Production Function. This concept is very
important in managerial economics in decision making.
· Production Function is a function that specifies the output of a firm for all
combinations of inputs. It gives the idea of relationship between inputs (various
combinations of factors of production) and maximum output. It states the
amount of product that can be obtained from every combination of factors and
is based on the most efficient available method of production.
· Production function is the flow concept because it relates to the flow of inputs
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The size of the fixed assets such as plant, machinery, equipments are fixed in
the short period. But these factors become variable in the long term. So in the
long run there is a full scope for adjustment between factors of production in
the production process. In Heavy industry like steel, chemicals the capital
equipments, machinery, which are used, are very complex and sophisticated
.It needs several years to erect a plant. Any rise in demand could be met only
by intensive use of existing plant capacity and by employing more labor and
capital etc. But if demand persists then a new plant has to be installed to meet
the increased demand. So the adjustment takes a long time
Very Long Term
When very long term is to be considered we have to give due consideration to
new, sophisticated and latest technology which has to be introduced and
production function itself will changed.
Activity A:
c. Fixed factors are fixed for short run but not for long run. Discuss.
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Table no 5.1
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Graph 4.1
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Graph no.4.2
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After seeing the table and the graph of Law of variable proportion we can
say that
Up to 7 unit of input some addition is made in production but at the 8 unit
th th
increasing and it is high at the 4th unit of input. Now it starts falling due to
insufficient input and at 8 unit it is ZERO. Total output is maximum when
th
Prof. Marshall “An increase in capital & labor applied in the cultivation of land
causes in general a less than proportionate increase in the amount of produce
raised unless it happens to coincide with an improvement in arts of
agriculture.”
Doses of input 1 labor + 1000/- capital (In quintal)
From the table above we find that as our input increases total output increase
in absolute term till 7th unit but after sometime the output increases but at
diminishing rate and at the end it becomes negative.
But this law has some limitations as under:
a) When barren land is brought under cultivation.
b) When earlier less capital/labor is applied.
c) When new technology is introduced.
During limitation the law will not apply initially but it will operate after achieving
the maximum output
But ultimately the law will apply, may be after some time. The law applies in
every field of production i.e. industry, agriculture, mining, fishery etc. In
Industry we find that this law applies also. The main idea is that if one of the
factors is kept constant and other factors are variable this law hold good. We
find an industrial unit which has been expanded becomes difficult to manage
and this leads to inefficiency and increase in the cost of production.
Activity B:
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Here we study the affect of long term changes in input and how output
responds in the long run to the changes in the scale of the firm, when all the
inputs are increased in the same proportion say by 10% and how does the
output change.
Here there are three possibilities.
a) If output increases by more than an increase inputs that increase in
output is more than 10%.It will be the case of increasing returns to
scale.
b) If output increases by less than the increase in inputs ,then it is the
case of decreasing return.
In the third case output may increase by exactly by the same proportion as
inputs that means doubling of inputs may lead to doubling of output. This is
case of constant return to scale.
Increasing return to scale is caused by indivisibities of fixed factors which are
of minimum size. The indivisibility of machine should be employed with the
level, size and capacity etc. of variable factors which are associated with the
fixed the fixed factors as more and more of variable factors are used along with
the fixed factors (Machine) it will give more return till the capacity of the
machine is fully utilized.
Decreasing Return starts when the fixed factors are fully utilized and any
further production by increasing variable factors will bring decreasing return.
This is due to difficulties in co-ordination and control.
Constant Return when the proportionate of input increases and the output
also increases in the same proportion, this is the case of constant return.
Here internal and external economies are balanced
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Graph 5.3
4.5 Summary
A production function gives the idea of inputs and outputs relationship. The
managers need to select various inputs, their combination and out puts with a
view to have minimum cost and maximum output. Selection of inputs-outputs
combination with minimum cost is the function of the manager.
Further the idea of law of diminishing marginal return gives the idea that, if one
factor of production is kept constant and other factors are variable, the output
will increase but at diminishing rate.
Similarly we have studied the relationship between total product, average
product, and marginal product. In law of variable proportion we studied three
stages of production. Stage I
Where MP>0 & MP>AP
Stage II where MP > 0 but MP < AP
Stage III where MP<0
Here stage II is desirable. The profit is maximized where the value of
MP=the price of output.
We have also given the idea of Return to Scale and about increasing return,
constant return and decreasing return.
4.6 Keywords
Average product: Total product ÷number of units of inputs.
Marginal product: The change in output resulting from a unit change in
one of the firm's variable input.
Total product: the firm's output for a given level of inputs used.
Short run period of time for which the one factor of production is variable
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UNIT 5
COST ANALYSIS
Learning Objectives
After going through this unit, you will be able to:
Learn various types of cost concepts used in cost analysis.
Learn various factors that determine cost.
Analysis relationship between the short term output and long term
output.
Learn about economies of scale and diseconomies of scale.
Learn the idea of Break Even point.
Structure
5.1 Introduction to coast analysis.
5.2 Cost concepts
5.2.1 Actual cost and opportunity cost.
5.2.2 Explicit and implicit cost.
5.2.3 Fixed and variable cost
5.2.4 Total cost, Average cost and marginal cost
5.2.5 Short run and long run cost.
5.2.6 Private and social cost.
5.3 Short run and long run output relation
5.4 Economies of scale.
5.4.1 Economies of scale. Internal economies and External economies of
scale
5.4.2 Diseconomies of scale - Internal diseconomies and external
diseconomies of scale
5.5 Concept of Break Even analysis
5.6 Summary
5.7 Keywords
5.1 Introduction
In unit no.4 we have already discussed with the idea of:
· Variable and fixed factor of production.
· Input and out- put relationship.
· The role of fixed and variable factors in the short run and in the long run.
In this unit we will explain various cost concepts and explain the relationship
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between cost of production and output. You will also learn about various cost
curves. Further you will learn about Break Even analysis.
The idea of cost of production is very important because he has to find out his
cost of production and the prevalent price of the product in the market so that
he can judge his profits.
5.2.1 Actual cost and Opportunity Cost.
Actual cost is the cost paid by the firm for labor, material, plant, building,
machinery, equipment, and transport etc. All these payments are recorded in
the account books of the firm. This concept comes under the accounting cost.
Opportunity cost. Opportunity cost is very important cost concept used in
business decisions. The opportunity cost is related to scarcity concept. It can
be explained as the return expected from second best use of the resources
which is forgone for availing the gains from the best use of the resources now.
For example a firm has to invest some amount. The firm has two option one
is to buy a printing machine costing Rs.20, 000/ or to buy a lathe machine
costing Rs.15, 000/-. If the firm decides to buy printing machine, the firm
loses the opportunity of buying lathe machine. Hence the opportunity cost
will be 20,000-15000=5000/- but this choice depends upon economic profit.
Investing in printing machine is preferable so long as it economic profit is
greater than zero. If the firm has the knowledge of economic rent of various
choices, there would not have been a problem but choice of the best
investment is a problem.
5.2.2 Explicit cost and implicit cost.
Explicit costs are those costs which are found in the books of accounts.
These costs are also called paid out cost or actual cost. The payments paid on
account of wages, salaries, raw material. Fees and taxes, interest, rent, power
charges etc.
Implicit cost These costs do not involve any cash payment and do not appear
in the accounting system. It can be defined as the earning of owner's resources
employed in the business in the form of capital investment, own premises used
for business, own services used in business instead of hiring a manager. So
these implicit costs include implicit wages, implicit rent, and implicit interest
etc. Implicit costs are not taken into account while calculating the profit or
losses of the business.
5.2.3 Fixed and variable cost
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Fixed costs are known as supplementary costs and indirect costs. These
costs are on volume for certain given output. Fixed costs are not variable with a
certain level of output. Fixed costs are
a) Managerial and administrative staff.
b) Depreciation of machinery, building and other fixed assets.
c) Costs on plant, building, land etc. And other fittings.
These costs are fixed for a short period. These costs have to be incurred even
if the plant is closed for a short period.
Variable costs
These are also known as prime costs, and direct costs. These costs vary with
production, so it is the function of output. Variable costs are:
a) Cost of Raw materials.
b) Direct labor costs.
c) Running cost of fixed capital assets such as fuel, oil, lubricants,
repairs, maintenance expenditure and all other input costs.
d) Taxes, indirect taxes such as excise duties, sales tax, value added
tax, octroi duty etc.
5.2.4 Total, Average and Marginal costs
Total cost: This cost includes all the values of resources used in production of
goods and services. All explicit and implicit costs are included i.e. include
labour cost, capital, land and opportunity cost, that means all variable cost and
fixed costs are included in the total cost.
Average cost: is obtained by dividing the total cost (TC) by the total output (Q)
i.e.
Average cost= TC/Q .
Marginal cost (MC) is the addition to the total cost on account of producing
one additional unit of a product. For example if to produce 10 units total cost is
100/- and if 11 unit is produced and the total cost is 109/- then the marginal
th
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society's point of view. Private costs are those which are actually incurred or
provided by an individual or by a firm for its business activities. Whereas social
costs are the total costs to the society which are incurred on account of
production of goods and services.
Some of the private costs are paid out or provided by the firm and other cost are
not paid by the firm but by the society The firms manufacturing paper and pulp
are discharging the affluent in the river. This causes water pollution It may also
cause air, and sound pollution the costs of which are paid by the society. It may
lead to health problems, and the society suffers Net social cost is total social
cost minus private cost.
Activity A:
b) In the short run Average cost and marginal cost are important to decide
the output.
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Col.2 gives the fixed cost since it is fixed for a short period.
Col.3 shows the total variable cost which goes on increasing as output
increases.
Col.4 shows the total costs that is col.2+col.3 i.e. total fixed cost+ total variable
cost.
Col.5 shows Average Fixed cost that is Col.2 ÷col.1. This cost goes on
decreasing as output increases.
Col.6 shows average variable cost that is col.3÷col.1.This cost goes on
declining in the beginning due to economies of scale and starts rising due to
diseconomies of scale. Here the AC cost is declining up to 4th unit of output
then it starts rising.
Col.7. shows average cost that is col.4 ÷col.1. Or add col.5, col.6. This cost
goes on declining till it reaches the minimum and then it starts rising. Here AC is
declining till 4th unit and then starts rising.
Col.8. Marginal Cost (MC) is the additional cost of one extra unit produced.
This cost is declining till 3rd unit of output and then it starts rising.
OUTPUT
Here T.F.C. remains constant for all units of output. When we want to
increase output we have to employ variable factors in the form of raw
materials, labor, and other consumable. When there is zero output total
variable cost is Zero. This cost increases with the increase in output. This
increase is not constant but in different proportions.
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Cost Curves
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of the firm are under - utilized. If the output is more than OQ then the firm is
over utilizing the plant.
Optimum output and cost curve
In the short run, optimum level of output is the one which can be provided at a
minimum Average cost, given the technology. The minimum level of AC is
determined by the point of intersection between Average Cost and Marginal
cost curves... At this level of output AC=MC
Here AC is the minimum. If production is less than this point or more than this
point the output will not be OPTIMAL
Here a point to be noted that optimum level of output is not necessarily the
Profitable output. In order to know the profit we should know firm's revenue
curves.
5.3.2 Long Run Cost Output Relation
The long run period is long enough to enable the firm to vary all its inputs i.e.
plant, machinery, equipments building and space. The firm is not tied to a
particular plant capacity. The firm can move from one plant capacity to another
plant capacity due to increase in demand of its product; similarly if the demand
persists the firm may put up another plant or expand the existing plant. In the
long run all costs are VARIABLE and no cost is fixed. Since new machinery,
plants can be added easily.
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In the fig. 5.3 above, AC1 curve has optimum point when the output is OM.
Further when output is increased the optimum point is Omi and here the AC
cost is lesser than that at OM because of economies of scale and at output Mii
here again AC is higher due to diseconomies of scale.
When all these minimum average costs curves of all the plants are joined
we can get LAC (LARGE RUN AVERAGE COST CURVE), as shown in fig,
below
Long term AC curve is also called ENVELOPE CURVE and planning curve. It
guides the firm for planning to expand for production in future. We can say that
long term AC CURVE is a series of plants AC curve plants which are installed to
increase production. Hence we have to study AC curve and MC curve for each
plant. In the fig SAC1, SC2, SC3 are short run Average cost curves at the
optimum level of out and by joining the optimum points of each plant we can
draw LAC curve.
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a) Explain short run average cost and marginal cost and discuss their
relationship.
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has to employ raw labour. Since input cost begins to rise the final product
becomes costly.
Difficulty in Decision Making: The firm cannot take quick decision because
of dynamic market conditions; any quick decision to be taken by the firm needs
consultation with the various departments which delays the decision, Hence
the firm may incur losses.
Increased Risk: When scale of production increases investment also
increases so also the risk of business. To bear greater risks it is an important
limitation to the expansion of the size of the firm. An error in judgment may
bring losses to the firm.
b. External Diseconomies
Labor Diseconomies: Extreme division of labor may result in lack of initiative
and drive in the executive personals. Hence a large firm has to adopt
bureaucratic way of administration. This leads to impersonal relationship
between management and labor. This situation may lead to grievances and
industrial unrest.
Scarcity of Supply of Factors of Production: With the expansion of
business and concentration of business in a locality there may be a shortage of
skilled labour force, shortage of raw material. This will increase the cost of
production.
Neglect of Individual Taste Due to mass production, individual taste is
ignored.
Possibility of Depression: Due to un-coordination among the various firms
regarding production, there may be over production .This may lead to
depression. Over production is one of the main causes of depression
Cut throat Competition : price war and increasing advertisement expenditure
will lead to increase in the cost of production and lower the profitability.
Dependence on Foreign Market; With the expansion of business the firms
have to depend upon the foreign market for raw materials and marketing of
their product .Any war or political disturbances in any country will affect the
business in our country.
Lack of Adaptability: It is the common complaint about big business house
that they find it difficult to adapt with the new situation
output. The breakeven point is located at that level of output or sales at which
the net income or profit is ZERO. Here the total cost = total revenue and there is
no profit. BEA traces relationship between cost, revenue and profit at varying
level of output
TC=TR
So at B.E.P. is the point where the level of output and the level of revenue is
equal to the cost of production and marketing.
Fig BEP
In the fig. above if a firm produces less than OQ it will incur losses because the
cost will be higher than the revenue. In case the firm produces OQ quantity
here at point B, the cost and the revenue are equal and if production is
continued then the firm starts making profit. Every firm desires to reach BEP at
its earliest so that it can start making profit
BEP=TFC÷(P-AVC)
=Total Fixed cost/ price-Average variable cost.
P-avc= contribution margin per unit
Example
a) Fixed cost=Rs20,000/-; Variable cost= Rs.4/- per unit : selling
price=Rs8/- per unit
So BEP = 20000/8-4=5000 units
So the total cost is FC=20000/- + V.C 4×5000=20000 so the total cost
is Rs.40,000/-
Total Revenue = 8×5ooo=Rs.40,000/-
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Activity C:
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c) The study of Break Even point is necessary for every business man.
Discuss
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5.6 Summary
a) The concepts of various costs are made clear since these concepts are
very useful in managerial economics and firm's decision making.
b) The ideas of total cost, average cost, marginal cost, average fixed cost, and
average variable cost are made clear.
c) Further we have explained how these cost curves are interrelated. We have
discussed the concept of marginal cost and average cost and their
importance in decision making.
d) The idea of short run and long run cost is made clear with the help of figs
and tables.
e) Economies of scale and diseconomies of scale are explained in details and
how these affect the cost of production.
f) Finally you have learnt the idea of break even analysis. Every firm is
desirous to reach the BEP at earliest. After breakeven point the firm starts
making profits. And till BEP the firm is not making any profit
5.7 Keywords
AFC - Fixed cost per unit of output.
A.T.C. - (AC or ATC) Total cost per unit of output.
AVC - Variable cost per unit of output.
Economies of scale - The reduction in unit cost as the firm increase its
capacity. It is long run phenomena.
Economies of scope - The reduction in cost resulting from the joint
production or two or more products or services by the same firm.
Diseconomies of scale- As the firm increases its capacity the
management cannot exercise the same supervision or control and it
reduces coordination among various departments
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Historical cost - The cost which has been incurred in the past activity.
Marginal cost (MC) - The cost to a firm of producing an additional unit of an
output.
Opportunity cost - The amount or subjective value foregone in choosing
one activity over the next best alternative.
Total cost - Total cost includes total variable cost + total fixed cost.
Total fixed cost - The cost that remains constant as the level of output
varies. It is short run analysis. Fixed cost is incurred even if the firm
produces no output.
Break Even analysis - It indicates the level of output and sales at
which cost and revenue are equilibrium.
Breakeven point - It is the point of zero profit.
Margin of safety - The excess of budgeted or actual sales over the
breakeven point.
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UNIT 6
SUPPLY ANALYSIS
Learning Objectives
After going through this unit, you will be able to:
Learn the meaning of supply of various goods and services and the
meaning of stock.
Learn the law of supply and its exceptions.
Learn about the shift in the supply curve.
Explain the idea of elasticity of supply.
Structure
6.1 Introduction
6.2 Stock and supply
6.3 Determinant of supply
6.4 Law of supply & exception to the law of supply
6.4.1 Meaning of supply
6.4.2 Law of supply
6.4.3 Exceptions to the law of supply
6.5 Shift in the supply curve
6.6 Elasticity of supply .
6.6.1 Elastic Supply.
6.6.2 Inelastic supply.
6.6.3. Measurement of elasticity of supply
6.7 Summary
6.8 Keywords
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The supply of goods is the quantity offered for sale, in a given market at a given
time at various prices. So it is defined as the amount of that commodity which
the sellers are able and willing to offer for sale at a particular price during
certain period of time.
Supply is relative term. It is referred to in relation to price and time.
Stock is the total of supply of a commodity which the seller is prepared to sell if
price is up to his expectation. If price offered is less the seller's expectation he
would bring a little of the supply. So stock is the determinant of supply and
stock is known as potential supply.
· Supply comes out of stock.
· Stock determines the potential supply.
Stock is the outcome of production. By increasing production the stock
can be increased as well as the potential supply will increase.
For example Mr. X gets 50 ltrs of milk from his cow. The price is Rs.30 a liter. He
takes out only 30 liter of milk to supply. One day he finds that the price of milk
has gone up to Rs.40/- per liter. He sells the whole stock of 50 liter of milk that
day. So we can say when the price was less he supplied only 30 liter of his
stock but when he got good price he brought the whole stock in the market.
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example where it has become necessary in life of man and cost has gone
down and supply has increased.
Tax & subsidy. Here the government plays an important role. Tax on a
commodity will increase the cost of production. Hence the supply will be
reduced. Similarly subsidy provided by the govt. will give incentive to the
producer. This will reduce the price and will increase supply.
Factors other the economic factors will also affect the supply. For example
weather condition, flood, drought, war and disturbance due to political
reasons will affect the supply of goods and services.
Transportation and communication. Development of transport and
communication system will increase the supplies of goods and services.
Any breakdown in transport system will reduce the supply. Industry
depends upon raw material which is brought from other parts of the country
and different part of the world.
Scale of production. If large scale production method is adopted it will
increase the supply and the cost will less. If small scale production method
is adopted then the cost will be more and supply less .Multinational
companies can provide goods and services at lower cost with ample
supply because these are operating on a very large scale.
Mobility of factors of production. If factors of production are free mobile it
will increase the supply of goods and services.
Goals of the firm also affect the supply of goods and services.
6.4.1 The law of supply gives the idea of the tendency of the sellers in offering
their stock of a commodity for sale in relation to change in prices. Supply is a
relative term of price and time. If the price is higher supply will increase. If
price is less supply will be less.
6.4.2 “other things remaining unchanged, the supply of a commodity
expands (rises) with a rise in it price and contracts (falls) with a fall in price.”
It means supply of a product will increase when the price rises and it falls when
the price falls. So supply varies directly with the changes in price. So a larger
amount is supplied at a higher price than at a lower price in the market. So
supply is the function of price.
SS=f (p) and supply varies directly with price
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f. Goods on auctions
g. Supply of labor as wages go higher and higher.
Activity A:
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Shift in the supply curve is due to price but other factors such as development
of new methods of production, govt. policy which relaxes the norms and tariffs
if Shift can be on the right side of the curve or on the left side of the curve. If the
shift is on the right side it is called increased in supply and if the shift is on the
left side of the curve it is called decrease in supply
Graph 6.2
Graph.6.3
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Es=0 When the price is not affecting the supply, where there is no possibility to
increase the supply such is the case with rare articles, old paintings etc. There
is no supply price for these goods.
Es<1 this is inelastic supply. In this case the changes in price increase or
decrease will affect the supply but the effect will be very small.
Es>1 Elastic supply and elasticity is greater than one. Here if the price falls
supply will decrease much and if price raises supply will increase very
much.
Es= ∞ it means price has no effect on the supply of the product.The supplier
is prepared to supply any quantity of the commodity on the prevailing price.
Activity B:
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6.7 Summary
You have learnt the difference between stock and supply. The meaning of
supply is, the quality that is offered at a given time and at a given price. You also
have learnt the law of supply. The law of supply tells you that a fall or rise in
price of a product will leads to fall or rise in the supply of goods and services.
Supply varies with price.
Further we have explained the exceptions to the law of supply. You have learnt
various factors which affect the supply of a commodity. Elasticity of supply
reflects the response of the supplier with a given rise or fall in supply and with a
given rise and fall in price.
We have also given the idea of measurement of elasticity of supply.
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6.8 Keywords
Supply: Means the quantity of goods which are offered for sale at a given
price and at a given time.
Stock: Potential supply of a commodity.
MNC: Multinational companies which deals in many countries with huge
investments
Tax: Compulsory contribution made by the residents of a country to the
govt. to meet the cost of running the govt.
Subsidy: It is the assistance given by the govt. to economic sector,
agriculture sector or poor section of the society.
Elastic supply: When supply is very responsive to the change in price.
Inelastic supply: when supply is less or least responsive to price.
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UNIT 7
PRICING PRACTICES
Learning Objectives
After going through this unit, you will be able to:
State the basis of pricing of different goods and services and
different methods of pricing
Define various pricing strategy followed by businessmen
Identify various pricing systems which are involve to fix the price of
a product
State the effects on pricing decision of a firm
Explain commonly used pricing methods in practice though devoid
of pricing theory but has an economic reason behind it.
Structure
7.1 Introduction
7.2 Factors involved in pricing policy
7.2.1 Concept of marginal cost prices
7.2.2 Cost plus pricing
7.2.3 Price leadership
7.2.4 Price skimming
7.2.5 Administrative prices
7.3 Summary
7.4 Keywords
7.1 Introduction
Pricing – In previous unit 7 you have learned about the market structure i.e.
firm and industry. How a firm and industry are in-equilibrium. You have also
learned the difference features of each market and how much they should
produce and at what price they sell to maximize their profits. Deciding pricing
policies is the most important role of managerial decision making. The firm has
to consider the cost of production, selling cost, production schedule, and
quality of the product.
In this unit how the prices of a product are fixed and what is the different
deciding factor which helps in pricing policy of a product. Pricing policy plays
the most important role of managerial decision making. The pricing have very
important role in the distribution of income in the society. The firm has to
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7.3.1 Marginal Cost is the increment cost of production of an extra unit. The
firm should charge price which is equal to marginal cost. Marginal cost is
based on only variable cost. It is short term cost. Marginal cost concept is an
economics study but in business it is known as incremental cost. Marginal
cost can easily give us the idea of shut down point. The shut down point is
when the plan fails to cover even the average variable cost (AVC) and the price
is lower than average variable cost. In short period AVC may be above the
price. But in the long run (Average fixed cost) AFC + AVC have to be covered
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otherwise the unit will have to be shut down permanently If firms follow the
marginal cost pricing it can put the firm in losses. So this is only a short term
concept when the price in the market is falling, but the price should be above
marginal cost otherwise the firm will have to be shut down.
If we study marginal cost pricing further we find that –
a) Marginal cost pricing is useful over the life cycle of the product
b) The firm having multi products, multi process, multi market firms, the
idea is full cost pricing which is absurd because different market,
different product, different process do not have equal input on the cost.
Marginal cost pricing has some limitation –
a) Increment cost pricing is useful for a short period and it can be used on
temporary basis
b) It does not guarantee that a firm will operate at breakeven point.
c) Sometime managers do not know marginal cost method of pricing.
But in spite of its limitation it can be used as under:
a) when a product is introduced in the new market
b) Firm facing stiff competition in the market
c) The firm has unutilized capacity. Mostly this method is used in
transport business by selling vacant seats at lower price in the
airlines.
7.2.2 Cost Plus pricing
It is called cost plus pricing or mark up pricing. . It includes total cost + selling
cost + some percentage of profit is added to the cost. It consists of variable
cost, fixed cost, fixed selling cost, administrative cost plus some added
percentage of profit. That will be price of the product –
Example
Fixed cost 20,000/-
Variable cost 30,000/-
Output 5000 units
Add 15% profit
So A.F.C = 20,000 divide 5000 = 4/=
A.V.C. = 30000 divide 5000 = 6/=
A.T.C= 4+6=10
Mark up price at 15% profit = 10 x 15% = 1.5
Mark up price=10.00 + 1.50 = 11.50
But this system has some draw back that is-
a) Market demand is not considered
b) Competitive forces are not considered
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Penetration Pricing –
If a firm wants to introduce a new product, the initial price of the product is kept
low to capture the market. There are some preconditions in the use of
penetration pricing:
(1) The market should be highly price sensitive and have high price
elasticity.
(2) Economics of scale, distribution; and ratio of variable cost to fixed cost
are low
(3) Low prices are likely to discourage competitors
(4) It should increase demand
(5) There is a heavy demand of the product
(6) The buyers are ready to pay higher price for the product
But this may lead to losses in the long run if continued for a long period.
Hence it is short term measure only.
7.2.3 Pricing leadership –
Price leadership is a situation where one firm is recognized as the leader of the
industry and all the other manufacturers follow and accept its pricing policy.
When one of the firms is very big, strong, has excellent brand image and have
very good sales. This industry will be the price leader. For example TISCO in
steel, Kellogg in cereals, Cadbury in chocolate, Hindustan lever in soap
industry etc are the price leader. This situation happens under oligopoly where
every firm is interdependent. So every firm has to follow the leader as these
firms are small. Every firm will keep an eye on the production and pricing policy
of the others.
7.2.4 Pricing skimming
Under this the price is fixed on the higher side and demand increases. But
before this policy is adopted it has to find out the large segment of people who
are having inelastic demand for the product and who are not sensitive to higher
prices. The products have low price elasticity of demand.
Secondly the unit cost relatively is unaffected by small volume of high ratio of
variable cost and fixed cost.
As the prices are high it is unlikely to attract competition. This enhances the
image of the product.
Here the example of mobile phone is suitable. In 1995 when mobile phone was
introduced in India the price was very high i.e. Rs 16/- for a call.
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7.3 Summary
In this unit we have learnt the practical way of pricing of a product. The people,
who have no knowledge, try to fix the prices by rules of thumb. This practice is
based on the consideration of cost only and other related factors are not
considered such as demand condition or market competitiveness or some
other economic factors.
1. Cost plus pricing is very popular and based on full cost + some
percentage of profit. So the price includes AVC + AFC + net profit
margin.
2. Margin cost which is also accepted as incremental cost is used for
pricing. It considers variable cost and is able to give the idea of shut
down point when the unit is not able to recover its variable cost
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7.4 Keywords
Cost Plus Pricing - Here prices are calculated with the help of cost
(fixed+ variable + other cost) and mark up the price.
Penetration Pricing – Here a firm charges a lower price than that
indicated by economic analysis. The main aim is to enter the market.
Price skimming - When for a new product the firm charges a price higher
than that indicated by economic analysis.
Price leadership – One firm is recognized as the leader and all other firms
follow. It generally happens under oligopoly. The example is Cadbury in
chocolate . This firm fixes the price and other small units follow that
price
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UNIT 8
Learning Objectives
After going through this unit, you will be able to:
Define plant, firm and industry
Explain the objectives of the firm
State about price determination in a free competitive market
State about the market structure
Explain the main features of pure and perfect competition,monopoly,
monopolistic competition, Duopoly and oligopoly
Enumerate how equilibrium is achieved in each type of market i.e.
determination of output and cost / price
Structure
8.1 Introduction
8.2 What do you mean by plant, firm and industry?
8.2.1 Objectives of the firm
8.3 Price determination in the free market
8.3.1 Concept of equilibrium
8.3.2 Determination of equilibrium
8.3.3 Shift in the demand and supply curves
8.4 Types of Market
8.4.1 Pure and perfect competition and its features.
8.4.1 (i) equilibrium of a firm and industry under perfect competition
8.4.2 Monopoly and its features
8.4.2 (i) Equilibrium under Monopoly
8.4.2. (ii) Discrimination under monopoly
8.4.3 Monopolistic competition and its features
8.4.3 (i) Equilibrium under monopolistic competition of a firm and industry
8.4.4 Duopoly, oligopoly and their features.
8.5 Summary
8.6 Keywords
8.1 Introduction
Under Unit No. 6 we have given you the basic idea of different cost concepts,
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and how costs will behave in the short run and in the long run. The break even
analysis will give you the idea when a unit can start making profit and how
much to produce to reach that point at the earliest. In this unit we are going to
study the theory of the firm i.e. firm's decision analysis Behavior under different
market conditions such as perfect competition, Monopoly Monopolistic
competition and oligopoly .The behavior of the firms depends upon its
objectives. We shall also study how price is determined in the free market and
the role of demand and supply in determining the price of a product. Any
change in demand and supply has its effects on the price of the product is also
explained.
We also will study about perfect competitive monopoly, monopolistic
competition, Duopoly and oligopoly and their main features of these markets.
Equilibrium conditions under different markets conditions will give the idea of
output and price determination.
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In the table one price is 100/- for a shift quantity demanded is 80,000 shirts but
supply is only 10,000 shirts. So there is a shortage of shirts. When price is
400/- the demand is 10,000 but supply is 80,000. This will create surplus in the
supply. But there is only one price i.e. Rs. 200/- where quantity supplied and
quantity demanded are equal i.e. 40,000 shirts. At all other prices either the
demand is more than supply or supply is more than demand. So there is
always a pressure either from supply side or from demand side to move
towards equilibrium price.
In the graph the equilibrium price is Rs. 200/- and quantity demanded and
quantity supplied is 40,000 shirts. When the price is Rs. 100/- demand is
80,000 but supply is 10,000 shirts. When the price is Rs. 400/- the demand is
10,000 shirts but supply is 80,000.
8.3.1 Shift in Demand and Supply Census and the Market
Any shift in the demand and supply curves in going to affect the price of a
commodity. If demand curve shifts to the right it is increase in demand and if it
shifts to the left it is decrease in demand. Similarly if the supply curve shifts to
the right it is increase in supply and if supply curve shifts to the left it means a
decrease in supply. In the graph 7.2 we have kept the supply curve constant
equilibrium price is OP and quantity is OQ and the demand curve is moved to
the right. Since the demand has increased the price has risen to OP' and
quantity to OQ'. Secondly, the demand curve moves to the left the price has
fallen to OP'' and quantity to OQ''
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Graph 8.2
Graph 8.2
In Graph 7.3, the demand curve is kept constant but supply curve is shifting to
the right and the left. The equilibrium is OP price and quantity is OQ and now
the curve is shifted to the right increasing the quantity supplied from OQ
quantity to OQ' The equilibrium price after the shift of the curve is OP'. The
price has fallen to OP'. Now the supply is reduced to OQ” and the price has
risen to OP''.
So here the shift of demand and supply curves affects the price in the market.
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Activity A:
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Market structure
The table above gives the picture of the structure of market such as Perfect
competition, monopolistic competition, oligopoly and monopoly.
Now we shall study their features.
8.4.1 Pure and perfect competition and its features.
Under perfect competition there are large number of buyers and sellers and no
one can influence the price. The price is determined by the forces of demand
of a product and the supply of that product. The firm is a price taker and has to
adjust itself as per the market price.
Perfect competition has the following special features:
a. Large number of buyers and sellers (firms) so no one can influence the
price.
b. Free entry and exit. Anybody can enter the business and anybody can
leave the business
c. No Government interference
d. Homogenous products
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e. Every buyer and seller is a price taker and not a price maker
f. Perfect knowledge of the market
g. No cost of transport
h. All factors of production are freely mobile
i. Automatic price mechanism because the price of a product is determined by
the forces of demand and supply.
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In the graph price is given as OP and from P horizontal line is drawn which
shows that any quantity of good can be sold at that price hence Price = AC =
MR because any increase in the sale of extra unit will bring the same price.
Then the cost curves are short term average cost curve and short term
Marginal cost curve.
It also explains that a firm will maximize profit where MC = MR. In the figs MC
and MR are equal at point E. This indicates that the output should be OQ and
price will be OP. Price has already been determined by the market forces of
demand and supply. Hence OP price is given as market price and MC = MR,
determines the output. A perpendicular is drawn to touch the X axis. Hence
The Revenue = Price x quantity. OP x OQ = OQEP.
Cost = AC x quantity OC x OQ = OQAC
Profit = AE OC. At output OQ and cost CP, the profit is CP x OQ and the
profit is PCAE.
So we find that the market price is determined by the forces of demand and
supply which is given under the condition of perfect competition. Now the aim
is to know how much output should be done to get maximum profit. In graph 8.4
the firm is getting abnormal profit since there is no restriction on entry and exit;
many firms will enter the business. This will increase the cost because the
suppliers of raw materials will raise their prices of raw materials and other
inputs. Further the new firms will increase the output. This will lead to
reduction in prices because of increase in supply. Now there will be losses to
the firm and they may decide to quit or leave the business.
Graph 8.5
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In Graph 8.5 the loss is PBAC, hence many firms will decide to exit the
business because the output is OQ and the loss per unit is PC hence the loss
will compel them to leave the business. Now the final stage is when no firm
would like to quit or no firm is going to enter the business and the situation will
be when the firm is making normal profit. This will be the equilibrium of the firm
in short run
Graph 8.6
In graph 8.6 the market price is OP and quantity of output is OQ. In this way the
firm is making normal profit and is in equilibrium. Hence a firm is in equilibrium
under perfect competition and when
MC = MR = AR = AR and this condition is fulfilled.
However, a firm will be shut down if the price in the market is lower than
Average Variable Cost (A.C.)
8.4.1 (iii) Long run equilibrium of firm & industry
In the long run every firm gets sufficient time to adjust its output in relation to
demand. New machinery, new techniques of production are available and the
firm can change the composition of various inputs for production.
In short run MR = MC is the equilibrium position. It is also applicable in the
long run. Hence MR, MC; AC & AR = Price. If he price is more than the
average cost, the firm can earn super normal profit. So it will attract entry of
more firms, more output and reduction in normal profit.
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Graph 8.7
When all the firms are in equilibrium, the industry as a whole is in equilibrium.
Equilibrium of the industry is determined by total demand, and total supply.
The price is determined by total demand and total supply. Hence it is
necessary that size of production should be stabilized at a certain point and
when ideal size of output is achieved and there is no temptation for new firms to
enter the industry and there is no reason to exit from the industry. The output is
stabilized at the optimum point marginal cost is equal to Marginal Revenue and
the firm would earn only normal profit. Hence the industry is in equilibrium.
The equilibrium also in the long run is, when MC = MR = AR = AC so there is a
need to fulfill these four conditions.
Activity B:
a) under perfect competition the seller is a price taker and not the price
maker
_________________________________________________________
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_________________________________________________________
_________________________________________________________
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_________________________________________________________
b) Discuss the condition of equilibrium under perfect competition.
_________________________________________________________
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Kind of monopoly
The emergence or survival of a Monopoly is due to the fact which prevents the
entry of other firm into the industry. The barriers to entry of other firms are a
main source of monopoly power. These barriers are as follow:
a) Legal restriction. These are controlled by the Govt. for the welfare of the
people. Public utilities are public monopolies. Public utilities are Railway,
Transport system, water supply, electricity generation and distribution, Post
and telegraph, Telephone roadways etc.
b) The state may grant monopoly power to the private sector by granting them
the permission and not allowing other firms to enter.
c) Control over key raw material. Some firms have traditional control of
some resources and key raw material. These raw materials are based on
production of different goods such as bauxite, graphite, diamond. These
monopolies also emerge because of monopoly over certain specific
knowledge or technique of product.
d) Patent right and copy right. These are monopoly because of a production
process. The firms have exclusive rights to produce the specified commodity,
copy rights are given to the writer or music composer, inventors and innovators
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so that they have the monopoly and enjoy the fruit of their labor.
8.4.2(i) Equilibrium under Monopoly
Marginal cost and Marginal Revenue- Under monopoly the firm is a price
maker. So the firm can fix the price of the product. The demand curve (AR
curve) is therefore downward sloping and so the Marginal Revenue curve is
below the AR curve, because downward sloping curve shows the application
of law of demand.
Graph 8.8
A monopolist can make either normal profits or super normal profit in the short
run. A monopolist making sub normal profit will remain in production in the
short run so long as its AVC is covered.
Graph 8.9
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In the Graph 8.9 Marginal cost and Marginal Revenue equal at point E. Thus
the point of equilibrium, the output is OM and the price is OP. AR = P'M Here
AC < AR and the firm makes a super normal profit. That is PTLP'. Here the
price is OP and the cost per unit is OT so the monopolist earns a profit of PT on
every unit of sale.
There is always a fear that the Govt. may intervene and control the price or may
nationalize the unit or the people may boycott the product. Hence the govt.
gets the chance to intervene.
During sub normal profit the firm may continue to produce because AVC is less
than the AR but if AVC is continue to be higher than AR the monopolist may
continue for some time but ultimately it may shut down.
In the long run the firm will be in equilibrium when MC = MR. These are the
basic conditions of the equilibrium. In the long run LRAC is flatter than the
short run average cost curve but conditions are the same i.e. MR = MC.
Graph 8.10
b) If the market is divided into sub market, the elastically of demand must
be different in each sub market.
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P’ P
MC
P
P”
E
E’ E” AR” CMR
In Graph 3 the point of equilibrium where MC = MR, OM is the total output of the
firm. This is to be sold in two markets. In market B, E'' is the equilibrium where
MC = MR, OM” is the output of price is OP”
In market A, E is the equilibrium where MC = MR' and output OM' and
1
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ignorance of the market. Many similar products having different brand name
are sold at different prices. Every producer enjoys the freedom to price his own
products but still he has to depend upon the other producers to decide his
policy regarding production and pricing.
d) Price war is common in order to extinguish the rival from the market. This
is done by reducing the prices to attract the new customers. The other
producers also follow and reduce their prices of their product. This lead to a
price war.
e) Gift articles. In this the producer instead of reducing the price offers some
different kinds of gifts to the customers. Tooth paste companies may offer free
tooth brushes along with tooth paste.
f) Unfair practices.
I. By snatching away good and skilled worker from the rival's company is very
common.
ii. Bribing the trade union leaders who control the rival's workers union to
interfere in rival company.
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Graph 8.13
In this graph Average Cost curve is higher than the Average Revenue curve.
Hence the firm is making losses. The equilibrium value MR & MC is at point E
and output is OM but cost per unit is OQ, so the producer is making a loss of RQ
x OM =QRSP, hence some firms will go out of business.
Long run equilibrium under Monopolistic Competition
Super normal profit has attracted many new firms to enter the business, but
sub-normal profit has made them to leave the business. Hence a situation has
come where no new firm is likely to enter the business and no old firm is going
to leave the business. All the firms are making normal profit in the long run.
Since there are a number of substitutes so the Marginal Revenue curve is
elastic.
Graph 8.14
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In this Graph, long run Average Cost output touches the Long Run Average
Revenue curve at point P. The equilibrium is at Point E where LMR and LMC
are in equilibrium and equilibrium output is OM which is ideal and the firm is
making normal profit at the price OP.
No firm would like to enter the business and no firm will leave the business.
Disadvantage of Monopolistic Competition
1. Heavy expenditure on advertisement and other selling expenses.
2. Creating artificial or imaginary difference between the products.
Product differentiation is achieved with the help of advertisement cost.
3. There is a possibility of increasing expenditure on cross transportation
of a product when Delhi seller sells its product in Pune and Pune seller
sells his product in Delhi causing a lot of expenditure on transport.
4. Inefficient firms may also continue to be in the business on the strength
of their product differentiation.
5. It creates excess capacity. The main manufacture can product all the
parts but his competitors may make his machine idle creating idle
capacity.
6. The Average cost is higher under Monopolistic competition.
oligopoly.
Features of oligopoly
· Few sellers – producing homogenous or differentiated products.
· Interdependence. The firms are interdependent regarding their
policy of output and pricing.
· High cross elasticity. So there is a fear of retaliation by rivals
because each product can be substituted.
· Advertisement. Selling cost is very high and is on advertisements
publicity etc.
· Constant struggle. Among the various producers to expand the
market and increase their share in the market.
· Price rigidity. Each firm sticks to its price nobody reduces its price.
· Kinked demand curve of their product.
Barrier to entry due to economy of scale of production, absolute cost
advantages to old firms, patent right and licensing and other barriers.
Graph 8.15
Kinked demand curve or the Average Revenue curve has two segments (i) The
relatively elastic demand curve & (ii) Relatively inelastic demand cure as
shown in the Graph. At price OP, there is Kink at point K on the demand
segment. Here the kink implies an abrupt change in the slope of demand
curve. Before the Kink past, the demand curve is flatter and after the kink it
becomes steeper.
If the seller increases the price of his product he may lose his customers since
no other seller will raise the price of his product. If a seller reduces his price of
the product, the other sellers may follow suit and reduces the price of their
product which may not increase the sale of the original seller.
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8.5 Summary
In the beginning of this unit, we have studied the meaning of plant, firm and
industry and the main objectives of a firm are also studied. The objectives are
conflicting in nature. How price is determined in a free market by the forces of
demand and supply. How a shift in demand curves and supply curves affects
the price in the market. The study of the structure of market is taken and how
market will be in equilibrium. The price has been determined by the free
market but the output is determined under the conditions, when Marginal Cost
= Marginal Revenue. This equilibrium point shows maximum profit or
minimum losses. The market is further classified as perfect market and
imperfect market. In perfect market we have discussed various features and
how the price and output is determined under perfect market. Under perfect
competition a firm has to be price taker which is determined by the market
force. In the short run a firm is in equilibrium when MC = MR cost in the long
run. The industry is in equilibrium when AR = MR = LAC = LMC. This condition
gives only normal profit. Also discussion is done when a firm has to be
shutdown the business. This situation comes when AVC is higher than the
market price so a firm has to shut down. Then a study of monopoly is done
along with its features and how a monopolist will earn maximum profit and how
a monopolist firm will be in equilibrium. Under what circumstances a
monopolist charges different price from different people and in different market
which is also known as price discrimination. The idea of degree of
discrimination is also given.
Then the idea of monopolistic competition is given with its features especially
product differentiation and selling cost. How the firm and industry will be in
equilibrium is also made clear.
Then the study of duopoly and oligopoly is taken up with its main features and
Kinky demand curve and rigidity of price. How this type of market is prevalent
in the developed countries. Most of the business is being run under oligopoly
condition. The examples are Pizza Hut, McDowall, Pepsi and Coco cola.
8.6 Keywords
Equilibrium Price. The price at which the quantity demanded by
consumers of a product, is equal to the quantity supplied by sellers of a
product.
Monopoly. Existence of one firm only. There is a complete barrier to
entry into the industry.
Normal Profit. The rate of profit just sufficient under condition of free
entry to keep the firms from leaving a given industry in the long run.
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Price taker. Firms that cannot influence the market price and is under
the condition of perfect competition.
Price discrimination. Changing different prices for the same product from
different consumers in different market based on elasticity of demand.
Profit Maximization Rule. Produce up to the point where Marginal
Revenue is equal to Margin cost.
Shut down point. When the firm is considering to stop production when
the Average variable cost is higher than the market price.
Cartel. A group of firms that have joined together to make agreement on
pricing and market strategy.
Duopoly. Where there is large number of buyers but two sellers.
Kinked demand curve. Graphical representations of a situation wherein
rival firms do not follow the price increase of a firm but follow price cut.
This curve is more elastic for prices alone, but less elastic for prices below
the going price.
Oligopoly. Where a few dominant firms in an industry, having barrier to
entry.
Product differentiation. A wide variety of activities such as design
changes, advertising that rival firms employ to attract customers by
showing their product as different product.
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UNIT 9
PROFIT MANAGEMENT
Learning Objectives
After going through this unit, you will be able to:
State the meaning of profit and its role in the economy
Explain the different kinds of profit
Discuss on measurement of profit
Describe different policy regarding profit
State the meaning of reasonable profit
Learn to know the standard of reasonable profit.
Structure
9.1 Introduction
9.2 Meaning of Profit
9.2.1 Kinds of profits
9.2.2 Role of Profit in the economy
9.2.3 Economic Profit and Accounting Profit
9.2.4 Gross profit and pure (Net) profit
9.3 Measurement of Profit
9.3.1 Economic concept of the net profit
9.3.2 Modern Method
1. Depreciation
2. Inventories
9.4 Profit Policy
9.4(a) Profit expectation
9.4 (b) External factors
9.5 Reasonable Profit target
9.6 Standard of reasonable profit
9.6.1 Setting the profit standard
9.7 Summary
9.8 Keywords
9.1 Introduction
In Unit No. 10 you are given the idea of failure of the working of the private free
economy in controlling inflation, recession and depression and many other
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c) Windfall profit – This profit arises due to changes in the general price level
in the market. Suppose he buys the inputs when the prices are low and sell his
output when the prices are high. He earns a windfall profit. Sometime back
the prices of petrol were raised by Rs.5/- per liter, the sellers earned a windfall
profit.
The windfall profit just happens it is not planned.
9.2.2 Role of Profit in the economy
The major function of profit in an economy is enhancing the production in the
economy. Higher level of profit means higher investment, higher personal
involvement, higher employment opportunities in the economy, higher
purchasing power of the people. All these will lead to higher economic
activities in the economy. Low profit will have reverse effects on the economy.
We know that for production more investment is necessary. For investment
profit is necessary. Higher the profit, higher will be the investment. Profit
guides to direct resources to those sector, where they are more productive. So
profits are the incentive to use resource efficiently and to produce the goods
and services which are required by the society.
Adam Smith has said, “The pursuit of profit is the invisible hand that guides all
market participants to produce and consume what society needs.”
The expenditure on Research and Development also depend upon higher
Profit, so higher profit will lead to the use of higher, sophisticated technology
along with dynamic efficiency.
Profit plays a very important role in some industries like exploration of oil, gas
and car industry.
When we analyze the role of profit, weightage needs to be given not to the
amount of profits but to the use to which the earned profits are employed.
9.2.3 Economic Profit and Accounting Profit
Profit means different things to different people, i.e. Businessman,
accountant, tax collector, workers and economists.
For Accountant – Profit means excess of revenue over all paid cash including
manufacturing cost and overheads.
Profit for businessman – It is business income plus non allowable expenses.
Economic Profit, Profit over and above opportunity cost
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Activity I:
a) Economic Profit
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b) Accounting profit
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The original value of machine minus depreciation will give its value for the
remaining period. For example if a machine is costing Rs.20,000/- and the life
of the machine is 1000 hrs. The depreciation per hour will be 20000÷1000 =
20/- per hour
If machine worked for 10 hours a day and 25 days a month then depreciation
would be - Daily 10 x 20 = 200/- x 25 days = 5,000/-
So after a month the depreciation will be Rs.5,000/- and the net value of the
machine shall be Rs. 15,000/-.
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Activity II:
a) Need of Inventories
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b) Depreciation for the development and growth of an economy
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Earning maximum profit is one of the main objectives of a firm. But how much
profit is to earn is a big question mark before the businessman. The
entrepreneur has to decide the ratio of profit which depends upon the nature of
the market and other constraints including legal, statutory provisions, business
convention, and consumers' resistance.
Maximization of profit is the objective of every firm but we manage the factors
of production which produce profit rather than managing profitability directly.
Proactive profit management allows you to know the effects in profitability of
different resources allocated before you make a decision as to which resource
to use and when it is to be used. Since business environments are variable
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and are changing constantly, so you have to decide how essential scarce
resources be consistently reallocated to the most profitable activities.The
profitability has been affected by internal factors and external factors. Internal
factors profit is expressed as gross profit and net profit or as percentage return
to the capital invested. Now this norm has been accepted in the form of
percentage net return to capital.
9.4 (a) Profit expectation- Generally the investor expects some profit from
his investment. These expectations are subject to the following conditions –
(I) The rate of profit should be sufficient to attract share capital, if necessary.
So the rate of profit should be good enough to command a good price for the
new issue of shares.
(ii) Profit should be comparable to that in similar companies.
(iii) The rate of profit should be comparable to their rate of profit in the past.
(iv)He profit should be large enough to plough back for the expansion of
business.
9.4 (b) External factors are required to be considered because these factors
do affect the profit. Following are some of the important external factors which
affect profit –
(I) Full employment. When a firm is working at full employment level and the
relation between management and workers are cordial. It will increase profit of
the firm. But if the firm's profit is very high, it may create unrest among the
workers and they would like to demand some share in extra profit, if not given
this will create conflict and may reduce profit.
(ii) Potential Rivals. If there is excessive profit this may encourage new
entrants and rivals may emerge. This will wipe out profit. So there is a need to
control profit.
(iii) Consumer's confidence. Consumers' confidence and satisfaction is
very important for profit. If unreasonable prices are charged the consumer
may lose confidence in the firm and may shift to other firm's product. So in
order to keep the consumer satisfied it is necessary that reasonable profit
should be expected by the firm and the consumer have confidence in the
product.
(iv) Political climate. Peace, law and order, strong government is necessary
elements for profit. Any change in political climate may affect the profit.
Government is a big customer along with the public sector's purchasing it can
affect the profitability of the firm. Further Govt. interference is common if it
finds that a firm is making abnormal profit. Policy of taxes, subsidy and
incentives of the Govt. also affect profit of a firm.
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Now it has become more practical to look for reasonable profit. The question
arises why to go for a reasonable profit and the way how to determine it
because of the following reasons –
(1) To prevent entry of the competitors especially applicable in a weak
monopoly.
(2) It will help to project a favorable image and it will not attract the Govt.
attention.
(3) It will help to restrain trade union demands for higher wages. If a unit is
making larger profit the workers, if do not get some share in profits, will
feel exploited and will demand higher wages and this will cause labor
grievances and conflict.
(4) Maintaining customer goodwill is very essential. This depends on
quality and fair price of the product. So a firm aiming at better profit
prospects in the long run should sacrifice short run profit.
(5) It will bring congenial relation at the executive level.
(6) It will help in forestalling application of antitrust law.
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9.7 Summary
All economic activities are based on one of the most important objectives
that are to make more profit. Profit gives incentive to a person to work hard
and try to get maximum profit.
We have tried to define profit and explained different types of profit i.e. in
economic term and in accounting term.
Profit plays a very important role in the economy. Profit being the reward of the
entrepreneur can be negative also when losses are incurred. Profit helps in
expansion and growth of a firm and industry and the economy. Expansion of
the unit is possible if a part of profit generated in the past is ploughed back.
Further if very high profit is made it will have some effects on the economy and
will encourage competitors. The Govt. may start paying attention when there
is a higher profit. Similarly the consumers will feel exploited. The workers may
demand more and more wages causing conflict between management and
labor.
Hence it is felt that profit should be reasonable and why reasonable profit is
necessary.
Discussion has also been done on different policies regarding profit which can
be adopted. How to calculate profit is also discussed.
Also the idea of inventories and depreciation is given to enable a person to
calculate profit properly. While calculating profit the role of inventories and
depreciation has to be considered.
9.8 Keywords
Dynamic state. The economic state where the future is likely to be
different from the present rate. This change is unpredictable.
Gross profit. The difference between receipts and payments over a time
period.
Net Profit. Profit net of implicit cost.
Normal Profit. The minimum expected return to keep an entrepreneur in
his present business.
Monopoly Profit. Profit that arises due to dis-equilibrium and imperfection
in the market.
Depreciation. Depreciation is the loss in value caused by the continuous
use of assets, because every durable asset has a certain life. After this it
has to be replaced.
Inventory. Inventories are in the form of raw materials, semi finished
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goods, finished goods, spare parts. These are very important to keep the
work/job working without any obstacle.
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UNIT 10
GOVERNMENT POLICIES
Learning Objectives
After going through this unit, you will be able to:
State the role of the government in handling National economic
affairs
Explain the monetary policy.
State use of monetary policy in controlling inflation and depression
to some extent,
Explain various methods used for the purpose
Describe monetary policy in the form of cheap money policy and
dear money policy and how it can control investment..
Explain about the fiscal policy i.e. the policy of taxation, public
expenditure and public borrowing.
Discuss how these policies can control inflation and depression and
help economic growth.
Discuss that during depression, fiscal policy is more effective than
monetary policy.
Structure
10.1 Introduction
10.2 Government policies
a) Monetary policy
b) Fiscal Policy
10.3 Monetary Policy Main purpose
10.3.1 Various tools used in Monetary Policy
10.3.1.(i) a contraction of money supply
10.3.1.(ii) Expansion Bank rate
10.3.1.(iii) Open market operation/statutory liquidity ratio (SLR)
10.3.1.(iv) Reserve ratio/Cash Reserve Ratio (CRR)
10.3.1.(v) Selective credit control
103.1.(vi) Margin
10.3.1.(vii) Control of credit
10.4 Fiscal Policy
10.4.1 Meaning and objective of Fiscal Policy
10.4.2 Tools of Fiscal Policy
10.4.3 Use of tools in various economic conditions in different economic
situation such as inflation, depression and unemployment
10.4.4 Limitation of Fiscal Policy
10.5 Summary
10.6 Keywords
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10.1 Introduction
In Unit No. 9 we have given the idea of trade cycle. Trade cycles throw light on
ups and downs in economic activities of a country. You have learnt different
phases of trade cycle and also learnt about inflation, recession and depression
in the economy. Some ideas of Govt. control, can effect inflation, recession
and depression.
In Unit No. 10 we shall give you the idea of Government interference in
economic activities to overcome various problems faced by the economy and
to assist the economy.
Government interferences, when there are some problems in the economy ,is
essential to reduce the bad effects on the economy. The Govt. has legal and
social frame work to control and regulate the economy. There are other ways
also to be used by the Govt. to improve the economic positions, welfare of the
economy. The Govt. has to control and regulate the economy to achieve its
objectives.
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goods and services is reduced. This will also reduce the power of credit
creation of the commercial banks, so the banks cannot lend more. This helps
to check the inflation. During depression R BI buys the securities etc and pay.
The cash is transferred to the public This will create the purchasing power of
the people and push the demand of goods and services and credit creation
power of the banks also increases and banks can lend more. This has many
benefits –
1. Influences internal prices and wages and affects the balance of payment
2. Open market operation gives good support to Bank rate policy and bank rate
policy become more effective.
3. It helps to fulfill needs of the economy during different seasons and different
situation.
But Open Market Operation has some limitations.
Lack of Securities Market which should be large and well organized. A well
developed security market is very essential for the effective working of Open
Market Operation.
Secondly Cash Reserve ratio is not stable, which is the need for the success of
Open Market Operation.
Thirdly there is a need of co-operation of the Banking Sector and the business
sector because when Central banks starts selling securities it is an indication
that credit control is necessary in the economy and the country.
1. Variation in the Reserve Ratio The Central Bank can change the reserve
ratio to control credit in India. CRR (Cash Reserve Ratio) is used to block at
least a part of the bank deposits and this amount is with the RBI and not
available to the banks for giving credit. The CRR is 5% and this controls the
credit creative power of the commercial banks.
Secondly the RBI has another tool such as SLR (Statutory Liquidity Ratio).
This refers to that portion of total deposits of commercial banks, which it has to
keep with itself in the form of liquid assets. At present 25% of the entire net
demand and time deposits are in this form.
Increasing the CRR/SLR means-
Reducing the commercial banks powers,
To create credit and lending capacity
When RBI wants expansion of credit during recession then this ratio is reduced
as was done in 2008.
This method has some limitations such as cash reserves with the commercial
banks are already very high. Further this CRR is applicable to all the banks in
India which is not good for the backward regions because the backward
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regions need a lot of credit to expand its economic activities and to create
employment opportunities.
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10.4.4 Limitation. There is a lot of time lag when the Govt. thinks of taking
action. Before it is implemented after some time the situation has gone very
bad. Secondly in order to meet the challenge the purchasing powers should go
to the masses that mean redistribution of income. Again this measure still
takes a lot of time. The action taken by the Govt. must be supported by the
private sector. But this sector is reluctant to cooperate with the Govt.
Further there is a lack of cooperation and cooperate in different field of the
economy.Algebra and Derivatives to use them as fundamental tools to
express complicated aspects of economic theories and models more precisely
and accurately. All these applications of mathematics are significant as a tools
and techniques to impart conciseness, precision and rigour to economic
analysis.
However, along with Monetary Policy the Fiscal policy has also to be used so
that some results can be achieved. Monetary policy may not be as effective as
the fiscal policy.
10.5 Summary
In this unit we have discussed different Govt. policies which affect the economy
of the country. Also we feel the role of the Govt. to support the economy in the
time of inflation and depression. Any fluctuation in the economy has to be dealt
with, by the Govt. The Govt. has already legal and social frame will be control
and regulate the economy.
The Govt. uses two measures that is (a) Monetary policy (b) Fiscal policy.
These two measures are mostly related to control or expansion of the supply of
money. When there is a rise in prices, that situation is called inflation and when
there is a fall in prices on large scale, unemployment and the economic
activities at very low level, this situation is called depression. Depression has
very bad effects on the economy so the Govt. has to adopt monetary measures
of expanding or contracting the supply of money. Similarly the Govt. uses the
Fiscal measures of taxation, Govt. expenditure and Public borrowing to tackle
inflation and depression when Govt. spends more money. This expenditure
increases the purchasing power of the common man and push up the demand,
of goods and service and the economy starts looking up. This is called
injection in the economy. During inflation Govt. tries to reduce the demand of
the people by taxation and can meet the challenge of inflation. This is called
withdrawal from the economy. But both the measures are to be used at the
same time to get better results. We have discussed all the measures in this
unit with their limitations.
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10.6 Keywords
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UNIT 11
Learning Objectives
After going through this unit, you will be able to:
Discuss about the general rise and fall in prices.
Describe business cycles and its phases.
Explain inflation, recession and depression.
State the reasons and causes of inflation and depression.
Discuss the kind of cyclical fluctuation in economic activities.
Suggest the measures to overcome cyclical conditions.
Structure
11.1 Introduction
11.2 Business cycles
11.2.1 Meaning
11.2.2 Phases
11.3 Inflation
11.3.1 Define inflation
11.3.2 Causes of inflation
11.3.3 Control of inflation
11.4 Recession and depression
11.4.1 Define recession
11.4.2 Causes of recession
11.4.3. Control of recession
11.5 Depression
11.5.1 Idea of depression
11.6 Summary
11.7 Keywords
11.1 Introduction
In unit No.8 you have learnt different strategies of pricing of a product followed
by the businessmen. There are various methods of pricing of a product. Each
pricing system has its advantages and disadvantages. So we have tried to give
you the idea of pricing a product in different market and different areas
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In the present unit we shall explain the idea of trade cycle .This is always
happening in a capitalist economy accompanied by fluctuation like ups and
downs in the economic activities. We find that this fluctuation in the economy
has affected the economic activities of the country. Phases of trade cycle are
also studied .Different methods are also explained to have some control or
reduce trade cycles bad effects to some extent. Business cycle is
accompanied by inflation; recession and depression are explained in details.
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Fig. 11.1
During recovery stage, expansion starts playing its role and this leads to
prosperity. During recession we have contraction of all economic activities and
this causes depression.
The business cycle starts from trough (lower point) passes through recovery
phase followed by a period of expansion (upper turning point) and
prosperity. After the peak point is reached there is a declining phase of
recession followed by depression and it continues simply with upward and
downward swing.
Explanation of phases of business cycle
a) Prosperity phase
There is an expansion of economic activities. Prices, employment, income and
production move upward. Total output starts growing at a rapid pace due to
higher investment and more employment. The producers gain because wages
and the prices of raw materials are low initially and move later on. There is
higher level of effective demand. The rate of interest increases due to more
demand for capital. This causes inflation, expansion of bank credit. There is
rise in the GNP. This further increases inflation and higher profits. There is
upswing in the economic activity and the economy reaches its peak. This is
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Activity 1:
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11.3 Inflation
Inflation may be defined as rise in the general price level. Inflation may occur
either due to increase in demand or increase in the cost of production. If it
caused by increase in demand of goods and services it is known as demand
pull inflation. Here the aggregate demand of goods and services exceeds the
available supply of the outputs and so causes the general rise in price level of
the economy.
The price may rise even when there is no increase in aggregate demand. This
could be due to rise in the cost of input. If the cost of any factor of production
increases the cost of goods is bound to go up. If the inflation is caused because
there is a rise in the cost of production as the inputs costs have gone up it is
known as cost pull inflation.
The producers pass on these cost to the consumers by increasing the price of
the product. For example with the rise in the price of diesel , this has increased
the price of different products.
11.3.1 Define Inflation
Inflation may be defined as general rise in prices in a persistent manner.
Prof. Crowther. He has defined inflation as a state in which the value of money
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and services so after the war when all controls are removed the
population uses that surplus funds to fulfill the suppressed demand
and this increases the price level.
h) Peace Time Inflation
During the peace time inflation the Govt. undertakes some projects like
construction of roads, bridges, dams etc. and uses the resource for
development of infrastructure to boost the economy. This excess
demand and excess expenditure causes inflation in the economy.
i) Tax Inflation
Tax inflation is caused by the Govt. under fiscal policy i.e. increasing
the tax on individual, goods and services. This will lead to rise in prices
and will cause inflation, for example Vat and service tax in India.
j) Sectoral Inflation
Sect oral inflation takes place when there is increase in prices of goods
and services produces by a certain section of industry for e.g. the
prices of agricultural produce are increasing and this is causing direct
effect on other sectors of the economy. Aviation industries are facing
inflation due to high rise in the crude oil prices.This inflation has
originated in one basic sector.
k) Pricing Power Inflation
It generally happens under the situation of oligopoly market for e.g.
pepsi, coke, Kellogg foods have increase the prices of their products,
because they have the power to fix the prices at a high level.
l) Stag Inflation
Under stage inflation we find that there is inflation in one sector of
economy where prices continue to rise but the whole economy is in
recession. For e.g. India is facing on one hand inflation and the prices
are rising but on the other hand the GDP of India is declining. This
situation causes financial crises in the economy.
Activity 2:
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methods used are raising the bank rates selling of Govt. securities in the open
market, raising the reserve ratio so that banks will have less liquid. Similarly
the Repo rate has to be raised. Also the reverse Repo rate is to be raised. This
will discourage the commercial bank borrowing from the central bank. This will
also control the supply of money in the market. It also includes selective credit
control and raising the margin requirements and regulating the consumer
credit finance.
(2) Fiscal Measures
Monetary measure may not be so successful in controlling inflation, but fiscal
measures do have a better result because fiscal measures are highly effective
for controlling Govt. expenditure, personal consumption by increasing taxes
and private and public investment.
(a) Reduction in unnecessary expenditure on non-development activities.
This will put a check on private investment also. This will reduce the
supply of money held by the people.
(b) Increase in taxes i.e. direct and indirect taxes. The need is to increase
personal taxes, corporate taxes commodity taxes. This will reduce the
disposable income of the people.
(c) Encourage private savings so that consumption expenditure is
reduced. It may be in the form of compulsory saving as was done in
1978 in India. The people had to deposit 4% of their salary in the
nationalized banks for fixed period of five years.
(d) The Govt. should adopt the policy of surplus budget and reduce deficit
financing.
(e) Public debt means more borrowing from the bank and the public so that
their purchasing power in the hands of public is reduced and bank are
restrained to create credit.
Other Measures
a) To increase production of essential consumer goods like food clothing,
etc or import of essential goods which are short in supply?
b) To increase the supply of raw material.
c) Rational Wage Policy and income policy under hyper inflation; there
is a wage price spiral so the need is to freeze the wages, income,
profits, dividend etc. But this measure can be adopted only for a short
period. In England this was done during Second World War, when
wages were frozen.
d) Price Control & Rationing Here prices of essential goods are to be
fixed and scarce articles should be distributed through fair price shops
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through rationing.
11.4 Recession
Recession It is the period of contraction in the business cycle. It is a general
slowdown in economic activities.
A decline in the GDP for two or more consecutive quarters is also called
recession.
Macro Economics indicators such as GDP, employment investment spending
etc., all fall and decline while rate of unemployment increases.
It happens when there is a wide spread drop in spending. It is often followed by
an adverse supply shock so Govt. has to follow expansionary macroeconomic
policies such as increasing money supply, increasing Govt. spending and
decreasing taxation. This will help in increase in disposable income in the
hands of the people. The people will demand more goods and services. This
will give a little push to the economy.
Causes of Recession - Over production by the firms ,which are independent
to take their decision. This lead to over production and it has to be sold either
at lower price or keep these in inventories and stop the production. . This will
lead to unemployment.
Secondly recession is caused by under consumption. The people consume
less and less.
Third cause is financial crises; here the bank would like to call back the loans.
This affects the firms and the firms have to sell their product at lower prices.
This results in heavy losses.
Impact of Recession – Recession will have following impact on the economy:
a) Bankruptcies
b) Credit crunch
c) Deflation
d) Foreclosure
Recession will cause bankruptcies in the market. Many firms will find it difficult
to repay the loans. This will crease credit crunch in the market. The banks
have no cash to lend but the banks have lot of mortgage properties and other
assets.
Further deflation will be caused which mean less of aggregate demand; This
will lead to unemployment, low wages, reduced purchasing power and reduce
the aggregate demand. The economic activities will be a lower level
When the customers fail to repay the loans, the banks opt for foreclosure a
legal process under which they can take the possession of mortgaged property
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11.5 Depression
Activity III:
b) Explain the term Repo rate and its role in controlling inflation
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c) Government injection is good during depression.
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11.6 Summary
Business cycle refers to the fluctuation in economic activities. It is occurring
regularly in the capitalist societies. The phases are recovery, prosperity,
recession, and depression. Recovery means revival of economic activity as a
whole. Prosperity means a period of abnormal economic activity. It gives
momentum to increase in prices, income and employment. After this the
period of recession starts and economic activity starts going down turn which
leads to reduction in output, employment and the economy then leads to
depression and all the economic activities are at the lowest ebb. Income is
reduced along with employment. Business cycle creates a situation of
uncertainty for businessmen and affects the business. The quantum of
inflation is also taken. Inflation is defined and the causes are discussed of
inflation. Further we studied the effects of inflation on the economy along with
the different measures to control inflation. Similarly we discussed depression
and its effects.
11.7 Keywords
Boom - (Prosperity). Phase of business cycle where there is repaid
upwards movement in income and employment and a great incentive for
fresh investment.
Depression - A situation created by over production because demand
starts falling faster than the fall in production of goods.
Recession - Where the business cycle takes a downwards turn from the
state of boom. and Output, profits and employment starts falling gradually.
Recovery – Revival of demand for goods and services. Economic activity
starts picking up. Business Psychology is optimistic.
Trough – is the turning point under depression to recovery a form Boom to
recession.
Inflation - It is a process of a steady and sustained rise in the prices.
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UNIT 12
Learning Objectives
After going through this unit, you will be able to:
Clarify the meaning of cost benefit analysis
Learn the need of such study
Explain various steps to be taken to get proper result.
Determine whether it is sound investment decision or not
Provide the basis for company projects on which the company
should take decision
Clarify the difference between social cost benefit and private cost
benefit.
Structure
12.1 Introduction
12.2 Steps involved in Cost Benefit Analysis
12.3 Cost Benefit Analysis Private And Social
12.4 Advantages of Cost Benefit Analysis
12.5 Limitation of cost benefit analysis
12.4.1 Disadvantage of cost benefit analysis
12.6 Summary
12.7 Keywords
12.1 Introduction
The cost benefit analysis will help to get the idea of the benefits and the costs of
various investment opportunities, which are available to the business houses
and the Govt. Here we have to find out whether it is worthwhile to invest in a
project and to study every alternative available. Further cost benefits analysis
refers to the analysis done to judge a project investment. It may be under the
Govt. or in the private sector. The cost benefit analysis is used to evaluate and
give a ranking to every project before it is undertaken for execution. Anybody,
who is thinking of investment, must try to get its cost benefit analysis done
before one takes the decision about the project. Cost Benefit Analysis focuses
on economic efficiency. It calculates the net benefits for each policy proposal.
It takes a long term to view and to incorporate all relevant factors regarding
costs and benefits.
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is done in time.
12.2.6 (f) Mid Term Project Evaluation
This is very necessary in order to keep the time schedule. If some drawbacks
are noticed, then alternation may be done to suit the project. If the project is
lagging behind necessary steps should be taken to see that the project is
completed in time. This will help in controlling unnecessary increase in the
cost of the project.
Some other easier ways for cost benefit analysis are –
1. List alternative projects/programs
2. Select measurements and measure all cost/benefits elements
3. Predict outcome of cost and benefits over relevant time period
4. Convert all costs and benefits into money
5. Apply discount rate
6. Net present value
7. Sensitivity analysis
8. Adopt recommended choice.
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12.6 Summary
Cost benefits analysis is an analytical framework to assess the costs and
benefits of a project. It is used by the policy makers to decide about selecting a
project from many different proposals of the different projects.
The study of cost and benefit analysis is necessary to determine the selection
of a project. There is a need to study different steps to be undertaken to
determine a feasible and viable project. This study helps to determine whether
the investment in the project is a sound decision or not.
We have also studied social cost benefit project because this study affect a
major portion of the population and the society. There may not be any
monetary gain, but it is very beneficial to the society. The constructions of a
road will definitely help the surrounding areas as the people will be induced to
invest in different types of economic activities and movement of goods and
services will be easy. The idea of externalities is also given which explains the
ill effects of private projects in the form of pollution of air, water and noise,
congestion in the city. This may affect the health of the people as we find in
Chembur, Mumbai. The people are suffering due to R.C.F.; and other
refineries. This has polluted the air of that area. Here the govt. can play an
important role in minimizing the harm and maximizing the benefits to the
society by enforcing the laws.
12.7 Keywords
Cost Benefit Analysis - It is used to assess the benefits and the cost of
proposal and decide whether to undertake the project.
Private cost benefit analysis – Here the analysis of the cost and the
benefit accrue to the investor. Here maximum profit is the main
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consideration
Social cost benefits analysis. Here the Govt. undertakes the project and
find out the benefit and the cost. Here the main consideration is the
benefits accrue to the society and not benefit in the form of profit or in terms
of money.
Technological feasibility means to consider the availability of
technology, its feasibility and availability of technical people.
Social cost. The cost incurred by the Government for the welfare of the
people and which improves the life of the people, such as water supply,
drainage system, construction of dams, canal, roads etc.
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UNIT 13
CAPITAL BUDGETING
Learning Objectives
After going through this unit, you will be able to:
Define capital budgeting and its meanings
Explain different steps involved in project evaluation
State different types of physical assets
Enumerate different methods of appraising investment proposal
Explain accounting rate of Return, Payback period and discounted
pay back
Describe net present value and time value of money.
Structure
13.1 Introduction
13.2 Idea of capital budgeting
13.2 (i) Classification of physical assets
13.2 (ii) Capital budgeting process
13.3 Methods of appraising an over view
13.3.1 Simple Methods
13.3.2 Scientific and complex method
13.4 Measurement Method
(i) Requirement of a good method
(ii) Principles of cash flows estimation
13.5 Time value of Money calculation
(a) Time concept of value of money
(b) Net Present value
(c) Internal Rate of Return
(d) Profitability Index
13.6 Summary
13.7 Keywords
13.1 Introduction
In Unit No. 13, we have studied the idea of National Income and its importance.
We learnt about measurement of national income. We have explained certain
concepts which are generally used in the study of National Income especially
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the concept like Gross Domesticl Production (GDP); Gross National Product
(GNP); Personal Income (PI); Disposable Income (D.I.). We have also
examined various difficulties faced in the measurement of National Income by
the experts. In this unit we are giving you the idea of capital budgeting, and all
related matters, especially steps involved in capital budgeting. You will come
to know the concept of time value of money. You will also learn the methods of
investment, discounted cash flow and Net Present Value and Internal Rate of
Return.
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In this method, the payback period is the time duration required to recover the
initial cash flows. The people think in terms of initial expenditure/outflows and
the time duration in which this amount can be recovered.
If the cash flows are uniform then
Payback period = Initial cash outflows
Annual cash inflows
For example if initial investment is Rs.1,00,000/- cash inflows –
First year = Rs. 20,000/-
Second year = Rs. 30,000/-
Third year = Rs. 30,000/-
Fourth year = Rs. 40,000/-
Fifth year = Rs. 40,000/-
So cumulative cash inflow of five years is Rs. 1, 60,000/-.
Hence the payback period is between third and fourth year. Assuming a
uniform collection rate the amount of Rs.20,000/-can be recovered in half year
or 6 months. So the payback period is 3 + 20000 ÷40000 -= 3-1/2years
Payback period concept is very simple and a layman can understand it easily.
This sort of project put recovery in less time and the element of risk will also be
less.
But the main defect in this method is that it considers early cash flows which
determine the payback, but it ignores those inflows which come later on
after the recovery of the initial investment.
Payback method also ignores time value of Money which is very important
concept.
This is clear from the example –
For example
Cash inflows
Year Project X Project Y
Investment 0 ( -) - 60,000 ( -) 60,000
1 10,000 30,000
2 20,000 20,000
3 30,000 10,000
Both projects X and Y have 3 years payback period but project Y is better
because of higher cash inflow in the beginning and will have a higher value if
time value of money is considered.
Thirdly the payback period is considered only as a measure of capital recovery
and does not consider good profitability. But this method is used, because it is
simple and easy for calculation for the layman.
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Activity I:
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there, if using own premises, rental cash outflow to be consider. Cash needs
for working capital be treated as cash outflow at the time of commencement of
a project and should be treated as inflow, when that cash is released at the time
of closure – increase – inflow, decrease- outflow capital.
How much Rs.100/- received five years from now to be worth today if the
rate of interest is 10%
PV = CFt / (1 + r)t
= 100 / (1 + .1)
t
= 62.09
That means the value of Rs.100/- after 5 years but its present value is Rs.62.09
only.PV = FV
(1 + i)
n
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= 100 (1 + .1
)2
Activity II:
1. 15000
2. 22000 NPV =sn Ai
3. 27000 t=1 (1-i) -_Co
t
4. 29000
5. 21000 =15000 + 22000 + 22000 + 29000 + 21000 - 80000
1.1 (1.1) 2
(1.1) 3
(1.1) 4
(1.1)5
-13,636.36 + 18,181.82 + 20,285.50 + 19,807.39 + 13039.43 - 80000
= 84950.50 – 80000 = 4950.50 Here NPV is Rs.495.50 and NPV is
positive. So the project is viable.
NPV method is very scientific and appropriate technique of budgeting so it
is widely used, because of the following reasons –
1) It considers time value of money
2) It is an absolute value
3) It has the property of addition
4) NPV for different rate of interest can be found separately.
5) It allows different rates of interest in different time period in the life of
a project.
Limitation of NPV
It gives absolute value and therefore comparison between two different project
not easy, when they are of different sizes.
1) Not possible to know in advance the rate of interest so at any given time
NPV may not be appropriate if the rate of interest has changed.
2) It may lead to wrong decision making, when the funds are limited, and
have to choose between different options.
(a) Internal Rate of Return
The internal rate of interest (IRR) is the discount rate at which the NPV for a
project is equal to zero. This means that the present value of cash inflows for
the project would be equal to present value of its outflows. So it can be called
as the break even discount rate. Generally the Internal Rate of Return is found
by trial and error method.
This method is based on the technique of discounting cash flow.
The Internal Rate of Return is the rate of return or the discount rate which
equals the discounted present value of its expected future marginal yields with
the investment cost of project.
So NPV = - C + R1
(i + C)
C is the cost of the investment project in the current year so it is
negative.
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13.6 Summary
13.7 Keywords
Capital budgeting.It is a decision making process concerned with
whether or not:
(1) The firm should invest funds in an attempt to make profit
(2) How to choose among competing projects.
Internal Rate of Return. (I.R.R.) it is a method of evaluating investment
proposals. It is the rate of discount (or interest rate) that equals the present
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UNIT 14
Learning Objectives
After going through this unit, you will be able to:
State the National income of a country
Discuss how to measure the National Income by different methods
Explain the difficulties in the measurement of National Income
State different concepts related to National Income such as GDP;
GNP; PI, DI
Structure
14.1 Introduction
14.2 Definition of National Income
14.2.1 Feature of National Income
14.3 Measurement of National Income – Method
14.3.1. Output method
14.3.2. Income method
14.3.3. Expenditure method
14.4 Difficulties in the measurement of National Income
14.5 Different concepts of National Income
14.5.1 G.D.P.
14.5.2 G.N.P.
14.5.3 Net National Income
14.5.4 P.I. (Personal Income)
14.5.5 D.I. (Disposable Income)
14.6 Importance of National Income estimates
14.7 Summary
14.8 Keywords
14.1 Introduction
In Unit No. 12 we have tried to explain the concept of cost benefit which is very
essential to know the return on our investment. Also we have given the idea of
steps to be taken to get the full idea of costs benefits. How cost benefit
analysis helps the managers to take decision in selection of different projects.
In this unit you will learn something about National Income. Method of
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National Income measurement and what difficulties are faced when we try to
measure the National Income. You will also learn some concepts of National
Income. These concepts are made clear and easy to understand about
National Income. You will also learn the importance of the study of national
income.
National Income is the money value of all the goods and services produced in
an economy over a period of one year.
Prof. Pigou, “National Income as that part of objective income of the
community including income derived from abroad which can be measured in
money.
Prof J. R. Hicks – the National Income consists of a collection of goods and
services reduced to a common basis by being measured in terms of money.”
Activity I:
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b) Income method
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Govt.
So GDP at factor cost = GDP at market price – IT + S
IT = indirect taxes and S = Subsidies
14.5.2 GNP (Gross National Product)
Gross National Product is the sum of gross domestic product and net factor
incomes from abroad.
GNP = GDP + Net factor income from abroad
GNP is a monetary value of annual final output.
14.5.3 NNP (Net National Product)
It is the net production of goods and services in a country during the year.
NNP = GNP – Depreciation
It is also referred to as national income market prices. It is a very useful concept
for the study of growth of economies. It has a difficulty about fixing the
appropriate rate of deprecation.
14.7 Summary
National Income is the indicator of economic activity. It is total market value of
all final products and services produced in a country during a year.
We have tried to explain about the National Income of the country. We have
explained different methods of measurement of National Income i.e. product
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method, income method, and expenditure method in details. We have given
the idea of various difficulties faced while measuring the National Income. We
have explained the concepts which are related to the N.I. i.e. GDP, GNP, PI and
Disposable income. We have given the idea of GDP at factor cost and at
Market price. We have also given the importance of the study of nation income.
14.8 Keywords
Disposable Personal income - The total income earned by households in
the society less the personal taxes.
Gross National Product – The total market value of all final goods and
services produced in an economy in a year.
Net National Product – means GNP – Depreciation
GDP at Factor cost – is estimated as the sum of net value added by
different producing units and the consumption of fixed capital.
GDP at Market Price – the sum of domestic factor incomes and
consumption of fixed capital
Net domestic product (NDP) here depreciation allowance (capital
consumption allowance) is to be reduced from GDP.
Personal Income. Sum of all incomes actually received by all individual
or households during a year.
Depreciation – It is the cost of consumption of fixed capital.
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UNIT 15
Learning Objectives
After going through this unit, you will be able to:
Discuss the need of Government intervention in the free Market
State the need for price control
Explain support price and administered price
Clarify the meaning of dual prices
Express the need of preventing and controlling of monopolies.
Structure
15.1 Introduction
15.2 Failure of market mechanism
15.3 Need for Government Intervention
15.4 Meaning of price control
15.5 Methods of price control
15.5.1 Prevention control of monopolies
15.6 Summary
15.7 Keywords
15.1 Introduction
In Unit No. 14we have tried to give you the idea of capital budgeting. What
steps are needed for project evaluation? We have explained about time value
of money. We have also explained how to appraise the investment and other
related concepts.
Now in this unit we shall explain the need of the Govt. intervention in business
because of failure of the market economy. In detail we shall study how Govt.
intervenes in the market. Some of the techniques which the Govt. adopts are
price control, support price, administered price etc. and also how to control and
prevent the formation of monopoly.
Duel pricing system is also one of the ways to help the weaker sector of the
society to get the essential goods.
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Adow Smith opposed any Govt. intervention in the private business. It may
hinder the free play of the market mechanism in a capitalist economy. Later he
accepted the same role of the Govt. is necessary in the market economy to
remove some of the failure of the market mechanism. The failure of market
mechanism has justified intervention of the Govt. in the market mechanism.
Following are the failures of Market Systems –
(i) Inequalities of income and wealth. Right to property and law of
intervention has given advantage to the people who get a good start in
life. Since they possess productive resources, which can be used to
earn more income and accumulate more wealth so it has resulted in
economic inequalities.
(ii) Economic instability. Market economy is fully dependent on the
level of demand. Any change in demand could upset an economy. A
fall in demand could bring down the prices, leading to retrenchment of
labour. This depression would engulf the whole economy. A rise in
demand will increase the productive activities and may lead to inflation.
This causes trade cycle which affect the economy because of
fluctuation in the economy.
(iii) Rise of Monopolies. Competition in the Market economy is healthy.
It will improve efficiency and quality of the product. But it also leads to a
cut throat competition which will help the strong and well established
producers to drive away the new comers from the market. It would lead
to creation of mo monopoly concentration of economic power in the
hands of a few producers. The monopolists can exploit the consumers
(iv) Failure to provide full employment. Market mechanism would
automatically establish equilibrium at the level of full employment. But
because of rigidity (especially wage rigidity due to trade union). The
economy will be in equilibrium at less than full employment so labor
force remains unemployed and hence wasted the chance of creative of
wealth.
(v) Sacrifice of Social welfare. In order to get maximum profit, the
producers produce these goods which have greater demand. So the
resources are diverted to produce luxury, semi luxury goods. The
goods are for mass consumption needed for the poor are neglected.
So the society is neglected.
(vi) Failure to satisfy all the needs. Market mechanism cannot satisfy
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the total needs of the society. Market economy can satisfy private wants but it
cannot satisfy social wants. Market economy works on exclusion principle i.e.
who cannot pay are denied its benefits but social wants such as defence street
lights it is not possible to exclude a person who does not pay. So it is the
responsibility of the Govt. to provide these services.
Seeing the failure of the capitalist free society, it is necessary that the Govt.
should intervene for smooth running of the economy.
To control cyclical fluctuations
The Govt. can adopt an anti-cyclical policy to control the economic in staturlity
The Govt. can increase expenditure during depression on the construction of
infrastructure. This helps to generate employment and stimulate aggregate
demand in the economy. In case of inflation the Govt. can exercise control
such as credit control and reduce Govt. expenditure and raise taxes. This will
reduce the supply of money in the society affecting aggregate demand.
Humanitarian consideration
Where market mechanism fails to serve the human needs, Govt. may
intervene. In developing countries allowance is given to the unemployed
destitute and the poor senior citizens. Similarly the Govt. can continue to
operate loss working unit so that the workers may not use their job.
Preventing Eco-inequality
The state can reduce economic inequality. The Govt. can adopt the policy of
progressive taxation such as income tax, estate duty and succession tax, more
taxes on higher income and revenue thus collected to be used for the welfare
schemes for the poor. It can pass the laws to curb monopoly. The Govt. can
spend money to create more opportunity for employment. The Govt. can
subsidize various essential goods for the poor and the weaker section of
society. For example the Govt. has adopted the policy of subsidizing gas,
kerosene oil, and fertilizer to enable the poor to use their essential
commodities.
So some of reasons stated above make the intervention of the Govt. desirable.
It will help to reduce the bad effect of market freedom to some extent.
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It will help to reduce the bad effect of market freedom to some extent.
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charge, is fixed. The customer can negotiate and buy at less price also
especially the prices of essential drugs are controlled.
b) Break up of monopoly power
Whenever monopoly power is exercised by the monopolist, and he
begins to exploit the people, the Govt. can break up it power for
encouraging the development of sure substitute. For this MRTP
(Monopoly Trade Practice Act) has been empowered to take action.
For example till 1982 in India Fiat/Ambassador cars had the monopoly
right from 1947 onward. The development of Maruti cars has broken
the monopoly power of these two car makers. In two wheeler industry
Bajaj, Rajdoot were dominating the market but introduction of Hero
Honda and other two wheelers have changed the scene fully. The
Monopoly power is broken.
c) Direct state provisions of goods and services
When certain goods and services are very essential but need large
capital investment and long period to receive the return. The state has
to invest funds to make the project operational. The private sector will
not enter such areas in India. Indian Railways has the monopoly and
providing service at reasonable charges. Post and telegraph,
telephone is other services but gradually the private sector is allowed
to enter but still the Govt. has dominantly position and has a last say.
d) Fiscal policy intervention
Fiscal policy which can affect the prices is taxation policy and public
expenditure. Indirect taxes (also known as commodity tax) can be
levied on luxuries and other non essential goods. This will make the
good costly. But it will tax the essential goods at a lower tax rate and
make these good affordable to the society. Further public expenditure
can definitely help in controlling the prices. It is done through subsidy
on various goods of mass consumption like gas, kerosene oil, fertilizer
etc. in India.
The state can also help the poor, the aged people through transfer
payment, by providing monetary assistance. For example the Govt.
provides unemployment allowances in some states in India. The
senior citizens are also receiving some monetary help and
concessions from the state. The state also undertakes civic works to
create employment. These steps help the unemployment to get some
purchasing power and fulfill their needs.
The Govt. is spending a lot of money to provide education and health
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Activity II:
b) Support price
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15.6 Summary
Unit 15 is regarding the need of the Govt. intervention in the free market and
economy. Free market has filed in many areas which has affected the
economy and has created many problems. Hence the Govt. intervention is felt
necessary to control and regenerate the free market. This intervention of the
Govt. is necessary to reduce the sufferings of the people and regulate its bad
effects on the economy. It is seen that there is a lot of fluctuation in the
economic activities in the free market. These fluctuations cause inflation and
depression in the economy which increase the sufferings of the people.
During inflation, the poor suffer and essential goods are beyond their reach.
Similarly during depression a large number of workers become unemployed
and economic activities are at lower level and wages are low.
So it is necessary to have some control over the prices of essential products
and service so that the poor can afford to buy these goods and services. So
the Govt. adopts various methods to control the prices by adopting price
control, fixing minimum and maximum prices. The Govt. also provides
subsidy on essential goods to make some goods cheaper. It adopts the policy
of dual price system. The main idea of govt. intervention is to make the
essential goods available to the masses at reasonable price.
15.7 Keywords
Administered Price is imposed by the Govt. or governing agency to make
some essential goods affordable to the poor.
Duel Price. Where different prices are charged for identical product from
different people
Support Price. It may be either subsidy or a price control in order to keep
the market price higher than the free market price.
Price control A price control is the minimum legal price a seller my chare.
It is fixed by the Government.
Rationing is the controlled distribution of scarce resources, goods or
services. It controls the size of the ration and everyone is assured of getting
certain amount of goods or services.
Exclusion Principle The owner of private goods may exclude others from
use unless they pay for it.
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