Managerial Economics HPUniv

M.Com.
1st Semester Course: MC-103
Managerial Economics
Discipline Specific Course (DSC)
Lesson 1 to 15
By: Rajneesh Kumar
International Centre for Distance Education and Open Learning (ICDEOL)

Himachal Pradesh University
Summer Hill, Shimla, 171005
CONTENTS
UNIT 1 OBJECTIVES OF A FIRM AND DEMAND ANALYSIS
Lesson Title of Lesson Page No.
1. Managerial Economics 1-13
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2. Firm’s Objectives 14-28
3. Demand Analysis 29-41
4. Demand Forecasting 42-55
UNIT 2 ECONOMIC FORECASTING, PLANNING AND PRDUCTION
ANALYSIS
5. Economic Forecasting and Planning 56-68
6. Production Function 69-83
UNIT 3 PRICE DETERMINATION AND DISCRIMINATION
7. Price Determination 84-99
8. Concept of Cost 110-114
9. Price Discrimination 115-130
UNIT 4 BUSINESS CYCLES, MONETARY AND FISCAL POLICIES
10. Business Cycles 131-146
11. Inflation 147-160
12. Monetary and Fiscal Policies 161-172
UNIT 5 PROFIT MANAGEMENT AND MEASUREMENT
13. Profit; Management and Measurement 173-201
14. Risk and Uncertainty 202-226
15. Break Even Analysis 227-247
Assignment 248
Sample Questions 249-250
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MC 103-MANAGERIAL ECONOMICS
Max Marks: 80 Internal Assessment: 20
Note: There will be Ten (10) questions in the paper spread into Five Units as Two questions from
each unit. The candidate will require attempting one question from each unit. Each question will carry
sixteen (16) marks.
COURSE CONTENTS
OBJECTIVE OF BUSINESS: Objective of a firm in microeconomics:
Principles in managerial decision analysis, Definition of Micro-Macro
Economics, Scope, Merits-demerits, Paradox of Micro Economics,
UNIT-I distinction between micro and macro economics.
DEMAND ANALYSIS: Theories in demand, types, and factors influencing
demand. Elasticity of Demand- concept, meaning, types, measurement,
influencing factors, importance.
ECONOMIC FORECASTING AND PLANNING: Need and methods of
economic forecasting for national planning; economic forecasting and
planning business; needs and methods. Techniques of forecasting
demand-survey and statistical methods.
PRODUCTION ANALYSIS: Concepts, Types of cost, cost curves, cost-
UNIT-II output relationship in the short-run and in the long run, LAC curve, Law of
variable proportions, economies of scale, diseconomies of scale, the profit
maximization objective and conditions of firms in short and long run
equilibrium.
PRICE DETRMINATION UNDER DIFFERENT MARKET CONDITIONS:
Market structure- concept, meaning, characteristics, classification of
different market structures; price determination and firm’s equilibrium under
UNIT-III different market structures, Pricing-types, cost pulls, going arte, imitative,
marginal cost, pioneering, transfer pricing.
PRICE DISCRIMINATION: Definition, concept, meaning, types, conditions,
dumping and socio-economic consideration in pricing.
BUSINESS CYCLES: concept, meaning, causes, phases of business
cycles, economic effects of production distribution and employment,
UNIT-IV remedies demand full vs cost push inflation, cobweb, theories of business
cycles.
MONETARY AND FISCAL POLICIES: meaning and objectives of
monetary and fiscal policies, role and impact on economic development,
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concept of sustainable development, consumption and its inclusive growth.
PROFIT MANAGEMENT: concept, nature and measurement of profit,
concept of risk and uncertainty, risk, uncertainty and innovations, theories
UNIT-V of profit, profit planning and forecasting, profit policies.
PROFIT MEASUREMENT: Determination of short-term and long-term
profits, measurement of profit. Break even analysis-meaning, assumptions,
determination of BEA, limitations, uses of BEA in managerial decisions.
References: -
1. T.R. Jain, “Business Economics” V K Publications
2. Alan Hughes, “Managerial Capitalism” The New Palgrave: A Dictionary of Economics.
3. Edward Lazear, “Personnel Economics” The New Palgrave: A Dictionary of
Economics.
4. W. Bruce Allen; Keith Weigelt; Neil A. Doherty; and Edwin Mansfield. “Managerial Economics:
Theory, Applications, and Cases” W. W. Norton & Company.
5. Arya Shri, “Managerial Economics” MEFA
6. Ramesh Singh, “Indian Economy” Mc Graw Hill Education
7. D. N. Dwivedi, “Managerial Economics” Vikas Publishing House
8. H. C. Peterson and W. C. Lewis, “Managerial Economics” Prentice Hall of India
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CHAPTER 1
MANAGERIAL ECONOMICS
SRUCTURE
1.1 LEARNING OBJECTIVES
1.2 INTRODUCTION
1.3 MEANING OF ECONOMICS
1.4 SCOPE OF ECONOMICS
1.5 NATURE OF ECONOMICS
1.6 MICROECONOMICS AND MACROECONOMICS
1.7 MANAGERIAL ECONOMICS: DEFINITIONS
1.8 SCOPE OF MANAGERIAL ECONOMICS
1.9 SIGNIFICANCE OF MANAGERIAL ECONOMICS
1.10 DIFFERENCE BETWEEN ECONOMICS AND MANAGERIAL ECONOMICS
1.11 RELATIONSHIP OF MANAGERIAL ECONOMICS WITH OTHER DISCIPLINES
1.12 SUMMARY
1.13 GLOSSARY
1.14 ANSWERS TO SELF CHECK EXERCISES
1.15 REVIEW QUESTIONS
1.16 SUGGESTED READINGS
After studying this chapter, you should be able to understand:
 The Meaning of Economics and Managerial Economics.
 The Nature and Characteristics of Managerial Economics.
 The Scope of Managerial Economics.
 The Relationship of Managerial Economics with other disciplines.
1.2 INTRODUCTION
Economics can be defined as a discipline that studies the behaviour patterns of human beings. The
main aim of economics is to analyse how individuals, households, organisations, and nations use
their scarce resources to achieve maximum profit. Economics is broadly classified into two parts,
namely microeconomics and macroeconomics. Microeconomics is a branch of economics that
studies the behaviour of individual consumers and organisations in the market. It focuses on the
demand and supply, pricing, and output of individual organisations. On the other hand,
macroeconomics examines the economy as a whole and deals with issues related to national
income, employment pattern, inflation, recession, and economic growth. With the advent of
globalisation and rise in competition, it is of paramount importance for managers to make rational
decisions. For this, managers should have a clear understanding of different economic concepts,
theories, and tools. Managerial economics or managerial economics is a specialised discipline of
economics that undertakes a study of various economic theories, logics, and tools used in business
decision making. It applies various economic concepts, such as demand and supply, competition,
allocation of resources, and economic trade-offs, to help managers in making better decisions
1.3 MEANING OF ECONOMICS
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In simple terms, economics can be defined as the study of how individuals, households,
organisations, and nations make optimum utilisation of scarce resources to satisfy their wants and
needs. The word economics has originated from a Greek word ‘oikonomikos’, which can be divided
into two parts: ‘oikos’ means home and ‘nomos’ means management. Thus, in earlier times,
economics was referred to as home management where the head of a family managed the needs of
family members from his limited income. However, over the years, the scope of economics has
broadened to society (that is referred to as home) and how it satisfies the needs of people by using
limited resources. Defining economics has always been a controversial issue since time immemorial.
Different economists have different viewpoints on economics.
Some economists had a viewpoint that economics is a study of money, while others believed that
economics deals with problems, such as inflation and unemployment. Therefore, to simplify the
concept, economics is defined by taking four viewpoints, which are given in detail as under: -
a) Wealth viewpoint: This is a classical viewpoint on economics that was given by Adam Smith,
who is also considered as the father of modern economics. According to him, Economics is “the
study of the nature and causes of nations’ wealth or simply as the study of wealth.” He stated that the
main purpose of all economic activities is to gain maximum wealth as possible. In Smith’s view, the
citizens of wealthy nations are happy; thus, economics shows nations to be wealthy.
b) Welfare viewpoint: It is a neo-classical viewpoint on economics that was given by Alfred
Marshall. According to Alfred Marshall, “Economics is a study of man in the ordinary business of life.
It enquires how he gets his income and how he uses it. Thus, it is on the one side, the study of wealth
and on the other and more important side, a part of the study of man.” He associated economics with
the welfare of men, who are responsible for generating wealth.
c) Scarcity viewpoint: It is a pre-Keynesian thought of economics that was given by Lionel
Robins in his book ‘Essays on the Nature and Significance of the Economic Science’ (1932).
According to Robins, “Economics is a science which studies human behaviour as a relationship
between ends and scarce means which have alternative uses”. The definition focused on human
behaviour in the optimum utilisation of scarce resources. It provides three basic features of human
existence, which are unlimited wants, limited resources, and alternative uses of limited resources
d) Growth viewpoint: This is the modern perspective of economics mainly given by Paul
Samuelson. He provided the growth-oriented definition of economics. According to him, “Economics
is a study of how men and society choose with or without the use of money, to employ scarce
productive uses resource which could have alternative uses, to produce various commodities over
time and distribute them for consumption, now and in the future among the various people and
groups of society.” The definition outlines three main aspects, namely human behaviour, allocation of
resources, and alternative uses of resources. Some other important growth-centred definitions are:
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J.M. Keynes, defined economics as “the study of the administration of scarce resources and
of the determinants of income and employment.” Benham’s, economics is “a study of the factors
affecting the size, distribution, and stability of a country’s national income.”
1.4 SCOPE OF ECONOMICS
Earlier, the scope of economics was limited to the utilisation of scarce resources to meet needs and
wants of people and society. However, over the years, the scope of economics has been broadened
to many areas, and the detailed description of the scope of economics is given as under: -
a) International Level: With the advent of globalisation and cross-border integration, economic
concepts are applied in order to conduct successful business dealings between countries. Economic
concepts can be used in areas, such as foreign trade (exports and imports), foreign exchange
(trading currency), balance of payments, and balance of trade.
b) Public finance: Economic concepts are also applied to assess the government’s collection of
taxes from the users of public goods as well as expenditure on production
and distribution of these goods to the general public.
c) Welfare: Economic theories and concepts are used to analyse the growth and development of
low-income countries. This helps in improving the living standard of people in less developed and
developing societies by understanding their needs for various facilities and utilities, such as health
and education facilities and good working conditions.
d) Health: Economic concepts are also applicable in assessing the problems faced in promoting
health in different countries. These concepts help the government in making decisions for defining
appropriate health packages and programs for the general public.
e) Environmental studies: Economic concepts are used to analyse the utilisation and depletion
of natural resources. Moreover, they are applied to study the impact of increasing ecological
imbalance on society.
f) Urban and rural development: In urban development, the scope of economics covers the
analysis of different urban issues such as crime, education, public transit, housing, and local
government finance. On the other hand, in rural development, economics can be used to analyse the
shortage of natural resources, obtain the best price for production, study constraints of productivity,
adapt to climate change, etc.
1.5 NATURE OF ECONOMICS
As that of definitions of economics, there are a number of controversial issues related to its nature.
Some economists believe economics as a science, while others have a notion that economics is a
social science. The explanation is given to understand the nature of economics:
a) Economics as a science: Science is a branch of knowledge that defines the relationship
between cause and effect. As results observed in science are measurable and based on facts,
economics also endeavours to find a relationship between cause and effect and provides measurable
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results. Similar to science, in economics, emphasis is laid on collecting relevant information, which is
categorized and analysed to reach conclusions.
b) Economics as a social science: Economics is also considered as social science as it deals
with studying the behaviour of human beings and their relationships in a society. This is because the
exchange of goods takes place within the society and among different societies to satisfy the needs
and wants of people.
c) Economics is an art: Art is a branch of study that deals with expressing or applying the
creative skills and imagination of humans to perform a certain activity. Similarly, economics also
requires human imagination for the practical application of scientific laws, principles, and theories to
perform a particular activity.
Self Check Exercise 1

1. Which one of the following does not fall under the scope of economics?
a. Public Finance c. Health
b. Welfare d. Poverty
2. Economics is considered as social science does not define the relationship between cause
and effect. (True/False)
Activity 1:
Find the role of economics in the Hospitality Sector by using Internet.
1.6 MICROECONOMICS AND MACROECONOMICS
The economics has a wide scope and involves several concepts, which cannot be studied under a
single discipline. Therefore, it is classified into two branches, namely, microeconomics and
macroeconomics. Microeconomics deals with the economic problems of a single industry or
organisation, while macroeconomics deals with the problems of an economy as a whole. Both of
these branches contribute a major part in business analysis and decision-making directly or
indirectly. Let us discuss two branches of economics in detail as follows:
a) Microeconomics: It is a branch of economics that deals with the study of economic

behaviour of individual organisations or consumers in an economy. Moreover, microeconomics
focuses on the supply and demand patterns and price and output determination of individual
markets. Microeconomics lays emphasis on decisions related to the selection of resources, the
amount of output to be produced, and the price of products of an organisation. Thus, it can be
said that the focus of microeconomics is always at individual level. The importance of studying
microeconomics is explained as follows: i) Microeconomics helps in understanding the mechanism
of individual markets; ii) It suggests ways for making full utilisation of resources; iii) It facilitates the
formation of economic models that can be further be used to understand the real economic
phenomenon.
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b) Macroeconomics: It is a branch of economics that mainly deals with the economic
behaviour of various units combined together. Macroeconomics focuses on the growth of an
economy as a whole by undertaking the study of various economic aggregates, such as
aggregate supply and demand, changes in employment, gross domestic product (GDP), overall
price levels, and inflation. The following points explain the importance of macroeconomics: i)
Macroeconomics helps in understanding the functioning of an economic system and provides a better
view of world’s economy; ii) It enables nations to formulate various economic policies; iii) It helps
economists in finding solutions to economic problems by providing various economic theories; iv) It
helps in bringing stability in prices by supporting detailed analysis of fluctuations in business
activities; v) It helps in identifying the causes of the shortage in the balance of payment and
determining remedial measures.

3. Both microeconomics and macroeconomics does not fall under the scope of economics.
(True/False)
4. Which one of the following shows the importance of microeconomics?
a. It helps in understanding the mechanism of individual markets.
b. It enables nations to formulate various economic policies.
c. It helps economists in finding solutions to economic problems by providing
various economic theories.
d. It helps in bringing stability in prices by supporting detailed analysis of
fluctuations in business activities.
Activity 2:
Considering the differences between economics and managerial economics mentioned
above, distinguish between economists and managers.
1.7 MANAGERIAL ECONOMICS: DEFINITIONS

Organisations face many problems on a day to day basis. These problems require careful analysis
and thoughtful consideration. For example, organisations are always concerned with producing
maximum output in the most economical way. To solve problems of such nature, managers are
required to apply various economic concepts and theories. The application of economic concepts,
theories, and tools in business decision making is called managerial economics or managerial
economics.
The following are some definitions of managerial economics:
Mansfield, “Managerial economics is concerned with the application of economic concepts
and economics to the problems of formulating rational decision making”.
Spencer and Seigelman, “Managerial Economics is the integration of economic theory with
business practice for the purpose of facilitating decision making and forward planning by
management.”
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Douglas, “Managerial economics is concerned with the application of economic principles and
methodologies to the decision making process within the firm or organization. It seeks to establish
rules and principles to facilitate the attainment of the desired economic goals of management”.
Davis and Chang, “Managerial economics applies the principles and methods of economics
to analyze problems faced by management of a business, or other types of organizations and to help
find solutions that advance the best interests of such organization.”
From the above definitions, it can be concluded that managerial economics is a link between
two disciplines, which are management and economics. The management discipline focuses on a
number of principles that aid the decision-making process of organisations. On the other hand,
economics is related to an optimum allocation of limited resources for attaining the set objectives of
organisations. Therefore, it can be said that managerial economics is a special discipline of
economics that can be applied in business decision making of organisations.
1.8 SCOPE OF MANAGERIAL ECONOMICS
Managerial economics involves the application of various economic tools, theories, and
methodologies for analyzing and solving different business problems. These business problems can
be related to demand and supply prospects of an organisation, level of production, pricing, market
structure, and degree of competition. The scope of managerial economics in detail is as under: -
a) Demand analysis and forecasting: Demand refers to the willingness or capability of
individuals to buy a product at a specific price. Demand analysis is a process of identifying potential
consumers, the amount of goods they want to purchase, and the price they are willing to pay for it.
This process is important for an organisation to analyse the demand for its products and produce
accordingly.
In managerial economics, demand forecasting occupies an important place by helping organisations
in business planning and deciding on strategic issues.
b) Cost and benefit analysis: By analysing costs, management can estimate costs required for
running the organisation successfully. Cost analysis helps firms in determining hidden and
uncontrollable costs and taking measures for effective cost control. It further enables the organisation
to determine the return on investment (ROI). In a nutshell, CBA is a process of comparing the costs
and benefits of a particular project or activity. Managerial economics involves various aspects of cost
and benefit analysis, such as cost-output relationships and cost control.
c) Pricing decisions, policies, and practices: Pricing is one of the key areas of managerial
economics. It is a process of finding the value of a product or service that an organisation receives in
exchange for its product/service. The profit of an organisation depends a great deal on its pricing
strategies and policies. Managerial economics includes various pricing-related concepts, such as
pricing methods, product-line pricing, and price forecasting.
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d) Profit Maximisation: Profit generation and maximisation is the main aim of every organisation
(except for non-profit organisations). In order to maximise profit, organisations need to have complete
knowledge about various economic concepts, such as profit policies and techniques, and break-even
analysis.
e) Capital management: Organisations often find it difficult to make decisions related to capital
investment. These decisions require sound knowledge and expertise on various economic aspects.
To make sound capital investment decisions, an organisation needs to determine various aspects,
such as cost of capital and rate of return.
1.9 SIGNIFICANCE OF MANAGERIAL ECONOMICS
Managerial economics plays an important role in decision making in an organisation. Decision
making is a process of selecting the best course of action from the available alternatives. In order to
make sound decisions; managers must have in-depth knowledge of economic concepts, theories,
and tools. The following points explain the importance of managerial economics:
i) Managerial economics covers various important concepts, such as demand and supply analysis;
short and long-run costs; and marginal utility. These concepts support managers in identifying and
analysing problems and finding solutions; ii) It helps managers to identify and analyse various internal
and external business factors and their impact on the functioning of the organisation; iii) Managerial
economics helps managers in framing various policies, such as pricing policies and cost policies, on
the basis of economic study and findings; iv) By studying various economic variables, such as cost
production and business capital, organisations can predict the future; v) Managerial economics helps
in establishing relationships between different economic factors, such as income, profits, losses, and
market structure. This helps in guiding managers in effective decision making and running the
organisation.

5. Demand analysis is a process of identifying _______________, the amount of goods they
want to purchase, and the price they are willing to pay for it
6. By studying various economic variables, such as production cost and business capital,
organisations cannot predict the future. (True/False)
Activity 3:
Prepare a report on the cost and benefit analysis (CBA) performed by Mahindra & Mahindra
for its product XUV 50.
1.10 DIFFERENCE BETWEEN ECONOMICS AND MANAGERIAL ECONOMICS

Economics and managerial economics are different from each other in various aspects. As
discussed earlier, economics is a study of human behaviour in making decisions related to the
allocation of resources. Managerial economics, on the other hand, deals with managerial decision
making in organisations. The following points distinguish between economics and managerial
economics:
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 Economics is a traditional subject that has prevailed from a long time, while managerial
economics is a modern concept and is still developing.
 Economics mainly covers theoretical aspects, whereas managerial economics covers
practical aspects.
 In economics, the problems of individuals and societies are studied. On the other hand, in
managerial economics, the main area of study is the problems of organisations.
 In economics, only economic factors are considered, whereas both economic and no-
economic factors are considered in managerial economics.
 Both microeconomics and macroeconomics fall under the scope of economics. On the
other hand, only microeconomics falls under the scope of managerial economics.
1.11 RELATIONSHIP OF MANAGERIAL ECONOMICS WITH OTHER DISCIPLINES
The managerial economics is related to various disciplines, which has been shown as under: -
a) Economics and Econometrics: Managerial economics is an application of economic theory
into business practices / management. Managerial economics uses both micro and macro
economics-their concepts, theories, tools and techniques. In managerial economics, we also use
various types of models such as schematic models (diagrams) analog models (flow charts) and
mathematical models and stochastic models. The roots of most of these models lie in economic logic.
Economics also tells us the art of constructing models. Empirically estimated functions, which are
being used in managerial economics, are basically econometric estimates.
b) Mathematics and Statistics – Mathematical tools are widely used in model building for
exploring the relationship between related economic variables. Most of the decision models are
constructed in terms of mathematical symbols. Geometry, trigonometry and algebra are different
branches of mathematics and they provide various tools & concepts such as logarithms,
exponentials, vectors, determinants, matrix, algebra, and calculus, differentials and integral.
Similarly, statistical tools are a great aid in business decision-making. Statistical tools such as theory
of probability, forecasting techniques, index numbers and regression analysis are used in predicting
the future course of economic events and probable outcome of business decisions. Statistical
techniques are used in collecting, processing and analyzing business data, and in testing the validity
of economic laws.
c) Operational Research (OR) – OR is used for solving the problems of allocation,
Transportation, inventory building, waiting line etc. Linear programming and goal programming models are very
useful for managerial decisions. These are widely used OR techniques. In fact, OR is an inter-
disciplinary solution finding technique. It combines economics, mathematics and statistics to build models
for solving specific problems and to find a quantitative solution there by.
d) Accountancy– It provides business data support for decision-making. The data on costs, revenues,
inventories, receivables and profits is provided by the accountancy. Cost accounting, ratio analysis,
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break-even analyses are the subject matters of accountancy and they are of great help to managers in
decision-making.
e) Psychology and Organisation Behaviour (OB)–In fact, managerial economics analyses the
individual behaviour of a buyer and seller [microeconomic units]. Psychology is helpful in understanding the
behavioural aspects like attitude and motivation of individual decision making unit. Psychological
Economics-a new discipline of recent origin analyses the buyer’s behaviour useful for marketing
management. Behavioural models of firms have also been developed based on organization psychology and
micro economics to explain the economic behaviour of a firm.
f) Management Theory – Management theories bring out the behaviour of the firm in its efforts to
achieve some predetermined objectives. With change in environment and circumstances, both the objectives
of firm and managerial behaviour change. Therefore sufficient knowledge of management theory is essential
to the decision-makers. The basic knowledge of the principles of personnel, marketing, financial and
production management is required for accomplishing the task.
1.12 SUMMARY
Economics can be defined as the study of optimum utilisation of scarce resources by individuals,
households, organisations, and nations to satisfy their wants and needs. Economics is defined by
taking four viewpoints, namely wealth viewpoint, scarcity viewpoint, welfare viewpoint, and growth
viewpoint. The Managerial Economics has emerged as a separate branch of knowledge in management
studies. Managerial Economics is the study of economic theory, logic and tools of economic analysis that are
used in the process of business decision making. Economic theories and techniques of economic analysis
are applied to analyze business problems, evaluate business options and opportunities with a view to arriving
at an appropriate business decision. Infact, it is an applied economics. The important features of Managerial
Economics are: Micro economic nature, economics of the firm, use of macroeconomic variables, normative
nature, focus on case study method, applied use of economics and more refined and developing discipline.
The scope of managerial economics spreads both to micro and macro economics. The theory of
demand, theory of production, analysis of market structure and pricing theory, profit analysis and
management, theory of capital and investment decisions are the subject matter of micro economics.
Macroeconomic issues pertain to macro economic variables, foreign trade and various policies of the
Government. Operational issues are internal and they are part of micro economics, while environmental
issues are exogenous and they are part of macro economics. Both these together constitute the subject
matter and scope of managerial economics.
1.13 GLOSSARY
 Managerial Economics: It is an applied Economics in the field of business management. It is an

application of economic theory and methodology in the business decision-making process. It is an
integration of economic theory with business practices.
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 Micro Economics: It is that branch of Economics in which the study of an individual economic unit
is done. For instance, the study of a firm is a subject matter of micro economics. It is also known as the
method of slicing.
 Macro Economic: It is that branch of Economics in which the economy as a whole is studied. It is
also known as the economics of lumping / aggregation.
 Macro Economic Variables: These are the variables which relate to the entire economy of a
nation / globe such as National Income, Inflation, Recession and they constitute the part of overall economic
environment.
 Positive Science: It pertains to the cause and effect relationship of an event. It is a factual analysis,
therefore, it studies ‘What is”.
 Normative Science: A science which studies “What ought to be”. In other words, it involves
value judgement; hence it is perspective in nature.
1.14 ANSWERS TO SELF CHECK EXERCISE
1.) d) Poverty
2.) True
3) False
4) a) It helps in understanding the mechanism of individual markets.
5) Potential Consumers
6) False
1. What does economic theory contribute to Managerial Economics?
2. What is the contribution of psychology and organization behavior to Managerial Economics?
3. How mathematics & statistics and operational research useful to Managerial Economics?
4. List the important characteristics of Managerial Economics.
5. Discuss the scope of managerial economics.
6. Why should you study the Managerial Economics?
7. Discuss the nature and significance of Managerial Economics.
8. Differentiate between economics and managerial economics.
9. Is it important to study managerial economics? Comment
10. Define macroeconomics. Discuss its importance.
11. What do you understand by microeconomics? Why it is important?
 Adhikary, M. Managerial Economics. Khosla Educational Publishers.
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 Brigham, E. & Pappas, J. Managerial Economics. Hinsdale Dryden Press.
 Dwivedi, D.N. Managerial Economics. Vikas Publishing House.
 Graham & Bodenhorn. Managerial Economic. Addison-Welsey Publishing Limited.
 Haynes, Mote and Paul, Managerial Economics — Analysis and Cases, Vakils. Feffer and
Simons Private Ltd., Bombay.
 Malcolm P. McNair and Richard S. Meriam, Problems in Business Economics, McGraw-Hill
Book Co., Inc.
 Mithani, D. M. Managerial Economics. Himalaya Publishing House.
 Mishra & Puri. Economics for Manager. Himalaya Publishing House.
 Pathania, Batra & Salwan. Managerial Economics. Regal Publications.
 Samuelson & Marks. Managerial Economic. John Wiley and Sons.
 Varshney & Maheshwari. Managerial Economic. Sultan Chand & Sons.
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CHAPTER 2
FIRM’S OBJECTIVES
STRUCTURE
2.2 INTRODUCTION
2.3 OBJECTIVES OF FIRMS
2.4 PROFIT: MEANING AND EXPLANATION
2.5 THEORIES OF PROFIT
2.6 CONCLUSION: THEORIES OF PROFIT
2.7 MANAGERIAL ECONOMIST
2.8 ROLES AND RESPONSIBILITIES OF MANAGERIAL ECONOMIST
2.9 FUNCTIONS OF MANAGERIAL ECONOMIST
2.10 FUNCTIONS PERFORMED BY MANAGERIAL ECONOMIST IN INDIAN CONTEXT
2.11 SUMMARY
2.12 GLOSSARY
 That what are objectives of the firm? And why they are operating?
 The meaning and theories of profit and why profit is important for the survival of a firm?
 The meaning, importance, role played and functions performed by managerial economist.
 The importance of managerial economist in Indian context.
2.2 INTRODUCTION
Economists have put forward various theories as to how firms behave in order to predict their
reaction to events. At the heart of such theories is an assumption about firm objectives, the most
usual being that the firm seeks to maximise profits. The present chapter examines a number of
alternative objectives open to the firm. It begins with those of a maximising type, namely profit, sales
revenue and growth maximisation, predicting firm price and output in each case. A number of non-
maximising or behavioural objectives are then considered. We see that although profit is important,
careful consideration must be given to a number of other objectives if we are accurately to predict
firm performance.
2.3 OBJECTIVES OF FIRMS
Sometimes there is an overlap of objectives. For example, seeking to increase market share, may
lead to lower profits in the short-term, but enable profit maximisation in the long run. The main
objectives of firms are as under: -
a) Profit Maximisation: Usually, in economics, we assume firms are concerned
with maximising profit. Higher profit means:
i) Higher dividends for shareholders.
ii) More profit can be used to finance research and development.
iii) Higher profit makes the firm less vulnerable to takeover.
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iv) Higher profit enables higher salaries for workers
However, in the real world, firms may pursue other objectives apart from profit maximisation.
b) Profit Satisficing: In many firms, there is a separation of ownership and control. Those who
own the company (shareholders) often do not get involved in the day to day running of the company.
This is a problem because although the owners may want to maximise profits, the managers have
much less incentive to maximise profits because they do not get the same rewards, (share
dividends). Therefore managers may create a minimum level of profit to keep the shareholders
happy, but then maximise other objectives, such as enjoying work, getting on with other workers.
(E.g. not sacking them) This is the problem of separation between owners and managers. This
‘principal-agent‘ problem can be overcome, to some extent, by giving managers share options
and performance related pay although in some industries it is difficult to measure performance.
c) Sales maximisation: Firms often seek to increase their market share – even if it means less
profit. This could occur for various reasons: i) Increased market share increases monopoly power and
may enable the firm to put up prices and make more profit in the long run. ii) Managers prefer to work
for bigger companies as it leads to greater prestige and higher salaries. iii) Increasing market share
may force rivals out of business. E.g. the growth of supermarkets has lead to the demise of many
local shops. Some firms may actually engage in predatory pricing which involves making a loss to
force a rival out of business.
d) Growth maximisation: This is similar to sales maximisation and may involve mergers and
takeovers. With this objective, the firm may be willing to make lower levels of profit in order to
increase in size and gain more market share. More market share increases their monopoly power
and ability to be a price setter.
e) Long run profit maximisation: In some cases, firms may sacrifice profits in the short term to
increase profits in the long run. For example, by investing heavily in new capacity, firms may make a
loss in the short run but enable higher profits in the future.
f) Social/environmental concerns: A firm may incur extra expense to choose products which
don’t harm the environment or products not tested on animals. Alternatively, firms may be concerned
about local community / charitable concerns. Some firms may adopt social/environmental concerns
as part of its branding. This can ultimately help profitability as the brand becomes more attractive to
consumers. Some firms may adopt social/environmental concerns on principal alone – even if it does
little to improve sales/brand image.
g) Co-operatives: Co-operatives may have completely different objectives to a typical PLC. A
co-operative is run to maximise the welfare of all stakeholders – especially workers. Any profit the co-
operative makes will be shared amongst all members.
17
1. Profit Maximisation is the main objective of the business firm but not the
profit satisficing. (True/False)
2. Which one is not the Primary objective of a business firm?
a) Profit Maximisation c) Growth Maximisation
b) Social/Environmental Concerns d) Customer Exploitation
Activity 1:
Analyse the social activities initiated by Bharti Airtel Limited in India and Write an
article on the same.
2.4 PROFIT: MEANING AND EXPLANATION

We all are familiar with the term ‘Profit’. It is quite a common-place word, but different people use it in
different senses. In Economics, however, the term has a precise meaning. Profit may be defined as
the net income of a business after all the other costs—rent, wages and interest etc., have been
deducted from the total income. Profits are, therefore, uncertain and vary from person to person and
from firm to firm. They may become zero, when costs are equal to income, and if the costs are
higher, profits may actually be converted into loss.
a) Entrepreneur’s Reward: Pure profit is the reward of entrepreneurial functions. It is what an
entrepreneur gets purely as an entrepreneur. What he gets as a landlord, manager or capitalist is
deducted from the total profits. Hence, Pure Profit is an amount which accrues to the entrepreneur for
assuming the risk inseparable from business.
b) True Profit is a Residual Element: Profit is arrived at after the other three factors of
production have received their remunerations out of national income. If may become zero or even
negative temporarily. But, in the long run, it must be positive, for otherwise the entrepreneur will give
up his independent activity and take to service for wages.
There are certain differences between total sale proceeds and total expenses over a year and
include the following besides net profit:
 Rent of the employer’s land or premises: Had similar premises been taken on rent, the
amount would have been added to costs. An equal figure should be deducted from gross profits to
find out net profit.
 Interest on entrepreneur’s capital: The interest on borrowed capital is usually deducted
before profits are worked out. Hence the interest which the owner’s own capital would have earned
elsewhere should be taken out before we can determine net profits.
 Wages of management: The entrepreneur may be himself providing the services of
management. If he had been employed elsewhere he would have earned some wages. An equal
amount has; therefore, to be deducted before net profits can be discovered.
 Maintenance charges: It is but reasonable that capital should be maintained intact. Worn-out
pieces should be replaced at the proper time. To do this, it is necessary to maintain a depreciation
fund. All expenses for this purpose should be deducted out of gross profits. If this is not done, profits
18
will appear to be large for a few years but one day the business will fail, because no funds will be
available to replace fixed assets like machinery.
 Net Profits: If we deduct from gross profits the above items, we shall get pure or net profits.
The entrepreneur is entitled to the following different kinds of payments which form a part of his net
profits.
c) Reward for risk-taking: Every business faces some risk of loss. But the risk of loss from
market-fluctuations has to be borne by the entrepreneur himself, and he will shoulder it only when he
has hopes to be paid for it.
d) Reward due to a monopolistic position: A particular entrepreneur may earn extra income
due to his control in the market over the entire supply of the commodity he produces.
e) Reward for better bargaining: If a business man is skillful in making bargains, he earns
more.
f) Windfalls: A sudden change in market conditions may bring in a large gain just by chance.
For instance, manufacturers of arms and ammunitions may earn much, if war breaks out.

3. _____________ is the reward of entrepreneurial functions.
4. Rent of employer’s land or premises is not included in profit. (True/False)
Activity 2:
Select any firm operating in your native place and calculate the net profit of that firm.
2.5 THEORIES OF PROFIT

Several theories have been put forward by way of explanation of profit. Let us examine some of well-
known among them.
a) Rent Theory of Profit: The Rent Theory of Profit was propounded by an American economist
F.A. Walker. He was the first to introduce a distinction between a capitalist and an entrepreneur into
English economic theory. An entrepreneur need not be a capitalist. He is a person who may
undertake a business without using any of his own capital.
Rent of Ability: Walker regards profit as rent of ability. Just as there are different grades of land,
there are different grades of entrepreneurs. The least efficient entrepreneur, who must remain in the
field of production to meet the current demand, just recovers his cost of production and nothing
besides. Above him are entrepreneurs of superior ability. Just as rent arises because of the
differential advantage enjoyed by superior land over the marginal land, similarly profit also is the
reward for differential ability of the entrepreneur over the marginal entrepreneur or the no-profit
entrepreneur.
Profit is thus like rent and, like rent it does not enter into price. Wages of management are not profit.
The marginal employer only earns the wages of management, and no more. With a slight unfavorable
turn of prices or costs, he would prefer to work as an employee rather than as an employer. Wages of
19
management thus must be paid to keep up the given supply of entrepreneurs. Such wages thus enter
into price.
Criticism: This theory has the same weakness as Ricardo’s theory of rent:
(i) The employer, who will leave the business with a slight unfavorable turn of events, is not
necessarily the least efficient. He may be higher up in the scale and may be attracted by more
profitable alternative employments.
(ii) The theory, moreover, does not explain the real nature of profits; it merely provides at best a
measure of profits.
(iii) Also, it is wrong to say that profits Jo not enter into price. They may not enter into price in the
short period but they must do so in the long run. Unless the price of the commodity he sells is high
enough to compensate the entrepreneur by ensuring the payment of normal profit, he will quit the
business. In this way, the supply of the commodity will decrease and its price rise to include normal
profit. Hence profit enters into price in the long run.
(iv) Finally, the theory fails to explain the size of the profit. The profit arises from scarcity of employers
and the theory of profits must explain the cause of this scarcity.
There is no doubt that there is differential element in profit ‘superior entrepreneurs earning higher
profit. But the analogy ends here. There can be no-rent land but there cannot any no-profit employer.
If he does not get profit in the long run, he will join the ranks of salaried employees. Nevertheless
profit does container element of rent because of differences in the ability of the entrepreneurs. But it
is not entirely of the nature of rent.
b) Dynamic Theory: This theory is associated with the name of J. B. Clark, who is of the opinion
that there can be no profit the static world where size and composition of the population, the .number
and variety of human tastes and desires, techniques of production, technical knowledge, commercial
organisation, etc. remain constant. In a world like this, everything is known and is knowable and can
be accurately foreseen. There is no risk, and hence no .profit Costs and selling price are always
equal, and there can be no profit beyond wages for the routine work of supervision. But we are not
living in a stationary state. Ours is a dynamic world and some changes are constantly taking place.
The clever entrepreneur foresees these changes. He is a pioneer. Somehow by invention or
otherwise, he lower his cost of production and makes profits.
The changing world offers limitless opportunities to the far-sighted, daring and clever entrepreneurs
to make profits by turning the facts of the situation in their favour. It is only because the world is
dynamic that it is possible for them to keep the lead and reap the profits. In a static state, profits will
disappear, and the entrepreneurs will only earn wages of management.
Criticism: Prof. Knight, however, is of the opinion that only those changes which cannot be foreseen
and which cannot be provided for in advance will yield profits and not others. He says, “It cannot,
then, be change, which is the cause of profit, since if the law of change is known as in fact is largely
20
the case, no profits can arise. Change may cause a situation out of which profit will be made, if it
brings about ignorance of the future”. Thus, it is the ignorance of the future or uncertainty, and not
necessarily change, which, according to Knight, is the cause of profit.
c) Reward for Risk-bearing: Most people do worry about the risk which makes them hesitate to
take a plunge in business. The greater the risk, the higher must be the expected gain in order to
induce them to start the business. All businesses are more or less speculative, and unless the risk-
taker is going to be amply rewarded, business will not be started. As risk acts as a great deterrent,
the supply of entrepreneurs is kept down, and those who do take the risk earn much more than the
normal return on capital. Hence profits are regarded as a reward for risk-taking or risk-bearing. The
theory of profit is associated with F. B. Hawley’s name. He says, profit is the reward for risks and
responsibilities that the undertaker…. subjects himself to.
Drucker mentions four kinds of risks: replacement, risk proper, uncertainty and obsolescence.
Replacement, generally known as depreciation, is calculable and is counted as a cost. Obsolescence
is the least calculable but is also an item in the costs. Risk proper (i.e., risk of marketability of the
product) and uncertainty are not costs in the conventional sense, but are charges against profits:
They may be called costs of staying in business. Physical risks like fire accident, etc., can be
provided against by insurance, and are, therefore, and included in costs. There are, however, risks
that cannot be foreseen, and hence cannot be provided against. It is for undertaking these risks that
an entrepreneur is rewarded.
Criticism: However, there is the view that though profits do contain some remuneration for risk-
taking, the high profits made by the entrepreneur cannot in their entirety be attributed to the element
of risk. They are not, at any rate, in proportion to the risks undertaken. On the contrary, it is pointed
out by Carver that profits arise not because risks are borne, but because the superior entrepreneurs
are able to reduce them.
We might say—though it may seem paradoxical—that profits are made not because risks are borne
but because they are avoided. Still it cannot be denied that great deals of pure profits are the reward
for risk-bearing.

5. Rent Theory of Profit is given by
a) F.A. Walker c) F.W. Taylor
b) J. B. Clark d) Amritya Sen
6. Dynamic theory of profit is given by J. B. Clark. (True/false)
Activity 3:
Apply dynamic theory of profit to calculate the profit in your organisation.
2.6 CONCLUSION: THEORIES OF PROFITS

We have discussed above the various theories of profit the question arises which theory we shall
accept’.’How does protitarise? Here we are thinking of not gross profits but net profit… The fact is
that, in the real world, there are several causes which give rise to profit, but the principal cause is
21
uncertainty. It is uncertainty which is the basic cause of profit. This uncertainty is due to the dynamic
nature of the world. In this real world of ours, some or the other change is always taking place. No
entrepreneur can foresee all these changes nor are the circumstances under his control.
The world is dynamic is due to two sets of factors: (a) Internal and (b) External
In other words, there are certain changes which the entrepreneur himself brings about, such as
innovation, and there are other changes which are brought about by external forces.
The external changes are of two kinds:
(a) Regular changes, like trade fluctuations, which affect all profits and
(b) Irregular changes, such as breaking out of fire, earthquake, floods, strikes, change in tastes,
changes due to government policies, war, etc.
Thus, profit irises on account of the occurrence of changes in the economy. In the static world, there
is no change, hence no profit in an economy where nothing changes, there can be no profit. But only
such changes are the causes of profit-as cannot be foreseen, as we have read in Knight’s theory.
However, in a static world, profit can arise in one way, i.e., owing to monopoly. The monopoly profit
arises in the dynamic world also. Besides monopoly, profit arises also from any other position of
advantage.
In short, we can say that there are two main sources of profits:
(a) Uncertainty; and
(b) Position of special advantage, monopoly or otherwise.
Thus, there is no single theory which will explain profit but a synthesis of all the theories mentioned
above. Profit is a reward for the services of the entrepreneur. The supply of the entrepreneurial ability
is limited, whereas the demand for their services is very great. The rate of profit, at any given
moment, will depend on the interaction of demand and supply of entrepreneurial ability for risking
capital and, in the long run, it must be such as to call forth and maintain the supply of entrepreneurial
services.
2.7 MANAGERIAL ECONOMIST
A managerial economist plays a very important role by assisting the management in using the
increasingly specialised skills and sophisticated techniques, required to solve the difficult problems of
successful decision-making and forward planning. In business concerns, the importance of the
managerial economist is therefore recognised a lot today. In advanced countries like the USA, large
companies employ one or more economists. In our country too, big industrial houses have
understood the need for managerial economists. Such business firms like the Tatas, DCM and
Hindustan Lever employ economists. A managerial economist can contribute to decision-making in
business in specific terms. In this connection, two important questions need be considered: a) what
role does he play in business, that is, what particular management problems lend themselves to
22
solution through economic analysis? B) How can the managerial economist best serve
management, that is, what are the responsibilities of a successful managerial economist?
2.8 ROLES AND RESPONSIBILITIES OF MANAGERIAL ECONOMIST
One of the principal objectives of any management in its decision-making process is to determine the
key factors, which will influence the business over the period ahead. In general, these factors can be
divided into two categories: a) External and b) Internal
The external factors lie outside the control of management because they are external to the firm
and are said to constitute business environment. The internal factors lie within the scope and
operations of a firm and hence within the control of management, and they are known as business
operations. To illustrate, a business firm is free to take decisions about what to invest, where to
invest, how much labour to employ and what to pay for it, how to price its products, and so on. But all
these decisions are taken within the framework of a particular business environment, and the firm’s
degree of freedom depends on such factors as the government’s economic policy, the actions of its
competitors and the like.
a) Environmental Studies of a Business Firm: An analysis and forecast of external factors
constituting general business conditions, for example, prices, national income and output, volume of
trade, etc., are of great significance since they affect every business firm. Certain important relevant
factors to be considered in this connection are as follows:
i) The outlook for the national economy, the most important local, regional or worldwide economic
trends, the nature of phase of the business cycle that lies immediately ahead;
ii) Population shifts and the resultant ups and downs in regional purchasing power; iii)
The demand prospects in new as well as established markets. Impact of changes in social behaviour
and fashions, i.e., whether they will tend to expand or limit the sales of a company’s products, or
possibly make the products obsolete?
iv)The areas in which the market and customer opportunities are likely to expand or contract most
rapidly;
v) Whether overseas markets expand or contract and the affect of new foreign government
legislations on the operation of the overseas plants?
vi) Whether the availability and cost of credit tend to increase or decrease buying, and whether
money or credit conditions ahead are likely to easy or tight?
vii) The prices of raw materials and finished products.
viii) Whether the competition will increase or decrease;
ix) The main components of the five-year plan, the areas where outlays have been increased and the
segments, which have suffered a cut in their outlays;
x) The outlook to government’s economic policies and regulations and changes in defence
expenditure, tax rates tariffs and import restrictions;
23
xi) Whether the Reserve Bank’s decisions will stimulate or depress industrial production and
consumer spending and how will these decisions affect the company’s cost, credit, sales and profits.
b) Business Operations: A managerial economist can also be helpful to the management in
making decisions relating to the internal operations of a firm in respect of such problems as price,
rate of operations, investment, expansion or contraction. Certain relevant questions in this context
would be as follows:
i) What will be a reasonable sales and profit budget for the next year?
ii) What will be the most appropriate production schedules and inventory policies for the next six
months?
iii) What changes in wage and price policies should be made now?
iv) How much cash will be available next month and how should it be invested?
2.9 FUNCTIONS OF MANAGERIAL ECONOMIST
The managerial economists can play a further role, which can cover the following specific functions
as revealed by a survey pertaining to Brittain conducted by K.J.W. Alexander and Alexander G.
Kemp:
i) Sales forecasting;
ii) Industrial market research;
iii) Economic analysis of competing companies;
iv) Pricing problems of industry;
v) Capital projects;
vi) Production programmes;
vii) Security / Investment analysis and forecasts;
viii) Advice on trade and public relations;
ix) Advice on primary commodities;
x) Advice on foreign exchange;
xi) Economic analysis of agriculture;
xii) Analysis of underdeveloped economics;
xiii) Environmental forecasting.
The managerial economist has to gather economic data, analyse all relevant information about the
business environment and prepare position papers on issues facing the firm and the industry. In the
case of industries prone to rapid theological advances, the manager may have to make continuous
assessment of tl1e impact of changing technology. The manager' may need to evaluate the capital
budget in the light of short and long-range financial, profit and market potentialities. Very often, he
also needs to prepare speeches for the corporate executives. It is thus clear that in practice,
managerial economists perform many and various functions. However, of all these, the marketing
functions, i.e., sales force listing an industrial market research, are the most important.
24
For this purpose, the managers may collect statistical records of the sales performance of their own
business and those rehiring to their rivals, carry out analysis of these records and report on trends in
demand, their market shares, and the relative efficiency of their retail outlets. Thus, while carrying out
their functions, the managers may have to undertake detailed statistical analysis. There are, of
course, differences in the relative importance of· the various functions performed from firm to firm and
in the degree of sophistication of the methods used in performing these functions. But there is no
doubt that the job of a managerial economist requires alertness and the ability to work under
pressure.
a) Economic Intelligence: Besides these functions involving sophisticated analysis, managerial
economist may also provide general intelligence service. Thus the economist may supply the
management with economic information of general interest such as competitor’s prices and products,
tax rates, tariff rates, etc.
b) Participating in Public Debates: Many well-known business economists participate in public
debates. The government and society alike are seeking their advice and views. Their practical
experience in business and industry adds prestige to their views. Their public recognition enhances
their protégé in the .firm itself.

7. The survey which revealed the functions performed by managerial Economist
was conducted by K.J.W. Alexander and Brittain. (True/False).
8. ____________ participates in public debates.
Activity 4:
Arrange a debate on Analysis of Underdeveloped Economies in your institution.
2.10 FUNCTIONS PERFORMED BY MANAGERIAL ECONOMIST IN INDIAN CONTEXT

In the Indian context, a managerial economist is expected to perform the following functions:
i) Macro-forecasting for demand and supply;
ii) Production planning at macro and micro levels;
iii) Capacity planning and product-mix determination;
iv) Economics of various production lines;
v) Economic feasibility of new production lines / processes and projects;
vi) Assistance in preparation of overall development plans;
vii) Preparation of periodical economic reports bearing on various matters such as the company's
product-lines, future growth opportunities, market pricing situation, general business and various
national/international factors affecting industry and business;
viii) Preparing briefs; speeches, articles and papers for top management for various chambers,
Committees, Seminars, Conferences, etc.;
ix) Keeping management informed of various national and International Developments on
economic/industrial matters.
25
With the adoption of the new economic policy, the macro-economic environment is changing fast and
these changes have tremendous implications for business. The managerial economists have to play
a much more significant role. As India marches towards globalisation, the managerial economists will
have to interpret the global economic events and find out how the firm can avail itself of the various
export opportunities or of establishing plants abroad either wholly owned or in association with local
partners.
2.11 SUMMARY
Economists have put forward various theories as to how firms behave in order to predict their
reaction to events. At the heart of such theories is an assumption about firm objectives, the most
usual being that the firm seeks to maximise profits. The managerial economist has a very important
role to play by helping management in successful decision-making and forward planning. But to
discharge his role successfully, it is necessary to recognise the 'relevant responsibilities and
obligations. To some business executives, however, a managerial economist is still a luxury or
perhaps even a necessary evil. It is not surprising, therefore, to find that while their status is
improving and their importance is gradually rising, managerial economists in certain firms still 'feel
quite insecure. Nevertheless, there is a definite and growing realisation that they can contribute
significantly to the profitable growth of firms and effective solution to the problems and this helps
them to predict a positive future of the firm.
2.12 GLOSSARY
 Business is an organisation or economic system where goods and services are exchanged
for one another or for money. Every business requires some form of investment and enough
customers to whom its output can be sold on a consistent basis in order to make a profit. Businesses
can be privately owned, not-for-profit or state-owned.
 Business Operations means everything that happens within a company to keep it running
and earning money is referred to collectively as business operations. Business plans often include a
section dedicated to operations so that company founders understand the systems, equipment,
people, and processes need to make the organization function.
 Entrepreneur is a person who sets up a business or businesses, taking on financial risks in
the hope of profit.
 Firm is organizations which sells or produces something or which provides a service which
people pay for.
 Managerial Economist helps the management by using his analytical skills and highly
developed techniques in solving complex issues of successful decision-making and future advanced
planning. He assists the business planning process of a firm.
26
 Profit is the financial gain from business activity minus expenses. Profit is the income
remaining after total costs are deducted from total revenue. It is the most commonly used measure of
success of a business.
 Rent is money or other consideration paid by a tenant to a landlord in exchange for the
exclusive use and enjoyment of land, a building or a part of a building. The word has also come to be
used as a verb as in to rent an apartment, although the proper legal term would be to lease an
apartment.
1. False
2. d) Customer Exploitation
3. Pure Profit
4. False
5. a) F.A. Walker
6. True
7. False
8. Business Economists
1. Discuss the importance of managerial economist in framing the objectives of a business firm.
2. What do you understand by business firm? Describe the objectives of a firm.
3. Profit maximisation is the primary objective of the firm. Do you agree? If yes, please specify
your answer with supportive examples.
4. Does social consideration is necessary for the long-run survival of a business firm? Comment.
5. Define the term Profit. How you can calculate the net profit of a business firm? Elaborate.
6. Discuss the importance of Rent theory and Dynamic theory theories of profit.
7. What do you mean by managerial economist? Discuss their role and responsibilities.
8. What are the main functions undertaken by Managerial Economist in an economy?

Book Co., Inc.
27
CHAPTER 3
DEMAND ANALYSIS
STRUCTURE
3.2 INTRODUCTION: CONCEPT OF DEMAND
3.3 DETERMINANTS OF DEMAND
3.4 IMPACT OF DETERMINANTS ON DEMAND
3.5 THE LAW OF DEMAND
3.6 ASSUMPTIONS
3.7 CHARACTERISTICS OF LAW OF DEMAND
3.8 DEMAND SCHEDULE
3.9 EXTENSION AND CONTRACTION OF DEMAND
3.10 INCREASE AND DECREASE IN DEMAND
3.11 ELASTICITY OF DEMAND
3.12 TYPES OR DEGREES OF PRICE ELASTICITY OF DEMAND
3.13 METHODS OF MEASURING PRICE ELASTICITY OF DEMAND
3.14 IMPORTANCE OF PRICE ELASTICITY OF DEMAND
3.15 SUMMARY
3.16 GLOSSARY
 The meaning and concept and determinants of demand.
 The impact of determinants on demand
 The meaning and concept of law of demand and exceptions to the law of demand.
 The price elasticity of demand
3.2 INTRODUCTION: CONCEPT OF DEMAND
Demand is a common parlance means desire for an object. But in economics demand is
something more than this. In economics “Demand” means the quantity of goods and services
which a person can purchase with a requisite amount of money. Stonier and Hague, “Demand in
economics means demand backed up by enough money to pay for the goods demanded”. In other
words, demand means the desire backed by the willingness to buy a commodity and purchasing
power to pay. Hence desire alone is not enough. There must have necessary purchasing power, i.e.
cash to purchase it. Thus the demand has three essentials-Desire, Purchasing power and
Willingness to purchase. It is a different and broad concept than the ‘desire’ and “Want”. The following five
elements are inclusive in it: -
a) Desire to acquire a product-willingness to have it;
b) Ability to pay for it-purchasing power to buy it;
c) Willingness to spend on it;
d) Given/particular price; and
e) Given/particular time period.
28
The presence of first three elements constitutes the ‘want’. Thus, it is evident that without
reference to specific price and time period, demand has no meaning. For instance, Ram is desirous of
buying a car, but he does not have sufficient money to buy it, it can’t be termed demand as he does not
have sufficient purchasing power to buy a car. Suppose, Ram is has sufficient money to buy a car, but he
does not want to spend on it-even in such a situation, the desire of Ram for a car will remain a desire.
What is required for being a demand is sufficient purchasing power and willingness to spend on that
product for which he has desire to acquire. Not only this, the demand for a product must be expressed in
reference to certain given price and time period, otherwise it won’t be a demand. Thus, the concept of
demand has following characteristics:
1. It is effective desire / want;
2. It is related with certain price; and
3. It is related with specific time period.
The complete definition of demand has been given by Prof. Meyers, “The demand for a good is a
schedule of the amount that buyers would be willing to purchase at all possible prices at any one instant of
time.”
3.3 DETERMINANTS OF DEMAND
The demand for a commodity arises from the consumer’s willingness and ability to purchase the
commodity. The demand theory says that the quantity demanded of a commodity is a function of or
depends on not only the price of a commodity, but also on income of the person, price of related
goods – both substitutes and complements – tastes of consumer, price expectation and all other
factors. Demand function is a comprehensive formulation which specifies the factors that influence
the demand for the product.
Dx = f(Px, Py, Pz, B, A, E, T, U).
Where, Dx = Demand for item x; Px = Price of item x; Py = Price of substitutes; Pz = Price of
complements; B = Income of consumer; E = Price expectation of the user; A = Advertisement
Expenditure; T = Taste or preference of user; U = All other factors
3.4 IMPACT OF DETERMINANTS ON DEMAND
a) Price effect on demand: Demand for x is inversely related to its own price. This can be
shown as: Dx ∝ 1/Px . This shows that demand for x is inversely proportional to price of x. This
means as price of x increases, the quantity demanded of x falls.
b) Substitution effect on demand: If y is a substitute of x, then as price of y increases, demand

for x also increases. Example: Tea and coffee, cold drinks and juice etc. are substitutes. This can be
shown as: Dx ∝ Px. This shows that the demand for x is directly proportional to price of substitute
commodity y. This means demand for x and price of substitute commodity y are directly related.
29
c) Complementary effect on demand: If z is a complement of x, then as the price of z falls, the
demand for z goes up and thus the demand for x also tends to rise. Example: Ink and pen, bread
and butter etc. are complements. This can be shown as: Dx ∝ 1/Px. This shows that the demand for
x is inversely proportional to the price of complementary commodity z. This means demand for x and
price for complementary commodity y are inversely directly related.
d) Price expectation effect on demand: Here the relation may not be definite as the psychology of
the consumer comes into play. Your expectations of a price increase might be different from your
friends’.
e) Income effect on demand: As income rises, consumers buy more of normal goods (positive
effect) and less of inferior goods (negative effect). Examples of normal goods are t-shirts, tea, sugar,
noodles, watches etc. and examples of inferior goods are low quality rice, jowar, second hand goods
etc. This can be shown as: Dx ∝ B, if X is normal good.; Dx ∝ 1/B, if X is an inferior good.
f) Promotional effect on demand: Advertisement increases the sale of a firm up to a point. This
can be shown as: Dx ∝ A. This means that, demand for x is directly proportional to advertisement
expenditure of the firm producing x. (Note: advertisements do not that powerful effect on demand)
Socio-psychological determinants of demand like tastes and preferences, custom, habits, etc. is
difficult to explanation theoretically.

1. Demand means the quantity of goods and services which a person can purchase with a
requisite amount of money.
(True/False)
2. Demand for a commodity arises from the consumer’s _______ and _____ to purchase
that commodity.
Activity 1:
Conduct a Group Discussion on the topic, “Impact of Determinants on Demand.”
3.5 THE LAW OF DEMAND

The law of demand states an inverse relationship between the price of a commodity and its quantity
demanded, if other things remaining constant (Ceteris Paribus), i.e., at higher price, less quantity is demanded
and at lower price, larger quantity is demanded. Prof. Paul Samuelson has defined the law of demand,
“if a greater quantity of a good is thrown on the market then - other things being equal- it can be sold only
at a lower price.”
3.6 ASSUMPTIONS
The law of demand is based on the following important assumptions: i) The money income of consumer
should remain the same; ii) There should be no change in the scale of preference (taste, habit & fashion)
of the consumer; iii) There should be no change in the price of substitute goods; iv) There should be no
expectation of price changes of the commodity in near future; and v) The commodity under question
should not be prestigious or of snob appeal.
Table 3.1: Price and Quantity Demanded
Relationship
Price (In Rs.)30 Quantity Demanded (In Units)
5 80
5 100
3 150
Total 200
3.7 CHARACTERISTICS OF LAW OF DEMAND
So by observing a demand curve the main characteristics are: i) Inverse relationship between the
price and the quantity demanded. i) This is shown by the downward sloping demand curve; ii) Price
is an independent variable and the demand is dependent. It is the effect of price on demand and
not vice versa; and iii) Reasons underling the law of demand- this inverse relationship can be
explained in terms of two reasons.
3.8 DEMAND SCHEDULE
It is a list of alternative hypothetical prices and the quantities demanded of a good corresponding to
these prices. It refers to the series of quantities an individual is ready to buy at different prices. An
imaginary demand schedule of an individual for apples is given below:
Table 3.2: Demand of a Consumer for apples
Price of Apple (In Rs.) Quantity Demanded of Apples (In
Dozens)
5 1
2 4
3 3
4 2
Assuming the individual to be rational in his purchasing behaviour, the above schedule
illustrates the law of demand. At Rs.5/- per apple, the consumer demands 1 dozen of apples; at
Rs.4/- per unit 2 dozens, at Rs.3/- per unit 3 dozens and at Rs.2/~ per unit 4 dozens. Thus the
inverse relationship between price and demand is shown in the demand schedule.
3.9 EXTENSION AND CONTRACTION OF DEMAND
Demand may change due to various factors. The change in demand due to change in price only
and other factors remaining constant. It is called extension and contraction of demand. A change
in demand solely due to change in price is called extension and contraction. When the quantity
demanded of a commodity rises due to a fall in price, it is called extension of demand. On the other
hand, when the quantity demanded falls due to a rise in price, it is called contraction of demand. It
can be understand from the following diagram:
3.10 INCREASE OR DECREASE IN DEMAND
When the price of commodity is OP, quantity demanded is OQ. If
the price falls to P2, quantity demanded increases to OQ2. When
price rises to P1, demand decreases from OQ to OQ1. In demand
curve, the area a to c is extension of demand and the area a to b is
contraction of demand. As result of change in price of a commodity,
the consumer moves along the same demand.
31
When the demand changes due to changes in other factors, like taste and preferences, income,
price of related goods etc. , it is called shift in demand. Due to changes in other factors, if the
consumers buy more goods, it is called increase in demand or upward shift. On the other hand, if
the consumers buy fewer goods due to change in other factors, it is called downward shift or
decrease in demand. Shift in demand cannot be shown in same demand curve. The increase
and decrease in demand (upward shift and downward shift) can be expressed by the following
diagram:
DD is the original demand curve. Demand curve shift upward
due to change in income, taste & preferences etc of consumer,
where price remaining the same. In the above diagram demand
curve D1- D1 is showing upward shift or increase in demand
and D2-D2 shows downward shift or decrease in demand.

3. A change in demand solely due to change in price is called ______ and contraction.
4. In law of Demand there is no inverse relationship between the price and quantity
demanded. (True/False)
Activity 2:
Draw the demand schedule for Petroleum products.
3.11 ELASTICITY OF DEMAND
A change in the price of a commodity affects its demand. We can find the elasticity of demand, or the
degree of responsiveness of demand by comparing the percentage price changes with the quantities
demanded. In this article, we will look at the concept of elasticity of demand and take a quick look at its
various types. It measures the percentage change in quantity demanded for a percentage change in
the price. Simply, the relative change in demand for a commodity as a result of a relative change in
its price is called as the elasticity of demand. “Elasticity of demand is the responsiveness of the
quantity demanded of a commodity to changes in one of the variables on which demand depends. In
other words, it is the percentage change in quantity demanded divided by the percentage in one of the
variables on which demand depends.” The variables on which demand can depend on are: i) Price of
the commodity; ii) Prices of related commodities; and iii) Consumer’s income, etc.
For example: a) the price of a radio falls from Rs. 500 to Rs. 400 per unit. As a result, the demand
increases from 100 to 150 units. b) Due to government subsidy, the price of wheat falls from Rs. 10/kg
to Rs. 9/kg. Due to this, the demand increases from 500 kilograms to 520 kilograms. In both cases a
and b, you can notice that as the price decreases, the demand increases. Hence, the demand for radios
and wheat responds to price changes.
3.12 TYPES OR DEGREES OF PRICE ELASTICITY OF DEMAND
32
The types of elasticity of demand are as under:
a) Perfectly Elastic Demand (EP = ∞): The demand is said to be perfectly elastic if the quantity
demanded increases infinitely (or by unlimited quantity) with a small fall in price or quantity
demanded falls to zero with a small rise in price. Thus, it is also known as infinite elasticity. It does
not have practical importance as it is rarely found in real life.
In the given figure, price and quantity demanded are measured

along the Y-axis and X-axis respectively. The demand
curve DD is a horizontal straight line parallel to the X-axis. It
shows that negligible change in price causes infinite fall or rise in
quantity demanded
b) Perfectly Inelastic Demand (EP = 0): The demand is said to be perfectly inelastic if the
demand remains constant whatever may be the price (i.e. price may rise or fall). Thus it is also called
zero elasticity. It also does not have practical importance as it is rarely found in real life.
In the given figure, price and quantity demanded are measured along the
Y-axis and X-axis respectively. The demand curve DD is a vertical
straight line parallel to the Y-axis. It shows that the demand remains
constant whatever may be the change in price. For example: even after
the increase in price from OP to OP2 and fall in price from OP to OP1,
the quantity demanded remains at OM.
c) Relatively Elastic Demand (EP> 1): The demand is said to be relatively elastic if the
percentage change in demand is greater than the percentage change in price i.e. if there is a greater
change in demand there is a small change in price. It is also called highly elastic demand or simply
elastic demand. For example: If the price falls by 5% and the demand rises by more than 5% (say
10%), then it is a case of elastic demand. The demand for luxurious goods such as car, television,
furniture, etc. is considered to be elastic.
d) Relatively Inelastic Demand (Ep< 1 )
In theinelastic
The demand is said to be relatively given figure, price and quantity
if the percentage changedemanded
in quantityaredemanded is less
measured along the Y-axis and X-axis respectively.
than the percentage change in price i.e. if there is a small change in demand with a greater change in
The demand curve DD is more flat, which shows that
theordemand
price. It is also called less elastic is elastic.
simply inelastic demand.The For
small fall inwhen
example: price
the price falls by
from OP to OP1 has led to greater increase in
10% and the demand rises by less than 10% (say 5%), then it is the case of inelastic demand. The
demand from OM to OM1. Likewise, demand
decrease
demand for goods of daily consumption more
such aswith
rice,small increase inetc.
salt, kerosene, priceis said to be inelastic.
In the given figure, price and quantity demanded are
measured along the Y-axis and X-axis respectively. The
demand curve DD is steeper, which shows that the
demand is less elastic. The greater fall in price from OP
to OP1 has led to small increase in demand
from OM to OM1. Likewise, greater increase in price
leads to small fall in 33
demand.
e) Unitary Elastic Demand ( Ep = 1): The demand is said to be unitary elastic if the percentage
change in quantity demanded is equal to the percentage change in price. It is also called unitary
elasticity. In such type of demand, 1% change in price leads to exactly 1% change in quantity
demanded. This type of demand is an imaginary one as it
is rarely applicable in our practical life.
. In the given figure, price and quantity demanded are
measured along Y-axis and X-axis respectively. The
demand curve DD is a rectangular hyperbola, which
shows that the demand is unitary elastic. The fall in
price from OP to OP1 has caused equal proportionate
increase in demand from OM to OM1. Likewise, when
price increases, the demand decreases in the same
proportion.
3.13 METHODS OF MEASURING PRICE ELASTICITY OF DEMAND

There are basically four ways by which we can measure price elasticity of demand. These methods
are:
a) Percentage Method: Percentage method is one of the commonly used approaches of
measuring price elasticity of demand under which price elasticity is measured in terms of rate of
percentage change in quantity demanded to percentage change in price. According to this method,
price elasticity of demand can be mathematically expressed as:
b) Total Outlay Method

Total outlay method, also known as total expenditure method of measuring price elasticity of demand
was developed by Professor Alfred Marshall. According to this method, price elasticity of demand can
be measured by comparing total expenditure on a commodity before and after the price change.
While comparing the expenditure, we may get one of three outcomes.
Elasticity of demand will be greater than unity (Ep > 1): When total expenditure increases with fall
in price and decreases with rise in price, the value of Price Elasticity of Demand will be greater than
1. Here, rise in price and total outlay or expenditure move in opposite direction.
34
Elasticity of demand will be equal to unity (Ep = 1): When total expenditure on commodity
remains unchanged in response to change in price of the commodity, the value of PED will be equal
to 1.
Elasticity of demand will be less than unity (Ep < 1) When total expenditure decreases with fall in
price and increases with rise in price, the value of PED will be less than 1. Here, price of commodity
and total outlay move in same direction.
Cases Price Quantity Total Outlay or Expenditure Price Elasticity of
(P) Demanded (Q) (E= P xQ) Demand (PED)
I 6 1 6
5 2 10 10/6, >1
II 4 3 12
3 4 12 12/12=1
III 2 5 106
1 6 6/10, <1
When the information from the above table is plotted in the graph, we get graph like the one shown
as:
In the graph, total outlay or expenditure is measured on the X-axis while price
is measured on the Y-axis. In the figure, the movement from point A to point B
shows elastic demand as we can see that total expenditure has increased with
fall in price. The movement from point B to point C shows unitary elastic
demand as total expenditure has remained unchanged with the change in price.
Similarly, the movement from point C to point D shows inelastic demand as
total expenditure as well as price has decreased. Total outlay method of
measuring price elasticity of demand does not provide us exact numerical
measurement of elasticity of demand but only indicates if the demand is elastic,
inelastic or unitary in nature. Therefore, this method has limited scope.
c) Point Method: The point method of measuring price elasticity of demand was also devised by
Prof. Alfred Marshall. This method is used to measure the price elasticity of demand at any given
point in the curve. According to this method, elasticity of demand will be different on each point of a
demand curve. Thus, this method is applied when there is small change in price and quantity
demanded of the commodity. According to this method, price elasticity of demand (PED) is
mathematically expressed as
However, the method of calculating PED depends upon the nature of the demand curve.
d) Arc Method: Any two points on a demand curve make an arc, and the coefficient of price
elasticity of demand of an arc is known as arc elasticity of demand. This method is used to find out
price elasticity of demand over a certain range of price and quantity. Thus, this method is applied
while calculating PED when price or quantity demanded of the commodity is highly changed.
35
In the figure, we can see that AB is an arc on the demand curve
DD, and point C is the mid-point on AB. If we followed point
method to measure PED at points A and B in the curve DD, we
get different coefficients as a result of using different bases. To
avoid this discrepancy, elasticity is measured by taking mean
values of price and quantity demanded in arc method.
The average of price and quantity demanded is calculated as follows:
Once the average value of price and quantity demanded are determined, PED at point C can be
calculated by applying following formula:
Where: -
ΔQ = change in quantity demanded = Q2 –
Q1; Q1 = initial quantity demanded;
Q2 = new quantity demanded; ΔP = change in
price = P2 – P1; P1 = new price; P2 = initial
price
3.14 IMPORTANCE OF PRICE ELASTICITY OF DEMAND

Price elasticity of demand is a very important concept. Its importance can be realized from the
following points:
a) International trade: In order to fix prices of the goods to be exported, it is important to have
knowledge about the elasticity’s of demand for such goods. A country may fix higher prices for the
products with inelastic demand. However, if demand for such goods in the importing country is
elastic, then the exporting country will have to fix lower prices.
b) Formulation of Government Policies: The concept of price elasticity of demand is important
for formulating government policies, especially the taxation policy. Government can impose higher
36
taxes on goods with inelastic demand, whereas, low rates of taxes are imposed on commodities with
elastic demand.
c) Factor Pricing: Price elasticity of demand helps in determining price to be paid to the factors
of production. Share of each factor in the national product is determined in proportion to its demand
in the productive activity. If demand for a particular factor is inelastic as compared to the other
factors, then it will attract more rewards.
d) Decisions of Monopolist: A monopolist considers the nature of demand while fixing price of
his product. If demand for the product is elastic, then he will fix low price. However, if demand is
inelastic, then he is in a position to fix a high price.
e) Paradox of poverty amidst plenty: A bumper crop, instead of bringing prosperity to farmers,
brings poverty. This is called the paradox of poverty amidst plenty. It happens due to inelastic
demand for most of the agricultural products. When supply of crops increases as a result of rich
harvest, their prices drastically fall due to inelastic demand. As a result, their total income goes down.

5. The Change in price of a commodity directly affects its demand. (True/False)
6. Total Outlay Method is also known as ___________ method of measuring price
elasticity of demand.
Activity 3:
Prepare a Power Point Presentation on importance of Price elasticity of demand.
3.15 SUMMARY
The demand for a commodity is its quantity which consumers are able and willing to buy at various
prices during a given period of time. So, for a commodity to have demand the consumer must
possess willingness to buy it, the ability or means to buy it, and it must be related to per unit of time
i.e. per day, per week, per month or per year. In economics, the demand for a commodity refers to
both the desire to purchase the commodity as well as the ability to pay for it. Since a business would
not be able to exist if there was improper demand estimate or demand forecast, hence demand
analysis is one of the most important aspects of managerial economics. The concept of elasticity of
demand plays a crucial role in the pricing decisions of the business firms and the Government when it
regulates prices. The concept of elasticity is also important in judging the effect of devaluation of a
currency on its export earnings. It has also a great use in fiscal policy because the Finance Minister
has to keep in view the elasticity of demand when it considers imposing taxes on various
commodities.
3.16 GLOSSARY
 Demand in economics is defined as consumers' willingness and ability to consume a given
good.
37
 Demand Schedule is a chart that shows the number of goods or services demanded at
specific prices. It is a table that shows the relationship between the price of goods and the amount of
goods consumers are willing and able to pay for them at that price.
 Determinants of Demand are factors that cause fluctuations in the economic demand for a
product or a service. A shift in the demand curve occurs when the curve moves from D to D₁, which
can lead to a change in the quantity demanded and the price.
 Elasticity of Demand is a measure of change in the quantity demanded in response to the
change in the price of the commodity. Simply, the effect of a change of price on the quantity
demanded is called as the elasticity of demand.
 Extension and Contraction of Demand means that demand for a commodity changes due to
a change in price. When there is decrease in price of commodity there is in increase in demand of
that commodity and vice-versa.
 Law of Demand is the inverse relationship between price and quantity demanded of a good
and it is represented by a downward sloping line known as the demand curve.
1. True
2. Willingness, Ability
3. Extension
4. False
5. True
6. Total Expenditure
1. What do you understand by demand? What are the determinants of Demand? Discuss.
2. How rise in price of petrol will affect the demand for cars? Elaborate.
3. What are the basic assumptions of law of demand? Discuss with the help of example.
4. Write short notes on:
a) Demand Schedule b) Extension and Contraction of Demand
c) Increase and Decrease in Demand
5. What do you mean by elasticity of demand? Discuss in brief the degrees of price elasticity of
demand.
6. What do you understand by Arc method of measuring the price elasticity of demand?

Book Co., Inc.
38
39
CHAPTER 4
DEMAND FORECASTING
STRUCTURE
4.2 INTRODUCTION: CONCEPT OF DEMAND FORECASTING
4.3 BASIS OF DEMAND FORECASTING
4.4 OBJECTIVES OF DEMAND FORECASTING
4.5 IMPORTANCE OF DEMAND FORECASTING
4.6 SCOPE OF DEMAND FORECASTING
4.7 STEPS IN DEMAND FORECASTING
4.8 TECHNIQUES OF DEMAND FORECASTING
4.8.1 QUALITATIVE TECHNIQUES
4.8.2 QUANTITTATIVE TECHNIQUES
4.8.3 SMOOTHING TECHNIQUES
4.8.4 BAROMETRIC METHODS
4.8.5 ECONOMETRIC METHODS
4.8.6 CORRELATION AND REGRESSION
4.9 LIMITATIONS OF DEMAND FORECASTING
4.10 SUMMARY
4.11 GLOSSARY
After studying this chapter, you will be able to understand:
 The concept of demand forecasting
 The various techniques of demand forecasting
 The limitations of demand forecasting
4.2 INTRODUCTION: CONCEPT OF DEMAND FORECASTING
Every business involves certain risks and uncertainties especially in today’s dynamic world. If these
risks are not mitigated on time, it may lead to huge losses for organisations. Organisations can
cope with these risks by determining the future demand or sales prospects for its products or
services. Demand forecasting is a process of predicting the demand for an organisation’s products
or services in a specified time period in the future. Forecasting simply refers to estimating or
anticipating future events. It is an attempt to foresee the future by examining the past. Thus
demand forecasting means estimating or anticipating future demand on the basis of past data.
Demand forecasting can be defined as a process of predicting the future demand for an
organisation’s goods or services. It is also referred to as sales forecasting as it involves anticipating
the future sales figures of an organisation.
Evan J. Douglas, “Demand estimation (forecasting) may be defined as a process of finding
values for demand in future time periods.” Cundiff and Still, “Demand forecasting is an estimate
of sales during a specified future period based on proposed marketing plan and a set of particular
uncontrollable and competitive forces.”
4.3 BASIS OF DEMAND FORECASTING
40
a) Level of Forecasting: Demand forecasting can be done at the firm level, industry level,
or economy level. At the firm level, the demand is forecasted for the products and services
of an individual organisation in the future. At the industry level, the collective demand for the
products and services of all organisations in a particular industry is forecasted. On the other
hand, at the economy level, the aggregate demand for products and services in the economy
as a whole is anticipated.
b) Time period involved: On the basis of the duration, demand is forecasted in the
short run and long term, which is explained as follows:
a) Short-term forecasting: It involves anticipating demand for a period not exceeding one
year. It is focused on the short- term decisions (for example, arranging finance, formulating
production policy, making promotional strategies, etc.) of an organisation.
b) Long-term forecasting: It involves predicting demand for a period of 5-7 years and may
extend for a period of 10 to 20 years. It is focused on the long-term decisions (for example,
deciding the production capacity, replacing machinery, etc.) of an organisation.
c) Nature of products: Products can be categorised into consumer goods or capital goods on
the basis of their nature. Demand forecasting differs for these two types of products, which is
discussed as follows:
i) Consumer goods: The goods that are meant for final consumption by end users are called
consumer goods. These goods have a direct demand. Generally, demand forecasting for these
goods is done while introducing a new product or replacing the existing product with an improved one.
ii) Capital goods: These goods are required to produce consumer goods; for example, raw
material. Thus, these goods have a derived demand. The demand forecasting of capital goods
depends on the demand for consumer goods. For example, prediction of higher demand for
consumer goods would result in the anticipation of higher demand for capital goods too.

1. Forecasting is estimating or anticipating future events. (True/False).
2. Demand forecasting is estimating __________ on the basis of past data.
Activity 1:
Organise a class seminar on the topic, “Importance of Demand Forecasting”.
4.4 OBJECTIVES OF DEMAND FORECASTING
41
a) Short Term Objectives: The short term objectives are as under: -
i) To help in preparing suitable sales and production policies;
ii) To help in ensuring a regular supply of raw materials;
iii) To reduce the cost of purchase and avoid unnecessary purchase;
iv) To ensure best utilization of machines;
v) To make arrangements for skilled and unskilled workers so that suitable labour force may be
maintained;
vi) To help in the determination of a suitable price policy;
vii) To determine financial requirements;
viii) To determine separate sales targets for all the sales territories; and
ix) To eliminate the problem of under or over production.
b) Long term Objectives: The long term objectives are: -
i) To plan long term production;
ii) To plan plant capacity;
iii) To estimate the requirements of workers for long period and make arrangements;
iv) To determine an appropriate dividend policy;
v) To help the proper capital budgeting;
vii) To plan long term financial requirements;
viii) To forecast the future problems of material supplies and energy crisis.

3. The short-term demand forecasting focused on decisions such as deciding the
production capacity, replacing machinery etc. (True/False)
4. Capital good are required to produce ________goods.
Activity 2:
Frame the short-term and long-term objectives to forecast the demand of XYZ Company.
4.5 IMPORTANCE OF DEMAND FORECASTING

Demand forecasting is important for every producer. He has to know the present level of demand as also
the increase that is expected to take place in the demand for his product over time. Demand forecasts
are generally useful for the following categories of decision makers:-
i) Importance for the producers;
ii) Importance for policy makers and planners;
iii) Importance for estimating financial requirements;
iv) Utility for determination of sales target & incentive;
v) Importance for regular supply of labour and raw material is made possible by demand forecasting;
vi) Production planning is possible with the help of demand forecasting;
42
vii) Use for other groups of the society researchers, social workers and other who have a futuristic
approach.
4.6 SCOPE OF DEMAND FORECASTING
Demand forecasting can be at the international level depending upon the area of operation of given
economic institution. It can also be confined to a given product or service supplied by a small firm in local
area. The scope of work will depend upon the area of operation in the present and proposed in future
much would depend upon the cost and time involved in relation to the benefit of the information acquired
through the study of demand. The factors determining the scope of demand forecasting are as follows:-
i) Period conversed under demand forecasting;
ii) Levels of demand forecasting;
iii) Purpose of demand forecasting;
iv) Nature of product;
v) Miscellaneous factors- socio-psychological factors, degree of competition impact of risk and Uncertainty.
4.7 STEPS IN DEMAND FORECASTING

Demand or sales forecasting is a scientific exercise. It has to go through a number of steps. At
each step, you have to make critical considerations. Such considerations are listed as follows:
Step-1-Nature of Forecast: To begin with, you should be clear about the uses of forecast data-
how it is related to forward planning and corporate planning by the firm. Depending upon its use,
you have to choose the type of forecasts: short-run or long-run, active or passive, conditional or
non-conditional etc.
Step-2-Nature of Product: The next important consideration is the nature of product for which
you are attempting a demand forecast. You have to examine carefully whether the product is
consumer goods or producer goods, perishable or durable, final or intermediate demand, new
demand or replacement demand type etc. A couple of examples may illustrate the importance
of this factor. The demand for intermediate goods like basic chemicals is derived from the final
demand for finished goods like detergents. While forecasting the demand for basic chemicals, it
becomes essential to analyze the nature of demand for detergents. Promoting sales through
advertising or price competition is much less important in the case of intermediate goods
compared to final goods. The elasticity of demand for intermediate goods depends on their relative
importance in the price of the final product.
Time factor is a crucial determinant in demand forecasting. Perishable commodities such as fresh
vegetables and fruits can be sold over a limited period of time. Here skilful demand forecasting
is needed to avoid waste. If there are storage facilities, then buyers can adjust their demand
according to availability, price and income. The time taken for such adjustment varies from
product to product. Goods of daily necessities that are bought more frequently will lead to
43
quicker adjustments. Whereas in case of expensive equipment which is worn out and replaced
after a long period of time, adaptation of demand will be spread over a longer duration of time.
Step-3-Determinants of Demand: Once you have identified the nature of product for which you
are to build a forecast, your next task is to locate clearly the determinants of demand for the
product. Depending on the nature of product and nature of forecasts, different determinants will
assume different degree of importance in different demand functions. In the preceding unit, you
have been exposed to a number of price-income factors or determinants-own price, related
price, own income-disposable and discretionary, related income, advertisement, price expectation
etc. In addition, it is important to consider socio-psychological determinants, specially
demographic, sociological and psychological factors affecting demand. Without considering these
factors, long-run demand forecasting is not possible.
Such factors are particularly important for long-run active forecasts. The size of population, the
age-composition, the location of household unit, the sex-composition-all these exercise influence
on demand in. varying degrees. If more babies are born, more will be the demand for toys; if
more youngsters marry, more will be the demand for furniture; if more old people survive, more
will be the demand for sticks. In the same way buyers’ psychology-his need, social status, ego,
demonstration effect etc. also effect demand. While forecasting, you cannot neglect these factors.
Step-4-Analysis of Factors &Determinants: Identifying the determinants alone would not do, their
analysis is also important for demand forecasting. In an analysis of statistical demand function, it is
customary to classify the explanatory factors into
(a) trend factors, which affect demand over long-run,
(b) cyclical factors whose effects on demand are periodic in nature,
(c) seasonal factors, which are a little more certain compared to cyclical factors, because there
is some regularly with regard to their occurrence, and
(d) random factors which create disturbance because they are erratic in nature; their operation and
effects are not very orderly. An analysis of factors is especially important depending upon whether
it is the aggregate demand in the economy or the industry’s demand or the company’s demand
or the consumers; demand which is being predicted. Also, for a long-run demand forecast, trend
factors are important; but for a short-run demand forecast, cyclical and seasonal factors are
important.
Step-5-Choice of Techniques: This is a very important step. You have to choose a particular
technique from among various techniques of demand forecasting. Subsequently, you will be
exposed to all such techniques, statistical or otherwise. You will find that different techniques may
be appropriate for forecasting demand for different products depending upon their nature. In some
cases, it may be possible to use more than one technique. However, the choice of technique has to
be logical and appropriate; for it is a very critical choice. Much of the accuracy and relevance of the
44
forecast data depends accuracy required, reference period of the forecast, complexity of the
relationship postulated in the demand function, available time for forecasting exercise, size of cost
budget for the forecast etc.
Step-6-Testing Accuracy: This is the final step in demand forecasting. There are various methods
for testing statistical accuracy in a given forecast. Some of them are simple and inexpensive, others
quite complex and difficult. This stating is needed to avoid/reduce the margin of error and thereby
improve its validity for practical decision-making purpose. Subsequently you will be exposed briefly
to some of these methods and their uses.

5. Which factor is crucial determinant in Demand Forecasting?
a) Money (Capital) c) Material
b) Market d) Minute (Time)
6. Which step is the last step in Demand forecasting?
a) Choice of Technique c) Testing Accuracy
b) Random Factors d) None from these
Activity 3:
Suppose you are an entrepreneur. You have to forecast the demand of your product. Write
down the procedure of demand forecasting for your enterprise.
4.8 TECHNIQUES OF DEMAND FORECASTING

Different organisations rely on different techniques to forecast demand for their products or services
for a future time period depending on their requirements and budget. Demand forecasting methods
are broadly categorised into two types, which are listed in Figure 6.4:
4.8.1 Qualitative Techniques
Qualitative techniques rely on collecting data on the buying behaviour of consumers from experts or
through conducting surveys in order to forecast demand. These techniques are generally used to
make short- term forecasts of demand. Qualitative techniques are especially useful in situations when
historical data is not available; for example, introduction of a new product or service. These
techniques are based on experience, judgment, intuition, conjecture, etc. Let us discuss different
types of qualitative techniques as under:
a) Survey Method: Survey methods are the most commonly used methods of forecasting
demand in the short run. This method relies on the future purchase plans of consumers and their
intentions to anticipate demand. Thus, in this method, an organization conducts surveys with
consumers to determine the demand for their existing products and services and anticipate the
future demand accordingly. As consumers generally plan their purchases in advance, their opinions
and intentions may be sought to analyse trends in market demand. The two types of survey methods
are explained as follows:
 Complete enumeration survey: This method is also referred to as the census method of
demand forecasting. In this method, almost all potential users of the product are contacted and
45
surveyed about their purchasing plans. Based on these surveys, demand forecasts are made. The
aggregate demand forecasts are attained by totaling the probable demands of all individual
consumers in the market. This implies that the probable demand of the consumers are added
together to obtain the probable demand for the product. For example, if a number of consumers
is n, their demand for a commodity X is D1, D2, D3….Dn, the total probable demand (Dp) is
calculated as follows: Dp= D1, + D2, + D3 +….Dn
 Sample survey: In this method, only a few potential consumers (called sample) are selected
from the market and surveyed. In this method, the average demand is calculated based on the
information gathered from the sample. The average demand is then multiplied by the total number
of consumers in the market, which gives the aggregate demand for the product (for which demand is
to be forecasted).
b) Opinion Polls: Opinion poll methods involve taking the opinion of those who possess
knowledge of market trends, such as sales representatives, marketing experts, and consultants.
The most commonly used opinion polls methods are explained as follows:
 Expert opinion method: In this method, sales representatives of different organisations get
in touch with consumers in specific areas. They gather information related to consumers’ buying
behaviour, their reactions and responses to market changes, their opinion about new products, etc.
In this way, the sales representatives provide an estimate of the probable demand for their
organisation’s product.
 Delphi method: In this method, market experts are provided with the estimates and
assumptions of forecasts made by other experts in the industry. Experts may reconsider and revise
their own estimates and assumptions based on the information provided by other experts. The
consensus of all experts on demand forecasts constitutes the final demand forecast.
 Market studies and experiments: This method is also referred to as market experiment
method. In this method, organisations initially select certain aspects of a market such as population,
income levels, cultural and social background, occupational distribution, and consumers’ tastes and
preferences. Among all these aspects, one aspect is selected and its effect on demand is determined
while keeping all other aspects constant. The controlled variable (the selected aspect) is changed over
time and subsequent changes in the demand over a period of time are recorded. Based on the data
collected, the demand for a product in the future is assessed.
4.8.2 QUANTITATIVE TECHNIQUES
Quantitative techniques for demand forecasting usually make use of statistical tools. In these
techniques, demand is forecasted based on historical data. These methods are generally used to
make long-term forecasts of demand. Unlike survey methods, statistical methods are cost effective
46
and reliable as the element of subjectivity is minimum in these methods. The different types of
quantitative methods are as under:
a) Time Series Analysis: Time series analysis or trend projection method is one of the most
popular methods used by organisations for the prediction of demand in the long run. The term time
series refers to a sequential order of values of a variable (called trend) at equal time intervals. Using
trends, an organisation can predict the demand for its products and services for the projected time.
There are four main components of time series analysis that an organisation must take into consideration
while forecasting the demand for its products and services. These components are:
 Trend Component: The trend component in time series analysis accounts for the
gradual shift in the time series to a relatively higher or lower value over a long period of time.
 Cyclical Component: The cyclical component in time series analysis accounts for the
regular pattern of sequences of values above and below the trend line lasting more than one year.
 Seasonal C omponent: The seasonal component in time series analysis accounts
for regular patterns of variability within certain time periods, such as a year.
 Irregular Component: The irregular component in time series analysis accounts
for a short term, unanticipated and non-recur-ring factors that affect the values of the time
series.
4.8.3 SMOOTHING TECHNIQUES: In cases where the time series lacks significant
trends, smoothing techniques can be used for demand forecasting. Smoothing techniques are used to
eliminate a random variation from the historical demand. This helps in identifying demand patterns
and demand levels that can be used to estimate future demand. The most common methods used in
smoothing techniques of demand forecasting are simple moving average method and weighted
moving average method. The simple moving average method is used to calculate the mean of
average prices over a period of time and plot these mean prices on a graph which acts as a scale.
For example, a five-day simple moving average is the sum of values of all five days divided by five. The
weighted moving average method uses a predefined number of time periods to calculate the
average, all of which have the same importance. For example, in a four-month moving average,
each month represents 25% of the moving average.
4.8.4 BAROMETRIC METHODS: Barometric methods are used to speculate the future
trends based on current developments. Barometric methods make use of economic and statistical
indicators, which serve as barometers of economic change. Thus, these methods are also referred
to as the leading indicators approach to demand forecasting. Many economists use barometric
methods to forecast trends in business activities. The basic approach followed in barometric
methods of demand analysis is to prepare an index of relevant economic indicators and forecast
future trends based on the movements shown in the index. The barometric methods make use of the
following indicators:
47
 Leading indicators: When an event that has already occurred is considered to predict the
future event, the past event would act as a leading indicator. For example, the data relating to
working women would act as a leading indicator for the demand of working women hostels.
 Coincident indicators: These indicators move simultaneously with the current event. For
example, a number of employees in the non-agricultural sector, rate of unemployment, per capita
income, etc., act as indicators for the current state of a nation’s economy.
 Lagging indicators: These indicators include events that follow a change. Lagging indicators
are critical to interpret how the economy would shape up in the future. These indicators are useful in
predicting the future economic events. For example, inflation, unemployment levels, etc. are the
indicators of the performance of a country’s economy.
4.8.5 ECONOMETRIC METHODS: Econometric methods make use of statistical tools
combined with economic theories to assess various economic variables (for example, price
change, income level of consumers, changes in economic policies, and so on) for forecasting
demand. The forecasts made using econometric methods are much more reliable than any
other demand forecasting method. An econometric model for demand forecasting could be single
equation regression analysis or a system of simultaneous equations.
4.8.6 CORRELATION AND REGRESSION: These involve the use of econometric methods
to determine the nature and degree of association between/among a set of variables.
Econometrics, you may recall, is the use of economic theory, statistical analysis and
mathematical functions to determine the relationship between a dependent variable (say, sales)
and one or more independent variables (like price, income, advertisement etc.). The relationship may
be expressed in the form of a demand function, as we have seen earlier. Such relationships, based
on past data can be used for forecasting. The analysis can be carried with varying degrees of
complexity. Here we shall not get into the methods of finding out ‘correlation coefficient’ or
‘regression equation’; you must have covered those statistical techniques as a part of
quantitative methods. Similarly, we shall not go into the question of economic theory. We shall
concentrate simply on the use of these econometric techniques in forecasting. We are on the
realm of multiple regressions and multiple correlations. The form of the equation may be: DX = a +
b1 A + b2PX + b3Py
You know that the regression coefficients b1, b2, b3 and b4 are the components of relevant
elasticity of demand. For example, b1 is a component of price elasticity of demand. They reflect
the direction as well as proportion of change in demand for x as a result of a change in any of
its explanatory variables. For example, b2< 0 suggest that DX and PX are inversely related; b4 > 0
suggest that x and y are substitutes; b3 > 0 suggest that x is a normal commodity with
commodity with positive income-effect. Given the estimated value of and bi, you may forecast the
48
expected sales (DX), if you know the future values of explanatory variables like own price (PX),
related price (Py), income (B) and advertisement (A). Lastly, you may also recall that the
statistics R2 (Co-efficient of determination) gives the measure of goodness of fit. The closer it is to
unity, the better is the fit, and that way you get a more reliable forecast. The principle advantage
of this method is that it is prescriptive as well descriptive. That is, besides generating demand
forecast, it explains why the demand is what it is. In other words, this technique has got both
explanatory and predictive value. The regression method is neither mechanistic like the trend
method nor subjective like the opinion poll method. In this method of forecasting, you may use not
only time-series data but also cross-section data. The only precaution you need to take is that data
analysis should be based on the logic of economic theory.
4.9 LIMITATIONS OF DEMAND FORECASTING
Although demand forecasting has wide applicability in an organisation, there are certain
limitations associated with demand forecasting. This is because demand forecasting is
based on the analysis of past and present events for determining the future course of
action. The events or occurrences in the past may not always be reliable to base the future
predictions on them. Apart from this, there are some other limitations of demand forecasting,
which are explained as follows:
(a) Lack of historical sales data: Past sales figures may not always be available with an
organisation. For example, in case of a new commodity, there is unavailability of historical sales data.
In such cases, new data is required to be collected for demand forecasting, which can be
cumbersome and challenging for an organisation.
(b) Unrealistic assumptions: Demand forecasting is based on various assumptions, which may
not always be consistent with the present market conditions. In such a case, relying on these
assumptions may produce incorrect forecasts for the future.
(c) Cost incurred: Demand forecasting incurs different costs for an organisation, such as
implementation cost, labour cost, and administrative cost. These costs may be very high depending
on the complexity of the forecasting method selected and the resources utilised. Owing to limited
means, it becomes difficult for new startups and small-scale organisations to perform demand
forecasting.
(d) Change in fashion: Consumers’ tastes and preferences continue to change with a change in
fashion. This limits the use of demand forecasting as it is generally based on historical trend analysis.
(e) Lack of expertise: Demand forecasting requires effective skills, knowledge and
experience of personnel making forecasts. In the absence of trained experts, demand
forecasting becomes a challenge for an organisation. This is because if the responsibility of
49
demand forecasting is assigned to untrained personnel, it could bring huge losses to the
organisation.
(f) Psychological factors: Consumers usually prefer a particular type of product over
others. However, factors, such as fear of war and changes in economic policy, could affect
consumers’ psychology. In such cases, the outcomes of forecasting may no longer remain
relevant for the time period.

7. Complete enumeration survey method is also known as _________ method of demand
forecasting.
8. Which limitations are associated with demand forecasting?
a) Cost incurred c) Change in fashion
b) Lack of expertise d) All of these
Activity 4:
Discuss in the class about importance of techniques of demand forecasting.
4.10 SUMMARY
Demand forecasting can be defined as a process of predicting the future demand for an
organisation’s goods or services. Demand forecasting helps an organisation to take various
business decisions, such as planning the production process, purchasing raw-materials,
managing funds, and deciding the price of its products. Demand forecasting methods are
broadly categorised into two types’ qualitative techniques (surveys and opinion polls) and
quantitative techniques (time series analysis, smoothing techniques, barometric methods,
and econometric methods). The effectiveness of demand forecasting depends on the
selection of an appropriate demand forecasting technique.
4.11 GLOSSARY
 Cost budget: It refers to the allocation of different costs to individual business activities, such
as allocation of administrative cost, financing cost, production cost, etc.
 Demand is an economic principle referring to a consumer's desire to purchase goods and
services and willingness to pay a price for a specific good or service.
 Demand Forecasting refers to the process of predicting the future demand for the firm's
product. The business world is characterized by risk and uncertainty, and most of the business
decisions are taken under this scenario.
 Semi-finished goods: These goods are used as inputs in the production of other
goods, such as consumer goods.
4.12 ANSWERS TO SELF CHECK QUESTIONS
1. True
2. Future Demand
50
3. False
4. Consumer Goods
5. d) Minute (Time)
6. c) Testing Accuracy
7. Census Method
8. d) All of These
1. What do you understand by demand forecasting? Discuss the basis of demand forecasting.
2. What are the objectives of demand forecasting? Discuss.
3. Discuss the importance and scope of demand forecasting.
4. Describe the steps in demand forecasting.
5. Write short notes on:
a. Qualitative Techniques of Demand Forecasting
b. Quantitative Techniques of Demand Forecasting
c. Smoothing Technique
d. Correlation and Regression Method of Demand forecasting

Book Co., Inc.
51
CHAPTER 5
ECONOMIC FORECASTING AND PLANNING
STRUCTURE
5.2 INTRODUCTION
5.3 CONCEPT OF ECONOMIC FORECASTING
5.4 TECHNIQUES OF ECONOMIC FORECASTING
5.5 ECONOMIC PLANNING: INTRODUCTION
5.6 FEATURES OF ECONOMIC PLANNING
5.7 ESSENTIAL CONDITIONS OF ECONOMIC PLANNING
5.8 OBJECTIVES OF ECONOMIC PLANNING IN INDIA
5.9 IMPORTANCE OF ECONOMIC PLANNING
5.10 SIZE OF THE ECONOMIC PLAN
5.11 ROLE OF GOVERNMENT IN ECONOMIC PLAN FORMULATION
5.12 EXECUTION OF THE PLAN
5.13 SUMMARY
5.14 GLOSSARY
 The concept of economic forecasting and planning.
 The importance, objectives and features of economic forecasting and planning.
 The techniques of economic forecasting.
 The role of government in economic plan formulation.
5.2 INTRODUCTION
Economic forecasting is the process of making predictions about the economy. Forecasts can be
carried out at a high level of aggregation—for example for GDP, inflation, unemployment or the fiscal
deficit—or at a more disaggregated level, for specific sectors of the economy or even specific firms.
Many institutions engage in economic forecasting: national governments, banks and central banks,
consultants and private sector entities such as think-tanks, companies and international organizations
such as the International Monetary Fund, World Bank and the OECD. Some forecasts are produced
annually, but many are updated more frequently.
5.3 CONCEPT OF ECONOMIC FORECASTING
The economist typically considers risks (i.e., events or conditions that can cause the result to vary
from their initial estimates). These risks help illustrate the reasoning process used in arriving at the
final forecast numbers. Economists typically use commentary along with data visualization tools such
as tables and charts to communicate their forecast. In preparing economic forecasts a variety of
information has been used in an attempt to increase the accuracy. Everything from macroeconomic,
microeconomic, market data from the future, machine-learning (artificial neural networks), and human
behavioral studies have all been used to achieve better forecasts. Forecasts are used for a variety of
purposes. Governments and businesses use economic forecasts to help them determine
52
their strategy, multi-year plans, and budgets for the upcoming year. Stock market analysts use
forecasts to help them estimate the valuation of a company and its stock.
Economists select which variables are important to the subject material under discussion.
Economists may use statistical analysis of historical data to determine the apparent relationships
between particular independent variables and their relationship to the dependent variable under
study. For example, to what extent did changes in housing prices affect the net worth of the
population overall in the past? This relationship can then be used to forecast the future. That is, if
housing prices are expected to change in a particular way, what effect would that has on the future
net worth of the population? Forecasts are generally based on sample data rather than a complete
population, which introduces uncertainty. The economist conducts statistical tests and develops
statistical models (often using regression analysis) to determine which relationships best describe or
predict the behavior of the variables under study. Historical data and assumptions about the future
are applied to the model in arriving at a forecast for particular variables.
5.4 TECHNIQUES OF ECONOMIC FORECASTING
a) Surveys: One of the methods of short-term forecasting is to make a survey of the type of
business that one is interested in. The method to do this is approximate because it is based on
beliefs, intentions and future budgeting of the government. It, however, broadly indicates the future
course of events in the economy. The method to forecast through surveys is either through personal
contact, i.e., to meet the people and to record conversations about their intention to invest money by
type of product, and by type of industry in future, and make analysis of it. A representative sample of
people in the same industry may be a good survey. The other method of survey is through the means
of detailed questionnaire which may either be filled in by meeting people personally or the respondent
may fill the form himself. The basic use of this method is to have insight of the kind of activity in the
economy.
b) Indicators: The second approach behaves like a barometer. It gives indication of the
economic process through cyclical timings. This project is a method of getting indications of the future
relating to business depressions and business prosperity. This method helps in finding out the
leading, lagging and coincidental indicators of economic activity. Although, a very accurate estimate
is not possible, the barometers indicate the level of economic activity. This indication works
geographically and through different weekly and monthly periods. Also, because it gives the leading
indication it shows the kind of production activity, the changes in the direction of productivity and the
turn of the direction of change in the economic activity. This method although has its advantages of
giving the future indications of the economy is not an exact method of finding out the economic
activity. It gives results approximately and is at best an estimation of the future of the economic
conditions.
53
c) Diffusion Indexes: The diffusion index is a method which combines the different indicators
into one total measure and it gives weaknesses and strengths of a particular time series of data. The
diffusion index is also called a census or a composite index. The method adopted in this economic
reading of the future, is to take the leading, the coincidental and the lagging factors together to
summarize them and then to draw out and infer a particular composite answer. Usually, both the
micro aspect of the data and the macro aspect are combined. This is a complex statistical method
and the combination of various factors in this technique makes it extremely difficult to draw out a
proper understanding of the forecasting methods.
d) Economic Model Building: This is a mathematical and statistical application to forecast the
future trend of the economy. This technique can be used by trained technicians and it is used to draw
out relationships between two or more variables. The technique is to make one independent variable
and dependent variable and to draw out a relationship between these variables. The answer of
drawing up these relationships is to get a forecast of direction as well as magnitude. This is a process
technique as it specifies a particular system and calculates the results through the simultaneous
equations taking both endogenous variables and exogenous variables. The endogenous variables
are usually predetermined and one equation is usually needed to find out the forecast value of the
endogenous variables. The limitations of this model in our country India are as follows:
i) There is a lack of computer facilities and programmers and clerical staff to support the formulations
of these forecasting projects;
ii) The data collected and processed through this method require a great deal of time and delays in
formulating the data changes the entire economic condition of the country by the time formulation
results are out.
The results and analysis through the method often becomes obsolete even before it has been
processed. The advantage of this method even if we take into consideration these limitations is the
precise nature of the answers and the accuracy in the forecast made. This system may be applied in
those advanced economics where the facilities of a computer are not difficult to arrange for.
e) Opportunistic Model Building: This method is the most widely used economic forecasting
method. This is also called sectoral analysis of Gross National Product Model Building. This method
uses the national accounting data to be able to forecast for a future short-term period. It is a flexible
and reliable method of forecasting. The method of forecasting is to find out the total income and the
total demand for the forecast period. To this are added the environment conditions of political
stability, economic and fiscal policies of the government, policies relating to tax and interest rates.
This must be added to Gross domestic investment, government purchases of goods in services,
consumption expenses and net exports.
The forecast has to be broken down first by an estimate of the government sector which is to be
divided again into State Government and Central Government expenses. The gross private domestic
54
investment is to be calculated by adding the business expenses for plan, construction and equipment
changes in the level of business. The third sector which is to be taken is the consumption sector
relating to the personal consumption factor.
This sector is usually divided into components of durable goods, non-durable goods and services.
When data has been taken of all these sectors, these are added up to get the forecast for the Gross
National Product. They are then tested for consistency. This may also be used in the form of a matrix
to find out the flow of savings as well as the flow of investments. This method of is very reliable and it
is often used for forecasting the economic conditions of an economy.
When an investor has made an analysis of the economic factors of the country taking into
consideration the leading, lagging and coincidental indicators and also taking into consideration the
monetary, fiscal policies of the country together with the demographic factors to find out the change
of direction through indicators.
The next step for the investor is to analyse the industry and more firmly the company in which he
wishes to invest. The analysis of this nature will indicate to an investor whether the industry is a
growth industry or it is an expanding industry or there is obsolescence in industry.
It is important for the investor to put the value of his money in the right kind of industry so that he may
benefit from his investments. An insight to industrial analysis will give the investor a choice of the
industry in which the investments should be made.
SELF CHECK EXERCISE 1

1. Economic forecasting is the process of making predictions of an economy.
(True/False)
2. ______ analysts use forecasts to help them estimate the valuation of a company and its
stock.
3. _______, ________, diffusion indexes, _________ and opportunistic model building
are the techniques used for economic forecasting.
Activity 1:
Discuss about the importance of Economic Forecasting
5.5 ECONOMIC PLANNING: INTRODUCTION

Economic planning is the making of major economic decision, what and how much is to be produced,
and to whom it is to be allocated by the conscious decision of a determinate authority, on the basis of
a comprehensive survey of the economic system as a whole.
5.6 FEATURES OF ECONOMIC PLANNING
The features of economic planning are as: -
i) It is concerned with survey and diagnosis of the present economic scenario;
ii) It defines policy and objectives to be achieved in future;
iii) It presents a macroeconomic projection for the whole economy;
iv) It formulates strategies through which objectives are to be achieved;
v) It guides and directs the economy along with the path of growth and development; and
55
vi) It creates productive capacity in the country.
5.7 ESSENTIAL CONDITIONS OF ECONOMIC PLANNING
The essential conditions for economic planning are as follows: -
 Well-Defined Aims and Objectives: Every plan must be associated with certain well defined
aims and objectives. In democratic planning there must be a large measure of agreement in the
community with regard to these aims and objectives.
 Emerge Out of the Conscious Decisions: Planning must emerge out of the conscious
decision of a determinate authority.
 Purposive Direction: In a federal structure, where there is the diffusion of power and
responsibility, there must be an overall unity of policy. The purposive direction, which planning
involves, must come from the Central Government.
 Carefully Fix the Targets: The planning authority must carefully fix the targets without
illusions as to what is possible. If the targets are fanciful, the whole plan will be fanciful. And this is as
true whether the targets are too large or too small. Planners, who promise more than they can
perform, throw everything out of gear, so that the economy might use as well not be planned at all.
Over-fulfillment is just as much a sign of bad planning as is under-fulfillment.
 Flexibility: There should be some measure of flexibility in planning, which means that the
plans can be revised and rephrased if circumstances demand it.
 Appropriate Duration: Planning very far ahead is not desirable. A general five-year plan for
the whole economy is no more than a game, because it is not possible to foresee what will happen to
productivity in five years.
 Scrupulously Earnest and Determined: Once the targets are carefully fixed, the government
must be scrupulously earnest and determined to achieve the targets.
 Adoption of Judicious Price Policy: In order that the objectives and targets, laid down in the
plan, might be achieved, there must be a judicious price policy, which will not only secure an
allocation of the resources for making the fulfillment of the targets possible, but will also maintain a
certain balance between the various classes of the community.
 Enthusiasm: In a democracy the government should make the objectives and targets known
to the people and make the final acceptance or rejection of the plan, dependent on the will of
Parliament. When the plan emerges in its final shape, the government must try to enlist the active
cooperation of the citizens in implementing the plan. Popular enthusiasm is both the lubricating oil of
planning, and the petrol of economic development, a dynamic force that almost makes all things
possible.
 Efficient Administrative System: There must be an administrative system with efficiency and
unimpeachable integrity, capable of discharging its responsibilities in connection with the execution of
the plan.
56
5.8 OBJECTIVES OF ECONOMIC PLANNING IN INDIA
The following are the objectives of economic planning in country like India: -
 Increase in National Income: This objective gets translated into an increase in not only the
national income, but also in the level of production and real per capita income.
 Achieving Full Employment: Unemployment is a curse in any society. It is more so when
there is an inadequate social security or its total absence. Employment imparts dignity to human
beings and is also an important means of reducing poverty and inequalities. The objective of planning
was not to reduce inequalities by lowering the income levels of the richer sections but by raising the
income levels of the poorer sections of the society.
 Reduction in Inequalities of Income and Wealth: India being an extremely poor country,
inequalities of income and wealth translate themselves into absolute poverty and destitution. There
can be no difference of opinion regarding the desirability of reducing such inequalities, particularly
because they also lead to inequality of economic opportunities.
 Creation of a Socialist Society: This was an obvious and generally accepted objective
inclusive-of there being equal opportunities of economic advancement for all sections of the society.
 Removal of Bottlenecks: Removal of Bottlenecks in the way of economic growth such as,
low rates of saving and investment, inefficient technology, problems of balance of payments, absence
of basic industries and insufficient infrastructure, etc. is also an important objective of the Indian
planning.
 Industrialization: Indian plans have adopted a strategy of industrialization of the economy
with particular emphasis on heavy and basic industries. It also assigned a high priority to agricultural
growth but in practice, agricultural and rural development received inadequate attention. Some
analysts are of the view that India, with its vast agricultural potential should have first concentrated on
the development of agriculture and rural parts of the economy. Such an approach would have
generated economic surplus needed for capital formation and investment.
 Self-Reliance: Our plans also aimed at “self-reliance”. It deals with the freedom from the need
to import and therefore a policy of “import substitution” regardless of its cost. This objective should
have been taken to mean “ability to pay for our imports through our export earnings”. Thus, we
should have added to our export capacity and competitive strength in international markets.
 Precedence to Public Sector: In our planned growth, public sector was assigned a place of
precedence over the private sector so as to acquire commanding heights of the economy and be in a
position to use it for guiding the private sector along chosen lines. This was done while ignoring the
fact that public sector undertaking is inherently less efficient than private ones.
Thus, the basic objectives of India’s Five Year Plans are rapid economic growth, full
employment, self-reliance and social justice. Apart from these basic objectives, each five- year plan
57
takes into account the new constraints and potential/possibilities during the period and attempts to
make the necessary directional changes and emphasis.
5.9 IMPORTANCE OF ECONOMIC PLANNING
The importance of economic planning may be explained as follows:
 Best Utilisation of Natural Resources: Economic planning facilitates best utilisation of
natural resources. By adopting the process of economic planning it is possible to utilise available
labour and capital in the interest of nation which helps in maximisation of national output.
 Growth in National and per capita Income: The maximum level of production increases the
level of savings and investment which ultimately provide sufficient capital for economic development.
Hence planned economy proves an important instrument for growth in national and per capita
income.
 Improvement in Living Standard: The standard of living of India’s population is far below the
required level. A subsistence segment of population fails to even meet their basic needs of life. The
main reason responsible behind such a miserable situation has been low level of per capita income
and social evils which can be improved by adopting the process of planning.
 Balanced Economic Development: The form of economic growth in India has always been
unbalanced. While preparing industrial plan, more emphasis has been given to development of
consumer industries whereas much is left remained to plan for development of basic industries. The
process of planning may be helpful in balanced economic development.
 Full Employment: The problem of unemployment can be scale-down by encouraging
development of small and cottage industries in the country. It will also reduce the pressure of
population on agriculture. In India’s five-year plans, efforts have been made to generate more and
more employment opportunities.
 Equal Distribution of Wealth and Income: In India, there exist serious inequalities in the
distribution of income and wealth. A small minority of population is rolling in luxuries, while the vast
masses of people are unable to make their both ends meet. The existence of plenty for the few
amidst mass poverty is indeed the most undesirable phenomenon in the country and intensity of
which can be minimised by adopting planned economy.
 For Self-Sufficiency: The initial process of economic development requires huge capital
investment. By adopting the process of planning available capital resources can be best utilised in
the interest of nation.
5.10 SIZE OF THE ECONOMIC PLAN
The size of the plan depends upon the following factors:
 On the basis of past experience certain facts are collected and calculated. Various inquiries
conducted in the past, reports and other research publications of the past will provide material which
58
would be included in the plan and which will partially represent or determine the magnitude of the
plan.
 Objectives of economic planning will determine the various targets of the plan and they would
thus characterise the largeness or smallness of the plan. They are factual basis on which the
framework of the plan is outlined.
 What would happen in the future will also affect the magnitude of the existing programme or
plan. Factors based on forecast may be real or unreal and may be certain or uncertain. And,
therefore, it is difficult to evaluate them. However, they can be roughly estimated and, as far as
possible, should be included in the plans as well. Crop position in future, price of imports and exports,
supply of foreign exchange, etc., are such factors which are sometimes difficult to be pre-determined
exactly, but they are so important they should be included in the plan.
5.11 ROLE OF GOVERNMENT IN ECONOMIC PLAN FORMULATION
The states, districts and the blocks are also supposed to make their own plans, keeping in view the
broad targets which are included in the draft outline. They are later on modified on the lines of the
preparation of the amended figures to be included in the final plan. In this way the tentative figures of
the draft outlines are sent from the Planning Commission to the states, districts and block planning
authorities, who discuss them, modify them and send them back to the Commission.
The Commission, on the basis of these requirements and suggestions, prepares the final plan, after
carefully examining their programmes and projects from a technical and economic point of view.
After making a five year plan, it is supposed to be one of the duties of the Planning Commission to
study and examine the various charges from time to time, and modify the plan as and when required.
Besides, the five year plan is broken into annual plans. In November or December of each year there
are a series of consultations between the Commission and Central and State Ministries for reviewing
the progress of the last year or years of the five year plan regarding the reassessment of resources
and technical possibilities of adjusting and readjusting the targets and requirements of the annual
plan for the next year.
The annual financial budgets of the Central as well as the State Governments are formulated in the
following February keeping in view these annual plans. The annual plan has now become a very
important part of the planning procedure in India and has in fact evolved into a very important
instrument of federal and state financial relationship. An annual plan introduces, on the one hand, a
much-needed flexibility in the implementation of the five year plan and, on the other, sets out the
programmes of development to be implemented every year with sufficient details.
5.12 EXECUTION OF THE PLAN
In most of the planned economies the central Planning Commission (NITI Ayog in India) is an
advisory body, and therefore the execution of plans is entrusted to the central administration called
government departments and various ministries. However, some contact is established between the
59
Planning Commission and the various central government organisations which are entrusted with the
task of executing the plan.
In executing the plan at the early stage of planning there may be greater centralisation, but later on
more and more decentralization is to be attained. It is so because in the early stage greater
centralisation is required for effective control and administration, while in the later stage
decentralisation bring effective administration and control.
Most of the planned economies of the world today, including Russia and East European countries,
are tending towards greater and greater decentralisation because it prevents concentration of
economic power which planning in the past tended to create and diminishes political danger directed
agents democracy.
There is a tendency towards establishing ‘democratic decentralisation’ in India as well. The pivot of
democratic decentralisation is the Panchayat Samiti consisting of Sarpanches and co-opted
members. For each block area there would be a samiti and it would be in charge of block activities as
also of some work out schemes to meet them and execute the schemes.
“The purpose is to generate within our various village communities social self-propulsion so that they
may all become dynamos of social energy that would develop the motive force necessary for the
progress of our country.”
Preparation of the plan and the task of translating the various objectives of the plan into a general
plan is the work of planning experts and for that a planning commission or a central planning
committee is appointed by the government. The Central Planning Commission is a special body of
experts and should work independently in its task of plan-formulation. If necessary, it must be able to
oppose the views of the central political government and to point out the limitations or the inner
contradiction in the various objectives of planning and should be able to “prepare alternatives and
variations with their pros and cons from the point of view of accepted criteria.”
SELF CHECK EXERCISES 2

4. Increase in National Income and achieving full employment are not the objectives of
economic planning n India. (True/False)
5. The problem of _______ can be reduced by encouraging development of ________
industries in the country.
Activity 2:
Discuss the role of Niti Ayog in economic planning.
5.13 SUMMARY
Economic forecasting is the process of attempting to predict the future condition of the economy
using a combination of important and widely followed indicators. Economic forecasting typically tries
to come up with a future gross domestic product (GDP) growth rate, involving the building of
statistical models with inputs of several key variables, or indicators. Some of the primary indicators
include inflation, interest rates, industrial production, consumer confidence, worker productivity, retail
60
sales and unemployment rates, to name several. Economic planning is a mechanism for
the allocation of resources between and within organizations which is held in contrast to the market
mechanism. As an allocation mechanism for socialism, economic planning replaces factor
markets with a direct allocation of resources within a single or interconnected group of socially
owned organizations. There are various forms of economic planning. The level of centralization in the
decision-making depends on the specific type of planning mechanism employed. As such, one can
distinguish between centralized planning and decentralized planning. An economy primarily based on
planning is referred to as a planned economy. In a centrally planned economy, the allocation of
resources is determined by a comprehensive plan of production which specifies output requirements.
5.14 GLOSSARY
 Economic forecasting is the process of making predictions about the economy.
Forecasts can be carried out at a high level of aggregation—for example for GDP, inflation,
unemployment or the fiscal deficit—or at a more disaggregated level, for specific sectors of the
economy or even specific firms.
 Economic planning is the process by which key economic decisions are made or influenced
by central governments.
 Plan is a written account of intended future course of action (scheme) aimed at achieving
specific goal(s) or objective(s) within a specific timeframe. It explains in detail what needs to be done,
when, how, and by whom, and often includes best case, expected case, and worst case scenarios.
1. True
2. Stock Market
3. Surveys, Indicators and Economic Model Building
4. False
5. Unemployment, Small and Cottage
1. What do you understand by economic forecasting? Discuss the importance of economic
forecasting.
2. Discuss the techniques used for economic forecasting.
3. Discuss about the concept of economic planning.
4. What are the features and essential conditions of economic planning? Discuss
5. Discuss the role of Government in formulation of economic planning.

61
Book Co., Inc.
62
CHAPTER 6
PRODUCTION FUNCTION
STRUCTURE
6.2 INTRODUCTION
6.3 PRODUCTION FUNCTION
6.4 FEATURES OF PRODUCTION FUNCTION
6.5 ISOQUANTS
6.6 ISOCOST LINES
6.7 COST MINIMISATION
6.8 TOTAL, MARGINAL AND AVERAGE REVENUE
6.9 LAW OF VARIABLE PROPORTION (RETURN TO A FACTOR)
6.9.1 WHY CALLED LAW OF VARIABLE PROPORTION?
6.9.2 STAGES OF LAW
6.9.3 SIGNIFICANCE OF THE THREE STAGES
6.10 LAW OF VARIABLE PROPORTION IN TERMS OF TPP AND MPP
6.10.1 LAW OF VARIABLE PROPORTION IN TERMS OF TPP
6.10.2 LAW OF VARIABLE PROPORTION IN TERMS OF MPP
6.11 REASON FOR THE OPERATION OF THE LAW
6.12 LAW OF RETURN TO SCALE
6.13 USES OF PRODUCTION FUNCTION
6.14 SUMMARY
6.15 GLOSSARY
 The concept of production and production function.
 The isoquants, isocost lines and cost minimisation.
 The law of variable proportions and concept of return to scale.
6.2 INTRODUCTION
Production is the result of co-operation of four factors of production viz., land, labour, capital and
organization. This is evident from the fact that no single commodity can be produced without the help
of any one of these four factors of production. Therefore, the producer combines all the four factors of
production in a technical proportion. The aim of the producer is to maximize his profit. For this sake,
he decides to maximize the production at minimum cost by means of the best combination of factors
of production.
The producer secures the best combination by applying the principles of equi-marginal returns and
substitution. According to the principle of equi-marginal returns, any producer can have maximum
production only when the marginal returns of all the factors of production are equal to one another.
For instance, when the marginal product of the land is equal to that of labour, capital and
organisation, the production becomes maximum.
6.3 PRODUCTION FUNCTION
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Production function refers to the functional relationship between the quantity of a good produced
(output) and factors of production (inputs). “The production function is purely a technical relation
which connects factor inputs and output.” Prof. Koutsoyiannis “Production function the relation
between a firm’s physical production (output) and the material factors of production (inputs).” In this
way, production function reflects how much output we can expect if we have so much of labour and
so much of capital as well as of labour etc. It shows the flow of inputs resulting into a flow of output
during some time. The production function of a firm depends on the state of technology. With every
development in technology the production function of the firm undergoes a change. The new
production function brought about by developing technology displays same inputs and more output or
the same output with lesser inputs. Sometimes a new production function of the firm may be adverse
as it takes more inputs to produce the same output.
Mathematically, such a basic relationship between inputs and outputs may be expressed as:
Q= f (LB, L, K, M, T, and t).
Where, LB= land and building; L = labour; K =capital; M = raw material; T = technology; t = time
Hence, the level of output (Q), depends on the quantities of different inputs (L, C, N) available to the
firm. In the simplest case, where there are only two inputs, labour (L) and capital (C) and one output
(Q), the production function becomes. Q =f (L, C)
6.4 FEATURES OF PRODUCTION FUNCTION
Following are the main features of production function:
 Substitutability: The factors of production or inputs are substitutes of one another which
make it possible to vary the total output by changing the quantity of one or a few inputs, while the
quantities of all other inputs are held constant. It is the substitutability of the factors of production that
gives rise to the laws of variable proportions.
 Complementarity: The factors of production are also complementary to one another, that is,
the two or more inputs are to be used together as nothing will be produced if the quantity of either of
the inputs used in the production process is zero. The principles of returns to scale is another
manifestation of complementarity of inputs as it reveals that the quantity of all inputs are to be
increased simultaneously in order to attain a higher scale of total output.
 Specificity: It reveals that the inputs are specific to the production of a particular product.
Machines and equipment’s, specialized workers and raw materials are a few examples of the
specificity of factors of production. The specificity may not be complete as factors may be used for
production of other commodities too. This reveals that in the production process none of the factors
can be ignored and in some cases ignorance to even slightest extent is not possible if the factors are
perfectly specific. Production involves time; hence, the way the inputs are combined is determined to
a large extent by the time period under consideration. The greater the time period, the greater the
freedom the producer has to vary the quantities of various inputs used in the production process. In
64
the production function, variation in total output by varying the quantities of all inputs is possible only
in the long run whereas the variation in total output by varying the quantity of single input may be
possible even in the short run.

1. _______ is the process of converting inputs into outputs.
2. Profit is the sum of cost and revenue. (True/False)
3. The main Factors of production are_____,______,______and______.
4. The production function assumes technology as fixed (True/False)
Activity 1:
Analyse the production process of any steel manufacturing industry of your choice. Write
down the details of inputs and outputs in the production of steel.
6.5 ISOQUANTS
An isoquant is a locus of points showing all the technically efficient ways of combining factors of
production to produce a fixed level of output. It is also known as the equal product curve. In case of
two variable factors, labour and capital, an isoquant appears as a curve on a graph the axes of which
measure quantities of the two factors. The curve shows the efficient alternative techniques of
production or alternative combinations of two factors that can produce a fixed level of output.
Table 1: Alternative Methods of Producing Six Units of Output
Method Units of K Units of L
a 18 2
b 12 3
c 9 4
d 6 6
e 4 9
f 3 12
g 2 18
Table 1 illustrates, by using hypothetical numbers, seven alternative methods of producing six units
of output. These alternatives are shown also in Fig. a, as represented by the curve Q = 6. Thus, the
firm could choose combination a (18K + 2L), combination g (2K + 18L) or any other combination shown
in Table 1.
Figure (a) Isoquants Lines Figure (b) Isocost Lines
Figure a shows two other isoquants, each corresponding to particular (fixed) level of output, viz., Q =
8 and Q = 10. Each curve shows the alternative combinations of labour and capital that would
produce 8 and 10 units of output, respectively. We could draw as many isoquants as we like.
65
6.6 ISOCOST LINES
An isoquant shows what a firm is desirous of producing. But, the desire to produce a commodity is
not enough. The producer must have sufficient capacity to buy necessary factor inputs to be able to
reach its desired production level. The capacity of the producer is shown by his monetary resources,
i.e., his cost outlay (or how much money he is capable of spending) on capital and labour, the prices
of which are taken as constant i.e. given in the market place. So, like the consumer the producer has
also to operate under a budget (resource) constraint. This is picturised by his budget line called
isocost line. To find the least cost combination of inputs to produce a given output, we need to
construct such equal cost lines or isocost lines.
An isocost line is a locus of points showing the alternative combinations of factors that can be
purchased with a fixed amount of money. In fact, every point on a given isocost line represents the
same total cost. To construct isocost lines we need information about the market prices of the two
factors. For example, suppose, the price of labour is Re. 1 per unit and the price of capital is Rs. 4
per unit. Then an outlay of Rs. 36 could buy 9K + 0L, 36L + 0K, or other combinations such as 5K +
16L. All these and other various combinations are shown in Figure b by isocost line C = Rs. 36.
Isocost lines C = Rs. 12, C = Rs. 24 and C = Rs. 48 show the alternative combinations of capital and
labour that can be purchased or hired by spending Rs. 12, Rs. 24 and Rs. 48, respectively. These
lines are straight lines because factor prices are constant and they have a negative slope equal to the
factor-price ratio, i.e., the ratio of labour price to capital price (i.e., the wage ratio -5- the rate of
interest).
6.7 COST MINIMISATION
Figure C Here, the firm seeks to minimise its cost of producing a given
level of output. To find the least-cost combination of factors for
fixed level of output we combine Figure a and Figure b in Figure
c. suppose, the producer wants to produce six units of output.
He could do so using the combination represented by points A,
B or C in Figure c.
For example, the cost would be Rs. 48 at C, Rs. 36 at B and Rs. 24 at A. The cheapest
method is at A, where the isoquant for output of six (Q = 6) is tangent to an isocost line (C = Rs. 24).
In Figure 3 the firm tries to find out the least expensive factor combination along its isoquant. It looks
for that factor combination that is on the lowest of the isocost lines. Where the isoquant touches (but
does not cross) the lowest isocost line is the least cost position. The tangency point shows that
optimisation in production is reached when factor prices and marginal product are proportional, with
equalised marginal product per rupee. The minimum-cost points are A, D and E. Each such point
shows the equilibrium factor combination for maximising output subject to cost constraint, i.e., subject
to fixed factor prices and fixed outlay (on resources).
66
We may now speak a few words about the slopes of isoquant and an isocost line. The slope of an
isoquant gives the marginal rate of technical substitution (MKTS) defined as the increase in the
quantity of one factor that is required to replace a unit decrease in another factor, when output is held
constant along any isoquant. It is also known as the desired rate of factor substitution, i.e., the rate at
which the producer wants to substitute one factor by the other.
MKTS is, in fact, the ratio of the marginal products of the factors. To see this, consider an example.
Assume that output is such that the MPLand the MPK are both equal to 2 (units of output), i.e., MPK =
MPL. If the firm is to maintain the same level of output while reducing capital by one unit, it needs to
replace one unit of capital by one unit of labour. If at another point on the same isoquant, the MPL =
2, while the MPK = 1, the firm needs to replace a unit of capital with only half unit of labour.
An isocost line shows the alternative quantities of two factors viz., capital and labour that can be
purchased or hired with a fixed sum of money. Its slope is given by the ratio of the prices of the two
factors. It is known as the actual rate of factor substitution, the rate at which the firm can substitute
labour by capital in the market place.
Thus, in Figure 3, given the prices of labour and capital at Re 1 and Rs. 4 per unit, respectively, the
slope of C = Rs. 12 is determined by drawing the line joining points 3K + 0L (which represents outlay
of Rs. 12 entirely on capital) and 12L + OK (Rs. 12 spent entirely on labour). All the isocost lines in
the diagram have the same slope because the relative prices of labour and capital are the same. If
labour were relatively more expensive, the isocost lines would be steeper in Fig. 2
Cost minimisation occurs when an isoquant is just tangent to (but does not cross) an isocost line.
When this happens the ratio of the prices of factors is the same as the ratio of their marginal
products. Symbolically: MPL/MPK = PL/PK
6.8 TOTAL, MARGINAL AND AVERAGE REVENUE
Revenue is the amount generated from sale of goods or services, or any other use of capital or
assets, associated with the main operations of firm before any costs or expenses are deducted. In
economics, we have three types of revenues-total revenue, average revenue and marginal
revenue-which are discussed as under: -
a) Total Revenue (TR)
Total revenue is the total money received from the
sale of any given quantity of output. The total revenue
is calculated by taking
67 the price of the sale times the
quantity sold, i.e. TR = Price × Quantity.
b) Average Revenue (AR)
Average revenue is the revenue received for selling a good per
unit of output sold. It is calculated by dividing total revenue by the
quantity of output, i.e. AR= TR/Quantity
Average revenue often goes by a simpler and more widely used
term- price. Using the longer term average revenue rather than
price provides a connection to other related terms, especially
total revenue and marginal revenue. When compared with
average cost, average revenue shows the amount of profit
generated per unit of output produced. Average revenue is often
shown by an average revenue curve, shown in Figure.
c) Marginal Revenue (MR)
Marginal revenue is the change in total revenue resulting from a
change in the quantity of output sold. Marginal revenue indicates how
much extra revenue a firm receives for selling an extra unit of output. It
is found by dividing the change in total revenue by the change in the
quantity of output. Marginal revenue is the slope of the total revenue
curve and is one of two revenue concepts derived from total revenue.
The other is average revenue. To maximize profit, a firm equates
marginal revenue and marginal cost. MR = Change in TR/Change in
Quantity
6.9 LAW OF VARIABLE PROPORTIONS (OR RETURNS TO A FACTOR)

The Law of Variable Proportions or Returns to a Factor plays an important role in the study of the Theory
of Production. In this article, we will look at the meaning, explanation, stages, significance, and reasons
behind the operation of the Law of Variable Proportions. This law exhibits the short-run production
functions in which one factor varies while the others are fixed. The Law of Variable Proportions concerns
itself with the way the output changes when you increase the number of units of a variable factor. Hence,
it refers to the effect of the changing factor-ratio on the output. In other words, the law exhibits the
relationship between the units of a variable factor and the amount of output in the short-term. This is
assuming that all other factors are constant. This relationship is also called returns to a variable factor.
The law states that keeping other factors constant, when you increase the variable factor, then the total
product initially increases at an increases rate, then increases at a diminishing rate, and eventually starts
declining.
6.9.1 WHY CALLED LAW OF VARIABLE PROPORTIONS?
68
As one input varies and all others remain constant, the factor ratio or the factor proportion varies. Let’s
say that you have 10 acres of land and 1 unit of labour for production. Therefore, the land-labour ratio is
10:1. Now, if you keep the land constant but increase the units of labour to 2, the land-labour ratio
becomes 5:1. Therefore, as you can see, the law analyses the effects of a change in the factor ratio on
the amount of out and hence called the Law of Variable Proportions.
EXPLANATION: Let’s understand this law with the help of another example:
Fixed Factor: Land Variable Factor: TPP (Total Physical MPP (Marginal
(Acres) Labour (Units) Product) (Quantity) Physical Product)
(Quantity)
1 0 0 -
1 1 2 2 Stage-I
1 2 6 4
1 3 12 6
1 4 16 4 Stage-II
1 5 18 2
1 6 18 0 Stage-III
1 7 14 -4
1 8 8 -6
In this example, the land is the fixed factor and labour is the variable factor. It shows the different
amounts of output when you apply different units of labour to one acre of land which needs fixing.
The diagram explains the law of variable

proportions. In order to make a simple
presentation, we draw a Total Physical Product
(TPP) curve and a Marginal Physical Product
(MPP) curve as smooth curves against the
variable input (labour).
6.9.2 STAGES OF LAW

The law has three stages as explained below:
 Stage I – The TPP increases at an increasing rate and the MPP increases too. The MPP
increases with an increase in the units of the variable factor. Therefore, it is also called the stage of
increasing returns. In this example, the Stage I of the law runs up to three units of labour (between the
points O and L).
 Stage II – The TPP continues to increase but at a diminishing rate. However, the increase is
positive. Further, the MPP decreases with an increase in the number of units of the variable factor.
Hence, it is called the stage of diminishing returns. In this example, Stage II runs between four to six
units of labour (between the points L and M). This stage reaches a point where TPP is maximum (18
in the above example) and MPP becomes zero (point R).
69
 Stage III – Now, the TPP starts declining, MPP decreases and becomes negative. Therefore, it
is called the stage of negative returns. In this example, Stage III runs between seven to eight units of
labour (from the point M onwards).
6.9.3 SIGNIFICANCE OF THE THREE STAGES
 Stage I: A producer does not operate in Stage I. In this stage, the marginal product increases
with an increase in the variable factor. Therefore, the producer can employ more units of the variable to
efficiently utilize the fixed factors. Hence, the producer would prefer to not stop in Stage I but will try to
expand further.
 Stage III: Producers do not like to operate in Stage III either. In this stage, there is a decline in
total product and the marginal product becomes negative. In order to increase the output, producers
reduce the amount of variable factor. However, in Stage III, he incurs higher costs and also gets lesser
revenue thereby getting reduced profits.
 Stage II: Any rational producer avoids the first as well as third stages of production. Therefore,
producers prefer Stage II – the stage of diminishing returns. This stage is the most relevant stage of
operation for a producer according to the law of variable proportions.

5. _______refers to the stage of production in which the total output increases, but
the marginal products starts declining with the increase in the number of workers.
6. If MPL>APL, then the production stage is increasing returns
(True/False)
Activity 2:
Discuss about the “Importance of Law of Diminishing Returns”.
6.10 LAW OF VARIABLE PROPORTIONS IN TERMS OF TPP AND MPP

6.10.1 Law of Variable Proportions – in terms of TPP
We know that the law of variable proportions shows the relationship between units of a variable factor
and the total physical product. Also, if we keep other factors constant and increase the units of the
variable factor, then the TPP initially increases at an increasing rate, then at a diminishing rate, and
finally declines. Therefore, it has three clear stages:
 Stage I – TPP increasing at an increasing rate; Stage II – TPP increasing at a diminishing rate;
and Stage III – TPP declining
Labour TPP (Total Physical
(Units) Product) (Quantity)
0 0
1 2 Stage-I
2 6
3 12
4 16
Stage-II
5 18 Diagram of Law of Variable Proportion in terms of TPP
6 18 Stage-III
7 14
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8 8
6.10.2 Law of Variable Proportions in terms of MPP
The Law also states that if we keep all other factors constant and increase the units of a variable factor,
then the marginal physical product initially increases, then decreases, and finally becomes negative.
Therefore, it has three stages:
 Stage I – MPP increasing; Stage II – MPP decreasing but remaining positive; and Stage III –
MPP continuing to decrease and becoming negative.
6.11 REASON FOR THE OPERATION OF THE LAW
 In the short-term, we cannot vary all factors of production.
 In this case, there is only one variable factor while others are fixed.
 All other factors combine optimally to produce the maximum output.
 Before the point of optimum combination, if the units of a variable factor increase, then the
factor proportion becomes more suitable and it leads to more efficient utilization of the fixed factors.
Therefore, the marginal physical product increases.
 During the initial stages, the total product tends to rise at an increasing rate when the producer
employs more units of a variable factor to the fixed factors.
 Subsequently, beyond the point of optimum combination, if the producer employs more units of
the variable factor, then the factor proportion becomes inefficient. Therefore, the marginal product of
that variable factor declines.
 Also, the producer sees a fall in the quantity of the fixed factor input per unit of the variable as
he increases the units of the variable factor.
 Therefore, successive units of the variable input add decreasing amounts to the total output as
they have less fixed inputs to work with.
6.12 LAW OF RETURN TO SCALE
The law of returns to scale explains the proportional change in output with respect to proportional
change in inputs. In other words, the law of returns to scale states when there is a proportionate
change in the amounts of inputs, the behavior of output also changes. The degree of change in
output varies with change in the amount of inputs. For example, an output may change by a large
proportion, same proportion, or small proportion with respect to change in input. On the basis of
these possibilities, law of returns can be classified into three categories:
i) Increasing returns to scale;
ii) Constant returns to scale; and
iii) Diminishing returns to scale
i) Increasing Returns to Scale: If the proportional change in the output of an organization is
greater than the proportional change in inputs, the production is said to reflect increasing returns to
scale. For example, to produce a particular product, if the quantity of inputs is doubled and the
71
increase in output is more than double, it is said to be an increasing returns to scale. When there is
an increase in the scale of production, the average cost per unit produced is lower. This is because at
this stage an organization enjoys high economies of scale.
The movement from a to b indicates that the amount of input is

doubled. Now, the combination of inputs has reached to 2K+2L
from 1K+1L. However, the output has Increased from 10 to 25
(150% increase), which is more than double. Similarly, when
input changes from 2K-H2L to 3K + 3L, then output changes
from 25 to 50(100% increase), which is greater than change in
input. This shows increasing returns to scale. There a number of
factors responsible for increasing returns to scale.
ii) Constant Returns to Scale: The production is said to generate constant returns to scale
when the proportionate change in input is equal to the proportionate change in output. For example,
when inputs are doubled, so output should also be doubled, then it is a case of constant returns to
scale.
When there is a movement from a to b, it indicates that input is

doubled. Now, when the combination of inputs has reached to
2K+2L from IK+IL, then the output has increased from 10 to 20.
Similarly, when input changes from 2Kt2L to 3K + 3L, then output
changes from 20 to 30, which is equal to the change in input. This
shows constant returns to scale. In constant returns to scale, inputs
are divisible and production function is homogeneous.
iii) Diminishing Returns to Scale:

Diminishing returns to scale refers to a situation when the proportionate change in output is less than
the proportionate change in input. For example, when capital and labor is doubled but the output
generated is less than doubled, the returns to scale would be termed as diminishing returns to scale.
Diminishing returns to scale is due to diseconomies of scale, which arises because of the managerial
inefficiency. Generally, managerial inefficiency takes place in large-scale organizations. Another
cause of diminishing returns to scale is limited natural resources. For example, a coal mining
organization can increase the number of mining plants, but cannot increase output due to limited coal
reserves.
When the combination of labor and capital moves from point a to point b,
it indicates that input is doubled. At point a, the combination of input is
1k+1L and at point b, the combination becomes 2K+2L. However, the
output has increased from 10 to 18, which is less than change in the
72when input changes from 2K+2L to 3K + 3L,
amount of input. Similarly,
then output changes from 18 to 24, which is less than change in input.
This shows the diminishing returns to scale.
6.13 USES OF PRODUCTION FUNCTION
The following are the uses for the management: -
i) To find the most profitable rate of operation of the firm;
ii) To determine the optimum quantity of output to be produced and supplied;
iii) To determine in advance the cost of business operations;
iv) To locate weak points in production management to minimize costs;
v) To fix the price of the product;
vi) To decide what sales channel to use;
vii) To have clarity about the various cost concepts;
viii) To decide and determine the very existence of a firm in the production field;
ix) To regulate the number of firms engaged in production; and
x) To decide about the method of cost estimation or calculations.

7. L-Shaped isoquant is the case of perfect substitutes. (True/false)
Activity 3:
Visit the industrial area of your vicinity and learn about factors of production employed.
6.14 SUMMARY
The production function depicts the relation between physical outputs of a production process and
physical inputs, i.e. factors of production. The practical application of production functions is obtained
by valuing the physical outputs and inputs by their prices. The economic value of physical outputs
minus the economic value of physical inputs is the income generated by the production process. By
keeping the prices fixed between two periods under review we get the income change generated by
a change of the production function. This is the principle how the production function is made a
practical concept, i.e. measureable and understandable in practical situations.
6.15 GLOSSARY
 Average revenue is the revenue generated per unit of output sold. It plays a role in the
determination of a firm's profit. Per unit profit is average revenue minus average (total) cost. A firm
generally seeks to produce the quantity of output that maximizes profit.
 Isocost line is an important component when analysing producer's behaviour. The isocost line
illustrates all the possible combinations of two factors that can be used at given costs and for a given
producer's budget. In simple words, an isocost line represents a combination of inputs which all cost
the same amount.
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 Isoquant is a firm's counterpart of the consumer's indifference curve. An isoquant is a curve
that shows all the combinations of inputs that yield the same level of output. 'Iso' means equal and
'quant' means quantity. Therefore, an isoquant represents a constant quantity of output.
 Marginal revenue is the additional income generated from the sale of one more unit of a good
or service. It can be calculated by comparing the total revenue generated from a given number of
sales and the total revenue generated from selling one extra unit.
 Production means the processes and methods used to transform tangible inputs (raw
materials, semi-finished goods, subassemblies) and intangible inputs (ideas, information, knowledge)
into goods or services.
 Production Function relates physical output of a production process to physical inputs or
factors of production. It is a mathematical function that relates the maximum amount of output that
can be obtained from a given number of inputs – generally capital and labor.
 Total Revenue refers to the total receipts from sales of a given quantity of goods or services.
It is the total income of a business and is calculated by multiplying the quantity of goods sold by the
price of the goods.
1. Production
2. False
3. Land, Labour, Capital and Enterprise
4. True
5. Diminishing Returns to Scale
6. True
7. False
1. What do you understand by production? Discuss the features of production functions.
2. Discuss in brief about the Isoquants and Isocost lines.
3. Explain the law of return to a factor.
4. Discuss the concept of return to scale.
5. Discuss the uses of production function for managers.

 Dean, J. Managerial economics (1st ed.). New York: Prentice-Hall.
Book Co., Inc.
74
75
CHAPTER 7
PRICE DETERMINATION
STRUCTURE
7.2 INTRODUCTION: CONCEPT OF PRICE DETRMINATION
7.3 FACTORS AFFECTING DETERMINATION OF PRICE
7.4 MARKET: A BRIEF INTRODUCTION
7.5 EXTENT (OR SIZE) OF MARKET
7.6 PERFECT COMPETITION
7.7 IMPERFECT COMPETITION
7.8 PRICE DETERMINATION UNDER PERFECT COMPETITION
7.9 PRICE DETERMINATION UNDER MONOPOLISTIC COMPETITION
7.10 PRICE DETERMINATION UNDER MONOPOLY
7.11 PRICE DETERMINATION UNDER PRICE DISCRIMINATION
7.12 SUMMARY
7.13 GLOSSARY
 The concept of price, price determination.
 The market and size of market.
 The types of competition and price determination under different market conditions.
7.2 INTRODUCTION: CONCEPT OF PRICE DETERMINATION
Price is the worth that buys a finite amount, weight, or another match of goods or services. In other
words, it also expresses the value of the goods produced and the services rendered by factors of
production such as land, labor, and capital. Thus, the determination of prices is of great significance in an
economy. Determination of Prices means to determine the cost of goods sold and services rendered in
the free market. In a free market, the forces of demand and supply determine the prices. The
Government does not interfere in the determination of the prices. However, in some cases, the
Government may intervene in determining the prices. For example, the Government has fixed the
minimum selling price for the wheat.
7.3 FACTORS AFFECTING DETERMINATION OF PRICE
The factors which affect the price determination of the product are:
 Product Cost: Product cost is one of the most important factors which affect the price. It
includes the total of fixed costs, variable costs and semi-variable costs incurred through the production,
distribution, and selling of the product.
 The Utility and Demand: The end user demands more units of a product when its price is low
and vice versa. On the other hand, when the demand for a product is elastic, little variation in the price
may result in large changes in quantity demanded. While, when it is inelastic a change in the prices
does not affect the demand significantly. In addition, the buyer is ready to pay up to that point where he
perceives utility from the product to be at least equal to the price paid.
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 The Extent of Competition in the Market: A firm can fix any price for its product if the degree
of competition is low. However, when there is competition in the market, the price is fixed after keeping
in mind the price of the substitute goods.
 Government and Legal Regulations: The firms which have a monopoly in the market, charge
a high price for their products. In order to protect the interest of the public, the government intervenes
and regulates the prices of the commodities. For this purpose, it declares some products as
indispensable products. For example, Life-saving drugs, etc.
 Pricing Objectives: Profit Maximization, Obtaining Market Share Leadership, Surviving in a
Competitive Market and Attaining Product Quality Leadership are the pricing objectives of an enterprise.
By and large, firm charges higher prices to cover high quality and high cost if it’s backed by the above
objective.
 Marketing Methods Used: A range of marketing methods such as circulation system, quality of
salesmen, marketing, type of wrapping, patron services, etc. also affects the price of manufactured
goods. For instance, an organization will charge sky-scraping revenue if it is using the classy material for
wrapping its product.
7.4 MARKET: A BRIEF INTRODUCTION
In Economics, the term “Market” does not refer to a particular place as such but it refers to a market
for a commodity or commodities. It refers to an arrangement whereby buyers and sellers come in
close contact with each other directly or indirectly to sell and buy goods. Further, it follows that for the
existence of a market, buyers and sellers need not personally meet each other at a particular place.
They may contact each other by any means such as a telephone or telex. Thus, the term “Market” is
used in economics in a typical and specialised sense. It does not refer only to a fixed location. It
refers to the whole area of operation of demand and supply. Further, it refers to the conditions and
commercial relationships facilitating transactions between buyers and sellers. Therefore, a market
signifies any arrangement in which the sale and purchase of goods take place.
7.5 EXTENT (OR SIZE) OF MARKET
A market can be local confined to a village, or it can cover whole of the country or may be spread
throughout the globe. If buyers and sellers of a given product are scattered throughout the world,
there will be a world market, e.g. for oil, jute, tea, etc. There are many factors, which contribute
towards the extension of a market. These can be classified into two parts: (A) quality of a commodity
and (B) internal conditions of a country:
(A) Quality of a Commodity – The most important factor influencing the extent of market is the
quality of a commodity. The essential characteristics determining the quality of a commodity are as
follows:-
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i) Size of Demand–A commodity which enjoys a universal demand, is likely to have a winder market.
Oil is one such commodity that has a world market. Market for those commodities on the other hand,
shall be limited that cater only to individual needs;
ii) Portability–Those commodities as can be easily transported to different places shall have large
market. Cosmetics, toilet goods, industrial machinery etc. have a large market. On the other hand,
commodities like sand, bricks, etc. have a limited market because of heavy costs involved in their
transportation;
iii) Durability–A community, which is durable in nature, shall have a wider market. Fragile and
perishable goods like delicate glassware, fish, milk etc., have a limited market. However, with the
development of cold-storage, refrigeration and packaging service, etc. It is becoming possible even
for these commodities to have spread-out-markets;
iv) Cognoscibility–Graded and Standardised products have a wide market. Goods which can be
easily identified by their brand and name have large market;
v) Adequate Supply–For a wide market, it is essential that the production must be in huge quantity
to feed the wide market for the product.
(B) Internal Conditions of a Country–The second important determinant of the extent of market is
the internal conditions of a country. Internal conditions of a country include the following: -
i) Level of National and the Per Capita Income–The countries with higher national and per capita
income tend to offer larger markets for then products. Limited purchasing power of the people
restricts the size of the market;
ii) Peace, Security and Stable Government in the Country–Peace and stability are conductive to
the growth of markets in a country. World peace as security offers a better climate for expression of
world market;
iii) Means of Transportation and Communication–Efficient and cheaper means of transportation
facilitate the expansion of market. Likewise availability of telephones, telegrams, telex services, etc.
brings into contact the new buyers of a product and thus helps expand its market;
iv) Development of Monetary and Banking Institutions-A well developed currency and credit
system helps in the expansion of trade and commerce and thus facilitates the expansion of markets;
v) Government Policy–A restrictive trade may hamper the growth of markets in a country. If the
governments of the different countries impose restrictions on export and import of commodities it will
have different effect on the development of markets. In brief, internal conditions of a country taken
together with the nature of the commodities determine the extent of market. We shall now study the
determination of prices in following market conditions:
(a) Under Perfect Competition Market;
(b) Under Imperfect Market Conditions.
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1. Determination of prices means that determining the cost of goods sold and services
rendered in the free market. (True/False).
2. Marketing methods used does not affect the determination of price. (True/False)
3. ____is the whole area of operation of demand and supply.
Activity 1:
Discuss why Government has fixed the Minimum Selling Price?
7.6 PERFECT COMPETITION

A perfect competition is an extension of pure market subject to wider scope. According to Robinson
perfect competition can be defined as, “When the number of firms being large, so that a change in
the output of any of them has a negligible effect upon the total output of the commodity, the
commodity is perfectly homogeneous in the sense that the buyers are alike in respect of their
preferences (or indifference) between one firm and its rivals, then the competition is perfect, and the
elasticity of demand for the individual firm is infinite.” The characteristics are as under: -
 Large number of buyers and sellers: In perfect competition, a large number of buyers and
sellers exist. However, the high population of buyers and sellers fails to affect the prices, and the
output produced by a seller or purchases made by a buyer are very less in comparison to the total
output or total purchase in an economy.
 Homogenous product: Another important characteristic of perfect competition is the
existence of homogenous product for buying and selling. This makes it possible for buyers to choose
the product from any seller in the market. Due to the presence of large number of sellers, the market
price remains same throughout the market.
 Ease of entry and exit from the market: In perfect competition, there are hardly any barriers,
such as government regulations and policies, to enter or exit the market. Consequently, firms find it
easy to enter the markets as all the organisations earn normal profits. Similarly, organisations also
easily exit the market as they are not bound by any rules and regulations.
 Perfect knowledge: In the perfectly competitive scenario, both buyers and sellers are
completely aware of the product price prevailing in the market. Thus, no seller would try to sell the
product at a higher price. However, this also leaves no scope for bargaining for buyers too.
 No transportation costs: In perfect competition, the existence of the same price is
because of zero transportation costs. Due to the absence of transportation costs, there is no
scope of price variation in all sectors of the market.
7.7 IMPERFECT COMPETITION
Imperfect competition is a competitive market where a large number of sellers are engaged in selling
heterogeneous (dissimilar) goods as opposed to the perfectly competitive market. The concept of
imperfect competition was first explained by an English economist, Joan Robinson. Under imperfect
79
competition, both buyers and sellers are unaware of the prices. Therefore, producers can influence
the price of the product they are offering for sale. Imperfect competition can be classified as under: -
a) Monopolistic competition is a type of imperfect competition, wherein a large number of
sellers are engaged in offering heterogeneous products for sale to buyers. The term monopolistic
competition was given by Prof. Edward H. Chamberlin of Harvard University in 1933 in his book,
Theory of Monopolistic Competition. Monopolistic competition is the most realistic situation that exists
in the market. Some important characteristics of monopolistic competition are:
 Large number of sellers and buyers: The presence of large number of sellers offering
different products to equal number of buyers is a primary characteristic of monopolistic competition.
 Product differentiation: Another important characteristic of monopolistic competition is
product differentiation; wherein products that are sold in the market vary in style, quality standards,
trademarks and brands. This helps buyers in differentiating among the available products in more
than one way. However, under monopolistic competition, products are close substitutes of each
other.
 Ease of entry and exit: Similar to perfect competition, under monopolistic competition,
organisations are free to enter or exit the market due to the limited number of restrictions imposed by
the government.
 Restricted mobility: Dissimilar to perfect competition, the factors of production are not
perfectly mobile in monopolistic competition. This is due to organisation’s willingness to pay heavy
transportation costs to move the factors of production or goods and services. This results in
difference in the prices of products of organisations.
 Price control policy: Under monopolistic competition, organisations do not have much control
over the price of the product. If the prices of products are higher, then the buyers would switch to
other sellers due to close substitutability of products. Therefore, the price policy of competitors greatly
influences the price policy of an organisation.
b) Oligopoly: Oligopoly is a type of imperfect competition, wherein there are few sellers dealing
either in homogenous or differentiated products. The term oligopoly has been derived from the two
Greek words, oligoi means few and poly means control. Thus, it means the control of the few
organisations in the market. For example, oligopoly in India exists in the aviation industry where there
are just few players, such as Kingfisher, Air India, Spice Jet, Indigo, etc. All these airlines depend on
each other for setting their pricing policies. This is because the prices are affected by the prices of the
competitors’ products. In oligopoly market structure, the interdependency of organisations may either
leads to conflicts or cooperation among sellers. Let us discuss the characteristics of oligopoly in
detail, as follows:
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 Existence of few sellers: One of the primary features of oligopoly is the existence of a few
sellers who dominate the entire industry and influence the prices of each other, greatly. In addition,
the number of buyers is also large. Moreover, in oligopoly, there are a large number of buyers.
 Identical or differentiated products: An important characteristic of oligopoly is the
production of identical products or differentiated products. This implies that organisations may either
produce homogenous products, such as cement, asphalt, concrete and bricks, or differentiated
products, such as an automobile. If organisations produce homogenous products, it is said to be pure
oligopoly.
 Impediments in entry: Another important characteristic of oligopolistic competition is that
organisations cannot easily enter the market; nor can they make an exit from the market. The
reasons for difficult entry in the market are various legal, social and technological barriers. This also
implies that the existing organisations have a complete control over the market.
 Enhanced role of government: Under oligopolistic market structure, the government has a
greater role as it acts as a guard to anti- competitive behaviours of oligopolists. It is often observed
that oligopolists may engage in the illegal practice of collusion, where they together make production
and pricing decisions. Oligopolists may start acting as a single organisation and further increase
prices and profits. Thus in such an environment, the government requires to keep a watch on such
activities to curb the illegal practices.
 Mutual interdependence: Under oligopoly market structure, mutual interdependence refers to
the influence that organisations create on each other’s decisions, such as pricing and output
decisions. In oligopoly, a few numbers of sellers compete with each other. Therefore, the sale of an
organisation is dependent on its own price of products, as well as the price of its competitor’s
products. Thus, in oligopoly, no organisation can make an independent decision.
 Existence of price rigidity: Under oligopolistic market, organisations do not prefer to change
the prices of their products as this can adversely affect the profits of the organisation. For instance, if
an organisation reduces its price, its competitors may reduce the prices too, which would bring a
reduction in the profits of the organisation. On the other hand, the increase in prices by an
organisation will lead to loss of buyers.
c) Monopoly: Monopoly can be defined as a market structure, wherein a single producer or
seller has a control on the entire market. The term monopoly has been derived from a Greek word
Monopolian, which means a single seller. Thus, in monopoly, a single seller deals in the products that
have no close substitutes in the market. Some important characteristics of monopoly are described
as follows:
 Existence of a single seller: Under monopoly market structure, there is always a single seller
producing large quantities of the products. Due to availability of only one seller, buyers are forced to
81
purchase from the only seller. This results in total control on the supply of products by the seller in the
market. Moreover, the seller has complete power to decide the price of products.
 Absence of substitutes: Another important characteristic of monopoly is the absence of
substitutes of the products in the market. In addition, differentiated products are absent in the case of
monopoly market.
 Barriers to entry: The reason behind the existence of monopoly is the various barriers that
restrict the entry of new organisations in the market. These barriers can be in the form of exclusive
resource ownership, copyrights, high initial investment and other restrictions by the government.
Some of the barriers that limit the entry of new organisations are: i) Restrictions imposed by the
government. For example, electricity in India is considered as an old monopoly; ii) Control over
resources required for production of other goods. For example, Japan is considered to have a
monopoly over electronic products; and iii) Technological efficiencies resulting in economies of scale.
 Limited information: Under monopoly, information cannot be disseminated in the market and
is restricted to the organisation and its employees. Such information is not easily available to public
or other organisations. This type of information generally comes in the form of patents, copyrights or
trademarks.
7.8 PRICE DETERMINATION UNDER PERFECT COMPETITION
The market price and output is determined on the basis of consumer demand and market supply
under perfect competition i.e. the firms and industry should be in equilibrium at a price level in which
quantity demand is equal to the quantity supplied. They make maximum profit if the firm and industry
are in equilibrium.
The table below shows that when the price of commodity is low, demand is more. The supply part
reveals that as the as price increases, supply also increases. When the price is low, the competition
between consumers can raise the price and when the price is high, the competition among the sellers
reduces the price. Thus, the price finally comes to be determined at such a place when the demand
and supply of a commodity are equal to each other. At Rs. 5/-, the demand and supply of the
commodity is equal i.e. 50 units.
Figure: Price and Output Determination under Perfect Competition Market
Price of Quantity Quantity Conditions

Commodity Demanded Supplied
(Rs.) (Units) (Units)
2 80 20
3 70 30 D>S
4 60 40
5 50 50 D=S
6 40 60
7 30 70 D<S
8 20 80
In the figure above, both the demand curve DD and the supply curve SS are intersecting at point E.
thus, the point E is equilibrium point. The price is fixed at OP and at price OP, the demand and
82
supply are equal to OQ. If the price rises from OP to OM, the supply increases. At price OM, MB
quantity is supplied but quantity demanded is MA only and AB quantity remained unsold. Due to this
the price got reduced and comes to remain at OP. when price reduced from OP to OL, the supply
decreased to LT but demand increased to LH. This is the situation, where demand is more than the
supply, because of this price rises to OP.
a) Short-Run Equilibrium under Perfect Competition
Whether a firm makes abnormal profit or loss, it depends upon the level of AC in the short run
equilibrium. There are three conditions: i) Abnormal Profit, ii) Normal Profit; and iii) Loss.
As per the Marginal Revenue and Marginal Cost approach a firm can get equilibrium when it fulfills
two conditions, which are given as : -
i) Marginal revenue (MR) must be equal to Marginal Cost i.e. MC=MR; and
ii) Slope of MC curve > Slope of MR curve i.e. MC curve cuts MR curve from below.
The figure below reveals that the demand curve DD and supply curve SS intersect each other at
point E, where the market price is P. firm A enjoys abnormal profit as AC lies below equilibrium of the
AR curve. So, the shaded region PACE1 is the abnormal profit enjoyed by the firm. The firm B faces
normal profit, as AC is tangent to AR at equilibrium. And firm C bears loss and the shaded region
PCBE3 is the loss faced by the firm.
Figure: Short-Run Equilibrium under Perfect Competition
b) Long-Run Equilibrium under Perfect

In the long-run, a firm can adjust their fixed inputs and entry and exit are easy and free. All the firms
in the perfect competition can earn only normal profit in the long-run. Under perfect competition, the
firms could be in long-run equilibrium if they fulfill the given conditions:
i) Long-run marginal revenue (LMR) = Long-run Marginal Cost (LMC);
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ii) Long-Run Marginal Cost (LMC) must cut long run marginal revenue (LMR) from below at
equilibrium point;
iii) the slope of LMC must be greater than the slope of LMR.
Figure: Long-Run Equilibrium
The given figure shows the equilibrium of firm and

industry under perfect competition market. The industry
demand curve DD1 and supply curve SS1 intersect each
other at point E, where the market price is P and at this
point, industry determine OP price for OQ quantity of
product. The next figure explains long-run equilibrium of
competitive firm, where LMC and LAC represent long-
run marginal cost and average cost curve where at point
E, P + LAR, LMR=LMC=LAC respectively. OP price is
determined for OQ1 level of output and firm making only
7.9 PRICE DETERMINATION UNDERnormal profit
MONOPOLISTIC COMPETITION
Equilibrium of a firm in monopolistic competition, since the product is differentiated between firms, each
firm does not have a perfectly elastic demand for its products. In such a market, all firms determine the
price of their own products. Therefore, it faces a downward sloping demand curve. Overall, we can say
that the elasticity of demand increases as the differentiation between products decreases.
Figure: Short-Run Equilibrium of a Firm in Monopolistic Competition: Supernormal Profit
The figure depicts a firm facing a downward

sloping, but flat demand curve. It also has a U-
shaped short-run cost curve.
a) Conditions for the Equilibrium of an individual firm

The conditions for price-output determination and equilibrium of an individual firm are as follows: i) MC =
MR; and ii) The MC curve cuts the MR curve from below.
In above figure, we can see that the MC curve cuts the MR curve at point E. At this point,
 Equilibrium price = OP; and Equilibrium output = OQ
Now, since per unit cost is BQ, we have: - i) Per unit super-normal profit (price-cost) = AB or PC; and ii)
Total super-normal profit = APCB.
Figure: Short-Run Equilibrium of a Firm in Monopolistic Competition: With Losses
The figure shows that per unit cost is higher than the
price of the firm. Therefore,
 AQ > OP (or BQ)
 Loss per unit = AQ – BQ = AB
 Total losses = ACPB
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b) Long-run equilibrium
If firms in a monopolistic competition earn super-normal profits in the short-run, then new firms will have
an incentive to enter the industry. As these firms enter, the profits per firm decrease as the total demand
gets shared between a larger numbers of firms. This continues until all firms earn only normal profits.
Therefore, in the long-run, firms, in such a market, earn only normal profits.
It is important to note that in the long-run, a firm is in an equilibrium position having excess capacity. In
simple words, it produces a lower quantity than its full capacity. From the figure above, we can see that
the firm can increase its output from Q1to Q2 and reduce average costs. However, it does not do so
because it reduces the average revenue more than the average costs. Hence, we can conclude that in
monopolistic competition, firms do not operate optimally.
Figure: Long-Run Equilibrium of a Firm in Monopolistic Competition
This figure shows the average revenue (AR) curve

touches the average cost (ATC) curve at point X. This
corresponds to quantity Q1 and price P1. Now, at
equilibrium (MC = MR), all super-normal profits are
zero since the average revenue = average costs.
Therefore, all firms earn zero super-normal profits or
earn only normal profits.
There always exists an excess capacity of production with each firm. In case of losses in the short-run,
the firms making a loss will exit from the market. This continues until the remaining firms make normal
profits only.
7.10 PRICE DETERMINATION UNDER MONOPOLY
A firm under monopoly faces a downward sloping demand curve or average revenue curve. Further,
in monopoly, since average revenue falls as more units of output are sold, the marginal revenue is
less than the average revenue. In other words, under monopoly the MR curve lies below the AR
curve.
The Equilibrium level in monopoly is that level of output in which marginal revenue equals marginal
cost. The producer will continue producer as long as marginal revenue exceeds the marginal cost. At
the point where MR is equal to MC the profit will be maximum and beyond this point the producer will
stop producing.
In the short run, the monopolist has to keep an eye on the variable cost, otherwise he will stop
producing. In the long run, the monopolist can change the size of plant in response to a change in
demand. In the long run, he will make adjustment in the amount of the factors, fixed and variable, so
that MR equals not only to short run MC but also long run MC
a) Price Discrimination in Monopoly: Price discrimination may be as under: -
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 Personal: It is personal when different prices are charged for different persons.
 Local: It is local when the price varies according to locality.
 Trade or Use: It is according to trade or use when different prices are charged for different
uses to which the commodity is put, for example, electricity is supplied at cheaper rates for domestic
than for commercial purposes.
Some monopolists used product differentiation for price discrimination by means of special labels,
wrappers, packing, etc. For example, the perfume manufacturers discriminate prices of the same
fragrance by packing it with different labels or brands.
b) Conditions of Price-Discrimination: There are three main types of situation:
 When consumers have certain preferences or prejudices. Certain consumers usually have
the irrational feeling that they are paying higher prices for a good because it is of a better quality,
although actually it may be of the same quality. Sometimes, the price differences may be so small
that consumers do not consider it worthwhile to bother about such differences.
 When the nature of the good is such as makes it possible for the monopolist to charge
different prices. This happens particularly when the good in question is a direct service.
 When consumers are separated by distance or tariff barriers. A good may be sold in one
town for Re. 1 and in another town for Rs. 2. Similarly, the monopolist can charge higher prices in a
city with greater distance or a country levying heavy import duty.
c) Conditions making Price Discrimination Possible and Profitable: The following conditions
are essential to make price discrimination possible and profitable:
 The elasticity’s of demand in different markets must be different. The market is divided
into sub-markets. The sub-market will be arranged in ascending order of their elasticities, the higher
price being charged in the least elastic market and vice versa.
 The costs incurred in dividing the market into sub-markets and keeping them separate
should not be so large as to neutralize the difference in demand elasticities.
 There should be complete agreement among the sellers otherwise the competitors will
gain by selling in the dear market.
 When goods are sold on special orders because then the purchaser cannot know what is
being charged from others.
7.11 PRICE DETERMINATION UNDER PRICE DISCRIMINATION
(i) First of all, the monopolist divides his total market into sub-markets. In the following
diagrams, the monopolist has divided his total market into two sub-markets, i.e., A and B:
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The monopolist has now to decide at what level of output he should produce. To achieve
maximum profit, hence, he will be in equilibrium at output at which MR= MC and MC curve cuts the
MR curve from below. In the above diagram (c) it is shown that the equilibrium of the discriminating
monopolist is established at output OM at which MC cuts CMR. The output OM is distributed between
two markets in such a way that marginal revenue in each is equal to ME. Therefore, he will sell output
OM1 in Market A, because only at this output marginal revenue MR’ in Market A is equal to ME (M 1E’
= ME). The same condition is applied in Market B where MR” is equal to ME (M2E” = ME). In the
above diagram, it is also shown that in Market B in which elasticity of demand is greater, the price
charged is lower than that in Market B where the elasticity of demand is less.
SELF CHECK EXERCISE 2:

4. Under monopoly market structure, there is always a single seller producing small
quantities of the products. (True/ False).
5. _____is a type of imperfect competition, wherein there are few sellers dealing either
in homogenous or differentiated products.
6. In __________ market, all the products are considered as substitutes of one-another.
7. Under imperfect competition both buyers and sellers are unaware of the prices.
(True/False)
Activity 2:
Find how the price is influenced under perfect and imperfect competitions and make a written
report.
7.12 SUMMARY
The perfect competition implies no rivalry among firms. In a perfectly competitive market structure
there is a large number of buyers and sellers of the product and the product is homogeneous. There
is free mobility of factors of production and the buyers and sellers have perfect knowledge of the
market. In the short run the best level of output of the firm is the one at which the firm maximises
profits or minimises losses. This is possible at P = MR = MC. The point at which the firm covers its
variable costs is called "the closing down point". In long run the best level of output is one at which
price P=LMC. At equilibrium the short run marginal cost is equal to the long run marginal cost and the
short run average cost is equal to the long run average cost.
7.13 GLOSSARY
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 Competition is a type of rivalry in which a seller makes an attempt at obtaining the same
profits, market share, quality, etc., sought by other sellers.
 Monopolist: It can be an individual or organisation that controls the production and
price of a good or service in the market.
 Perfect competition: A market structure characterized by a complete absence of rivalry
among the individual firms.
 Profit: Difference between total revenue and total cost Market period: A very short period in
which the supply is fixed, that is no adjustment can take place in supply conditions.
1. True
2. False
3. Market
4. False
5. Oligopoly
6. Purely Competitive
7. True
1. Discuss about the factors affecting price determination.
2. How would you determine the price under perfect competition? Discuss
3. Elaborate how price have been determine under monopolistic competition?
4. What do you understand by price discrimination? Discuss with the help of an example.
Book Co., Inc.
 McEachern, W., & Lunn, J. (2012). Microeconomics (1st ed.). Australia: South-Western,
Cengage Learning.
 P. K. Jha (2011). Economics II, Dreamland Publications.
88
 Wilkinson, N. (2005). Managerial economics (1st ed.). New York: Cambridge University Press.
89
CHAPTER 8
CONCEPT OF COST
STRUCTURE
8.2 INTRODUCTION: CONCEPT OF COST
8.3 COST FUNCTION
8.4 SHORT-RUN AND LONG-RUN COSTS
8.5 SHORT-RUN AVERAGE COSTS AND OUTPUT
8.6 SHORT-RUN AVERAGE FIXED COST
8.7 AVERAGE VARIABLE COST
8.8 AVERAGE TOTAL COST
8.9 SHORT-RUN MARGINAL COST (MC) AND OUTPUT
8.10 COSTS IN THE LONG RUN
8.11 TOTAL COST, AVERAGE COST AND MARGINAL COST
8.12 ECONOMIES AND DISECONOMIES OF SCALE
8.12.1 INTERNAL DISECONOMIES AND ECONOMIES OF SCALE
8.12.2 EXTERNAL DISECONOMIES AND ECONOMIES OF SCALE
8.13 SUMMARY
8.14 GLOSSARY
 The concept of cost and various types of costs.
 The cost function.
 The short run and long run costs.
 The economies and diseconomies of scale.
8.2 INTRODUCTION: CONCEPT OF COST
Costs are very important in business decision-making. Cost of production provides the floor to
pricing. It helps managers to take correct decisions, such as what price to quote, whether to place a
particular order for inputs or not whether to abandon or add a product to the existing product line and
so on. Ordinarily, costs refer to the money expenses incurred by a firm in the production process. But
in economics, cost is used in a broader sense. Here, costs include imputed value of the
entrepreneur’s own resources and services, as well as the salary of the owner-manager. There are
various concepts of cost that a firm considers relevant under various circumstances. To make a
better business decision, it is essential to know the fundamental differences and uses of the main
concepts of cost.
A) ACTUAL COSTS AND OPPORTUNITY COSTS: Actual costs refer to the costs which a firm
incurs for acquiring inputs or producing a good and service such as the cost of raw materials, wages,
rent, interest, etc. The total money expenses recorded in the books of accounts are the actual costs.
Opportunity cost is the cost of sacrifice of the best alternative foregone in the production of a good or
service. Since resources are scarce, they cannot be used to produce all things simultaneously.
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B) DIRECT COSTS AND INDIRECT COSTS: Direct costs are the costs that have direct relationship
with a unit of operation, i.e., they can be easily and directly identified or attributed to a particular
product, operation or plant. For example, the salary of a branch manager, when the branch is a
costing unit, is a direct cost. Direct costs directly enter into the cost of production but retain their
separate identity. On the other hand, indirect costs are those costs whose source cannot be easily
and definitely traced to a plant, a product, a process or a department, such as electricity, stationery
and other office expenses, depreciation on building, decoration expenses, etc. All the direct costs are
variable because they are linked to a particular product or department.
C) INCREMENTAL COSTS AND SUNK COSTS: Incremental costs denote the total additional costs
associated with the marginal batch of output. These costs are the additions to costs resulting from a
change in the nature and level of business activity, e.g., change in product line or output level, adding
or replacing a machine, changes in distribution channels, etc. In the long-run, firms expand their
production; employ more men, materials, machinery and equipment. All these expenses are
incremental costs. Sunk costs are the costs that are not affected or altered by a change in the level or
nature of business activity. It cannot be altered, increased or decreased by varying the level of
activity or the rate of output. All past or actual costs are regarded as sunk costs.
D) EXPLICIT COSTS AND IMPLICIT COSTS: Explicit costs are those payments that must be made
to the factors hired from outside the control of the firm. They are the monetary payments made by the
entrepreneur for purchasing or hiring the services of various productive factors which do not belong
to him. Such payments as rent, wages, interest, salaries, payment for raw materials, fuel, power,
insurance premium, etc. are examples of explicit costs. Implicit costs refer to the payments made to
the self-owned resources used in production. They are the earnings of owner’s resources employed
in their best alternative uses. For example, a businessman utilises his services in his own business
leaving his job as a manager in a company.
E) HISTORICAL AND REPLACEMENT COSTS: The historical cost is the actual cost of an asset
incurred at the time the asset was acquired. It means the cost of a plant at a price originally paid for
it. In contrast, replacement cost means the price that would have to be paid currently for acquiring the
same plant. So historical costs are the past costs and replacement costs are the present costs. The
concept of replacement cost is very useful for the management. It projects a true picture while the
historical cost gives poor projection to the management. Historical cost of assets is used for
accounting purposes, in the assessment of net worth of the firm, while the replacement cost is used
for business decision regarding the renovation of the firm.
F) PAST COSTS AND FUTURE COSTS: Past costs are the costs which have been actually incurred
in the past. They are beyond the control of the management because they are already incurred.
These costs can be evaluated with retrospective effect. On the contrary, future costs refer to the
costs that are reasonably expected to be incurred in some future periods. They involve forecasting for
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control of expenses, appraisal of capital expenditure decisions on new projects as well as expansion
programmes and profit-loss projections through proper costing under assumed cost conditions.
G) BUSINESS COSTS AND FULL COSTS: Business costs are the costs which include all the
payments and contractual obligations made by the firm together with the book cost of depreciation on
plant and equipment. They are relevant for the calculation of profits and losses in business, and for
legal and tax purposes. In contrast, full costs consist of opportunity costs and normal profit.
Opportunity costs are the expected earnings from the next best use of the firm’s resources. Normal
profit is the minimum profit required for the existence of a firm.
H) SHUTDOWN COSTS AND ABANDONMENT COSTS: Shutdown costs are the costs that are
incurred in the case of a closure of plant operations. If the operations are continued, these costs can
be saved. These costs include all types of fixed costs, the costs of sheltering plant and equipment,
lay-off expenses, employment and training of workers when the operation is restarted. On the other
hand, abandonment costs are the costs which are incurred because of retiring altogether a plant from
use. These costs are related to the problem of disposal of assets. For example, the costs are related
to the discontinuance of tram services in Delhi.
I) URGENT COSTS AND POSTPONABLE COSTS: Urgent costs are those costs that are necessary
for the continuation of the firm’s activities. The cost of raw materials, labour, fuel, etc. may be its
examples which have to be incurred if production is to take place. The costs which can be postponed
for some time, i.e. whose postponement does not affect the operational efficiency of the firm are
called postponable costs. For example, maintenance costs which can be postponed for the time-
being. This distinction of cost is very useful during war and inflation.
J) ESCAPABLE COSTS AND UNAVOIDABLE COSTS: Escapable costs are the costs which can be
reduced by contraction in business activities. Here, net effect on costs is important. However, it is
difficult to estimate indirect effects such as the closure of an unprofitable business unit which will
reduce costs but will increase the other related expenses like transportation charges, etc. On the
other hand, unavoidable costs are the costs which do not vary with changes in the level of
production, but they are unavoidable such as fixed costs.
K) INCREMENTAL COSTS AND MARGINAL COSTS: There is close relation between marginal cost
and incremental cost. But they have difference also. In reality, incremental cost is used in a broad
sense in relation to marginal cost. Marginal cost is the cost of producing an additional unit of output,
while incremental cost is defined as the change in cost resulting from a change in business activities.
In other words, incremental cost is the total additional cost related to marginal quantity of output. The
concept of incremental cost is very important in the business world because, in practice, it is not
possible to use every unit of input separately.
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SELF CHECK EXERCISE 1:-
1. ______ are the costs borne by an organisation that don’t change with changes in the
output level.
2. Future costs are costs to be incurred in near future.
(True/False)
3. Incremental costs include only variable cost
(True/False)
4. ______ Costs are required to be incurred when the production operations are
suspended.
5. ______ Costs are traceable costs.
Activity 1:
Discuss what types of costs you would incur if you have to organise an international
conference in you university.
8.3 COST FUNCTION

The cost function expresses a functional relationship between total cost and factors that determine it.
Usually, the factors that determine the total cost of production (C) of a firm are the output (0, the level
of technology (T), the prices of factors (Pf) and the fixed factors (F). Symbolically, the cost function
becomes: - C=f (Q, T, Pf, F).
Such a comprehensive cost function requires multi-dimensional diagrams which are difficult to draw.
In order to simplify the cost analysis, certain assumptions are made. It is assumed that a firm
produces a single homogeneous good (q) with the help of certain factors of production. Some of
these factors are employed in fixed quantities whatever the level of output of the firm in the short run.
So they are assumed to be given.
The remaining factors are variable whose supply is assumed to be known and available at fixed
market prices. Further, the technology which is used for the production of the good is assumed to be
known and fixed. Lastly, it is assumed that the firm adjusts the employment of variable factors in such
a manner that a given output Q of the good q is obtained at the minimum total cost, C.
Thus the total cost function is expressed as: C=f (Q)
Which means that the total cost (C) is a function if) of output (Q), assuming all other factors as
constant. The cost function is shown diagrammatically by a total cost (TC) curve. The TC curve is
drawn by taking output on the horizontal axis and total cost on the vertical axis, as shown in Figure 1.
It is a continuous curve whose shape shows that with increasing output total cost
also increases. The total cost function and the TC curve relate total cost to
output under given conditions. But if any of the given conditions such as the
technique of production change, the cost function is changed. For instance, if
there is an improved technique of production, the cost of production for any given
output will be less than before which will shift the new cost curve TС1below the
old curve TC, as shown in Figure 1. On the other hand, if the prices of factors
rise, the cost of production will increase which will shift the cost curve upwards
from TC to TС2 as shown in Figure 1.
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8.4 SHORT RUN AND LONG RUN COSTS
The short run is a period of time in which the output can be increased or decreased by changing only
the amount of variable factors such as labour, raw materials, chemicals, etc. In the short run the firm
cannot build a new plant or abandon an old one. If the firm wants to increase output in the short run,
it can only do so by using more labour and more raw materials. It cannot increase output in the short
run by expanding the capacity of its existing plant or building a new plant with larger capacity.
Long run, on the other hand, is defined as the period of time in which the quantities of all factors
may be varied. All factors being variable in the long run, the fixed and variable factors dichotomy
holds good only in the short run. In other words, it is that time-span in which all adjustments and
changes are possible to realise.
Short run costs are those costs that can vary with the degree of utilisation of plant and other fixed
factors. In other words, these costs relate to the variation in output, given plant capacity. Short run
costs are therefore, of two types: fixed costs and variable costs. In the short run, fixed costs remain
unchanged while variable costs fluctuate with output. Long run costs in contrast are costs that
can vary with the size of the plant and with other facilities normally regarded as fixed in the short
run. In fact, in the long run there are no fixed inputs and therefore, no fixed costs, i.e. all costs are
variable.
8.5 SHORT RUN AVERAGE COSTS AND OUTPUT
The cost concept is more frequently used both by businessmen and economists in the form of cost
per unit or average cost rather than as totals. We, therefore pass on to the study of short run average
cost curves.
8.6 SHORT RUN AVERAGE FIXED COST (AFC): Average fixed cost is the total fixed cost
divided by the number of units of output produced. Therefore, AFC= TFC/Q; where Q represents the
number of units of output produced. Thus, average fixed cost is the fixed cost per unit of output.
Since total fixed cost is a constant quantity, average fixed cost will steadily fall as output increases.
Therefore, average fixed cost curve slopes downward throughout its length. As output increases, the
total fixed cost spreads over more and more units and, therefore, average fixed cost becomes less
and less.
8.7 AVERAGE VARIABLE COST (AVC): Average variable cost is the total variable cost divided by
the number of units of output produced. Therefore, AVC = TVC/Q
Thus, average variable cost is the variable cost per unit of output. We know that the total variable
cost (TVC) at any output level consists of payments to the variable factors used to produce that
output. Therefore TVC= P1V1 + P2V2 + …. PnVn, where P is the unit price and V is the amount of
the variable input. Average variable cost for a level of output (Q), given P is: AVC = TVC/Q=PV/Q=
[PxV/Q]
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The term V is the number of units of input divided by the number of units of output. Since the
average product (AP) of an input is the total output divided by the number of units of input (V), so we
can write, V/Q=1/Q/V=1/AP
AVC= P [V/Q] = P [1/AP]
That is, average variable cost is the price of the input multiplied by the reciprocal of the average
product of the input. We know that due to first increasing and then decreasing marginal returns to the
variable input, average product initially rises, reaches a maximum and then declines. Since average
variable cost is 1/AP, the average variable cost normally falls, reaches a minimum and then rises. It
first declines and then rises for reasons similar to those operating in case of TVC.
8.8 AVERAGE TOTAL COST (ATC): The average total cost or what is called simply average cost
is the total cost divided by the number of units of output produced. Therefore, ATC= TC/Q. Since the
total cost is the sum of total variable cost and total fixed cost, the average total cost is also the sum of
average variable cost and average fixed cost. This can be proved as follows: ATC = TC/Q; Since TC
= TVC+TFC;
Therefore, ATC = TVC+TFC/Q = TVC/Q + TFC/Q = = AVC + AFC.
ATC is also known as unit cost, since it is cost per unit of output produced.
8.9 SHORT RUN MARGINAL COST (MC) AND OUTPUT
Marginal cost is the addition to the total cost caused by producing one more unit of output. In other
words, marginal cost is the addition to the total cost of producing n units instead of n-1 units. MCn =
TCn–TCn–1
In symbols, marginal cost is rate of change in total cost with respect to a unit change in output, i.e.
MC=d (TC)/dQ; where d in the numerator and denominator indicates the change in TC and Q
respectively.
It is worth pointing out that marginal cost is independent of the fixed cost. Since fixed costs do not
change with output, there are no marginal fixed costs when output increases in the short run. It is
only the variable costs that vary with output in the short run. Therefore, marginal costs are, in fact,
due to the changes in variable costs.
MC= d(TVC)/dQ
The independence of the marginal cost from the fixed cost can be proved algebraically as follows:
MCn = TCn – TCn–1 = (TVCn + TFC) – (TVCn–1 + TFC) = TVCn + TFC – TVCn–1 – TFC
= TVCn – TVCn–1
Hence, marginal cost is the addition to the total variable costs when output is increased from n-1
units to n units of output. It follows, therefore, that the marginal cost is independent of the amount of
fixed costs.
In next Table, MC is the slope of the TC curve. As TC curve first rises at a decreasing rate and later
on at an increasing rate, MC curve will also, therefore, first decline and then rise.
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8.10 COSTS IN THE LONG RUN
The long run is a period of time during which the firm can vary all its inputs. None of the factors is
fixed and all can be varied to expand output. Long run is a period of time sufficiently long to permit
changes in the plant, that is, in capital equipment, machinery, land, etc., in order to expand or
contract output. The long run cost of production is the least possible cost of production of producing
any given level of output when all inputs are variable including the size of the plant. In the long run
there is no fixed factor of production and hence there is no fixed cost. If Q = f(L, K); TC = L.PL + K.PK
Given factor prices and a specific production function, one can draw an expansion path which gives
the least costs associated with various levels of output which in fact yields the long run total cost
schedule/curve. LTC is an increasing function of output. The rates of change in these two variables
are not known unless the qualitative relationship is quantified. If one recalls the concept of returns to
scale and assumes fixed factor prices, one could see three things: i) When returns to scale are
increasing, inputs are increasing less than in proportion to increases in output. It follows that total
cost also must be increasing less than in proportion to output. This relationship is shown in Figure (a);
ii) When returns to scale are decreasing, total cost increases at a faster rate than does output. This
relationship is shown in Figure (b); and iii) When returns to scale are constant, total cost and output
move in the same direction and same proportion. This is also shown in Figure (c).
Thus, depending upon the nature of returns to scale, there will be a relationship between LTC and
output, given factor prices. It is generally found that most industries and firms reap increasing returns
to scale to start with which are followed by constant returns to scale which give place to decreasing
returns to scale eventually. Such a total cost function would be associated with a U-shaped long run
average cost function.
From LTC curve we can derive the firm's long run average cost (LAC) curve. LAC is the long run total
cost (LTC) divided by the level of the output (Q). That is, LAC=LTC/Q
Similarly, from the LTC curve we can also derive the long run marginal cost (LMC) curve. This
measures the change in LTC per unit change in output and is given by the slope of the LTC curve.
That is, LMC= change in TC/ change in Q or d(LTC)/ dQ
The relationships among the long run total cost, long run marginal cost with respect to output are
explained in the following table and Figure d.
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Figure (a) Figure (b)

Figure (c)
Economic theory often mentions U-shaped nature of average cost curve, but in reality, we come
across various other types like the stair-shaped one, L-shaped learning curve or flat bottomed
average cost curve. To take care of these empirical situations, the modern theory of costs has been
developed.
The LTC curve gives the least total cost for various levels of output when all the factors of production
are variable. Its shape is such that the curve is first concave and then convex as looked from the
output axis. As seen above its shape follows from the operations of the varying degrees of returns of
scale, given the factor prices.
The relationship between LAC and LMC follow from that of

LTC curve. Both LAC and LMC are U-shaped. Further, the
following relationships hold good: i) At the point of inflection
on LTC curve (A), LMC takes the minimum value; ii) At the
point of kink of LTC curve (B) — where the slope of the
straight line from origin to the LTC curve is the minimum —
LAC assumes the minimum value; iii) LAC is the least when
LMC = LAC; iv) LAC curve is falling when LMC < LAC; and
v) LAC curve is rising when LMC > LAC.
8.11 TOTAL COST, AVERAGE COST AND MARGINAL COST

Total cost includes all cash payments made to hired factors of production and all cash charges
imputed for the use of the owner's factors of production in acquiring or producing a good or service.
Thus, total cost of a firm is the sum total of the explicit plus implicit expenditures incurred for
producing a given level of output. For example, a shoe maker's cost will include the amount he
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spends on leather, thread, rent for his workshop, wages, interest on borrowed capital, salaries of
employees, etc., and the amount he charges for his services and his own funds invested in the
business. Average cost is the cost per unit of output assuming that production of each unit of output
incurs the same cost. That is, it is obtained by dividing the total cost by the total quantity produced. If
TC=100 and X=10, AC = 10.
Marginal cost is the extra cost of producing one additional unit. At a given level of output, one
examines the additional costs being incurred in producing one extra unit and this yields the marginal
cost. For example, if the total cost of a firm is 5,000 when it produces 10 units of a good but when 11
units of the good are produced, it increases to 5,300 then the marginal cost of the eleventh unit is
5,300 – 5,000 = 300. In other words, marginal cost of nth units (MC n) is the difference between total
cost of nth unit (TCn) and total cost of n-1th unit (TCn-1).
MCn = TCn – TCn–1.
8.12 ECONOMIES AND DISECONOMIES OF SCALE
Economies of scale refer to these reduced costs per unit arising due to an increase in the total output.
Diseconomies of scale, on the other hand, occur when the output increases to such a great extent that
the cost per unit starts increasing.
8.12.1 INTERNAL DISECONOMIES AND ECONOMIES OF SCALE
While studying returns to scale, we observed that they increase during the initial stages, remain constant
for a while, and then start decreasing. The reason is simple – initially, the firm enjoys internal economies
of scale and after a certain limit; it suffers from internal diseconomies of scale. Let’s look at the types of
economies and diseconomies:
a) Technical: Large-scale production is linked to technical economies. When a firm increases its
scale of operations, it needs to use a more specialized and efficient form of capital equipment and
machinery. Such machinery helps to produce larger outputs at a lower unit cost. Further, as the scale of
production increases and the amount of labor and other factors becomes larger, the firm manages to
reduce costs by introducing a degree of division of labor and specialization. However, beyond a certain
point, the firm experiences diseconomies of scale. This happens because after reaching a large enough
output, the firm utilizes almost all possibilities of the division of labor and employment of efficient
machinery. Post this, any increase in the size of the plant causes the costs to rise. When the scale of
operations becomes too large, the management finds it more difficult to control and coordinate the
operations.
b) Managerial: As the output increases, the firm can apply the division of labor to the management
as well. For example, the production manager can look after production; the sales manager can look
after sales, etc. When the scale of production increases further, the firm divides each department into
sub-departments like sales is divided into advertising, exports, and service. Thus helps in increasing the
efficiency and productivity of the management team since a specialist manages each sub-department.
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Further, the firm has the option to decentralize decision-making authority enhancing the efficiency
further. Therefore, specialized management allows the firm to reduce managerial costs.
However, as the firm increases its scale of operations beyond a certain limit, the management finds it
difficult to control and coordinate between departments. This leads to managerial diseconomies.
c) Commercial: As a firm increases its volume of production, it requires large amounts of raw
material and components. Hence, it places a bulk order for such material and components and enjoys
discounted pricing for them. Economies are also achieved during sales. If the sales staff is working
under-capacity, then the firm can sell additional output at little extra cost. Further, as the scale of
production increases, the advertising cost per unit fall. Hence, the firm benefits from economies of
advertising too. After an optimum level, these economies start becoming diseconomies though.
d) Financial: When a firm wants to raise finance, a large-scale firm has many benefits like:
i) Better security to bankers; ii) Well-known; and iii) Can raise finance at lower costs, etc.
However, after the optimum scale of production, the financial costs rise faster due to the increased
dependence on external finances.
e) Risk-bearing: A firm enjoys the economies of risk-bearing if it has a large-scale operation with
diverse and multi-production capabilities. However, if the diversification increases the economic
disturbances rather than covering them, then the risk increases.
8.12.2 EXTERNAL DISECONOMIES AND ECONOMIES OF SCALE
External diseconomies and economies of scale are very important to a firm. These are a result of the
expansion of output of the entire industry and not limited to an individual firm. They are available to one
or more firms in the following forms:
a) Economical Raw materials and Capital Equipment: At times, the expansion of an industry
results in new and cheaper sources of raw material, machinery, and other capital equipment. It also
results in an increased demand for the various types of materials and equipment required by the
industry. Hence, such materials/equipment can be purchased from other industries on a large scale.
This, eventually, leads to a lower cost of production and lower price. Therefore, firms using
materials/equipment get them at lower prices.
b) Technological External Economies: Usually, when an entire industry expands, new technical
knowledge is discovered leading to new and improved machinery for the said industry. This changes the
technological coefficient of production and enhances the productivity of the firms in the industry. Hence,
the cost of production reduces.
c) Development of Skilled Labor: As the industry expands, the labor gets accustomed to
managing various production processes and learns from the experience. This increases the number of
skilled workers which in turn has a favorable effect on the levels of productivity.
d) Growth of Ancillary Industries: When a certain industry expands, many ancillary industries
start specializing in the production of raw materials, tools, machinery, etc. These ancillary industries offer
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the materials/machinery at a low price. Similarly, some ancillary industries also start processing
industrial waste and create a useful product out of it. Overall, it leads to a lower cost of production.
e) Better Transportation and Marketing Facilities: An expanding industry, usually, results in
better transportation and marketing networks. These aspects help reduce the cost of production in the
firms from the industry. It is important to note that, certain disadvantages can neutralize the advantages
of the expansion of industry and cease the external economies of scale. These are external
diseconomies. When an industry expands, demand for certain materials and skilled labor increases. If
these factors are in short supply, then their prices can increase. Further, the geographical concentration
of firms from the industry can lead to higher transportation costs, marketing costs, pollution control costs,
etc.

6. ______ is obtained by dividing Total Cost by the Total Quantity produced.
7. Fixed Costs cannot be altered in short-run. (True/False)
8. The _____ Cost Concept in useful in Break-even analysis.
Activity 2:
Discuss about the factors leads to economies and diseconomies of scale.
8.13 SUMMARY
For clear business decisions it is necessary to have complete understanding of different cost
concepts. For proper knowledge of cost analysis, various cost concepts include and determine cost of
production which enables management for correct business decisions. Various combinations of costs
ingredients account for various kind of management decisions. In short period, the price cost relating to
labour and raw material can be varied whereas fixed cost remains the same. On the other hand in long
period even fixed cost relating to plant and machinery staff salaries can be varied or in other words in long
run all costs are variable.
8.14 GLOSSARY
 Short-run period refers to the conceptual time period in which at least one factor of
production is fixed in amount, while others are variable.
 Long-run period refers to the conceptual time period in which there are no fixed
factors of production with respect to the changes in output level.
 Iso-cost line refers to the locus plotted by using various combinations of labour and capital
resources, each of which costs the same amount of money.
1. Variable Costs
2. True
3. False
4. Shut-Down Costs
5. Direct Cost
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6. Average Cost
7. True
8. Total Cost
1. Explain the concept of cost and discuss various types of costs.
2. Describe the short-run and long-run costs of production.
3. Explain the concept of economies and diseconomies of scale.
4. Distinguish between:
(a) Direct and Indirect cost
(b) Incremental and Marginal cost
(c) Explicit and Implicit cost
Book Co., Inc.
Cengage Learning.
101
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CHAPTER 9
PRICE DISCRIMINATION
STRUCTURE
9.2 INTRODUCTION
9.3 DEFINITIONS
9.4 TYPES OF DISCRIMINATING MONOPOLY
9.5 CONDITIONS FOR PRICE DISCRIMINATION
9.6 EQUILIBRIUM UNDER PRICE DISCRIMINATION
9.7 DEGREES OF PRICE DISCRIMINATAION
9.8 PRODUCT VERSIONING
9.9 DIAGRAM FOR PRICE DISCRIMINATION
9.10 PROFIT MAXIMIZATION UNDER PRICE DISCRIMINATION
9.11 IMPORTANCE OF MARGINAL COST IN PRICE DISCRIMINATION
9.12 ADVANTAGES OF PRICE DISCRIMINATION
9.13 DISADVANTAGES OF PRICE DISCRIMINATION
9.14 SUMMARY
9.15 GLOSSARY
 The concept and meaning, types and conditions of price discrimination.
 The equilibrium and degrees of price discrimination.
 The profit maximization, advantages and disadvantages of price discrimination.
9.2 INTRODUCTION
Price discrimination is a price-setting policy when different customer groups are charged different
prices for the same products at the same time. The difference in cost is not attributable to any
objective reason: the production and transportation of products do not cost manufacturers any
additional money; various prices make a product seem more attractive to a particular consumer
segment. In this case, the term "discrimination" should not be interpreted negatively: it does not mean
bias against a certain group of consumers but a desire to differentiate between various types of
customers and create a more agreeable environment for them. Price discrimination aims to sell more
goods for the maximum price that consumers are willing to pay. There are different kinds of price
discrimination, depending on how prices are formed.
Price discrimination refers to the charging of different prices by the monopolist for the same product.
The difference in the product may be on the basis of brand, wrapper etc. This policy of the monopolist
is called price discrimination. It's a common experience for people to learn that they paid a
significantly different price for a product or service than someone else. Chris' neighbor paid Rs.
35,000 for his new car. Chris bought the same car at the same dealership, but he paid Rs. 36,500.
This type of discrepancy is known as price discrimination.
The price discrimination is when a seller charges different prices to different consumers based on
what price they think the consumer will actually accept. The purpose of price discrimination is to
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increase profits through prices without making a wholesale price change. Is price discrimination legal
and ethical? Yes, and it's much more common than one might think. For example, any bar that
has ladies' night is using price discrimination to attract women to the bar. Men pay full prices while
women get a discount. For another example, if a car dealership is selling the newest model SUV and
advertises the price starting at Rs. 36,000. Any customer that comes in will expect to pay at least Rs.
36,000 but might pay more. The dealer has the ability to move the price based on the customer and
the dealer's perception of what the buyer is willing to pay.
9.3 DEFINITIONS
“Price discrimination exists when the same product is sold at different prices to different buyers.” -
Koutsoyiannis
“Price discrimination refers to the sale of technically similar products at prices which are not
proportional to their marginal cost.” -Stigler
“Price discrimination is the act of selling the same article produced under single control at a different
price to the different buyers.” -Mrs. Joan Robinson
“Price discrimination refers strictly to the practice by a seller of charging different prices from different
buyers for the same good.” -J.S. Bain
“Discriminating monopoly means charging different rates from different customers for the same good
or service.” -Dooley
9.4 TYPES OF DISCRIMINATING MONOPOLY
Price discrimination is of following three types:
 Personal Price Discrimination: Personal price discrimination refers to the charging of
different prices from different customers for the same product. For example, a doctor charges
different fees for the same operation from rich and poor patients.
 Geographical Price Discrimination: Under geographical price discrimination, the monopolist
charges different prices in different markets for the same product. It also includes dumping
where a producer may sell the same commodity at one price at home and at the other price
abroad.
 Price Discrimination according to Use: When the monopolist charges different prices for the
different uses of the same commodity is called the price discrimination according to use.
9.5 CONDITIONS FOR PRICE DISCRIMINATION
For price discrimination to exist, it requires the basic conditions. These are:
 Difference in Elasticity of Demand: Price discrimination is possible only when elasticity of
demand will be different in different markets. The monopolist will fix higher price where
demand is inelastic and low price where the demand will be elastic. In this way, he will be able
to increase his total revenue.
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 Market Imperfections: Generally, price discrimination is possible only when there is some
degree of market imperfections. The individual seller is able to divide his market into separate
parts only if it is imperfect.
 Differentiated Product: Price discrimination is possible when buyers need the same service
in connection with differentiated products. For example, railways charges different rates for the
transport of coal and copper.
 Legal Sanction: In some cases price discrimination is legally sanctioned. As, Electricity Board
charges lowest for electricity for domestic use and highest for commercial houses.
 Monopoly Existence: Price discrimination is also called discrimination monopoly. It is evident
that price discrimination is possible only under conditions of monopoly.
Hence, we can conclude that a monopolist who employs price discrimination, charges a higher price
from the market with inelastic demand. On the other hand, the market which is more responsive is
charged less. Here is an example to understand price discrimination more clearly.
Example: The single monopoly price of a product is Rs. 30. The elasticities of demand for the product
in markets A and B are 2 and 5 respectively. Therefore, the marginal revenue in market A (MRA) is:
MRA=ARAe−1e=302–12=15
Similarly, the marginal revenue in market B (MRB) is MRB=ARBe−1e=305–12=24.
Hence, we can see that the marginal revenues of the markets A and B are different when the elasticities
of demand at a single price are different. Further, we also find that the MR of the market with higher
elasticity is higher than the MR of the market with a low elasticity of demand.
A monopolist, in such a case, transfers some amount of product from market A to market B. This is
because, in market B, the high elasticity of demand implies larger marginal revenue. It is important to
note here that when units are transferred from A to B, price in A will rise and fall in B. However, there is
a limit to which the monopolist can transfer between markets A and B. Once he reaches that limit and
reaches a point where the MRs in both the markets become equal due to the transfer of output,
transferring more will no longer be profitable. At this stage, the monopolist starts charging different
prices in the two markets. So, he charges a higher price in the market with a lower elasticity of demand
and a lower price in the market with a higher elasticity of demand.
9.6 EQUILIBRIUM UNDER PRICE DISCRIMINATION
Under price discrimination, a monopolist charges different prices in different sub-markets. To begin with,
he divides the market into sub-markets based on their elasticity of demand. We will take the case when
a market is divided into two sub-markets, for simplicity. Next, the monopolist is faced with making two
decisions:
 How much output should he produce?
 How should he divide the output between the two sub-markets and how should he price them?
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The monopolist compares the marginal revenues with the marginal cost of the output. However, before
that, he must calculate the aggregate marginal revenue of both sub-markets taken together and
compare this value with the marginal cost of the total output.
Figure: Fixation of Total Output and Different Price in the Two Sub-Markets by the Discriminating
Monopolist
In the above figure, MRa is the marginal revenue curve in the sub-market A having a demand curve Da.
Similarly, MRb is the marginal revenue curve in the sub-market B having a demand curve Db. The
aggregate marginal revenue curve (AMR), shown in III above, is an addition of MRa and MRb. The AMR
curve shows the total amount of output sold in both the sub-markets. Further, the marginal cost curve
(MC) is also depicted in III above.
Step 1: The monopolist maximizes his profits by producing the level of output at which MC intersects
AMR. From III above, we can see that the intersecting point is E which corresponds to OM level of
output. Once the monopolist determines the total output to be produced, he starts planning about
distributing the output between the two sub-markets. He distributes it in a manner that the marginal
revenues in both the sub-markets are equal. This ensures maximum profits.
Step 2: If he does not ensure that the marginal revenues in the two sub-markets are equal, then he will
transfer from one to another since it offers him profits. Once the MRs is equal, the transfer becomes
unprofitable. However, for price discrimination, he must also ensure that the MRs is equal to the
marginal cost of the total output. This ensures that the amount sold in both the sub-markets is equal to
the whole output OM which is fixed after equalizing AMR with the marginal cost. From figure III above,
we can see that at equilibrium output (OM), the marginal cost is ME.
From figure I above, we can see that OM1 must be sold in sub-market A because the marginal revenue
at M1E1 at amount OM1 = marginal cost ME. Similarly, OM2 must be sold in sub-market B because the
marginal revenue at M2E2 at amount OM2 = marginal cost ME. It is important to note that OM = OM1 +
OM2.
Step 3: Finally, to determine the price for markets A and B, the monopolist looks at the demand curve
and does the following:
 Sets the price in sub-market A = OP1.
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 Sets the price in sub-market B = OP2.
Since, the price in A > the price in B (because demand in A is less elastic than in B), OP1 > OP2.
Activity 1
Discuss in the class about the Need to understand the concept of Price Discrimination.

1) The maximum price that a consumer is willing to pay for each unit bought is
the ________ price.
a) Market b) Reservation
c) Consumer surplus d) Auction
e) Choke
2) Under perfect price discrimination:

a) There is a positive dead weight loss.
b) The monopolist makes zero profit.
c) Consumers are exploited.
d) Consumers’ surplus is zero.
e) There is excess demand.
3) Under ordinary price discrimination, the monopolist charges a higher price
in the market with:
a) Unit elasticity of demand. b) Lower elasticity of demand.
c) Lots of consumers. d) Higher elasticity of demand.
4) Under ordinary price discrimination in several markets, a monopolist would
allocate output to ensure that in each market:
a) Quality of service is the same.
b) The slope of the demand curve is the same.
c) Marginal revenue is the same.
d) The consumer surplus of the consumer with the highest willingness-to-pay
is the same.
e) The elasticity of demand is the same.
5) Perfect price discrimination results when:
a) Every consumer is forced to pay above his or her reservation price.
b) Every consumer is forced to pay below his or her reservation price.
c) A firm can raise its price for the marginal customer.
d) Every consumer is forced to pay his or her reservation price.
9.7 DEGREES OF PRICE DISCRIMINATION

The following are the degrees of price discrimination:
a) First Degree Price Discrimination: This involves charging consumers the maximum price
that they are willing to pay. There will be no consumer surplus.
b) Second Degree Price Discrimination: This involves charging different prices depending
upon the choices of consumer. For example quantity, time period, collecting coupons
 After 10 minutes phone calls become cheaper.
 Electricity is more expensive for the first number of units. For a higher quantity of electricity
consumed the marginal cost is lower.
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 Loyalty cards reward frequent buyers with discounts on future products.
 If you collect coupons from a newspaper you can get a discount.
2nd-degree price discrimination is sometimes known as ‘indirect price discrimination’ because the
firm allows consumers to choose which price they will pay. Some choices are offered cheaper
because they impose costs on consumers (e.g. collecting coupons, buying in bulk or unsocial hours.
c) Third Degree Price Discrimination – ‘Group price discrimination’: This involves charging
different prices to different groups of people. For example:
 Student discounts,
 Senior citizen rail card
 Peak travel/ off-peak travel
 Cheaper prices by the time of the day (e.g. happy hour’s in pubs – usually earlier on in
evening where demand is lower.
Third degree price-discrimination is sometimes known as direct price discrimination. Because a firm
directly sets different prices depending on distinct groups of consumers (e.g. age)
9.8 PRODUCT VERSIONING
One way firms practise price discrimination is to offer slightly different products as a way to
discriminate between consumers ability to pay. For example:
 Priority boarding tickets. Same flight but for a premium, you get a shorter queue.
 Organic coffee / fair trade coffee
 Extra legroom on aeroplanes
 First-class/second class
This is a form of indirect segmentation. By offering slightly different choices, the firm is able to
separate consumers who are willing to pay higher prices.
9.9 DIAGRAM FOR PRICE DISCRIMINATION
Without price discrimination, the firm charges one price Rs. 7 * 100 = Rs. 700 revenue
WIth price discrimination, the firm can charge two different prices:
 Rs. 10 * 35 = Rs. 350
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 Rs. 4 * 120 = Rs. 480
Total revenue = Rs. 830. Therefore, the firm makes more revenue under price discrimination.
9.10 PROFIT MAXIMIZATION UNDER PRICE DISCRIMINATION
To maximise profits a firm sets output and price where MR=MC. If there are two sub-markets with
different elasticities of demand, the firm will increase profits by setting different prices depending
upon the slope of the demand curve.
 Therefore for a group, such as adults, PED is inelastic – the price will be higher
 For groups like students, prices will be lower because their demand is elastic
9.10.1 Diagram of Price Discrimination
Profit is maximised where MR=MC. WIthout price discrimination, there would just be one price set for
the whole market (A+B). There would be a price of P3.
 However, price discrimination allows the firm to set different prices for segment A (inelastic
demand) and segment B (elastic demand)
 Because demand is price inelastic, segment (A) will have a higher profit maximising price (P1)
 In segment (B) demand is price elastic, so the profit maximising price is lower.
9.11 IMPORTANCE OF MARGINAL COST IN PRICE DISCRIMINATION
In markets where the marginal cost of an extra passenger is very low, the firm has an incentive to use
price discrimination to sell all the tickets. This is why sometimes prices for airlines can be very low
just before their date. Once the company is due to fly the MC of an extra passenger will be very low.
Therefore this justifies selling the remaining tickets at a low price. The following are the examples
which help in understanding the importance: -
a) Time of Purchase:
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This petrol station is offering cut-price fuel for two days a week. The petrol station isn’t even telling
you which days have cut-price fuel. The logic is that only the most price-sensitive consumers will take
the trouble to find out which two days have cut-price fuel and then drive to the petrol station on those
days. This takes planning and only the most price elastic consumers will buy on these cut-price days.
Most consumers will not take the trouble to visit the petrol station on those two days. They will
continue to buy when most convenient.
It is also a clever marketing strategy because from a distance, it is advertising ‘cut-price fuel’ you only
notice the ‘2 days a week’ on closer inspection. This is a type of third-degree price discrimination.
b) Airline travel and time of departure: Airlines charge different prices depending on the
season and day of the week. During the peak holiday season in August and Easter, the price will be
higher because demand is greater and more inelastic. Flights which occur during the week e.g. Mon
to Fri will be more expensive because these are typically taken by business travelers. If you stay for
over the weekend, the price will be lower, as business travelers will not want to stay over the
weekend, just to get a cheaper flight. I often go to New York for a week in October. For a flight from
Mon to Fri, the price quoted is usually around Rs. 2,500. If I change dates to leaving or arriving on the
weekend, the price falls to Rs. 1,050.
c) Quantity Purchased: For electricity, consumers get charged different tariffs depending on the
quantity consumed. The first 100 units of electricity consumed are charged at a higher tariff, e.g. 25p
kWh. After these first 100 units, consumers get charged a lower rate. The logic is that the first 100
units of electricity are essential, and therefore demand is more inelastic. However, after the first 100
units of electricity, your demand is less essential, so you become more prices sensitive. Therefore,
the electricity company charges a lower rate. This graph shows that the average price of electricity
falls, as firms get bigger and consume more electricity.
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Source: energy prices
d) Coupons: Firms often give coupons to selected consumers. For example, Tesco may send
coupons to regular customers to get special offers, e.g. 20% off selected items. These coupons are
often highly targeted to your spending habits. e.g. if you average weekly shopping bill is Rs. 50,
Tesco may send you a Rs. 10 off voucher if you spend over Rs. 70. This is an indirect way of
segmenting the market. Someone walking into the shop cannot benefit from the lower prices. It is
also a clever marketing ploy to get people to come back. A price-sensitive consumer is more likely to
be willing to spend time to get the price saving. A high-income consumer who is less price-sensitive
will be unwilling to spend the time. This is an example of indirect price discrimination because it is up
to the consumer whether they get the cheaper price.
e) Age Discounts:
A popular way to segment the market is by age category, e.g. students and OAPs often get
discounts, such as 10% off. For rail travel, people with railcards can get up to 33% off. The popularity
of age discounts is that it is relatively easy to segment the market (you just need to prove your age).
Also, different age groups generally have different elasticities of demand. Students and OAPs have
lower income than working adults and so are more sensitive to changes in price.
f) Means-tested student fees: Means-tested student fees are a type of price discrimination. If
you can prove you have low income, the university may offer lower tuition fees. This is a rare
example, of pricing being determined by income; usually, it is considered too difficult.
g) Resident parking charges: In some tourist cities, residents get lower prices for public
transport and parking. For example, in York, residents get lower parking charges. This is because
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tourists tend to have more inelastic demand. Also, residents use the facilities throughout the year and
contribute more taxes. Tourists will have greater demand during the peak holiday season. The higher
price for tourists is a way of taking consumer surplus from the inelastic demand of tourists.
h) Auction for Car registration plates: Some popular car registration plates e.g. 001 are sold
via vehicle registration authority. You place a bid for the maximum price you would be willing to pay.
The auction firm starts off at a certain price, e.g. Rs. 10,000 and every week reduces the price, until
the person with the highest bid is reached. They then get the number plate. This is a type of first-
degree price discrimination because, in theory, it takes all consumer surpluses.
i) Loyalty cards
Some coffee shops offer a reward to regular consumers. If you buy nine coffees, you get the tenth
free. This is a reward for buying a higher quantity. For one-off visitors to a coffee shop, people are
likely to be fewer or less prices sensitive.
j) Choosing your seat early: Airplanes offer numerous ways to charge different prices for
variations on a plane ticket. For example, if you want to choose your seat, you can pay a premium of
£30. This is not strictly price discrimination because it becomes a slightly different product. But, it is a
way of extracting higher prices from those who want to pay for extras.
k) Three for Two offers
The lower prices for consumers who buy a higher quantity is very common marketing technique in
bookselling.
l) Bulk-buying: If you buy a 12 pack of toilet rolls, it is probably cheaper than buying a smaller
quantity. The consumer gets a lower cost but has the ‘cost’ of greater storage. Price sensitive
consumers may prefer the cheaper prices and having the ‘storage costs’
9.12 ADVANTAGES OF PRICE DISCRIMINATION
The advantages of price discrimination are as under: -
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 Firms will be able to increase revenue. Price discrimination will enable some firms to stay in
business who otherwise would have made a loss. For example price discrimination is
important for train companies who offer different prices for peak and off-peak. Without price
discrimination, they may go out of business or be unable to provide off-peak services.
 Increased investment. These increased revenues can be used for research and development
which benefit consumers
 Lower prices for some. Some consumers will benefit from lower fares. For example, old
people benefit from lower train companies; old people are more likely to be poor. Also,
customers willing to spend time in researching ‘special offers’ and travelling at awkward times
will be rewarded with lower prices.
 Manages demand. Airlines can use price discrimination to encourage people to travel at
unpopular times (early in the morning) This helps avoid over-crowding and helps to spread out
demand.
9.13 DISADVANTAGES OF PRICE DISCRIMINATION
The disadvantages of the price discrimination are as follows:
 Higher prices for some. Under price discrimination, some consumers will end up paying
higher prices (e.g. people who have to travel at busy times). These higher prices are likely to
be allocatively inefficient because P > MC.
 Decline in consumer surplus. Price discrimination enables a transfer of money from
consumers to firms – contributing to increased inequality.
 Potentially unfair. Those who pay higher prices may not be the poorest. For example, adults
paying full price could be unemployed, senior citizens can be very well off.
 Administration costs. There will be administration costs in separating the markets, which
could lead to higher prices.
 Predatory pricing. Profits from price discrimination could be used to finance predatory
pricing.
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6) An electric power company uses block pricing for electricity sales. Block
pricing is an example of
a) First-degree price discrimination. b) Second-degree price
discrimination.
c) Third-degree price discrimination.
d) Block pricing is not a type of price discrimination
7) When a firm charges each customer the maximum price that the customer
is willing to pay, the firm
a) Engages in a discrete pricing strategy.
b) Charges the average reservation price.
c) Engages in second-degree price discrimination.
d) Engages in first-degree price discrimination.
8) Second-degree price discrimination is the practice of charging
a) The reservation price to each customer.
b) Different prices for different quantity blocks of the same good or service.
c) Different groups of customers different prices for the same products.
d) Each customer the maximum price that he or she is willing to pay.
9) A firm is charging a different price for each unit purchased by a consumer. This
is called
a) First-degree price discrimination.
b) Second-degree price discrimination.
d) Fourth-degree price discrimination.
e) Fifth-degree price discrimination.
10) A tennis pro charges Rs. 15 per hour for tennis lessons for children and Rs.
30 per hour for tennis lessons for adults. The tennis pro is practicing
a) First-degree price discrimination.
b) Second-degree price discrimination.
d) Fourth-degree price discrimination.
e) Fifth-degree price discrimination.
Activity 2
Ask your class teacher to about the Degrees of Price Discrimination and collect the
examples regarding the same.
9.14 SUMMARY
For certain types of companies, the effects of price discrimination can be positive and negative: if
successful, the business will achieve its goals and dramatically improve its performance, and if it fails,
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it will incur losses. When it comes to the economy of any country or even the entire world, price
discrimination, on the one hand, makes goods more accessible to different groups of customers. But,
on the other hand, it can lead to the creation of monopolies. The price discrimination could manifest
itself, among other things, in the emergence of monopolies. For example, suppose a company
regularly buys raw materials at a reduced price because it can buy them in bulk. This situation will set
a lower price for the end consumer, forcing out competitors and leading the company to dominate the
market or become a monopoly. This is how price discrimination may lead to an emergence of a
monopoly.
At the same time, price discrimination can contribute to the obliteration of monopolies. The situation
occurs when different companies, including startups, benefit from price discrimination. Favourable
prices allow smaller companies to enter the market. Price discrimination is when different prices are
set for different customers. This strategy helps capture consumers' attention and makes the product
more affordable to customers with different financial circumstances. Nonetheless, if only a limited
number of companies benefit from price discrimination, this could create monopolies.
9.15 GLOSSARY
 Economic Equilibrium: It is a condition or state in which economic forces are balanced. In
effect, economic variables remain unchanged from their equilibrium values in the absence of external
influences. Economic equilibrium is also referred to as market equilibrium.
 Marginal Cost: It is the change in total production cost that comes from making or producing
one additional unit.
 Price: It is the amount of money that has to be paid to acquire a given product. Insofar as the
amount people are prepared to pay for a product represents its value, price is also a measure of
value.
 Price Discrimination: It involves the use of different prices charged to various customers for
the same product or service. It is commonly used by larger, established businesses to profit from
differences in supply and demand from consumers.
 Profit: It is the excess of total revenue over total cost during a specific period of time. In
economics, profit is the excess over the returns to capital, land, and labour (interest, rent, and
wages).
 Profit Maximization: It is a process business firms undergo to ensure the best output and
price levels are achieved in order to maximise its returns. Influential factors such as sale price,
production cost and output levels are adjusted by the firm as a way of realizing its profit goals.
9.16 ANSWERS TO SELF-CHECK EXERCISES
1. (b), Reservation
2. (d), Consumer’s surplus is zero.
3. (b), Lower elasticity of demand.
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4. (c), Marginal revenue is the same.
5. (d), Every consumer is forced to pay his or her reservation price.
6. (b), Second-degree price discrimination
7. (d), Engages in first-degree price discrimination
8. (b), Different prices for different quantity block of the same god or service.
9. (a), First-degree price discrimination
10. (c), Third-degree price discrimination.
1. What do you mean by price discrimination? Discuss the conditions for equilibrium under it with
suitable example.
2. What are the different degrees of price discrimination? Elaborate.
3. What do you understand by product versioning? Enumerate.
4. Is there any significance of marginal cost in price discrimination? Discuss.
5. What are the pros and cons of price discrimination? Discuss with the help of example.
6. Do you agree that price discrimination is a negative aspect? Elaborate with the help of suitable
example.
Book Co., Inc.
Cengage Learning.
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CHAPTER 10
BUSINESS CYCLES
STRUCTURE
10.2 INTRODUCTION
10.3 MEANING
10.4 CHARACTERISTICS OF BUSINESS CYCLES
10.5 PHASES OF BUSINESS CYCLES
10.6 ATTRIBUTES OF CYCLE
10.7 THEORIES OF BUSINESS CYCLE
10.8 SUMMARY
10.9 GLOSSARY
 The concept and meaning of business cycles.
 The characteristics and attributes of business cycles.
 The various phases of business cycles and their importance.
 The theories of business cycles.
9.2 INTRODUCTION
The term “business cycle” (or economic cycle or boom-bust cycle) refers to economy-wide
fluctuations in production, trade, and general economic activity. From a conceptual perspective, the
business cycle is the upward and downward movements of levels of GDP (gross domestic product)
and refers to the period of expansions and contractions in the level of economic activities (business
fluctuations) around a long-term growth trend.
9.3 MEANING
Many free enterprise capitalist countries such as USA and Great Britain have registered rapid
economic growth during the last two centuries. But economic growth in these countries has not
followed steady and smooth upward trend. There has been a long-run upward trend in Gross
National Product (GNP), but periodically there have been large short-run fluctuations in economic
activity, that is, changes in output, income, employment and prices around this long- term trend. The
period of high income, output and employment has been called the period of expansion, upswing or
prosperity, and the period of low income, output and employment has been described as contraction,
recession, downswing or depression. The economic history of the free market capitalist countries has
shown that the period of economic prosperity or expansion alternates with the period of contraction or
recession.
These alternating periods of expansion and contraction in economic activity has been called business
cycles. They are also known as trade cycles. J.M. Keynes writes, “A trade cycle is composed of
periods of good trade characterised by rising prices and low unemployment percentages with periods
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of bad trade characterised by falling prices and high unemployment percentages.” A noteworthy
feature about these fluctuations in economic activity is that they are recurrent and have been
occurring periodically in a more or less regular fashion. Therefore, these fluctuations have been
called business cycles. It may be noted that calling these fluctuations as ‘cycles’ mean they are
periodic and occur regularly, though perfect regularity has not been observed.
The duration of a business cycle has not been of the same length; it has varied from a minimum of
two years to a maximum of ten to twelve years, though in the past it was often assumed that
fluctuations of output and other economic indicators around the trend showed repetitive and regular
pattern of alternating periods of expansion and contraction. However, actually there has been no
clear evidence of very regular cycles of the same definite duration. Some business cycles have been
very short lasting for only two to three years, while others have lasted for several years. Further, in
some cycles there have been large swings away from trend and in others these swings have been of
moderate nature.
A significant point worth noting about business cycles is that they have been very costly in the
economic sense of the word. During a period of recession or depression many workers lose their jobs
and as a result large-scale unemployment, which causes loss of output that could have been
produced with full-employment of resources, comes to prevail in the economy. Besides, during
depression many businessmen go bankrupt and suffer huge losses. Depression causes a lot of
human sufferings and lowers the levels of living of the people. Fluctuations in economic activity
create a lot of uncertainty in the economy which causes anxiety to the individuals about their future
income and employment opportunities and involve a great risk for long-run investment in projects.
Who does not remember the great havoc caused by the depression of the early thirties of the
present century? Even boom when it is accompanied by inflation has its social costs. Inflation erodes
the real incomes of the people and makes life miserable for the poor people. Inflation distorts
allocation of resources by drawing away scarce resources from productive uses to unproductive
ones. Inflation redistributes income in favour of the richer actions and also when inflation rate is high,
it impedes economic growth.
9.4 CHARACTERISTICS OF BUSINESS CYCLES
The characteristics of the business cycles are as follows: -
i) Industrialised capitalistic economies witness cyclical movements in economic activities. A socialist
economy is free from such disturbances;
ii) It exhibits a wave-like movement having regularity and recognised patterns. That is to say, it is
repetitive in character;
iii) Almost all sectors of the economy are affected by the cyclical movements. Most of the sectors
move together in the same direction. During prosperity, most of the sectors or industries experience
an increase in output and during recession they experience a fall in output;
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iv) Not all the industries are affected uniformly. Some are hit badly during depression while others are
not affected seriously. Investment goods industries fluctuate more than the consumer goods
industries. Further, industries producing consumer durable goods generally experience greater
fluctuations than sectors producing nondurable goods. Further, fluctuations in the service sector are
insignificant in comparison with both capital goods and consumer goods industries;
v) One also observes the tendency for consumer goods output to lead investment goods output in the
cycle. During recovery, increase in output of consumer goods usually precedes that of investment
goods. Thus, the recovery of consumer goods industries from recessionary tendencies is quicker
than that of investment goods industries;
vi) Just as outputs move together in the same direction, so do the prices of various goods and
services, though prices lag behind output. Fluctuations in the prices of agricultural products are more
marked than those of prices of manufactured articles;
vii) Profits tend to be highly variable and pro-cyclical. Usually, profits decline in recession and rise in
boom. On the other hand, wages are more or less sticky though they tend to rise during boom;
viii) Trade cycles are ‘international’ in character in the sense that fluctuations in one country get
transmitted to other countries. This is because, in this age of globalisation, dependence of one
country on other countries is great;
ix) Periodicity of a trade cycle is not uniform, though fluctuations are something in the range of five to
ten years from peak to peak. Every cycle exhibits similarities in its nature and direction though no two
cycles are exactly the same. In the words of Samuelson: “No two business cycles are quite the same.
Yet they have much in common. Though not identical twins, they are recognisable as belonging to
the same family.”; and
x) Every cycle has four distinct phases: (a) depression, (b) revival, (c) prosperity or boom, and (d)
recession.
9.5 PHASES OF A BUSINESS CYCLE
A typical business cycle has two phase’s expansion phase or upswing or peak and contraction phase
or downswing or trough. The upswing or expansion phase exhibits a more rapid growth of GNP than
the long run trend growth rate. At some point, GNP reaches its upper turning point and the
downswing of the cycle begins. In the contraction phase, GNP declines. At some time, GNP reaches
its lower turning point and expansion begins. Starting from a lower turning point, a cycle experiences
the phase of recovery and after some time it reaches the upper turning point the peak. But,
continuous prosperity can never occur and the process of downhill starts. In this contraction phase, a
cycle exhibits first a recession and then finally reaches the bottom—the depression. The phases are
as follows:
i) Depression;
ii) Revival;
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iii) Boom; and
iv) Recession.
These phases are shown in the given figure.
In this figure, the secular growth path or trend
growth rate of GNP has been labelled as EG.
Now we briefly describe the essential
characteristics of these phases of an idealised
cycle
a) Depression or Trough: The depression or trough is the bottom of a cycle where economic
activity remains at a highly low level. Income, employment, output, price level, etc. go down. A
depression is generally characterised by high unemployment of labour and capital and a low level of
consumer demand in relation to the economy’s capacity to produce. This deficiency in demand forces
firms to cut back production and lay-off workers. Thus, there develops a substantial amount of
unused productive capacity in the economy. Even by lowering down the interest rates, financial
institutions do not find enough borrowers. Profits may even become negative. Firms become hesitant
in making fresh investments. Thus, an air of pessimism engulfs the entire economy and the economy
lands into the phase of depression. However, the seeds of recovery of the economy lie dormant in
this phase.
b) Recovery: Since trough is not a permanent phenomenon, a capitalistic economy experiences
expansion and, therefore, the process of recovery starts. During depression some machines wear out
completely and ultimately become useless. For their survival, businessmen replace old and worn-out
machinery. Thus, spending spree starts, of course, hesitantly. This gives an optimistic signal to the
economy. Industries begin to rise and expectations tend to become more favourable. Pessimism that
once prevailed in the economy now makes room for optimism. Investment becomes no longer risky.
Additional and fresh investment leads to a rise in production. Increased production leads to an
increase in demand for inputs. Employment of more labour and capital causes GNP to rise. Further,
low interest rates charged by banks in the early years of recovery phase act as an incentive to
producers to borrow money. Thus, investment rises. Now plants get utilised in a better way. General
price level starts rising. The recovery phase, however, gets gradually cumulative and income,
employment, profit, price, etc., start increasing.
c) Prosperity: Once the forces of revival get strengthened the level of economic activity tends to
reach the highest point—the peak. A peak is the top .of a cycle. The peak is characterised by an all
round optimism in the economy—income, employment, output, and price level tend to rise.
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Meanwhile, a rise in aggregate demand and cost leads to a rise in both investment and price level.
But once the economy reaches the level of full employment, additional investment will not cause GNP
to rise. On the other hand, demand, price level, and cost of production will rise. During prosperity,
existing capacity of plants is over-utilised. Labour and raw material shortages develop. Scarcity of
resources leads to rising cost. Aggregate demand now outstrips aggregate supply. Businessmen now
come to learn that they have overstepped the limit. High optimism now gives birth to pessimism. This
ultimately slows down the economic expansion and paves the way for contraction.
d) Recession: Like depression, prosperity or pea, can never be long-lasting. Actually speaking,
the bubble of prosperity gradually dies down. A recession begins when the economy reaches a peak
of activity and ends when the economy reaches its trough or depression. Between trough and peak,
the economy grows or expands. A recession is a significant decline in economic activity spread
across the economy lasting more than a few months, normally visible in production, employment, real
income and other indications. During this phase, the demand of firms and households for goods and
services start to fall. No new industries are set up. Sometimes, existing industries are wound up.
Unsold goods pile up because of low household demand. Profits of business firms dwindle. Output
and employment levels are reduced. Eventually, this contracting economy hits the slump again. A
recession that is deep and long-lasting is called a depression and, thus, the whole process restarts.
9.6 ATTRIBUTES OF CYCLE
The four-phased cycle has the following attributes:
i) Depression lasts longer than prosperity;
ii) The process of revival starts gradually;
iii) Prosperity phase is characterised by extreme activity in the business world; and
iv) The phase of prosperity comes to an end abruptly.

1. Business cycle is also known as economic cycle or boom-bust cycle.
(True/False)
2. GDP stands for ______________________
3. GNP stands for Grading New Product.
(True/False)
4. ________ defines that, “A trade cycle is composed of periods of good trade
characterised by rising prices and low unemployment percentages,
5. The four phases of cycle are __________, __________, _________ and
____________.
6. Depression lasts longer than prosperity is one of the attribute of business
cycle. (True/False)
Activity 1:
Draw and explain the business cycle for cement industry in Himachal Pradesh.
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9.7 THEORIES OF BUSINESS CYCLES
a) Psychological Theory: This theory was developed by A.C. Pigou. He emphasized the role of
psychological factor in the generation of trade cycles. According to Pigou, the main cause for trade
cycle is optimism and pessimism among business people and bankers. During the period of good
trade, entrepreneurs become optimistic which would lead to increase in production. The feeling of
optimism is spread to other. Hence investments are increased beyond limits and there is over
production, which results in losses. Entrepreneurs become pessimistic and reduce their investment
and production. Thus, fluctuations are due to optimism leading to prosperity and pessimism resulting
depression. Though there is an element of truth in this theory, this theory is unable to explain the
occurrence of boom and starting of revival. Further this theory fails to explain the periodicity of trade
cycle.
b) Schumpeter’s Innovation Theory: Joseph A. Schumpeter has developed innovation theory
of trade cycles. An innovation includes the discovery of a new product, opening of a new market,
reorganization of an industry and development of a new method of production. These innovations
may reduce the cost of production and may shift the demand curve. Thus innovations may bring
about changes in economic conditions. Suppose, at the full employment level, an innovation in the
form of a new product has been introduced. Innovation is financed by bank loans. As there is full
employment already, factors of production have to be withdrawn from others to manufacture the new
product. Hence, due to competition for factors of production costs may go up, leading to an increase
in price.
When the new product becomes successful, other entrepreneurs will also produce similar products.
This will result in cumulative expansion and prosperity. When the innovation is adopted by many,
supernormal profits will be competed away. Firms incurring losses will go out of business.
Employment, output and income fall resulting in depression.
Criticism: Firstly, Schumpter’s theory is based on two assumptions viz., full employment and that
innovation is being financed by banks. But full employment is an unrealistic assumption, as no
country in the world has achieved full employment. Further innovation is usually financed by the
promoters and not by banks. Secondly, innovation is not the only cause of business cycle. There are
many other causes which have not been analysed by Schumpter.
c) Monetary Theories
i) Over-Investment Theory: Prof. Von Hayek in his books on “Monetary Theory and Trade Cycle”
and “Prices and Production” has developed a theory of trade cycle. He has distinguished between
equilibrium or natural rate of interest and market rate of interest. Market rate of interest is one at
which demand for and supply of money are equal. Equilibrium rate of interest is one at which savings
are equal to investment. If both equilibrium rate of interest and market rate of interest are equal, there
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will be stability in the economy. If equilibrium rate of interest is higher than market rate of interest
there will be prosperity and vice versa.
For instance, if the market rate of interest is lower than equilibrium rate of interest due to increase in
money supply, investment will go up. The demand for capital goods will increase leading to a rise in
price of these goods. As a result, there will be a diversion of resources from consumption goods
industries to capital goods industries. Employment and income of the factors of production in capital
goods industries will increase. This will increase the demand for consumption goods. There will be
competition for factors of production between capital goods and consumption good industries. Factor
prices go up. Cost of production increases. At this time, banks will decide to reduce credit expansion.
This will lead to rise in market rate of interest above the equilibrium rate of interest. Investment will
fall; production declines leading to depression.
Weaknesses:
i) It is not easy to transfer resources from capital goods industries to consumer goods industries and
vice versa;
ii) This theory does not explain all the phases of trade cycle;
iii) It gives too much importance to rate of interest in determining investment. It has neglected other
factors determining investment;
iv) Hayek has suggested that the volume of money supply should be kept neutral to solve the
problem of cyclical fluctuations. But this concept of neutrality of money is based on old quantity
theory of money which has lost its validity.
ii) Hawtrey’s Monetary Theory: Prof. Hawtrey considers trade cycle to be a purely monetary
phenomenon. According to him non-monetary factors like wars, strike, floods, and drought may
cause only temporary depression. Hawtrey believes that expansion and contraction of money are the
basic causes of trade cycle. Money supply changes due to changes in rates of interest. When rate of
interest is reduced by banks, entrepreneurs will borrow more and invest. This causes an increase in
money supply and rise in price leading to expansion. On the other hand, an increase in the rate of
interest will lead to reduction in borrowing, investment, prices and business activity and hence
depression.
Hawtrey believes that trade cycle is nothing but small scale replica of inflation and deflation. An
increase in money supply will lead to boom and vice versa, a decrease in money supply will result in
depression. Banks will give more loans to traders and merchants by lowering the rate of interest.
Merchants place more orders which induce the entrepreneurs to increase production by employing
more labourers. This results in increase in employment and income leading to an increase in demand
for goods. Thus the phase of expansion starts. Business expands; factors of production are fully
employed; price increases further, resulting in boom conditions. At this time, the banks call off loans
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from the borrowers. In order to repay the loans, the borrowers sell their stocks. This sudden disposal
of goods leads to fall in prices and liquidation of marginal firms. Banks will further contract credit.
Thus the period of contraction starts making the producers reduce their output. The process of
contraction becomes cumulative leading to depression. When the economy is at the level of
depression, banks have excess reserves. Therefore, banks will lend at a low rate of interest which
makes the entrepreneurs to borrow more. Thus revival starts, becomes cumulative and leads to
boom.
Criticism:
i) Hawtrey’s theory is considered to be an incomplete theory as it does not take into account the non-
monetary factors which cause trade cycles;
ii) It is wrong to say that banks alone cause business cycle. Credit expansion and contraction do not
lead to boom and depression. But they are accentuated by bank credit;
iii) The theory exaggerates the importance of bank credit as a means of financing development. In
recent years, all firms resort to plough back of profits for expansion;
iv) Mere contraction of bank credit will not lead to depression if marginal efficiency of capital is high.
Businessmen will undertake investment in-spite of high rate of interest if they feel that the future
prospects are bright; and
v) Rate of interest does not determine the level of borrowing and investment. A high rate of interest
will not prevent the people to borrow. Therefore, it may be stated that banking system cannot
originate a trade cycle. Expansion and contraction of credit may be a supplementary cause but not
the main and sole cause of trade cycle.
d) Cobweb Theory: The Cobweb Theorem attempts to explain the regularly recurring cycles in
the output and prices of farm products. Frankly speaking, it is not a business cycle theory for it relates
only to the farming sector of the economy. In 1930 Cobweb Theory was advanced by the three
economists in Italy, Netherlands and the United States, apparently independently of each other
almost at the same time. The Henery Schultz (U.S.A.), Jam Tinbergen (Netherland) and Althus
Hanau (Italy) are associated with’ the theory, although the term Cobweb Theory was first suggested
by Professor Nicholas Kaldor in 1934. It was so named because the pattern traced by the prices and
output movements resembled a cobweb. The Cobweb Theory of trade cycle is based upon the
foundation of ‘lag’ concept. It asserts that supply adjusts itself to changing conditions of demand
which arc manifested through price changes not instantaneously but after certain period. This time,
taken by the supply to adjust itself to changes in demand is known as lag.
Thus the quantity supplied during any given time period is the function of the price prevailed in earlier
time period to while the demand depends upon the price that prevails in period t itself. The core of
this theory is that the response of supply to price ranges is not instantaneous.
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The Cobweb Theory of trade cycle has its chief application in the case of agricultural products the
supply of which can be increased or decreased with certain time-lag. Most crops can be sown and
reaped only once a year. For instance, if the price of wheat increases say in September 2007 then
supply will not increase instantaneously. The farmer will, of course, devote larger farm acreage to
wheat cultivation in the next crop season and so it will take one year before supply increases in
response to increase in wheat price. Thus the supply of wheat in 2008 will depend upon the price of
wheat that prevailed in 2007 which offered the farmer inducement to devote more land to wheat
cultivation.
Assumptions:
i) Perfect competition in which each producer assumes that present prices will continue and that his
own production plans will not affect the market;
ii) Price is completely a function of the preceding period’s supply;
iii) The commodity concerned is perishable. These assumptions show that the theory is particularly
applicable to agricultural products.
Since the supply in farming is slow to adjust itself to changes in demand and, violent fluctuations in
prices and outputs are most likely to occur. For instance, an increase in demand will at once result in
a spiral rise in price, since in the short period there can be no increase in supply. This high price may
make farmers increase their outputs to a greater degree than is justified by the increase in demand.
Consequently when this increased supply comes to the market, there will be a sharp fall in price
which may then result in a reduction in output in the next period to a greater extent again than is
justified. The result is that violent changes in output succeed price longer in farm products. Professor
Tinbergen has extended the application of Cobweb’s analysis to durable goods the supply of which
responds to demand changes after a significant time-lag because on account of long “gestation
period”, there is a considerable lag between the decision to produce and the actual deliveries of the
durable goods.
e) Hicks’ theory: Prof Hicks explains the phenomenon of trade cycles by combining the principle
of multiplier and acceleration. According to Hicks, investment is of two types: -
i) Autonomous investment; and
ii) Induced investment.
Autonomous investment is independent of the variations in income, output and consumption, while
induced investment is determined by the fluctuations in income, output and consumption. The force
of autonomous investment is expressed in multiplier while the force of induced investment is
expressed in acceleration. Thus, according to Hicks, autonomous investment and induced investment
cause cyclical fluctuations in economic activity via multiplier and accelerator respectively. Let us
assume that the initial equilibrium position of the economy is disturbed by a change in autonomous
investment. This will lead to increase in income and output to the extent indicated by the multiplier.
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Now this expansion of income and output will affect the induced investment via the accelerator. This
gives rise to further expansion of income (multiplier) and investment (accelerator) of the economy
and so on.
In this way during this period of upswing, output increases faster than the equilibrium rate. Investment
also increases faster than the normal rate. The expansion of income and output will continue till the
economy reaches the upper limit or ceiling determined by full employment. After this ceiling, it starts
declining. The rate of expansion in output and income is slowed down to the natural rate. This leads
to decrease in the amount of induced investment. The multiplier and accelerator forces will work in
the reverse order.
A fall in investment reduces income at a faster rate and the reduced income again reduces the level
of investment and so on. Now the level of output and income will not only reduce to the equilibrium
level but rather below it.
The reason is obvious as the multiplier and the accelerator work just in the opposite directions. This
will go on declining till it reaches the minimum (lower) turning point. Thus, the cycle is complete the
main limitation of this theory lies in the use of acceleration principle which the modern economists
consider as a crude tool. This principle assumes that investment generated by a change in output is
independent of the absolute size of the change.
f) Samuelson’s Model: Prof. Samuelson constructed a multiplier-accelerator model assuming
one period kg and different values for the MPC (a) and the accelerator (b) that result in changes in
the level of income pertaining to five different types of fluctuations. The Samuelson model is Yt= Gt
+Ct+ It … (1)
Where: - Y is national income Y at time t which is the sum of government expenditure G t,
consumption expenditure Ct and induced investment It.
According to Samuelson, “If we know the national income for two periods, the national income for the
following period can be simply derived by taking a weighted sum. The weights depend, of course,
upon the values chosen for the marginal propensity to consume and for the relation (i.e. accelerator)”.
Assuming the value of the marginal propensity to consume to be greater than zero and less than one
(0< a <1) and of the accelerator greater than zero (b > 0), Samuelson explains five types of cyclical
fluctuations which are summarised in the Table below: -
Table: Samuelson’s Interaction Model
Case Values Behaviour of the Cycle
1 a = 0.5, b=0 Cycleless Path
2 a = 0.5, b=1 Damped Fluctuations
3 a = 0.5, b=2 Fluctuations of Constant Amplitude
4 a = 0.5, b=3 Explosive Cycles
5 a = 0.5, b=4 Cycleless Explosive Path
Case 1: – Samuelson’s case 1 shows a cycle less path because it is based only on the multiplier
affect, the accelerator playing no part in it.
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Case 2: - shows a damped cyclical path fluctuating around the static multiplier level and gradually
subsiding to that level.
Case 3: - depicts cycles of constant amplitude repeating themselves around the multiplier level.
Case 4- reveals anti-damped or explosive cycles.
Case 5: - relates to a cycle less explosive upward path eventually approaching a compound interest
rate of growth.
The five cases explained above, only three cases 2, 3 and 4 are cyclical in nature. But they can be
reduced to two because case 3 pertaining to cycles of constant amplitude has not been experienced.
The case 2 of damped cycles is concerned these cycles have been occurring irregularly in a milder
form over last half century. Generally, cycles in the post-World War II period have been relatively
damped compared to those in the inter-World War II period. They are the result of “such disturbances
”which may be called “erratic shocks” arising from exogenous factors, such as wars, changes in
crops, inventions and so on ‘which’ might be expected to come along with fair persistence.” But it is
not possible to measure their magnitude.
Case 4 of explosive cycles has not been found in the past, its absence being the result of
endogenous economic factors that limit the swings. Hicks has, however, built a model of the trade
cycle assuming values that would make for explosive cycles kept in check by ceilings and floors.
Critical Appraisal: The interaction of the multiplier and the accelerator has the merit of raising
national income at a much faster rate than by either the multiplier or the accelerator alone. It serves
as a useful tool not only for explaining business cycles but also as a guide to stabilisation policy. As
pointed out by Prof. Kurihara, “It is in conjunction with the multiplier analysis based on the concept of
marginal propensity to consume (being less than one) that the acceleration principle serves as a
useful tool of business cycle analysis and a helpful guide to business cycle policy.” The multiplier and
the accelerator combined together produce cyclical fluctuations. The greater the value of the
accelerator (b), the greater is the chance of an explosive cycle. Greater is the value of the multiplier,
the greater the chances of a cycleless path.
Limitations: Despite these apparent uses of the multiplier-accelerator interaction, this analysis has
its limitations:
i) Samuelson is silent about the length of the period in the different cycles explained by him;
ii) This model assumes that the marginal propensity to consume (a) and the accelerator (b) are
constants, but in reality they change with the level of income so that this is applicable only to the
study of small fluctuations;
iii) The cycles explained in this model oscillate about a stationary level in a trendless economy. This
is not realistic because an economy is not trendless but it is in a process of growth. This has led
Hicks to formulate his theory of the trade cycle in a growing economy;
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iv) According to Duesenberry, it presents a mechanical explanation of the trade cycle because it is
based on the multiplier-accelerator interaction in rigid form; and
v) It ignores the effects of monetary changes upon business cycles.

7. Psychological Theory of business cycle was developed by
___________________.
8. ____________ gave the Innovation Theory of trade cycle.
9. The Over-Investment Monetary Theory was developed by Prof. Von Hayek.
(True/False)
Activity 2:
Discuss the importance of “Samuelson’s Interaction Model.”
9.8 SUMMARY
Business cycles are identified as having four distinct phases: peak, trough, contraction, and
expansion. Business cycle fluctuations occur around a long-term growth trend and are usually
measured by considering the growth rate of real gross domestic product. The business cycle model
shows how a nation’s real GDP fluctuates over time, going through phases as aggregate output
increases and decreases. Over the long-run, the business cycle shows a steady increase in potential
output in a growing economy.
9.9 GLOSSARY
 Business is defined as an organization or enterprising entity engaged in commercial,
industrial, or professional activities. Businesses can be for-profit entities or non-profit organizations
that operate to fulfill a charitable mission or further a social cause.
 Business Cycle describes the rise and fall in production output of goods and services in an
economy. Business cycles are generally measured using the rise and fall in the real gross domestic
product (GDP) or the GDP adjusted for inflation. The business cycle should not be confused with
market cycles, which are measured using broad stock market indices. The business cycle is also
different from the debt cycle, which refers to the rise and fall in household and government debt. The
business cycle is also known as the economic cycle or trade cycle.
 Trade is a basic economic concept involving the buying and selling of goods and services,
with compensation paid by a buyer to a seller, or the exchange of goods or services between parties.
 Unemployment occurs when a person who is actively searching for employment is unable to
find work. The most frequent measure of unemployment is the unemployment rate, which is the
number of unemployed people divided by the number of people in the labor force.
1. True
2. Gross Domestic Product
3. False, (Gross National Product)
4. J. M. Keynes
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5. Depression, Revival, Prosperity or Boom and Recession
6. True
7. A.C. Pigou
8. Joseph A. Schumpeter
9. True
1. Discuss the concept of business cycle. Why it is important?
2. What are the characteristics of business cycle? Elaborate
3. Discuss the different phases of Business cycle for Telecom Industry.
4. What are the attributes of business cycle? Discuss
5. Write Short Notes: -
a) Innovation Theory
b) Monetary Theory
c) Cobweb Theory
d) Hick’s Theory
 Peterson, H. C. and Lewis, W. C. “Managerial Economcis” Prectice hall of India
 Gandhar, H and Mangla, A. “Managerial Economics” Kalyani Publishers
 Jain, T. R. “Business Economics” V K Publications
Book Co., Inc.
Cengage Learning.
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CHAPTER 11
INFLATION
STRUCTURE
11.2 INTRODUCTION: CONCEPT OF INFLATION
11.3 DEFINITIONS
11.4 CHARACTERSITICS OF INFLATION
11.5 CAUSES OF INFLATION
11.6 TYPES OF INFLATION
11.7 THEORIES OF INFLATION
11.7.1 DEMAND-PULL INFLATION
11.7.2 COST–PUSH INFLATION
11.8 MEASURES OF INFLATION RATE
11.9 EFFECTS OF INFLATION
11.10 SUMMARY
11.11 GLOSSARY
 The concept of inflation and its characteristics and causes.
 The different types of inflation
 The theories of inflation
 The measures of inflation rate
 The effects of inflation on the economy
11.2 INTRODUCTION: CONCEPT OF INFLATION
Inflation is the rate of price rises, and essentially how much the currency is worth at a given moment
with regards to purchasing. The idea behind inflation being a force for good in the economy is that a
manageable enough rate can spur economic growth without devaluing the currency so much that it
becomes nearly worthless.
By inflation we mean a general rise in prices. To be more correct, inflation is a persistent rise in the
general price level rather than a once-for-all rise in it. On the other hand, deflation represents
persistently falling prices. Inflation or persistently rising prices is a major problem in India today.
When price level raise due to inflation, the value of money falls. When there is a persistent rise in
price level, the people need more and more money to buy goods and services. To enable the people
to meet their daily needs of consumption of goods and services when their prices are rising, their
incomes must rise if they have to maintain their standard of living. For government employees, their
dearness allowance is increased. Wages and salaries employed in the organised private sector are
also raised, though after some time- lag.
But people with fixed incomes and those who are self-employed are unable to raise their prices and
suffer a lot due to inflation. The poor suffer the most from persistent rise in prices, especially of food-
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grains and other essential items. Rate of inflation during the seventies and eighties was very high as
compared to the rates of inflation experienced earlier during previous periods. In India, in recent
years, 2010-11, 2011-12 and 2012-13, rate of inflation as measured by consumer price index (CPI)
has been in double digit figures. Prior to Jan. 2013, even WPI inflation was quite high which
compelled Reserve Bank of India to adopt tight monetary policy.
11.3 DEFINITIONS:
A sustained or rapid increase in prices, as measured by a broad index (such as the Consumer Price
Index) over months or years, reflected in the currency's correspondingly decreasing purchasing
power. It has the greatest impact on fixed-wage earners and acts as a disincentive to save. There is
no one single, universally accepted cause of inflation, and the modern economic theory describes
three types of inflation:
(1) Cost-push inflation is due to wage increases that cause businesses to raise prices to cover higher
labor costs, which leads to demand for still higher wages (the wage-price spiral),
(2) Demand-pull inflation results from increasing consumer demand financed by easier availability of
credit;
(3) Monetary inflation caused by the expansion in money supply (due to printing of more money by a
government to cover its deficits).
In simple words, “Inflation is a rise in the general level of prices.” Here the term general means that if
price of one commodity has gone up it is not called as inflation, it becomes inflation, when prices of
most of commodities have gone up. The opposite of inflation is deflation which means “fall in the
general level of prices.”
11.4 CHARACTERISTICS OF INFLATION
a) Persistent rise in prices: The first characteristic feature of inflation is the persistent rise in
prices. This conclusion is based on observation of facts and it is by a large correct. Though there may
be recovery of prices here and there due to monetary and fiscal measures undertaken by the
government, it is an agreed fact that excessive rise in prices is the hallmark of inflation.
b) Excessive supply of money in economy: The second feature of inflation is an excessive
supply of money in the economy. In times of war or sudden preparations for war, the resources at the
disposal of the government may not be sufficient and the government may adopt war time measures
to augment the resources to meet the emergent situation. The government may resort to banks which
make advances on the basis of government bonds and securities. This results in an expansion in the
paper currency as well as bank credit in the economy.
c) Vicious circle of inflationary spiral: Another important characteristic feature of inflation is
the vicious circle of inflationary spiral created by the velocity of circulation of money. Inflation will feed
on itself to grow into an inflationary spiral.
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11.5 CAUSES OF INFLATION
a) Increase in money supply: Over the last few years the rate of increase in money supply has
varied between 15 and 18 per cent, whereas the national output has increased at an annual average
rate of only 4 per cent. Hence the rate of increase in output has not been sufficient to absorb the
rising quantity of money in the economy. Inflation is the obvious result.
b) Deficit financing: When the government is unable to raise adequate revenue for its
expenditure, it resorts to deficit financing. During the sixth and seventh Plans, massive doses of
deficit financing had been resorted to. It was Rs. 15,684 crores in the sixth Plan and Rs. 36,000
crores in the seventh Plan.
c) Increase in government expenditure: Government expenditure in India during the recent
years has been rising very fast. What is more disturbing, proportion of non-development expenditure
increased rapidly, being about 40 per cent of total government expenditure. Non-development
expenditure does not create real goods; it only creates purchasing power and hence leads to
inflation. Not only the above mentioned factors on the Demand side cause inflation, factors on the
Supply side also add fuel to the flame of inflation.
d) Inadequate agricultural and industrial growth: Agricultural and industrial growth in our
country has been much below what we had targeted for. Over the four decades period, food grains
output has increased and-.i.e. of 3.2 per cent per annum. But there are years of crop failure due to
droughts. In the years of scarcity of food grains not only the prices of food articles increased, the
general price level also rose. Failure of crops always encouraged big wholesale dealers to indulge in
hoarding which accentuated scarcity conditions and pushed up the price level. Performance of the
industrial sector, particularly in the period 1965 to 1985, has not been satisfactory. Over the 15 years
period from 1970 to 1985, industrial production increased at a modest rate of 4.7 per cent per annum.
Our industrial structure, developed on the basis of heavy industry-led growth, is not suitable to meet
the current demand for consumer goods.
e) Rise in administered prices: In our economy a large part of the market is regulated by
government action. There are a number of important commodities, both agricultural and industrial, for
which the price level is administered by the government.
f) Rising import prices: Inflation has been a global phenomenon. International inflation gets
imported into the country through major imports like fertilisers, edible oil, steel, cement, chemicals,
and machinery. Increase in the import price of petroleum has been most spectacular and its
contribution to domestic price rise is very high.
g) Increasing taxes: To raise additional financial resources, government is depending more and
more on indirect taxes such as excise duties and sales tax. These taxes invariably raise the price
level.
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1. Inflation means general rise in prices. (True/False)
2. The rise in price level due to inflation results fall in the value of money.
(True/False)
3. Deflation means ______ in the general level of prices.
4. The persistence rise in prices is not the features of inflation. (True/False)
5. Write down the causes of Inflation.
Activity 1:
Discuss about the causes of Inflation in Indian Economy.
11.6 TYPES OF INFLATION

Inflation refers to the persistent rise in the general price level of goods and services. The following
are the types of inflation: -
a) On the basis of Rate; and
b) On the basis of Cause
a) On the Basis of Rate:-
 Moderate Inflation: The moderate inflation, also called as Creeping Inflation refers to a single
digit annual increase in the general price level. During the moderate period, the price increases
persistently, but at a mild or moderate rate, i.e. less than 10% or a single digit inflation rate. A
moderate rate may vary from country to country, but however an important trait of this inflation rate is,
it is predictable.
 Galloping Inflation: The galloping inflation refers to the exceptionally high inflation rate that
leads to an increase in the general price level. Generally, the inflation is in double or triple digit and is
reflected in the high price of goods and services, i.e. prices increase manifold. The double-digit
inflation varies from 10% to 999% per annum and there is a great difference between these two
limits. A country with 900% inflation will have more devastating effects than the one having 20-30%
inflation.
 Hyper Inflation: As the name suggests, the hyper inflation is the situation when the prices rise
at an alarmingly high rate, i.e. more than a three-digit per annum. The prices rising above 1000% per
annum marks the beginning of hyper inflation. During this period, the paper currency becomes
worthless, and people start trading in kind, such as gold and silver and often resort to the old barter
system of commerce.
b) On the Basis of Cause
 Demand-pull Inflation: The demand-pull inflation exists when the aggregate demand
increases rapidly than the aggregate supply. In other words, for a given level of aggregate supply the
aggregate demand increases manifold, then the demand-pull inflation occurs. This increase in the
demand can be due to the monetary factors i.e., increase in money supply and real factors, Viz. Cut
in tax rates, increase in government expenditure, upward shift in investment function, etc.
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 Cost-Push Inflation: The Cost-Push inflation occurs when the cost of raw material, labor, and
inputs necessary for the production of final goods increases. Such inflation is often caused by the
monopolistic groups of the society such as labor unions and firms in the monopoly and oligopolistic
market setting. Strong labor unions force the wage price to go up that leads to an increase in the
price of goods and services. This rise in the price level is called as wage-push inflation. Also, the
firms enjoying the monopoly in the market raise the price level to increase their profit margins due to
which the general price level increases. This is called as profit-push inflation. Another kind of cost-
push inflation is the supply-shock inflation when the firms restrict the aggregate supply of goods and
services.
11.7 THEORIES OF INFLATION
The Modern Theories of Inflation follows the theory of price determination. This means the general
price level can be determined by aggregate demand and aggregate supply of goods and services.
The variations in the general price level are caused by a shift in the aggregate demand and
aggregate supply curves. The theories of inflation are in fact the blend of classical and Keynesian
theories of inflation. The classical theory laid emphasis on the role of money, i.e., the price rises in
proportion to the supply of money, and ignored the non-monetary factors affecting inflation. While, the
Keynesian theory laid emphasis on the non-monetary factors, i.e. aggregate demand in the real
terms and ignored the effect of monetary expansion (money supply) on the price level.
The modern theories of inflation show that the price level is influenced by one or both of the demand-
side and the supply-side factors. The factors which are functional on the demand side are called as
the demand-pull factors, and those who operate on the supply-side factors are called as cost-push
factors. Thus, there are two types of inflation:
i) Demand-pull Inflation; and
ii) Cost-push Inflation
11.7.1 DEMAND-PULL INFLATION
The Demand-pull Inflation occurs when, for a given level of aggregate supply, the aggregate demand
increases substantially. In other words, demand-pull inflation exists when the aggregate demand
increases rapidly than the aggregate supply. The increase in aggregate demand may be due to:
a) Monetary Factors i.e., an increase in the supply of money; and
b) Real Factors i.e., an increase in the demand for real output
 Demand-pull Inflation due to Monetary factors: The increase in money supplies more than
the increase in potential output is one of the major reasons for demand-pull inflation. Let’s see how
the money supplies cause the demand-pull inflation. At a given level of output, when the monetary
and real sectors are in equilibrium, then the economy is also in equilibrium. Since the economy is in
general equilibrium, the general price level corresponding to it is called as equilibrium price level.
With an increase in the money supply, the other things remaining the same, the real stock of money
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at each price level increases. As a result, the interest rates decreases and the people’s desire to hold
money increases. With a decrease in the interest rates, the investment also increases, which leads to
more income.
The increase in income causes an increase in the consumption expenditure and thus, a rise in
investment and consumption expenditure increases the aggregate demand and aggregate supply,
other things remaining the same. This increase in the aggregate demand is exactly proportional to
the increase in the money stock. Thus, a rise in aggregate demand, for a given level of aggregate
supply, leads to an increase in the general price level in the economy, which may be inflated.
 Demand-pull Inflation due to Real Factors: The following are some of the real factors that
cause demand-pull inflation in the economy: -
i) Increase in government expenditure without any change in the tax revenue;
ii) Cut in the tax rates without any change in the government expenditure;
iii) Upward shift in the Investment Function;
iv) Downward shift in the Saving Function;
v) Upward shift in the Export Function; and
vi) Downward shift in the Import Function.
The first four factors directly contribute towards an increase in the level of disposable income. Since
the aggregate demand being the function of income, an increase in aggregate income leads to an
increase in the aggregate demand, thereby causing the demand-pull inflation. Let’s see how real
factors cause demand-pull inflation. Suppose the government increases its spending financed
through external borrowings from abroad. The rise in government expenditure generates additional
demand and thus, the aggregate demand increases. Since it is assumed that there is full
employment, then the additional resources can be acquired only by bidding a higher price. As a
result, the prices rise while the output remains unchanged.
Thus, the transaction of demand for money increases and in order to meet the increased demand for
money people sell their financial assets such as bonds and securities. Eventually, the prices of bonds
and securities go down and the rate of interest increases. In the product market, the price rises to
such a level that the additional spending by the government is absorbed by such price rise. This
shows that the real factors also cause inflation.
11.7.2 COST-PUSH INFLATION
The Cost-Push Inflation occurs when the price rise due to the increase in the price of factors of
production, Viz. Labor, raw materials, and other inputs which are essential for the final production of a
product. As a result, the aggregate supply decreases, demand remaining the same, an increase in
the price of commodities leads to an overall increase in the general price level.
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Often, the cost-push inflation is caused by the monopolistic groups in the society such as labor
unions and firms operating in monopolistic and oligopolistic market setting. The following are the
major kinds of cost-push inflation:
 Wage-push Inflation: The Strong labor unions force the money wages to go up, due to which
the price increases. This kind of rise in the general price level is called as wage-push inflation. The
powerful and well-organized labor unions exercise their monopoly power and compel their employers
to increase their wages above the competitive level irrespective of their productivity (output). An
increase in wage money brings a corresponding increase in the cost of production and this increase
in the cost of production causes an aggregate supply curve to shift backward (aggregate supply
decreases). A backward shift in the aggregate supplies causes the prices level to go up. It is to be
noted that every time a rise in the wage money is not considered to be inflationary. The following
conditions supplement this:
i) Increase in wage rate due to an increase in the productivity;
ii) Rise in wage rate due to inflation caused by other factors;
iii) Rise in wage where the unionized wage bill is very small;
iv) Wage rises due to the shortage of labor.
 Profit-push Inflation: The profit-push inflation is attributed to the monopoly power exercised
by the firms under the monopolistic and oligopolistic market that tries to enhance their profit margins
by keeping the prices relatively high. The wage-push inflation and profit-push inflation goes hand-in-
hand, which means as the labor unions force their employer to increase their wage money the cost of
production also increases. And in order to meet the increased cost, the monopolistic and oligopolistic
firms raise the price level often more than proportionately. This is done to enhance the profit margins
of the firm. If this process of; a hike in the price of the commodity following an increase in the wage
money continues, then this is called as ‘profit-wage spiral.’
 Supply-Shock Inflation: This kind of cost-push inflation is caused due to an unexpected
decline in the supply of major consumer goods and key industrial inputs. Such as the prices of food
product shoots up due to a crop failure and the prices of key industrial inputs Viz. Coal, iron, steel,
etc., increases because of the natural calamities, lockouts, labor strikes, etc. Also, the prices may rise
due to the supply bottlenecks in the domestic economy or international events (generally, war),
thereby restricting the movement of internationally traded goods. As a result, the supply decreases
and the import of industrial inputs increase. Thus, these are the major kinds of cost-push inflation that
show the supply side being responsible for the inflation in the economy, i.e. fall in supply results in a
rise in the general price level.
11.8 MEASURES OF INFLATION RATE
Unchecked inflation can ruin the whole economy. There are many examples from African and South
American economies which got shattered by the high inflation rates. But who measures inflation rate
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in India? And what are they types of Inflation indices in India? Inflation can be measured at three
levels – producer, wholesaler and retailer (consumer). Prices generally rise in each level till the
commodity finally reaches the hand of consumer.
a) Inflation at Producer Level: As of now in India, there is no index to measure inflation at
producer level. A Producer Price Index (PPI) is proposed, but so far this type of inflation calculation
has not started in India.
b) Inflation at Wholesale Level: This is the most popular inflation rate calculation methodology
in India. The index used to calculate wholesale inflation is known as Wholesale Price Index (WPI).
This inflation rate is often known as headline inflation. WPI is released by the Ministry of Commerce
and Industry. The RBI used WPI for most of its policy decisions before 2014. But WPI based inflation
calculation was not false proof. WPI shows the combined price of a commodity basket comprising
676 items. But WPI does not include services, and it neither reflects the bottlenecks between
producer and wholesaler nor between wholesaler and retailer (consumer). Hence from 2014, as part
of the reforms initiated by RBI governor Raghu Ram Rajan, RBI shifted to CPI for policy decisions.
c) Inflation at Retail Level (Consumer Level): Consumer often directly buys from retailer. So
the inflation experienced at retail shops is the actual reflection of the price rise in the country. It also
shows the cost of living better. In India, the index which shows the inflation rate at retail level is
known as Consumer Price Index (CPI). CPI is based on 260 commodities, but includes certain
services too. There were four Consumer Price Indices covering different socio-economic groups in
the economy. These four indices were Consumer Price Index for Industrial Workers (CPI-IW);
Consumer Price Index for Agricultural Labourers (CPI-AL); Consumer Price Index for Rural
Labourers (CPI -RL) and Consumer Price Index for Urban Non-Manual Employees (CPI-UNME). CPI
is now using a new series on the base 2010=100 for all-India and States/UTs separately for rural,
urban and combined. The Central Statistics Office (CSO), Ministry of Statistics and Program
Implementation releases Consumer Price Indices (CPI). CPI is based on retail prices and this index is
used to calculate the Dearness Allowance (DA) for government employees.
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11.9 EFFECTS OF INFLATION
a) Effects of Inflation on Production: Inflation has the following effects on production activities:
i) Inflation may or may not result in an increase in production;
ii) As long as the economy does not reach the full employment stage, inflation has a favorable effect
on production;
iii) Usually, as the price level increases, profits increase too;
iv) During inflation, businessmen tend to raise the prices of their products to earn better profits;
v) However, if the wages and production costs start rising rapidly, then this favorable effect of inflation
does not last long;
vi) If the inflation in an economy is of the cost-push type, then the inflationary situation usually leads to
a fall in production;
vii) There is no direct correlation between prices and output.
b) Effects of Inflation on the Distribution of Wealth: Inflation has the following effects on the
distribution of wealth:
i) usually, during inflation, most people experience a rise in their income levels;
ii) Some people might gain at the cost of others, as the sellers will be able to sell the goods at a higher
rate to its customers due to inflation;
iii) A certain set of people gain because their money income rises faster than the prices;
iv) A different set of people lose because prices rise faster than their incomes during inflation.
c) Effects of Inflation on Different Categories of People: Let’s look at how inflation affects
different categories of people.
 Debtors and Creditors:
i) During inflation, borrowers tend to gain. Hence, lenders tend to lose;
ii) Borrowers gain because they repay less in real terms as compared to when they had borrowed the
money;
iii) Lenders lose because when they receive repayment of their debts, the real value of their money
declines by the amount of increase in the price levels; and
iv) In other terms, a borrower receives ‘dear rupees’ but pays back ‘cheap rupees’.
 Bond and Debenture Holders:
i) Debenture and Bond Holders earn fixed income on their investments;
ii) Therefore, when the price levels rise, they suffer a reduction in real income; and
iii) Beneficiaries of life insurance programs also suffer badly because the real value of their savings
deteriorates
 Investors: During inflation, businesses have an opportunity to earn good profits. Therefore,
people who invest in shares during inflation tend to gain. As the businesses earn higher profits, they
usually distribute the profit among investor and shareholders too.
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 Salaried People and Wage-earners:
i) During inflation, people earning a fixed income face a lot of damage because the rate of increase in
wages is always behind the rate of increase in prices;
ii) Therefore, inflation results in a drop in the real purchasing power of people earning a fixed income.
Hence, people earning a flexible income tend to gain during inflationary periods.
 Profit Earners, Speculators, and Black Marketers:
i) During inflation, the profit-earners gain;
ii) Businessmen also raise the prices of their products and earn bigger profits;
iii) Speculators gain by inflation, especially when the prices of factors of production increase too; and
iv) Black marketers tend to gain since the price of products increases with time
SELF CHECK EXERCISE 2:

6. Name the types of inflation on the basis of cause.
7. Name the levels at which inflation can be measured.
8. During inflation borrowers tend to gain as compared to lenders.
(True/False)
9. Investors bear losses during inflation.
(True/False)
10. Black marketers gain more during inflation.
(True/False)
Activity 2:
Discuss about the factors of Demand-Pull and Cost-Push.
11.10 SUMMARY
The high rate of inflation is not good for the economy, a mild inflation, says fewer than 3%, and may
turn, at times, useful for the economy. As we hinted in the beginning, inflation can occur because of
high demand too. High demand on scarce resources will automatically increase prices. This is called
demand pull inflation. But demand for a commodity is a good sign from the industry perspective.
Industries now will try to produce more commodities to reap the benefit of high prices and demand.
More production will trigger GDP growth. The inflation, especially a runaway inflation, is an unstable
situation. It makes the business world uneasy and uncertain. Society gets disturbed as there grows
discontentment among the salaried people and they demand an increase in their wages and salaries.
The middle-class people suffer hard as the real value of their income becomes very low. Inflation is
also unjust as it makes one class of people richer and the other poorer. But the most serious effect of
inflation from the standpoint of the economy is that it makes the economic environment of business
unstable.
11.11 GLOSSARY
 Consumer Price Index is a comprehensive measure used for estimation of price changes in a
basket of goods and services representative of consumption expenditure in an economy.
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 Inflation is basically a rise in prices. It is a situation of a sustained increase in the general
price level in an economy. Inflation means an increase in the cost of living as the price of goods and
services rise.
 Producer price index (PPI) is a group of indexes that calculates and represents the average
movement in selling prices from domestic production over time. PPI is a product of the Bureau of
Labor Statistics (BLS). The PPI measures price movements from the seller's point of view.
 Wholesale Price Index (WPI) represents the price of goods at a wholesale stage i.e. goods
that are sold in bulk and traded between organizations instead of consumers. WPI is used as a
measure of inflation in some economies. Description: WPI is used as an important measure of
inflation in India.
1. True
2. True
3. Fall
4. False
5. Increase in money supply, deficit financing, increase in government expenditure, inadequate
agricultural and industrial growth, rise in administrative prices, rising import prices, increasing taxes
6. Demand-Pull Inflation and Cost-Push Inflation
7. Producer Level, Wholesaler Level and Retail (Consumer) Level
8. True
9. False
10. True
1. Define Inflation. How it affects the economy of a country? Discuss.
2. Discuss the characteristics and causes of Inflation.
3. Elaborate the effects of Inflation with the help of examples.
4. Write Short Notes:
a) Demand-Pull Inflation
b) Cost-Push Inflation
5. What measures are used to calculate the inflation rate? Discuss
140
 Jain; Ohri and Khanna “Introductory Microeconomics and Macroeconomics” VK Global
Publications.

Book Co., Inc.
Cengage Learning.
 Peterson, H. C. and Lewis, W. C. “Managerial Economics” Prentice hall of India
 Singh, Ramesh “Indian Economy” Mc Graw Hill.
 Wilkinson, N. (2005). Managerial Economics (1st ed.). New York: Cambridge University Press.
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CHAPTER 12
FISCAL AND MONETARY POLICIES
STRUCTURE
12.2 INTRODUCTION
12.3 CONCEPT OF FISCAL AND MONETARY POLICY
12.4 FISCAL POLICY
12.5 OBJECTIVES OF FISCAL POLICY
12.6 REASONS TO DESIGN FISCAL POLICY
12.7 MONETARY POLICY
12.8 INSTRUMENT OF MONETARY POLICY
12.9 OBJECTIVES OF MONETARY POLICY
12.10 SUMMARY
12.11 GLOSSARY
 The concept of economic policy, Fiscal policy and monetary policy.
 The importance and objectives of Fiscal and Monetary Policies.
 The reasons to frame Fiscal and Monetary Policies.
 The instruments of Monetary Policy.
12.2 INTRODUCTION
Economic policies are integrated part of the overall macro planning and management. A free market
economy was once believed to be capable of functioning without interference by government;
however, it does not automatically establish optimum demand for goods and services. During the
1920’s the quantity theory of money became widely accepted, and the Federal Reserve was believed
to be capable of preventing future fluctuations. The great depression shattered those hopes, resulting
in increased emphasis on fiscal policy. A free market economy was once believed to be capable of
functioning without interference by government; however, it does not automatically establish optimum
demand for goods and services. During the 1920’s the quantity theory of money became widely
accepted, and the Federal Reserve was believed to be capable of preventing future booms and
busts. The great depression shattered those hopes, resulting in increased emphasis on fiscal policy.
12.3 CONCEPT OF FISCAL AND MONETARY POLICIES

Fiscal policy and monetary policy are the two tools used by the State to achieve its macroeconomic
objectives. While the main objective of fiscal policy is to increase the aggregate output of the
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economy, the main objective of the monetary policies is to control the interest and inflation rates. The
celebrated IS/LM model is one of the models used to depict the effect of interaction on aggregate
output and interest rates. The fiscal policies have an impact on the goods market and the monetary
policies have an impact on the asset markets and since the two markets are connected to each other
via the two macro variables — output and interest rates, the policies interact while influencing the
output or the interest rates.
Traditionally, both the policy instruments were under the control of the national governments. Thus
traditional analyses made with respect to the two policy instruments to obtain the optimum policy mix
of the two to achieve macroeconomic goals as the two were perceived to aim at mutually inconsistent
targets. But in recent years, owing to the transfer of control with respect to monetary policy
formulation to Central Banks, formation of monetary unions (like European Monetary Union formed
via the Stability and Growth Pact) and attempts being made to form fiscal unions, there has been a
significant structural change in the way in which fiscal and monetary policies interact.
There is a dilemma as to whether these two policies are complementary, or act as substitutes to each other
for achieving macroeconomic goals. Policy makers are viewed to interact as strategic substitutes when one
policy maker’s expansionary (contractionary) policies are countered by another policy maker’s contractionary
(expansionary) policies. For example: if the fiscal authority raises taxes or cuts spending, then the
monetary authority reacts to it by lowering the policy rates and vice versa. If they behave as strategic
complements, then an expansionary (contractionary) policy of one authority is met by expansionary
(contractionary) policies of other.
The issue of interaction and the policies being complement or substitute to each other arises only when the
authorities are independent of each other. But when, the goals of one authority is made subservient to that of
others, then the dominant authority solely dominates the policy making and no interaction worthy of analysis
would arise. Also, it is worthy to note that fiscal and monetary policies interact only to the extent of influencing
the final objective. So long as the objectives of one policy are not influenced by the other, there is no direct
interaction between them. Here it is important to mention that both these policies are complementary to each other
and not substitute.
12.4 FISCAL POLICY
Fiscal policy deals with the taxation and expenditure decisions of the government. Some of the major
instruments of fiscal policy are as follows: Budget, Taxation, Public Expenditure, public revenue,
Public Debt, and Fiscal Deficit in the economy. Fiscal policy means the use of taxation and public
expenditure by the government for stabilization or growth of the economy.
According to Culbarston, “By fiscal policy we refer to government actions affecting its receipts and
expenditures which ordinarily as measured by the government’s receipts, its surplus or deficit.” The
government may change undesirable variations in private consumption and investment by
compensatory variations of public expenditures and taxes.
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Fiscal policy also feeds into economic trends and influences monetary policy.
When the government receives more than it spends, it has a surplus. If the government spends
more than it receives it runs a deficit. To meet the additional expenditures, it needs to borrow from
domestic or foreign sources, draw upon its foreign exchange reserves or print an equivalent amount
of money. This tends to influence other economic variables.
Excessive printing of money leads to inflation. If the government borrows too much from abroad it
leads to a debt crisis. Excessive domestic borrowing by the government may lead to higher real
interest rates and the domestic private sector being unable to access funds resulting in the “crowding
out” of private investment. So it can be said that the fiscal deficit can be like a double edge sword,
which need to be tackled very carefully.
12.5 OBJECTIVES OF FISCAL POLICY
a) General objectives of Fiscal Policy are given as:
i) To maintain and achieve full employment;
ii) To stabilize the price level;
iii) To stabilize the growth rate of the economy;
iv) To maintain equilibrium in the Balance of Payments; and
v) To promote the economic development of underdeveloped countries.
b) The main objectives of Fiscal Policy are: -
i) Improving the growth performance of the economy; and
ii) Ensuring social justice to the people.
12.6 REASONS TO DESIGN THE FISCAL POLICY
The fiscal policy is designed to achieve certain objectives as follows:-
a) Development by effective Mobilisation of Resources: The principal objective of fiscal policy
is to ensure rapid economic growth and development. This objective of economic growth and
development can be achieved by Mobilisation of Financial Resources. The central and state
governments in India have used fiscal policy to mobilise resources. The financial resources can be
mobilised by:-
b) Taxation: Through effective fiscal policies, the government aims to mobilise resources by way
of direct taxes as well as indirect taxes because most important source of resource mobilisation in
India is taxation.
c) Public Savings: The resources can be mobilised through public savings by reducing
government expenditure and increasing surpluses of public sector enterprises.
d) Private Savings: Through effective fiscal measures such as tax benefits, the government can
raise resources from private sector and households. Resources can be mobilised through
government borrowings by ways of treasury bills, issuance of government bonds, etc., loans from
domestic and foreign parties and by deficit financing.
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e) Reduction in inequalities of Income and Wealth: Fiscal policy aims at achieving equity or
social justice by reducing income inequalities among different sections of the society. The direct
taxes such as income tax are charged more on the rich people as compared to lower income groups.
Indirect taxes are also more in the case of semi-luxury and luxury items which are mostly consumed
by the upper middle class and the upper class. The government invests a significant proportion of its
tax revenue in the implementation of Poverty Alleviation Programmes to improve the conditions of
poor people in society.
f) Price Stability and Control of Inflation: One of the main objectives of fiscal policy is to
control inflation and stabilize price. Therefore, the government always aims to control the inflation by
reducing fiscal deficits, introducing tax savings schemes, productive use of financial resources, etc.
g) Employment Generation: The government is making every possible effort to increase
employment in the country through effective fiscal measures. Investment in infrastructure has
resulted in direct and indirect employment. Lower taxes and duties on small-scale industrial
(SSI) units encourage more investment and consequently generate more employment. Various rural
employment programmes have been undertaken by the Government of India to solve problems in
rural areas. Similarly, self employment scheme is taken to provide employment to technically
qualified persons in the urban areas.
h) Balanced Regional Development: there are various projects like building up dams on rivers,
electricity, schools, roads, industrial projects etc run by the government to mitigate the regional
imbalances in the country. This is done with the help of public expenditure.
i) Reducing the Deficit in the Balance of Payment: Some time government gives export
incentives to the exporters in order to encourage the export. In the same way import curbing
measures are also adopted to check import. Hence the combine impact of these measures is
improvement in the balance of payment of the country.
j) Increases National Income: it’s the strength of the fiscal policy that is brings out the desired
results in the economy. When the government wants to increase the income of the country then it
increases the direct and indirect taxes rates in the country. There are some other measures like:
reduction in tax rate so that more peoples get motivated to deposit actual tax.
k) Development of Infrastructure: when the government of the concerned country spends
money on the projects like railways, schools, dams, electricity, roads etc to increase the welfare of
the citizens, it improves the infrastructure of the country. A improved infrastructure is the key to
further speed up the economic growth of the country.
l) Foreign Exchange Earnings: when the central government of the country gives incentives
like, exemption in custom duty, concession in excise duty while producing things in the domestic
markets, it motivates the foreign investors to increase the investment in the domestic country.
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1. _________ are the integrated part of macro-planning and management.
2. The state used fiscal and monetary policies as tools to achieve its
macroeconomic objectives. (True/False)
3. Fiscal Policy deals with the _______ and ________ decisions of the
Government.
4. Fiscal Policy does not influence Monetary Policy. (True/False)
5. If receipts > Spending = Surplus (True/False)
6. If receipts < Spending = Deficit (True/False)
7. Excessive printing of money leads to inflation. (True/False)
Activity 1:
Discuss about the Fiscal Policy of India prior to 1991 and after 1991.
12.7 MONETARY POLICY

The monetary policy refers to a regulatory policy whereby the central bank (RBI in case of India)
maintains its control over the supply of money to achieve the general economic goals. Reserve Bank
of India (RBI) is the sole authority which prints and supplies the currency in the whole country. Coins
are minted by the ministry of Finance but supplied by the RBI. Main instruments of the monetary
policy are: Cash Reserve Ratio, Statutory Liquidity Ratio, Bank Rate, Repo Rate, Reverse Repo
Rate, and Open Market Operations.
Monetary policy refers to the credit control measures adopted by the central bank of a country. In
case of Indian economy, RBI is the sole monetary authority which decides the supply of money in the
economy. The Chakravarty committee has emphasized that price stability, growth, equity, social
justice, promoting and nurturing the new monetary and financial institutions have been important
objectives of the monetary policy in India.
12.8 INSTRUMENTS OF MONETARY POLICY
The instruments of monetary policy are of two types:
i) Quantitative, general or indirect (CRR, SLR, Open market operations, bank rate, repo rate, reverse
repo rate); and
ii) Qualitative, selective or direct (change in the margin money, direct action, moral suasion)
These both methods affect the level of aggregate demand through the supply of money, cost of
money and availability of credit. Of the two types of instruments, the first category includes bank rate
variations, open market operations and changing reserve requirements (cash reserve ratio, statutory
reserve ratio). They are meant to regulate the overall level of credit in the economy through
commercial banks. The selective credit controls aim at controlling specific types of credit.
They include changing margin requirements and regulation of consumer credit. These are discussed
as under: -
a) Bank Rate Policy: The bank rate is the minimum lending rate of the central bank at which it
rediscounts first class bills of exchange and government securities held by the commercial banks.
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When the central bank finds that inflation has been increasing continuously, it raises the bank rate so
borrowing from the central bank becomes costly and commercial banks borrow less money from it
(RBI).
The commercial banks, in reaction, raise their lending rates to the business community and
borrowers who further borrow less from the commercial banks. There is contraction of credit and
prices are checked from rising further. On the contrary, when prices are depressed, the central bank
lowers the bank rate.
It is economical to borrow from the central bank on the part of commercial banks. The latter also
lower their lending rates. Businessmen are encouraged to borrow more. Investment is encouraged
and followed by rise in Output, employment, income and demand and the downward movement of
prices is checked.
b) Open Market Operations: Open market operations refer to sale and purchase of securities in
the money market by the central bank of the country. When prices start rising and there is need to
control them, the central bank sells securities. The reserves of commercial banks are reduced and
they are not in a position to lend more to the business community or general public.
Further investment is discouraged and the rise in prices is checked. Contrariwise, when recessionary
forces start in the economy, the central bank buys securities. The reserves of commercial banks are
raised so they lend more to business community and general public. It further raises Investment,
output, employment, income and demand in the economy hence the fall in price is checked.
c) Changes in Reserve Ratios: Under this method, CRR and SLR are two main deposit ratios,
which reduce or increases the idle cash balance of the commercial banks. Every bank is required by
law to keep a certain percentage of its total deposits in the form of a reserve fund in its vaults and
also a certain percentage with the central bank. When prices are rising, the central bank raises the
reserve ratio. Banks are required to keep more with the central bank. Their reserves are reduced and
they lend less. The volume of investment, output and employment are adversely affected. In the
opposite case, when the reserve ratio is lowered, the reserves of commercial banks are raised. They
lend more and the economic activity is favourably affected.
d) Selective Credit Controls: Selective credit controls are used to influence specific types of
credit for particular purposes. They usually take the form of changing margin requirements to control
speculative activities within the economy. When there is brisk speculative activity in the economy or
in particular sectors in certain commodities and prices start rising, the central bank raises the margin
requirement on them.
e) Change in Margin Money:
The result is that the borrowers are given less money in loans against specified securities. For
instance, raising the margin requirement to 70% means that the pledger of securities of the value of
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Rs 10,000 will be given 30% of their value, i.e. Rs 3,000 as loan. In case of recession in a particular
sector, the central bank encourages borrowing by lowering margin requirements.
f) Moral Suasion: Under this method RBI urges to commercial banks to help in controlling the
supply of money in the economy.
12.9 OBJECTIVES OF THE MONETARY POLICY
a) Price Stability: Price Stability implies promoting economic development with considerable
emphasis on price stability. The centre of focus is to facilitate the environment which is favourable to
the architecture that enables the developmental projects to run swiftly while also maintaining
reasonable price stability.
b) Controlled Expansion Of Bank Credit: One of the important functions of RBI is the
controlled expansion of bank credit and money supply with special attention to seasonal requirement
for credit without affecting the output.
c) Promotion of Fixed Investment: The aim here is to increase the productivity of investment
by restraining non essential fixed investment.
d) Restriction of Inventories: Overfilling of stocks and products becoming outdated due to
excess of stock often results is sickness of the unit. To avoid this problem the central monetary
authority carries out this essential function of restricting the inventories. The main objective of this
policy is to avoid over-stocking and idle money in the organization
e) Promotion of Exports and Food Procurement Operations: Monetary policy pays special
attention in order to boost exports and facilitate the trade. It is an independent objective of monetary
policy.
f) Desired Distribution of Credit: Monetary authority has control over the decisions regarding
the allocation of credit to priority sector and small borrowers. This policy decides over the specified
percentage of credit that is to be allocated to priority sector and small borrowers.
g) Equitable Distribution of Credit: The policy of Reserve Bank aims equitable distribution to all
sectors of the economy and all social and economic class of people
h) To Promote Efficiency: It is another essential aspect where the central banks pay a lot of
attention. It tries to increase the efficiency in the financial system and tries to incorporate structural
changes such as deregulating interest rates, ease operational constraints in the credit delivery
system, to introduce new money market instruments etc.
i) Reducing the Rigidity: RBI tries to bring about the flexibilities in the operations which provide
a considerable autonomy. It encourages more competitive environment and diversification. It
maintains its control over financial system whenever and wherever necessary to maintain the
discipline and prudence in operations of the financial system.
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8. RBI stands for Reorganised Banking Industry of India.
(True/False)
9. _________ prints and supplies currency in whole country i.e. India.
10. The main instruments of the monetary policy are cash reserve ratio, statutory
liquidity ratio, bank rate, repo rate, reserve repo rate, open market operations.
(True/False)
Activity 2:
Discuss why coins are minted by the Ministry of Finance and Supplied by the RBI
and write down all the point.
12.10 SUMMARY
The implementation of the monetary policy plays a very prominent role in the development of a
country. It’s a kind of double edge sword, if money is not available in the market as the requirement
of the economy, the investors will suffer (investment will decline in the economy) and on the other
hand if the money is supplied more than its requirement then the poor section of the country will
suffer because the prices of essential commodities will start rising.
Fiscal policy formulated by the Government of India has been creating considerable impact on the
economy of the country. Taxation, public expenditure and public debt have been increasing at a
considerable proportion. Public sector of the country has also been expanded considerably. The
country has been able to attain significant development of its industrial and infrastructural sector. But
the burden of taxation in our country is comparatively heavy and thereby it has been affecting the
saving capacity of the people. Moreover, the fiscal policy of the country has also failed to check the
extent of inequality in the distribution of income and wealth and has also failed to solve the problem
of unemployment and poverty even after 50 years of planning. The fiscal policy has also failed to
maintain stability in price level of the country. It would now be better to study the advantages and
shortcomings of the fiscal policy of the country in a brief manner.
12.11 GLOSSARY
 Economic policy is a course of action that is intended to influence or control the behavior of
the economy. Examples of economic policies include decisions made about government spending
and taxation, about the redistribution of income from rich to poor, and about the supply of money.
 Fiscal policy is the means by which a government adjusts its spending levels and tax rates to
monitor and influence a nation's economy. It is the sister strategy to monetary policy through which a
central bank influences a nation's money supply.
 Monetary policy is the macroeconomic policy laid down by the central bank. It involves
management of money supply and interest rate and is the demand side economic policy used by the
government of a country to achieve macroeconomic objectives like inflation, consumption, growth
and liquidity.
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 Receipt is a written acknowledgment that something of value has been transferred from one
party to another. In addition to the receipts consumers typically receive from vendors and service
providers, receipts are also issued in business-to-business dealings as well as stock market
transactions.
 Reserve Bank of India (RBI) is the central bank of India, which was established on April 1,
1935, under the Reserve Bank of India Act. The Reserve Bank of India uses monetary policy to
create financial stability in India, and it is charged with regulating the country’s currency and credit
systems.
12.12 ANSWERS TO SELF CHECHK EXERCISES
1. Economic Policies
2. True
3. Taxation, Expenditure
4. False
5. True
6. True
7. True
8. False (Reserve Bank of India)
9. Reserve Bank of India (RBI)
10. True
1. Discuss the importance of Fiscal Policy in India.
2. What are the objectives of Fiscal Policy? Discuss
3. What are the reasons to design the Fiscal Policy? Elaborate
4. Why Monetary Policy is framed? Discuss.
5. What are the basic instruments of Monetary Policy? Discuss.
6. Why Monetary Policy is important? What are it objectives?
7. “Fiscal Policy deals with the taxation and expenditure decisions of the Government” Comment.
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Publications.

Book Co., Inc.
Cengage Learning.
151
CHAPTER 13
PROFIT: MANAGEMENT AND MEASUREMENT
STRUCTURE
13.1 Learning Objectives
13.2 Introduction
13.3 Profit
13.4 Features of Profit
13.5 Types of Profit
13.6 Profit Policies
13.7 Alternative Profit Policies
13.8 Aims of Profit Policies
13.9 Operative Organisational Goals
13.10 Measurement of Profit
13.11 Profit Planning and Control
13.12 Essential Elements in Profit Planning
13.13 Steps in Profit Planning
13.14 Need for Profit Planning
13.15 Aids to Profit Planning
13.16 Control of Profit
13.17 Profit Policy and Forecasting
13.18 Profit Forecasting
13.19 Approaches to Profit Forecasting
13.20 Problems in Setting a Profit Policy
13.21 Summary
13.22 Glossary
13.23 Answers to Self Check Exercises
13.24 Review Questions
13.25 Suggested Readings
After studying this chapter, students will be able to understand:
 The concept, meaning, features and types of profit
 The profits, aims, measurement of profit
 The profit planning and control, element, steps, need, aids and control of profit planning
 The profit policy and forecasting, approaches of profit forecasting and problems in setting a
profit policy.
13.2 INTRODUCTION
Profit management means the manipulation of financial statement items within the framework of
accounting standards that may be for the benefit of the company or for the benefit of the opportunity.
There are many incentives for profit management, for example managers use profit managers to pay
less tax. This may be through accruals, Or for managers to increase their rewards to manage profits
and show more profits. Other incentives for earnings management include attracting investors,
reducing earnings fluctuations and keeping track of the business and reputation of managers, etc.
Profit is the income received by the organizer. It is the reward for the services of an entrepreneur. A
firm makes profit when it receives a surplus after it has paid interest on capital, wages to laborers’
and rent for land. Profit, in other words, is the residual income which is equal to the different between
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the total revenue and the total cost of production. In economic terms profit is defined as a reward
received by an entrepreneur by combining all the factors of production to serve the need of
individuals in the economy faced with uncertainties. In a layman language, profit refers to an income
that flow to investor. In accountancy, profit implies excess of revenue over all paid-out costs.
13.3 PROFIT
The concept of profit entails several different meanings. Profit may mean the compensation received
by a firm for its managerial function. It is called normal profit which is a minimum sum essential to
induce the firm to remain in business. Profit may be looked upon as a reward for true entrepreneurial
function. It is the reward earned by the entrepreneur for bearing the risk. It is termed as supernormal
profit analysis. According to Henry Grayson, “profit may be considered as a reward for making
innovations, a reward for accepting risks and uncertainties, a result of imperfections in the market.
Any one of these conditions or a combination of them can give rise to economic profit”. According to
Prof. J.K. Mehta, “The element of uncertainty introduces a fourth category of sacrifice in the
productive activities of man in a dynamic world. This category is risk-bearing or uncertainty bearing. It
is remunerated by profit”.
Profit may imply monopoly profit. It is earned by a firm through extortion, because of its monopoly
power in the market. It is not related to any useful specific function. Thus monopoly profit is not a
functional reward. Profit may sometimes be in the nature of a windfall. It is an unexpected reward
earned by a firm just by mere chance, an inflationary boom. Profit is the earning of entrepreneur. To
the economist, the most significant point about profit is that it is a residual income. However, the term
profit has different connotations. It is one of the most important terms in business and finance.
Properly understanding what profits are allows you to have a better idea of how a company is
performing. It is essentially the financial reward that business people strive to receive. It is a reward in
compensation for the risks that they take. Net profits are what are left after we add up all the costs of
running a company and subtract the total from its sales revenue. In most cases, we calculate net
profits after the company has paid its taxes.
Profit is not just the difference between the price of product or service and its cost. When calculating
a business’ profits, you must also account for overhead costs. Overhead costs include fixed costs,
i.e., periodic costs that remain the same, such as salaries, rent, and insurance. They also include
variable costs i.e., costs that fluctuate with output, such as labor and materials.
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Figure: A graph that illustrates the point of maximum profit relative to revenue and costs
In addition to overhead costs, you also have to calculate how much tax you must pay out of your
income. Profit is equal to the sale of a product minus all these operating and other expenses, i.e.,
fixed costs, variable costs, and taxes.
If a company is making a profit it is profitable. If it is active and also profitable, it is a going concern.
Profitable is the opposite of unprofitable. When a company is losing money or just breaking
even, we say that it is unprofitbable. We call organizations that try to have greater revenue than
costs ‘for-profit organizations.’ They form a crucial part of a capitalist, free-market economy.
13.4 FEATURES OF PROFIT
The following are the distinctive features of profit as a factor reward:
 It is not a predetermined contractual payment.
 It is not a fixed remuneration.
 It is a residual surplus.
 It is uncertain.
 It may even be negative. Other factor rewards are always positive.
13.5 TYPES OF PROFIT
a) Gross Profit: Gross profit is a term in which the following items are included in addition to the
net profit due to the entrepreneur:
 Remuneration for factors of production contributed by entrepreneur himself.
 Depreciation and maintenance charges.
 Extra personal profits.
 Net profit.
In short, Gross Profit = Net profit + implicit rent + implicit wages + implicit interest + normal profit +
depreciation and maintenance charges + non-entrepreneurial profit.
b) Net Profit: Net profit is the exclusive reward for the entrepreneur for the following functions
performed by him:
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 Reward for co-ordination
 Reward for risk taking
 Reward for uncertainty bearing, and
 Reward for innovation.
Net Profit = Gross profit – (implicit rent + implicit wages + implicit interest + normal profit +
depreciation and maintenance charges + non-entrepreneurial profit)
In fact, Net Profit = economic profit or pure business profit. It is the net profit which may be positive or
negative. A negative profit means a loss.
c) Accounting Profit and Economic Profit: An accountant looks at profit as a surplus of
revenues over costs, as recorded in the books of accounts. An accountant is interested in
accounting, auditing, planning and budgeting profit. The accountant does not take care of implicit or
opportunity cost. Accounting profit is also called residual profit. For the business firm, accounting
profit is very important. Accounting profit is defined as the revenue realised in a given period after
providing for expenses incurred during the production of a commodity. A firm while making
accounting profits may be incurring economic losses. Such a firm would have to withdraw from
business in the long run. In the balance sheet of a firm, accounting profit occupies an important
place. The economist, however, does not agree with the accountant’s approach to profit. The
accountant would only deduct the explicit or actual costs from the revenues to determine profit. The
economist points out that in addition to the deduction of explicit cost, imputed cost, i.e., the cost that
would have been incurred in the absence of the employment of self owned factors, should also be
deducted. Their examples are:
 Entrepreneur’s wages that he could earn by working for someone else,
 Rental income on self-owned land and building employed in the business, and
 Interest on self owned capital that could have been earned by investing it elsewhere.
Thus the profit arrived at after deducting both explicit and imputed costs may be called economic
profit. From the managerial point of view, economic profit is very important because this alone shows
the viability of a firm.
d) Normal Profits and Supernormal Profits: Normal profits refer to the imputed returns to
capital and risk-taking just necessary to prevent the owners from withdrawing from the industry. The
normal profits are usually defined as the supply price or opportunity cost of entrepreneurship. Such
cost must be covered if the firm is to stay in business in the long run. When competition among
entrepreneurs is perfect, the market price of the product is equal to average cost which itself includes
‘normal profit’. Normal profit is the minimum to induce the entrepreneur to remain in the business in
the long run. It is possible that the entrepreneur may not get normal profit in the short run and may
have to sell his product at a loss, but in the long run every entrepreneur must get at least the normal
profits. It is assumed to be part of the price. In the words of Mrs. Joan Robinson, “Normal profit is that
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profit which neither attracts a new firm to enter into the industry nor obligates the existing firm to go
out of the industry.”
Supernormal profit is defined as the surplus over the normal profit. It is obtained by the super -
marginal firms. The marginal firm gets only the normal profit, but determines the supernormal profit of
the intramarginal firm.
e) Monopoly Profit: When a firm possesses monopoly power, it can restrict output and obtain a
higher profit than it could under competitive conditions. Profit is the result of continued scarcity. It can
exist only in an imperfect market where output is for various reasons restricted and the consumers
are deprived of the opportunity of alternative sources of supply.
Sources of such powers are usually found in legal restrictions, sole ownership of raw materials or
access of sale to particular markets. Even some degree of uniqueness in a firm’s product confers
some monopoly power. Summarising, it can be said that profits may come to exist as a result of
monopoly.
f) Windfall Profit: Some consider profit as a windfall gain. According to them, profit is not a
reward for any entrepreneurial function or monopoly power. It is merely a windfall gain. It arises due
to changes in the general price level in the market. If the producer or trader buys his inputs and raw
materials when the prices are low and sells the output when the prices have abruptly gone up due to
some unforeseen external factors, we call the profit as windfall profit. This is also included under net
profit.
13.6 PROFIT POLICIES
It is generally held that the main motive of a firm is to make profits. The volume of profit made by it is
regarded as a primary measure of its success. Economic theory advocates profit maximisation as the
chief policy of a firm. Modem business enterprises do not accept this view and relegate the profit
maximisation theory to the back ground. This does not mean that modem firms do not aim at profits.
They do aim at maximum profits but aim at other goals as well. All these constitute the profit policy.
 Industry Leadership: Industry leadership may involve either the achievement of the maxi-
mum sales volume or the manufacture of the maximum product lines. For the attainment of
leadership in the industry, there has to be a satisfactory level of profit consistent with capital invested,
labour force employed and volume of output produced.
 Restricting the Entry: If a firm follows a policy of restricting its profit, no competitors are likely
to enter the market. Reasonable profits which guarantee its survival and growth are essential.
According to Joel Dean, “Competitors can invade the market as soon as they discover its profitability
and find ways to shift the patents and make necessary changes in design, technique, and production
plant and market penetration.”
 Political Impact: High profits are considered to be suicidal for a firm. If the government comes
to know that the firms are earning huge returns, it may resort to high taxation or to nationalization.
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High profits are often considered as an index of monopoly power and to prevent the government may
introduce price control and profit regulation policies.
 Consumer Goodwill: Consumer is the foundation of any business. For maintaining consumer
goodwill, firms have to restrict the profit. By maintaining low profit, the firms may seek the goodwill of
the consumers. Consumer goodwill is valued so much these days that firms often make organised
efforts through advertisements.
 Wage Consideration: Higher profits may be taken as an evidence of the ability to pay higher
wages. If the labour associations come to know that the firms are declaring higher dividends to the
shareholders, naturally they demand higher wages, bonus, etc. Under these circumstances in the
interest of harmonious relations with employees, firms keep the profit margin at a reasonable level.
 Liquidity Preference: Many concerns give greater importance to capital soundness of a firm
and hence prefer liquidity to profit maximisation. Liquidity preference means the preference to hold
cash to meet the day to day transactions. The first item that attracts one’s attention in the balance
sheet is the ratio of current assets to current liabilities. In order to give capital soundness, the
business concerns keep less profit and maintain high cash.
 Avoid Risk: Avoiding risk is another objective of the modem business for which the firms have
to restrict the profit. Risk element is high under profit maximisation. Managerial decision involving the
setting up of a new venture has to face a number of uncertainties. Very often experienced manage-
ments avoid the possibility of such risks. When there is oligopolistic uncertainty, firms may focus
attention at minimising losses. The guiding principle of business economics is not maximisation of
profit but the avoidance of loss.
13.7 ALTERNATIVE PROFIT POLICIES
Economists have suggested different profit policies which business firms may adopt as an alternative
to profit maximisation. These alternative profit policies are listed below:
Prof. K. Rothschild observes, “Profit maximisation has until now served as the wonderful market key
that opened all doors leading to an understanding of the behaviour of the entrepreneur. It was always
realised that family pride, moral and ethical considerations, poor intelligences and similar factors may
modify the results built on the maximum profit assumption, but it was right by assuming that these
disturbing phenomena are sufficiently exceptional to justify their exclusion from the main body of
price theory. But there is another motive which cannot be so lightly dismissed and which is probably a
similar order of magnitude as the desire for maximum profits, namely the desire for secure profits”.
He has suggested that the primary motive of an enterprise is long run survival.
According to him, the assumption of profit maximisation is no doubt valid to the situation of perfect
competition or monopolistic competition. Under monopolistic condition, the aim of the firm is to secure
monopoly profits. In the case of oligopoly, he says that the assumption of profit maximisation is not
sufficient.
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W.J. Baumol puts forth the maximisation of sales as the ultimate aim of the firm. He says while
maximising sales the producer will not regard costs incurred as output and profits to be made. If the
sales of the company increase, it means that the producer is not only covering costs but also making
a usual rate of return on investment. Baumol’s theory of sales maximisation as a rational behaviour of
the producer is considered as an alternative to the theory of profit maximisation.
Benjamin Higgins, Mekin Reder and Tibor Scitovsky have developed another alternative to the theory
of profit maximisation, that of utility maximisation, if the producer is supposed to maximise his
satisfaction. In this approach, they have introduced leisure as a variable. Leisure is an essential
ingredient of an individual welfare. If more work is put in by the producer, the less leisure he will be
able to enjoy. It is said that the producer would get maximum satisfaction where his net profit is
optimum.
Donaldson and Lorsch are of the opinion that career managers prefer policies that favour long term
stability and growth of their firms which are possible only when they get maximum current profits. For
the survival, self sufficiency and success, the top managers strive hard and augment corporate
wealth. The more the wealth, the greater the assurance of the means of survival.
13.8 AIMS OF PROFIT POLICY
The firm seeks to achieve many objectives and profit making is the main objective but it is not the
only objective. Profit making is no doubt necessary. In addition to adequate profit, the firm often
pursues multiple and even contradictory objectives. If a firm makes sufficient profits, it can give good
dividends and attractive salaries, etc. The firm can fix a target rate for profits as its investment. There
is a problem in determining the target rate of profits. They are:
a) Competitive rate of profit is the rate earned by other companies in the same industry or of
selected companies in other industries working under similar conditions. It may be slightly different
from the rate of profit of other companies.
b) Historical rate of profit is the rate of profit determined as the basis of past earnings in the
normal times. The rates should be sufficient enough to attract equity capital, have provided adequate
dividend to share holders and have not encouraged much competition.
c) Rate of profit sufficient enough to protect the equity is the rate sufficient enough to attract
equity capital and the rate of return on investment should protect the interest of present shareholders.
d) Plough back of profit rate is that late of profit which should be such that there is a surplus
after paying the dividends to finance further growth of the industry.
13.9 OPERATIVE ORGANISATIONAL GOALS
Cyert and March have focused on five aims which represent main operative organisational goals.
They are:
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a) Production Goal: The firms want to maintain the production of the product at a stable level to
ensure stable employment and growth. The basic requirement is that the production does not
fluctuate.
b) Inventory Goal: To ensure a complete and convenient stock of inventory throughout the pro-
duction, a minimum level of inventory has to be maintained so that the firm can prevent fluctuations in
prices.
c) Sales Goal: It is considered as very important from the point of view of stability and survival of
the firm. Increasing sales mean progress of the firm. Sales strengthen the organisation. The more are
the sales, the more is the profit.
d) Market Share Goal: Company sales do not reveal how well the company is performing. If the
company’s market share goes up, the company is gaining as a competitor, if it goes down the
company is losing relative to competitors.
e) Profit Goal: Profits are a function of the chosen price, advertising and sales promotion
budgets. Normal profit is essential not only to pay dividends but also to ensure additional resources
for reinvestment.
13.10 MEASUREMENT OF PROFIT
The problem of profit measurement has always been a difficult affair. In the present business world,
the tendency is to discard the word ‘profit’ and use a neutral expression as “business income”. In the
accounting sense, profit is an ex-post concept. Accountants follow conventions and define their terms
by enumeration. Conventional accounting is largely concerned with historical profits rather than
anticipated profits. Economists disagree with conventional techniques and they define their terms
functionally. For an economist, profit is an ex-ante concept. It is a surplus in excess of all opportunity
costs or the difference between the cash value of an enterprise at the beginning and end of a period.
From the management point of view, economic profits are a better reflection of profitability of
business. The economist is basically interested in the theoretical analysis of profit. The most
important points of difference between the economist’s and accountant’s approaches centre on:
i) Inclusiveness of Costs: To determine profits, economists include in costs, wages, rent and
interest for all the services employed in the business, including both those actually paid for in the
market and virtual wage or interest or rent for services rendered by the owner himself. To determine
profits, accountants only deduct explicit or paid out costs from the income. The non-cost items as the
entrepreneurial wages, rental income on land and the interest that the capital could earn elsewhere
do not appear in the books of accounts. The economist s costs of production are a payment which is
necessary to keep resources out of the next best alternative employment. The economist does not
agree with the accountant’s approach. The accountant would only deduct actual costs from the
revenues, the economist points out that in addition to the deduction of actual cost imputed cost
should also be deducted.
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ii) Depreciation: The treatment of depreciation has an important bearing on the measurement of
profit. To the economist, depreciation is capital consumption cost. The cost of capital consumption is
the replacement cost of the equipment. It has various meanings. In the accounting sense, it refers to
the writing off the unamortized cost over the useful life of an asset. In the value sense, it may be
defined as the lessening in the value of a physical asset caused by deterioration. Economists
recognise only two kinds of depreciation charges and they are:
 The opportunity cost of the equipment, and
 The exhaustion of a year’s worth of limited valuable life.
The former includes the most profitable alternative use of it that is forgone by putting it into its present
use, while the latter aims at preserving enough capital so that the equipment may be replaced without
causing any loss. Both these concepts are useful to the management.
iii) Causes of Depreciation: The major causes of depreciation may be classified as follows:
a) Physical depreciation resulting in the decline of the physical usefulness of an asset due to
normal use is frequently known as physical depreciation. The deterioration may be due to abrasion,
shock, vibration, impact and so on.
b) Functional depreciation arises due to economic factors such as suppression, obsolescence
and inadequacy. Here nothing happens to the ability of the asset but the demand for an asset may be
suppressed or it becomes so obsolete or it is not adequate enough to accommodate the demand
placed upon it.
c) Accidental depreciation may be the physical damages caused by fire, explosion, collision
and wind storm are generally insured and there are some normal risks or business such as minor
damages due to natural calamities. All these are, therefore, accounted and treated as depreciation.
iv) Methods of Depreciation: In the economics of an enterprise, the methods of depreciation
occupy a very important role. Depreciation is an important internal source of funds and the method of
depreciation becomes important as a tool of capital accumulation. Different methods are used to
offset depreciation. The main aim of depreciation policy is to reduce the gap between the present
depreciated value of the asset and its present book value. There are many accepted methods of
depreciation and they are:
a) The Straight Line Method: It is the simplest and the most commonly used method of
depreciation. It is otherwise known as proportional or equal installments method. This method is
based on the assumption that the value of an asset declines at a constant rate. The amount of annual
depreciation is calculated by dividing the initial costs of the assets by the estimated life in years,
assuming that there is no scrap value. If the asset has scrap value then the amount should be
deducted from the initial cost.
b) The Unit of Production Method: This method is also known as machine hour rate method. This
method of depreciation is more or less a depletion method. Under this method, instead of counting
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the life of the assets in years, it is estimated in terms of working hours. The speciality of this method
is that it utilises production instead of time as the unit of measurement. According to this method,
capital expenses of the equipment are recovered on the basis of the expected production. This
method is best suited for providing depreciation on costly machine.
c) The Sinking Fund Method: Under this method of depreciation, the amount written off as
depreciation is calculated by means of fixed periodic charges and is deposited in readily saleable
securities at compound interest which accumulates to provide a sum equal to the original cost of the
asset. The securities are then sold and the new asset is purchased with the sale proceeds. This
method is useful if the asset has to be replaced when it becomes a scrap. It is best suited for the
replacement of machinery and plant.
d) The Declining Balance Method: It is differently known as “fixed percentage method or Mathesan
method of depreciation.” Under this method, a constant percentage of depreciation is charged each
year as the value of the asset as it stands in the books at the beginning of the year. The basic idea
behind the use of this method is to provide for a more or less uniform total cost of production of the
asset over different years of its life. Under this method, depreciation is high in the early part of the
asset’s life but it declines in the later years.
e) The Double Declining Balance Method: Under this method, depreciation is provided at a uniform
rate on the book value of the asset as it stands at the beginning of the year. The book value is the
balance of the unamortised cost of the asset as well as depreciation expenses and both go on
declining at a constant rate. Any method of calculating depreciation that allows huge amounts in the
initial years is preferred by management, as it helps in the quick recovery of the major part of the
original investment.
f) The Sum of the Years Digit Method: Previously, this method was known as Cole method. Under
this method, annual depreciation charge also declines each year. The economic advantage of this
method is that it allows one to write off investment very rapidly. The very idea of this method is similar
to that of the declining balance method. The amount of depreciation in the beginning of the life of the
asset is higher and it declines with the span of time. This method is realistic. It takes into account the
immediate drop in the value of the asset and makes the decision to sell and replace the asset earlier
before die expiry of its estimated life.
g) The Revaluation Method: This method is frequently used in the case of small items such as
loose tools, laboratory glassware, livestock, jigs, packages, patterns, etc. where it is not possible to
provide for depreciation on mathematical basis. The method of providing depreciation by means of
periodic deductions each of which is equal to the difference between the value of such assets and
their revalued value at the close of the financial year is considered as the amount of depreciation.
h) The Repair Provision Method: According to this method, the cost of repairs is added to the cost
of the equipment. This method provides for the aggregate of depreciation and maintenance cost by
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means of periodic charges each of which is a constant proportion of the aggregate of the cost of the
asset depreciated and the expected maintenance cost during its life. This method is commonly used
by the public works contractors while hiring their own plants to other contractors. This method not
only deals with depreciation but with repairs and maintenance too.
i) The Retirement Accounting Method: This method stresses that we shall charge the cost of
capital less salvage value as depreciation only when the asset is worn out. This method is considered
one of the most objective methods. The validity of the method is that the total cost of the capital is
charged as depreciation once and for all.
j) Insurance Policy Method: This method is similar to sinking fund method. According to this
method, an endowment policy is taken as the life of the asset so that at the end of a definite period
the insurance company will pay the assured money and with the help of that money a new asset can
be purchased. This method is suitable for leases where the life of the asset is definitely known.
k) The Mileage Method: This method is otherwise known as ‘use method’. This method appears to
be fair as the depreciation charged will be according to the use to which the asset is put. This
technique is followed in the case of those assets the use of which can be measured in terms of miles,
e.g. automobiles. So far we have discussed the different methods of depreciation but not about the
methods used in actual practice. The suitability of methods of depreciation depends on the nature of
assets concerned and their owner’s discretion. But a liberal depreciation policy is helpful to stimulate
capital formation and encourages risky investments.
l) Treatment of Capital Gains and Losses: All the assets of a firm are subject to windfalls due to
inflation or natural calamities or legal judgements. It plays an important role in the economics of a
firm. These changes generally result in larger losses than gains. Conservative concerns never record
such changes. The gains accruing from revaluation of assets are usually transferred to capital
reserves.
Certain concerns add capital gains to the profit of the year in which such gains occur. Capital losses
are charged either to current profits or to retained earnings. Economists are least interested in
recording these windfalls. They are concerned about the future. Economists are of the view that most
of these gains or losses can be foreseen before they are realised.
Conclusion: Thus profit estimates play a pivotal role in business decision. For measuring profits,
accountants rely on historical costs rather than current prices. Economists are concerned with
income, assets and net worth in the future. Gross profits for the economist come much closer to the
accountant’s net profits.
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1. If actual reward is greater than value of risk then the company will face:
a) Loss b) Profit c) Equilibrium Stage d)
Shutdown
2. ______is the residual after the payment of rent, wages, interest.
a) Income b) Tax c) Profit d) Loss
3. Which of the following is the first order condition to profit maximization?
a) TR-TC b) MR-MC
c) MR cuts MC from below
d) All of these
4. Which theory of profit holds that profit will be higher in industries
characterized by a high degree of variability in their revenues or their costs?
a. Risk-bearing theory b. Frictional theory
c. Monopoly theory d. Innovation theory
5. Which theory of profit holds that profit will be higher in industries where
firms in the industry are able to prevent other firms from entering the industry?
a) Risk-bearing Theory b) Frictional Theory
c) Monopoly Theory d) Managerial Efficiency Theory
ACTIVITY 1
Visit the industrial area near to your educational institution and ask from the
financial head or personnel of the firms how they are framing the policies to
manage the profit of their firm. Note down all the important point and in the form
of assignment submit it to the co-coordinator.
13.11 PROFIT PLANNING AND CONTROL

Profit planning is a disciplined method whereby the environments encroaching on an organisation are
analysed, the available resources and internal competence identified, agreed objectives established
and plans made to achieve them. Profit planning is largely routine and covers a definite time span.
Strategy is a word often used in conjunction with profit planning. Profit planning and strategy formula-
tion are complementary. Profit planning is often a reasonable substitute for the fair and imagination
need of the entrepreneurs.
13.12 ESSENTIAL ELEMENTS IN PROFIT PLANNING
The following are the essential elements in profit planning:
 Objectives and results are established and measured at all management levels.
 The role of the chief executive is often vital in ensuring success.
 The system should become the major framework in guiding and controlling management
performance.
 The system should be totally pervasive, especially in framing objectives.
 The system is recognised as the key method of management in the organisation.
 Planners have been trained in economics or associated disciplines.
 Budgeting, cost control, and contribution analyses are the key elements in controlling a profit
plan.
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13.13 STEPS IN PROFIT PLANNING
Some rudimentary form of planning may already be in existence in most organisations. Many of the
techniques used in profit planning may be in use. The following activities will need to be introduced or
improved or enhanced if they are undertaken at present.
Step-1-Establish Suitable Objectives: Objectives can cover many factors of the business survival,
profits or increase in net worth. The way in which objectives are determined is nearly as important as
the types that are pursued. It will be essential to take account of past performance, resource
availability, management competence, environment changes, competitors’ activities and so on.
Objectives should not be imposed.
Step-2-Establish Suitable Control System: Profit planning and control may have grown out of
budgetary control systems. It is necessary to have some form of budgetary cost control, plan monitor-
ing and management information systems which will serve to enable profit planning to be effective.
Step-3-Establishing Job Responsibilities: Often job responsibilities are too imprecise to provide
the information on which performance standards can be established and then judged. It is necessary
to have job breakdowns in such detail that the need for resources can be identified.
Step-4-Carry Out a Situation Audit: It entails an audit of all the factors both internal and external
that will have an influence on company affairs. It should include establishing the skills of competition,
the economic situation which will impinge on company performance and the potential and actual
social, technological and cultural changes to be accommodated.
Step-5-Gap Analysis: This is an activity where the desired company objectives are compared with
the probable results of continuing current trends. A gap will almost certainly be obvious between the
two. Profit planning is largely concerned with how the gap can be closed.
Step-6-Establishing Base Data: Often the base data essential for profit planning is either
nonexistent or set out in a way that is inappropriate for planning purposes. The data include product
and operational costs, production speeds, material utilisation, labour efficiency, etc.
Step-7-Establish Appropriate Plans and Strategies: The management should ensure that there is
plan integration. Strategies are the results of choosing between alternatives in the use of the
company resources through which it is hoped that the corporate objectives will be achieved. They
can be highly complex and appropriate alternatives need to be set out.
13.14 NEED FOR PROFIT PLANNING
The need for profit planning arises:
 To improve management performance.
 To ensure that the organisation as a whole pulls in the right direction.
 To ensure that objectives should be set which will stretch but not overwhelm managers.
 To encourage strict evaluation of manager’s performance in monetary terms.
 To run a company in a more demanding way.
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13.15 AIDS TO PROFIT PLANNING
The following are the aids to profit planning in an organisation:
 Organisation: Profit planning organisation must ensure that it is sensitive to environmental
changes and that such changes are speedily reflected in profit plans. To carry profit planning,
the organisation must be designed accordingly. A high state of expertise is required and this
should be reflected in the profit planning organisation. Involvement and participation are more
important. Wherever possible, decentralisation should be established. It is essential that the
organisation should be dynamic. The organisation must help goal identification and problem
resolution.
 Information System: Management information systems are an essential factor in profit plan-
ning and control. This system must help to provide the means for allocation of resources and
the measurement of results. It should help to identify the various strategy alternatives and help
for the integration of various main plans and sub-plans.
 The Computer: A computer can be applied in profit planning modelling. Information of all
kinds can be obtained much faster than when normal files are used. The computer should be
able to help management to make profit planning decisions. The interactive nature of many
planning decisions can be generated more cheaply. Application programme changes are
simplified and amendments to output requirements take less time and cost.
 Use of Modelling: A model is a representation of a real life situation. A model is fabricating
and integrating the relationships. Models have been used to aid decision making and
forecasting. A model provides an opportunity to manipulate a situation. It is the only way in
which a solution to the problem can reasonably be obtained.
 Planning Techniques: Profit planning should be a management activity that guides the use of
company resources at all management levels. Profit planning can itself be regarded as a
technique. Most techniques used by management services like forecasting, investment
appraisal, risk analysis, decision theory, and organisational development might be applied in
profit planning.
13.16 CONTROL OF PROFIT
The main goal of the business firm is to produce and market the goods and services which satisfy the
buyers and thereby earn a profit sufficient for the survival and growth of business. Profit making is no
doubt an essential function of a business firm. Profit as such is not at all a defective objective. The
future growth of the economy depends upon generation and reinvestment of profit. Profit should
serve as a motivation for expansion, diversification and innovation. Therefore, we need some control
over it. Profit control may be achieved by controlling the internal and external factors which have an
influence on profits. Some planning at a particular level has to be done to achieve this control. For
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this, we have to find out the chief factors which influence the volume of profit. In reality, sales revenue
and the total cost of production are the chief factors which influence the volume of profit.
Profit is usually interpreted as the difference between the total expenses involved in making or buying
of a commodity and the total revenue accruing from its sales. However, sales revenue, the price per
unit of output sold, the total cost of production, the volume of inputs and the price per unit of input are
all interrelated. Similarly, provision of depreciation and taxes create measurement problems in profit
analysis, as they are likely to vary from firm to firm depending on the method of estimation and
taxation laws respectively. A large firm may follow different method of depreciation accounting than a
smaller one.
Let us go back to the profit accounting system. For that the relationship between various factors
mentioned above are to be understood and established. If profit (P) is the difference between the
sales revenue (R) and the total cost of production (C), the relationship is:
P = R-C
P is gross or net profit which depends on what is included in C. We may express С =r. K+D where С
is the total cost of production, r is a rate of return covering depreciation, interest rate and risk
premium appropriate to the industry and К is capital. D is direct cost such as labour cost, material
cost, cost of fuel and power, selling cost, managerial remuneration, etc.
Now the sales revenue (R) is the result of the volume of sale (S), and the price per unit of output sold
is (U),
Therefore, the relationship is: R = S.U
The total cost of production (C) is the result of the price per unit of input (I) and the volume of inputs
(V).
Hence the relationship is: С =I.V
Let us re-write the three equations:
P = R-C
R = S.U
С – I.V
P – (S. U) – (I. V)
To control profits, the volume of sales (S) or the volume of inputs (I) can be manipulated. Therefore, if
a firm wants to increase its profits, it may either increase the volume of sales or reduce the volume of
inputs.
13.17 PROFIT POLICY AND FORECASTING
A project plays two primary roles in the functioning of the economic system. First, the project acts as
a signal to producers to change the rate of output or to enter or leave an industry. Second, profit is a
reward that encourages entrepreneurs to organise factors of production and take risk. High profits in
an industry usually are a signal that buyers want more output from that industry.
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Those profits provide the incentive for firms to increase output and for new firms to enter the market.
Conversely, low profits are a signal that less output is being demanded by consumers or that
production methods are not efficient. Firms may not maximise profit, but they do have a profit policy.
Profit policy and profit planning must go together. The profit policy is more strategy-oriented and the
profit planning is more technique-oriented.
The firm has to consider a lot of short run and long run factors in designing its profit policy. The main
motive of the businessman is to make profits. The profit that a firm makes should not be at the point
of exploitation of consumers. The firm while making profits should also satisfy the requirements of the
consumers. At present, the concept of social obligations has been thrust upon the businessman. The
business community is required to safeguard the health and wellbeing of the society. The business
people should have concern for the public. They should give priority to the goals set by the
government for the betterment of the people. They are expected to solve many social and ecological
problems. There are two issues involved in profit policy decisions and they are:
(i) Setting Profit Standards: Profit standards involve a choice of a particular measure and concept
of profit with reference to which achievements and aspirations may be compared. In profit policy
decision, the task is to decide 011 an acceptable rate of profit. The firm has to consider rate of profit
earned by other firms in the same industry, historical profit rate earned by the firm itself in the past,
rate of profit sufficient to attract equity capital and rate of profit necessary to generate internal finance
for replacement and expansion.
(ii) Limiting the Target Profit: Apart from setting profit standards, the firm should also consider a set
of environmental factors to limit its rate of target profit. The profit target should be limited which
means the shareholders do not ask for higher dividends, the wage earners do not ask for higher
wages, the government does not impose high taxes, the consumers do not ask for lower prices, the
suppliers do not ask for higher rates, and the goodwill of the business is not affected. Profit policy is
programmed through profit planning. Profit planning gives a concrete shape to the profit policy of the
firm.
13.18 PROFIT FORECAST
It is usual to calculate a profit forecast for each major product group or service which an organisation
offers. It presupposes that it is possible to assume what rates of inflation will occur, the market share
the company will obtain and the degree of overall economic activity which the company will enjoy.
Profit forecasting means projection of future earnings taking into consideration all the factors affecting
the size of business profits. It is an essential part of operation planning. The major factors are the
turnover and costs.
a) Turnover: Turnover is the major factor and its element is the product. It must, however, be
emphasised at the outset that the product is the starting point for all planning activities. To a
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manufacturer, the special aspect of a product is most relevant which earns good profit. A higher
turnover indicates a healthier performance.
b) Costs: It is the costs that form the basis for many managerial decisions. It is the level of costs
relative to revenue that determines the firm’s overall profitability. In order to maximise profits, a firm
tries to increase its revenue and lower its costs. The costs can be brought down either by producing
the optimum level of output, using the least cost combinations of inputs or increasing factor
productivities, or by improving the organisational efficiency. The elements of costs are sales cost,
product development, distribution, inventories, production, general administration, depreciation and
reserves.
(i) Sales Costs: Sales costs consist of salesmen’s compensation, sales promotion, market research
and administration. The salesman is the key figure in the economy. Salesmen have to be recruited,
trained, directed, motivated and supervised. There is particular significance in devising a good
compensation plan in the case of salesmen because the functions of selling are such that its results
can be judged in concrete terms. The level of comparison refers to the overall remuneration paid to
salesmen. Of these, the more common forms of payments are: (i) Salary; (ii) Commission; (iii) A
combination of salary and commission; and (iv) Bonus.
 Sales promotion is designed to supplement and co-ordinate personal selling and
advertisement effort. Sales promotion techniques include trading stamps, mail refunds, trade
shows, free demonstrations and sales and displays at retail centres. It is expensive but at the
same times a controllable variable. It does not involve mass media.
 Marketing research has grown into importance very rapidly. It is mainly concerned with
market identification, market size, market share, market segmentation and market trends. It is
a systematic search for information. It involves data collection, analysis and interpretation.
Research cannot drown decisions, but it helps the marketers in the task of decision making. It
is also expensive and time consuming.
 Administration is the policy making function and a top level activity. Administration handles
the current problems arising out of the policies laid down by the management. It requires the
services of a large number of personnel. These personnel occupy the various positions
created through the process of organising.
 Top management is chiefly concerned with performing administrative activities. There are
many decisions which the marketing manager takes which have a significant impact on the
profitability of the firm. The production manager controls a major part of the investment in the
form of equipments, materials and men. The top management which is interested to ensure
that the firm’s long term goals are met, finds it convenient to use the financial statements as a
means for keeping itself informed of the overall effectiveness of the organisation.
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Administration expenses will include all accounting, personnel and legal expenses and office
expenses.
(ii) Product Development: In many organisations, this activity is part of R&D’s responsibility.
However, the need for sales to start in the market place suggests that marketing involvement with
product development should have a good impact on sales revenue and profit. Product development
involves R&D and production engineering.
 R&D implies a function that will promote and defend profitability by maintaining and improving
the company’s position in product design, quality and cost and developing new products,
materials and production methods where the improvement of current products is not
economic. R&D must be used to help to close the gap between the required or desired profit
and that anticipated, after all cost reduction and marketing plans have been made.
 Production engineering co-ordinates search for knowledge in rational manner cutting across
the entire spectrum of integrated management and processing activities to attain optimal
economic objectives of sufficiency. It lays down a disciplined use of strategies for increased
productivity with ensured quality and quantity. Production engineering is the thread of the
garland of flowers of agricultural, civil and architecture; mechanical, electrical and electronics;
metallurgy and mining; chemical and environment; textile; computer and telecommunications;
marine and such others.
(iii) Distribution: When a product has been developed and made ready and its price also
determined, the next task is distribution, to bring it to the market and reach it to the consumer.
Distribution is a key external resource and is much important as the internal operations of research,
engineering and production. It involves two operations and they are:
 Selection of the channel of distribution, and
 Physical distribution. It involves warehousing, packaging and transport.
 The place where the goods are stored is known as warehouse. It implies a house for wares.
Warehouse is a building for the accommodation of goods, possessing facilities to perform
other marketing functions. It is meant for final products. It holds the goods as a distribution
centre. In the warehouse, allied marketing functions such as grading, standardisation,
blending, mixing and packing are performed. It facilitates the user to sell the goods at the best
possible price and thus derive better profit.
 Packaging is an activity which is concerned with protection, economy, convenience and
promotional consideration. The packaging of a consumer product is an important part of the
marketing. It prevents breakage, contamination, pilferage, chemical change and insect attack.
 Attractiveness is a major consideration in modem packaging. A good package stimulates
sales. Packaging is the subdivision of the packing function of marketing. Innovative packaging
can bring large benefits to consumers and profits to producers.
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 Transportation means the physical movement of persons and goods from one place to
another. It is the blood stream of a country’s economy. It is described as physical marketing. It
is the key link between the production and other marketing functions. It develops trade and
commerce. It encourages specialisation, division of labour, large scale production and the
extent of market. It increases the mobility and widens the market. Both consumers and
producers benefit by the extension of the market.
(iv) Inventories: In today’s competitive and ever changing environment, it is essential to hold
adequate stocks to minimise production holdups and win customer satisfaction. Material constitutes a
recurring investment and modem management has recognised that a constant review of inventory
can reduce this capital tied up without limbering the production and customer goodwill. Holding large
stocks will mean high inventory carrying charges and possible losses caused by price declines.
Similarly, shortages in inventories interrupt production, making machines and men idle and causing
sales loss. Hence there is need for inventory control or what is sometimes termed as inventory
planning. It would be appropriate to mention that an effective inventory control system secures
various benefits to the concerned business unit. The purpose of holding inventories is to allow the
firm to separate the process of purchasing, manufacturing and marketing of its primary products.
Inventory planning involves a forecast of unit requirement during the future period. Both a sales
forecast and an estimate of the safety level of support in unexpected sales opportunities are required.
The marketing department should also provide pricing information so that higher profit items receive
more attention.
(v) Production: Production reflects the ability of the organisation to produce whatever is demanded
by the environment. The measures of production include profits, sales, market share, students
graduated, clients served and the like. It is concerned with the supply side of the market.
The basic function of a firm is that of readying and presenting a product for sale, presumably at profit.
While the broader measurement of profit and return as investment will indicate to some extent the
efficiency of the manufacturing units, more appropriate and directly applicable measurements such
as added value and resource utilisation of various kinds are needed. Managers will usually have a
major proportion of the company’s resources under their control. How they delay these resources,
could have a fundamental effect as the profit plan is being made. It involves labour, materials,
manufacturing, overheads and maintenance.
(vi) General Administration: Making policies is the function of administration. In all kinds of
business, the function of administration is the same. Administration personnel are normally engaged
in two activities. First, routine- covering sales order, processing accounting, secretarial duties, filing,
etc. Second, development-activities that can be used to give positive help to other major functions
such as the use of the computer, management accounting development, management services,
various personnel services, etc. The two activities need to be planned but with a different emphasis in
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each case. In a manufacturing organisation, the administration plan should show the relationship
between the cost and numbers of administration staff and those in other functions and activities.
(vii) Depreciation: There are two measures of working capital and they are gross working capital
and net working capital. Gross working capital is the total of current assets. Net working capital is the
difference between the total of current assets and the total of current liabilities. The working capital of
a concern is normally replaced by income from sales and is available to the owners for the payment
of salaries, the purchase of raw materials and the acquisition of productive services. But the originally
invested capital wears out or becomes obsolete with the passage of time.
It cannot be recovered when the usefulness of these assets is exhausted. Businessmen, therefore,
have realised that in order to state business income properly, some provision should be made to
recover that part of the original asset which eventually becomes worthless because of depreciation.
Depreciation means a fall in the quality or value of an asset. An accountant is interested in
accounting, auditing, planning and budgeting profit. The accountant does not take care of opportunity
costs. On the other hand, the economist is very much concerned with the opportunity cost. The
opportunity cost includes the most profitable alternative use of it that is foregone by putting it into its
present use. This concept is useful to the management since it is needed for operating problems of
profit making.
(viii) Reserves: Reserve is an amount set aside out of profits and other surpluses. It is not designed
to meet any existing liability, contingency or diminution of value of assets. Reserves may be divided
into two main classes. Reserves arising from normal profits are known as Revenue Reserves. They
are available for distribution through the profit and loss account. Reserves arising out of unusual
profit such as sale of fixed assets at a profit on revaluation of assets and liabilities are known as
Capital Reserves. There are not generally available for distribution. These are used to write off capital
loss such as loss on sale of a fixed asset, discount allowed on shares or debentures, etc. A Revenue
Reserve may be created out of profits in order to strengthen the financial position of the business.
This is called a ‘General Reserve’. It is a free reserve available for any purpose whatsoever. It may
be used for covering unforeseen losses. It may be even distributed among the proprietors, or it may
be used as an additional working capital.
 Secret Reserve: Where the existence of a reserve is not disclosed by Balance Sheet, it is
called Secret Reserve. It means that the net asset position is stronger than that disclosed by
the balance sheet. Secret Reserves are created by various ways:
 By exclusive depreciation of assets,
 By under valuation or omission of assets,
 By making accessing provision for bad debts, and
 By charging a capital expenditure to revenue.
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 Reserve Fund: When a reserve is created out of profits and a corresponding amount of cost
is withdrawn from the business and invested outside in securities, the reserve is called
Reserve Fund. This depends upon the nature of the business and the purpose of the reserve.
Thus reserve is an appropriation of profits. A reserve can be created only when there are
profits. The object of a reserve is to strengthen the financial position of the business. A reserve
is available for distribution.
13.19 APPROACHES TO PROFIT FORECASTING
Profit forecasting is indispensable for profit planning. It means projecting the future profits assuming
the factors such as growth of the size of the business, the pricing policies of the firm, the cost control
policies, depreciation and others. It is also necessary from the point of view of economic health and
stability of the firm to project for certain years the growth of sales increase in costs and consequently
the profits also. According to Joel Dean, there are three approaches to profit forecasting:
 Spot Projection: It relates to projecting the entire profit and loss for a specified period; say
five years or seven years or ten years. The projection of profit and loss statements for this
period depends on the projection of sales, costs and prices of the same period. Since profits
are surpluses resulting from the forces that shape demand for the company’s products and
govern the behaviour of costs, their predictions are subject to wide margins of error, from
culmination of errors in forecasting revenues and costs, and from the interrelation of the
income statement.
 Environmental Analysis: It relates the company’s profit to key variables in the economic de-
velopment during the relevant period. The key variables are general business activity and
general price level. These are external to the company. These factors are beyond the control
of the firm and force the firm to abandon the profit maximising goal. In reality, factors that
control profit have a tendency to move in regular and related patterns. The controlling factors
of profit are the rate of output, prices, wages, material costs and efficiency. These are all inter-
connected in aggregate business activity. The environmental analysis might show areas where
the company has superior competence or advantage of some kind.
 Break-Even Analysis: The break-even analysis is a powerful tool for profit planning and man-
agement control. Of the three techniques, the break-even analysis is the most important tool of
profit forecasting. The break-even analysis involves the study of revenues and costs of a firm
in relation to its volume of sales and particularly the determination of that volume at which the
firm’s costs and revenues will be equal. The break-even point may be defined as the level of
sales at which total revenues equal total costs and the net income is equal to zero. This is also
known as no-profit no-loss point. The main objective of the break-even analysis is not simply
to spot the ВЕР, but to develop an understanding of the relationship of costs, price and volume
within a company’s practical range.
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13.20 PROBLEMS IN SETTING A PROFIT POLICY
The objectives and aims of a business may be different. In fact, most business concerns like to earn
a target rate of return on their investment. There are four criteria to judge the target rate of return:
 Rate adequate enough to attract equity capital
 Rate earned by other companies in the same industry
 Normal or historical profits rate of return
 Rate sufficient to finance growth from internal sources

6. Which theory of profit holds a firm’s profits can differ from zero only in the
short-run?
a) Risk-bearing Theory
b) Frictional Theory
c) Monopoly Theory
d) Managerial Efficiency Theory
7. Which theory of profit vies as a reward for introducing a new product or
technique?
c) Monopoly Theory
d) Innovation Theory
8. Which theory of profit views profit as a firm's reward for keeping costs below
or revenues above the levels experienced by other firms in the industry?
c) Innovation Theory
d) Managerial Efficiency Theory
9. What social function is served by profits in a free-enterprise system?
a) Taxes on profit support government programs
b) They provide an incentive for the reallocation of resources
c) Profits allows individuals to accumulate wealth and engage in capital
investment
d) Profits result in higher levels of employment
10. The modern theory of the firm holds that firms behave in a way that is
designed to maximize
a) Profit
b) The value of firm
c) Monopoly Power
d) Total Revenue
ACTIVITY2
Search for the essential elements included by the Indian organistions such as
Tata, Birla, Adani and Ambani in their profit planning and forecasting process.
13.21 SUMMARY
Profit is the surplus of revenue over the cost. Every business enterprise desires to maximize its profit.
The condition for profit maximization is the level of output where Marginal Revenue = Marginal Cost.
We have also considered concepts of gross profit and net profit besides profit in accounting sense.
The aim is to maximize profit but if not maximum profit then at least certain satisfactory level of profit.
However, following factors relegate profit maximization policy to the background i.e. threat of entry of
new firms, government interference and tarnishing of the image of the firm.
13.22 GLOSSARY
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 Organizational goals: These are strategic objectives that a company's management
establishes to outline expected outcomes and guide employees' efforts.
 Profit: It describes the financial benefit realized when revenue generated from a business
activity exceeds the expenses, costs, and taxes involved in sustaining the activity in question.
 Profit Forecast: It is a prediction based on the financial data you have available of what your
business income will be at set intervals or a set time in the future.
 Profit Planning: It is the set of actions taken to achieve a targeted profit level. These actions
involve the development of an interlocking set of budgets that roll up into a master budget.
 Profit Policies: It is generally held that the main motive of a firm is to make profits. The
volume of profit made by it is regarded as a primary measure of its success.
 Profitability Control: It allows a company to closely monitor its sales, profits, and
expenditures. Profitability control demonstrates the relative profit-earning capacity of a
company's different products and consumer groups.
13.23 ANSWRERS TO SLEF CHECK EXERCISES
1. b) Profit
2. c) Profit
3. b) MR = MC
4. a) Risk Bearing
5. (c) Monopoly Theory
6. (b) Friction Theory
7. (d), Innovation Theory
8. (d), Managerial Efficiency Theory
9. (b), They provide the incentive for the reallocation of resources.
10. (b), The value of the firm
1. What do you mean by profit? Discuss its need and features.
2. What are the different types of profit? Elaborate with the help of example the various kinds of
profit.
3. Discuss the policies of profits taken into consideration by the business organizations to
manage their profit margin.
4. Elaborate the process and aims of profit policy.
5. Profit planning is essential or not. Explain with the help of suitable example.
6. Why forecasting is significant in profit planning process? Discuss
7. Discuss the various approaches of profit forecasting.
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Publications.

Book Co., Inc.
Cengage Learning.
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CHAPTER 14
RISK AND UNCERTAINTY
STRUCUTRE
14.2 Introduction
14.3 Risk
14.4 Types of Risk
14.5 Measurement of Possibility of Risk
14.6 Uncertainty
14.7 Kinds of Uncertainty
14.8 Degrees of Uncertainty
14.9 Difference between Risk and Uncertainty
14.10 Uncertainty and Investing
14.11 Factors Turning Uncertainty into an Advantage
14.12 Strategies to Cope with Risk and Uncertainty
14.13 Innovation
14.14 Fields of Innovation
14.15 Types of Innovation
14.16 Stages of Corporate Innovation
14.17 Encouraging Innovation in Business
14.18 Protection of Innovations
14.19 Innovation, Risk, Uncertainty and Incentives
14.20 Summary
14.21 Glossary
14.22 Answers to Self-Check Exercises
After studying this chapter, students will able to understand:
 The concept, meaning, types of risk and measurement of possibility of risk.
 The meaning, kinds, degrees of uncertainty.
 Difference between risk and uncertainty
 Factors turning uncertainty into advantages, strategies to cope with risk and uncertainty.
 Meaning, fields, types, stages and encouraging innovation.
14.2 INTRODUCTION
Risk is the chance that an investment's actual outcome will differ from the expected outcome.
Uncertainty is the lack of certainty about an event. A risky situation has more than one possible
outcomes and the risk-taker is aware of all possible outcomes. In an uncertain situation, the precise
nature of these outcomes is not known. For example, A firm with Rs. 100,000 in cash that can be
invested in a 30-day Treasury bill yielding 6 percent (Rs. 493 interest income for 30 days) or used to
prepay a 10 percent bank loan. A retailer can just as easily predict cost savings earned by placing a
given order directly with the manufacturer. Many other important managerial decisions are made
under conditions of risk or uncertainty.
Economic risk is the chance of loss because all possible outcomes and their probability of happening
are unknown. Actions taken in such a decision environment are purely speculative. All decision
makers are equally likely to profit as well as to lose; luck is the sole determinant of success or failure.
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In an uncertain business environment, managers can make informed decisions by limiting the scope
of individual projects and developing contingency plans for dealing with failure. Experience, insight,
and prudence allow managers to devise strategies for minimizing the chance of failing to meet
business objectives - but luck still plays a role in determining ultimate success. When the level of risk
and attitudes toward risk taking are known, the effects of uncertainty can be directly reflected in the
basic valuation model. The certainty equivalent method converts expected risky profit streams to their
certain sum equivalents. Using this technique, discounted expected profit streams reflect risk
differences and become directly comparable.
14.3 RISK
Risk refers to the probability or threat of loss, liability, injury, damage, or any other negative
occurrence resulting from external or internal vulnerabilities, and that may be prevented or avoided
through preventive action. Investors who place their money in high-risk investments expect a high
return in compensation, while those who invest in safer investments expect a low return. Risk is part
of every human endeavor. From the moment we get up in the morning, drive or take public
transportation to get to school or to work until we get back into our beds (and perhaps even
afterwards), we are exposed to risks of different degrees.” Risk analysis programs are designed to
help an organization deal as effectively as possible with existing or potential threats. The four main
elements of risk analysis are:
 Identifying corporate assets and assessing their value.
 Identifying vulnerabilities and threats to the security of those assets.
 Quantifying the probability of those threats and their potential impact on the business.
 Compare the potential economic impact of the threat versus the cost of the countermeasures
required to protect the organization from it.
14.4 TYPES OF RISK
The following are the different types of risk:
 Business Risk: It is the chance of loss associated with a given managerial decision. Such
losses are a normal by-product of the unpredictable variation in product demand and cost
conditions. Business risk must be dealt with effectively; it seldom can be eliminated. In a
globally competitive environment with instant communication, managers face a wide variety of
risks.
 Market Risk: For managers, a main worry is something called market risk, or the chance that
a portfolio of investments can lose money because of overall swings in the financial markets.
Managers must be concerned about market risk because it influences the cost and timing of
selling new debt and equity securities to investors. When a bear market ensues, investors are
not the only ones to lose. The companies unable to raise funds for new plant and equipment
must forego profitable investment opportunities when the cost of financing escalates.
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 Inflation risk: It is the danger that a general increase in the price level will undermine the real
economic value of corporate agreements that involve a fixed promise to pay a specified
amount over an extended period. Leases, rental agreements, and corporate bonds are all
examples of business contracts that can be susceptible to inflation risk.
 Interest-rate risk: It is another type of market risk that can severely affect the value of
corporate investments and obligations. This stems from the fact that a fall in interest rates will
increase the value of any contract that involves a fixed promise to pay over an extended time
frame. Conversely, a rise in interest rates will decrease the value of any agreement that
involves fixed interest and principal payments.
 Credit risk: It is the chance that another party will fail to abide by its contractual obligations. A
number of companies have lost substantial sums because other parties were either unable or
unwilling to provide raw commodities, rental space, or financing at agreed-upon prices.
 Liquidity Risk: Like other investors, corporations must also consider the problem of liquidity
risk, or the difficulty of selling corporate assets or investments that are not easily transferable
at favorable prices under typical market conditions. Another type of risk is related to the rapidly
expanding financial derivatives market. Financial derivative is a security that derives value
from price movements in some other security.
 Derivative risk: It is the chance that volatile financial derivatives such as commodities futures
and index options could create losses in underlying investments by increasing price volatility.
 Cultural risk: It is borne by companies that pursue a global investment strategy. Product
market differences due to distinctive social customs make it difficult to predict which products
might do well in foreign markets. For example, breakfast cereal is extremely popular and one
of the most profitable industries in the United States, Canada, and the United Kingdom.
However, in France, Germany, Italy, and many other foreign countries, breakfast cereal is less
popular and less profitable. In business terms, breakfast cereal doesn’t “travel” as well as
U.S.–made entertainment like movies and television programming.
 Currency risk: It is another important danger facing global businesses because most
companies wish to eventually repatriate foreign earnings back to the domestic parent. When
the U.S. dollar rises in value against foreign currencies such as the Canadian dollar, foreign
profits translate into fewer U.S. dollars. Conversely, when the U.S. dollar falls in value against
the Canadian dollar, profits earned in Canada translate into more U.S. dollars. Because price
swings in the relative value of currencies are unpredictable and can be significant, many
multinational firms hedge against currency price swings using financial derivatives in the
foreign currency market. This hedging is not only expensive but can be risky during volatile
markets.
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 Government Policy Risk: Global investors also experience government policy risk because
foreign government grants of monopoly franchises, tax abatements, and favored trade status
can be tenuous. In the “global friendly” 1990s, many corporate investors seem to have
forgotten the widespread confiscations of private property owned by U.S. corporations in
Mexico, Cuba, Libya, the former Soviet Union, and in a host of other countries.
 Expropriation risk: It is the risk that business property located abroad might be seized by
host governments, is a risk that global investors must not forget. During every decade of the
twentieth century, U.S. and other multinational corporations have suffered from expropriation
and probably will in the years ahead.
14.5 MEASUREMENT OF POSSIBILITY OF RISK
There are two methods of measuring probability of risk:
a) Priori Principle or Deduction Method: Under this method of measuring the probability or
risk, the probability of risk is measured on the basis of imaginary principles. No past experience is
used for help under this method. For example, If a firm is engaged in illegal business, it is all the
times possible that it will come to light and be punished sooner or later. It is always possible to loose
in the transactions of speculation. Now the question arises now is the probability of risk measured? It
can be said in this regard that though there is no certainty of these measurements, however, the
results of these measurements are always expected to be within a certain limit.
b) Posteriori Principle or Past Experience Method: According to this principle of measuring
probability or risk, help of past experiences is taken to measure the probability of risk. This principle is
based upon the assumption that ‘History repeats itself. In other words, it is assumed under this
method that the past incidents will occur again. Therefore, past experience can be used to predict the
probability of risk. Insurance companies determine the rate of premium on the basis of the calculation
of the death rate according to this method.
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1. Which one of the following does measure risk?
a) Coefficient of variation b) Standard deviation
c) Expected value d) All of the above are measures of risk.
2. If a person's utility doubles when their income doubles, then that person is
risk
a) Averse b) Neutral
c) Seeking d) There is not enough information given in the
question to determine an answer
3. Strategy A has an expected value of 10 and a standard deviation of 3.
Strategy B has an expected value of 10 and a standard deviation of 5. Strategy C
has an expected value of 15 and a standard deviation of 10. Which one of the
following statements is true?
a) A risk adverse decision maker will always prefer A to B, but may
prefer C to A
b) A risk neutral decision maker will always prefer C to A or B
c) A risk seeking decision maker will always prefer C to A or B
d) All of the above are correct

4. If a decision maker is risk averse, then the best strategy to select is the one
that yields the
a) Highest expected payoff
b) Lowest coefficient of variation
c) Highest expected utility
d) Lowest standard deviation
5. A risk-return tradeoff function
a) Shows the minimum expected return required to compensate an
investor for accepting various levels of risk.
b) Slopes upward for a risk averse decision maker
c) Is horizontal for a risk neutral decision maker
d) All of the above are correct
ACTIVITY 1
Visit the campus of Himachal Pradesh University, Summer Hill and Analyse and
note the types of risk present in the functioning of whole university.
14.6 UNCERTAINTY
Uncertainty is just opposite to the situation of certainty. Uncertainty is a situation in which the result of
various decisions cannot be predicted and their probability can also not be measured. The term
uncertainty has been defined as under: “Uncertainty has been defined as a state of knowledge in
which one or more alternatives result in a set of specific outcomes but where the probabilities of the
outcomes are neither known nor meaningful.” “Uncertainty is relatively subjective, there being
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insufficient past information, insufficient stability of the structure of variables to permit exact
prediction.” Uncertainty is a situation in which the decision-maker does not know probable results of
the alternatives. Uncertainty is also termed as immeasurable risk. It is the result of imperfect
knowledge about each alternative. In this situation all the decisions are taken in the atmosphere of
uncertainty.
14.7 KINDS OF UNCERTAINTY
A large number of decisions are taken in every business firm on various issues. All the important
decisions of a firm are taken by management with the advice of managerial economist. Success of a
firm depends to a large extent upon the effectiveness of these decisions. However, all the decisions
are taken in an atmosphere of uncertainty. Therefore, it becomes necessary to understand the types
and various areas of uncertainty in which management of a business firm has to take decisions. Main
areas of uncertainty are as follows:
a) Demand Uncertainty: The first and the most important uncertainty faced by management in
the process of decision-making is the uncertainty regarding demand of the products of the firm.
Forecasting of the demand is essential to take decisions regarding production, cost of production,
capital requirements etc. management prepares a demand table and analyses it but that all is done
under uncertainty and is simple a guess.
b) Production Uncertainty: Second most important uncertainty to be faced by management is
regarding production. What should be the quantity of production? What should be the production
schedule? What resources should be employed in production process? How should these resources
be allocated to different production activities? etc., are the questions that create an atmosphere of
uncertainty in the process of decision-making.
c) Profit Uncertainty: As already discussed, main object of every business firm is to earn
maximum profit. Profit is the difference between cost and revenue. Both the cost and revenue are
uncertain. Therefore, what will be the profit of firm, is also uncertain.
d) Price Uncertainty: Determination of price for a product of the firm is the most important
aspect of decision-making process. Success of a business firm depends to a large extent upon this
decision, but pricing decision is affected by a large number of external factors over which the
management can have no control. Therefore, there is an element of uncertainty in pricing decision.
e) Cost Uncertainty: Cost of production is important factor for demanding the price of the
products of a firm. It is also important for determining profit of the firm. Generally, the cost estimates
are based upon the historical cost data available from the records of a firm. Different elements of cost
are always uncertain. Therefore, the element of uncertainty exists in this regard also.
f) Labour Uncertainty: Labour is the force that converts all the decisions and plans of a firm into
actions. Regular supply and efficiency of labour are the factors that determine success of a firm. If the
management faces a problem in getting required labour force at required time or if the workers do not
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Co-operate in the accomplishment of organisational objectives the firm cannot be successful. But the
supply and efficiency of labour are always uncertain.
g) Capital Uncertainty: There are many uncertainties in the field of capital also of a business
firm because capital market is affected by many economical and political factors.
h) Environmental Uncertainty: Decisions of a business firm are effected by many
environmental factors also. Social, economical and political circumstances in which the firm is
operating affect the process of decision-making of a firm but it is never certain to predict these factors
successfully.
14.8 DEGREES OF UNCERTAINTY
Eminent Scholars of Managerial Economists have described following three degrees of uncertainty:
a) Complete Ignorance: Complete ignorance is the situation in which a business executive does
not know anything about future. He is unable in making any prediction of future events. Therefore, he
can decide a problem in the manner that may not be profitable or that may cause loss also to the
firm. On the contrary, his view may be highly profitable to the firm. It is to remember in this regard that
in this situation, all the decisions depend upon logic and rational only. There is no scientific base of
such decisions.
b) Partial Ignorance: Partial ignorance is the situation of uncertainty in which a business
executive is neither fully aware nor fully ignorant of a problem. This is the state between complete
knowledge and complete ignorance. In this situation, uncertainty is converted into risk.
c) Complete Knowledge: It is the situation in which a business executive has full knowledge of
all the facts related with a problem but the probability of alternative results is fully uncertain. In this
situation, the business executive analyses these facts with the help of statistical methods and
techniques. Thus, in this situation decisions are taken with the help of analytical study of relevant
facts.
14.9 DIFFERENCE BETWEEN RISK AND UNCERTAINITY
Risk is basically the possibility of something bad happening. In business and finance, the risk is the
chance that an investment’s actual outcome will differ from the expected outcome. Risks can include
the possibility of losing all or some of the original investment in a business. However, risk can be
calculated to some extent using historical data and market factors. It’s also important to note that the
higher the risk an investor is willing to take, the greater the protentional return. No investment is free
of risks, but there are some investments that have lower practical risks than others. There are two
main types of financial risk; they are systematic risks and unsystematic risks. Systematic risk can
affect the entire economic market or a larger part of the market. This involves interest rate
risk, inflation risk, sociopolitical risk, and currency risk. Unsystematic risks, on the other hand, are a
type of risk that only affects a specific company or industry. This can be due to a change in
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management, new competitors in the market, regulatory changes that would affect sales, a product
recall, etc.
Uncertainty is basically a lack of certainty about an event. In finance and business, uncertainty
implies that there is an inability to predict outcomes or consequences due to some lack of knowledge
or data, which makes it impossible to make predictions. There can be multiple possible outcomes, but
the possible outcomes are also not certain. COVID 19 pandemic situation is an example of making
decisions under uncertainty. When the pandemic first hit, there was a lot of uncertainty – we didn’t
know how to safeguard ourselves, how to continue our daily routine, etc. Uncertainty is different from
risk in that risk can be measured and quantified in advance from historical data. Therefore, risk is
easier to manage, especially if we observe proper measures. We can insure against risks, but not
against uncertainties.
 Definition: Risk is the chance that an investment’s actual outcome will differ from the
expected outcome, while uncertainty is the lack of certainty about an event.
 Potential Outcomes: In risk, potential outcomes are known, but in uncertainty, potential
outcomes are unknown.
 Measurement: Risks can be measured and quantified using theoretical models, but
uncertainty cannot be measured.
 Control: Moreover, risks can be controlled if proper measures are taken at the right time;
however, uncertainty is beyond control.
 Conclusion: Risk is the chance that an investment’s actual outcome will differ from the
expected outcome, while uncertainty is the lack of certainty about an event. The main
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difference between risk and uncertainty is that risk is measurable while uncertainty is not
measurable or predictable.
Example of Risk and Uncertainty: To illustrate the differences between risk and uncertainty, let us
tackle the following example:
Let’s say a gardener puts two different plants in two pots and labels them A and B. Now, he calls an
apprentice gardener and tells him the things to do to plant A, which include putting it under the sun
for several hours a day every day, watering it two times a day, and weeding it every other day. On the
other hand, he says not to do any of these things to the other plant but will give it organic fertilizer to
help it grow. He then asks which of the two will probably live and thrive. Of course, given the
background and the knowledge of the things the gardener will do, the apprentice can weigh which of
the two plants will most probably grow. This is an example of risk. Now, what if the gardener says he
will do nothing to either of the plants and asks the apprentice which he thinks will most likely survive?
The answer would be uncertain because of the lack of sufficient information and the inability to
predict the outcome.
14.10 UNCERTAINTY AND INVESTING
Uncertainty is one concept in finance and accounting that should be deeply understood. Business
owners, as well as investors, want to access credible and honest financial statements during times of
uncertainty. Through generally accepted accounting principles, including those that are from the
Financial Accounting Standards Board, there are now processes that can be used to identify, record,
and disclose uncertainty. Using accounting principles consistently makes it possible to compare
financial records from various periods.
14.11 FACTORS TURNING UNCERTAINTY INTO AN ADVANTAGE
The only thing certain thing about uncertainty is that it can happen anytime, and when it does, no
company is exempt from feeling its effects. Therefore, the most effective thing to do is to prepare for
it and turn it into an advantage. Here’s how:
 Forecasting is essential: Companies who rely on annual budgets are finding themselves in
shallow waters nowadays because the figures may no longer be applicable even before a
specific financial year is over. This is why forecasting and updating plans regularly are
important.
 Shift to automation: Manual collection of data takes up more time than actually analyzing it,
which is why it is often too late when problems are identified. Business organizations should
shift to automation because it cuts the time needed for data collection and analysis.
 Self-service is key: Stakeholders are an important component of an organization, which is
why providing self-service apps is helpful. For example, users can use a specific app that lets
them open their accounts and evaluate the data by themselves. This not only gives them the
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freedom to do so anytime it is convenient for them but it also frees up work for the
organization’s IT team, letting them concentrate on more important processes.
15.12 STRATEGIES TO COPE WITH RISK AND UNCERTAINITY
There are four strategies to deal with risk and uncertainty, which pull together insights from many
different fields of research. The intention is not to design a firm strategy that allows it to survive a
giant meteor strike on earth. An airline may, for instance, determine that it wants to be able to survive
its fleet being grounded for two weeks. These are as under:
 Benchmark Strategy: The first strategy follows the strategy that would be optimal if risky
variables were close to their expected values and uncertainty shocks don’t present a threat to
firm survival. The better the access to capital that the firm has, the greater the shocks the firm
can take on the chin. A firm following this strategy would be doing sensitivity tests, but if the
firm in the end doesn’t let risk and uncertainty considerations affect fundamental decisions of
what it produces and sells, the firm follows the benchmark strategy.
 Financial Hedging Strategy: The essence of financial hedging is that it makes the value of
the firm less sensitive to changes in risk factors. For an airline, we may think of an idealized
situation where by trading in forward contracts on jet fuel the firm is perfectly hedged against
the effects of prices of jet fuel on profits. On the other hand, uncertainty still remains and ash
clouds, terrorists crashing into the World Trade Center or the appearance of a new competitor
are not easily hedged on financial markets. The potential for adverse uncertainty shocks is
therefore the same as in the benchmark. We assume that there is a small cost of setting up
the ability to engage in financial hedging strategy. If risk factors hover around their expected
value, the profits are thus lower under the financial strategy; but if lower tail outcomes
triggered by risk factors are a concern, the financial hedging strategy will be preferred. Note
that it may also be useful to distinguish between two reasons for derivatives use. What
concerns us in this strategy is to avoid costly lower tail outcomes that have a major impact on
firm value, and these are the motivations that have been largely explored in the academic
literature. Another motivation for using derivatives is to make it easier to determine the need
for liquid funds in a firm in the short to medium run. While the latter explanation has not been
the focus of the academic literature, the empirical evidence is largely consistent with this being
an important motivation for derivatives use.
 Flexible Strategy: Consider now the strategy that we term “flexible”. It is a strategy that
explicitly takes account of how risk factors can take on different values and that there will be
shocks due to uncertainty. A firm that follows this strategy tailors operations and processes in
a way so as to be able to quickly respond and make the best of the conditions—it strives to
make profits more responsive to positive shocks and less so to negative shocks; using a
technical term, we would say that it strives to make profits into a convex function of the risk
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factor. This implies that expected profits for a firm increases as conditions become more
variable—by adjusting and making the most of favorable conditions, profits increase in good
times, and in bad times the flexible firm will cut back and thereby limit the harm. Such flexibility
can, for instance, come about via production possibilities (such as being able to rapidly adjust
volumes or input sourcing) or via marketing-related strategies (such as an ability to set
different prices to different consumer groups). The strategy can be seen as a simple way to
capture real options—the essence of which is that they become more valuable as risk
increases. The flexibility can also be generated by choosing to organize lines of control in the
firm to be more flexible. In keeping with standard assumptions in economics, all good things
come at a cost—and we assume that there is a fixed cost of building up the capacity to be
flexible. In the airline setting, flexibility can, for instance, be associated with leasing rather than
owning planes or having a large share of personnel that are on short-term contracts. Having a
diverse fleet of airplanes is another way to gain flexibility, enabling a better fit between local
market conditions and the size of planes. Such flexibility would be associated with higher
maintenance costs. In the figure below, we illustrate such convexity of profits relative to the
benchmark. We consider a case where a “passive” strategy would lead to profits improving
one-for-one with the risk factor and where a flexible strategy implies adjustment—the more risk
factors deviate from their expected values, the greater the difference.
Figure: Comparing Profits under the Flexible and the Benchmark Strategies
 Operational Hedging Strategy: We finally consider the strategy of “operational hedging”.
This refers to ways of adjusting operations or management processes so as to make the
profits of the firm less sensitive to changes in risk factors and uncertainty shocks. One
example of an operational hedging strategy would be to diversify—for an airline to also own
another business that is less sensitive to those risks. An airline that also owned a soft drink
business could thus be an example of operational hedging. Buying planes that are more fuel
efficient would be another way of engaging in operational hedging—if they are costlier to
purchase, they might be less profitable when fuel prices are around average, but they make
profits less sensitive to swings in the fuel price. For instance, in their 2014 article “Does
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Operational and Financial Hedging Reduce Exposure? Evidence from the U.S. Airline
Industry”, Stephen Treanor and coauthors examine the sensitivity of the stock market
valuation to the price of jet fuel of airlines. They find that both financial hedges and fleet
diversity lower the sensitivity; the strongest effect that they find, however, relates to fuel
efficiency and hence to operational hedging.
Figure: Strategy in the Face of Risk and Uncertainity

A long tradition in economics and finance has tried to make progress by in essence treating
uncertainty as risk. This article has hoped to show that there is a promise of a way forward in a
setting that treats them as different, while still keeping the insights on risk that the literature of the last
50 years has brought us.

6. According to Prof Knight, profit is the reward for
a) Innovation b) Capital
c) Foreseeable risks d) Uncertainty bearing
7. The uncertainty-bearing theory of profit was propounded by
a) F. H. Knight b) F. B. Hawley
c) P. A. Samuelson d) Joseph Schumpeter
8. The marginal utility of money diminishes for a decision maker who is
a) A risk seeker b) Risk Neutral
c) A Risk Averter d) In a situation of uncertainty
9. Which of the following is a way to deal with decision making under
uncertainty?
a) Simulation b) Diversification
c) Acquisition of additional information
d) Application of the Maximin criterion
10. A situation in which a decision maker must choose between strategies that
have more than one possible outcome when the probability of each outcome is
unknown is referred to as
a) Diversification b) Certainty
c) Risk d) Uncertainty
ACTIVITY 2
Visit the campus of Himachal Pradesh University, Summer Hill and Analyse and
note the types of uncertainty present in the functioning of whole university.
Suggest the strategies to cope with these uncertainties.
14.13 INNOVATION
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Innovation is the practical application of ideas that result in different new types of new offerings, like
products, services, processes, and business models, intending to improve or disrupt existing
applications or creating new solutions. Innovation can be a confusing topic because there are so
many different kinds of innovations out there and everyone seems to use the term differently.
Although you often hear about innovation in terms of technology and although it’s true that
technological innovation has been, and will likely continue to be, the most obvious form of innovation,
it comes in variety of other forms too.
Most innovations are smaller, gradual improvements on existing products, processes and services
while some innovations can be those ground-breaking technological inventions or business models
that transform industries. Because the environment and the needs of your customers are constantly
changing, you need to be able to improve different areas of your business to solve emerging
problems and to keep creating new value for your customers. Thus, knowing what types of
innovations there are for an organization to pursue can help you discover the ones that are most
suitable for your business. Understanding and focusing on the most potential ones not only helps you
respond to these changing needs but also allows you to improve your ability to grow the business. It
doesn’t matter if you are getting the ideas from outside the organization, through brainstorming,
combining of existing ideas or radical new thinking within your field. But it should be at the heart of
your business and it should constantly be done to ensure business survival.
14.14 FIELDS OF INNOVATION
Innovation can be in different forms and outcomes. When we talk about innovation, most people think
of new products while there is a wide array of different innovation outcomes possible. Here we list the
most common fields:
 Product & Product Performance Innovation: Either a new product is developed or the
performance of an existing product is improved. This kind of innovation is very common in the
business world.
 Technology Innovation: New technologies can be also the basis for many other innovations.
The best example was the Internet, which was itself an innovation but also lead to other
innovations in various fields.
 Business Model Innovation: Many of the most successful companies in the world managed
to innovate their business model. Using different channels, technologies and new markets can
lead to new possible business models which can create, deliver and capture customer
value. Digital ecosystems are a well-known example of innovation using several technologies
and creating a whole new type of business.
 Organizational Innovation: Managing and sharing resources in a new way can also be an
innovation. This way it’s possible to use resources and assets in a completely new way.
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 Process Innovation: Innovation in the processes can improve the efficiency or effectiveness
of existing methods. Possible process innovations involve production, delivery, or customer
interaction.
 Marketing / Sales – New Channel Innovation: New methods to capture and hold attention
from customers either through the use of innovative marketing/sales concepts or the use of
new channels for customer acquisition/sales.
 Network Innovation: By connecting different groups and stakeholders it might be possible to
create extra value. This type of innovation is very common due to the use of ICT services.
 Customer Engagement / Retention: Innovative concepts that try to increase the engagement
of customers and keep the retention up. The goal is to have innovative models to keep the
customers “locked-in” or engaged.
14.15 TYPES OF INNOVATION
First, we need to understand that there are various ways that innovation can have an impact on
products, services, and processes. Most commonly we differentiate between four levels of innovation
depending if they open up new markets or when the technology is changing. The four different types
of innovation are:
a) Incremental Innovation, (Existing Technology, Existing Market): One of the most common
forms of innovation that we can observe. It uses existing technologies within an existing market. The
goal is to improve an existing offering by adding new features, changes in the design, etc. For
example, the best Example for incremental innovation can be seen in the Smartphone market where
the most innovation is only updating the hardware, improving the design, or adding some additional
features/cameras/sensors, etc.
b) Disruptive Innovation, (New Technology, and Existing Market): Disruptive innovation is
mostly associated with applying new technologies, processes, or disruptive business models to
existing industries. Sometimes new technologies and business models seem, especially in the
beginning, inferior to the existing solutions but after some iteration, they surpass the existing models
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and take over the market due to efficiency and/or efficacy advantages. For examples, Amazon used
Internet-Technologies to disrupt the existing industry for book-shops. They had the existing market
for books but changed the way it was sold, delivered and experienced due to the use of disruptive
technologies. Another example was the iPhone, where existing technologies in the market (Phones
with buttons, keypads, etc.) were replaced with touch-interface-centered devices combined with
intuitive user interfaces.
c) Architectural Innovation, (Existing Technology, and New Market): Architectural innovation is
something we see with tech giants like Amazon, Google, and many more at the moment. They take
their domain expertise, technology, and skills and apply them to a different market. This way they can
open up new markets and expand their customer base. For example, Especially digital
ecosystem orchestrators like Amazon and Alibaba use this innovation strategy to enter new markets.
They use existing expertise in building apps, platforms, and their existing customer base to offer new
services and products for different markets. A recent example for this: Amazon recently entered the
medical care field.
d) Radical Innovation, (New Technology, and New Market): Even it is the stereotypical way
most people see innovation; it is the rarest form of them all. Radical innovation involves the creation
of technologies, services, and business models that open up entirely new markets. For example, the
best example of radical innovation was the invention of the airplane. This radical new technology
opened up a new form of travel, invented an industry, and a whole new market.
14.16 STAGES OF CORPORATE INNOVATION
To create a successful and sustainable innovation process, your company needs to go through
different stages of corporate innovation. This includes Idea Generation, Evaluation, Testing and
Experimentation, Development and Implementation, and Optimization. Each stage is important for
the overall success of your innovation initiative. These are as follows;
 Stage-1-Ideation & Idea generation: The process of generating new ideas and drafts. This
stage is all about coming up with new and innovative ways to improve your business, and
services or products. Some common methods for generating new ideas include brainstorming,
customer feedback, new technologies, changing economy or other sources for new ideas. No
matter how you generate them, it’s important to have a steady flow of new ideas to evaluate
and move forward with.
 Stage-2-Evaluation: Many companies skip the step of evaluating their ideas and this can be
costly. Without taking the time to properly evaluate an idea, you may end up investing in a
project that is not feasible or profitable. It’s important to take the time to assess each idea
before moving forward with it, so you can make sure you are investing in projects that have the
greatest potential for success.
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 Stage-3-Testing, Experimenting and MVP: The process of testing an idea to see if it works
in practice. This stage involves prototype development, market testing, and user feedback.
However, it’s important to first start with small-scale MVPs to reduce the risk of investing in a
project that is not feasible or profitable. MVPs are a great way to test an idea without spending
too much time or money on development.
 Stage-4-Development and Implementation: A successful test can give you good first
feedback that can help you create a plan and then execute the full-scale development of the
innovation. After a successful test, it’s important to take that feedback and use it to build out a
development plan. This plan should include all the steps necessary for bringing the innovation
to market. Once the plan is in place, it’s time to execute that plan and bring the innovation to
life. This also involves Marketing, Sales, and Support.
 Stage-5-Optimization & Scaling: After the innovation has been launched, it’s important to
track the performance and optimize where necessary. This stage is all about making sure the
innovation is successful and sustainable in the long term. It involves continual tracking,
analysis, and improvement. Once the innovation is established and performing well, it’s time to
scale it up and bring it to more customers.
14.17 ENCOURAGING INNOVATION IN BUSINESS
Innovation is sometimes a key critical area for the survival of many businesses and industries. But
encouraging your employees to come up with new ideas can be sometimes stressful.
Here are some tips on how to get more innovation going:
 Actively encourage your employees
 Ask customers for feedback/invite customers for feedback rounds
 Ask stakeholders for feedback
 Invest in your employee’s education
 Actively reserve resources for Research and Development (R&D)
 Build a reward system for innovative thinking
 Collaborate with start-ups and innovative companies
 Build an entrepreneurship program
 Do active research on the internet (follow industry news, tech news, etc.)
 Ask / interview experts
Innovation is a calculated risk that needs to be addressed. Not all projects will be successful, and the
company’s process needs to be managed to filter out potential fails before they have a too big impact
on your innovation budget. Try to streamline the process and maybe create your own innovation
program which covers some of the points mentioned above. This way you can manage it better and
get a better overview.
14.18 PROTECTION OF INNOVATIONS
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There are many ways in which you can protect your innovation. We focus here on the 2 major
protection methods which are either “legal protection” or being the market leader due to a “first-mover
advantage”.
a) Legal Protection: Depending on the type of innovation, it might be useful to patent your
invention to monetize it and protect it from others. There also needs to be an understanding of the
cost of patent protection. While the initial cost might not be as high, it can be that the legal costs to
enforce possible patent infringements can skyrocket and make it harder for smaller companies to get
their right. It is also important to understand that not everything can be protected and patented. While
products, processes, and technologies are usually easier to be protected/patented, it’s
harder/impossible to protect software or business models.
b) First-Mover Advantage: Especially software companies make use of the first-mover
advantage. A company that has a new process, new business model, or new product tries to get as
much market share as possible while the competition is still developing its offering. This headstart
gives the first-mover the advantage of incrementally improving the product. This way it’s possible to
grab a market share and offer a better product/service faster than others.
14.19 INNOVATION, RISK, UNCERTAINTY AND INCENTIVES
There is significant potential for policy to boost innovation, and thereby boost economic growth. To
design policy that effectively and efficiently fosters innovation, we must understand how actors along
the innovation chain respond to the risks and incentives they face. “Risk” and “uncertainty” in
economic analyses are often used interchangeably but the American economist Frank Knight
distinguished them along the following lines:
• “Risk” can be thought of as measurable and quantifiable in terms of probabilities, and is most useful
for describing investment in predictable advances further along the innovation chain. Intel’s
investments in chip technology, for example, produce incremental improvements that are predicted
years in advance according to Intel’s “tick-tock” model of chip improvement, where improvements are
reliable enough that the metaphor of a clock fits.
• “Uncertainty” can be thought of as that which is not easily measurable in terms of probabilities,
where we may even be unsure of what possibilities exist. This can be the case in complex, chaotic
systems composed of many interacting elements — and along the innovation chain, “all of the actors
operate under conditions of uncertainty”. This applies especially in early phases of the chain, and in
innovation over the long term.
Being exposed to risk is part of doing business. But some risks are appropriate guides to decision-
making, while others may be unhelpfully imposed. Deciding not to proceed with an innovation
investment because there is a high risk of insufficient demand is a sensible decision — the kind of
decision that firms make routinely in order to maximize their value. Deciding not to proceed with a
very promising innovation because of the risks imposed by regulatory unpredictability (e.g. policy
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risk), lack of appropriability (unclear patent law), or barriers to entry (e.g. incumbent power), is a lost
opportunity. It is through such risk-inducing channels that “government failure” can hamper innovative
activity. The role of government is, rather, to influence the balance of risks, so that actors’ decisions
relate, as much as possible, to the long-term value of innovation investments.

11. Innovation is defined as:
a) The commercialization of a new product or process
b) The invention of a new product or process
c) A new product or process idea
d) The implementation of a new production method
12. Process innovation refers to:
a) The development of a new service.
b) The development of a new product
c) The implementation of a new or improved production method
d) The development of new products or services
13. Innovation can help to provide a temporary competitive advantage when:
a) Barriers to entry are high
b) Barriers to imitation are low and intellectual property rights are
difficult to enforce.
c) There are few other competitors
d) Barriers to entry are low.
14. Following establishment of a dominant design in the product life cycle,
what would you expect to happen?
a) Emphasis on product innovation rather than process innovation
b) Emphasis on process innovation rather than product innovation
c) Competition to increase as new firms enter the industry
d) Competition to decrease as more firms exit than enter the
industry

15. Established firms relative to new firms are better at:
a) All types of innovation.
b) Innovation which is competence-enhancing
c) Innovation which is competence-destroying.
d) Innovation which is disruptive
ACTIVITY 3
Visit the campus of Himachal Pradesh University, Summer Hill and Analyse
innovative aspects used in running the university and discuss with your subject
teacher about the innovative ideas used by the university authorities.
14.20 SUMMARY
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In an uncertain business environment, managers can make informed decisions by limiting the scope
of individual projects and developing contingency plans for dealing with failure. When the level of risk
and attitudes toward risk taking are known, the effects of uncertainty can be directly reflected in the
basic valuation model. Uncertainty is a situation in which the result of various decisions cannot be
predicted and their probability can also not be measured. In this situation all decisions are taken in an
atmosphere of uncertainty. Uncertainty is also termed as immeasurable risk because we have
imperfect knowledge about each alternative. There is significant potential for policy to boost
innovation, and thereby boost economic growth. Policy must understand how actors along the
innovation chain respond to the risks and incentives they face. Some risks are appropriate guides to
decision-making, while others may be unhelpfully imposed.
14.21 GLOSSARY
 Business: It is defined as an organization or enterprising entity engaged in commercial,
industrial, or professional activities. Businesses can be for-profit entities or non-profit
organizations. Business types range from limited liability companies to sole proprietorships,
corporations, and partnerships.
 Economic Uncertainty: It is defined as the situation where future outlook for the economy is
unpredictable. In case of rising uncertainty, agents in the economy are negatively affected
because their expectations are blurred and they are not able to foresee the consequences of
their decisions.
 Innovation: It describes the development and application of ideas and technologies that
improve goods and services or make their production more efficient. A classic example of
innovation is the development of steam engine technology in the 18th century.
 Investigation: It examines the use of fiscal policy in regulating the performance of the national
economy. The investigation begins with a brief reading that discusses the nature, objectives,
and the tools of fiscal policy.
 Risk: It is defined in financial terms as the chance that an outcome or investment's actual
gains will differ from an expected outcome or return. Risk includes the possibility of losing
some or all of an original investment. Quantifiably, risk is usually assessed by considering
historical behaviors and outcomes.
1. (C), Expected Value
2. (b), Neutral
3. (d), All of the Above
4. (c), Highest expected utility
5. (d), All of the above
6. (d), Uncertainty bearing
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7. (a), F. H. Knight
8. (c), A risk averter
9. (a), Simulation
10. (d), Uncertainty
11. (a), The commercialization of a new product or process
12. (c), The implementation of a new or improved production method.
13. (b), Barriers to imitation are low and intellectual property rights are difficult to enforce.
14. (b), Emphasis on process innovation rather than product innovation
15. (b), Innovation which is competence-enhancing.
1. Define the term risk. What the different types of risks associated with business organisations?
Discuss,
2. How can you measure the possibility of risk? Elaborate.
3. Uncertainty and risk both are favourable for business. Do you agree? Comment
4. Elaborate the types and degrees of uncertainty.
5. Distinguish between risk and uncertainty.
6. How can you turn uncertainty into advantage? Discuss
7. What strategies have been used to cope with the risk and uncertainties? Elaborate
8. What is the contribution of innovation in business? Discuss
9. Describe the different types of innovation with suitable examples.
10. What are the various stages of corporate innovation? Elaborate.
11. How encourage innovation in business? Comment
12. Discuss the process of protecting innovation.
13. What is the relationship between risk, innovation and uncertainty? Discuss
Publications.
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
Book Co., Inc.
Cengage Learning.
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CHAPTER 15
BREAK EVEN ANALYSIS
STRUCTURE
15.2 Introduction
15.3 Need for Break Even Analysis
15.4 Importance of Break Even Analysis
15.5 Costs Associated with Break Even Analysis
15.6 Uses of Break Even Analysis
15.7 Assumptions of Break Even Analysis
15.8 Purpose of Break Even Analysis
15.9 Ways to Reduce Break Even Analysis
15.10 Components of Break Even Analysis
15.11 Computation of Break Even Point
15.12 Benefits of Break Even Analysis
15.13 Limitations of Break Even Analysis
15.14 Evaluation of Break Even Analysis
15.15 Summary
15.16 Glossary
15.17 Answers to Self Check Exercises
After studying this chapter, students will able to answer:
 The meaning, concept, need and importance of break even analysis
 The costs associated with break even analysis
 The uses, assumptions, purpose and components of break even analysis
 The ways to reduce break even analysis
 The process of computation of breakeven point
 The benefits and limitations of break even analysis
15.2 INTRODUCTION
Break-even analysis is a tool used by the business organizations to find out the minimum number of
units it needs to sell or the amount of sales revenue it has to generate for meeting up the total cost
incurred. It is the initial judgement on whether the project is viable or not. Break-even analysis is of
vital importance in determining the practical application of cost functions. It is a function of three
factors, i.e., sales volume, cost and profit. It aims at classifying the dynamic relationship existing
between total cost and sale volume of a company. Hence it is also known as “cost-volume-profit
analysis”. It helps to know the operating condition that exists when a company ‘breaks-even’, that is
when sales reach a point equal to all expenses incurred in attaining that level of sales. A break-even
analysis is an economic tool that is used to determine the cost structure of a company or the number
of units that need to be sold to cover the cost. Break-even is a circumstance where a company
neither makes a profit nor loss but recovers all the money spent. The break-even analysis is used to
examine the relation between the fixed cost, variable cost, and revenue. Usually, an organisation with
a low fixed cost will have a low break-even point of sale. Break-even analysis looks to be a very
valuable and useful aid to decision making. Certainly, break-even charts are relatively easy to
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construct and provide managers with information on break-even forecasts, margins of safety and
profit and loss at different output levels. Manipulation of break-even charts can be used to answer;
'what if?' questions and can be part of a strategic analysis, including the setting of prices and
establishing the resource levels required to hit target profits. Break-even analysis is the process of
calculating and evaluating an entity's margin of safety based on collected revenues and
corresponding costs. To put it another way, the research demonstrates how many sales are required
to cover the cost of doing business. The break-even analysis establishes what level of sales is
required to cover the company's total fixed expenses by analyzing various pricing levels in relation to
various levels of demand. A demand-side study would provide a seller with a lot of information about
their selling ability. From stock and options trading to corporate planning for various initiatives, break-
even analysis is widely utilized.
15.3 NEED FOR BREAK-EVEN ANALYSIS
You must be wondering why there is a need for performing break-even analysis. When is it done? To
answer the above queries, let us now understand the three major business decisions which are taken
with the help of break-even analysis:
 Setting Up of New Business: To start a new business, the initial step is finding out the
feasibility of the project. It helps to determine whether the business idea is profitable and also
provides an actual estimation of cost to frame the pricing strategy in a better way.
 Replacing the Business Model: It plays a vital role when the management plans to change
the business model. For instance, the organization decides to convert from an assembling unit
to a manufacturing unit. It needs to clearly understand and interpret the cost involved, output
and prospective revenue and profit, before implementing such decisions.
 Creating New Product: If the organization is planning to launch a new product which involves
huge cost and capital expenditure; it must find out the potential of the product in the market
through break-even analysis.
15.4 IMPORTANCE OF BREAK-EVEN ANALYSIS
The importance of break even analysis is described as under:
 Manages the size of units to be sold: With the help of break-even analysis, the company
or the owner comes to know how many units need to be sold to cover the cost. The
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variable cost and the selling price of an individual product and the total cost are required to
evaluate the break-even analysis.
 Budgeting and setting targets: Since the company or the owner knows at which point a
company can break-even, it is easy for them to fix a goal and set a budget for the firm
accordingly. This analysis can also be practised in establishing a realistic target for a
company.
 Manage the margin of safety: In a financial breakdown, the sales of a company tend to
decrease. The break-even analysis helps the company to decide the least number of sales
required to make profits. With the margin of safety reports, the management can execute a
high business decision.
 Monitors and controls cost: Companies’ profit margin can be affected by the fixed and
variable cost. Therefore, with break-even analysis, the management can detect if any
effects are changing the cost.
 Helps to design pricing strategy: The break-even point can be affected if there is any
change in the pricing of a product. For example, if the selling price is raised, then the
quantity of the product to be sold to break-even will be reduced. Similarly, if the selling
price is reduced, then a company needs to sell extra to break-even.
15.5 COSTS ASSOCIATED WITH BREAK-EVEN ANALYSIS
The following costs have been associated with break even analysis:
 Fixed costs: These costs are also known as overhead costs. These costs materialise
once the financial activity of a business starts. The fixed prices include taxes, salaries,
rents, depreciation cost, labour cost, interests, energy cost, etc.
 Variable costs: These costs fluctuate and will decrease or increase according to the
volume of the production. These costs include packaging cost, cost of raw material, fuel,
and other materials related to production.
15.6 USES OF BREAK-EVEN ANALYSIS
Break-even analysis is not only used for taking strategically decisions but has also proved to be
applicable in day to day business activities. Let us now go through its following uses in business
functions:
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 Goals: Through the break-even analysis, the company can determine the number of units to
be sold or sales revenue to be generated for reaching the break-even point.
 Planning: The further plans of expansion or growth can be set easily if the management
knows what exactly is to be aimed.
 Material: Material management becomes easy with break-even analysis since the company
decides to advance the cost and quality of material to be used as input.
 New Product: Break-even analysis is also used by the management for monitoring the
performance of a new product.
 Prices: It is an essential tool for balancing the cost of a product and setting up a competitive
price. For instance, if the price is low, it becomes difficult for the company to attain a break-
even position on time.
15.7 ASSUMPTIONS OF BREAK-EVEN ANALYSIS
The break-even analysis is based on the following set of assumptions:
 The total costs may be classified into fixed and variable costs. It ignores semi-variable
cost.
 The cost and revenue functions remain linear.
 The price of the product is assumed to be constant.
 The volume of sales and volume of production are equal.
 The fixed costs remain constant over the volume under consideration.
 It assumes constant rate of increase in variable cost.
 It assumes constant technology and no improvement in labour efficiency.
 The price of the product is assumed to be constant.
 The factor price remains unaltered.
 Changes in input prices are ruled out.
 In the case of multi-product firm, the product mix is stable.
15.8 PURPOSE OF BREAK-EVEN ANALYSIS
The purpose of break even analysis is given as under:
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 A break-even analysis is a financial calculation used to identify a company's break-even
point (BEP).It's an internal management tool, not a calculation, that's typically shared with
outsiders like investors or regulators.
 Financial institutions, on the other hand, could ask for it as part of your bank loan
application's financial forecasts. In terms of unit pricing and profit, the calculation considers
both fixed and variable costs.
 Fixed costs are those that do not change regardless of how much of a product or service is
sold. Fixed costs include facility rent or mortgage, equipment expenditures, salaries, capital
interest, property taxes, and insurance premiums, to name a few.
 Variable expenses grow and decrease in response to sales fluctuations. Variable expenses
include direct hourly worker payroll costs, sales commissions, and raw material, utility, and
shipping costs, to name a few. The total of the labor and material expenses required to
create one unit of your product is known as variable costs.
 By multiplying the unit cost by the number of units produced, the total variable cost is
calculated. For example, if producing one item costs Rs. 20 and you make 50 of them, the
total variable cost is Rs.20 x 50 = Rs.1000
 The contribution margin is the difference (more than zero) between the product's selling
price and its total variable cost. If a suitcase is sold for Rs. 125 and the variable cost is
Rs.15, the contribution margin is Rs.110. This margin aids in the offset of fixed expenses.
15.9 WAYS TO REDUCE BREAK-EVEN POINT
Break-even point has a broader scope in business other than just recovering the total cost by
revenue. A minimum break-even point is considered to be optimal for the company. Following are
some of the means to reduce the break-even point:
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 Cost Analysis: The total cost of a product can be decreased by eliminating the unwanted
fixed and variable cost, which ultimately increase the profitability and reduces the break-even
point.
 Price Analysis: Keeping control over the price of the products by reducing discounts and
other coupons is another means since it accelerates the break-even point.
 Margin Analysis: Another method is monitoring the profit margin. Thus, taking essential steps
to boost the sales of those products which have a high margin to minimize the break-even
point.
 Technology Analysis: Break-even point can also be reduced by implementing the latest
technology in the business, which increases an organization’s productivity and performance at
a minimal cost.
 Outsourcing: One of the most effective ways is to reduce fixed cost by outsourcing a product
or service which was earlier being produced by the company itself. This will convert such fixed
value into a variable cost, charged per unit.
15.10 COMPONENTS OF BREAK-EVEN ANALYSIS
Break-even analysis is done by establishing a relationship between three significant elements of a
project, i.e., costs, revenue and contribution margin. Let us go through each of these components in
detail below:
 Costs: The total expenses incurred on a project or product is its cost. It can be categorized as
follows:
a) Fixed Costs: Those costs which remain the same throughout irrespective of the sales
or revenue are known as the fixed costs, e.g. rent, interest, depreciation, etc.
b) Variable Costs: The expenses which are progressive with the increasing sales and
production volume are called variable costs, e.g. raw material, fuel, electricity, etc.
 Revenue: The return generated from the sales of a product during a particular period is
termed as revenue. In simple terms, it is the total sales value or amount.
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 Contribution Margin: Contribution margin is the ratio of the revenue available for meeting
fixed costs per unit to the sales price of each unit.
15.11 COMPUTATION OF BREAK-EVEN POINT
A break-even point is that position where a business entity can recover its cost through the revenue it
generates from the sales. Here, we can say that the company is now able to meet its expenses
through its sales revenue. BEA is the means to identify the effect of variation in sales volume on the
cost, revenue and profitability of a project or a product. It consists of several calculations, based on
which the business organizations determine the feasibility and viability of starting a new project or
producing a new product. It is just an estimation of sales and does not determine the actual revenue
generated by the products or projects. Break-even point is that point of sale where the revenue
generated by the company is equal to the total cost incurred by it. It is a position where the
organization is at a no-profit no loss situation. Break-even analysis is an essential tool in the hands of
the business experts, management, financial experts and professional for determining the success
possibilities of a project on various parameters. These parameters can be better understood in the
following discussion:
With the help of the above diagram, we can identify that the break-even point is where the company
can meet its expenses from the sales revenue it generates.
a) Break-Even Point: Break-even point is that point of sale where the company can meet the
project’s cost from the revenue generated by that particular project. The formula for determining the
break-even point is as follows:
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Or
Or
The number of units denotes break-even point.

b) Cash Break-Even Point: We know that it is quite challenging for the new projects to attain the
break-even point in the first few years of business. Therefore, for the concept of cash break-even
point was introduced where the total revenue generated is equivalent to the total cash expenditure
incurred. Following is the formula to calculate the cash break-even point:
Where,
and,
In the above equation, an adjustment is made, i.e., depreciation which was previously included in the
total cost is deducted from it, to exclude it in the total cash cost.
c) Contribution Margin Ratio: This ratio provides the percentage of the sales revenue
generated from the project, which is available to meet its fixed cost. The formula for finding out the
contribution margin ratio is as follows:
It is denoted in the percentage value.

d) Contribution Margin per Unit: Contribution refers to the amount of sales revenue which is
available to pay off the fixed cost of the project after meeting the variable cost. Per unit contribution
margin determines the amount available for meeting the fixed cost of each unit of the product. Let us
see the equation for calculating the contribution margin per unit:
It is denoted in the amount.

e) Margin of Safety: the actual sale made over the break-even point, which generates profit is
considered as the margin of safety. The formula for the margin of safety is depicted below:
It is merely the difference between the total sales and the sales at the break-even point, denoted in
amount.
204
f) Margin of Safety Ratio: The percentage representation of the margin of safety is called a
margin of safety ratio. Its formula is as follows:
It indicates the profitability and strength of a business. It also helps to find out whether the company
is financially sound and can keep up even after a slight fall in sales.
g) Profit Volume Ratio: The profit volume ratio depicts the percentage of contribution generated
from the sales of the product. The formula of P/V ratio is:
Higher the P/V ratio better is the profitability of the business.

h) Composite Break-Even Point: Now, we can also determine the break-even point for the
business units manufacturing multiple products. The related equation is given below:
The composite break-even point denotes sales revenue which a firm needs to generate for meeting
up its total cost.
For Example: XYZ Ltd. manufacture bags and the selling price is ₹100 per bag. If ₹200000 is the
fixed cost, and the variable cost increases proportionately to the sales, costing ₹50 per unit. Also,
₹20000 was charged as depreciation. The following table explains the sales revenue and the number
of units sold:
UNITS SOLD REVENUE

1000 100000
2000 200000
3000 300000
4000 400000
5000 500000
6000 600000
7000 700000
8000 800000
With the help of the above data, calculate the break-even analysis.
Break Even Point=Fixed Cost/(Sales Price-Variable Cost)
Break Even Point=200000/(100-50)
Break Even Point=4000 units
Cash BEP=Cash Fixed Cost/Cash Contribution Per Unit
Cash BEP=180000/55
Cash BEP=3273 units (rounded off)
205
Cash Fixed Cost=Fixed Cost-Depreciation
Cash Fixed Cost=200000-20000
Cash Fixed Cost=₹180000
Cash Contribution Per Unit=Sales Price Per Unit-(Variable Cost Per Unit-Depreciation Per Unit)
Cash Contribution Per Unit=100-[50-(20000/4000)]
Cash Contribution Per Unit=100-(50-5)
Cash Contribution Per Unit=₹55
Contribution Margin Ratio=(Contribution Margin Per Unit/Sales Price Per Unit)x100
Contribution Margin Ratio=(50/100)x100
Contribution Margin Ratio=50%
Contribution Margin Per Unit=Sales Price Per Unit-Variable Cost Per Unit
Contribution Margin Per Unit=100-50
Contribution Margin Per Unit=₹50
Margin of Safety=Total Sales-Sales at Break Even Point
Margin of Safety=800000-(100×4000)
Margin of Safety=₹400000
Margin of Safety Ratio=(Margin of Safety/Sales)x100
Margin of Safety Ratio=(400000/800000)x100
Margin of Safety Ratio=50%
Profit Volume Ratio=(Contribution/Sales)x100
Profit Volume Ratio=(400000/800000)x100
Profit Volume Ratio=50%
Contribution=Total Sales Price-Total Variable Cost
Contribution=800000-(50×8000)
Contribution=₹400000
Suppose the manufacturer expands his business and now sells three products, i.e., bags (as given
above), t-shirts and track pants. The related data is given in the below table:
TOTAL FIXED TOTAL TOTAL

PRODUCTS
COST (₹) CONTRIBUTION (₹) SALES (₹)
Bags 200000 400000 800000
T-Shirts 300000 600000 1200000
Track Pants 500000 1000000 2000000
Total 1000000 2000000 4000000

Find out the Composite Break-Even Point.
Composite Break Even Point=Total Composite Fixed Cost/Composite Profit Volume Ratio
206
Composite Break Even Point=1000000/50
Composite Break Even Point=₹20000
Composite P/V Ratio=(Total Composite Contribution/Total Composite Sales)x100
Composite P/V Ratio=(2000000/4000000)x100
Composite P/V Ratio=50%
Break-Even Chart
Break-even analysis of the above example can be better understood with the help of the following
graph:
In the above diagram, we can identify the break-even point at (4000, 400000) where the total sales
and total cost cut each other. Moreover, the contribution margin also includes the profit generated by
the business.
Break-Even Analysis Formula: Break-even point = Fixed cost/-Price per cost – Variable cost
Example of break-even analysis: Company X sells a pen. The company first determined the fixed
costs, which include a lease, property tax, and salaries. They sum up to ₹1,00,000. The variable cost
linked with manufacturing one pen is ₹2 per unit. So, the pen is sold at a premium price of ₹10.
Therefore, to determine the break-even point of Company X, the premium pen will be:
Break-even point = Fixed cost/Price per cost – Variable cost
= ₹1,00,000/(₹12 – ₹2)
= 1,00,000/10
= 10,000
207
Therefore, given the variable costs, fixed costs, and selling price of the pen, company X would need
to sell 10,000 units of pens to break-even.
15.12 BENEFITS OF BREAK-EVEN ANALYSIS
The following are the benefits of break even analysis: -
 Pricing: Break-even analysis is a very valuable technique for a corporation, and it has a lot of
benefits. It demonstrates how many things they must sell in order to make a profit. It
determines if a product is worth selling or is too dangerous to sell. It indicates how much
money the company will make at each level of output.
 Gaining funds: When it comes to collecting financing, break-even analysis is usually an
important part of a company's strategy. If you want to get funding for your firm or startup, you'll
almost certainly need to do a break-even study. Furthermore, a low break-even point will likely
help you feel more at ease about taking on extra debt or funding.
 Setting revenue targets: A break-even analysis may also be a useful tool for determining
precise sales goals for your team. When you have a precise quantity and a timeframe in mind,
it's typically easier to decide on revenue goals.
 Reduce risk: Some company concepts are simply not intended to be followed. Break-even
analysis can help you reduce risk by guiding you away from investments or product lines that
are unlikely to be successful.
 Relying on accurate data: Costs can sometimes be classified as both fixed and variable. This
can make computations difficult, and you'll almost certainly have to fit them into one of the two.
Correct data is required for your break-even point to be accurate. You won't obtain a
trustworthy result if you don't enter good data into the calculation.
 Competitors are ignored: As a newcomer to the market, you will have an impact on rivals
and vice versa. They might modify their pricing, affecting demand for your goods and forcing
you to adjust your prices as well. If they expand swiftly and a raw resource that you both use
becomes scarce, the price may rise. Finally, break-even analysis will provide you with a firm
knowledge of the prerequisites for success. It's a must-have. However, it isn't the only study
you should conduct before beginning or changing a firm.
 Pays of fixed expenses: Most people think about price in terms of how much it costs to make
their product. These are referred to as variable costs. You must still pay for fixed expenditures
like insurance and web development. You may achieve this by performing a break-even
analysis.
 Make better choices: Entrepreneurs frequently make decisions based on their emotions. If
they are enthusiastic about a new enterprise, they will pursue it. It's necessary to know how
you feel, but it's not enough. Entrepreneurs that are successful make judgments based on
208
facts. When you've put in the effort and have meaningful data in front of you, making a
decision will be much easier.
15.13 LIMITATIONS OF BREAK-EVEN ANALYSIS
The following are the limitations of break even analysis:
 The assumption behind break-even analysis is that all costs and spending can be clearly
divided into fixed and variable components. In reality, however, a clear distinction between
fixed and variable expenses may be difficult to make.
 Assuming that the selling price remains constant results in a straight revenue line, which may
or may not be accurate. The selling price of a product is determined by a variety of factors
such as market demand and supply, competition, and so on, and it seldom remains constant.
 In actuality, it's rare to discover the assumption that just one product will be created or that the
product mix would remain stable.
 It presupposes that production and sales quantities will be equal, and that there would be no
change in the opening and closing stock of completed goods; however, this is not true in
actuality.
 The quantity of capital used in the firm is not taken into account in the break-even analysis. In
reality, the amount of capital utilized is a key factor in determining a company's profitability.
 It is proven to be inappropriate in sectors such as shipbuilding. If fixed expenditures are not
taken into account while valuing work in progress, losses may occur each year until the
contract is finished. It may result in income tax issues.
 A corporation may choose to place an excessive order at a cheaper price based on the
marginal cost concept, ignoring plant capacity. It may entail extra labor and the expansion of
manufacturing capacity, both of which might raise production costs and cause changes in fixed
expenses. Often, the company will lose money.
 Fixed costs are assumed to be constant at all levels of activity. Fixed expenses, it should be
mentioned, tend to vary after a given degree of activity.
 It is assumed that variable costs are proportional to output volume. They move in correlation
with production volume in practice, although not always in exact proportions.
 Sales income and variable expenses do not grow in lockstep with the production value. They
are less proportional than they should be at greater levels of output. This is due to trade
discounts, bulk buying economies, concessions for bigger sales, and so on. (source)
 The distribution of fixed costs across a number of items is problematic, and it believes that
business circumstances will remain constant, which is not the case.
15.14 EVALUATION OF BREAK-EVEN ANALYSIS
209
Examiners like break-even questions as they are relatively easy to set, and require students to show
numeracy skills. However, there are many assumptions in the break-even process that may limit its
usefulness:
 All output is sold: break-even works on the basis that all output is turned into sales revenue.
In reality, firms will have stocks of unsold items at any one time, unless they can work on a
purely just-in-time basis.
 One product and price: most businesses sell more their products at different prices in
different markets and to different customers. Customers who buy in bulk, for instance will be
entitled to a discount. Break-even ignores all economies of scale.
 Straight line costs and revenue curves: if a firm is forced to adopt lower prices at higher
output because the market is becoming saturated, then the revenue curve will not be a straight
line. Similarly a firm's average variable costs are likely to be lower at higher outputs as it can
negotiate a discount from its suppliers. The straight line assumption also means that semi-
variable costs are assumed to be directly proportional to output and in essence are just
lumped together with other variable costs - in fact the term semi-variable is not used at all.
 A static model where variables change independently of each other: in reality, the
business world is dynamic and any increase in output and any change in costs is likely to
impact on price levels. Break-even, like a balance sheet is only a snapshot of a situation at a
particular point. Increasing shortages of energy, for example, will result in some significant
increases in both variable and fixed costs.
 Not all costs can be easiliy classified as fixed or variable:
 The result is no more accurate than the accuracy of the original data it is based
on.
 It ignores all factors other than costs and revenues: production is also
affected by the availability of finance, people and management influences, competitive
action etc. For example, maximising production may place excessive pressure on staff
and may require existing employees to work overtime, so changing the cost base.
 Reactions of competitors: break-even analysis ignore the fact that competitors
may change their products/and or prices.
210
SELF CHECK EXERCISE
1. The Break-even Point of a company is that level of sales income which
will equal the sum of its fixed cost.
a) True b) False
2. Which of the following are characteristics of B.E.P?
a) There is no loss and no profit to the firm.
b) Total revenue is equal to total cost.
c) Contribution is equal to fixed cost.
d) All of the above.
3. While measuring break-even analysis, it is considered that during a
specific period there will be no change in general price level, i.e., labor,
cost of material and other overheads.
a) True b) False
4. Which of the following are limitations of break-even analysis?
a) Static concept
b) Capital employed is taken into account.
c) Limitation of non-linear behavior of costs
d) Limitation of presence of perfect competition
5. Break-even analysis is used in “Make or Buy” decision.
a) True b) False
6. Using equation method, Break-even point is calculated as
a) Sales = Variable expenses + Fixed expenses + Profit
b) Sales = Variable expenses + Fixed expenses - Profit
c) Sales = Variable expenses - Fixed expenses + Profit
d) None of the above
7. Given selling price is Rs 10 per unit, variable cost is Rs 6 per unit and
fixed cost is Rs 5,000. What is break-even point?
a) 500 units b) 1,000 units c) 1,250 units
d) None
8. Contribution is also known as
a) Contribution margin b) Net Margin
c) Both a and b d) None of the above
9. Given selling price is Rs 20 per unit, variable cost is Rs 16 per unit
contribution is
a) Rs 1.25 per unit b) Rs 4 per unit
c) Rs 0.8 per unit d) Rs. 4.10 per unit
10. At breakeven point
a) Total expenses = Total revenue
b) Total expenses > Total revenue
c) Total expenses < Total revenue
d) None of the above
ACTIVITY
Draw the Break Even Point for the Himachal Pradesh University by taking into
consideration the essentials elements required for break even analysis.
15.15 SUMMARY
Break-even is a circumstance where a company neither makes a profit nor loss but recovers all the
money spent. Usually, an organisation with a low fixed cost will have a low break-even point of sale.
Break-even analysis looks to be a very valuable and useful aid to decision making. Break-even
211
analysis is the process of calculating and evaluating an entity's margin of safety based on collected
revenues and corresponding costs. It establishes what level of sales is required to cover the
company's total fixed expenses. Manipulation of break-even charts can be used to answer; 'what if?'
questions.
15.16 GLOSSARY
 Break-even analysis: It tells you how many units of a product must be sold to cover the fixed
and variable costs of production. The break-even point is considered a measure of the margin of
safety. Break-even analysis is used broadly, from stock and options trading to corporate budgeting
for various projects.
 Break-even point: It is the level of production at which the costs of production equal the
revenues for a product.
 Contribution Margin: It is computed as the selling price per unit, minus the variable cost per
unit.
 Cost: It is the value of money that has been used up to produce something or deliver a
service, and hence is not available for use anymore. In business, the cost may be one of acquisition,
in which case the amount of money expended to acquire it is counted as cost.
 Economic Loss: It can be caused by a number of different situations, and range in severity
depending on each individual case. Economic loss leans toward the side of facts and figures and is
more “clear-cut” when compared to non economic loss.
 Fixed costs: These are costs that do not vary with the amount produced. Examples are
interest on debt, property taxes and rent. Context: Economists also add to fixed cost an appropriate
return on capital which is sufficient to maintain that capital in its present use.
 Margin of safety: It is a principle of investing in which an investor only purchases securities
when their market price is significantly below their intrinsic value. In other words, when the market
price of a security is significantly below your estimation of its intrinsic value, the difference is the
margin of safety.
 Profit: In business usage, the excess of total revenue over total cost during a specific period
of time. In economics, profit is the excess over the returns to capital, land, and labour (interest, rent,
and wages).
 Revenue: The income that a firm receives from the sale of a good or service to its customers.
 Sale: It is a transaction between two or more parties in which goods or services are
exchanged for money or other assets. In the financial markets, a sale is an agreement between a
buyer and seller involving the price of a security and its delivery for agreed-upon compensation.
 Variable cost: It is a corporate expense that changes in proportion to how much a company
produces or sells. Variable costs increase or decrease depending on a company's production or
sales volume—they rise as production increases and fall as production decreases
212
15.17 ANSWERS TO SLEF CHECK EXERCISES
1. (a), True
2. (d), All of the above
3. (a), True
4. (a), Static concept,
5. (a), True
6. (a), Sales = Variable expenses + Fixed Expenses + Profit
7. (c), 1250 units
8. (a), Contribution margin
9. (b), Rs. 4 per unit
10. (a), Total Expenses = Total revenue
1. What do you understand by break even analysis? Discuss its need and significance.
2. There are various costs associated with break even analysis. What are those? Explain with the
help of suitable examples.
3. What are the uses and assumptions of break even analysis? Discuss
4. Elaborate the purpose of using break even analysis.
5. Discuss the various components of break even analysis.
6. How you can compute the breakeven point? Discuss the process of computation of BEP.
7. What are the pros and cons of break even analysis? Enumerate
8. How you can evaluate the break even analysis? Elaborate.
Publications.

Book Co., Inc.
213
Cengage Learning.
ASSIGNMENTS
Note: Attempt 75% of the assignment questions
1. Discuss the nature, scope and importance of managerial economics.
2. What do you understand by Demand? What are its determinants? Discuss the factors which
affect demand.
3. Discuss the significance and objectives of elasticity of demand.
4. What is demand forecasting? Discuss it techniques.
5. What do you understand by Production Function? Discuss its theories in brief.
6. Do you agree that Inflation affects the economy of a country? Discuss.
7. Discuss the importance of Fiscal Policy and Monetary Policy.
214
SAMPLE QUESTIONS
Class: M.COM. (New Syllabus) Subject: MANAGERIAL ECONOMICS PAPER - MC
103 Time: Three Hours Maximum Marks: 80
Instruction 1: The Candidate shall limit their answers precisely within the Answer-Book (40 pages) issued
to them and no Supplementary/Continuation sheet will be issued. So try to attempt all the answers in the
sheets specified in you booklet.
Instruction 2: Dear candidate you have to attempt any five questions from the given questions. All
question carry equal marks.
The sample questions are as follows:
1. ‘‘Managerial Economics is the integration of economic theory with business practice for the
purpose of facilitating decision making.’’
2. Define the concept of Elasticity of Demand. Explain the relation between Price Elasticity of
Demand, Average Revenue and Marginal Revenue.
3. Discuss the utility of ‘Demand Forecasting’. What are possible approaches for forecasting the
demand of new product?
4. Explain the law of increasing returns. Explain how increasing returns and perfect competition
can’t co-exist.
5. Define Price Discrimination. How is price determined under discrimination monopoly?
6. ‘‘Pricing in practice is completely divorced from the theory of the firm. ‘Explain with special
reference to Dual Pricing.’’
7. What is a Business cycle? Discuss critically the Hicksian theory of Business Cycle.
8. Explain Clearly : i) Demand Pull and Demand Shift inflation, and (ii) Cost push inflation
9. Among the multiplicity of objectives that a modern firm has profit maximisation continues to be
the most important. ‘Comment.
10. Write short notes on the following: i) Superiority of Revealed Preference Theory (ii) Cobb-
Douglas Production Function.
11. What are the basic functions of a Manager? How does managerial economics help him in
achieving his organisational goals?
12. Explain and illustrate Hicksian and Slutskian methods of decomposing income and substitution
effects of price effect.
13. What is indifference curve? What are its properties? What role does it play in consumer
analysis?
14. Distinguish between laws of returns to variable proportions and laws of return to scale. Explain
the
15. Factors which cause increasing returns to scale. What are the reasons for the operations of
law of the diminishing return?
16. What are the characteristics of Perfect Competition? Distinguish between ‘pure’ and ‘perfect’
competition.
17. What is transfer pricing? How is transfer price determined if: i) there is no external market for
the transfer product, and ii) there is external market for it?
18. Describe briefly the main functions of monetary and fiscal policies. Which of the two policies is
more effective in controlling trade cycle in a developing economy?
215
19. Write short notes on the following: i) Demand Pull and Demand Shift Inflation, and ii) Cost
Push Inflation.
20. Examine critically profit maximisation as the objective of business firms. What are the
alternative objectives of business firms?
21. Write short notes on the following: i) Discriminating monopoly; ii) Utility of Demand
Forecasting.
22. Define managerial economics and discuss the role and responsibilities of managerial
economist.
23. Explain the elasticity of demand and examine its different types. Discuss the role of price
elasticity of demand in business decisions.
24. Enumerate and explain the properties of indifference curves with the help of suitable diagrams.
How will you measure substitution effect with the help of indifference curve?
25. What is the meaning of Demand Forecasting? Which factors affecting demand forecasting for
a new SUV Vehicle?
26. Describe the main features of Perfect Competition. Discuss fully how the value is determined
under the perfect competition?
27. Explain the concept of Business Cycles. What are the monetary and non-monetary factors
which affect business cycles?
216

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M.Com.

1st Semester Course: MC-103

Discipline Specific Course (DSC)

By: Rajneesh Kumar

International Centre for Distance Education and Open Learning (ICDEOL)

Self Check Exercise 1

1.6 MICROECONOMICS AND MACROECONOMICS

a) Microeconomics: It is a branch of economics that deals with the study of economic

Self Check Exercise 2

1.7 MANAGERIAL ECONOMICS: DEFINITIONS

Self Check Exercise 3

1.10 DIFFERENCE BETWEEN ECONOMICS AND MANAGERIAL ECONOMICS

 Managerial Economics: It is an applied Economics in the field of business management. It is an

1.14 ANSWERS TO SELF CHECK EXERCISE

4) a) It helps in understanding the mechanism of individual markets.

 Adhikary, M. Managerial Economics. Khosla Educational Publishers.

2.4 PROFIT: MEANING AND EXPLANATION

Self Check Exercise 2

2.5 THEORIES OF PROFIT

Self Check Exercise 3

2.6 CONCLUSION: THEORIES OF PROFITS

Self Check Exercise 4

2.10 FUNCTIONS PERFORMED BY MANAGERIAL ECONOMIST IN INDIAN CONTEXT

 Adhikary, M. Managerial Economics. Khosla Educational Publishers.

b) Substitution effect on demand: If y is a substitute of x, then as price of y increases, demand

Self Check Exercise 1

3.5 THE LAW OF DEMAND

Self Check Exercise 2

In the given figure, price and quantity demanded are measured

3.13 METHODS OF MEASURING PRICE ELASTICITY OF DEMAND

b) Total Outlay Method

The average of price and quantity demanded is calculated as follows:

3.14 IMPORTANCE OF PRICE ELASTICITY OF DEMAND

Self Check Exercise 3

 Adhikary, M. Managerial Economics. Khosla Educational Publishers.

Self Check Exercise 1

4.4 OBJECTIVES OF DEMAND FORECASTING

Self Check Exercise 2

4.5 IMPORTANCE OF DEMAND FORECASTING

4.7 STEPS IN DEMAND FORECASTING

Self Check Exercise 3

4.8 TECHNIQUES OF DEMAND FORECASTING

calculated as follows: Dp= D1, + D2, + D3 +….Dn

Self Check Exercise 4

 Adhikary, M. Managerial Economics. Khosla Educational Publishers.

SELF CHECK EXERCISE 1

5.5 ECONOMIC PLANNING: INTRODUCTION

SELF CHECK EXERCISES 2

 Adhikary, M. Managerial Economics. Khosla Educational Publishers.

Self Check Exercise 1

Figure (a) Isoquants Lines Figure (b) Isocost Lines

6.9 LAW OF VARIABLE PROPORTIONS (OR RETURNS TO A FACTOR)

The diagram explains the law of variable

6.9.2 STAGES OF LAW

Self Check Exercise 2

6.10 LAW OF VARIABLE PROPORTIONS IN TERMS OF TPP AND MPP

The movement from a to b indicates that the amount of input is

When there is a movement from a to b, it indicates that input is

iii) Diminishing Returns to Scale: