Managerial Economic

MANAGERIAL ECONOMICS BY

Prof. Pradeep Datar M.A. (Economics)

Published by

Symbiosis Center for Distance Learning, Pune.

© Symbiosis Center for Distance Learning (SCDL) No part of this book may be reproduced or copied or transmitted in any form without prior permission of the publisher.

April 2004

PREFACE Dear Reader, This book on Managerial Economics is written to present a simple text to the students who have limited exposure to Economics and are pursuing a programme in management studies.The book is also designed to provide standard reading materials especially for the students of M. B. A., M. M. M., C.A., Diploma and Degree Courses in Business Management. This book will satisfy the needs of the students who are pursuing a Distance Learning Programme in management studies. The book, I hope, would also help refresh the practicing managers. The book mainly lays emphasis on the applied part of the principles of Economics. The text of the book relies on standard works on the subject. I am deeply indebted to my teachers as well as colleagues, for inspiring me to write this book. To cap it all, my special thanks to the Director and the respected staff of Symbiosis Center for Distance Learning (SCDL) for their kind cooperation. Prof. Pradeep Datar Pune. April, 2004

ABOUT THE AUTHOR The author of this book is a Lecturer in the Department of Economics at S.P. College, Pune since 1980. He has written a few books on Economics both in English and Marathi. He has also been associated as a visiting faculty at various management institutes in and around Pune. As a member of the visiting faculty, he has been teaching a variety of subjects related to Economics, such as Managerial Economics at Master in Marketing Management Course., D. B. M.; Degree in Hotel Management and Catering Technology; Economics of Labour at M.P.M., Indian Economic Environment at M.M.M. level etc. All these courses are affiliated to Pune University. Furthermore, he has also worked as a visiting faculty at SIMS, Pune; teaching Managerial Economics to PGDBM students and delivered lectures on Monetary Economics to the students pursuing a course in M. A. Economics. The author has judiciously used his wide academic experience, knowledge and observation about the current economic affairs at Global and Indian level, to present updated information which can immensely benefit the students pursuing a programme in Management Studies. Mrs. Swati Chaudhari Director - S. C. D. L.

CONTENTS Chapter

TITLE

No.

Page No.

1

Introduction to Managerial Economics

1

2

Types of business Organizations

17

3

Profit

65

4

Demand Analysis

83

5

Production and Costs

141

6

Pricing and output determination in different markets

185

7

Cost- Benefit Analysis

257

8

Macro Economic Analysis

285

9

Government and Private Business

319

Reference Book

351

Chapter 1 INTRODUCTION TO MANAGERIAL ECONOMICS Preview Introduction, Definition of Managerial Economics, Nature and Scope of Managerial Economics, Significance of Managerial Economics, Economic Problem.

INTRODUCTION Managerial Economics generally refers to the integration of economic theory with business practice. While economics provides the tools which explain various concepts such as Demand, Supply, Price, Competition etc. Managerial Economics applies these tools to the management of business. In this sense, Managerial Economics is also understood to refer to business economics or applied economics. “Managerial Economics lies on the border line of management & economics. It is a hybrid of two disciplines and it is primarily an applied branch of knowledge. Management deals with principles which help in decision making under uncertainly and improve effectiveness of organization. Economics on the other hand provides a set of propositions for optimum allocation of scarce resources to achieve the desired objectives. 1.

Definitions of Managerial Economics

1.

Prof. Spencer Sigelman : Managerial Economics deals with integration of economic theory with business practice for the purpose of facilitating decision making and forward planning by management.

2.

Prof. Hague : Managerial Economics is concerned with using logic of economics, mathematics & statistics to provide effective ways of thinking about business decision problems.

3.

Prof. Joel Dean : “The purpose of Managerial Economics is to show how economic analysis can be used in formulating business polices.”


1

4.

Prof. Mansfield : “Managerial Economics attempts to bridge the gap between the purely analytical problems that intrigue many economic theories and the problems of policies that the management must face.”

5.

Mc Nair and Meriam : Managerial economics consists of the use of economic modes of thought to analyse business situations.

The definitions given above highlight the following points : i)

Economic theory provides the basis for the decision making process.

ii)

There is some difference between the generalizations based on abstraction and actual practices.

iii)

Besides economic theory, mathematics & statistics help in decision-making.

iv)

An attempt is made to arrive at generalizations regarding business policies.

v)

Since decisions have repercussions on the working of firms in future, and most firms envisage to continue operations over a period of time, forward planning becomes an important element.

The problem of decision making arises whenever a number of alternatives are available For example :

What should be the price of the product? What should be the size of the plant to be installed? How many workers should be employed? What kind of training should be imparted to them? What is the optimal level of inventories of finished products, raw mater spare parts, etc.?

The significance of a good system of forward planning can be appreciated from the fact that it helps in selecting the plant to be installed and it is not possible to change its capacity as and when required. Also different production process require different skills which have to be provided. Similarly, based on the long-term plans, funds have to be arranged : either procured from outside or retained out of the earnings of the firm. Economics provides the solution to some of these problems to enable the firm to achieve its objective. For example, the demand for a product is influenced by factors such as (i) the distribution of income, (ii) prices of related products, and (iii) data on demand at some future point of time facilitates the task of forward planning. Similarly, the theoretical explanation of the problem of input-mix (the ratio in which machines, men and other resources are to be employed) is provided by production function along with the prices of inputs. This indirectly facilitates the choice regarding the technique of production to be employed and the plant to be installed. 2

Managerial Economics

The propositions of economics, however, require to be modified keeping in mind the constraints of availability of requisite data and the time at the decision-maker. 2.

Nature of Managerial Economics :

1.

It is true that managerial economics aims at providing help in decision-making by firms. For this purpose, it draws heavily on the propositions of micro economic theory. Note that micro economics studies the phenomenon at the individual’s level : behavior of individual consumers, firms. The concepts of micro economics used frequently in managerial economics are : (i) elasticity of demand, (ii) marginal cost, (iii) marginal revenue, (iv) market structures and their significance in pricing policies, etc. Some of these concepts, however, provide only the logical base and have to be modified in practice.

2.

Micro economics assists firms in forecasting. Note that macro economic theory studies the economy at the aggregative level and ignores the distinguishing features of individual observations. For example, macro economics indicates the relationship between (i) the magnitude of investment and the level of national income, (ii) the level of national income and the level of employment, (iii) the level of consumption and the national income, etc. Therefore, the postulates of macro economics can be used to identify the level of demand at some future point in time, based on the relationship between the level of national income and the demand for a particular product. For example, there is a relationship between the level of national income and demand for electric motors. Also, the demand for durable goods such as refrigerators, air-conditioners, motor cars depends upon the level of national income.

3.

Managerial Economics is decidedly applied branch of knowledge. There fore, the emphasis is laid on those propositions which are likely to be useful to the management.

4.

Managerial Economics is prescriptive in nature and character. It recommends that a thing should be done under alternative conditions. For example, If the price of the synthetic yarn falls by 50%, it may be desirable to increase its use in producing different types of textiles. Thus, managerial economics is one of the normative sciences and reflects upon the desirability or otherwise of the propositions. For example if the analysis suggests that the benefit-cost ratio of a large plant is less than that for a smaller plant and the benefit-cost ratio is used as the criterion for project appraisal it is recommended that the firm should not install a large plant. Contrast this with the positive sciences which state the propositions without commenting upon what should be done. For example, if the distribution of income has become more uneven, it is stated without indicating what should be done to correct this phenomenon.

5.

Managerial Economics, to the extent that it uses economic thought, is a science, but it is an applied science. Economic thought uses deductive logic (if X is true, then Y is


3

true). For example, if the triangles are congruent, their angles are equal. To have confidence in the findings, the propositions deduced are subjected to empirical verification. For example, empirical studies try to verify whether cost curves faced by a firm are really Ushaped as suggested by the theory. Furthermore, there is an attempt to generalize the propositions which provide a predictive character. For example, empirical studies may suggest that for every 1% rise in expenditure on advertising, the demand for the product shall increase by 0.5%. From the above it follows that managerial economics uses a scientific approach. In practice, some firms may use simple rules based on past experience. However, the quality of discussions made can be improved using a systematic approach. This is attempted in managerial economics. 3.

Scope of Managerial Economics :

The scope of Managerial Economics is so wide that it embraces almost all the problems & areas of the manager and the firm. It deals with demand analysis and forecasting, production function, cost analysis, inventory management advertising price system, resource allocation, capital budgeting etc. While an in-depth treatment is given to these aspects in the relevant chapters, a cursory treatment of these aspects has been attempted here, merely to explain the scope of the subject. 1.

Demand analysis and forecasting : It analyses carefully and systematically the various types of demand which enable the manager to arrive at a reasonable estimate of demand for products of his company. He takes into account such concepts as income elasticity and cross elasticity. When demand is estimated, the manager does not stop at the stage of assessing the current demand but estimates future demand as well. This is what is meant by demand forecasting.

2.

Production Function : We know that resources are scarce and also have alternative uses. Inputs play a vital role in the economics of production. The factors of production, otherwise called inputs, may be combined in a particular way to yield the maximum output. Alternatively, when the price of inputs shoot up, a firm is forced to work out a combination of inputs so as to ensure that this combination becomes least cost combination. In this way, the production function is pressed into service by managerial economics.

3.

Cost Analysis : Cost analysis is yet another area studied by managerial economics. For instance, determinants of cost, methods of estimating costs, the relationship between cost & output, the forecast of cost and profit-these are very vital to a firm. Managerial Economics

4


touches these aspects of cost-analysis, an effective knowledge and application of which is cornerstone for the success of a firm. 4.

Inventory Management : An inventory refers to stock of raw materials which a firm keeps. Now the problem is how much of the inventory is ideal stock. If it is high, capital is unproductively tied up, which might, if the stock of inventory is reduced, be used for other productive purposes. On the other hand, if level of inventory is low, production will be hampered. Therefore, managerial economics will use such methods as ABC analysis, a simple simulation exercise and some mathematical models with a view to minimize the inventory cost. It also goes deeper into such aspects as the need for inventory control; it classifies inventories and discusses the costs of carrying them.

5.

Advertising : It may sound strange when we say that advertising is an area which managerial economics embraces. While the copy, illustration, etc., of an advertisement are the responsibility of those who get it ready for the press, the problems of cost, the methods of determining the total advertisement costs and budget, the measuring of the economic effects of advertising – these are the problems of the manager. To produce a commodity is one thing; to market it is another. Yet the massage about the product should reach the consumer before he thinks of buying it. Therefore, advertising forms an integral part of decision-making and forward planning.

6.

Price System : It has already been pointed out that the pricing system as a concept was developed by economics and it is widely used in managerial economics. The central functions of an enterprise are not only production but pricing as well. While the cost of production has to be taken into account while pricing a commodity, a complete knowledge of the price system is quite essential to determination of price. For instance, an understanding of how a product has to be priced under different kinds of competition, for different markets is essential to the pricing of those commodities. An understanding of the pricing of a product under conditions of Oligopoly is also essential. Pricing is actually guided by considerations of cost plus pricing and the policies of public enterprises. Further, there is such a thing as price leadership and non-price competition. It is clear from these facts that the price system touches upon several aspects of managerial economics and aids or guides the manager to take valid and profitable decisions.

7.

Resources Allocation : Scarce resources obviously have alternate uses. How best can these scarce resources be allocated to competing needs? The aim, of course, is to achieve optimization. For


5

this purpose, some advanced tools, such as linear programming, are used to arrive at the best course of action for a specified end. Generally speaking, two kinds of problems are of the utmost importance and concern to the manager. First, how should he arrive at an optimum combination of inputs in order to get the maximum output? Secondly, when the prices of inputs increase, what type of sub-situation should he resort to? Or, alternatively, what type of combination of inputs should he work out in order to ensure the least-cost combination? 8.

Capital Budgeting : This is another area which calls for a thorough understanding on the part of the manager if he is to arrive at meaningful decisions. Capital is scarce, and it costs something. Now the problem is how to arrive at the cost of capital; how to ensure that capital becomes rational; how to face up to budgeting problems; how to arrive at investment decisions under conditions of uncertainty; how to effect a cost-benefit analysis, etc. These areas cannot be ignored by any manager. It is obvious form the foregoing discussion that managerial economics is applied economics. It makes use of the tools which have been developed not only be economics but by other disciplines as well. The subject matter of managerial economics covers two important areas, namely, decision-making and forward planning. These two areas are essential to every stage of planning, production, marketing, etc. Managerial economics, therefore, plays a vital role in the successful business operations of a firm.

Some other areas covered by Managerial Economics are : 1.

Linear programming, its assumptions and solutions.

2.

Decision making under risk and uncertainty.

3.

Profit planning and investment analysis. Sources of information on new projects, methods of project appraisal, social benefit cost analysis etc.

4.

Significance of Managerial Economics./ How Does Economics Contribute to Management?:

While performing his functions, a manager has to take a number of decisions in conformity with the goal of the firm. Many of the decisions are taken under the condition of uncertainty and therefore involve risk. Uncertainty and risk arise mainly due to uncertain behaviour of the market forces, i.e. the demand and supply, changing business environment, government policy, external influence on the domestic market and social and political changes in the country. The complexity of the modern business would add complexity to the business decision - making. However, the degree of uncertainty and risk can be greatly reduced if market conditions could be predicted with a high degree of reliability.

6


Taking appropriate business decisions requires a clear understanding of the technical and environmental conditions under which decisions are to be taken. Application of economic theories to explain and analyse the technical conditions and the economic environment in which a business undertaking operates contributes a good deal to the rational decision-making. Economic theories have therefore gained a wide application to the analysis of practical problems of business. With the growing complexity of business environment, the usefulness of economic theory as a tool of analysis and its contribution to the process of decision- making has been widely recognized. Prof. Baumol has pointed out three main contributions of economic theory to business economics. First, ‘one of the most important things which the economic (theories) can contribute to the management science’ is building analytical models which help in recognizing the structure of managerial problems, eliminating the minor details which might obstruct decisionmaking, and in concentrating on the main issue. Secondly, economic theory contributes to the business analysis ‘a set of analytical methods’ which may not be directly applied to specific business problems but they do enhance the analytical capabilities of the business analyst. Thirdly, economic theories offer clarity to the various concepts used in business analysis, which enables the managers to avoid conceptual pitfalls. 5.

Economic Problem :

THE SOURCE OF ECONOMIC PROBLEMS Resources and scarcity The resources of a society consist not only of the free gifts of nature, such as land, forests and minerals, but also of human capacity, both mental and physical, and of all sorts of man-made aids to further production, such as tools, machinery and buildings. It is sometimes useful to divide those resources into three main groups : 1.

All those free gifts of nature, such as land, forests, minerals, etc., commonly called natural resources and known to economists as LAND;

2.

All human resources, mental and physical, both inherited and acquired, which economists call LABOUR; and

3.

All those man-made aids to further production, such as tools, machinery, plant and equipment, including everything man-made which is not consumed for its own sake but is used in the process of making other goods and services, which economists call CAPITAL.

These resources are called FACTORS OF PRPDUCTION because they are used in the process of production. Often a fourth factor, ENTEPRENEURSHIP (from the French word entrepreneur, meaning the one who undertakes tasks), is distinguished. The entrepreneur is the one who


7

takes risks by introducing both new products and new ways of making old products. He organizes the other factors of production and directs them along new lines. (When it is not distinguished as a fourth factor, entrepreneurship is included under labour.) The things that are produced by the factors of production are called commodities. Commodities may be divided into goods and services : goods are tangible, as are food grains, cars or shoes; services are intangible, as they are valued because of the services they confer on their owners. A car, for example, is valued because of the transportation that it provides – and possibly also for the flow of satisfaction because of the transportation that it provides – and possibly also for the flow of satisfaction the owner gets from displaying it as a status symbol. The total output of all commodities in one country over some period, usually taken as a year, is called Gross National Product, or often just National Product. In most societies goods and services are not regarded as desirable in themselves; no great virtue is attached to piling them up endlessly in warehouses, never to be consumed. Usually the end or goal that is desired is that individuals should have at least some of their wants satisfied. Goods and services are thus regarded as means by which the goal of the satisfaction of wants may be reached. The act of making goods and services is called production, and the act of using these goods and services to satisfy wants is called consumption. Anyone who helps to produce goods or services is called a producer, and anyone who consumes them to satisfy his or her wants is called a consumer. The wants that can be satisfied by consuming goods and services may be regarded, for all practical purposes in today’s world, as insatiable. In relation to the known desires of individuals for such commodities as better food, clothing, housing, schooling, holidays, hospital care and entertainments, the existing supply of resources is woefully inadequate. It can produce only a small fraction of the goods and services that people desire. This gives rise to one of the basic economic problems : the problem of scarcity. Every nation’s resources are insufficient to produce the quantities of goods and services that would be required to satisfy all of its citizens’ wants. Most of the problems of economics arise out of the use of scarce resources to satisfy human wants. 6.

Meaning of Economic Problem :

Now, if we put together the four characteristics – namely, human wants are unlimited, that human wants vary in their intensity, that means or resources are relatively limited, and they have alternative uses, but if used to satisfy one want, the same means cannot be used to satisfy any other want – it becomes clear that every man begins to face the problem of economizing his means. The problem of economy is how to use the relatively limited resources

8


with alternative uses in the face of unlimited wants. Naturally, everyone will so try to use his relatively limited resources with alternative uses that he gets maximum satisfaction out of his resources. In view of limited resources and unlimited wants, he will try to satisfy those wants which are most urgent or intense and then those wants slightly less urgent and so on thus sacrificing the satisfaction of those wants which are lower on the scale of preference for which he may not have resources. This is the problem of economy – how to economics or make the maximum use of limited resources. In the light of the above situation, Lionel Robbins writes : “Economics is a science which studies human behavior as a relationship between ends and scarce means which have alternative uses.” Economic Problem at the Family Level Almost in every community, family is the basic unit of social organization. Just as, every individual has to face the basic economic problem – namely unlimited wants and limited means with alternative uses – exactly in the same way, every family, poor or rich, Indian, European and American, ancient or modern, finds that it has unlimited wants (e.g. food grains, clothing, shelter, education of children, medicines during sickness, insurance, tax-payment, guests, recreation, religious and social ceremonies, etc.) ; but the resources at its disposal are relatively limited. Every family, poor or rich, therefore faces the basic economic problem – how to make the best use of the limited resources so as to secure maximum satisfaction out of them. The Indian family may be thinking in terms of Rs.5,000/- which may be its monthly income, whereas an average American family earning U.S. $ 5,000 a month may be thinking in terms of that as a fairly big amount. But as we have observed, each family in relation to its wants, finds that the resources at its disposal are limited, that they have alternative uses and therefore the problem of economizing them must be faced. No family can avoid this basic economic problem. Economic Problem at the Universal Level Or Economic Problem – A Universal Problem The same basic economic problem – unlimited wants and relatively limited resources - arises at all levels of human organization. Thus whether we are thinking of a Grampanchayat, or of Zilla Parishad, or of a club or hospital or university or the national government, all have to face the same basic economic problem. Thus whether it is the Government of India or the Government of the richest country namely the United States, the problem of economy is always there. The Government of India with an annual revenue of about Rs.1,00,000/- corers has innumerable demands on its resources such as meeting mounting defense expenditure, expanding expenditure in respect of development that is to be brought about in various sectors like agriculture, industries, transport, education and so on and so forth, with no limit on its increasing wants. The Government of India therefore continually faces


9

the basic problem of economy of how to make the best use of its limited resources. In the some way, the Federal Government of the United States, the richest government, faces the same basic economic problem. Though in absolute terms, its annual revenues are enormous running into billions or trillions of dollars, its needs are also unlimited – expanding and modernizing defense forces, establishing military bases all over the world giving economic and military assistance to friendly countries, meeting expanding expenditure on space and military research, exploring oceans and so on and so forth. And therefore even the richest Government of the United States is always confronted by the same basic economic problem – unlimited wants and limited resources with alternative uses. Every nation, poor or rich, small or great, with small population or with huge population, has to face this basic economic problem; no nation can ever escape it. Thus there is something ‘universal’ about the problem of economy. The basic problem of economy arises in the case of an aboriginal, a villager, a city – dweller, in the case of the poor as also the rich, in the case of an Indian, a Frenchman and an American, in the case of associations like clubs, schools, hospitals and government organizations right from the village level to the national level. The problem of economy was there in ancient times and it is there before everybody at present. The problem of economy – unlimited wants and limited means with alternative uses – has been forever confronting mankind. The economic problem is a universal problem. Economic problem does not recognize boundaries of caste, creed, colour , religion, culture Basic Economic Problems Seven more general questions that must be faced in all economies, whether they be capitalist, socialist or communist, & mixed are explained below.

10

7.

Seven Questions faced by all economies :

1)

What commodities are being produced and in what quantities? This question arises directly out of the scarcity of resources. It concerns the allocation of scarce resources among alternative uses (a shorter phrase, resource allocation, will often be used). The question ‘What determines the allocation of resources or resource allocation?’ have occupied economists since the earliest days of the subject. In free – market economies, most decisions concerning the allocation of resources are made through the price system. The study of how this system works is the major topic in the THEORY OF PRICE.

2)

By what methods are these commodities produced? This question arises because there is almost always more than one technically possible way in which goods and services can be produced. Agricultural goods, for example, can be produced by farming


a small quantity of land very intensively, using large quantities of fertilizer, labour and machinery, or farming a large quantity of land extensively, using only small quantities of fertilizer, labour and machinery. Both methods can be used to produce the same quantity of some good; one method is frugal with land but uses larger quantities of other resources, whereas the other method uses large quantities of land but is frugal in its use of other resources. The same is true of manufactured goods; it is usually possible to produce the same output by several different techniques, ranging from ones using a large quantity of labour and only a few simple machines to ones using a large quantity of highly automated machines rather than another, and the consequences of these choices about production methods, are topics in the THEORY OF PROCDUCTION. 3)

How is society’s output of goods and services divided among its members? Why can some individuals and groups consume a large share of the national output while other individuals and groups can consume only a small share? The superficial answer is because the former earn large incomes while the latter earn small incomes. But this only pushes the question one stage back. Why do some individuals and groups earn large incomes while others earn only small incomes? Economists wish to know why any particular division occurs in a free – market society and what forces, including government intervention, can cause it to change. Such questions have been of great concern to economists since the beginning of the subject. These questions are the subject of the THEORY OF DISTRIBUTION. When they speak of the division of the national product among any set of groups in the society, economists speak of THE DISTRIBUTION OF INCOME.

4)

How efficient is the society’s production and distribution? This questions quite naturally arises out of question 1, 2 and 3. Having asked what quantities of goods are produced, how they are produced and to whom they are distributed, it is natural to go on to ask whether the production and distribution decisions are efficient. The concept of efficiency is quite distinct form the concept of justice. The latter is a normative concept, and a just distribution of the national product would be one that our value judgments told us was a good or a desirable distribution. Efficiency and inefficiency are positive concepts. Production is said to be inefficient if it would be possible to produce more of at least one commodity without simultaneously producing less of any other – by merely reallocating resources. The commodities that are produced are said to be inefficiently distributed if it would be possible to redistribute them among the individuals in the society and make at least one person better off without simultaneously making anyone worse off. Questions about the efficient of production and allocation belong to the branch of economic theory called WELFARE ECONOMICS.


11

Questions 1 to 4 are related to the allocation of resources and the distribution of income and are intimately connected, in a market economy, to the way in which the price system works. They are sometimes grouped under the general heading of MICRO ECONOMICS. 5)

Are the country’s resources being fully utilized, or are some of them lying idle? We have already noted that the existing resources of any county are not sufficient to satisfy even the most pressing needs of all the individual consumers. Surely if resources are so scarce that there are not enough of them to produce all of those commodities which are urgently required, there can be no question of leaving idle any of the resources that are available. Yet one of the most disturbing characteristics of free – market economies is that such waste sometimes occurs. When this happens the resources are said to be involuntarily unemployed (or, more simply, unemployed). Unemployed workers would like to have jobs, the factories in which they could work are available, the managers and owners would like to be able to operate their factories, raw materials are available in abundance, and the goods that could be produced by these resources are urgently required by individuals in the community. Yet, for some reason, nothing happens : the workers stay unemployed, the factories lie idle and the raw materials remain unused. The cost of such periods of unemployment is felt both in terms of the goods and services that could have been produced by the idle resources, and in terms of the effects on people who are unable to find work for prolonged periods of time. Why do market society’s experiences such periods of involuntary unemployment which are unwanted by virtually everyone in the society, and can such unemployment be prevented from occurring in the future? These questions have long concerned economists, and have been studied under the heading TRADE CYCLE THEORY. Their study was given renewed significance by the Great Depression of the 1930s. In the USA and the United Kingdom, for example, this unemployment was never less than one worker in ten, and it rose to a maximum of approximately one worker in four. This meant that, during the worst part of the depression, one quarter of these countries’ resources were lying involuntarily idle. A great advance was made in the study of these phenomena with the publication in 1936 of the General Theory of Employment, Interest and Money, by J. M. Keynes. This book, and the whole branch of economic theory that grew out of it, has greatly widened the scope of economic theory and greatly added to our knowledge of the problems of unemployed resources. This branch of economics is called MACRO ECONOMICS.

6)

12

Is the purchasing power of money and savings constant, or is it being eroded because of inflation? The world’s economies have often experienced periods of prolonged and rapid changes in price levels. Over the long swing of history, price levels have sometimes risen and sometimes fallen. In recent decades, however, the course of prices has almost always been upward. The 1970s, 1980s and 1990s saw a period of Managerial Economics

accelerating inflation in Europe, the United States and in most of the world, more particularly in the less developed countries. Inflation reduces the purchasing power of money and savings. It is closely related to the amount of money in the economy. Money is the invention of human beings, not of nature, and the amount in existence can be controlled by them. Economists ask many questions about the causes and consequences of changes in the quantity of money and the effects of such changes on the price level. They also ask about other causes of inflation. 7)

Is the economy’s capacity to produce goods and services growing from year to year or is it remaining static? Why the capacity to produce grows rapidly in some economies, slowly in others, and not at all in yet others is a critical problem which has exercised the minds of some of the best economists since the time of Adam Smith. Although a certain amount is now known in this field, a great deal remains to be discovered. Problems of this type are topics in the THEORTY OF ECONOMIC GROWTH.


13

Exercise :

14

1.

Define Managerial Economics.

2.

Explain the Nature and Scope of Managerial Economics.

3.

What is the Significance of Marginal Economics?

4.

What is an economics problem?

5.

“There is something Universal about and economic problem” Discuss.


NOTES


15

NOTES

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Chapter 2 TYPES OF BUSINESS ORGANISATIONS

Preview Introduction, A firm, plant, Industry, Types of Business organizations - Proprietary Firms, Partnership Firms, Joint Stock Companies, Public Sector Undertakings, Co-operative Societies ,Non-profit organizations, Business Organization in new millennium, Organization Goals Profit Maximization, sales Maximization, Satisfying Theory, other goals or objectives of firms.

INTRODUCTION Organisation of production requires bringing together various factors of production and coordinating the efforts of all the participants in the process of production. The level at which this is done is the level of a firm. Production with the profit motive is modern concept, in the sense that it has become dominant only after the Industrial Revolution. Before the Industrial Revolution, most of the economies of the world were agricultural economies. The profit motive was always a secondary motive in an agricultural economy. But in modern times the profit motive became the only dominant motive of production. A firm is a unit of production where production is done with the sole aim of profit maximization. 1.

Definition of a firm as a producing unit.

For the sake of understanding this concept of the firm, let us study some definitions of the firm given by eminent economists. 1.

Hansn : The firm may be defined as an independently administered business unit.

2.

"A firm is a centre of control where the decisions about what to produce and how to produce are taken."

3.

"A firm is a business unit which hires productive resources for the purpose of producing goods and services."

Types of Business Organisations

17

4.

Harvey Leibenstein : A firm is " an independent organization whose destiny is determined by the magnitude of the aggregate pay off and in which the aggregate pay off depends directly on its performance and especially on the production and sale of services or goods."

5.

In the words of Prof. Lipsey, "The firm is defined as the unit that uses factors of production to produce commodities that it then sells either to other firms, to households or to the central authorities (meaning government, public agencies etc.) The firm is thus the unit that makes the decisions regarding the employment of factors of production and the output of commodities." How much to consume is decided by the households. In keeping with preferences of the consumers, the firms decide how much to produce, how to produce etc. Through advertisements, a firm may try to increase its sales, but the decisions to buy belong to the buyers. The decisions regarding choice of techniques and quantify of a commodity are taken by the firm. The firm is assumed to take consistent decisions in relation to the choice open to it. The internal problems regarding the process of decision - making i.e. who reaches decision, how are they reached etc. are ignored. We take firm as a single unit - smallest possible unit. It is taken as our atom of behavior on the demand side. Again, just as the household is assumed to seek satisfaction maximization, the firm is assumed to seek maximization of its profits. The firm may be a proprietorship firm or a partnership firm or a Multi-National Corporation. That it is a unit of decision - making is our criterion. Therefore, for an economist, Tata Engineering and Locomotive Company Ltd. is a firm. Again, what form of business organization and management experts? An economist assumes that the firm is internally properly organized and is capable of taking decisions.

From the above definitions, it will be seen that there is a substantial difference in all these definitions and still in their own way they describe the firm correctly. This is so because these economists have given prominence to the questions which were more important for them or for their country or when they were writing, and so if we study the various features of firm as revealed by these definitions, the concept will be more clear. The following features of a firm emerge from these definitions:

18

1)

It is a centre where decisions about what, where, how and how much to produce are taken.

2)

It is a centre where the means of production are hired or purchased and used for production.

3)

It is a centre, where the success of production is reviewed in its entire context and decisions are taken.


4)

It is a centre, where the means of production are collected, the production is done, and the sale and distribution of production is also affected.

5)

It is a centre, where all the decisions about production are taken. These include decisions regarding the distribution of the product, advertising, sale and those regarding facing competition also.

From the above features of a firm, it will be clear that a firm has to perform several functions simultaneously - i.e. to produce a commodity, to sell and distribute the commodity, to advertise the commodity and to perform all those things which will be required to survive competition. To cap it all, the firm is expected to make as much profits as possible. Theoretically speaking, a firm is expected to organize all the factors of production in the most profitable manner. If one studies the structure and function of modern firm the above definitions will appear to be too simple, because in modern times the firm is expected to perform so many other functions. Formerly, the entrepreneur was taken to be an independent factor of production. Even today the entrepreneur is no doubt a very important factor of production but he has become so highly indispensable that it is very difficult to separate him from the production unit of the firm because ultimately the will to produce is provided by the entrepreneur. The mere presence of all the factors of production and a market does not guarantee production. The will be to produce is very important and it cannot be separated from the entrepreneur. Thus, the entrepreneur becomes inseparable from the firm. 2.

The firm and the industry

For understanding the difference between a firm and an industry, it would be advisable to understand the nature of a competitive industry. A competitive industry has three basic characteristics: (a) Large number of firms, (b) Homogeneous product; and (c) Freedom of entry and exit. In a competitive industry, there is a large number of firms so that the action of a single firm has no effect on the price and output of the whole industry. Every firm therefore enjoys the freedom to increase or decrease its output substantially by taking the price of the product as given. Secondly, every firm in a purely competitive industry, it must be making a product which is accepted by customers as being identical with that made by all the other producers in the industry. This is known as the condition of homogeneity. This ensures that all firms have to charge the same price. The buyers, of course, are to decide that the product is the same. The buyers should not find any real or imaginary differences between the products sold by any two pairs of firms, Finally, there should be no barriers to the entry of new firms (or exit of old firm) to (or from) the industry.


19

We considered competitive industry because we wanted to contrast such an industry with a monopoly. Under monopoly, there is only one firm producing a product. Entry into the industry is not free; because if entry of an additional firm is allowed, it no longer remains a monopoly. Thus, under monopoly, the firm is the industry or the distinction between the firm and the industry disappears under conditions of monopoly. Between these two extremes, we get a wide range of marked structures where there are more than one firms product. Strictly speaking, all firms producing the same i.e. homogeneous product make an industry and whatever all such firms supply becomes the supply of the industry. In practice, however, we speak of the cotton textile industry, though all cotton textile units do not produce identical textile products. Though the sugar produced by sugar factories might have different grades of quality, we speak of one sugar industry. Similarly, we speak of the automobile industry, steel industry, cement industry and so on. It should, therefore, be clear that all firms, producing a given product, together make an industry. 3.

The firm and the plant

A plant is a technical unit of a given capacity of output. For example, we speak of sugar plant What is it? It is nothing but an assembly of several machines, linked together (not necessarily physically but by processes also) capable of producing a given quantity of sugar per day. There is, for example, a weighing system which weighs the sugarcane, the conveyor system what takes the cane for crushing, the crushing machinery, and the machinery for removing impurities and so on, until finally sugar is filled in gunny bags. This whole plant taken together is capable of producing a given quantity of one product sugar. A plant thus produces any one product, obviously in cooperation with other factors of production. A sugar plant will produce sugar in co-operation with workers, managers, technicians etc. and after the necessary amounts of raw material; other chemicals and fuel are supplied to it. The firm, on the other hand, is an economic unit. The decisions are taken by the firm. What quality of sugar is to be produced, how much of it is to be produced, to which market it should be sold and from which farmers the sugarcane should be purchased etc. are decisions to be taken by the firm. It is not necessary that a firm has only one plant. Thus, for example, a sugar factory (i.e. a firm engaged in the production of sugar) may have a sugar plant, an alcohol plant (i.e. a distillery), a cattle - feed plant (producing cattle feed out of bagasse) - all under one management. When we say one management, we are implying one firm though there are various plants, it is also possible that a plant supplies goods to more than one firms. The difference, basically, is that between a technical unit and an economic unit.

20


One last word about a firm. We speak of the producer or the entrepreneur. Whenever we speak of a producer or an entrepreneur we imply a firm that takes decisions. Internally the decisions might be taken by a group of directors, managers or a sole proprietor - our unit on the supply side is the firm. 4.


Introduction: A business organization is concerned with how production and sale of a commodity are organized. In this chapter, we study various forms of business organization. l

Types of Business Organization :

The main types of business organization are as follows: i)

One -man Business or Individual or Sole Proprietorship or Proprietary Firms.

ii)

Partnership

iii)

Joint Stock Company

iv)

Joint Hindu Family Firms

v)

Co-operative Organizations

vi)

State Enterprise/Public Enterprises

vii)

Joint Sector Organizations

viii) Non-Profit Organizations and ix)

Business Organizations of the New Millennium

A.

Private Sector :

In a capitalist economy, the first four types of business organizations are set up in the private sector. The private sector is owned by private individuals, families or groups of individuals. It is characterized by private ownership in the means of production, economic freedoms and profit motive. In addition to the first three types of business organization, there are also Joint Hindu Family Firms in the private sector in India and Business Organizations of the New Millennium. B.

Public Sector :

The public sector includes public or state enterprises like railways, post sand telegraphs, etc. The public sector is owned and controlled by the State. In India we have also a number of public enterprises like Hindustan Machine Tools, Life Insurance Corporation, Bharat Heavy Electrical Ltd. etc. They are constituted as companies, public corporations and departmental undertakings. Types of Business Organisations

21

C.

Co - operative Sector :

There are many co-operative organizations in the private sector. But they are non-capitalist in nature, e.g., Co-operative credit societies, consumers' co-operative societies, producers' cooperative societies, service societies, etc. D.

Joint Sector :

Joint sector organizations or enterprises are jointly owned by the public and private sectors. But day-today management is left to the private sector. The following chart indicates various forms of business organization: Types of Business Organization

Private Sector

Capitalist Form

Public Sector

Joint Sector

(7) State Enterprises

(8) Public Private Organizations

Non - Capitalist Form

1) Proprietary Firms 6) Co-operative or Proprietorship Organizations 2) Partnership 3) Joint-Stock Company 4) Joint-Hindu Family Firms 5) Business Organizations of the New Millennium Let us now study the types of business organizations as given in the above chart. 1.

SOLE PROPRIETORSHIP OR PROPRIETARY FIRMS :

(A) Definition : Individual or sole proprietorship which is also called sole trader ship or single entrepreneurship or proprietary firms is the most common, the simplest and the oldest form of business organization. In such a unit, a single man called proprietor organizes a business. It is owned, managed, controlled and directed by him.

22


He fixes the amount of capital to be invested, (his own or borrowed), uses his own labour and that of his family members, hires factors, whenever necessary, organizes production as efficiently as possible and markets the product at the highest possible prices. He assumes full responsibility for all business risks. He alone enjoys all profits, if he is successful and suffers all losses, if his business fails. (B) Characteristics: The definition of sole proprietorship Proprietary Firm gives its characteristics or features which are as follows: (i)

Ownership by a Single Person: A single person initiates a business whose ownership lies in his hands. He enjoys full powers to fix the lay-out of his business firm.

(ii)

Organization and Control: A single person organizes and manages his business according to his experience and efficiency. He has full powers to conduct his business in any manner he likes. He need not consult any one. He is also not required to take approval or agreement from others.

(iii) Capital: The owner uses his own capital. He may also borrow capital to invest it in his business and thereby expand it. (iv)

No Sharing of Profits and Losses: All the profits of business earned by the owner are enjoyed by him alone. These profits of business are not shared with other persons. On the other hand, if there are losses, he has to bear them alone entirely.

(v)

Unlimited Liability: His liability is unlimited for all his debts. If he fails to clear his business debts, all his private property can be attached by his creditors.

(vi)

Easy to Form: It can be easily set up. It is not subject to any special legislation. So no legal formalities are involved in starting such a concern by any person who is of major age, i.e. 18 years and above.

(vii) Legal Status: A sole trading concern cannot be legally separated from its owner or proprietor. The owner and organization are the same. The life of such a concern depends upon the life of its proprietor. This type of organization is found in agriculture, retail trade, hotel, printing press, tailoring etc.

(C) Merits and Demerits of Sole Proprietorship or Proprietary Firm : MERITS OF PROPRIETORSHIP OR PROPRIETARY FIRM : (i)

Easily Started: Such a concern can be easily started without any legal formalities. There is also little government interference. Also it is simple to manage and control and


23

requires a small amount of capital for generally it adopts labour - intensive techniques. He can also get finance on personal credit. (ii)

Prompt Action: The proprietor can take quick decisions and prompt action regarding his business, its location, method of production etc. He need not consult others about these problems.

(iii) Personal Interest: He would always take personal interest in the business with a view to finding out causes of loss and waste of resources. He would then take measures to remove them. Thus he would maximize his profits. (iv) Requirements of Consumers: He has direct contact with his customers, so he can personally attend to all their requirements. He can produce goods according to their desires, tastes and needs. His attempts to meet their needs will help him to increase his sales and profits. Thus it is suitable for small business. (v)

Cordial Relations: He has direct and continuous contact with his employees. So he can establish cordial relations with them. This is because he will be in a continuous touch with them. He can also supervise them directly. Hence any scope for conflict between workers and himself can be avoided.

(vi) Efficiency, Hard Work and Direct Gain: He will always attempt to work hard, efficiently and continuously. This helps to enjoy maximum profits and avoid any loss for his liability is unlimited. (vii) Business Secrecy : He can carry on his business in secrecy. He is not required to give publicity to the activities of his concern nor disclose his profits to the public. He can also make use of any new idea for his business. (viii) Winding Up: Just as a sole trader can easily start a business, so also he may easily wind up his business at any time. (ix) Economy in Expenses : Its overhead expense are low. Hence it is economical. The number of employees employed by him is low. Hence the working expenses can be minimized. (x)

Flexibility and Elasticity : Any change in business can be easily introduced without consulting any body. So it is flexible and elastic. It can easily and quickly adapt to changes in the market conditions.

(xi) Transferability : It is easily transferable to heirs. (xii) Self - Employment : It promotes self-employment, self-reliance, development of one's personality, self-confidence etc.

24


(xiii) Lower Tax Burden : It is also subject to lower tax burden than other forms of business organizations. (xiv) Concentration of Wealth : It helps prevent concentration of wealth and income in the hands of a few persons. DEMERITS OF PROPRIETORSHIP OR PROPRIETARY FIRM : (i)

Limited Capital : The amount of capital which an individual can command is limited. He has to depend mainly on his own savings. So it would be difficult for him to expand his business activities much. It may also be difficult for him to raise additional capital by borrowing from banks. Hence the size of his business is small.

(ii)

Unlimited Liability and Risks : It may be very risky for him to invest in a particular business. This is because if he adopts a wrong policy, he may lose everything and also become insolvent. This is because his liability is unlimited. This implies that if his debts exceed his business assets and if he suffers a loss, he will have to use his private property to clear his debts. So the unlimited liability restricts his business activities.

(iii) Lack of Skill for Efficient Management : It may not also be possible for him to attend personally to all the activities of his concern such as correspondence, maintaining accounts, advertisements, supervision, arrangement of finance etc. He cannot undertake all activities alone efficiently. Further his business activities may be spread in different places and he may not possess all the qualities and skill required for an efficient management, supervision and control. (iv) Limited Ability of Management : The limited managerial ability may make it difficult for a sole proprietor to face competition in his business which is subjected to many changes. (v)

No Economies of Scale : A sole trader cannot secure many of the economies of large - scale production such as purchase of raw materials at low prices, advantages of specialization etc., and minimize its cost of production or running business.

(vi) Weakness in Bargaining and Competition : On account of the limitations of capital, ability and skill, the proprietor is likely to remain weak in respect of bargaining and competition. (vii) Wrong Decisions : All the decisions about his business are taken by the sole proprietor. Some of his decisions may prove to be wrong. This may involve him in losses and ruin. (viii) Closure on Death : Such a concern may be closed on the death of the proprietor. This is because he may not have heirs to run it or they may not like to continue in his business. Hence the business may not be continued. Types of Business Organisations

25

2.

PARTNERSHIP :

(A) Definition and Meaning : The Indian Partnership Act, 1932, defines the partnership as "the relation between two or more persons who have agreed to share profits of a business carried on by all or any one of them acting for all." The English Partnership Act, 1890, defines partnership as "the relation which subsists between persons carrying on a business in common with a view to profit." So a partnership refers to an organization owned and managed by two or more persons. They pool their capital and undertake all risks associated with their business. Thus there is joint ownership, management, control and risk - taking. The persons who own the partnership concern are called "partners" Collectively, all partners constitute a "firm".

(B) Characteristics or Features of a Partnership Firm : (i)

Contract : It is formed voluntarily by an agreement between two or more persons carrying on a particular business for common benefit. It may also be formed to carry on certain trade, profession or lawful occupation.

(ii)

Age Limit : Only persons who have attained the major status can become partners. In other words, minors cannot become partners.

(iii) A Partnership Deed : A partnership is formally based upon a partnership deed or agreement. It indicates the names of partners, the shares of individual partners in the capital, their rights and duties, proportion for sharing profits and losses by each of them etc. (iv) Registration : The registration of a partnership firm is voluntary. It may or may not be registered. However, if the partners so desire, it can be registered at any time. (v)

Joint - Ownership : The partners are joint owners of the property of the firm. Its property must be used only for the business purpose for which the partnership was formed. It cannot be used by any partner for his personal purposes.

(vi) Joint - Management : All the partners enjoy equal rights of management. So every partner can participate in management. But for the sake of convenience, a single partner may be given right to manage the firm. (vii) No Remuneration : No remuneration is paid to any partner for services rendered by him to the firm. Each partner is supposed to work in the best possible manner for promoting the interest of the firm.

26


(viii) Statutory Limit or Number of Partners : It consists of minimum two persons and maximum 20 persons in the case of general business and maximum 10 persons in the case of banking. (ix) Business Activity : Any business selected by the partners can be undertaken. All of them or any of them can carry on business activity for all. (x)

Sharing of Profit and Losses : There is a sharing of profits and losses. Profits can be distributed according to the partnership agreement or the capital ratio. Profit may be shared equally by partners, if nothing is mentioned in the partnership deed. A manager who is an employee of the firm may also be given a part of the profits.

(xi) Mutual Confidence and Faith : A partnership is based upon mutual confidence and trust of partners in each other or one another. Every partner must be honest regarding the partnership dealings and should provide all the facts and information regarding their business to all partners. (xii) Combination of Capital, Abilities and Skill : In a partnership firm, some offer capital, some management and organizational abilities and others, technical skills etc. (xiii) Working and Dormant Partners : Some of the partners who provide only capital, and enjoy limited liability as in England are called Sleeping or Dormant or Special Partners while others who run and manage the concern are called Active or Working or General Partners. But, in India all partners have unlimited liability. (xiv) Unlimited Liability : The liability of all partners is unlimited. Hence all partners are, jointly and severally, held responsible for the losses or debts of the firm to the full extent of their personal assets. Creditors are entitled to attach assets of any one partner or those of others so as to recover their dues. (xv) Non-Transferability of Interest : A partner cannot transfer his powers or rights to any third party to do any work of the firm on his behalf. If he cannot do it himself, he has to retire from the partnership firm. However, a partner may admit another person as a new partner if other partners give their consent. (xvi) Principle of Agency : Every partner carries on business activities on behalf of the firm. So he binds the firm and other partners for every commitment that he makes in conducting business. Likewise he is bound by the business activities of the other partners. Thus every partner becomes a principal at one time and an agent of the firm at another time. Hence a partnership firm can be run by one or more partners acting on behalf of all partners.


27

(xvii)Dissolution : A partnership firm may not last long. It may be dissolved by any partner after giving a written notice to other partners and a new partnership may be formed by the remaining partners. It may also be dissolved due to the death of a partner or due to an adjudication of a partner as an insolvent. Such partnership firms are found among builders, solicitors, chartered accountants, small factories etc. (C) MERITS AND DEMERITS OF PARTNERSHIP : MERITS OF PARTNERSHIP : (i)

Easy to Form : A partnership firm can be easily formed. Its formation does not involve legal formalities.

(ii)

More or Additional Capital : Under the partnership, more funds can be raised by all partners to start a business on a large scale. Because of the reputation of the partners and their contacts, it will not be difficult for a partnership concern to borrow from banks on easy terms.

(iii) Greater Efficiency due to Division of Labour : There is a greater efficiency in the working of partnership concerns because different partners can be assigned those tasks for which they are best suited as per their qualifications, experience, abilities, talents and aptitude. Thus, there would be specialization in the task of every partner. (iv) Expansion of Business : A partnership firm can expand its business by admitting more partners and raising more capital from them and thereby attempt to earn more profits. (v)

Flexibility : It is also quite flexible and capable of adapting itself to changed circumstances of business by means of quick decisions and prompt action by the partners, i.e. it can quickly adapt itself to change in demand for its product, by increasing and decreasing its business operations and by changing its business policy. Thus the organizational structure of a partnership firm is flexible. The decision taking by a partnership firm does not involve any legal procedure. Its operations are not also subject to any restriction by a government.

(vi) Co-operation : It may elicit full co-operation from workers by keeping a close touch with them, by understanding and solving their difficulties. (vii) Advantages of Large-scale Production : It can secure all the advantages of large scale production such as advantages of division of labour, bulk purchases of raw materials at lower price, best use of machinery etc. (viii) Business Secrecy : All the activities of partnership concerns need not be given any publicity. Hence they can carry on their activities under secrecy so far as the outsiders are concerned. It is not compulsory for a partnership concern to publish its profit and loss account and its balance sheet. Outsiders are not given its business secrets. 28


(ix) Business Risks and Rewards : Business risks are equally shared by all the partners. In case business fails, they would suffer losses. But if it succeeds, they will enjoy profits. Hence, they will try to manage it efficiently and make their business profitable by putting the assets of the firm to the best uses so as to avoid waste. (x)

Close Watch : Every partner has a right to take part in the partnership business. Since there is unlimited liability, every partner will keep a close watch on the activities of other partners so that losses are avoided and profits are maximized. Thus the interest of every partner is protected.

(xi) Unlimited Liability : Since there is unlimited liability, the business status of a partnership firm is raised. Hence it will be easy for it to get loans from financers. (xii) Management and Organizational Abilities : In a partnership firm, there is a combination of capital, abilities and skill. Some partners offer capital. Some partners are experts in management and organization. Some of them possess technical skill. As a result of the pooling of the expert services of all partners, it is possible to run a partnership firm efficiently. (xiii) Dissolution : In case a partner is not happy with the working of his partnership firm, he can legally dissolve it. He can do so by giving a written notice to the other partners indicating his decision to resign from it. (xiv) Mutual Consent : All the business decisions are taken with mutual consent of all partners. They hold mutual consultations and discussions on important matters. Thus every partner benefits form the advice of other partners. As a result, their wisdom is pooled for the benefit of the firm. DEMERITS OF PARTNERSHIP (i)

Unlimited Liability and No Risk Business : On account of the principle of unlimited liability, any bad or irresponsible partner may ruin all the partners. This is because his activities will be binding on all other partners. Every partner runs a considerable risk for any one of them is, jointly or severally, held responsible for the debts or losses of the firm. Further due to unlimited liability, the partners may not undertake any risk in business or take any hasty step to expand business. Hence the spirit of enterprise is checked.

(ii)

Limited on Size of Business : It is also difficult to increase the size of business on account of limited amount of capital which the partners can raise or provide from their own sources. A partnership firm cannot also admit more than 20 members for raising additional resources. This limitation on the number of partners restricts the growth of a partnership form.


29

(iii) Short - Lived : A partnership can be dissolved by any partner by giving a written notice to other partners. So this type of business is short-lived. Also default, bankruptcy or insanity of any one of the partners leads to dissolution of the firm unless a provision is made in the partnership deed to the contrary. (iv) Non - Transferability : A share in a partnership firm cannot be transferred by any partner without the consent of all the partners. He cannot also transfer his powers or rights to any third party to do any work of the firm on his behalf. (v)

Differences of Opinion : The partners may not agree upon certain matters of business policy. There might by differences of opinion, clashes of interest, mistrust, disputes etc. Such differences among partners may result in dissolution of partnership firms.

(vi) No Trust : The activities of a partnership firm are kept secret from outsiders. It is not required to publish its accounts. It is also not subject to legal restrictions. Hence people may not fully trust a partnership concern. (vii) No Government Control : There is no government control or supervision on the activities of a partnership concern. Hence there is lack of public confidence in such concerns. (viii) Leakage of Important Information : Some of the partners may leak important information to outsiders. This may happen when there are differences of opinion among the partners. Hence it may be difficult to maintain business secrecy in a partnership firm. (ix) Joint Liability and Dishonest Activities of Some Partners : The activities of a partner are binding on the partnership firm. Some partners may not behave properly. Some of them may be dishonest. Hence they may misuse their rights and bring the firm into difficulties and ruin its business. As a result, the honest and efficient partners will have to suffer losses. 3.

JOINT - STOCK COMPANY :

Introduction : In a modern economy, the predominant form of business organization is the Joint - Stock Company which is called Corporation in the U. S. A. Such form of business organization is necessary to undertake any business or industry on a large scale. This is because it overcomes the drawbacks of sole proprietorship and partnership. (A) Definition : In the words of Mr. Kuchhal, a joint -stock company is "an incorporated association which is an artificial legal person, having independent legal entity, with a perpetual succession, a carrying a limited liability." As per the Indian Companies Act of 1956, a joint - stock company is a company which has a permanent paid-up or nominal share capital or a fixed amount of capital divided into shares held and transferable as stock by shareholders who are its members. 30


Thus a joint-stock company is a voluntary incorporated association of shareholders or stockholders who contribute to the common stock, (i.e., capital) of which they are the owners. But all of them do not directly manage it. It is managed by some directors elected by shareholders. Their liability is limited to the value of shares held by them. They share in profits and losses. (B) How Is It Formed ? : Minimum seven persons have to come together to start a joint stock company. Those who take initiative to start it are called promoters. The promoters of a company have to get it incorporated by filing with the Registrar of Companies various documents such as Memorandum of Association, Articles of Association, Prospectus, List of Persons who have agreed to act as directors etc. The Memorandum of Association : This gives information about the company, namely, its place of location, its objects, the amount of capital to be raised etc. The Articles of Association : This gives us information about the rules and regulations and bye-laws of the company. The Registrar of Joint - Stock Companies is given these documents. After going through these documents, the Registrar issues a Certificate of Incorporation. After this, the company comes into existence.

Hence the registration of a joint - stock company is compulsory. (C) Features of a Joint - Stock Company : (i)

Voluntary Organization : A joint - stock company is a voluntary organization or association of shareholders.

(ii)

Legal Person : It is a legal or an artificial person as a result of law. It has no physical existence. But it functions as a separate and independent legal person. It is distinct from its shareholders and its directors.

(iii) Perpetual Succession : It has a perpetual or continuous succession under the law because it continues to exist even if some shareholders or directors die or become insolvent or leave the company by transferring their shares. (iv) Common Seal : It has a common seal to be affixed on its contracts and legal documents. (v)

Open Membership : Its membership is open to any person in any part of a country.

(vi) Limited Liability : Liability of shareholders is limited to the nominal value of shares held by them. Types of Business Organisations

31

(vii) Free Transferability of Shares : The shareholders are free to transfer or sell their shares to any person. (viii) Management by Elected Board of Directors : It is owned by its shareholders. But it is managed by a Board of Directors elected by shareholders. (ix) Fragmented Rights of Ownership : the shareholders enjoy a fragmented right of ownership due to shares purchased by them. (x)

Dividends : The profits of a joint - stock company are annually distributed as dividends among its shareholders.

(D) How is Capital Raised By a Joint Stock Company?: (a)

Methods of Raising Capital : A company raises its capital in two ways, namely, (i)

Through the sale of shares or stocks and

(ii)

Through the sale of bonds or debentures.

Sale of shares of stocks (b)

Types of Share Capital : A company divides its share capital as : (i)

Registered or Authorized Capital,

(ii)

Issued Capital and

(iii) Paid - up Capital. (i)

Authorized Capital : Authorized Capital refers to the maximum amount which can be raised by a company by selling shares. This may be, say, Rs. 20 crores.

(ii)

Issued Capital : Issued Capital refers to that part of the authorized capital which is issued to the public for subscription by dividing into shares. This may be, say, Rs. 16 crores.

(iii) Subscribed Capital : Subscribed Capital refers to that part of the issued capital which is actually subscribed by the public. This may be say, Rs. 14 crores. (iv)

(c)

Paid - up Capital : Paid - up Capital refers to that part of the subscribed capital which the public directly pay-up to the company, as a part payment of the value of their shares. This may be, say, Rs. 10 crores. The remaining amount of the subscribed capital is paid after further calls from the company.

Types of Shares : The capital of a company can be divided into three types of shares : (i)

Equity or Ordinary Shares,

(ii)

Preference Shares and

(iii) Deferred Shares. 32


(i)

Equity or Ordinary Shares : Such shares form the main basis of the finance of a company. The holders of such shares get dividend only after the preference shareholders are paid out of its profits. Hence they bear maximum risk. This is because they do not get any dividend if the company does not make any profit. At times when profits are high, they get much more than the rate of dividend paid to preference shareholders. The ordinary shareholders have the right to vote to elect the Board of Directors of the Company. They have also the right to vote on policy decisions of the company. Hence they control the affairs of their company.

(ii)

Preference Shares : These shareholders enjoy a preferential or prior right over equity shareholders to the profit of a company. They are entitled to a fixed rate of dividend after paying interest on debentures and before any dividend is paid to equity shareholders. However, preference shares are classified as : (a)

Simple or Non-Cumulative Preference Shares,

(b)

Cumulative Preferences Shares,

(c)

Participating Preference Shares and

(d)

Redeemable Preference Shares.

(a)

Simple or Non-Cumulative Preference Shares : People holding such shares are entitled to a fixed rate of dividend only in the year in which profits are made. They get the dividend before it is paid to other types of shareholders.

(b)

Cumulative Preference Shares : Such shareholders are entitled to a fixed rate of dividend even when there are no profits in any year. These claims will stand as arrears to be paid first out of subsequent year's profit before it is paid to other types of shareholders.

(c)

Participating Preference Shares : The holders of such shares are paid a fixed rate of dividend before it is paid to other classes of shareholders. They are also entitled to participate in the balance of profits,in a certain proportion along with equity shareholders, after reasonable claims of these equity shareholders are met.

(d)

Redeemable Preference Shares : Capital raised by issuing such shares must be paid back after a certain period of time either out of profits or by raising fresh capital by issuing new shares or by selling some of the assets of the company.


33

The preference shareholders do not enjoy normal voting rights. However they have a prior claim on the assets of the company in the event of its liquidation. (iii) Deferred Shares : They are called the Promoters' or Management's of Founders' shares. The holders of such shares are paid dividend last out of the profits left after meeting the claims of ordinary and preference shareholders and the reserve funds. Normally they are issued to promoters of a company but they may also be issued to public. If dividend paid to other classes of shareholders is restricted, the deferred shareholders will enjoy a bigger share of profits. But if there are no profits, they do not get anything. The deferred shareholders enjoy special or preferred voting rights. But the Indian Companies Act. Of 1956, has eliminated the system of issuing deferred shares by public limited companies. However a private limited company can issue deferred shares also. Sale of Bonds or Debentures – Debentures : A company may also raise additional finance by borrowing from the public for a specific period of time, say, 15 to 25 years, at a particular rate of interest. This is done by issuing debentures or bonds. A debenture is an undertaking by a company to repay the borrowed money on or before the specified date at a particular interest rate, irrespective of profit or loss made by the company. The capital raised by selling debentures is like taking loans form the public. Hence, a debenture-holder is a creditor of a company with no voting right. As such, he cannot directly interfere with the activities of its management.

A Debenture may be classified as (i) secured and (ii) simple. (i)

A secured debenture is secured against the assets or property of a company.

(ii)

A simple debenture is not secured against its assets or property.

A company is also free to issue convertible debentures which can be converted into equity shares after a period of time, say, 5 to 10 years, at a ratio fixed in advance. (E)

Types of Joint - Stock Companies : On Ownership Basis, all types of the registered companies in the private sector can be classified as :

34

(a)

Public Limited Companies and

(b)

Private Limited Companies. Managerial Economics

In the public sector, we have government companies in which 51% of the paid-up share capital is held by the government. (F)

Distinction Between Private Limited Companies and Public Limited Companies (Limited By Shares) : (1)

A private limited company can be formed with two to fifty members maximum excluding employee shareholders of the company. But a public limited company can have any number of the members of the public but it should have a minimum 7 members.

(2)

Public limited companies are required to issue prospectus before allotting shares. But it is not necessary in the case of private limited companies.

(3)

Public limited companies must submit statutory reports to the Registrar of Companies. But private limited companies are not required to do so.

(4)

A public limited company has to send its duly audited accounts to its shareholders. But a private limited company is not required to publish its accounts for the information of the public. However a private limited company must send three certified copies of its balance sheet to the Registrar of Companies.

(5)

The shares of a private limited company cannot be freely transferred on stock exchanges. But the shares of public limited companies can be freely transferred on stock exchanges.

(6)

The share of a private limited company openly invites public to subscribe to its shares or debentures. But a private limited company cannot appeal to the public to do so.

(7)

A private limited company can start its business after it is registered. But a public limited company can do so only after it gets a certificate for commencement of business.

(8)

A private limited company should have minimum two directors. But a public limited company must have at least three directors.

(9)

A private limited company may increase its number of directors without the government's approval. But a public limited company can do so only after getting the government's approval.

(10) In the case of a public limited company only an individual can be appointed as its manager. But a private limited company can appoint a firm a as its manager.


35

(11) A private limited company can issue different classes of shares with disproportionate voting rights. But there are restrictions in this respect on a public limited company. A partnership may be converted into a private limited company to enjoy the advantages of limited liability. (G) Management of Joint - Stock Companies : There is separation between ownership and management in a joint-stock company. Its ownership is in the hands of shareholders. But they do not manage it directly. They elect a Board of Directors which manages the company. The policies of the company are laid down by the directors. These policies are executed by salaried managers and executives. (H) Merits and Demerits of Joint-Stock Companies : MERITS OF JOINT - STOCK COMPANIES : (i)

Limited Liability : The principle of limited liability is applicable to a joint-stock company. Hence we write word "Ltd." after the name of a company. Since the liability of shareholders is limited, risk faced by them are reduced. Hence even if a company suffers losses, they need not pay more than the face value of shares purchased by them. So the creditors of the company cannot make personnel attachments on their private property. Hence people are induced to invest their money in such companies.

(ii)

Large Amount of Capital : Large - scale production is facilitated under the company form of business organization. This is because it is easy for a company to raise a large amount of capital, by accepting fixed deposits from the public. Thus the savings of the people can be productively used.

(iii) Transfer of Shares : The shares of a company are transferable whenever one likes. Hence it would encourage small savers to invest in the shares of companies. If they do not like to keep their funds in a particular company, they would be free to sell their shares on stock exchange and invest in some other companies. Thus the money of a share holder is not blocked. At the same time, this does not affect the company in any way. This is because the sales of shares of a company by some are counterbalanced by the purchase of these shares on a stock exchange by others. (iv) Shares of Different Varieties : The shares of a company are of different types, namely, equity shares, simple preference shares, cumulative preference shares etc. The equity shares may be purchased by people who want take greater risks. On the other hand, those who do not want to take any risk may invest in cumulative preference shares. Thus, by providing a wide choice to shareholders, it is possible for a company to raise a large amount of capital. 36


(v)

Risky Enterprises : A joint-stock company can start a risky enterprise. This is because the risks associated with a business are greatly reduced due to the limited liability of shareholders and a small value of the shares of each shareholder. Further an individual may purchase shares of different companies so as to minimize the loss still further. So even if there is a loss in the case of one company, the individual shareholders may not be affected much.

(vi) Less Danger of Misappropriation of funds : There is a less danger of misappropriation of funds. This is because the audited accounts of the companies must be published. (vii) Combination of Capital and Business Abilities : Many individuals possessing a large amount of capital and not having capacities to start and run a business can invest in companies. Other persons, having no capital but possessing capacities to manage a business, can secure jobs as managers and executives in companies. (viii) Efficient Management : In a joint-stock company, the ownership and management are separated. The shareholders are owners but they do not manage it. It is managed by experts in different fields, who work under the direction of the Board of Directors. (ix) Economies of Scale : A joint - stock company can enjoy the economics of scale such as advantages of specialization and division of labour etc. by making full use of managerial skills and abilities and other factors of production. (x)

Continuity and Stability : Since it has a perpetual succession, a company continues to carry on its business even if some of the original shareholders leave the company or die or become insolvent. So it is permanent and stable in nature. So the business activities can be undertaken with a long-term objective.

(xi) Legal control : Since companies are subject to rules and regulations of the Companies Act, they are supposed to work in the interest of their shareholders. (xii) Democratic Management : There is democratic management in a joint-stock company. This is because the directors are elected by shareholders from time to time. The elected board of directors manage the company successfully because of their wide experience, abilities and efficiencies. (xiii) Research : Because of its continuous existence and a large amount of resources at its disposal, a company can conduct research and experiments, and apply the fruits of research to industrial uses. This will enable it to improve the quality of its product, reduce its cost of production and thereby enjoy good profits in due course. DEMERITS OF JOINT - STOCK COMPANIES : (i)

Lack of Personal Interest and Inefficient Management : The actual management of a joint - stock company is in the hands of salaried executives. They have no personal interest in the functioning of their company. Hence they may not always manage the


37

affairs of their company efficiently. Some of them might even leak out secrets of their company to rival companies. (ii)

Indifference of Shareholders and Oligarchy : On account of their : limited liability, many of the shareholders are indifferent. They may not take an active part in the affairs of their company. They are also scattered. They are interested only in dividend. So a few big shareholders manage to get directorships and take all decisions. So, in actual life, there is oligarchy rather than democracy in the management of a company. Further these few directors manage to remain in power by some means or the other and enjoy vast powers of management and decision making. So shareholders are owners only in name.

(iii) Promotion of self - interests and misuse of power by directors : A few big directors, who control the affairs of the company, try to promote their own interests in various ways at the cost of other shareholders. Further when the directors are dishonest, they may commit some frauds and cheat and exploit the shareholders. They may also purchase inputs from their friends and relatives at high prices and resort to other corrupt practices. They may also claim excessive fees. (iv) To Risky Ventures : the directors may be inclined to start very risky enterprises which may fail. Hence they will involve the shareholders in losses. (v)

Extravagance : The directors may not behave in a responsible manner. They may spend in an extravagant way.

(vi) Favouritism : The selection of the staff to work in various departments may not be made by directors or managers on the basis of merit, but on the basis of favouratism, influence, personal relations etc. They may employ their friends and relatives in high posts paying high salaries. Hence the general working of a company is likely to suffer. (vii) Unethical Practices : Directors possess inside information of the working of their company. Hence they may dispose of their shares at high prices by creating an impression that their company is going to make good profits when, in fact, the things are otherwise. So those who buy such shares will suffer losses. In the opposite case, when a company is likely to make good profits, they may try to create an impression that it would suffer losses. This impression will induce other shareholders to sell their shares. They buy them through their agents. Hence they can get all the profits for themselves. The transferability and marketability of shares is also responsible for unhealthy speculative activities on stock exchanges on the part of some directors. As a result, the interests of shareholders are ignored with the result that a large number of them may be ruined.

38


(viii) Conflict : There is no close personal contact between employees and management. Hence there is likely to be a conflict between employees and the management. At times, this may result in strikes and lockouts. So the company's output would suffer causing thereby a loss to the shareholders. (ix) Political Corruption : A number of joint-stock companies may pay a large amount of money as donations to political parties. They are given for the personal benefit of directors and / or for the benefit of the company at the cost of the public. (x)

Concentration of Economic Power and Wealth and Inefficient Management : Most of the important companies in a country are dominated by a few wealthy individuals. As they are elected as directors, there would be a concentration of wealth and economic power in their hands. They manage to get themselves re-elected by some means or the other. However such people may lack adequate experience and skill. Hence they may not be in a position to manage the affairs of the company efficiently.

(xi) Delay in Taking Decisions : The Board of Directors of a joint-stock company cannot take quick decisions and prompt action to meet the changes in demand for its product. This is because there is a lot of discussion and consultation before taking any decision. This causes unnecessary delay. Hence when quick decision and prompt action are required, a company form of organization is not suitable as a partnership concern or even a private proprietorship concern. CONCLUSION : The joint-stock system has much contributed to economic progress. This is because it is responsible for tremendous industrial progress, production and trade. 4.

JOINT - HINDU FAMILY FIRMS OR ORGANISATIONS : Such organization undertaking business activities exist in India. They are also called Hindu Undivided Family Business (HUF). In a Hindu Joint Family firm, all members of a family come under 'karta', a common head, who is the eldest member in the family. The Hindu Law determines their rights and liabilities. Such organizations were important in the past. But now their importance has declined. This is because they are not suitable for many economic activities in modern times. Joint Hindu Family have some of the features of a partnership firm. However, the ownership of a joint family firm is not due to A contract but due to inheritance. Hence the male members of joint family firms are called co-parceness and not partners.

5.

CO-OPERATIVE SOCIETIES OR CO-OPERATIVE FORM OF BUSINESS ORGANISATIONS : Introduction : The co-operative movement started in England and Germany in the middle of the 19th century. But, in India, it began only in 1904 after the Co-operative Societies


39

Act, 1904, was passed. This Act was passed mainly to provide credit to farmers and prevent them from borrowing from money-lenders. Since 1904, the co-operative movement has made considerable progress in India. (A) Definition of Co-operation : In a wide sense, "co-operation means working together for a common purpose". Hence, in the co-operation, the main principle adopted is" all for each and each for all". As per the International Labour Organization (ILO). Co-operation is a voluntary association of individuals with limited income on the basis of equal rights and responsibilities for achieving certain economic interests common to all of them. This is done by forming a democratically controlled organization and making an equitable contribution to its capital and accepting a fair share of risks and benefits of the organization. (B) Principles of Co-operative Organizations : (i)

A co-operative organization is a voluntary association.

(ii)

It is established to promote common economic interests of all its members and thereby promote their general welfare.

(iii) Its management is democratic in nature. There is one vote for one member. (iv)

All members enjoy equal rights and status.

(v)

Its business is very often confined to the members only.

(vi)

Profit motive is not supreme. It stresses mutual help, honest means and moral values. It believes in the principle of "all for each and each for all".

(C) Features of Co-operative Organizations : (i)

Voluntary Association : A co-operative society is a voluntary association of individuals having limited means, formed to promote and protect their common economic interests.

(ii)

Democratic Management : The members of the managing committee are elected by the members of a society on the basis of "one head" one vote", whatever be their individual share holding.

(iii) Equality : A co-operative society functions on the basis of equal rights, equal status and responsibilities of members.

40


(iv) Equitable Contribution : The members make an equitable contribution to its capital. (v)

Thrift and Self-help : It promotes thrift, self-help and mutual assistance.

(vi) Sharing of Risks and Profits : The members have to bear a fair share of risks and enjoy a fair share of profits from their co-operative society. (vii) Service Motive : Although a society enjoys profits, its main objective is service for promoting common economic interests of the members as well as for promoting self-reliance, brotherhood, honesty and social relations among them. (viii) Evils of Capitalism : It eliminates some of the evils of capitalism, e.g., exploitation of consumers, workers, concentration of wealth and economic power in a few hands, etc. (ix) Legal Status : A co-operative society enjoys a legal status, for it is registered under the Co-operative Societies Act. (x)

Government Control : Such societies are controlled and regulated by the government.

(D) Types of Co-operative Societies : There are various types of co-operative societies such as Consumers' Co-operative Societies, Producers' Co-operative Societies, Co-operative Credit Societies, Cooperative Service Societies, Co-operative Farming Societies, Co-operative Marketing Societies, Co-operative Housing Societies, etc. (E)

Merits and Demerits of Co-operative Societies : Merits of Co-operative Societies. (a)

Voluntary Association : They are formed voluntarily. Individuals are free to join or leave the societies.

(b)

No Evils of Capitalism : Such societies can eliminate some of the evils of capitalism and communism for they lie in between the two extreme economic systems. They check the malpractices of monopolists and capitalists.

(c)

Purchases and Sale of Goods : There is no speculative buying of goods. There is also no problem of sales promotion by means of advertisement.

(d)

No Malpractices and Reasonable Prices : They can also remove malpractices in business like black-marketing, adulteration of goods, etc. The consumers also get various goods at low prices.

(e)

Legal Status : A co-operative society has an independent legal status.


41

(f)

Common Benefits : People with small means can easily form such societies to promote their common interests. They do not involve many legal formalities.

(g)

Team Spirit : They are democratically managed, i.e. they are managed by elected representatives. The members have right to vote. Such societies help develop team spirit among their members.

(h)

Social Values : They promote social values such as mutual sacrifice, mutual help etc. and bring about an economic equality. They stress equal distribution of wealth.

(i)

Service Motive : They provide various types of services to their members. They also obtain voluntary services from their members. Hence their cost of operation is low.

(j)

Liability : In such a society, the liability of members in limited to the extent to which they hold the shares therein.

(k)

Concessions and Encouragement : The government provides various facilities to promote their growth by means of assistance, concessions etc. For e.g. the low income groups can form housing societies to solve their housing problem in cities and towns.

(l)

Debt, Insolvency etc. : They are not affected by debts, insolvency or insanity of their members. Hence they are relatively stable.

(m) Undistributed Profits : Their undistributed profits add to their capital which can be used to expand their activities. Demerits of Co-operative Societies.

42

(a)

Malpractices : Some of the members of a society may be unscrupulous. They may resort to malpractices to exploit weak members and to promote their personal interest. This would result in conflicts, rivalry, quarrels and failure of the society to function properly.

(b)

Limited Finance : As compared to a joint-stock company, the power of a co-operative society to raise finance is limited. So it is financially weak.

(c)

Inefficient Management : Members of the management of such societies may be selected on personal considerations. They may not be honest and competant. They may not also possess skill and efficiency to run them efficiently. Hence their efficient management is difficult. They cannot also secure the services of experts and specialists nor can they get trained personnel. This is because they cannot afford to pay high salaries.

(d)

Rivalry : There may be rivalry among the members of the society to secure control over the management of societies.

(e)

Lack of zeal : Their member may not possess zeal, enthusiasm and urge to members and may not extend whole-hearted co-operation. They try to get only the services rendered by a co-operative society and enjoy their benefits. Managerial Economics

(f)

Lack of Co-operative Spirit : Lack of co-operative spirit and Lack of knowledge of the principles of co-operation on the part of members may obstruct the growth of co-operative organizations.

(g)

Business Secrecy : In such societies, business secrecy may not be maintained because their affairs are carried on democratically.

(h)

Government Control : They are subject to too much government control and regulations. Hence they might not be in a position to work efficiently.

(i)

Limits of Expansion : Such organizations cannot extend their activities much due to limited finance and limited management skill.

(j)

Limited Buyers : The sales of a co-operative society are generally restricted to a limited number of buyers.

(k)

Political Parties : The political parties may use such societies to promote their interests.

However, in spite of their limitations, they have an important role to play in improving the conditions of the poor people. Hence they should be made more effective. 6.

PUBLIC ENTERPRISES / PUBLIC SECTOR UNDERTAKINGS (P.S.U’s) :

(A) Definition : The public enterprises refer to enterprises which are owned, managed and controlled by the government – either Central or State or Local self governments. They are called "state enterprises" or "public undertakings". They include Indian Railways, river projects, basic and key industries, various public utility undertakings providing road transport, water, electricity, gas etc. (B) The Main Features of Public Enterprises : (1)

State Control : They are owned, managed and controlled by the departments concerned of the government or by the government bodies.

(2)

Management : Some of them may be managed by professionals.

(3)

Accountability : They are accountable to the public because they are accountable to the government which represents the people.

(4)

Separate Funds : They are assigned separate funds to undertake their activities.

(5)

Legal Status : Each public enterprises is a separate legal entity, for it is established by law. Some of the public enterprises enjoy autonomous status operating as per the state policy and general directives from the government. So they are influenced more by the state policy than the enterprises in the private sector.

(6)

Profit : Some of them may work for promoting welfare of the people rather than making profits. Some of them are run on commercial principle so as to make profits. But profit-making is not their main motive for, at the same time, they have to promote social ends.


43

(C) Forms of Public Enterprises : There are three forms of organization adopted for the management of public enterprises. 1)

Departmental Management

2)

Company Management or management by boards and

3)

Public Corporations.

1)

Departmental Management : There are some undertakings which are run by the government departments e.g. posts and telegraphs, railways, defence industries, information and broadcasting, atomic energy etc. Normally enterprises which are strategically important and which provide steady income to the government are departmentally-managed.

The main features of the Departmentally - managed Undertakings are : 1.

They are managed by various departments of the government.

2.

The civil servants are assigned the job of running them.

3.

The ministries concerned exercise control over them.

4.

They are financed by the government by means of annual appropriations from the treasury.

5.

They are accountable to the public through the government.

Their defects are : Such departmentally-run enterprises are subject to a number of criticisms such as lack of initiative, rigidity in operations, ignorance of consumers' requirements, red-tapism, delay in taking decisions, wrong decision, politicallymotivated decisions, etc. Hence their working efficiency suffers. It these defects are eliminated, they can be run efficiently. This can be achieved, to a large extent, if an autonomy is given to such enterprises in their day-to-day working. 2)

Joint Stock Company Form of Management : Certain enterprises, which may be entirely owned by the government, are operated as private limited companies. The main features of the Government Companies are :

44

1.

They are owned by the government.

2.

They are commercial in nature. They are dynamic and quick in decision - making.

3.

They are registered as private limited companies.

4.

Their financial operations are subject to a close scrutiny by the government.


5.

Their attempt to eliminate some of the defects of the departmentally run enterprises.

Some of the important government companies in India are : The Bharat Heavy Electricals Ltd., (BHL), the Hindustan Steel Limited (HSL), the Hindustan Antibiotics Limited (HAL), the Bharat Aluminum Company Limited (BACL), the Steel Authority of India Limited (SAIL), etc. 3)

Public Corporations : Public corporations refer to autonomous organizations created by statutes or special acts of the legislature to run the nationalized to run the nationalized enterprises or newly set up public undertakings.

Their main feature are : 1.

They are created by special acts of the parliament. So they are legal entities owned by the government.

2.

They enjoy internal and financial autonomy, i.e. they are financially independent autonomous institutions. So they are free from the parliamentary control in respect of their day-to-day management t and financial operations. They take all decisions independently.

3.

Their powers and functions are clearly laid down by respective acts of the parliament.

4.

They are run like commercial concerns.

5.

They attempt to blend the public ownership and private initiative and flexibility for they are free from bureaucracy in administration and management.

6.

They are supposed to eliminate the defects of the departmentally - run enterprises as well as those of company type undertaking of the state.

7.

They are managed by Boards of Directors appointed by the government who need not be form the cadre of civil servants.

Some of the corporation set up in India are the Life Insurance Corporations (LIC), the State Road Development Corporation (SRDCs), the State Trading Corporation (STC), The Damodar Valley Corporation (DVC), the Reserve Bank of India (RBI), the Oil and Natural Gas Commission (ONGC), the Air India, the Indian Airlines Corporation, the Industrial Finance Corporation of India (IFCI), Food Corporation of India etc. (D) Advantages (i.e. Merits) and Disadvantages (i.e. Demerits) of Public Enterprises : Merits of Public Enterprises 1)

Use of Profit : Some of the public enterprises like post and telegraphs are not run for earning profit while other enterprises like Hindustan Machine Tools (HMT) as in


45

India are run for making profits. But the profits earned by them are utilized for improving services rendered or for further expansion of their activities. Thus profits earned by state enterprises can be used to promote general welfare. 2)

Nature of Investment : There are certain fields in which the private sector will not invest either because it is too risky or because the yield on such investment is too low and spread over a very long period. The government has, therefore, to undertake such investment in the interest of society, e.g. construction and management of river linking projects.

3)

Sufficient Capital : It is also quite likely that the private sector may not be in a position to raise enough capital for a project or an industry. But the government can raise any amount of capital from various sources for investment in any project or an industry. Hence such projects or industries are started in the public sector.

4)

Public Welfare : In certain fields, the state enterprises may work more efficiently than private enterprises. This is particularly the case with public utility services like electricity, water, railway service etc. If they are left to the private sector, the consumers may be exploited. Hence they are organized by the government on the monopoly basis to secure economies of scale.

5)

Economies of Large-scale Production : On account of large-scale production, they can enjoy the economies of large-scale production.

6)

Consumer Interests and Quality of Goods : As compared with the private sector enterprises, the quality of goods or services provided by the public enterprises is likely to be better. They will also be made available at reasonable prices. Hence the interests of consumers would be safeguarded.

7)

Labour Relations : The scope for conflicts between workers and the public enterprises would be minimum. This is because the workers are likely to be more contented due to security and justice in service.

8)

Industrial Development : When a country has a few entrepreneurs and the skilled labour is limited. The government may set up a number of industries by inviting foreign skilled labour to help it to accelerate the pace of industrial development. It may also attract very efficient personnel and best managerial talent by offering high salaries and better service conditions.

9)

No Wastes : All wastes of economic resources in the form of existence of excess capacity in the private sector industries, competitive advertisement etc. can be eliminated if they are nationalized and run by the government.

10) Check on Concentration of Economic Power and Private Monopoly : The public enterprises can help to check the concentration of economic power in the hands of a few individuals and the growth of private monopolies. 46


11) Balanced Development : They can contribute to a balanced regional development by locating public enterprises in less developed areas and thereby reduce the regional income inequalities. 12) Ultimate Control by People : The working of the public enterprises is subject to the criticism of the people and the Members of Parliament. Hence, if there is anything wrong in the working of the public enterprises, it would be set right. So the public enterprises are ultimately controlled by the people themselves.

Demerits of Public Enterprises : 1)

Inefficient management : The government officials may take a long time in taking decisions as well as action. Hence the government enterprises may be run with excessive social cost of operation. This may be so because all of them may not possess much business experience.

2)

No Incentive for Hard Work : The public enterprises may not create incentives for hard work for their workers. The managers may not take any risk. This is because their acts are questioned.

3)

Bureaucracy and Red-tapism : Bureaucracy, red-tapism and corruption may obstruct the growth of public enterprises. The bureaucrats may not take quick action because they have followed the established procedures. Hence they may cause losses to the public enterprises. This would involve a burden to the taxpayers.

4)

Lack of Incentives : Because of lack of incentives, personal initiative may be lacking and the responsibilities may be avoided. This is because the government officials may work in a routine way. In other words, they may not work enthusiastically and efficiently.

5)

Extravagance : The officials in charge of managing these enterprises may plan in a big way and spend extravagantly. This would cause much loss to the public sector year after year.

6)

Friction : There may also be an internal friction between various officials in a public enterprise. Hence its efficiency would suffer.

7)

Political Considerations : Political considerations may determine appointments, transfers and promotions. Hence right man may not be placed in the right place. Such a policy is detrimental to the efficient working of the public enterprises. Further bribery and corruption may predominate. Also an enterprise may be located in a particular area out of the political rather than economic considerations.

8)

Rigidity : There may be rigidity in the working of the public sector enterprises due to strict rules and regulations.


47

9)

Transfers : There might be frequent transfers of the government officials. This would disturb the smooth working of the government enterprises.

10) Helplessness of Consumers : Individual consumers will be helpless when goods and services are provided by big public enterprises. They may not much care for the public. They may not get proper treatment from the officers in the public enterprises. 11) Personal Liberty : Extension of the public sector may result in centralization of powers and a loss of personal liberty. Also it may reduce resources available for investment in the private sector. Hence the working to the private sector industries would suffer. 12) Government Interference : Due to too much interference form the government, the executives in charge of the public enterprises may not take their own decisions to run them properly. 13) Workers' Interests : The workers' interests may not always be protected resulting in labour unrest. However the authorities may, sometimes, yield to the pressure of workers' demand due to the political considerations. 14) Prices : The public enterprises may go on increasing prices of their goods and services periodically. This would result in a decline in the welfare of the people. Some of these disadvantages can be largely eliminated if autonomy is ensured in their internal working and proper incentives are provided for their successful working. This would reduce economic inequalities and promote public welfare. 7.

JOINT - SECTOR ENTERPRISES : In India, the concept of joint-sector was accepted by the Government of India through its Industrial Licensing Policy of 1970. The Government reiterated it in its Industrial Policy decision of February, 1973. In simple terms, the joint-sector is a form of partnership between the private sector and sector and the government. In this, the government and public financial institution provide a part of the capital and the other part of the capital comes from the private sector and investing public. However the day-to-day management of the joint-sector enterprises is left in the hands of the private sector which possesses the technical and managerial expertise. However on the Board of Directors of a joint-sector, the government is adequately represented to regulate its functioning. The Board of Directors would lay down the policies for the joinsector enterprises. The government has to guide their management and operations.

48


Thus the joint-sector enterprises are controlled by the government and the private sector jointly. The joint-sector can be used to promote socio-economic objectives of the government such as regional dispersal of industries, etc. Thus a joint-sector involves a social control over industries without resorting to their nationalization, i.e. it lies between private enterprise and outright nationalization. In India, some of the important joint-sector enterprises are Indian Telephone Industries Limited (ITI), Hindustan Machine Tools (HMT), etc. The state government in India have also entered into joint ventures with the multi-national corporations. 8.

NON - PROFIT ORGANISATIONS : Non - Profit organisation can be classified into public sector organisations and private sector organisations. Some organisations created by the Government in the public sector are directed towards meeting the basic needs of the people. Many private sector organisations are created by socially oriented people with a view to meet certain needs of the society which are not yet fulfilled. In both these cases profit making is not a goal. It is possible to classify non- profit organisation into public utilities and social service organisations. Water supply, postal services, general hospitals, etc., are examples of public utilities. On the other hand, organisation of voluntary social workers, also known as NGOs (non-governmental organisations) working in the fields like rehabilitation of disabled persons, pensioners' homes, adult education, non-formal education, schools for the blind or the deaf, HIV/AIDS awareness etc., are examples of this type. The following chart illustrates this classification : Non-Profit Organisation

Public Sector

Private Sector

Public Utilities

Social Service Organisations


49

Organisation : Public sector non - profit organization can take various forms like departmental establishments, autonomous boards / corporations etc. Their organizational patterns, merits and demerits are as discussed earlier under public sector undertakings. Some characteristics, however are worth noting. (i)

Most of these organizations enjoy a certain degree of autonomy to make room for flexibility and quick decision;

(ii)

Such organizations have a provision for advisory boards or committees which can provide broad guidelines for the functioning of the organization as well as for the purpose of a general monitoring;

(iii) Normally local or regional branches / boards have the freedom to adjust their activities to the local needs of the society; (iv)

The beneficiaries or the users can send their suggestions / complaints for improving the performance of these organizations;

(v)

Annual accounts are audited and placed before the house concerned like the municipal corporation, legislative assembly or the parliament.

Private sector organizations usually prepare their own constitution and get the organization registered under the Public Trust Acts as well as / or Societies Act. The members constituting such charitable social service organization constitute what is known as the General Body which meets once a year to review the report and to accept the accounts. The day - to - day functioning is taken care of by the Executive Committee or the Management Council or some such committee under any other name like the business council, supervisory board etc. Whatever the type of non-profit organization, a common characteristics is that it serves some very important need of the people which either cannot be met through the market mechanism or, if left to market mechanism, users are likely to be exploited or go unserved. The pricing policy of such organizations depends upon whether the organization is aided or funded by some other philanthropic organization. At times the services are rendered free of charge and the costs are entirely borne by the funding agencies or the government, as the case may be. Sometimes the prices are subsidized for keeping them low and within the reach of the low income beneficiaries. Sometimes prices / fees are discriminatory being linked to the annual income of the users. In some cases, the prices just cover the costs. In modern times, and especially in more developed countries, voluntary agencies are being entrusted with task which earlier were performed by the government. This arrangement of voluntarism has various advantages. Such voluntary organizations -

50


9.

(i)

can provide quality service for they are run by committed social workers,

(ii)

can ensure peoples, participation due to their service motive,

(ii)

can be flexible in procedure and approach and this suits the people,

(iv)

are close to the people and therefore, can remain in touch with the users and can monitor the way in which needs of the people are met,

(v)

can take a feed back and re-adjust their methods / procedures to instill more efficiency or better quality in service.

BUSINESS ORGANISATIONS OF THE NEW MILLENNIUM : By the turn of the century, mainly due to the technological developments, the firms all over the world started experiencing phenomenal changes and challenges. The following can be listed as the major ones : (i)

With a systematic removal of barriers to trade, under the WTO system, the markets widened suddenly and extended to global dimensions.

(ii)

Relaxation of exchange controls and freedom of convertibility of currencies expanded investment opportunities and subsequent flows of capital.

(iii) Mass production of personalized products replaced mass production of the yester years. (iv)

Aggressive sales promotion and attractive marketing campaigns became an inevitable part of the firm's business strategy.

(v)

Widening of markets and reduction in average costs shifted the point of optimum production so high that the firms kept growing and reaping advantages of largescale production.

(vi)

The incidence of industrial sickness and closures reached unforeseen dimensions.

(vii) The process of acquisitions and mergers was accelerated out of the survival instinct of the firms. (viii) Advertising, mainly through the powerful electronic media, reached unprecedented proportions and started designing the tastes of the consumers. (ix) The competition that emerged was in pleasing the consumers by apparently satisfying his need which, in reality, were actually tailored by the gigantic firms with their clever manipulation.


51

10. DISTINCTION BETWEEN PRIVATE SECTOR AND PUBLIC SECTOR : (i)

On the Basis of Economic System : The private sector is fully owned and managed by private individuals and private firms. There is private ownership in the means of production. But the public sector is fully owned and managed by the State. There is public ownership in the means of production.

(ii)

On the Basis of Economic System : The private sector is based upon capitalism. But the public sector is based upon socialism.

(iii) On the Basis of Motive : The private sector is profit-motivated. But the public sector is to promote social welfare by rendering various types of services to public. (iv) On the Basis of Principle of Pricing : In the case of the private sector, the prices of goods and services are determined by the market forces of supply and demand. The prices are fixed in such a way that the profits are maximized. For maximizing profits, the marginal cost is equated to marginal revenue. In the case of the public sector, the prices are administratively fixed. They are not determined by market forces. The objective of social welfare is given emphasis while fixing the prices in the public sector. (v)

On the Basis of Controls : The private sector is controlled by individuals, partnership firms and joint-stock companies. But the public sector is controlled by the State.

(vi) On the Basis of Nature of Investment : The private sector is interested mainly in the investments in those industries which provide reasonable profits in a short period, e.g., light consumer goods industries, durable consumer goods industries, etc., producing TV sets, medicines, cloth, transistors, etc. But the public sector invests in those industries or projects in which the private sector will not invest either because it is too risky or because the yield on such investment is very low and spread over a very long period, e.g., defense industries, river projects, iron and steel industry, fertilizer industry, railways, posts and telegraphs, oil exploration etc. 11. SPECIFIC ORGANISATIONAL GOALS / MOTIVATION / OBJECTIVES OF FIRMS : Introduction : The decision-making of firms is guided by the goals and objectives which they seek to achieve. Over time different assertions have been made regarding their objectives. This is particularly so since corporations have emerged as an important form of organization. Even in developing economies, corporations contribute a significant percentage of manufacturing activities. The objectives of the firm as put forth by Williamson, Marris, Simon, Cyert and March start from this basic fact, i.e. the emergence of corporations as an important form of organisation. Since the interests of managers may be different from those of owners, different hypothesis have been presented by these authors regarding the objectives of the firm. Those modify the decision-making process. 52


A)

MAXIMIZATION OF PROFIT / TRADITIONAL APPROACH : Profit maximization has been the most important assumption on which economists have built price and production, theories. This hypothesis has however been strongly questioned. This issue will be dealt with later. Let us first look into the importance of the profit maximization hypothesis and theoretical conditions of profit maximization. The conventional economic theory assumes profit maximization as the only objective of business firms. Profit maximization as the objective of business firms has a long history in economic literature. It forms the basis of conventional price theory. Profit maximization is regarded as the most reasonable and analytically most 'productive' business objective. The strength of this assumption lies in the fact that this assumption 'has never been unambiguously disproved'. Besides, profit maximizations assumption has a great predictive power. It helps in predicting the behavior of business firms in the real world and also the behavior of price and output under different market conditions. No alternative hypothesis explains and predicts the behaviour of firms better than the profit maximization assumption.

Maximum Profit Conditions : There are two conditions that must be fulfilled for the profit to be maximum : (i) necessary conditions and (ii) secondary conditions. The necessary condition requires that marginal revenue (MR) must be equal to marginal cost (MC). Marginal revenue is obtained from the production and sale of one additional unit of output. Marginal cost is the cost arising due to the production of one additional unit of output. The secondary condition requires that the necessary condition must be satisfied under the condition of decreasing MR and rising MC. i.e. MC curve must cut the MR curve from below. The fulfillment of the two conditions makes the sufficient condition.

Controversy over Profit Maximization : Although profit maximization has been the most widely known objective of business firms, some economists have raised doubts on the validity of this objective. The important objections to this objective are the following. First, profit maximization assumption is too simple to explain the business phenomenon in the real world. In fact, businessmen are themselves not aware of this objective attributed to them. Second, it is claimed that there are alternative and equally simple objectives of business firms that explain better the real world business phenomenon, e.g. sales maximization, a target rate of return, a target market share, preventing price competition and so on.


53

Third, it is argued that firms do not have the necessary knowledge and a priori data to equalise MR and MC. Hence firms cannot attempt to maximize their profits in the manner suggested by the conventional theory.

In Defense of Profit Maximization Assumption : The conventional economic theory defends the profit maximization assumption on the following grounds. First, only those firms survive in the long run in a competitive market which are able to make a reasonable profit. Once they are able to make profit, they would always try to make it as large as possible. All other objectives are subjugated to this primary objective. Second, profit maximization assumption has been found extremely accurate in predicting certain aspects of a firm's behaviour. Friedmen argues that the validity of profit maximization hypothesis cannot be judged by a priori logic or by asking the business executive. The ultimate test is its ability to predict the business behaviour and trends. Third, profit maximization assumption is a time-honored objective of a business firm and evidence against this objective is not conclusive or unambiguous. Fourth, though not perfect, profit is the most efficient and reliable measure of efficiency of a firm. If is also the source of internal finance. In developed economies, internal source contributes more than three fourths of the total finance. B)

REASONABLE PROFIT TARGET : We have noted that profit maximization is theoretically the most sound and time-honoured objective of business firms. But profit maximization in a technical sense, i.e. making MC = MR, is beset with serious computational and data problems. Most goods and services are produced in large quantities - bulks and batches. Only few goods like ships, planes, turbines, big plant and machinery, etc., are countable in units. Business books of accounts do not reveal unit cost and revenue. For Example HMT or TITAN would not be able to find cost of one additional wrist watch produced and the addition to its total revenue. In practice, therefore, modern firms and corporations do not aim at profit maximization. Instead they have "a standard", "a target" or "a reasonable profit" which they strive to achieve. Why do modern corporations aim at a "reasonable profit" rather than attempting to maximize profits?

Reasons for Aiming at "Reasonable Profits" For a variety of reasons, modern large corporations aim at making a reasonable profit rather than at maximizing the profit. Joel Dean has listed the following reasons.

54


C)

1.

Preventing entry of competitors : Profits maximization under imperfect market conditions generally leads to a high 'pure profit' which is bound to attract competitors, particularly in case of a weak monopoly. The firms therefore adopt a pricing and a profit policy that assures them a reasonable profit and, at the same time, keeps potential competitors away.

2.

Projecting a favourable public image : It often becomes necessary for large corporations to project and maintain a very good public image, for if public opinion turns against it and government officials start raising their eyebrows on profit figures, corporations may find it difficult to sail smoothly. So most firms set prices lower than that conforming to the maximum profit but high enough to ensure a "reasonable profit".

3.

Restraining trade union demands : High profits make trade unions feel that they are deprived of their due share and therefore they raise demands for wage hike. Wage-hike may lead to wage - price spiral and frustrate the firms' objective of maximizing profit. Therefore, profit restrain is sometimes used as a weapon against trade union activities.

4.

Maintaining customer goodwill : Customers' goodwill plays a significant role in maintaining and promoting demand for the product of a firm. Customers, goodwill depends largely on the quality of the product and its, 'fair price'. What consumers view as fair price may not be commensurate with profit maximization. Firms aiming at better profit prospects in the long run, sacrifice short-run profit maximization in favour of a "reasonable profit'.

5.

Other factors : Some other factors that put restraint on profit maximization include (a) managerial utility function being preferable to profits maximation for executive, (b) congenial relation between executive levels within the firm, (c) maintaining internal control over management by restricting firm's size and profit, and (d) forestalling the anti-trust suits.

SALES REVENUE MAXIMIZATION : Baumol has suggested maximization of sales revenue as an alternative objective to profitmaximization. The reason behind this objective is the separation of ownership and management interests. This dichotomy gives managers opportunity to set their goals other than profit maximization which most owner-businessmen pursue. Given the opportunity, managers choose to maximize their own utility function. According to Baumol, the most plausible factor in managers' utility functions is maximization of the sales revenue. The factors which explain the pursuance of this goal by the managers are the following. First, salary and other earnings of managers are more closely related to sales revenue than to profits. Secondly, banks and financial corporations look at sales


55

revenue while financing the corporation. Thirdly, trend in sales revenue is the readily available indicator of performance of the firm. It helps also in handling the personnel problem. Fourthly, increasing sales revenue enhances the prestige of managers while profits go to the owners. Fifthly, managers find profit maximization a difficult objective to fulfill consistently over time and at the same level. Profits may fluctuate with changing conditions. Finally, growing sales strengthen competitive spirit of the firm in the market and vice versa. D)

MAXIMIZATION OF FIRM'S GROWTH RATE : Prof. Morris has suggested another alternative objective i.e., maximization of balanced growth rate of the firm, which means maximization of 'demand for firm's product' or 'growth of capital supply'. According to Morris, by maximizing these variables, managers maximize both their own utility function and that of the owners. The managers can do so because most of the variables (e.g., salaries, status, job security, power, etc.) appearing in their own utility function and those appearing in the utility function of owners (e.g. profit, capital, market share, etc.) are positively and strongly correlated with a single variable, i.e. size of the firm. Maximization of these variables depends on the maximization of the growth rate of the firms. The managers therefore seek to maximize the steady growth rate. Morris's theory, though more rigorous and sophisticated than Baumol's sales revenue maximization, has its own weaknesses. It fails to deal satisfactorily with oligopolistic interdependence. Another serious shortcoming of his model is that it ignores price determination which is the main concern of profit maximization hypothesis. Morris's model too does not seriously challenge the profit maximization hypothesis.

E)

SATISFYING BEHAVIOUR : Some economists like Cyert R. M. and J. G. March argue that the real business world is full of uncertainty, accurate and adequate data are not readily available; where data are available managers have little time and ability to process data; and managers work under a number of constraints. Under such conditions it is not possible for the firms to act in terms of rationality postulated under profit maximization hypothesis. Nor do the firms seek to maximize sales, growth or anything else. Instead they seek to achieve a 'satisfactory profit', a 'satisfactory growth', and so on. This behaviour of firms is termed as 'Satisfaction Behaviour'. The underlying assumption of 'Satisfaction Behaviour' of firms is that a firm is coalition of different groups connected with the various activities of the firm e.g., shareholders, managers, workers, input supplier, customers, bankers, tax authorities and so on. All of these groups have some kind of expectations - often conflicting - from the firm, and the firm seeks to satisfy all of them in one way or another. The behavioural theory has however been criticized on the following grounds. First, though the behavioural theory deals realistically with the firm's activity, it cannot explain the

56


firm's behaviour under dynamic conditions in the long run. Secondly, it cannot be used to predict exactly the future course of firm's activities. Thirdly, this theory does not deal with equilibrium of the industry. Fourthly, like other alternative hypothesis, this theory, too fails to deal with interdependence and interaction of the firms. F)

LONG-RUN SURVIVAL AND MARKET SHARE GOALS : Another alternative objective of a firm - as an alternative to profit maximization - was suggested by Rothschild. According to him, the primary goal of the firm is long - run survival. Some others have suggested that attainment and retention of a constant market share is the objective of the firms. The managers therefore seek to secure their market share and long-run survival, the firms may seek to maximize their profit in the long-run, though it is not certain.

G)

ENTRY - PREVENTION AND RISK AVOIDANCE : Yet another alternative objective of the firms suggested by some writers is to prevent entry of new firms into the industry. The motive behind entry-prevention may be (a) profit maximization in the long run, (b) securing a constant market share, and (c) avoidance of risk caused by the unpredictable behaviour of the new entrants. The evidence on whether firms maximize profits in the long run is not conclusive. Some argue that where management is divorced from the ownership, the possibility of profit maximization is reduced. Some argue that only profit-maximizing firms can survive in the long run. They can achieve all other subsidiary goals easily if they maximize their profits. No doubt, prevention of entry may be the major objective in the pricing policy of the firm, particularly in case of limit pricing. But then, the motive behind entry-prevention is to secure a constant share in the market. Securing constant market share is compatible with profit maximization.

H)

THE HOMEOSTATIC THEORY Prof.Kenneth Boulding was critical of the traditional theory on the ground that it ignored the information that could be available to the firm and assumed the availability of information which could never be available. The theory therefore, was of no use as a guide to practical policy. For this reason he advocates the homoeostatic theory. According to the homeostatic approach, there is some state of the system which it is designed to maintain. If any disequilibrium in this state occurs, counteracting forces start operating and the desired state is re-established. the organism has a usual tendency to maintain its stability by keeping its mood and configuration stable. Only when some stress is applied, the organism causes a deviation from normal state. Such a deviation brings about changes in mood and configuration and the effects of the stress are nullified.


57

In explaining the approach, Boulding says," There is some desired quantity of all the various items in the balance sheet, and that any disturbance of this structure immediately sets in motion forces which will restore the status quo. Thus, if a customer purchases a product, this diminishes the firms' stocks of finished product, and increases its stock of money. In order to restore the status quo, the firm must spend the increased money stock to produce more finished products'. A firm adjusts its entire behavior to maintaining a given state or position. Its existing asset-structure, for instance, is what it would seek to preserve. Any change in this structure would be responded by countervailing action. A fall in liquidity, to take another example, would prompt the firm to restore its original liquidity position. The homeostatic theory is useful as a first approximation regarding the motivation of a firm. But when we extend this theory to complex areas of decision-making, it breaks down. Main objections raised against the theory can be summed up as following: i) It is static theory and does not allow any change in the original state, ii) it has nothing to say regarding normal and ideal structure of a balance-sheet which the firm tries maintain. iii) a study of the decision taken by firms does not be what Boulding says. Even in the short-run certain fluctuations arise which actually show a lack of an adequate homeostatic mechanism. I)

THE LIFE-CYCLE APPROACH Like all organism, the firm, too is an organism, according to the life-cycle theory. The firm therefore, has its own law of growth and survival. It exhibits a cycle of birth, growth, decay and death. A firm is born when there is an opportunity and a scope for its existence. An existing firm may face unfavorable circumstances in terms of rising costs of inputs or falling demand. When such a firm incurs losses, it may continue to operate for a while; but will ultimately close down. This is because the resources available to the firm can be utilized productivity in some other field. In the early stages the firm has the advantage of a new market or a new product and can forge its way ahead with strong competitive courage and capability. With growth, it consolidates its position and gets structured with internal efficiency and managerial acumen. At a later stage rival firms may cause an erosion of its market mainly due to their superior techniques or marketing advantages. The firm's objective then becomes increasing competitive strength. But as the industry approaches maturity, demand is saturated, costs of further market penetration get high and the firm aims at long-term growth and flexibility, though these objectives become difficult to attain. The firm may survive for some time or may face decay, at such a time. This is an evolutionary approach and it does apply to all organisms living in a dynamic world. However, in the short -run, evolutionary characters do not become apparent. Again, the theory leaves out several other considerations which are relevant.

58


12. OTHER GOALS OR OBJECTIVES OF FIRMS : Normally, it is the entrepreneur who decides about the size of the firm which he wants to manage or start. This he will decide after finalizing the aims and objectives of the firm. So we have to consider the other possible objectives of a firm in addition to the goals we have already discussed in a free enterprise economy. The following are the other objectives of a firm in a free enterprise economy: 1.

Personal Ambitions: Many times a firm desires to increase its own individual importance in the business world. Many times this craving is found among firms owned by one single individual or family. This is done in more than one way. Some may have a desire to earn a name as a great donor others may desire to eliminate labour dissatisfaction, while some others may be out to provide comforts for their workers and so on. This being a personal choice any whim of the entrepreneur or owner may be the aim of the firm.

2.

Political Dominance: In a democracy, political parties and elections are inevitable. Many industrialists or businessmen have a desire to back a particular political party and to acquire political importance.

3.

Facing Competition: Every businessman or producer has to face competition. By reducing the cost of production to the minimum, a producer may survive or face competition. But if every producer does this, his cost reaches the rock-bottom and further reduction in cost is not possible. Under these circumstances, a producer may even prefer to incur losses and continue to reduce the price even though he cannot reduce the cost. This is done on the presumption that sooner or later, some of the competitors may be out of the business and then those who survive may be able to make profit and make up their losses. Under these conditions, the aim of production is not to make profit but to drive away competitors.

4.

Establishment of Monopoly : Establishment of monopoly of a particular product may even be the aim of production. For establishing monopoly, more than one trick are employed by the producers - advertising on a very large scale, dumping, selling the product at two different prices in two markets, offering rewards, etc. It is very difficult to establish and maintain monopoly over the production of any commodity. Thus, in such an effort, maximization of profits becomes a secondary objective of production and establishing monopoly becomes the primary objective.

5.

Maximization of Long-run profits: Modern production has become very complicated. Production necessarily being on a large scale includes several things, such as advertising, printing price lists and labels, supplying these lists to retailers, etc. This involves a lot of expenditure in terms of money and time. Under these circumstances, it becomes more desirable to keep long term maximum profit as the goal of production. This enables the producer to neglect short term marginal losses.


59

6.

Reasonableness of Price of Production Policy: In modern times, while planning production and the price strategy, it is necessary to take into account the probable effects of the strategy. If the price appears to be too high, the government may interfere and fix the price. In rare cases even the consumers' boycott cannot be ruled out. Avoiding any of these may even be the objective of production. We have discussed several objectives of production, other than profit maximization. In practice, we find that all these objectives do exist. But finally profit - maximization remains the only most important motive of production because without obtaining maximum profit no firm can remain in business for ever. The index of the success of production is the rate of profit. Even the success of a joint stock company is gauged by the rate of dividend. So theoretically speaking, profit maximization must be taken to be the only goal of production. Even while determining the ideal size of the unit of production, we have taken profit maximization as the only motive of production.

60


Exercise: 1.

What is 'plant', 'firm' and 'industry'?

2.

Explain 'Proprietary firm' as a form of business Organization. State its merits and demerits.

3.

Explain partnership form of business organization. State its merits and demerits.

4.

Explain the features / characteristics of a cooperative organization. Point out its merits and demerits.

5.

Write short notes on a)

Profit maximization

b)

Prof. Baumol's sales maximization goal,

c)

Reasonable Rate of profit as an organization goal

d)

Satisfying behavior theory as an organization goal

e)

The Homeostatic Theory

f)

The Life Cycle Approach


61

NOTES

62


NOTES


63

NOTES

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Chapter 3 PROFIT

Preview Meaning of Profit, Accounting Profit vs. Economic Profit, A brief review about the theories of profit, Measurement of profit, Profit Policies and Reasons for limiting profit, standard of limited profits. 1.

MEANING OF PROFIT :

Profit means different things to different people. "The word 'Profit' has different meanings to businessmen, accountants, tax collectors, workers and economists and it is often used in a loose sense that buries its real significance. In general sense, 'profit' is regarded as income accruing to the equity holders, in the same sense as wages accrue to the labour, rent accrues to the owners of rentable assets; and interest accrues to the money lenders. To a layman, profit means all incomes that flow to the investors. To an accountant, 'profit' means the excess of revenue over all paid-out costs including both manufacturing and overhead expenses. It is more or less the same as 'net profit'. For all practical purposes, businessmen also use this definition of profit. For taxation purposes, profit or business income means profit in accountancy sense plus non-allowable expenses. Economist's concept of profit is of 'Pure Profit', also called 'economic profit' or 'just profit'. Pure profit is a return over and above the opportunity cost, i.e. the income which a businessman might expect from the second best alternative use of his resources. These two concepts of profit are discussed below in detail. Accounting Profit Vs. Economic Profit The two important concepts of profit that figure in business decisions are 'economic profit' and 'accounting profit'. It will be useful to explain the difference between the two concepts of profit. In accounting sense, profit is surplus of revenue over and above all paid-out costs, including both manufacturing and overhead expenses. Accounting profit may be calculated asAccounting profit = TR - (W + R + I + M) where W = Wages, R = Rent, I = Interest and M = cost of materials. Obviously, while calculating accounting profit, only explicit or book costs, i.e. the cost recorded in the books of accounts, are considered. Profit

65

The concept of 'economic profit' differs from that of 'accounting profit.' Economic profit takes into account also the implicit or imputed costs. The implicit cost is opportunity cost. Opportunity cost is defined as the payment that would be 'necessary to drawforth the factors of productions from their most remunerative alternative employment'. In simple terms, opportunity cost is the income foregone, which a businessman could expect from the second best alternative use of his resources. For example, if an entrepreneur uses his capital in his own business, he foregoes interest which he might earn by purchasing debentures of other companies or by depositing his money with joint stock companies for a period. Furthermore, if an entrepreneur uses his labour in his own business, he foregoes his income (salary) which he might earn by working as a manager in another firm. Similarly, by using productive assets (land and building) in his own business, he sacrifices his market rent. These foregone incomes - interest, salary, and rent - are called opportunity costs or transfer costs. Accounting profit does not take into account the opportunity cost. It should also be noted that the economic or pure profit makes provision also for (a) insurable risks, (b) depreciation, and (c) necessary minimum payment of shareholders to prevent them from withdrawing their capital. Pure profit may thus be defined as 'residual left after all contractual costs have been met, including the transfer costs of management, insurable risks, depreciation and payments to shareholders, sufficient to maintain investment at its current level'' Thus. Pure profit = Total revenue - (explicit costs + implicit costs). Pure profit so defined may not be necessarily positive for a single firm in a single year - it may be even negative, since it may not be possible to decide beforehand the best way of using the resources. Besides, in economics, pure profit is considered to be a short term phenomenon - it does not exist in the long run under perfectly competitive conditions. An entrepreneur brings together various factors of production such as land, labour and capital. He ensures co-ordination between the factors and supervises the productive activity. He looks after purchase of raw materials, production, marketing, recovery of receivable and personnel. The most important function performed by an entrepreneur is, however to undertake risk and uncertainty in business. The reward which is paid to an entrepreneur for discharging this function is called Profit. In this chapter, we propose to study the emergence of profit.

(A) Gross Profit and Pure (Net) Profit When cost of production is deducted from the total sales proceeds, the residual portion is called Gross Profit. Gross Profit = Total Receipts - Total Expenditure An entrepreneur is required to make following payments out of the Gross Profit :

66


(a)

Remuneration for the factors of production contributed by the entrepreneur himselfHe must pay rent for the use of land. If the land is owned by him, he must pay notional reward for the use of land, because, he is otherwise required to pay rent if he hires land from some other person.

(b)

Depreciation and Maintenance Charges Some portion should be deducted from gross profit by way of depreciation on machinery and other assets.

(c)

Extra - Personal Profits This includes -

(d)

i)

Monopoly Profits : If a producer is a monopolist, he may be earning monopoly profits. These are profits not because of the business skill or ability of the entrepreneur, but because he is a monopolist in his field. Monopoly profits must be deducted from gross profits to arrive at net (pure) profits.

ii)

Chance Profit : An entrepreneur may earn high profits just 'by chance', say because of an outbreak of war. This is not a part of net profits.

Net Profits : When all the above payments are made out of gross profit, the residual portion is called Pure (Net) Profit. The reward which an entrepreneur gets (i) for undertaking risk and uncertainty, (ii) for co-ordinating and organizing production and (iii) for innovating is called Pure Profit.

2.

THEORIES OF PROFITS :

Various theories have been developed to explain the emergence of Profit. It is worthwhile to explain some of the theories of profit. (1)

Risk Taking Theory The Risk-Taking Theory was developed by the American economist Hawley. According to him, profit arises because considerable amount of risk is involved in business. Profit is, therefore, the reward for risk-taking. Hawley's theory has been criticized on several grounds. In the first place, Hawley has not classified the types of risks. Secondly, as Cawer has pointed out, profit is not the reward for risk-taking. It is the reward for riskavoiding. An entrepreneur is required to minimize his, risk, if he cannot eliminate it totally. A successful entrepreneur is he who earns good profits by eliminating the risk.

Profit

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On the other hand, a mediocre businessmen is not able to reduce the risk in business; and therefore, is subjected to losses. (2)

Uncertainty-Bearing Theory of Profit : Uncertainty-Bearing Theory of profit was developed by the American economist, Prof. F.H. Knight. He has classified the risks under the two heads. (a)

Certain risks such as risk of fire, risk of theft, risk of accident etc. are less important because they can be passed on to an insurance company. An entrepreneur can take an insurance policy by paying the premium. Since such risks are covered by insurance, they are called "Insurable Risks."

(b)

There are other risks which cannot be passed on to an insurance company or to the paid managers. Every business involves great amount of uncertainty and the losses arising there from cannot be estimated with precision. The prices of raw materials may suddenly increase, the supply of raw materials may be restricted and introduction of new substitutes in the market may reduce the demand for the product. When demand declines, large stocks may remain unsold in the go-down. A producer may have to face keen competition. if the market is characterised by monopolistic competition. All these factors are uncertain and losses arising there from cannot be insured with any insurance company. These risks and losses must be borne by the entrepreneur himself. According to Prof. Knight, profit is, therefore, the reward for uncertainty-bearing.

Uncertainty theory of profit has gained wide popularity since its publication. After the Industrial Revolution, production is carried out on a large scale and in anticipation of demand. Producers take into account the tastes and fashions of the people and produce the goods accordingly. Sudden change in the tastes and fashions may affect the demand for products. If a particular fashion is receded in the background, goods may not be sold at all. The losses arising out of such uncertainty cannot be estimated with precision. According to Prof. Knight, profit is, therefore, a reward of uncertainty. Uncertainty theory has been criticized on the ground that profit is the reward paid to an entrepreneur for discharging several duties. Prof. Knight has overlooked other duties and has glorified the uncertainty; the theory has no sound foundations either in logic or in practice. A number of illiterate producers who have not studied the theory, are able to anticipate precisely the profits or losses that would arise in future. (3)

Innovation Theory of Profit. Innovation Theory was developed by Joseph Schumpeter. According to him, profit is the reward paid to an entrepreneur for his innovative endeavours.

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Schumpeter has made distinction between invention and innovation. A scientist may make an invention, but this invention is exploited on a commercial basis by an entrepreneur. The basis on which the invention is exploited depends upon the innovative nature of the entrepreneur. If he is successful in exploiting the invention it is innovation. According to Schumpeter, profit is the reward for innovation. Schumpeter's theory has been criticized on several grounds. Profit is the reward for discharging so many duties; but Schumpeter has overlooked the other duties. Another point of criticism is that Schumpeter has neglected the fact that profit is also the reward for risk and uncertainty bearing. The most serious criticism of this theory is that a particular producer who exhibits an innovative character may earn super-normal profits in the shortrun. But the super normal profits will attract new firms to the industry. If new firms enter the industry, the super-normal profits would be shared between the existing as well as the new firms. In the long run, super normal profits would, therefore, disappear. It is said that profits are caused by innovation and disappear by imitation. Schumpeter's theory is, therefore, to be taken to a limited extent. (4)

Dynamic Theory of Profit The Dynamic Theory of Profit was developed by the renowned economist, J.B. Clark. Prof. Clark points out that the whole world is dynamic. Changes after changes are taking place every day; and the economic consequences of these changes are of a far reaching character. Prof. Clark has pointed out the following types of changes. a)

Changes in the quantity and quality of human needs;

b)

Changes in the techniques of production

c)

Changes in the supply of capital

d)

Changes in organization of business

e)

Changes in population

These changes can occur at any time. Techniques of production may change and improved machinery may be introduced. This may reduce the cost and increase the profit and output. But to purchase the improved machinery, a larger amount of fixed capital is required. This may necessitate the admission of a new partner or conversion of the partnership firm into a joint stock company to raise capital on a large scale. All these changes can occur suddenly, and an entrepreneur has to face them properly. A producer who overcomes these hurdles is successful in earning higher profits. He must adjust himself to the changing times. A producer who cannot address himself to the dynamic world lags behind. In order to survive and grow every producer must change the methods to suit the changing needs. According to Prof. Clark, profit is the reward paid for dynamism. Profit

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Profits in a Static Society According to Prof. Clark, profit cannot arise in a static society. In a static society there are no changes. Population is stable and the demand is stationary. Since the demand is limited, output is also limited. The general price level and factor prices being stable; the cost of production is constant. The selling price and the margin of profit are also constant. A producer has to produce a limited quantity of goods and it is sold immediately, the moment it is produced. Since demand is constant, a producer does not run the risk of uncertainty. In static society, there are no inventions and producers are not required to make innovations. Producers in a static society have not to face any changes in the tastes, fashions and output. They produce a given quantity and sell it in a routine manner. A producer in a static society works like a paid manager. He performs only the routine duties and gets normal profit. The normal profit which he gets may be called 'Wages for Management'. According to Prof. Clark, a producer in a static society gets only normal profits, because pure profit does not arise. Conclusion Prof. Clark's Dynamic Theory of Profit has been criticized on several grounds. He has classified the changes under five categories but has overlooked many other important changes. In this dynamic world, the Government policy may suddenly change. A change in the Monetary Policy of the Central Bank may bring about an expansion or contraction in the supply of money. This may lead to an expansion or contraction in the supply of capital. Ultimately it may affect the fortunes of business. Prof. Clark has overlooked such important factors. 3.

MEASUREMENT OF PROFIT :

Our discussion of profit so far, has made it clear how difficult it is to have a simple definition of profit that is acceptable to all. The measurement of profit is also equally difficult. For one thing, the economic concept of profit-and loss and the legal concept of profit-and-loss are not the same. This is especially difficult when it comes to the measurement of net profit. For calculating net profit, it is necessary to deduct all costs from the total revenue. But the inclusiveness of costs itself involves many difficulties. All these problems, therefore, deserve a more careful and detailed analysis. (A) Economic Profit and Accounting Profit : Let us take an example to understand the difference between the economic concept of profit and the accounting concept of profit. Suppose an individual starts at his residence the business of repairing scooters. At the end of the year, he gets a total revenue of Rs.1,50,000/-. Out of this, let us say, he spent Rs.50,000/- on the wages of his helper, tools and spare parts, etc. What remains is a sum of Rs.l,00,000/-. Apparently, one would be tempted to conclude that this is his profit. But it is not so. The place that is available to him might have saved him a sum of, say Rs.30,000/-. In other words, the place of work might have an opportunity cost. His own transfer earnings may be say 70


Rs.60,000/-. Had he borrowed the money capital, the interest would have been say Rs.l0,000/-. Besides, a provision will have to be made for the wear and tear of the tools and instruments, i.e. a certain amount will have to be deducted for depreciation. Thus, calculated, the total costs would be (i) Helper's wages, spares etc. Rs.50,000 + (ii) Rent Rs.30,000 + (iii) Entrepreneur's management wages : Rs.60,000 + (iv) Interest : Rs.l0,000 + (v) Depreciation Rs.5,000. This takes the total cost equal to Rs.l,55,000 against the total revenue of Rs.l,50,000 showing a let net loss of Rs.5,000. The loss in the above example does not become apparent because the entrepreneur uses some of the factors owned by himself and therefore, the remunerations to these are not actually paid. It should be obvious from the above example that these difficulties may not arise in respect of large industrial units. In such units, ownership is with the shareholders while the management is entrusted to the salaried managers. Thus, most of the costs enter the account books and the accounting and economic concepts of costs in such cases come closer. According to the financial accounting principle, the assets of a concern have claims from two sides : from the owners and from the lenders. Therefore, in any business unit, Assets = Liabilities + Proprietorship Therefore, Assets - Liabilities = Proprietorship or the net worth The balance sheet of any concern shows, during a given period, the total liabilities and the net worth after these are deducted. Similarly, the profit and loss account or the income statement shows the changes in the balance sheet of the unit from the beginning of the year and those at the end of the year is the net income or profit. The funds statement is based on this profit and loss statement. This statement indicates the financial standing of the business concern. The funds statement shows the amount of cash available and how it has been invested. While preparing all these statements, the accountant has to include items, the truth about which can be tested. But in doing so, many difficulties arise. For example, while preparing the balance-sheet, the cost of the asset that is taken is the one at which the asset was purchased. The current value of the asset is not considered. Similarly the changes in the value of money are ignored. It is also incorrect as is done in financial accounts, to calculate net profits by deducting from the total revenue of year the total costs incurred during that year. The economic concept of net profit will have to be altogether different. In the valuation of any asset, the economist is guided by the concept of opportunity cost. For example, the accounting method will take into account the original price of a machine; but in the economic concept, the replacement cost of the machine would be used. For valuation of Profit

71

the machine, further alternatives would be to take the price of a similar machine, if the same is not available; or to consider the total expected return of the machine and from that calculate the present worth of the machine. We are familiar with the various cost concepts. Thus, the differences in the profit concepts arise out of the differences in cost concepts. The modern method used for valuation is based on the cash flow technique. It will also be necessary to remember that the sum total of all the individual machines added together will not be the correct value of the total establishment. This is because the goodwill enjoyed by the concern will also have to be included in its total worth. This is how the economic and the accounting approaches differ and make measurement of profit more complicated. (B) Factors Leading to Differences in the Economic and the Traditional Concepts of Valuation The above discussion makes it clear how valuation of asset is important in the measurement of profits. Let us now consider those factors which underline the differences in the economic and the accounting approaches to the problem. These factors are : (a) Depreciation, (b) Inventory Valuation and (c) the unaccounted value changes in the assets and the liabilities. a)

Depreciation : Depreciation is the loss in value caused by the continuous use of an asset. Every durable asset has a certain life at the end of which it has got to be replaced. For such a replacement, a provision in the form of depreciation is required to be made. There are various methods of calculating this depreciation. Following are the important ones among them.

i)

Staright Line Method This is the simplest method of all. What is done is the life of an asset is first estimated and then the share of one year in the total value of the asset is deducted. What remains is taken as the value of the asset for the next year. In this way, at the end of the life-time of the asset, the firm will have collected an amount equal to the value of the asset. If, for example, the price of a machine is P, the scrap-value at the end of its life-time is S and the life of the machine is Y years, then the amount of depreciation (D) will be given by the formula : D =

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P – S Y


If P = Rs.25,000/-; S = Rs.5,000/- and Y = 20 years, the annual amount of depreciation will be 25,000 – 5,000 = 2000. This means that the 20 annual allotment towards, depreciation will have to be Rs.2000 only.

(ii)

Diminishing Balance Method In this method, the amount of depreciation is large in the initial years. Suppose the annual amount of depreciation is taken as 10 per cent of the value of the machine. Then, in the first year the depreciation will be 10 per cent of the value of the machine; but during the second year, it will be l0 per cent of the total value minus the depreciation fund created during the first year. By this method, the value of the machine will never become zero and the amount of depreciation will go on diminishing.

(iii) Annuity Method In this method, equal annual amounts are first calculated for the length of the life of an asset. However, along with the annual allotment, the interest that can be earned is also calculated.

(iv) Service Unit Method Instead of considering the life of an asset in years, the actual working hours can be taken. This is the basis of service unit method. If a machine can work for l,000 hours, then the value of the machine divided by l,000 will be the hourly rate of depreciation. The total number of hours for which the machine was actually used during a given period can thus give us the amount of depreciation during that period. The original value of machine minus depreciation will give its value for the remaining period. Whatever method used for the valuation of assets, in the accounting sense, some problems remain unsolved. Thus, for instance, every asset has a limited life and at the end of it, the asset needs to be replaced. At the time of replacement, new and more efficient machines may be available. If such new machines are to be purchased, how much money will be required and at what rate depreciation will have to be provided cannot be decided before hand, by any of these methods. This makes measurement of profit difficult. (b)

Inventory Valuation Another difficulty that is encountered is in respect of inventory valuation. This difficulty would not arise if the prices of all products and the level of all production were constant. But this never happens. The raw materials are purchased at different prices. The costs of production also change from time to time. This makes the

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valuation of of stocks of finished products very difficult. Let us first consider the two most widely used methods of inventory valuation. i)

First-In-First Out Method (FIFO) : In this method, it is assumed that goods which entered the firm's stock first were used first. Then, in this assumption, the cost of producing the given output is estimated.

ii)

Last-In-First Out Method (LIFO) : In this method, the cost of production is calculated on the assumption that the material which was last to enter the inventory of the company was used first.

It is obvious that a change in the use from either of the two methods mentioned above to the other one must lead to a change in estimate of profit. There would be a great divergence between the profits estimated by these two methods especially when the above mentioned changes in prices etc. are very rapid. The profit would appear to be abnormally high if it is calculated on the basis of FIFO in times of inflation and abnormally low in times of deflation. The methods, however, are in use due to their convenience from accounting point of view. It is thus, clear that by either method, it is difficult to state precisely the value of the inventory. This is mainly because of the changes in the value of money. Taking a stable value of money, i.e. valuation at constant prices would also not serve the purpose. Thus, due to these difficulties in the valuation of inventories, the measurement of profit is rendered difficult. (c)

The Unaccounted Value Changes in the Assets and the Liabilities Besides the above two factors which create difficulties of valuation, there is a third category of changes in the value of assets and liabilities that poses a challenge to valuation. The research that is undertaken to improve the quality of the product, the expenses on improving the efficiency of management etc. increase the value of the establishment. These costs create assets, which cannot be precisely valued. They do increase profits but cannot be expressed in terms of money, and therefore, measurement of changes in the value of assets becomes difficult. Thus, it is clear, how difficult the precise measurement of profits is. By simply using historical cost the profits are likely to be either inflated or deflated. It is, therefore, necessary to calculate costs and profits at constant price to take utmost care in calculating depreciation, to take cognizance of modern methods like cost flow techniques, management accounting and so on, and to use opportunity costs wherever necessary. Even then, a correct amount of profit may not be found out. But we shall be close to the correct estimate. The calculation of profit will also vary according to the purpose for which the calculation is required.

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4.

PROFIT POLICY :

By and large, we say that an entrepreneur aims at maximum profits. But 'how much' profit should be taken as the maximum ? This is a difficult question to answer. A scientific thought to this question must provide a guidance on the following two lines : (a) What profit should an entrepreneur expect in any enterprise, and (b) How far is profit influenced by factors, which are external to the firm. It must be understood at the outset that the freedom of an entrepreneur to decide his rate of profit depends on the nature of the market and other constraints including legal provisions, business conventions, consumer resistance and so on. Profit is usually expressed as gross profit, or as net profit or as a per cent return to capital invested. In modern business, the common practice is to express profit as a per cent net return to capital. (a)

(b)

Profit Expectations : The profit that an entrepreneur should expect can be subjected to a number of criteria. The following four criteria are widely accepted : i)

The rate of profit should be sufficient to attract share capital if felt necessary. When new shares are to be issued for expansion, the old shareholders should not have a feeling of having suffered a capital loss. New shares must therefore be sold at a price that gives the old shareholders a satisfaction that they are in possession of sound shares. Their rate of profit should be enough to command a good price for the new issue of shares.

ii)

The rate of profit should be comparable to that in similar companies. Many times, there are many independent units under the same management. In all these siter-concerns, the rates of profitability should be comparable.

iii)

The profit rate should be comparable to the profit rates in the past.

iv)

The profits should be large enough to allow for a plough-back for business expansion. It is, however, necessary to see that reinvestment of profits does not cause a dwindling in the reasonable rate of profit.

External Factors : Besides the criteria mentioned above, there are certain external factors that influence the profitability of a firm in modern times. These factors are : i)

Profit

Full Employment : Under conditions of full employment, maintenance of cordial labour relations is of utmost importance. Excessive profits, under such circumstances, become an invitation to labour unrest. Care should be taken to keep profits within reasonable limits.

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ii)

Potential Rivals : In any business, the possibility of emergence of rival firms must be taken into consideration. Abnormal profits attract rivals and wipe out profits. To keep away the rivals, it becomes necessary to control profits. Whether this will be possible depends upon many factors, but an effort should be made to abide by this rule.

iii)

Consumers' Confidence : It is also necessary to maintain the confidence of the consumers in the reasonableness of the firm's prices. Those entrepreneurs who are tempted to exploit the situation of reaping huge profits usually lose the sympathies of their customers. It pays in the long-run to overcome such temptations and continue to enjoy the confidence of the customers.

iv)

Political Climate : In modern times, entrepreneurs are also required to take note of the political climate in the country. This is especially true where a firm supplies products to government departments, or public enterprises. Charges of profiteering and exploitation may invite public inquiries and this will cause a great deal to the firm. It is, therefore, advisable to keep profit rates low and create an image of a firm with fair dealings. Thus, profit policy involves many important considerations and all the factors noted above go into the formulation of a sound profit policy.

5.

REASONABLE PROFIT TARGET :

We have already studied that modern firms and corporations may not aim at profit maximization. Instead they set 'a standard', 'a target' or 'a reasonable profit' which they strive to achieve. We have also studied the reasons for aiming at ‘Reasonable Profits’ in the previous chapter. Let us now look into the policy questions related to setting standards or criteria for reasonable profits. The important policy questions are : a)

What are the criteria for determining the profit standard?

b)

How should 'reasonable profits' be determined? Let us now briefly examine the policy implications of these questions.

a)

Standards of Reasonable Profits :

When firms voluntarily exercise restraint on profit maximization and choose to make only a 'reasonable profit', the questions that arise are : (i) what form of profit standard should be used, and (ii) how should reasonable profits be determined ?

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Forms of Profit Standard The profit standards may be determined in terms of (a) aggregate money terms, (b) percentage of sales, or (c) percentage return on investment. These standards may be determined with respect to the whole product line or for each product separately. Of all the forms of profit standards, the total net profits of the enterprise usually receive the greatest attention. But when purpose is to discourage the potential competitors, then a target rate of return on investment is the appropriate profit standard, provided competitors' cost curves are similar. b)

Setting the Profit Standard

The following are the important criteria that are taken into account while setting the standards for a 'reasonable profit'. Capital attracting standard An important criterion of profit standard is that it must be high enough to attract external capital. For example, if stocks are being sold in market at five times their current earnings, it is necessary that the firm earns a profit of 20 percent on the book investment. There are however certain problems that are associated with this criterion : (i) capital structure of the firms (i.e. the proportions of bonds, equity and preference shares) affects the cost of capital and thereby the rate of profit, (ii) whether profit standard has to be based on current or long run average cost of capital as it varies widely from company to company and may at times prove treacherous i.e. unpredictable. 'Plough back' standard In case a company intends to rely on its own sources for financing its growth, then the most relevant standard is the aggregate profit that provides for an adequate "plough-back" for financing a desired growth of company without resorting to the capital market. This standard of profit is used when maintaining liquidity and avoiding debt are main considerations in profit policy. Plough back standard is however socially less acceptable than capital-attracting standard. The reason, that, it is more desirable that all earnings are distributed to stockholders and they should decide the further investment pattern. This is based on a belief that market forces allocate funds more efficiently and the individual is the best judge of this resource use. On the other hand, retained earnings which are under the exclusive control of the management are likely to be wasted on low-earning projects within the company. But one cannot say for certain as to which of the two allocating agencies is actually superior. It depends on 'the relative abilities of management and outside investors to estimate earnings prospects."

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Normal earnings standard Another important criterion for setting standard of reasonable profit is the 'normal' earnings of firms of an industry over a normal period. Company's own normal eanrings over a period of time often serve as a valid criterion of reasonable profit, provided it succeeded in (i) attracting external capital, (ii) discouraging growth of competition, (iii) keeping stockholders satisfied. When average of 'normal earnings of a group of firms is used, then only comparable firms and normal periods are chosen. However, none of these standards of profit is perfect. A standard is therefore chosen after giving due consideration to the prevailing market conditions and public attitudes. In fact, different standards are used for different purposes because no single criterion satisfies all the conditions and all the people concerned.

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Exercise : 1.

Give a brief review about the theories of profit.

2.

Critically evaluate F.H. Knight's Uncertainly Bearing Theory of Profit.

3.

Distinguish between gross and net profit.

4.

How would you distinguish between Accounting Profit and Economic Profit?

5.

"Profit is a reward of the entrepreneur for innovation" Discuss.

6.

State and explain Dynamic Theory of Profit.

7.

Explain how profit can be measured in practice.

8.

Write notes on: (a) Profit Policy (b) Standards of reasonable profit (c) Reasons for limiting profits.

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NOTES

80


NOTES

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NOTES

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Chapter 4 DEMAND ANALYSIS

Preview Introduction: Concept of demand, Individual Demand and Market Demand, Determinants of Demand, Law of demand, Elasticity of demand, Measurement and its uses. Demand Forecasting-methods/ techniques of demand forecasting. Introduction to Index Numbers. 1)

CONCEPT OF DEMAND

In Economics, ’Demand’ does not mean simple desire. Thus, a poor man’s desire to have a motor-car or middle class person’s desire to have an air-conditioned bunglow in a city or suburb will not have any influence on the production of cars and bunglows. Nor does ‘Demand’ mean ‘need’. For example a beggar’s need for more bread, clothing and shelter will have absolutely no influence on the production of those three goods, however urgently they may be needed by a beggar. In Economics ‘Demand’ means ‘desire backed by adequate purchasing power’ or enough money to purchase desired goods. In fact, in Economics, ‘demand’ means specific quantity of a commodity actually purchased or bought. Further, since quantity purchased will depend upon price of the commodity in question, it follows that ‘demand means at a specific price’. Unless the price per unit of the commodity is stated, the concept of demand will not be clear. ‘Demand’ in Economics also means ‘demand per unit of time’, say per day, per month, per year and so on. Thus, it can be said that in Pune, demand (i.e. quantity actually purchased) for milk per months is 1,50,000 liters when the price of milk is Rs. 15 per litre. Or at an individual level, a person demands (i.e. actually purchases) one litre of milk per day (or 30 litres of milk per month), when the price of milk is Rs. 15 per litre. Demand Analysis

83

Other examples explaining the concept of demand may be as follows : In India, demand (i.e. actual quantity that is purchased) for wheat per year is 40 lakh tones, when the price of wheat is Rs. 15 per Kg. Though not generally mentioned in any book, along with price and unit of time, it would be logical to mention specific market in which buying and selling transactions are taking place, say demand in a village, in Pune, in Mumbai, in India and so on. Thus, now the full statement of the concept of demand would be as follows: At a price of Rs. 15 per litre in village A, 100 litres of milk are demanded (i.e. actually bought) per day. In Pune, at the price of Rs. 15 per litre, 1,50,000 litres of milk are demanded (actually purchased) per day. In Mumbai, at the price of Rs. 15 per litre, 4,50,000 litres demanded (actually purchased) per day. In Maharashtra at an average price of Rs. 15 per litre, 50 lakh litres of milk are demanded (actually Purchased) per day. The above examples should make the concept of demand clear. Omission of price per unit of a commodity, or unit of time or of specific market would leave the concept of demand vague. Determinants Of Demand : Demand for a commodity depends on a number of factors. a)

Factors Influencing Individual Demand

An individual's demand for a commodity is generally determined by factors such as : i)

PRICE OF THE PRODUCT : Price is always a basic consideration in determining the demand for a commodity. Normally, a larger quantity is demanded at a lower price than at a higher price.

ii)

INCOME : Income is an equally important determinant of demand. Obviously, with the increase in income one can buy more goods. Thus, a rich consumer usually demands more goods than a poor consumer.

iii)

TASTES AND HABITS : Demand for many goods depend on the person's tastes, habits and preferences. Demand for several products like ice-cream, chocolates, behl-puri, etc. depend on an individual's tastes. Demand for tea, betel, tobacco, etc. is a matter of habit. People with different tastes and habits have different preferences for different goods. A strict vegetarian will have no demand for meat at any price, whereas a non-vegetarian who has liking for chicken or fish may demand it even at a high price. Similar is the case with demand for cigarettes by non-smokers and smokers.

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iv)

RELATIVE PRICES OF OTHER GOODS : SUBSTITUTES AND COMPLEMENTARY PRODUCTS : How much the consumer would like to buy of a given commodity, however, also depends on the relative prices of other related goods such as substitutes or complementary goods to a commodity. When a want can be satisfied by alternative similar goods, they are called substitutes. For example, peas and beans, groundnut oil and til oil, tea and coffee, jowar and bajra etc., are substitutes of each other. The demand for a commodity depends on the relative prices of its substitutes. If the substitutes are relatively costly, then there will be more demand for the commodity in question at a given price than in case its substitutes are relatively cheaper. Similarly, the demand for a commodity is also affected by its complementary products. When in order to satisfy a given want, two or more goods are needed in combination, these goods are referred to as complementary goods. For example, car and petrol, pen and ink, tea and sugar, shoes and socks, sarees and blouses, gun and bullets etc. are complementary to each other. Complementary goods are always in joint demand. Thus, if a given commodity is a complementary product, its demand will be relatively high when its related commodity's price is lower than otherwise. Or, when the price of one commodity decreases, the demand for its complementary product will tend to increase and vice versa. For example, a fall in the price of cars will lead to an increase in the demand for petrol. Similarly a steep rise in the price of petrol will cause a decrease in demand for petrol driven motor cars and its accessories.

v)

CONSUMER'S EXPECTATIONS : A consumer's expectations about the future changes in the price of a given commodity also may affect its demand. When he expects its prices to fall in future, he will tend to buy less at the present prevailing price. Similarly, if he expects its price to rise in future, he will tend to buy more at present.

vi)

ADVERTISEMENT EFFECT : In modern times, the preferences of a consumer can be altered by advertisement and sales propaganda, albeit to a certain extent only. Thus, demand for many products like tooth-paste, toilet-soap, washing powder, processed foods, etc., is partially caused by the advertisement effect in a modern man's life.

b)

Factors Influencing Market Demand :

The market demand for a commodity originates and is affected by the form of change in the general demand pattern of the community of the people at large. The following factors affect the common demand pattern for a commodity in the market. 1)

PRICE OF THE PRODUCT : At a low market price, market demand for the product tends to be high and vice versa.

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85

2)

DISTRIBUTION OF INCOME AND WEALTH IN THE COMMUNITY : If there is equal distribution of income and wealth, the market demand for many products of common consumption tends to be greater than in the case of unequal distribution.

3)

COMMUNITY'S COMMON HABITS AND SCALE OF PREFERENCES : The market demand for a product is greatly affected by the scale of preferences by the buyers in general. For example, when a large section of population shifts its preference from vegetarian foods to non-vegetarian foods, the demand for the former will tend to decrease and that for the latter will increase.

4)

GENERAL STANDARDS OF LIVING AND SPENDING HABITS OF THE PEOPLE : When people in general adopt a high standard of living and are ready to spend more, demand for many comforts and luxury items will tend to be higher than otherwise.

5)

NUMBER OF BUYERS IN THE MARKET AND THE GROWTH OF POPULATION : The size of market demand for a product obviously depends on the number of buyers in the market. A large number of buyers will constitute a large demand and vice versa. Thus, growth of population is an important factor. A high growth of population over a period of time tends to imply a rising demand for essential goods and services in general.

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6)

AGE STRUCTURE AND SEX RATIO OF THE POPULATION : Age structure of population determines market demand for many products in a relative sense. If the population pyramid of a country is broad-based with a larger proportion of juvenile population, then the market demand for milk, toys, school bags etc. - goods and services required by children - will be much higher than the market demand for goods needed by the elderly people. Similarly, sex ratio has its impact on demand for many goods. An adverse sex ratio, i.e. females exceeding males in number (or, males exceeding females as in Mumbai), would mean a greater demand for goods required by the female population than by the male population (or the reverse).

7)

FUTURE EXPECTATIONS : If buyers in general expect that prices of a commodity will rise in future, etc. present market demand would be more as most of them would like to hoard the commodity. The reverse happens if a fall in the future price is expected.

8)

LEVEL OF TAXATION AND TAX STRUCTURE : A progressively high tax rate would generally mean a low demand for goods in general and vice-versa. But a highly taxed commodity will have a relatively lower demand than an untaxed commodity - if that happens to be a remote substitute.

9)

INVENTIONS AND INNOVATIONS : Introduction of new goods or substitutes as a result of inventions and innovations in a dynamic modern economy tends to adversely affect the demand for the existing products, which as a result of innovations, definitely become obsolete. For example, the advent of latest digital media like Compact Disks (C.Ds) has made audio & video cassettes obsolete. Managerial Economics

10) FASHIONS : Market demand for many products is affected by changing fashions. For example, demand for commodities like jeans, shirts, salwar-kameej etc. are based on current fashions. 11) CLIMATE OR WEATHER CONDITIONS : Demand for certain products are determined by climatic or weather conditions. For example, in summer, there is a greater demand for cold drinks, fans, coolers, air conditioners etc. Similarly, demand for umbrellas and raincoats are seasonal. 12) CUSTOMS : Demand for certain goods are determined by social customs, festivals, etc. For example, during Diwali holidays, there is a greater demand for sweets, crackers, vehicles and white goods; and during Christmas, cakes, sweets and confectioneries are in more demand. 13) ADVERTISEMENT AND SALES PROPAGANDA : Market demand for many products in the present day are influenced by the sellers' efforts through advertisements and sales propaganda. Demand is manipulated through selling efforts. Of course, there is always a limit. When these factors change, the general demand pattern will be affected, causing a change in the market demand as a whole. 2.

DEMAND SCHEDULE :

A tabular statement of price-quantity relationship is known as the demand schedule. It narrates how much amount of a commodity is demanded by an individual or a group of individuals in the market at alternative prices, per unit of time. There are, thus, two types of demand schedules : (i) the individual demand schedule, and (ii) the market demand schedule. INDIVIDUAL DEMAND SCHEDULE A tabular list showing the quantities of a commodity that will be purchased by an individual at various prices in a given period of time (say per day, per week, per month or per annum) is referred to as an individual demand schedule. Price of X in Rs. (per kg.)

Quantity Demanded of X per week (in Kg.)

30

2

25

4

20

6

15

10

10

16

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87

This illustrates a hypothetical (purely imaginary) demand schedule of an individual consumer Mr A for commodity X. CHARACTERISTICS OF DEMAND SCHEDULE 1)

The demand schedule does not indicate any change in demand by the individual concerned, but merely expresses his present behaviour in purchasing the commodity at alternative prices.

2)

It shows only the variation in demand at varying prices.

3)

It seeks to illustrate the principle that more of a commodity is demanded at a lower price than at a higher one. In fact, most of the demand schedules show an inverse relationship between price and quantity demanded.

MARKET DEMAND SCHEDULE It is a tabular statement narrating the quantities of a commodity demanded in aggregate by all the buyers in the market at different prices in a given period of time. A market demand schedule, thus, represents the total market demand at various prices. Theoretically, the demand schedules of all individual consumers of a commodity can be compiled and combined to form a composite demand schedule, representing the total demand for the commodity at various alternative prices. The derivation of market demand from individual demand schedules is illustrated in the table given below. Here it is assumed that the market is composed only of three buyers. Price in Rupees (per unit)

Units of Commodity X Demanded per day by Individuals

Quantity Demanded in the market for X

A+

B+

C+

=

4

1

3

3

7

3

2

4

5

11

2

3

5

7

15

1

5

9

10

24

Apparently, the market demand schedule is constructed by the horizontal additions of quantities at various prices shown by the individual demand schedules. It follows that like an individual demand schedule, the market demand schedule also depicts an inverse relationship between the price and quantity demanded.

88


4.

THE DEMAND CURVE :

A demand curve is a graphical presentation of a demand schedule. When price-quantity information of a demand schedule is plotted on a graph, a demand curve is drawn. Demand curve thus depicts the picture of the data contained in the demand schedule. Conventionally, a demand curve is drawn by representing the price variable on the Y-axis and the demand variable on the X-axis. Fig. given below illustrates the demand curve based on the data contained in Table. In this figure, the quantity demanded is measured on the horizontal axis (X-axis) and the price per kg. is measured on the vertical axis (Y-axis). Corresponding to the price-quantity relations given in the demand schedule, various points like a, b, c, d and e are obtained on the graph. These points are joined and the smooth curve DD is drawn, which is called the demand curve. The demand curve has a negative slope. It slopes downwards from left to right, representing an inverse relationship between price and demand. Y D a

Price (Per Kg.)

30

b

25

c

20

d

15

e

10

D

5

O

X 2

4

6

8

10 12 14

16

Quantity Demanded

Individual Demand Curve The figure, given above, represents an individual demand curve. Likewise, by plotting the market demand schedule graphically, the market demand curve may be drawn. DERIVATION OF MARKET DEMAND CURVE Market demand curve is derived by the horizontal summation of individual demand curves for a given commodity. Figure given on the next next illustrates this:

Demand Analysis

89

A’s Demand

Y

B’s Demand

Y

C’s Demand

Y

Market Demand

Price (Per Unit)

Y

D(A)

D(B) +

+

O

XO

D(C) =

XO

XO

D(Market)

X

Quantity Demanded of X

Derivation of Market Demand Curve It may be observed that the slope of the market demand curve is an average of the slopes of individual demand curves. Essentially, the market demand curve too has a downward slope indicating an inverse price-quantity relationship, i.e. quantity demand rises when the price falls, and vice-versa. 5.

THE LAW OF DEMAND :

The general tendency of consumers' behaviour in demanding a commodity in relation to the changes in its price is described by the law of demand. The law of demand expresses the nature of functional relationship between two variables of the demand relation, viz., the price and the quantity demanded. It simply states that demand varies inversely with change in price. Statement of the Law The law may be stated thus : "Other things being equal, the higher the price of a commodity, the smaller is the quantity demanded and lower the price, larger is the quantity demanded." In other words, the demand for a commodity expands (i.e., the demand rises) as the price falls and contracts (i.e. the demand falls) as the price rises. Or briefly stated, the law of demand emphasises that, other things remaining unchanged, demand varies inversely with price. The conventional law of demand, however, relates to the much simplified demand function : D = f(P) Where, D represents demand, P the price and f connotes a functional relationship. It, however, assumes that other determinants of demand are constant and only price is the variable and influencing factor. The relation between price and quantity of demand is usually an inverse or negative relation, indicating a larger quantity demanded at a lower price and a smaller quantity demanded at a higher price. 90


EXPLANATION OF THE LAW OF DEMAND The law of demand is usually referred to the market demand. The law of demand can be illustrated with the help of a market demand schedule, thus : i.e. as the price of a commodity decreases, the corresponding quantity demanded for that commodity increases and viceversa. Price of Commodity X (in Rs.) per unit

Quantity Demanded per week

5

10

4

20

3

30

2

40

1

50

This table represents a hypothetical demand schedule for commodity X. We can read of from this table that with a fall in price at each stage, quantity demanded tends to rise. There is an inverse relationship between price and quantity demanded. Usually, economists draw a demand curve to give a pictorial presentation of the law of demand. When the data of table are plotted graphically, a demand curve is drawn as shown in Figure given below. (Here, incidentally, the demand curve being a straight line is a linear demand curve. Demand Curve Y

Price (Per Unit)

5

D

4 3 2 1 O

D 10

20 30 40 50 Quantity Demanded of X

X

In this figure, DD is a downward sloping demand curve indicating an inverse relationship between price and quantity demanded. From the given market demand-curve one can easily locate the market demand for a product at a given price. Further, the demand curve geometrically represents the mathematical demand function : Dx = f (Px)

Demand Analysis

91

ASSUMPTIONS UNDERLYING THE LAW OF DEMAND The above stated law of demand is conditional. It will hold good only if certain conditions are given and constant. Thus, it is always stated with "other things being equal". It relates to the change in price variable only, assuming other determinants of demand to be constant. The law of demand is, thus, based on the following ceteris paribus assumptions.

92

1)

NO CHANGE IN CONSUMER'S INCOME : Throughout the operation of the law, the consumer's income should remain the same. If the level of a buyer's income changes, he may buy more even at a higher price, invalidating the law of demand.

2)

NO CHANGE IN CONSUMER'S PREFERENCES : The consumer's tastes, habits and preferences should remain constant.

3)

NO CHANGE IN FASHION : If the commodity in question goes out of fashion, a buyer may not buy more of it even at a substantial price reduction.

4)

NO CHANGE IN THE PRICES OF RELATED GOODS : Prices of other goods like substitutes and complementary goods remain unchanged. If the prices of other related goods change, the consumer's preferences would change which may invalidate the law of demand.

5)

NO EXPECTATIONS OF FUTURE PRICE CHANGES OR SHORTAGES : The law requires that the given price change for the commodity is a normal one and has no speculative consideration. That is to say, the buyers do not expect any shortages in the supply of the commodity in the market and consequent future changes in the prices. The given price change is assumed to be final at a time.

6)

NO CHANGE IN SIZE, AGE-COMPOSITION AND SEX RATIO OF THE POPULATION : For the operation of the law in respect of total market demand, it is essential that the number of buyers and their preferences should remain constant. This necessitates that the size of population as well as the age-structure and sex-ratio of the population should remain the same throughout the operation of the law. Otherwise, if population changes, there will be additional buyers in the market, so that the total market demand may not contract with a rise in price.

7)

NO CHANGE IN THE RANGE OF GOODS AVAILABLE TO THE CONSUMERS : This implies that there is no innovation and arrival of new varieties of products in the market which may distort consumer's preferences.

8)

NO CHANGE IN THE DISTRIBUTION OF INCOME AND WEALTH OF THE COMMUNITY : There is no redistribution of income either, so that the levels of income of the consumers remain the same. Managerial Economics

9)

NO CHANGE IN GOVERNMENT POLICY : The level of taxation and fiscal policy of the government remain the same throughout the operation of the law. Otherwise, changes in income tax, for instance, may cause changes in consumers' income or changes commodity taxes (sales tax or excise duties) may lead to distortions in consumer's preferences.

10) NO CHANGE IN WEATHER CONDITIONS : It is assumed that climatic and weather conditions are unchanged in affecting the demand for certain goods like woollen clothes, umbrellas etc. In short, the law of demand presumes that except for the price of the product, all other determinants of its demand are unchanged. Apparently, the validity of the law of demand or the inference about inverse relationship between price and quantity demanded depends on the existence of these conditions or assumptions. EXCEPTIONS TO THE LAW OF DEMAND OR EXCEPTIONAL DEMAND CURVE :

Price (Per Unit)

It is almost a universal phenomenon of the law of demand that when the price falls, the demand expands and it contracts when the price rises. But sometimes, it may be observed, though, of course, very rarely, that with a fall in price, demand also falls and with a rise in a price, demand also rises. This is a paradoxical situation or a situation which is apparently contrary to the law of demand. Cases in which this tendency is observed are referred to as exceptions to the general law of demand. The demand curve for such cases will be typically unusual. It will be an upward sloping demand curve as shown in Figure given below. It is described as an exceptional demand curve.

Exceptional Demand Curve Demand Analysis

93

In this fugre, DD is the demand curve which slopes upward from left to right. It appears thus that when OP1 is the price, QQ1, is the demand and when the price rises to OP2' demand also expands to QQ2. Thus, the upward sloping demand curve expresses a direct functional relationship between price and demand. Such upward sloping demand curves are unusual and quite contradictory to the law of demand as they represent the phenomenon that 'more will be demanded at a higher price and vice versa". The upward sloping demand curve, thus, refers to the exceptions to the law of demand. There are a few such exceptional cases, which may be categorised as follows : 1)

GIFFEN GOODS: In the case of certain inferior goods called Giffen goods, as introduced by Robert Giffen when the price falls, quite often less quantity will be purchased than before because of the negative income effect and people's increasing preference for a superior commodity with the rise in their real income. Probably, a few appropriate examples of inferior goods may be listed, such as foodstuffs like cheap potatoes, cheap bread, pucca rice, vegetable ghee, etc., as against superior commodities like good potatoes, cake, basmati rice, pure ghee.

2)

ARTICLES OF SNOB APPEAL : Sometimes, certain commodities are demanded just because they happen to be expensive or prestige goods, and have a 'snob appeal'. These are generally ostentatious articles, and purchased only by rich people for using them as 'status symbol'. Thus, when prices of such articles like say diamonds rise, their demand also rises; similarly, Rolls Royce cars, Johney Walker Scotch Whiskey are another outstanding illustration.

3)

SPECULATION : When people speculate in changes in the price of a commodity in the future, they may not act according to the law of demand at present. Say, when people are convinced that the price of a particular commodity will rise still further, they will not contract their demand with the given price rise; on the contrary, they may purchase more for the purpose of hoarding. In the stock exchange market, some people tend to buy more shares when the prices are rising, in the hope that the rising trend would continue, so they can make a good fortune in future.

4)

CONSUMER'S PSYCHOLOGICAL BIAS OR ILLUSION: When the consumer is wrongly biased against the quality of a commodity with the price change, he may contract his demand with a fall in price. Some sophisticated consumers do not buy when there is a stock clearance sale at reduced prices, thinking that the goods may be of bad quality.

6.

CHANGES IN QUANTITY DEMANDED AND CHANGES IN DEMAND:

In economic analysis, the terms 'changes in quantity demanded' and 'changes in demand' have different meanings.

94


The term 'changes in quantity demanded' or variation in demand relates to the law of demand. It refers to the changes in quantities purchased by the consumer on account of changes in price only. Thus, we may say that the quantity demanded of a commodity increases when it's price decreases, or the quantity demanded decreases when it's price increases. But, it is incorrect to say that demand decreases when price increases or demand increases when price decreases. For "increase" and "decrease" in demand refers to "changes in demand" caused by the changes in various other determinants of demand, price remaining unchanged. Changes in quantity demanded in relation to the price are measured by the movement along the demand curve, while changes in demand are reflected through shifts in the demand curve. The terms" changes in quantity demanded essentially means variation in demand referring to " expansion" or "extension" or "contraction" of demand which are quite distinct from the terms "increase" or "decrease" in demand. A)

EXPANSION OR (Changes in Q. D.):

EXTENSION

AND

CONTRACTION

OF

DEMAND

A variation in demand implies "expansion" or "contraction" of demand. When with the fall in the price with the commodity is brought, there is expansion of demand. Similarly, when a lesser quantity is demanded with a rise in price, there is contraction of demand. In short, demand expands when the price falls and it contracts when the price rises. Thus the terms "expansion" & "contraction" are used in stating the law of demand. The terms "expansion" and "contraction" of demand, should, however, be distinguished from increase or decrease in demand. The former is used for indicating increase in demand, while the later is used for indicating changes in demand, and Variation in demand is the connotation of the law of demand. It expresses a functional relationship between quantity demanded and price. a change in demand due to change in price is called expansion or contraction. Expansion and contraction refer to the same demand curve. A change in demand due to causes other than price is called increase or decrease in demand. In graphical exposition, expansion or contraction of demand is shown by the movement along the same demand curve. A downward movement from one point to the another on the same demand curve implies expansion of demand, for instance, movement from a to b in the following figure. It suggests that when the price decreases from OP to OP1, demand expands from OQ to OQ1. While an upward moment from one point to another on the same demand curve implies contraction of demand, eg: movement from a to c in the diagram.

Demand Analysis

95

Co nt ra io n

Price (Per Unit)

ct

c

a

Ex

pa

ns

ion

b D

Quantity Demanded of X

Expansion and Contraction of demand The fig. shows that when price rises from OP to OP2 demand contracts from OQ to OQ2. In short, a change in quantity demanded in response to the change in price is explained by the terms expansion or contraction of demand. Further, expansion or contraction implies a movement on the same demand curve which means the demand schedule remains the same. B)

INCREASE AND DECREASE IN DEMAND (Changes in Demand): These two terms are used to express changes in demand. Changes in demand are result of the change in the conditions or factors determining demand, other than the price. A change in demand, thus implies an increase or decrease in demand. When more of a commodity is bought than before at any given price, there is increase in demand. Similarly, when with price remaining unchanged less of a commodity is bought than before, there is decrease in demand. In other words, an "increase" in demand signifies either that more will be demanded at given price or the same will be demanded at a higher price. Thus, an increase in demand means that more is now demanded than before, at each and every price. likewise, "a decrease in demand signifies either that less will be demanded at given price or the same quantity will be demanded at a lower price. Thus increase and decrease in demand are shown by shifting the demand curves. The terms" increase" or "decrease" in demand are graphically expressed by the movements from one demand curve to the another. In other words, the change in demand is denoted by the shifting of the demand curve. In the case of an increase in demand, the demand curve is shifted to the right. In the following figure (A), thus, the movement of demand curve from DD to D1D1 shows an increase in demand. In this case, the movement

96


from point a to b indicates that the price remains the same at OP, but more quantity OQ1 is now demanded, instead of OQ. Thus increase in demand is QQ1. Similarly, as in Fig B, a decrease in demand is depicted by the shifting of the demand curve towards it's left. Y

Y D

D1

D2

Increase

P

b

a

D1

Price (Per Unit)

Price (Per Unit)

D

Decrease

P

a

c

D

D O

Q1

Q

D2 X O

Q

Q2

(A)

X

(B)

Increase & Decrease in demand In the above fig, thus, the movement of demand curve from DD to D2D2 show a decrease in demand. In this case, movement from point a to c, indicates that the price remains same at the OP, but less quantity OQ2 is now demanded than before. Here decrease in demand is QQ2. REASONS FOR CHANGE (Increase or Decrease in Demand) A change in demand occurs when the basic conditions of the demand change. Thus an increase or decrease in demand is brought about by many kinds of changes. Some of the important changes are: 1)

Change in Income

2)

Change in the pattern of income distribution.

3)

Change in tastes, habits and preferences.

4)

Change in fashions and customs.

5)

Change in the supply of the substitutes and in their prices.

6)

Change in the supply or demand supply of the complementary goods and change in their prices.

7)

Change in population.

8)

Advertisement and Publicity persuasion.

Demand Analysis

97

7.

ELASTICITY OF DEMAND :

INTRODUCTION Demand for goods varies with price. But the extent of variation is not uniform in all cases. In some cases the variation is extremely wide; in some others it may just be nominal. That means, sometimes demand is greatly responsive to changes in price; at other times, it may not be so responsive. The extent of variation in demand is technically expressed as elasticity of demand. According to Marshall, the elasticity (or responsiveness) of demand in a market is great or small, depending on whether the amount demanded increases much or little for a given fall in price; and diminishes much or little for a given rise in price. A)

ELASTICITY OF DEMAND : PRICE ELASTICITY OF DEMAND The term "elasticity of demand", when used without qualifications is commonly referred to as price elasticity of demand. This is a loose interpretation of the term. In a strict logical sense, however, the concept of elasticity of demand should measure the responsiveness of demand for a commodity to changes in its determinants. There are, thus, as many kinds of elasticities of demand as its determinants. Economists usually consider three important kinds of elasticity of demand : (1) Price elasticity of demand, (2) Income-elasticity of demand and (3) Cross-price elasticity of demand or just cross elasticity. "Price elasticity" refers to the degree of responsiveness of demand for a commodity to a given change in its price. "Income elasticity" refers to the degree of responsiveness of demand for a commodity to a given change in the income of the consumer. "Cross elasticity" refers to the responsiveness of demand for a commodity to a given change in the price of a related commodity - substitute or complementary product. In the present chapter, we shall study them one by one.

B)

PRICE ELASTICITY OF DEMAND The extent of the change of demand for a commodity to a given change in price, other demand determinants remaining constant, is termed as the price elasticity of demand. The coefficient of price elasticity of demand may, thus, be defined as the ratio of the relative change in demand to the relative change in price. Since the relative change of variables can be measured either in terms of percentage change or as proportional change, the price elasticity coefficient can be measured : The percentage change in quantity demanded e = –––––––––––––––––––––––––––––––––––––– The percentage change in price

98


Price elasticity of demand can also be measured alternatively as Net change in Quantity demanded Net change in price e = –––––––––––––––––––––––––––––– : –––––––––––––––– Original Quantity demanded Original price Representing it in symbols, thus, the price elasticity formula can be stated as : êQ êP : Q P êQ P X = Q êP êQ P X e= ê P Q Q = the original demand (Say Q1)

e=

∴

P

=

êQ=

the original price (Say P1) the change in demand. It is measured as the difference between new demand (say Q2) and the old demand (Q1) Thus, ê Q = Q2 - Q1

êP=

the change in Price. It is measured as the difference between new Price P2' and the old price (P1) Thus, ê P = P2 - P1

The above formula, in fact, relates to point-price elasticity of demand, that is, the coefficient signifies very small or marginal changes only. To illustrate the use of the formula, let us consider the following information from the demand schedule : Price of Tea (Rs.)

Quantity Demanded (Kg.)

20 (P1)

10(Q1)

22 (P2)

9(Q2)

Demand Analysis

99

Thus, ê P = 22 - 20 = 2, and P = P1 = 20 ê Q = 09 - 10 = 1, and Q = Q1 = 10 (Here, minus signs are ignored) Therefore

êQ X ê P 1 X = 2 = 1

e=

∴ e

P Q 20 10

This means, the elasticity of demand is equal to one or unity. Using the above formula, the numerical coefficient of price elasticity can be measured from any such given data. Apparently, depending upon the magnitude and proportional change involved in the data on demand and prices, one may obtain various numerical values of coefficients of price elasticity, ranging from zero to infinity. TYPES OF PRICE ELASTICITY : DEGREE OF ELASTICITY OF DEMAND Demand may be elastic or inelastic, depending on the degree of responsiveness of the demand for a commodity to a given change in its price. By elastic demand, we mean that demand responds greatly or relatively more to a price change. It however, does not imply that the consumers are fully responsive to a price change. What it means is simply this that a relatively larger change in demand is caused by a smaller change in price. Similarly, inelastic demand does not mean that demand is totally insensitive. It only means that the relative change in demand is less than that of price. It means demand responds to a lesser extent only. Measuring numerical coefficient of price elasticity in different cases, we will find that its value ranges from zero to infinity. When the elasticity coefficient is greater than one, demand is said to be elastic; and it is inelastic when the numerical coefficient is less than one; and when it is exactly one (or unity), the demand is unitary elastic. Treating this concept in a more elaborate manner, we may mention the following five types of price elasticity of demand :

100

1)

Perfectly elastic demand

when e = ∝

2)

Perfectly inelastic demand

when e = O

3)

Relatively elastic demand

when e = >1

4)

Relatively inelastic demand

when e = <1

5)

Unitary elastic demand

when e = 1


1)

Perfectly Elastic Demand (e = α)

An infinite demand at the given price is a case of perfectly elastic demand. When demand is perfectly elastic, with a slight or infinitely small rise in the price of the commodity, the consumer stops buying it. The numerical coefficient of perfectly elastic demand is infinity (e = .

α)

In fact, the degree of elasticity determines the sahpe and slope of the demand curve. Thus, elasticity of demand can be ascertained from the slope of the demand curve. The slope of demand curve reflects the elasticity of demand. In the case of a perfectly elastic demand, the demand curve will be a horizontal straight line. Thus, the demand curve in Figure A given below implies, that at the ruling price of OP, the demand is infinite, while a slight rise in price would mean a zero demand. This figure indicates that at price OP, a person would buy as much of the given commodity, as can be obtained, i.e. an infinite quantity, and that at a slightly higher price he would buy nothing. Perfectly, elastic demand is a case of theoretical extremity. It is hardly encountered in practice. (A) Y

Price (Per Unit)

e=α α

P

O

D D

X

Quantity Demanded

Types of Price Elasticity of Demand In economic theory, however, the demand for the product of a firm in a perfectly, competitive market is assumed to be perfectly elastic. Theoretically, perfectly elastic demand or the horizontal demand curve (as shown in Figure above), from the firm's point of view implies that it can sell as much as it produces at the ruling market price, since at the given price (say OP in Figure shown above), buyers tend to have an infinite demand for its product in the market.

Demand Analysis

101

2)

Perfectly Inelastic Demand (e = 0) (B) Y

Price (Per Unit)

e= 0

D

P1 P2 P3

D X Q Quantity Demanded

O

When the demand for a commodity shows no response at all to a change in price, that is to say, whatever the change in price the demand remains the same, then it is called a perfectly inelastic demand. Perfectly, inelastic demand has, thus, zero elasticity (e = 0). In this case, the demand curve would be a straight vertical line as in Figure B shown above. This figure indicates that whether the price moves from Op1 to OP2 or Op3, the quantity demanded remains the same OQ only. Perfect inelasticity is again a theoretical consideration rather than a practical phenomenon. However, a commodity of absolute necessity like salt seems to have perfectly inelastic demand for most consumers.

3)

Relatively Elastic Demand ( e > l ) (C) Y

Price (Per Unit)

e>1

D P1 P2 D

X Q1 Q2 Quantity Demanded O

When the proportion of change in the quantity demanded is greater than that of price, the demand is said to be relatively elastic. The numerical value of relatively elastic demand 102


lies between one and infinity. Thus, what Marshall called as elasticity of demand being greater than unity referred to 'relatively elastic' demand or 'more elastic' demand. A relatively elastic demand will be represented by a gradually sloping, i.e. rather a flatter demand curve as shown in Figure(C) above. In this Figure(C) above when the price falls by P1 P2, the demand expands by Q1 Q2 which is relatively large in proportion to the change in price. êQ e

=

ê P ÷

=>1

Q P Therefore, elasticity is greater than one, it is a more realistic concept, as many commodities can have more elastic demand. 4) Relatively Inelastic Demand ( e < l ) (D) Y e<1

Price (Per Unit)

D P1

P2

D O

Q1

Q2

X

Quantity Demanded

When the proportion of change in the quantity demanded is less than that of price, the demand is considered to be relatively inelastic. The numerical value of relatively inelastic demand lies between zero and one. Hence, the concept "relatively inelastic" or 'less elastic" demand is the same as what Marshall presented as elasticity being less than unity. A relatively inelastic demand will be represented by a rapidly sloping, i.e., rather a steeper, demand curve as shown in Figure (D) above. In Figure (D) when the price falls by P1 P2, the demand expands just by Q1 Q2 which is relatively small in proportion to the change in price. êQ e

ê P

=

÷ =<1 Q P Therefore, elasticity is less than one. This is also a very realistic concept.

Demand Analysis

103

5)

Unitary Elastic Demand (e = 1) (E) Y

Price (Per Unit)

D

e=1 1

P1 P2

O

D

Q1

Q2

X

Quantity Demanded

When the proportion of change in demand is exactly the same as the change in price, the demand is said to be unitary elastic. The numerical value of unitary elastic demand is exactly 1. In the case of unitary elastic demand, the demand curve would be a rectangular hyperbola asymptotic to the two axis, as shown in Figure (E ) above. In Figure (E), when the price falls by P1 P2,, the demand expands by Q1 Q2 which is in the same proportion to change in price. êQ e

=

ê P ÷

Q

= 1 P

Hence, elasticity is equal to unity. This is a theoretical norm, which helps to distinguish between elastic and inelastic demand in general. The different kinds of price elasticity of demand discussed above have been summarised in Table A on the next page.

104


Table A PRICE ELASTICITY OF DEMAND (Definition e = Percentage change in the quantity demand : Percentage change in price)

C)

Numerical Value

Terminology

Description

e=α

Perfectly (or infinitely elastic)

Consumers have infinite demand at a particular price and none at all at even slightly higher than this given price.

e=O

Perfectly (or completely) inelastic

Demand remains unchanged whatever may be the change in price.

e>1

Relatively elastic

Quantity demanded changes by a larger percentage than does price.

e<1

Relatively inelastic

Quantity demanded changes by a smaller percentage than does price.

e=1

Unitary elastic

Quantity demanded changes by exactly the same percentage as does price.

MEASUREMENT OF ELASTICITY There are five different methods of measuring price elasticity of demand- (1) Percentage Method (2) Point elasticity Method (3) Total outlay Method (4) Point Geometric Method and (5) Arc elasticity Method.

(1)

Percentage Method : The following formula is used e=

% Change in Quantity Demanded % Change in Price % Change in Q.D. =

New Quantity Demanded – Old Quantity Demanded X 100 Average Quantity Demanded

% Change in Price =

(2)

Point Elasticity Method The calculation of the coefficient of price elasticity has been already discussed in the previous sub unit using the ratio : êQ e = –––– Q

∴

New Price – Old Price X 100 Average Price

êP ÷ –––– P

êQ e = –––– ÷ Q

Demand Analysis

P –––– ê P

105

∴

êQ P e = –––– ÷ –––– êP Q

(3)

Total Outlay Expenditure or Revenue Method Dr. Alfred Marshall suggested that the easiest way of ascertaining whether or not demand is elastic is to examine the change in the total outlay of the consumer or the total revenue of the seller. Total outlay (or Total Revenue) = Price per unit x Quantity demanded Dr. Marshall laid down the following propositions :

1)

When with a change in price, the total outlay remains unchanged, demand is unitary elastic (e = 1). The total outlay remains constant in the case of unitary elastic demand, because the demand changes in the same proportion as the price. This is illustrated in Table B given below : Table B TOTAL OUTLAY METHOD

(2)

Price (per unit) (Rs.)

Quantity demanded (Units)

Total Outlay (or revenue) (Rs.)

Elasticity of Demand

Original

5

16

80

–

Change 1

8

10

80

} e=1

Change 2

1

80

80

} (unitary)

When with a rise in price, the total outlay falls, or with a fall in price, the total outlay rises, elasticity of demand is greater than unity. This happens because the proportion of change in demand is relatively greater than that of price. In short, when the price and total outlay move in opposite directions, demand is relatively elastic (see Table C below). Table C TOTAL OUTLAY METHOD

106





Original

5

20

100

–

Change

8

10

80

} e<1

Change

4

4

160

} (Elastic)


(3)

When with a rise in price, the total outlay also rises, and with a fall in price, the total outlay falls, elasticity of demand is less than unity. This happens because the proportion of change in demand is relatively less than the proportion of change in price. Briefly, thus, when the price and total outlay move in the same direction, demand is relatively inelastic (see Table D below). Table D TOTAL OUTLAY METHOD





Original

5

13

65

–

Change

8

10

80

}e<1

Change

2

14

28

} (Inelastic)

We may now summaries the total outlay method as follows : Price (per unit)

Total Outlay

Types of Elasticity

1.

Increases Decreases

Constant Constant

e=1 (Unitary)

2.

Increases Decreases

Decreases Increases

e> 1 (Relatively elastic)

3.

Increases Decreases

Increases Decreases

e<1 (Relatively inelastic

Thus, from the behaviour of the total outlay or the total revenue, we can infer the nature of price elasticity of demand. Likewise, from a given price elasticity, we can conclude about the nature of change in the consumer's total outlay or the seller's total revenue. In the case of unitary elastic demand, with any change in price, the total revenue remains unaltered. But when there is elastic demand, the total revenue would change in the opposite direction of the price change. In the case of inelastic demand, the total revenue would change in the same direction as the price changes. The total outlay method of measuring elasticity is, however, less exact. It can indicate only the type of elasticity, but not its exact numerical value. To get the exact numerical value, we have to resort to the ratio method or the point method. However, the economic significance of the total outlay or the total revenue method is that it tells more directly

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what happens to the total outlay or revenue as a practical guide for determining a price policy and its effect on demand and revenue.

(4)

Point Geometric Method Dr. Alfred Marshall also suggested another method called the geometrical method of measuring price elasticity at a point on the demand curve. The simplest way of explaining the point method is to consider a linear (straight-line) demand curve. Let the straight-line demand curve be extended to meet the two axes, as shown in Figure shown below. When a point is taken on the straight-line demand curve (like point P in Fig below), it divides the straight-line demand curve into two segments (parts). The point elasticity is, thus, measured by the ratio of the lower segment of the curve below the given point to the upper segment (the upper part) of the curve above the point. For brevity, we may again put that Lower segment of the demand curve below the given point Upper segment of the demand curve above the point L or, to remember through symbols, we may put it as e = ––– U where, e, stands for point elasticity, L stands for lower segment and U for the upper segment.

Price (Per Unit)

Price (Per Unit)

Point elasticity =

Point Method

108

Point Method


In the Figure on the previous page, AB is a straight-line demand curve, P is a given point. Thus, PB is the lower-segment, PA is the upper segment. e=

L U

PB PA

=

If after actual measurement of the two parts of the demand curve, we find that PB = 4 cm. and PA = 2 cm., the elasticity at point P

3 2

=

=

1.5.

If, however, the demand curve is non-linear, then draw a tangent at the given point, extending it to intercept both the axes (See figure) Point elasticity at point P in Figure is measured as (5)

Arc Elasticity Method : This method is used to measure elasticity of demand on an arc of the demand curve. The formula is (Q0 – Q1)

(P0 – P1)

(Q0 + Q1) e=– x

(P0 + P1) ÷

2 ∴

PB PA

e=– x

(Q0 – Q1) X (Q0 + Q1)

2 (P0 + P1) (P0 – P1)

Here, Q0 = Original demand Q1 = New demand P0 = Original price P1 = New price There can be different answers to elasticity of demand ranging from zero to infinity. 8.

FACTORS INFLUENCING PRICE ELASTICITY OF DEMAND :

Whether the demand for a commodity is elastic or inelastic will depend on a variety of factors. The major factors affecting elasticity of demand are :

1.

Nature of Commodity Certain goods by their very nature tend to have an elastic or inelastic demand. By nature, goods may be classified into luxury, comfort or necessary goods. In general, demand for

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luxuries and comforts is relatively elastic and that of necessaries relatively inelastic. Thus, for example, the demand for food grains, cloth, vegetables, sugar, salt etc. is generally inelastic.

2.

Availability of a Substitute Where there exists a close substitute in the relevant price range, its demand will tend to be elastic. But in respect of a commodity having no substitute, the demand will be somewhat inelastic. Thus, for example, demand for salt, potatoes, onions, etc., is highly inelastic as there are no close or effective substitutes for these commodities, while commodities like tea, coffee or beverages such as Thums Up, Mangola, Gold Spot, Fanta, Limca etc. have a wide range of substitutes and therefore they have a more elastic demand in general.

3.

Number of Uses Single-use goods will have generally less elastic demand as compared to multi-use goods, e.g., for commodities like coal or electricity having a composite demand, elasticity is relatively high. With a fall in price, these commodities may be demanded greatly for various uses. It is, however, also possible that the demand for a commodity which has a variety of uses may be elastic in some of the uses, and may be inelastic in some other uses, e.g., coal used by railways and by consumers as fuel. But the former's demand is inelastic as compared to the latter's.

4.

Consumer's Income Generally, the larger the income of a consumer, his demand for overall commodities tends to be relatively inelastic. For example, the demand pattern of a millionaire is rarely affected even by significant price changes. Similarly, the redistribution of income in favour of low-income people may tend to make demand for some goods relatively inelastic.

5.

Height of Price and Range of Price Change There are certain white goods like costly luxury items or bulky goods such as double door refrigerators, Colour T.V. sets, D.V.D. players etc. which are highly priced in general. In their case, a small change in price will have an insignificant effect on their demand. Their demand will, therefore, be inelastic. However, if the price change is large enough, then their demand will be elastic. Similarly, there are divisible goods like potatoes and onions, etc. which are relatively low priced and bought in bulk, so a small variation in price will not have much effect on their demand, hence demand tends to be inelastic in their case.

6.

Proportion of Expenditure Items that constitute a smaller amount of expenditure in a consumer's family budget tend to have a relatively inelastic demand, e.g., a cinegoer who sees a film every fortnight is not likely to give it up when the ticket rates are raised. But one who sees a film every

110


alternate day perhaps may cut down the number of films seen per week. So is the case with matches, sugar, kerosene candles, broomstick, haircut etc. Thus, cheap or small expenditure items tend to have more demand inelasticity than expensive or large expenditure items.

7.

Durability of the Commodity In the case of durable goods, the demand generally tends to be inelastic in the short run, e.g., furniture, motor cycles, T.V. sets etc. In the case of perishable commodities, on the other hand, demand is relatively elastic, e.g. milk, vegetables etc.

8.

Influence of Habit and Customs There are certain articles which have a demand on account of conventions, customs or habit with which these articles are closely associated and in these cases, elasticity is less, e.g. Mangal Sutra to a Hindu bride or cigarettes to a smoker or alcohol to an alcoholic have inelastic of demand.

9.

Complementary of Goods Goods which are jointly demanded have less elasticity, e.g. ball-point pen and refills, motor cycle and petrol etc. have inelastic demand for this reason.

10. Time In the short period, demand in general will be less elastic, while in the long period, it becomes more elastic. This is because (i) it takes some time for the news of price change to reach all the buyers; (ii) consumers may expect a further change, so they may not react to an immediate change in price; (iii) people are reluctant to change their habits all of a sudden, but gradually, in the long run, their habits may change and so too the demand pattern; (iv) durable goods take some time to exhaust their utility. In the long run, lapse of time results in their wearing out, then these are demanded more; (v) demand for certain commodities may be postponed for some time, but, in the long run, it has to be satisfied.

11. Recurrence of Demand If the demand for a commodity is of a recurring nature, its price elasticity is higher than that of a commodity which is purchased only once. For instance, motorcycles, V.C.D. players, T.V. sets etc. are purchased only once, hence their price elasticity will be less. But the demand for cassettes or Compact Disks may remain relatively elastic.

12. Possibility of Postponement When the demand for a product is postponable, it will tend to be price-elastic. In the case of consumption goods which are urgently and immediately required, their demand will be inelastic. For example life saving drugs during sickness, habituated goods etc.

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9.

PRACTICAL SIGNIFICANCE OF THE CONCEPT OF ELASTICITY OF DEMAND :

The concept of elasticity of demand has a wide range of practical application in economics and business.

1.

Its importance to the Businessman The elasticity of demand for the product he produces is the prime concern of every producer. It guides him in determining the price policy for his product. He finds that it will be profitable to raise prices, provided the demand is inelastic. And in the case of products having a highly elastic demand, it is better to lower their prices so that, with a little marginal profit, their sales will be more, hence their total revenues, and thus the total profit will be large.

2.

Importance to Government In determining fiscal policy, the concept of elasticity of demand is very important to the government. The Finance Minister has to consider the elasticity of demand while selecting commodities for taxation. Tax imposition on commodities for getting a substantial revenue becomes worthwhile only if taxed goods have an inelastic demand. Otherwise, if their demand is more elastic, then it will contract very much with a rise in price as a result of added taxation (like sales tax or excise duty), hence the total revenue yield would not be much different from the earlier one. That is, there will not be any significant rise in revenue. That is why, generally taxes are levied on commodities like petrol, cigarettes, alcohol, steel, white goods like refrigerators, washing machines etc. which have an inelastic demand.

3.

Its Importance to the Trade Unionists The concept of price-elasticity is useful to trade union leaders in wage bargaining. The union leader, when he finds that demand for their industry's product is fairly elastic, will ask for a high wage for workers and suggest the producer to cut the price and increase sales which will compensate for his loss in total profit.

4.

Its importance to Economists The concept is highly useful to the economists in understanding and solving many problems. For instance, the concept is useful in solving the mystery as to how farmers may remain poor despite a bumper crop. Since agricultural products, particularly foodgrains, have an inelastic demand, when there is a bumper crop it can be sold only by cutting down prices substantially. Hence, the total income of farmers will be lower inspite of a bigger crop. Thus, for policy-makers, it implies that higher farm incomes depend, among other things, upon restriction of the supply of foodgrains and other farm products.

5.

Its importance in International Trade If demand for Indian goods in foreign countries is inelastic, India can raise the price of its commodities substantially and still export the same quantity at a higher price, thus, getting larger amount of money and higher profit from their exports.

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Thus, during 1950’s when demand for Indian jute manufactures in foreign countries was highly inelastic, realizing this fact Government of India raised the price of jute manufactures by practically trebling export duty on these goods forcing foreign importers to pay nearly three times the price as compared to old price and yet selling same quantity as before, thus getting higher amount of profit by exporting the same amount of jute manufactures as before. Similarly, during 1970’s, petroleum oil-exporting countries formed OPEC, a monopolistic organization of oil-exporting countries and raised the price of crude oil from 3 dollars per barrel to nearly 30 dollars per barrel and still could export the same quantity as before, thus making enormously larger profits than before. This made the Middle East oilproducing Arab countries very rich as petroleum has as yet no substitute. For example, India’s oil bill rose nearly ten times though importing the same quantity as before from the Middle East. All this could happen because of the highly inelastic demand for crude oil produced in the Middle East countries which are the main supplier of crude oil to the world. Thus, in international trading transactions, trading nations make an effort to know the degree of elasticity of demand for their goods in foreign countries with a view to fix prices of export goods at a level that would give exporting countries maximum profit. 10. INCOME ELASTICITY OF DEMAND : As indicated in the beginning, we can now switch over to another determinant of demand viz. income and consider elasticity of demand by holding all other determinants, including price, constant. Income elasticity of demand for a product shows the extent to which a consumer's demand for that product changes consequent upon a change in his income. Income elasticity of demand can be defined as the ratio of proportionate change in the quantity demanded of the commodity to a given proportionate change in income of the consumer. (A) MEASUREMENT OF INCOME ELASTICITY The formula for measuring income elasticity of demand can be stated thus : Formula 1 : Ey =

Proportionate change in quantity demanded ––––––––––––––––––––––––––––––––––––– Proportionate change in consumer's income

Example : A 20% rise in income causes a 30% increase in demand for a product 'X", what will be the income elasticity of demand for 'X" ?

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Solution : According to formula mentioned above : Ey

30 –– 20

=

=

1.5

Formula 2 A second formula which is mathematically more rational is suggested as under : Q2 - Q1 Y2 - Y1 Ey = ––––––– ÷ –––––– Q2 + Q1 Y2 + Y1 In this formula Q1, is the initial consumer expenditure on any commodity 'X" (which represents the demand for the product 'X") and Q2 is the new expenditure on the same commodity after a change in income. Y1 denotes initial income and Y2 stands for changed or new income. Example : A consumer spends Rs.60/- per month on sugar when his income is Rs.l,500/ - per month. When his income increases to Rs.1800/- per month he spends Rs.84 on sugar. What will be the income elasticity of demand for sugar in this case? Solution : According to the above formula

∴

84 - 60 Ey = ––––––– 84 + 60

÷

1800 - 1500 –––––––––– 1800 + 1500

=

24 ––––––– 144

÷

300 ––––––– 3300

=

24 ––––– 144

x

3300 –––––– 300

=

1 –––––– 6

x

11 –––––– 1

=

11 ––––– = 1.8 6

Ey =

>1

(Income elasticity of demand in this case is 1.8 ∴ positive)

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B)

Types of Income Elasticity of Demand According to the value of income elasticity of demand, we can classify income-elasticity into the following types : 1.

Negative Income Elasticity : When the demand for a product decreases as income increases and conversely where demand for a product increases as there is fall in income, the income elasticity of demand is negative. The demand for inferior goods is of this type.

2.

Zero Income Elasticity : When a change in income has no effect upon the quantity demanded of a product, the income elasticity of demand would be zero. Demand for salt is an example of this type.

3.

Unit Income Elasticity : Income elasticity of demand will be equal to unity (i.e.1) when demand for the product increases in the same proportion in which income increases. Unit elasticity of demand is considered to be a dividing line between necessaries and comforts. In other words the income elasticity of demand for necessaries will be less than unity : while the income elasticity of the demand for comforts will be more than unity. Both these cases are noted below.

4)

Low Income Elasticity of demand : When the income elasticity of demand for a product is positive i.e. greater than zero, but less than one, we say that the income elasticity of that demand is relatively less. Such a variety of relatively less income elasticity or incomeelasticity of demand suggests that the commodity concerned must be necessary. This is because as income increases the percentage of income spent on necessaries goes on diminishing, according to the Engel's Law of family expenditure.

5)

High Income Elasticity As opposed to the above category, we get high income elasticity of demand for products which satisfy the consumers' comforts and luxuries. In other words, the income elasticity of demand for articles of comforts and luxuries is greater than unity. The income elasticity for different products differs widely. Income - elasticity of demand tends to be very high in respect of luxury articles like gold, jewellery, precious stones, paintings, cars etc. As against this, income elasticity of demand is very low in respect of commodities like salt, vanaspati, matches, kerosene, washing soap etc. Besides the type of a commodity i.e. whether it is a necessary or comfort or luxury, the proportion of a consumer's income spent on the commodity is also a major factor influencing income elasticity of demand.

C)

Uses of the Concept of Income Elasticity of Demand The concept of income elasticity of demand is useful in many areas of economic policy formulations as well as analyses of various situations.

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115

1)

Economic Development : In case of economic development, when notional income is increasing, we can find out how much will be the increase in the demand for a given product, by considering the income elasticity of demand for that product.

2)

Economic Fluctuations : Economic fluctuations are the characteristic features of a capitalistic economy. Phases of prosperity and depression alternate in such an economy. The concept of income elasticity can be a very useful guide in finding out what products would be demanded during the phase of prosperity. Similarly, during the phase of depression, certain necessaries will continue to be demanded. As noted above, necessaries are commodities with very low income elasticities.

3)

Economic Planning : The concept of income elasticity of demand is of great help to the planners who are planning for the economy as a whole. When economic development is being planned, the planners have to set targets of production in terms of physical quantities for various sectors of the economy. With the help of income elasticity, the planners can estimate the possible increase in demand for the product as a result of the targeted rate of growth of the economy. This would make the physical targets more realistic and would serve to maintain physical balances - a difficult task for the planners.

4)

Demand Forecasting : Firms are required to forecast the demand for their product. With the help of statistical information regarding trends in growth of income as well as changes of distribution of income, the firm can forecast the demand for its product by using income elasticity of demand for that product as a guide.

5)

Foreign Trade : In the area of foreign trade, a country needs to take into account the income elasticity of demand for its imports as well as exports. A country exporting agricultural products and articles of necessity faces an income-elastic demand, compared to a country which is exporting articles of luxury. This difference influences terms of trade. Income elasticity of demand serves as a guide in the matter of balance of payments disequilibrium also. For example, India has been an exporter of jute, tea, coffee and spices; but the demand for all these commodities is incomeinelastic. The rate of growth of India's exports therefore has remained relatively low. As against this, India's demand for imports like electronics, machinery, consumer durable etc. is income-elastic. Consequently, the rate of growth of India's imports has remained high. Thus we have been facing the problem of an increasing trade deficit in India during the last few years. The list of areas where income elasticity of demand is useful can be increased further by mentioning public finance, labour policy, industrial policy etc. where the concept is useful.

11. CROSS ELASTICITY OF DEMAND : In practice, commodities are seldom independent of one another. Among the wide range of

116


products that we see at the market, we find that most of these goods are related. On the basis of the relationship, we can group these products either as substitutes or as complements or as a third group of goods which are neutral. In the context of the relationship between goods, the concept of cross elasticity of demand can be used. Cross elasticity of demand may be defined as the ratio of proportionate change of quantity demanded of commodity 'X' to a given proportionate change in price of the related commodity 'Y'. With the help of formula, similar to the one we noted earlier, we can say : Ec =

Percentage change in quantity demanded of 'X' ––––––––––––––––––––––––––––––––––––––––– Percentage change in the price of 'Y'

If we assume the two commodities X and Y are substitutes of each other and that the price of Y rises but that of X remains constant, the quantity demanded of X will increase because the consumers will substitute X for Y, since Y has become costlier. Conversely, if the price of Y falls leaving the price of X unchanged, the quantity demanded of x will decrease because the consumers will now substitute Y for X since Y has become cheaper than before. Cross elasticity can also be measured by another formula as given below Ec =

OX2 – OX1 OX2 + OX1

:

PY2 – PY1 PY2 + PY1

In this formula QX2 is the new demand for X, QX1 is the original demand for X; PY2 is the new price of Y and PY1 is the original price of Y. If X and Y are perfect substitute for each other, the cross elasticity of demand will be infinity. It means that the slightest rise in the price of Y will cause an almost infinite rise in the demand for X and the slightest fall in the price of Y will reduce the demand for X to almost zero. If, on the other hand, two goods are not substitutes at all, the cross elasticity of demand will be zero. A change in the price of one commodity will not affect the quantity demanded of the other commodity. It will thus be clear that the cross elasticity of demand for substitutes varies between zero and infinity. If the relationship between X and Y is that of complementary, the cross elasticity in such a case will be negative. A rise in the price of Y will mean not only a decrease in the quantity demanded of Y but also a decrease in the quantity demanded of X because both are demanded together. For example, ball-point pens and refills are complementary goods. When the price of refills rises, it causes a fall in the demand for refills as well as for ball-point pens, because both are demanded together.

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Commodities X and Y will be the perfect substitutes only when they are totally identical. In that case, they will not be two different commodities at all. Therefore, in practice, infinite cross elasticity of demand cannot be found. In practice, the cross elasticity of demand can thus be positive, zero or negative. The cross elasticity is positive when X and Y are good substitutes (and almost infinity when X and Y are almost substitutes). It is zero when X and Y are not related to each other or do not possess any substitutability : they are independent of each other. It is negative when X and Y are complimentary goods. In the first case, a rise in the price of Y (price of X remaining constant) will cause an increase in the quantity demanded of X. In the second case, a rise or fall in the price of Y (price of X remaining unchanged) does not affect the quantity demanded of X at all. In the third case, a rise in the price of Y (the price of X remaining unchanged) will cause a decrease in the quantity demanded of X. Example : Because the price of Y increases from Rs.10 to Rs.12 per kg., the sale of a firm’s product commodity X rises to 220 kg. from 200 kg. per week. Find out the cross elasticity and state the relationship between commodities X and Y. Solution : Ec =

OX2 – OX1 OX2 + OX1

:

PY2 – PY1 PY2 + PY1

=

220 – 200 –––––––– 220 + 200

:

12 – 10 –––––––– 12 + 10

=

220 – 200 –––––––– 220 + 200

X

12 +10 –––––––– 12 – 10

20 Solution : Ec =–––––––– 420

X

22 ––– 2

∴ Ec =

11 21

The cross elasticity of demand is positive and X and Y are substitutes. 12. USES OF CROSS ELASTICITY OF DEMAND : Perfect substitutes are seldom found in practice. Perfect complementarity is equally rare. But, broadly speaking, there is complimentarity or competition i.e. substitutability among several commodities. Under such circumstances, the entrepreneur can judge the effect of his pricing policy on the quantities demanded of the products of others and vise versa on the basis of the cross elasticity of demand.

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13. DEMAND FORECASTING : (A) Meaning and Importance A forecast is a guess or anticipation or a prediction about any event which is likely to happen in the future. Forecasts are made either through experience or through statistical methods. As individual may forecast his job prospects, a consumer may forecast an increase in his income and therefore purchases, similarly a firm may forecast the sales of its product. Predictions of future demand for a firm's product or products are called demand forecasts. Demand Forecasting is the method of predicting the future demand of a firm's product. (B) Necessity of Forecasting Demand As mentioned above, demand forecasts may be based on judgment of the experienced staff of a business concern or on scientific analysis (with the help of statistics). When a firm is small in size it may not need or afford an organized forecasting system. They can base their forecasts on the judgment or foresight of their experienced staff. However, as a firm increases in size and produces a number of products and uses modern techniques of production, it becomes necessary for the firm to forecast the demand for its various products, in a more scientific manner. Such forecasts are more accurate and thus help the firm to produce efficiently, with the help of the available resources. Forecasts have become a part of business management of most of the firms. Forecasts are necessary for :

(1)

Fulfillment of objective of the Plans Every business unit, industry or the government starts with certain pre-decided objectives. These objectives can be fulfilled with the help of accurate demand forecasts.

(2)

Preparation of a Budget Scientific forecasts are useful to the entrepreneur to take business decision. Every business unit has to prepare a budget. A budget includes the cost and expected revenues. Expected revenues can be estimated only on the basis of demand forecasts.

(3)

Stabilization of Employment and Production Demand for a product changes according to seasons or business cycles or tastes etc., the supply, however, cannot be changed suddenly if however, it is possible to estimate the demand for a firm's product, it can be possible to produce according

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to the expected demand. This can avoid wastage of scarce resources of the firm. So also the employment policy can be decided in advance, with the help of these forecasts.

(4)

Expansion of firms When a firm has to decide whether it should expand or not and to what extent it should expand, it has to consider the expected demand for its product, at a future date. Demand forecasts become useful in such cases.

(5)

Other Uses Demand forecasts are also useful to a firm, for long-term investment decision. Budgeting policies and Warehouse and Inventory Control.

(C) Factors Influencing Demand Forecasts A number of factors affect the demand forecasts. Each of these factors has to be studied together with the other factors while forecasting demand. Thus, these factors outline the scope of demand forecasting.

1.

Time-Period Forecasts can be for a short-period, long period or very long (secular) period. a)

Short-period These forecasts are for a period of one year and are based on the judgment of experienced staff of the firm. Within this short period the sales promotion policies of the firm or the tax-policies of the government do not change. Short period forecasts are important for deciding the production policy, price policy, credit policy and marketing and distribution of the firm's product.

b)

Long-period forecasts These are forecasts for a period of 5 to 10 years and are based on scientific analysis and statistical methods. Long period forecasts are important to decide about whether a new factory is to be established, a new product can be introduced, or capital needs are to be raised.

c)

Very-long period forecasts These are for a period of over 10 years. Secular factors like growth of population, development of the economy, the political situation in the country, the changes in the international trade, sociological factors, like age of marriage, changes in traditions, have to be considered for forecasting the demand over a very long period.

2)

Level of Forecasts Forecasts can be made at the level of the firm or the industry or the nation.

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a)

A firm A firm forecasts the sales of its products. It bases its forecasts on the forecasts of the industries and the nation.

b)

An Industry Forecasts at this level are prepared by the trade association. These are based on statistical data and market survey. These forecasts are available to all the firms of the industry.

c)

The Nation These forecasts are national level forecasts and are based on indices such as national income and national expenditure.

3)

General and Specific Forecasts Forecasts can be of a general type, giving a total picture of the demand for all the products of a firm or demand from all the markets of the firm's product. These are not very useful to a firm. Specific demand forecasts give specific information. Product-specific demand forecasts give the forecasts of each of the products produced by the firm. Area, specific demand forecasts give the forecasts each of the markets for the firm's he markets for the firm's product.

4)

Established Products and New Products Established goods, are goods which are already established in the market; information about these goods is available, the present demand, the number of substitutes to the product, the level of competition, the markets are known. New products are those which are yet to be introduced in the market, information about these products is not known. Thus depending on whether the product is an established or new product, different methods are used for forecasting demand.

5)

Product-Classification For the purpose of Demand Forecasting products can be classified as a)

Capital Goods and Consumer goods

b)

Durable goods and Perishable goods

a)

The demand for capital goods (machinery, spare parts) is a derived demand. It is derived from the demand for the product produced by the capital goods. This demand is highly fluctuating.

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121

The demand for consumer goods depends on the incomes of the consumers. An increase in income leads to an increase in the demand for consumer goods, but a fall in the income does not immediately lead to a decrease in the demand for consumer goods; (e.g. Sugar, Food grains, Soaps etc.) b)

The demand for durable goods can be postponed. Thus if prices of these goods increase, then the demand falls, because people will postpone their consumption of these goods (e.g. washing machines, refrigerators, mixers etc.) The demand for perishable goods like vegetables and fruits depends on the current incomes and current demand. Thus, depending on the type of product, demand forecasts and methods of forecasting demand will be different.

6)

Other Factors The level of uncertainty, the nature of competition, the number of substitutes to a product, the elasticities of demand for the product are important factors which have to be considered while forecasting the demand for a product. These factors depend on the type of product, on the market for the product and on the time-period. Thus, tastes and preferences and fashion have to be considered while forecasting demand for readymade garments. Weather forecasts are important for the firms producing raincoats, rainy-shoes and umbrellas.

D)

Techniques or Methods of Forecasting Demand The methods of forecasting demand depend upon, whether the product is an established good or a new good, and on the level of forecasts, i.e. macro or micro level. Macro-level forecasts are used in national economic planning. These are forecasts about general business conditions, and these forecasts make use of information regarding the macro-variables, like government expenditure, savings, the aggregate demand etc. Micro level forecasts are at the level of the firm or industry. These forecasts make use of macro-level information. We are concerned with these types of forecasts. As mentioned above, the methods of forecasting demand for established goods and for new goods are different. We shall first study the methods of forecasting the demand for established goods and then for new goods.

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(a)

Methods of Forecasting Demand for Established Goods Information about established goods is available and so forecasts can be based on this information. There are two basic methods of forecasting the demand for established goods.

(I)

1)

Interview and Survey Approach (short period forecasts)

2)

Projection Approach (long period forecasts)

Interview and Survey Approach : (for short Period Forecasts) To anticipate the expected sales of a commodity, it is necessary to collect the information regarding the expected expenditures of the consumers. The interview and survey approach, tries to collect this information, in different ways, and forecasts are based on this information. Depending on how this information is collected, we have different sub-methods of this survey approach.

1)

Opinion-Polling Method This method tries to collect information, directly or indirectly, from the prospective consumers. This is possible through the market research department of the firm or through the wholesalers and retailers. If consumers cannot be contacted personally or directly, then they are contacted through mail or now-a-days they can be contacted on 'internet' and the information regarding their expected expenditure is collected. This method is useful when the product and consumers come into direct contact or when the number of consumers is small. This method is also useful when the consumer is another firm. Limitations

2)

1)

Individual consumers are not sure of their purchase Plans

2)

It is difficult and costly to contact all the consumers

3)

Useful only in the short period

Collective Opinion method Large firms have an organised sales department. The salesmen have technical training about how to collect the information from the buyers. Many times the production manager, sales manager, finance managers come together and make use of this information to finalise the forecasts. These forecasts are based on information which is more certain and thus forecasts based on this information may be more accurate.

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Limitations

(3)

1)

This method based on value-judgement and has no scientific basis

2)


3)

It is difficult and costly to contact all the consumers.

Sample-Survey Method The total number of consumers for a firm's product is called the population. When the number of consumers is very large (size of population is large), it is not possible to contact each and every consumer. A few consumers are contacted, this forms the sample. Information is collected from the consumers in the sample and forecasts are based on this information. These forecasts are then generalized for the whole population. This is possible through the advanced statistical methods. Limitations

(4)

a)

Information collected may not be accurate.

b)

The sample selected must be a random sample, so that when the results are generalized for the population, accurate forecasts are made very often, the sample is not a random sample.

c)

Consumers do not co-operate by giving a correct idea of their expected purchases. Sometimes, the consumers themselves make unplanned purchases.

Panel of Experts Panel of experts consists of either persons from within the firm or from outside. These experts come together and forecast the demand for the firm's product. If forecasts are based on judgement of these experts, the forecasts will have no scientific basis, and thus, may be less accurate. If however, forecasts are made on the basis of statistical information and with the use of scientific methods, the forecasts will be more accurate.

(5)

Composite Management Opinion The opinions of the experienced persons with the firm are collected and a committee or the general manager of the firm analyses this information and forecasts the demand for the firms product. This method is quick, easy and saves time and cost, but is not based on scientific analysis and thus may not give very accurate results.

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(II)

Projection Approach (for long period forecasts) In this method, the past experience is projected into the future. This can be done with the help of statistical methods. (1)

Correlation and Regression Analysis

(2)

Time series Analysis

In both these methods, past data is collected, a trend is observed then a functional relationship (correlation) is established between the variables. This is done with the help of Regression. Once a relationship is established, it is possible to project this into the future. 1)

Correlation and Regression Analysis

As mentioned above, the past data regarding the factors affecting demand can be collected. It is possible to express this on a graph. This is a scatter diagram. For example, if we collect the past data about the sales and advertisement expenditure of a firm, it is possible to express this in the form of a scatter diagram, as shown below : Y

Sales

A

A

O

Advertisement Expenditure

X

Now, with the help of Regression Techniques, like, the least square method or the maximum likelihood method (correlation), it is possible to get the best fit, i.e. a best possible functional relationship between the variables. In the above diagram, we get this functional relationship as a straight-line AA. There are some independent variables (Advertisement expenditure, in our example) and some dependent variables (sales, in our example). The relationship (cause effect) between these variables is the correlation and the technique of establishing Demand Analysis

125

this relationship is regression. If the past correlation is assumed to remain the same in the future, we can use this relationship to estimate the demand for the future. In simple correlation, we have a relationship between two variables and a relationship between more than two variables is multiple correlation. For example Simple Correlation C = f(Y) where C is the consumption (Demand), and Y is the consumers income. Suppose, from past-experience, we have a specific functional relationship C = a + .8y Then, if we know the changes in Y (income) we can predict or project the changes in consumption, and thus forecast the demand for the product. Limitations

2)

a)

Assumption made is that the correlation between the two variables will continue in future also, this might not happen. E.g. Number of students and the demand for text books, may have a direct relationship, but when the text-books change, this relationship no longer holds good in future.

b)

Correlation does not necessarily mean that there is a cause effect relationship between the two variables Eg. suppose, in a particular year, the incomes of consumers have increased, and in the same year the demand/sales of cassettes have increased, can we conclude that there is a direct (positive) correlation between income and demand for cassettes ? Even though it appears that there is a positive correlation between income and demand for compact disks, it is just chance that in that year both income and demand for compact disks increased. There is no cause-effect relationship and thus forecasts based on this relationship will not be correct.

Time-Series Analysis Demand forecasts for a period of more than 2-3 years are based on Time-Series Analysis. Time-series Analysis is similar to correlation analysis. It is based on the assumption that the relationship between the dependent and independent variables will continue to hold in the future.

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(b)

METHODS OF DEMAND FORCASTING NEW PRODUCTS As mentioned above, new goods are goods which are new to the market. The information regarding these new goods is therefore, not available. However, firms producing these goods find it necessary to estimate the future demand for their product. Thus, indirect methods of forecasting are used to estimate the demand for new products. Joel Dean suggests the following methods.

1)

Evolutionary Method Some new goods evolve from already established goods. The demand forecasts of such new goods can be based on the information about the already established goods from which it is evolved. Thus, the demand for coloured T.V.'s could be based on the assumption that, it has been evolved from black and white T.V.'s, thus the information about black and white T.V.'s can be used to estimate the demand for coloured T.V. Limitations

2)

a)

The new products should have been evolved from existing product.

b)

It ignores the problem of how the new product differs from the established product.

Substitution Method Some new goods are substitutes of already established goods. Since most new goods are substitutes of already established goods, this method has wide-uses. New L.C.D., T.Vs are substitutes of already established Colour & Black & White T.Vs. Limitations

3)

(a)

Some new products have many uses and each use has a different substitutability, forecasting demand of such new goods becomes difficult.

(b)

When a new substitute is added to the market, the existing firms react in different ways (changes in price, advertisement etc.)

Growth Pattern Method If there is some relationship between the new good and an already established good. It is possible to estimate the demand for the new good by studying how the established good has grown. Thus, we can study the growth pattern of all the toothpaste in the market, and make use of this information to forecast the demand for the new toothpaste. Limitations a)

This method is very time-consuming and has limited use.

b)

This is useful for the forecasts of the new goods at a later stage of growth.

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127

4)

Opinion-Polling Method The expected consumers/buyers are directly contacted and their opinion about the new product is gathered. If the number of expected consumers is very large, then a sample is selected and the results obtained from the sample are generalised for the population. This is very useful method and is used by many firms to estimate the demand for their new product. A new drug, for example, is to be introduced in the market, the firm concerned will contact the doctors and gather their opinion about the drug, before it is introduced in the market. Limitations

5)

a)

Individual consumers are not sure of their purchase plans

b)

It is difficult and costly to contact all the consumers.

c)


Sample-Survey Method The new product is first introduced in some sample-markets and the results seen in the sample market are generalised for the total market. Limitations

6)

a)

The sample chosen, should be a correct representation of the toal.

b)

Tastes and preferences differ from market to market.

Indirect Opinion-Polling Method The opinions of the consumers are indirectly collected through dealers who are aware of the needs of the consumers. However, the success of this method depends on the judgement of these dealers. Limitations

C)

a)

Based on value judgement, therefore, has no scientific basis, and forecasts may not be accurate.

b)

Limited scope.

Criteria for a Good Demand Forecast A forecast is said to be good when the expected demand is close to the actual demand. A firm has to choose the best method of forecasting, so that the forecasts are good. The following are the criteria which need to be considered before forecasting the demand for a product.

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a)

Accuracy : Forecasts must be as close to reality as possible. There is no point in spending so much money and time if the forecasts do not give a real picture of the market demand.

b)

Durability : Forecasts require a lot of time and money, thus they should be such that they can be used for a long period, they should be durable. The relationship between the variables should be stable, for the forecasts to be durable.

c)

Flexibility : Forecasts should be adjustable. Business means a lot of uncertainty and to accommodate this uncertainty, the forecasts should take into account all the possible factors affecting the forecasts.

d)

Acceptability : Advanced statisical techniques are available to the firms for forecasting demand. But because they are very complex, these methods are not acceptable by most firms. Firms prefer simple and easy method for forecasting the demand for their product.

e)

Availability : Sufficient and upto-date data must be available for the forecast to be good. Also, the forecasts must be available to the firms on time, so that the firms can make the necessary arrangements to produce and supply their product in the markets.

f)

Plausibility : Forecasts should be plausible. They should be understood by the executives who are going to make use of it.

g)

Economy : Economy or the cost-factor is very important in demand forecasting, because good forecasts require both time and money. While incurring costs on forecasting, a firm should weigh the costs and benefits. If accurate forecasts are going to give very high returns, then it is worth spending more money on forecasting demand. If however, accuracy of forecasts will mean a lot of money, but will not make much difference to the return, in such cases, a slight degree of inaccuracy would not matter and it will save money at the same time.

14. INTRODUCTION TO INDEX NUMBERS : 1)

MEANING OF INDEX NUMBERS Index number is defined by the classical economist Edgeworth as : "a number by its variations to indicate the increase or decrease of a magnitude not susceptible to accurate measurements." In fact, the index number is a statistical device for measuring differences in the magnitude of a group of related variables over two different situations. The two 'different situations' may refer to two different periods or two different places. The group of variables may be phenomena like the price of commodities, the quantity of goods produced, marketed or consumed etc. An index number compares one group of related variables with another

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group in a relative sense. The comparison may be between periods of time, or between places. Thus, we may have index numbers comparing the prices of a specified group of commodities at different times or in different countries or localities, the level of production in different years and so on. Index numbers measure changes in accordance with a reference base or comparison base expressed as 100. Thus, index numbers are always expressed in the form of percentages, compared with the base year index which is always assumed to be 100. Because an index number is a measurement of relative and not absolute changes in the variable over a period, it is a coefficient or relative measure of movement of a statistical variation from a standard giving a general trend. Thus, index numbers are applied to the measurement of the general movement of prices, cost of living, wages, production, consumption, employment etc. Since changes in such variates are not easily capable of direct quantitative measurement, they are relatively measured in terms of percentage by the technique of index numbers. As R.G.D. Allen states, the range of index number is very great and they can indicate changes in variables such as wage rates, shipping freights, security prices, commodity prices, volume of output, sales and profits. Therefore, index numbers are generally used by businessmen, economists and social workers to measure changes in prices, wages, sales, production, stocks, exports, imports and cost of living etc. Index numbers are described as "economic barometers". They are indispensable to economists, businessmen, planners, policy-makers and statesmen alike. 2)

CLASSIFICATION OF INDEX NUMBERS From the point of view of "what they measure", index numbers may broadly be classified as : "Price Indices, Quantity indices and Special purpose indices.

1.

Price Indices A price index number is a sort of average of the individual price relative to a set of commodities, and it measures the price changes of all such commodities collectively. Thus, price indices measure and permit compariason of the prices of certain goods. Price indices may either be of : (1) Wholesale prices or (2) retail prices. Thus, price indices may further be classified as : (1)

Wholesale price index numbers, and

(2)

a)

Retail price index numbers

b)

Consumer price index numbers or cost of living index numbers

Wholesale price index numbers measure the changes in the general price level of a country. It is interesting to note that such indices published in India are known as Economic Advisers Index Numbers of Wholesale Prices. 130


Retail Price Index Numbers are compiled to measure the changes in retail prices of various commodities such as consumption goods, stocks and shares, bonds and government securities, treasury bills etc. which have bearing on various economic aspects. Moreover the common man is "largely affected by the retail prices than the whole-sale price level in the country. In India such indices are available in the form of : (1)

Index Number of Security Prices

(2)

Labour Bureau Index Number of Retial Prices (Urban Centre); and

(3)

Labour Bureau Index Number of Retail Prices (Rural Cedntre)

Consumer's price index numbers are the specialised forms of retail price indices in which only prices of those commodities are considered which enter into the consumption of different classes of people. Consumers' price index numbers are compiled to measure the changes in the cost of maintaining a consumption pattern (i.e., standard of living) of a class of people over a period of time. Therefore, these indices are popularly known as cost of living index numbers. There are three prominent types of cost indices available in India. (1)

Cost of living index numbers of the employees of the Central Government.

(2)

The middle-class cost of living index numbers, and

(3)

The working class cost of living index numbers

However, the first two are ad hoc enquiries and the data are compiled after making family budget enquiries. The working class cost of living index numbers are published by the Labour Bureau, Ministry of Labour, Government of India. Cost of living index numbers are of great practical use to trade, commerce and industry. Wage policies are laid down and wage disputes may be settled on the basis of these indices.

2.

Quantity Indices A quantity index number expresses the relative average of the volume of production in different sectors of an industry. Thus, quantity index numbers measure and permit comparison of the volume of goods produced or distributed or consumed. The index of production is the leading type of quantity index number. There are indices of industrial production, agricultural production and so on and so forth. Production indices are highly useful as indicators of the level of output in the economy. The growth rate and the direction in which an economy is moving is shown by how much is being produced and whether the present production level has gone up or gone down as compared to the previous levels.

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3.

Special Purpose Indices A large variety of index numbers used for specific purposes may be included under this heading. To study the various special kinds of problems such index numbers are compiled. For instance, there are import-export indices, stock-exchange share price indices, labourproductivity indices, etc.

3)

PRINCIPLES AND PRACTICAL STEPS INVOLVED IN THE CONSTRUCTION OF A PRICE INDEX NUMBER THE BASIC PRINCIPLES INVOLVED IN CONSTRUCTION OF A PRICE INDEX NUMBER ARE : 1)

The object of the index number be determined.

2)

A base year is selected and the price of a group of commodities in that year are noted.

3)

Prices of the selected group of commodities for the given years that are to be compared are noted.

4)

The index number for the base year prices is always denoted as 100.

5)

Changes in the prices of the given years (current years, in statistical terms) are shown as a percentage variation from the base.

Thus, the construction of a price index number involves the following steps :

4)

a)

The choice of the base year;

b)

The choice of commodities whose prices are to be taken into account'

c)

The collection of data, i.e. price quotations, for the selected group of items in the base year and the current year;

d)

assigning proper weights to different items. If so desired, to remove ambiguity or bias; and

e)

Averaging the data so as to express the prices of the given years as percentage of the prices of the base year.

PROBLEMS OF CONSTRUCTION OF INDEX NUMBERS The construction of an index number involves the consideration of the following major problems :

(1)

Purpose of Index Number It is absolutely necessary that the purpose of the index number should be clearly and unambiguously defined, since most of the later problems will depend upon the purpose.

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Before collecting data and making calculations, it is important that one knows what one wants to measure and how to make use of the given measure. Once the purpose is clear, the rest of the procedure is easy to apprehend. One must be sure of which type of index number is to be computed - whether it is wholesale price index number, consumer's price index number, the quantity index number and then proceed accordingly. Similarly, it is also necessary to determine the scope of the index number - such as, the regional coverage or the place, the frequency of compilation, etc. Indeed, the scope will be determined on the basis of the object. (2)

SELECTION OF BASE PERIOD Base period is a point of reference for comparison to measure the relative changes in the level of a phenomenon (e.g. price level in the case of a price index number) for the current period. Usually, against the base year's norm (100), the relative changes for all the other years are compared. Suppose the price levels of two time periods, that of 1994 with that of 1990, the former is called current period and the latter base period. The base period, therefore, is the basis of comparison. Selection of the base year needs to be done with utmost care. The base year should be a normal economic year. It should neither be a year of economic crisis nor of unprecedented boom. There should not be any erratic forces in operation like political upheavals, war, floods, famines etc. If by change an abnormal or inappropriate base year is chosen, the indices related to such a base year present distorted figures and conclusions. For instance, a base period at the peak of a boom or inflation makes the index numbers appear unusually low at most other periods. Conversely, a base at the trough of economic depression makes all the indices appear unusually high.

(3)

SELECTION OF ITEMS Selection of items is another problem. Out of unwieldy list of commodities, the required representative items are to be selected according to the purpose and type of the index number. In selecting items the following points are to be considered. a)

items should be representative of the tastes, habits and traditions of the people.;

b)

they should be cognizable;

c)

they should be such as are not likely to vary in quality over two different periods and places;

d)

the economic and social important of the various items of consumption should also be considered; and

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133

e)

the items must be fairly large in number, because reliability greatly depends on the adequacy of the number.

The right selection of items presents the real difficulties. As a general working rule, a reasonable number of commodities should be selected, consistent with economy in time, money and labour, simplicity and accuracy of measurement. (4)

PRICE QUOTATIONS Collection of price quotations for the commodities selected is a somewhat more difficult problem. The price of a commodity varies from market to market and even at one market, from shop to shop. It is not possible, therefore, to obtain price quotations from all the markets where a commodity is bought and sold. A selection of representative markets is to be made. There may be a number of such agencies. viz. business firms, chambers of commerce, news correspondents, trade associations, government agents etc. Select an agency which is most reliable. To check the accuracy of price quotations supplied by an agency, obtain such quotations from more than one reporting agency. Another problem associated with the price quotation is the frequency of price quotation. That is, how often the price quotations should be obtained, on weekly or monthly basis. Usually, in the case of weekly index numbers, one quotation per week for each commodity is considered sufficient. For instance, the Economic Advisers Index Number of Wholesale Prices in India is a weekly index number and is based on price quotations obtained every Friday. But if a monthly base is considered, a more frequent quotation may be desirable.

(5)

PROBLEM OF WEIGHTING The items included in the index numbers are not of equal importance. So the different items included in the index number must be weighted according to their importance. The purpose of weighting is to make the index truly representative of the population it is to measure. The system of weighting may be either arbitrary or rational. Arbitrary or chance weighting means that the statistician is free to assign weights to different items, which he thinks fit or reasonable. Rational or logical weighting means some criteria have to be fixed for assigning weights. However, it is impossible to give a comprehensive definition to the term "rational weights". Weights which are perfectly rational for one investigation may be equally unsuitable for another. In fact, a decision regarding rational weights depends on the purpose of the index number and the nature of the data related to it.

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(6)

SELECTION OF AN AVERAGE Since an index number is a technique of averaging all the changes in a group of values over a period of time, the problem is to select an average which summarises the changes in the component items adequately. Usually, the arithmetic mean is employed for constructing the index numbers. For arithmetic mean is simple to calculate.

(7)

SELECTION OF FORMULA A large number of formulae has been devised for constructing index numbers. They are simple aggregate indices, weighted aggregate indices and Laspeyre's formula, Paasche's formula. etc. for computing weighted averages of price relatives. The device of a particular formula will depend upon the information available and the accuracy desired.

(8)

THE PROBLEM OF DYNAMIC CHANGES In a dynamic economy, there is a continuous change in the nature of consumption and commodities which adds to the difficulties of comparison and the construction of index numbers over a period of time.

(9)

(a)

Many new commodities may come into existence and the old may disappear.

(b)

The quality and quantity of commodities may change from time to time, e.g. the quality of a l09- model motor car is quite different from that of a 1990 model.

(c)

Income, education, fashion and other factors may change the consumption pattern of the people and indices compiled for a period of time may become incomparable.

(d)

In the modern world, due to changes in fashions, tastes, outlook of the people and technological advancement, more and more new goods appear in the market while old goods often disappear, over a period of time. Thus, a comparison of either price level or quantity levels from two separate and distant points of time becomes difficult. Therefore, most index number series are to be revised periodically, every decade or so. A new and more modern samples of comparable items have to be included.

DIFFICULTY IN USAGE An economic statistic an has to be very careful in using the index numbers for economic analysis. The following points must be borne in mind in this regard.

a)

An index number deals with averages - the average tastes and habits, earning and spending of an average number of people. Since it deals with averages, it cannot deal with one individual's money and changes in its purchasing power since an individual may not be affected by a rise or fall in the price level to the extent indicated by the index number.

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b)

An index number constructed for one purpose may not be useful for another. A wholesale price index cannot be compared with a cost of living retail price index. Similarly, the cost of living index number of textile workers cannot be used to measure changes in the value of money of the middle-class group.

c)

Index numbers do not provide a reliable basis for comparison of international prices, so that differences in changes in the value of money between two countries may be measured. As items included in the index number of different countries differ in pattern and quality, comparison is not possible. The base years will also not be the same. Moreover, there are various methods of averaging the use of different types of averages by different countries in the computation of index numbers gives different results, thereby making comparison even more difficult. As a result of all these difficulties, the index number is seriously limited in its utility, i.e. in comparing the purchasing power of money over time and space. In the face of these difficulties and inaccuracies in its construction, the index number can simply be regarded as a mere approximation indicating the rising or falling trends.

6.

LIMITATIONS OF INDEX NUMBERS The following are the limitations of index numbers :

(1)

Approximation – They are only approximate indicators of the relative changes, due to the fact that one cannot conceive of absolute accuracy in their construction. There can be errors not only in the collection of data but also in the selection of the base, selection of representative items and selection of appropriate weights. Any such error means inaccuracy in the construction of index numbers.

(2)

Sample-based – An index number is generally based on samples. Thus, the problem of computing an index number is the problem of describing a universe from the sample. If proper and adequate samples are not selected, then the computed indices may not be truly representative. Therefore, Ilersic said that, "the index numbers are often unrepresentative as they are usually based on imperfect data."

(3)

Disregard qualitative change – The index numbers of prices or production may not take into account variations in quality, which may be significant. Naturally, a superior commodity will cost more at any given time than an inferior commodity, and a rise in the price index may be due to an improvement in quality and not to a rise in prices but very often there is no information on this point.

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(4)

Arbitrariness – Weights are assigned arbitrarily.

(5)

Differences – An index number can be calculated in so many different ways and different methods give different answers. Unless a proper method is used in a given situation, the results may be misleading and inaccurate.

(6)

Limited Scope – An index number is useful for the purpose for which it is designed. Hence its use is limited to a particular phenomenon only. Thus, indices constructed for one purpose should not be used for other purposes where they may not be fully appropriate and given erroneous conclusions. They are not intentionally comparable.

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137

Exercise :

138

1.

What is demand in Economics ? Explain the determinants of market demand.

2.

State and explain the law of demand.

3.

What is price elasticity of demand ? What are its types?

4.

Explain the methods of measurement of price elasticity of demand.

5.

Write short notes on. (a) Total outlay Method of measuring elasticity of demand (b) Demand Forecasting. (c) Determinants of demand (d) Criteria for good demand forecasting (e) Significance or Practical uses of price elasticity of demand. (f) Increase and decrease in demand. (g) Techniques of demand forecasting for new products. (h) Expansion and Increase in demand (i) Exceptional demand curve (j) Cross elasticity of demand (k) Income elasticity of demand (l) Index Numbers.


NOTES

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NOTES

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Chapter 5 PRODUCTION AND COSTS

Preview Meaning of Production function, Law of Variable proportion and Laws of Returns to Scale, Economies Diseconomies of scale, Law of Supply and Elasticity of Supply, Cost Concepts Accounting (actual) Costs, Economic Cost, Opportunity costs, Individual and Social Cost, Explicit and Implicit Cost, Fixed Cost and Variable Cost, Avoidable and Unavoidable Costs, Incremental and Sunk Costs, Common and Traceable Costs, Historical (past) and Replacement (present) Costs, Short Run Cost, Short Run Cost Curves and their use on decision making, Determinants of Cost, Break Even Point (i.e. The Traditional Concept of Equilibrium of a firm). INTRODUCTION Uptill now we have studied demand analysis i.e. individual demand curve, market demand curve, law of demand and elasticity of demand and demand forecasting. In our study of demand side the demand was expressed as Da = f (Pa, Pb, I, P3 ---- n). Now we will shift our attention to the study of supply side of the product pricing i.e. "Theory of Production" and cost. By production or the act of production involves "transformation of inputs into output". By output we mean supply of product which depends upon cost of production which again depends upon input price & relationship between input and output which is called production function. Theory of production means nothing but study of production function. 1.

PRODUCTION FUNCTION :

Production function is the relation between Input and output. The production function is the name given to the relationship between the rates of input of productive services and the rate of output of a product. Thus the production function expresses the relationship between the quantity of output and the quantities of various inputs used for the production. With the technological advances, the flow of output increases form the given input. The two aspects which are stressed under production function are :


141

1)

Maximum quantity of output that can be produced from any chosen quantities of various inputs

2)

Minimum quantities of various input that are required to yield a given quantity of output The production function can be studied in three ways :

1)

Law of Variable proportion : Where quantities of some factors is kept fixed but the other factors is varied.

2)

Laws of Return to Scale : Where quantities of all factors is varied

3)

Optimum combinations of inputs.

The cost of production is also influenced by input prices. Input price depends upon demand for factors of production which ultimately depends upon marginal productivity of the factor. The demand for factors is derived from marginal productivity curve which is actually taken in economics as a part of theory of distribution. That means theory of production is related to factor prices such as wage, rate of interest which is a micro aspect. Macro aspect i.e. aggregate wages, share of profit in national income are related to production function. Production function can be algebraically expressed as : Q = f (N, L, K, T) Where Q = Quantity of output N, L, K, T = quantities of factors (Inputs) f = unspecified form of functional relationship between 'N, L, K, T where through mathematical methods we can work out quantitative measure of this relationship. The inputs or the factors of production can be classified into fixed and variable inputs. The fixed inputs are those which do not change in quantity irrespective of the level of output. As output increases the fixed inputs used per unit of output declines. In the short run a firm uses fixed inputs such as land, building, plant & machinery. The variable inputs are those inputs whose quantity changes along with a change in the output. It means, the variable inputs are required more & more to increase production. The practical observation of the production function indicates 2 normal relationships :

142

1)

When the quantity of a variable input increases while other inputs remain fixed, the output also increases. It means, there is a direct relation between variable input and output.

2)

Input and output do not increase in the same proportion. There may be a phase when output increases faster than increase in a particular variable input. This is a phase of increasing returns to the variable input. When input and output increase in the same proportion, it is a phase of constant returns. Managerial Economics

2.

PRACTICAL IMPORTANCE OF PRODUCTION FUNCTION :

The concept of production function is practically significant and useful for the following reasons : 1)

Production function gives us idea of the optimum level of the output and the optimum employment of the variable inputs. A firm which wants to maximize the efficiency with given prices of inputs should try to find out the optimum proportion between fixed and variable input. This can be discovered with the help of production function.

2)

Production function tells management the budget constraint for increase in output. As generally output cannot be increased without an increase in the input. It follows that the expansion of a firm requires more funds to employ more inputs. The firm can judge how far it is worthwhile and profitable to increase output.

3)

The production function explains the degree of substitution and complementarity of different factors of production. From this the firm can select its expansion path. It means, if the firm wants to increase output in what proportion it should increase its various inputs can be judged from the observed behaviour of production function.

4)

The management should endeavour to produce an upward shift in production function which can definitely improve its financial performance under the given market conditions. Because, such upward shift in production function involves technological progress and indicates the possibility to generate surplus. The use of better methods of production, reorganization of production activity and creating more incentives and motivation to produce more can help a firm to produce such upward shift.

5)

The theory of production function can also explain the possibility of disguised unemployment. When we excessively employ only one factor in the production of a certain commodity, we reach a stage when the marginal product of that factor becomes zero or negative. This stage is called disguised unemployment which is supposedly present in the agricultural sector in countries like India. Such disguised unemployment indicates that it is possible to divert surplus labour to other sectors where their marginal product would be greater than zero. Therefore, it gives policy guidance to both management and government about the priority in the development process.

6)

As production function is an engineering concept, we can study the behaviour of production function under different conditions. It can explain inter - firm, inter regional or international differences in the productivity. It can explain why the reward to the factors and the rate of industrial growth are not same at all the places in all the countries. Thus the concept of production function supplemented with other tools of economic analysis is relevant for rational decision - making in practical business.


143

Linear Homogeneous Production Function This is a particular production function which assumes constant returns to scale. It states that if all inputs are increased in the same proportion, the output also increases in the same proportion. It means, the change in scale of production does not have any effect on efficiency of the firm. The returns to scale are constant. According to Stigler, the production function is "the name given to relationship between rates of input of productive services to the rates of product output and it is economist’s summary of technological knowledge". We have also said that in the simplest form, it is the relationship between "Input and output" and further this relationship can be studied with reference to two laws : A.

Law of variable proportion

B.

Laws of returns to scale

In case of former quantities of some factors are fixed while that of others are varied and in case of later all factors are variable. Before discussing law of variable proportion let us consider the following definitions which will help in understanding the law. 1.

Total Physical Product : Total quantity of output produced in physical units by a firm during a period of time.

2.

Marginal Product :

The change in total product caused as a result of one additional unit of variable factor employed in combination with fixed factors is called marginal product. ∆ T. P. M. P. = –––––––––––––––––– ∆ Variable factor units

3.

Average Product :

It is the total product that a firm produces in a given time period divided by the quantity of a variable factor that is used to produce it. A. P. =

T. P. ––––––––––––––––– Variable factor Units

Alternative way of describing relationship between total product, marginal product and average product is : All these measures " Total product", "Marginal Product" and "Average Product" are related in a simple mathematical way which can be explained with the help of table given under the law of variable proportion. 144


It is necessary to make clear distinction between (a) Short run, (b) Long run and (c) Very long run. These are the three time spans for decision - making for a firm. At any given time a firm is less than perfectly flexible which means when firm enters in Industry, it comes with certain size or capacity and commitment. It has commitment to buy contain minimum material inputs or have leased land for some years or firm has some fixed obligations at any given time and therefore we say it is a less than perfectly flexible. Short Run : It is period of time during which at least one of the firms input can not be varied. It is not possible to tell how long short run will last. For a small house painting firm it may be for 2 days because two days are enough to buy more equipment and hire more workers / painters. But for steel making firm short run lasts for 4 years even as 4 years is the time it takes to change furnace and built separate plant, building, add more furnaces etc. In other words steel plant has a commitment to its present plant for 4 years. Long Run : It is the period of time long enough to make all the changes that a firm wants to make within limits of existing or present production function. This is the second time span in which business decisions are made. Except level of technology, everything else changes in the long run. When new technology is introduced and production function itself changes then it is a case of a very long run. Very Long Run : It is the period of time long enough that the whole new technology can be introduced and production function itself is changed. 3.

The Law Of Diminishing Returns or The Law of Variable Proportion. Or The Laws of Returns :

Introduction : Law of variable proportion occupies an important place in economic theory. This law examines the production function with one factor variable, keeping the quantities of other factors fixed. In other words, it refers to the input output relation when the output is increased by varying the quantity of one input. When the quantity of one factor is varied, keeping the quantity of the other factors constant, the proportion between the variable factor and the fixed factor is altered; the ratio of employment of the variable factor to that of the fixed factor goes on increasing as the quantity of the variable factor is increased. Since under this law, we study the effects on output variations in factor proportions, this is known as the law of variable proportions. The law of variable proportions is the new name for the famous "Law of Diminishing Returns" of classical economics. Statement of the Law : 1)

As equal increments of one input are added; the inputs of other productive services being held, constant, beyond a certain point the resulting increments of product will decrease, i.e., the marginal product will diminish". (G. Stigler)


145

2)

As the proportion of one factor in a combination of factors is increased, after a point, first the marginal and then the average product of that factor will diminish". (F. Benham)

3)

An increase in some inputs relative to other fixed inputs will, in a given state of technology, cause output to increase; but after a point the extra output resulting from the same additions of extra inputs will become less and less". (P. A. Samulson)

It is obvious form the above definitions of the Law of variable proportions (or the law of diminishing returns) that it refers to the behaviour of output as the quantity of one factor is increased, keeping the quantity of other factors fixed and further it states that the marginal product and average product will eventually decline. Assumptions of the Law of Variable Proportion : The law of variable proportion (or diminishing returns) as stated above holds good under the following conditions : 1)

The state of technology is assumed to be given and unchanged. It there is improvement in technology, then marginal and average product may rise instead of diminishing.

2)

There must be some inputs whose quantity is kept fixed. It is only in this way that, we can alter the factor proportions and know its effects on output.

3)

The law is based upon the possibility of varying the proportions in which the various factors can be combined to produce a product. The law does not apply to those cases where the factors must be used in fixed proportions to yield a product.

4)

Homogeneous nature of units of variable factor is assumed.

5)

It is assumed that units of variable factor are divisible in to smaller homogeneous units. This assumption may not always be true.

6)

While discussing the Law of Returns money and monetary value of output is not at all taken into consideration. Only physical relationship between factor inputs and output of products is considered.

Explanation of the Law of Diminishing Returns (Variable proportion) with the help of a table :

146


Fixed Factor (say land & Capital

Variable Factor (Labour units)

Total Product (units)

Average Product (units)

Marginal Product (units)

F

1

5

5

5

F

2

15

7.5

10

F

3

30

10

15

F

4

50

12.5

20

F

5

70

14.0

20

F

6

90

15

20

F

7

105

15

15

F

8

115

14.3

10

F

9

120

13.3

5

F

10

124

12.4

4

F

11

127

11.5

3

F

12

127

10.5

0

F

13

118

9.07

-9

} }

}

Increasing Returns Constant Returns

Diminishing Returns

Negative Returns

Average Marginal Relationship : Observations of the table : The above table shows that eventually the total product also starts declining. But first to decline is the marginal product. The relationship between them is as follows : 1)

As long as average product is rising, marginal product would be larger than the average product.

2)

M. P. is less than A. P., when A. P. is decreasing.

3)

The A. P. remains constant when M. P. and A. P. are equal. Also, when A. P. is maximum M. P. equals A. P.

4)

Total product is maximum when M. P. is zero.

5)

M. P. becomes negative when T. P. falls.

6)

It will be noticed from the table that when 1 to 4 workers are employed, the marginal product goes on increasing. This is the phase of 'Increasing Returns'.

7)

When workers 4, 5 and 6 are employed we notice that in their case, that M. P. is 20, 20, 20. This is the phase when the 'Law of Constant Returns' is in operation.


147

8)

Form 7 to 11 workers, it is noticed that though T. P. is increasing, the M. P. goes on decreasing. This is the phase of 'Diminishing Returns'. This phase may also be called the phase of 'Diminishing Marginal Returns'. Thus, we observe that the 'Law of Diminishing Marginal Returns' (M. P.) is in operation in the third phase.

Thus, the Law of Returns states that, if one factor of production (Land or Capital) is held constant and other factor is varied, for sometime the Law of Increasing Returns, then the Law of Constant Returns and finally the Law of Diminishing Returns come into operation. Diagrammatic illustration of the law of diminishing returns (variable proportion) Three stages of the Law of Variable Proportions or diminishing returns The following figure is a diagrammatic presentation of the Laws of Returns roughly representing the figures in the table given before. Y H

F T.P., A.P., M.P.

T.P. Curve

Stage I

Stage II

Stage III

S

A.P. Curve

X

M Units of Variable factor (labour) employed M.P. Curve

Three stages of the law of diminishing returns (variable proportions) point H is the maximum point of T. P. when M. P. = O. 148


It will be observed from the figure that the T. P. curve goes on increasing to a point and after that it starts declining. A. P. and M. P. curves also rise and then decline. M. P. curve starts declining earlier than the A. P. curve. The behaviour of the output when the varying quantity of one factor is combined with a fixed quantity of other can be divided into three distinct stages, which are explained below : Stage I : Increasing Returns In this stage T. P. to a point increases at an increasing rate. In the figure from the origin to the point F, slope of the total product curve T. P. is increasing i.e. up to the point F, i.e. T.P. increases at an increasing rate, which means that M. P. rises. From the point F onwards during the Stage 1, the T. P. curve goes on rising but its slope is declining which means that from point F onwards the T. P. increases at a diminishing rate i.e. M. P. falls but it is positive. The point F where the total product stops at an increasing rate and starts increasing at a diminishing rate is called the 'point of inflexion'. Corresponding vertically to this point of inflexion, M. P. is maximum, after which it slopes downwards. The stage I ends where the AP curve reaches its highest point S. Stage 1 is known as the stage of 'increasing returns' because A. P. of the variable factor increases throughout this stage. It should be noted that the M. P. in this stage increases but in a later part it starts declining but remains greater than the A. P. so that the A. P. continues to rise. Stage II : Diminishing Returns In stage II, the T. P. continues to increase at a diminishing rate until it reaches its maximum point H where the second stage ends. In this stage both the M. P. and A. P. of the variable factor is zero (when T. P. is highest as shown by point H). Stage II is important because the firm will seek to produce in its range. This stage is known as the 'stage of diminishing returns' as both the A. P. and M. P. continuously fall during this stage. Stage III : Negative Returns In stage III T. P. declines and therefore T. P. curve slopes downwards. As a result M. P. of the variable factor in negative and the M. P. curve goes below the X axis. This stage is called the stage of negative returns, since the M. P. of the variable factor is negative during this stage. Explanation of the Various Stages 1)

Increasing returns : In the beginning, the quantity of fixed factor is abundant relative to the quantity of the variable factor. As more and more units of variable factors are added to constant quantity of fixed factor then fixed factor gets more intensively & effectively utilized and production increases at a rapid rate. Let us consider the example through the table mentioned in the three stages of law of variable proportion. Through out the three stages fixed variable i.e. machinery (capital)


149

remains constant. The variable factor i.e. no. of workers increase as a firm expands its production. A worker contributes 5 units per day to the firms output. The total product reaches 50 units per day when the 4th worker contributes to the production. Fuller utilization of capital is possible due to the addition of a variable factor. One worker cannot take full advantage of the capabilities of capital. When the fourth worker joins it is possible to use the full potential of the capital. Moreover increasing returns can also be attributed to the principle of division of labour of specialization of work. The question may arise that if fixed factor is abundant as compared to variable factor, why fixed factor be not taken in accordance to the availability of variable factor. The answer is that fixed factors are fixed i.e. they are indivisible. The number of machinery cannot be changed in the short run. 2)

Diminishing returns : The peculiar feature of this stage is that the marginal product falls through out the stage and finally touches to zero. Corresponding vertically is the point H which is the highest point of the TP curve. Here stage II ends. In the table given on page 147, the third stage is set in by hiring 7th worker who adds only 15 units per day as compared to 20 units per day added by the 6th worker. Total product increases but gain form 7th worker is not as great as gain from 6th worker. Explanation to this can be given as once the point is reached at which variable factor is sufficient to ensure full utillisation of fixed factor, then further increase in variable factor will cause MP as well as AP to fall because fixed factor has now become inadequate (as against it was abundant earlier) relative to the quantity of variable factors. In stage two fixed factor is scarce as compared to variable factor. According to Mrs. Joan Robinson, a famous economist, the factors of production are imperfect substitutes for on another, the stage of diminishing returns occur. Fixed factor is scarce and variable factor then fixed factor would not have remained scarce. The paucity of fixed could have been made up by such perfect substitutes. If one of the variable factor added to the fixed factor were perfect substitute deficiency of fixed could have been made up but elasticity of substitute between factors is not infinite, substitution is not possible and diminishing returns occur.

3)

Negative returns : In this stage, marginal product falls below 'X' axis i.e. negative because total product starts falling. In our example this is set in by hiring 13th worker. The total product falls from 127 units to 118 units. The large number of variable factors impairs the efficiency of the fixed factor. The excessive variable factor as compared to less fixed factor results in a fall of total output. In such a situation, a reduction in the units of the variable factor will increase the total output.

Limitation of the Law of Diminishing Returns : There are a number of exceptions to this law. This law does not apply to all conditions in agriculture.

150


(i)

New methods of cultivation : As mentioned earlier, this law assumes no change in the technique of production. Scientific rotation of crops, better quality seeds, modern implements, fertilizers, better irrigation facilities, however are the changes which take place in agriculture. The marginal product under these conditions, will in fact increase. New methods of cultivation, therefore, are an exception to the law.

(ii)

New Soil : When new land (soil) is brought under cultivation, the marginal product will increase for a time; thus the law of diminishing returns does not operate in the beginning.

(iii) Insufficient Capital : If capital is not sufficient, increased used of capital, will give more than proportionate return, but later the marginal return will decrease. The early stage is an exception to the law of variable proportion. Application of the Law of Diminishing Returns : The law of diminishing returns applies to agriculture, because land if fixed. From society's point of view as Recardo assumed and other factors are variable. However, the law has universal application and operates in all fields of productive activity where one or more fixed factors are combined with one or more variable factors. Thus, if an industrial enterprise capital is kept fixed and other factors are increased, the marginal product will initially increase but will ultimately diminish. Thus, the law also operates in industries like mining, fisheries and also in building industries. 4.

Returns to Scale or Laws of Returns to Scale :

Under the law of diminishing returns (i.e. variable proportion) we have studied the behaviour of output (T. P., M.P. and A. P.) when factor proportions are changed. That is, we have seen the behaviour of output by keeping the quantity of one or some factors fixed and changing the quantity of other (e.g. Labour) Now, we will undertake the study of changes in output when all factors of production or inputs are increased together. In other words, we shall now study the behaviour of output in response to changes in scale. An increase in the scale means that all inputs or factors are increased in the same proportion. Increase in the scale thus occurs when all factors or inputs are increased keeping factor proportions unchanged. The study of changes in output as a result of changes in the scale forms the subject matter of "returns to scale".


151

The Laws of Returns to Scale :

Sc ale

Constant Returns To Scale

To

Inc re as ing

ns tur Re

Re tu rn s

To

ing as cre De

Marginal Product

Y

ale Sc

X O

1)

Scale or Proportion

Law of Increasing Returns to Scale : Meaning : If the increase in all factors leads to more than proportionate increase in output, returns to scale are said to be increasing. Thus, if all factors are doubled, and output increases by more than double, then the returns to scale are increasing. If for instance, all inputs are increased by 25%, and output increases by 40% then the increasing returns to scale will be prevailing. This is because of greater specialization of labour and machinery. This phenomenon according to Prof. Baumol also occurs because of dimensional relations. For example, if the diameter of a pipe is doubled, the flow of water through it is more than doubled. Another reason for increasing returns is because of the indivisibility of some factors. These factors are available in large and lumpy units and can therefore be used with utmost efficiency at only larger output. This reason is given by Prof. Mrs. Joan Robinson, Kaldor and Lerner.

2)

Law of Constant Returns to Scale : Meaning : If we increase all factors of production (i.e. scale) in a given proportion and the output increases in the same proportion, returns to scale are said to be constant. Thus, if doubling or trebling of all factors causes a doubling or trebling of output, returns to scale are constant. In mathematics, the case of constant returns to scale is called ' linear and homogeneous production function' or 'homogeneous, production function of the first degree'.

3)

Law of Diminishing or Decreasing Returns to Scale : Meaning : If the increase in all factors leads to a less than proportionate increase in output, returns to scale are decreasing. When a firm goes on expanding all its inputs, then eventually diminishing returns to scale will occur. Diminishing returns to

152


scale eventually occur because of increasing difficulties of management, coordination and control. When the firm has expanded to a too gigantic size, it is difficult to manage it with the same efficiency as previous. This in other words, means that the firm starts suffering from the diseconomies of scale. 5.

ECONOMIES AND DISECONOMIES OF SCALE :

Introduction : An attempt is made in this sub -unit to outline the economies of large - scale production with reference to the Laws of Returns.

a)

Diseconomies of Small - Scale Production: Any firm which is newly established operates on a small scale in the initial stages. Production on a small scale is, however, found to be disadvantageous on the following grounds.

b)

(a)

A new firm is required to acquire land, construct factory building, install machinery and provide other infrastructural facilities. A lot of time is wasted in erecting the factory. Meanwhile, the firm has to spend on preliminary expenses. All these expenses are debited to the profit and loss account for the first operating year. If the total expenditure incurred during the first year is taken into account, the average cost of production works out to be very high in the initial stages.

(b)

The workers appointed in the factory take some time to adjust themselves to the techniques of production. Till this adjustment is made, there is lot of wastage of raw materials and power. Naturally, the average cost of production is high.

(c)

In the initial stages, production is on a small scale because the product is not yet known in the market. The firm is not sure whether the entire production would be sold. Every new firm, therefore, decides to produce on a small scale till it gets a 'real feel of the market'. In the initial stages small - scale production may, therefore, lead to a high average cost and losses.

Economies of Scale: But with the passage of time, the firm is fairly established in the market. Its products are constantly in demand. The workers also acquire proficiency in producing high quality goods. As a result, the firm decides to increase the scale of production. Ultimately, a number of economies of scale accrue to the firm. These economies are classified as internal and external economies. It is worthwhile to explain the economies at length : Internal economies are those advantages of large - scale production which accrue to a firm on account of its superior techniques and management. They are broadly classified under the following heads:


153

(a)

Technical Economies : A firm that produces goods on a large scale can install improved and up - to - date machinery. On account of new machines, a firm is able to effect a substantial reduction in the cost of production. It is also possible in a big firm to avail the benefits of specialization and division of labour. Quality of goods produced by such a firm is, therefore, superior.

(b)

Commercial Economies : A firm that produces on a large - scale is required to buy raw materials on a large scale. Bulk buying enables a firm to procure the materials at a lower cost. A firm making purchases on a large scale acquires a strong bargaining power in the market. It can secure favorable credit terms from the suppliers. A big firm can negotiate with transport operators and can secure concessional freight rates for transportation of raw materials and finished products. A big firm enjoys high reputation and its products are in constant demand in the market.

(c)

Managerial Economies : A firm producing on a large scale can afford to hire the services of expects in various fields such as purchases, production, marketing and finance. These experts utilize their knowledge and experience towards maximization of profits.

(d)

Financial Economies : A firm which is producing on a large scale can avail the benefits of cheaper finance. A firm which has acquired reputation and a high credit - rating can raise new capital quickly, easily and on much favourable terms.

(e)

Risk and Uncertainty : A firm which produces on a large scale can earn large profits. It can build up huge reserves out of undistributed profits. Capacity of such a firm to sustain losses is, therefore, big. On the other hand, a smaller firm with slender reserves cannot withstand the losses incurred in the business.

c)

External Economies : The above advantages of large - scale production may accrue to an individual firm because they arise out of the superior technique and management of the firm. If in a particular region, many such firms are concentrated they may promote some common activities. These activities may bring several benefits for all the firms, in an industry. For example, in such a region facilities of transport, banking, post - office etc. may be developed and all the firms can take the benefits of these services. What is more important is that, a number of new firms dealing in ancillary products are developed in this region. These firms may manufacture spare parts on a large scale. The big firms can buy the spare

154


parts at a lower cost. If the big firms produce the spare parts themselves, the cost would be higher. It would, therefore, be profitable for big firms if they buy the parts from small firms. Similarly, various firms concentrated in a particular region can start a Research Institute. The benefits of this research can be passed on to all the firms. All such economies are called external economies.

d)

Diseconomies of Large - Scale Production : Large - scale production may encounter certain diseconomies and disadvantages. In course of a firm's expansion, a stage may be reached when the firm becomes too large to manage. It may face several problems just because its size has become very large. Let us note these disadvantages of large - scale production.

Internal and External Diseconomies : As a firm expands beyond a certain limit, it becomes unmanageable and unwieldy. The top executive may find it impossible to look into even the broad functioning of various departments. Delegation of responsibilities and decentralization of very large number of work can not be stretched too far. Co-ordination of various activities becomes impossible. A very large number of workers may cause factions and groupism amongst them. This may disturb the healthy atmosphere and may cause indiscipline, quarrels, and rivalries. A large establishment with thousands of employees makes work impersonal and the relations between the employers and employees becomes formal. This fact causes strains on industrial relations. With increase in the number of salaried administrative, managerial and sales staff, personal touch with dealers and customers is lost. Because these salaried employees have to stake in the company, efficiency, urge, punctuality, integrity and inventiveness disappear and their place is taken by disinterestedness, routine dealings and work to rule. The internal diseconomies of large - scale production can be summarized thus : (i)

Management and supervision becomes difficult and waste of time and material results.

(ii)

For want of a personal touch, strikes, lockouts and such other eventualities causing stoppage of work or obstructions to work increase.

(iii) No direct contact with customers is possible. So, tastes of consumers are ignored. Products are standardized and no specialized services to consumers are possible. (iv)

Large - scale production may cause overproduction and this may result in losses.

(v)

Large producers have to fight for capturing and maintaining markets. This may result in cut-throat competition.

(vi)

Large firms cannot easily adapt to ups and downs in business.

(vii) Large - scale production may involve imports of raw materials and exports of products.


155

(viii) There are additional elements of risk due to possibilities of war, changed international relations and so on. Expansion of industry and overcrowding of industrial units in a locality also causes diseconomies which can be called external diseconomies. The competition among firms to secure raw materials and other resources for itself causes their prices to rise. Moreover, with increase in demand for resources, additional resources which become available are naturally of a lower quality compared to those already employed. For example, the best workers are selected first and as more and more workers are required, a firm has to appoint whosever are available rather than who are suited for the work. Thus, not only wage - rates increase, but productivity per worker goes down. The same applies to machinery spare parts, raw materials, distribution channels and so on. Similar external diseconomies flow from concentration of industries in certain localities. Overcrowding of cities, traffic congestion, pollution of air and water, strain on civic amenities like drinking water, public health, sanitation etc. and problems of housing, education, medical care and law and order are some of the consequences. They affect efficiency of labour, availability of quick transport, timely deliveries of finished products and an overall strain on the whole industrial system. 6.

SUPPLY ANALYSIS :

a)

Meaning of Supply : In economics, supply during a given period of time means the quantities of goods which are offered for sale at particular prices. Thus, the supply of a commodity may be defined as the amount of the commodity which the sellers (or producers) are able and willing to offer for sale at a particular price, during a certain period of time. Supply is a relative term. It is always referred to in relation to price and time. A statement of supply without reference to price and time conveys no economic sense. For instance, a statement such as : "the supply of milk is 500 liters" is meaningless in economic analysis. One must say, "the supply at such and such a price and during a specific period." Hence, the above statement becomes meaningful if it is said "at the price of Rs.20. per liter, a dairy - farm's daily supply of milk is 500 liters." Here, both price and time are referred to with the quantity of milk supplied. Secondly, supply is what the seller is able and willing to offer for sale. The ability of a seller to supply a commodity, however, depends on the stock available with him. Thus, stocks is the determinate of supply. Similarly, another determining factor is the will of the seller. A seller's willingness to supply a commodity, however, depend on the difference between the reservation price, the minimum or cost price the seller must get and the prevailing market price or the price

156


which is offered by the buyer for that commodity. If the ruling market price is greater than the seller's reservation price, he (the seller) is willing to sell more. But at a price below the reservation price, the seller refuses to sell. In short, supply always means supply at a given price. At different prices, the supply may be different. Normally, the higher the price, the greater the supply and vice versa. b)

Determinants of Supply : There are a number of factors influencing the supply of a commodity. They are known as the determinants of supply. The important determinants of supply are : 1)

Price : Price is the single largest factor influencing the supply of a commodity. More commodity is supplied at a higher price and less commodity is supplied at a lower price. The change in the quantity supplied in response to the change in price is known as the variation in supply. Even expectations about the future price affect the supply. If a dealer expects the price to rise in the future, he will withhold his stock at present and so there will be less supply now. There are several factors other than the price, influencing the supply. The changes in these factors lead to changes in the supply of the commodity. The change in the supply may be in the form of the increase or decrease in supply. These other factors are given below.

2)

Natural Conditions : The supply of some commodities, such as agricultural products, depends on the natural environment or climatic conditions like rainfall, temperature, etc. A change in these natural conditions will cause a change in the supply. For instance, a good monsoon will produce a good harvest; so the supply of the agricultural products will increase. On the other hand, their supply decreases during the drought conditions.

3)

State of Technology : The improvement in the technique of production leads to increased productivity and results in an increase in the supply of manufactured goods.

4)

Transport Conditions : The difficulties in transport may cause a temporary decrease in the supply, as goods cannot be brought in time to the market. So, even at the rising prices, the quantity supplied cannot be increased.

5)

Factor Prices and their Availability : When the factors of production are easily available at low prices, more investment is encouraged due to better returns. Under such circumstances the supply of the commodity which these factors help to produce may tend to increase and vice versa.

6)

Government's Policy : The government's economic policies like industrial policy, fiscal policy, etc., influence the supply. If the industrial licensing policy of the government is liberal, more firms are encouraged to enter into registrations and


157

high custom duties may decrease the supply of the imported goods but it would encourage the domestic industrial activity, so that the supply of domestic products may increase. An increase in tax such as excise duties will reduce the supply while granting of subsidy will increase the supply.

7.

7)

Cost of Production : If there is a rise in the cost of production of a commodity, its supply will tend to decrease. So, with the rise in the cost of production, the supply curve tends to shift leftward. Conversely, a fall in the cost of production tends to increase the supply.

8)

Prices of other Products : The prices of substitutes or related products also influence the supply of a commodity. If the price of wheat rises, the farmers may grow more of wheat and less of rice. So the supply of rice will decrease. Again, if the prices of fountain pens rise, the prices of ink will also tend to rise. If the price of sugar rises, the price of jaggery (gur) will also tend to rise.

THE LAW OF SUPPLY :

The law of supply reflects the general tendency of the sellers in offering their stock of a commodity for sale in relation to the varying prices. It describes seller's supply behaviour under given conditions. It has been observed that usually sellers are willing to supply more with a rise in prices.

Statement of the Law : The law of supply may be stated as follows : Other things remaining unchanged, the supply of a commodity expands with a rise in its price and contracts with a fall in its price. The law, thus, suggests that the supply varies directly with the change in price. So, a larger amount is supplied at a higher price than at a lower price in the market.

Explanation of the Law ; The law can be explained and illustrated with the help of a supply schedule as well as a supply curve, based on imaginary data, as follows :

158

Price of Ballpen (per unit) Rs.

Quantity Supplied (in '000 per week)

10 12 14 16

10 13 20 25


Supply Curve

Price Per Unit

Y

S 16 14 12 S

10

O

5

10

15

20

25

X

Quantity Supplied (Units) X axis = Units of Ball Pen Y axis = Price per Unit When the data of Table are plotted on a graph, a supply curve can be drawn as shown as shown in Figure. From the supply schedule, it appears that the market supply tends to expand with the rise in price and vice versa. Similarly, the upward sloping curve also depicts a direct relation between price and quantity supplied.

Assumptions Underlying the Law of Supply : The law of supply is conditional, since we have stated it under the assumption : "other things remaining unchanged". It is based on the following ceterius paribus assumptions : 1)

Cost of production is unchanged : It is assumed that the price of the product changes, but there is no change in the cost of production. If the cost of production increases along with the rise in the price of product, the sellers will not find it worthwhile to produce more and supply more. Therefore, the law of supply is valid only if the cost of production remains constant. It implies that the factor prices, such as wages, interest, rent etc., are also unchanged.

2)

No change in technique of production : The technique of production is assumed to be unchanged. This is essential for the cost to remain unchanged. With the improvements in technique, if the cost of production is reduced, the seller would supply more even at falling prices.

3)

Fixed scale of production : During a given period of time, it is assumed that the scale of production is held constant. If there is a changing scale of production, the level of supply will change, irrespective of the changes in the price of the product.


159

4)

Government policies are unchanged : Government policies like taxation policy, trade policy, etc., are assumed to be constant. For instance, an increase in or totally fresh levy of excise duties would imply an increase in the cost or in case there is fixation of quotas for the raw materials or imported components of a product, then such a situation will not permit the expansion of supply with a rise in prices.

5)

No change in transport costs : It is assumed that transport facilities and transport costs are unchanged. Otherwise, a reduction in transport cost implies lowering of cost of production, so that more would be supplied even at a lower price.

6)

No speculation : The law also assumes that the sellers do not speculate about the future changes in the price of the product. If, however, sellers expect prices to rise further in future, they may not expand supply with the present price rise.

7)

The prices of other goods are held constant : The law assumes that there are no changes in the prices of other products. If the price of some other product rises faster than that of the product in consideration, producers might transfer their resources to the other product which is more profit - yielding due to rising prices. Under this situation, more of the product in consideration may not be supplied, despite the rising prices.

Exceptions to the Law of Supply (Backward - sloping Supply Curve) : The law of supply states that supply, tends to rise with a rise in price is a universal phenomenon. There are, however, a few exceptions to this law. Supply of labour and savings are two such exceptions commonly pointed out by the economists. It may be observed, in these cases, that the supply tends to fall with a rise in prices at a point. This paradoxical situation of supply behaviour is represented by a backward sloping or regressive supply curve over a part of its length as shown in the following Figure. It is also known as an exceptional supply curve, as such a thing happens only in some exceptional cases like labour supply or savings. Y

S1

Wage Rate

200 M

180 160 150

S O

50 55 60 65

Quantity Supplied of Labour in hours

X Leisure

Backward Sloping Supply Curve of Labour 160


In figure the curve SMS1 represents a backward - sloping supply curve for labour as a commodity. Here, the wage - rate is regarded as the price of labour and the labour supply is determined in terms of labour - hours the worker is willing to work at a given wage rate. It is observed that as wages increase, a worker might work for a lesser number of hours than before. To illustrate the point, say, when the wage rate is Rs. 150 per hour, the worker works for 50 hours per week and gets Rs. 7,500; when it is Rs. 160 per hour, he works for 60 hours per week, and gets Rs.8,800; at Rs. 180, he works for 65 hours and gets Rs. 11,700 and at Rs. 200, he works for 60 hours and gets Rs. 12,000. As exception to the law is also seen in the case of persons who want to have a fixed income from their investment. As interest rates rises, the amount on investment required to reach the same amount of interest yields is obviously less. For instance, a person wants to earn Rs.100 per year require an investment of Rs. 1,000 and at 20 per cent, he will require an investment of Rs.500. Thus, as the rate of interest rises, the volume of investment required declines. In this case, he will decrease his savings and investment when the rate of interest rises and increase his savings and investment when the rate of interest falls, which is contrary to the usual law of supply. 8.

EXPANSION AND CONTRACTION IN SUPPLY :

The law of supply refers to the change in supply due to a change in price. If, with a rise in price, the quantity supplied rises, it is called expansion of supply. If with a fall in price, the quantity supplied declines, it is called contraction of supply. The change in the quantity in accordance with the price change is, thus, called either as "expansion" (or extension) or "contraction" of supply and refers to the same supply curve. In figure, the movement from point a to b on the supply curve shows expansion and b to a shows contraction of supply. Production and Costs

161

9.

INCREASE AND DECREASE IN SUPPLY :

These two terms are introduced to explain the change in supply without any change in price. Sometimes, there might be more supply forthcoming in the market without a change in Y

S2

S

Price (Per Unit)

Price (Per Unit)

Y

S1 a P

b

S

S P

Q

M

Quantity Supplied (Increase In Supply)

Fig. A

X

a

K

Q

S2 S

S1 O

b

O

X

Quantity Supplied (Decrease In Supply)

Fig. B

price, in which case it is called increase in supply. There might be less supply forthcoming in the market without a change in price, then it is called decrease in supply. The change in supply due to causes or determinants other than price is called "decrease" or "increase" in supply, and can be shown on different supply curves. In figure A, at price OP, the supply is QQ. Later on, at the same price, when the supply increases from OQ to OM, it is called increase in supply. It cannot be shown on the initial supply curve, but the supply curve shifts to the right as S1S1 curve. Likewise, in figure B, when at price OP, the supply becomes OK instead of OQ, it means a decrease in supply. This can be shown by leftward shifts which need not be parallel.

The Causes of Change in Supply : There are many causes which bring about a change (increase or decrease) in the conditions of supply. The important ones among them are :

162

1)

Cost of Production : Given the price, the supply changes with the change in the cost of production. If the cost of production increases because of higher wages to workers or higher price of raw materials, there will be a decrease in supply. If the cost of production falls due to any of the above reasons, the supply will increase.

2)

Supply also Depends on Natural Factors : There might be a decrease in the supply due to floods, paucity of rainfall, pests, earthquakes, etc. Absence of the above calamities or an exceptionally good as well as a timely monsoon might increase supply.


3)

Change in Technique of Production : This has an important influence on supply. An improvement in the technique of production might go a long way in increasing the supply. For instance, introduction of highly sophisticated machines increases the supply of goods.

4)

Policy of Government also Influences Supply : Taxes on production, sales, import duties and import restrictions may reduce supply. It may also be deliberately reduced by government policies.

5)

Development of Transport : Improvement in means of transport obviously increases the supply of goods as they facilitate the movement of goods from one place to another.

6)

Business Combines : The producers also might reduce the supply by entering into an agreement among themselves through their business combines like trust, cartel or business syndicate, with a view to raising prices in the market.

10. ELASTICITY OF SUPPLY : Supply changes due to change in price. The extent of change in supply in accordance with the change in price is called elasticity of supply. When, with a little change in price (rise or fall), there is a considerable change in quantity supplied (expansion or contraction) the supply is said to be elastic. When, with a considerable change in price, there is little change in quantity supplied, the supply is said to be less elastic. More precisely, with a small fall in price, when there is a big contraction of supply or with a small rise in price, when there is a big expansion of supply, the supply is said to be elastic. If, with a big fall in price, there is very little contraction of supply or with a big rise in price, there is a very small expansion of supply, the supply is said to inelastic. a)

Elasticity of supply may be defined as the ratio of the percentage change or the proportionate change in quantity supplied to the percentage or proportionate change in price : Thus, es =

Percentage change in Quantity Supplied ------------------------------------------------------------------------------------Percentage change in price

Elasticity of supply can also be measured alternatively as

es =

Net change in Quantity Supplied ---------------------------------------------------------------- ÷ Original Quantity Supplied


Net change in Price --------------------------------------------------Original Price

163

Representing it in symbols, thus elasticity of supply formula can be stated as : ê QS êP es = -------------- ÷ ---------------QS P

=

êQS P -------------- x ---------------QS êP

êQS P Therefore, es = -------------- x -------------êP QS QS = The Original Quantity Supplied êQ = Net change in Quantity Supplied P = The original Price êP = Net change in Price. For example, if, as a result of a change in the price of a commodity from Rs. 40 to Rs. 45 per unit, the total Quantity supplied of the commodity by the sellers is increased from 1,000 units to 1,200 units, then the elasticity of supply may be calculated as under : 200 es = -------------- x 5

164

40 -------------- = 1.6 1000


There are, thus, various degrees of elasticity of supply. It may be relatively elastic, relatively inelastic or may have perfect elasticity or inelasticity. Different types of supply elasticity's have been illustrated in the following Figure.

(Per Unit)

(Per Unit)

Elasticity of Supply - Extreme Cases The panel (a) of Figure represents the supply curve of zero elasticity. Irrespective of the price, the producer would be supplying OQ quantity (es = 0). The (b) represents the supply curve of infinite elasticity. At OP price, the producer would be supplying any amount of the commodity. (es = α).

(Per Unit) (Per Unit)

Elasticity of Supply - Usual Cases In the above figure in panel (a) the curve SS represents the supply curve of unit elasticity. Any variation in price will be accompanied by an equally proportionate variation in the amount supplied (es = 1). Similarly, in panel (b), the curve S1, represents a relatively inelastic supply, (es < 1), and S2 represents elastic supply, (es > 1). Production and Costs

165

b)

Measurement of Elasticity of Supply : There are two methods of measuring elasticity of supply : (1) the ratio method, and (2) the point method. ∆Q –––––– Q

es =

x

P –––––– ∆P

The coefficient of elasticity of supply(ies) may vary between zero to infinity.

The Point Method :

F

Price (Per Unit)

Price (Per Unit)

On a given supply curve, the elasticity of supply at point P is measured by the ratio of the distance along the tangent (drawn to the curve at the point) from the point P on the supply curve to the point where it intersects the horizontal axis and the distance along the tangent from the point P on the supply curve to the point where it intersects the vertical axis.

F

Measurement of Point Elasticity of Supply To find out the elasticity on the supply curve at point P as in the above Fig., draw a tangent TF to the supply curve SS at point P intersecting the horizontal axis at T. Draw a perpendicular PB form point P and intersecting at point B on the horizontal axis. The elasticity of supply at point P is measured as : TB Es = –––––– OB In panel (1) TB < OB, therefore, as es < 1 at point P. In panel (2) TB > OB, therefore, es > 1 point P. 166


c)

Factors Determining Elasticity of Supply :

The elasticity of supply of commodities depends on a number of factors, such as : 1)

Nature of commodity : In the case of some commodities like antiques, old wines, old stamps, old and original handwritten manuscripts, etc. their supply remains fixed or constant as they cannot be reproduced in their original form or shape. In the case of such commodities price changes will have no influence on their supply. In the case of houses, high artistic works, paintings and statutes, etc. it may take quite some time for their supply to expand in response to rise in their prices. In respect of commodities like cloth and other factory-made goods of daily consumption, response of supply in response to change in their prices would be fairly quick.

2)

Level of Technology : Higher level of technology in a country generally helps to bring about a relatively quicker response from the supply side to change in their prices. Thus, if a community depends for its cloth only on handloom technology, changes in price of cloth would take relatively longer time for supply to respond, than if that community possesses technology consisting of modern automatic spinning and weaving machines.

3)

Time Element : Time element is very important factor in determining elasticity of supply. Generally, shorter the time-span, less responsive will be the supply side; and longer the time-span, generally more responsive would be the supply side of the commodity to changes in price. Thus, if price of a commodity rises, that may cause no response from supply side in one or two hours or even one or two days(except in the case of commodities like shares and internationally traded goods like gold, silver and other valuable metals in case of which future trading takes place on telephone, telex etc.). Rise in price of houses may bring only gradual response from the supply side of houses, as it takes some time to build new houses.

4)

Scale of Production : Goods produced on a small scale have a relatively inelastic supply, while gods produced on a large scale have a relatively elastic supply.

5)

Size of the Firm and the Number of products produced : When the big firms produce a variety of products at a time, they can easily transfer the resources from one product to the other so that the supply may become more elastic.

6)

Natural Factors : Natural factors like climate, monsoon, fertility of the soil, etc., considerably affect the elasticity of supply of agricultural goods. The supply of agricultural goods is relatively inelastic, because these natural factors are beyond the control of


167

man. The seasonal nature of cultivation is the main contributory factor, making the supply of agricultural commodities less elastic. 7)

Mobility of Factors : In those industries where there is a high degree of mobility of factors of production, supply will be more elastic. Immobility of factors causes inelasticity of supply.

11. COST CONCEPTS :

Meaning and Importance : The cost of production of an individual firm has an important influence on the market supply of a commodity. The product prices are determined by the interaction of the forces of demand and supply. We have seen that the basic factor underlying the ability and willingness of firms to supply a product in the market is the cost of production. A firm aims at maximizing its profits; profits depend on the costs of production and the prices of products. Thus, given the market price of the firm's; product, the amount a firm is willing to supply in the market will depend on the cost of production. It is therefore, necessary to have a clear idea about the concept of the cost of production. Costs may be nominal costs or real costs. Nominal cost is the money cost of production. It is also called expenses of production. The real cost is the opportunity cost of production (see below). Money costs and real costs do not coincide with each other. Types of Costs : 1)

Accounting Costs : Accounting costs are the costs of production of the firm. These are money costs or expenses of production. These costs are paid for by the producer and are also known as entrepreneur's costs. These are the explicit costs, and they enter the accounts books of the firms. These costs include : (i) wages to labour, (ii) interest on borrowed capital, (iii) rent or royalty paid to owners of land which is borrowed by the firm, (iv) cost of raw materials, (v) replacement and repairing charges of machinery, (vi) depreciation of capital goods, and (vii) normal profits of the manufacturer (amount sufficient to induce him to continue production). Accordingly costs may be classified as : (a) Production costs, including material costs, wage cost and interest cost (b) Selling costs, including costs of advertising and (c) Other costs, including insurance charges, taxes etc. These accounting costs are important from the point of view of the producer. He must make sure that the price of the product, must cover these costs and normal profits, or else, he cannot afford to continue production.

168


How do we measure the cost of inputs? Economists might want to discuss the production behaviour of firm for a number of reasons : (a)

To predict how the firm's behaviour will respond to a given change in the conditions it faces.

(b)

To help the firm make the best decisions it can in achieving its objectives.

(c)

To find out how well the firms use scarce resources.

The same measure of cost may not be correct for each of these purposes. Economists know exactly how to define costs in order to solve problems like (b) and (c). Only if we assume that, the businessman (accountant) uses the same concept of costs, the economist's definition will be useful for problems like (a). The economic costs are based on a common principle that is sometimes called user cost, but is commonly known as opportunity cost.

2)

Economic costs : The economist's idea of cost is based on the fact that resources are scarce and have alternative uses. Thus if resources are used for the production of some commodities, then it means that the production of some alternative commodities are foregone. Thus, by economic costs is meant those payment which must be received by resource - owners in order to ensure that they will continue to supply the resources for production. Explicit costs, implicit costs and normal profits together form the full costs of a firm (economic costs).

3)

Opportunity Costs (Alternative or Transfer costs) Since productive resources are limited, the production of one commodity can only be at the cost of another. The commodity that is sacrificed is the opportunity cost of the commodity produced. Thus, economists define the cost of production of a particular product as the value of the foregone alternative products, that resource used in its production could have produced. The opportunity cost of a product, is therefore, the opportunity lost of not being able to produce some other product. Resources can be used for a number of purposes. The opportunity cost of these resources to a firm is the value in their next best alternative use.


169

Example Thus, if Rs. 20 lakhs are invested in project A at a 10 per cent rate of return, and if this amount was not invested in project A, it would have been invested in project B (next best alternative use of Rs. 20 lakh) at 9 per cent rate of return. Then the opportunity cost of Rs. 20 lakh in project A is 9 per cent, which is the value of this amount in its next best alternative use. Similarly, if a consumer uses Rs. 20,000 to buy a washing machine, he cannot use this money to buy a microwave oven. By buying a washing machine, he has forgone the opportunity of buying a microwave oven. Thus, the opportunity cost of buying a washing machine is the opportunity cost of not being able to buy a microwave oven. Therefore we can say that the opportunity cost of producing X having considered Px in terms of Y given Py is = Px Py (a)

Significance of Opportunity Costs : The concept of opportunity costs is an important tool to measure the implicit costs of a firm. The implicit costs distinguish the accounting costs from the economic costs. Thus, the economic profits to a firm can be calculated with the help of implicit costs of a firm, and these costs are imputed on the basis of the opportunity cost principle. This concept is, therefore, used for, (a) measuring profits, (b) policy decision of the firms, (c) forming capital budget and (d) alternatives available to the firm. The opportunity cost principle has a wide application in economic theory. It is useful in the determination of values internally and internationally. It is also used to understand income distribution.

(b)

Limitations : There are, however, some limitations in its application.

(i)

Specific : It does not apply to productive services which are specific. A specific factor has no alternative use. Its opportunity (transfer) cost is, therefore, zero.

(ii)

Factors are not homogeneous : Units of productive services are not homogeneous, this obstructs their transfer.

(iii) Wrong - Assumption : The theory is based on the assumption of perfect competition which rarely exists. (iv)

170

Individual and Social Costs : A product may cost the firm Rs. 5,000 per unit, but to the society it will cost something in the form of bad - health due to the smoke


and soot that this firm let out. This creates problems for measuring opportunity costs. Conclusion : Inspite of these limitations, the theory of opportunity costs, is the most widely used theory of cost at present.

4)

Explicit and Implicit Costs : Costs of production have also been classified as explicit and implicit costs. From the point of view of the firm, we can say that economic costs are those payments a firm must make, or incomes it must earn, to owners of factors of production to attract these resources away form other uses. These payments or incomes may be either explicit or implicit.

(a)

Explicit Costs : The money payment, which a firm makes to those 'outsiders' who supply labour services, raw materials, transport services, electricity etc. are called explicit costs. Thus, explicit costs are out - of - pocket costs, i.e. payments made for resources purchased or hired by the firm. These are expenditure costs, like, the salaries and wages paid to the employees, prices of raw materials, fixed or overhead costs, and payments into depreciation and sinking fund accounts. These are firm's accounting expenses.

(b)

Implicit Costs : But in addition, the firm often uses resources which the firm itself owns. The costs of 'self owned' resources which are employed by the firm are nonexpenditure or implicit costs, like, the salary of the proprietor, or the interest on the entrepreneur's own investment, rent on own land used by the firm.

To the firm the implicit cost are the money - payments which the self - owned and employed resources could have earned in their next best alternative use. Thus, since implicit costs are nonexpenditure costs and actual payment is not made, these costs have to be calculated or imputed. Implicit costs are calculated on the basis of the opportunity cost principle. Implicit costs are ignored while calculating the expenses of production. These costs do not enter the account books of a firm.

(c)

Normal Profits as a cost : Explicit costs, implicit cost and normal profits together form the full costs o a firm (economic costs). The entrepreneur must be sure of normal profits if he is to continue in business. Thus, normal profits are also costs.


171

(d)

Economic (or Pure), Profits : From the above discussion of accounting and economic costs, it becomes clear that economists and accountants use the term 'profits' differently. By 'profits' the accountant means total revenue minus explicit costs. But to the economist 'profits' means total revenue minus all costs (i.e. explicit costs, implicit costs and normal profits). Therefore, when an economist says that a firm is just covering its costs, he means that all explicit and implicit costs are being covered and that the entrepreneur is therefore, receiving a return just large enough to keep him in his present job. If a firm's total revenue is more than all the economic costs, then the residue is to the entrepreneur. This residue is economic or pure profit. It is not a cost, because by definition, it is a return more than the normal profits required to keep the entrepreneur in his present line of production.

Other Production Costs : As discussed above, the term cost has varied meanings. We shall now discuss some important types of costs of production. i)

Fixed Costs and Variable costs ( F.C. and V.C ) : This distinction between fixed and variable costs is relevant in the short period only. In the short period, some factors, like capital, machinery, land, management, are fixed and some factors, like labour, electricity, raw material, etc are variable. Costs on fixed factors are called fixed costs and costs on variable factors are called variable costs. The costs which remain fixed irrespective of the level of output are called fixed costs. These costs remain fixed till the capacity output is reached. Fixed costs include costs on capital, land, and salaries of top managers who are permanent employees. Variable costs are those costs which vary with the level of output. Variable costs include costs of raw material, electricity charges, wages etc. Fixed costs do not change with change in production. Variable costs, however, change with the change in production. F.C. + V.C. = T.C. (Total Cost). In the long period, however all factors are variable and so all costs are variable. The difference between the fixed and variable costs disappears in the long period.

ii)

Avoidable and Unavoidable costs : At times a firm faces a problem of retrenchment or contraction. Costs which can be avoided due to contraction of the firm are called avoidable costs and the costs which cannot be avoided because of contraction are unavoidable costs. E.g.: A firm decides to close it's showroom. By closing the showroom it can

172


avoid the rent of the showroom, wages to workers in the showroom, electricity charges etc. these are avoidable costs. However, it has to continue to employ the salesman who move from place to place; the salaries of these salesman cannot be avoided because of contraction of the firm; these become unavoidable costs. iii)

Incremental and Sunk Costs : At times the firm undertakes expansion. It might set up a new factory or introduce a new product. Costs which increase because of expansion of a firm are called incremental costs, and costs which have to be borne whether there is expansion or not are called Sunk costs.

For example, if a firm wants to purchase a machine, it has to bear the following costs: 1)

Cost of purchase.

2)

Installation charges.

3)

Maintenance charges

4)

Operational charges.

Now, instead of purchasing the machine a firm decided to hire a machine (not expansion), it does not have to bear the cost of purchase and the maintenance or installation charges. These are costs which increase only through expansion and are incremental costs. However, by hiring a machine the firm cannot avoid operational charges. These costs have to borne by the firm whether there is expansion or not; these are Sunk costs. iv)

Common and Traceable costs : Today, most firms are multiple product firms, i.e. firms producing more than one product. Some costs are common to all the products of multiple product firm. These are common costs. However, there are some costs which are traceable to a particular product of a multiple product firm; these are called traceable costs. For example, consider a press, publishing a newspaper and a monthly magazine, some costs like a cost of printer, salaries of publishers etc are common to both these products; these are common costs. However, the raw material used or a cutter used for the magazine or newspaper can be specific to a particular product; these are traceable costs.

v)

Historical and replacement costs: Cost of purchase of a capital asset, when it was initially purchased, say, 1994 is the historical cost of the asset. Over a period, the value of every asset depreciates; and a time comes when it becomes necessary to replace the asset.


173

The cost of the asset when it is to be replaced say in the year 2004, is the replacement cost of the asset. vi)

Short run and Long run costs: All the costs discussed previously are important. However, for our present study we shall concentrate on firms fixed and variable costs. This distinction between FC and VC depends on the time period. In the short period some costs are fixed and some are variable. We shall now study the short run costs with reference to total marginal and average costs. To understand the meaning of these costs and relationship between them, we will make use of cost curves as shown on next page.

Firms Cost curves : (A) Short run Cost Curves: Short run is a period within which some costs change, (because some factors like labour change), whereas some costs do not change (because some factors like machinery, capital, do not change). Thus, we talk of fixed costs and variable costs in the short run. a)

Total Fixed Costs (TFC): Some factors like machinery, land, capital remain fixed in the short period, the total cost of all these factors is the total fixed costs. TFC's do not change in the short period. They are the same for any level of production (see figure mentioned below). The TFC curve is a horizontal straight line parallel to X axis.

b)

Total Variable Costs: (TVC) : Some factors like raw material, electricity, spare parts and labour change as the output changes. The cost on these factors is the total variable costs. The total variable costs increase with increase in production(see fig shown on next page). We have a rising TVC curve.

c)

Total Costs (TC) : The sum of total fixed costs and total variable costs is the total cost. This is the total cost of production. TC = TFC + TVC The TFC is constant, but TVC increases as production increases, so TC also increases as production increases. The TC curve is also a rising curve and the vertical distance between the TVC and TC curve, for any level of production is the same and is equal to TFC(see the figure shown on next page).

174


d)

Average Fixed Costs(AFC) and Average Variable Cost (AVC) : AFC is the per unit fixed cost of production which is calculated as: AFC = TFC / Units of Output Since TFC is constant as production increases; the AFC decreases as production increases (see fig shown below). AVC is the per unit variable cost of production which is calculated as AVC = TVC / Units of Output The AVC curve is a U shaped curve, which means that, initially AVC decreases as output increases and later AVC increases as output increases (see fig shown below).

e)

Average Cost of Production (AC): Average cost is the cost per unit of output produced which is calculated as: AC = TC / Units of output OR AC = AFC + AVC The AVC curve is also a U shaped curve, which means that initially, AC decreases as output increases and later AC increases as output increases (see the fig shown next page).


175

Cost

Units of outputs

f)

Marginal Cost: The marginal Cost is the change in total cost caused due to one additional unit of output produced. MC is therefore, the rate of change of total cost. It is calculated as, MC = ∆ TC / ∆ Output The MC curve is a U shaped curve which implies that the MC decreases as output increases initially, but ultimately the MC starts decreasing with increase in Output (as shown in the above fig). this also means that TC (and TVC) initially increases at a decreasing rate and later it increases at an increasing rate. The relationship between TVC and MC is the same as the relationship between TC and MC because TVC changes at the same rate as TC, since TFC is constant. MC = MVC + MFC, but MFC = 0, therefore, MC = MVC Also, the relationship between AVC and MC is the same as the relationship between AC and MC. Thus, the MC curve cuts both the AVC and AC curves at their respective lowest points.

176

Units of output

Total Fixed Costs

Total Variable Costs

Total Costs (2) + (3)

Average Fixed Costs (2) : (1)

Average Variable Costs (3) : (1)

Average Costs (5) + (6)

Marginal Costs

1

2

3

4

5

6

7

8

0

15

0

15

––

0

––

––

1

15

5

20

15

5

20

5

2

15

9

24

7.5

4.5

12

4

3

15

12

27

5

4

9

3

4

15

16

31

3.75

4

7.75

4

5

15

25

40

3

5

8

9


(B) Why Short Run Average Cost Curves are U - shaped? The average cost (AC) is made up of average fixed cost (AFC) and average variable cost (AVC). The total fixed cost is fixed as output increases, so the AFC declines as output increases. In the initial stages the AVC also declines as output increases. Thus, upto same level of output the AC (AFC + AVC) also declines as output increases. However, even though AFC falls continuously as output increases, the AVC increases steeply, after reaching a minimum. This rise in AVC more than offsets the fall in AFC and the AC (AFC + AVC) starts rising as output increases. We can explain the short - run average cost curves with the help of the Law of Variable Proportion. The marginal cost and average cost falls as output increase, in the initial stage of production because : (i)

The fixed factor is used in a better and better way in the initial stage of production therefore, the AFC falls steeply and thus AC falls steeply.

(ii)

The average variable cost falls initially till the normal capacity of the machine is used up, because the variable factors are used only to assist the fixed factors, the AC falls steeply.

But after a certain stage, the AC will register a sharp rise because, (i)

The fixed factors are used up, and further production is possible only with more of variable factors, the TVC cost increases sharply as output increases, therefore, the AVC also increases sharply, and it cannot be offset by the slow fall in AFC over larger output. Thus fixity of factors causes the AC to rise sharply over larger output.

(ii)

Further, factors of production are not perfect substitutes of each other; thus if the fixed factor is used up, the variable factor cannot be used instead of the fixed factor. Thus, both the AFC and AVC and so the AC rises as output increases.

An initial fall in AC as output increases, and then a rise in AC as output increases further, gives the AC curve a U - shaped curve. One can conclude that the short run AC curve is U - shaped and this is explained by the Law of Variable Proportion, which operates only in the short - run. 12. DETERMINANTS OF COSTS : The determinants of demand have already been discussed in the Chapter "Demand Analysis and Forecasting." The idea was to identify the more important determinants of demand, so Production and Costs

177

that each determinant might be taken care of at the time of a forecast. Now, the more important determinants of cost have to be identified, so that each determinant might be forecast, and we are able to arrive at a realistic picture of cost behaviour in the future. There are so many factors which determine cost that is virtually impossible to enumerate them. However, it is possible to identify the more important factors of cost which influence cost pattern or cost behaviour. When the factors which influence or constitute cost are spelt out, it is possible to build up the cost function. Generally speaking the prices of inputs, the rate of output, the size of the plant, the technology used broadly constitute the cost. In other words, cost is a function of prices, of inputs, the rate of output, the size of the plant and technology. Therefore, the cost function may be written as : Cost = f (I, O, P,T) Where I

- denotes the prices of such inputs as labour and capital material.

O - denotes the rate of output, i.e., how fast or slow the fixed plant is utilized. P - denotes the size of the plant T - denotes the state of technology. These constituents of cost help one to conceive cost behaviour as a single comprehensive cost function which expresses the complex relationship of cost to its many constituents. Each component of this complex function is a separate function by itself; and the sum of these separate functions pluralistically yields the complex function. For example, consider the first determinant in this complex function, that is input. Now the cost - input relationship is a seperate function. Similarly, the cost output relationship is another separate function; and so on. Consider now the cost - input relationship.

Cost - Input Relationship : In the cost - input relationship, it is the prices of various inputs which make up the cost. For example, α

α

O = AL K1-

Where, O = the amount of output A = a constant L and K denote labour and capital α

α and 1- are the production co – efficient or elasticities

178


Now, the cost - input function can also be written as C = f (La Kb Mc) where C denotes the cost which is a function of L (labour) and a the price of the factor labour. K denotes the quantity of capital, b the price of capital and Mc denotes materials and the price of materials. These input factors, namely, labour, capital and materials, multiplied by their quantities, determine the cost. The quantities which are bought, however, depend upon their prices. It has already been indicated that producers generally try to combine the factors of production in such a way as to minimize cost. In other words, they go on substituting one factor for another till all the costlier factors are replaced by the factors which are cheaper. This is known as the process of substitution. The purpose of this substitution is to enable the management to arrive at the least - cost combination of factors or inputs; and this process goes on till a stage is reached at which further substitution is not possible. This process is known as the marginal rate of substitution. In the costing of inputs, a cost function is developed on the same lines on which the production function is developed. The objective of the production function is twofold : to arrive at the least cost combination and to achieve the maximum output. In the cost function, the least - cost combination of inputs is determined. For example, if labour is costly, the producer goes in for a capital intensive technique. On the other hand, if capital is costly, the labour intensive technique is adopted. In other words, a relation of substitution between labour and capital is established. But what happens when capital is constant and the price of labour or the price of materials rises ? it is difficult to analyse this situation because labour is costly, the producer cannot use less of labour and more materials. This would be absurd because labour and materials cannot be substituted for each other. The ingenuity of the managerial economist arises when he goes beyond this limitation and find out whether there is some factor influencing labour and materials alike. If labour is costly and the price of materials is constant, a capital - intensive technique would be used. On the other hand, if materials are costly, research receives an impetus, for it becomes necessary to find substitutes. These facts indicate that the cost - input function is one of the complex functions of cost analysis.

Cost - Output Relationship : Cost generally vary with the level of output. When we analyse how and why the cost varies, what we have in mind is to determine how costs vary over a period of time. This time period is a crucial factor in any analysis of costs, and is generally broken into two parts, namely, short - run, and long - run factors. It has often been claimed that, in the short - run, certain factors do not change; for example, the size of a plant, the state of technology, etc. In the long - run, however, these factors adapt themselves to changed conditions. In other words, in the short run, only certain factors, vary and not all; for example the raw materials vary in price; so do wages because these factors, namely, raw materials and labour, are subject to the forces of demand and supply. In other words, this is a short - run phenomenon. Production and Costs

179

And so one arrives at an analysis of short-run cost behaviour and long-run cost behaviour. Costs, of course, are of several kinds - fixed cost, variable costs, average costs and marginal costs. However, the total cost is the summation of fixed and variable costs. Fixed and variable costs have already been dealt with. For the purpose of the cost - output analysis, what is needed is a study of the total cost, the average cost, and the marginal cost, both in the short - run and in the long - run. The relationship between the total cost the average cost, the marginal cost, the total fixed cost, and the average fixed costs is illustrated in table given previously. 13. BREAK EVEN POINT :

The Traditional Concept of Equilibrium of a Firm Equilibrium of the Firm : By total Revenue and Total Cost Curves : We have noted that, a firm will be said to be in equilibrium when it tends to stabilize at a given level of output and is reluctant either to increase or to decrease its output. Since maximizing money - profits is assumed to be the objective of the firm, the firm will try to attain that level of output which fetches maximum profits. Once this level is attained, the firm will tend to stabilize this level of output. In other words, equilibrium of the firm will be established where its output maximizes its money profits. Since profit is the difference between total revenue and total cost, to maximize this difference becomes the objective of a firm. We have already considered the behaviour of costs in relation to variations in the output of a firm. Now we shall consider the behaviour of revenue of a firm. To simplify our analysis, we shall assume that the firm is producing one product only. Table indicates the movements of total cost and total revenue as the level of output which corresponds to the longest vertical distance between total revenue and total cost, the latter being less than the former. The following figure illustrates the equilibrium of a firm with the help of Total Revenue (TR) and Total Cost (TC) curves. This is known as a 'break - even chart' or Cost - volume profit analysis, in the business world. The TR and TC curves in figure are total revenue and total cost curves respectively. The TR curve originates form point O since total revenue is zero when production is zero. However, a firm is required to incur fixed costs even when its level of production is zero. Total cost is more than revenue until OA level of output is reached. At OA level of output, TR = TC which means the firm is making neither profits nor losses. Point D in the figure,

180


Y TC

Total Cost & Total Revenue

K E

G TR

J

F

D

M

L H

O

A

B

C

X

Output (Units)

Equilibrium of a firm with the help of TR &TC method which is a point of intersection of TR and TC curves, is therefore, known as the break - even point. As output increases beyond the level OA, TR curve rises above the TC curve and the gap between the two goes on increasing. This widening of the gap between the two curves indicates increasing profits. The vertical distance between TR and TC curves indicates total profits. This vertical distance is longest at OB level of output, where EF is the total profit and EF is the longest possible vertical line that can be drawn between the two curves TR and TC as drawn here. Hence, OB is the profit maximizing level of output and at this level of output the firm will be in equilibrium. If production increases further, profits will decline. At point G, TR and TC are again equal. Point G, therefore, is the second break - even point. OC level of output is again a no- profit no -loss level of output. If output is increases beyond OC the firm will incur losses which will increase as output is increased beyond OC. In order to decide the largest vertical distance between TC and TR, we can draw a number of tangents to the TR and TC curves. Of all theses tangents, we have to find a pair of lines which are parallel to each other and at the same time, the points of tangency are on a straight line drawn perpendicular to X axis. In fig. JK/LM are the parallel lines and E and F are the points of tangency. These two points (E and F) are on the straight line BFE which is drawn perpendicular to the X axis. To ensure that EF is the longest vertical distance between TR and TC. EF is the total profit at OB level of output. This method can illustrate the equilibrium of the firm. Besides, it is most widely used in business to find out total profits of a firm. But this method has two limitations : (i) The longest vertical distance between TC and TR curves is difficult to find out at a glance. We have to draw many tangents to the two curves before we come across a pair of tangents which are parallel to each other. (ii) Secondly, the price per unit of the commodity cannot be shown in the same diagram. It is true that TR : Units produced would be the price per unit. In fig. BE : OB is the price. But still we cannot precisely show the price as a particular distance. Hence, the method is not very significant especially in the context of problems in the theory of value we are required to discuss with the help of equilibrium of the firm. Instead, the equilibrium as based on marginal analysis, i.e., by the curves of marginal revenue and marginal cost, proves to be more useful. Production and Costs

181

Exercise :

182

1.

Explain The Law of Variable proportion with the help of three stages.

2.

State and explain Law of Supply? What are its exceptions?

3.

What is elasticity of Supply? What are the types of elasticity of Supply?

4.

Write short notes on : (a) Methods of measurement of elasticity of supply (b) Diseconomies of large scale production (c) Opportunity Cost and Actual Costs (d) Explicit & Implicit Cost (e) Past and Present Cost (f) Fixed and Variable Costs (g) Avoidable and Unavoidable Costs (h) Incremental & Sunk Cost (i) Increase and decrease in quantity supplied and increase and decrease in supply. (j) Determinants of cost of production (k) Short run cost curves.

5.

Explain with illustration the Laws of Returns to Scale.


NOTES


183

NOTES

184


Chapter 6 PRICING AND OUTPUT DETERMINATION IN DIFFERENT MARKETS Preview Introduction, Meaning of Market, Traditional view, Modern View, Classification of Markets based on the Notion of Competition, Pure and Perfect Competition, Determination of Price and output under perfect Competition, Price in Short run and long rung, Equilibrium of Firm and Industry Under Perfect Competition, Imperfect Competition, - Monopoly, Distinction between perfect competition and Monopoly, Determination of Price and Output (Equilibrium Under Monopoly); Monopolistic Competition (Features), Determination of Price and Output under Monopolistic Competition, Oligopoly and Duopoly (Features), Pricing Methods / Pricing Practices, Introduction to Cost Pricing. INTRODUCTION Demand and Supply are the powerful forces operating in any market. They act and react upon each other and determine the price of a product. In the previous chapters, we have already studied the nature of Demand and Supply. In this chapter we propose to study the market where these forces are constantly at work. An attempt is, therefore, made in the following few paragraphs to define the term 'market' and explain the nature of competition. 1)

What is 'Market'?

In the traditional sense, market is a place where buyers and sellers meet each other to effect a business transaction. It is a place, a street or a building where a number of shops dealing in a particular commodity are located. Several examples of market in Pune can be given for exmple Mahatma Phule Market is a retail market in vegetables whereas, Gultekdi Market Yard is a wholesale market in vegetables. In Mumbai, Zaveri Bazar is the market for gold and silver ornaments. The diamond market in Mumbai is located in two sky-scrapers at Opera House viz.- Pancha - Ratna and Prasad Chambers. Wholesale textile business in Mumbai is concentrated in Swadeshi Market, Mulji Jetha Market and Mangaldas Market. Similarly, most of the Indian and foreign banks are concentrated near Horniman Circle and Nariman Point in Mumbai. These areas, therefore, constitute the Mumbai Money Market. Dalal Street in Mumbai is known for the Bombay Stock Exchange. It is the largest capital market in shares, stocks, Pricing and Output Determination in Different Markets

185

debentures and government securities. It will be seen from these examples that the market for a particular commodity is concentrated in a particular building or a street in a city. 2)

National Markets

Like a particular street in a city, the entire city may sometimes specialize in the production of a particular commodity. In course of time, the city acquires the status of a national market. Thus, Ahmedabad has specialized in the manufacture of textiles, Banaras in silk, Kashmir in shawls and Faridabad in bangle-making industry. Similarly, Coimbatore in South India has developed a big market in spinning. The market for leather goods is concentrated in Kanpur, and Kolkata whereas hosiery market is centered in Ludhiana. Recently, Surat has specialized in diamond polishing. 3)

Modern View

Above examples would indicate how various markets are developed at various places in a country. Meaning of the term market, as understood in the above sense is, however, traditional; and is not acceptable to the economists. In economics, the term market is understood in a different sense. According to Jevons, an eminent English economist, it is not necessary for the sellers to exhibit their products at a particular place or a building. The goods may be stored in a warehouse, and the buyers and sellers may be away form each other by thousands of miles still, they may be able to talk to each other over telephone or through the post-office and finalize the transaction of sale or purchase. The same view has been expressed by Cournot, the renowned French economist. According to him, the buyers and sellers may be away form each other; but they may be able to establish contacts through communication, so as to finalize the transactions. If they are able to speak with each other, prices in different parts of a country, would tend to equality easily and quickly. Thus, according to the modern view, (a)

It is not necessary that market for a commodity should always be located on a particular street or in a building.

(b)

The buyers and sellers may be away form each other and yet they may constitute a market over telephone or through internet.

(c)

When buyers and sellers are in close contact with each other, prices prevailing in different parts of a country would tend to equality.

It is clear that modern economists have considerably widened the scope of the term 'market'. If this meaning is accepted, the entire world may be described as a single market.

186


4.

Classification of Market based on the Nature of Competition : MARKET

Perfect Competition

Pure

Imperfect Competition

Perfect

Monopoly Duopoly

Oligopoly Monopolistic Monopsony Competition

Competition in the market can be either perfect or imperfect. The Classical economists assumed the existence of perfect competition, and all their analysis is based on this assumption. The dream of the Classical economists is, however, hardly realized in practice. It has been pointed out that the real world is full of imperfect competition. In particular, Mrs. Joan Robinson of the Cambridge University and Prof. Edward Chamberlin of Harward University have done a pioneering analysis of imperfect competition. Based on their analysis, competition in the market is classified as under. (A) Pure and Perfect Competition : Usually, a distinction is made in economic theory between pure competition and perfect competition. The concept of perfect competition is much broader in scope than pure competition. It includes all the features of pure competition plus some more features of the two forms; let us discuss first the features of pure competition. a)

Large Number of Buyers & Sellers (Firms) The number of buyers and sellers operating under pure competition is very large. The position of an individual seller is like a drop in the ocean. An individual seller cannot, therefore, fix the price nor can he change it by his individual action. Similarly, no single buyer can fix the price or change it by his action. Even if he increases or reduces his demand, it does not make any effect on the total demand in the market. Price of a product is determined by the interaction of total demand and total supply in the market. Naturally, it is beyond the capacity of an individual seller or a buyer to determine or influence the price. Every seller and a buyer under pure competition is a Price-Taker and not a Price-Maker.

b)

Homogeneous Products The products sold by different sellers under pure competition are homogeneous i.e. exactly alike in quality. Usually, a product which is capable of being standardized is sold by the sellers. For example, rice produced in different parts of India is classified under different standard grades such as Resham Basamati, Kamod,

Pricing and Output Determination in Different Markets

187

Kali, Much, Ambemohor etc. Since every buyer is buying the standard variety, he does not bother to know as to which particular farmer has grown that rice. He is interested in ensuring that all the rice in the bag is homogeneous, i.e. exactly alike in quality. c)

Free Entry & Free Exit of Firms Another important feature of pure competition is that there is free entry and exit of firms. An entrepreneur who has the necessary capital and skill can start any business of his choice. In every industry, new firms are, therefore, opened from time to time. Similarly, an existing producer is free to close down his business if he so chooses. As a result, some firms are going out of the industry. Since there are no hindrances to the entry of new firms and exist of existing firms, the number of total firms under pure competition always remains very large.

(C) Perfect Competition : It has been already remarked that the concept of perfect competition is broader than pure competition. This means that perfect competition does exhibit the above features of pure competition viz. large number of buyers and sellers, homogeneous products and free entry and exist of firms. In addition to these, perfect competition exhibits the following features. a)

Perfect Knowledge All the buyers and sellers operating under perfect competition have perfect knowledge of the market conditions. For example, every seller knows the total quantity supplied and sold on a particular day or during a week. Similarly, every buyer knows what is happening in the other corner of the market.

b)

No Discrimination Under perfect competition, no seller should discriminate between buyers. He cannot say that he would sell his product only to white and handsome people; and not to the black and ugly people. The seller must deliver the goods so long as every buyer, visiting his shop, is willing to pay the required price. Similarly, no buyer would discriminate between sellers. He cannot say that he would buy only from a particular seller and that he would not buy from others. A buyer has no reason to discriminate between sellers so long as every seller is charging the same price.

c)

No Cost of Transportation Under perfect competition, it is assumed that the cost of transportation does not exist for carrying goods from one place to another.

d)

Mobility of Factors of Production Various factors of production are assumed to be perfectly mobile from one place to another and from one occupation to another. For example, a worker would migrate

188


from industry can be diverted to another industry if the return on investment is going to be higher. It is assumed that all the factors of production are perfectly mobile and that there are no hindrances to their movement. Mobility of factors of production is guided under perfect competition, by self-interest and profit-motive, the principle so nicely elaborated by Adam Smith in his Book, 'Wealth of Nations'. e)

Automatic Price Mechanism The most significant feature of perfect competition is the existence of an automatic price mechanism. Price of a product is determined by the interaction of total demand and total supply in the market. Since there are many sellers and many buyers, no individual seller or a buyer can fix or influence the price. The forces of demand and supply are very powerful and always remain outside the control of an individual seller or a buyer. Price mechanism is not only automatic but is delicate.

(D) Demand Curve under Perfect Competition : Under perfect competition, the number of firms in the industry is very large. Each firm is very small in size. A single firm action does not affect the market supply. Thus, each firm is a price-taker under perfect competition. The price is determined in the market and every firm has to accept this price. MARKET Price (Per Unit)

DM

PM

Price (AR)

FIRM

SM

EM

OP0

AR Perfectly Elastic Demand Curve

DM

SM QM

X O Quantity Demanded/Supplied

O

X Output (Units)

In the fig DM DM is the market demand curve and SM SM is the market supply curve, EM is the point of market equilibrium where market demand and a market supply are equal to OQM. This gives the equilibrium price in the market (OPM). This price is accepted by every firm. (OP0) under perfect competition. Thus the demand curve of the firm is perfectly elastic under perfect competition. (A) Determination of Price And Output Under Perfect Competition : INTRODUCTION Perfect Competition is said to exist when the number of buyers and sellers operating in the market is very large. Then buyers and sellers have perfect knowledge of the conditions prevailing in different parts of the market. All the sellers are selling homogeneous products which are exactly alike in quality. Moreover, no seller would discriminate between buyers and no buyer Pricing and Output Determination in Different Markets

189

would discriminate between sellers. That is to say, a seller has no reason to refuse to sell to a particular buyer who is willing to pay the required price. Similarly, no buyer would hesitate to buy form a particular seller who is charging the same price. Under perfect competition, no buyer or seller can fix the price of a product, nor can he influence it by his own action. Price is determined by the interaction of demand and supply. Demand and Supply are powerful forces which constitute the essence of price-mechanism under perfect competition. The price mechanism determines the price and output of various products. It is, therefore, worthwhile to explain the working of the price mechanism under perfect competition.

General Rule Of Price Determination : Under Perfect Competition, generally, demand and supply play an equally important role in determining the price. They act and react upon each other and determine the price at the equilibrium point. This is called Equilibrium Price. Determination of equilibrium price can be explained with the help of the following demand and supply schedule and demand and supply curves. Demand for & Supply of Textiles Price (Rs. Per metre)

Quantity Demanded (million metres)

Quantity Supplied (million metres)

250

19

28

240

20

26

230

22

22

220

25

17

210

30

10

The above demand schedule can be shown with the help of the following diagram. Equilibrium Price Price per unit

Y

D S

P

E S

O

D M

X

Quantity Demanded/Supplied

190


In the figure quantity demanded and sold is shown on the X- axis and the price is shown on the Y- axis. DD is the demand curve showing total demand at different prices, and SS is the supply curve representing the quantity supplied at different prices. The demand curve and the supply curve balance each other at point E. This point is called on Equilibrium point. Under perfect competition, the equilibrium price would, therefore, be Rs.230/- per metre and at this price quantity OM would be sold in the market.

Changes in Equilibrium Price : The equilibrium price, determined by the interaction of demand and supply need not remain constant. It can change with every change in the relative positions of demand supply. For example, if some festival is forthcoming, demand for a product would increase. The supply being constant, price would rise. Similarly, during a slack season, demand may fall, but supply being constant, price would fall, Changes in supply would also influence the equilibrium price. For example, in a particular year, the cotton crop may be affected on account of natural calamities. Supply of cotton in this case is reduced; but demand being constant, price of cotton textiles would rise. There is a third possibility; demand and supply may both change simultaneously. In all the three cases, the equilibrium price would change. It is worthwhile to see how changes in demand, changes in supply and changes in both, affect the equilibrium price. (A) Changes in Demand Y

Changes in Demand

Price Per Unit

D

D1

S

P1 P

F E

S O

D

D1

M M1

X

Quantity Demanded/Supplied In figure changes in demand are shown by different demand curves DD and D1D1. The supply is shown by the supply curve SS. Demand for a product may increase on account of a festival, growth of population or on account of some other factor. In figure original equilibrium price is shown at point E i.e. OP. But on account of a higher demand curve


191

D1D1 a different picture would emerge. The new demand curve D11 intersects the supply curve at point F. The new price would, therefore, be OP1. Thus it is clear that supply being constant, every increase in demand would lead to a rise in the equilibrium price. D ↑ E. (B) Changes in Supply Similarly, demand being constant, every change in supply would change the price. This is clear form the following figure. Changes in Supply Y S1

D

Price Per Unit

S

E1

P1 P

E

S1

S

O

D M1 M

X

Quantity Demanded/Supplied In figure, the quantity is shown on the X-axis and the price is shown on the Y- axis. DD is the demand curve and SS is the original supply curve. These curves balance each other at point E; i.e. equilibrium point. OP is, therefore, the equilibrium price. Now, S1S1 is the new supply curve which shows a reduction in the supply. The new supply curve S1S1 intersects the demand curve at a new equilibrium point E1. OP1 would, therefore, be the new price. This means that the total supply has diminished from OM to OM1; and at the same time, price has risen from OP to OP1. (C) Changes in Demand and Supply The third possibility is that demand and supply both may change simultaneously. On account of these changes, a new equilibrium price would be established. This would be clear form the following figure.

192


Changes in Demand and Supply Y D1

D

S

Price Per Unit

S1

P1 P

E1

E

D1 S D

S1 O

M

M1

X

Quantity Demanded/Supplied In figure, DD is the original demand curve and SS is the original supply curve. They balance each other at point E. The equilibrium price is, therefore, OP. Now D1D1 is the new demand curve which shows a higher demand, and S1S1 is the new supply curve. The new equilibrium price would, therefore, be OP1.

Laws of Demand, Supply & Price : From the foregoing discussion the following laws of demand, supply and price can be stated : (d)

Under perfect competition, price of a product is determined by the interaction of total demand and total supply in the market. This is called 'Equilibrium Price.'

(e)

If demand increases, supply being constant, the price would rise. If demand falls, supply being constant, price would fall.

(f)

If supply is reduced, demand being constant, price would rise and if supply increases, demand being constant, the price would fall.

(g)

If a change occurs in demand and supply simultaneously, a new equilibrium price is established.

Price in the Short Run and Long Run : The above laws of demand, supply and price, however, constitute the general framework of price determination. As Marshall has elegantly pointed out, time element plays an important role in determination of price. Marshall has classified the period of time under four heads; but for the sake of simplicity we can reduce this classification of period only under three heads viz.


193

(i)

Market Period (ii) Short Run, and (iii) Long Run.

It is worthwhile to see how price is determined in the market, in market period, Short period and the Long run or period. (i)

Market Period : According to Marshall, market period relates to few hours or few days. Perishable goods such as fish, eggs, leafy vegetables etc. are sold in this market. The supply of these goods on any particular day is fixed. It cannot be increased or decreased within the market period. At the same time, such goods being perishable, their supply cannot be held back from the market. The entire supply is to be disposed off on the same day; because it cannot be stored or preserved. In such circumstances, price would be determined according to the total demand in the market. If on a particular day, more customers come to buy, the supply would be less and the supply being constant, price would rise. Thus, in the short run, determination of price in the market period is shown in the following figure : Price in Market Period Y D2 D

S

Price Per Unit

D1

P2 P D2

P1

D D1 O

S

X

Quantity Demanded/Supplied In figure, SS is the supply curve representing perfectly inelastic or a fixed supply in the market period. Since supply cannot be increased or decreased in a very short period, the supply curve is vertical to the X-axis. Demand is shown by different demand curves, i.e. DD, D1D1 and D2D2. Accordingly, OP would be the price if demand is shown by the curve DD. If on the next day, only a few customers come, demand would be shown by D1D1 and the price would fall to OP1. If on some other day, demand is higher it would be shown by D2D2 and the price would rise to OP2. Thus, price in the market period is determined from the demand side, and supply plays a passive role. 194


(ii)

Short-Run : In the short-run, supply of goods can be adjusted to the demand to some extent, because, some factors remain fixed, whereas other factors can be changed in the short - period, the price in the short period is thus determined with the help of the active role of both supply as well as demand. Y S

Price Per Unit

D

P D S

O

Q

X

Quantity Demanded/Supplied

In figure, the supply curve is positively sloping, the equilibrium price is OP at which quantity supplied equantity demanded equals OQ. (iii) Long - Run : In the Long - run, supply of goods can be adjusted to the demand, Dr. Marshall has taken an example of durable goods, which are sold in the long run. Durable goods such as wheat, rice, oil, textiles etc. can be stored for some time. Their supply can be increased or reduced according to the demand. Since the supply is adjustable, supply curve is horizontal to the X-axis. The sellers of durable goods are unwilling to sell unless they recover a minimum price. This price is based on the cost of production. Producers of durable goods would not, therefore, sell unless the cost of production is recovered. If the price is less, they would hold back the supply from the market. On the other hand, if they are getting the minimum expected price which covers the cost of production, they would be prepared to sell more. i.e., they would increase the supply at the same price. Determination of price in the long run is shown in the following diagram :


195

Long Run Normal Price

Y

Price Per Unit

D

D1

D11

P

S

D11 D

D1

X

O Quantity Demanded/Supplied In figure the supply curve is horizontal to the X-axis because it is adjustable to demand. Here, price of the product would be OP which covers the cost of production. In this case, an increase or decrease in demand would not influence the price because it is based on the cost of production. If less people come, a small quantity would be supplied and if more people come, a larger quantity would be sold at the same price. It will be seen that in the long run, supply plays a dominant role and demand is passive in determining the price.

Conclusion : Under perfect competition, price is determined by the interaction of total demand and total supply in the market. The price which is so determined is called the Equilibrium Price. The equilibrium price may change on account of changes in the relative positions of demand and supply. The most significant point to be emphasized here is that the time element plays an important role in determination of price in the short and long run. In the short run demand is active, whereas in the long run supply is active in determining the price. By introducing the importance of time element, Dr. Marshall has made a significant contribution to the theory of value. (B) Equilibrium of Firm And Industry Under Perfect Competition INTRODUCTION In the previous sub-unit, we have studied how price of a product is determined by the interaction of demand and supply. We have also seen the important role played by the time element in the theory of value. We have thus studied the rules of price determination under perfect 196


competition. However, we have not yet studied how a firm or an industry would maximize its profits. An attempt is, therefore, made in this chapter to explain how equilibrium position of a firm or an industry is reached under perfect competition.

Firm And Industry : Before explaining the equilibrium of a firm or an industry it is necessary to revise the distinction between a firm and an industry. Any business unit organized under one ownership and management is called a firm. The firm may be organized as a sole proprietorship, partnership or a joint stock company. The form of organization can be anything. It is necessary that the business should be owned and managed by one management. An industry is a group of firms dealing in the same line of business. The ownership and management of each firm may be different; but since all such firms are engaged in the production of the same commodity, they are collectively called an industry. Thus Swadeshi Mills in Mumabi is a firm dealing in textiles. Similarly, Shriram Mills is another firm and Kohinoor Mills is still another firm dealing in textiles. But when we take into account all the textile firms in India we describe them collectively as the cotton textile industry of India.

Concept of Equilibrium : The term equilibrium is frequently used in economic theory. Thus, there is an equilibrium of a consumer, an equilibrium of a firm or an equilibrium of an industry. Since the concept occupies a central position in the theory of value it is necessary to know the meaning of the term equilibrium. A consumer who spends his income on various goods may derive satisfaction from the consumption of those goods. When consumer maximizes his satisfaction he is said to be in equilibrium. In the case of a firm, equilibrium is reached when the firm's profits are maximized. The ultimate aim of every firm is to maximize its profits. Accordingly, the firm tries to reach the stage of maximum profit by adjusting its output. In the initial stages, when production is on a small scale, the margin of profit is small. But when the scale of production is increased the average cost goes on diminishing and the margin of profit goes on increasing. After some time, the disadvantages of large-scale production begin to operate. As a result, the difference between the selling price and the cost goes on diminishing. Even though the margin of profit is reduced, there is still some addition to the total profits. It is, therefore, worthwhile to carry on production for some more time. Finally, a point is reached when cost of production exceeds the selling price. From this point, losses begin to occur. Every firm would, therefore, stop to produce. At this point, the total profit is maximum and the firm is said to be in equilibrium. Like a firm, an industry can also achieve its equilibrium when all the firms in the industry are in equilibrium.


197

Equilibrium of Firm : There are two methods to study the equilibrium of a firm. Viz. (a)

Total Cost and Total Revenue method, and

(b)

Marginal Cost and Marginal Revenue method.

Before we examine these methods, it is worthwhile to know the assumptions on which our analysis is based : (i)

It is presumed that a firm is managed as a sole proprietary concern. This would enable us to study the behaviour of an individual.

(ii)

Every individual proprietor aims at profit maximization and he exhibits rational economic behavior.

(iii) It is also assumed that the firm is producing only one commodity. It is possible to consider a firm producing more commodities, but in that case, our analysis would become more complicated. For the sake of simplicity we, therefore, assume that the firm is producing only one commodity. Equilibrium of a firm with Marginal Cost and Marginal Revenue Method The total cost incurred to produce a given quantity is called the Total Cost (TC). Now, the addition made to the total cost on account of production of one more unit of output is called the Marginal Cost (MC). Similarly, the revenue received from the sale of a given output is called Total Revenue (TR) and the addition made to the total revenue on account of sale of one more unit is called Marginal Revenue (MR). (i)

Marginal Revenue should be equal to Marginal Cost i.e. MR = MC

(ii)

The marginal cost curve should cut the marginal revenue curve from below at the equilibrium point.

Firm's equilibrium, arrived at by this method is shown in the following diagram : Equilibrium of a Firm MR = MC Y

Cost/Revenue

MC AC

G Q S

T

E K R

D H

AR MR

O

L

M N

X

Output 198


In figure, MC is the marginal cost curve and MR is the marginal revenue curve. Similarly, AC is the average cost curve and AR is the average revenue curve. When OM output is produced, MC and MR curves balance each other at point E. At this point the firm's profits are maximum and the firm is in equilibrium. If smaller output is produced than OM the marginal cost is smaller than marginal revenue, which means that addition to the cost is less than addition to the revenue by producing more output. This means that there is scope to earn more profits be increasing output. Output will, therefore, be increased from OL to OM. When production is OL, average cost is LH and average revenue is LG. Profit per unit is HG. Since there is marginal profit, output will be carried on upto OM. After the point OM, marginal cost would exceed the marginal revenue; and the firm's profit will begin to fall, because more is added to cost than to revenue by increasing output. For example, if ON output is produced, KN is the average cost and SN is the average revenue. There is a profit per unit to the extent of SK, which is less than QD (profit per unit at output OM). Therefore, it would not be worthwhile to produce ON output. The firm should stop production when its output is OM, and its profits are maximum.

Equilibrium of Firm under Perfect Competition : The conditions equilibrium of a firm are applicable to all the types of markets. i.e. they are applicable to perfect competition, monopoly, monopolistic competition etc. These conditions are i) MR = MC and ii) MC Curve must cut MR curve from below. An attempt is made below to examine the equilibrium of a firm under perfect competition.

Cost / Revenue

Equilibrium under Perfect Competition

X Output (units) Under perfect competition, no firm can fix the price or influence it by its own action. Price is determined by the interaction of total demand and total supply in the market. Under these circumstances the firm has to satisfy both the conditions to achieve its equilibrium, viz.,


199

(i)

Its marginal revenue should be equal to marginal cost, and

(ii)

Marginal cost curve should cut the marginal revenue curve from below.

The general rule of firm's equilibrium under perfect competition is shown in the figure. In figure, the curve PL shows marginal revenue as well as average revenue. The curve MC shows the marginal cost. When price is OP, marginal cost curve cuts the marginal revenue curve from below, at point R. Therefore, the firm will be in equilibrium when its output is OM and the price is OP.

Short - Run Equilibrium Although we have discussed the general rule of firm's equilibrium under perfect competition, it is worthwhile to follow Dr. Marshall's classification of time - period into short-run and long-run. In particular, we would like to see how a firm achieves its equilibrium in the following circumstances : (i)

When the firm earns supernormal profits.

(ii)

When the firm earns only normal profits.

(iii) When the firm begins to incur losses. (iv) (i)

When the firm is obliged to stop production.

Super - Normal Profits : In figure, Op1 is the price, P1 L1 is the average revenue curve - MC is the marginal cost curve which intersects the average revenue curve at point Q from below. Therefore, at point Q the firm is in equilibrium and OM' is the ideal output. Here average cost is M'G and profit is equal to GQ. This firm is earning supernormal profit equal to P1QGH. Since all the firms in the industry are working more or less under the same cost conditions, all of them would be in equilibrium. The fact that the existing firms are earning super-normal profits may attract new producers to the industry. But in the short-run it will not be possible for them to start new firms.

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Short-Run Equilibrium of a Firm Y MC

Price Cost / Revenue

Q

L1 (AR) = MR

P1 F H

E R

P

G L (AR) = MR

P2

L2 (AR) = MR

S

O

AC

M2

M

M1

X

Output (units) (ii)

Normal Profit : In figure, OP is the price and PL is the average and marginal revenue curve. Here, the firm is in equilibrium at point R and the ideal output is OM. This form is earning only the normal profit. Therefore, there would be no reason for new producers to enter this industry. Like this firm, the entire industry is in equilibrium at point R. Thus in the short-run, both the firm and the industry, are in equilibrium.

(iii) Losses : In figure, if the price falls to OP2 the firm will be in equilibrium at point S; because at this marginal cost curve intersects the marginal revenue curve from below. But at this point, when output is OM2, the firm is making losses because the average revenue of SM2 is less than the average cost of EM2. Thus the firm is incurring a loss P2SEF. If the firm desires to continue to produce, it must incur this minimum loss. It is obvious that greater production would mean a grater loss. Since all the firms under perfect competition are working more or less under the same cost conditions, all the firms would have to incur losses; if they continue to produce more. Some of the firms, which are incurring losses, may think of closing down the production. But in practice, firms cannot stop their production and cannot avoid losses. This is because, every firm has to incur some fixed costs on account of bank interest, insurance, depreciation, rent etc. even if production is stopped. By stopping the production, a firm can only reduce its variable cost on account of raw materials, wages and power. Thus, if a firm decided to close down production it can save variable costs; but it cannot save fixed costs. Every firm, therefore, decides to continue to produce so long as it is able to recover its variable costs. In other, words, a firm would produce more even if it incurs a loss equal to the fixed costs. Here, every firm takes an optimist view that "half a glass of water is better than nothing". Pricing and Output Determination in Different Markets

201

(iv) Closing - down Production :


Closing - down Production

Output (units) If the price falls further and is less than the average variable cost, the firm cannot afford to carry on its production. Because, here the firm is neither able to stop its fixed cost, nor the average variable cost. Even in the short-run the firm will have to stop its production. This would be clear form the above figure. In the above figure, price has fallen to P4. This price does not cover even the average variable cost. The firm will, therefore, have to stop its production at point D, price OP3 and output OM2.

Long - Run Equilibrium In the long-run every firm gets sufficient time to adjust its output in relation to the demand. It also finds time to buy new machinery or to implement new techniques of production. In the fairly long run, the firm can change the composition of various factors of production. In the short-run a firm reaches its equilibrium when MR = MC. This principle is also applicable to the long-run equilibrium. In the long-run one more thing is, however, necessary. i.e. the marginal cost, marginal revenue, average cost and average revenue should all be equal. Thus, under perfect competition in the long-run a firm is in full equilibrium when MR = MC = AC = AR = Price If the price is more than the average cost, the firm may earn supernormal profits and this would attract new firms to the industry. Entry of new firms would result in a greater production, and a reduction in supernormal profit. In the long run, all firms would, therefore, 202


earn only the normal profit. Similarly, if the price is less than the average cost, losses would occur and this may drive some of the firms out of the industry. The firm's equilibrium under perfect competition in the long run is shown in the following diagram. In the following figure, marginal cost, marginal revenue and price are all equal at point E. The firm is, therefore, in equilibrium in the long run when its output is OM and price is OP.


Y

Long - Run Equilibrium of a Firm

P

AR = MR = Price

M

X

Output (units)

Equilibrium of Industry When all the firms engaged in an industry are in equilibrium, the industry as a whole is in equilibrium. This means that equilibrium is established by total supply and total demand in the industry. If demand is more than the supply, production may be increased, Conversely, if demand is less than the supply, output may be curtailed. Such changes in the output can not take place when the industry is in equilibrium. Equilibrium of the industry is determined by total demand and total supply. The price is also fixed by total demand and total supply of the industry; and not by any single firm. It is, therefore, necessary that, for equilibrium of the industry size of production should be stabilized at a certain point. There should be no tendency for firms to increase or curtail their output. When ideal size of output is achieved, there is no temptation for new firms to enter the industry and there should be no reason for existing firms to go out of the industry. Thus, when output is stabilized at the optimum point, marginal cost will be equal to marginal revenue and the firm would earn only normal profit. All the firms would earn normal profits. If they earn super-normal profits or incur losses, it would lead to an entry or exit of firms; ultimately, equilibrium of the industry would be disturbed.


203

Conclusion It will be seen form the foregoing discussion that a firm maximizes its profit and achieves an equilibrium position when its marginal cost, is equal to marginal revenue. When all the firms in an industry are in equilibrium, the industry as a whole is also in equilibrium. In the long-run equilibrium of an industry, output is stabilized at an optimum or ideal size and there is no entry or exit of firms; because in the long run every firm is earning only the normal profit. (B) Imperfect Competition : In the real world, perfect competition is seldom realized. What we experience is the imperfect competition in its several forms. In the 20th century, markets all over the world have become imperfect on account of several factors. Buyers and sellers do not possess perfect knowledge and the products sold are no more homogeneous. They are often differentiated as to their size, design and colour. The number of buyers and sellers is also small. Depending on the number of sellers operating in the market, imperfect competition is further classified under the following heads : 1) Monopoly 2) Monopolistic Competition 3) Monopsony 4) Oligopoly 5) Duopoly 1)

Monopoly : The other extreme type of market, is the one where there is absence of any competition. This is a situation, where there is only one producer, it is called Monopoly. (a)

Pure and Perfect Monopoly For pure monopoly to exist, the following conditions must be satisfied :

(b)

(i)

One firm producing in the market,

(ii)

The commodity produced should have no substitute.

Impure Monopoly Impure or simple monopoly exists in the market of a commodity, where there is only one producer of the commodity; and the commodity has no close substitute. Since there is only one producer, the distinction between the firm and the industry does not exist under monopoly.

(c)

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The following features are seen under simple or limited monopoly : (i)

Single Producer : For monopoly to exist only one producer should be in the market. The producer may be an individual, a partnership firm, the Government or a Joint-stock Company.

(ii)

No Close Substituties : To avoid any possibility of competition in the market, there should be no close substitutes for the product of the monopolist. This means that the cross-elasticity of demand for the monopolists product is low. Managerial Economics

(iii) Barriers to entry of firms : The basis of monopoly is the barriers or restrictions of new firms into the market; these can either be natural barriers or artificial barriers. (iv) Demand Curve under Monopoly : the above features explain the demand curve or the average revenue (AR) curve under monopoly. The demand curve for a firm (which means the industry under monopoly) is downward sloping. It is the monopolist who is the price-maker in the market.

AR/Price

Y

AR/Demand Curve

O

X Units of output

The Demand Curve Under Monopoly Under monopoly, there is only one seller who controls the entire supply in the market. Since there is the only producer and a seller he can fix the price of his product. In order to maximize his profit, he may raise the price frequently. He may exploit the consumers by charging an exorbitant price. Since there are no sellers, the buyers have no alternative than to buy from the monopolist. Indeed, all buyers are put at the mercy of the monopolist. Many times, monopolies are created under Law. Urban transport, supply of cooking gas and electricity and such other public utilities are usually managed as monopolies. Such monopolies are called Natural Monopolies. On the other hand, if a producer acquires monopoly on the basis of Patent Laws, it is a case of an Artificial Monopoly. (d)

Distinction between Perfect Competition and Monopoly : Monopoly differs from perfect competition in the following important respects. (a)

Under perfect competition, there are many buyers and many sellers. No individual seller or buyer is able to fix or change the market price. The price under perfect competition is fixed by the interaction of total demand and total supply in the market. It is beyond the scope of an individual seller to influence the price by his own action. On the other hand, under monopoly there is only one seller who is free to fix the price, or change it, whenever he likes.


205

(e)

(b)

Under perfect competition there are many firms in an industry; and all of them are selling homogeneous products; but under monopoly the distinction between firm and industry receeds in the background. Since there is only one seller, firm and industry is the same under monopoly.

(c)

Under perfect competition there is free entry and free exit of firms. There are no hindrances to the new producers who desire to enter the industry. But under monopoly entry of new firms is prohibited. For example, in India no new firm can be started to deal in railways; because the monopoly of railways has been entrusted to the Indian Railways.

(d)

Under perfect competition every seller is charging the same price in the long run and is making normal profits. If a particular firm charges a slightly higher price the customers would turn to other sellers. But under monopoly, there is only one seller, and he can raise the price any time; and the customers have no other alternative than to buy from the same monopolist. Under perfect competition a firm attains its equilibrium when marginal cost is equal to average cost, marginal revenue, average revenue and price. But under monopoly, average cost is much lower than the price.

(e)

Since under monopoly, average cost is much lower than the price, the monopolist can earn supernormal profits in the long run. Under perfect competition, however, a firm can earn only the Normal profits in the long run. If it earns supernormal profits, there will be entry of new firms and this profit would be shared by all the firms. Ultimately, the firm would earn only the normal profit. Under monopoly, the entry of new firms being prohibited, the monopolist can earn supernormal profit in the long run.

(f)

Since there many firms operating under perfect competition, total output in the society is larger and the price charged is also reasonable. But under monopoly, total output is smaller and the price charged is unreasonable.

Determination of Price and output (Equilibrium Under Monopoly) :

Marginal Cost and Marginal Revenue : Under monopoly, the firm is a price-marker, a firm can therefore fix the price of its product, given the output. The demand curve (AR curve) is therefore, downward sloping under monopoly, and so the MR curve is below the AR curve The conditions of equilibrium are the same as under perfect competition, i.e.

206


MR = MC and MC curve cuts MR curve from below. Y

AR MR

AR

MR

X

O

Output (units) Short - run

A monopolist can make either normal profits or supernormal profits in the short-run. A monopolist making sub-normal profits will remain in production in the short-run so long as its AVC is covered. Thus, in the short-run under monopoly, there are three possibilities as shown below.


Y

Normal Profits MC

P1

AC

A1

E1 AR MR O

X

Q1 Output (units) Normal Profits

In the figure, E1 is the point of equilibrium, OQ1 is the equilibrium output and OP1 is the equilibrium price. AC = A1Q1

AR = A1Q1


207

AC = AR, the firm makes normal Profits.


Super-Normal Profits

A2

Output (units) In the above figure, E2 is the point of equilibrium, OQ2 is the equilibrium output, OP2 is the equilibrium price. AC = A2Q2 AR = R2Q2 AR > AC, the firm makes Super- Normal profits equal to the area given by P2R2A2C2.


Sub-Normal Profits Covering AVC

208


In the figure, E3 is the point of equilibrium, OQ3 is the equilibrium output, OP3 is the equilibrium price. AC = A3Q3 AR = R3Q3, AVC = R3Q3 AR < AC, the firm makes sub-normal profits equal to C3A3R3P3. Even though the firm makes losses, it continues to produce in the short-run because AVC are covered.

Long - run equilibrium under Monopoly A firm under monopoly may make normal profits in the long-run; however, it tries to make super-normal (abnormal) profits in the long-run. The LRAC is flatter than the short-run average cost curve, but the conditions of equilibrium are the same as in the short-run. E0 is the point of equilibrium, OQ0 the equilibrium output, OP0 equilibrium price. AR = R0Q0. AC = C0Q0, AR > AC so the firm makes super - normal profits equal to P0R0C0P. A Fig showing Long Run Equilibrium under Monopoly Y


LRMC

Po

Ro LRAC

P Co Eo

AR MR

O

MC Qo Output (units)

(f)

Price Discrimination Under Monopoly :

INTRODUCTION By following Trial and Error method, a monopolist fixes the price of his product so as to maximize his profit. There is a second alternative open to the monopolist. He can discriminate between buyers and charge different prices to different customers. This is called Price Discrimination or Discriminating Monopoly. An attempt should, therefore, be made to explain how price discrimination is practiced by the monopolist. Pricing and Output Determination in Different Markets

209

(1)

What is Price Discrimination? Instead of charging a uniform price to all the consumers a monopolist may divide the market into different classes of people. One market segment may consist of poor, whereas another market segment may be inhabited by the rich. The monopolist may charge a lower price to the poor and middle class people whereas he may charge a higher price to the rich customers. Charging different prices to different customers for the same product is called Price Discrimination. Examples of price discrimination are many. A surgeon may charge Rs. 5000/- for operating a middle class patient, whereas he may charge Rs. 10000/- for the similar operation of a rich patient. The skill used in both the operations is the same; but the fees charged to different patients are different. Similarly, different prices are charged by a cinema house for different classes of viewers. All the viewers see the same movie; but they have to pay a higher price for occupying a seat in the first class or balcony. Railway companies also charge different fares to first class, second class and air-conditioned class passengers. As a matter of fact, the passengers in different compartments reach the destination at the same time. But they have to pay different fares for traveling by II class, I class or AC class. Similarly, an electricity company can charge lower rates for domestic consumption and higher rates for commercial consumption. Although there is some difference in the comforts provided to different classes of customers, this difference is negligible. Difference in the prices charged is, however, substantial. Thus, a monopolist can charge different prices to different segments of markets so as to maximize his profit.

(2)

When is Price Discrimination Possible? Charging different prices to different customers is rendered possible in the following circumstances :

(a)

Legal Sanction : Public utilities such as railway or electric supply companies, cooking gas supply companies are allowed under Law to charge different prices to different classes of consumers.

(b)

Nature of Commodity : Price discrimination is possible where personal service sold to the customers cannot be resold. Thus a surgeon may charge a lower fee for operation of a poor patient than a rich patient for similar operation. Similarly, an advocate may charge very high fees to a rich client, whereas he may charge a lower fee to a poor client for a similar court litigation.

(c)

Geographical Barriers : If two markets are separated from each other on account of geographical barriers it may enable a monopolist to charge different prices in two different markets. In

210


international trade, markets are separated by raising the protection wall and different custom duties are charged on the imports from different countries.

(d)

Ignorance of Buyers : Price discrimination is possible if the consumers in one market do not know that a lower price is charged in another market. Ignorance of consumers thus enables the monopolist to charge different prices. Sometimes, the consumers may exhibit an irrational feeling that they are paying a higher price for better quality of goods. It is likely that the customers may know that a lower price for bertter quality of goods. It is likely that the customers may know that a lower price is being charged in another market; but the difference in price being negligible they may not go to the other market. This may enable the monopolist to charge different prices in different markets.

(3)

Conditions of Price Discrimination The foregoing discussion should explain the situations when price discrimination is possible. For price discrimination to be successful the following conditions should be fulfilled :

(4)

(a)

The two markets in which the product is sold should be kept separate. i.e. There should be no contact between buyers in the two markets. If buyers in one market know that the price charged in another market is lower, they would buy the product in another market and sell it in their own market. This will lead to equality of price in both the markets and price discrimination would no more be possible. No possibility of resale of the product.

(b)

The elasticity of demand in different markets should be different. Price discrimination may not be possible if elasticity of demand is the same in both the markets.

(c)

Market must be imperfect.

When is it Profitable? Having known the conditions of price discrimination, it is worthwhile to know when it is profitable to the monopolist. In other words, it is necessary to study the position of equilibrium when the monopolist maximizes his profit. The principles which apply to the equilibrium of a firm are also applicable in this case. An additional assumption to be made here is that the monopolist is selling his product in two different markets. This would make our analysis complicated but it does not affect the basic principle of equilibrium, viz. a firm is in equilibrium when its marginal cost is equal to marginal revenue. One more assumption is that the elasticity of demand in two different markets is different.

(5)

Conditions of equilibrium under price-discrimination (a) MR = MC (B) MRA = MRB where A and B are two markets.


211

On the basis of these assumptions, let us understand when price discrimination would be profitable. Let us presume that the monopolist sells his product in market A and market B. Demand in market A is inelastic or rigid and demand in market B is very elastic i.e. responsive to the changes in price. Under such circumstances the monopolist would raise the price in market A. His sales in this market would not be affected because demand is inelastic. On the other hand, the demand in market B being elastic, a slight reduction in the price would increase the sales. The monopolist would, therefore, raise the price in market A and would reduce it in market B. The volume of sales in market A would remain more or less the same, but sales in market B will increase, on account of reduction in the price would increase the sales. The monopolist would, therefore, raise the price in market A and would reduce it in market B. The volume of sales in market A would remain more or less the same, but sales in market B will increase, on account of reduction in the price. Naturally, the monopolist would have to divert the supply form market A to market B. If sales in market A are slightly reduced on account of higher price, this loss would be compensated by an increase in sales in market B. A pertinent question that arises here is that how long supply would be transferred form market A to market B ? the answer to this question is that the supply would be diverted so long as the marginal revenue earned in market B is higher than the marginal revenue earned in market A. The transfer of supply from market A to market B would be stopped when marginal revenue in both the markets is equal. At this point, total profit earned by the monopolist is maximum and he is in equilibrium. Equilibrium under Discriminating Monopoly Y

P1 E1 AR1 MR 1

O

Q1

X

Output

Market A

Price /Cost/Revenue

Price /Cost/Revenue

Y

Y

P2 E2

AR2 MR 2

O

X

Q2

Output

Market B

Price /Cost/Revenue

(6)

MC C

E MR

O

Q

X

Output

Total A+B (figure 3)

Consider two markets, market A with relatively inelastic demand and market B with relatively elastic demand. In figure 3, E is the point of equilibrium where MR = MC, OQ is the total output of the firm. This is to be sold in the two markets at different prices. In Market B, E2 is the point at which MC = MR which is related to MR2. OQ2 is the output sold in market B and at price OP2. 212


In Market A, E1 is the point at which MC = MR which is related to MR1. OQ1 is the output sold in market A sold and at price OP1. Thus, OQ = OQ1 + OQ2. The price in market A is higher than the price in market B; and the sales in market A are lower than the sales in market B. The total revenue to the firm, however, increases because of price-discrimination. (7)

Dumping Where monopolist is charging a higher price in the home market and a lower price in the international market, it is called Dumping. In Dumping, the losses incurred in the international market are compensated in the home market. The weapon of dumping is successfully handled by the monopolist. In India, dumping is encouraged with a view to promoting the exports. The Indian exporters are selling their products abroad at lower prices. The losses they incur in foreign markets are converted in the home market where higher price is charged. If the monopolist is unable to recover his losses he is given a subsidy or an Export Bounty, by the Government of India. The incentive of export bounties has contributed to higher exports and earnings of foreign exchange.

(8)

Degrees of Price Discrimination The degrees of price discrimination have been elegantly shown by Prof. A. C. Pigou. According to him, there are three degrees of price discrimination. (a)

Under the first degree, the monopolist charges the highest price. This does not leave any consumer's surplus to the buyers. An example of this degree is provided by a surgeon or a barrister who charges the maximum fees.

(b)

Under the second degree of price discrimination the monopolist does not charge different prices to individual customers. Instead, he classifies the customers into certain groups according to the level of their incomes. Thus, he may classify the customers into the rich, middle class and poor customers. He charges different prices to different groups of people. The example of this type is provided by a railway company that charges different fares to II class, I class and Air-conditioned class passengers. Under this degree, the lowest price which the poorest customer from every group can bear is charged. Therefore, it leaves some surplus to other consumers who are relatively better off than others in that group.

(c)

Under the third degree, different prices are charged in different markets. The example is provided by dumping where a lower price is charged in the international market and a higher price is charged in the home market.


213

(9)

Conclusion Thus a monopolist can practice price discrimination by charging different prices to different customers. It is also practiced under dumping where different prices are charged in international and the home market. Such price discrimination,

2)

(a)

adds to the power of the monopolist,

(b)

adds to the profit of the monopolist, and

(c)

adds to the total output than the output under pure monopoly.

Monopolistic Competition - Features (i)

Fairly Large Number of Firms The number of sellers operating under this type of competition is larger than under oligopoly but less than under perfect competition. There may be 20-25 sellers engaged in the same line of business. They are producing commodities which are close substitutes for each other. Every seller has to compete with others to increase his sales. Since every seller is selling a standardized product for a long time, he acquires monopoly of that product. When such monopolistic producers are competing amongst themselves, it is called monopolistic competition. The competition being very keen, the sellers have to find out different methods to maintain their sales and profit. Professor Chamberlin has elegantly shown the methods used by such monopolistic producers. Most of these methods are hazardous and each seller tries to be rich at the cost of others. This competition is, therefore, called cut-throat competition and the methods followed are called 'Beggar thy Neighbour tactics'. It is worthwhile to outline the salient features and the methods of monopolistic competition.

(ii)

Product Differentiation Under monopolistic competition, every seller tries to distinguish his product from the products manufactured by others. He claims that his Research and Development Department has developed a new product after considerable research. As a matter of fact, the product so introduced in the market is not new. The same old product is sold under a different trade name, style, design and colour. Thus, by changing the outward appearance of the product, the general public is made to believe that it is a new product. Basically, it does not differ in quality and the process of manufacture. But the people are fooled by stating that it is a product different than the old one. This is called Product Differentiation. For example, Hindustan Lever Ltd. sells bathing soaps under different trade marks such as Lux and Rexona. Basic contents and ingredients in both the soaps are the same. They different. Lux may be used by one popular actress, whereas Rexona may be used by another popular actress

214


from the films. Differences thus exist only in outward appearance, not in their contents. Such a method of product differentiation helps the producers under monopolistic competition to increase their total sales. (iii) Selling Costs Every producer operating under monopolistic competition spends huge amounts on publicity. He follows all the media of advertising such as press, radio, television, hoarding, sites, neon signs etc. Every effort is made to keep the product before the eyes of the consumers, throughout the year. Whether he likes it or not, he has to spend huge amounts on publicity. This is because when others are spending, he cannot afford to lag behind in the race. Every producer therefore attempts to spend more than his rivals. (iv) Multiplicity of Prices Due to factor-immobilities, or transport costs or ignorance of market, a single uniform price cannot be established in the market characterised by monopolistic competition. On the contrary, similar products which are differentiated by brand names and advertisements are sold at different prices. Every producer enjoys the freedom to price his own product; this freedom is within certain limits. Every producer has his own price-policy. Under perfect competition, this freedom is not available to an individual firm. (v)

Elastic Demand The Average Revenue Curve of a firm under monopolistic competition is not parallel to the X-axis as it is under condition of perfect competition. Because, the products of all firms are not identical, buyers can have preferences. So it is not possible for a firm to sell an infinite amount of the product at the ruling price as it is assumed to happen under perfect competition. Therefore, under monopolistic competition, the Average Revenue Curve of a firm is not parallel to the X-axis as it is under perfect competition. Under monopoly, the Average Revenue Curve of the firm is steep because there are no close substitutes for the product. Under monopolistic competition, on the other hand, a firm’s product does have close subsitutes, and therefore, the Average Revenue Curve cannot be steep. Thus, the AR Curve faced by a firm under monopolistic competition is shallow indicating a highly elastic demand. Therefore, if a firm reduces the price of its product while prices of rival products are unchanged, there would a sizable increase in the sales of the firm.


215

(vi) Price War Another method followed to extinguish the rivals from the market, is a reduction in the selling price. In order to attract new customers, a particular producer may reduce the price of his product. Naturally, other producers are required to reduce their prices in order to retain their customers. Price reduction is sometimes carried to such an extent that it takes the form of a price war. An example of price war is provide by the Indian shipping industry. The Scindia Steam Navigation Company Limited was started by Seth Walchand Hirachand on the 19th June 1919. He purchased a second-hand ship called S. S. Loyally and started the voyage. In course of time, the company made good progress, acquired more fleet and began to compete with the British Shipping Companies. In these days, shipping industry was controlled by the British and the British ship-owners did not like that an Indian company should come up to share the profits. In order to extinguish the Scindia Steam, the British shipowners reduced the freight charges. The Scindia too was required to reduce its freight. The reduction in freight rate went to such an extent that the British shipowners began to advertise in the newspapers that they were prepared to carry the cargo from Bombay to Rangoon free of charge. They thought that the Scindia would not be able to withstand the shocks of the price war; but the Scindia could manage in such critical times and could come up as the nation's largest shipping company in the private sector. (vii) Gift Articles Price war is, however, harmful to all the sellers because it reduces the profits of all. Producers working under cut-throat competition have, therefore, found out a novel method of increasing the sales. Instead of reducing the price, they hand over small gift articles to the buyers who buy the product. The gift scheme is operative only for a limited period and it is advertised in the newspapers on a large scale. This enables a producer to achieve a substantial increase in sales within a short-time. For example, there are many tooth-paste manufacturing companies such as Colgate, Palmolive, Promise, Close-up, Babul, Cibaca etc. In order to increase the sales, a particular company may hand over a tooth-brush free, to a buyer who buys the tooth-paste. Companies like Nescafe or Cadbury organize cross-word competitions. An essential condition for submitting an entry form in the crossword contest is that a certain number of used wrappers are to be attached to the entry form. Since many customers participate in the contest it results in an automatic increase in sales within a short time.

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(viii) Unfair Methods Under cut-throat competition, a number of unfair methods are used to extinguish the rivals from the market. Some of these methods may be described in brief. (a)

A producer who maintains a skilled and qualified staff, is able to produce high quality products. On the basis of quality he can capture the whole market within a short time. Other producers who cannot compete with him may, therefore, snatch away key persons from his factory, by paying them higher salaries. Thus, when the Chief Production engineer is snatched away the quality of goods is deteriorated and the firm loses its control on the market. The other producer, who has snatched away the engineer, may gain control on the market.

(b)

A firm which has prospered becomes a target of attack by the rival producers. They may get hold of the Union Leader in the prosperous company; and may ask him to arrange a strike. This would affect the production schedule of the prosperous company and at the same time, help the rivals to gain control over the market.

(c)

The rivals may try to lower the reputation of the prosperous producer. They pass on false information to the government departments. They may make several allegations that the prosperous producer is evading excise duty, sales tax and income tax. Government departments may institute raids on the prosperous producer. This may lower his reputation and he might be extinguished form the market. Thus, the methods followed under cut-throat competition are hazardous, harmful and immoral. Thus, the market form with characteristics noted above, contains elements of both monopoly as well as competition and therefore it is called monopolistic competition. Products like tooth paste, tooth brush, soaps, detergents, cigarettes, different brands of alcohol, different brands of body talcum powder, cosmetic etc. are produced under the conditions of monopolistic competition.

(1)

Determination of Price and Output under Monopolistic Competition : The foregoing account would indicate how monopolistic competition is characterized by product differentiation, selling costs, price war and unfair methods. It is worthwhile to see how price of a product is determined under monopolistic competition. Every producer operating under monopolistic competition is selling his product under a particular brand or trade name. Before, fixing the price he has to take into


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account the prices of substitutes. The prices charged by rivals enable him to fix his price. A producer who has introduced a new product in the market, would necessarily fix the price which is lower than the price charged by his rivals. The price, fixed in this manner, may not, however, remain constant. The producer may be required to reduce his price, if the competitors have reduced their respective prices. Although an individual producer, under monopolistic competition, is free to fix his price, he cannot fix it without taking into account the prices charged by rivals. The price policy under monopolistic competition is thus dependent on the prices charged by other rival firms. It is, therefore, worthwhile to see how price is fixed and the equilibrium position is reached under monopolistic competition in the short-run.

Short-run Equilibrium under Monopolistic Competition Under monopolistic competition, equilibrium of a firm is arrived at in the same manner as under other forms of competition. A firm's profit is maximum and the firm is in equilibrium when its marginal cost is equal to marginal revenue. This would be clear form the following diagram : Short - Run Equilibrium Under Monopolistic Competition : Profit

In figure, MR is the marginal revenue curve and AR is the average revenue curve. Similarly, AC is the average cost curve and MC is the marginal cost curve. Here, the price is OP and the total profit is TSPP'. The profit is shown by the shaded area. This profit is supernormal. An existing firm can also incur losses in the short- run. If the position of demand and cost is unfavorable, the firm may incur losses as shown below :

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Losses under Monopolistic Competition Y MC

AC

T

P

S

P1

E AR MR X

O

Output

In figure, AC is the average cost curve and it is higher than the average revenue curve AR. Here the firm would incur a loss of STPP'. Thus, in the short-run a firm working under monopolistic competition can earn supernormal profit as well as incur a loss or may earn normal profits.

Long-run Equilibrium under Monopolistic Competition The supernormal profit earned by a firm may not last long; because new firms may be attracted to the industry, and the excess profits would be shared between existing and new firms. The supernormal profits earned in the short-run would, therefore, disappear in the long-run. Another characteristic of long term equilibrium is that a number of substitutes are available in the market. The marginal revenue curve is, therefore, elastic. The following figure would show how the firm would earn normal profits under long-run equilibrium. Long Run Equilibrium under Monopolistic Competition

Cost/Price/Revenue

Y

MC AC

T P E

AR

MR X O

M Output


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In figure, AR is the average revenue curve and MR is the marginal revenue curve. Similarly, MC is marginal cost curve and AC is the average cost curve. The average cost curve touches the average revenue curve at point T. At point E, MC = MR, OM is the ideal output and OP is the price. At this price and output the firm's profit is maximum and it is in equilibrium. (2)

Group Equilibrium under Monopolistic Competition We have seen how equilibrium of a firm is reached under monopolistic competition. We have now to see how and when the equilibrium of all the firms is reached. Under monopolistic competition the number of sellers is large and each seller is selling his product under a particular Trade name. These products are not homogeneous, but are differentiated from each other. It is therefore, difficult to analyse the conditions of group equilibrium where different firms are selling different products. For the sake of simplicity of analysis, we would, therefore, make the following assumptions : (a)

(d)

Competing firms are selling more or less the same product.

(b)

The share of every firm in the total sales is equal.

(c)

All firms are working with same efficiency.

The number of sellers is large and there is free entry and exit of firms. Under these assumptions, let us see how group equilibrium is reached. If these firms are earning supernormal profits in the short-run new firms may be attracted to the industry. The new firms would charge a lower price so as to secure some customers. This will compel the old existing firms to reduce their prices. Naturally, the supernormal profits earned in the short-run will disappear in the long-run. All the firms would then earn only the normal profit as shown in figure. Thus, when all the firms are earning normal profit, the long-run group equilibrium would be reached. This position is similar to the one prevailing under perfect competition. The only difference is that under perfect competition, output is very large, whereas under monopolistic competition output is much less. Another point of distinction is that under perfect competition an inefficient firm is thrown out of the industry whereas under monopolistic competition even an inefficient firm can survive.

(3)

Comparison of Long-run Equilibrium under Perfect Competition and Monopolistic Competition Both under perfect competition and under monopolistic competition the firm makes normal profits in the long-run. However, the price-output situation is different in the two cases. This is seen clearly in figure.

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Y

Cost/Price/Revenue

RMC RAC Pm Pp

E1

Ep

ARp = MRp

Em MRm O

ARm X Qp

Qm

Output The description of the figure showing the comparison between Long run equilibrium under perfect competition and monopolistic competition is as below. Perfect Competition

Monopolistic Competition

1. ARp = MRp (i.e. average revenue equals marginal revenue)

1.

ARm (i.e. average revenue is falling) MRm (marginal revenue is below the average revenue.)

2. Ep equilibrium where LRMC = MRp

2.

Em equilibrium where LRMC = MRm

3. OQp equilibrium output. (also optimum output because LRMC is minimum at this output).

3.

OQm equilibrium output (less than optimum output OQp)

4. OQp > OQm Output under perfect competition is more than output under monopolistic competition.

4.

OQm < OQp Output under monopolistic competition is less than under perfect competition.

5. Full capacity used up because equilibrium output is optimum output.

5.

Waste of capacity is equal to Qm Qp because equilibrium output is less than optimum output. "Wastes of competition."

6. Firm is in full - equilibrium ARp = MRp = LRMC - LRAC

6.

Firm not in full equilibrium.

7. OPp equilibrium price is less than price OPm under monopolistic competition.

7.

OPm equilibrium price is more than OPp price under perfect competition.

8. Firm makes normal profits. (ARp = AC - Ep Qp) at OQp output.

8.

Firm makes normal profits. (ARm = AC = E1Qm) at OQm output.


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We can the conclude, that, the long - run price is lower and output is higher under perfect competition as compared to under monopolistic competition. 3)

Monopsony Another type of imperfect competition is called Monopsony. Under Monopsony, there are many sellers but only one buyer. The buyer is influential and determines the price of the product. He may exploit the sellers by offering a very low price. An example of monopsony in India is provided by the Cotton Corporation of India who purchases all cotton grown by the farmers. Since there is only one buyer the CCI can influence the prices of cotton. Monopsony is the opposite form of Monopoly.

4)

Oligopoly and Duopoly : Oligopoly is a type of imperfect market. A few firms exist in the industry. An extreme case of Oligopoly is Duopoly since Duopoly is an extension of an oligopoly market, it is not necessary to discuss its features separately, where only two firms exist in the market. The following are the features of Oligopoly : (i)

Small number of Producers : The small number of firm dominates the market of the commodity. Each firm has a large share of market supply, therefore, all firms action results in a reaction of other firms in the market. This means that firm under Oligopoly are mutually dependent on each other. In Duopoly, the number of firms is two. These firms are also dependent on each other.

(ii)

Product may be homogenous or there may be product differentiation : Duopolistic or Oligopolistic firms producing raw materials or intermediate products, generally produce homogeneous products, as for example, the production of coal, copper or any other metal; whereas, firms producing automobiles, computers are firms which differentiate amongst their products.

(iii) Restrictions to Entry : Under Duopoly and Oligopoly, there are restrictions to the entry of new firm into the industry. These restrictions are generally financial or technological in nature. However, entry is not impossible under Oligopoly / Duopoly but it is difficult.

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(iv)

Advertisement : If product differentiation exists, it becomes necessary to advertise the firms product. This is done to convince the buyers about the superiority of the product over the products of rival firms. However, if the products are homogeneous advertisement may take the form of informative advertisement.

(v)

Price - Control : Firms under oligopoly / duopoly are mutually dependent. Thus all firms actions results in the reaction by other firms.


If one firm reduces the price of its product, other firms will follow. The first firm will again reduce its price, the other firms will again follow. This process can continue till the price falls even below the cost of production. This situation is called a price - war. Thus, there is a tendency that one of the firms not reducing its price to start with. Similarly, if a firm increases the price of its product, other firms will not follow. The first firm will therefore, lose its customers. To start with, therefore, the first firm will not increase its price. The above explanation leads us to the conclusion, that prices tend to be sticky or rigid under oligopoly / duopoly. (vi)

Demand Curve under Oligopoly / Duopoly : Y D1

K

Price (AR)

P

D2 O

X Quantity Demanded

Demand Curve under Oligopoly Since firms under Oligopoly - Duopoly are mutually dependent, there is a situation of action and reaction by firms. This explains that prices tend to be rigid at OP under Oligopoly / Duopoly. If any firm tries to increase the price of its product above OP, other firms will not react. This results in a large fall in the quantity demanded of the firm which increases the price of its product. The demand curve (D1K) is thus relatively elastic. If however, a firm reduces the price of its product, other firms will also reduce their prices and there would be a price war. The quantity demanded of the firms' product would increase less than proportionately, the demanded curve (KD2) is therefore, relatively inelastic. Thus, the demand curve under Oligopoly, is a kinky demand curve. Price tends to be rigid at the kink, K. Pricing and Output Determination in Different Markets

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More about Equilibrium under Oligopoly : Oligopoly, as we have already noted, is a market structure in which a small number of large firms producing either homogeneous or differentiated products dominate an industry. A characteristic feature of oligopoly is that any change in the output or price of one firm almost always provokes retaliation from other producers. This reaction can take many forms. All the firms may come together to form a cartel or they may openly or tacitly accept the price leadership of the largest firm or firms may enter into non-price competition or a situation of price rigidities may prevail. Producers of differentiated products in oligopoly are actually free to set their own prices. But experience shows that they try to maintain status quo. This is so because a price-cut initiated by any one firm can trigger off a chain of reactions. A price-cut once introduced is not reversible. A price - war may start. Ultimately all stand to lose. Under such circumstances non-price competition on the basis of quality design, service, sales - promotion etc. is preferred to a price competition. Oligopoly prices therefore are found to be rigid. Various models have been suggested to demonstrate the equilibrium and price - and output determination under oligopoly. Prof. Paul Sweezy's model is perhaps the most popular one and hence we shall consider that one model only. This model provides an explanation of price - rigidity, i.e. why price is not changed. The individual oligopolist sees the situation somewhat like this. If he raises the price his rivals would not follow suit and would do the same thing quickly. As a result, at a price higher than the customary one, demand is seen to be highly elastic; while at a price lower than the ruling one, the demand is seen to be highly inelastic. See figure given here. In this diagram, DD1 is the demand curve which is more elastic in the portion DP1 and less elastic in the portion P1D1. Y D P1

P AR,MR,MC

H

MC1 MC

D1

O

R

X

Q Output MR

Figure showing Oligopoly Equilibrium: Kinked demand curve model 224


The equilibrium condition is the profit maximizing condition i.e. MR = MC. Note that the DD1 curve is the AR curve. The marginal revenue curve (MR) is discontinuous between points H and R. It is this gap HR that explains price-rigidity. According to the usual condition MC = MR, we can find out the profit maximizing output. Marginal cost curves like MC, MC1 cut the discontinuous portion HR of the MR curve so as to give the same equilibrium output OQ. The price therefore remains unchanged at OP though costs rise or fall. If the second option of a cartel is chosen by the oligopolists, and if it is a perfect cartel, the price would be determined by the joint MC and MR curves of all firms taken together. All the firms would then adjust their individual supplies to the cartel price as given. Some firms may earn profits and other may earn only normal profits. Due to such differences in profitability, cartels do not last long. At times, therefore, profits are pooled together and are then distributed. But this arrangement also cannot satisfy all. Price Leadership is another possibility when there is one big or established firm, it sets the price and others accept that price for adjusting their supplies. If the product is homogeneous, one price may get fixed. If products are differentiated, a range a prices may move together. Thus, for example, cigarettes, bathing soaps, washing soaps, electric fans; etc. are produced in oligopolistic conditions, in India, and a particular grade of the product is priced between a certain price - range. A change in the price is usually effected by the price - leader and others follow suit. To conclude, therefore, we can say that oligopoly is more common but since it can take various forms, a single model cannot explain its price and output equilibrium. Non-price competition makes things more complex. Rivals use advertising quality changes, competition. A determinate economic explanation as a guide to policy is therefore not possible though broadly one can describe how output and pricing policies are determined by the oligopolists.

Miscellaneous Issues in Monopolistic Competition : Having discussed the determination of price and output under monopolistic competition we are now required to study some miscellaneous issues. These issues are as follows : (a)

Selling Costs

(b)

Non - Price Competition

(c)

Wastes of Monopolistic Competition

(a)

Selling Costs :

(i)

Meaning :

Selling cost is the cost of increasing the sales of the firm. It is the cost which the firm bears in order to try to increase the demand for its product. Selling Costs can


225

be looked at the cost borne by the firm to convince the consumer to demand one commodity instead of another. In effect it means that the cost borne by the firm to 'create' demand for its product is the selling cost. Many times the consumers do not know what they need. It is the producers who have to make the consumers aware of their needs. This is done through selling costs. Sales promotion includes not only taking 'orders' for their goods but also creating demand for their goods. Under conditions of perfect - competition, it is assumed that the consumers have perfect knowledge about the market and thus the concept of selling costs is not relevant under perfect competition. Selling costs is a feature of an imperfect market condition. Selling costs include not only cost on advertisement (which forms a large part of selling costs), but also salaries of sales - managers and sales- representatives, cost on exhibitions, show - room expenditure, cost on attractive wrappings, gifts, etc., thus any expenditure which the firm makes, in order to promote its sales, is selling cost.

(ii)

Selling - cost curve is U - shaped :

Selling Cost

Y

O

S1 Quantity Sold

X

As the sales of the firm increase, the average selling cost (ASC) first decreases (upto OS1 sales), and then the ASC increases (after OS1 sales), thus the ASC curve is a U-shaped curve.

ASC =

Total Selling Cost ––––––––––––––– Quantity Sold

ASC decreases upto OS1 sales because of (i)

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Economies of specialization : As output and sales increase, a large amount is used for promoting sales and the firm can employ experts to increase its sales or Managerial Economics

it can advertise through mass media. These methods of promoting sales are expensive but the sales increase to an extent that the average selling cost (ASC) decreases. (ii)

Economies of repetition : As a firm advertising, initially it does not influence the minds of the consumers. But repeated advertising, slowly has an impact on the minds of the consumers and the sales increase. And ASC decreases.

ASC increases beyond OS1 sales because of (i)

Difficulties in trying to influence the buyers' preferences : Once the weak consumers are influenced, it is difficult to influence the more 'hardened' consumers (who are already using another brand of the product), and so the expenditure on sales increases but sales do not increase much. The ASC therefore, increases.

(ii)

Counter - advertisement by competitors : Once a producer reaches a high level of sales, his competitors are affected and they try to defend themselves by advertising their product. The producer now has to spend more money to increase the sales. The ASC increases.

(iii) Factors influencing selling costs :

(iv)

(1)

Type of Product : With product differentiation, the sale - expenditure increases.

(2)

Introduction of new goods : Firms producing commodities, like clothes, cosmetics, where the fashion and styles charge, have to bear large selling costs.

(3)

Technology changes : Firms producing commodities, like machines, also have to resort to advertisement, but this is of the informative type.

(4)

Other factors : The number of competitors, the psychology of the consumers, the elasticity of demand and promotional elasticity of a product also affect the selling costs of a firm.

Selling Cost and the Demand (Average Revenue) Curve of the firm : There are two effects of the selling costs on the demand curve of a firm. (1)

The demand curve shifts to the right : Selling costs result in higher quantity being demanded at every price. So, the original demand curve DD shifts to the right to D1D1.

(2)

The demand curve becomes relatively inelastic (Steeper) : Selling Costs result in consumer preferences being stronger. If a consumer likes a particular


227

brand of a product, a charge in the price of the product will not affect the quantity demanded of the product, by the consumer. The demand becomes relatively inelastic (Steeper). In the figure the original demand curve DD is less steeper (less inelastic) than the new demand curve D1D1.

Price per unit

Y

X

Quantity Demanded

Effect of Selling Costs on the Demand Curve of a firm

The average cost curve of the firm, AC, moves upwards to AC1 because of selling costs as shown in the following figure :

Average Cost

Y

O Production (v)

X

Effect of Selling costs on the Price of the Product : The selling costs are initially borne by the producers, but ultimately they are passed - on to the consumers in the form of a higher price of the product. This is possible because through selling costs, the demand for the firm's product becomes relatively inelastic, because consumer preferences become stronger.

(b)

Non - Price Competition : We have seen earlier that under monopolist competition the sellers reduce their prices in order to attract new customers. The reduction in price may go to such an extent that it may become a price war. Since this type of competition is based on price reduction, it is called ' price competition'.

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Price competition is, however harmful to all the sellers. Instead of competing by price - reduction they, therefore, use some other methods. When they compete on grounds other than the price, it is called 'Non-Price Competition'. Non-Price Competitions is usually practiced through advertising or gift articles. It is true that spending large amounts on advertising or gift articles amounts to losses. But this loss is preferable to the loss incurred on account of price-reduction. There is a vital difference between the two types of losses. In the first place, reduction in price is against the business ethics. On the other hand, nobody raises any objection if a producer spends too much amount on advertising. If the producers find that the expenditure on advertising does not promote sales, they can curtail it. But when price is reduced it cannot be increased immediately. If expenditure on advertising is fruitful its benefit is permanent. Similarly, the losses incurred on account of price reduction are permanent. Most of the producers operating under cut-throat competition, therefore, prefer to spend more on advertising, rather than effecting a reduction in price. This does not mean that advertising is done through newspapers, radio or television. Since any expenditure on sales promotion is included in the selling costs, the producers under monopolistic competition spend on the following schemes of sales promotion. (i)

Gift Articles : To promote sales, a producer may hand over a gift article to the buyers who purchases the product at the usual price. A customer who receives the article is permanently attracted to the product. For example, various breads are manufactured and sold by companies like Hindustan, Bharat Bakery, Modern Bakery, Kwality, Blue Diamond, etc. A few years ago a new bread was introduced by Bakeman Company. The Bakeman bread at once captured the market because from the very beginning the company was giving stickers along with the bread. Initially the stickers contained pictures of various models of cars. Thereafter, they contained the photographs of the actors and actresses in the popular T.V. series viz. Mahabharat. The children, therefore, developed a hobby of collecting these stickers. Since every Bakeman bread was accompanied by a free sticker, the sales of this bread have surpassed the sales of all other breads in the Indian market. Similarly, toothpaste manufacturers in India give a free toothbrush along with the toothpaste to the buyers.

(ii)

Crossword Contests : Some producers organize crossword contests or painting contests for children. An essential condition is that the entry form to be submitted in the contest, is to be accompanied by a certain number of used wrappers companies like Nescafe or Cadbury organize such contests. The


229

companies which organize such contests also award prizes to the winners. For example, the winner of the first prize can visit Singapore or Honkong at the cost of the Company. Thus, by giving free gift articles or by organizing crossword contests, the producers are able to achieve a tremendous increase in their sales. Since in this type of competition, the price of the product remains unaltered, it is called Non-Price Competition. (c)

Wastes of Monopolistic Competition : Monopolistic competition results in the waste of resources in the following manner : (i)

Selling Costs : Products under monopolistic competition are spending huge amounts on advertising and publicity. Much of this expenditure is wasteful from the social point of view. It is argued that instead of spending so much amount on publicity; producers can reduce the price. This would be beneficial to the consumers and the society at large.

(ii)

Excess Capacity : Under imperfect competition, the installed capacity of every firm is large, but it is not fully utilized. Total output is, therefore, less than the output which is socially desirable. Since production capacity is not properly capacity under perfect competition is fully utilized leading to full employment of factors of production.

(iii) Unemployment : Idle capacity under monopolistic competition leads to unemployment. In particular, unemployment of workers leads to poverty and misery in the society. If idle capacity is fully used, the problem of unemployment can be solved to some extent.

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(iv)

Cross Transport : Under monopolistic competition expenditure is incurred on cross transportation. Goods produced in Ahmedabad are sold in Chennai and goods produced in Chenni are sold in Ahmedabad. If these goods are sold locally, wasteful expenditure on cross transport could be avoided.

(v)

Lack of Specialization : Under monopolistic competition there is little scope for specialization or standardization. Product differentiation practiced under this competition leads to wasteful expenditure. It is argued that instead of producing too many similar products, only a few standardized products may be produced. This would ensure better allocation of resources and would promote economic welfare of the society.

(vi)

Inefficiency : Under perfect competition, an inefficient firm is thrown out of the industry. But under monopolistic competition inefficient firms continue to survive.


Thus under imperfect competition, inefficiency is worshipped and efficiency is dispensed with. PRICING METHODS OR PRICING PRACTICES INTRODUCTION As already discussed, firms pursue a variety of objectives with different weightages to different objectives. The pricing policy of a firm must therefore conform to the composite objective accepted by a firm. This can be ensured by following certain guidelines or 'pricing objectives'. Several such pricing objectives have been suggested; and are actually being pursued by firms. One such pricing objective is stability. Firms tend to keep-prices stable and short-run fluctuations in costs, demand etc. are not allowed to influence the price. Maintaining one's share of the market is another such objective. This is a norm which can be monitored and hence is accepted as an important one. A decline in the market share can be taken as an indication of falling popularity of the product. Target Return on Capital is another objective adopted by firms. A certain target rate of return on capital provides a guarantee of a floor limit. Pricing policy also, at times, aims at meeting or preventing competition as a goal. This approach underlines a long-run view of the pricing policy. Finally, when private firms help the government in carrying out socio-economic programmes like supply of medicines or school books or nutrition's food etc., they follow the principle of Ethical Pricing, i.e. reasonableness of pricing that would create a good image of the firm. The aforesaid principles act as pointers to a proper pricing policy. The method of pricing to be chosen is a major decision. Basically there are two methods of deciding the selling price : 1) Full Cost Pricing and 2) Marginal Cost Pricing. In the first one, cost is the decisive factor; while in the second one, various other consideration are involved. 1)

FULL COST OR COST PLUS PRICING According to this method, the price is set to cover costs; material, labour, overheads and a certain percentage of profit. Costs to be included in the price are normally actual costs, expected costs or standard costs. Actual costs are costs actually incurred in the production period. Expected costs are based on forecasts of production and prices. Standard costs are based on the forecasts made on the basis of the assumption that the efficiency, sales, prices, etc., will be normal. For the profit make-up to be included in costs, various practices are followed. Sometimes profit is expressed as a percentage of costs. By simple arithmetic, a formula is usually evolved. For example, let us say, a producer produces 10 units of product X. He then estimates overhead costs, labour costs and material cost. Supposing allocable to X and divides it by 10. This gives per unit overhead,


231

labour, material cost. Supposing they are Rs.10, Rs.10 and 5, and profit mark-up is 12% of costs, the price of product X per unit will be Rs.1- + 10 + 5 + 3 = Rs.28. Though relating profit to costs is easy, it is not scientific. Profit should be related to investment. Whatever the method of deciding costs and profit make-up, the cost plus the profit gives what is known as cost plus or full cost price. This is also known as basic price because as and when any of the cost component charges, necessary adjustments in price are made accordingly. If, for instance, labour cost increase, the per unit increase in labour costs can be added to the basic price to give the selling price of the product. Inadequacies of Cost Pricing (1)

This method ignores demand. The price the consumer is willing to pay is important for purposes of calculating profits. The price the consumer is willing to pay has no relation with costs. Thus, a price based on cost is one-side.

(2)

This method is easy to operate; but is ignores the nature of competition in the market. Whatever price is fixed is bound to invite reactions form rival firms. But this the method ignores. It also ignores the future possibilities of competition as a result of the price policy.

(3)

The cost-plus method assumes that costs can be allocated to individual products. This assumption, as is clear form the example, we have taken, is unrealistic. Many costs are common and cannot be traced to individual products.

(4)

It considers full costs. This is not always logical. For planned expansion, incremental costs rather than full costs should be taken as a basis. Also to base future prices on present or past costs is equally illogical.

(5)

Cost plus pricing suffers from the fallacy of circular reasoning. Sales depend upon price, production depends upon sales, costs depend upon production (because costs change as level of production change) and price is said to depend upon costwhich completes the circle !

Justification of cost plus pricing In spite of the above mentioned inadequacies, the method is widely used for several reasons which are : (1)

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In practice, businessmen may not strictly adhere to the cost plays formula. Many times this formula gives a comparative picture of prices of different products. But in personal interviews many businessmen say that they follow this method because


this method sounds just, in the sense that cost plus a reasonable profit is taken as price, there is no profiteering and no exploitation of the consumer. (2)

Profit maximization is not the only, or even the principal objective of all firms. The firms want to ensure that they are earning profits which they feel are 'fair'. This can be done by adding the profit mark-up to the cost; by following full-cost method.

(3)

It is possible that the faith that in the long run only normal profit can be earned might be at the roots of popularity of this method. In the long run, this method ensuring fair return to capital appears to be logical.

(4)

In practice, firms are uncertain about the shape of their demand curve and about the return to capital appears to be logical.

(5)

For pricing new products, this method is suitable. If the new product fetches a price that covers full cost, the product can remain in the market. Otherwise, the firm can conclude that it cannot afford to produce that product.

(6)

When there is competition in the product market, and costs are more or less the same for all the firms, cost plus pricing can introduce a particular level of prices and avoids a price-war.

(7)

If an average level of production is taken into account for calculating price, this method is secure in the sense that excessive profits during prosperity compensate for the losses during depression.

Role of Cost-plus Pricing (1)

For product Tailoring : Many times there already exists a great deal of competition in the field where a firm wishes to enter. As such a common level of prices has already been established in the market. Under such circumstances, the producers can first determine the price and work back by calculating the retailers marginal distribution costs, own profit and what remains is the cost of production. A product that first in such a cost by its design, etc., is then selected for production. This is known as product-tailoring.

(2)

For Refusal Pricing : When products are supplied according to specifications given by the customer; minimum price can be decided by full cost method. For example, while supplying school uniforms, minimum price below which the offer cannot be accepted, can be fixed on the basis of this method.

(3)

For Monopsony Pricing : When there is only one or very few buyers for a product, it is desirable to charge full cost price only. This is so because the bulk buyers are mostly business concerns who may otherwise decide to produce the commodity


233

themselves. For example, let us suppose, the university wants to get some books printed. The printing press should charge at 'full cost' rates otherwise the University may decide to print the books in its own press if rates quoted are high. (4)

For Public Utility Pricing : When the Government (or a private company) supplies public utilities like electricity, water, telephone, etc., to the people, cost of service, is considered as the proper basis. Even when an element of profit this included in price, the method is cost plus pricing.

Pricing of Multiple Products The economic theory assumes that a firm produces only one homogeneous commodity. This is done to simplify the analysis. But, in practice, a firm produces many commodities and, in Managerial Economics, it is necessary to take cognizance of this fact and examine the problem of pricing multiple products. Opportunities to produce Multiple Products : A firm gets an opportunity to produce multiple products due to the following reasons. (1)

Excess Capacity : The reason for adding a new product to the product-time is usually to increase profits or to increase competitive strength. To attain this goal, a firm may use its excess capacity (i.e. unused capacity to produce) if it is there. A simple example will make this point clear. Suppose, a press printing a daily newspaper installs new machinery which can print 1 lakh copies. This means half the capacity of the machine is unused. To utilize this excess capacity, the press may think of starting a new weekly, fortnightly etc. In the above example, excess capacity in technical factor is considered. Similar, excess capacity, may occur in the fields of management, distribution etc. The existence of such an excess capacity provides an opportunity to add new products to the line.

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(2)

Seasonal Variations : Some times the demand is specific to certain seasons, i.e., the commodity is in demand in a particular seasons. For instance, the demand for umbrellas. In other seasons, the machinery and other factors may remain unemployed. This provides an opportunity to produce some other commodities during off season.

(3)

Cyclical Changes : When demand fluctuates as a result of business cycles, i.e., when demand increases and decreases alternatively, the firm suffers. These ups and downs in business are more accentuated in respect of durable consumers' goods and luxuries. The producers of such products, therefore, may add some new products which are not affected (or less affected) by these ups and downs in demand.


(4)

Secular Shifts : When there are secular changes in conditions of demand and supply like changes in the tastes of the consumers, income of the consumers, availability of raw material, etc., it may be necessary to drop old products and add new products to the line. For example, in the face of competition of mill cloth, the handloom industry had to introduce a variety of designs to increase its competitive strength.

(5)

Vertical Integration : Vertical integration of different production processes also offers an opportunity for increasing the number of products. For example, printing of books and publication are two processes which can be integration if the publisher purchases a printing press. Now, after printing all the books he is publishing, if the press remains idle for some period of the year, this excess capacity may be utilized by accepting outside jobs like printing of visiting cards, receipt books, hand-bills etc.

(6)

Research : Research creates new methods of production, new techniques, etc. Old techniques then become outmoded. New products are therefore, discovered which can be produced with the help of tile machinery, at hand.

Policy of Adding Products In a dynamic business world, monopoly power does not last long and competition forces firms to introduce new products. Hence, the policy of adding new products becomes important, in practice. In selecting new product; the following problems arise. (1)

Standards of Profitability : The products to be selected are to be considered in order of profitability - the most profitable getting priority. Here, the question is what concept of profit should be adopted? Should the firm use 'incremental profit' as a test? That is, should the addition product is made to bear its share of common costs? If the new product is to be adopted temporarily, the former concept of profit will be appropriate; but id the new product is to be added permanently, the latter concept will be suitable. Once the concept of profit is finalized, the problem of measurement of profit arises. Contribution of each unit to total profits, percentage return to investment and total money profits are the each unit to profit is a better measure of profitability. If, no the other hand, new products are being added on a large scale, percent return to additional investment is a desirable measure of profitability. It is not possible to forecast the profit contribution of a product throughout its life. But such forecasts are usually made for a period of 3 to 5 years and on that basis, order of preferences is prepared for addition to the product-line.


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(2)

Product Strategy : Profit is just one consideration in the policy of adding new. But there are other objectives as well and a strategy of choosing new products has to be evolved, which keeps in view all these objectives. This 'strategy' has to be evolved with an eye on the policies of rival firms. Complementarity is an important part of this strategy. If products in a product-line are complementary to one another, they create demand for one another. For example, if an electric supply company starts the production of electrical appliances like fans, irons etc., the demand for these appliances increases the demand for electricity. Some times, it is desirable to establish the reputation that the firm supplies all alternatives. For example, for a company producing paints and varnishes, it is desirable that it produces all types and shades of paints. This establishes the company's reputation and the customers rely on the company for all their requirements Besides the above considerations, common raw material, common processes of production, common distribution channels, etc., are additional considerations which are important in the product strategy.

(3)

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Criteria for New Products : What has been referred to above as additional consideration can be considered in details as criteria for choosing new products. They are : (a) Interrelation of demand characteristics : New products and existing products may have a demand relationship of either complementarity or of alternative character. A firm may decide to produce alternatives to retain its goodwill and it may also win over new customers if it successfully establishes a reputation as a firm producing up-to date alternatives. Similarly, in case of complementary goods 'we supply the whole range' is a good motto for the firm. If a firm is already producing household appliances like choppers, mixers, toasters, etc., it is desirable to add heaters, geysers, cookers, etc., and make the range a s complete as possible. (b) Distinctive know-how : When a company has some distinctive know-how, it is desirable to add products that can be based on the same know-how. For example, a firm producing electronic appliances can add more electronic appliances only. (c) Common production facilities : We have already seen that new products utilizing existing production facilities and excess capacity are desirable. (d) Common distribution channels : It is also desirable to select a new product that can be brought to the market through the existing distribution channels. For example, a company producing medicines can add a few cosmetics, but not readymade garments. (e) Common raw materials : It is obviously economical to add a product that uses the same raw materials being used for existing products or that which uses the by products of existing products. A textile mill can start the production of towels and bed-sheets or raw cotton blankets. (f0 Benefit to present product lint : Managerial Economics

So far we have considered the benefits of existing products to new products. Here we have to consider the benefit of new products the established ones. This criterion suggests the benefits accruing to the old products (i) of demand inter-relationship, (ii) of research for new products, and (iii) of market surveys for new products. Policy of Dropping Products The policy of dropping old products is as important as that of adding new products. (1)

How does the problem arise? : Sometimes the choice of the product proves wrong Sometimes some other company is merged with a company when the products of that company which are unprofitable also come into the product line. Sometimes due to product improvements effected by rival companies, the existing products become out dated. In all these circumstances, the need arises for dropping old products.

(2)

What are the choices? : When the profit s or sales of a product are found unsatisfactory, the company may try to improve distribution or reduce costs of production or improve the quality of the product. Bulk sales or buying from others and selling under the firm's label can also be tried. When all these efforts are rendered useless the only alternative is dropping the products, i.e., to stop its production.

Cost of Multiple Product In a firm producing many products, the problem of determining costs of individual articles is of great practical importance. The accounting allocation of production cost is useful only for a few-business decisions. They are mainly useful for computing enterprise profits. But these product-costs supplied by conventional cost accounting are, according to Joel Dean defective in several respects : (i) Over - heads that do not vary with a decision are nevertheless allocated to individual products; (ii) the method of allocation is scientific, but arbitrary; (iii) No distinction is made between joint and alternative products, and (iv0 there is no recognition of the significance of controllability of the product mix in estimating costs. The analysis of the economic characteristics of the managerial problems and of the production process can help rectify these defects.

Jointness of Products : The problem of allocation arises when costs are common. This may happen with respect to joint products or alternative products. As we have already seen, joint products are produced together (meat and raw hides and skins). In the case of joint products there are two possibilities : one that the proportions of joint products are variable, i.e. one of the two can be increased by keeping the other constant. If this is the case, the cost of each can be found out by keeping one product Pricing and Output Determination in Different Markets

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constant and observing how much is the increase in costs by increasing the production of the other product. In the second possibility, where the proportions are fixed, like meat and skins, it is not possible to find out individual product costs. When products are alternative, (case of dressed chicken and eggs as we saw earlier), the costs can be estimated by the use of the concept of opportunity costs. For example, the cost of dressed chicken is the earnings foregone of eggs that could be sold. When products are in joint supply, the product-mix is difficult to control when the proportions are fixed. In other cases, product-mix can be controlled. The problem then is easy, as the output of one product can be increased by keeping the other constant.

Allocation of Variable Overheads : The only problem that now remains is allocating short run common overhead costs which are variable. This can be done in various ways : (1)

Share in common costs can be estimated by proportions in traceable costs, e.g., if direct labour cost is traceable and is 10% of the common can also be treated allocable.

(2)

The some method may be applied by taking together all traceable costs, e.g., adding direct labour and direct material to find proportion in total costs.

(3)

The most closely associated traceable cost can be selected as the basis of the allocation of common cost, e.g., the cost of electricity (common cost) can be estimated individually by taking into account the machine hours worked for the product.

Any of these or a different method can be accepted. Thus the jointness of production, is not a difficult problem. To sum up, in case of multiple products, the problem wit cost allocating arises where costs are not traceable. In such cases, more logical methods of allocation than those followed in accounting practices are desirable. Such methods can be found for joint products with variable proportions and alternative products. In case of joint products with fixed proportions, however, the allocation has to be arbitrary, as no logical method of allocation can be thought of. 2)

GOING RATE PRICING

While full-cost pricing takes into account the cost of production, without reference to demand, the going rate pricing emphasizen the market conditions. The firm does have control over its own price and output. However, the firm adjusts its own pricing finding and allocation of costs

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is very difficult. In many cases, where costs are difficult of measurement, this method id adopted. In cases, where a price leader exists and he charges a price in keeping with what the followers are charging, some firm may follow this policy. Where demand is elastic and where price competition is likely to set in motion a price-war, a firm may begin its calculations form price rather than from costs. Thus, for instance, a firm may accept a certain price as a going rate price and then adjust its costs by providing for a certain margin of profits. This method of pricing is simple to grasp and can be of help where the products have reached a mature stage. In such a situation, customers as well as rival firms prefer a stable price. This method seeds to maintain price-stability and allows changes in costs where necessary. Hence cost control is a problem in this method. In a way, this method is exactly opposite the above one; the one we saw earlier was a method of cost-plus pricing. While the one we are discussing here is a method of price-minus costing. B)

Marginal Cost Pricing

One of the most sound pricing practice is the full-cost pricing which we discussed in great detail. Going-rate pricing is, as we saw, approaching the problem form the opposite end. Going-rate pricing, however, is not a policy that could by followed on a permanent and a longterm basis. This is obviously because of the fact that a firm cannot accept the responsibility of controlling costs, all the time. Many elements of costs are such as are hardly within a firm's control. Transport costs, fuel costs, taxes are just a few examples worth mentioning. The second approach to pricing which calls for our attention now is marginal pricing. Marginal analysis occupies an important position in the classical economic theory. A firm's equilibrium can be explained by comparing marginal revenue and marginal cost at each level of output. Where marginal revenue just covers marginal cost, a firm can stabilize its production or output. What price should be charged? One that is given by the average revenue curve (or the demand curve) at the equilibrium level of output, is the answer. The marginal cost pricing appears to suggest that price charged should be equal to the marginal cost. This policy must entail losses and this fact can be ascertained by a look at the diagrams explaining equilibrium of a firm. What marginal cost pricing suggests is that it sets the lower limits a firm can set a price that ensures the targeted or possible level of profitability. The method of pricing we are discussing is 'marginal' cost pricing while the sub-title we have given is 'incremental' cost pricing. Are they the same? Strictly speaking, they are not the same. The incremental principle is commonly used in business decisions. When a firm takes any decision, it involves a course of action. This course of action must have some impact upon total cost and total revenue. According to the incremental principle, the decision can be considered sound if incremental revenue i.e. increase in revenue exceeds incremental cost or increase in costs. It is possible that both these quantities would be negative. In other words, a course of action may involve a fall in cost as well as a fall in revenue. However, the action can Pricing and Output Determination in Different Markets

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be justified if a fall in revenue is less than the fall in costs. As against this, marginal cost refers to the change in total revenue following a unit change in total revenue following a unit change in output. Marginal revenue, in the same way, is a charge in total revenue following a unit change in output. In spite of this technical difference, business discussion usually ignores the difference and the two terms are used interchangeably. In the context of pricing, marginal cost would be the proper expression to denote the method. In this method of pricing, fixed costs are ignored, because marginal cost represents addition to total cost, which takes place due to variable costs only. When fixed costs are high, full-cost pricing is likely to make the price uncompetitive. Marginal cost pricing avoids this possibility. Orders are not turned down because the price offered does not cover average cost. Whatever excess of price over average variable cost is available can be used for meeting profit requirements and contribution towards fixed costs. Marginal cost pricing helps the firm to become more aggressive at the market. The firm can take a full-life perspective and can plan to cover full costs over a long period. Where full-cost pricing is difficult for reasons noted earlier, marginal cost pricing is found to be very convenient, though not necessarily satisfactory. This method has been criticized on the following counts. (1)

In practice, this method faces many difficulties. Many business do not possess the knowledge of finding out marginal cost and marginal revenue.

(2)

Pricing has to take into account, future costs and prices. Due to uncertainties involved on both sides, there always arises a discrepancy between planned profits and actual profits.

(3)

It is pointed out that a strict adherence to marginal cost pricing leads to frequent price changes. Such changes are not liked by the buyers. Moreover, they create problems in planning, distribution and credit sales and purchases.

(4)

A price-cut is usually irreversible and in the absence of a necessary upward revision of prices, the firm stands to lose.

(5)

For a firm producing different products, the cost of operating this method is very high. This is because the operation involves the creation of a machinery that calculates and monitors demand elasticity's, sales forecasts etc.

(6)

Adherence to marginal cost pricing puts the firm to losses because overhead costs are not covered by this price.

The criticism is not fully warranted. The points that this method will put the firm to losses is based on the assumption that MC > AC. We have seen that this holds goods only when c0sts are diminishing. When costs are rising, MC > AC. Again, full-cost principle may suggest that one should not produce so long as all the costs are fully covered. This is obviously wrong. Fixed costs must be incurred even with zero production level. Wisdom, therefore, lies in 240


producing when incremental costs are covered. This, however, would be a short-term policy. Marginal cost pricing therefore should be viewed as measure of suggesting the floor-price of a product and as a guide for modifying profit-maximizing price when market conditions so demand. 4)

SOME OTHER APPROACHES

Full-cost marginal-cost are the two basic methods we noted so far. In practice, we come across a very wide, variety of practices in pricing. Let us consider the major approaches, to pricing which lie at the basis of actual pricing practices. These approaches are not alternatives but can act as complementary or supplementary to one another. (A) Intuitive Pricing : This psychological and subjective approach to pricing is surprisingly very common. Intuitive pricing, as the term itself suggests, is a response or a reaction to the feel of the market. The approach can be variously applied. Price based on pure lunch can be taken as a starting point. At the other end, price based on full cost is taken as a basis. This priceestimate can then be modified according to the market conditions and the nature of competition. Thus, though the approach is intuitive, the price cannot be entirely left to the intuition of the entrepreneur. The success of pricing policy can be judged by whether the price that the firm needs and that which the buyers want is the same, or at least, the two come very close. This is hardly possible and requires a great deal of knowledge on the parts of both sellers and buyers. Some managements can guess correctly the future treads in demand and competition. Their intuitive prices prove to be successful. (B) Experimental Pricing : In search of an optimum price, the firm takes some cognizance of the demand for the product, and proceeds, to fix a price by a trial- and - error method. This is experimental pricing. Usually a sample of test markets is selected, and price is varied to see the reactions. These reactions are observed and then a price that maximizes profits is fixed. This method is widely used in respect of new products. This method has the potential of providing a scientific base for pricing policy. However, in oligopolistic structure, where buyers cannot be separated, this method has got to be applied with caution. (C) Imitative Pricing As the name itself suggests, the firm fixes its price equal to, or in some proportion of, the price of another firm. We have already noted the possible price-leadership situation in the context of oligopoly. A firm that initiates a change in price in the price-leader. Other known as price - followers, make adequate change in price. Price-leader usually has a large share in the market or an established reputation or a sound profit history. Others, therefore, hope to gain by the leader's experience without risking their own market share.


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Imitative pricing perhaps is the easiest method to follow and finds popularly in many fields. Especially in retail trade or in other manufacturing areas where monopolistic competition exists, prices are kept imitative so as not to disturb the inter-firm competitive structure. The firm can then conveniently concentrate on non-price competition. The disadvantage of this method is that it sacrifices flexibility and leaves no room for adjustments as per local conditions. 5)

SOME GUIDELINES FOR FIXATION

The foregoing discussion concerned some of the approaches to pricing. We shall now try to provide practical guidelines evolved by people through their business experience. These guidelines are important in bridging the gap between theoretical prescriptions and practical applications. (A) Single Product Pricing

1.

Pioneering Price Every product has a life-cycle : a product is new, it clicks and gets established; but after some time stagnation and decline phases follow. Once this fact is accepted, two possible approaches emerge for a pioneering price. They are :

2.

(a)

Skimming Price : The entry of a new product into the market is usually preceded by a great deal of research and promotional expenditure. For a new product, the demand initially is not likely to be price-elastic. A firm can decide to skim the cream of the market by charging a high price. Subsequently price can be reduced to reach lower income customers.

(b)

Penetration Price : Alternatively a firm can begin by charging a very low price to penetrate the market. In the short-run the firm may make losses; but in the long-run profits can be earned. This is because, after capturing a large part of the market, the firm can gradually raise the price. Where large-scale production is likely to reduce costs considerably, this policy is helpful.

Price in Maturity After the take-off a product reaches maturity stage. During this stage, competition is keener, substitutes are available and preference for the product becomes weaker. There aspects of maturity therefore become relevant for reckoning :

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(a)

technical maturity reflected in increasing standardization with set prototypes and less product variation;

(b)

market saturation with weakened preference and a higher ratio replacement sales to new sales; and


(c)

3.

stability of production methods, market shares and price-structures. During this stage, therefore, price should be set carefully by taking into account estimated elasticity of demand, competitive degeneration as well as the possibilities of non-price competition.

Cyclical Price : In course of its life, a product experiences fluctuations in demand. Firms may decide to respond to these fluctuations by reducing off-season prices and raising prices when conditions are brisk. Alternatively, a firm may decide to maintain its quality- and - price reputation by keeping the price unchanged throughout recession and prosperity.

4.

Backward Cost Pricing When competition is keen and quality as well as price are consequential to the buyers, a selling - price is determined first and by working backward, the product design can be arrived at. A wide variety of products including electrical appliances automobiles are subjected to this type of pricing; by cause the market is flooded with competitive products.

5.

Refusal Pricing Many products are such as to serve specific needs of the users. Surgical equipment is an example of this type. High price and profiteering cannot be followed - in such cases. Therefore, cost plus limits as floor price are ascertained. No price-reduction is possible. So, at less than this, he seller just refuses to supply the product.

6.

Psychological Consideration Many times producers resort to tactics which actually exploit the consumers psychologically. Double-pricing is one such tactic. On the price-tag two prices ate printed with upper one, which is a higher one, crossed. The consumer get a feeling that price is lowered by the company and therefore sales get boosted. Prestige pricing is another tactic. A high price is maintained where buyers attach prestige considerations to the product. Customary prices are charged in respect of commodities having kinked demand curves. These are a few guidelines for single product, i.e. where the firm is producing a single product. However, when a firm is producing many products-and such firms are many - a problem of product line pricing arises.

(B) Product Line Pricing A modern firm produces a wide range of products. Under such circumstances, the problem of pricing these multiple products in a product line is of vital importance.


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1.

Alternative Policies of Price Relationship In pricing products in a line, various alternatives are possible. Important among them are :

244

(a)

Price that are proportional to full cost : According to this policy common costs are allocated to individual products. Traceable costs are then added to them and then by6 adding a profit mark-up the selling price is fixed. This is the cost plus price we have discussed earlier.

(b)

Prices the are proportional to incremental costs : Without considering common costs only incremental costs may be taken into account and prices may be fixed in proportion of three products - A, B and C costs are increasing by Rs.4,000/-, Rs.3,000/- and Rs.1000/- respectively, the expected revenue form the three products will be distributed over these in the proportion 4:3:1. By dividing the expected revenue from each by the units of that product, we get the price. This removes the defect of arbitrariness in the first method. But this does not recognize the extent of composition in the market or the elasticity of demand.

(c)

Prices with profit margins proportional to conversion costs : Conversion cost is the cost of converting raw material into final product. This may not be the same for all the products in the line. E.g. the milk collected by a dairy can be pasturised and bottled or can be powdered and filled into tins. The conversion costs of these two are obviously different. If these costs are 4:6 then the profit also may be divide in the proportion 4:6. With this profit added to costs the price can be fixed.

(d)

Price that produce contribution margins that depend upon the elasticity of demand of different market segments : The market is divided into segments according to elasticity. Elastic demand has to escape with a low profit margin while inelastic demand can be burdened with a high profit margin. Firms can take advantage of the ignorance of customers or a desire for distinction or just the laziness of customers. These provide opportunities for changing different prices. The more complicated the process and design of the product the more are opportunities for such discrimination. E.g. the price differences in the case of A and B grade sugar cannot be much. But with different cases and dials, two wrist-watches with the same machines can be sold at a difference of a hundred rupees. In this method, differences in elasticity are taken maximum advantage of.

(e)

Prices that are systematically related to the stage of the market and the competitive development of individual members of the product line : Every product has to pass through three stages : It is introduced reaches the height Managerial Economics

of popularity then lags behind. It is possible that different products in a line are in different stages. An old product should have a law price. A product that is on the top of popularity can bear a high price. A new product has to be low-priced. That is why Mr. E. S. Freeman compares a product line with a family. Young children have a share in costs. The old members of the family earn just enough for their upkeep or live by the pension they get for the work done when they were in this price. But the total cost of the family is covered by the total family earnings. This analogy explains the price policy under consideration most eloquently. What each product should earn is dependent upon the nature of the competition in the market and the elasticity of demand for each product. 2.

Factors to be considered in pricing Of the alternative pricing policies suggested above, whichever is chosen, the following factors need to be considered : (a)

Demand Relationship in the Product Line : Products in the same line have many types of demand relationships. They may be complementary products, e.g. torches and cells produced by the same company. They may be alternative products e.g. different models of a radio set produced by the same company. A new product can be introduced in the market by taking advantages of these demand relationships. This is how new models of radio-sets are introduced, or this is why a company producing tooth past introduces it s tooth brush (complementary) and tooth powder (alternative) as well. Differences in the elasticity of demand provide an opportunity for increasing profits by taking advantage of the ignorance of customers or their craze for distinction.

(b)

Competitive Differences : All markets where products form one product line are sold do not have the same degree of competition. The number of competing firms the firm's share in the total market supply and differences in the nature of competing products indicate the extent of competition. The competition also depends upon the costs of entry, the costs of acquiring new patents. Capital and technical difficulties in starting a new firm etc. the less the possibility of emergence of competition, the more, obvious are the opportunities of increasing profitability by charging high prices.

(c)

Cost Estimates : Each set of process will produce a particular product-mix (i.e. proportions of sales of various products in the line) and a corresponding total revenue and total cost. This is so because as price changes, demand changes and so does the total revenue. Similarly, because supply changes, costs will also change. That set of price is the best which fetches the maximum profit. The cost estimate to be used here will be dependent on the objectives


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of the firm. If for example, profits are subject to letal restriction, full cost should be included. If using excess capacity is the objective, incremental costs are relevant and a nominal profit will be considered satisfactory. 3.

Some Problems of Product - Line Pricing (1)

Pricing Products that Differ in Size : It is desirable to charge different prices for different sizes of a product? Price can be the same if costs and satisfaction accruing to the consumer are the same. E.g. in the case of footwear for adults, costs do not differ much and it is not the that a man wearing a bigger shoe simply because their feet are of different sizes. But if it is decided to vary prices according to sizes, it is desirable to have a systematic pattern. E.g. if a shirt of 75 cm is charged at Rs.40 and that of 80 cm is charged at Rs.45, than that of 85 cm should be charged Rs.50. This has an appearance of equity. While pricing alternative sizes, it is advantageous to reduce the price as the size increases. E.g. the price of a 20ml. bottle of hair oil should be less than the price of two bottles of 100 ml. taken together. This saves packing costs and encourages demand.

(2)

Pricing Products that Differ in Quality : When there are products of different quality in a product line, their prices will be determined in accordance with the objectives of the firm. Sometimes the objective is to bring prestige to the entire line. Then some high price products are kept deliberately. This increases the sale of low and medium priced products. If a company prices its quality neckties at Rs.50 each it can sell cheap ties in large numbers. It is these cheap ties that really fetch profit. If price competition is the objective the firm produces low quality products and charges minimum prices. This enables the firm to project its image as 'a firm charging reasonable prices'.

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(3)

Charm Prices : There has been a belief in the business would that prices ending in odd figures give a feeling that they are reasonable and they appear to be less than what they actually are. This increases sales. This is why prices like Rs.9.95, Rs.24.95 are charged in place of Rs.10 or Rs.25.

(4)

Pricing Special Designs : When a product is custom made or prepared on special order and specifications, what price should be charge ? As already seen, if the customer himself is a producer, full cost price is desirable. Alternatively, what businessmen calla 'parity price' or what economist call 'opportunity cost' should be charged. Managerial Economics

(6)

(5)

Charging Different Prices at Different Times : When the demand is seasonal at least fixed costs are required to be borne in the off-season. To cover such costs concessional prices can be charged in the off-season. For instance, fans in winter and blankets in summer can be sold at concessional prices. It is possible to win new customers by keeping price low at a time when demand is less. E.g. when matinee shows are screened at lower charges, it is possible to attract spectators who are not habituals. The same group may later be habituates and may start visiting regular shows.

(6)

Pricing Repair Parts : Many firms producing spare parts earn more than firms producing the whole machine. Because of the irregularity of demand and the risk of obsolescence, the price of spare parts are required to be kept high. It is desirable to distinguish between parts that can be produced easily which must be sold at a competitive price and parts requiring specialized techniques that can be sold at a high price.

Pricing in Public Sector Undertakings (PSU)

The price policy of public enterprises has special significance: i)

The price fixed by a public enterprise should be such as to enable it to raise adequate resources for re-investment;

ii)

The price policy of a public enterprise should be such as to enble it to operate at the lowest cost possible and maximise efficiency;

iii)

The price policy should be such as to enble consumers at all levels to buy and make use of the goods and services produced by the public enterprise;

iv)

It will have to calculate costs and benefits to the various sections of the community and

v)

The price policy in a public enterprise shall have to consider the requirements of foreign trade, competition from private enterprises, inter-enterprises relationship, etc.

All these factors make the price policy of public enterprises really significant as well as difficult Responsibility for pricing : In a Private company, management has the responsibility of fixing prices for the goods the company produces, though, of course, the broad principles of the price policy are laid down by the Board of Directors representing the general body of shareholders. In public enterprises the pricing function is "diffused over the minister, the department and the managers". The government has the ultimate responsibility to decide about the way a public undertaking will conduct its affairs. This is particularly so when the quantum of profits which the undertaking has to earn is to be decided. Even when the government, through the minister concerned,


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decides about the general price- profit policy in a PSU, the actual details of the price structure will have to be worked out by the managers of the undertaking. In general, therefore, the government decides the price policy while the managers of particular enterprises decide the price structure within the general framework of the government's price policy. Features of pricing in public enterprises In order to appreciate the pricing policy in public enterprises in India, it is necessary to understand the distinctive features of pricing of public enterprises. These features may relate to the demand side or on the supply side.

248

1)

On the demand side, the main problem is one of maintaining conditions of full competition between the public and private sector units. A public enterprise may attract demand because of its special strength. Government enterprises working under competitive conditions are: Ashoka Hotel and Janpath Hotel and the shipping Corporation Ltd. The pricing problem becomes more significant and highly complicated when a public enterprise operates under conditions of monopoly. A private monopoly will generally aim at profit maximizing price but a public enterprise may or may not follow such a policy. Essentially, the price policy of the public enterprise will depend upon the profit target fixed by the government. Generally, the public enterprise enjoying a high degree of monopoly power may opt for a high price structure. On other hand, such government undertaking may opt for a low price structure, if among other things, the management in under a bias for full utilization of resources or maximum production of the commodity or service. The Railways, the Indian Airlines Corporation (till recently) and the Electricity Boards are monopolies. Hindustan Steel Ltd. and the Fertiliser Corporation of India are operating in a seller's market. In these cases, the possibility of inter-unit competition does not exist or is only nominal. In such cases, it is the lowest possible costs which determine the prices in the long run," unless the Government creates, openly or covertly, unequal conditions of competition in favour of public enterprises."

2)

On the cost and supply side, public enterprises are generally set up with large capacities even from the beginning and naturally, larger production up to the full capacity will be accompanied by declining costs. At the same time, public enterprises may get hold of some or all factors at lower prices. For instance, government enterprises may have the advantages of bulk contracts of purchases and concessions available to government. Moreover a government enterprise can get hold of cheap capital either through government subscription or under government guarantee. This is indeed a great advantage for capital intensive projects.

3)

Public enterprises may incur some social costs which private enterprise may not bear at all or may shift to other agencies. For example a public enterprise may engage large labour force, spend more heavily on employees- housing, or provide generous medical facilities and consumer amenities than a private enterprise may be willing to do. Managerial Economics

4)

Public enterprises are subject to the investigations by parliamentary committees, criticism by members of parliament, audit by the Comptroller and Auditor- General and public criticism in press. As a result, they are very careful in their expenditure. This leads to delay in taking important decisions and higher costs naturally follow.

5)

Moreover, public enterprises may have to incur higher costs because they are subject to certain external pressures. For instance, a public enterprise may be forced to go slow in its construction work. Or the Government may decide to over-capitalise the enterprise from the start and hence may force the enterprise to have heavy overhead capital in the early periods. Or complementary resources may not have been developed and may subject an enterprise to unfavorable cost conditions.

Thus there are many distinctive features of pricing in government enterprises which are not generally met with in private enterprises. Price Policies of Public Enterprises in India Government undertakings in India have not developed any precise and uniform policy of pricing. Each undertaking has been following a price policy conditioned by certain internal and external circumstances. Some of the following features of price polity are to be met with in India. i)

Profit as the basis of price policy – public enterprises in India generally follow a policy of profitability. Profits of a public enterprise indicate its efficiency (apart from its monopoly character) as well as serve important sources of self-financing. The Indian Railways and the Reserve Bank of India are two important Government undertakings which contribute considerable amounts to the general exchequer. Sindri Fertilizers,Hindustan Antibiotics, Hindustan Machine Tools, etc. were some of the public enterprises whose profits were ploughed back for expansion.

ii)

No profit basis – Some Government enterprises have been required by law or by the Memorandum and Articles of Association to follow a "no- profit no- loss" price policy. The Hindustan Antibiotics and the Hindustan Insecticides have been following this rule. These corporations have been marketing their products on "no profits no loss basis."

iii)

Import-parity Price – Those public enterprises whose products are in direct competition with imported goods have adhered to a policy of import - parity prices. The Hindustan Shipyards Ltd. accepted the principle of selling the ships in the Vishakhapatanam shipyard at a price approximately equal to the cost of building a similar ship in the United Kingdom.

Guidelines on Pricing Policy The Government of India has issued three guidelines on Pricing Policies for the public sector enterprises, viz., a)

Public enterprises should be economically viable units and an all out effort should be made to increase their efficiency and to establish their profitability at the earliest;


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b)

Public enterprises which produce goods and services in competition with the domestic producers, the normal market forces of demand and supply will operate and their productivity will be governed by the prices prevailing in the market; and

c)

Public enterprises which operate under monopolistic and semi-monopolistic conditions, the pricing of their products should be on the basis of the landed cost of comparable imported goods which would be the normal ceiling. According to the Bureau of Public Enterprises (1986-87). "it has been accepted in principle that prices of products produced and services rendered by public enterprises should be so determined that at a satisfactory level of capacity utilization these enterprises not only cover their costs of production, but also generate a reasonable amount of surplus"" Profit making in public enterprises is considered quite consistent in public purpose. There may be situations where profitability in the strict sense of the term may be somewhat of secondary importance. For instance, the prices of infrastructural services and basic industrial and agricultural inputs, such as transport, coal, steel, petroleum products and fertilizers, have to be regulated /administered in line with economic costs to prevent a spiralling effect on prices. In general, the prices of such products and services should be rationalized in a manner as to cover total costs and bring about a fair margin of return by means of general improvements in efficiency and greater utilization of capacity." With this policy, the Government took a number of decisions in raising the prices of steel, coal, petroleum products, fertilizers, aluminium, molasses, alcohol. Similarly the price of indigeneous crude oil was revised. These price escalations are motivated by the desire to earn more revenue for the Government. The critics however believe that instead of absorbing the rise in costs by improving efficiency and productivity, the govt. has been adopting the rather easy method of raising administered prices. The Government intends to generate more profit by the use of its monopoly power. The critics further state that this is in direct conflict with the guidelines on pricing policy laid down by the Government.

(7)

Pricing in co-operative societies

In India, the co-operative sector has expanded considerably in the last 50-70 years. However co-operative management in India, for most of its part, has come under criticism for the lack of professionalism, absence of marketing skills, lack of productive efficiency and cost-heavy structures. Of late there are signs of the emergence of a professionally managed co-operative sector. In the areas of food processing, milk production, transport, production of sugar etc. several cooperative institutions have made their mark. Pricing of products/services in these co-operative organizations now needs our attention. Production in the co-operative sector, in a way, stands between that in the public sector and the same in the private sector. Like the public sector, the co-operative sector also has to fulfill certain social objectives and a purely commercial approach is, therefore, ruled out. At the 250


same time, some co-operative organizations are operating in competition with private sector organizations and are expected to remain economically viable. As such, the pricing policy of co-operative societies conforms to the norms of public sector pricing where the situation so demands. Alternatively, in some cases, they have to face market competition and have to set competitive prices or leave the prices to the market forces. 1)

Cost-based pricing : In many cases, pricing aims at covering the total cost. This is applicable to societies where goods/services are of an essential nature and the benefits of the services are required to be distributed among the users in the form of cheap or fair priced availability of goods/services. Distribution of food grains, lift irrigation services are examples of this type. In some cases cost-plus pricing method is followed in this case, the price is fixed to equal average maintenance of certain quality of products/services. In the first case the price is said to equal the average cost; while in the latter case, some profit is ensured for the organization. In cases where all the beneficiaries are only the members of the co-operative society, full-cost pricing (or price equating average cost) is followed. In cases where the number of users is much larger than the number of members, cost-plus pricing is followed. The credit and micro-credit societies belong to the former category.

2)

Subsidized pricing : Many co-operative societies are following certain social objectives. Weavers' societies, handicrafts societies or farm-service societies are examples of this type. Such societies have objectives like providing employment, preserving traditional skills, supplying cheap inputs or supplying onsumers products ay fair prices. Such societies are therefore based on 'average cost minus subsidy per unit basis. Sometimes the subsidy is available in a lumpsum and sometimes it is paid in thus form of rebate per unit of the product sold, as in case of handloom fabrics.

3)

Demand- based Pricing : In many producers 'co-operatives pricing is required to follow the dicates of demand. In keeping with the law of demand, the price is an important independent variable and lower the price the greater is going to be the demand. The society would therefore be free to charge a high price and get a limited demand or charge a low price and get a higher demand. Sometimes, if the society enjoys a certain amount of monopoly, it can resort to price discrimination. Discrimination can be as between and the rest of the society or as between different uses or as between different places. As a case of discriminating prices one can cite the example of dual pricing of sugar which was followed in India. I this case, the government imposed a certain percentage of levy on sugar factories most of which are in the co-operative sector. This levy sugar quantity was purchased by the government at a low price and was distributed through fair - price shops at remaining sugar produced by the factories, they were given the freedom to price sugar in such a way as to compensate for the loss they incurred in selling the levy sugar to the government and also to charge a costplus price and supply


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the sugar to the market as free sale sugar. Other pricing practices like penetrating price and price skimming are also at a loss in the beginning for penetrating the market and then raise the price when the favourable conditions at the market so as to earn maximum possible profit. It is necessary to remember that such commercial and competitive practices can be followed by a very small number of co-operatives which are competitive enough both in terms of quality as well as cost of production. For example, co-operatives like Anand Milk Union Ltd. (amul) can afford to follow such practices. 4)

Competitive Pricing : When a society is embarking upon a new venture, it has to price its product on the basis of going rate and many times such a rate has got to be comparable to imported products. When there exists competition among the local producers, the price has got to be comparable to the range of prices of similar products produced by other firms, For example, societies producing milk and milk products, or those producing mango pulps or orange syrups and squashes have to set prices which are comparable to other firms' prices of their existing products. Sometimes, sealed bids are sell the bagasse in their factories by following this method. The pricing methods discussed above are subject to regulations and rules framed by the government, in this regard. CO-operatives are in the jurisdiction of the state government in India and, in many cases, the prices charged by co-operatives need an approval of the stat government. This is especially true in respect of prices of commodities like milk, sugar, cotton and cotton-yarn, etc. This is because the commodities concerned have either the potential of generating cost-push inflation or they are essential consumption goods which can exclude poor consumers when the goods are priced high.

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Exercise : 1.

How is the price of a product determined under conditions of perfect competition in the short run and in the long run?

2.

Explain how price is determined under monopoly? What is price discrimination? When is it possible and profitable?

3.

How is the price determined under monopolistic competition in both the short and long run ?

4.

Write Short notes on : (a) Perfect Competition (b) Monopoly (c) Monopsony (d) Selling costs (e) Wasteges of competition. (f) Short run cost curves (g) Imitative pricing (h) Intuitive pricing (i) Customary prices (j) Features of oligopoly (k) Non-price competition (l) Pricing in public sector undertakings (m) Cost plus pricing (n) Pricing in cooperative societies (o) Changes in equilibrium price.

5.

What guidelines for price fixation can be suggested?


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Chapter 7 COST BENEFIT ANALYSIS

Preview Introduction, Private versus Public Goods, Government Investment, Overall Resource Allocation -Steps in Cost-Benefit Analysis-Justification for the use of Cost-Benefit Analysis. INTRODUCTION The cost-benefit analysis, in a very narrow sense, would just be limited to finding out the benefit cost ratio which happens to be a measure inter alia, to analyse various investment opportunities and to find out the worth of each of them. However, in its broader sense, cost benefit analysis refers to the analysis undertaken to judge any project f investment whether government or private and find out its worth and facilities its comparison with other available opportunities of investment. In this sense, the cost-benefit analysis refers to finding out the worth of investment and enable ranking of optional investments by using any one of the methods (or more than one methods in combination). It should be obvious that anybody contemplating investment must try to judge its cost benefits. But whatever has been said here, regarding the 'broader' sense has a reference to a micro level decision, whether by a private or by a public sector undertaking. However, in the broadest sense, the cost-benefits can be adopted on a macro level either at the level of the economy as whole, as a part of a five year plan, or for the public sector activity where such a partial or overall analysis is more important a guide for the government as well as for the business world. 1.

PUBLIC GOODS VS PRIVATE GOODS :

The Product Divisibility There are certain goods the availability of which to users can be decided in a discriminatory manner. A good may be priced in the market and only those may be allowed the use of it who pay its stipulated price. To put it differently, such a good may be priced and the principle of exclusion may be applied to its use. Those who do not agree to pay its market price, or those who cannot pay for it, are excluded from its use. In this way, the good becomes divisible so far as its use is concerned. Thus, the ability to price a good, its divisibility of a good and the Cost Benefit Analysis

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exclusion principle, all go together. The indivisibility characteristic is also stated to mean that each individual has an access to the entire amount of public good. His use of it does not reduce its availability to others. Tuning in of a radio or TV programme by one does not deprive anyone else from enjoying the same programme. On the other hand, it may be that in the case of a certain good, some members of the society cannot be prevented from its consumption, provided some other members have the access to its use. A typical example would be the defence service. Once the country is protected against foreign aggression, every citizen is more or less equally protected and benefited. A section of the society cannot be excluded from enjoying the benefit of this protection. The defence service, in other words, is indivisible. It cannot be priced in the market in order to deprive some members of the society from its use or its benefits. In some cases a consumer cannot surrender the use of a service even if he wants to. An individual cannot ask to be left undefended by the defence arrangement of the state, or refuse the benefit of a reduction in air pollution or that of street lighting etc. People voluntarily decide to pay for the supply of good which can be priced and to which the exclusion principle applies because those who do not pay can be excluded from its use. If, for example, an individual does not voluntarily agree to pay the market price for the milk, the market would refuse to supply him the required quantity. But we have seen that this exclusion principle can not be applied to the indivisible goods. And this creates a problem of raising the necessary finances in their case. For example, in the case of defence service, every individual would argue that even if he does not pay for it, the supply of the service will still be there. So he would rather avoid the payment and let others contribute for providing the defence service. Under the influence of this argument, very few would pay voluntarily, hoping that through the contributions and efforts of others the service will be there. This is referred to as the problems of free riders - which means that everybody would like to have the benefit of the good without sharing the cost of its supply and so the necessary finances cannot be raised on a voluntary basis. As a result the provision of such a good or service has to be made through compulsory contributions by the members of the society - such as through taxation. In the case of a good which cannot be priced, the buyers would decide, through their demand, preferences, whether or not it is to be supplied at all; and in case it is to be supplied, then they will also decide about the quantity of its supply. But in the case of an indivisible good, such decisions cannot be taken through market mechanism. The society has to decide the way in which these decisions will be taken and financed and these decisions need not be unanimous. As seen above, since very few individuals beneficiaries will be ready to pay for it voluntarily, there is to be some form of compulsion in providing the necessary finance. The decisions regarding these goods are, therefore, left to the government agencies. The indivisible goods, whose benefits cannot be priced, and therefore, to which the principle of exclusion does not apply, are called pure public goods. Pure private goods, are completely

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divisible and to them the principle of exclusion applies in full measure. In the market, any one who disagrees to pay (or cannot pay) the requisite price would be excluded from their consumption. It must be noted that the indivisibility of a good does not necessarily imply that every citizen of the society has actually an equal share in its benefits. People living near the political boundaries of a country may, for obvious reasons, be relatively less protected. People living near public parks are actually more benefited even when the parks are accessible to all the members of the society. Thus, the main criterion of indivisibility is that the good in question should be equally available to to all the members of the society (or a section there of) irrespective of the ability or willingness of the individual members to pay for it. The financing of the concerned activity has to be through public expenditure and not through market pricing. This conclusion implies that the pure public goods must be in the hands of public sector only. It, however, does not prove as to which sector (Public or Private) should provide the pure private goods. In order to get an answer to this question we have to consider the following additional factors: i.

The level of the efficiency at which the public and private sectors may be expected to operate and productive resources at disposal of the two sectors;

ii.

The political and social considerations such as the philosophy that the economy should not be dominated by private monopolies.

iii.

Additional characteristics of pure public and pure private goods.

Externalities Another important characteristic of pure pubic goods is the existence of externalities. The term externalities refers to the economic effects which flow from the production or use of the good to other parties or economic units. Such economic effects may also be called spill-over effects, neighbourhood effects or third party effects. Such an externality may be an economic gain or an economic loss to other economic units and would be referred to as pecuniary externality. (This is in contrast with a technological externality in which the consumption/ production levels of an economic unit affects those of others in the economy.) This affects the prices in the economy which in turn transmit their effects on to production and consumption decisions of other economic units. This causes a divergence between the "internal" (or "private") and "social" marginal costs (or benefits) of the goods in question. Thus, for example, a powerhouse using coal would cause a lot of ash-throwing in the neighbourhood through its chimneys. Similarly, the railways using a lot of coal in firing the steam locomotives put the residential and other areas near the railway loco-shades to a lot of sufferings on account of smoke nuisance. This is a cost to society but not to the individual undertakings like the power house or the railways. Similarly, driving the smoke-emitting buses and trucks in the cities add to the social cost of these transport facilities. An example of the externalities in the form of an

Cost Benefit Analysis

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economic gain would be the benefits of social overhead like a road to areas and the industries served by it. These externalities are of two types: i.

market-external effects, and

ii.

non-market-external effects

When the external effects cannot be priced in the market with reference to the demand and supply behaviour, they are termed ‘non-market-external effects’. It means that through the market mechanism, individual economy units cannot be protected from the economic loss (or cannot be excluded from the economic gain) resulting from the public good in question. Thus, in our above example, it is highly difficult to apportion the economic gains of the new road amongst its beneficiaries. Even if it was possible to identify some of the beneficiaries such as those who actually use the road, other beneficiaries would be left out. Therefore, the pricing of economic benefits of a road would not be strictly satisfying the rule of exclusion. It would follow that such public goods as have non-market external effects should be preferably in the hands of the public authorities (provided they can run these undertakings efficiently) since they can decide about the creation and location of industries producing public goods irrespective of their commercial profitability of the same. Thus, it follows that those amongst pure public goods which have non-market external effects would qualify for inclusion in the public sector. Those pure public goods which have market external effects may be left in the hands in private sector from this point of view. (However, remember that even then the characteristics of indivisibility of pure public goods still tells us that they should be in the hands of the public sector only). By contrast, a pure private good is supposed not to have any externalities. In its case, there will be no difference between private and social marginal costs of supply. The market pricing would, therefore, be representing the social cost of supplying the goods and so even if it is left in the hands of private sector, its supply would be at the socially optimum level. Ordinarily, therefore, the provision of pure private goods should be entrusted to the private sector. But on account of various reasons this may not be adhered to in every case. The government might decide to step in where 'merit wants' are concerned. Other relevant considerations could be the cost conditions (discussed below), resource availability, social and political philosophy, and so on. Marginal Cost A likely characteristic of a pure public good is that its marginal cost would be zero or close to zero. It means that an additional member of society can be benefited by its use without appreciably adding to its total cost. To put it differently, the use of a pure public good by one more member of the society does not reduce its availability to the others. A good example of it is the tuning in of your radio set. Still another example is that of a bridge over which an additional vehicle may pass without any additional cost to the society. It must, however, be 260


remembered that mostly this principle applies in reality, only to a limited extent. One cannot say that we can keep on adding to the number of vehicles that may use the same bridge; we cannot have the same defence budget if our population keeps on increasing, and so on. Also it may be added that a large number of members of the society may not be able to enjoy the benefits of the public good without adding to the cost of its supply. Similarly, the provision of the public goods may be increased or decreased for budgetary reasons or due to extraneous factors. Pure public goods which possess this characteristic have a strong case for inclusion in the public sector since public goods are indivisible also. In the case of private goods, on the other hand, the argument is basically in the favour of large-scale production - for which either the society should agree to monopolistic type of private enterprise or should go in for public sector. Decreasing Average cost Another likely characteristic of pure public goods is that it would be subject to the law of decreasing costs. Being lumpy, it would be subject to the economies of scale. If the public good is provided in small units, then the average cost is likely to be much more. For example, the average costs of operating a sewerage system would be much less if it serves a wide area than when it serves only a portion of the city. When it comes to the choice between public and private sectors for the provision of goods possessing this characteristic, considerations similar to the ones mentioned above in the case of 'Marginal cost' characteristic apply. IMPURE PUBLIC GOODS It would be noticed that it is highly difficult to come across which fully satisfy all the characteristics of the pure public goods. Similarly, it is highly difficult to come across pure private goods. In general most goods possess elements of both 'publicness' and 'privateness'. The difference between goods is mostly of degree and not of kind. Such goods which are neither pure public goods nor pure private goods are called impure public goods (also called quasi-public goods or quasi-private goods). If the elements of 'publicness' are predominant in the mixture of characteristics of a good, then it may be termed a public good; and in the opposite case, a private good. 2.

STEPS IN COST BENEFITS ANALYSIS :

The cost-benefits analysis is a technique used for analyzing investment and for rating the alternative investment opportunities as well as for ranking such opportunities on the basis of the rate of return to investment. Investment analysis is very important but very difficult due to the elements of uncertainty, changing value of money etc., as discussed above. besides, there are capital constraints and social costs and benefits involved. steps above. Besides there are capital constraints and social costs and benefits involved. Steps involved in the costbenefit analysis are, in fact, the steps involved in capital budgeting and then in analysing various projects from the point of view of an individual investor. The cost -benefit analysis as a method for investment analysis can proceed along the following steps: Cost Benefit Analysis

261

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1)

Identification of a Project : The first thing an investor has to do is to search various investment opportunities for the purpose of finally selecting one of them. In doing so, he has to keep in mind the size of the investments he has contemplated and his own expertise and interest. For this purpose, the investor can get the necessary information from development organizations who are engaged in developing project profiles. He can also borrow ideas from the established and reputed investors within and outside the country. It is possible that he has some new project ideas. Whatever the case, one has to choose a few project alternatives for further scrutiny by carefully including the good or sound projects promising a high rate of return.

2)

Formulation of the Project : Once a list of projects chosen for scrutiny is ready, with a blue print and all details of requirements in terms of land, building, plant and machinery, raw materials fuel, and power, labour and technocrats etc. with prices of each, one can proceed further. The next thing he has to take into account is the capacity likely to be created and possible utilization of the capacity over time and the prices at which the products could be sold over the time -span considered ads the life of the project. After the alternatives are formulated, each of them has to be examined in terms of its feasibility. Feasibility of implementation includes technical feasibility, i.e., the availability of land, plant and machinery, raw materials, and technical know-how; financial feasibility, i.e., availability of finance in time and at reasonable rates and for desired time periods; economic feasibility ,i.e., prospects of employment generation, development of backward areas/ social groups etc.; and management feasibility ,i.e., availability of management personnel for implementing and running the project smoothly and professionaly. It should be obvious that some of the projects identified and selected for scrutiny could be dropped at this stage because they are not feasible on anyone or more of the feasibilities listed here.

3)

Appraisal and Selection of the Project : Appraisal of feasible projects refers to their assessment in terms of economic viability. This can be done with the help of projected cash outflows and inflows from each project and then comparing them out on merit. For this purpose various measures used for evaluating the investment worth, including costbenefit analysis, can be adopted. Through this step of screening, those of the selected projects which are viable as well as within the investment limit contemplated by the investor are selected.

4)

Comparison of Cash-Flow : Projects which pass the third test of feasibility are then put to best comparing the cash-flows by using the cost-benefit ratio (or any of the other measures discussed above). If and where critical values are involved, each measure would produce several outcomes. This would enable the investor to compare the rates of return along with the risks involved. This sort of comparison is of crucial importance because one determinate mathematical solution is not available and one has to be guided by one's subjective evaluation of the risk involved as well as one's attitude towards Managerial Economics

acceptance of risk. One may select a project promising high returns with high uncertainty or low profitability with low risk level. 5)

Selection and Implementation: Keeping in view the funds available for investment one or more of the projects can be selected for implementation. The selected projects will then be implemented in accordance with the blue prints already prepared. While implementing the project after it being commissioned, it is necessary to monitor the project on a regular basis. This includes ensuring the projected time period involved is observed in practice, after ascertaining the quality and quantity are as per norms assumed and the marketing of the product industrial relations, repayment of loans and payments of dividend follow the norms anticipated while formulating the project.

6)

Mid-term Project Evaluation: A post- compilation audit of the project is the last step. But in respect of long term projects, amid-term appraisal is always desirable. This can be done by re-calculating the measure of investment worth with a view to find out the actual worth and compare it with the anticipated worth at the stage of anticipated worth estimated at the formulation stage. This would enable the investor to find out whether the expected results have been realized or not and then find out the causes responsible for divergence between the expected and the realized results. Such an appraisal provides opportunity for rectifying any mistakes and improving upon the performance.

3.

JUSTIFICATION FOR THE USE OF COST-BENEFIT ANALYSIS :

We have discussed above various techniques of measuring the worth of investment. However, the reader must have realized that all these measures use the rate of return as the criterion for deciding the acceptance or rejection of an investment project as well as for ranking of the projects. it is only the cost -benefits analysis which provides as insight into the private as well as social costs and benefits involved. It can also incorporate other consideration besides the monetory returns, for assessing the worth of an investment. In justification of the cost-benefits analysis, therefore, we can enumerate the following arguments: 1)

Social Costs and Benefits : As discussed in a subsequent section, the government has to intervene, regulate and even control; the business activities even in a market-driven economy, as and when necessary. We have also noted the distinction between private and social costs and benefits. At the macro level it is necessary to minimize the divergence between public and private costs and benefits. By going through the exercise of finding out such divergence it becomes the duty of the government to formulate adequate policies aimed at minimizing such cases of divergence. However, it is in the interest of private firms to look for social benefits and costs involved in their private project and take necessary measures to reconcile the conflicting interests. This is possible by resorting to a modified version to reconcile the conflicting interests. This is possible by resorting to a discussed in detail.


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2)

Intangible Factors : many times certain intangible factors enter into the consideration of project appraisal and such factors are not unimportant. The prestige of the business firm, the reputation or the image of the firm in the market, the moral of the employees, the long stranding tradition of then company or the ideas and the values inherited by a company over the long period of its existence are some such examples. Under such circumstances, the pecuniary (ie monetary)considerations may not be proper guides for acceptance or rejection of a project. It is true that these ultra-financial criteria are difficult to quantify. But this cannot be an excuse for discarding them. There are ways like shadow/pricing which can be adopted for computing costs or benefits of such intangible factors. This is possible only with the broad-based or a comprehensive cost-benefit analysis.

3)

Overall Profitability : A strict adherence to the rate of return criterion would lead to the choice of a smaller investment proposal with a higher rate of return. In such a case, a proposal with a smaller rate of return but a larger size of investment would get rejected. Such a decision would lead some of the funds unutilized. In fact the overall profitability, i.e., the rate of return related to all the investible funds available with the company rather than funds actually invested would be a better guide to investment policy. Such a criterion can be evolved with the help of cost-benefit analysis.

4)

Certain Uncertainty Vs. Uncertain Certainty : uncertainty is an important element in case of any business in the modern dynamic competitive world. But the investor would always endeavour to minimize uncertainty. in this exercise he would come across a certain lucrative return whose occurrence ma be rendered uncertain due to the rapidity in the changes of technology and /or changes in the market conditions. As against this, some projects would involve uncertainty which can be incorporated in the measure adopted, as disused earlier. This (latter) then becomes a case of certain uncertainty. The investor therefore is faced with a choice between certain uncertainty and uncertain certainty. When guided by the cost-benefits analysis rather than by a leap in the dark(i.e. purely subjective valuations), the investor would prefer an uncertainty which is certain i.e., estimable.

5)

Social Scale of Preferences : A private firm guided by its own private cost and benefit is likely to ignore the social scale of preferences involving social investments and social urgencies. Such a neglect would accentuate the gap between the organized sector and the unorganized sector in a dualistic developing economy. It is necessary to remember that the development of the economy presupposes the development of the entire society and if no heed is paid to the needs of the deprived unorganized sector, it can act as limping partner and thwart the pace of development. It is for this reason rather than for any other form of social obligation that the business sector has to care for social fall-outs of their activities. The cost benefit analysis is a measuring rod that can be used for recognizing and incorporating the social scale of preferences into the appraisal of an investment proposal. Managerial Economics

6)

National Industrial Policy : Every country has its own set of economic policies including the industrial policy. In India we have the industrial policy announced by the government of India and modification changes in the same are announced from time to time. Besides the industrial policy, there are other policies like the import-export policy, the MRTPA & policies under the act, the monetory policy, the fiscal policy etc. which have a bearing on an industry's performance. While preparing the cost-benefit analysis, cognizance has got to be taken of the implications of these policies upon the costs as well as the benefits accruing to the firm. Further in view of the fact that there is a divergence between private and social costs and benefits, the policies formulated by the government contain correctives for narrowing down the gaps between the private and the social costs/benefits. in fact such policies are viewed as instruments of performing these tasks, inter alia. This fact about the State policy as it effects the performance of industries justifies the cost benefits analysis.

7)

Future Disposable value : The cost- benefit analysis is the right measure for deciding the worth of an investment project and such an exercise is needed to be undertaken with a certain periodicity like a year or two years. This enables the firm to find out the current worth of the project and also enables it to project the future worth over a period of time. Such a regularity of analyzing costs and benefits not only helps to review the performance but also provides basis for acquisitions and mergers etc. which have become a familiar event in the present context of liberalization. With intense global competition and highly dynamic changes taking place in the business world, no firm can rule out the possibility of handing over or taking over or purchasing a share in investment of some other firm. Under such circumstances, a scrupulously carried out cost benefit analysis on a continuing basis has become as important prerequisite.

8)

Unforeseen Circumstances : in spite of all the efforts at a systematic planning of future steps and the incorporation of uncertainty in the investment analysis, contingencies and eventualities may occur which were unforeseen at the time of the launching of the project. Natural calamities, wars, mass riots etc., are such examples. Such calamities not only demand urgent steps and expenses to make good the losses but also a quick quantification of such losses. For this purpose cost-benefit analysis can be of great help.

4.

COST-BENEFIT ANALYSIS: PRIVATE AND SOCIAL :

We have noted earlier that economics and accounting concepts of costs are different. We also saw that the economic concept of opportunity cost is more relevant than the accounting concept of total cost or individual resource cost. This is why, when we come to the distinction f\between private and social cost-benefit analysis, the latter is recognized as economic costbenefit analysis to be contra-distinguished from financial cost-benefits analysis which his analogous to private cost- benefit analysis.


265

It was well-known Cambridge economist, Prof. A.C. Pigou, who discussed at length the divergence between (what he called) Marginal Private Net Product and Marginal Social Net Product (MPNP and MSNP), way back in 1920 in his book economics of welfare'. this pathbreaking work not only placed the 'Welfare Economics' branch of economics on the right pedestal it deswerved, but also triggered off pioneering line of thinking in the area of private Vs. social accounting of resource allocation emerging through the market mechanism. Modern economists treat the social costs and benefits as externalities of private investment and production decisions. Prof. Samuelson, for instance, uses the terms Marginal Social Damage (MSP) and Marginal Private Damage MPD to denote social and private costs of externalities like pollution and goes further to clarify the divergence between the two and the costs of abatement of damage involved for the private enterprise and the society as a whle and advocates public intervention for reconciling the two abatement costs. Managerial economics, as a social science more concerned with the application of economic principles to management practices, relates this divergence to the cost-benefit analysis. The firm’s cost-benefit analysis would remain incomplete, and even irrelevant in the modern business environment, if the social aspect of its operation is neglected. Its is therefore, necessary to understand the distinction between private and social cost-benefit analysis.

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i)

Private Vs. Social Goals : In a market economy, a firm in the private sector basically aims at maximization of money profits. Social goals, on the other hand, are different. At the level of the society as whole, the macro-economic objectives of economic stabilization, employment generation, reduction in the distribution of income, promotion of regional balance in course of economic development, economic development itself alleviation of poverty etc., are important. the 'divergence' noted above starts from the divergence, between objectives only. A firm is guided by its own private motives and endeavours to make its own investment economically viable. But whatever the firm does may entail externalities which may ne in the contravention of socially desirable goals. It is also possible that the pursuit of social objectives may go against personal or a private firm's interest. It is necessary to remember that the modern business management understands that, in its own long-term interest, a firm has to take cognizance of social obligations as well. But individuals tend to limit their frame of reference to the present. Hence, arises the distinction between private and social valuations of costs and benefits.

ii)

Partial Contradiction between Interests : The classical advocated of near-complete economic freedom believed that if every individual member of the society was allowed freely to maximise his interest, maximum social benefit would be automatically achieved. It was Karl Marx who emphatically refuted this belief. What he meant was, in terms of the well-known dictum,' one man's food is another man' poison'. This is of course partially true. What we have referred to as 'externalities' arise and lead to a conflict of interests which needs to be resolved. Industrialization and concentration of industrial activity at Managerial Economics

one locality leads to several social costs in terms of air and water pollution, emergence of slums, traffic congestions, accidents, strain on civic amenities and several health hazards. All these are social costs not included in any of the firm's account -books. On the other hand, when a private project involves construction of a swimming pool, a play field, a garden etc. which are open to public, social exceeds private benefit. Plantation programmes undertaken for making one's own factory environment - friendly generates social benefits for which no social cost has been incurred. The above examples clearly show that a private project may involve, alongwith private costs and benefits, certain social costs and benefits. Sometimes social costs exceed private costs; while at other times a private benefits would be less than social benefits. Therefore, we can say that there is a partial contradiction as between private and social interests. Private firms tend to be unmindful of both costs and benefits for the society arising out of their pursuits of self-interest. One can not forget the Bhopal gas tragedy entailing social suffering for years on end; nor can we ignore the damage being done by the factories at and around Agra to Taj Mahal. We must pay enough attention to the social costs and benefits involved, though they are difficult to measure. iii)

Valuation of costs and Benefits : A fundamental difference between the private and the social costs and benefits arises due to the problem of finding out the values involved. So far as the private costs and benefits are concerm\ned, they can be found out by taking into account the prices received in case of benefits and the prices paid in case of costs incurred. However when it comes to comparison with social costs and benefits, the problem of valuation arised due to the difficulties in quantifying the costs and benefits. What is the cost of sufferingd by the people due to pollution ? how to value the damage to the priceless heritage of Taj caused by all the industrial units in tis vicinity? For overcoming this difficulty, one method suggested by experts for valuing social costs and benefits was to value these costs and benefits at the world prices; while a U.N. agency advsed to use shadow prices (i.e. resource costs) for the same purpose. In respect of the formar, the problem of valuation of items which are not traded remains unresolved. Therefore, the World Bank, in 1975 suggested a synthesis of the two approaches. According to the World Bank 's approach, the tradeable items would be valued at the corresponding world prices; and the non- tradeable ones at the shadow prices. In adopting both these methods foreign exchange earnings as well as expenses or uses of foreign exchange are valued at the shadow exchange rae(and not at the official or market rate). Siumilarly, the labour cost, too, is computed at the shadow rate. Systematic methods for calculating shadow prices have been evoled in most of the developing countries. In India, the planning commission has evoled sech methods and announces the shadow exchange rates and shadow wage rates from time to time.


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iv)

Methods of valuation : In the valuation of costs and benefits, for finding out the present valuve, one has to use a discount rate. In the private cost-benefit analysis, the weighted average cost of capital for the project can be used for discounting. In respect of the social costs and benefits, our concern is to know the cost to the society. The government, on behalf of the society, undertakes social investmensts. Therefore, one cant trun to the rates at which the government could have got the funds from international financial institutetions, the funds here would be the equivalent of those employed in a private project under review. This rate could be treated as the rate of discount for finding out the present cost of the private project to the society. In case of the private cost-benefit analysis, in this way, private costs and benefits valued at their respectivew market prices are taken into account. This can be done by using various investment appraisal techniques, on he basis of the weighted average cost of capital as the discount rate. By this procedure, one can take the investment decision. In the social cost-benefit accounting, these two are vlued at the world or shadow prices and then various measures of finding out the worth of investment can be adopted. Again, in finding out social benefits and costs, due attention is paid to the social objectives like employment generation, reduction of regional disparities etc. For example, if a project is located in a backward region or provides employment to unskilled workers in large numbers, then the social benefits of such a project are compounded to incorporate these benefits. If a project, on the other hand, is producing goods which are luxuries or are likely to create health hazards, the social benefits would be discounted to incorporate the undesirable effects on society It is necessary to remember that the points of difference between the private and the social cost-benefits analysis relate to (a) the estimates of costs and benefits, and (b) the discount or hurdle rates used. However, the techniques or methods of assessing the investment worth remain the same. in other words, in both these analysis, one can use the Pay Back period method or the Internal Rate of Return Method or the Net Present Value Method etc., for the purpose of judging the acceptability or otherwise of any project and /or ranking of alternative investment opportunities on the basis of their worth. For a better understanding of the divergence between private and social costs, let us take the example of pollution, as is done by Prof. Samuelsonm.He then proceeds to illustrate his point with the help of a diagram. The figure to follow on the next page shows the divergence and suggests the correction of such a divergence.

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Figure Showing Divergence between Marginal, Private and Social Costs and it's Correction

Y

Pollution Standard Inposed

Marginal Social Damage (MSD)

C Marginal Cost of Abatment (MCA)

S

Marginal Cost and Damage per tonne (Rs.)

Z

P

E T

Marginal Private Damage (MPD)

B O

Q2

Q1

R

X

Pollution Quantity (per tonne)

In the above diagram, Marginal Social Damage (MSD) and the marginal private damage (MDP) lines indicate the incremental damage done to the society by the pollution produced by a factory. MPD (dotted line) shows the damage including the done; while the MSD line, which is higher, shows the total social damage including sufferings of the people living around or passing by and inhaling polluted air. The MCA line shows the marginal cost of abatements, i.e. how much the firm will have to pay to reduce pollution per tonne of pollution for every increment of out put. Without any intervention by the pollution control authority, the firm will strike equilibrium at pint P where marginal private cost and marginal private benefit would be balanced. It should be noted that at this equilibrium level of output of pollution, marginal private damage is QT but marginal social damage is Q1S which is at least three times the private damage. If a pollution standard is imposed by the government, the equilibrium point will be at E, the MPD and MSD are equal. If this standard limit is crossed, the factory willhave to pay a penalty plus a pollution tax on a continuing basis. As a result, the MPD line moves upward and ultimately the factor's own MPD plus tax/penalty would make MPD= MSD, so that the gap between the two would be bridged and the equilibrium level will correspond to the standard level of OQ2 which might be judged as the safe limit of pollution. 5.

Policies to Reconcile Private and Public Costs and Benefits : AS we saw earlir, the private costs and benefits ae 'internal' to a firm and as external diseconomies or economies of the activites going on in the firm itself, they are counted by the firm. The social costs and benefits,however, are the external economies and diseconomies resulting fro the firm's activities. they are therefore, known as 'externalites'.


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As some exmples of the negative externalities. i.e. social costs, Prof. Samulson mentions the air and water pollution, risks from unsafe factories or nuclear power plsnts,danger from drunken drivers or gargantuan trucks etc. these he calls negative economies. As positive externalities, he cities the examples of radical inventions, the radio or TV signals that we get free of charge or the benefits of widespread public health measures that have eradicated epidemics such as small-pox, polio,typhoid, plague etc. All these externalities are suggestive of a market failure or an inefficiency on the part of free markets."……… the general remedy for externalities", observes Prof. SAmulson,' is that the externality must be somehow internalized". Interms of the diagram of divergence between private andsocial costs/benefits, we saw that when pollution standards are imposed, the MPD corresponds to the MSD because of the incentive to improve (or a disincentive to degenenrate). Private Action providing Correctives: In most of the developing countries, an action on that part of the government would be necessary in such cases. However, in advanced countries, where the legal and judiciary systems are transparent, private approaches may also succeed. i)

Negotiation: One such remedy is negotiation .If a factory is polluting the water or air of a locality, the local residents can use the company and place a claim fo compensation. The time involved and the affected people and pay compensation to motivate the company to negotiate with the afffectd eople and pay compensation to the people. This corrective ,however, has three limitations: i) the negitiatied compensation would be less than warranted by the damage; ii) the loss o damage must be indentifiable ; and iii) the number of firms as well as that of the affected people must be limited.

ii)

Liability Rules: where tha law clearly lays down reules regarding liability of the person/s causing damage, the affected people can always take resourse to judicial intervention and demand compensation. The court may order a compensation which would fully (or partly) bridge the gap between MPD and MSD.

Government Action: A more effective solution to the problem of internalizing these externalities is an intervention by the government in the form of some action against the generation of social costs. Such action may be in terms of a direct control or financial penalties. i)

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It is observed that in most of the countries, governments rely on direct controls in t matter of combating health and safety-related externalization including pollution. in cases of firms or persons causing damage, the government orders to keep the damage under specified limits which are judged to be safe. Such safe limits are


publicized and those who exceed these limits are penalized. The pollution under control (PUC) certificate to be kept ready for examination by environment. in the diagram we have already seen how such a standard -setting works. The pertinent question however is does this solution work in practice? This brings us to the practical problems and limitation standards involved in the imposition of these and subsequent penalties. These limitations are: i) for choosing a minimum standard, the government has to perform a cost-benefit analysis for which it must have full data regarding damage and abatement costs. Such a situation is almost impossibleto obtain. ii)strictly speaking the standard willl have to be zero, in which case the factory will ah veto be cloe\sed down unless it invents and adopts a new pollution-free-technology. iii) The enforcement of control is not effective enough. In fact, unless the penalty imposed exceeds the cost of removing the short-comings, the private firms/persons will never reach the required standards. They may opt to pay the firm and continue doing he damage because this is a cheaper option. iv) The enforcing officials themselves must be above suspicion, or else they could be bribed to ignore the default, v) finally, the law fails to distinguish between large firms and small firms, more hazardous and less harmful pollutants, and so on. Such a road roller application of standards cannot work. Moreover, under such a system of rules, the big defaulters escape and the small ones penalty. ii)

Externality taxes : Another way suggested by economists is the imposition of an emission tax or an externality tax, in general. The rate of taxation will have to be high enough to induce the firm to adhere to the standards rather then pay the tax. This measure also suffers from certain limitation: i) though economists have advocated these taxes, in practice, very few governments have given them atrial, may be because they think it difficult to impose and collect them. For one thing, the legislative bodies should have the political will to follow this course of action.ii) secondly, the taxmeasure should be economical, I,e, the cost of collection should be reasonable,andshould be cartain, not fetch revenue to the treasury but to hit the target of bringing round these guilty of showering externalities on the society. But these considerations are unattractive to the politicians on whose initiative rests the tax-measure legislation. iii) finally, there is basic conflict of objectives whichstrenthens the inaction referred to in the preceding limitation. The success of this tax measure lies in damage -control but this means the tax would notyield any revenue; and if it does, it would confirm its failure to control the dmage caused by the externality concerned.


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6.

COST BENEFITS ANALYSIS AND OVERALL RESOURCE ALLOCATION :

We saw that in a market economy where consumers and producers are enjoying maximum economic freedom, the role of the government as a producer gets limited. However, the government is not supposed to simly watch what is happening in the economy as a whole. Infact, in a modern economy, the complexities of economic relations have increased so much that the government has to remain on its toes so that no undesirable set of actions is undertaken by any of the economic palyers. Therefore, after carefully outlining the objectives of such a policy, the government has to plan macro-economic policy. The need for such a policy can be stated as follows:

272

i)

Correctives fir shocks and disturbances: Inspite of the fact that the market mechanism functions automatically, the free enterprise system does not automatically adjust itself to the variety of shocks and dusturnaces which are bound to appear in an open economy. for adjusting the economy to such shocks and abrrations, awell thought-out policy has got to be formulated.

ii)

Speeding up the pace of the Economy: Every government has a set of well- defined and declared objectgives that the economy would be expected to attain but by itself the economy may taker a long time to attain these objectives. A macro-economic policy and a governmental intervention is needed to give a stimulus to forces declared objectives. Such an action/policy instrument becomes necessary when the economy is either going to slow or it is going in the wrong direction.

iii)

Weeding out Economic Evils: Unemployment, inflation, business fluctuations etc. are the economic evils which need to be eradicated by adopting the right types of macroeconomic policy instruments. These instruments would serve to stimulate the right types of forces and to discourage or suppose the undesirable trends in the economy. In a dynamic global modern economy, such situations are likely to occur from time to time and they need to be corrected in time.

iv)

Structural Changes in the Economy: The very dynamism of the economy makes it necessary to adopt structural changes in the economy. However, there are several obstacles and frictions in switching over to the new order. But the system demands that these changes must be brought about promptly and properly. The State is, therefore, called upon to intervene and take necessary legislative and regulatory measures for assisting the smooth change-over.

v)

Fine Tuning of the Economy: The functioning of the economy, at any given time, could be going through deviations from the normal and competent course. Under such circumstances many of the economic operations might need a fine-tuning. This task can be performed by macro-economic policy instruments.


[A] Cost-Benefit Considerations at the Macro Level The cost-benefit analysis is expected to provide an approach to the implementation of macro-economic policy which happens to be the responsibility of the government. This approach has been found to be useful in handling the problems related to the welfare objectives. However, welfare consideration follows the net wealth consideration. This is because thecost-benefit analysis is basically devised to maximize the net wealth i.e. to maximize the difference between benefits and costs. Our objective would be to understand the functioning of the cost-benefit analysis as such and then to find out qualifiacations which can be added to this analysis for applying it in the formulation of a macro economic policy aiming at maximizing social benefit. With a view to understand the working of the cost-benefit principles, let us start by assuming that economic welfare as part of total community welfare can be maximized by maximizing net wealth. A little elaboration, at this juncture, is perhaps necessary. Welfare is the resultant of a state contenment and fulfillment which itself is the result of the feeling of satisfaction. Since satisfaction is a state of mind,there is no way of quantifying it. Moreever, satisfaction can result from many non-economic activities. Therefore total welfare of an individual or of the society comprises of various human activities which lead to welfare. Here, we are concerned with economic welfare whch is assumed to be maximized by satisfying as many of human wants as possible. For satisfying wants we need the production and/ or acquisition of economic goods and services. There are, however, various qualification to assumptions that maximization of net wealth maximizes social benefit. In the first plcace, the satisfaction of wants as a pre- condition for wellbeing can be applied and accepted in respect of necessaries of life and of efficiency. But when it comes to comforts and luxurious, the same can not be said .Secondly many economic activities generate wealth but do not lead towelfare. Production and trading of several commodities can be cited as an exmple of this type. Production of cigarettes, liquor or drug-trafficking are examples of this type. Thirdly, on the macro-level, a summation of maximum individual welfare does not automatically lead to maximum social welfare. This is because one man's food, as the saying goes, is another man's poison. Finally, dividing welfare parameters involve value judgements which may vary from society to society and from one set of objectives to another . For acheiveing the maximization of net wealth, full utilization of all the resources is necessary. Ths is because the addition to total level of wealth which we called net wealth is nothing but the net value of producers' and consumer's goods and services produced by the economy during a given period -usually one year. Maximum oyutput that can be produced during a year issubject to the constraint of production possibility which demarcates the boundary or the frontier which cannot be crossed, given the amount of available resources.See the following figure as an illustrsation. In this diagram, the curve


273

AB is the frontier which is known as the production possibility curve or the production possibility frontier. With the resources being given and limited, the limit AB can be rached only by using the resources fullu. In this diagram, we assume that the economy has an option of producing either commodity X(shown along the X-axis) or commodity Y(shown along the Y-axis); or a combination of both X and Y. By using all the resources, the economy can produce OB amount of commodity X or OA amount of commodity Y. Y

Commodity Y

A

E C D

M

O

N

B

X

Commodity X

Figure showing Production Possibility Curve Alternatively, the economy can produce a combination of X and Y as given by all the points on the curve AB or inside the curve AB. For example, point D indicates the possible combination as OM amount of commodity Y plus ON amount of Commodity X. In the same way, any other point on the AB curve, like thepoint E, would show the maximum possible amount of output with varying resources. As against this, point C in the diagram indicates under utilization of resources. As against this, point C in the diagram indicates under utilization of resources, since the production has been stabilized at point C when it is possible to move forward to any other point like D and E. It should therefore be clear what we mean by full utilization of resources. It should also be clear that the terms maximization of output or maximization of net wealth imply reaching any point on the production possibility frontier AB. For maximization of output, we have to utilize fully all the resources available to us which means discarding any position like the one shown by point C and trying to reach the boundary by aiming at any combination of X and Y of our choice. By doing this output can be maximized and employment (which means harnessing the productive resources for producing a given level of output) can also be maximized. If we want to produce more than what the production possibility curve demands, we shall have to reach a point which

274


would lie on another and outer production possibility curve which would lie beyond AB and away from the point of origin O. This would be possible only by raising the productive capacity of the economy, either by finding out or mobilizing additional resources or by increasing the productive efficiency of the existing resources. Such a shift in the production possibility curve indicates economic growth. For achieving economic growth we shall have to maximize the output in the existing conditions of resource-availability. The costbenefit analysis, under the assumption noted above, can serve as a guide for macro economic policy. (B) ADVANTAGES OF COST - BENEFIT ANALYSIS : The policy objective of maximizing the difference between cost and benefit has various advantages which can be noted briefly as follows : i)

It aims at maximization of social welfare through maximization of net wealth, on the assumption that any move that increases net wealth can increase social benefit and, in turn, can increase social welfare.

ii)

In following this principle, the problem of infinite target value does not arise. This is because, by assuming a definite correlation between wealth and economic welfare, the principle can suggest measures to maximise the difference between the total benefit and the total cost.

iii)

By using this analysis we can show the measures necessary for attaining maximum net wealth and optimal policy aiming at this goal.

iv)

Even when a target is partially attained, the costs and benefits can be calculated and whatever change has taken place in the net wealth can be ascertained at that point of time.

v)

The measurement of a trade - off between different targets is always a difficult problem. In this case, the problem does not arise because the money value of costs and benefits associated with the achievement of alternative targets can be explicitly pointed out. This enables us to measure objectively the trade-off.

vi)

In this approach, the cost of a policy measure can be explicitly identified and can be incorporated in the total cost of the project.

vii)

By adopting a suitable discounting method, the costs and benefits as arising in different periods of time in future can be estimated. The problem of assigning costs and benefits to various targets does not arise in this analysis.


275

(C) LIMITATIONS OF COST - BENEFIT ANALYSIS : The cost - benefit analysis as discussed above obviously suffers form certain limitations.

7.

i)

Critics have pointed out that this analysis is applicable in a partial equilibrium framework. However economists like A. C. Harberger have shown that it can be applied to the general equilibrium analysis as well.

ii)

The exactness and usefulness of this analysis is limited by the fact that it is based on the assumption that maximization of net wealth can ensure maximization of social welfare. We have already seen that this is not so.

iii)

The cost benefit analysis is applied on another assumption that the existing pattern of distribution of income, distribution is given and has to be kept as it is. In fact, a change in income distribution does lead to a change in net wealth and further in social welfare.

iv)

Another limitation of the analysis is that it ignores the effect of diminishing marginal utility of additional wealth or income with every incremental dose of income or wealth being added to the existing total.

v)

By assuming the positive correlation between wealth and welfare, the analysis assumes away all difficulties involved in the calculation of present and future cost as well as private and social cost.

vi)

Whatever applies to costs also applies to benefits i.e., calculation of present and future benefits as well as private and social benefits involves similar difficulties.

Overall Resource Allocation :

Market System or Market Economy (or Market Mechanism or Price Mechanism) comes into existence when custom gives place to competition and practically everyone begins to produce goods and services for the market with a view to make maximum profit out of the production for the market. Market System or Market Economy may be said to come into existence when freely fluctuating prices in the market begin to influence allocation of the community's resources and distribution of income and wealth produced in the community During modern times we get what is called 'Market System' or 'Market Economy'. Increasing division of labour or specialization has been taking place in both developing and developed countries. This means everyone is at present producing goods and services (including labour of various types) for the market. Everyone at present carries thousands of exchanges which alone enable him to live comfortably. Market has become the pivotal point in modern capitalist and mixed economies. All prices have become closely interrelated and influence all other prices. It is when market becomes the pivotal or central folcrum of the economy and influences allocation of resources and distribution of income and wealth, we say that there has emerged ''Market System' or 'Market Economy'. 276


Market mechanism or freely fluctuating price mechanism is another system of solving the basic economic problem before the community: In this system all the persons are supposed to enjoy personal freedom as consumers and producers and are free to use their resources as they please without any legal or other restrictions or barriers. Consumers, who are free to spend their income as they please, express their preferences through prices. Thus if consumers begine to prefer TV sets than radio sets, prices of TV sets will go on rising more relatively to prices of radio sets. Under market mechanism, since producers are free to use their resources as they like, and as they are motivated to make maximum profit, they will divert their resources from production of radio sets to the production of TV sets. Thus more TV sets and relatively less radio sets will be produced for the market. People express their preferences through prices. Changes in free fluctuating prices act as signal to producers. They switch their resources, on the basis of price changes, to the production of goods according to the changing preferences of consumers. This gives consumers what they prefer more. Naturally this results in maximization of welfare of the community everyone getting what he wants. This also means that market mechanism brings about most efficient use of the community's resources. Shift of resources from production of radio sets to production of TV sets will go on until more TV sets in the market and relatively less radio sets there will bring down the prices of TV sets and raise the prices of radio sets as there are fewer radio sets available, to a level where profits in both TV manufacturing and radio manufacturing industries become equal. Market (or price) mechanism is explained above with a simple model of only two commodities. Market or price mechanism operates along the same principle even when there are many commodities and services. Thus market or price mechanism is supposed to help solve the basic economic problem - how to make the most efficient use of community's resources and how to derive the maximum satisfaction from the community's resources. Assumption of Market (or Price) Mechanism There are certain assumptions on which operation of the market (or price) mechanism is based. The important assumptions are as follows: i.

Each consumer knows what is in his best interest and acts rationally to secure maximum satisfaction.

ii.

There is perfect competition in the market - competition among consumers and among producers, each consumer and producer knowing fully well what is taking place in the market and hoe prices are moving.


277

iii.

Different factors of production have perfect mobility and they can move easily and quickly from one industry to any other in search of higher profits.

Criticism of Market or Price mechanism But in actual life market or price mechanism does not operate as smoothly and efficiently as described in the above model. This is because the above assumptions are not always and fully valid and do not obtain in real world. Thus consumers do not always know what is in their best interest and do not always act rationally. The competition among consumers and producers assumed in the above model is often absent. There is also not full knowledge among consumers and producers about market conditions and happenings. Absence of competition often gives rise to monopoly which can prevent entry of outside units in its line of production and manipulate prices by creating artificial scarcities. There is never perfect mobility of factors of production, especially in the case of labour. Some factors of production are specific and can produce only certain goods and not other goods though the prices of the latter may rise. Different factors of production even if there is competition will find it difficult to move from industry to industry in search of higher profits as depicted in the above model. 8.

FOUNDATIONS OF MARKET SYSTEM OF ECONOMY

The market system of economy (also known as Laissez Faire capitalism or simply capitalism) is built on the following foundations: i.

Individual, the best judge of self-interest : In the market system or capitalist economy, it is assumed that every individual is the best judge of his personal interest. Every individual knows what is in his interest and no one does that well than himself. Every individual should therefore be left free to carry on his economic activities as a consumer and as a producer and so on without being dictated by any one else including the government.

ii.

Consumer's Sovereignty : The above assumption implies that in a market system of economy, a consumer with his complete freedom to spend his income as he likes is sovereign as a consumer dictating to producer what goods he prefers and therefore should be produced. This means the market system of economy is characterized by consumer's sovereignty.

iii.

Freely Fluctuating Price Mechanism : The sovereign consumers express their demands and preferences through freely operating prices or through price mechanism. Freely operating price mechanism thus acts as a signaling system indicating to various producers ,consumers' preferences - that they prefer TV sets to radio and radio sets to gramophone and so on - and influencing and

278


bringing about allocation of limited resources of the community in accordance with consumers' preferences. iv.

Private Enterprise : In the market system in economy, most of the goods and services are produced by individual producers or groups of individual producers. That is why the market system is also known as private enterprise economy. The government has no role to play as a producer of goods and services except to a very limited extent where private enterprise may not be interested.

v.

Private Profit Motive : In the market system of economy most of the goods and services are produced by individual producers who enjoy perfect freedom as producers without being dictated in this regard by anyone else including the government. The chief or major foundation of the market system or private enterprise economic system is that among all motives to human activities, private profit motive (i.e self-interest) is the most powerful motive which will bring out the best effort by every individual. And therefore under this system all production is carried on by individual producers with a view to maximize their personal profit.

vi.

Institution of Private Property : Another major foundation of the market system of economy is the institution of private property (i.e. exclusive right to own and enjoy one's property in land, buildings, factories, precious metals like gold and silver, share and other financial assets and such other tangible and intangible goods).

vii. Existence of Competition : Open and free competition among consumers and producers may be said to be the very soul of the market system of economy. In this system consumers compete among themselves for goods and services in the market by offering competitive prices to get them, and producers compete among themselves for getting factors of production to produce goods and services to be sold to consumers at competitive prices. viii. Harmony between Individual Interests and Interests of the community : Since in the market systems (or private enterprise economy or capitalism) each individual is free to strive to maximize his personal satisfaction of which he is the best judge, it follows that when all individuals attain maximum satisfaction of their own, community made up of those individuals would automatically attend the maximum satisfaction or welfare. There is thus no clash between interest of an individual and that of community.


279

ix.

Non-Interference by the State (or Laissez Faire) : If under the market system every individual acting for his personal interest or personal profit can automatically ensure maximum welfare, not only of himself but also that of the community, and if there is no clash between interest of an individual and welfare of the community, and no clash of interest between welfare of consumers and that of producers, if freely functioning price-mechanism with its competitive system can automatically ensure maximum welfare of the consumers and most in the State or government trying to interfere in the economic activities of the people telling to do this and not to do that and so on. People should free to carry on their economic activities as consumers and as producers. The above are the foundations (that means the assumptions) on which the 'Market System' (also known as Market Economy or Capitalism) stands or functions.

280


Exercise : 1.

Explain fully the distinction between Public goods and Private goods.

2.

Give an idea about government investment in the context of Indian economy.

3.

Explain with illustration, how resource allocation and income distribution takes place in a free enterprise economy.

4.

What are the foundations of Market Economy?

5.

Compare and Contrast Private and Social Cost-Benefit.


281

NOTES

282


NOTES


283

NOTES

284


Chapter 8 MACRO ECONOMIC ANALYSIS

Preview Macro Economics - The Keynesian Macro Economic Theory - Income determination, Consumption and Investment Function; Business Fluctuations, Inflation - Macro Polices of Full Employment, Economic Stabilization. MICRO ECONOMICS INTRODUCTION Macro-economics is the study of the aggregate behaviour of the economy as a whole. It is concerned with the macro-economic problems such as the growth of output and employment, national income, the rates of inflation, the balance of payments, exchange rates, trade cycles, etc. According to Prof. Ackley: "Macro economics deals with economic affairs 'in the large'; it concerns the overall dimensions of economic life." In short, macro-economics deals with the major economic issues, problems and policies of the present times. Macro-economics deals with the major economic issues, problems and policies of the present times. National income, money, total investment, savings, unemployment, inflation, balance of payments, exchange rates, etc. Are the crucial economic aggregates. In macro-economic analysis the behaviour of economic agents such as firms, house-holds and government is seen in total, disregarding details at the particular level - i.e., micro level. An individual consumer, particular market for a given commodity, operation of a firm, etc are the subject matter of Micro economics. Macro-economics deals with the market for all goods as a whole. It is considered as the product or commodity market in general. Similarly, labour


285

market is taken as a whole for the entire labour force in the economy. Likewise, financial market is taken as a whole which covers money market, capital market and all banking and non-banking institutions taken together. Prior to Keynesian revolution in economic thinking in the 1930s, the classical economists had concentrated more on micro-economic approach and macro behaviour was also described as mere summation of individual observations. Prof. J. M. Keynes in 1936 published The General Theory of Employment, Interest and Money which revolutionized the whole economic thinking. He suggested that macro economic behaviour should be studied separately. Behaviour in total is quite different then what we may try to infer by summation of individual behaviour. He said that, for instance, saving is a private virtue but it is a public vice in a matured economy cause deficiency of demand leading to depression. Keynes prescribed macro-economics as a policy - oriented science to deal with the problems like unemployment, inflation etc. Economics of Keynes serves as the foundation centre for the modern economics. It follows that the scope of macro-economics is confined with the behaviour of the economy in total. It does not examine individual behaviour. It relates to the economy-wide total or aggregates and problems of general nature. Its policies are general. The subject matter of macro-economics includes the theory of income and employment, theory of money and banking, theory of trade cycles and economic growth. IMPORTANCE OF MACRO - ECONOMIC STUDIES Macro - economic studies have unique theoretical and practice significance.

286

1)

Macro - economics provides an exploration to the Functioning of an Economy in general: Using macro - economic tools and technique of economic analysis one can understand the working of the economic system in a better way.

2)

Empirical Evidences : Macro - studies are based on empirical evidences of the theoretical issues. Macro - economics is more realistic.

3)

Policy - orientation : Macro - economics is a policy - oriented science. It suggests a best of policy measures, such as fiscal policy, monetary policy, income policy, etc. to deal with complex economic problem like unemployment, poverty, inequality, inflation, etc. faced by the country in modern times.

4)

National Income : Macro - economics teaches the computation, use and application of national income data. With the help of national income statistics and accounting one can understand and evaluate the growth performance of an economy over a period of time. Managerial Economics

5)

Income and Employment Theory and Monetary Theory: Economics of employment and income and monetary economics are the major fields of macro - economics which have utmost practical relevance. Planning and policy making is not possible without the base of the understanding of these two fields.

6)

Dynamic Science: Macro - economics is a dynamic science. It studies and suggests solutions to the issues and problems from the dynamic view point. It allows for changes. One can have a better idea of a dynamic perspective in the real economic would in the light of macro - economic tools and mode of its general equilibrium analysis.

The Keynesian Macro Economic Theory : INTRODUCTION: In his book, The General Theory of Employment, Interest and Money (popularly known as 'The General Theory'), published in 1936, Prof. J. M. Keynes rejected the classical dogma of full employment equilibrium by invalidating Say's Law of markets. He, thus, propounded a macroeconomic theory of income and employment that highlighted the real nature of the determinants of income in a modern economy. In contrast to the classical theory, the Keynesian theory is demand-oriented. It stresses effective demand as a crucial factor in determining the level of income and employment.

Macro-economic Analysis: The economic analysis by Keynes is a macro-economic analysis. In macro-economic analysis, the functioning of economic system is viewed as a whole or in an aggregate sense. This is in contrast to the classical micro-economic approach, which dealt with the segregated behaviour of individual economic entities (such as a particular consumer's demand behaviour, a particular firm's production behaviour, etc. in the system). The basic concepts underlying the Keynesian theory are interpreted in aggregative terms only. Thus, in his General Theory, we come across concepts like aggregate demand and aggregate supply, 'consumption' implying total consumption of the community, 'income' for national income, 'employment' for total employment; 'output' meant aggregate national output, 'saving' implied total savings in the economy; and the term 'investment' connoting aggregate real investment. As such, the economics of Keynes is also referred to as 'Aggregative Economics'.

Short - Period Analysis: Keynes realistically adopts the short-term variables. He believed in the short-run philosophy of life. To him, 'in the long run, we are all dead'. Thus, Keynes presumed an economic model as a short-period model in his analysis. Since it deals primarily with short-term phenomena in economic life, many of the strategic variables in the Keynesian theory, like consumption function, interest rates etc. are assumed to be constant, as they would change very little in the short period. Macro Economic Analysis

287

Again, on account of his short-period analysis of the problem, Keynes treated national income as Gross National Product (GNP), rather than Net National Product (NNP). Because he felt that in the short period, repairs, replacement etc. have no significant relevance; so depreciation allowances, etc. are to be considered only in the long-run analysis. So, GNP is appropriately used for measuring the community's total income during the short run.

Generality of Approach: Keynes' theory is general. Its approach and analysis are general. It is general in the sense that it is not time - bound. Keynesian tools of analysis are applicable at any point of time, in any economy. Again, Keynesian, analysis being macro-economic, it contains generality in approach. It takes a general view of the economic system as a whole. Keynes argued that the postulates of the classical theory are applicable to a special case of full employment only and not to general cases. He criticized classical economists for their unrealistic assumption of full employment equilibrium condition in their economic models. He observed that there is always less than full employment in the economy; full employment is only a rare phenomenon. He claimed his theory to be general in the sense that it deals with all levels of employment and in all cases. It applied equally well to economies with less than full employment, under - employment or full employment. Thus, its generality implies its universal applicability.

The Principle of Effective Demand : The gist of Keynesian analysis of income determination lies in the principle of effective demand. Keynes pointed out that the level of income and output in an economy is determined by the level of employment (i.e. the employment of workers along with the exploitation of other given resources such as land, capital, etc.) Which, in turn, is determined by the level of effective demand. In a money economy, effective demand is revealed by the total expenditure incurred by the people on real goods and services, meant for consumption as well as investment. The flow of expenditure, in turn, determines the flow of income, as one man's expenditure becomes another man's income in the economic system. It thus follows that Total Expenditure = Total Income. As the flow of expenditure varies, the level of income also varies accordingly. That is to say, if the total expenditure flow in an economy increases, the flow of income will also increase in the same proportion. And, if the aggregate expenditure flow decreases, income flow also decreases likewise.

288


In real terms, the expenditure flow in the community consists of consumption expenditure and investment expenditure, expressing the total demand for consumption goods and capital goods. Effective demand, thus, represents the total expenditure on the total output produced, at any equilibrium level of employment. It thus denotes the value of total output of the community, which is described as national income. Obviously, national income equals national expenditure. And, as total output comprises consumption goods and capital or investment goods, so the national expenditure consists of expenditure on consumption goods plus investment goods. In short, there are two basic determinants of effective demand in an economy. These are consumption and investment. The level of effective demand determines the level of employment which, in turn, determines the level of output and income in the economy. It follows, thus, that the level of employment is fundamentally determined by consumption and investment. Since Keynes sought to explain the point of effective demand in a capitalist economy, free from government intervention, he considered consumption and investment expenditure of the community relating to private individuals and enterprises only. But, in modern times, a capitalist economy is actually a mixed economy due to that, government expenditure is also a significant determinant of effective demand in a modern economy. Modern economists, therefore, define effective demand as: Effective demand = C + I + G, Where, C

=

Consumption expenditure of the households.

I

=

Investment expenditure of private firms.

G

=

Government's expenditure on consumption and investment goods.

It must, however, be noted that government expenditure is autonomous. Thus, it is the outcome of government's value judgment and policies, based on political and social considerations rather than economic forces. Following Keynes, we shall, however, restrict our analysis to the consumption and investment, elements of effective demand relating to the private sector only. If must be borne in mind that the investment and employment activities in the private sector are induced and not autonomous, as in the case of public sector. Again, from the Keynesian dictum that the level of employment and income depends on the level of effective demand in an economy, it also follows that the lack of effective demand implies unemployment and corresponding poverty, or low level of income. As such, to ease the unemployment problem, and to raise the level of income and economic prosperity, the level of effective demand has to be raised. Income and employment, thus, increase only when the total demand either from consumption side or from the investment side increases. Macro Economic Analysis

289

Analysis of The level of Effective Demand (Factors Determining Effective Demand) : Since the level of activity in an economy is a matter of demand and supply, using technical terminology, Keynes stated that effective demand is determined by the interaction of the aggregate supply function and the aggregate demand function. That is to say, the volume of employment in an economy is determined by the entrepreneur's considerations of the aggregate demand price and the aggregate supply price at that particular level of employment. Price here means the amount of money received from the sale of output, i.e. sales proceeds.

Aggregate Supply Function (ASF): The "supply price" for any given quantity of commodity refers to that price at which the seller is willing to or induced to supply that amount in the market. Hence, the supply schedule of that commodity shows the varying level of quantities of the commodity the seller offers for sale at alternative prices. Similarly, the aggregate supply schedule for the economy as a whole refers to the response of all entrepreneurs in supplying the whole of the output of the economy. Keynes measured the whole of output of the economy in terms of the amount of laboour employed with a given marginal productivity. He, thus, said that the level of output varies with the level of employment, obviously, each level of employment results in a certain level of output of commodities, i.e. real income along with the money income generated in the process of investment expenditure. Each level of employment (of labour) necessitates certain quantities of the other factors of production like land, capital, raw materials, etc., to assist the labour employed. All these factors of production are to be paid according to the prevailing factor prices, which are known as cost of production. Thus, each level of employment would involve certain money costs (including profits). Every prudent entrepreneur must at least seek to recover the total cost of production, including normal profit. Thus, the entrepreneur must get some minimum amount of sales revenue to cover the total costs incurred at a given level of employment. Only if the sales proceeds are high enough to cover the total costs of production at a given level of employment and output, the entrepreneur will be induced to provide that particular level of employment. This minimum price of revenue proceeds that the entrepreneurs must get from the sale of output, associated with different levels of employment, is defined as, "aggregate supply price schedule" or "aggregate supply function". Thus, the aggregate supply function refers to a schedule of the various minimum amounts of proceeds or revenues which must be expected to be received by the entrepreneur class from the sale of output resulting at various levels of employment. According to Keynes, using employment as a single measure of total output of the economy, the supply price of employment can be determined in terms of labour cost. We may illustrate the Keynesian aggregate supply function hypothetically as in following Table :

290


The Aggregate Supply Function Level of employment (in lakhs of workers) (N)

Money wages (per annum in 1,000) (W)

Aggregate Supply Price (ASF) (in crores of Rs.) (N x W)

1

10

100

2

10

200

3

10

300

4

10

400

5

10

500

6

10

600

In the table it is assumed that money wages, on an average to be paid per year, is. Rs.10,000. Thus, the schedule shows for each alternative level of employment how much minimum sales proceeds must be raised by the entrepreneurial class to undertake to level of employment. It can be seen that to employ one lakh workers during the year, entrepreneurs should expect to get a minimum of Rs.100 crores from the economy by selling the resulting output. Similarly, for two lakh workers to be employed, the minimum expectation of sales proceeds is Rs.200 crores, and so on. Graphical Presentation : The numerical schedule of aggregate supply price of employment may be plotted graphically and the cruve so derived is called ASF curve. Following figure illustrates the ASF curve drawn by the graphical representation of data contained in previous table.

Minimum Receipts/Income

Rs. crores

ASF Y

Q Employment (N) (In lakhs of workers)


291

In the figure, the X - axis represents the level of employment and the Y - axis measures the expected minimum sales proceeds. The curve ASF represents the aggregate supply function. It is linear, because we have assumed a constant wage rate. But, if the wage rate is changing (increasing) or costs of employment are rising with an increase in employment, the ASF curve will be non-linear and upward sloping. Indeed the aggregate supply price is correlative with the employment level, in any case. However, the aggregate supply function - ASF curve - will become perfectly inelastic at a point where the economy is at a full employment level. Thus, at the full employment level, the aggregate supply function will be a vertical straight line. Suppose, in our illustration, the economy reaches full employment when all its 6 lakh workers are employed, then the ASF curve will become vertical at point Z as shown in the figure. That means, the level of employment cannot exceed Q level (i.e.600 in our example), whatever the expectations of minimum sales proceeds. It is interesting to note that modern economists measure the aggregate supply function in terms of real income or value of total output by measuring GNP rather than the level of employment as Keynes did.

The Shape of ASF Curve : As has been seen in previous figure, the ASF curve is an upward sloping curve, but it is not very easy to conclude about its shape. To determine the shape of the curve ASF, the relationship between employment (N) and marginal productivity should be traced. The value of marginal product (VMP) is called marginal productivity which is obtained by multiplying the marginal physical product (MP) of labour with price of output (P). In a technical sense, thus, ASF is obtained by aggregating the expected total revenue functions of all the firms. The actual shape of the ASF curve, however, will be determined by the aggregate production functions of all firms in the economy and money wages. Apparently, the linear ASF curve, assumed in previous figure, is a much simplified case. It is based on the assumption that : (i) the money price of all outputs and inputs is constant, and (ii) when prices are constant, the community's total outlay (national expenditure) which is measured at these constant prices and the level of employment and income, change in the same proportion. This means that if the total money expenditure is doubled, employment and income will also double and vice versa. In reality, however, such proportionate relationship is rarely found. Thus, the actual ASF curve which relates to changes in prices of all outputs and inputs, cannot be linear. The linear ASF curve was assumed by Keynes for the sake of simplicity in analysis. Again, the steepness of the ASF curve depends on the technical production conditions. It depends on the productivity of labour, capital and other resources employed by the economy.

Aggregate Demand Function (ADF) : In the Keynesian terminology, the aggregate demand function refers to the schedule of maximum sales proceeds which the entrepreneurial community actually does expect to be received from the sale of different quantities of output, resulting at

292


various levels of employment. Thus, the quantum of maximum sales revenue expected from the output produced is described as the demand price of a particular level of employment. There is a positive correlation between the level of employment and the demand price, i.e. expected sales receipts. Thus, with an increase in the level of employment, the aggregate demand price tends to rise, and vice versa. The aggregate demand price - the maximum sales proceeds expected for a given level of output - depends upon the total expenditure flow of the economy, which is determined by the spending decisions of the community as a whole. In a free capitalist economy, households and firms are the two major economic sectors which spend on consumption and investment. Now, what these sectors are expected to spend in the next period is viewed as the aggregate demand price, the expectation of sales revenue, for the given level of output and employment by the entrepreneurs. A much simplified presentation of aggregate demand function may be illustrated through the following hypothetical table.

The Aggregate Demand Function (Schedule) Level of Employment (N) (in lakhs of workers)

Expected minimum sales proceeds (expected Total Expenditure ADF) (in crores of Rs.)

1

175

2

250

3

325

4

400

5

475

6

550

The aggregate demand schedule links real income or output (which Keynes measured in terms of the quantity of employment) and spending decisions, thus, the expenditure flow in the economy as a whole. Evidently, the aggregate demand schedule shows the aggregate demand price for each possible level of employment. The aggregate demand function may be represented graphically as in following figure. In following figure, the curve ADF represents the aggregate demand schedule. It shows that the aggregate demand price is the direct or increasing function of the volume of employment.


293

Maximum Expected Receipts (Anticipated Total Expenditure)

ADF = f (N)

Volume of Employment (In lakhs)

The ADF curve drawn in the above figure is linear. It can be non-linear, too. Its shape and slope depend on the assumptions and nature of data related to the aggregate demand schedule. For the sake of simplicity, we shall, however, consider linear functions only. Thus, it may be recalled that the statement showing the varying levels of aggregate demand prices, i.e. expected sales revenue by the entrepreneur for the output associated with different levels of employment, is called the aggregate demand price schedule or the aggregate demand function.

Equilibrium Level of Employment - The Point of Effective Demand : The intersection of the aggregate demand function with the aggregate supply function determines the level of income and employment. The aggregate supply schedule represents costs involved at each possible level of employment. The aggregate demand schedule represents the expectation of maximum receipts of the entrepreneurs at each possible level of employment. It, thus follows that so long as receipts exceed costs, the level of employment will go on increasing. The process will continue till receipts become equal to cost. Needless to say, when costs exceed receipts, the employment level will tend to decrease. This is what we can observe by comparing the two functions as represented in the following table.

294


The Equilibrium Level of Employment Employment

Aggregate

Aggregate

(in lakhs of

Supply Function

Demand Function

Comparison

Direction of change in

workers)

(in crores of Rs.)

(in crores of Rs.)

employment

(N)

(ADF)

(ADF)

(DN)

1 2 3 4 5 6

100 200 300 400 500 600

175 250 325 400 475 550

ADF > ASF ADF > ASF ADF > ASF AD = AS ADF < ASF ADF < ASF

Increase Increase Increase Equilibrium Decrease Decrease

So long as the aggregate demand price (ADF is greater than the aggregate supply price (ASF), the level of employment tends to increase. The economy reaches equilibrium level of employment when the aggregate demand function becomes equal to the aggregate supply function. At this point, the amount of sales proceeds which entrepreneurs expect to receive is equal to what they must receive in order to just appropriate their total costs. In the given schedule above, it is Rs.400 crores which is the entrepreneur's expected minimum as well as maximum sales proceeds, so that 4 lakh workers' employment is the equilibrium amount. This is the point of effective demand. In graphical terms, the point of effective demand and equilibrium of the economy can be represented in the following figure. Following figure has two panels. Panel (A) depicts linear AD and AS curve. Panel (B shows non-linear AD and AS curves. We have preferred linear curves for the sake of simplicity of analysis, though non-linear curves are more realistic. Y

ASF Z

R

(B) ASF

ADF

E

E

a

ADF

ADF

ADF

b

&

Y

(A)

&

ASF

ASF O

N1 N Nf Volume of Employment (N)

X

O

N Volume of Employment

X

Effective Demand Macro Economic Analysis

295

In the Figure (A), on the previous page the two curves ADF and ASF intersect at point E, which is called the point of effective demand. In fact, the value OR, i.e. the sales proceeds which entrepreneurs expect to receive at the point of aggregate demand function where it is intersected by the aggregate supply function, is called the effective demand because it is at this point that the entrepreneurs' expectation of profits will be maximized. Thus, when the aggregate demand prices are equal to the aggregate supply prices, the entrepreneurs would earn the highest normal profits as their sales proceeds equal their total costs at this point. it goes without saying that so long as the aggregate demand function lies above the aggregate supply function, i.e. ADF > ASF, indicating that costs remain less than the revenue, the entrepreneurs would be induced to provide increasing employment till both of them are equalized. But after the point of intersection of the aggregate demand function and the aggregate supply function, for a further rise in employment, the aggregate supply prices become higher than aggregate demand price, i.e. ASF > ADF, indicating that total costs exceed total revenue expected, so that entrepreneurs would incur losses and refuse to employ that particular number of workers. Diagrammatically, thus, actually only ON number of men will be employed where the aggregate demand function (ADF) equals the aggregate supply function (ASF). ON1 number of workers will provide some possibility of maximising profits by increasing the employment further, since ADF > ASF by ab, whereas, any number of men exceeding ON cannot be employed, because then ASF would exceed ADF, implying losses to the entrepreneurs. it is only at point E where ADF = ASF and the normal profit is maximum that the equilibrium level of employment is ON. Thus, it may be concluded that employment in an economy will increase till ADF = ASF. Thus, point E, the point of effective demand, is called the point of equilibrium which determines the actual level of employment and output. It should be noted that though E is the point of equilibrium, it does not imply that the economy is necessarily having full employment at this equilibrium point. According to Keynes, the equilibrium between the aggregate demand function and the aggregate supply function can, and often does, take place at a point less than full employment. To him, ADF = ASF at full employment level, only if the investment spending is appropriately adequate to fill the gap emerging between income and consumption in relation to full employment. But, this is scarcely found in practice. Usually, the investment outlay is insufficient to fill the gap between income and consumption, hence ADF = ASF at less than full employment. This is how Keynes explains the points of under - employment equilibrium in a real economy. Of these two determinants of the level of effective demand, Keynes' effective demand, however, assumes the aggregated supply function as given in the short run. Thus, he speaks little about the aggregate supply function. Keynes did not make a detailed study of the ASF, firstly, because he assumed a static macro-economic model of the economy, which ruled out the possibility of t5echnological and other changes of a dynamic nature and, secondly, he was concerned with the short period analysis during which prevailing conditions are unlikely to change. Especially, changes in 296


technical conditions and technological advancement can occur only in the long period. He, therefore, assumed a given ASF curve for the economy, simply ignoring it in the further analysis of income - employment determinants. Stonier and Hague observe that another important reason why Keynes did not pay much attention to the analysis of ASF is that he was mainly concerned with solving the problem of unemployment caused by the cyclical phase of the Great Depression in the mid-thirties. In view of the mounting unemployment, it was unnecessary for him, to examine the problem of optimum use of the given resources. His main task was to show hot to use the given unutilised resources and create more employment and income. Again, he felt that the problem of ASF and especially the optimum use of the given resources, was adequately dealt with by the classical (and neo-classical) economists in developing the marginal productivity theory of distribution. But, it was aggregate demand which was not adequately analysed, and rather neglected, in the past, Keynes, thus, concentrated on the analysis of aggregate demand function. Since the aggregate supply function is assumed as given, the essence of Keynes' theory of employment and income is found in his analysis of the aggregate demand function. that is why his theory is sometimes regarded as a theory of aggregate demand. the aggregate demand schedule is a vital factor in his employment theory, for only if aggregate demand is large enough will all resources be used, with any given aggregate supply function. The aggregate demand schedule shows how much money the community is expected to spend on the products resulting a t various levels of employment. Thus, the Keynesian economics may also be called the economics of spending. In the equilibrium model, ADF is known by the sum total of expenditure of all the buyers in the economy. It represents money expenditure of all buyers on domestically produced goods to the level of aggregate employment. In fact, ADF is the schedule which indicates the alternative expenditure totals in relation to alternative levels of employment in the economy. The volume of total expenditure, as given by the ADF, where it is intersected by the ASF, is described as "effective demand". Effective demand is the point where the actual total expenditure of the community equals the aggregate required sales receipts and their expectations by the entrepreneurial class as a sales receipts and their expectations by the entrepreneurial class as a whole. That is to say, the level of effective demand represents an equilibrium level of expenditure at which entrepreneurial expectations are just being realised, so that the amount of labour hired and investment incurred in the economy are unlikely to vary at this point. Apparently, the aggregate demand function signifies a functional relationship between total expenditure and total income of the community. It must be noted that this relationship between expenditure and income traced in the Keynesian model is behavioural. In short, Kenyes' theory stated that, in the short run, the equilibrium level of employment is determined by the actual level of aggregate demand with a given aggregate supply function. The greater the aggregate demand is at the point where it is equal to aggregate supply, the higher will the employment be; thus, it is the aggregate demand function which becomes "effective" in determining the level of employment. This implies that in order to raise the level Macro Economic Analysis

297

of employment in any economy, it requires an increase in the effective demand by raising the level of aggregate demand. In graphical terms, the higher the aggregate demand function curve, with a given aggregate supply function schedule, the higher will be the level of employment;following figure illustrates this point. ASF

Y

E2 Receipts/Income

R2 E1

ADF2

ADF1

R1

O

N2 N1 Level of Employment

X

In the above figure, curve ADF1 (representing the aggregate demand function) indicates an employment level up to ON1 at point E1 of the effective demand. While curve ADF2 is at a higher level and shows a higher level of employment ON2 at point E2 of effective demand. Thus, the diagram reveals the point that a higher aggregate demand function leads to a higher level of employment. In short, the point of effective demand at which the aggregate demand function intersects the aggregate supply function is the point of macro-economic equilibrium. Indeed, effective demand equals the total expenditure on consumer goods plus investment goods. It can be said that the level of employment which depends on effective demand also depends on the volume of consumption expenditure. Thus, consumption and investment are the main determinants of effective demand, and in turn the level of employment and income. Introduction to Consumption Function and Investment Function : According to Keynes, the aggregate demand function - the "effective" element of effective demand - depends on two factors : (i) the consumption function (or the propensity to consume), and (ii) the investment function (or the inducement to invest). This consideration is based on the fact that effective demand is the sum of expenditure on consumption on investment in a community. It implies that if consumption is constant and investment is increases, employment will increase. Similarly, if investment is constant and consumption increases, employment will increase. Increase or decrease in both consumption and investment will cause an increase or decrease in the levels of employment respectively. Thus, the fundamental idea of the 298


Keynesian economics is that an increased level of employment can only be achieved and maintained by an increased level of expenditure on either consumption or investment or both. In short, effective demand which determines the level of employment in an economy is determined by the size of aggregate demand expenditure or the aggregate demand function, which is composed of consumption and investment functions.

Consumption Function : The consumption appears to be a significant factor, determining the level of effective demand in an economy. Consumption function, or the propensity to consume, denotes the consumption demand in the aggregate demand of the community, which depends on the size of income and the share that is spent on consumption goods. The propensity to consume is schedule showing the various amounts of consumption corresponding to different levels of income. Thus, by consumption function, we mean a schedule of functional relationship, indicating how consumption reacts to income variations. Keynes, on the basis of a fundamental psychological law, observed that as income increases, consumption also increases, but less proportionately. Secondly, he also states that the propensity to consume is relatively stable in the short run and, therefore, the amount of community's consumption varies in a regular manner with aggregate income. Since consumption increases less than income, there is always a widening gap between income and consumption as income expands. Keynes, thus, argued that in order to sustain the level of income and employment in the economy, investment demand should be increased because consumption demand is relatively a stable component of the aggregate "effective demand". Thus, the crucial factor in employment - income theory is the investment function.

Investment Function : Investment Function or the inducement to invest is the second but crucial factor of effective demand. Effective demand for investment or the investment demand function is more complex and more unstable than the consumption function. According to Keynes, by investment is meant only real investment, denoting an addition to real capital assets as well as the accumulated wealth of the society. The volume of investment in an economy depends on the inducement to invest on the part of the business community. But the induce expectations about the profitability of business. Thus, according to the Keynesian theory, inducement to invest is determined by the business community's estimates of the profitability of investment in relation to the rate of interest on money for investment. The estimates or the expectations of profitability of new investment by the entrepreneurs are technically termed as the Marginal Efficiency of Capital. Thus, there are two factors determining the investment functions, namely, (i) the marginal efficiency of capital and (ii) the rate of interest. Accordingly, when the marginal efficiency of capital is greater than the rate of interest, the greater is the inducement to invest. Macro Economic Analysis

299

Thus, in general, entrepreneurs keep a fair margin between the two variables. In this sense, the marginal efficiency of capital and the rate of interest combine to influence the rate of investment in an economy. Keynes defined marginal efficiency of capital as the highest rate of return over cost expected form producing an additional (or marginal) unit of a special asset. The marginal efficiency of capital is, thus, estimated by taking two factors into account: (i) the prospective yield of a particular capital asset, and (ii) the supply price or the replacement cost of that asset. The marginal efficiency of capital is estimated to be greater if the difference between the prospective yield and the supply price of a capital asset is larger. The supply price of a capital asset can be easily calculated and it is more or less a definite quantity, while the prospective yield is a very indefinite factor as it relates to future, which is highly uncertain. Nevertheless, entrepreneurs do make their own estimates on the marginal efficiency of new capital assets by taking these two factors into account. Keynes, however, mentioned that the marginal efficiency of capital is a highly fluctuating phenomenon in the short run and has a tendency to decline in the long run. Once the marginal efficiency of capital is estimated, it is to be compared with the rate of interest. Thus, the rate of interest is the second important determinant of the investment function. The rate of interest, according to Keynes, depends upon two factors : (i) the liquidity preferences function, and (ii) the quantity of money (or the money supply). The first factor pertains to the demand aspect, and the second, to the supply aspect, of the price of borrowing money, i.e. the rate of interest. Thus, the liquidity preference function determines the demand for money. It denotes the desire of the people to hold money or cash balance as the most liquid assets. According to Keynes there are three different motives for holding cash for liquidity preference : (i) the transactions motive, (ii) the precautionary motive, and (iii) the speculative motive. Thus, the total demand for money is the aggregate demand for each under the three motives. Keynes, thus, formulates his own theory of interest called "liquidity preference theory of interest". He stated that liquidity preference is an important factor affecting the rate of interest. To him, the other factor, namely, the money supply, is not very significant in the short run, because it does not change all of a sudden and it is relatively a stable phenomenon. It is the liquidity preference function which is a highly fluctuating phenomenon, specially due to the speculative motive. Thus, assuming money supply to be constant, the rate of interest can be directly related to the liquidity preference function. Hence, the higher the liquidity preference, higher will be the rate of interest and the lower the liquidity preference, the lower will be the rate of interest. Keynes, however, regarded that the rate of interest is relatively a stable factor in the short run, and does not change violently. Thus, it follows that the investment function is largely influenced by the behaviour of the marginal efficiency of capital which is a fluctuating variable in the short 300


run. Thus, the marginal efficiency of capital with a given rate of interest, is the most significant factor determining the inducement to invest. In fact, as Keynes believed, fluctuations in the marginal efficiency of capital are the fundamental cause of trade cycles and income fluctuations in a capital economy. It is to be noted here that we have so far considered consumption and investment expenditure of the community relating to private individuals and enterprises only, because the original Keynesian Theory of Employment has considered consumption and investment expenditure only, and does not take government expenditures into account. But, modern economists give due recognition to government expenditure as an important factor of effective demand. In today’s world, government expenditure is day be day increasing, and it cannot be ignored in estimating the effective demand in a community. Thus, to be more realistic, we may formulate effective demand thus : Effective demand = C + I + G, where, C

=

Consumption outlay for the households,

I

=

Investment outlay in the private sector, and

G

=

Government's spending for consumption as well as investment.

It should be noted, however, that government expenditure is autonomous, as it depends on the policies of the existing government which are largely influenced by political and social rather than economic factors. BUSINESS FLUCTUATIONS INTRODUCTION Business fluctuations, booms and slumps, in the economic activities form essentially the economic environment of a country. They influence business decisions tremendously and set the trend of future business. The period of prosperity opens up new and larger opportunities for investment, employment and production, and thereby promotes business. On the contrary, the period of depression reduces the business opportunities. A profit maximizing entrepreneur must therefore analyse the economic environment of the period relevant for his important business decisions, particularly those pertaining to forward planning. This part of the chapter is in fact devoted to a brief discussion of, main phases of business cycles and their causes.


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Definition of a Business or Trade Cycle The term "trade cycle" in economics refers to the wave-like fluctuations in the aggregate economic activity, particularly in employment, output and income. In other words, trade cycles are ups and downs in economic activity. A trade cycle is defined in various ways by different economists. For instance, Mitchell defined trade cycle as “a fluctuation in aggregate economic activity”. According to Haberler, "The business cycle in the general sense may be defined as an alternation of periods of prosperity and depression, of good and bad trade." The following features of a trade cycle are worth noting : (a)

A trade cycle is wave - like movement.

(b)

Cyclical fluctuations are recurrent in nature.

(c)

Expansion and contraction in a trade cycle are cumulative in effect.

(d)

Trade cycles are all-pervading in their impact.

(e)

A trade cycle is characterized by the presence of crisis, i.e., the peak and the trough are not symmetrical, that is to say, the downward movement is more sudden and violent than the change from downward to upward.

(f)

Though cycles differ in timing and amplitude, they have a common pattern of phases which are sequential in nature.

Keynes, points out that "A trade cycle is composed of periods of good trade characterized by rising prices and low unemployment percentages, altering with periods of bad trade characterized by falling prices and high unemployment percentages." Keynes, thus, stresses two indices namely, prices and unemployment, for measuring the upswing and downswing of the business cycles. PHASES OF BUSINESS CYCLES The ups and downs in the economy are reflected by the fluctuations in aggregate economic magnitudes, such as, production, investment, employment, prices, wages, bank credits, etc. The upward and downward movements in these magnitudes show different phases of a business cycle. Basically there are only two phases in a cycle, viz., prosperity and depression. But considering the intermediate stages between prosperity and depression, the various phases of trade cycle may be enumerated as follows :

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1.

Expansion

2.

Peak


3.

Recession

4.

Trough

5.

Recovery and expansion.

The five phases of a business cycle have been presented in the figure. The steady growth line shows the growth of the economy when there are no economic fluctuations. The various phases of business cycles are shown by the line of cycle which moves up and down the steady growth line. The line of cycle moving above the steady growth line marks the beginning of the period of 'expansion' or 'prosperity' in the economy. the phase of expansion is characterized by increase in output, employment, investment, aggregate demand, sales, profits, bank credits, wholesale and retail prices, per capita output and a rise in standard of living. The growth rate eventually slows down and reaches the peak. The phase of peak is generally characterized by slacking in the expansion rate, the highest level of prosperity, and downward slide in the economic activities from the peak.

Business Fluctuations. A figure showing phases of Business Cycle The phase of recession begins when the downward slide in the growth rate becomes rapid and steady. Output, employment, prices, etc. register a rapid decline, though the realized growth rate may still remain above the steady growth line. So long as growth rate exceeds or equals the expected steady growth rate, the economy enjoys the period of prosperity - high and low. When the growth rate goes below the steady growth rate, it makes the beginning of depression in the economy. In a stagnated economy, depression begins when growth rate is less than zero, i.e. the total output, employment, prices, bank advances, etc., decline during the subsequent periods. The span of depression spreads over the period growth rate stays below the secular growth rate or zero growth rate in a stagnated economy. Trough is the phase during which the down - trend in the economy slows down and eventually stops, and the economic activities once again


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register an upward movement. Trough is the period of most severe strain on the economy. When the economy registers a continuous and repaid upward trend in output, employment, etc., it enters the phase of recovery though the growth rate may still remain below the steady growth rate. And, when it exceeds this rate, the economy once again enters the phase of expansion and prosperity. If economic fluctuations are not controlled by the government, the business cycles continue to recur as stated above. Let us now describe in some detail the important features of the various phases of business cycle, and also the causes of turning points.

Prosperity : Expansion and Peak The prosperity phase is characterized by rise in the national output, rise in consumer and capital expenditure rise in the level of employment. Inventories of both input and output increase. Debtors find it more and more convenient to pay off their debts. Bank advances grow rapidly even thought bank rate increases. There is general expansion of credit. Idle funds find their way to productive investment since stock prices increase due to increase in profitability and dividend. Purchasing power continues to flow in and out of all kinds of economic activities. So long as the conditions permit, the expansion continues, following the multiplier process. In the later stages of prosperity, however, inputs start falling short of their demand. Additional workers are hard to find. Hence additional workers can be obtained by bidding a wage rate higher than the prevailing rates. Labour market becomes seller's market. A similar situation appears also in other input markets. Consequently, input prices increase rapidly leading to increase in cost of production. As a result, prices increase and overtake the increase in output and employment. Cost of living increases at a rate relatively higher than the increase in household income. Hence consumers, particularly the wage earners and fixed income class, review their consumption. Consumer's resistance gets momentum. Actual demand stagnates or even decreases. The first and most pronounced impact falls on the demand for new houses, flats and apartments. Following this, demand for cement, iron and steel, construction-labour tends to halt. This trend subsequently appears in other durable goods industries like automobiles, refrigerators, furniture, etc. This marks reaching the Peak.

Turning - Point and Recession Once the economy reaches the peak, increase in demand is halted. It even starts decreasing in some sectors, for the reason stated above. Producers, on the other hand, unaware of this fact continue to maintain their existing levels of production and investment. As a result, a discrepancy between output supply and demand arises. The growth of discrepancy, between supply and demand is so slow that it goes unnoticed for some time. But producers suddenly realize that their inventories are piling up. This situation might appear in a few industries at the first instance, but later it spreads to other industries also. Initially, it might be taken as a problem arisen out of minor mal-adjustment. But, the persistence of the problem makes the

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producers believe that they have indulged in 'over-investment'. Consequently, future investment plans are given up; orders placed for new equipments, raw materials and other inputs are cancelled. Replacement of worn-out capital is postponed. Demand for labour ceases to increase; rather, temporary and casual workers are removed in a bid to bring demand and supply in balance. The cancellation of orders for the inputs by the producers of consumer goods creates a chain -reaction in the input market. Producers of capital gods and raw materials cancel their orders for their input. This is the turning point and the beginning of recession. Since demand for inputs has decreased, input prices, e.g., wages, interest etc., show a gradual decline leading to a simultaneous decrease in the incomes of wage and interest earners. This ultimately causes demand recession. On the other hand, producers lower down the price in order to get rid of their inventories and also to meet their obligations. Consumers in their turn expect a further decrease in price, and hence, postpone their purchases. As a result, the discrepancy between demand and supply continues to grow. When this process gathers speed, it takes the form of irreversible recession. Investments start declining. The decline in investment leads to decline in income and consumption. The process of reverse of (of negative) multiplier gets underway. (The process is exactly reverse of expansion). When investments are curtailed, production and employment decline resulting in further decline in demand for both consumer and capital goods. Borrowings for investment decreases; bank credit shrinks; share prices decrease; unemployment gets generated along with a fall in wage rates. At this stage, the process of recession is complete and the economy enters the phase of depression.

Depression and Trough During the phase of depression, economic activities slide down their normal level. The growth rate becomes negative. The level of national income and expenditure declines rapidly. Prices of consumer and capital goods decline steadily. Workers lose their jobs. Debtors find it difficult to pay off their debts. Demand for bank credit reaches its low ebb and banks experience mounting of their cash balances. Investment in stock becomes less profitable and least attractive. At the depth of depression, all economic activities touch the bottom and the phase of trough is reached. Even the expenditure on maintenance is deferred in view of excess production capacity. Weaker firms are eliminated from the industries. At this point, the process of depression is complete.

How is the process reversed? The factors reverse the downswing vary form cycle to cycle like factors responsible for business cycle vary form cycle to cycle. Generally, the process begins in the labour market, Because of widespread unemployment; workers offer to work at wages less than the prevailing rates. The producers anticipating better future try to maintain their capital stock and offer jobs to some workers here and there. They do so also because they feel encouraged by the halt in decrease in price in the trough phase. Consumers on their part expecting no further decline in price begin to spend on their postponed consumption and Macro Economic Analysis

305

hence demand picks up, though gradually. Bankers having accumulated excess liquidity (idle cash reserve) try to salvage their financial position by the private investors. Consequently, security prices move up and interest rates move downward. On the other hand, stock prices begin to rise for the simple reason that fall in stock prices comes to an end and an optimism is underway in the stock market. Besides, there is a self - correcting process within the price mechanism. When prices fall during recession the prices of raw materials and that of other inputs fall faster than the prices of finished products. Therefore, some profitability always remains there, which tends to increase after the trough. Hence the optimism generated in the stock market gets strengthened in the commodity market. Producers start replacing the worn - out capital and making - up the depleted capital stock, though cautiously and slowly. Consequently, investment picks up and employment gradually increases. Following this recovery in production and income, demand for both consumer and capital goods, start increasing. Since banks have accumulated excess cash reserves, bank credit becomes easily available and at a lower rate. Speculative increase in prices give indication of continued rise in level. For all these reasons, the economic activities get accelerated. Due to increase in income and consumption, the process of multiplier gives further impetus to the economic activities, and the phase of recovery gets underway. The phase of depression comes to an end over time, depending on the speed of recovery.

The Recovery As the recovery gathers momentum, some firms plan additional investment, some undertake renovation programmes, some undertake both. These activities generate construction activities in both consumer and capital good sectors. Individuals who had postponed their plans to construct houses undertake it now, lest cost of construction mounts up. As a result, more and more employment is generated in the construction sector. As employment increases despite wage rates moving upward the total wage income increase at a rate higher than employment rate. Wage income rises, so does the consumption expenditure. Businessmen realize quick turn over and an increase in profitability. Hence, they speed up the production machinery. Over a period, as the factors of production become more fully employed wages and other input prices move upward rapidly. Investors therefore, become discriminatory between alternative investments. As prices, wages and other factor - prices increase, a number of related developments begin to take place. Businessmen start increasing their inventories, consumers start buying more and more of durable goods and variety items. With this process catching up, the economy enters the phase of expansion and prosperity. The cycle is thus complete. INFLATION

The Meaning of Inflation In the words of Prof. Samuelson, "Inflation occurs when the general level of prices and costs is rising - rising prices for bread, gasoline, cars; rising wages, land prices, rentals 306


on capital goods". Thus, inflation marks rising commodity prices as well as factor prices. Factor prices when rise, cause an increase in costs. According to Milton Friedman, inflation is "process of a steady and sustained rise in the prices". Many more definitions of inflation can be given. Instead of going into all these definitions, let us outline the characteristics of inflation as they emerge form the above - mentioned (and other similar) definitions of inflation : (i)

Inflation is a phenomenon of rising prices. However, every price - rise is not inflationary, though every period of inflation indicates price - rise. In other words, temporary price rise in some sectors may occur due to some causes but they may not necessarily be indicative of inflation.

(ii)

Inflation is a sustained and appreciable rise in prices. Once started, inflation goes on feeding itself and it is not self-limiting. It is a continuous process.

(iii) Inflation is a general and a dynamic phenomenon. It is not limited to one or two sectors or geographical localities of a country. Rather, it takes within its stride the entire country and all the sectors of the economy. It is dynamic in the sense that its severity, nature etc. go on changing (and causing changes) over a period of time. Inflation occurs over a period of time. (iv)

True inflation or pure inflation starts only after reaching the full employment level.

(v)

It cannot be anticipated, in the sense that one cannot be sure regarding the timing and intensity of inflation.

(vi)

Inflation is characterized by an excess of demand or an increase in costs or usually both.

The Causes of Inflation The causes of inflation can be studied from two sides, i.e. from the demand side and from the supply side.

1.

The Factors from Demand Side (i)

Increase in Public Expenditure : There may be an increase in the expenditure of the government because of wars or for developing the economy. This increase in government expenditure means an increase in the total demand, which leads to rise in prices. This demand is in addition to the normal demand, which leads to a price rise.

(ii)

Increase in Private Expenditure : When optimism prevails in the business world, businessmen are eager to spend more money on capital goods. This increases the


307

demand for capital goods, and in turn, brings about an increase in the demand for consumer's goods. This is because there is an increase in the income of the people who work in capital goods' industries. Therefore, they are in a position to spend more, and thus, there is an increase in the demand for the both types of goods. (iii) Increase in Foreign Demand : When there is an increase in foreign demand for the goods manufactured in a country, exports increase and the prices of commodities in the country increase, as their supply cannot be increased instantaneously.

2.

308

(iv)

Reduction in Taxation : If there is a reduction in the taxes levied by the government, people are left with more money, which can be spent. This increases their expenditure, as well as the prices of commodities.

(v)

Repayment of Internal Debts : When the government repays old loans, more purchasing power is placed at the disposal of the people. A part of the amount obtained in this manner, may be re-invested in various assets, but the rest of it, may be spent on consumer's goods and services. It is responsible for increase in prices to the extent that this repayment of loans leads to an increase in the total demand.

(vi)

Changes in Expectation : In the context of the price - rise, the expectations of the people play a very important role. When people expect a rise in prices, businessmen increase their investment and this leads to an increase in the demand for capital goods. If the consumers think that there will be an increase in prices in the future, they will start purchasing commodities which they will require in the future. This increases the demand for consumer's goods. The increase in the demand for both, consumer's and producers' goods leads to the rise in prices.

Factors form Supply Side (i)

Scarcity of the Factors of Production : If one or more factors of production are in short supply, there is a reduction in production or hurdles may be created in the expansion of product6ion. This reduces the total supply and causes a rise in price.

(ii)

Bottlenecks : At times, all the factors are or may be available. But bottlenecks are created and this makes it difficult to make these factors available at the right time and place, for actual production. For example, iron ore and coal are available at mines, but the transport facilities required to transport these raw materials to the production site are not available. Transportation then becomes a bottle-neck. Therefore, in this case, production will suffer. Similarly, the paucity of credit facilities, labour unrest and strikes, the unreliability of transport and several other difficulties may arise and make production impossible or difficult. This may cause an increase in prices. Managerial Economics

(iii) Natural Calamities : There are several natural calamities which may reduce production. Excess of rains, drought, earthquakes, cyclones, may substantially reduce the total annual production. Agricultural production suffers and all other agro - based industries such as the sugar industry, the textile industry (cotton and jute) the oil industry, etc., also suffer. This results in the reduction of production and this leads to a rise in the prices. (iv)

Hoarding by Merchants : When traders and merchants know that there is a short supply of any commodity, they will purchase and stock large quantities of these commodities. These commodities then go underground and are not available in the open market. Thus, there is a shortage of other commodities too and this leads to a rise in prices.

(v)

Rise in Costs : Rise in costs due to an increase in factor prices is another cause from the supply side. Rent, interest and wages can rise due to a number of reasons. The Central Bank may raise interest rates or unions may cause a wage - rise. This may lead to inflation.

Consequences of Inflation Effects or Consequences of Inflation can be studied under (i) Effects on Production, (ii) Effects on Distribution, (iii) Other Effects, and (iv) Non - economic Effects.

1.

Effects on Production The effects of inflation on production are very important. As long as there is no full employment and inflation is proceeding at a slow rate, inflation may be helpful. As some of the factors of production are unemployed, there is no change in the costs of production. But prices continue to rise, which results in larger profits, and tempts entrepreneurs to increase investment. This increases total production and employment. This process continues undisturbed till the full employment level is reached. But once the full employment level is reached or crossed, prices start rising rapidly and there is true inflation. This rapid inflation is very dangerous to the smooth working of any economy. Hyperinflation is perhaps the worst from the point of view of production. Inflation affects production in the following manner : 1.

Through Investment : During a period of rising prices, because of several reasons, investment in the field of production goes on decreasing. The value of money falls, the propensity to save is reduced, and this results in the reduction of savings, which in turn reduces the rate of capital accumulation. The value of foreign capital is reduced, and there is flight of capital from the country, which results in reduction in investment and in turn, reduces production.

2.

Switchover of Business : During a period of rising prices, speculation and stockpiling appears to be more profitable. To undertake production, one has to begin with


309

obtaining a license, and go to the other end and maintain good relations with labour. This is very troublesome. Instead, if one indulges in purchase and sales of products property and other types of assets one can perhaps earn equal or even more profits, and avoid all the headaches mentioned above. These opportunities of making easy money, tempt capitalist to invest their capital in these activities rather than undertake production. Thus, there is no growth in production. But if prices rise very fast, production may even decrease.

2)

3.

Uncertainty : During a period of rising prices, there is an atmosphere uncertainty in every field. This makes entrepreneurs more and more reluctant to accept any risks in production. This results in decrease in production.

4.

Change in the Composition of Production: Rising prices also influences the composition of production. During the period of rising prices, those who get large profits and easy money become rich. Similarly, the owners of factors of production who are in short supply (eg. Owners of land, plots, houses etc ), get huge profits because of rising prices. On the contrary, the working class, the middle class and others who belong to fixed income group, are put to great hardships. They are not even in a position to satisfy their basic needs because they do not have the required purchasing power. As the income of the rich increases, the demand for luxuries go on increasing. As supply always follows demand, the production of luxury articles increases and that of necessities decreases. It is most undesirable to spend the resources of a country in producing luxury articles before producing adequate necessities. So, this change in the composition of production is said to be undesirable.

5.

Poor Quality of Output: During a period of rising prices, there is a scarcity of goods and services on a very large scale. This results in the deterioration of the quality of production, because anything and everything that is produced, is sold. Thus, inferior commodities flood the market.

6.

Public Unrest: When the pangs of price- rise are felt by the labourers, they become frustrated, and there are demonstrations, strikes, and several other types of agitations to secure higher wages. Because of this, production decreases further, which leads to further shortages and thus, price-rise.

7.

Distortion of prices: The expansion of currency creates several hurdles in the pricing system, and makes it weak. It's essential to have a properly functioning price mechanism in order to have smoothly functioning production system. This distortion of the price mechanism is another adverse effect on production.

Effects on Distribution : The effects of inflation on various groups of people on society can be summarized as follows:

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a)

The creditor and debtor: During periods of inflation, creditors are put to losses because there is difference in the value of the unit of currency when it was loaned out, and when it was returned. As prices rise, the value of money goes on decreasing with lapse of time. The case of borrowers is exactly the opposite. A borrower is benefited as the value of money when he borrowed it, is more than when he repays it.

b)

The wage and salary earners: Those who get fixed income in terms of money, are put to losses during inflation. If workers are well organized, they can secure dearness allowances or a rise in wages or salaries. But even then, in the race between the rise in prices and the rise in wages, the rise in prices is more rapid, thereby putting wage earners to a great loss. The fortune unorganized labour is extremely pitiable. Thus, as a result of inflation, the fixed income earners suffer great hardships. Those whose income is permanently fixed, are put to heavier losses. Pensioners mainly belong to this class.

c)

The entrepreneurs as a Class: The traders, merchants and manufacturers are the people who benefit more during inflation. Inflation is the great opportunity for them to make huge profits. The prices of stocks of finished products hoarded by these businessmen go on increasing continuously, and they get huge profits on these goods by selling them in the black market. Moreover. expenses to be incurred on wages, raw materials and machinery, lag behind prices. This leads to a continuous rise in profits. If the rate of growth of inflation is very high, there is a tendency of stockpiling by the traders. In this way, the share in the national income of the entrepreneurial class as a whole, goes on increasing.

d)

Investors as a class: Normally, investors are found to invest their money in the following two ways: 1) In such assets which give fixed and guaranteed returns per year. For e.g. : Bonds, Debentures, long term, deposits in banks etc. 2) In share or equity capital which do not give guaranteed returns. The investors belonging to the first category are put to a loss, but those in the second category may stand to gain profits. Because of rising prices, companies make huge profits declare large dividends, and thus, their real income increases. In most cases, the rich invest in equity shares as their capacity to take risk is more. The middle class people, whose savings are limited, invest in assets earning guaranteed returns. So here again, the rich have an advantage.

e)

The farmers: During periods of inflation, the income of farmers as a class increases. The supply of agricultural goods is normally inelastic. So it is not possible to increase production immediately. In the mean time, prices rise further. Moreover, whenever there is a price-hike, the prices of agricultural goods increase sharply and quickly. This is a common experience in developing countries. But even in this field, the small farmers are benefited least because they do not have large quantities of


311

agricultural goods as marketable surplus. But, the large farmers get the maximum possible advantage.

3)

4)

Other Consequences : a)

Financial institutions: When inflation is limited, banks, insurance companies and other financial institutions get advantages because their activities are boosted. But as soon as prices begin to rise at a faster rate, the savings of the people are reduced, and most of the financial institutions fall in trouble.

b)

Foreign Trade: Foreign goods become cheaper and imports increase, and simultaneously, exports dwindle as the prices of domestic goods rise. This creates several problems in the balance of payments. If restrictions are imposed, to check imports, smuggling activities increase.

c)

Price structure: During inflation, the prices of all goods rise. But the prices of those goods whose supply is inelastic, rise more. This disturbs the entire price structure as well as the distribution system in the economy. For e.g., If the price of the steel furniture is very high, the available steel will be used for the manufacture of steel furniture, even though the manufacture of railway wagons and rails may be more necessary.

d)

Reduction in development expenditure: Inflation has very bad effect on Economic planning and public expenditure. People who are already suffering from rising prices, cannot be overburdened by increasing the taxation. But the expenditure of the Government increases with rising prices. During periods of Economic planning, large investments have to be made in the Public sector. The saving capacity of the people is reduced, and the invested amounts become less and less valuable which makes it difficult to raise loans. Additional deficit financing is likely to increase inflation further. Thus, it becomes imperative for the government to reduce its expenditure on development plans. Several expansion programs have to be dropped. Inflation mostly affects the schemes to improve educational, medical aid, research and other social welfare programs.

e)

Effect on Currency: If inflation rises very rapidly, people loose faith in the currency and the currency cannot function as a currency at all. This endangers the very existence of the economy.

Non- Economic Effects : There are several political and social effects. These are very serious and may continue to be in existence for a very long period of time. The gap between the rich and the poor widens. Those who toil and moil continue to become poorer, and those who hold important positions, go on amassing wealth. This puts an end to harmony and understanding in society. Morality and business ethics are violated and people do not hesitate to do

312


anything unscrupulous to become rich quickly. Thefts, dacoity, gambling and other social evils become rampant. Demonstrations, arson and looting becomes very common and there is difficulty in maintaining law and order. Political stability in the country is endangered. The desire to amass wealth and become rich as early as possible gives rise to bribery, corruption, favouritism etc. Once the seeds of corruption are sown corruption spreads very easily and becomes all- pervasive. This gives rise to several social, economic and political evils.

MACRO POLICIES INTRODUCTION Business cycles i.e., fluctuations in the economic activities, cause not only harm to business but also misery to human beings by creating unemployment and poverty. Economists and the government have, of late, felt concerned with the business cycles and suggested various ways and means to control the economic fluctuations. The experience of the Great Depression and Keynesian revolution in mid - 1930s assigned a big role to the government in economic growth, employment and preventing business fluctuations. Therefore, the government interventions with the economy all over the world increased in a big way. The free enterprise economies not only entered the production of commodities and services but also adopted a number of fiscal and monetary measures to control and regulate the economy and prevent violent economic fluctuations. The governments in many developing countries like India assumed the role of a key player in economic growth, employment and stabilization. The problems similar to those faced in the different phases of the trade cycle are being faced by the world in modern times. The major stabilisation problem in the developing countries is the problem of controlling prices and preventing growth rate from sliding further down. For developed countries maintaining the growth rate to, fight against recession world over are the major stabilisation problems. We have discussed below the major macro economic stabilisation policies which are relevant to the current problems of the world.

1)

Full Employment Full employment is the commonly accepted goal of macro economic policy in a developed country. The classical economists assumed that full employment is automatically attained by a free and competitive market economy in the long run. Keynes, however, pointed out that full employment in practice is a rare phenomenon. Actually an economy attains equilibrium at under employment level. Accepting Keynesian argument, countries have set full employment as an important goal in their macro - economic policies.


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In the technical language of macro - economic analysis, full employment is viewed as an equilibrium situation in which the sum of the demands in all labour markets tends to be equal to the sum of the supplies, though, of course, in many of these markets, there is the likelihood of an excess of demand over supply, or of supply over demand, Keynes also provides an alternative definition of full employment in that it is "a situation in which aggregate employment is inelastic in response to an increase in the effective demand for its output." He, therefore, suggested that an economic policy aiming at achieving full employment, should be designed to uplift the effective demand appropriately.

2)

Economic Stabilisation Stabilisation broadly means preventing the extremes of ups and downs or booms and depression in the economy without preventing factors of economic growth to operate. It also implies preventing over and under - employment. Stabilisation does not mean rigidities, it should permit a reasonable degree of flexibility for 'self - adjusting forces of the economy.' The major objective of stabilization policies are : (i)

preventing excessive economic fluctuations,

(ii)

efficient utilization of labour and other productive resources as far as possible;

(iii) encouraging free competitive enterprise with minimum interference with the functioning of the market economy. The two most important and widely used economic policies to achieve economic stability are (i) fiscal policy; and (ii) monetary policy. a)

Fiscal Policy :

The 'fiscal policy' refers to the variations in taxation and public expenditure programmes by the government to achieve the predetermined objectives. Taxation is a measure of transferring funds from the private purses to the public coffers; it amounts to withdrawal of funds from the private use. Public expenditure, on the other hand, increases the flow of funds into the private economy. Thus, taxation reduces private disposable income and thereby the private expenditure, and public expenditure increases private incomes and thereby the private expenditure. Since tax-revenue and public expenditure form the two sides of the government budget, the taxation and public expenditure policies are also jointly called as 'budgetary policy.' Fiscal or budgetary policy is regarded as a powerful instrument of economic stabilization. The importance of fiscal policy as an instrument of economic stabilization rests on the fact that government activities in modern economies are greatly enlarged, and government

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tax-revenue and expenditure account for a considerable proportion of GNP, ranging from 10 - 25 per cent. Therefore, the government may affect the private economic activities to the same extent through variations in taxation and public expenditure. Besides, fiscal policy is considered to be more effective than monetary policy because the former directly affects the private decisions while the latter does so indirectly. If fiscal policy of the government is so formulated that it during the period of expansion, it is known as 'counter - cyclical fiscal policy'. b)

Monetary Policy :

Monetary policy refers to the programme of the Central Bank's variations, in the total supply of money and cost of money to achieve certain predetermined objectives. One of the primary objectives of monetary policy is to achieve economic stability. The traditional instruments through which Central Bank carries out the monetary policies are : Quantitative Credit Control Measures such as open market operations, changes in the Bank Rate (or discount rate), and changes in the statutory reserve ratios. Briefly speaking, open market operation by the Central Bank is the sale and purchase of government bonds, treasure bills, securities, etc., to and form the public. Bank rate is the rate at which Central Bank discounts the commercial banks' bills of exchange or first class bill. The statutory reserve ratio is the proportion of commercial banks' time and demand deposits which they are required to deposit with the Central Bank or keep cash - in - vault. All these instruments when operated by the Central Bank reduce (or enhance) directly and indirectly the credit creation capacity of the commercial banks and thereby reduce (or increase) the flow of funds from the banks to the public. In addition these instruments, Central Banks use also various selective credit control measures and moral suasion. The selective credit controls are intented to control the credit flows to particular sectors without affecting the total credit, and also to change the composition of credit from undesirable to desirable pattern. Moral suasion is a persuasive method to convince the commercial banks to behave in accordance with the demand of the time and in the interest of the nation. The fiscal and monetary policies may be alternatively used to control business cycles in the economy, though monetary policy is considered to be more effective to control inflation than to control depression. It is however, always desirable to adopt a proper mix of fiscal and monetary policies to check the business cycles.


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Exercise : 1.

Define Macro Economics.

2.

Explain the nature and scope of Macro economics.

3.

Explain J. M. Keynes' analysis of income determination in the context of the principle of Effective Demand.

4.

Write Short notes on : a) Factors determining Effective Demand b) Consumption Function c) Investment Function d) Fiscal Policy e) Monetary Policy.

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5.

Explain with an illustration, various phases of Business Cycle.

6.

Define Inflation. Explain the Causes of Inflation.

7.

What are the consequences of Inflation?

8.

Explain Macro Economic Polices with special emphasis on a) Full Employment and b) Economic Stabilization.


NOTES


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NOTES

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Chapter 9 GOVERNMENT AND PRIVATE BUSINESS

Preview Introduction, Need for government intervention in the market, Price Controls(Indian Experience),Causes of Price rise in India, Price controls in India, Support prices and Administered Prices, P.D.S., Protection of consumers' interest; Economic Liberalization, Process of Disinvestment - need and methods, Disinvestment of PSU in India, Policy Planning as a guide to overall business development. INTORDUCTION In our discussion of business decisions regarding production, pricing, investment etc, in previous chapters, we assumed the existence of a 'free enterprise system' in which there is the least interference by the State with the choices, preferences and decisions of the individuals regarding their economic pursuits. The real life situation is however quite different even in the free enterprise economies, let alone the State-controlled economies. The government holds tremendous authority not only to influence the private business decisions but also to control and regulate, directly and indirectly, the private business activities. By using its powers, the government can enact the laws against production, sale and consumption of certain goods; can prevent the entry of private entrepreneurs to certain industries through its Industrial Policy, can limit the growth of private firms beyond a certain limit (e.g., MRTP Act.); and can nationalize the industries whenever it thinks necessary and desirable. Another form of government intervention with private business is formulation and implementation of various kinds of economic policies such as fiscal policy, monetary or credit policy, industrial licensing policy, commercial policy, exchange control policy, etc. Besides, the government affects private business also in its capacity of a competitor in the input market. Public sector industries being owned and managed by the government get a preferential treatment in the allocation of scarce input. All these activities and policies of the State are the various forms of intervention with the free enterprise system, which affect the private business activities. The interference raises several questions: Is government intervention with free enterprise inevitable? Government and Private Business

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If yes, what should be the limit of government intervention or the limit of government economic activities? How can the public and private sector in a mixed economy work in cooperation and coordination with each other? How and to what extent do the government’s economic policies affect the private business ? We shall answer some of these questions in this part of the book. 1)

NEED FOR GOVT. INTERVENTION:

The need for government intervention with the functioning of free market mechanism has arisen out of failure of free market economy expected to ensure (i) that all those who are willing to work at prevailing wage rate get employment; (ii) that all those who are employed get their living in accordance with their contribution to the total output, (i.e., their productivity); (iii) that factors of production are optimally allocated between the various industries; and (iv) production and distribution pattern of national product is such that all get sufficient income to meet their basic needs - food, clothing, shelter, education, medical care, etc. The world has however experienced that the free enterprise system has failed to orgainse the economy which would satisfy the above requirements. The failure of the free market economy is attributed to its following shortcomings. Shortcomings of Market System/ Limitations or Defects of Market System : Following are the important limitations of the market mechanism (i.e. of market economy or capitalism) :

(i)

Inequalities of Income and Wealth : One of the serious limitations of market mechanism is that it results in extremely unequal distribution of income and wealth. In a free competitive economic system, those with productive resources or intellectual abilities find it easy to obtain rising income and wealth, whereas those who have no productive resources or mental abilities do not get much share in annual national income and wealth. And the number of such people in any society is generally so great that they constitute the majority. Thus, market mechanism results in unequal distribution of income and wealth and their concentration in the hands of a few people in society. The rich go on becoming richer, while the poor who constitute majority continue to remain poor. These economic inequalities give rise to social and political unrest disturbing social and political peace in the country.

(ii)

Emergence of Monopolies: It is observed from the economic histories of the United States and West European countries that competition which is the heart of market mechanism itself gives rise to monopolies. If for example there are a number of producers of a commodity, the efficient ones who are always few because of uneven distribution of organizational abilities among people, will begin to absorb the inefficient ones. The final result is that only one (absolute

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monopoly), two (duopoly) or a few (oligopoly) units in the industry remain. These units naturally begin to enjoy monopolistic power exploiting both consumers and workers. Also, these monopolies establish political lobbies and through corruption and other favors to legislators get suitable legislation passed thus protecting their own interests and sacrificing the interests of vast body of consumers.

(iii) Failure to Provide Full Employment : It was assumed that under competitive conditions, market mechanism or price mechanism would automatically bring about and establish equilibrium at the level of full employment. J. M. Keynes however showed that due to several rigidities (especially wage rigidities due to emergence of trade unions in the labour market), it so happens that the economy may get established at the level of less than full employment. Thus market mechanism does not ensure full employment of labour force. Thus the labour force which could have produced much needed wealth lies unemployed and is wasted.

(iv) Instability : Market economy or private enterprise economy is a planless economy. In such an economy where millions of consumers and millions of producers are taking their own independent decisions, it is rarely that some sort of balance would be achieved between demand for thousands of commodities and their supply. This imbalance gives rise to frictional disturbances and cyclical booms and depressions. It is inconceivable that the modern complex economy involving millions of commodities and millions of consumers and producers would always work smoothly. Market economy is bound to be characterized by great instability.

(v)

Wastages of Market Economy : As we have seen, market system or market economy suffers from time to time from economic depressions. During period of depression various factors of production lie unutilized. These factors could have been used to produce much needed wealth for the poorer sections of the society. Secondly, we have seen that competition often gives rise to monopolies. Often these monopolies purposely keep certain factors of production idle creating artificial scarcities of their products with a view to raise prices to the maximum, if such a step gives maximum profit. Thus under monopoly there is tremendous wastages of productive resources. In those lines of production where competition exists, there appear what may be called wastages of competition. Thousands of units in the same industry take independent decisions regarding production. Often there is over-production in some industries and there is under-production in certain other industries.


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Also, in a competitive regime, there are wastages of advertisement. Hundreds of producers of a similar commodity spend vast amounts on advertisement. Since rivals are advertising, it is possible that the final effect of advertisement by rival parties is neutralized. This would mean that great amount of labour and other resources employed for advertisement are wasted. While some advertisements are truly informative most are misleading and therefore, the claim that under free enterprise system or market system competition leads to the most efficient use of community's various productive resources is not valid. On the contrary capitalism abounds in wastages due to unemployment, over and underproduction and vast expenditure on advertisements necessitated by cut-throat competition among rival firms.

(vi) Indifference to and Sacrifice of Social Welfare : In a market economy or free enterprise economy, production of goods and services is all guided by the aim of securing maximum private profit. Goods are produced for which there is greater demand. That is how in capitalism luxury and semi-luxury goods, which richer sections of the community can afford to buy because they have the necessary purchasing power, get preference over production of mass consumption goods needed by poorer sections of the community. Their production is neglected in preference to production of luxury and semi-luxury goods for richer sections of society. This means that very little attention is paid to the welfare of the society.

(vii) Poverty in the midst of Plenty : In a market economy, inspired by private profit motive, tremendous technological progress has taken place. This has tremendously increased productive powers of the economy and production of various goods and services. But due to the institution of private property and law of inheritance and succession (which are basic features of free enterprise system of economy), rich become richer who continue to exploit the vast poor masses. The vast masses of people living on bare minimum wages prevailing under competitive conditions cannot get continually rising share in the increasing productivity and production of wealth in the commodity. In a free enterprise economy, there is thus observed the existence of contradictory position of poverty in the midst of plenty.

(viii) Undesirable Psychological and Social Effects : Capitalism with emphasis on private profit motive and money making has great adverse social, cultural and psychological effects. In capitalism, money becomes the yardstick of measuring success in every field - art, music, literature and so on. Art, music and literature all come to be judged by their financial success and not on the basis of their inherent quality or merit.

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Emphasis on private profit motive and on money-making arouses in capitalist regime instincts of acquisitiveness, unscrupulousness, combativeness and immorality suppressing good human instincts like kindness, love, cooperation and consideration for the welfare of others.

(ix) Exploitation of Backward Countries and World Rivalry : The developed capitalist countries, with a view to make higher and higher profits, have been exploiting backward countries in Africa and Asia through great multi national corporations and through the sale of arms and ammunition to both the opposing parties or countries (Arabs versus the Jews, India versus Pakistan, etc.) just because the defence industries owned by rich capitalists in Western countries should make rising profits. Developed capitalist countries are putting restrictions on exports from developing or backward counties thus hampering their rapid economic development. Giant multi national corporations try to subvert national governments opposed to their interests by sabotage and various other methods. All this has led to international rivalry, disturbances and violence which go against economic development of poor and backward countries in Asia. Africa and Latin America. Concluding Remarks: It would thus be seen that while free enterprise economy or market system has some solid achievements to its credit, it also suffers from very serious limitations or evils, affecting both its own working and that of other countries. 2)

PRICE CONTROLS IN INDIA

CAUSES FOR RISE IN PRICES IN INDIA: A strong inflationary pressure has been built into the Indian economy for a long time - precisely from the start of the Second World War - partly through ever-mounting demand on the one side and inadequately rising supply on the other. The expanding demand is due to the rapid growth of our population, rising money income, expansion in money supply and liquidity in the country, rising volume of black money and continuous rise in demand for goods and services due to periodic wars, rapid economic development, etc. Supply of goods and services too has been rising but the rise in supply has not been proportionate and matching the rise in demand; this is due to monsoon, use of backward technology, bottlenecks in transport and power and shortages of various inputs. At any given time, therefore, there is demand and supply imbalance. Let us emphasize some of the causes behind the inflationary rise in prices in India in recent years.


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A.

DEMAND PULL FACTORS (i)

Mounting Government Expenditure - Government expenditure has been steadily increasing over the years. The total expenditure of both Central and State Governments including Union Territories had risen from nearly Rs.740 crores in 1950-51 to Rs.37000 crores in 1980-81; and nearly Rs.5, 69,400 crores in 19992000 an more than Rs. 11,000 crores in 2003 approximately. In a predominantly agricultural economy like India, big programmes of economic development involving huge investments have been undertaken. Mounting government expenditure implies a growing demand for goods and services and thus, is an important factor for the rise in price. Beside, continuous increase in government expenditure has the effect of putting in large money income in the hands of the general public and causing the fire of inflation.

(ii)

Deficit Financing and increase in money supply - the Government of India is responsible for adopting deficit financing as a method of financing economic development. Mounting Government expenditure financed through deficits pushes up the money supply in the country and consequently pushes up the public demand for goods and services. The Government of India has been responsible for the inflationary situation in the country through its policy of deficit financing and state governments contributed their share through their persistent financial indiscipline, reckless expenditures and unauthorized over-drafts.

(iii) Role of Black Money - It is well-known that there is a large accumulation of unaccounted money in the hands of income-tax evaders, smugglers, builders and corrupt politicians and government servants estimated at Rs.6,00,000 crores in 1997-98. There is considerable slush money with politicians and Government servants, especially those dealing with licensing, registration, collection of taxes, etc. A large part of the unaccounted money is used in buying and selling of real estate in urban areas, extensive hoarding and black marketing in many essential and inflation - sensitive goods, such as sugar, edible oils, etc. It is difficult to estimate the amount of black money or the precise influence of this money in pushing up prices but there is no denying the fact that one of the important factors responsible for inflationary pressures in recent years is the existence and the active role of black money. (iv)

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Uncontrolled growth of population - It is the continually rising population in India which is responsible for the persistent gap between demand and supply, in almost all consumer goods and services, thus exerting continuous pressure on prices. Managerial Economics

B.

COST - PUSH FACTORS If supply of goods and services can be increased to correspond with every increase in demand, price level will tend to be stable. Prices, however, rose whenever the production of food grains and other consumer goods declined or was stagnant. (i)

Fluctuation in output and supply - In this connection, we may refer to violent fluctuations in food grains output. Such huge fluctuations in the output of food grains in certain years was a major factor in the rise of food grains prices as well as general prices. Likewise, we may also refer to the fact that the supply of manufactured goods, did not increase adequately in certain periods. Power breakdowns, strikes and lock-outs and shortage of transport facilities are major factors for lower rate of production of manufactured goods. With ever rising demand for manufactured products, the producers are in a position to push up the prices of their products. Apart from fluctuations in production, market arrivals have also tended to be erratic. In fact, the upward pressure on agricultural prices is also due to large hoarding by farmers, and hoarding and speculation of food grains by traders and blackmarketeers. At one time, hoarding was done only by middlemen but now farmers have also joined the traders in this vicious game. With increased credit facilities from the cooperative societies and commercial banks, even small farmers have now more holding capacity. They hold on to their stock in anticipation of higher prices.

(ii)

Taxation, as a factor in rising costs - Cost-push factors consist mainly of rise in wages, profit-margins and rise in other costs. In this connection the government and the public sector were also responsible, to a large extent, for pushing up the price level in the country. With every budget, the government imposed fresh commodity taxes and gave an opportunity to the trading classes to raise the prices, often more than the levy of the taxes.

(iii) Administered price - The public sector enterprises too were continuously raising the prices of their products and services which generally constitute raw materials for other industries. A good example is the Railways which have been regularly raising fares and freight rates in the last few years. Likewise, there has been regular upward revision of several administered prices such as those of petrol, diesel, steel, cement, coal, etc., pushing up the price level further. Every rise in administered prices adds fuel to the inflationary potential in the country. (iv)

Hike in oil prices and global inflation - Serous inflationary pressures were also created because of the sharp hike in the price of crude oil since September 1973 and the consequent upward revision of the prices of oil and oil-based goods. In 1980 alone, there was 130 per cent increase in all fuel prices by the OPEC. The


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gulf-surcharge which raised the prices of petroleum products to an unprecedented level in one single jump is major cause for rise in price during 1990-91. C.

OTHER FACTORS The failure of the Government policy on the price front at various times was a serious factor in the inflationary rise in prices. We can cite specific cases. In 1973, the Government nationalized the wholesale trade in wheat along with a threat to introduce a similar measure for rice. This measure completely upset the normal trade and the price of open market wheat shot up. At the same time, the government did not fail to procure adequate amount of food grains for the public distribution system, nor was it able to import the necessary quantity from foreign countries. The Government of India has generally followed a highly vacillating and anti-peasant policy in fixing procurement prices. This is equally true in fixing and controlling prices of such essential goods as sugar, vanaspati, soap, cloth, etc. Nor are the controls properly enforced thus giving great scope for rampant black-marketing to exist, for the benefit of the traders.

Causes for inflationary pressure in the 90's and after 2000 All the causes we have discussed above are basic causes for the existence of general inflationary pressure in the Indian economy and they have been present and active over the last many years. The immediate cause for the pressure on prices since, 1990, as mentioned earlier, was the Gulf War and the consequent shortages and increase in the prices of administered items such as coal, petroleum products, fertilizers, electricity, etc. According to the Government, the buildup of inflationary pressure during the Nineties was mainly attributable to:

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(a)

Higher fiscal deficit - large and persistent fiscal deficits over the years resulting in excessive growth in money supply and liquid resources with the community: there was automatic monetization of fiscal deficit.

(b)

Sharp reserve money (RM) during the three years (1993-96) due to large inward remittances and heavy accumulation of net foreign exchange assets with RBI; this was the basis of the rise in money supply and liquid resources with the general public at that time;

(c)

Supply-demand imbalances - sensitive commodities like pulses, edible oils, and even onions and potatoes due to shortfalls in domestic production; and

(d)

A sharp increase in procurement prices of cereals and consequent rise in the issue price;

(e)

The 9/11 attack on W.T.C. (U.S.A.); U.S. and allied forces invading Afghanisthan, Iraq and take-over of the Iraq by U.S. and allied forces global recession etc. Managerial Economics

3)

PRICE CONTROLS IN INDIA :

A wide range of measures are being adopted to ensure stable conditions as well as to prevent speculators form taking an undue advantage of the conditions of scarcity. Since the price situation is the outcome of shortages in basic goods and services and a rapid growth in money supply and bank credit, various types of measures relating to money supply, pricing and distribution of commodities are pressed into service.

Demand Management (i)

Fiscal measures - The Government of India has generally insisted on controlling its own expenditure and keeping in check both its revenue deficit and fiscal deficit - this has been a major instrument of inflation - control. In July 1974, for example, the Government of India promulgated three ordinances to limit the disposable money incomes in the hands of consumers through freezing wages and salaries on the one side and dividend incomes on the other. Again in January 1984, the Government of India announced a package of programmes to curtail public expenditure, to postpone fresh recruitments to Government job etc. It was only since 1990-91 that the Government of India has appreciated the importance of reducing fiscal deficit. The Government of India since 1991-92 restricted its borrowing from RBI through the issue of ad hoc treasury bills and thus reduced the issue of new currency. These measures, along with monetary measures helped to contain the volume of monetary measures helped to contain the inflationary pressure on price since 1995-96.

(ii)

Monetary measures - The monetary policy of RBI consists of extensive use of general and selective credit control measures. The main thrust has been to restrict bank-credit against inflation sensitive goods and to influence the cost and availability of commercial bank credit. The RBI relies heavily on selective credit controls on bank loans against food grains, cotton, oil-seeds and oils, sugar and textiles so as to discourage speculative hoarding. During the Eighties and Nineties, monetary policy has been directed essentially to prevent any excessive increase in liquidity and at the same time to ensure that the genuine credit requirements of the industrial sector and the priority sectors are adequately met. The cash reserve ratio (CRR) was raised from 6 to the statutory maximum of 15 per cent gradually. These steps resulted in a large measure, 'in mopping up excess liquidity in the economy, moderating monetary and credit expansion and consequently helped in bringing down the rate of inflation.


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In general, RBI uses its monetary policy to achieve a judicious balance between the growth of production and control of the general price level. Generally RBI uses Bank Rate, CRR., SLR and open market operations to increase bank credit and expansion of business activity (in times of business recession) or to contract bank credit and check business and speculative activity (in periods of inflation).

Supply Management Supply management is related to the volume of supply and its distribution system. On the commodity front the Government has generally focused its attention in securing greater control over the prices of rice, wheat, sugar, oils and other commodities of mass consumption. Through increase in domestic supplies, large releases from official stocks and widening and streamlining of the network of public distribution, the Government attempts to prevent an undue increase in the prices of essential commodities. Let us touch some of the important aspects of this policy. (a)

Fixation of Maximum Prices - For elimination the incentive for hoarding and speculative activity in food grains, the State Governments have been asked to fix the wholesale and retail prices of food grains. Further, the Government also fixes minimum procurement prices for major crops on the recommendation of the Agricultural Prices Commission (APC). Prices of other important goods like cloth, sugar, vanaspati, etc., are also controlled.

(b)

The system of dual prices - The Government has adopted a system of dual prices in the case of goods like sugar, cement, paper, etc. Under this system, the weaker sections of the community are supplied these goods through fair price shops, at controlled prices and the rest and allowed to purchase their requirements at higher prices from the open market.

(c)

Increase in Supplies of Food grains - The Government attempts to increase supplies of food grains and other essential goods in times of internal shortage through larger imports.

(d)

Problem of oilseeds and edible oils - In recent years, steep rise in the prices of edible oils along with those of pulses, tea and sugar have been responsible for rise in the general price level. The Government has prepared medium and long-term plans to step up the production of oilseeds in the country. The Government has announced higher support prices for groundnut, soybean and sunflower seed - the last two crops offer the maximum scope for augmenting the supply of edible oil in the country. In the short period, the Government has been relying on imports of edible oils, at reduced or confessional import duties. In this connection, we should refer to the steps taken by the Government to increase the production of all other agricultural products.

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(e)

Public Distributions System (PDS) and consumer protection - An important aspect of the Government's policy was strengthening of the PDS. The Government has set up a network of fair price shops numbering nearly 4,00,000 which cover a population of over 5million and which distribute wheat, rice, sugar, imported edible oils (palm oil), kerosene, soft coke and controlled cloth. The public distribution system serves two purposes. Firstly it helps to hold down prices. Secondly, it provides essential commodities to low income groups at relatively low prices. But whenever the PDS is hard pressed due to inadequate supply, prices of essential goods tend to rise. PDS has been strengthened and extended to rural areas.

(f)

Control over Private Trade in Food grains - To check prices and to eliminate hoarding and speculative activity in food grains trade, wholesale dealers in food grains were licensed in many States. Limits were also fixed beyond which traders and producers could not hold stock without declaration. The Food Corporation of India has helped a lot to buy in surplus areas and sell in deficit areas and thus moderate the differences in prices.

g)

Other relevant measures by Government of India to control inflation. i)

Adoption of OGL (Open General License) import policy for importing sugar, pulses etc.

ii)

Adjustment in trade and tariff policies in the Central Government Budgets to ensure their domestic prices of Industrial products remain competitive.

iii)

Great reduction in excise duties on a numbers of items expected to accelerate the speed of industrial revival and raise industrial growth.

(1)

Administered Prices : The Government of India follows administered price policy in respect of commodities which are either vital industrial raw materials, produced wholly or largely in the public sector such as steel, fertilizer, coal and petroleum products. The Government also fixes the rates and charges of public utilities like railways and state electricity boards. The products and services produced by the public sector in India constitute important raw materials for other industries and are subject to serious output and price fluctuations. Administered prices are normally set on the basis of cost plus a stipulated margin of profit. There are two basic objectives of administered prices. : (i)

to fix and maintain the prices of essential raw materials so to avoid cost and price escalation; this has special significance during a period of shortages and rising prices; and

(ii)

to ensure economic prices to uneconomic units so that the latter too can earn profits.


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Whenever there is a change in cost, the administered price is also changed. As the Government is generally slow and sluggish in its actions, the change in administered prices may not be proportionate to change in cost and, besides, the change in price may come much later than change in cost. In fact, this has been a major criticism against administered prices in India. As the administered prices are often inadequate to meet cost escalation, basis industries like fertilizers and cement were unable to generate sufficient financial resources for modernization and expansion. The present policy of the Government is to adjust administered prices to enable public sector units to earn sufficient profits and over a period of time give up the system of administered prices.

(2)

The System of Dual Prices : It is a commonly accepted principle in India that the basic needs of the weaker sections of the community should be met and for this the Government should subsidies the prices of certain basic goods. This does not mean that the benefit of subsidy and low price should go even to those who do not require it. At the same time the burden of subsidy should not fall on the producers of these basic goods but should be spread on the community as a whole. Such a policy is (a) in the interest of the vulnerable sections, and (b) it does not discourage the producers from expanding production and investment in the particular sector. Originally started with the price of steel, dual pricing was extended to many other essential goods such as major food grains, sugar, edible oils, and cheaper varieties of cotton cloth. Dual pricing is a form of short cut price control and it enabled the Government to acquire essential goods at lower controlled prices for its own use, even though it was meant to benefit the weaker sections.

(3)

SUPPORT / PROCUREMENT PRICES : A proper price policy will have to include measures directed towards cereals, pulses and oil-seeds viz. their production, purchase, movement, sale and distribution. The level at which agricultural prices should be stabilized is important from the point of view of production and consumption. In fixing food grain prices, three aspects may be kept in mind :

330

(a)

The Government should fix and guarantee such procurement prices for various food grain as will provide suitable incentives to the producers. This is particularly important as the volume of production has increased considerably under the influence of the "green revolution".

(b)

The retail prices should be fixed in such a way that the interests of the consumers are safeguarded and at the same time there is no scope for hoarding Managerial Economics

and speculation. Food zones are abolished and inter-state movement of the food grains is the monopoly of the Food Corporation of India. (c)

Holding the price line covers not only to cereals, but to all basic consumption goods as for instance pulses, sugar, oil and vanaspati, cloth, kerosene, etc.

The Government of India announces support prices on the recommendations of the Agricultural Prices Commission, redesignated as Commission for Agricultural Costs and Prices. The Commission is guided in recent years by the three-fold objectives of (a)

raising productivity through assured remunerative prices to farmers ;

(b)

procuring sufficient quantities of rice and wheat for running the public distribution system; and

(c)

promoting a desirable inter-crop balance.

While making recommendations to the Government regarding revision of minimum procurement and support prices, the Commission takes into account, among other things, the changes in production costs, the inter-crop balance and the terms of trade between agriculture and other sectors of the economy. The basic framework for determining support prices for major cereals has been relatively fair. The interests of both farmers and general consumers have been well protected. But there are a number of distortions: One is the announcement of higher minimum prices by state Government to satisfy local interests. Another is that support prices for coarse grains, pulses and oilseeds are of a notional nature and are not backed by an organized system of official procurement. In these case also, support prices should be rationally determined (as in the case of wheat and rice) and should be made effective through public purchases and public distribution.

(4)

Public Distribution System : Rationale of PDS : The distribution of essential commodities through fair price shops at government - controlled prices has come to be known as public distribution system. There are various reasons for the setting up of the public distribution system in India. 1)

In order to maintain stable price conditions, an efficient management of the supplies of essential consumer goods is necessary. Moreover, as most of these commodities are agriculture-based, their prices are subject to large seasonal variation. Public distribution system will, therefore, have to play a major role in ensuring supplies of essential consumer goods of mass consumption to people at reasonable prices, particularly to the weaker sections of the community.


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State trading and buffer stock operation on the one side and public distribution on the other are essential in the case of agricultural products. 2)

A large proportion of agricultural products - both food grains and raw materials - come to the market soon after the harvest when prices are depressed. It is necessary to devise a scheme to buy such commodities at prices which ensure a certain minimum profit to the farmers. The Food Corporation of India (FCI) and other institutions have been set up to buy agricultural goods at prices that would ensure minimum profit for the farmers; they also help in stabilizing agricultural process. At the same time, these goods would be supplied through public channels to consumers especially the weaker sections of the community - this would mean that in critical times, they would receive supplies of essential commodities at reasonable prices.

3)

The PDS has become a stable and permanent feature of India's strategy to control prices, reduce fluctuations in prices and achieve an equitable distribution of essential consumer goods among the people.

Goods to be included in the public distribution system. Since distribution is a highly complex matter, only the most essential goods of mass consumption should be brought under the public distribution system, e.g. cereals, sugar, edible oils and vanaspati, kerosene, soft coke, controlled cloth, tea, toilet soap and washing soap, match boxes, exercise books for children, etc. Supplies to the public distribution system. Both Central and state Governments have made arrangements to procure essential commodities and supply them through the public distribution outlets. In the case of food grains, FCI undertakes the necessary operations. In regard to sugar, FCI undertakes these operations. The State Trading Corporation (STC) has been entrusted with the responsibility of importing and distributing edible oils. Kerosene is being handled by the public sector corporations like Indian Oil Corporation (IOC), Hindustan Petroleum, Bharat Petroleum, etc. The production of controlled cloth has now been generally entrusted to the National Textile Corporation (NTC) and distributed through the National Consumers Co-operative Federation (NCCF). 5)

PROTECTION OF CONSUMER INTEREST:

The consumer who is often considered as the king is practically enslaved by the aggressive and dominant market manipulations by the large-sized corporations. The tug-of-war between monopoly producers and scattered consumers obviously works to the advantage of the producers. This is why Prof. J.K.Galbraith favoured the organization of the advantage of the producers. This he termed countervailing power. A consumer's interest has several facets and

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its protection amounts to empowering the consumer. Such an empowerment can be achieved by the consumers themselves by organizing together and further by creating consumer's cooperatives. Such an option is difficult to achieve, especially where the consumers are spread over a vast area and where they lack in awareness, education and organizational ethics. It is under these conditions that the government is called upon to step in, in order to protect the consumer's interest. One way of protecting the interest of the consumers is the formation of their co-operatives. But due to various limitations it is lengthy and tedious process. Therefore, the government, at best, can announce a set of concessions and facilities for their development. The direct way with which we are concerned here is an effective intervention in the price system and in the supply of commodities by undertaking legal measures. The consumer Protection Act, 1986, in India is such an effort. The act provides for the settings up of quasi-judicial bodies at the district, state and central levels for the redressal of consumer protection act which provides for reliefs and compensation to the consumers wherever deemed appropriate. A consumer's interests or rights as enunciated by The Consumer Protection Act 1986 are as follows: i)

Protection from Hazardous Commodities: A consumer is within his right to demand protection against the marketing of goods and services which are hazardous to life and property.

ii)

Right to Information: A consumer has a right to the information regarding the quality, quantity, potency, purity, standard and the price of goods and services as the case may be, so that he can protect himself against unfair trade practices like being misguided and cheated.

iii)

Right to a competitive Price: Wherever possible, the consumer must be assured of an access to a variety of goods and services at a competitive price. This right, on the one hand accepts the freedom of retailers from the exploitative conditions imposed by the producers and on the other hand, contains the monopoly powers of the producers.

iv)

Right to be Heard: The establishment of appropriate forums at various levels aims at hearing the grievances of the consumers.

v)

Right to Information regarding Protection: By passing an act the interests of the consumers cannot be protected unless the consumers have full knowledge of the protection given to them. It is therefore, necessary to educate the consumers in this protection given to them. It is therefore, necessary to educate the consumers in this regard.

Consumers protection involves protection from unfair trade practices for the purpose of promoting sales and making money at the cost of the consumers health and wellbeing. Such practices include; a) False representation of the quality, quantity, grade,


333

composition, style, etc. of the product; b) False claims regarding the quality, grade or effectiveness of a service; c) False representation regarding re-built, removed, reconditioned or old goods as new goods; d) False claims regarding sponsorship, approval, performance uses or benefits which the goods really do not possess; e) false representation regarding affiliation or authorized dealership; f) misleading representation concerning the need for or the usefulness of goods/services; and g) giving as untested or unrealistic guarantee regarding the quality /performance of the goods /services. Protection of a consumer’s freedom to buy the goods and services of his choice is necessary, and goods which are found defective must be treated as an infringement of his freedom of choice. Therefore, action is required to be taken against the producers/ sellers of substandard goods and services. For this purpose action based upon certain standards should be laid down, like AGMARK or ISI seal, can be taken by the government. Similarly, protection against deficiency in the product or service implying a fault, imperfection, shortcoming or inadequacy in the quality, nature or performance has got to be accorded. It is necessary to remember that in respect of the protection of consumer's interests, the Consumer Protection Act is not only act concerned. In fact, the Indian ContractAct, the Sale of Goods Act, the Negotaible Instrument Act, the Banking Regulation Act, the Compines Act etc.,also contain provisions regarding protection accorded to the consumers in cases relevant under the Act concerned. Because the Consumer Protection Act is specially intended and framed for this purpose, we have discussed some of the provisions/ considerations of this Act. Under the various Acts, in accordance with the provisions in this regard, the consumer has to be provided with an access to the machinery evolved for or already existing to the redressal of his grievances. As such as aggrived parties, the consumers can take resourse to filing suits in the relevant course. Obviously, this whole issue of consumer protection is shrouded with complexities and demands the government to undertake the responsibility of safeguarding the interests of the consumers not only as consumers but also as ordinary citizens of the land. This is a part of the normal functions of the government and it is in conformity with the government's responsibility in the dispensation of natural justice. As such, it involves various steps by way of creating machinery,monitoring the performance and penalizing the defaulters. This in turn, created the need for maintaining inspection/ supervision personnel, procedures for enforcing the laws and actions for penalizing the defaulters andcompensating the sufferers. Needless to say that this is a major and pervasive intervention in the system of marketing and pricing. In this context, it is essential to implement fhe suggestions and recommendations given by a committee headed by Anna Hazare, a great Social Reformer.

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6)

THE NEW INDUSTRIAL POLICY (1991) :

The Congress Government led by Mr. Narasimha Rao announced the new industrial policy in July 1991. The main aim of the new industrial policy was: (a)

to unshackle the Indian industrial economy form the cobwebs of unnecessary bureaucratic control,

(b)

to introduce liberalization with a view to integrate the Indian economy with the world economy,

(c)

to remove restrictions on direct foreign investment as also to free the domestic entrepreneur form the restriction of MRTP Act, and,

(d)

The policy aimed to shed the load of the public enterprises which have shown a very low rate of return or are incurring losses over the years.

All these reforms of industrial policy led the government to take a series of initiatives in respect of policies in the following areas : (a) Industrial licensing; (b) Foreign investment; (c) Foreign technology policy; (d) Public sector policy; and (e) MRTP Act.

Industrial Licensing Policy In the sphere of industrial licensing, the role of the government was to be changed from that of only exercising control to one of providing help and guidance by making essential procedures fully transparent and by eliminating delays. (A) Industrial Licensing to be abolished for all projects except for a short list of industries related to security and strategic concerns, social reasons, hazardous chemicals and overriding environmental reason and items of elitist consumption. Industries reserved for the small scale sector will continue to be so reserved. List of Industries in Respect of which Industrial Licensing will be Compulsory 1. Coal and Lignite. 2. Petroleum (other than crude) and its distillation products. 3. Distillation and brewing of alcoholic drinks. 4. Sugar. 5. Animal fats and oils. 6. Cigars and cigarettes of tobacco and manufactured tobacco substitutes. 7. Asbestos and asbestos based products. 8. Plywood, decorative veneers, and other wood based products such as particle board, medium density fiber board, block board. 9. Raw hides and skins, leather, chamois leather and patent leather. 10. Tanned or dressed fur skins. 11. Motor cars. 12. Paper and Newsprint except bagasse-based units. 13. Electronic aerospace and defense equipment; all types. 14. Industrial explosives, including detonating fuse, safety fuse, gun powder, nitrocellulose and matches. 15. Hazardous chemicals. 16. Drugs and Pharmaceuticals (according to Drug Policy). 17. Entertainment Electronics


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(VCRs, Colour TVs, C.D. Players, Tape Recorders). 18. White goods (Domestic Refrigerators, Domestic Dish Washing Machines, Programmable Domestic Washing Machines, Microwave ovens, Air conditioners). The compulsory licensing provisions would not apply in respect of the small-scale units taking up the manufacture of any of the above items reserved for exclusive manufacture in small sector. (B) Areas where security and strategic concerns predominate, will continue to be reserved for the public sector. List of Industries to be reserved for the Public Sector 1. Arms and ammunition and allied items of defense equipments, Defense aircraft and warships. 2. Atomic Energy. 3. Coal and lignite. 4. Mineral oils. 5. Mining of iron ore, manganese ore, chrome ore, gypsum, sulphur, gold and diamond. 6. Mining of copper, lead, zinc, tin, molybdenum and wolfram. 7. Minerals specified in the Schedule to the Atomic Energy (Control of production and use) Order, 1953. 8. Railway transport. (C) In projects where imported capital goods are required, automatic clearance will be given in cases where foreign exchange availability is ensured through foreign equity; or if the CIF value of imported capital goods required is less than 25% of total value (net of taxes) of plant and equipment, up to a maximum value of Rs.2 crore. In ore cases, imports of capital goods will require clearance form the Secretariat of Industrial Approvals (SIA) in the Department of Industrial Development according to availability of foreign exchange resources. (D) In locations other than cities of more than 1 million population, there will be no requirement of obtaining industrial approvals from the Central Government except for industries subject to compulsory licensing. In respect of cities with population greater than 1 million, industries other than those of a non-polluting nature such as electronics, computer software and printing will be located outside 25 kms of the periphery, except in prior designated industrial areas.

Foreign Investment In order to invite foreign investment in high priority industries, requiring large investment and advanced technology, it has been decided to provide approval for direct foreign investment upto 51 per cent foreign equity in such industries.

Foreign Technology With a view to injecting the desired level of technological dynamism in Indian industry, government would provide automatic approval for technology agreements related to high priority industries 336


within specified parameters. No permission will be necessary for hiring of foreign technicians, foreign testing of indigenously developed technologies.

Public Sector Policy Public enterprises have shown a very low rate of return of the capital invested. This has inhibited their ability to regenerate themselves in terms of new investments as well as in technology development. The result is that many of the public enterprises have become a burden rather than being an asset to the Government. The 1991 Industrial Policy has adopted a new approach to public enterprises. The priority areas for growth of public enterprises in the future will be the following : (a)

Essential infrastructure goods and services.

(b)

Exploration and exploitation of oil and mineral resources.

(c)

Technology development and building of manufacturing capabilities in areas which are crucial in the long term development of the economy and the long term development of the economy and where private sector investment is inadequate.

(d)

Manufacture of products where strategic considerations predominate such as defence equipment.

Government will strengthen those public enterprises which fall in the reserved areas or are generating goods or reasonable profits. Such enterprises will be provided a much greater degree of management autonomy through the system of memoranda of understanding. Competition will also be induced in these areas by inviting private sector participation. In the case of selected enterprises, part of Government holdings in the equity share capital of these enterprises will be disinvested in order to provide further market discipline to the performance of public enterprises. There are a large number of chronically sick public enterprises incurring heavy losses, operating in a competitive market and serving little or no public purpose. The following measures are being adopted. (i)

BIFR - Public enterprises which are chronically sick and which are unlikely to be turned around would, be referred to the Board for Industrial and Financial Reconstruction (BIFR) for formulation of revival / rehabilitation schemes. A social security mechanism is to be created to protect the interests of workers likely to be affected by such rehabilitation packages.

(ii)

Disinvestment - In order to raise resources and encourage wider public participation, a part of the government's shareholding in the public sector would be offered to mutual funds, financial institutions, the general public and workers.


337

(iii) Boards of public sector companies would be made more professional and given greater powers. (iv)

There would be greater trust on performance imnprovement and managements would be granted greater autonomy through Memorandum of Understanding (MOU) and would be held accountable.

MRTP ACT. With the growing complexity of industrial structure and the need for achieving economies of scale for ensuring higher productivity and competitive advantage in the international market, the interference of the Government through the MRTP Act has to be restricted. Towards this end. (i)

The pre-entry scrutiny of investment decisions by so-called MRTP companies will no longer be require. Instead, emphasis will be on controlling and regulating monopolistic, restrictive and unfair trade practices rather than making it necessary for the monopoly houses to obtain prior approval of Central Government for expansion, establishment of new undertakings, merger, amalgamation and takeover and appointment of certain directors.

(ii)

The thrust of policy will be more on controlling unfair or restrictive business practices.

Further Liberalization by de-reservation : a)

The Government decided in April 1993 remove three more items from the list of 18 industries reserved for compulsory licensing. These three items were : motor cars, white goods (which include refrigerators, washing machines, air conditioners, etc.) and raw hides and skins and patent leather. The basic purpose fo dereservation of these items was to increase the flow of investment in these industries. With the growth of a large middle class, ranging between 100 to 120 milions, the demand for the white goods like washing machine, refrigerators, air conditioners is growing and these items are no longer viewed as luxury goods. Similary the demand for motor cars by the upper middle class and the affluent sections is also growing, more especially when the government is providing loans to businee executives and other senior officials to buy cars. To provide a boost to th motor car and white goods industries, the government has decided to de-reserve these items so that their production improves as response to the market, instead of remaining shackled by the bureaucratic process of liscenceing. Regardsing raw hides and skins and patent leather, the Government wants to push up their exports. Leather and good quality shoes have a tremendous export postential and the small scale units are ill equipped to provide quality goods for the international markets. In pursuance of the liberalization policy towards foreign investment, the Government decided in December 1996 to include 16 categories of industries in respect of which

338


automatic approval would be accorded to foreign equity participation up to 51 per cent. This additional list of industries eligible for automatic approval up to 51 per cent foreign equity cover a wide range of industrial activities in the capital goods and metallurgical industries, mining (up to 50 per cent), and those having significant export potential. b)

The government, however, also added another list of nine industries for which automatic approval upto 74 per cent would be allowed. The nine industries are mining services related to oil and gas fields services, basic metals and alloy industries, not-conventional energy sources, manufacture of navigational, meteorological, geophysical and related instruments and apparatus, electric generation and transmission, construction and maintenance of roads, ropeways, ports, harbors, construction and maintenance of power plants. Besides, land transport, water transport and storage and warehousing services have also been included. The basic thrust of these changes is that there will be no case-by-case approval for various proposals lying before the government. The main aim of the major policy initiative is to facilitate foreign direct investment in infrastructure sector, core and priority sectors, export oriented industries, linkage with agro and farm sectors.

7)

ECONOMIC LIBERALISATION:

The first phase of economic reforms is believed to have begun in 1985 when Rajiv Gandhi enunciated the uppermost goals of the new economic policy as improvement in productivity, absorption of modern technology and full utilization of capacity. The strategy visualized for the purpose gave increasingly greater scope for the private sector This shift in favour of the private sector encompassed a wide range of measures demanding a reformulation of several policies like the industrial licensing policy, export import policy, policy towards foreign capital, policy regarding rationalization and technology upgradation etc., which are covered by the umbrella of economic reforms. The real all-pervading beginning of economic reforms were however witnessed since the installation of the P.V. Narsimha Rao's Congress Government in Mid-1991 The reins of the reforms were in the hands of Dr. Manmohan Singh the then Finance Minister, who enumerated the objectives of the new Economic Policy as under: a)

To increase the efficiency and international competitiveness of industrial production.

b)

To utilize foreign investment and technology to a much grater degree than in the past,

c)

To improve the performance and rationalize the scope of the public sector, and

d)

To reform and modernize the financial sector so that it can more efficiently serve the needs of the economy.


339

For achieving these long-term objectives, the government undertook to instill internal and external confidence in to the economy by adopting stabilization measures, the major ones beings as follows:

340

i)

Fiscal Policy Reforms aimed at reducing the overall public sector defict from 12.5% to 4% of GDP by mid-nineties. This involved raising the income level through both tax and non-tax revenues and controlling public expenditure. This required a greater tax-effort, a more realistic administered price structure, a reduction in subsidies and a better fiscal discipline.

ii)

Financial Sector Reforms based on stricter monitory policy first and then a reversal to a liberal policy, embraced a wide range of industrial areas including the Reserve Bank, Sheduled Banks, CO-operative Banks ,Foreign Banks, Mutual Funds Insurance Companies, Housing Finance Companies, and Stock exchanges. Measures as recommended by both the Narasimha Committees(1991 and 1998) and accepted by the Government included a restructuring of controls by the RBI and the SEBI, norms of capital adequacy, insistence of credit rating and scaling down of interest rates and more autonomy to the financial institutions. All these aimed at strengthening the financial sector and making it more competitive

iii)

Social Sector Policy was guided by the needs of human development. It aimed at revitalized efforts at poverty alleviation, spread of education through formal and nonformal streams, employment guarantee initiatives, supply of safe drinking water,revamping of housing programmes, immunization and other health measures and special attention to the welfare of woman, children and the privileged sections of the society.

iv)

Industrial Policy was thoroughly reformed so as to provide unhindered and uninhibited access to new initiatives by the domestic as well as foreign private sector. This was sought to be achieved by following a phased programme of de-regulation. Expecting the industries of strategic: importance in the areas of defence, defence production and internal energy and such other industries related to protection of environment and internal security, industrial licensing was abolished. The Monopolies asn Restrictive Trade Practices Act was amended and modified so that the big industrial houses do not need a prior permission of the Government either for expansion or for establishing a new undertaking. Areas of industrial activity reserved for the public sector were opened to the private sector, thereby narrowing down the scope of the public sector.

v)

The policy regarding Foreign Capital was recast so as to attract foreign capital, increase foreign exchange earnings, avail of marketing techniques. For this purpose, several reforms and changes were made in the policy. Diract Foreign Investment, up to 51%, was permitted in export=oriented industrial units, trading companies too could have 51% foreigners held equity if they were primarily engaged in export trade. For foreign collaborations,


automatic permission was granted subject to a ceiling on royalty payment of 5% of domestic trade of 8% of export trade or a lumpsum of Rs. 1 crore. vi)

Trade Policy was modified, in phases, so as to remove most of the protection granted to Indian industries and to make then internationally competitive import and export duties were readjusted in keeping with the WTO agreement with effect from April 2001, all quantitative restrictions on imports were removed and a system of price-based system of duties, wherever necessary, was substituted.

vii)

Public Sector Policy underwent an overhaul. The new involved a more realistic review of earlier policy, greater autonomy to units which needed to continue in the public sector, a progressive reduction in the budgetary support to public sector, a discipline to make public sector undertaking (PSUs) more competitive and cost-effective and making all PSUs self-reliant (no losses to be incurred) With these ends in view, the measures taken included a) reduction in the number of industries reserved for the public sector from 17to 8, b) rehabilitation of sick units through BIFR (Board for Industrial and Financial Reconstruction), c) a close monitoring to ensure profitability, and d) a policy of disinvestment. Besides, several steps for protecting the interests of the employees were taken which included VRS packages, retaining programmes etc. A preview of the deals of liberalisation is not very encouraging from certain angles. It has opened up new avenues for enterprise and has attained some success in terms of global linkages of the Indian economy. However, the rates of industrial growth have fallen, agriculture remains neglected, regional as well as personal income disparities have widened and poverty, unemployment and development have attained higher magnitude, as if to mock reforms!

8)

THE PROCESS OF DISINVESTMENT: NEED AND METHODS

With economic liberalization, the private sector was given more freedom and greater scope in the interest of improving the overall performance of the economy as a whole. Greater scope for the private sector may mean incremental disinvestment which connotes the expansion of PSUs can be left to some private company. It may also mean denationalization of the public sector units taking private sector as a partner. In other words, disinvestment is a part of the process of privatization.

a)

Need for Disinvestment Over a period of four decades beginnings with the 1950s, the scope of public sector was continuously expanding, due to various reasons like lack of public sector's funds, non-


341

interest on the part of private sector in undertaking long-term investment projects and so on. With the onset of the New Economic Policy oriented towards providing an upper hand to the private sector, a reversal of the erstwhile policy of public-sector-dominance was set in motion. As a part of this, the process of disinvestment which meant selling of the shares of a PSU to private corporates and individuals started. By selling stocks the public sector could encash part of its investment and hence, the term disinvestment. The need for disinvestment can arise due to any one or more of the following reasons:

342

i)

Phased Privatization: Larger scope for the private enterprise menas a shrinking of the public to the private sector. This is done through disinvestment.

ii)

Professionalism: Ina highly dynamic modern world, efficiency and competitive strength requires the association of professional and management experts with the PSUs (public sector undertakings). But the cream of such expertise is always attracted by the private sector by offering them lucrative, flexible and potentially progressive working conditions. If this expertise is to be available to the public sector, the public sector must offer a share in ownership to the private sector. The public sector in India has continuously been under criticism ofr its lack of a professional approach, mainly due to the fact that most of these units are headed by administrative experts rather than management experts.

iii)

Reducing deficit: As noted earliar, the Government of India was keen on reducing the overall deficit of the public sector to 4% of GDP. For this purpose it needed funds which would help bridge the gap. Disinvestment provided an opportunity of selling stocks and raising funds.

iv)

Re-allocation of Resources: Conceptually, the process of disinvestment amounts to reallocation of resources between the private and the public sectors. This step, in the new business environment, was expected to improve the productive efficiency of the PSUs, thereby paving the way for improving the performance of the economy as a whole.

v)

Capital Support to Plans: Non-Plan expenditure has been continuously increasing due to a number of reasons like higher rates of D.A. for the employees, a rise in the salary bill due to the Fifth Pay Commission's recommendations, rising prices of goods purchased plan projects which needed capital support were therefore, starved of investible funds. Desinvestment accruals are a part of the capital receipts and can be diverted to the capital needs of the plan projets.

vi)

Substitute for Taxation: If we take into account the ground-level need in the midst of present difficulties faced by the Government of India, the disinvestment programme Managerial Economics

apparently is viewed by the government as a substitute of greater tax-effort and curtailment of subsidies both of which are being opposed by parties in the coalition. 'Selling family silver for getting a series of square meals over a number of days appears to be a softer option for tiding over, the temporarily, the finanacial crisis.

b)

Methods of Disinvestment Disinvestment, in itself, is a method of privatization. The methods followed are as under: 1)

Partial Transfer of Ownership: Disinvestment mostly is through this method of ownership transfer under which the ownership is transferred fully or partly. In the present method we are concerned with partial ownership transfer. Ownership can be transferred by selling a part of the shares to individuals, co-operative societies or corporate organizations. Such a transfer results in the creation of joint sector where the public sector and the private sector jointly hold the stocks, jointly exercise their voting rights and jointly participate in the exercise of control.

In India, the proposals of creating a joint ownership are contemplated on the following three lines: i)

Transfer of 25% of shares to the private sector (i.e. to banks, to mutual funds) corporations or individuals including workers who are given a share up to 5% of the total equity. This type of transfer ensures government control with private partnership that enables the unit of avail of the guidance and advice of the private sector.

ii)

Government may retain 51% of the equity with itself and transfer 49% to similar private sector patners/s. It provides for a sizeable ownership transfer. At the same time the majority voting rights remain with the government.

iii)

In this case, majority of the ownership i.e. 74% is transferred to the effective in achieving while the government retains 26% with itself. As saving clause, usually there is provision for veto a power with the government is respect of major decisions.

So far as the first variant is concerned, it is not likely to be very effective in achieving the objective of greater operational efficiency and higher level of competitiveness. The second variant transfers almost half ownership and as such, is likely to bring about certain noticeable changes in the terms of revamping of managerial practices, cost-effectiveness and the units capacity to generate profits, for the simple reason that the stakes are higher for the private sector. In case of the third variant, the private sector will be the real owner in matters of policy decisions and operational control. Government's veto power is reserved only for ensuring that the firm's operation is consistent with the macroeconomic objectives. Micro-decisions are left fully in the hands of the private sector.


343

c)

2)

Total Denationalization: The second method involves a complete sellout of a PSU to a private corporate organization- it may be domestic or foreign or a collaboration concern. Such a step can be taken under a number of possible situations. Firstly, it is possible that the unit which earlier existed in the private sector was nationalized, with a specific objective. Once the objective is fulfilled, the same unit can be denationalized. Secondly, it is possible (though conceptually only!) that the unit was sick and was taken over by the state. After its complete recovery and rehabilitation, the same can be handed back to the private sector. Finally, a PSU is incurring losses due to mismanagement in the public sector. If a private body corporate comes forward with confidence to set things right, it can buy the entire unit with all assets and liabilities.

3)

Liquidation: By going through the procedure laid down by the constitution/MOU of the PSU, the government may announce its decision of going into liquidation in case of the unit concerned. A Private buyer may buy it and use the assets so purchased for the same type of production or for some other variety of production

4)

Management buy-out: As a special case of de-nationalization, a PSU can be sold to the employees of the project. All the assets could be sold to the employees organization which could be formed as a worker's cooperative, or they can form a joint companies act. Provision of bank finance for enabling the workers to buy the assets can be made. The employees would continue getting wages as before plus a divided from the companies pool of distributed profits.

5)

Disinvestment without privatization: one more method of disinvestment which is mainly designed to overcome the capital paucity is to sell part of the equity to other public sector organization mainly from the financial system. The buyers of stocks, in such cases, can be the Life Insurance Corporation of India, the General Insurance Corporation of India, the Industrial Development Bank of India, and the Unit Trust of India and so on.

Methods of Implementation: Once the decision is taken regarding the option of disinvestment to be choose a method of disinvestment, i.e. actual implementation of the decision to part with ownership either partially or wholly, either in favour of the employees or in favour of other public sector institutions etc. There are various methods of implementation for achieving this end. 1)

344

Sale of Stocks and Allotment: Like any other company a PSU can announce not a new issue but existing shares - an issue with a premium and a policy of allotment intending buyers may apply and will be allotted shares. In keeping with the goals to be predetermined, the PSU concerned can decide upon a premium over and above the face value and can also decide the mode of allotment. /it would


include the proportion to be allotted to individuals, the same to be sold to institutions and so on. 2)

Negotiating joint ownership: when a part of equity is to be made over to a prospective buyer, such a buyer has got to be identified and then the terms and conditions of partial transfer of ownership are to be negotiated. When an agreement is reached and is duly signed, the process of disinvestment is carried out in accordance with the agreement, i.e. whether the entire sum is to be paid in a lump sum or whether it is to be paid partly or wholly in a foreign currency or whether payment to be made is through installments, etc. This method can be adopted where specialized products are involved are a few reputed accountability, the whole deal must be transparent and a fairly reasonable price must be negotiated.

3)

Open auction: Another method is the auction method. Under this method, the government may announce its intention to sell a given amount of shares to a particular class of buyers (e.g. individuals, resident or non-resident, institutional: domestic or/ and foreign etc.) and may invite bids or offers. The highest bid may be accepted. However, this can be qualified with other conditions like technical know- how, managerial track-record, market reputation and so on. It is possible that a prospective buyer offers a second best price but has a very good track- record and a reputation in the market. Such an offer may be accepted.

4)

Informal Approach: Informally, the government department concerned or the PSU itself may probe into the world-wide corporate sector for finding a prospective partner. Such a buyer may then be contacted and the terms and conditions may be finalized. These terms and conditions would include the payment in foreign or domestic currency, its mode; powers etc. and such a deal would be subject to the approval of the public authorities concerned like the disinvestment committee and parliament.

5)

Pre-planned Transfer: In cases of types (4) and (5) discussed above, a systematic plan can be prepared and worked out. When the company is to be handed over to the employees, all details like price per share amount of down payments, the mode of allotment ,loan- arrangements phased transfer of management, policy regarding managerial/supervisory staff, the form of oraganisation to be adopted etc. are to be well planned and then the whole plan has got to be implemented. Where the ownership is to be partially transferred to other public sector institutions, the quota given to each such institution is fixed in consultation with these institutional buyers as well as the central bank of the country.

6)

Systematic Denationalization: Such a step involves a phased programme.Generally, stocks are dispensed with in lots and then the promoters or


345

the business house concerned would elect/select a board of directors and take over the responsibility. A phased out programmers is preferred because a sudden transfer may send shock waves in the stock market as well as among the working classes and the employees. Repercussions on demand are also expected through a change in the expectations of the consumers. 7)

d)

Liquidation: Incase of liquidation, the procedure is analogous to any private company going into liquidation. Asset values are low, share-prices are to be valued through assessors and share holder being the government, it receives payment in installments and on the basis of the price decided by the assessor/expert committee appointed for this task.

Disinvestment of Public sector share holding- Indian experience: Considering the performance and shortcomings of the Public Sector Undertakings, the government has gone in for a programme of disinvestment of public sector enterprises. The 1991 Industrial Policy Statement envisaged the disinvestment of a part of the government sharholding in selected PSUs to provide financial discipline and improve their performance. In the 1991-92 budget, the government announced the intention of partial disinvestment in selected PSUs in order to raise resources, encourage wider public participation and promote greater accountability. Upto 20% of the government equity in 31 selected enterprises was offered to Mutual Funds, Financial / Investment Institutions, workers and general public. It is likely that such a measure may provide resources to the tune of Rs.2,500 crores to the Government to reduce its deficit. Disinvestment of PSU Shares : In pursuance of Industrial policy Statement of 1991, the Government has carried out various rounds of disinvestment of equity shareholding, realizing a total amount of Rs.20,320 crores form PSUs till March 2000. The Government of India set up the Disinvestment Commission in August 1996 to advise it on the extent, strategy, methodology and hiring for investment in each PSU. Till March 1998, the Government referred 50 PSUs to the Commission for its advice. So far the Commission has given its recommendations on 41 PSUs - these recommendations include trade sale (6 units), strategic sale (18 units) and offer of shares (5 units). In other 12 cases, the Commission has recommended : no disinvestment, disinvestment deferred, and closure and sale of assets (for 4 units) As against a total budgeted estimate of Rs.38,307 crores during 1991-92 and 2000-01, the Government realized only Rs.20,320 crores i.e. 38.4 per cent of the budgeted amount. Obviously, Government failed to raise the budgeted disinvestment in the capital market. Many reasons may by ascribed for this failure, but the most important is the non-

346


acceptability of the shares of PSUs in the capital market. The token privatization to the extent of 8 - 10 per cent of the shares of PSUs did not enthuse the Indian / foreign investors to buy these shares because they could hardly exercise any control on PSUs. Year wise Receipts from Disinvestment of PSUs Rs. Crores

Source :

Year

Disinvestment Budgeted estimate

Receipts Actual

1991-91

2,500

3,038

1992-93

2,500

1,913

1993-94

3,500

Nil

1994-95

4,000

4,843

1995-96

7,000

168

1996-97

5,000

380

1997-98

4,800

910

1998-99

9,006

5,371

1999-2000

10,000

1,829

2000-2001

10,000

1,869

Total

58,306

20,320

RBI, Report on Currency and Finance (1998-99) and Economic Survey (2002-2002.)

The Cabinet Committee on Disinvestment in its meeting held on June 23, 2000 gave a clearance for disinvestment to 11 PSUs including IBP. MMTC, STC and SCI. BESIDES THE 11 PSUs cleared, 19 other PSUs had been given clearance earlier. All this is being done to fulfill the objective of raising Rs.10,000 crores form disinvestment during the year. The Government hopes to complete the disinvestment process in Indian Airlines, Air India, ITDC, BALCO and IPCL within the financial Year 2000-01.


347

Exercise:

348

1)

What is the need for government's intervention in a free enterprise market economy?

2)

Explain the causes of price rise in India, what are its consequences?

3)

Briefly outline various measures taken by the government to control the problem of rapidly growing prices in India.

4)

Explain the policy of economic liberalization as followed in India.

5)

Write notes on : a)

Support prices

b)

Administered prices

c)

Public Distribution System (PDS)

d)

Price controls

e)

Consumer Protection Act

f)

Methods of implementing the policy of disinvestment

g)

Disinvestment of Public Sector Undertakings in India

h)

Limitations of market system


NOTES


349

NOTES

350


REFERENCE BOOKS FOR FURTHER READING 1)

Economics - Samuelson.

2)

Introduction to Positive Economics - Richard Lipsey

3)

A study of Managerial Economics - D.Gopalkrishna

Reference Books

351

NOTES

352


NOTES

Reference Books

353

NOTES

354


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Managerial Economic

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