1

Syllabus
M.A. Part I, Paper - I
Industrial Economics
1. Theory of the Firm
Undifferentiated Products - Cournot, Stackelberg, Dominant
firm model, Bertrand-Heterogeneous products - Chamberlins
small and large number case-Kinked demand curve theory -
Bains limit pricing - Sales and growth maximization hypothesis
- Managerial theories of the firm - Game theoretical models.
2. Investment Decisions
Conventional and modern methods - Risk and uncertainty -
Sensitivity analysis - Financial statements and ratio analysis -
Inflation accounting - Project appraisal methods - Industrial
finance-Sources of finance - Capital structure - Incentive,
signaling and control arguments - Separation of ownership and
control.
3. Vertically Related Markets and Competition Policy
Successive and mutually related market power - Monopoly,
variable proportions and price discrimination - Monopsony and
backward integration - Uncertainty - Diversification, rationing
and cost economics and asset specificity - Internal hierarchies-
Hierarchies as information systems - Incentive structures and
internal labour markets - Supervision in hierarchies -
Competition policy: Need and requirements - Mergers and
acquisitions - Coordination with other policies.
4. Product market Differentiation and Imperfect Information
Lancastrian and Hotelling approaches - representative
consumer approach and Chamberlins model of diversity of
tastes - The address approach -Competition in address-Free
entry-Pure profit and non-uniqueness in free entry equilibrium-
product diversity and multi address firms - Bargains and ripoffs
- Theory of sales - Quality and reputations-Product variety-
Imperfect discrimination and price dispersions -Advertising -
Dorfman Steiner condition - Lemons and information
asymmetries.
5. Technical Change and Market Structure
The Economics of patents - Adoption and diffusion of
innovations - Innovations and rivalry : Kamien and Schwartz -
Measures of concentration - Concentration ratio - Hirschman -
Herfindahl index - Entropy measure - Structure conduct
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performance paradigm - Contestable markets - Fixed costs,
Sunk costs and contestability - Stackelberg - Spence - Dixit
model.
6. Indian Industry
Industrial growth in India: Trends and prospects - Public
enterprises; efficiency, productivity and performance constrains
- Small scale industries : definition, role, policy issues and
performance - Capacity utilization - Industrial sickness and Exit
policy - Concept of competitiveness - Nominal protection
coefficients (NPC) and effective rate of protection (ERP) - Total
factor productivity - Technology transfer - Pricing policies:
Administered pricing and LRMC based tariffs - Industrial
location policy in India; regional imbalance - Globalization and
competition - Privatization.
Reference :
1. Ahluwalia, I. J. (1985), Industrial Growth in India - Stagnation
since Mid-sixties, Oxford University Press, New Delhi.
2. Ahluwalia, I. J. (1991), Productivity and Growth in Indian
Manufacturing, Oxford University Press, New Delhi.
3. Desai, A. V. (1994), Factors Underlying the Slow Growth of
Indian Industry, in Indian Growth and Stagnation - The Debate
in India Ex. Deepak Nayyar, Oxford University Press.
4. Ferguson, Paul R. and Glenys J. Ferguson, (1994), Industrial
Economics - Issues and Perspectives, Macmillan, London.
5. Shepher, William G. (1985), The Economics of industrial
Organisation, Prentice - Hall, Inc, Englewood Cliffs, N. J.
6. Staley, E & Morse R. (1965), Modern Small Industry for
Developing Countries, McGraw Hill Book Company.
7. Vepa R. K. (1988), Modern Small Industry in India, Sage
Publications.
8. Srivastava, M.P. (1987), Problems of Accountability of Public
Enterprises in India, Uppal Publishing House, New Delhi.
9. Mohanty, Binode (1991), Ed. Economic Development
Perspectives, Vol. 3, public Enterprises and Performance,
Common Wealth Publishers, New Delhi.
10. Jyotsna and Narayan B. (1990), Performance Appraisal of
PEs in India: A Conceptual Approach, in Public Enterprises in
India - Principles and Performance, Ed. Srivastave V.K.L.,
Chug Publications, Allahabad.
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11. Mathur, B. L. (1996), Organisation Patterns for PEs, in
Organisational Development and Management in PEs, Ed
Mathur B. L., Arihant Publishing House, Jaipur.
12. Murty, Varanasy S. (1978), Management Finance, Vakils,
Feffer and Simons Ltd.
13. Tirole, J. (1996), The Theory of Industrial Organization,
Prentice - Hall.
14. Holmstrom, B.R. & J. Tirole, The Theory of the Firm, in
Handbook of Industrial Organization, Vol. 1, North-Holland
15. Shapiro, C., Theories of Oligapoly Behaviour, in Handbook of
Industrial Organization, Vol. 1, North-Holland.
16. Curtis Eastion, B. & R.G. Lipsey, Product Differentiation, in
Handbook of Industrial Organization, Vol. 1, North-Holland.















4
1
Module 1
THEORY OF THE FIRM
MODELS OF OLIGOPOLY AND GAME
THEORETICAL MODELS
Unit structure :
1.0 Objectives
1.1 Introduction
1.2 Cournot Model
1.3 Stackelberg Model
1.4 Bertrand Model
1.5 Dominent Firm Model
1.6 Game Theoretical Models
1.7 Prisoners Dilemma
1.8 Summary
1.9 Questions
1.0 OBJECTIVES
- To understand oligopolistic market structure.
- To analyse Cournots and Stackelbergs model.
- To understand the market outcomes when the choice
variable is changed from quantity to price Bertrand model.
- To understand dominant firms strategy of price
determination. To have understanding of application of game
theory to oligopoly.
1.1 INTRODUCTION
The ideal most type of market is perfect competition. It is a
market where neither a buyer nor a seller can influence price but
market forces of demand and supply work together in determining
the equilibrium price. At this price the buyers can maximize their
welfare or satisfaction and the sellers maximize their profits. At the
other end, monopoly is a type of market which is characterized by a
single seller who is a price maker and who has a complete control
5
over an industry. These two types of market structures perfect
competition and monopoly are the polar cases and most of the
industries in todays market lie between these two extremes. Some
of the industries may be facing monopolistic competition wherein a
large number of firms may produce differentiated products or
oligopoly wherein there are very few firms producing homogenous /
undifferentiated or heterogenous / differentiated products. In this
unit, we are going to understand some of the theoretical models of
firms price determination techniques under oligopolistic market
structure.
Oligopoly is a market structure where there are a few firms,
large in size, accounting for most of the production. All of these
firms, generally, can enjoy substantial profit in the long-run due to
entry barriers. That means, due to large size of existing firm or
heavy initial investment, entry of new firms, in the oligopolistic
markets, is restricted. Examples of oligopolistic industries may
include automobiles, heavy machinery & equipment, power
generation, Steel, petrochemicals, etc.
In any other type of market, each firm could take either price
or market demand as given and largely ignored its competitions. In
oligopolistic market however, it is necessary to consider the
behaviour of competition while determining the output or price.
Similarly, the competition will also base his decision on the
behaviour of the first firm. In other words, all the firms in oligopoly
are interdependent. This makes their pricing strategies to be
different from other types of market structure. Following is a brief
analysis of some of those models.
1.2 COURNOT MODEL
The model of pricing put forward by Augustin Cournot in
1838 is a duopoly model (existence of only two firms in the market).
Cournots model assumes that there are only two firms in the
market A and B each one producing mineral water at zero cost
(This is because each of the firms is assumed to be owning a
spring of mineral water). In other words, the model is based on
following assumptions.
1) There are two firms A and B.
2) They are operating with zero cost.
3) They are producing identical product.
4) They decide their own output on the assumption that the
competition will not change his output level.
5) Firm A starts producing first.
Based on these assumption, the duopoly firms will operate in
the market as shown in the following diagram.
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Diagram 1.1
As per the diagram 1.1,
DD
1
demand curve
MR
A
market and MR
B
marginal revenue curves of firm A & B,
respectively.
Since the operating cost of firm A is zero, the diagram does
not have cost curve.
Firm A will produce at that point where the profits are
maximized. (The students can recollect the equilibrium condition
MC = MR)
A Level of output for firm A where MC (which is equal to
zero in this model) = MR
A
.
OP equilibrium price for Firm A.
CE
1
Firm Bs demand curve (under the assumption that the
competition will not change his output level. In this case firm A is
assumed to keep its output fixed at OA).
B- equilibrium point where MC (which is equal to zero) = MR
B
AB profit maximizing output for firm B
OP
1
- profit maximizing price for firm B
As can be seen from the diagram, Firm B produces half of market
not supplied by Firm B that means it produces th of the market.
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In the next period, Firm A will produce of the market not
supplied by B (under the assumption that the competition will not
change the output level). So A will produce th of total market.
1 1 3
1
2 4 8
| |
=
|
\ .
Now Firm B will react by producing of the remaining
market which is
5
16
1 3 5
1
2 8 16
| |
=
|
\ .
According to Cournot, this kind of action reaction pattern of
firms will continue till they cover 2/3 rd of the total market.
Equilibrium of Cournots model is explained below.
I Firm As output
Period 1
Period
1 1 3
2 1
2 4 8
| |
=
|
\ .
Period
1 5 11
3 1
2 16 32
| |
=
|
\ .
The output of firm A goes on declining and by solving this
geometric series what is obtained is 1/3 of the market is supplied by
firm A. In the similar way, firm B also supplies 1/3 rd of the market.
Both the firms together supply 2/3 rd of the market.
[ For Firm B,
Period 2 output
1 1 1
2 2 4
| |
=
|
\ .
Period 3 output
1 3 5
1
2 8 16
| |
=
|
\ .
Period 4 output
1 11 21
1
2 32 64
| |
=
|
\ .
and so on]
1 total market demand
1
4
Firm Bs market share
1
2
half of the market not supplied by B
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Important observations from the Cournot Model.
1) Cournot solution is stable.
2) More the number of firms in the market, more will be the
quantity supplied and less will be the price. (It can be shown
that if 3 firms exist in the market, 3/4 the of the market
demand will be supplied).
3) Since the firms do not recognize the interdependence, they
can not act as monopolist.
4) Each firm maximizes its profit in each period but industrys
profits are not maximized.
1.2.1 Criticism of Cournots Model :
Cournots duopoly model, expressing the limiting case of
Oligopoly, is criticized on many grounds. Following are some of the
important ones : -
a) Assumption of costless production is highly unrealistic.
b) It is a closed model where there is no entry for new firms.
c) In each successive period, price is brought down by the
action-reaction pattern of two firms.
1.3 STACKELBERGS DUOPOLY MODEL
This model was developed by a German economist
Stackelberg. In the Cournots model it was assumed that both the
competitions make their output and price decisions at the same
time. Situation will be different if one of them moves first.
Stackelberg presented a duopoly model in which one of the two
firms sets its output before the other firm.
Let us first understand the concept of linear demand curve
with the help of numerical example. [from Pindyck and others-
Microeconomis.
Suppose duopolists face following market dd curve.
P = 30 - Q. Q = Total output (Q = Q
A
+ Q
B
)
A & B - two duopoly firms.
Suppose both the firms have zero marginal cost.
MC
A
= MC
B
= 0
To maximize profit, firm A sets MR = MC. So its total
revenue TR
A
is given by
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TR
A
= P. Q
A
= (30 - Q) Q
A
(Recall that total revenue is
obtained by multiplying price by Quantity).
= 30Q
A
- (Q
A
+ Q
B
) Q
A
(because Q = Q
A
+ Q
B
)
=
2
A A B A
30Q Q Q Q
Marginal Revenue of firm a is additional revenue resulting
from additional output so
A
A A B
A
TR
MR 30 2Q Q
Q
A
= =
A
The equilibrium condition is setting MR
A
= MC
A
which is
equal to zero. So Firm As output is
A B
1
Q 15 Q
2
= . Equation (1)
Doing similar calculations for firm B would give Bs output
curve as
B A
1
Q 15 Q
2
= . Equation (2)
Equilibrium will be that levels of output Q
A
& Q
D
at which the
two output curves intersect. (That is, that level of output which one
gets by solving equations (1) and (2)).
Q
A
= Q
B
= 10
Total quantity produced in the market is 20. So equilibrium
price is P = 30 - Q = 10.
Each firms profit is P Q
10 10 = 100.
Using the above-explained numerical example, we will try to
understand which firm benefits more in a situation analysed by
stackelbergs model and how the output levels of each firm will be
determined.
Suppose Firm A sets the output first and in setting its output
it has to consider the reaction of firm B.
Firm B decides its output level after firm B and it takes Firm
As output as fixed
10
B A
1
Q 15 Q
2
= . Equation (3)
Firm 1 will choose its output at that level where MR = MC
(which is equal to zero).
TR
A
= PQ
A
=
2
A A B A
30Q Q Q Q Equation (4)
Because the revenue earned by firm A depends upon the
output level of firm B (Q
B
), firm A must anticipate what firm B would
produce Frim B, on the other hand, will produce by taking firm As
output as fixed. So by substituting equation (3) for Q
B
in equation
(4), we will get.
TR
A
=
2
A A A A
1
30Q Q Q 15 Q
2
| |

|
\ .
=
2
A A
1
15Q Q
2

Its marginal revenue is -
A
A A
A
TR
MR 15 Q
Q
A
= =
A
Equation (5)
By soling equation (5) using MR
A
= 0; we get the output
level.
Firm A = 15
Firm B = 7.5
That means firm A produces twice the level of firm B and
hence enjoys the profit twice as much Firm B. stackelberg calls it as
the advantage of first mover.
Important implications of Stackelbergs model.
1) The first mover will announce higher output and to maximize
the profit, the other producer has to acknowledge it and produce a
lower level of output. Otherwise price will come down and both the
firms will suffer.
2) Stackelberg model brings about the need for collusive
agreement between the duopolists as they are mutually
interdependent.
1.3.1 Conclusion :
Cournot and Stackelberg models are two different
approaches to oligopolistic market. for those industries where all
the firms have more or less similar market share and none of then
has leadership position, Cournots model may be applicable.
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Whereas, for those industries like mainframe computers (where
IBM is the leading firm) Stackelbergs model may be more
appropriate.
1.4 THE BERTRAND MODEL
Bertrand developed the model in 1883. The model is
applicable for the firms which produce homogenous product and
make their pricing & output decisions at the same time. The model
differs from that by Cournot on the ground that the firms compete
on the basis of price and not on the basis of quantities (as was the
case in Cournot model). Another important assumption on which
the mo0del is based is that there are only two firms competing in
the market.
By using the same tool & demand equations introduced in
the earlier section, we will show, how the two firms determine their
equilibrium, by choosing prices instead of quantities. Suppose the
market demand curve is P = 30 - Q.
As we are aware, Q = Q
A
+ Q
B
i.e. quantity produced by firm
A and firm B.
Suppose the marginal cost of production for both the fimrs is
Rs. 3 (instead of zero in the earlier models), MC
A
= MC
B
= 3.
By solving this equation for Cournots equilibrium, (as per the
earlier section) we get following results.
Q
A
= Q
B
= 9
Price = 12
Profit = 8 for each firm.
As per Bertrand, the firms will compete on the basis of price.
Since they produce homogenors products, the consumer will buy
from the firm selling the product at the lowest price. So there will be
3 possibilities in the market.
1) A firm which charges higher price than its competition will have
no market share.
2) A Lower-price firm will capture entire market.
3) If both the firms charge same price, the consumers will be
indifferent. That means both the firms will supply half of the
market each.
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Now, if the P = MC
A
= MC
B
= 3, then Q = 27 and each firm
will supply 13.5 units of the product. (Substitute P = 3 in the above
equation and equally divide Q into both the firms).
Since P = MC, each firms makes only normal profit (or zero
economic profit). Even though both the firms make zero profit, they
will have no tendency to increase the price. This is because, if one
of the firms raises the price, it will loose entire market. On the other
hand, if one of the firms reduces the price below Rs. 3/- it will
capture the market, but its profits will become negative (as it is
already facing zero profit situations). Suppose both the firms decide
to raise the price to say Rs. 6. In this case, there may not be a
stable situation. Either of the firms may use the strategy of slightly
reducing the price and capturing the entire market. Each
competition may under cut the price till both reach back to
P = Rs. 3.
We can conclude this section by commenting that a change
in strategic variable firm quantity to price, a drastic change is
evident in the market outcomes.
1.5 DOMINANT FIRM MODEL
In same oligopolistic markets, one large firm has a major
share of market while the remaining market is supplied by the
remaining smaller sized firms. Such a large sized firm is called a
dominant firm. It sets the price that maximizes its own profit and the
other smaller firms accept that price as given and produce
accordingly.
Following diagram explains how a dominant firm determines
price and quantity.
part I part II
As per the part I of fig. 1.2
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DD - market demand curve.
S
1
- supply curve of the smaller firms (the dominant firm may
know about smaller firms. Supply curve from the past experience.)
At each price, the demand for product of dominant firm will be equal
to the difference between market demand and the supply by the
smaller firms.
At price
1
P demand for dominant firms product is zero as
the entire market is supplied by smaller firms.
At price P -
PB - Smaller firms supply
BC - Dominant firms supply
At price P
2
P
2
A - Small firms supply
AD
2
- Dominant firms supply
At price P
3
P
3
D
3
- Dominant firms supply (entire market is supplied by
dominant firm).
By using this information, one can obtain dominant firms
demand curve as shown is part 2 of the diagram.
D
L
- dominant firms demand curve at different prices.
MR - Marginal Revenue, MC - Marginal Cost, P - Equilibrium
price (Where MC = MR).
At price P
Total Market demand is PC, where PB is small firms supply
and BC is dominant firms supply. [Shown in part 1 of the diagram]
BC = O
x
[in part 2 of the diagram].
At this point, the dominant firm maximize profit and other
smaller firms take that price as given.
1.6 GAME THEORETICAL MODELS
In the earlier part of the unit, we have discussed some of the
models of price and output determination under oligopoly. These
models are based on the interdependence of firms under
oligopolistic market structure. But there is an inherent uncertainty in
these models because the reactions of competitions can not be
effectively guessed. Collusive models, limit pricing models (to be
covered in next unit) or managerial models (to be covered in unit 3)
can not fully analyse oligopolistic market. use of game theory has
been an important development in this respect to understand the
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behaviour of markets and decision making. By the managers in the
conditions of oligopoly. In this part of the unit, we will understand
simplest types of game theory models.
1.6.1 Explanation of some concepts related to game theory :
A Game - It is a situation in which the players (or participants)
make strategic decisions. That means they take
account of reactions of the others.
Pay - offs - Outcomes that generate rewards for the players. In
other words, it is a strategy that will bring about
gains to the players for any counter reaction by the
competition.
Strategy - It is a rule for playing the game.
Pay off Matrix -It is a table showing pay-offs to the firm as a result
of each possible combination of strategies adopted
by the firm and its rivals.
Following is a pay-off matrix. Suppose firm A chooses out of
three strategies (A
1
, A
2
and A
3
) and Firm B reacts by adopting any
one of four strategies ( )
1 2 3 4
B ,B ,B andB , then for each strategy of
Firm A, there are 4 strategies of firm B. the pay-off matrix will
include 3 4 = 12 pay offs.
Suppose G
ij
is a pay off, i refers to strategy by firm A and j
refers to strategy by firm B, then the pay off matrix will look as
follows.
Pay - off Matrix for
Firm A
Firm Bs Strategies
B
1
B
2
B
3
B
4
A
1
G
11
G
12
G
13
G
14
A
2
G
21
G
22
G
23
G
24
F
i
r
m
s
A

s
S
t
r
a
t
e
g
y
A
3
G
31
G
32
G
33
G
34
When the game theory is applied to oligopoly, oligopolistic
firms are the players each firms movement is followed by many
counter movements by the other players. Game theory highlights
that in an oligopolistic market a firm adopts strategic decision-
making which means that while taking decisions regarding price,
output, advertising, etc. it takes into account how its rivals will react
to its decisions and assuming them to be rational, it thinks that they
15
will do their best to promote their interests and take this into
account while making decisions.
1.6.2 Non-Co-operative and Co-operative Games :
The economic games can be either Co-operative or non-co-
operative. This distinction is based on whether or not there is a
possibility of any finding agreement among the players or the firms.
Co-operative games can be played when the players can negotiate
a binding agreement and plan joint strategies to maximize their
profits. non-co-operative games can be played when no binding
contracts are possible. The games explained in this unit are mostly
the non-co-operative games.
1.6.3 Dominant Strategy :
Some Strategy of the firm will be successful or yield more
profits only if the competitors make certain choices or only when
the competitions react in a particular way. However these strategies
would fail if the competitor reacts in some other way. But there are
certain strategic that are successful regardless of the reaction of
competitors. Such strategies are dominant strategies.
Following example explains the dominant strategy.
Suppose there are two firms - A and B. They want to
undertake advertising campaign and they will be affected by each
others decisions. The pay off matrix of possible outcomes is given
below.
Matrix For Advertising Game
Firm B (Profits in Rs. crores)
Advertising Non advertising
Advertising A : 10 A : 15
B : 05 B : 00
Firm A
Non Advertising A : 06 A : 10
B : 08 B : 02
The matrix should be read as follows :
1. If both the firms are advertising - A earns profits equal to Rs.
10 crores & D Rs. 5 crores.
2. If A is advertising and B is not advertising, then A gets Rs. 15
crores and B does not get any profit.
3. If A does not advertise & B advertises, the profits of A & B are
Rs. 6 crores and 8 crores respectively.
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4. If A does not advertise & B also does not advertise, A gets
Rs. 10 crores and B gets Rs. 02 crores.
Given above situation, Firm A will always be better off if it
advertises its product (irrespective of whether B is advertising or
not). So for firm A Advertising the product is a dominant strategy.
Same is true for Firm B. So assuming that both the firms are
rational, outcome of advertising game is that both the firms will
advertise.
1.6.4 Nash Equilibrium :
We have explained above the game with dominant strategy.
But many times, the games may not have dominant strategies and
still they can achieve equilibrium. Nash equilibrium describes a set
of strategies or actions such that each player is doing the best it
can, given the actions of the opponent. No player has any incentive
or intention to deviate from the Nash strategy.
It can be explained by an example by Pindyck, Rubinfeld
and Metha. It is called product choice problem.
Suppose there are tow breakfast cereal companies. They
are in the market where a new variety of crispy cereals or sweet
cereals can be introduced. Each firm can introduce only one
variety due to resource constraints. The pay-offs of these two firms
are given below :
Product Choice Problem
Firm 2
Crispy Sweet
Crispy Firm 1 - 5 Firm 1 - 10
Firm 1 Firm 2 - 5 Firm 2 - 10
Sweet Firm 1 - 10 Firm 1 - 5
Firm 2 - 10 Firm 2 - 5
As per the matrix
1. If firm 1 introduces sweet cereal, firm 2 may introduce crispy
cries and neither of the firms would deviate from this decision.
2. If they do not deviate Firm 1 will have pay off of 10 and Firm 2
also will have pay off of 10
3. If any one of them deviates, both will have pay-off - 5
4. Strategy in the left-hand corner of the matrix is stable and it
constitutes Nash equilibrium.
5. Similarly upper right hand corner of pay off matrix is also Nash
equilibrium because no player will have incentive to deviate
from here.
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1.7 PRISONERS DILEMMA
As stated earlier, Nash equilibrium is a non-co-operative
equilibrium where each firm makes decisions that give it the highest
possible profit, given the actions of competitions.
A classic example of game theory that explains the problem
faced by oligopoly is Prisoners Dilemma Two Prisoners are
accused of a joint crime and they are put in two different jails. They
can not communicate with each other. They are asked to confess.
1. If both confess, both will get 5 years of imprisonment.
2. If no one confesses, both will get only 2 years of jail.
3. If one confesses and the other does not confess, the one who
confesses will be jailed for one year and the other - 10 years.
Pay off Matrix for
Prisoners Dilemma
Prisoner B
Crispy Sweet
Confess - 5 - 5 -1 - 10
Prisoner A
Dont
Confess
- 10 - 1 - 2 - 2
In this situation, most likely strategy will be both the
prisoners would confess and get 2 years of imprisonment,
oligopolistic firms often find themselves in a prisoners dilemma.
They have to decide :
a) Whether to compete aggressively & capture larger market
share.
b) Co-operate and compete more passively.
Actually both the firms would do better by co-operating and
charging high price. But the firms are in prisoners dilemma, where
neither can trust its competitors to set a higher price.
1.8 SUMMARY
1. Oligopoly is a market with a few sellers and homogenous or
differentiate products.
2. There are different models of oligopoly given by Cournot,
Bertrand and stackelberg, focusing on different conditions of
oligopolistic markets. Some of these models explain market
equilibrium with homogenous products, some models explain
equilibrium with one dominant firm, etc.
18
3. Game theory is an important development in understanding the
behaviour of oligopolistic firms in the conditions of uncertainty
and indeterminateness.
4. Nash equilibrium is a non-co-operative equilibrium where each
firm makes decision that give it highest possible profit given the
actions of competitors.
5. Prisoners Dilemma is the classic example of application of
game theory to oligopolistic market conditions.
1.9 QUESTIONS
1. Write detailed notes on
a) Cournot Model
b) Stakelberg Model.
c) Bertrand Model.
2. Explain the leadership models of oligopoly.
3. How is game theory made applicable to understand
uncertainty under oligopolistic market conditions?












19
2
MODELS OF OLIGOPOLY
Unit Structure :
2.0 Objectives
2.1 Introduction
2.2 Chamberlins Model (Large Group)
2.3 Chamberlins Model (Small Group)
2.4 Kinked demand curve theory
2.5 Bains Limit Pricing
2.6 Summary
2.7 Questions
2.0 OBJECTIVES
- To understand monopolistic competition as a new type of
market structure.
- To analyse different models of market equilibrium given by
Chamberlin.
- To throw light on Chamberlins oligopoly model of small
group of firms.
- To understand price rigidity of oligopolistic firm with the tool
of Kinked demand curve.
- To understand price determination with the threat of entry of
new firms as given by Bains Model.
2.1 INTRODUCTION
The classical theory of markets considered perfect
competition and monopoly as two main models explaining price
determination. These models, however, failed to explain some of
the empirical observation like use of advertising by the firms,
heterogeneity of products and so on. Joan Robinson and E.
Chamberlin described a new market structure having features of
both perfect competition and monopoly. Under this kind of market,
known as monopolistic competition, in spite of free entry and exit
for the firms and existence of large number of firms, each firm
20
enjoys some degree of monopoly power. This may be because of
differentiated products. When there is a large number of firms
producing differentiated products, each one has a monopoly of its
own product. But at the same time, there is also a degree of
competition because of competitors producing close substitutes.
Under such a market, the demand curve for the product of
individual firm depends upon the nature and prices of its closely
competing substitutes. Thus, according to Chamberlin,
Monopolistic Competition concerns itself not only with the problem
of an individual equilibrium, but also with that of a group
equilibrium. A group is a number of producers whose goods are
fairly good substitutes.
In this part of the unit, we will focus on Chamberlins Group
equilibrium model.
2.2 CHAMBERLINS MODEL (LARGE GROUP)
As stated earlier, Group refers to the collection of firms that
produce closely related but not exactly identical products. since the
firms in a group produce substitutes and not ho9mogenous
products, the demand for the product of one producer is dependent
on the price and nature of the products of his rivals. Basic
assumptions of the Chamberlins large group model are as follows.
1. There are large number of buyers and sellers in a group.
2. The products of each firm are differentiated but still they are
close substitutes of each other.
3. There is free entry and exit in a group.
4. Profit maximisation is an important objective of a firm
5. The prices of factors of production are given.
6. Demand and cost curves for all products in a group are uniform.
Chamberlins has accepted traditional cost concepts for his
analysis. So the average variable cost (AVC), Marginal cost (MC)
and Average Total Cost (ATC), all are U shaped in nature. He
introduced the concept of selling cost for the first time in his
analysis. Because each firm produces differentiated products,
advertising and selling costs play important role in these markets.
Selling cost curve is also assumed to be U-shaped in nature.
Product differentiation established by advertising, packaging,
differences in design, etc. give some monopoly power to each
producer. So the producer is not price - taken and he enjoys some
degree of power in determining price.
21
Due to product differentiation, it is difficult to get market
demand and supply. Summation of individual demand and cost
curves to form Group demand and supply requires the use of
some common denominator. This compels the Group not to have
unique equilibrium price
2.2.1 Equilibrium of the firm
The firm has negatively sloped demand curve. It implies that
if the firm raises price, it will lose some of its market share. although
it has downward sloping, demand curve, it is highly elastic in nature
as shown in the following diagram.
Fig. 2.1
Firm, in the short run, acts as a monopolis and given its
demand and cost curves, it maximizes its profit at the point where
MC = MR. But to be able to understand the equilibrium of an
industry, Chamberlin has developed three models.
Model 1 - Equilibrium with new firms entering into industry.
Model 2 - Equilibrium with price competition
Model 3 - Equilibrium with price competition and free entry.
2.2.2 Model 1. Equilibrium with new firms entering the
industry.
In this model, Chamberlin assumed that the firms are in
equilibrium with excess profit (in the short run) and hence, there
new firms can enter the market in the long run. Following diagram
shows equilibrium of a firm and industry in the same diagram.
22
Fig. 2.2
LAC & LMC - Long run average cost and long run marginal cost
curves.
dd - demand curve of a firm.
P
M
- equilibrium price (corresponding to MR = MC) - students
should recollect the determination of equilibrium price and quantity
with MC - MR approach).
ABCP
M
- Excess profit enjoyed by the firms in the short - run.
Excess profit situation leads to entry of new firms into the
market. As a result the demand curve for the firm will shift
downwards (since there are more sellers in the market now, the
share of each firm in catering total demand will come down).
D
E
d
E
1
- New demand curve
MR
2
- Corresponding marginal revenue.
P
E
- Equilibrium price (where MC = MR)
At this price, excess profits are wiped off and firms are in
stable equilibrium with normal profit.
2.2.3 Model 2. Equilibrium with price competition :
This model is based on the assumption that the number of
firms in an industry is exactly compatible with long-run equilibrium
but the existing price charged by the firms is higher than the
equilibrium price. The firms charge price not as a reaction to their
competitors, but each firm fixes price independently with an
objective of profit maximisation. If a firm aims at reducing the price
to increase its sales, it can not enjoy fullest possible benefit of price
reduction because; all other competition firms would reduce their
price and expand their own sales simultaneously. Hence, even if
23
price reduction takes place, the share of all the firms remain more
or less constant. In this model, the firms are shown to be suffering
from myopia. They do not learn from experience and continue to
lower price to increase sales. There is a discrepancy between
expected sales (after price reduction) and actual sales because all
firms act identically. The adjustment process will stop at point
where the demand curve is tangent to the average cost curve. That
means a point at which a firm enjoys normal profit.
2.2.4 Model 3 : Price Competition and free entry :
In this model, Chamberlin shows how the actual life
equilibrium is achieved by both price competition and free entry.
According to him price adjustment by the existing firms and entry of
new firms together would work towards stable equilibrium.
Chamberlins theory is criticized on many grounds. It is said
that the firms having competitors who produce substitutes, can not
act independently as assumed in this model. Firms will learn from
the past experiences or mistakes and then take decisions regarding
price and quantity. Further, it is difficult to define the concept of
industry with product differentiation. Two different products can not
form an industry. So some of the assumptions of Chamberlin seen
to be unrealistic. Thirdly, some people have criticized the model on
the ground that it is indeterminate. Effects of product changes and
sales. Promotion activity create a situation of indeterminate
equilibrium.
2.3 CHAMBERLINS OLIGOPOLY MODEL (SMALL
GROUP)
The Small group model by Chamberlin indicates that if the
firms in a small group realize their interdependence, they can attain
stable equilibrium with profit maximisation and in fact all can enjoy
monopoly profit. According to him if the firms do not recognize their
interdependence, they may have either Cournot equilibrium (where
a firm assumes that its competitors will keep quantity of output
constant) or Bertrand Equilibrium (where firm assumes that its
competitors will keep price constant).
But according to Chamberlin, firms are well aware of the fact
that the competitors price & quantity decisions are going to have
direct and indirect effect on the firms equilibrium position. With the
understanding of such effects, olitopolistic firms can achieve stable
equilibrium with monopoly profit for all the firms in a group.
24
It is explained with the help of following diagram.
Fig. 2.3
DD Market demand with negative slope
OX Firm As output
M
P - Firm As monopoly price
Firm B, (under cournet assumption that the rival firm A will not
change its quantity), will consider its demand curve to be CD and
produce quantity equal to XB.
As a result, price falls to OP. Firm A decides to reduce
output to OA. It should be noted that OA XB = . This raises the
price to
M
OP . Firm B realises that price
M
OP is the best for both of
them (as it gives monopoly profit to both the firms) and hence it
keeps the quantity same (at XB).
2.4 THE KINKED-DEMAND MODEL :
The origin of kinked demand curve can be traced in
Chamberlins analysis. But he did not explicitly used this tool in his
analysis. Hall and Hitch, in their article Price Theory and Business
Behaviour used the term kinked demand curve for explaining the
price-stickiness in oligopolistic markets. It was Paul Sweezy, who
for the first time, used kinked demand-curve as a tool for explaining
equilibrium in the oligopolic market. In this part of the unit, we will
try to focus on how oligopoly firms will attain equilibrium when the
prices are sticky.
It has been observed that under oligopolistic markets, price
and quantity tend to remain inflexible. Kinked demand curve
hypothesis is used to explain such a rigidity of prices. Under
oligopoly without product differentiation, if a firm raises the price, it
25
will loose all its customers. So this firm will have no tendency to
change its price. Alternatively, firms without product differentiations
may enter into formal or informal agreement and maintain price
rigidity.
Following diagram explains kinked demand curve
hypothesis.
Fig. 2.4
DKD, is the demand curve showing a kink at point k which
corresponds to existing price-level. DK is more elastic portion of
demand curve.
1
KD is more inelastic portion of demand curve.
Demand curve is said to be having a kink of point K
because each oligopolistic firm believes that though its rivals will
not increase the price, if this firm increases the same, but they will
certainly reduce the price, if this firm decides to do so.
If a firm decides to reduce the price below prevailing price
level (OP), the competitors will fear that their customers will start
buying from that firm and their market share will go down, so the
competitors follow price cut policy and hence the firm will not gain
much in terms of market share. As per the diagram (2.4), firm will
reach inelastic part
1
KD of the demand curve.
In case a firm decides to increase the price, the competitors
may not follow the firm and hence the firm may loose a large part of
its customers. In other words, if firm raises the price, it will reach at
the DK part of demand curve which is highly elastic in nature.
It is obvious from the above discussion that whether a firm
reduces the price or increases the price, it will be a loser. So this
firm has no inclination of changing the price. Price remains sticky
or rigid at OP.
26
2.4.1 Explanation of Price Rigidity :
As explained in the earlier section, oligopolists will adhere to
a certain price and will neither increase the price (as they will
experience substantial fall in sales) nor decrease the price (as they
will have no substantial gain in terms of market share). This
situation will not change even if the cost of production or demand
for product change.
Fig. 2.5
Fig. 2.6
27
In fig. 2.5 OP - Prevailing Price (at which there is a kink)
which is rigid / sticky.
To understand profit maximising situation of an oligopolist,
marginal revenue and marginal cost curves are drawn.
MR Discontinuous marginal revenue curve with discontinuosu
portion HR
E Equilibrium point where MC = MR
Since at this level of output and price, profits are maximised,
the oligopolist has no inclination to change the price.
MC' - New Marginal Cost curve with rise in cost
E' - New equilibrium point
It should be noted that at new equilibrium point, quantity and price
remain the same. So even if the costs rise, equilibrium price
remains the same.
In Fig. 2.6, changes in demand curve are depicted, even if
the demand curve shifts upward from dKD to d'K' D' , equilibrium
price remains the same.
In conclusion it may be noted that under oligopoly, price will
remain rigid irrespective of changes in cost of production or
demand conditions.
2.5 BAINS LIMIT PRICING :
J.Bain, in his article Oligopoly and Entry Prevention has
touched upon one more aspect influencing the price and quantity
decisions of oligopolistic firms_threat of entry of new firms. Bain
maintained that the firms fix the price above the competitive price
(where there are only normal profits) and below monopoly price
(where profits are maximised). Such a price level is called by him
as limit price which according to him is the highest price that a firm
can charge without the entry of new firms.
His models ofoligopoly pricing are based on following
assumptions.
1) The long-run demand curve for industry is determinate and is
unaffected by the price adjustments by the existing firms or by
the entry of new firms.
2) There is a collusion (Agreement) among the oligopolists.
3) The firms can calculate limit price.
28
4) Below limit price, new firms will not enter the market and above
limit price, entry is attracted.
5) Firms aim at maximisation of profits.
Based on these assumptions, Bain presented two version of
his model.
1. Model A : With no collusion with the new entrants.
2. Model B : With collusion with the new entrants.
2.5.1 Model A : No collusion with new entrants.
Fig. 2.7
In the diagram,
DABD _ Market Demand Curve
Dabm _ Marginal Revenue Curve
L
P _ Limit price (which is supposed to be known to the oligopolistic
firm. It will be sent depending on :
1) estimation of costs of the potential entrants
2) market elasticity of demand
3) shape and level of long-run average cost curve
4) size of market
5) number of firms in industry
AD' _ Certain part of demand curve
am _ Certain part of marginal revenue curve
29
DA _ uncertain part of demand curve because behaviour of new
entrants is not known.
LA
1
C and
2
LAC _ long run average cost curves
1
MC and
2
MC _ Marginal cost curves
At
1
LAC
Two alternatives are possible for the firm. Either to charge price
L
P _ which gives certain level of profit
L
P A dPC' or charge
monopoly price given by the MC = MR condition. This price will be
higher than
L
P , may give monopoly profits but it is on the uncertain
part of the demand curve. So firm may compare certain profit level
with uncertain profit level and choose between
L
P and
M
P .
In case of long-run average cost curve being
2
LAC , profit
maximising price is
2
PM (based on MC = MR condition). At this
price, profits are maximised and this price is lower than
L
P . So firm
will prefer
2
PM over
L
P .
In summary, with a threat of entry of new firms,
L
P will be the
limit price and existing firms can choose any one of the following
options.
1. To charge the price equal to
L
P and prevent entry
2. To charge the price below
L
P and prevent entry
3. To charge the price above
L
P and take risk associated with
new entry.
2.5.2 Collusion takes place with new entrant :
Fig. 2.8
Diagram explains a situation of collusion between
established firms and new entrants.
30
DD' _ demand curve
DD" _ demand curve after allocating a share of profit to new
entrant at each price
New demand curve is a certain demand curve as there is a
collusion with the new entrants.
There are three options.
1. Charge
L
P , or limit price and utilise AD' portion of the demand
curve without the entry of new firms. (As explained in the earlier
model)
2. Charge price above limit price and move on to DD demand
curve with collusion with the new entrants.
3. Charge monopoly price
M
P if
M L
P CP (As explained in the earlier
model)
Thus, Bains model of limit pricing takes into account the
threat of new entrants. The existing firms may either call accept
collusion with the new entrants or go for profit maximisation.
2.6 SUMMARY :
1. Monopolistic competition is a market structure having blend of
features of monopoly and perfect competition.
2. Chamberlin provided for a detailed analysis of equilibrium
conditions of firm and industry under this kind of a market. He
introduced a concept of Group in which there are firms
producing close substitutes or products with differentiation.
3. In the Large Group model of Chamberlin, due to entry of new
firms in the group, a stable equilibrium with normal profit
situation can be achieved.
4. Price competition among existing firms under Chamberlins
model leads to adjustment process and the end result of this
process is a stable equilibrium with normal profit.
5. In a small group model, Chamberlin has explained how both the
firms enjoy supernormal profit by taking into consideration the
competitors reaction.
6. The kinked demand curve model explain price rigidity under
oligopoly.
7. All the earlier models of oligopoly do not consider the threat
from potential entry of new firms. Bain, through his limit pricing
model, has explained the equilibrium situation of oligopolistic
firms with new entrants.
31
2.7 QUESTIONS :
1. Explain Sweezys kinked demand curve model of oligopoly.
How does it explain price rigidity under oligopoly?
2. What are different types of price leadership models under
oligopoly? Explain output determination where leadership is by
the dominant firm.
3. What is meant by price rigidity? Why are prices rigid under
oligopoly? Using the technique of kinked demand curves
explain price rigidity.
4. Explain Chamberlins concept of group. How does the group
attain equilibrium.
5. What is Limit Price? Explain Bains theory of limit pricing.
6. Write short notes on.
a) Dominant Firm Model
b) Bains Limit Pricing
c) Chamberlins Large Group Model
d) Kinked Demand Curve Hypothesis.













32
3
MANAGERIAL THEORIES OF FIRM
Unit Structure
3.0 Objectives
3.1 Introduction
3.2 Baumols Sales Maximisation Model
3.3 Morriss Managerial Theory of Firm
3.4 Conclusion
3.5 Summary
3.6 Questions
3.0 OBJECTIVES
- To understand the origin and importance of managerial
theories of firm
- To evaluate the sales Maximization Model by Baumol.
- To understand how growth rate miximisation is achieved as
a long-term objective of a firm through Marris Model.
3.1 INTRODUCTION
Traditionally, profit maximization has been an important
objective of a firm. But over years alongwith profit maximization
objective, some other objectives like maximization of sales
maximisation of growth rate have also gained importance. There
ahs been a bifurcation of ownership and management of a firm due
to complex nature of business activity in the recent years. New
theories of firm take into consideration the role of managers in
determination of price and quantity. In the modern business
structure, ownership lies in the hands of shareholders who are
large in numbers. They have a power of appointing the board of
directors who in turn select the top management. It is the top
management that is involved in daily operations of the firm. Share-
holders, who are the owners of a company, are the risk bearers and
are interested in profit maximization by the firm. Managers, on the
other hand are hired on a fixed salary and hence they may pursue
the goal of maximizing their own utility or maximizing sales
(because many times managers perks are attached to sales)
33
Profit of course is an important determinant of all activities of
a firm, Managers and other stake holders job security is
endangered if the firm is not making profit. But in the new pattern of
business, where ownership and management are handled by two
different groups of people, profit maximization has no more
remained the only important objective.
Managerial Theories of firm consider the fact that the
managers maximize their utility subject to minimum profit
constraint. In this unit, we will learn three models of managerial
theory of firm Baumol and Marris.
3.2 BUMOLS SALES MAXIMISATION MODEL OF
OLIGOPOLY FIRMS
3.2.1 Why sales Maximisation ?
As we have discussed earlier, the structure of business
organisation has undergone transformation in the recent times. In
corporate form of organisation, Mangers dominate in the entire
decision making process of business. In such a situation, according
to W. J. Baumol, an American Economist, Sales maximization
seems to the more realistic assumption in comparison with the
profit maximization. Baumol advocates sales maximization as an
objective of firm under following grounds :
1) Modern firms have separated the managerial functions away
from the ownership. In other words, owners of the firm need
not be managing the day to day activities of a firm.
2) Mangers generally pursue maximization of sales, than profit
as their earnings are more closely linked with sales than
profit.
3) Raising of funds from banks become easier for the firms with
large size and growing sales.
4) Employees can be given better salaries and parts when
sales are rising
5) Firm can be more competitive or can survive better in
competition when its sales are rising.
Baumol, however, did not ignore profits. His theory aims at
sales maximisation under the condition of minimum profit. In other
words, minimum level of profit must be earned by the manager
pursuing the sales maximisation goal to ensure future growth of a
firm and confidence of share holders. It is worth noting Baumols
words.
My hypothesis then is that oligopolists typically seek to
maximize their sales subject to a minimum profit constraint. The
34
determination of the minimum just acceptable profits level is a
major analytical problem and I shall only suggest here that it is
determined by long-term considerations. Profits must be high
enough to provide the retained earnings needed to finance current
expansion plants and dividends sufficient to make future issue of
stocks attractive to potential purchasers. In other words the firm will
aim for the stream of profits which allows for the financing of
maximum long-run sales. The business jargon for this is that
management seeks to retain earnings in sufficient magnitude to
take advantage of all reasonably safe opportunities for growth and
two provide a fair return to share holders. (W. J. Baumol, On
Theory of Oligopoly Economical, New Series, Vol. 25, 1958)
3.2.2 Oligopoly and interdependence of firms
You are aware that one of the important characteristics of
oligopoly is interdependence of firms. Under oligopoly, there are a
few firms and they are interdependent on each other, they have to
think about the reaction of their competitors while taking any
decision about price and quantity changes of their product.
According to Baumol, oligopolistic firms, in their day to day
operations, need not worry about the competitors reaction. In other
words, firms daily decisions are taken on the premise that these will
not bring about changes in the behaviour of competition firms.
However, the reaction of competitors becomes more important
when oligopolistic firm takes some radical decision like launching
new product or advertising campaign etc. Thus the mangers will
ignore the competitors to the extent that their actions do not
encroach on the firms market and do not interfere with the desired
growth rate and market share of a firm.
Baumols model is based on the following basic assumptions
1) It s a single period analysis
2) During this period firm aims at maximizing total sales
revenue (and not physical quantity of output under minimum
profit constraint)
3) Minimum profit level is determined exogenously by the
demands and expectations of shareholders, banks and
financial institutions.
4) Conventional cost analysis based on U-shaped cost curve
is assumed under this model
Based on these models we will understand three different
models described by Baumol :-
1) Single product without advertising
2) Single product with advertising
3) Multiple products without advertising
3.2.3 Single product without advertising
35
We first explain Baumols model for a firm which produces a
single product and does not incur any advertising expenditure. It is
necessary to understand following diagram to explain price
quantity determination under this model.
Figure 3.1
In the diagram
TR Total Revenue curve for the firm
TP Total Profit curve for the firm
TC Total Cost curve
ML Minimum level of profit which the firm must earn.
Total profit is a different between total cost and total revenue
of a firm.
We will first understand how a firm determines quantity and
price with the objective of profit maximization. Since profit is a
difference between total cost and total revenue, maximum profit will
be at that point where the vertical distance between TR and TC is
maximum or where the TP curve reaches to its (highest) level. So
under profit maximisation objective firm will produce OA level of
output because that level of output corresponds to the highest point
on TP curve (Point H).
Next to understand is the situation in which a firm would aim
at sales maximization in the diagram; sales are maximized at the
level of output OC, which corresponds to highest revenue R.
As per the assumption of Baumols model a sales revenue
maximizing firm has a minimum profit constraint. In other words,
even if the firm is maximizing sales revenue, it has to do so under
the conditions of minimum profit level AT OC level of output even
36
though the sales are maximized minimum profit level (ML) is not
reached. At OC level of output profit level is less than ML. So this
is not what Baumol has contented.
Equilibrium price and quantity under oligopoly with sales
maximisation subject to minimum profit constraints is at the output
level OB.
It should be noted that under Baumols model of oligopoly
firm, sales revenue maximisation leads to more quantity at lower
price as compared to profit maximisation situation.
3.2.4 A single product model with advertising
Under oligopoly, firms compete not only in terms of price but
also in terms of advertising expenditure, product changes, after
sales services etc. Baumol presented another version of sales
maximisation model with advertising as one of the policy variables.
An important assumption of this model is that advertising
expenditure will always shift demand curve to the right indicating
that the firm will be able to sell more and get larger revenue after
advertising expenditure. Following diagram explains this version of
Baumols model.
Figures 3.2
As per the diagram advertising expenditure is shown on the
x-axis and total cost total revenue and total profit is shown on the y-
axis. As stated earlier according to Baumol, increase in advertising
outlay will lead to increase in sales of the firm (sometimes at
diminishing rate) Increase in the physical volume of sales leads to
increase in the total revenue of the same firm
TR total Revenue
OD advertising cost
37
Production costs (fixed and variable costs) are shown
independent of advertising expenditure. So by adding fixed cost
(OT) to the advertising cost curve OD we get total cost curve TC.
Difference between TR and TC is profit Therefore
PP Total profit curve
Profit maximizing output level will be produced with
advertising expenditure equal to OA
1
, (because at that level the
total profit is highest)
Revenue maximizing output level will be reached with
advertising expenditure equal to OA
2
, (Where the firm maximizes
its total revenue with minimum profit constraint)
As seen in the diagram OA
2
is greater than OA
It may be, hence concluded that in order to maximize sales
with minimum profit. Constraint greater level of advertising
expenses are to be incurred by the firm as compared to advertising
expenses of profit maximizing firm.
3.2.5 Multi product firm without advertising
This version of model explained by Baumol is based on the
assumptions such as
1) Costs are given
2) Firm produces two commodities and Y
To explain the equilibrium condition of a firm aiming at sales
maximisation with multiple products and without advertising
expenses, Baumol has made use of two apparatus
1) Transformation curve or marginal rate of product
transformation, which is a ratio of marginal costs of two
commodities x and y. Product transformation curve is
concave to the origin showing increasing cost of reducing
one product (say y) and reallocating the resource to produce
other commodity (say x)
2) The iso-revenue curve is the curve showing same revenue
earned by different combinations of x and y. Higher the iso-
revenue curve higher will be the total revenue earned.
Following diagram shows equilibrium of multiproduct firm
without advertising.
38
Fig 3.3
Firm is in equilibrium at point E where the product
transformation curve TT is tangent to the highest possible iso-
revenue curve (R
2
).
It should be noted that the solution is diagram 3 is identical
with the solution for profit maximizing firm. (Students should recall
that the firm maximizes profit at a point where the slopes of product
transformation curve and iso-revenue curve are identical). Thus in
this version f Baumols model, a firm maximizes sales at that level
of output where the firm maximizes its profit. In other words,
whatever output combination maximizes revenue, also maximizes
profit.
3.2.6 Critical Appraisal of Baumols sales maximisation model
The sales maximisation theory by Baumol implies of
favorable effect on the welfare of people. This is because under
sales maximization with minimum profit constraint, output will be
greater and price will be lower than that under profit maximization.
Shepherd has criticized the model on the ground that the
oligoplistic firm faces kinked demand curve and if the kink is quite
large, total revenue and total profits would be maximized at the
same level of output.
According to Hawkins in case of single-product firm, as
compared to profit maximizing firm, output will greater, smaller or
same and advertising expense also will be greater, smaller or same
depending upon the responsiveness of demand to advertising
expenditure and not to price cut.
Another criticism against Baumols model is that his theory
does not show haw equilibrium in an industry will be attained. He
has not been able to establish relationship between a firm and
industry.
39
3.3 MORRISS MANAGERIAL THEORY OF FIRM
Another new theory, stressing the role of managers and their
behavioural pattern in determining output and price of firm was put
forward by Marris. According to him, Managers do not aim at
maximizing profits but they seek to maximize balanced growth rate
of a firm Maximisation of balanced growth rate means maximizing
the rate of growth of demand for the products of firm and the rate of
growth of capital supply
Maximise g = g
D
= g
c
Where
g = balanced growth rate
g
D
= growth of demand for product of a firm
g
c
= growth of supply of capital
While maximizing growth rate, there are two constraints
faced by the manager of a firm :-
1) Managerial constraints
2) Finanacial Constraints
Managerial constraints are set by the available managerial
team and its skill. Financial constraints are set by desire of
managers to achieve maximum job security. It is important to note
here that the managers aim of maximizing rate of growth of
demand to maximize their own utility and they aim at maximisation
of growth of capital to maximize the utility of owners and
shareholders.
3.2.1 Mangers utility Function
Mangers utility function includes the variables like salaries,
status, powers and job security. Owners utility function includes
variables like profits, size of output, size of capital, share of market
and public image. Thus, due to division of management and
ownership has resulted in setting goals which may not necessarily
coincide.
Um = f(salaries, power, status, job security) This is mangers
utility function.
3.3.2. Utility function
Uo = f* (profits, capital, output, market share, public esteem)
This is owners utility function
The managers aims at maximizing utility as per Um function
and the owners aim at maximizing Uo function. According to
40
Marris, the difference between these two functions is not wide
because most of the variables are strongly correlated with each
other. Marris believes that the size of a firm may be measured by
the level of output, capital supply, sales revenue and market share.
Achieving steady balanced growth implies the growth of most of the
variable occurring in above mentioned functions such as sales,
output, supply of capital etc. Marris further argues that the
maximization of growth rate of firm is compatible with the interests
of share holders. So growth of demand/output of a firm. (g
n
) and
growth of capital supply (g
c
) of a firm need not be differentiated. In
other words, when the rate of growth of firm is higher, mangers
salaries will be higher they will have power and more job security.
So mangers utility function can be written as
U
M
= f(g
D
, S)
Where g
D
- growth of demand
S measure of job security
On the other hand, owners utility depends upon the growth of
capital supply. So his utility function can be written as
U
O
= f* (g
c
)
Following E Penroses Theory of Growth of firm Marris
argued that g
D
or growth of demand for product is constrained by
decision making capacity of a manager Job Security S is
determined by three financial indicators
1) Liquidity Ratio
2) Debt. Asset. Ratio and
3) Profit Retention Ratio
Marriss treats s as an exogenously determined constraint
in the managerial utility function. Taking this factor into
consideration managers utility function may be rewritten as
U
M
= f(g
D
) s
Where s is a security constraint.
3.3.3. Constraints in the Model
As discussed in the earlier part of the theory, thee are two
constraints in the model.
The Managerial constraint and
The Job security constraint
Since the decision making and planning of firms operation
are the result of team work of managers, the efficiency of top
41
management acts as the managerial constraint in the model.
Research and Development (R & D) department also set limit to the
rate of growth of firm. Thus, both g
D
and g
c
have managerial
constraint.
The job security constraint makes managers become risk-
avoiders by choosing steady performance and not risky ventures
which may be highly profitable. Managers also prefer prudent
financial policies by determining optimum levels for the three
financial ratios mentioned in the earlier section :- Liquidity Ratio,
Debt ratio, and Retention Ratio. These three financial ratios are
combined into a single parameter a which is called financial
security constraint. It is exogenously determined by the top
management.
According to Marris, two ponts need to be stressed
regarding the overall financial constraint a .
a
1
= Liquidity Ratio
L Liquid Assets
A Total Assets
=
a
2
= Debt Ratio
D Value of Debt
A Total Assets
=
a
3
= Retention Ratio
R
Re tained profit
Total
t
=
t Profit
1) Overall a is negatively related to a, and positively related to
a
2
and a
3
.
2) There is a negative relationship between job security (s) and
financial constraints ( a )
3.3.4 Equilibrium of a firm
Managers aim at maximisation of their own utility
U
M
= f(g
D
)
Owners aim at maximisation of their own utility
U
O
= f*(g
c
)
Firm is in equilibrium when
g
D
= g
c
= g* maximum
where g* is maximum balanced growth rate g
D
will depend
upon the rate of diversification or introduction of new products (d)
and the proportion of successful new products (k) which in turn will
depend upon price of product (p), advertising expenditure (A) and
expenditure on Research and Development (R & D), Thus
g
D
= f(d, k)
g
c
(Rate of growth of capital supply) will depend upon the
magnitude of profit
g
c
= f(t) t = profits
42
According to Marris, further, growth rate of supply of capital
depends upon average rate of profits (m) which is obtained by
deducting cost per unit, advertising expenditure per unit and R & D
expense per unit from the price of product
m = p c (A) (R & D)
Growth rate of capital supply also depends upon the rate of
diversification (d). So
t = f(m, d)
Substituting this profit function the in the function governing
supply of capital, we have
g
c
= a (t)
Where a is financial security constraints
As long as financial security constraint is constant, growth of
capital and magnitude of profit are not competing goals. Higher
levels of profits means the higher growth of capital supply.
Given the above function related to rate of growth of demand
for product and the rate of growth of capital supply, the firm will be
in equilibrium when it is achieving the highest rate of balanced
growth
g
D
= g
c
= g* maximum
3.3.5 Evaluation of Marriss Model
The most important contribution of Marris model of
managerial theory of firm is the inclusion of financial policies of the
firm into the decision-making process. The financial constraint
coefficient a plays a very important role in the entire model as a
policy variable. However, the model actually does not say much
about the value of a . It is assumed to be exogenously determined.
According to the conclusion of the model balanced growth
solution will maximize the utility functions of both mangers and
owners. But it may be so during the periods of steady growth and
not during recessions or tight markets.
One of the implications of the model is that both the mangers
and owners prefer maximization of rate of growth over the
maximization of profits. Marris does not justify the preference of
owners for capital growth over the maximisation of profits.
The model assumes price and cost to be constant. It fails to
take into consideration the interdependence of firms under the
oligopolstic structure.
43
Further, the model assumes a continuous growth by crating
new product. But it fails to realize that new products may be
imitated by the rivals and this, in the longrun will hinder the steady
growth of firm.
There are many restrictive assumption on which the Marris
model heavily relies. Such as each firm has its own R & D
department, R & D and advertising expenses together influence the
growth rate of capital supply etc.
3.4 CONCLUSION
In conclusion it may be observed that managerial theories of
firm in general fail to explain the oligopolistic structure of market.
These theories are excessively dependent on the assumption of
unlimited power of firms to influence market through advertising
and introduction of new products. These theories also fail to explain
the price determination pricess in the oligoplistic market.
3.5 SUMMARY
1) In addition to traditional profit maximisation as an objective firm,
many other objectives such as sales maximisation growth
maximisation etc. have been put forward in the recent years.
2) Due to bifurcation of management and ownership function of a
firm, sales maximisation has become important objective,
according to Baumol.
3) Though Baumol stresses on the sales maximisation objective of
the firm, minimum profit constaint plays important role in his
analysis.
4) According to Marris, long run growth rate maximisation is an
objective of a firm. Maximisation of rate of growth of demand for
the products of the firm and the rate of growth of capital supply,
would bring about maximisation of balanced growth rate.
3.6 QUESTIONS
1) Discuss the importance of managerial theories of firm.
2) Critically evaluate Baumols sales maximisation model.
3) Explain Marriss Growth maximisation model.

44
4
Module 2
INVESTMENT DECISIONS
Unit structure :
4.0 Objectives
4.1 Introduction
4.2 Investment decision Capital appraisal-methods
4.3 Risk and Uncertainty
4.4 Sensitivity analysis
4.5 Financial statements
4.6 Summary
4.7 Questions
4.0 OBJECTIVES:
- To understand risk involved project selection
- To understand various methods of project appraisal and
investment decisions
- To know what is risk and uncertainty
- To understand the relevance of sensitivity analysis
- To know about financial statements and its components
4.1 INTRODUCTION:
Every industry or company wants to grow and expand its
business locally and globally. Need always arises to expand the
operation through branches or new set up. Most of the companies
expand their business by investing in new projects. However it is
not a sudden decision they make but it needs proper evaluation of
projects and their viability of success. So the terms like capital
budgeting and sensitivity analysis are common in this regards. In
this module we are going to study about the investment decisions
taken in the industry or company while selecting project for
business development. Module will focus on investment related
terms and finance. Company maintains accounts and financial
statements to know the profits and operational efficiency. They
45
compare their profits with other concerns or for years for self
concern progress indications. This module discusses about the risk
and uncertainties prevailing in project selection and sensitivity in
making investment decision accordingly.
4.2 INVESTMENT DECISION AND PROJECT
APPRAISAL METHODS
There are many methods of appraising the projects. Before
taking capital investment decision it is necessary to do a project
planning. Project planning starts with the exploration of a business
opportunity. In this detailed investigation is made of different
aspects such a managerial, technical, marketing, economics,
operational and financial toward the project acceptance. After
evaluating the project, a report is made known as project report. It
is a real blue print on which basis the project gets a concrete
shape. It has importance because every firm intends to maximize
its profit.
Investment decisions are based on the evaluation of such
projects living scope for capital budgting. Capital investment is
concerned with comparing the benefits that accrue over a period of
time with amount invested. Therefore all the project proposals have
to be ranked in the order of preference yielding maximum returns. It
is absolutely necessary to evaluate the projects before making
investments.
There are three methods of appraising projects:
4.2.1. Pay-back method:
The most simple and widely accepted of project evaluation is
pay-back period or pay-out or pay-off period. By this method it is
calculated that within what time the investment done is recovered in
the form of annual cash flows. In simple language, it is the period or
number of years required to recover the original cash outlay
invested in a project. This method is also known as cash-to-cash to
method. every project generates annual cash flows. Therefore it is
seen which project investment amount is recovered soon and
accordingly that projects is ranked first.
The formula used in this calculation is :
Pay-back period = Total Investment outlays/Annual cash flow.
Merits:
- It is simple and easy method of evaluating and ranking projects.
It is more concrete and realistic.
46
- It problem of liquidity is easen as it considers the annual and
regular recovery of cash flow.
- Risk can be minimized by selecting most beneficial project first.
- This method is widely used in industries for project evaluation.
- This methods is used for short terms as well as long term
investment projects.
- It is suitable when firm is in urgency of cash realization.
Limitations:
- It stresses on only one aspect more that is of liquidity.
- Long term projects cannot be evaluated by this method
properly.
- Consistent cash flow is assumed in this method so change is
cash flow is not considered in this method
- Time value of money is not considered in this type of method.
- Sales promotion techniques are not considered in this methods
being the most cash realizing factor those are adding to cash
inflows.
4.2.2 Net present Value method :
In this method, the investors take investment dictions on the
basis of net present value. It is also known as discounted present
value method. Here the fact is considered that the amount of
money received today is more valuable that the one received after
year or years. The intention behind is that the money received
today can be invested to earn certain amount of interest. The
present value of an investment proposal is the difference between
the total of present values of the estimated annual cash flows over
the life of the project and initial investment of the project.
NPV is difference between discounted value of all the net cash
flows and capital cost of the project.
Decisions with consideration of NPV is taken on the basis of
following rules:
If NPV is positive, the project will be accepted
If NPV is negative, the project is rejected
If NPV is zero, there will be indifference in selecting the project in
the choice.
Merits:
- It takes into consideration income derived from capital over the
entire life time
- For many projects this method is useful
- Time value of money is highly considered in this method
- It is widely used and popular method of project evaluation
47
- If number of investment proposals are to be considered the
following formula is used:
- NPV indeed = Total present valued of all cash flows
----------------------------------------------
Initial investment made
Demerits:
- If the rate of investment is to be considered over the investment,
then it is absolute method.
- It is more subjective, lengthy and complex method as compared
to pay back method of project evaluation.
4.2.3 Internal rate of return (IRR) method:
Under this method, time factor and opportunity cost of
investment is considered. It is same like MEC method given by
Keynes. MEC stands for Marginal Efficiency of Capital. This
method is based on the technique of discounting cash flow. It is the
discount rate which equates the discounted present value of its
expected future marginal yields with the investment cost of project.
IRR is the annual expected rate of profit over the life of the machine
from the investment in a project. It is the rate of discount which
equates the present value of the income stream over the life of the
machine with the net cash investment.
The rate of return calculation that takes into account the time
value of money is called discounted cash flow method.
Trial and error procedure has to be employed in finding out
the internal rate of return because cash benefits consists of an
uneven series. If the IRR exceeds the market rate of
investment(cost of capital), such a project is accepted.
Merits:
- It recognizes time value of money
- It considers whole annual returns earned during the lifetime of
the project
- Decisions are most polished.
Demerits:
- It is difficult and complex method.
- It is lengthy procedure and not easy to calculate
- Projects having different investment costs can never be ranks
properly by this method.
- It is more objective because the IRR is not directly influenced by
decisions regarding depreciation methods, capitalization versus
expenses decisions and conservatism.
48
PRACTICAL SUMS SOLVED
From the information below calculate:
i)Pay Back Period
ii)Pay Back Profitability
Particular Model A Rs. Model B Rs.
Investment 5,00,000 7,50,000
Estimate Life ( in years) 10 10
Sales 10,00,000 20,00,000
Direct materials 4,00,000 6,00,000
Direct Labour 1,20,000 2,00,000
Cash Overheads 1,60,000 2,40,000
Depreciation 50,000 75,000
Solution:
Calculation of Labour Inflow
Particular Model A Rs. Model B Rs.
Sales
(I)
10,00,000
Less: Variable Cost
Material 4,00,000 6,00,000
Labour 1,20,000 2,00,000
Cash
Overheads
1,60,000 2,40,000
6,80,000 10,40,000
Contribution(I-II)
(II)
3,20,000 9,60,000
Less: Depreciation 50,000 75,000
P.B. Tax 2,70,000 8,85,000
Less: Tax -- --
P.A. Tax 2,70,000 8,85,000
Add: Depreciation 50,000 75,000
3,20,000 9,60,000
49
i) Payback
Period
A B
=
=
= 1.5625 years = 0.78125 year
ii) Payback
Profitability
=3,20,000 *10 =32,00,000 96,00,000
Less: Cost =5,00,000 7,50,000
=27,00,000 =88,50,000
Q 2. Base Line Ltd; has a machine which has been in operating
since 6 years. The management is considering a proposal to
purchase an improved model of a similar machine which will give
an increased output. You are given the following information.
Particular Old Machine Rs New Machine Rs
Cost of Machine 8,00,000 20,00,000
Variable cost per
unit
300 300
Fixed overheads
excluding
depreciation
2,00,000 4,00,000
Selling price per unit 600 600
Output 1,500 Units 2,500 Units
The Life of both the machine is 10 years each. Depreciation by
SLM. Tax rate 50%. Calculate PB period and payback
profitability.
Solution:
Calculation of cash Inflow
Particular Old Machine Rs. New Machine Rs.
Selling Price 600 600
Less: Variable Cost 300 300
Contribution 300 300
Output ( Units) 1,500 2,500
Contribution 4,50,000 7,50,000
50
Less: Fixed cost 2,00,000 4,00,000
PBD & Tax 2,50,000 3,50,000
Less: Depreciation
( )
80,000 2,00,000
Profit before Tax 1,70,000 1,50,000
Less: Tax 50% 85,000 75,000
Profit after Tax 85,000 75,000
Add: Depreciation 80,000 2,00,000
CASH IN FLOW 1,65,000 2,75,000
i)Pay back period=
8,00,000 20,00,000
4.8484 years 7.2727 years
ii)Payback Profitability =
Inflow * No of Years
16,50,000 22,75,000
Less: Investment 8,00,000 20,00,000
=8,50,000 2,75,000
Q3 Following is the relevant data for two machines A & B.
Particular A Rs. B Rs.
Capital Outlay 2,000 2,400
Net Cash Flow
1
st
Year 1,000 800
2
nd
Year 1,000 800
3
rd
Year Nil 2,000
Find out which of the two is a better investment, showing
workings. Use Pay Back Period.
Solution:
(A)Pay Back Period Method
Particular Machine
A B
Pay Back Period 2 years
2 years + i.e.,2
Machine A is a better investment, as it has a lower Pay Back
period.
51
(B) Post Pay back Profitability Method:
Post Payback Profitability = Total Savings Capital Outlay.
Machine A = 2,000 2,000 = Nil
Machine B = 3,600 2,400 = Rs. 1,200
In this case Machine B is a better investment.
Illustration 10
Shobhit ltd; is considering to purchase a machine. Two Machines
A and B available at the cost of Rs. 1,20,000 each. Earnings after
tax but before depreciation are likely to be under:
Year Machine A
Rs.
Machine B
Rs.
1 50,000 20,000
2 40,000 30,000
3 30,000 50,000
4 20,000 40,000
5 20,000 40,000
Evaluate the two alternatives by using:
(1) Pay Back period method
Solution:
(1)Calculation of pay back period:
Year Machine A Machine B
C.I Cum. C.I. C.I. Cum. C.I.
1 50,000 50,000 20,000 20,000
2 40,000 90,000 30,000 50,000
3 30,000 1,20,000 50,000 1,00,000
4 -- -- 40,000 1,40,000
C.I. = cash Inflow.
P.B.P. Machine A = 3 years
P.B.P. Machine B = 3 years + years 6 months
Ans:
As recovery of investment done on machine A is early of 3 years it
is preferable to invest in the same.
4.3 RISK AND UNCERTAINTY
Risk and uncertainty has been the inseparable part of
business activities or investment decisions. Only difference in both
52
is that risk can be insured while uncertainties are true risk which
may make suffer or prove harmful for business.
According to the Oxford dictionary definition of risk the
possibilities of meeting danger or of suffering harm or loss. There
are many kinds of risks observed in investment they are
- Business and financial risk:
They are actually two separate type of risks but are
interrelated too. Business risk is also known as operating risk and is
associated with day to day operations of the business. While,
financial risk is the risk created by debt and preference shares and
securities. These risks are dependent or caused upon competition,
new technologies, change in consumer preference, government
policies and poor performance of business.
- Interest rate risk:
It is another risk. It occurs due to change in interest rates of
securities. It happens due to speculations.
- Market risk:
This kind of risk arises due to the change in psychology of the
investors, unexpected war conditions, political instability,
speculation etc.
4.4 SENSITIVITY ANALYSIS
Risk has been the matter of profitability in the business.
Without risk, profit cannot be expected. In fact, profits is the reward
for risk undertaking. Every project undertaken has to be evaluated
from the point of its profitability therefore the sensitivity analysis has
a scope and relevancy in the industrial capital budgeting and
investment decision making. Starting new project always has more
uncertainties than expanding the existing one. Therefore with
reference to capital budgeting, results may vary from estimated to
actual terms. The greater the variability between the two, more
risky is the project. Therefore the measure which expresses the risk
in more precise terms is sensitivity analysis.
Sensitivity analysis is a behavioral approach that uses a
number of possible values for a given variable to assess its impact
on a firms returns. In the area of finance, such kind of analysis is
related with capital budgeting decisions.
It focus light on the sensitivity of the project in respect its
expected cash flow, the discount rate. It is very important because
the future is uncertain and nothing can be estimated perfectly as
errors are ought to happen all the time. Therefore this kind of
53
analysis leaves scope for the project evaluation in the better
manner. The viability of outcome is estimated with expected cash
inflow and decisions are taken accordingly. The various estimates
are made regarding cash flow estimates under three assumptions
the worst (most Pessimistic), the expected (the most likely) and the
best (the most profitable).
Significance of sensitivity analysis:
- It ensures the benefits to be derived from the chosen project.
- It considers terms of risk and uncertainty to ensure project
viability
- It ensure more than one estimate of the future return of a
project.
- It gives precise idea about project viability and makes easy its
selection
- It expands the study of increasing returns and wise investments.
4.5 FINANCIAL STATEMENT
Financial statements are the financial reports referring two
statements reflecting assets and liabilities of the company. They
are very important in accounting and corporate reporting. They
support whole accounting system. They are balance sheet and
profit and loss a/c. balance sheet represents capital, assets and
liabilities of the company and Profit and Loss a/c indicates the
results of operations of the company during a given period of time.
They are summary of accounting transactions. They are needed
and prepared for reviewing periodic progress of the company.
Financial statements are prepared in a certain format by following
certain rules. It facilitates the users to compare different companies
and their financial performance.
Components of financial statements:
- Profit and loss account :
It is also called as Income statement. It indicates the
amount of net income or loss obtained by the company during a
particular period. Net income in excess of revenue over its
expenses. It is the best measure to assess the profitability and
performance of the company.
- Balance Sheet :
It is also called as statement of Financial Position. It
represents financial position of a company on particular date. A
company can obtain finance from owners and outsiders. Thus the
54
balance sheet three major sections viz assets, liabilities and
shareholders equity. The fundamental accounting equation of:
Assets = Liabilities +Equity
Characteristics:
- They are generally report prepared on the basis of the
accounting transactions taken place already. They never deal
with the future operation estimations.
- They are the summarized reports of the whole business
transaction taken place during a give period of time. It also
classified items accordingly.
- Most of the financial statements are prepared on accrue basis
rather than on cash basis. Expenses due but not paid and
income due but not received are mentioned.
- It has the blending of economic and legal aspects. Conventions
are followed while preparing these statements.
- Most of the time, these statements are based on the estimates,
personal opinions and judgments.
- These statements are based on the reliable facts and
verification. So there are less chances of false or fake
transaction.
- Financial statements are interrelated the for they are said to be
Articulated
- The base of preparing financial statement is monetary
transactions. Without cash transactions these statements are
useless.
IMPORTANCE/ SIGNIFICANCE/ ROLE/NEED FINANCIAL
STATEMENTS
Communication:
The main purpose of these statements is to communicate
with the interested parties. This helps in making economic
decisions. Statements are prepared for letting know the
stakeholders about the operations and economic activities carried
by the company.
a) Bankers.
Banks before granting loans to the corporate and companies
takes into consideration the progress of the company through their
financial statements. The come to know the profitability, solvency,
liquidity of the company.
55
b) Shareholders:
Being the owner of the company, shareholders always are
interested to know the financial statements of the company to know
the progress and value of appreciation of their shares invested in
the company.
c) Lenders:
banks, financial institutions and other lenders of funds to the
business entity also wish to know the profitability and liquidity
position of the of the company whome they lend. It provides some
kind of assurance to them of their returns.
d) Suppliers:
Suppliers of the company are interested to know the short
term liquidity of the company. It decides the credit rating status of
the company. These statements helps them to ascertain the
capacity of the organization to pay them on time for the goods and
services supplied.
e) Employees:
Most of the incentives policies of the company depends
upon the profitability of the company, so employees are always
curious to know the profitability of the company. This they come to
know from the financial status of these statements.
f) Government:
Financial statements helps government to decide the correct
tax and duties to be levied on the industries. Therefore the tax
payable by the enterprise is dependent on the financial statements
of the company.
g) Information:
Financial statements are prepared for the showing changes
in economic resources. It helps in revealing reliable information to
all, who are concerned with the progress of the company.
h) Prediction:
Financial statements are prepared in a way to provide
information that is useful in predicting the future earning power of
the enterprise or industry.
i) For reliability:
FS are prepared to provide reliable information about the
earnings of the business enterprise and its ability to operate at a
profit in future. This helps the above stakeholders to trust the
management or organization.
56
Q Characteristics/good essentials of financial statements:
a) Understandability:
Information provided in the financial statements must be
readily understandable and comprehend. It does not mean that
complex information should be excluded. But it has to be presented
to comprehend or understand easily.
b) Reliability :
Information provided in the statements should be reliable.
Reliability means faithful information which is presented. There
should not be error, bias. It must be complete within the limits of
materiality of cost.
c) Relevance:
When the information of financial statement is useful for
decision making, then it is said to have relevancy. Information is
said to be materialistic if its omission or misstatements could
influence the economic decision of users.
d) Comparability:
The statements should be comparable across companies to
make resource allocation decisions. Trends of statements should
be comparable over the period of time to know the progress of the
company. Lack of consistency threatens the comparability of the
financial statements.
Check Your Progress :
1. Bring out difference between Risk and Uncertainties
2. What do you mean by capital budgeting?
3. What are the methods project evaluation and investment
decision making?
4. What do you mean by Financial statements and what are the
major components of it?
5. Why sensitivity analysis is necessary? Give reasons for it.
57
4.6 SUMMARY
1. Investment and capital budgeting is done by companies when
they need to chose new project for expansion purpose. These
decisions are very sensitive because they may result in profit or
may lead to loss.
2. Risk and Uncertainty has been the integral part of business
which makes it to earn profit. Risk is expected and so can be
insured but Uncertainties are situational and cannot be insured
and are truly called risk.
3. Many methods are used for selecting project on the basis the
period within which it covers the investment made and earning
capacity. Pay-back, IRR and NPV methods are most common
method being used by companies for making investment
decision out of many proposals available.
4. Companies keep record of their operations in the form of
financial statement like Profit and Loss analysis and balance
sheet focuses on total assets and liabilities held by the company
and the operational profit and loss incurred.
4.7 QUESTIONS:
1. What do you mean by capital budgeting and what are the
various methods of project evaluation?
2. What are the conventional and modern methods of investment
decisions?
3. Explain terms Risk, Uncertainty and Risk sensitivity analysis.
4. What do you mean by financial statements? Explain its
characteristics, components and significance in brief ?





58
5
RATIO ANALYSIS
Unit structure
5.0 Objectives
5.1 Introduction
5.2 Ratio analysis
5.3 Inflation accounting
5.4 Sources of finance
5.5 Capital structure
5.6 Separation of ownership and control
5.7 Summary
5.8 Questions
5.0 OBJECTIVES
- To know uses of Ratio analysis in managerial decision making
- To know what is inflation accounting
- To know various financial sources to raise funds
- To understand what is capital structure and its principles
- To understand difference between ownership and control
separation principle.
5.1 INTRODUCTION
Last part we focused on capital budgeting and investment
decisions to be taken by considering many methods of it. In this
module we shall try to learn about how the profit and loss status or
position by companies by adopting tools like ratio analysis.
Companies do calculate their operation numerically and find out
progress of them. Due to change in prices day by day companies
are also required to consider price fluctuations to prepare financial
statements to show real position of the companies. This is learnt by
knowing term like Inflation accounting. In this module we are also
going to learn how companies raise finance from their internal as
well as external sources. How do they keep proportion between
owned and borrowed capital is known by capital structure term.
59
Moreover this module also explains the difference between
ownership and management of the company.
5.2 RATIO ANALYSIS
A ratio is one figure expressed in terms of another figure. It
has mathematical application to find out the relationship between
two numbers or items of the financial statements. Ratio is
expressed by dividing one figure by other related figure. It is
expressed in fraction or as pure ratio. Ratio analysis is a very
powerful tool used for measuring performance of the organization.
It expresses the inter-relationship among the figures appearing in
the financial statements. It helps firm to analyze the past
performance and carry out future projections. Ratio is expression of
one number against another. For ratio analysis various formulas
are used to know the solvency, liquidity of the firm.
Ratio may be expressed in percent (40%) or proportionate ratio
(4:1) or in times ( 4 times a year).
Importance:
- It helps in making inter-firm comparisons among various firms
and even between the difference divisions of company.
- By using trend analysis along with ratios helps a firm to know
the performance of the company over the period of time.
- It helps in analyzing causal relationship among different items
by considering past results.
- It throws light on the efficiency of the management being
barometer for future.
- It simplify and summarize numerous accounting data in a
systematic manner so that the simplified data can be used
effectively for analytical studies.
- It helps in controlling efficiency and profitability of a business
entity.
- They are yardsticks, used by all institutions in evaluating the
credit-standing of their borrowers and customers.
- Departmental performances can be traced and expressed by
ratio analysis.
- They assist investors in making sound investment decisions and
also the shareholders in evaluating the share performance.
60
Ratio statements:
Balance sheet ratios Revenue statements
ratio
Composite ratios
Liquid ratio Operating ratio Return on capital
employed
Current ratio Gross profit ratio Return on owners
fund
Properitory ratio Expenses ratio Return on equity
Capital-gearing ratio Net profit ratio Earning per share
Stock-working ratio Stock-turnover ratio Debtors turnover
ratio
Classification of the ratios:
1. Liquidity Ratio:
Short term and immediate financial position of a business
organization is analysed by these ratios. They indicate the ability of
the organization to meet its short term obligation, so called
liabilities. They are also known as solvency ratios. They see the
asset adequate to meet its liabilities .
2. Activity ratios:
It indicates how effectively firm is using its funds. They are
so called as performance or efficiency ratios as they indicate the
degree of efficiency of the organization. It reveals operational
behavior of the organization.
3. Leverage ratios:
If measure the relationship between proprietors funds and
borrowed funds. They indicate companies debt and financing.
4. Profitability ratio:
They reflect the over-all efficiency of the organization its
focuses light on the investment policies.
Exhibits 2.3 RATIOS COMPUTATION AND COMMENTS
Objectives of
analysis
Ratio to be
Computed
formula
Immediate
Liquidity
Quick Ratio
]
Short term
Liquidity
(A) Current Ratio
]
61
Liquidity of Stock ( B) Stock Working
Capital
]
( C)Stock Velocity
2
Liquidity of
debtors
(D) Debtors
Velocity
Liquidity of
creditors
(E) Creditors
Velocity
Long Term
Solvency &
stability
(A) Proprietory
Ratio
(B)Debt Equity
Ratio
Operating or
trading efficiency
(A)Gross Profit
Ratio
* 100
(B)Operating Ratio
( c)Operating Net
Profit ratio
62
(D)Expenses Ratio
(E) Net Profit Ratio
Overall
Profitability
(A)Return on
Capital Employed
(B)Return on
Proprietors Fund
( C)Return on
Equity Capital
Capital Structure (A)Capital Gearing
(B) Debt. Equity
( c)Proprietory
Ratio
Overtrading or
Under trading
(A)Proprietory
Ratio
(B)Stock Turnover
( c) Current Ratio
63
Coverage (A)Dividend
Payout
(b)Interest
Coverage
Q Limitations of ratio analysis:
- It is basically historical in nature unless projected studies are to
be made.
- Difference in accounting policies and accounting period make
the accounting data of two firms non-comparable.
- In case of firms having diversified product lines, of different
industries, the ratio calculated aggregately cannot be used for
inter-firm comparison.
- Seasonal factors may also influence financial data. As the stock
may be high or low according to festivals and seasons.
- Ratios are only symptoms and not solutions.
- In many situations, accountant has to make choice out of
various alternatives available. So subjectivity is high in this
case.
- It is quantitative in nature and not qualitative in nature.
- Realities behind the prepared may be different than what is
presented in the ratios because most of the firms go for window
dressing to show their balance sheet strong.
- Price level changes make ratio analysis meaningless.
5.3 INFLATION ACCOUNTING
Inflation refers to a rise in price level and fall in money value
after full employment level has been achieved. Under such
conditions only prices will rise and output will remain the same.
Inflation is a state where aggregate demand for goods and services
exceeds aggregate supply. When aggregate demand is higher
more than aggregate supply, the prices level generally increases. If
such a situation persist for a long period of time, it leads to inflation.
Due to change in factor prices and goods prices need is to study
inflation accounting. It is exactly opposite to historical cost
accounting where changes (inflation) on income and assets are
completely ignored.
64
Inflation accounting is also known as accounting for
changing prices. It can be defined as a system of accounting
which regularly records all items in financial statements ate their
current values or changed values. It is new accounting
development which studies impact of changing prices over
historical costs. It shows inflation adjustments to the historical
figures appearing in the books of accounts of a company. This
accounting do consider that due to rise in prices, purchasing power
of the consumers is decreasing day by day. Financial statements
are prepared on the basis of current prices prevailing in the
economy.
Objectives:
- To show real financial position in present day terms and to show
the real capital employed.
- To make sure that sufficient funds will be available to replace
the assets when their replacement is due.
- To know the real profits and loss for the year based on current
change prices
- To know profit in constant rupee keeping in view the general
changes in prices.
- To enable stakeholders and management real position of
operations with references to price fluctuations.
Approaches of inflation accounting
Current Purchasing Power Accounting (CPPA):
Under this method the historical accounting data are
adjusted on the basis of any established and approval general price
index at a given date. It considers the changes in the value of items
as a result of the general price level. It ignores changes in the value
of individual items. This method was recommended by English
Institute of Chartered Accountants. According to them company
should continue to prepare financial statements on historical cost
basis. Under this method price level adjustments are made for all
the items of income statement and balance sheet.
Current cost accounting (CCA):
It is also known specific price level approach because
change in the general level of prices which occur as a result of
change in the value of the monetary unit are measured by index
numbers. Specific price changes occur if prices of a particular
assets held change irrespective of any changes in general price
65
level. This method has also been named as replacement cost
accounting. In this method, historic values of items are not taken
into account; rather currency values of individual items are taken as
the basis for preparing profit and loss account and balance sheet.
This method seeks to state the assets and liabilities in the balance
sheets their current values.
5.4 SOURCES OF FINANCE
Industrial Finance may be required for short period or for
long period. It may be raised by investment of proprietors as
ownership funds or by borrowings. Finance is the blood of the firm,
so it has to be managed from the own pocket or borrowed from
institutions. The various sources of finance may be broadly
classified as under: industrial finance is needed for long term,
medium term and short term requirements:
A) LONG TERM FINANCE:
Owned funds:
It includes owners investment as sole proprietor or partners
of a firm. In companies it is raised by issue of shares, ploughing
back of profits, depreciation policy, dividend policy. Companies
raise long term finance by issuing equity shares and preference
shares in the market. The main motive behind is that it can use the
money collected by such issues as owned capital. Equity share
carry no fixed obligation against the returns or dividend .
1.PloughingBackofProfits
Like all individuals, companies also save a portion of their
profits to be used to meet future needs. When the profits earned by
a company, instead of being fully distributed to shareholders in the
form of dividends, a portion is retained in the business as additional
capital. Every company keeps some reserves with it to meet future
requirement of cash or money. Whole of its profits is not distributed
by the way of dividend or interest but kept aside to use as owned
fund for growth or expansion of business.
2. Borrowed Fund:
There are external sources of business. It includes
borrowings from relatives and other sources by sole owners and
partners of business. Owned capital is never sufficient for the
company. So it has to raise money from the financial institutions on
the fixed interest obligations . In companies borrowed funds include
debentures public deposits, banks, insurance companies and
special financial institutions.
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3. Depreciation Policy.
Depreciation is permanent decrease in the value of an asset
through wear and tear in use or passage of time. It represents
permanent fall in the market value of the asset. Therefore it is
necessary to make a provision for the replacement of an
depreciated assets. So companies make provision for the
deprecation, by which every year some amount compared with total
life of the asset is shown as depreciation. The same amount is
used to buy or purchase new asset after that period of time. A good
management policy, provides for adequate depreciation on its
assets. Adequate depreciation charge is made with a view to
recover through current earnings the original investment in the
assets
4. DividendPolicy:
A good company always provides for all its liabilities before
paying dividend to its shareholders. It is a part of a sound financial
policy that company must try to establish a stable dividend rate. It
affects the raising capital name of the company a lot. Dividend is
the return on money invested in shares. So it is absolutely
necessary to make polices to handle the matter of dividend
distribution.. For maintaining a stable dividend rate, the
management is justified if does not pay dividends during the first
few years in the case of new company which requires funds for
development and financial stability.
The dividend may be paid in cash or by issue of bonus
shares according to the availability of liquid assets and the extent of
under capitalization existing in the company.
5.Reorganization
Reorganization of a company is done when it is in financial
difficulties or when it is desired to like advantage of certain
favorable conditions in the market. It is necessary to make
profitable and efficient again. Reorganization may be internal or
external.
Internal Reorganization: In internal reorganization the share
capital is reorganized. A portion of capital is also cancelled to wipe
out the capital losses.
External Reorganization: It takes place when a company goes
into liquidation and a new company is formed with the value of
assets and liabilities suitable adjusted. Money is realized by this
process.
67
B) MEDIUM TERM FINANCE:
Public deposits:
Company also accept public deposits to make available
working capital for smooth operations. It is accepted for 6 month to
3 years period. Companies offer good rate of interest on such a
deposits because it satisfies the liquidity need of the company for
the medium term tenure.
Term loans:
Loans having maturity period of one year are term loans.
They are repaid over a period of stimulated time.
Lease financing:
Some financial sound companies buy or purchase plant or
equipments and give them on lease ( rental basis). It is also the
source of finance for them. The giving company is called as lessor
and the firm who are given such machineries to use on rental basis
are called lessee.
C) SHORT TERM FINANCE:
Trade credit:
It is credit granted by the suppliers. It has duration of 15 to
90 days. It is common practice followed in business operations. It is
very flexible.
Bank credit:
Banks do lend money by different methods such a cash
credit, bills discounting and overdraft facility to the current account
holders(businessmen). Bank is pioneer in granting such loans to
the firms to meet their financial needs.
5.5 CAPITAL STRUCTURE
Term capital is taken as wealth or total assets employed in
the business. Capital structure planning is done with an objective of
maximization profit and minimizing cost of capital. Capital used by
the firm is mixed of owned and borrowed capital. So structure of
capital has to be considered to determine which type of capital
company is intended to use. It answers how much should be the
debt and equity capital ratio. Capital structure deals with mixing the
debt and equity capital. One represent owned capital and other
represents borrowed capital. Company knows that depending upon
borrowed capital more is always obligatory as it makes it to pay
regular interest and payments on it. While using the equity capital
comprising investments done by shareholders is less obligatory as
risk is born by the shareholders themselves. The essence of
68
capital structure decision is to determine the relative proportion of
equity and debt.
Characteristics capital structure :
Profitability:
The capital structure of the company should be most
advantageous. Within the limitation, maximum use of the leverage
at minimum cost should be made so as to obtain maximum
advantage of trading on equity at minimum cost.
Flexibility:
It should be flexible to meet the changing conditions. It
should make company possible to provide funds whenever needed
to finance its profitable activities.
Control:
The capital structure should involve minimum risk of loss. It
should be used for controlling risks.
Broadly speaking, there are three fundamental patterns of
capital structure in new concern
Financing of capital requirement exclusively by equity.
Financing of capital requirement by equity and preferred stocks
Financing of capital needs by equity and preferred stocks and
bonds.
Principles to be considered by finance manager while
choosing pattern of capital structure:
Cost principle:
According to this principle, ideal pattern of capital structure is
one that minimizes cost of financing and maximizes earnings. Cost
of capital is subjected to the payment of interest and tax. So
decisions is to be taken which kind of capital is to be used, equity
based or loan based and in what proportion. Debt capital is
obligatory but its better because the debenture holders or bond
holders do not claim on the profit of the company but are only
concerned with rate of interest agreed upon payable to them.
Risk principle:
According to his principle, capital structure should be
devised so that the company does not run the risk of brining the
receivership with all its difficulties and losses. Bonds are long term
obligations so they are risky. The may be fatal if raised beyond
limits. Equity stocks are less risky according to his principle
because it is the non-obligatory capital and in case of loss of
company, claim does not stand of its payment.
69
Control principle:
According to his principle , the finance manager should keep
eye on the controlling position of residual owner remains
undisturbed. Care has to be taken that not all the profit is
distributed among the creditors but maximum benefits must also go
to the owner (shareholders). Indebtedness and bankruptcy should
not be the result of borrowing excessive fund from out.
Flexibility principle:
According to his principle, the management should strive
toward achieving such combination of securities that the
management finds easy to source. Not only various alternatives
should be considered for raising funds but bargaining position of
the industry should also be considered.
Timing principle:
According to his principle, capital structure should be based
on the time and business cycle, opportunities available, and
demand of different kind of securities.
5.6 OWNERSHIP AND CONTROLS SEPARATION
There is difference between ownership and management of
company. Ownership of the company lies with shareholders
because they invest in equity and preference capital of the
company. They are part of owned capital of the company. Equity
shareholders do take risk by investing big amount in the company
to gain more dividends or return. So they have ownership status of
the company. They are spread all over the nation or today foreign
investors are also investing, so they are globally spread also. It is
not possible for them to come and run the business. They are only
interested in earning dividend. So they appoint their representatives
to run the company affair. They are the Board of Directors. So
Board Of Directors are the management of the company. They do
carry business accordingly and prove their efficiency by showing
financial statements properly audited and presenting financial
report in the Annual General Meeting. They are responsible for
running business of the company and looking its affairs. It is the big
controversy and matter of transparency in this regards. In order to
better control between these two terms, Corporate Governance is
needed which makes BOD obligatory toward fair business and
enables owners to control business well.
70
Check your progress :
1. What do you mean by Ratio Analysis?
2. What is Inflation accounting and how it is different form historical
accounting?
3. What are the sources of raising finance?
4. What is capital structure and what are its principles?
5. Explain the difference between term Ownership and
Management.
5.7 SUMMARY
- In ratio analysis one number is expressed with another in the
form of percentage or times or proportion. It is necessary to
bring out the relationships and compare the changes taken
place so far in the concern. It is an important tool which focuses
light on the progress of the company and also the enables
managers to compare their progress with other companies. It
not only expresses past performance but also helps in
projections for future.
- Inflation accounting is the accounting where the price
fluctuations are considered. Due to increase in the prices of
goods and services, financial statements are prepared
accordingly. This kind of accounting has two approaches
namely; CPPA and CPA.
- Industrial finance is the finance needed for running companies
efficiently. It is needed for short term, medium term or long term
purposes. There are many sources of raising finance. Internally
or externally finance is raised from time to time.
- Capital structure term deals with industrial finance. Companies
finance is categorized in two sources i.e. Owned fund and
Borrowed fund. It shows the proportion in which required
finance is to be raised. It should be sound and should consider
principles of minimizing cost of raising funds, flexibility, control,
timing etc.
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- Company is owned by shareholders who are spread nationwide
or worldwide by investing into shares. While the company is run
by Board Of Directors who are the managers of funds and
operations. So ownership lies with shareholders and
management lies with BOD of the company.
5.8 QUESTIONS
1. Critically explain Ratio Analysis as a tool of decisions making
and performance evaluation?
2. What is Inflation accounting? Explain various approaches it.
3. What is industrial finance and what are the sources of industrial
finance?
4. What are the principles of sound capital structure?
5. Write a note on: Separation of ownership and management
control.
















72

6
Module 3
VERTICALLY RELATED MARKETS AND
COMPETITION POLICY
Unit Structure :
6.0 Objectives
6.1 Introduction
6.2 Market Power and Monopoly Market
6.3 Social Cost of Monopoly Power
6.4 Measurement of Monopoly Power
6.5 Monopoly and Back ward Integration
6.6 Question
6.0 OBJECTIVES
- Market power may exist in both the buyers and sellers
market. Major objective of this unit is to understand the
concept of market power.
- We will also analyse the benefits and social cost of
monopoly power in the sellers market.
- Monopsony or the market power in the buyers market will
also be analysed in this unit.
6.1 INTRODUCTION
The neo-classical economics criticized monopoly market and
monopoly power on the ground that misutilises the resources and
leads to inefficiencies in the market. As a result, optimization of
social welfare is not possible. The neo-classical ideology regarding
monopoly power is reflected in many anti-monopolistic legislations
passed by the governments of the countries, like UK, USA etc. The
73
major objective of such anti-monopoly laws is to identify the
presence of monopoly power, and then regulate or eliminate any
such monopoly power. The problem in this respect, is that the
monopoly power is not easily identifiable. There is an absence of
unanimity on the factors that lead to monopoly power and hence it
is difficult to quantify monopoly power so that an appropriate action
can be taken to regulate it.
In this unit, we will try to understand the factors that lead to
monopoly power. We will also understand welfare impact of
monopoly power. We will also discuss how the monopoly power
can be measured to enable the government authorities to take
appropriate policy measures.
6.2 MARKET POWER AND MONOPOLY MARKET
6.2.1 Meaning of Monoploy Power :
According to neo-classical economic thoughts, monopoly
power of a seller is determined by two factors.
1. The degree of freedom the seller has in deciding his price.
2. The extent to which price exceeds marginal cost or the seller
enjoys long-run abnormal profit.
Since the seller under perfect competition does not have
freedom either to determine price or to charge price higher than
marginal cost, there is no monopoly power present under such
market. Greater or lower degrees of monopoly power may be
present with monopoly or oligopoly markets. Under the monopoly
market, even if there is a single seller, (who does not have any
competitor at the moment) the monopolist may not be able to enjoy
excess profit out of the fear of potential new competitors. Hence,
existence of monopoly with single seller or oligopoly with a few
sellers does not necessarily imply an existence of monopoly power.
6.2.1 Benefits of Monopoly Power
It is important, at this stage, to understand whether the cost
conditions are likely to remain the same when a number of firms
are combined to become a monopoly. In other words, it is
necessary to analyse whether a monopoly firm (which produces on
a large scale) faces similar cost conditions as compared to a
number of competitive firms producing the same product (on a
smaller scale). Two views need to be considered in this case:-
1. The monopolist can enjoy various economies of scale such as
grater specialization, larger markets, cheaper finance, buying
raw materials in bulk, spending more money on research and
74
development, applying modern techniques of production and
management, etc. All these will result in the fall in cost of
production. If these economics of scale (leading to fall in cost
production) are large enough leading to substantial fall in cost,
the monopoly price may be smaller than that under perfect
competition.
2. The monopolists can charge different price, different buyers, as
he is the sole producer in the market. In other words, there is a
possibility of price discrimination under monopoly and not so
under perfect competition. The monopolist can maximize his
profit by charging higher price from the market where his
product faces inelastic demand and less price from the market
where the demand for his product is highly elastic. The
possibility of charging different price also may promote social
welfare as explained in the unit Price Discrimination.
6.3 SOCIAL COST OF MONOPOLY POWER
(WELFARE EFFECTS OF MONOPOLY POWER)
6.3.1 MONOPOLIES WITH THE COSTS HIGHER THAN
COMPETITIVE MARKET.
As you are aware, under monopoly, the consumers will have
to pay the price which is higher than the marginal cost and the
monopolist enjoys supernormal profit at the expense of consumers.
This result in two things.
a. Consumers face welfare loss as their consumer surplus
declines. (because they have to pay higher price)
b. Producer gains (as he enjoys super normal profit)
In order to understand the welfare loss or gain under
monopoly, the concept of consumer surplus can be sued. (It may
be recalled that the consumer surplus is the difference between
price the consumer is willing to pay and the price which he actually
pays). Following diagram explains welfare gains or losses arising
out of existence of monopoly power (When the costs under
monopoly are higher than the costs under perfect competition).
75
Figure 6.1
In the diagram 6.1
MD demand curve for the product.
MR Marginal Revenue Curve
AC Average Cost
MC Marginal Cost
Pc Price under perfect competition. (The students may recall
that the price under perfect competition is equal to
marginal cost.
QCc - Output under perfect competition
MGPc - Consumer surplus (which is equal to the area under
demand curve a006Ed above the price) under perfect
competition.
The consumer surplus perfect competition. The consumer
surplus arises because the consumers are willing to pay higher
price (maximum OM in the case) but they are actually paying less
(OPc)
P
M
- Price under monopoly.
OP
M
Output produced by the monopolist (The monopolist
equates marginal revenue and marginal cost to determine
equilibrium price & quantity.)
It may be noted that for the monopoly market, the equilibrium
price is higher and the equilibrium quantity is lower than that under
perfect competition.
MKP
M
Consumer surplus under monopoly (which is less than that
under perfect competition)
P
M
K E P
C
(Area 2) excess profit earned by the monopolist.
At this point it may be noted that there is a fall in consumer
surplus and a redistribution of income from consumers to producers
(in the form of excess profit which was not so under the perfect
competition).
76
P
M
K E P
C
Gains to the producer (Area 2)
An important point to be noted here is that the loss to the
consumer in the form of reduction in consumer surplus is more than
the gains to the producers in the form of excess profit. Only a part
of the loss to the consumers, is redistributed to the producer. Out of
total loss to the consumer (Area 2 + 3), only a part (area 2) is the
gain to the monopolist. The rest, shown by triangle KGEC (area 3)
is called as the dead weight loss. It arises due to inefficiency of
resource allocation under monopoly. It is considered as the social
cost of monopoly. In short, monopoly leads to misallocation of
resources and hence there is a social cost of monopoly in the form
of dead weight loss. The extent of welfare reduction depends upon
the price- elasticity of demand for the product and the difference
between monopoly and competitive prices.
Table 6.1 summaries the welfare implications of monopoly
power.
Area in
fig 1.1
Competitive market monopoly
1 Consumer surplus Consumer surplus
2 Consumer surplus Excess profit
3 Consumer surplus Dead-weight loss
4 Input costs Input cost resources used
some where else in the
economy
5 Input costs
The analysis in this section deals with the situation where
the costs under monopoly are higher than those under the prefect
competition. But this may not always be the case. Next section
deals with the situation where the monopolist produces at the cost
lower than that under perfect competition.
6.3.2 MONOPOLIES WITH COST LOWER THAN THE
COMPETITIVE MARKETS
Sometimes, the monopoly firms may be able to produce at
the cost lower than that under competitive market. This may be so
because of the economic of scale that may be enjoyed by the big
size monopoly firm or due to an easier access to superior
technology as compared to the competitive firm, etc. Under such a
situation, it is possible that the welfare gains associated with more
efficiency (Production at a lower cost) may compensate for the
dead-weight loss as shown in the following figure.
77
Figure 6.2
Figure 6.2 depicts a situation where costs are lower (MC
M
)
under monopoly as compared to the costs under perfect
competition (MC
PC
). Price under perfect competition (OPc) is lower
than that under monopoly (OP
M
). it implies that the monopoly firms
enjoy super-normal profits. As explained in the earlier diagram
(6.1), monopoly market faces a deadweight loss equal to the
shaded triangle in the figure. The monopolist makes abnormal
profits, but in this case, the profits are due to lower costs than the
higher price. The cost reduction arised out of various factors
mentioned earlier, economies on the use of resources which can be
allocated to some other lines of production. These production gains
shown by the shaded area, more than compensate the dead-weight
loss and hence lead to overall improvement in welfare. Thus, in
spite of existence of monopoly power, in spite of existence of
monopoly power, in spite of market concentration, the welfare
improvement will take place. To conclude, the monopolies may or
may not reduce welfare. It would depend on whether and to the
extent to which their costs are higher or lower than that in the
competitive industry.
78
Check Your Progress :
1. Define following terms
a) Monopoly power
b) Economies of scale
c) Price discrimination
d) Social cost of monopoly power
e) Consumer surplus
f) Dead-weight loss
6.4 MEASUREMENT OF MONOPOLY POWER
The degree of monopoly power is measured by taking
perfect competition as a base, professor A. P. Learner has
regarded perfect competition as the market providing socially
optimum (maximum) welfare. Any deviation from perfect
competition implies an existence of monopoly power, according to
him.
Under perfect competition, price is equal to marginal cost at
the equilibrium level. The level of output associated with equilibrium
price implies optimum allocation of resources. When the degree of
competition is less than perfect, i.e. under the imperfect market, the
demand curve is downward sloping and price is not equal to
marginal cost. The divergence between price and marginal cost is
an indicator of the existence of monopoly power, according to Prof.
Lerner. Greater. The divergence between the price and marginal
cost, higher is the monopoly power enjoyed by the seller,
symbolically.
Degree of monopoly
P-MC
=
P
Where P is equilibrium price.
MC - Marginal cost at the equilibrium level of output.
Under perfect competition, difference between marginal cost
and price is zero so
79
Degree of monopoly
P- MC O
= = =O
P P
There is an absence of monopoly power under perfect
competition. Greater the value of the index
(
(

P- MC
P
, the greater is
the degree of monopoly power possessed by the seller.
Lerners Measure of monopoly power is criticized on the
following grounds-
1. This measure is not useful in the market where there is non-price
competition or product differentiation. Such as under the
monopolistic competition. In other words, when the products
compete with each other, not in terms of price, but in terms of
product variation, advertising, or any other sales promotion
practices, the above-mentioned formula can not be used to
measure the degree of monopoly power.
2. Another important point of criticism against Lerners measure of
monopoly power is that, this measure is based on only one aspect
of monopoly and that is the control over prices. The degree of
control over prices depends on the availability of existing
substitutes. But the monopoly power may also be threatened by
potential substitute which is not considered by this measure.
6.5 MONOPSONY AND BACKWARD INTEGRATION.
The term monopsony is opposite of the term monopoly.
Whereas, monopoly refers to a condition or activity in the sellers
market, monopsony is a sellers market, monopsony is a condition
or activity in the buyers market. In the recent times, the issues
arising out of monopsony are gaining prominence in the developed
markets the buying power of the supermarkets and other retail
chains has been increasing. Hence it is necessary to examine
consequences of growing monopsony power through consolidation
mergers and the buyers groups. The monopsony may also bring
about wholesale price changer.
According to K. Lancater, monopsony is the economic term,
used to describe a market involving a buyer with sufficient market
power to exclude competitors and affect the price paid for its
products. Monopsony in the buyers market is the counter part of
monopoly in the sellers market. Monopsony will generally exist
when there is a corresponsing monopoly in the sellers market
since. All the firms in the market generally need to purchase similar
products. Thus, if monopoly is held in the output market, the
monopolist will generally hold maonopsony power in the input
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market. Vertical integration normally involves a producers
integration into next level of production. That means, a producer
may himself, take over distribution of his product. This is forward
integration. Backward integration on the other hand, occurs when
the producer seeks to integrate into his supply market that means,
the producer may himself, take over supply of inputs for his firm. A
firm generally uses monopoly power to have forward linkages and
monopsony power to have the backward linkages.
6.6 QUESTIONS
1. Explain in detail the social cost incurred due to existence of
monopoly power.
2. What are the benefits of monopoly power?
3. Explain the concept of dead-weight loss under monopoly with
the help of a diagram.
4. How is the market power measured?
5. What is monopsony? Why does it come into existence?
6. Explain the concept of backward and forward linkages and
existence of market power.

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7
PRICE DISCRIMINATION
Unit Structure
7.0 Objectives
7.1 Introduction
7.2 Possibility of Price Discrimination
7.3 Types of Price Discrimination
7.4 Price Discrimination and Social Welfare
7.5 Questions
7.0 OBJECTIVES:
- To understand the concept of price discrimination
- To differentiate between different types of price discrimination.
- To discuss the welfare effects of price discrimination.
7.1 INTRODUCTION:
The manufacturers often find it profitable to group the
consumers according to the intensity or elasticity of demand for a
produce and charge price differently from different groups. This act
is in contrast with the pricing policy followed by the monopolist
which assumed uniformity of price for each buyers are charged the
same price irrespective of differences in geographical distances
among the markets or income differentials of the buyers or
purchase quality differences. Such a uniform pricing policy leaves
some consumer surplus with every buyer.
7.1.1 Concept of Consumer Surplus:
We have studied the concept of consumer surplus
elsewhere. Here it is explained once again. The consumer surplus
is a difference between the price consumer is willing to pay for a
unit of a product and the price he actually pays while buying that
product. In other words, people generally get more utility from the
consumption of products than the price they actually pay for them.
The extra satisfaction the consumer gets from buying the product
has been called consumer surplus. The consumer surplus is
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represented by the area under demand curve as shown in the
following figure.
Figure 7.1
Marshalls Measure of Consumer Surplus
As per the diagram, Consumer is willing to pay ODSM to buy
OM units of a product But given the market price of OP, he has to
pay only PSMO (which is lesser than ODSM). So the difference
between what consumer is willing to pay (ODSM) and what he is
actually paying (PSMP) is consumer surplus (DPS).
The concept of consumer Surplus is important in our analysis of
price discrimination for the following reasons:
1) Under perfect competition, consumers are charged uniform
price. Hence the consumer surplus is higher.
2) Under monopoly, manufacturers discriminate among the
buyers and charge different prices for different buyers and
change different buyers. So the amount of consumer surplus
is smaller.
7.1.2 Meaning of Price Discrimination:
From the discussion in the earlier section. It is clear that the
producers charge different prices for the same product, from
different units of the same product at different prices is called price
discrimination. By doing this, the producer tries to capture more &
more consumer surplus, from the buyer to maximize his profit. Price
discriminating is followed by grouping the consumers. In some
cases, forming groups of consumers is easier as the heterogeneity
(differences) of consumers is directly observable. In some cases,
however the differences among consumers are not visible. In such
cases, the producers have to offer different menus or packages of
products at different prices and allow consumers to choose from
among alternative choice. Thus, price discrimination refers to the
act of manufacturer of selling the same product at different prices to
different buyers.
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7.1.3 Examples of Price Discrimination:
Monopolist firm many times charges different prices from
different consumers, for the same product and without much cost
differentials. Following examples would clarify the point.
1) A doctor or a lawyer may charge different fees from different
patients / clients for the similar services.
2) A producer may charge different price for the same product at
different parts of a country.
3) Same product / services may be sold to the same buyer at
different price for varying quantity. For example price for 10 kg
of rice may be higher than the price for 100 kg of rice of the
same quality.
4) Consumers may be classified into different categories and by
changing the quality of services, different rates may be charged.
For example first class and second class fares in the train,
ordinary or business class in the plane.
All these examples make it clear that price discrimination is
quite common while aiming at maximization of profit. Prof. Stiglers
definition of price discrimination brings about one more aspect of
the concept. According to Prof. Stigler Price discrimination is
defined as the sale of technically similar products at prices which
are not proportional to marginal costs.
The concept of price discrimination as indicated in Prof.
Stiglers definition may be well understood with the help of following
example.
Suppose a hard-bound and color edition of Microeconomics
book by Mankiv costs Rs.500 and a soft-bound block and white
edition of the same book costs Rs.400 for the publisher. Also
suppose that he sells the colored edition for Rs.750 and the black
and white edition for Rs.500. in this example, the manufacturer is
said to be practicing price discrimination as the price differences
between two types of books (750-500) are more than the cost
differences (500-400).
Check Your Progress:
1. What do you understand by Consumer Surplus?
2. Define the concept price discrimination.
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7.2 POSSIBILITY OF PRICE DISCRIMINATION:
A monopolist can follow price discrimination only under two
fundamental conditions.
1) There should be no possibility of transforming any unit of
product from one market to the other transferability of
commodities.
2) There should be no possibility of buyers transferring
themselves from the expensive market to the cheaper
market transferability of demand.
It is understand from the above points that the monopolist
can practice price discrimination only if the units of goods or the
units of demand (i.e. the buyers) cannot be transferred from one
market to another. It is possible to discriminate among the buyers
only if two types of arbitrage or transaction costs are present.
These are as follows.
1) Arbitrage associated with the transferability of a
commodity.
If it is possible to transfer a commodity from one person to
another with very less transaction cost, price discrimination is not
possible. In other words, price discrimination becomes possible
only when it is costlier to resell a product to another consumer may
buy goods to resell them to the high price consumer. A low price
consumer is the one who gets a commodity at a lower price due to
quantity discounts. A high price consumer the one who does such
discounts, in case the transaction cost is low, the former (low-price)
consumer will buy in bulk and sell it to the latter (high-price)
consumer. This does not allow the discriminating monopolist to
charge different prices from different consumers.
Thus, it is possible to undertake price discrimination in case
of services which have a very low or no transferability. For
example, doctor can charge discriminating prices to one patient to
another. Otherwise, in case of most of the retail products, price
discrimination may be difficult. Wherever it is difficult, the
monopolist may practice partial discrimination. He may sell his
products to retailer at lower price and ensure that his product is
sold to the final consumer.
2) Arbitrage associated with the transferability of demand.
In case of such arbitrage, the products physically may not be
transferable between the consumers, but the demand for product is
transferred between different packages. For example, the
consumer may be charged different prices based on price-quantity
package or price-quality package makes.
85
The price-quantity package makes consumer choose
between say buying two units of a product at certain price or buying
one unit of a product at some price. A shirt may cost Rs.250 but if
consumer buys two shirts he may be charged Rs.450 (instead of
Rs.500).
The price-quality package discriminates between the
consumers on the basis of quality of a product / service. First class
and second class on the train, ordinary or deluxe room
accommodation in a hotel are some of the examples of price
discrimination which help the monopolist to maximize his profit by
charging different price from different consumer.
The two types of arbitrage discussed above are different in
terms of their impact on price discrimination. As stated earlier, if
there is a possibility of transferring products from one consumer to
another, without much arbitrage or transaction cost, one consumer
may buy more goods and resell them to the others. Monopolist will
not be able to gain from price discrimination in such a case. The
transferability of demand, on the other hand, includes the
monopolist to discriminate among the consumer by charging
different prices from them. In the sections to follow we will try to
analyze the welfare effects of price discrimination.
7.2.1 Concluding Remarks:
From the discussion about the possibility and practicality of
price discrimination, it is clear that there should not be any seepage
or communication between two markets. Thus, price discrimination
depends upon the ability of the monopolist to keep two markets
quite separate. To conclude, price discrimination is possible under
following circumstances:-
1) The nature of product sold is such that there is no possibility of
transferring product / service from one market to another.
2) The geographical distance between two markets is very large or
the markets are separated by the tariff barriers.
3) Legal section is given to charge different prices from different
consumers like electricity for domestic use and for industrial
use.
4) Consumer snobbish attitude that higher priced goals are
superior to lower priced ones.
5) Monopolistic or oligopolistic market structure.
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Check Your Progress:
1) State the conditions to be followed by a monopoly for price
discrimination.
2) Explain the concept of arbitrage and state how it is important
factor determining price discrimination.
3) Find out more examples of price quantity and price quality
packages offered by the monopolist to discriminate against
different consumers.
4) What is the difference between arbitrage associated with
commodity transfer and the arbitrage associated with demand
transfer?
7.3 TYPES OF PRICE DISCRIMINATION:
According to Prof. A. C. Pigou, there are three types of price
discrimination.
A) First Degree Price Discrimination
B) Second Degree Price Discrimination
C) Third Degree Price Discrimination
7.3.1 First Degree of Price Discrimination:
In case of first degree price discrimination the monopolist
separates the whole market into each individual consumer and
charges the price each on is willing and able to pay. This helps the
monopolist to extract entire consumer surplus from each of the
consumer. Suppose each consumer has W as his reservation
price or his willingness to pay for a unit of a product. The
monopolist is said to be successful in extracting entire consumer
surplus if his price P=W. This is also called as perfect price
discrimination. This is based on the assumption that the
monopolist knows each individual demand curves of the
consumers. There are some problems with the application of first
degree price discrimination. A consumer may not reveal his
willingness to pay higher price for the product and hence the
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monopolist will not be able to charge price according to consumers
reservation price.
Suppose pricing schedule or tariff for a product is the total
amount of money to be paid by the consumer is T, quantity
consumed is q and price of the product is P, then
T(q) = pq under uniform pricing Policy (where there is no price
discrimination)
P = W when monopolist practices first degree price discrimination
under the assumptions that (i) w is the willingness to pay for
the product revealed by a consumer and (ii) Consumers
have different demand functions (they are not identical), the
monopolist must know each consumers demand curve in
order to extract their entire consumer surplus.
7.3.2 Second Degree Price Discrimination:
When the monopolist does not have complete knowledge
about consumers willingness to pay, he may have to extract
consumers surplus by using self-selecting devices. There may not
be any exogenous signals to discriminate consumers on the basis
of some criteria like say age, income differentials, occupation, etc
Price discrimination, followed by the monopolist in such a case of
imperfect information is called second degree price discrimination.
Here, the monopolist may offer several bundles of options to
choose from as seen earlier, these may be price-quantity bundles
(charging different prices for different quantities of a product) or
price-quality bundles (changing different prices for the similar
product or service based on quantity)
The second degree price discrimination may be explained
with the help of the concept of two-part tariffs. Under this, the
monopolist charges initial fee for the right to buy the product or
service and also the wage fee or specified charges which may vary.
For example, a telephone company requires a user to pay monthly
rental and then some charge per call. The concept of two-part
tariffs may be further explained below:
Two-part tariffs:- T(q) = A + P(q)
Where A-Initial fixed amount
T-Tariff (total amount to be paid by the consumer)
q- quality purchased
1) For Services like telephone, gas, electricity
T
1
(q) = A + Pq
Where A- rental for the usage of these services
P- price which may vary according to the number of
unites bought
88
2) Polaroid Camera
T
2
(q) = A + Pq
A- Camera (Fixed premium)
P- Price which may vary according to the amount of films.
3) Amusement Park
T
3
(q) = A + Pq
Where A = Entrance Fee which is fixed.
P = price may vary according to the number of rides.
4) Taxi or Rickshaw
T4 (q) = A + Pq
Where A = lnitical meter reading (minimum fare)
P = may vary according to distance.
By following two-part tariffs, the producer aims at extracting
as much consumer surplus as possible from the buyers and
maximizes the profit. In order to pursue with this kind of price
discrimination the monopolist must have a large market power. He
should be able to fix price and he should also be aware of how the
demands differ over consumers. Under such a situati on, the
monopolist can charge the price per unit equal to the marginal cost
and the initial fee equal to the entire potential consumer surplus as
shown in the following diagram.
Figure 7.2
As per the diagram price will be OP which is equal to
marginal cost. Initial fee / premium (A in the above equations) will
be equal to AEP the entire consumer surplus.
7.3.3 Third Degree Price Discrimination:
When the monopolists do not have perfect knowledge about
consumers demand function but discrimination among the
consumer on the basis of certain signals like age, income
differentials, gender, it is called as Third Degree Price
Discrimination. An important difference between second degree
and third degree price discrimination is that the monopolist under
third degree price discrimination uses direct signals about the
demand, whereas the second degree price discrimination selects
indirectly among the consumers through their choices between
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different packages. In other words, in case of third degree price
discrimination, the monopolist is able to divide total demand into
different markets or groups (m) on the basis of any one of the
following:-
1) Age - Citizens / Senior Citizens
2) Gender Male / Female
3) Location Urban / Rural
4) Occupation Service / Business
5) Type of Buyer First Time / Second Time Buyer
Each of these markets (m) have a separate downward-
sloping demand curve which is known to the monopolist. Under
such a situation the monopolist can charge a separate linear tariff
for each group. Generally, the monopolist would charge higher
price from the markets having lower elasticity of demand. In such a
market, the consumers response to price rise will be less than
proportionate.
7.4 PRICE DISCRIMINATION AND SOCIAL WELFARE:
Whether price discrimination promotes social welfare or not
is difficult to say. In other words, there is ambiguity as far as the
welfare effect of price discrimination is concerned. It is important to
consider whether social welfare is defined in terms of total output or
distribution of given output. This is because, the total output effects
of price discrimination may have positive welfare effects, whereas
distribution may be adversely affected after practicing price
discrimination.
As per the Pareto optimality, one of the maximum condition
for maximization of social welfare is that the marginal rate of
substitution between two goods for different consumers, should be
the same. But when a monopolist follows price discrimination, the
above-mentioned marginal condition is violated.
But another aspect of welfare effects of price-discrimination
may be understood by acknowledging the total output effects of
price discrimination. According to Joan Robinson, price
discrimination sometimes may lead to increase in output. That
means, the total output may be more when the monopolist
practices discriminating prices rather than a uniform price. Thus,
from the point of view of total output, when a society prefers more
output to less output, price discrimination may promote social
welfare.
To conclude the discussion on welfare effects of price-
discrimination, following points need to be considered.
90
1) The losses incurred by the consumers in low electricity market
in the form of reduction in the consumer surplus as the
monopolist charges higher price for them.
2) The gains enjoyed by the consumers in high elasticity market in
the form of increased consumer surplus, as the monopolist
charges lower price from them.
3) If price discrimination is not exercised by the monopolist and
uniform price policy is followed, there is a possibility that some
markets may be closed for the monopolist (particularly the high
elasticity markets as they have to accept monopoly price).
4) Price discrimination leads to redistribution of income from the
consumers in low elasticity markets to the consumers in high
elasticity markets and the monopolist. Since the consumers in
low elasticity market are generally richer, redistribution may
increase social welfare.
7.5 QUESTION
Explain by giving examples
a) Price Discrimination
b) First Degree Price Discrimination
c) Second Degree Price Discrimination
d) Third Degree Price Discrimination
1) Define and explain the concept of consumer surplus. Find out at
least five commodities where we are actually paying less than
what we would have paid, instead of going without the
consumption of those commodities.
2) Do you really think price discrimination is common? Enumerate
your own example of price discrimination.
3) Do you think price discrimination should be allowed? Substantial
your answer.







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8
COMPETITION POLICY
Unit Structure :
8.0 Objectives
8.1 Introduction
8.2 General Features of Industrial Policy
8.3 Competition Policy
8.4 Co-Ordination of Industrial Policy with other Policies
8.5 Questions
8.0 OBJECTIVES
- To internalize the externalities in case of market failures,
government policies are formulated, even under market
economy. The present unit aims at understanding the need for
the industrial policy and its basic requirements.
- Industrial policy is an integration of competition policy, mergers,
trade policy, innovation policy, etc. This unit also aims at
explaining the role of other policies in effective implementation
of industrial policy.
- The unit also introduces, in brief, the features and functioning of
competition policy in select countries.
8.1 INTRODUCTION
Operation of individual firms, industry and hence economic
welfare will be highly influenced by the nature of policies towards
industrial organisation. Different polices having impact on the
working of industrial sector of a country are - competition policy,
regional policy, innovation policy, trade policy, policy towards
mergers and acquisition and so on. A success of any policy
depends not only on its design but also its effective implementation.
There are many examples of a well defined policy, not being
effective due to improper implementation. In this unit, we will try to
understand the ingredients of some of the important policies
towards industrial sector.
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8.2 GENERAL FEATURES OF INDUSTRIAL POLICY
In order to improve the efficiency of industrial sector
government of any country has to intervene in the functioning of
industries, in the form of various policies. An intervention by
government in industrial operations is justified on the ground that it
helps in reinforcing the market mechanism by minimizing market
failures. In order to be effective in promoting economic welfare of a
country, industrial policy should possess following features :-
1. There should be co-ordination among different types of policies
towards industries. As seen earlier there are many kinds of
polices announced by the government for smooth operations of
industrial sector such as competition policy, policy towards
mergers and acquisitions, trade policy, location policy, etc.
There is every possibility that the objectives of these polices
may be in conflict with each other or an implementation of one
policy may adversely affect the other policy. For example trade
liberalization policy may conflict with the policy of government
support to priority sectors in the country. Hence it is important
that various policies towards industrial operation work towards
similar final goal.
2. Policies towards industrial organisation should be designed in
such a way that there is an administrative ease. The clauses of
policy should be clear and should not have internal
contradiction. This helps in effective implementation of industrial
policy is facilitated. In order to minimize human interpretation,
and intervention, a computerized system may prove to be more
effective, less costly in terms of money and will minimize the
delays. For example, payment of taxes, application for approved
etc.
3. The impact of a particular policy may be different for the
industries of different size certain policies may favour the large-
sized industries more than the smaller firms. For examples
environment related rules enforcing the use of greener
techniques of production. Use of such a technology may be cost
effective for the bigger firms. In such cases, a separate
consideration should be made for the smaller firms by
announcing a separate policy for small scale industries.
The political considerations may come in the way of effective
implementation of policies. In order to retain or gain the support of
voters, the government may compromise on stricter implementation
of certain provisions in the policy. This may be done by announcing
soft loan (loans with lower interest rates) schemes for certain
industrial activities to be important even in the periods of industrial
decline. Such considerations, many times, force policy - makers to
93
adopt second best option by which two objectives :- welfare
maximization and vote maximization- would be achieved.
Check your Progress:
a. What do you mean by market failures?
b. Why is the government intervention necessary in case of
market failures?
c. What should be the features of a well designed industrial
policy?
d. How do the political considerations force to adopt second
best option for maximization of economic welfare? Explain by
giving examples.
8.3 COMPETITION POLICY
8.3.1 Meaning
Competition policy includes measures aiming at
I) Promotion of competitive environment in the industrial sector
II) Prevention of forces that reduce the competitiveness in
industrial sector
The competition policy aims at breaking up or regulating
monopolies. It aims at preventing all those activities of a firm which
put barriers to entry of new firms in the market. The dominant firm
in the market may practice many anti competitive practices such as
resale price maintenance or price agreements by the group of firms
etc. Competition policy is expected to remove all barriers to
competition and encourage the development of new products and
the entry of new firms in the market. According to some
economists, the competition policy not only should focus on the
elimination of barriers imposed by the dominant firms, but also on
the removal of government actions that restrict competition. These
actions may include import restrictions, or any other kind of
licensing requirements that limit the entry of new firms in the
market.
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8.3.2 Competition policy in Different countries.
The structure conduct performance approach (SCP) implies
that the competition policy must aim at restructuring the market
structure In favour of competition. Under this approach, monopoly
is considered to be a departure from the maximization of social
welfare and hence the prevention of such a monopoly is supposed
to be an important objective of competition policy of a country. In
the recent years, there has been a change in the attitude towards
monopoly forces. The industrial policy measures have undergone
substantial changes and the presence of uncontrolled monopoly is
considered to be a matter of investigation.
Competition policy in the USA
It is enforced by the Federal Trade Commission and the
Department of Justice. The important legislations related to
competition policy in the USA are :-
A) Shermans ACT 1890
B) Claytons ACT 1914
C) Federal Trade Commission ACT 1914
D) Robinson - Patman ACT 1936
Economic regulation of American industry goes back more
than a century. First of such legislations was applied to
transportation in 1887 by the Inter state Commerce Commission
(ICC). The ICC was supposed to control the price wars and ensure
transport services to the smaller town. In the later years, such
regulation spread to many other sectors like banking, electric
power, security markets, communication, etc.
Anti-trust legislation is another way of promoting competition
in industry. The Sherman ACT (1890), prohibits contracts,
combinations or conspiracies restraining trade. Section 2 of the Act
prohibits monopolizing and conspiracies to monopolize any explicit
agreement among the producers to restrict output or fix prices
above the competitive level is prohibited under this Act.
Clayton ACT (1914) was passed to clarify & strengthen the
provisions under Sherman Act any practice to drive the competitor
out of market and to discourage a new firm to enter the market was
considered to be anti- competitive of illegal. The Act ruled out
typing contracts in which the customer is forced to buy a particular
product even if he is not interested, it ruled out price discrimination
and it also banned the interlocking directorates in which some
people would be directors of more than one firm in the same
industry. The Clayton Act also prohibits mergers and acquisitions, if
they tend to create monopoly.
95
In 1914, Federal Trade Commission (FTC) was established
to disallow anti- competitive mergers and to prohibit unfair methods
of competition. The FTC was also empowered to ban false and
deceptive advertising.
Robinson patman Act (1936) protect against price
discrimination. It basically protect the buyers against price
differences charges by the sellers which are likely to injure
competition.
To conclude, anti-trust legislation in the USA is much more
stringent than any other country Anti-trust laws have been
important in maintaining competition and fostering economic
growth.
Competition Policy in Europe.
With the emergence of European Union, anti- trust
legislation also has emerged in the European countries. The
responsibility of enforcing such a legislation on industries is vested
in competition Directorate located in Brussels. But a separate anti-
trust authority within the member country of the EU is responsible
for the issues related to member countries. The treaty of European
Community focuses on the abuse of power by the dominant firms.
Article 81 is concerned with the restraints of trade mergers and
acquisitions are also dealt with in the same article.
Competition Policy in India
Since 1969, the Monopolies and Restrictive Trade Practices
(MRTP) Act is an important legislation towards improving the
competitiveness of industrial sector. The preamble of the Act states
that it is an act to provide that the operation of economic system
does not result in the concentration of economic power to the
common detriment and is for the control of monopolies, prohibition
of monopolistic and restrictive trade practices and for the matters
connected with such practices.
The functions of MRTP Act may be summarized as follows:-
A) Prevention of concentration of economic power which may be
detrimental to public interest.
B) Control of restrictive trade practices.
C) Control of unfair practices.
D) Control of monopolistic trade practices.
An implementation of MRTP Act came under severe
criticism. It was always commented that the MRTP Act was anti-
size and not anti monopoly. It was also commented that despite all
96
regulations and restrictions imposed on large business- houses,
there was still concentration and monopoly in some industries.
A new competition policy was adopted in the post- reform
period in India. Under the new Competition Act of 2002,
Competition Commission of India (CCI) was established. The CCI
is a body formulated with the members including experts and
eminent persons from different fields. All the complaints related to
infringement of Indian Competition Act would be received by CCI.
The commission will work towards elimination of practices having
adverse effect on competition, promote and sustain competition,
protect the interests of the consumers and ensure freedom of trade
to all the new entrants in the market.
Check Your Progress:
1. What is competition policy? What are its important features?
2. Discuss important anti-trust provisions in
A) USA B) European countries and C) India.
8.4 CO-ORDINATION OF INDUSTRIAL POLICY
WITH OTHER POLICIES
Effectiveness of industrial policy is also dependent upon its
co-ordination with other policies like regional or location policy,
policy towards innovation, trade policy, merger and acquisition
policy, etc. A coherent approach to industrial policy to integrate
variety of policy measures is essential to maximize social welfare.
Hence, it is necessary that the industrial policy is not only
consistent with its own measures but must also be consistent with
other related policy measures.
The Memorandum on the communitys industrial policy
identified five broad objectives on industrial policy, which are as
follows:-
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1. To pursue establishment of single market by removal of barriers
such as national preference by state bodies.
2. To move towards the harmonization of legal, financial, fiscal
environment in which the firm operates.
3. To promote mergers between the firms of different member
states of European Community.
4. To facilitate adoption by firms to changed market
circumstances, particularly with regard to new industries plus a
science and technology policy to facilitate the emergence of
new industries.
5. To adopt a common policy with respect to economic outside the
community to ensure fair competition in foreign market.
An understanding of these objectives emphasizes the needs
for industrial policy to co-ordinate with different policies. Every
country may need to consider such an integrated approach.
Regional or location policy, for example, aims to direct the
location of industrial units in such a way to avoid uneven
distribution of firms among different regions. In the process of
economic development, it may be experienced that some areas
become prosperous and develop more rapidly, leaving some other
areas in the country, under developed. This phenomenon may have
an impact on wage rate. Regions with less industrial development
may experience fall in wages and vice versa Young, more qualified
and skilled workers will migrate towards the prosperous regions.
Hence, the best way to improve economic welfare of a country as
a whole is to design regional policy in such a way as to attract more
and more firms towards the under developed regions.
Policy towards innovations aims at ensuring adequate or
desired level of innovation activity by the firms. Innovations
enhance economic welfare. But sometimes, deliberate policy
measure may be required to encourage firms to undertake research
and development. This may be done by the government by
improving R & D infrastructure of reducing the costs to the firms of
information gathering (by setting up a government agency for that
purpose.) In order to ensure increasing profits to the innovator, the
government may adopt patent system or provide financial support
to innovating activity or may sponsor academic research programs.
Tax policy also may be used in favour of innovative firms.
Trade policy also may be used to achieve industrial
objectives. Many provisions of trade policy directly improve the
industrial environment within the country. By restricting foreign
competition, by imposing import tariffs or quotas, the trade policy
may protect the domestic industry. The protective trade policy may
encourage industrial development, at least in the initial years of
98
industrial development. Once the domestic industry obtains
optimum size, protection may be removed.
In conclusion, it may be noted that there are conflicts among
the objectives of different types of policies towards industrial
development. But a co-ordinated approach, an integrated approach
will help in enhancing the overall national economic welfare. In
implementing the industrial policy, if a combination of competition,
location or regional, innovation and trade policies is practiced,
important social, political and economic objectives can be achieved.
8.5 QUESTIONS
1. Discuss why is there a need for co-ordination of different
policies for effective implementation of industrial policy.
2. Write a note on competition policy.
3. What are the objectives of competition policy?

99
9
Module - 4
PRODUCT MARKET
DIFFERENTIATION AND IMPERFECT
INFORMATION
Unit Structure :
9.0 Objectives
9.1 Introduction of Product Differentiation
9.2 Lancastrian Approach
9.3 Hoteling Model
9.4 Questions
9.0 OBJECTIVES
- To understand the meaning of Product Differentiation
- To study the Lancastran Approach of product market
differentiation
- To study the Hotelling approach of product market
differentiation
9.1 INTRODUCTION OF PRODUCT DIFFERENTIATION
Understanding product differentiation is crucial to
understanding how modern market economies operate. A trip to
supermarket shows that many similar products are offered for sale
to appeal to the tastes and requirements of different consumers.
Supermarkets themselves are differentiated by the range of
products they offer, their geographical location, the quality of their
meat or fruits departments etc.
In the words of Chamberlin, a general class of product is
differentiated. If any significant basis exists for distinguishing the
goods (or services) of one seller from those of another. Such a
basis may be real or fancied, so long as it is of any importance
whatever to buyers, and leads to a preference for one variety of the
product over another. Where such differentiation exists, even
100
through it be, slight, buyers via be paired with sellers, not by
chance and at random (as under pure competition), but according
to their preferences.
Differentiation may be based upon certain characteristics of
the product itself, such as exclusive patented features, trade marks,
trade names, quality, design, colour, style. It may also exist with
respect to the conditions surrounding its sale. In retail trade, these
conditions include such factors as the convenience of the sellers
location, the general tone, or character of his establishment, his
way of doing business, his reputation for fair dealing, courtesy,
efficiency and all the personal links which attach his customers
either to himself or to those employed by him. In so far as these
and other intangible factors vary from seller to seller, the product
in each case in different, for buyers take them into account, more or
less, and may be regarded as purchasing them along with the
commodity itself. When these two aspects of differentiation are held
in mind, it is evident that virtually all products are differentiated, at
least slightly, and that over a differentiation is of considerable
importance.
The wide array of products in the market place is a response
to the wide diversity of consumer tastes. There are two levels of
taste diversity. Individuals may want to consume different products
may want to consume different products on different occasion,
expressing a preference for variety over time (e.g. not eating the
same dish at the same restaurant every night). Individuals may also
have idiosyncratic tastes about their most preferred variants (e.g.
beer drinker and cigarette smoker often stick to brands they like
least). Thus we view the population as a whole as heterogeneous,
and this intra-and inter-individual heterogeneity generates a
demand for product diversity in the aggregate.
Once it is recognized that consumers have idiosyncratic
preference, it follows that they are prepared to pay more for
variants that are better suited to their own tastes. It is these Premia
that are the source of market power for firms. Despite the wide
diversity in tastes, the market is unlikely to support a large number
of products because of increasing returns to scale in research and
development, production, marketing and distribution. Such
increasing returns are necessary for firms to exist.
In a competitive market, products are standardized. A firm
will be able to sell all it wishes at the market price. It will not be able
to sell anything above that price, no matter how much it advertises
or promotes its product. In contrast, if products are differentiated,
each variety will have its own demand curve. By engaging in sales
efforts, a firm can change the location of the demand curve for its
variety. It will generally be profitable to invest in shifting the location
of the demand curve. But the sales efforts will occur only in markets
101
where there is some product differentiation, so that competition is to
that extent already imperfect.
Since sales efforts arise in markets where products are
differentiated we take note of bases of product differentiation.
9.2 LANCASTRIAN APPROACH
Lancaster proposed a framework starting from the premise that
what consumers desire (and what gives them utility) are not goods
themselves, but the characteristics or qualities embodied in those
goods. A good then should be analysed as a bundle of
characteristics. The characteristics themselves are the arguments
of the utility function. The usual assumption apply- that more
characteristics are preferred to fewer, that consumer can express
consistent preferences over different bundles of characteristics, and
that the marginal rate of substitution is diminishing along an
indifference curve in characteristics space.
The analysis which follows from these assumptions is
explained in the following diagram.
Figure 9.1
Each ray, in the above diagram, OA< OB, OC< and OD represents
the proportion of characteristics 1 and 2 supplied in a particular
good. The points a, b, c, and d represent the amount of
characteristics that can be obtained initially for a unit expenditure.
Indifference curve for one individual is shown by IC. Clearly, he will
maximize his satisfaction, given his preferences, by purchasing
good B at B
i
. Now we vary the price of B. as it rises, the amounts of
characteristics purchased for one unit of expenditure will fall to b
2
and then to b
3
. If the characteristics are separable, the demand for
B will fall to zero when the price rises beyond the point represented
by b
2.
At that point, it becomes cheaper for consumers to obtain the
102
desired combination of characteristics in the form of a mixture of A
and C, along the broken line ac. (if the characteristics are not
separable from the good, then the point b
3
becomes the critical
point for the consumer whose indifference curve is shown in the
diagram. He will then prefer to purchase C).
We should note that a fall in price of B, say to b
1
, will have
adverse effects on the demand for C, since a combination of b
1
and
d gives the characteristics mix of good C for a lower price than at
price C. The demand curve for good B will therefore exhibit some
sharp discontinuities. This is shown in the following figure.
Figure 9.2
In this P
2
is the price at which good B is eliminated from the
market by goods A and C, and P
1
is the price at which good B
captures the market of good C.
The key feature of this analysis for further discussion is that
a variation in the price of B has a direct effect of the demands for A
and C, which are the near neighbour goods. This sharp
interdependence between near neighbours will certainly affect
pricing strategy.
However, Archibald Rosenblush show that, when the
number of characteristics is four or more, the number of near
neighbours is on average n/2, where n is the number of firms. The
interdependence of near neighbours is thus weakened when n is
large, and each product may have its own differentiated demand
curve.
Within this framework, there is also a natural definition of an
industry. Suppose that 2 is a m vector of characteristics, and that q
is a n vector of goods. Then we can define a consumption
technology by a m x n matrix, B, of coefficients, which defines the
relationship of characteristics to goods.
2 = Bq
If on inspection we find the B matrix to be block-triangular,
e.g. of the form.
103
1
2
3
B
0 0
0 0 (
(
B
(
(
0 0 B

then it seems natural to desire an industry by the m
1
x n
1
block of
coefficients which make of B
1
, and so on, these are products that
have certain characteristics in common, shared by no other
products. Of course, this does not exclude the possibility of
substitution in consumption n between one group of products to
another. That could be alone only on the assumption of weakly
separable utility function i.e., that the marginal rate of substitution
between the characteristics of one group is independent of the
quantity consumed of any characteristic outside the group. Whether
the consumption matrix is block diagonal is a matter of empirical
analysis.
The main disadvantage of this theory is the unrealistic
assumption that goods are actually divisible into their
characteristics. Thus, in the example analysed above it was
assumed that the characteristics of good B could be obtained from
a mixture of goods A and C. In practice, it is hard to think of
plausible examples where the characteristics can be unscrambled
and recombined in the desired proportions. It is this assumption
that leads to the discontinuities in the demand.
In response to this criticism, Lancaster reformulated his
analysis. He dropped the assumption that goods are divisible into
their component characteristics. The basic framework is illustrated
in the following diagram.
Figure 9.3
The Product Differentiation Curve (PDC) shows the various
maximum combinations of characteristics that can be produced
with one unit of resources. Each combination along the curve
represents a potential differentiated good.
104
a) The curve is convex to the origin.
b) We consider a consumer whose most preferred good would be C
given the constraint of the PDC.
However, suppose that only good B is available. Then the
consumer needs the quantity of good B represented by point B
1
to
give equal satisfaction to the good C. but B
1
requires more
resources and the distance BB
1
is the measure of requirement.
Lancaster calls this as compensation function. The of
compensation depends on
1) The curvature of the PDC and the indifference curve and
2) How far good B is from the most preferred good C for that
consumer.
Lancaster makes the concept of compensation function more
manageable by a transformation. The PDC is mapped into a line,
the limits of which represent the two extreme goods and with points
on the line representing different combinations of goods. The
compensation function (distances like BB
1
) is then drawn in relation
to that line. The result is shown in the following diagram.
Figure 9.4
In the above diagram, c indicates the consumers most
preferred specification of the good and h(x) is the compensation
function where x is the distance (along the PDC) from C. for further
analysis, Lancaster then assumes that,
1) The shape of the compensation function h(x) is identical, no
matter what the consumers preferred goods and
2) Consumers are spread evenly along the line in respect of their
most preferred specification.
The function h(x) is used to define the demand curve for one
of the group of differentiated products, and for the group as a
whole, following the Chamberlain analysis.
105
Here, there are two elements involved
1) The substitution between the group of differentiated products
and outside goods.
2) The choice of consumers over the good itself.
The list raises no new issues. For 2
nd
, let us suppose that we
are examining the choice of the consumer whose most preferred
specialisation is C, between goods on offer at a, b, c and d in the
above diagram (D). From the properties of the compensating
function, we know that one unit of each of these goods is equivalent
to 1/ [h(a c)],1/ [h(b c)] , and 1/ [h(c d)] of good C. (the products
are located on the line by assuming that the left hand end of the
line is the origin, products and consumers are located by their
distance from this origin). If the prices of these goods are P
d
, P
b
and P
a
, then by one unit of expenditure the consumer will obtain the
equivalent of
d b
1/ [P h(c d)],1/ [P h(b c)] , and
a
1/ [P h(a c)] of the
most desired goods. Maximisation of satisfaction will be there by
choosing whichever gives the largest equivalent in terms of the
most desired goods. Let us assume that this gives a choice
between goods d and b, and that the consumer is indifferent
between these i.e.
d b
1 1
P h(c d) P h(b c)
=

OR
d b
P h(c d) P h(b c) =
From the definition of the compensating function, it is clear
that the consumer at C marks the boundary between those who
prefer good d (their most preferred good lies between d and c) and
those who prefer good b (most preferred good between c and b)

9.3 HOTTELING MODEL
Diversity is very important as well as long debated issue in
economics. Many different applications of this concept are studied
from bio to technological or institutional diversity. Here we take a
special interest in the economic analysis of product diversity, whose
growth is an important feature of economic development.
Product diversity was 1
st
studied by theorists of monopolistic
and imperfect competition (Hotelling, Chamberlin, Robinson,
Lerner, and Singer). Two kinds of models may be distinguished in
product diversity. On the one hand we get the numerous variants of
the spatial one (Hotelling, Lancaster and one the other hand those
that assume convex preferences for consumers. (Dixit and Stiglitz).
106
Hotellings model is one of the most popular instruments of modern
economic analysis.
The spatial model was at the beginning a linear model
A line represents the main street of a small town. Customers
are located all along this line. Here only one consumer named A
was represented. The sellers are named as X and Y. Every one
of them sells the same product to consumers. Thus, they are
competing through their selling price and their localisation on the
street. Here, the product diversity is represented by the way
vendors are localised on the line. Supposing that this line
represents a characteristic of a good. The line represents all the
people that want to buy Cider. On the extremity, we find the people
that prefer it sweet and on the other the people that prefer is sour.
In the above figure X produces a sweeter cider that Y but since
they are not on the extremities it could be possible to produce a
sweeter cider or a sourer cider.
We study some of the implications of product differentiation
for oligopoly competition. It is done by considering a model of
horizontal product differentiation. It is explained with another
example.
Let us consider a mile-long beach with two ice-cream
vendors, one at each extreme of the beach. Even if we assume
both sellers offer the same product, very few consumers are
indifferent to buying from one seller or the other. If both vendors sell
at the same price, a consumer who is located close to one end of
the beach naturally prefers the seller who is located nearby. In fact,
if the costs of travelling to visit such a seller are lower than the
costs of travelling to visit the other one, and other than travel costs,
the two products are identical, even in prices. The reverse is true
for a consumer located near the other end of the beach. Generally,
consumers do not see both vendors as the same, even though they
sell products that are physically identical; different consumers value
sellers differently, specially, each consumer values sellers
according to his or her location.
The above example is more general. First, it generalises to
any situation wherein sellers and buyers are physically located at
different places and a transportation cost must be paid by buyers to
purchase from a specific seller (gas stations, restaurants, steel
mills, etc.). Second, by analogy, it also applies to situation wherein
sellers offer products that differ according to some characteristic,
and buyers differ among themselves as to how they value such a
characteristic.
107
For example, consider the market for corn flakes and
suppose there are two brands that differ only according to
sweetness: Brand 1 has no sugar added, whereas Brand 2 has
large quantities of sugar added. This is analogous to two sellers at
the end of a beach, whereby one end corresponds to minimum
sweetness and the other end to maximum sweetness. A
consumers location would indicate his or her preference for
sweetness. If the consumer is closely located to Brand 1s end of
the beach, then the consumer has a strong preference for no-
sugar added corn flakes. Conversely, a consumer located close to
the other end of the beach has a sweet tooth. And a consumer
located in the middle has a strong preference for corn-flakes with
some, but not a lot, of sugar added. Finally, the travelling or
transportation cost measures the consumers aversion to buying
something different from his or her optimal degree of sweetness.
Thus, even though we refer to location and transportation costs, the
idea developed in the context of spatial product differentiation can
also be applied to differentiation according to some other product
characteristic.
How do firms compete in prices when their products are
differentiated in this way. We can explain this by above examples
through Hotteling model. E.g. suppose there is a large number of
buyers (e.g. one million) who are distributed along a segment of
length one (e.g. one mile). There are two sellers, each located at
the end of set prices, and buyers choose from which seller to buy.
A buyer located at point X must travel a distance X to buy
from firm 1. travel costs t per unit of distance. Therefore, the total
cost for buying at store 1 is given by P
1
, the price, plus t
x
, the
transportation cost. The total cost for buying from firm 1, p
1
+t
x
, is a
particular value of P
1
. At x=0 (left axis), total cost is simply price,
P
|
1
. As the consumer is located farther away from Firm 1, total cost
increases at the rate t per unit of distance. A consumer located at
Firm 2s location (x=1) would heed to pay a total cost P

1
+ t to
purchase from Firm 1.
By analogy, a buyer located at point X must travel a distance
1-x to buy from Firm 2. The total cost of buying from Firm 2 is
therefore given by P
1
+ t(1-x). A consumer located where Firm 2 is
located (x=1) would have to pay a total cost P
2
. At the other
extreme, a consumer located at Firm 1s location (x=0) must pay a
total cost P
2
+ t to buy from Firm 2. Contrary to Firm 1, the total cost
of buying from Firm 2, P
2
+ t (1-x), is a downward sloping curve,
that is, it is lower the farther to the right the consumer is located.
108
Suppose that all consumers purchase one unit. This
amounts to assuming that the utility of buying one is high, so that
the consumers decision is not whether to buy but simply which
seller to buy from. Because the products sold by firms 1 and 2 differ
only according to the firms location, all that consumers have to do
is choose the firm that minimizes their total cost, prices plus
transportation cost.
Figure 9.5(A)
Figure 9.5 (B)
Figure 9.5 (C)
109
From figure A we see that for P
1
=P
2
, a consumer located at
x
1
is indifferent between purchasing from Firm 1 and purchasing
from Firm 2. A consumer located to the left of X
1
, i.e. located at
x<x
|
, strictly prefers to buy from Firm 1. Finally, a consumer located
to the right of
1
1
X , i.e., located at X>X
1
strictly prefers to buy from
Firm 2. this implies that Firm 1s demand is given by all consumer
located to the left of
1
1
X , where as Firm 2s demand is given by all
consumers located to the right of x
1
. If we assume that consumers
are uniformly distributed along the segment, then Firm 1s demand
is given by X
1
, whereas Firm 2s demand is given by 1-X
1
.
From Figure A we see that, although Firm 1 prices higher
than its rival
( )
l l
1 2
P P > , it still receives positive demand. The
products sold by each firm are no longer identical in the eyes of
consumers. This is because of transportation costs. If the
transportation costs are negligible (low), then the slope of the total
cost curves would be very low, and the firm with the lowest price
would effectively take all of the market demand.
Under Hotelling model, each firm faces a downward-sloping
demand curve. This is given in figure B. the figure reproduces the
calculations from figure A. If firm 1 sets
ll
1
P and firm 2 sets
ll
2
P , the
Firm 1 receives demand d
1
=X
1
. Suppose that Firm1 sets
ll
1
P
instead. At this price the indifferent consumer is located at X=1.
That is, P
1
is so low that all consumers prefer buying from Firm 1.
Generally, for P
1
between the extremes
ll
1
P and
lll
1
P we obtain the
demand curve d
1
(P
1
/
l
1
P ). The demand curve is a function of Firm
2s price. If P
2
were different from
l
1
P , then we would obtain a
different demand curve.
Having derived Firm 1s demand function, we can now
identify the Nash Equilibrium of the Hotteling mode. Now we look
for a pair of prices (P
1
, P
2
) such that no firm has an incentive to
change prices. Suppose that marginal cost is constant and equal
to C for both firms, and suppose that Firm 2 sets P
2
=P
2
N
. What is
Firm 1s optimal price?
The solution is in figure C. From Firm 1s demand curve,
d
1
(P
1
/P
2
N
), we derive Firm 1s marginal revenue curve, r
1
(P
1
/P
2
N
).
Firm 1s optimum results from equating marginal revenue to
marginal cost, r
1
(P
1
/P
2
N
)=C which corresponds to P
N
1
. Because,
both firms have the same marginal cost and P
1
N
=P
2
N
, we conclude
that these prices constitute a Nash equilibrium.
110
Figure C suggests a number of interesting facts about the
equilibrium of the Hotteling model. In contrast with the Bertrand
model, equilibrium price is strictly greater than marginal cost. This
results from the fact that each firm faces a continuous, downward
sloping demand curve, which in turn results from the fact that
consumers must incur transportation costs to make a purchase. In
fact, if transportation costs are small i.e., if the value of t is small,
then each firms demand curve is flat (Dia.B) and equilibrium price
is close to marginal cost (Dia.C). A greater value of t, corresponds
to a greater degree of product differentiation. We thus conclude that
the greater the degree of product differentiation, the greater the
degree of market power.
9.4 QUESTIONS
1. Critically examine the Lancastrian approach of product market
differentiation.
2. Explain in detail the Hotelling model of product differentiation.






111
10
THE ADDRESS APPROACH
Unit Structure
10.0 Objectives
10.1 The Address Approach
10.2 Price Dispersion
10.3 Dorfman-Steiner Model
10.4 Information asymmetric and Lemons
10.5 Questions
10.0 OBJECTIVES
- To study the Address Approach
- To understand the meaning of Price Dispersion
- To study the Dorfman-Steiner condition of advertising
behaviour
- To study the meaning of Lemons and Information
Asymmetric
10.1 THE ADDRESS APPROACH
The address (or characteristics) approach of modelling
product differentiation can be traced back to the pioneering work of
Hotelling (1929). This approach is based on an explicit description
of individual behaviour. An address model is defined as one in
which both commodities and consumers can addresses, in a
characteristics space.
On the commodity side, (Lancaster), it has become common
to view a good as composite of the characteristics (or attributes that
it embodies. For e.g. the characteristics of a car that interest
consumers include gas consumption, comfort, power, reliability,
and design. The motivation for this approach stems from the
observation that commodities are not desired themselves but rather
it is attributes they possess that form the basis for consumer
preferences. A commodity then represented as a vector whose
components indicate how much of each attribute is embodied in
112
one unit of it. This vector is the address of the commodity in the
characteristics space.
On the consumer side, preferences are assumed to be
defined over all potential addresses of commodities. An individuals
address is defined by his or her ideal bundle of characteristics. This
address is analogous to a consumers location in geographical
space, and transportation costs in the geographical framework are
analogous to the disutility attributable to not consuming at ones
address in the characteristics setting. Just as transportation costs
increase with distance from ones residence to the shopping area,
the disutility rises with distance between the consumers address
(or ideal point) and the commoditys address in the characteristics
space.
There are many similarities between address and discrete
choice models. Both describe the demands of a population of
consumers with heterogeneous tastes for variants of a
differentiated produce. Each individual typically consumes only one
variant and in many models it is further assumed that each
consumer purchases only one unit of the selected variant.
The address model used to compare this approach to
discrete choice model is designed as follow:
There are m characteristics so that each potential variant
and each consumer ideal point is describe by a vector of m
numbers. Hence both potential variants and ideal points belong to
R
m
, called the characteristics space. Then n( n 2 > ) variants of the
differentiated products are located at n distinct points of R
m
;
m 1 m
1 1
1
Z (Z Z ) Zn (Z n Zn )
1
= = . There is a continum of
consumers distributed over R
m
according to a nonnegative
continuous density function g(Z), Z being the vector
1 m
(Z Z )
and g(z)dz N = =
}
the total population. Each consumer buys one
unit of the variant that offers the greatest conditional indirect utility
given by
m
k k 2
v (z) y p a r (z z )
i i i 1
k 1
= +
=
, i=1.n, .(a)
Where z is the consumers address (also called ideal or location) in
the characteristics space and r is positive scalar measuring
consumer sensitivity to distance in this space. The first three terms
of the above equation i.e. y, p
i
and a
i
are common to all consumers.
The last term
m
k k 2
(z z )
i
k 1

=
is individual specific in the sense that
this disutility, which has the same functional from across
consumers, is evaluated at individual locations z . This particular
specification of the disutility function has been chosen to determine
113
in a simple way an address framework consistent with discrete
choice models. The above equation implies that the consumers
indifferent between variants z
i
and z
j
(i j) = are located on a hyper
plane perpendicular straight line passing through z
I
and z
j
. this
property considerably simplifies the analysis.
The market space of variant is defined as
m
i i j
M {z R ,v (z) v (z), j 1...n} = e > = , that is, the set of consumer
points for which variant 1 is (weakly) preferred to all others. Using
equation a, the market space is also given by
m
m k k k k k
j j j i i j j i
h 1
M {z R (a p ) (a p ) (z zi )(z z 2z ), j 1.....n}
=
= e > t + =
.(b)
Hence m
i
is the intersection of n-1 closed half spaces, the
boundaries of which are hyper planes orthogonal to the straight line
passing through
i
z and
j
z , j=1n and j=1. Since each consumer
buys one unit of a single variant, the address demand for variant i is
i
i z
m
x g(z)d =
}
, i=1 .n, .(c)
which is the mass of consumers in is market space.
Finally the sum of variant demands equals total population
n
i
(m)
X N =
The above models a b c are called as quadratic address
model (QAM).
We can explain the address approach in another way.
The products that firms produce are differentiated, they are
not identical but similar. There are two approaches to modelling
product differentiation.
1) Address Models:- Consumers have preferences over the
characteristics of products.
- Vertical differentiation: the characteristic concerns for example
quality, which the consumes agree on the ranking of.
- Horizontal differentiation: the consumers have heterogeneous
preferences regarding the characteristics. E.g. departure times for a
particular airline route, cars of different brands but priced at a
similar level.
2) Non-address(or goods) Models:- Consumers have
preferences over goods and they have a taste of variety
monopolistic competition.
114
Address Model:
Each brand of a good is defined by its location. If one or two
diminutions: this could be a firms location in physical or
geographic space and also could be some other attributes of the
goods. For e.g. breakfast cereals.
Breakfast Cereals:
Figure 10.1
Consumer preference distributed in the same product space.
A consumer is utility of purchasing one unit of brand i:
( , ) v T(1 1) P
i i i i
- -
u u = u u ,
Where

i
u is the brand the consumer consumes

-
u is the consumers ideal brand, or her location
T ( ) is an increasing function (measuring transportation costs
or mismatch cost
P
i
price the consumer must pay to get one unit of the bread
V
i
utility that the consumer would get from consuming (one
unit of) brand I for free and without having to travel
10.2 PRICE DISPERSION
Price dispersion means the observed range of prices for
each class of customers. Because limited consumer information
can lead to higher prices, it may be in a firms best interests to
create noise in the market by charging different prices for nearly
identical products or for the same Product at different stores. That
is, by creating price dispersion, they may be able to reduce
consumers information.
For e.g. Some durable goods manufacturers sell nearly
identical products under two or more brand names. A product may
be available under the manufacturers own brand name at a
115
relatively high price and be available under another brand name at
a lower Price.
Firm has conflicting objectives. On one hand, because
search by consumers is costly and may lead them to drop out of the
market by raising the total cost of a Product, the firm wants to
reduce Price dispersion to eliminate unnecessary search costs.
That is, because search cost raise the price to customers but do
not directly benefit the firm, they should be eliminated, all else the
same.
On other hand, when consumers have different costs of
collecting information, Price dispersion may benefit the firm by
allowing it to price discrimination. That is, informed consumers
(People who search a lot) are able to find the low-price items, but
many of the uniformed consumers (People who do little searching)
pay the higher Price.
Thus price dispersion is a costly device for sorting
consumers into groups for the purpose of price discrimination. If
search does not cost enough to drive consumers from the market
and if demand elasticities vary in a certain direction, then creating
dispersion is more profitable than charging a single price.
For e.g. Suppose a monopoly owns all n restaurants in town.
Each restaurant serves the same type of food. For simplicity, meals
are produced at zero marginal cost.
There are L consumers of these L are natives who have
no search costs and by 1 unit of the monopolys product if the price
is no higher than p
n
. The (l - ) L tourists have high search costs
and by 1 unit of the product if the price is no higher than p
t
, where
p
t
> p
n
. That is, natives are willing to pay less per meal at local
restaurants than do tourists, and natives have Perfect information
about prices. Tourists typically choose restaurants. randomly
because they do not know where the low-price (or high quality)
restaurants are located.
It may pay for the monopoly to vary its prices across
locations, No restaurant can charge more than p
t
, because at a
higher price, the restaurant draws no customers. Similarly, no
restaurant should charge less than p
n
because by assumption,
natives have an inelastic demand for a meal upto a price p
n
.
Lowering the price from p
n
does not increase the number of meals
the monopoly can sell, so its profit maximising price is at least p
n
. If
it pays for the monopoly to charge different prices at various
locations, it sets a low price, p
n
, at only one restaurant, because
natives always search for the minimum prices, and tourists never
116
go to more than one outlet. All the other restaurants discover
restaurants by chance.
If the monopoly charges more than p
n
, no native dines at
local restaurants. In that case, profit on meals sold to tourists is
maximized by setting price at p
t
. The profit on the tourists meals is
(1-) L p
t
. Where (1-) L is the number of meals sold at price p
t
.
If the monopoly charges p
n
at one location and pt at all other
locations, it sells meals to all L potential consumers. All the natives
eat at the low-price restaurant, so the profit on meals sold to
natives is ) L p
n
. A large fraction of the tourists, [n-1]/n, eat at the
high price restaurants, but 1/n of the tourists are lucky and find the
low price restaurants. Thus, the monopoly is expected profit, t,
from both groups is.
n n t
Lp (1/ n) (l ) Lp ((n 1) / n) (1 ) Lp , (1) t = + +
Where the first term is the profit from the L natives, the
second term is the expected profit from the [l-] L/n luck tourists
who find the low price restaurant, and the last term is the expected
profit from the [1-] L[n-l]/n unlucky tourists who pay the high
price pt.
If the profit when it charges two prices (t in 1
st
equation) is
greater than the profit if it charges a single price of p
t
, (1-)Lpt, it
pays for the monopoly to be noisy and price discriminate. The
difference in profit, A, between discriminating and setting a single
price is
n t n
Lp ((1 ) / n)L(p p ) 2 A =
It pays for the monopoly to Price discriminate if A is positive.
Because the first term on the right hand side of equation 2 is
positive, and the second term is negative, Price discrimination is
more likely as the second term becomes small in absolute value
relative to the first term. By inspection, as the share of tourists, 1-,
falls or as the number of firms, n, increases, the second term falls in
absolute value relative to the first term, and price discrimination
becomes relatively more attractive.
As the share of tourists become small, it pays the monopoly
to sell to natives as well as tourists. Thus, it becomes more likely
that the monopoly gains by price discrimination as (1-) shrinks.
(The derivative of A with respect to is d A/d = L [p
n
+ (p
t
p
n
)/n]
>o]
Similarly, as the number of restaurants, n, rises, Price
discrimination is more likely to pay. [The derivative of A/dn=(1-) L
(p
t
p
n
) / n
2
>0]. If the monopoly can operate extra restaurants at
little or no additional cost, it can set n large enough that the second
117
term in equation 2 is essentially zero so that it pays to be noisy.
That is, if the monopoly can make it extremely difficult for tourist to
find the low-price restaurant, it pays to price discriminate.
Thus, where there are both informed and uninformed
consumers in a market, it often pays for a monopoly to create
noise, i.e. it has an incentive to charge different prices for a
homogeneous good at various locations to make it more difficult for
uninformed consumers to find the low-price store. The monopoly is
able to price discriminate because search costs prevent consumers
from buying at the low-price restaurants.
10.3 DORFMAN-STEINER MODEL
This is the most Popular model of advertising behaviour.
The model is specified as follows:
Let profit equation for the firm is written as
Profit = R C A ----------------------------------------------- (1)
where R = Revenue, C = TC and A = Advertising expenditure. This
equation is expanded as :
Profit = P[Q(P,A)] C (Q) - A-------------------------------- (2)
where Q(P,A) = Quantity Demanded or Sales in physical term.
The firm chooses P and A in such a way as to maximise
profit. The first order conditions for profit maximisation are
d dQ dC dQ
P 1 0
dA dA dQ dA
t ( (
= =
( (

d dQ dP dC dQ
P Q 1 0
dP dP dP dQ dP
t ( (
= + =
( (

------------ -------- (3)
Multiplying the second equation of (3) by P/Q we get
dQ P P dC dQ P
P Q 0 - - - - - - - - - - - - - -(4)
dP Q Q dQ dP Q
( | | | |
+ =
| | (
\ . \ .
dQ P
Now eQP=
dP Q
= Price Elasticity of demand so, equation
4 can be written as,
P (-e
QP
) + P Mc (-e
QP
) = 0-----------------------------------(5)
By simplifying this we get
QP
P Mc 1
P e

= ------------------------------------------------------(6)
Similarly, first equation of (3) can be rewritten as
( )
dQ
P MC =1
dA

Multiplying both the sides by A/PQ and simplifying the
expression, we get
118
QA
A P MC
e
R P
| |
=
|
\ .
--------------------------------------- (7)
Where,
QA
e is the advertising elasticity of demand and
R P.Q =
From equation (7), we find that advertising expenditure of
the firm depends on
a) Revenue of the firm (R)
b) Advertising elasticity of demand
( )
QA
e and
c) Monopoly power of the firm measured through the Lerners
index ( ) P MC P
Substituting (6) in (7) we get the expression.
QA
QP
e A
R e
= --------------------------------------------------- (8)
That is, the advertising intensity (A/R) is the rate of the two
elasticities as defined above. This may be further simplified as
PA
A R e = ------------------------------------------------ (9)
That is advertising intensity defined as A R is nothing but
the price-elasticity of Advertising. It simply shows that greater the
sensitivity of product price to advertising expenditure, the greater
will be the advertising sales ratio of the profit maximising firm.
The above derivation is relevant for a firm having some
monopoly power. For industry as a whole, the expression (6) is
modified as
QP
P MC* H
P e

= ------------------------------------------- (10)
Where MC* is average MC for the firm in the industry and H
is the Herfindahl index of market concentration.
Substituting (10) in (7) we get
QA
QP
e A
H
R e
= -------------------------------------------------- (11)
That is, apart from other things as mentioned above,
advertising intensity of a firm in an oligopolistic industry depends on
the degree of market concentration.
The Dorfman-Steiner model expressed in terms of the
equation (7) to (9) takes current advertising expenditure into
account via the demand function. It failed to cover up the
accumulated goodwill generated by the past advertising. This fact
has been taken into account by Nerlove and Arrow in modifying the
model as
( )
QA
QP
e A
R e r
=
+ o
Where r = discount rate which decays overtime at the rate of o .
119
Further, in the Dorfman-Steiner mode/no provision has been
made to take into account the reactions of the other firms. This
provision has been made by Schmalene in his advertising model.
A change in the intensity of one element in the marketing
mix of a firm, such as a product cycle or sales promotion change,
will normally cause a change in both its demand (MR and AR) and
cost (MC and / or AC) functions. This in turn may lead to an
adjustment in the price and output level of the firm and in the levels
of other marketing elements. There are interdependencies between
the quantities of the different marketing elements.
If a firm wishes to maximise its profits and possesses perfect
knowledge and unbounded rationality, it should simultaneously
equate the MC and MR associated with each of its price and non-
price decision variables. The simultaneity condition is important
because, for e.g., equating the MC and MR of product style
changes without at the same time equating the MC and MR for the
determination of price, advertising etc., would result in a style
expenditure level that was inconsistent with the objective of
maximum profits.
It is explained in the following diagram.
Figure 10.2
0
E is the original point of equilibrium, the price is
0
OP and
the original output is
0
OQ . With the original revenue and cost
structure
0 0 0 0
AR ,MR , AC MC . The new revenue and cost functions
are
1 1 1 1
AR MR , AC MC , , , are based on the profit maximising quantity
of the non-price variable of
1
OQ units and the TR function of non-
price variable.
1
COP is new profit maximising price.
If firms behave in the way assumed above, using a form of
analysis originally developed by Dorfman and Steiner, the
120
determinants of the marketing mix and each of its elements can be
simplified assuming that advertising is the only non-price variable, it
can be deduced that
a
A P MC
.E
PQ P

=
Which indicates that the profit maximising ratio of advertising
(A) to sales (PQ) depends upon the excess of price (P) over the
marginal cost of the firms product (MC) as a promotion of price and
upon the advertising elasticity of demand for the firms product
a
E ).
Thus, the advertising sales ratio will be higher, other being equal,
if :
1) the firms price cost margin is increased,
2) its advertising elasticity of demand rises;
3) its price elasticity of demand falls; or,
4) the reactions of competing firms to an increase in its
advertising level are reduced.
However, the usefulness of this type of model in relation to
price behaviour in oligopolistic markets has already been
questioned above because of the indeterminate nature of rivalrous
behaviour, the pursuit of objectives that differ from profit
maximisation and the prevalence of uncertainty and bounded
rationality in decision making (see the equation). These same
consideration in relation to non-price behaviour.
The behaviour of markets rivals in oligopolistic conditions will
affect both a firms price-cost margin and its advertising elasticity of
demand and through these its advertising sales ratio.
10.4 INFORMATION ASYMMETRIC AND LEMONS
In the modes of perfect competition we assume that the
market participants such as consumers, firms or the govt. had
perfect information. They had full information about the goods being
bought and sold.
In studying the behaviours of consumers, producers and the
market now there we address the problem of Uncertainty regarding
the choice of optimum bundle of consumption, production and
deciding the market prices and sales quantities. The economic
agents were certain to execute their behaviour in the process of
market transactions. The factor that was working behind the scene
was the informational symmetry regarding the entire market
variables.
121
But it is not always true that all the economic agents know all
about the market. In reality, individuals and firms are not perfectly
well informed. Thus, information or its absence plays an important
role in determining the shape of markets and the ability of private
markets to ensure that the economys scare resources are used
efficiently.
The Problem that arises is the asymmetry of information
among different economic agents that makes the ground for
explaining uncertainties in outcomes of economic transactions.
Asymmetric information is a market situation in which one
party in a transaction has more information than the other party.
The problem of asymmetric information can affect a firms
strategies. It can lead to market failures and such market failures
are often used by governments to regulate industries.
Asymmetric information can lead to poorly functioning
markets ie too much or too little of a good may be produced
contracting can be difficult. Fraud is possible. Consumers may fear
purchasing goods when they know that the sellers know more
about the quality of a good than they do.
Many institutions and practices have arisen to tackle the
Problem of asymmetric information.
The asymmetry in information can arise from two types of
information firstly, about the characteristic, where in one side knows
some characteristic which the other side world like to know, but
does not know; and the second, about an action that one side can
take and the other side cannot directly observe. The former is
referred to as a situation of hidden action.
The market for lemons is a market for a detective product
such as bad used cars. This is an important example of asymmetric
information. (George Akerlof Noble prize winner)
The market for lemons is explained with respect to market
for used cars. Let us assume that in the market for used cars there
are two kinds of used cars ie high quality and low quality (lemon: a
colloquialism for a defective old car). If there is perfect information
ie both the buyer and the seller could know whether a car is a good
used car or a lemon there would be two separate markets. There
would be a demand for and supply of good used cars and an
equilibrium price. Similarly, there would be a separate market for
lemons and an equilibrium price for it. We would expect the price
for good used cars to be higher than the price for lemons.
122
In the case of imperfect information, the sellers of used cars
would have a lot of information about the quality of used car, while
the prospective buyers will not have all these information. As a
consequence, the market price for used cars will depend on the
quality of the average used cars available for sale. For eg. Suppose
the price of high quality car in ` 4000/- and that of low quality cars
(lemons) is ` 1000/-. In the case of imperfect information the buyer
has a 50% chance of a purchased car being high quality and 50%
chance of the purchased car being low quality. Thus, the market
price of used cars will be average price ie ` 2500/- (ie 50% x `
4000/- + 50% x ` 1000/-) = ` 2500). Thus the owners of lemons
would tend to receive a higher price that their cars are worth, while
the owners of high quality used cars would tend to get a lower price
than their cars are worth. Thus, the owner of good quality used cars
would withdraw their cars from the market. This will lower the
average quality and the price of remaining used cars available for
sale. This process may continue till only the low quality cars are
sold in the market at a very low price. This is inefficient, because no
buyer is able to buy a high quality car and no owner of a high-
quality car is able to obtain its true value. The market fails due to
lack of information.
Figure 10.3
The above diagram explains the market for lemons with
respect to a market for used cars.
In the market for used cars consisting of low quantity and
high quality cars, if there is perfect information, there would be a
market for low quality cars, and separate market for high quality
cars.
123
The supply and demand curve for high quality used cars are
shown by S
H
and D
H
carves respectively. Similarly, the supply and
demand curves for low quality used cars are shown by S
L
and D
L
carves respectively. The S
H
and D
H
are above S
L
and D
L.
The
equilibrium price of high quality cars is P
H
and amount of such cars
sold is N
H
and the quantity is N
L
. The number of high and low
quality cars sold is same ie. N
H
+ N
L
, but P
H
> P
L
.
Suppose there is insufficieut information and therefore, the
buyers cannot distinguish between high quality and low quality
cars. In this case, if there are N cars in the market, buyers would
consider a given car to be as likely to be a low quality as a high
quality car. So the buyers would be prepared to pay a price P = 0.5
P
H
+ 0.5 P
L
. (ie the price will be equal to half of the price of low
quality car) for a car. Thus, the new demand curve D
1
lies half-way
between demand curve. D
H
and D
L
. In this case the price of high
quality car will fall to
I
H
P and the number of high quality cars sold
falls to
I
H
N and the price of low quality car rises to
I
L
P and the
number of low quality cars sold rises to
I
L
N .
This causes the buyers to revise downwards the Chances of
being offered a low quality car. This will cause a further leftward
shift in the demand curve. This process continues and the demand
curve continue to shift left and finally to
Final
D . At this point there is
no supply of good quality cars in the market (this is because the
demand curve D
Final
start from point at which supply curve SH stats)
and only low quality cars are sold. The price falls to close to the
price of low quality cars.
Thus, the end result is that low quality cars drive high quality
cars out of the market. This is known as adverse selection.
The problem of adverse selection arising from asymmetric
information can be overcomed or reduced by providing more
information to the party lacking it. For e.g., in the used car market,
a prospective buyer may be allowed to evaluate the car by an
dependent automotive service centre or the dealer in the used car
market can provide guarantees for the cars they sell. With more
information on the quality of used cars, buyers would be willing to
pay a higher price for high quality car. The problem of asymmetric
information or adverse selection can be reduced
124
10.5 QUESTIONS
1. Explain in detail the Address Approach of modelling product
differentiation.
2. Explain how monopolist use price dispersion to maximize his
profits.
3. Examine the Dorfman-Stenier model of Advertising behaviour.
4. Write a note on Asymmetric Information by giving suitable
example.












125
11
Module 5
TECHNICAL CHANGE AND MARKET
STRUCTURE
Unit Structure :
11.0 Objectives
11.1 Introduction
11.2 The Process of Innovation: Concepts and Relationship
11.3 Measurement of Innovation Activities and Patents
11.4 The Theory of Technological Innovation: Kamien and
Schwarts
11.5 Mansfields Model
11.6 Nordhauss Model
11.7 Diffusion of New Technology
11.8 Summary
11.9 Questions
11.0 OBJECTIVES:
To study :
- The process of innovation
- The measurement of innovation activity
- The theory of technological innovation
- The Kaien and Schwartsz Model
- The Mansfields Model, the Nodhous Model
- The Diffusion of the technology.
11.1 INTRODUCTION
This chapter is concerned with the analysis of innovation or
research and development activities which are quite prevalent in
manufacturing and other business circles. Innovation is one of the
several strategies through which a firm could change its situation in
the market in pursuit of its objectives. It is an instrument which the
firm uses to enhance its competitive power in the market. It
provides a basis for greater degree of diversification and hence
126
growth of the firm. New products, new methods of production, new
markets and new forms of industrial organization etc. which are
elements of innovation or technological change, make the firms and
industries to run efficiently over time.
11.2 THE PROCESS OF INNOVATION: CONCEPTS
AND RELATIONSHIP
To understand the process of innovation in a clear
perspective, we have to define first its terminology. The terminology
consists of a set of interrelated terms. The first and perhaps the
most important one is the concept of invention. An invention is the
creation of a new technology. By technology we mean any tool or
technique, and product or process, any physical equipment or
method of doing or making, by which human ability is extended. It
is an intellectual act which involves a perception of a new image, of
a new connection between old conditions, or of a new area for
action. All inventions, big or little, are made for some practical uses.
The process of adopting an invention in a practical uses is called
innovation. It is the second important concept which is the focus of
the study in this chapter.
The three terms invention, innovation and imitation are the
successive stages of the process of innovation or technological
change. Imitation is not possible without innovation which in turn is
not possible without invention. The first stage i.e. the invention will
be usually a lonely activity of an individual or team of individuals
requiring intensive mental exploration. The entire process of
innovation i.e. from invention to imitation comes under research
and development activity of the firm. Each stage of this process is
a process itself.
The process of technological change constituting the above
three stages invention, innovation and imitation may be different
in different industries. Some industries provide better opportunities
for innovation or change as compared to others. Why is this so?
What determines innovation? These are important questions which
we would like to discuss in this chapter. But, before taking them, we
deal with the problems of measuring innovation activity in the
following section.
11.3 MEASURMENT OF INNOVATION ACTIVITIES
AND PATENTS:
Like any other economic activity we need precise
measurement of innovation in order to estimate its extent in reality
at firm and industry levels, and to establish its bahavioural relations
quantitatively with its determinants. There is no unique method for
127
this. Researchers in the field tackled the problem by measuring
either the inputs put in the process of R & D or the output of this
activity. The most simple and widely used method is to take the
statistics of R & D expenditure, absolute or a proportion of total
annual budget of the firm, as a measure of innovation activity. The
assumption for this method is that larger the volume of R & D
expenditure more will be the activities in innovation, particularly at
the stage of basic research leading to some invention. The
investment made by the firm for adopting the invention whether
related to the processing technology or product variation at the
second and third stages of innovation should be included in R & D
expenditure, otherwise it will be a partial index of measurement for
innovation. This method is useful if all R & D activities are in
organized form. There may be significant contribution by the
individuals or departments of the firm which do not come under R &
D unit. How to measure their contribution is a problem. At present it
is generally ignored and available statistics on R & D is used simply
to measure the innovational activities.
There is another method in which the number of scientists
and engineers in the R & D department is taken as a measurement
of innovational activities. The assumption in this case is that greater
the number of such personal more will be the R & D activities of the
firm of research organization. This measure has limitations similar
to the R & D expenditure contributions made by non-scientists or
non-engineers are not captured by this index.
Similarly, individuals doing research work independently,
that is, who do not belong to either a firm or research organization,
are likely to be left out by the index. However, this may be a minor
omission. By the large, when we are interested in analyzing the R &
D activities of a firm the index is appropriate for measuring that.
From the output side one may use either the number of
patents issued or sale of new products as appropriate
measurements of innovation or R & D activities. Taking number of
patents as a measure of innovation has some drawbacks.
Patenting generally refers to invention stage. It does not reflect
innovation and diffusion stages properly. An invention if patented
need not be put immediately in use. That is, the innovation
sequence of the invention may be deferred for some time. Further,
all inventions are not patentable equally. Inventions made by R & D
departments of government and universities are meant for all, so a
firm can use them for its innovation plans. Patent registration varies
between firms and industries and normally there will not be any
common pattern in this regard large firms doing research may avoid
patenting of their inventions in order to escape fro monopoly
regulation practices. They may keep their invention secret for long
time, as we observe in drug industry by registering the patents,
128
since a patent can be brought or copied by rivals. Further patenting
is more appropriate for product innovation. In the case of process
innovation it does not fit properly. Patent system does not reflect
the quality of innovation also on the whole, taking number of
patents as a measure of R & D activities is a partial index. In spite
of its drawbacks the index is popular for empirical studies. All
patents may not be significant indicators of R & D output. An
alternative method of measuring this, is therefore, to take the
number of major or significant invention and/or innovations in a
particular industry or within a given time period. This is an ideal
approach in principle but the major problem with this approach is to
find the basis of determining a major or minor invention and/or
innovation. An invention and/or innovation may be treated as a
major one if it has potentially many uses, makes important
qualitative changes in the output. But, again an element of
judgment is involved in such assessment of an invention and/or
innovation.
The index of sales of new product is another measurement
of R & D output. But this is again a partial index reflecting the side
of product innovation. It does not take into account changes in the
process of manufacturing and saving of costs arising as a result of
innovation have also been suggested such as the frequency of
publication in scientific or trade journals and estimating savings of
inputs per unit output of an industry or sector. These are however,
subject to more shortcomings and have been less frequently used
than the measures discussed earlier.
The final choice of the method to be used for measuring
innovation is left to the convenience and judgment of the
researchers. There is nothing much on the basis of which we can
discriminate the methods. Normally as found empirically by Mueller,
Carter and Williams and Mansfield whatever goes into inventive
process (i.e. inputs) will be closely correlated with the output (i.e.
patents) of the process. So, if we choose inputs to R & D or
number of patents as an index for measuring innovation or
technological change is not a matter for serious debate on the
subject. Both are equally appropriate seeing their inter correlation.
However, since data on R & D expenditure is easily available so it
is normally preferred over the number of patents or other indices for
measuring technological innovations.
11.4 THE THEORY OF TECHNOLOGICAL
INNOVATION: KAMIEN AND SCHWARTZ
The theory dealing with the process of technological
innovation has not yet taken proper shape. There is however
intensive search going on for such a theory at present in the realm
129
of industrial economics. Attempts are being made by economists to
identify the conditions which encourage initiation and adaptation of
a new technology. To begin with the identification of such
conditions, we may pose a simple but basic question related to the
technological innovation, why do scientists or engineers or anybody
else make invention? In a different may, we may ask this questions
as: why is a huge amount of money being spent on R & D activities
all over the world? The answer to this question is straight forward,
that is, inventions are made because there is a need for them. Fast
moving modes of transportation came into existence because there
was a need for them. Radio, television and hundreds of other
inventions were made with some purpose. Through inventions and
their commercial exploitation for personal or social uses cannot be
viable. Given this basic proposition of need which backs up
inventions, that is, makes them goal oriented, we have to identify
the conditions which are conducive or which accelerate the pace of
invention and innovation or broadly the technological change in the
economy. Since we are concerned with the study of the economic
behavior of firms and industries in this book, we will therefore
examine the determinants of R & D intensity in this context.
The first and most intensively debated determinant of R & D
is the market structure of the industry. Particularly, the elements of
market structure. Such as the degree of market power and absolute
size of firms were used in theory and empirical work on R & D
behavior of the firms and industries. Perfect competition and
monopoly were taken as the two extreme contrasting situation to
analyze the link between innovational motivation and market power.
To test this link, the major hypothesis was put forward by
Schumpeter who argued that a monopoly firm has a greater
demand for innovation because its market power increases its
opportunity to gain from them. This assertion has not been
accepted by the economists unanimously. At present they are
divided into two opposite school one is the competitive pressure
school. The competitive pressure school argues that in an
automistically competitive situation, with its strong profit there will
be great pressure and hence inducement for making cost-saving
innovations. Such pressure diminishes as market power of the firm
increases and so the rate of innovation will be inversely related to
the degree of market power. In fact, Arrow, a leading supporter of
the competitive school, has shown maximum gain from cost-
reducing innovation in a socially managed market followed by a
competitive one and then monopoly. In his own words, the
incentive to invent is less under monopolistic than under
competitive conditions, but even in the latter case it will be less than
is socially desirable. The monopoly profit school does not agree
with such contention. It argues that since innovation is risky, it will
not be undertaken in automistically competitive markets where the
gains from innovation will be momentary. According to this school,
130
the conditions for sustained R & D activities are best provided by
the monopoly or concentrated markets. The basis for such
contention is simple to understand. Through R & D activities a firm
gains and acquires monopoly power over its rivals. The firm would
like to perpetuate its monopoly power by undertaking new
innovational activities. There is thus a positive relationship between
the rate of innovation and the degree of monopoly power as
conceived by the monopoly profit school. Normally, large firms in
industries will be having considerable monopoly power. They will be
capable of providing adequate resources for R & D and taking the
associated risks. The monopoly power and large absolute size are
thus complementary attributes which are relevant determinants for
R & D activities. Taking this view in mind we may summarize the
stand of the monopoly profit school as the greater the profit and
the degree of market power or firm size the greater should be the
efforts to innovate.
Monopoly and perfect competition are the extreme forms of
market structure. Both of them, because of different reasons may
not provided significant incentive for innovation. Most of the authors
now take an intermediate form of market structure, having both,
competition and monopoly power, as a realistic market setting for
effective innovational activities. The reference here is to the
oligopoly market structure, which provides both monopoly power
and competitive environment for innovation. In oligopoly only few
firms will be having effective control over the market. Such firm will
be large enough and competing among themselves for greater
market power. Being small in number they will be unable to keep
their plans or strategies unnoticed by the rivals and so eventually
they will be in a situation of interdependency. They will be unable to
compete with themselves through manipulation in prices. So R & D
expenditure together with advertisement provide on alternative
mode of competition. Each firm will try to have either product or
process innovation. Through process innovation the cost of
production can be reduced and hence a firm can maintain higher
price cost margin. It can keep its innovations secret or protect them
through patent right. Because of lower cost of production such firm
will be in a position to reduce its product price. In this situation the
competitors of the firm will also reduce their prices in order to keep
their market shares intact. However, in the absence of innovation,
their price-cost margins will be lower than of the innovating firm. To
keep the margin high, they will be forced to apply their energies to
cost reduction. In other words, they will be induced to have
defensive innovation as a result of offensive R & D strategy of any
one or more optimistic firms. The innovation activities should not be
confined to cost reduction only in such a situation. The firms may
also adopt product innovation strategies to complete among them
selves as we find under monopolistic competition. In this way, there
will be all kinds of innovational activities in oligopolistic market
131
situations, competition among few leading firms induces them to
innovate while the monopoly power and large absolute size of such
firms provide the threshold conditions for undertaking R & D
activities, both with respect to resource availability and risk-bearing
ability. Smaller firms, even under oligopoly are unlikely to under
take R & D activities because of their inability to take the risks
associated with R & D and lack of adequate finances.
The threshold or what we may call alternatively, minimum
level of investment for R&D activities, varies between industries
and between different type of products in the same industry.
Freeman, For example estimated on amount of 175,000 per
annum as the threshold level of R and D expenditure for radio,
receivers and between 2 million to 8 million as the level for
communication satellites. Greater the requirement of money for the
threshold level of R&D larger will be the incentive for innovation by
the firm. The scientific and technological bases of the industries to
a great extent determine the threshold levels of R&D expenditure
for them. Differences in the scientific and technological nature of
the industries are likely to influence the rate of innovation
independently. Science-based industries such as aircrafts,
chemicals and petroleum, electrical goods and electronics,
machinery and vehicles etc. are likely to have a higher rate of
technological innovation than the industries based on conservative
technology such as textiles, sugar, garment manufacturing,
furniture, etc. share used the term technological opportunity to
show such differences across the industries. Greater the
technological opportunity of the industry, i.e. more scope for
advancement of scientific and technical knowledge, higher we
expect the rate of innovation irrespective of market structure or firm
size.
Another important factor that affects the rate of innovation is
the nature of the elasticity of demand for a product or products of
an industry. Rapid technological changes are seen in the industries
having elastic demand. Most of the luxury goods industries fall in
this category. We know the link. MR = P [1-1/led] where MR is the
marginal revenue, P is product price and ed is price elasticity of
demand. This equation shows positive marginal revenue when
elasticity of demand is greater than unity and negative marginal
revenue when ed is less than unity. MR will be zero when ed = 1.
Suppose there is a process innovation such that cost of production
reduces by a reduction in cost of production the firm will be in a
position to reduce product price in order to get more revenue Ci. E
positive MR if elasticity of demand is more than one, the firm will do
so. It is beneficial to the firm as well as to the customers of the firm
since they pay less price for the product now and the firm gets
more revenue. Thus, There will be more inducement for innovation
when price elasticity of demand for products of the firm or industry
132
is elastic, Kamien and Schwartz have, in fact, clearly shown such
possibility, but Needham has given an opposite view on the role of
elasticity of demand as a determinant of R & D behaviour of the
firm.
R&D intensity also depend on diversification. It has been
postulated that a firms degree of diversification will positively
influence is profit expectations from R & D. The basis for this
relationship is that a more diversified firm will be in a better position
to exploit research outputs than the one having a narrow base of
operations. There is another aspect of this relationship. If a firm
contemplates diversification of its operations because of some
reasons then it may also contemplate simultaneously to have an
R&D unit for being technologically independent. In this case both,
diversification and R&D may be treated as endogenous effects of
some exogenous conditions. The positive relationship between
them may be spurious if this is so. Take for example, a firm under
monopolistic competition. In order to increase or maintain its market
share, the firm adopts non-price competition. Product variation or
diversification is one of the strategies, for this. The make such
diversification, the firm may need R&D activites. It is therefore a
chain of reactions; market conditions determine scope for
diversification which in turn opens scope for R&D. The basic factor
in this example is the market structure, i.e. monopolistic competition
that generates conditions for diversification and R&D activities. A
firm, further, may adopt these two strategies simultaneously as
barriers to entry for potential rivals. The cause and effect sequence
between them is concerned, it is positive on a priori grounds.
R&D activities also show strong positive association with
growth of output of a number of industries Schmookler examined
such relationship in four U.S. industries railways, horseshoes,
petroleum, refinery and construction. He found it valid in every
case. The conclusion we can draw from his study is that R&D
activites are comitted intensively where the growth prospects are
good and profits are likely to be high. However, their may be an
upper limit for such positive relationship. A stage will come when a
product reaches maturity stages of its life cycle with no more
growth prospects. At this stage, the firm has to go through intensive
R&D activities, in search of a new product or products to replace
the old one. The relationship therefore may not hold true or it may
be negative after such stage is reached.
Yet another factor that we may mention here as a
determinant of R & D behaviour of the firm, is the return on R&D
investment itself. Greater the expected return from such investment
more will be the current volume of investment, committed to R&D
activities such relationship defines R&D investment at par with
other types of investment made by firm. It is undertaken either for
increased profits and / or to stabilize the position of the firm in the
133
market. The material presented above gives us a fairly good
description of the theoretical determinants of R&D activities of the
firms. Let us now review some analytical models suggested by the
economists for this.
11.5 MANSFIELDS MODEL
Mansfield, one of the leading economists working in the area
of R&D economics, suggested a simple and operational theoretical
model to find the rate of return from industrial research and
development. He assumed a neo-classical production function for
output rate of a firm with labour, capital and R&D expenditure as
relevant inputs. All inputs were further assumed growing
exponentially over time. With a set of simplifying propositions such
as constant returns to scale from labour and capital inputs,
depreciation of R&D capital, past R&D investment determining
current output of the firm etc. the expression developed by
Mansfield for marginal rate of return from R&D expenditure can be
shown as.
2 o 1
2 1
r (P )Q/ R
( 1)(P ) (1 )k
= o + + +
o + +
where r = marginal rate of return on extra expenditure on
R&D Q = output value in 1960 at constant prices, R
o
= R&D
expenditure in 1960,
1
= rate of technical change without R&D
expenditure
2
= elasticity of output with respect to cumulative past
net R&D expenditure, P = rate of increase of R&D expenditure over
time, = annual depreciation of R&D capital, o = rate of increase of
price of. R&D capital and = output elasticity with respect to labour
which means (1 - ) as output elasticity with respect to capital and
1 and k are the growth rates for labour and capital inputs
respectively.
This model and its variants have been used by Mansfield for
empirical work in his later works. He emphasized mainly on
productivity aspect of innovative activities by taking into
consideration changes in input characteristics, volume of R&D
expenditure etc. Not much attention was paid in his models to
explain the R&D behaviour of the firms under different market
situations.
11.6 NORDHAUS MODEL
Nordhaus has given a fairly exhaustive theory of
technological change. In chapter of his book he presented the
basic model of invention for a firm. The firm is assumed to
maximize profit and produce a single homogeneous product under
134
certainty. Further, competitive conditions are such that the output
of the firm is almost negligible as compared to the output of the
whole industry. The production function of the firm includes R&D
as one of the inputs, which affects the productivity of conventional
factors like labour and capital. The specific form of the production
function used by the author was
( ) ( ) Q a R F K,L =
Where ( ) a R is the level of productivity or denotes the level
of technology as a function of R&D. It is called the invention
possibility function. F is the conventional production function some
simplifying assumptions were made about the shape of this
function. It is assumed that capital and labour are used in fixed
proportions. With this assumption, the production function for the
firm can be reduced to
( ) Q a R L =
The firm is profit maximizer. The profit equation can be
expressed as
( ) ( ) ( ) ( ) t p t a R L W t L sR t =
Where ( ) P t is price of product, ( ) w t is the price of a bundle
of conventional inputs expressed in labour units, s is the average
cost of research at time t 0 = . Let us assume that the innovation
gives return to the firm up to T periods. The present value of total
profit up to T periods can be expressed as
( ) ( ) ( )
rT T
rv
0
1 e
V v e dv p. a R L WL sR
r

= t = =
(
(

Where P and W are assumed to be constant over time, as a

=

This expression indicates that marginal value of product
attributed to R&D input is equal to its marginal cost taken in terms
135
of price (P) as numerative. ( ) a' R is the first derivative of the
innovation possibility function with respect to R, it is assumed to be
declining showing the diminishing returns to R&D. The marginal
value of product of R is the product of three terms ( ) a' R , L and .
L indicates the level of output through the production function.
greater the output of the firm greater will be use of labour. This
implies that marginal value of R&D increases with size of the firm.
This aspect we have already covered above while discussing the
determinants of R&D. schmookler has given great deal of attention
to it in his book. The other multiplicative factor in the marginal
value of product of R, is the present value of a stream of income of
one unit of money from time 0 to time t = T. Greater the value of
more will be the inducement to innovate. This factor further
indicates that the amount of research varies positively with life of
invention (T) and inversely with the interest rate ( r) . The
equilibrium situation for the firm with respect to its R&D behaviour is
shown at R where marginal value of product of R&D equals its
marginal cost.
0 R
AVC, MVP & MC OF R & D
Average value product of R & D input
M.C. of R & D
Marginal Value product of R & D
Level of R & D
Fig. R & D Equilibrium
Figure 11.1
Nordhaus extends his basic theory of innovation further by
relaxing the assumptions, and introducing new elements such as
imperfections in the production of knowledge, barriers to entry,
optimal life of patent and welfare implications of R&D etc. but we
will not go through these aspects at this stage.
11.7 DIFFUSION OF NEW TECHNOLOGY
This is an important aspect of the innovation process. A new
technology invented by a firm is likely to be less diffusible as its
adaptation by the rival firms will be restricted through patent right.
However, when such technology is developed by a Government
136
research institute for common use, the rate of its diffusion or
adaptability may be slow or fast depending on certain economic
factors such as reduction in cost of production, improvement in the
quality of output of the technology, requirement of capital amount
for new technology, the skills needed to make it operational,
malleability or the ease of disposal for the existing obsolete capital
stock, the nature of demand elasticity for the products of the new
technology, the rate of growth of the market, size of individual firms,
and the structure of industry, etc. It is presumed that the new
technology is available free of cost. When it is not so, i.e. some
cost is involved in getting the right to use the technology, such as
royalty or license fee, the amount of such cost will be an additional
factor for determining the rate of diffusion of the technology.
There are some interesting studies on technological
diffusion. In his pioneering study salter examined the diffusion
process in U.S. blast furnaces where the average productivity of
plants was only half of the best practice technology i.e. that of new
plants and it took 15 years for average productivity to reach the
best practice level. In this study, salter developed a simple theory
of technological diffusion for a competitive industry with static
demand and free information about the new technology. The
efficiency of the new technology is judged through savings in labour
cost of production.
Mansfield used a model of the learning process to study the
diffusion of new innovations in coal mining, iron and steel, brewing
and rail roads industries. The model is based on the hypothesis
that the number of firms that will adopt a new process in the
subsequent time period, expressed as a proportion of all firms not
using the process is a linear function of the proportion of the firms
in the whole industry i.e.
t 1 t t
t
m m m
n m n
+

=

Where
t 1
m
+
is number of firms having the new process in
t 1 + period,
1
m is the number of the firm having the new process in
t period, n is total number of firms in the industry and is a
constant. This expression, on simplification yields
( )
t
k t
m 1
n
1 e
+
=
+
This shows on S-shaped learning curve where is defined
as the rate of learning which is also the rate of diffusion of a
technology. Empirical estimate were made for by Mansfield who
found it varying significantly across the industries.
Other important studies on technological diffusion were
conducted by Ray, Romeo, Metcalfe, and Globerman, Davies,
137
Jensen Quirmbach, focusing attention on different aspects of
technological diffusion.
11.8 SUMMARY :
We are now in a position to conclude our discussion on R&D
economics various aspects of R&D such as its conceptual
definitions, measurements, theoretical basis at firm or industry
level, analytical models and empirical evidences were examined in
this chapter. The material was kept at the expository level rather
than a critical appraisal of the various issues discussed. We
examined R&D just like any other business activity of a firm
directed for profit, stability of earnings and growth, etc. It is on
instrument through which the firm enhances its market power and
so competes with its rivals effectively. There are conditions under
which the firm will be able to do so which we tried to elaborate in
this chapter along with other aspects of R&D.
11.9 QUESTIONS
1. Explain the process of innovation.
2. Explain and discuss the measurement of innovation activity.
3. Describe the theory of technological innovation.
4. Examine the Mansfields model.
5. Discuss the Nordhaus model.
6. What is the diffusion of technology?

138
12
MARKET CONCENTRATION
Unit structure
12.0 Objectives
12.1 Introduction
12.2 Measurement of market concentration
12.2.1 The Concentration Ratio
12.2.2 The Hirschman - Herfindahl Index
12.2.3 The Entropy Index
12.3 Concentration and the market performance
12.3.1 Concentration and Profits
12.3.2 Concentration and Price-cost margin
12.3.3 Concentration and Growth of the firm
12.4 Contestable Markets
12.5 Summary
12.6 Questions
12.0 OBJECTIVES:
- Measure the market concentration
- Know the concentration and the market performance
- Understand the concentration ratio
- Understand the Hirschman - Herfindahl Index
- Understand the Entropy Index
- Explain the concept of concentration and profits
- Explain the concept of contestable markets
12.1 INTRODUCTION:
Market concentration or, more specially, the degree of
sellers concentration in the market, is an important element of the
market structure which plays a dominant role in determining the
behaviour of a firm in the market. By market concentration we
mean the situation when an industry or market is controlled by a
small number of leading producers who are exclusively or at least
139
very largely engaged in that industry. Two variables that are of
relevance in determining such situation are (i) the number of the
firms in industry, and (ii) their relative size distribution. In the
context of industrial economics the implication of market
concentration are far wider than whatever we find in the theory of
the firm. It will be our attempt in this chapter to focus on such
implication in the framework of market-structure-conduct-
performance link.
12.2 MEASUREMENT OF MARKET CONCENTRATION
AND MONOPOLY POWER :
In order to test empirically the behavioural hypotheses about
the firm and industries, we need a measurement of market
concentration. Various quantitative indexes have been suggested
for this purpose which we are going to summaries in this section.
Some of them are used to measure the monopoly power of the
firms and some for market concentration. These two terms, i.e.
monopoly power and market concentration, are closely interrelated
and can not be separated from each other in the measurement
process. The degree of market concentration would vary with the
monopoly power in a particular industry, or we may also say that
existing firms acquire monopoly power if market is concentrated.
The indexes that we are going to discuss here would therefore be
indicating to us almost similar things with minor differences. The
measures for monopoly power would be more appropriate at firm
level. They indicate the actual monopoly power exercised by the
firms. The measure of concentration on the other hand would give
us the potential monopoly power in the market or industry as a
whole obviously some firms would be having monopoly power in
the situation of market concentration. If the market of firms and
their relative sizes in the market are changing, we expect a change
in the monopoly power of the firms. The concentration is, therefore,
a necessary condition for the monopoly power although it is difficult
to say that there is one to one proportionality between them.
Before discussing the indexes it will be useful here to
mention some general conditions or requirements which should be
satisfied by each one of them. this helps us in screening the
indexes while making the final choice for empirical work. The
conditions are :
a) The measure must yield an unambiguous ranking of industries
by concentration. Consider Fig.___ in which concentration
curves, i.e. the graphs between cumulative number of firms from
largest to smallest and cumulative percentage of market supply
are shown by
1 2 3
I , I , I for their industries separately.
1
I is above
2
I and
3
I every where. It means the industry which is
140
represented by it is more concentrated than the other two.
However, there is ambiguity in the ranking of the second and
third industries represented by
2
I and
3
I respectively.
Market Supply Cumulative %
J1
J2
J3
0 4 8 12
Cummulative no. of firms
(Largest to Smallest)
Figure 12.1 : Hypothetical Cumulative Number of Firms
b) The concentration measure should be a function of the
combined market share of the firms rather than of the absolute
size of the market or industry.
c) If the number of firms increases then concentration should
decrease. However, if the new entrant is large enough, then
concentration may go up.
d) If there is transfer of sales from a small firm to a large one in the
market, then concentration increases.
e) Proportionate decrease in the market share of all firms reduces
the concentration by the same proportion.
f) Merger activities increase the degree of concentration.
12.2.1 The Concentration Ratio :
The most popular and perhaps simplest index for
measurement of market concentration or monopoly power of the
few firms is the use of the concentration ratio, that is, the share of
the market or industry held by some of the largest firms. The
market share of such firms may be taken either in production or
sales or employment or any magnitude of the market. In symbolic
form the concentration ratio is written as
=
= =

m
i
i 1
C P m 4, 8,10,12,..., 20,...
141
where
i
P = market share of i
th
firm in descending order. The
normal practice is to take the four-firm (m = 4) concentration ratio
but if the total number of firms operating in the market is large
enough then one 20-firm concentration ratio to assess the situation.
The higher the concentration ratio the greater the monopoly power
or market concentration existing in the industry.
There are some limitations of this index. It does not take the
entire concentration curve into account; it rather indicates market
concentration at a point of the curve. The ranking of industries
depends on the point chosen. If the point is changed there may be
changes in the ranking of the industries also. This is the situation
shown in Fig.___ for
2
I and
3
I curves on the basis of the 4-firm
concentration ratio, industry 3 is more concentrated than industry 2,
but on the basis of the 12-firm concentration ratio the ranking is
reserved. For the 8-firm concentration point both are equally
concentrated. There is thus some ambiguity as to which point is to
be chosen. Further the concentration ratios depend to a great
extent on how the market is defined. A broad market would tend to
reduce the computed concentration ratio whereas a narrow one
would usually have the opposite effect. This means, in the
standard industrial classification, the concentration ratios will be
lower for the two-digit major industry group than the ratios for the
three-digit industries in the same group. The data for the finer
classification of the industries may not be available, hence it may
be difficult to have precise idea of market concentration using the
aggregate data more over, it may not be comparable with other
industries or countries data. There are other limitations also. The
ratio do not reflect the presence of or absence of potential entry of
firms, they being based upon national figures, do not say anything
about the regional market power; they do not describe the entire
number and size distribution of firms, only a part of that is
considered by them; they do not say anything about monopoly
power of the individual firms in the market and ignore the role of
imports in the domestic market. The ratios may give conflicting
picture of the concentration with the use of different variables for
size of the firms.
In spite of the limitations, the ratios are widely used in
industrial economics. They are simple to compute, readily available
for the manufacturing sectors, and capable of measuring market
concentration with a finer classification of the industries. They are
consistent with the economic theory, as we know that, other things
being equal, monopolistic practices are likely to be in operation to a
greater extent where a small number of the leading firms account
for the bulk of any industrys output than where the industrys output
is evenly distributed among the firms.
142
12.2.2 The Hirschman - Herfindahl Index :
It is the sum of the squares of the relative sizes (i.e. market
shares) of the firms in the market, where the relative sizes are
expressed as proportions of the total size of the market
symbolically,
Herfindahl Index (H) ( )
=
=

n
2
i
i 1
P
where, =
i i i
P q Q, q is output of i
th
firm and Q is total output
of all the firms in the market, and n is the total number of firms.
This index takes account of all firms in the market (i.e. industry).
Their market shares are weighted by the market share itself. The
larger the firm, more will be its weight in the index. The maximum
value for the index is one where only one firm occupies the whole
market. This is the case of a monopoly. The index will have
minimum value when the n firms in the market hold an identical
share. This will be equal to 1/n, that is
=
(
= =
(

2
n
i 1
1 1
H
n n
H decreases as n increases. Inverse of H gives us number
equivalent measure of the market concentration. The index is
simple to calculate. It takes account of all the firms and their
relative sizes, it is therefore popular in use and consistent with the
theory of oligopoly because of its similarity to measures of
monopoly power. Adelman has explored its properties extensively
and related it directly to the concentration curve.
12.2.3 The Entropy Index :
This index has been suggested by Hart to measure the
degree of market concentration. It uses the formula
=
= s s

n
i n n
i i 1
1
E P 1 ; 0 E 1 n
P
where E is defined as Entropy Coefficient;
i
P is the market
share of i
th
firm and n the number of firm. This coefficient in fact
measures the degree of market uncertainty faced by a firm in
relation to given customer. This will be the situation when number
of firms is large enough. i.e. market is not concentrated. For a
monopoly firm (n = ) the entropy coefficient takes the value of zero
which means no uncertainty and maximum concentration. Thus we
find opposite (inverse) relationship between the entropy coefficient
143
E and the degree of market concentration. If there are n firms, all
equal in size, then
=
= =

n
n n
i 1
1
E 1 n I n
n
Both, increased equality of market shares and an increase in
the number of firms increase the entropy coefficient but the latter
factor plays a diminishing role because of the use of logarithms
which implies that addition of an extra firm, when number is already
large enough, it becomes less significant from the point of view of
market concentration. In terms of number equivalent the number
can be measured as exp (E).
To take into account the number of firms as a determinant of
the entropy coefficient one may use the relative measure of the
entropy, i.e. the entropy coefficient E divided by the maximum value
of the coefficient (log n)
E
Er ; O Er 1
Inn
= s s

This expression indicates the actual degree of dispersion of
market share to the maximum dispersion possible for a given
number of firms.
The entropy coefficient is a useful measure of market
concentration in the sense that the population of the firms for which
the entropy coefficient is to be computed can be decomposed or
disaggregated into several groups, say on the basis of sizes,
regions, products and the classification of industry, etc. to compute
separate entropy coefficients for them, a weighted sum of such
coefficients would then give the overall entropy coefficient. Such a
decomposition is not possible in the case of other indexes of
market concentration.
12.3 CONCENTRATION AND THE MARKET
PERFORMANCE OF A FIRM
There are many behavioural hypotheses about concentration
and market performance which we would like to discuss in brief in
this section. As we read in microeconomics, a firm with substantial
monopoly power will tend to charge high price, produce and sell
less output, make high rates of profit, grow faster than others,
capable of doing anything it wants in connection with its business
such as R & D, advertisement and so on. Let us presume that
concentration is an appropriate measure of such power, we are
then in a position to verify the various propositions of the economic
144
theory which reflect the relationship between concentration and
market performance of the firm. This will naturally be based on the
empirical evidence available so far but no attempt will be made to
make an exhaustive survey of this here. Only few selected studies
will be referred in connection with the individual hypotheses.
12.3.1 Concentration and Profits :
A firm derives market power or monopoly power in the
situation of concentration. Such market power, via market conduct
activities or directly leads to an increase in the profitability of the
firm. It is frequently assumed that persistency of high rates of profits
over a long period is the consequence of high degree of intra-
industry concentration. J. S. Bain was the first to make an empirical
study of this proposition, who found it valid for the U.S. industries.
The relationship was found so strong than Bain was to argue for the
profit rate as an index to measure the concentration. Since then
there has been a flood of studies on the relationship which by and
large supported this but some of them were, of course, very critical
also.
There are some difficulties in establishing the correct
relationship between the two variables (concentration & profitability)
as both of them are subject to ambiguities of measurement which
index of measurement is to be used for concentration? There are
so many of them. If one measure is taken, it may have strong
correlation with profitability, but if another is taken, it may have a
weak relationship. Further, measurement of profit rates is also not
free from bias. This is generally based on accounting data which
ignores certain opportunity cost elements related to own funds or
own labour of the entrepreneur in the business some arbitrary
valuation are placed for such elements which may induct bias in the
relationship. What denominator is to be used to compute profit rate
is also not clear sales or assets or production or something like
that. Researchers make their own choices for such rates, without
giving the proper rationale for that. In spite of such difficulties we
should not discard the relationship between concentration and
profitability. It is a positive one which is consistent with the
theoretical logic, through very precise estimation of which is yet to
come.
12.3.2 Concentration and Price-cost Margins :
Price-cost margin is another way to define profitability. This
is a short-term view of profitability based on current sales and cost
figures. Say the average price-cost margin is just a ratio of these
two magnitudes. Empirical studies particularly those conducted by
Collins and Preston supported the positive relationship between
concentration and the price-cost margin for the American four digit
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industries. Shephered also confirmed the positive relationship
between them for most of the U.S. industries Koch and Fenili
however, looked at the concentration acting as a surrogate for other
determinants of price cost margins because of its being causally
linked with them. they found it as an insignificant predictor of price
cost margins when other relevant indicators of market structure like
product differentiation, rate of technological change, etc. were also
considered side by side. We may not agree with their findings
simply because when all such determinants were taken together
along with concentration, multicollinearity might have distorted their
relationship making concentration insignificant. For its significance,
there is a strong theoretical base which cannot be demolished
because of statistical inadequacies of measurement.
In a recent book, Hay and Morris have presented a summary
table of 67 studies on market structure and profitability for the
period 1971 to 1988. According to this, market concentration was
found to be a significant determinant of profitability with expected
sign in 28 studies, insignificant in an other 28 studies; and doubtful
in the remaining studies. All this reveals that no specific
generalization could be made about the relevance of the market
concentration as a determinant of profitability although major
support is coming for its being a positive factor as per the theory.
12.3.3 Concentration and Growth of the Firm :
The growth of the firm is a topic which requires a full chapter
for discussion. Here we will just mention how concentration is
relevant for this. There are two different streams of thoughts to
explain the causal relationship between the two variables.
According to one view, a firm with market power, as a consequence
of concentration, may prefer to maintain its high rate of profit by
restricting the output and charging high price. If it grows, it has to
sacrifice some profit margin, and lower price which may not be in its
interest. Moreover, there will be all kinds of restrictions imposed by
the Government to stop further growth of such firm. Furthermore,
static diseconomies of scale and numerous dynamic factors and
bottlenecks all adversely affect the ability of such firm to grow.
Thus, we except that higher the monopoly power of the firm lesser
may be its growth. The few firms in the concentrated industry may
be dominant enough to restrict the growth of the other firms and to
stop the entry of new ones because of the various barriers to entry
at their disposal. There is, thus very little prospective for the growth
of the firms in a concentrated industry and so for the overall growth
of the industry itself. There are some empirical studies where the
inverse relationship between initial market concentration and
subsequent market growth has been verified.
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The second view about the concentration and growth of the
firm and hence of the market, is a positive one. In order to
maximize the long-term profit, firms may like to grow over time even
under market concentration. They may prefer to create excess
capacity to meet the future growing demand and to discourage new
entry in the market. They may have some short-term sacrifice of
profit in order to stimulate long-term benefits. So we find a case for
the positive relationship between initial market concentration and
growth of the firms. The firms with market power may be finding
themselves at ease regarding finances and other requirements of
growth. They would, therefore, like to avail the opportunities for that
other things remaining the same. There are empirical evidences for
such proposition also.
There are all kinds of problems in establishing which view is
valid. The empirical studies differ in scope, coverage of period, data
base and even measurement of concentration and growth. No
definite verdict is, therefore, available from them. For the present,
the relationship between concentration and growth of the firm and
market, is an open issue for further verification.
Concentration and Technological change :
The issues related to technological change and market
structure will be examined later on in a full chapter of this book. At
this stage, let us look into one aspect of this, that is, whether
concentrated industries are the most research oriented and
technically progressive. It is true that the few firms who enjoy
monopoly power in a concentrated industry will be large enough.
They will be having stability, financial resources and ability to
initiate the processes of R&D and gain the benefits from them.
Dasgupta and Stigliz, in their papers clearly showed the situation
when market concentration and innovative activities are positively
correlated. There is no conclusive empirical evidence to prove
such proposition. In fact, studies conducted by Williamson have
shown quite opposite results. Doubts about this have also been
expressed by Bliar. It may not be the concentration but the other
attributes of market structure like size of firm, product differentiation
possibilities, etc, which may be having collinearity with
concentration and thus causing a spurious positive correlation
between concentration and thus causing a spurious positive
correlation between concentration and technological change.
Nothing can be said in either way about the relationship. It is open
for further empirical verification.
Concentration and other aspects of Market Performance :
We may briefly mention some other aspects of market
performance which may be having some association with market
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concentration stability in the business, which may be judged either
by persistency of profit rates or sales volume or market share, is
one of them. Greater the market power of a firm the more we
expect its stability. The uncertainties faced by the firm may be
smaller. Further, if there is high concentration in the market the
existing few large firms may maintain their size ranking in order to
keep the leadership with them. If the size ranking of the firms,
which is defined as turnover is changing, this implies that the
competitive forces are in action in the market. Lack of such a
change, that is, of turnover means a lack of competition and a
possible tacit or alright collusion.
12.4 CONTESTABLE MARKETS :
A new type of market structure has been suggested by
Baumol Panzar and Willing in 1982 which they named as
contestable market. The theory of the market as propounded by
them may be taken as an extension of the competitive markets but
it has its own relevance in the context of industrial economics as we
will see in the following overview of the theory.
Like any other type of market, the theory of contestable
markets is based on certain fundamental assumptions.
1) There is at least one incumbent i.e. a firm already existing in the
market, and one potential entrant to the market. Potential as
well as incumbent firms are assumed to face same set of
productive techniques and market demands.
2) There is no legal restrictions on market entry and exit.
3) There are no special costs that must be borne by any entrant as
well as incumbent firms. In other words, the technology may
offer scale economies but must not require sunk costs. It
means that the capital investment is fully recoverable and
mobile i.e. it is resaleable or reusable without any loss in earlier
business.
4) Incumbent firms can only change prices with a non-zero time
lag (price sustainability assumption) but consumers respond to
price differences with shorter time-lag.
Given the above conditions a perfectly contestable market
operates in a simple way. Incumbent, i.e existing firm in the market
fix or post prices for their products. Their prices would remain
unchanged for some time. A new firm enters (i.e. hits) the market
with somewhat lesser prices for its products than that of the
incumbent firms and earns more profit or sales by attracting
customers from it rivals, i.e. incumbent firms because of price
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differences. The incumbent firm respond to the new prices in the
market with a time lag after the new firm invades the markets. The
incumbent firms may not have much cost disadvantages at this
state. They can cut their prices by increasing the scale of
production although it takes sometime. By reducing the prices by
the incumbent firms some what below the prices of the entrant firm,
they reestablish their market share and in fact may increase it
attracting customers from the entrant firm. At this stage, the entrant
firm leaves the market (i.e. runs away) since the retaliatory price-
cuts by the incumbent firms leave no scope for profitable existence
for the firm. There are no sunk costs so the firm would not face any
problem of capital loss in leaving the market. Thus, the entrant firm
may be regarding as following the hit and run tactics in the market.
This is a major characteristics of the contestable markets.
Suppose the entrant firm charges less prices for its products
which are inferior than the product of the incumbent firms. Sooner
the consumers will detect these facility products but before that the
entrant firm runs away from the market. In the short period of stay
in the market such firm makes lot of gains with no prospect of it if
the firm continues in the market under the changed situation.
The contestable market as briefly described above is
different from the perfect competition. Although both the types of
market assume frictionless free entry and exist, they differ on the
number criteria. Under perfect competition the number of sellers
and buyers has to be quite large so that each one of them is not
able to influence the market individually but under contestable
market there is no such restriction. This type of market may be in
operation even with one incumbent and one entrant firms. Further
homogeneity of the product assumption as under perfect
competition need not to be equally valid for the contestable market.
in fact, a contestable market paves the way for the multi product
firms.
The theory of contestable market as developed by Baumol,
Panzar and Willig is an important contribution in industrial
organization. It provides the normative base for increase in
industrial efficiency under effective threat from the entrant even
under monopoly. However, from empirical or operational point of
view it has several drawbacks. The assumption of price
sustainability, perfect mobility of capital with no sunk costs, etc.,
may not hold true in practice. Further every firm in the market will
be entrant at some point of time. If it follows the hit and run tactics
then how to justify the existence of the incumbent firms at all. It
appears that the notion of contestable market is a faulty one and it
will take long time before the theory of constable markets is totally
acceptable as a working model for operation.
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12.5 SUMMARY
After going through this unit you will be able to measure the
market concentration through the concentration ratio, the
Hirschman-Herfindahl index, and the entropy index. You have also
understood the connection between the concentration and the
market performance.
12.6 QUESTIONS
1. Explain how the market concentration is measured?
2. Explain the Hirschman-Herfindahl index.
3. Discuss the Entropy index.
4. Examine the concept of concentration and market performance.















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13
Module - 6
INDIAN INDUSTRY
SMALL SCALE INDUSTRY
Unit Structure :
13.0 Objectives
13.1 Introduction
13.2 Key role of SSI in the Indian economic structure
13.3 Policy issue and performance
13.4 Summary
13.5 Questions
13.0 OBJECTIVES
- To understand the meaning of SSI
- To study the role of SSI in Indian Economy
- To study the performance of SSI during post independence
period in India.
13.1 INTRODUCTION
In 1947 after gaining independence, India initiated a path of
industrialization to achieve economic prosperity. India focused on
developing the manufacturing base. Much of the countries
development was done through the five year plans. Industries like
iron and steel, oil refineries, cement and fertilizer were brought
under the gamut of public sector enterprises. The decision makers
then encouraged the development of small scale industries. They
perceived that Indian small scale industries would play a vital role in
the economic progress of the country and had immense potential
for employment generation. Developing small scale sector would
also result in decentralized industrial expansion, better distribution
of wealth and to encourage investment and entrepreunial talent.
The government has initiated several policies for the growth
and development of small scale industries. They included
reservation of certain items to be manufactured only by the small
scale sector. Other measures include credit marketing, technology,
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and entrepreneurship development, fiscal, financial and
infrastructural support. In 1999, the government established the
Ministry of Small Scale Industries and Agro and Rural industries to
make policy decisions for the development and well being of the
small scale industries.
Initially the small scale sector was characterized as
traditional labor intensive units with outdated machineries and
inefficient production techniques. But in the recent past the
condition of the small scale units has improved. Today they have
installed modern machines, applied better management techniques
and are much more productive than before.
Definition and historical context
The definition for small-scale industrial undertakings has
changed over time. Initially they were classified into two categories-
those using power with less than 50 employees and those not using
power with the employee strength being more than 50 but less than
100. However, the capital resources invested on plant and
machinery buildings have been the primary criteria to differentiate
the small-scale industries from the large and medium scale
industries. An industrial unit can be categorized as a small- scale
unit if it fulfils the capital investment limit fixed by the Government
of India for the small-scale sector.
As per the latest definition which is effective since December
21, 1999, for any industrial unit to be regarded as Small Scale
Industrial unit the following condition is to be satisfied: -
Investment in fixed assets like plants and equipments either
held on ownership terms on lease or on hire purchase should not
be more than Rs 10 million.
However, the unit in no way can be owned or controlled or ancillary
of any other industrial unit
The small companies are defined as those with less than US
$180,000 in capital equipment (USAEP, 1996). In India the
definition of SSI has undergone changes over the years in terms of
investment limits in the following manner.
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Traditional and modern small industries:
Traditional small industries include khadi and handloom,
village industries, handicrafts, sericulture, coir, etc. Modern SSIs
produce wide range of goods from comparatively simple items t
sophisticated products such as television sets, electronics, control
system, various engineering products, particularly as ancillaries to
the large industries. The traditional small industries are highly
labour-intensive while the modern small- scale units make the use
of highly sophisticated machinery and equipment. For instance,
during 1979-80, traditional small-scale industries accounted for only
135 of the total output but their share in total employment was 56%.
As against this, the share of modern industries in the total output of
this sector was 74% in 1979-80 but their share in employment was
only 33%. Obviously, these industrial units would be having higher
labour productivity. One special characterstic of traditional small-
scale industries is that they cannot provide full time employment to
workers, but instead can provide only subsidiary or part time
employment to agricultural laborers and artisans. Among traditional
village industries, handicrafts possess the highest labour
productivity, besides handicrafts make a significant contribution to
earning foreign exchange for the country. Nowadays Indian small-
scale industries (SSIs) are mostly modern small-scale industries.
Modernization has widened the list of products offered by this
industry. The items manufactured in modern Small-scale service &
Business enterprises in India now include rubber products, plastic
products, chemical products, glass and ceramics, mechanical
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engineering items, hardware, electrical items, transport equipment,
electronic components and equipments, automobile parts, bicycle
parts, instruments, sports goods, stationery items and clocks and
watches.
SSI-Location
Small Scale Industries are located throughout the country,
though predominantly in the rural areas. The small scale industries
in the rural areas are skill based, wherein the skill for manufacturing
is passed on from one generation to another. Some of the goods
manufactured in these units are textile handicrafts, woodcarving,
stone carving, metal ware etc. Small scale industrial factories are
also present in urban areas and usually they account for the
maximum volume of production for that particular good in the
country. For e.g. Ludhiana in the state of Punjab is the main center
in the country for producing woolen hosiery, sewing machine parts,
bicycles and its parts, similarly Tiruppur in Tamil Nadu accounts for
small scale firms that are involved in spinning, weaving and dying
of cotton garments.
SSI -After Post Liberalization
Post liberalization economic conditions has created
immense growth prospect for the small scale industries. The
government has also supported the small scale industries by the
way of implementing policies like investment ceiling for the SSI
sector and priority lending. The formation of WTO in 1995 resulted
in a major challenge to the well being of the SSI. The protection
given to the SSI in the form of reservation and quantitative
restrictions has been withdrawn. More than 160 items reserved
under the SSI category have been de reserved. It has been found
that if the SSI upgrades the technology, adopt better management
practices, reengineer the factories to improve productivity and
provide qualitative product, they would be competitive in the post
WTO scenario. The advancement in computer and
telecommunication technology, increase in e commerce, opening
up of markets due to WTO, mergers and acquisitions, improved
infrastructure and outsourcing noncore area of business have all
contributed to the growth of SSi.
13.2 KEY ROLE OF SSI IN THE INDIAN ECONOMIC
STRUCTURE
India has traditionally always had a very vibrant and
competitive SSI. Even after the dawn of industrialization, British
producers of textiles found hand made Indian textiles such a threat
that they lobbied hard to have its import banned, succeeding in the
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late eighteenth century . During pre-economic liberalization period a
wide variety of incentives, concessions and institutional facilities
were extended for the development of SSIs. But these socialistic
promotional policy measures, in many cases resulted in protection
of weak units rather than the independent growth of units under
competitive business environment. Such situation was continued up
to the mid of 1991. Under the regime of economic liberalization, the
focus was shifted from protection to competitive promotion.
The public policy in India had been attaching lot of
importance to village and SSI on the following grounds. SSI being
labor-intensive, helped to increase the volume of employment,
particularly in rural areas, it is estimated that about 2 crore persons
are engaged in India in these industries. The handloom industry
alone employs 50 lakh people. They account for 6% of GDP, 95 %
of all industrial units, and 34% of total exports. Around 39 lakhs
SSIs in India has emerged versatile producing over 8000 products,
from traditional handicrafts to high-end technical instruments.
In developed OECD economies, about 60 % of GDP is
generated by small enterprises, i.e., enterprises with a maximum of
50 employees. The reason being large number of small enterprises
guarantees a high degree of competition, and variety of economic
activities that require millions of enterprises to be reasonable
competitive and efficient. The indirect jobs created through forward
and backward linkages are no less important. In real terms, the SSI
recorded a growth rate of 10.1% in 1994-95 as against 7.1% in
1993-94 and 5.6% in 1992-93. By the year 2025, if not controlled,
this sector will grow even more rapidly (Parthasarathy, 1996).
Generalizations are also difficult because though there are
firms which are growing rapidly, there also exist 1,38,000 sick units
within the sector in India. The contribution of SSI in India to national
development was meager as compared to the contribution of SSI in
other countries of the world. Indias SSI shared 95 % of all
establishments, 40 % of output, 45% of employment and 35 % of
exports. But Taiwan ranked first with a share of 97% of
establishments, 81 % of output, 7% of employment, 48 % of
exports followed by Japan contributing highly with 99 % of
establishments, 52 % of output, 72 % of employment and 13 % of
exports (SIDBI Report, 2000).
1. SSIs Role in Production:
The small-scale industries sector plays a vital role in the
growth of the country. It contributes almost 40% of the gross
industrial value added in the Indian economy.
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It has been estimated that a million Rs. of investment in fixed
assets in the small scale sector produces 4.62 million worth of
goods or services with an approximate value addition of ten
percentage points.
The small-scale sector has grown rapidly over the years.
The growth rates during the various plan periods have been very
impressive. The number of small-scale units has increased from an
estimated 0.87 million units in the year 1980-81 to over 3 million in
the year 2000.
When the performance of this sector is viewed against the
growth in the manufacturing and the industry sector as a whole, it
instills confidence in the resilience of the small-scale sector.
Year Target Achievement
1991-92 3.0 3.1
1992-93 5.0 5.6
1993-94 7.0 7.1
1994-95 9.1 10.1
1995-96 9.1 11.4
1996-97 9.1 11.3
1997-98 * 8.43
1998-99 * 7.7
1999-00 * 8.16
2000-01 (P) * 8.90
P-Projected (April-December)
* Target not fixed at constant prices
2. SSIs role in Employment
SSI Sector in India creates largest employment opportunities
for the Indian populace, next only to Agriculture. It has been
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estimated that 100,000 rupees of investment in fixed assets in the
small-scale sector generates employment for four persons.
3. Generation of Employment - Industry Group-wise
Food products industry has ranked first in generating
employment, providing employment to 0.48 million persons
(13.1%). The next two industry groups were Non-metallic mineral
products with employment of 0.45 million persons (12.2%) and
Metal products with 0.37 million persons (10.2%).
In Chemicals & chemical products, Machinery parts except
Electrical parts, Wood products, Basic Metal Industries, Paper
products & printing, Hosiery & garments, Repair services and
Rubber & plastic products, the contribution ranged from 9% to 5%,
the total contribution by these eight industry groups being 49%.
In all other industries the contribution was less than 5%.
4. Per unit employment
Per unit employment was the highest (20) in units engaged
in beverages, tobacco & tobacco products mainly due to the high
employment potential of this industry particularly in Maharashtra,
Andhra Pradesh, Rajasthan, Assam and Tamil Nadu.
Next came Cotton textile products (17), Non-metallic mineral
products (14.1), Basic metal industries (13.6) and Electrical
machinery and parts (11.2.) The lowest figure of 2.4 was in Repair
services line.
Per unit employment was the highest (10) in metropolitan
areas and lowest (5) in rural areas.
However, in Chemicals & chemical products, Non-metallic
mineral products and Basic metal industries per unit employment
was higher in rural areas as compared to metropolitan areas/urban
areas.
In urban areas highest employment per unit was in
Beverages, tobacco products (31 persons) followed by Cotton
textile products (18), Basic metal industries (13) and Non-metallic
mineral products (12).
Location-wise Employment Distribution
Rural
Non-metallic products contributed 22.7% to employment
generated in rural areas. Food Products accounted for 21.1%,
Wood Products and Chemicals and chemical products shared
between them 17.5%.
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Urban
As for urban areas, Food Products and Metal Products
almost equally shared 22.8% of employment. Machinery parts
except electrical, Non-metallic mineral products, and Chemicals &
chemical products between them accounted for 26.2% of
employment.
In metropolitan areas the leading industries were Metal
products, Machinery and parts except electrical and Paper products
& printing (total share being 33.6%).
State-wise Employment Distribution
Tamil Nadu (14.5%) made the maximum contribution to
employment.
This was followed by Maharashtra (9.7%), Uttar Pradesh (9.5%)
and West Bengal (8.5%) the total share being 27.7%.
Gujarat (7.6%), Andhra Pradesh (7.5%), Karnataka (6.7%) and
Punjab (5.6%) together accounted for another 27.4%.
Per unit employment was high - 17, 16 and 14 respectively - in
Nagaland, Sikkim and Dadra & Nagar Haveli.
It was 12 in Maharashtra, Tripura and Delhi.
Madhya Pradesh had the lowest figure of 2. In all other cases it was
around the average of 6.
Year Target
(lakh nos.)
Achievement
(lakh nos.)
Growth rate
1992-93 128.0 134.06 3.28
1993-94 133.0 139.38 3.28
1994-95 138.6 146.56 5.15
1995-96 144.4 152.61 4.13
1996-97 150.5 160.00 4.88
1997-98 165 167.20 4.50
1998-99 170.1 171.58 2.61
1999-00 175.4 177.3 3.33
P-Provisional
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5. SSIs role in Export:
SSI Sector plays a major role in India's present export
performance. 45%-50% of the Indian Exports is contributed by SSI
Sector. Direct exports from the SSI Sector account for nearly 35%
of total exports. Besides direct exports, it is estimated that small-
scale industrial units contribute around 15% to exports indirectly.
This takes place through merchant exporters, trading houses and
export houses. They may also be in the form of export orders from
large units or the production of parts and components for use for
finished exportable goods.
It would surprise many to know that non-traditional products
account for more than 95% of the SSI exports.
The exports from SSI sector have been clocking excellent
growth rates in this decade. It has been mostly fuelled by the
performance of garments, leather and gems and jewellery units
from this sector.
The product groups where the SSI sector dominates in
exports, are sports goods, readymade garments, woollen garments
and knitwear, plastic products, processed food and leather
products.
The SSI sector is reorienting its export strategy towards the
new trade regime being ushered in by the WTO
.
Year Exports (Rs. Crores)
(at current prices)
1994-95 29,068 (14.86)
1995-96 36,470 (25.50)
1996-97 39,249 (7.61)
1997-98 43946 (11.97)
1998-99 48979 (10.2)
1999-00 (P) 53975 (10.2)
P-Provisional
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These industries are also very important for welfare reasons.
People of small means can organize these industries. This in turn
increases their income levels and quality of life. As such these can
help in reducing poverty in the country. Further, these industries
tend to promote equitable distribution of income. The reasons are
obvious. One, a large proportion of income generated in these
enterprises is distributed among the workers. Two, income are
distributed among a vast number of persons throughout the
country. All these benefits flow from the fact that these industries
are highly labour-intensive, and that these can be set up anywhere
in the country. Distributive aspect of small-scale industries further
unravels their two-fold beneficial character. On the one hand, these
industries enable a vast number of people to earn income, and on
the other hand, the very people among whom these are distributed
generate this income
13.3 POLICY ISSUE AND PERFORMANCE
After independence, Indian planners and policy-makers felt
that protection was essential to the development of a strong and
indigenous economy. The Indian state played an integral role in the
industrial and economic development of the country resulting in a
dominant public sector and heavily regulated private sector.
Viewing this, the protection was also extended to SSI as it was an
important tool in employment generation, value creation and
poverty alleviation. These SSI also support entrepreneurial talent
and skills, stimulate personal savings, and help in developing
innovative and appropriate indigenous technology, providing
dynamism and contributing to competition. Over 800 products were
exclusively reserved for SSI, where some of the products produced
were purchased by government agencies. Apart form this, supply of
scarce materials, input price concessions like lower interest rates
and numerous fiscal measures such as excise duty exemptions and
other tax concessions were also given (Source-Business Today,
September 10, 2006).
Government has reserved certain products for manufacture
in the small scale sector in areas where there is techno-economic
justification for such an approach. Large/Medium units can;
however, manufacture such reserved items provided they
undertake to export 50% or more of their production. As on March
2005, the total number of items reserved for small-scale sector is
506.
In the second plan (1956-61), the SSI was given priority due
to its consequence in creation of diversified employment
opportunities and wide dispersal of industrial production. The
policies proposed then, were, and remain the main backbone of
public policy relating to the SSI. What we see however is that this
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policy has been largely unhelpful, if not detrimental to the
development of the sector. The policy regulations relating to the
SSI are such that they ensure that units stay just small.
Promotional measures aim to increase the efficiency and
economic viability of small units by providing infrastructure facilities
and improving access to markets. On the other hand, protective
measures give small units preferential treatment. Continuous
measures are those benefits which a small unit may avail of as long
as it falls under that category, while one-shot are those which may
be availed of only once, and tends to be discretionary in nature.
Most policies like preference in government purchases; lower
interest rates etc. are continuous in nature. Discretionary measures
are those, which require an examination on a case-by-case basis
and are not blanket measures available to all units, which fall under
the definition of small. Non discretionary, by implication, are those
measure which are based on some objective criteria and are
applicable to all units that meet the criteria. The government has
also provided measures such as greater infra-structural support,
more and easier availability of credit, lower rates of duty,
technology up-gradation, assistance to build entrepreneurial talent,
facilities for quality improvement, and export incentives.
The Ministry of Small Scale Industries (MoSSI) designs
policies, programmes, projects and schemes in consultation with its
organizations. It also performs the function of policy advocacy with
other Ministries/Departments of the Central Government and the
States and Union Territories. Implementation of the policies and
programmes/projects/schemes for providing various support
services to the MSEs is undertaken through its attached office,
namely, the Office of Development Commissioner (Small Scale
Industries) also known as Small Industries Development
Organisation (SIDO) and the National Small Industries Corporation
(NSIC) Ltd., a public sector undertaking of the Ministry. There are
three national level Entrepreneurship Development Institutes
supported by the Ministry viz. National Institute of Small Industry
Extension Training (NISIET), Hyderabad, National Institute of
Entrepreneurship and Small Business Development (NIESBUD),
NOIDA and Indian Institute of Entrepreneurship (IIE),Guwahati.
Financial aid for SSI
Credit is the prime input for sustained growth of SSI and its
mobilization for meeting fixed and working capital needs poses the
foremost problems. Credit provided for creation of fixed assets like
land, building, plant and machinery is called long term credit. Credit
provided for running the industry for its day-to-day requirement for
purchasing raw material and other input like electricity and water
etc. and for payment of wages and salaries is called short-term
credit or working capital.
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The Laghu Udyami (small enterprise) Credit Card Scheme
has been provided to SSI where they can credit up to Rs.10lakhs.
Apart from this, credit facilities up to maximum of Rs.25lakhs are
provided through Credit Guarantee Fund Trust in collaboration with
SIDBI and Govt. of India. Table X provides further insight into credit
related information. The SSI is provided working capital by
commercial banks and in some cases by cooperative banks and
regional rural banks. Term loans are provided by State Financial
Corporations (SFCs), Small Industries Development Corporations
(SIDCs), National Small Industries Corporation (NSIC) and National
Bank for Agriculture and Rural Development (NABARD). Financial
assistance from NSIC and to some extent from SIDCs is available
in the form of supply of machinery on hire purchase basis/deferred
payment basis. Small sized SSI and tiny units also get some term
loans from commercial banks along with working capital in the form
of composite loans. The Small Industries Development Bank of
India (SIDBI) provides refinance to these institutions. Such
refinance comprises assistance provided to State Financial
Corporation Bills, Finance Scheme, Special Capital/Seed Capital
Scheme, and new debt instruments and to National Small
Industries Corporation. Long-term loan are provided to the smalls
scale industrial units by SFCs mainly through Single Window
Scheme and National Equity Fund as also direct assistance
provided to State Financial Corporations in the form of refinance.
Some part of working capital for pre-operative expenses is also
provided by State Financial Corporations to Small Scale Industrial
Units under the Single Window Scheme.
13.4 SUMMARY:
Small industry sector has performed exceedingly well and
enabled our country to achieve a wide measure of industrial growth
and diversification. By its less capital intensive and high labor
absorption nature, SSI sector has made significant contributions to
employment generation and also to rural industrialization. Under
the changing economic scenario, SSI has both the challenges and
opportunities before them. The business can compete on cost,
quality and products at domestic and international level only if ideal
investment in technology production process, R&D and marketing
are made. Infrastructure bottlenecks are not completely solved. The
promotional activities for SSI in India need to concentrate on
improved credit flows, human resource development, appropriate
technology and funds for modernization. It may be said that the
stance is optimistic, indeed promising, given some protection. This
expectation is based on an essential feature of the Indian industry
and the demand structures. The variety in the demand structures
will ensure long-term co-existence of many layers of demand for
consumer products / technologies / processes. There will be
flourishing and well grounded markets for the same
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product/process, differentiated by quality, value added and
sophistication. This characteristic of the Indian economy will allow
complementary existence for various diverse types of units.
13.5 QUESTIONS
1. Define small scale industry. Explain the role of SSI in Indian
Economic structure.
2. Explain policy issues & performance of SSI after
independent.




















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14
INDUSTRIAL LOCATION AND
REGIONAL IMBALANCE
Unit Structure :
14.0 Objectives
14.1 Introduction
14.2 Webers theory of industrial location (The pure theory)
14.3 Regional imbalance : (Regional disparity and development
policies in India)
14.4 Policy initiatives for balanced regional growth
14.5 Globalization
14.6 Privatization
14.7 Summary
14.8 Questions
14.0 OBJECTIVES
- To study the meaning and factors influencing industrial
location.
- To Study Webers Theory of industrial location.
- To study the causes of regional imbalance
- To study the impact of Globalization and Privation on Indian
industries.
14.1 INTRODUCTION
Location of industries is influenced by economic
considerations though certain non-economic considerations also
might influence the location of some industries. Maximisation of
profit which also implies cost minimization is the most important
goal in their choice of particular places for the location of industries.
There are several factors which pull the industry to a particular
place. Some of the major factors influencing location are discussed
below:
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Factors Influencing Industrial Location
1. Availability of raw materials:
In determining the location of an industry, nearness to sources
of raw material is of vital importance. Nearness to the sources of
raw materials would reduce the cost of production of the
industry. For most of the major industries, the cost of raw
materials form the bulk of the total cost. Therefore, most of the
agro-based and forest-based industries are located in the
vicinity of the sources of raw material supply.
2. Availability of Labour:
Adequate supply of cheap and skilled labour is necessary for
and industry. The attraction of an industry towards labour
centres depends on the ratio of labour cost to the total cost of
production which Weber calls Labour cost of Index. The
availability of skilled workers in the interior parts of Bombay
region was one of the factors responsible for the initial
concentration of cotton textile industry in the region.
3. Proximity to Markets:
Access to markets is an important factor which the
entrepreneur must take into consideration. Industries producing
perishable or bulky commodities which cannot be transported
over long distance are generally located in close proximity to
markets. Industries located near the markets could be able to
reduce the costs of transport in distributing the finished product
as in the case of bread and bakery, ice, tins, cans
manufacturing, etc. Accessibility of markets is more important in
the case of industries manufacturing consumer goods rather
than producer goods.
4. Transport Facilities:
Transport facilities, generally, influence the location of industry.
The transportation with its three modes, i.e., water, road, and
rail collectively plays an important role. So the junction points of
water-ways, roadways and railways become humming centres
of industrial activity. Further, the modes and rates of transport
and transport policy of Government considerably affect the
location of industrial units. The heavy concentration of cotton
textile industry in Bombay has been due to the cheap and
excellent transportation network both in regard to raw materials
and markets.
5. Power:
Another factor influencing the location of an industry is the
availability of cheap power. Water, wind, coal, gas, oil and
electricity are the chief sources of power. Both water and wind
power were widely sought at sources of power supply before the
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invention of steam engine. During the nineteenth century,
nearness to coal-fields became the principal locating influence
on the setting up of new industries, particularly, for heavy
industries. With the introduction of other sources of power like
electricity, gas, oil, etc. the power factor became more flexible
leading to dispersal and decentralization of industries.
6. Site and Services:
Existence of public utility services, cheapness of the value of the
site, amenities attached to a particular site like level of ground,
the nature of vegetation and location of allied activities influence
the location of an industry to a certain extent. The government
has classified some areas as backward areas where the
entrepreneurs would be granted various incentives like
subsidies, or provision of finance at concessional rate, or supply
of power a cheaper rates and provision of education and
training facilities. Some entrepreneurs induced by such
incentives may come forward to locate their units in such areas.
7. Finance:
Finance is required for the setting up of an industry, for its
running, and also at the time of its expansion. The availability of
capital at cheap rates of interests and in adequate amount is a
dominating factor influencing industrial location. For instance, a
review of locational history of Indian cotton textile industry
indicates that concentration of the industry in and around
Bombay in the early days was mainly due to the presence of
rich and enterprising Parsi and Bhatia merchants, who supplied
vast financial resources.
8. Natural and Climatic Considerations:
Natural and climatic considerations include the level of ground,
topography of a region, water facilities, drainage facilities,
disposal of waste products, etc. These factors sometimes
influence the location of industries. For instance, in the case of
cotton textile industry, humid climate provides an added
advantage since the frequency of yarn breakage is low. The
humid climate of Bombay in India and Manchester in Britain
offered great scope for the development of cotton textile
industry in those centres.
9. Personal Factors:
In deciding location of industrial units, sometimes an
entrepreneur may have personal preferences and prejudices
against certain localities. For instance, Mr. Ford started to
manufacture motor cars in Detroit simply because it was his
home-town. In such cases, personal factor dominates other
considerations. However, this kind of domination is rare.
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10. Strategic Considerations:
In modern times, strategic considerations are playing a vital role
in determining industrial location. During war-time a safe
location is assuming special significance. This is because in
times of war the main targets of air attacks would be armament
and ammunition factories and industries supplying other
commodities which are required for war. The Russian
experience during the Second World War provides and
interesting example.
11. External Economies:
External economies also exert considerable influence on the
location of industries. External economies arise due to the
growth of specialized subsidiary activities when a particular
industry is mainly localized at a particular centre with port and
shipping facilities. External economies could also be enjoyed
when a large number of industrial units in the same industry
were located in close proximity to one another.
12. Miscellaneous Factors:
Historical incidents also play a dominating role in determining
the location of industries in certain cases. The development of
cotton-textile industry in Lancashire provides an interesting
example for this. Further, the size of and industrial unit would
also have much influence in choosing location. This is because
the size of industrial units depends upon the radius of the circle
within which they can profitably distribute their goods and upon
the density of population living within the circle.
14.2 WEBERS THEORY OF INDUSTRIAL LOCATION
(THE PURE THEORY)
Alfred Weber, a German economist, enunciated a systematic
theory of industrial location in 1909. Webers theory of location is
purely deductive in its approach. He analyzed the factors that
determine the location of industry and classified these factors into
two divisions. These are:
(i) Primary causes of regional distribution of industry (regional
factors)
(ii) Secondary causes (agglomerative and deglomerative factors)
that are responsible for redistribution of industry.
(i) Primary Causes (Regional Factors)
According to Weber, transport costs and labour costs are the
two regional factors on which his pure theory is based. Assuming
that there are no other factors that influence the distribution of
industry, except transportation costs. Then it is clear that the
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location of industry will be pulled to those locations which have the
lowest transportation costs. The key factors that determine
transportation costs are
(i) the weight to be transported and
(ii) the distance to be covered.
Weber lists some more factors which influence the
transportation costs such as (a) the type of transportation system
and the extent of its use, (b) the nature of the region and kinds of
roads, (c) the nature of goods themselves, i.e., the qualities which,
besides weight, determine the facility of transportation.
However, the location of the place of production must be
determined in relation to the place of consumption and to the most
advantageously located material deposits. Thus, locational figures
are created. These locational figures depends upon (a) the type of
material deposits and (b) the nature of transformation into products.
Weber classifies and calls those raw materials, which are available
practically everywhere as ubiquities (like brick-clay, water, etc) and
localised (like iron-ore, minerals, wood, etc) which are available
only in certain regions. It is clear that localized materials play a
more important role on the industry than the ubiquities. Further,
regarding the nature of the transformation of materials into
products, Weber categorized the raw materials as pure and
weight losing. Pure materials impart their total weight to the
products (eg. cotton, wool, etc) and the materials are said to be
weight losing if only a part enters into the product (eg. wood, coal,
etc.). Hence, the location of industries using weight-losing materials
is drawn towards their deposits and that of industries using pure-
materials towards the consumption centres.
Weber further examines the cause of deviation of industrial
location from the centres of least transport costs. The existence of
differences in labour costs leads an industry to deviate from the
optimal point of transport orientation. Geographical distribution of
the population would give rise to differences in wages for labour.
Naturally, the transport oriented location of an industry is drawn out
and attracted towards the cheaper labour centres. Such migration
of an industry from a point of minimum transport costs to a cheaper
labour centre may be likely to occur only where the savings in the
cost of labour are larger than the additional costs of transport which
it ought to incur.
(ii) Secondary Causes (Agglomerative and Deglomerative
Factors)
An agglomerative factor is an advantage or a cheapening of
production or marketing which results from the fact that production
is carried on at one place. A deglomerative factor is a cheapening
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of production which results from the decentralization of production
i.e., production in more than one place. To some extent these
agglomerative and deglomerative factors also contribute to local
accumulation and distribution of industry. These factors will operate
only within the general framework formed by the two regional
factors, i.e., costs of transportation and costs of labour. The
advantages which could be derived in this context are external
economies.
The pulls which the agglomerative factors possess to attract
an industry to a particular point are mainly dependent on two
factors. Firstly, on the index of manufacture (the proportion of
manufacturing costs to the total weight of the product) and
secondly, on the locational weight (the total weight to be
transported during all the stages of production). To deduce a
general principle, Weber uses the concept of co-efficient of
manufacture which is the ratio of manufacturing cost to locational
weight. Agglomeration is encouraged with high co-efficient of
manufacture and deglomeration with low co-efficient of
manufacture and these tendencies are inherent in their nature.
Split Location:
Productive activities could be divided depending on the
nature of raw-materials, industry and market. Weber considers the
location for an industry at more than one place. According to
Weber, a split of production into several locations will be the rule for
productive process which can technically be split. For instance, the
first stage of production may be near the raw material deposits and
the subsequent stages near the place of final consumption.
Likewise, in a paper industry the manufacture of pulp may be
carried on near the supplies of the raw materials and the second
stage of paper manufacture near the consumption outlet.
Locational Coupling:
Weber also conceived the advantages of setting up different
types of industries in the same locality. The production of quite
different articles may be combined in one plant because several
raw materials may diverge from a common source. This may be
either due to technical or economic reasons: for instance, certain
chemical industries, garments factories which manufacture over-
coats, shawls, blouses, etc. Locational coupling may also occur due
to connection through materials. If the by-product of an industry
happens to be the raw material of another industry, then the two
industries may select a single place of location. For instance, the
dye-stuff industry is connected with other industries using coke,
because coal tar (upon which the dye-stuff industry is based) is a
by-product of the burning coke.
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Criticisms:
Webers theory of location has been criticized on various
grounds which may be summarized as follows:
1. Weber has been criticized for his unrealistic approach and
deductive reasoning. According to Sargant Florence, vague
generalizations cannot provide suitable solutions to the theory of
location as non-economic considerations will also influence which
are not mentioned in the pure theory. He says that Webers theory
fails to explain locations resulting from historical and social forces.
2. A.Predohl criticizes Webers theory as more a selective theory
than a deductive theory. The very distinction between primary and
secondary is itself artificial, illogical and arbitrary.
3. Weber assumes fixed labour centres and unlimited supplies of
labour which are unrealistic. The rise of industry may create new
labour centres and we cannot assume unlimited labour supplies at
any centre.
4. In a competitive market structure, the assumption of fixed points
of consumption is unrealistic. Country-wise scattering, usually, of
consuming public is a reality and there may be a shift in the
consuming centres with a shift in industrial population.
5. A. Robinson also considers Webers division of raw materials
into ubiquities and localised as artificial.
Webers deductive theory of location, in spite of the
shortcomings, is the only theory which has been neither enjoying
the universal acceptance and application, as all the other
alternative suggestions are neither complete nor comprehensive.
14.3 REGIONAL IMBALANCE: (Regional disparity and
development policies in India)
I) Post-Independence Period:
Governments economic policies during the colonial period
were more to protect the interests of the British economy rather
than for advancing the welfare of the Indians. The primary
concerns of the Government were law and order, tax collection and
defence. As for development, Government adopted a basically
laissez-faire attitude. Of course, railways, irrigation systems, road
network and modern education system were developed during this
period. Railways and road network were more to facilitate
movements of goods and defence personnel and to facilitate better
administrative control. Irrigation canal system was mainly to fight
repeated droughts and famines and to boost land revenue.
170
Education, to begin with, was developed mainly to train lower-
ranking functionaries for the colonial administration.
Particularly lacking was a sustained positive policy to
promote indigenous industry. Indeed, it is widely believed that
government policies, far from encouraging development, were
responsible for the decline and disappearance of much of Indias
traditional industry.
Altogether, the pre-independence period was a period of
near stagnation for the Indian economy. The growth of aggregate
real output during the first half of the twentieth century is estimated
at less than two per cent per year, and per capita output by half of a
per cent a year or less.
There was hardly any change in the structure of production
or in productivity levels. The growth of modern manufacturing was
probably neutralised by the displacement of traditional crafts, and in
any case, was too small to make a difference to the overall picture.
Along with an impoverished economy, independent India
also inherited some useful assets in the form of a national transport
system, an administrative apparatus in working order, a shelf of
concrete development projects and a comfortable level of foreign
exchange. While it is arguable whether the administrative
apparatus built by the British helped or hindered development since
1947, there is little doubt that its existence was a great help in
coping with the massive problems in the wake of independence
such as restoring civil order, organising relief and rehabilitation for
millions of refugees and integrating the Princely States to the
Union.
The development projects initiated in 1944 as a part of the
Post-war Reconstruction Programme was of particular value to
Independent Indias first government. Under the guidance of the
Planning and Development Department created by the Central
Government, a great deal of useful work was done before
Independence to outline the broad strategy and policies for
developing major sectors and to translate them into programmes
and projects. By the time of Independence several of these were
already under way or ready to be taken up. They included
programmes and projects in agriculture, irrigation, fertilizer,
railways, newsprint and so on. Though the first Five Year Plan
began in 1950-51, with the establishment of Planning Commission,
a well-rounded planning framework was in place only with the
second Five Year Plan after five years. By and large, the basis of
the first Five Year Plan was the groundwork done before
independence. Most of the principal projects were continuations
and major efforts were made to complete them early.
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II. Recent Trends
Regional disparities are the result of our unfinished task of
nation building. These reflect essentially the inadequacies of the
development strategy followed since independence and its failure
to correct the distortions brought about by colonial rule. Of late,
these tensions have acquired alarming proportions and are
threatening to strike at the very roots of the nation state. This has
brought to sharp focus the need of better understanding of the
pattern of regionalization, the nature of regional imbalances and
their changing structure over time.
Hence, balanced regional development is necessary for the
harmonious growth of federal state like India, however, presents a
picture of wide regional variations, in terms of per capita income,
proportion of population living below the poverty line, working
population in agriculture, the percentage of urban population over
total population, etc.
To study the regional imbalance, the 15 major states of India
have been classified into two major groups
Imbalance in per capita :
172
Since, per capita income shows the average annual
earnings of a single person in a particular region. It can be treated
as an indicator for regional development. As the past record shows
that the Punjab topped the list as it had the highest per capita
income in 1990-91 and Orissa was at bottom. In 2002-03,
Maharashtra was at top and Bihar was at bottom on the basis of
per capita income. However, this list was again changed in 2005-
06, Haryana was at top and Bihar was at bottom on the basis of per
capita income. This implies that the backward states with very large
population share U.P., Bihar and Madhya Pradesh acted as a
drag on the growth process of the Indian Economy.
Indian economy has experienced an average annual growth
rate of around 6 per cent during the last two decades. Though,
moderate compared to the performance of several east Asian
economies during the same period, this was quite impressive
compared to the performance of Indian economy during the
preceding three decades when the average growth logged 3.5 per
cent per annum. Even the growth rate of 3.5 per cent experienced
during the first three decades of the republic had been
spectacularly better that the virtual stagnation of the Indian
economy during the first half of the Twentieth Century. In terms of
per capita income, the improvement has been even more
remarkable - around 4 per cent per annum in the recent period as
compared to less than 1.5 per cent in the earlier period. Further,
during the recent period, there has been a steady acceleration in
the growth performance over the years. The average compound
growth per annum was 5.7 per cent during the Sixth Five Year Plan
(1980-85), 6.0 per cent during the Seventh Plan (1985-90) and 6.6
per cent during the Eighth Plan (1992-97). While the growth rate
dropped to 3.1 per cent during the two-year period 1990-92 in the
wake of international payment crisis and the introduction of major
economic reforms, the growth process picked up fast in the
subsequent years. Indeed, the growth averaged about 7.5 per cent
during the three-year period ending 1996-97, which is impressive
by any standards. The growth rate has been somewhat lower in
the subsequent three years. In contrast to stagnation/negative
growth of most of the East Asian economies Indias performance,
however, is remarkable. The World Bank and other international
agencies have characterized India as one of the fastest growing
economies of the world.
As is to be expected, improvement in economic growth and
per capita income translated, at least partly, into reduction in the
level of poverty in the country. Though there are differences in the
estimates of the percentage of the poor by different sources, all
agree that there has been a secular decline in the share of poor in
the population since the late Seventies. The official estimates of
population below poverty line released by the Planning Commission
173
on the basis of the Expert Group methodology indicate this secular
downward trend:
Year 1977-78 1983 1987-88 1993-94 1999-2000
Percentage
of poor
51.3 44.5 38.9 36.0 26.10
The last two decades had seen the introduction/expansion of
several anti-poverty programmes and public intervention policies in
favour of the poor including public distribution of subsidized food
grains. The reduction in poverty in the recent period is attributed to
anti-poverty programmes by their protagonists and to accelerated
economic growth by market friendly experts.
Along with faster economic growth and reduction in poverty,
there has been accelerated improvement in various indicators of
human development since the early Eighties whether it is in the
case of demographic characteristics or social development
indicators. During the last two decades, the country has made
major strides in health and education sectors. The economy got
diversified significantly and the share of the service sector in
employment and incomes improved considerably. While there is a
broad consensus on the overall improvement of the economy and
quality of life during the period under consideration, there are
significantly differing perceptions about the distributional impacts of
these gains.
Disparities in economic and social development across the
regions and intra-regional disparities among different segments of
the society have been the major planks for adopting planning
process in India since independence. Apart from massive
investments in backward regions, various public policies directed at
encouraging private investments in such regions have been
pursued during the first three decades of planned development.
While efforts to reduce regional disparities were not lacking,
achievements were not often commensurate with these efforts.
Considerable level of regional disparities remained at the end of the
Seventies. The accelerated economic growth since the early
Eighties appears to have aggravated regional disparities. The on-
going economic reforms since 1991 with stabilisation and
deregulation policies as their central pieces seem to have further
widened the regional disparities. The seriousness of the emerging
acute regional imbalances has not yet received the public attention
it deserves.
Most of the studies on inter-country and inter-regional
differences in levels of living and income are done within the
theoretical framework of neoclassical growth models. These
174
models, under plausible assumptions demonstrate convergence of
incomes. Three notable recent studies
3
, however, indicate that in
the Indian context these convergence theories do not explain the
ground realities.
The scope of analysis in this section is restricted to a
comparative analysis of the emerging trends in fifteen major States
4
in respect of a few key parameters which have an intrinsic bearing
on social and economic development. The variables chosen for
examination include those which have a bearing on gender and
equity issues. The fifteen States together account for 95.5 per cent
of the population of India. The remaining 4.5 per cent of the
population is spread out in 10 smaller States and seven Union
Territories including the National Capital Territory of Delhi. Leaving
out these States and UTs from detailed study is mainly due to non-
availability of all relevant data and also to keep the data sets
analytically and logistically manageable. The fifteen States taken up
for the detailed study have been grouped into two - a forward group
and a backward group. The forward group consists of Andhra
Pradesh, Gujarat, Haryana, Karnataka, Kerala, Maharashtra,
Punjab and Tamil Nadu. The backward group comprises of Assam,
Bihar, Madhya Pradesh, Orissa, Rajasthan, Uttar Pradesh and
West Bengal.
Geographically, the forward group of States fall in the
Western and Southern parts of the country and are contiguous
except for Punjab and Haryana which are separated by Rajasthan
from the rest of the States in this group. The group of backward
States are in the Eastern and Northern parts of the country and are
geographically contiguous. Another notable geographical feature is
that while six out of eight States, except Haryana and Punjab, in the
first group have vast sea coasts, only two out of the seven in the
second group viz., Orissa and West Bengal are littoral. While the
forward group of States account for about 40.4 per cent of the
national population, the backward group accounts for as much as
55.1 per cent of the population of the country according to 2001
census
5.
In terms of natural resources including mineral wealth,
water resources and quality of soil, the latter has definite edge over
the former.
A limitation of inter-regional analysis using States as units is
the fact that this may not be able to capture the significant intra-
State disparities in economic and social development, which exists
today. The larger States in both the groups have regions within
themselves, which are vastly different in terms of various indicators
of development. There are identifiable distinct regions, at different
stages of development, in several States. After discussing the
inter-regional disparities in development, treating States as units,
we will take up intra-State disparities for a brief analysis in the latter
part of the present study.
175
14.4 POLICY INITIATIVES FOR BALANCED
REGIONAL GROWTH
We shall initiate the discussion on initiatives for balanced
regional growth by illustrating two instances of initiatives in the past.
One relates to agriculture and the other relates to industry, the two
most important sectors of our economy. The strategy to boost
agricultural production and to ensure food security was evolved in
the mid-Sixties when the country faced a grim situation following
two consequent years of severe draught. The strategy consisted of
various incentives to farmers to adopt high yielding seeds of wheat
and paddy along with complimentary inputs, assured minimum
support prices for the output, buffer stocking of the foodgrains and
supplying the same to the States to distribute through the public
distribution system (PDS) to the consumers, especially in the deficit
regions. To back up this strategy, institutions like Agricultural
Prices Commission (APC), Food Corporation of India (FCI) and
Warehousing Corporation of India and other ancillary institutions
were established. Arrangements were made to spread the
message of high yielding seeds and the associated package of
inputs and practices.
The above strategy ushered in a green revolution, which
resulted in doubling of wheat and rice production in the country
over a short period. Adequate foodgrains surpluses were
generated to build up the needed buffer stock. India was no more a
basket case.
The initial success of green revolution strategy was
restricted to Punjab, Haryana and western Uttar Pradesh where
assured irrigation networks already existed. Subsequently it was
extended to a few irrigation commands in the South and West also.
It was, however, expected that with the expansion of assured
irrigation the green revolution would spread to other parts of the
country soon. In the event this did not happen. Even today almost
the entire foodgrain surpluses are generated by the small region,
which benefited initially. Though massive public funds are spent on
food subsidies, very little is spent on spreading irrigation. Besides
food subsidies, large implicit subsidies to farmers for power, diesel,
canal irrigation, fertilizer and credit are born by public exchequer at
the Centre and in the States.
Agricultural Price Policy which was evolved by APC to
ensure adequate protection to the interests of the producers and
consumers has been high-jacked to serve the interests of the large
farmers who produce for the market. It hardly serves the interests
of farmers in the emerging surplus regions. The distinction
between support price and procurement price is no more there.
176
Similarly, the Food Corporation of India and the associated
procurement agencies operate, by and large, only in the traditional
surplus regions and farmers in newly emerging surplus regions
almost invariably end up selling their surpluses in distress.
Today the foodgrain management and the food security
system is near collapse. As against a total requirement of 24
million tonnes of foodgrain for buffer stock and PDS together, the
public stock is over 60 million tones as on July 1,2001. A
substantial share of this is not even properly stored and may not be
suitable for human consumption. On the other hand due to severe
drought conditions large scale unemployment and hunger are
reported from several States. Per capita net availability in the
market has come down. PDS system has virtually collapsed. Poor
people cannot afford the so called economic price of foodgrains
available in the PDS shops.
The economic liberalization policy initiated since the early
1991 has made large-scale delicensing of industry and changes in
the industrial location policies, and thus, curtailed the role of the
state as industrial owner and location regulator. With the increasing
dominance of private sector in industrialization under liberalization it
is expected that industries will be more spatially concentrated in the
leading industrial regions. However, the neoclassical principle
suggests that in the long run "divergence is followed by
convergence". This is in contrast with the theory that raises the
question about the regional industrial development in India under
the two policy regimes.
Industrial undertakings are free to select the location of a
project. In the case of cities with population of more than a million
(as per the 1991 census), however, the proposed location should
be at least 25 KM away from the Standard Urban Area limits of that
city unless, it is to be located in an area designated as an
industrial area before the 25th July, 1991. (List of cities with
population of 1 million and above is given at Annexure-V).
Electronics, Computer software and Printing (and any other
industry which may be notified in future as non polluting industry)
are exempt from such location restriction. Relaxation in the
aforesaid location restriction is possible if an industrial license is
obtained as per the notified procedure.
The location of industrial units is further regulated by the
local zoning and land use regulations as also the environmental
regulations. Hence, even if the requirement of the location policy
stated in paragraph 1.3 is fulfilled, if the local zoning and land use
regulations of a State Government, or the regulations of the
Ministry of Environment do not permit setting up of an industry at a
location, the entrepreneur would be required to abide by that
decision.
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Liberalisation of the Location Policy A significantly amended
locational policy in tune with the liberlised licensing policy is in
place. No industrial approval is required from the Government for
locations not falling within 25 kms of the periphery of cities having a
population of more than one million except for those industries
where industrial licensing is compulsory. Non-polluting industries
such as electronics, computer software and printing can be located
within 25 kms of the periphery of cities with more than one million
population. Permission to other industries is granted in such
locations only if they are located in an industrial area so designated
prior to 25.7.91. Zoning and land use regulations as well as
environmental legislations have to be followed.
Policy for Small Scale A differential investment limit has been
adopted since 9th October 2001 for 41 reserved items where the
investment limit upto rupees five crore is prescribed for qualifying
as a small scale unit. The investment limit for tiny units is Rs. 25
lakhs.
749 items are reserved for manufacture in the small scale sector.
All undertakings other than the small scale industrial undertakings
engaged in the manufacture of items reserved for manufacture in
the small scale sector are required to obtain an industrial licence
and undertake an export obligation of 50% of the annual
production. This condition of licensing is, however, not applicable to
those undertakings operating under 100% Export Oriented
Undertakings Scheme, the Export Processing Zone (EPZ) or the
Special Economic Zone Schemes (SEZs).
Non-Resident Indians Scheme
The general policy and facilities for Foreign Direct
Investment as available to foreign investors/company are fully
applicable to NRIs as well. In addition, Government has extended
some concessions specially for NRIs and overseas corporate
bodies having more than 60% stake by the NRIs. These inter-alia
includes (i) NRI/OCB investment in the real estate and housing
sectors upto 100% and (ii) NRI/OCB investment in domestic airlines
sector upto 100%.NRI/OCBs are also allowed to invest upto 100%
equity on non-repatriation basis in all activities except for a small
negative list. Apart from this, NRI/OCBs are also allowed to invest
on repatriation/non-repatriation under the portfolio investment
scheme.
Electronic Hardware Technology Park (EHTP)/Software
Technology Park (STP) scheme for building up strong electronics
industry and with a view to enhancing export, two schemes viz.
Electronic Hardware Technology Park (EHTP) and Software
Technology Park (STP) are in operation. Under EHTP/STP
scheme, the inputs are allowed to be procured free of duties.
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The Directors of STPs have powers to approved fresh STP/EHTP
proposals and also grand post-approval amendment in repsect of
EHTP/STP projects as have been given to the Development
Commissioners of Export Processing Zones in the case of Export
Oriented Units. All other application for setting up projects under
these schemes, are considered by the Inter-Ministerial Standing
Committee (IMSC) Chaired by Secretary (Information Technology).
The IMSC is serviced by the SIA.
Policy for Foreign Direct Investment (FDI)The Department has
put in place a liberal and transparent foreign investment regime
where most activities are opened to foreign investment on
automatic route without any limit on the extent of foreign ownership.
Some of the recent initiatives taken to further liberalise the FDI
regime, inter alia, include opening up of sectors such as Insurance
(upto 26%); development of integrated townships (upto 100%);
defence industry (upto 26%); tea plantation (utp 100% subject to
divestment of 26% within five years to FDI); Encenhancement of
FDI limits in private sector banking, allowing FDI up to 100% under
the automatic route for most manufacturing activities in SEZs;
opening up B2B e-commerce; Internet Service Providers (ISPs)
without Gateways; electronic mail and voice mail to 100% foreign
investment subject to 26% divestment condition; etc.
14.5 GLOBALIZATION
One of the most significant changes in the world economy
over the past two decades has been a growing globalization of
markets and industries. Numerous forces have contributed to rising
globalization, including reductions in multilateral and regional trade
barriers, reduced costs of international transport and
communications and reform and greater global integration of capital
markets. The ongoing consequences of globalization include
widespread industry rationalization and heightened competition at
national, regional, and global levels as evidenced by significantly
higher levels of foreign competition and increases in both cross-
border mergers and acquisitions and the number of multinational
firms.1 Increasing vertical linkages, as production activities become
more specialized and spatially dispersed,2 have complemented the
growing horizontal linkages among nations. The ongoing processes
of globalization, particularly changes in the competitive conditions
facing firms as markets and industries globalize, are significant
economic phenomena that can, like other phenomena that change
a firms business and competitive conditions, be expected to induce
changes in corporate strategy. Such influences may in particular
impact a firms international diversification strategy, defined as the
decision to expand
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Definition: Though the precise definition of globalisation is still
unavailable a few definitions worth viewing, Stephen Gill: defines
globalisation as the reduction of transaction cost of transborder
movements of capital and goods thus of factors of production and
goods. Guy Brainbant: says that the process of globalisation not
only includes opening up of world trade, development of advanced
means of communication, internationalisation of financial markets,
growing importance of MNC's, population migrations and more
generally increased mobility of persons, goods, capital, data and
ideas but also infections, diseases and pollution
Globalization and competition:
1) The causes of increased global trade include:
Economic growth itself which both creates ever increasing
demand for imports and also increases the capacity of
economies to produce exports; it also generates greater
amounts of savings which may be invested domestically and
internationally to meet the greater investment demands
associated with economic growth.
Technological innovation. This pervades most fields of
economic activity but is especially great in the areas of
information and communication technology. A sector
particularly affected by technological growth in these areas is
the financial services sector which, in turn, facilitates higher
degrees of financial and economic interaction between
economies in different countries.
Falling transport costs.
International, as well as domestic, liberalisation of trade,
investment and economic activity generally.
It is important to note that the European Union has been
particularly active in trying to promote a global approach to
competition policy and in promoting the inclusion of competition
issues in the next round of trade negotiations at the WTO.
2) Global Cartels
Global cartels, that is, cartels organised on an international
scale, have been in existence since the beginnings of international
trade. There is a long history of cartels, in particular, during the
nineteenth and early parts of the twentieth century. Indeed, in 1907
an important US Antitrust case sought to end the tobacco cartel
which had divided up world markets between British producers,
who controlled the UK; US producers, who controlled the US; and
the rest of the world, which was divided up and allocated to either
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British or American producers who agreed not to compete in one
another's markets.
3) Global mergers:
In recent times there has been a spectacular increase in the
extent of international merger activity, in one sector after another
finance, communications, oil, airlines, pharmaceuticals, automotive
professional services and so on. For the most part, these mergers
are not anticompetitive and pose no major challenge to the global
economy's major competitiveness. Indeed, in many cases, they
enhance competitiveness and improve economic efficiency by
creating more efficient arrangements for international business
transactions.
4) Globalizations facilitated by rapid advances in technology,
are creating new dynamics of competition and, in so doing, render
the determinants of competitiveness much more complex. As
already established in the preceding discussion, greater efficiency
is the source of competitiveness. In the context of international
trade, competitiveness is traditionally defined in terms of exchange
rates, costs and prices. Nowadays a distinction is drawn between
static competitiveness and dynamic competitiveness.2 In the
former, the emphasis is on price competition whereby firms
compete on the basis of received endowments such as low-cost
labour and natural resources. Under these circumstances, retaining
competitiveness is dependent on maintaining or lowering
production costs. This is the basis on which many developing
country firms compete. Dynamic competitiveness is associated with
the changing nature of competition, which places a premium not
only on the relationship between costs and prices but also on firm-
level ability to learn, rapidly adjust to new market conditions and
innovate (where innovation is defined in the broadest terms and is
not necessarily confined to radical technological innovation).3 In
this framework, competitiveness refers to the ability of firms to
produce goods and services that stand the test of international
competition, while upgrading technological capabilities.
5) With globalization and liberalization, the boundaries between
national and international markets have become blurred, traditional
distinctions between national and international competitiveness
thus becoming redundant. This blurring of boundaries has
implications particularly for small and medium-sized enterprises
(SMEs), which were previously insulated from international
competition by national borders. A lack of finance and insufficient
technological capabilities limit the ability of even firms that were
domestically competitive prior to liberalization to respond to
competition that cuts too quickly into their market share. In
underdeveloped markets with few participants, technological
learning can be extremely risky and expensive for the individual
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firm and is often not undertaken in the absence of supporting
policies to facilitate their adjustment.
6) A notable feature of the changing nature of competition is a
radical alteration in the organization of firms as well as the
organization of production, marketing and distribution of goods and
services at the international and national levels. In order to adapt
and remain competitive firms are exploiting externalities or
knowledge spillovers through inter-firm cooperation. Access to
and possession of knowledge, in addition to technical hardware,
has become an important asset for global producers. Networking
and being part of a production network is an increasingly important
way in which firms get to know-what, know-how, know-why and
know-who in their particular line of business. The importance of
innovation, and its research and development costs, has given rise
to the duality of cooperation and competition.
7) An increasingly significant form of inter-firm cooperation and
coping mechanism utilized by firms in the face of the new
competition is mergers and acquisitions. Globalization, capital
market pressures, the evolution of technical infrastructure required
to support networking and the advent of the Internet have
precipitated global industry consolidation. Among the industries in
which this trend towards consolidation is documented are banking
and financial services, cigarettes, petroleum products, airlines,
telecommunications, chemicals, sport shoes, beverages,
automobile production and food services. According to a recent
study on the phenomenon,5 at the end of the various stages of
consolidation, the three largest market participants will typically
have captured 7080 per cent of the market.
8) Although high concentration does not necessarily equate
with a lack of competition and need not have a negative impact on
economic performance, it does facilitate the exercise of market
power and anti-competitive behaviour.6 The duality between
cooperation and competition is not only a justification for countries
to develop and enforce competition policies, but it also demands
increased vigilance and sophistication on the part of competition
policy enforcement authorities to ensure that cooperation does not
lend itself to anticompetitive behaviour by merged or networked
firms, care being taken at the same time not to stifle innovation and,
in so doing, competition and competitiveness.
14.6 PRIVATIZATION
The term "privatization" also has been used to describe two
unrelated transactions. The first is a buyout, by the majority owner,
of all shares of a public corporation or holding company's stock,
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privatizing a publicly traded stock, and often described as private
equity. The second is a demutualization of a mutual organization or
cooperative to form a joint stock company.
Privatization is frequently associated with industrial or
service-oriented enterprises, such as mining, manufacturing or
power generation, but it can also apply to any asset, such as land,
roads, or even rights to water. In recent years, government services
such as health, sanitation, and education have been particularly
targeted for privatization in many countries.
Privatization is the incidence or process of transferring ownership
of a business, enterprise, agency or public service from the public
sector (the state or government) to the private sector (businesses
that operate for a private profit) or to private non-profit
organizations. In a broader sense, privatization refers to transfer of
any government function to the private sector - including
governmental functions like revenue collection and law
enforcement.
In theory, privatization helps establish a "free market", as
well as fostering capitalist competition, which its supporters argue
will give the public greater choice at a competitive price.
Conversely, socialists view privatization negatively, arguing that
entrusting private businesses with control of essential services
reduces the public's control over them and leads to excessive cost
cutting in order to achieve profit and a resulting poor quality service.
In general, nationalization was common during the immediate post-
World War 2 period, but privatization became a more dominant
economic trend (especially within the United States and the United
Kingdom) during the 1980s and '90s. This trend of privatization has
often been characterized as part of a "global wave" of neoliberal
policies, and some observers argue that this was greatly influenced
by the policies of Reagan and Thatcher. The term "privatization"
was coined in 1948 and is thought to have been popularized by The
Economist during the '80s.
Indian scenario:
1) The process of privatization in India is linked with the economic
reforms launched in 1991. The trigger for the reforms was a
severe financial crisis the government faced. Caused by the
profligate external borrowing of the eighties and the 1991 Gulf
crisis, a severe shortage of foreign exchange led to a situation
where basic petroleum supplies could not be obtained. Under
pressure from the World Bank and the International Monetary
Fund (IMF), the government agreed to several macroeconomic
reforms. At that time it was realized that a process of
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microeconomic reforms could be implemented. Several of these
ended the policy of trade and industrial licensing that the
licence raj had been built on. These opened up the Indian
industry to the forces of entrepreneurship and competition, and
made Indian markets contestable. The entry by private
enterprises into sectors that were reserved for the state or
where the state had a significant presence could, therefore,
create competitive pressures on existing state-owned units to
perform better, or through a process of atrophy reduce the
proportion of overall low performing units in Indian industry as a
whole.
2) With respect to the issue of privatization, the government
recognized the need, from a fiscal perspective, of superior
performance from the public sector. State-owned enterprises
were an economic deadweight, causing substantial losses to the
economy. The main activities during the reforms process were
that of de-licensing and removal of controls. These activities
required notification processes to be undertaken, and these to
be undertaken by the ministries concerned, rather than the
undertaking of several operational activities required to actually
implement procedural changes in government departments or
agencies. Institutional competence extended to the drafting of
resolutions, but not to the myriad operational tasks that would
normally accompany the re-structuring of processes and
procedures or the sale of assets.
3) In accordance with this approach, the public-sector reforms
were initially based on what I term a strategy of notification, this
being a relatively easy and painless activity to perform relative
to the much harder to perform privatization activity with its
various operational tasks and requirements. Before the reforms
were launched in 1991, 17 specific areas of activity were
exclusively reserved for the public sector. The reforms of 1991
reduced the number of exclusive areas reserved for the public
sector to eight, which were: arms, ammunition, defence
equipment, including aircraft and warships; atomic energy; coal
and lignite; mineral oils; mining of ferrous and certain non-
ferrous metals, gold and diamonds; atomic mineral; and railway
transport. In 2002, this list has been subsequently brought down
to three sectors: atomic energy; atomic minerals; and railway
transport. This opening up of industry segments would energize
the private sector and lead to the entry of new firms.
4) Several actual privatizations were anticipated.10 Nevertheless,
in the period 199192 to 199798, the pace of privatization of
government-sector enterprises in India has been extremely
slow. Unlike, say, the privatization process in the United
Kingdom, in which majority stakes in state enterprises were sold
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outright in a short time, small minority stakes were sold in Indian
companies. Data from the Department of Disinvestment show
that in the early years of the reforms process, the years 1991
92 and 199293, minority stakes in 47 and 35 companies were
sold. In all of the subsequent later years to 199798, minority
stakes in just 20 companies were sold. Of the targeted receipts
of almost Rs 30,000 crore from privatization, the actual receipts
from privatization amounted to Rs 11,000 crore in the entire
period. These were extremely trivial amounts.
5) The amounts raised via privatization are extremely small when
viewed against the average book value of investments of, say,
Rs 200,000 crore in the central sector enterprises in that same
overall period. The receipts from the privatization of the
enterprises owned by the governments of the various states of
the Indian union, in which approximately over Rs 250,000 crore
have been sunk, has been nil and on the other hand, a number
of these enterprises have been closed down with the
governments making separation payments to the staff involved.
The sums received are hardly likely to make more than a tiny
hole in the fence that runs around the boundaries of the
involvement of the state in Indian industry, or for that matter, in
the fiscal deficit.
6) Thus, a reasonably easy conclusion to draw is that the quantum
of privatization in India has been so negligible as to be non-
existent. This, in part, may reflect the ambivalence of the then
prime minister, the late Mr P.V. Narasimha Rao, towards
privatization. Das writes that: He was against privatization of the
public sector because of his deep faith in Nehrus mixed
economy. You dont strangulate a child to whom you have
given birth, he said. However, he sought to improve the public
sectors performance by introducing competition from the private
sector. (Das 2002: 223)
7) If privatization has been negligible and inconsequential, are the
boundaries of the state in Indian industry shrinking at least
because of private-sector enterprise growth, or do they still
remain as they were? In the next section, the DCA data that are
used to address this issue are described. The results of the
analyses are reported on in subsequent sections.
14.7 SUMMARY
1) The economic reforms initiated in 1991 were also essentially
crisis driven. It was the international payment crisis which
forced the country to carry out deregulation of trade and
industry. Again, once the crisis was overcome reforms also
slowed down. There are several vital areas of reforms, which
we have been talking about for the last one decade without
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doing muchpublic sector reforms, reform of labour laws,
reform of the legal system, establishment of effective regulatory
bodies and so on. Again, it is the politicians, the bureaucrats,
the Deshi industrialists and the trade union leaders who are
standing in the way. They do not want to give up the powers,
perks and monopoly profits, which they have been enjoying.
2) The main interest of the foreigners in India is its large potential
market. Unless the rural incomes grow, especially in the
backward regions this potential market will not be realized.
Corporate India must realize that its future lies with the masses.
Raising rural incomes should no longer be looked upon only as
a philanthropic objective.
3) Also reduction of regional disparities should be looked upon as
a national objective. The strength of a building depends on the
strength of its weakest pillar. In a similar way the strength of the
Indian economy depends on the strength of the economy of
Bihar. Similarly, the bottomline of Indias human development
will depend on the incomes and socio-demogrpahic indicators of
development in northern and eastern India.
4) While the development of depressed regions is a national
responsibility, the solution mainly rests with the local leadership.
Unless the local leadershippolitical, bureaucratic and
intellectualresolve to usher in development based on sharing
the gains on egalitarian basis with the masses, results will be
hard to come by. Resources are not the real constraint. It is the
way resources are spent. Large sums are spent on education
and health care in the backward States. But the results are not
there. This happens because the teachers and medical
personnel who are expected to provide the requisite services
draw their salaries but provide poor services or no services.
Unless this kind of work culture in public services changes,
funds alone will not solve the problems.
5) Industrial growth is essential for raising the economic growth in
a country like India. However, the regional variation in the
industrial development is one of the primary causes of the
regional disparities in India. The findings show that the post
liberalization period has witnessed more concentration of
manufacturing industries, which suggests widening the inter-
regional divergence in India in terms of industrial development
in the post liberalization period. The Southern region has gained
employment shares over the years at the cost of the Eastern
region and to some extent Central region. At the states level,
the share of West Bangle and Maharashtra has declined
significantly, while that of Andhra Pradesh and Tamil Nadu has
increased. Considering the degree of diversification it if found
that Central and Southern regions have become more
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diversified, while Eastern and Northwest regions become less
diversified over the years. It is observed that the nature of
specialization varies with the degree of diversification. The less
diversified states, in general, specialized in a set of consumer
goods industries, while the middle level diversified and
diversified states are specialized in intermediate goods and
capital goods industries. Further, it show that the less diversified
states remain in the same relative ranks over the years, while
changes have taken place in the relative ranks of the middle
level diversified and diversified states. On the whole it
concludes that India is diverging, not converging in terms of
inter-regional distribution of manufacturing industries in the post
liberalization period. The tendency to catch up the industrially
developed states is hardly seen among the backward states.
Thus, we can say that the regional development of industries in
India in the post liberalization period follows the classic virtuous
cycle principles.
14.8 QUESTIONS
1. Explain the factors influencing Industrial location.
2. Critically examine the Webers Theory of Industrial location.
3. Discuss the causes of regional imbalances in India.
4. Explain the Policy initiatives by the government for balanced
regional growth in India.
5. Discuss the impact of Globalization and Privatization on Indian
industries.