National Institute of

Business Management
Master of Business
Administration (MBA)
Managerial Economics
 CONTENTS

Chapter Title Page No.

I INTRODUCTION 5

II OBJECTIVES OF BUSINESS FIRMS 11

III ANALYSIS OF INDIVIDUAL DEMAND 16

IV ANALYSIS OF MARKET DEMAND AND

DEMAND ELASTICITIES 23

V DEMAND FORECASTING 30

VI THEORY OF PRODUCTION 35

VII THEORY OF COST AND BREAK-EVEN

ANALYSIS 40

VIII MARKET STRUCTURE AND PRICING

DECISIONS 45

IX CAPITAL BUDGETING AND

INVESTMENT UNDER CERTAINTY 57

X INVESTMENT DECISIONS UNDER RISK

AND UNCERTAINTY 63

XI NATIONAL INCOME:
CONCEPT AND MEASUREMENT 66

XII BUSINESS CYCLES AND STABILIZATION 72

 CHAPTER – I

INTRODUCTION

OBJECTIVE

Managerial economics (also called business economics), is a branch of economics that applies
microeconomic analysis to specific business decisions. As such, it bridges economic theory and economics in
practice. It draws heavily from quantitative techniques such as regression and correlation, Lagrangian calcu-
lus, [[linear If there is a unifying theme that runs through most of managerial economics it is the attempt to
optimize business decisions given the firm’s objectives and given constraints imposed by scarcity.

Almost any business decision can be analyzed with managerial economics techniques, but it is most
commonly applied to:

• Risk analysis - various uncertainty models, decision rules, and risk quantification techniques are
used to assess the riskiness of a decision.
• Production analysis - microeconomic techniques are used to analyze production efficiency, opti-
mum factor allocation, costs, economies of scale and to estimate the firm’s cost function.
• Pricing analysis - microeconomic techniques are used to analyze various pricing decisions including
transfer pricing, joint product pricing, price discrimination, price elasticity estimations, and choosing
the optimum pricing method.
• Capital budgeting - Investment theory is used to examine a firm’s capital purchasing decisions.

DEFINITIONS

Managerial economics is most easily understood as the applications of economic analysis to business
problems. This comes in a wide variety of subject matter and a number of very different approaches to the
subject.

Managerial economics and microeconomics are closely associated as most of the economics
analysis found in books has its origin in theoretical microeconomics. Topics like the theory of demand the
profit- making, optional prices and advertising expenditures and the impact of market structure on the firm’s
behaviour are all approached using the economist’s standard intellectual ‘tool kit’ which consists of trading
and testing models.

‘Managerial economics is concerned with the application of economics concepts and economics
to the problems of formulating rational decision making’
-Mansfield

‘‘Managerial economics is the integration of economics theory with business practices for the
purpose of facilitating decision making and forward planning by management’’
-Spencer and Seigelman
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 ‘Managerial economics is concerned with the application of economics principles and methodologies
to the decision-making process within the firm or organization. It seeks to establish rules and principles to
facilitate the attainment of the desired economics goals of management’’

–Douglas

‘‘Managerial economics applies the principles and methods of economics to analyze problems faced
by management of a business, or other types of organizations and to help find solutions that advance the
best interests of such organizations’’. -Davis and Chang

These definitions of managerial economics together reveal the nature of managerial economics.

Three major factors have contributed to the emergence of managerial economics as a separate
course of managerial studies they are (a) changing market condition (b) the increment of the use of
economics logic concepts theories and tools of economics analysis in the process of business decision
making. (c) Rapid increase in demand for professionally trained managerial power.

WHAT IS MANAGERIAL ECONOMICS

Economics theories and analytical tools that are widely applied to business decision-making constitute
managerial economics. First of all let us understand what is economics. Economics is a social science where
the basic function is to study how people, individuals households, firms and nations maximize their gains
from their limited resources and opportunities. It is in economics terminology is called maximizing behaviour
or more appropriately optimizing behaviour. Optimizing behaviour is selecting the best out of available options
with the objective of maximizing gains from the given resources. Economics is thus a social science which
studies human behaviour in relation to optimizing allocation of available resources to achieve the given ends.
The analytical tools and techniques, economic laws and theories developed by economists constitute the
body of economics. Business decision making with present scenario makes use of economic laws and tools
of economic analysis resulting in the emergence of a separate branch of study called ‘Managerial
Economics’

Working knowledge of economics is essential for managers, as they have to take a number of
decisions in conformity with the goals of the firm under the condition of uncertainty and risk. The process of
decision-making comprises of four main stages.

1. Determining and defining the objective to be achieved.

2. Collection and analysis of information regarding economics, social, political and technological
environment and seeing the necessity and occasion for decision.

3. Inventing, developing and analysis of possible course of action.

4. Selecting a particular course of action from available alternation.

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Scope of Managerial Economics

Microeconomics and Macroeconomics are the two main branches of economics. Both the branches
are applied to business analysis and decision-making, directly or indirectly. The purpose of analysis will
choose between micro and macroeconomics. In other words managerial economics is broadly applied
economics.

Economic theories, which can be directly be applied to areas of business, may be divided into
two main categories-

1. Operational or internal issues.

2. Environmental or external issues.

Operational problems include all those problems which emerge with in the business
organization and fall with in the purview and control of the management. Theory of demand:
consumer’s behaviour is explained by the Demand theory. It answers the questions of which product
to buy, the quantity to buy, where to stop consuming a commodity, how does the price influence the
choice, how does the fashion faster the change etc. The knowledge of demand theory will be helpful in
the choice of commodities for production.

Theory of Production and Production decision

This is also called the theory of the firm, which explains the relationships between inputs and outputs.
It explains the conditions where the cost increases or decreases; how total output increases when units of
one factor (input) are increased keeping other factors constant or when all the factors are simultaneously
increased, the system by which output is maximized from a given quantity of resources, how can optimum
size of output be determined etc. This help in determining the size of the total output and the account of
capital of labor to be employed.

Analysis of Market Structure and Pricing Theory

This explains how prices are determined under different market conditions when price discrimination
is desirable, feasible and profitable, to what extent advertising can be helpful in expanding sales in competitive
market etc. Price and production theories get the help in determining the optimum size of the firm.

Profit Analysis and Profit Management

For most of the business undertaking there is no guarantee that a business venture will make
reasonable profit. There is always an element of risk but the firm will have to safeguard against this. Project
Theory guides the firms in the measurement and management of profit, in making allowances for the risk
premium, in calculating the pure return on capital and pure profit and also for future profit placing.

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Theory of capital & investment decisions
All inputs especially capital is a scarce and expensive factor. It is the foundation of business and
its efficient allocation and management is one of the most important tasks of he managers and a yardstick of
the success level of the firm. Choice of investment project, assessing the efficiency capital and most judicious
allocation of capital are the major wares related to capital.

Macroeconomics applied to business environment

Environmental issues pertain to the general business environment in which a business operates.
They are related to the overall economic, social and political atmosphere of the country. The factors which
constitute economic environment of a country include the following factors:
(i) The type of economic system of the country,
(ii) General trends in production, employment, income prices, saving and investment, etc.,
(iii) Structure of and trends in the working of financial institutions, e.g., banks, financial corporations,
insurance companies, etc.,
(iv) Magnitude of and trends in foreign trade,
(v) Trends in labour and capital markets.
(vi) Government’s economics policies, e.g., industrial policy, monetary policy, fiscal policy, price policy,
etc.,
(vii) Social factors like the value system of the society, property rights, customs and habits.
(viii) Social organizations like trade unions, consumers’ cooperatives and producers’ unions,
(ix) Political environment is constituted of such factors as political systems, democratic, authoritarian,
socialist, or otherwise, state’s attitude towards private business, size and working of the public
sector and political stability, and
(x) The degree of openness of the economy and the influence of MNCs on the domestic markets.

MACROECONOMICS ISSUES

1. Issues Related to macro Variables.

There are issues that are related to the trends in macro variables, e.g., the general trend in the
economics activities of the country, investment climate, trends in output and employment, and price trends.
These factors not only determine the prospects of private business, but also greatly influence the functioning
of individual firms.

2. Issues Related to foreign trade.

An economy is also affected by its trade relations with other countries. The sectors and firms dealing
in exports and imports are affected directly and more than the rest of the economy. Fluctuations in the
international market, exchange rate and inflows and outflows of capital in an open economy have a serious
bearing on its economic environment and, thereby, on the functioning of its business undertakings.
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3. Issues Related to Government policies.
Government policies designed to control and regulate economic activities of the private business
firms affect the functioning of the private business undertakings.

SOME OTHER TOPICS IN MANAGERIAL ECONOMICS

Mathematical tools

Businessman deal firstly with concepts that are essentially quantitative in nature, e.g., demand, price,
cost, product, capital, wages, inventories, etc. these variables assume different meanings in different contexts.
What is needed is to have clarity of these concepts in order to have, as far as possible, accurate estimates
of these economic variables. The use of mathematical logic in the analysis of economic variables provides
not only clarity of concepts, but also a logical and systematic framework within which quantitative relationship
may be explored. Mathematical tools are widely used in ‘model’ building for exploring the relationship
between related economic variables. Mathematical logic is, therefore, a great aid to economic analysis.

Statistics

Similarly, statistical tools are a great aid in business decision-making. Statistical techniques are used
in collecting, processing and analyzing business data, testing the validity of economic laws with the real
economic phenomenon before they are applied to business analysis. Good deals of business decisions are
based on probable economic events. The statistical tools e.g., theory of probability, forecasting techniques
and regression analysis help the decision-makers in predicting the future course of economic event and
probable outcome of their business decisions.

Operations Research (OR)

OR is an inter-disciplinary solution finding techniques. It combines economics, mathematics and

statistics to build models for solving specific business problems and to find a quantitative solution thereto.
Linear programming and goal programming are two widely used OR in business decision-making.

Management theory and accounting

Management theories bring out the behaviour of the firm in their efforts to achieve certain
predetermined objectives. Accounting is the main sources of data regarding the functioning and performance
of the firm. Besides, certain concepts used in business accounting are different from those used in pure
economic logic.

SUMMARY

Areas of Managerial economics may be divided or classified in various ways, including:

• microeconomics and macroeconomics
• positive economics (“what is”) and normative economics (“what ought to be”)
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 • mainstream economics and heterodox economics
• fields and broader categories within economics.

One of the uses of managerial economics is to explain how economies work and what the relations
are between economic players in the larger society. .While macroeconomics is a broad field of study, there
are two areas of research that are emblematic of the discipline: The attempt to understand the causes and
consequences of short-run fluctuations in national income (the business cycle), and the attempt to understand
the determinants of long-run economic growth (increases in national income).

Macroeconomic models and their forecasts are used by both governments and large corporations to
assist in the development and evaluation of economic policy and business strategy. In order to try to avoid
major economic shocks, such as great depression, governments make adjustments through policy changes
which they hope will succeed in stabilizing the economy. Governments believe that the success of these
adjustments is necessary to maintain stability and continue growth. This economic management is achieved
through two types of strategies.

• Fiscal Policy
• Monetary Policy

QUESTIONS:
1. What are the processes of Decision Making?
2. What are the categories of Economic Theories? Describe the theories?
3. What are the factors which constitute Economic environment of a country?
4. Discuss Macroeconomic issues?
5. Write notes on
(a) Mathematical Tools
(b) Statistics
(c) Operational research
(d) Management theory and accountin

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 CHAPTER - II

OBJECTIVES OF BUSINESS FIRMS

OBJECTIVE

Objectives of Business firms are to support the entrepreneurial process, helping to increase survival
rates for innovative startup companies. Only entrepreneurs with feasible projects are admitted into the incu-
bators, where they are offered a specialized menu of support resources and services. The resources and
services open to an entrepreneur include: provision of physical space, management coaching, help in making
an effective business plan, administrative services, technical support, business networking, advice on intellec-
tual property and sources of financing. The objective process is intended to last around 2-5 years.

Business objectives can be private or public. Private objectives are for-profit firms that take equity or
receive a fee for the business services they provide to their clients. In essence, they are a consulting firm that
is specialized in new firm creation. In the last twenty years, many developed and developing countries have
started large systems of public business objectives to encourage and assist entrepreneurship. In many cases,
public objectives are designed to stimulate the development of new products and services in high-tech indus-
tries. For science-based business objectives, an effective collaboration with universities and research institu-
tions can motivate researchers into taking the risk of initiating a company.

Since new firms require finance to grow, incubators have close relationships with many kinds of
investors. Seed capital and venture capital funds, business angels, and banks provide most of the seed and
start-up capital for companies. Since business objectives are powerful economic development tools, they
collaborate actively with regional and national government agencies, from which they often receive financial
grants. In many countries, business objectives have national associations to represent their interests and orga-
nize meetings where best practices are disseminated.

Conventional theory of firm assumes profit maximization, as the sole objective of business firms.
Some important objectives, other than profit maximization, are: (a) maximization of sales revenue, (b)
maximization of firm’s growth rate, (c) maximization of manager’s utility function, (d) making satisfactory
rate of profit, (e) long-run survival of the firm, and (f) entry-prevention and risk-avoidance.

PROFIT AS BUSINESS OBJECTIVE

Meaning of profit

Profit means different things to different people. ‘The word’ profit’ has different meaning to
businessmen, accountants, tax collectors, workers and economists and it is often used in a loose polemical
sense that buries its real significance…’’In a general sense, ‘profit’ is regarded as income accruing to the
equity holders, in the same sense as wages accrue to the labour; rent accrues to the owners of rentable
11
assets; and interest accrues to the money lenders. ‘Economist’s concept of profit is of ‘pure profit’ called’
economics profit’ or ‘just profit’.

Accounting profit vs. Economic profit

The two important concepts of profit that figure in business decisions are ‘economic profit’ and
‘accounting profit’. It will be useful to understand the difference between the two concepts of profits’. As
already mentioned, in accounting sense, profit is surplus of revenue over and above all paid out costs, including
both manufacturing and overhead expenses. Accounting profits may be calculated as follows.

Accounting profit = TR- (W+R+I+M)

Where W = wages and salaries, R = rent, I = interest, and M = cost of materials.

The concept of ‘economic profit’ differs from that of ‘accounting profit’. Economic profit takes
into account also the implicit or imputed costs. The implicit cost is opportunity cost. Opportunity cost is
defined as the payment that would be necessary to draw forth the factors of production from their most
remunerative alternative employment’.

Pure profit may thus be defined as ‘a residual left after all contractual costs have been met, including
the transfer costs of management, insurable risks, depreciation and payments to share holders sufficient to
maintain investment at its current level.’ Thus pure profit = total revenue- (explicit costs + implicit costs)

PROFIT MAXIMIZATION AS BUSINESS OBJECTIVE

As mentioned earlier, profit maximization has been the most important assumption on which
economics have built price and production theories. This hypothesis has, however, been strongly questioned
and alternative hypothesis suggested. This issue will be discussed in the forthcoming sections. Let us first
look into the importance of the profits maximization hypothesis and theoretical conditions of profit
maximization.

The conventional economic theory assumes profit maximization as the only objective of business
firms. Profit maximization as the objective of business firms has a long history in economic literature. It forms
the basis of conventional price theory. Profit maximization is regarded as the most reasonable and analytically
the most ‘productive’ business objective. The strength of this assumption lies in the fact that this assumption
has never been unambiguously disproved’.

The Defence of Profit Maximization

The arguments against the profit-maximization assumption, however, should not mean that pricing
theory has no relevance to the actual pricing policy of the business firms. A selection of economists has
strongly defended the profit maximization objective and ‘marginal principle’ of pricing and output decisions.
Businessmen even if they do understand economic concepts, would not admit that they are making abnormal
profits on the basis of marginal rules of pricing. They would instead talk of a ‘fair profit’. Many are of the
12
opinion that the practices of setting price equal to average variable cost plus a profit margin is not incompatible
with the marginal rule of pricing and that the assumptions of traditional theory are plausible.

Arguments in Defence of Profit Maximization Hypothesis

1. Profit is indispensable for firm’s survival.

The survival of all the profit-oriented firms in the long run depends on their ability to make a
reasonable profit depending on the business conditions and the level of competition.

2. Achieving other objectives depends on firm’s ability to make profit.

Many other objectives of business firms have been cited in economic literature, the achievement
of such alternative objectives depends wholly or partly on the primary objective of making profit.

3. Evidence against profit maximization objective not conclusive.

Profit maximization is a time-honoured objective of business firms.

4. Profit maximization objective has a greater predicting power.

Compared to other business objectives, profit maximization assumption has been found to be a
much more powerful premise in predicting certain aspects of firms’ behaviour.

5. Profit is a more reliable measure of firm’s efficiency.

Thought not perfect, profit is the most efficient and reliable measure of the efficiency of a firm. It
is also the source of internal finance.

ALTERNATIVE OBJECTIVES OF BUSINESS FIRMS

While postulating the objectives of business firms, the conventional theory of firm does not distinguish
between owner’s and managers’ interests. The recent theories of firm called ‘managerial’ and ‘behavioural’
theories of firm, however, assume owners and managers to be separate entities in large corporation with
different goals and motivation.

Baumol’s Hypothesis of Sales Revenue Maximization

Baumol has postulated maximization of sales revenue as an alternative to profit maximization

objective. The reason behind this objective is the dichotomy between ownership and management in large
business corporations. According to Baumol. The most plausible factor in managers’ utility functions is
maximization of the sales revenue.

Williamson’s Hypothesis of Maximization of Managerial Utility Function

Like Buamol and Marris, Williamson argues that managers have discretion to pursue objectives
other than profit maximization.
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 According to Williamson’s hypothesis, managers maximize their utility function subject to satisfactory
profit. A minimum profit is necessary to satisfy the shareholders or else manager’s job security is endangered.

Rothschild’s Hypothesis of Long-run Survival and Market Share Goals

Another alternative objective of a firm-as an alternative to profit maximization-was suggested by

Rothschild. According to him, the primary goal of the firm is long- run survival.

Entry-prevention and Risk-avoidance

Yet another alternative objective as suggested by some economics is to prevent entry of new firms
into the industry. The motive behind entry-prevention may be (a) profit maximization in the long run, (b)
securing a constant market share, and (c) avoidance of risk caused by the unpredictable behaviour of new
firms. The evidence of whether forms maximize profits in the long-run is not conclusive. Some economics
argue, however, that where management is divorced from the ownership, the possibility of profit maximization
is reduced.

REASONABLE PROFIT TARGET

Maximization of profit in technical sense of the term may not be practicable, but profit has to be
there in the objective function of the firms. The firms may differ on ‘how much profit’ but they set a profit
target for themselves. Some firms set their objective of a ‘standard profit’, some of a ‘target profit’ and
some of a ‘reasonable profit’. A ‘reasonable profit’ is the most common objective.

PROFIT AS CONTROL MEASURE

An important managerial aspect of profit is its in measuring and controlling performance of the
executives of the large business undertakings. Researches have revealed that business executives of middle
and high ranks often deviate from profit objective and try to maximize their own utility functions. They
think in terms of job security, personal ambitions for promotion, larger perks, etc.

SUMMARY

Profit is a systematic and holistic method for business improvement and managing execution. Profit
helps companies achieve their cost and operational objectives by linking organizational decisions and activities
directly to the business objectives. This ensures that every action, from the corporate suite to the production
floor or services environment, will bring the organization closer to business success as defined by its strategy.
Profit is actually a verb that describes the application of the ProFIT-MAP Methodology to address
a particular business challenge. ProFIT-MAP is a parametric activities-oriented approach grounded in systems
theory for understanding the process characteristics, resource requirements, and financial performance
implications for any operational change.

Profit is used by companies to execute their strategy no matter what it is. Strategy can range from
everything to improving profitability, increasing customer satisfaction, reducing costs, becoming more flexible
in product or service delivery, reducing waste, and so on.
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 As companies translate strategy into measurable objectives, Profit then bridges the gap between
planning and execution. It does this by identifying:

• The nature of the problem within the context of the capabilities and constraints of the organization.
• The specific parameters under management control that are linked to the business challenges.
• The sensitivity of the various parameters for improving business performance.
• An execution roadmap showing the specific steps and actions required to achieve the business objec-
tives.

Profit complements the many strategic frameworks, improvement approaches, and measurement
options in business today. It does not replace what companies already find helpful. Rather, its integrated and
dynamic nature enhances existing business improvement efforts by providing additional critical “perspective”
and guidance that might not otherwise be available to decision makers.

QUESTIONS:

1. Define Profit? What is the difference between Accounting Profit & Economic Profit?
2. What is Profit Maximization?
3. Explain the arguments in defence of Profit Maximization Hypothesis?
4. Describe the alternative objectives of Business Firms?
5. What is reasonable profit target and profit as a control measure?

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 CHAPTER - III
ANALYSIS OF INDIVIDUAL DEMAND
OBJECTIVE
The basic business activity is the same even though the objectives of the business firms may be
different. All of them produce or buy and sell goods and services that are in demand. All productive activities
depend on the Demand. The satisfaction of demand is the chief aim of production. Increasing demand for a
product offers a high business prospect. A clear understanding of the following factors of demand for one’s
product will be essential for the efficient functioning of business managers.

The objectives of business firms can be various. Objectives of business firms may be different
but their basic business activity is the same. They all produce or buy and sell goods and services that are
in demand. Demand is, in fact, the basis if all-productive activities. Just as ‘necessity is the mother of
invention’. Demand is the mother of production. Increasing demand for a product offers a high business
prospects in future and decreasing demand for a product reduces the business prospect. For example,
increasing demand for computers, cars, mobile phones in India has enlarged the business prospect for both
domestic and foreign companies. On the other hand, declining demand for black and white TV sets and
manual typewriters is forcing the companies to switch over to modern substitutes or go out of business. It
is, therefore, essential for business managers to have a clear understanding of the following aspects of demand
for their products:

(i) What are the sources of demand?

(ii) What are the determinants of demand?

(iii) How do the buyers decide the quantity of a product to be purchased?

(iv) How do the buyers respond to change in product prices, their income and prices of the related
goods?
(v) How can the total or market demand for a product be assessed and forecast?
These questions are answered by the Theory of Demand. In this chapter we will discuss the theory
of individual and market demand. Let us begin with the meaning of demand.

MEANING OF DEMAND
Conceptually, the term ‘demand’ implies a ‘desire’ for a commodity backed by the ability and
willingness to pay for it. Unless a person has adequate purchasing power or resources /and the
preparedness to spend his resources, his desire for a commodity would not be considered as his
demand. For example, if a man wants to buy a car but he does not have sufficient money to pay for
it, his want is not his demand for the car. And, if a rich miserly person wants to buy a car but is not
willing to pay, his desire too is not his demand for a car. But if a man has sufficient money and is willing
to pay, his desire to buy a car is an effective demand.
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 The desires without adequate purchasing power and willingness to pay do not affect the market,
nor do they generate production activity. A want with three attributes – desire to buy, willingness to pay
and ability to pay – becomes effective demand. Only an effective demand figures in economic analysis and
business decisions.

The term ‘demand’ for a commodity (i.e. quantity demand) always has a reference to ’a price’, ‘a
period of time’ and ‘a place’. Any statement regarding the demand for commodity without reference to is
price, time of purchase and place is meaningless and is of no practical use. A meaningful statement regarding
the demand for a commodity should, therefore, contain the following information:

(a) the quantity demanded,

(b) the price at which a commodity is demanded,

(c) the time period over which a commodity is demanded, and

(d) the market area in which a commodity is demanded.

THE BASIS OF CONSUMER DEMAND: THE UTILITY

The consumers demand a commodity because they derive or expect to derive utility from that
commodity. The expected utility form a commodity on the basis of demand for it. Though ‘utility’ is a term
of common usage, it has a specific meaning and use in the analysis of consumer demand.

The meaning of Utility

The concept of utility can be looked upon from two angles from the commodity angle and from
the consumer’s angle. Looked at from a consumer’s angle, it is the want-satisfying property of a commodity.
Looked at from a consumer’s angle, utility is the psychological feeling of satisfaction, pleasure, happiness
or well being which a consumer derives from the consumption, possession or the use of a commodity.

There is a subtle difference between the two concepts which must be borne in mind. The concept
of a want-satisfying property of a commodity is absolute in the sense that this property is ingrained in the
commodity irrespective of whether a person is literate or illiterate. Another important attribute of the ‘absolute’
concept of utility is that it is ‘ethically neutral’ because a commodity may satisfy a frivolous or socially moral
need, e.g., alcohol, drugs or prostitution.

On the other hand, from a consumer’s point of view, utility is a post-consumption phenomenon as
one derives satisfaction from a commodity only when one consumes or uses it. Utility in the sense of
satisfaction is a ‘subjective’ or ‘relative’ concept because (i) a commodity need not be useful for all –
cigarettes do not have any utility for non-smokers, and meat has no utility for strict vegetarians; (ii) utility of
a commodity varies from person to person and from time to time; and (iii) a commodity need not have the
same utility for the same consumer at different points of times, at different levels of consumption and at
different moods of a consumer. In consumer analysis, only the ‘subjective’ concept of utility is used.
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 Having explained the concept of utility, we now turn to some concepts about utility used in utility
analysis, viz. total utility and marginal utility.

TOTAL UTILITY AND MARGINAL UTILITY

Total Utility

Assuming that utility is measurable and additive, total utility may be defined as the sum of the utilities
derived by a consumer from the various units of goods and services he consumes.

Marginal Utility

Marginal utility is another most important concept used in economic analysis. Marginal utility may
be defined in a number of ways. It is defined as the utility derived from the marginal unit consumed. It may
also be defined as the addition to the total utility resulting from the consumption of one additional unit.

THE LAW OF DIMINISHING MARGINAL UTILITY

The law of diminishing marginal utility is one of the fundamental laws of economics. This law states
that as the quantity consumed of a commodity increases, the utility derived from each successive unit
decreases, consumption of all other commodities remaining the same. In simple words, when a person
consumes more and more units of a commodity per unit time, e.g., ice cream, keeping the consumption of
all other commodities constant, the utility which he derives from the successive units of consumption goes
on diminishing. This law applies to all kinds of consumer goods – durable and non-durable sooner or later.

CARDINAL AND ORDINAL CONCEPTS OF UTILITY

Utility is a psychological phenomenon. It is a feeling of satisfaction, pleasure of happiness.

Measurability of utility has, however, been a contentious issue. Early economics-classical economists,
viz., Jeremy Bentham, Leon Walrus, Carl Menger, etc. and neo-classical economist, notably Alfred
Marshall-believed that utility is cardinally or quantitatively measurable like height, weight, length,
temperature and air pressure. This belief resulted in the Cardinal Utility concept. The modern
economists, most notably J.R.Hicks and R.G.D.Alen, however, hold the view that utility is not
quantitatively measurable – it is not measurable in absolute terms. Utility can be expressed only ordinally,
relatively or in terms of ‘less than’ or ‘more than’. It is, therefore, possible to list the goods and services in
order of their preferability or desirability. This is known as the ordinal concept of utility.

The Two Approaches to Consumer Demand Analysis

Based on cardinal and ordinal concepts of utility, there are two approaches to the analysis of
consumer behaviour:

(I) Cardinal Utility Approaches, attributed to Alfred Mashall and his followers, is also called the
Noe-classical Approach.
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 (II) Ordinal Utility Approach, pioneered by J.R.Hicks, a Nobel laureate and R.G.D.Allen, is also
called the Indifference Curve analysis.

The two approaches are not in conflict with one another. In fact, they represent in consumption
theory based on ordinal utility, the classical demand theory based on cardinal utility has retained its appeal
and applicability to the analysis of market behaviour. Besides, the study of classical demand theory serves
as a foundation for understanding the advanced theories of consumer behaviour. The study of classical
theory of demand is of particular importance and contributes a great deal in managerial decisions.

ANALYSIS OF CONSUMER BEHAVIOUR:-

CARDINAL UTILITY APPROACH

The central theme of the consumption theory is the utility maximizing behaviour of the consumer.
The fundamental postulate of the consumption theory is that all the consumers – individuals and households
– aim at utility maximization and all their decisions and actions as consumers are directed towards utility
maximization.

The theory of consumer behavior postulates that consumers seek to maximize their total utility or
satisfaction. On the basis of this postulate, consumption theory explains how a consumer attains the level
of maximum satisfaction, under certain given conditions.

The cardinal utility approach to consumer analysis makes the following assumptions.

(i) Rationality. It is assumed that the consumer is a rational being in the sense that he satisfies his
wants in the order of their preference.

(ii) Limited money income. The consumer has a limited money income to spend on the goods and
services he or she chooses to consume.

(iii) Maximization of satisfaction. Every rational consumer intends to maximize his/her satisfaction
from his/her given money income.

(iv) Utility is cardinally measurable. The cardinalists have assumed that utility is cardinally measured
and that utility of one unit of a commodity equals the money which a consumer is prepared to pay
for.

(v) Diminishing marginal utility. Following the law of diminishing marginal utility of one unit of a
commodity equals the money which a consumer is prepared to pay for.

(vi) Constant marginal utility of money. The cardinal utility approach assumes that marginal utility
of money remains constant whatever the level of a consumer’s income is.

(vii) Utility is additive. Cardinalists assumed not only that utility is cardinally measurable but also
that utility derived form various goods and services consumed by a consumer can be added together
to obtain the total utility.
19
Consumer’s Equilibrium

Conceptually, a consumer is said to have reached his equilibrium m position when he has maximized
the level of his satisfaction, given his resources and other conditions. Technically, a utility-maximizing consumer
reaches his equilibrium position when allocation of his expenditure is such that the last penny spent on each
commodity yields the same utility.

The Law of Demand

The law of demand is one of the fundamental laws of economics. The law of demand states that
the demand for a commodity increases when its price decreases and falls when its price rises, other things
remaining constant. This is an empirical law, i.e., this law is based on observed facts and can be verified
with new empirical data. As the law states, there is an inverse relationship between the price and quantity
demanded. This law holds under the condition that “other things remain constant.” “Other things” include
other determinants of demand, viz., consumers’ income, price of the substitutes and complements, tastes
and preferences of the consumer, etc. These factors remain constant only in the short run. In the long run
they tend to change. The law of demand, therefore, holds only in the short run.

Factors Behind the Law of Demand : -

Substitution Effect When the price of a commodity falls, prices of its substitutes remaining
constant, then the substitutes become relatively costlier. Or, in other words, the commodity whose price
has fallen becomes relatively cheaper.

Income Effect When the price of a commodity falls, other things remaining the same, then the
real income of the consumer increases. Consequently, his purchasing power increases since he is required
to pay less for a given quantity.

Utility-Maximizing Behaviour The utility-maximizing behaviour of the consumer under the

condition of diminishing marginal utility is also responsible for increase in demand for a commodity when its
price falls.

ANALYSIS OF CONSUMER BEHAVIOUR:

ORDINAL UTILITY APPROACH

Assumptions of Ordinal Utility Theory

1. Rationality. Rationality means that a consumer aims at maximizing his total satisfaction given his
income and prices of the goods and services that he consumes and his decisions are consistent
with this objective.
20
 2. Ordinal Utility. Indifference curve analysis assumes that utility is only ordinally expressible. That
is, the consumer is only able to tell the order of the preference for different basket of goods.

3. Transitivity and consistency of choice. Consumer’s choices are assumed to be transitive.

Transitivity of choice means that if a consumer prefers A to B and B to C, he must prefer A to C.

4. Nonsatiety. It is also assumed that the consumer is never ever-supplied with goods in question.
That is, he has not reached the point of saturation in case of any commodity. Therefore, a consumer
always prefers a larger quantity of all the goods.

5. Diminishing marginal rate of substitution. The marginal rate of substitution is the rate at which
a consumer is willing to substitute on commodity (x) for another (y) so that his total satisfaction
remains the same.

SUMMARY

In economics, utility is a measure of the relative happiness or satisfaction (gratification) gained by

consuming different bundles of goods and services. Given this measure, one may speak meaningfully of
increasing or decreasing utility, and thereby explain economic behavior in terms of attempts to increase one’s
utility. Utility is applied by economists in such constructs as the indifference curve, which plots the combination
of commodities that an individual or a society requires to maintain a given level of satisfaction. Individual
utility and social utility can be construed as the dependent variable of a utility function (such as an indifference
curve map) and a social welfare function respectively. Consumer behavior is the study of how people buy,
what they buy, when they buy and why they buy. It is a subcategory of marketing that blends elements
from psychology, sociology, sociopsychology, anthropology and economics. It attempts to understand the
buyer decision making process, both individually and in groups. It studies characteristics of individual
consumers such as demographics, psychographics, and behavioral variables in an attempt to understand
people’s wants. It also tries to assess influences on the consumer from groups such as family, friends, reference
groups, and society in general.

Ordinal utility theory states that while the utility of a particular good and service cannot be measured
using an objective scale, a consumer is capable of ranking different alternatives available. Goods are often
considered in ‘bundles’ or ‘baskets. Consumer theory is a theory of economics. It relates preferences (through
indifference curves and budget constraints) to consumer demand curves. The models that make up consumer
theory are used to represent prospectively observable demand patterns for an individual buyer on the
hypothesis of constrained optimization. Cardinal utility is a theory of utility under which the utility (roughly,
satisfaction) gained from a particular good or service can be measured and that the magnitude of the

21
measurement is meaningful. The marginal utility of a good or service is its utility in its least urgent use of the
most-desired available uses, in other words, the use that is just in the margin. The same object may have
different marginal utilities for different people. The concept grew out of attempts by economists to explain
the determination of price.

QUESTIONS:
1. How can the total or market demands for a product assessed and forecast?
2. What are the approaches to the analysis of Consumer Behavior?
3. Describe the assumptions of cardinal utility approach to Consumer Analysis?
4. Write notes on
(a) Consumer’s Equilibrium
(b) The law of demand
5. What are the factors behind Law of Demand?

22
 CHAPTER - IV

ANALYSIS OF MARKET DEMAND AND

DEMAND ELASTICITIES

OBJECTIVE

In economics and business studies, the price elasticity of demand (PED) is an elasticity that measures
the nature and degree of the relationship between changes in quantity demanded of a good and changes in
its price.
The analysis of total demand for a firm’s product plays a crucial role in business decision-making.
For its successful operation the form has to plan for future production, the inventories of raw materials and
advertisement, and setting up sales outlets. Therefore, the information regarding the magnitude of the current
and future demand for the product is indispensable. Theory of demand provides an insight into these
problems.

ANALYSIS OF MARKET DEMAND : -

Meaning of Market Demand

The market demand is the sum of individual demands for a product at a price per unit of time.
We may recall that the quantity demanded of a commodity by an individual per unit of time, at a given
price, is known as ‘individual demand’ for that commodity. The aggregate of individual demands for a
product is called market demand for the product. In other words, the total quantity that all ‘the consumers/
users of a commodity are willing to buy per unit of time at a given price, all other things remaining the same,
is called ‘market demand’ for that product.

Types of Demand : -

Individual and Market Demand:

As mentioned earlier, the quantity of a commodity which an individual is willing buy at a particular
price during a specific time period, given his money income, his taste and prices of other commodities
(particularly substitutes and complements), is called ‘individual’s demands of commodity’.

Demand Firm’s Product and Industry’s Products:

The quantity of a firm’s product that can be disposed of at a given price over a time period connotes
the demand for the firm’s product. The aggregate of demand for the product of all the firms of an industry
is known as the market demand or demand for industry’s product.

Autonomous and Derived Demand:

An autonomous demand or direct demand for a commodity is one that arises on its own out of a
natural desire to consume or possesses a commodity.

23
 On the other hand, the demand for a commodity that arises because of the demand for some
other commodity, called ‘parent product’, is called derived demand.

The conceptual distinction between autonomous demand (i.e., demand for a ‘parent product’) and
derived demand would be useful from a businessman’s point of view to the extent that the former can serve
as an indicator of the latter.

Demand for Durable and Nondurable Goods:

Demand is also often classified under demand for durable and nondurable goods. Durable goods
are those whose total utility or usefulness is not exhausted in a single or short-run use. Such goods can be
used repeatedly or continuously over a period of time. Durable goods may be consumer goods as well as
producer goods. Durable consumer goods include clothes, shoes, houses, furniture, utensils, refrigerator
scooters, cars, etc. The durable producer goods include mainly the items under ‘fixed assets’, such as
building, plant, machinery, office furniture and fixtures etc. The durable goods, both consumer and producers
goods, may be further classified as ‘semi-durables (e.g., clothes and furniture) and ‘durables’ (e.g., residential
and factory building cars etc.)

Durable goods create replacement demand whereas nondurable goods do not. Also, the demand
for nondurable goods increases (or decreases) lineally whereas the demand for durable goods increases
(or decreases) exponentially due to an increase in stock of durable goods and hence accelerated depreciation.

Short-term and Long-term Demand : -

Short-term demand refers to the demand for goods that are demanded over a short period. In
this category are found mostly the fashion consumer goods, goods of seasonal use, inferior substitutes during
the scarcity period of superior goods, etc.

The long-term demand, on the hand, refers to the demand which exists over a long period. The
change in long-term demand is perceptible only after a long period. Most generic goods have long-term
demand. For example, demand for consumer and producer goods, durable and nondurable goods is long-
term demand, though their different varieties or brands may only have a short-term demand.

Determinants of Market Demand

In general, however, following are the factors which determine, by and large, the market demand
for a product:

1. Price of the product,

2. Price of the related goods–substitutes, complements and supplements,

3. Level of consumers’ income,

4. Consumers’ taste and preference,

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 5. Advertisement of the product,

6. Consumer’s expectations about future price and supply position,

7. Demonstration effect and ‘band-wagon effect’,

8. Consumer-credit facility,

9. Population of the country (for the goods of mass consumption),

10. Distribution pattern of national income, etc.

ELASTICITIES OF DEMAND

Importance of the Elasticity Concept

We have earlier discussed the nature of relationship between demand and its determinants. From
managerial point of view, however, the knowledge of nature of relationship alone is not sufficient. What is
more important is the extent of relationship or the degree of responsiveness of demand to the changes in its
determinants. The degree of responsiveness of demand to the change in its determinants is called elasticity
of demand.

The concept of elasticity of demand plays a crucial role in business– decisions regarding
manoeuvering of prices with a view to making larger profits. For instance, when cost of production is
increasing, the firm would want to pass the rising cost on to the consumer by raising the price. Whether
raising price following the rise in cost or otherwise proves beneficial depends on:

a) the price-elasticity of demand for the product, i.e., how high or low is the proportionate change in
its demand in response to a certain percentage change in its price; and

b) price-elasticity of demand for its substitutes increases automatically even if their prices remain
unchanged.

Raising the price will be beneficial only if (i) demand for product is less elastic; and (ii) demand
for its substitute is much less elastic. Although most businessmen are intuitively aware of the elasticity of
demand of the goods they make, the use of precise estimates of elasticity of demand will add precision to
their business decisions.

The concepts of demand elasticities used in business decisions are: (i) Price elasticity, (ii) Cross-
elasticity; (iii) Income elasticity; and (iv)Advertisement elasticity, and (v) Elasticity of price expectation.

Price Elasticity of Demand

Price elasticity of demand is generally defined as the responsiveness or sensitiveness of demand

for a commodity to the changes in its price. More precisely, elasticity of demand is the percentage change
in demand as result of one percent change in the price of the commodity.
25
Determinants of Price Elasticity of Demand

1. Availability of Substitutes. One of the most important determinants of elasticity of demand for
commodity is the availability of its close substitutes. The higher the degree of closeness of the
substitutes, the greater the elasticity of demand for the commodity.

2. Nature of Commodity. The nature of a commodity also affects the price-elasticity of its demand.
Commodities can be grouped as luxuries, comforts and necessities. Demand for luxury goods (e.g.,
high-price refrigerators, TV sets, cars, decoration items, etc., is more elastic than the demand for
necessities and comforts because consumption of luxury goods can be dispensed with or postponed
when their prices rise. On the other hand, consumption of necessary goods, (e.g., sugar, clothes,
vegetables) cannot be postponed and hence their demand is inelastic.

3. Weightage in the total consumption. Another factor that influences the elasticity of demand is
the proportion if income which consumers spend on a particular commodity. If proportion of income
spent on a commodity is large, its demand will be more elastic and vice versa.

4. Time factor in adjustment of consumption pattern. Price-elasticity of demand depends also

in the time consumers need to adjust their consumption pattern to a new price: the longer the time
allowed, the greater the elasticity.

5. Range of commodity use. The range of uses of a commodity also influences the price-desticity
of its demand. The wider the range of the uses of a product, the higher the elasticity of demand
for the decrease in price. As the price of a multi use commodity decreases, people extend their
consumption to its other uses.

6. Proportion of market supplied. The elasticity of market demand also depends on the proportion
of the market supplied for the ruling price. If less than half of the market is supplied at the ruling
price, price-elasticity of demand will be higher.

Cross-Elasticity of Demand

The cross-elasticity is the measure of responsiveness of demand for a commodity to the changes
in the price of its substitutes and complementary goods.

Uses of Cross-Elasticity:
An important use of cross-elasticity is that it is used to define substitute goods. If cross-elasticity
between two goods is positive, the two goods may be considered as substitutes of one another. Also, the
greater the cross-elasticity, the closer the substitute.

Income-Elasticity of Demand
Apart from the price of a product and its substitutes, consumer’s income is another basic determinant
of demand for a product. As noted earlier, the relationship between quantity demanded and income is of
26
positive nature, unlike the negative price-demand relationship. The demand for goods and services increases
with increase in consumer’s income and voice-versa. The responsiveness of demand to the changes in
income is known as income-elasticity of demand.

Unlike price-elasticity of demand, which is always negative, income-elasticity of demand is always

positive because of a positive relationship between income and quantity demanded of a product.

Nature of commodity and Income-Elasticity:

For all normal goods, income-elasticity is positive though the degree of elasticity varies in accordance
with the nature of commodities. Consumer goods of the three categories, viz., necessities, comforts and
luxuries have different elasticities.

Uses of Income-Elasticity in Business Decisions

While price and cross elasticities are of greater significance in the pricing of product aimed at
maximizing the total revenue in the short period, income-elasticity of a product is of a greater significance in
production planning and management in the long run, particularly during the period of a business cycle. The
concept of income-elasticity can be used in estimating future demand provided that the rate of increase in
income and income-elasticity of demand for the products are known. The knowledge of income elasticity
can thus be useful in forecasting demand, when a change in personal incomes is expected, other things remaining
the same. It also helps in avoiding over-production or under-production.

The concept of income-elasticity may also be used to define the ‘normal’ and ‘inferior’ goods.
The goods whose income- elasticity is positive for all levels of income are termed ‘normal goods’. On the
other hand, goods whose income elasticities are negative beyond a certain level of income are termed ‘inferior
goods’.

Advertisement or promotional elasticity of sales

The expenditure on advertisement and on other sales-promotion activities does help in promoting
sales, but not in the same degree at all levels of the total sales. The concept of advertisement elasticity is
useful in determining the optimum level of advertisement expenditure. The concept of advertisement elasticity
assumes a greater significance in deciding on advertisement expenditure, particularly when the government
imposes restriction on advertisement cost or there is competitive advertising by the rival firms.

Determinants of advertisement elasticity : -

(i) The level of total sales. In the initial stages of sale of a product, particularly of one which is
newly introduced in the market, the advertisement elasticity is greater than unity. As sales increase,
the elasticity decreases.

(ii) Advertisement by rival firms. In a highly competitive market, the effectiveness of advertisement
by a firm is also determined by the relative effectiveness of advertisement by the rival firms.

27
 (iii) Cumulative effect of past advertisement. In case expenditure incurred on advertisement in
the initial stages is not adequate enough to be effective, elasticity may be very low. But over time,
additional doses of advertisement expenditure may have a cumulative effect on the promotion of
sales and advertising elasticity may increase considerably.

(iv) Other factors. Advertisement elasticity is also affected by other factors affecting the demand for
a product, e.g., change in products’ price, consumers’ income, growth of substitutes and their prices.

Elasticity of price expectations

Sometimes, mainly during the period of price fluctuations, consumer’s price expectations play a
much more important role in determining demand for a commodity than any other factor. The price-
expectation-elasticity refers to the expected change in future price as a result of change in current prices of
a product.

SUMMARY

Elasticity of demand describes the relationship between changes in quantity demanded of a good or
service and changes in the price for that good or service. When prices fall, the quantity consumers demand
normally rises—if it costs less, consumers buy more. A measure of price elasticity of demand is essentially a
measure in the change in quantity demanded per change in price. If price drops 10% but the quantity de-
manded increases by 20%, quantity demanded changes at a faster rate relative to the price and the good or
service is relatively elastic. More specifically, the price elasticity of demand would be 20 %/10 %, or 2. Any
number above 1 indicates relative elasticity. (In determining elasticity, absolute values govern—negative and
positive signs may be omitted.) Numbers between 0 and 1 indicate relatively inelastic demand.

For normal goods, a price drop results in an increase in the quantity demanded by consumers. The
demand for a good is relatively inelastic when the quantity demanded does not change much with the price
change. Goods and services for which no substitutes exist are generally inelastic. Elasticity of demand is rarely
constant throughout the ranges of quantity demanded and price. A good or service can have relatively inelastic
demand up to a certain price, above which demand becomes elastic. Elasticity of demand remains valid only
over a specific (and small) range of price. Elasticity of demand can change dramatically across a range of
prices.

In elastic demand is commonly associate with “necessities,” although there are many more reasons a
good or service may have inelastic demand other than the fact that consumers may “need” it. Substitution
serves as a much more reliable predictor of elasticity of demand than “necessity.” However, products with a
high elasticity usually have many substitutes.
28
 It may be possible that quantity demanded for a good rises as its price rises, even under conventional
economic assumptions of consumer rationality. Another case is the price inflation during an economic bubble.
Consumer perception plays an important role in explaining the demand for products in these categories.

QUESTIONS:
1. What is a Market Demand? What are the types of Demand?
Explain the factors which determine the Market Demands for a Product?
2. What is the importance of the elasticity concept?
3. What is Price Elasticity of Demand? What are the determinants of Price Elasticity of Demand?
4. What is Cross Elasticity of Demand? What are its uses?

29
 CHAPTER - V

DEMAND FORECASTING

OBJECTIVE
Demand Forecasting is the process of estimation in unknown situations. Prediction is a similar, but
more general term, and usually refers to estimation of time series, cross-sectional or longitudinal data. In more
recent years, Forecasting has evolved into the practice of Demand Planning in every day business forecasting
for manufacturing companies. The discipline of demand planning, also sometimes referred to as supply chain
forecasting, embraces both statistical forecasting and consensus process. Some forecasting methods use the
assumption that it is possible to identify the factors that might influence the variable that is being forecasted.

Why demand forecasting

Demand forecasting is predicting demand for a product. The information regarding future demand
is essential for planning and scheduling production, purchase of raw materials, acquisition of finance and
advertising. The information regarding future demand is also essential for the existing firms to be able to
avoid under or over-production.

TECHNIQUES OF FORECASTING DEMAND

Survey methods : -

Survey methods are generally used where the purpose is to make short-run forecast of demand.
This method includes:

(i) Survey of potential consumers to elicit information on their intentions and plan;

(ii) Opinion polling of experts, i.e., opinion survey of market experts and sales representatives and
through market studies and experiments.

(I) Consumer survey methods-direct interviews:

The consumer survey method of demand forecasting involves direct interview of the potential
consumers. It may be in the form of

(a) Complete enumeration,

(b) Sample survey, or

(c) End-use method.

These consumer survey methods are used under different conditions and for different purposes.

(a) Complete Enumeration Method:

In this method, almost all potential users of the product are contacted and are asked about their
future plan of purchasing the product in question. The quantities indicated by the consumers are added
together to obtain the probable demand for the product.
30
(b) Sample survey Method:

Under this method, only a few potential consumers and users selected from the relevant market
through a sampling method are surveyed. Method of survey may be direct interview or mailed questionnaire
to the sample-consumers.

(c) The End-use Method:

The end-use method of demand forecasting has a considerable theoretical and practical value,
especially in forecasting demand for inputs. Making forecasts by this method requires building up a schedule
of probable aggregate future demand for inputs by consuming industries and various other sectors. In this
method, technological, structural and other changes which might influence the demand, are taken into account
in the very process of estimation. This aspect of the end-use approach is of particular importance.

(II) Opinion Poll Methods:

The opinion poll methods aim at collecting opinions of those who are supposed to possess
knowledge of the market, e.g., sales representatives, sale executives, professionals marketing experts and
consultants. The opinion poll methods include:

a) Expert-opinion method,

b) Delphi method, and

c) Market studies and experiments.

a) Expert-Opinion Method:
Firms having a good network of sales representatives can put them to the work of assessing the
demand for the product in the areas, regions or cities that they represent.

b) Delphi Method:

Delphi Method of demand forecasting is an extension of the simple expert opinion poll method.

Under the Delphi method, the experts are provided information on estimates of forecasts of other
experts along with the underlying assumptions. The experts may revise their own estimates in the light of
forecasts made by other experts.

c) Market Studies and experiments:

An alternative method of collecting necessary information regarding demand is to carry out market
studies and experiments on consumer’s behaviour under actual, though controlled, market
conditions. This method is known in common parlance as market experiment method. Under this
method, firms first select some areas of the representative markets- three or four cities having similar
features, viz., population, income levels, cultural and social background, occupational distribution, choices
and preferences of consumers.
31
Statistical Methods : -

We will explain statistical methods which utilize historical (time-series) and cross-section data for
estimating long-term demand. Statistical methods are considered to be superior techniques of demand
estimation.

(I) In the statistical methods, the element of subjectivity is minimum,

(II) Method of estimation is scientific, as it is based on the theoretical relationship between the dependent
and independent variables,

(III) Estimates are relatively more reliable, and

(IV) Estimation involves smaller cost.

Statistical methods of demand projection include the following techniques:

1. Trend Projection Methods,

2. Barometric Methods, and

3. Economic Method.

1. Trend projection Methods:

Trend projection method is a ‘classical method’ of business forecasting. This method is essentially
concerned with the study of movement of variables through time. The use of this method requires a long
and reliable time-series data. The trend projection method is used under the assumption that the factors
responsible for the past trends in the variable to be projected (e.g., sales and demand) will continue to play
their part in future in the same manner and to the same extent as they did in the past in determining the
magnitude and direction of the variable. This assumption may be quiet justified in many cases.

2. Barometric Method of Forecasting:

The barometric method of forecasting follows the method meteorologists use in weather forecasting.

The basic approach of barometric technique is to construct an index of relevant economic indicators
and to forecast future trends on the basis of movements in the index of economic indicators. The indicators
used in this method are classified as:

(a) leading indicators,

(b) coincidental indicators, and

(c) lagging indicators.

The leading series consists of indicators which move up or down ahead of some other series.

The coincidental series, on the other hand, are the ones that move up or down simultaneously
with the level of economic activity.

The lagging series, consists of those indicators which follow a change after some time-lag.

32
3. Econometric Methods:

The econometric methods combine statistical tools with economic theories to estimate economic
variables and to forecast the intended economic variables. The forecasts made through econometric methods
are much more reliable than those made through other methods. The econometric methods are, therefore,
most widely used to forecast demand for a product., for a group of products and for the economy as a
whole. Our concern here is primarily to explain econometric methods used for forecasting demand for a
product.

The econometric methods are briefly described here under two basic methods.

1. Regression method, and

2. Simultaneous Equations model.

1. Regression Method:

Regression analysis is the most popular method of demand estimation. This method combines
economic theory and statistical techniques of estimation.

In regression technique of demand forecasting, the analysis estimates the demand function for a
product. In the demand function, the quality to be forecast is a ‘dependent variable’ and the variables that
affect or determine the demand (the depended variable) are called ‘independent’ or ‘explanatory’ variables.
For example, demand for cold drinks in a city may be said to depend largely on ‘per capital income’ of the
city and population. Here demand for cold drinks is a ‘dependent variable’ and ‘per capital income’ and
‘population’ are the ‘explanatory variables.’

SUMMARY

Forecasting involves the generation of a number, set of numbers, or scenario that corresponds to a
future occurrence. It is absolutely essential to short-range and long-range planning. By definition, a forecast is
based on past data, as opposed to a prediction, which is more subjective and based on instinct, gut feel, or
guess. Regardless, the terms forecast and prediction are often used inter-changeably. Forecasting is based on
a number of assumptions:

The past will repeat itself. In other words, what has happened in the past will happen again in the
future.As the forecast horizon shortens, forecast accuracy increasesForecasting in the aggregate is more
accurate than forecasting individual items. This means that a company will be able to forecast total demand
over its entire spectrum of products more accurately than it will be able to forecast individual stock-keeping
units (SKUs). Forecasts are seldom accurate. Furthermore, forecasts are almost never totally accurate. While
some are very close, few are “right on the money.” Therefore, it is wise to offer a forecast “range.Number of
characteristics that are common to a good forecast:
• Accurate—some degree of accuracy should be determined and stated so that comparison can be
made to alternative forecasts.
33
 • Reliable—the forecast method should consistently provide a good forecast if the user is to establish
some degree of confidence.
• Timely—a certain amount of time is needed to respond to the forecast so the forecasting horizon must
allow for the time necessary to make changes.
• Easy to use and understand—users of the forecast must be confident and comfortable working with
it.
• Cost-effective—the cost of making the forecast should not outweigh the benefits obtained from the
forecast.
Forecasting techniques range from the simple to the extremely complex. These techniques are usually
classified as being qualitative or quantitative.

Qualitative forecasting techniques are generally more subjective than their quantitative counterparts.
Qualitative techniques are more useful in the earlier stages of the product life cycle, when less past data exists
for use in quantitative methods.
• Quantitative forecasting techniques are generally more objective than their qualitative counterparts.
Quantitative forecasts can be time-series forecasts (i.e., a projection of the past into the future) or
forecasts based on associative models (i.e., based on one or more explanatory variables).
Forecasting process consists of:
• Determine the forecast’s purpose: Factors such as how and when the forecast will be used, the
degree of accuracy needed, and the level of detail desired determine the cost (time, money, employ-
ees) that can be dedicated to the forecast and the type of forecasting method to be utilized.
• Establish a time horizon: This occurs after one has determined the purpose of the forecast. Longer-
term forecasts require longer time horizons and vice versa. Accuracy is again a consideration.
• Select a forecasting technique: The technique selected depends upon the purpose of the forecast,
the time horizon desired, and the allowed cost.
• Gather and analyze data: The amount and type of data needed is governed by the forecast’s
purpose, the forecasting technique selected, and any cost considerations.
• Make the forecast.
• Monitor the forecast. Evaluate the performance of the forecast and modify, if necessary.

QUESTIONS:

1. Why demand is forecasting?

2. Explain the techniques of forecasting demands?

34
 CHAPTER - VI

THEORY OF PRODUCTION

OBJECTIVE

Production is simply the conversion of inputs into outputs. It is an economic process that uses re-
sources to create a commodity that is suitable for exchange. This can include manufacturing, storing, shipping,
and packaging. Some economists define production broadly as all economic activity other than consumption.
They see every commercial activity other than the final purchase as some form of production.

Production is a process, and as such it occurs through time and space. Because it is a flow concept,
production is measured as a “rate of output per period of time”. There are three aspects to production
processes:

1. the quantity of the commodity produced,

2. the form of the good produced,
3. the temporal and spatial distribution of the commodity produced.

A production process can be defined as any activity that increases the similarity between the pattern
of demand for goods, and the quantity, form, and distribution of these goods available to the market place.

Whatever the objective of business firms, achieving optimum efficiency in production or minimizing
cost for a given production is one of the prime concerns of the business managers. In their effort to minimize
the cost of production, the fundamental questions which managers are faced with are:

1. How can production be optimized or cost minimized?

2. How does output behave when quantity of inputs is increased?

3. How does technology matter in reducing the cost of production?

4. How can the least-cost combination of inputs be achieved?

5. Given the technology, what happens to the rate of return when more plants are added to the firm?

SOME BASIC CONCEPTS

Meaning of Production : -

In economic, the term ‘production’ means a process by which resources (men, material, time etc.)
are transformed into a different and more useful commodity or service. In general, production means
transforming inputs (labour, machines, raw materials, time, etc.) into an output. This concept of production
is however limited to only ‘manufacturing’.
35
 In economics sense, production process may take a variety of forms other than manufacturing.
Besides, production process does not necessarily involve physical conversion of raw materials into tangible
goods. Some kinds of production involve an intangible input to produce an intangible output.

Input and Output: -

An input is a good or service that goes into the process of production. In the words of Baumol,
“an input is simply anything which the firm buys for use in its production or other processes.” An output is
any good or service that comes out of production process.

The term ‘inputs’ needs some more explanations. Production process requires a wide variety of
inputs, depending on the nature of product. But, economics have classified input as (1) labour, (2) capital,
(3) land, (4) raw materials; and (5) time. All these variables are ‘flow’ variables, since they are measured
per unit of time.

Fixed and Variables Inputs: -

Inputs are classified as (1) fixed inputs or fixed factors, and (2) variable inputs or variable factors.
Fixed and variable inputs are defined in economic sense and in technical sense. In economic sense, a fixed
input is one whose supply is inelastic in the short run. Therefore, all of its uses together cannot buy more of
it in the short-run. In technical sense, a fixed factor is one that remains fixed (or constant) for a certain level
of output.

A variable input is defined as one whose supply in the short-run is elastic, e.g., labour and raw
material, etc. All the users of such factors can employ a larger quantity in the short-run. Technically, a variable
input is one that changes with the change in output. In the long run, all inputs are variable.

Short-Run and Long-Run: -

The reference to time period involved in production process is another important concept used in
production analysis. The short-run refers to a period of time in which the supply of certain inputs (e.g.,
plant, building, machinery, etc.) is fixed or is inelastic. In the short-run therefore, production of a commodity
can be increased by increasing the use of only variable inputs like labour and raw materials.

The long-run refers to a period of time in which the supply of all the inputs is elastic, but not enough
to permit a change in technology. That is, in the long-run, all inputs are variable. Therefore, in the long-run,
production of a commodity can be increased by employing more of both variable and fixed inputs.

PRODUCTION FUNCTION

Production function is a tool of analysis used to explain the input-output relationship. A production
function describes the technological relationship between inputs and output in physical terms. In its general
form, it tells that production of a commodity depends on certain specific inputs. In its specific form, it presents

36
the quantitative relationships between inputs and output. Besides, the production function represents the
technology of a firm, of an industry or of the economy as a whole.

Assumptions: -
A production function is based on the following assumptions:
1. perfect divisibility of both inputs and output;
2. there are only two factors of production-labour (L) and capital (K);
3. limited substitution of one factor for the other;
4. a given technology; and
5. inelastic supply of fixed factors in the short-run.

THE LAWS OF PRODUCTION

The laws of production state the relationship between output and input. The traditional theory of
production studies the marginal input-output relationships under (i) short run, and (ii) long run conditions. In
the short run, input-output relations are studied with one variable input, other inputs held constant. The laws
of production under these conditions are called ‘The laws of Variable Proportions’ or the ‘Laws of Returns
to a Variable Input’. In the long run input-output relations studied assuming all the input to be variable. The
log run input-output relations studied under ‘Laws of Returns to Scale’. In the following sub-section, we
will explain the ‘Laws of returns to a variables input’. The laws of ‘returns to scale’ or what is also called
‘long-run laws of production’, will be discussed in the following subsection.

Short Run Laws of Production

By definition, some factors of production are available in unlimited supply even during the short
period. Such factors are called variable factors. The laws which bring out the relationships between varying
proportions and output are therefore known as the Law of Diminishing Returns.

The Law of Returns to a variable Input : The Law of Diminishing Returns

The law of diminishing returns states that when more and more units of a variable input are applied
to a given quantity of fixed inputs, the total output may initially increase at an increasing rate and then at a
constant rate but it will eventually increase at diminishing rates.

Assumptions.

The law of diminishing returns is based on the following assumptions: (1) the state of technology is
given, (2) labour is homogenous, and (3) input prices are given.

SUMMARY

A production process is efficient if a given quantity of outputs cannot be produced with any less
inputs. It is said to be inefficient when there exists another feasible process that, for any given output, uses

37
less inputs. The inputs or resources used in the production process are called factors by economists. The
myriad of possible inputs are usually grouped into four or five categories. These factors are:

• Raw materials (natural capital)

• Labour services (human capital)
• Capital goods
• Land

Sometimes a fifth category is added, entrepreneurial and management skills, a subcategory of labour
services. Capital goods are those goods that have previously undergone a production process. They are
previously produced means of production. Some textbooks use “technology” as a factor of production.

In the “long run” all of these factors of production can be adjusted by management. The “short run”
however, is defined as a period in which at least one of the factors of production is fixed. A fixed factor of
production is one whose quantity cannot readily be changed. Examples include major pieces of equipment,
suitable factory space, and key managerial personnel. A variable factor of production is one whose usage rate
can be changed easily.

Production function asserts that the maximum output of a technologically-determined production pro-
cess is a mathematical function of input factors of production. Considering the set of all technically feasible
combinations of output and inputs, only the combinations encompassing a maximum output for a specified set
of inputs would constitute the production function. Alternatively, a production function can be defined as the
specification of the minimum input requirements needed to produce designated quantities of output, given
available technology. It is usually presumed that unique production functions can be constructed for every
production technology.

By assuming that the maximum output technologically possible from a given set of inputs is achieved,
economists using a production function in analysis are abstracting away from the engineering and managerial
problems inherently associated with a particular production process. The engineering and managerial prob-
lems of technical efficiency are assumed to be solved, so that analysis can focus on the problems of allocative
efficiency. The firm is assumed to be making allocative choices concerning how much of each input factor to
use, given the price of the factor and the technological determinants represented by the production function. A
decision frame, in which one or more inputs are held constant, may be used; for example, capital may be
assumed to be fixed or constant in the short run, and only labour variable, while in the long run, both capital
and labour factors are variable, but the production function itself remains fixed, while in the very long run, the
firm may face even a choice of technologies, represented by various, possible production functions.

The relationship of output to inputs is non-monetary, that is, a production function relates physical
inputs to physical outputs, and prices and costs are not considered. But, the production function is not a full
model of the production process: it deliberately abstracts away from essential and inherent aspects of physical
38
production processes, including error, entropy or waste. Moreover, production functions do not ordinarily
model the business processes, either, ignoring the role of management, of sunk cost investments and the
relation of fixed overhead to variable costs.

The primary purpose of the production function is to address allocative efficiency in the use of factor
inputs in production and the resulting distribution of income to those factors. Under certain assumptions, the
production function can be used to derive a marginal product for each factor, which implies an ideal division
of the income generated from output into an income due to each input factor of production.

QUESTIONS:

1. How can production be optimized or cost minimized?

2. How does output behave when quantity of inputs is increased?
3. How does technology matter in reducing the cost of production?
4. How can the least cost combination of inputs be achieved?
5. Given the technology, what happens to the rate of return when more plants are added to a firm?

39
 CHAPTER - VII

THEORY OF COST AND BREAK-EVEN ANALYSIS

OBJECTIVE

Cost of Production is simply the conversion of inputs into outputs. It is an economic process that uses
resources to create a commodity that is suitable for exchange. This can include manufacturing, storing, ship-
ping, and packaging. Some economists define production broadly as all economic activity other than con-
sumption. They see every commercial activity other than the final purchase as some form of production.

Production is a process, and as such it occurs through time and space. Because it is a flow concept,
production is measured as a “rate of output per period of time”. There are three aspects to production
processes:

1. the quantity of the commodity produced,

2. the form of the good produced,
3. the temporal and spatial distribution of the commodity produced.
A production process can be defined as any activity that increases the similarity between the pattern
of demand for goods, and the quantity, form, and distribution of these goods available to the market place.
Business decisions are generally taken on the basis of money values of the inputs and outputs.
Inputs multiplied by their respective prices and added together give the money value of the inputs, i.e., the
cost of production. The cost of production is an important factor in almost all business analysis and decisions,
specially those pertaining to (a) locating the weak points in production managements; (b) minimizing the
cost; (c) finding the optimum level of output; (d) determination of price and dealers margin; and (e) estimating
or projecting the cost of business operation.

COST CONCEPTS

The cost concepts which are relevant to business operations and decision can be grouped, on the
basis of their nature and purpose, under two overlapping categories: (i) concepts used for accounting
purposes, and (ii) analytical cost concepts used in economic analysis of business activities.

Some Accounting Cost Concepts

1. Opportunity Cost and Actual Cost : - The opportunity cost may be defined as the expected
returns from the second best use of the resources which are foregone due to the scarcity of
resources. The opportunity cost is also called alternative cost. Had the resource available to a person,
a firm or a society been unlimited there would be no opportunity cost. Associated with the concept
of opportunity cost is the concept of economic profit. In contrast to the concept of opportunity
cost, actual costs are those which are actually incurred by the firm in payment for labour, material,
40
 plant building, machinery, equipment, traveling and transport, advertisement, etc. The total money
expenses, recorded in the books of accounts are for all practical purpose, the actual costs.

2. Business Costs and Full Costs : - Business cost include all the expenses which are incurred
to carry out a business. The concept of business costs is similar to the actual or real costs. Business
costs “include all the payments and contractual obligations made by the firm together with the book
cost of depreciation on plant and equipment.”

3. Explicit and Implicit or Imputed Costs : -

Explicit costs are those which fall under actual or business costs entered in the books of accounts.
The payments for wages and salaries, materials, license fee, insurance premium, depreciation charges
are the examples of explicit costs. These costs involve cash payment and are recorded in normal
accounting practices.

In contrast to explicit costs, there are certain other costs which do not take the form of cash outlays,
nor do they appear in the accounting system. Such costs are known as implicit or imputed costs.
Opportunity cost is an important example of implicit cost.

4. Out-of-Pocket and Book Costs : - The items of expenditure which involve cash payments or
cash transfers, both recurring and non-recurring, are known as out-of-pocket costs. All the explicit
costs (e.g., wages, rent, interest, cost of materials and maintenance, transport expenditure, etc.)
fall in this category.

Some analytical Cost Concepts

1. Fixed And Variable Costs : Fixed costs are those which are fixed in volume for a certain given
output. Fixed costs does not vary with variation in the output between zero and a certain given
level of output. In other words, costs that do not vary for a certain level of output are known as
fixed costs.

Variable costs are those which vary with the variation in the total output. Variable costs include
cost of raw material, running cost of fixed capital, such as fuel, repairs, routine maintenance
expenditure, direct labour charges associated with the level of output, and the costs of all other
inputs that vary with output.

2. Total, Average and Marginal Costs :

Total cost (TC) is the total expenditure incurred on the production of goods and service. It refers
to the total outlays of money expenditure, both explicit and implicit, on the resources used to produce a
given level of output.

Average cost (AC) is of statistical nature-it is not actual cost. It is obtained by dividing the total
cost (TC) by the total output (Q), i.e.,
41
 AC= TC / Q

Marginal cost (MC) is the addition to the total cost on account of producing one additional
unit of the product. Or, marginal cost of the marginal unit produced. Marginal cost is calculated as TC n –
TC n-1 where ‘n’ is the number of units produced. Alternatively, given the cost function, MC can be defined
as
MC=ä TC / ä Q
3. Short –Run and Long- run Costs : - Short-Run costs are the costs which vary with the
variation in output, the size of the firm remaining the same. In other words, short-run costs are the
same as variable costs. Long-run costs, on the other hand, are the costs which are incurred on
the running cost and depreciation of the capital assets are included in the short-run or variable costs.
Broadly speaking, the ‘short-run costs are those associated with variables in the utilization of fixed
plant or other facilities whereas long-run costs are associated with the variables in the utilization of fixed
plant or other facilities where as long-run costs are associated with the changes in the size and kind of plant.’
4. Incremental Costs and Sunk Costs : - The concept of incremental cost is based on the fact
that in the real world, it is not practicable (for lack of perfect divisibility of inputs) to employ factors
for each unit of output separately.
The sunk costs are those which cannot be altered, increased or decreased, by varying the rate of
output.
5. Historical and Replacement Costs : - Historical cost refers to the cost of an asset acquired
in the past whereas replacement cost refers to the outlay which has to be made for replacing an
old asset. These concepts owe their significance to the unstable nature of price behaviour.
6. Private and Social Costs : - There are, however, certain other costs which arise due to the
functioning of the firm but do not normally figure in the business decisions nor are such costs explicitly
borne by the firms. The costs on this category are borne by the society. Thus, the total cost generated
by a firm’s working may be divided into two categories: (i) those paid out or provided for by the
firms, and (ii) those not paid or borne by the firms including the use of resources freely available
plus the disutility created in the process of production. The costs of the former category are known
as private costs and of the latter category are known as external or social costs.
Private costs are those which are actually incurred or provided for by an individual or a firm on
the purchase of goods and services from the market.
Social costs, on the other hand, refer to the total cost borne by the society due to production of a
commodity. Social cost includes both private cost and the external cost.

BREAK-EVEN ANALYSIS

Break-even analysis or what is also known as profit contribution analysis is an important analytical
technique used to study the relationship between the total costs, total revenue and total profits and loses
over the whole range of stipulated output. The break-even analysis is a technique of having a preview of
42
profit prospectus and a tool of profit planning. It integrates the cost and revenue estimates to ascertain the
profits and losses associated with different levels of output.

Use of Break-Even Analysis

1. Sales volume can be determined to earn a given amount of return on capital.
2. Profit can be forecast if estimates of revenue and cost are available.
3. Effect of change in the volume of sales, sale price, cost of production, can be appraised.
4. Choice of products or processes can be made from the alternatives available. Product-mix can
also be determined.
5. Impact of increase or decrease in fixed and variable costs can be highlighted.
6. Effect of high fixed costs and low variable costs to the total cost can be studied.
7. Valid inter firm comparisons of profitability can be made.
8. Cash break-even charts helps proper planning of cash requirements.
9. Break-even analysis emphasizes the importance of capacity utilization for achieving economies.
10. Further help is provided by margin of safety and angle of incidence.
Limitations: - We have discussed above that the break-even analysis based on linear assumptions.
The linearity assumption can be removed by pre-testing the cost and revenue functions and by using, if
necessary, the non-linearity conditions. Nevertheless, the break-even analysis can be applied only to a single
product system. Under the condition of multiple products and joint operations the break-even analysis can
be applied only if product-wise cost can be ascertained which is, of course, extremely difficult. Second,
break-even analysis cannot be applied usefully where cost and price data cannot be ascertained beforehand
and where historical data are not relevant for estimating future costs and prices. Despite these limitations,
the break-even analysis may serve a useful purpose in production planning if relevant data can be easily
obtained.

SUMMARY

• Opportunity cost analysis is an important part of a company’s decision-making processes, but is not
treated as an actual cost in any financial statement. The break even point for a product is the point
where total revenue received equals total costs associated with the sale of the product (TR=TC). A
break even point is typically calculated in order for businesses to determine if it would be profitable to
sell a proposed product, as opposed to attempting to modify an existing product instead so it can be
made lucrative. Break-Even Analysis can also be used to analyze the potential profitability of an
expenditure in a sales-based business. Break-even analysis is only a supply side (ie.: costs only)
analysis, as it tells you nothing about what sales are actually likely to be for the product at these
various prices.
• It assumes that fixed costs (FC) are constant

43
 • It assumes average variable costs are constant per unit of output, at least in the range of likely quan-
tities of sales.
• It assumes that the quantity of goods produced is equal to the quantity of goods sold (i.e., there is no
change in the quantity of goods held in inventory at the beginning of the period and the quantity of
goods held in inventory at the end of the period.
• In multi-product companies, it assumes that the relative proportions of each product sold and
produced are constant (i.e., the sales mix is constant).

QUESTIONS:

1. Explain Accounting Cost Concepts?

2. Describe Analytical Cost Concepts?
3. Define Break-Even Analysis? What are its uses and limitations?

44
 CHAPTER - VIII

MARKET STRUCTURE AND PRICING DECISIONS

OBJECTIVE

Market structure (also known as market form) describes the state of a market with respect to com-
petition.

The major market forms are:

• Perfect competition, in which the market consists of a very large number of firms producing a homo-
geneous product.
• Monopolistic competition, also called competitive market, where there are a large number of inde-
pendent firms which have a very small proportion of the market share.
• Oligopoly, in which a market is dominated by a small number of firms which own more than 40% of
the market share.
• Oligopsony, a market dominated by many sellers and a few buyers.
• Monopoly, where there is only one provider of a product or service.
• Natural monopoly, a monopoly in which economies of scale cause efficiency to increase continuously
with the size of the firm.
• Monopsony, when there is only one buyer in a market.

The imperfectly competitive structure is quite identical to the realistic market conditions where some
monopolistic competitors, monopolists, oligopolists, and duopolists exist and dominate the market condi-
tions.

These somewhat abstract concerns tend to determine some but not all details of a specific concrete
market system where buyers and sellers actually meet and commit to trade.

INTRODUCTION

Production is the act of making things, in particular the act of making products that will be traded or
sold commercially. Production decisions concentrate on what goods to produce, how to produce them, the
costs of producing them, and optimizing the mix of resource inputs used in their production. This production
information can then be combined with market information (like demand and marginal revenue) to determine
the quantity of products to produce and the optimum pricing.
Maximization of output or minimization of cost or optimization of resource allocation is, however,
only one aspect of the profit maximizing behaviour of the firm. Another and equally important aspect of
profit maximization is to find the price from the set of prices revealed by the demand schedule that is in
agreement with only one price for each product commensurate with profit maximization, under the given
conditions. The profit-maximizing price does not necessarily coincide with minimum cost of production.
Besides, the level of profit-maximizing price is generally different in different kinds of markets, depending
on the degree of competition between the sellers. Therefore, while determining the price of its product, a

45
firm has to take into account the nature of the market. In this chapter, we will discuss the theory of price
determination and also firm’s equilibrium in various kinds of market structure.

Market Structure and Degree of Competition

In an economic sense, a market is a system by which buyers and sellers bargain for the price of a
product, settle the price and transact their business – buy and sell a product. Personal contact between the
buyers and sellers is not necessary. In some cases, e.g., forward sale and purchase, even immediate transfer
of ownership of goods is not necessary. Market does not necessarily mean a place. The market for a
commodity may be local, regional, national or international. Market is a set of buyers, a set of sellers and a
commodity. While buyers are willing to buy and sellers are willing to sell, and there is a price for the
commodity.
How is the price of a commodity determined in the market? The determination of price of a
commodity depends on the number of sellers and the number of buyers. Barring a few cases, e.g., occasional
phases in share and property markets, the number of buyers is larger than the number of sellers. The number
of sellers of a product in a market determines the nature and degree of competition in the market. The
nature and degree of competition make the structure of the market. Depending on the number of sellers
and the degree of competition, the market structure is broadly classified as given in below Table.
Table: Types of Market Structure
Market No of firms Nature of Control over Method of
structure and degree of Industry where price marketing
production prevalent
differentiation
1. Perfect Large no. of Financial None Market
Competition firms with markets and exchange or
identical some farm auction
products products
2. Imperfect
Competition:
(a) Many firms Manufacturing Some Competitive
Monopolistic with real or tea, toothpastes, advertising
competition perceived TV sets, shoes, quality rivalry
product refrigerators, etc.
differentiation
(b) Oligopoly Little or Aluminum, Some Competitive
product steel, cigarettes, advertising,
differentiation cars passenger quality rivalry
cars, etc.
(c) Monopoly A single Public utilities: Considerable Promotional
producer, Telephones, but usually advertising if
without close Electricity, etc. regulated supply is large.
substitute

46
Market Structure and Pricing Decisions : -

The market structure influences firm’s pricing decisions a great deal. The degree of competition
determines a firm’s degree of freedom in determining the price of its product. The degree of freedom implies
the extent to which a firm is free or independent of the rival firms in taking its own pricing decisions. As a
matter of rule, the higher the degree of competition, the lower the firm’s degree of freedom in pricing decision
and control over the price of its own product and vice versa. Let us now see how the degree of competition
affects pricing decisions in different kinds of market structures.

PRICING UNDER PERFECT COMPETITION

Characteristics of perfect competition

The term perfect competition refers to a set of conditions prevailing in the market. A perfectly
competitive market is one which has the following characteristics.

1. A large number of sellers and buyers :

Under perfect competition, the number of sellers and buyers is very large. The number of sellers
and buyers is so large that the share of each seller in total supply and the share of each buyer in total demand
is so small that no single seller can affect the market price by changing his supply, nor can a single buyer
influence the market price by changing his demand.

2. Homogeneous products :

Products supplied by all firms are approximately homogenous. Homogeneity of products means
that products supplied by various firms are so identical in appearance and use that buyers do not distinguish
between them nor do they prefer the product of one firm to that of another.

3. Perfect mobility of factors of production :

For a market to be perfectly competitive, there should be perfect mobility of resources. This means
that the factors of production must be in a position to move freely into or out of an industry and from one
firm to another.

1. Free entry and free exit of firms :

There is no restriction, legal or otherwise, on the firm’s entry into or exit from industry.

2. Perfect knowledge :

There is perfect dissemination of the information about the market conditions. Both buyers and
sellers are fully aware of the nature of the product, its availability or sale ability and of the price prevailing in
the market.

3. Absence of collusion or artificial restraint :

There is no sellers union or other kind of collusion between the sellers such as cartels or guilds,
nor is there any kind of collusion between the buyers.
47
 4. No government intervention :

In a perfectly competitive market, there is no government intervention with the working of the market
system. There is no licensing system regulating the entry of firms to the industry, no regulation of market
prices, i.e., fixation of lower or upper limits of prices, no control over the supply of inputs, no fixation of
quota on production, and no rationing of consumer demand, etc.

Perfect competition, as characterized above, is an uncommon phenomenon in the real business

world. However, the actual markets that approximate to the conditions of perfectly competitive model include
the share markets, securities and bond markets, and agricultural product markets, e.g., local vegetable markets.

Sometimes a distinction is made between perfect competition and pure competition. The difference
between the two is only a matter of degree. Perfect competition less perfect mobility of factors and perfect
knowledge is regarded as per competition.

Price Determination Under perfect Competition : -

By definition, perfect competition is a market setting in which, there are a large number of sellers
of a homogeneous product. Each seller supplies a very small fraction of the total supply. No single seller is
powerful enough to influence the market price. Nor can a single buyer influence the market price. Market
price in a perfectly competitive market is determined by the market forces-market demand and market supply.

In a perfectly competitive market, therefore, the main problem for a profit-maximizing firm is not
to determine the price of its product but to adjust its output to the market price so that profit is maximum.

The mode of price determination-price level and its variation-depends on the time taken by the
supply position to adjust itself to the changing demand conditions. Price determination under perfect
competition is analyzed under three different time periods:

— Market period or very short run.

— Short run, and

— Long run.

As regards the market period or very short run, it refers to a time period in which quantity supplied
is absolutely fixed or, in other words, supply response to price is nil. Price determination in the three types
of perfectly competitive markets is described below.

a. Pricing in Market Period : -

In a market period, the total output of a product is fixed. Each firm has a stock of commodity to
be sold. The stock of goods with all the firms makes the total supply. Since the stock is fixed, the supply
curve is perfectly inelastic. In this situation, price is determined solely by the demand condition. Supply remains
an inactive agent.
48
 b. Pricing in the Short Run : -

A short run is, by definition, a period in which firms can neither change their size nor quit, nor can
new firms enter the industry. While in the market period (or very short-run) supply is absolutely fixed, in the
short-run, it is possible to increase (or decrease) the supply by increasing (or decreasing) the variable inputs.
In the short-run, therefore, supply curve is elastic.

c. Pricing in the Long-Run : -

In contrast to the short run, in the long run, the firms can adjust their size or quit the industry and
new firms can enter the industry. As a result, new firms get attracted towards the industry causing a rightward
shift in the supply curve. Therefore, marginal firms quit the industry causing a leftward shift in the supply
curve. The rightward shift in the supply curve pulls down the price and its leftward shift pushes it up.

PRICING UNDER PURE MONOPOLY

The term pure monopoly signifies an absolute power to produce and sell a product which has no
close substitute. In other words, a monopoly market is one in which there is only one seller of a product
having no close substitute. The cross elasticity of demand for a monopoly product is either zero or negative.
A monopolized industry is a single-firm industry. Firm and industry are identical in a monopoly setting. In a
monopolized industry, equilibrium of the monopoly firm signifies the equilibrium of the industry.

Causes and Kinds of Monopolies : -

The emergence and survival of monopoly is attributed to the factors which prevent the entry of
other firms into the industry and eliminate the existing ones. The barriers to entry are, therefore, the major
sources of monopoly power. The major sources of barriers to entry are:

— Legal restrictions or barriers to entry of new firms;

— Sole control over the supply of scare and key raw materials; and

— Efficiency and economies of scale.

1. Legal Restrictions:

Some monopolies are created by law in the public interest. Most of the state monopolies in the
public utility sector in India, e.g., postal, telegraph and telephone services, radio and TV services, generation
and distributions of electricity, Indian Railways, Indian Airlines and State Roadways, etc., are public
monopolies.

2. Control over Key Raw Materials:

Some firms acquire monopoly power because of their traditional control over certain scarce and
key raw materials which are essential for the production of certain other goods, e.g., bauxite, graphite,
diamond, etc.
49
 3. Efficiency:

A primary and technical reason for monopolies is the economy of scale. If a firm’s long-
run minimum cost of production or its most efficient scale of production almost coincides with the
size of the market, then the large-size firm finds it profitable in the long run to eliminate competition through
price cutting in the short run. Once its monopoly is established, it becomes almost impossible for the new
firms to enter the industry and survive. Monopolies created on account of this factor are known as natural
monopolies. A natural monopoly may emerge out of the technical conditions of efficiency or may be created
by law on efficiency grounds.

Price Discrimination Under Monopoly : -

Price discrimination means selling the same or slightly differentiated product to different sections
of consumers at different prices not commensurate with the cost of differentiation. Consumers are
discriminated on the basis of their income or purchasing power, geographical location, age, sex, colour,
marital status, quantity purchased, time of purchase, etc. When consumers are discriminated on the basis of
these factors in regard to prices charged from them, it is called ‘price discrimination’. There is another kind
of price discrimination. The same price is charged from the costumers of different areas while cost of
production in two different plants located differently is not the same.

Necessary Conditions for Price Discrimination : -

First, different markets must be separable for a seller to be able to practice discriminatory pricing.
The market for different classes of consumers must be so separated that buyers of one market are not in a
position to resell the commodity in the other.

Second, the elasticity of demand must be different in different markets. The purpose of price
discrimination is to maximize the profit by exploiting the markets with different price elasticities. It is the
difference in the elasticity which provides an opportunity for price discriminations.

Third, there must be imperfect competition in the market. The firm must have monopoly overt he
supply of the product to be able to discriminate between different class of consumers, and charge different
prices.

Fourth, profit-maximizing output is much larger than the quantity demand in a single market or
section of consumers.

Price Discrimination by Degrees:

The degree of price discrimination refers to the extent to which a seller can divide the market or
the consumers and can take advantage of it in extracting the consumer’s surplus. The economic literature
presents three degrees of price discrimination.
50
First degree:

The first degree of price discrimination is the limit of discriminating pricing. When a seller is in a
position to know the price each consumer or consumer group is willing to pay, (i.e., he knows his buyers
demand curve for his product), he sets the price accordingly and tries to extract the whole consumer surplus.

Second degree:
Where market size is very large, perfect discrimination is neither feasible nor desirable. In that
case, a monopolist uses second-degree discrimination or block pricing method. A monopolist adopting the
second-degree price discrimination intends to siphon off only the major part of the consumer’s surplus, rather
than the entire of it. The monopolist divides the potential buyer’s into blocks, e.g., rich, middle class and
poor, and sells the commodity in blocks-first at the highest price to the rich, then at a lower price to the
middle class, and so on.

Third degree:
When a profit maximizing monopolist sets different prices in different markets having demand curves
with different elasticities, he is practicing the third degree price discrimination. It happens quite often that a
monopolist has to sell his goods in two or more markets, completely separated from one another, each
having a demand curve with different elasticity.

MEASURES OF MONOPOLISTIC POWER

The efforts to devise a measure of monopoly power have not yielded a universal or non-controversial
measure. As Alex Hunter has observed, “The idea of devising a measure of monopoly power, with reference
both to its general incidence and to particular situation, has been and probably always will remain, an attractive
prospect for economists who wish to probe in this field”.
Therefore, devising at least a ‘conceivable’ measure of monopoly, even if ‘practical’ measurement
is impossible, continues to interest economists, for at least two reasons.

First, apart from intellectual curiosity, people would like to know about the economy in which
they live, about the industrial structure, and about the industries from which they get their supplies and how
their prices are determined.

Second, growth of private monopolies has often led to economic inefficiency and exploitation of
consumers. Therefore, the government of many countries have found it necessary to formulate policies and
to device legislative measures to control and regulate monopoly. If the government is to succeed in its policy
of restraining monopoly, it must have at least some practicable measure of monopoly power and monopolist
trade practices.

The Measures of Monopoly Power : -

In spite of problems in measuring the power of monopoly, economists have devised a number of
measures of monopoly power though none of these measures is free from flaws.
51
1. Number – of – Firms Criterion :

One of the simplest measures of degree of monopoly power of firms is to count the number of
firms in an industry. The smaller the number of firms, the grater the degree of monopoly power of each firm
in the industry, and conversely, the larger the number of firms, the greater the possibility of absence of
monopoly power.

This criterion however has serious drawback. The number of firms alone does not reveal much
about the relative position of the firms within the industry because (i) ‘firms are not of equal size,’ and (ii)
their number does not indicate the degree of control each firm exercises in the industry. Therefore, the
‘number-of-firms’ criterion of measuring monopoly power is of little practical use.

2. Concentration Ratio:

The concentration ratio is one of the widely used criteria for measuring monopoly power. The
concentration ratio is obtained by calculating the percentage share of a group of large firms in the total output
of the industry. ‘The number of firms chosen for calculating the ratio usually depends on some fortuitous
element-normally the census of production arrangement of the country concerned’.

Concentration ratio, although a very widely used measure of monopoly power, has it own
shortcomings.

First, the measures of concentration ratio involve statistical and conceptual problems. For examples,
production capacity may not be used straightway as it may include ‘unused, obsolete or excess capacity’
and the value of assets involves valuation problem as accounting method of valuation and market valuation
of assets may differ.

Second, the measures of concentration ratio do not take into account the size of the market. The
size of the market may be national or local. A large number of firms supplying the national market may be
much less competitive than the small number of firms supplying the local market.

Third, the most serious defect of concentration ratio as an index of monopoly power is that it
does not reflect the competition from other industries.

3. Excess Profit Criterion :

J.S. Bain and, following him, many other economists have used excess profit, i.e., profit in excess
of the opportunity cost, as a measure of monopoly power. If profit rate of a firm continues to remain
sufficiently higher than all opportunity costs required to remain in the industry, it implies that neither competition
among sellers nor entry of new firms prevent the firm from making a pure or monopoly profit. This method
of measuring the degree of monopoly power is considered to be theoretically most sound. Nevertheless, it
has been criticized on the following grounds.

52
 First, any formula devised to measure the degree of monopoly power should bring out the difference
between the monopoly output and competitive output or the ‘ideal’ output under optimum allocation of
resources.

Second, price-cost discrepancy may rise for reasons other than monopoly, and price and cost
may be equal or close to each other in spite of monopoly power.

Third, since data on MC are hardly available, this formula is of little practical use.

4. Triffin’s Cross-Elasticity Criterion :

Triffin’s criterion seems to have been derived from the definition of monopoly itself. According to
his criterion, cross-elasticity is taken as the measure of degree of monopoly. The lower the cross elasticity
of the product of a firm, the greater the degree of its monopoly power.

PRICING AND OUTPUT DECISIONS UNDER MONOPOLISTIC COMPETITION : -

The model of price and output determination under monopolistic competition developed by Edward
H. Chamberlin in the early 1930’s dominated the pricing theory until recently. Although the relevance of his
mode has declined in recent years, it has still retained its theoretical flavour. Chamberlin’s model is discussed
below.

Monopolistic competition is defined as market setting in which a large number of sellers sell
differentiated products. Monopolistic competition has the following features :
— Large number of sellers
— Free entry and free exit
— Perfect factor mobility
— Complete dissemination of market information

— Differentiated product

PRICING AND OUTPUT DECISIONS UNDER OLIGOPOLY : -

Definition, Sources and Characteristics

Definition :- In this section, we will discuss price and output determination under oligopoly. Let
us first look at the market organization characterized by oligopoly. Oligopoly is defined as a market structure
in which there are a few sellers selling a homogenous or differential product. Where oligopoly firms sell a
homogenous product, it is called pure or homogenous oligopoly. For example, industries producing bread,
cement, steel, petrol, cooking gas, chemicals, aluminium and sugar are industries characterized by homogenous
oligopoly, and, where firms of an oligopoly industry sell differentiated products, it is called differentiated or
oligopoly differentiated or heterogenous oligopoly.

53
 Be it pure or differentiated, “Oligopoly is the most prevalent form of market organization in the
manufacturing sector of the industrial nation….” . In non-industrial nations like India also, a majority of big
and small industries have acquired the features of oligopoly market.

Sources of Oligopoly : - The factors that give rise to oligopoly are broadly the same as those
for monopoly. The main sources of oligopoly are described here briefly.

1. Huge capital Investment.

Some industries are by nature capital-intensive, e.g., manufacturing automobiles, aircrafts, ships,
TV sets, refrigerators, steel and aluminium goods, etc., and hence require huge investment.

2. Economic of scale.

By virtue of huge investment and large scale production, the large units enjoy absolute cost
advantage due to economies of scale in purchase of industrial inputs, market financing, and sales organization.

3. Patent rights.

In case of differentiated oligopoly, firms get their differentiated product patented which gives them
an exclusive right to produce and market the patented commodity. This prevents other firms from producing
the patented commodity.

4. Control over certain raw materials.

Where a few firms acquire control over the entire supply of important inputs required to produce
a certain commodity, new firms find it extremely difficult to enter the industry.

5. Merger and takeover.

Merger of rivals firms or takeover of rival firms by the bigger ones with a view to protecting their
joint market share or to put an end to waste of competition is working, in modern times, as an important
factor that gives rise to oligopolies and strengthens the oligopolistic tendency in modern industries.

Features of Oligopoly : - Let us now look at the important characteristics of oligopolistic

industries.

1. Small number of sellers:

As already mentioned, there is a small number of sellers under oligopoly. How small is the number
of sellers is not given precisely: it depends largely on the size of the market. Conceptually, however, the
number of sellers is so small that the market share of each firm is so large that a single firm can influence the
market price and the business strategy of its rival firms.
54
2. Interdependence of decision-making:

The most striking feature of an oligopolistic market structure is the interdependence of oligopoly
firms. The characteristic fewness of firms under oligopoly brings the firms in keen competition with each
other. The competition between the firms takes the form of action, reaction and counteraction in the absence
of collusion between the firms. Since the number of firms in the industry is small, the business strategy of
each firm in respect of pricing, advertising, product modification is closely watched by the rival firms and it
evokes imitation and retaliation.

3. Barriers to entry:

Barriers to entry to an oligopolistic industry arise due to such market conditions as (i) huge
investment requirement to match the production capacity of the existing ones, (ii) economies of scale and
absolute cost advantage enjoyed by the existing firms, (iii) strong consumer loyalty to the products of the
established firms based on their quality and service, and (iv) resistance by the established firms by price
cutting.

4. Indeterminate price and output:

Another important feature, though controversial, of the oligopolistic market structure is the
indeterminateness of price and output. The characteristic fewness and interdependence of oligopoly firms
makes derivation of the demand curve a difficult proposition. An opposite view is that price under oligopoly
is sticky, i.e., if price is once determined, it tends to stabilize.

SUMMARY

Pricing is one of the four p’s of the marketing mix. The other three aspects are product management,
promotion, and place. It is also a key variable in microeconomic price allocation theory.

Pricing is the manual or automatic process of applying prices to purchase and sales orders, based on
factors such as: a fixed amount, quantity break, promotion or sales campaign, specific vendor quote, price
prevailing on entry, shipment or invoice date, combination of multiple orders or lines, and many others. Auto-
mated systems require more setup and maintenance but may prevent pricing errors. A price-taking firm al-
ways faces an upward-sloping supply curve, and therefore sells little or nothing at prices above equilibrium. In
contrast, a business with monopoly power can choose the price at which it wants to sell. If it sets a high price,
it may sell less; if it sets a lower price, it will likely sell more, however this difference is much smaller.

In most markets, falling demand associated with a price increase is due partly to losing customers to
other sellers and partly to customers who are no longer willing or able to buy the product. In a pure monopoly
market, only the latter effect is at work. Therefore, the drop in units sold as prices rise may be much less
dramatic than one might expect, especially for necessary commodities such as medical care. However, unless

55
the monopoly is a coercive monopoly, there is also the risk of competition arising if the firm sets its prices too
high. Even a monopoly can be subject to competitive forces. An Oligopoly is when a market is controlled by
a small number of sellers. Very often, there are only 3 or 4 of them. Oligopolies are very common. The main
feature of the oligopoly is that a decision made by one market player influences the whole market.

QUESTIONS:
1. How is the price of a commodity determined in the market?
2. What are the types of market structure?
3. Describe the characteristics of a perfect competitive market?
4. What is pure monopoly? What are its hinds and causes?
5. What are the measures of monopolistic power?

56
 CHAPTER - IX

CAPTIAL BUDGETING AND

INVESTMENT UNDER CERTAINTY

OBJECTIVE
Investment is an activity of spending resources (money, labour and time) on creating assets that
can generate income over a long period of time or which enhances the returns on the existing assets. In a
broader sense of the term, investments that generate returns over a number of years can be classified under
the following categories.

1. Investment in Financial Assets including bank deposits, deposits with companies, contribution to
provident fund (in excess of compulsory deduction), shares and debentures, government bonds
and treasury bills, purchase of NSC, buying units, personal lending, etc.

2. Investment in Physical Assets including purchase of land, building, machinery, plants, etc.

3. Investment in Human Capital including expenditure on skill formation through education and training
that increases productivity and earning capacity of a person.

4. Miscellaneous Investment including expenditure on replacement of depreciated and obsolete

machinery, product diversification, R & D, installation of safety measures for employees, pollution
control for public health and safety, and meeting legal requirements.

PRE-REQISITES OF CAPITAL BUDGETING

Capital budgeting is of great significance for at least two reasons. One, capital expenditure is
generally irreversible. Once an investment is made in some specialized kind of machinery, plant or equipment,
it cannot be converted into cash without a loss because resale value of machinery and equipment is often
much lower than their original price. Two, the very survival of the firm depends on how well planned, the
capital expenditure. It is, therefore, essential that investment projects are well conceived; evaluated and gainful
projects are selected, given the objective of the firm. Let us now look at the pre-requisites of capital budgeting.

Defining Capital Expenditure : -

The term ‘capital’ assumes a specific meaning in investment decisions. Joel Dean has suggested
that ‘capital expenditure should be defined in terms of economic behaviour rather than in terms of accounting
convention’. In terms of economic behaviour, capital expenditure means, as already mentioned, the
expenditure of acquiring assets that yield returns over a number of years. For the purpose of capital budgeting,
only long-term capital expenditure, not adjustable in the short run, are taken into account. The short-run
capital expenditure like ‘inventories’ and receivables which keep varying and are adjustable in the short-run
are ignored. Although long-term capital expenditure varies according to the nature and duration of working

57
life of the project, the capital expenditures involving a commitment for at least one year are generally
considered for capital budgeting. Broadly speaking, the long-term capital expenditure includes the following
items:

a) Expenditure on new capital equipments by a new firm in the short-run,

b) Expenditure on long-term assets by a new firm,

c) Expenditure on expansion or diversification of assets and addition to the existing stock of capital
by old firms,

d) Expenditure on replacement of depreciated capital,

e) Expenditure on advertisement which bears fruit over time, and

f) Expenditure on research, development and innovation.

Deciding Planning Period : -

The gestation period and overall success of capital expenditures involve a high degree of ‘uncertainty
and risk’. The risk arising out of uncertainty can be reduced considerably by planning capital expenditure
for the predictable future. Therefore, another major issue involved in capital budgeting is the determination
of span of planning period.

Choice of Decision Rules : -

One of the essential requirements of sound capital budgeting is the choice of criteria for accepting
or rejecting a project. The criteria must be carefully decided in advance. It must be borne in mind that a
particular capital project may be capable of standing the test against several criteria, or in other words, may
be capable of serving several purposes. But the various criteria considered for evaluating a project may not
be in conformity with one another or their fulfillment may not be the objective of the firm. It is, therefore,
necessary that decision rules for accepting or rejecting a project must be decided before hand.

The criteria and decision rules are normally chosen on the basis of the objective of the firm, such
as profit maximization of short or long-terms gains, etc.

Therefore, the first step in determining the decision rules is to clearly define the objective of
investment. The second step is to select the criterion for evaluating the projects. The important evaluation
criteria are following.

a) Pay-back period;

b) Discounted cash flow (present value criterion); and

c) Internal rate of return.

Pending a detailed discussion on these investments criteria, it may be added here that once an
evaluation criterion is selected, the third step is to decide on the approach for the final selection of projects.
58
 An important aspect of capital budgeting is to collect relevant, reliable and adequate data on (i)
alternative avenues of investment, (ii) cost of investment projects, (iii) the expected returns from the projects,
(iv) period of maturity, fruition, and the productive life of the projects, (v) the market rate of interest, and
(vi) availability of internal and external finances. This information is necessary to determine where to invest
and how much to invest.

The following procedure of estimating the earnings on capital expenditures is generally used.

I. Earnings of each project should be estimated separately.

II. The most important sources of earning, viz., cost savings and sales expansion or added profits,
must be taken into account.

III. For estimating future earnings, profit projections must be based on the estimated future prices and
costs.

IV. Not only the actual earnings but also the opportunity cost of an investment should be taken into
account.

V. The stream of capital earning in the distant future must be appropriately discounted to know its
present value, particularly in the case of long-term projects.

VI. For assessing and comparing the earnings, average of invested capital per time unit should be used,
instead of initial capital outlay.

VII. Productivity of capital should be estimated on the basis of earnings over the lifetime of the asset
less cost of the investment.

VIII. Estimated earnings must be adjusted on account of the indirect contribution of the proposed
investment to the existing production facility. This is, however, a very difficult task and may involve
a big margin of error.

IX. In a highly competitive market, abnormal profits create conditions for self-destruction by inviting
larger investments from the competitors. This possibility should be thoroughly examined and taken
care of in estimating the future earnings.

X. The assessment of the riskiness of projects may involve a varying margin of error. Some systematic
method should be followed to make the necessary adjustment on account of margins of error.

XI. Where earnings are ‘defused and conjectural’ (e.g., earnings from expenditure on researches and
employee’s recreation facilities) and quantification thereof is not possible for lack of requisite data,
estimating such earnings should be avoided till such data are available.

INVESTMENT DECISIONS UNDER CERTAINTY

In this section, we will discuss investment decisions under the condition of certainty. The condition
of certainty refers to a state of perfect knowledge. It implies that investors have complete knowledge about
59
the market conditions, especially the investment opportunities, cost of capital and the expected returns on
the investment. Of the several criteria proposed for evaluating the profitability of the various kinds of projects,
the three most commonly used criteria under certainty are:

I. Pay –back (or pay-out) period;

II. Net discounted present value; and

III. Internal rate of return or marginal efficiency of investment.

These criteria are equally applicable to a variety of investment decisions regarding new investments
and those pertaining to replacement, scrapping, and widening or deepening of capital. Incidentally, from
analysis point of view, there is no structural difference between decisions on new investment and those on
replacement. Let us now briefly describe the three criteria and look into their applicability.

SOURCES AND COST OF CAPITAL

The two important aspects of the supply side of the capital market are (i) the sources of capital,
and (ii) the cost of capital.

Sources of Capital

Business firms meet their demand for capital from various sources which can be grouped under (i)
Internal sources, and (ii) external sources. Let us now discuss the implications of capital raised from these
sources and also the cost thereof.

1. Internal sources of Capital: -

The firm’s own saving is its internal source of capital. Internal savings are normally generated into
two ways: (i) by creating depreciation funds; and (ii) by ploughing back the profit or through the retained
earnings. Depreciation reserves are created out of firm’s earnings with a view to maintaining capital intact
or for replacement of worn-out capital.

2. External Sources of Capitals: -

A. Sale of bonds:

The firms may borrow funds directly from the capital market by selling some kind of bonds,
e.g., mortgage and debenture bonds. Raising funds through the sale of bonds has certain advantages
(i) the total interest on bonds and debentures is permissible as business cost under cooperate income-
tax laws; and (ii) it increases the share of stockholders in case the company is making higher profits as
bond holders get only a fixed rate of interest.

B. Issue of new common stock (or equity shares) :

Another common method of raising funds from the market is to issue common stocks. The extent
to which a company can issue finances by issuing new shares depends, among other things, on the liking or
disliking of old stockholders.
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 C. Issue of preferred stock :

The third method of capital accumulation from the market is the sale of preferred stock. The main
distinction between preferred and common stock is that preferred stockholders get preference over common
or equity holders in the payment of divident.

D. Convertible securities, direct loans, etc.

The other methods of borrowing from the market are (a) direct borrowing from the financial
institutions such as commercial banks, insurance companies, Industrial Finance Corporations, Industrial Credit
and Investment Corporation of India (ICICI), Industrial Development Bank of India (IDBI) and the Unit
Trust of India (UTI), etc.; and (b) issuing hybrid securities such as convertible bonds which can be traded
in the market like equity shares, under certain restrictions; this is an advantage too for the security holders.

The Cost of Capital

Capital has a price too, termed as cost of capital. The cost of capital may be explicit or implicit.
Explicit cost of capital is the interest paid on it whereas implicit cost is the opportunity cost, expected return
from the second best use of money capital. In the strict sense of the term, implicit cost of capital is the
opportunity cost of money capital.

The cost of capital plays an important role in capital budgeting decisions. Since capital is available
at a cost, it implies the managers to make best possible use of available funds.

Capital budgeting is not only one of the most important tasks of business management, but also a
complicated procedure. Manager’s skill, experience, intuition and foresight are perhaps needed more in
taking appropriate investment decisions than in any other aspect of business management. The managers
should, therefore, clearly define the objective and targets, find out the most suitable projects of investment
relevant to the firm’s objective examine the feasibility and profitability of the projects, select the projects on
the basis of appropriate investment criteria and determine their demand for capital. They should next examine
the cost of various sources of capital, accumulate the necessary funds and then, finally take up the investment
projects.

SUMMARY

Capital budgeting (or investment appraisal) is the planning process used to determine a firm’s long
term investments such as new machinery, replacement machinery, new plants, new products, and research
and development projects.

Many formal methods are used in capital budgeting, including the techniques such as

• Net present value

• Profitability index

61
 • Internal rate of return
• Modified Internal Rate of Return, and
• Equivalent annuity.

These methods use the incremental cash flows from each potential investment, or project. Techniques
based on accounting earnings and accounting rules are sometimes used - though economists consider this to
be improper - such as the accounting rate of return, and “return on investment.” Simplified and hybrid meth-
ods are used as well, such as payback period and discounted payback period. constant.

Investment or capital accumulation in classical economic theory is the production of increased capital.
In order to invest, goods must be produced which are not to be immediately consumed, but instead used to
produce other goods as a means of production. Investment is closely related to saving, though it is not the
same. Investment is the production per unit time of goods which are not consumed but are to be used for
future production. In measures of national income and output, gross investment I is also a component of Gross
domestic product (GDP). Investment, as production over a period of time (“per year”), is not capital. The
time dimension of investment makes it a flow. Investment is often modelled as a function of income and interest
rates, given by the relation I = f(Y, r). An increase in income encourages higher investment, whereas a higher
interest rate may discourage investment as it becomes more costly to borrow money. Even if a firm chooses
to use its own funds in an investment, the interest rate represents an opportunity cost of investing those funds
rather than loaning them out for interest.

QUESTIONS:

1. Define investment? How is it classified?

2. What are the pre-requisites of Capital Budgeting?
3. Define Capital Expenditure?
4. Enumerate the procedure of estimating the earnings on Capital Expenditure?
5. What criteria is adopted on investment decisions under certainty?

62
 CHAPTER - X

INVESTMENT DECISIONS UNDER RISK

AND UNCERTAINTY
OBJECTIVE
In reality, however, a large area of investment decisions falls in the realm of risk and uncertainty.
It is important to note here that risk and uncertainty go hand in hand. Wherever there is uncertainty, there is
risk. The probability of some kinds of risk is calculable whereas that of some other kinds of risk not. The
calculable risk like accident, fire, theft, etc. are insurable. Therefore, decision-making in case of insurable
risks is a relatively easier task. But, incalculable risks are not insurable. Therefore, investment decision is
greatly complicated where the probability of an outcome is not estimable. However, some useful techniques
have been devised and developed by economists, statisticians and management experts to facilitate business
decision-making under the conditions of risk and uncertainty. Many such techniques are applied to investment
decision-making. The techniques and methods are many and are applied under different business conditions
and for evaluating investment decision-making.

CONCEPTS OF RISK AND UNCERTAINITY

Here, let us have a closer look at the concept of certainty and then proceed to explain the concepts
of risk and uncertainty. Certainty is the state of perfect knowledge about the market conditions. In the state
of certainty, there is only one rate of return on the investment and that rate is known to the investors. That
is, in the state of certainty, the investors are fully aware of the outcome of their investment decisions.

However, there is a vast area of investment avenues in which the outcome of investment decisions
is not precisely known. The investors do not know precisely or cannot predict accurately the possible return
on their investment. Some examples will make the point clear. Suppose a firm invests in R & D to innovate
a new product, spends money on its production and sale. The success of the product in a competitive market
and the return on investment in R & D and in production and sale of the product can hardly be predicted
accurately. There is, therefore, an element of uncertainty.

Risk :

In common parlance, risk means a low probability of an expected outcome. From business
decision-making point of view, risk refers to a situation in which a business decision is expected to yield
more than one outcome and the probability of each outcome is known to the decision makers or can be
reliably estimated.

There are two approaches to estimate probabilities of outcomes of a business decisions, viz.,
(i) a priori approach, i.e., the approach based on deductive logic or intuition, and (ii) posteriori
approach, i.e., estimating the probability statistically in the basis of the past data. In case of a priori probability,
63
we know that when a coin is tossed, the probabilities of ‘head’ and ‘tail’ are 50:50, and when a dice is
thrown, each side has 1/6 chance to be on the top. The posteriori assumes that the probability of an event
in the past will hold in future also. The probability of outcomes of a decision can be estimated statistically
by way of ‘standard deviation’ and ‘coefficient of variation’.

Uncertainty :
Uncertainty refers to a situation in which there is more than one outcome of a business decision
and the probability of no outcome is known or can be meaningfully estimated. The unpredictability of outcome
may be due to lack of reliable market information, inadequate past experience, and high volatility of the
market conditions.
The long-term investment decisions involve a great deal of uncertainty with unpredictable outcome.
But, in reality, investment decisions involving uncertainty have to be taken on the basis of whatever information
can be collected, generated and guesstimated. For the purpose of decision making, the uncertainty is classified
as :
(a) complete ignorance, and

(b) partial ignorance.

In complete ignorance, investment decisions are taken by the investors using their own judgement
or using any of the rational criteria. What criterion he chooses depends on his attitude towards risk. The
investors attitude towards risk may be that of (i) a risk averter, (ii) a risk neutral, or (iii) a risk seeker or
risk lover. In simple words, a risk averter avoids investment in high-risk business. A risk-neutral investor
takes the best possible decision on the basis of his judgement, understanding of the situation and his past
experience. He does his best and leaves the rest to the market. A risk lover is one who goes by the dictum
that the higher the risk, the higher the gain. Unlike other categories of investors, he prefers investment in
risky business with high-expected gains.

In case of partial ignorance, on the other hand, there is some k knowledge about the future market
conditions; some information can be obtained from the experts in the field, and some probability estimates
can be made. The available information may be incomplete and unreliable. Under this condition the decision
makers use their subjective judgement to assign an a priori probability to the outcome or the pay-off of
each possible action such that the sum of such probability distribution is always equal to one. This is called
subjective probability distribution. The investment decisions are taken in this case on the basis of the subjective
probability distribution. Decision making process under partial ignorance is described in the following section
beginning with the pay-off matrix.
SUMMARY
Investment decisions are made by investors and investment managers.
Investors commonly perform investment analysis by making use of fundamental analysis, technical
analysis and gut feel.

64
 Investment decisions are often supported by decision tools. The portfolio theory is often applied to
help the investor achieve a satisfactory return compared to the risk taken. Risk is a concept that denotes a
potential negative impact to an asset or some characteristic of value that may arise from some present process
or future event. In everyday usage, “risk” is often used synonymously with the probability of a known loss.
Paradoxically, a probable loss can be uncertain and relative in an individual event while having a certainty in
the aggregate of multiple events (see risk vs. uncertainty below).

Risk communication and risk perception are essential factors for every human decision making. Many
definitions of risk depend on specific application and situational contexts. Generally, a qualitative risk is con-
sidered proportional to the expected losses which can be caused by a risky event and to the probability of this
event. The harsher the loss and the more likely the event, the greater the overall risk. Measuring risk is often
difficult; rare failures can be hard to estimate, and loss of human life is generally considered beyond estimation.

... Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which
it has never been properly separated. The term “risk,” as loosely used in everyday speech and in economic
discussion, really covers two things which, functionally at least, in their causal relations to the phenomena of
economic organization, are categorically different. ... The essential fact is that “risk” means in some cases a
quantity susceptible of measurement, while at other times it is something distinctly not of this character; and
there are far-reaching and crucial differences in the bearings of the phenomenon depending on which of the
two is really present and operating. ... It will appear that a measurable uncertainty, or “risk” proper, as we
shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all. We
... accordingly restrict the term “uncertainty” to cases of the non-quantitive type.

Incidental risks are those which occur naturally in the business, but are not part of the core of the
business. Inherent risks have a negative effect on the operating profit of the business.

QUESTIONS:

1. Explain the concepts of Risk and Uncertainty?

2. What is Risk?
3. Define Uncertainty?

65
 CHAPTER - XI

NATIONAL INCOME :
CONCEPT AND MEASUREMENT
OBJECTIVE
National income is the final outcome of all economic activities of a nation valued in terms of money.
National income is the most important macroeconomic variable and determinant of the business level and
environment of a country. The level of national income determines the level of aggregate demand for goods
and services. Its distribution pattern determines the pattern of demand for goods and services, i.e., how
much of which good is demanded. The trend in national income determines the trends in aggregate demand
and also the business prospectus. Therefore, business decision makers need to keep in mind these aspects
of the national income, especially those having long-run implications. National income or a relevant component
of it is an indispensable variable considered in demand forecasting.Measures of national income and output
are used in economics to estimate the value of goods and services produced in an economy. They use a
system of national accounts or national accounting first developed during the 1940s. Some of the more
common measures are Gross National Product (GNP), Gross Domestic Product (GDP), Gross National
Income (GNI), Net National Product (NNP), and Net National Income (NNI). Formerly in the Soviet
Union and its friendly states COMECON, Net Material Product (NMI) was estimated (NNP-Services).
In relation to greening the national accounts the United States Congressional Budget Office concludes “a
gradual process of modifying measures of national economic performance is consistent with the history and
development of the national accounts.”

Definition of National Income:

Conceptually, national income is the money value of the end result of all economic activities of the
nation. Economic activities generate a large number of goods and services, and make net addition to the
national stock of capital. These together constitute the national income of a ‘closed economy’-an economy
which has no economic transaction with the rest of the world. In an ‘open economy’, national income
includes also the net results of its transactions with the rest of the world (i.e., exports less imports).

Economic activities should be distinguished from the non-economic activities from a national point
of view. Broadly speaking, economic activities include all human activities which create goods and services
that can be valued at market price. Economic activities include production by farmers (whether for household
consumption or for market), production by firms in the industrial sector, production of goods and services
by the government enterprises, and services produced by business intermediaries (wholesalers and retailers),
banks and other financial organizations, universities, colleges and hospitals, etc. On the other hand, non-
economic activities are those which produce goods and services that do not have any economic value. Non-
economic activities include spiritual, psychological, social and political services. The non-economic category

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of activities also includes hobbies, service to self, services of members of family to other members and
exchange of mutual services between neighbors.

We have defined national income from the angle of product flows. The same can be defined
in terms of money flows. While economic activities generate flow of goods and services, on the one
hand, they generate money flows, on the other, in the form of factor payments-wages, interest, rent,
profits, and earnings of self-employed. Thus, national income may also be obtained by adding the factor
earnings and adjusting the sum for indirect taxes and subsidies. The national income thus obtained is known
as national income at factor cost. It is related to money income flows.
The concept of national income is linked to the society as a whole. It differs fundamentally from
the concept of private income. Conceptually, national income refers to the money value of the entire final
goods and services resulting from all economic activities of the country. This is not true of private income.
Also from the calculation point of view, there are certain receipts of money or of services and goods that
are not ordinarily included in private incomes but are included in the national incomes, and vice versa. National
income includes, for example, employee’s contribution to the social security and welfare funds for the benefit
of employees, profits of public enterprises, and services of owner occupied houses. But it excludes the
interest on war-loans, social security benefits and pensions. These items are, however, included in the private
incomes. The national income is, therefore, not merely an aggregation of the private incomes. One can
however obtain an estimate of national income by summing up the private incomes after making necessary
adjustments for the items excluded from the national income.

MEASURES OF NATIONAL INCOME : -

Gross National Product (GNP) :

The GNP is defined as the value of all final goods and services produced during a specific period,
usually one year, plus incomes earned aboard by the nationals minus incomes earned locally by the foreigners.
The GNP so defined is identical to the concept of gross national income (GNI). Thus, GNP = GNI. The
difference between the two is only of procedural nature. While GNP is estimated on the basis of product-
flows, the GNI is estimated on the basis of money income flows, (i.e., wages, profits, rent, interest, etc.).

Gross Domestic Product (GDP):

The Gross Domestic Product (GDP) is defined as the market value of all final goals and services
produced in the domestic economy during a period of one year, plus income earned locally by the foreigners
minus incomes earned abroad by the nationals. The concept of GDP is similar to that of GNP with a significant
procedural difference. In case of GNP the incomes earned by the nationals in foreign countries are added
and incomes earned locally by the foreigners are deducted from the market value of domestically produced
goods and services. In case of GDP, the process is reserve-incomes earned locally by foreigners are added
and incomes earned abroad by the nationals are deducted from the total value of domestically produced
goods and services.
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Net National Product (NNP):

NNP is defined as GNP less depreciation, i.e., NNP = GNP - Depreciation.

Depreciation is that part of total productive assets which is used to replace the capital worn out
in the process of creating GNP. Briefly speaking, in the process of producing goods and services (including
capital goods), a part of total stock of capital is used up. ‘Depreciation’ is the term used to denote the
worn out or used up capital. An estimated value of depreciation is deducted from the GNP to arrive at
NNP.

The NNP, as defined above, gives the measure of net output of net output available for consumption
by the society (including consumers, producers and the government). NNP is the real measure of the national
income. NNP = NNI (net national income). In other words, NNP is the same as the national income at
factor cost. It should be noted that NNP is measured at market prices including direct taxes. Indirect taxes
are however, not a point of actual cost of production. Therefore, to obtain real national income, indirect
taxes are deducted from NNP.

Thus, NNP- Indirect taxes = National Income

METHODS OF MEASURING NATIONAL INCOME :

For measuring national income, the economy through which people participate in economy through
which people participate in economic activities, earn their livelihood, produce goods and services and share
the national products is viewed from three different angles.

1. The national economy is considered as an aggregate of producing units combining different sectors
such as agriculture, mining, manufacturing, trade and commerce, etc.

2. The whole national economy is viewed as a combination of individuals and households owing different
kinds of factors of production which they use themselves or sell factor-services to make their
livelihood.

3. The national economy may also be viewed as a collection of consuming, saving and investing units
(individuals, households and government).

Following these notions of a national economy, national income may be measured by three different
corresponding methods:

1. Net product method- when the entire national economy is considered as an aggregate of producing
units;

2. Factor-income method-when national economy is considered as combination of factor-owners and

users;

3. Expenditure method- when national economy is viewed as a collection of spending units.

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 The procedures which are followed in measuring the national income in a closed economy-an
economy which has no economic transactions with the rest of the world-are briefly described here. The
measurement of national income in an open economy and adjustment with regard to income from abroad
will be discussed subsequently.

Net Output or Value Added Method:

The net output method is also called the value added method. In its standard form, this method
consists of three stage: “(i) estimating the gross value of domestic output in the various branches of production;
(ii) determining the cost of material and services used and also the depreciation of physical assets; and (iii)
deducting these costs and depreciations from gross value to obtain the net value of domestic output…….”
. The net value of domestic product thus obtained is often called the value added or income product which
is equal to the sum of wages, salaries, supplementary labour incomes, interest, profits, and net rent paid or
accrued. Let us now describe the stage (i) and (ii) in some detail.

Measuring Gross Value:

For measuring the gross value of domestic product, output is classified under various categories
on the basis of the nature of activities from which they originate. The output classification varies from country
to country depending on (i) the nature of domestic activities; (ii) their significance in aggregate economic
activities, and (iii) availability of requisite data. For example, in the US, about seventy-one divisions and
subdivision are used to classify the national output; in Canada and the Netherlands, classification ranges
from a dozen to a score; and in Russia, only half a dozen divisions are used. According to the CSO
publication, fifteen sub-categories are currently used in India.

Estimating Cost of Production :-

The next step in estimating the net national product is to estimate the cost of production including
depreciation. Estimating cost of production is, however, a relatively more complicated and difficult task
because of non-availability of adequate and requisite data. Much more difficult is the task of estimating
depreciation since it involves both conceptual and statistical problems. For this reason, many countries adopt
factor-income method for estimating their national income.

Factor- Income Method:

This method is also known as income method and factor-share method. Under this method, the
national income is calculated by adding up all the “incomes accruing to the basic factors of production used
in producing the national product”. Factors of production are conventionally classified as land, labour, capital
and organization. Accordingly, the national income equals the sum of the corresponding factor earning. Thus,
National income = Rent + Wages + Interest + Profit

Labour Incomes:

Labour incomes included in the national income have three components: (a) wages and salaries
paid to the residents of the country including bonus and commission, and social security payments; (b)

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supplementary labour incomes including employer’s contribution to social security and employees welfare
funds, and direct pension payments to retired employees; (c) supplementary labour incomes in kind, e.g.,
free health and education, food and clothing, and accommodation, etc.

Capital Incomes:

According to Studenski, capital incomes include the following capital earnings:

1. dividends excluding inter-corporate dividends;

2. undistributed before-tax profits of corporations;

3. interest on bonds, mortgages, and saving deposits (excluding interests on war bonds, and on
consumer-credit);

4. interest earned by insurance companies and credited to the insurance policy reserves;

5. net interest paid out by commercial banks;

6. net rents from land, buildings, etc., including imputed net rents on owner occupied dwellings;

7. royalties; and

8. profits of government enterprises.

Mixed Income:

Mixed incomes include earnings from (a) farming enterprises, (b) sole proprietorship (not included
under profit or capital income); and (c) other professions e.g., legal and medical practices, consultancy
services, trading and transporting etc. This category also includes the incomes of those who earn their living
through various sources as wages, rent on own property, interest on own capital, etc.

Expenditure Method :

The expenditure method, also known as final product method, measures national income at
the final expenditure stages. In estimating the total national expenditure, any of the two following
methods are followed: first, all the money expenditure at market price are computed and added up
together, and second, the value of all the products finally disposed of are computed and added up,
to arrive at the total national expenditure. The items of expenditure which are taken into account
under the first method are (a) private consumption expenditure; (b) direct tax payments, (c) payments
to the non-profit-making institution and charitable organizations like schools, hospitals, orphanages,
etc.: and (d) private savings. Under the second method, the following items are considered: (a) private
consumer goods and services; (b) private investment goods; (c) public goods and services; and (d) net
investment abroad. The second method is more extensively used because the data required in this method
can be collected with greater ease and accuracy.

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Treatment of Net Income from Abroad:

We have so far discussed methods of measuring national income of a ‘closed economy’. But most
economies are open in the sense that they carry out foreign trade in goods and services and financial
transactions with the rest of the world. In the process, some nations get net income through foreign trade
while some lose their income to foreigners are deducted from the total national income arrived at through
any of the above three methods.

SUMMARY

The total net value of all goods and services produced within a nation over a specified period of time,
representing the sum of wages, profits, rents, interest, and pension payments to residents of the nation.

There are at least two or three different ways of calculating these numbers. The expenditure approach
determines aggregate demand, or Gross National Expenditure, by summing consumption, investment, gov-
ernment expenditure and net exports. On the other hand, the income approach and the closely related output
approach can be seen as the summation of wages, rents, interest, profits, no income charges, and net foreign
factor income earned. The three methods must yield the same results because the total expenditures on goods
and services (GNE) must by definition be equal to the value of the goods and services produced (GNP)
which must be equal to the total income paid to the factors that produced these goods and services (GNI).

In actual fact, there will be minor differences in the results obtained from the various methods due to
changes in inventory levels. This is because goods in inventory have been produced (and therefore included in
GDP), but not yet sold (and therefore not yet included in GNE). Similar timing issues can also cause a slight
discrepancy between the value of goods produced (GDP) and the payments to the factors that produced the
goods, particularly if inputs are purchased on credit. Gross National Product (GNP) is the total value of all
final goods and services produced by a country’s factors of production and sold on the market in a given time
period. Gross Domestic Product (GDP) is the total value of final goods and services produced within a
country’s borders in a year. GDP counts income according to where it is earned rather than who owns the
factors of production. In the above example, all of the income from the car factory would be counted as US
GDP rather than German GDP. To convert from GNP to GDP you must subtract factor income receipts from
foreigners that correspond to goods and services produced abroad using factor inputs supplied by domestic
sources. To convert from GDP to GNP you must add factor input payments to foreigners that correspond to
goods and services produced in the domestic country using the factor inputs supplied by foreigners.

QUESTIONS:

1. Define National Income?

2. Explain the measures and methods of national income?

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 CHAPTER - XII

BUSINESS CYCLES AND STABILIZATION

OBJECTIVE
The historical evidence, however, shows that most economies of the world have experienced
business cycles at different stages of their economic growth. The economic history of various economies is,
in a fact, a history of ups and downs, booms and slumps, prosperity and depression. Briefly speaking, business
cycles have characterized the free enterprise industrial world over the past one and half centuries. If frequent
and violent fluctuations are not taking place in the world economies, it is mainly because of government’s
intervention with the market system with its corrective policy measures. Yet, the global inflation and world
economic recession of the 1980’s are a clear warning against any complacency towards the dangers of
economic fluctuations.

Business cycles, i.e., boom in one period and slump in another, in economic activities, are essentially
perpetual features of the economic environment of a country. They influence business decisions tremendously
and set the trend for future business decisions tremendously and set the trend for future business. The period
of prosperity opens up new and larger opportunities for investment, employment and production, and thereby
promotes business. On the contrary, the period of depression reduces business opportunities. A profit-
maximizing entrepreneur must, therefore, analyze the economic environment of the period relevant for his
important business decisions, particularly those pertaining to forward planning.

PHASES OF BUSINESS CYCLES :

Business cycles, the periodic booms and slumps in economic activities, are generally compared to
‘ebb and flow’. The ups and downs in the economy are reflected by the fluctuations in aggregate economic
magnitudes, including production, investment, employment, prices, wages, bank credits, etc. The upward
and downward movements in these magnitudes show different phases of business cycles. Basically, there
are only two phases in a cycle, viz., prosperity and depression. However, considering the intermediate stages
between prosperity and depression, the various phases of trade cycle may be enumerated as follows :

1. Expansion of economic activities,

2. Peak of boom or prosperity,

3. Recession, the downtrend,

4. Trough, the bottom of depression, and

5. Recovery and expansion.

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 The five phases of a business cycle are presented in the figure given below

Steady Growth Line

Prosperity

Expansion
Growth rates

Peak

Recession
Expansion

Recovery
Prosperity

Depression

Line of cycle
Trough

0 Time
The steady growth line shows the growth of the economy when there are no business cycles.
The various phases of business cycles are shown by the line of cycle which moves up and down the
steady growth line. The line of cycle moving above the steady growth line marks the beginning of
the period of ‘expansion’ or ‘prosperity’ in the economy. The expansion phase is characterized by
increase in output, employment, investment aggregate demand, sales, profits, bank credits, wholesale
and retail prices, per capita output and a rise in standard of living. The growth rate eventually slows
down and reaches its peak. The peak is generally characterized by slacking in the expansion rate
and the end of expansion. It foretells the downward slide in the economic activities from the peak.
The phase of recession begins when the downward slide in the growth rate becomes rapid and steady.
Output, employment, prices, etc. register a rapid decline, though the realized growth rate may still
remain above the steady growth line. So, as long as growth rate exceeds or equals the expected steady
growth rate, the economy enjoys the period of prosperity-high and low. But, when the growth rate
goes below the steady rate, it marks the beginning of depression in the economy.

In a stagnated economy, depression begins when growth rate turns negative i.e., total output,
employment, prices, bank advances, etc., decline during the subsequent periods. The span of
depression spreads over a period during the growth rate stays below the secular growth rate or below
the zero growth rate in a stagnated economy. ‘Trough’ is the phase during which the down-trend in
the economy slows down and eventually stops, and the economic activities once again register an
upward movement with a lapse of time. Trough is the period of most sever strain on the economy.
When the economy registers a continuous and rapid upward trend in output, employment, etc., it
enters the phase of recovery though the growth rate may still remain below the steady growth rate.
And, when the growth rate crosses the line of steady growth rate, the economy once again enters the
phase of expansion and prosperity. If economic fluctuations are not controlled by the government,
business cycles continue to recur as stated above.
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Turning – Point and Recession :

As already mentioned, once the economy reaches the peak, increase in demand is halted.
The demand starts even decreasing in some sectors, for the reason stated above. Procedures, on the
other hand, unaware of this fact continue to maintain their existing levels of production and investment.
As a result, a discrepancy arises between output supply and demand: supply exceeds demand. The
growth of this discrepancy between supply and demand is so slow that it goes unnoticed for sometime.
However, producers suddenly realize that their inventors are piling up. This situation might appear
in a few industries at the first instance, but later it spreads to other industries also. Initially, it might
be taken as a problem arisen out of minor maladjustment. But, the persistence of the problem makes
the producers believe that they have indulged in ‘over-investment’ and over-production. Consequently,
future investment plans are given up; orders placed for new equipments, raw materials and other
inputs are cancelled. Replacement of worn-out capital is postponed. Demand for labour ceases to
increase; rather, temporary and casual workers are laid off in a bid of bring demand and supply in
balance. The cancellation of orders for inputs by the producers of consumer goods creates a chain-
reaction in the input market. Producers of capital goods and raw materials cancel their orders for
their input. This is the turning point ad the beginning of recession.

Since demand for inputs has decreased, input prices, e.g., wages, interest, etc., show a gradual
decline leading to a simultaneous decrease in the incomes of wage and interest earners. This ultimately
causes demand recession. On the other hand, producers lower their price in order to get rid of their
inventors and also to meet their financial obligations. Consumers, is their turn, expect a further
decrease in price, and hence, postpone their purchases. As a result, the discrepancy between demand
and supply continues to grow. When this process gathers speed, it tales the form of irreversible
recession. Investments start declining. The decline in investment leads to decline in income and
consumption. The process is exactly reverse of expansion. When investments are curtailed, production
and employment decline resulting in further decline in demand for both consumer and capital goods.
Borrowings for investment decreases; bank credit shrinks; stock prices decreases; unemployment
increases even though there is a fall in wage rates. At this stage, the process of recession is complete
and the economy enters the phase of depression.

How is the Process Reversed ?

The factors that reverse the downswing vary from cycle to cycle like factors responsible for
business cycle vary from cycle to cycle. The basic thing is that there is a limit to which an economy
can go down. When the economy hits the bottom and stays there for sometime, it marks the end of
pessimism and beginning of optimism. This reverses the process. The process of reversal generally
begins in the labour market. The widespread unemployment forces workers to work at wages less
than the prevailing rates. The producers anticipating better future try to maintain their capital stock
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and offer jobs to some workers here and there. They do so also because they begin to take an optimistic
view of the situation due to the halt in decrease in price in the trough phase. Consumers on their part
expecting no further decline in price begin to resume their postponed consumption and hence demand
picks up, though gradually. Bankers having accumulated excess liquidity (idle cash reserve) try to
salvage their financial position by lowering the lending rate and by investing their funds in securities
and bonds, even if rate of return is very low. Similar action is taken by the private investors.
Consequently, security prices move up and interest rate move down ward. On the other hand, stock
prices begin to rise for the simple reason that fall in stock prices comes to an end and an optimism is
underway in the stock market.

The Recovery :

As the recovery gathers momentum, some firms plan additional investment, some undertake
renovation programmes, and some undertake both. These activities generate construction activities
in both consumer and capital good sectors. Individuals who had postponed their plans to construct
should mount. As a result, more and more employment is generated in the construction sector. As
employment increases despite wage rates moving upward, the total wage incomes increase at a rate
higher than employment rate. Wage income rises and so does the consumption expenditure.
Businessmen realizing a quick return with high profitability, speed up the production machinery.

ECONOMIC STABILIZATION POLICIES

Business cycles, especially the violent fluctuations in economic activities, cause not only
harm to business but also misery to human beings by creating unemployment and poverty during
the depression period. Economists and the government have, of late, felt concerned with the
consequences of business cycles and suggested various ways and means to control economic
fluctuations. The realization of need for stabilizing economy and, thereby, preventing severe economic
ups and downs came quite recently. Till the Great Depression of 1930’s there prevailed an orthodox
economic belief that ‘invisible market forces,’ would automatically maintain balance in the economy.
It was rather suggested that the economic activities should be left alone to take their own course.
The Great Depression, however, proved this belief untenable. The experience of the Great Depression
and Keynesian revolution in mid-1930’s assigned a big role of the government in maintaining
economic growth and preventing unemployment and business fluctuations. Therefore, the government
interventions with the economy all over the world increased in a big way. The government in free
enterprise economies not only entered the production of commodities and services but also adopted
a number of fiscal and monetary measures to control and regulate the private economy and prevent
violent economic fluctuations. The governments in many developing countries like India assumed
the role of a key player in economic growth, employment and stabilization.

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Concept and Objectives of Stabilization

The major objectives of Stabilization policies are :

1. preventing excessive economic fluctuations, making allowance for fluctuations necessary

for a long-term, sustained economic growth;

2. efficient utilization of labour and other productive resources as far as possible;

3. encouraging free competitive enterprise with minimum interference with the functioning of
the market economy; and

4. avoiding as far as possible, the conflict between the internal and external interests of the
economy.

The two most important and widely used economic policies to achieve economic stability
are (i) fiscal policy; and (ii) monetary policy.

Fiscal Policy

The ‘fiscal policy’ refers to the government policy of changing its taxation and public
expenditure programmes intended to achieve certain predetermination objectives. Taxation is measure
of transferring funds from the private purses to the public coffers; it amounts to withdrawal of funds
from the private use. Public expenditure, on the other hand, increases the flow of funds in the economy.
Thus, taxation reduces private disposable income and, thereby, the private expenditure. The public
expenditure, on the other hand, increases private incomes and, thereby, the private expenditure. Since
tax-revenue and public expenditure from the two sides of the government budget, the taxation and
public expenditure policies are also jointly called as ‘budgetary policy.’

Fiscal or budgetary policy is regarded as a powerful instrument of economic stabilization.

If fiscal policy of the government is so formulated that it generates additional purchasing power during
the period of expansion, it is known as ‘counter-cyclical fiscal policy.’

Public Expenditure and GNP.

An increase in public expenditure raises the level of GNP. The size of increase in the GNP
as a result of additional public expenditure is determined by the multiplier. Public expenditure in the
form of purchase of goods and services household incomes-wage, interest, rent and business profit-
which in turn increase government’s tax revenue.

Taxation and GNP

Direct taxes without an equivalent public expenditure have adverse effect on GNP. Direct
taxes have, therefore, a deflationary impact on the economy. Increase in taxation through increase in
the rates of existing taxes and imposition of new taxes reduces GNP. The size of decrease in GNP
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as a result of increase in taxation depends on the tax-multiplier. The multiplier in case of taxation
works in the reverse direction. Reverse multiplier or tax-multiplier will be 1 less than public-expenditure
multiplier, even if mpc is same in both the cases.

Problems in formulating Counter-Cyclical Fiscal policy : -

1. All expenditures do not have the same multiplier effect. For example, transfer payments by
the government do not create a demand for goods and services. Some kinds of public
expenditures (e.g., those on free education and hospital facilities) replace the private
expenditure

2. Not all tax-changes have the same multiplier effect. For example, taxes paid by the upper income
groups have lower multiplier effect than those paid by the lower income groups, because of
differences in their mpc. The multiplier effects of indirect taxes are not clearly known.

3. Deficit financing through public borrowing may reduce private investment through crowding out
effect. This kind of deficit financing reduces the multiplier effect.

4. There are practical difficulties with regard to the assessment of time-lags and accuracy of forecasts.
There is uncertainty with regard to effectiveness of fiscal policy.

Monetary Policy:

Monetary policy refers to the central bank’s programme of changing monetary variables,
viz., total supply of money, interest rates and credit rationing, to achieve certain predetermined
objectives. One of the primary objectives of monetary policy is to achieve economic stability. The
following are the traditional monetary instruments through which a central bank carries out the
monetary policies.

1. open market operations,

2. changes in bank rate (or discount rate), and

3. changes in the statutory reserve ratios.

Briefly speaking, open market operation by the central bank is the sale and purchase of
government treasury bills, securities, etc., to and from the public. Bank rate is the rate at which central
bank discounts the commercial bank’s bills of exchange or first class bills. The statutory reserve
ratio (SRR) is the proportion of commercial banks time and demand deposits which they are required
to deposit with the central bank or keep cash-in-vault. All these instruments when operated by the
central bank reduce (or enhance) directly and indirectly the credit creation capacity of the commercial
banks and thereby reduce (or increase) the flow of funds from the banks to the public. The pattern
of use and working of these instruments is described here briefly.

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1. Open Market Operations :

During the period of expansion, the central bank sells the government bonds and securities to the
public. The sale of securities depresses their price on the one hand, and results in withdrawal of money
from the public. To the extent the government securities are purchased through the transfer of bank deposits
to the central bank account, it reduces the credit creation capacity of the commercial banks.

2. The Bank Rate or Rediscount Rate:

Where the objective is to control inflation, the central bank raises the bank rate. A rise in the
bank rate increases the cost of borrowing from the central bank. Following the increase in bank rate,
commercial banks raise their own discount rates for the public. The increase in cost of borrowing discourages
the borrowing from the commercial banks. Thus, the flow of money towards the private economy is restrained.

3. The Statutory Reserve Ratio (SSR) :

When the central bank wants to reduce the credit creation capacity of the commercial banks, it
increases the ratio of their demand and time deposits to be held as reserve with the central bank, and vice
versa.

Selective Credit controls and Moral Suasion:

In addition to the instruments discussed above, central banks often use various selective credit
control measures and moral suasion. The selective credit controls are intended to control the credit flows to
particular sectors without affecting the total credit, and also to change the composition of credit from an
undesirable to a desirable pattern. Moral suasion is a persuasive method to convince the commercial banks
to carry out their business in accordance with the demand of the time and in the interest of the nation.

The fiscal and monetary polices may be alternatively or simultaneously used to control business
cycles in the economy. The choice of the policy should be made in view of their suitability, applicability and
their limitations. The policy needs of a country vary from problem to problem and therefore the choice of
policy. For instance, monetary policy is considered to be more effective to control inflation than to control
depression. It is, however, always desirable to adopt a proper mix of fiscal and monetary policies to check
the business cycles. It is essential also because both the polices have their own limitations. Therefore, an
appropriate mix of fiscal and monetary policies would always prove more effective than a single policy.
Besides, a proper mix of the two policies is essential also because it would avoid the possible conflict between
them. It is therefore, always desirable to formulate a counter-cyclical policy with a proper co-ordination of
fiscal and monetary polices.

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SUMMARY

A business cycle is a short-run repetitive change in real output. During the cycle output grows faster,
then slower, eventually declines, and then recovers. The expansion is the phase of a business cycle when the
rate of growth of output is positive and increasing. Coming out of a trough, the economy goes through an initial
period of “recovery”. The recovery is marked by a sharp upturn in economic activity and, generally, very
rapid growth. The rapidity of the growth depends on how much excess capacity is left over from the previous
downturn. The more excess capacity, the more rapidly the economy grows during the recovery. Once the
expansion is well under way, the economy enters a period of “prosperity” . An expansion is also called an
“upturn” or “upswing.” When the economy is expanding, but at a rate below its long-run average, the period
is called a “growth recession.”

The peak is the phase of a business cycle when the rate of growth of real output is at its highest. A
peak is also called “boom.” The contraction is the phase of a business cycle when the rate of growth of output
is falling. First, the economy experiences a slowdown. Eventually, the rate becomes negative and real output
actually declines. A contraction is also called a “downturn” or “downswing.” Contractions are sometimes
distinguished by their length and severity. A recession is generally not very long in duration nor severe in terms
of the hardships it creates for the unemployed. Officially, the U.S. economy is in a recession when real output
declines in two successive quarters (six months).A depression is generally longer in duration and more severe
than a recession. However, the U.S. has no identifiable measure of when a recession becomes a depression
and the fact is that some of the so-called “depressions” of the 19th century were shorter and milder than the
more recent “recessions” of 1973-75, 1981-83, and 1989-1993. The truth is that, after the Great Depres-
sion, which lasted from 1929-1939, the term “depression” had such a negative connotation that, for political
reasons, contractions were renamed “recessions.” The trough is the phase of a business cycle when the rate
of growth or level of real output is at its lowest . A trough is also called a “bust”! A growth recession is a period
when the economy is growing, but at a rate below its historical (long-run) average rate of growth. In a growth
recession, the unemployment rate generally increases, because the economy is not expanding fast enough to
absorb all new entrants into the labor force.

QUESTIONS:

1. Explain the phases of Business Cycles? How is the process reversed?

2. What are economic stabilization policies? Discuss its objectives and concept?

79
 MODEL QUESTION PAPER
National Institute of Business Management
Chennai - 020

THIRD SEMESTER MBA

Subject : Managerial Economics

Time : 3 hours Marks : 100

Section A

I Answer all questions. Each question carries 2 marks :-

1. Define Managerial Economics.
2. What is ‘OR’ in Managerial Economics?
3. What is the meaning of ‘Demand’ in business firms?
4. Which are the two approaches for the analysis of consumer behaviour?
5. Define Market Demand.

5x2=10 marks
Section B

II Answer all questions. Each question carries 6 marks :-

1. What is Managerial Economics?
2. What is ‘Utility’ in consumer demand?
3. What do you mean by Cardinal Utility approach in the analysis of consumer behaviour?
4. Explain the types of Market Demand.
5. What are the determinants of Market Demand?
5x6=30 marks
Section C

III Answer any three questions. Each question carries 20 marks :-

1. Explain the scope of Managerial Economics.
2. Write briefly on objectives of Business firms.
3. Explain the concepts of demand elasticities used in business decisions.
4. Write briefly about the techniques of Forecasting Demand.
5. Explain the categories of lost concept which are relevant to business operations and deci-
sions.

3x20=60 marks